Published by Bob Ciura on November 14th, 2017
The Dividend Aristocrats are the dividend “cream of the crop”, but even Dividend Aristocrats encounter challenges from time to time.
The Dividend Aristocrats are a group of 51 companies in the S&P 500 Index, with 25+ consecutive years of dividend increases.
We review all 51 Dividend Aristocrats each year. The next stock in the series is healthcare distributor Cardinal Health (CAH).
Cardinal Health is currently challenged by falling pharmaceutical prices. This has caused the stock to lose approximately 19% of its value year-to-date.
However, the company has increased its dividend for 32 years in a row. Its most recent increase was a 3% hike on May 3rd.
It can continue to raise its dividend, because it still generates more than enough cash flow support annual increases. While it has encountered tougher competition recently, it is still highly profitable, with the potential for future growth.
Lastly, Cardinal Health has an attractive valuation and a solid 3.2% dividend yield.
This article will discuss why Cardinal Health is a buy.
Business Overview
Cardinal Health was founded in 1971. Today, it is a giant in the healthcare supply industry. It has approximately 50,000 employees, operates in 60 countries, and generates annual revenue of approximately $129 billion.
Source: 2017 Annual Stockholder Meeting, page 5
The company has two operating segments:
- Pharmaceutical (89% of revenue)
- Medical (11% of revenue)
The pharmaceutical segment distributes branded and generic drugs, and consumer products. It distributes these products to hospitals and other healthcare providers.
The medical segment distributes medical, surgical, and laboratory products to hospitals, surgery centers, clinical laboratories, and other service centers.
The business climate for Cardinal Health is challenged. Falling drug prices has negatively impacted margins in the company’s core pharmaceutical segment.
As a result, Cardinal Health’s strong performance has slowed down over the past year. For example, in fiscal 2016, revenue and operating profit increased 19% and 18%, respectively.
In fiscal 2017, while revenue increased 7% earnings-per-share declined 7%. Excluding non-recurring expenses, adjusted earnings-per-share increased 3% last fiscal year.
One of the biggest challenges for Cardinal is drug price deflation, driven by increased shipments of generics. Pharmaceutical segment revenue increased 7% in 2017, but operating profit fell by 12%. Pricing drove margin erosion in the pharmaceutical segment in fiscal 2017, and will continue to do so.
Adding to this are reports that e-commerce retail giant Amazon (AMZN) is preparing to enter the medical supply business. This would only further the competitive pressures facing Cardinal Health.
Fiscal 2018 will be a difficult year for Cardinal Health, which has caused the stock valuation to contract. However, the company still has a viable path for a return to long-term growth.
Growth Prospects
Slowly but surely, Cardinal Health is regaining momentum.
In the fiscal 2018 first quarter, revenue increased 2%, and adjusted earnings-per-share declined 12%. Not surprisingly, the pharmaceutical segment continued to struggle.
Source: First-Quarter Earnings Presentation, page 5
Management expects adjusted earnings-per-share of $4.85 to $5.10 in 2018, which would be a decline of 5% to 10% from last year.
Fortunately, the medical segment is helping to cushion the impact of lower pharmaceutical product margins. In fiscal 2017, medical revenue and operating profit increased by 9% and 25%, respectively.
And, there are catalysts to return to earnings growth. Cardinal Health is investing organically and through acquisitions.
In the past five fiscal years, the company utilized $7 billion for acquisitions. It invested another $1.6 billion in capital expenditures in that time. There was plenty of cash left over for shareholder returns.
Source: 2017 Annual Report, page 15
The result of this investment is that Cardinal Health now has a huge branded portfolio, which consists of nearly 12,000 product SKUs, in 850 categories.
Going forward, there are multiple catalysts for the pharmaceutical segment to improve. These include moderating price deflation, growth in specialty products, and cost cuts.
In addition, price deflation in pharmaceuticals has eased as of late. Last quarter, the rate of deflation in generics was less than at the same time last year.
Stabilization of pricing is boosted by the company’s joint venture with CVS Health (CVS), called Red Oak Sourcing. Joining forces helps the two companies negotiate better generic pharmaceutical prices.
Cardinal Health also recently acquired the Patient Recovery business from Medtronic (MDT) for $6.1 billion, which will broaden the company’s product offerings. Cardinal Health management expects the Patient Recovery acquisition to add $0.21 of earnings-per-share in 2018, and $0.55 in 2019.
Competitive Advantages & Recession Performance
The biggest competitive advantage for Cardinal Health is its distribution capabilities, which make it very difficult for competitors to successfully enter the market.
Cardinal Health distributes its products to nearly 85% of U.S. hospitals. It also serves more than 24,000 pharmacies. The company’s home healthcare business serves 2 million patients, with nearly 50,000 products.
And, Cardinal Health operates in a stable industry, with high demand. The company should remain steadily profitable, as there will always be a need for pharmaceutical products to be distributed.
However, Cardinal Health is not immune from recessions. Its earnings-per-share declined significantly during the Great Recession:
- 2007 earnings-per-share of $3.41
- 2008 earnings-per-share of $3.80 (11% increase)
- 2009 earnings-per-share of $2.26 (40% decline)
- 2010 earnings-per-share of $2.22 (1.8% decline)
That said, the 2009 spin-off of CareFusion distorted Cardinal Health’s GAAP earnings that year. The core business still performed relatively well, and earnings returned to growth in 2011 and beyond.
Valuation & Expected Returns
Cardinal Health had GAAP earnings-per-share of $4.03 in fiscal 2017. As a result, the stock has a price-to-earnings ratio of 14.3. Cardinal Health is currently valued well below its 10-year average, of 16.9.
Source: Value Line
Based on fiscal 2017 adjusted earnings-per-share of $5.40, Cardinal Health stock trades for a price-to-earnings ratio of 10.7. This is a very low valuation, which reflects the high degree of market pessimism.
If the company can return to positive earnings growth, it could easily justify a higher valuation. This would generate significant returns. If Cardinal Health returned to its 10 year average valuation multiple of 16.9, it would generate returns of 58% from current levels.
In addition to multiple expansion, future returns could be generated from earnings growth and dividends.
Revenue growth of 3% to 5% per year, along with margin expansion from cost cuts and acquisition-related synergies, could propel double-digit earnings growth moving forward.
With dividends, total returns could reach the following levels:
- 3%-5% revenue growth
- 1%-2% margin expansion
- 1% share repurchases
- 3% dividend yield
In this scenario, total returns could reach 8%-11% per year. This forecast could prove overly conservative, if margins expand at a higher-than-expected rate.
In total, we believe Cardinal Health stock to have a fair value estimate of $82 per share. At that price, it would have a price-to-earnings ratio of 16.5, based on the midpoint of 2018 earnings guidance. This would represent a 40% return, not including dividends.
Final Thoughts
The economics of the healthcare distribution industry have deteriorated over the past year. This has impacted all the major players, including Cardinal Health.
However, high-quality companies like Cardinal Health have withstood difficult periods before, and will do so again.
The factors impacting the stock in the short-term may simply be a great buying opportunity.
