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Cardinal Health reset investor expectations lower when it cut its fiscal 2017 guidance late October. The company operates in an attractive oligopolistic industry and is trading at less than 14 times current fiscal-year earnings with a free cash flow yield north of 10%. Is it worth a look?
By Alexander J. Poulos and Brian Nelson, CFA
Overview
The bulk of Cardinal Health’s (CAH) massive $120 billion revenue stream is generated from the distribution of healthcare needs. The company operates a network of warehouses whose primary purpose is to distribute healthcare products to a broad swath of customers ranging from your local drug store to hospitals. Due to the expense and unpredictability of inventory needs, customers prefer the next day delivery option where they rely on wholesalers to deliver immediate solutions to their pressing healthcare requirements. For example, a rare med such as Albenza, an expensive treatment for intestinal parasites, is often not carried by the local pharmacies due to the enormous cost of the product. The wholesalers fill a critical need in the supply chain by making such products available, often the next day to take care of the healthcare needs of the community.
The wholesale business operates on razor-thin margins. Cardinal is no exception to this rule, as its $2.45 billion in operating earnings during 2015 earned it a meager 2.02% operating margin for the year – but that’s just the way of the distributor business (razor thin margins translate into material profits thanks to robust volume). Cardinal generates a far-higher margin on generic or multi-source medications than branded meds which carry a higher price tag, however. The most opportune time for the wholesale industry, in our view, is when a branded product loses patent exclusivity. Typically, the generic manufacturer that is first to file will be granted a six-month exclusivity period where they often charge in line with the branded product. Once the product is open to multi-source producers, a period exists where reimbursements are lowered to reflect the increase in competition. The margin often exceeds what is usually generated, setting up a virtuous profit cycle for the wholesale industry.
The wholesale industry carries an enormous amount of inventory (net inventories are about one third of total assets in Cardinal’s case, for example). Valued at the lower of cost or market (LIFO), as in the case of Cardinal, merchadise inventory held on the books generally tends to appreciate as prices usually advance with each passing year. For example, inventory purchased several reporting periods ago generally costs less than what is available on the market, netting the wholesale industry a larger reported profit margin (assuming there is a decrease in inventory levels that have experienced appreciation). Conversely, however, the opposite would be true as price deflation would have a negative impact on reported profit margins (or when there is a decrease in inventory levels that have experienced price declines). The latter is the current dilemma as generic price deflation works its way through the industry. The effect was most recently witnessed in Cardinal Health’s first-quarter 2017 results, where pharmaceutical segment profit margin dipped 76 basis points due to “generic pharmaceutical pricing and changes in product and customer mix,” even while revenue in its pharmaceutical division increased 14% on a year-over-year basis during the period. Pharmaceutical segment profit (about 80% of total) fell 19%.
The end demand for medications certainly remains robust, and while we suspect the deflationary environment is temporary, the timing of any recovery is difficult to predict, especially as politicians continue to badger pharma pricing in general. To help mitigate the impact of margin pressure in its pharmaceutical segment, however, the Cardinal management team has skillfully acquired complimentary lines of business outside of their core distribution arm. In addition to distributing branded, generic, specialty, and OTC pharmaceuticals, the company’s medical segment (about 20% of total company profit), while much smaller than its pharmaceutical one, distributes a broad range of medical, surgical, and laboratory products. It accounts for a far lower percent of overall revenue and profits, but the profitability of the medical segment business continues to move in the right direction. During the first quarter of fiscal 2017, revenue in the division advanced 12%, while segment profit increased 26% (segment margins leapt 42 basis points).
Oligopoly
The medical distribution industry operates as a virtual oligopoly, with the three largest players controlling over 85% of overall market share—McKesson (MCK) and AmerisourceBergen (ABC) are the other two players. As an oligopoly, pricing decisions tend to remain rational, and the characteristically low margins of the distribution industry often preclude a price war. Also, the recession-resistant nature of the business augurs well for the generation of excess free cash flow by participants.
New entrants are largely shut out, too. Once a distribution network is built, capital spending needs are minimal, allowing companies to earmark profits to either grow their businesses through bolt-on acquisitions or to reward shareholders via a combination of dividend increases and share repurchases. We like Cardinal’s industry dynamics, and the field remains rational with little incentive for a margin-crushing price war, in our view. Due to the stable pricing and high barriers to entry, it’s easy to understand why we assign Cardinal Health a very attractive Economic Castle rating.
Red Oak Sourcing
In July 2014, Cardinal entered into a generic drug sourcing agreement with CVS Health (CVS). The agreement allows the two entities to combine their respective buying power to negotiate a top rate price for generic drugs. We have been excited about the deal for two reasons. The primary reason is the tighter integration between the two companies. Due to the sourcing agreement, Cardinal has become a much more formidable rival against its two peers.
The second reason is the deal allows Cardinal to source products at the absolute lowest price, thus ensuring as robust a margin as possible. The cost savings from the Red Oak venture should help Cardinal mitigate margin pressure in its pharmaceutical division, partially serving to offset the deflationary forces that are plaguing the industry. The benefits from Red Oak Sourcing may be less significant in fiscal 2017 than in prior years, however, and we’d be remiss not to note that Cardinal’s sales and credit concentration with CVS is significant at more than 20%, respectively.
Financials
Cardinal Health is forecasting revenue to advance at a high-single-digit clip during fiscal 2017, and non-GAAP earnings per share to be in the range of $5.40-$5.60 for the year (was $5.48-$5.73 previously), up from $5.24 in fiscal 2016. The first quarter of fiscal 2017 witnessed non-GAAP earnings per share drop 10% on a year-over-year basis, so we expect fiscal 2017 to be back-end loaded when it comes to the company achieving its own forecasts. In addition to generic pharmaceutical pricing, reduced levels of branded inflation, stimulated by political pressures, could also act as a headwind to the company achieving its targeted bottom-line range. Customer attrition and increased expenses related to ongoing investments in its information systems are other areas that could pose challenges during the year, but even if the team comes up short, shares seem to offer a nice margin of safety.
We think Cardinal Health’s balance sheet is solid, even though it does hold a net debt position of ~$3.5 billion, as of the end of the first quarter of fiscal 2017 and up from ~2.6 billion at the end of the first quarter of the prior fiscal year. Though it is not a hard-and-fast rule and taking advantage of the low interest rate environment can be opportunistic at times, we tend to prefer equities that have strong net cash positions. That said, Cardinal’s net-debt-to-capital ratio of 35% at the end of the first quarter of fiscal 2017 isn’t too frightening, even though it is up 7 percentage points on a year-over-year basis. Cardinal Health also stands to benefit from proposed domestic tax law changes as the company is based in the US and pays a corporate tax rate of ~37%.
Conclusion
At Valuentum, we love free cash flow. A company’s ability to consistently grow cash flow from operations above the needs of the capital required to maintain the business leaves ample room to reward shareholders in the form of an increasing dividend and share repurchases. Cardinal Health exemplifies the type of company we tend to like.
The company generated ~$2.5 billion in free cash flow during fiscal 2016, ~$2.2 billion in fiscal 2015, and ~$2.3 billion in fiscal 2014 thanks to robust cash flow from operations generation and manageable capital spending. Capital spending is expected in the range of $400-$500 million during fiscal 2017, the midpoint slightly lower than the $465 million mark during fiscal 2016. On the basis of last year’s free cash flow, Cardinal’s equity is trading at a free-cash-flow yield of over 10%. We reiterate that it is very rare to find such a well-run company trading at a free cash flow above 10%, especially in today’s frothy market.
The company’s strong free cash flow generation should allow Cardinal Health to repurchase shares and continue to raise the dividend (at the time of this writing, its Dividend Cushion ratio was a solid 2.9). Cardinal Health is slated to repurchase between 8-10 million of its undervalued shares before the close fiscal year 2017, which concludes in June 2017. Also, the yearly dividend of $1.80 per share equates to a yield of 2.4%, which isn’t too shabby. Though there are myriad risks, including generic price deflation and concentration to CVS Health, Cardinal Health’s attractive free cash flow yield and earnings multiple of less than 14 times 2017 expected earnings may make it one worth considering. Though we’re not quite ready to include the company in the Dividend Growth Newsletter portfolio just yet, we wanted to get this one in front of you. We think it is worth a look.
Healthcare Products Distributors: ABC, CAH, ESRX, HSIC, MCK, OMI, PDCO, STAA