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Healthcare product distributor and Dividend Aristocrat Cardinal Health has had its share price performance in 2018 dampened by a number of factors, including generic drug price deflation weighing on its ‘Pharmaceutical’ segment, struggles in its ‘Medical’ segment, and the potential for disruption within its industry.
By Kris Rosemann
The drug distribution industry is attractive as a result of the group’s predictable revenue streams and the strong competitive positions of a number of participants, which result from the barriers to entry that are difficult-to-replicate distribution networks, myriad regulatory compliance issues, and industry relationships. The industry currently operates as an oligopoly with McKesson (MCK), Cardinal Health (CAH), and AmerisourceBergen (ABC) collectively controlling more than 90% of the market. All three of these companies boast solid Dividend Cushion ratios, thanks in part to the predictable nature of their businesses, and Cardinal Health qualifies as a Dividend Aristocrat and holds the highest dividend yield of the three at just over 3.5% as of this writing, compared to ~1.8% and ~1.2% for AmerisourceBergen and McKesson, respectively.
In addition to the aforementioned barriers to entry, Cardinal Health boasts competitive advantage via its route density, warehouse infrastructure, and logistical expertise, all of which are thanks in part to its scale advantages–despite it being the third largest drug distributor–that are exacerbated by those very same industry characteristics. Cardinal is the main supplier to CVS Health’s (CVS) extensive retail pharmacy network, and its joint sourcing agreement with CVS Caremark may prove to be a material benefit over the long haul should it help the two companies negotiate better discounts from generic drug manufacturers.
However, the ongoing threat of Amazon (AMZN) is waiting in the wings to potentially disrupt the pharmaceutical product distribution space, and CVS Health’s deal for Aetna (AET) has largely been viewed as a defensive move as it seeks to deliver an easier-to-navigate health system for consumers. We have our fair share of skepticism over the viability of such an integrated model, but in addition to feeling the heat from Amazon, CVS is working to stay relevant in the pharmacy benefit management (PBM) space as managed care organizations look to integrate or insource PBM businesses to help drive down costs. Nevertheless, the potential shifting of power in the space leaves an air of uncertainty throughout the pharmaceutical supply chain, which is only heightened by the potential for regulatory changes in the broader healthcare space.
Perhaps the largest immediate threat to the bottom-line of the drug distribution space is ongoing generic drug deflation, another byproduct of broad based pressure to reign in healthcare spending. Cardinal Health did not provide internal projections for the rate of generic drug pricing in its fiscal year 2019 (ends June 2019), but it expects its ‘Pharmaceutical’ segment’s profit to decline at a high-single to low-double digit rate while revenue growth is expected to be in the low-single digits. Generic program performance is cited as a key headwind in the margin contraction. AmerisourceBergen no longer provides an explicit guidance range for its forecast of generic drug inflation, but it does note that it expects such deflation in its fiscal year 2019 (ends September 2019) to be similar to the tail end of its fiscal 2018, which it estimated at roughly 7%.
In its fiscal 2019, Cardinal Health expects revenue growth at a low-single-digit rate over fiscal 2018 levels, and it guides non-GAAP earnings per share to a range of $4.90-$5.15 compared to $5.00 in fiscal 2018. This relative bottom-line weakness–its effective tax rate and share count are both expected to drop in the year–is due in part to the aforementioned profit pressure in its ‘Pharmaceutical’ segment emanating from generic drug deflation. It expects its ‘Medical’ segment to deliver a low-single-digit revenue growth rate and a mid- to high-single digit profit growth rate.
Cardinal Health has done well in covering cash dividends paid with free cash flow in recent years, and we expect it to continue to defend its title of Dividend Aristocrat with ongoing annual increases. Over the past three fiscal years (fiscal 2016-2018) the company averaged nearly $1.9 billion in free cash flow–including a down year of only $797 million in fiscal 2017–a figure that dwarfs its annual run rate cash dividend obligations of $581 million. This robust free cash flow generation is the driver of Cardinal’s Dividend Cushion ratio, which sat at 2.4 at last check. We expect that to come down in a notable way but remain above parity upon the next update of the model as the company’s net debt load, inclusive of short-term debt, leapt to $7.25 billion at the end of fiscal 2018 from $3.5 billion a year earlier as a result of acquisitions in its ‘Medical’ segment.
The company’s net debt position fell to less than $7 billion after the first quarter of fiscal 2019, but it does not plan to alter its capital allocation in a material way at the moment. Generally speaking, management is dedicated to having a reasonable capital structure, financial flexibility, and returning cash to shareholders. We expect Cardinal’s dividend to continue growing, though potentially at a more moderate pace than in recent years due to the aforementioned uncertainties facing its business as well as the increased debt load. Shares of Cardinal Health are currently changing hands in the bottom half of our fair value range. We’re not interested in adding exposure to Cardinal or the drug distribution group at this juncture, but the positive tone from AmerisourceBergen regarding the potential easing of deflationary pressures is a step in the right direction for the space.
Healthcare Products Distributors: ABC, CAH, ESRX, HSIC, MCK, OMI, PDCO, STAA
Health Care Providers & Services: CERN, CPSI, DGX, LH, MDRX, MDSO, QSII, TVTY
Health Care Services: CYH, DVA, EHC, LPNT, MD, THC, UNH, UHS
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Kris Rosemann does not own any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.