It’s been nearly three months since I last covered Cardinal Health (CAH), and since then, the shares have posted a total return of -9.65% when dividends are factored in. This makes me think about a CNBC report that was published today, in which Bank of America (BAC) noted that value investing is very much alive, with many companies trading at a large valuation gap to the expensive technology darlings. At the same time, it also emphasized the importance of avoiding value traps. With this mindset, I evaluate whether if Cardinal Health continues to belong in the value category, so let’s get started!
(Source: Company website)
A Look Into Cardinal Health
Cardinal Health is the smallest of the big 3 drug distributors in the U.S., sitting behind McKesson (NYSE:MCK) and AmerisourceBergen (NYSE:ABC). Its two primary segments, Pharmaceutical and Medical, serve hospitals, pharmacies, and health systems in 46 countries. In the U.S., Cardinal Health serves nearly 90% of hospitals and more than 29,000 pharmacies, including a strategic partnership with CVS Health (NYSE:CVS). It is ranked among the Fortune 25, has 50K employees worldwide, and is a member of the exclusive Dividend Aristocrats group.
With regards to the opioid litigation, a report last week stated that states are seeking $26.4B in total payments from Johnson & Johnson (JNJ) and the Big 3 pharmaceutical distributors, with just over $21B coming from the latter. While this may seem like a hefty sum, I view this as a positive, as it removes a major overhang that the company has had over the past two years. If approved, this settlement would be payable over 18 years, which makes this easier to bear.
Doing a scenario analysis, I assume that Cardinal Health is roughly responsible for 25% of the $21B, based on its market capitalization compared to that of McKesson and AmerisourceBergen. This equates to a $5.25B share for the company, or $291M per year, over 18 years. This represents just 15% of Cardinal Health’s trailing 12 months’ operating cash flows, and is further supported by the $2.8 billion of cash that it currently has on its balance sheet. As such, the company is more than capable of covering this settlement cost, with the benefit of the real cost diminishing over time through inflation and revenue growth.
The company continues to see challenges from COVID-19, as evidenced by the 12% decline in operating earnings in the latest quarter. It should be noted, however, that a part of the decline can be attributed to accelerated pharmaceutical sales due to ‘medicine-cabinet stuffing’ during the prior quarter, ended March 30th.
Overall, I see the company’s fiscal year 2020 (ended June 30th) as being a reset year, as it took the opportunity to both buy back shares at depressed prices, and shore up its balance sheet, as noted by management during the latest conference call (emphasis added by author):
“We paid down $1.4 billion in debt, and we returned over $900 million to shareholders through dividends and share repurchases. Our effective tax rate for the year was 25%. We finished the year with earnings per share of $5.45, up more than 3% versus prior year, which exceeded our guidance range.”
While management has provided 2021 EPS guidance that is essentially flat on a YoY basis, at the midpoint of $5.25-$5.65 per share, I see longer term benefits from the operational efficiencies and cost saving initiatives that are in play. An example of this is the new distribution center with state-of-the-art cold chain complex that the company is building in Nashville, Tennessee. All in all, initiatives such as this is expected to reap substantial benefits, as noted by the management during the conference call (emphasis added by author):
“Let me now turn to the Enterprise. Our commitment to efficient operations will enable us to optimize and invest. To that end, we have multiple initiatives in-flight that will deliver savings in excess of our multiyear $500 million target, as well as technology and process improvements that drive future growth.”
Turning to analyst estimates, I’m encouraged by average price target of $59, which sits comfortably above where the shares are trading at today. As such, I believe Cardinal Health presents investors with an opportunity for share price appreciation while collecting a safe, 3.9% dividend yield at the same time. At a payout to earnings ratio of just 35%, there is strong potential for future dividend raises down the line for investors who are willing to be patient.
Cardinal Health is one of the Big 3 healthcare distributors, and serves hospitals, health systems, and pharmacies in the U.S. and around the world. While it’s currently facing challenges from COVID-19, I see the headwinds as being temporary. Meanwhile, I’m encouraged by the progress that management has made in paying down the debt, while returning value to shareholders at the same time. Longer term, I see the investments in operating efficiencies as bearing fruit down the line.
I have a Buy rating on shares at the current price $50.56 and a P/E ratio of just 9.3. At the current P/E, the market is essentially pricing in a no-growth future for the company, which I do not believe to be the case. At a bare minimum, the company can still utilize its cash flows to repurchase shares and grow EPS. As such, I view Cardinal Health as being a classic value stock that’s positioned to reward investors over the long term.
(Source: F.A.S.T. Graphs)
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.