Dividend Aristocrats Part 17 Of 52: Cardinal Health Inc (CAH) by Ben Reynolds, Sure Dividend

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Cardinal Health (CAH) is a large pharmaceutical and medical products distributor.  The company generates sales of over $100 billion a year.

Cardinal Health was founded in Columbus, Ohio in 1971.  The company has a long history of paying rising dividends; Cardinal Health has paid increasing dividends for 31 consecutive years.

The image below gives an overview of Cardinal Health’s operations:

 Cardinal Health

Source:  Cardinal Health Bank of America Presentation, slide 3

Cardinal Health operates in two segments; pharmaceutical and medical.  Each segment’s percentage of total company operating income in fiscal 2015 is shown below:

  • The medical segment generated 17% of total operating income
  • The pharmaceutical segment generated 83% of total operating income

The pharmaceutical segment generates the majority of its profits from distributing generic and branded pharmaceuticals as well as over-the-counter healthcare and consumer products in the United States.

The medical segment distributes gloves, gowns, drapes, and other medical supplies for use in various health care facilities.  The segment also manufactures a wide range of its own products for distribution in the United States, Canada, and China.

Efficiency & Scale Form Cardinal Health’s Competitive Advantage

Cardinal Health’s primary competitive advantage comes from the sheer volume of its supply chain.  The company serves over 100,000 health care locations daily.

The company generated over $100 billion in revenue over the last 12 months, primarily from the consolidation and distribution of generic pharmaceuticals and medical products.

Cardinal Health operates in a low margin industry.  The company’s net profit margin in 2015 was 1.2%.  Profit margins have been below 2.0% for the last decade.  Few companies operate on such razor thin margins as Cardinal Health.

The low margins in the pharmaceutical and medical supply industry mean less efficient players cannot compete.  Cardinal Health’s competitive advantage is based on its large size and scale.

The company’s competitive advantage is very durable.  The company will likely maintain its competitive advantage as long as medical supplies and pharmaceuticals require distribution in North America.  What specific pharmaceuticals are distributed doesn’t matter to Cardinal Health.  What matters is that pharmaceutical products of any kind continue to be prescribed.

The low-tech scale and price advantage that Cardinal Health has over competitors creates an extremely durable competitive advantage that is unlikely to be diminished for a very long time.

Cardinal Health’s Growth Story

Cardinal Health’s management has done an excellent job of positioning the company for future growth through partnerships, acquisitions, and thoughtful international expansion.

At the end of 2013, Cardinal Health and CVS Health (CVS) entered into a sourcing agreement.  The company’s created a 50-50 sourcing joint venture called Red Oak Sourcing.  Red Oak Sourcing combines the supply chains and purchasing power of both companies to negotiate better deals on generic and pharmaceutical purchases.

Cardinal Health is focusing its international expansion on the Chinese market.  The company currently generates around 3% of its sales in China, but plans to grow rapidly in the region both organically and through acquisitions.

The company’s CFO Michael Kaufmann had this to say about Chinese operations in the company’s most recent 4th quarter earnings call:

“Our business in China generated over $3 billion in revenue for the year, resulting in strong double-digit top and bottom line growth. The team there continues to execute well through a combination of organic and inorganic moves and we continue to gain share in our ranking among the top 10 healthcare distributors in China.”

Cardinal Health is forecasting EPS growth of between 7% and 12% next year, with lower revenue growth.  About 2 percentage points of growth will come from share repurchases net of share issuances.  The bulk of the growth is expected to come from organic growth and margin improvements as the company realizes gains from its Red Oak Sourcing venture.

Cardinal Health made two important acquisitions in 2015:

The bolt-on Harvard Drug acquisition bolsters Cardinal Health’s pharmaceutical segment.  Harvard Drug is a generic and over-the-counter health care distributor.

The Cordis acquisition is more interesting.  Cordis was owned by Johnson & Johnson (JNJ) – the company is a manufacturer and distributor of cardiology devices and endovascular solutions. The acquisition was done to:

“Expand our Medical segment’s portfolio of self-manufactured products and its geographic scope. Cordis is a global company, with operations in more than 50 countries.”

Cardinal Health’s strong competitive advantage in medical supplies distribution could give it an advantage in selling its own manufactured products.  The company’s expansion of its ‘self-manufactured products’ portfolio with the Cordis acquisition hints that Cardinal Health may be focusing on expanding its higher margin manufacturing business, which is complemented by its existing excellent supply chain.

Expected Total Returns for Shareholders

Cardinal Health has compounded its earnings-per-share at 8.1% a year since the 2009 CareFusion spin-off.  Dividends have grown at a 16.0% a year clip over the same time period.

Value Line is projecting earnings-per-share growth of 15.0% in fiscal 2016, and compound earnings-per-share growth of 12.5% a year over the next 4 to 5 years.

15% growth next year is certainly possible.  Over the long-run, I expect the company to compound its earnings-per-share at 4.5% to 9.5% from the following sources:

  • Share repurchases of 1.5% a year
  • Sales growth of 2.0% to 5.0% a year
  • Margin improvements of 1.0% to 3.0% a year

The company should experience more rapid earnings-per-share growth in the next few years as margins expand quicker than what is sustainable over the long-run.

In addition to 4.5% to 9.5% earnings-per-share growth, Cardinal Health also offers investors a 1.9% dividend yield at current prices.

Including its dividend yield, investors should expect total returns of around 6.5% to 11.5% a year over the long-run from Cardinal Health.  Short-term total returns will likely be higher.  Click here to see why total return trumps growth and value.

Valuation Is Too Rich At Current Prices

In general, when a company has favorable short-term growth prospects, its price-to-earnings ratio expands.

Cardinal Health today is no exception.  Over the last decade, Cardinal Health’s average price-to-earnings ratio is 16.5.  It is currently at 22.7. 

Even if Cardinal Health grows its earnings-per-share at 15% a year, it would take more than 2 years for the company’s earnings to ‘catch up’ to its current price-to-earnings ratio (if you believe 16.5 is a fair price-to-earnings ratio for the company).

As a result, I believe Cardinal Health to be overvalued at current prices.

There is nothing wrong with Cardinal Health – it has a strong and especially durable competitive advantage.  It is a high quality business with a shareholder friendly management and favorable growth prospects.

The company’s valuation makes now a poor time to start a position in Cardinal Health.  The company is currently ranked as a hold using The 8 Rules of Dividend Investing.

While the underlying business is excellent, I believe there are better high quality divided growth stocks to invest in than Cardinal Health at this time.