Cardinal Health (CAH) stock fell nearly 10% on October 28th.  The next day markets were open (October 31st), the company’s stock gained around 4%.

This level of volatility is unusual for any stock…  And Cardinal Health is no ordinary stock.  The company is very stable.

Cardinal Health was founded in 1971.  It is one of the 3 largest pharmaceutical distributors in the United States.  Together, the ‘Big 3’ have around an 85% market share.

Note:  AmerisourceBergen (ABC) and McKesson (MCK) are the other two.

Cardinal Health has increased its dividend payments for 31 consecutive years.  It is no small feat to have increased dividends every single year for 3 decades.

[drizzle]The company is a member of the exclusive Dividend Aristocrats Index, which is comprised of just 50 S&P 500 stocks with 25+ years of consecutive dividend increases.  You can see a list of all 50 Dividend Aristocrats here.

Cardinal Health’s stock price collapse on October 28th because rival McKesson released weak quarterly numbers.  The company saw its revenue grow just 2%.  Adjusted earnings-per-share fell 7%.  McKesson shares fell over 23% on the day of the announcement.

On October 31st, Cardinal Health released its quarterly numbers…

Keep reading this article to learn more about the investment prospects of Cardinal Health.

Cardinal Health’s Quarterly Numbers

Cardinal Health’s most relevant quarterly numbers are below:

  • Revenue increased 14%
  • Adjusted earnings-per-share fell 10%

Obviously, 14% top line growth is very good.  This is in direct contrast to McKesson’s 2% revenue increase.

Adjusted earnings-per-share declines of 10% are not good.  The primary driver of the earnings-per-share decline is increased competition amongst the ‘Big 3’.  A price war is breaking out.

AmerisourceBergen appears to be the instigator of the price war.  The company is lowering prices to gain market share.  Cardinal Health’s 14% revenue increase shows the company is not afraid to match AmerisourceBergen.  McKesson, however, has not followed.

You can see the impact of lower margins by looking at the performance of Cardinal Health’s 2 segments.  The company’s medical segment performed very well.  Margins and revenue both increased, resulting in 26% profit growth.  Revenue increased in the pharmaceutical segment, but margins declined 29% from 2.62% to 1.86%.

Cardinal Health

Source:  Cardinal Health Q1, 2017 Presentation
In the short run, pricing pressure will hurt margins.  In the long run, price wars will cease and margin stability will resume.  Cardinal Health’s rapid revenue growth shows that the company is likely gaining market share.

The company’s management is still expecting positive growth in fiscal 2017.  Management is expecting very strong long-term growth as well:

Cardinal Health

Source:  Cardinal Health Q1, 2017 Presentation

Cardinal Health’s Place in the Pharmaceutical Supply Chain

Cardinal Health serves 2 primary functions:

  1. Provide generic and brand name drugs to smaller independent pharmacies or group purchasing organizations.
  2. Provide brand name drugs to large retail chains

Cardinal Health

Source:  Morningstar Healthcare Observer
Gross margins in the industry for working with smaller players are around 4.0% to 5.0%.  Gross margins in working with the large retail chains are around 0.3% to 0.6%.  These are razor thin margins.

Distributors play an important function in the supply chain.  They provide the infrastructure to move drugs from the manufacturer to pharmacies and on-line/mail-order retailers.  Cardinal Health has annual sales of over $120 billion.  The scale of the operation makes it very efficient.

The distribution industry has almost impossibly small margins.  It is very clearly not the reason drug costs are so high – and rising.

Getting drugs from the manufacturer to retailers in as efficient a manner as possible is vital to the supply chain.  Cutting out distributors would very likely lead to an increase in prescription costs because individual manufacturers could not provide this service as efficiently as the ‘Big 3’ large distributors.

The Investment Prospects of Cardinal Health

Cardinal Health is a compelling investment at current prices.  The company has a long history of paying rising dividends.  This is important because it shows management prioritizes shareholders.

The company currently has a dividend yield of 2.7% and a payout ratio of around 35%.  The company has compounded its dividend payments at 25% a year over the last decade.  This growth rate is unsustainable, but dividends should continue to increase at around 10% a year over the next several years.

Cardinal Health also has an above-average expected earnings-per-share growth rate over the next several years.  The company’s management is anticipating 10% to 15% earnings-per-share growth.  This may be a bit optimistic, but the company has grown earnings-per-share at 10% a year over the last 5 years.

Growth will come from Cardinal Health’s investments in China, share repurchases, and an aging United States population.  The use of prescription medicine (and its cost) is only increasing.  These trends will very likely continue as baby boomers continue to age, and society becomes increasingly accepting of younger people taking a host of prescription medications.  Overall, I believe it is likely Cardinal Health continues compounding its earnings-per-share at around 10% a year.

Cardinal Health is a high quality business with a shareholder friendly management.  In today’s low interest rate environment, you usually have to ‘pay up’ in the form of high price-to-earnings multiples for quality investments…

Fortunately, that isn’t the case with Cardinal Health.  The company has a price-to-earnings ratio (using adjusted earnings) of just 13.7.  The company’s average price-to-earnings ratio since 2014 is around 20.  Cardinal Health looks undervalued at current prices.

The company ranks in the Top 10 and is a strong buy using The 8 Rules of Dividend Investing.  Cardinal Health is an excellent choice for dividend growth investors looking for above-market total returns over the next 5 to 10 years.

Article by Ben Reynolds

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