The healthcare sector has significantly outperformed the broader market so far this year, as demonstrated by the roughly flat return of the S&P 500 Healthcare Sector Index. The S&P 500 has plummeted more than 20% year to date.
A flat return suggests the possibility of a wide dispersion within healthcare, and that’s certainly the case. Some healthcare names have outperformed their index dramatically, while others have generated negative or lackluster returns.
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Cardinal Health Inc (NYSE:CAH) and McKesson Corp (NYSE:MCK) are both firmly in the outperformance camp, with Cardinal up more than 50% year to date and McKesson having gained nearly 60%.
Some investors may hesitate to invest in companies that have gained so much in a down market, fearing that all the upside is gone. However, a closer look suggests Cardinal and McKesson could see even more upside in the coming months.
Cardinal Health distributes pharmaceuticals and manufactures and distributes laboratory and medical products. It also provides data solutions to healthcare facilities. Cardinal's two operating segments are pharmaceutical and medical supply and distribution.
Fundamentals are the greatest concern for Cardinal Health, as it has struggled to turn a profit in recent years despite raking in more than $181 billion in revenue for the fiscal year that ended in June 2022. Additionally, the company's balance sheet isn't particularly great, although it does de-risk the business with its $44.6 billion in liabilities balanced out by its $44 billion in assets.
However, activist investment firm Elliott Management took up a significant position in Cardinal Health earlier this year, suggesting future solutions to the company's profitability issues. Since Elliott established its stake, it has shaken up the company's board.
A new chief executive officer was also brought on board, furthering the potential for solutions to the previous management's execution missteps.
With Elliott Management on board, we can expect significant changes to unlock value at Cardinal Health, which has already announced improvements to its governance practices. The company has also formed a new committee to review its business operations, strategy and portfolio, suggesting more changes are probably forthcoming.
What Changes Can Be Expected At Cardinal Health?
One critical issue that could be causing a sizable part of the profitability issues could be the lack of synergies among Cardinal's two businesses. For example, Cardinal's pharmaceutical business is part of an oligopoly with two other companies.
However, while it's growing faster than its peers based on revenue, Cardinal is trading at only eight times EBITDA due to operational missteps like poor acquisition decisions. Despite the pharmaceutical segment's $16 billion in revenue in the last quarter, it was unprofitable.
Some potential steps to unlock value at Cardinal Health could involve selling off non-core assets like the Nuclear and Precision Health Solutions business. The company could also unload its Cardinal Health at-Home Solutions business, which has grown significantly since its acquisition about 10 years ago. Of course, it will take some time to make decisions about the best ways to unlock value at Cardinal Health, but it seems like a brighter future is coming.
With a trailing P/S of around 0.11 times, Cardinal Health also looks significantly undervalued relative to its peers. The healthcare sector's three-year average P/S is around 2.4 times. It could take a while for the bull thesis for Cardinal Health to play out, but it seems like there's nowhere to go but up from current levels.
McKesson distributes pharmaceuticals and provides medical supplies, health information technology, and care management tools. The company delivers one-third of all the pharmaceuticals used in North America.
The story with McKesson is significantly different from that of Cardinal Health. Its fundamentals are far healthier, and it has a solid track record of beating estimates for earnings and revenue. Additionally, McKesson is taking steps to unlock value without prompting from an activist investor.
For example, the company is exiting its European business with the intent of focusing more on its businesses with higher margins. Of note, Warren Buffett's Berkshire Hathaway owns shares of McKesson, which was one of its top purchases in the second quarter.
The firm held nearly 3.2 million shares of the company as of the end of June after increasing its position from 0.25% of its portfolio to 0.34%. It's no wonder that Buffett, the legendary value investor, scooped up more shares of McKesson during the second quarter, as it looks undervalued.
The company trades at a P/S of about 0.22 times and a P/E of about 28.5 times, versus the healthcare sector's three-year average P/S of 2.4 times and three-year average P/E of around 48 times. The healthcare sector currently trades at a P/E of around 40 times, further demonstrating how undervalued McKesson is despite its skyrocketing share price.
Cardinal Health And McKesson Both Look Solid
It's important to realize that the bull theses for both Cardinal Health and McKesson could take a while to play out. The current market conditions make it incredibly challenging to pick winners right now. However, the fact that both stocks have been surging shows that other investors are recognizing the value offered by these two companies.
At the end of the day, a long-term mindset is generally better because it provides opportunities to smooth out some of the market's volatility. This certainly couldn't be truer of Cardinal Health and McKesson.