CAH: A Wonderful Healthcare Stock Trading At A Reasonable Price
Brian Bollinger | Feb 24, 2016 03:08PM ET
Cardinal Health (N:CAH) scores extremely well for Dividend Safety (95) and Dividend Growth (91). The company has increased its dividend by 15% per year over the last five years and shows no signs of slowing down.
With a reasonable earnings multiple of 15.4x, now could be a good time to consider buying Cardinal Health for our Top 20 Dividend Stocks portfolio.
Business Overview
Cardinal Health was founded in the 1970s and has grown to become one of the largest healthcare companies in the world with over $100 billion in annual sales. It primarily makes money by distributing a wide variety of pharmaceutical and medical supplies.
The company does business with more than 5,000 pharmaceutical and medical surgical suppliers to serve over 25,000 U.S. retail pharmacies and provide products to more than 75% of U.S. hospitals. Overall, Cardinal Health sells over 2.5 billion healthcare products each year.
Cardinal Health’s Pharmaceutical segment generated 89% of the company’s total sales and 83% of its segment profit last fiscal year. This business distributes a wide range of branded and generic drugs, specialty pharmaceuticals, and over-the-counter products.
The company’s Medical segment distributes medical, surgical, and laboratory products to hospitals and other healthcare providers. This business accounted for 11% of Cardinal Health’s total sales and 17% of its segment profit last year.
By geography, roughly 95% of Cardinal Health’s sales are in the U.S., although it also has some meaningful operations in China.
Business Analysis
As middlemen, distributors typically generate very little gross profit on each sale they make. For example, Cardinal Health earned a paltry 5.6% gross margin last fiscal year.
These companies depend significantly on generating a high volume of sales to turn a meaningful profit. The best distributors to do business with are ones that offer the broadest range of products with the most reasonable prices and highest quality delivery standards.
As a result, distributors with massive distribution networks, long-standing customer contracts, and economies of scale are best positioned to exceed.
In healthcare, cost-effective distributors are especially important. Hospitals and pharmacies are under ever-increasing amounts of pressure to save money and reduce waste. If they can consolidate the number of distributors they work with, they can achieve greater efficiency and lower costs for their customers.
Cardinal Health’s scale and expertise provides it with advantages over smaller companies that allow it to profitably pursue some of the biggest deals in the industry. For example, the company established Red Oak Sourcing, a 10-year generic pharmaceutical sourcing venture with CVS Health (N:CVS) in July 2014.
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Cardinal Health is also somewhat unique in that it manufactures some of its own medical products and operates its own retail pharmacy, providing it with some vertical integration cost benefits. The company is also working to increase its mix of generic drugs, which generally carry higher margins.
To maintain its size and cost advantages, Cardinal Health is constantly acquiring other businesses that expand its breadth of products, customers, and geographies. The industry is also extremely fragmented and under an increasing amount of regulation, which should provide plenty of opportunity for continued growth as consolidation continues.
Cardinal Health’s Key Risks
The U.S. healthcare system is undergoing significant changes due to the Patient Protection and Affordable Care Act. While a significantly higher number of people will have health insurance coverage, driving more demand for Cardinal Health’s products, price pressure will likely intensify.
The healthcare system needs to become more efficient, which means efforts to reduce costs across the board in the form of lower reimbursement rates for pharmaceutical companies (especially for high-margin generic drugs) and others. The result could be more pressure on Cardinal Health’s margins and growth prospects.
Additionally, some of Cardinal Health’s distribution contracts with certain customers are extremely large. CVS Health accounted for 27% of Cardinal Health’s revenue last year, and its five biggest customers represented 41% of total sales. The contract with CVS Health runs through 2019.
If the company is unable to renew these contracts or is forced to accept less favorable terms, its business can be significantly impacted. For example, Cardinal Health lost its $22 billion pharmaceutical distribution contract with Walgreens (O:WBA) in 2013 and its $9 billion supply contract with Express Scripts (O:ESRX) in 2012.
It’s also worth mentioning that the profitability of Cardinal Health’s Pharmaceutical segments is impacted by its mix of generic and branded drugs, as well as the timing of new drug launches. All of these factors impact the prices received for the products Cardinal Health distributes and can result in tailwinds or headwinds any given year. However, we do not believe this is a risk to the company’s long-term earnings power.
Dividend Analysis: Cardinal Health
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.
Dividend Safety Score
Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
Cardinal Health has a Dividend Safety Score of 95, which indicates that it has one of the safest dividend payments in the market. Over the last 12 months, the company’s dividend has consumed 37% of its earnings and 20% of its free cash flow. These are relatively low payout ratios which provide plenty of safety.
Looking further back, we can see that Cardinal Health’s payout ratios have increased significantly over the last 10 years but have averaged 20-30% during the last five years. Once again, it looks like the business has plenty of room to continue paying and growing its dividend even regardless of near-term business trends.
Source: Simply Safe Dividends
Source: Simply Safe Dividends
Cardinal Health’s business also performed very well during the last recession, which further boosted its Dividend Safety Score. Most of the healthcare products the company distributes are non-discretionary in nature. The company’s ability to continue acquiring other distributors also helps it continue growing. We can see below that its sales grew each year during the recession.
Source: Simply Safe Dividends
Free cash flow generation is the sign of a healthy business and is the foundation needed for sustainable dividend payments. As seen below, Cardinal Health has generated free cash flow in each of its last 10 fiscal years. Distributing essential healthcare products is certainly a dependable business that throws off nice cash flow.
Source: Simply Safe Dividends
Despite earning low profit margins as a distributor, Cardinal Health has been able to generate a solid return on invested capital of about 10-12% most years to create economic value. We generally prefer to invest in businesses that can earn double-digit returns with capital deployed because they can compound earnings faster and often have numerous competitive advantages.
Source: Simply Safe Dividends
Looking at the balance sheet, we can see that Cardinal Health has just over $2.3 billion in cash compared to $5.5 billion in debt. It could cover its entire book debt with cash on hand and just 1.4 years of earnings before interest and taxes (1.4), which seems very reasonable to us given the predictable earnings of the business.
Source: Simply Safe Dividends
Overall, Cardinal Health’s dividend is very safe. The company has low payout ratios, a healthy balance sheet, consistent free cash flow generation, and a portfolio of non-discretionary products.
Dividend Growth Score
Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
Cardinal Health has increased its regular dividend by 15% per year over the last five years and most recently raised its dividend by 13% in early 2015. The company’s Dividend Growth Score of 91 also suggests that its dividend has faster growth potential than over 90% of all dividend-paying stocks in the market.
As a member of the dividend aristocrats list, Cardinal Health’s dividend growth is about as reliable as it gets. With a 37% earnings payout ratio over the last 12 months, very predictable cash flow generation, and potential for double-digit earnings growth, we expect future dividend growth to remain strong.
Valuation
CAH’s stock trades at 15.4x forward earnings estimates and has a dividend yield of 1.9%, which is in line with its five-year average dividend yield.
The company has a solid track record of generating double-digit earnings growth, although acquisitions have served as a strong driver. We think this business can generate sustainable earnings growth in the mid- to high-single digits, reflecting the maturity of Cardinal Health’s markets and the company’s ability to continue playing the role of consolidator.
Under these assumptions, CAH’s stock appears to offer total return potential of 8-10% per year.
We believe the stock is reasonably priced today for long term dividend investors who are comfortable with Cardinal Health’s customer concentration and the risks created by healthcare reform in the U.S.
Conclusion
Cardinal Health is a blue chip dividend stock that offers excellent dividend growth potential for long term investors. We believe the company will continue enjoying steady growth as it consolidates several large healthcare distribution markets.
While the stock’s 1.9% dividend yield is lower than we like for companies under consideration for our Top 20 Dividend Stocks portfolio, it does appear to be reasonably priced today for dividend investors looking to pick up some exposure to the healthcare sector.
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