Published on February 9th, 2018 by Bob Ciura
The Dividend Aristocrats are among the best dividend growth stocks in the entire stock market. Dividend Aristocrats are stocks in the S&P 500 Index, with 25+ consecutive years of dividend increases. There are just 53 Dividend Aristocrats. You can see all 53 Dividend Aristocrats here.
Cardinal Health (CAH) is a Dividend Aristocrat, and has increased its dividend for 32 years in a row, including a 3% hike on May 3rd 2017. Over the past few years, Cardinal Health has struggled with deflation and rising competition in its core business of pharmaceutical distribution. At the same time, the company has a leading position in the industry, and has a long track record of dividend growth.
While it has encountered significant operating challenges recently, the company is building a successful turnaround. Its most recent quarterly earnings report, released on February 8th, provided even more evidence that the turnaround is working.
This article will review Cardinal’s strong earnings report, and discuss why the stock is still attractive for value and dividend growth investors.
Cardinal Health is a giant in the healthcare supply industry. It operates in 60 countries, and generates annual revenue of approximately $129 billion.
Source: 2017 Annual Stockholder Meeting, page 5
The company has two operating segments, Pharmaceutical and Medical product distribution. Pharmaceutical products comprise roughly 90% of Cardinal Health’s total revenue.
For the fiscal 2018 second quarter, Cardinal Health reported adjusted earnings-per-share of $1.51, which included a $0.20 per-share benefit from tax reform. Excluding the tax-related boost, adjusted earnings-per-share were $1.31, on revenue of $35.19 billion.
Both figures significantly beat analyst estimates. Earnings-per-share and revenue beat expectations by $0.16 and $540 million, respectively, which indicates a strong beat on both the top and bottom line.
Revenue increased 6% last quarter, year over year. Adjusted earnings-per-share of $1.31 (excluding the tax impact) fell 2.2% from the same quarter a year ago. Following a familiar trend, Cardinal Health saw price deflation in the pharmaceutical segment, due to generics, which drove down segment operating profit by 4% last quarter.
Source: Earnings Presentation, page 5
Helping to offset this, was higher volumes, which resulted in 5% revenue growth for the pharmaceutical segment. Meanwhile, the medical segment continued to perform well, with revenue and operating profit growth of 19% and 38%, respectively.
The business climate for Cardinal Health remains challenged. Falling drug prices has negatively impacted margins in the company’s core pharmaceutical segment, a headwind that is expected to persist in 2018.
For the full year, management expects pharmaceutical revenue to increase at a low-to-mid single-digit pace, but segment operating profit is expected to decline by at least 10%. Generic drug prices are expected to decline in the mid-single digits for 2018.
Source: Earnings Presentation, page 12
The good news is, many of these fundamental headwinds are starting to abate. Plus, Cardinal Health remains highly profitable, which allows the company to reinvest excess cash flow in growth initiatives.
Cardinal Health’s recent earnings report confirms there is moderating price deflation in pharmaceutical products.
Stabilization of pricing is boosted by the company’s joint venture with CVS Health (CVS), called Red Oak Sourcing. Joining forces helps the two companies negotiate better generic pharmaceutical prices.
In addition, Cardinal Health continues to fine-tune its product portfolio, to ensure it is capitalizing on growth trends. For example, in 2017 Cardinal Health acquired the Patient Recovery business from Medtronic (MDT) for $6.1 billion, which will broaden the company’s product offerings. Cardinal Health management expects the Patient Recovery acquisition to add $0.21 of earnings-per-share in 2018, and $0.55 in 2019.
The company also divests businesses that are not deemed a critical part of future growth plans. For example, on February 2nd Cardinal Health finalized the $1.2 billion sale of its Cardinal Health China business. Raising cash will help the company reinvest in new growth opportunities, and buy back stock.
Cardinal Health announced a new $2 billion share repurchase authorization, which will help accelerate future earnings growth.
Along with its most recent quarterly earnings report, Cardinal Health raised its forecast for the remainder of fiscal 2018. For the full year, management expects earnings-per-share in a range of $5.25 to $5.50. Tax reform is expected to add $0.40 per share of benefit to the company’s earnings-per-share. This represents a significant increase, from prior guidance of $4.85 to $5.10 in 2018.
Valuation & Expected Returns
For fiscal 2018, Cardinal Health expects adjusted earnings-per-share of $5.37, at the midpoint of guidance. As a result, the stock has a price-to-earnings ratio of 12.7. Cardinal Health is currently valued at a 24% discount from its 10-year average, of 16.8.
Source: Value Line
This is a very low valuation, which indicates a significantly undervalued stock, particularly since Cardinal Health’s earnings are still growing. With positive earnings growth, the stock could easily justify a higher valuation. This would generate significant returns.
For example, our fair value estimate for Cardinal Health is $82 per share, which represents a price-to-earnings ratio of approximately 15. If the valuation expanded to our fair value estimate, it would yield a return of 19%.
In addition to multiple expansion, future returns can be generated from earnings growth and dividends. Revenue growth of 3% to 5% per year, along with share repurchases, could fuel high single-digit earnings moving forward.
With dividends, total returns would be as follows:
- 3%-5% revenue growth
- 1% share repurchases
- 2.7% dividend yield
In this scenario, total returns could reach 7%-9% per year, plus the potential returns from an expanding price-to-earnings ratio. As previously discussed, we believe Cardinal Health is approximately 19% undervalued.
If it took five years to reach our estimate of fair value, the expanding price-to-earnings ratio would add approximately 4% to annual returns. As a result, total annual returns could reach 11% to 13% each year, including the impact of valuation expansion.
The economics of the healthcare distribution industry have deteriorated in recent years, due to price deflation from generics. This has impacted all the major players in healthcare distribution, including Cardinal Health.
However, Cardinal Health’s turnaround is materializing, which has re-positioned the company for a return to growth.
Cardinal Health’s long-term growth potential remains intact. The recent earnings report is a confirmation that conditions are steadily improving.
Cardinal Health is still undervalued, with an attractive dividend payout.