Updated on February 11th, 2019 by Bob Ciura
The Dividend Aristocrats are the “cream of the crop”, but even Dividend Aristocrats encounter challenges from time to time.
The Dividend Aristocrats are a group of 57 stocks in the S&P 500 Index, with 25+ consecutive years of dividend increases.
One of the Dividend Aristocrats battling through a tough climate is healthcare distributor Cardinal Health (CAH).
Cardinal Health is currently challenged by falling pharmaceutical prices. This has caused the stock to lose approximately 19% of its value year-to-date.
However, the company has increased its dividend for 33 years in a row. Its most recent increase was a 3% hike on May 9th, 2018.
It can continue to raise its dividend, because it still generates more than enough cash flow to support annual increases. While it has encountered tougher competition recently, the company is still highly profitable, and is making progress in its turnaround initiatives.
Cardinal Health stock looks like a bargain due to its low valuation, growth potential, and 3.6% dividend yield. We explore the company’s investment thesis in this article. Before reading, you may want to familiarize yourself with Cardinal Health’s long-term fundamentals, which we have plotted below:
Cardinal Health was founded in 1971. Today, it is a giant in the healthcare supply industry. It has approximately 50,000 employees, operates in over 40 countries, and generates annual revenue of approximately $137 billion.
The company has two operating segments: Pharmaceutical and Medical. The Pharmaceutical segment is by far the company’s largest, as it represents nearly 90% of total revenue.
Source: Investor Presentation
The pharmaceutical segment distributes branded and generic drugs and consumer products. It distributes these products to hospitals and other healthcare providers. The medical segment distributes medical, surgical, and laboratory products to hospitals, surgery centers, clinical laboratories, and other service centers.
The business climate for Cardinal Health is challenged. Falling drug prices have negatively impacted margins in the company’s core pharmaceutical segment.
As a result, Cardinal Health’s strong performance slowed last year. Higher selling volumes pushed revenue up 5% in fiscal 2018, but Cardinal Health’s adjusted earnings-per-share declined 7.4%, to $5.00 for the year.
One of the biggest challenges for Cardinal is drug price deflation, driven by increased shipments of generics. Negative pricing effects drove margin erosion in the pharmaceutical segment last year, and could continue to do so if political and competitive pressure on drug prices remains.
Adding to this concern are reports that e-commerce retail giant Amazon (AMZN) is preparing to enter the medical supply business. Amazon’s nearly $1 billion acquisition of online pharmacy PillPack last year was widely viewed as a precursor to a bigger move into the healthcare industry.
Given these challenges, it is even more impressive that Cardinal Health grew revenue in fiscal 2018, and should return to earnings growth over the long-term.
On February 7th, 2019 Cardinal Health released second-quarter results for fiscal year 2019. For the quarter, Cardinal Health reported revenue of $37.7 billion, a 7% increase compared to the $35.2 billion posted in the same quarter of fiscal year 2018.
On the bottom line, adjusted earnings-per-share totaled $1.29 versus $1.51 in the year ago period, a 15% year-over-year decline.
Both of the company’s segments saw deteriorating profitability last quarter. Revenue increased 8% in the Pharmaceutical segment, but segment operating profit declined by 14%.
Source: Investor Presentation
The Medical segment, which had previously been growing at a fast rate, also disappointed last quarter. Medical segment revenue declined 1%, with operating profit down 14% for the quarter.
Cardinal Health’s earnings-per-share result left a lot to be desired last quarter. However, the company raised its adjusted earnings-per-share guidance for the full fiscal year to a range of $4.97 to $5.17 (from $4.90 to $5.15 previously).
At the midpoint of earnings-per-share guidance–approximately $5.07 for fiscal 2019–Cardinal Health expects 1%-2% earnings growth this year.
There are multiple catalysts to return to even stronger earnings growth rates going forward. One of them is acquisitions.
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 $0.55 to earnings-per-share in 2019.
The result of this investment is that Cardinal Health now has a huge branded portfolio, which consists of nearly 12,000 product SKUs, in 850 categories.
Another important catalyst for a return to growth is moderating price deflation, growth in specialty products, and cost cuts. First, price deflation in pharmaceuticals has eased as of late. In the most recent recent quarter, Cardinal Health noted the rate of deflation in generics was less than at the same time last year.
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.
Specialty products are another emerging area of growth. Over the past several years, Cardinal Health has grown its specialty products business from $1 billion in annual sales to $15 billion.
Competitive Advantages & Recession Performance
The biggest competitive advantage for Cardinal Health is its distribution capability, which makes it very difficult for competitors to successfully enter the market.
Cardinal Health distributes its products to nearly 85% of U.S. hospitals. It also serves more than 26,000 pharmacies, as well as over 10,000 specialty physician offices and clinics. It also serves over 6,700 laboratories with more than 53,000 laboratory products. The company’s home healthcare business serves nearly 3 million patients, with more than 45,000 products.
And, Cardinal Health operates in a stable industry with high demand. The company should remain steadily profitable, as there will always be a need for pharmaceutical products to be distributed.
However, Cardinal Health is not immune from recessions. Its earnings-per-share declined significantly during the Great Recession:
- 2007 earnings-per-share of $3.41
- 2008 earnings-per-share of $3.80 (11% increase)
- 2009 earnings-per-share of $2.26 (40% decline)
- 2010 earnings-per-share of $2.22 (1.8% decline)
That said, the 2009 spin-off of CareFusion distorted Cardinal Health’s GAAP earnings that year. The core business still performed relatively well, and earnings returned to growth in 2011 and beyond.
Since people will always need their medications and healthcare products, regardless of the economic climate, Cardinal Health could be considered more recession-resistant than the average company.
Valuation & Expected Returns
Based on anticipated adjusted earnings-per-share of $5.07 for fiscal 2019, Cardinal Health stock has a price-to-earnings ratio of 10.4. Cardinal Health is currently valued well below its 10-year average price-to-earnings ratio of 14.2.
Our fair value estimate is a price-to-earnings ratio of 14.0, which indicates the stock is severely undervalued today. This very low valuation reflects a high degree of market pessimism.
If the company can return to positive earnings growth, it could easily justify a higher valuation. This is why we believe a price-to-earnings ratio of 14.0 is a reasonable estimate of fair value. Expansion of the stock valuation could fuel annual returns of 6.1% through 2024.
In addition to multiple expansion, future returns will be generated from earnings growth and dividends.
We expect Cardinal Health to grow earnings-per-share by 5% per year, primarily from revenue growth and share repurchases, with a modest decline in margins. The company has reduced its share count by 2.1% per year on average from 2014 through 2018.
Lastly, the stock has an attractive current dividend yield of 3.6%. And, as a Dividend Aristocrat, Cardinal Health is likely to continue raising its dividend each year. The company’s dividend is highly secure, with a projected dividend payout ratio of 38% for fiscal 2019.
The following video discusses Cardinal Health’s dividend safety in further detail:
The economics of the healthcare distribution industry have deteriorated over the past year. This has impacted all the major players, including Cardinal Health.
Fortunately, Cardinal Health continues to grow revenue. And while margin erosion has led to declining earnings, the company has put in place a number of initiatives that should return it to positive earnings growth going forward.
High-quality companies like Cardinal Health have withstood difficult periods before, and will do so again. The factors impacting the stock in the short-term may represent a great buying opportunity for this Dividend Aristocrat.