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MagicDiligence (< 20)

Magic Formula Stock Review: Cardinal Health (CAH)



January 12, 2010 – Comments (0) | RELATED TICKERS: CAH , MCK , ABC

Cardinal Health (CAH) is a pharmaceutical distributor, acting as the middleman between drug manufacturers and consumer delivery firms, such as retail pharmacies and pharmacy benefit managers (PBMs). Cardinal provides the benefits of consolidated purchasing power, warehousing, repackaging of drugs, procurement, and so forth. The firm is now a pure play on drug distribution, having completed the spin-off of their medical products division into CareFusion (CFN) back in September.

MagicDiligence has written a few pieces before on the drug distribution business, comparing the three major players against each other and also taking an in-depth look at competitor McKeeson (MCK). The industry has some attractive qualities. It is largely recession proof, as medications often are critical in extending the quality or duration of life. It also has very high barriers to entry. With operating margins barely over 1.5%, scale is critical to being sufficiently profitable, given the high amount of fixed costs required. It is unlikely that a new competitor would be interested in putting forth the capital and time required to build the necessary scale, given the margins involved. This will likely leave the market to the three current players: Cardinal, McKeeson, and AmerisourceBergen (ABC). With this comfortable oligarchy, irrational pricing is another competitive risk we can largely eliminate.

Cardinal should also benefit from some secular trends over the next several years. An intense focus on lowering health-care costs and a massive branded drug patent cliff in the next 3-5 years should move the drug market towards generic prescription drugs. Scale is critical to generics makers and distributors like Cardinal are key in driving volume, allowing distributors to earn higher margins from generics. Demographics in North America are favorable too. As the "baby boom" generation reaches retirement age, increased pharmaceutical sales are inevitable. Mid-to-high single digit revenue growth annually is likely, and the stable competitive forces should keep operating margins steady.

The company is solid financially. After spinning off CareFusion, Cardinal's balance sheet is in good shape, with about $2.5 billion in total debt offset by $1.6 billion in cash, and an annual normalized free cash flow run rate around $1.2 billion. Management can rely on the steady and recession-resistant cash flows to pay an attractive dividend yield (currently 2.2%) and buy back shares (3.8% share reduction annually for past 5 years). The dividend, in particular, should grow nicely, as it is currently just 17% of free cash flow and Cardinal has limited opportunities for growth re-investment. Combine a decent and sure-to-rise dividend with share buybacks and fair organic growth, and you have a recipe for a solid investment, particularly considering the modest downside risks.

As for those risks, the primary one is customer concentration. Cardinal gets 23% of revenue from Walgreen (WAG), 21% from CVS Caremark (CVS), and about 53% from its top 5 customers. Should one of them defect to a competitor, the repercussions would be dramatic. The company also faces the standard risk in the industry of customer consolidation. As drug store market share continues to be gobbled up by big, national chains, Cardinal's services are less important than they were for small, local drug stores. PBMs (basically mail-order suppliers) like Express Scripts (ESRX) are also gaining share. They take deliveries in bulk, providing significantly lower margins. These risks are faced by all of the 3 major distributors. None of them are likely to be an issue over the course of a one year Magic Formula holding period.

Cardinal Health is probably the least attractive choice from this group (which are all Magic Formula stocks currently). McKeeson runs a higher margin healthcare technology business that juices profit margins and provides cross-selling opportunities in both directions. AmerisourceBergen is a pure play like Cardinal, but their customer roster is skewed more towards independent and small-chain pharmacies. Cardinal derives about half of their sales from bulk supply, earning a razor-thin 0.6% margin on those sales. Also, with the divestiture of CareFusion, the company lost some opportunities to cross-sell services to customers.

That said, Cardinal is also priced the cheapest, with a 13.8% earnings yield against expected 2010 results. I believe the stock makes a decent choice for a conservative MFI investor, or one interested in the dividend growth potential. MagicDiligence is assigning a positive opinion. But both of its primary competitors are more attractive investments, and the stock does not come close to making the Top Buys list.

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