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A Fortune 500 stock on sale
Cardinal Health, the nation's 17th-biggest company, has run into some problems. But it's still likely to post impressive growth, making its stock a good long-term buy.
By Robert Walberg
People change as they grow older. So do companies. Understanding where a company is in the maturation cycle is an important element of successful investing, and one that can be challenging, especially when a business is transitioning from one stage to the next.
Such is the case for Cardinal Health (CAH, news, msgs), and it's creating an opportunity for investors.
Cardinal is a large, diversified health care services company that makes and distributes pharmaceuticals, as well as medical and surgical products. It also offers pharmaceutical delivery and automation technologies. Over the past 12 months, Cardinals sales have topped $67 billion, placing it 17th in the Fortune 500. Its market capitalization is a hefty $24 billion.
Despite its size, investors had been able to count on Cardinal to deliver double-digit sales and earnings-per-share growth for years. In fact, the average annual sales and EPS growth rates over the past five years were an enviable 19% and 22%, respectively.
But savvy investors have seen a subtle but distressing change in recent years. Sales and earnings growth have been slowing. Whats slowing the growth: Lower drug-price inflation. Drug prices used to increase by 10% or more per year. But in recent years, that rate has slowed considerably. With increasing competition from generic drug makers, growing pressure on health care providers to control costs and the recent spat of negative press about adverse side-effects of several high-profile drugs, its unlikely that 2005 will see a return to the glory days. Most analysts see a low- to mid-single digit increase in drug prices this year.
This fundamental shift has affected wholesale drug distributors like Cardinal, McKesson (MCK, news, msgs) and AmerisourceBergen (ABC, news, msgs), cutting already razor-thin profit margins. (The industry average net profit margin over the last five years has been 1.4%.) So Cardinal and the others have decided to change their business models.
Instead of buying drugs at one price and distributing them at a higher price, the industry is shifting to a fee-for-service model: It will charge the major pharmaceutical companies a fee to distribute their products.
Encouraging change
With most of the market share concentrated in the hands of these three major distributors, Cardinals management expects the drug makers to grumble but ultimately get on board with the change this year. Last month, Cardinal inked just such a deal with Eli Lilly (LLY, news, msgs). But it is not clear just how much the drug makers will pay for distribution services.
Though its likely that this fee-for-service shift will take hold, the lack of deals and the inability of analysts and investors to get their arms around the fee structure clouds the near-term earnings visibility for Cardinal and the industry. If theres one thing that drags down multiples, its earnings uncertainty.
Of course, earnings warnings are even worse, and thats just what Cardinal did last month. Citing difficult business conditions, especially in its medical/surgical products and pharmaceutical technologies/services units, the company guided estimates lower. It now sees earnings per share in the year's first half declining by 10% to 15% from the year-earlier period. For the year, the company put EPS growth in the low single digits, down from its prior outlook for growth of at least 10%.
Interestingly, the Street is even more cautious. The average estimate for 2005 of $3.46 per share represents a 3% year-over-year decline. What this says is that Cardinals management has lost some credibility on Wall Street, another red flag for investors.
Helping to fuel that credibility gap is an ongoing Securities and Exchange Commission investigation into the companys accounting practices. Last summer, the SEC started looking into the company's methods for classifying revenue from its pharmaceutical distribution business. Though generally considered immaterial to the bottom line, there are concerns that the company's aggressive accounting of its acquisitions could also be in question. As long as these issues remain in question, the Street is unlikely to reward Cardinal with the premium multiples it enjoyed in the recent past.
Aggressive steps
To Cardinals credit, it's taking steps to get its growth back on track. In addition to taking the aggressive step of changing its drug-distribution business model, Cardinals management recently announced Cardinal will close 25 facilities and reduce worldwide headcount by 4,200 jobs, or 7%. Cardinal also named a new CEO in its key pharmaceutical technologies and services unit and announced plans to buy back $500 million of its stock.
Cardinals efforts will take time to bear fruit. But the company has a history of delivering solid, dependable growth plus a leadership position in an industry that will benefit from long-term demographic trends. The bottom line for investors: Take advantage of any news-related weakness over the next three months to buy the stock. Its fair to view Cardinal as a decent long-term value play, especially if short-term earnings disappointments take another 10% or so off the stock, moving it toward support at around $50 to $52 a share.
Using $51, the midpoint of that range, as an entry point, the stock would be trading at less than 15 times estimated fiscal 2005 earnings of $3.46 and a mere 12.5 times projected fiscal 2006 earnings of $4.08. The stocks five-year low price-to-earnings ratio is 15, with a high during that period of 41. While it's highly unlikely that the high will be seen again, a multiple of 15 to 17 times earnings seems reasonable for a company expected to achieve average annual earnings growth of roughly 15% over the next three to five years. By comparison, the S&P 500 ($INX) trades at a little over 20 times earnings; long-term earnings growth is in the 10%-to-12% range.
Traders should also note that Cardinal generates significant free cash flow ($2.2 billion in fiscal 2004) and that its net margins and return on equity are the highest in its group.
There are still outstanding concerns, especially about the adoption of the new business model and the fate of the SEC probe. These concerns are apt to keep the stock under pressure over the short term. But unless both turn out much worse than expected, Cardinals additional downside risk should be minimal.
In the longer term, as the transition to the new model takes hold and the restructuring efforts kick in, Cardinal will be set for a run to the mid-to-high $60 range. Thats nothing like the old days when it hit $77, but not a bad move for a mature company of its size.
At the time of publication, Robert Walberg neither owned nor controlled shares in any equities mentioned in this column.
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