Playing the Cardinal Health Spinoff

Cardinal Health (CAH - commentary - Trade Now), whose earnings have stagnated in recent years, has two main health care businesses. The result is that the investment case is twofold: The stock is statistically cheap, Graham and Dodd style, and there is a catalyst for near-term price appreciation in the form of a pending spinoff of the less-promising business.

The main operation (which will keep the Cardinal name) focuses on supply-chain and drug-delivery applications. It also has a products business, CareFusion, whose profits are under pressure, but which will shortly be spun off.

The combined company has over $90 billion in sales, but most of these come from the inherently low-margined distribution business. Net margins have declined from over 2.5% five years ago to about half that today. The normal margins for the new Cardinal are just over 1.0%. It was CareFusion that formerly led to a decidedly higher "blended" margin, but whose margin compression brought down that of the combined Cardinal.

The combined company probably earned about $3.50 a share (adjusting for non-recurring items), in the June 30 fiscal year just ended. On a pro forma basis, we believe that earnings can increase to $3.80 a share in the coming fiscal year, and then at a healthy 9% clip thereafter, just by tracking sales growth. The stock is selling for about my proprietary investment value metric, $23 book value plus 10 times dividends, or $30 a share. On more traditional measures, it is selling for 9 times trailing earnings or 8 times forward earnings. It has raised the dividend to an annualized 70 cents a share, the latest in several years of double-digit percentage increases.

Covering Dividends and Debt

The two companies will be separated by a distribution of 0.5 CareFusion shares for each Cardinal share. The ratio of operating profits would be about 3 to 1 (Cardinal to CareFusion) and on a pro forma basis, 2008 fiscal year earnings might be about $2.50 a share for Cardinal and $1 a share for Care Fusion, after some adjustments. We believe that most, if not all, of the dividend will be picked up by the larger and faster-growing Cardinal. On the other hand, CareFusion, whose earnings are more stable, will absorb about 40% of the combined company's debt, a disproportionate share.

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Thomas P. Au, CFA, is a principal with R. W. Wentworth, a financial services firm in New York City. Earlier he was an emerging markets portfolio manager for the investment arm of Cigna Corp. and an analyst with Unifund, S.A. of Switzerland and Value Line. He graduated cum laude with a B.A. in Economics and History from Yale University and an M.B.A. in Finance from New York University. Au is the author of A Modern Approach to Graham and Dodd Investing, a book for times of economic uncertainty. Au appreciates your feedback; click here to send him an email.