Cardinal Health Has Some Convincing to Do

Because of the potential for overstated earnings at a serial acquirer, an investor's trust in management is absolutely essential. Sometimes balance-sheet income can be found by comparing the cash-flow statement to balance-sheet changes. Cardinal doesn't give an analyst a chance to find it, though. The cash-flow statement contains a catch-all category "Other operating items, net."

Return on equity is overstated. Accounting rules changed a couple of years ago so that pooling-of-interests accounting for acquisitions is no longer acceptable. Only purchase accounting may be used. Cardinal used pooling in $11 billion worth of acquisitions from 1996-2000.

Had the company used purchase accounting back then, the current balance sheet would look a lot different (i.e., much more goodwill). My calculations indicate that the ROE would have been about 9% in 2002, instead of the reported 19%. It's impossible to justify a premium valuation for a company with such a low ROE.

The business model is weak. Absent acquisitions, distributors generally are low-growth, low-margin businesses. I can't think of a distribution/wholesale model in any other industry category that has generated reasonable long-term returns for shareholders. That's because the distribution model requires lots of capital coincident with low profitability.

Margins and Mergers

The bulk of Cardinal's business is distributing commodity products at very low margins. Competitors AmerisourceBergen (ABC - commentary - Cramer's Take) and McKesson (MCK - commentary - Cramer's Take) make only 1 cent to 1.5 cent per dollar of revenue. The big three in this space -- Cardinal, Amerisource and McKesson -- are running out of potential acquisition targets. Antitrust concerns should prevent a merger among these three.

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Playing Politics With Accounting Rules

Note also that Cardinal securitizes and sells lease receivables via off balance sheet partnerships (special purpose entities). Management has control, of course, over the timing of gains from these sales. In addition, there are lots of special charges contained in Cardinal's financials. Many of these look like ongoing expenses to me.

I realize that Cardinal is a favorite of institutional investors and widely admired by analysts. But the very bedrock of this type of business and its valuation rests on the trustworthiness of management. After reviewing this company and its financials, I think that the stock merits a discount, not a premium valuation. Accordingly, I'd recommend that investors run, not walk, away from this stock.

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Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor specializing in turnaround situations. At time of publication, neither Alsin nor ACM held a position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback and invites you to send it to [e-mail]. Click here to receive Arne's latest favorite stock picks from his newsletter, The Turnaround Report.