In the past few years, the company has dealt with the loss of a huge pharmacy customer, sluggish U.S. economic growth, and margin-eroding price deflation in its core pharmaceutical business.
And yet, Cardinal continues to grow revenue, generate billions of cash flow, and raise its dividend each year.
Cardinal is a Dividend Aristocrat, a group of companies in the S&P 500 that have raised dividends for 25+ years.
Cardinal stock is cheap, which makes it an attractive choice for investors looking for growth and income.
Business Overview: Cardinal Health is a giant in the medical distribution field. It has a massive distribution system, consisting of 25,000 pharmacies in the U.S.
In addition, Cardinal provides supplies to nearly three-fourths of all hospitals in the U.S., and manufactures nearly 3 billion consumer and OTC health care products each year.
Cardinal is organized into two operating businesses:
- Pharmaceutical (77% of operating profit)
- Medical (23% of operating profit)
Cardinal has been in a difficult turnaround, ever since it lost pharmacy retail giant Walgreens Boots Alliance(WBA) - Get Report , one of Cardinal's largest individual customers. After its Walgreens contract expired, Cardinal's revenue fell 10% in 2014. Due to its industry-leading distribution and positive brand reputation, the company managed to offset the loss of Walgreens by adding new customers.
Cardinal's revenue growth since 2014 has been highly impressive.
Source: 2016 Annual Report, page 14
2016 was a highly successful year for Cardinal on a number of fronts. It posted 19% revenue growth along with 18% growth in operating profit, for the year. Revenue of $121.5 billion hit a record for the company. The core pharmaceutical segment led the way last year. Revenue soared 20%, to $109.1 billion. Segment profit increased 19% for the year.
Growth Prospects: Just as Cardinal's business recovered following the expiration of its contract with Walgreens, it got hit with a new setback: drug pricing deflation. Intensifying political pressure on drug prices in the U.S. has caused margins to fall in Cardinal's pharmaceutical segment, its core market. This has hampered the company's profitability.
For example, last quarter Cardinal's pharmaceutical segment increased revenue by 5%, but profits fell by 14%.
The company expects drug price deflation will be a drag for the rest of fiscal 2017.
Source: Q2 Earnings Presentation, page 11
The good news is that even though Cardinal operates in a low-margin business, it has proven it doesn't need to generate high margins.
Cardinal owns a huge piece of a highly-concentrated industry.
Even with low profit margins, the company still generated $3 billion of operating cash flow in fiscal 2016 alone.
It consistently generates strong cash flow, which allows it to invest in the business, and reward shareholders at the same time.
Source: 2016 Annual Report, page 9
From fiscal 2012-2016, Cardinal invested $8.5 billion in combined acquisitions and capital expenditures, and returned more than $5 billion to shareholders in share repurchases and dividends.
Cardinal frequently utilizes M&A to generate growth.
Its major acquisitions in fiscal 2016 included the $1.9 billion acquisition of Cordis, and the $1.1 billion purchase of Harvard Drug Group. These acquisitions boosted both of Cardinal's major businesses. By buying Cordis, which has operations in more than 50 countries, Cardinal expanded the geographic reach of its medical segment. And, it supplemented Cardinal's portfolio of cardiology devices. The Harvard Drug deal significantly boosted Cardinal's distribution of generic pharmaceuticals, and represents the company's willingness to adapt to the changing climate.
Continued investment, both organically and through M&A, should help Cardinal generate positive earnings growth over the long term.
Competitive Advantages & Recession Performance: One of the downsides of Cardinal Health's business model is that it does not provide many competitive advantages.
Cardinal Health operates in a low-margin business, that is susceptible to deflationary pricing pressure.
Still, the company has managed to differentiate itself, based on its huge distribution network and strong brand.
Cardinal has a market capitalization of $25 billion, and a vast network. Including Cardinal, three main players in the health care distribution industry control more than 80% of the market. This has enabled the company to expand customer relationships, and grow revenue at a high rate.
And, health care product distribution is a defensive business. As such, Cardinal Health is a recession-resistant company.
Like most companies in the S&P 500, Cardinal suffered a significant earnings decline during the 2007-2009 recession:
- 2007 earnings-per-share of $3.41
- 2008 earnings-per-share of $3.80
- 2009 earnings-per-share of $2.26
- 2010 earnings-per-share of $2.22
That said, Cardinal maintained solid profitability throughout the Great Recession, and quickly recovered after 2010.
The company's industry leadership and scale allow it to generate significant earnings, even when the economy enters recession. This is one of the benefits of operating in the health care sector-consumers need their medications and health care supplies, no matter the prevailing condition of the U.S. economy.
Valuation & Expected Total Returns: Based on fiscal 2016 adjusted earnings-per-share of $5.24, Cardinal stock trades for a price-to-earnings ratio of approximately 15. By comparison, the S&P 500 Index trades for an average price-to-earnings ratio of 26.
The stock trades for a discounted multiple, presumably because of the downward pressure on Cardinal's margins. However, if the company can continue to grow revenue and eventually return to earnings growth, the stock valuation could expand.
In addition, Cardinal stock will generate returns based on earnings growth and dividends. A potential breakdown of shareholder returns moving forward is below:
- 4%-6% revenue growth
- 1% margin expansion
- 1% share repurchases
- 2% dividend yield
Under this scenario, total returns could reach approximately 8.2%-10.2% annualized.
Cardinal is an attractive dividend stock, not just because of its above-average dividend yield, but also because of its high dividend growth.
Thanks to its strong free cash flow, the company can return a lot of cash to shareholders.
For example, in 2016 Cardinal increased its dividend by 16% and also approved a new $1 billion share repurchase authorization.
Cardinal Health has faced a number of headwinds in recent years, but it continues to generate high levels of cash flow. This provides it with the ability to raise dividends at a high rate each year, even in a harsh operating environment.
Due to its strong industry position, profitability, growth potential, and above-average dividend yield, Cardinal stock ranks very highly using The 8 Rules of Dividend Investing.
As a result, Cardinal is one of the most attractive health care dividend stocks for 2017.
I am not long any of the stocks mentioned in this article.