Cardinal Sin: Shortfall Unleashes Rout

Cardinal Health ( CAH) has fallen ill.

News of a profit shortfall and an expanding government probe sent the stock skidding 24% on Thursday. The health care company warned late Wednesday that both current results and future profits will fall shy of expectations. It also announced that it had received a subpoena -- some 10 days ago -- from the Securities and Exchange Commission requesting new information about the company's revenue classification. In addition, the company said that the U.S. attorney's office in New York has now joined in the formal SEC probe that it disclosed last month.

Still, analysts seemed more troubled by the company's profit warning than anything else.

Raymond Falci of Bear Stearns did raise concerns that the SEC subpoena may have been driven by "a real or perceived sense of lack of cooperation on CAH's behalf." But he focused primarily on the company's profit slowdown -- which is expected to continue through next year -- when cutting his recommendation on the stock to peer perform.

Cardinal expects to post fourth-quarter profits of between 93 cents and 95 cents a share -- as much as 10 cents shy of the consensus estimate -- because of an unexpected drag in two of its core businesses. The company also projected next year's profit growth at around 10% instead of the "midteens or better" it had hoped for.

Like Falci, Jefferies analyst David Francis promptly cut his recommendation on Cardinal's stock upon hearing the dismal news.

"We are not fans of downgrading stocks simply on the basis of missed earnings," said Francis, who now has a hold rating on Cardinal's shares. "However, the confusing nature of CAH's rationale behind the company's disappointing 4Q04 June performance -- and the outlook for subpar earnings growth in FY2005 -- creates a head-scratcher for investors. ... This management team, which had been battling back strongly from a perceived credibility gap since questions about the company's accounting practices surfaced two years ago, will go back under a very hot and bright light again."

Francis went on to describe Cardinal's fourth-quarter miss as a "shocker" that appeared to catch even the company itself by surprise. Falci went a step further by trying to explain the shortfall.

He blamed two factors almost equally for the profit hit. First, he pointed to "continued margin erosion in Cardinal's core pharma distribution segment" as the company tries to adopt a new business model. Then he highlighted "soft operational dynamics" related to sterile manufacturing delays that he nevertheless views as "clearly fixable."

"We don't see yesterday's announcement as a sign of a major fundamental break in the CAH model," Falci wrote. But "we are still lowering our rating based on delays in business stabilization across several CAH units and ongoing overhang of increased/expanded SEC investigation."

Cardinal's stock plunged $16.87 to $53.18 on Thursday. And Falci questions whether the stock -- helped by buybacks in the past -- will quickly rebound this time around.

"While CAH's past two lowered guidance events in the last 18 months have been followed by 15%-plus gains within a few months, we see this as hard to predict in the near term," he stated.

To be sure, the mounting government probe could weigh on the stock for a while. Last month, Cardinal announced that the SEC had launched a formal probe of the company's methods for classifying revenue from its pharmaceutical distribution business. Specifically, the agency is examining whether certain amounts should be counted as revenue from bulk deliveries to customer warehouses instead of operating revenue.

Falci notes that at least one of Cardinal's peers, McKesson ( MCK), excludes such deliveries from operating revenue. But he also believes that Cardinal's accounting makes more sense. Moreover, he views the matter as rather immaterial since it should have no impact on bottom-line profitability in the end.

Still, Cardinal itself has already admitted that the SEC's inquiries "are not limited to this subject."

At least one other analyst, Sean Wieland of WR Hambrecht, downgraded Cardinal on Thursday. Wieland cut the stock from buy to hold, primarily because of the company's diminished growth outlook.

"Multiple investigations, lowered guidance and a hazy outlook on growth have shaken our thesis that CAH is a 'buy and hold forever' stock," Wieland concluded.

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