Cardinal Health: Don’t Forget About This Undervalued Aristocrat (NYSE:CAH)


As multiples expand, growth companies trade at record-high valuations, it becomes easy to fall into what I see as a trap, of investing in high-yielding companies for the sake of yield more than safety.

I will try to counteract this not only in myself but also in you as well, by focusing more on presenting conservative companies with excellent potential upsides. They may not be the most exciting or innovative companies, but they provide you with a relatively safe and conservative income. These are the sort of companies I personally want to hold – and I believe you should want to hold as well.

Cardinal Health – How has the company been doing?

On a 1-year basis, the company shows significant growth and returns – but compared to some of the companies that have rebounded since COVID-19, Cardinal Health (CAH) has recently dropped from prices of close to $60/share to current prices of around $50/share. It belongs to the category of healthcare stocks which, despite a recovery and bullish situations for drug companies due to the pandemic, don’t trade at any particularly high multiple.

(Source: Cardinal Health FY18 Report)

The current valuation is in part driven by company results. The company presented 4Q20 during August, and the quarter saw:

  • Exceeded the company’s own non-GAAP guidance range, bringing in results beyond the company’s own expectations.
  • Paid down $1.4B in long-term debt.
  • Surpassed cost savings target thanks to contributions from the manufacturing/supply chain.
  • Enjoyed positive results from its generic program.
  • No significantly negative COVID-19 impact, given that operations across all manufacturing and distribution facilities were maintained.
  • Provided very minimal SCM disruptions thanks to Red Oak.

While these points sound positive, the fact is that the company’s guidance was well below 2019 levels, so an earnings beat based on this was still a 12-13% drop in operating earnings on a YoY basis. In fact, everything dropped – revenues, margins, earnings/net earnings, and EPS. The only thing positive on a YoY basis was the savings in SG&A, which did come in lower.

Pharmaceutical demand hit CAH, with COVID-19 meaning a lower demand for key products in the company’s lineup in generics and precision health. Though the company expected this, we’re still looking at a 26 bps margin drop to just north of a 1% segment profit margin for the Pharma segment.

(Source: Cardinal Health 2Q20 Presentation)

Things were different in the medical segment, however. The segment saw margin and profit expansion due to cost savings and charges – and the negative distribution and product effects, which will turn around eventually, will further add to the company’s future profits.

The company expects the COVID-19 impact to essentially continue until the end of 2021 when the impact will be considered mild. The demand for PPE will continue to trouble the company, as demand will be far higher than supply and procuring costs are up, and there will be key impacts in elective procedures and physicians’ office visits – key segments for the company’s sales – until the end of 2021 when the company expects things to return to more normal levels.

For the next fiscal, the company forecasts growth in revenue and profits (provided that the generics program continues to deliver), and no further significant costs from opioid legal issues – around $100M as in 2020. The company’s revenue and profit expansion is expected to come from the company’s Specialty Care and Connected Care segments – both key growth areas for Cardinal Health. Things in the medical segment are expected to decline due to COVID-19 effects, at least in terms of sales. Excluding COVID-19, the company expects profit to actually be significantly positive, but given the pandemic, Cardinal Health doesn’t see good things for the Medical segment profit.

Going forward, CAH will focus on optimizing its global SCM processes, such as finding new PPE suppliers/manufacturers, leveraging its generic program, invest in the aforementioned growth areas, and pay down another $0.5B of debt during the next year. The dividend growth rate is also expected to be maintained as well.

In my previous article, I wrote:

My overall thesis for Cardinal Health has always been to stop expecting double-digit revenue and earnings growth, and hence to expect only small increases to the company dividend, but that the company still represents a 3.5-.4.2% safe yield in an overall conservative business where CAH enjoys many structural and company-specific market advantages. That has made the company worth buying in the past.

(Source: Wolf’s Corona Discounts: Cardinal Health)

This specific thesis and expectation are something that’s still very much relevant and should be considered the core of investing in the company. While we certainly, eventually, will see a return to some sort of more normalized earnings multiple, in the meantime, we’re enjoying a significant yield.

While this is an article about Cardinal health and 4Q20, we should also look at this as the end of fiscal 2020 for Cardinal Health. So, while results on a quarterly basis YoY were down, the company’s FY20 results were actually good, compared to FY19. Operating earnings were above the guidance range, the company exceeded its cost-savings target, strengthening the balance sheet while continuing to execute on the company strategy. The company has also, like many others, moved to a remote work model.

In terms of liquidity, the company has a $2.8B cash balance and nothing drawn on the over $3B worth of credit facilities – and this with significant reinvestments into IT infrastructure and other growth opportunities, as well as $1.4B in debt, as well as over $900M returned to shareholders through dividends. All in all, the company sports a truly excellent capital position.

So, while 4Q20 came in a bit low, the full-year results for the company in terms of 2020 are actually very good. COVID-19 and the development here will be key for the company’s profits in certain segments, and Cardinal Health enters the new year expecting some drops in key areas here. The company also completed its divestiture of the remaining stake in NaviHealth, a company that tracks patient recoveries and attempts to target wasteful healthcare spend trend.

All in all, there was nothing in the quarter or the full-year that justifies any sort of significant change of stance for Cardinal Health. My fair value targets remain, and my outlook for the company remains.

Let’s look at the current valuation.

Cardinal Health – What is the valuation?

(Source: F.A.S.T Graphs)

I don’t think it hyperbole to say the company remains one of the most appealing investments in the sector. At a 3.84% YoC and an expected earnings growth rate of 5.17% per year until 2023, the company presents a very natural potential annual rate of return, both at trading at current valuation and returning to its more common 10-year average ~13X earnings multiple.

Even expecting a return only to 12X earnings until 2023, based on a 0% EPS growth next year, followed by 6-7% the following years, results in a potential annual rate of return on 19%, turning $10,000 into $16,373 including dividends until that time for a total rate of return of 63.73%. Even trading at today’s valuation of 9.29X P/E, the 3-year return for such a $10,000 investment would amount to a total return rate of 33.34%, or $13,334 including dividends – or an annual rate of return of 10.68%.

Given that we’re talking of a very conservative dividend aristocrat with decades (29 years) of maintaining its dividend, we’re talking about a truly excellent company with only a 36% LTM EPS payout ratio – the dividend can indeed be considered safe here, and I consider Cardinal Health to be class 2 stock on account of this. The company is investment-grade rated, and Morningstar considers the company’s moat to be “narrow” but existing.

Given such upsides, Cardinal Health is one of three companies I now consider extremely investable in the sector, and while the upsides in the other two may be higher, I don’t consider their operations as conservatively safe as I do Cardinal Health. It is because of this that if someone asks me of an undervalued, safe healthcare/pharma stock, I always mention Cardinal health as at least one of the options a potential investor should look at.

Cardinal Health’s valuation combines underestimation of the company’s results and expectations in terms of actual headwinds with a company that’s extremely conservative, well-run, and – while it holds low operating margins – stable.

My price target for the company is a 12X earnings multiple to represent the headwinds presented in elective segments by COVID-19, and the fact that the company needs to better its SCM processes, but weighted up by the company’s stable legacy operations and investments into new growth areas, excellent balance sheet and the fact that we’re looking at a company that’s represented in the healthcare sector as it is.

The price target here, therefore, is $66/share, coming to a potential upside of 30%.

Cardinal Health – Bulls & Bears

The continued bull thesis is based on Cardinal Health’s continuation as a conservative dividend aristocrat. This doesn’t necessarily, as I see it, mean that things won’t go down from time to time for the company. There are upcoming headwinds originating from the pandemic and related effects – but the long-term outlook for the company remains a positive one.

Cardinal Health wouldn’t be a buy at a higher valuation, given the company’s muted earnings growth prospects, but when you include a potential multiple expansion back to normal levels, the bullish thesis becomes clearer and the positives become easier to see. Outperforming broader indices through an annual return of 19% through a conservative business like CAH is no mean feat, and this is a core part of what I consider to be the bullish thesis for the company.

I’ve already mentioned the company’s balance sheet, payout, dividend track record, and similar variables – all of which point to a very positive situation, as I see it.

Combining these two factors – fundamentals and valuation – creates a bullish thesis which is hard to beat, as I see things. There are very few catalysts, given the company’s operations, that could essentially drive the company’s results so far into the ground that fundamental deterioration would follow.

This makes the bearish thesis at the current valuation a hard one to justify. You could argue that the company headwinds could be worse than expected, with the pharma segment suffering multi-year declines as a result of low volumes in elective surgeries and the like. Combine this with failures in the company’s growth-oriented investments, and a political reality that forces companies like CAH to lower prices – perhaps that’s a situation where I could see Cardinal Health declining significantly further than we’d see today.

This is an unlikely trifecta of headwinds, however, as the growth prospects haven’t shown any such indications, recovery is ongoing and the political realities remain to be seen. This also wouldn’t differentiate Cardinal Health from similar players in the same space, so such a decline coming from political realities would be general, not specific to Cardinal Health.

Only the most fundamental of disbelief or lack of faith in the company and sector should discourage someone from looking at this company and the investment prospect here, and this is the basis for my overall thesis.

Thesis

I like mixing pharma companies with healthcare companies, and distributors like Cardinal Health make for an interesting investment. At the current upside, yield, dividend safety, and company fundamentals for this business, it presents one of the better prospects on the market today.

In a market where many prospects are significantly overvalued and where undervaluation is to be found only in specific sectors or very few companies – out of a list of nearly 300 companies, only 23 are currently what I would consider “interesting” – Cardinal Health does stand out quite a bit. Yet it seems that many investors seem to forget about this company, or somehow not consider it interesting for their portfolio.

While not as depressingly valued at 8X P/E, the company still sports an over 30% undervaluation to what I consider to be a conservative fair value for the business. That means that forgetting about Cardinal Health isn’t really something that should become a habit, especially not in a market where undervaluation is easy to find. This article serves as a reminder to followers and readers, that Cardinal Health does exist, and the company offers a still-enticing potential upside and downside protection equaled only by a small number of similar-quality companies in similar sectors.

Because of this, Cardinal Health remains a “BUY”.

Thank you for reading.

Stance

Cardinal Health remains an appealing “BUY” at 30% undervaluation to what I consider to be “fair” value.

Disclosure: I am/we are long CAH. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: While this article may sound like financial advice, please observe that the author is not a CFA or in any way licensed to give financial advice. It may be structured as such, but it is not financial advice. Investors are required and expected to do their own due diligence and research prior to any investment.

I own the European/Scandinavian tickers (not the ADRs) of all European/Scandinavian companies listed in my articles.

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