Cardinal Health (CAH, Financial) stock fell nearly 10% on Friday, Oct. 28. The next day markets were open (Oct. 31), the company’s stock gained around 4%.
This level of volatility is unusual for any stock, and Cardinal Health is no ordinary stock. The company is very stable.
Cardinal Health was founded in 1971. It is one of the three largest pharmaceutical distributors in the U.S. Together, the "Big Three" have around an 85% market share.
Note: AmerisourceBergen (ABC, Financial) and McKesson (MCK, Financial) are the other two.
Cardinal Health has increased its dividend payments for 31 consecutive years. It is no small feat to have increased dividends every single year for three decades.
The company is a member of the exclusive Dividend Aristocrats Index, which is comprised of just 50 Standard & Poor's 500 stocks with 25-plus years of consecutive dividend increases. You can see a list of all 50 Dividend Aristocrats here.
Cardinal Health’s stock price collapsed on Oct. 28 because rival McKesson released weak quarterly numbers. The company saw its revenue grow just 2%. Adjusted earnings per share fell 7%. McKesson shares fell over 23% on the day of the announcement.
On Oct. 31, Cardinal Health released its quarterly numbers.
Cardinal Health’s quarterly numbers
Cardinal Health’s most relevant quarterly numbers are below:
- Revenue increased 14%.
- Adjusted earnings per share fell 10%.
Obviously, 14% top line growth is good. This is in direct contrast to McKesson’s 2% revenue increase.
Adjusted earnings per share declines of 10% are not good. The primary driver of the earnings per share decline is increased competition among the "Big Three." A price war is breaking out.
AmerisourceBergen appears to be the instigator of the price war. The company is lowering prices to gain market share. Cardinal Health’s 14% revenue increase shows the company is not afraid to match AmerisourceBergen. McKesson, however, has not followed.
You can see the impact of lower margins by looking at the performance of Cardinal Health’s two segments. The company’s medical segment performed well. Margins and revenue both increased, resulting in 26% profit growth. Revenue increased in the pharmaceutical segment, but margins declined 29% from 2.62% to 1.86%.
Source: Cardinal Health Q1, 2017 Presentation
In the short run, pricing pressure will hurt margins. In the long run, price wars will cease and margin stability will resume. Cardinal Health’s rapid revenue growth shows that the company is likely gaining market share.
The company’s management is still expecting positive growth in fiscal 2017. Management is expecting strong long-term growth as well:
Source: Cardinal Health Q1, 2017 Presentation
Cardinal Health’s place in the pharmaceutical supply chain
Cardinal Health serves two primary functions:
- Provide generic and brand-name drugs to smaller independent pharmacies or group purchasing organizations.
- Provide brand-name drugs to large retail chains
Source: Morningstar Healthcare Observer
Gross margins in the industry for working with smaller players are around 4.0% to 5.0%. Gross margins in working with the large retail chains are around 0.3% to 0.6%. These are razor-thin margins.
Distributors play an important function in the supply chain. They provide the infrastructure to move drugs from the manufacturer to pharmacies and on-line/mail-order retailers. Cardinal Health has annual sales of over $120 billion. The scale of the operation makes it efficient.
The distribution industry has almost impossibly small margins. It is clearly not the reason drug costs are so high – and rising.
Getting drugs from the manufacturer to retailers in as efficient a manner as possible is vital to the supply chain. Cutting out distributors would likely lead to an increase in prescription costs because individual manufacturers could not provide this service as efficiently as the "Big Three" large distributors.
The investment prospects of Cardinal Health
Cardinal Health is a compelling investment at current prices. The company has a long history of paying rising dividends. This is important because it shows management prioritizes shareholders.
The company currently has a dividend yield of 2.7% and a payout ratio of around 35%. The company has compounded its dividend payments at 25% per year over the last decade. This growth rate is unsustainable, but dividends should continue to increase at around 10% per year over the next several years.
Cardinal Health also has an above-average expected earnings per share growth rate over the next several years. The company’s management is anticipating 10% to 15% earnings per share growth. This may be a bit optimistic, but the company has grown earnings per share at 10% per year over the last five years.
Growth will come from Cardinal Health’s investments in China, share repurchases and an aging U.S. population. The use of prescription medicine (and its cost) is only increasing. These trends will likely continue as baby boomers continue to age and society becomes increasingly accepting of younger people taking a host of prescription medications. Overall, it is likely Cardinal Health continues compounding its earnings per share at around 10% per year.
Cardinal Health is a high-quality business with a shareholder-friendly management. In today’s low interest rate environment, you usually have to "pay up" in the form of high price-earnings (P/E) multiples for quality investments.
Fortunately, that isn’t the case with Cardinal Health. The company has a P/E ratio (using adjusted earnings) of just 13.7. The company’s average P/E ratio since 2014 is around 20. Cardinal Health looks undervalued at current prices.
The company ranks in the Top 10 and is a strong buy using The 8 Rules of Dividend Investing. Cardinal Health is an excellent choice for dividend growth investors looking for above-market total returns over the next five to 10 years.
Disclosure: I am not long any of the stocks mentioned, but may buy shares of Cardinal Health in the next 72 hours.
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