Dividend aristocrats, such as Cardinal Health (CAH), have long been a staple in dividend growth investors’ portfolios, and for very good reason.
Nothing says “stable, growing, and healthy business” like 25+ years of consecutive dividend growth. With 30 straight years of very impressive 19.7% average annual payout increases, Cardinal Health has proven itself as a dominant industry leader and excellent long-term investment.
However, the medical industry is undergoing some major shifts, resulting in changes that could ultimately threaten Cardinal Health’s business model, future profit growth, and its ability to continue generating strong dividend increases.
As a result, Cardinal Health’s stock has underperformed the S&P 500 by approximately 30% over the past year, sending its dividend yield to an all-time high last month.
Let’s take a closer look at this beaten-down dividend aristocrat to see whether or not it low share price is more likely a buying opportunity or a value trap.
Founded in 1971 in Dublin, Ohio, Cardinal Health is one of the world’s three largest medical supply and pharmaceutical distributors. The company essentially acts as a middleman that sources over 400,000 medical supplies and drugs from over 5,000 pharmaceutical and medical supply companies.
It then distributes these products to various clients along the medical industry supply chain. Cardinal Health operates two business segments:
Pharmaceutical (90% and 85% of fiscal 2017 sales and segment profits, respectively): distributes branded and generic pharmaceutical, specialty pharmaceutical, over-the-counter healthcare, and consumer products to retailers, hospitals, and other healthcare providers, including over 24,000 pharmacies, 140,000 doctors offices and clinics, and 85% of hospitals in the U.S. It also serves clients in China.
The pharmaceutical segment also offers data and drug supply and distribution management (i.e. back office logistics) services to its clients and suppliers.
Medical (10% and 15% of fiscal 2017 sales and segment profit, respectively): manufactures, sources, and distributes medical, surgical, and laboratory products, including cardiovascular and endovascular products; wound care products; surgical drapes, gowns, and apparel; exam and surgical gloves; fluid suction and collection systems; and incontinence, enteral feeding, urology, operating room supply, electrode and needle, and syringe and sharps disposal product lines to hospitals, ambulatory surgery centers, and clinical laboratories in the U.S., Canada, Europe, and China.
It’s important to note that, while Cardinal Health does operate overseas, including a fast-growing Chinese business, 95% of sales are derived from the U.S.
The major investment thesis for Cardinal Health hinges on a fast-aging population driving U.S healthcare spending, especially on pharmaceuticals and medical supplies, much higher over the coming decade and beyond.
For example, according to a recent report by the Centers for Medicare & Medicaid Services (CMS), U.S. healthcare spending is set to rise from $3.4 trillion in 2016 to $5.5 trillion by 2025, or 20% of GDP. Retail pharmacy sales meanwhile, were around $300 billion in 2016.
In other words, the U.S. healthcare sector is expected to grow 5.6% annually for the next decade, about double the rate of overall economic growth.
And indeed the past five years have been a time of strong growth for Cardinal Health, with impressive increases in the bottom line resulting in substantial capital returns to shareholders, including significant dividend increases.
That being said, recently conditions have soured greatly for Cardinal Health, as well as its two mega-peers, McKesson (MCK) and AmerisourceBergen (ABC).
That’s because, while sales continue to grow robustly (fiscal 2017 pharma and medical sales up 7% and 9%, respectively), pharma margins aren’t holding up.
The main reason for the profit decline in its dominant business is falling generic drug prices, which in 2013 and 2014 saw surprise price increases due to higher-than-expected demand. This allowed medical wholesalers such as Cardinal to pass on higher costs to clients and boost margins.
However, the FDA responded with faster approvals of generic drug applications in 2015, resulting in the supply and demand situation reversing.
In the meantime, the highly complex medical supply chain has seen massive consolidation as concerns over fast-rising medical expenses have forced everyone to maximize economies of scale and thus the ability to negotiate lower prices.
This consolidation trend has resulted in major pricing pressures on all medical wholesalers because large customers can play the industry giants off each other.
For example, in 2012 Safeway cancelled its drug supply contracts with McKesson in favor of Cardinal Health; however, in 2016 Safeway decided to drop Cardinal after its 2015 merger with Albertsons.
Similarly, Cardinal Health had a long and profitable relationship with Walgreens up through 2012, until Walgreens signed a 10-year service agreement with AmerisourceBergen.
Cardinal was able to come back though, thanks to the creation of Red Oak Sourcing, a 50/50 joint venture with CVS Caremark designed to streamline their respective drug supply chains and lower costs through economies of scale.
Another problem for medical wholesalers has been that a traditional source of higher profits, independently owned pharmacies, have now started banding together in Group Purchase Organizations, which increases their collective purchase power over suppliers.
All told, the current down cycle for generic drugs has left Cardinal Health predicting drug deflation “to be in the low-double digits” for its 2017 fiscal year and “to moderate to mid-single digits in fiscal 2018” (ending June 30, 2018).
This resulted in management offering disappointing guidance for the next year, calling for adjusted EPS to decline by 7.8%.
On the plus side, Cardinal Health expects generic prices to stabilize within the next 12-18 months, resulting in 2019 adjusted EPS coming in at “at least $5.60” per share, which would represent a 12.5% increase over 2018, though just a 3.7% increase from fiscal 2017 levels.
How can management be optimistic about the future when it seems that there is such a strong downtrend for generic drug prices? There are four primary reasons.
First, drug prices tend to be cyclical, so rising demand from a growing and aging global population is still expected to result in an eventual stabilization of wholesale drug distribution even with the growing supply of generics.
Of course, the stronger top line growth is expected to come at the expense of lower margins, resulting in about 25% slower EPS growth for distributors like Cardinal.
Which is why management is also investing in the rather nebulous “customer investments” and IT upgrades, to help boost margins going forward.
In addition, the company is looking to overseas expansion, where it’s seeing “solid sales growth in Asia-Pacific, Latin America, and Europe.” That’s to capture share in the fast-growing global healthcare market, which analyst firm Deloitte projects to reach $8.7 trillion by 2020.
Finally, Cardinal Health continues to diversify and grow via acquisitions including its purchases of Cordis, naviHealth, and the Harvard Drug Group in 2015, as well as its most recent large scale deal, Medtronic’s Patient Care, Deep Vein Thrombosis and Nutritional Insufficiency business for $6.1 billion.
Cardinal Health’s medical segment is actually experiencing not only stronger revenue growth than its pharma segment, but also expanding margins, thanks to the acquisition of Cordis, who’s interventional cardiology and endovascular products offer far higher margins.
Given that operating margins in medical were 4.2% compared to just 1.9% in pharma, it’s understandable that management would want to increase its exposure to this fast-growing and more profitable business.
Adding some of Medtronic’s products will likely provide economies of scale in medical products manufacturing and sourcing (helping profitability) while increasing the company’s product breadth.
There are several significant risks to understand before investing in Cardinal Health.
First, the medical industry is highly complex, with five levels of supply chain (manufacturers, distributors, pharmacy, pharmacy benefit managers, and payers – insurance companies or Medicare/Medicaid).
This is made more so by the complex interplay between private and public funding sources and a desperate need to lower medical costs which have been far outpacing inflation for over 30 years.
Combined with the razor-thin margins of many parts of the supply chain (especially distribution and pharmacy), there is an endless shifting of the various players into often confusing relationships as everyone attempts to maximize margin while putting the screws to their own suppliers.
Simply put, it is a very complex and dynamic landscape.
Investors considering the space need to be comfortable with the highly dynamic nature of this business and trust that management will be able to continue growing sales, earnings, cash flow, and the dividend in the coming years despite occasional setbacks, such as loss of supply contracts with major retailers.
Then there’s the constant threat of increased government regulation of medical prices or even just Medicare/Medicaid potentially being able to negotiate bulk purchases (currently illegal), which could result in ongoing industry uncertainty and potentially permanently lower margins.
Next, we need to consider that Cardinal Health’s plan to grow and diversify into higher-margin medical devices could run into trouble in two ways.
First, there is execution risk, specifically of overpaying and failing to achieve expected synergistic cost savings. In other words, large blue chips that are struggling to grow often attempt to reach for growth by acquiring companies outside their area of expertise. This is why the far majority of large M&A deals actually end up destroying shareholder value.
Next, Cardinal Health has been using the current period of record low interest rates to take on a large amount of debt to fund its medical products purchases. For example, $5.2 billion out of the $6.1 billion purchase price for the Medtronic deal was funded with debt.
In a rising rate environment, Cardinal Health could be forced to slow down its pace of acquisitions to deleverage its balance sheet.
Finally, we can’t forget that just as the world of medical wholesaling is marked by cutthroat competition and a constant battle to maintain margins, the same is true for medical devices.
After all, Medtronic is a dividend aristocrat with 39 years of dividend growth under its belt and arguably one of the medical device industry’s top managed names.
In today’s challenging healthcare market, in which prices for such assets are falling, one might assume that the product portfolio Cardinal Health is buying isn’t necessarily growing like a weed or generating extraordinarily high margins.
Of course, given that Cardinal Health’s margins and returns on shareholder capital are currently below the industry average (in an industry already marked by rock bottom profitability), there is a chance that medical segment acquisitions will improve the company’s overall margins and returns on capital over time.
Cardinal Health Trailing 12-Month Profitability
Cardinal Health’s Dividend Safety
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.
Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.
Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.
We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.
Cardinal Health has a Dividend Safety Score of 86, indicating a highly secure and dependable dividend, which is to be expected from a dividend aristocrat that’s been raising its payout every year since 1987.
The key to such consistent growth, even in a cyclical and low margin business, is management’s disciplined pace of dividend increases. As you can see, Cardinal Health has maintained highly conservative EPS and FCF per share payout ratios over the last decade.
This means that even in the bad times, such as now, Cardinal’s payout remains comfortably covered by earnings (45% EPS payout ratio over the trailing 12-month period) and cash flow (72% FCF payout ratio), ensuring that management can continue to invest in growth yet also deliver the clockwork-like dividend increases that investors have come to expect.
Another protective factor is a strong balance sheet, with a reasonable net debt burden that’s easily serviced by cash flows, as well as a high current ratio (short-term assets/short-term liabilities).
However, it is important to note that while Cardinal’s balance sheet remains sound, as evidence by its high interest coverage ratio and solid investment-grade credit rating, its debt levels are substantially higher than its peers due to its recent medical segment acquisitions.
Going forward, investors will want to make sure that management delevers the balance sheet in order to ensure not only a safe dividend, but strong financial flexibility in this fast-changing industry.
Cardinal Health’s Dividend Growth
Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
Cardinal Health has a Dividend Growth Score of 45, indicating that investors probably need to expect slower dividend growth going forward than they have enjoyed in previous decades.
For example, while Cardinal Health has traditionally grown the dividend in the mid to high double-digit range, the most recent increase of 3% is the slowest growth rate in at least 25 years.
That certainly could explain why many investors perhaps assume the company’s business model is permanently broken.
However, most analysts believe that even in a new world of slower EPS and FCF per share growth, Cardinal Health should be able to generate around 8% annual sales growth, and thanks to steady 1% to 2% share buybacks, grow its bottom line (and its dividend) by 8% to 9% over the next decade.
Over the past year, concerns over the future of medical wholesale distributors have battered Cardinal’s share price and caused it to underperform the S&P 500 by around 30%.
However, if you understand the risks and believe that generic drug prices will recover (in other words, this time isn’t different), today could be the ideal time to acquire shares of one of the most hated dividend aristocrats on Wall Street.
For example, Cardinal’s forward P/E ratio of 13.9 is far below that the S&P 500’s 17.5, the industry median of 20.1, as well as the stock’s own historical norm of 15.9.
Perhaps more importantly for income investors, CAH’s dividend yield of 2.7% is not only higher than the S&P 500’s 1.9% and the industry median of 1.4%, but also significantly higher than the stock’s historical 2% yield.
In fact, currently Cardinal Health’s yield is near it’s all-time high, signaling either a new normal of lower growth going forward or perhaps an interesting buying opportunity.
If management’s expansion plans into medical products succeeds and generic drug prices stabilize, Cardinal Health’s stock has potential to deliver annual total returns between 10.7% and 11.7% (2.7% dividend yield plus 8% to 9% annual earnings growth).
While that is one of the most tantalizing return profiles of any dividend aristocrat today, I remain skeptical of the company being able to deliver those results in light of fast-changing industry conditions. Lower growth is more likely to be the new normal, in my opinion.
The medical sector’s desperate need to cut costs means the future of the medical distribution industry will be one where scale is larger, but companies like Cardinal Health will struggle to maintain their already low margins.
Management’s plan to diversify into higher (though still low) margin medical equipment and wholesaling could return the company to solid high single-digit growth beyond 2019.
However, given the token dividend increase this year, along with the ongoing fear, uncertainty, and doubt that pervades the industry (and all of its complexities), Cardinal Health can’t be described as a “sleep well at night” stock and thus may not be suitable for a conservative dividend growth portfolio.
My personal preference is to own companies with greater pricing power and lesser dependence on factors outside of their control.
As drug buyers and manufacturers look to continuing wringing out costs to preserve their margins, drug distributors could become further commoditized as the healthcare sector seeks more efficiency.
Although Cardinal Health’s relatively low P/E ratio and high dividend yield look tempting, I think they simply acknowledge the company’s structurally lower growth profile and the risks faced by management’s large expansion into medical products.
For even more detailed commentary on the risks Cardinal Health faces in drug distribution, I recommend reading my note here.