Dividend Aristocrat Cardinal Health (CAH) Drops 12% – Buying Opportunity or Value Trap?

Cardinal Health (CAH) updated its guidance Tuesday morning, causing its stock price to plunge nearly 12% on the day.

The company previously cut its profit guidance in October 2016, but today’s news was clearly still a big surprise.

Many investors like owning dividend aristocrats such as Cardinal Heath because they have been less volatile than the broader market (learn about all 51 dividend aristocrats here).

Let’s take a closer look at why the market was so disappointed with Cardinal Health’s business update and if the stock could be an attractive investment opportunity for our Top 20 Dividend Stocks portfolio.

How does Cardinal Health make money?

Founded in 1971, Cardinal Health is one of the largest healthcare companies in the world. The business primarily makes money by distributing a wide range of pharmaceutical products and medical supplies (2.8 billion healthcare products are manufactured or sourced by Cardinal Health each year).

Over 70% of U.S. hospitals use Cardinal Health’s resources, and the company serves more than 25,000 pharmacies.

Cardinal Health splits its business into two segments. The Pharmaceutical segment accounts for 90% of sales and 85% of profits. This unit distributes a wide range of branded and generic drugs, specialty pharmaceuticals, and over-the-counter products.

The company’s Medical segment accounts for 10% of sales and 15% of profit. It distributes medical, surgical, and laboratory products to hospitals and other healthcare providers.

Cardinal Health is essentially a middleman in the healthcare sector, making purchases from drug manufacturers and selling its acquired inventory for a small profit to pharmacies and hospitals.

The company’s operating margin typically sits between 1% and 2%, reflecting the small sliver of profit Cardinal Health makes on each sale. The firm therefore depends on generating a high volume of sales to turn a meaningful profit.

The most attractive distributors are able to offer a wide range of products with competitive prices and dependable delivery standards.

They tend to benefit from having substantial distribution networks, long-standing customer contracts, and economies of scale.

Why did Cardinal Health’s stock drop?

Cardinal Health announced that its fiscal 2017 non-GAAP earnings per share will be at the bottom of its previous guidance range.

The largest factor dragging down results is generic drug price deflation, which management now expects to be in the low-double digits for the full fiscal year.

Investors were perhaps even more concerned with the company’s guidance for fiscal 2018, which calls for non-GAAP earnings to be flat to down mid-single digits compared to 2017.

Cardinal Health’s fiscal 2018 earnings guidance essentially missed analysts’ expectations by around 10% and was nowhere close to management’s long-term goal of 10-15% annual non-GAAP earnings per share growth.

In addition to slashing its guidance due to greater-than-expected generic drug price deflation, Cardinal Health announced it is acquiring Medtronic’s Patient Care, Deep Vein Thrombosis, and Nutritional Insufficiency businesses for $6.1 billion.

Here’s a look at some of the key medical products Cardinal Health is acquiring:

Management hopes this business will provide economies of scale in medical products manufacturing and sourcing (helping profitability) while increasing the company’s product breadth.

Is Cardinal Health’s stock price decline news or noise?

If the drop in Cardinal Health’s stock price was driven by short-term factors that have no bearing on the company’s long-term earnings outlook (and the stock’s valuation now looks reasonable), this week’s events could be a buying opportunity for long-term dividend investors.

However, I think the issues weighing on Cardinal Health could structurally impact the company’s future profitability and growth opportunities.

Let’s start with the main issue – declining profitability in Cardinal Health’s Pharmaceutical segment, which generates 85% of profits.

Cardinal Health benefited from the boom in generic drugs over the past five years. Tens of billions of dollars worth of brand-name drugs lost patent protection in 2012, for example, resulting in a boom in generic competition over the following years.

Generic drugs carry higher margins for Cardinal Health compared to branded drugs. As generic drug pricing increased, the company enjoyed a boost to its gross profits.

However, the tide is now going back out. Most of the entire pharmaceutical value chain is under pressure to cut costs and make healthcare more affordable.

Many pharma businesses are moderating price increases on their drugs in response to increased political pressure. Generic drug prices have also been hit by because of faster approvals by the Food and Drug Administration (resulting in more generic drug supply) and a price-fixing investigation, according to The Wall Street Journal.

The Wall Street Journal went on to note that “drug distributors had feasted for years on stable or rising drug prices, which allow them to more easily mark up prices while profiting by arbitraging annual price increases. Now, the more rapidly prices fall, the more difficult it becomes for distributors like Cardinal to resell drugs from manufacturers to pharmacies at a profit.”

Equally important, pharmacies have meaningfully consolidated in recent years as they faced increased margin pressure from lower reimbursement rates.

As a result, they have been able to exert more pressure on the prices they pay Cardinal Health for the drugs it resells to them. In fact, Cardinal Health’s CEO noted on the company’s earnings call that pricing pressures are on the “sell-side downstream to the customers. It’s still a little bit more than what we modeled.”

I think the economics of the drug distribution business are structurally changing. A company like Cardinal Health will always play a role, but the middlemen seem increasingly likely to bear the brunt of healthcare reform and sell-side consolidation.

DrugChannels.net provided an excellent review of the margin pressures that wholesale distributors face. You can read their take here.

Assuming sell-side price pressure remains high, there is increased risk that competition will only increase between the three companies that control almost all of the drug distribution business (McKesson and AmerisourceBergen are the other two).

Since distribution is largely a scale game, these rivals might battle even harder with each other for market share, and the stakes are high.

For example, CVS Health (CVS) accounted for 25% of Cardinal Health’s sales last year, and two group purchasing organizations (GPOs) combined for another 17% of revenue. Losing major customers or having to further concede on pricing to retain them could really impact the company’s bottom line, especially if Cardinal Health is unable to negotiate better terms with its drug manufacturers.

Management’s decision to take on substantial debt to acquire some of Medtronic’s medical products is another signal that Cardinal Health’s core pharma distribution business might not have the favorable long-term outlook that the company once thought (thus there was increased pressure to diversify).

I am not a medical products expert, but this seems to be a price-sensitive business that can be challenging to compete in. I’m not sure that Cardinal Health will have much of a durable competitive advantage here either.

Closing Thoughts on Cardinal Health

The healthcare sector is undergoing a number of structural changes, many of which seem likely to continue causing disruption for drug distributors such as Cardinal Health.

The issues that caused the drop in Cardinal Health’s stock price seem more like news than noise to me, and the increasing complexities of the drug distribution chain only further serve to keep me out of the stock.

I would rather own businesses with greater pricing power and more controllable competitive advantages. Drug distributors seem to be largely commodity-type businesses, and their margins could be further squeezed as both drug buyers and manufacturers look to preserve their margins in an increasingly cost-conscious healthcare world.

I expect Cardinal Health to retain its favorable Dividend Safety Score, indicating that its payout remains very secure, but I have my doubts about the company’s long-term growth profile.

While the stock’s forward P/E multiple of about 14 looks tempting, I think Cardinal Health is cheap for a reason.