Description

Investment Thesis

Cardinal Health (CAH) is a high quality business with a sustainable competitive advantage.  The strength of the business is masked by issues that are transitory in nature. The business can generate at least inflation-like earnings growth over the cycle ( I assume 2.5%).  At $53.4, long CAH should provide 48% upside ($79.3) vs 5% downside ($50.8) for a risk/reward ratio of 1:9.6

Company Description

Cardinal Health is a distributor of pharmaceutical drugs and healthcare products to healthcare services providers including hospitals, clinical labs and pharmacies.  The business is organized as two separate segments - Pharmaceutical and Medical.

The Pharmaceutical segment distributes both branded and generic drugs, specialty drugs and OTC products.  It operates a JV with CVS named Red Oak Sourcing (to gain better scale) for generics. It also provide support services   (development, marketing, supply-chain management, etc.) and operates nuclear pharmacies and radiopharmaceutical facilities that are highly regulated.

The Medical segment manufactures, sources and provides surgical and laboratory products.  It distributes both branded and private-label products that are generally considered more commoditized (i.e. medical gloves).

Why does this opportunity exist/why is CAH down?

Cordis weighed on 3Q18 results and is expected to be a drag in FY-2019

The Cordis medical device business has been struggling and was a drag on earnings.  CAH lowered its FY18 EPS guidance by 9%. The expectation is that the competition with specialized products would lower price on commoditized products to take market share and squeeze CAH.

My Variant View

While Cordis is expected to be problematic possibly beyond FY 2019, CAH has enough capital to continue to invest and buildout the infrastructure of Cordis which would lower operating costs.  The loss was caused by inventory write-downs, which suggests this is not a recurring issue and could be work through over time.

Generic Drugs deflation

In the last 2 years, price deflation on generic drugs led to lower profit dollar contributions, albeit the the decline in profit dollar was at a lower rate than deflation.  Management revision to “sell-side generic pricing” from mid-single-digit to mid to high-single-digit re-ignites concern about profitability.

My Variant View

As explained in “Generic Drug Pricing” below, profitability is driven by the difference between “buy-side generic pricing” and “sell-side generic pricing”.  Deflation in “sell-side generic pricing” is a negative headline, but if accompanied by the same magnitude of deflation in “buy-side generic pricing”, profitability would remain the same.  While there are volatility, over the long term, changes in buy-side and sell-side pricing are roughly the same.

Industry Dynamics

Pharmaceutical Distribution is highly complex and heavily regulated

The pharmaceutical distribution business is very different than distribution of typical consumer goods due to regulation and the importance of authenticity, safety and security.  If Amazon delivered a wrong laptop or missed a delivery, it would have an unhappy customer; but if drugs are incorrectly labeled or delivery is delayed, someone could die.

The value-add of pharmaceutical distribution is to provide an essential link between manufacturers to healthcare providers

The economies of scale, investment in logistic infrastructure, supply chain management systems enable distributors to be highly efficient.  In most cases, it is more effective for providers to deal with distributors than to deal with manufacturer directly.

Why can’t the distributor be cut off?

Distributors are trusted counterparty.  Buying from CAH/ABC/MCK comes with an implicit guarantee  of authenticity and regulatory compliance and certain level of service related to timely delivery and administrative support.  

Beyond delivery, distributors provide additional services that are also essential to both manufacturers and providers.  These services include inventory management, compliance support, chargeback administration, order management, and product launch support.

Additionally, to protect the integrity of the supply chain, distributors would perform due diligence on potential supplier and customers.  The process include reviews of registrations and licenses, and may include site visits and review of historical order flow .

The alternative of not dealing with distributors is to establish relationships, trust, familiarity and operational process with hundreds of manufacturers/providers which are time-consuming, cost-prohibitive, and practically impossible in the highly regulated industry of pharmaceuticals.

Generic Drug Pricing

“Buy-side” pricing refers to the price that distributors pay, while “sell-side” pricing refers to the price that distributors receive.  The spread between buy-side and sell-side pricing represents the profits of the distributors. There are some visibility to buy-side pricing through data providers, but sell-side pricing is highly guarded as it is vital to profitability and for competitive reasons.  CAH/ABC/MCK have all partnered with pharmacy chains and form procurement consortiums for generic drugs.

On average, buy-side pricing deflates at mid-single-digit rate, and sell-side pricing would follow, and thus lead to stable profits. But the reality is more nuanced; buy-side deflation is sometimes faster, sell-side pricing sometimes react to other factors other than buy-side deflation.  For instance, unique circumstances (shutdown of plants, backlog of filings at FDA) led to unprecedented generic drug inflation in 2014 - 15; contract renewal led to sell-side price decline in 2017.

The point is all the headwinds/tailwinds related to generic drugs are temporary for distributors.  Over the long term, the profit dollars are pretty stable because each year there are drug patents expiring.

Moat/Competitive Advantage

CAH operates in an oligopolistic industry

The industry is dominated by 3 companies - CAH, ABC and MCK.  Collectively they control near 95% of the market. They are all sophisticated operators with pricing discipline.

CAH provides an essential link for manufacturers and providers that are irreplaceable

As outlined above in “Why can’t the distributors be cut off?”, CAH acts as a trusted counterparty and provides critical services including logistics, inventory management, compliance management, and supply-chain integrity.  It is deeply entrenched in the healthcare vertical.

The existing relationships, low operating margins and massive capital investments are high barriers to entry

First, CAH has multiple relationships in a highly regulated industry.  New entrants, with no track records, have to convince existing operators to give them business.  Operations (i.e. electronic data interchange, link up order management systems, be in compliance with federal and state regulations, infrastructure buildout) are onerous and time consuming.

Second, the rewards are not exactly rewarding.  Margins are thin; adjusted EBITDAR margins (definition provided below) for CAH, an oligopolistic operator with scale, ranged from 1.7% - 3.0% during FY 2007 - 17.  Furthermore, CAH/ABC/MCK each has assets in multiple tens of billions, and require $300 - 500mm of capex annually, which means new entrants have to commit at least $20B of capital to have a realistic chance.

Bezos/Buffett/Dimon Healthcare JV

Combined together, the barrier to entry are too high even for Amazon.  It is widely reported in April that Amazon had tried and failed to break into the drug distribution business.  I am not worried about the new Bezos/Buffett/Dimon healthcare JV. They are going after bloated costs - margins are already razor-thin at CAH and there is nothing much to cut.

Risks

Questionable capital allocation outside drug distribution business

Its recent acquisitions in medical equipment production are dilutive both to earnings and business quality.  It is unclear if these businesses possess the same competitive advantage as the core distribution business.

Headline risks from generic drug deflation

Although this does not impact long term earnings power, stock price will decline because this is what investors focus on.

Valuation Math

* Adjusted EBITDAR and Operating Income

* Long term organic gross margin growth

Key Assumptions

1. I assume margins would mean-revert as the business is not structurally impaired.

2. GM/Revenue is volatile due to revenue mix-shift and generic drug pricing dynamic.  I focus on EBITDAR/Gross Margin because GM is more stable than revenue.

3. Given the moat of the business, I am highly confident that organic growth before reinvestment of retained earnings, would track inflation which I assumed to be 2.5%.  This is very conservative as CAH pays out less than 40% of its earnings. I assumed zero earnings growth from reinvestment of retained earnings.

4. Assume 100 bps increase in interest rate paid on debt

Catalyst

* Stabilized results from Medical Supplies

* Cordis beat already low expectation