Cardinal Health CAH W
October 22, 2004 - 3:55pm EST by
2004 2005
Price: 38.50 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 16,500 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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Cardinal Health is to the growing health care industry what GE is to manufacturing: #1 or #2 in every category in which they participate, with a strong culture of excellence propelling their success. Barriers to entry are moderate to high in many of their businesses, and businesses in which they are the lowest cost operator represent the majority of their sales. Over the past decade, sales per share have grown faster than 15% annualized, while per share cash flow and earnings have grown at better than a 20% annualized rate, which suggests that their many acquisitions over the past decade have added value overall (as compared with poor performance by competitor MCK). The company is having its worst year ever, where earnings are likely to “only” grow by single digits as opposed to the usual 20%+, and much of this earnings is free cash flow. Yet, the enterprise value is approximately 7 x EBITDA (and the P/E is about 11), the lowest valuation of the last 15 years, while the stock price is close to a 4 year low. The stock price is low due to a several issues, most of which I believe are temporary.

This high quality of a company obviously deserves a higher valuation (perhaps 10x EBITDA or $57/share) if one believes that it will continue to use capital as wisely and grow at even 2/3 the rate it has over the past decade. That is, if you believe the business model is still intact and the financial statements are to be trusted. Therefore, this report is intentionally light on numbers, and will mostly focus on discussing issues that I believe are the investor concerns that are depressing the stock price:

1) Distribution Business Model Transition
2) SEC investigation & CFO resignation
3) Flat Drug prices (usually happens around election)
4) MCK price aggressiveness
5) Recent pricy acquisitions (and prospects for ROI on future acquisitions)
6) Other

The Numbers

The 10K has been delayed due to investigations by the SEC and NY Attorney General’s office, so I’m not going to bombard you with a seemingly precise numerical array of financial statistics which will need to be changed anyway when the 10K is released. Based on my best guesses, I believe the following (FY ends June 30):

FY04 FY05 FY06 FY07
EPS $3.50 $3.60 $4.00 $4.80
EBITDA 2630 2700 2950 3550

(based on 3/31/04 debt level of $2.6 billion - I did not reduce this by cash as the off-balance sheet debt nearly offsets cash, does not factor in the Alaris acquisition, which will raise EBITDA but also cause EV to be higher after FY04)

It should be noted that my FY05 estimate is significantly below company guidance of 3.85, as I believe it is a bit of a stretch by management to assume that the second half of the year will make up for the lackluster first half alluded to in the 9/13/04 8k filing (that Q1 would be down 25%, and Q2 down 10%).

1) Distribution Business Model Transition

Three companies account for 90% of the distribution of pharmaceuticals in the U.S: CAH, MCK, and ABC, each with a similar level of revenue. For years, this industry relied on forward buying for a large portion of profits. The way this works is that vendors routinely announce price increases of 5% to 10%. Before price increases went into effect, a drug distributor would buy far more inventory than normally needed at the old price, but pass on the price increase to customers after the date of the announced increase, thus reaping the price differential for as long as inventory lasted. For example, if the price increase was 10%, and 6 extra months of inventory was purchased, this would lead to a 21% before-tax return on the investment in extra inventory. CAH claims that they earned 15-20% before-tax returns on the extra inventory they carried as a result of forward buys. I assume for the rest of this report that the average number was 18%.

Beginning nearly 2 years ago, large drug manufacturers were criticized for inflating their sales by stuffing the distribution channels with extra product. Responding to this criticism, over the past 18 months several large drug manufacturers have reduced or eliminated all forms of channel stuffing, including restricting distributors CAH, MCK, and ABC from buying extra inventory before price increases. Responding to these changes, all three distributors have been transitioning all of their customers from the old buy-and-hold model to a new fee structure where distribution fees are charged commensurate with the cost to distribute and an adequate profit. For more details on this transition, see CAH’s Dec 2003 newsletter:

The transition is taking much longer than the industry anticipated. All three companies have lost credibility as to how long it will take to complete the transition and when margins will bottom out, as they all predicted it would take about a year and it’s already been 18 months with margins continuing to fall each quarter. Part of the problem is that the first round of new agreements, while not allowing buy-and-hold practices, still included a component of the agreement that was tied to drug price inflation (which tends to be high single digit increases each year). As is historically the case, drug manufacturers have drastically slowed down their drug price increases during the presidential election season. So a new round of negotiations is currently in progress at the big 3 that will create agreements with vendors that adequately compensate distributors and are in no way linked to drug price inflation.

CAH was supposedly the most aggressive of the three with regards to forward buys and has inventory (as of 6/30/04) that I estimate is $1 billion less than what it would have been if inventory had risen with sales in the old buy-and-hold model. Given that they used to earn 18% or so on this inventory, that’s $180m or so of lost income in the distribution segment, or .35% of the projected 2004 sales in the distribution segment. My rudimentary model suggests that .35% is not far off from the drop in margins CAH experienced for FY2004 in its distribution segment, so the end of forward buying does seem to account for the margin drop. This is the main reason stock prices of CAH, MCK, and ABC have fallen over the past 2 years.

However, there are now two reasons I have for believing the bottoming of distribution margins will occur over the next 2 quarters:

a) While the big 3 have all been insisting that their vendors must agree to a fee structure, CAH has actually sent formal letters with a deadline of April 1 (get with the program or get lost). See 9/1/04 8-K. With the possible exception of Pfizer (which accounts for 11% of pharmaceutical market share), none of CAH’s customers a large enough to self-distribute more economically than using the services of the big 3. So CAH can insist on appropriate fee structures, because the only choice for the vendors is to take it or go to ABC or MCK where they will also be required to adopt an appropriate fee structure.
b) In 10/21/04 earnings release, MCK claims to have already signed fee-for-service agreements with 80% of their vendors, and 25% of their largest vendors. Their forward guidance came down a little, but not nearly as much as some analysts were expecting, so the stock price rallied on the belief that the bottom in distribution margins is close. MCK also mentioned that 2.0% to 2.5% is the normal range of operating margins in their distribution segment (when the impact of bulk deliveries is stripped out). CAH has historically had better distribution margins by about 20 to 25 basis points, so it wouldn’t be unreasonable to think that CAH will end up no lower than 2.2% for distribution margins over the long run.
c) CAH distribution margins must be below 2% for the first half of FY05 to be consistent with recent guidance. Therefore, I expect that earnings will rebound once all the new agreements are in effect.

It may take a quarter or two after 4/1/05 for the last of the new agreements to take effect. But no matter how dim one’s view of CAH’s distribution segment, it’s important to note that portion of earnings from distribution has been declining for years as CAH has successively diversified (by acquisition) into other areas of health care. Operating Earnings from distribution were 52% in FY02, and I estimate will be 40% in FY05 without even including the impact of the recent, sizeable Alaris acquisition.

ABC and MCK have a higher percentage of earnings from distribution, so theoretically CAH should trade at a premium compared to their competitors if declining distribution margins were the only concern. Indeed, CAH has historically traded at a premium compared to these peers but currently trades for a slight discount, probably due to the SEC investigation and delayed 10K release.

2)CAH has been the subject of investigations by the SEC and now the NY Attorney General. The issues that have been uncovered so far have been very minor, but the company has nevertheless pressured out its CFO as a gesture to show that they don’t generally condone aggressive accounting practices. In the past, CAH has made a point in several shareholder reports to emphasize the importance of ethics and cultural fit within their own organization and when considering acquisitions. An interesting anecdote in that regard is the Syncor acquisition. During due diligence, CAH uncovered some fraudulent accounting and required some actions to be taken before they closed the acquisition. I can think of quite a few companies that might have missed or purposely ignored such information if they were to discover similar issues during an acquisition.

Nevertheless, as is always the case with these things, the investigation is not restricted to the immaterial findings listed in the 8k of 9/13/04. Therefore, investors are afraid something else of a more material nature may come up.

While one can never know for sure, some of the indications I look for to see if fraud of a larger nature may be happening are not present in this case. The factors I do NOT see present in this case include:

Heavy and increasing debt burdens: $2.5b (and a little more off-balance sheet) is a moderate debt load for a company with over $4.6b in tangible book value, though this will increase with the Alaris acquisition.

Doing phenomenal compared to competitors (the distribution segment has eroded at a similar rate to competition, and their long-term advantage is on the order of 20 or 25 basis points)

Little free cash flow present (excluding acquisitions, FCF was over $1 billion just the first 9 months of FY04 due to the temporary factor of fewer buy-ins freeing up working capital.)

Incomprehensible line items in the investing activities section of the cash flow statement (not present)

That being said, there are at least 3 risk factors present worth noting:

A stream of acquisitions in recent years (While this can impact earnings through cookie jar reserves, it’s less likely to impact the cash flow statement, and cash flow appears to be strong and growing. Management has said repeatedly that restatements are unlikely to have an impact on historical cash flow)

Special purpose entity (The dollar amounts don’t seem large enough to matter, though)

A recent draw down of the line of credit (the company claims this is needed temporarily for stocking a new distribution center with inventory). This one particularly spooked investors, causing the stock price to drop over 10% in several hours before it partially recovered. Perhaps some investors are wondering if some of the balance sheet quantities are faked. I would not that frauds of this type have occurred in some prominent companies over the past few years (i.e. Healthsouth) but they are pretty rare and I just don’t see enough yellow flags to think that something like this is happening.

The company is currently anticipating releasing its 10K by the end of October. If there were very material and/or complex restatements, the company would very likely already have announced an additional delay by now.

3)Flat drug prices during election year

Yes, drug price increases have stopped for the last few months and probably won’t continue gain until after November. It exposed the fact that many if not all of the new fee based distribution contracts (among all 3 distributors) relied to some extent on inflation. But this is obviously a temporary phenomenon, as elections occur once every 4 years, and the contracts are in the process of being reworked at all three companies. In my mind, this is what creates the buying opportunity (arguably for all 3 distributors): investors lost confidence that the distributors would every stem margin erosion, when in reality they just did a lousy job of reworking the contracts last time around – a very fixable problem.

4)MCK price aggressiveness

Don’t know how much a factor this is for investors, but for whatever it's worth, MCK appears to have pulled back on the price aggression front (they gained two large customers from ABC in the past couple years so there was the possibility they might get some business from CAH). In the last 10/21/04 CC, they even claimed they were purposely redeploying their sales force from new account pursuit to getting more business from existing accounts, as that has a higher ROI.

It’s worth noting here that CAH and ABC have been disciplined on price. Furthermore, CAH claims to have better, more detailed cost accounting than their competitors, which probably plays a part in the slightly better operating margins.

5)Recent pricy acquisitions (and prospects for ROI on future acquisitions)

This is actually my biggest concern. In my mind, Alaris was an expensive acquisition (and they could have bought it for less than 1/5 the price 2 years earlier). The company will tell you (look at recent newsletters) that through synergies, cross selling, etc. that they expect to increase earnings by at least $80 million, and that they will therefore meet their usual goal of earning higher than their WACC by the end of year 3.

I discussed this with their VP of Investor Relations at length. He acknowledged that the acquisition was expensive, but reiterated that unlike many prior acquisitions, this one appeared to be an incredible fit for the company in terms of synergies, etc. He told me that WACC is currently 8.5% after-tax for CAH (which means around 13% before tax, I suppose). He also said that historically, on average, they have met this goal, though some acquisitions have exceeded this target, and others have lagged. He said that almost uniformly that the ROI for acquisitions keeps going up after year 3 as further benefits of integration are reaped.

I do buy the line that the distribution business is a good platform for vertically integrating their many manufacturing operations, and I do buy the idea that CAH has presented a more integrated sales approach over the past year or two which is getting them more incremental business with large accounts. But he did freely admit that competition for acquisitions is getting tougher, pushing up prices. And of course, the billion dollars of cash that came out of inventory earning 18% will not be earning much lower than that with Alaris, even at the 13% rate in year 3. So there will be an “earnings gap” where the lost earnings from the risk free inventory buy-ins will replaced by a lower earnings yield from acquisitions like Alaris that are obviously riskier an will take several years, if ever, before they earn a better yield.

For this reason, I don’t think it’s realistic to expect CAH to return to earnings growth rates of higher than 20%/year, if debt continues to be a relatively fixed percent of equity. But this IS a growing industry, and CAH does have a very strong competitive position in all of the markets in which they participate. I expect growth of at least 10% per year after FY05, and 15% is not out of the question. I think 7XEBITDA is a cheap price to pay for this kind of growth, even though it won’t be as good as it was in the past, and capital will not be as efficiently deployed.

It should be noted that the company speaks intelligently about capital allocation, and implied in my conversation that if the stock price is still low after the 10K is filed, stock buy backs are likely.

6) Other

There are other issues that could be of concern. There have been some delays in plant startup and regulatory approvals in the Sterile division, but this seems to be of a temporary nature.

Many wonder about how drug imports from Canada will impact the big 3. Every drug imported is a drug that doesn’t go through one of the big 3’s facilities. However, if this becomes big, I suspect all three of them will expand operations into Canada, either internally or through acquisition. There are obviously barriers to entry for small players in this industry but ABC, MCK, and CAH are all big enough to enter into the Canadian drug distribution business as just an extension of their current business.

There is always the possibility of true health care reform (i.e. a single payer system in the U.S.), a risk to any company involved in health care, and that’s the case here too. However, I believe the risk for distribution is lower than that for other segments of health care. While governments have proven adept in some cases at insisting on lower rates from drug companies and doctor compensation, there just isn’t much to be squeezed out of distributors in comparison – they are not one of the problem areas of the health care supply chain. And reforms being talked about recently are incremental in nature, not revolutionary. Nevertheless, you never know.

In summary, CAH is a well run growth company selling at a historicaly low valuation. If I am right that the SEC investigation will blow over with minor findings, and that the distribution business is close to a bottom, then I don't think it will take too long for the stock price to return to the high 50s, and then track future growth from there.


10k filed (possibly be end of October)
stock buybacks after 10k filed
new fee-based agreements take effect (middle of calandar 2005)
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