24/7 Wall St. 2007 Break-Up Values: Cardinal Health $73.50 (Current Price $71.28)

By Ryan Barnes. Edited By Douglas A. McIntyre

Cardinal Health Inc. (CAH) – Price $71.28; Break-up Value $73.50

Cardinal Health is currently in the midst of a large-scale business model transition.  Their core business segment is, and has been, acting as the middleman between pharmaceutical manufacturers and end clients such as Walgreen’s, CVS, and major hospital groups.  But up until a few years ago they acted almost as commodity raiders, buying up excess supply from the drug makers in the hopes of selling the bulk of it later when drug prices were higher.  This model worked great when Big Pharma had pricing power, but that environment is largely dead, both through generic pressure and political/social headwinds. 

It didn’t help matters that the SEC stepped in to question the practices in terms of consumer fairness and revenue recognition.  In response, the drug wholesaling industry, largely comprised of Cardinal, Amerisource-Bergen (ABC), and McKeeson (MCK), shifted to a model of charging a flat fee for services such as packaging, distribution, and inventory management.  As the largest of the three big players, Cardinal stands to benefit from this trend in the long run – they should be able to out-execute their competitors with their larger distribution system.  So far they seem to be doing just that, sporting higher operating margins than both, which is key in a business that runs on some of the thinnest margins you’ll find (industry averages are 1.5 -2.5%).

There are limited break-up options now that Cardinal has sold off its worst performing segment in a $3.3 billion all cash deal last quarter.  Cardinal used the proceeds to ramp up its buyback schedule, something they should be able to do a lot more of with vastly improving free cash flow numbers.  Three of the four company-designated operating segments deal with services that are bundled together under the single-fee structure.  These cannot be divested at this point as it’s the key to their future earnings potential.  There may be a fee war approaching as the new model matures, and Cardinal needs to be ready to do battle – and it’s a battle they’re likely to win, which should allow them to pick up market share over the next 3-5 years.

In the most recent quarter they turned 13% revenue growth in the core segment into 19% operating income growth, so we can see the cash flow story playing out.  The name of the game will be operational performance and retiring shares, the best bet for long-term shareholder value. 

The one straggler segment, Medical Products Manufacturing, has solid margins but is near-meaningless to the bottom line (less than 10% of earnings).  By getting rid of it, Cardinal can announce to everyone that they’re in the big game to win it.  A sale of this segment should go for about 1.5x sales, or $2.7b that could bolster the credit rating and be added to the share buyback pool.  And with all non-core business divested, Cardinal can take its rightful place at the top of the industry multiple range, or 22x trailing earnings.  In our limited breakup analysis, Cardinal is worth $73.50/share.  As we can see, the company is currently fairly valued – future shareholder gains will come incrementally as the company should outperform their rivals and start winning the biggest contracts in the industry. 

Ryan Barnes

Ryan Barnes has over 10 years’ experience in portfolio management and investment research, covering equities, fixed income, and derivative products. Ryan spent the past 5 years working as an institutional trader & manager for high-net worth investors, working with Merrill Lynch, Charles Schwab, Morgan Stanley, and many others.  Ryan is currently working as a writer and financial modeling consultant on hedging and capital appreciation strategies, and does not own securities in the companies being covered.

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