The Case for Cardinal Health, Inc. (CAH)

Summary:

Cardinal Health, Inc. (CAH) is primarily a pharmaceutical wholesaler that distributes the medicines drug manufacturers produce to pharmacies. CAH also manufactures and distributes CAH-branded medical, surgical, and laboratory products in the U.S. and Canada.

Perhaps the key positive for a middleman like CAH in the pharmaceutical industry is the consistent, long-term growth of the industry.[1] An independent market research firm estimates that the Pharma Wholesale and Distribution market, which totaled about $844 billion in 2023, will grow at an 8.7% compounded annual rate over the ten-year period 2024-2034.[2] This implies an eye-popping $2 trillion market by the middle of the next decade.

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Why We are Bullish on CAH

• CAH possesses three of the most prized attributes of any stock:
  1. strong, predictable growth prospects
  2. low business risk from an entrenched market position as a leading wholesale drug distributor and
  3. normalized free cash flow generation capability of more than $2 billion per year

• Many observers consider the wholesale drug distribution business to be essentially an oligopoly whereby CAH, together with two other large distributors, dominate the distribution of pharmaceuticals to retail pharmacies and other locations. Such a market structure generally allows the key players to capture a much larger profit than in a fully competitive environment.

• Given the strong fundamentals and CAH’s market position, we believe investors significantly undervalue the stock. CAH trades at only a 13.4x P/E multiple, a ~35% discount to the S&P 500 Index.

• At this valuation, the market seems to imply CAH is ex-growth and ignores its normalized free cash flow of $2+ billion per year, around $8-$9 per share, or an ~8% FCF Yield to EV.

• CAH trades at substantial discounts to its large drug distributor peers, Cencora, Inc. (COR) and McKesson Corporation (MCK). Despite having broadly similar growth prospects, cash-generating ability, and balance sheet strength, those stocks trade at an average 17x P/E multiple.

• If CAH’s P/E multiple equaled its peers, the stock would be 25% higher or roughly $125.

• Moreover, if CAH shares were accorded a P/E multiple in line with the S&P 500, a very reasonable target in our opinion, the stock would be trading about 50% higher than current prices.

• CAH could be an effective hedge against a market correction; the stock soared 54% in 2022 as investors turned toward stocks of conservatively managed companies with predictable growth prospects.

What is the Bear Case?

As the percentage of senior citizens in the U.S. and worldwide population continues to increase, the pharmaceutical industry should grow regardless of the economic climate. Distributors of specialty drugs are entering the industry and could disrupt the oligopoly. In our view, they seem unlikely to threaten the dominant drug wholesale distribution positions of CAH, COR, and MCK for quite some time.

Company Description

Formed in 1979 and headquartered in Ohio, Cardinal Health, Inc. (CAH) is primarily a pharmaceutical wholesaler that distributes the medicines produced by drug manufacturers to pharmacies. CAH also manufactures and distributes CAH-branded medical, surgical, and laboratory products in the U.S., Canada, and other markets.

CAH’s Pharmaceutical segment is responsible for the bulk of the company’s revenue (92% of consolidated revenue in FY 2023, the twelve months ending June 30, 2023) and operating profits (95% of FY 2023 operating profits before corporate expenses). The Medical unit comprises the balance. Pharmaceutical segment revenue increased 15% in FY 2023 and 11% over the first nine months of FY 2024.

A Rising Tide Lifts All Boats

Perhaps the key positive for a middleman like CAH in the pharmaceutical industry is the projected consistent, long-term growth of the industry. Most market intelligence firms project the drug industry will increase at an 8+% long-term annual pace. Visiongain, an independent market research firm, published a study in February 2024 that theorizes that the Pharma Wholesale and Distribution market, which totaled about $844 billion in 2023, will grow at an 8.7% compounded annual rate over the ten-year period 2024-2034.[3] This implies an eye-popping $2 trillion market by the middle of the next decade.

Pushed by the rousing success of COVID vaccines, governments seem now to recognize the key role that pharmaceuticals play in public health. In turn, nations are implementing initiatives that foster the development, accessibility, and affordability of pharma products. Streamlining the drug approval process is a central part of these efforts. Another is increased government willingness to offer grants and research funding both to drugmakers and academic institutions.

In addition, Visiongain notes that drugmakers that specialize in niche drugs and therapies could realize even faster growth. Manufacturers and distributors of such medications seem likely to encounter reduced competition and realize wider profit margins. Furthermore, wholesalers that gain expertise in such specialized drugs could become preferred partners for the manufacturers of those medications.

The Graying of America is Another Constructive Factor

About 62 million Americans are 65 years of age or older. This age group is the fastest growing segment in the U.S. and comprises 18% of the country’s population. Thirty years from now, the number of adults aged 65 or more is expected to reach 84 million, or 23% of the population.[4] Older Americans suffer from more chronic illnesses and disabilities than the rest of the population and frequently utilize the medications that CAH distributes to pharmacies. Indeed, senior citizens account for about 37% of personal healthcare spending in the U.S.[5]

Pharmaceutical Supply Chain

The key players in the drug supply industry are summarized below:

• Manufacturers: Pharmaceutical giants like Merck, AbbVie, Eli Lilly, and Pfizer research, develop and produce drugs.
• Payers: Entities other than patients who pay for care (usually insurance companies). Some of the biggest health insurance companies are UnitedHealth Group, Elevance Health Inc. (formerly Anthem), Humana, and CVS Health
• Drug Wholesalers: Wholesalers such as CAH, Cencora, Inc. (COR, formerly called AmerisourceBergen), and McKesson Corporation (MCK) buy large quantities of drugs from pharmaceutical manufacturers and resell them to pharmacies.
• Patients: Individuals who ultimately receive and take a drug or medication.
• Pharmacies: The stores on seemingly every other street corner in the U.S. that receive drugs from wholesalers and distribute them to patients.
• Specialty Pharmacies: These entities manage the distribution of expensive and/or uncommon drugs.
• Pharmacy Benefits Managers or PBMs: PBMs negotiate drug prices with manufacturers on behalf of their clients, including health insurers, Medicare Part D drug plans, and large employers. In turn, PBMs are paid rebates by drug manufacturers.

PBMs such as CVS Caremark, Express Scripts, and OptumRx work in conjunction with drug makers, wholesalers, health insurers, and pharmacies but play no direct role in pharmaceutical distribution. They only handle negotiations and payments within the supply chain.[6]

The gross margins realized by the players in the pharmaceutical industry reflect the degree of business risk each takes. For example, the typical gross margin for a drug manufacturer is 70+%; insurance companies and pharmacies are each at around 20%; and only about 6% for PBMs and 4% for drug wholesalers, which are middlemen that take very few operating risks.

Phrased differently, for each $100 spent at a retail pharmacy, about $60 goes to the drugmaker, of which about $17 covers its direct production costs. The balance, or around $40, accrues to intermediaries in the system — pharmacies, insurers, drug wholesalers, and PBMs.[7]

The specific interactions between all these parties in terms of the flow of pharmaceuticals, services, and money are illustrated in Figure 1.

Growth in Specialty Drug Sales is Key to Cardinal Health’s Long-Term Growth

As noted above, specialty drugs are prescription medications that are particularly expensive or require complicated handling. Spending on these medications, which carry much higher margins for drugmakers and distributors, is growing dramatically. Despite comprising only 2% of overall prescription volume, specialty medications account for more than half of total annual pharmacy spending.[8]

This current margin — and margin growth — opportunity has not been lost on the drug wholesalers. According to commonwealthfund.org, specialty drugs account for about 30% of the revenue of the three leading wholesalers: MCK, COR, and CAH.[9] As the volume of specialty drugs seems certain to grow, so will the margin opportunities for the giant wholesalers.

A risk for the large drug wholesalers is smaller new distributors coming into the space that offer manufacturers high degrees of collaboration and service on individual drugs. For example, Biogen has chosen Accredo as the exclusive pharmacy and distributor of SpinrazaÒ, a therapy for patients with spinal muscular atrophy[10]. SpinrazaÒ generated $1.74 billion in revenue in 2023[11]. Accredo is a wholly owned subsidiary of the PBM giant Express Scripts, which is owned by Cigna Corp.

Nevertheless, a pharmaceutical pie that is growing as rapidly as it is will, in our view, allow the large distributors to continue to thrive even if some smaller distributors continue to reach one-off deals to distribute some drugs.

OptumRx Opts Not to Renew Contract with Cardinal

In April, OptumRx, a large PBM, opted not to renew its pharmacy distribution contracts with CAH. The high-revenue, low-margin accords reflected in CAH’s Pharmaceutical Distribution segment will expire on June 30, 2024. The OptumRx sales generally represented non-specialty bulk shipments to Optum’s mail-dispensing facilities.[12]

Sales to OptumRx represented 16% of CAH’s consolidated revenue in FY 2023, or about $1.1 billion (16% x $6.9 billion). Several analysts have stated that McKesson will take over the OptumRx business on July 1.

To illustrate the low-margin nature of the OptumRx business that CAH lost to McKesson, CAH did not change its key profitability targets due to the contract expiration. Specifically, CAH has introduced FY 2025 adjusted diluted EPS guidance of at least $7.50 and maintained its 12%-14% compounded annual EPS growth target for the period FY 2024 through FY 2026 (with FY 2023 as the baseline). CAH expects new customer wins and growth in its specialty business will offset the lost Optum margins.

In addition, CAH expects its adjusted free cash flow will continue to average about $2 billion per year over FY2024-FY2026. However, FY 2025 free cash flow will fall below that norm due to the unwinding of working capital associated with the OptumRx contract.

Cardinal Health – Consistent Earnings Growth and Strong Free Cash Flow

Table 1 lists a summary of financial parameters for CAH over the last two fiscal years and the first three quarters of FY 2024.

• CAH’s adjusted fully diluted EPS is expected to reach about $7.35 in FY 2024, up from $5.79 in FY 2023 and $5.06 in FY 2022. This represents compounded average annual growth of over 20%.

• As an intermediary, CAH’s required capital spending is modest, allowing the company to generate enormous amounts of free cash flow. CAH’s free cash flow over the first three quarters of FY 2024 and the full fiscal years 2023 and 2022 totaled $1.37 billion ($5.58 per share), $2.36 billion ($9.00 per share), and $2.74 billion ($9.80 per share), respectively.

• CAH applies much of its free cash flow to share repurchases. Over the last eleven quarters, it has bought back $3.75 billion of its own stock.

CAH is Valued at Sharp P/E and Enterprise Value-to-Revenue Discounts to Its Peers

Table 2 lays out key financial statistics for the largest wholesale drug distributors in the U.S. – CAH, COR, and MCK.

Despite operating very similar, highly profitable, relatively low-risk businesses, CAH trades at sharp P/E multiple discounts to both MCK and COR (13.4x versus 17.6x and 16.6x, respectively, based on forward year earnings).

Similarly, CAH trades at a 30% to 50% lower enterprise value (EV)-to-revenue multiple than its peers. Note that the EV-to-revenue multiples of drug wholesalers are much lower than those of the typical stock because of their low 3%- 4% gross margins.

The total debt levels of all CAH, COR, and MCK are remarkably similar ($5.2 billion to $5.8 billion).

CAH Could be an Effective Hedge Against a Stock Market Correction

The consistent growth and low-risk nature of CAH’s business is a powerful combination in any stock market environment, but these characteristics may allow CAH to perform especially well if the equity markets were to suffer a correction. Indeed, the stock soared 54% in 2022 as investors turned toward stocks of conservatively managed companies with predictable growth prospects. The S&P 500 Index, on the other hand, turned in its seventh worst year in history in 2022, declining 19.4%.

Of course, CAH may not display such stark relative outperformance in the next downturn, but the stock still has the same positive attributes today that it had two years ago.

Investment Summary

CAH possesses three of the most prized attributes of any stock: strong, predictable growth prospects; low business risk, which includes an entrenched market position as a leading wholesale drug distributor; and normalized free cash flow generation capability of more than $2 billion per year.

Many observers consider the wholesale drug distribution business to be essentially an oligopoly whereby CAH and two other large distributors dominate the distribution of pharmaceuticals to retail pharmacies and other locations. Such a market structure generally allows the key players to capture a much larger profit than in a fully competitive environment. While other smaller distributors are entering the pharmaceutical distribution space, the three large players will likely control the business for quite some time.

Given these strong fundamentals and CAH’s advantaged market position, we believe investors significantly undervalue the stock. CAH trades at only a 13.4x P/E multiple (based on forward-year estimates), or about a 35% discount to the S&P 500 Index. In addition, the market seems to be applying little weight to CAH’s normalized annual free cash flow capability of $2+ billion per year, or around $8-$9 per share, in assigning such a modest valuation to the company’s shares.

Furthermore, CAH trades at substantial discounts to its large drug distributor peers MCK and COR. Those stocks trade at an average 17x P/E multiple based on forward-year earnings — despite having broadly similar growth prospects, cash generating ability, and balance sheet strength. If CAH were to be revalued such that its P/E multiple equaled those of its peers, CAH’s stock price would be about $125, or 25% higher than it is today. Moreover, if CAH shares were accorded a P/E multiple in line with the S&P 500, a very reasonable target in our opinion, the stock would be trading about 50% higher than current prices.