This is my second article focused on Cardinal Health (NYSE: CAH) after “Cardinal Health: Healthcare Dividend Aristocrat – Second Look” (“Second Look”). Since then, Cardinal Health has outperformed the S&P 500 by about 200 basis points. In this article, I assess its likelihood of continuing to outperform.
Cardinal Health replaces 5-year-old CEO with former CFO
Cardinal Health replaces CEO Mike Kaufmann, a Cardinal Health lifer. Kaufmann joined the company in 1990. In 2018, he rose from CFO to CEO. Kaufmann’s replacement, Jason Hollar, joined Cardinal as CFO in 2020 and followed the well-worn path from CFO to CEO on 09/01/2022.
In its 11/8/2022 statement announcing the change, Cardinal Health noted that Hollar had:
…has served as Cardinal Health’s Chief Financial Officer since May 2020, leading financial activities across the company, including financial strategy, capital deployment, treasury, tax, investor relations, management risk management, accounting and reporting. During his tenure, he helped Cardinal Health prioritize investments in growth businesses, strengthen the balance sheet and return capital to shareholders.
Apparently, this decision was the result of militant pressure that had developed around the company. Just days after taking over as CEO, on 09/05/2022, Cardinal Health reached a high-profile deal with activist investor Elliott Investment Management LP
The deal, reported in a 05/09/2022 8-K, gives Elliot significant influence in the company as described with four appointed independent directors on a 13-person board. The establishment of :
…a Business Review Advisory Committee (the “Business Review Committee”) to deal with matters contemplated by the Cooperation Agreement and the Business Review Committee Charter. The committee is comprised of three members: Jason M. Hollar, Chairman of the Business Review Committee and Chief Executive Officer of the company, the designated investor and Akhil Johri. The Business Review Committee, with the assistance of the Company’s legal and financial advisors, will make recommendations to the full Board.
Cardinal operates with a bifurcated business model
Cardinal Health reports results based on a fiscal year ending 6/30. Accordingly, its latest 10-K is a Q4 2022 report. In Second Look, I explain that Cardinal Health divides its business into two segments, pharmaceutical and medical.
Its resilience is based on its pharmaceutical activity, which is a reliable source of growth. Its medical sector has been problematic as discussed below.
Its fourth quarter 2022 results presentation describes the results of its pharmaceutical segment for fiscal 2022 as follows:
Its outsized $165 billion in revenue, with a low single-digit profit margin, is typical of a wholesale distributor model. The wholesale market accounts for approximately 92% of prescription drugs in the United States. AmerisourceBergen (ABC), McKesson Corporation (MCK) and Cardinal form an oligopoly controlling >90% of this vast market. Cardinal is the smallest of the big three drug wholesalers in the United States.
Although it is the smallest of the big three wholesalers by volume, it holds its own in terms of its stock performance over a one-year period, but falls behind on a 5-year review. It was that five-year metric, plus Cardinal’s struggling medical segment, that likely caught Elliot’s eye.
Cardinal’s second segment is its medical sector. As shown in its earnings slide from its Q4 2022 results presentation below, fiscal year 2022 was quite negative:
While its pharmaceutical business posted the modest level of profit associated with a wholesale business model, Cardinal’s medical segment posted a loss. Such a situation for a mature company reflects a failing business model. Its number one earning engine was reported as its Cordis divestiture.
Cordis was a manufacturer and supplier of cardiology and endovascular devices that Cardinal acquired from Johnson & Johnson (JNJ) in 03/2015 in a deal valued at approximately $2 billion. The deal closed towards the end of the 2015 calendar. Cardinal announced its closing in 10/2015 with enthusiastic proclamations as to how it would combine with Cardinal’s other offerings:
…to offer quality daily use products; reliable and traceable inventory and logistics; and in-depth analytics capabilities that will result in a comprehensive offering for the entire care episode. This multidimensional set of solutions will become increasingly important with the emergence of value-based payment models.
Such was the dream. Things didn’t turn out that way. The reality of corporate mergers turned out to be totally different. Initially, Cardinal faced the situation with courage, such as CEO Barrett discussing Cordis during his Q1 2018 earnings call:
We also had to work on this integration with a third party, which is the partner who sold us the product line. It therefore requires a lot of interfaces, moving parts and great disciplines. And I think we’ve, over the year, refined that more and more.
By the third quarter of fiscal 2018, Cordis’ problems were no longer tolerable. CEO Kaufmann opened the call as follows:
Let me start by saying that we recognize that today’s results did not meet your expectations or ours. The main variable driving these results was a disappointing and unanticipated performance in our Cordis business, which masked an otherwise better than expected quarter.
In 50 subsequent mentions, Cordis’ situation was laid bare with all its warts, including:
- tax issues
- coordinating inventory with product demand
- international operations management
When asked how long it would take Cardinal to unplug Cordis, Kaufmann was unable to provide a timeline. As events unfolded, it took some time to figure out; Cardinal was eventually able to strike a deal to sell it to a private equity firm for around $1 billion in 03/2021; the deal was completed a few months later in 08/2021.
As it stands with its rearview mirror shut down, Cardinal Health is far from free. Now it has a new litany of horrors besetting its medical segment, as described below during its fourth quarter 2022 earnings call (the “Call”), including:
- Isale of PPE,
- decrease in laboratory test volumes,
- global supply chain constraints.
Cardinal’s guidance for fiscal year 2023 reflects continued positive results for the pharmaceutical sector and challenges for the medical sector.
Orientation of the pharmaceutical segment
Seeking Alpha’s quantitative rating system gives Cardinal Health a rare “A+ for growth as of this writing on 9/25/2022. This is a leap from its “F” in beginning of 2022/08. Pharma revenue growth, as shown in his presentation outlook slide from 2022/11/08 below, is likely the explanation:
Cardinal’s pharmaceutical segment is the gift that keeps on giving. The market dynamics referenced in its generic programs are described in the Call. It refers to tailwinds from improving volumes partially offset by headwinds from technological improvements and inflationary supply chain costs.
In the appeal, it describes its productive specialty pharmaceuticals as:
… oncology and emerging therapeutic areas driven by our offerings, including …[Navista] TS [tech solutions]. We announced a complementary acquisition of GPO Bank care [group purchasing organization] and investment in their core service organization. These will further strengthen the Rheumatology GPO, the cornerstone of Specialty Solutions, which provides innovative office management solutions and robust access to specialty medications to more than 1,300 rheumatology providers nationwide.
Its reduced opioid litigation costs are good news. Second Look describes the outline of this hydra-headed dispute. There is reason to hope that a national settlement to which Cardinal is a party will see a continued reduction in the risks and legal costs for this. Unfortunately, as described in Cardinal’s 10-K, this was not a settlement with all of Cardinal’s opioid claim plaintiffs.
Orientation of the medical segment
Cardinal’s pharmaceuticals segment is credited with driving significant revenue growth with modest growth in segment earnings. As is becoming an unfortunate rule for the medical segment, its outlook is not so rosy according to Cardinal’s medical outlook slide below:
When we strip out the various headwinds and tailwinds and then look at the overall quarterly revenue for the $3.7 billion segment, it appears that its problems are endemic. By checking the Call, we remember that the revenues are impacted by the sale of Cordis. For some reason not mentioned on this slide.
Before you give up and say medical smallpox, consider that Cardinal is aiming for:
…at least $650 million in medical sector profits by FY25, thanks to the medical improvement plan we are presenting today.
He has a plan which he outlines on slide 15 (providing a profit deck to show detailed plan expectations) and slide 16 below:
Cardinal Health is a good conservative choice for dividend growth investors with a significant spoiler in its medical segment. Its PE of ~12.5 is in line with AmerisourceBergen’s ~12.5 and McKesson’s ~14. In today’s uncertain market, I call it a catch, but I’ll be watching to see how it resolves its struggles in the medical sector.