3 Reasons To Buy The Most Undervalued Dividend Aristocrat In America

Posted On August 14, 2018 1:39 pm

Dividend aristocrats, those S&P 500 companies with at least 25 years of consecutive annual dividend growth, have historically proven to be great ways for investors to compound their wealth over time. For example since 2000 the dividend aristocrats have managed to generate 10.4% total returns, which is nearly double that of the S&P 500 while suffering 26% less volatility.

Source: Ploutos Research

A problem with many aristocrats is that a bull market that’s now in its 10th year means that many are trading at rather rich valuations. However, something is always on sale and for patient investors willing to wait for management to complete its turnaround Cardinal Health (CAH) might prove an excellent high-yield long-term dividend growth investment.

Not only has Cardinal Health (31 straight years of dividend hikes) generated 2,820% total returns or 11.9% annually over the past 30 years (compared to the 1,350% or 9.3% annually for the S&P 500) but if management is successful in its restructuring then this stock is potentially capable of 20% annualized returns over the next decade. Or to put another way, the most undervalued dividend aristocrat in America might generate 700% total returns over the next 10 years.

Cardinal Health: A Dividend Aristocrat In Turnaround Mode

Founded in 1971, Cardinal Health is one of the world’s largest medical distributors, operating in 60 countries. It manufactures or distributes over 400,000 medical products to 85% of US hospitals, over 24,000 pharmacies, 140,000 doctors offices, and over 10,000 specialty doctors offices and clinics. While an international company 90% of its sales are generated in the US. The company is the third largest medical distributor in America and is the main supplier for CVS Health’s network of pharmacies. Note that Cardinal Health, Amerisourcebergen, and McKesson combined control over 90% of the medical distribution market. That’s because in the razor thin margin business massive economies of scale are required which gives each a wide moat thanks to their advanced supply chains and logistics networks that smaller rivals can’t compete with.

The trouble for Cardinal Health, and the reason why its adjusted EPS plunged 80% in the last 12 months, is due to the company restructuring or evolving its business model to adapt to shifting industry conditions. Specifically falling generic drug prices in 2017 and 2018 have caused margins to fall in its pharmaceutical distribution business which accounts for about 90% of sales and 85% of profits.

The restructuring charges associated with sale of its Chinese distribution business, the integration costs of its $6.1 billion acquisition of Medtronic’s patient recovery business, and a one time inventory write down at its Cordis subsidiary (a cardiovascular device maker it bought from Johnson & Johnson in 2015), combined to cause its adjusted earnings (and share price) to fall off a cliff. However, Cardinal Health’s free cash flow or FCF, what’s left over after running the business and investing for future growth, still came in at a strong $2.6 billion over the last 12 months. FCF is what funds buybacks and dividends as well as repays debt. And in the past year Cardinal Health’s FCF was enough to cover its dividend nearly five times over and left it with $2 billion in retained FCF (FCF minus dividend).

Now a 1.9% FCF margin doesn’t sound all that impressive, but remember that the medical distribution business is one where razor thin margins are the norm. Cardinal Health actually has strong competitive advantages due to its industry leading economies of scale and management (and analysts) think there are three reasons the company’s cash flow is set to grow strongly in the coming years.

First, the generic drug market is seeing prices stabilize. That’s not surprising given that 90% of drug sales ($360 billion of America’s $400 billion in annual drug spending) are for generic medications and demand for prescription drugs is climbing steadily due to a rapidly aging US population. Meanwhile the company’s recent partnership with CVS in joining forces to source cheaper generics from drug companies should help boost margins in the coming years.

The second reason for optimism is management’s strong cost cutting efforts. Specifically, the company is streamlining its supply, logistics, and manufacturing chain to squeeze out $200 million in annual cost savings (enough to boost earnings 12%) by 2020. Meanwhile the company expects to achieve another $150 million in annual cost savings by 2020 from integrating its recent Medtronic asset acquisition.

But the real key to Cardinal Health’s turnaround is its growing medical device business, which saw revenue growth of 15% and profit growth of 16% (margins expanded in this business unit). In fact the company’s operating margins in medical devices are 4.3% compared to 1.6% in pharmaceuticals. Management expects it can boost those margins further through cost savings, both from the Medtronic synergies and by improving Cordis’ supply chain which it has struggled with in the past year.

Overall analysts expect that Cardinal Health completes its turnaround in 2019 that it should be capable of generating high single digit EPS and FCF/share growth of about 8.5%. That’s expected to be driven by a combination of about 4.5% long-term sales growth, higher margins and 2% to 3% per year in share buybacks. That might not sound like much but as I’ll now show, it’s actually potentially enough to  turn Cardinal Health into one of the best high-yield dividend growth investments of the next decade.

Photo: “[201] SALE” by rbrwr is licensed under CC BY-SA

About author

Dividend Sensei
Dividend Sensei

I'm an Army veteran and former energy dividend writer for The Motley Fool. I'm a proud co-founder of Wide Moat Research, Dividend Kings, and the Intelligent Dividend Investor. My work can be found on Seeking Alpha, Dividend Kings, iREIT, and the Intelligent Dividend Investor. My goal is to help all people learn how to harness the awesome power of dividend growth investing to achieve their financial dreams and enrich their lives. With 24 years of investing experience, I've learned what works and more importantly, what doesn't, when it comes to building long-term wealth and income streams and achieving long-term financial goals.

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