Cardinal Health: Downgrading Due To Absence Of Safety Margin (Rating Downgrade) (NYSE:CAH)

Introduction

It has been 16 months since my latest article on the intrinsic valuation of Cardinal Health, Inc. (NYSE:CAH) was published. Based on the stock’s more than 60% increase since the release of the article, I am now changing my rating from “Buy” to “Hold.” This decision is not due to any decline in the company’s fundamentals, but because I now believe CAH stock has reached its intrinsic value.

However, the fiscal Q2 2023 earnings report released at the beginning of this month exceeded expectations and may sustain the current momentum, potentially driving CAH stock to valuations above my estimate.

Q2 2023 Earnings

In addition to exceeding expectations on both revenue and earnings, the company also raised its guidance. During the second quarter of fiscal year 2023, Cardinal Health reported revenues of $51.5 billion, a 13% increase from the same period in the previous year. The Pharmaceutical segment was the primary driver of this growth, with revenues increasing by 15% from $41.7 billion to $47.7 billion. According to management, this increase was due to strong growth in brand and specialty pharmaceutical sales from both existing and new customers. On the other hand, the Medical segment saw a decline in revenue by 7% to $3.8 billion, primarily due to lower sales of Products and Distribution, including PPE pricing and volumes.

Despite a small decline in the profit margin for both segments, the Medical segment experienced a significant 66% decrease in profits, dropping from $50 million to $17 million. Meanwhile, the much larger Pharmaceutical segment was not able to match the revenue growth in terms of profit growth, but still managed to achieve a 9% increase in profits. Overall, the company reported Q2 EPS of $1.32, exceeding expectations by $0.18. The revenue of $51.47B exceeded expectations by $1.44B.

In my opinion, the key highlight of Cardinal Health’s recent earnings report is the updated profit projection for 2023, which has the potential to uphold the current favorable momentum of the company’s stock. This momentum has been witnessed over the past year, beginning just weeks after I published my latest article on the company’s valuation.

Valuation

In my view, being cautious before considering purchasing shares in Cardinal Health is prudent, as the company’s standard earnings multiple is now at approximately 15. Despite the strong earnings report and raised guidance, I still do not believe that there is a sufficient margin of safety. When valuing the company based solely on the 15 standard multiple, which is very close to its historical average, the stock appears to be fairly valued.

However, when factoring in the company’s debt, the stock seems to be slightly overvalued. Based on a conservative intrinsic calculation estimate, with ~$2 billion in net debt added to the market capitalization at a 15 earnings multiple, which would be at its current market cap of ~$20.2, the estimated intrinsic valuation would be approximately ~$73 per share.

Although there is a strong possibility, that the stock is valued fairly, investors can still expect single-digit annual EPS along with dividends. Assuming a 15 earnings multiple and a payout ratio of around 35%, the remaining earnings will likely be used for share repurchases, resulting in a potential return of approximately 4.3% per year plus dividends. While there may be some organic net income growth, the low reinvestment rate limits the potential for significant gains in this area. Nonetheless, the combination of share buybacks and dividends should provide decent returns, as they have in the past.

Stock Chart

Quick disclaimer: A technical analysis in itself is not a good enough reason to buy a stock, but combined with the company’s fundamentals, it can greatly narrow your price target range when you invest.

The current Cardinal Health, Inc. stock price has exceeded the 200-month moving average. In my previous analysis, I suggested that buying shares below this moving average would provide a good margin of safety. However, with the recent strong performance of the business, as demonstrated by the earnings beat and raised guidance, it is unlikely that Cardinal Health stock will return to this level anytime soon. Still, caution should be exercised before purchasing shares at the current price, as the margin of safety may not be sufficient.

Final Thoughts

Despite the positive momentum in Cardinal Health, Inc. stock and the raised guidance, it is important to remain rational and evaluate whether a margin of safety still exists. As previously discussed in the “Valuation” section, using both a standard and conservative intrinsic valuation estimate, Cardinal Health, Inc. stock appears to be fairly valued at best. Additionally, factoring in the upcoming opioid payments, which can be viewed as debt, further supports the argument that CAH stock is no longer undervalued. However, if purchasing at a fair valuation is not a concern, Cardinal Health may still be an attractive investment opportunity.

Cardinal Health, Inc. can still be expected to deliver mid single-digit returns along with dividends in the future. Considering the analysis provided above, I have decided to revise my rating for Cardinal Health, Inc. from “Buy” to “Hold.”