Cardinal Health: Solid Business But Overvalued (NYSE:CAH)

CAH is overvalued

Cardinal Health (NYSE:CAH) caught our attention recently when we were screening for stocks with yields noticeably outside their normal range. And CAH really caught our attention because its dividend yield is currently way out of its historical range. As you can clearly see from the charts below, its current yield of 1.88% is among the lowest levels in at least 5 years. It is lower than its 5-year average yield of 3.25% by a whopping 42%, implying substantial overvaluation. Other valuation metrics such as P/E paint the same picture. As seen in the second chart below, at its current price of $106 as of this writing, it is trading at a TTM P/E of 15.7x, about 1/3 above its 5-year average.

When the valuation ratios are so out of the ordinary range for a mature stock like CAH (BTW, it is a dividend champion), our immediate response is that the stock has gained a new crucial growth catalyst recently so it can grow at extraordinary rates now relative to its past. But that is not what I see after digging into the stock further, as detailed next.

Growth projections

The next chart shows CAH dividend growth rates in recent years. Given its dividend champion status, I think it is very reasonable to use its dividend payouts as an indicator of its true economic earnings. Under this assumption, I do not really see anything standing out in terms of growth rates. Overall, CAH receives a dividend growth grade of C+ only. Its dividend growth rate has been in the range of 1.41% to 1% in the past 1, 3, and 5 years. And the FWD growth rate is projected to be at 1.72%, slightly higher but not enough to justify the valuation premium just mentioned.

Looking further out, consensus projects a moderate growth rate in the mid-single digits for the next 5 years. Based on the estimates of EPS shown in the table below, analysts have consensus estimates for CAH’s future earnings to grow at a 7.8% CAGR for the next 5 years. More specifically, for FY 2024, its EPS is estimated to be $7.29, representing a fairly large YoY growth of 25.94%. But starting in FY 2025, its EPS is estimated to grow at a much more tempered rate, resulting in an average growth rate of around 7.8%.

Next, I will argue that A) such a projection is on the aggressive end, and B) even at this growth rate, the stock is still quite overvalued.

Return projections

My method for estimating the organic growth rates of mature is detailed in my other articles. The results are that:

The method involves the return on invested capital (“ROIC”) and the reinvestment rate (“RR”). The ROCE for CAH is around 32% currently as seen in the chart below. Its RR is about 10% on average. With these inputs, CAH’s growth rate would be ~3.2% (32% ROIC x 10% RR = 3.2%). Note this number is the real growth rate without inflation. To obtain a notional growth rate, one would need to add an inflation escalator. Assuming an average inflation of 2.5% would bring the terminal growth rate to 5.7%.

Therefore, I think the above consensus estimate is on the more aggressive end. Furthermore, note that CAH’s ROIC has been quite uneven in recent years and its current ROIC of 32% is among the height level in at least 5 years. I expect its average ROIC to be lower in the long run.

Now, on to return projections. Again, given its dividend champion status, CAH is a case to apply the discounted dividend model (“DDM”). To be more specific, I will use a two-stage DDM model. As detailed in my earlier article:

There are a total of 3 key parameters in the 2-stage DDM: the discount rate, the growth rate in stage 1, and the terminal growth rate. For the discount rate, I relied on the so-called WACC, the weighted average cost of the capital model. The discount rate for CAH is about 8.0% on average in recent years following this model.

For the growth rate in the 1st stage, I will be on the generous side and use the CAGR of 7.8% implied in the consensus projections. Further, I will also extend this growth rate for 5 years, essentially assuming its earnings can grow at a 7.8% annual rate for the next 10 years.

For the terminal growth rate, I will assume it can sustain the same ROIC as it did in the past 7 years (which turned out to be around 20%) and the same 10% RR. I also assumed an inflation escalation factor of 2.5%. All these lead to a nominal growth rate of 4.5%.

With all the parameters estimated above, the next table summarizes the results. Note I used its FWD dividend of $2.0 per share. The fair price of CAH is around $79. Even under all the rather aggressive assumptions, there is still too much valuation risk to my liking compared to its current price of $106.

Other risks and final thoughts

I’ve been focusing on the downside risks so far. And there are some highlights in its business fundamentals that I need to point out. The Pharmaceutical division is a key growth area in my view. It has been reporting double-digit YOY growth rates in recent quarters. I expect the momentum to continue, driven by brand and specialty pharmaceutical sales growth from existing customers. Also, the company enjoys strong financial strength, which I expect to become even stronger as the company uses its earnings to pay down debt (see the top panel of the next chart) and augment its liquidity position. As a matter of fact, after all these, the company still has extra cash to be a consistent buyer of its own shares (see the bottom panel of the chart below).

Weighing the above factors, I rate CAH as a hold under current conditions. Its prominent position in the stable pharmaceutical distribution industry offers some security. Its future earnings growth projections are moderate, but healthy enough for a mature business. My main concern is the valuation risks. The current high P/E ratio and low yield suggest the stock is substantially overvalued, severely limiting the potential upside.