Undervalued Dividend Growth Stock of the Week: Cardinal Health Inc. (CAH)

It occurs to me that there are a lot of different “camps” in the investment community.

Some think the best way to invest in stocks is with “growth” companies.

Others believe it’s best to go after “value” stocks.

And then others, especially older investors, chase after “income”.

But I think you can have all three, simultaneously.

You tend to get all three when you invest in high-quality dividend growth stocks at reasonable valuations.

You shouldn’t want a company that isn’t growing. And you shouldn’t want to pay more for a stock than it’s worth. Finally, you should expect some recurring income for putting your money on the line.

Well, the growth is right in the name of a dividend growth stock. And the income is there, too, via the dividends. Finally, a reasonable valuation would mean that one is paying less than fair value.

I want all of that when I buy stock.

These are thoughts running through my mind every single time I buy a dividend growth stock.

Indeed, that’s the thought process I was using whenever I added a stock to my real-life dividend growth stock portfolio, which now pumps out enough passive and growing dividend income to pay my bills, rendering me financially independent in my 30s.

I chose dividend growth investing as the investment strategy to help me reach financial freedom at an early age because of the robustness and tangibility of it.

It’s robust, as it’s such a straightforward and simple way to invest: it’s not hard to figure out that the best businesses in the world are most often delivering great returns and huge dividends for their shareholders.

Moreover, growing dividend income for years on end usually serves as a pretty good litmus test for quality.

The tangibility of the strategy is that growing dividend income, which reminds me that these are real-life businesses selling real-life products and/or services that are generating real-life profit.

Furthermore, growing dividends are an excellent source of passive income that can pay my own real-life bills!

Since starting my journey to financial independence in early 2010, I did my best to build up excess capital by living below my means.

And I would then invest this capital into a high-quality dividend growth stock, often found on David Fish’s Dividend Champions, Contenders, and Challengers list.

Of course, I would make sure the valuation at the time of investment was as far below fair value as possible.

Price is simply what you pay. Price is what’s on a price tag. Price is how much money something costs.

But value is what you get. Value isn’t on a price tag. Value is how much something is worth.

Price is easy to get, but value is much more difficult to ascertain or estimate.

However, it’s value that tells you much more. Value gives context to price.

Without knowing value, it’s nigh impossible to know whether or not the price of something is rational.

When talking about dividend growth stocks, value can have a significant impact on the long-term output and success of one’s investment.

An undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and less risk.

This is all relative to what the same dividend growth stock would offer if it were fairly valued or overvalued.

Price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.

This higher yield positively impacts current and ongoing income. It also positively impacts total return, as total return is comprised of income (dividends/distributions) and capital gain.

Total return is also given a big boost via the “upside” that exists between the lower price paid and the higher intrinsic value of a stock.

While price and value can wildly diverge over the short term, they tend to better converge over longer periods of time.

If you can buy a great dividend growth stock when value and price have favorably diverged (meaning price is well below fair value), that sets you up very nicely for when price more accurately reflects value.

Maximizing upside simultaneously minimizes downside. You can’t do one without the other.

And so paying less reduces one’s risk, as it creates a margin of safety, or a buffer, that exists to protect one’s downside, just in case a stock’s value drops in light of something that goes wrong with the investment thesis or business.

Undervaluation can help with two of the three aforementioned desires of most long-term stock investors: value and income. Growth, of course, is always up to a business to generate.

But undervaluation can certainly confer huge benefits to a long-term investor.

Fortunately, it’s not all that difficult to estimate the intrinsic value of just about any dividend growth stock out there.

For example, fellow contributor Dave Van Knapp put together a great article on how to value dividend growth stocks, and this resource is freely accessible to all readers out there.

In the end, buying high-quality dividend growth stocks when they’re undervalued tends to be a great long-term investment decision.

And that’s what today’s article is all about.

I’m going to reveal a high-quality dividend growth stock that looks undervalued at this very moment…

Cardinal Health Inc. (CAH) is a major distributor of pharmaceuticals and medical supplies to a variety of healthcare clients.

Pharmaceuticals and medical products are a necessary part of everyday life.

In fact, many people quite literally can’t live without their regular consumption of drugs and/or medical supplies.

Well, our country – and the world at large – is growing larger and older. At the same time, people, on average, are becoming wealthier.

These long-term trends bode well for the consumption of the products that Cardinal Health (and companies like it) distribute.

More people means more potential customers.

And as people live longer, they’re naturally going to increase their odds of running into medical problems that would necessitate the usage of pharmaceuticals and medical supplies.

Lastly, wealthier individuals demand and gain access to the high-quality healthcare that unlocks the very products we’re talking about here.

If you can afford the products that will lengthen your life and keep it as high quality as possible, you’re going to everything you can to take those associated products.

All of this bodes well for Cardinal Health’s business model, and it also bodes well for its ability to pay and increase its dividend.

This is a company that obviously has the commitment and wherewithal to pay a growing dividend, as we’ll see.

They’ve increased their dividend for 21 consecutive years, which is mighty impressive.

And over the last decade, their dividend growth rate stands at 22.7%.

Huge dividend growth here, obviously. Well above the rate of inflation.

However, there’s been marked deceleration in dividend growth, with the most recent dividend increase being in the mid-single digits.

While I wouldn’t expect dividend growth that light to persist, the payout ratio has risen somewhat significantly over the last decade. That’s because the dividend has been growing faster than the business.

The payout ratio is currently at 46%.

That’s certainly not worrisome.

In fact, it’s pretty close to what I consider a “perfect harmony” between retaining earnings for growth and paying out shareholders their fair share of profit.

But the payout ratio has climbed quite a bit from where it was a decade ago, and so future dividend growth will have to very likely be lower than where it’s been at over the last decade as a consequence.

The good news, though, is that the yield is much higher now than it was a decade ago.

So investors buying the stock today might be giving up some future dividend growth potential, but they’re getting a lot more current income in exchange.

The stock offers a yield of 2.75% right now.

That’s higher than the broader market by a good measure. It’s also more than 70 basis points higher than the stock’s own five-year average yield.

All in all, there’s a lot to like here about the dividend.

You’re getting an appealing yield, decades of proven dividend growth, and a moderate payout ratio.

But we invest in where a business/stock is going, not where it’s been.

And in order to build out an expectation for where Cardinal Health’s dividend might be going forward, we must first look at where the business has been over the last decade.

Valuing the business will require us to estimate its future growth. Well, no better place to start than what the company has done in terms of growth over the long haul.

So we’ll look at what Cardinal Health has done in terms of top-line and bottom-line growth over the last decade, and we’ll then compare those results to a near-term forecast for profit growth.

Combing the past and future like this should give us a reasonable expectation moving forward.

Cardinal Health has grown its revenue from $91.091 billion in fiscal year 2008 to $129.976 billion in fiscal year 2017 (FY ends June 30). That’s a compound annual growth rate of 4.03%.

This is a really solid top-line long-term compound annual growth rate for a mature company like Cardinal Health, especially considering the large numbers we’re working with here. I mean, we’re talking growing off of a base of over $90 billion 10 years ago.

Seeing as how we’re now talking over $130 billion in revenue, it seems likely that top-line growth will be even more challenging. As such, bottom-line growth will be more reliant on margins and buybacks.

Speaking of which, the company increased its earnings per share from $3.57 to $4.03 over this period, which is a CAGR of 1.36%.

That long-term EPS growth rate is obviously poor, and it’s pretty disappointing.

However, Cardinal Health takes a number of hits to GAAP EPS seemingly every year, which can cause the numbers to vary quite a bit from year to year. Adjusted EPS shows a much smoother ride – and better growth.

The good news is that a number of these impacts relate to favorable acquisitions and tuning of the business, which should position the company better moving forward.

That’s because the core of the business is in pharmaceutical distribution. While this business looks great over the long term (due to the aforementioned tailwinds), it’s also a low-margin business that competes heavily on price. Recent competition on generic pricing has materially impacted reported EPS.

Furthermore, any disruption to the current distribution model would strongly and negatively affect Cardinal Health.

As such, they’ve been acquiring bolt-on businesses in the medical space that diversify and further insulate the company, such as the recent acquisition of the Patient Care, Deep Vein Thrombosis and Nutritional Insufficiency business for $6.1 billion from Medtronic PLC (MDT).

Meanwhile, the company continues to buy back a lot of its stock – the outstanding share count is down by approximately 12% over the last decade.

Looking out over the next three years, CFRA is forecasting a 10% compound annual growth rate for Cardinal Health’s EPS, which is a pretty strong call.

They believe recent acquisitions (like Medtronic’s business) will be accretive, especially after savings from synergies. They also expect benefits to materialize from the Red Oak drug purchasing JV. Continued share repurchases should also benefit EPS growth.

That said, this would be a notable acceleration from what we see above. Even if we back the 10-year comparison up by one fiscal year, Cardinal Health is growing at an annual clip of 9%.

However, the moderate payout ratio means that Cardinal Health could only grow the underlying business by 7% or so annually and still grow the dividend at a very appealing rate up in the upper single digits for years to come, without issue.

The company’s other fundamentals also look solid.

Cardinal Health’s balance sheet has taken somewhat of a hit recently, with that aforementioned major acquisition.

The long-term debt/equity ratio is sitting at 1.33, while the interest coverage ratio is at over 10.

Good numbers, but I’m looking to see these improve as the cash flow increases from the acquisitions and JVs.

As mentioned earlier, this is a low-margin business. And so it’s necessary to have huge scale in order for it to work out. Cardinal Health obviously has the scale, but those low margins negatively skew profitability.

Over the last five years, Cardinal Health has averaged net margin of 0.99% and return on equity of 16.06%.

All in all, Cardinal Health is operating a really good business with huge tailwinds and a fantastic dividend legacy, but the razor-thin margins and pricing competition are drawbacks.

If we’re able to get the stock at an appealing valuation, though, it could make for a great long-term dividend growth investment.

That valuation does indeed look fairly appealing right now…

The stock is trading hands for a P/E ratio of 16.69 right now, which compares very favorably to the five-year average P/E ratio of 27.3. While that five-year average is somewhat higher than it should be due to the way GAAP EPS is routinely skewed by temporary events, one could just as well point to the fact that the most recent fiscal year EPS is likely lower than it should be – and the P/E ratio is still quite low. In addition, the yield, as shown earlier, is significantly higher than its recent historical average.

So the stock does look fairly cheap with a low P/E ratio on artificially low EPS, but what might a reasonable estimate of the stock’s intrinsic value be?

I valued shares using a dividend discount model analysis.

I factored in a 10% discount rate and a long-term dividend growth rate of 7.5%.

That growth rate is lower than I’ve used in the past for the stock, as the recent slips in the business, lower recent dividend growth, and slight deterioration in the balance sheet all make me feel more comfortable with a downward revision there.

But the moderate payout ratio, dividend growth commitment, and possibility for growth acceleration (after recent moves possibly result in accretion looking out over a year or two) still paint a very nice picture for long-term dividend growth.

The DDM analysis gives me a fair value of $79.53.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

So even with a downward revision in the anticipated dividend growth rate moving forward, the stock still looks quite cheap here. However, my analysis and opinion is but one of many, which is why I like to compare my conclusion to that of what professional stock analysts come up with.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.

1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates CAH as a 4-star stock, with a fair value estimate of $84.00.

CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.

They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

CFRA rates CAH as a 3-star “HOLD”, with a fair value calculation of $81.70.

So I came out the lowest here after that revision, but there’s still a pretty tight consensus here. Averaging the three numbers gives us a final valuation of $81.74, which would indicate the stock is potentially 21% undervalued.

Bottom line: Cardinal Health Inc. (CAH) is a high-quality firm that provides the necessary distribution of necessary pharmaceuticals and medical supplies, which will almost surely be more necessary and in demand as the country – and world – becomes bigger, older, and richer. More than 20 consecutive years of dividend increases, a market-beating yield, exciting recent acquisitions, and the possibility of 21% upside means this is a healthcare stock that should be on every dividend growth investor’s radar.

— Jason Fieber

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