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

Almost everything in life can be as simple or as complicated as you’d like to make it.

But I’m like electricity: I try to always take the path of least resistance.

It doesn’t make sense to live one’s life in any other way.

There’s no need to overcomplicate things.

This concept translates pretty well to investing.

Dividend growth investing is such a beautiful long-term investment strategy because it greatly simplifies investing, making it pretty straightforward for just about anyone to invest, generate growing passive income, and even potentially retire very early in life. 

I’m proof of this.

I was a college dropout who found himself broke and unemployed during the depths of the Great Recession in 2009.

But I discovered dividend growth investing in 2010.

And this completely changed my life, eventually allowing me to quit my job at 32 and become financially independent at just 33 years old.

This process of going from below broke to financially independent in six years was recounted in my Early Retirement Blueprint, which is a step-by-step guide that could put you on the track to your own early retirement dreams.

The foundation of my own early retirement is built on the five-figure and growing passive dividend income my real-life and real-money dividend growth stock portfolio generates on my behalf.

You can even see what that six-figure portfolio looks like by checking out my FIRE Fund.

Dividend growth investing is incredibly simple because you’re basically just buying shares in some of the best businesses in the world.

Being a great business is strongly evidenced by the existence of a lengthy track record of growing dividends, which can only occur when a company is producing the growing profit necessary to sustain such behavior.

Jason Fieber's Dividend Growth Portfolio

You can see how this manifests itself by perusing the late, great David Fish’s Dividend Champions, Contenders, and Challengers list – a compilation of data on more than 800 US-listed stocks that have raised their dividends each year for at least the last five consecutive years.

It should be no surprise that many companies on that list – especially those with many decades of dividend growth – are world-class enterprises due to the conditions that must be present in order to give rise to rising dividends.

Growing dividends serve as a great litmus test for business quality. 

But growing dividends are perhaps even more valuable in a very practical sense: they can be the very bedrock to build one’s early retirement upon. 

If the dream is ditching the job, collecting dividends, and going about your life, dividend growth investing makes that dream possible.

However, as great as dividend growth investing is, you can’t approach it blindly.

You should have a grasp on how to analyze a company’s fundamentals, qualitative aspects, and risks.

And arguably even more importantly, you should be able to value a company and it stock.

Valuation can and will have a major impact on your investment.

Price is what you pay, but value is what you end up getting.

When you’re able to pay a price that’s well below intrinsic value, you’re buying an undervalued stock.

This is fantastic for a number of reasons.

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

That’s all relative to what the same stock might otherwise 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.

That higher yield means more investment income on the same invested dollar, which greatly speeds the journey to early retirement.

And since total return is comprised of capital gain and investment income (via dividends or distributions), a higher yield thus gives you greater long-term total return potential.

That’s not to mention that capital gain is given another potential boost via the “upside” that exists between a lower price paid and higher intrinsic value.

This favorable gap can exist because the stock market isn’t necessarily great at accurately pricing stocks over the short term, leading to the very undervaluation and mispricing we’re talking about here.

But the market can and often does more accurately price stocks over the long term, reflecting earnings power in a stock’s price.

And when that initial favorable gap closes, as a stock is more accurately priced, that leads to capital gain, giving total return another boost (on top of the higher yield laid out above).

That’s all on top of whatever upside would naturally play out as a company becomes worth more (as it increases its profit and dividend), causing a rise in its stock price.

Of course, this all has a way of reducing risk, too.

Risking less capital per share, or even the total amount of capital on the transaction (by buying a fixed number of shares), is risk reduction at face value.

In addition, you’re also building in a margin of safety when undervaluation is present, for it protects you against ending up with an investment that’s upside down (worth less than you paid).

The greater the gap between price and value, the larger that margin of safety is.

While these dynamics are obviously advantageous, you have to be able to identify them at the outset of investment.

Fortunately, fellow contributor Dave Van Knapp has made that process much easier by sharing a valuation system that can be applied to just about any dividend growth stock out there.

That system is part of an overarching series of lessons that serve to educate investors on all things dividend growth investing.

The lesson that focuses specifically on valuation is Lesson 11: Valuation.

With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…

Cardinal Health Inc. (CAH)

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

This is a necessary company in the ecosystem of the US healthcare system.

Pharmaceuticals and medical supplies can’t get to hospitals, doctors, pharmacies, or consumers if they’re not being properly and effectively procured and distributed, which is where Cardinal Health comes in.

And Cardinal Health, with its $100+ billion in annual revenue, has the economies of scale and purchasing power needed to squeeze every bit of juice out of its potential.

What’s particularly great about this particular business model, besides the necessity of it, is the fact that it operates within an oligopoly – there are only three major pharmaceutical distributors in the United States.

This market control and limited competition offsets a major negative aspect of the distribution business model, which always has low margins due to the very nature of being a middle man. There is limited opportunity for new entrants.

In addition, there’s the ubiquity, necessity, and growth profile of the very products this company is distributing.

The healthcare space is basically guaranteed to do well over the long run, for the US is becoming bigger, older, and wealthier.

Demand for and access to high-quality medical products and pharmaceuticals will never be in short supply, which bodes well for Cardinal Health, its profits, and dividend growth.

Speaking of which, the company has increased its dividend for 23 consecutive years now, which is almost a quarter century.

That’s a fantastic track record that shows no signs of ending.

That’s partially based on a payout ratio of just 35.5%.

With the dividend consuming less than 40% of earnings, they’re in a great position to continue growing the dividend.

That growth, by the way, looks like this: the 10-year dividend growth rate stands at 19.7%.

However, that’s tempered by a rather severe deceleration in dividend growth; the most recent dividend increase was only 3%. And the preceding dividend increase was also 3%.

But that marked drop in dividend growth has been accompanied with a higher yield (on a valuation drop, which we’ll get into).

The stock now yields 3.79%, which is more than 160 basis points higher than the stock’s five-year average yield.

That’s not to mention that the yield is substantially higher than the industry average and the broader market as a whole.

So the dividend growth has slowed, but you’re getting a revaluation and higher yield in exchange.

All in all, that’s not necessarily the worst thing in the world.

That said, I would like to see the dividend growth accelerate from here, which I think is a very realistic expectation moving forward.

Building that expectation, of course, requires looking at the overall growth of the business, which we’ll now get into.

We’ll first see what Cardinal Health has done over the last decade (using that as a proxy for the long term) in terms of top-line and bottom-line growth, before moving into a near-term professional forecast for profit growth.

Blending the known past and estimated future in this manner should give us a pretty good framework to work with, which should allow us to extrapolate a trajectory for dividend growth (which greatly aids us in the valuation).

The company grew its revenue from $87.408 billion to $129.976 billion between fiscal years 2008 and 2017. That’s a compound annual growth rate of 4.51%.

That’s a very solid top-line growth rate, especially considering the fact that the starting base was so large.

Of course, that base is even larger now, so forward-looking top-line growth may be slightly more limited.

Meanwhile, earnings per share increased from $3.57 to $4.03 over this same time period, which is a CAGR of 1.36%.

This is obviously not what we’d like to see; however, the company has taken a number of hits to GAAP EPS lately that don’t necessarily correlate very well to the company’s true earnings power.

For perspective on this non-GAAP EPS for last fiscal year came in at a much higher $5.40.

Even more perspective is provided via CFRA’s forecast for Cardinal Health’s three-year EPS compound annual growth rate, which stands at 8%.

That would be quite the acceleration off of what we see above, but I don’t think Cardinal really has to grow like that in order to provide for a very solid long-term investment at today’s prices.

Even bottom-line growing coming in at somewhere around 6% or so could provide for high-single-digit dividend growth (based on the low payout ratio) for years to come.

And combining that with a yield that’s approaching 4% is a lot to like.

The company’s balance sheet has long been extremely solid, but recent acquisitions (which account for much of the gyrations in GAAP EPS discussed above) have impacted the metrics recently.

For example, Cardinal Health, in 2017, completed the acquisition of the Patient Care, Deep Vein Thrombosis and Nutritional Insufficiency business for $6.1 billion from Medtronic PLC (MDT).

But with a long-term debt/equity ratio of 1.33, total cash that is 3/4 of long-term debt, and an interest coverage ratio over 10, there’s not much to really worry about here.

Furthermore, the debt/equity ratio is negatively impacted more by low common equity than some kind of issue with debt.

Profitability is fairly robust, but we have to keep in mind that distribution is always a low-margin business model.

Over the last five years, the company has averaged annual net margin of 0.99% and annual return on equity of 17.01%.

Both numbers have been negatively impacted by GAAP results in certain years, but the overall business remains quite profitable for its industry. That said, ROE is given a boost by the low common equity.

Overall, there’s a lot to like about this business for a dividend growth investor.

You’ve got a member of an oligopoly firmly entrenched in one of the best and fastest-growing industries in the US, the wherewithal for and clear commitment to reliable dividend raises, a relatively large yield, and demographics that practically guarantee future prosperity.

However, regulation, litigation, and competition (limited as it may be) are all key risks to consider.

And any major change in the US healthcare system (like some kind of nationalization) would almost surely directly impact Cardinal Health.

While growth has slowed, the ~35% drop in the stock’s price, and downward revaluation that’s occurred as a result, has appeared to put the stock squarely into undervalued territory…

The stock is now trading hands for a P/E ratio of 9.36, which is almost 1/3 of the stock’s five-year average. That P/E ratio is also obviously less than 1/2 of where the broader market is at.

Revenue has a multiple of just 0.1.

The stock’s cash flow multiple is less than 1/2 of its three-year average.

And the yield, as noted earlier, is significantly higher than its recent historical average.

This stock looks silly cheap here, but what might be a reasonable estimate of intrinsic value? How cheap might it 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%.

I’ve lowered that DGR since the last time I looked at the stock to account for the back-to-back 3% dividend raises.

But the low payout ratio, forecast for EPS growth moving forward, commitment to dividend growth, and long-term DGR all point to better days ahead, in my view.

The DDM analysis gives me a fair value of $68.12.

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 the basic valuation metrics and DDM analysis both show a cheap stock, but my perspective is but one of many on this stock.

Let’s see what two professional stock analysis firms think about this stock and its valuation right now.

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 5-star stock, with a fair value estimate of $82.00.

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 5-star “STRONG BUY”, with a 12-month target price of $65.00.

Averaging these three numbers out gives us a final valuation of $71.71, which would indicate the stock is potentially 43% undervalued here.

Bottom line: Cardinal Health Inc. (CAH) is a major player in an oligopoly, in one of the most appealing and fastest-growing industries in the US. Almost 25 consecutive years of dividend raises, a low payout ratio, a yield significantly higher than the broader market, and the possibility that shares are 43% undervalued means dividend growth investors may want to distribute shares of this business into their portfolios.

-Jason Fieber

Note from DTA: How safe is CAH’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 92. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, CAH’s dividend appears very safe and extremely unlikely to be cut. Learn more about Dividend Safety Scores here.

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