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

Warren Buffett has so many fine quotes.

But one of my favorite Buffett quotes says so much in so few words.

“Someone is sitting in the shade today because someone planted a tree a long time ago.”

Mic drop. 

No, this isn’t about gardening.

It’s about taking advantage of opportunities and investing for the long haul so as to one day provide yourself with the ability to essentially live life more or less however you want.

If you want to one day have it made in the shade, you need to plant the seeds of opportunity today.

I’d know a lot about planting the seeds of opportunity and then having it made in the shade.

I spent about six years of my life living extremely frugally and aggressively investing my excess capital into high-quality dividend growth stocks like those you’ll find on David Fish’s Dividend Champions, Contenders, and Challengers list.

The result? 

Financial independence at 33 years old, which is underpinned by the five-figure passive dividend income my real-life six-figure dividend growth stock portfolio generates on my behalf.

I seriously have it made in the shade these days. There’s a 100-foot-tall oak tree that follows me around, everywhere I go.

The crazy thing about it?

It was incredibly simple.

There’s nothing particularly complicated about saving money and intelligently investing that capital.

However, it’s difficult to actually execute the necessary steps in real-time, day after day, year after year.

And nobody will plant those seeds for you. You have to put in the work yourself.

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

I’m going to highlight a high-quality dividend growth stock that appears to be undervalued at current prices. 

This could be just the information you need to plant a seed and watch the fruit of your labor and foresight grow to your advantage.

A high-quality dividend growth stock can serve as an excellent long-term investment in and of itself. 

That’s because the very business that can generate a longstanding track record of growing dividends is very often a wonderful business.

After all, it’s quite difficult to pay shareholders growing dividends for years – or decades – on end without doing a lot of things right, as those growing dividend payments require the underlying profit growth necessary to fund and sustain the growing dividends.

But if you’re able to buy a high-quality dividend growth stock when it’s undervalued, that’s a whole new ballgame.

Undervaluation (i.e., when the estimated intrinsic value of a stock is higher than its price) can greatly magnify an investor’s long-term success, making that shade tree even taller.

That’s because an undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and less risk. 

This is relative to what the same stock might otherwise offer an investor if it were fairly valued (price and estimated intrinsic value are roughly equal) or overvalued (price is above estimated intrinsic value).

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

That higher yield not only means more ongoing investment income, but it also positively impacts long-term total return potential.

Investment income (via dividends or distributions) is one component of total return.

And the other component, which is capital gain, is also given a boost with undervaluation, as there’s “upside” that exists between price and value in that scenario.

While the market isn’t necessarily very good at appropriately pricing stocks over the short term, price and value tend to more closely track one another over the long term.

If/when that short-term mispricing is corrected by the market over time, that results in extra capital gain. And that’s on top of whatever organic upside and capital gain is possible as a business naturally becomes worth more over time, increasing its valuation and stock price.

This dynamic has a way of reducing risk, too, due to the fact that a margin of safety is introduced while simultaneously risking less capital on a per-share basis.

Intrinsic value is always estimated.

So if one estimates intrinsic value to be $50, you want to make sure you pay a price that’s as far below that number as possible.

That way, there’s a margin of safety present that serves to protect the investor’s downside in case the valuation estimate is too high.

In addition, there’s always the chance that a business might not perform to expectations, or a management team does something wrong that ends up reducing the value of the business.

Buying a wonderful business at a fair price is a great seed to plant. But an even more powerful tree can eventually spring up if a wonderful business is purchased when it’s undervalued.

Fortunately, estimating intrinsic value can be a straightforward process.

And it’s been made to be even more straightforward by fellow contributor Dave Van Knapp, as he penned a “lesson” on valuation that greatly simplifies estimating fair value of just about any dividend growth stock out there.

We’re now going to take a look at a high-quality dividend growth stock that appears to be undervalued, which could be just the seed of opportunity you need to make sure you’re made in the shade in the near future…

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

This business has many attractive qualities to it.

First, it operates in what’s essentially an oligopoly, as there are three major pharmaceutical distributors in the States that control almost the entire market.

In addition, the healthcare space itself is a fantastic place to be.

This is because more people simultaneously growing older and wealthier gives rise to increasing demand for the very products that Cardinal Health is distributing.

These are not often discretionary purchases. If there are pharmaceuticals that extend or increase the quality of your life, you’re going to do whatever necessary to procure these drugs.

And so demand for and access to these products are both increasing at the same exact time, which almost certainly bodes well for most companies in the healthcare space.

That would include Cardinal Health. They serve a critical role in the supply chain.

And due to the razor-thin margins that the drug distribution business model carries, massive volumes are necessary in order to make that model work.

The volumes build in a competitive advantage for the drug distributors, as it would be incredibly difficult for a new entrant to profitably scale out in any reasonable amount of time, thus protecting the incumbent players.

And this should also protect Cardinal Health’s ability to pay and increase its dividend.

That dividend growth track record is already impressive as it sits.

The company has paid an increasing dividend for 21 consecutive years.

However, while the dividend raises keep on coming like clockwork, there’s been a marked deceleration in dividend growth.

The 10-year dividend growth rate is incredibly impressive, sitting at 19.7%.

But the three-year dividend growth rate is a bit above 12%. And the most recent dividend increase was only 3%.

That said, the stock makes up for some of that deceleration via a much higher starting yield relative to where it’s typically been, on average, over the last five years.

For context, the stock currently yields 2.67%.

That’s almost 60 basis points higher than the stock’s five-year average yield of 2.1%.

So, sure, the dividend growth has slowed. But the starting yield is a lot higher in compensation of that.

But I also wouldn’t say that ~3% dividend growth should be the new expectation moving forward, nor would expecting that ~20% 10-year dividend growth rate to continue indefinitely be a rational thing to think.

Somewhere in the middle (and that’s a big middle) would be pretty appropriate.

And that idea is supported by a 47.2% payout ratio (against TTM EPS that factors out major one-time gains on Q2 FY 2018 GAAP EPS).

As such, the dividend could afford mid-single-digit annual growth for the foreseeable future, even absent like EPS growth. But I think EPS growth will actually match or exceed that mark, allowing for even better dividend growth.

But in order to build that dividend growth expectation moving forward, we must first build the EPS growth expectation. That’s because dividend and EPS growth should and likely will roughly match each other over the very long term.

So we’ll look at what Cardinal Health has done over the last decade (using that as a proxy for the long haul) in terms of top-line and bottom-line growth, as that tells us a lot about what the company is doing over a long period of time.

And we’ll then compare that to a near-term professional forecast for EPS growth.

Blending and combining the known past and estimated future in this manner will help us build a foundation of expectations for the company and its growth moving forward.

The company increased its revenue from $91.091 billion to $129.976 billion from FY 2008 to FY 2017. That’s a compound annual growth rate of 4.03%.

I think that’s right about what you’d want to see for a large and mature company such as this.

This company has to increase its revenue at a pretty strong clip due to the fact that massive volume is what makes them tick. However, we have to weigh that against the fact that they’re already a massive business – the starting base here was $90 billion.

With revenue being even higher now than it was 10 years ago, bottom-line growth moving forward will likely be more reliant on buybacks. And management may look for ways to expand margins.

That bottom-line growth over the last decade looks like this: earnings per share advanced from $3.57 to $4.03, which is a CAGR of 1.36%.

That’s obviously disappointing.

But Cardinal Health’s GAAP EPS can oscillate quite a bit from year to year, with the impacts not always making much of a difference to the company’s true earnings power and ability to generate cash flow.

Adjusted EPS over this same time grew at a faster rate – and it was smoother growth.

The good news is that many of the impacts to GAAP EPS were related to acquisitions, which should serve to diversify the business and better position it in the future.

While the core business model (drug distribution) is large and strong, any disruption to the way in which pharmaceuticals are distributed in the US could severely harm Cardinal Health.

An example of the company protecting itself from adverse changes is the recent acquisition of the Patient Care, Deep Vein Thrombosis and Nutritional Insufficiency business for $6.1 billion from Medtronic PLC (MDT).

Looking out over the next three years, CFRA is predicting that Cardinal Health will compound its EPS at an annual rate of 10% over that period.

This would be a rather significant acceleration of EPS growth off of what transpired over the last decade.

CFRA believes the recent acquisitions I was just hinting at will end up being highly accretive to Cardinal Health’s bottom-line performance moving forward.

While this remains to be seen, EPS growth coming in somewhere between 7% and 8% (which would fall quite short of CFRA’s forecast) would be more than enough to fuel high-single-digit dividend growth.

That’s because that scenario would allow for 8% to 9% dividend growth with minor or no payout ratio expansion.

The company’s balance sheet has historically been a source of strength, but recent acquisitions (the large Medtronic business being particularly notable) have added diversification and breadth at the expense of more long-term debt.

As it sits, the long-term debt/equity ratio is 1.33. And the interest coverage ratio is over 10.

These are good numbers. It’s just that they aren’t as good as they were just a few years ago.

But I think these numbers will improve as accretive earnings and cash flow from acquisitions and JVs allow the company to grow itself out of the additional debt.

Meanwhile, profitability is right about what you’d expect.

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

Routinely registering a net margin near 1% annually means the business really has to do a lot of business to make the numbers work. But we see that Cardinal is doing well over $100 billion in sales per year.

The good news is that this works. And it protects the business against new entrants, because it would be incredibly hard to economically scale.

The bad news is that the company’s size works against it, too, as it limits the growth potential. The very thing that protects the business also serves to limit it.

Of course, regulation, litigation, and the reliance on distribution are other key risks to consider.

Nonetheless, this is a very strong business operating within an oligopoly. And the dividend growth track record is rather impressive.

If the stock is available at the right price, it could be a fantastic long-term investment.

Is the price right?

The stock is available for a P/E ratio of 17.69 (using TTM GAAP EPS that factors out significant one-time gains for Q2 FY 2018 EPS). That’s not only well below the broader market, but it’s also well below the stock’s own five-year average P/E ratio of 28.1 (that is no doubt affected by oscillating GAAP EPS that include major impacts).

Factoring out those impacts to earnings, the stock’s P/CF ratio of 11.1 is below its three-year average P/CF ratio of 12.0.

And thestock’s current yield, as shown earlier, is materially higher than its own recent historical average.

It appears to be undervalued at first glance, but how undervalued might it be? What’s a reasonable estimate of intrinsic value?

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 long-term DGR seems reasonable when factoring in the moderate payout ratio, 10-year demonstrated dividend growth, and near-term forecast for EPS growth (which should more or less translate to dividend growth).

However, those numbers are offset by recent dividend increases that were relatively small, a disappointing 10-year EPS growth rate, the reliance on low-margin distribution, and the high starting base for sales.

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.

The stock does appear to be cheap after looking at it from multiple angles, but we’ll consider another angle by comparing my valuation to that of what two different professional stock analysis firms have concluded.

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 $87.41.

So I came out the most conservative here. But averaging the three numbers out gives us a final valuation of $83.65. That would indicate the stock is potentially 21% undervalued right now.

Bottom line: Cardinal Health Inc. (CAH) is a high-quality business that operates within an oligopoly. Numerous long-term tailwinds bode well for the company. And recent acquisitions have diversified the business model away from distribution. A yield near 3%, more than 20 consecutive years of dividend increases, and the possibility that the stock is 21% undervalued means dividend growth investors may want to consider picking up some shares here.

— 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 95. 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 with an extremely unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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