This Pharma Products Company Is Still A Buy

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Cardinal Health (NYSE: CAH) took a big hit last week, down as much as 8% on the news that its pharmaceutical distribution contract with Walgreen Company (NYSE: WAG) would not be renewed. The agreement is scheduled to expire at the end of August 2013. So is the pull back a buying opportunity, or is the fact that Walgreen accounts for over 20% of Cardinal revenues a reason to run?

Cardinal did not provide 2014 guidance after the announcement, except to say that they look for 2014 to be at least similar to the fiscal year 2013 guidance range of $3.42 to $3.50. Not bad considering over 20% of revenues will be wiped out. Part of the reason for this is that 60% of the that Walgreen revenue is "very" low-margin bulk sales.

Not all bad

The other fallout out from the Walgreen contract expiration will be a significant decrease in net working capital. This comes as inventory and accounts receivable will be reduced, and due to the expected working capital decrease, Cardinal is now expecting "a meaningful net, after-tax benefit to cash flow from operating activities in fiscal 2014."

Other tailwinds

  • Cardinal has already renewed a few key chain customer contracts, binding them through 2015, including Kroger and K-Mart.
  • Last quarter, its pharmaceutical segment (its key business) profit was up 12% year over year to thanks to strong performance in generics. 
  • Cardinal's cash for last quarter came in at $2.26 million, compared to its long-term debt obligations of $2.42 million.  

Although Walgreen plans to dump Cardinal (see what hedge funds think about Walgreen), it decided to enter an agreement with Alliance Boots Gmbh to purchase a minority stake in drug distributor AmerisourceBergen Corp. (NYSE: ABC), which is a major competitor of Cardinal. However, the concentrated customer base of Cardinal's appears to be standard for the industry. 

AmerisourceBergen, like its major drug distributing peers, is dependent on a small number of customers, which includes its largest customer Medco Health Solutions (part of Express Scripts), which accounts for around 17% of revenues, and its top ten customers account for about 40%. 

AmerisourceBergen is also expected to continue growing nicely, much like Cardinal, suggesting there are potential industry tailwinds at work as well. The company reiterated its guidance for fiscal 2013, now expecting EPS to come in between $3.06 and $3.16 per share, reflecting year-over-year growth of 11% to 14%, on the back of expected revenue growth of 6% to 9%. 

McKesson Corporation (NYSE: MCK) is the other major pharma distributor, next to Cardinal and AmerisourceBergen, with a large dependence on a just a small number of customers as well. For 2012, McKesson's ten largest customers accounted for over 50% of revenues. The two largest customers, CVS Caremark and Rite Aid Corp, accounted for 16% and 10% of total revenues, respectively.

McKesson took a big hit in 2009 when it lost two customer and lost business worth $3 billion, and the company also appears to be struggling of late, missing earnings last quarter badly (read more about the miss). Mckesson now plans for 2013 EPS to come in at $7.10 to $7.30, compared to the previous $7.15 to $7.35 guidance. 

Dividend & Valuation

So what makes Cardinal's stock compelling? The company pays a solid dividend yield of 2.6%, which comes after a 10.5% hike in its dividend during July 2012, then another 16% in October 2012. Its annual dividend payout now stands at about 33% of earnings, very healthy. 

Since the news that the Walgreen agreement would not be renewed, analysts have lowered their 2014 (ends June) EPS estimate from $3.81 to $3.71. Even still, placing a P/E of 13 on the $3.71 EPS figure suggests upside of around 15% still remains for the stock. A P/E of 13 is the company's current P/E and also happens to be the mid-range of its 5-year P/E trading range. 

Don't be fooled

Cardinal still appears to be a strong company despite losing its largest customer. The impact on EPS is expected to be minimal compared to 2013 and with the recent stock price decline, now could well be a good time to buy this dividend paying drug distributor (see what hedge funds things about Cardinal).


Marshall Hargrave has no position in any stocks mentioned. The Motley Fool recommends Covidien and McKesson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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