Cardinal's Virtues

S&P thinks the drug distributor's stable of strong businesses and robust cash flow make it a compelling buy

By Phillip Seligman

The use of prescription drugs in the U.S. continues to rise, and Cardinal Health (CAH ), the nation's leading pharmaceutical distributor, stands ready to benefit. Standard & Poor's views Cardinal, with its diversified portfolio of well-performing businesses and solid management team, as a compelling investment in today's uncertain economic environment. That's why the shares carry S&P's highest investment ranking of 5 STARS (buy).

S&P believes that Cardinal's long-term financial goal of 20%-plus annual earnings per share growth looks achievable over the next three to five years. Why? Cardinal continues to gain market share through expansion of its existing businesses and strategic acquisitions. It's also benefiting from the rapid growth of generic drugs, which are accounting for an increasing portion of revenues. Generics carry lower prices -- yet significantly wider margins -- than branded drugs. One other trend that will aid earnings: continued healthy expansion of Cardinal's profitable manufacturing and consulting and services segments.

We at S&P expect the company's core pharmaceutical-distribution segment, which accounted for 82% of fiscal 2002 (ended June) operating revenues, to generate revenue growth of approximately 14% to 17% in fiscal 2003 -- likely outpacing the rest of the industry. That's a result of Cardinal's client base, which includes national pharmacy chains such as CVS and Walgreens that are growing faster than other pharmacy outlets.


  We project that operating earnings for this segment will increase 18% to 21% on greater generic penetration, the successful integration of distributor Bindley Western (acquired in February, 2001), and tight cost controls. However, S&P's earnings model excludes Cardinal's coming acquisition of Syncor, a specialty drugs distributor, which should have a positive impact on both sales and gross margins.

Cardinal's other businesses should also post impressive results. Its medical/surgical products and services unit's (14% of fiscal 2002 revenue) should climb 5% to 7% on new distribution business, thanks in part to a reorganization of its sales force. Its operating earnings should climb 12% to 15% as it benefits from new proprietary technologies and productivity gains.

The pharmaceutical technology and services segment's revenue (3% of the total) should grow more than 20%, while its operating earnings rise more than 25%, on new sterile-technology product launches and more pharmaceutical products, as drugmakers continue to outsource manufacturing.


  Finally, the automation and information services segment (1% of the total) should see revenue and operating earnings growth of 20% to 22% and 22% to 25%, respectively, on new products and new markets, given increased government and societal focus on patient safety.

Over the past few years, Cardinal's financial strength has improved dramatically. From fiscal 1995 to fiscal 2002, its return on sales expanded from 2.1% to 4.4%; return on committed capital, from 21.7% to 32.5%; and operating cash flow, from $11 million to $984 million. The company's balance sheet strengthened, with net debt to capital declining from 22% to 12%. Looking ahead, we see continued, healthy gains in each of these measures.

Cardinal also maintains conservative accounting practices, supporting earnings that are of high quality: In fiscal 2002, stock options, if expensed, would have reduced earnings per share by only 16 cents, to $2.48 from $2.64, and earnings weren't boosted by pension gains.


  For fiscal 2003, S&P estimates that EPS will increase by 21%, to $3.19, and by an another 21% in fiscal 2004, to $3.85. The stock was recently trading at a price-to-earnings multiple of 21 times our fiscal 2003 estimate, a significant premium to the p-e of the S&P 500-stock index. S&P believes, however, that Cardinal deserves its premium. Its prospects for sustainable, long-term EPS expansion appear more robust and reliable than those of most companies in the S&P 500.

We see significant upside for the shares over the next 12 months. A three-year EPS growth target of 21% gives the shares a p-e to growth (PEG) ratio of 1.0, based on our fiscal 2003 estimate -- the same as the health-care-distribution industry average for 2002. Even so, given the S&P 500's PEG of 1.3 and our confidence that Cardinal's EPS is more sustainable than that of most S&P 500 companies -- and that it's capable of exceeding its EPS growth target -- we applied a PEG of 1.3 to our fiscal 2003 estimate and derived a reasonable value for the stock of $88.

Our bullishness for Cardinal shares is also supported by the company's strong generation of free cash flow. Indeed, S&P's discounted cash-flow analysis implies an intrinsic value of $82 a share, a 21% premium to the stock's recent price. S&P's overall 12-month target of $85 is based on a blend of the two valuation approaches mentioned above.

Analyst Seligman follows health care distribution stocks for Standard & Poor's

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