By CrossProfit

05/14/2007

The big three distributors dominating the pharmaceutical distribution market in the US are; Cardinal Health (CAH), Mckesson Corp. (MCK) and AmerisourceBergen (ABC). Market cap is approximately $26.6B, $17.9B and $9.8B respectively.

For years this segment has enjoyed strong year over year growth in excess of 20% per annum. As stated in a previous article from 08/2006, organic growth was anticipated to cool down a bit in 2007. Based on first quarter results (calendar year); this is precisely what was happening. Apparently, Cardinal’s management wasn’t going to swallow this pill lying down.

There are three areas of interest regarding this sector. First, maintaining revenue growth, second, maintaining or increasing margins in a historically low margin business and third, as growth stocks commanding above average multiples, EPS is a major consideration. As mentioned in our previous article, dividends are not a major factor (for now).

Revenue Growth

Back in August 2006 we calculated CAH’s 2007 revenue growth coming in at 5.5%. Subsequently the company guided higher in the most recent conference call reporting Q3 FY2007 (fiscal year ending June) revenue growth at 8%. The company also announced that it would beat its previous forecast and that FY2008 earnings would be "materially above" the 12% to 15% estimate.

Knowing that Cardinal had just completed selling its Pharmaceutical Technologies and Services division to Blackstone (April 2007) for an impressive $3.3B, we were wondering (since August 2006) who they were going to acquire. When the company guided higher for FY2008, it was so obvious that only the blind didn’t see an acquisition in the cards. The only way to make good on the "materially above" 15% earnings growth forecast was via a substantial acquisition.

Today (05/14/2007), CAH announced that it was acquiring Viasys Healthcare Inc (VAS) @$42.75 cash. The total price tag including debt is $1.5B. This means that there are still one or two more acquisitions in the works. Chances are that there is only one smaller acquisition in play as CAH repurchased $1.4B of stock in the last reported quarter. This is approximately $1B more than what they would have done without the PTS sale to Blackstone. We are now screening for an acquisition in the $300M to $750M range.

Margins

Like their supermarket cousins, pharmaceutical distributors work on 1% to 3% margins. This is a cut throat business. Cardinal’s current pretax margins are running just below 2.3% and the all important Supply Chain Services (SCSP) division is just below 2%.

Over the next several months, we anticipate some tough negotiations for the renewal of distribution contracts. Should margins slip, this will have an adverse effect upon earnings growth.

Earnings per Share

Cardinal’s management has cleverly counteracted the consequence of slower revenue growth using a two prong approach. First, a massive share buyback program, culminating in reducing the outstanding share count by nearly 10% by the end of FY2007. Second, selling the underperforming PTS division (3% of revenue) and replacing it with VAS. VAS will be a drag on 2007 EPS, however with 5% net margins; overall margins should improve in FY2008. When combined with the share buyback program, EPS should continue to grow.

Note that the company statement refers to earnings growth in absolute terms and not EPS. This means that the "materially above" 15% figure is exclusive of the share buybacks. We ponder if a clarification will be forthcoming. Curiously enough, to date, none of our colleagues know for sure what the company meant to say. We assume, like everyone else, that FY2008 EPS will be at least 25% higher in accordance with company guidance. Currently, this is achievable when taking into account that an entire quarter’s profits was wiped out in FY2007 due to a one time charge.

With revenue growth ahead of target and EPS growth in the bag, the stock is slipping!

All of the above is cancelled out in FY2007 with the allotment of $600M to pay for past mistakes (2004 accounting litigation). In the last quarter, CAH reported a net loss of $0.01 per share. To be fair, back in August 2006 we anticipated that CAH would announce a charge in Q3 FY2007 in the vicinity of $400M. What we did not anticipate was the sale price achieved for the PTS division on the one hand and the VAS acquisition (dilutive to EPS) on the other hand. When all is said and done, this turns out to be a wash. In other words, our estimated EPS for calendar year 2007 remains at $3.60. This is what we call analytical luck – no brains, especially since CAH is one of the stocks featured on our homepage for the past month!

There is no change to the evaluation line as well.

Disclosure: No conflicts.

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