Cardinal Health; In the Middle of the Storm

Summary

#1 Revenue increases, but not earnings.

#2 CAH is looking outside its business model to find growth.

#3 The company remains a leader in its market and a Dividend Aristocrat

What Makes Cardinal Health (CAH) a Good Business?

Cardinal Health is one of the three leaders in pharmaceutical distribution with AmerisourceBergen (ABC) and Mckesson (MCK). CAH operates under 2 business segments; the Pharmaceutical segment (89% of revenue) distributes branded and generic pharmaceutical, specialty pharmaceutical, over-the-counter healthcare and consumer products and the Medical segment (11% of revenue) distributes a range of medical, surgical and laboratory products, and provides services to hospitals, ambulatory surgery centers, clinical laboratories, and other healthcare providers. CAH operates in 60 countries and is a key player in the healthcare industry.

CAH presentation

However, this industry is hit by a serious decrease in drug pricing. In a world where margins are already close to 0, the whole business model is put to a serious test.

Source: Ycharts

Revenue

Revenue Graph from Ycharts

Cardinal Health benefits from a natural growth coming from the current demographic situation. As the population is aging and insurance covering is increasing, there are more drugs to be distributed across the healthcare network.

The rise of speciality drugs also acts as a growth vector. CAH has combined its generic sourcing operation in a partnership with CVS Health (CVS). I expect CAH revenue to continue growing for another decade as the population ages.

How CAH fares vs My 7 Principles of Investing

We all have our methods for analyzing a company. Over the years of trading, I’ve been through several stock research methodologies from various sources. This is how I came up with my 7 investing principles of dividend investing. Let’s take a closer look at them.

Principle #1: High Dividend Yield Doesn’t Equal High Returns

My first investment principle goes against many income seeking investors’ rule: I try to avoid most companies with a dividend yield over 5%. Very few investments like this will be made in my case (you can read my case against high dividend yields here). The reason is simple. When a company pays a high dividend, it’s because the market thinks it’s a risky investment… or that the company has nothing else but a constant cash flow to offer its investors. However, high yield hardly comes with dividend growth and this is what I am seeking most.

Source: data from Ycharts.

CAH has been flying under the radar of many income seekers as it offered a yield under 2% during a good part of the past decade. The recent shift in the industry (cost of generic drugs dropping on price pressure), pushed the stock down by 32% since January 1st, 2016 (as of December 6th). This had the opposite effect of boosting CAH yield over 3%. Yet, keep in mind there is a good reason why the stock is dropping. I’ll get back to it in a moment.

CAH meets my 1st investing principle.

Principle#2: Focus on Dividend Growth

Speaking of which, my second investing principle relates to dividend growth as being the most important metric of all. It proves management’s trust in the company’s future and is also a good sign of a sound business model. Over time, a dividend payment cannot be increased if the company is unable to increase its earnings. Steady earnings can’t be derived from anything else but increasing revenue. Who doesn’t want to own a company that shows rising revenues and earnings?

Source: Ycharts

Cardinal Health is part of the elite group of Dividend Aristocrats (25 years + with dividend increases) with 32 consecutive increases. While the past 5 years dividend growth rate is quite impressive (10.95 CAGR), the company only raised it by 3% in 2017. This is a situation that doesn’t worry me for now, but is a good reason to put CAH on the watch list.

CAH meets my 2nd investing principle.

Principle #3: Find Sustainable Dividend Growth Stocks

Past dividend growth history is always interesting and tells you a lot about what happened with a company. As investors, we are more concerned about the future than the past. This is why it is important to find companies that will be able to sustain their dividend growth.

Source: data from Ycharts.

While CAH’s dividend growth has slowed down in 2017, the dividend is far from threatened. With a payout ratio around 50% and a cash payout ratio of 30%, shareholders can expect CAH to maintain its dividend raise streak for many years to come.

CAH meets my 3rd investing principle.

Principle #4: The Business Model Ensures Future Growth

CAH occupies a crucial role in the pharmaceutical business. It is a key element of the healthcare industry. Pharmaceutical wholesalers have built a solid fence around their business model. Thanks to their efficient network and their buying capacity, it is nearly impossible for new competitors to enter this market. ABC, MCK, and CAH dominate this market now and will continue to do so in the future.

This is how each company can generate sustainable earnings and cash flow regardless of their thin margins. We are in a volume game here and no other players are invited to the table.

In order to pursue additional growth, management decided to look outside their pharmaceutical distribution business. CAH recently acquired Medtronic’s Patient Care, Deep Vein Thrombosis, and Nutritional Insufficiency business for $6.1 billion. I am not convinced CAH should take away its focus from pharmaceutical to improve its medical segment revenue. However, if it succeeds, it will definitely be a growth vector for years to come. It’s just that razor-thin industries don’t allow much room for mistakes.

CAH still shows a strong business model and meets my 4th investing principle.

Principle #5: Buy When You Have Money in Hand – At The Right Valuation

I think the perfect time to buy stocks is when you have money. Sleeping money is always a bad investment. However, it doesn’t mean that you should buy everything you see because you have some savings aside. There is a valuation work to be done. In order to achieve this task, I will start by looking at how the stock market valued the stock over the past 10 years by looking at its PE ratio:

Source: data from Ycharts.

Considering the overall market, I’d say that a 17.5 PE ratio and a forward PE of 12 looks like a decent deal for me. Now, it’s more a matter of knowing if the market sees something we don’t.

Digging deeper into this stock valuation, I will use a double stage dividend discount model. As a dividend growth investor, I see companies like big money making machine and assess their value as such. I decided to go “rough” and use a 5% dividend growth rate for the upcoming 10 years and a 6% afterward. Here are the details of my calculations:

Input Descriptions for 15-Cell Matrix INPUTS
Enter Recent Annual Dividend Payment: $1.85
Enter Expected Dividend Growth Rate Years 1-10: 5.00%
Enter Expected Terminal Dividend Growth Rate: 6.00%
Enter Discount Rate: 9.00%
Discount Rate (Horizontal)
Margin of Safety 8.00% 9.00% 10.00%
20% Premium $107.83 $72.13 $54.28
10% Premium $98.84 $66.12 $49.75
Intrinsic Value $89.86 $60.11 $45.23
10% Discount $80.87 $54.10 $40.71
20% Discount $71.88 $48.09 $36.18

Source: how to use the Dividend Discount Model

In the light of my calculation, it appears that CAH trades at fair value. If I had used the past 5 years CAGR, we would have gotten a nice bargain. However, I would rather look toward the future than look back.

CAH meet my 5th investing principle and currently trades at fair value.

Principle #6: The Rationale Used to Buy is Also Used to Sell

I’ve found that one of the biggest investor struggles is to know when to buy and sell his holdings. I use a very simple, but very effective, rule to overcome my emotions when it is time to pull the trigger. My investment decisions are motivated by whether the company confirms my investment thesis. Once the reasons (my investment thesis) why I purchase shares of a company are not valid anymore, I sell and never look back.

Investment thesis

Investing in CAH is picking up a stock that has been hit hard during a bullish market. My take on this year is that investors get greedy and look for immediate results. Since CAH is more a long term type of holding and will reward shareholders over the long run, it doesn’t fit the “quick rich trade” many search for in the market. Since CAH is a dominant player in a key sector in the healthcare industry, I don’t see any reason to worry about the dividend payment or future cash flow generation.

I think many downsides have been factored in the price as of now. The market is well aware of the generic price pressure all wholesalers must face. This situation confirms that margins will remain at a minimum for years and earnings growth will be difficult. CAH will have to show other growth vectors at some point in time if it wants to continue raising its dividend.

CAH shows a solid investment thesis and meets my 6th investing principle.

Principle #7: Think Core, Think Growth

My investing strategy is divided into two segments: the core portfolio built with strong & stable stocks meeting all our requirements. The second part is called the “dividend growth stock addition” where I may ignore one of the metrics mentioned in principles #1 to #5 for a greater upside potential (e.g. riskier pick as well).

Cardinal Health evolves in an oligopoly where there is a natural growth coming from the current demographic. However, don’t expect any distributors in any business to come with a major breakthrough that will make their business model explode. For this reason, CAH is a solid dividend payer, but definitely not a growth oriented company.

CAH is a core holding.

Final Thoughts on CAH – Buy, Hold or Sell?

There are lots of changes going around the healthcare industry. Companies like ABC, MCK and CAH are not the only one affected. Pharmacy such as Walgreens Boots Alliance (WBA) and CVS Health (CVS) also have to manage throughout this evolving industry. At the moment, I’m not convinced CAH is a buy. It looks undervalued, but the growth vectors are not obvious enough to become a screaming buy either.

Disclaimer: I do not hold CAH in my DividendStocksRock portfolios.

 

Price-Earnings Ratio Expansion Explained – And Why You Should Care

The market is more expensive today than it was a year ago.

We all hear that, but do we really know what they are talking about? When we read about the average market Price-Earnings Ratio (PE Ratio) going up, what does that really mean? You pay more than you used to. This phenomenon is called “PE expansion.”  I’ve built this small guide to tell you what it is and why it has an impact on your portfolio.

A quick review of the PE Ratio

The PE ratio refers to the number of times you pay the profit per share of a company. For example, if a company reports earnings of $1 per share and the stock trades at $11, this means you pay 11 times its profit. In other words, the value of the company is equal to 11 times its profit today. If you own all shares of that company, you would need 11 years to get all of your money back, assuming profit doesn’t change.

What happens when you pay more

Imagine the same company with the same earnings suddenly trades at $13. An affluent of new investors want to buy shares of this company and they are ready to pay a more expensive price ($13). At that time, we are looking at the same company with the same profile and earnings. The only difference is that it costs $2 more per share. The only reason why you pay more today for the stock is because there are more people wanting it.

This could be because they think the company will go through a major breakthrough and that earnings will go up. This could be because interest rates are low and investors are ready to pay a higher price for a solid dividend payer (hence, pushing the yield lower at the same time).

A real-life example

Let’s use 3M Co (MMM) as an example. Here’s a graph showing MMM stock price along with its earnings per share (EPS):

Source: Ycharts

A quick look at such graphs and everything looks normal. The price goes up as the EPS goes up. This would falsely lead us to think that both metrics go up following the same trend. After all, it’s only normal to pay a higher price for a stock that shows a higher EPS, right? When we take both metrics, but look at the normalized variation, we have a totally different landscape:

Source: Ycharts

As you can see, the stock price is going up a lot faster than the earnings. You can also see how high MMM PE ratio goes over the past decade:

Source: Ycharts

10 years ago, MMM used to trade at 14 times its earnings. Today, it is around 26 times. If MMM was a money making machine it would have required 14 years to recoup your investment if you would have purchased it in 2007. Today, if you buy the upgraded money making machine model (it is upgraded as it makes more money than it used to 10 years ago), you would need 26 years to recoup your investment.

I am not talking about the price paid here, but rather the number of years before the company can technically reimburse you for your investment. If you buy MMM today, you would need to wait 12 more years than if you would have bought it 10 years ago. Does the new money making machine looks attractive compared to the old model? Not really.

Potential opportunities

From time to time, there are opportunities on the stock market where a stock is trading at a lower PE based on fears and false assumptions. A good example would be Apple (AAPL):

Source: Ycharts

Based on the thesis that Apple would not be competitive in the smartphone industry, AAPL stock dropped close to a 9 PE ratio back in 2013. It happened again in 2016 when investors lost interest in the company. However, paying only 9 times the revenue of a company as solid as Apple is definitely a bargain. It becomes less obvious when it trades around 19 times its earnings.

You can then purchase a stock based on a lower PE ratio in the hopes that there will be a PE expansion. On the other side, you can always buy a stock at a higher PE ratio in the hopes that the company will make more profit in the future and bring down this valuation metric.

Potential risk

When the PE expansion is too important and happens without a good rationale, it could become highly dangerous. When faith in the market starts to fade, higher valued companies will be the first to plunge. Technically, they are the ones that are the farthest to their intrinsic valuation.

As you can see, MMM used to trade over a 26 PE ratio before the latest crisis. You can also note how fast the stock price dropped during the financial crisis:

Source: Ycharts

How to prevent it – Using other valuation models

The PE ratio is one valuation model among many others. In order to have a clear view of how the market looks at a company, I like to use a 10 year history. This shows me the PE fluctuations through a longer period and helps me find the most accurate multiplier for that investment. But this is only good to give me a hint about where to look. I rather use a more precise model such as the Discounted Cash Flow and the Dividend Discount Model to find the stock intrinsic value.

By using those models, I am able to not only find a fair value before I make a purchase, but I can also calculate a margin of safety. This is particularly useful when you invest in such a highly valued stock market as today.

Final thoughts

Depending on when you invest and the overall market sentiments, PE ratios could be high or low. The current bullish market has been supported by an unprecedented low interest rate environment and massive cash flow injected by central banks. It is hard to determine if we will enter into a PE contraction phase at one point or if this is now the new norm. As long as there will be faith in the stock market, the bull will continue to ride. In the meantime, I stay invested in strong dividend growth stocks as they always tend to perform well in the long run!

Disclaimer: I’m long MMM & AAPL

 

Mondelez: 5 Years After Spinning-Off Kraft

What Makes Mondelez (MDLZ) a Good Business?

When I think of Mondelez, I think… yummy! I must admit I’m a bit biased; Oreo Cookie & Cream are my favorite cookies. Besides making delicious cookies, Mondelez is one of the world’s largest snack manufacturer. The company is mostly known for its cookies and chocolate brands representing 71% of its revenue.

Source: MDLZ fact sheet

The company is driving 70% of what they call their “power brand” as follows:

Source: MDLZ fact sheet

Revenue

Revenue Graph from Ycharts

Over the years, MDLZ has grown to a point beyond reason. In fact, Mondelez is the result of a separation of Kraft (formerly KFT) and what became Mondelez after the spin-off in 2012. Since then, Kraft has been bought by Warren Buffett and merged with Heinz to create Kraft Heinz (KHC). Are you lost? Imagine that in early 2017, rumors spread that KHC eyed Mondelez for a potential acquisition… When riches don’t know what to do with their time…

Over the past few years, MDLZ continued to sell their smaller brand in order to improve its focus around its Power Brands. During their latest quarter, management posted some solid numbers showing their strategy worked:

MDLZ Q3 2017 presentation

How MDLZ fares vs My 7 Principles of Investing

We all have our methods for analyzing a company. Over the years of trading, I’ve been through several stock research methodologies from various sources. This is how I came up with my 7 investing principles of dividend investing. Let’s take a closer look at them.

Principle #1: High Dividend Yield Doesn’t Equal High Returns

My first investment principle goes against many income-seeking investors’ rules: I try to avoid most companies with a dividend yield over 5%. Very few investments like this will be made in my case (you can read my case against high dividend yield here). The reason is simple: when a company pays a high dividend, it’s because the market thinks it’s a risky investment… or that the company has nothing else but a constant cash flow to offer its investors. However, high yield hardly comse with dividend growth and this is what I am seeking most.

Source: data from Ycharts.

As you can see, when there is a major spin-off, it is difficult to analyze what is left of the “new company”. The dividend kept increasing after the spin-off and so did the price. MDLZ currently rewards shareholders with a 2% yield.

MDLZ meets my 1st investing principles.

Principle #2: Focus on Dividend Growth

Speaking of which, my second investing principle relates to dividend growth as being the most important metric of all. It proves management’s trust in the company’s future and is also a good sign of a sound business model. Over time, a dividend payment cannot be increased if the company is unable to increase its earnings. Steady earnings can’t be derived from anything else but increasing revenue. Who doesn’t want to own a company that shows rising revenues and earnings?

Source: Ycharts

Over the past 5 years, MDLZ has increased its dividend payment. This makes it half-way to becoming a Dividend Achiever. The Dividend Achievers Index refers to all public companies that have successfully increased their dividend payments for at least ten consecutive years. At the time of writing this article, there were 265 companies that achieved this milestone. You can get the complete list of Dividend Achievers with comprehensive metrics here.

Mondelez hasn’t just increased its dividend, it offered a double-digit dividend growth (11.1%) over this period.

MDLZ meets my 2nd investing principle.

Principle #3: Find Sustainable Dividend Growth Stocks

Past dividend growth history is always interesting and tells you a lot about what happened with a company. As investors, we are more concerned about the future than the past. This is why it is important to find companies that will be able to sustain their dividend growth.

Source: data from Ycharts.

While shareholders have received a substantial raise in paycheck, the company’s dividend payout ratios are still well under control. I don’t expect a double-digit dividend growth rate for several years again, but a high single digit seems sustainable.

MDLZ meets my 3rd investing principle.

Principle #4: The Business Model Ensure Future Growth

I like MDLZ’s focus on strong brand while ignoring underperforming ones. I think that a company should always bet on its strengths to become the best in its field. This is exactly what MDLZ is doing. The company currently manages eight $1+ billion brands.

Source: Mondelez website

On top of their Power Brands, MDLZ continues to show positive results across emerging markets and with their eCommerce strategy.

MDLZ Q3 2017 presentation

There is definitely a growing interest for the snack industry across the world. The middle class is growing in many emerging markets, leading to additional buying powers and the desire for treats like chocolate and cookies.

MDLZ still shows a strong business model and meets my 4th investing principle.

Principle #5: Buy When You Have Money in Hand – At The Right Valuation

I think the perfect timing to buy stocks is when you have money. Sleeping money is always a bad investment. However, it doesn’t mean that you should buy everything you see because you have some savings aside. There is valuation work to be done. In order to achieve this task, I will start by looking at how the stock market valued the stock over the past 10 years by looking at its PE ratio:

Source: data from Ycharts.

I must admit that the current 29 PE ratio is not something that makes me cheer. The 12 month forward PE makes more sense at 19.68. Still, we are probably not talking about a deal here.

Digging deeper into this stock valuation, I will use a double-stage dividend discount model. As a dividend growth investor, I’d rather see companies like big money-making machines and assess their value as such.

I’ve used a strong 8% dividend growth rate for the first 10 years. After all, management shows a clear commitment toward rewarding shareholders. Since the company can afford it, the generous increase makes sense.

Here are the details of my calculations:

Input Descriptions for 15-Cell Matrix INPUTS
Enter Recent Annual Dividend Payment: $0.88
Enter Expected Dividend Growth Rate Years 1-10: 8.00%
Enter Expected Terminal Dividend Growth Rate: 6.50%
Enter Discount Rate: 9.00%
Discount Rate (Horizontal)
Margin of Safety 8.00% 9.00% 10.00%
20% Premium $85.54 $51.07 $36.31
10% Premium $78.41 $46.81 $33.28
Intrinsic Value $71.28 $42.56 $30.25
10% Discount $64.15 $38.30 $27.23
20% Discount $57.02 $34.04 $24.20

Source: How to use the Dividend Discount Model

According to the DDM, MDLZ trades at a fair market value. Since the market has desperately been seeking for income over the past decade, I appreciate there is no deal for a company generating recurring revenues.

MDLZ meet my 5th investing principle

Principle #6: The Rationale Used to Buy is Also Used to Sell

I’ve found that one of the biggest investor struggles is to know when to buy and sell his holdings. I use a very simple, but very effective rule to overcome my emotions when it is the time to pull the trigger. My investment decisions are motivated by whether or not the company confirms my investment thesis. Once the reasons (my investment thesis) why I purchase shares of a company are not valid anymore, I sell and never look back.

Investment thesis

An investment in Mondelez is an investment in a leader in the food industry. What I like about MDLZ is its focus on its power brands. Those brands enjoy stronger pricing power leading to better margins. Mondelez also benefits from a steady growth from emerging markets and its online strategy. As the food industry is consolidating, MDLZ could also become an interesting acquisition for a larger company such as KHC or Unilever (UL).

Potential downsides

The price of commodities such as cocoa and sugar can fluctuate and give MDLZ headaches from time to time. As I previously mentioned, the snack business shows growth opportunities other players haven’t missed. Hershey (HSY), for example, is eyeing the snack business to diversify its operation away from the chocolate industry. This will incur additional pressure on margins.

MDLZ shows a solid investment thesis and meet my 6th investing principle.

Principle #7: Think Core, Think Growth

My investing strategy is divided into two segments: the core portfolio built with strong & stable stocks meeting all our requirements. The second part is called the “dividend growth stock addition” where I may ignore one of the metrics mentioned in principles #1 to #5 for a greater upside potential (e.g. riskier pick as well).

I see Mondelez as a healthy business with interesting growth vectors. However, keep in mind this is a company evolving in a mature market and don’t expect its business to surge from nowhere. MDLZ will be a “hold steady” stock in your portfolio rewarding you with an increasing dividend.

MDLZ is a core holding.

Final Thoughts on MDLZ – Buy, Hold or Sell?

Overall, I like MDLZ business model and growth perspective. I think it’s a good holding for any investors who wish to patiently wait and watch its paycheck growing year after year. As it is currently priced at a fair value, there are better opportunities in the stock market at the moment. I have done a Stock Card on Hershey (HSY) showing it is probably a better deal.

Disclaimer: I do not hold MDLZ in my DividendStocksRock portfolios.