Cardinal Health

Moat: 3/5

Understandability: 2/5

Balance Sheet Health: 4/5

Cardinal Health is a global healthcare services and products company, providing tailored solutions to hospitals, healthcare systems, pharmacies, and other healthcare providers, enhancing efficiency and patient outcomes.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Cardinal Health (CAH) operates within the healthcare industry, a sector known for its defensive nature, meaning it’s generally less susceptible to economic downturns. This makes it a compelling area to analyze for strong, long-term business models with potential moats.

Business Overview Cardinal Health operates through two main segments:

  1. Pharmaceutical and Specialty Solutions: This segment focuses on distributing branded and generic pharmaceutical, specialty pharmaceutical, and over-the-counter healthcare products. It provides solutions to help with vendor relationships, supply chain efficiency, inventory management, new product launches, and regulatory compliance. It also distributes specialty pharmaceuticals to hospitals, specialty pharmacies, and other healthcare providers. A significant portion of this business is in generics, which are generally subject to pricing pressure due to their commoditized nature. In recent times, this segment has faced issues related to distribution agreements and supply contracts.

Notably, in fiscal year 2024, pharmaceutical revenue increased 11 percent YOY and is expected to show further growth in fiscal year 2025. This indicates a strong demand for its products and services.

  1. Global Medical Products and Distribution: This segment manufactures, sources, and distributes Cardinal Health-branded medical, surgical, and laboratory products, as well as related services. Its target clients are hospitals, surgery centers, clinical laboratories, and other healthcare facilities.

This segment also distributes products to patients in their homes through its at-Home solutions division, while logistics operations are handled through OptiFreight Logistics, indicating a diversified reach.

Moat Assessment: Cardinal Health possesses a narrow moat, rating a 3/5. Here’s the reasoning:

  • Switching Costs: Cardinal Health benefits from customer stickiness, making a switch to a competitor complex and costly. This is due to the integration of their logistics and supply chain systems into their clients’ daily operations. For instance, if a hospital changes medical supply distributors, it has to retrain staff and change all their internal processes, creating high friction and making a switch very difficult. This provides some stickiness.
  • Scale and Cost Advantages: Cardinal Health is among the largest healthcare distributors globally. This scale allows them to negotiate favorable deals with manufacturers, which results in lower costs than other competitors. Their expansive distribution network and logistics infrastructure also results in economies of scale, which contribute to a cost advantage. However, the commoditized nature of some of their products, especially generics, and significant competition in certain segments limits the pricing power that would give a wide moat.
  • Intangibles (Brand and Regulatory): Cardinal Health has a solid reputation in the healthcare industry, which plays a role in trust and long-term relationships with partners. It also has FDA approvals and various other regulatory approvals to operate. Those elements give some degree of moat, but not as strong as companies with true pricing power over differentiated product or brands.
  • Mistaken Moats: The business operates in highly competitive segments, where commoditization is a frequent concern. While they provide valuable services, they are not easily irreplaceable, many smaller competitors could offer similar services, and their size isn’t an unreplicable moat like a Coca Cola brand or a technology platform.

Risks to the Moat and Business Resilience:

  • Competition and pricing pressures: The healthcare distribution industry is very competitive, which limits Cardinal Health’s ability to charge high premiums and puts pressure on margins. Also, they are heavily dependent on generics which have low pricing power and are subject to price competition.

In the recent earnings call, Cardinal Health noted lower profits than expected in the pharmaceutical segment, due to price fluctuations and pressure in the generics market.

  • Loss of Key Customers or Contracts: Their customers (hospitals, pharmacies) are getting more consolidated and could exert more bargaining power and shift to another supplier. A loss of important contracts with suppliers or clients could severely hurt the business profitability and scale advantages.
  • Regulatory Changes: The healthcare industry is highly regulated. Changes in policies related to Medicare, Medicaid, or pharmaceutical pricing can lead to a change in Cardinal’s business and reduce profitability, particularly in the pharmaceutical segment. Changes in the legal and regulatory environment have been found to have a very high effect in the profits of pharmaceutical companies.
  • Technology Disruption: New technological solutions for supply chain management could undermine Cardinal Health’s business. For instance, new methods or processes that can eliminate the necessity of having large supply chains or offer much cheaper logistics can become serious problems for the business.
  • Supply Chain and Inflation: Rising costs and issues with supply chains and transportation may impair their gross margins, increase operational risks, and can increase the cost of capital for the company. They need to handle this well to retain profitability.
  • Opioid Litigation: Cardinal Health has been facing many legal battles from state, local and tribal governments related to the opioid crisis. In fact they accrued more than $6 billion in expenses to settle this litigation. The Opioid Litigation Settlement Agreement is a key risk that has been weighing down this company. However, they are slowly paying this down.

Business Financials

  • Revenues: In fiscal year 2023, consolidated revenue grew by 11 percent to $205 billion, primarily due to the growth in the pharmaceutical segment. The company’s revenue comes from contracts with customers for providing pharmaceutical and medical products, as well as related services. The revenue model also includes the sale of branded products, generics and branded generics as well as specialty pharmaceuticals and related services.
  • Gross Margins: Consolidated gross margins were 5.27% in 2023, 5.06% in 2022 and 4.59% in 2021.

The company also provides information on Adjusted Gross Profit. Adjusted gross profit for Fiscal 2023 was $11.1 billion.

  • Operating Expenses: In fiscal year 2023, they had operating expenses of $8.2 billion. These included distribution, selling, general and administrative expenses.
  • Profitability: Their operating income for fiscal year 2023 was 2.3 billion.

Cardinal Health reported a loss of $668 million in the fiscal year 2023, due primarily to the litigation. But it returned to profitability with 1.06 billion in profit in the most recent quarter.

  • Cash flows: In the most recent quarter, cash and equivalents were 4.8 billion as of September 2023, compared to 5.1 billion as of June 2023. Net cash from operations were $471 million during this quarter, indicating that they can effectively generate free cash to fuel its operations.
  • Debt: As of June 2023, their total long-term debt stands at about 8 billion dollars, which puts them in a good position, and the debt is manageable and the company is stable.
  • Share repurchase: In February 2023, the board authorized a share repurchase of $3 billion dollars. This signals that management believes the company is undervalued.

Understandability Rating: 2/5

  • Cardinal Health’s business model is moderately complex to understand. While their core operations are relatively straightforward-distribution and selling of products-their financial reporting is complex, involving many non-GAAP adjustments and special items. Also, factors affecting their business environment such as the opioid litigation, regulations, and the consolidation of large health care providers, add a significant layer of complexity that requires in-depth knowledge and experience. They have operations in pharmaceutical products, medical devices and distribution, which need specific insights in different areas. Their business strategy, while based on common principles, is also implemented differently across the segments and geographies they operate.

This complexity makes it essential to dig into the details when doing research on this company.

Balance Sheet Health Rating: 4/5

  • Cardinal Health has a pretty strong balance sheet. It can easily cover all its short term liabilities and has significant cash reserves. Also the company has been repaying debt in the recent years. Their liquidity levels are also good with a good current ratio and quick ratio. They have managed to maintain their working capital properly and have a good cash conversion cycle, which makes them relatively healthy.
  • They have a manageable amount of debt, but this can be a cause of concern in a high interest rate environment.

Recent Concerns/Controversies/Problems:

  • Opioid Litigation: The ongoing opioid litigation is a significant issue for Cardinal Health. They have reached a settlement with states and tribes which requires them to pay around $5 billion over time. This creates uncertainty regarding future profits and may have a significant impact on their valuation. While the settlement removes the risk of long-term litigation, it also weighs down the financial health and flexibility.

The settlement was negotiated to create stability and certainty, but requires continued payouts and financial commitments which could alter their balance sheet.

  • Impact of Generic Pricing: Pricing pressure in the generics market has become more pronounced, as their brand name products lose market exclusivity. The company’s strategies for dealing with these pricing pressures, including new product launches and growth in branded generics, are essential for maintaining profit margins.

In Conclusion: Cardinal Health is a large, defensive player in a complex industry. While it benefits from its scale and relationships, competition, regulatory changes, and business complexity limits its pricing power. This gives the business a narrow moat, which provides some stability. While the company’s financials are overall healthy and stable, litigation and debt repayments should be closely watched. The investor also needs to thoroughly analyze and understand how the company is dealing with competition and pricing pressures in the pharmaceutical industry. The core focus should be on business fundamentals, which should be assessed based on a thorough quantitative analysis with support from their annual reports and other filings, with more recent info getting higher priority. While they have decent profitability and consistent cash flows, the financial performance of the business is dependent on future earnings and growth.