CAH

A focus list of buys and sells for our readers to use as a starting point when looking to make changes to portfolio. This list contains attractive and unattractive stocks from every major sector excluding financials. AFG's buy and sell lists have proven through time to provide a significant spread between the buys and sells helping you to identify winners and avoid potential torpedoes.

Among the many reasons given for spinning off a company, time and again managements often tout promises to unlock value. Is that the case this time when Cardinal Health (CAH) released CareFusion (CFN) from its reins and allowed it to run free as a stand-alone publicly traded company that officially began trading on September 1, 2009?

After adjusting for what remains of CAH to account for total sales that are about 5% lower, but assets that declined more than 33%, CAH is still a dominant North American pharmaceutical and medical supply distributor. Since CFN accounted for the majority of capital expenditures, rental and research & development, (95%, 90%, and 99%, respectively), as well as virtually all of the international manufacturing and sales operations, CFN is characteristic of a growth company while CAH is not. Leaving with CFN are products in global markets, an innovation engine and high growth prospects, key characteristics necessary to compete in the medical instruments and supplies industry. Staying with CAH is a large distributor of drugs and supplies with national scale, negotiating power and single-digit growth.

Let us step back a bit and look at CAH’s history since 1996 when it began to expand its operations with mergers, launching the beginning of a legacy of acquisitions, restructurings, and diverted attention away from wholesale distribution of pharmaceuticals and medical supplies. In fiscal year (ends in June) 1996, CAH merged with Medicine Shoppe and Pyxis, increasing its exposure into retail pharmacy services and medication management systems, respectively. In 1999, CAH merged with Scherer (manufacturer of drug delivery systems) and Allegiance (distributor and manufacturer of medical, surgical and respiratory therapy products). All of these, plus more, were done under the leadership of founder and CEO, Robert Walter. Then, in 2006, newly appointed CEO, Kerry Clark, inherited a global restructuring program called One Cardinal Health that more or less attempted to refocus the company’s attention to its core businesses and divest underperforming and non-core operations. The result is a little over 3 years of restructuring, closed manufacturing facilities, a DEA license suspension for problems with controlled substance distribution, several divestitures, and now finally the spin-off of CareFusion. Which brings CAH right back to where it started before all the merger and acquisition activity that took off in 1996. The remaining company distributes pharmaceuticals and medical supplies at wholesale, just like it did in the early ‘90s.

Were all the acquisitions and divestitures worth it? One way to answer this is to look at how its competitors, McKesson (MCK) and AmerisourseBergen (ABC), performed as they have mostly remained purely wholesale distributors.

From 1996 to 2001, CAH’s corporate performance (seen in the Economic Margins in the charts below) was not as good as ABC (fiscal year ends in September), which was known as AmeriSource Health at that time. Then AmeriSource merged with its competitor, Bergen Brunswig, in 2001 and CAH’s EMs performed better after that. The impact to ABC’s EM in 2001 demonstrates the negative impact to economic profitability when a company completes a major merger or acquisition. In effect, large transactions tend to destroy wealth. CAH continued to expand its core wholesale distribution business as well as acquire small, higher-margin clinical and medical product lines, while ABC struggled as a larger company that was divided into traditional pharmaceutical distribution to hospitals, physicians, and pharmacies in its AmeriSource business and institutional pharmacy services to long-term care facilities with its Bergen business. Additionally, ABC’s aspirations to significantly increase its distribution capacity took its toll on EM (Invested Capital), until it divested its long-term care business in 2007. After that divestiture, ABC’s EMs outperformed CAH.

Compared to MCK (fiscal year ends in March), CAH performed like a rock star in all the years until fiscal 2007. MCK has grown through acquisitions, just like its competitors, but they have mostly remained within its expertise of wholesale pharmaceutical and medical-surgical product distribution. However, MCK was an early acquirer of IT-based businesses, including electronic medical record management software, health care information systems, and Internet-based physician-client communication applications. In fiscal 1999, MCK divested its only non-health care segment that distributed bottled drinking water to retail outlets, a very small part of its overall business. As a result, MCK has maintained a focus in only two segments; Distribution Solutions (pharmaceuticals, medical supplies and equipment) and Technology Solutions (health care information technology). CAH’s EM underperformance since fiscal 2007 stems mostly from massive restructuring efforts and several distractions, most of which are complete and resolved.

All in all, CAH is back to its roots, and if you believe its business segment structure will maintain some stability, is composed of only the Pharmaceutical and Medical segments. Its Clinical & Medical Products segment was spun off and is now CareFusion. The only remaining divestitures, mentioned so far, are Martindale and SpecialyScripts. Taking these business divestitures into account, as well as the company’s pro forma financial statements as a stand-alone business, CAH shares look attractive. We project very low sales growth and EBITDA margin expansion that may result from optimizing its drug and medical supply distribution, while controlling costs. It seems that our projections are in-line with major competitors, and even a little too pessimistic.

CFN will compete as a stand-alone company against a variety of peers, three of which are compared below. The company's market capitalization is above $4 billlion and is included in the S&P 500. CFN’s management stated that they hope to achieve long-term sales growth in the mid-single digits and earnings growth in the range of 11% - 15%. While fiscal 2010 will be a challenging year, due to hospitals’ tightfisted spending on capital equipment, CFN may not grow their top & bottom lines as much as their long-term goal in the first year as a publicly traded company. Adjusted EPS guidance for fiscal 2010 of $1.10 - $1.20 is about 20% lower than the proforma adjusted EPS earned in fiscal 2009. Management claims that much of this is due to $100 million or so of additional costs the company needs to incur to maintain documentation and personnel to handle the day-to-day activities as a public company, as well as additional employee compensation and higher R&D spend. CFN claims that the additional R&D investments will pay off in a few years. This is critically important, as differentiation in terms of technologically advanced medical products is the key to success in this industry. Given management’s optimism and their stated focus on growing margins beyond the suppressed levels in this fiscal 2010, CFN shares also look attractive.

Still, for CAH and for CFN, we’d like to hear what management has to say after it reports its fiscal Q1 2010 to be more comfortable with our full year projections. CAH, although more focused on its core businesses, may have to continue to restructure portions of its segments or dissolve certain businesses. Those types of initiatives can be difficult to model. Additionally, CFN operates in growing industries, but health care reform, timing of resumed hospital spending, future R&D success and operating outside of the CAH umbrella are all unknowns. From where these companies stand today, CAH looks to have actually done in the CFN spinoff what it said it was going to do: unlock value. Hopefully, they keep the acquisitions to a minimum.

 

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On March 9th 2009, the S&P 500 hit its low mark of the year of 666.79. Since March the market has rallied up to 1,068.78 as of the close on September 16, 2009 and we thought it timely to analyze the companies that have made the biggest gains and losses since the low and provide some insights on how we view the 10 biggest gainers and losers in the index going forward. All of the biggest movers have been ranked based on attractiveness according to The Applied Finance Group’s (AFG’s) investment criteria and valuation model. The companies with the most attractive valuations and positive Economic Margin (AFG’s measure of corporate performance) movement have proven to be more likely to outperform those companies that look unattractive according to AFG investment criteria and that look expensive within AFG’s valuation model.

The list below contains the companies that have experienced the biggest price movements in the S&P 500 since the March 9th low and how each of these companies measure up going forward, according to AFG’s investment criteria and valuation model. Companies that look attractive according to AFG’s valuation model along with improving Economic Margins have proven through vigorous back-tests to identify the company’s most likely to outperform their benchmark.

AFG Investment Opportunity Rank within Sector % Move Since March 9th Low Ticker Name Sector Valuation Signal EM Change Signal S&P 500 Biggest Gainers Since March 9th Low (ex. Financials) (NYSE:TXT)  TEXTRON INC Capital Goods Unattractive Unattractive Negative 416% (NASDAQ:WYNN)  WYNN RESORTS LTD Consumer Services Unattractive Unattractive Negative 366% (NYSE:GCI) GANNETT CO INC Consumer Services Unattractive Unattractive Negative 365% (NYSE:ODP) OFFICE DEPOT INC Consumer Services Fair Unattractive Positive 969% (NYSE:GT)  GOODYEAR TIRE & RUBBER Consumer Durable Fair Unattractive Positive 342% (NYSE:F) FORD MOTOR CO Consumer Durable Fair Unattractive Positive 314% (NYSE:THC)  TENET HEALTHCARE CORP Health Fair Unattractive Fair 538% (NYSE:IP) INTERNATIONAL PAPER CO Basic Material Fair Unattractive Fair 467% (NYSE:WYN) WYNDHAM WORLDWIDE CORP Consumer Services Fair Fair Negative 422% (NYSE:DOW) DOW CHEMICAL CO THE Basic Material Fair Attractive Positive 308% S&P 500 Biggest Losers Since March 9th Low (ex. Financials) (NYSE:FDO)  FAMILY DOLLAR STORES INC Consumer Services Attractive Attractive Positive -12% (NASDAQ:CEPH) CEPHALON INC Health Attractive Attractive Positive -6% (NYSE:ABT) ABBOTT LABORATORIES Health Attractive Attractive Positive 1% (NYSE:DF) DEAN FOODS Consumer Non Durable Fair Attractive Positive -5% (NYSE:AZO)  AUTOZONE INC Consumer Services Fair Attractive Positive -2% (NYSE:PCS) METROPCS COMMUNICATIONS Technology Fair Attractive Fair -34% (NYSE:CAH) CARDINAL HEALTH INC Health Fair Attractive Negative -8% (NYSE:SUN)  SUNOCO INC Energy and Extraction Fair Attractive Negative 1% (NYSE:HES)  HESS CORP Energy and Extraction Fair Attractive Negative 1% (NYSE:HRB)  H&R BLOCK INC Consumer Services Fair Fair Positive -2%

 

Other Popular Articles: 

S&P 500 Expectations and Market Analysis 

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What Drives Market Prices? The Valuation vs. Momentum Dichotomy

In life, the most attractive people are in shape and have good looks, just look at Hollywood. The same is true the majority of the time in investing. The most attractive stocks have healthy financial statements and look good from a valuation standpoint.

The Altman Z-score is a metric that gives insights into the likelihood of a firm going bankrupt in the next 2 years. The model was developed by Professor Edward I. Altman of the NYU’s Stern School of Business and first published in The Journal of FINANCE in September 1968. A common critique to this metric is that it was developed over 40 years ago and is no longer relevant.

In 2001, Professor Joseph D. Piotroski of The University of Chicago Graduate School of Business, published a paper called, Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers. Piotroski showed that value investors were rewarded by looking at a firm’s financial health and he showed that Z-score was a meaningful statistic.
More recently, on December 5, 2008, Dr. Altman was called to testify before a House of Representatives Committee on the condition of U.S. Automakers. In his testimony, he noted that Bloomberg, Inc. reported, “that approximately 1,000 users of their system per day access the Altman Z-Score model.”

The Altman Z-Score breaks down firms into 3 zones:
• >2.99 – Not Likely to Go Bankrupt
• 1.8 - 2.99 – Gray Area
• <1.8 – Likely to Go Bankrupt in the Next 2 Years

Using AFGView.com, we screened for firms that looked relatively attractive from a valuation perspective and had an Altman Z-Score above 2.99. Below is a list of those firms. Later we will look at firms that are expensive and have a Z-Score below 1.8.

Sales Expectations for Companies with an Attractive Valuation and Healthy Balance Sheet

EQ is important in this current market environment because so many companies are feeling pressure to meet their sales expectations. Many companies are channel-stuffers, which is one form of accruals that often leads to negative earnings surprises. A recent poster-child for this example of sending excess inventory to stores that could not sell their products would be Crocs and the way they tried to pad their sales numbers.

Earnings Quality: Accrual

•An accrual is the difference between Cash Flow and Net Income.

•Net Income = Cash Flow + Accruals

•Low Accrual companies outperform high accrual

 Two ways to approach accruals:

1. Cash Flow Statement

•Difference between Net Income and Cash Flow

2. Balance Sheet

•Change in Net Operating Assets from Period t-1 to t

•Net Operating Asset equals Total Assets Less Cash, Less Non-Debt Liabilities (excl. Minority Interest)

-Our studies show that the Balance Sheet approach is superior to the Cash Flow Statement approach.

-We found the Balance Sheet approach is also easier to expand to international companies.

 We screened the  S&P500 to identify those firms with the worst EQ scores. The score is given from 1-100, 1 being the best EQ company, 100 being the company with the highest amount of accruals and the worst EQ. Because high EQ companies are more likely to have negative earnings surprises, this is a group of companies you may want to avoid. The EQ variable works well as an exclusionary variable coupled with AFG’s valuation model.

After running our screen we identified 14 firms as the worst Earnings Quality firms. You can set yourself up for success and save time by narrowing your list of constituents to only those that meet our standard valuation, Economic Margin and Management Quality checks and following that up by filtering out those companies most likely to have negative earnings surprises (high EQ). The Chart Below identifies the firms that met our screen criteria, along with the EQ score and our VE analysis.

 

Worst 10% Earnings Quality Companies In the S&P 500

 

 

Universe Size: 4,000 to 5,000 Firms

Source: Applied Finance Group Database from 9/1998-5/2008

 This variable does not add any value for companies within the financial sector and those companies are automatically screened out when using this variable.

Recently we also screened the S&P 500 to identify investment opportunities and identified over 150 companies (industrials) that have negative sales growth expectations embedded into their current market valuations. These companies include high quality companies such as: COH, DOW, CAH, TGT, JNJ, UTX, SBUX, and WAG, among others. If you would like to Read our study Click Here