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Moody's Upgrades Cardinal Health's Outlook

Zacks Equity Research

Moody's Investors Service – the credit rating agency of Moody’s Corporation (MCO) –has upgraded its outlook on Cardinal Health, Inc.'s (CAH) and its subsidiary, Allegiance Corporation's to stable from negative. At the same time, it has affirmed the company's existing Baa2 long-term and Prime-2 short-term ratings as well as the subsidiary’s existing Baa2 long-term ratings.

Earlier last month, Fitch Ratings affirmed a BBB+ rating on Cardinal Health’s long-term debt based on the similar factors considered by Moody’s. Fitch reiterated a stable outlook for Cardinal Health.

Moody’s expects Cardinal Health to generate sufficient internal cash to fund operations and growth initiatives, execute shareholder payouts and carry out targeted mergers and acquisitions.

Cardinal Health has a large revenue base and Moody’s expects its liquidity to remain strong over the ratings horizon. Moody’s expects moderate leverage at the company as its Debt/EBITDA is currently below 1.5 times, which, if sustained, could further support an upgrade.

According to Moody’s, Cardinal Health’s profit margins in its core drug distribution segment have improved owing to increased generic drug sales and price increases. The expiration of its lower margin business contract with Walgreen Co. (WAG) in Mar 2013 is expected to support margins further, according to the rating agency. The agency also noted that Cardinal Health experienced margin expansion in its medical segment, assisted by the AssuraMed acquisition in 2013 as well as stronger sales of its self-manufactured products.

Moody’s also believes that the 10-year generic drug joint venture that Cardinal Health announced with CVS Caremark Corp. (CVS) in Dec 2013 is expected to reduce the former’s generic drug costs as it will benefit from greater scale of operations.

Cardinal Health also disclosed that it has extended its distribution contract with CVS through 2019. Moody’s expects that the collaboration will help offset lower pricing that was negotiated as part of the 3-year extension of its aforementioned distribution contract.

Our Take

Cardinal Health has been witnessing rising earnings estimates on the back of impressive fiscal second-quarter results and an upgraded guidance for fiscal 2014.

Cardinal Health posted fiscal second quarter adjusted earnings per share of 90 cents which is 3.2% lower than the year-ago level of 93 cents. Revenues in the quarter went down about 12% to $22,240 million. The earnings and revenues in the quarter comfortably beat the Zacks Consensus Estimates despite being lower than the year-ago level by 7 cents and $1458 million, respectively.
For fiscal 2014, Cardinal Health raised its forecast for adjusted earnings per share to the range of $3.75 to $3.85 from the earlier guidance of $3.62 to $3.72. The company’s efficient operating performance was quoted as the reason behind the upgraded guidance.

For 2014, twelve estimates were revised upward over the last 60 days, with no downward revision over the same period, lifting the Zacks Consensus Estimate by 3.5% to $3.83 per share. The company delivered positive earnings surprises in all of the last four quarters with an average beat of 16.7%.

We are encouraged by Cardinal Health’s consistent margin improvement, favorable drug pricing and the addition of AssuraMed which is beginning to yield positive results for the company’s medical segment.

However, the company's significant under-representation in specialty drug distribution relative to its peers continues to be a concern. Moreover, having lost its contract with Walgreens, Cardinal will no longer benefit from the operating stability and superior growth prospects generally associated with these drug channel participants. The removal of such a large amount of drug volume will lessen Cardinal Health's ability to leverage the largely fixed cost structure inherent in drug distribution.

Cardinal Health currently has a Zacks Rank #2 (Buy).

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