Cardinal Health, Inc. (CAH): Despite a Big Contract Loss, This Healthcare Service Company is a Buy

In the first quarter of 2013, many famous investors either exited or reduced their positions in Cardinal Health, Inc. (NYSE:CAH). While Larry Robbins, Scott Black and Jim Simons sold out their positions, Joel Greenblatt and Paul Tudor Jones reduced their exposures to this stock. Indeed, Cardinal has recently lost several big contracts, implying declining sales over the next year.

Used to rely on two major customers

Cardinal Health, Inc. (NYSE:CAH) had two major customers, CVS Caremark Corporation (NYSE:CVS) and Walgreen Company (NYSE:WAG). With total 2012 revenue of $107.5 billion, CVS Caremark accounted for 22% of Cardinal’s total revenue, while Walgreen represented as much as 21% of its total sales. The two contracts with those two biggest customers will expire soon, in June 2013 for CVS Caremark and in August 2013 for Walgreen. The positive note for Cardinal Health, Inc. (NYSE:CAH) is the contract renewal with CVS Caremark Corporation (NYSE:CVS), securing more than $20 billion in revenue for the company. The contract will be valid until the middle of 2016. However, it did not get lucky with Walgreen. In 2012, Cardinal Health let its competitor AmerisourceBergen Corp. (NYSE:ABC) took away $9 billion annual revenue from drug benefits manager Express Scripts.

AmerisourceBergen took away the Walgreen contract

Many investors also worry about the recent lost of contract with its second biggest customer, Walgreen. Walgreen Company (NYSE:WAG) announced in March that it would not renew its contract with Cardinal Health, Inc. (NYSE:CAH), but rather be pursuing a 10-year agreement with AmerisourceBergen for daily drug distribution to Walgreens’ retail stores and specialty pharmacies. Moreover, Walgreen and its partner Alliance Boots also have the right to acquire up to 23% of AmerisourceBergen, including 7% open market purchase and 16% in warrants. This vertical integration will help all parties involved to increase operating efficiency, lower costs and gain bargaining power in the pharmaceutical industry. AmerisourceBergen Corp. (NYSE:ABC) is trading at $55.90 per share, with a total market cap of $12.9 billion. The market values the company at 9 times its trailing EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization).

The positive effect of the contract loss

Nevertheless, the loss of the contract with Walgreen has some positive effects on Cardinal Health, Inc. (NYSE:CAH)’s business. It expected lower working capital needs, thanks to the decreased inventory and accounts receivable when the Walgreen contract expires. In its Q3 2013 conference call, the company estimated that it could generate over $500 million in extra cash due to the reduced working capital, loss after-tax earnings and other cash tax impacts. Moreover, according to Barron’s, J.P Morgan thought that Cardinal Health could experience growth in its distribution margin, from 1.6% to more than 2% next year, because the contract losses mean putting an end to the low-margin businesses. EPS might experience a small decline in the next year, and then after that the business could have double-digit growth. Cardinal Health, Inc. (NYSE:CAH) is trading for lower valuation than AmerisourceBergen. At $48.80 per share, it is worth $16.70 billion on the market. The market values Cardinal Health at more than 7.5 times trailing EBITDA.