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Tickers in this Article: CAH, ABC, MCK
Cardinal Health Inc. (NYSE: CAH) is essentially a drug middleman, operating between the pharmaceutical companies that supply drugs and the healthcare providers and retailers that purchase them. There has been big change to Cardinal's business model in the past few years; these days Cardinal looks to charge a flat "fee-for-service" for its bundled logistical services, such as product packaging and distribution, medication tracking and inventory management.

In the past, Cardinal would often act as a "drug speculator", purchasing inventory from big pharmaceutical companies in the hopes that prices would later rise.

Cardinal could turn a profit when it then sold the drugs to its end customers. Such practices led to accounting irregularities and exposed Cardinal to unnecessary risk, especially in today's environment where increasing political pressure is being placed on "Big Pharma" to offer affordable and consistent pricing.

A Clean Bill of Health?
Cardinal sold off its worst-performing division earlier this year, unloading its Pharmaceutical Technologies and Services segment to private equity firm, Blackstone, for $3.3 billion - a much higher price than most analysts thought it could get when it first announced intentions to sell in 2006.

In the company's last earnings release, Cardinal reported that operating earnings rose by 10% on an 8% rise in revenue to $21.9 billion. Net earnings were hurt by a $600 million reserve that was set aside to settle an outstanding litigation issue surrounding the company's accounting problems of 2004.

Company forecasts for the current year call for EPS from continuing operations of $3.32 to $3.40, a range that was tightened during the last earnings call on May 3. Also in that call, management said it expects Fiscal 2008 earnings to be "materially above" the company's target of 12% to 15% growth, in the range of $3.95 to $4.15. (To make sense of all these numbers, see Reading The Balance Sheet.)

Fierce Competition
The pharmaceutical distribution business is essentially dominated by three companies – Cardinal, McKesson Corp. (NYSE: MCK), and Amerisource Bergen (NYSE: ABC). Cardinal Health is the largest of the three in terms of market cap ($28.9 billion) and a close second to McKesson in revenue, but Cardinal also has a key competitive advantage over the other two.

The drug wholesaling business is defined by ultra-low margins - in the range of 1% to 2% - that put a huge premium on scale and cost control. In the most recent quarter, Cardinal's operating margin in the core, drug-distribution business was 1.97% to McKesson's 1.34%.

This may not seem like much, but when carried across the over $80 billion in revenue seen during the full year, this small edge in efficiency really pays off. What's possibly more important is the fact that Cardinal has room to take market share by being diligent on costs, and, with three strong players in the space, competitive pressures will remain tough in the years ahead.

The Ever-Shrinking Share Base

Cardinal is also in the middle of a $4.5 billion share buyback plan, of which over $2 billion is still available after the company purchased $1.4 billion in shares during the first three months of the year. Investors should expect Cardinal to remain aggressive in repurchasing shares as the company's cash flow improves, as nearly 10% of the outstanding shares will have been retired in the past 12 months.

In the last quarter, Cardinal generated $676 million in operating cash flow, which is an annual run rate of over $2.5 billion. This should be the key metric for investors to follow in the ensuing quarters; the company is not overly leveraged, so, much of the cash flow improvement should result in share buybacks and dividend increases, such as the recently announced 33% dividend hike, which now sits at 12 cents per quarter.

I think Cardinal Health shares - which currently trade for about 21-times current and 17-times forward estimates - represent a solid long-term holding, if not a core holding. Aging baby boomers also provide a strong secular story for growth well into the future, and the company has effectively swapped out all its senior management in an effort to distance itself from past accounting problems. Cardinal Health also has profitable operating segments in drug-delivery technologies, outpatient services and hospital equipment - all of which saw double-digit revenue growth in the last fiscal year.

While there is sure to be short-term competitive noise in the drug wholesaling industry, Cardinal can potentially leverage its best-of-breed distribution system into higher market share and profits, while remaining dedicated to shrinking the share base and returning cash to investors.

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