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Monday, September 18, 2006

ABCs for ABC, Cardinal Health and McKesson

Submitted by CrossProfit (ABC, CAH, MCK)

We don’t often write about stocks that have reached or crossed the CrossProfit evaluation line so this article is an exception to the rule.

We like Cardinal Health (CAH) and think it is a solid play. A dip to the low 50’s would provide an excellent investment opportunity though it doesn’t seem likely to happen just yet. CAH is currently trading at $69.50 and in our opinion at a PE of 29.3, is about as high it is going to go for now.

Here are some of the fundamentals from our proprietary research/analysis compiled recently.

Drug Wholesale Comparison as of 08/23/2006

Cardinal Health (CAH) is classified as a Drug Wholesaler. For the sake of clarity we will include Amerisourcebergen Corp. (ABC), McKesson Corp. (MCK) and Henry Schein Inc. (HSIC) in this sector comparison. Note that HSIC is not a drug wholesaler per se yet its business model strongly resembles the other three and is a Healthcare Distributor.

Market Cap and Dividend Yield:

CAH = 28.1 Billion / 0.5%
ABC = 8.9 Billion / 0.2%
MCK = 15.4 Billion / 0.5%
HSIC = 4.3 Billion / none

As per above we are dealing with a sector that consists of large cap growth stocks and NOT large cap dividend stocks. Such being the case we are looking for an entry point into the stock that will provide a potential profit of at least 20% over a 12 month period.

This may sound like a high percentage to some investors but the reason we start out with a 20%+ calculation is; 1) stock is classified as a growth stock (the nature of the beast) 2) we are dealing with the stock market. Nothing is for certain and the unforeseen will happen. What is for certain is that maybe/perhaps/likely and unlikely are correct for all analysis. In the end an investor may decide to play it safe and take a 10% or 12% profit and not risk losing the entire paper profit.

A prudent investor will wait for the right entry price. If it doesn’t come, there will always – yes always be another stock that is near a good entry point. Shorting is another option.

Trailing P/E and Pretax Margin:
CAH = 29 / 2.2%
ABC = 25 / 0.9%
MCK = 21 / 1.3%
HSIC = 30 / 5.7%

We expect revenue growth for 2007 to slow down to 5.5% for the entire sector. However we expect a slight improvement in margins due to increasing sales of generics and the implementation of various cost saving measures taken by all of the above companies.

2007 earnings growth varies between 9% and 13%.

The CrossProfit evaluation line (meaning buy below the line and sell above the line) is as follows;

CAH EOL 10/06 = 68.40
ABC EOL 10/06 = 47.60
MCK EOL 02/07= 52.00
HSIC no CP evaluation line

For those that are unfamiliar with the term, EOL = end of line. The evaluation line is a twelve month forward looking line that specifies a risk/reward evaluation factoring in market volatility and determines whether or not an investment opportunity exists. Towards the ‘end of the line’ the line is usually less accurate as the evaluation was based on data available a while ago. In plain English, the CAH evaluation line is less reliable because it ends in 10/06. The MCK evaluation line is more reliable because there is still five months to go.

The reason we threw HSIC into the comparison mix was to emphasize that we are talking about growth stocks that are trading at above average PE’s due to their potential to increase revenues and profits on a YOY (year over year) basis. Dividends are NOT a factor for these types of stocks. Once a noticeable change has occurred in the ability for these companies to deliver the revenue and/or earnings growth, the market reassigns a lower multiple. It doesn’t mean that the companies aren’t doing well or that there is anything fundamentally wrong with the stock. You just have to make sure not to overpay when buying in.

The common theme for CAH, ABC and MCK is that 2007 will be a lower top end (revenue) growth year. Earnings growth will still be relatively strong but it too will be lower than the past few years. As such we take the CAH 2007 estimated EPS (earnings per share) of $3.60 and apply a 19 multiple that gives us 68.40.

Another way of explaining the analysis is that in 2007 share prices (of these stocks) won’t go up much from current levels even though earnings will increase because the price earnings multiple (PE) is coming down in response to slower revenue growth.

At $53/54 CAH has a relatively easy 20% upside. Wait for the stock to trade in this range. Buy at 53/54. Sell at 68/70. Remember this is a growth stock hitting a stall pattern = buy and sell stock and not a buy and hold for dividends or buy and hold for long term growth. When long term top line growth becomes visible again the analysis is updated.

Likewise ABC is quickly approaching the top of its range. Currently at $46.40 with a PE of 25.7, our evaluation line is pegged and reconfirmed to be $47.60.

Likewise MCK has crossed the line. Currently at $54.10 with a PE of 22, our evaluation line is pegged at $52.00.

Since everyone loves hindsight… three weeks ago when our article first appeared the stocks were trading at; CAH $67.25, ABC $44.10, MCK $51.40. We still think that waiting for a better entry point is sensible.

Disclosure: This article was written by a CrossProfit analyst and does reflect the opinion of Unless explicitly stated otherwise there are no conflicts of interest.

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