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Cardinal Health, Heal Thyself


For 25 years, Cardinal Health Inc. (CAH) has been an earnings machine. The Dublin (Ohio) distributor of health-care products consistently boosted profits by at least 20%, through a combination of deft acquisitions and adroit management of its supply chain. Management gurus gushed about Cardinal's ability to soar above its low-margin business by not just shipping pills to customers, but selling them on new ways to automate and run their business. But then this summer, Robert D. Walter, Cardinal's CEO, alerted Wall Street that the dynamics of that business -- buying drugs and medical supplies from Big Pharma and reselling them to hospitals and pharmacy chains -- was changing for the worse. Suddenly, Cardinal seemed to fall to earth. Profits in its main distribution business are expected to grow by only 4.5% next year, according to Goldman, Sachs & Co. (GS) health-care analyst Christopher D. McFadden. The combination of events has knocked Cardinal's stock down 16% in the past year, to 57. Today, Walter concedes, "we're running scared, like everybody else."

That's not to say he's without a plan. Walter, 58, who purchased Cardinal back in 1971 through a leveraged buyout and shifted its focus from food to drugs, is determined to expand overseas and manufacture more of the products that Cardinal distributes. Most of all, he's counting on offering drugmakers and hospitals even more of the tools they need to manage their own drug inventories. It's hard to argue with his track record: For more than a decade, Cardinal gobbled up other distribution outfits, to the point where it now ships about 30% of all the drugs sold in the U.S. and has annual sales of $56.7 billion. Cardinal's sales dwarf those of its principal competitors, AmerisourceBergen Corp. and McKesson Corp., which are far more dependent on their wholesale drug distribution business for profits. For the past three years running, Cardinal has made the BusinessWeek 50 list of top-performing companies, with three-year average earnings growth of 29.7%.

ONE-TWO PUNCH. Even Walter, however, might not be able to buck the changes that are sweeping the drug distribution business. On the supply side, big pharmaceutical companies just aren't turning out as many new products as they did in the past, a situation that analysts say may take years to reverse. So growth is stagnating. And drugmakers are balking at letting wholesalers stock up on drugs ahead of price increases -- a practice that enabled Cardinal and others to ship cheaper drugs at higher prices. The shift is squeezing Cardinal customers at the other end. Drugstore chains such as CVS Corp. (CVS) and Rite Aid Corp. (RAD) -- which declined to comment for this story -- are under pressure to keep prices down. But with Cardinal's own margins under pressure, it can't offer the discounts the chains want. Those chains often bypass the wholesalers altogether to seek out discounted and generic drugs from specialty distributors.

The result: Gross drug distribution margins, which in the best of times are typically about 7%, are just over 4% today. Cardinal did manage to increase its net earnings in its latest period, the fiscal first quarter, by 12%, to $329 million, but still failed to meet Wall Street expectations. The betting among many investors is that even if Walter is able to expand the services, medical products, and technology side of his business -- which accounts for more than half of Cardinal's profits -- the days of 20%-plus earnings growth are gone.

ROBO MEDS. In addition, some critics are unimpressed by Walter's efforts to buy his way back to double-digit gains. The stock market shrugged in October, when Cardinal offered to pay $400 million to acquire Intercare Group PLC (ICGRF), a European pharmaceutical supplier that, among other things, is gearing up to produce hundreds of million of syringes a year.

Walter, however, says the Intercare deal fits his strategy like a surgical glove, pushing Cardinal into Europe, where it now pulls only about $200 million in revenue from medical products. Walter also believes that other deals can quickly beef up the nondistribution end of the business. He points to the 1996 acquisition of Pyxis Corp., which brought Cardinal a smart machine -- a robot of sorts -- that sits in a hospital room and knows precisely which drug a nurse needs to dispense. It's an example of why automation services are a fast-growing part of Cardinal, with profits expected to rise 16% next year.

The sector of Cardinal whose profits are projected to grow the fastest -- by 29% next year -- is its pharma technologies group, where Cardinal also plans to expand by acquisition. This unit has some of its best-known properties, such as the proprietary technology for soft-gel capsules, used in such popular over-the-counter medicines as Advil Liquid Gel Caps.

But some analysts say those small deals do nothing to fix Cardinal's main business and don't have the heft to replace it. "They've not been at the same level of strategic thinking or financial contribution that the company is known for," says Goldman Sachs's McFadden. And it's questionable whether Walter and his distribution czar, James F. Millar, will be able to squeeze much new business out of drugmakers. For instance, the Cardinal execs have been negotiating with manufacturers to get fees for meeting special distribution requirements, such as overnight delivery or the refrigeration of certain drugs. Analysts, however, have serious doubts that Cardinal can make its suppliers believe that forking over more cash is really in their interest.

To beat the odds, Walter has increasingly turned to hospitals and their in-house pharmacies for more business. Cardinal has come a long way from being just a bare-bones wholesaler. It controls the distribution of drugs all the way through hospitals to the patient's bedside, with automated systems that can offer pharmacies and hospitals up-to-the-minute data about where a drug is located or which nurse has it. That tracking can cut down on costly errors caused by old-fashioned human data entry. "We'll come in and manage your pharmacy for you," Walter says. "There's nobody that does what we do." Still, it will be a tough slog convincing enough hospitals and drug stores.

As if Walter didn't have enough to worry about, the company is also under the cloud of a Securities & Exchange Commission investigation. The agency is looking into how and when Cardinal recognized a $22 million gain from a legal settlement last year. It's possible -- although not likely -- that Cardinal will have to restate earnings. Some investors believe that, since the amount involved is small and nothing criminal seems to have occurred, things will be O.K. "I haven't seen any evidence of other inconsistencies in their accounting," says Theodore L. Parrish, co-manager of the Henssler Equity Fund, (HEQFX) which holds 40,000 Cardinal shares.

That's the good news for Cardinal. The bad news is that Walter has a lot of work ahead of him if he's going to live up to his stellar track record. By Roger O. Crockett in Dublin, Ohio


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