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Subject: Cardinal Health CAH Date: 8/13/2004 10:58 PM
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Cardinal Health

The company has four reporting segments. The following table outlines the growth of each segment:

Operating Revenues
Years ended June 30, 2003 2002 2003 2002 2001

Pharmaceutical Distribution
and Provider Services 14% 17% 82% 82% 81%
Medical Products
and Services 6% 6% 13% 14% 15%
Pharmaceutical Technologies
and Services* 44% 12% 4% 3% 3%
Automation and
Information Services 19% 19% 1% 1% 1%

Total Company 14% 15% 100% 100% 100%

*The acquisition of Syncor, effective January 1, 2003, contributed to the growth in this segment. Excluding Syncor, this segment experienced revenue growth in the high teens during fiscal 2003.

While pharmaceuticals is there largest segment, it grew only 14%
The pharmaceutical technology and services sector is growing more rapidly aided heavily be the most recent acquisition.
Medical products lags.
Overall growth is 14% and has been cut to 11% by the company for fiscal 2004.

The probability of declining margins also overshadows returns in 2004. The gross margins in the pharmaceutical distribution and provider services segment may be
affected in future years by changes occurring in the industry, such as changes in vendor supply chain management policies, including the use of inventory management agreements. These changes provide fewer opportunities for the pharmaceutical distribution business within the segment to make large purchases of product with related vendor margin incentives. With fewer opportunities to make attractive inventory investments, the Company expects to deploy less capital in this segment. Gone are the days when companies like Bristol Myers could warn of a price increase and then offer distributors attractive pricing and terms to take on loads of inventory. BMY is working its way out of a channel stuffing charge with a series of fines, legal actions and civil suits. You can be assured major drug companies are going to be careful to avoid similar prosecution. This hampers distributors ability to cash in on the former special incentives given by pharmaceutical companies. The margins are guaranteed to shrink. Odd how what was illegal for big pharma was an integral part of the business model for distributors.

Margins by segment

2003 2002 2001

Pharmaceutical Distribution and Provider Services 4.6% 5.0% 5.1%
Medical Products and Services 21.9% 21.9% 22.1%
Pharmaceutical Technologies and Services 33.1% 34.1% 33.6%
Automation and Information Services 70.3% 68.5% 68.6%

Total Company 8.9% 9.1% 9.3%

The overall gross margin as a percentage of operating revenue decreased in fiscal 2003 and 2002 due to the mix of businesses contributing to the consolidated gross margin. The decrease in gross margin as a percentage of operating revenue within the The biggest decliner was the pharmaceutical distribution and provider services segment.

Reasons include

(1) an increase in sales to lower-margin customers (which have a lower cost of distribution) that reduced gross margins

(2) competitive pricing

(3) a moderation in vendor margins due to manufacturers attempting to better match their shipments to meet market demand, resulting in less surplus inventory

These changes provide fewer opportunities for the pharmaceutical distribution business within the to make large purchases of product with related vendor margin incentives. With fewer opportunities to make attractive inventory investments, they expect to deploy less capital in this segment.

Technologies and services segment decreased during fiscal 2003 primarily driven by the addition of Syncor's nuclear pharmacy services business. Syncor has a slightly lower gross margin ratio than the other businesses within this segment.

Ratios income statement

2003 2002 2001 2000 1999
gross margins 9% 9% 9% 8% 9%
operating margins 4% 4% 4% 3% 3%
net margins 3% 2% 2% 2% 1%
growth revenue 14% 15% 1% 17% --
growth gross 11% 12% 15% 11% --
growth operating 14% 22% 28% 23% --
growth net 33% 23% 26% 49% --
growth COGS 14% 15% 31% 20% --
growth SGA 7% 6% 20% 4% --
growth EPS diluted 35% 22% 18% 42% --
growth EPS 35% 18% 18% 14% 13%
growth depreciation 9% -13% 14% 5% --
tax rate 34% 34% 36% 37% 40%
increase interest -13% -14% 32% 18% --

Total revenue includes bulk sales; gross margins do not include bulk sales as there is no cost of sales associated

No troubling trends annually yet. Look for already slender margins to decline.
Interest expenses decrease as they pay down debt and the rates improve. Their credit rating was just cut by Moody's. Their spread has increased substantially.

During fiscal 2003 and 2002, they recorded income from net litigation settlements of $101.5 million and $11.3 million, respectively--$102.9 million and $13.3 million were recorded as special items during fiscal 2003 and 2002, respectively. The remaining $22.0 million had previously been recorded ($10.0 million in the second quarter of fiscal 2001 and $12.0 million in the first quarter of fiscal 2002) and reflected as a reduction of cost of goods sold. the positive impact of the COGS decrease on gross margins will be absent in 2004. The increase in net from special items increased growth in net and EPS and that too will disappear. Growth in net and EPS may more closely approximate the 11% forecast.

They are also currently under SEC investigation relating to the recovery from the vitamin litigation. There is a question of recognizing the settlement as operating income--it is obviously non-operating income. The details have not been entirely disclosed.

Quarterly ratios

Mar 04 Dec 03 Sep 03 June 03
growth revenue 0% 6% 1% 3%
growth gross income 9% 8% -12% 3%
growth EBIT 13% 12% -9% -5%
growth net income 14% 14% -10% -4%
growth EPS 20% -4%. 4% 28%
gross margin 8% 7% 7% 8%
gross operating 4% 4% 3% 4%
gross net 3% 2% 2% 2%
growth COGS 9% 5% 0% 12%
growth SGA 4% 7% -10% 5%

Total revenue includes bulk sales and gross income and margin do not.
Gross margins are declining as the impact of sales from big pharma is felt

Balance sheet ratios annual

2003 2002 2001 2000 1999

current ratio 1.8 1.7 1.6 1.6 1.7
quick ratio 0.2 0.2 0.1 0.1 0.06
AR growth 21% -5% 44% 5% --
DSO 20.1 18.8 22.7 15.9 17.8
inventory days 60.5 66.5 65.4 52.7 48.3
growth in payables -4% 3% 76% 28%
growth in inventory 4% 17% 63% 31%
CCC 38.6 35.6 32.8 27.3 27.3
ROE 18% 17% 16% 16% 14%
ROA 8% 6% 6% 7% 6%
ROIC 14% 15% 13% 13% 13%
debt/equity 34.8% 34.8% 42.2% 34.4% 35.4%
debt/capital 26% 26% 30% 26% 26%
book value 17.3 14.2 12.1 10.6 8.6
cash/share $3.84 $3.08 $2.08 $1.22 $0.45
NC WC 4439.9 3731.6 3630.8 2132.8 2134.6
change in NC WC 708.3 100.8 1498 -1.8 2134.6
payable days outstanding 42.0 49.7 55.3 41.3 38.7

CAH carries a fairly consistent 34% D/E debt load. This could be problematic in the future as the debt rating was cut. Covenants may get more restrictive and they may have trouble borrowing.

Returns are consistent but not high

AR is increasing out of proportion to revenues by 7%. Other measures including DSO and inventory days are in line. As they quit taking on large amounts of product to hold for sale, expect inventory levels to be flat or decline nd working capital may also decrease.

Book value increase. At present the company sells at around 2.5 BV
Efficient cash conversion cycle

Quarterly ratios

Mar 04 Dec 03 Sep 03 June 03
AR growth 4% 12% 8% -2%
inventory growth 1% 4% 8% -13%
payables growth 10% 3% 16% -18%
DSO 23.5 24.6 23.1 21.5
inventory days 47.5 47.0 48.2 45.1
payable days 47.1 46.5 47.5 40.9
CCC 19.5 19.0 18.2 20.7

AR continues to outstrip growth in revenue. Other signs of premature revenue recognition are absent--DSO and inventory are not indicative. Their stated policy of revenue recognition regarding each segment is appropriate and conservative. We are left to wonder if they are doing some juggling not reported on the financials or if they are just not getting paid. With the current interest by the SEC in their revenue recognition policies, it would seem likely something is not right. As investors, we only know what they choose to tell us. We are not forensic accountants. It would be prudent to await the results of the investigation to see if restatements are forth coming before committing investment dollars.

Cash flow statement ratios annual

2003 2002 2001 2000 1999

growth in operating cash flow 42% 13% 73% 70% --
operating cash/revenue 3% 2% 2% 1% 1%
operating cash/debt+interest 4.0 6.5 1.5 3.4 2.1
growth capex -33% -5% -276% 21%
capex/operating cash 32% -68% -81% 80% 171%
free cash flow 948 314.7 166.2 904.7 803.4
common shares 448.4 448.8 448.7 414.5 410.6
free cash flow/share $2.11 $0.70 $0.37 $2.18 $1.96

CAH generates positive operating cash flow and free cash flow consistently yoy. This is one of their biggest charms.
Operating cash flow easily covers capex
Operating cash flow is sufficient to pay debt and interest
Shares have decreased slightly

Quarterly cash flow

Mar 04 Dec 03 Sep 03 June 03
growth operating cash flow 144% 86% -79% 171%
operating cash flow/revenue 8% 3% 2% 9%
operating cash flow/ ST debt+interest 16.2 2.0 1.1 5.5
Free cash flow 502.2 -114.8 201.3 948
free cash flow/share $1.17 $(0.26) $0.47 $2.11

*sharp drop net income Sept 03 large merger charge and charge to loss from discontinued operations taken


Over the last five years, the Company has completed a number of business combinations including the following.

On August 7, 1998, CAH completed a merger transaction with R.P.Scherer Corporation. They issued approximately 51.3 million Common Shares to Scherer stockholders and Scherer's outstanding stock options were converted into options to purchase a total of approximately 5.3 million Common Shares.

On February 3, 1999, they completed a merger transaction with Allegiance
Corporation a McGaw Park, Illinois-based distributor and manufacturer of medical, surgical and laboratory products. They issued approximately 106.1 million shares to Allegiance stockholders and Allegiance's outstanding stock options were converted into options to purchase a total of approximately 15.5 million Common Shares

On September 10, 1999, CAH completed a merger transaction with Automatic Liquid Packaging, Inc. a Woodstock, Illinois-based custom manufacturer of sterile liquid pharmaceuticals and other health care products.CAH issued approximately 8.7 million Common Shares to ALP stockholders.

On August 16, 2000, they completed the acquisition of Bergen Brunswig Medical Corporation, a distributor of medical, surgical and laboratory supplies to doctors' offices, long-term care and nursing centers, hospitals and other providers of care, for approximately $181 million in cash.

On February 14, 2001, they completed a merger transaction with Bindley Western Industries, an Indianapolis, Indiana-based wholesale distributor of pharmaceuticals and provider of nuclear pharmacy services.

On April 15, 2002, CAH completed the acquisition of Magellan Laboratories Incorporated a Research Triangle Park, North Carolina-based pharmaceutical contract development organization that provides a wide range of analytical and development services to pharmaceutical and biotechnological industries. The aggregate consideration for the transaction was approximately $221 million

On June 26, 2002, they completed the acquisition of Boron, LePore & Associates a Wayne, New Jersey-based full-service provider of strategic medical education solutions to the health care industry. They paid approximately $189 million and converted BLP's outstanding stock options into options to purchase a total of approximately 1.0 million Common Shares.

On January 1, 2003, they completed a merger transaction with Syncor International Corporation a Woodland Hills, California-based company which is a provider of nuclear pharmacy services. CAH issued approximately 12.5 million Common Shares to Syncor stockholders and Syncor's outstanding stock options were converted into options to purchase a total of approximately 3.0 million Common Shares.

CAH has also completed a number of smaller acquisition transactions (asset purchases, stock purchases and mergers) during the last five years, including acquisitions of Pacific Surgical Innovations; Med Surg Industries; RexamCartons; International Processing Corporation; American Threshold Industries; and SP Pharmaceuticals

Here is what it cost:

(in millions, except per Common Share amounts) 2003 2002 2001

Merger-related costs:
Direct transaction costs $ - $ - $ (20.8)
Employee-related costs (18.7) (23.7) (46.2)
Pharmaceutical distribution center consolidation (22.7) (52.4) (10.3)
Asset impairments & other exit costs (5.4) (9.0) (8.5)
Other integration costs (27.6) (46.8) (32.3)

Total merger-related costs $ (74.4) $(131.9) $ (118.1)

Other special items:
Distribution center closures $ - $ - $ (5.0)
Manufacturing facility closures & restructurings (40.2) (2.8) (6.8)
Employee-related costs (6.9) (15.2) -
Asset impairments and other (19.9) - -
Litigation settlements, net 101.5 11.3 5.0
Total other special items $ 34.5 $ (6.7) $ (6.8)

Total special items $ (39.9) $(138.6) $ (124.9)
Tax effect of special items 6.7 51.5 39.6
Net effect of special items $ (33.2) $ (87.1) $ (85.3)

Net effect on diluted earnings per Common Share $ (0.07) $ (0.19) $ (0.19)

They make a fair number of acquisitions. To their credit they do tend to stay in related fields that appear to b accretive. They continue to grow, however it is certainly not solely organic. It's strategy that is paying. Syncor increased the growth of the medical technologies sector by 44%. The cost per share has been fairly high at 6% of EPS for 2002 and 2001. They have taken a lot of restructuring charges to manage the


With 40.9 million outstanding options the potential dilution is 9.5%
They are worth $898.2 million
Per share= $2.07
6.2 million were exercised for an expense of $167.6 million

Balance at June 30, 2002 37.1 $43.64
Granted 9.5 67.49
Exercised (6.2) 27.04
Canceled (2.5) 63.29
Other 3.0 49.23

Balance at June 30, 2003 40.9 $50.92

The weighted average fair value of options granted during fiscal 2003
and 2002 are $21.96 and $25.95, respectively.


The debt outstanding is going t become increasingly important as the company deals with the new debt rating. They have amounts coming due in 2004 of $200 million and $317 million the year after. That is $500 million due in the next year and a half. Suppose they get hit with a huge SEC fine? And as margins decrease and cash flow slows and growth declines, this could put some strain on their cash flow. With a worse debt rating, they may find refinancing at attractive rates becomes difficult.

By any measure Cardinal Health is not looking too hunky-dory these days: SEC and Justice Department investigations into its accounting, the unexpected departure of its chief financial officer, suspended financial statements and slashed earnings guidance.

The latest blow came from Moody's Investors Service, which slashed the drug wholesaler's rating a full two notches to Baa2 and threatened to cut it further on worries about the company's "diminished" financial flexibility.

The aggressive Moody's move suggests to some traders that the other major ratings agencies -- Standard & Poor's and Fitch Ratings -- could soon follow suit, and the bleeding of Cardinal's credit spreads is not over just yet.

The two-notch ratings cut by Moody's to Baa2 caught investors and traders off guard, sending Cardinal's credit spreads soaring. In less than a month, Cardinal's standard five-year spreads in the credit derivatives market have more than quadrupled.

Cardinal's five-year credit default swaps have suffered mightily, jumping up to 140 basis points, or $140,000 a year for default protection on $10 million of debt. That spread stood at just 32 basis points about a month ago.

CAH uses rate swaps to hedge interest rates and this will put them at a disadvantage in their current positions and cost them money.

June 30, June 30,
2003 2002

4.00% Notes due 2015 $ 475.7 $ -
4.45% Notes due 2005 317.8 304.6
6.00% Notes due 2006 158.0 148.5
6.25% Notes due 2008 150.0 150.0
6.50% Notes due 2004 100.0 100.0
6.75% Notes due 2011 495.4 494.8
6.75% Notes due 2004 100.0 100.0
7.30% Notes due 2006 135.2 126.4
7.80% Debentures due 2016 75.7 75.7
7.00% Debentures due 2026
(7 year put option in 2003) 92.0 192.0
Preferred debt securities 400.0 400.0
Short-term borrowings, reclassified 21.0 22.4
Other obligations; 79.8 110.0
------------- -------------

Total 2,700.6 2,224.4
Less: current portion 228.7 17.4
------------- -------------
Long-term oblig $ 2,471.9 $ 2,207.0

More bad news--underfunded pension plan

2003 2002
-------- --------

Change in projected benefit obligation:
Projected benefit obligation at
beginning of year $ 128.8 $ 104.5
Benefits paid (4.5) (5.5)
projected benefit obligation at end of
year $ 161.0 $ 128.8
======== ========

2003 2002
-------- --------

Change in plan assets:
Fair value of plan assets at
beginning of year $ 68.4 $ 58.0
Actual return on plan assets (2.9) (0.1)
Employer contributions 5.4 5.3
Plan participant contributions 1.2 1.3
Benefits paid (3.9) (4.9)

Settlements (1.4) -
Translation 7.2 8.8
-------- --------
Fair value of plan assets
at end of year $ 74.0 $ 68.4

They are $87 million short funding the plan. They contributed $5.4 million this year. and paid out $3.9 million. They are behind. This takes some financial flexibility away from future projects.

For fiscal 2003 and 2002, the weighted average actuarial assumptions used in determining the funded status information and net periodic benefit cost information were: discount rate of 6.0% and 6.3%, expected return on plan assets of 6.9% and 7.2% and rate of compensation increase of 3.8% and 4.0%, respectively. They have a very conservative estimate of returns. This will make the plan less vulnerable to severe underfunding.


Danger Will Robinson(from ValueLine)
Cardinal Health recently pared its earnings guidance for this fiscal year and next (years end June 30th). Earlier in fiscal 2004, management had issued a significant revision in its expectations for the company's bottom line, from the typical 20%-plus year-over-year earnings advances that investors had come to expect to a more modest ``mid-teens or better' growth rate--with margin pressure responsible for much of the bad news. However, Cardinal now expects to finish out the fiscal year with only an 11% improvement in net income, followed by an even more lackluster 10% advance in fiscal 2005, as delayed regulatory approvals in a key business and drug manufacturers' tight rein on drug supplies have put additional pressure on margins

Inputs and assumptions

EPS $3.10 diluted
Dividends $0.12
Capex per share $0.98
Depreciation per share $0.62
Revenue per share $116.80
Noncash WC per share $10.27
Change in noncash WC $1.63
Beta 1
Risk free rate 4.45
Market risk premium 5.51
5 year high growth at 5%
Stable growth 3%
Capex, noncash wc and depreciation grow at same rate as earnings
Capex exceeds depreciation by 100% in stable growth
Value of stock $52.07
With options $50.00

CAH has enormous cash flows and a track record for producing and maintaining good cash flow. Since their troubles began, this has been the only positive noted by most analysts. That cash flow is worth around $50.00. Suppose the SEC fines the company, or they begin paying higher interest rates and lose money on their swaps? We know for certain margins are going to come down and squeeze the bottom line. For all these uncertainties, CAH is not worth an investment at $43(approximate price today). They would be better avoided until some of the uncertainties are worked through to positive resolutions. If they were selling at a 40% discount, they would be a probable buy--that's $30 and I doubt we will see that. For those reasons, it should be on a watchlist. If they get cheap enough or resolve their legal problems, they would rate removal from a watchlist to a buy.

They are likely to experience cash flow problems and have obligations that will decrease their financial flexibilty. They have an underfunded pension plan, debt and a ratings down grade, SEC investigation and possible fine and lots of litigation. Add shrinking margins and slowing growth and that makes the future certainly less robust than the past. They like to grow by acquisition and that avenue may close as money gets tighter.

Current legal problems

The New York law firm of Wechsler Harwood LLP today announced that it has commenced an investigation against Cardinal Health, Inc. for violations of the Employee Retirement Income Security Act of 1974 (``ERISA') in relation to its handling of investments in the Company's employee retirement benefit plan.

In particular, the investigation focuses on whether the Company and certain Plan administrators breached their fiduciary duties by: (a) negligently misrepresenting and negligently failing to disclose material facts to the Plan and the Plan participants in connection with the management of the Plan's assets and (b) negligently permitting the Plan to purchase and hold Cardinal stock when it was imprudent to do so.

The material facts being investigated include, but are not limited to the allegations that, Cardinal failed to record, on a timely basis, litigation claims it owed, causing its earnings and assets to be artificially inflated. The Company also allegedly misclassified non-operating revenues as operating, giving a misleading picture of the Company to investors, and improperly accounted for the $22 million recovered from vitamin makers accused of overcharging Cardinal by booking such recoveries as revenue when the antitrust cases had not been resolved. Finally, it is alleged that defendants made misleading, materially incomplete statements about its transition to a fee-for-service model of drug distribution. On June 21, 2004, Cardinal announced that it received a subpoena from the U.S. Securities and Exchange Commission in connection with a formal investigation announced on May 14, 2004. Cardinal is also under investigation by the Department of Justice.

Cardinal's Chief Financial Officer, Richard J. Miller, abruptly resigned his post yesterday after certain financial reporting practices and judgments that occurred during his tenure had come under increasing scrutiny in ongoing investigations. The Company named J. Michael Losh in his place. It was also confirmed that Cardinal Treasurer Donna Brandin left the Company. Following this announcement, the stock closed at $44 per share after trading as high as $76 per share in May.

In June, a number of class actions were filed in the United States District Court for the Southern District of Ohio against the Company as well as Robert Walter and Richard Miller alleging violations Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder.

CAH has pages of litigation ranging from a latex allergy suit inherited from Baxter to several class action suits. They tend to be hazy on the actual amounts these suits could inflict. Hence the most recent suit mentioned above.

The company revealed their treatment of the revenue recognition from the vitamin litigation settlement. This was plainly stated in the 10K. It does not seem to be done maliciously or surreptitiously. At worst it just seems to be bad accounting.

They mention many times the changes fee-for-servive model is going to make. They warn margins will contract--no specific numbers are mentioned. Again, they do not appear to be negligent here. The shareholders and pensioners may not be reading the documents.
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