卡地納健康 (CAH) 2015 Q3 法說會逐字稿

Good day and welcome to the Cardinal Health third-quarter FY15 earnings conference call.

Today's conference is being recorded.

At this time I'd like to turn the conference over to Ms. Sally Curley.

Please go ahead.

Thank you, Jennifer, and welcome to our third-quarter FY15 earnings call today.

We will be making forward-looking statements.

The matters addressed in the statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected or implied.

Please refer to the SEC filings and the forward-looking statement slide at the beginning of the presentation, found on the Investor page of our website for a description of risks and uncertainties.

In addition we will reference non-GAAP financial measures.

Information about these measures and reconciliations to GAAP are included at the end of the slide.

I'd also like to remind you of a few upcoming investment conferences and events.

We will be webcasting our presentations at the Bank of America Merrill Lynch 2015 Health Care Conference on May 13th at 8:00 am local time in Las Vegas and at the Goldman Sachs 36th Annual Global Healthcare Conference on June 10 at 10:00 am local time in Rancho Palos Verdes, California.

Today's press release and details for any webcasted events are or will be posted on the IR section of our website, at cardinalhealth.com, so please make sure to visit the site often for updated information.

We hope to see many of you at an upcoming event.

Now I'd like to turn the call over to our Chairman and CEO, George Barrett.

George?

Thanks, Sally.

Good morning, everyone, and thanks to all of you for joining us on our third-quarter call.

I'm pleased to report another strong period of results with third-quarter revenues of $25.4 billion, an increase of 18%.

Third-quarter non-GAAP diluted EPS was $1.19, up 18% from last year.

Based on the strength of our performance year-to-date, we're increasingly confident that we will finish our FY15 in the upper half of our full-year non-GAAP EPS guidance range of $428 to $4.38.

This is an extraordinary time in healthcare and our Organization is doing an outstanding job of serving today's needs, while at the same time, leveraging our experience to address the demands of a system in transition.

Our people have done this through a disciplined focus on execution, while using our capabilities and insights to anticipate change and commit to providing solutions to emerging healthcare challenges.

Within this as backdrop, since we last reported earnings, we've made some important moves in areas of strategic focus.

On March 2, we announced our plan to acquire the Cordis cardiology business from Johnson & Johnson, and earlier this month, we completed the acquisition of the specialty distribution business of Metro Medical, expanding our presence and reach in specialty business.

I'll come back to each of these important initiatives in my segment remarks.

First our Pharmaceutical segment.

Our Pharmaceutical segment had a very strong third quarter, with revenues of $22.6 billion, an increase of 20% compared to the prior-year third quarter.

And our Pharmaceuticals segment profit was up 25%.

The Pharmaceutical segment continues to operate with great efficiency, attention to detail, and strong strategic position.

Red Oak Sourcing, our joint venture with CVS Health, continues to operate extremely well.

We can now report that suppliers who were representing nearly 100% of the total generic spend have transitioned into the venture.

At a time of great change, it is not just the scale which brings value to our customers, but also the combined knowledge of our two experienced organizations.

Our Specialty Solutions business continues to achieve extremely high growth rates, and earlier this month we closed the acquisition of the specialty distribution business of Metro Medical, the largest privately owned specialty distributor in the US.

This move strengthens our presence in the therapeutic areas of rheumatology, nephrology, and oncology, expands our scale, and positions us to provide more cost-effective services to our customers.

For clarity, we expect to exceed the $5 billion Specialty revenue figure for FY15, which we highlighted in our last earnings call, even without the contribution of the Metro Medical specialty business.

As you know, over the last few months, we've seen some important developments in the world of biosimilars and we've said to you before, it's very difficult to make categorical predictions on the evolution of this new subset of products.

We continue to believe that each product will have its own characteristics, driven by many factors, including regulatory interchangeability, the disease which the drug addresses.

The need for patient support, the location and mode of delivery, and of course, the competitive response.

We feel well-positioned to participate in each of these opportunities as they emerge, and the acquisition of Metro Medical expands our reach.

Turning to our Medical segment, we reported revenues for the quarter of $2.8 billion, an increase of 4% versus the prior year.

Our segment profit was down 8% in an operating environment largely similar to that which we've outlined in prior quarters.

I'd like to take a few minutes to address this and give some perspective on the Medical segment's performance, positioning, and role in Cardinal Health's growth plan.

This is the commentary I would more typically provide at year-end, but as our Medical numbers in the last few quarters have dragged below standards, I wanted to address it directly now.

We take great pride in being best-in-class in the distribution of traditional branded medical/surgical products, but market forces have put pressure on prices in this legacy line of business.

This is not new, and over recent years, we have been purposely building a new range of products and services that are strategically aligned with healthcare trends, are highly valuable to our customers, expand margins, and build on our base in traditional distribution.

Why has this been a more difficult year for our Medical segment?

Simply put, price erosion in that legacy branded med/surg distribution business combined with the challenges in the Canadian market have been more pronounced in this past year.

And while we have seen uplift from the newer services and products, the uplift has not been large enough to offset those factors.

How have we been responding to this?

We are relentlessly driving cost efficiency, while at the same time, continuing to reposition our Medical segment portfolio to ensure we are bringing to market the products and services that meet the future needs of our customers in a rapidly changing environment.

I'd like to highlight a few of these moves.

We've expanded our consumable product line to position us to drive more Cardinal Health medical products and through more channels.

Our move to acquire Cordis significantly enhances our scale, product line, and capabilities in cardiology, building on our acquisition of AccessClosure, and aligning with our overall strategy around physician preference items.

Together, they complement our moves in orthopedics and wound management to bring standardization and efficiency to medical devices, a major pain point for our IDN customers and a meaningful driver of profit growth in coming years.

More about Cordis in a few moments.

Cardinal Health at Home, formerly AssuraMed, continues to grow significantly in excess of market growth.

We have unique capabilities in the fulfillment and the complex administration of serving patients in the home.

Our colleagues at Cardinal Health at Home interact with these patients every day.

They're extremely well-trained and totally committed to supporting the needs of these patients.

We did complete one small home health tuck-in acquisition during the quarter.

We continue to see great potential as more care is delivered in the home.

Our strategic partnership with Henry Schein is off to a good start.

While still new, we are now able to bring the Schein physician practice capability to our IDN customers.

We're beginning to ship products to Schein facilities and plans are to have the integration substantially completed during the June quarter.

I had the opportunity in recent weeks to address the combined teams at the Schein's national sales meeting and it was clear that the group is extremely optimistic about the opportunities in front of them.

To be clear, these strategic initiatives are not a departure from our traditional distribution; rather, they draw upon our expertise, our considerable channel strength, and the Cardinal Health name to bring the additional products and services that our customers and patients and customers need to thrive in this dynamic healthcare environment.

What do we see going forward in our Medical segment?

We don't expect major changes in the environment over the next few quarters and we could see a bit of choppiness.

But as we look forward and into the back half of FY16, we would expect to see the new and growing business lines in the Medical segment and the increased utilization giving us a more sustainable uplift.

Going back to Cordis, which we announced on March 2, we're making excellent progress in our work to move toward closing.

Leadership teams and organizational design have been defined in all key markets and recently we received early termination of the Hart-Scott-Rodino waiting period, the first of a series of steps to close.

Finally, China continues its track record of double-digit growth.

We continue to see great opportunities in this expansive market.

It is very clear that the growth of the healthcare market in China will continue to outpace general economic growth, driven by demographics, lifestyle changes, and strong government prioritization.

Overall, Cardinal Health is performing at a high level, generating strong cash flow, and showing consistent growth.

The repositioning of our portfolio over the last one-half decade has been driven by a clear perspective on how we see healthcare evolving.

Most of our customers across multiple channels are experiencing new dynamics, as both public and private sector forces push them to deliver care more cost effectively, in a more coordinated fashion, into emerging sites of care, and in such a way as to bring the patient more squarely in to the equation.

Our ability to offer a broad and integrated set of solutions across the continuum of care and to continue to innovate around our customer base has enabled new opportunities for growth.

And at the same time, helped us to absorb the bumps that can occur in a system going through rapid change.

It's an indicator of the overall strength of our portfolio that, even through these transitions, we expect to deliver non-GAAP operating earnings growth for this full fiscal year in the mid-teens.

There is no other healthcare company that has quite the range of tools we can bring to the market and do so at a time when comprehensive solutions are the need of the day.

Put another way, we can address a larger percentage of virtually any customer's overall business than any other company in healthcare.

With that, I'll turn the call over to Mike.

Thanks, George, and thanks to everyone joining us on the call today to hear about our strong third-quarter results.

My comments will walk through our third-quarter consolidated financial performance, as well as expectations for the quarter ahead, as we close out our 2015 fiscal year.

You can refer to the slide presentation posted on our website as a guide to this discussion.

Third-quarter non-GAAP earnings per share grew 18% to $1.19.

Total Company revenues were $25.4 billion, which was also an increase of more than 18%.

Total Company gross margin dollars were up more than 12% versus the same quarter in the prior year.

Consolidated SG&A increased 9% versus the prior year, with the largest driver being acquisitions.

Next, non-GAAP operating earnings in the quarter were $656.7 million, which is a 17% growth versus the prior year.

Moving below the operating line, net interest and other expense came in at $32.7 million in the quarter.

As a reminder, Q3 of the prior fiscal year included a $0.06 per share after-tax gain related to the sale of our minority equity interest in two investments.

Our non-GAAP effective tax rate in the quarter was 36.5% and our diluted weighted average shares outstanding were about 334 million.

Moving to operating cash flows, we generated $658 million in the quarter.

At March close, our cash balance was $3.2 billion, with $447 million of this held offshore.

We remain committed to our previously stated balanced capital deployment policy of focusing on reinvesting in our business and maintaining our differentiated dividend, while pursuing strategic M&A and stock buybacks on an opportunistic basis.

Next I'll review each segment's performance.

Let's start with the Pharmaceutical segment.

Revenues were up 20% year-over-year to $22.6 billion, due to the growth of existing and new customers across all business lines in the segment.

Segment profit was $567 million, an increase of 25% versus the prior year.

This was due to the strong performance of our generics program, including the net benefit of Red Oak Sourcing, as well as growth from our existing customers and contribution from new customers.

Segment profit margin rate increased by 10 basis points, driven by the performance of our generics program, which offset the impact of customer price changes and the dilutive impact of branded hepatitis C therapies.

Clearly, the performance of our generics program has been excellent.

Enhanced sourcing under Red Oak, customer wins, and growth of existing accounts have all been key drivers.

Manufacturer price inflation or deflation, new item launches, penetration of existing accounts, and advanced pricing analytics are also factors in determining our program's success.

I remain confident we can balance all of these for continued growth in our generics program.

Besides the contribution from generics, our branded drug business continues to go well, with strong performance under our fee for service agreements.

As has been typical over the past several years, inflation tends to be a larger component in the third quarter versus other quarters.

The rate of inflation was essentially the same as the prior year, in the low double-digits.

As George mentioned, in our Specialty business, we closed the acquisition of Metro Medical earlier this month.

Let me give you a few details.

Metro Medical has various business lines.

We acquired their specialty distribution, specialty GPO, specialty pharmacy, and private label medical/surgical disposable products business.

The Metro Medical online and Metro Medical partners pieces of the business were not included in the acquisition.

This acquisition will provide us the opportunity to expand our Specialty distribution scale and deepen our reach into the rheumatology, nephrology, and oncology markets.

We have been working on this deal for several months and had already contemplated the bottom line impact in our FY15 EPS guidance range.

Now let's move to our Medical segment performance.

Third-quarter revenue grew 4% to $2.8 billion, primarily due to the contribution from acquisitions.

Segment profit declined by $9.1 million to $101.5 million.

This was a result of the decline in the contribution of national brand med/surg distribution, and the continued impact of the previously communicated challenges in the business in Canada.

These same drivers contributed to a margin rate decline of 50 basis points versus the prior-year period.

Let me give you a few other highlights to consider.

First, revenues from our strategic accounts continues to significantly outpace our remaining book of business.

In addition, top-line growth from our higher margin wrap-around services is outpacing overall Medical segment revenues.

Our Cardinal Health at Home business has grown at or above market each quarter of this fiscal year.

And finally, we are continuing to build out the position preference item strategy.

In this space, our acquisitions of AccessClosure and Innovative Therapies are off to a good start and are performing better than the business case.

Our recent announcement of our intent to acquire Cordis, which we still expect to close before the end of the calendar year, will only accelerate our work in this space.

Let me reiterate some key points surrounding this deal.

First, we will be acquiring Cordis for $1.944 billion in cash, or approximately $1.6 billion, net of roughly $350 million in cash tax benefits.

Next, we plan to finance the acquisition with debt and cash on hand.

Our intent is to issue debt some time in the next few months and take out the $1 billion bridge financing that we secured as a contingency.

From a non-GAAP EPS perspective, we expect slight dilution in FY16 as a result of the three factors that we mentioned at the time of the announcement.

First, FY16 will only include a partial year of Cordis earnings; second, we expect approximately a full year of interest expense, estimated at $0.07 to $0.08; and third, there will be $0.13 to $0.15 of unfavorable impact due to an inventory fair value step-up.

Then in FY17, the first full year post-close, we expect the transaction to be greater than $0.20 accretive and increasingly accretive there after.

We still expect operational synergies of at least $100 million annually by the time we exit FY18.

Before I move to our outlook for the rest of the fiscal year, I'd like to add a few updates on China, which reports into both segments.

Our businesses in China continue to perform well.

We continued to see strong double-digit revenue growth for the quarter, up 25%.

Also during the quarter, we closed on an acquisition of a local distributor in northeastern China, which expands our local direct distribution to 11 cities.

Turning to slide number 6, you will see our consolidated GAAP results for the quarter.

The variance to non-GAAP results was primarily driven by amortization and other acquisition-related cost, which reduced our GAAP results by $0.15 per share.

Looking forward, we're increasingly confident in the upper half of our non-GAAP EPS range of $4.28 to $4.38.

Let me finish with the following updates around our Corporate assumptions.

We continue to expect our full-year non-GAAP tax rate range to be between 36% to 37%.

This obviously implies that our fourth-quarter rate will be higher, likely between 38% and 41%, based on the timing and outcome of various discussions we are having with tax authorities.

We're expecting capital expenditures to come in at about $330 million.

Our full-year amortization expectations increase to about $190 million, based on the acquisitions we've completed as of March 31.

We don't expect the Metro Medical acquisition to add a significant amount to our final number for the year.

In closing, we're pleased with our overall performance in the third quarter, recognizing that we've got some important work to do in Medical to shift the trajectory.

We've taken great steps during the past several years to build a strong foundation for sustainable future growth.

That's why, across the Enterprise, I expect a solid finish to our fiscal year.

With that, let's begin Q&A.

Operator, please take our first question.

(Operator instructions)

Bob Jones, Goldman Sachs.

Thanks for the questions.

As you think about the performance in Medical, George, it seems like volumes have been improving on the in-patient side, you've added some accretive margin deals, sounds like private label is still growing, yet the business has struggled.

I know you mentioned Canada being an issue for the balance for the year, but I'm just curious if you can maybe give us some insight on when you think this business could really start to turn around?

Good morning, Bob.

Thanks for the question.

Yes, taking a look at Canada has definitely been a tough challenge all year, and as you said, we tried to be pretty clear about the work that we need to do and are doing in the Med segment.

We just have to get through some short-term choppiness.

I mentioned during the call that the traditional -- the legacy lines of traditional branded med/surg has been largely the challenge, and it's really been largely repricing of some accounts.

I think we'll start to see the benefit of all the initiatives that we've described begin to more sustainably feel like uplift as we get into second half of 2016.

But I actually like our positioning.

I think we're doing really good work.

If you look underneath the numbers over the last three years, for example, we've had very good growth of our private label products and just contribution of margin from them.

So it's really about this shift in the model where the legacy line is becoming a smaller component of the overall mix and those newer products and services are beginning to grow.

So we've done some really important work there and we've made some big moves this year to strengthen that and feel good about that.

If I could just sneak one in on Specialty.

I know in the quarter you acquired Metro Medical.

Just curious maybe if you could give a little bit more on how that business specifically enhances your specialty footprint?

Then I know, broadly, George, you've gotten this question in the past, but increasingly seems like Specialty is obviously in a very important channel for the wholesalers.

And I'm just curious, how do you feel about your footprint, even in light of the Metro Medical deal, and are there bigger deals out there that could really give you greater exposure to this important channel?

Bob, let me answer that and I just to follow-up a little bit on the first part of the question again.

But Metro Medical really just helps us expand our reach.

We've been growing at a pretty hefty clip over these last couple of years and our scale is now at a point where we really are a meaningful factor in the market.

That's important, given some of the trends in healthcare.

Metro Medical just expands that reach and footprint.

So we're excited about it.

Whether or not there are other opportunities out there, we continue to look at every opportunity that's in our areas of strategic focus.

Obviously, specialty is one.

Whether or not you find the assets at the right moment at the right price is always a question for us, but this is clearly an area of priority and so we'll continue to look for opportunities.

But we're excited about the Metro Medical.

Just backing up, I wanted to make sure I highlighted this on the Medical, just as a reminder that our customers are really becoming much more complex.

They're no longer a single line of activity.

I do think that's part of what we felt strongly about, is that these complex systems need products and services that cross all of the lines of business.

So that's really important, at a time where you're seeing the change in incentives, which has been completely activity-based over the years, just a different incentive system.

The tools that we really bring are going to become increasingly important.

I didn't want to miss the opportunity to say that, related to the first part of the question.

Operator, next question.

Ricky Goldwasser, Morgan Stanley.

Hi, good morning.

A question on M&A, post Cordis.

What is your appetite for M&A?

Obviously, you did Metro Medical, which is on the smaller size, but what leverage are you comfortable going up to?

And when you think about the areas you're interested, obviously Specialty is one, but maybe if you can rank order them for us?

Good morning, Ricky.

First, appetite is --.

We want to grow this business.

We want sustainable, competitive positioning and we believe that there are key areas strategically that are aligned with where care is going.

We've been pretty clear about that.

It's around generics, it's around specialty, it's around every opportunity to provide performance management for large integrated customers.

It's the home.

Opportunities in China, which is a unique market.

We'll continue to look for those opportunities.

Obviously, we have a strong balance sheet, but again, we're going to be very disciplined about the moves we make, when we make them, how we make them, to make sure that we can execute and that's always been a priority for us.

We feel well-positioned.

Strong balance sheet.

I don't know if, Mike, you want to add anything to that.

Ricky, it's going to depend on whether it's a strategic fit, whether the culture fits for us, the growth trajectory, all of those types of things of the acquisitions.

But from a balance sheet standpoint, we have said that we would like to keep our on debt ratio to 1.5 to 1.75 is the range that we're comfortable in.

Could we at times make a decision to go slightly above that for the right type of acquisition and stretch ourselves some?

Sure, we would be open to doing that.

We're always going to want to be concerned about where the debt rating agencies see us and that's an important thing for us to consider, and how they view us and so sometimes the type of acquisition matters when we deal with those folks.

And remember the last thing too, we like to keep about $1 billion to $1.5 billion cash on hand just for our everyday working capital and needs because of the fluctuations in the business.

Those are some of the things that we try to keep in mind.

Okay.

And then one just quick follow-up.

Obviously, in the prepared remarks, you talked about the strong branded inflation, I think it was in the low double-digits, and we're hearing strong inflation on generics.

Where do you think we are on the pricing cycle in the sustainability of the trend, across the portfolio, because we're seeing it both in brand, generic, and specialty?

Ricky, I'll start with it, but then I'll welcome Mike to join in.

Predicting this going forward is always difficult.

The branded side, as you've seen, has been on average, which is interesting, relatively consistent for a while, but actually inside that average is a lot of different rates.

So it's one of the things that makes it, in a way, hard to predict, but in some ways a little easier because you have this smoothing effect.

On generics, it's such a tough call because, as you know, it's an enormous product line that we call generics, so the number of products that can move the needle can be relatively small.

You can talk about 50, 75, 100 products that move the needle, so it's really difficult for us to give a forward-looking guidance on what we see.

We've done this in the past, and I probably did today, we're talking about the environment and what are the conditions of the environment and I'm not sure that those conditions have changed materially from last period.

But we have seen some variation.

Mike can touch on that.

I would agree with George.

On the branded space, it's been pretty consistent over the last several years, that branded inflation rate has stayed in that low double-digits area.

We've not seen a lot of fluctuation there.

I just wanted to really call it out this quarter, remind folks of the seasonality component and why the third quarter tends to be bigger than some of the other quarters.

And again, we all know, the majority of the fees are earned on the fee-for-service agreement, so inflation on brand is a much lower component of our margins than it used to be in the buy-and-hold periods.

But again, in third quarter, it's important, so that's really why we called it out.

On generics, it is important, but one of the things that we keep trying to emphasize is that, in our mind, it probably gets a little bit too much attention at times because there are a lot of other levers in our generics program that are going to help us perform over the years.

We really believe confidently that even in a -- if generic inflation were to decline, there's a lot of other levers for us around our penetration, around our pricing and analytics capabilities, around the new business that we've won, et cetera that we can still compete effectively and perform well.

Operator, next question.

Eric Percher.

Hello?

Eric?

Can you hear me now?

Got you, Eric.

There we go.

Dead head set.

Med/surg, two questions, one would be your comment in the press release on national brand distribution.

Is that meant to reflect your commentary on pricing erosion, or is there anything else meant by that?

And then also relative to Canada, have we now reached a point where next quarter we'll anniversary some of those initial issues and customer departures or movement in house?

Does that help in the second half?

Really -- Eric, good morning -- what we're talking about primarily is really pricing on the traditional med/surg.

It's probably not much more complicated than that, and a lot of that is actually repricing some meaningful accounts for us, which we're happy to have in the long run, important customers, strategic customers.

I'm sorry, the second part of your question?

Was within Canada, it feels like it's been about a year since we first saw some of those issues.

I know there were a couple customers that moved in house.

Will we now anniversary that?

Here's what I would say, and I mentioned this earlier, I would say probably a couple of choppy quarters.

We're taking some pretty significant actions in Canada to address some changes in that market and then we'll start to feel a more normalized rate.

Eric, I would expect us to still see some pressures in Canada through the end of the calendar year, so it will still affect us for the first two quarters of FY16 and then beginning in our Q3 of FY16, we begin to see a more normal and leveling off in the Canadian business.

Operator, next question.

David Larsen, Leerink.

Can you talk a bit about biosimilars and what opportunity you're looking at?

And maybe touch on the different channels that biosimilars will flow through if they ship to the member at home, whether they self-inject, or of they ship to the doc office.

Are you better positioned in any one of those channels than the other?

Thanks.

Good morning, David.

Again, I'm not sure I can add that much to what I said in my earlier comments, but again I'll just highlight this.

Many of you have asked this over the years, something we've been anticipating in terms of biosimilars, that we've always felt that there would be some uniqueness to each product.

And as you said, the root of administrative, which channel it goes through, whether or not there is substitutability,, these are all things that will influence what kind of services the patient needs.

We actually feel well-positioned regardless of route, is what I would tell you.

As you know, we've got an extremely strong position in hospitals, we've expanded our position in all kinds of clinics.

We're very strong in pharmacy, we've got specialty pharmacy, clinics are an area, and now obviously, we've got some enhanced strength in the small physician practices.

So from our standpoint, we've got great reach across therapeutic areas, which is very important, and from a channel perspective, we're in a pretty good position regardless of that route.

The only thing I would add to that, George, is that also from a services standpoint upstream to the manufacturer, we feel that we're in as good or better position than anybody in the industry to provide any type of services that they might need, whether it be specific cold chain or other type of transportation needs, whether it be hub services, data and analytics, we know that we can provide all of those services, too.

So we really feel that we're in a great position, both upstream and downstream, on biosimilars.

Great.

Thanks a lot.

Thank you.

Next question?

John Kreger, William Blair.

Hi.

Thanks very much.

George and Mike, if you're willing, thinking about some of the puts and takes for next fiscal year, how do you feel about the outlook, realizing it's early, compared to some of your longer-term growth goals?

Again, John, good morning.

It's a little early for us to be saying a lot about 2016.

We're finishing our budget process.

Obviously, at year-end, we provide guidance.

But in terms of our long-term goals, we still feel good about those.

The Organization right now has, it feels like, a lot of momentum, actually.

If you go around Cardinal Health, you'd see a group that's very energized.

We're very clear about our goals, very disciplined in managing to those.

And we'll have a little bit of bumps in any part of the business, but the overall Cardinal Enterprise feels good and on target to achieve the goals that we've set up.

I would agree.

We do need to get through the budgeting process this summer.

That's really important.

Probably the only thing that we'd really mentioned about next year that I can give you a quick update on was around the commodities.

We did say for FY16 that they would be about $10 million to $20 million of benefit commodities.

We have updated that work and we can still continue to believe that's the right number for next year.

I know that's only one small component that goes in to it, but it is the only thing that we've given you any insight on.

And the Cordis mechanics.

And then the Cordis mechanics that I've walked through.

Very helpful.

Thanks.

Just one quick follow-up on Red Oak.

As you move into year two, it sounds like you pretty much finished your work with supplier recontracting.

What happens next?

Is there an opportunity for meaningful growth in year two, as well?

Yes, I'm really excited about where we are in Red Oak.

I serve on the Board of Red Oak and recently had a Board meeting and continue to be incredibly impressed with the team.

We've again been able to retain all of the key folks from both companies and have decades of generic buying experience on there, which again, to get through essentially 100% of the spend in this short a period of time has been exciting.

We do expect there to be uplift in FY16.

A big piece of that is just because we'll have a full year of all of the benefits while we were ramping this year.

But even on top of that, we do expect to continue to generate value.

As I met with the team, they're constantly looking at different ways to work with the manufacturers to try to create more incremental value for both parties.

Operator, next question.

Glen Santangelo, Credit Suisse.

Thanks.

And George, I just want to come back and revisit this Medical segment issue a little bit further.

You talked, obviously, a lot on the call about the pricing pressure within the segment.

Is that repricing certain GPO customers that you got hit with, and is there anything else on the horizon that would impact the pricing as we go forward over the next 12 months?

I'm also curious, could you talk about the overall pricing of the underlying inventory you're selling?

Are you seeing price deflation on the products you're selling, or is that still somewhat inflationary and is that impacting the product margins at all either?

I'm going to come back to the second part.

I'm not completely sure I understand the question.

We'll make sure we do and then Mike will address that.

But this is really not a GPO issue, Glen.

This is just individual accounts that happen to fall during the period of time where we're signing some long-term agreements.

No single one of them, by the way, is big enough to call out or necessarily move the needle.

It's just a general dynamic.

What again, I wanted to highlight during the call is that over many years, the traditional, what we call branded med/surg business is going through this dynamic, and so that's really not new.

I don't want to make it sound like there's one big contract that was the key; it was just some repricing in that aspect of the business, we felt.

I hope that answers that part of it.

The second part of the question, Mike, did you get--?

Let me take a stab at it, and if I don't get it right, Glen, please just ask again.

Agree with George as far as the GPOs.

We always work with them, but in tandem, we work individually with the hospitals.

If you take a look at the product portfolios, I don't think this is really necessarily a deflationary environment on all the items.

You're going to see certain items that may go up, and some that are going to go down but I wouldn't say there is any one trend either way that's actually affecting us.

This is our ultimate net price to the customer themselves, not the items driving it.

Okay.

Maybe if I could jut one follow-up.

Could you maybe elaborate a little bit more on what the challenge is in the Canadian market?

Because it sounds like it's going to persist for another two to three quarters and it would be helpful if you'd just remind us exactly what that issue is?

Really two things.

One is, similar to what we just described, some repricing of customers.

Then, as we mentioned last time, there were a couple customers that we did lose in Canada that we won't actually anniversary until the end of the calendar year.

One of those brought in house the services they were doing, and one switched to a competitor.

So that's really what's driving it, is a loss of a couple larger customers, as well as some pricing and retention of some other customers and those are really two big factors.

The other piece that I'd mentioned is some shifting in the reimbursement dynamics around that market.

Again, that is a component in that pricing aspect.

Remember, those customer losses are not new ones.

Those are the ones I mentioned last quarter that are out there; it's just that it was going to take till the end of the calendar year for us to anniversary them.

Operator, next question.

Ross Muken, Evercore ISI.

Good morning.

I wanted to just touch base regarding Cordis.

Obviously, you haven't closed the deal yet, but you do have very close relationships with some of your physician and hospital partners.

You've got some key thought leaders in the field that you interact with on a regular basis.

What's the dialogue been post the announcement, now that it's seasoned a bit, with those individuals and what other things has it sparked in your mind as you think about the long-term strategic value of the endeavor?

Good morning, Ross.

This has been actually a really interesting period since the announcement.

A couple things happened, many of which we thought could happen, which is just a high amount of energy around this insider organization.

The people that are going to be joining us from J&J are pretty excited about where this falls for us in terms of priority.

We're getting great feedback from our advisory boards, as we've mentioned before.

We've got really world-class advisory boards who are working with us.

We've started to, as you might imagine, hear from other players in the market, who recognize that we might be an interesting partner for them, as we expand our commercial capabilities both here and outside the US in these medical products.

So what we're seeing is a pretty high level of enthusiasm across the board.

Obviously, we've got a lot of work to do to get to the finish line and the closing, but it's been really well-received.

One of the things that I would highlight is people are now beginning to realize that it's not just about the product.

So that we're talking about a different service offering, in terms of being able to bring the medical device and some wrap-around services that help manage inventory, eliminate waste, prevent errors.

These are all part of this strategy in helping in the physician preference area.

So what's happening both internally and externally is that our excitement about joining those two components, the service component and the product component, are giving us a sense of optimism about the future on this.

Great, thanks, George.

Operator, next question.

Lisa Gill, JPMorgan.

Thank you.

I'm just wondering, can you give us maybe some color, George, around the size of Metro Medical?

Obviously, you talked about it being in 2015 numbers, but maybe on a revenue basis, how big is this?

Lisa, good morning.

Unfortunately, I can't provide that information right now.

What we -- as we've come out of our year and we start guiding into next year, some of that will become a little bit more apparent, but at this point I can't provide more information.

I'm sorry.

Okay.

And then secondly, as we think about Red Oak, and we think about relationships with manufacturers, there's a lot of talk about continued consolidation of generic manufacturers.

Can you talk at all about your expectation, you or Mike, around Red Oak and how that will impact you going forward?

Let me just start and then Mike can speak more specifically to Red Oak.

Lisa, as you know, consolidation is not really new to the industry, it's been happening for quite some time.

It's something we're used to.

It's a dynamic we understand.

It's one of the reasons that having scale is really important.

It's also a reason that the knowledge base of what each supplier's strategy is all about, because that actually matters, because ultimately what we're looking for in the best of situations is those win-win moments.

We understand the landscape well and we know the players well, and so consolidation can be a double-edged sword, but for us, we see the opportunity to work more closely with companies.

We see that as an opportunity.

Mike, I don't know if you want to add to it more narrowly from the Red Oak perspective?

Probably the only thing I would add, is first I would emphasize, I really like where our relationships are with the manufacturers.

They value us.

They understand the simplicity and the speed of our model, and particularly, the transparency, and the feedback we're getting from manufacturers around those components has been incredibly positive.

And what that leads to is us being willing to try new things with them.

We're also very focused on not only the large manufacturers but also smaller- and medium-sized ones that have really mentioned that they appreciate that they've been able to be part of the program.

So consolidation is part of the industry, but we like where we're at, and we think in certain situations, if we needed to, we can work with folks to try to create the right competitive environment to get the type of pricing we need.

Operator, next question.

Steven Valiquette, UBS.

Thanks.

Good morning, George and Mike.

Just within the Medical segment, I'm curious in relation to the Cordis acquisition, is your plate going to be pretty full over the next year, just on the integration of this fairly large asset, or if let's say other medical manufacturing assets are potentially available for acquisition, would you have the bandwidth to do additional medical manufacturing M&A deals in this segment over the next year or so?

Thanks, Steve.

Good morning.

Obviously, I'm going to answer this with some care.

Let me start with the basics.

As I mentioned earlier, our balance sheet strong, our Organizational capacity is very significant, but we always put a high priority on execution.

So, we think about, when we look at acquisitions, not just the financial capacity to execute and integrate, but the Organizational capacity to do that.

So we're very mindful of that.

I'd also note though that we have a very broad-based employee population.

For example, we can have a group of folks that are very deeply dedicated to the integration of one asset and literally another group whose lives are untouched by that.

So what we're mindful of, as we look across at opportunities externally, is making sure that we're not doubling down on those people who are trying to do one execution -- execution of one deal.

But always mindful of that, but we have a pretty talented, diverse Organization with a lot of capacity.

But we'll always think about execution.

Okay, got it.

Okay.

Thanks.

Next question.

John Ransom, Raymond James.

I had a question about the independent pharmacy channel.

Are you seeing any more signs of stress in that channel, just given some of the fundamentals around generic inflation and reimbursement squeeze?

And if so, are you approaching that marketplace differently than, say, you were three, four years ago?

John, let me start.

Good morning, first.

Then I'm going to turn it to Mike because we'll probably have two angles on this.

We've been doing really well providing value to these independent pharmacy customers.

The key is recognizing that there are certain market dynamics and market pressures that they deal with and what we do is focus on how do we relieve those pressures, how do we create value in that environment.

What's happened is we've become increasingly targeted on how we create value for those kinds of customers in this environment.

Our Organization has done a really good job in terms of expanding our position there and growing some share and I feel good about our position, about how we're creating value.

Certainly, there are pressures out there that they have to deal with; we're doing a lot to help them.

I can think of a couple specific examples.

First of all, obviously, Red Oak and our ability to be competitive on the generic programs and recognizing the need in how we price generics at different life cycles of reimbursement.

That's always important to do that.

Our PSAO has been growing steadily and we've added a lot of members and we've been able to do some unique things with them and get out and market our PSAO and work with our customers to help them on their star ratings to make sure that they're the type of customers that the PBMs want to do business with, and we're incredibly excited about those.

And then in other areas, in the out front part of the store, we've been expanding our programs and opportunities there, to work with the folks.

We really like where we're headed with some of our Cardinal private label lines and our opportunities to help them manage inventory both on the out front and behind the counter.

We have a lot that we're doing.

I wouldn't say that we're seeing any decline that we've seen in this.

We continue to grow our share in that space.

And that's how I feel.

One thing, if you didn't know what I meant, for those on the phone, about a PSAO, that's our third-party contracting arm, where we work with third-party payers on behalf of our retail independents, to get them reimbursement.

And my other question, just checking in on your other channel, you sell under a lot of IDNs.

What are they asking for from you that they were not asking for two years ago?

Is there any effect yet that you're seeing from the ACA, in terms of what capabilities you need?

Yes, it's a really interesting question because what they're seeing is -- many of the big acute care and integrated systems are recognizing that, in a world where there's probably some shifting and incentives, we're looking at bundles of care and payments, where there are penalties for readmission, they're just beginning to look at each line more holistically.

One of the changes we've seen -- certainly, you still have to be very, very competitive in each line -- is that the institution at the enterprise level of the IDN is thinking holistically about how do we compete, how do we thrive in this new environment?

That's why our work across the enterprise is particularly resonating right now, because we're really not just able -- we're not just talking about lines of business, we're talking about being able to address a huge percentage of their activity.

I think we're the only one who can do this in quite that way.

Thanks a lot.

Operator, next question.

Garen Sarafian, Citigroup.

Good morning, everyone.

Good morning.

I just had a couple questions on the quarter.

First, on the Pharma segment.

Could you elaborate a little bit more on the revenue growth that's 20%.

You called out growth from both new and existing customers so maybe if you could break those two out or give us an idea?

And any other relevant metrics, such as volume growth, or other inflation, Hep C, so on and so forth?

I can give you a little color.

First of all, the Hep C component of our growth is still less than 25% of the overall growth.

It's an important driver but it is less than 25%.

New customers would be the largest component of our growth.

Then growth on our existing customers would be next.

Keep in mind, with branded drug inflation being in the low double-digits, that's going to be a huge driver of overall top-line revenue growth, particularly in the market where you haven't seen very large generic launches, that would be taking away some top-line volume.

So those would be the key drivers to help you understand that.

Useful.

Then as a follow-up, on branded side of the business, has the non-fee-for-service, so the buy-and-hold portion of the business, remained the same as a percent of the entire business, and what's in it?

Have the mechanics changed at all in the past few quarters, maybe couple of years, to alter the profitability profile in any meaningful way?

That's been really, really steady.

Over an annual period, it's still averaging about 80% is non-contingent of our branded buy-side piece.

But as I mentioned, in the third quarter, it's a little more slanted toward inflation, but again, over a whole-year period, it's still running 80%.

The agreements continue to be about the same.

Often they renew very similar terms and conditions.

We continue to tweak them, but this is an area that we continue to feel good about.

Got it.

Great.

Thank you.

Operator, next question.

Robert Willoughby, Bank of America Merrill Lynch.

George or Mike, maybe this is more a J&J question, but can you give us any color on the Cordis results, or hopefully, post-change of control announcement, the wheels don't come off there, and maybe remind us of your budget plans there and what infrastructure you would want to put in place internationally to really maximize that opportunity?

Good morning, Bob.

Unfortunately, the first part of your question really is a J&J question and I can't answer for them.

Regarding the second, we have been really hard at work, on really working across the globe on what that organization is going to look like and it all feels like it's going very well in the US.

As you know, we have some cardiology assets here, so we've been looking at how we're going to coordinate and integrate those activities, have a very clear game plan.

Ex-US, we've got organizational design under control; we've got the leadership in all key markets.

Looking about key positions, we want to make sure we retain some of the great tradition of that existing Cordis, but we want to bring some of that Cardinal approach to it.

So what we're -- one of the things I mentioned earlier, Bob, that is pretty interesting, is as we go outside the US and we talk to the organization, again, recognizing that certain conversations we can't have at this stage as two separate companies, they're particularly interested in our service model, in how we can help bring additional efficiency to the medical device side to it.

So people are beginning to realize that we can bring more than product scale.

Again, short-term critical issue for us, I talked about execution earlier, it was the Hippocratic oath, do no harm.

So where the businesses are performing very well and there are many, many markets where they're one or two in the market, we're going to make sure that we, quote, do no harm there and keep the business executing.

Hope that helps as an answer.

Maybe just a point to drill down, you're looking at the services side of things obviously, but is there ever an R&D line item that you'll be breaking out with this and other assets that you have in place now, requiring a bit more investment on that front?

That's a good question.

In terms of how we break it out, I can't answer it fully yet.

What I can tell you in strategy, this is not going to be a big research-based business unit inside of us.

There will be development because -- and we do that today, by the way.

As a medical device Company today, we're doing DOD as development all the time, but you should not expect us to be a research-based med device company in a big way.

That's not really the game plan here.

All right.

Thank you.

Operator, next question.

Dave Francis, RBC Capital Markets.

I wanted to go after Special piece at a little different angle.

Looking at the fact that you are at a $5 billion revenue level, or will be as you exit the year there, is the business now, either from a critical mass of revenue perspective or a service portfolio perspective, now at that place where you think you're big enough to grow the business organically through internal development efforts above the market rate, or do you still need to deploy capital externally to get to the point where you're able to capture additional market share?

Yes, good morning.

Actually, the answer is we are growing it organically, quite rapidly.

So that's the good news.

We have the scale; we've got great talents.

It's a really innovative group.

We've got a pretty good group behind that driving new models for how to create value for our Specialty customers and our suppliers.

I think we're actually getting very strong organic growth and we'd continue to expect to, but again, we'll look for opportunities to deploy capital if we see opportunity, but we're getting very strong organic growth.

As a quick follow-up, looking back at the med/surg business, you have been spending a lot of time trying to get the business repurposed, and a little more focused on the ambulatory side of the business, as well.

Can you talk about trends that you're seeing, in terms of actual utilization or actual volumes being pushed outside of the in-patient environment that might be starting to pay dividends for you in terms of investments in the home health and other ambulatory environments?

I would say these trends, in terms of care moving, relative here to ambulatory settings is probably unambiguous.

This is absolutely happening across the board.

Getting actual exact numbers in this is difficult because our system is not used to tracking this.

I don't mean Cardinal system; I'd say those who track this data.

When we talk to IDN customers and we look at our data, it's pretty clear that more activity is being driven to different sites of care and that plays to the strategy.

It helps explain some of the moves that we've made and it's really going to be for us, as we go forward, a tailwind because that is a natural byproduct of some of the changes in the incentive systems in the industry.

We've seen a lot of that with our At Home business already, with those changing dynamics, that it continues to grow, not only significantly, but above market itself.

So we (multiple speakers) there -- and our surgery center business where we continue to have very large share.

That's another area that we really like.

Operator, next question.

Charles Rhyee, Cowen and Company.

Thanks for getting me in here at the end.

Obviously, a lot of discussion around Medical.

Maybe one last question on the topic, but maybe following up on the last question here.

Part of, George, when you talked about repurposing the Medical business, you also talked about having a more extensive dialogue with the C-suite of your hospital customers and it was something maybe that the Organization wasn't really in deep with previously.

Can you talk about where you are in that progress to really explain what Cardinal can do for them, for IDNs in general?

Maybe where we are at that stage and what inning and how much further can we get?

Do we need to go before we can really drive that?

Good morning, Charles.

That's a hard question.

As you think about what the inning are we, that's always a hard question because the system is going through this change.

Let me, highlight a couple things.

Again, as a reminder, I would say, our largest customers across healthcare are becoming more complex, more integrated, and their needs now cross more products and services than we've seen historically.

We've been, at the same time, aligning with that, and one of the things that we did over the last year is to create these strategic account teams.

We've always had strength in our selling organization, selling lines of business.

We'll continue to do that, but part of what we've trying to leverage and this is what you're touching on is that need for the integrated system, for that complex customer, to think about a changing world and which are the partners who can help them.

Again, as they think about changing from an industry which has been activity-based to one with different incentives, a pay-per-outcome, or a fee-per-outcome, all the tools that we bring, standardized consumables, private label medical products, services that enable increased efficiencies, helping them navigate across their channels.

Our physician preference strategy, our work in the home, these are all valuable to them.

Then you combine this with our Pharmaceutical lines and our Specialty and we have a unique set of offerings.

We're trying to make sure that we're positioned to address that at the most senior levels of the Organizations because it's really now about competing in a world that looks, in the future, a little bit different than it did historically.

Great.

That's all I really had.

Thanks a lot.

Operator, next question.

George Hill, Deutsche Bank.

Hello.

One-upping Charles.

Thanks for squeezing me in at the end (laughter).

Good morning.

I just want to touch on something quickly I thought I heard you say in your prepared comments, but I might have gotten the notes wrong.

Did you say customer price changes were serving as a headwind in the drug distribution business?

And if you did say that, can you put a little more color around what that meant?

It was one of the offsets.

We said the positives was the growth in new customers and the net benefits from Red Oak that were offsetting some of the customer price changes.

Those wouldn't be anything more than the normal types of day-to-day renewals we see with all of our customers.

So there's really nothing new there, no new news, it's just typical.

It always tends to be one of our largest headwinds and we're constantly working on the opposite side, obviously, to more than offset those.

Okay.

Fair enough.

So just the normal pricing pressure that's part of renewals.

Yes.

And then maybe just, as we've talked about pricing pressure in the med/surg business, George or Mike, how should we think about how that pricing pressure impacts what will be the Cordis business?

Is that business immune from that pricing pressure?

Will that see pricing pressure as well?

I'm always reluctant to say anything is immune from pricing pressure.

That's obviously a big statement to make.

But we've really been talking primarily about something that is a dynamic that's been occurring over some time, in what I'm going to call the traditional legacy med/surg business.

I really would not connect that necessarily as to a line of business.

This is just a trend that we've seen for some time.

And what we're seeing over the other lines of business, is actually they are drivers in the opposite direction.

Thanks, George.

Thanks, George.

Operator, do we have any other questions?

At this time, there's no further questions.

I'll turn the call back to George Barrett.

Thanks all for your questions and for being on this call.

We appreciate your doing this.

We look forward to getting a chance to talk to you and seeing many of you in the near future.

Thanks again.

This does conclude today's conference.

We thank you for your participation.