卡地納健康 (CAH) 2016 Q2 法說會逐字稿

Good day, and welcome to the Cardinal Health second-quarter FY16 earnings conference call.

Today's conference is being recorded.

At this time, I would like to turn the conference over to Sally Curley.

Please go ahead.

Thank you, Bethany, and welcome to Cardinal Health's second-quarter FY16 earnings call today.

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 statements slide at the beginning of the presentation found on the investor page of our website for a description of those risks and uncertainties.

In addition, we'll reference non-GAAP financial measures.

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

In terms of upcoming events, we will be webcasting our presentation at the Leerink 5th Annual Global Healthcare Conference on February 10 in New York.

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, and thanks to all of you for joining us.

We reported a strong quarter this morning, wrapping up an excellent first half to our FY16.

Our second-quarter revenues increased 23% to $31.4 billion.

Non-GAAP operating earnings increased 14% to $726 million, and we reported non-GAAP diluted earnings per share of $1.30, an increase of 8% over the prior year.

Our Organization continues to demonstrate the discipline necessary to compete in a very dynamic environment, and the capacity and readiness to take the actions to position us to sustain growth over the long term.

We are confident about our position and our ability to create value for health systems experiencing change, and we are reaffirming our full-year non-GAAP diluted earnings per share guidance of $5.15 to $5.35.

This range represents an 18% to 22% growth rate over our FY15.

Both of our reporting segments demonstrated strong operating performance in the second quarter.

Specifically, the Pharmaceutical segment reported significant profit growth, and the Medical segment showed strong underlying performance, largely masked by the Cordis-related inventory fair value step-up.

Adjusting for this, both segments reported robust revenues and double-digit growth in segment profit.

Turning to our segments: Our Pharmaceutical segment continued its momentum with a very strong second quarter.

Revenue for the Pharma segment increased 25% to $28.3 billion, and segment profit increased 16% to $627 million.

Over the past few years, we've referred a number of times to the importance of having deep expertise in two specific areas in our Pharmaceutical business: in our drugs, which represent the vast majority of prescriptions filled in the US; and specialty pharmaceuticals, which account for many new launches and a significant number of development projects in the pipeline of the pharmaceutical industry.

As you know, these products tend to require very distinct capabilities.

We continue to show excellent progress in both of these areas.

As it relates to generics, we continue to grow our base of customers, spanning independent pharmacies, chain, mail order, institutional, and hospital pharmacies.

Our generics program is designed to meet the needs of our pharmacy customers who recognize that generic drugs are extremely important to support their patients, and our program is strengthened through the purchasing capacity of Red Oak Sourcing, our joint venture with CVS Health.

While our generics program is an important offering for all of our customers, and for us, it is also the broad and deep range of services that we provide to these customers which enable pharmacists to provide clinical support, both to their patients and to the physicians with whom these pharmacists will increasingly be coordinating.

As more precision medicine emerges from the pipelines of the pharmaceutical industry, our Specialty Solutions group builds the linkages between biopharmaceutical manufacturers and physicians, and to help manage the complexity in delivering this important care to patients.

Our Specialty Solutions business continues its steep growth trajectory, growing both in our base of provider customers we serve, and in tools that make us an outstanding partner to biopharmaceutical companies.

We're confident that our Specialty Solutions sales will exceed $8 billion for our FY16.

Our Medical segment continues its repositioning, and is adding value through reinvigorated distribution businesses, new product lines and services, as well as new channels inside and outside of the US.

Revenue for the Medical segment was up 9% to $3.2 billion.

Segment profit declined 8% versus the prior year, to $106 million.

You'll remember that this is the first quarter that includes the impact from the Cordis-related inventory step-up.

Excluding that impact, Medical segment profit growth was 10% versus the prior year.

Mike will provide more color in his commentary.

The work that we're doing in consumables, physician preference items, medical supplies to the home, our service offerings, and discharge management all align with the trend towards value-based payment models.

Related to this, it's our ability to bring our increasingly complex customers the full Cardinal Health portfolio across both our Medical and Pharmaceutical segments that will help as new payment and delivery models begin to emerge.

Our business in China continues to grow at double-digit rates.

Of course, China has been a subject of considerable economic news over these past months.

And while the economic slowdown has significant impact for many industrials, the impact in the services sector has been more muted.

Health care specifically continues to be a national priority.

China's policy reforms, aging population, public health issues, and expanding middle class have created increased opportunities for scaled healthcare solutions, and we expect the healthcare market in China to continue to grow.

Finally, a few words on Cordis: As you know, we closed the acquisition of Cordis on October 2, 2015.

This is not a simple integration process, and our teams are doing an outstanding job managing all of the many moving parts across multiple markets.

The integration of Cordis has gone well and is on target.

Of greatest significance, on day one we were ready to serve customers and their patients seamlessly in markets across the globe.

Our new Cordis leadership team is off to a strong start, and this reinforces our optimism that Cordis will serve as a platform for growth.

As the healthcare market introduces fee-for-value models, our physician preference item strategy is designed to help our customers meet this challenge.

Our offering of products, combined with business model innovation that includes services and analytics, creates real value for our customers.

Cost effective, meaningful and measurable solutions -- this is at the heart of our value proposition.

We closed out the first half of FY16 with strong results, and well positioned for long-term growth.

Ours is an Organization that internalizes its mission.

And seeing our people work to serve our customers through the extreme weather of the last few weeks is a reminder of their deep commitment, not only to our customers, but also to their patients, and I want to take this opportunity to thank them for their work.

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

Thanks, George, and thanks to everyone joining us on the call today.

As George mentioned, we had a strong quarter; and halfway through our FY16, we're off to a good start.

We feel comfortable reaffirming our non-GAAP EPS guidance range.

In my remarks, I first want to review our second-quarter financial performance in more detail, and then I'll end with some additional color on our expectations for the full year.

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

Second-quarter non-GAAP diluted earnings per share were $1.30, growth of 8% versus the prior year.

Starting with consolidated Company results, revenues were $31.4 billion, growth of 23%.

Based on what we've seen through the first half of the year, we are updating our full-year revenue assumption from mid-teens to mid- to high-teens percentage growth versus the prior year.

Total Company non-GAAP gross margin dollars were up 13%.

Consolidated Company SG&A increased by 13% versus the prior year, with the vast majority due to acquisitions.

We remain focused on disciplined management of our core SG&A to ensure that we maintain a lean, efficient Organization.

Resulting non-GAAP operating earnings in the quarter were $726 million, an increase of 14% versus the prior year.

Below the operating line, net interest and other expense was $43 million for the quarter.

This is an increase versus the prior year, primarily due to the interest expense related to long-term debt issued in June of 2015 to fund the acquisitions of Cordis and the Harvard Drug Group.

Our non-GAAP effective tax rate in the quarter was 37%.

While this is 3 percentage points higher than the prior year, it is common for the rate to fluctuate from quarter to quarter.

For the full fiscal year, we still expect our non-GAAP effective tax rate to be between 35.5% and 37%.

Diluted weighted average shares outstanding were nearly 332 million shares, slightly fewer shares versus the second quarter of last year.

We did not repurchase shares in the quarter, and had about $700 million remaining on our Board-authorized share repurchase program.

As I've said in the past, we will continue to evaluate share repurchases opportunistically in the context of our overall capital deployment strategy.

In the quarter, operations generated cash flow of nearly $1.5 billion.

As a reminder, quarterly operating cash flows can be affected by timing.

It's more representative to look at operating cash flow over a longer period, such as the first half of our fiscal year.

Operating cash flow for the six-month period was $1.4 billion.

At the end of the second quarter, we had a cash balance of $2.3 billion, with $394 million held internationally.

Overall, we have a strong and flexible balance sheet.

I'll now review segment performance, starting with the Pharmaceutical segment.

In the second quarter, the Pharma segment increased revenues by 25% to $28.3 billion.

This was a result of continued growth in our existing and new customer relationships, and to a lesser degree, the recent acquisitions of Harvard Drug and Metro Medical.

Segment profit increased 16% to $627 million, driven by growth from existing and new customer relationships, which includes strong performance from our generics program.

The acquisitions of Harvard Drug and Metro Medical also contributed to segment profit growth in the quarter.

Segment profit margin rate for the quarter was down 17 basis points versus the prior year.

As we've previously mentioned, our new relationship with a large mail order customer, while positive from an earnings and capital standpoint, was dilutive to margin rates.

Our integration of Harvard Drug continues to go well.

And while still early, we are on track to achieve our accretion targets of greater than $0.15 in this fiscal year, and greater than $0.20 for FY17.

Our specialty business had strong double-digit growth, which includes the contribution from the acquisition of Metro Medical, which is also going well.

Of late, many of you have been asking us about branded and generic manufacturer pricing.

I'll share our current view, which is consistent with what we recently communicated at a mid-January webcasted event.

We continue to model that branded manufacturer price increases will generally be similar to historical levels.

This would be in line with our FY16 assumptions.

Now, as it relates to generic pricing, over the last 18 months, our commentary and assumptions have been that generic inflation would moderate.

In our FY15, that moderation was about as we expected.

When we provided assumptions for our FY16, we communicated that we expected further moderation.

In fact, we are seeing moderation in generic pricing, although, as we recently shared, it is somewhat steeper than we had originally modeled.

That being said, generic manufacturer pricing is only one piece of our overall generics program, which, in total, we still see as meeting our expectations.

Our solid work in sourcing, attracting new customers, penetrating existing customers, utilizing data and analytics, as well as executing on new item launches has been key in our overall success.

I continue to be excited about our overall generics program and the different components we have created to ensure long-term sustainability.

Overall, this was another solid quarter for the Pharmaceutical segment.

And while there are always puts and takes, the quarter was largely in line with our assumptions.

Now let's go to the Medical segment performance.

Second-quarter revenues grew 9% to $3.2 billion, driven by the net impact of acquisitions and divestitures.

Our at-home business, which grew double digits, also contributed to top-line growth for the segment.

Segment profit decreased 8% versus the prior year to $106 million.

As a reminder, this was the first quarter that included the acquisition of Cordis and the related impact of the inventory fair value step-up.

Excluding the step-up of $21 million, the Medical segment profit grew 10%.

The total step-up came in at about $0.08, which is lower than the $0.13 to $0.15 of EPS impact we had anticipated.

We expensed $0.04 in Q2, and we will do the same in Q3.

There will be no inventory fair value step-up to recognize in Q4.

In this quarter, the favorability of the step-up, as compared to our original guidance, was offset by some one-time items resulting from the execution of the transaction, as well as FX.

Looking to Q3, we expect the step-up favorability and FX to be a wash.

Setting those non-operating pieces aside, as George mentioned, Cordis is off to a good start, with all key personnel in place, and day-to-day operations up and running.

As we integrate the Cordis business through the remainder of our fiscal year, we continue to be excited and will work to drive efficiencies.

As we previously shared, in FY17 we still expect the transaction to be greater than $0.20 accretive, and increasingly accretive thereafter.

We are also working towards achieving the $100 million of annual synergies as we exit our FY18.

Switching to other pieces of our Medical business, as expected, from an operational standpoint, our Canadian business has stabilized, though foreign currency created a bit of a headwind.

The team there continues to work diligently to ensure we position our Business for the future.

Our Cardinal Health brand products continued to grow over and above the incremental increase from Cordis.

Notably, we saw this growth in our strategic accounts, which are those customers that we have identified as key partners in the continually evolving healthcare landscape.

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

The $0.32 variance to non-GAAP results was primarily driven by amortization and other acquisition-related costs, as well as a $39 million LIFO-related charge.

With the first half behind us, there are two variables I'd note that probably have the most impact on us achieving the very high end of our guidance range for the full year.

The first is generic manufacturing pricing levels, and the second is the net impact of foreign currency exchange rates related to our specific businesses.

These items moving in our favor would push us toward the achievement of the very top end of our non-GAAP EPS guidance range of $5.15 to $5.35 that we reaffirmed this morning.

As a reminder, this is a growth of 18% to 22% to the prior year.

While there are a few moving parts, our overall breadth and presence across the continuum of care provides us with the confidence to deliver on our commitments.

I believe we have positioned ourselves well in the first half.

We continue to be focused on our customers, and have the talent to drive results and execute against our strategic priorities.

Operator, let's now go to the questions.

(Operator Instructions)

We'll take our first question from Eric Percher from Barclays.

Please go ahead.

Thank you.

With FX called out as one of the key elements to hitting the higher end of guidance, could you speak a bit to the exposure in FX now with Cordis under your control and some of the elements of scale or maybe impact at the top line, as well as offsets at the profit line?

And maybe also touch on Canadian exposure?

Yes, Mike, why don't you -- good morning, Eric.

Mike, want to grab that?

Eric, as you can imagine, with a Company with our breadth, not only in our commercial operations overseas, but we also have manufacturing operations overseas.

So, we are seeing FX be both positive and negative, depending on which country we're talking about, and whether or not we're talking about on the manufacturing side or on the commercial operations.

And so, clearly with Cordis, we are getting some additional exposure with FX, with 70% of that business being overseas.

But to be able to actually get into any detail about how that FX will be impacting our Business exactly, it's really difficult to do that, and not something at this time that I'd be comfortable with talking about.

But it's something that we'll take a look at as we go forward, and decide how much more color we can provide.

As you're considering that color, at this point is there a general rule of thumb that you've thought about, maybe even pre-Cordis, in terms of when you see the exchange rate moving, how much is naturally offset because of their location of operations?

No, I wouldn't say there's a general rule of thumb.

As one moves one direction, often other ones could be moving in other directions, so it's very difficult.

Also, as you can imagine, with us just starting up with Cordis, we're just beginning to ramp up our hedging strategies, and taking a look at all the things we can do in terms of hedging to be able to make sure that we have more consistent earnings.

So, it's just so early with the changes in the mix of our Business.

It's hard for me to be able to provide you a lot more detail than what I said, which is that right now we see FX as a little bit of a headwind in the second half of the year.

But other than that, I really can't give you more details.

Operator, next question?

We'll take our next question from Ricky Goldwasser from Morgan Stanley.

Mike, I think you mentioned that to arrive at the high end of your guidance, generic manufacturing needs to be at a certain level.

Can you just give us more color on your assumption at the high end of the guidance range?

Around generic pricing, do you assume that it's going to accelerate from current levels, stay the same?

Also, at the low end of the guidance range, what are you assuming for generic inflation?

Thanks, Ricky.

I would tell you this: I think, what we were trying to communicate there was that, right now, we're assuming that the moderation of generic pricing is steeper than we originally modeled at the beginning of the year.

So, generic pricing we expect to be a little bit more of a headwind in the second half than we had originally anticipated.

Now, as I have mentioned, there's other things going in the direction, which is why we reaffirmed our overall guidance.

But the two things that we think that would need to go back to more similar to the first half would be FX and generic pricing.

If they were to return to more similar levels, as where they were in the first part of this fiscal year, then that would enable us to get to the very high end of our non-GAAP EPS guidance.

And, Ricky, it's George.

As a reminder, and I know I do this probably every call, but it's really important: This is a huge number of products in this line, so it doesn't take -- that's one of the challenges always in modeling is that it doesn't take that many products moving to alter the overall equation.

But in the big sense, it tends to be driven by a small percentage of the overall total of products.

Okay.

Just one follow-up, just because there are a number of moving parts in the quarter.

So, can you quantify for us what same-store top-line growth for distribution segment after you normalize for Metro and for Harvard and for the new Optum business, and also on the EBIT line, what we think about as normalized growth for the distribution segment?

Go ahead, Mike.

That would be hard to do, Ricky.

Clearly, Harvard, Cordis, Metro Medical are all providing revenue uplift for us.

But other than the fact that we've said they are one of the components of our revenue and earnings growth, we still are just having really robust activities and growth with our existing and new customers.

And to split that apart would be difficult, and not something I think would be right for us to do right now.

I would probably add -- if you look at the revenue line, the contribution is not overwhelmingly coming from those forces.

It's really our core business, and our customers and new customers.

Operator, next question?

Okay.

We will take our next question from Ross Muken from Evercore ISI.

So, it feels, on the Medical side, like we're trending in a much better direction.

As you think about -- on the basis -- so, let's put Cordis aside for a minute, seems like the home piece is doing well.

On the traditional base business, if you look at maybe ex what happened in Canada, where do you see the key trends that are moving in the right direction?

And where do you feel like you've met plan versus are there any areas in that piece where you actually feel like you've exceeded plan?

Good morning, Ross.

This is George.

I'll take that.

And, Mike, jump in.

I think the underlying characteristics actually feel as good as they have in some time.

I think partly the value proposition across our lines of business, Ross, helps us to sell the individual lines of business, because I think what -- we're going to our customers, who basically have very new kinds of strategic and financial needs, with a line of products and services that I think touch those hot buttons.

And I think, increasingly, that just allows us to strengthen the position of each of the lines.

So, our underlying Business feels like it's going pretty well.

Of course, it's always competitive out there, but I think we've done a good job of articulating that value proposition.

We've also done a good job, I think, Ross, in some of our legacy lines of improving efficiency and reducing cost where necessary.

And I think that was also an important thing for us to do over this last year.

So, I think, in general, we feel good progress along many of the lines in the Medical segment.

That's helpful, George.

And again, just sticking on Ricky's theme, because I think the heart of what everyone's trying to figure out is, amongst the three players, each of you obviously have slightly different generic businesses and transact slightly differently.

And so, can you help us understand?

It seems like Cardinal has weathered this storm, at least relative to one of your peers, better, in terms of a change in the market, and you've had a more balanced portfolio in generics.

Could you just help us philosophically understand maybe some of the differences, at least as you see it, for Cardinal relative to the peers?

I'll try to stay to Cardinal.

It's really -- it's tricky for me to try to speak for peer group, and I shouldn't, and probably won't.

I think, what I would say is that, as you guys look at peer groups -- again, we have many different competitors in different lines of business, and I always have to remind you of that.

But I think every business is different.

Everybody's product line is different.

Their product mixes are different, and their customer mixes are different.

So, from our standpoint, we have devoted a lot of energy over these last seven years to positioning ourselves, both in terms of product line and in terms of customer mix, to be on what we think are the right side of trends.

And so, again, this is not a -- for me, a comment on anybody else, but on our Business.

I think our teams have done a good job of segmenting our markets, understanding what their needs are, and how we can attach value from our work to theirs.

It's been a long process, but I think we're generally doing that fairly effectively.

So, it's a hard question to answer as a comparative answer.

But I think I can describe our Organization, which is very much focused on certain key trends, and we have been for quite some time, and then really disciplined execution around priorities that tie to those.

I would just add that I think that we've been really focused on the day-to-day blocking and tackling, as well as the strategic priorities that we're on.

So, when it comes to things like focused on our SG&A, to really making sure that we're investing in the right places and controlling that, staying insanely focused on the customer to deliver value to them, and listening to what they need, I really like what both the M and the P teams are doing there.

Then you take a look at the acquisition, on the acquisitions, and how we're performing on those has been excellent, and then overall just execution against our strategic priorities.

So, all those things also I think are helping contribute to our success.

Operator, next question?

(Operator Instructions)

We will now take our next question from Charles Rhyee from Cowen and Company.

George, you mentioned earlier about your physician preference item strategy here and the shift to value-based care.

Can you talk about where your customers are in this progress?

If you look at targets from CMS and et cetera, it looks like there's aggressive targets out there, but hospitals might be moving at a little bit of slower pace here.

Can you talk about how they are viewing it, and how that fits into your strategy, and when we could maybe see maybe acceleration and driving into your numbers?

Thanks.

Sure, I'll try.

Good morning, Charles.

This is a process.

Obviously, we have an enormous healthcare system that's been operating with a certain financing model for many, many years.

Change doesn't happen overnight.

We don't expect it to.

I think what's going to happen is -- it's a process.

We'll be living in a world in which both the fee-for-service model exists, and alternate models are emerging.

I think, again, you can look around the country at different health systems, and they're all responding differently.

There are, of course, pressures from, as you said, the public and the private sector to move to some new financing models, which focus more on outcomes than activity.

I think everybody's at a different stage of adapting to that.

What we've tried to do is make sure we're in a position to compete in either model.

In a fee-for-service model, we know how to do that.

I think we're very, as Mike said, disciplined about that.

But we have started to build some tools that allow us to be a valued partner in models that are emerging.

As you're describing, it's a mixed bag around the system, but the pressures to move toward some kind of value-based model exist.

That's probably true here; it's probably true elsewhere in the world, as well.

Great.

And just to follow up, can you talk about M&A opportunities then?

As you keep trying to build out your capabilities here, how do you see the landscape, and just in your capabilities to tack on it?

Thanks.

Look, for us, this is very hard to comment on.

I would say this: As Mike highlighted in his commentary, we've got great financial flexibility.

But, for us, it's always a question of strategic positioning, whether or not we see opportunities to enhance the capabilities, the scale, the efficiency of some operation we do or some market that ties into some value that's really connected to a customer need.

We'll continue to be open-minded about that, as we have been.

I don't think our view has changed as it relates to the overall balance of our capital deployment.

We will look at that as one of the tools, and we'll continue to look if the opportunities are right.

We have the financial flexibility to do that, and I think organizational capacity.

I agree.

Our capital deployment policy hasn't changed.

We still believe that CapEx is obviously number one on our list, and then continuing with our differentiated dividend.

Then we're going to look opportunistically at both M&A and share repurchases.

And as George said, we're going to stay balanced and disciplined on that.

Operator, next question?

We'll take our next question from Lisa Gill from JPMorgan.

George, just really want to follow up -- or Mike -- want to follow up on thoughts around the Medical segment.

Mike, I think you made a comment that Cardinal Health products grew again this quarter.

Can you give us an idea of what you've seen from a growth rate perspective?

And then secondly, I think you have a [rule] out in the marketplace around where you can get the margin on the Medical segment over time.

If I back out the one-time item around inventory step-up in the quarter, it looks like the margins are trending just above 4%.

So, can you talk to us about how do you reach that goal of above 5% over the next couple of years?

Is it the private label product?

What are the things that we need to see in that segment, and do you feel like you're on target for reaching that goal?

Let me start with first a couple things.

I think, first of all, our Cardinal Health brand products, even if you pulled out Cordis, still were able to grow.

So, we were excited about the execution of the team being able to sell those products.

So, important to note: Even without Cordis, the Cardinal Health brand products did grow.

As you know, there's many margin initiatives in Medical that we can get to go after, getting to our aspiration of 5.75%.

And as you know, by definition, an aspiration means it's something you think you can achieve, but it's hard to reach, and something that you've got to execute and get a lot of things done to do.

We're not backing away from that aspiration.

But it's not only growing the Cordis products; it's the other Cardinal Health brand.

It's growing the at-home business, which also had a nice revenue growth this quarter.

It's also our services businesses, which tend to be higher margin rates.

And we've always said all along that to get to that rate, there would probably be additional M&A to get there.

So, we're going to continue to evaluate, in a very disciplined way, other M&A opportunities to reach that goal.

If we think about the comments that you made, additional M&A around [fit to recycle], but do you feel like operationally you're where you wanted to be as we think about the margin today, or do you see more enhancements that you need to do in your core business, outside of acquisitions?

I don't think -- whether it's Don or Jon or George or I or any of us -- are ever operationally where we want to be.

We're always striving to get better.

That's what I think makes us as successful as we have been lately, is that we're always focused on getting better.

But I do like where we're at on the Medical side, as far as how they're executing on all those things I mentioned earlier, like services, like the current products businesses, launching new products ourselves and our more commodity-like lines, as well as driving our higher physician preference items.

So, I don't know, George, do you have anything else?

I think that's right.

Lisa, we're going to be -- I think one of the things that you hopefully will see for us is we have tried to adapt quickly, where we need to.

So, for example, we talked about the legacy business on the med/surg side.

We had to make some moves to tighten the reins there in certain parts of it, manage the expenses differently, but also manage the mix differently.

A lot of this is about that discipline to manage both on the expense side, but certainly the mix of products.

And so, I think that's an effective and important tool, and we can still get better.

We will take our next question from George Hill from Deutsche Bank.

Mike, I wanted to follow up on Ross's question a little bit.

When we think about generic inflation, can you qualitatively talk about the buckets where you monetize either the inflation or the deflation, the buy-side margin, the sell-side margin, the carry margin?

And how should we think about the importance of each of the buckets or the sizes of each of the buckets?

Obviously, George, I won't be able to get into lots of detail, but I'll give you a little bit of information to see if I can be helpful.

First of all, we can make money in both an inflationary environment on generics, or a deflationary environment.

Historically, generics has been a deflationary environment, and we've been able to make money in that.

I look at is as two ways.

Think about it this way: When generics are going up in price, you do make some inventory revaluation income, or some people call that buy-side margins.

And so, in a deflating market, you don't make the upside on the inventory inflation, but you're protected from any inventory exposure.

You get floor stock adjusted.

So, you basically, in an inflating environment, make the money on the extra bucket of money on the inventory inflation.

But in both environments, you're able to reprice to the customer, and be able to adjust your pricing in order to work on your margins.

But I think one of the keys you have to remember: Whether you're in an inflationary or deflationary environment, every single day, our goal is to keep our customers competitive.

And our pricing is based on what we need to do to be able to sell the products and keep our customers competitive, as they look at things like reimbursement that impact them every single day.

So, that's really important to us.

And there's a lot more levers than just generic pricing.

As I mentioned before, our ability to launch drugs effectively, penetrate current customers and existing customers; Red Oak has clearly been a driver of our ability there.

There's just a lot of pieces that go together, and it's hard to disconnect any one of those and try to quantify those when it's all blended together.

That's helpful.

And then maybe a quick follow-up on one of the other levers is, you hear a lot of also small- and mid-size brand drug manufacturers complaining about the fees that they pay to the wholesalers to access the channel.

I know that brand drugs as a portion of the margin -- as a portion of the total segment margin -- are a smaller piece.

But how should we think about how important those fees from the smaller- and mid-size branded guys are, and what's the risk to that segment of that Business if they're consolidated away?

And I'll hop off, thanks.

I think all of our manufacturer partners are important to us.

We work really, really hard to make sure, no matter what size you are, whether you're in Medical or in Pharma, that you're seen as important.

That's one of the things that Red Oak has done a good job of is also -- is working hard to treat every manufacturer like an equal partner.

As you think about the pricing, sure, I think most suppliers were always going to say that their fees are too high, but we're very, very disciplined about how we charge our fees.

And we look at things like line extensions, whether they're control drugs, whether they're refrigerated drugs -- all those different costs that we incur that they would have to incur that if they were to go direct, we look at those to understand what we should charge as a fee.

And so, we work incredibly hard to make sure that we don't charge fees to manufacturers that would be more expensive than them going around us.

And so, I feel really confident with our model and our pricing that we're the most efficient way of getting products through the supply channel.

I don't see any country that's more efficient or any supply chain that's more efficient than the United States.

And I think the other piece is, I can't even remember the last time there's been any significant supply chain integrity issue in the US.

And so, that, to me, is incredibly important.

George, I'd like to follow up again, just having had some experience outside the US.

The supply chain for pharmaceuticals in the US is the most efficient, has the highest line item fill rates, is the safest, and is the most secure in the world.

I think that this is something that is important to our partners.

We actually generally hear very positive things from them about that work, and that's important in terms of our value proposition.

Operator, next question?

We will take our next question from Dave Francis from RBC Capital Markets.

Sorry to keep going back to the pricing well, but given the focus everybody's had on it of late, I had a couple more questions.

First, from your seat, George and Mike, how are you seeing your end customers in the marketplace -- whether it be health systems or PBMs or retailers -- how are they reacting either strategically or operationally to the changing price dynamic in both the brand and generic baskets?

And how is that affecting your Business particularly?

It's a hard question to answer because it really depends what seat you're in.

I do think that, as Mike described, all of our customers are influenced by the reimbursement dynamics -- how they're compensated -- and that can come either from the private sector or the public sector.

I think what can be worrisome to them is when there's lags between how they get compensated in reimbursement -- not just time lags, but lags in general, between what their costs look like and what their reimbursement looks like.

So, we just try to stay very close to it.

It can vary by product, and it can vary by different classes of drugs.

But I do think it's an environment in which -- as you have all said, a lot of attention on this.

We try to stay very close to it.

I think, we pride ourselves on having a certain intimacy with our customers, and understanding where they are.

We try to make sure that we do everything that we can to put them in a position to be successful in serving their patients.

A lot of it has to do with reimbursement dynamics, and what's happening around financing models in the system.

I think also, Dave, just so you know, I think while costs and reimbursement are obviously incredibly critical to our customers, there's a lot of other services that we provide that are helpful to them.

Helping them take capital out by helping them manage their inventory, helping giving them a broader array of private label products or physician preference products, or helping them with various types of programs to run their business are also critical.

So, we try hard to find more than -- while we focus incredibly hard every day on having the best cost to provide great pricing, there's a lot of other pieces that are critical.

Just to add one piece to that: One of the things that we find is that the absence of standardization around healthcare is often a source of inefficiency.

One of the things that we've been able to help many of our customers do is standardize, like, for example, around consumable products.

When they do that, that tends to be much more cost effective, and so that's one of the tools that we use.

And a quick follow-up, just to put a fine point on it, understanding there are a lot of moving pieces in it, but would you characterize the overall generic basket today as still being moderately inflationary, or have you seen it gone deflationary?

It's clearly moderated significantly.

So, I would say it's very close to -- right -- almost a wash in between right now -- what we're seeing right now.

So, it's hard to say whether it's slightly inflationary or slightly deflationary, depending on the day of the week and where you are.

But it is clearly moderated steeper than we had said.

But again, while it's moderated more than we expected it to, we're doing really well overall in our overall generics program, and like the other components that are delivering valuable.

Dave, as a reminder, because you describe the overall basket -- just as a reminder, the overwhelming majority of products are moving the way they typically move.

And then, what tends to swing the total or the net aggregate is just a relatively small basket of products.

I think that's probably worth noting all the time -- thousands of products that are moving fairly typically.

Next question, operator?

We will now take our next question from David Larsen from Leerink.

Can you talk a little bit more about the Pharma operating margin itself?

It looks like revenue was good in the quarter, but according to our model, it looks like an 18-basis-point contraction year over year, and a slight decline in operating profit itself on a sequential basis.

Any more color around that?

Is that new customer starts, or is it all generic inflation, or have you changed the way that you're pricing new business, what Dave Francis was asking about?

Thanks.

No real fundamental changes to the way we're pricing, or the competitive environment, or anything like that.

This is merely -- the 18 basis points is really -- the majority of it is the addition of a new customer that was added in the quarter.

That was at lower margin rates.

Remember, we talked about this, and that this is a situation while the margin rates are lower, the amount of capital that we deploy is incredibly efficient.

And so, we're willing to take lower margin rates when we have the ability to match our capital effectively.

As far as the sequential drop, remember last quarter, we did mention that there was about $0.11 in that quarter that we said were like one-timers; part of it being those generic items that were operating a little bit differently than we anticipated.

And then also, we had the acceleration of some of the benefits of our M&A in the quarter that was a little bit better than we thought.

So, if you think about $0.11 of extra in last quarter, the reason we talked about that then, it was to give you some insight that was a way to think about how this quarter would be.

So, this was very much in line with what we expected for this quarter.

That's very helpful.

Thanks a lot.

You made some comments I think on the Cardinal home health business growing, I think, double digits year over year.

Is that the top-line organic growth rate -- the home health business is growing over 10% per year on the top line?

Is that correct?

Yes, that's top line.

Operator, next question?

Okay.

We will now take our next question from Garen Sarafian from Citi Research.

On branded Pharma contracts and inflation, Mike, you had mentioned last quarter that you try to proactively manage those agreements, and I'm assuming you had at least some contracts that were up for renewal at calendar year end.

So, could you elaborate a bit on how those conversations have changed in any way, even if -- I think you mentioned that they were broadly in line, in the prepared remarks?

Thanks for the question, Garen.

I wouldn't say anything's different.

I'm not getting a different sense from the manufacturers.

There's always a good negotiation, every time one of these happen.

Everybody wants to pay lower; we want to get paid more.

We spend a lot of time talking about the various dynamics of the manufacturers' mix, and whether their line extension's gone up or down, whether or not they've changed their mix as far as control drugs or refrigerated items.

So, we work through all those.

We have incredibly productive relationships with our manufacturers.

And so, I would tell you that the way these are going, still trending the way they have historically, and they're still about 80% or so of the margins are coming from a non-contingent standpoint, and roughly 20% or so are coming from what we call a contingent basis, which means that inflation can drive the actual value of the dollars when we talk about contingent versus non-contingent.

Got it.

Great.

And apologies if I missed this in your prepared remarks, but on you having raised the high end of sales guidance, did you mention which segments or specific businesses you're seeing evolve more favorably?

Thanks a lot.

Our revenue overall was an overall revenue guidance increase.

But as you can see, obviously the Pharma segment has performed well; but with the addition of Cordis and some other good activities, Medical also had a good top-line growth.

That was an overall to go from mid-teens to mid- to high-teens.

We will now take our next question from John Kreger from William Blair.

This is Robbie Fatta in for John today.

Thanks for taking the question.

You mentioned earlier in the call that there were a few things on the generic side that are offsetting the inflation rate moderation.

Can you flush that out a little bit?

Perhaps give us a sense of what percent of customers are currently still buying direct versus how many have shifted to buying through the channel?

I won't be able to do that.

I know that's a question, but go ahead, George, do you want to comment?

Why don't you take the first part, which is the moving parts.

From a moving parts standpoint, I would tell you that the two things that we said would moderate this year, as we've talked about a couple times, was generic inflation.

As I've mentioned, it's moderated a little bit more than we had modeled.

We expect generic launches for this year to be slightly less than this past year.

But in terms of, overall, our ability to source products is doing better.

Our ability to penetrate existing and new customers is going very well.

Our use of data and analytics, and how we price our products, is going really well.

So, when you wrap it all together, I still feel like our overall generics program is performing about as we expected, but it's just coming in a little bit differently.

Other than that, I really can't split it down more.

Actually, even if I wanted to, it's incredibly difficult because they're all so inter-related on how we work with customers.

It's very difficult to split it apart.

Robbie, I'll try to touch on one part of your question, which was -- those customers that source generics from us.

I think, if you look at our numbers, it's pretty clear that has increased for us.

I do think the market recognizes that, particularly given the strength of our capacity in working through Red Oak, that we're a very attractive partner.

So, I think there are many customers in the system that actually have done, for years, a blend of buying generics -- some directly, some through distribution partners.

And so, even small swings in those percentages can be beneficial to us.

We think our value proposition is very strong, as Mike said, and getting increasingly strong.

So, we're hoping that we can continue to attract those customers.

Great.

Thanks very much.

One quick one on Medical, if I could?

Is there any update on what commodity-related tailwind you might see in the coming quarters, if oil remains low?

Remember, too, the oil price that you see every day is more of a spot market versus more the forward curves.

But at the beginning of the year, we had mentioned that we thought commodities would be a $10 million to $20 million good guy for us this year, and that's still tracking essentially as we said it would at the beginning of the year.

And the other thing to remember is that we've employed a host of hedging strategies.

We've renegotiated our contracts over the last several years with manufacturers, as well as, if you look at the overall supply line and our commitment to inventory, it takes about six months before any type of changes in commodities will have an impact on us.

And then last bucket is that we have a lot of different commodities, and not all move with oil.

And so, where probably 5 to 10 years ago, oil was a much better proxy for how our commodities would go, it's very different today when you look at our mix of commodities that we buy.

Many of them do not move in correlation with oil at all.

Operator, next question?

We will take our next question from Steven Valiquette from UBS.

I guess just from me, one question that we keep getting from investors -- this relates to Red Oak a little bit -- but without going into specific details, investors keep wondering, is there anything maybe mechanical about Red Oak that perhaps smoothes out your generic profits, where perhaps Cardinal made a little bit less profit during the big generic hyper-inflation quarter, but maybe it shields you a little bit on the way down on generic pricing.

Or, if there is a better smoothing of generics profits for Cardinal versus peers, as some investors perceive, does it maybe have nothing to do with Red Oak in your view?

Just curious if you want to offer any additional color on that?

Thanks.

I think it's a little bit Red Oak.

This was really pre-Red Oak was that, probably about four years or so ago when we were re-evaluating our overall way we buy generics, we made a very conscious decision that we would cut back on our spec buying, and the way we managed inventory with generics.

And we really want to focus on -- how can we be the best possible partner for our generic partners?

And trying to manage inventory more from a supply standpoint versus a pricing standpoint was a way that we felt that it would go.

It was better for the manufacturers, and we thought over the long run it would improve our relationships, and hopefully make them stickier, as well as lead to a better everyday low price for us.

And so, we did that.

And that philosophy was also shared by CVS when we formed Red Oak, is that our focus is, at Red Oak is, how can we be the absolute best partner to our manufacturers?

Obviously, we want to get a great price, but we want to be transparent, we want to be easy to do business with, we want them to want to come do business with us.

One of that way is helping smooth out fluctuations in the supply chain, which is something that we've done for a while that I think maybe has made us a little different from an exposure standpoint to declines in pricing.

Okay.

So, maybe it's just a little bit less forward buying versus your peers that, again, didn't necessarily have to do with Red Oak, but forward buying?

It's hard for me to say what my peers were doing.

I won't comment on what they were doing.

But I can just tell you that, for us, managing inventory more around being a great partner and making it efficient in the supply chain was the focus for us, versus other types of activities.

Thanks, Steve.

Operator?

We will take our final question from Eric Coldwell from Robert W. Baird.

Question -- first question's around Pharma -- very strong growth in the quarter, couple of billion of upside versus Street.

Seems like that was probably your net-wins-driven, but can you give us a sense on the M&A impact in Pharma, in terms of percentage points of growth, and also maybe your best estimate of what your same-store trend might be, excluding net wins and losses?

I would tell you that the majority of our growth was growth from our relationships with new and existing customers.

Acquisitions were a smaller contributor of our overall growth.

But that's the best I can give you in terms of trying to size the two.

Eric, just as a reminder, we have tens of thousands of customers.

And so, again, small movements in those customers can be meaningful.

Of course, as you know, in the branded side, over the last [years], have seen a lot being driven by some of the important new products in the system.

So, we shouldn't ignore that, as well.

That's fair.

Just quick follow-up: We didn't hear much about the Henry Schein relationship.

I'm just curious if you could give us a sense if that was a driver of your Cardinal brand growth in the quarter, and how that's tracking to date?

Again, pleased with the relationship.

I wouldn't say economically yet a big driver, but definitely positive to be able to sell many of our Cardinal brand products through these additional channels.

So, we really look forward to greater growth there.

And again, it's early, but it's off to a pretty good start.

Operator, is anybody else in queue?

No, there is not.

I will turn the call over to George Barrett for closing.

Sure.

Thank you, Bethany.

Again, just in summary, I think we're off to a really good start to the first half of our FY16.

We thank all of you for joining us this morning and for your questions.

And I look forward to seeing many of you in the coming weeks.

And with that, we'll close the call.

Thank you.

At this time, this does conclude today's conference.

Thank you for your participation.

You may now disconnect.