卡地納健康 (CAH) 2017 Q1 法說會逐字稿

Good day and welcome to the Cardinal Health first-quarter FY17 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, Ashley, and welcome to Cardinal Health's first-quarter FY17 earnings call. As a reminder, during Q&A please limit your questions to one and one follow-up so we may get to everybody in queue. We'll do our best this morning to get to everyone, but if we don't please feel free as always to reach out to the IR team after this call with any additional questions.

Also 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 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. In terms of upcoming events, we will be webcasting our 2016 annual meeting of shareholders on November 3 at 8:00 AM Eastern at our presentation at the Credit Suisse 25th Annual Healthcare Conference on November 8 at 8:30 Mountain Time.

Today's press release and details for any webcasted events are or will be posted on the IR section of our website at www.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 all of you for joining us.

Allow me to start by being direct. Our first quarter of FY17 certainly had its share of challenges, but it came in much as we suggested to you that it would, with healthy and growing revenues up 14% versus the prior year and non-GAAP operating earnings down 9% versus the first quarter of last year.

I'll focus my commentary on the broad outlook for our business and our future, and Mike will walk you through our financials for the quarter with more detail and specificity. Let me frame the start to our fiscal year with two lenses. One, the operating performance of our integrated business lines, and the other, the environment in which we compete.

Our teams continue to demonstrate their commitment to strong operating performance. Our service levels are extremely high. We are experiencing very high rates of customer retention and our enterprise-wide customer reach is expanding, including the on-boarding of some very strategically important customers in the med segment.

We also continue to launch new products and service offerings, increasing our value to our customers as they navigate significant change in the industry. And as is embedded in our DNA, we are taking a disciplined and determined approach to managing our working capital. But make no mistake, this is a very challenging near term environment. This is particularly true for our pharmaceutical distribution business.

The public discourse around drug pricing has, at least for the moment, had a significant impact on the way pharmaceutical companies are pricing their products on both the branded and generic side. Combining this with limited generic product launches and significant reimbursement pressure on our customers, the competitive intensity has increased.

As a result, price erosion during the period has been more pronounced than it has been in quite some time for our industry. Our commitment has been, and will continue to be, to providing world class service, tools, technology, and solutions to help our customers thrive in a challenging environment and better serve their patients. This is central to our value proposition.

At the same time that our retail pharmacy customers are experiencing unique dynamics, we are also working closely with our large integrated system customers to help them adapt to a changing environment, one where pressures to be efficient are relentless, where the configuration of their own businesses and portfolios are more complex and where the need to operate across their own internal boundaries is a high priority.

As a result, the historically siloed, or departmentally-driven operating model is evolving to one that places a premium on operating coordination across the system and strategic alignment with other healthcare players who can enable their strategies. This is who we are. Our focus is on finding more efficient and of effective ways to create real value for our customers across our lines of business.

Today our customers look to us for our integrated solutions to help them reduce costs, increase efficiency, and improve quality. All of this requires deep, multidisciplinary healthcare expertise and real strategic partnership, which we deliver every day for those we serve. These are the characteristics of the moment. Some very encouraging, others creating short-term headwinds.

Of course, I'd like some of that to be different, but this is the environment in which we must compete now. We will play for the long game with the strategic eye on the future, mobilizing the best talent and building the right lines of business to help our customers compete in this changing world.

With this as backdrop, and modeling in an adjustment for the current pricing environment, we are slightly lowering our FY17 non-GAAP EPS guidance to $5.40 to $5.60, from our prior range of $5.48 to $5.73. Let me be clear. We remain committed to navigating today's challenges, embracing tomorrow's opportunities for our customers and shareholders.

Within our pharmaceutical segment, revenue was up 14% versus the prior year to $28.8 billion. Segment profit declined 19% versus the prior year to $534 million. This was primarily driven by generic pharmaceutical pricing, reduced levels of branded inflation and the loss of Safeway, which we previously discussed.

However, the work that we have done over the past few years has strategically positioned us to more effectively support our customers. The range of our retail service offerings has never been stronger and the Red Oak Sourcing venture with CVS Health continues to be an effective, productive and profitable partnership. We see this as a long-term driver of value for us and our customers. Our Specialty Solutions Group continues to perform well, driven by both our provider-facing and biopharma offerings. Once again, showing strong double-digit growth.

We are confident that our growing portfolio of services is well aligned with and valuable to the strategies of our biopharmaceutical partners. I want to thank John Jochman and his pharma segment teams for their commitment to navigating these challenging dynamics and remaining focused on our customers, with a clear eye towards managing efficiency.

Our medical segment had a strong first quarter across multiple dimensions. First, revenues for the medical segment were up 12% versus the prior year to $3.3 billion. Second, segment profit was up 26% versus the prior year to $127 million. And third, our medical segment customer base has been expanding, a testament to the value we've created across our lines of business and the strong partnerships we've developed with our customers.

Every day we see our customers focusing more on the total care of the patient and they recognize the growing shift to value-based reimbursement models. Discussions with our customers reinforce that they are looking to us as a broad based integration solutions provider and a source of expertise across the continuum of care. Our Cardinal Health branded products continue to be a driver of growth for the segment as we increase our account penetration and growth in our strategic accounts is outpacing the market.

During the quarter, we on-boarded a large complex customer in our medical segment. We learned a lot from this rapid deployment and we are very grateful both to our employees and to our new partner for working together to move us toward the finish line.

October 2 marked a year since we closed the Cordis acquisition. John Casey and his team have done a tremendous job leading the integration, thoughtfully phasing in new systems and processes and building out an important platform.

The integration of Cordis has proved to be an excellent example of how we can bring together best practices across borders. We have seen over this past year, that taking the time to do things right is essential to best serve our customers. We have also seen growth in some important markets including Europe, where we believe that taking an integrated cohesive approach to our customers will position us for measurable growth over the long term.

Cordis is also providing us with additional partnership opportunities to build out our products, tools, and services. As an example, we have signed an exclusive distribution agreement with Biosensors, to bring their coronary interventional products to our customers in Europe and Japan as another offering in the bag to deliver even greater value. While we are operating today in a tough and unique environment, we believe that we are well prepared to lead and quick to adapt.

By working with our customers holistically, driving our own efficiencies and delivering integrated, effective solutions we've developed strong partnerships with our customers. We remain committed to focusing our product lines and capabilities around the patient to position ourselves to capitalize on the changes in our industry. And to the collective drive and dedication of our 37,000 people, we'll continue to deliver meaningful results and measurable growth for our customers, patients, and shareholders.

With that, I'd like to turn the call over to Mike for a detailed review of the financials. Mike.

Thanks, George.

And thanks to everyone joining us on the call today to discuss the first quarter. I'd like to begin by reviewing our first quarter financial performance and then walk through our full year FY17 expectations. Please note that with all of my comments, I'll begin with GAAP and then provide the comparable non-GAAP figure.

The slide presentation on our website should be a helpful guide throughout this discussion, as it includes our GAAP to non-GAAP reconciliation tables. Our first quarter FY17 results were about as we expected, with GAAP diluted EPS at $0.96 and non-GAAP EPS at $1.24, a 17% and 10% decrease respectively.

In our August call, I mentioned this would be due to some challenging trends and some tough year-over-year comps, particularly on some key generic items in our pharmaceutical segment, as well as discrete tax items, partially offset by strong performance in the medical segment. And that's largely what we saw.

I'll discuss both segments in greater detail later, but let me start with consolidated Company results. Revenues increased 14% year-over-year, totaling $32 billion. Total Company gross margin dollars were up 1% versus the same quarter in the prior year. Consolidated SG&A increased 9% versus the prior year, primarily driven by strategic acquisitions. If you exclude acquisitions, SG&A was favorable for the quarter. Both consolidated GAAP and non-GAAP operating earnings declined versus the prior year by 14% and 9% respectively.

Moving below the operating line, net interest and other expense was approximately $41 million in the quarter, a decrease versus the prior year. The GAAP effective tax rate for the first quarter was 37.3%. Our non-GAAP effective tax rate this quarter was 36.4%, which is 3.5 percentage points higher on a comparative basis, primarily due to several favorable discrete items that occurred in last year's first quarter. We continue to expect our full year non-GAAP effective tax rate to be between 35% and 37%.

Our first quarter diluted average shares outstanding were 322 million, about 9 million shares fewer than the first quarter of FY16. This was due to the benefit from our opportunistic share repurchases over the last 12 months, which includes $250 million of share repurchases in the first quarter. We have just under $800 million remaining on our Board-authorized share repurchase program.

In addition, we generated approximately $104 million in operating cash flow during the quarter. And due to efficient and effective working capital management by our teams, we ended September 30 with a strong balance sheet. Our cash balance, including short-term investments, was $2.2 billion, of which $622 million were held internationally.

Now let's move to segment performance, starting with pharma. Our pharmaceutical segment revenue increased 14% to $28.8 billion. This increase was from growth in net new and existing pharmaceutical distribution customers, driven mainly by the win of a previously announced large mail order customer and the impact of branded inflation. While a smaller driver, the strong performance of our specialty business, also drove the revenue increase.

Despite the revenue growth, segment profit for the quarter decreased 19% to $534 million. This decrease was a result of generic pharmaceutical pricing and to a lesser extent, reduced levels of branded inflation, as well as the previously announced loss of a large pharmaceutical distribution customer. This was partially offset by solid performance from Red Oak Sourcing. These same factors, as well as changes in our product and customer mix, mainly the on-boarding of a previously discussed large mail order customer, reduced our segment profit rate by 76 basis points to 1.86%. As a reminder, next quarter we will fully lap the on-boarding of this large mail order customer.

Getting back to Red Oak, as we've mentioned in the past, if it achieved certain milestones it would trigger the second of two predetermined payments beginning in FY17. Because of excellent performance, Red Oak met these milestones, though we've made our second and final $10 million increase to the quarterly payment to CVS Health beginning in Q1.

As anticipated, our new quarterly payment is $45.6 million for the remaining eight years of the agreement. Let's now go to medical segment performance, which had a strong first quarter. Revenues for the quarter grew 12% to $3.3 billion, primarily driven by contributions from our strategic acquisition and growth from net new and existing customers.

Medical segment profit increased 26% to $127 million during the quarter, due to contributions from acquisitions and Cardinal Health brand products. Segment profit margin rate increased 42 basis points in the quarter to 3.87%, driven by acquisitions and Cardinal Health brand products, partially offset by the change in customer mix. This change primarily comes from the accelerated on-boarding of a new large medical distribution customer.

The recent wins in the medical segment on the distribution side are exciting and very important. They add to our profitability, but are dilutive to our medical segment margin rates. Specific to Cordis, it continues to meet our performance expectations and make real and measurable progress.

As we mentioned last quarter, our integration team is on track to have our operations fully stood up and exit the TSA agreements, by the end of this fiscal year, while our transition manufacturing agreements will extend for a couple of years. Until we exit these TSAs, they can create some variability in our segment profit rate, although this quarter it was about on track. Overall, our team has done an outstanding job driving strong, healthy growth in the medical segment.

Before moving to our FY17 outlook, you can turn to slide number 7, where you'll see our consolidated GAAP to non-GAAP adjustments for the quarter. The $0.28 variance to non-GAAP diluted EPS results was primarily driven by amortization and other acquisition-related costs.

Next, I'd like to discuss our FY17 non-GAAP earnings guidance range and assumptions. Before doing that, let me comment on Q2. While we don't typically provide quarterly guidance, we want to keep you informed when there are meaningful shifts. So as it relates to the second quarter, the generic pricing environment, and to a lesser extent the brand inflation rates, lead us to now expect the second quarter FY17 pharma segment profit decline to be relatively in line with the first quarter on a percentage basis.

Now, you can follow along starting on slide 9 of the presentation. As George mentioned earlier, based on Q1 actuals, second quarter expectations and trends we noted, we are slightly lowering our non-GAAP earnings per share guidance range we provided in August to $5.40 to $5.60 -- from $5.48 to $5.73.

Let me give you some color around this adjustment by walking through our corporate and segment assumptions. Turning to slide 10, all but two of our FY17 corporate assumptions remain unchanged. First, we have updated our weighted average shares outstanding assumption to 320 million to 322 million shares, which is lower than the initial range provided of 324 million to 326 million shares. This new range reflects potential additional repurchases.

Second -- our assumption for acquisition-related intangible amortization increased to approximately $385 million, or about $0.79 per share. That does not affect our non-GAAP earnings.

On slide 11, there are three updates to our full year pharmaceutical segment assumptions that I would like to take a minute to highlight. First, we previously expected pharma segment profit for FY17 to be essentially flat. We now expect full year segment profit to be down mid to high single digits versus the prior year, due to the generic pharmaceutical pricing environment, and while much less of an impact, lower than anticipated brand pharmaceutical inflation. To clarify, when we refer to generic drug pricing, we are referring to a combination of all factors affecting generic selling price, such as manufacture inflation and deflation and customer pricing.

We now expect this to be in the mid to high single digit deflation for the full fiscal year. Lastly, we have adjusted our brand manufacture inflation assumptions to a range of 7% to 9% from approximately 10%. Overall, we still expect pharma segment profit to be back-half weighted.

Now, turning to the medical segment, all of our FY17 medical segment assumptions remain on target and unchanged. We are still on track to achieve mid single digit percentage growth in revenue and double-digit growth in segment profit.

Now turning back to overall Company guidance, since we are slightly lowering our overall FY17 earnings guidance range to 3% to 7% growth, from 5% to 9% growth versus the prior year, we've updated some of our original assumptions to achieve that growth on slide 13. The line titled business growth is now assumed to be flat to 3% and capital deployment is now assumed to contribute 3% to 4% for the year.

From a corporate standpoint, we are focused on expense management and other actions to achieve these results. Keep in mind that the benefits related to these important items are held at the corporate level and not reflected at the segment level. And while we aren't providing the EPS bridge slide we presented on our August Q4 call, you can infer that based on my comments about the generic pricing environment being more challenging, it would result in a decrease to that line item, while increasing our capital deployment assumptions would result in an increase to that line item.

Net customer activity remains about the same, but our existing or remaining businesses bucket would increase as it includes the corporate actions I just referenced. Additionally, we told you on our fourth quarter call that we were assessing the timing of the adoption of new accounting treatment for the tax effect of share-based compensation. Our 2017 guidance does not include this, as we believe it is simpler to adopt the new treatment in our first quarter of FY18, according to the required schedule.

So as you can see, we've now aligned our guidance range, given the current pricing environment I've just described. To close, let me highlight a few key points before I turn to your questions. First, while we are experiencing a tough near term environment, we continue to aspire to the long-term goals we communicated before.

In our pharmaceutical segment, we do see generic pharmaceutical pricing, and to a lesser extent, branded inflation as challenges. However, we continue to see strong performance from Red Oak Sourcing, continued focus on operational excellence and positive feedback from our robust customer base. In addition, Harvard Drug, specialty, and nuclear are all delivering value for our customers and our business.

On the medical side, we've also won some important new medical distribution customers, which should help us gain scale in sourcing and leverage our cost structure to create greater efficiencies. In addition, we continue to see strong growth in our Cardinal Health brand products and services and above market revenue growth in Cardinal Health at Home. Finally, Cordis continues to perform well and we are confident in both the fundamentals and growth initiatives in that business.

Overall, it was a challenging quarter, but I want to acknowledge our team for their strong execution and focus in a tough environment. I believe this excellent execution and focus combined with our broad portfolio and balanced capital deployment will allow us to drive long-term, sustainable growth.

And with that, operator, let's begin our Q&A.

(Operator Instructions)

Bob Jones, Goldman Sachs

Great. Good morning. Thanks for the questions. George --

Good morning.

George, you talked about the moderation in the pricing environment, but I think your comments seemed largely focused on the buy-side part of the business? I have just obviously wanted to get your views on the sell-side of the business, given your peer last week talked about more aggressive pricing in the retail independent channel? So just wanted to see what you're seeing there currently?

Hi, Bob. Good morning. Yes, actually my comments really were about the overall pricing environment. So I was talking about sell-side as well. And here's my perspective. There are, as I mentioned, a number of factors coming together to make this a bit of a unique moment.

So we're not going to over-react to that moment. Our position, our plans for growth really aren't different today than they were six months ago. Our value proposition is very clear. We're extraordinarily attentive partner to our customers. We have a unique ability to follow the patient across the continuum of care.

Service offerings are extensive. That's really the heart of our positioning. That's I think important to state upfront. I think we're describing some similar characteristics to what you described.

Okay. Great. And then I guess Mike, if I could just go over to the guidance? Overall looks like the range is coming down by $0.11 at the midpoint? You talked a lot about generic inflation getting a little bit worse than previously thought, and then modestly less branded inflation?

If I look at the guidance for the pharma segment specifically, it seems like that take-down in what you're assuming around profit margins there, overall profits there -- mid to high single digits -- would actually indicate something more in $0.25 to $0.40 headwind? Just trying to square those two things relative to the overall amount coming down, compared to what you're suggesting is going on with the pharma segment for the rest of the year?

Thanks, Bob. Let me hit a few different things. I think first of all, just to be clear, when we talk -- when I was talking about generic pharmaceutical pricing, I wasn't really talking about the headwind-tailwind you used to hear over the last couple of years of inflation and deflation on generic products.

Because that's about where we model it to be this year. We're not really seeing it. We expected it to be a net deflation environment, and that's what we're seeing. That's not really the driver. What we're talking about is more the downstream pricing component of our generic pricing.

That's where we're seeing an uptick in competitiveness or a little more erosion than we had expected to be. And that really is the main driver of us taking down our pharmaceutical distribution numbers. And as I mentioned a couple times, to a lesser extent, brand inflation. So we had said about 10% before on brand inflation.

We're now modeling in the 7% to 9%. That impact -- I guess I would put it this way. If that were the only thing going on this year, we probably wouldn't be adjusting guidance. More the combination of the generic pricing and then that on top of that. But I think that's the first thing I wanted to say. The second thing, I can understand why you maybe have a little trouble with your numbers.

I can't quote exactly or comment on exactly what the numbers should be. But remember, I did make a comment in here that we have some significant initiatives around expenses and other initiatives that will be captured in our corporate numbers. And so those aren't going to show up in the segment numbers because we don't push those down at the end of the year.

So probably the piece that you're missing as you try to reconcile having pharma down, capital deployment up, midpoint down, the last bucket that you're missing is that the corporate numbers, we're going to have savings there that will be in the overall corporate bucket.

Charles Rhyee, Cowen & Company

Charles?

Hello?

You may need to take your phone off mute.

Hearing no response --

Let's go back to Cowen if they get back in queue. Let's go to the next.

Garen Sarafian, Citigroup.

Good morning, everyone. Thanks for taking the questions. So Mike and George, you guys just commented a little bit on the downstream, the sell-side dynamics? On the independent front, you guys aren't as active as some of your peers?

So just wondering what business segments are you seeing that? And if you could give a little bit more flavor as to sort of the more recent trends into this month, sort of the dynamics and how they're trending that?

Garen, good morning. Let me start and then Mike jump in. Actually we have a very strong position with independents and have for quite some years. The dynamic Mike described, we are seeing in that segment. So I don't know what else to add to that, Mike. Anything?

We have a lot of programs, services. We continue to stay very, very focused on that bunch of customers. We continue to have very high retention rates and so we feel really good about where we're positioned in the generic independent space.

Are you seeing that in other segments other than just the independents? Is sort of where I was trying to lead to -- or is it just focused specifically and only on that segment?

Let me try. I think it's probably been most intense there. We often have to deal on -- this is sort of a normal thing with repricing of contracts. Thankfully, as you know, we've not had a lot of big contracts up for renewal. But I think it has been a distinctly noteworthy environment, the independents, would you say, Mike?

I would totally agree with that. I think you have to think about the way contracts are written, and just certain customers' contracts are written in ways that generic pricing, or the way it works is one way in other areas it's much more competitive.

Where they haven't committed to buy all their generics so they're constantly shopping them. That's typically in independent space. That's where you're going to see some more of these competitive pressures.

That's useful. Just as a follow-up, on the upstream on the branded inflation side with the branded manufacturers? The moderating inflation has been sort of a factor that has been discussed in prior quarters? I thought that at some point there was an opportunity to go back to the branded manufacturers and sort of to readjust and realign the contract so it benefits all? So I'm wondering, have you done that in between contracts yet or is this sort of still waiting until the contract renews, where those conversations come up again? And I'll stop there, thank you.

Thanks. Good question. I would say that's really kind of across the board. It just depends on the individual manufacturer. As you know, about 15% of our branded margins are based on a contingent basis, which means that generic, or branded inflation is a piece of the driver of the value that we receive.

Every one of those where we are not getting the value that we believe we should be compensated for the services that we deliver, we are having discussion with the manufacturers. Some of those are going to move quicker than others, depending on contract dates and based on prior discussions with those manufacturers on how those deals were arrived.

And so you can you imagine, with every manufacturer, where we believe we're being compensated less than we should have been or should be, we are working with those manufacturers.

Next question?

Charles Rhyee, Cowen and Company

Yes. Sorry about that earlier. Thanks, George. You were talking in your comments about -- sorry, Mike, you were talking about in your comments making the second payment to CVS as related to Red Oak? How much -- can you kind of helps us understand how much more of a benefit you think you're getting right now this year on your generic procurement?

And how much of a benefit can we anticipate that we should get the rest of this year? The point I'm trying to get at is, you talk about your overall estimate on generic deflation? How much is this procurement benefit you think is helping offset? I think, George, in relation to your earlier comment to Bob's question, you did kind of mention that you are starting -- you are seeing a similar kind of characteristics in the market relative to comments from last week? Thanks.

I would say, clearly the number one offset to what we're seeing in the competitive pricing on generics, has been and should continue to probably be Red Oak Sourcing. I continue to be impressed with the team there, the depth of talent that we have on the team, the way they're looking at things, the creative ways they're working with manufacturing partners.

And CVS Health couldn't be a better partner working together with us to drive value at Red Oak. So Red Oak would continue to be a positive driver for us when it comes to offsetting that.

And then is there any other things that we can think about that can be offsets? Or the other way I'd say it is, when you think about the impact that you are seeing potentially in the independents, does your guidance kind of extrapolate out potentially what that might look like throughout your entire book of business?

Or are you only kind of anticipating what you're seeing currently? Thanks, stop there.

Yes, we said that we have lots of different things. One of the things that I think is really helpful for Cardinal in general, is our broad portfolio.

So while we are seeing pressure from generic pricing and as I said to a lesser extent branded inflation, when you look across the rest of the P segment, whether it be how we're performing particularly in specialty, how we're getting and working through with nuclear and some of our other components within that business, we continue to drive value in other areas.

As you can imagine, when you're in a challenging environment like that, everyone, whether you're in P, M, or corporate is focused on expense control and making sure we're very diligent on those types of things. And so we have that benefit. As I mentioned, medical is continuing to do very well.

We expect them to have a very good year and they are going -- moving along as planned. And so I do think our broad portfolio of having medical being able to drive some initiatives at a corporate level which are going to show up at the end of the year, as well as some of the other parts of pharma are what we'll be able to use.

And using our balance sheet too from a capital deployment standpoint, through M&A and stock repo -- is how we're going to continue to manage the rest of the year.

Eric Percher, Barclays.

Thank you. I'm going to return to the question of the independents and pricing? It feels like there's a pretty big difference in the magnitude of pressure that we see in your guidance, as compared to one of your peers? Mike, I know you've been willing to go into some of the mechanics on items like brand inflation in the past?

If we think about the mechanics of independent contracting, could you tell us a little bit about how much of the book is truly small and mid-size customers versus larger buying groups than dependents? And do you see significant differences in those? And maybe the last part of that would be do you have any major contracts that may be coming up or how much -- how important are those?

Let me try a couple things and feel free to follow up with another question if I miss it, but a couple different things. First of all, I hate to ever comment on our competitors' numbers. We always want to be careful of those. But remember, mix matters.

What I mean by mix is how much of their mix may be branded generics versus our mix. You look at other components of our pharmaceutical distribution segment, with our growth in specialty, nuclear and other things. It's hard to comment on all the various moving parts of any of our competitors on what's in those segments.

Second of all, I think you hit on something which is customer repricings. We didn't have -- we basically had very few major repricings this year and over the next couple years we don't have a ton of those. We're in pretty good shape, particularly with some of our larger customers.

I think that may be a different thing as where we're seeing some of our competitors may or may not have more large repricings with some of their customers which can affect each one of us in different timing within the years. So I think it really gets back to mix of customers, timing of repricings, and those types of things can drive differences between each one of us as well as maybe the expectations that we originally set at the beginning of the year and how we looked at things.

That's helpful. My follow-up would just be -- having exposure to telesales and Harvard, has that changed your insight into the market and-or your exposure into the market?

I think in some ways it's a little bit of both. Because a lot of their sales are into the independent market. You can imagine we're seeing some competitive generic pricing against our telesales business which obviously is a little bit of a headwind for that group.

On the flip side, because we do have so many contacts into the independent and regional chain space with our telemarketing business, it gives us a lot of competitive intel on what market price is. And we stay very focused at trying to make sure that we're pricing at that market price, and not trying to do anything outside of that. Because we believe we have a great service offering that we don't need to price below market in order to win and compete effectively.

Very helpful. Thank you.

Ross Muken, Evercore ISI.

Good morning, guys.

Hey, Ross.

You guys compete on the pharma side, right, in an industry structured primarily as an oligopoly, right? For many years we haven't seen these sort of spurts of aggressive competitiveness, obviously it's a tough environment? But when you look back at prior periods and talk to folks in the organization who have been looking at this longer than probably myself, what are the key telltale signs of sort of the end of that, right?

So looking for okay, we saw a flair-up, something happened and then behavior returned back to more normal? Is it -- so one, what should we be looking for to judge whether or not this is sort of temporal? And then secondarily, how do you ultimately go back to that customer group and recapture some value, right?

Because inherently your business model has been delivering a ton of value to the independent base for a very long time. Obviously the margin levels take a hit and then historically they've come back? So help us think about those, the sequence of sort of what happens next, I guess?

Ross, why don't I start? Let me start by saying we always operate in a competitive environment. That is the nature of our business. Obviously I've been doing this, as has Mike for quite some time. We've lived through multiple cycles, for me, in multiple parts of the industry.

This is a bit of a unique moment. You've got all of the public discourse around healthcare costs and pharma costs. It's loud and it's emotional. At the same time, healthcare is going through some changes. So I don't think it's shocking that there's some near term disturbance.

My experience tells me that over time you see some shifting out, essentially settling of the dust. Sometimes when aggressive moves don't result in much change or value creation, then things just sort of stabilize. So we've lived through different cycles in the past and that's what I would expect here.

For us, again, the important thing is for us to be creating new value sources for our customers and our manufacture partners and we work -- you've heard the positioning that we've had over these last seven or eight years. It's really been about broad value creation. We'll continue to focus on that as our priority.

I think ultimately the reason that our business has been improving in recent years is essentially the ability to create value. And so we'll continue to focus on those dynamics. But we have seen occasionally these kinds of cycles -- for me over unfortunately many decades in different parts of the industry. So that's my general point of view.

That's helpful. And maybe just quickly, Mike, on the balance sheet? You guys are in pretty strong position here? You're talking about dislocations a bit in some of the pharma service part of the market?

I'm assuming to private and other competitors that's also painful? What about the M&A pipeline at this point? Obviously you're doing a lot on the repurchase, you have a healthy dividend but there's a lot of balance sheet capacity there. Could we see you guys get more active again?

A couple comments. I think it's good to hear you mention the dividend, because that's something I would like to stress. I think we have a very differentiated dividend and it's something that we continue to be committed to our 30% to 35% payout. It's very much a differentiator between us and others.

I agree with that on one side. Again, I would tell you that when it comes to deployment of capital, we would love to find great M&A targets. That's probably where we would lean, overstock repo, but we're going to stay disciplined.

If we can't find the right target at the right price and that has the right culture that fits into our business, then we're not going to move forward and if that means there's some excess cash on the balance sheet, then we will take a look at deploying that into stock repo. I think our pipeline is still decent right now.

As you can imagine, we look at dozens of items before we ever purchase one. So it's always hard to tell exactly when something might come out of that. We continue to be very active in the M&A front, but won't trap cash on the balance sheet either if we can't find the right opportunities.

Thanks, Mike.

Ricki Goldwasser, Morgan Stanley.

Yes, hey, good morning. Couple questions here. First of all, does your guidance assume any additional stepdown in distribution, sell-side pricing for your independent book? So did you assume the step-down in the pricing that you're seeing in the marketplace today will spill over to your entire independent book?

Well, I guess the only way I can respond to that is I mentioned in my remarks our guidance includes not only what we saw in Q1, what I have kind of foreshadowed in Q2 but also that it was based on some of the trends we're seeing in Q1 and Q2. So yes, it does include some continued challenges with generic pricing and branded inflation.

Let me just add to this, Ricki. General market price is very -- it's very efficient market. So the market just tends to be the market. And so you can't think of this necessarily individual customers.

But, George, doesn't that mean that there's risk that you may have to lower your prices in the future to match a new lower price point in the market? I guess the question is there any lower price point in the market?

We're always lowering our pricing in the generic market, always has been that way, and so generally you constantly are competing on generics. All we're saying is right now it's just a little bit of an unusual period of time where we're seeing a little more aggressive repricing. But there's always some repricing built into your go-forward.

We're always going to price to market. We're not ever trying to lead the market down. But we're in, we believe, the best competitive position from a cost standpoint that we can always stay competitive.

Greg Bolan, Avondale Partners.

Thanks, guys. Maybe just qualify what you said here? On the distribution side, your margins on the buy-side are about the same? Your margins on the sell-side downstream have gotten a little bit worse?

And so that's, A, and then B, Mike, if we could go back to this time last year, if I remember correctly you guys were already dealing with a little bit of a difficult comp on the distribution margin side, if I remember correctly? You got about $0.08 of incremental tailwind from generic pricing this time last year?

I think about $0.03 from synergies from acquisitions? So could you maybe talk a little about that and how much of this year-over-year difficult comp kind of played into 1Q? Thanks.

Thank you. I did mention that in my remarks that part of the reason for our Q1 is the comps. That's why we called out Q1 being down was -- you were right on with that, we did have $0.08 last year that we called out, a favorability largely from benefits related to certain competitive dynamics on a few key generic items that we thought were going to deflate last year that didn't.

And they stayed up. Since then, they have deflated and then as you mentioned, $0.03 on accelerated integration of some acquisitions. So those were favorable items last year, as well as from an overall basis. Remember, we had a favorable tax component last year too.

And then in last year we did see in the first quarter branded inflation was a little higher than we had anticipated. So that's right. Those were the positive things. You also summarized accurately the generic piece. When you really break it down into two components, one is the manufacturing actions, which is them either raising or lowering price.

We're seeing, for instance, less inventory inflation on generics. But it's really no different than we had originally anticipated. As we mentioned in the past, FY14 was a good year. 2015 was a solid year and then it started coming down in 2016 and we kept calling that out.

And we said we expected that to be down, and that's how we essentially budgeted and looked at it for this year. We're not seeing anything real different when it comes to what the manufacturing actions are related to inflation and deflation. It is the competitive environment downstream and our actual pricing out to the customers.

That's great. Then just real quickly, if I kind of think back to Kinray six years ago now, and what you guys have been able to do there with Kinray and other kind of organic build outs on the community pharmacy side, I think you guys are now one of the largest, if not the largest independent pharmacy space, with the high 20% market share?

As I think about the competitive dynamics around that market, you guys have kind of lived in a world where you've been constantly trying to take share and been successful at that? It doesn't sound to me like -- it certainly doesn't sound as what you're saying today is as Draconian as maybe what we were kind of -- what I was set up for going into the weekend?

And so if you think about -- you keep saying short-term you think it's transient, George? What needs to happen over the next, say, year or so, for you guys to kind of maybe mitigate this -- the downstream margin side and kind of how you're positioned to continue to maintain or even grow market share going forward? Thanks.

So Greg, let me start. This is really important. Our market share, our independent has grown over years basically. This is not a sudden phenomenon. Actually right now it's relatively stable.

It's probably been growing over the seven years, this team's leadership here. Obviously the Kinray acquisition gave us a very significant boost there. That's not a sudden thing. It's been a thoughtful, purposeful strategy to make sure that we have a good balance to our business.

We really feel like we create a huge amount of value for those independents, service offerings and product lines, especially as the world has unfolded as it is. Start by that. I don't think there's a discrete moment of change. We're obviously in the middle of a lot of things.

The election cycle clearly is creating an enormous amount of discussion and noise, which I do think has an effect on the way people behave. I do think generic cycles come in lumps and we see that they tend to have some cyclicality. We'll see some growth coming from biosimilars, which will affect the market, probably each product differently.

And I think, again, most times in competitive moments you have companies just adjusting to what's working and what's not. And so that's my experience over a lot of years. I think the moment right now has a lot of factors coming together to make for a tough environment. We're going to stick to our value proposition and our long-term view as to how we compete in the market and how important service and product offerings are.

Lisa Gill, JPMorgan.

Thank you. And good morning. George, I just want to go back to your comments around the branded side and that primarily everything today is driven more on the generic side and pricing competition? But you brought the branded expectation down from roughly 10%, down to the expectation of 7% to 9%?

Can you talk, is that what you're seeing right now? Is that kind of your future look? We've heard from a number of manufacturers that they're lowering their expectation into what their price inflation will be (inaudible) in 2017, and I want to understand that, number one?

Number two, I just want to understand, because the way that I've historically thought about this is that 15% that's on a contingent basis was probably more profitable than a fee for service contract? And so drug price inflation would have a bigger impact on that component of the business? I just want to know if I'm thinking about that correctly?

Mike, you want to start on this one? I can jump in.

Sure. Actually, the 15% piece was margin dollars. It wasn't number of contracts. So it was assumed to be margin -- of our margin dollars generated.

I wouldn't say that group was a lot more profitable. A lot of the folks that are in there are obviously the smaller manufacturers, so it's going to have an overall little higher average rate just by the nature of being smaller manufacturers. I don't think that's a big component of it.

As far as what we've seen so far, I would tell you that what we've seen so far has been pretty light when it comes to manufacturer inflation. That all being said, really January, as you know, our Q3 or the first quarter of a calendar year is always a big quarter for the branded manufacturer price increases. And the 7% to 9% is really an average for the entire year.

So while it's a little lighter than we would have expected now, that's what we're building in, to why we're lowering, is that we would expect it hopefully after election and looking at all those other components we'll see a little bit more normalcy. Probably not as high obviously as what it used to be but we think we'll get back into that 7% to 9% range.

If that adjust much differently than that we'll have other updates after that. Right now that's what we're expecting.

George Hill, Deutsche Bank.

Hey, good morning, guys. I appreciate you taking the questions. Mike, first off, if we think about the change in the guidance on the generic side, are you able to quantify from down mid single digits to mid to high single digits how much of that change is do to the underlying pricing environment of the drugs themselves, the deflationary environment versus how much of that is the sell-side margin pressure?

My second question would be, you started to run down the rabbit hole of purchasing compliance a little bit? Could you talk about what you're seeing in the contracting environment and how that -- how pricing is leading -- how pricing is tying into the purchasing compliance discussion?

Yes. So as far as the adjustment from mid singles to mid singles to mid to high single digit net deflation, really that entire adjustment is due to what we're seeing in the generic pricing environment. As I've mentioned, we're not really seeing the inflation-deflation piece to be significantly different than what we modeled. So you can assume all of that is essentially related to the generic pricing.

The sell-side part.

That's right, the sell-side part. As far as compliance goes, that's highly contract-dependent. When we have customers -- we're very diligent about the way we write our contracts. If we have a customer contract that says they've got to buy X% of their generics from us, we monitor that, make sure that they do.

On the piece they don't have to directly buy from us in order to make that deal work, they can shop that piece. We've always known that. That's the component that we would see obviously some more pricing pressure on.

Okay, and maybe if I could steal a real quick follow-up for George? When we talk about this increase in the sell-side competitive environment, how far off normal are we if you think about historical spikes and when we've seen heightened competition?

I don't think I'm able to give you a specific number here. What I can say is the kind of erosion that we've seen typically, and it's been relatively predictable, has just been different over these last couple months.

And so it is different and noteworthy, and I think is the largest component as to why we're adjusting our model for the year. The branded part as Mike said is much smaller. But I can't quantify that for you, George, but it is noticeably different.

Thank you.

(Operator Instructions)

Michael Cherny, UBS.

Good morning, guys. Thanks for all the detail so far.

Good morning, Michael.

So I think the pharma question's been kind of beaten to death, I'll ask one on the medical side? You talked a little about the recent share gains you had? Obviously Kaiser is a very notable contract win?

Can you maybe talk especially with Cordis anniversarying over the last year, as you think about now your go-to-market strategy versus two years ago, what are the biggest differences? Obviously Cordis is one component, but in terms of being able to gain competitive scale, what's changed the most or most improved your competitive win rate?

Thank you for the question. You're making Don happy, a question on medical. So let me just give you a perspective. Our go-to-market model over recent years has really been focused broadly on a couple of really important changes.

A lot of our customers are getting much more complex. They're bigger systems. What historically might have been a single hospital is now an academic medical center, plus some community hospitals, plus surgery centers and oncology clinics, and now some doctor offices.

That requires a different partner. I think our ability -- we've seen this. We built our business around that expectation. And I think what's happening is our ability to serve across that continuum of care, to create value in different ways for systems that are much more complex than they once were, is important.

One of the shifts I want to describe is a little bit more of an elevation of those conversations, away from the purely departmentally driven ones into a conversation that's more broadly at the system level. I think that's playing to our strength. Again, we have to be very strong in each of the departments.

We have to be content experts, and we are still that. But I do think that the reason that we've been growing I think, is largely that we're positioning well to adapt and we anticipated these changes in the way that these big health systems were going to look and I think that's been beneficial to us.

The only thing I would add to that is I think part of that growth is the really measured and smart approach I think we've taken to expanding our portfolio in the medical segment. And so our reps are able to leverage a lot more products in the bag and so when we call on a customer we have more to sell them. We can leverage our expense structure. We can be more meaningful to them.

And I think it would be -- I don't think we should also ignore the fact that we've given a lot of energy to the Cordis business. We've put some great people in charge there. It's a business that we're paying a lot of attention to. Don himself has a lot of experience in this area, as does David Wilson who is running it.

I think there's a lot of be said for when you have people that are excited, know you're investing in the business, really are committed to that -- and we've hired some great people -- I think that's driving some of the things we're seeing in Cordis too.

If I could, I just want to add one more piece, because we're talking primarily in this context about the medical but it does connect to our pharmaceutical business and our medical business and many of these customers are part of that overall offering. I didn't want to miss the opportunity to share that.

Thanks, guys. I'll let you get to the rest of the queue.

Thanks, Michael.

David Larsen, Leerink.

Can you talk a bit about your efforts to improve your cost structure in the corporate division, what's going to drive that and any sort of quantification around that would be very helpful? Thanks.

Yes. So good question. I mentioned it is a big driver when you think about that EPS bridge as we mentioned with the generics slightly or going down and net customer activity staying the same. We needed to actually have a real focus on that expense initiative. So a lot of the corporate departments across the Company are all located in corporate.

A lot of the initiatives and things that we fund, we fund out of corporate. So all of those things we're taking a really, good hard look at. Making sure we're investing in the right things. We've we're being very targeted on those things and driving discipline throughout our corporate departments in all lines of our P&L to make sure that we can help contribute to offsetting some of the decline we're seeing on generic pricing.

Okay. Great. Can you just remind me again, so the 2Q operating income expectations for the pharma division, pretty significant change there relative to comments last quarter? Can you remind me what's driving that and what's going to sort of cause the reacceleration in growth in the back half of the year?

Q2 is really being driven by the same trends that we discussed when we take a look at that, the trends that we saw in Q1 related again to generic pricing as well as branded inflation rates being lower than we had anticipated, are the two key drivers in Q2 and why we gave you some early information that it would be similar to the percentage decline we saw in Q1.

As far as what's going on back half weighted, some of it has to just do with comps and things that are going to happen in the quarters like branded inflation tends to always be stronger in our Q3 and we have a lot of other initiatives that we're working on that we believe will deliver value in the second half. Remember, we have the step-up in Cordis that impacted our Q2 and Q3 last year that doesn't impact our Q2 and Q3 this year.

Plus we'll have a full year of growing and getting after that business as well as on-boarding some other new customers. So we think we have enough initiatives in the back half to be able to get us to where we need to for the year.

Bob Willoughby, Credit Suisse.

Good morning, George and Mike. While we know absolutely no one speculates on inflation anymore, it did appear your competitor bought some inventory in the inflationary market last year? Liquidated this last year? Medical skews that somewhat? Isn't it safe to assume there's some bucket of profits that have fallen out of the model here, year-over-year?

Well, I think in the sense of -- if we're relating it specifically to branded manufacturing, when you do have less branded manufacturer inflation, you do as I mentioned a couple l times, when that happens quickly, you have those immediate adjustments where that 15% of your portfolio that is dependent upon that inflation sees less inflation.

So you do have to go through and renegotiate your agreements with manufacturers. So that's the first important piece. As I mentioned, we are doing that with manufacturers. Any time you see a sudden change, you have to go do that.

As far as speccing on generics or on brand, that was something that we quit doing a long time ago, several years ago because of the nature of our relationships with generic manufacturers, with Red Oak, as well as our agreements on the branded side, speccing is minimal to almost none of an impact.

And Mike, can you reaffirm a cash flow target for the year or is that not the call today?

Yes, we don't as you know give cash flow targets for the year. There's nothing I would say when I look at what's going on in our business that would make me think we're not going to be able to deliver strong cash flow this year.

Thank you.

Thanks, Bob.

John Kreger, William Blair.

Hello, thanks very much. Could you give us an update on what sort of brand inflation you're seeing within the specialty bucket? And what sort of assumption you're making in guidance for that category?

Yes, we don't break that out specifically. Generally, inflation on specialty tends to be a little bit lower, because they're higher priced items than in the overall bucket, but our overall 7% to 9% target is across the board for all branded pharmaceuticals, including specialty and what's going through our normal pharmaceutical distribution bucket.

Thanks, Mike. And one other one on the medical front? Can you give us a sense about what your organic revenue growth was in the quarter, now that you're lapping Cordis? We were thinking about 6%, is that about right?

I can't give you the exact number but I would definitely tell you that we were positive growth in the medical segment without Cordis. We do still expect Cordis to deliver $0.15 for FY17. So if you were to back Cordis out you would still see nice growth, healthy growth in the medical segment.

Great. Thank you.

Steven Valiquette, Bank of America.

Thanks. Just one more here on the sell-side customer pricing? I guess I'm just curious, is there any evidence of a change in the actual price methodology in the market being offered by some wholesalers? And the reason why I ask is there was some chatter about maybe a shift to a cost plus pricing model on generics, as opposed to just random spot pricing? Thanks.

I think all the time people are always trying to be creative on how they price and how to work with customers and different customers have different needs. I don't see a wholesale change, though, in the way people are pricing in the market. The majority of the areas where we're seeing the pricing pressure are just in that normal day-to-day pricing.

Whether or not that's changing on larger deals and stuff, it's hard for me to speak to our competitors on how they might be doing that. Deals can get often very complicated on how you compare one to another. I wouldn't notice any notable change at this point in time.

Okay. Great. Okay. Thanks.

That concludes today's question-and-answer session. At this time I would like to turn the conference back over to George Barrett for any additional or closing remarks.

Well, look, first, thanks to all of you for your good questions and for joining us today. I know that we'll be seeing many of you in the coming weeks and we look forward to that. With that, we'll close the call. Thank you all.

That concludes today's presentation. We thank you all for your participation and you may now disconnect.