卡地納健康 (CAH) 2017 Q2 法說會逐字稿

Good day and welcome to the Cardinal Health second-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, ma'am.

Thank you, Eric, and good morning, everyone.

Welcome to Cardinal's second-quarter FY17 earnings call.

I'm Sally Curley, Senior Vice President of Investor Relations, and joining me on the call this morning are Chairman and CEO, George Barrett, and CFO, Mike Kaufmann.

Today we will be making forward-looking statements.

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

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

In addition, we will reference non-GAAP financial measures.

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

As a reminder, during the Q&A we ask that you please limit your questions to one, with one follow-up, so that we can address everyone in queue.

We'll do our best this morning to get to everyone's question, but if we don't, please feel free to reach out to IR VP Lisa Capodici or myself after the call.

In terms of upcoming events, we will be webcasting our presentation at the Barclays Global Healthcare Conference on March 16 at 8:30 AM Eastern.

Today's press release and details for any webcasted events are or will be posted on the IR section of the 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.

Also, please note that neither this call nor any other Cardinal Health event can be rebroadcast without the express written permission of Cardinal Health.

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

George?

Thanks, Sally.

Good morning, everyone, and thank you for joining us this morning.

As I typically do, I'll spend a few minutes of my discussion covering at a high level our performance for the quarter.

However, these are not typical times and on the surface, not a typical year for Cardinal Health.

The impact of this year's generic pricing environment accounts for the primary headwind on our financials.

It is masking the fact that we are seeing growth in more key initiatives and priorities than we have seen in quite some time.

In that context, I want to make sure that woven throughout my comments we address the following three questions.

One, how are we executing and competing in the market?

Two, how to characterize some of the more recent market dynamics?

And three, how are we positioned for long-term sustainable growth?

Before I get to that, I want to acknowledge that in spite of the extraordinary dynamism in the industry, we at Cardinal Health remain focused on the millions of people that we touch every day.

We embrace our vital role at the center of the healthcare continuum and our responsibility remains unchanged.

Our role, providing the highest quality products and services to all of our partners and their patients around the world, lies at the core of who we are and what we do.

Because the healthcare discussion in the US has been so prominent, my commentary today will be more focused on the US.

So how did we do this quarter?

To summarize the performance for Q2, the revenue was up 5% versus the prior year, to $33.1 billion.

Non-GAAP earnings per share increased 3%, to $1.34, versus prior year.

And non-GAAP operating earnings were down 4% versus the second quarter of last year, to $701 million.

At the segment level, our Pharmaceutical segment performed a bit better than we had expected this quarter.

Revenue was up 5% versus the prior year, to $29.7 billion, and segment profit declined 14% versus the prior year, to $537 million.

This decline was almost entirely the result of generic pharmaceutical pricing and the loss of Safeway, both of which we covered in our last call.

Our Medical segment had another strong quarter, continuing its repositioning to better serve the needs of its evolving market.

Revenue for the Medical segment was up 8% versus the prior year, to $3.4 billion, and segment profit was up 50% versus the prior year.

I would note here, about 50% of this is attributable to the mechanics of last year's inventory step up.

These are really strong numbers.

As you know, our guidance for the year, which we provided in early August, was based on both our plans for the upcoming year, as well as our assessment of market conditions at the time.

By the time we reported our first quarter, we had seen a step down in generic pricing which prompted us to make a small change to our guidance for the year to reflect that dynamic.

At the time, Mike also provided you with the key factors which could dictate where we might fall in that range.

With actual data from Q2 and preliminary data from January, we can now forecast that the top end of that range is unlikely.

This is more a function of the math rather than any further deterioration of market conditions.

With that mind, and wanting to provide enough of a range to account for the normal variables, we are adjusting our guidance range for FY17 to $5.35 to $5.50 from our prior range of $5.40 to $5.60.

Mike will provide some additional color on how the various factors were included in this decision.

Across the board, Cardinal Health is seeing the results of our team's dedication to addressing the needs of our customers and the people they treat every day.

This team's hard work is evident, as our lines of business are showing strong fundamentals.

Unit sales are strong, our customer service levels have never been higher, and our ability to operate across the continuum of care with a broad range of products and services creates a uniqueness to our model which is resonating with our customers across the enterprise.

Our rates of customer retention are extraordinarily high and we are growing with our customers, building on a sustainable value proposition that aligns with long-term trends.

We are confident that we can improve efficiency for virtually any part of our customer base and do so with a valuable and integrated portfolio.

At a time of rapid change, we know how essential it is to demonstrate customer intimacy in ways that meet their specific needs and enable them to adapt to a shifting landscape.

I've had the chance in recent weeks to meet with many of our customers, both upstream and downstream, and I came away from those conversations with the clear sense that they are eager to work closely with us.

Together, we are better equipped to address the complexities of the system with Cardinal Health well positioned as a partner.

Reinforced through these conversations, I'd like to focus on five major initiatives, which should be familiar to you.

They are one, growing our generics program; two, driving growth in our Specialty Solutions group; three, increasing our offerings of valuable products and services to our acute and integrated delivery customers; four, driving additional penetration of Cardinal Health consumable medical products and physician preference items; and five, establishing a leading position in the post acute space.

Let me walk through these one by one.

On generics, as I said, industry pricing dynamics were challenging throughout the first half of our FY17.

We are, however, seeing some signs of a return back to more typical patterns.

While it may be too early to characterize this as a trend, we see it as encouraging.

Our customer base is solid and we continue to offer tremendous value for any retail or institutional customer looking to offer an industry-leading generics program.

Our team's innovative approach to generics serves our customers well.

And our joint venture with CVS Health Red Oak continues to be a driver of value and, in our view, a unique source of competitive advantage.

Turning to Specialty Solutions, our group continues its high rate of growth, increasing our reach across key therapeutic areas and strengthening our suite of services that we can offer our pharmaceutical partners who seek to get closer to their patients.

We have more than doubled the number of clients in our Specialty hub and significantly grown the client base in our 3PL business.

We are beginning to see the first wave of biosimilars entering the market.

We've built the right therapeutic footprint to effectively serve any part of this system with these products and have a team of experts in place to support this business.

With regard to our acute and integrated delivery customers, these providers of healthcare are experiencing significant changes, changes in the size and complexity of their systems, the new technologies which they employ, the shifting sites of care, the adoption of more integrated delivery models which are directed towards more patient-centered value-based designs, and the accompanying evolution of payment systems which align with that value-based model.

As their partners, we have built a suite of products and services that are designed to address these forces.

Let me give you some examples.

We offer critical supply chain and inventory management solutions that allow clinicians to focus on their patients and remove themselves from supply chain activities and administrative documentation.

Our solutions provide visibility to real-time analytics, enabling customers to make data-driven decisions around products supporting patient safety up to the point of care.

This past week, we celebrated the third anniversary of our Academy for Excellence in Healthcare, kicking off our 11th cohort.

This program, based on our deep expertise in operational excellence, Lean and Six Sigma techniques, has been designed to help healthcare organizations identify and solve their greatest operating challenges, ultimately driving results that can significantly reduce costs and improve patient outcomes.

To date, we have worked with 36 hospitals training and coaching 49 teams comprised of hundreds of medical providers and the group has published 16 white papers.

Through this work, we have helped our partners reduce readmissions, improve the discharge management process, reduce length of stay and surgical wait times, and increased patient satisfaction.

Our medical surgical distribution business is highly efficient and growing again, and we continue to see growth in Cardinal Health brand products, which, as you know, includes Cordis.

We continue to grow the number of products and product categories in our Cardinal Health brand and now offer more than 19,000 SKUs in 110 product families.

Our Cordis acquisition is largely on plan, and I'm proud of the way in which our teams have come together around the world during this first year.

We feel very confident that we can add value to any system in their interventional cardiology activity.

Demographics and delivery system shifts remain key drivers behind our focus on the post acute world.

We believe that patients can be treated more efficiently, more safely, and with better outcomes using the right tools.

In our Cardinal Health at Home business, we continue to focus on bringing medical products to patients in their homes; and the work we are doing at NaviHealth in post acute care management and care transitions is industry-leading and growing quite dramatically.

That business uses the tools and clinical data needed to create the optimal care experience for patients.

In summary, our value proposition is increasingly resonating with our customer, and this includes our manufacture partners, who are also dealing with a dynamic and shifting landscape.

We have a unique capacity to navigate through environmental road bumps.

Our portfolio is robust, balanced and fully integrated.

Our organization has critical scale, but is still nimble enough to deal with short-term disturbances.

And our team has proven their mettle.

They're mission-driven and possess a clear sense of where we're going.

Because of this, as an enterprise, we are positioned for sustainable and enduring value creation for our business partners and for you, our shareholders.

Finally, we are an active participant in the unfolding policy discussions around healthcare.

We bring to those conversations our key tenets.

All people should have access to coverage for health care, which most experts agree requires a stable insurance system.

We need to support our providers of care, most of whom recognize that healthcare can be centered more around the patient, it can be more clearly coordinated, and incentives can be designed to encourage innovation, including ways to drive the best outcomes in the most affordable and accessible way.

And we know that the overwhelming power of demographics will continue to fuel demand.

Those are the inescapable realities which guide our course.

This commitment to our true north helps us serve our customers and the people that they treat every day.

So with that, I'll turn the call over to Mike and be back to you during the Q&A.

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

This morning, I'll start with a review of our second quarter financial performance and then provide some additional color around our expectations for the remainder of the fiscal year.

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.

Starting on slide 4, our second quarter fiscal results were slightly better than expected, with GAAP diluted EPS at $1.02 and non-GAAP diluted EPS at $1.34, a 4% and 3% increase, respectively.

Note that both the GAAP and non-GAAP diluted EPS for the quarter benefited from a lower effective tax rate and fewer outstanding shares as compared to the prior year.

I'll review both segments in greater detail later, but let me start with consolidated results.

Revenue increased 5% year-over-year, to $33.1 billion.

Consolidated GAAP gross margin dollars were flat, while non-GAAP gross margin dollars were down 2% versus the same quarter in the prior year.

GAAP gross margin rates were down 29 basis points for the quarter, while non-GAAP gross margin rates were down 38 basis points.

The decline in rates is best described in the explanations of the Pharma and Medical segment profit rate changes, which I will cover in a few minutes.

Consolidated SG&A was down by 1%.

As you would expect, we continue to have a disciplined approach to managing cost while still investing in our future.

Both consolidated GAAP and non-GAAP operating earnings declined by 4% versus the prior year.

Below the operating line, net interest and other expense was $51 million for the quarter, a moderate increase over the prior year.

For the second quarter, the GAAP tax effective rate was 34% and the non-GAAP effective tax rate was 34.2%, both somewhat lower than historical norms.

Both declined 3 percentage points versus the prior year and these lower rates were primarily due to a few favorable discrete tax items.

Our second quarter diluted weighted average shares outstanding were 319 million, 13 million shares fewer than the second quarter of FY16.

This is a result of our share repurchases, including $350 million worth of shares repurchased during the quarter.

We now have $443 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 strategies.

We generated $554 million in operating cash flow during the quarter.

At the end of the second quarter, our cash balance including short-term investments was $2.1 billion, with $552 million held outside the United States.

Now I'll move to the segment reviews.

You can follow along on slides 5 and 6. Our Pharmaceutical segment revenue increased 5%, to $29.7 billion.

This increase was a result of growth from existing Pharmaceutical Distribution customers, as well as strong performance from the Specialty business.

Segment profit for the quarter decreased 14%, to $537 million.

Generic pharmaceutical pricing and, to a lesser extent, the previously announced loss of Safeway, partially offset by solid performance from Red Oak sourcing, drove this decrease.

Note that while profits tied to branded inflation were a headwind in Q2, this headwind had a smaller impact than the loss of Safeway.

Remember that less than 15% of our branded margin is tied to inflation, and we continue to work with our branded partners to ensure that we receive fair value for our services.

My expectation is that this contingent component will be less than 10% in the near future.

Segment profit margin rate for the quarter was down 41 basis point to 1.8%, largely due to generic pharmaceutical pricing.

Last quarter, we told you we expected that generic pricing and brand inflation would cause Q2 Pharma segment profit to decline a percentage similar to Q1.

While these items came in about as expected, our better than anticipated performance in Specialty Distribution, as well as SG&A, contributed to the Pharma segment's better than expected results.

The excellent performance in Specialty was driven by growth in the acute space in Metro Medical on the provider facing side and growth in our 3PL and regulatory science service offerings on the bio pharma side.

Now let's go to the Medical segment, which had another strong quarter.

Revenue for the quarter grew 8%, to $3.4 billion, driven by contributions from net new and existing customers.

Segment profit increased 50%, to $159 million, due to the contribution from Cardinal Health brand products, which includes Cordis.

This increase reflects the $21 million unfavorable impact of the Cordis-related inventory fair value step up in the second quarter of FY16.

Excluding this step up, year-over-year Medical segment profit growth was a robust 25%.

Please remember that in the Q3 comparison, we will have this same $21 inventory step up from FY16.

Segment profit margin rate increased 132 basis points to 4.68%, due to the Cardinal Health brand products which, as noted above, includes Cordis.

Overall, the Medical segment team is working well together to drive results.

My comments until now have been largely US focused, so I want to highlight two global items.

First, Cordis is performing well, particularly in Europe and Latin America; and second, the China team continues to execute well and they are on track to achieve double-digit top and bottom line growth for the full fiscal year.

On a related note, during the quarter, we didn't see much of an impact resulting from foreign exchange or commodities.

Before I discuss our outlook for the full year, you can turn to slide number 7 to see our consolidated GAAP to non-GAAP results for the quarter.

The $0.32 variance to non-GAAP diluted EPS results was primarily driven by amortization and other acquisition-related costs.

Let me move to our FY17 non-GAAP earnings guidance range and assumptions on slides 9 through 12.

As George mentioned earlier, with six months of data behind us and a good view into January, we believe achieving the upper half of our $5.40 to $5.60 guidance range will be challenging.

So to adjust for this and provide some room for variability, we are modifying our guidance range to $5.35 to $5.50.

To be specific, the most significant parts for the second half are mainly environmental.

They are generic market pricing, taxes and brand inflation.

So all this translates to a non-GAAP EPS growth rate of between 2% and 5% for the fiscal year, a minor adjustment from our prior guidance.

With that context as a backdrop, I'll walk through our updated corporate assumptions on slide 10.

We expect diluted weighted average shares outstanding to be between 320 million and 321 million shares.

Additionally, our updated assumption for acquisition-related intangible amortization will be about $384 million, or $0.77 per share, which does not affect our non-GAAP earnings.

As you can see, all of our other corporate assumptions remain unchanged.

On slide 11, there are two updates to our full-year Pharmaceutical segment assumptions.

First, based on our six months of data, plus a good view into January, we are updating our generic drug price assumption from mid to high single digit deflation to high single digit deflation for the full fiscal year.

Second, our Q1 assumptions expected Pharma segment profit for FY17 to be down mid to high single digits versus the prior year.

Based on the factors I discussed earlier, we now expect full-year Pharma segment profit to be down high single to low double digits.

All other Pharma segment assumptions are unchanged.

Now turning to the Medical segment assumptions on slide 12.

We are on track to achieve mid to high single digit percentage growth in revenue, up from our previous assumption of mid-single digit percentage revenue growth.

All of our other Medical segment assumptions are unchanged and we expect to see double-digit profit growth versus the prior year for the segment.

One final comment.

As you can see, based upon our first half performance and updated total year guidance, we expect our second half to be somewhat better than our first half, with Q3 slightly larger than Q4.

Overall, we believe that we are well positioned to manage the changing healthcare landscape with a clear, well-defined strategy across the enterprise.

The vast majority of our businesses and initiatives are going very well and we know our key priorities and how to get after them.

With that, operator, let's go to the questions.

(Operator Instructions)

Ricky Goldwasser, Morgan Stanley.

Yes, hi.

Good morning and thank you for all the details.

Good morning.

Just a follow-up on how we should think about the updates to guidance and when we think about the different factors that are getting worse in the second half, are these things that you think are going to be isolated to one, the third or fourth quarter, or should we expect some of these headwinds to persist throughout the year?

Basically, what I'm trying to get is, will some of these things carry over or through to FY18?

How should we think about that?

Ricky, good morning.

It's George.

I'll start and then I'll let Mike pick up.

Again, it's important, in my commentary, I made the observation that actually we're not seeing a further deterioration, that, in fact, as we started to come to the very end of our Q2, we started to see more normal patterns on generics.

So largely, and I'll let Mike touch on this, the base reset lower.

But Mike, want to answer that?

Yes, I would just emphasize, Ricky, as I look across all of our businesses and all of the various factors that contribute to our overall results, I would emphasize that, as we've been saying for the last couple quarters, it's really this generic pharmaceutical pricing that is the number one factor.

And all we're saying here is that it basically ended up finishing a little lower than we expected to, in the sense that our base has reset a little bit lower than we expected it to, but the actual activity that we saw in December and January looks to be stabilizing and that we've just set at a little bit lower base.

And so when we took that lower base and spread it across our second half, that's really essentially what lowered our overall guidance.

So as you think about the various components, I mentioned three things, generic pricing being the biggest factor that can have a little bit of variability to it.

But again, as George mentioned and I mentioned, it's looking much better over the last couple months.

Branded inflation, we did see some branded inflation in January and it seems to be about where we're expecting it to be, but again, depending on what happens over the last five months, we just want to call that out.

And lastly, taxes, which I called out as the third factor, it's more about timing within quarters than overall being concerned that we're going to fall outside our 35% to 37% guidance range.

It's really that you might see it be a little bit better in one quarter and a little worse in the other, but overall for the year we expect it to be.

Right.

Ricky, my comments were specifically about the generic environment, which is what I thought your were asking.

But I think Mike captured the more broad perspective on this.

Yes, and I would emphasize, I think it's really just a slight EPS reduction, because of, again, this variability in the generic market pricing.

And just to clarify on the generic pricing and deflation, I know last quarter you mentioned that the generic deflation is also a mix, so it's the sell side versus buy side.

So should we read into your comments that you've seen both the sell side and buy side environment stabilizing?

Yes, I would say that answer is yes.

As far as price activity from manufacturers to us, that's been tracking all year about as what we expected.

It was really the sell side that started out for the first couple quarters lower than we had originally anticipated.

But again, we see it stabilizing now.

Lisa Gill, JPMorgan.

Thanks very much.

Can I start and just follow-up there, just so that I understand this, George.

When you talk about it stabilizing, but yet we think about the fact that you're lowering the back half of the year, I'm just trying to understand that math, how that works.

So if it stabilized in the most recent quarter and SG&A in Specialty drove a little bit of a better upside, was it just that your anticipation was that things were going to get better in your fiscal back half of the year, and now they're somewhat carrying through, although they've stabilized?

Yes, that's a fair question, Lisa.

I would say that's pretty much accurate.

I'd say that where it stabilized at was just a little bit lower than we had originally anticipated when we projected our second half.

And so that even though Specialty is overperforming and we're seeing some really good controls in SG&A, that when you mix the two together, that at net was a little bit potentially lower for us, and that we just wanted to give ourselves a little bit of variability.

When we first thought about taking off the top half of the range and having just a $0.10 range, that seemed a little tight for us only halfway through the year.

And so we thought that adding another $0.05 to give us a little bit of room would be the smart thing to do.

Okay.

And then Mike, you also made a comment about Q3 being better than Q4.

Can you just talk about, is there something specific that you're anticipating in either side of your business in Q3, or was that comment specific to drug distribution?

No, that was just specific overall, just to try to be helpful.

Obviously, you'll be able to estimate we think the second half will be, and then I just wanted to give you a little thoughts that Q3 would be bigger and Q4, mainly because that's the quarter where you see the majority of the branded inflation anyway.

As you know, that's typically the quarter where you see it.

And so I thought you guys are all going to be thinking Q3 is bigger than Q4 generally, because it historically always is, but I just wanted to give you little thoughts around that it should be slightly bigger than Q4, to give you a little help.

Thanks, Lisa.

Ross Muken, Evercore.

Good morning, guys.

George, appreciate the commentary.

Obviously, it's a tough environment for all of us to navigate.

And amongst your peers, the commentary regarding the outlook has been slightly different in terms of various drivers.

From your standpoint, what do you think are the one or two things we need to be spending the most time thinking about as we analyze and grade how this business is doing, given all these macro factors?

And obviously, you felt as if the underlying was better than what the guidance or the quarter showed.

And so help us think through what KPIs you're looking at or how you're thinking about the evolution relative to how the last 12 months played out.

Because it's obviously been a pretty volatile environment relative to what this business has been used to.

Sure, thanks, Ross.

Let me try to do this.

And I'll comment a little bit on the unique dynamic of having some of our peers report with actually different year-ends.

And Mike will touch on that, because actually I think it's an interesting dynamic at work.

For us, the drivers, we know that economically, as we've said, that the generic pharmaceutical pricing environment is a big factor.

We'll watch to see, for us, that those rates look more normalized.

We started to see that towards the end of the quarter and the beginning of January.

Obviously, as I said, a little early to declare a trend, but I thought that was an encouraging sign and something I said to you guys I thought would start to happen.

The other thing is all of our priorities have to be going in the right direction.

Our Specialty business is in a really good position right now.

We're seeing really good signs of growth broadly, both downstream and upstream.

Across our Medical segment, we're seeing really encouraging signs, even in what you think of as our legacy Medical Surgical business is really beginning to get a little bit of wind in their sails.

So watching for all the components, our service lines in Medical, our Cardinal Health branded products, our work in NaviHealth, our activity with our Med Surg products, these are all, for us, key indicators of our long-term positioning playing out the way we want, and actually the general growth in customer base.

We want customers to see us as that go-to company at a time of complexity.

So we're beginning to see that.

And so actually, we're feeling quite optimistic about where we are.

We're having to navigate and have had to navigate through a little bit of a tough environment in generics.

But as we've said to you, that happens from time to time, and we're keeping disciplined about how we see the future of the business.

Anything to add to that, Mike?

I think the only thing I would add is that as you mentioned, generic pharmaceutical pricing is a key driver.

And I think the timing of the three distributor's year ends is an important factor to consider.

When you think that what we really saw, the impact of that was really in our Q1.

And I just put it simply, if our year-end had been three months later, we probably wouldn't be revising guidance, because we'd have had some insight and built that into the year.

If our year-end had been three months earlier, we probably would've had a bigger miss, because we'd have had even less insight into what.

So it's difficult to compare when you have three different year ends.

Thanks.

And obviously, George, you talked about, in terms of key priorities.

On the Medical business, the growth there has obviously been quite good.

You've gained some shared, you've executed on the deals.

The balance sheet still has some capability.

In terms of adding incremental assets to the mix and continuing to evolve that strategy, where are you in terms of appetite for, having digested Cordis, contemplating whether or not it makes sense to add more into the bag there in Medical?

Yes, thanks, Rob.

I'll just do this very generally and probably consistent with comments we've made in the past.

We continue to look for opportunities to grow our business organically and certainly through the strength of our balance sheet.

And so to the extent that we see opportunities to grow capabilities that we think have sustainable competitive advantage, position us for this continuing evolving market, we will not be shy to look at those opportunities.

But again, hopefully you'll expect from us discipline in doing.

But certainly a part of the equation for us is how we use our balance sheet, and that may be through activities that are available external to us and the other ways that we deploy capital.

Eric Percher, Barclays.

Thank you.

I think I'd like to maybe split hairs a little bit on the drug pricing conversation.

So I heard you loud and clear on the impact to this quarter from generic drug pricing assumptions moving to high single digit deflation.

I want to make sure I understand perfectly that commentary relative to competition in the marketplace and your view, did that competition element impact the change in guidance or are we really focused on the element in the assumption that you focused on?

I think one feeds the other.

The competitiveness in the generic market is what drove the revision to the generics being down net high single digit deflation for the year.

Because it's made up of two key components, pricing from the manufacturers, which we said we haven't seen really much variability from what we expected for the year, and then our pricing downstream to the customers.

The combination of those two drive that factor.

And so since we've seen, like we said, more aggressive pricing in the market early on in the year, although, again, we've seen some positive signs lately, that is what drove that number to be down high single digits.

Okay.

Now I get it relative to the math factor expectations.

That's helpful.

And then your comment on Q3 versus Q4, Mike, we've been trying to understand the ramp through the year.

Should I expect that we're still down high single digits in Q3, but then potentially up as we get to Q4 and you lap some of the headwinds?

As far as actually giving growth percentages, I don't want to necessarily step right into that.

But I do think that, again, just trying to be helpful, if you take what you obviously think the guidance for the year is and take a look at the second half, we just wanted to give you a little bit of color that Q3 would be slightly larger than Q4.

Robert Jones, Goldman Sachs.

Great.

Thanks for the questions.

Just following up, Mike, on the back half commentary.

Seeing some of the key metrics stabilizing as you move into the back half, other than maybe some residual impact from something like Safeway, do you feel that the back half, as you look at it today, is more representative of the New World order?

Is this how we should think about how the business can perform in this environment, as you think about obviously a little bit of a difference between 3Q and 4Q, but taken together, is that how you envision the business performing going forward?

Generally probably overall, it's not a bad assumption.

Again, I'd have to think through all the pieces and how it relates over a full year, because you've got comps and stuff to the prior year.

But if you think about certain things like if the generic market has stabilized, which again, we say early results we've seen, we'll lap Safeway in the fourth quarter, and then you have the $21 million step up in Q3 that completely goes away.

So you do have some large moving parts that kind of settle out during the year.

But you're going to continue to have positives, like Red Oak and some the other initiatives that were driving, that continue to be tailwinds for us.

But yes, a lot of those things that have created some noise in the P&L should either be stabilizing or we should be lapping.

Okay.

Got it.

And I know we spent a lot of time on the generic pricing side, but can you remind us on the branded side what's factored in for the year?

Specifically, is there another assumption in your fiscal 4Q that you would see another round of more significant branded price increases?

Yes, it's a great question.

It's hard to know whether or not we'll see another set of increases or what they'll be for the rest of the year.

But we still believe that our estimate of 7% to 9% for the full fiscal year is approximately the right number to be at.

Again, that's a range that obviously there's some variability into that.

So we're trying to take into account all of those factors as to whether or not there should be.

I would also mention that again, most of the price increases in the second half do happen in January, so we have seen a lot of it.

So the amount of it in the second half that's left to go is not necessarily huge.

Yes, and I think the other thing, again, just as a moving part, movement here is not as relevant as economically as what we were describing in generic.

George Hill, Deutsche Bank.

Good morning, guys, and thanks for taking the question.

Mike and George, I'd ask, what type of insights is Red Oak giving you in the ability to forecast in generic drug pricing and does Red Oak provide you any protection from downward price activity that might differentiate you from your peers?

Yes, George, I'll start with that and then Mike.

So on the buying side, remember, there are two components to this, there's the buy and the sell.

Red Oak, I think we've got really sophisticated analytics capabilities and just great dialogue with our manufacturing partners.

So as much as you can, obviously these are products that, as you know, change frequently in the generic world.

But I would say we've got pretty good line of sight and really good analytics and great teams.

The sell side is a different story.

So Mike, thoughts on that?

Yes, I'd say the first comment, emphasizing what George said on Red Oak.

The ultimate, for lack of a better word, game in generics is while you can have a deflating sell price, but if you're managing your cost better, you can always be expanding your margins.

And so if you're asking me, do I think we're in a great position with Red Oak?

Absolutely, based on what George said.

I have a ton of faith in the team.

The analytics, the fact that we're the largest in that standpoint, I feel really good about that.

As far as Red Oak working together with the sell side, there's actually no cut over.

Red Oak doesn't do anything or have anything to do with what our sell price should be.

Their goal is to ultimately go out and get us the best absolute cost.

And then we have a firewall between the two, because I think it's incredibly important that our selling side folks aren't actually seeing the cost of our generics, because I don't want that to influence how they decide to price.

We want to price the market, and we want to make sure we're overall evaluating our overall selling proposition.

So we actually have a very strong firewall between our sell side decisions and our costing decisions with Red Oak.

What I would add to this, George, is that I do think our telemarketing operations give us, on the sell side, probably a very nice line of sight, because we're having so much daily dialogue with the pharmacy world.

So I think we're as good a line of sight as we can.

But as you know, this year has been a little more difficult to model than past years, but we're a little bit encouraged by the more recent signs.

Okay.

And then maybe a quick follow-up might just be, your largest customer seems poised for some market share losses.

I know for you guys, that's largely brand business.

Is the any impact to market share shifts on the retail end factored into the guidance or is it immaterial?

Yes, we knew about all of that in the past, as we mentioned before.

All that was factored into our guidance.

Steven Valiquette, Bank of America Merrill Lynch.

Thanks.

Good morning, George and Mike.

So just on the generics and these signs of returning back to more normal, typical pricing patterns, just curious to get more color on what you think are the drivers of that slightly improving generic deflation rate?

Not to throw things out there, but I'm curious, are you seeing some price increase activity to offset price erosion on others, or is it just anniversarying tougher comps?

Just want to get more color on what you're seeing that's leading to the better trend.

Steve, I'll do the best I can on this, because these are complex markets.

I would say in general, we saw what we felt to be a pretty unusual flurry of activity in the early part of our fiscal year.

And our expectation, just based on history, was we see those things from time to time and they tend to stabilize and become, revert back to more normal patterns if you don't see significant movement of share.

And I would say that's probably what we saw.

So what happened during a period of time was that the steepness of the curve was sharper.

It was a more steep downward curve.

There's always erosion on the sell price.

That's the normal pattern.

But the rate, the steepness of that curve was a little heightened.

And our feeling was that what we might see and we expected to see was a bit of a calming down of that at some point, and I think that's largely as best as we can describe that dynamic.

Okay.

Quickly on the brand side, you mentioned that 15% of the profits may be tied to brand inflation.

For whatever reason, it seems like investors have a higher than normal amount of focus on the upcoming mid-year round of brand price increases for the industry.

My sense, as you touched on a little bit earlier, it's just not that critical to the overall earnings picture, really, in any year.

I'm just wondering, is there any breakdown of how much of that 15% of those economics occurs around the January round of brand inflation versus the mid-year round?

I'm guessing the overwhelming majority is tied to the January round.

Thanks.

Yes, absolutely.

When you take a look at the historical patterns and even so far what we've seen this year is the branded price increases are heavily more weighted to the January time frame than any other time.

Probably that mid summer timeframe is the second largest.

But it's by far larger in the January time frame.

And it's again, to emphasize, if I had to talk about the three variables, I would rank them in order of generics by far being the largest, and then the taxes, only because of its variability between quarters, and then brand being the smallest of the three, at least for our mix of products and what we're expecting.

Charles Rhyee, Cowen and Company.

Thanks for taking the question.

George, and Mike, if we go back to the Dublin day in December, you had talked about the competitive environment on the sell side, highlighting your independent book.

And George, if I recall, you made a comment saying that you had factored in the competitive step down in the pricing into your guidance here.

So then when I think about your comments today, are you saying that we continue to see more competitive price erosion, or was it your assumptions on what you needed to give in terms of maintaining your book had changed?

Thanks.

Hello, Charles.

Good morning.

I think largely what we're saying is that as we came to the tail end of Q2, we started to see more typical rates of erosion in comparison to what we had seen in the early fall, which was more sharp.

So actually again, we're being a little bit cautious here, because I wish I had more data to say this is a discernible trend.

But I would say that it's a good sign that we did see some stabilization to the more normalized rates.

Mike, add to it?

I'd just again emphasize that at the time in December, we didn't have quite as much information as we did by the end.

And bottom line is it just settled out a little lower than we expected it to across all of the channels where we sell generics.

But the good news is it seems to have stabilized at that lower level and we just needed to update where we were for the rest of the year.

Great.

And then as a follow-up, you mentioned earlier you expect the component of your fee for service that's contingent to be less than 10%.

I missed the timeframe that you expect that to happen.

Is that as we get into FY18 or is that a contracting cycle within the next few years?

Thanks.

Yes, I would say that it would be more of a next 12 months type of a thing.

Right now, it's less than 15%.

I would expect it to get to that [$0.10] range within the next 12 months.

John Kreger, William Blair.

Hi.

Good morning.

This is Jon Kaufman for John Kreger.

Thanks for taking the question.

So you noted strong growth in your Specialty business this quarter.

So could you touch on how your discussions with specialty drug manufacturers are going?

Then, how quickly is your Specialty Distribution business growing compared to the health services piece?

How confident are you that growth in Specialty over the long run won't cause some downward pressure on margins?

Yes, so there were a couple of parts to that question, Jon.

I just want to make sure I got them right.

One is, I think you're saying, what's driving it, if I got it right, again, multiple components, what's driving it, do we see it as sustainable, and the impact to margin rates.

So let me start with the basics.

I think we're driving it and have been very consistently been driving growth in two primary areas.

One is our reach across therapeutic areas has just become dramatically larger over these last 3 to 4 years.

So we were present in certain areas in the institution, and we started to grow our oncology businesses.

We've expanded into urology and rheumatology.

And so I would say our overall footprint downstream in therapeutic areas right now is very strong.

And that just makes us a stronger partner for anyone.

On the upstream, I think we've started to build more tools and capabilities for the manufacture partners.

And particularly, I'd highlight our patient hub.

And this is a time where manufacturers really want to connect with their patients, and I think our hub allows us to do that.

So we do see continued progress in our Specialty business.

As it relates to margin rates, we don't break out the specific margin rates in Specialty versus traditional Pharma.

Having said that, we don't see the Specialty as being dilutive to it.

And again, Mike, I'll ask you to just qualify anything I --

Just a couple quick comments.

I would say, if you think about Specialty just separated in two different businesses, services upside, the bio pharma downstream to the providers, both are growing significantly.

On the downstream side, although we've lapped the Metro Medical acquisition, it continues to perform very well in some of the areas where we weren't as strong before the acquisition.

For instance, we were strong in oncology, they were very strong in rheumatology and nephrology, and those areas continue to go very well for us.

And the team down there executes very well.

So we're seeing very strong growth downstream on the provider side.

That's going to be our more lower margin typical distribution type of margin business.

And then upside, on the bio pharma side, the strong areas have really been our hub, our 3PL business, and our scientific and regulatory businesses are all doing very nicely.

And these are going to be much higher margin service businesses.

So when you blend it together, it makes for a nice mix for us.

Okay.

Great.

Thank you.

David Larsen, Leerink.

Congratulations on a good quarter.

Mike, can you talk about -- yes, very good quarter on both divisions -- can you talk about your SG&A costs?

Those looked like the lowest percentage of revenue that I've seen in four years.

Are there any focused efforts going on at Cardinal to maybe reduce costs?

Can you talk about that, please?

Sure.

As you can imagine, any time when you're not performing at the level that you would expect yourself and hold yourself accountable to delivering, you're going to get after managing your expenses maybe even tighter than you normally would.

And so I think that both the Pharma and the Med team, even though the Med team's performing very strongly, they're also paying attention to their expenses, too, because we're all one company, we're all Cardinal.

But the Pharma side is just being very thoughtful about where they're making investments, trying to prioritize.

And I did want to emphasize, we're still making investments.

It's important to know that while we're paying attention to our SG&A, we're also, at the same time, prioritizing things that are still important to our future and investing in those.

So I would say it's really about tight focus, prioritization, and just managing through those types of things.

Okay.

And then on the Medical side, if Don is there, maybe he can comment on the margins and is this a good go forward run rate?

Yes, I think we're going to continue to see some fluctuation in our margin rates in Medical, but I do think that you're now starting to see a margin rate where we would expect it to be.

As you said, we've never given up on our goal to at 5.75%, both through our organic growth and inorganic moves that we'll continue to make.

I think you're that going to see big wins, like Kaiser that we talked about.

While that's a distribution customer, it's going to be margin dilutive because it's more of a distribution business.

And then you're going to see adding businesses like Cordis, which are going to be higher margin.

Then you're going to see us convert our customers to more Cardinal Health brand products, which is going to increase our margin rates, grow our at home business, which has grown our margin rates, as well NaviHealth.

So I think we have a lot of moving parts in Medical that should continue to help us with the momentum on growing our margin rates on that side of the business.

Michael Cherny, UBS.

Good morning, guys.

Most of my questions have been answered.

Just quickly, Mike, one for you.

Just a more technical question than anything else.

It looks like, just from your updated share count assumptions, that we're pretty much assuming no real incremental buyback, based on current levels at the back half of the year.

Is that how you guys think about it, and then to be opportunistic if you see fit?

Like you said it about perfectly.

Yes.

We're not anticipating any more stock repurchases in the second half.

However, if there is an opportunity and depending where our cash is at, we may opportunistically do that.

But right now, we're not planning to do that, at this point.

Got it.

Must be the Patriots blood in me.

And then George --

Don't encourage Sally.

(Laughter)

George, one big picture question for you, particularly as you move into your role as head of Healthcare Leadership Council.

As you think about all the moving pieces in DC and whether it's the uncertainty around stuff around tax reform, be it corporate tax reform in the US, border adjustability, all of the moving pieces related to the changing landscape of healthcare reform, and the will they/won't they on the Obamacare repeal, how do you think about positioning the business and positioning the Company so that you are as nimble as possible as some of these changes come down the landscape?

And is there any way you can even pre prepare the business for something that's a moving target?

That's a great question, Mike.

I appreciate it.

So let me do the best I can.

One of the interesting things about our business is that our fundamental strategic direction had been set really for a number of years.

And we actually had a strategic planning process that we do with 100 or so people in the organization a couple times a year.

And as it turns out, we had one just a few days after the election.

And the first thing we did with the group was put out a chart in front of them and said, these are our priorities, these are the trends in healthcare, what changes?

With the exception of the fact that we're going to have to deal with some policy issues along the way, fundamentally the directions are clear.

Demographics will not turn backwards.

We know it's an inexorable march.

We know that care is going to move to more ambulatory settings, move to different settings.

We know that there's going to be a focus on efficiency and coordination of care, that the post acute worlds going to be important.

So we built our strategy around those things.

So it's been really interesting to try to navigate the short-term stuff but keep our eye very much on the long term.

Here's what I'd say just very, very generally about the two things you mentioned, the Affordable Care Act and the tax-related issues.

The President and the majority party have made it very clear that their intentions are to repeal the Act through the budget reconciliation process.

And through that, as you probably know, they can eliminate components of the law.

But they've also reaffirmed their commitment to retain certain aspects of the law, like the pre-existing conditions requirement.

So again, these are complex moving parts.

And so the thing that we're doing is making sure that we're there as an educator, that we're reminding people about whether we're going to replace or rebuild or repair, whatever the right term is, we want to make sure that there's a stable insurance foundation to support it, and that is a key opening part to it.

And we think that's, at this point, well understood and that the timelines are probably going to adjust a little bit as people try to figure out how to navigate that.

We'll make sure our voice is heard.

On the tax proposals, we generally have been a supporter, as you know, of tax reform, but again, we want to make sure that we are educators and informers on certain dynamics.

So for example, we know that many medical products, including some of ours, are made outside of the US in regulated facilities.

And so we want to make sure that that information is well understood as policies are starting to come through.

So yes, it's an interesting time, both as Cardinal Health and certainly in my new role as Chair of HLC.

But I think we're well positioned broadly, and I think we're nimble enough to continue to adapt to short-term dynamics at work.

Eric Coldwell, Baird.

Thanks very much.

Medical, obviously I think everybody is feeling a little better about it today.

That being said, you do have a very large win with Kaiser.

I'm just trying to pull back the layers of the onion here a little bit.

If we could strip out Kaiser, my guess is growth looks like 3% to 4%.

What is the growth in acute care standalone, ex Kaiser?

You've got a lot of small businesses that are growing faster, doing better.

I'm just trying to make sure that the acute care distribution piece standalone ex- market share isn't actually flat to shrinking, at this point, or maybe it is?

Yes, Eric, thanks for the question.

I don't want to pull Kaiser out, for two reasons.

One is I wouldn't want to talk specifics about the size of any one customer.

But second of all, it is part of our business.

It is the result of all of the work that the team has done to reposition the business as a thought leader, as a business that has lots of other services, a broad product line.

And so to me, it is more of the result of all of the work we've done.

So to pull it out doesn't make sense.

Now the business is still definitely growing without the Kaiser piece in it.

But it's hard to break it out, and I don't know that that would be appropriate.

George?

Yes, Eric.

If it's okay, I'll do this.

Because we break out individual pieces, and we certainly don't want to break out individual customers.

But remember I talked to you about, and someone asked earlier about lead indicators, so they're all looking green.

Our Medical Surgical distribution business is probably in the healthiest position we've seen in quite some time.

So we're seeing really a very good organic activity and growth there.

So I think I can answer it qualitatively without breaking out the individual pieces.

Mike, I don't want to take Kaiser away from you.

I actually think you're structurally advantaged perhaps versus some in the market.

I'm just trying to get a sense of where the market is.

Understood.

Absolutely.

And I didn't mean it any other way there, but I appreciate that.

Okay.

Thank you.

We can take it off-line.

Thanks.

Thanks, Eric.

Garen Sarafian, Citi.

Good morning, George and Mike.

High level question on procurement in generics.

One of your peers is in the market getting updated pricing that includes the volume of a large new retail client.

So how has that impacted the market?

And how long do you think whatever changes are going on take to flow through?

Gosh, that's a tough question, because I don't really want to speak for our competitors and I'm not sure of the timing of exactly when they're launching and all the different pieces of when they go to market.

But I will say that, as you can imagine, our Red Oak team is paying attention to that, has great relationships with the manufacturers, and we'll be paying attention to that to make sure that we are costed appropriate for our size and simplicity and transparency of our model.

And other than that, that's probably all I can say.

Okay.

Fair enough.

And if there's anything on how long, in generic terms, when there's a large new client, it takes to flow through the system?

But the follow-up was actually going to be to close out a prior question on the impact of branded price increases and the impact to Cardinal.

Could you put some broad weightings around impact of January price increases versus the mid-year?

Is it more of 66%, 33% or is it more 80/20, or something else that you could share?

Thank you.

Yes, I probably can't share that level of detail, because it's obviously hard to know, and manufacturers move slightly between month to month quarter to quarter.

So again, I'll just emphasize, January's bigger, the biggest month.

But other than that, George?

Garen, I'd just add to this.

Typically, January's bigger, as Mike said.

The other thing that we need to note is it's been an unusual stretch for some time.

And so again, predicting exact ramp behavior is always a little bit tricky.

As you know, years ago it was very, very systematic and today it's a little bit more one-offs.

But I think, as Mike said, January typically is a bigger month.

But I think we have to recognize that things are a little bit different and maybe not as predictable, in terms of exactly when things occur, as they might have been five years ago.

Yes, and to answer your other question around generics and being able to execute on that, I think that just depends very differently on how you go to market, the size of that customer, whether it even deserves a repricing, and then how you go about that, how your relationships are with the manufacturers.

So I think that can vary drastically and dramatically between different players in the marketplace.

I know we feel really good about when we combined how quickly we executed.

But I'm not sure I can say that anybody else would go faster or slower than us.

Greg Bolan, Avondale Partners.

Thanks, guys.

And I hate to ask this at the very end of the call, George -- and by the way, I very much enjoyed the white paper on DIRs that just was issued, I guess, what, last month -- but from the standpoint of your ability to defend or protect independent pharmacies and obviously maintain, maybe even gain market share in the independent pharmacy space as it relates to DIRs, where do you guys sit in the spectrum?

Because it does feel like this is obviously, these revelations that we're starting to see on DIRs, it's a very painful experience for your pharmacy customers.

And I just wanted to see how you guys could possibly or how you are potentially defending them, protecting them, when they are obviously experiencing these pretty massive decremental margins 90, 120 days after the fact.

So there are two parts to this.

So let me answer the second part first.

I'm not sure there's a company more focused on the community pharmacy and pharmacy industry in general.

We believe that they're going to be a key player as healthcare continues to evolve.

We have shortages of primary care physicians.

We think pharmacists will and should play a more active role.

We're doing an incredible amount of work through John Jochman's organization to make sure that we are close to them and providing all the solutions and tools that can help them compete in the market, and actually help them provide cognitive care, which we think is very important.

Going back to your first point, I want to make an important note about this, because we've gotten a few questions.

We are a player in oncology and as such, we've been a member of the Community Oncology Alliance.

And as a member of that, we have funded research.

But you specifically referred to a particular project.

We did not direct the research or set the subject.

So it's just important for me to comment on that.

We've had questions about that paper.

We didn't specifically fund a paper on this.

We are basically part of an alliance and that group does research.

But the summary of what I'm describing is our work around community pharmacy and around pharmacy in general is very much a part of what we do, whether it's through generic programs, abilities to help them tie to a hospital system or to a post acute facility or to set up a diabetes center.

We've done a huge amount of work in providing tools to help community pharmacy compete in what is for all of us an interesting and challenging environment.

Thank you.

You're welcome.

This concludes our question-and-answer session.

Mr. Barrett, I will turn the call back to you for any additional remarks.

Sure.

Thank you, Eric, and thanks to all of you for your questions today.

Our organization, just in summary, remains focused on execution, on driving our strategic priorities, on making sure that we are creating, what I would say is again, sustainable value creation for our partners and for patients and for you all.

And we look forward to seeing you all in the near future, and thanks for joining us on the call today.

Thanks, everyone.

This concludes today's call.

Thank you for your participation.

You may now disconnect.