麥卡遜 (MCK) 2017 Q2 法說會逐字稿

Good afternoon, and welcome to the McKesson Corporation quarterly earnings call.

(Operator Instructions)

Today's call is being recorded. If you have any objections you may disconnect at this time. I would now like to introduce Mr. Craig Mercer, Senior Vice President of Investor Relations.

Thank you, Noah. Good afternoon and welcome to the McKesson FY17 second quarter earnings call.

I am joined today by John Hammergren, McKesson's Chairman and CEO; and James Beer, McKesson's Executive Vice President and Chief Financial Officer. John will first provide a business update and then James will review the financial results for the quarter. After James' comments, we will open the call for your questions. We plan to end the call promptly after one hour at 6:00 PM eastern time.

Before we begin, I remind listeners that during the course of this call we will make forward-looking statements within the meaning of the Federal Securities laws. These forward-looking statements involve risks and uncertainties regarding the operations and future results of McKesson. In addition to the Company's periodic, current and annual reports filed with the Securities and Exchange Commission, please refer to the text of our press release for a discussion of the risks associated with such forward-looking statements.

Please note that on today's call we will refer to certain non-GAAP financial measures. In particular, John and James will reference adjusted earnings, which excludes four items; amortization of acquisition related intangibles, acquisition expenses and related adjustments, claim and litigation reserve adjustments and LIFO related adjustments.

Finally, I would call your attention to the supplemental slides, which we will reference on today's call, and those can be found on the investors page of our website. We believe the supplemental slides, which include non-GAAP measures, will provide useful information for investors with regard to the Company's operating performance and comparability of financial results, period over period.

Please refer to our press release announcing second quarter FY17 results and the supplemental slides for further information and a reconciliation of the non-GAAP performance measures to the GAAP financial results. Thank you.

Here is John Hammergren.

Thanks, Craig, and thanks, everyone, for joining us on our call. Before I jump into our second quarter results, I'd like to take a few moments to frame our discussion today as events impacting our second quarter results have implications for our outlook for FY17.

Let's start with our revised FY17 outlook. In particular, we now provide an update to our expectation of a lower profit contribution resulting from recent customer pricing activities and lower operating profit as a result of further moderating branded pharmaceutical inflation trends compared to previous expectations. Both of which affect our US pharmaceutical business within Distribution Solutions.

As a result of these updates, we now expect $12.35 to $12.85 per diluted share, which excludes from adjusted earnings, a goodwill impairment charge in our enterprise information solutions business, which James will cover in his comments, as well as estimated charges related to our cost alignment plan that was previously announced in March of 2016.

As we built our plan and entered FY17, we assumed some moderation around drug inflation activity. In particular, we commented on our expectation for a nominal contribution from generic pharmaceuticals that increase in price. We also commented that our expectation that branded pharmaceutical price trends would be modestly below those experienced in FY16.

First, generic price inflation has been largely in line with our original assumption, however, customer pricing and branded inflation continue to evolve. In our first quarter we witnessed some evidence of inflation and pricing softness in line with our original assumptions, however, this softness became much more pronounced in our second quarter, first around brand inflation, and later around customer pricing.

While we generally do not provide specific assumptions around customer pricing activity, we do operate in a competitive environment, and though competitive, we've always been focused on delivering value to our customers. Value not just defined by price but by service, innovation that helps our customers partner, manage, and run their operations, and manage their capital more effectively, and innovation that helps our customers connect with patients in a more informed and intimate way.

Now price is always a consideration. We provide our customers a premium value through our superior service and innovation, for which we expect to get an appropriate price. We believe that delivering premium value builds more sustainable customer relationships and long term shareholder value.

Generally speaking, we anticipate pockets of increased competitive activity as part of our normal course of business. What we began to see more recently is competitive activity that is broader than our original expectations, more aggressive and across several areas of our US pharmaceutical business.

As I've mentioned in the past, McKesson manages pricing on a centralized basis. Although I think all of our customers believe we've been charging fairly for the service we provide, and are willing to pay for this service, when a competitor significantly undercuts our existing pricing, we are compelled to respond. And although we cannot be absolutely assured that recent price concessions will address the recent heightened competitiveness fully, we believe our responses have been appropriate and measured.

We remain committed to our careful and thoughtful approach to customer pricing and to the value we deliver to help differentiate our customers capabilities and performance relative to their competitors. We believe the services we provide to both our provider customers and our manufacturer customers offer substantially greater value than what either party could develop with a more direct relationship. We expect that with our focus on the value we deliver our margins will recover over time.

As for branded inflation, I suspect many of you have tracked the evolving conversation in the US. Last month, James highlighted concerns we had around some manufacturers appearing to delay some price increases we would have otherwise anticipated based on their historical and our historical experience. What we have seen this year-to-date, are fewer products with price increases and those price increases are at lower rates than both prior year results and our expectations for the current fiscal year.

Given our second quarter performance specific to branded price inflation, we now expect full year branded pharmaceutical pricing trends to be both meaningfully below those experienced in FY16. Let me spend a minute and talk about how we are compensated for branded pharmaceutical product distribution services.

Today all of our contracts with branded pharmaceutical manufacturers are individually negotiated, but generally are constructed around charging for the service we provide. In almost all cases, the charge is derived as a percent of revenue managed and delivered by McKesson for that specific manufacturer. These charges vary not only by manufacturer, but also by the service requirement at the product level.

Clearly, revenue based fees are all affected at some level by inflation, however, in some cases the benefit from inflation is greater given the specifics and the characteristics of individual contracts and the specific behavior of the manufacturers that are a party to these agreements. So although a large majority of our compensation is relatively easy to forecast, inflation based income derived from these relationships can impact our results on a more variable basis.

Through these agreements, speculative buying or buying large quantities of product in front of anticipated price increases no longer exists. Essentially, all of McKesson's pharmaceutical purchases are done in partnership with the manufacturer, unlike the industry standard practice years ago before any contracts presided over the relationships between the wholesalers and their manufacturer partners.

These changes that happen years ago have translated into more stable inventory levels that are appropriate to meet the customer demands and service levels. So the takeaway here is that branded inflation still plays a meaningful role, and in is some cases it can be an important part of our overall compensation with specific manufactures, and we can be impacted by their decisions relative to price increases.

Although some contracts of manufacturers may not have specific compensation elements tied to product price changes, our internal branded price inflation assumptions often appear to be directionally aligned with externally published data. But the mix matters, so even relatively small changes in behavior could have a more or less impact on our results depending on the characteristics of that individual manufacturer contract. We would like to think we do a superior job of exceeding the expectations of these partners, so there should be even some variability in our industry related to results driven by brand and generic inflations.

So what does all of this mean moving forward? It means we expect to receive less compensation from branded price increases than we originally anticipated in FY17. It means we will continue to monitor pricing activities throughout the year, especially in our fiscal fourth quarter, which is typically an important quarter for price increases. And it means we are engaging with our manufacturer partners to ensure we receive appropriate compensation relative to the services and value we deliver amidst a softer pricing environment.

Now turning to our revised outlook for FY17. We expect the combination of recent competitive pricing and further moderating branded price increase activity will have a combined negative effect on our business by approximately $1.60 to $1.90 per diluted share, versus our July FY17 outlook with the larger impact coming from competitive pricing.

Turning now back to our second quarter results. In the interest of time, I'll hit a few key themes and then will hand the call over to James to cover our financial performance. Let me start with the progress we made on integrating the several acquisitions we closed last quarter, as well as early progress on Sainsbury's, which we closed at the beginning of September.

These are important strategic investments that are tracking to our expectations and contributing positively to our financial performance. We were especially pleased by the stronger than expected performance of our biologics acquisition, which is an important offering to our manufacturing partners in the rapidly growing oncology specialty pharmacy market.

Turning now to some highlights within distribution solutions segment for the quarter. Our sourcing partnership with Wal-Mart is progressing well. We made considerable progress to date in our efforts to establish the new sourcing function, and we are on track to realize benefits from this new venture in FY18.

We remain confident in our assumption that we will service the Rite-Aid business through our current fiscal year given that the acquisition by Walgreens is still pending. We will continue to follow the progress of this transaction as well as any new developments around the opportunity to serve any of the acquired or divested stores.

We are making a fundamental change to the structure in terms of our relationship with both providers and manufactures as it relates to hundreds of specialty products. We are charging separately for the supply chain value we add across a wide array of product categories and manufactures. Our conversations with customers and suppliers around specialty pricing are proceeding as expected, and we are pleased with the responses we are receiving.

I'd like to take a moment to acknowledge the great work from our US pharmaceutical teams that support our customers every day. We started the fiscal year with the successful onboarding of the Albertsons/Safeway network and another successful idea share conference with our independent retail pharmacy customers. And in the second quarter, Health Mart stores were ranked highest overall in customer satisfaction among chain drug pharmacies across the US in the J.D. Power 2016 Pharmacy Satisfaction Study. It's great to see recognition for the positive experiences patients receive every day in these pharmacies.

Turning now to our international pharmaceutical distribution and services. As we mentioned in our earnings call last quarter, the reimbursement cuts imposed by the UK government to retail pharmacy rates, as well as the UK's decision to exit the EU, have unfavorably impacted Celesio's operating performance. Despite these headwinds, I'm encouraged by the significant progress we've made to help shape the long term opportunities we expect are available to us across the European markets in which we operate.

In addition to our internal focused strategy such as Six Sigma training and a standard ERP platform across our many geographies, we are engaged with external stakeholders in productive discussions around services we can offer to State-run health systems, where wholesalers today often play a limited role, or in expanding the services a retail pharmacy may deliver to its customers. We continue to make good progress on further developing our opportunities in our European markets.

As for our other Distribution Solutions businesses such as McKesson Specialty Health, McKesson Canada, Medical-Surgical, they are all performing very well showing strong growth and profitability including double digit adjusted operating profit growth year-over-year for all of these businesses in Q2.

Turning now to Technology Solutions. I'm encouraged by the exceptional performance from our Technology Solutions team. Even with considerable distractions to support the creation of a new Company with Change Healthcare, this segment delivered solid results. We continue to make steady progress across technology solutions in support of a strong future with Change Healthcare, while managing the work to retain the relay pharmacy business and prepare the EIS business for strategic alternatives.

In Q2, we recorded a material non-cash goodwill impairment charge related to EIS. As you may recall, we are considering strategic alternatives for EIS, which is part of our broader Technology Solutions strategy that we unveiled earlier this year. Our commitment has been and will always be to the long term value creation for our customers, employees and shareholders and we are confident in the direction we are headed with our Technology Solutions businesses.

Now to wrap up my comments, we have spoken for a few quarters about how generics inflation and customer consolidation challenges that we identified last year, which were incorporated into our FY17 outlook.

We have effectively lapped these items at this point in time, however, we recently experienced new challenges around pricing softness in the form of increased competitive pricing activity and lower branded inflation, which I discussed a few moments ago. These new challenges resulted in a lower fiscal second quarter result and a revision to our previous full year outlook for FY17 of a $13.43 to $13.93 old range to a new range of $12.35 to $12.85.

Our business remains structurally sound. We are in the right businesses in the right markets and we bring scale and efficiency to all stakeholders. Our leadership team and I met with each of our business unit leaders earlier this month. These visits reinforce my conviction that we have the best people in the business making the right decisions every day to help our customers lead the change across the healthcare system we serve.

We consider it an honor to serve in this capacity, and clearly our people have the passion necessary to lead through change. The quality and ingenuity of our team give me great confidence in our future.

We have a strong balance sheet and robust cash flow generation. We are extremely well positioned to deploy capital and deliver value for our shareholders through a combination of internal capital investments, acquisitions, share repurchases, and dividends. And we're pleased to announce earlier today an increase of $4 billion to our existing share repurchase authorization.

With that, I'll turn the call over to James and will return to address your question when he finishes. James?

Thank you, John, and good afternoon, everyone.

Today I will first discuss our FY17 outlook and then review our second quarter results. In addition, I will provide more information related to the pending Change Healthcare transaction prior to John and I taking your questions. Before I get to our outlook, I want to note that in addition to our earnings press release and customary tables we have published a supplemental presentation on our website.

This presentation provides an operational view of our FY17 earnings or adjusted earnings excluding unusual items. We exclude from this view the non-cash pre-tax goodwill impairment charge taken in our EIS business within our Technology Solutions segment during the second quarter, as well as charges or related reversals associated with the cost alignment plan we announced in March 2016. This view also excludes prior year gains on the sales of two businesses.

To expand on these unusual items in the second quarter, we recorded a non-cash pretax goodwill impairment charge of $290 million or $1.24 per diluted share associated with our EIS business. Also, in the second quarter, we recorded pretax credits of $10 million or $0.02 per diluted share related to the cost alignment plan.

Now I will focus on our FY17 outlook. As John discussed earlier, based on our reported earnings and expectations for the remainder of the year, we have lowered our FY17 guidance for adjusted earnings per diluted share from $13.43 to $13.93 to a new range of $12.35 to $12.85. This new range excludes approximately $1.31 to $1.33 from adjusted earnings driven by the combination of the EIS goodwill impairment charge and anticipated charges during the fiscal year for the cost alignment plan.

Our revised outlook includes the impacts of competitive customer pricing and softness in brand inflation that John just discussed. We expect these two headwinds to drive a combined reduction of between approximately $1.60 and $1.90 to our FY17 adjusted EPS. We expect the larger of the two impacts to be driven by more competitive pricing.

These headwinds will be partially offset by a number of items including savings from ongoing cost management efforts, lower interest expense, a lower tax rate, and the effects of our ongoing capital deployment. A listing of the key assumptions underpinning our FY17 outlook can be found in the supplemental slide presentation on slides 17 and 18. I will not take you through each key assumption on this call, however, I would like to draw your attention to the following significant updates to our revised outlook.

We now expect the Distribution Solutions adjusted operating margin, excluding anticipated cost alignment charges, to be approximately 30 to 40 basis points below the FY16 adjusted operating margin, excluding unusual items, of 234 basis points. We now expect our interest expense to be down by a mid-teen percentage compared to FY16. We also expect a full year adjusted tax rate, excluding the EIS goodwill impairment charge, of approximately 27.5%, which may vary from quarter to quarter.

Weighted average diluted shares used in the calculation of earnings per share are expected to be approximately 226 million for the year. And as a reminder, given the expected timing of the close of the transaction with Change Healthcare, we are not currently assuming that the creation and operation of the new Company will impact our FY17 adjusted earnings per diluted share.

As it relates to the progression of our FY17 results, we expect that our second half results will be more weighted to our fourth quarter. While we are lowering our guidance today, we are promptly taking steps to address the industry headwinds that we have identified. For example, our cost alignment plan and additional ongoing cost management initiatives continue to bring savings to the Company and position us well for future growth, and I am pleased by our strong operating cash flow generation in the first half of the year.

For the full year we continue to expect cash flow from operations to increase approximately 15% year-over-year excluding approximately $270 million in cash payments related to the cost alignment plan and the settlement agreement with the DEA and DOJ. For the balance of FY17, we expect to continue to deploy capital in line with all four elements of our portfolio approach.

Now let's move to our results for the second quarter. Our adjusted EPS was $1.72 per diluted share. Our adjusted EPS excluding unusual items was $2.94 per diluted share. As a reminder, our second quarter FY16 adjusted EPS of $3.31 per diluted share included a $0.14 gain on the sale of the ZEE Medical business. For comparison purposes, our second quarter adjusted EPS, excluding unusual items, was $3.17.

Now I will review our consolidated results. Consolidated revenues for the second quarter increased 3% in constant currency. Second quarter adjusted gross profit, excluding unusual items, was down 6% in constant currency year-over-year driven by the expected weaker profit contribution from generic inflation trends and the impact of previously disclosed customer consolidation activity and lower compensation from a branded manufacturer, partially offset by our recent business acquisitions in global procurement benefits. Further, as I previously discussed, we also saw softness in certain branded manufacturer pricing activity and more recently, increased competitive customer pricing activity.

Second quarter adjusted operating expenses, excluding unusual items, decreased 1% in constant currency reflecting actions taken in the fourth quarter of FY16 related to our cost alignment plan as well as ongoing cost management efforts. Adjusted other income was $25 million for the quarter, an increase of 47% in constant currency consistent with our FY17 guidance. Interest expense of $78 million decreased 14% in constant currency for the quarter.

Now moving to taxes. Our adjusted tax rate, excluding the EIS goodwill impairment charge was 25.4% driven by our mix of income and multiple discrete tax benefits. Our adjusted net Income from continuing operations, excluding certain items, totaled $669 million. Our second quarter adjusted EPS, excluding unusual items of $2.94, decreased 7% versus the prior year. Wrapping up our consolidated results, diluted weighted average shares outstanding decreased by 3% year-over-year to $228 million.

Let's now turn to the segment results. Distribution Solutions segment constant currency revenues of $49.6 billion were up 3% year-over-year during the quarter. North America pharmaceutical distribution and services revenues increased 2% in constant currency. International pharmaceutical distribution and services revenues were $6.6 billion for the quarter on a constant currency basis, up 12% driven by acquisitions and market growth. Revenues were impacted by approximately $305 million in unfavorable currency rate movements.

Moving now to the Medical-Surgical business. Revenues were up 4% for the quarter driven by growth in our primary care business, partially offset by the prior year sale of the ZEE Medical business. Distribution Solutions adjusted gross profit, excluding unusual items, was down 6% on a constant currency basis for the quarter, consistent with my previous comments.

Second quarter Distribution Solutions segment adjusted operating expenses, excluding unusual items, increased 2% on a constant currency basis. Segment operating expenses reflect an increase in expenses related to recently completed acquisitions substantially offset by our cost reduction actions. Distribution Solutions second quarter segment adjusted operating profit, excluding unusual items, was down 15% in constant currency at $933 million.

The second quarter segment adjusted operating margin rate, excluding unusual items, was 188 basis points, a decrease of 40 basis points on a constant currency basis driven by the same factors as previously discussed.

Technology Solutions revenues were down 6% for the quarter to $680 million on a constant currency basis, driven by the anticipated decline in our hospital software business, partially offset by growth in our other technology businesses. Second quarter adjusted segment gross profit, excluding unusual items, was down 7% on a constant currency basis. Second quarter adjusted segment operating expenses, excluding unusual items, decreased 6% in constant currency from the prior year, driven by our cost reduction actions.

Adjusted segment operating profit, excluding unusual items, decreased 10% in constant currency resulting in an adjusted operating margin, excluding unusual items, of 20.74%, down 104 basis points relative to the prior year. The reduction was driven primarily by the expected decline of our hospital software business, partially offset by lower operating expenses.

I'll now review our balance sheet metrics. As you've heard me discuss before, each of our working capital metrics can be significantly impacted by timing, including which day of the week marks the close of a given quarter. For receivables, our day sales outstanding are flat from the prior year at 26 days. Our day sales in inventory decreased two days from the prior year to 29 days, and our day sales in payables increased six days from the prior year to 59 days.

The increase in day sales in payables relative to the prior year is largely due to a steady increase in our generic pharmaceuticals sourcing scale and the fact that generic pharmaceuticals have longer payment terms than branded pharmaceuticals.

We generated $2.9 billion in cash flow from operations during the first half of our fiscal year. We ended the quarter with a cash balance of $5.5 billion with $2.9 billion held offshore. In the first half of the year, McKesson paid $2 billion for acquisitions and spent $240 million on internal capital investments. And earlier today, the Board of Directors approved the quarterly dividend of $0.28 a share and authorized a new $4 billion share repurchase program.

Now moving to our announced transaction with Change Healthcare. While the transaction has not yet closed and McKesson and Change Healthcare continue to operate as separate companies, we wanted to provide some updates and clarity around how the transaction will impact McKesson upon a successful closing. We continued to be optimistic that the transaction will close in the first half of calendar year 2017.

The assets and liabilities being contributed to NewCo have been reclassified as held for sale as of September 30, 2016. In addition, we expect that our 70% equity ownership contribution from NewCo will be reported in the other income line. This line item will reflect the pretax equity income from our share of NewCo. At the time of the close of the transaction, McKesson is anticipated to record a significant one-time gain on the divestiture and related contribution of our net assets to NewCo.

Next I'd like to address the drivers that I previously mentioned that will have an impact on McKesson's EPS results when the transaction closes. First, NewCo will be servicing approximately $6.1 billion of debt with an interest rate of approximately 5% to 7%, thus driving higher interest expense estimated to be between approximately $210 million and $300 million year-over-year, after accounting for our 70% share of NewCo's earnings.

Second, as is customary with transactions involving technology companies, we will record fair value adjustments to the contributed businesses deferred revenue, which we expect to reduce reported earnings year-over-year by approximately $150 million to $200 million after adjusting for our 70% portion of NewCo's earnings. Please note that the deferred revenue range I have provided today is sensitive to our fiscal year end sales activity.

Assuming that the transaction closes on April 1, 2017, the combination of financing costs and accounting related fair value adjustment is expected to drive between approximately $1.10 and $1.30 in FY18 adjusted EPS dilution, which will be partially offset by an operating profit benefit including the first year synergies from our 70% portion of NewCo's earnings. This benefit will be higher than the amount that the MTS contributed assets would have generated absent our transaction with Change Healthcare.

While this transaction will initially impact our adjusted EPS, we continue to believe that the creation of NewCo is very much in the best interest of our shareholders. Working with Change Healthcare, we will drive significant customer and financial synergies. In addition, we have a strong partner in Blackstone with a shared focus on value creation and agreed upon path to an IPO and a plan that allows us to exit the investment in a tax efficient manner.

In closing, while we are currently being adversely impacted by multiple market conditions, our talented team focused on both gross profit initiatives and the expense management, strong cash flow generation and balance sheet flexibility underpin the confidence we have in our business.

Thank you, and with that, I will turn the call over to the operator for your questions. In the interest of time, I ask that you limit yourself to just one question and a brief follow-up to allow others an opportunity to participate. Noah?

Thank you.

(Operator Instructions)

Our first question comes from Ross Muken with Evercore ISI.

Good afternoon. So, John, having been covering this Company a long time, I can't recall the last time we had a discussion on competitive pricing, so I guess, what do you think caused that part of the environment to change over the last three or six months? And obviously, the magnitude that you've given is quite large, and so it's a fairly substantial change.

Obviously, we're seeing a lot of different constituents talk about drug pricing and all sorts of other things, but this seems actually unrelated. So help us just understand, one, what you think caused this, how you think the industry will then respond and hopefully heal, and then secondarily, on your end, how we should put this into context of what has happened historically if there's anything that you would compare this to?

Let me start with that, Ross. I guess I have seen this obviously throughout my career but we also saw it at McKesson that, where in particular we took sort of a step function down with pricing, you may recall in, I think in the early part of 2008. We had talked publicly about a significant price-related challenge that we were facing.

Now, it happened that year that we were able to fill the margin hole created from that stairstep through the unique opportunity to be the sole provider of the H1N1 flu vaccine back then, and that gave us a stream of profitability that allowed us to grow through that challenge. So it does happen from time to time.

You'd have to really probably ask the companies involved in it as to why they would pursue price. I can tell you that McKesson doesn't believe you can build sustainable relationships with customers or value for shareholders with a price-oriented approach, and I know that at least one company in our sector has been pretty public about growing revenues above market and about regaining market share, particularly in the independent space.

So I think that certainly people have different motives perhaps to grow their business beyond the market. I would tell you that what McKesson has been focused on, as we've talked about year in and year out, is the expansion of the service we provide our customers and the value that we deliver to create those relationships and expand our margins while we do so. And margin growth comes from solid relationships that are built over time. And from time to time, those relationships can be challenged if the price differential between where the customer perceives the market price to be and what we're asking for become disconnected.

So it has happened before. We covered through those periods of time. And like I said, I don't think a price-oriented approach to market share is something that's stable in the end anyway.

That was helpful, thanks, John.

Our next question comes from George Hill with Deutsche Bank.

Thanks for taking the question, and, John, you may have just spoken to it because you called out the pricing pressure and I wanted to see if you could comment on which market subsegments are you seeing the pricing pressure the most? It seems like you spoke to independents, but also, is it in the independents and the franchisees and the big boxes? Any more color on the pricing pressure would be helpful.

Thanks for the question, George. I think the most acute area right now is in our independent segment, and clearly that's a place where you have lots of customers that have had long-term relationships, but they also can be fluid. And I think what we've tried to say today is that we plan to maintain our share positions and to grow our Business on the value we deliver, and that's really what we're after. And the rest of our segments are always competitive, but this is the most material impact we've seen in some time.

Okay, and then just my only follow-up would be from a quantification perspective, is there -- you gave us the basis-point impact, but is there a way to think about the magnitude of the pricing change in that segment that you're seeing? Quantify the magnitude, I'm sorry.

I think James talked a little bit about the reduction in our expectations and how that's split with a larger portion really coming from the price pressure we feel, and so that gives you a sense for the magnitude. And clearly, the independent segment for us is a very valuable and important franchise, and we have a lot of business there. So I think that between those comments you should be able to get a sense directionally for the size of the challenge.

Okay, appreciate the color, thanks.

Our next question comes from Lisa Gill with JPMorgan.

Thanks very much. John, just looking at the industry, my understanding was always that a bigger component of your margin actually came from the manufacturers versus the customer relationships. So can you talk about what's happening on that side of your Business? And our understanding has been that inventory management agreements cover 80% or 85%.

What are you seeing in the that other 15% to 20%? I mean, is that having a direct correlation on what you're seeing as far as the reduction in earnings as well?

Well, there really are two factors. And I'll have James talk a little bit about the manufacturers in a minute because that obviously, when we talk about brand price inflation trends, and we tried to quantify once again in our prepared comments how much of this challenge we had this quarter and we forecast for the year is coming from that component. We do have some variability that resides in that part of our Business. Clearly, the manufacturers play a very important role for us, and we're constantly working with the manufacturers to make sure that we've identified the value we deliver and that we're properly reimbursed for that value, and we plan to continue to do so.

On the customer side, it's not unimportant I think to point out that we do have a nice and profitable relationship with customers on the generic portion of our Business, and albeit we may not make much or any on the brand side, the profit stream we get from generic participation, as we've talked about before when we were picking up the Rite Aid generic business or the Target generic business, that generic business is a source of profitability. And there is obviously flexibility in how we price those generics. And there's a market for generics and we have to be responsive to how the market pricing plays for generics. James, maybe you can talk a little bit about the manufacturer side.

Yes, in terms of when we came in to the year, we were assuming that the level of brand manufacturer pricing inflation would be modestly below what we had seen in the previous fiscal year, and today we've updated that type commentaries are now being meaningfully below what we saw last year. To try to perhaps put a little bit more quantification around that, I would say that the delta, if you will, between the rate of inflation that we expected and the one that we have seen thus far year to date is greater than a third reduction versus our original expectations.

The other thing I would comment on, in terms of the brand income, why this inflation rate is important is that there is both a fixed component and a variable component of the income that we receive from branded manufacturers. Now, a year or more ago, we were talking about that being roughly an 80/20 type split in terms of the fixed component of the equation versus the variable component. As, in part, the contracts have evolved, but also in part as inflation rates have come down in the last few months, I'd peg that split more at 90/10. 90% of our income is fixed, 10% is variable, but obviously that 10 points is still being able to have a meaningful impact on the financials that we've been talking about today.

Can you help us understand what the actual rate of inflation was last year? When you say expected it to be down but now it's meaningfully down, is there a number you can put around that?

I wouldn't throw out a specific number, but that's why I articulate the decline that we have seen in the inflation rate is greater than a third of the original expectation for the year, so it's a significant decline.

Okay, great, thank you.

I think, Lisa, also, when we look at what we come up with from a calculation perspective on branded inflation, it's plus or minus what you'll see from published sources of inflation. But it is also important to point out that those averages sometimes don't necessarily tell the whole story because of the mix, or the relationship, or the individual products that are going up or going down, and the portfolios can be materially different. So I do think the economics aren't always necessarily driven with a direct correlation to the average price increases that everybody talks about.

Okay, thanks.

Our next question comes from Michael Cherny with UBS.

Good afternoon, guys. I'm going to take this a little bit of a different direction. I want to clarify relative to the Change Healthcare deal; James, if you don't mind going back over it? So you said, I believe $1.10 to $1.30 of dilution from the deal, offset by some other estimate. So is that $1.10 to $1.30 a net dilution number to the entire Business, or is that offset by those benefits, in which case we are on our own to make the assumptions from that front?

So you should think of the $1.10 to $1.30 as the combined effect of the two items that I discussed: the impact of the deferred revenue and then the impact of the higher interest expense on the $6.1 billion worth of debt. So, wanted to put quantification around those two items.

Then, the other comment I made was getting at the reality that, as we're actually operating the Business and starting to drive the synergies, the EPS that will drive from the contributed assets, if you will, our share of NewCo will be greater than the ability of those assets, absent our deal with Change Healthcare, to drive EPS. So there's an accretive effect, if you will, on that element of the equation, as you would expect when we come together and drive synergies in a deal. But there are also going to be these two large, very distinct items that will drive dilution: the interest expense and the deferred revenue haircut you could call it, and that those two items total to this $1.10 to $1.30 range that I mentioned.

Thank you. I know this is a complicated transaction; I appreciate the color. I'll let other people ask some of their questions.

Thank you.

Our next question comes from Robert Willoughby with Credit Suisse.

To that, James, do you have any growth forecasts for each of the businesses, EIS and the others? I don't think I see them anywhere.

And just maybe can you speak to the inventory environment? I know last year you scaled up inventory meaningfully in the third quarter; this year you liquidated some. I mean, does that not account for some of the profit shortfall that -- I know you say you don't do it, but isn't there some opportunity associated with that practice from a profit standpoint that maybe fell out of the model?

No, nothing unusual. In the third quarter, you would very normally have an inventory build as you come into the winter season. So, no, I wouldn't point to anything odd around inventory management.

Our cash flow was obviously a bright spot in our numbers here, and that was very much a result of ongoing working capital management initiatives, so these sorts of things that have been going on at McKesson for years, as well as our underlying operating profitability, obviously, as well. But the working capital initiatives have been an important focus for us and we will continue to have that.

In terms of the first part of your question, the technology businesses, I wouldn't get into specific growth rates around EIS or any particular segment of the Business. Overall, we feel as though our technology segment is performing very nicely. They're very much where we expected them to be at this point in the year, even though, as John mentioned in his remarks, there's plenty of work going on around setting up the new company or preparing to set up the new company, so that we have been pleased that they've been able to maintain their focus. And so we feel good about the trajectory of those businesses generally.

Just a clarification, James, you did liquidate inventory in the September quarter of this year that did not scale up. Is it just the combined effect of all of the businesses resulted in a modest reduction?

Yes, what I was observing is, in Q3, you would normally have an inventory buildup as you go into the winter season. So, yes, that's right.

All right, thank you.

Okay.

Our next question comes from Robert Jones with Goldman Sachs.

Thanks for the questions. John, I guess like others, I'm surprised to hear you highlight competitive pricing, just given how rational the industry has been for so long. And I guess if I take a step back, this year alone we've seen the negative impact to profitability from generic pricing moderating; now we're talking about a slowdown in branded inflation. Is there any thought that those dynamics themselves are what are forcing your competitors to maybe go harder after market share to make up for what seemingly would have created a shortfall in profit?

And then I guess more importantly, how sustained do you think this competitive behavior could be? Do you think this is more of a one-off, a few accounts they went after harder, or do you think this could potentially be a more lasting, changing dynamic?

I think those are all good questions. I think the best way for me to answer them would be the way we think at McKesson. I can't speak to how our competitors make their decisions or how they make their pricing calls in the industry.

I can tell you that McKesson is focused on retaining our customer base, and creating additional value for our customers, as I talked about before, and charging a fair price. And on that fair price idea, there is plenty of headroom in terms of the value we deliver to the industry that we don't charge for.

And as I've seen in the past when we have faced pressures like this, whether it's been a reduction in product launches or other things happen, when some of the profit pools become more difficult, typically what we would attempt to do is reduce the level of incremental discounts that we pass on to our customers when we're in those discussions. But clearly that conversation isn't successful if there are alternatives that are providing something that's even more significant.

So I can't -- my best hope is that we demonstrate to our customers that they are going to always get a fair price from us, and in return, they are going to get superior service and tremendous focus on their success, and that's where we plan to stay. And I know at McKesson at least, we think growing market share through a price-oriented approach ultimately will not be successful because customers don't want to change. Our customers, when they get a better deal, come to us and say: Hey, listen, can you match this deal because I'd like to stay with you. So that customer pressure to remain with us because they like us always provides McKesson an advantage when we're in these discussions.

Understood, I'll leave it there, thank you.

Our next question comes from Charles Rhyee with Cowen & Company.

Yes, hi, thanks for taking the question. Just curious, James or John, when we think about the reduction in guidance for the year, can you give us a split maybe between how much you think is coming from the customer side versus how much is from the brand inflation side? Is it half and half?

Yes, so couple of points: In terms of the negative effects, I would say it's the competitive pricing having a greater impact than the brand manufacturer price inflation rate. But also remember that we offered $1.60 to $1.90 range for those two items.

We're bringing the overall Company range down by less than that because we've got tailwinds in our view around our tax rate, around our share count, around our interest expense and so forth. So that's going to drive the delta between the two ranges that we're offering today.

And then just a follow-up on the brand inflation side: Obviously, I think most people coming in would have thought the elections are a factor driving this. How are you thinking about it as we move into next year, post the elections, obviously a lot of spotlight in Congress right now on this topic. How are you at this point thinking about -- do you think it bounces back or do you think this is maybe the new normal and we have to wait for it to anniversary? Any thoughts there would be helpful, thanks.

Well, I think the view we have is sort of a year-to-date view. We have the same information that you have and probably the same visibility, and we're just guessing as to what manufacturers are likely to do going forward, like everybody else.

They control their pricing decisions, and we don't have much visibility into anything other than their historic behavior. And their historic behavior obviously has been rising over the last several years. And if you go back before the more recent years, there's always been a level of -- at least in our data, always been a level of inflation that has occurred.

And you do hear some manufacturers talking today about having a policy around how much inflation they think they should be able to provide to the industry over time. Some of them are making those statements more publicly than others. And clearly, there might be some near-term changes in their behavior that will be different over the longer haul.

We do think that innovation requires profitability. We think that the lack of new product launches in the face of generic conversions causes pressure to branded manufacturers and that they ought to have the ability to raise price appropriately on branded drugs to help fund their R&D requirements and their profitability requirements. And so I think that a common person's view would be that you'd still see inflation at some levels.

I think the outer bounds of inflation that have been experienced in the past by our industry, that we've had conversations about in the past, are probably likely to not exist anymore. So I just think those heavy outliers on both brand and generic, those outliers will come in, which obviously will have an effect. But it's probably a little bit early to speculate. And I think as we get through the rest of this year, we've given you some assumptions about directionally where we think it's going to be the balance of this year, and as we get into next fiscal year we'll give you a sense for where we think it's going to be.

Thanks. Is it possible to renegotiate these contracts on the fly or do you have to wait as the terms come up? And I'll stop there. Thanks.

Well, I think anything is possible. We typically have renegotiated the contracts when they come up, as opposed to whenever we're under significant pressure. But I think that we always have the opportunity to go back to manufacturers and demonstrate once again the value that we deliver.

And in particular, where manufacturers' behavior has changed dramatically from its previous behavior, and we had come to depend on those mechanisms as part of our funding source with that manufacturer, I think we have every right to go back to those manufacturers and say: You know, listen, we need to open the dialogue again because you have, by your unilateral decision, you have significantly impacted our profitability on your particular product lines and we don't think that's fair and we want to recover that lost margin. So I think that certainly is something we plan to pursue.

Thank you.

Our next question comes from Ricky Goldwasser with Morgan Stanley.

Yes, hi. Good evening, a few questions here. First of all, just to clarify, John, when you talk about inflation being meaningfully lower, I mean, I hear you saying that year to date you're seeing greater than a third reduction. And I think going back to past comments, I think you saw 12% last year for your fiscal year, or getting to around fiscal year, 7% year to date.

But are you -- when you think about the December quarter and the March quarter, which usually has a lot of inflation, in your assumption, are you assuming that the second half you're going to see that same reduction that you've seen year to date, or are you assuming some acceleration in that, given that all the commentary we're hearing about the industry trying to self-regulate. I'm just trying to better understand, are you clearing the decks here with this $1.60 to $1.90, or could there be potential more downside if, in the second half of your fiscal year, brand inflation decelerates even more?

James, why don't you --?

Yes, Ricky, to answer your question very directly, what we've assumed for the back half of FY17 is a continuation of the inflation rate that we have experienced year to date.

Okay, so basically the same type of price increases we've seen year to date to continue for the next couple of quarters?

Yes.

Okay, so then, when we think about the sell-side pressure that you're talking about, is that a number that we can take and annualize into next year? And I think my point being is that obviously, it's a big EPS hit. And when we think about the margin implication, is it fair to assume that you just repriced that portion of the contracts that's up for renewal for this year, or have you also gone proactively to your customers and locked in contracts that are going to come up in the next year or two at a new pricing level?

Well, I think those are obviously both good questions. I think to the point that James is making when he answered a moment ago, we typically see stronger price inflation as you get into our third and fourth quarters. And so when we say we're guiding on a year-to-date basis, that already tells you that we believe there will be some moderation in those quarters relative to previous behaviors.

On the sell-side, it's a little bit more difficult to make projections because we're basically in a position where we are reacting, to some extent, and not being the people that are making the decision. I think that our view is that we have made a very significant change in our pricing practice to match where the market is today. And we, like I said to answer another question that was asked, we have seen this kind of event happen in the past as well, and we didn't see a continuation of the event. And our objective is to continue to maintain our market share.

So I think we believe we provided guidance that has reasonable expectations from that perspective and that you can count on the range. But that's one of the reasons that the range is somewhat wider though is it's somewhat dependent on what happens going forward.

I think one of the things we're all trying to get a better sense of is when we think about FY18, and I fully understand that you're not guiding to 2018, and there are a lot of moving parts, but is it reasonable for us to take that $1.60 to $1.90 in EPS impact that we're going to see in the second half of the year and just use it as a run rate for FY18, just for these two components?

Well, at this very early stage, Ricky, it's really I don't think appropriate for us to try to make any predictions about FY18. So I think really we should leave that for closer to the start of that fiscal year, and we'll obviously be getting into our guidance process as normal.

I'm just assuming all steady state, right? So if you've seen the step down in your sell-side margin, translate to the EPS impact or does it just flow through? I guess that's the question.

Yes, I understand the logic. It's just hard for me to take a position on FY18 at this very early stage.

I think it's a difficult question to answer, but I think I did try to at least bound the conversation around customer pricing, and that this is a pretty significant step down. And we believe that allowed us to maintain the relationships with our customers, given what was a pricing environment where we were higher priced than where we needed to be, and that has occurred and is baked into the guidance that we have provided you, in terms of the range that we've just refreshed. Now, I think to James's point, it's pretty early to speculate on what branded inflation might be next year and what else might happen with our customer base, but we tried to give you as much visibility as we possibly can.

I know you guys are on a short time frame. Let me close this call, if I can, and let you know that I know you share with us the disappointment in today's news. This is not what we had expected and certainly not what we want. But despite this downward revision to our outlook, we do believe in, and remain committed to, the value we demonstrate every day to our customers and our manufacturing partners.

And as I mentioned a few moments ago, we believe the increased competitive pricing activity does not build sustainable customer relationships or long-term shareholder value. We are all about sustainable relationships and creating long-term shareholder value. And we're supported by McKesson's great tradition of customer focus, operational excellence, and disciplined execution. And our talented workforce, robust cash flow generation, and strong balance sheet position us for the long-term value creation that we strive to obtain.

We remain as committed as ever to our value proposition, and I'll now hand the call off to Craig for his review of upcoming events for the financial community. Craig?

Thank you, John. I have a preview of upcoming events for the financial community. On November 8, we will present at the Credit Suisse healthcare conference in Scottsdale, Arizona. On January 10, we will present at the JPMorgan healthcare conference in San Francisco, California.

We will release third-quarter earnings results in late January. Thank you, and goodbye.

Thank you for joining today's conference call. You may now disconnect. Have a good day.