麥卡遜 (MCK) 2017 Q3 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 third-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's 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 to your attention to the supplemental slides, which we will reference on today's call and 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 third 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, and here's John Hammergren.

Thanks, Craig, and thanks, everyone, for joining us on our call. Before I begin my review of our third quarter results, I'd like to take a few moments to share my thoughts on a number of recent topics.

During January, we've heard from the new administration on the prospect for planned changes to the US healthcare system, as well as potential tax changes. We are all interested in these topics, yet it is extremely difficult to provide any kind of assessment on the impact of reform, as we don't have solid details on what those changes will be as we sit here today.

We look forward to engaging in the dialogue regarding these issues that may impact our industry, our business, and the customers we serve, as proposals evolve into real policy positions. There are many moving pieces to reform and we will continue to monitor and assess the potential impacts of any proposals, as we receive more information.

Moving on, we are pleased to have announced today that we have entered into a definitive agreement to acquire CoverMyMeds. CoverMyMeds' mission is to help patients get access to the appropriate drugs for their care. Their service automates and accelerates the prescription approval process, known as electronic prior authorization, which is otherwise manual and time-consuming.

CoverMyMeds takes administrative cost out of the system, which supports patient health through drug adherence, manufacturers by reducing prescription abandonment, and providers and payers through automation and appropriate patient access to medications.

CoverMyMeds products today streamline the prior authorization process from 47,000 pharmacies and 700,000 prescribers in the nation's largest health plans. The company has partnered with McKesson's RelayHealth Pharmacy business since 2010 to expand its reach and offer its capability to a broad customer base.

As a reminder, RelayHealth Pharmacy is a connectivity network, providing real-time claims processing and other services to more than 50,000 retail pharmacy locations. Together, CoverMyMeds and RelayHealth Pharmacy can develop even more innovative tools for manufacturers, pharmacies, patients, payers and prescribers, and continue to take administrative costs and inefficiency out of the healthcare system.

CoverMyMeds, RelayHealth Pharmacy, and our other pharmacy technology businesses underpin our strategy to differentiate and add value to our Distribution Solutions business. As a reminder, RelayHealth Pharmacy will remain with McKesson following the close of the transaction with Change Healthcare.

We're also making good progress on a couple of other important transactions. First, on December 20, the Department of Justice closed its review and terminated the waiting period under the Hart-Scott-Rodino Act, bringing us one step closer to the creation of the new Change Healthcare.

Key leaders have been named and they are building out their teams, as well as the support structure to allow the new business to meet the demands of its customers from day one. Management expects to raise the necessary financing and close the transaction later this quarter. We will provide additional updates after the transaction closes.

Additionally, we are pleased to have closed the Rexall transaction and the integration work is underway. I look forward to working again with Domenic Pilla, who will assume overall leadership responsibility for McKesson's Distribution and Retail businesses in Canada, including Rexall Health. Some of you may remember Domenic. He previously spent 10 years leading McKesson Canada, from 2001 to 2011, and then built his retail expertise running Shoppers Drug Mart through its successful sale in 2014. I want to welcome the thousands of employees that are joining McKesson on this new exciting opportunity.

Last, we're very excited about the progress we made early on in launching Claris One, our sourcing activity with Walmart. That organization is up and running and expanding our capabilities with suppliers. Our objective is to enhance our great partnerships with manufacturers and look for innovative ways to create value for all stakeholders.

Turning now to our recent financial performance, in our US Pharmaceutical business, as a result of the generic pricing actions we began to implement late in our second quarter, we won back units and retained our independent stores. However, our prices were ultimately set at a lower level than our initial expectations that were included in our previous guidance.

As a result, we realized a lower contribution in the current quarter from this part of our business. And although branded pharmaceutical pricing trends were weak in the third quarter relative to our expectations, full-year contribution from branded pharmaceutical compensation remains on track with our revised expectations that we shared with you last quarter.

Additionally, we incurred a few nonrecurring charges in our Distribution Solutions segment that resulted in lower than expected operating profit contribution. James will go through those in a moment.

As for our other North America Pharmaceutical businesses, we continue to realize strong growth and we are making solid progress integrating Biologics, Vantage and Rexall.

Moving on to our international operations, despite meaningful UK pharmacy reimbursement cuts that we previously discussed, I am pleased with the constant currency revenue growth reported in the quarter. Our UK business continues to be impacted by reimbursement actions taken by the government; however, our teams are diligently working to offset and grow through these changes.

I'd also like to take a moment to acknowledge the tremendous contributions by Marc Owen over his past 15 years with McKesson, from leading our enterprise strategy to most recently heading up our operations in Europe. Marc will retire at the end of this fiscal year, so we are preparing for the transition of responsibilities to Brian Tyler, a 20-year veteran who has served leadership positions across nearly all of our Distribution Solutions segment, including most recently as President and Chief Operating Officer of Celesio, working with Marc.

And last, in our Medical-Surgical business, despite some revenue softness from the termination of a long-term care customer and a weaker impact from the flu season, I'm encourage particularly by the progress we are making to expand our presence in the fast-growing lab and home care businesses.

Now for Technology Solutions, we again posted strong performance relative to our expectations and prior year, even amidst all of the work underway to prepare for the Change Healthcare transaction. I commend the team for their focus throughout these events, and I look forward to a strong finish to a very productive year.

Now turning to our outlook for FY17, upside from our share repurchase activity in the quarter, combined with a lower effective tax rate, more than offset the lower than expected full-year contribution from our Distribution Solutions segment. Based on these updates, we now expect our full-year outlook for FY17 to be in the range of $12.60 to $12.90, compared to our previous outlook of $12.35 to $12.85.

Now to wrap up my comments, McKesson is a company that has seen significant change over its more than 180 year history, and we've built a resilient company, a business that focuses every day on the success of its customers and the efficiency of the healthcare system it serves.

As we look to the future, we see significant growth prospects and have put in place the right assets in the right markets to take advantage of these opportunities. For example, McKesson now operates at scale and is highly efficient in every segment we serve. Our diverse set of global businesses are well positioned to take advantage of overarching demographic trends. We believe that retaining control over our global procurement and sourcing capabilities is key, and we have built comprehensive capabilities to capture growth in Specialty.

We have a large and growing footprint in Retail. We have a strong value proposition to partner effectively with manufacturers and to service our customers, including meaningful pharmaceutical technology solutions.

Across McKesson, there is an experienced and long tenured management team. And finally, we continue to expect robust operating cash flow growth that is deployed in a disciplined approach and focused on long-term shareholder value creation.

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

Thank you, John, and good afternoon, everyone. Today I will review our third quarter results and discuss our FY17 outlook. In addition, I will provide updates with respect to our recently closed and announced M&A transactions.

Before I get to our results, 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 charges or related reversals associated with the cost alignment plan that we announced in March, 2016. This view also excludes 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 prior year gains on the sales of two businesses.

Now let's move to our results for the third quarter. Our adjusted EPS was $3.03 per diluted share. Our adjusted EPS, excluding unusual items, was $3.05 per diluted share, as we recorded a $0.02 charge related to the cost alignment plan.

Now I will review our consolidated results: consolidated revenues for the third quarter increased 6% in constant currency versus the prior period. Third quarter adjusted gross profit, excluding unusual items, was down 6% in constant currency year-over-year, driven by the increased competitive customer pricing activity we discussed last quarter, the timing of branded manufacturer inflation, and the expected weaker profit contribution from generic manufacturer inflation trends, partially offset by our recent business acquisitions and organic growth in our Specialty and Canadian businesses.

Third quarter adjusted operating expenses, excluding unusual items, increased 2% in constant currency, driven by recent acquisitions partially offset by our ongoing cost management efforts. Other income was $26 million for the quarter, an increase of 93% in constant currency, driven primarily by our equity investment in [Brocasser], a pharmacy operator in the Netherlands. For FY17, we now expect other income to increase approximately 50% year-over-year.

Interest expense of $74 million decreased 15% in constant currency for the quarter, consistent with our prior expectations. We continue to expect interest expense for FY17 to be down by a mid-teen percentage compared to FY16.

Now moving to taxes, our adjusted tax rate was 14.3% for the quarter, driven by the beneficial impact of an intercompany sale of software, our mix of income, and discrete tax benefits. Expanding on this sale, in December McKesson sold various software and ancillary intellectual property relating to our Technology Solutions segment to a US-based McKesson entity. This sale of allows McKesson to claim tax deductions for the fair value of the assets and recognize the resulting tax benefit in our P&L over the estimated remaining lives of the assets. As a result of this sale, and excluding the EIS impairment charge taken in the second quarter, we now expect a full-year adjusted tax rate of approximately 24.5%.

I want to caution you that FY17's expected adjusted tax rate is not an indicator of our future expected adjusted tax rate. Going forward, I would expect our adjusted effective tax rate to be closer to 30%.

Our income attributable to non-controlling interests, excluding unusual items, was $14 million for the quarter. We now expect income attributable to non-controlling interests to increase approximately 20% from FY16.

Our adjusted net income from continuing operations, excluding unusual items, totaled $677 million. Our third quarter adjusted EPS, excluding unusual items of $3.05, decreased 4% versus the prior year.

Wrapping up our consolidated results, during the quarter we completed share repurchases of common stock totaling $2 billion, resulting in our diluted weighted average shares outstanding decreasing by 4% year-over-year, to 222 million. As a result of the share repurchase activity in the third quarter, we now expect our weighted average diluted shares for FY17 to be approximately 223 million. And we now have $3 billion remaining on our share repurchase authorization.

Let's now turn to the segment results, Distribution Solutions' segment constant currency revenues of $49.9 billion were up 6% year-over-year during the quarter. North America Pharmaceutical Distribution and Services revenues increased 5% in constant currency. International Pharmaceutical Distribution and Services revenues were $6.6 billion for the quarter on a constant currency basis, up 10%, driven by acquisitions and market growth. Revenues were impacted by approximately $440 million in unfavorable currency rate movements.

Moving now to the Medical-Surgical business, revenues were down 1% for the quarter, driven by the termination of a long-term care contract and a weaker impact from the flu season. For Medical-Surgical, we now expect low- to mid-single digit revenue growth in FY17.

Distribution Solutions' adjusted gross profit, excluding unusual items, was down 8% on a constant currency basis for the quarter, driven by the increased competitive customer pricing activity we discussed last quarter, the timing of branded manufacturer inflation, and the expected weaker profit contribution from generic manufacturer inflation trends, partially offset by our recent business acquisitions and organic growth in our Specialty and Canadian businesses.

Third quarter Distribution Solutions segment adjusted operating expenses, excluding unusual items, increased 3% on a constant currency basis. Segment operating expenses reflect an increase related to recently completed acquisitions, partially offset by our cost reduction actions. Distribution Solutions third quarter segment adjusted operating profit, excluding unusual items, was down 23% in constant currency, at $815 million. The third quarter segment adjusted operating margin rate, excluding unusual items, was 163 basis points, a decrease of 61 basis points on a constant currency basis, driven by the same factors as previously discussed.

As John mentioned, the segment adjusted operating profit results include two non-recurring charges. Together, these total approximately $60 million. We expect our Distribution Solutions adjusted operating margin, excluding anticipated cost alignment charges, to be approximately 35 to 40 basis points below the corresponding FY16 figure of 234 basis points.

Now moving to Technology Solutions, revenues were flat for the quarter, at $694 million on a constant currency basis, driven by the anticipated decline in our hospital software business, offset by growth in our other technology businesses. Third quarter adjusted segment gross profit, excluding unusual items, was up 7% on a constant currency basis.

Third quarter adjusted segment operating expense, excluding unusual items, decreased 4% in constant currency from the prior year, driven by our ongoing cost management efforts. Adjusted segment operating profit, excluding unusual items, increased 25% in constant currency, resulting in a corresponding adjusted operating margin of 23.92%, up 476 basis points versus the prior year. The increase was driven by growth outside of our hospital software business and lower operating expenses. We continue to be pleased by the ongoing execution of our Technology Solutions segment, as we work to close the Change Healthcare transaction.

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 days sales outstanding were little changed, at 26 days. Our days sales in inventory decreased 2 days from the prior year, to 31 days. And our days sales in payables increased 5 days from the prior year, to 59 days. The increase in payable days relative to the prior year is largely due to a steady increase in our generic pharmaceutical sourcing scale and the fact that generic pharmaceuticals have longer payment terms than branded pharmaceuticals.

We ended the quarter with a cash balance of $2.4 billion, with approximately $1.8 billion held offshore. For the first nine months of the year, McKesson paid $4.2 billion for acquisitions, repurchased $2 billion in common stock, repaid approximately $390 million in long-term debt, and spent $369 million on internal capital investments. We now expect property acquisitions and capitalized software expenses to be between $550 million and $650 million in FY17. And earlier today, the Board of Directors approved the quarterly dividend of $0.28 per share.

McKesson generated $3.3 billion in cash flow from operations during the first nine months of our fiscal year. In this quarter alone, we deployed more than $4 billion on acquisitions and share repurchases. 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 a recent settlement with the DEA and DOJ.

Now I will focus on our FY17 outlook. Relative to our prior expectations, our third quarter earnings were favorably impacted by the lower than expected tax rate. We now expect a full-year adjusted tax rate, excluding the EIS goodwill impairment charge in the second quarter, of 24.5%, a decrease of 3 percentage points from our prior expectation.

In addition, we now expect the weighted average diluted shares for FY17 to be 223 million, following share repurchase activity in the third quarter, compared to our previous expectation of 226 million. These tax and share count items will drive upside of approximately $0.65 of earnings per diluted share for the full year.

As a reminder, during the third quarter, we recorded non-recurring charges that approximated $60 million, which will impact our full year. And as John discussed, while our pricing of generic pharmaceuticals in our independent pharmacy channel has helped us retain share, our pricing is now set at a level lower than our previous expectations. As a result, we expect the profit contribution from these customers will be reduced versus our previous guidance.

Regarding the brand manufacturer pricing environment, pricing remained weak in the third quarter, as discussed at a recent investor conference. However, we have seen activity in January that is in line with our previous full-year expectation of mid- to high single digit brand manufacturer price inflation.

And lastly, we expect our Distribution Solutions adjusted operating margin, excluding anticipated cost alignment charges, to be approximately 35 basis points to 40 basis points below the corresponding FY16 figure of 234 basis points.

As a result of these updates, we have raised and narrowed our FY17 guidance for adjusted earnings per diluted share from $12.35 to $12.85 to a new range of $12.60 to $12.90. This range excludes approximately between $1.28 and $1.30 from adjusted earnings, driven by the combination of the EIS goodwill impairment charge taken in our second quarter and the anticipated charges during the fiscal year for the cost alignment plan. A list of the key assumptions underpinning our updated FY17 outlook can be found in the supplemental slide presentation on slides 17 and 18.

Before I wrap up my comments on our FY17 outlook, I also wanted to mention that while not yet a material contributor to our current earnings, we are pleased by the progress we're making in establishing Claris One, our sourcing initiative with Walmart.

Now I'd like to take a moment to discuss our recently closed and announced M&A transactions. First, we closed the Rexall transaction in late December. As a reminder, for FY17, we expect the earnings attributable to Rexall Health will be offset by an anticipated charge related to a fair value adjustment of acquired inventory.

Now moving to our announced acquisition of CoverMyMeds. McKesson has entered into a definitive agreement to acquire CoverMyMeds for approximately $1.1 billion, or approximately $900 million net of incremental cash tax benefits. An additional $270 million will be paid if CoverMyMeds reaches certain performance metrics through FY19.

The transaction is subject to customary closing conditions, including anti-trust approval, and is expected to close in the first half of FY18. We expect the transaction will be funded by a mix of cash and debt. By the third year following the close of the transaction, McKesson expects accretion of $0.30 to $0.40 to adjusted earnings per diluted share.

This transaction will complement our other Distribution Solutions technology businesses, such as Relay Pharmacy and our McKesson Pharmacy Technology and Services business, which are both core to executing on our strategy. Given the double digit growth opportunities we see for these businesses, I believe they can drive combined revenues of approximately $1 billion and become a material contributor to McKesson's operating profit growth within three years.

Moving now to the pending Change Healthcare transaction. We expect the transaction will close this quarter; and at that time, we expect to record a significant one-time gain on the contribution of our net assets to Change Healthcare. This gain will be excluded from our adjusted earnings.

In addition, McKesson will receive $1.25 billion of cash at closing. Due to the numerous moving pieces that are involved in a transaction of this kind, we will provide more detailed information following its close. To be clear, McKesson's current FY17 guidance range of $12.60 to $12.90 assumes a full quarter of MTS earnings. In closing, we are actively engaged in planning for the next fiscal year and will provide our FY18 outlook and underlying assumptions when we announce our fourth quarter earnings in May.

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)

Robert Jones, Goldman Sachs.

Great. Thanks for the question. John, I'm still struggling to understand a little bit the magnitude over the last two quarters from the negative impact from branded pricing specifically. If we think about some of the comments previously about 10% to 20% of branded contracts being linked to non-fee for service, just having trouble bridging the reduction given from the last two quarters. So I was hoping maybe you could just walk us through a little bit of how we bridge that gap around the EBIT within pharma distribution and the reductions from last quarter and now this quarter.

Well, I'm going to turn this over to James. To start out, though, I think we have done some really good work over the last several years to make sure we have the right balance of fixed compensation and variable compensation from the branded manufacturers. And that work continues. And I believe now the split of our profit from the branded partners is roughly in that 90/10 kind of a range. So we have reduced the exposure to both the risk and the opportunity here. But having said that, it still remains a material amount of our profitability, to your point. And we knew that there was going to be some risk in this quarter related to our back half guidance, but we'd hoped that the fourth quarter was going to be stronger than, certainly the third quarter and in line with the guidance we provided you on the last call. And that's really, I think, what we're saying today is that from a full-year perspective, based on January, we believe we're going to have the back half performance that we'd anticipated. James?

I'd just add that in Q3, the profit contribution from branded manufacturer price inflation was really quite weak. There was a real holding back in terms of manufacturers taking price increases. And that certainly was a material driver in our Q3 EPS result. As John's saying, we're seeing a different situation playing out in Q4 thus far. So our expectation is when you look at the back half, and indeed, the full year, we're able to continue to forecast what we had said previously about branded inflation being in that mid- to high single digit range. So certainly a soft Q3, but it appears to be stronger in Q4.

Great. And just the follow-up related to the reduction in the quarter, or the shortfall in the quarter related to pharmaceutical distribution. It sounds like, John, if I heard you correctly, the pricing on independents ended up ultimately being a little bit lower than what you guys had assumed last quarter. What drove this? And is there still what you would describe as maybe outsized pricing pressure in the marketplace around that customer segment?

Well, I think you have the first half of that assumption correct. It ended up being a little lower than what we had built into our previous guidance than when the price for our customers was set at the end of the quarter, we ended up producing less profitability than we had anticipated. But clearly, the units recovered and our relationship with our customers improved as we went throughout the quarter. So I think we've got that issue behind us, at this point, at least today, and I think it was just a question of making an estimate early in the quarter, when we were still in the process of implementing our reaction to those pockets of increased competition.

And then the other thing I would just reinforce for the third quarter that impacted the results were these two non-recurring items that I referred to in my text that totaled $60 million in profit contribution. So that was certainly an important driver, as well.

Got it. Thanks so much.

Steven Valiquette, Bank of America.

Thanks. Good afternoon. Just for us, you guys obviously don't normally break out any operating profit by geography, but just thinking about the fact that Distribution Solutions was down about 24% year-over-year in the quarter, is there any way to comment, just at a high level, when thinking about US versus Europe, was the decline in the US more or less than that 24% average? And then also, just thinking about some of those moving parts in Europe, too, I guess we're all just curious how geographically things shook out, just between those two when thinking about the average? Thanks.

As you mentioned, we don't break out the profit by geography. I think the way to think about it is that we had gone into this fiscal year with a view of what might happen from a reimbursement perspective in the UK. And then we very quickly realized the UK reimbursement environment was going to be more difficult. And I think ourselves and others talked about the challenge that put in front of us. And I think we've done a really good job of now understanding what that effect is on that business and working hard to offset it and to grow through it. I think that the thing that became a surprise, obviously, at the of the year here for us, in the back half, was both these one-time items, as well as the view that the independent generic pricing environment was going to be a bit difficult for us. I think other than that, it's probably difficult for us to provide you more nuanced guidance, other than that clearly having two markets that are significant to us being negatively impacted simultaneously. And then in addition to having the inflation environment on brand being below what we had expected at the beginning of the year, both played into a weaker than we had expected, certainly, quarter, and obviously the year, as well.

And I would just add that while obviously, we've seen those challenges in the UK market around reimbursement, we haven't seen similar things playing out in other European countries for Celesio. Those have been tracking very much along the lines of our expectations during the year.

And we're happy with the growth in those markets. I think the team is beginning to expand beyond just the retail pharmacy business into other areas of opportunity, and we're encouraged by that. And the acquisitions we've made have been well executed and are delivering real value. So we talked about the revenue growth on the call, but if you look under the covers, if you take out the UK reimbursement challenge, the business is performing well.

Okay. Appreciate the extra color. Thanks.

Ricky Goldwasser, Morgan Stanley.

Good afternoon. So first of all, one follow-up on the prepared comments. You talk about the weaker trends on generic inflation. But when we think about these trends, were they in line with what you expected when you provided guidance at the end of the second quarter, or has generic deflation environment deteriorated throughout the quarter, as well?

I'd say a couple of things. The way that we have been seeing generic inflation playing out, obviously that's on a very small subset of the overall molecule base, that has continued to be in line with our expectations, very similar to the story of the last couple of conference calls.

In terms of the generic deflation environment, which is obviously the norm in this part of the marketplace, across the complete [swathe] of molecules, we continue to gain, see nothing abnormal here that's having a material impact on the business model. So very much consistent with what we have been saying all this year.

Okay. And then with all the uncertainty around manufacturers' ability to raise brand prices and questions on whether the second July price increase can ultimately happen, it seems that shifting all of your revenues to fee-for-service and removing this contingency on price is increasingly more relevant. So one, can you talk about where you are in this process? I know, John, that you've talked about it in your prepared remarks, but if you can give some more details. And second of all, if hypothetically branded manufacturers opt for only one price increase in the calendar year, how should we think about this when we model? Should we then model, and I noted I'm spilling into 2018 question, but should we hypothetically then think about a September quarter where profits would be down 10% year-over-year if no price increases happen this quarter? Just conceptually, how should we be thinking about that and how we can assess that embedded risk of that bear case scenario?

I think to the first part of your question, we are working actively with the manufacturers to make sure that we have a line of sight to the economics that are appropriate for the service that we provide. I think the manufacturers very much appreciate the work that we do and certainly have a willingness to fund our business model to help us manage their business in a way that's more efficient, frankly, for them. And so we're excited to continue to play that role. And with many of our manufacturer relationships, our economics have been properly set for a long time, and the vehicle that we've been using to be paid is not as risky as a price increase vehicle might be, as the method by which we would be paid the fees that we deserve.

And so to your point, to the extent that we have been dependent on price increases as a funding mechanism with a manufacturer who is no longer on their own taking those price increases, we'll certainly go back to them and, because of that behavior change, work to negotiate a relationship that gives us, as I said, our compensation.

On the second front, it's difficult for us to predict when manufacturers are going to have price increases, whether they're going to have one or two or more, what the rate of increase will be, if they say they're going to have one, are they going to have all the ones at the same time or are they going to have multiple increases on these product at different times of year, or different products at different times during the year. So I think it is a little bit of a black box, to your point.

From a modeling perspective, it's probably a little premature for us to give you a view as to how we're going to think about the quarterly progression of our profitability. And clearly, when we are on our conference call in May, to the extent that we have better visibility, we'll try to help you not only understand the risk we still have in our model, which we ty to outline at the beginning of every fiscal year with our assumptions, but we'll try to also help you understand how price increase behavior quarter to quarter may create variability or risk.

Okay. Thank you.

Garen Sarafian, Citi.

Good afternoon, John and Jim. Following up on a prior question regarding independent pharmacy pricing to further clarify, could you discuss the current market environment that you're seeing? So has pricing stabilized? Was any of the downside related to additional actions by either of your competitors, or was it just you're only in the midst of the process when you made an estimate, or any other factor that you could elaborate on would be appreciated?

Clearly, we have great visibility to our customers' demand from us, and we have great visibility to the mix of product that they order and just the relationship overall. As I mentioned in my prepared comments, with our customer base we saw a recovery of both units and, frankly, attitude related to their long-term partnership with us. And we've retained our relationship and our business with those stores. So that's an indication that the pricing decision that we made in the quarter and talked about on the previous call was appropriate and that the price that we set at the end of the process in the quarter was the appropriate price. Otherwise, we would not have seen that customer retention or that unit recovery.

So I hesitate to say that pricing isn't a fluid environment, but we typically don't see these large pockets of price competition in our base of customers, and we seem to have resolved that with the actions we took it earlier in the quarter. And I think lastly what I'd say is I think the estimate we made early was more informed as we got through the process and it was more of an estimate as we started the process. And so to answer your question about continued heightened or unusual competition in our independent customer base, we believe has largely subsided because of the actions we've taken.

Got it. That's useful. And then as a follow-up, on the branded drugs, you mentioned that you're now at the 90/10 breakout. So within that 90% that's fee-for-service, do you typically build in any flexibility into those types of contracts where you'd be relatively agnostic to either net or gross pricing or any clause to revisit the contracts should certain situations occur?

First of all, I'd like to maybe clarify a point about the contracts being 90/10, as opposed to the income being 90/10. So when James and I talk about a 90/10 ratio on profit from generic -- from branded manufacturers, excuse me -- that's really how the dollars result out of those relationships. You shouldn't take it to mean that 90% of our contracts are fixed and 10% of our contracts aren't.

Absolutely, I misspoke. Correct.

And secondly, we have an ongoing discussion with our partners, as you might imagine, and it is a good relationship. And I believe that the dollar value of the service we provide is where our conversations typically are focused. Now it's obviously derived by a multiple of revenue or throughput through our business, but the dollars are what funds our activity. And so if there were to be a dramatic change in the way our partners price their product, and your description of going from a gross price to a net of rebates price, we clearly would only be happy if we could recover the same dollar result out of that new metric as opposed to a different kind of relationship.

So I think that the likelihood of that happening, number one, is slim, and second, if it were to happen, we clearly would actively renegotiate our contracts to create a mirror image result that we have today with a different set of multipliers or factors involved. At least that's the way I would attempt to reconcile it.

That's very useful. Thank you.

Lisa Gill, JPMorgan.

Thanks very much. Good afternoon, John and James. James, let me just start with the first question around the non-recurring items that you called out for $60 million. One, did I just miss in all the commentary what they're for? And if they were included in this quarter, does that help to explain the progression as we get into your guidance for, or the implied guidance for drug distribution in the fourth quarter?

So the $60 million was the two items recorded in Q3. So yes, that's an important element in bridging through to the full-year guide. So that is something I particularly do want to emphasize. That's correct.

Can you tell us or give us a little more color what they were for?

One was a resolution of a customer contract that had related to a variety of years going back in time. So certainly something that I think of as a one-time type item. And the other was an accounting reserve that we believe was appropriate to take, again around receivables in a certain segment of the business within Distribution Solutions. So we feel as though we've been appropriately conservative around those reserves.

Okay. Great. And then just to stick on that topic, as we think about going into the fourth quarter, John, you discussed a ton around this dynamic in the independent market, but I just want to make sure that I understand, in the third quarter we saw all the pricing impacts. So when we think about this progression from the third quarter to the fourth quarter, independent stays the same, the pricing on branded looks a little bit better, because it's coming in within your expectations versus the third quarter that was below. We don't have these one-time items as we go into the fourth quarter. And I think that you commented also, again, correct me if I'm wrong, that generic price deflation is also roughly within your expectations. Will we also see Claris One start to impact the numbers in that fourth quarter?

You gave me a pretty good bunch of questions there, Lisa. But let me start, and I'll have James jump in if I miss something. Clearly, there might be a little bit of a tale of continued lap negative on the independent pricing, just because, as I mentioned, our estimate on the last call was slightly higher than where it actually netted when we set the price. And that netting process probably left us a month or weeks off in the full quarter effect in Q3, if that makes sense to you.

It does.

As you go into Q4, there's a little missing hole there on that net price effect on the independent business. On the branded price inflation, I think that it's early in this quarter to call it, but I would say that we believe that on the back half guide for branded price inflation, we're going to be in pretty good shape. We didn't have much in our expectations around generic price increases, and then we had these one-time items that James referred to a few moments ago. And James?

And in Claris One, I wouldn't expect that to be a material contributor in Q4. I think that will help us in FY18.

Okay. Great. That's helpful. Thank you.

George Hill, Deutsche Bank.

Good afternoon, guys, Thanks for taking the question. I know this hasn't come yet -- well, it has come up -- but James, can you quantify or provide any kind of sense of severity around what was the step down in the sell side pricing versus what you thought it was at the end of fiscal 2Q versus where came in at the end of fiscal Q3?

I'm not going to offer a specific guide around that. As John was alluding to, the effect is going to be at sort of the full run rate in Q4, and we saw the significant majority of that same effect in Q3, but there was a certain movement downward during the quarter, after we had last spoken to you on this equivalent call.

Okay. And then maybe just a quick follow-up, just one more on this topic, is that if most of the impact was absorbed in fiscal Q3 and, I guess, fiscal Q2, 3 and 4, then there's a little bit of a lapping impact that takes place early in FY18 and then it's kind of fully behind us from a comp perspective. I want to make sure that I'm not missing something either in the contracting methodology or in the pricing methodology where the pricing impact of this is able to be contained and then margins expand again. It's the pricing that's occurred with this segment of the market that those profits have been extracted and have been passed through to the customer, that's not something that returns to us.

So I would expect the lapping effect that you're referring to in the first half of the year, just a little bit into Q3, as well, because of what I was just saying a moment ago.

Okay.

George, I think that some people probably don't fully understand that we price the generics, every day we're pricing generics. So to forecast where the generic profitability will be for our customer base next year is probably difficult. Obviously, Claris One will have an effect on us from a buying perspective, and we set our sell side prices on the generic space so that our customers get a competitive price and a fair price. But that is a bit of a moving target, and I don't want you to think that our pricing has been "locked in" in some type of formulaic way. It really is responsive to market conditions.

Okay. That's helpful. Thank you.

Ross Muken, Evercore ISI.

Good afternoon. So I realize you're not going to give us details on 2018 in terms of guidance in general, but from a methodology standpoint, given the volatility we've had in results this year and given some of the challenges in forecasting some of the specific factors, is there any thought, whether it's from a transparency or in terms of other, seeing as you will give us to help understand the trajectory, any thoughts on the methodology of whether or not you intend to guide as you typically do and provide many of the same metrics, or do you think now that, with some hindsight, maybe there are other things we should be looking at to get a better sense? Because it does feel like there's a lot going on in the business right now, and it's kind of hard to ascertain Q to Q the flow of where profits are going.

I'm certainly sympathetic to the difficulty in terms of understanding the dynamics of our business. I think that I'll let James jump in here a little bit on the whole forecasting and what we might provide you in terms of views as we get into next fiscal year.

I will say, however, that the business is always complex and there are lots of moving parts to it and there always have been lots of moving parts. The challenge that we have this fiscal year, in particular, is that the moving parts are moving negative on us simultaneously. And usually, you have things that are offsetting in the business, so we don't end up with, as you said, the challenge in forecasting, because we've generally offset some of the negative things with more positive things. And unfortunately this year, we haven't had that type of a dynamic.

I would just add that obviously, we're still going through our FY18 planning process. As I think about the discussions we've had on the three conference calls this fiscal year, obviously we've ended up having to talk about different things in a more detailed manner to be able to lay out the underlying drivers of the results. And we will take that perspective into how we think about discussing our guide, as well. So I think that does logically expand the variables that we have traditionally talked about when we've done the May earnings calls, just because we have been expanding our discussion during the last three conference calls with you.

No, that's helpful perspective. And I guess, obviously, you executed quite a bit of the share repurchase this quarter. You still have quite a bit outstanding, but you also have a lot of cash coming in and you'll have the proceeds from Change. Obviously, you guys have always done a portfolio approach. Is there any bias to share repurchases medium term still, just given where the stock is and how you compare that to the external opportunities, or do you still see a ton in the pipeline that you feel like can give you more superior returns than buying your own stock today?

Well, we certainly continue to like the portfolio approach to capital allocation that we've deployed for a number of years. Obviously, in the last quarter we did a goodly amount of both M&A, as represented by the Rexall transaction, as well as share buyback. Today we've announced the acquisition of CoverMyMeds.

So that's just illustrative, we continue to see opportunities to deploy capital to M&A that we believe can generate long-term cash flow profit growth and build the strategic capability of the company. That said, we are pleased with our cash flow generation. And that's, of course, giving us more flexibility to take advantage, as I think we have in this last quarter, with a quite large share buyback action at a time when our stock was trading at a relatively low multiple.

Great. Thanks, James.

Michael Cherny, UBS.

Good afternoon, guys. Most of my questions have been answered, but I think there was a question a while back around your conversations with manufacturers and how that's changing, especially in light of the changing pricing dynamics. I guess, John, over time you mentioned the relationship you guys have is a value for value rationale and you guys are true partners. As you think going forward, as you go back to have these conversations, what are the key selling points that you are focused on offering them, particularly in an environment where these manufacturers continue to get questions about their pricing environment? And how do you think about the incremental value proposition above and beyond what you guys have done for the last 10, 20, 30,180 years with these various different companies?

Well clearly, we're trying to build out our capabilities. So to your point, the value proposition we deliver to them, hopefully year in and year out, is increasing in value. And frankly, the CoverMyMeds discussion we had at the beginning of this call is a very positive example of where we're deploying capital to help our manufacturers, particularly the branded manufacturers, on the revenue side of their P&L, which, frankly, is probably a lot more important to them than the basis point side of their P&L where they pay us. And I think that the ability for us to get people on their meds, to reduce the friction associated with getting prescriptions filled, and to keep people on their meds after they've been prescribed, and to reduce the administrative costs associated with payers and pharmacies dealing with patients and physicians who are trying to get prescriptions filled will be very helpful and has proven to be very helpful. And clearly, we've done the same thing on our US Oncology business, where we're no longer just a necessarily a commodity wholesaler trying to sell oncology products, but we're a company that can truly partner with a physician to change the character of their practice and the profitability of their practice. So you'll see us continue to do that.

And on the specific issue of the fee structure with manufacturers, clearly, if we have been working alongside them for years and developed a relationship around being paid through price inflation, I think it's fair for us to go back and ask them when they've changed their behavior, not related to us, to go back to them and ask them to pay us a different way, if they're are no longer going to use price increases as the funding mechanism for their wholesale relationships. So are we going to be successful as rapidly as we want and are we going to be 100% successful? That's yet to be seen. But that clearly is our objective, adding more value and making sure that we strike a bargain where they can feel the competition we've asked for is fair.

Thanks, John. I know it's odd times. I appreciate the color.

You're welcome.

Robert Willoughby, Credit Suisse.

Just a quick one for James. You mentioned that you would comment on the Change Healthcare transaction upon closing. Is that sometime inter quarter, as you mentioned, or will the comments really on the guidance and the contribution come with the May conference call?

No, I would expect that we'll be closing the transaction during this quarter, and it would be appropriate to update you at that time.

Okay. Press release then and call, or just press release?

Well, we haven't sorted through those details. So it may be a press release. We'll see how things play out in the next three or four weeks.

And certainly, if we don't have a public call, obviously the IR team is available to help address questions, if it's not clear from the press release.

Perfect. Thank you.

I want to thank you, Noah, for your help today, and I want to thank all of you on the call for your time today. We continue to focus on the success of our customers and the value we deliver every day. And we look forward to updating you on our FY18 outlook when we provide you our fourth quarter earnings results in May. So thank you and good-bye.

And that does conclude today's conference. Thank you for your participation and you may now disconnect.