CAH
#Thanks, <UNK>, and thanks to everyone joining us on the call today
In my comments this morning, I'll first provide some context around our third quarter performance
Then, I'll review the expectations we detailed a couple of weeks ago for our full fiscal year
At this time, we don't have any updates to our FY 2018 or FY 2019 early thoughts we provided on April 18, so I won't say anything more, other than our leadership team has a strong sense of optimism and accountability
We are managing the company with discipline and for the long-term
Please note that, with all of my comments, I'll begin with GAAP, and then provide the comparable non-GAAP figure
The slide presentation on our website should be a helpful guide throughout this discussion, as it includes our GAAP to non-GAAP reconciliation tables
Starting on slide 4 with our consolidated company results, our third-quarter GAAP diluted EPS was $1.20 and non-GAAP diluted EPS was $1.53, an increase of 3% and 7%, respectively
Note that both the GAAP and non-GAAP diluted EPS for the quarter benefited from a lower effective tax rate and fewer outstanding shares as compared to the prior year
Total company revenues grew 4% versus the prior year to $31.8 billion
Consolidated GAAP and non-GAAP gross margin dollars increased by 2% and 1%, respectively
GAAP gross margin rates were down 8 basis points for the quarter, while non-GAAP gross margin rates were down 15 basis points, primarily due to generic pharmaceutical pricing
Consolidated company SG&A increased 5% from the prior year
Since we have lapped our significant acquisitions, the growth is mainly driven by the costs associated with our pharma IT system refresh, new Medical segment business wins, and Cordis infrastructure expense, partially offset by assumptions around incentive compensation
As you would expect, we continue to be disciplined in our expense management
Both GAAP and non-GAAP operating earnings declined in the quarter versus the prior year by 8% and 4%, respectively
Moving below the operating line, net interest and other expense was $41 million, a 7% decrease over the prior year
This decrease was driven by deferred compensation income, which has an equal offset in SG&A expense, so there is no net impact to EPS from this favorable variance
For the third quarter, the GAAP and non-GAAP effective tax rate was 32.3%, down 4.6 and 4.3 percentage points, respectively, versus the prior year
This improvement was due to a few favorable discrete items in the quarter
Diluted weighted average shares outstanding were 318 million, 13 million fewer shares than the third quarter in the prior year
During the quarter, we did not repurchase any shares and, as of the end of the quarter, had $443 million remaining on our board-authorized share repurchase program
During the quarter, we had net operating cash outflows of $198 million
We ended the quarter with a cash balance, including short-term investments, of $1.6 billion, with $514 million held outside the United States
While we don't typically provide cash flow forecast or guidance, we do expect to generate significant cash in the fourth quarter
Consequently, as we shared with you on April 18, about $1.6 billion of cash on hand will be used during the first quarter of FY 2018, when we expect to close the purchase of the Patient Recovery business from Medtronic
Next I will cover segment performance, beginning with this Pharmaceutical segment
Revenues grew 3% to $28.4 billion due to performance from the Specialty Solutions business and growth from Pharmaceutical Distribution customers
Segment profit for the quarter decreased 7% to $611 million
This decrease was driven by generic pharmaceutical pricing, the final quarterly impact of the loss of Safeway, and the investment in our pharmaceutical IT platform
This was partially offset by solid performance from Red Oak Sourcing
During the third quarter, we began to see planned incremental expenses associated with the first few phases of our pharma IT refresh project
This multiyear project is on-time and on-budget
It will enable us to maintain the excellent service our customers have come to expect from Cardinal Health, provide us with the ability to expand in a cost-efficient manner, and better facilitate our ability to go-to-market as an integrated enterprise
Finally, our Pharma segment profit margin rate of 2.15% for the quarter was down 25 basis points versus the prior year, largely due to generic pharmaceutical pricing
A couple of other points to note on the quarter, our Specialty Solutions and China businesses saw double-digit bottom-line growth
Now, I'll move to our Medical segment results
Revenues for the quarter grew a robust 9% to $3.4 billion, driven by contributions from new and existing customers
Medical segment profit increased 16% to $148 million, reflecting solid performance from naviHealth, supply chain services, and Cardinal Health consumable products
The quarter was unusual, in that we saw a decline in Cordis profit
This decline was mostly related to increased SG&A expenses to support our investment in an international infrastructure
This investment will benefit us as we integrate the Patient Recovery business
The increased SG&A expense was partially offset by the net impact of the Cordis inventory adjustments
Let me explain the third quarter inventory adjustments in more detail
First, this year benefited from the absence of the inventory step-up which we recorded in the prior year
This benefit was largely offset by an increase to an inventory reserve in the quarter – in the current year
This reserve is an estimate based on information often provided by third parties, including under-the-transition service agreements and from various service providers
During the period, we received more detailed information for this reserve and have adjusted it accordingly
As both <UNK> and I have mentioned in the past, the exit from the transition service and manufacturing agreements could result in some lumpiness to the Cordis earnings, but we fully expect this to diminish as we move forward
We expect Cordis to return to growth in the fourth quarter and are working hard to ensure we have the right infrastructure for the long-term to support our customers and their patients
Segment profit margin rate increased 26 basis points to 4.34% due to the same factors I just mentioned on the segment profit dollars
Turning to slide number 7, you will see our consolidated GAAP and non-GAAP reconciliation for the quarter
The $0.33 variance to non-GAAP diluted EPS results was primarily driven by amortization and other acquisition-related costs
I'll now update you on our assumptions for the fiscal year
We expect full year 2017 revenue growth to be in the mid to high single-digit percentages, which is a change from our previous outlook of high single-digit growth
One item of note, the actual closing date for the Medtronic transaction we announced on April 18 involves multiple parties, including regulators
Because of this and other factors, we need to quickly be ready to execute the best possible financing to secure attractive terms associated with the acquisition
This means that we could issue debt in the fourth quarter and, if we do, we would see up to $0.05 of financing cost, which is not included in our current fiscal 2017 EPS guidance
We will let you know when we access the debt market and be transparent on the incremental costs
To reiterate, as we shared with you on April 18, we expect our full year non-GAAP EPS to be at the bottom of our $5.35 to $5.50 range, and this served as the base for our fiscal 2018 early outlook
Moving on to slide 10 of the presentation, the corporate assumptions around tax rate, shares, and CapEx will be at the low-end of the range, and acquisition-related intangible amortization will now be about $389 million, or $0.81 per share, which does not affect our non-GAAP earnings
You can turn to slide 11 to see our Pharma segment assumptions for the full fiscal year
We now expect mid to high single-digit percentage revenue growth for 2017, a change from our previous outlook of high single-digit growth
This is largely related to the loss of brand sales associated with the retail network changes at CVS/pharmacy, which they disclosed in late 2016. Additionally, we now expect full year Pharma segment profit to decline low double digits versus the prior year
Note, this tightening of the range is primarily due to the previously mentioned generic market pricing, which, while less deflationary than what we saw earlier this year, is still lower than we modeled for the second half of the year
All other Pharma segment assumptions remain unchanged
On slide 12 you can see there is only one change to our Medical segment assumptions, which is we now expect a high single-digit percentage increase in revenues versus the prior year, up from our previous assumption of mid to high single-digit growth
Let me close with this
I am confident we are well-positioned and are working on the right things at the right pace for both the near term and long term
Thanks
And with that, operator, let's go to the questions
Question-and-Answer Session
Thanks for the question
As far as the deflation goes in the quarter, we're not going to specifically comment on quarter by quarter deflation rates, other than, as you know, we did update to be – that deflation for the entire year we now expect to be in the low double digits
So, again, as I emphasized before, it's definitely lower than we had modeled in the second half, but it's improving
Yeah, thanks
First of all, I think one of the biggest things to think about how it will improve next year is if you actually have to break down the individual items and take a look at where the various items are going
And as you do that, what we see in that is there's a very small subset of items that have deflated significantly this year, items you probably might be aware of over the last couple of years at launch that had limited competition, either because they were hard to make or there was raw material issues or those types of things, that were relatively high priced towards the beginning of the year, or higher priced in terms of generics go, and then they deflated significantly during the year
And what we believe is that subset, that small subset of items which are very material, have really reached probably near the bottom of where they'll be
And so the impact of those items we don't see reoccurring next year, and that has a significant impact on the overall deflation rate for next year
And then when you combine that with all of the other efforts that we have in terms of pricing, sourcing, working with our customers on penetration and things like that, that's why we feel confident about where the overall deflation rate's headed
Thanks for the question, Ricky
As you can imagine, back on April 18, while we weren't completely closed with the quarter, we had very good line of sight into what the quarter was going to look like
So when I talked about those discrete items, I was taking into account what we expected to see for really the entire full year
So those were given with the knowledge of what was going in the third quarter, so there would be no update – I'll go through the details, but there would be no update to those four discrete items just because of the actual results in the Q3 are what we see happening in Q4. Those four items were, first and foremost, the largest was tax and reserve adjustments
And, as you can see, in this quarter this year we mentioned as one of the drivers for the quarter that tax was a positive for us versus the prior year
And we knew that when we gave you some insight a few weeks ago that that would be the largest
So of the greater than $0.50 of discrete items we expect to incur this year that we'll not incur next year, tax and some reserve adjustments that I've talked about was the biggest one
The second bucket – and the next three are all similar in size – would be compensation
You heard me mention that today
So that will be an adjustment year-over-year
Investments in the business where we were very disciplined this year, particularly early on in the year as we knew how things were shaping up to be, very careful in that area and to manage our SG&A expense
And then in P-Mod, which is our Pharma Distribution IT refresh project, we know and have known that as we roll this out, that we're going to be incurring some incremental expenses over the next couple of years, particularly next year is a larger year for us in P-Mod expenses
And so those are the four that add up to the greater than $0.50, with the tax and reserve adjustments being the largest
Yeah
As far as the brand one related to the CVS piece, again, this was all contemplated in the guidance that we had
We had some insight into that, and is low-margin brand sale
And it doesn't really have any pull-through impact to us on generics as far as it goes to CVS
So we feel very comfortable that all of that sales decline is already modeled into our outlook for 2017, as well as our early thoughts on 2018. As far as generic deflation goes, I'm not sure what more I can talk about on that other than, again, we see it getting better
We feel like we're positioned incredibly well with Red Oak Sourcing and our pricing teams, and it's definitely getting better
Not quite as good as we modeled, but definitely getting better
Thanks, <UNK>
A couple things on that
I think, we always have a portion of our contracts that are renewing every single year
And when we talk about renewals, we're really talking about those large renewals that are out there and to your point
So there's always independents that are renewing and other acute hospitals and stuff
And so we're constantly looking at our contracts and trying to make sure that they're fair to both the customer and to us
And so where customers are looking for improved branded pricing or improved generic pricing, we're, of course, going to look at things like, okay, then you need to commit to higher percentage of your generics from us
You're going to need to buy more OTC, HBA products from us
You may need to accelerate your terms and pay faster
And so we constantly look, as we model, to make sure we're doing all the right things to pull the levers to be fair to both the customers to meet their needs in the marketplace as well as making sure that we protect our profitability
Yeah
So brand inflation, just a couple comments
As I mentioned earlier, I did say it was just a little bit less than where we expected it to be within the range of the 7% to 9% that we gave in the last quarter
And so it's still tracking within that range, but again, a little lower than we had originally modeled for the quarter in the second half
And that being said, it's a small driver for the second half of the year
And quite honestly, we have been at – over 85% of our branded agreements are now non-contingent to inflation
I would expect that, if not by the end of FY 2018, definitely during the year, or by the end, we will be at closer to 90%, if not even slightly over 90% by the end of the year
So, I think what we're – we're seeing a couple things
One, we're making ourselves less and less dependent upon it
And because it's already gone down from low double digits to more high single, I think the risk of it going significantly lower in the future, I think, is lower also
And so I don't see that as a big driver, one way or the other, for 2018 and, honestly, even probably 2019 and those years going forward, unless there's dramatic changes in the environment
Yeah
A couple things
Remember, when we're talking about an entire year rate of low double digits, and it was significantly lower in the first half of the year, so, as you could imagine, what we'd expected it to improve a little bit more, to average out to low double digits for the year
And so, again, it is improving, and the low double digits is an average for the entire year
And you do remember, probably back on one of the other quarter calls, we said we started seeing it get better in the December quarter
There was a lot of noise in there for launches
And, as I said, we see it getting better in the second half, just not as good as we had modeled
The only thing I would add is, my whole comment around going from 85% to at least 90% is all around the success of those agreements, and we're already seeing that rate increase
So you can assume that we've been able to work through some of the conversations with some of the manufacturers, and are continuing to have very productive dialogue with other manufacturers, and that's what's leading to us being able to increase from over 85% to 90% timeframe
And as far as working capital goes, Bob, there's nothing fundamental that's changed in the net working capital
In other words, no big vendor term changes or customer mix changes or anything
It's more just the timing around some inventory builds related to some of the IT changes that we're doing and a few other projects that we have going on that we think we'll work through here in the fourth quarter and see significant cash flow in the fourth quarter
But no fundamental changes going on in the net working capital
<UNK> <UNK> - Credit Suisse Securities (USA) LLC <UNK>, is there a new business number or a backlog number, anything like that, for naviHealth we can point to?
And again, even if there was, just because the agreements take time for the results to pop out, we might indicate what's in the pipeline, but it would still be hard to predict what the savings are until you actually work through the process with the customer
Yeah, just a couple things
Related to the transition service agreements, transition manufacturing agreements, we actually have them going both ways
And so both companies are highly invested in each other's success here
So I think that will be an important thing as we work through those, and I think that's important
A couple other learnings is, on the Cordis piece, the U.S
piece has gone really well, in terms of infrastructure, has gone right according to plan
And remember that this Patient Recovery business is largely U.S
, and so we feel really good about our back office capabilities in the U.S
And as <UNK> mentioned, ex-U.S, we are definitely going to be able to leverage what we're doing with Cordis on the Patient Recovery business
And then just two other quick things is, I think we've done a very nice job in managing the R&D mix in terms of expenses and managing that
Don and team have been able to manage that well, really held onto sales momentum and actually created some
And just to wrap it up, from my point is that we did mention too, that the Cordis business would return to growth in Q4.
No, I wouldn't think so
I would say that the repricing has been normal in the brand and specialty
The only reason you heard a little bit of a hesitation is they're all kind of bid as one basket, right? And so if you just look at a customer who was buying brand from us in one year to the next, I wouldn't say there's been anything unusual at all from any erosion on that
That tends to be – it flows right off of the WACC manufacturer price, whereas the generics is more of a market price that adjusts up and down on a daily basis
So they're very different markets, but no, nothing of concern in the brand or specialty market that I would call out
That's hard to do
Let me see if I can help a little bit
Again, the low double digits is an annual rate, and so if you start with a higher double digits number in the first half of the year, you have to see second half has to be better, and again, we are seeing it better than the first half, but not quite as good as what we had expected
Again, if you just take a look at the curve is – what we're saying is better means it's less steep on the curve, and so the declines are less in the second half
Now we've always, historically, typically get deflation and we've just seen over the last few years some unique sets of items seeing significant inflation that have offset that
So I think it's hard to just look at the deflation as one single component
To me, the key is that curve being less steep, but at the same time, using Red Oak and our customer mix and our other initiatives to continue to drive down costing even more so that we can begin to either maintain or grow our margins
That to me is one of the keys that we're clearly working on
Yeah, that's really the news that CVS had given at late in calendar 2016 around some of the contract changes that they had
And so we saw that hit us early right in the quarter, and so we saw the impact in the March quarter, we projected it into our Q4 and through next year
So this all contemplated in everything that we've given you in terms of brand sales and our impact on the revenue line and the bottom line, and so it is low-margin brand sales and so we don't see it having a significant impact to it
But again, everything that it does have and any impact is already contemplated in all of the 2017 and 2018 guidance that we've given to you guys
