Cardinal Health Inc (CAH) — Q1 2015 Earnings Call Transcript

Thank you, everyone, and welcome to Cardinal Health First Quarter Fiscal 2015 Earnings Call. Today, we will be making forward-looking statements. The matters addressed in these statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected or implied. Please refer to the SEC filings and the Forward-looking statements slide at the beginning of the presentation, which can be found on the Investor page of our website for a description of those risks and uncertainties. In addition, we will reference non-GAAP financial measures. Information about the measures is included at the end of the slides. I'd also like to remind you of a few upcoming investment conferences and events. We will be webcasting our presentation at the Crédit Suisse First Boston Conference on November 11 in Phoenix. And in addition, we will be hosting one-on-one meetings at the Bank of America One-on-One Conference in Chicago on December 11. Today's press release and details for any webcasted events will be posted on the IR section of the website at cardinalhealth.com. So please make sure to visit the site often for any updated information. We hope to see many of you at an upcoming event. Now I'd like to turn the call over to our Chairman and CEO, George Barrett.

Thanks, Sally, and good morning, everyone. Our fiscal 2015 is off to a really good start. Our organization performed well across the board, and I'm proud of the work our people have done in positioning the organization to anticipate and address the evolving needs of a fast-changing market. During Q1, we saw growth in both Pharmaceutical and Medical segment profits. Our gross margin rate expanded by over 40 basis points to 5.6%. And we returned nearly $500 million in cash to our shareholders in the form of dividends and share repurchases. Total revenues for the quarter were $24.1 billion, a decline of 2% versus last year's first quarter. This is the last quarter in which we will be comparing to a prior year period, which included sales to Walgreens. The declines in the Walgreens contract expiration were largely offset by sales growth from both new and existing customers. Our first-quarter non-GAAP diluted EPS was $1, down from last year's $1.10, which included an $0.18 benefit related to tax settlements. Back in August, as we began our fiscal 2015 year, we provided a non-GAAP EPS guidance range of $4.10 to $4.30. We are reaffirming that guidance today. I will note that while we still expect the contribution to profit to be more back-half weighted, the strong start to the year is certainly an encouraging sign. I'll provide a very quick overview of our first quarter, which Jeff will cover in greater detail during his remarks. I'd like to devote the rest of my time this morning to covering our progress on our strategic priorities. Our Pharmaceutical segment reported revenues of $21.2 billion, down 3%. Revenue growth from both new and existing customers partially offset the Walgreens impact. Our Pharma segment margins continued to expand. Pharmaceutical Distribution had an excellent beginning to the year. We continue to outgrow all markets, with the exception of chain drug, where, of course, Walgreens affected the numbers. And I'm happy to say, this is the last quarter where we will feel the Walgreens quarterly headwind. Our Pharma teams continue to demonstrate a deep understanding of market dynamics and the tools which can help our customers compete in this extraordinary market. Investments in analytics, reporting, and dashboarding are giving customers needed visibility into their performance against critical metrics. Improving performance is essential to network access and a top priority for pharmaceuticals. Specialty Solutions continues its strong performance, again showing double-digit sales growth in the first quarter. And our Nuclear pharmacy business has made excellent progress after the dramatic market changes of the past few years. The introduction of Xofigo, a product used to treat metastatic cancers in bone, has been an important introduction for the radiopharmaceutical market and should increasingly contribute to our Nuclear performance. Our Medical segment had a good start to the year. First-quarter revenues were $2.9 billion, up 5%, and segment profit increased by more than 6%. This is good news in the context of an environment in which system-wide utilization has remained somewhat subdued. Cardinal Health at Home, the former AssuraMed business, continues to perform well. We're particularly excited that our direct-to-patient business reported strong double-digit growth. We continue to see great opportunity here, enabled by an expanding product line and an increase in Cardinal Health brand products for the home. Overall, our Medical segment continues to demonstrate great balance, which is very valuable at a time with enormous and rapid change. Just as important, our Medical segment continues to innovate and explore new ways to bring value to a system hungry for solutions to new challenges. I will touch on these as I discuss our strategic priorities. Finally, in relation to the quarter, I would note that China had an outstanding first quarter, with revenues up by more than 30%, as well as expanding operating margins. We continued to broaden our footprint, build the direct-to-patient pharmacy business, and offer both distribution and a widening range of services aligned with our biopharma and medical device partners. As I mentioned earlier on the call, I'd like to devote much of my time today to covering the progress we're making on our strategic priorities. Over the past few years, we have been intensifying our efforts in these priority areas. Each of these priorities aligns with the powerful changes occurring around health care. Success in these areas continues to contribute to value for our customers, growth of our business, and expansion of our margins. These priorities include: generic pharmaceuticals; solutions in the specialty pharmaceutical arena; growth in our product and service offerings to hospitals and health systems; increasing presence in ambulatory and post-acute settings; and growth in the Chinese market.

Thanks, George. I'm really excited to be moving into the CFO role. What you may not know about me is that while I've spent most of my 24 years here at Cardinal Health in sales, procurement, and general management, I've also been a division controller and CFO for our Medical and Pharmaceutical Distribution businesses. I've also spent over 5 years in public accounting before I joined Cardinal. So in many ways, I'm going back to my roots. George, Jeff, and I are already working together on the transition. And with Jeff here through August, I'm confident it will be smooth. I look forward to meeting many of you over the coming months at the various conferences and events. But for now, I'll turn the call over to Jeff for his final earnings call as CFO.

Good morning, everyone. Thank you, George and Mike. I share George's sentiment in welcoming Mike and look forward to officially handing over the CFO responsibilities to him in a few weeks. As George mentioned, we are off to a strong start and making good progress on our key strategic initiatives that will enhance our performance this fiscal year and beyond. In my prepared remarks, I will first outline the factors influencing our first-quarter financial performance and then share our expectations as we progress through the remainder of fiscal '15. You can refer to the slide presentation on our website for guidance in this discussion. While our non-GAAP EPS for the quarter was $1, a 9% decrease compared to the previous year, the first quarter of fiscal '14 benefited from an $0.18 positive impact related to the resolution of federal and state tax matters. When excluding the tax factors from the previous year, non-GAAP EPS increased by 9%. Revenues reached $24.1 billion, surpassing our expectations for the first quarter. Excluding the impact of the Walgreens contract expiration, our first quarter revenue for fiscal 2015 grew strongly by 13%. Gross margin dollars rose by 6% this quarter, and the gross margin rate improved by 42 basis points compared to the same quarter last year. Total SG&A rose by 6% compared to the prior year, driven by increased expenses related to acquisitions. Consolidated non-GAAP operating earnings increased by 6% to $566 million, while the non-GAAP operating margin rate climbed 18 basis points from the prior year to 2.35%. Interest and other expenses remained roughly the same as last year. Our non-GAAP tax rate for the quarter was 36.5%. It is important to note that last year's Q1 tax rate was unusually low due to specific favorable settlements. Excluding those settlements, the fiscal 2014 first quarter non-GAAP effective tax rate would have been 37.3%, slightly above this year's first quarter tax rate. Our diluted average shares outstanding for the first quarter were 340 million, which is 3.6 million shares better than the same quarter last year. We repurchased $360 million in shares during the quarter, and I'm confident we will surpass the $500 million in share repurchases we announced in August as part of our fiscal '15 plans. At the end of Q1, we had nearly $1.4 billion remaining in repurchase authorization approved by our Board. Now, looking at consolidated cash flows and our balance sheet, operating cash flow was relatively light this quarter, primarily due to timing as we saw some shifts between quarters. As a reminder, Q1 of FY '14 saw unusually high operating cash flow because of the rapid wind down of the Walgreens contract. At the end of the recently closed quarter, we had $2.5 billion in cash on our balance sheet, which includes $447 million held internationally. Working capital days were at 8.7 days. Compared to the previous year, this figure is significant as last year's results were affected by the Walgreens contract rollout. Moving on to segment performance, starting with Pharma, revenue for the Pharmaceutical segment decreased by 3% to $21.2 billion. The quarter's comparison includes two months of revenue impact from Q1 of FY '14 due to the end of the Walgreens contract. Excluding that impact, Pharma segment revenues increased by 15% year-over-year, supported by growth from our existing customer base and new clients, as well as substantial growth in our Pharma segment in China. Additionally, Pharma revenues improved across our generics, specialty, and Nuclear segments. Pharma segment profit grew by 4% to $451 million, with a margin rate up 14 basis points compared to the same quarter last year. These results were driven by growth in both new and existing customers, along with strong performance in our generics programs. Regarding our generics programs, the net impact of the Red Oak JV was slightly positive this quarter, although we are in the early stages of realizing the expected benefits. We observed a slight year-over-year increase in contributions from generic price increases during this quarter. Overall, generic inflation was higher than last year's Q1 but consistent with Q4 of last year. Just a reminder, we calculate generic price changes based on products that have been on the market for at least a year using weighted average selling prices. Lastly, I want to highlight that the quarter included benefits from the resolution of several longstanding customer issues, valued at about $20 million. Now, let’s examine the Medical segment performance. Revenue for the Medical segment rose by 5% to $2.9 billion, driven by acquisitions and a net positive impact from customer growth. Within our strategic hospital accounts, we saw organic growth, with those customers increasing by nearly 4%. This is a clear indication that we are focusing on what matters most to our customer base. On a broader scale, we have observed some stabilization in overall utilization, with pockets of growth developing in healthcare. However, we are not yet at a stage where we would classify this as an overall market uptick. During the quarter, Medical segment profit increased more than 6% to $113 million. This increase stemmed from profit growth in Cardinal Health branded products and service growth, which was partially offset by a decline in contributions from national brands. Our Canadian business continues to face a challenging market environment, but we are making the necessary operational and product mix changes to adapt. As George mentioned, we have successfully entered three targeted categories for our Cardinal Health brand physician preference items. While we are pleased with this advancement, we are still in the early phases of this medium-term growth driver and expect gradual growth throughout the year. Much of our focus now is on launching these products and positioning our organization to foster future growth in this area. I would also like to address our operations in China, which span both of our reporting segments. As we approach the fourth anniversary of our initial Yong Yu acquisition, I am very pleased with the progress we have made, much of which George highlighted. China revenues experienced strong growth this quarter, showing a year-over-year increase of 34%, driven by both new and existing customers. We are outpacing overall healthcare market growth in China while pursuing our strategy of geographic expansion to significant population centers and enhancing our capabilities to meet the needs of this unique market. Looking at our consolidated GAAP results for the quarter, the $0.22 difference from non-GAAP results was mainly attributed to amortization, other acquisition-related costs, and litigation expenses. Litigation expenses increased due to a $27 million reserve tied to the previously mentioned Florida DEA matter. As we look ahead to the rest of the fiscal year, we are reaffirming our non-GAAP earnings per share guidance of $4.10 to $4.30. Reflecting this range are a few updated assumptions from what we had outlined during our August earnings call. First, we are becoming more optimistic about the consolidated revenue growth for the full year, which we previously described as modest growth. This is mainly driven by pharma brand sales. Second, we have lowered our forecast for earnings contribution from new generic launches. Specifically, we had initially anticipated a benefit from a planned generic Nexium launch in November of this year, but given recent developments, we no longer expect this to contribute to fiscal 2015. Third, based on our observations from the first quarter, our expectation for full-year generic pricing has shifted from slight deflation to slight inflation. However, we still expect the earnings impact from generic price increases to be lower than what we experienced last year. Finally, based on fluctuations in oil prices, we expect some positive impact on specific commodity costs within the Medical segment in the second half of the year, although this benefit is partly countered by unfavorable foreign exchange movements. Most foundational corporate assumptions remain unchanged from our previous comments, but I want to point out a couple of items. We continue to anticipate the full-year tax rate to be between 36% and 37%. As previously mentioned, this will likely vary quarterly due to unique factors impacting individual periods. Additionally, we are raising our estimate for acquisition-related intangible amortization to about $184 million or $0.35 per share, due to a few smaller acquisitions that were finalized during the quarter. This change does not affect our non-GAAP earnings. In summary, and considering that we are just one quarter into the year, our overall guidance range has not changed. I want to make one last comment about the evolution of earnings throughout the year, a pattern that remains largely consistent with our initial expectations. We anticipate the year to be back-end loaded in terms of operating earnings growth, influenced by several factors. As I mentioned earlier, benefits from the Red Oak Sourcing entity will ramp over time, and we will be investing initially to accelerate the growth of Cardinal Health brand physician preference items over the medium term. In conclusion, there are various factors to consider this year. However, I feel optimistic about our organization's ability to adapt to a rapidly changing environment and how we've positioned ourselves coming into the first quarter. In closing, I would like to say that after nearly 40 earnings calls, more than 150 sell-side events, and approximately 1,700 investor meetings, I am eager to get some more sleep. As I mentioned to some of you in person, I have always found investor relations to be one of the most fulfilling aspects of my role. I view investors and analysts as customers, and I have valued the exchanges and relationships we've shared over the last decade. I take pride in the fact that your confidence and investments in Cardinal have been rewarded over the years. To all of our Cardinal employees, I will still be around until next summer. I look forward to working with Mike as he transitions into the CFO role and to continue collaborating closely with George and my colleagues in China until my retirement next August. This is my final earnings call as your CFO, and I want to express what a privilege it has been to serve in this role for the past 9.5 years. We've been through a lot together, and we've built a great company to be proud of. Thank you all. Now, let's begin our Q&A.

I was curious if you think the Canadian business was weak as a protest to your leaving the company.

I'm sure that had a big piece to play in it, yes, Ross.

There were many changes in assumptions on the generics side. We are aware of some delays, and of course, we have all been monitoring inflation. When looking at the Pharma business performance, the growth was impressive when excluding lag. As you analyze the profit side for the quarter, while specific numbers are limited, could you share your thoughts on where you excelled in margin dollars and where you anticipate improved performance for the year? We know Red Oak is coming in, but I'm interested in more details on the line items.

Let me just start. I think part of the driver for us is a focus on key priorities, and that really influences the mix of our product lines and services. And so as we look across the business, those areas where we're growing, I think, are higher value areas for our customer base. And as a result, they tend to be higher-margin businesses for us. So again, I think we're doing very well in generics. That customer base is expanding. Our specialty business continues to grow. On our medical side, again, utilization was okay. Obviously, we’re still seeing it to be somewhat subdued. But I think we're really doing well with our strategic accounts and then, again, with key products in those accounts that are really important drivers for us and important value drivers for them. So I think it's largely about a very clear focus on priorities and mix. Jeff, I don't know what we might want to add to that.

Yes. If you look at the different segments within Pharma, such as core Pharma Distribution, Nuclear, specialty, and the China segment, they all exceeded our expectations for the quarter. Overall, we are quite satisfied with the results. However, the one area that hasn’t yet reached its full potential is the Red Oak joint venture. As we've indicated, there will be a gradual increase over time. The first quarter mainly focused on establishing the joint venture, initiating discussions with manufacturers, and beginning to sign them up. The real benefits will materialize over time, so I would say that this aspect was somewhat lacking in Q1, but it was anticipated.

Yes, it's important. That is what we anticipated. So again, not just one that didn't happen, I think that's key, is that we know that, that flows as the year goes.

On the Medical side, we are pleased to see some profit growth for the quarter, especially in a utilization environment that hasn't significantly improved yet. One area to note, which is not a disappointment but rather something we anticipated, is our continued investment in our physician preference item rollouts. This phase is more about investing than profiting at the moment, which we expected. We aim to ensure we are well-positioned with the right product portfolio and sales force. Consequently, we expect to see benefits more in the later part of this fiscal year and into next year. So again, this is not a disappointment; it's just not a significant driver for us in the quarter.

That's helpful. And just quickly, it seems like you picked up the tuck-in M&A activity strictly in the Medical side. You've got sort of a differentiated strategy there. What's the pipeline look like? And do you feel like you're filling in a lot of the holes? You moved into wound care, you've got some stuff in ortho now. What else is sort of left?

Well, I mean, I think now it's executing. As Jeff said, these are major initiatives for us that we've always described as sort of midterm drivers, Ross. So I think the positioning on orthopedics is really good. By the end of this year, we're going to start to see some of that flow through the system. The move into cardiovascular, interventional cardiology, I think, was really exciting for us. It's doing well, and that bag will begin to fill. And then as we think about wound care, that's a really interesting area for us. And as I mentioned, we are talking about 250 launches that are sort of in process. So I think now, it's more about rolling it out, executing, and we're really excited about these programs.

And Jeff, just let me say that I wish you well in your retirement, and I really enjoyed working with you over the years and the last 40-plus earnings calls. So my first question, really, George, just to follow up on what you're talking about around PPI products and clearly, tuck-in acquisitions. But do you see any bigger opportunities in the market? This is clearly a place that Cardinal has differentiated themselves in the med-surg side. I think I heard you earlier talking about continuing to take action to deliver products to physician offices. Do you feel like you have what you need in order to deliver to physician offices? Or do you need to make an acquisition to continue to grow that business?

There are two parts to your question. The first part concerns our PPI program. We are satisfied with our current position and will always seek opportunities to enhance these programs. Our responsibilities are twofold: first, to ensure we are taking the right strategic actions to achieve a strong position with adequate coverage, and second, to focus on execution to bring those plans to fruition. We have established a solid foundation, but we will keep looking for ways to grow through both organic developments and potential external opportunities. The second part relates to the physician's office. There are two narratives here. The physician office business is increasingly aligning with Integrated Delivery Networks (IDNs), with which we have built substantial enterprise-wide relationships, making us stronger in that area. However, we have not performed as well with independent practices and are exploring various strategies to improve that segment of our business. Overall, while we feel confident in our continuum of care, we will continue to seek means to bolster any areas where we may be lacking.

I guess, really, what I'm looking for is, as we think about Cardinal, you've got a lot of cash spinning on your balance sheet, your business is running very well, should we expect to see you do a larger acquisition this year? I mean, that's really what I'm looking at. So I was trying to figure out different places where you could potentially add to your business. But really, the core of my question is, should we expect Cardinal to do something bigger in this fiscal year?

I understand your question, Lisa. It’s a tough one to answer. You should expect Cardinal to use its capital efficiently and intelligently. When we identify external opportunities that align with our strategies, we're willing to pursue them. However, we also feel it is our duty to return cash to shareholders. If suitable strategic acquisition opportunities don’t arise, we will carefully consider how we allocate our capital. Jeff, do you want to add anything?

An example of that is what happened in the first quarter, right? We were building up cash, and those significant opportunities were executed during Q1. So we found an opportunity to use that cash to buy back shares, and that sort of will be our ongoing approach to it.

And Jeff, I'll continue with pats on the back. Nice work. And it's been a pleasure working with you. I’d like to revisit Red Oak. I’m somewhat surprised to learn that it has been accretive so early in the joint venture. Could you provide any additional insights on the accretion? I assume it was accretive after the payment to CVS. Additionally, you mentioned that manufacturers appreciate how simple and streamlined the program is. Can you share how Red Oak might be or how you perceive it to be different from other procurement programs?

Thank you for the kind words, George. We did not incur any expense related to the payment to Cardinal Health in the first quarter. That payment will be reflected for the first time in the second quarter of this year, and we will start recognizing it on a monthly basis beginning in October. Therefore, there was no expense associated with that payment in the first quarter. The benefits we observed primarily contributed to the bottom line, although I would characterize those benefits as relatively minimal at this stage.

George, I'll address the second point. I'll be cautious because the work we're doing in Red Oak and our relationships with manufacturers are quite sensitive. There's a lot of change occurring in the system that may be unsettling for some. We realized early on that establishing a strong relationship with manufacturers depended on being very clear about terms and conditions and decision-making processes. There are many moving parts in a generic program, and we understood that simplifying this would be beneficial. We've already had numerous meetings, with very positive feedback indicating that people understand our goals. They are cooperative in working with us and have shown support for our approach and the simplicity of the program.

That's helpful. As a quick follow-up, it appears that in looking at other procurement situations in the industry, the ramp-up from these joint ventures tends to be quite rapid. Is your assumption the same that Red Oak will ramp up quickly and by the end of fiscal '15, we should see close to the full annualized benefit?

Well, let me start first, and then I'll turn it to Jeff. This is George. I probably would not comment on anybody else's programs and the speed at which they can achieve that. It's just not my place. I think for us, I'm incredibly proud of the work that's been done in less than a year to get this thing rolling. You would be astonished at how many moving parts there are. So great work has been done. As we've said, we do expect to start to see a more rich benefit as the year unfolds. But Jeff, a little...

Yes. George, I like the way you described it, as getting to a more normal run rate by the end of this fiscal year, is a fair comment and consistent with what I've said previously. That doesn't mean there won't be incremental benefits that we’ll go for in FY '16 and '17 and beyond. That definitely will be the case. But again, characterizing it as reaching a more normal run rate by the end of fiscal '15, I think is fair.

Strategic priority commentary, and I wanted to drill in a little bit on specialty, where you talked about moving from $1 billion to $5 billion today. I guess, my first question is, is the $5 billion really specialty distribution, specialty pharmacy, hub services outside of specialty flowing through the traditional wholesale business? And then could you talk a bit about where you focused and grown in those different components of the specialty business?

Yes, thanks, Eric. This is George. It's a bit of everything. First, we're discussing our run rate, which has been encouraging. The good news is that we've taken a methodical approach to our specialty business, primarily focusing on organic growth. Each subsegment of our specialty work, whether in biopharma services or distribution, plays a crucial role. Revenue-wise, distribution will always have a larger impact. Overall, we're quite positive about our progress. The introduction of our patient hub is still in its early stages, but I believe it presents a significant opportunity for us to support pharma companies in enhancing their patient engagement. In summary, we're very encouraged by the developments in our various sub-businesses and the organic growth we've experienced.

Let me just add to that. We've always stated that success in specialty depends on two key factors: first, achieving critical mass and size to remain relevant to manufacturers, doctors, and payers. With a $5 billion run rate, we can clearly assert our relevance and now hold a significant share of the specialty market. The second aspect is that as we grew in size and relevance, we needed to continue integrating services around that volume for profit generation with manufacturers and others. This integration has progressed, particularly since last January with the acquisition of Sonexus, which has enhanced the services we now offer in specialty. Overall, I feel very positive about the positioning we've established over the past couple of years.

And Jeff, it's been a pleasure. I wanted to shift over to Medical, where revenue came in at the high end of your low- to mid-single digit range for the year. Several med tech companies this quarter have been citing improved volumes. Your largest competitor on the acute side talked about it, one of the best environments they've seen in a while. Can you maybe just talk about what you're seeing within the marketplace? I know you commented briefly on it in the prepared remarks. But just curious, from a volume standpoint, demand standpoint, how that market has been trending and probably, more importantly, how you're contemplating the progression of that market into your fiscal '15 guidance?

Yes, thanks. I'll take this. We've obviously heard a lot of commentary on different companies. And actually, we're hearing quite different things, and I think there's a good reason for that. I would say this. Because of our really broad reach, we have a relatively good line of sight on the system. And so what we'd say from a system perspective, utilization is somewhat flat to slightly up, although I would say it's early to describe that as a trend overall. What's noteworthy, and this is why you may be hearing different perspectives, is that it's not one-size-fits-all. We are seeing some systems and some hospitals showing disproportionate growth in relation to others. And we're seeing some shift in channels, so some utilization that was, for example, happening in the acute care centers moving to ambulatory centers. And so you have this interesting dynamic, which is an overall system number, but some shifting on how and where it's done. And so that partly explains, I think, why you might be hearing things. We certainly believe, over the long haul, both through access to healthcare, insurance and demographics, we're going to see a lift. I would say, right now, in the short term, it's still relatively modest.

No, that's helpful. And then, I guess, just a follow-up on inflation, just given how important it is to the business. I know you guys guided for moderation in generic inflation for fiscal '15. But this quarter, it sounds like you said inflation was consistent. I'm just wondering, have you started to see any signs of the actual moderation in the marketplace? And George, even longer term, obviously having sat on the other side of this equation, how prolonged can this inflationary environment go in your view from a high level? I mean, are we talking quarters, are we talking multiyear? Any perspective there would actually be really helpful.

Yes, there are two parts to your question, and the last part is quite challenging to address. Historically, we do observe cycles, which is not uncommon. The duration of these cycles varies and is influenced by numerous factors, including how many companies are resolving technical issues that allow them to return to the market. Unfortunately, I can't provide a solid forecast on the length of that cycle. However, in the short term, it seems consistent, as Jeff would agree, reflecting what we observed in the last quarter.

Last quarter. But it was better than what we had originally modeled for Q1. And that's the reason why we've changed our overall assessment for the year, now looking at slight inflation versus a slight deflation that we had talked about back in August.

And Jeff, I know we'll miss you. Enjoy your extra sleep time. And Mike, welcome. Welcome to the role. I'm looking forward to working with you more closely beyond just the once-a-year card at Dublin Day. So I have 2 follow-up questions. The first one is around specialty. At $5 billion run rate, based on our assumptions, I think Cardinal now accounts for about 8% of the specialty market. So can you help us better understand whether this is more concentrated around some specific drug therapies where you have higher share? And also, as we think of new drug launches in the coming years, should we assume that you're now in a position to gain your fair share, i.e. that 8% across the different drug categories?

I'll begin by stating that I believe we are well positioned. We have a strong presence throughout the business. While there will always be individual products with specific service contracts, the same is likely true for our competitors. We are prepared to engage in various segments of the specialty area. Additionally, I would like to highlight that we have effectively connected the perspectives of payers, pharmaceutical companies, and patients, especially in a landscape filled with risk management challenges. We've developed some innovative solutions in this regard. Overall, I believe we are equipped to compete widely and anticipate capturing our fair share of growth as the system expands.

And do you think there are any more assets that you could consider through M&A that, for any reason, didn’t qualify a few years back?

We've mentioned this previously. We are continuously looking at our strategic priorities where we believe we can add real value. We are doing this internally through our own efforts and investments, but we will also seek external opportunities that align with our strategy and where we can successfully execute. We will keep actively pursuing these opportunities, even though they do not arise every day. Our strategy will focus on driving organic growth, enhancing our capabilities, leveraging our growing scale, and exploring external opportunities.

George, just wanted to ask about the Medical segment. I think this is an area that has been a focus for you since you became CEO. And it feels like the company's been constantly investing in this area. And I would say, I think it's fair to say that the profit margins in the segment are probably not where you'd like them. And if we go back to Analyst Day, you laid out some pretty aggressive assumptions over the next several years in terms of the profit margins in that segment. So maybe could you opine on kind of where you think we are at this point and what you see as the keys to success to be able to improve the profit margins in that division?

Yes. So generally, as Jeff mentioned earlier, the profit margins in that segment tend to be higher than the profit margins in our Pharma segment. So a, it is accretive to the work in our Medical business is accretive to our margin rate. Number two, we have been seeing some really encouraging work that's affecting our margins, and it really has to do with the mix of products and services that we provide. The areas that we are prioritizing tend to be areas that are actually accretive to our margin rate, and we'll continue to drive those. So we've talked about the consumables area. Those are positive to us. Our growth in the direct-to-patient work that we're doing through Cardinal at Home, that is beneficial to our margin rate. Honestly, it's a midterm driver that we've talked about in terms of preferred products or physician preference items that is accretive to our margin rates. So what I would say is, these are all, for us, priorities because they're really needed, they address real pain points in the system, but they're also beneficial to us in terms of our overall mix and profit. So I'm pretty excited about the work that we're doing and the recent moves we've made, particularly to build that foundation, and the physician preference items is probably a good news story. I don't know if Jeff wants to add.

Yes, the goal we set during Investor Day last December was to reach a 5.75% operating margin or segment profit margin in Medical for fiscal year 2017. I believe we have taken the necessary steps to stay on track to achieve that. However, it won’t be a perfectly smooth process. There will be quarters when we need to invest to accelerate specific areas, and there may always be aspects of the business that experience some setbacks. In this particular quarter, we faced one of those setbacks from an operating perspective, influenced by market conditions. Nonetheless, the overall trajectory we are on is still aligned with the 5.75% target we established.

I'll add my congratulations and hope to see you on another trip down to Vanderbilt sometime soon. If I could revisit George's earlier question about Red Oak and the timing of its benefits, could you explain the process for how simple annual contracts are renegotiated? What are the mechanics involved in getting the Red Oak aspect operational quickly enough to recognize the benefits in the income statement?

So again, I'll try to give you some color without providing answers that would make us uncomfortable given our proprietary relationships with our suppliers. We started working on this right away, identifying the teams with a clear sense of what we wanted to do. And so in a way, it was just a discipline of putting the teams together, identifying the right talent. We've got tremendously capable people working in this and then the support of 2 companies from the back office perspective. What we had to do was to really do a full analysis of the market, every product line, every supplier, all their capacities, what their pipelines look like. And so the Red Oak team, I think, has done all of them. But I would describe it as serious analytics work to identify what the opportunities were and how to work with each manufacturer. Each of those relationships is very, very distinct, and so we work very hard at making sure that everybody feels like they're in the tent, both big companies and small. The Red Oak teams have been having meetings, really, since early July with all those manufacturers. And so the progress has been really gratifying. I'm extremely proud of this team, but I’m impressed by what I've seen. And they're working their tails off. This is incredibly hard work. As I've said, I don't think anybody can ever appreciate how many moving parts there are, how many products themselves, how many manufacturers, kind of multiple products. And so I think just doing this work and doing the analytics to support a simple program was enormous. It's hard to give more color than that, but I...

My question is focused on your and CVS' contractual relationships with the manufacturers. It seems that, structurally speaking, things are on a relatively short timeline, allowing you, as a combined purchasing entity, to reorganize those agreements and start realizing the benefits sooner than we might have expected. Is that accurate?

I believe we are all transitioning. We all have obligations and commitments along with existing product relationships, and I think that will continue to evolve. As we progress through the year, I see us acting as a sourcing entity, which I believe manufacturers will recognize. I expect to see the benefits of this as the year unfolds.

That's helpful. And as a quick follow-up, if I may ask. Appreciate the color relative to your expectations on Nexium in the fiscal year. More broadly speaking, as it relates to other generic launches going forward and understanding that Nexium has some specific circumstances surrounding it, are you guys seeing anything differently from either an FDA perspective or a manufacturing perspective that might create a more drawn-out process relative to other larger products going through a generic launch process? Or is Nexium and perhaps some of the others out there that we've seen some delays where those are just one-off kind of situations? Is there something more endemic there?

I think they're largely one-off stories. I think actually FDA has been talking about increasing their cycle times, speeding up their cycle time, so I'm not sure we're seeing an endemic situation at all. These tend to be very unique issues that may or may not have legal issues or manufacturing issues, but I think what we would say is these are largely one-off dynamics that we're describing.

Excluding Walgreens, the revenue growth of 13% year-over-year looks very good. Can you discuss the significant wins in the Pharma division? What are the new developments in the market this year compared to last year? From a Pharma Distribution perspective, what strategies are you implementing that set you apart from your competitors?

I'm usually hesitant to compare ourselves directly to competitors during this call, but I'd like to share my perspective. Our team has a strong understanding of how we create value. We are becoming more attuned to our customers' needs, and we show that consistently. This isn’t a statement about others; I just believe our team is excelling and gaining recognition as a company that truly understands the dynamics at play. We're experiencing positive momentum in our customer interactions and in addressing their needs. It's difficult to elaborate further, but the quality of our work is impressive, and I'm monitoring it closely. For instance, at our recent retail business conference, I observed the quality of our customer interactions and the services we offer, and the feedback has been overwhelmingly positive.

No, that's helpful. And then, I guess, just a follow-up on inflation, just given how important it is to the business. I know you guys guided for moderation in generic inflation for fiscal '15. But this quarter, it sounds like you said inflation was consistent. I'm just wondering, have you started to see any signs of the actual moderation in the marketplace? And George, even longer term, obviously having sat on the other side of this equation, how prolonged can this inflationary environment go in your view from a high level? I mean, are we talking quarters, are we talking multiyear? Any perspective there would actually be really helpful.

My question is about the physician preference items. Jeff and George, you mentioned investing in this area, and you're anticipating improved contributions in the second half of the year. Could you elaborate on these investments? Are they focused on the clinical aspect or the marketing aspect? Additionally, can you address the level of customer acceptance regarding these physician preference items? Is it considered preference items or medical devices?

So let me do a little defining. These physician preference items are medical devices, so it's just a subset of medical devices, David. So largely, the investment is in a couple of areas: building out the infrastructure and sales force, making sure that we can do what we need to do to get the products in and out of the system. We had some development costs. These are not what I would call research costs in the classic sense. These are more sort of development, making sure that the product line is positioned the way we want. And so for example, just expanding that emerged product line requires some costs. We've got launch activities associated with some of these wound management products. So I think we're a little bit in that stage, but we're pretty excited about the flow of products. And I would say, the customer response is very positive right now. And as Jeff said, we're looking towards the back half with some greater sense of enthusiasm about the flow.