Cardinal Health Inc (CAH) — Q2 2015 Earnings Call Transcript

Thank you, Lisa, and welcome to today's second quarter fiscal 2015 earnings call. Today, we'll 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 our SEC filings and the Forward-looking statement slide at the beginning of the presentation, found on the Investor page of our website for a description of those risks and uncertainties. In addition, we'll 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'll be webcasting our presentation at the Leerink Partners Global Healthcare Conference on February 12 at 08:30 AM local time in New York, the RBC Capital Markets 2015 Global Healthcare Conference on February 24th at 08:00 AM local time in New York; the Cowen and Company's 35th Annual Healthcare Conference on March 30th, 08:00 AM local time in Boston, and the Barclays Global Healthcare Conference on March 10th at 08:30 AM local time in Miami. Today's press release and details for any webcasted events are or will be posted on the IR section of our website at cardinalhealth.com. So please make sure to visit this site often for any updated information, and we hope to see many of you in an upcoming event. Now I'd like to turn the call over to our Chairman and CEO, George Barrett. George?

Thanks Sally. Good morning everyone and thanks to all of you for joining us on our second quarter call. I am pleased to report a very strong second quarter, bringing to completion an excellent first half of fiscal 2015. I'd like to take a moment to welcome Mike Kaufmann to his first quarterly earnings call as the CFO of Cardinal Health. Mike and Jack have worked closely during the transition and I appreciate their collaboration. Mike brings tremendous operating experience to our financial team and has adjusted quickly to his new role. Total revenues for the second quarter were $25.5 billion, an increase of 15% versus last year's second quarter. We were pleased to see sales growth from both existing and new customers. Our second quarter non-GAAP diluted EPS was $1.20, up 33% from last year's $0.90. Remember that our same quarter last year included a $0.16 expense related to a tax item. When we adjust for the tax item, our second quarter FY15 non-GAAP diluted EPS increased by a robust 13%. At the same time we returned $438 million to our shareholders through a combination of stock repurchases and dividends during the second quarter bringing the total amount returned to our shareholders for the first half of the fiscal year to over $900 million. Based on our results for the first half of fiscal 2015 and our perspective on the back half of the year, we are now raising our guidance to a full year EPS range of $4.28 to $4.38. As I typically do, I'll provide some color on the segments, but before I do that I'd like to offer a slightly different perspective on being Cardinal Health. Our health system is going through significant changes, not the least of which is a continued blurring of the lines between healthcare players and channels. Our approach to addressing the market has been aligned to this trend, bringing the full range of Cardinal Health capabilities in a holistic framework to address the needs of these increasingly integrated customers. With this as a backdrop, I'll speak about the segments, but please recognize that in many instances we are going to the market not as a Pharmaceutical segment, not as a Medical segment, but as Cardinal Health, an integrated source of strategic solutions and the creation of our strategic account teams will only expand this enterprise-wide effort. Now to the segments, first our Pharmaceutical segment. Second quarter Pharmaceutical segment revenue was very strong. Sales for the quarter were $22.6 billion, an increase of 16% over the prior year, showing positive signs in nearly all of our business lines and in all classes of trade. Our organization has been unwavering in its commitment to ensure that our customers see us not only as extraordinarily reliable, but also able to help them adapt to the changes in the system. A couple of notes here on revenues. On a year-over-year basis we were pleased to pick up some new business crossing all classes of trade, including one larger mail order customer, which as you know historically contributes to our margin rates. And as many of you know, the treatment of hepatitis C has evolved into a major therapeutic class, and one which has changed dramatically over this past year. The distribution of these products contributed meaningfully to our revenue growth, but has a dilutive effect on our margin rates. The overall performance of our generic programs remains strong and Red Oak Sourcing, our venture with CVS Health is clearly an important strategic initiative for us. We are increasingly excited about this partnership, and are very pleased about the way our collective talent has fully integrated as one team. They've been working hard to make sure that our supplier partners feel that they are part of something that creates value for all stakeholders. We feel confident that the Red Oak model was designed thoughtfully and built to prioritize execution and simplicity, and I can report at this stage, we’re tracking somewhat ahead of our plan to transition manufacturers to the Red Oak program. Of course sourcing product is only half the story. We have seen continued growth in our base of customers and an increasing number of home source generics from us, and our range of products and services continues to attract pharmacy customers. Our specialty solutions organization continues its track record of excellent revenue growth. You will remember from our last earnings call that we expect sales for this unit to attract $5 billion for the year and we are increasingly confident that we will exceed that number for our fiscal year. We continue to look for opportunities to expand our reach to a broader range of therapeutic areas. We have positioned our specialty business at the nexus of biopharma, payer, provider, and patient. We’re committed to keeping the patient at the center of our strategy and our enhanced patient access and support reinforces that focus. Upstream we continue to look for opportunities to broaden our pharmaceutical and biotech relationships and to expand the tools we offer these partners who serve unique patient populations. So next, our Medical segment. We reported revenues for the quarter of $2.9 billion, an increase of 4% versus the prior year. Our Medical segment's top-line was driven by recent acquisitions and growth in existing customers. Our profits were affected by continued challenges in Canada and the year-over-year customer loss in surgical kitting referred to in our calls. One important financial note, our Medical segment profits were significantly impacted this quarter by increased incentive compensation, a byproduct of raising our enterprise-wide forecast and the company expenses to the segment. Having said this, our strategic initiatives in the Medical segment continue to send positive signals, each of which is critical to our overall positioning. We’ve spoken consistently about the movement of care migrating into more ambulatory settings. Our collaboration with Henry Schein addresses an important link in the chain as we serve highly integrated health systems, whose networks now include many smaller physician practices as well as independent practices. Combining Henry Schein’s logistics and service capabilities with Cardinal Health's strength in other channels will enable us to serve these customers more efficiently while increasing the flow of Cardinal Health products into these new channels. The partnership is off to a good start. Meetings with our two sale organizations have gone well and they're working hard on the implementation of the integrated selling effort. We’ve made our first customer presentations as a combined selling organization and here at Cardinal Health we’ve seen our first orders for products destined for these new channels. Consistent with our perspective that care will increasingly be delivered in different settings, we continue to be really excited about our work in the home. Cardinal Health at Home continues to deliver good growth. Our direct-to-patient business Edgepark continues to grow at double-digit rates. We’ve have been introducing Cardinal Health branded products into this channel. Specifically we would expect that by the end of fiscal 2015 to have launched over 100 new products through this platform, primarily in the areas of wound care and incontinence. Our strategy around private label consumables and physician preference items is aligned to address an important need in the system tackling the inefficiency associated with the proliferation of products and the need for standardization. Building scale, reducing variability, improving outcomes while reducing cost, this is at the heart of our strategy. Specifically in the trauma area, we’ve made tremendous progress in building out our product line, helped by the acquisition of Emerge Medical. We expect to be able to offer a reasonably full line of trauma products by early next year. At the same time we have trained over 200 residents on orthopedic trauma using the Cardinal Health trauma products. In wound management, we've made a strong commitment to negative pressure wound therapy, and we're in the process of launching 25 SKUs in this area. As is true with all of our products, the introduction of a wound care portfolio leverages our channel reach to create an integrated wound care solution that stretches across the continuum of care. Finally, at interventional cardiology our AccessClosure acquisition is going extremely well. Some recent new sales on closure devices in our strategic account is an encouraging sign as it relates to the power of combining AccessClosure's product line and the breadth of our customer relationships. Further, on the technical side, our MynxGrip is now the only closure device in the US indicated for venous closure. Finally, China continues to execute well against our plan with very robust double-digit sales growth. As you know, our development in China has been thoughtful and purposeful, built on a foundation of service, integrity, and compliance as a key differentiator. Our balance sheet remains strong and we will not be shy about deploying capital to achieve the best sustainable competitive positions in strategically important areas. Having said this, we will continue to be both focused and disciplined in our deployment of capital, using partnerships to strengthen our position where that's more efficient, Red Oak and Henry Schein being two recent examples. Let me conclude my comments by offering this perspective. This remains an exciting time to be in healthcare and our organization is aligned with the important trends which are shaping our new landscape. But we're also an organization committed to disciplined execution in a business that demands great attention to detail. Over the past 18 months, our pharmaceutical segment has come to a critical transition, repositioning its customer base and dramatically improving its tools and has emerged stronger than ever. Our medical segment is going through its own transition moving from an organization focused on med/surge distribution to an organization which creates value in new ways for customers with new needs. It is also a segment which contains many important mid and long-term drivers of growth. In summary, it seems clear that growth will be driven by demographics, by more Americans having health coverage in some form, that care will continue to be delivered in new settings and at times by different caregivers. Consumers will be more actively involved in their own care. Pharmaceutical innovation will continue to create treatments and in some cases cures for life's most threatening diseases. Those who bring tools to help manage the quality and the cost of care will be winners, and the efficiency created by scale will be valuable. We bring these things and we are increasingly aware that we have a unique position in the marketplace. It's difficult to find another company with this kind of reach across the system and we are committed to bringing increasingly integrated marketplace solutions across traditional lines. This is central to our competitive advantage. And with that I'll turn the call over to Mike.

Thanks George and good morning everyone. Before we get into the earnings discussion, I just want to say that it has been an exciting few months for me since becoming CFO. I've enjoyed not only leading the Cardinal Health finance team but also meeting with many of you, our investors and analysts. For those of you I have not met, I look forward to speaking with you soon. Now on to the quarter. As George mentioned, we are happy to report strong financial performance this quarter, and to be raising our non-GAAP EPS guidance. I will first walk through the drivers for the quarter's financial performance and then provide some insight into our expectations for the remainder of the fiscal year. You can refer to the slide presentation posted on our website as a guide to this discussion. I will start by talking about consolidated results and then go into more detail in my segment discussions. Non-GAAP EPS for the quarter was $1.20, an increase of 33% versus the prior year. As a reminder, the prior year quarter includes a $0.16 charge related to a tax item. Eliminating this item, non-GAAP EPS grew 13% year-over-year. Again, this quarter revenues exceeded our expectations, up 15% to $25.5 billion. Total company gross margin dollars were up 8% for the quarter but the rate was compressed a bit largely because of Hepatitis C therapies launched within the last year and some shifts in the margin rates related to the recent expansion of our customer base. Total SG&A increased 6% versus the prior year, primarily driven by the impact of acquisitions. Consolidated non-GAAP operating earnings were up over 10% to $639 million or a non-GAAP operating margin rate of 2.5%. In the quarter, net interest and other expenses were $7 million higher, due in large part to the timing of various components of the long-term debt refinancing we completed during the quarter. On tax, as we have said in the past, our non-GAAP effective tax rate can fluctuate quarterly due to changes in international and U.S. state effective tax rate resulting from our business mix and discreet items. This is why we only provide annual tax rate guidance. You will notice that for the first half of this fiscal year, our non-GAAP tax rate was 35%. We still expect our full year tax rate to be 36% to 37%, which implies a higher tax rate in the second half of this fiscal year. Our second quarter diluted weighted average shares outstanding were $334 million, 12 million shares favorable to the prior year’s quarter. During Q2, we repurchased $324 million worth of shares leaving about $1 billion of share purchase authorization remaining under our Board approval. To complete my review of the consolidated numbers, let's move to the consolidated cash flows in the balance sheet. We generated a robust $953 million in operating cash flow in the quarter. As a reminder, operating cash flow was light in Q1, which was largely just a function of timing and we expected some shift between quarters. At the end of the second quarter, we had cash on our balance sheet of $2.9 billion, which includes $448 million held internationally. Our balance sheet allows us the flexibility to deploy capital in the most efficient way to return value to shareholders and to drive sustainable growth. Speaking of capital deployment, as Pharmaceutical segment CEO, I was part of our capital committee and actively involved in all major deployment decisions. You should expect that our strategies around capital deployment will remain intact. Now let me take a moment to reiterate these priorities. First, we are committed to investing in activities that reinforce the sustained strength of our core businesses. Next, we remain committed to our differentiated dividend that we expect to grow at least in line with our long-term non-GAAP earnings growth rate. Third, we will not be hesitant to deploy capital for acquisitions which further strengthen our businesses and best position us for leadership in this evolving environment. We’ve thought pretty consistently about our strategic priorities and these will of course be the areas where we will devote the most attention as we consider inorganic moves. And as we’ve done in the past, we will continue to consider share repurchases. This fiscal year, we have repurchased $684 million worth of shares. Now let's move to segment performance, starting with pharma. Pharmaceutical segment revenue increased 16% to $22.6 billion, driven by growth in our base of existing customers, as well as the impact of new customers. Pharma segment profit increased 12% to $542 million, due to strong performance under generic programs, which includes the net benefit of Red Oak Sourcing. Also our profit was positively impacted by continued growth from existing customers, as well as growth from new customers. The Pharmaceutical segment profit margin rate decreased 9 basis points, impacted by customer pricing changes, newly launched hepatitis C pharmaceutical products, and the impact of new customers. These were partially offset by strong performance from generic programs, which again includes the net benefit of Red Oak Sourcing. The branded hepatitis C therapies launched within the last year have been a topic of great interest in healthcare. Just to be clear, for Cardinal Health, these sales contribute to top-line growth but the overall impact is dilutive to margin rates. Additionally as a reminder, these products are recorded within the pharmaceutical distribution results, not our Specialty sales. With respect to our generic programs, we saw strong unit growth this quarter. Also, as projected, Red Oak Sourcing was accretive in the quarter, net of the $25.6 million payment we made to CVS Health. As a Board member of Red Oak, I continue to be impressed with the efficiency and speed at which the Red Oak team has executed. They have now transitioned suppliers representing greater than 95% of the total generic spend. For the quarter, as it relates to the impact of generic manufacturer price increases, we did see a slight year-over-year decrease in contribution. Now let's go to the Medical segment performance. Revenue for the Medical segment increased 4% to $2.9 billion, driven by acquisitions and growth from existing customers. Medical segment profit decreased 12% to $115 million, with the largest negative driver being a year-over-year increase in enterprise-wide incentive compensation, as well as the continued impact of market pressures in Canada and the related repositioning of that business. These factors also drove the Medical segment profit margin rate this quarter, which decreased by 73 basis points. Since the performance of our Canadian unit has been a challenge over the last nine months, let me take a moment to discuss it. I recently met with the Canadian team and left impressed with the new team members, the optimism of the entire team, their pipeline, and their strategic plan, which includes accelerated movement of Cardinal Health branded products. We should see some recovery in that business starting later this calendar year. While there have been challenges in certain discrete areas, the medical segment continues to execute against the strategic priorities. For example, within our strategic hospital accounts, we continued to achieve organic growth of more than 5% versus the prior year quarter. This remains a key area of focus, as we demonstrate to the large integrated health systems that we create enterprise solutions to address the challenges they face. Now I'd like to give you my observations on our Medical segment, not only from my new CFO seat, but also from my experience as CEO of the Pharmaceutical segment and President of the Medical business some seven years ago. As George mentioned, medical has been going through a critical transition. I'm particularly aware of this as I compare our profit drivers today to what they were seven years ago. Over this time, the profit pools have shifted and under Don's leadership, the team has adapted and made tough decisions to invest in certain key priorities while reducing emphasis and investment in others. Our medical team has built new capabilities and made the moves necessary to reposition the segment to create more value for customers and partners and to participate in new profit pools going forward. Before we move on, I'd like to briefly touch on what we are seeing around commodities as this has been top of mind for many of you. For FY15, as we previously said, due to the time lag within our supply chain, we only expect to see very slight benefit and that is included in our updated guidance range. Now while it is very early, I just want to give you my preliminary observations regarding FY16. We're continually updating our commodities forecast, including analyzing them based on forward curves. Our most recent analysis indicates there will be a modest benefit of $10 million to $20 million in fiscal '16. For those of you who remember commodities being a large headwind some years ago, this may seem low. While there are several factors causing this, let me touch on two of them. First, over the past few years, the prices of inputs to our Cardinal Health brand products no longer move in tandem with crude oil prices. Second, since we experienced significant commodity exposures in the past, we have worked to temper these through strategic and operational measures we have taken with our suppliers. Any updated estimates would be included in the FY16 guidance that we typically provide on our Q4 call. Now turning to Slide No. 6, you will see our reconciliation of consolidated GAAP results to non-GAAP for the quarter. The $0.34 variance to non-GAAP results was primarily driven by litigation expenses, amortization and other acquisition-related costs and loss on extinguishment of debt. You will see on the schedule that the net of tax impact of the debt redemption resulted in a $37 million GAAP expense. Let me begin to wrap up with a brief discussion on the remainder of FY15. Based on our strong first half performance, and helped a bit by the lower tax rate in Q2, we are increasing and tightening our overall FY15 non-GAAP EPS guidance range to $4.28 to $4.38 from the prior range of $4.10 to $4.30. A few comments about the new guidance range, what we've realized today and what we are assuming. Based on the overall revenue growth fiscal year to date, we are updating our total company revenue guidance from modestly compared to FY14 to now expecting the full year revenue growth to be in the high single digits. As for each segment, we continue to expect our Medical segment revenue growth to be as originally provided, low to mid single-digit growth versus FY14. And following two quarters of strong growth, we now expect the full year Pharma segment revenue growth to be in the high single to low double-digit range compared to the prior year. With respect to Red Oak, as George mentioned, the transition of the manufacturers to the Red Oak program has been a little faster than our previously discussed expectation. It is too early to comment on the timing, sequencing or impact around the possible Nexium launch, and so we have not included this in our updated guidance. There are multiple variables that are still up in the air including legal maneuvers, the timing of launches, capacity and the number of other companies who could potentially launch. When the facts become clearer we will evaluate its impact on our new guidance. Also, it is worth mentioning that our assumptions around branded and generic inflation have not changed. We still expect branded inflation to be about the same as fiscal ’14 in the low double-digits and across our generic portfolio, while we still expect slight inflation, we have modeled the overall benefits to moderate in our second half versus what we experienced in the first half. Our guidance range also assumes that our headwinds we’ve experienced in Canada year-to-date will carry through the remainder of the fiscal year. Looking at our corporate assumptions, our full year non-GAAP tax rate guidance of 36% to 37% remains unchanged, which as I mentioned previously implies a higher tax rate during the second half of this fiscal year. We are slightly reducing our interest at other range to $135 million to $145 million. We are also lowering our diluted weighted average shares outstanding range to 336 million to 337 million shares. We are modifying our capital expenditure guidance to $340 million to $350 million, and finally our amortization slightly increased, based on the few previously mentioned small acquisitions we’ve completed in the first half of the fiscal year. In summary, we are really pleased with the progress we have made in the first half of fiscal ’15 and expect similar execution in the back half of the year. So with one quarter under my belt as the new CFO, I look forward to sharing our progress with you in the coming weeks and months. Operator, let's begin our Q&A.

I seem to have a couple of questions on Medical, trying to calibrate things here. I know you guys had mentioned incentive compensation as a headwind in the quarter. Could you maybe just give us a sense of what the margin in Medical would have been if you adjust for incentive comp year-over-year?

This is Mike and thanks for the question. Really can’t go into details of what it would be adjusted, but I will give you a little color in that the majority of the compensation that you saw pushed out into the Medical segment was in the area of 401(k) and that's because that’s based on employees and as you know, a significant portion of our employees are in the Medical segment.

That's helpful. A key question I have is regarding our current position in Medical margins and our long-term goal of 5.75%. Can you help us understand the path to reach that target? Additionally, Mike, about commodities, I recall you mentioning a tailwind of $10 million to $20 million for next year. Looking at your 10-K filing, it appears that a 10% move in the example you provided would have led to approximately a $30 million impact. Can you clarify if there have been any changes in hedging between June and now?

Thank you for your questions. I will discuss commodities first and then provide additional information on medical margins, or George can address that. Regarding commodities, it's important to remember a couple of things. Firstly, as I've mentioned, the components that comprise our commodities do not align closely with crude oil prices as they used to in the past. Previously, changes in crude oil prices would generally drive changes in commodity prices, but that correlation has weakened significantly. This shift is a major factor as we analyze both current and future commodity rates. Additionally, following the major issues we faced in the past, we revisited our contracts with manufacturers. We aimed to renegotiate these agreements to better stabilize our costs and avoid similar fluctuations in the future. This approach likely affects your estimates.

Bob, let me touch on the factors influencing our goal of increasing margins in Medical. Key areas driving growth will be the services related to our distribution platform. Our supply chain activities have expanded into a broader range of services, which typically carry higher margins. We're seeing growth in our consumables, especially private label products and physician preference items, including wound management, interventional cardiology, and trauma, all of which have higher margins. Growth in the Home sector is also significant for us, where we’ve observed excellent expansion of margins. The overall positioning of these activities really affects our product mix. For instance, private label products are now being integrated into our home strategy, which contributes positively to margins. Finally, our positioning with key accounts in the system is crucial; a large part of this involves the mix of product lines and to some extent, the mix of customers.

Could you provide some insight on how the Medical segment is performing over the last couple of quarters if we exclude the Canadian business? Specifically, what have you seen in terms of margin improvement as you've been promoting preferred products and physician preference items?

Yes, I can appreciate the question but I really don't want to go into that level of detail on it. Again there are a couple of discrete items that we mentioned. It's really the Canadian business that is a big factor and a pushdown of compensation are really driving the Medical segment year-over-year negative performance.

Then maybe on the Canadian side, you talked about meeting with the team and you said you like the strategy they're kind of playing out to you. Can you maybe give us a little bit more details on how you guys are planning to tackle some of the issues here? I know you talked about more Cardinal branded products. But what is specifically there that we can hope to kind of get around some of the issues?

I appreciate your question. I recently had the opportunity to visit the team and have been involved with them over the years. They are focused on shifting our Cardinal branded products, which is significant. It's also important to note that we are the only distributor in the med/surge area with coverage across all of Canada. The team has done well in leveraging our supply chain to collaborate with manufacturers and create more opportunities. Additionally, they are actively assessing their cost structure and making strategic changes within their management team. I'm particularly impressed with the fresh perspectives brought in by new talent, including our new CFO who has experience from one of our customers and will contribute innovative ideas.

This is George. I want to add to the conversation you started. We won't be breaking out the details of our medical business, but I can share this. When evaluating our strategic priorities and metrics for the medical sector, we see promising signs, and it's performing as per our internal forecast. Our growth in strategic accounts and consumables is strong. The physician preference item strategy is a mid-term growth driver, and we appreciate the positive underlying trends we've observed. Over the years, the traditional med/surge distribution has faced pricing pressure, which we anticipated. However, we are pleased with the growth in the home sector. Overall, we are satisfied with the components of this segment and how they are developing. We will need to adapt to the changes we encountered in the Canadian market, and we also expect to navigate through the market changes we've addressed.

George, I just want to follow up on some of the commentary around generic price inflation. I think you seemed to suggest that maybe you saw slightly better inflation on generics sort of year-over-year. But I think you're moderating your assumptions in the second half of the fiscal year versus the first half. Are you kind of implying that maybe some of that was pulled forward? Could you maybe just flesh out a little bit more what you're seeing in the marketplace and how we should think about the trends?

Glenn, let me start and then I'll be happy to have Mike chime in and he's obviously been very close to it from his prior role. When we talk about moderating for the back half of the year, it's largely just a model at this point. We don't have perfect transparency on pricing. We have historical models. We do the best we can to use those to guide us going forward. We have in the interactions with the suppliers. But there is not something absolutely discrete perfect trend line that tells us what to do. We just thought the numbers in the first half were reasonably strong. And so what we did was we just moderated that somewhat in the second half, and that's the way we've approached it. But it's difficult to come to a perfect number on this.

Yes, I can just add a little bit of color. So as I did mention, for the quarter as it relates to generic inflation, this quarter was slightly less than last year's quarter, as there was a year-over-year decrease in the contribution. As far as Q1 versus Q2, Q1 was a little stronger than Q2 in terms of rate. And you were right, you did hear me right. We do expect the second half of the year total generic inflation contribution to our bottom line will be moderated compared to the first half of the fiscal year.

Maybe if I could just follow up on capital deployment. George, you said all along that your preference is clearly to do strategic M&A versus share repurchase, but here we are halfway through the fiscal year and you’ve kind of already blown through your share repurchase target. Should we sort of read into that, that maybe you don’t see anything on the strategic M&A front that interests you, or maybe if you can just give us an update there on how we should think about capital deployment through the balance of the fiscal year, given where the leverage sits on the balance sheet?

Thanks, Glen. No, I don’t think you should read anything into it actually. We are always looking at the most efficient way to create a great position for strategic growth. And there are moments where those opportunities are right in front of you and there are moments where they are not, but I don’t think you should read into it. We’ve done a couple of small moves in the physician preference item area over the last few months. And we’re always actively looking. It's just a matter of finding that opportunity you think drives the value you want and you have to have someone there decide really to do it at that moment. But I don’t think you should read anything into it.

We will continue to be opportunistic with share repurchases when it makes sense, but it’s important to note that we are being disciplined. We will ensure that we pursue opportunities that align with our strategic priorities and are offered at the right price.

Maybe, Mike, quickly on generic inflation, when you talk about the decreasing impact year-over-year, should we think about the decreasing impact as lower sell side margin contribution on higher generic drug prices or should we think about kind of lower carry on inventory that inflates? What's the right way to think about the contribution there?

I can't provide too much detail on that. However, I can offer some insight. There are various ways to generate revenue from generics, primarily through the difference between the selling price and the purchase price, which remains a key focus for us. Additionally, there is value gained from inventory appreciation when prices increase. Several factors, including pricing strategies and customer penetration, impact our programs and help enhance margins. Explaining how a specific margin category operates would be challenging, and our contracts with manufacturers are highly confidential and competitive.

I want to ensure I understood the question correctly, but I don’t believe there is anything specific we are emphasizing here. It's simply the general pricing environment. Therefore, if that's the question, it doesn't point to a unique mechanical dynamic. I think Mike is just outlining the overall pricing trend.

That’s helpful. Can you provide more insight into what might be driving the significant increase in 401(k) contributions in the Medical segment compared to other segments of the business?

So the best way to think about it is as we look at compensation. We look at it all of Cardinal. And so when there is overall performance from the business, then one of the biggest pieces that gets funded first is our 401(k) program. And we don’t distinguish between our employees on whether they're in the Medical or the Pharmaceutical segment when overall Cardinal Health is performing. And so since we had a strong first half, it caused us per our internal guidelines to increase our accruals on our 401(k) and knowing that a significant portion of our employees are in the Medical segment, then those costs just get allocated to the Medical segment for the employees and their 401(k) contribution.

Hey, can you provide more details about the operating margin in the Pharma division? You mentioned a few factors such as pricing, new customers, and Hep C. I noticed that the margin declined by about 8 basis points year-over-year. Can you share more information on the significance of each of those factors and which ones had the greatest impact?

I provided some detail previously, but those were the two main factors contributing to over 9 basis points of decline in the margin rate. The primary reasons were the addition of some new customers, including a large mail order customer that typically operates at lower margin rates. Additionally, as many in the industry have noted, hepatitis C drugs have been performing exceptionally well. This class of drugs is very significant, and we have also experienced substantial sales in this area. However, since these drugs come in at much lower margin rates than our average, they are reducing our overall margin rate.

So you obviously saw a good growth year-over-year in terms of dollars, I think up 12% year-over-year. So the mail order customer, such as a new customer that came in at lower margins as a percentage of revenue? Is that correct? It wasn’t a shift just to mail? And then obviously the Hep C is new revenue at a lower margin rate, right? Is that correct?

That's correct. It's a new customer that is primarily focused on brand business, which typically has a lower margin rate.

This is Elizabeth Anderson in for Ross. I had a question about the Hep C product as a percentage of your total sales. Could you provide a little more detail on that?

Sure, our Hep C drugs as a percentage of our total Pharma segment revenues is less than 25%.

Okay. And in addition, I was just wondering if you could give some additional color on the early wins and challenges from Red Oak? I know you said that you have sort of 90% of first 5% of contracts. But I was just wondering if there are any more specifics you could give us on that?

Sure, let me clarify that. The Hep C drugs accounted for less than 25% of our overall growth for the quarter, not less than 25% of our drug spend volume. As for Red Oak, I continue to be impressed with the team. The leadership has done an excellent job of integrating the employee bases. It's hard to distinguish between CVS and Cardinal employees, which has been highlighted by several members of our executive management lately. From a cultural perspective, this is significant. Additionally, we've successfully transitioned all the key individuals we wanted from CVS and Cardinal, which allowed us to hit the ground running. We had experienced experts in the generic business move directly to Red Oak without any need for training, which has been a positive development. Overall, the culture is thriving, our discussions with manufacturers are going well, and over 95% of them have transitioned over. I'll let George add a few comments.

Just one additional thing, because you asked about challenges. We were very focused on simplicity, speed, and clarity for the manufacturers. So one of the biggest challenges, it's an incredibly complicated system, but if you look at all of generics and trying to do all the trade terms and conditions with every manufacturer. So as Mike said getting through this many, given the complexity and then trying to come out with a program that was really straightforward and simple, was a great challenge and I think the team did an amazing job of doing that.

I have a couple of follow-up questions. First, regarding the top line growth. Mike, you mentioned that Hep C contributed less than a quarter to growth, which is about a 3% contribution. When we look at the new customers in Hep C, how much of that growth do you attribute to Cardinal specifically versus the overall market growth?

I can't provide specific details, but generally, we've observed that the IMS data shows strong growth compared to past figures, typically ranging from 1% to 4%. Over the last few months, this growth has been notable, contributing to our overall revenue increase. However, distinguishing between industry growth, new customer acquisition, existing customer retention, and factors like brands transitioning to generics is quite challenging. Additionally, there are numerous other influencing factors in the market.

Ricky I want to make sure I understand your question, but again in general terms, our prescription growth was very good. As Mike said, our unit growth in generics was very good, our positioning in the market was very good. And again the IMS data, last time it was 3 point something. So there is clearly some demand growth which is good in the system. Our position in the market is good. And so that is a good combination. So I'm not sure if you're asking about Hep C and whether we're disproportionately, and I was trying to make sure I understood that question. But I say again, for us think about it just, we've got a base of customers. Those Hep C products flow through different channels and we're present in all those channels.

I'm actually trying to understand what growth is, when you normalize for Hep C, right, assuming that over time will actually settle down?

I don't think we'd probably take any piece of business out of our business and say that's normal. I think this is now part of the base of the business. Yes, I just want to give a little bit more color based on what George said. So what we did is look across our overall growth of our existing customer base and our new customers. We think we can actually get reasonable share growth on our existing but it is really a balancing act of all of them tied together. So again while Red Oak is already reflected into that growth, I think there is a good bit underneath that growth, it's really steady through all of that. I don't mind adding a little point. As we've said before, we have seen a pretty sequential increase on the generic side, too, but we did see some very good performance from a solid base of generic January growth this quarter, so it's been good for the business.

The key point is we've committed our team on Red Oak and the other directories of our business to really enhance our generics program where we can bring more value to the table on those sides and help fill in our differentiated models at a specific point.

George, just following up on thinking about Red Oak and your opportunities with share existing customers, can you maybe talk about the Greenfield opportunity for customers that source generic products from Cardinal?

Yes, good morning Lisa. We believe we have a unique model and an exciting partnership that we are optimistic about. As we examine the overall market for generic buyers, we are noticing some shifts as companies reconsider the best ways to source their products. Some companies that have traditionally sourced directly are now evaluating whether that is the most efficient option for them. In some cases, we have demonstrated that we, as Cardinal Health, are a very appealing alternative. Although it's difficult to quantify that opportunity, it is evident that some existing players are still trying to assess the most effective ways to source products. We believe we can be an attractive supplier for them, and we have seen an increase in business in this area, which are positive indicators.

Is there a figure you can provide regarding the percentage of your existing customers that source and purchase generics through you? Is it more than 50% or even 90%? I'm trying to gauge the potential opportunity within your current customer base.

Yes, we can provide that exact percentage. Every customer purchases at least some generics from us, but the percentage of their generic spending with us varies. Sometimes we are in a backup position, and at other times they buy everything from us. We still have opportunities for growth in this area, and we have historically done well in penetrating various segments such as change, independence, and our hospital market with solid oral products.

Maybe I’ll start by following up. You just mentioned you’ve been able to penetrate even independents in hospitals. I'm curious, you’ve brought on a mail customer recently that you spoke of, that is probably quite a bit smaller than your sourcing program when it comes to purchasing. So is there a value proposition even where you wouldn’t be taking over the fulfillment of the products?

Yes, absolutely. We think we offer really great solutions Eric, not only in terms of the potential to save money in terms of cost, but also in the terms of our quality of the products, the supply, the way we work with the customer. And so, we’ve a lot of components of our program that we’re going to work with each customer. Now that being said, I can’t speak for any individual customer and they may have various reasons why they may choose or not choose sourcing from us, but we think we have as competitive or more competitive a program than anybody else. I'm out there and then we do see opportunities going forward or working with our various customers who are not buying 100% of the generics from us. Yes, it's been a couple of things. Generally, overall I would just say it's really market pressures, and those market pressures, a lot related to reimbursement in the environment have driven a lot of behaviors as you could imagine, less purchases of capital equipment, utilization, all those types of things, pricing pressures are on there. So it's really reimbursement pressures in the market have put a lot of pressure on that business, and it has forced them to relook at their model and work with their customers in different ways.

George could you give us an update on how the China business is doing and what aspects of that business are gaining the most traction?

Yes, it's going well. We saw significant double-digit growth again in China, with all components of the business expanding. Our distribution platform is continuously growing. We've been providing additional services to our customers and enhancing our marketing presence, which presents exciting opportunities. Our geographic reach is broadening, and we now have about 30 direct-to-patient pharmacies. The product lines we offer at those pharmacies have also increased. It's common for us to carry a double-digit number of products, which is great as it expands our connections with patients and strengthens our relationships with biopharmaceutical partners. We're optimistic about the ongoing growth in China and view it as a very promising market.

And then maybe a quick follow-up. Can you remind us how the Henry Schein alliance will flow through the P&L? Did that have an impact on the quarter to support it or will it mostly...

So essentially what's going to happen is the sales that used to be reported through a part of our Medical business which was in ambulatory, those sales will ship to Schein? We will see our value coming through the gross margin line and our products flowing through their channel. So that's the basic mechanics. And you would not have seen any value in the quarter completed.

And obviously our sales reps obviously moved over to Henry Schein. So revenue expenses moved over to Henry Schein and obviously the margin will generate that but that's going to be more than offset. As we said this will be accretive. So, it's by the margin that we will make on our sale of products to Henry Schein.

Could you elaborate on the factors driving the current pricing activity in the generic market? Is it due to pushback from insurers or retailers in the supply chain trying to balance supply and demand, or are there other influences affecting pricing moderation in generics?

Yes, it's not a single factor, and it's challenging to identify a specific trend. We've discussed the conditions that may have contributed to the rise in prices. Overall, we're not observing significant changes systemically; instead, it's about individual behaviors and specific products. When we refer to price movements, the most considerable fluctuations over the past few years have been on hundreds, not thousands, of products. It's very specific to each supplier and their product line, so I wouldn't say that the market conditions as a whole have changed significantly. Based on some data we've gathered and observed in the first half, we chose to moderate our model for the second half. However, it remains extremely difficult to project this because it is largely dependent on individual companies and their unique product lines.

As a follow-up, going to the capital deployment side of things, you guys have quite a few different strategic development efforts going on across both product lines and geographies. Is it possible to try and tease out from you a little bit more about where you see more specifically in the different areas that you're looking at better options than others relative to putting capital to work on the acquisition front?

It's a good question. I wish I could provide a complete answer about what we consider. Let me highlight the key areas. We definitely prioritize building scale in our pharmaceutical business, particularly around generics, as these opportunities are infrequent. Specialty remains a focus area as we expect continued growth in specialty biopharmaceuticals and products for unique patient populations. We're actively exploring this sector. Our integrated delivery network hospital services are crucial, especially as many hospitals are adapting to changes in reimbursement, including bundled payment models. Areas that were once revenue drivers may become more stable, offering opportunities for us to provide those services. Growing our consumables and physician preference items is also a clear priority. We are focusing on our home activities and initiatives in China as well, which we consider high priority. You are aware of the system there, where some areas have numerous activities and players, while others are more consolidated. Overall, these are the priority areas we're continually evaluating, and opportunities will arise when they do.

So for the medical segment, I guess as we move further into calendar '15. Are there any signs at all or any buzz still within the industry about accelerated patient volume growth for your hospital customer base related specifically to health reforms. There still seems to be some mixed views on this within the investment community for the hospital sector in particular.

I think mixed use is probably the right term. There are clear signs, and CMS is currently reporting that enrollment is close to 10 million through the ACA. It's challenging to determine the exact contribution in a hospital setting. As we examine our pharmaceutical business and prescription centers, there are indications, although more intuitive than factual, that there are more patients in the system. It seems reasonable to assume that having more patients covered impacts the hospital side, but isolating this effect is difficult, especially with changes in channel behavior. For instance, moving from an acute care setting to an ambulatory setting can alter volume. Consequently, understanding the total volume impact of the Affordable Care Act on acute care centers is complex due to a natural shift in how care is delivered. We're also observing some shifts in market share among different players, influenced by network design issues within the system. Therefore, it's challenging to provide a clear picture for you.

And you actually hear your customers talking about there or is it just sort of a quiet on that front right now?

No, you actually hear views from different customers. So there are some that are stating that they're seeing increases and some that are not experiencing quite as much. So as you describe mixed signals, it's probably a little bit of an accurate description.

I'm trying to understand how conservative your guidance is excluding Nexium. Considering the strong Pharma sales, there may be a slightly lower margin from Hep C. The Red Oak contribution is progressing ahead of schedule, and there is a slight tailwind from commodities. However, guidance likely needs to be raised by an amount equivalent to the litigation beat. Is the offset due to incentive compensation in Canada that might not have been fully factored in earlier? Is that the correct way to approach it, or should I consider anything else?

One important factor to keep in mind is that the tax rate is a significant influence. I'm uncertain how the litigation aspect would impact things. This refers to GAAP figures, not our non-GAAP numbers. So, I'm not entirely clear on its effect, but the tax rate is worth considering. Last year, we also had notable minority investment income in Q3, which we have mentioned previously. We do not anticipate that repeating in the latter half of this year, as it was a substantial figure. We expected the pressures from Canada to persist for the rest of the year, and while we indicated that Red Oak commenced a bit earlier, it doesn’t necessarily imply it will escalate significantly in Q3 and Q4. It simply started somewhat sooner.

Again, I'm going to just jump in here for second. Again I wouldn’t comment on how conservative or not conservative our guidance is. I'd say that we’re performing very well right now in general, and so we feel very good about the first half and actually pretty excited about the second half of the year. So our guidance was increased. We feel good about that and again, we'll leave it to others to judge whether or not it was conservative or aggressive. But we like our positioning and we’re pushing ahead.

Can you hear me? A quick one here off topic related to foreign currency. I didn’t hear a lot about that today. I'm curious about the impact overall of course specifically in Canada, with the Canadian dollar we gained about 17% in the last six months. Two is on the impact to the medical surgical segment and if you can talk through some of the dynamics on revenue and profit dollars related to that? Thanks.

I can provide some information on that. We experienced a smaller benefit from foreign exchange in the second quarter compared to the first quarter, but it was minor. For the rest of the fiscal year, we expect a slight positive impact from foreign exchange, which is already reflected in our guidance. It's important to note that since we operate in some countries while purchasing in others, the effects can vary; one may have a positive impact while another could have a negative one. Overall, the net effect is quite small at this time.

Eric or the operator, do you have a follow-up?

With that, thank you all for you questions and I very much appreciate all of you joining us on today’s call. We look forward to speaking with all of you later. Thanks.