Cardinal Health Inc (CAH) — Q3 2015 Earnings Call Transcript

Thank you, Jennifer, and welcome to our Third 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, found on the Investor page of our website, for a description of risks and uncertainties. In addition, we will reference non-GAAP financial measures. Information about these measures and reconciliations to GAAP are 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 presentations at the Bank of America Merrill Lynch 2015 Health Care Conference on May 13 at 8:00 a.m. local time in Las Vegas and at the Goldman Sachs 36th Annual Global Healthcare Conference on June 10 at 10:00 a.m. local time in Rancho Palos Verdes, California. 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 the site often for updated information. 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.

Thanks, Sally. Good morning, everyone, and thanks to all of you for joining us on our third quarter call. I'm pleased to report another strong period of results, with third quarter revenues of $25.4 billion, an increase of 18%. Third quarter non-GAAP diluted EPS was $1.19, up 18% from last year. Based on the strength of our performance year-to-date, we are increasingly confident that we will finish our fiscal 2015 in the upper half of our full year non-GAAP EPS guidance range of $4.28 to $4.38. This is an extraordinary time in health care, and our organization is doing an outstanding job of serving today's needs, while at the same time, leveraging our experience to address the demands of a system in transition. Our people have done this through a disciplined focus on execution by using our capabilities and insights to anticipate change and commit to providing solutions for emerging health care challenges. With this as a backdrop, since we last reported earnings, we've made some important moves in areas of strategic focus. On March 2, we announced our plan to acquire the Cordis cardiology business from Johnson & Johnson. And earlier this month, we completed the acquisition of the specialty distribution business of Metro Medical, expanding our presence and reach in the specialty business. I'll come back to each of these important initiatives in my segment remarks. First, our Pharmaceutical segment. Our Pharmaceutical segment had a very strong third quarter with revenues of $22.6 billion, an increase of 20% compared to the prior year third quarter. Our Pharmaceutical segment profit was up 25%. The Pharmaceutical segment continues to operate with great efficiency, attention to detail, and a strong strategic position. Red Oak Sourcing, our joint venture with CVS Health, continues to operate extremely well. We can now report that suppliers representing nearly 100% of the total generic spend have transitioned into the venture. At a time of great change, it is not just scale which brings value to our customers, but also the combined knowledge of our two experienced organizations. Our Specialty Solutions business continues to achieve extremely high growth rates. Earlier this month, we closed the acquisition of the specialty distribution business of Metro Medical, the largest privately owned specialty distributor in the U.S. This move strengthened our presence in the therapeutic areas of rheumatology, nephrology, and oncology, expands our scale, and positions us to provide more cost-effective services for our customers. For clarity, we expect to exceed the $5 billion specialty revenue figure for fiscal 2015, which we highlighted in our last earnings call, even without the contribution of the Metro Medical specialty business. As you know, over the last few months, we've seen some important developments in the world of biosimilars, and we've said to you before, it's very difficult to make categorical predictions on the evolution of this new subset of products. We continue to believe that each product will have its own characteristics, driven by many factors, including regulatory interchangeability, the disease which the drug addresses, the need for patient support, the location and mode of delivery, and of course, the competitive response. We feel well positioned to participate in each of these opportunities as they emerge, and the acquisition of Metro Medical expands our reach. Turning to our Medical segment. We reported revenues for the quarter of $2.8 billion, an increase of 4% versus the prior year. Our segment profit was down 8% in an operating environment largely similar to that which we've outlined in prior quarters. I'd like to take a few minutes to address this and give some perspective on the Medical segment's performance, positioning, and role in Cardinal Health's growth plans. This is the commentary I would typically provide at year-end. As our Medical numbers in the last few quarters have lagged below our high standards, I wanted to address it directly now. We take great pride in being best-in-class in the distribution of traditional branded medical surgical products. Market forces have put pressure on prices in this legacy line of business. This is not new. Over recent years, we have been purposely building a range of new products and services that are strategically aligned with health care trends, highly valuable to our customers, expand margins, and build on our base in traditional distribution. Why has this been a more difficult year for our Medical segment? Simply put, price erosion in that legacy branded med-surg distribution business, combined with challenges in the Canadian market, have been more pronounced this past year. While we have seen uplift from the newer services and products, the uplift has not been large enough to offset those factors. How have we been responding to this? We are relentlessly driving cost efficiency while continuing to reposition our Medical segment portfolio to ensure we are bringing to market the products and services that meet the future needs of our customers in a rapidly changing environment. And I'd like to highlight a few of these moves. We've expanded our consumable product line to position us to drive more Cardinal Health medical products through more channels. Our move to acquire Cordis significantly enhances our scale, product line, and capabilities in cardiology, building on our acquisition of AccessClosure and aligning with our overall strategy around physician preference items. Together, they complement our moves in orthopedics and wound management to bring standardization and efficiency to medical devices, a major pain point for our IDN customers and a meaningful driver of profit growth in the coming years. More about Cordis in a few minutes. Cardinal Health at Home, formerly AssuraMed, continues to grow significantly in excess of market growth. We have unique capabilities in the fulfillment and complex administration of serving patients in the home. Our colleagues at Cardinal Health at Home interact with these patients every day. They are extremely well-trained and totally committed to supporting the needs of these patients. We completed one small home health tuck-in acquisition during the quarter. We continue to see great potential as more care is delivered in the home. Our strategic partnership with Henry Schein is off to a good start. While still new, we are now able to bring Schein physician practice capability to our IDN customers. We're beginning to ship products to Schein facilities and plans are to have the integration substantially completed during the June quarter. I had the opportunity in recent weeks to address the combined teams at Schein's National Sales Meeting, and it was clear that the group is extremely optimistic about the opportunities in front of them. To be clear, these strategic initiatives are not a departure from our traditional distribution. Rather, they draw upon our expertise, our considerable channel strength, and the Cardinal Health name to bring the additional products and services that our customers and patients need to thrive in this dynamic health care environment. That leads me to going forward in our Medical segment. We don't expect major changes in the environment over the next few quarters, and we could see a bit of choppiness. However, as we look forward into the back half of FY '16, we would expect to see the new and growing business lines in the Medical segment and the increased utilization giving us a more sustainable uplift. Going back to Cordis, which we announced on March 2, we are making excellent progress in our work to move toward closing. Leadership teams and organizational design have been defined in all key markets. Recently, we received early termination of the Hart-Scott-Rodino waiting period, the first of a series of steps to close. Finally, trying to continue this track record of double-digit growth, we continue to see great opportunities in this expansive market. It is very clear that the growth of the health care market in China will continue to outpace general economic growth, driven by demographics, lifestyle changes, and strong government prioritization. Overall, Cardinal Health is performing at a high level, generating strong cash flow and showing consistent growth. The repositioning of our portfolio over the last half-decade has been driven by a clear perspective on how we see health care evolving. Most of our customers across multiple channels are experiencing new dynamics, as both public- and private-sector forces push them to deliver care more cost-effectively, in a more coordinated fashion, into emerging sites of care, in such a way as to bring the patient more squarely into the equation. Our ability to offer a broad and integrated set of solutions across the continuum of care and to continue to innovate around our customer base has enabled new opportunities for growth while helping us absorb the bumps that can occur in a system undergoing rapid change. I think it indicates the overall strength of our portfolio that even through this transition, we expect to deliver non-GAAP operating earnings growth for this full fiscal year in the mid-teens. There's no other health care company that has quite the range of tools we can bring to the market and do so at a time when comprehensive solutions are the need of the day. Put another way, we can address a larger percentage of virtually any customer's overall business than any other company in health care. With that, I'll turn the call over to Mike.

Thanks, George, and thanks to everyone joining us on the call today to hear about our strong third quarter results. My comments will walk through our third quarter consolidated financial performance, as well as expectations for the quarter ahead as we close out our 2015 fiscal year. You can refer to the slide presentation posted on our website as a guide to this discussion. Third quarter non-GAAP earnings per share grew 18% to $1.19. Total company revenues were $25.4 billion, which was also an increase of more than 18%. Total company gross margin dollars were up more than 12% versus the same quarter in the prior year. Consolidated SG&A increased 9% versus the prior year, with the largest driver being acquisitions. Next, non-GAAP operating earnings in the quarter were $656.7 million, which is a 17% growth versus the prior year. Moving below the operating line, net interest and other expenses came in at $32.7 million in the quarter. As a reminder, Q3 of the prior fiscal year included a $0.06 per share after-tax gain related to the sale of our minority equity interest in two investments. Our non-GAAP effective tax rate in the quarter was 36.5%, and our diluted weighted average shares outstanding were about 334 million. Moving to operating cash flows, we generated $658 million in the quarter. At March close, our cash balance was $3.2 billion, with $447 million of this held offshore. We remain committed to our previously stated balanced capital deployment policy of focusing on reinvesting in our business and maintaining our differentiated dividend while pursuing strategic M&A and stock buybacks on an opportunistic basis. Next, I'll review each segment's performance. Let's start with the Pharmaceutical segment. Revenues were up 20% year-over-year to $22.6 billion due to the growth of existing and new customers across all business lines in the segment. Segment profit was $567 million, an increase of 25% versus the prior year. This was due to the strong performance of our generics program, including the net benefit of Red Oak Sourcing, as well as growth from our existing customers and contributions from new customers. Segment profit margin rate increased by 10 basis points, driven by the performance of our generics program, which offset the impact of customer price changes and the dilutive impact of sales of branded hepatitis C therapies. Clearly, the performance of our generics program has been excellent. Enhanced sourcing under Red Oak customer wins and growth of existing accounts have all been key drivers. Manufacturer price inflation or deflation, new item launches, penetration of existing accounts, and advanced pricing analytics are also factors in determining our program's success. I remain confident we can balance all of these for continued growth in our generics program. Besides the contribution from generics, our branded drug business continues to go well with strong performance under our fee-for-service agreements. As has been typical over the past several years, inflation tends to be a larger component in the third quarter versus other quarters. The rate of inflation was essentially the same as the prior year, in the low double digits. As George mentioned, in our Specialty business, we closed the acquisition of Metro Medical earlier this month. Let me give you a few details. Metro Medical has various business lines. We acquired their specialty distribution, specialty GPO, specialty pharmacy, and private label medical surgical disposable products business. The Metro Medical Online and Metro Medical Partners pieces of the business were not included in the acquisition. This acquisition will provide us the opportunity to expand our Specialty distribution scale and deepen our reach into the rheumatology, nephrology, and oncology markets. We have been working on this deal for several months and had already contemplated the bottom line impact in our FY '15 EPS guidance range. Now let's move to our Medical segment performance. Third quarter revenue grew 4% to $2.8 billion, primarily due to the contribution from acquisitions. The segment profit declined by $9.1 million to $101.5 million. This was a result of the decline in the contribution of national brand med-surg distribution and the continued impact of the previously communicated challenges in the business in Canada. These same drivers contributed to a margin rate decline of 50 basis points versus the prior year period. Let me give you a few other highlights to consider. First, revenues from our strategic accounts continue to significantly outpace our remaining book of business. Additionally, top line growth from our higher-margin wraparound services is outpacing overall Medical segment revenues. Our Cardinal Health at Home business has grown at or above market each quarter of this fiscal year. Finally, we are continuing to build out the physician preference items strategy. In this space, our acquisitions of AccessClosure and Innovative Therapies are off to a good start and are performing better than the business case. Our recent announcement of our intention to acquire Cordis, which we still expect to close before the end of the calendar year, will only accelerate our work in this space. Let me reiterate some key points surrounding this deal. First, we will be acquiring Cordis for $1.944 billion in cash, or approximately $1.6 billion, net of roughly $350 million in cash tax benefits. Next, we plan to finance the acquisition with debt and cash on hand. Our intent is to issue debt sometime in the next few months and take out the $1 billion bridge financing that we secured as a contingency. From a non-GAAP EPS perspective, we expect slight dilution in FY '16 as a result of the three factors we mentioned at the time of the announcement: first, FY '16 will only include a partial year of Cordis earnings; second, we expect approximately a full year of interest expense estimated at $0.07 to $0.08; and third, there will be $0.13 to $0.15 of unfavorable impact due to an inventory fair value step-up. In fiscal 2017, the first full year post-close, we expect the transaction to be greater than $0.20 accretive and increasingly accretive thereafter. We still expect operational synergies of at least $100 million annually by the time we exit fiscal 2018. Before I move to our outlook for the rest of the fiscal year, I’d like to add a few updates on China, which reports into both segments. Our businesses in China continued to perform well. We continued to see strong double-digit revenue growth for the quarter, up 25%. Also, during the quarter, we closed on an acquisition of a local distributor in northeastern China, which expands our local direct distribution to 11 cities. Turning to Slide #6, you will see our consolidated GAAP results for the quarter. The variance to non-GAAP results was primarily driven by amortization and other acquisition-related costs, which reduced our GAAP results by $0.15 per share. Looking forward, we are increasingly confident in the upper half of our non-GAAP EPS range of $4.28 to $4.38. Let me finish with the following updates around our corporate assumptions. We continue to expect our full year non-GAAP tax rate range to be between 36% to 37%. This obviously implies that our fourth quarter rate will be higher, likely between 38% and 41%, based on the timing and outcome of various discussions we are having with tax authorities. We are expecting capital expenditures to come in at about $330 million and our full year amortization expectations increase to about $190 million based on the acquisitions we have completed as of March 31. We don't expect the Metro Medical acquisition to add a significant amount to our final number for the year. In closing, we're pleased with our overall performance in the third quarter, recognizing that we've got some important work to do in Medical to shift the trajectory. We've taken great steps during the past several years to build a strong foundation for sustainable future growth. That’s why, across the enterprise, I expect a solid finish to our fiscal year. With that, let's begin Q&A. Operator, please take our first question.

Yes. As we think about the performance in Medical, George, it seems like volumes have been improving on the inpatient side. You've added some accretive margin deals. It sounds like private label is still growing, yet the business has struggled. I know you mentioned Canada being an issue for the balance of the year. So I'm just curious if you can maybe give us some insight on when you think this business could really start to turn around.

Bob, thanks for the question. Yes, look, Canada has definitely been a tough challenge all year, and as you said, we tried to be pretty clear about the work that we need to do and are doing in the Med segment. I think we just have to get through some sort of short-term choppiness. I mentioned during the call that the traditional, the legacy lines of branded med-surg have been a large part of the challenge, and it's really been largely re-pricing of some accounts. I think we'll start to see the benefit of all the initiatives that we've described begin to more sustainably feel like uplift as we get into the second half of '16. But I actually like our position. I think we're doing really good work. If you look underneath the numbers, over the last three years, for example, we've had very good growth of our private label products, a good contribution of margin from them. So it's really about this shift in the model where the legacy line is becoming a smaller component of the overall mix, and those newer products and services are beginning to grow. We've done some really important work there. We've made some big moves this year to strengthen that, and we feel good about that.

If I could just sneak one in on Specialty, I know in the quarter you acquired Metro Medical. Just curious maybe if you'd give a little bit more on how that business specifically enhances your Specialty footprint. And then I know broadly, George, you've gotten this question in the past, but increasingly seems like Specialty is obviously an important channel for the wholesalers. And I'm just curious, how do you feel about your footprint even in light of the Metro Medical deal? Are there bigger deals out there that could really give you greater exposure to this important channel?

Yes. Bob, let me answer that, and I just wanted to follow-up a little bit on the first part of the question again. But Metro Medical really just helps us expand our reach. We've been growing at a pretty hefty clip over these last couple of years. I think our scale is now at a point where we really are a meaningful factor in the market. I think that's important, given some of the trends in health care, and Metro Medical just expands that reach in that footprint. So we're excited about it. Whether or not there are other opportunities out there, we continue to look at every opportunity that's in our areas of strategic focus. Obviously, Specialty is one. Whether or not you find the assets at the right moment at the right price is always a question for us. But this is clearly an area of priority, and so we'll continue to look for opportunities. But we're excited about the Metro Medical. Again, just sort of backing up, I wanted to make sure I highlight this on the Medical – just as a reminder. Our customers are really becoming much more complex. They're no longer a single line of activity. I think that's part of what we've felt strongly about is that these complex systems need products and services across all of the lines of business. So that's really important at a time where you're seeing the change in incentives, which has been completely activity based over the year, just a different kind of incentive system. I think the tools we really bring are going to become increasingly important. So I just didn't want to miss the opportunity to say that related to the first part of the question.

A question on M&A. Post Cordis, what is your appetite for M&A? Obviously, you did Metro Medical, which is on the smaller side. But what leverage are you comfortable going up to? And when you think about the areas you're interested, obviously Specialty is one, but maybe if you can kind of rank order them for us?

Yes. We want to grow this business and achieve sustainable competitive positioning. We believe there are key strategic areas aligned with the direction of care, such as generics, specialty, and opportunities to enhance performance management for large integrated customers. We also see potential in the home market and in China, which is a unique opportunity. We will continue to seek these opportunities while maintaining a strong balance sheet. However, we will be very disciplined in our approach regarding the timing and execution of our actions to ensure effective implementation, which has always been a priority for us. We are well positioned with a strong financial foundation. Mike, would you like to add anything?

Yes, Ricky, it will depend on whether the acquisition aligns strategically, fits our culture, and shows potential for growth, among other factors. In terms of our balance sheet, we've indicated a preference to maintain our debt ratio between 1.5 and 1.75. There may be situations where we choose to exceed that range for a suitable acquisition, and we would consider doing so. We will always be mindful of how debt rating agencies perceive us, as this is crucial. The nature of the acquisition can influence their perspective. Additionally, we aim to keep around $1 billion to $1.5 billion in cash available for our operational needs due to business fluctuations. These are important considerations for us.

Okay. And then just one quick follow-up. Obviously, in the prepared remarks, you talked about the strong branded inflation. I think it was in the low double digits. And we're hearing strong inflation on generics. Where do you think we are in the pricing cycle and kind of like the sustainability of the trend, kind of across your portfolio? Because we're seeing it both on brand, generic, and specialty.

Ricky, I'll start with this and then invite Mike to join in. Making predictions going forward is always challenging. The branded side has been fairly consistent for a while, but within that average, there are many different rates, making it harder to predict, yet a bit easier due to this smoothing effect. On generics, it's even more difficult to assess because it's such a vast product line. The number of products that significantly impact results is relatively small, so there could be 50, 75, or 100 products that do so. Consequently, it's quite tough for us to provide forward-looking guidance. Although we've talked about the environment and the conditions within it in the past, I'm not sure those conditions have materially changed from the last period, though we have noticed some variance. Mike can elaborate on that.

Yes, I would agree with George. On the branded space, it's been pretty consistent over the last several years that branded inflation rate has stayed in that double-digits area, and we've not seen a lot of fluctuation there. I just wanted to really call it out, this quarter remind folks of the seasonality component and why the third quarter tends to be bigger than some of the other quarters. Again, we all know the majority of the fees are earned on the fee-for-service agreements, so inflation is a much lower component of our margins than it used to be in the buy-and-hold period. But again, in the third quarter, it's important, so that's why we call it out. On generics, it is important, but one of the things we keep trying to emphasize is that in our mind, it probably gets a little too much attention at times because there are a lot of other levers in our generics program that are going to help us perform over the years. We really believe confidently that even if generic inflation were to decline, there are a lot of other levers for us around our penetration, pricing, and analytics capabilities, around new business that we won, etc., that we can still compete effectively and perform well.

Okay. So med-surg, two questions. One would be your comment in the press release on national brand distribution. Is that meant to reflect your commentary on pricing erosion, or is there anything else meant by that? And then also relative to Canada, have we now reached a point where next quarter will anniversary some of those initial issues and customer departures or movement in-house? Does that help in the second half?

Yes. So really, Eric, what we're talking about primarily is really pricing on the traditional med-surg. It's probably not much more complicated than that. A lot of that is actually repricing some meaningful accounts for us, which we were happy to have in the long run, important customers, strategic customers. I'm sorry, the second part of your question?

Within Canada, it feels like it's been about a year since we first saw some of those issues. I know there were a couple of customers that moved in-house. Will we now anniversary that?

Yes, here's what I would say. I mentioned this earlier. I'd say probably a couple of choppy quarters. We’re taking some significant actions in Canada to address some changes in that market; I think then we'll start to feel a more normalized rate.

Eric, I would expect us to still see some pressures in Canada through the end of the calendar year. So it will still affect us for the first two quarters of FY '16. Beginning in our Q3 of '16, we should see a more normal leveling off in the Canadian business.

Can you guys talk a bit about biosimilars and what's sort of opportunity you're looking at? Maybe just touch on the different channels that biosimilars will flow through. If they ship to the member at home where they self-inject, or if they ship to the doctor’s office, are you better positioned in any one of those channels than the other?

Yes. Again, I'm not sure I can add that much to what I said in my earlier comments, but again, I'll just sort of highlight this. I think many of you have asked this over the years, something we've anticipated in terms of biosimilars that we've always felt there would be some uniqueness to each product. As you said, the route of administration, which channel it goes through, whether there's substitutability, these are all factors that will influence what kind of services the patient needs. We feel well positioned, regardless of route, is what I would tell you. As you know, we've got an extremely strong position in hospitals. We've expanded our position in all kinds of clinics. We're very strong in pharmacy. We have got specialty pharmacy. So clinics are an area. And now, obviously, we've got some enhanced strength in the small physician practices. From our standpoint, we've got great reach across therapeutic areas, which is very important. From a channel perspective, I think we're in a pretty good position, regardless of that route.

The only thing I would add to that, George, is that also from a services standpoint upstream to the manufacturer, we feel that we're in as good or better position than anybody in the industry to provide any type of services that they might need, whether it'd be specific cold chain or other type of transportation needs. Whether it'd be hub services, data and analytics, we know that we can provide all of the services too. We really feel that we're in a great position, both upstream and downstream, on biosimilars.

George and Mike, if you're willing, thinking about some of the puts and takes for next fiscal year, how do you feel about the outlook realizing it's early compared to some of your longer-term growth goals?

It's a bit early for us to share too much about 2016 since we're still finalizing our budget process. We will provide guidance at year-end, but we remain confident in our long-term goals. Currently, the organization seems to have a lot of momentum. If you were to look around Cardinal Health, you'd notice a highly energized team. We have a clear understanding of our objectives and are disciplined in pursuing them. While there may be some challenges in different areas of the business, the overall Cardinal enterprise feels strong and is on track to meet the goals we've established.

No, I would agree. We do need to get through the budgeting process this summer. That's really important. Probably the only thing that we've really mentioned about next year that I can give you a quick update on was around the commodities. We did say that for FY '16, that they would be about $10 million to $20 million of benefit from commodities. We have updated that work, and we can still continue to believe that that's the right number for next year. I know that's only one small component that goes into it, but it is the only thing that we've really giving you any insight on.

I guess and the Cordis mechanics.

And then the Cordis mechanics that I've walked through, yes.

Very helpful. Just one quick follow-up on Red Oak. As you move into year two, it sounds like you've pretty much finished your work with supplier recontracting. What happens next? Is there an opportunity for meaningful growth in year two as well?

Yes, I'm really excited about where we are in Red Oak. I serve on the board of Red Oak and recently had a board meeting and continue to be incredibly impressed with the team. We've again been able to retain all of the key folks from both companies and have decades of generic buying experience on there, which, again, to get through essentially 100% of the spend in this short a period of time has been exciting. We do expect there to be uplift in FY '16. A big piece of that will just be because we'll have a full year of all of the benefits we were ramping this year. But even on top of that, we expect to continue to generate value. As I met with the team, they're constantly looking at different ways to work with the manufacturers to try to create more incremental value for both parties.

And George, I just want to kind of come back and revisit this Medical segment issue a little bit further. You talked, obviously, a lot on the call about the pricing pressure within the segment. Is that repricing certain GPO customers that you got hit with? Is there anything else on the horizon that would impact the pricing as we go forward over the next 12 months? I'm also kind of curious, could you talk about the overall pricing of the underlying inventory you're selling? Are you seeing price deflation on the products you're selling, or is that still somewhat inflationary? Is that impacting the profit margins at all either?

I'm going to come back to the second part. I'm not completely sure I understand the question, but we'll make sure we do and then Mike will address that. This is really not a GPO issue, Glen, and so this is just individual accounts that happen to fall during a period of time where we're signing some long-term agreements. No single one of them, by the way, is big enough to call out or necessarily move the needle. It's just a general dynamic. What I wanted to highlight during the call is that, over many years, the traditional, what we call, branded med-surg business is going through this kind of dynamic, and so that's really not new. I don't want to make it sound like there is one big contract that was the key, which is some repricing in that aspect of the business we felt. I hope that answers that part of it. The second part of the question, Mike, did you get?

Let me take a stab at it, and if I don't get it right, Glen, please just ask again. I agree with George as far as the GPOs. We always work with them, but in tandem, we work individually with the hospitals. If you take a look at the product portfolios, I don't think this is really necessarily a deflationary environment on all the items. You're going to see certain items that may go up and some that are going to go down, but I wouldn't say there's any one trend either way that is actually affecting this. This is just our ultimate net price to the customer themselves, not the items driving it.

Okay. Maybe if I can just ask one follow-up. I mean, could you elaborate a little bit more on what the challenge is in the Canadian market? It kind of sounds like it's going to persist for another 2 to 3 quarters, and I think it would be helpful if you'd kind of just remind us exactly what that issue is.

Really two things. One is similar to what we just described, some repricing of customers. As we mentioned last time, there were a couple of customers that we did lose in Canada that we won't actually anniversary until the end of the calendar year. One of those brought in-house, the services they were doing, and one switched to a competitor. That's really what's driving it is a loss of a couple of larger customers as well as some pricing and retention of some other customers, and those are really two big factors.

The other piece that I'd mention is, there's been some shifting of reimbursement dynamics around that market, and so again, that is a component of that pricing aspect.

Remember, those customer losses are not new. Those are the ones I mentioned last quarter that are out there. It just was going to take to the end of the calendar year for us to anniversary them.

I wanted to just touch base regarding Cordis. So obviously, you haven't closed the deal yet, but you do have very close relationships with some of your physician and hospital partners. You've got some key thought leaders in the field that you interact with on a regular basis. What's the dialogue been post the announcement now that that's seasoned a bit with those individuals? What other sort of things has it sparked in your mind as you think about kind of the long-term strategic value of the endeavor?

Yes. So this has been actually a really interesting period since the announcement. A couple of things happened, many of which we thought could happen, which is just a high amount of energy around this inside our organization. I think the people that are going to be joining us from J&J are pretty excited about where this falls for us in terms of priority. We're getting great feedback from our advisory boards. As I think we've mentioned before, we've got really world-class advisory boards who are working with us. We've started to, as you might imagine hear from other players in the market, who recognize that we might be an interesting partner for them as we expand our commercial capabilities, both here and outside the U.S., in these medical products. I think what we're seeing is a pretty high level of enthusiasm across the board. Obviously, we've got a lot of work to do to get to the finish line and the closing, but it's been really well received. I think that one of the things I would highlight is, people are now beginning to realize that it's not just about the product. We're talking about a different service offering in terms of being able to bring the medical device and some wraparound services that help manage inventory, eliminate waste, and prevent errors. These are all part of the strategy in helping in the physician preference area. What’s happening both internally and externally is our excitement about joining those two components — the service component and the product component — is giving us a pretty good sense of optimism about the future on this.

I'm just wondering, can you give us maybe some color, George, around the size of Metro Medical? Obviously, you talked about it being in 2015 numbers, but maybe on a revenue basis, how big is this?

Lisa, unfortunately, I can't provide that information right now. As we finish this year and start planning for next year, some of that will become clearer. But at this point, I can't share any more details. I'm sorry.

Okay. And then secondly, as we think about Red Oak and we think about relationships with manufacturers, there is a lot of talk about continued consolidation of generic manufacturers. Can you talk at all about your expectation, you or Mike, around Red Oak and how that will impact you going forward?

Yes. Well, let me just start and then Mike can speak more specifically to Red Oak. Lisa, as you know, consolidation is not really new to the industry; it's been happening for quite some time. It's something we're used to. It's a dynamic we understand. It is one of the reasons that having scale is really important, and it's also a reason that the knowledge base of what each supplier's strategy is all about matters. Ultimately, what we're looking for in the best situations are those win-win moments. We understand the landscape well, and we know the players well. Consolidation can be a double-edged sword, but for us, we see the opportunity to work more closely with companies. We see that as an opportunity. Mike, I don't know if you want to sort of add to it more narrowly from the Red Oak perspective.

Probably the only thing I would add is that, first, I guess I would emphasize I really like where our relationships are with the manufacturers. They value us. They understand the simplicity and speed of our model, and particularly, the transparency. The feedback we're getting from manufacturers around those components has been incredibly positive. What that leads to is us being willing to try new things with them. We are also very focused on not only the large manufacturers but also smaller and medium-sized ones that have really mentioned that they appreciate that they've been able to be part of the program. Again, consolidation is part of the industry, but we like where we're at. We think, in certain situations, if we needed to, we can work with folks to try to create the right competitive environment to get the type of pricing we need.

So I guess just within the Medical segment, I'm curious in relation to the Cordis acquisition. Is your plate going to be pretty full over the next year just on the integration of this fairly large asset? Or if, let's say, other medical manufacturing assets are potentially available for acquisition, would you have the bandwidth to do additional medical manufacturing M&A deals in this segment over the next years?

Yes. Thanks, Steve. Obviously, I'm going to answer this with some care. Let me just start with the basics. As I mentioned earlier, our balance sheet is strong. Our organizational capacity is very significant. But we always put a high priority on execution. When we look at acquisitions, we think not just about the financial capacity to execute and integrate but the organizational capacity to do that. So we're very mindful of that. I would also note that we have a very broad-based employee population. We can have a group of folks that are very deeply dedicated to the integration of one asset while literally another group whose lives are untouched by that. What we are mindful of as we look across opportunities externally is to ensure that we’re not doubling down on those people who are trying to execute one deal.

I just had a question about the independent pharmacy channel. Are you seeing any more signs of stress in that channel just given some of the fundamentals around generic inflation and reimbursement squeeze? If so, are you approaching that marketplace differently than, say, you were 3 or 4 years ago?

John, let me start first, and then I'm going to turn it to Mike. Again, we'll probably have two angles on this. We've been doing really well providing value to these independent pharmacy customers. The key is recognizing that there are certain market dynamics and pressures that they deal with, and what we do is focus on how do we relieve those pressures and create value in that environment. We've become increasingly targeted on how we create value for those kinds of customers in this kind of environment. Our organization has done a good job in expanding our position there and growing some share, and I feel good about our position with how we're creating value. There are pressures out there that they have to deal with. I think we're doing a lot to help them.

I can think of a couple of specific examples. First of all, obviously, Red Oak, and our ability to be competitive from a generic program and recognizing the need and how we price generics at different lifecycles of reimbursement is always important. Our PSAO has been growing steadily, and we've added a lot of members. We've been able to do some unique things with them and get out and market our PSAO and work with our customers to help them on their star ratings to make sure they are the type of customers that the PBMs want to do business with, and we are incredibly excited about those. In other areas in the out front part of the store, we've been expanding our programs and opportunities there to work with the folks. We really like where we're headed with some of our Cardinal private label lines and our opportunities to help them manage inventory, both on the out front and behind the counter. So we have a lot that we're doing. I wouldn't say that we're seeing a decline that we've seen in this. We continue to grow our share in that space.

And my other question, just checking in on your other channel. You sell under a lot of IDNs. What are they asking for from you that they were not asking for two years ago? Is there any effect yet that you're seeing from the ACA in terms of what capabilities you need?

Yes. It's a really interesting question because many of the major acute care and integrated systems are recognizing that with potential changes in incentives and a focus on bundled care and payments, where there are penalties for readmission, they are starting to look at each aspect more comprehensively. One notable change is that the institution at the enterprise level of the Integrated Delivery Network is considering how to compete and thrive in this new environment. As a result, our work across the enterprise is particularly resonating right now because we can address a significant portion of their activities. I believe we are one of the few that can offer this level of support.

I just had a couple of questions on the quarter. So first, on the Pharma segment. Could you elaborate a little bit more on the revenue growth of 20%? You called out growth from both new and existing customers, so maybe if you could break those two out or give us an idea. Any other relevant metrics, such as volume growth or other inflation, hep C, and so on and so forth?

Yes. I can give you a little color. First of all, the hep C component of our growth is still less than 25% of the overall growth. It's an important driver, but it is less than 25%. New customers would be the largest component of our growth. Growth from our existing customers would be next. Keep in mind, with branded drug inflation being in the low double digits, that's going to be a huge driver of overall top-line revenue growth, particularly in a market where you haven't seen very large generic launches that would take away some top-line volumes. Those would be the key drivers to help you understand that.

Got it. Useful. And then as a follow-up, on the branded side of the business. Has the non-fee-for-service, so the buy-and-hold portion of the business remained the same as a percent of the entire business? Within it, have the mechanics changed at all in the past few quarters, maybe a couple of years, to alter the profitability profile in any meaningful way?

No, that's been really steady. Over the course of a year, about 80% of our branded buy-side segment remains noncontingent. As I mentioned in the third quarter, there's a slight inclination towards inflation, but over the entire year, it remains at 80%. The agreements are consistent and often renew under similar terms and conditions. We continue to make slight adjustments, but this area has remained stable.

Hey, George or Mike. Maybe this is more a J&J question, but can you give us any color on the Cordis kind of results? Hopefully, post-J&J controlled announcement, the wheels don't come off there? And maybe remind us of your budget plans there and what infrastructure you would want to put in place internationally to maximize that opportunity?

Unfortunately, the first part of your question is a J&J question, and I can't answer for them. Regarding the second, we have been really hard at work on really working across the globe on what that organization is going to look like. I think, it all feels like it's going very well in the U.S. As you know, we have some cardiology assets here, and so we've been looking at how we're going to coordinate and integrate those activities with a very clear game plan. Looking about key positions, we want to ensure that we retain some of the great tradition of that existing Cordis; while we want to bring some of that Cardinal approach to it. I think people are beginning to realize that we can bring more than just product scale. Again, short-term critical issue for us, I talked about execution earlier, we're sort of the Hippocratic Oath, 'do no harm.' So where the businesses are performing very well. There are many markets where there are one or two in the market, we're going to make sure that we 'do no harm' there and keep the business executing. I hope that helps an answer.

Maybe just a point to drill down. You're looking at the services side of things, obviously. Is there ever an R&D line item that you'll be breaking out with this and other assets that you have in place now requiring a bit more investment on that front?

That's a good question. In terms of how we break it out, I can't answer it fully yet. What I can tell you about our strategy is that this will not be a large research-based business unit for us. There will be development because we are already engaged in that. However, you should not expect us to operate as a research-based medical device company in a substantial way. That's not really the plan here.

I wanted to go after the specialty piece a little different angle. Looking at the fact that you guys are at a $5 billion revenue level or will be as you exit the year there, is the business now, either from a critical mass of revenue perspective or a service portfolio perspective, at that place where you think you're big enough to grow the business organically through internal development efforts above the market rate? Or do you still need to deploy capital externally to get to the point where you are able to capture additional market share?

Yes, actually, the answer is, we are growing it organically, quite rapidly. That's the good news. I think we have the scale. We've got great talent. It's a really innovative group. We have a good team driving new models for how to create value for our specialty customers and our suppliers. We are getting very strong organic growth, and we would continue to expect to, but again, we'll look for opportunities to deploy capital if we see opportunity. But we're getting very strong organic growth.

And then as a quick follow-up, looking back at the med-surg business. You guys have been spending a lot of time trying to get the business repurposed and a little more focused on the ambulatory side of the business as well. Can you talk about trends that you're seeing in terms of actual utilization or actual volumes being pushed outside of the inpatient environment that might be starting to pay dividends for you in terms of the investments in home health and other ambulatory environments?

Yes. So there, it’s probably unambiguous that the trends in care moving from acute care to ambulatory settings are absolutely happening across the board. Getting actual numbers is difficult because I think our system is not used to tracking this accurately. However, when we talked to IDN customers and looked at our data, it's clear that more activity is being driven to different sites of care. I think that plays to the strategy as well. It helps explain some of the moves we’ve made, and it's really going to be, for us, a tailwind because I think that is a natural byproduct of changes in the incentive systems in the industry.

We've seen a lot of that with our at-home business already with those changes in dynamics that it continues to grow significantly, not only above market itself. We also see our mix in our ambulatory surgery center business growing steadily where we continue to have very large share. That's an area that we really like.

There has been a lot of conversation around the Medical segment. I have one more question related to this topic, following up on the previous inquiry. George, when you mentioned the repurposing of the Medical business, you also referred to having better communication with the executive teams of your hospital clients. Can you share your current progress in conveying what Cardinal can offer them and integrated delivery networks overall? Specifically, where do we stand in this process, how much further can we advance, and what additional steps are needed to truly drive this initiative?

Yes, that's a hard question. As you guys think about the 'what inning we are in,' that's always a hard question because the system is going through this change. Let me highlight a couple of things. As a reminder, I would say our largest customers across health care are becoming more complex, more integrated, and their needs now cross more products and services than historically. We have been aligning with that, and one of the things we did over the last year is create strategic account teams. We've always had strength in our selling organization across lines of business. We'll continue to do that, but we have been leveraging the integrated system for that complex customer to navigate a changing world and the partners who can help them. Our tools and expertise are particularly resonating right now, as we are addressing a larger percentage of their activity than we ever could before.

Mike, I just wanted to touch on something quickly. I thought I heard you say in your prepared comments, but I might have gotten the notes wrong. Did you say the customer price changes were serving as a headwind in the drug distribution business? If you did say that, can you put a little more color around what that meant?

Yes, it was one of the offsets. We said the positives were growth in new customers and the net benefits from Red Oak that were offsetting some of the customer price changes. Those are nothing more than the normal types of day-to-day renewals we see with all of our customers. So there's really nothing new there; it's just typical. It’s always been one of the largest headwinds, and we're constantly working on the opposite side, obviously, to more than offset those.

Okay, fair enough. So just the kind of the normal pricing pressure that's not part of renewals?

Yes.

And then maybe just, as we've talked about pricing pressure in the med-surg business, I guess, George or Mike, how should we think about how that pricing pressure impacts what will be the Cordis business? Is that business immune from that pricing pressure, or will that see pricing pressure as well?

Well, I'm always reluctant to say anything is immune from pricing pressure; that would obviously be a big statement to make. But I think we're really talking primarily about something that is a dynamic that's been occurring over some time in the traditional, legacy med-surg business. I really wouldn't connect that necessarily — this is just a trend we've seen for some time. What we're seeing with the other lines of business is actually they are driving in the opposite direction.

All right. Well, thanks, all, for your questions and for being on this call. We appreciate you doing this. We look forward to getting a chance to talk to you and seeing many of you in the near future. Thanks again.