Cardinal Health Inc (CAH) — Q3 2019 Earnings Call Transcript

Thank you, Jake. Good morning, and welcome to Cardinal Health Third Quarter Fiscal 2019 Earnings Call. I'm joined today by our CEO, Mike Kaufmann, and Chief Financial Officer, Jorge Gomez. During the call, we will provide details on our third quarter results and full-year outlook. You can find today's press release and presentation on the IR section of our website at ir.cardinalhealth.com. During the call, 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 our SEC filings and the forward-looking statements slide at the beginning of our presentation for a description of these risks and uncertainties. During the discussion today, our comments will be on a non-GAAP basis unless they are specifically called out as GAAP. Our GAAP to non-GAAP reconciliations for all relevant periods can be found in the schedule attached to our press release. In addition, during the call, we will provide an update to our FY '19 outlook on a non-GAAP basis. We do not provide guidance on a GAAP basis due to the difficulty in predicting items that we exclude from our non-GAAP earnings per share and non-GAAP effective tax rate. As always, the IR team will be available after this call, so feel free to reach out to us with any additional questions. I will now turn the call over to Mike.

Thanks, Lisa, and good morning, everyone. Today I'll begin with some comments on our third quarter of fiscal 2019 and then I'll discuss our progress on a number of fronts to drive future growth. Overall, for the third quarter, revenue was up 5%, and operating results were in line with our expectations. Non-GAAP EPS for the quarter was $1.59, up 14% from the prior year. Based on the year-to-date performance and our current expectations for Q4, we are raising the bottom end of our EPS guidance to a new range of $5.02 to $5.17. As I reflect on the quarter, we made progress in several areas, including our strategic initiatives, and the team is focused on delivering full year expectations as we navigate the current healthcare environment. As I have recently spent time with our upstream and downstream customers, I am hearing from both that what we do and how we do it are as important today as they have ever been. We have scaled businesses that are important to our customers' success as they look for the most efficient ways to deliver high-quality care to patients. Our commitment to innovation and strong customer focus were keys to recent pharma renewals. Most notably, we've extended our distribution agreement with CVS Health for 4 years beginning July 1. We look forward to working hand-in-hand with CVS Health to further enhance our relationship with them. In that regard, we continue to work with all of our customers across our portfolio of businesses as they balance their commitment to deliver high-quality care with the need for efficiency. For example, retail independent pharmacy customers have navigated years of change in their pharmacies, and we've been right by their side helping them succeed in learning in the process. We are advancing solutions that help them address reimbursement, manage their inventory, and place the right focus on the front of store. In addition, through our connected care platforms, we offer pharmacies medication therapy management services and the ability to communicate with patients to help them follow their prescribed course of care. We continue to develop these types of strategic capabilities as they enable our customers to navigate the evolving pharmacy landscape where improving both patient care and the linkage among providers, payers, pharmacies, and patients remains critical. In our generics program, we are seeing market dynamics and program performance consistent with prior quarters. We continue to invest in data and analytics and allocate significant time to improving the overall performance of our generics program, which is key for long-term growth in the Pharmaceutical segment. Our commitment to innovations, our customers, and their success is also bearing fruit across the balance of the Pharmaceutical segment where we are seeing strong positive contributions to earnings from both specialty and nuclear. Turning to Medical, while we have made significant strides, we are disappointed with the segment performance this quarter. We would like to see quicker progress on several initiatives including our global cost structure. We continue to actively evaluate how we can accelerate our progress here while balancing our commitment to maintain service levels and deliver an outstanding customer experience. We are moving with a sense of urgency to address the opportunities for improvement we've identified in the Medical segment. Importantly, the Patient Recovery primary TSA exits are now complete, leaving just a few minor exits in action. At Cordis, the stabilization program remains on track. We continue to see improving service levels and fill rates, lower back orders, and increased cost discipline. Cardinal Health at Home and our Services businesses continue to flourish. Services continues to expand its niche, providing value-added technology and logistics support to our partners while the at-home business is capitalizing on a number of larger healthcare trends. Let me briefly touch on our strategic priorities. As I had shared already this morning, we are making progress in our Pharma segment, Cordis, and Patient Recovery. The team has also made excellent strides on our overall cost structure, and we are already realizing the benefit in our results. Regarding capital deployment, I would note that we continue to execute a very disciplined and thoughtful strategy to fund the future growth of the business, return cash to shareholders, and maintain our healthy balance sheet, and Jorge will share the details. Altogether, we remain highly focused on how we can deliver the greatest value and be nimble in the ever-changing healthcare environment so that we can respond to our customers' challenges. We know that our success begins with an emphasis on the longer-term, a balanced thoughtful approach to how we prioritize and deploy capital, and discipline in our cost structure. The team is focused on executing across both our newer and existing businesses, investing in what makes us stronger, and continuing our essential role in the healthcare system. The value we provide to customers and suppliers is as strong today as it has ever been. I want to thank our entire team for the work they are doing. We look forward to continuing to deliver for our customers, shareholders, employees, and the communities we serve. With that, let me turn it over to Jorge.

Thanks, Mike, and thanks, everyone, for joining us today. Let me start with a quick overview of the quarter. We made operational and commercial progress in both segments to strengthen our relationships with our strategic partners and benefited from a few tax items that drove our effective tax rate below typical levels. This morning, I will focus on our Q3 performance, our view of the current fiscal year, and updates on a few of our strategic initiatives. Our Q3 total operating results, which exclude tax, were in line with the expectations we had for this period when we updated guidance last quarter. Total company revenue was strong again, increasing 5% versus last year to $35.2 billion. Total company gross margin was down 8% from last year to about $1.8 billion. Operating earnings were $667 million. As Mike said, our EPS for the quarter was $1.59, a 14% increase versus last year. This increase was driven by a lower tax rate and by prudent balance sheet actions which resulted in fewer shares outstanding and lower interest expense. Our Q3 effective tax rate was lower than expected, at 21.6%, driven by net favorable discrete tax items of $0.06. The largest discrete item was a True-Up related to the Patient Recovery acquisition. In the quarter, we saw a 3% improvement in SG&A due to divestitures and the ongoing benefit from our cost optimization efforts which I'll discuss when I cover strategic initiatives. Interest and other expenses improved 24% versus prior year to about $62 million. It was driven by the change in the value of our deferred compensation plan, which as I explained previously, is fully offset above the line in corporate expenses and had no impact on the net income or EPS line. Average diluted shares outstanding were approximately 299 million, about 16 million fewer shares than last year. We generated very strong operating cash flow of $1.5 billion in Q3, which includes a large benefit from the timing of inventory purchases. Our year-to-date operating cash flow is $2.2 billion. We ended the quarter with a cash balance of $3.4 billion, with about $800 million held outside the U.S. Now I'll turn to segment results, starting with the Pharma segment. Sales to Pharmaceutical and Specialty Distribution customers were strong in the quarter, driving segment revenue growth of 6% to $31.4 billion. Although segment profit of $536 million was lower than last year, it was ahead of our expectations from a quarter ago. The 10% decrease versus last year reflects the negative impact from generics program performance, prior customer renewals, and opioid litigation expenses. These headwinds were partially offset by Specialty, which again delivered very strong top and bottom line growth. Of note, key customers continue to reward Cardinal Health with a troth of long-lasting partnerships. The renewal of CVS Health validates both our strong value proposition and our reputation as a trusted and effective long-term partner. Turning to Medical, segment revenue for Q3 was down slightly to $3.9 billion driven by previously discussed divestitures, offset by growth from existing customers. Excluding divestitures and FX, revenue was up low-single digits. Segment profit decreased 22% to $155 million driven by the performance of Cardinal Health Brand products. Market dynamics in our product businesses as well as incremental supply chain costs contributed to this lower-than-expected performance. In response to these challenges, we are moving forward with the work that I mentioned last quarter to drive efficiencies across the Medical segment through refining our commercial, operational, and data capabilities. We currently have teams deployed to support each of these pillars of work through activities including global product and geography rationalization, supply chain optimization, and selling strategies. Now let me share a few updates on some specific business areas. What we refer to internally as Medical Solution businesses, which includes Patient Recovery and our legacy Cardinal Health brand products, is experiencing challenges relative to market dynamics and supply chain integration activities. However, the team is actively engaged in multiple initiatives to drive greater operational efficiency and to address the below-target service levels experienced over the last few months. As a result of this work, we are seeing improvement in service level trends, particularly in the U.S., where the levels are reaching 6-month high. At the same time, all areas of our Medical businesses are showing strong growth. We see a strength in our strategic accounts which are growing above market rates. Also, Cardinal Health at Home had another terrific quarter. The customer pipeline for this business is healthy, and our cost management was extremely effective, producing another quarter of double-digit growth. National brand distribution had a strong performance as did its services which delivered above-market growth in Q3. At Cordis, we are seeing top-line growth in several geographies, most notably in the U.S., Latin America, Canada, and Asia Pacific. As we move forward with our stabilization plan, we are seeing improvement in fill rates and backorders, with Q3 reflecting the lowest backorder levels we have seen in 18 months. Also, service levels are improving due to our work on SKU rationalization, and additional technologies will help us better manage both inventory and sales productivity. We also continue to evaluate product mix and partnership agreements. Our key challenge remains our cost structure, primarily outside the U.S., which we are actively working to address. Turning to our full-year outlook for fiscal '19. Based on our most current expectations for our effective tax rate and operating performance in both segments, we are raising the lower end of our EPS guidance from $4.97 to $5.02. Our updated range for the year is $5.02 to $5.17. We are making the following changes to our assumptions for the full year. For the segment assumptions, due to the dynamics that we continue to experience in Medical, we now expect segment profit to be down low to mid-single digit. For our corporate assumptions, we now expect our effective tax rate to be in the range of 23.5% to 25.5%. This update reflects a few favorable discrete tax items, including the impact of tax reforms, the legal entity restructuring work we completed earlier this year, and the tax true-up related to Patient Recovery that I mentioned before. Also, we now anticipate our interest and other expenses as well as capital expenditures for the year to be lower. We expect interest and other expenses in the range of $330 million to $350 million. The new range for capital expenditures is $310 million to $340 million. I'll now provide an update on some of our strategic initiatives. First, regarding our cost optimization efforts. We will exceed our initial commitments of $100 million in annualized savings by the end of fiscal '19 and the aggregate $200 million by the end of fiscal '20. We will provide more precise numbers when we finish the year. To deliver these savings we have developed a comprehensive, data-driven approach that extends beyond budgeting and is supported by an organized program structure. Leaders across the company are accountable for initiatives that we are rigorously identifying, operationalizing, and tracking to support these commitments, and all of this work is enabled by a more agile, forward-thinking mindset that we are embedding at every level of the enterprise. This broad approach stands across strategy, tactics, and culture will enable value creation for our shareholders, customers, and employees. We said previously that we will reinvest some of these savings we generate from this work back into the enterprise. For these investments, we are focused on opportunities to rapidly implement and enable digital technologies with the goal of streamlining our processes, creating greater efficiencies, and optimizing our data capabilities. We will share updates as specific initiatives are operationalized. Second, with respect to capital, we have generated strong cash flow and remained very disciplined in our approach to capital deployment. Our financial flexibility allows us to efficiently fund both current operations and investment opportunities for long-term growth. As part of this disciplined approach, we plan to use cash on hand to repay $1 billion of debt that matures next month. Additionally, we maintained a significant level of scrutiny and selectivity regarding all allocations such as capital expenditures and acquisitions with a focus on high thresholds for strategic fit, ability to execute, and return metrics. Overall, as I look back on the quarter and year-to-date, while internal and external dynamics continue to evolve, we continue to be resilient and agile. We remain thoroughly focused on delivering our commitments as we finish the year. With that, I'd like to open the line and invite your questions.

This is Jonathan Young on for Steve today. Just going to CVS renewal. Were there any changes in the contract? Or anything that we should consider given that you guys got the renewal?

Thanks for the question, John. First of all, we're really excited and pleased to extend our partnership with CVS. As you know, they've been a long-term customer of ours. I can tell you that the contract is for a 4-year period. Actually, the new pricing goes into effect July 1, and other than that, it's the same business and same typical structure that we've had in the past. Nothing that I would call out differently.

Okay, great. And then just turning to the Medical business. I guess kind of what were the challenges that you're seeing in the business related to supply chain activities, et cetera?

Let me take that question. Good morning. Yes. We feel that we had a difficult quarter in Medical in Q3. As I indicated in my prepared remarks, the largest driver in the quarter was the performance of our Cardinal brand products. Within that, I think there are two key buckets: the first one is just the normal market dynamics that we typically overcome through actions around mix and commercial efficiency and volume. This time and in this quarter, we were not able to offset those dynamics because there were additional challenges from supply chain cost integration work that resulted in backorders and higher expenses as we were trying to meet commitments to our customers. Those are kind of the two main issues. This is what we're doing about that. We clearly have deployed a number of teams to work on the short-term issues around operational efficiency, below-target service levels, and we are seeing improvements in that. Our service levels and backorder trends towards the end of the quarter were improving. In fact, in the U.S., our service levels are now reaching a 6-month high. But from a long-term perspective, as I mentioned in my remarks as well, we are working on global product and geography rationalization to simplify our business. We are trying to optimize our supply chain, and we are making good strides on that. We are also working on our selling strategies. Obviously, all of these actions have different timelines, and some of them are being executed very quickly. As I said before, we are seeing improvements. All initiatives will take a little bit longer. Overall, we're actually encouraged with the underlying demand for this business, and we have a very strong conviction about the value proposition we're bringing to our customers every single day.

I just want to follow back up as we think about the Cardinal Health Brand products on two levels. Just one, when you talk, Jorge, about the supply chain cost, is that actually commodity cost or is it the actual process that you just described in the last question? And then Mike, can you talk about the current competitive landscape? It appears that just in the peer U.S. distribution you have a competitor that's really struggling in the marketplace. I would have anticipated that that would have created opportunities for someone with a strong balance sheet like Cardinal to continue to gain market share. So just some thoughts around the competitive landscape would be helpful.

Great. I'll let Jorge start, and then I'll answer your question.

Yes. Thanks, Lisa, for the question. The cost challenges expand over all of the areas of the P&L. From a manufacturing perspective, commodities are actually one of the headwinds, and there are other elements within costs that are creating some short-term challenges. Then the overall supply chain as we finish integration work and as we continue to improve our network, especially outside the U.S., we have experienced a higher cost, which essentially stems from the fact that we want to make sure that we balance cost with servicing our customers at the best possible level. So all of those areas of the P&L from a cost perspective impacted the segment this quarter.

And as far as the competitive environment in the Medical side, we continue to see a competitive environment, no differently than we have in the past. Obviously, I don't want to comment on any specific competitor, but I think the dynamics are similar to what they have been in the past. We feel really good about our value proposition. We want to make sure that we're focused on winning and retaining customers who appreciate our value proposition, which is being both a strong distribution medical business and a products company that people see as someone who can bring them equal to or better products at lower cost.

Just so I understand all the comments around this. As we think about this going into next year, Mike, do you feel like you can really get your arms around these costs and continue to win customers based on what you just talked about? Or do you think that this is kind of a multiyear challenge as we think about it?

Thanks, Lisa. I think Jorge from what he said emphasizes a few things. First of all, I think there are some things that are highly fixable in a short-term period, and we have put the right people on them and we've made very solid progress. Some of the other things, for instance, evaluating our global manufacturing footprint and looking at our U.S. distribution footprint. We believe there are areas for opportunity to streamline and maximize efficiency in both our manufacturing and distribution footprints as well as the overall supply chain. Those aren't going to happen overnight; those are going to take time as we work through those. Ultimately, as much as we'd like to go faster, the most important thing is keeping our eye on our customers, and we don't want to do anything that would disrupt the overall demand for the products, which we continue to see strong, and we still believe in our value proposition. So it's truly balancing our known opportunities and our footprint while making sure that we don't let any customers down.

Thanks for the question. I guess just to stick there with Medical, Mike, I want to make sure I understand. It does seem like a fairly dramatic shift from last quarter's update. So does this boil down to really just some fulfillment issues that created higher cost, which I would imagine is obviously within your control to fix? Or is it that plus a bigger issue that you're seeing as far as the macro backdrop in that sector? I know, Jorge, you mentioned demand still felt really good for the lines of business here. So just really want to make sure I understand what shifted from last quarter to this quarter? And was it really more just around some fulfillment miscues and costs that were obviously associated with that?

Yes, and thanks for the follow-up. Totally get the question. It obviously was a significant change in our assumption for this business, so very fair observation. I would say first of all, we've said several times that when you exit TSA, they can sometimes be lumpy. I would say the exits we’ve had recently have been a little bit more lumpier than we would have expected, and some of those created some unexpected service level challenges Jorge mentioned in our Q3, and we're still working through those as quickly as possible, but we still have a bit of work to do on that. As Jorge mentioned, we are seeing some challenges in our cost structure, some of it related to commodities and FX, some of it related to some cost initiatives that we hope to move quicker but had to slow down in order to ensure we don’t have service level disruptions. Jorge, would you add anything?

To clarify, the change in expectations for the segment was primarily due to volume issues stemming from our internal challenges with bill rates, and we experienced backorders throughout the quarter. As I mentioned regarding demand, we haven't observed any significant changes since our last discussion about Medical. The issues are mainly related to volume within our business.

That's really helpful. I guess just one follow-up if we could shift over to Pharma. You guys mentioned obviously good performance in the quarter, but you did mention one of the negatives being the generic performance, the performance of the generic program. Could you maybe just elaborate on what exactly you're seeing there? I'm imagining it's more in the sell side, but just the dynamics that led that to be a bit of a negative in the quarter would be helpful to better understand.

Yes. In generics, we really look at all of the factors, which for us includes inflation, deflation rates, launches, penetration, and the ability of Red Oak to take out costs. When we look at combining all of those together, we still continue to see our generics program to be a significant headwind for us both in Q3 and for the entire year. So I wouldn't necessarily say that we've seen a drastic change in any of those components; just that it continues to be consistent with prior quarters versus seeing some improvement that we would obviously like to see.

Jorge, could you say that you had to scale back your ambitions for cost reduction in part because of what is occurring in the Medical business this quarter?

No. Actually, our cost initiatives are tracking ahead of our internal plan. What happened this quarter is that some of those savings, we actually had to redirect and reinvest in trying to fix some of the short-term challenges that we're seeing in Medical. So that's why we weren't seeing the entire benefit of cost savings dropping to the bottom line because we have been using those to cover some of the short-term challenges. But the initiatives are very much on track. In fact, every quarter, we are gaining more confidence in those targets, and we will exceed the targets for this year. Yes. I think really nothing has changed fundamentally, but as we indicated, we have been extremely disciplined and strict about return metrics and thresholds for investment. When you add that to the bandwidth and the things that we're trying to take care of in the short term, we believe that the new amount we are guiding to is a reasonable fluid amount for this year.

I wanted to come back to Medical again, more of a big picture question. So if we look at the revised EBIT outlook for the segment, it looks like it's somewhere around $640 million. Based on your previous guidance for Patient Recovery, I would estimate that that's contributing somewhere around near $450 million of EBIT. So if you look at the legacy medical EBIT for Cardinal, it would be something less than $200 million. It would be helpful to us if you could rank the decline in terms of drivers over the past 2 years? It feels like the issue has shifted slightly from quarter-to-quarter, and I think it will be really helpful to have sort of the cumulative sense of what's happening in the business over the past couple of years.

Yes, let me address the question. We've been very open about the Cardinal brand products' performance this quarter and the challenges we're experiencing with volume in that area. Overall, the main parts of the business unit within the segment are performing close to our expectations, but we do face some short-term difficulties. Some of our core legacy businesses are performing quite well. As I mentioned earlier, our services at Home are doing exceptionally well. Patient Recovery is still on track to meet our operational goal for this year, though our current projections are likely lower than we initially anticipated due to volume challenges. However, we expect to achieve our accretion goal for fiscal '19.

Just a quick follow-up. Is it possible to comment on what revenue trends look like sort of ex-Patient Recovery?

The underlying revenue trends in the segment, as I indicated, when you exclude dispositions and FX, the business is tracking pretty much in line with the market and with the expectations, so no major changes there.

Can you talk a little more about the spread we are seeing on the generic side of the house? One of your peers is obviously talking about Pharma operating income growth over the next year, but from your tone or from your comments it sounds like you're not necessarily seeing an improvement on the generic side. What's the difference in your view? What do you think the difference could be?

Yes. It's hard to comment on other people's views of generics based on the fact that we all have different mixes and we may define and putting different things in various buckets, but I would tell you that we do see it as more consistent with the prior quarters. Again, I would not say that we have noticed any one factor; as you know, we've said that's beginning in the year that we expected that all those components to be a net headwind for us, and it has been a net headwind for us for the year. So far, through three quarters, it has been consistent market dynamics. It's hard for me to comment on ours compared to someone else.

Okay. And when you use the term consistent, is your spread expanding or is it contracting? Is it a consistent rate of contraction in the spread? Any more thoughts there would be helpful, Mike.

Yes. When we're talking about consistent, we are looking at deflation rates, we assess the value we expect to get from launches, et cetera. Those are basically tracking where we anticipated. The deflation rate is relatively consistent quarter-to-quarter. For us, it's again a net headwind, and we're continuing to see consistent net headwind quarter-to-quarter, not necessarily seeing that headwind reducing at this point in time through three quarters.

So not to keep going back to Medical, but as we look and think about your guidance and how it plays through the fiscal fourth quarter, would you consider that a run rate as we move into 2020? Is there anything in there that's sort of one-time? Or should we think about this as the base of which X any seasonality in that business that we should be thinking about growing off of moving forward?

Good morning, Kevin. Thanks for the question. At this point, it's early for us to start talking about trends going into next year. We've taken down the guidance for the rest of the year. It reflects the challenges that I discussed before that we are seeing. We had a good first half. The second half of the year is going to be relatively consistent in terms of the challenges. That's why we have taken down the guidance for Medical for Q4. It's too early to start talking about expectations for next fiscal '20.

Okay. That's fair. And just on the CVS renewal. You said everything was the same in terms of the business structure, pricing starts July 1. Just a couple of questions around the pricing. Was there an incremental step-down in the renewal contract? We understand that. Was the incremental step-down typical with most renewals that you do? And then secondly, this contract through 2023 also incorporate your relationship with Red Oak? Or is it simply on the distribution side?

Yes, this contract was strictly on the distribution side. Our Red Oak agreement still has 5 years left on that agreement. The first 5 years will expire here at the end of June 30, and then we have another 5 years left on that agreement, so there’s no immediate need to address that contract. Things continue to go really well with Red Oak. We love the team and appreciate the partnership that we've had with CVS on that. As far as the deal goes, the new pricing goes into effect July 1 for us. I would say that it was a renewal like we would expect in the marketplace for customers of this size and importance and how they're growing. We feel that it's a fair and appropriate renewal, and we are excited to have the business for 4 more years.

Jorge, I just want to clarify. You mentioned it's a bit early to provide details about fiscal '20. Is this specifically for Medical or for the entire business? Additionally, considering the changes this year compared to the last three quarters when you had some insight into the upcoming year, what influenced your decision to withhold any details as we approach next year?

Good morning, Michael. Thank you for your question. We typically do not provide guidance for the following year at the end of Q3. Our usual practice for offering insights into the next fiscal year occurs during our August call, and we will maintain that approach. This is not aligned with our standard practices. My comments regarding the lack of information about Medical pertain to the entire company and all figures across the enterprise.

Yes. I have a few quick comments on that. Last year, we had made some earlier remarks about five to six in the marketplace, and then we decided to adjust based on that. Last year was different, but that is not our usual approach, and it's not something we would typically do. We want to remain disciplined regarding our earnings call in August.

This is Bryan Ross on for Brian Tanquilut. When you look at the generic landscape across the buy side and sell side in terms of what you're seeing now versus historical norms, I guess what inning do you think you're in getting back to that normalized generic pricing environment? Are you expecting to get back to that over the next year? Or do you think that's further off than that?

Thanks for the question. It's really hard to say, and again, that would really be based on giving guidance, and we just want to stay away from that. For us, again, just keep emphasizing that it continues to be a significant headwind for us in fiscal '19. The market dynamics across our various components have remained consistent, but we'll give more color to your question in August regarding not only our results for our Q4 but what our thoughts are around that for our fiscal '20.

Got it. And then just a follow-up on the 4Q guidance. Relating to last year, somewhat of an easier comp and factoring in cost optimization and some of the actions you're taking in Medical, what are the puts and takes that give you the confidence in the year-over-year ramp implied by the fiscal year guidance?

You're talking about the Medical segment or...

No, overall just the fourth quarter in respect to the full fiscal year guidance?

I guess it's a couple of different components. I know Jorge went through the details here, but as you said, as he mentioned, he has the ETR benefit we've had so far this year. Now we expect it to be higher in Q4. We’ve also changed our Medical guidance for the year, so we've taken down what we expect our Medical segment earnings to be. Other opportunities, like the Pharma business doing well, will obviously offset some of that expense initiatives. Think of it as a total of all those when you look at it. We feel like our new guidance is the best indication of where we think we’ll finish for the year.

We can look at the generic marketplace just with a handful of public companies and we can look at pricing data, but the analysis sort of stops there. I'm curious, if you were to compare today to say a couple of years ago and think about your top 50, 100 drugs, do you see a material decline in the number of suppliers for, say, a generic Lipitor or some of the larger products? What we have seen with big public companies is they appear to be abandoning mid-tier products, and of course, the public drug store chains are complaining about the lack of generic deflations. So I would assume that we just have fewer suppliers, and I'm just kind of curious to your perspective on that?

Yes. It's an interesting question. I would say that I would not say that overall, we're seeing fewer generic suppliers. There’s clearly been a lot of public discussion around some of the larger ones rationalizing their supply chains and their portfolio of products. However, we’re still seeing the FDA approve generic drugs at a record pace. We are still seeing suppliers from outside the United States come in both on newer drugs as well as opportunities on some of the older drugs. Most importantly, whether there are 5 or 10 players, it probably doesn't make that big of a difference for us because as long as there is a certain amount of competition, we’re going to be able to get the cost that we need to from a Red Oak perspective. When we’ve seen it start to reach fewer suppliers on certain specific items than we wanted, Red Oak has done a nice job of working with companies to either get them back in supply or find ways to get agreements to continue to get the cost. So I wouldn’t say that I've seen a material difference in the net overall number of suppliers on items, although you can always pick 1 or 2 items where you might see significant changes.

So if that's true, it's not entirely clear, at least to me, where the pressure will be coming from. And certainly you would say there's a lot of stress in the retail channel, so you're having to give a little more price concessions downstream because your retail customers need every bit of margin they can find? Or is there something else that we're missing?

So I think that what we've said in the past is that when you look at all the components, when you take a generic deflation, which we at Cardinal define as sell-side deflation, and you net it against launches, penetration, and the ability for Red Oak to reduce costs, the net of all that is a net headwind for us, and has been through the quarter and for the year so far. What we’re seeing, again, is more pressure on the sell side, and we are able to offset that with launches, penetration, and cost decreases, and we're seeing margins shrink.

Mike, just to maybe follow-up on the Pharmaceutical segment for a moment. It looks like the headwind that you experienced in 3Q was smaller than what you did in the first and second quarter, so the operating profit was probably better than most people on this call were looking for. It doesn't sound like it came from the generics program at all. So was there something else within the Pharmaceutical segment that maybe performed a little bit better than what you or we all would have thought?

Remember Q3 is always going to be the quarter that has the most seasonality and relates to brand price increases in the January timeframe. While those came in roughly about where we expected, I would say for us, the quarter came in about where we expected it to be in Pharmaceutical. I wouldn't call out any individual item being significantly better or worse than we anticipated for the quarter.

And then just a follow-up on that. I was just curious how you may be the conversations are trending with the manufacturers given all the scrutiny around rebates and the HHS proposal and all of that. Are there any sort of initial what-if type acquisitions or is it just business as usual?

Thanks, that's a good question. I would say it appears what we're hearing from manufacturers continues to be very open and transparent conversations. We have been working very diligently to ensure our contracts are structured appropriately, to protect ourselves in the event of any sudden changes in WAC prices that might potentially alter our dollar earnings from those manufacturers. The conversations with manufacturers continue to be fruitful, positive, and very transparent about all the various things that we're seeing out there that could impact both of us.

I wanted to follow up on the Medical area. There was a sterilization plan in February and some articles related to that which may have impacted certain manufacturers, possibly affecting you as well. How much of this is related to the discussions on challenges regarding fill rates? Jorge, you mentioned that the accretion from the deal in '19 is still on track. Does this mean that the accretion targets for Patient Recovery you provided were not just for '19 but also included fiscal '20? Are the fiscal '20 targets still in place considering that we have reinvested some of those in the short term? Additionally, what about the $150 million synergy target you initially outlined?

Yes, that’s related to the sterilization method used here and is something we need to pay attention to. However, for the quarter, that was immaterial. Like I said, at this point in time we continue to look at alternatives and make sure that we’re prepared in case there are any other changes related to that.

Charles, your question about Patient Recovery. As I said before, we are on target this year. We are trending below what we thought we were going to achieve this year from a growth perspective in Patient Recovery, especially due to the disruptions we experienced lately. However, we are still within our target for accretion and trajectory.

Guys, on the Medical side, is there any incremental thought on sort of the portfolio mix? And maybe as you thought about the longer-term strategy, given some of the volatility you've seen in some of the units and maybe changes in the end market, whether or not you're sort of in all the right markets? And secondarily, is there anything else you see on the outside that would be synergistic with it in terms of pivoting in a direction where maybe you've had more success versus some of the areas where pricing and other elements have been more challenging?

Thanks, Ross. I think a couple of things to highlight. Our overall strategy in Medical leverages our historical distribution routes alongside our broad and well-known product portfolio. We still think that leveraging those two things is vital and remains essential to our approach. We still have work to do, as we've stated, around how we adjust our comp structure and go-to-market strategies to drive this. So as we've said, we know we’re making progress, but this takes time.

Yes, Ross, just to touch on your specific point about being in the right place, as we've indicated multiple times in the past, as well as today, part of our ongoing work is evaluating our entire global portfolio, looking for rationalization opportunities. A couple of quarters ago, we discussed a few small geographies we exited, and that process remains active. We will continually look for opportunities to improve our footprint, possibly add and, in many other cases, exit in geographies or certain product lines. That’s part of our ongoing strategic work. Yes. So this year, as you may recall, the number that we have included in our Pharmaceutical segment. We include all the opioid litigation expenses in Pharmaceutical; those are tracking in line with the guidance we provided a few quarters ago. We're probably around the $70 million area, plus or minus a few million dollars. That is a major headwind for us this year. Obviously, we work very hard to offset that with all cost-saving initiatives, but that is trending in line with what we were expecting for this year.

So two questions here. First of all, if you think about the Pharma segment and think about what guidance implies for fourth quarter, it seems that there is still a fairly wide range in your expectations from operating income. When we look at the numbers, it seems that at the high end, you expect operating income to potentially be up year-over-year versus a scenario where operating income is still down, so can you just help us better understand what are the swing factors into fourth quarter? Are you expecting generics to do better? Is there anything that you see that would drive that variability?

Yes. Ricky, this is Jorge. The drivers for the fourth quarter are the same that we've experienced throughout the year. Obviously, what happens with our generics programs is an important factor. The Specialty business has been showing strong growth all year and has performed well for us, which is a swing factor. Additionally, the type of savings we are able to achieve through our internal programs is another key variable in this equation. There’s nothing new that is driving the range you're talking about.

Okay. And then we think about the Specialty. You highlighted strong growth in Specialty helping you for a few quarters. Can you give us some context on what's driving Specialty growth? Is it pricing? Is it market share gains, new products?

For the most part, the key driver in Specialty growth is overall market growth. Obviously, we feel very good about our offerings and performance in the marketplace, as well as our discipline around cost structure, but the primary factor for Specialty growth is robust market growth that we're able to leverage.

Yes. Thanks, everyone, for joining us today. As you can see, we continue to execute our plans and position Cardinal for future growth, and we really look forward to reporting on our progress with you over the next several months and particularly in August when we discuss our fiscal '20 outlook. Thanks, and have a great day, everybody.