Mckesson Corporation (MCK) — Q1 2018 Earnings Call Transcript

Thank you, Anthony. Good morning and welcome to the McKesson fiscal 2018 first-quarter earnings call. I'm joined today by John Hammergren, McKesson's Chairman and CEO; and James Beer, McKesson's Executive Vice President and Chief Financial Officer. John will first provide a business update, and then James will review the financial results for the quarter. After James' comments, we will open the call for your questions. We plan to end the call promptly after one hour, at 9:30 AM Eastern Time. Before we begin, I'll remind listeners that during the course of this call we will make forward-looking statements within the meaning of the federal securities laws. These forward-looking statements involve risks and uncertainties regarding the operations and future results of McKesson. In addition to the company's periodic, current and annual reports filed with the SEC, please refer to the text of our press release for a discussion of the risks associated with such forward-looking statements. Finally, please note that on today's call, we will refer to certain non-GAAP financial measures. In particular, John and James will reference adjusted earnings, adjusted operating profit margin excluding non-controlling interests, and items excluding foreign currency exchange effects. We believe these non-GAAP measures provide useful information for investors with regard to the company's operating performance and comparability of financial results period-over-period. Please refer to our press release announcing first quarter fiscal 2018 results for further information and a reconciliation of the non-GAAP performance measures to the GAAP financial results. Thank you, and here's John Hammergren.

Thanks, Craig. And thanks everyone for joining us on our call. Today we reported a solid start to fiscal 2018. For the first quarter, we achieved total company revenues in excess of $51 billion and adjusted earnings per diluted share of $2.46, consistent with our expectations. Combined with our share repurchases completed in the first quarter, we are raising our fiscal 2018 adjusted earnings outlook to $11.80 to $12.50 per diluted share. Before I dive into the details of the quarter, I'd like to take a moment to discuss the progress that demonstrates our continued commitment to long-term shareholder value creation. First, we continue to proactively develop our portfolio of distribution businesses. In the past quarter, we announced the signing of three acquisitions primarily in the specialties space. We closed four acquisitions, including CoverMyMeds, in early April and we started the important work to integrate Rexall and other recent acquisitions which are beginning to contribute to our earnings growth. Each of these acquisitions that we've announced or are in the process of integrating highlight our commitment to expand our specialty capabilities, enhance our leading technology solutions for our Distribution Solutions customers, and grow our retail pharmacy footprint internationally. Second, we continue to make progress on the strategic shift to realign our businesses to focus on distribution and retail pharmacy solutions following the creation of Change Healthcare. This quarter represents the first time we include the results for our equity investment in Change Healthcare; the new company was created to deliver a broad portfolio of solutions that will help lower healthcare costs, improve patient access and outcomes, and make it simpler for payers, providers, and consumers to manage the transition to value-based care. Change Healthcare is now a focused and scaled enterprise executing on this mission. Additionally, I'm encouraged by the recent developments in our pursuit of the strategic alternatives for our Enterprise Information Solutions business, and I expect we will have more to announce in the near-term.

Thank you, John, and good morning, everyone. As John discussed earlier, we are raising our fiscal year 2018 adjusted earnings outlook to $11.80 to $12.50 per diluted share, which reflects our first quarter results that were very much in line with our expectations and the positive full-year impact of incremental share repurchases completed in the quarter. Please note the underlying assumptions that were detailed in our fourth quarter press release are being reiterated today, unless stated otherwise. Now let's move to our results for the quarter. My remarks today will focus on our first quarter adjusted EPS of $2.46, which excludes the following items: amortization of acquisition-related intangibles, acquisition-related expenses and adjustments, LIFO inventory-related adjustments, gains from antitrust legal settlements, restructuring charges, and other adjustments. You may recall that when we provided our initial guidance and further commentary at our Investor Day, we noted the quarterly progression of our fiscal 2018 performance being back-half weighted. This timing reflects, in part, our ongoing contract renewal work with our customers and manufacturer partners, where we are reflecting the differential economics of brand, generic, specialty, biosimilar, and OTC products, as John mentioned previously. These ongoing contract renewals also reflect reduced variability in our compensation, resulting from manufacturer pricing actions. Our ongoing success with these contract renewals did, however, create a timing headwind for our Q1 earnings. Turning now to our consolidated results, which can be found on Schedule 2 and Schedule 3. Consolidated revenues for the first quarter increased 4% in constant currency. First quarter adjusted gross profit was down 6% in constant currency year-over-year, driven by the planned lapping effect of increased competitive pricing in our independent pharmacy business, weaker pharmaceutical manufacturer pricing trends, some timing items driven by our ongoing contractual renewal progress with certain manufacturer partners, and lower profit in our Technology Solutions business driven primarily by the contribution of the majority of businesses to Change Healthcare, partially offset by acquisitions and organic growth including the ClarusONE joint sourcing entity. First quarter adjusted operating expenses increased 5% in constant currency, driven by acquisitions, partially offset by the Change Healthcare transaction and ongoing cost management efforts. Adjusted other income was $13 million for the quarter, a decrease of 43% in constant currency. Adjusted equity income from Change Healthcare was $70 million for the first quarter. We are pleased with the progress of Change Healthcare; the management team has come together to cohesively lead the new organization and begin the work of both identifying opportunities to further expand our customer relationships and realizing meaningful synergies. I'd like to reiterate our prior guidance that Change Healthcare will generate between $370 million and $430 million of pre-tax earnings, reflecting our 70% ownership of the joint venture. At the same time, we have made a refinement to our estimate of the way tax expense is attributed to the joint venture's profits. Including tax expenses now expected to be accounted for within Change Healthcare, we project our adjusted equity income from the Change Healthcare joint venture will be between $250 million and $310 million in McKesson's fiscal 2018 P&L. Again, this reflects no material change in our full-year expectation for pre-tax earnings to be generated by the Change Healthcare joint venture; rather, it is a refinement in where taxes are reflected in our income statement.

Turning now to our business results for the quarter. Our North American pharmaceutical distribution and services businesses, which include U.S. Pharmaceutical, McKesson Specialty Health, McKesson Canada, and our recently formed McKesson Prescription Technology Solutions business, had revenue growth in the first quarter of 5% on a constant currency basis. I'd like to take a moment to highlight a few matters specific to our U.S. Pharmaceutical business. Revenue in our U.S. Pharmaceutical business met our expectations in the first quarter driven by organic growth. Next I want to provide an update on the pricing environment as we've transitioned into fiscal 2018. We entered this year with an assumption of branded inflation in the mid-single-digits and our first quarter experience was slightly ahead of this assumption. Additionally, you'll recall that during fiscal 2017, we saw increased price competition in the independent retail pharmacy channel, which eventually resulted in reduced volumes from McKesson. Over time we adjusted our strategy and we were able to recapture that lost volume, retain our share, and build upon our longstanding relationships. Consistent with our update over the last two quarters, we continue to see a competitive market for selling generic pharmaceuticals in the U.S., albeit with less pricing variability. We expect to lap the independent pharmacy sell-side pricing impact by the end of our fiscal 2018 second quarter.

So the business you're referring to is the coming together of three previous sub-businesses if you will. One that focuses historically on distributing technologies to pharmacists to help them manage their business, then the Relay Pharmacy business, which is a switch business across which so many transactions between the pharmacy and the payer move, and then also the new acquisition of CoverMyMeds. So, I was alluding, earlier in one of my answers, to the opportunities that we're seeing for new improvements across these businesses and I'm pleased that we've been able to bring them together under a single preservant to really drive the full opportunities that we think these assets provide. I think they can be higher growth. John mentioned they're higher margin, so there will be a particular focus on these businesses going forward.

Thanks very much and good morning. James, let me just start with trying to understand the cadence of the earnings. I understand you were talking about it being more heavily back-half weighted, but given where the Street was in this quarter versus what you delivered and where you said this was in line with your expectations, I just want to make sure that we have this lined up correctly, especially as we think about next quarter and think about having to lap some of the pricing issues; is there anything more that you can give us directionally as we think about the second quarter?

Well, obviously a few factors are driving the quarterization of the fiscal 2018 guide, in particular, Q1 was impacted by that lapping effect of last year's activity, enhanced pricing activity around the independent pharmacy space, and then also, as we had assumed going into the fiscal year, we did see lesser brand manufacturer price increase activity than we've seen in some other years. And also made note at the start of my remarks, as to in Q1 in particular, there were two contracts with the manufacturers as we went through our renewal process, that is focusing our activity on the relevant economics for each of the five categories of our work, that both John and I referred to, namely the brand, generic, specialty, biosimilar, and OTC, but also those renewals focused on our interest in seeing less variability to the branded manufacturer pricing actions.

Okay, great. And then, just my follow-up would be for John. John, in your prepared comments, you made a comment that you feel that things have stabilized, and they're competitive when we think about the independent market for generics. Can you just maybe give us a little more color as to what you're really seeing in the market and what gives you that confidence?

Thanks for the question, Lisa. I think at the time that we talked about this unusual activity in the prior year, during the prior year, I made the comment that we had – we don't see that type of activity frequently, and when we've seen it in the past, it tended to stabilize or revert back to competitive, but less variable over time. And I think that, that prognosis or forecast in terms of where we thought things would go has proven to be accurate, and obviously, things can change at any point in time, but I would say that we've gone back to an environment which is competitive, but certainly not out of line with the kind of competitive activity that we would have typically seen prior to fiscal 2017. So I would say that that's the best way I could characterize it, is it's back to competitive and less variable.

Good morning, guys. Thanks for the color. Maybe thinking a little bit and building off of Lisa's question a bit more, as you think about some of the other moving pieces that get better into the back half of the year, particularly the pricing environment, I guess, how do you check the growth points along the line to make sure that what you think about relative to brand inflation which I think you said came in a little bit better, generic deflation, all against the backdrop of some of the contract changes are falling in line with your plans? And I guess, how much visibility at this point do you have into some of those changes?

Well, I think it's fair to say that when we had our guidance discussion at the end of our fiscal year and again at our Analyst Meeting, we talked very specifically about how we saw the year playing out and I guess what we're seeing today is it's playing out as we had anticipated it would play out. We may not have done an effective job of messaging it to you given where the Street has been in the quarter, but clearly it's in line with our expectations and we typically have pretty good visibility throughout the year. And as James mentioned, if you think about our renewal cycle of both with our customers and our large manufacturing partners, you can clearly see how the changes in those relationships will be reflected in future financial results.

Okay, thanks. I'll leave it at one.

Good morning, guys. Maybe just a quick update on how some of the recent acquisitions are sort of trending, particularly some of the maybe newer businesses to you, like Rexall or Biologics, so just love to understand how they're doing versus sort of their base M&A case when you bought them?

Right. I think that as I said earlier, we have a pretty good track record in realizing the synergies that we forecast and I would say that we're generally in line on these acquisitions in terms of their performance. Biologics might be performing slightly ahead of its acquisition case and we've been very pleased with that acquisition, and Rexall is really in line with this – I'd say a little bit newer than Biologics is. And then the rest of our acquisitions like CoverMyMeds, et cetera, are all performing at or above our expectations. So, I'm quite pleased with not only the performance financially, but the strategic position that these acquisitions put us in.

And while we don't look at this in our business cases that underpin the acquisitions themselves, I've been pleased so far with the opportunities that are starting to evolve for groups like CoverMyMeds to work with other parts of our business, Relay Pharmacy for example on the Rexall side, the discussions that are really ongoing now with other parts of retail across our organization. So that's not a short-term synergy opportunity. It's not something that's part of the business case, but I'm encouraged that there's quite an opportunity I think over the longer-term for us to really benefit from this portfolio of assets that we've built up over the years.

And I also mentioned, Ross, in my comments about Med-Surg and our exposure to laboratory and our entrance into the lab business, principally in the physician space, but also in the smaller hospitals where they've been underserved from a laboratory supply perspective, and that business is growing nicely for us and it's higher margin and higher growth than the baseline businesses. So, we think we're well positioned.

And maybe just as a follow-up, historically you guys have been tremendous stewards of capital and M&A has always been a hallmark, and I always think of you as being a pretty creative and value-based buyer. I guess, in an environment where we are with multiples, et cetera, how would you sort of characterize more the mid-to-small size tuck-ins that you guys typically do? What does that environment look like? Is there a pretty good pipeline or valuations still amenable in certain areas? How are you sort of thinking about just the overall backdrop?

First, thanks for the compliment, and we appreciate the fact that we've represented good stewards of capital, and that we have a track record of executing. And clearly, if you overpay, there's no ability to create value and so, that discipline upfront is extremely important. But, I'd say, as evidenced by the frequency of our acquisitions in the last year and already into this year, you can see we find creative spots to deploy capital and to your point about sort of innovation and creativity, we're typically not that are all chasing the deal or chasing an opportunity. We have our teams focused on building relationships with potential sellers long before they're interested in selling, and then we create a positive environment for those transactions to be completed.

Good morning, John and James. I guess more of a big picture question on procurement. So, distributors have clearly gained share and enlarged the pie in terms of the level of generics purchased through you for a variety of reasons. But from a high level, could you describe what that does to the marketplace from a procurement perspective? So, for example, in North America, you've completed signing contracts with the new retail client via ClarusONE and now one of your peers is embarking on adding a PBM and then incremental retail line. So, does that cause any disruption in your contracting or does that impact your assumptions in terms of generic contributions, as maybe pricing deflates at a different rate or other factors investors should think about as these types of events occur?

Well, I think it's a good question and a complex question. I would say that as a backdrop, I believe that the large buyers of generics are relatively comparable in terms of what we're attempting to do, and the results that we're achieving. I would say that clearly incremental volume plays a role in all of this, but I think that the difference between any of us at any one time is not significant, and I think McKesson and certain molecules with certain manufacturers would be superior and in other cases, others may beat us. But if you put it all together as a basket, I'm pretty confident we buy as well as anyone. As it relates to the deflation environment related to our activity in the procurement side, clearly we're trying to get the best deal we possibly can for ourselves and for our customers, and we want to make sure that our customers are receiving a competitive price for the service and value that we deliver including the product price.

And perhaps just to add on to that from a more technical perspective, as we look at the economic drivers of our results, our ability to flow through effectively on the generic side in this deflationary type environment has net-net been supportive to our results.

Okay, that's helpful. And changing gears a little bit, on Rite Aid, you mentioned you're using public Walgreens comments and your assumptions for the year on the portion that Walgreens is taking over, but how do you think of the rest of the business where there's also a part of that deal, some pricing terms for the remainder of Rite Aid? Should they continue to or would they want to use Walgreen? So, the rest of the business, how you're thinking about it, as to what the realistic options are?

Well, clearly, we're pleased for both Walgreens and Rite Aid, that they've been able to find a new deal that they believe, they'll be successful with and obviously, we're also pleased that that new deal has some remainder of Rite Aid, not only the corporate side of the entity of Rite Aid, but certainly a large portion of their stores that will remain. And that we've been a long-term valued partner with Rite Aid. And I certainly would hope and expect that relationship would continue.

Okay. Thanks. Good morning, John and James. So just based on simple math, I mean the SG&A seem to be pretty high in the quarter with distribution gross profits growing 4% to 5%, but distribution EBIT down about 10% year-over-year, and just based on your comment, it seems like the biggest delta on getting that gross profit growth and EBIT growth is closer to each other for the rest of the year is mainly acquisition integration; is that an accurate assessment or are there other key factors there?

Well, I would say that there are more variables that are at play; it's really the combination of the opportunity for organic growth right across the businesses, as well as the impact of acquisitions. And then obviously, we've discussed the ebbing of this lapping effect around sell-side independent pharmacy space. In terms of the expense side of the ledger, we've talked about how we've been looking to invest some in expenses, particularly focused around information technology investments in the coming year. On the other side of the coin, one of the attributes that I was pleased about in terms of the U.S. Pharma, our performance in Q1 was the productivity efficiency that they were generating out of that part of the business as a result of our ongoing capital expenditure investments and other process improvements that they've made in that business.

Okay. And just a quick follow up on that, just on the M&A. You mentioned that some of the recent acquisitions were higher margin, it might be tough to answer this on the fly, but when we do look at that 4% to 5% gross profit growth in Distribution Solutions in the quarter, do you know how much of the acquisitions contributed to that growth versus what that growth might have been organically in the quarter, is there any just rough assessment of that?

Well, we don't bring that out specifically, but obviously those acquisitions are going to build gradually, so I wouldn't want to overstate the impact of those acquisitions in the first year or so. When we've announced acquisitions like CoverMyMeds for example, we noted that come year three, we'd be driving between $0.30-$0.40 of accretion from that acquisition. But that builds gradually particularly in that first year, where oftentimes there is some additional investment spending that goes into the equation for us to be able to really drive that accretion in the second year and third year and so forth.

Thanks for the questions. I guess just want to go back to the SG&A, James, I guess I'm still just a bit confused. I think everyone was anticipating the headwinds in the quarter coming from the things that arose in 2Q last year, the branded pricing and the competitive environment, but really relative to expectations the shortfall this quarter was from SG&A and in particular it looks like from Distribution Solutions scope. Can you just go back and maybe explain a little bit more what exactly happened in the quarter relative to operating expenses and how should we think about those as we progress through the year?

Well, another item that is relevant on the expense side of the ledger is obviously that we've reset our assumptions around various variable compensation programs, and so forth. So that becomes an element of the equation and in certain of our geographies, there were some additional expense resets around salaries and so forth. So, a variety of different factors, but overall, we feel comfortable with the level of spend, as I say, the focus on the investments to drive down expenses over time and right across the management team, we're very focused on improving our spend performance quarter by quarter.

And I'd also say, Robert, the spend level in the quarter was not something that was a surprise to us. It was factored into our planning when we gave you the full-year guidance. So, I would say that the way the P&L has played out for us in the quarter is in line with what we expected it to be when we gave you the original guidance months ago and that's only the additional cover I give you. It may be surprising to you, but we had factored this in because we could see the investment in the mix changes and the acquisitions et cetera, as we looked at the quarter.

No, that makes sense, John. I think, we, obviously, were focused more on the headwinds that had come up last year, and I think that's where it probably differed in the model. But I guess, James, just if I could go over to pricing, I wanted to get a better understanding of what you guys are seeing on generic pricing, and in particular I'm thinking about the buy side part of the equation; how has that trended relative to expectations? And then probably, more importantly, as you guys look forward given some of the FDA's recent statements and goals of accelerating generic approvals, how do you foresee generic pricing playing out into the future?

Well, on the generic manufacturer side of things, we went into the year assuming a very nominal benefit from those molecules where we would be seeing price inflation and that's very much as things are playing out, very limited effects there. On the broader generic molecule spectrum, we've been talking earlier in one of our responses about the deflation environment, and net-net, I observed that for our sourcing capacities, or our in-house capabilities as such that we see this environment as a net driver of our overall economic, so we're happy with the situation there. In terms of the FDA and their part to drive more approvals and therefore potentially put greater numbers of manufacturers into a specific molecule, obviously you've got an overall supply-demand balancing equation there that will impact the pricing environment net-net, it is a generic type marketplace after all.

Yeah, good morning. So, first of all, just a follow-up on the question on the SG&A. So just to clarify going forward now that these acquisitions are part of the business. Is that the state that we should model between COGS and gross profits versus operating expenses?

Well, I think it's fair to say that, as John was alluding to, these figures were very much in line with our plan and so, as we're bringing on acquisitions in the year-over-year expense base, you're obviously going to see step function increases commensurate with bringing on those acquired expense bases. So I would again rest assure that we'll continue our ongoing focus on cost management, but directionally, yes, you'll see some step function increases as the likes of Rexall come into the P&L for example.

And I think also, Ricky, one of the challenges from the P&L perspective is that the incremental profit delivered by the acquisitions even in the first order before we realized the synergies was vastly offset by the year-over-year lapping problem that James mentioned earlier related to independent pricing effects in the prior year. So when you think about why didn't we see a margin lift in terms of the acquisitions and all we saw was the expense lift is because the margin lift from the acquisitions could easily be offset by the two dimensions that James mentioned. One is the lapping effect of independent pricing last year, and the effect of our continued work from the manufacturer contracting perspective that we talked about previously.

Hi, good morning. Thanks for taking my call. Question on ClarusONE; is there a cadence declaration for ClarusONE in terms of the profitability over the course of the year? I'm assuming it will grow and become more profitable as the year progresses. That's the first question on ClarusONE. The second one is, you talk about other opportunities with Walmart and with ClarusONE, is this the kind of relationship where you could get in and help the medical side of your business as well? Are you going to be able to get into products and the like there?

In terms of the cadence, you're right, I would expect that to build profit contribution as the quarters of the year go by, and obviously, in the last few months, we've really just been getting started and we're very pleased with the momentum that, that team is building around sourcing results. So, yeah, I'd be absolutely looking for a steady build as the year goes along.

It's difficult for me to perhaps articulate what opportunities would be in front of us like Clarus because we have a partner there that needs to engage in that opportunity as well. So I'm not speaking on behalf of Walmart. But if you wanted to look at opportunities, you certainly could think about everything that a Walmart store in the U.S. purchases today, and think about what McKesson would also be purchasing for our clients and non-Walmart clients, and all of those would provide opportunities for us to move them to ClarusONE in a way that would be perhaps productive for both companies and our combined customers. I would also say that ClarusONE is specifically focused on U.S. so there might be other U.S. Walmart opportunities as well as global opportunities that both companies could bring together.

Great. Thanks. And if I can do one quick follow-up. I'm a little confused on the impact of the manufacturer contracting and sort of how that works; why would something like that become more profitable over the course of the year? Is there an exclusive on a product launch or a generic or something like that? I just don't really understand how that would work?

Well, I won't be able to get into the specifics of these two particular contracts with some of the larger manufacturers, but it did create in essence a headwind for Q1 and we would look for a smoother introduction of contribution for us in the quarters remaining in the year, Q2 through Q4. So, in the net result, which we're pleased about is less variability around a manufacturer's pricing actions. Obviously we don't take those decisions. So we're interested in smoothing out the impact on our P&L from the actions of others.

Well, thanks for the question. Clearly, we've been focused on making sure that we think about the strategic alternatives for our EIS business. We believed there were other places where that business might be able to grow more rapidly than inside of McKesson and we've been pursuing evaluation of those strategic alternatives and my comments were nothing more than to reinforce the fact that we – the process continues to be underway and that we're encouraged by the level of interest in alternatives that we're seeing and we hope to have more news here in the short term.

Thank you, John. I have a preview of upcoming events for the financial community. On September 12, we will present at the Morgan Stanley Global Healthcare Conference in New York. We'll release second quarter earnings results in late October. Thank you, and goodbye.