Mckesson Corporation (MCK) — Q2 2018 Earnings Call Transcript

Thank you, Jessica. Good morning and welcome to the McKesson fiscal 2018 second 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 9:00 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 Securities and Exchange Commission, 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 second 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 solid operational performance across our business as we make continued progress towards a strong finish to our fiscal 2018. For the second quarter, we achieved total company revenues of $52 billion and adjusted earnings per diluted share of $3.28, and we are reiterating our fiscal 2018 adjusted earnings range of $11.80 to $12.50 per diluted share. Before I dive into the details of the quarter, let me briefly touch upon today's announcement that Paul Julian will be retiring at the end of the calendar year. I'd like to acknowledge the tremendous contributions by Paul over the past two decades. Paul's business acumen and strategic leadership have helped us expand our market reach as well as the breadth of services and solutions we offer to our customers. His dedication and tireless commitment to our people, our customers and the industry set him apart. Starting in McKesson Health Systems, the company's distribution business for hospitals, he led many of the businesses that now comprise our Distribution Solutions segment. Paul has had a four-decade career in healthcare. He has received numerous awards and throughout his career has been recognized for his many contributions. He has demonstrated exceptional character, accomplishment and leadership in the industry and in the community. I worked closely with Paul for many years and he is my friend as well as a close colleague. His perspective and insights are critical to the growth and success of McKesson, including building a deep bench of talented leaders to carry McKesson into the future. On Paul's retirement, the presidents of these businesses within Distribution Solutions will report to me. I will miss working with Paul and wish him the very best in this new chapter of his life. Turning now to our business results, 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 year-over-year revenue growth in the second quarter of 5% on a constant currency basis. I'd like to discuss a few highlights in our U.S. Pharmaceutical business. We are recognized as a leader in delivering novel solutions to the market. We find innovative ways to expand our value proposition across the entire supply chain. For example, AccessHealth continues to successfully partner with independent pharmacies, enabling improved financial performance and broadening access to narrow patient/payer networks. We also recently closed the BDI Pharma acquisition. This business complements our existing plasma offerings and allows us to expand plasma and biologic distribution into specialty pharmacy and homecare with differentiated expertise. And ClarusONE, which is performing in line with our plan, leverages our scale and our unique in-house sourcing capabilities. These examples demonstrate our ongoing strategy to build scale, expand our pharmaceutical offerings, enhance our manufacturer value proposition, and enable our customers' continued success. Next, we're pleased with the progress of our multiyear initiative to implement differential pricing for brand, generic, specialty, biosimilar, and OTC drug classes as we work through our contract renewal cycles. Finally, Walgreens' asset purchase of a number of Rite Aid stores was approved by the FTC last month. Based on Walgreens' public statements that they began last week to transition stores and will carry through the spring of 2018, we expect to be impacted in our fourth quarter as stores progressively migrate to Walgreens over the transition period. We've had constructive dialog with Rite Aid on how we can continue to support their success during the transition period and beyond to the mutual benefit of both parties. As I mentioned in the past, Rite Aid has only a modest impact on our P&L. We are comfortable that our sourcing scale and capability will not be impacted by this transition. Turning now to McKesson Specialty Health, with the closing of the intraFUSION acquisition earlier this quarter, along with the BDI Pharma acquisition I spoke about a moment ago, I'd like to highlight how we continue to enhance our specialty capabilities across the organization. We provide manufacturers with an integrated solution set starting from clinical research and development to drug launch and distribution services, and from patient reimbursement and access solutions to real-world evidence-based capabilities. Biologics and biosimilars continue to represent an emerging opportunity for the industry. We are proud to be a leader, supporting clinical trials for these and other innovative new therapies for many years. And I'm excited about the opportunity that CoverMyMeds provides across our businesses with the e-Referral platform for specialty prescriptions, connecting providers with specialty pharmacies and payers and improving care coordination and care management for complex health conditions. I'll move next to our Canadian business, where we saw nice growth in the quarter with constant currency results that were in line with our expectations. During the quarter, McKesson Canada closed the Uniprix banner acquisition, where we will continue to offer Uniprix owners retail banner management expertise and best-in-class supply chain network, designed to ensure patient safety and reduced costs. All of these services help strengthen independent pharmacies. Uniprix integration activities are progressing well as are those supporting the GMD Distribution acquisition. Our McKesson Prescription Technology Solutions business continues to make progress on the CoverMyMeds integration. We are encouraged by the level of collaboration we are already seeing between CoverMyMeds and our other businesses. Turning now to our results for international pharmaceutical distribution and services, on our last earnings call, we mentioned that recently announced reimbursement cuts in the UK were in excess of historic levels and also greater than what we planned for in fiscal 2018. After studying the nature of the cuts, we decided it was necessary to take action to position the business for sustained long-term growth by initiating a plan to rationalize our store footprint and streamline our back-office operations. As a result, we recorded certain charges within our UK retail operations. James will provide more detail on these items. We see our global retail presence as a way to stem the tide of growing healthcare costs as we anticipate more services migrating from higher-cost locations into the lower-cost pharmacy setting. We believe that pharmacists play an important role in providing the range of healthcare services. Our Medical-Surgical business continues to deliver consistent results, benefiting from the shift of care to lower-cost sites. In summary, I was pleased with how our Distribution Solutions segment performed in the quarter. Turning now to our Technology Solutions segment, we reached another milestone on October 2 with the sale of our Enterprise Information Solutions or EIS business. This represents another important step in the strategic shift to realign our business focus on Distribution Solutions, following the creation of Change Healthcare earlier this calendar year, which is a testament to the team at EIS when we consider the results they achieved for the first half of the year, given the uncertainties around the extended strategic review process that is now complete. In addition, I have confidence that EIS customers have a partner committed to their success. For Change Healthcare, we continue to see encouraging progress against the execution of the business case and the realization of the anticipated cost synergies. To summarize, McKesson's fiscal second quarter results represent solid execution across the enterprise, and we are reiterating our adjusted earnings range of $11.80 to $12.50 per diluted share for our full year fiscal 2018 outlook. We are extremely well-positioned to execute our portfolio approach to capital deployment and deliver value for our shareholders through a mix of internal capital investments, acquisitions, share repurchases, and dividends. Before I hand the call over to James, I'd like to spend a moment on a topic of national importance, the opioid epidemic. This is a crisis that has touched many Americans, including many Americans that live here at McKesson and are part of our family. McKesson takes our role in the supply chain very seriously. We've invested considerable time and resources to help stop diversion at a time when diversion tactics are constantly changing. We've implemented sophisticated analytic tools, hired experienced diversion investigators, and enhanced the effectiveness of our controlled substance monitoring program. We work collaboratively with the DEA to better understand diversion trends. This working relationship is critical, since the DEA has singular line of sight into the total volume of opioids sold to any licensed pharmacy or hospital. The trends in this crisis continue to evolve, and we are regularly enhancing our programs to further limit the misuse and abuse of prescription opioids while simultaneously protecting the availability of the appropriate treatments for patients with serious illnesses and injuries. But our company's, and our industry's, commitment to public health and safety was recently called into question by certain media outlets. Those outlets sought to place blame for the tragic opioid epidemic on distributors and elected officials who, with bipartisan Congressional support and after consultation and input from the DEA and the Department of Justice, enacted a clarifying enforcement bill that was signed into law. As recent Congressional testimony indicated, since the passage of the law, the quantity of opioids distributed has decreased, and the number of enforcement actions by the DEA has increased. Many press articles have since corrected the misinformation that resulted from those earlier media stories and subsequently, there has also been more attention put on the need to control the annual production of opioids, on the illicit opioids entering our country from other sources, and on the critical role of healthcare professionals who are at the frontlines in dealing with patients and ensuring that only patients with legitimate medical needs receive the appropriate amount of these medications. McKesson is also committed to helping promote forward-looking solutions to this public health problem. That's why over a year ago, we convened a taskforce of policy and clinical experts to help create a public policy white paper, which outlined a set of proposals to help combat the epidemic going forward. These proposals include changing the medical community's approach to prescribing opioids, requiring e-prescribing to avoid modification or manipulation of the prescription. It created a national patient safety network that provides real-time patient information to pharmacists while they're directly interacting with the patients seeking these drugs. We look forward to continuing to work with all parties; federal, state, and local governments, manufacturers, insurance companies, pharmacies, and the medical profession, to implement practical and effective solutions. Lastly, let me touch upon the tragedies that recently unfolded across the U.S. and Puerto Rico. McKesson was fortunate to have avoided material impacts to our operations or to our facilities from the devastation resulting from Hurricanes Harvey, Irma, and Maria, and the recent fires across Northern California. We are proud to have played a role in the emergency efforts, providing pharmaceuticals and medical supplies to the affected areas. Our employees in the McKesson Foundation have been extremely generous with their support for displaced coworkers and other residents, contributing more than $700,000 in relief efforts. We continue to aid in the recovery of our affected employees, customers, and communities. With that, I'll turn the call over to James and will return to address your questions when he finishes. James?

Thank you, John, and good morning, everyone. Today, we reported second quarter adjusted EPS of $3.28, which was slightly better than our previous expectations, and we are reiterating our fiscal 2018 adjusted earnings outlook of $11.80 to $12.50 per diluted share. Unless stated otherwise, the underlying assumptions that were detailed in our fourth quarter fiscal 2017 press release, and on our first quarter fiscal 2018 earnings call, are being reiterated today. I will talk in more detail about our outlook, but first let's review our results from the fourth quarter. GAAP earnings per diluted share from continuing operations equated to $0.01 for the second quarter. These earnings include impairment and restructuring charges of $2.60 per diluted share related to our retail pharmacy business in the UK. As we discussed on our last earnings call in July, the UK government announced additional reimbursement cuts, which were incremental to their more typical annual reimbursement reductions and to those assumed in our plan. Primarily as a result of these cuts, we have identified and started to implement initiatives to partially offset the impact of these cuts, which include approximately 190 store closures and divestitures. The resulting savings from this program are expected to more meaningfully benefit our fiscal 2019 performance. The program's total asset impairment and restructuring charges are expected to be between $650 million and $750 million. Specific to the second quarter, we recorded goodwill and other long-lived asset impairment and restructuring pre-tax charges totaling $586 million. As a reminder, these charges will impact our GAAP financial results. However, they will be excluded from adjusted earnings. Now, let's turn to our second quarter adjusted earnings, which exclude 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. Turning now to our consolidated results, which can be found on Schedules 2 and 3. Consolidated revenues for the second quarter increased 4% in constant currency year-over-year. Second quarter adjusted gross profit was up 2% in constant currency from a year ago, and second quarter adjusted operating expenses increased 6% in constant currency year-over-year. Adjusted other income was $27 million for the quarter, an increase of 8% in constant currency. Adjusted equity income from Change Healthcare was $75 million for the second quarter. We are encouraged by the progress of Change Healthcare and continue to expect our adjusted equity income from Change Healthcare joint venture will be between $250 million and $310 million in McKesson's fiscal 2018 P&L. Interest expense of $69 million decreased 12% in constant currency for the quarter, driven primarily by the refinancing of debt at lower interest rates. Our adjusted tax rate was 23.6% for the quarter, driven by our mix of business. Our full year tax rate for McKesson is now estimated to be approximately 24%, down from our previous estimate of 25%, reflecting our mix of business. Our income attributable to non-controlling interest, or NCI, was $55 million for the quarter, an increase of 218% in constant currency. As a reminder, the increase in NCI year-over-year is primarily driven by fee income from ClarusONE, a joint sourcing entity with Walmart. We now expect income attributable to non-controlling interests to be between $210 million and $230 million in fiscal 2018, reflecting ClarusONE's ongoing success at sourcing generics at prices lower than we originally anticipated. Our adjusted net income from continuing operations totaled $689 million with our second quarter adjusted EPS at $3.28 per diluted share, up 11% compared to $2.96 in the prior year. Our second quarter EPS growth was driven by organic growth across multiple business units, including ClarusONE, a lower share count and incremental profit contribution from acquisitions, which more than offset the year-over-year lapping effect of increased price competition in our independent pharmacy business in fiscal 2017 and the impact of reduced reimbursement in our UK retail pharmacy business. Wrapping up our consolidated results, diluted weighted average shares outstanding were 210 million, down 8% compared to the prior-year period. Let's now turn to the segment results, which can be found on Schedule 3. Distribution Solutions segment revenues were $51.9 billion. On a constant currency basis, revenues were up 5% year-over-year. Reported revenues benefited from $344 million in favorable currency rate movements. North America pharmaceutical distribution and services revenues increased 5% in constant currency, driven by market growth and acquisitions, partially offset by brand-to-generic conversions. International pharmaceutical distribution and services revenues were $6.8 billion for the quarter. On a constant-currency basis, revenues were up 4%, driven by acquisitions and market growth. Reported revenues benefited from $237 million in favorable currency rate movements. As a reminder, our previous full-year assumption was that foreign currency exchange rate movements would have a net unfavorable impact of up to $0.05 per diluted share year-over-year. During the quarter, foreign currency rates trended favorably versus our original assumptions. As a result, we now expect foreign currency exchange rate movements will have a net favorable impact of approximately $0.10 for the year. Moving now to the Medical-Surgical business, revenues were up 2% for the second quarter, driven by market growth. Distribution Solutions adjusted gross profit was up 15% on a constant currency basis for the quarter, driven by acquisitions, organic growth across multiple business units, including strategic sourcing benefits from ClarusONE and increased branded compensation, more than offsetting the planned year-over-year lapping effect of increased competition in our independent pharmacy business in fiscal 2017 and the impact of reduced reimbursement in our UK retail pharmacy business. Following the close of the second quarter, we have now fully lapped the impact of increased competition in our independent pharmacy business, and the sell-side pricing environment continues to remain competitive with less pricing variability. Now, let me turn to branded compensation and branded pharmaceutical price increases. As noted on our first quarter earnings call, based on our previously discussed differential pricing effort, we renewed contracts with two large branded manufacturers during the first quarter. These renewals drove lower compensation in the first quarter and a resulting step-up in compensation in the second quarter. Additionally, in the second quarter, we also benefited from a pull forward of certain branded compensation that we had expected in the third quarter. That said, our expectations for the full year contribution from branded compensation remain unchanged. I'd like to remind everyone, however, as is typical based on our historical experience, that the majority of manufacturer pricing activity is expected to occur in our fiscal fourth quarter. Distribution Solutions segment adjusted operating expenses increased 18% on a constant-currency basis for the quarter. Segment operating expenses reflect an increase driven by acquisitions and the increased mix of retail business in the segment, partially offset by our ongoing cost management efforts. Going forward, we expect our full year adjusted operating expenses as a percent of revenue to be at levels roughly consistent with the first half of this year. As we diversify our Distribution Solutions businesses, our adjusted gross profit margin rate benefits from our recent retail pharmacy and technology acquisitions. Similarly, these acquisitions are increasing our adjusted operating expenses as a percent of revenue. To our adjusted operating profit, Distribution Solutions segment adjusted operating profit was up 12% in constant currency year-over-year, at $1 billion. The segment adjusted operating margin rate was 201 basis points on a constant currency basis, an increase of 13 basis points driven by the same factors as previously discussed, partially offset by our customer and product mix, including the growth of higher-priced specialty pharmaceuticals. As a result of this revenue mix and the pressures on our UK business, we now expect our full year Distribution Solutions' adjusted operating margin rate to be at the lower half of our previously guided range of 198 basis points to 208 basis points. Now, moving to Technology Solutions, as a reminder, in fiscal 2018, MTS segment revenues, adjusted gross profit and adjusted operating expenses contain only the results of our Enterprise Information Solutions business, or EIS. Revenues were $120 million, while adjusted segment gross profit was $60 million. Adjusted segment operating expenses were $44 million and adjusted operating profit, excluding the equity contribution from Change Healthcare, was $17 million. Additionally, following the close of the quarter, we completed the sale of our EIS business. As a result, there will be no contribution from this business in the second half of fiscal 2018. Going forward, MTS operating profit will represent only the equity contribution from Change Healthcare. I'll now review our balance sheet metrics. As you've heard me discuss before, each of our working capital metrics can be significantly impacted by timing, including which day of the week marks the close of a given quarter. For receivables, our days sales outstanding increased 1 day from the prior year to 27 days. Our days sales in inventory increased 2 days from the prior year to 31 days, and our days sales in payables increased 2 days from the prior year to 61 days. We ended the quarter with a cash balance of $2.6 billion, with approximately $1.9 billion held offshore. In the first six months of fiscal 2018, McKesson generated $1.3 billion in cash flow from operations. We continue to deploy capital in line with our portfolio approach. In the first six months of fiscal 2018, we spent $255 million on internal capital investments and repaid $545 million in long-term debt. In the second quarter, we repurchased $400 million in common stock. The FY 2018 EPS impact of this buyback approximately offsets the loss of EIS' earnings in the back half of this fiscal year. Share repurchases during the first six months of fiscal 2018 now totaled $650 million. We now expect our weighted average diluted shares to be approximately 211 million for the full year, reflecting share repurchases completed in fiscal 2018. We have approximately $2.1 billion remaining on our share repurchase authorization. We spent $1.9 billion on acquisitions during the first six months of fiscal 2018, which includes the second quarter acquisitions of intraFUSION, BDI Pharma, and Uniprix, all of which we discussed at Investor Day. Yesterday, the Board of Directors approved the next quarterly dividend of $0.34. Let me briefly touch on Rite Aid. Our original guidance range assumed a full year revenue contribution from Rite Aid of approximately $13 billion and an estimated annual adjusted earnings per share contribution of between $0.20 and $0.40. We also noted that should Rite Aid be acquired by Walgreens, we would expect a material one-time cash flow impact driven by the favorable working capital terms associated with our generics business. In September, Walgreens announced it had received regulatory clearance to purchase approximately 40% of Rite Aid stores and that some store transitions would begin this month and all impacted stores would be a part of Walgreens operations by the spring of 2018. We will keep you updated on the earnings and cash flow impact of the eventual store transition program during the next two quarters. While our relationship with Rite Aid will be smaller going forward, the performance of ClarusONE continues to illustrate the competitiveness of our global sourcing scale and operations. Now, let me provide more detail on our fiscal 2018 adjusted EPS outlook. We are reiterating our fiscal 2018 adjusted earnings of $11.80 to $12.50 per diluted share. This reiterated range includes the earnings headwinds of the recently completed sale of our EIS business, an estimate of the effect of the Rite Aid store transition, and our projection of the challenges expected in the UK during the remainder of FY 2018. Offsetting these headwinds, our guidance range benefits from share repurchases completed in the second quarter, the anticipated favorability to results driven by foreign currency exchange rate movements, and the new estimated adjusted tax rate of approximately 24%. The various items that I've just mentioned largely offset one another, resulting in our reiteration of the previously-guided range. Each year, as we develop our annual plan, we contemplate a range of possible outcomes. Based on our performance year-to-date, I continue to be comfortable with the midpoint represented by our full year guide. As for our quarterly progression, let me remind you of my earlier comments regarding the pull forward of branded compensation that we had originally expected in the third quarter. As in most previous years, we expect our fourth quarter to be our largest in terms of EPS contribution in the fiscal year. In closing, our second quarter results were somewhat ahead of our expectations, driven by timing. I'm pleased to reiterate our full year guide in the face of the sale of EIS, the transition of the Rite Aid stores, and UK headwinds. As a reminder, our fiscal 2018 adjusted earnings of $11.80 to $12.50 per diluted share excludes the following items: amortization of acquisition-related intangibles of $2.40 to $2.70 per diluted share, acquisition-related expenses and adjustments of $0.90 to $1.10 per diluted share, LIFO inventory-related charges of $0.20 to credits of $0.10 per diluted share, gains from antitrust legal settlements of up to $0.10 per diluted share, restructuring charges of $1.10 to $1.40 per diluted share, and other net charges of $1.40 to $1.60 per diluted share. Thank you. And with that, I will turn the call over to the operator for your questions. In the interest of time, I ask that you limit yourself to just one question and a brief follow-up to allow others an opportunity to participate. Jessica?

Great. Thanks for the question. James, lot of moving parts, but wanted to make sure I understood what was factored into the full year guidance today versus the previous update. So just, is it correct to assume that guidance now contemplates roughly an additional $30 million from additional UK reimbursement cuts that weren't in the previous guidance? And then, with the EIS divestiture or sale intra-quarter, is that about $35 million that you're absorbing into the full year range that's unchanged? Are those the two biggest new things that we should be thinking about in the full year guidance range?

Well, in terms of the three headwinds UK, EIS, and Rite Aid, I would say the figure is higher than what you were mentioning there, so we'll update you as time goes by. With EIS, as I mentioned, the EPS impact in FY 2018 of the buyback roughly offsets what we would have benefited from EIS in our back half of the year. For Rite Aid, you can think about the original guide that we put out of $0.20 to $0.40, effectively, we're going to have about a 10% effect of that in the balance of the fiscal year. So, hopefully, that helps give you a little bit of direction around that.

No, it does. I guess just ultimately trying to get a better sense that, there really was not a change to the core drug distribution outlook then, as we think about the previous update relative to this update? Is that a fair statement?

That's right, because the three items, the UK, the EIS, and Rite Aid, obviously, two of those are embedded within the Distribution Solutions business. Those are, in essence, being offset by share count, tax rate, and FX assumptions.

Okay. Great. And then just, John, a quick follow-up, two significant management departures announced this week. Can you talk about the process, as you think about backfilling, big shoes to fill, with Paul and Mark's departures announced this week?

Sure. As you might expect, the management team and the board have a very rigorous process of, not only talent development and talent review and sort of talent planning, but also a lot of work is done, particularly at the higher levels, in terms of succession planning. So, yeah, Paul and I have worked together for an awfully long time, and one of the priorities we've had together for that entire tenure together has been the development of a very strong bench. We announced very quickly a replacement for Mark Walchirk upon his departure, and we're really pleased at, not only the contribution he's made to us over his career, but the fact that he landed in an important job, and it shows that McKesson executives are sought after and that they're well-trained and that they can take on big responsibilities. So, I think that's the good part of that news for him certainly, and we're excited that we are able to replace him, in the new combined responsibility for both our U.S. Pharmaceutical business and our Specialty business, with Nick Loporcaro. You probably met Nick on occasion on our Investor Days. Nick runs our Specialty business now and will also have the combined responsibility for our U.S. Pharmaceutical business. Honestly, I think Nick is very well-suited for this job. He ran all of our Canadian distribution and operations businesses in Canada. He knows retail pharmacy well. He knows hospital pharmacy. He knows independence and chains. He understands the manufacturing environment. He certainly understands what we think is a significant going-forward opportunity in Specialty. So, we're excited about his leadership and what he can do for us. And as I said, it's not as if Paul was going to be here forever and we've always been thinking about how we are going to make sure that we are well positioned in the event that he decides to pursue retirement. So, I'm excited for Paul, excited for Mark and especially excited for Nick.

Great. Thanks for that.

Great. Thanks for taking the questions. Just to follow up on the cadence in the guidance. So James, is there any – you talked about the pull forward – I'm sorry, the step up in 2Q from the manufacturer contracts. Are there any kind of step-downs in the back half of the year that we should be aware of?

Well, I would say, as you think about the progression of Q3 and Q4 and the relative contribution of those quarter to the full year, I would see Q4 generating a number of percentage points more than Q3 will. Indeed, I commented on that, that trend pull forward into Q2 from Q3. So, I think that, hopefully, helps a little bit on the sequencing of the quarter.

Okay. That does. And then, John, you talked about moving into differential pricing. Can you comment on the progress that you've seen so far? And particularly, are you seeing any kind of pushback from clients, maybe from some of your larger ones? And maybe can you help characterize what those discussions look like? Thanks.

Thanks for the question, Charles. We have been in a consistent process with our renewals of our agreements with our customers and I think we've been quite successful. Our customer base understands that the pricing that we used 20 years ago, which were basically a brand and generic and even mostly brand if you go back that far, just doesn't work in today's environment. Having a more specific approach to pricing categories of products that are more similar to one another, we think, is better for us and, frankly, better for them as well. You're not mixing discounts between different types of products and different revenue and margin characteristics, and this provides better clarity for both of us. So, I think we've been almost universally successful in getting this accomplished, and we feel confident we will continue to do so as we finish this contract renewal cycle over the next several years.

Great. Thank you.

Yeah. Hey. Good morning and thanks for taking the questions, and if Paul is listening, I want to wish him well, John, because I know he served you a long time. I guess, James, I would ask, is there any chance that you can quantify kind of the impact of ClarusONE and the brand drug pull forward in the quarter? And should we think of the brand drug impact is not repeatable in Q3, but ClarusONE should be a more sustainable contribution? Like, I'm just trying to make sure I have a good understanding of the cadence of the balance of the year.

Yeah in terms of the branded compensation, as I mentioned, we do have these timing elements from Q1 to Q2 and Q3 into Q2, but for the overall year, we're not expecting a change in the branded comp that we would receive. In terms of ClarusONE and their work around the generics, we've been very pleased with how that has proceeded. I mentioned in my remarks that the NCI line reflects the progress that ClarusONE has been making at sourcing pharmaceuticals at lower prices than we had expected at the outset of the year. So, our COGS are benefiting, our Walmart's colleagues COGS are benefiting from the progress that ClarusONE is making.

Okay. Then maybe my follow-up would just be a little bit nuanced. Is that the outperformance in the quarter, I guess, versus consensus expectations was pretty strong. Should we think of that largely as the timing of the brand contribution versus maybe what the Street might have been expecting for the year?

Yeah, that's certainly one driver of it. Obviously, tax rates have come down as well. We've updated our full-year guide in that regard. And I did note that Q2's results were slightly ahead of where we had planned to be originally at the start of the year.

Yeah. Hi. Good morning and congrats on a very good quarter. So, two questions. First, John, for you. We're hearing, obviously, a lot of discussion and getting a lot of questions on Amazon. Can you just share with us your thoughts? And also, do you see opportunity for you guys to work together with Amazon if they were to enter the drug supply chain?

Thanks for the question, Ricky. To some extent, we were Amazon before it was cool to be Amazon. Now, if you think about our business model, largely it is an online order relationship. From an order processing perspective, it is very well functioning that has been in place for a long time, next-day delivery and a complete process from a logistics perspective. But it's also supported by field salespeople, return goods management, sometimes private trucking, and certainly things like controlled substance management, billions of dollars of inventory, and very significant back-office operations that reconcile the significant delta in various pricing strategies that our manufacturer partners, both in medical supplies as well as in pharmaceuticals, rely upon with us in partnership. I would say, in some ways, it's very similar to what Amazon would do logistically. But if you actually think about what's behind the scenes in terms of us taking credit risk, in processing invoices, processing returns and then processing pricing on a regular basis, it's quite significant and more nuanced, perhaps, than it would appear on the surface. Clearly, we are also heavily focused on trying to make sure that our customers have the right tools and capabilities to help them with all of their particularly in the independent side with all of their requirements in terms of patient relationships to make it more than just a transaction and make it a healthcare experience supported by a professional pharmacist who really understands the nuances of drug-to-drug interaction, understands what it means to dispense things like opioids and other products, and understands certainly the regulatory framework and the larger clinical issues that may be facing the patients that they're working with every day. The easiest thing to talk about in the world of wholesaling is the logistics function. But I would say that that's probably the simplest part of our business. We try to excel in myriad of other areas that we think differentiate us. Having said all of that, we don't take the entry of any competitor lightly and we continue to evolve our strategy so that our value to both the manufacturer and to our customers is unique and superior.

Okay. Thank you for that. And then, just a follow-up question in terms of the guide and the progression. So, you've tightened the range on your LIFO credits. So, what are you seeing in terms of the deflationary environment? How do you think about the progression for the second half of your fiscal year? And then also, how should we think about that in the context of your Distribution operating margin goals for the fiscal year?

In terms of generic deflation, as we've discussed before, ClarusONE is doing an excellent job. We're purchasing pharmaceuticals at lower prices than we'd expected when we first put the plan together. Now, again, as we've discussed, that equation of optimizing our cost of goods sold is quite separate to the economic equation on the sell side, where I mentioned in my prepared remarks that, suddenly, the environment is still competitive, but with less pricing volatility than we would have been looking at this time last year. In terms of our Distribution Solutions operating margin guide, I felt it was appropriate to really direct you to the lower half of that original guided range, based on the UK situation that we've been discussing at some length. And then, of course, there'll be some effect on the P&L that will impact the Distribution Solutions operating margin from Rite Aid as well as those stores transition at a yet-to-be-determined rate.

Thanks very much. I also want to add my congratulations to Paul on his retirement and we'll definitely miss him, John. First, just trying to reconcile a number of the statements that have been made today. James, you just talked about sell-side pressure continuing to be less volatile, you talked about the benefit to COGS on ClarusONE. Is the expectation, as we move throughout the rest of the fiscal year, that you have to share some of that ClarusONE savings back with customers? I'm just trying to understand how do we think about ClarusONE, specifically, as we're thinking about the cadence of the quarter?

Well, I think the best way to think about it, as James mentioned a moment ago, is really in two distinct buckets. Our ability to manage our costs across the board are an important aspect of what we do, whether it's a cost of our operations and the productivity improvements we get or whether it's the cost of the goods we purchase, driving those costs down to market levels or below should be our priority, and our focus has always been to buy right and to manage right and to be efficient. The second priority is to make sure that our customers are getting the deal that they need to continue to be competitive in the marketplace. Largely, that's determined on what the market price is for products. We have a completely separate team that decides what we're going to sell products for from what the team is that does the buying of our activity. We're focused on making sure that we have the right data on both sides of those operations to assure ourselves of market competitiveness, and that's what we're attempting to do, and that's where the margin comes from is our ability to manage those operations with, hopefully, solid execution. The more we overachieve the ClarusONE and the more stable the market can be, then more likely it is for us to get margin expansion over time to grow our business, and that should be our priority for it to create value.

Okay. That's helpful. And then secondly, John, you did mention in your prepared comments talking about the opioid issue in the U.S. and talking about these media reports. Over the last several years, the drug distributors have had several settlements around DEA issues, et cetera. Can you maybe just talk about what your anticipation is around opioids? Would you expect that there will be some cash flow impact, we'll see incremental settlements? Or do you think that that's largely behind you at this point and this is more of a regulatory issue rather than the states coming back to the drug distributors looking for some kind of settlement?

Well, in a larger context, not even speaking necessarily about this particular issue, when you're faced with litigation or litigation risk, you usually find opportunities to try to determine whether or not there's any real risk there or any data that would support the alleged activity or risk that you may be facing. You trade that off against what it would cost for us to not eliminate that risk and the associated potential liability if you're not successful. I think all of those decisions are made on their own and probably in isolation from one another. Are we concerned about opioid and the continued risk and things that are going on in the marketplace? Certainly, but we're probably more focused – as I tried to mention in my conversation at the beginning here, we're more focused on solutions that we think can make a difference. Frankly, lawsuits from various parties and settlements don't solve the problem. What solves the problem is thinking in a broader context and putting solutions in place that can actually prevent this from happening. When I mentioned physicians at the start of this, it really is related to how they think about the prescriptions they're providing to their patients and the quantities that they're writing in those scripts. Clearly, whether the script is legitimate or not when it shows up at the pharmacy, if we use electronic prescribing, that can make a difference. If we have information about the patient real-time in the workflow at the pharmacy when they're doing the rest of their adjudication of the claim if they understood that the patient recently had four other scripts filled in the last two weeks from five different pharmacies across state lines, it might give them a little bit of a pause before they yet fill one more script. This is a much larger problem. We're trying to focus on solutions. Some people ask me if this is going to be a tobacco overhang, and I don't think that's what we're going to face as an industry. Clearly, we have a role to play, but we don't see the patient, we don't prescribe the drugs, we don't dispense the drugs, we don't have all the data on the care, and I don't know how we can be responsible solely for this challenge.

I agree. I appreciate your comments.

Hey. Thanks for taking my call. So, another question on ClarusONE. Looking at the non-controlling interest line, it was sort of flat sequentially and for the year, your guidance implies not a significant amount of growth in that number over the course of the year. I guess my question is, is ClarusONE a growth opportunity sort of going forward, or are we sort of peaking? Is it something that can grow as we get into fiscal 2019?

Well, I think when we talk about ClarusONE, it's important to think about the two places on our P&L where it drives the benefit. So, the first place is the cost of goods sold.

And maybe I can jump in there, because the NCI is really not an indication of ClarusONE's opportunity and its growth. It is an accounting-related matter that James will address here in just a moment. But we see a great opportunity with ClarusONE, frankly. Today, it's focused primarily on generics. As James mentioned, we actually overachieved our objectives, in terms of the results of our sourcing activity, and it's being reflected in our cost of goods. Obviously, we're pleased with that. But beyond just generics, and beyond just generics in the U.S., we think ClarusONE can grow. Walmart is very satisfied with what we've done thus far, and our ability to expand into other product categories and other geographies in partnership with Walmart, we think, will be continued opportunities for us to grow the ClarusONE relationship and thus, the impact on ClarusONE's cost of goods into our businesses and other categories. That may or may not affect the NCI line. The NCI is really an artifact of the current construct of the generic relationships we have and the joint venture partnership we have. It's an output, basically, from that relationship, as opposed to something else that will be put into this category, OTCs or something else, may not have an NCI component to them.

So, think of the cost of goods sold line as the line that receives the primary benefit from the work of ClarusONE. Then the NCI line is, as I mentioned in my prepared remarks, it's fee income. So, think of that as the fees earned by ClarusONE, which is a contracting entity, in many ways. And so again, in the text, I mentioned that the future guide for the NCI line is really underpinned by the fact that, as ClarusONE continues to have more success than we originally planned for in its sourcing capabilities, then there'd be a lesser level of fee income enjoyed by ClarusONE. That's an important distinction to make between COGS and the NCI line, and then focusing on the NCI line as fee income from a contracting outfit.

That's incredibly helpful. One just quick follow-up. You spent about $1.9 billion in acquisitions. You've highlighted them to us already. Is there any potential impact from these acquisitions in the second half of this year, or will the benefits be mostly a fiscal 2019 type of event?

I think it's most likely going to fall into FY 2019. We contemplated the closure of some of these acquisitions as we provided the original guidance, and we knew that certain of these transactions were going to close. But I don't think they'll have any material impact on our FY 2018 guidance. Whatever impact we do anticipate is embedded in our reaffirmation of that guidance today.

Great. Thanks. A follow-up to the last question, I guess, can you give us an update on the performance and where we stand with some of the potential synergies and contributions from some of the recent acquisitions, like CoverMyMeds and Rexall and Biologics? Could you also speak to maybe the profit profile of some of the more recent acquisitions that you've done? Thanks.

I'd say that our approach to the integrations of those various transactions that you note are going along nicely. We're hitting our synergy cases and so forth. So no, we're pleased. We feel as though those acquisitions fit very nicely with the strategies that we're pursuing across our organization. So, in terms of the margin profile, as I say, that was going to follow more aligned with the kind of businesses that they are. So, the distribution-related businesses will have more of a distribution margin and the technology businesses, like CoverMyMeds, will have a margin rate that's much higher and much similar to the rest.

And one further thing that I would note, going back to how we were talking about operating expenditure for the full year, multiple of those transactions, those acquisitions fall into either the retail arena or the technology arena. In those types of businesses, you tend to have more operating expenditures as a percent of revenue than would be the norm for our traditional business. It's probably difficult to speculate on what the annual deal spent would be. I think what's best for us to sort of reaffirm here is that we do prefer M&A. But as you know, we do this in a portfolio way. We're not afraid to do share repurchases. We talked about our share repurchases in the quarter, and we clearly talked about our dividend again in this press release, and we talked about M&A. The critical thing, from my perspective, is that the M&A has to make financial sense. We focus on our long-term cost of capital and making sure that these acquisitions come in well above our cost of capital and that we get the kind of returns that are appropriate on these investments. The other part of your question, we do have a pipeline of acquisitions that we actively work on almost seemingly all the time. Sometimes they come to be and sometimes they don't for various reasons, but I think we're pleased there are still opportunities for us in various markets.

Oh, boy, I get to be last. That's better than nothing. So, thank you for squeezing me in. I'm sorry that was – I didn't mean that to be serious. Just one thing in our model that there seems to be a big sequential drop in depreciation from the second quarter. So, the EBIT number was better, but the EBITDA number was a little below our number. Can you provide some help on that number? Is this the new normal given some of the portfolio changes that you've made?

Well, perhaps, one thing to note is that as we proceeded to be close to the sale of EIS to Allscripts, that transaction closed on the first day of Q3. But in terms of the way our accounting runs, we put it as held-for-sale in Q2. So, that might be one of the items that you'd want to focus on.

But I mean – so you are running about, what, $27 million or something in depreciation in the third – it was like a $70 million drop. I'm just asking on a go-forward basis, is this the right depreciation number for the back half of the year?

I wouldn't expect anything material in terms of the rate and pace of change in depreciation. But we can certainly follow up with you on the specifics.

Alright. Thanks, John, and...

Thank you, John. I have a preview of upcoming events for the financial community. On November 7, we will present at the Credit Suisse Healthcare Conference in Scottsdale, Arizona. On December 5, we'll present at the Global Mizuho Investor Conference in New York City. On December 6, we will present at the Citi 2017 Global Healthcare Conference in New York City. And on January 9th, we will present at the JPMorgan Healthcare Conference in San Francisco. We will release third quarter earnings in late July. Thank you and goodbye.