McKesson Corporation (MCK) Q2 2012 Earnings Report, Transcript and Summary

Good afternoon, and welcome to the McKesson Corporation Quarterly Earnings Call. [Operator Instructions] Today's call is being recorded. If you have any objections, you may disconnect at this time. I would now like to introduce Ms. Ana Schrank, Vice President of Investor Relations. Please go ahead.

Thank you, Rebecca. Good afternoon, and welcome to the McKesson Fiscal 2012 Second Quarter Earnings Call. With me today are John Hammergren, McKesson's Chairman and CEO; and Jeff Campbell, our CFO. John will first provide a business update, and we'll then introduce Jeff who will review the financial results for the quarter. After Jeff's comments, we'll open the call for your questions. We plan to end the call promptly after 1 hour at 6:00 p.m. Eastern Time. Before we begin, I 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 which we exclude from our GAAP financial results acquisition-related expenses, amortization of acquisition-related intangible assets and certain litigation reserve adjustments. We believe these non-GAAP measures will provide useful information for investors. Please refer to our press release announcing second quarter fiscal 2012 results available on our website for a reconciliation of the non-GAAP performance measures to the GAAP financial results. Thanks, and here is John Hammergren.

Thanks, Ana, and thanks, everyone, for joining us on our call. I'm pleased with the continued momentum in our business. For our second quarter, we achieved total company revenues of $30.2 billion and adjusted earnings per diluted share of $1.63. This performance is a result of strong contributions from both Technology Solutions and Distribution Solutions and was helped by our acquisition of US Oncology. Based on the momentum from our first half results, we are now raising our previous outlook for the fiscal year and now expect adjusted earnings between $6.19 and $6.39 per diluted share for the fiscal year ending March 31, 2012. Before I turn the call over to Jeff for a detailed review of our financial results, I will provide some highlights from both segments of our business. In Distribution Solutions, we were particularly pleased to see steady demand across all of our pharmaceutical and Medical-Surgical distribution businesses. We know that there are concerns in the industry about utilization trends, but we've seen healthy demand in our diverse set of distribution businesses. In addition to strong revenue growth, Distribution Solutions' operating margins expanded 19 basis points with U.S. Pharmaceutical, Canada, Medical-Surgical and Specialty Health all contributing to that outstanding performance. Our U.S. Pharmaceutical Distribution business continues to perform in an exceptionally high level. Again this quarter, the U.S. Pharmaceutical team did a great job controlling costs, resulting in a relatively flat expense for the quarter, which contributed nicely to the segment's operating margin expansion. We continue to benefit from our long-standing relationships with branded manufacturers, delivering great value to them and earning steady levels of compensation in return. Overall, U.S. Pharmaceutical is right on target for the year. I'm extremely pleased with the results of our Specialty Health business, which includes the operations of US Oncology. We…

Well, thanks, John, and good afternoon, everyone. McKesson posted another quarter of strong financial results with both segments contributing to our performance. Great execution is driving our operating results, and we retain the financial flexibility to create shareholder value over the long term. Let me briefly mention one item that impacted our financial statements this quarter, specifically the $118 million AWP litigation charge. This charge was based on 2 primary factors. First, McKesson has now reached an agreement to settle the public entity claims brought by a nationwide class of cities and counties for $82 million. This settlement agreement in a case we refer to as Douglas County, Kansas included an express denial of any liability on the part of the company. As a result of this settlement and progress made toward potentially resolving other public entity claims, the existing litigation reserve of $324 million has been increased by $118 million, bringing the total reserve for AWP public entity claims to $442 million. This $118 million pretax, noncash charge has been recorded in the Distribution Solutions segment, and it equates to $0.31 per diluted share. My comments today will focus on our $1.63 adjusted earnings per share, which, as you'll recall, excludes 3 items: acquisition-related expenses, amortization of acquisition-related intangibles and any litigation reserve adjustments, including the charge I just reviewed. The numbers I'll review in my discussion can be found on Schedules 2 and 3, included in today's press release. I'll begin with our consolidated results for the quarter, which can be found on Schedule 2A. Total revenues grew 10% for the quarter to $30.2 billion. Excluding the impact of the US Oncology acquisition that we completed last December, total revenues increased 7% for the quarter versus the prior year with both segments growing at very robust rates. Total…

[Operator Instructions] Your first question will come from Steven Valiquette from UBS.

And on the -- this trend of "less generic deflation than normal" had been a tailwind for you guys in the first half of calendar '11. I'm just curious. Just given the strength in the distribution profits for this quarter, just want to get a sense for how much that might have helped you guys in the upside from this reported quarter as well.

Well, Steve, as you'll recall, our guidance for the full year is based on both the branded and the generic side, seeing price trends continue the pretty favorable levels that they were at in our prior fiscal year. Now we're only 6 months into the year, so it's too early to make a call for the full year. But I would tell you that those first 6 months on both the branded and generic side are certainly consistent with the levels we experienced for the full year last year and consistent with our assumptions. So that does help us as we look at the results from the first half of the year.

Next, we'll go to Tom Gallucci with Lazard.

Just wondering, where were you in the first half, and I guess the second quarter as well, relative to your own internal expectations? And I was wondering if you could just maybe explain the 5-day issue in the med-surg business.

Well, I'd say, Tom, as we look at the first half of the year and, more importantly, as we look at the components of what drives our earnings, we're a little bit ahead of where we thought we'd be at this time of the year, year-to-date, and we're confident that the momentum will continue. And that's why since we started the year, you've now seen us come up about $0.20 on the guidance. In terms of med-surg, when -- this really goes back -- well, I guess we acquired the company back in the 90s, and they just have a convention and a set of systems and an operational process that is based on what's known as a 445 close process in about every 5 years or so to keep them relatively in sync with the rest of the company. We have a quarter where they get these 5 extra days.

I guess 2006 was a long time ago. So we probably all forgot about that. I appreciate it.

I -- that's fair.

Next we'll hear from Glen Santangelo with Credit Suisse. Glen J. Santangelo - Crédit Suisse AG, Research Division: Oh, yes, I just wanted to ask about the timing of the price increases on the branded side. If I remember back to 4Q '11, the company had a very unusually strong operating margin in Distribution. And I think one of the reasons was that you got paid for some of those branded price increases. They got pulled forward into fiscal '11 and maybe that somewhat explained the pretty large drop-off in op margin into the first quarter of fiscal '12. And now, all of a sudden, the margin has kind of ramped back up pretty significantly. Is there something about the timing of when you're getting paid for these branded price increases that's impacting the quarterly fluctuations the way it is?

Well, I think historically, Glen, it's always impacted our progression from a margin perspective, and that's why it's difficult for us to comment specifically about quarterly performance. We're pretty good about the year, but we can't control certain aspects to our business model directly and we certainly can't control the timing of -- the timing or magnitude of price increases or decreases in the case of the generic products. So I think that we try to spell those out for you at the beginning of the year when we give you guidance in terms of what our assumptions are. Clearly, people might have different assumptions than ours. And we know the progression is going to be uncertain, and that's, I guess, the fact.

From Barclays Capital, we'll hear from Larry Marsh.

So John, just looking back, another topic. I can't think in your tenure, your 11th year of being CEO, where -- you or McKesson lost a single super-sized contract. You've certainly won some. And so, obviously, VA's coming up. I know you've said it's hard to handicap. But I guess clearly, be a big disappointment given your relationship. And I guess just to make sure we're thinking the same way, if you were to lose it, would you anticipate giving some size to the impact of fiscal '13 given the turmoil we saw in the market last time? And I think, Jeff, you've talked about sort of the economic impact as really on a gross basis. So we should really think of it as closer to $6 billion even though it's $4 billion net?

Well, I think, Larry, clearly, thank you for the acknowledgment about our performance with our major customers over the last 11 years. We have a great team and we deliver superior performance for our customers on almost every dimension, and we're pleased with the retention rate. I would point out, though, that this industry has typically not turned over a lot of big customers. The business is stickier than some people may realize, and incumbent relationships clearly are important and there's a cost to switching. So it is a good business, and it's a good business for McKesson. As it relates to specific comments related to the VA, we have talked in the past about how this is a unique contract by the character under which the government negotiates with branded pharmaceutical manufacturers and the type of service we deliver to them, and it's not fair to probably compare them on a revenue basis to other customers of similar size because of some of these dynamics. I think it's probably premature for us to speculate what the loss of this customer would mean to us financially and what offsets we might be able to find. And clearly, it's not a fiscal '12 issue. It would be a fiscal '13 issue, as you point out, and we would have some time before we arrive in fiscal '13 to build that into whatever outlook we're going to give you for fiscal '13 if that circumstance were to arise. And it's also difficult to comment or speculate about how our last 8 years of superior performance for them would weigh into their consideration relative to making an award decision. They clearly set out a set of criteria in their request for proposals, and we responded. And we certainly would like to believe that our incumbent performance would matter to them and there would be some value given to the cost to switch. However, we can't control any of those decisions. All we can do is provide great performance on the metrics that we do have control over and hope that they're valued by any customer at any time they're making a decision to either stay or go. So I wish I could be more specific about it or more optimistic or pessimistic. You should take this as a completely neutral comment. I really don't know how to handicap this one.

Right. Still thinking by the end of the year? I know they said at least early January.

Yes, and we don't control it either, Larry. As you know, we certainly would -- and if it follows last or the last pattern, it would be sometime before the end of the year, and it could come this -- anytime. But we're -- we've given them all the information they need to make their decision and it's in their hands.

Our next question will come from Robert Jones with Goldman Sachs.

Just looking at the back half guidance and some of the color you gave around 4Q, it looks like 3Q will actually be quite a bit lower than 2Q and lower than our expectations. Just thinking about that against some of the key generic launches that we should see in your fiscal 3Q, I was hoping maybe you could just help us reconcile maybe why 3Q would be below 2Q and obviously below 4Q.

Yes, it's really a function of about 3 things. First off, just the timing this year, as we sit here in October, of when the branded manufacturer compensation is coming to us will mean a significant sequential decline in the December quarter, and then January is generally the biggest quarter. So that's the first driver. The second thing is while you're correct that certainly, Lipitor launching November 30 will help, that's only 1 month of their quarter. It'll be much more important than the March quarter. And on the Specialty generics side, sequentially you have a couple of important drugs that will be entering a little less profitable part of their lifespan. And so that'll be a sequential drop from September to December. And third, as we just look at the way the implementation schedule has worked out in our hospital software business, we'd expect the December quarter to be down a little bit sequentially and then the March quarter to pop back up. You also had a -- in our payer-facing technology business, a pretty sizable disease management contract that we were winding up with the State of Illinois. We had expected to see that sequentially or fairly steadily recognized throughout the year, but we reached settlement with them, which pulled essentially the whole year into the September quarter. So that's the last component of why the sequential drop that you're describing is nothing to be concerned about. It's just sort of the way that the timing of these couple of issues has worked out this fiscal year.

That's helpful. And then, Jeff, just one more on the back half. You mentioned the Lipitor. Obviously, there's been some speculation around different PBM strategies around Lipitor. I was wondering if you could provide some insight to how you guys are thinking about the generic launch of Lipitor today. And is there any reason for concern around your expectations for generic penetration relative to a typical generic launch?

Obviously, it is a big drug, and there's a lot of work being done on many parties' [ph] parts to make sure that this is handled properly. I think the view we had at the beginning of the fiscal year is still the view that we have today, and I would say that the economics we believed at that time that would fall to McKesson continue to be the economics we believed way back when we gave guidance for the fiscal year. So clearly, there's a little bit of noise in the channel around various alternatives that people might be pursuing. But as it relates to at least our business, I think we're still pretty confident that it'll fall, like we believed that it would.

We'll go to George Hill from Citi.

A lot my basic ones have been answered. John, could you maybe talk a little bit on the -- talk a bit about on the HCIT side? You guys started to see some pull-through with respect to the clinical functionality, and McKesson has a pretty large footprint with respect to financial tools. Has the company had any conversations in hospitals yet about the need for ICD-10 upgrades? And can you talk about what that opportunity can look like?

Well, I think everybody's concerned about ICD-10 upgrades, and I think we have an action plan with almost all of our -- in fact, all of our customers. We've had a discussion with them, and most of them are already building the implementation plans to make sure their products are ICD-10 compliant and ready. And it goes to the payer business as well and not just the hospital business. So it's a pretty significant change for our industry. It's consuming a whole bunch of resource when there's not a lot of resource available. But we would expect that not only will all of our products be ICD-10 compliant and ready, but our customers will hopefully be ready as well, and that's what we're working on. So that's part of the momentum we see in the business also.

Next we'll hear from Lisa Gill with JPMorgan. Lisa C Gill - JP Morgan Chase & Co, Research Division: I just had a couple of follow-up questions. Jeff, on Lipitor, when you contemplated Lipitor in your guidance last year, were you expecting that Ranbaxy was going to launch? Or were you always anticipating that there potentially would only be one manufacturer? How should we think about that?

Well, when we -- as a reminder, Lisa, what we said is our basic assumption was the November launch with 2 players. We weren't speculating on who those players might be or how they get to market. That remains our assumption. Certainly, there's an almost infinite number of scenarios that are out there. But I think we feel confident within the kind of guidance range we've given you for the year. As we look at the landscape right now, we're pretty comfortable with our assumptions and what's built into our forecast.

And I'll also say, Lisa, I think it's also important to know that these are -- this is a big product, but we also have a portfolio of margin that comes in not only from generics but also from branded companies. And if our speculation on Lipitor happened to be slightly off one direction or the other, I'm not sure that it would have a significant impact on our company, particularly with the fact that this is mostly an FY '13 opportunity for McKesson given that it falls late in our fiscal year. So I don't -- we're not particularly stressed by the various speculation that's out there and what it might do. Now clearly, they can be significantly different than what we think. Lisa C Gill - JP Morgan Chase & Co, Research Division: And then just one other thing. I know, Jeff, you normally don't like to give quarterly guidance. But based on the fact that we know now 2 quarters and you've given us some indication on the fourth quarter, just coming back to the third quarter if I do the math around the range, you're in essence saying that it would be flat year-over-year. Is there anything specific to this quarter or perhaps maybe some of the price increases that you saw on branded inflation where they pulled forward? Is there something that got pulled forward from the third quarter to the second quarter? How should we think about that?

Yes, there's about 4 components that explain the sequential move down from the September quarter. One is just the pattern this year of the -- when branded price increases are coming in. Second, on the Specialty generic side, you actually have a couple of large drugs that are entering the less profitable part of their life cycle in the December quarter. Third, you had a large disease management contract in our payer-facing business with the State of Illinois that we settled completely and, therefore, had a large drop to the bottom line in the September quarter. But that was something we had expected to see in the back half of the year. And then last, just the way that the implementations are playing out in our MPT or hospital-facing business, the December quarter will be the weakest quarter of the year and then March will pop back up. So those are really things, none of which has anything to do with the fundamental outlook for the year. It's just the way the timing has evolved.

From Deutsche Bank, we'll go to Ross Muken.

So as we look at the balance sheet, I mean, you've obviously amassed a pretty big cash hoard here. And certainly, you guys have been excellent historically on the capital deployment side. I mean, as you think about sort of where -- how you're prioritizing kind of uses of capital at this point given, one, where the stock is trading and, two, sort of the M&A environment, which should kind of come into your favor with the market multiple and valuations pulling in, how are you thinking about deployment? And how do you see multiples from the M&A standpoint kind of come into that degree? Or do you still see some parts where things are fairly frothy?

Well, I think it's a good question, Ross. We have a -- we do have a significant opportunity in front of us to more deploy our balance sheet in a way that delivers incremental value for all of our shareholders. And I would imagine, consistent with our past practice, we will continue to take a portfolio approach, which includes clearly share repurchases that we talked about this quarter, and continue the acquisitions and, of course, our dividend policy at this point. So I don't think it'll be a change from what we've done before. We'll be -- you can control share repurchases -- purchases and dividends. In some respects, acquisitions kind of follow their own course, and opportunities come and go depending on value, as you point out, and multiples of frothiness, but also in terms of willing sellers and our view of our team's ability to get the appropriate synergies and value out of any transaction. So it's a multi-pronged approach when you analyze acquisitions. And I think we still believe there are targets out there for us to continue to follow. And as you mentioned, if multiples contract, it makes those targets even more interesting to us. So I think it'll be more of what you've seen.

And just quickly on -- from a size basis, if we were to see something more sizable, say, north of $500 million, would you assume that would be more likely to occur in the traditional Distribution business or in the Technology business where you've been doing more tuck-ins?

No, I don't want you to misread this comment. I don't think we necessarily look at it based on our business segments. We look at it based on the myriad of factors we evaluate any acquisition on. Is it a business we know and understand? Does it strategically position us in a better place? Is the price reasonable from a financial perspective? How much dependence do we have on synergies? How much of those synergies are we giving back to the seller? And can we deliver value? Is it going to have the right characteristics, providing returns above our cost of capital, obviously. And the returns, frankly, over time, that should be far superior to a share repurchase, which is more simple to execute. So I think we look at it on that composite way. Having said all of that, most acquisitions in the technology space, particularly like hospital software companies, at $500 million or above would carry a multiple that would immediately stop us from going down that path. Having said that, I'm not sure that those multiples will hold after this buy cycle is done and people begin to look at other opportunities to spend their money. We think McKesson is very well positioned with our portfolio of technology companies to take advantage of the buying that will continue, like connectivity and transaction process and the kinds of things that are core to our business. And perhaps those companies that are dependent on single applications where the buying cycle may be less predictive -- predictable, those valuations could soften, so.

Next question comes from Ricky Goldwasser with Morgan Stanley.

I have a couple of follow-up questions. First of all, Jeff, on State of Illinois, can you quantify database management payments because I might have missed it?

I don't think we gave a precise number, but I suppose the way I would think about it is this is revenue that pretty much drops straight to the bottom line and it added a couple of pennies to our earnings this quarter. And we thought instead what it would be doing would be adding a little less than $0.01 throughout each of the quarters of the rest of the year.

And then, John, you mentioned before that Lipitor contribution is going to be more significant for you in fiscal year '13. I mean, fiscal year '12 has 4 months of exclusivity versus 2 in fiscal year '13. So should we interpret your comment as Lipitor during multisource period being just more profitable for you than a usual, multisource-type drug?

I think it's difficult to predict at any one drug what its profitability might be in one period versus another. I think we just look at it in a simple way than this. We're going to have more months in fiscal '13 to sell a product. It'll be in our plan -- in our business for a full year as opposed to only a partial year. And Lipitor is not the only drug, obviously, that's going to go through this cycle. So fiscal '13, frankly, will be a better year on generics because of that cycle, at least our fiscal '13. So each one of our companies in our sector have different fiscal years, and you're going to get different views on the product based on perhaps a person's view of the fiscal years. But that was it -- I was not trying to make a call on its profitability past exclusivity.

Okay. And then just the last one is on the contribution from the new client win in the quarter that you mentioned in the prepared remarks. Can you just clarify to us? I mean, you've had phenomenal growth on the top line for drug distribution especially in light of the utilization environment. So when we think about that growth, like what percent came from that new client win in the quarter? And then should I think about the remaining of the growth really coming from just that branded price inflation that was stronger in the quarter? Is that a good way to think about it?

Well, I guess, Ricky, what I would say is the warehouse revenues would have been pretty flat year-over-year without the new customer. On the direct revenues side, the -- it's really just strong performance across all customer segments, and new business did not play the material role that it did play on the warehouse side.

We'll go to Eric Coldwell from Robert W. Baird. Eric W. Coldwell - Robert W. Baird & Co. Incorporated, Research Division: Kind of a complex question, but I'm looking at some of the details you provided on OpEx and stripping out US Oncology and the selling day comparisons. A quick message is that OpEx in total is growing at about half the rate of, of course, same-day revenue. And I guess the question here is, is that leverage, that favorable trend, is that something that's sustainable? Or are you perhaps getting some additional benefit in the near term because of the strengths in branded and generic pricing, timing pull-forward, the sweet spot on some generics, et cetera? I guess what I'm trying to think of overall is OpEx as a percent of revenue on same-store, same-day basis and how much room we have left there.

Well, clearly, our expectation is that our business will continue to drive efficiencies and that we should be able to grow OpEx slower than we grow revenues. Okay? Clearly, there's a crossover point. Particularly, if you think about the business less from a revenue perspective but from a gross margin or gross profit dollar growth perspective, that leverage should be retained. And as you think about the generic wave, our revenues may come under some pressure, but our gross profits shouldn't. And if we can keep growing our gross profits at or above the rates of our expenses, then we're going to get a very positive lift right to the bottom line. So that's the model. There's nothing in the model that should be changing going forward. And clearly, to the extent that there's inflation that's added into the model and it's something you don't have to add expense against, then that's certainly a helpful force. But I don't think the efficiency we've gained at McKesson is over yet. Eric W. Coldwell - Robert W. Baird & Co. Incorporated, Research Division: Yes, that's great. I guess really, what I'm trying to drive to is that you've just done a really phenomenal job on this, and I want to make sure that we're not so hung up on generics, timing and pricing and specific drugs coming to the market that we lose sight of maybe future investments that might be needed in the core distribution platform, and whether we should be thinking about any future repositionings or growth in the distribution network, for example, things of that sort, especially given the strong top line growth you have.

Well, I think we believe strongly that our model for 178 years is for us to deploy capital smartly in our distribution network to keep it contemporary and efficient. But we don't typically go to massive re-works to try to catch up with the productivity issues we haven't addressed. And so every year, we're investing in our capabilities and sequentially going through our network to make sure that its world class. And I think you'll see that continue. And we want to stay ahead of the expense pressures by producing leverage in our business through productivity and Six Sigma and Lean and lots of other things we think we have done a great job of rolling out. And those opportunities to reduce variability in our operation and to improve our efficiency have by no means been exhausted. And Paul Julian and the team and all of our distribution businesses have been, I think, really focusing on continuing the string of 11 years of investing in our business with the people and the systems to improve our results. Eric W. Coldwell - Robert W. Baird & Co. Incorporated, Research Division: That's great.

And we have time for one final question, and that'll come from A.J. Rice with Susquehanna Financial Group.

Just asking, obviously, about the trends in the medical-surg business. I guess even if you x out the 5 percentage point benefit from the 5 days, you've seen a sequential increase there. Can you comment on sort of the underlying, what you're seeing medical utilization-wise and whether we're seeing some stabilization to pickup there? And I think there was a comment about flu vaccine, that you've seen some early shipments there. What is your expectation for flu vaccine this year versus last year and timing versus the next 2 quarters?

Well, I think our Medical-Surgical business continues to perform well. I think that we have had some positive flu this year, but I would say that it's not really an abnormal flu season. Our strength really has been across the board in our med-surg business. Brian Tyler was the President of that business until we brought him back to San Francisco to lead our Pharmaceutical distribution business. And Brian and the team at med-surg really built momentum around the products and solutions that we bring to our customers. And their -- that business is an example where I believe we are gaining incremental momentum in the marketplace and growing faster than the market because our solution set with our customers is more attractive. In particular, our long-term care business has been growing very nicely there. Our home care business. And even in the physician business, we have not seen the softness in utilization that some people have been concerned about. And perhaps it's because we're growing our penetration of our existing customers, particularly with things like McKesson brand, which carry significant operating opportunity for us to improve our margins and provide a better product at a better price to our customers. So almost without exception, as you dig under the covers of that business, we've performed well there, and I think we got a good team with the right strategy. I want to thank you, operator, and all of you on the call today for your time. We've had a very solid first half, and I'm excited about the opportunities that lie ahead. I'm now going to hand the call over to Ana to talk about our upcoming events for the financial community. Ana?

Thanks, John. I have a preview of upcoming events. On November 10, we'll present at the Credit Suisse healthcare conference in Phoenix. On November 16, we'll present at the Lazard Capital Markets Healthcare Conference in New York. On January 9, we'll present at the J.P. Morgan healthcare conference in San Francisco. We will release third quarter earnings results in late January. We look forward to seeing you at one of these upcoming events. Thanks, and goodbye.

Thank you for joining today's conference call. You may now disconnect. Have a good day.