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McKesson (NYSE:MCK)

Q3 2013 Earnings Call

January 31, 2013 5:00 pm ET

Executives

Erin Lampert

John H. Hammergren - Chairman, Chief Executive Officer and President

Jeffrey C. Campbell - Chief Financial Officer and Executive Vice President

Analysts

Lisa C. Gill - JP Morgan Chase & Co, Research Division

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

Steven Valiquette - UBS Investment Bank, Research Division

Eric W. Coldwell - Robert W. Baird & Co. Incorporated, Research Division

Robert P. Jones - Goldman Sachs Group Inc., Research Division

George Hill - Citigroup Inc, Research Division

Robert M. Willoughby - BofA Merrill Lynch, Research Division

Ricky Goldwasser - Morgan Stanley, Research Division

Charles Rhyee - Cowen and Company, LLC, Research Division

David Larsen - Leerink Swann LLC, Research Division

Glen J. Santangelo - Crédit Suisse AG, Research Division

Ross Muken - ISI Group Inc., Research Division

Operator

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. Erin Lampert.

Erin Lampert

Thank you, Amber. Good afternoon, and welcome to the McKesson Fiscal 2013 Third 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 will then introduce Jeff, who will review the financial results for the quarter. After Jeff's comments, we will open the call for your questions. We plan to end the call promptly after one 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 federal securities law. 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 expenses and related adjustments, 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 third quarter fiscal 2013 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.

John H. Hammergren

Thanks, Erin, and thanks, everyone, for joining us on our call. Today we reported third quarter results with total company revenues of $31.2 billion and adjusted earnings per diluted share of $1.41.

Distribution Solutions continues to turn in solid results, and our view of the full year operating performance of the business has improved from our original expectations. However, third quarter financial results in the Distribution Solutions segment were impacted by a $40 million pretax charge related to a legal dispute in our Canadian business.

In our Technology Solutions segment, again our primary businesses performed well in the third quarter, and our view of their full year operating performance remains unchanged. Third quarter results and our view for the full year are impacted by revenue deferral on certain products in our international business. So overall for the full year, our improved outlook of the operating performance and Distribution Solutions allows us to offset the revenue deferral in our international technology business and much of the charge in our Canadian business. As a result, we are updating our outlook for the fiscal year and now expect to achieve adjusted earnings per diluted share of $7.10 to $7.30 for fiscal 2013.

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. Within our Distribution Solutions segment, our U.S. pharmaceutical business led the way with solid operating results for the quarter.

We continue to benefit from our strong and long-standing relationships with brand manufacturers, where we deliver a broad range of value-added services and remain a valued supply chain partner. We also continue to benefit from the growth in generic pharmaceuticals. In calendar 2012, we saw the largest number of generic launches the industry has seen to date, and we are pleased to deliver great value to our generics customers with the breadth of our portfolio, our supply chain expertise and our high service levels. Compared to calendar 2012, calendar 2013 stands out for the particularly low number of expected generic launches for the year. And we have talked publicly about the challenge that creates for our U.S. pharmaceutical business in our fiscal 2014. That said, we also view the opportunities in our generics business in the following years quite favorably. So we remain excited about the future of this business and our opportunity to continue to bring innovative services, technology and products to support the future growth in generics.

Turning to our results in Canada. Our Canadian distribution business had solid revenue and gross profit growth in the core operations of the business in the third quarter. We are approaching the 1 year anniversary of our acquisition of the Katz Banner business, and as I've mentioned in previous quarters, we remain very pleased with this acquisition. We continue to see good growth in the number of independent pharmacies operating within the acquired Katz Banner business, and we use trade names like Drug Trading and the Medicine Shoppe Canada to grow our business.

McKesson Canada has a long history of supporting independent pharmacy through our banner offering. We have a strong track record of improving the efficiency of store operations and providing great value for our banner members who also benefit from the focused leadership team in McKesson Canada dedicated to developing and delivering services tailored to the needs of the independent pharmacy.

We continue to see tremendous momentum in our Medical-Surgical business as we benefit from the growth in our alternate site markets and our ability to win new customers and certainly from the contribution from tuck-in acquisitions. Our McKesson Medical-Surgical customers from the small physician practice to larger groups of physicians practicing as part of an integrated delivery network see increasing value in working with a partner who understands the unique requirements and challenges of the physician business.

With respect to the acquisition of PSS World Medical, we were pleased to receive notification of early termination of the waiting period under the Hart-Scott-Rodino Act at the end of the third quarter. This was an important step in the process of completing our acquisition of PSS. I've had the opportunity to spend time with key members of both our Medical-Surgical team and the PSS team. They're all excited about the opportunities they see to combine the best of both businesses and bring increased valued to our physician and extended care customers. We expect to close the acquisition during our fourth quarter, and I'm looking forward to welcoming the PSS team members into McKesson.

In summary, I'm pleased with the operating performance in our Distribution Solutions segment for the third quarter, and I'm confident in our improved outlook for our full year operating performance.

Turning now to Technology Solutions. For the third quarter, revenues were flat, and adjusted operating margins were 11.9%. As I mentioned in my opening remarks, Q3 results were impacted by revenue deferral on certain products in our international business. For those of you who may not be familiar with our international business, let me take a moment to give you a brief overview. Our international technology business offers workforce and healthcare system solutions primarily in the United Kingdom. Our workforce solutions help the National Health Service recognize the full benefits of their electronic staff records as a strategic workforce management system. And our healthcare solutions deliver a range of technology products to hospitals, surgery centers and clinics throughout the United Kingdom.

In fiscal 2012, we acquired a software provider in the U.K. called System C. System C brings updated systems to our acute care customer base, and we've been pleased with the customer response to our expanded offering and the resulting bookings experienced in the business. As we enhanced our products to address the evolving needs of the market and as we work with our customers on the pace of implementations, we have determined it is appropriate to defer revenue on certain products to future periods. This decision impacts our outlook for the rest of the year, which Jeff will discuss in further detail in his remarks.

Moving on to the rest of our Technology Solutions segment. Our RelayHealth business and our payer software business, which combined to contribute just over 50% of the operating profits of the segment, continue to perform well and deliver steady growth. Customers are increasingly seeking the technology in our RelayHealth business as they look to establish clinical and financial connections between healthcare providers in the community. RelayHealth is an important partner, delivering innovative solutions to efficiently manage revenue cycle. And we also help providers better engage patients in their care and collaborate with the patient's other providers regardless of their technology infrastructure.

For our payer customers, healthcare reform has created an intense focus on reducing administrative waste and finding new ways to work with providers to become more connected and, in some cases, to share risk for patient care and outcomes. As the largest solutions provider for payers in the U.S., McKesson understands the technology and analytics required to best support both payers and providers as they experiment with new models in patient care.

And finally, turning to our Provider Technologies business. Approximately 1 year ago, we announced a series of product strategy changes in our hospital business to converge our core clinical and revenue cycle solutions onto the Paragon platform. We are pleased that more customers than we had originally anticipated have either already moved to Paragon or have confirmed their intention to move to Paragon. We're also very pleased that Paragon was once again named the Best in Class in the Community Hospital Information Systems category for the seventh consecutive year. In addition, Paragon was rated #2 in overall software suite rankings for the second consecutive year, reflecting the attractiveness of the solution to the large hospital marketplace.

In summary, the core operating performance in our Distribution Solutions business remains solid, and our outlook for the full year has improved from our original expectations. While we are disappointed with the revenue deferral in our international business, the primary businesses in Technology Solutions continue to perform well.

We're fortunate to be in businesses that generate healthy cash flows. And over time, we've used our portfolio approach to capital deployment to create value for our shareholders. Consistent with this approach, I am pleased to announce that our Board of Directors increased the company share repurchase program by $500 million. We also expect to close our acquisition of PSS World Medical late in our fiscal fourth quarter. The strength of our business provides us the continued financial flexibility to create value for our shareholders through our capital deployment program, which continues to be portfolio-based.

With that, I'll turn the call over to Jeff, and we'll return to address your questions when he finishes. Jeff?

Jeffrey C. Campbell

Well, thanks, John, and good afternoon, everyone. As you've just heard, we are pleased by the operating strength in our Distribution Solutions business as we look towards the full year, and the primary businesses in our Technology Solutions segment continue to perform well.

There are a number of complexities to our results this quarter, which I'll try to sort out as we walk through our financial results. I would summarize now, however, by saying there were 3 aspects to our financial results that I would draw particular attention to this afternoon. First, and perhaps most important when thinking about our business going forward, is the nice strength we are seeing in our Distribution Solutions segment operating results as we look towards the full year. Second, is the charge we took for the legal dispute in our Canadian business of $40 million, which, to be clear, we do include in our adjusted earnings. Third is the revenue deferral in our international business and Technology Solutions. I'll cover each of these as I go through my remarks.

My comments today on our earnings will focus on our $1.41 adjusted earnings per share, which, as you recall, excludes 3 types of items: amortization of acquisition-related intangibles, acquisition expenses and related adjustments and certain litigation reserve adjustments. The numbers I will review in my discussion today will be based on an adjusted earnings basis and can be found on Schedules 2 and 3 included in today's press release.

Let me begin by reviewing our consolidated results for the quarter, which can be found on Schedule 2A. Consolidated revenues were up 1% to $31.2 billion for the quarter, as we again see a large volume of brand-to-generic conversions slowing our revenue growth. This is, of course, a good thing for our business, and you see this in looking at our adjusted gross profit, which grew 6% to $1.7 billion.

Total adjusted operating expenses for the quarter increased 13% to $1.1 billion. While this increase seems large on its face, there were 3 primary drivers to this increase. First, the $40 million pretax charge in our Canadian business represented approximately 4% of this expense growth. To provide a little background for this, as we've previously reported in our SEC filings, McKesson has for a number of years cooperated and responded to an investigation by the agency known as RAMQ, which is a provincial government agency with authority over the conduct of pharmaceutical business in the province of Québec.

In the third quarter of 2013, we engaged in settlement discussions to resolve potential legal claims against the company and our customers and suppliers. In consideration of the pace and progress of settlement discussions, which are at an advanced stage, we recorded a pretax charge of $40 million for the estimated probable loss from potential legal claims arising from the investigation.

Turning back to the overall increase in operating expense. The second factor was the acquisitions we've made over the last year, which added roughly another 3% to our expense growth. Finally, our corporate expenses for the quarter are up $27 million year-over-year, which was approximately another 3% of the operating expense growth for the total company. Let me remind you, though, that we typically see a fair amount of variability from quarter-to-quarter in our corporate expense line. For the full year, we expect our corporate expenses to be approximately flat versus the prior year. Adjusting for all 3 of these factors, our overall operating expenses are tracking more in line with the normal growth we would expect.

Other income for the quarter was $10 million. As a reminder, last year's third quarter other income was impacted by an asset impairment recorded in our corporate segment. Interest expense declined $6 million versus the prior year to $58 million, driven primarily by the repayment of $400 million in long-term debt in February of fiscal 2012.

As I projected on our earnings call last quarter, we did proceed with issuing $900 million in long-term debt in December to refinance the $400 million in debt that was repaid in February 2012 and to prefund a $500 million maturity coming due this March. So to be very clear, the December $900 million financing was just a refinancing of existing debt and is independent of the PSS transaction.

To turn to the financing for PSS, our latest thinking is that we will likely finance a little less than 1/2 of the transaction with permanent debt sometime subsequent to the closing of the acquisition. We now have a bridge facility in place to fund the close itself.

Moving now to taxes. In the third quarter, we recognized some unfavorable discrete tax items, which drove our adjusted tax rate up to 32% for the quarter. We continue, however, to estimate that our full year adjusted tax rate will remain at 30.5%. Adjusted net income for the quarter was $340 million, and our adjusted earnings per share was $1.41.

To wrap up our consolidated results, weighted average diluted shares outstanding decreased 4% for the quarter to $240 million. This year-over-year decline was primarily due to the cumulative impact of our share repurchases. For the full year, we continue to expect our average diluted shares to come in around our original guidance assumption of 239 million shares outstanding.

Let's turn now to our segment adjusted earnings results, which can be found on Schedule 3A. In Distribution Solutions, total revenues were up 1% for the quarter versus the prior year. Looking at the components, direct distribution and services revenues were up 4% year-over-year for the quarter to $22.4 billion. The key drivers of this were market growth and having one extra sales day.

Our warehouse revenues declined 14% year-over-year as the large volume of brand-to-generic conversions particularly impacts our warehouse revenues. While our total U.S. pharmaceutical distribution and services revenues are roughly in line with our expectations year-to-date, we have seen a shift of existing customer business from warehouse to direct store delivery.

Canadian revenues on a constant currency basis grew 3% for the quarter, primarily due to market growth and having one extra sales day in the quarter.

Medical-Surgical revenues were up a strong 15% for the quarter to $874 million, driven by market growth and new customers. The quarter also benefited from an acquisition and from having one extra sales day. These 2 items combined, however, account for only about 4% of the overall 15% growth. So we are particularly pleased to see this kind of continued strong growth in our Medical-Surgical business. And with the acquisition of PSS expected to close later this quarter, we are well positioned to carry this momentum forward.

Adjusted gross profit in Distribution Solutions increased 7% for the quarter to $1.3 billion, representing an adjusted gross margin improvement of 24 basis points versus the prior year. We did, of course, have strong growth in oral generic profits this quarter. However, the increase in generic profit was partially offset by the expected decline in sell margin that was primarily driven by the BA.

In addition, while our view of our brand manufacturer economics for the full year has grown more positive relative to our original expectations, less came in the third quarter and more has shifted to the fourth quarter. One other point, we did benefit in the third quarter from $8 million in antitrust settlements.

Our Distribution Solutions adjusted operating expenses were up 15% for the quarter to $725 million. Once you factor out the $40 million pretax charge as well as the various acquisitions, the number is more in line with what we would usually expect. The adjusted operating margin rate for the segment was 187 basis points this quarter versus 191 basis points a year ago. For the full year fiscal 2013, we continue to expect Distribution Solutions adjusted operating margin improvement in the high-single-digit basis points. Eventually, the operating strength we are seeing across the segment should at least offset the charge for the legal dispute in our Canadian business.

Turning now to Technology Solutions. Total revenues were flat for the quarter at $826 million. The revenue deferrals that John discussed in our International business lowered our revenues in the quarter by approximately $16 million, and we have lowered our full year expectation by approximately $30 million. These revenues essentially would have fallen straight to the bottom line. As a result, adjusted operating profit in our Technology Solutions segment this quarter was $98 million, and our adjusted operating margin was 11.9%. This is obviously below our original expectations.

As a result of these developments, turning to the full year, we still expect our revenues in MTS to approximate the level of growth experienced in fiscal 2012. The weaker revenues we now expect in our international business will be roughly offset by the acquisitions we closed in the third quarter.

On the operating margin side, we now expect our adjusted operating margin in Technology Solutions to approximate the level we saw in fiscal 2012.

Leaving our segment performance and turning now to the balance sheet and our working capital metrics. Our receivables were $10 billion, up from the prior year balance of $9.7 billion, and our days sales outstanding were unchanged to 25 days. Inventories were flat for the quarter at $10.4 billion, with our days sales in inventory of 32 days also flat to prior year. Compared to a year ago, payables were down 4% to $15 billion. Our days sales in payables of 46 days was 2 days below last year.

Year-to-date, we've generated $276 million in operating cash flow. As you know, our cash flow varies from quarter to quarter depending on seasonal and timing factors. In addition, as Paul Julian talked about at our Investor Day in June, earlier this year, our U.S. pharmaceutical distribution business opened a new national redistribution center through which we flow a significant portion of our inventory. We have managed this transition conservatively and have built up some extra inventory to ensure we meet customer needs. This is lower than our operating cash flow year-to-date, but as the transition is close to conclusion, overall we do not expect it to have an impact on our full year. So we continue to expect our cash flows from operations for the full year to be between $2 billion and $2.5 billion, though I do think it's more likely now that we'll be in the low end of that range.

We ended the quarter with a cash balance of $2.7 billion. Of this amount, approximately $1.5 billion was offshore. Our capitalized spending was $268 million for the first 9 months of the fiscal year, and we now expect to come in a little bit below the low end of our prior range of $425 million to $475 million. Overall, our gross debt to capital ratio was 37% for the quarter and remains within our target range of 30% to 40%.

We did spend roughly $360 million on share repurchases in the third quarter. And as John mentioned earlier, we are pleased that the Board of Directors recently approved an additional $500 million share repurchase authorization. This brings our total share repurchase authorization outstanding to $1.1 billion, giving us additional flexibility to deploy our capital and maximize shareholder value in a variety of ways.

Now I'll turn to our outlook. Let me once again remind you that our earnings this quarter were impacted by 3 items that also affect our full year outlook. First, the $40 million pretax charge for a legal dispute in our Distribution Solutions segment had a negative impact of approximately $0.12 per diluted share for the quarter and for the full year. Second, the revenue deferrals and slower implementations in our international technology business and our Technology Solutions segment lowered our adjusted earnings by approximately $0.05 this quarter. Full year impact is expected to be about $0.09 per diluted share. Third, our full year expectation for our other businesses, primarily in Distribution Solutions, has improved by about $0.16 per diluted share, and essentially all of this increase will be seen in our March quarter.

As a result of these 3 items, we are updating our guidance for the year on adjusted earnings from $7.15 to $7.35 to a new range of $7.10 to $7.30. The new range remains within our original guidance range of $7.05 to $7.35 that we issued at the beginning of this fiscal year, but we've now narrowed the top end of that range by $0.05.

Turning back to the December quarter results for just a minute, I would say that relative to our expectations, our December quarter results also reflect a timing shift into our March quarter in 2 areas, both of which I've discussed: brand manufacturer economics and taxes.

Now as John mentioned, when you think about fiscal 2014, you have a big drop off in new generic launches, which we've said for a long time represents a challenge for us. Of course, we run the company for the long term, and over the next several years, we are quite positive about generic launches. We are beginning our detailed planning process for the next fiscal year and working hard to make the right decisions in the coming months to position the company for the short-term challenges and the long-term opportunities.

One final point about our fiscal 2013 outlook. In terms of guidance on our non-GAAP adjustments, I would remind you that our convention is to not include any forward impact from acquisitions on our guidance until the acquisitions have actually closed. With that in mind, we expect $0.55 per amortization of acquisition-related intangible assets, and due to the AWP litigation charges we recorded in the first half of the fiscal year, we are assuming $0.15 for litigation reserve adjustments. Also, including the impact, the $81 million pretax acquisition-related gain in the first quarter of fiscal 2013, we expect acquisition expenses and related adjustments to add approximately $0.13.

In summary, we've had 3 solid quarters and our view of the operating results of our primary businesses remains strong. Thanks, and with that, I'll turn the call over to the operator for your questions. [Operator Instructions] Operator?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Lisa Gill with JPMorgan.

Lisa C. Gill - JP Morgan Chase & Co, Research Division

I had a question, John, on the Med-Surg business. Clearly, 15% is really strong. Jeff talked about the extra day in the acquisitions being 4%, but 11% growth. Can you talk about where that's coming from? And how you see that business evolving? Was part of this flu and therefore more onetime-ish, or are you seeing a pickup in the overall business?

John H. Hammergren

I think we're seeing a pickup in the overall business, Lisa. I think we're doing a better job of penetrating our existing customer base from a sales perspective, selling more of what they need to run their practices. And clearly in the alternate site markets, we're growing rapidly in home care and extended care. I also would say that I think we are gaining some additional new customers as we progress with our value proposition in our offering. We're making our sales force more efficient through the productivity tools we're giving them so they have more time to spend with the customers, and we're providing tools to our customers, frankly, so they can order more efficiently from us. I would also say that the flu impact as we began to see it was more late in December. We might see some of it in our fourth quarter. I mean clearly, the January and February effects we'll see -- it won't really be that material on Med-Surg. But it's an important part of our business, and clearly we are seeing an uptake in physician office visits and emergency room visits, et cetera, in our industry. But I think overall, it's just kind of solid momentum across the board and almost all of the businesses that comprise Med-Surg and continued traction with the value proposition we've given to our customers.

Lisa C. Gill - JP Morgan Chase & Co, Research Division

And then just as a follow-up, Jeff. But when we think about the technology and the deferred revenue, the $16 million and the $30 million, can you give us an idea of when that will ultimately be recognized?

Jeffrey C. Campbell

Well, the reality as we sit here today, Lisa, is we have a situation where we've got a lot of bookings, a lot of implementations, a lot of customers who like the product, but a structure where that revenue is liable to be sitting on our balance sheet for an extended period of time. And so I can't give you a solid end point sitting here today. I would tell you that as we think about our FY '14 plans, that revenue is unlikely to reverse in FY '14 even. And so the magnitude of the challenge I just described in '13 is liable to be somewhat replicated in FY '14.

John H. Hammergren

Yes, I will also just add to Jeff's comments here, I think we're excited about the progress the team is making in getting customers on board with our value proposition. But in the near term, with that revenue rec issue being out in front of us, we actually probably are booking more expenses in the near term and it can't be delayed, and the revenue gets delayed as we get these implementations done and continue to build up the value of the product for our customers. So it actually has a compounding effect. The success of the bookings raises expenses, and the revenue gets delayed as we try to get it. Now we are getting the cash though, and so I think there's an indication that products are working and our customers are happy. It really is just an issue of making sure that we've met the obligations and the requirements our customers have in front of us before we can actually book the revenue.

Jeffrey C. Campbell

Just to be very clear on the accounting, Lisa and John. So all of the expenses associated with these customers, we just book ratably as we incur it. That's why I made the comment earlier that I described the revenue that's being deferred is really revenue that...

John H. Hammergren

It's almost...

Jeffrey C. Campbell

We would have, and when it hits the P&L, will be almost 100% earnings.

John H. Hammergren

Right.

Operator

And we'll go next to Tom Gallucci with Lazard Capital Markets.

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

I guess just on the drug business or actually the Distribution business, obviously Med-Surg did a little bit better. On the drug side, you mentioned maybe branded price inflation or benefits from branded price have gone up a little bit. But can you give us some more understanding of what's driving a pretty big upside, I guess, in the distribution business overall versus what your expectations were?

John H. Hammergren

I think that it's really across the board, Tom. I think the branded guys -- or excuse me, the distribution guys are really performing very well. They're focused in executing well across the board. As Jeff mentioned, we do see continued strength in our relationships with the branded manufacturers. Frankly, most of that strength will be realized in our fourth quarter as we've seen the progression of what's transpired early in this calendar year. So I think we are feeling good about what's going on. Our Canadian business, setting aside the charge, is performing well. And I think our generic business is executed very well as well. So -- and I think that we've -- we're in pretty good shape in that business and are executing well.

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

I guess just as a follow-up. Any color you can offer within the specialty business, whether it be sort of the traditional side or the US Oncology side?

John H. Hammergren

I think we're actually having strength across the board also in specialty. I think we've seen a nice ramp in customers who have either already joined or indicated an interest in joining our US Oncology Network, which, as you know, is the most intimate of the relationships we have with our customers in that space. Our value proposition there is quite expansive, and as customers come under pressure, clearly US Oncology is an alternative that I think most folks are considering. One of the things we're tracking a lot now is what benefit are our customers realizing by being part of the US Oncology Network and is that benefit improving year-on-year and quarter-on-quarter. And I can tell you, we're tracking very nicely for our customers as it relates to their performance under these programs with us. So that's a real positive. And I do think that the segment overall continues to be poised for a good growth as we look forward.

Operator

And we'll go next to Steven Valiquette with UBS.

Steven Valiquette - UBS Investment Bank, Research Division

Just at the end of the prepared comments, you guys -- you mentioned something along the lines of working hard to make the right decisions regarding short-term challenges in fiscal '14. And I guess, are you generally referring to potential uses of balance sheet capacity when you say that, or are there other things you're referring to with that comment? Just trying to get more color on that.

John H. Hammergren

Yes, I think we look at our opportunities in fiscal '14, both from a headwind and a tailwind perspective, et cetera, how are we going to position for an environment where generics are going to grow slower than they have historically. Now I think everybody understands it's going to be difficult for us to fill the gap year-on-year on the performance related to what drove -- what was driven by generics. But from time to time, not unlike any company of our size, we have to review ways in which we might become even more efficient and be more effective as an organization. We have a very strong culture of Six Sigma and continuous improvement in our business, and we're always thinking about things that we can do to optimize our facilities or consolidate various systems to get the potential outcome -- best potential outcome we can for our company. There's always trade-offs in making these decisions, and we have to be careful about the kinds of things we might consider. But clearly, we want to be lean and mean, and we want to make sure that we're doing everything we can to optimize our performance in '14. But the most important thing for us to do in '14 is not to impact negatively our trajectory going into '15, because we see this hiatus of generics in the next year as not something that's a permanent reset in the way our business operates but a temporary year-on-year comparison that we'll get through, and then as we get into the next year, we're going to be poised once again to experience the type of growth that we have historically. So that's really what we're looking at, and I think we want to be as efficient as we can be.

Jeffrey C. Campbell

The other thing I might remind you of, Steve, is as we always point out when we first provide guidance for the year, when we're providing guidance, we always exclude any potential future material litigation reserve adjustments or acquisitions divestitures or material charges that we take because of any restructuring decisions we might make.

Operator

And we'll go next to Eric Coldwell with Robert W. Baird.

Eric W. Coldwell - Robert W. Baird & Co. Incorporated, Research Division

Actually, I think everybody's thinking along the same lines, most of my questions have been asked. But I'm just curious if you could give a little more detail, Jeff, on your comments on the corporate expense being up $27 million in the quarter. Was there anything specific to call out realizing the full year is somewhat normal? And then this may be difficult, but as a follow-up, just with the Canadian legal settlement, do you believe with the $40 million you've taken to full magnitude of the potential outcome or could there be additional charges taken that would be material enough to call out in the future?

John H. Hammergren

Well, let me maybe do those in reverse order. On the Canadian charge, we clearly think the $40 million is the right reserve because that's what we booked. I would emphasize that those are discussions that are at a very advanced stage, so nothing is over until it's over. But I would say, Eric, that gives us a pretty high level of confidence that we have the right number and that's the end of it. On corporate expenses, you are right. They vary a lot quarter-to-quarter. I suppose one of the realities of being a company founded in 1833 is sometimes we have history. So last year, we had an old -- a little bit of an asset impairment in that line. This year, you have things like a environmental charge we took that relates to the chemical business we were once in, and it's a pretty sizable charge. So over the course of a year, all those things tend to kind of net out. And that's why I feel pretty good when I look at that corporate expense line and what we're projecting for the full year, and it's pretty flattish. This year, just because of the timing of the way things happened in last year's December quarter versus this year's December quarter, with the example I just gave you of environmental -- significant environmental charge, it looks tough year-over-year. But I don't think there's anything that you need to think about or model in from a run rate perspective.

Operator

And we'll go next to Robert Jones with Goldman Sachs.

Robert P. Jones - Goldman Sachs Group Inc., Research Division

Jeff, I just want to follow up on the healthcare IT guidance for this fiscal year. It sounds like you're expecting the margin there to be slightly below the long-term target of mid-teens. I just want to make sure I understood that correctly as you referred back to last year's fiscal operating profit number. And then looking out longer term, any reason to think that, that mid-teens goal is not -- still intact beyond to this fiscal year?

Jeffrey C. Campbell

No, it would work backwards. Certainly, our goal has not changed at all, and it's obviously frustrating and disappointing to us that a change in how we view what's going on in the -- that international technology business in terms of the rev rec is going to keep us from getting to it for the year. To be clear, for the year, yes. If you go back and you look at the operating margin last year, our guidance is we should -- you should see revenue growth off last year's revenue similar to the kind of growth we had last year, which was 4%. And the operating margin will be pretty flat to last year, so that gives you a pretty tight band in which you can think about the operating profit of that segment.

Robert P. Jones - Goldman Sachs Group Inc., Research Division

Great. And then just if I could follow up on the new authorization, I think that brings the total buyback now to over $1 billion. I wasn't sure how much buyback would play into fiscal fourth quarter or to next year given the proposed acquisition. I guess is there any message or direction you'd care to give us around the potential buyback as we think about next fiscal year?

John H. Hammergren

Well, we never like to tell people exactly when we're going to be buying stock back and when we're not. I think there's a couple of important messages here. One is that we continue to have -- be in great cash businesses, and we have a very strong balance sheet. So even with the upcoming $2.1 billion acquisition of PSS, we're confident that you will see some level of continued share repurchase, albeit obviously lower than it would have been if we weren't buying PSS. And I think the incremental authorization that the board gave us this week is a sign of all of our confidence in the future and where we're going as a company.

Operator

We'll go next to George Hill with Citi.

George Hill - Citigroup Inc, Research Division

Just number -- first, Jeff, I know that you're loath to talk about fiscal '14, but is there any chance you'd give us directionally some quantification of the headwind with the contribution of generic conversions in fiscal '13 versus the headwind that you'll face in fiscal '14?

Jeffrey C. Campbell

George, we have not taken a cut at it because one thing we certainly learned is that the world of generic launches changes every week. And that's why when we give you guidance in late April or early May, we'll be very precise on what we're assuming. When we go to make those assumptions, I make the observation that we're using the same data that is available to everyone publicly. And so I've seen several people take estimates at this, and it's a big number. And the estimates range just like our own estimates range, but it's a big number. But I don't want to -- if I gave you a number today, I'm sure I'd have to give you a different number in 3 months because the world will change.

John H. Hammergren

No, I think it's also fair to say, George, that generic is but one component of our overall performance, and we're doing everything we can to make sure that we've -- we're piling up more tailwinds than we have headwinds. Now, it's always an ongoing battle, and we're not finished with our planning for next year. But I think that's why Jeff is a little reluctant to say, well, here's the challenge generics might be. First of all, we don't necessarily know the full number yet because our teams are still working on what their projections are going to be. And secondly, hopefully, there'll be other things that are going in our favor that will help minimize that effect to the extent that we can.

George Hill - Citigroup Inc, Research Division

Fair enough. And then maybe, John, just a quick strategic follow-up. I want to follow on Steve's question. It sounds like what you're telling us strategically regarding fiscal '14 is that while generics are a tough comp, expense ratio versus profit levels might seem a little higher in fiscal '14. But you guys want to stay at a strategic level given the long-term profile or the growth profile of the business, I guess, am I thinking about that right? It sounds like you're telling us you don't want to be in a position of having to cut expenses given the opportunity despite the challenges in '14.

John H. Hammergren

Right. I think the way you should interpret what I said was that like anybody else, we have an opportunity to look at where you can tighten the belt and what steps you can make and the rock you haven't lifted in a couple of years might be lifted and provided an opportunity. And I think what we're saying is that in the next several months, we are going to be focused on how do we provide more momentum going into FY '14, to some of the measures we can control, things we can do, and it could be our sourcing activities, even our indirect sourcing activities and things like copy paper, how do we refine what we do to reduce our spending as much as we can. But the real message I was leaving you was we're not going to do anything to the company in fiscal '14 because I mean structurally, like shutting down 1/2 our distribution centers, et cetera, because we believe our growth trajectory is going to come back as we look at fiscal '15 and beyond. And so this is not an issue of an industry reset where the distribution business is going to lose significant volumes and therefore we have to restructure our cost. I think this is an opportunity for us to just be responsible and be reflective and make sure that we're positioning the company properly as we come back into what we think will be more promising years ahead.

Operator

And we'll go next to Robert Willoughby with Bank of America Merrill Lynch.

Robert M. Willoughby - BofA Merrill Lynch, Research Division

Jeff and John, you've mentioned some deal-related costs for transactions that had closed this year as contributing to the cost in the third quarter. Any indication how quickly those will drop off?

Jeffrey C. Campbell

Well, we gather, Bob, in our acquisition-related expense line anything that is directly related to either the transaction costs, so something large like PSS when we get there. It will be things like the cost of doing the bridge loan, et cetera. We also put in there integration costs, restructuring costs as you go about consolidating facilities, et cetera. So when we -- what is a little confusing about that line, however, this year is we have this unusual accounting earlier in the year where we have a very large gain related to buying the other 50% of our headquarters building we didn't previously own. If you strip that out, it looks like a more normal number. So as the other thing, just to be very clear, is what's -- what we've got in there in the 9 months year-to-date is obviously anything that has been incurred related to a transaction that we have announced. So, for example, there's a little bit of PSS cost in the year-to-date, about $6 million and the -- related to PSS because we incurred those costs subsequent to announcing it. But as I give you guidance for the March quarter on those numbers, we haven't closed PSS, so I'm not including in those estimates, all of the costs that we will in fact incur at the time we close PSS because it would still be an estimate. So, boy, if I -- listening to myself, I know I made this very, very confusing.

John H. Hammergren

I think one of the positives about providing adjusted earnings is that we take some of that complexity out. And so when Jeff spent the last portion of his prepared remarks talking about these items, I believe all of those items are actually adjusted out. And so that was meant to help you reconcile between adjusted and GAAP as opposed to some flavor on onetime issues in the quarter that were adjusted -- the one, our -- the Canadian issue and those other issues flowed through earnings and were not adjusted. And when we talk about litigation-related expenses, for example, they're related to very specific litigation items, of which primarily AWP, maybe all AWP and this RAMQ thing, for example, doesn't get adjusted out. So we've ...

Jeffrey C. Campbell

Just in operating [indiscernible]...

John H. Hammergren

We've tried to be pretty specific about what we put in and what we put out, and that was a bit of a reconciliation.

Robert M. Willoughby - BofA Merrill Lynch, Research Division

I will follow up on that. Is it possible that you could just give us any kind of clue as to how PSS World did in the quarter. I doubt we are going to see those results ever. Will we?

Jeffrey C. Campbell

Well, you probably will see their results because as an SEC registrant who's independent, and we obviously can't speak for PSS because we don't own them today, they have an SEC filing requirement and they will be filing their Q in early February in line with their filing obligations. And I would estimate that we'll be closing around the end of February.

Operator

And I'll go next to Ricky Goldwasser with Morgan Stanley.

Ricky Goldwasser - Morgan Stanley, Research Division

Jeff, in the prepared remarks, I think you mentioned that you've seen a shift from warehouse to direct sales in the quarter. Can you talk about what's driving this change? Is this is a specific client or is this something that you're seeing -- a change that you're seeing in the marketplace? And do you expect it also to continue into your -- the March quarter?

Jeffrey C. Campbell

We only have a few customers in our warehouse line. And the warehouse line has been partially negatively affected by the move to generics. When a brand moves to generic, many of these customers will -- first of all, it goes down in price. Secondly, it may be sourced on a direct basis where otherwise, it might have been a warehouse item. But the phenomena moving to direct clearly is a separate issue, and I think our customers see tremendous value in the service we provide in a direct model. And so several of our customers have said I know we used the warehouse and that sells -- shifts into our warehouses, we prefer to have you manage this directly to our store so we don't have to go through the supply chain expense of handling it ourselves. So there's lots of reasons people would pick to do that. But generally speaking, I think our customers see value in going on a direct model with us.

Ricky Goldwasser - Morgan Stanley, Research Division

So should I think about it as partially a revenue mix? Because to your point, some of the warehouse revenues are coming out of the system because the brand goes to generic and partly also in incremental dollar growth in direct-store sales, assuming our associate with higher margins around customers to see that value, basically 2 separate drivers?

Jeffrey C. Campbell

Yes. So -- and then to be clear, Ricky, this is really relative to our expectations for the year. The very good news to John's point is while we knew warehouse revenues were going to have a significant downward hit from the brand-to-generic conversions because it's all brand product, we have seen more of an offset than we expected as the handful -- less than a handful really of customers that John was talking about have chosen to put a little bit more through the direct channel than the warehouse channel. It's a very good thing for us.

Operator

And we'll go next to Charles Rhyee with Cowen and Company.

Charles Rhyee - Cowen and Company, LLC, Research Division

Jeff, maybe if I can just also go back to some of the items that you said at the end of your prepared comments as we think about, I guess, the rest of fiscal '13. I got most of it here. You talked obviously about the $0.12 for Canada, the, I guess, $0.05 for the deferred rev, $0.04 in the fourth quarter. And then you mentioned this $0.16 benefit from the other businesses. I think I missed part of your comments, if you could just kind of explain that again.

Jeffrey C. Campbell

Yes, Charles, I'm happy to reprise the math because it is a little -- our results are not as simple as we might have hoped this quarter. But the charge in Canada equates to $0.12. And then the full year impact relative to our expectations of the revenue deferrals in our international business is $0.09. So that would -- if there were nothing else going on, you'd think we would take our guidance range down by the $0.21. The very good news is we're feeling much more positive about the full year results across really all of our other businesses, although it is primarily distribution. And that's about $0.16 of upsides. And that's why if you look at what do we do with our guidance range versus 90 days ago, we've only moved it down $0.05, despite the challenge of the $0.12 of the charge in Canada.

Charles Rhyee - Cowen and Company, LLC, Research Division

I got it. Okay, that's helpful. And then part of that $0.16, is it fair to think that it's also part of the brand economics or is that sort of a separate issue then?

Jeffrey C. Campbell

That would certainly be one driver.

Operator

And we'll go next to David Larsen with Leerink Swann.

David Larsen - Leerink Swann LLC, Research Division

Could you guys talk a little bit more about the -- you said there was a better-than-expected uptick in the Paragon conversions. Is there any way you can sort of size sort of how many McKesson Horizon hospitals have converted so far or sort of what gives you comfort in that statement?

John H. Hammergren

Well, I guess, we typically don't talk about customer accounts by products and in certain markets who's buying what. I guess the comment or the discussion was meant to provide some confidence with our stakeholders that the Paragon product line is being well received. And that many of our customers that had been using the Horizon product line that have been faced with a serious question about the consideration of Paragon versus the consideration of other alternatives that more than we had expected are actually committing to Paragon and moving forward with that decision. We've also made tremendous progress with Horizon. Our customers are stable, our implementations have gone well, people are getting to Meaningful Use attestation, and our products are coming GA at the time frame that we had expected. And our Paragon roadmap is solid and remains on track as well. Our emergency department product is now GA-ed or getting close to GA-ing. Our reviews with the firms that have been helping us to make sure that we're on track on the development perspective are pleased. And as I mentioned in my comments, class has now rated the product for the seventh year in a row Best in Class for Community Healthcare. But I think surprisingly -- surprising to some, not to us, but to some, the product is now rated basically #2 in the marketplace overall because of its ease of use, its integration and its cost of ownership. So we're really pleased with the customer satisfaction really across the board, even when you think about the larger hospitals that are moving from Horizon to Paragon. It's going quite well.

David Larsen - Leerink Swann LLC, Research Division

That's great. Will Horizon bring hospitals through Stage 2 and 3 of Meaningful Use?

John H. Hammergren

Yes, we're committed to making our customers successful. I don't want to get too specific about the specific individual customers. But clearly, Meaningful Use is important to us. And we want these customers to get there, and we'll help them get there on Horizon and on Paragon.

Operator

And we'll go next to Glen Santangelo with Crédit Suisse.

Glen J. Santangelo - Crédit Suisse AG, Research Division

John and Jeff, if I listen to what you're saying about the fourth quarter, by my math, it kind of feels like you need over an 80-basis-point sequential improvement in your op margin and Distribution Solutions to kind of get to the midpoint of your range. And I understand there's some noise in the 3Q number. But given that you told us over the years that you're not as dependent on price inflation and, John, I think you called out some branded manufacture economics, is it all coming on the branded side? And what's really driving it? Is it the price inflation in 1Q? Like what drives such a huge sequential increase like that?

Jeffrey C. Campbell

Well, let me just remind you, Glen, of one thing, which is while there is only a modest piece of our annual economics with brand manufacturers that is price dependent, even for the portion where we know what we're going to make in a year, the timing of which quarter we get it can still be completely driven by price increases. And so what we clearly saw this year as they shipped out of the December quarter and into the March quarter, so I mean your -- I haven't done the math maybe exactly the way you did, but we're quite confident in the guidance we've given. If it checks out with the math you've done, yes, we will have a very unusually strong March quarter driven by all parts of our business. But the timing of those brand economics will be a significant piece of it.

Glen J. Santangelo - Crédit Suisse AG, Research Division

Okay. And then maybe if I could just follow up, Jeff. In the press release, in one of the footnotes, you said that in the third quarter and first 9 months, you recorded a product alignment charge in the Tech Solutions business of $42 million. And I went back to the past releases and never saw this charge before. And I'm wondering when did you record these charges?

Jeffrey C. Campbell

That was -- actually that was last December quarter when we -- a year ago when we made the decision to make Paragon the key...

Glen J. Santangelo - Crédit Suisse AG, Research Division

Oh, I get it, okay. So that's all part of that. There's nothing in this quarter.

Operator

And we'll take our final question from Ross Muken with ISI Group.

Ross Muken - ISI Group Inc., Research Division

So just quickly on the PSS financing and sort of where we are, can you just remind us when you gave sort of your initial assumptions around the transaction, what your assumptions were around financing? It feels like it might be more cash now. And so I'm just trying to figure out sort of what's changed in that mix versus when it was originally reported.

Jeffrey C. Campbell

Yes, I may have confused people, Ross. We really have not previously given any assumptions about financing. To help people just with the math, what I said when we first announced it was, look, if you're thinking about what kind of earnings will it generate in the first 12 months, if you were to assume we 100% financed it at 4% debt, you would have $0.15 to $0.25 of accretion. I didn't mean to imply we were going to 100% finance it. It was just a way to help people be very clear on the math. Accretion's kind of a funny number when you think about it in isolation for a transaction of this size because, of course, we would have done something else with the cash if we hadn't bought -- if we weren't buying PSS. So I'd caution people about being purely incremental on the accretion related to this.

Operator

That concludes today's question-and-answer session. I will now turn the call back over to the speakers for any additional or closing remarks.

John H. Hammergren

Excellent. Thank you very much, Amber, and thank you also for joining us on the call today. I'm very pleased with our operating performance in Distribution Solutions, including the strong momentum in our Medical-Surgical business, as we move closer to completing our acquisition of PSS World Medical. I continue to believe we are well positioned to deliver value to our customers by helping them improve their business health and their ability to connect with other stakeholders and ultimately deliver better care to their patients. And like always, I want to thank our McKesson associates for their hard work and focus on our customers' success. I now will hand the call over to Erin for a review of our upcoming events for the financial community.

Erin Lampert

Thank you, John. I have a preview of upcoming events. On February 13, we will present at the Leerink Swann Global Healthcare Conference in New York, and on May 15, we will present at the Bank of America Merrill Lynch Health Care Conference in Las Vegas. We will release fourth quarter earnings results in early May. We look forward to seeing you at an upcoming event. Thank you and goodbye.

Operator

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

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