Cardinal Health Inc. (NYSE:CAH)
Barclays Global Healthcare Conference
March 13, 2013 9:30 am ET
Jeffrey W. Henderson - Chief Financial Officer
Kipp R.F. Davis - Barclays Capital, Research Division
Kipp R.F. Davis - Barclays Capital, Research Division
All right. So good morning, everybody. I'm Kipp Davis, I work on the healthcare distribution and tech team here at Barclays. Welcome to Day 2 of our Global Healthcare Conference.
Our next company presenting is going to be Cardinal Health. We'll have Jeff Henderson, who's the CFO of Cardinal, give some prepared remarks. And then following the presentation, we'll have a breakout session in Poinciana 4, which is just down the hall.
I'm sure most of you are familiar with Cardinal already. But for those of you who aren't, Cardinal is one of the leading pharmaceutical wholesalers and medical distributors in the United States. I was talking to Elliot earlier. I've also been doing some channel checks on the conclave. Well, folks like Cardinal Health is also the frontrunner to be the next pope. So Jeff may be able to give us a little on that as well. Sorry, that was a once-in-a-lifetime opportunity.
So with that said, Jeff, go ahead and take it away.
Jeffrey W. Henderson
It might be a once-in-a-lifetime opportunity you shouldn't have taken. But hello, everyone. Welcome to not-so-sunny Miami. This little green lights that flash once in awhile are pretty funky actually. Anyways, thank you for joining the Cardinal Health presentation this morning.
As always, we'll be making forward-looking statements. And I would encourage you to read our Safe Harbor Statement on around this page. It's also available on our website as well. So with that, why don't we go ahead and get started?
Let me start off by saying that I think as many of you know, healthcare is an extraordinary place to be right now. Put very simply, there are a very few industries in the world that have a certainty of future demand that health care does, not only in the U.S., but around the world. The population is aging, particularly in the countries that we service: U.S., Canada and China. Public health issue such as chronic disease continue to grow in importance and prevalence. And domestically, here in the U.S., that Affordable Care Act provides additional impetus for demand growth in the future.
So all that bodes very well for an industry going through incredible change right now. But with that opportunity comes some challenges. And as a society, as an industry, as a country, we have to deal with this demand in very new and perhaps unprecedented ways. The demand is clearly going to be there. The question for us is how do we serve it in a way that's most cost-effective and allows us as a country to afford it and to deliver on the promises that we've made to ourselves going forward.
With that as backdrop, as we look into the future, in order to achieve that goal of providing healthcare in a more cost-effective manner, we believe that healthcare has going to have to have the following characteristics, many of which you can see starting to emerge as we speak.
First of all, focus on efficiency. Clearly, the days of being paid for the inefficient delivery of healthcare are behind us, and all of us are being paid for value creation, no longer simply fee for providing a service. With that comes a need for greater coordination of care. We -- many of us are used to the old system where healthcare was in well-defined silos. As I'll speak to more in a few moments, that is clearly changing. Certainly, care is going to be delivered in the most appropriate setting by the appropriate caregiver. And in many cases that means that our existing paradigm of how care best delivered is going to change. Care is moving to places that we never thought it would a few years ago. Five years ago, all of us went to our doctor for flu shots. Today, I suspect many of you like me, go to our local pharmacy to get our flu shot. And in a relatively short period of time, those sort of transitions have happened and we believe will accelerate going forward.
And finally, there's going to be a greater and greater focus on outcome as opposed to inputs, which is hard to argue with as an admirable goal. We believe Cardinal Health is extremely well positioned to help as we move in all these directions.
With that as context, let's spend a little bit of time discussing Cardinal Health. I think for many of you, the information you see on this slide is old news, but let me just cover it quickly. We do report in 2 segments: Pharmaceutical segment and our Medical segment. And although there are distinct elements in each of those segments, there's also significant areas of overlap or businesses that straddle both of those segments, and a great example of that are how we go to the hospital in the U.S. and our China business, which again, straddles both segments.
Sorry about that. In many ways, we are the connecting tissue in the healthcare supply chain. We create the critical bullet -- bridge between thousands or tens of thousands of manufacturers, both in the biotech pharma world and the med-surg world and hundreds of thousands of providers, whether it be hospitals or retail pharmacies, surgery clinics, physicians' offices and very shortly, the home. We are a logistical and strategic partner that enables the link between the upstream and the downstream.
To give you an idea of the scope and scale of our operations, we have 85 distribution centers now across the U.S., Canada and China. We partner with over 2,700 suppliers. We serve over 29,000 retail and hospital pharmacies, close to 8,000 retail independents, 20,000 chain stores and 2,200 hospitals. We deliver pharmaceuticals and medical supplies to more than 85% of the U.S. hospitals, and we operate the largest network of nuclear pharmacies in the U.S. And on an annual basis, dispose -- dispense almost 12 million doses of radiopharmaceuticals.
Imagine earlier the world that many of us grew up with where we had very distinct points that we went to for healthcare is very much blurring. In order to improve outcomes and really cost effectiveness, we know that care is going to have to be delivered in the most cost-effective location going forward. At the same time that care is going to have to be coordinated in a very deliberate way as patients move from the hospital to physicians' offices to pharmacies and to the home, very often for the exact same condition. And that -- as a result, the white space between those various providers is disappearing, and our job as Cardinal Health is really to fill in that white space to position ourselves to service the patient no matter where they are in that continuum of care.
Now as you look at those individual elements, we do have unique service-- product and service offerings that cater to those individual elements of the continuum of care. And what you see here is a sample of the types of offerings that we provide to our retail pharmacy customers, and this is particularly prevalent for our retail independent pharmacy customers. And really for the retail independent, our services allow them to compete in a way that they otherwise wouldn't be able to. We provide everything from value price generics to private label, over-the-counter products as well as multiple services that allow them to run their business on a day-to-day basis. And we're also helping them expand into new areas of business as they look to increase their influence in the communities they serve and that includes things like setting up specialized care centers to deal with chronic diseases such as diabetes. We also allow them to provide home healthcare products to their patients who are looking for those expanded services from their local pharmacy, and we have the ability to provide those as well.
As we focus on our hospital and hospital network customers, the products and services -- again, although there's some overlap, they are uniquely tailored for these particular customers. It's pretty worth noting that as a nation, our spend in this area, the hospital providers is probably our largest challenge. We provide a host of products and services to allow our hospital customers to provide care in the most cost-effective manner. That includes our Presource kits for example, which can be delivered just in time to the operating room to allow the doctor and the clinical staff to focus on the patient and provide the optimal surgical kit to the operating room in a very efficient manner. It includes our freight management and ValueLink Services that optimize the delivery of products to the hospital doors, in many cases, right to the wards or the operating rooms. It includes our Operational Excellence services, where we can go into a hospital and help them optimize their supply chain within the hospital. And our Preferred products or private label products, where we give the hospitals an alternative to purchase a very broad range of categories that again, allow them to achieve the promise of high-quality products at a much lower price.
Most of what I've said up to now applies to our U.S. and Canadian customers, but we have now also have the opportunity to bring these exact same tools and offerings to China. As many of you know, a little over 2 years ago, we acquired a company called Yong Yu in China, which really became our platform for expanding in this very, very important market. As I've explained before, the choice to enter China was a very deliberate and strategic one and really was predicated on a number of factors that went into our decision, obviously, it's a large market and a rapidly growing market. In fact, the healthcare market in China is projected to reach $1 trillion by 2012. But that wasn't enough. We also needed to enter a market where we can make a difference, where we could participate in the consolidation of a fragmented industry over time and add a unique value equation to the market. And we found that in China, we also found the right asset with the right management team that allowed to -- us to enter the market in a significant way.
So we've been in China over 24 months now. The business itself has performed equal to or better than what we originally projected from a financial standpoint. But it's also been a very interesting learning experience. Some things have turned out the way we expected, others have -- other surprises have come up in a very positive way, but on balance -- I would say the net of those surprises has been a very positive outcome. And as I said, we've been able to innovate in some expected and somewhat unexpected ways. And we've seen the power of our brand emerge in China, in a way that really doesn't exist in our U.S. or Canadian markets. And it's been very interesting and probably the best example of this is our direct-to-patient specialty pharmacies, which we now have 6 of in the country. Where our value proposition to both the Western manufacturer and the patient is that we can control the supply chain from the moment the product enters the port in Shanghai to the time that we hand the bag to the patient in the pharmacy. And in a country where there are concerns about supply chain integrity and product integrity, we provide that end-to-end service and the assurance of the Cardinal Health brand, which gives the patient the comfort who's very often spending cash out-of-pocket for these very high-end Western products. We give them the assurance that the product they're receiving is the real thing and has the Cardinal Health brand stamp of approval, which is very important in a market like China.
Most recently we also announced the expansion of our portfolio with the decision to acquire a company called AssuraMed, which is a leading provider of products to the rapidly growing home healthcare market here in the U.S. We feel this is a very natural extension of our efforts to serve the entire continuum of care. I spoke earlier about us positioning ourselves to service patients whether they be in the hospital, long-term care facilities, physicians' office, retail pharmacy, the one gap in that coverage was really our approach to the home. And when this transaction closes in the next several weeks, we will close that gap in a very, very significant way.
It does provide us immediate access to an outstanding growth platform in a part of the healthcare market, which we believe will grow in a very significant manner in the next 10, 20 years.
The company we acquired is about a $1 billion business based on pro forma calendar year 2012 operations. It serves over 1 million patients, and has over 1,200 payor contracts with all the key payors in the U.S. market. Has very strong brands, brings with it small package distribution capabilities and really an industry-leading reimbursement platform. And these are all very, very key elements that we believe we can build on in the coming years to drive significant revenue and profit growth.
Those we acquired really operates in 2 distinct business lines that share some back-office capabilities but go to the customer in very distinct ways. The Edgepark businesses is really a direct-to-consumer model, where patients are referred to Edgepark by the hospital or payors or even manufacturers. They then order either through phone or e-commerce sites. And the shipment and payment is a direct interaction between Edgepark and the patient and their insurance companies.
In the case of Independence Medical, this is more of a B2B service, where we contract with other providers, retail pharmacies, for example, who may have patients coming in who want home healthcare products. The retail pharmacy doesn't have the product line up or capability to service those patients at home. So they contract with AssuraMed to provide direct shipments to the patient's home, and in that case, for receiving payment from the provider themselves. Both of these business models are very important to the overall platform and both have been growing very nicely.
On the following slide on AssuraMed, this provides a little bit more info on the assets that we're acquiring. As I mentioned earlier, this company comes with a low-unit-of-measure distribution capability, which is a capability that actually as Cardinal Health, we've been lacking for some time. And although we provide low-unit-of-measure shipments to customers like physicians' offices, for example, in all honesty, we've never been the most efficient in this regard because the bulk of our physical infrastructure and systems are geared towards large package shipments, large pallets going to hospitals, for example. So having a low-unit-of-measure of distribution capability is something that we cannot only leverage to go to the home in a more expanded way, but also to service our physicians' office customers for example.
As I said earlier, they also service over 1 million patients and have 13,000 provider customers. Those patient interactions are very key. There's over 6,000 patients who are in touch with the AssuraMed business on a daily basis and that provides opportunities for adherence monitoring, for additional sales and gathering data over time, which is very critical to the overall business model. And they have over 20,000 referral sources. Again, this is very key in an industry that has really sort of grown up as a bit of a mom-and-pop type of industry, home health care I'm referring to, having providers, again, whether they be payers or hospitals that trust the home healthcare provider. And for example when a patient is discharged from the hospital, it's in the hospital's increasingly best interest to ensure that, that patient is adhering to the treatment regimen when they go home, and referring that patient to a world-class trusted home healthcare provider that the hospital or payor has experience with is absolutely critical to ensuring the continuity of that continuum of care outside of the hospital and preventing things like readmissions.
Our ability to pursue and fund great opportunities like AssuraMed, has really been facilitated by our strong balance sheet and really the excellent financial performance that we've demonstrated over the past few years. We've driven non-GAAP EPS CAGR of close to 20% since fiscal 2010, well above the 10% goal that we established for ourselves in December of 2010. An important part of that growth has been the expansion of our margins as you can see on this chart. And that's been a very deliberate focus through the investments and certain strategic growth areas and to a concerted effort to improve our customer and product mix. The net result of this is an annualized market TSR, for those of you who were invested in us over that period, which over that 3-year period equate to an annualized TSR of about 26.5%.
Now dig down into our most recent operating periods, our strong earnings growth has very much continued both in our FY '12 and so far through the first half of our fiscal '13. As a reminder, our fiscal year ends in -- at the end of June, so we're a little more than halfway through our fiscal 2013 at this point. But that strong earnings growth and margin expansion has continued through these periods.
As many of you know, what I wanted to highlight on this chart, in our fiscal '13, you can actually see a revenue decline. That was very much expected really for 2 reasons: Number one, that we're seeing an unprecedented conversion of branded products to generics, which is dilutive on our revenue, but very accretive to our gross margin line. And secondly, this reflects the -- as of October 1 of 2012, the termination of our Express Scripts contract, which was a very high-revenue, relatively low-margin contract that transferred away at that point.
Looking specifically at our most recent quarter, and this is the Q2 that ended in our most recent December. We reported these results in February, and we're very pleased, not only by the overall earnings growth that you see on this page and margin expansion on a consolidated basis, but most particularly important to us, it was the belt contribution from both our pharmaceutical and medical segments, which is something we are very much looking for.
From a capital deployment strategy, our philosophy in this regard really hasn't changed over the past 3 to 4 years. We do believe in a balanced approach, with the only really 2 givens our desire to continue to maintain and grow our differentiated dividend and to appropriately fund our organic CapEx, which generally in any given year, ranges from $200 million to $250 million, a large chunk of which goes into either internal or customer-facing IT systems.
Beyond that, nothing is really set in stone as we approach each year. We really look at M&A and share repo on a flexible, opportunistic basis. It really depends on the opportunities that present themselves. 2.5, 3 years ago, we spent a significant portion of our capital on M&A really to establish some platforms in some key strategic growth areas that we had identified. Then 2 years after that, really the focus was on repo, both because of the availability of cash and what we viewed as an attractive opportunity to buy back our own stock. And then most recently, we announced the decision to use $2.1 billion of capital to acquire AssuraMed. So again, that is the approach that we will continue to take beyond the dividend and CapEx. It will be very much a balanced and opportunistic approach to deploying capital.
With respect to our dividend, we are very proud of the fact that we have a strong, growing and differentiated dividend within our space. We think the combination of an attractive dividend yield, which now averages about 2.5%, together with what we think is a strong growth story is somewhat rare in health care, and maybe rare in the broader world. Our goal is to continue to return a substantial portion of our cash flow to shareholders beginning with the dividend, which we've increased over 27% over the past year. But through the combination of dividends and share repo, in both FY '12 and our expectation for FY '13, we expect to return over 60% of our operating cash flow to shareholders and are very much committed to continuing to have a shareholder-friendly approach to our balance sheet.
Internally, as we look at the future and this is the chart that we've been showing for a few years now, there are some very specific key strategic priorities that we've identified: Really to focus our investments and really be the basis for our growth in the near term, medium term and longer term. And we believe investments in these areas have positioned us to be really at the forefront of the healthcare industry for the next coming periods.
As we discussed during our August 2012 conference call, our goal is to leverage these growth drivers to deliver operational TSR of at least 11% and non-GAAP EPS growth of at least 10% per year. And by operational TSR, I mean the combination of EPS growth plus the dividend yield over a sustained period of time.
So let me conclude with just a final couple of words. I'm not going to read this chart to you because I've gone through most of these points already. But as I started off saying, we think we are extremely well positioned in a healthcare world that's going through massive change, a massive change that we think very much plays to our strength as being a company that focuses on the cost effectiveness of healthcare and really providing the continuity in the coordination of care across the whole spectrum of healthcare providers.
With the financial strength and the performance we've demonstrated and really the business portfolio that we have, we think it sets us up extremely well for the exciting years that we've been going through and are about to embark in the -- embark on for the foreseeable future.
So with that, I will bring us to an end. Thank you for your attention. I think we're going to be moving to a breakout room next -- that way in a few moments, so hopefully, I'll see you all there. Thanks.
Jeffrey W. Henderson
Hello, everyone. We're going to get started. Thanks for joining us.
Jeff, I'll start out with one. So, as you think about your ability to grow your non-bulk business, I know you've talked not just about growing non-bulk business and some of the many large customers that you have specifically around the Walgreens and the CVS around the world, so what are some of the things you're doing to help you drive those non-bulk revenues? What are some of those things that you've kind of demonstrated value at the store levels post doing bulk distribution to some of those customers and how -- what's the sort of competition there?
Jeffrey W. Henderson
So question is repeated for the webcasters. What actions are we taking to really drive an increase in non-bulk revenues with-- with our customers and I hope that was specific to large chain customers. It's been a concerted focus really for the past 4 years to improve that customer mix. And if you look at where our bulk business has moved over the past 3 or 4 years, it's gone from over 50% of our Pharma segment to now in the 30%. That's a pretty significant transition over that period. And much of that's been very deliberate. It's represented a focus on growing our retail independent customers, it's represented increased penetration with our existing customers and with our large chains, it's really been about demonstrating to them that we are the most efficient and effective model for getting daily deliveries to their store. Now I can't necessarily speak for CVS or Walgreens as to why they may have shifted some of their bulk purchases to non-bulk. It's a question you have to ask them. But our job day-in and day-out is really to get to increasingly more efficient in how we deliver to their stores and to make sure that we look at the entire system, right? I mean, because of the pretty significant coordination that's required between us and our large customers when we're going to 8,000 stores a day, we look at everything in the system, not just what's within our 4 walls of our trucks, but we look at the system as a whole and say, "How do we reduce the overall inventory that we collectively have to carry? How will we reduce the amount of waste that's in the system collectively?" And to the extent that results in more daily, direct-to-store deliveries, that's great. And that's really the ultimate outcome, but it starts with really focusing on the overall efficiency of the system. Yes?
Do you have any feel just for Walgreen, the cost of the group’s distributing in terms in Europe, relative to your cost of distributing in the U.S. Second question, which is the [indiscernible] consists some -- just on the working capital if we bring changes, the payment types, by 5 days, what sort of impact does that have on your cash flow operations, roughly?
Jeffrey W. Henderson
So the question was related to our Walgreens customer and first part of it was, do I have any idea of the relative cost to serve in Europe per boots versus what are my costs in the U.S.? And second, if there's a change in payment terms with Walgreens, what impact does that have on our working capital. So on the first one, I can't honestly speak to boot's cost of distribution into Europe. I do know that the European market is very different than the U.S. model, which is really all I can speak to is an incredibly efficient model. We have set up our network nationally to optimally serve really every single part of the country. And we leveraged our very, very significant scale across many, many customers to deliver that -- those products in the most cost-effective and capital-effective way we believe possible. So -- the net result has been a U.S. distribution system that we think is best in the world. It's incredibly efficient. I don't think there's many people who would argue with that. And that we also think that trying to replicate that system in the U.S. would be a somewhat difficult and expensive proposition. But again, I think to the rest of that question, you probably have to direct towards Walgreens. Regarding the change in payment terms, again, I'm always loathe to talk specifically about customer contracts, but I think as most of you could probably figure it out, you know we do about $20 billion of business with Walgreens. I think it wouldn't be hard to figure out what a day of receivables would mean to our working capital, if that changed. And that -- I don't want, in any way, signal that may be changing, I was just answering your question.
Can you sort of get to medical quickly? Can you come up what sort of the competitive environment is interesting out there and maybe may be effects on culture or format, and more specifically, have you guys quantified for what percentage roughly is for that traditional doc business? How's your big -- a largest scale acquisition in that space pretty recently. So I'm just trying to get a sense of what you're seeing in terms of the competitive environment and maybe you'd sort of roughly break it down as for traditional doc business or [indiscernible] the next year or 2.
Jeffrey W. Henderson
Yes, by doc, you mean physician's office?
Jeffrey W. Henderson
Okay. Yes, our -- we really talk about our it as our Ambulatory businesses was a combination of both doctors' offices and surgery centers that may be remote from the hospital. With the exception of the very recent period, for the past 3 years or so, we have outgrown the market in that space. That all said, I would say our Ambulatory business is still a relatively small percentage of our overall business in the U.S. and Canada. But it's also a big focus for us. We know it's important for us to get bigger in the ambulatory setting, not only because it's an important and growing market in its own right and it will continue to grow going forward, but because increasingly, it's getting linked to the hospital market. I mean, more and more IDNs are forming these large networks. They're buying up doc's offices, they're buying up surgery centers, and they're forming these large regional networks that are getting increasingly complicated and require coordination. We believe there's no one better suited to provide that coordination than us. If you think about it, we're really the only full product line player on the both the pharma and the med-surg side that can go to hospitals, can go to surgery centers can go to physicians' offices, can go to pharmacies, and very shortly, I hope we can go to the home. And our most sophisticated customers are looking for that kind of coordination because it's very difficult for them to do it themselves. And in many cases, they don't want to do it themselves. So providing that offering that can cover their entire network is getting increasingly important. In terms of the competitive environment, hospital environments have always been competitive. And I'm not sure I can definitely say that it's changed, they're under pressure. Our job is to realize that and provide them products and services that allow them to alleviate that pressure. That doesn't necessarily mean just dropping our fees. It means giving them alternatives to their current buying patterns. So in many cases, we'll go into a hospital and analyze their spend and come back to them and say, "If you switch these 6-product categories over to our private label products, you can save x million dollars a year." That's where the real benefits are coming in. And that's where our portfolio provides us a distinct competitive advantage that some of our competitors can't meet. So if it's just about dropping the fees on distribution of national-branded products, we can be as competitive as anyone, but that's not really where the money is going to be made for either us or the hospitals in the future. It's going to be from looking at how they're running their hospitals from a supply chain perspective and giving them products and services that can bring down the overall costs. And we've had some great success in that area. We're continuing to invest in our preferred product portfolio so that we can expand the types of categories that we can offer to them. And we're also expanding the types of services that we're providing to hospitals, things like freight management services, where we can leverage our national scale to manage their logistics and the cost of the logistics coming into the hospital. These are the sorts of things that are going to be important going forward.
Jeff, can you just give us an update on P4 and maybe the other applications -- just sort of where you are in the sort of plan to get bigger and better in the specialty and the challenges, what's worked out better than planned and kind of the objective of the [indiscernible] perhaps bigger?
Jeffrey W. Henderson
So we acquired P4 -- question was about our historical acquisition of P4 and what are our plans are to get bigger and better in this specialty area. So we acquired a company called P4 Healthcare about 2.5 years ago. It was really part of our decision to establish a platform in specialty pharma. Up until that point, we were largely irrelevant in specialty pharma with the exception of certain particular areas like plasma, for example, where we had a large business. But in some of the key disease states like oncology, rheumatoid arthritis, urology, we really weren't a significant player. And it was a hole in our strategic portfolio, and we knew it. We also knew that we need a platform to sort of jumpstart our growth in that area, made a decision to acquire P4 Healthcare, and I would say our results since have been mixed, quite honestly. The core part of the P4 business that we acquired, parts of it such as the payor business, have done very well. Other parts such as the pharmaceutical manufacturing business haven't due to some loss of the contracts that we have discussed earlier. But what it has done is it did achieve our goal of establishing a platform and capabilities and specialty, which we have since leveraged to grow our distribution of specialty product to sell additional services to the providers and really establish our clinical pathways as one of the market leaders in this area. And we've also taken what was our initially an oncology platform and expanded it into areas like urology and rheumatoid arthritis. It's been slower than we anticipated, in all honesty, but we have reached critical mass now in terms of the products that we buy and sell. We have been able to increase our capabilities and we have reduced our dependence on the pharma manufacturing part of the business, which is, again, where we saw some of the shortfalls from the original plan. So we need to continue to build on it. That doesn't necessarily require big acquisitions, but it means selectively adding capabilities, some of those will happen organically, some of those will happen through small M&A opportunities. And we've done some of those. But I think the important thing now is we have a platform that will allow us to participate in the growth of specialty pharmaceuticals for the next 10 years, right, which we didn't have 3 years ago. And if and when biosimilars ever come to this country, we also have a platform that allows us to participate in that. So I think we have achieved our basic strategic objective, which has become relevant in this space. But now we need to focus on making it big enough, so it can truly move the needle at the consolidated level.
Are there deals to be done that can help in that, big or small?
Jeffrey W. Henderson
Yes, I think they're mostly small, quite honestly. The question was, are there deals to be done that can help them in that regard. I think they're mostly small. I don't think there's any one deal out there that could automatically dramatically change our market share, but, are there smaller deals that can improve our capabilities? Yes. Because at the end of the day, this is isn't necessarily about having the best distribution platform, right? Distribution sort of -- is a net result from providing other value-added services and capabilities to the manufacturers, the providers or the payors. And many of those capabilities are buried in small companies, right, that we can then buy and use our channel to leverage in the broader market. So yes, there are opportunities. The key sort of filtering through those and making sure you're buying one that makes sense for us. And we have done some and then there are others that we'll look at it but I'd characterize most of them as quite small.
Jeff, in specialty pharmacy, there's a push from CAGRs and PDM to shift to a buy-and-build model under the medical benefit, so that it being under the pharmacy benefit and more closely control whether doc's are taking money off the tier [ph] by itself. So, is that a headwind for you guys? How do you deal with that? How do you work with the payors on one side and then the providers on the other side, which might have competing objectives?
Jeffrey W. Henderson
Yes. So the question was there's a transition going on in the way that providers are compensated for dispensing pharmaceuticals from the old buy-and-build model to a different model going forward. One of the advantages of being the new kid on the block is you can participate in the transition as opposed to defending the status quo, and that transition is happening. And actually I think it's a tailwind for us because through our clinical pathways programs, where we work with the payors to provide data and systems that facilitate the transition to a new way of paying docs, we can benefit from that. And I think the reality is -- change is always difficult, right? And we always know that providers need to be appropriately compensated for the services they're providing to their patients. And we believe as we move towards a new model, we can accomplish what the payors' want, which is to provide world-class clinical care at the most cost-effective level and ensure that providers are appropriately compensated. And that's really what our clinical pathways programs are geared to do, to really help facilitate the change in a way -- change in the way the providers are compensated. And our goal here isn't to result in the providers getting paid less. The goal is to get rid of perverse incentives, all right? and to ensure that the providers are appropriately compensated, but done so in a way that makes sense for the system and for the patient. And that change seems almost inevitable. It is happening and it's happening on an accelerated basis. It's going to be a tailwind for us. Go ahead, Kipp.
Kipp R.F. Davis - Barclays Capital, Research Division
On AssuraMed, you talked -- in your original presentation about the ability to use their capabilities and know your measure. I'm just wondering from a DC standpoint, whether it's systems infrastructure, processes, are you looking to take some of that capability and obviously, a lot of this is direct to home and use that sort of trough here to their existing physician business into their infrastructure over time so you can presumably extend margin in your existing physician business due to efficiency. What's the strategy there and how long is it going to take, and what does that do -- I don't expect you to break out your position margins but there have been other players in the space and kind of know what their relative margins are at. What's the impact?
Jeffrey W. Henderson
Yes. So the question was how do we plan on utilizing the AssuraMed, low unit of measure platform for our physician office business going forward and what's sort of timing and impact may that have. First of all, that is the plan. One of the side benefits of the AssuraMed acquisition as I said earlier, was they have a world-class -- from an efficiency standpoint, a world-class, small package distribution network. And the reason that's important to us really is because currently, our physicians' office pick, pack and ship capabilities are suboptimized. We're using our large -- our large customer network to service small physicians' offices, and that results in an -- from an efficiency perspective, suboptimal cost, which means we're probably not competitive in terms of bottom line operating costs when it comes to servicing physicians' office customers, and that results in reduced margins for us. We've been looking to solve that problem for a long time, either through organic investment or through acquisitions. The acquisition of AssuraMed actually accomplished a lot of things. It got us into the home and finally, provided that low-unit-of-measure capability that we've been looking for. So yes, the plan over time is to shift our physician's office fulfillment business to their platform. It won't happen overnight. It will probably take a couple of years because we don't want to disrupt their existing model. We want to make sure it's done right and that we don't, in any way, jeopardize their existing home healthcare model. But they've done physicians' office distribution in the past off that platform, so they know how to do it. So I believe the transition over time will be relatively seamless and will occur over a couple of years. Now the other advantage of this from a physicians' office standpoint is that there's a large product overlap between stuffs that goes to the home and stuff that goes to the physicians' office. So we have the ability now to collectively leverage our scale buying platform in the physicians' office and in the home, and it even overlaps with our hospital customers, and lets us buy products at a much more efficient rate. So all around, this is sort of a win-win for the various parts of our business. And our biggest challenge right now will be making sure that we get the pacing correct, so that it happens in a way that's relatively seamless to the customer. Yes?
[indiscernible] business in Q2, can you talk about some of the headwinds [indiscernible]?
Jeffrey W. Henderson
Yes. So the question was on our Medical segment referring to the fact that we saw growth in Q2 and what the future looks like in terms of headwinds and tailwinds? First of all, I'm very excited about where the Medical business is headed and I recognize we've gone through a bumpy stretch. Some of that is self-inflicted, some of it driven by commodity prices over the past couple of years. As I look forward though and I point to headwinds and tailwinds, let me start with headwinds. The medical device tax kicked in for us effective January 1. We said previously with the impact of that could be $13 million to $20 million, or $13 million and $23 million, was the range that we gave for half a year. But we also indicated in our Q2 calls that based on our current interpretation of the regs that were published that probably the impact for this year will be at the lower end of that range, if not below the lower end of that range. So that's good news. It's still a headwind but less significant than what we originally had feared. Tailwinds, we continue to focus on our private label portfolio and that will drive margin expansion and growth -- earnings growth for us in the foreseeable future. The big uncertainty there though is commodity prices. I would describe them right now in our current period as being a tailwind what they're going to look like on our income statement, 6 or 9 months from now is a bit of a question mark. We've budgeted for oil in the 90s range, oil is currently in the 90s range. So we're sort of on-track as we look forward. But obviously, there's always some volatility there that we need to deal with. I think our Medical business transformation implementation, which really started over a year ago, is largely behind us at this point. We went through some significant change management efforts, which impacted us in our Q1. I'm happy to say we now have our salespeople back to selling, which was probably the biggest negative impact of the changed management, as we needed to divert our salespeople to working with customers to understand the system and fix any problems that arose. We're largely through that. And as I said, our customers are back focusing on selling products, which is what they should be doing. We've made some recent decisions regarding restructuring. It's really about continuing to focus on our costs. We've decided to consolidate our surgical kitting into our 2 lowest cost operations, which will begin to impact our product cost heading into next year. And we've also reorganized our commercial operation to ensure they're focused on the highest value-added customers and providing the appropriate products and services to those customers. So I would say most of what we're seeing ahead of us right now nets out to a tailwind, with again, the biggest question mark being what happens with commodity prices.
Jeff, in private label, can you just talk about kind of what the percentage products you might believe were being used right now, I guess? Or where you think it could go, is there runway left there, it's obviously continued to grow quite a bit it's going to create a tailwind especially in an environment where you've had some other challenges?
Jeffrey W. Henderson
Yes. Question was about private label your products and what it represents in terms of the overall product lineup and where it can go. Currently, it represents about 23% of our revenues within the Medical segment and somewhere between 35% and 36% of our gross profit. Clearly, it's a higher margin part of our business, and one that we want to grow. We said previously that in the medium-term, we are targeting getting that revenue to 30%. Could it go well above that? Yes, it could. And part of it will depend on decisions we make in the next couple of months and quarters regarding which additional product categories we're going to expand into. I'm not being evasive. We haven't decided yet on some of those and some of those can be very big dollar categories. We have had some success moving up scale in the product categories we service. We recently launched a line of orthopedic trauma products, 6 months ago. Demand for those has been outstanding, which really represents, I think, a tipping point in the attitude of our hospital customers towards which products they're willing to consider from a private label standpoint. So that's been some good learning for us, all the way around, and both in terms of understanding where the market is now, also in terms of what it takes for us to source and market those products and support those customers. So part of the changes we've made within the Medical segment over the very recent past have been towards ensuring we have the right people focused on the right product categories and driving those product categories. And I truly believe in the next 2, 3, 5 years, this particular area represents perhaps the biggest opportunity for the large hospital systems to deal with the reimbursement pressure that they're facing and to really take a hard look at their product categories. And there'll always be some that will be purchased in a certain way and that's fine. There's certain categories that just don't make sense for us, but to the extent that we can provide cost-effective alternatives that our big wins for customers, also big wins for us economically, we're going to pursue it. And I think it's -- it's one of the most exciting growth opportunities we have.
Do you think the higher margin of private label are sustainable or will they fall down over time?
Jeffrey W. Henderson
Question was, do I think the higher margins for private label products are sustainable or will they fall down over time? I think in any particular product category, there'll be pressure over time, right? A lot of the products that we sell right now, I would say -- if you look at the spectrum of technology in the med device world, with a 1 being a band-aid and 10 being a cardio implant or something, most of the products that we sell are in the 1 to 3, 1 to 4 category. They are higher-margin products for us. I expect that they'll stay higher margin than distributing national brand products for us. But will they face pricing pressure over time? Yes, it's inevitable right? The customers look to drive down their costs and as other players come into those markets. But I believe that will be more than offset by the fact that we're going to continue to move up the technology spectrum, sell products that actually have much higher margins. So the mix shift, I believe, will be very advantageous to us for the foreseeable future.
One quick question. There's a bunch of big moving parts with generics, customer losses. Looking forward, notwithstanding -- think of -- changing in terms of contracts, customers, is there a right rule of thumb for sort of operating cash flow or free cash flow as a percentage of net income, of revenue, or EBITDA, and any other sort of income statement item?
Jeffrey W. Henderson
Yes. Question was, is there any sort of rule of thumb on cash flow as a percent of other parts of our income statement? Not one that I've really spoken about. This year, for example, I said I expected our cash flow to be about $500 million less than a typical year due to both the unwind of the Express Scripts contract and some large tax payments that we expect to make in the second half of our year. A more typical year probably is $1.2 billion, $1.3 billion, $1.5 billion. This year could be under $1 billion. I expect that we'll see it to grow over time, but in terms of the specific rule of thumb, I'm not sure if there's necessarily one that I have.
I'll take one more question and I'll probably have to end.
Jeffrey W. Henderson
Yes. What we said -- question was about the CVS and Walgreens contract. And I'd love to give you a great answer right now but as you would probably suspect, I won't. So I did -- we have said previously we would expect to have a much better idea by the end of the March quarter. That's still the case. Now we may not be in a position to necessarily announce by the end of the March quarter because until we actually have the contract signed, neither party would be comfortable announcing, assuming it is going to be signed. And I don't want to foreshadow one-way or the other. I remain very, very happy with the relationship we have with both CVS and Wags, I think they would say the same thing in terms of efficiency that we bring to their operations. We're going through the RFP process right now. We're in discussions with both of them. But at this point, there's really not anything more I can say until they get resolved one-way or the other. But again, my original statement that we would expect to know more by the end of this quarter still stands. But I can't say definitively that we'll have an announcement by the end of this quarter.
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