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Cardinal Health Inc. (NYSE:CAH)

Morgan Stanley Global Healthcare Conference Call

September 9, 2013 10:35 AM ET

Executives

George Barrett – Chairman and Chief Executive Officer

Analysts

Ricky Goldwasser – Morgan Stanley

Ricky Goldwasser – Morgan Stanley

Good morning everybody and welcome to our next presentation here on stage with me is George Barrett, and can you all hear me? – Is George Barrett, CEO of Cardinal Health and we will kick off the presentation just with five minutes where George is going to frame for us kind of like, the year end perspective and how should we think about the Cardinal story going forward.

George Barrett

Sure, maybe I’ll stand for just a moment and then I’ll come back and join Ricky, if that’s okay. So good morning, it’s good to see everyone. We thought this would be perhaps more interesting to do this more as a fire side chat and I hope that you find it that way, but I thought it might make sense to just take a couple of minutes to describe a little bit about where we are, it’s been a pretty eventful last 12 month to 15 months for Cardinal Health and we are in a pretty exciting place as a Company.

As many of you know, we came through a very critical year with I think some significant inflection points, repositioning our business and this has been in some ways part of a journey we’ve been on and along the way repositioning both the distribution of our customer mix and our product volumes line mix and as I said, part of a long journey that has been pretty productive since the spin-off of CareFusion.

I think our annualized TSR growth rate has been about 21%, we had a strong year, we finished our fiscal year in 2013 at the end of June with about a 10% operating income and 16% non-GAAP EPS. If you exclude the benefit that we got from a one-time tax settlement, so a pretty strong track record, but just as important I think we come out of the year in a very interesting position with a stronger base, really focused in around a couple of key dynamics that we see unfolding in our market and these are really long-term powerful forces. Certainly the number one force is demographics, public health and economic issues, these are sort of the inescapable realities particularly demographics, it’s an incredible number, 10,000 people a day roughly entering Medicare age.

ARP just came out with a report the other day saying that we have somewhere in the range of 11 million people over the age of 80 now, they are projecting that number is going to be, as we approach 2030, that number is going to be like 20 million people over the age of 80, sort of incredible numbers. So inescapable forces around demographics, which has its own economic dynamics associated with it.

Second, we know that we are going to have a system that is much more focused on dealing with this in an efficient way, so how are we going to do that as a society, how are we going to do that as a system, how are we going coordinate care, which we believe, is going to continue to happen. We’ve had very disconnected components to our healthcare system, which are beginning to work together on a more cohesive way but that still has to take place.

And our view of that is that will continue to mean care is delivered in the most effective ways, in the most effective settings and again probably more care being delivered out of those acute care setting. We can imagine that acute care hospitals in the future are going to be places where people are very, very sick and more patients will be cared for as you move out of the hospital and in our view ultimately in the home, which is a part of the reason that we made the decision to acquire AssuraMed, which we did this year.

We also believe that health systems will continue to look for players who offer broad sets of solutions to deal with problems that are very different for them, particularly as mixed swings for them they are going to be looking for solution providers who have broad sets of capabilities to help them navigate a very difficult environment.

So in all that, we do see ongoing demand. There will be pressure as we see to limit per capita utilization and there are various forms of doing that, benefits design et cetera, but again the powerful force underlying this all is this increasing explosion of people who are aging with certainly public health issues, multiple chronic care illnesses who need care.

So we’ve come out of 2013 in a really good place, we are excited about 2014, we’ve given some initial guidance and as you know we – those of you who follow us, we did not renew our contract with Walgreens and so we’ve provided some initial guidance around that and then we started the year of 2014, [solidified] [ph] that guidance.

And so roughly our year 2014 against 2013 is approximately the same, I would say some pretty solid accomplishment given that huge swing just to give you a little bit of a perspective on the kind of mix that we’ve been able to achieve over these last few years.

If you go back even to 2012 and you look at our EPS, 2012 versus let’s say the mid-point of our 2014 guidance, we are up 10%, that is after shedding Walgreens Express Scripts. So our mix of business and the strength of our business I think has really changed and changed in a very productive way. And I think we’re really positioned in a good way as it relates to those forces that we see in the future.

So with that I will sit down and let Ricky take us forward.

Question-and-Answer Session

Ricky Goldwasser – Morgan Stanley

Thank you. And if any of you have questions just raise your hand and we’ll take the questions as they come. So just to take Walgreens out of the way as of September 1, you have transitioned to Walgreens business?

George Barrett

Yes.

Ricky Goldwasser – Morgan Stanley

So can you just share your perspective on how the transition is going and what opportunities you’re seeing on the fixed cost structure?

George Barrett

Yes, so from our standpoint the transition is very straightforward. We serviced Walgreens full blast; our people are very clear about our responsibilities and our service levels are probably 99% service levels right up to the day that we – the contract expired at the end of August. So for us, that transition is completely done, again they are on-boarding transitioning their side, we will let them and their business partners talk to over the coming stretch, but from our standpoint, it’s really completely done. So the second part of it was?

Ricky Goldwasser – Morgan Stanley

On the cost structure?

George Barrett

Oh, so yes. Clearly Walgreens did consume some resources and so there are some variable costs that existed in our organization and we’ve largely eliminated those costs, some are just finishing off in these last few weeks. And again that did unfortunately involve some headcount and there are some folks who devote their full-time to the Walgreens work whether that’s in a distribution centre or a call centre, or one of our service centers, we certainly had some variable costs associated with supporting that business.

There are some fixed cost, some of which we’ve been able to work on, we have over these last 18 months or so, been aware that the possibility that this could occur and we’ve done some work to sort of reduce some fixed cost, but there will be some fixed costs that just goes with being in the facilities, we are still a national footprint and this doesn’t change that, we are a company that continues to have enormous scale, we have whatever 18,000-ish pharmacies and if you add clinics and hospitals we are probably about 20,000 at this point. So we’ve got a full boat and we will have some fixed costs that we just have to live with.

Ricky Goldwasser – Morgan Stanley

And globalization of the supply chain and sourcing has been a very topical issue in the last six months. How has your thinking evolved about global sourcing, competitors are getting larger, does that give them an advantage versus the Cardinal and is there something that you need to do in order to improve your sourcing?

George Barrett

So let me take a step back for a - we’ve always been a global sourcer and we remain so today very actively, very creatively and I would say the generic supply system has been a global supply system for decades. So I don’t think frankly this changes my perspective on that, the interesting question people ask, is there a global distribution system, it’s a completely different question and that is a hard one to answer.

So I have a hard time seeing distribution as global as much as I see distribution being local and sourcing and procurement being global. From our standpoint we continue to be a company with enormous scale, so we didn’t de-scale during this process, the work that we are doing for Walgreen as it relates to generic was really primarily contract - the backup work that we are doing on the contracts they had between manufacturers and themselves. So we didn’t really lose scale in generics on that, so we remain a company of enormous scale and we’re getting bigger in generics and we’ve continued to get bigger in generics and it’s helped fuel some of our growth and I think it’s helped us position ourselves with our downstream market.

So the change really describing – the one change you are describing is this interesting connection between Walgreens, Alliance Boots and then AmeriSourceBergen. And I won’t say too much about it. I think it’s really for them to comment on. I would say this we feel very competitive in our positioning around generics, we are very open-minded about it, it would be hard today to discern a noticeable change other than the fact that this occurred and the noise surrounding it, that has not to dismiss it or be dismissive in any level, but if I had to describe the market today you would not particularly notice a difference.

For us and we get asked this question all the time, have the independents reacted, has that caused some big swing. And I think the way to think about this it’s very early, most independent pharmacies are just watching to see whether this has any impact on their daily lives, and that’s really at the heart of it and I think – so it’s not – it’s certainly consumed an enormous amount of energy for all of us, in thinking about it, discussing it.

And fortunately after three decades of being around the business, so I have some perspectives on it, but we remain a company full of options as we think about how this might unfold, but at this point, it’s too early to say whether or not it has any real impact, or will have any impact on the market.

Ricky Goldwasser – Morgan Stanley

And you talked about your generic sourcing is increasing in this last recent years. Can you share with us how Cardinal is achieving that right in a very difficult year for generics pipeline, basically year-over-year comparison and yet you are growing your generic business, you are improving your margins. How were you able to do that and how should we think about the next 12 months because next 12 months we are seeing some improvements in the generic pipeline, could you add on top of just kind of like that product line also?

George Barrett

Yeah, so this is really interesting question. So there are two – couple of parts to it. One is simple strategies and philosophies around global sourcing, this is a work that we’ve done for many years, as I said I have a little bit of an advantage of having some background in this and knowing the players quite well. But Cardinal is doing this you know certainly long before my arrival, I think we’ve ramped it up, I think it’s not just about identifying the global sources of high quality products around the world that’s understanding what they are looking for, every company has its own strategy, we try to tailor our thinking around what they need based on awareness of what their strategy is by product.

And so what is interesting in generics and I think I have said this to many of you before even in lives prior to Cardinal, in some ways each generic product is its own market, it’s literally its own market, the supply system is different, the number of players is different, the pricing strategies are different, the downstream customers are different, what level of substitution are you going to see.

So I think we’ve just become increasingly sophisticated about how to do this on a global basis, how creatively to think about capturing value by partnering with companies, but also about being good at the downstream and the reality is having been a manufacturer what I really wanted from my partner was to move the needle downstream and so the better that we’ve gotten downstream the more valuable we’ve become to our partners.

In our growth in independent pharmacies has been really noteworthy and along with that growth comes additional scale in generics, and it gives us a greater pool of customers who will benefit from the scale that we can bring, and so it’s a bit of a virtuous cycle, scaled us beneficially, you have more scale you can source more effectively, you source more effectively you are more attractive to your customers, you are more attractive, you have more customers, you can create more volume and it’s a bit of a wheel and if we do it well, it works in our favor.

Going back to the second part of your question about the year, interestingly our expectation at this stage of the year as you know generics this well can change quickly. Our expectations from a launch perspective, our fiscal year meaning starting July 1, our 2014 is probably a lower year in launch value than 2013, but we expect our generic contribution to grow during this year. And that’s something that’s not – its sort of counterintuitive for many, so let me just say it again, in spite of the fact that the launch value in this coming year will be lower than in the prior year, our generic contribution will increase.

And there is a lot to that but part of it is that again, remembering that every generic product has a lifecycle and that we captured value differently along the stages of the lifecycle of a drug and I think we are getting better as a company at capturing value along the full lifecycle of the drug and again that virtue of cycle is at work.

Ricky Goldwasser – Morgan Stanley

That was interesting, to your point you are capturing more value upstream.

George Barrett

Well we can’t – essentially I had put it in a positive way. The positive perspective is a manufacturer is likely to share some of their value with you if you are really creating value for them. Right, so the notion is if I'm creating market share for you and you are capturing X margin from that market share then there is a partnership that’s more rich, and so in a sense it gives us greater ability to do greater things with those companies.

Ricky Goldwasser – Morgan Stanley

We have any questions? And no questions, I will ask a question around specialties.

George Barrett

Sure.

Ricky Goldwasser – Morgan Stanley

Specialty drugs sector accounts for 50% of drugs spend the next five years. Cardinal’s relatively exposure rights due to historical decisions that you were not part of, is smaller compared to their peers in the area of specialty. Can you grow, can you be relevant in the specialty market, how do you get there?

George Barrett

So let me answer the second question which is really important. We are growing very rapidly and we are relevant, I think we are the only one of our peer group that presented at ASCO postures around some of the work that we are doing and connecting providers, oncologists with payers and some new models just to deal with some of the changes in this system. So we are and we will continue to be relevant, we are definitely smaller than a couple of peers and we’ve been very transparent abound that it’s not hard to see it. That can be challenging, that can also in some ways be liberating, because we know that there are changes in the system.

Oncologists were under enormous pressure, you know just as sequester alone has been challenging for oncologists, the changes in the system, practice is being required and affiliated has been a huge challenge for them, and so I think we are at a place in a way as a business where we are at a size where we can be very creative about trying the things without jeopardizing an old model, so I would love to be bigger, but actually we were growing at about 60%, 70% I think during the back half of the year, so we are growing quite quickly.

A lot of that in specialty distribution but also in some of these services that we provide are the specialists whether its an oncologists, rheumatologists, a neurologists what we are beginning to focus in areas that I think are really important and there is no question as you said that this is going to be a growing area of pharmaceuticals. We are really seeing a – so for this bifurcated model or this huge, huge bonus of generic drugs that whatever 83 or 82 whatever current IMS number is present on scripts and then a huge amount of activity research innovation happening on the specialty side whether or not that’s in immunology or other areas and we are really building capabilities here, I also think our team is fantastic, we are really tracking in some very good talents.

So I think we are growing very quickly, we are relative, we will increase relevance, it is a relatively small business today, so it doesn’t move the needle that much for us, but we think we are actually pretty well positioned and I would love to be bigger, but I also now that we have the latitude now to really be pretty creative about trying things and we will be pretty innovative and pretty experimental in that business.

Ricky Goldwasser – Morgan Stanley

Cardinal has very strong position what health systems and with hospital and is the hospital systems buys physicians [ph], are you seeing change in the decision making, is that purchasing shifting.

George Barrett

[Indiscernible] into the microphone. Apologies.

Ricky Goldwasser – Morgan Stanley

Have some water

George Barrett

That would be great. Well there is no question that more physicians’ practices are either being acquired, partnered or affiliated with health system, that’s not a question mark, that’s happening, that trend has been quite dramatic. How that affects sort of shifting in the system and this reason is a little bit tricky, I mean we are already selling those big acute care systems through that channel.

So there will be probably some a long way and its hard to tell how this is going to play out still, because you can have – it varies at the end you can have an idea and that’s very aggressively trying to manage those networks, including Clinical Pathway management, procurement, everything and others that really are not doing that yet, they just want to make sure that they have a network, but they are not aggressively managing their practices and so I think we are going to see it all over the board for a while, but I don’t think the trend is necessarily going to stop in the short-term.

Now we could see overtime some resistance to the trend, because we’ve seen this before, but I do think for the time being I think we are continuing to see practice as being a fair later acquired.

Ricky Goldwasser – Morgan Stanley

Okay.

Unidentified Analyst

The question is, the resources Walgreens were consuming will those shift to CVS and how those – the call centers and distribution centers how those change and also the CVS, will that relationship grow or change in anyway?

George Barrett

So I head the second one very clearly, let me repeat the first and tell me if I got it right. You are asking about the work that folks were doing to support Walgreens and whether or not that will shift to CVS is that the question?

Unidentified Analyst

Correct.

George Barrett

Look, we certainly have in our many thousands of people, people that are cross trained and they can work from area-to-area, but if the volume of activity for example in a call center is going to be reduced by X number of calls that were coming in from 7,000 pharmacies then we’ve reduced cost.

So we’ve had lots of opportunity to redeploy people to move them around, but we’ve still had to make some difficult decisions to downsize because some of the activity is just not necessary, if that’s helpful. On the second part, has it changed our relationship with CVS? Well our relationship with CVS is terrific, again it’s always tricky for me to standup here and voice it up here and talk about any specific relationship and again I think in some ways CVS needs to do that for themselves.

I will say that it’s a long history, we’ve had a great relationship, we felt very good about the resigning of that agreement and the nature, the design, the structure and the economics of it and I think in some ways we probably again to use that word, we are a bit liberated to try things in that relationship that would have been more challenging having these two large customers, because obviously we always had to be conscious of the relative position of those two customers. So I wouldn’t be in anyway specific it’s just, I think we probably have a greater degrees of freedom to explore ways of creating value for one another and always we are eager to do that.

Ricky Goldwasser – Morgan Stanley

Just into the medical segment, you in the past talked about the opportunities that you see in medical segment, especially in kind of like the private-label side is similar to what you have seen in the world of generics, ten, fifteen years ago. So can you talk a little bit about that opportunity and how do you think it’s going to translate into margin expansion in growth of business?

George Barrett

So let me start sort of with a conceptual notion, the conceptual notion and we’ve seen this over 35 years in the drug industry, which is that for matured drugs we had a system to make those more affordable and accessible and I would argue which enabled us to create the head space in the system to focus on innovation and if you look research right now and particularly in specialty, it’s intense, there’s huge amount of innovation happening.

So again, for those who might put innovation as [indiscernible] at all and it tends to be cyclical. But there is a place for these competitive price products for the matured products, we should have a system like into of that in medical devices and that is beginning to unfold and I think that underlies our view that our preferred product portfolio is essentially that.

Now again, we don’t have the exact analogue to generics, you don’t have any of the rating system, for example, but we believe that there are certain areas and we’ve already begun to move aggressively in the area of trauma for example, where there are matured medical devices that could be made more accessible to systems at lower cost and this actually is really important.

And I would say for a system, it is actually a good thing, because again we should be innovating in medical devices, which we are doing as a system, as well as pharmaceuticals.

So I think that there is going to be a place for looking at these mature products and you can use the word generic or you can – we have a preferred product program it includes our profit label programs, as well as some preferred relationships where we believe that we can bring those products to the market in a more affordable way, and I think hospitals are going to have to think about this, because in the changes in our system you can’t just deal with it by squeezing unit costs, you have to change the behavior at some point.

And you’ve heard, all of you I'm sure many hospitals talk about how they are really thinking about change and this is one of the solutions that we can bring to our hospital, to our home customers, to our ambulatory customers and clinic, and service centers, and doctors’ offices and so we are going to continue to twitch down that path.

Ricky Goldwasser – Morgan Stanley

And can you – oh there is a questions over there.

Unidentified Analyst

So two questions, just to follow-up on that the degree of complexity and devices are just medical distribution, how across the value chain are you looking to go?

George Barrett

Yes, it’s a great question. So the question is really about where does that line exist between the highly differentiated clinically relevant medical device in a product that essentially is not differentiated right, and so the answer just are low and I think its reasonable to do that its also very important to have the clinical shop and its clinical capabilities to be able to interact with those physician in their field of expertise.

So that’s when we talk internally about our capabilities, our capabilities have always been incredibly strong around logistics, and finance, and supply chain management, distribution, we are building clinical capability all along the way, that’s been happening in the specialty business and pharmaceuticals for sure and its happening in our medical products business, because we need to be able to speak the language of orthopedics if we are going to be talking about trauma so the answer is it’s a huge spectrum at the top, you are talking about products that’s highly clinically differentiated and probably don’t lend themselves to this, at least not in today's environment and other products that are much more supply oriented. So it’s a whole spectrum from barely not differentiated at all to highly clinically volatile [ph].

Unidentified Analyst

And then to follow-up with previous question earlier in the conversation. Just to be very clear it sounds as if you don’t see the need for a major deal at all to reach parity with peers on any kind of international exposure.

George Barrett

No I not to the need to make a move right now, but I also – I’ll tell you what I tell our organization that dumbest thing in earth is just assuming the smartest person on earth all the time. So we will watch, and we will watch continually in terms of what is evolving. I would say right now, what really matters is scale in market and so we don’t feel compelled to make some other kind of move. We could choose to do so or something that we are seeing in the market can say to us you know we should make some kind of adaptation, but I would say today, we don’t see a compelling argument for some huge move today.

Unidentified Analyst

So George, we have about a minute left. No compelling reason to do larger acquisitions, a freed up capital as a result of the Walgreen transition, how are you thinking about capital deployment, how are you thinking about share buyback?

George Barrett

So our philosophy on this has probably been pretty consistent and I should acknowledge that this is a year in which we will – with the expiration of that Walgreen contract, there is a freeing up of capital and the net effect to that is about roughly again plus, minus $500 million.

So our strategy has been the same, A, make sure we are investing in our core business, I would argue that it is critical that the base is robust in order to do the things that we want to do, its what allows us, it’s a platform that allows us to touch all the system, we will continue to invest in that, we’ve been very committed to a strong dividend, if you look at our dividend versus even April 2012 we were up about 40% in our most recent dividend, so growing dividend which we think is important to our shareholders.

We’ll continue to look for the right opportunities in acquisitions, if they continue to position us for continued growth in the environment as we see it evolving, and in a way that expands our margin, and we’ll continue to look at repo, if we’re beginning to accumulate cash and we’ve assumed I think in this year’s guidance about $215 million, but early in the year that’s a base assumption. But our goal is not to trap cash, so if we’re beginning to generate cash, and we don’t see more effective ways to deploy capital for our shareholders then we’re always ready to consider repurchases. So it’s really the sort of thinking about that opportunistically.

Ricky Goldwasser – Morgan Stanley

Thank you George. Our time is up.

George Barrett

Thanks all.

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