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Executives

Jeffrey Henderson - Chief Financial Officer

George Barrett - Chairman, Chief Executive Officer and Chairman of Executive Committee

Sally Curley - VP IR

Analysts

Michael Cherny - Deutsche Bank AG

Lisa Gill - JP Morgan Chase & Co

Ricky Goldwasser - Morgan Stanley

Steven Valiquette - UBS Investment Bank

Robert Willoughby

Lawrence Marsh - Barclays Capital

Garen Sarafian - Citigroup Inc

Verdell Walker - Goldman Sachs Group Inc.

Eric Coldwell - Robert W. Baird & Co. Incorporated

Andrea Alfonso - Merrill Lynch

Roberto Fatta

Cardinal Health (CAH) Q3 2011 Earnings Call April 28, 2011 8:30 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the Third Quarter 2011 Cardinal Health Inc. Earnings Conference Call. My name is Luanne, and I will be your coordinator for today. [Operator Instructions] As a reminder, today's conference is being recorded for replay purposes. Now I would like to turn the conference over to your host for today, Ms. Sally Curley, Senior Vice President, Investor Relations. Ms. Curley, please proceed.

Sally Curley

Thank you, Luanne, and welcome to Cardinal Health's Third Quarter Fiscal 2011 Conference Call. Today, we will be making forward looking statements. The matters addressed in these statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected or implied. Please refer to the SEC filings and the forward-looking statement slide at the beginning of the presentation, which can be found on the Investor page of our website for a description of those risks and uncertainties. In addition, we will reference non-GAAP financial measures, information about these measures is included at the end of the slide.

Before I turn the call over to Chairman and CEO, George Barrett, I'd like to remind you of a few upcoming investor conferences and events in which we will be webcasting, notably the Deutsche Bank 36th Healthcare Conference on May 2 in Boston, the Bank of America Merrill Lynch 2011 Healthcare Conference on May 10 in Las Vegas, the Stanford Bernstein 27th Annual Strategic Decisions Conference on June 1 in New York, the Goldman Sachs 32nd Annual Global Healthcare Conference on June 7 in California and the William Blair 31st Annual Growth Stock Conference on June 14 in Chicago. The details of these events are or will be posted on the IR section of our website at cardinalhealth.com. So please make sure to visit the site often for that updated information. We look forward to seeing some of you at these upcoming events.

Now I'd like to turn the call over to George Barrett. George?

George Barrett

Good morning, everyone, and thank you for joining us on our third quarter call. I'm very pleased with our performance this quarter, which continued the momentum we built in the first half of fiscal 2011. We reported revenues for the third quarter of $26.1 billion, up 7% over the prior year period and a non-GAAP EPS number of $0.75, up 23%. This excellent overall performance was led by our Pharmaceutical segment, fueled by our Pharmaceutical distribution business and boosted by the contribution from acquisitions we completed earlier in the fiscal year.

These 3 strategic investments: P4, giving us a presence in oncology and specialty Pharmaceutical services; Kinray, dramatically increasing our footprint in community pharmacy; and Yong Yu, establishing a new platform for growth in China, one of the largest healthcare markets in the world, are already creating value for us. Our emphasis on execution, margin expansion and disciplined management of working capital is continuing to bear fruit. We have further enhanced the customer experience and strengthened our competitive position across all of our businesses and in new areas that help us position for future growth.

Based on our performance in the first 3 quarters of fiscal 2011, we are increasing our full year fiscal 2011 guidance and now expect our non-GAAP earnings to be in the range of $2.61 to $2.67. Jeff will walk you through our core assumptions during his remarks.

Now let me provide some color on each segment separately. Our Pharma segment continued its excellent performance in the third quarter. Revenue increased by 7%, and segment profit increased by 25% versus prior year. Including strong results from our Pharmaceutical distribution business and the contribution from P4, Kinray and Yong Yu.

Let me take a moment to discuss our Kinray and Yong Yu acquisitions. In both cases, their integration has progressed swiftly and seamlessly. Customer retention at Kinray is very high. In fact, since the acquisition, we have slightly increased our overall base in the New York metropolitan area. And as we've said in the past, we continue to support these customers using the same service model and with the same sales and customer service team with which they are familiar.

Similarly, the Yong Yu integration is going exceedingly well. Yong Yu's overall growth in the third quarter versus its performance in the same period last year is strong, largely driven by the local direct distribution business, a key area of focus for us.

In addition to the growth potential and distribution, we continue to be excited about the opportunities to offer many of the products and services we have developed in the U.S. to providers in China. Healthcare providers in both countries face similar challenges, increasing access, driving efficiencies in the supply chain, reducing costs and improving quality, and we can help. As you know, Jeff is leading our China Advisory Council, and he will provide additional color on Yong Yu in his remarks.

U.S. Pharmaceutical distribution did extremely well in the quarter, driven by excellent performance in our Generics program, solid performance under our branded manufacturer agreements and strong sales in our retail base. Sales under our SOURCE Generic program increased by 32%, with overall generic sales up by 23%. Thus far, our fiscal 2011 has been an outstanding year for generics both in terms of our based generics performance, as well as the number and the value of new launches.

Let me say that we expect our fiscal 2012 to be relatively comparable to fiscal 2011 in terms of newly and recently launched generic value. All in all, we're increasingly well positioned to drive value in our generic program and to satisfy the growing demand for generic drugs in fiscal 2012 and beyond.

We continue to build out our specialty platforms, further enhancing our tools that help providers manage their practices more efficiently, expanding our biopharma relationship and extending the reach of our P4 Pathways programs with both providers and payers. And we are making good progress in each of these areas. We are particularly pleased with the rate of adoption in our Pathways program and the quality of the next generation of our EOB 1 [Explanation of Benefits] practice management software. While uptick in specialty distribution will take some time, we have recently signed a number of new agreements with providers and manufacturers. And we look forward to the potential here.

And our nuclear business continues to work hard on the confidence campaign we initiated at the beginning of this fiscal year to rebuild demand and eliminate lingering concerns around supply constraints. In each of the past 3 months, we have seen a steady sequential increase in procedure volume, an encouraging sign, although demand has not returned to pre-shortage level.

In the positron emission tomography, or PET space, we continue to work with our pharmaceutical and research partners on what is now 25 new compounds in various stages of development, whereby even more accurate diagnosis and effective treatment of disease. To support our expanding work with innovators and the science of molecular imaging and technology and to accelerate the commercialization process of these new imaging agents, we will be launching a state-of-the-art facility called the Center for the Advancement of Molecular Imaging in Phoenix in June. This facility will house our scientists, engineers and researchers will focus on enabling our partners in the accelerated development of novel new array of pharmaceuticals.

Turning to Medical. This segment saw a revenue increase of 5% in the quarter, primarily from higher sales to existing customers. The Medical team has continued to compete well and to improve our win-loss ratio. Providers throughout the country are looking for ways to be able to compete and thrive in a health system undergoing significant change. For some of our recent wins, we see signs in our ability to provide broad categories of products across multiple channels is a source of competitive advantage, and we believe that our value proposition is increasingly resonant with customers. We are recently awarded a 20-month contract with the U.S. Department of Defense for the distribution of medical supplies. As was announced by the DOD, the contract also has an option for 2 additional 20-month contract periods for a total of 5 years. We expect to see the positive incremental impact of this win in the back half of fiscal 2012.

Segment profit in Medical segment decreased slightly by less than 1% versus the prior year period, but was up sequentially versus the second quarter. This is solid performance, given the continued impact from commodity price increases. As we indicated last quarter, the full fiscal 2011 impact from commodity prices on our cost of goods is likely to be approximately $60 million. Of course, we continue to work to find ways to mitigate this impact to our sourcing, product design and with the customer, as well as through careful management of expenses. As you are well aware, oil, latex and cotton prices have remained high in recent months, and we do expect that we'll have to wrestle with this headwind for sometime into the next fiscal year. Our preferred products continue to be an important part of our category management strategy.

We launched new private brand products in 2 important categories in the quarter, and found a number of new commercialization agreements with national brand suppliers. We should note, however, that surgical procedure volumes remain somewhat sluggish and has dampened segment revenue and profit growth in the quarter.

The Ambulatory Care and lab channels performed very well, outpacing industry growth in their respective channels and each posting double-digit revenue growth in the quarter.

In summary, we had a terrific quarter, and I'm very confident in our ability to execute going forward. Our people continue to demonstrate their commitment to our customers and to high performance.

On one final note, I'd like to publicly thank Jon Borschow for his service with Cardinal Health. As many of you know, Jon is the founder of our Puerto Rico business, which we acquired in 2008. After building a successful business from the ground up and then personally overseeing its integration with the Cardinal Health, Jon has decided to retire in June of this year. I want to take the opportunity on behalf of all of Cardinal Health to thank him for his incredible passion, his business insight and his customer focus. We have greatly enjoyed working with Jon and know that General Manager, Debbie Weitzman, who has been working closely with Jon for a number of years will do a fantastic job building upon the strong company he founded. With that, let me turn the call over to Jeff.

Jeffrey Henderson

Thanks, George, and hello, everyone. It's great to be discussing another very strong quarter results. I'll begin my remarks today by expanding on some financial trends and drivers in the third quarter, and then try to add more color around our updated fiscal '11 guidance, including some of our key expectations from our corporate and segment standpoint. I'll conclude my remarks by providing a few preliminary fiscal '12 assumptions for certain corporate items to which we have some visibility. Consistent with our general practice of aligning the timing of giving guidance with our internal budget process, we will provide guidance for fiscal 2012 on our Q4 call.

Let's start with Slide 4. During the quarter, we grew our non-GAAP EPS by 23% to $0.75, leveraging 7% revenue and 21% non-GAAP operating earnings growth. Notably, the $26.1 billion of revenue recognized in Q3 represents an all-time high for Cardinal Health since the company's inception, including the period pre-spin when we are still reporting the CareFusion businesses in our results.

Once again, we are reporting strong progress on our goal to expand margins, with both gross margin rate and non-GAAP operating margin rate increasing versus Q3 of last year, up 31 basis points and 20 basis points, respectively. Although non-GAAP operating expenses were up 11.5%, this was largely driven by the expenses added to the net impact of acquisitions and divestitures.

Let me pause here to comment in a little more detail on the impact of our acquisitions on the quarter's results. Overtime, as the recent acquisitions become more integrated into our overall business, they become increasingly difficult for us to break out the impact of the specific deals. However, since this is the first full quarter in which we have the collective benefit of Yong Yu, Kinray and P4, I do want to try to give you some idea of the combined impact on our financials. If you exclude the impact of these 3 acquisitions in the quarter, on a consolidated non-GAAP basis, revenue grew 2%, SG&A would have been up less than 2% and operating earnings increased 16%.

Interest and other expense came in better than our expectations than last year, driven by favorability realized interest rate swaps, foreign exchange and gains on our deferred compensation plan. And as stated before, we generally do not try to predict continuations of these items when we prepare our internal forecast.

On last quarter's call, I mentioned that we expected our non-GAAP tax rate in the back half of the year to be higher than the full year rate due to the impact of certain discrete items. Consistent with these comments, our non-GAAP tax rate this quarter was 40.5%, above last year's rate of 38.2%. The unfavorable discrete items in the quarter net to approximately $15 million are a non-GAAP basis. This included tax law change in Puerto Rico, which reduced the value of our deferred tax assets and the impact of unfavorable changes in state tax items. Note that we are still maintaining our previous non-GAAP tax rate guidance of approximately 37% for the full year.

Finally, we continue to benefit from the $450 million in share repurchases we executed last summer, with our share count at about 353 million diluted average shares outstanding versus 362 million in last year's Q3.

Before shifting the discussion to segment results, let me comment on consolidated cash flow and the balance sheet. We have excellent operating cash flow in Q3 at over $900 million, bringing the total year-to-date to $1.3 billion. This outstanding result is primarily driven by our strong earnings performance as well as further working capital improvements. I will point out that Q3 is typically our strongest quarter for operating cash flow, and it was particularly so this year. Let me also add that quarterly cash flow is a highly volatile number and very difficult to predict accurately. That all said, I don't anticipate near that kind of cash generation in Q4. Overall, we are very pleased with where we are from a cash perspective.

Clearly, our ongoing focus on working capital excellence continues to pay dividends, resulting in a 0.6 day reduction versus last year. The variation within certain components of networking capital days is largely driven by our recent acquisitions and timing. But the net result clearly highlights our continued disciplined asset management.

We ended the quarter with $2 billion in cash, of which $205 million is held overseas. As a reminder, this cash balance does not include our investments in held-to-maturity fixed income securities as they are classified as other assets on the balance sheet. At quarter end, these investments, the maturity is less than 2 years, totaled $153 million.

One final note on the balance sheet. During the quarter, we paid $220 million of long-term debt to maturity, bringing our long-term obligations to $2.4 billion. This paydown was funded by the $500 million of debt we opportunistically issued last December.

Now let's move to Q3 segment performance, referring primarily to Slide 5 and 6 and starting with the Pharma segment. Revenue in the segment increased 7.3% with the acquisitions we completed earlier in the fiscal year contributing 5.6 percentage points to this growth rate. Sales to non-bulk customers grew 21% in the quarter while sales to bulk customers declined 7%. This decline in bulk sales is attributable to a shift in shipments to certain national chain customers from bulk to non-bulk, as well as the impact of certain branded products converting to generics. It's worth noting that sales to non-bulk customers now comprised 57% of total segment sales.

Within the category of non-bulk growth, I'd like to point out that revenues from retail independents continue to grow at a rate above the market, and it is an important classic trade. Even when excluding the sizable impact of the Kinray acquisition.

Let me also add a few comments about growth in our China business, whose results are captured in our Pharma segment. Revenue for the Yong Yu business grew 25% in Q3 versus its performance as a separate company in the same time period last year. Eric and his team are doing a great job in driving the business forward. Growth was particularly high in our local direct distribution business, an area where we're focusing our efforts to expand geographic breadth and penetration. As George said, I just returned from a visit in China but we are focused on reviewing strategic initiatives in the FY '12 budget. My second level of our potential in this market seems only to grow each time I visit, both in the base business but also as we explore possible opportunities in additional areas like nuclear pharmacy, lab distribution and supporting the growth of retail pharmacy.

Now turning back to the overall Pharma segment. Segment profit margin rate increased by 23 basis points compared to the prior year's Q3, driven by an increase in non-bulk margins and the continued mix shift towards non-bulk. In addition to the ongoing success of our generic sales and sourcing programs, we also saw a continued benefit from new and recently launched generic items during the quarter, as well as an overall generic deflation rate that continues to be below historical norms. By our performance under our branded manufacturer agreements was also a positive driver. Net debt to the Pharma segment again had an excellent quarter, which resulted in an increase in segment profit of 25% to $384 million. I will note that the acquisition has contributed 5.7 percentage points of the segment profit growth in the quarter.

Now turning to our Medical segment. Revenue for this segment increased by 5.1% to $2.2 billion, driven by increased sales to our existing customers. As the volume from recent customer wins phases in, they're beginning to offset our customer losses from prior periods. By Q4, that impact will be a distinct net positive. Our inventory business, a continuing focus for us, grew its revenue by 13% during the quarter. We also saw a strong growth in our lab business, which grew nearly 12% over the prior year quarter. Medical segment profit declined 0.6% to $107 million as volume growth was offset by the negative impact of commodity price increases on the cost of products sold. Specifically, commodity prices impacted our current period cost of goods sold by $12 million versus last year. This commodity headwind reduced segment profit by 11 percentage points versus last year.

Blue had a negligible year-on-year earnings impact in the quarter. I'll also mention that inpatient surgery procedures continue to be somewhat sluggish, which disproportionately impacts our higher-margin preferred products including our Presource kits. We remained very focused on cost containment across the Medical segment as we continue to work to offset some of the external environmental factors we have faced in recent periods.

Overall, despite continued headwinds for our Medical business, we continue to show good progress in the end of the line performance and believe we are well positioned for longer-term growth.

Now let me turn to Slide 7, although I won't go through the schedule in details, I will mention that GAAP results included items that had a negative $0.04 per share net after-tax impact. One additional comment. You may notice the schedule shows a loss in the sale of CareFusion shares taking place in the third quarter. Despite the fact that we have sold all of our stake in CareFusion in prior periods, let me explain. Upon finalizing the fiscal 2010 federal income tax return in the third quarter, we adjusted the value of certain deferred income tax accounts related to CareFusion, increasing our cost basis. This resulted in a $3 million reduction of our previously recognized gain on the sale of CareFusion shares.

Now lets' turn our discussion to our updated fiscal '11 guidance, starting with Slide 9. As George mentioned, based on our strong fiscal year-to-date performance, we're increasing our full year guidance range or non-GAAP EPS to $2.61 to $2.67 from a previous range of $2.54 to $2.60. This increasing guidance range reflects our strong performance in generics and better contribution from the recent acquisitions than we previously noted on our Q2 call. There is a possibility that we may have to take a LIFO charge in our Pharma segment in Q4, which is the primary explanation for why we are providing the breadth of earnings range that we are at this stage of the year. Our overall revenue guidance remains at low single-digit growth.

Slide 10 outlines some of our key corporate expectations for the year. The only change shown in red from our previous assumption we shared in our February call is that we are now expecting interest and other to net to approximately $80 million, which incorporates the benefits we saw in Q3.

I'd now like to spend a couple of minutes going through some of the specific segment assumptions in more detail. Starting with just a few items relating to the Pharma business on Slide 11. Expectation for brand inflation is that the rate will be similar to or perhaps slightly higher than what we saw in fiscal '10. We continue to expect a positive earnings effect from generic launches versus FY '10. And I mentioned earlier, the possibility of a LIFO charge in Q4, which is we have incorporated into our guidance range.

Turning to Slide 12 in the Medical segment. Our guidance continues to include an expectation of approximately $60 million of full year negative impact on cost of goods sold due to commodity price movements. Thus far in fiscal '11, we realized about $45 million of negative impact. As you may recall, this $60 million figure is the same that we indicated to you back in the February during our Q2 call. Although there has been significant commodity price volatility since, but given the lag time we have as input costs flows through our channel, we actually had a pretty good level of visibility at that time through much of the remainder of the year.

Our Medical Business Transformation is now in the testing phase, and on track for a national implementation in calendar 2012 with the phase rollout scheduled to begin in the fall of this calendar year. As we said before, this is a significant business transformation designed to further enable our channel and category management strategy and enhance the customer expense. We continue to expect meaningful contribution of margins from this effort in fiscal 2013.

Finally, I want to note a change that will impact the optics of our P&L from Medical going forward. As we have been implying for some time, we are transitioning our distribution model of CareFusion from a net service-fee-based arrangement to a traditional branded distribution agreement, which will increase our reported revenue by approximately $50 million to $60 million per quarter beginning in Q4. Although this transition will have an insignificant impact on margin dollars, they will have the effect of somewhat depressing our segment profit margin rate going forward in the range of approximately 25 basis points.

Before we move into Q&A, I thought it would be helpful to provide a few preliminary corporate assumptions for fiscal '12 on this call. Although we are not at the point in our budget process where we can provide operating assumptions, we have relatively good visibility into the items shown on Slide 14 at this point. And we thought we'd share our thinking here.

Starting with non-GAAP effective tax rate, we are expecting a rate of between 37% and 37.5% for the full year. Note that this rate may continue to fluctuate quarterly due to unique items affecting certain periods. Next, we expect our diluted weighted average shares outstanding to be between 353 million and 354 million in fiscal '12. You will note that this is an increase from our forecasted in fiscal '11 we had averaged slightly above 352 million shares. Although this forecast for fiscal '12 assumes $250 million of the gross share repurchases, consistent with the amount we repurchase in fiscal '11. There are certain assumptions that counteract this, such as the impact of share price on both the number of shares repurchased and also the dilution calculation in exercising of options.

Interest and others, net, we anticipate a range of $100 million to $110 million of the year. This forecast generally assumes certain items that benefit us in fiscal 2011 such as interest rate swaps, foreign exchange and deferred compensation do not necessarily repeat in fiscal '12. And we are estimating approximately $250 million of capital expenditures next year, with a continued focus on the Medical Business Transformation project and customer-facing IT investments.

To sum my remarks, let me say that I am again pleased with the overall performance in the quarter and the results we have delivered year-to-date, positioning us very well for the future. With that, let me turn it over to our operator to begin the Q&A session.

Question-and-Answer Session

Operator

[Operator Instructions] And your first question comes from the line of Ricky Goldwasser of Morgan Stanley.

Ricky Goldwasser - Morgan Stanley

I have one question, just a clarification then another follow-up. George, you've said today and you've said in the past that 2012 should be comparable to 2011 in terms of the generic volumes. So just to clarify, you're referring to your fiscal '12 versus fiscal '11 or are you referring to calendar year?

George Barrett

Ricky, I don't know if you're on a mobile, we're having a really difficult time picking you up, would you try that one more time?

Ricky Goldwasser - Morgan Stanley

Sure. Can you hear me now?

Ricky Goldwasser - Morgan Stanley

Better.

Ricky Goldwasser - Morgan Stanley

Just to clarify, George, on your comments on the generics here that you said 2012 should be comparable to 2011, just to clarify, are you referring to Cardinal's fiscal year '12 versus fiscal year '11 or are you speaking to calendar year?

George Barrett

Thanks, Ricky. We're just talking about our fiscal year expectations, yes.

Ricky Goldwasser - Morgan Stanley

Okay, great. And then obviously great performance on the generics side. Yesterday, one of the smaller distributors lowered their guidance for the year, citing difficult generics comparison. The question here is do you think that you are gaining share from the smaller distributors? And is the shortage in supply that we're hearing about in the marketplace helping you not just from pricing perspective but also from product allocations perspective?

George Barrett

I agree, Ricky. Let me say, it's very difficult to comment on other company's characterization. So it's hard to do that. I'll comment the best I can on ours. I think, in general, our programs are performing very well. Our penetration continues to be strong. Our customers are doing well, the demand for generics continues to be robust. I think our service levels and our broad base of distribution covering all the retail channels -- remember, we are also in hospitals and clinics. So we've got a very broad base of distribution. The flow of new products was reasonably robust. And in general, I think, obviously, the addition of Kinray also added somewhat to our overall generic business although they're not really yet fully on our SOURCE program. So those are sort of all the areas that, that contributed to it. I'm not sure that the supply issues necessarily alter the dynamics of share around the industry. I probably would not point to that.

Operator

And your next question comes from the line of Tom Gallucci of Lazard Capital Markets.

Andrea Alfonso - Merrill Lynch

This is Andrea Alfonso for Tom. The first question is on commodities. A while back, you had suggested a rough rule of thumb for the earnings impact on the company for every $1 that oil rises. Is there still a simple formula to follow here? And if so, how do you think about it?

Jeffrey Henderson

Thanks, Andrea. That's a good question and one that I expect I'll be getting a lot over the coming days, just given the prevalence of discussion about commodities and commodity inflation that's impacting a lot of companies these days. So let me try to answer that by starting very broadly and then getting a little more specific. I think the rule of thumb that we used to have, probably it isn't as simple as that anymore and that -- our overall exposure has continued to grow, the number of commodities we're exposed to has continued to grow and quite frankly, the number of commodities that are showing price volatility has changed. A year ago, we didn't talked a whole lot about cotton or even latex, and now those are some of the most volatile commodity prices that are out there. So again, this might be a longer answer to your question, but I thought it was important to give you the full picture. So to be clear, our current estimate of total gross exposure to commodities. And this include both direct and indirect exposures. And this is an estimate for next year, so fiscal '12. It's somewhere between $500 million and $600 million. Again, I want to reiterate that's our total gross exposure, and it's probably the broadest definition possible since it includes the raw material inputs we buy directly, as well as those products that we source or we have more indirect exposures to cost input movement. It also, as I said a gross number, so it reflects none of our hedging programs or programs that we're undertaking to mitigate our exposure. Again, that amount of $500 million to $600 million also reflects the entire range of commodities not only items like oil and oil-based resins but things like cotton and latex and corrugates and other materials. So again, that will be our total exposure from a cost of goods standpoint. Now one of the things I would like to point out, it's not as simple as sort of applying one commodity price movement to that total bucket, and coming up with the rule of thumb because a lot of these commodities aren't correlated and may, in fact, move in opposite directions at the same time. So I guess that will be the first answer to question. The other question that I'm sure will come up that's related to this, that I'll just get out there is what -- if you look at that total basket of exposure, what's the potential headwind for next year. Now I'll probably give you a partial answer to that because we're still only 9.5 months or 10 months into FY '11. So there's a lot of FY '11 and obviously FY '12 to play out and a lot of things can change. But because there's a lagging effect related to commodity price movements and our cost of goods sold, we do have some limited visibility on the commodity impact in fiscal '12. But again, I'll point out that it's still very early, prices are volatile and our planned mitigation actions aren't fully worked through yet. And we'll be going through those -- continue to go through those over the next couple of months as we do our planning. But in early estimate, based on today's spot rates and forward curves would imply an incremental headwind next year in about the same range as the one that what we experienced in fiscal '11. But again, I'd point out, it's early and we'll have a better view of our commodity headwind and mitigation strategy. So we can provide guidance on our Q4 earnings call. So again, a long answer to your question, but I think the situation has gotten more complex. So there's no simple algorithm that we can probably point to but hopefully, that gives you a little bit of directional input.

Andrea Alfonso - Merrill Lynch

Great. I appreciate all the color. And I guess, just to transition to George's earlier comment about his expectations for fiscal '12 to be comparable to fiscal '11 in terms of generic value. Just to clarify, is any aspect of that due to Cardinal just making internal progress as far as generics in '11 over and above market dynamics such that in fiscal '12, the internal progress slows down a bit so it normalizes things for you?

Jeffrey Henderson

Let me clarify because I want to make sure we don't confuse two different issues. So what I was referring to is our fiscal year-over-year launched and newly launched value. So we're not talking about the base of our program, we're just talking about the flow of new and what we would call recently launched products. So this is just a snapshot of what we see in the launch landscape, as we look forward 12 to 15 months. As you know, a lot can change in that and does change often because you can't perfectly have visibility on litigation and challenges, et cetera. I would say, having said that, '11 has been a very, very strong year for us. And so that's good news. It's been strong for us both on the core activities and our level of effectiveness with our program, as well as a good year of launches. And I would say also as it relates to inflation deflation, it's been a relatively strong year with less inflation that we have seen in the prior years.

Operator

And your next question comes from the line of Garen Sarafian of Citigroup.

Garen Sarafian - Citigroup Inc

One is a clarification question. George, you had mentioned that you had started to sign some new agreements with specialty manufacturers, but it would take some time. Can you just elaborate on that a little bit as to the progress that you've made and sort of maybe some sort of like a baseball analogy, what inning you're in to become for this process to work itself out? And when we could expect Cardinal to have a full specialty capability in terms of distribution?

George Barrett

Thanks. We're probably still early stages. I don't know -- say, we're in the second or third inning. I would say from the standpoint of building our capabilities, we're actually reasonably in good shape. What I've said to you before is that for us, a building up the specialty distribution depends on building the right presence in the community of oncology and other specialty areas. And we've just really begun to do that in recent months and we've just began to sign our early agreements. So we expect that, that distribution aspect would grow gradually. And we really are in the early phases. I will say that this is going a bit slower than I'd like. You probably know that I am not a very patient person. But the flip side is that other aspects of our specialty business, particularly the Pathways program has probably taken a hold a bit quicker than we expected. So I would say that we're early stages in specialty distribution. It's hard to time that for you but the better we build our positioning in the provider community, the greater our ability to secure deals on distribution.

Garen Sarafian - Citigroup Inc

So it sounds like it's more of at least 2013 type of a story?

George Barrett

It's very hard to time for you. The good news is that we are relatively small, and so, the ability to move the needle for us may be a little quicker. So I'm not going to try to time that for you. I'm hopeful that we'll make some good progress during the next 6 to 12 months. But again, it's going to be a building process, and we're prepared to see that through.

Garen Sarafian - Citigroup Inc

Regarding generics, you had another impressive quarter of year-over-year growth in your SOURCE Generics program. Still trying to grasp, what's behind that? Was that impacted disproportionately by Kinray or were there new customers or just a greater share? What was it?

George Barrett

It's an interesting question because really, Kinray is not part of that SOURCE number at this point. We're just beginning to integrate -- that, we haven't really done that yet. So the SOURCE growth is really a broad based growth. We've seen it in almost every channel for us. It's been with that solid generic penetration rate. And interestingly, it's been a fair amount of supply disruption. So in spite of the supply disruption in the system, we've done pretty well. I think our teams are just very focused. I think our program is good, our offering is flexible. Our customers understand the value proposition. And I think, we've done a reasonably good job of driving it. I think we've also done a good job of working collaboratively with our suppliers upstream to get the right value proposition for them. So I think it's really an alignment of all the components I've said before about generic. It's not just one piece, you've got to get everything working right from the SOURCE into the selling, into the incentive systems. And I think we've got probably got things lining up increasingly in the right direction.

Operator

And your next question comes from the line of Ross Muken of Deutsche Bank.

Michael Cherny - Deutsche Bank AG

This is Mike in for Ross. I just want to dig on to Kinray a little bit. You guys, you said that the integration is going very well. Obviously, Kinray is a big contribution during the quarter. Kinray bring their community and independent expertise. Can you talk about some of the lessons you've already learned from Kinray in terms of applying that to your legacy independent community base?

George Barrett

Yes. Thanks, its' a good question. We've really enjoyed getting to know the folks in Kinray. There's a lot of things we do very similarly. But in many ways, the New York market is actually quite unique and it always has been in retail pharmacy. And so there are learnings about different approaches to the model that we gained from them, but we also recognized that some of the things that we do and that they do in New York are so specific to the characteristics of that market. And so, I think, hopefully we're a good learning company as well as a good teaching company when we acquire and we work very hard at making sure that the flow of information and learnings go in both directions. And I think we'll continue to learn from each other. It will be hard to call out one specific thing, but I do think that there's plenty for us to teach one another.

Michael Cherny - Deutsche Bank AG

Great. And then obviously, at the end of 2010 was a busy year for you guys on the M&A side. You talked about integration going along well. At this point, how do you feel in terms of readiness for further acquisitions? And if so what areas are you focused in or is integration still going to be the near-term focus?

George Barrett

Let me start by saying that execution on our recent acquisitions remains for us a very high priority. So again, we'll be very clear about that. And having said that, I think our conversation is capable, and I think, from talent management standpoint, we're really thrilled about the team and the depth that we've been building. And our goal over the long term is to position ourselves for long term and sustainable competitive advantage. And of course, we'll always continue to look for opportunities to do that, both organically and externally. But again, I should say that focus on execution on our acquisition is very important to us right now.

Operator

And your next question comes from the line of Steve Valiquette of UBS.

Steven Valiquette - UBS Investment Bank

I just want to get a sense for the current environment for generic drugs supply shortages, more from a manufacturer's side that could be driving better pricing on generics, this come up obviously last quarter as well. I think, just generally, how would you characterize the current environment in the March quarter or in April, let's say, versus 12 months ago, just sort of generally speaking, and supply disruption is helping you on generic pricing, it is better or worse or about the same versus a year ago?

George Barrett

The only correct answer to the question, independent of the question of pricing because I think it's really a noteworthy. I would say that level of supply disruption is higher today than it was 12 months a ago. I'm not sure it's changed, particularly over the last 3 or 4 months, but I would say the last 6 to 7 months has been quite lumpy out there. But certainly, if I compare it to a year ago, I would say there's been more disruption across the spectrum in the generic supply system. It probably is one of the explanations and we talked about this before for some of the moderating deflation that in some products, you simply got your competitors because the companies struggled. There's been some compliance issues around heightened scrutiny on many companies. So I think I would probably say that, that's higher than it was one year ago.

Operator

Your next question comes from the line of Lisa Gill of JPMorgan.

Lisa Gill - JP Morgan Chase & Co

Just a couple of just quick follow-ons here. George, have you been able to pass along any of the increase in commodity pricing to your customers? And as Jeff talked about the lag around commodity pricing and $60 million being the headwind next year, is there some expectation that either hedging or passing it along to the customer will help to mitigate some of what we're seeing right now?

George Barrett

Lisa, let me start, and I'll give you a bit of a generalized answer because it's really very specific to the condition. Certainly during the course of this year, we've been evaluating some and at some cases implementing how and when, it's appropriate to pass this cost along to our customers. These are often delicate discussions that involve trade-offs. And so we look at this but we look at this quite carefully. As you also know, there are often contracts in this part of our business and so they are forward-looking obligation. But we have worked closely with customers in some cases. We've been asking them to share some of the burden with us. In some cases, we had to offer additional services to them to help mitigate the impact for them. So we're really working very carefully on ways essentially for the whole supply chain to mitigate the cost of this. So that's probably the best answer I can give you. And Jeff, I don't know if you want to add to that?

Jeffrey Henderson

Let me kind of brief you on hedging. We hedged about 50% to 75% of our exposure to diesel fuel. We've also began hedging our exposure to cotton in the last quarter or so. And we continually look for other ways of financially hedging our exposure. Although as you know, it's always somewhat difficult because you got to find the right coloration between the financial derivatives and your underlying exposure in order to get hedge accounting treatment. And some of our exposures are indirect either because we're looking at the root of the commodities or because we're not directly biting the right inputs. It's not always easy to get that hedge accounting treatment that allows you to lessen the volatility in your income statement. But again, we continue to expand our hedging efforts and are looking for more opportunities there. We also take the approach that we need to continually adjust to our cost level in organization. Sometimes, that means reducing other costs. And as I mentioned in my prepared remarks, the Medical segment continue to be very focused on cost containment to ensure that we're minimizing our overall cost structure, not just cost of goods sold to the extent that we can.

Lisa Gill - JP Morgan Chase & Co

And then just -- as my second question, when I look at the preliminary numbers to think about for '12 that you put out, Jeff. I noticed that share count will be going up in '12. Can you maybe just reiterate for us, I know there's been questions today around acquisitions, what your capital deployment strategy is? Is there not plans for share repurchase as we look into '12? Or is there something else that's driving that share increases as we go into next year?

Jeffrey Henderson

Thanks for the question. First of all, we currently have a $750 million share reprogram authorized by our board last November. Currently it us untapped so we have the full amount available. The assumption in next year's number is that we used $250 million of that authorization to buy back shares, which is similar, so exactly the same amount of those repurchases we did in fiscal '11. So when you look at that, in isolation, you'd say our share count should be going down. However, when we sort of estimate our share count, we also take into account things like assumed timing of repurchase and perhaps even more importantly, what our share price is going to be. And given the recent escalation in share price and our projections for that in the future, we then run that through our option dilution model and our option exercise model. And one of the reasons we're seeing a fairly high offset to our repo next year is that we have a fair number of option tranches and at strike prices in the low 40s to mid-40s. So as we sort of pass those strike prices, we're sort of go over a cliff, and you begin having the potential for option exercises, which affects our base share count, and then just a dilutive impact when you do the option dilution calculation, which affects our diluted shares outstanding. So that's really what's driving the offset to the assumed share repurchase next year.

Operator

And your next question comes from the line of Larry Marsh of Barclays Capital.

Lawrence Marsh - Barclays Capital

Maybe just a follow-up, and then second question there. Just around you're thinking about 2012. I guess the good news is assuming your shares are going up, but what's the size of the potential option impact, the treasury stock method, Jeff, as you sort of think about what could be the offset to potential share repurchases?

Jeffrey Henderson

You can easily have a several million dollar dilutive impact either from options being exercised or the dilutive impact from passing those strike rates over the course of the year.

Lawrence Marsh - Barclays Capital

All right. Okay. A follow-up question then is really around the Medical business. I think the good news in the quarter, your $60 million estimated impact that you communicated last quarter is consistent with what you've said this quarter, which you obviously said you were proactive and thinking conservative, and thinking about commodity cost. And you're communicating a potential headwind of another $0.10 for next year. I know the big picture, George, you've talked about the Medical business through the Medical Transformation initiatives is a platform that you think can be nicely more profitable through a combination of factors. You've had to fight through this headwind this year. You're communicating another headwind next year. When do you think we'll see the nice ramp in margins with Mike and his team and what gets us there?

George Barrett

So let me just give you, first, a general observation, Larry, which is -- again, our Medical group has really been battling 2 kinds of headwinds in the last 8 to 12 months. Obviously, commodity issue that we've talked about, but also a relatively sluggish procedure volume, particularly in hospital surgical procedures, which is a significant driver for us. And it's actually a margin driver as well because a lot of our preferred products are used in the OR. So if you actually strip those away, in a sense, the underlying performance has actually been quite encouraging. And I'm really pleased at what's happening both in terms of our market position, the kind of account wins we've had, the focus on category and what I think is our ability to create value for our customers through our tools ranging from the back belt that we deployed in our operations to the preferred products program. So those are also to me margin expanders. And I think what's been happening in some ways is that some of the good work has actually been masked by some of those headwinds. So I'll try to time all this because -- again, because of the sort of commodity aspect that we look and a little bit of these procedure issues that are tied to the economy. But my general sense is that we are feeling momentum now, actually. I would say that state of confidence in our group is high, and I think we just got to keep that, our strategy, the medical trends, I think we'll start to -- just probably be more in '13 than in '12. But those are all about driving margin. We actually feel fairly good about where we're position and the team is on it and their hungry.

Operator

And your next question comes from the line of Robert Willoughby of Bank of America Merrill Lynch.

Robert Willoughby

Can you just comment on the D&A run rate, is the current experience is what we should carry forward? And secondarily, you've commented somewhat on the share base for next year. Can you remind us what's your long-term dividend payouts goals are? Will we make some progress towards getting there next year?

Jeffrey Henderson

Bob, this is Jeff. I mentioned in the last call that our anticipation for intangible amortization with next year was somewhere in the $85 million to $95 million range. We're still finishing evaluation for two of our acquisition. So I don't have any new information to apply to that. That will get finalized in the next month or so, and we'll be able to give a more firm number when we give the guidance for next year. So I would say that $85 million to $95 million number for amortization next year is just probably as good as any, which is a slight increase in this year's as you would expect as the full year impact of the acquisitions come in. In terms of depreciation run rate, I would actually expect depreciation to go up next year, reflecting as part of Medical business transformation going live and we'll begin to depreciate the capital that we've put into that program starting next year. In terms of the dividend, obviously, that's up to our board ultimately to decide. And we'll communicate when and if that decision is made. But our longer-term goal of growing the dividend at or above the longer-term earnings growth rate over time is still our expectation.

Operator

And your next question comes from the line of Eric Coldwell of Baird.

Eric Coldwell - Robert W. Baird & Co. Incorporated

I was hoping we can dig into the Ambulatory segment growth. I think you quoted 13%. What are the drivers of that growth penetration versus share volume pricing impact of health systems, consolidating medical groups and physician practices? If you could give us some sense of what you think the real market growth is and what's driving your 13% performance?

George Barrett

Eric, thanks for the good question. We're encouraged by the growth here. This is, as you know, has been an area of some focus for us. There are couple of things happening: One, obviously, we've deployed more resources into this group, believing that this is a very natural linkage to our acute care strategy, particularly as IDNs begin to extend their footprint into the Ambulatory settings. So partly it's about focus about deployment of our team and about resources. It's somewhat about our offering which I think has been -- we've done a better job -- some of the work that we've done in the customer phasing, IT investments have really been about making us a more natural player in that market. So I think we've done well, they were down particularly well in surgery centers where we have I think some natural opportunity, particularly in the kitting area. So I think, that's largely been what's going on there. There's probably also as elements of this connection as you said just to the IDN. You have the large integrated systems to increasingly extending their footprint beyond the acute care box, towards the Ambulatory setting. And that's probably a gravitational pull that is a natural affinity for our business and for our strategy and for a lot of our capability.

Eric Coldwell - Robert W. Baird & Co. Incorporated

That's great. My second question relates to conversations we've had recently with supply chain managers and health systems. We get the sense that some are looking to really revisit how they contract with vendors looking to put in place long-term coterminous contracts where, for example, they would look at Cardinal's nuclear, pharma, lab, med/surg, pharmacy consulting businesses, et cetera, in total as a corporate relationship and move them all to one contracting process, perhaps with an extended renewal date, say 3, 5, 7 years down the road. Are you seeing a big shift in how the supply-chain managers within health systems are looking at your business in total. And if so, what the impact of that might be?

George Barrett

Again, I don't want overstate this because it's important. But I do think that we believe that there is value in doing that. Many health system today, given the environment around them are looking for new ways to create value and to approach their business. And this really is an area that plays to our strength. We reached completely across categories, products and drugs and also across channels. And I think the ability to bring this suite of those tools to a large system can be a value creator and we are seeing some of that. But again, I don't want to overstate it as if it's a massive change. But I do think they get something that we're seeing. We think it will continue and we think that plays to our strength. Jeff, I think he wanted to clarify something from the last subset?

Jeffrey Henderson

I was just going to add on to your answer to the prior question from Eric and that is -- as we look at inventory, as you may know, our inventory is composed of all surgery center and physician's offices. We look at both in total and separately for those subset. So I would say, both of those is very, very well showing strong growth in Q3, which indicates that we're growing well above market in both of those subsets, which is very important.

Sally Curley

Luanne, in the interest of time, I think we've got time for probably 2 more folks in queue and then any other questions we will be more than happy to take after the call.

Operator

The next question does come from John Kreger of William Blair.

Roberto Fatta

This is Robbie Fatta in for John Kreger. On the generic side, given the supply disruptions that you talked about and the impact of the complexity of some of the new drugs that are going to be losing protection the next year, what are your expectations for generic deflation in fiscal 2012?

George Barrett

That's hard to answer, Robbie. We've generally not guided on a deflation rate. It is really the composite of so many forces. Some of which, we don't have control over, as you know. If a certain product is in the exclusive or semi-exclusive status and it's stays there for 3 more months than we model, then deflation will be less than we expected. So it's very difficult to give you a forward-looking model on deflation rates. What we can say is that certainly, over the last 9 months or so -- again, that's an inexact time table, we have seen a lower rate of deflation. Some of the conditions that I think are causing that, we continue to see, but I don't know that I can give you a guidance on a deflation rate.

Operator

And your next question comes from the line of Robert Jones of Goldman Sachs.

Verdell Walker - Goldman Sachs Group Inc.

This is Verdell Walker in for Robert Jones. I just have a quick question on the CareFusion transition, just some clarification. I think you said that we can expect a $50 million to $60 million quarterly impact from that going forward. I was just wondering could you just walk us back through that on the revenue and the margin side of the transition.

George Barrett

Sure. And [indiscernible] let me give you a little bit more detail on this because some people are a little bit confused on exactly what's happening here.

Verdell Walker - Goldman Sachs Group Inc.

Absolutely, thanks.

George Barrett

At the time of the spin, we put in what was a temporary arrangement with CareFusion, particularly around -- or primarily around our businesses in the Chicago area that had been linked for some time, going back to the allegiance phase really. And because we needed some time for CareFusion to get its own independent systems up and running, we put in place a temporary arrangement where effectively we manage most of their distribution for them and then charged a fee. So it was a quality PPO [ph] relationships really for that particular business, which primarily affects their V. Mueller and respiratory products. The plan was always eventually they would get their own systems up and running, which they did on this quarter actually. And once they did that, we agreed that we would move from that service fee based arrangement where we just got a service fee for the products that we handle to a more traditional brand distribution agreement, where we actually took ownership of the products, recognized the revenue and then realized the margin on that revenue that went down to our bottom line. That transition is happening now, and will begin to affect us economically in Q4 this year and then going forward. Now really it's more of a P&L optics issue because the bottom line impact is about the same for us before and after the transition. But because we're now recognizing the revenue, it has the impact of boosting our revenue and reducing our margin. And that's where we get to that $50 million to $60 million of incremental revenue figure per quarter starting in Q4, and also the dilutive effect on our margins -- our segment profit margins of about 25 basis points. So hopefully, that helps.

Operator

You have no further questions at this time. I'll turn the call back over to Mr. Barrett for your closing remarks.

George Barrett

Thank you, Luanne. Let me close by saying that we feel very positive about the performance in this quarter and about our trajectory going forward. And I want to thank all of you for joining us in today's call, and have a good day.

Operator

Ladies and gentlemen, that concludes today's presentation. You may now disconnect, and have a good day.

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