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McKesson (NYSE:MCK)

Q2 2012 Earnings Call

October 25, 2011 5:00 pm ET

Executives

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

Ana Schrank - Former Vice President of Investor Relations

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

Analysts

Ross Muken - Deutsche Bank AG, Research Division

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

George Hill - Citigroup Inc, Research Division

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

Steven Valiquette - UBS Investment Bank, Research Division

Ricky Goldwasser - Morgan Stanley, Research Division

Lawrence C. Marsh - Barclays Capital, Research Division

Glen J. Santangelo - Crédit Suisse AG, Research Division

Albert J. Rice - Susquehanna Financial Group, LLLP, Research Division

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

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

Operator

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

Ana Schrank

Thank you, Rebecca. Good afternoon, and welcome to the McKesson Fiscal 2012 Second Quarter Earnings Call. With me today are John Hammergren, McKesson's Chairman and CEO; and Jeff Campbell, our CFO. John will first provide a business update, and we'll then introduce Jeff who will review the financial results for the quarter. After Jeff's comments, we'll open the call for your questions. We plan to end the call promptly after 1 hour at 6:00 p.m. Eastern Time.

Before we begin, I remind listeners that during the course of this call, we will make forward-looking statements within the meaning of the federal securities laws. These forward-looking statements involve risks and uncertainties regarding the operations and future results of McKesson.

In addition to the company's periodic, current and annual reports filed with the Securities and Exchange Commission, please refer to the text of our press release for a discussion of the risks associated with such forward-looking statements.

Finally, please note that on today's call, we will refer to certain non-GAAP financial measures in which we exclude from our GAAP financial results acquisition-related expenses, amortization of acquisition-related intangible assets and certain litigation reserve adjustments. We believe these non-GAAP measures will provide useful information for investors. Please refer to our press release announcing second quarter fiscal 2012 results available on our website for a reconciliation of the non-GAAP performance measures to the GAAP financial results.

Thanks, and here is John Hammergren.

John H. Hammergren

Thanks, Ana, and thanks, everyone, for joining us on our call. I'm pleased with the continued momentum in our business. For our second quarter, we achieved total company revenues of $30.2 billion and adjusted earnings per diluted share of $1.63. This performance is a result of strong contributions from both Technology Solutions and Distribution Solutions and was helped by our acquisition of US Oncology. Based on the momentum from our first half results, we are now raising our previous outlook for the fiscal year and now expect adjusted earnings between $6.19 and $6.39 per diluted share for the fiscal year ending March 31, 2012.

Before I turn the call over to Jeff for a detailed review of our financial results, I will provide some highlights from both segments of our business. In Distribution Solutions, we were particularly pleased to see steady demand across all of our pharmaceutical and Medical-Surgical distribution businesses. We know that there are concerns in the industry about utilization trends, but we've seen healthy demand in our diverse set of distribution businesses. In addition to strong revenue growth, Distribution Solutions' operating margins expanded 19 basis points with U.S. Pharmaceutical, Canada, Medical-Surgical and Specialty Health all contributing to that outstanding performance.

Our U.S. Pharmaceutical Distribution business continues to perform in an exceptionally high level. Again this quarter, the U.S. Pharmaceutical team did a great job controlling costs, resulting in a relatively flat expense for the quarter, which contributed nicely to the segment's operating margin expansion. We continue to benefit from our long-standing relationships with branded manufacturers, delivering great value to them and earning steady levels of compensation in return. Overall, U.S. Pharmaceutical is right on target for the year.

I'm extremely pleased with the results of our Specialty Health business, which includes the operations of US Oncology. We began this year with a set of priorities focusing on integrating the 2 companies and creating an expanded customer base and an expanded value proposition to these important customers that brings together all of our assets of both businesses. Thus far, we made great progress combining the 2 organizations, and the majority of the integration work is now complete and we are realizing synergies from the transaction. We're also creating real momentum in the marketplace.

At the end of the second quarter, our Specialty business launched a new name and offering to the marketplace, reflecting the expanded business unit created by merging McKesson Specialty Care Solutions and US Oncology. Now called the McKesson Specialty Health, the business empowers providers, from hospitals to community oncologists to other multi-specialty providers, to advance the science, technology and quality of care through innovative clinical, research, business and operational solutions. Our customers are responding very positively to our new, broader offering.

While we've expanded our value proposition considerably, I would note that generics continue to play an important role in Specialty's performance. We've had strong results year-to-date, and we expect the trend to continue for the remainder of the fiscal year.

Our Medical-Surgical revenues grew 13% in the second quarter, partially due to 5 extra days of sales but also as a result of very steady market growth in the physician office and long-term care segments and above-market growth in the home care segment for McKesson. This year, we saw slightly earlier sales of flu vaccine as well. We remain focused on delivering value to our Medical-Surgical customers by optimizing our sourcing of the McKesson brand where we deliver high-quality private label products at great savings. In addition, we continue to drive leverage through aggressive cost management.

The team in our Canadian Distribution business has done an outstanding job of working to offset public policy-related price reductions on generic drugs. Solid top line growth, a continued focus on expense control measures and global sourcing of McKesson products led to a good performance for the quarter. Clearly, the environment in Canada has been challenging for retail pharmacies over the past year and, in particular, for independent pharmacies. McKesson Canada has a long history of supporting independent pharmacies through our banner offering and our retail automation solutions and, of course, our broad Specialty offering. We've built a strong brand in Canada with leading physicians in every market segment and close customer relationships. This continues to be a terrific business for us. Our comprehensive set of both distribution and technology solutions for customers clearly differentiates McKesson, and our goal is to continue to grow in Canada.

To sum up Distribution Solutions, in Distribution solutions we had a strong second quarter performance resulting from our terrific combination of assets and a seasoned leadership team that continues to perform exceptionally well. I have great confidence in our full year performance.

Turning now to Technology Solutions. I'm pleased with our performance across the segment. All of the businesses that make up Technology Solutions performed well this quarter, resulting in strong revenue growth and operating margin expansion. As we look across our portfolio of technology businesses, we see steady demand resulting from a number of factors, including the government's focus on broad adoption of Electronic Health Record Solutions, the transaction-based nature of certain of our businesses such as RelayHealth and the increasing demand for solutions that help payers manage financial, administrative and clinical processes, all while improving quality.

This quarter, in our Provider Technology (sic) [Technologies] business, we made solid progress with implementations at both our Horizon and Paragon systems with several customers successfully attesting [ph] for Meaningful Use in both product sets. We also had good expense control, which helped drive financial performance beyond what we experienced 90 days ago. With the publication of the final rule for Medicare Shared Savings Program, sometimes referred to as accountable care regulation, we expect to see continued activity where providers are seeking to defend or grow market share in their area. With the revision of several major components of the regulation, we believe this will accelerate demand for our unique solutions.

To address the various approaches customers are taking, we recommend and offer solutions to our customers that include connectivity and patient engagement, analytics, care management and payment mechanics. McKesson's accountable care solution bundle combines RelayHealth Connectivity assets with the care and population management assets in our payer business, McKesson Health Solutions. These solutions can be combined with Horizon, Paragon and enterprise intelligence to help providers preserve and extend existing investments while managing to a strategic organizational structure that fits their needs. We believe our comprehensive set of solutions for hospitals, payers, pharmacies, physicians and patients is a strong differentiator for us.

Both our payer-facing Health Solutions business and our RelayHealth Connectivity business showed steady results year-over-year in the September quarter. As a reminder, these 2 businesses account for over half of the profits in Technology Solutions, and a number of these solutions require little capital investment by the customer. Therefore, they are very steady growth businesses that have continued to demonstrate considerable stability during the past 2 years of economic uncertainty.

In our Health Solutions business, we learned this quarter that CMS will use McKesson's InterQual criteria for the 12th consecutive year to support Medicare initiatives. The long-standing nature of this relationship is a good example of the value that our solutions bring to our partners year-after-year.

In our RelayHealth business, we focus on one thing, connectivity, so consumers and health care organizations can securely exchange information. This focus reflects our belief that a streamlined exchange of information is better for everyone touched by the nation's health care system. In the quarter, RelayHealth was awarded multiple contracts to support the Department of Defense and the military health system's strategic goals for a more patient-centric medical home model of care. RelayHealth will provide a full suite of secure online services to connect patients who are active-duty military, retirees, spouses and dependents with their health care providers and the care team, to a secure messaging platform and integrated personal health record. This capability provides the Department of Defense with the unique ability to deliver more advanced, patient-centric care directly and the ability to extend this connectivity out to the community providers, enabling an exceptional connectivity platform to improve patient-centric care across the country.

In summary, we're off to a good start to fiscal 2012. In addition to solid operating performance, our strong balance sheet and steady cash flow provide us with opportunities to deploy capital. And in the second quarter, we completed our $650 million accelerated share repurchase program. We target a portfolio approach to capital deployment, which should also include acquisitions. You should feel confident that we intend to continue deploying our capital wisely and strategically. I believe we're well positioned for continued success.

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

Jeffrey C. Campbell

Well, thanks, John, and good afternoon, everyone. McKesson posted another quarter of strong financial results with both segments contributing to our performance. Great execution is driving our operating results, and we retain the financial flexibility to create shareholder value over the long term.

Let me briefly mention one item that impacted our financial statements this quarter, specifically the $118 million AWP litigation charge. This charge was based on 2 primary factors. First, McKesson has now reached an agreement to settle the public entity claims brought by a nationwide class of cities and counties for $82 million. This settlement agreement in a case we refer to as Douglas County, Kansas included an express denial of any liability on the part of the company. As a result of this settlement and progress made toward potentially resolving other public entity claims, the existing litigation reserve of $324 million has been increased by $118 million, bringing the total reserve for AWP public entity claims to $442 million. This $118 million pretax, noncash charge has been recorded in the Distribution Solutions segment, and it equates to $0.31 per diluted share.

My comments today will focus on our $1.63 adjusted earnings per share, which, as you'll recall, excludes 3 items: acquisition-related expenses, amortization of acquisition-related intangibles and any litigation reserve adjustments, including the charge I just reviewed. The numbers I'll review in my discussion can be found on Schedules 2 and 3, included in today's press release.

I'll begin with our consolidated results for the quarter, which can be found on Schedule 2A. Total revenues grew 10% for the quarter to $30.2 billion. Excluding the impact of the US Oncology acquisition that we completed last December, total revenues increased 7% for the quarter versus the prior year with both segments growing at very robust rates.

Total adjusted gross profit increased 21% from the prior year to $1.7 billion with both segments contributing nicely to this result as well. As a reminder, last year's adjusted gross profit was impacted by a $72 million noncash, pretax asset impairment charge in our Technology Solutions segment. Excluding the impact of both US Oncology this year and the prior year asset impairment, overall adjusted gross profit would have increased 9% for the quarter versus last year.

Total adjusted operating expenses were up 11% to $999 million for the quarter. Higher expenses in the quarter were primarily driven by the impact of the US Oncology acquisition, which contributed roughly 5 percentage points to the total adjusted operating expense growth.

Other income was fairly flat for the quarter, $6 million. Interest expense, $64 million, was $20 million greater than the prior year due to the debt we've put in place as a result of the US Oncology acquisition. Our full year assumption of $260 million of interest expense in fiscal 2012 remains unchanged.

Turning now to taxes. Our adjusted tax rate this quarter came in at about 32%, and that remains our estimate for the full year. Adjusted net income for the quarter was $408 million, and our adjusted earnings per diluted share was $1.63.

To wrap up our consolidated results, this year's earnings per share number was aided by the cumulative impact of our share repurchases, which lowered our diluted weighted average shares outstanding by 5% year-over-year to 250 million.

One other point about the share count. You heard John mention earlier that we completed our $650 million accelerated share repurchase program in August. This completion date was earlier than we originally anticipated. And due to overall market movements, the final share price came in slightly lower than we originally anticipated. Taking this into account, we now expect our full year average diluted shares to come in a bit below the original guidance assumption of 253 million shares outstanding.

Let's now move on to the segment results, which can be found on Schedule 3A. In Distribution Solutions, overall revenue growth was 10% compared to the same quarter last year. Direct revenues were up 11% for the quarter to $21.1 billion. When you exclude the impact of US Oncology, our second quarter revenues increased approximately 6%, primarily driven by solid performance across our entire customer base. Warehouse revenues increased 5% to $4.9 billion, benefiting from the revenues associated with a new customer.

Canadian revenues on a constant currency basis grew 2% for the quarter. Including a favorable currency impact of 6%, Canadian revenues grew 8% for the quarter. Year-to-date, our overall Canadian results are tracking modestly better than our plan because of the team's ability to effectively mitigate the regulatory challenges we faced in that marketplace.

Medical-Surgical revenues were up 13% to $873 million primarily due to 5 extra days of sales in the quarter. Excluding the impact of these 5 extra days of sales, Medical-Surgical revenues increased approximately 5% versus the prior year, partially aided by earlier flu vaccine sales.

Distribution Solutions' adjusted gross profit increased 16% for the quarter to $1.3 billion. Factoring out the US Oncology acquisition, adjusted gross profit would still be up a strong 9% for the quarter. The key drivers of this adjusted gross profit growth were increased profit from generics and the timing of the compensation we receive from branded manufacturers.

Adjusted operating expense in the segment was up 12% to $628 million for the quarter. Excluding US Oncology, adjusted operating expense increased 5% versus last year with the 5 additional days in our Medical-Surgical business comprising 2 of these 5 points.

Adjusted operating margin rates for the quarter were 216 basis points, an increase of 19 basis points versus the prior year. Excluding the impact of US Oncology, we are showing an 11-basis-point adjusted operating margin improvement year-over-year in this segment. Given that quarterly timing varies in this segment, we always focus on full year margins. In this context, we continue to expect adjusted operating margin improvement in the high single-digit basis points for fiscal 2012.

In summary, we're extremely pleased with the first half performance and margin expansion for businesses within Distribution Solutions.

In Technology Solutions, total revenues increased a strong 7% to $825 million for the quarter with all businesses in the segment contributing to this growth. Adjusted gross profit for the segment grew 41% to $394 million, driven by the prior year's asset impairment charge. Excluding the asset impairment charge, Technology Solutions' adjusted gross profit would have increased about 12%.

Our total gross R&D spending was $115 million compared to $107 million in the prior year. Of this amount, we capitalized 9% versus 16% a year ago.

Technology Solutions' adjusted operating profit this quarter was $126 million compared to $29 million in the prior year. Excluding the prior year asset impairment charge, Technology Solutions' adjusted operating profit would be up a healthy 25%.

Adjusted operating margins in this segment were 15.27%. Based on our implementation progress to date, we have now modestly increased our full year forecast for this segment. We continue to expect our full year adjusted operating margin to be in the low end of our long-term Technology Solutions adjusted operating margin goal range of mid-teens. Said another way, I would expect our full year margin for Technology Solutions to be below the margin we experienced this quarter.

Leaving our segment performance and turning now to the balance sheet and working capital metrics. As you've heard me say before, we took -- our working capital metrics can be impacted by timing, including the timing of payments or what day of week marks the close of our quarter. Our receivables were $9.5 billion, up from the prior year balance of $8.2 billion, and our days sales outstanding increased by 1 day to 25 days. Inventories were $9.4 billion, an increase of 8% over the prior year, and our payables increased 16% to $14.9 billion from a year ago. This resulted in our days sales and inventory remaining flat at 30 days, while our days sales in payables increased 3 days from a year ago to 47 days.

These working capital metrics resulted in McKesson generating $1.4 billion in operating cash flow year-to-date. Given this strong performance, we now expect to generate at least $2 billion in cash flow from operations this fiscal year.

Capitalized spending was $227 million for the first 6 months of the year, and we continue to expect full year capitalized spending between $450 million to $500 million. We ended the quarter with a cash balance of $3.9 billion.

Overall, we are pleased with our year-to-date performance and expect that first half momentum to continue. As a result, we're raising our guidance on adjusted earnings from $6.09 to $6.29 to a new range of $6.19 to $6.39. As John and I have both now discussed, we have seen modest strength across pretty much all of our businesses in both segments, which drives the guidance raise.

Now keeping in mind that we do not routinely provide quarterly EPS guidance, we still do anticipate our fourth quarter to be unusually strong this fiscal year. As always, I would say that our quarterly progression could change from what we believe or can forecast today. That said, as a rough guide, I'd expect as of today that measured as a percentage of our overall earnings for the year, we expect this year's fourth quarter to be similar to our experience in the fiscal 2011 fourth quarter.

One last point about our fiscal 2012 outlook. We expect $0.07 for acquisition-related expenses and $0.46 for amortization of acquisition-related intangible assets. In addition, due to the AWP litigation charge we recorded this quarter, we are now assuming $0.31 for litigation reserve adjustments.

In closing, we feel McKesson has executed well across all our businesses through the first half of fiscal 2012. We have great financial flexibility, which provides us a good opportunity to continue our capital deployment strategy to enhance shareholder value. Thanks. With that, I will turn the call over to the operator for your questions. [Operator Instructions] Operator?

Question-and-Answer Session

Operator

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

Steven Valiquette - UBS Investment Bank, Research Division

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

Jeffrey C. Campbell

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

Operator

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

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

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

Jeffrey C. Campbell

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

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

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

Jeffrey C. Campbell

I -- that's fair.

Operator

Next we'll hear from Glen Santangelo with Credit Suisse.

Glen J. Santangelo - Crédit Suisse AG, Research Division

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

John H. Hammergren

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

Operator

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

Lawrence C. Marsh - Barclays Capital, Research Division

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

John H. Hammergren

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

Lawrence C. Marsh - Barclays Capital, Research Division

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

John H. Hammergren

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

Operator

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

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

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

Jeffrey C. Campbell

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

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

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

Jeffrey C. Campbell

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

Operator

We'll go to George Hill from Citi.

George Hill - Citigroup Inc, Research Division

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

John H. Hammergren

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

Operator

Next we'll hear from Lisa Gill with JPMorgan.

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

I just had a couple of follow-up questions. Jeff, on Lipitor, when you contemplated Lipitor in your guidance last year, were you expecting that Ranbaxy was going to launch? Or were you always anticipating that there potentially would only be one manufacturer? How should we think about that?

Jeffrey C. Campbell

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

John H. Hammergren

And I'll also say, Lisa, I think it's also important to know that these are -- this is a big product, but we also have a portfolio of margin that comes in not only from generics but also from branded companies. And if our speculation on Lipitor happened to be slightly off one direction or the other, I'm not sure that it would have a significant impact on our company, particularly with the fact that this is mostly an FY '13 opportunity for McKesson given that it falls late in our fiscal year. So I don't -- we're not particularly stressed by the various speculation that's out there and what it might do. Now clearly, they can be significantly different than what we think.

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

And then just one other thing. I know, Jeff, you normally don't like to give quarterly guidance. But based on the fact that we know now 2 quarters and you've given us some indication on the fourth quarter, just coming back to the third quarter if I do the math around the range, you're in essence saying that it would be flat year-over-year. Is there anything specific to this quarter or perhaps maybe some of the price increases that you saw on branded inflation where they pulled forward? Is there something that got pulled forward from the third quarter to the second quarter? How should we think about that?

Jeffrey C. Campbell

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

Operator

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

Ross Muken - Deutsche Bank AG, Research Division

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

John H. Hammergren

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

Ross Muken - Deutsche Bank AG, Research Division

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

John H. Hammergren

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

Operator

Next question comes from Ricky Goldwasser with Morgan Stanley.

Ricky Goldwasser - Morgan Stanley, Research Division

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

Jeffrey C. Campbell

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

Ricky Goldwasser - Morgan Stanley, Research Division

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

John H. Hammergren

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

Ricky Goldwasser - Morgan Stanley, Research Division

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

Jeffrey C. Campbell

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

Operator

We'll go to Eric Coldwell from Robert W. Baird.

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

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

John H. Hammergren

Well, clearly, our expectation is that our business will continue to drive efficiencies and that we should be able to grow OpEx slower than we grow revenues. Okay? Clearly, there's a crossover point. Particularly, if you think about the business less from a revenue perspective but from a gross margin or gross profit dollar growth perspective, that leverage should be retained. And as you think about the generic wave, our revenues may come under some pressure, but our gross profits shouldn't. And if we can keep growing our gross profits at or above the rates of our expenses, then we're going to get a very positive lift right to the bottom line. So that's the model. There's nothing in the model that should be changing going forward. And clearly, to the extent that there's inflation that's added into the model and it's something you don't have to add expense against, then that's certainly a helpful force. But I don't think the efficiency we've gained at McKesson is over yet.

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

Yes, that's great. I guess really, what I'm trying to drive to is that you've just done a really phenomenal job on this, and I want to make sure that we're not so hung up on generics, timing and pricing and specific drugs coming to the market that we lose sight of maybe future investments that might be needed in the core distribution platform, and whether we should be thinking about any future repositionings or growth in the distribution network, for example, things of that sort, especially given the strong top line growth you have.

John H. Hammergren

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

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

That's great.

Operator

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

Albert J. Rice - Susquehanna Financial Group, LLLP, Research Division

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

John H. Hammergren

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

I want to thank you, operator, and all of you on the call today for your time. We've had a very solid first half, and I'm excited about the opportunities that lie ahead. I'm now going to hand the call over to Ana to talk about our upcoming events for the financial community. Ana?

Ana Schrank

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

Operator

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

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