McKesson Management Discusses Q2 2013 Results - Earnings Call Transcript

 |  About: McKesson Corporation (MCK)
by: SA Transcripts


Good day, and welcome to the McKesson Corporation Quarterly Earnings Call. [Operator Instructions] Today's call is being recorded. If you have any objections, you may disconnect at this time. I would now like to introduce Ms. Erin Lampert. Please go ahead, ma'am.

Erin Lampert

Thank you, Jim. Good morning, and welcome to the McKesson's Fiscal 2013 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 will open the call for your questions. We plan to end the call promptly after 1 hour at 9:30 a.m. Eastern Time.

Before we begin, I'll remind listeners that during the course of this call, we will make forward-looking statements within the meaning of 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 releases for a discussion of the risks associated with such forward-looking statements.

Finally, please note that on today's call, we will refer to certain non-GAAP financial measures, in which we exclude from our GAAP financial results acquisition expenses and related adjustments, amortization of acquisition-related intangible assets and certain litigation reserve adjustments. We believe these non-GAAP measures will provide useful information for our investors. Please refer to our press release announcing second quarter fiscal 2013 results available on our website for a reconciliation of non-GAAP performance measures to the GAAP financial results. Thanks, and here is John Hammergren.

John H. Hammergren

Thank you, Erin, and good morning, everyone. Thanks for joining us on our call. This morning, McKesson announced our agreement to acquire PSS World Medical for a total consideration of approximately $2.1 billion. The close of the transaction is subject to customary conditions, including all necessary regulatory clearances and the approval of the PSS shareholders.

McKesson's Medical-Surgical business and PSS will combine to form a leading provider of medical supplies and services and technology. We're very excited about this transaction and the value it will bring to our customers, our supply chain partners, the employees of both organizations and to our shareholders.

Before I walk through our thoughts on the strategy of the combined organization, let me review the primary financial impacts of the transaction, and Jeff will also provide more information in his remarks.

Under the terms of the agreement, McKesson is acquiring all of the outstanding shares of PSS World Medical for $29 in cash. In total, including PSS World Medical's existing debt of about $480 million and related transaction costs, the transaction is valued at approximately $2.1 billion.

The value and synergy in this transaction will happen over time. By the fourth year, we expect to realize annual pretax synergies in excess of $100 million. This transaction underscores McKesson's deep commitment to its physician and extended care customers. Industry participants will play an increasingly important role as the implementation of health care reform continues and demographic shifts increased demand.

By preserving the strengths of both businesses, the combined organization will bring extensive distribution capabilities, deep product and technology expertise and a broad portfolio of business services to the industry.

The combined organization will benefit from the addition of PSS World Medical's distribution network, private fleet, broad laboratory customer base and strong private-label offerings, which will complement McKesson's broad portfolio of solutions to maximize value for our customers.

Upon the close of the transaction, the 2 management teams have come together under the combined leadership of Stanton McComb, President of McKesson Medical-Surgical business; and Gary Corless, President and Chief Executive Officer of PSS. The combined business will report to Paul Julian, Executive Vice President and Group President of McKesson. Stanton and Gary are both exceptional leaders who are passionate about their teams and the opportunity to enhance the value we deliver to our customers.

In summary, we have a great track record of deploying capital wisely, and we are very excited about the opportunity to bring together these 2 great organizations.

Turning now to McKesson's results for the second quarter. Today we reported another solid quarter with total company revenues of $29.9 billion and adjusted earnings per diluted share of $1.92. Based on our performance year-to-date, we are updating our previous outlook for the fiscal year and now expect to achieve adjusted earnings per diluted share of $7.15 to $7.35 for fiscal 2013.

Before I turn the call over to Jeff for a detailed review of our financial results, I will provide some highlights from both of our segments of our business.

Distribution Solutions had strong operating profit growth on revenue that was down 1% compared to the prior year. As you know, our fiscal 2013 is a robust year for oral generic launches, and in particular, our second quarter saw a number of sizable launches which had a deflationary impact on our revenue line.

As a result, adjusted operating profit grew by 10%, driven by strong execution across the segment.

So overall, I'm pleased with the financial performance of the Distribution Solutions segment in the first half of the fiscal year, and I remain confident in our full year expectations.

Turning now to our U.S. Pharmaceutical distribution business. I want to highlight a couple of important accomplishments. First, I know there's been a fair amount of discussion about the overall competitive environment, perhaps driven by a few very public contract awards in our industry in the current year.

We are proud to have long-standing customer relationships, and that the core of McKesson's values as a company is to deliver outstanding service, products, technology and innovation so that we have the opportunity to create customers for life.

As a matter of what we consider to be good business practice, we don't make a habit of talking about our customers or our competitors' customers publicly. We believe our customers value the confidential nature of our business relationship. One of the few relationships that is more public than others due to our customers' disclosure requirements, is our relationship with Rite Aid. McKesson has enjoyed a long-standing relationship with Rite Aid, and we're very pleased to have recently extended our distribution agreement through March of 2016.

Turning to another important part of our U.S. Pharmaceutical business. For the third time in 4 years, McKesson's Health Mart franchise achieved the highest ranking in overall customer satisfaction among chain drugstore pharmacies in the J.D. Power and Associates 2012 U.S. National Pharmacy Study. The study encompassed responses from more than 12,700 consumers surveyed on overall customer satisfaction. Our Health Mart pharmacists delivered outstanding personalized care to their patients every day, and we're proud that their dedication has been acknowledged.

This recognition from consumers further reinforces the value patients receive from Health Mart pharmacies and also demonstrates the value of the partnership between Health Mart and community pharmacies. We're also extremely pleased to reach the milestone of 3,000 Health Mart stores during our second quarter.

And finally, in the second quarter, we named Mark Walchirk as the new President of our U.S. Pharmaceutical distribution business. Mark has held numerous roles inside of McKesson over the past 11 years, including Chief Operating Officer of McKesson Specialty Health and Chief Operating Officer of our U.S. Pharmaceutical business.

Mark succeeds Brian Tyler, who is appointed Executive Vice President of Corporate Strategy and Business Development in August, following Marc Owens' appointment as President of McKesson Specialty Health. These executive appointments demonstrate the deep bench strength of leadership talent within McKesson, and I believe we have the best business leaders in the industry.

In the specialty market, we continue to strengthen our position. I've been pleased to see our teams' ability to win new customers and expand our value to existing customers in this market through a combination of great service and great technology. We also continued to add physicians to our US Oncology network and grow and expand our innovative partnerships with hospitals throughout the country.

In our Canadian Distribution business, we delivered solid operating performance across our many lines of business in the second quarter, and I'm pleased to see the steady progress our team continues to make in Canada. And the acquisition of the Katz's banner business is performing extremely well. We've not only succeeded in working closely with the acquired banner members to strengthen their business but we've also seen benefits across our existing banner network from the expanded scale we acquired with the Katz acquisition.

Through acquisitions like the Katz Group, as well as the solid execution and innovation of our team in Canada, we continue to find ways to mitigate the impact of government-imposed price reductions on generic drugs.

Turning to our Medical-Surgical business, we continue to benefit from organic growth as well as our ability to gain new customers.

Revenues were flat for the quarter, but this was mainly due to there being 5 fewer days of sales in the quarter. Adjusting for the difference in sales days, revenues increased approximately 8% in the quarter.

We've had terrific momentum and strong results in our Medical-Surgical business for some time. With the acquisition of PSS World Medical, we will leverage the best of both organizations including the unified strength of the most knowledgeable and tenured sales teams in the industry.

The combination of great products, services, technology and people will be the platform to continue this momentum and enhance the value we will bring to our customers.

In summary, I'm pleased with the solid performance of our Distribution Solutions segment. We are excited about the opportunities in front of us and confident in our outlook for the rest of the fiscal year.

Turning now to Technology Solutions. Our first half results have been modestly better than we had planned, primarily due to timing. But our full year expectations remain unchanged.

For the second quarter, revenues were flat and adjusted operating margins were 13.83%. We continue to make progress in ensuring our customers' success and supporting them on their journey to reaching important Meaningful Use milestones as they move forward with creating more connected and accountable health care communities.

We start with a portfolio that is unmatched in breadth, which gives McKesson a unique view in the flow of information between patients, providers, hospitals and pharmacies as it takes place today and what will be necessary for the future. As our customers' needs evolve, we will invest internally and externally in the critical technologies that will help them succeed.

In the second quarter, we announced 2 acquisitions, and although they are not expected to have material impact on earnings in the near-term, they are important to our strategy going forward. At the end of September, we announced our acquisition of MedVentive which will become part of our provider technology business. MedVentive's products and solutions will work together to enable providers to proactively manage the clinical health of at-risk patient populations by identifying gaps in care and delivering actionable information to care providers. These capabilities are important to the accountable care and patient-centered medical home offerings across our Technology Solutions segment.

In early October, we announced our plans to acquire Med3000 which further strengthens our core offering in revenue management solutions. Just to remind people, who might not be as familiar with our revenue management solutions business, this business offers leading outsourced financial and billing solutions primarily to physician practices and hospitals. These solutions are more important than ever as physicians, hospitals and other entities work to reduce costs and run their businesses more effectively.

Turning to McKesson Health Solutions. We've been investing and creating more connected solutions for our customers, and one recent example is McKesson Reimbursement Manager. This solution has the ability to manage multiple reimbursement models by identifying the correct provider reimbursement rate based on the unique combination of several provider- and client-specific attributes.

This capability is important to payers and providers as they navigate the complex reimbursement models that are becoming more common in the marketplace.

And finally, turning to RelayHealth, which is a key length in bringing together many of our solutions for our customers, you've heard us talk about the pharmacy and hospital network business and we have -- also have been growing the business in the management of clinical information. Our ability to connect health care information in a secure way helped us position for win the recent TRICARE award for secure messaging throughout the entire military health system, and for the Air Force award for automatically populating patient health records with actionable information from the Air Force's data repository.

In summary, we report another solid quarter of operating performance, and I'm pleased to use the tremendous strength of our balance sheet to bring together 2 great organizations, our Medical-Surgical business and PSS World Medical. And we still have the financial flexibility to continue our portfolio approach to capital deployment to create value for our shareholders.

I'm proud of our accomplishments and excited about the opportunities that lie ahead. 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 morning, everyone. Our second quarter results reflect a solid performance at this halfway point in our fiscal year.

We're obviously pleased that the strength of our balance sheet has allowed us this morning to announce our transaction with PSS. And I'll offer a few financial comments on PSS at the end of my remarks.

My comments today on our earnings will focus on our $1.92 adjusted earnings per share, which as you recall, excludes 3 types of items, amortization of acquisition-related intangibles, acquisition expenses and related adjustments and certain litigation reserve adjustments.

The numbers I'll review in my discussion today will be based on an adjusted earnings basis and can be found on Schedules 2 and 3 included in today's press release.

Let me first turn to our consolidated results for the quarter which can be found on Schedule 2A. Consolidated revenues were $29.9 billion for the quarter, down 1% from the prior year. There are a number of factors behind this 1% decline, and I'll cover these as I discuss each of the segments in more detail.

On this small decline in revenues, our adjusted gross profit was up 4% for the quarter. I'd remind you that this quarter reflects a record number of recent generic launches which had a deflationary impact on revenues while driving up our adjusted gross profit.

Total adjusted operating expenses were up just 2% to $1 billion for the quarter as we showed good expense management across the company.

Moving down the P&L. Other income was up $4 million for the quarter to $10 million and interest expense declined 14% to $55 million for the quarter. As you recall, we repaid $400 million in long-term debt in February of fiscal 2012, and we now have another $500 million maturity due in March of fiscal 2013.

Looking ahead, we expect to refinance both amounts later this fiscal year. As a result, we would expect our interest expense to increase modestly in the back half of fiscal 2013. I would point out that this is just a refinancing of existing debt and is independent of the PSS transaction, the financing for which I will come back to at the end of my remarks.

Turning now to taxes. Our adjusted tax rate for the quarter of approximately 30% benefited from $7 million of net favorable discrete tax items. Similar to the first quarter, some of these favorable tax discrete items came in earlier in the fiscal year than we had originally anticipated. Also, for the full year, we now expect a higher total of net favorable discrete tax items.

As a result of these changes, we've lowered our full year estimate of the adjusted tax rate a bit from 31% to 30.5%.

Adjusted net income for the quarter was $461 million, up 13% from the prior year. Our adjusted earnings per share was $1.92, an increase of 18%, compared to last year's adjusted EPS of $1.63.

And wrapping 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 4% year-over-year to 240 million. We continue to expect our full year average diluted shares to come in around our original guidance assumption of 239 million shares outstanding.

Before moving on to our segment results, let me comment on one other item, which while not impacting our adjusted earnings, did impact our GAAP results this quarter, specifically the $44 million AWP litigation charge.

As a reminder, last quarter, we reached a final agreement with the coalition of State Attorneys General to resolve the majority of state medicaid claims related to AWP. Since then, we have continued to work through the remaining state Medicaid cases. As a result of progress made towards resolving these remaining state Medicaid cases, we have increased the AWP litigation reserve by $44 million.

This charge has been recorded in the Distribution Solutions segment, and it equates to $0.11 per diluted share.

Let's now move on to our segment adjusted earnings results which can be found on Schedule 3A. In Distribution Solutions, total revenues were down 1% for the quarter versus the prior year. Direct distribution and services revenues were also down 1% for the quarter to $20.9 billion. This is roughly in line with our original expectations as we continue to expect direct revenues to be fairly flat for the full fiscal year due to the record number of generic launches in fiscal 2013.

Our warehouse revenues decreased 2% year-over-year. The primary driver of this decline was brand-to-generic conversions which particularly impact our warehouse revenues. Relative to our original expectation of unusually strong growth in our warehouse revenues this year, we now expect warehouse revenues to be fairly flat for the full year. As you know, we earn lower margins on our warehouse revenues relative to the margins on our direct revenues. Therefore, the impact on earnings from lower warehouse revenue is quite modest.

Canadian revenues, on a reported basis, declined 5% for the quarter primarily due to an unfavorable currency impact and there being 1 less sales day in the quarter. Factoring out both of these items, Canadian revenues declined just 1% for the quarter. And as John mentioned earlier, our team in Canada continues to do a good job of mitigating the impact of government-imposed price reductions on generic drugs.

Moving on to Medical-Surgical. While reported revenues were flat for the quarter at $873 million, results were impacted by there being 5 fewer sales days in the quarter this year. Excluding the impact of having 5 fewer sales days, Medical-Surgical revenues grew a healthy 8% for the quarter driven by market growth and new customers.

We are pleased to see continued steady growth in our Medical-Surgical business and believe we are well positioned to carry this momentum forward.

Distribution Solutions' adjusted gross profit increased 6% for the quarter to $1.3 billion. This represents an adjusted gross margin improvement of 34 basis points versus the prior year. There were a number of components driving these results. We did, of course, have tremendous growth in oral generic profits this quarter. The quarter also benefited from 2 timing items that particularly aided our results. First, we received $19 million of favorable antitrust settlements in the quarter which added roughly $0.05 to $0.06 to our adjusted earnings this quarter. We do plan, over the course of the year, for some level of these types of settlements, but the timing and precise amount always varies.

Second, we also saw a timing shift this quarter with our manufacturer economics. When you think about our relationships with manufacturers, the majority of our compensation is fixed over the course of a full year. However, the timing of when we recognize that compensation can be impacted by price increases and other factors, some of which were particularly strong this quarter.

Adjusted operating expense in the segment was up just 3% for the quarter primarily driven by the costs associated with acquiring the Katz assets. Given this, we were pleased overall with the expense management in this segment.

The adjusted operating margin rate for this segment was 241 basis points this quarter, an increase of 25 basis points versus the prior year. As you've heard me say many times before, given the quarterly variability in this segment, we always focus on full year margins. Based on our first half fiscal 2013 results, we now expect adjusted operating margin improvement in the high single-digit basis points compared to our full year fiscal 2012 adjusted operating margin rate of 210 basis points.

In summary, we're pleased with the first half performance in our Distribution Solutions segment.

Moving now to Technology Solutions. Total revenues were flat for the quarter at $824 million and adjusted gross profit declined 3% to $384 million.

Technology Solutions' gross R&D spending was $116 million, roughly flat with last year's $115 million. The capitalization rate was unchanged at 9%.

Adjusted operating expense increased by just 1% in the quarter to $272 million, and we are pleased with the team's ability to control expense growth.

Technology Solutions' adjusted operating profit was down 10% versus 1 year ago to $114 million and our adjusted operating margin was 13.83% compared to 15.27% 1 year ago. For the full year, we continue to expect our adjusted operating margin to be in the low end of our long-term Technology Solutions adjusted operating margin goal range of mid-teens or 14% to 16%.

Leaving our segment performance now and turning briefly to the balance sheet and our working capital metrics. Our receivables were $9.8 billion, up from the prior year balance of $9.5 billion and our day sales outstanding increased by 1 day to 26 days. Compared to 1 year ago, inventories increased 7% to $10.1 billion and payables were up 4% to $15.5 billion.

This resulted in our day sales in inventory increasing by 2 days to 32 days, and our day sales and payables increasing by 3 days to 50 days. These working capital metrics resulted in McKesson generating $459 million in operating cash flow year-to-date. For the full year, we continue to expect our cash flows from operations will be between $2 billion and $2.5 billion.

We ended the quarter with a cash balance of $2.8 billion. And of this amount, approximately $1.6 billion was offshore. Overall, our gross debt-to-capital ratio was 31.7% for the quarter, at the low end of our target range of 30% to 40%.

Capitalized spending was $167 million for the first 6 months of the year, and we continue to expect full year internal capital spending between $425 million and $475 million.

Now I will turn to our outlook. Given the solid first half results, we are updating our guidance on adjusted earnings from $7.05 to $7.35 to a new range of $7.15 to $7.35. In addition, we now expect $0.54 for amortization of acquisition-related intangible assets. And due to the AWP litigation charge we recorded this quarter, we are now assuming $0.15 for litigation reserve adjustments.

Also to remind you, as a result of the $81 million pretax acquisition-related gain we had in the first quarter of fiscal 2013, we expect acquisition expenses and related adjustments to add approximately $0.18.

Now let me take a few moments to talk about the financial aspects of the PSS transaction that we announced today. As in all our acquisitions, this acquisition had to make both great strategic sense and great financial sense.

As you've heard me say before, we look at many financial metrics when evaluating acquisition opportunities. We believe PSS will provide a great return on capital for our shareholders, create value we can only get by combining the 2 companies and reasonably share that value creation between the 2 companies' shareholders.

For now, we have chosen to not include any impact from this transaction in our fiscal 2013 guidance, which I just took you through, since we cannot predict the precise timings of the close.

To help you think about the P&L impact, however, if you were to simply assume that the transaction was 100% debt-financed at a 4% interest rates, we would expect the acquisition to be $0.15 to $0.25 accretive in the first 12 months after closing on an adjusted earnings basis.

For those of you who track us on a GAAP basis, our initial estimate for intangible amortization is roughly $100 million per year. Longer term, as John stated earlier, our synergies in this business case of over $100 million per year will be realized incrementally over the first 4 years as we integrate the companies.

To be clear, our intention on permanent financing will be to use a mixture of cash on hand and new debt. Initially, we will be putting in place a bridge facility to help fund the close of the transaction. The precise amount of new permanent debt, we then issue after the transaction closes, will vary depending upon circumstances at that time.

To make another probably obvious point, probably the transaction of this size, given our portfolio approach to capital deployment, we are likely to do a little less share repurchases than we otherwise would've done in the near-term.

And finally, once the transaction is closed, we will be reporting the results of PSS as part of our Distribution Solutions segment.

Thanks and with that, I'm going to turn the call over to the operator for your questions. [Operator Instructions] Operator?

Question-and-Answer Session


[Operator Instructions] We'll take our next question from Steven Valiquette from UBS.

Steven Valiquette - UBS Investment Bank, Research Division

So basically my question is -- my understanding is the companies have slightly different distribution models when you look at McKesson versus PSSI, where one is kind of using a third-party carrier. The other one's using may be a fleet of vans for a lot of the physical delivery. So I'm just trying to get a sense whether you thought about the go-forward strategy and the physical distribution. Is that also a major part of the cost synergies of the deal? Just looking for more color on that.

John H. Hammergren

Well, clearly, I think both companies have a great track record of customers with strong relationships and long-term relationships with our organization. And those relationships are built by a combination of the quality of the people that we use in the field, both the delivery people, the distribution workers that pick the product to make sure the order's delivered on time. And clearly, the sales force that has a relationship. So we're going to be very careful and very thoughtful about any changes we make that might disrupt those customer relationships. And frankly, there's things we can learn from both of our approaches relative to distribution and transportation that we need to take the sort of the best of the best approach in the marketplace. So I think I don't want to get too specific, but I think we believe they're significant value from the combination. And we should make sure that we're very careful about preserving what we're doing. Our synergy number that we provided, we think, is appropriate and will not cause significant disruption that will be noticed by our customers as a result of taking out the cost.


Moving on, we'll take our question again from Tom Gallucci from Lazard Capital Markets.

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

I guess, 2 questions. Just the first one was on the process, if you can give us any background on the deal itself, how it came together? And anything in that realm, that’d be helpful.

John H. Hammergren

Well, obviously, we have had a long-term industry relationship with PSS World Medical. And as I mentioned on with Steven, I think that our organizations know each other well. We've competed well in the field, and I think that we have had mutual admiration for the cultures built by both companies. And so I think as you would expect, off and on over the years, we probably have had lots of conversations about opportunities. And all I would say is that the door was made available to us when the discussion opened up around their extended care business. And through those discussions, we were able to expand the discussion to talk about the larger transaction. We know these businesses well. We have a strong footprint in the primary care and physician business as well as in extended care. And I think that relationship over decades really in the marketplace has afforded us the opportunity.

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

Okay. And then, you did mention a couple of the IT deals that you had done. Med3000, I thought, was a decent size. Could you guys offer any color on the financial impact there both in terms of balance sheet as well as income statement?

John H. Hammergren

Let me talk a little bit about the strategy and then Jeff, perhaps, can talk about the financials of the transaction. You're right, Med3000 is slightly larger than the MedVentive deal. The Med3000 deal fits nicely with the assets that had been previously acquired by Per-Se, and then acquired by McKesson when we acquired Per-Se. We believe we are the market leader in revenue cycle management and services, like billing and collections, with physician offices in this country, and we've got a very good model to make that happen. And we are pleased to bring the Med3000 team into the fold. Frankly, their model is a little more expansive, not as scaled as ours. But it goes into other areas of the marketplace where we are looking to build our capabilities, and so we're excited to bring that team on. And it's got a great leadership and management team, and I think it'll move us strategically. The MedVentive deal, as you mentioned, is more of a technology asset. And that fills a need -- bringing together several of the McKesson existing assets as our customers struggle with the complexity associated with trying to manage patient populations and be at risk for those populations. And so I think that, that also positions us well. A frankly smaller scale and -- but that company has been around almost a decade, perhaps slightly longer. So they've been working on this process of taking a longitudinal view of a patient and their care for a long time. So they both fit nicely for us. And Jeff, maybe you could talk a little bit about the financing?

Jeffrey C. Campbell

Well, from a financial perspective, Tom, in the near-term, both deals have an immaterial impact on the income statement. And from a cash and purchase price perspective, they're small enough. So we won't be breaking out the specific purchase price which just tells you that the cash involved is not material relative to the $2 billion to $2.5 billion of operating cash flow we'll have this year. Certainly, as they close, you'll see in our cash flow statement next quarter our total spending on all the acquisitions that closed in the quarter.


Moving on, we'll take our next question from Lisa Gill, JPMorgan.

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

I have a couple -- I just had a couple of questions. John, maybe bigger picture, we've been talking in the last few quarters about hospitals buying physician practices and how that market is changing and hearing about what margins will look like going forward. Can you talk to us about what you see going forward under ACA, should it stay? And physicians buying -- I'm sorry -- hospitals buying physician practices, and what this means to now be the leader in that marketplace?

John H. Hammergren

Sure, Lisa. Clearly, we have to continue to evolve our model as our customers aggregate together perhaps in larger practices, or as you said, some of them have chosen to sell their practices to hospitals or to IDNs. What's great about McKesson is we have a very, I think, a strong relationship and an understanding for the acute side of the business. As you may recall, we had an acute Med-Surg business at one point, which we sold. But our knowledge of that marketplace, in how hospitals operate and hospital GPOs operate, I think, has benefited us as we've evolved our model to provide service and solutions to customers who either are existing customers who are being acquired and want to remain with McKesson or -- and frankly, new customers that have been acquired by hospitals, where hospitals are struggling with a more unified approach to their supply chain requirements. Clearly, the acute care distributors stand in a position to compete with us for that business, but because they have a position in the hospital space. But we also think there's an opportunity for us to continue to service these customers, and we have had very little customer attrition through an acquisition by a health system or a hospital. And I think the priority for those health systems, frankly, is not the 1% or 2% of the supply chain cost that those physicians may represent of their entire medical-surgical spend, I think they're more focused on the productivity and efficiency and alignment those physicians might have with the enterprise, particularly if they're trying to build a at-risk ACO or PCMH kind of a model. And so I think that to the extent that they can put the logistics and supply chain requirements behind them and not have to disrupt that productivity by making significant changes in distribution, they benefit. So we have successfully navigated with our customers these changes in their ownership models, and I think we're well positioned to handle the scale requirements that are necessary for hospital customers. Having said that, clearly, we have competitors on the acute care side that have an avenue into this marketplace, and we have to be vigilant on our value proposition.

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

And then just as a follow-up, John, for you or Jeff. How do we think about the synergies that you talked about, the $100 million, is that just cost? Or do you think that there's some level of revenue synergies, especially from an IT perspective? My understanding is that today, Athena has a relationship with PSS. So do you see that as a future revenue relationship opportunity?

John H. Hammergren

Well, just to answer the question directly, our synergy model is really all cost base, and we believe we have a line of sight to those synergies. It'll take us some time, as Jeff and I have mentioned, this is not an easy process and we want to make sure that we're not disrupting our customer relationships. But we -- to the extent that there's upside in this from a revenue and a value proposition perspective, we'll continue to build that out, and that's not included in the numbers that we provided this morning. As it relates to relationships that PSS World Medical may have with others in the industry, whether they're on a laboratory side, frankly, in terms of their sourcing and their power in that space or whether it's on the technology side, as you noted, there may be opportunities for us to leverage what they're doing through our sales force, and we look forward to that. And if they have relationships with companies that McKesson has been unable to build, we look forward to extending those relationships across our footprint. And at the end, even to the extent that we might have some competition with McKesson's internal capabilities across the footprint, we're not going to -- out of the gate discourage any or dismantle any of the relationships that PSS World Medical has built without careful evaluation. Athenahealth has built a great model, I know the team there. And their model, frankly, is a little different than the model we have in our REMS business. We have a different physician practice target that we're looking at compared to what they're doing, and so I wouldn't jump to any conclusions.

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

Okay, great. And then I know I'm only supposed to be asking 2 but I just want a clarification here. Does the transaction include the Elder Care Business because I know you're in the long-term care business as well?

John H. Hammergren

Yes. The transaction is for PSS World Medical, as it stands today. The transaction that had been spoken about by the PSS World Medical management relative to their extended care platform is where we began. But that is no longer going to be sold as a separate asset.


Moving on, we'll go to Eric Coldwell from Robert W. Baird.

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

I want to follow up -- I think, it was Tom's question, and you addressed most of it. But you did mention during the call that you expect your Technology Solutions outlook to be the same as before. And previously, you'd stated Technology Solutions growth similar to last year's rate of about 4%. Since then, you've acquired 2 businesses, which on a full year basis, would add about 5 points to growth by my math. So I'm curious if you've just not included the acquisition revenue performance? Or if you're implicitly showing us that Technology Solutions' underlying organic growth is perhaps a little less than you originally expected?

Jeffrey C. Campbell

Well, the key here clearly is the acquisitions are closing late in the year and have no actually material impact on our revenues this year. So our view of the underlying performance of the organic MTS businesses hasn't changed at all.

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

Jeff, I'm sorry if I missed this one, when do you expect the acquisitions to close?

Jeffrey C. Campbell

Well, they're closing in the third -- late in the second quarter and sometime during the third quarter.

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

So about a 0.5 year influence? Okay, that's good.

Jeffrey C. Campbell



Moving on, we'll go to Robert Jones with Goldman Sachs.

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

I just wanted to go back to the sales force question and then on the synergies. Obviously, this is largely sales force-driven market. So I was hoping if you could share some thoughts on maybe the different approach from the 2 companies as it relates to that. And then maybe how you're thinking about the overall sales footprint once McKesson Medical and PSS are combined.

John H. Hammergren

Well, we have a great admiration for the sales force that has been built over time at PSS World Medical. And we believe strongly that sales force is one of the points of significant value in this transaction, as is the Medical-Surgical sales force at McKesson. And so we hope that we will be able to retain all of the sales reps on both sides. Our synergy case has no reduction in sales force modeled into it, and we don't plan to reduce the size of our sales footprint at all. Now we'll have to do some reconciliation in the marketplace relative to territories so that -- we have some overlaps in certain markets and what we're going to do there. But all in all, I would hope that the sales forces in both companies look at this as a significant opportunity because we expand what's in their bag. And the culture and economic models for the reps are very similar, I don't think that there'll be a compensation surprise for the sales force. And as I said, we're focused on retaining them. The other part of that is the service model behind it. The distribution networks and the ability to deliver -- the ability to make sure that the product is available. All of those infrastructure capabilities may change slightly. But our goal is to make sure that we don't disrupt the expectation from a service perspective that our customers have become dependent on. So I think that this should be seen as real positive by the sales forces.

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

That's helpful. And then, Jeff, if I could just ask one on the quarter. The operating margin was particularly strong in the Distribution business. And by your account, this wasn't an outsized quarter for exclusive launches per se. And I know you mentioned the timing around the antitrust and the manufacturer compensation, I was wondering if maybe you could just talk about the drivers of that margin in the quarter. And then what things should we be thinking about tempering in the back half relative to the revised guidance that you gave us?

Jeffrey C. Campbell

Well, you are correct. The quarter was strong but it was particularly strong driven by just the timing of there being strong brand price increases, and that just pulls forward in most cases, what you would otherwise have expected to get over the course of the year from our brand manufacturers. The favorable antitrust settlement was a significant item that we certainly didn't expect to happen this early in the year. So those are really the 2 things, combined with the fact that, as you point out, it was really strong oral generics quarter as we all expected that drove the margin rate in the quarter so high. But since the first 2 of them really just have to do with timing, that's why you don't see that much change in our view for the year. And we've ticked up a little bit our expectation of the full year margin expansion in Distribution Solutions. But that's mainly driven by that change in our outlook on warehouse revenues because as our warehouse revenues come down a little bit, that does add a little bit to the margin.


Moving on, we'll take our next question from Robert Willoughby from Bank of America Merrill Lynch.

Robert M. Willoughby - BofA Merrill Lynch, Research Division

John, could you hazard a guess of market share for each of the franchises post-transaction? And then maybe secondarily, we've never seen PSS World's ROIC ever tick above 6%. Admittedly, it's been a comedy of strategic mishaps historically. But the $100 million synergy estimate just doesn't seem like, to me, that it gets -- gives you much leverage to ever improve that metric? So what's -- is there -- what can you say about the secret sauce here that really justifies the deal premium here?

John H. Hammergren

Well, Robert, I had a hunch you might have a view on the Medical-Surgical business given our history together. I don't think that if you actually look inside of our Medical-Surgical business, you'd see very healthy ROIC characteristics. And in particular, that business has gained significant momentum once we sold our acute care business. And so I think that we believe strongly that we can get a good return on the investment in PSS World Medical and that we also can continue to improve not only the ROIC of the acquired asset but the combined assets' ROIC will improve over time. And as you know, when we model acquisitions, we model acquisitions with a long-term view of our cost of capital and a very laser-like focus on our ability to continue to improve ROIC in the company. As it relates to the shares of these businesses, although we will be a very large player in all of our, alternate-site markets, they still are highly fragmented. And I would tell you that it remains extremely competitive in the marketplace. So I think that the combination of the 2 companies clearly is an opportunity for us to create value. But I don't think anybody should assume that this isn't going to remain a competitive industry in both extended care, primary care, home care, all the other alternate-site markets that we compete in.

Robert M. Willoughby - BofA Merrill Lynch, Research Division

And do you have a capital savings number, John, to go with that $100 million cost savings number?

John H. Hammergren

Well clearly, we would expect capital to be taken out of the business as we rationalize inventory investments and focus on credit and collections, the kinds of things that we do very well. And I'm sure we will be taking investment out. Now having said that, there will probably be some facility and other capital requirements as we go through this. But certainly, the day-to-day working capital should come down in the business.


Moving on, we'll take our next question from Ross Muken from ISI Group.

Ross Muken - ISI Group Inc., Research Division

Can you talk a bit about, in the IT business, sort of the Paragon transition what you've seen so far, what the feedback's been, how you feel about sort of the momentum you have in that side of the software hospital market?

John H. Hammergren

Sure, Ross. The Paragon transition is a part of our, MPT business, which is a part of MTS. And Paragon is our electronic medical record and health care information systems product lines, both the financial and the clinical, for, primarily, the hospital or IDN marketplace. The transition you're referring to is our work with our customers to migrate them from our Horizon platform for clinicals to the Paragon platform for clinicals because we believe it drives a significant amount of efficiency, and it's a lot less costly to own and to operate. That transition has gone well for us in the marketplace. We have had some customer attrition, primarily driven by customers' requirements that Paragon doesn't currently have. But I think that customers that have transitioned to Paragon have great confidence that we will continue to build out our capability, particularly in the nonhospital part of the applications that need to be built in ambulatory. So I would say that we're on, or ahead, of our business case in that transition across the board. There have been some customer losses in that segment or that product line, but I would tell you that, that attrition is in line with our expectations.


Moving on, we'll take our next question from Ricky Goldwasser from Morgan Stanley.

Ricky Goldwasser - Morgan Stanley, Research Division

Yes. Can you give us some color on the CVS RFP process? And secondly, with the implied second half guidance a little bit lower than we expected, is it just solely a function of the pull forward of the $19 million benefit in the price increases? And was the timing of the Rite Aid renewal factored into that updated guidance as well?

John H. Hammergren

As we discussed in our earlier remarks, we typically don't talk about our customers or our competitors' customers, for that matter, relative to their status, relative to contracting. So I guess I would say that on a global basis, we remain committed to the renewal of our customer base and to competing them the full value that we deliver for our customers over time. We have a long track record of renewing our relationships. About 1/3 of our business every year comes up for renewal, and our track record of success in that has been, I think, very good. And so we would hope that we would continue to earn the privileges serving our customers, and that's, I guess, my view. And Jeff, maybe you could talk a little bit regarding quarters?

Jeffrey C. Campbell

Sure. I think, Ricky, relative to where we started the year, there's probably 4 things that have pulled forward, just from a timing perspective, into the first half of the year versus the second half of the year. So you've got the manufacturer economics driven by the way our agreements work in some of the strong brand price increases that many people have commented on in the marketplace. We did have the favorable antitrust settlement, which was sizable, a $19 million settlement. We have seen the tax discrete items that we anticipated for the year would be much more front end or first half-loaded than we expected. And last, although much smaller, as I also mentioned, we do, just the timing of how we're managing our balance sheet, we expect to do a little bit of debt refinancing in the back half, that's going to tip our interest expense up a little bit. And as I said in my remarks, that's independent of how we ultimately choose to finance the PSS transaction. So those items really are what caused us to feel we are solidly on track with our plan for the year. It has ended up a little bit more front end-loaded than we had expected, but we feel good about our numbers for the full year.


Moving on, we'll take our next question from George Hill with Citi.

George Hill - Citigroup Inc, Research Division

John, following up on Lisa's question a little bit, just big picture. You guys have just made a $3 billion commitment to the ambulatory setting or the physician practice market. Just can you tell us how does McKesson think about the longer term viability of the physician practice market and the direction of the independent physician practices, given the acquisition of PSS and Med3000?

John H. Hammergren

Well, we believe that the physician market is going to remain very robust. And in fact, if you actually think about what's going on in the marketplace, particularly the consolidation of physicians into the acute care setting, it's really an indication of the importance those physician practices, the important role those physician practices play in the total delivery of health care. If you don't have a line of physicians in the care network, you're never going to get at the issue of cost and quality and health care the way that we need to as a nation. And so we believe strongly that the physicians are going to remain in more and more demand. There aren't enough of them to satisfy the patient demands that are out there today. And demographics are only going to increase the import of physicians. I want to be clear in my view on this relative to the -- where physicians might reside, whether they're large physician groups in clinic settings, or they're parts of surgery centers, or they're acquired by hospitals in their -- in the satellite of those hospitals. And we don't believe that our business model is impacted negatively at all. And in fact, if anything, as our customers become more sophisticated, our sophisticated solutions meet their needs. We probably agree with a general view that physician practices that are 1 or 2 folks in a box down the street are probably under some pressure to aggregate either into a health care system or into a practice group of some kind. But we've been growing nicely in those settings. And you've seen these consolidation and physician practices underway perhaps for the last several years, yet you've seen McKesson's ability to grow through that because we'd come at the solution set with a more robust set of tools for our sales forces and our management teams to use to meet the needs of our customers. So these ambulatory customers that are being acquired, I think, will be as, or more, dependent on the services McKesson can provide as compared to the past. And on the Med3000 acquisition, or our REMS business, frankly, most of the physicians in those businesses are physicians that are already practicing in hospitals. They're emergency room doctors, they're anesthesiologists, they're radiology doctors. And so I think that this movement into a more connected health care system from a delivery perspective, and once again, if anything, a positive on what we do there because our customers are aggregating together in larger settings. And the complexity of what they're doing with -- from a billing and payment perspective, is only increasing. So I think that our skill sets fit perfectly with where we think health care is going, and we're excited to bring these assets together.

Jeffrey C. Campbell

And John, I might just add 1 financial comment, which is if you combine the $2.1 billion we're spending on PSS and Med3000, you don't get anywhere near a number that would round to $3 billion. So I know we haven't broken out, in fairness, George, the purchase price on Med3000, but I would tell you we wouldn't get anywhere near that range.

John H. Hammergren

Yes. When you said immaterial, with -- materiality would certainly start below $1 billion for that increment.


Moving on, we'll take our next question from John Ransom with Raymond James.

John W. Ransom - Raymond James & Associates, Inc., Research Division

Jeff, let's just assume for simplicity, this deal closes at the beginning year, fiscal '14's. What, say -- we can probably back into these numbers, but I'd like to get your take on what sort of EBITDA contribution you would think about for PSSI in fiscal '14 as well as what the first year synergies might look like?

Jeffrey C. Campbell

Well, I think, John, I don't probably want to go beyond the comments I made in my script, which is if it were to close March 31, we'd expect the transaction, if you were to assume it was fully debt-financed at 4%, to be $0.15 to $0.25 accretive on an adjusted basis. And our very rough estimate right now in terms of intangible amortization, it'd probably be about $100 million a year. So you could -- the synergies in this case do happen over a more extended period of time than we see in many of these kinds of transactions because as John, I think, has really articulated, there's a lot of good things at both companies that we are going to very thoughtfully think about as we go through how to take the best of both companies and create something of real value for our customers. So the synergies will be relatively modest in year 1 and then grow significantly as the years go by. So I think I'd probably prefer to leave my comments at that, and you can probably take a good cut at the EBITDA based on those.


Moving on, we'll take our next question from David Larsen from Leerink Swann.

David Larsen - Leerink Swann LLC, Research Division

It looks like the operating expenses within the Distribution division came in better than I was looking for, maybe an improvement sequentially, can you talk about what drove that? Was that, possibly, tape synergies? And then also, was there any benefit on a relaunch of generic oxaliplatin in the quarter? And then just lastly, the U.S. Pharma bulk revenue came in later than I was looking for, maybe a sequential decline there, was that driven mainly by generics? Maybe 5 fewer days? Or was there something else going on there?

Jeffrey C. Campbell

I'll tick those off one at a time. On expense, there's really no single driver of the good expense management in Distribution Solutions other than all of our businesses and what is always a competitive environment really, doing a great job of managing across the board. On oxaliplatin, I would say, yes, it relaunched. And yes, that was in our results. It is not particularly material to us. And certainly, the economics around it are nothing like what the industry saw on its previous launch. So it's certainly a nice thing, but it is not -- nothing like last time. On bulk, you are correct that relative to our original expectations, our warehouse revenues were a little softer. There's really a couple of things going on. They vary a lot from quarter-to-quarter because it's driven by the purchasing patterns of a handful, less than a handful really, of big customers. All of those big customers have much broader relationships with us with lots of direct buying as well. So sometimes they choose to buy more direct and less warehouse, and that's actually a good thing for us. But it drops the warehouse revenue line. And then, the third thing going on there is we have seen, on some of the new generic launches, a little bit larger dropoff in our warehouse revenues due to those launches than we had anticipated. So that's not something that has a material impact on the bottom line, but does impact that revenue line.


We'll take our final question from Charles Rhyee from Cowen and Company.

Charles Rhyee - Cowen and Company, LLC, Research Division

Can I just -- maybe a more market question for you, John. And it really, so I guess, the med-surg. And obviously, we're hearing some comments about sort of weak utilization volumes in the market from companies across many subsectors, health care. Can you give us some comments on what you're seeing, I guess, first in the physician market? And then secondly, maybe more broadly, what you're seeing across all your businesses?

John H. Hammergren

Well, we have -- I think we have a pretty good dial tone on what's going on in health care because of the breadth of our service offering. And as we talked about earlier, with the Med3000 acquisition and our REMS business, where we actually do patient office billing. We have a pretty good insight into the actual frequency of visits and the types of visits that might be going on. I don't think we've seen a significant change in the cadence of health care this year compared to last, and I think that we haven't seen a big change in the last quarter compared to the quarter before that. So I think our businesses actually have been performing quite well, and we have not seen a real step-down now. And clearly, there might be soft spots in certain parts of the market, but overall, we're pleased with our performance and pleased with what we see.

Charles Rhyee - Cowen and Company, LLC, Research Division

So -- and just a follow-up there. When you talk about the flat year-over-year, where -- on the res, we're saying it's solely the 5 less business days and -- and within that 8% underlying growth, you wouldn't point to any kind of softness, that it could have been stronger had utilization been better or you're saying that's just been pretty steady?

John H. Hammergren

Yes. I think the 8% is reflective of a slightly better-than-market growth, but we still think that markets are growing in the 4% to 6% kind of range. And that we're competing in a way that is allowing us to grow slightly faster. But I think overall, we still feel good about it. The flatness in the revenue and distribution is driven primarily by generics. And so that when you think about the corporation overall and our ability to grow revenue, it has been impacted by generics, which is a positive thing on the gross margin in the operating income line, but is dampening our revenues. So we'll see that dampening continue through the year and then as we start to go into next year, our revenue line should begin to grow again as generics begin to taper off, at least from this year.

I want to thank you all for your time and your questions today, I thought they were terrific. I'm certainly pleased with our accomplishments during the first half of the year and excited about the opportunities that lie ahead. I'll now hand the call over to Erin for some discussions about upcoming events.

Erin Lampert

Thank you, John. I have a preview of upcoming events for the financial community. On November 15, we will present at the Credit Suisse Health Care Conference in Phoenix. And on January 7, we will present at the JPMorgan Health Care Conference in San Francisco. We will release our third quarter earnings results in late January, and we look forward to seeing you at one of these upcoming events. Thank you, and goodbye.


Thank you, that will conclude today's conference. We thank you for your participation.

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