Cardinal Health, Inc.
Q3 2015 Earnings Call Transcript

Published: 30 Apr 2015

[Operator:]

Good day, and welcome to the Cardinal Health Third Quarter Fiscal Year 2015 Earnings Conference Call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Ms. Sally Curley. Please go ahead.

[Sally Curley:]

Thank you, Jennifer, and welcome to our Third Quarter Fiscal 2015 Earnings Call today. We will be making forward-looking statements. The matters addressed in the statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected or implied. Please refer to the SEC filings and the forward-looking statements slide at the beginning of the presentation, found on the Investor page of our website, for a description of risks and uncertainties. In addition, we will reference non-GAAP financial measures. Information about these measures and reconciliations to GAAP are included at the end of the slides. I'd also like to remind you of a few upcoming investment conferences and events. We will be webcasting our presentations at the Bank of America Merrill Lynch 2015 Health Care Conference on May 13 at 8

[George S. Barrett:]

Thanks, Sally. Good morning, everyone, and thanks to all of you for joining us on our third quarter call. I'm pleased to report another strong period of results, with third quarter revenues of $25.4 billion, an increase of 18%. Third quarter non-GAAP diluted EPS was $1.19, up 18% from last year. Based on the strength of our performance year-to-date, we are increasingly confident that we will finish our fiscal 2015 in the upper half of our full year non-GAAP EPS guidance range of $4.28 to $4.38. This is an extraordinary time in health care, and our organization is doing an outstanding job of serving today's needs, while at the same time, leveraging on our experience to address the demands of a system in transition. Our people have done this through a disciplined focus on execution by using our capabilities and insights to anticipate change and commit to providing solutions for emerging health care challenges. With this as backdrop, since we last reported earnings, we've made some important moves in areas of strategic focus. On March 2, we announced our plan to acquire the Cordis cardiology business from Johnson & Johnson. And earlier this month, we completed the acquisition of the specialty distribution business of Metro Medical, expanding our presence and reach in specialty business. I'll come back to each of these important initiatives in my segment remarks. First, our Pharmaceutical segment. Our Pharmaceutical segment had a very strong third quarter with revenues of $22.6 billion, an increase of 20% compared to the prior year third quarter. And our Pharmaceutical segment profit was up 25%. The Pharmaceutical segment continues to operate with great efficiency, attention to detail and strong strategic position. Red Oak Sourcing, our joint venture with CVS Health, continues to operate extremely well. We can now report that suppliers representing nearly 100% of the total generic spend have transitioned into the venture. At time of great change, it is not just the scale which brings value to our customers, but also the combined knowledge of our 2 experienced organizations. Our Specialty Solutions business continues to achieve extremely high growth rates. And earlier this month, we closed the acquisition of the specialty distribution business of Metro Medical, the largest privately owned specialty distributor in the U.S. This move strengthened our presence in the therapeutic areas of rheumatology, nephrology and oncology, expands our scale and positions us to provide more cost-effective services for our customers. For clarity, we expect to exceed the $5 billion specialty revenue figure for fiscal 2015, which we highlighted in our last earnings call, even without the contribution of the Metro Medical specialty business. As you know, over the last few months, we've seen some important developments in the world of biosimilars, and we've said to you before, it's very difficult to make categorical predictions on the evolution of this new subset of products. We continue to believe that each product will have its own characteristics, driven by many factors, including

[Michael C. Kaufmann:]

Thanks, George, and thanks to everyone joining us on the call today to hear about our strong third quarter results. My comments will walk through our third quarter consolidated financial performance as well as expectations for the quarter ahead as we close out our 2015 fiscal year. You can refer to the slide presentation posted on our website as a guide to this discussion. Third quarter non-GAAP earnings per share grew 18% to $1.19. Total company revenues were $25.4 billion, which was also an increase of more than 18%. Total company gross margin dollars were up more than 12% versus the same quarter in the prior year. Consolidated SG&A increased 9% versus the prior year, with the largest driver being acquisitions. Next, non-GAAP operating earnings in the quarter were $656.7 million, which is a 17% growth versus the prior year. Moving below the operating line, net interest and other expense came in at $32.7 million in the quarter. As a reminder, Q3 of the prior fiscal year included a $0.06 per share after-tax gain related to the sale of our minority equity interest in 2 investments. Our non-GAAP effective tax rate in the quarter was 36.5%, and our diluted weighted average shares outstanding were about 334 million. Moving to operating cash flows. We generated $658 million in the quarter. At March close, our cash balance was $3.2 billion, with $447 million of this held offshore. We remain committed to our previously stated balanced capital deployment policy of focusing on reinvesting in our business and maintaining our differentiated dividend, while pursuing strategic M&A and stock buybacks on an opportunistic basis. Next, I'll review each segment's performance. Let's start with the Pharmaceutical segment. Revenues were up 20% year-over-year to $22.6 billion due to the growth of existing and new customers across all business lines in the segment. Segment profit was $567 million, an increase of 25% versus the prior year. This was due to the strong performance of our generics program, including the net benefit of Red Oak Sourcing as well as growth from our existing customers and contribution from new customers. Segment profit margin rate increased by 10 basis points, driven by the performance of our generics program, which offset the impact of customer price changes and the dilutive impact of sales of branded hepatitis C therapies. Clearly, the performance of our generics program has been excellent. Enhanced sourcing under Red Oak customer wins and growth of existing accounts have all been key drivers. Manufacturer price inflation or deflation, new item launches, penetration of existing accounts and advanced pricing analytics are also factors in determining our program's success. I remain confident we can balance all of these for continued growth in our generics program. Besides the contribution from generics, our branded drug business continues to go well with strong performance under our fee-for-service agreements. As has been typical over the past several years, inflation tends to be a larger component in the third quarter versus other quarters. The rate of inflation was essentially the same as the prior year, in the low double digits. As George mentioned, in our Specialty business, we closed the acquisition of Metro Medical earlier this month. Let me give you a few details. Metro Medical has various business lines. We acquired their specialty distribution, specialty GPO, specialty pharmacy and private label medical surgical disposable products business. The Metro Medical Online and Metro Medical Partners pieces of the business were not included in the acquisition. This acquisition will provide us the opportunity to expand our Specialty distribution scale and deepen our reach into the rheumatology, nephrology and oncology markets. We have been working on this deal for several months and had already contemplated the bottom line impact in our FY '15 EPS guidance range. Now let's move to our Medical segment performance. Third quarter revenue grew 4% to $2.8 billion, primarily due to the contribution from acquisitions. The segment profit declined by $9.1 million to $101.5 million. This was a result of the decline in the contribution of national brand med-surg distribution and the continued impact of the previously communicated challenges in the business in Canada. These same drivers contributed to a margin rate decline of 50 basis points versus the prior year period. Let me give you a few other highlights to consider. First, revenues from our strategic accounts continues to significantly outpace our remaining book of business. In addition, top line growth from our higher-margin wraparound services is outpacing overall Medical segment revenues. Our Cardinal Health at Home business has grown at or above market each quarter of this fiscal year. And finally, we are continuing to build out the physician preference items strategy. In this space, our acquisitions of AccessClosure and Innovative Therapies are off to a good start and are performing better than the business case. Our recent announcement of our intend to acquire Cordis, which we still expect to close before the end of the calendar year, will only accelerate our work in this space. Let me reiterate some key points surrounding this deal. First, we will be acquiring Cordis for $1.944 billion in cash or approximately $1.6 billion, net of roughly $350 million in cash tax benefits. Next, we plan to finance the acquisition with debt and cash on hand. Our intent is to issue debt sometime in the next few months and take out the $1 billion bridge financing that we secured as a contingency. From a non-GAAP EPS perspective, we expect slight dilution in FY '16 as a result of the 3 factors that we mentioned at the time of the announcement

[Operator:]

[Operator Instructions] We'll go first to Bob Jones with Goldman Sachs.

[Robert P. Jones:]

Yes. As we think about the performance in Medical, George, it seems like volumes have been improving on the inpatient side. You've added some accretive margin deals. It sounds like private label is still growing, yet the business has struggled. And I know you mentioned Canada being an issue for the balance of the year. So I'm just curious if you can maybe give us some insight on when you think this business could really start to turn around.

[George S. Barrett:]

Bob, thanks for the question. Yes, look, Canada has definitely been a tough challenge all year, and as you said, we tried to be pretty clear about the work that we need to do and are doing in the Med segment. I think we just have to get through some sort of short-term choppiness. I mentioned during the call that sort of the traditional -- the legacy lines of sort of traditional branded med-surg has been a large of the challenge, and it's really been largely re-pricing of some accounts. I think we'll start to see the benefit of all the initiatives that we've described begin to more sustainably feel like uplift as we get into the second half of '16. But I actually like our position. I think we're doing really good work. If you look underneath the numbers, over the last 3 years, for example, we've had very good growth of our private label products, a good contribution of margin from them. So it's really about this shift in the model where the legacy line is becoming a smaller component of the overall mix and those newer products and services are beginning to grow. So we've done some really important work there. We've made some big moves this year to sort of strengthen that, and feel good about that.

[Robert P. Jones:]

If I could just sneak one in on Specialty, I know in the quarter you acquired Metro Medical, just curious maybe if you'd give a little bit more on how that business specifically enhances your Specialty footprint. And then I know broadly, George, you've gotten this question in the past, but increasingly seems like Specialty is obviously in a very important channel for the wholesalers. And I'm just curious, how do you feel about your footprint even in light of the Metro Medical deal? And are there bigger deals out there that could really give you greater exposure to this important channel?

[George S. Barrett:]

Yes. Bob, let me answer that, and I just wanted to follow-up a little bit on the first part of the question again. But Metro Medical really just helps us expand our reach. We've been growing at a pretty hefty clip over these last couple of years. And I think our scale is now at a point where we really are a meaningful factor in the market. I think that's important, given some of the trends in health care, and Metro Medical just expands that reach in that footprint. So we're excited about it. Whether or not there are other opportunities out there, we continue to look at every opportunity that's in our areas of strategic focus. Obviously, Specialty is one. Whether or not you find the assets at the right moment at the right price is always a question for us. But this is clearly an area of priority, and so we'll continue to look for opportunities. But we're excited about the Metro Medical. Again, just sort of backing up. I wanted to make sure I highlight this on the Medical, just as a reminder. Our customers are really becoming much more complex. They're no longer a single line of activity. And so I do think that's part of what we've felt strongly about is that these complex systems need products and services across all of the lines of business. So that's really important at a time where you're seeing the change in incentives, which has been completely activity-based over the year, just a different kind of incentive system. I think the tools we really bring are going to become increasingly important. So just I didn't want to miss the opportunity to say that related to the first part of the question.

[Operator:]

We'll go next to Ricky Goldwasser with Morgan Stanley.

[Ricky R. Goldwasser:]

A question on M&A. Post Cordis, what is your appetite for M&A? Obviously, you did Metro Medical, which is on the smaller size. But what leverage are you comfortable going up to? And when you think about the areas you're interested, obviously Specialty is one, but maybe if can kind of rank order them for us?

[George S. Barrett:]

Yes. So first -- again, appetite is a -- we want to grow this business. We want sustainable competitive positioning, and we believe that there are key areas strategically that are aligned with where care is going. And we've been pretty clear about that. It's around generics. It's around specialty. It's around every opportunity to improve performance management for large integrated customers. It's the home, opportunities in China, which is a unique market. So we'll continue to look for those opportunities. Obviously, we have a strong balance sheet. But again, we're going to be very disciplined about the moves we make, when we make them, how we make them, to make sure that we can execute, and that's always been a priority for us. But we feel well positioned, strong balance sheet. I don't know if Mike you want to add anything to that.

[Michael C. Kaufmann:]

Yes. Ricky, I think -- again, it's going to depend and whether it's a strategic fit, whether the culture fits for us, the growth trajectory, all of those types of things of the acquisitions. But from a balance sheet standpoint, we have said that we would like to keep our debt ratio to 1.5 to 1.75 is the range that we're comfortable in. Could we at times make a decision to go slightly above that for the right type of acquisition and stretch ourselves some? Sure, we would be open to doing that. We're always going to want to be concerned about where our -- where the debt rating agencies see us, and that's an important thing for us to consider and how they view it. And so sometimes, the type of acquisition matters when we deal with those folks. And so -- and remember, it's the last thing, too, we like to keep about $1 billion to $1.5 billion of cash on hand just for our everyday working capital and needs because of the fluctuations in the business. So those are some of the things that we try to keep in mind.

[Ricky R. Goldwasser:]

Okay. And then just one quick follow-up. Obviously, in the prepared remarks, you talked about the strong branded inflation. I think it was in the low double digits. And we're hearing strong inflation on generics. Where do you think we are in the pricing cycle and kind of like the sustainability of the trend, kind of like across your portfolio? Because we're seeing it both on brand, generic and specialty.

[George S. Barrett:]

Ricky, I'll start with it, but then I'll welcome Mike to join in. Predicting this going forward is always difficult. The branded side, as you've seen, has been, on average, which is interesting, relatively consistent for a while. But actually, inside that average, there's a lot of different rates. And so it's one of the things that makes it in a way hard to predict, but in some ways little easier because you have this smoothing affect. On generics, it is such a tough call because, as you know, it is an enormous product line that we call generics. And so the number of products that can move the needle can be relatively small, and you can talk about 50, 75, 100 products that move the needle. So it's really difficult for us to give a forward-looking guidance on what we see. We've done this in the past, and I probably do it today -- we talked about the environment and what are the conditions of the environment. And I'm not sure that those conditions have changed materially from last period, but we have seen some variance -- variation. Mike can touch on that.

[Michael C. Kaufmann:]

Yes, I would agree with George. On the branded space, it's been pretty consistent over the last several years that branded inflation rate has stayed in that double digits -- low double-digits area, and we've not seen a lot of fluctuation there. I just wanted to really call it out, this quarter remind folks of the seasonality component and why the third quarter tends to be bigger than some of the other quarters. And again, we all know the majority of the fees are earned on the fee-for-service agreement, so inflation is a much -- on brand, is a much lower component of our margins than it used to be in the buy-and-hold period. But again, in the third quarter, it's important, so that's really why we call it out. On generics, it is important, but one of the things that we keep trying to emphasize is that in our mind, it probably gets a little bit too much attention at times because there are a lot of other levers in our generics program that are going to help us perform over the years. And we really believe confidently that even in a -- if generic inflation were to decline, there's a lot of other levers for us around our penetration, around our pricing and analytics capabilities, around new business that we won, et cetera, that we can still compete effectively and perform well.

[Operator:]

We'll go next to Eric Percher.

[Eric R Percher:]

Okay. So med-surg, 2 questions. One would be your comment in the press release on national brand distribution. Is that meant to reflect your commentary on pricing erosion, or is there anything else meant by that? And then also relative to Canada, have we now reached a point where next quarter will anniversary some of those initial issues and customer departures or movement in-house? Does that help in the second half?

[George S. Barrett:]

Yes. So really, Eric, what we're talking about primarily is really pricing on the traditional med-surg. It's probably not much more complicated than that. And a lot of that is actually repricing some meaningful accounts for us, which we were happy to have in the long run, important customers, strategic customers. I'm sorry, the second part of your question?

[Eric R Percher:]

Within Canada, it feels like it's been about a year since we first saw some of those issues. I know there were a couple of customers that moved in-house. Will we now anniversary that?

[George S. Barrett:]

Yes, so here's what I would say, and I mentioned this earlier. I would say probably a couple of choppy quarters. And then I think we're taking some pretty significant actions in Canada to address some changes in that market, and I think then we'll start to feel a more normalized rate.

[Michael C. Kaufmann:]

Eric, I would expect us to still see some pressures in Canada through the end of the calendar year. So it will still affect us for the first 2 quarters of FY '16. And then beginning in our Q3 of '16, we begin to see a more normal and leveling off in the Canadian business.

[Operator:]

We'll go next to David Larsen with Leerink.

[David Larsen:]

Can you guys talk a bit about biosimilars and what's sort of opportunity you're looking at? And maybe just touch on the different channels that biosimilars will flow through. If they ship to the member at home where they self-inject or if they ship to the doc office, are you better positioned in any one of those channels than the other?

[George S. Barrett:]

Yes. Again, I'm not sure I can add that much to what I said in my earlier comments, but again, I'll just sort of highlight this. And we've -- I think, many of you have asked this over the years, something we've been anticipating in terms of biosimilars -- that we've always felt that there would be some uniqueness to each product. And as you said, the route of administration, which channel it goes through, whether or not there's substitutability, these are all things that will influence what kind of services the patient needs. We actually feel well positioned, regardless of route, is what I would tell you. So as you know, we've got a extremely strong position in hospitals. We've expanded our position in all kinds of clinics. We're very strong in pharmacy. We have got specialty pharmacy. So clinics are an area. And now, obviously, we've got some enhanced strength in the small physician practices. So I think, from our standpoint, we've got great reach across therapeutic areas, which is very important. And from a channel perspective, I think we're in a pretty good position, regardless of that route.

[Michael C. Kaufmann:]

The only thing I would add to that, George, is that also from a services standpoint upstream to the manufacturer, we feel that we're in as good or better position than anybody in the industry to provide any type of services that they might need, whether it'd be specific cold chain or other type of transportation needs. Whether it'd be hub services, data and analytics, we know that we can provide all of the services too. So we really feel that we're in a great position, both upstream and downstream, on biosimilars.

[Operator:]

We'll go next to John Kreger with William Blair.

[John Kreger:]

George and Mike, if you're willing, thinking about some of the puts and takes for next fiscal year, how do you feel about the outlook realizing it's early compared to some of your longer-term growth goals?

[George S. Barrett:]

So again, John, it's a little early for us to be saying a lot about '16. We're finishing our budget process. Obviously, at year end we provide guidance. But in terms of our long-term goals, we still feel good about those. The organization right now has -- it feels like a lot of momentum, actually. And I think, if you go around Cardinal Health, I think you'd see a group that's very energized. We're very clear about our goals, very disciplined in managing to those. And we'll have a little bit of bumps in any part of the business, but the overall Cardinal enterprise feels good and on target to achieve the goals that we've set up.

[Michael C. Kaufmann:]

No, I would agree. We do need to get through the budgeting process this summer. That's really important. Probably the only thing that we've really mentioned about next year that I can give you a quick update on was around the commodities. And we did say that, for FY '16, that they would be about $10 million to $20 million of benefit from commodities. We have updated that work, and we can still continue to believe that that's the right number for next year. I know that's only one small component that goes into it, but it is the only thing that we've really giving you any insight on.

[George S. Barrett:]

I guess and the Cordis -- and the Cordis mechanics.

[Michael C. Kaufmann:]

And then the Cordis mechanics that I've walked through, yes.

[John Kreger:]

Very helpful. Just one quick follow-up on Red Oak. As you move into year 2, it sounds like you've pretty much finished your work with supplier recontracting. What happens next? Is there an opportunity for meaningful growth in year 2 as well?

[Michael C. Kaufmann:]

Yes, I'm really excited about where we are in Red Oak. We -- I serve on the board of Red Oak and recently had a board meeting and continue to be incredibly impressed with the team. We've, again, been able to retain all of the key folks from both companies and have decades of generic buying experience on there, which -- again, to get through essentially 100% of the spend in this short a period of time has been exciting. We do expect there to be uplift in FY '16. A big piece of that will just because we'll have a full year of all of the benefits while we were ramping this year. But even on top of that, we do expect to continue to generate value. And as I met with the team, they're constantly looking at different ways to work with the manufacturers to try to create more incremental value for both parties.

[Operator:]

We'll go next to Glen Santangelo with Credit Suisse.

[Glen J. Santangelo:]

And George, I just want to kind of come back and revisit this Medical segment issue a little bit further. You talked, obviously, a lot on the call about the pricing pressure within the segment. Is that repricing certain GPO customers that you got hit with? And is there anything else on the horizon that would impact the pricing as we go forward over the next 12 months? And I'm also kind of curious, could you talk about the overall pricing of the underlying inventory you're selling? Are you seeing price deflation on the products you're selling, or is that still somewhat inflationary? Is that impacting the profit margins at all either?

[George S. Barrett:]

I am going to come back to the second part. And I'm not completely sure I understand the question, but we'll make sure we do and then Mike will address that. But this is really not a GPO issue, Glen, and so this is just individual accounts that happen to fall during a period of time where we're signing some long-term agreements. No single one of them, by the way, is big enough to call out or necessarily move the needle. It's just a general dynamic. What again I wanted to highlight during the call is that, over many years, the traditional, what we call, branded med-surg business is going through this kind of dynamic, and so that's really not new. So I don't want to make it sound like there is one big contract that was the key, which is some repricing in that aspect of the business we felt. And I hope that answers that part of it. The second part of the question, Mike, did you get?

[Michael C. Kaufmann:]

Let me take a stab at it, and if I don't get it right, Glen, please just ask again. But I agree with George as far as the GPOs. We always work with them, but in tandem, we work individually with the hospitals. And if you take a look at the product portfolios, I don't think this is really necessarily a deflationary environment on all the items. You're going to see certain items that may go up and some they're going to go down, but I wouldn't say there's any one trend either way that is actually affecting this. This is just our ultimate net price to the customer themselves, not the items driving it.

[Glen J. Santangelo:]

Okay. Maybe if I can just ask one follow-up. I mean, could you maybe elaborate a little bit more on what the challenge is in the Canadian market? Because it kind of sounds like it's going to persist for another 2 to 3 quarters, and I think it'd be helpful if you'd kind of just remind us exactly what that issue is.

[Michael C. Kaufmann:]

Really 2 things. One is similar to what we just described, some repricing of customers. And as we mentioned last time, there were a couple of customers that we did lose in Canada that we won't actually anniversary until the end of the calendar year. One of those brought in-house, the services they were doing, and one switched to a competitor. So that's really what's driving it is a loss of a couple of larger customers as well as some pricing and retention of some other customers, and those are really 2 big factors.

[George S. Barrett:]

The other piece that I'd mention is, there's been some shifting of reimbursement dynamics around that market, and so again, that is a component of that pricing aspect.

[Michael C. Kaufmann:]

And remember, those customer losses are not new ones. Those are the ones I mentioned last quarter that are out there. It just was going to take to the end of the calendar year for us to anniversary them.

[Operator:]

We'll go next to Ross Muken with Evercore ISI.

[Ross Muken:]

So I wanted to just touch base regarding Cordis. So obviously, you haven't closed the deal yet, but you do have very close relationships with some of your physician and hospital partners. You've got some key thought leaders in the field that you interact with on a regular basis. What's the dialogue been post the announcement now that, that's seasoned a bit with those individuals? And what other sort of things has it sparked in your mind as you think about kind of the long-term strategic value of the endeavor?

[George S. Barrett:]

Yes. So this is -- it's been actually a really interesting period since the announcement. A couple of things happened, many of which we thought could happen, which is just a high amount of energy around this inside our organization. I think, the people that are going to be joining us from J&J are pretty excited about where this falls for us in terms of priority. We're getting great feedback from our advisory boards. As I think we've mentioned before, we've got really world-class advisory boards who are working with us. We've started to, as you might imagine hear from other players in the market, who recognize that we might be an interesting partner for them as we expand our commercial capabilities, both here and outside the U.S., in these medical products. So I think what we're seeing is a pretty high level of enthusiasm across the board. Obviously, we've got a lot of work to do to get to the finish line and the closing. But it's been really well received. And I think that one of the things that I would highlight is, people are now beginning to realize that it's not just about the product. And so that we are talking about a different service offering in terms of being able to bring the medical device and some wraparound services that help manage inventory, eliminate waste, prevent errors, these are all part of the strategy in helping in the physician preference area. So I think what's happening both internally and externally is that our excitement about joining those 2 components, the service component and the product component, are giving us a pretty good sense of optimism about the future on this.

[Operator:]

We'll go next to Lisa Gill with JPMorgan.

[Lisa C. Gill:]

I'm just wondering, can you give us maybe some color, George, around the size of Metro Medical? Obviously, you talked about it being in 2015 numbers, but maybe on a revenue basis, how big is this?

[George S. Barrett:]

Lisa, unfortunately, I can't provide that information right now. I think what we -- as we come out of our year and we start guiding into next year, I think some of that will become a little bit more apparent. But at this point, I can't provide more information. I'm sorry.

[Lisa C. Gill:]

Okay. And then secondly, as we think about Red Oak and we think about relationships with manufacturers, there is a lot of talk about continued consolidation of generic manufacturers. Can you talk at all about your expectation, you or Mike, around Red Oak and how that will impact you going forward?

[George S. Barrett:]

Yes. Well, let me just start and then Mike can speak more specifically to Red Oak. Lisa, as you know, consolidation is not really new to the industry, it's been happening for quite some time. It's something we're used to. It's a dynamic we understand. And it's one of the reasons that having scale is really important, and it's also a reason that's sort of the knowledge base [ph] of what each supplier's strategy is all about. But that actually matters, because ultimately what we're looking for in the best of situations is those win-win moments. So I think we understand the landscape well and we know the players well. And so consolidation -- so it can be a double-edged sword, but I think for us, we see the opportunity to work more closely with companies. We see that as an opportunity. Mike, I don't know if you want to sort of add to it more narrowly from the Red Oak perspective.

[Michael C. Kaufmann:]

Probably the only thing I would add is that, first, I guess I would emphasize I really like where our relationships are with the manufacturers. They value us. They understand the simplicity and the speed of our model, and particularly, the transparency. And the feedback we're getting from manufacturers around those components has been incredibly positive. And what that leads to is us being willing to try new things with them. And we are also very focused on not only the large manufacturers but also smaller and medium-size ones that have really mentioned that they appreciate that they've been able to be part of the program. And so, again, consolidation is part of the industry. But we like where we're at. And we think, in certain situations, if we needed to, we can work with folks to try to create the right competitive environment to get the type of pricing we need.

[Operator:]

We'll go next to Steven Valiquette with UBS.

[Steven Valiquette:]

So I guess just within the Medical segment, I'm curious in relation to the Cordis acquisition. Is your plate going to be pretty full over the next year just on the integration of this fairly large asset? Or if, let's say, other medical manufacturing assets are potentially available for acquisition, would you have the bandwidth to do additional medical manufacturing M&A deals in this segment over the next years?

[George S. Barrett:]

Yes. Thanks, Steve. Yes. So obviously, I'm going to answer this with some care. Let me just start with the basics. As I mentioned earlier, our balance sheet is strong. Our organizational capacity is very significant. But we always put a high priority on execution. And so we think about, when we look at acquisitions, not just the financial capacity to execute and integrate, but the organizational capacity to do that. So we're very mindful of that. I would also note that we have a very broad-based employee population. So for example, we can have a group of folks that are very deeply dedicated to the integration of one asset and literally another group whose lives are untouched by that. And so what we are mindful of as we look across opportunities externally is making sure that we're not doubling down on those people who are trying to do a one-to-one execution, execution of one deal. But always mindful of that, but I think we have a pretty talented diverse organization with a lot of capacity. But we'll always think about execution.

[Operator:]

We'll go next to John Ransom with Raymond James.

[John W. Ransom:]

I just had a question about the independent pharmacy channel. Are you seeing any more signs of stress in that channel just given some of the fundamentals around generic inflation and reimbursement squeeze? And if so, are you approaching that marketplace differently than, say, you were 3 or 4 years ago?

[George S. Barrett:]

John, let me start first, and then I'm going to turn it to Mike. Again, we'll probably have 2 angles on this. We've been doing really well providing value to these independent pharmacy customers. And so I think the key is recognizing that there are certain market dynamics and market pressures that they deal with, and what we do is focus on how do we relieve those pressures, how do we create value in that environment? So I think what's happened is we've become increasingly targeted on how we create value for those kinds of customers in this kind of environment. And our organization has done a really good job in terms of expanding our position there and growing some share, and I feel good about our position with how we're creating value. But certainly, there are pressures out there that they have to deal with. I think we're doing a lot to help them.

[Michael C. Kaufmann:]

I mean, I can think of a couple of specific examples. First of all, obviously, Red Oak and our ability to be competitive from a generic programs and recognizing the need and how we price generics at different lifecycles of reimbursement, that's always important to do that. Our PSAO has been growing steadily, and we've added a lot of members. And we've been able to do some unique things with them and get out and market our PSAO and work with our customers to help them on their star ratings to make sure that they are the type of customers that the PBMs want to do business with, and we are incredibly excited about those. And then in other areas in the out front part of the store, we've been expanding our programs and opportunities there to work with the folks. And we really like where we're headed with some of our Cardinal private label lines and our opportunities to help them manage inventory, both on the out front and behind the counter. So we have a lot that we're doing. I wouldn't say that we're seeing any decline that we've seen in this. We continue to grow our share in that space. And that's how I feel. One thing, though, if you didn't know what I meant, and for those on the phone, about the PSAO, that's our third-party contracting arm where we work with third-party payers to -- on behalf of our retail independents to get them reimbursements.

[John W. Ransom:]

And my other question, just checking in on your other channel. You sell under a lot of IDNs. What are they asking for from you that they were not asking for 2 years ago? And is there any effect yet that you're seeing from the ACA in terms of what capabilities you need?

[George S. Barrett:]

Yes. It's a really interesting question because I think what they're seeing is a -- I think, many of the big acute care and integrated systems are recognizing that in a world where there's probably some shifting in incentives, where you're looking at bundles of care in payments, where there are penalties for readmission, they're just beginning to look at each line more holistically. I think that one of the changes that we have seen, certainly you still have to be very, very competitive in each line, is that the institution at the enterprise level of the IDN is thinking holistically about how do we compete, how do we thrive in this new environment? And I think that's why our work across the enterprise is particularly resonating right now, because we're really not just able to -- we're not just talking about lines of business. We are talking about being able to address a huge percentage of their activity, and I think we're sort of the only one that can do this in quite that way.

[Operator:]

We'll go next to Garen Sarafian with Citigroup.

[Garen Sarafian:]

I just had a couple of questions on the quarter. So first, on the Pharma segment. Could you elaborate a little bit more on the revenue growth of 20%? You called out growth from both new and existing customers, so maybe if you could break those 2 out or give us an idea. And any other relevant metrics, such as volume growth or other inflation, hep C so on and so forth?

[Michael C. Kaufmann:]

Yes. So I can give you a little color. First of all, the hep C component of our growth is still less than 25% of the overall growth. I mean, it's an important driver, but it is less than 25%. New customers would be the largest component of our growth. And then growth on our existing customers would be next. Keep in mind, with branded drug inflation being in the low double digits, that's going to be a huge driver of overall top line revenue growth, particularly in a market where you haven't seen very large generic launches that would be taking away some top line volumes. So I think those would be the key drivers to help you understand that.

[Garen Sarafian:]

Got it. Useful. And then as a follow-up, on the branded side of the business. Has the non-fee-for-service, so the buy-and-hold portion of the business, remain the same as a percent of the entire business? And within it, have the mechanics changed at all in the past few quarters, maybe a couple of years, to alter the profitability profile in any meaningful way?

[Michael C. Kaufmann:]

No, that's been really, really steady. Over an annual period, it's still averaging about 80% is noncontingent of our branded buy-side piece. And then -- but as I mentioned in the third quarter, it's a little bit more slanted towards inflation. But again, over a whole year period, it's still running 80%. The agreements continue to be about the same. Often, they renew very similar terms and conditions. We continue to tweak them, but this is an area that we continue to feel good about.

[Operator:]

We'll go next to Robert Willoughby with Bank of America Merrill Lynch.

[Robert M. Willoughby:]

Hey, George or Mike, maybe this is more a J&J question, but can you give us any color on the Cordis kind of results, or, hopefully, post J&J controlled announcement, the wheels don't come off there? And maybe remind us of your budget plans there and what infrastructure you would want to put in place internationally to really maximize that opportunity?

[George S. Barrett:]

Unfortunately, the first part of your question really is a J&J question, and I can't answer for them. Regarding the second, we have been really hard at work on really working across the globe on what that organization is going to look like. And I think, it all feels like it's going very well in the U.S. As you know, we have some cardiology assets here, and so that we've been looking at how we're going to coordinate and integrate those activities, have a very clear game plan. x U.S., I think we've got organizational design under control. I think we've got the leadership in all key markets. Looking about key positions, we want to make sure that we retain some of the great tradition of that existing Cordis, but we want to bring some of that Cardinal approach to it. And so I think what we're -- one of the things that I mentioned earlier, Bob, that I think is interesting is, as we go outside the U.S. and we talk to the organization -- again, recognizing that certain conversations we can't have at this stage as 2 separate companies, they're particularly interested in our service model in how we can help bring additional efficiency because of the medical device side of it. So I think people are beginning to realize that we can bring more than product skill. Again, short-term critical issue for us, I talked about execution earlier, we're sort of the Hippocratic Oath, "do no harm." So where the businesses are performing very well -- and there are many, many markets where there are 1 or 2 in the market, we're going to make sure that we "do no harm" there and keep the business executing. So I hope that helps an answer.

[Robert M. Willoughby:]

Maybe just a point to drill down. You're looking at the services side of things, obviously. But is there ever an R&D line item that you'll be breaking out with this and other assets that you have in place now requiring a bit more investment on that front?

[George S. Barrett:]

That's a good question. In terms of how we break it out, I can't answer it fully yet. What I can tell you in strategy, in strategy, this is not going to be a big research-based business unit inside of us. They'll be development because -- and we do that today, by the way. As a medical device company today, we're doing D of D [ph] as in development all the time. But you should not expect us to be a research-based med device company in a big way. That's not really the game plan here.

[Operator:]

We'll go next to Dave Francis with RBC Capital Markets.

[David K. Francis:]

I wanted to go after the specialty piece a little different angle. Kind of looking at the fact that you guys are at a $5 billion revenue level or will be as you exit the year there, is the business now, either from a critical mass of revenue perspective or a service portfolio perspective, now at that place where you think you're big enough to grow the business organically through internal development efforts above the market rate? Or do you still need to deploy capital externally to get to the point where you are able to capture additional market share?

[George S. Barrett:]

Yes. Actually, the answer is, we are growing it organically, quite rapidly. So that's the good news. I think we have the scale. We've got great talents. It's a really innovative group. We have got a pretty good group behind that driving new models for how to create value for our specialty customers and our suppliers. So I think we're actually getting very strong organic growth and we would continue to expect to, but again, we'll look for opportunities to deploy capital if we see opportunity. But we're getting very strong organic growth.

[David K. Francis:]

And then as a quick follow-up, looking back at the med-surg business. You guys have been spending a lot of time trying to get the business repurposed and a little more focused on the ambulatory side of the business as well. Can you talk about trends that you're seeing in terms of actual utilization or actual volumes being pushed outside of the inpatient environment that might be starting to pay dividends for you in terms of the investments in the home health and other ambulatory environments?

[George S. Barrett:]

Yes. So thanks, Dave. So there, the -- I would say, these trends in terms of care moving, home acute [ph] care to ambulatory settings is probably unambiguous. This is absolutely happening across the board. And getting actual exact numbers in this is difficult because I think our system is not use to tracking this. I don't mean Cardinal system, I'd say the -- those who track this kind of data. But when we talked to IDN customers and we looked at our data, it's pretty clear that more activity is being driven to different sites of care, and I think that plays to the strategy. It helps explain some of the moves that we've made, and I think it's really going to be, for us, as we go forward, a tailwind, because I think that, that is a natural byproduct of some of the changes in the incentive systems in the industry.

[Michael C. Kaufmann:]

We've seen a lot of that with our at-home business already with those change in the dynamics that it continues to grow not only significantly but above market itself. So we've [indiscernible] mix there in our ambulatory surgery center business where we continue to have very large share. That's another area that we really like.

[Operator:]

We'll go next to Charles Rhyee with Cowen and Company.

[Charles Rhyee:]

Obviously, a lot of discussion on Medical. I guess maybe one last question on this topic, but maybe following up on the last question here. I think part of, George, when you talked about repurposing the Medical business, you also talked about having a more extensive dialogue with the c-suite of your hospital customers. And it was something maybe that the organization wasn't really in deep with previously. Can you talk about where you are in that progress to really kind of explain what Cardinal can do for them and for IDNs in general? And so, look, maybe like where we are at that stage, in what inning, and how much further can we get -- do we need to go before we can really drive that, I guess?

[George S. Barrett:]

Yes, that's a hard question. And as you guys think about the "what inning we are in," that's always a hard question because the system is going through this change. Let me highlight a couple of things. Again, as a reminder, I would say our largest customers across health care are becoming more complex, more integrated and their needs now cross more products and services than we've seen historically. So we have been, at the same time, aligning with that, and one of the things we did over the last year is to sort of create these strategic account teams. We've always had strength in our selling organization, selling lines of business. We will continue to do that, but I think a part of what we've been trying to leverage, and this is what you're touching on, is that need for the integrated system for that complex customer to think about a changing world and which are the partners who can help them. So again, as I think about changing from an industry which has been activity-based to one with different incentives to sort of a pay-for-outcome or a fee-for-outcome, I think all the tools that we bring, standardized consumables, private label and medical products, services that enable increased efficiencies, helping them navigate across their channels, our physician preference strategy, our work in the home, these are all valuable to them. And then you combine this with our pharmaceutical lines and our specialty, and I think we have sort of a unique set of offerings. We're trying to make sure that we are positioned to address that at the most senior levels of the organizations, because it's really now about competing in a world that looks in the future a little bit different than it did historically.

[Operator:]

And we'll take our last question from George Hill with Deutsche Bank.

[George Hill:]

Mike, I just wanted to touch on something quickly. I thought I heard you say in your prepared comments, but I might have gotten the notes wrong. Did you say the customer price changes were serving as a headwind in the drug distribution business? And if you did say that, can you put a little more color around what that meant?

[Michael C. Kaufmann:]

Yes, it was one of the offsets. So we said the positives was the growth in new customers and the net benefits from Red Oak that were offsetting some of the customer price changes. And those wouldn't be anything more than the normal types of day-to-day renewals we see with all of our customers. So there's really nothing new there, no new news. It's just typical. It always tends to be one of our largest headwinds, and we're constantly working on the opposite side, obviously, to more than offset those.

[George Hill:]

Okay. Fair enough. So just the kind of the normal pricing pressure that's not part of renewals?

[Michael C. Kaufmann:]

Yes.

[George Hill:]

And then maybe just, as we've talked about pricing pressure in the med-surg business, I guess, George or Mike, how should we think about how that pricing pressure impacts what will be the Cordis business? And is that business immune from that pricing pressure, or will that see pricing pressure as well?

[George S. Barrett:]

Well, I'm always reluctant to say anything is immune from pricing pressure, that's obviously -- would be a big statement to make. But I think we're really talking primarily about something that is a dynamic that's been occurring over some time in, what I would call, the traditional legacy med-surg business. I really would not sort of connect that necessarily -- line of business. This is just a trend that we've seen for some time. And I think what we're seeing with the other lines of business is actually they are drivers in the opposite direction.

[Operator:]

At this time, there is no further questions. I'll turn the call back to George Barrett.

[George S. Barrett:]

All right. Well, thanks, all, for your questions and for being on this call. We appreciate you doing this. We look forward to getting a chance to talk to you and seeing many of you in the near future. Thanks again.

[Operator:]

This does conclude today's conference. We thank you for your participation.