Cardinal Health, Inc. (CAH) Earnings Call Transcript & Summary

Hi, everyone. Thank you for joining us today. My name is Erin Wright. I'm Morgan Stanley's Healthcare Services and Distribution analyst. I'm pleased to have Cardinal's CEO, Jason Hollar, with us, so welcome. And with him, we also have Kevin Moran, who heads up the IR for it as well. So for important disclosures, please see the Morgan Stanley research disclosure website at morganstanley.com. If you have any questions, please reach out to your Morgan Stanley sales representative. And with that, I will hand it over to Kevin for some more riveting regulatory disclosures.

Thanks, Erin, and thanks for hosting us here today. During the fireside chat, we will be making forward-looking statements, and our actual results could differ materially from those projected or implied. For more information about the factors, which could cause our actual results to differ, please visit our SEC filings, which can be found on our Investor Relations website at ir.cardinalhealth.com. Thanks.

Great. Thanks, Kevin. And thanks, Erin, and good morning. I'd like to just make a couple of comments here. Well, first and foremost, continue to be, as you would expect, incredibly excited for this opportunity. I think it's a wonderful time to be stepping into this role of leadership with this company right now and more than anything I want to express that. I also want to spend a few moments just to step back and summarize some of the key themes and items that you heard at our August earnings release and just reinforce what my key priorities and focal points will be in the near term. I've been in the role now 2 weeks and it was announced about a month ago. But with that said, I had a good understanding of what I wanted to focus on and achieve stepping into the role. And you heard that the August earnings release, first and foremost, we need to improve the underlying performance of the Medical segment. The Medical improvement plan is a key priority for the organization and for myself personally, and I'm sure we'll get into some questions on that topic, so I'll just leave it there for now. For the Pharma business, to continue to build on the growth and the resiliency that we've seen with that business over the more recent past. Really pleased with last year's results, 5% growth in that business while still absorbing about $50 million of inflationary headwinds. And now we have a guidance in place for fiscal '23 of similar level of growth, low- to mid-single digits, very consistent with our long-term targets, while also expecting a similar level of inflationary headwinds this year. So in that somewhat challenging environment, still growing consistent with our long-term targets. And then thirdly, our focus is very much on relentless focus on shareholder value creation. This comes in a couple of different forms. We had very strong cash flow last year. We are guiding for strong cash flow again this year. And with that, we're still meeting all of our obligations, paying down debt, investing heavily into the business in terms of CapEx, while still having availability for $1.5 billion to $2 billion of share repurchases, which we continue to believe in. But also, beyond the cash focus and generation, what you heard last week is additional actions to enhance our governance structure. And of course, we'll be talking about that further here today as well. But it's all part of being very, very focused on the shareholder. Now those are the key priorities. Underlying all of that, you've heard a theme that's come through these last 2 weeks in a variety of different announcements and that's related to simplification efforts. Last week, I announced the new structure for the Pharma segment. And this was a wonderful restructuring because they accomplished a couple of taps all at once. It simplified the business. It streamlines the business. It allows for quicker decision-making. Of course, there's a lower cost that comes as a result of that. But also, and as importantly, it allows us to bring that Specialty business closer and into the core. It's such an important part of our future growth for it to be more core to the business as this structure will enable that. So within all that simplification work in Pharma, we also have what we had announced today as it relates to the Medical segment, some actions taken on the gloves portfolio to simplify how we go to market in that business as well. And that brings with it some actions and some decisions. One of those, in particular, is the decision to exit our nonmedical portfolio. So this has been a source of volatility for us, part of our write-down in the prior year in fiscal '21. And it's very much a distraction for the core medical health care customers. And so what we have chosen to do is to exit that particular product line and with that comes some cost to exit those businesses, but we think it's the right thing for the future of that business. So with that $25 million inventory write-down that comes with those actions, we did still reiterate our full year EPS guidance -- that guidance range. And of course, that's implying that the rest of our business is performing well, and we would expect to have other levers to be able to offset over the course of the year. So Erin, over to you for some questions.

Great. So that's a great segue for my first question here, which is the obvious one, which is on the news today. And you're refining your guidance for the first quarter, but reiterating EPS guidance. What does that mean in terms of your underlying assumptions for the year for operating profit growth within the core segments? What are those offsets that you're seeing for the remainder of the year? And are those operating -- operational target still intact?

Yes. So the overall targets are intact for the enterprise. We have a little bit of work to do for the specific towers of different performance. We give a lot of detail on our guidance. So we have a little bit of work to do to clarify each and every one of them. But overall, the business is operating as expected in the first couple of months of the year. And we believe we had, of course, a fairly wide range of our guidance to start with. And so we'll continue to work within that and believe that there's some opportunities, and we'll get into those details more in the next earnings call.

Okay. That's fair. And so you've laid out -- so we'll stick with Medical. And you've laid out this plan for the $650 million in EBIT by fiscal year '25. And an element of this goal is tied to a normalizing operating environment. But can you also talk about, for instance, your efforts in gloves and other rationalization and simplification efforts that are tied into that $650 million? Is that also still intact even with some of those initiatives in mind?

Yes. A lot of what we announced today is onetime, very much an exit cost to be able to get through to where we need to be. So there's nothing that harms us long term. If anything, I would say that. This is a really small part of our business, by the way, the revenue margin associated with what we're exiting is very small, but it has been a distraction. It has been very volatile. So in no way impacts our longer-term earnings prospects for the business. The $650 million goal absolutely remains intact. And the key driver of that, the biggest piece, roughly 2/3 of the improvement from where we are today to where we need to be is the $300 million related to the mitigation actions on the inflation of supply chain constraints. Of course, pricing is a component of that. Also, we think the costs will continue to normalize to some extent. We're seeing that in certain areas, especially in the international freight component of the inflation. We are seeing costs across the board moderate, come down to some extent. The international freight has been better than what we had expected. While the other commodities have continued to improve, they've been declining a little bit at a slower rate than what we had expected. So there's a bit of an offset there. But the most important point as it relates to the inflation and the pricing that goes along with it is it that inflationary cost does take up to 6 months to work its way through our P&L. So what we're expensing right now is what we bought 6 months ago. Meaning that even as some of these costs have come down more recently, they will only benefit us into the latter half, the latter quarter perhaps of fiscal '23. But those costs are at least moving in the right direction. We're seeing there would be the appropriate movement. But put all that aside because the cost will be what they will be, and I can't control those industry dynamics. What we can control and what we are controlling are the pricing elements of that. The key philosophy that I continue to maintain, I've been very clear on this for quite some time is that, our industry, certainly, our company does not have the margin or the business model to absorb economic shocks like this. It's not a part of what was ever intended or expect and certainly not a part of the pricing or the margin that was originally provided for these products. So we will continue to push for fair and appropriate pricing, which is to recover these costs. And that's all that the $300 million is, is a recovery of what we're already being incurred with. And so we're not gaining incremental margin with this, we're just recovering those costs that have occurred over the last 18 months or so. So we are very focused on that. We had the first significant price increases of March in this last year. We had the second wave in July. We have the third wave coming up in October. Everything is consistent with the plan that we laid out starting a few quarters ago, and we continue to believe that is the appropriate way to remedy this. Those price increases and those waves are kind of off contract. They kind of accelerate some of the contractual elements, which will also occur over that period of time. And so that's why we have confidence that this will continue to march along over the course of this fiscal year and next fiscal year to the point by the time we exit fiscal 2024, we would expect to be very close to the parity in offsetting the vast majority of those costs. And so far, we're on that path.

Okay. And then how -- as you think about your medical improvement plan, a portion of that is also private label and Cardinal brand products, I guess that represents about 1/3 of revenue within the segment now, but where does it go? What percent of profit and where does it go over time?

Yes. So the outside of the $300 million for the pricing are those three other growth drivers, roughly 1/3 or so of the total benefit from where we are today to where we need to be to hit the $650 million. The largest within that is the growth of the Cardinal brand portfolio. These are our brands, higher value add, higher margin categories. There are areas where we see opportunities to invest in both product innovation but also product capacity. So we are out of capacity on some of these product lines, so high-growth, high-margin products and we're not able to satisfy all those orders. So that's why we have confidence that we have a good opportunity to grow at that 3% CAGR for that part of our business. And if you think about market growth, it's probably 1% to 2%. So we're not that much over market growth for this assumption and why we think it's a very reasonable goal to have. The other component of that profit improvement plan is the ongoing growth of our higher growth businesses. That includes our at-Home business and some of our medical services businesses. So parts of the industry market that are growing faster than normal, so we should be able to pick up on that momentum and grow our profits incrementally from there as well. And then the final complaint is through the simplification efforts and others, we would expect ongoing cost reduction.

Okay. And so at this point and taking a step back and looking at full Cardinal enterprise, what are the synergies between the Pharma segment and the Medical segment? And where do you see that evolving? What's the end game for Medical? And what's your overall commitment to the Medical business at this point?

There are synergies between these different businesses. We go to the same customers, same health systems, we operate in the same industry. There's very similar centers of excellence and fixed overhead that operate within there. And we have some of our businesses sell across the segment line. So there's synergies there. But I think the focal point of this question, the real intent is, okay, you can have that and you can still consider other alternatives. And the key -- a couple of key things I want to stress on this topic is, first of all, we've demonstrated that we have always looked at our portfolio. We've communicated that, that's a natural part of how management interacts with our Board. It's something that I've seen in my time here. And I've seen both of my time here as well as in the past, where we've taken over the last several years, we sold off 3 significant parts of our business, in part because of that portfolio review. So that process is there, it functions. With that said, we're always looking at that. We're always considering other alternatives. And with the creation of the business review committee, it just formalizes what we are already doing as a business and creates -- now additional Board members help provide us that insight and focus into this topic. So we think that there is always opportunity to continue to evaluate that portfolio, but as it relates specifically to the Medical business and what I said in the last earnings call is that, I don't know what the right answer is for the business longer term. But in the near term, it's very, very clear to me. Under all scenarios, we need to improve the performance of that business. As we improve that business and execute the medical improvement plan, we will then have options that we can evaluate at the right time.

And I promise I'll move on from this, but at the same time, with the new Board members as well, has that accelerated some of this portfolio review or expanded it into other categories that than maybe previously haven't been assessed?

Well, how I would express that is, again, we've always had a process. We've always had a focus. We are welcoming of open arms, other thoughts and other opinions because it is a complex topic, and we have a wonderful slate of Board members here, both the existing Board and the new Board members, all bring with them different skill sets and capabilities. And so the diversity is outstanding and the capability is outstanding. So that's why we need to work further with them. And of course, they just stepped on our Board about a week ago. So we have a little bit of time to get them up to speed, onboard them and to work through these topics.

Okay. Great. So Pharma Distribution, you've guided to 10% to 14% top line, 2% to 5% operating profit for '23. I guess, what's giving you visibility and confidence in this guidance? And can you speak to a little bit of the underlying utilization environment as well, excluding kind of COVID dynamics?

Yes. So overall, the business has been performing as expected. So within the fiscal '23 guidance, we talked about a few moving items that we had some unusual items related to ongoing inflation is the $50 million headwind, but we also had some tailwinds associated with lower technology spending because of the bolus of spending we had in the prior year and lower opioid legal fees. So a number of moving pieces, but if you think about the value of each of those, they generally offset. So that really leads us to our guidance and our expectation today is still the same that we're not seeing a lot of abnormalities within this particular segment and is operating as we expected. The underlying utilization is much more normalized. We obviously saw the volatility back during the heavier COVID days. We are seeing less volatility day-to-day, week-to-week, month-to-month. It's still perhaps a little bit more than what was there prior to the pandemic, but we're getting to a much more normalized environment, which is also partly why we have good confidence in our ability to achieve those earnings results for this year.

And from a drug pricing perspective, and we've asked other drug distributors here the same question, but it has been a relatively stable environment. Is this sustainable? Is this the new normal to what degree is your model more or less sensitive to, for instance, generic or pricing dynamics? And how has it has evolved in the past few years?

Well, there's a lot into that question, and it kind of depends on which part of our business, but it is more fixed than it has been in the past overall. But generics remains an important part of our business, but it has been very stable volumes, very consistent dynamics. And so when you think about the history of the volatility of the generics business, it has been stable for much more of its history than it has been. There's just been a few pockets of stream volatility that the margins now are much lower than where they were back in that period of time, and they were impacted by different events like the barring consortiums and things of that nature. So barring an outside influence, I wouldn't expect there to be the same type of volatility. The volatility usually results from some type of act. And at least from our perspective, we continue to see those consist of dynamics, and I think that's why our guidance and our long-term targets make sense with where we're at right now.

And on the regulatory front, how are you exposed to the new price control measures and the Inflation Reduction Act? And how do you expect to kind of better position yourself over the next few years? You do have some time on this front, so how do you think of yourself as exposed, not exposed?

These types of changes -- you just put it perfectly, Erin. These types of changes when there's a forewarning are very easy to be managed as a distributor, right? We don't carry the risk of the product cost for the vast -- really all everything branded that you're describing there. So especially with the timeline and the foresight that we have, it's even more manageable than if it were a shock to us and we'd have to manage it. And even there, we have confidence that ultimately that gets pushed to the final consumer in some form or another. But especially, in this situation where we have even more of a time horizon of seeing it coming, of course, we'll work with manufacturers and customers to ensure that, that's seamless. But as a distributor, again, our role is not to take on those types of price shocks.

And I'll ask a question also on biosimilars. But also, if there's questions in the audience, feel free to raise your hand, and we'll get a mic over to you. Opportunity for your both near term and over the longer term exposure to Part B versus Part D and how you're kind of positioned on that front from a biosimilar perspective?

Well, overall, from biosimilars, it's a small but growing part of our business. So we're looking forward to when it grows even larger and becomes more of a driver for us. So I think in the near term, it's unlikely you're going to hear us talk a lot about those specific drivers but we're very well positioned to be able to participate and drive some of that growth. When we think about where we see biosimilars going, expanding into new therapeutic areas, additional sites of care, we are even better positioned for where we see that business going. We see that more of a retail and specialty pharmacy path, fits nicely with our capabilities, more exposure to products that serve areas like diabetes and immunology are more within our critical mass as an organization. So we can and do service across the spectrum, but we have different concentrations that we think that the next phases of biosimilars will further support and improve. But importantly, we continue to invest both upstream, downstream to ensure that we are the right partner for both our customers and biopharma partners.

And you haven't been involved, for instance, in some of the government contracts. But does the COVID vaccines and treatment distribution moving to the private market CDC, does that potentially present an opportunity for you?

Well, as you mentioned, we haven't participated a lot in the current arrangements. So it certainly isn't bad for us. I think how we always look at it is, what's best for the final patient. And we continue to believe that bringing the full capability of the entire industry to serve and provide the services that we can provide, and it gets better access to all Americans. And we continue to think that, that's the right answer. And of course, we'll continue to work with the government and regulators to figure out the best path there as we have this whole time, even though we did not have much of a horse in the race, we still supported our pharmacies to ensure that they had access to product, and we're going to continue to do so and do the right thing. But at some point, I would expect this to be an opportunity for us, but it's nothing that we're expecting in the near term. It's not included in any of our guidance at this point.

Okay. And then on -- just more broadly on Specialty, what's your opportunity in your view to improve the mix of your overall business? Can you speak to what's feasible in terms of your -- the potential opportunity for you to increase exposure to Specialty over time? Can you do this without triggering price competition and margin dilution? How do you think about what's feasible and over what sort of time frame and the pace of what you can achieve on that front? Or is that part of the priority at all?

Yes. Well, absolutely it's part of the priority. And I've touched on in a few different ways already today, and I'll bring them together. Just even last week's Pharma segment restructuring very much was focused on this, how can we get more out of our Specialty business. Very successful, very high growth, very relevant, large, profitable business for us today. But what do we need to do for the next generation of opportunities in front of us and to have one face to the customer, one face to the manufacturer so that we can bundle -- not bundle, but bring together different services and capabilities that we can have different options and opportunities for those customers and for those suppliers is an important value that we can bring. That's already part of the same segment, but now for the different operators that we would focus with. So that's very much a part of it, just getting the right structure and right people in the right place. It's also what I referenced before, just how the industry itself is going to with biosimilars, that will be very much a part of leaning into that growth further. It will be -- we have, of course, upstream and downstream investments I mentioned earlier. So more downstream being our Navista TS platform, technology platform, upstream, our 3PL, large business, very relevant, very helpful to providing services for the biopharma manufacturers. We are winning additional business there and growing nicely. So we see that these areas of business we already have are continuing to grow more and more and getting them closer to the rest of the Pharma business so that we can leverage that value and create more capabilities and possibilities to our customers and biopharma manufacturers is absolutely intact.

Okay. And then let's switch to capital deployment. Can you speak a little bit about kind of the priorities and you're new at the helm, but not new to Cardinal, guidance that suggest $1.5 billion to $2 billion in buybacks in '23. But how should investors think about the appetite for M&A and areas of interest potentially in like, Specialty and others?

Yes. So the capital deployments have not -- the priorities have not changed. It's very consistent with what we've been talking about for the last couple of years. We have leaned in a little bit more on CapEx. So -- and when I think about the highest priority in terms of driving that organic growth, we have a lot of organic growth opportunities. The medical improvement plan does require some additional capital. But you're talking about a normal run rate of around $400 million to being closer to $500 million through the cycle. So pretty small when you think about the total cash that's being deployed. Of course, we continue to be refocused on the balance sheet and continuing to have a very strong balance sheet. So we have the debt that will come due this year that we would expect to pay from cash generated and then ongoing modest increases in our dividend. So that gives us with last year's cash flow and this year's expected cash flow, very good flexibility for this year, and that's why we're comfortable with the $1.5 billion to $2 billion for the share repurchases. We have completed some small acquisitions recently, but we don't have that being the highest priority. We think that there is significant opportunity with the organic growth, the organic investments. And that's where we're most focused. We will evaluate tuck-in M&A. I would not expect anything greater than something considered tuck-in. And even there, it would be very much focused like our more recent acquisition, being in the Specialty space is very much a sweet spot where we see good accretion for those types of investments. And so we would consider something along those lines, perhaps other growth areas of our business. But in the near term, I would expect us to be much more focused on the core.

Okay. And with the recent management changes, the organizational changes, what more is to come in terms of changes from a management perspective? Should we anticipate more announcements like this on an inter-quarter basis? And how involved, for instance, are some of your more recent investors in this process? I would assume so since they're now part of the Board, and yes, what's to come on that front?

Well, I firmly believe that these are the right decisions to take, and I've certainly driven these actions. And it's for all the right reasons that I've described here today. There will be more changes, right, because we have an external search right now for our CFO, and I've been very clear that we'll be attracting talent from the outside. I'm very pleased with some of the initial possible candidates brought in front of us. There's great opportunities for an organization like us to bring in great talent. So we will have an evolution of that. But I also wanted to try to take as much action as possible in the first couple of weeks here. I certainly knew I'd be on a public stage here and be able to talk about how these things all come together. So for the media term, these were my focal areas and what I wanted to get completed. So now the team can focus on driving the business and get as much out of the quarter and the year as possible.

Okay. And then in terms of -- we've been asking everyone kind of a macro question here. In terms of durability of your business and in varying economic backdrop, how does this compare to, for instance, [ '08, '09 ]? And how do we think about kind of just general utilization trends in terms of in varying kind of economic backdrop?

Well, I think especially as you think about the Pharma business. Even in COVID, where the volatility was extreme in so many different industries that highlighted that within the size of our business, we are talking about single percent type of impact. And so it all depends on your reference point. And so I think what COVID has demonstrated is the biggest part of our business where most of our value and earnings are generated has been incredibly resilient within that construct. And if you have a very profitable -- and cash flow was very strong throughout that period of time as well, and that's, I think, a very good proof point to the underlying resiliency of our entire enterprise. Certainly, we have work to do in the Medical business. The initiatives that I highlighted in the medical improvement plan, it fixes the near-term issue that's in front of us here. A key component of those mitigation actions are getting the right contracts in place so that in the future, we don't have the same responsibility for those cost shocks. Again, as a distributor as well as a product provider, it should not be entirely our responsibility over that period of time when there are economic shocks that occur. It's very unusual for our product-based businesses like that to absorb that over a multiyear period. And we continue to work to put the right contracts in place so that we, at a minimum, share that responsibility. And in the future, I would expect any type of future shock that looks anything like this would have a dramatically lower impact to our business.

And you spoke to this a little bit earlier, but on some of the technology enhancements that you're doing, can you speak a little bit more about what's entailed on that front? Where the areas of focus are near term? And longer term, what this means for margin profile?

Sure. So tactically, there's a component of this that -- I just want to make sure I clarify that we had $80 million of incremental IT spending in fiscal '22 related to a broad-based ERP rollout and implementation. $30 million of that has now reduced in fiscal '23. So our guidance for '23 was for $50 million. And that was because that was the kind of the project and rollout expenses. The remaining $50 million that we are seeing in '23 is largely depreciation and therefore, is going to be fixed. So from a tactical standpoint perspective, the future, you should expect a pretty similar level of expense related to IT investments, all things being equal, at least as it relates to that project. To your point, Erin, the real intent of a new ERP and other technology that went with it is to improve the underlying performance of the business, customer service, customer delivery as well as the operational effectiveness. That's still all elements that we're working on, working through. It's a component of our guidance. It's also a component of our ongoing cost reductions as an enterprise is partly being driven by those investments.

Okay. And then lastly here in terms of the guidance and how we're thinking about the quarterly progression from here, you did give specific quarterly guidance on the call, which you typically don't do, but -- and then give us some more detail today. But anything else that we should be thinking about in terms of that quarterly progression from a modeling perspective, especially on the Pharma side in the first quarter, but also kind of in the back half of this year?

Yes. In terms of the timing around Pharma, the biggest element to understand is that, that inflation is going to be first half. It started in more of January of this last year. So we had half of it in the second half of '22 and then half of it will be in the first half of '23. So when you think about that $50 million, it will be entirely in the first half of the year or the vast majority in the first half of the year. On the Medical side, the timing is going to be much more dictated around the -- how the pricing and cost flows through our P&L for inflation. And that's why we provided guidance for the first quarter is that we would expect the most significant impacts to be in Q1. Every quarter for the rest of the year, I would expect cost to go down related to inflation and pricing to go up related to inflation. And so we would expect that impact to go from a 25% offset in terms of the pricing relative to the gross impacts in the first quarter to exiting fiscal '23 at a 50% offset and then fiscal '24 exiting that at 100% offset.

Okay. Okay. Thank you so much. I really appreciate the time and hope you have a great conference.

Yes. Thank you, Erin. Appreciate it.