Cardinal Health, Inc. (NYSE:CAH) Q3 2023 Earnings Call Transcript

Cardinal Health, Inc. (NYSE:CAH) Q3 2023 Earnings Call Transcript May 4, 2023

Operator: Hello and welcome to the Third Quarter Fiscal Year 2023 Cardinal Health Incorporated Earnings Conference Call. My name is George. I’ll be your coordinator for today’s event. Please note this conference is being recorded, and for the duration of the call, your lines will be in a listen-only mode. However, you will have the opportunity to ask questions at the end of the presentation. And I would now like to hand the call over to your host today. Mr. Kevin Moran, Vice President of Investor Relations, to begin today’s conference. Please go ahead, sir.

Kevin Moran: Good morning. Today we will discuss Cardinal Health’s third quarter fiscal 2023 results, along with updates to our full year outlook. You can find today’s press release and earnings presentation on the IR section of our website at ir.cardinalhealth.com. Joining me today are Jason Hollar, our Chief Executive Officer; and Aaron Alt, our Chief Financial Officer. During the call we will be making forward-looking statements. The matters addressed in the statements are subject to the risks and uncertainties that could cause actual results to differ materially from those projected or implied. Please refer to our SEC filings and the forward-looking statement slide at the beginning of our presentation for a description of these risks and uncertainties.

Please note that during the discussion today, our comments will be on a non-GAAP basis unless they are specifically called out as GAAP. GAAP to non-GAAP reconciliations for all relevant periods can be found in the schedules attached to our press release. For the Q&A portion of today’s call, we kindly ask to limit yourself to one question so that we can try and give everyone in the queue an opportunity. With that, I’ll now turn the call over to Jason.

Jason Hollar: Thanks, Kevin, and good morning, everyone. Overall, we’re pleased to deliver another quarter demonstrating progress against our plans with our Q3 results led by continued momentum and growth in the Pharma segment. With a strong overall performance in the quarter and our increased confidence in the rest of the year, we are raising and narrowing our fiscal ’23 EPS and adjusted free cash flow guidance. Our Pharma business is a resilient and growing business where we’re well positioned given our critical role in the pharmaceutical supply chain and strong and diverse customer base. We’ve seen ongoing stability in the underlying fundamentals of the business, including consistent market dynamics in our generics program.

We’ve also seen continued broad-based strength in pharmaceutical demand spanning across product categories and classes of trade. Pharma team is executing our plans to build upon this growth, both in our core distribution operations and in Specialty, where we’re focused on capturing the increasing demand for Specialty Products and Services. In short, we’re pleased with the resiliency and strength of the business and to be able to raise our Pharma outlook for fiscal ’23. Medical, we remain confident in our medical improvement plan target of at least $650 million of segment profit by fiscal ’25, driven by our inflation mitigation and growth initiatives. While we are making progress with the second consecutive quarter of positive segment profit, we remain focused on taking actions to drive more predictable financial performance in line with this business’s underlying potential.

For several quarters now, we’ve seen demand for our higher margin Cardinal Health brand products remain generally stagnant, which we’ve reflected in our updated fiscal ’23 outlook. We continue to achieve progress with inflation mitigation, the number one key to returning the business to a more normalized level of profitability. Across the enterprise, we are operating with urgency to drive our businesses forward. We’re collectively focused on our three key strategic priorities of executing on the medical improvement plan, building on the growth and resiliency of the Pharmaceutical segment, and maintaining a relentless focus on maximizing shareholder value. I’ll provide some further updates on our continued progress shortly, but first, let me turn it over to Aaron to review our results and updated outlook.

Aaron Alt: Thank you, Jason. I am pleased to join you this morning on my first call since assuming the CFO role with nearly 90 days now under my belt. What I could see from the outside has proven to be true on the inside. Cardinal Health is a business with a strong leadership team and engaged board, a defined strategy, a strong balance sheet and plenty of operational opportunities to promote value creation for our stakeholders. I’ll begin today with the enterprise’s strong results for the third quarter. Total revenue increased 13% to $50.5 billion and gross margin increased 6% to $1.8 billion, both driven by the Pharma segment. Consolidated SG&A increased 4% to $1.2 billion, primarily reflecting inflationary supply chain costs, which were offset in part by our comprehensive enterprise wide cost savings initiatives.

Operating earnings of $606 million were 11% higher than the third quarter of last year, driven by significant Pharma segment profit growth with opportunities remaining for us to achieve Medical segment profit increases in future quarters. Moving below the line interest and other decreased 32% to $28 million, driven primarily by increased interest income from cash and equivalents. As a reminder, our debt is largely fixed rate, resulting in a net benefit from rising interest rates. Our third quarter effective tax rate finished at 22.4%, slightly lower than we had expected, reflecting some positive discrete items in the quarter. Diluted weighted average shares were 258 million, 7% lower than a year ago due to continued share repurchase actions.

The net result of the progress against our strategy was adjusted earnings per share of $1.74 in the third quarter growth of 20% versus the prior year. Now turning to the balance sheet. We ended the quarter with strong liquidity with $4 billion of cash on hand. The business generated robust adjusted free cash flow of $1.3 billion in the third quarter. Year-to-date adjusted free cash flow is $2.1 billion. Given our cash balances, we ended the period with no outstanding borrowings on our credit facilities. And in further support of our strong investment grade rating, during the quarter, we paid down $550 million of maturing March 2023 notes with cash on hand consistent with our plans. We also extended our $2 billion revolver of backup liquidity until February of 2028.

Earlier in my remarks, I referenced return of capital to shareholders. During the quarter, we returned $378 million to shareholders through a $250 million accelerated share repurchase program and payment of our long standing dividend. Year-to-date, we’ve returned $1.5 billion through share repurchase and made nearly $400 million in dividend payments. Now I will cover our segment performance beginning with Pharma on slide five. Third quarter revenue increased 14% to $47 billion, driven by brand and specialty pharmaceutical sales growth from existing customers. We saw strong, broad based pharmaceutical demand, particularly from our largest customers. GLP1 medications also provided a revenue tailwind in the quarter. Pharma segment profit increased 23% to $600 million.

We were pleased to see that this progress was driven by both positive generic program results, including volume and mix, and by a higher contribution from brand and specialty products. Within our generics program, we continue to see consistent market dynamics and strong performance from Red Oak Sourcing. With regards to branded and specialty products, the higher contribution reflects a modest benefit from manufacturer price increases. As a reminder, while over 95% of our overall branded margin is derived from fixed fee-for-service agreements, the contingent portion is highly concentrated in our fiscal third quarter. Moving to the key growth area of Specialty. We’ve seen strong double-digit growth across specialty distribution along with our upstream manufacturer services.

Our nuclear business, which is tracking ahead of plan, continued its double-digit growth, including benefiting from recent launches of Novel Theranostics. Within our pharmaceutical supply chain, we continue to effectively manage through the incremental inflationary cost pressures seen industry wide. And in the third quarter, these net impacts were not material on a year-over-year basis. Finally, in the quarter, we lapped more significant opioid related legal costs and higher costs related to the now completed ERP technology enhancements. Now turning to Medical on slide six. Third quarter revenue decreased 5% to $3.7 billion, driven by lower products and distribution sales, primarily due to expected PPE volume and price declines. Medical segment profit decreased 66% versus prior year to $20 million, primarily due to lower products and distribution volumes and unfavorable sales mix.

Additionally, these results reflect both net unfavorable non-recurring adjustments, including simplification actions and some modest year-over-year improvements in PPE margins. Similar to Q2, we observed normalized PPE margins in the third quarter. Regarding the demand environment, we’ve previously discussed some overall volume softness in our products and distribution business, including Cardinal Health brand. In the quarter, volumes for our Cardinal Health brand products were roughly flat sequentially. We achieved inflation mitigation of over 40% during the quarter, driven by our continued efforts. We also saw benefits from our ongoing cost savings initiatives such as in our manufacturing and supply chain. Now for our updated fiscal ’23 outlook beginning on slide eight.

Our team is working hard and we are seeing positive results in key parts of our portfolio. As we move into the final quarter of the year, we are narrowing and raising our non-GAAP EPS guidance range from $5.20 to $5.50 to a new range of $5.60 to $5.80. At the midpoint, this represents a $0.35 cent increase and 13% year-over-year growth. This update primarily reflects an improved outlook for the Pharmaceutical segment for the year, as well as a more modest short-term outlook for Medical. While we will save commentary or updates on long-term segment guidance for our upcoming Investor Day on June 8th, we are sharing today that we are reaffirming the long-term financial guidance in the medical improvement plan for the Medical segment. We are also updating some key enterprise wide assumptions as seen on slide eight.

Based on year-to-date performance, we now expect interest and other in the range of $95 million to $105 million, a non-GAAP ETR of approximately 22% to 23% for the year and adjusted free cash flow generation of $2 billion to $2.3 billion for the year. We expect diluted weighted average shares outstanding in the range of 262 million to 263 million, reflecting our year-to-date repurchase activity and continued expectation of $1.5 billion to $2 billion in total share repurchases in fiscal ’23. Finally, we now expect capital expenditures of approximately $450 million, reflecting the timing of our continued investment to drive organic growth. Turning to the segments on slide nine. In Pharma, with a strong pharmaceutical demand and performance that we’ve seen to date, we now expect full year revenue growth in the range of 14% to 15% and segment profit growth between 10.5% to 12% growth.

We are extremely pleased with the ongoing resiliency and strength of the business and our plans to drive double-digit profit growth in fiscal year ’23. Yet when looking at the more normalized performance of the Pharma business, it’s important to note our fiscal ’23 outlook includes two non-recurring year-over-year tailwinds. First, as noted, we experienced a modest benefit from branded manufacturer price increases in fiscal year ’23 that we assume is unlikely to repeat in future years. Additionally, relative to the prior year comparisons, our previous fiscal year ’23 guidance assumed offsetting year-over-year impacts in total between several non-recurring drivers, higher than usual inflationary supply chain costs, lower opioid related legal costs and lower costs for technology enhancements compared to fiscal year ’22.

However, we now expect the in-year comparison to fiscal year ’22 for these items to produce a modest year-over-year tailwind unique to fiscal year ’23. We will provide insights into our long-term targets for Pharma during our Investor Day, including some early guidance for fiscal year ’24. Turning to Medical, we now expect a revenue decline of approximately 6% and a segment profit decline of approximately 50% for the year. This updated outlook reflects three key changes. First, third quarter actual results, as I’ve already discussed. Second, updated assumptions around Cardinal Health brand volumes, namely that we will see relatively consistent demand patterns for the remainder of the fiscal year. Third, delayed realization of lower costs, which we have previously incurred primarily related to international freight.

Based on our updated volume expectations, we now expect some of the previously anticipated fourth quarter improvements in the P&L to shift into fiscal ’24. As a reminder, on the cost side, we’ve seen significant improvement in incurred international freight costs, which are capitalized into inventory on our balance sheet. These costs are then recognized in our P&L results on a delay as we sell through the products. We continue to have strong line of sight into this eventual benefit. However, due to timing, the impact to our fourth quarter results will be more modest than previously assumed. Importantly, we continue to expect to exit the year, offsetting at least 50% of the gross impact from inflation. Looking ahead to the fourth quarter, the approximate $60 million sequential improvement in Medical segment profit embedded in our guidance primarily reflects the combination of three items.

First, the normalization from the non-recurring adjustments from Q3. Second, continued improvement in progress on our mitigation initiatives, including the benefit from the previously incurred international freight costs. Third, and to a lesser extent, normal seasonality improvements in the fourth quarter. So in financial summary, an excellent financial quarter overall, our raise to guidance with opportunities still in front of us. With that, I’ll now turn it back over to Jason.

Jason Hollar: Thanks, Aaron. Now a few key updates on our three strategic priorities for fiscal ’23. First, executing our medical improvement plan initiatives. We remain on track with our mitigation actions for inflation and global supply chain constraints, and I’m pleased with our continued incremental progress on this critical front. We’ve now mitigated over 40% of the gross impact to our business through our mitigation initiatives. This includes widespread temporary price increases across nearly all of our Cardinal Health brand product categories, supplier distribution fee increases to offset higher transportation, labor and fuel costs, and our focus on other offset opportunities such as additional sourcing efficiencies. We continue to work collaboratively with our industry partners to make pricing adjustments that are reflective of current market conditions on our path to fully mitigating this headwind by the time we exit fiscal ’24 through these collective actions.

By taking a transparent approach, we are also advancing our re-contracting efforts, successfully adjusting long-term product contracts as they renew, and including language that allows for greater future flexibility. While costs generally remain significantly elevated relative to pre-pandemic levels, we’ve seen a stabilization across most areas, along with improvement in international freight. We believe we are now past peak overall cost levels as the improved international freight costs will begin to be reflected in our fourth quarter results. We remain committed to our mitigation efforts, as highlighted earlier. To drive growth outside our mitigation actions, we are focused on optimizing and growing our Cardinal Health brand portfolio, accelerating our growth businesses and driving simplification and continued cost optimization.

As Aaron indicated, demand for our Cardinal Health brand products has remained generally stagnant over the first three quarters of fiscal ’23. We believe market demand will improve in fiscal ’24 and ’25 coinciding with our ongoing initiatives to increase product availability, drive new product innovation and implement other commercial improvements. As an example of product innovation, we recently unveiled the new Kangaroo OMNI Enteral Feeding platform at the ESPEN Congress. OMNI is the only enteral pump cleared to accurately deliver thick formula and is designed to meet enteral feeding needs from the hospital to home, infancy to end of life. OMNI has received very positive feedback from both clinicians and patients, generating excitement for the launch in early fiscal ’24.

Outside of US product and distribution, we’re driving growth in other key areas of the segment. at-Home Solutions, Medical Services, including OptiFreight Logistics and WaveMark and international products and distribution. For example, in at-Home Solutions, we are expanding our footprint to match the sustained growth of home health care we are seeing in the industry and our business. Our new Central Ohio distribution center is now operational. This new location is the next step in supporting our growth strategy and will be equipped with systems and automation capabilities to improve safety, service and operational efficiencies. A new audited storage and retrieval system will increase throughput and capacity. An ideal technology for at-Home Solutions facilities that are primarily focused on direct-to-patient fulfillment.

In OptiFreight Logistics, we are accelerating our growth as a leader in tech-enabled logistics management by driving best-in-class customer experience and continually diversifying our product offerings. And we continue to take action to drive simplification across our Medical business by optimizing our distribution and global supply chain network and through our active approach to product life cycle management. Next, in Pharma, we’re building upon the growth and the resiliency of the business. We are privileged to serve and partner with a broad customer base, providing essential health care services in their respective communities, including leaders in retail pharmacy, mail order, grocery and health systems among the many classes of trade. We support our customers by bringing significant scale and leading offerings to market, including our comprehensive generics program anchored by the capabilities of Red Oak Sourcing.

To keep pace with the strong and resilient demand we are seeing from our customers, we continue to focus on strengthening our core operations by continually developing customer focused solutions and investing in new technologies across our supply chain. Our goal is to continue providing innovative tools that address the unique challenges of our customers while unlocking value and further efficiencies across our distribution supply chain. We’re also prioritizing the area of specialty through our actions and investments. Our new organizational design is driving efficiencies and further effectiveness, enabling us to move quicker and better prioritize the needs of our customers and manufacturer partners. Downstream, we’ve seen continued double-digit growth across specialty distribution, including in health systems and alternative care.

And in the physician office channel, our acquisition of the Bendcare GPO and investment in their MSO continues to drive a differentiated engagement model for rheumatologists through our expanded capabilities. Upstream with biopharma manufacturers. We again saw double-digit growth for manufacturer services in the third quarter. Our leading specialty 3PL continues to win new business, including in the area of cell and gene therapy. Through Q3, we supported 27 product launches with double-digit launches anticipated in the fourth quarter. And in our nuclear business, we’re seeing a growing demand pipeline for our Center for Theranostics Advancement in Indianapolis. We’ve seen strong volumes from recent Theranostics launches, such as radiopharmaceutical supporting prostate-specific PET imaging.

With the continued success of the business, combined with the innovation that’s occurring in the space, we continue to be excited about this very promising area. And lastly a brief update regarding our relentless focus on shareholder value creation. We have placed a strong emphasis on responsible capital deployment, including the return of capital to shareholders. This is evident through our plans to return over $2 billion to shareholders in fiscal ’23 through dividends and share repurchases. We will continue to pursue opportunities for additional shareholder value creation. Our management team has made significant progress in realigning our operations to drive focus and simplicity. Our work is ongoing and we continue to work through a comprehensive review of our company’s strategy, portfolio, capital allocation framework and operations with the support of our Board and the business review committee.

Given the importance of this work today, we announced that the Board has extended the term of the committee for an additional year through July 15, 2024, and we have also extended the term of the cooperation agreement with Elliot. We are very much looking forward to our upcoming Investor Day on June 8th in New York City and the opportunity to further articulate why we believe Cardinal Health is well positioned for long-term success and our plans to maximize shareholder value. Among other topics, we plan to detail our growth strategies and provide updates on our long-term outlook, capital allocation framework and the ongoing business and portfolio review. Before I conclude, I want to thank our Cardinal Health employees who are advancing our key strategic priorities and fulfilling our essential role in health care, serving customers and their patients.

While there’s still work to do, I am encouraged by our team’s continued progress and excited about our future opportunities. With that, we will take your questions.

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Q&A Session

Operator: Thank you very much, sir. Today’s first question is coming from Michael Cherny coming from Bank of America. Please go ahead. Your line is open.

Michael Cherny: Good morning and thanks for taking the question. Maybe if I can just dig in on the Medical side and just get an understanding, especially given the bridge dynamics between where you’re run rating versus the build to the $650 million in ’25. Is there any way you can go into more detail about what the quantitative and qualitative components of what led to the nonrecurring piece that’s been absorbed within the segment? And then as you think about the dynamics behind that, how does that roll off over time as part of that build towards the longer-term multiyear targets?

Jason Hollar: Sure. Thanks, Michael. Yes. Let’s break down the inflation into the components as a way of giving you the pieces I think you’re asking for there. And we’ve given you enough of this, you can back into these numbers, but let me just be really explicit around the impact of inflation across the quarters in fiscal ’23 and what that then implies for ’24 and beyond. And I think that will get at most of your questions. So the first half of the year, namely within Q2, somewhere around Q1, Q2, we saw the peak net impact of inflation, gross inflation net of the mitigation actions. And then specifically in Q2, we had about $100 million included in our reported Medical segment earnings. Now we have had improvements over the course of the last quarter.

So in Q3, we saw both the ongoing pricing dynamics as expected and the costs continue to be incurred at lower levels as expected. And what that did then was drove a P&L benefit related to those mitigation actions of $20 million to $30 million for the quarter. The difference in the quarter is that both Q3 as well as Q4, our volumes are now expected to be lower. So what we see in the P&L is a little bit less than what we had anticipated. But what we’re spending on those incurred costs are coming in as expected. So again, that’s Q2 to Q3, a $20 million to $30 million improvement in the net impact. And then we expect pricing to continue to improve as we roll over more and more contracts into the new permit structure. And then we have ongoing the international freight especially continue to roll through our P&L, again, at a slower pace than originally anticipated, but we still expect that benefit in the fourth quarter, and that’s another $20 million to $30 million.

So as you think about that Q2 to Q4 journey, that’s $40 million to $60 million or let’s call it about $50 million of benefit just related to the mitigation actions. So again, the actions are entirely consistent with our expectations. It’s just that volume component is effectively delaying the benefit of what we see until some of it spilling over into fiscal ’24 more than what we had anticipated. So that’s the biggest part of the bridge because our guidance implies an $80 million-ish type of run rate in the fourth quarter. And so getting that Q2 to Q4, $50 million of that, that kind of gets you there. Now to your point, in Q3, there were some nonrecurring items, some puts and takes that we don’t anticipate will continue on into Q4, let alone 2024 and 2025.

So that’s kind of in and out and not really something to think about so much in terms of that overall bridge. Now the last part of this story then is, okay, so that gets you to the run rate of about $80 million in the fourth quarter. And as I said, we started with $100 million at the beginning of the year, Q2 impacted because of inflation. The $20 million to $30 million each quarter takes you down to the $50 million in Q4. That implies that in that $80 million of profit as we exit the year in our Q4 results, still includes $50 million for the quarter related to the net impact of inflation. That’s the opportunity that we remain committed to. Nothing we’re talking about here is different than our expectations. I continue to expect us to fully mitigate through pricing of the ongoing renewals as well as this cost will continue to come down in terms of what impacts our P&L.

We do not anticipate significant further reductions in other commodity areas, but we do expect that international freight will stay at the low levels that it currently is at. Next question please.

Operator: Thank you, sir. Next question is coming from Lisa Gill of JPMorgan. Please go ahead.

Lisa Gill: Thanks very much and thanks for all the detail. Jason, I know you’re going to talk about this at your Analyst Day around the portfolio review. But there’s been some speculation around your nuclear business. Can you just talk about the contribution that, that had maybe overall thus far this year and how you see that? Is that a core component of your business going forward? Or is this something that you would think about when you think about your portfolio review? And any insights you have around nuclear would be helpful?

Jason Hollar: As you would expect, Lisa. First of all, good morning. I’m not going to comment on the any of the rumors or speculation. What I’ll say is nuclear is a fantastic business. In our segment footnote, we break out the revenue that’s trending a little above $1 billion. It did increase a bit here because of some RevRec changes that’s taking our revenue growth at well over 30%. But the kind of the normalized level of revenue growth has been in the low double-digit type of revenue growth. So it’s been growing nicely. We’ve never broken out the margin, but we have indicated it’s a higher than average margin. So it’s a growing business. It’s a strong business and a great secular area. And that’s all that we’re going to say about that. Next question please.