Cardinal Health Inc Q2 FY2020 Earnings Call

Good day, and welcome to the Cardinal Health, Inc. Second Quarter Fiscal Year 2020 Earnings Call. Today’s conference is being recorded. At this time, I would like to turn the conference over to Kevin Moran. Please go ahead.

Good morning and thank you for joining us as we discuss Cardinal Health’s second quarter fiscal 2020 results. I am Kevin Moran, Vice President of Investor Relations and joining me today are Mike Kaufmann, our Chief Executive Officer, and Dave Evans, our interim Chief Financial Officer. You can find today’s press release and presentation on the IR Section of our website at ir.cardinalhealth.com. 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. During the discussion today, our comments including an update to our FY 2020 outlook 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. During the Q&A portion of today’s call, we kindly ask that you limit yourself to one question with one follow-up so that we can try and get everyone an opportunity to ask a question. With that, I’ll now turn the call over to Mike.

Good morning, and thanks for joining us. Before we discuss our Q2 performance and our outlook for the year, I would like to reiterate a few things we shared last Thursday regarding voluntary recalls for any level three surgical gowns and certain free source packs containing those affected gowns. The full press release and additional information regarding this issue can be found on our website. First and foremost, we apologize to our customers and their patients. We understand the gravity of this situation and are dedicated to resolving this issue as quickly as possible. Simultaneously, we are doing everything we can to prevent this from happening again. We are engaging third-party experts to conduct a comprehensive review of our quality assurance processes and business practices and we are committed to executing corrective and preventative actions. As we shared last week, related to these recalls, we recorded a $96 million charge in our Q2 GAAP results. This charge represents our best estimate of costs for the recalls, including inventory write-offs, as well as certain remediation and supply disruption costs such as cost to replace recalled products. To provide some clarity, $56 million of this is within cost of products sold and $40 million is within SG&A. This charge and any future adjustments made to it will be excluded from our non-GAAP financial results. On behalf of the entire Cardinal Health leadership team, I would like to thank our employees for their dedication and tireless effort. All of us, myself included, are focused on resolving this issue as quickly as possible for our customers and their patients. I’ll now turn the call over to walk through our Q2 results and updated fiscal 2020 outlook. And then I’ll share some thoughts on our path forward.

Thanks, Mike. I’ll start with an overview of our performance for the second fiscal quarter and then provide an update to our fiscal 2020 guidance. In Q2, we delivered earnings of $1.52 per share, an increase of 18% from the prior year. This result exceeded our expectations and was driven by a combination of operating and non-operating activities which I will elaborate on in the comments to follow. Total company revenue increased 5% versus last year to $39.7 billion and consolidated gross margin increased 2% from last year to $1.8 billion. SG&A increased 3% to $1.1 billion. This increase was driven by higher costs to support sales growth and by fluctuations in deferred compensation liabilities. These items were partially offset by the benefits of enterprise-wide cost savings measures. The net result for the quarter was consolidated operating earnings of $646 million, a 1% increase from the prior year. Moving below operating earnings, interest and other income and expense decreased 48% to $51 million. This was primarily driven by the change in value of deferred compensation plan investments and lower interest expense as we continue to execute our de-leveraging plans. Of note, in the quarter, we paid down more than $700 million of long-term debt and have now paid down nearly $800 million through the first half. Our effective tax rate for the quarter was 25% nearly four percentage points lower than the prior year primarily due to the favorable impact of changes in jurisdictional mix. Average diluted shares outstanding were 294 million, about 6 million fewer than last year. During the quarter, we completed a $350 million accelerated share repurchase program initiated in Q1. We repurchased 7.3 million shares over the first two quarters at an average value of $48 per share. We now have $943 million remaining under our Board authorized share repurchase program. Moving on to cash flow. Operating cash flow for the quarter was approximately $700 million. We ended the quarter with a cash balance of $1.7 billion, which included $788 million held outside the U.S. As a reminder, timing, in particular the day of the week in which the quarter ends affects point-in-time cash flows. Moving on to the segment results starting with Pharma. We were encouraged to see positive momentum across many areas of the segment. Segment revenue increased 6% to $35.7 billion, driven by growth in our Pharmaceutical Distribution and Specialty Solutions divisions. Segment profit increased 4% to $462 million, with our generics program being the largest driver. As a reminder, what we refer to as our generics program includes sourcing, sell-side pricing, volume, and new item launches. For the first time in several quarters, our generics program reverted from a net earnings headwind to a tailwind. At the same time, we continued to see strong growth in our Specialty Solutions business. Brand sales and mix also positively contributed as we manage changing dynamics to capture the value we create through our supply chain. These tailwinds were partially offset by Pharma Distribution customer contract renewals. Transitioning to Medical, revenue for the segment was flat to prior year at $4 billion. Growth in Cardinal Health at-Home was offset by a decline in products and distribution. As a reminder, products and distribution includes both Cardinal Health brand and national brand products. Overall, Cardinal Health brand volumes have lagged our expectations through the first half. While we recognize we still have progress to make, this validates the importance of our commercial initiatives which Mike will discuss in his remarks. Medical segment profit increased 4% to $195 million. This reflects the benefits of ongoing initiatives to improve our cost structure including work to optimize freight and IT relationships. These benefits were partially offset by a decline in products and distribution. Medical segment profits are now up 13% compared to fiscal 2019 on a year-to-date basis. Moving now to our full year outlook. With half the year behind us, we’re raising our full year fiscal 2020 EPS guidance to the range of $5.20 to $5.40 from the prior range of $4.85 to $5.10. I’ll call out a few items contributing to this increase. First, we now have additional clarity regarding external factors we mentioned last quarter that affect the enterprise, including brand inflation, the medical device tax and tariffs. Also based on the sustained improved trends in our generics program, we now expect the Pharma segment to exceed our original expectations for the full year. A few additional items to note in the Pharma segment as we look to the second half of the year. First, from a year-over-year comparison perspective, recall that it was in Q4 of last year when we started to see an improvement in the generic market dynamics which means we’ll be comping more challenging performance in Q4 of this year. Second, we now expect opioid-related legal cost to be in the range of $100 million to $125 million for the year with the majority of the year-over-year increase occurring in the back half of the year. As a reminder, these expenses are recorded in our Pharma segment. Third, on brand inflation: while the January price increases from our contingent vendors fell within the range of our expectations, they continue to be a smaller dollar contribution each year. And in Medical, I’ll remind you of the charge we took in the fourth quarter of fiscal 2019 related to quarters. This will affect our year-over-year growth rates in the second half for the segment. Regarding the rest of our corporate assumptions, we now anticipate FY 2020 interest and other income and expense in the range of $260 million to $280 million. This improvement is largely due to the favorability we’ve seen thus far with our deferred compensation plan investments and the benefits of debt deleveraging that I mentioned earlier. As a reminder, we plan to reduce outstanding long-term debt by at least $1 billion in fiscal 2020. Finally, we expect diluted weighted average shares to be in the range of 293 million to 296 million for the full fiscal year. Given that we are halfway through the year, we’ve decided to narrow this range. Regarding our segment assumptions, we are making one update. With the favorability I discussed, we now expect Pharmaceutical segment profit to decline low single digits. This is a significant improvement from our original expectation of a low double digit decline. With that, let me turn it back over to Mike.

Thanks, Dave. As we look to the remainder of this year and the next few, we will continue to focus on enhancing our established core businesses and on fueling sustained growth in evolving areas including Specialty and at-Home. In Pharma, let me start by saying we continue to be actively involved in ongoing negotiations of the terms for a global settlement and we remain committed to being part of the solution to the opioid epidemic. Overall, we have increased confidence in our work to drive growth across the Pharma segment. Our investments in our generic pricing and analytics capabilities as well as continued strong performance from Red Oak and improving market dynamics are enabling our generics program to now be a tailwind for the year rather than a headwind as we previously expected. Also, our investments in both our Specialty and Connected Care businesses enable us to capture value in the ever changing healthcare landscape. Moving to Medical. I mentioned last quarter that we had multiple initiatives in flight to enhance our commercial approach and streamline our supply chain. Our work in these areas continues. However, with the recent recalls, we are currently deploying our Medical segment teams to meet the most immediate needs of our customers and their patients. While we recognize this will slow momentum in our commercial and supply chain initiatives, we remain confident in the underlying strategies of these work streams, and we are dedicated to their success. We will provide an update on our next call. At the enterprise level, we remain committed to a disciplined capital allocation approach that prioritizes reinvesting in the business, maintaining a strong balance sheet and modestly growing our dividends. Opportunistically, we will continue to explore share repurchases and M&A. Across the company, we continue to prudently manage our cost structure. We’re doing this through focusing our resources, improving our processes, and embracing new technologies that create better visibility and velocity throughout the company. Our goal is to be easier to do business with. As this new mindset takes root, we will continue to see a sustainable behavioral shift and ongoing value creation for years to come. With that, I’ll now pause to open it up for questions.

Thank you. Operator provides instructions. And we’ll take our first question from Glen Santangelo with Guggenheim.

Yes, thanks and good morning. Just a quick question regarding the guidance in the Medical segment. I’m kind of curious, does the recall have any implications for the outlook in the second half of the year? Because if you look through the first six months, your operating profit is already up double digits and Dave, as you sort of alluded to you have that easy comp coming in the fourth quarter from that charge last year. So by maintaining the guidance there, it kind of implies that the operating performance would be pretty weak in the second half. And I’m just kind of curious if I’m looking at that correctly or if there’s anything else there?

Yes, Glen. This is Dave. Good question. So we—as you could see, we collected the direct costs and included those in our charge of $96 million. What we have uncertainty on, and frankly at this very early stage is, implications to the second half in terms of revenue, margin and any disruptions with our customers. So I would say that you’ve read this fairly well and that we’ve reflected some of that uncertainty in the guidance that we’re providing for the second half for Medical.

Okay. And then maybe if I could just ask a quick follow-up to Mike with respect to opioids, I think you were sort of forecasting about $85 million of expenses and now you’ve taken your opioid litigation expenses up to $100 million to $125 million. The framework’s been out there for a few months. It kind of sounds like you’re confident. Why the increased litigation expense now? Hopefully, we’ll be winding the stack. Could you maybe give us an update on the timeline of maybe what we should be expecting from here?

Yes, thanks for the question. We are still dedicated to the framework and progress does continue. So that’s a positive. But as you can imagine, these are incredibly complicated arrangements. We have to work through with 50 different states that we’re working with. And so to get this over the goal line, there is a lot of work that’s going to be done over the next several weeks and months to get that done. And even when it’s agreed to, it’s got to get papered. And then we’ve got to work through implementation of the various components of it. And so when you begin to look at all of those costs and the way they spend, we believe the spend will ramp up. We believe that—you're right—the costs are going to go from $85 million, our original estimate, to $100 million to $125 million with a significant portion ramping up in Q3 and probably a little more in Q4.

We will go to our next question from Robert Jones with Goldman Sachs.

Yes. Thanks for the questions. I guess just to stick with that topic, Mike, because obviously it’s so important to Cardinal and to the group. One of your peers talked about narrowing conversations around a potential opioid settlement. You obviously sound incrementally more positive that this is progressing. Could you maybe just give a little bit more on how many other states, maybe not specifically, but are more states and local governments and municipalities engaging at this point? I think the original framework that we had all seen obviously highlighted just four state AGs and I’m just curious specifically, are you seeing more people coming to the other side of the table?

Yes, thanks again for the question on this important topic. As I said, we remain committed to this framework and we’re very appreciative of the four AGs that took the initial lead on this. They have been working with all 50 states. We continue to get the feedback from those states and look to the various components of the details of the agreement. But it wouldn’t be appropriate for me right now to try to tell you or handicap how many states are in or out. But I will tell you that the four AGs that we talked to continue to make progress and I think we all believe that this is the right thing to do for the companies and for the country to help get some relief to the people that need it, with not only the dollars we’re talking about, which are important, but equally the other components which are distributing the free goods and working with them on programs to improve the overall monitoring of the opioids.

No, I appreciate that, Mike. And I guess just to go back to this generic program dynamic, you highlighted it’s the first time in several quarters it went from a headwind to a tailwind. You guys talked specifically about four components that comprise your generic program. Could you maybe just dive a little deeper into what exactly changed to flip the generics from a headwind to a tailwind in the quarter?

Yes. I think a couple of things. By far this is the item that drove the difference in our expectations for the quarter. As Dave mentioned, pretty much everything else was right there where we expected to be. Maybe a little bit better, but this was the big driver. And it’s really good performance across all of the components. We’re very happy with Red Oak. They continue to perform at a very high level, not only in getting after cost for us, but also just doing an excellent job on service level. We really believe we have industry-leading service levels, and that really helps lead to maintaining and growing our volumes, which is an important part of it. So while volumes were a little lighter than we had expected originally this year, due to the situation with Fred’s that went bankrupt and some other customers that are winding down a few stores, we are still seeing volume growth. And then the other big factor is market dynamics. We’ve seen significant improvement in the overall market dynamics on the pricing side. So when you put all of the components together—and we had a strong quarter on launches—it was really strength across all of the components that made the program overperform.

Yes, just—Mike, you hit it at the end there. I think we did have an earlier-than-expected launch of some new items. That was helpful for the quarter. In addition, we had a fairly favorable mix that helped drive the results we saw in the second quarter.

Next question, please.

We will go next to Ricky Goldwasser with Morgan Stanley.

Yes, hi, good morning, and congrats on a very good quarter. Mike, going back to your comments on market dynamics and just improved pricing, digging a little deeper into that. When we think about the pricing, are you seeing improved pricing on the sell side versus the buy side? And focusing on the buy side, China is an important source of generic API supply. Given what we’re seeing there with the coronavirus, how does that impact supply overall in the marketplace? And what could be the potential implications on potential return to generic inflation? And is any of that in your second half outlook?

Yes. I’ll start with the second half outlook: we are basically taking the trends that we’ve seen for the first half of the year around generics, our overall programs and forecasting those out for the rest of the year. We’re not projecting any specific improvements or inflation beyond what we’ve seen; it’s really about being more confident that what we’re seeing—now that we have roughly eight months of activity versus five last quarter—we feel like we’ve had enough activity to increase our guidance related to that. And that is clearly the biggest item. As far as color on it, it’s hard to focus on just the buy side or just the sell side because they work in tandem; it’s really about driving margin per unit. What we’re seeing is a much better balance between what’s happening on the sell side in terms of the amount of inflation being less than historical, and being able to balance any decreases there with good performance at Red Oak so that we can continue to manage our margin per unit in a way that allows the overall program to grow. And as Dave said, the units and launches helped too. Regarding China API, you can imagine this is something we monitor. Red Oak is in charge of that for us, and they do a great job understanding where raw materials are coming from and where they’re manufactured. There are a decent amount of API manufactured in China and some of the affected areas. Where we have risk, we’ve worked with manufacturers to try to increase supplies ahead of this. I do think it’s something the industry should be able to work through, but it’s hard to say how long it will last, and it’s something we will keep an eye on.

Next question, please.

We will go to our next question from Lisa Gill with JPMorgan.

Hi, thanks very much. Good morning. Mike, you called out Specialty as being a growth area again in the quarter. Can you just remind us the size of that business and the capabilities versus some of your peers? And then as we think about the potential for IPI and potential changes around reimbursement, can you talk about your thoughts on that? And any impact that you could see in your Specialty business?

Thanks for the question. Our Specialty business, the last number we publicly gave for FY 2019 is that we finished around $19 billion in sales. We continue to expect that business to have significant growth this year across all of its areas. It includes sales into downstream providers in the acute space as well as upstream services to manufacturers. We are seeing good momentum across all three areas in that business and continue to feel good about not only their quality of service to customers, but some of the investments we’re making in the business that we’ll be able to talk about more in the future, including a recent investment we’ve made in a partner company that was announced that we believe will also be an area of help in the cell and gene area. We continue to be excited about the specialty area. As it relates to IPI, we’re in favor of anything that can help reduce the cost of healthcare to the U.S. healthcare system. When you think about IPI or any similar programs, the impact to us generally is where it could change list prices—whether manufacturers change list prices or reduce price increases. We have worked to make the part of our margin dependent on inflation less than 5% of our overall margin rate, which helps protect us. We’ve also demonstrated our ability to renegotiate DSAs over time as WAC prices fluctuate, so we feel confident we can manage impacts to list prices effectively. The piece that’s really important to us is the impact to our customers. We look at any legislation through the lens of its effect on customers and patient access, and we want to ensure such legislation doesn’t reduce access or the ability of our customers to provide care.

Thank you.

Thanks, Lisa.

And we’ll go next to George Hill with Deutsche Bank.

Hey, good morning, guys. Thanks for taking the question. I guess, Mike and Dave, I’d ask you a little bit more about the generics program contribution in the quarter. What I’m looking at is you highlighted big generics-related beats this quarter that don’t seem repeatable in the next quarter and the balance of your fiscal year. Could you provide a little more color on the earlier-than-expected launch of the new items that was highlighted and maybe the contribution in the quarter? And maybe some more commentary around what was delivered in the quarter that might seem more one-time versus what might be repeatable on a go-forward basis? Thanks.

George, when we talk about the four elements of the generic dynamic—sourcing, sell-side pricing, volume, and launches—those are continuation trends that we would expect to see in Q3 and Q4. We expect to see year-over-year some healthy improvement in Q3. In Q4 we don’t expect the same year-over-year improvement because Q4 of last year was the first quarter where we began to see the inflection in the deflationary trend, so we have a much tougher comp in Q4. With respect to the accelerated launch of new items, that’s not necessarily a one-time event; it’s just a pull forward of something that was anticipated later in the year. So I think you can expect, which is why we raised our guidance for Pharma, some positive results in Q3 and possibly moderation in the year-over-year comparison in Q4.

Next question.

We’ll take our next question from Elizabeth Anderson with Evercore ISI.

Hi, good morning. If you could talk a little bit more about some of the Specialty profit drivers in the quarter and more broadly—beyond that, is it an increase in services? Is this the launch calendar? Any additional color you can provide on that would be helpful.

In Specialty a lot of this is the normal growth of specialty. We’re continuing to see certain drugs grow in the marketplace because of their success, particularly in oncology, getting new indications and normal growth. That’s a big piece. Part of it is some uptake of biosimilars; they generally act like branded items, and there are some smaller opportunities on the earning side that earn slightly better margins. We’ve seen nice growth in our services business upstream with wins in our 3PL business; our hub and other businesses have continued to grow. So nothing unique like a large one-time movement—just steady, solid growth with volumes across the board.

Thank you. That’s helpful.

Next question, please.

We’ll go next to Stephen Baxter with Wolfe Research.

Hey, thanks for the question. Based on how you sized the relative components of the Pharma guidance coming into the year, it seemed like renewals were driving at least half of the high single digit to low double digit profit decline you were assuming. I assume the renewal impact hasn’t changed, so the revised guidance for the low single digit percent decline would seem to indicate a decent amount of underlying growth excluding the renewals and the opioid expenses, which have now moved higher too. Just wanted to check and see whether you agree with that logic or whether anything has changed about the sizing of the renewals throughout the year? And therefore, whether we should be expecting segment profits to return to growth on a reported basis as we move into next year? Thanks.

Stephen, this is Dave. Your assumptions are pretty spot on. Per usual practice, we’re not in a position to comment on 2021 at this early date. But overall, I think you have a good handle on it.

Next question.

We’ll go next to Erin Wright with Credit Suisse.

Great, thanks. Does your guidance assume any meaningful contribution from biosimilars? Do you continue to view that as sort of an opportunity longer term?

Our guidance assumes normal expectations related to biosimilars, but there were no new launches that created the increase. We continue to think it’s an area to watch. In the short term they act more like branded drugs and margins are similar. There is a little opportunity to make a bit more on some biosimilars depending on customer programs, but I would not call them a large short-term driver. Over the mid- to long-term, particularly if they become interchangeable, they could be a much bigger driver.

Okay, great. And then where are you in terms of the streamlining of your commercial and supply chain initiatives on the medical side of the business? You suggested that maybe you faced a little bit of a setback here in terms of the recent recalls, but would you say you’re still seeing some progress and focus on that front? Also, if you could break out the recent quarter’s trends specifically, that’d be helpful. Thanks.

On Cordis, nothing to report outside of expectations; the business is continuing to grow and perform to our expectations. As far as the initiatives in Medical, we remain committed to both the commercial realignment and supply chain initiatives. There is nothing about the underlying strategies that makes me feel differently than we have been talking about. However, the recalls have slowed execution because we have deployed sales reps and others into the field to help customers manage through this challenge. It’s important we take care of our customers and patients. We have completed the plan for the supply chain by the end of Q2; however, as we look at implementation, we are taking this disruption into account and re-evaluating to ensure the global supply chain is right. On the commercial side, we are on track to hire for the roles, but some people are deployed to help customers right now.

Next question, please.

We’ll go next to Michael Cherny with BofA Securities.

Good morning and thanks for all the details so far. So as you think about the opportunity, you highlighted Specialty as a growth opportunity. How do you think about that against the backdrop of capital deployment? How do you think about areas where your customers are asking for you to do more versus previous capital deployment and M&A opportunities—are there components of the business that make sense to beef up right now?

We feel really good about several strategic growth areas: Specialty, at-Home, Connected Care services, and our medical services businesses. These areas are seeing significant top-line and bottom-line growth and are aligned with care moving toward the home and specialized therapies. We are prioritizing capital expenditures to those areas to focus on organic growth. If M&A opportunities make sense, those are the areas we would focus on. We will continue to support core businesses to maintain and grow them, but extra capital allocation will prioritize those strategic growth areas.

If I can add, we’re focusing more on partnerships than in the past. For internal capital, we think about maintenance capital, cost-out initiatives, capacity for growth, and capital to explore new growth areas. It’s a balanced, disciplined approach to getting a return on our CapEx.

Okay, thanks.

Next question.

We’ll go next to Steven Valiquette with Barclays.

Great, thanks. Good morning everyone. Two quick items on Specialty. First, I was a little surprised about the biosimilar comment because there have been a bunch of biosimilar sales dollars in the physician channel. But that was not really a driver—does that change the price experience with either customers or suppliers and separating specialty pricing from traditional brand pricing? Could that have played a role in some of the better Pharma Distribution segment results?

Thanks. From a pricing standpoint, we’ve been disciplined for several years to split out Specialty pricing so that it is priced differently than normal brand. That allows us to make a fair return on specialty drugs. We’ve continued that discipline with new business and renewals—specific pricing or mix protections in agreements so that if mix goes the wrong way, the cost of goods adjusts. We continue to be very focused in Pharma Distribution. In Specialty there’s very little generics; it’s priced on an individual drug basis and we remain disciplined. I wouldn’t say pricing changes drove our growth in Specialty, but we don’t ignore it. As for biosimilars, when a biosimilar launches you typically replace existing branded volume rather than grow overall volume. It’s an opportunity to influence market preference and that’s where incremental dollars can be made when we work with downstream customers. Over time biosimilars could be a bigger driver, but at this point they are not a significant driver of the current results.

We’ll go to our next question from Charles Rhyee with Cowen & Company.

Hey, it’s James on for Charles. Can you give us a quick update on the cost savings program—how much of the $130 million of incremental savings expected this year has been achieved? Is it tracking in line with expectations? And perhaps how much of that’s been reinvested versus dropping to the bottom line?

James, thanks for the question. We’re making great progress against that program and we’re still on track to achieve the $500 million target as previously communicated. We’re on track to realize the $130 million or more this fiscal year. We’ve got a pipeline of opportunities at various stages of maturation and we’re confident in our ability to attain the entire $500 million. We’re focusing not just on cost out but driving improved value and speed throughout the organization. With respect to reinvestment, we encourage the organization to reinvest in high-return projects. I can’t quantify the exact amount reinvested today, but we’re seeing more opportunities as the culture builds and we expect the program to be a success.

Okay, and just another technical question: in the share count guidance, does that include any additional share repurchase beyond the $350 million from the ASR?

No. James, that assumes that we completed the $350 million ASR, and there will be no further purchases for this fiscal year contemplated in that guidance.

Thanks for the questions. Next question, please.

Our next question comes from Eric Percher with Nephron Research.

Thank you. I’d like to return to the Medical recall. I recognize you’re still working through the potential impact going forward. But could you provide us some context for how surgical gowns and kits fit into Medical broadly—maybe starting with market share, where your customers are turning, and impact on other elements of the business?

I won’t provide market share specifics, but a lot of surgeries in the U.S. use kits. Several companies compete in that space, and we compete very effectively with market-leading quality, service, kit design and pricing. Because gowns are included in many kits, even though this may be a relatively small percentage of total gowns sold in the U.S., because they’re in kits it has a larger operational impact. That’s why the recall has a larger effect than you might expect.

So concerns from hospital purchasers around impact on utilization and impacts on their business. You started with an apology and are taking that head on. What is your take on the ability to remedy this and any impact on the business from what this has done to relationships here?

Any time you have a challenge, the way you respond matters. I’ve been very impressed with how our Medical team—from leadership to distribution centers—have responded, taking accountability and ownership and doing everything possible to help customers. We’ve deployed hundreds of people—Medical, Pharma and Corporate functions—to the field to pack kits and support customers at their locations. Feedback so far from the majority of customers is they understand issues can happen and they appreciate how we’re responding. We don’t know the ultimate effect on our business, and we’re hoping it’s limited, but we recognize we created pain and our top priority is supporting customers and patients. We’re also taking other actions: increasing production of similar or replacement products, offering more protective level 4 gowns to bridge supply gaps, ramping up sourcing from multiple locations, and working with manufacturers of both brand and private-label products to increase supply so surgeries can continue.

Next question please.

We’ll take our next question from Kevin Caliendo with UBS.

Hi, thanks for taking my question. I just want to go back to the opioid comment. I think you called out that it could take weeks or months to get this done. That would run into two pretty high-profile state trials that are scheduled. How does this increase in spending relate to a potentially longer timeline? How should we think about those two state trials in terms of expected spend now versus before?

If those trials do happen, our spending would go up, which is why we provided a range. We intend to vigorously defend ourselves and be prepared for trials. We’re not going to panic or do something that doesn’t make sense. We continue to work with the four AGs and other states to finalize the framework, which is still our goal. The increased spending is more related to finishing negotiations, papering the agreements—which takes legal time—and implementing components like distribution of free goods and changes to monitoring systems. All of that requires legal and implementation costs, which is why you see the range.

If I can ask one quick follow-up on the API issue—Ricky brought it up earlier—you said you thought the supply chain has enough to manage. Can you quantify how much is in the supply chain? If China were to have a six- or eight-week disruption, would you still feel comfortable?

I can’t give that level of quantification. We’ve looked at product-by-product risk and identified products with greater potential supply risk due to raw material sourcing. We’ve worked to ramp up supply and carry a bit of extra inventory in some cases. From what we see today we’re not anticipating problems, but if shutdowns in China last longer or spread, it could create challenges. We’re managing it as best we can.

That’s really helpful. Thanks so much.

Welcome.

And we’ll take our last question from Eric Coldwell with Baird.

Hey thanks. Good morning. So in med-surg distribution, you cited that as both a headwind for revenue and profit. I’m a little surprised. We’ve seen both inpatient and emergency department volumes increasing here for the last several quarters, and it’s been accelerating. We also had an early flu season. What’s going on in core med-surg distribution in the U.S.? What challenges are you seeing now?

I’ll start. We’re not seeing anything that suggests med-surg volumes have dramatically changed. Last year we had lumpiness in the first couple quarters related to the TSAs, which affects comparability. If you look at our first half, we’re roughly up 2%, which seems more in line. We need another quarter or two to get more clarity. The kit and gown recall add challenges we’re working through, but there isn’t a large structural change. We remain confident in our commercial restructuring and supply chain initiatives as multi-quarter value creators, but we must get through these near-term challenges for that to happen.

Right. I know the kit recall didn’t pop up until January, so I was talking about the last couple quarters.

Absolutely.

Eric, I’d reiterate what Mike said: I wouldn’t read too much into a single quarter because of all the transitions last year. Look at the first half versus expectations—the first half is very much in line with our expectations.

All right, so let me close. I’d like to close by saying we remain focused on our customers and their patients, and we will continue to deliver on our strategic priorities. Thanks for your questions and your time today, and we look forward to speaking with each of you soon. Take care.

This concludes today’s call. Thank you for your participation. You may now disconnect.