Cardinal Health, Inc. — Q2 FY2014 Form 10-Q
Reporting period: Quarter and six months ended December 31, 2013. Amounts are in U.S. dollars; financial statement figures are in millions unless stated otherwise.
Business context and results
Cardinal Health provides pharmaceutical and medical products and services through its Pharmaceutical and Medical segments. The quarter’s results reflect the August 31, 2013 expiration of its pharmaceutical distribution contract with Walgreens, as well as growth in Medical and new and existing pharmaceutical customers.
| Metric | Three months ended Dec. 31, 2013 | Year-over-year | Six months ended Dec. 31, 2013 | Year-over-year |
|---|---|---|---|---|
| Revenue | $22,240 | Down 12% | $46,763 | Down 9% |
| Gross margin | $1,345 | Up 10% | $2,608 | Up 9% |
| Operating earnings | $519 | Up 2% | $990 | Up 3% |
| Continuing-operations earnings | $275 | Down 9% | $614 | Up 7% |
| Net earnings | $278 | Down 8% | $617 | Up 7% |
| Diluted EPS | $0.80 | Compared with $0.88 | $1.79 | Compared with $1.67 |
Financial position and cash flow
- Gross margin was approximately 6.0% of revenue for the quarter and 5.6% for the six-month period, versus approximately 4.8% and 4.7%, respectively, a year earlier. Operating margin was approximately 2.3% and 2.1%, versus approximately 2.0% and 1.9%.
- Cash and equivalents were $2.741 billion at December 31, 2013, up from $1.901 billion at June 30, 2013. Six-month operating cash flow was $988 million, compared with $438 million in the prior-year period; the current period benefited from lower working capital associated with Walgreens’ contract expiration.
- Investing cash outflow was $140 million, including $90 million of capital expenditures and $50 million for acquisitions. Financing cash outflow was $8 million, including $208 million of dividends and $50 million of share repurchases.
- Long-term obligations, including current obligations and short-term borrowings, totaled $3.934 billion; cash less these obligations was approximately negative $1.193 billion. Current assets were $17.248 billion and current liabilities were $13.362 billion.
- The company reported no outstanding commercial paper or receivables-facility borrowings and no revolving-credit borrowings other than $42 million of standby letters of credit. It was in compliance with its credit-facility financial covenants.
Material changes and management commentary
- Pharmaceutical revenue fell 15% for the quarter and 11% for six months, primarily due to Walgreens’ contract expiration; the six-month comparison also reflects the earlier expiration of the Express Scripts contract. Medical revenue rose 13% in both periods, benefiting from acquisitions and existing-customer volume.
- Gross margin improved due to acquisitions and margin-rate expansion, including stronger generic programs, branded agreements, and generic price appreciation. Management cautioned that generic price appreciation may not continue.
- AssuraMed acquisition-related expenses increased SG&A and amortization; interest expense also rose, primarily reflecting $1.3 billion of notes issued in connection with that acquisition.
- Management expects Walgreens’ expiration to continue adversely affecting year-over-year revenue and operating-earnings comparisons through the remainder of fiscal 2014 and the first quarter of fiscal 2015. The filing provides no specific earnings guidance.
- In December 2013, Cardinal and CVS agreed to form a 50/50 generic sourcing joint venture, expected to begin operations as soon as July 1, 2014, subject to final documentation and customary closing conditions. Cardinal agreed to pay CVS $25 million quarterly over the arrangement’s 10-year term. The companies also extended their existing distribution contracts through June 2019.
Risks, contingencies, and unusual items
- Quarterly earnings were affected by $56 million of unfavorable tax remeasurement related to proposed assessments, contributing to a 44.1% effective tax rate. Six-month results also included a favorable $67 million settlement of federal and state tax controversies; the six-month effective tax rate was 34.2%.
- The IRS was auditing fiscal years 2006–2010, including transfer-pricing arrangements. Unrecognized tax benefits were $520 million at December 31, 2013; the company estimated a possible net decrease of up to $75 million over the next 12 months, excluding interest and penalties.
- Matters include the DEA/DOJ investigation concerning controlled-substance distribution, a West Virginia action alleging failures related to controlled-substance controls and reporting, and a DOJ investigation concerning a Medical segment federal prime-vendor agreement. The filing says loss ranges cannot be estimated for certain matters at this stage; outcomes could materially affect an individual period.
- A $8 million write-down of Waukegan property was recorded in connection with the Medical segment restructuring. Estimated total pre-tax restructuring costs are approximately $77 million, with about $6 million remaining through fiscal 2014.
- The company identifies failure to implement the CVS sourcing joint venture successfully or realize its benefits as a risk. It states that it had adequate capital resources for anticipated needs and no significant off-balance-sheet arrangements.
Important facts for investors to verify
- How much of future Pharmaceutical segment performance and cash generation is affected by Walgreens’ contract expiration, and whether new-customer growth offsets the loss.
- Whether generic price appreciation and margin expansion persist, given management’s caution about their continuation.
- Implementation progress, economics, and expected benefits of the CVS sourcing joint venture, including the quarterly payment commitment.
- Developments in IRS audits and proposed assessments, and the status and potential financial effects of the controlled-substance and DOJ matters.
- AssuraMed-related amortization, interest costs, and restructuring spending relative to operating earnings and cash flow.