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Edited Transcript of MCK earnings conference call or presentation 18-May-17 9:00pm GMT

Thomson Reuters StreetEvents

Q4 2017 McKesson Corp Earnings Call

SAN FRANCISCO May 25, 2017 (Thomson StreetEvents) -- Edited Transcript of McKesson Corp earnings conference call or presentation Thursday, May 18, 2017 at 9:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Craig Mercer

McKesson Corporation - SVP of IR

* James A. Beer

McKesson Corporation - CFO and EVP

* John H. Hammergren

McKesson Corporation - Chairman, CEO and President

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Conference Call Participants

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* Brian Gil Tanquilut

Jefferies LLC, Research Division - Equity Analyst

* Charles Rhyee

Cowen and Company, LLC, Research Division - MD and Senior Research Analyst

* David M. Larsen

Leerink Partners LLC, Research Division - MD, Healthcare Information Technology and Distribution

* Eric R. Percher

Barclays PLC, Research Division - Senior Analyst

* Garen Sarafian

Citigroup Inc, Research Division - VP and Healthcare Technology and Distribution Analyst

* Lisa Christine Gill

JP Morgan Chase & Co, Research Division - Senior Publishing Analyst

* Michael Aaron Cherny

UBS Investment Bank, Research Division - Executive Director and Healthcare Technology and Distribution Analyst

* Rivka Regina Goldwasser

Morgan Stanley, Research Division - MD

* Robert Patrick Jones

Goldman Sachs Group Inc., Research Division - VP

* Ross Jordan Muken

Evercore ISI, Research Division - Senior MD, Head of Healthcare Services and Technology and Fundamental Research Analyst

* Steven J. James Valiquette

BofA Merrill Lynch, Research Division - MD

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Presentation

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Operator [1]

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Good afternoon, and welcome to the McKesson Corporation Quarterly Earnings Call. (Operator Instructions) Today's call is being recorded. If you have any objections, you may disconnect at this time. I would now like to introduce Mr. Craig Mercer, Senior Vice President, Investor Relations.

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Craig Mercer, McKesson Corporation - SVP of IR [2]

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Thank you, Melissa. Good afternoon, and welcome to the McKesson Fiscal 2017 Fourth Quarter Earnings Call. I'm joined today by John Hammergren, McKesson's Chairman and CEO; and James Beer, McKesson's Executive Vice President and Chief Financial Officer. John will first provide a business update, and then James will review the financial results for the quarter and full year. After James' comments, we will open the call for your questions. We plan to end the call promptly after 1 hour at 6 p.m. Eastern Time.

Before we begin, I remind listeners that during the course of this call, we will make forward-looking statements within the meaning of the federal securities laws. These forward-looking statements involve risks and uncertainties regarding the operations and future results of McKesson. In addition to the company's periodic, current and annual reports filed with the Securities and Exchange Commission, please refer to the text of our press release for a discussion of the risks associated with such forward-looking statements.

Please note that on today's call, we will refer to certain non-GAAP financial measures. In particular, our fiscal 2017 adjusted earnings excludes 4 items: amortization of acquisition-related intangibles; acquisition-related expenses and adjustments, claim and litigation reserve adjustments, and LIFO-related adjustments. Also, James will discuss our operating performance, further adjusting for the impact of net charges associated with the Cost Alignment Plan that we announced in March 2016 as well as the noncash pre-tax goodwill impairment charge we took related to our EIS business within our Technology Solutions segment during the second quarter. For fiscal '16, we excluded the gains on the sales of 2 businesses.

Consistent with how we've discussed our fiscal '17 results in prior earnings calls, which reconciles adjusted earnings to adjusted earnings excluding these unusual items, the supplemental presentation is useful when reviewing the fiscal 2017 versus fiscal 2016 results discussed today. In connection with the issuance of our fiscal 2018 outlook and in consideration of investor feedback, benchmarking relative to peer companies and in line with management's view of our operating performance, we are revising our adjusted earnings definition. The revision will principally exclude gains from anti-trust legal settlements, restructuring charges and other adjustments, including asset impairments and gains or losses on disposal of businesses or assets. We filed a second 8-K with the SEC today, which includes the full text of our revised definition of adjusted earnings as well as a recast of quarterly and full year fiscal 2017 results. This will allow you to compare our fiscal 2018 outlook to our revised adjusted earnings for fiscal 2017.

For reference, Slide 14 of the supplemental presentation provides a visual walk from fiscal 2017 adjusted EPS to adjusted EPS excluding unusual items. Then, it bridges that measure to the fiscal '17 revised adjusted EPS.

We believe the earnings press release, supplemental slides and the recast 8-K, which include -- which all include non-GAAP measures, will provide useful information for investors with regard to the company's underlying operating performance and comparability of financial results period-over-period. Please refer to these materials, which may be found in the Investors section of our company website, for further information and a reconciliation of the non-GAAP performance measures to the GAAP financial results.

Thank you, and here's John Hammergren.

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John H. Hammergren, McKesson Corporation - Chairman, CEO and President [3]

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Thanks, Craig, and thanks, everyone, for joining us on our call. I'm pleased with our fourth quarter results, which are driven by solid execution across both of our Distribution Solutions and Technology Solutions segments. James will cover our annual financial performance in greater detail, but let me provide some color on the year just concluded.

If you recall, as we entered fiscal 2017, we were working had to mitigate headwinds resulting from moderating generics inflation and customer consolidation. During fiscal '17, we implemented a Cost Alignment Plan to achieve improved efficiencies and realize material savings across our enterprise. We announced a new sourcing partnership for generics with Walmart. We entered into a plan with Blackstone to create a new scaled health care technology business, and we announced several acquisitions intended to, among other things, expand our retail footprint and broaden our specialty capabilities. We successfully executed against each of these major initiatives, which were transformative in nature and better position the company for long-term growth. However, we did not anticipate the sizable additional headwinds we experienced around pricing for branded pharmaceuticals and the degree of sell-side price competition for generics, particularly within the independent retail pharmacy channel.

Let me take a moment to provide an update on those 2 topics specifically. First, on branded pricing. Throughout the past year, there has been increased pressure on manufacturers and the pricing decisions they make, which led to lower inflation levels than we had originally assumed in our fiscal 2017 outlook. However, it is important to note that in the fourth quarter, the compensation that we earned from brand pricing changes was largely in line with the expectations that we shared during our last earnings call.

As we entered into a new fiscal year, we've assumed a mid-single-digit rate of brand inflation, less than what we experienced in fiscal 2017. We believe this level of assumed inflation is appropriate given the degree of uncertainty around branded pricing and the reality that we're not involved in setting drug prices.

Switching now to generic pricing. While the rate of price changes in our generic pharmaceutical portfolio has varied from year-to-year, we have historically experienced deflation, which we define as a reduction in our cost of acquiring generic drugs from the manufacturers. For McKesson, there are multiple drivers of generic deflation, which include competition, supply, the maturity of launched products and our sourcing efforts. The rate of deflation is specific to McKesson's generic product mix, customer mix, ongoing negotiations and relationships with manufacturers and our specific fiscal year. We consider it to be unique and proprietary and thus, do not disclose rates of deflation for our generic purchases.

An additional factor impacting generics is the sell price environment. We operate in a competitive marketplace, and the competitive nature of generics is a function of market-based pricing. You'll recall that in the first half of our fiscal year, we saw increased price competition in the independent retail pharmacy channel, which eventually resulted in reduced volumes for McKesson. Over time, we were able to recapture that lost volume and retain our share after adjusting our sell-side pricing. Consistent with our update last quarter, we continue to see a competitive market for selling generic drugs in the U.S. and less pricing variability within this customer segment.

In the end, it was important that we are able to recapture our volume, but it's even more significant to retain and build upon our long-standing relationships we have established with our customer base. This included expanding our Health Mart franchise this past fiscal year, adding hundreds of new stores.

Next, we're pleased with the progress of our -- next, I'd like to discuss our relationship with Walmart. It was a year ago that we announced ClarusONE, our now operational collaborative generic sourcing initiative with Walmart. I'm very encouraged with the remarkable progress we've made in the short amount of time. Walmart is largely realizing these initial benefits from this initiative, and we're now progressing on discussions with manufacturers based on our joint volumes from which we expect to realize and share in additional synergies. We are encouraged by the early success of this initiative, which demonstrates how our sourcing expertise delivers significant value, and we are optimistic that we will identify expanded opportunities to partner with Walmart in the future.

Next, we're pleased with the progress of our multiyear initiative to implement differential pricing for brand, generic, specialty, biosimilar and OTC drug classes in line with the services we provide to both our customers and manufacturer partners in all of these 5 categories. We continue to address these important changes as we have worked through our contract renewal cycles.

Moving on to Change Healthcare. I want to thank the current McKesson teams who worked so diligently to successfully launch this new organization, and I want to also thank our former McKesson employees who recently joined the new company for their ongoing commitment to a thriving health care technology enterprise. This dedicated team of individuals successfully delivered on a challenging fiscal '17 Technology Solutions business plan while simultaneously contributing to the closing of the Change Healthcare transaction. I thank them all and congratulate them on their success.

Before I wrap up, I'd like to take a few moments to discuss McKesson's role in public policy. While policy decisions are being evaluated, McKesson continues to engage as a key stakeholder in educating policymakers, addressing issues that may impact our industry and our business and our customers' business, and helping to drive the necessary change to support access, quality and affordability for a sustainable health care system. We continue to engage in dialogue with policymakers as proposals evolve towards legislation. We remain confident in McKesson's path forward, the critical role of the services we provide to the health care industry today and our ability to identify and apply solutions to address the most pressing challenges to health care systems globally.

In closing, while fiscal 2017 was certainly a tough year and we faced multiple material headwinds that impacted our U.S. Pharmaceutical business, I was encouraged by a number of things during the year. First, despite industry challenges, the underlying operating performance of U.S. Pharmaceutical business was improved through our focus on operational excellence and best-in-class customer service. This business is growing and is well positioned.

Next, absent the material U.K. reimbursement cuts we have previously discussed, Celesio's businesses performed nicely. In addition, we completed multiple acquisitions during the year, which have helped to expand our strong platform for growth.

For Canada, the business grew nicely in fiscal 2017, and we completed the acquisition of Rexall, expanding our retail pharmacy footprint in Canada. And in Medical-Surgical, we delivered another year of solid growth and substantially grew in the lab space, complementing our non-acute service platform.

Overall, we continue to build the competitiveness of our broad portfolio of businesses, which allowed us to mitigate some of the very material industry challenges we encountered during the year at U.S. pharmaceutical.

I'm extremely proud of this management team's ability to adapt and maintain a constant focus on building the strength of our customer and supplier relationships, which will continue to drive growth and long-term value creation for our shareholders.

Last, I'd like to take this opportunity to thank our employees for their dedication, leadership and consistent focus on putting our customers' success at the forefront of everything we do.

With that, I'll turn the call over to James, and will return to address your questions when he finishes. James?

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James A. Beer, McKesson Corporation - CFO and EVP [4]

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Thank you, John, and good afternoon, everyone. As John discussed earlier, we are pleased by our strong results in the fourth quarter. Adjusted EPS, excluding unusual items, was $3.42 per diluted share, which gives us a solid momentum heading into fiscal 2018. I also want to highlight our record operating cash flow in fiscal '17, which allowed us to return more than $2.5 billion in cash to our shareholders during the past year.

Today, I will review our fiscal 2017 results and introduce our fiscal 2018 guidance range. Before I discuss our fiscal 2018 outlook, I will spend some time walking you through the changes to our definition of adjusted earnings.

Now let's move to our fiscal 2017 results. As I have a lot of information to cover today and we want to provide ample time for Q&A following my remarks, I will primarily focus on our full year fiscal 2017 results. First, our consolidated results. As a reminder, the fourth quarter and full year revenue and operating results of MTS were impacted by the creation of the Change Healthcare joint venture as announced on March 2, to which McKesson contributed the majority of its MTS businesses. McKesson will account for its equity share of Change Healthcare's earnings on a 1-month lag. Therefore, for the month of March, McKesson's consolidated income statement contained neither the results of the MTS contributed businesses nor any equity earnings from the new company.

Consolidated revenues for the full year increased 5% in constant currency versus the prior period primarily driven by market growth and acquisitions. Full year adjusted gross profit, excluding unusual items, was down 2% in constant currency year-over-year, driven by increased competitive pricing in our independent pharmacy business and weaker pharmaceutical manufacturer pricing trends, partially offset by contributions from acquisitions closed in fiscal 2017, anti-trust legal settlements, greater global procurement benefits and organic growth.

Full year adjusted operating expenses, excluding unusual items, increased 2% in constant currency driven by acquisitions closed in fiscal 2017, partially offset by savings from the Cost Alignment Plan and ongoing cost management efforts.

Adjusted other income was $101 million for the year, an increase of 63% in constant currency, driven primarily by our equity investment in Brocacef, a pharmacy operator in the Netherlands.

Interest expense of $308 million decreased 13% in constant currency for the year, consistent with our expectations.

Now moving to taxes. Our adjusted tax rate, excluding Cost Alignment Plan charges and the impact of the EIS goodwill impairment charge taken in the second quarter, was 22.6% for the year, driven by the beneficial impact of the onshoring of our MTS intellectual property in the third quarter, our mix of income and discrete tax benefits.

Our income attributable to noncontrolling interests or NCI was $83 million for the year, an increase of 60% in constant currency. The increase in NCI was primarily driven by ClarusONE, the joint sourcing entity that we have created with Walmart, and the acquisition of Vantage Oncology. Our adjusted net income from continuing operations, excluding unusual items, totaled $2.9 billion.

Our full year adjusted EPS was $11.61 per diluted share. Our adjusted EPS, excluding unusual items, was $12.91 per diluted share as during the year, we recorded a $0.04 charge related to the Cost Alignment Plan, and in the second quarter, we recorded a noncash pretax goodwill impairment charge of $1.26 related to our EIS business.

Wrapping up our consolidated results. During the fourth quarter, we completed share repurchases of common stock totaling $250 million, bringing our total share repurchases in fiscal 2017 to $2.3 billion. As a result of share repurchase activity, particularly in late fiscal 2016 and during fiscal 2017, our full year diluted weighted average shares outstanding decreased by 4% year-over-year to 223 million.

Let's now turn to the segment results. Distribution Solutions segment constant-currency revenues of $197.1 billion were up 5% year-over-year. North America pharmaceutical distribution and services revenues increased 4% in constant currency, driven by market growth and acquisitions, partially offset by brand-to-generic conversions. International pharmaceutical distribution and services revenues were $26 billion for the year on a constant-currency basis, up 11%, driven by acquisitions and market growth. Revenues were impacted by approximately $1.2 billion in unfavorable currency rate movements.

Moving now to the Medical-Surgical business. Revenues were up 3% for the year, driven by market growth and an acquisition. Distribution Solutions adjusted gross profit, excluding unusual items, was down 2% on a constant-currency basis for the year, driven by competition in our independent pharmacy business and weaker pharmaceutical manufacturer pricing, partially offset by contributions from acquisitions closed in fiscal 2017, anti-trust legal settlements, greater global procurement benefits and organic growth.

Distribution Solutions segment adjusted operating expenses, excluding unusual items, increased 6% on a constant-currency basis for the year. Segment operating expenses reflect an increase related to recently completed acquisitions, partially offset by savings from the Cost Alignment Plan and ongoing cost-reduction actions. When removing the impact of acquisitions, adjusted operating expenses, excluding unusual items, decreased year-over-year.

Distribution Solutions segment adjusted operating profit, excluding unusual items, was down 11% in constant currency year-over-year at $3.9 billion. The segment adjusted operating margin rate, excluding unusual items, was 200 basis points on a constant currency basis, a decrease of 35 basis points, driven by the same factors as previously discussed.

Now moving to Technology Solutions. As a reminder, our MTS segment for fiscal '17 reflects only 11 months of results for those businesses that were contributed to Change Healthcare. Revenues decreased 9% for the year to $2.6 billion on a constant-currency basis. Adjusted segment gross profit, excluding unusual items, was down 5% on a constant-currency basis. Adjusted segment operating expenses, excluding unusual items, decreased 11% in constant currency from the prior year.

Despite realizing only 11 months of results from the contributed MTS businesses, adjusted segment operating profit, excluding unusual items, increased 4% in constant currency, resulting in an adjusted operating margin rate of 22.33%, up 295 basis points versus the prior year. We are very pleased with the performance of the Technology Solutions segment in fiscal 2017 as the team worked simultaneously to execute their business plans and close the Change Healthcare transaction.

I'll now review our balance sheet metrics. As you've heard me discuss before, each of our working capital metrics can be significantly impacted by timing, including which day of the week marks the close of a given quarter. For receivables, our days sales outstanding decreased 1 day to 27 days. Our days sales in inventory decreased 2 days from the prior year to 30 days. And our days sales in payables increased 2 days from the prior year to 61 days.

We ended the quarter with a cash balance of $2.8 billion with approximately $2.3 billion held offshore. For the year, McKesson paid $4.2 billion for acquisitions, repaid approximately $1.6 billion in long-term debt, spent $562 million on internal capital investments and paid $253 million in dividends. In addition, McKesson repurchased approximately $2.3 billion in common stock in fiscal 2017, and we now have $2.7 billion remaining on our share repurchase authorization.

In fiscal '17, McKesson generated $4.7 billion in cash flow from operations, inclusive of the $256 million in cash outflows related to the Cost Alignment Plan and our settlement with the DEA and DOJ. The year-over-year growth of approximately 29% was primarily driven by several working capital initiatives across our U.S. businesses and lower cash taxes.

To wrap up my fiscal 2017 comments. While McKesson faced significant challenges during the year, I am pleased with how we were able to manage through adversity, drive strong cash flow and end the year in a solid financial position.

Now before I get to our fiscal 2018 outlook, let me take a moment to discuss the revision to our definition of adjusted earnings. After careful consideration, we have made the decision to revise our definition of adjusted earnings effective with our fiscal '18 outlook. We believe this revision will allow us to provide better clarity on our underlying operating performance as it closely aligns with both how we internally manage the enterprise and the definition used by others in our industry.

Let me walk you through the changes at a high level. First, the revised definition retains the amortization of acquisition-related intangibles, LIFO inventory-related charges or credits and acquisition-related expenses and adjustments, although this category has been expanded to include certain fair value adjustments.

An example of a fair value adjustment is the expected non-cash deferred revenue haircut in fiscal '18 resulting from the Change Healthcare transaction.

Second, the revised definition will now adjust for gains from anti-trust legal settlements, restructuring charges and other adjustments, which will include impairments, gains or losses on the disposal of businesses or assets and the former stand-alone category of claim and litigation charges or credits.

The restructuring charges that will be excluded are represented by programs such as the Cost Alignment Plan or other restructuring programs that are considered significant. And the other adjustments category will exclude items such as the EIS goodwill impairment charge we took in the second quarter and gains from sales of businesses such as the 2 businesses we sold in fiscal 2016.

Again, these adjustments are intended to provide investors a better view of the underlying operating performance of McKesson. I encourage you to review the second 8-K that we filed today for the full description of each item included in our revised adjusted earnings definition as well as the recast of our fiscal 2017 results utilizing this revised definition of adjusted earnings.

Before I wrap up my comments on adjusted earnings, I want to confirm that, as you would expect, we will continue to provide all the GAAP information that we have historically provided, including the reconciliation of our adjusted earnings to our GAAP earnings.

Now let me provide you with the details of our fiscal 2017 results on this revised basis in order for you to derive the year-over-year performance we expect in fiscal 2018. Then, I will provide details on our fiscal 2018 outlook.

I will point you to Slide 14 of the supplemental presentation as it provides a fiscal 2017 EPS walk that includes a reconciliation from adjusted earnings, excluding unusual items of $12.91 per diluted share, to our revised adjusted earnings. From the $12.91 per diluted share, we will now exclude the benefit of $144 million or $0.39 per diluted share in anti-trust settlements recorded in fiscal 2017 and $15 million or $0.04 per diluted share in gains on asset dispositions. We will also exclude 2 headwinds: first, $10 million or $0.03 per diluted share in fair value adjustments; and second, $10 million or $0.03 per diluted share in restructuring charges. These adjustments result in revised adjusted earnings of $12.54 per diluted share for fiscal '17.

Now turning to our fiscal 2018 outlook. In fiscal 2018, McKesson expects adjusted earnings per diluted share of $11.75 to $12.45. This guidance range reflects a decrease of 6% to approximately flat adjusted earnings year-over-year. To be clear, the fiscal 2018 outlook excludes the negative impact of the noncash deferred revenue haircut from the Change Healthcare transaction, which is now expected to be approximately $200 million, as it will be excluded from adjusted earnings based on our revised definition.

In lieu of outlining each of the assumptions underpinning our fiscal 2018 outlook, I will refer you to the list of the key assumptions included in the press release we issued today. Instead, I will walk you through the key items included in our outlook.

First, I'll start with the overall market environment. We expect Distribution Solutions revenues, which are primarily derived from North America, to grow in the mid-single digits year-over-year, driven by market growth and recent acquisitions. In the U.S. market, branded pharmaceutical manufacturer prices are assumed to increase by a mid-single-digit percentage in fiscal 2018. This is a more conservative assumption than the result from fiscal '17. As we do not make these pricing decisions and because there may be variability in the timing, frequency and magnitude of pricing actions taken by manufacturers, we believe our assumption of mid-single-digit price increases is prudent.

On the generics side, we expect a nominal contribution from generic pharmaceuticals that increase in price in fiscal 2018, consistent with what we experienced in fiscal '17. We also expect the profit contribution from the launch of new oral generic pharmaceuticals in the U.S. market to be nominal year-over-year.

As John mentioned, our overall basket of generic pharmaceuticals generally declines in price over time, reflecting competition, supply, the maturity of launched products and our sourcing efforts. And for the sell-side pricing environment, we see the marketplace as competitive but with less pricing variability, consistent with our remarks on our last earnings call in January.

Moving on to Rite Aid. As mentioned in our press release, our guidance range assumes a full year revenue contribution from Rite Aid of approximately $13 billion and an estimated annual adjusted earnings per share contribution of between $0.20 and $0.40. Given our understanding of where things stand today with the pending merger agreement, we feel confident that we would not see volumes transition in this calendar year. If Rite Aid's volume were to transition in early calendar 2018, this would only have a small impact on our FY '18 adjusted earnings per diluted share, although we would expect a material onetime transition impact to our cash flow driven by the mix of our business with Rite Aid. It is worth noting that our ongoing domestic and international sourcing scale is such that the potential loss of Rite Aid's volume would not meaningfully alter our sourcing economics with manufacturers.

Now let's move to our expanded sourcing agreement with Walmart and the mechanics of ClarusONE. We announced our joint sourcing relationship with Walmart in May 2016. Since that announcement, McKesson and Walmart have worked to build out the new sourcing organization, ClarusONE. This new organization first focused on harmonizing pricing across our respective sourcing arrangements. This was completed late in fiscal 2017.

Walmart is largely realizing the benefits from this initiative, and we are now progressing on discussions with manufacturers based on our joint volumes from which we expect to share additional synergies. That being said, because McKesson has control of ClarusONE, we consolidate the results of the entity. You will see the full results of ClarusONE in our consolidated P&L, including revenue, gross profit, operating expense and operating profit. We then remove Walmart's portion of ClarusONE's earnings via the noncontrolling interest line, which appears below net income in our P&L.

However, it is important to note that the economics from ClarusONE included in the NCI line represent only a portion of the overall value of the expanded relationship with Walmart as the majority of the joint sourcing value is realized in the cost of goods sold line. This COGS value is directly recognized in the accounts of McKesson and Walmart and is not a part of the ClarusONE accounts.

The noncontrolling interest line now removes 3 items from our net income: Walmart's share of ClarusONE's earnings, the Celesio dividend and partner income associated with other smaller non-wholly owned subsidiaries. We expect our income from noncontrolling interests to increase approximately 200% from fiscal 2017.

Now moving to our International segment. We expect percentage revenue growth in the mid-single digits on a constant-currency basis. In addition, we expect the International business to be impacted by additional U.K. reimbursement cuts, although, at present, the announced incremental cuts that will impact fiscal 2018 are materially smaller than what we experienced in fiscal '17. We will keep you up to date on this as the year unfolds.

Based on the assumptions outlined, we expect our Distribution Solutions adjusted operating margin to be between 198 and 208 basis points. The way to think about our fiscal 2018 adjusted operating margin is that our adjusted operating profit will benefit from our organic growth, the impact of FY '17 acquisitions and the profits of our joint venture partners, such as Walmart in the case of ClarusONE, which are consolidated in our results in accordance with GAAP. The margin rate is further aided by our revised definition of adjusted earnings and the inclusion of RelayHealth Pharmacy. Partially offsetting these positive items, our margin rate will be impacted by our growing mix of higher-priced specialty pharmaceuticals, assumed weaker pharmaceutical manufacturer pricing trends and the lapping effect of increased competitive sell-side pricing.

Moving now to McKesson's equity investment in Change Healthcare and other MTS considerations. We expect the adjusted equity earnings contribution from Change Healthcare to be between $370 million and $430 million, which reflects our 70% ownership. To be clear, we are assuming that our equity interest in Change Healthcare will not be diluted by the impact of a potential IPO.

The MTS segment also reflects the contribution from our EIS business, which is expected to generate full year revenues of between approximately $450 million and $500 million as an adjusted operating margin rate in the single-digit range. We continue to make progress on reviewing the strategic alternatives for this business.

Now moving to corporate expenses, taxes and our share count. Corporate expenses are expected to be between approximately $435 million and $465 million in fiscal 2018, primarily driven by our technology investments and incentive compensation programs being reset to target expectations. The guidance range assumes a full year adjusted tax rate of approximately 27%, which may vary from quarter-to-quarter. This rate is reflective of the ongoing beneficial impact of an intercompany sale of software in the third quarter of fiscal 2017, our mix of business and the impact of minority interest earnings that are included in profit before tax but are not taxable to McKesson.

We expect the weighted average diluted shares for fiscal 2018 to be 213 million, which reflects the impact of share repurchase activity completed in fiscal 2017. In addition, we expect a negative foreign currency impact of up to $0.05 in fiscal 2018.

Switching to cash flow. Our operating cash flow is expected to decline by approximately 10% relative to the prior year. This decline is primarily driven by the loss of the majority of MTS' cash flow following the creation of Change Healthcare as well as very strong cash generation at the end of fiscal 2017.

And last, as you think about the quarterly progression of our results in fiscal '18, we expect our results to be weighted to the second half of the year, primarily driven by the anticipated strength of fourth quarter results given the seasonality of branded manufacturer pharmaceutical price increases. And for the first half of fiscal '18, we expect the second quarter will be stronger than the first quarter.

Thank you, and with that, I will turn the call over to the operator for your questions. (Operator Instructions) Melissa?

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Questions and Answers

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Operator [1]

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(Operator Instructions) And we'll first take our question from Eric Percher with Barclays.

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Eric R. Percher, Barclays PLC, Research Division - Senior Analyst [2]

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I'd like to go back to, John, your comment on differential pricing, and I don't think that was called out as one of the elements impacting the MTS profit. I know there are quite a few puts and takes there. But has it been a material factor? And could you give us some detail on what you're trying to do both upstream with the manufacturer and downstream with your customers?

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John H. Hammergren, McKesson Corporation - Chairman, CEO and President [3]

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Yes. I do think it is certainly an important factor. I'll leave the materiality to the accountants. But it certainly is an important part of our businesses as we look at it, and we've made significant progress in our conversations with both our manufacturing partners as well as our end-user customer partners. So we're excited about the progress. I think people understand that the cost of handling certain of these items is different than having them all blended together. And certainly, the services we provide are different and the economics associated with handling the products is different. And we're pleased with the progress. We have more work to do. As you know, we're -- we do this systematically as our contracts are revised, but I feel good about the progress, Eric.

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Eric R. Percher, Barclays PLC, Research Division - Senior Analyst [4]

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Is the key driving services that are unique? Or is it segmenting fees and charging separately for what you're providing?

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John H. Hammergren, McKesson Corporation - Chairman, CEO and President [5]

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It's probably a combination of both. Clearly, to the extent that our previous discounting didn't reflect the true cost of handling the products, that needed to be modified. And to the extent that customers or manufacturers are asking us to perform new or different services, we've taken that on as well. So I think it's in both dimensions. I don't think, in the past, with the way we used to price our contracts, we segmented enough, and as obviously, these other categories begin to grow, it's important that we price them in a more discrete fashion and that's what we've attempted to do.

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Operator [6]

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We'll next go to Lisa Gill with JP Morgan.

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Lisa Christine Gill, JP Morgan Chase & Co, Research Division - Senior Publishing Analyst [7]

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John, I just want to go back to some of your comments on ClarusONE and just really understand where you are with the manufacturers. Obviously, today, we saw WBAD sign with Express Scripts, and increase the size of their procurement entity. Is there any pushback around the manufacturers in the anticipation of potentially losing Rite Aid to WBAD? I mean, how do we think about the contracting from that perspective?

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John H. Hammergren, McKesson Corporation - Chairman, CEO and President [8]

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I think James, in his prepared remarks, made a specific comment related to Express, and we don't see any impact related to the potential loss of our Rite Aid business and -- excuse me, he made a comment about Rite Aid, not about Express, let me be clear. And I don't think that when you get to a certain scale and a certain amount of materiality with the manufacturers, I don't think there's much of a difference in the way that the manufacturers behave with any of us. And so I have said this before, I believe we're extremely well positioned. I think our contracts are very competitive. I think Walmart has benefited significantly from the relationship. And as to where we stand in it, the normalization of the agreements between McKesson and Walmart and our respective partners help drive a lot of very quick incremental, I think, value to Walmart. And I believe that this next phase, as we complete our negotiations and contracting with the manufacturers, we're already beginning to see a reflection of the combined value of us putting our businesses together and committing to these partners for a long period of time. Clearly, we have the ability because our customers tell us what -- whether our pricing in the marketplace is competitive or not, and with that customer feedback, we're constantly adjusting our perspective on what price is a fair price to sell at and what a price -- what a fair price to buy at is. And through that intelligence, we're -- I think, we remain very confident that our scale and our purchasing is doing the job it needs to do.

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Operator [9]

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

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Rivka Regina Goldwasser, Morgan Stanley, Research Division - MD [10]

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So one question that I have, John, obviously, 2017 was a challenging year, but here we are, and you made some changes to how you revised the definition of adjusted earnings. You moved some business to distribution. If we think about the operating margin guidance, the 198 to 208 [-- to 2.8], is this a new base that you feel that you can expand margins from? And along the same lines, you talked about mid-single growth rate for distribution for the revenue line. How should we think about the growth algorithm for the operating income? Should we think about mid-single digits as well? If you can just give more color on that.

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John H. Hammergren, McKesson Corporation - Chairman, CEO and President [11]

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Well, I'll have James jump in here in just a moment. I think the principal drivers of our challenge in the previous year was the brand price inflation came in obviously below where we expected it to be and then the very significant issue related to generic pricing that took the sell side of generics in the marketplace. And I think that we would expect that we will get op margin growth going forward. And so obviously, we always think that. And we -- and last year, we had a surprise -- or a couple of surprises, but this year, you can see that we really don't have built into our guidance inflation on the generic side beyond nominal and the branded inflation we've guided, I think, to a responsible range. And the underlying operations of our business continue to perform very well, and the generic pricing challenges we faced last year in the independent segment, as we've commented in the past, have been somewhat transitory in their nature. And we certainly -- we have to continue to be competitive in the marketplace, but those kinds of dislocations don't happen on a frequent basis. So having said all of that, our expectation is that our margins will expand from here.

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James A. Beer, McKesson Corporation - CFO and EVP [12]

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Yes. And in terms of the Distribution Solutions operating profit, there are a few items to think through there. First of all, obviously, as we're going to benefit from the acquisitions that we entered into in fiscal '17, then we have these lapping effects of last year's headwinds, both the brand manufacturer price increase situation as well as on the generic side, the sell-side environment, particularly through to independent pharmacies. But setting those headwinds aside, I'm pleased to see U.S. pharma getting back to operating profit growth. And then you add to that the ongoing operating profit growth of our remainder portfolio of businesses, which, as you know, is quite diverse.

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Operator [13]

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We'll go next to Robert Jones with Goldman Sachs.

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Robert Patrick Jones, Goldman Sachs Group Inc., Research Division - VP [14]

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Just to go back and follow up on the Distribution Solutions operating margin. If I look back in the guidance you guys provided, I mean, if I think back to October when you guys lowered guidance on competitive pressures and in the moderating inflation and I look about that in the back half of '17, it seems like the negative impact from those changes would have certainly had your operating margins for fiscal '18 pointing to something down year-over-year, and yet, here you are giving very encouraging operating margin guidance. So other than something like ClarusONE being an incremental positive year-over-year, did anything change in your underlying assumptions as far as those 2 specific pressure points that you talked about last year, competitive pressure and moderating inflation? And I guess, you -- one just kind of follow-on to that. I know you don't guide to gross profit within Distribution Solutions. But would we anticipate, John, that gross profit would also be growing specifically in North American distribution?

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John H. Hammergren, McKesson Corporation - Chairman, CEO and President [15]

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Yes, we certainly would expect gross profit in North American distribution to grow, and I would say further that we made significant progress in the operations of our company last year. And to James' point, that progress was largely overshadowed by the significant headwinds that we faced as we went into the back half of last year and obviously coming to this year, we'll be facing the remainder of those headwinds. But if you actually look under the covers, the rest of our company's performing quite well, and I'm pleased with the fact that we can continue to show progress in our business. Clearly, some of the changes that James mentioned in terms of the definition of adjusted earnings make our operating performance more clear, and we've tried to recast last year's and this year's so you can see how they would have compared. But, James, jump in here if there's some other color you'd like to provide.

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James A. Beer, McKesson Corporation - CFO and EVP [16]

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Yes. I was just going to particularly emphasize 2 things, that change in the definition of adjusted earnings and in the second 8-K, we have broken out the FY '17 data in line with that new definition. So you'll be able to see the year-over-year type effects there. And then also, just to reemphasize that, because of the way the accounting works, remember that profits of our joint venture partners, such as Walmart's profit as a part of ClarusONE, that actually gets counted in our operating profit line and therefore, benefits our operating margin rate. Lower down at the bottom of the P&L, we have to extract that out in terms of the noncontrolling interest. So there's a complexity there, and that's very much how GAAP requires us to do things. And again, in the 8-K, we've tried to break out in the last of the schedules that we have there both the operating margin on a gross basis, if you will, then also net of that NCI effect. So there are a few steps to move through there, but hopefully, we've been able to lay things out such that you can sort through that.

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Operator [17]

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We'll next go to Steven Valiquette with Bank of America Merrill Lynch.

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Steven J. James Valiquette, BofA Merrill Lynch, Research Division - MD [18]

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Just regarding the Rite Aid EPS contribution of $0.20 to $0.40 for fiscal '18 if I heard that right, I think most of us would have assumed that EPS run rate maybe could have been -- or would have been a little bit higher than that at $13 billion of revenues. So I guess, if we compare that number for FY '18 to Rite Aid contribution over the past couple of years, has it been in that same range? Or has it come down perhaps for various reasons?

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John H. Hammergren, McKesson Corporation - Chairman, CEO and President [19]

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Well, I think it's probably fair to say that when our margins dropped across the company, and particularly in the U.S. Pharmaceutical business, I should narrow the focus on U.S. Pharmaceutical as a result of the phenomenons we've been talking about, that same kind of degradation in the performance of every one of our -- probably every one of our customers in the U.S. Pharmaceutical business was affected. It just becomes a question of mix. And so it's fair to say that most of our customers in U.S. pharma are less profitable today than they were a couple of years ago, and you've seen it in our overall margin rate in that business.

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James A. Beer, McKesson Corporation - CFO and EVP [20]

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Yes. And you're correct. It was $0.20 to $0.40 of contribution from Rite Aid for the full year.

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Operator [21]

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We'll next go to Garen Sarafian with Citigroup.

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Garen Sarafian, Citigroup Inc, Research Division - VP and Healthcare Technology and Distribution Analyst [22]

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So going to your generic assumptions, setting aside the downstream pressures from this past year that's now less variable, have you changed the underlying assumptions in any way that nets out to nominal contributions for fiscal '18? And maybe related to that, since we're talking qualitatively and not quantifying, does the low end of guidance capture worse-than-expected trends in generics so that if there were, say, no contributions from generics increasing in price or maybe the overall generics basket deflating more than your base case, would you still be in this year's EPS range?

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James A. Beer, McKesson Corporation - CFO and EVP [23]

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Well, on the generics guide, we talked about a nominal contribution, an economic contribution from generics increase in price, so very much the same guide that we offered this time last year; and then also similarly, a nominal economic contribution from brand to generic conversions that we expect to see in fiscal '18. Now as to the range of the guide, that's always going to be driven by a mix of all of the variables that we've been talking about and have laid out in the press release. So I wouldn't want to particularly sort of center up on one. But clearly, that word nominal for both generic price inflation and generic conversions, I think appropriately sets out very modest expectations there.

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John H. Hammergren, McKesson Corporation - Chairman, CEO and President [24]

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And I would follow on to the last part of question related to generic deflation. We've talked about it in the past as not having much of an effect on our business and part of our normal operating model when you think about the overall way we manage our generic portfolio and the fact that we've had deflation historically on a basket basis for a long time. And the deflation on our purchase of generics doesn't necessarily translate into a deflation on the way we sell our market generics, and so the 2 are distinct. And the challenge we faced last year was not the rate of deflation on what we paid for generics. The issue we faced last year was an acceleration in the normally competitive market on generics to become even more competitive on the sell side, and that's what we faced in the back half of last year that we tried to discuss on previous calls. And to be clear, we don't anticipate that level of price erosion on the sell side of our generic portfolio going back to what we experienced in the last half of last year. We expect it to continue to be competitive but not as volatile as we experienced.

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Operator [25]

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

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Ross Jordan Muken, Evercore ISI, Research Division - Senior MD, Head of Healthcare Services and Technology and Fundamental Research Analyst [26]

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Today, a 2-part question. So probably the most common thing in my inbox is sort of trying to tease out the comparability of the updated guidance with sort of what was expected versus The Street. I'm not going to ask you to comment on The Street estimates. But if you can, James, maybe just help us think through the few components that most materially changed and just maybe repeat it in terms of the prior year as we think relative to the updated guidance, would be helpful. And secondarily, a few of the assumptions you had talked about prior, like the deferred revenue piece, is there anything else aside from that, that changed materially that you had communicated before? And then if you could help us just sort of figure out what's the most sensitive point here. I mean, there's clearly a ton of assumptions. And so when you think about which one you probably have not the least confidence in but maybe has the widest interval of outcome, what would you sort of point to, 1 or 2 things, that maybe could be a little bit causing upper end or lower end of the range more so than others?

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James A. Beer, McKesson Corporation - CFO and EVP [27]

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Well, obviously, there are a few moving parts here in the guide. But as I think about some of the bigger economic drivers that would perhaps be a little different to perhaps some of the expectations out there, I'd point to our assumption around mid-single digits for branded manufacturer price increase. Yes, that is a lower assumption than that that we experienced in fiscal '17, but we think that's the prudent thing to do for the reasons we talked about in the prepared remarks. Think about the contribution from Rite Aid that we've been quite clear on. The change in the adjusted earnings definition, there's a material impact there because up until today, we've been talking about that deferred revenue haircut that would impact the Change Healthcare income. And so now we don't have to deal with that in adjusted earnings. And then the other thing I would say is our tax rate is probably, at 27%, lower than perhaps some expectations because we've got a variety of drivers there that we're continuing to benefit from as we look forward into fiscal '18. So in terms of the variability, well, we'll obviously see what the branded manufacturers actually do during the year. And one of the other important assumptions we've made is around the lapping effect on the generics sell side, the lapping effect of what happened in the independent space last year. As John has been indicating, we're seeing less volatility there. Obviously, that's a helpful situation. We'll see how things play out in that part of the marketplace.

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Operator [28]

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We'll next go to Michael Cherny with UBS.

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Michael Aaron Cherny, UBS Investment Bank, Research Division - Executive Director and Healthcare Technology and Distribution Analyst [29]

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I know you provided a lot of details, particularly around the change in the non-GAAP adjustments, but I wanted to just make sure everything's level set again on that front. Just, there are a lot of moving pieces. In terms of the change specifically related to the deferred revenue adjustment, I know a lot of companies that in the tax base have done this in the past. Is this just the way you guys are recognizing it going to be a onetime adjustment and then you'll go back to normalized margins for the Change business? Or is this going to be now part of the base as you kick forward in terms of thinking of how that's going to continue to flow through into your P&L given the 70% ownership structure?

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James A. Beer, McKesson Corporation - CFO and EVP [30]

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So in essence, we will not take that onetime decline in what would flow off the balance sheet into revenue. So we will not be impacted by what we now quantify as a $200 million deferred revenue haircut effect. Obviously, that's a part of the GAAP books, but that will not be showing up in our adjusted earnings.

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John H. Hammergren, McKesson Corporation - Chairman, CEO and President [31]

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And that's related to the transaction of McKesson and Change Healthcare. It's not a comment on Change Healthcare's treatment of deferred revenue.

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Operator [32]

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We'll next go to David Larsen with Leerink.

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David M. Larsen, Leerink Partners LLC, Research Division - MD, Healthcare Information Technology and Distribution [33]

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Can you please just clarify, on the buy side for generics, are you seeing an inflationary environment or a deflationary environment? And then can you also comment on the hospital market? Like, Cardinal has developed a lot of new capabilities, especially on the medical side. Are you seeing any sort of more aggressive competition within the facility space or not?

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John H. Hammergren, McKesson Corporation - Chairman, CEO and President [34]

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Well, we -- I think in a previous comment, I talked about generic deflation and how we believe it will continue and has for a long time. We don't really comment on the rate of deflation because it's not a big factor that plays into the way our economics or our P&L operates. Deflation is typically not an issue that we have to guide on or that we miss or make on. It's something just part of our business model, and we attempt to manage it. And this is the deflation as it relates to what we buy at. We don't necessarily comment on what we price the product at unless there's some kind of unusual circumstance like we faced last year when we talked about generic price erosion in the marketplace. That's a sell-side comment, not what we buy the product for. The second part of your question was related to the hospital market, and we certainly have competed in the hospital market for a long time. We used to be in the medical supply business in hospitals and frankly, found it difficult to compete with the likes of Cardinal in the hospital market. But as it relates to the business that we retain in the hospital business, it's really in 2 categories. One is in the physician office part of medical supply offices in the hospital segment, where they own the doctors and ask for us to provide shipment to the smaller physician office facilities and practices that they own. We're very strong there and continue to be strong. And clearly, in the pharmacy business of hospitals, we have a very strong value proposition and remain very strong there. And I never take competition lightly, but I don't believe the continued investment that Cardinal's making in the medical-surgical business necessarily will correlate to some change in competitive dynamics on the pharmacy side. But that's yet to be seen.

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Operator [35]

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We'll next go to Brian Tanquilut with Jefferies.

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Brian Gil Tanquilut, Jefferies LLC, Research Division - Equity Analyst [36]

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Just wanted to ask John, like, as we think about the competitiveness of the sell side that we saw last year, where does your confidence come from that it's not going to recur this year, especially as we just saw what WBAD did this morning with bringing on Express Scripts?

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John H. Hammergren, McKesson Corporation - Chairman, CEO and President [37]

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Well, I can only speak from 20-plus years now of experience here at McKesson and watching how the market pricing has evolved and how our customers have come to us over time. We continue to build out a very significant value proposition for our customers, particularly independent customers. They always get a competitive price from us. They always get a good deal from us. And our ability to source product, I think, is second to none. Having said that, on occasion in the past, infrequently, we'll see a period of deflation on the sell side that has accelerated or price competition that has accelerated, and that's what we faced last year. It may have been 7 or 8 years between the last year that we experienced and the last time we experienced an event like that. So could it happen every year? Sure, it could happen. Eventually, you race to the bottom, and there's nothing more to give. But I don't forecast that just based on historical activity. As it relates to WBAD's activity, certainly, I can't speak to what incremental buying power they may garner a result of bringing Express Scripts together with them. I don't feel we've been at a disadvantage. I don't feel we will be at a disadvantage. And I'd also say it's not necessarily a direct correlation that if someone buys better, that they determine that they will increase their level of discounts and pass it all back into the marketplace. So if that were to occur, if they bought better and their partners ended up buying better and then they decided to put it into the marketplace, we'd have to respond, and it would be a year similar to this year.

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Operator [38]

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

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Charles Rhyee, Cowen and Company, LLC, Research Division - MD and Senior Research Analyst [39]

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John, obviously, you've given us an outlook here for fiscal '18, and it looks like, to a certain extent, things are starting to normalize. When we think about the future, you look at some of your peers here and they're deploying capital into areas of growth outside of, let's say, core -- of the pharma distribution business. And in here, we are divesting a good chunk of our technology business into Change Healthcare. Can you talk about how you look at the longer-term outlook for McKesson in terms of where do you think you're going to be looking to find growth in? And what should we think about the longer-term outlook for growth?

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John H. Hammergren, McKesson Corporation - Chairman, CEO and President [40]

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Well, we like the Pharmaceutical business, and we like it globally. We've certainly liked it in the U.S., and we like it in Canada. And we like the medical supply business in the alternate site markets. We believe those markets and also the site medical are growing fast and will continue to grow at a nice pace as people move out of less convenient, more costly settings for their care and have a more value orientation and a more physician-centric relationship perhaps. And we like the pharmaceutical business. You can see, we -- as an industry, the pharmaceutical business continues to grow propelled by innovation and biosimilars and new treatments coming out. Clearly, the demographics of pharmaceutical usage is improving, and we see that trend globally as well. So I think we continue to feel good about our position, and you see us deploying capital, I think, in a very intelligent way in high-growth areas, not only in new markets where we can, I think, be a consolidator and a new service provider, but also in our specialty acquisitions. You saw us buy Biologics last year with Vantage, which are good acquisitions for us. And we made a technology acquisition called CoverMyMeds, which comes in with a different profit profile and certainly not only is a good business on its own but provides significant service to the pharmaceutical manufacturers, the pharmaceutical payers and the patients that are dependent on getting their drugs at the right time at the right price at the pharmacy counter. And clearly, we continue to make Canadian acquisitions, another one of which was announced today. So I think we are well positioned. I think we've got the right assets. I think these assets have a correlation across borders and across boundaries in our businesses, and we have synergy that we can take advantage of that, in the end, delivers better value for our customers, so they can do a better job of clinical care and clearly do a better job of the economics associated with delivering that care.

I think that was our last question. I want to thank you, operator, and thank all of you on the call for your time today. We've got a very solid operating plan for fiscal 2018, and I'm certainly excited about the growth opportunities across McKesson.

With that, I'll turn it over to call on Craig to answer a few questions about our upcoming events.

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Craig Mercer, McKesson Corporation - SVP of IR [41]

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Thank you, John. We will participate in the Goldman Sachs Global Healthcare Conference in Southern California on June 15. We look forward to seeing you on the new fiscal year. Thank you, and goodbye.

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Operator [42]

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Thank you for joining today's conference call. You may now disconnect. Have a great day.