Good day, and welcome to the McKesson Q1 Earnings Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Craig Mercer. Please go ahead.
Thank you, Anthony. Good morning and welcome to the McKesson's fiscal 2018 Q1 earnings call. I am joined today by John Hammergren, McKesson's Chairman and CEO and James Bier, 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. After James' comments, we will open the call for your questions.
We plan to end the call promptly after 1 hour at 9:30 am 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 SEC, please refer to the text of our press release for a discussion of the risks associated with such forward looking statements. Finally, please note that on today's call, we will refer to certain non GAAP financial measures.
In particular, John and James will reference adjusted earnings, adjusted operating profit margin excluding non controlling interest and items excluding foreign currency exchange effects. We believe these non GAAP measures provide useful information for investors with regard to the company's operating performance and comparability of financial results period over period. Please refer to our press release announcing Q1 fiscal 2018 results for further information and a reconciliation of the non GAAP performance measures to the GAAP financial results. Thank you and here's John Hammergren.
Thanks Craig and thanks everyone for joining us on our call. Today, we reported a solid start to fiscal 2018. For the Q1, we achieved total company revenues in excess of $51,000,000,000 and adjusted earnings per diluted share of $2.46 consistent with our expectations. Combined with our share repurchases we completed in the Q1, we are raising our fiscal 2018 adjusted earnings outlook to $11.80 to $12.50 per diluted share. Before I dive into the details of the quarter, I'd like to take a moment to discuss the progress that demonstrates our continued commitment to long term shareholder value creation.
First, we continue to proactively develop our portfolio of distribution businesses. In the past quarter, we announced the signing of 3 acquisitions primarily in the specialty space. We closed 4 acquisitions including CoverMyMeds in early April. And we started the important work to integrate Rexall and other recent acquisitions, which are beginning to contribute to our earnings growth. Each of these acquisitions that we've announced are in the process of integrating, highlight our commitment to expand our specialty capabilities, enhance our leading technology solutions for our distribution solutions customers and grow our retail pharmacy footprint internationally.
2nd, we continue to make progress on the strategic shift to realign our businesses to focus on distribution and retail pharmacy solutions following the creation of Change Healthcare. This quarter represents the first time we include the results for our equity investment in Change Healthcare. The new company was created to deliver a broad portfolio of solutions that will help lower healthcare costs, improve patient access and outcomes and make it simpler for payers, providers and consumers to manage the transition to value based care. Change Healthcare is now a focused and scaled enterprise executing on this mission. Additionally, I'm encouraged by recent developments in our pursuit of the strategic alternatives for our Enterprise Information Solutions business, and I expect we will have more to announce in the near term.
Turning now to our business results for the quarter. Our North American pharmaceutical distribution and services businesses, which include U. S. Pharmaceutical, McKesson Specialty Health, McKesson Canada and our recently formed McKesson Prescription Technology Solutions business, had revenue growth in the Q1 of 5% on a constant currency basis. I'd like to take a moment to highlight a few matters specific to our U.
S. Pharmaceutical business. Revenue in our U. S. Pharmaceutical business met our expectations in the Q1, driven by organic growth.
Next, I want to provide an update on the pricing environment as we've transitioned into fiscal 2018. We entered this year with an assumption of branded inflation in the mid single digits and our Q1 experience was slightly ahead of this assumption. Additionally, you will recall that during fiscal 2017, we saw increased price competition in the independent retail pharmacy channel, which eventually resulted in reduced volumes for McKesson. Over time, we adjusted our strategy and we were able to recapture that lost volume, retain our share and build upon our long standing relationships. Consistent with our update over the last two quarters, we continue to see a competitive market for selling generic pharmaceuticals in the U.
S, albeit with less pricing variability. We expect to lap the independent pharmacy sell side pricing impact by the end of our fiscal 2018 Q2. Next, I'd like to discuss ClarusONE. We are pleased with the progress we've made so far in our manufacturer discussions, and we are in line with our plan. McKesson continues to be encouraged by our partnership with Walmart, and we are looking at opportunities in which we can expand the relationship.
We're also 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 manufacturing partners in each of the 5 categories. We continue to address these important changes as we work through contract renewal cycles. Turning to Rite Aid's recent announced asset purchase agreement. Based on public comments made by Walgreens, they indicated anticipated 6 month regulatory review, followed by a 6 month phased transition period. Therefore, we continue to anticipate a full year contribution from Rite Aid in our fiscal 2018 guidance.
I would also like to call out our recently announced acquisition of BDI Pharma, which allows us to provide our customers with broader plasma and related offerings and complement our current health system and alternate site channels. We also expect to bring more value to our manufacturer partners through increased scale and customer penetration. Turning now to McKesson Specialty Health. We recently announced the closing of our acquisition of IntraFusion, which further strengthens our multi specialty offerings. And through our commitment to the transition to value based care, we support approximately 800 physicians who participated in the CMS oncology care model over the last year.
This represents greater than 1 third of all participating providers being supported by McKesson Specialty Health, an unparalleled commitment to value based oncology. Moving to our Canadian business. We had nice growth in the quarter, which result with results that were in line with our expectations. Our Canadian operations represent a diverse collection of businesses similar to those in the U. S, with a particular emphasis on full line distribution, specialty and infusion services and owned and banner retail pharmacies.
We are making progress on the Rexall integration, which further enhances McKesson's retail pharmacy capabilities, procurement scale and leading pharmacy care for patients across Canada. We've also broadened our specialty offerings upon closing the acquisition of GMD Distribution. GMD is a leading provider of specialty pharmaceuticals and expands our multi specialty presence across Canada, while further strengthening our current physician and manufacturing relationships. Finally, our recent CoverMyMeds acquisition is now part of the newly formed McKesson Prescription Technology Services business. CoverMyMeds automates and accelerates the prescription approval process known as electronic prior authorization, which is otherwise manual and time consuming therefore takes administrative cost out of the system.
Covered MyMeds allows us to support patient health through drug adherence, manufacturers by reducing prescription abandonment and providers and payers through automation and appropriate patient access to medications. We are excited about the meaningful improvements this technology represents for these stakeholders. Turning now to our results for international pharmaceutical distribution and services. Revenues for the Q1 were $6,400,000,000 up 6% year over year on a constant currency basis. And operating performance from Celestio was in line with our expectations for the quarter.
While we continue to monitor reimbursement developments in the U. K, we remain encouraged by the growth delivered by the rest of the Celestio enterprise. And finally, our Medical Surgical business performed well in the quarter with revenues of $1,500,000,000 an increase of 4% over the prior year, driven by market growth, including strong performance from our recent investment in laboratory distribution. In summary, I'm pleased with the performance of our Distribution Solutions segment in the Q1. And as I noted in my earlier remarks, we are encouraged by the progress made by management at Change Healthcare since its creation just over a quarter ago.
Now to wrap up my comments, McKesson's Q1 results represent solid execution across both segments, and we are raising our full year outlook for fiscal 2018 adjusted earnings to a range of $11.80 to $12.50 per diluted share. We believe we are well positioned to drive future growth with our scaled global sourcing capabilities, expanded global retail footprint, growing specialty business in the U. S. And overseas and our leading technology solutions for our distribution solutions customers. We are extremely well positioned to execute our portfolio approach to capital deployment and deliver value for our shareholders through a mixture of internal capital investments, acquisitions, share repurchases and dividends.
With that, I'll turn the call over to James and we'll return to address your questions when he finishes. James?
Thank you, John, and good morning, everyone. As John discussed earlier, we are raising our fiscal 2018 adjusted earnings outlook to $11.80 to $12.50 per diluted share, which reflects our Q1 results that were very much in line with our expectations and the positive full year impact of incremental share repurchases completed in the quarter. Please note the underlying assumptions that were detailed in our Q4 press release are being reiterated today unless stated otherwise. Now let's move to our results for the quarter. My remarks today will focus on our 1st quarter adjusted EPS of 2.46 dollars which excludes the following items, amortization of acquisition related intangibles, acquisition related expenses and adjustments, LIFO inventory related adjustments, gains from antitrust legal settlements, restructuring charges and other adjustments.
You may recall that when we provided our initial guidance and further commentary at our Investor Day, we noted the quarterly progression of our fiscal 2018 performance being back half weighted. This timing reflects in part our ongoing contract renewal work with our customers and manufacturer partners, where we are reflecting the differential economics of brand, generic, specialty, biosimilar and OTC products, as John mentioned previously. These ongoing contract renewals also reflect reduced variability in our compensation resulting from manufacturer pricing actions. Our ongoing success with these contract renewals did however create a timing headwind for our Q1 earnings. Turning now to our consolidated results, which can be found on Schedule 23.
Consolidated revenues for the 4% in constant currency. 1st quarter adjusted gross profit was down 6% in constant currency year over year, driven by the planned lapping effect of increased competitive pricing in our independent pharmacy business, weaker pharmaceutical manufacturer pricing trends, some timing items driven by our ongoing contractual renewal progress with certain manufacturer partners and lower profit in our technology solutions business driven primarily by the contribution of the majority
sourcing entity.
1st quarter adjusted operating expenses increased 5% in constant currency, driven by acquisitions, partially offset by the Change Healthcare transaction and ongoing cost management efforts. Adjusted other income was $13,000,000 for the quarter, a decrease of 43% in constant currency. Adjusted equity income from Change Healthcare was $70,000,000 for the Q1. We are pleased with the progress of Change Healthcare. The management team has come together to cohesively lead the new organization and begin the work of both identifying opportunities to further expand our customer relationships and realizing meaningful synergies.
I'd like to reiterate our prior guidance that Change Healthcare will generate between $370,000,000 $430,000,000 of pre tax earnings, reflecting our 70% ownership of the joint venture. At the same time, we have made a refinement to our estimate of the way tax expense is attributed to the joint venture's profits. Including tax expenses now expected to be accounted for within Change Healthcare, we project our adjusted equity income from the Change Healthcare joint venture will be between $250,000,000 $310,000,000 in McKesson's fiscal 2018 P and L. Again, this reflects no material change in our full year expectation for pre tax earnings to be generated by the Change Healthcare joint venture. Rather, it is a refinement in where taxes are reflected in our income statement.
Our full year tax rate for McKesson is now estimated to be approximately 25%, down from our original estimate of 27%. The net effect of these two updates is neutral to the original guidance for fiscal 'eighteen that we provided in May. Also note that we do not expect a cash tax impact to McKesson as a result of this refinement. Now continuing down the income statement, interest expense of $68,000,000 decreased 14% in constant currency for the quarter, driven primarily by the refinancing of debt at lower interest rates. Our adjusted tax rate was approximately 26.5% for the quarter.
Our income attributable to non controlling interests or NCI was $56,000,000 for the quarter, an increase of 2 17% in constant currency. As a reminder, the increase in NCI year over year was primarily driven by ClarusONE, our fully operational joint sourcing entity with Walmart. Our adjusted net income from continuing operations totaled $523,000,000 with our 1st quarter adjusted EPS at $2.46 per diluted share, down 22% compared to $3.15 in the prior period. Wrapping up our consolidated results, diluted weighted average shares outstanding were 213,000,000, down 7% compared to the prior period. Let's now turn to the segment results, which can be found on Schedule 3.
Distribution Solutions segment revenues were $50,900,000,000 On a constant currency basis, revenues were up 5% year over year. Revenues were impacted by approximately $400,000,000 in unfavorable currency rate movements. North America Pharmaceutical Distribution and Services revenues increased 5% in constant currency, driven by market growth and acquisitions, partially offset by brand to generic conversions. International Pharmaceutical Distribution and Services revenues was $6,400,000,000 for the quarter. On a constant currency basis, revenues were up 6%, driven by acquisitions and market growth.
Revenues were impacted by approximately $300,000,000 in unfavorable currency rate movements. In mid July, the UK government announced further reimbursement cuts. We are assessing both the economic impact of these changes on McKesson and potential business initiatives to help mitigate these government actions. Moving now to the Medical Surgical business. Revenues were up 4% for the Q1, driven by market growth.
Distribution Solutions adjusted gross profit was up 7% on a constant currency basis for the quarter, driven by acquisitions and organic growth, including contributions from ClarusONE, partially offset by the planned lapping effect of increased competition in our independent pharmacy business and the expected weaker pharmaceutical manufacturer pricing trends. Let me for a moment touch on branded pharmaceutical price increases. The June quarter has traditionally included modest brand price increases and our Q1 experience was slightly ahead of the assumption included in our plan. I would remind you that in addition to timing, frequency and magnitude, the mix of which manufacturers initiate price adjustments has an important effect on our overall compensation. Distribution Solutions segment adjusted operating expenses increased 18% on a constant currency basis for the quarter.
Segment operating expenses reflect an increase driven by acquisitions, partially offset by ongoing cost management efforts. Distribution Solutions segment adjusted operating profit was down 10% in constant currency year over year at $887,000,000 The segment's adjusted operating margin rate was 173 basis points on a constant currency basis, a decrease of 28 basis points driven by the same factors as previously discussed, as well as our growing mix of higher priced specialty pharmaceuticals, partially offset by the beneficial contribution from ClarisONE. We continue to expect our full year distribution solutions adjusted operating margin rate to be between 198 basis points and 208 basis points. Our operating margin rates will be supported by organic growth, including the contribution from ClarusONE, recent acquisitions and the lapping of previously discussed headwinds as we proceed through the year. Now moving to Technology Solutions.
As a reminder, in fiscal 2018, MTS segment revenues, adjusted gross profit and adjusted operating expenses contain only the results of our Enterprise Information Solutions business. Revenues were $120,000,000 while adjusted segment gross profit was $61,000,000 Adjusted segment operating expenses were $44,000,000 and adjusted operating profit, excluding the equity contribution from Change Healthcare was $17,000,000 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 one day from the prior year to 26 days. Our days sales in inventory decreased one day from the prior year to 29 days and our days sales in payables was flat to the prior year at 59 days.
We ended the quarter with a cash balance of $2,300,000,000 with approximately $1,700,000,000 held offshore. And in the first quarter, McKesson generated $741,000,000 in cash flow from operations. We continue to deploy capital in line with our portfolio approach in fiscal 2018 priorities. In the Q1, we spent $118,000,000 on internal capital investments and repaid $541,000,000 in long term debt. We also repurchased $250,000,000 in common stock in the Q1.
We now expect our weighted average diluted shares to be approximately 212,000,000 for the full year. And we now have approximately $2,500,000,000 remaining on our share repurchase authorization. We also paid $1,500,000,000 for acquisitions during the Q1, which included the closing of CoverMyMeds as previously announced on April 3. And yesterday, the Board of Directors approved a quarterly dividend of $0.34 an increase of $0.06 or 21%. This dividend will be payable to shareholders in October and reflects our commitment to the dividend as a part of our portfolio approach to capital deployment.
Now let me briefly touch on Rite Aid. While Rite Aid has announced a new transaction with Walgreens, our guidance range continues to assume a full year revenue contribution from Rite Aid of approximately $13,000,000,000 and an estimated annual adjusted earnings per share contribution of between $0.20 $0.40 Based on Walgreens public comments that they expect the regulatory review of this new transaction to take approximately 6 months and that if approved, the stores involved would be transitioned over a subsequent 6 month period, we feel comfortable with our fiscal 'eighteen assumption. And as you think about the cadence of our earnings in fiscal 2018, I'd like to reiterate my previous comments that our results will be more heavily weighted to the second half of the fiscal year. Consistent with our historical experience, we expect the 4th quarter to be the strongest. Also in our Q2, we will continue to be impacted by a lapping effect from last year's increased competitive pricing in our independent pharmacy business.
Throughout the remainder of the year, we will benefit from the increasing contribution of ClarusONE, additional organic growth and our recent acquisitions. In closing, McKesson delivered 1st quarter results that were in line with our expectations. In addition, our cash flow generation allowed us to address each of the four pillars of our capital deployment strategy. And our Q1 share repurchases are driving our updated fiscal 2018 adjusted EPS outlook of $11.80 to $12.50 Thank you. And with that, I will turn the call over to the operator for your questions.
In the interest of time, I ask that you limit yourself to just one question and a brief follow-up to allow others an opportunity to participate. Operator?
Thank you. Today's question and answer session will be conducted electronically. Our first question comes from Lisa Gill with JPMorgan. Your line is open.
Thanks very much and good morning. James, let me just start with trying to understand the cadence of the earnings. I understand you were talking about it being more heavily back half weighted, but given where the Street was in this quarter versus what you delivered that where you said this was in line with your expectation, I just want to make sure that we have this lined up correctly, especially as we think about next quarter and think about having to lap some of the pricing issues. Is there anything more that you can give us directionally as we think about the Q2?
Well, obviously, a few factors driving the quarterization of the fiscal 'eighteen guide. In particular, Q1 was impacted by that lapping effect of last year's activity, enhanced pricing activity around the independent pharmacy space. And then also, as we had assumed going into the fiscal year, we did see lesser brand manufacturer price increase activity than we've seen in some other years. But I also made note at the start of my remarks as to in Q1 in particular, there were 2 contracts with the manufacturers as we went through our renewal process that is focusing our activity on the relevant economics for each of the 5 categories of our work that both John and I referred to, namely the brine, generic specialty, biosimilar and OTC, but also those renewals focus on our interest in seeing less variability to the branded manufacturer pricing actions. Of course, we don't take those decisions.
So it's helpful for us to have a little less variability to pricing. And so that issue in particular, those two contract renewals did have an impact on Q1 and there will be a beneficial impact later in the year. Not surprisingly, we always see Q4 as the strongest of the quarters, given that, that is traditionally when branded manufacturers take the majority of their price increases. And then the other factors to really think through is as the year proceeds, we'll continue to see nice organic growth across the businesses. And also, obviously, we invested substantially in acquisitions over the last 12 to 18 months.
So as those new parts of our company progress against their business cases, I'm expecting that we'll see additional earnings benefits from them as the year progresses.
Okay, great. And then just my follow-up would be for John. John, in your prepared comments, you made a comment that you feel that things have stabilized and they're rational but competitive when we think about the independent market for generics. Can you just maybe give us a little more color as to what you're really seeing in the market and what gives you that confidence?
Well, thanks for the question, Lisa. I think at the time that we talked about this unusual activity in the prior year during the prior year, I made the comment that we don't see that type of activity frequently and when we have seen it in the past, it tended to stabilize or revert back to things would go things would go has proven to be accurate. Obviously, things can change at any point in time, but I would say that we have gone back to an environment which is competitive, but certainly not out of line with the kind of competitive activity that we would have typically seen prior to fiscal 2017. So I would say that that's the best way I could characterize it is it's back to competitive and less variable. Our next question comes from Michael Cherny with UBS.
Good morning, guys. Thanks for the color. Maybe thinking a little bit and building off of Lisa's question a bit more. As you think about some of the other moving pieces that get better into the back half of the year, particularly the pricing environment, I guess, how do you check the road points along the line to make sure that what you think about relative to brand inflation, which I think
you said came in a
little bit better, generic deflation, all against the backdrop of some of the contract changes are falling in line with your plans? And I guess how much visibility at this point do you have into some of those changes? I think it's fair to say that when we had our guidance discussion at the end of our fiscal year and again at our Analyst Meeting, we talked very specifically about how we saw the year playing out. And I guess what we're seeing today is, it's playing out as we had anticipated it would play out. We may not have done an effective job of messaging it to you given where the Street has been in the quarter, but clearly it's in line with our expectations.
And we typically have pretty good visibility throughout the year. And as James mentioned, if you think about our renewal cycle of both of our customers and our large manufacturing partners, you can clearly see how the changes in those relationships will be reflected in future financial results. And so I would say on those dimensions, clearly, we have better visibility and perhaps less variability than we would have had in an environment where we were more dependent on price increases as a piece of our business model. Clearly, we can't entirely forecast acquisitions with 100% certainty, but we have a pretty good track record of getting the synergies out of the capital that we deploy and giving the returns to our investors that are appropriate given the risk that we take and the other alternatives like buying our stock back. So if you believe the 3 principal drivers are the sort of the calendarization of our earnings with manufacturers, the impact of acquisitions as they get closed and integrated and things like Northstar, our private label products and higher growth in our higher margin businesses, frankly, we can see that with pretty good accuracy.
So I think that we would not have confirmed our guidance here and the raise, as James mentioned was related to the share repurchase. We would not have done that if we didn't believe that it was an accurate representation of our belief going forward. Okay, thanks. I'll leave it at once, Shneur. Okay.
Our next question comes from Ross Muken with Evercore ISI.
Good morning, guys. Maybe just a quick update on how some of the recent acquisitions are sort of trending, particularly some of the newer businesses to you like Rexall or Biologics? I just love to understand how they're doing versus sort of their base M and A case when you bought them?
Well, I think that as I said earlier, we have a pretty good track record in realizing the synergies that we forecast. And I would say that we're generally in line on these acquisitions in terms of their performance. Biologics might be performing slightly ahead of its acquisition case and we've been very pleased with that acquisition and Rexall is really in line. Just have that's a little bit newer than Biologics is. And then the rest of our acquisitions like CoverMyMeds etcetera are all performing at or above our expectations.
So I'm quite pleased with not only the performance financially, but the strategic position that these acquisitions put us in. As you can imagine, we are investing in higher margin businesses in the case of biologics and CoverMyMeds, etcetera, and we're investing in businesses that in the case of Rexall that are not only higher margin, but they're also allowing us to have more control over the selection of product. And that control allows us to deliver more value to the manufacturers that we do business with. And so it's part of a long term strategy frankly on both of those fronts to be more exposed to specialty because of its higher growth and be more meaningful to manufacturers. James, you made us something to add.
And while we don't look at this in our business cases that underpin the acquisitions themselves, I've been pleased so far with the opportunities that are starting to evolve for groups like Kevin Mymeds to work with other parts of our business, Relay Pharmacy, for example, on the Rexall side, the discussions that are really ongoing now with other parts of retail across our organization. So that's not a short term synergy opportunity. It's not something that's part of the business case, but I'm encouraged that there's quite an opportunity, I think, over the longer term for us to really benefit from this portfolio of assets that we've built up
over the years. And I also mentioned, Ross, in my comments about MedSurg and our exposure to laboratory and our entrance into the lab business, principally in the physician space, but also in the smaller hospitals where they've been underserved from a laboratory supply perspective. And that business growing nicely for us and it's higher margin and higher growth than the baseline businesses. So we think we're well positioned.
And maybe just as a follow-up, historically you guys have been tremendous stewards of capital and M and A has always been a hallmark and I always think of you as being a pretty creative and value based buyer. I guess in an environment with where we are with multiples etcetera, how would you sort of characterize more of the mid to small size tuck ins that you guys typically do? What does that environment look like? Is there a pretty decent pipeline or valuations still amenable in certain areas? How are you sort of thinking about just the overall backdrop?
Well, first, thanks for the compliment. We appreciate the fact that we represented good stewards of capital and that we have a track record of executing. And clearly, if you overpay, there's no ability to create value. And so that discipline upfront is extremely important. But I'd say, as evidenced by the frequency of our acquisitions in the last year and already into this year, you can see we find creative spots to deploy capital.
And to your point about sort of innovation and creativity, we're typically not buying in front of the hordes that are all chasing the deal or chasing an opportunity. We have our team is focused on building relationships with potential sellers long before they're interested in selling and then we create a positive environment for those transactions to be completed and for their teams to continue to come to McKesson and deliver not only value to us but careers for themselves and that combination makes us an attractive partner. When many times these companies are privately owned or certainly heavily influenced by entrepreneurs that may own them, we're a good place for people to continue to grow and develop and be rewarded for their performance. And I think that makes us a preferred alternative in many cases. So obviously when multiples start to trade up, it makes it more difficult.
But we're patient and we'll wait for the right opportunities. Our next question comes from Garan Sarafan with Citi Research.
Good morning, John and James. I guess more of a big picture question on procurement. So distributors have clearly gained share and enlarged the pie in terms of level of generics purchased through a variety of reasons. But from a high level, could you describe what that does to the marketplace from a procurement perspective? So for example, in North America, you've completed signing contracts with the new retail client via Claris 1 and now one of your peers is embarking on adding a PBM and then incremental retail volume.
So does that cause any disruption in your contracting or does that impact your assumptions in terms of generic contributions as maybe pricing deflates at a different rate or other factors investors should think about as these types of events occur?
Well, I think it's a good question and a complex question. I would say as a backdrop, I believe that the large buyers of generics are relatively comparable in terms of what we're attempting to do and the results that we're achieving. I would say that clearly incremental volume plays a role in all of this, but I think that the difference between any of us at any one time is not significant. And I think McKesson on certain molecules with certain manufacturers would be superior. In other cases, others may beat us.
But if you put it all together as a basket, I'm pretty confident we buy as well as anyone. As it relates to the deflation environment related to our activity in the procurement side, Clearly, we're trying to get the best deal we possibly can for ourselves and for our customers. And we want to make sure that our customers are receiving a competitive price for the service and value that we deliver including the product price. Having said all of that, the deflation that occurs through better sourcing is not an automatic pass through into the marketplace. We want to make sure we are competitive.
But at the same time, obviously, the investment to create Aclaris I needs to be appropriately funded and provide us the appropriate returns. And so we're focused on making continue to be our focus. So I think we're optimistic that our procurement activity will continue to be best in class and we will continue to add capabilities there over time and maybe new product categories and obviously new customers etcetera. But I feel pretty comfortable we're managing it appropriately.
And perhaps just to add on to that from a more technical perspective, as we look at the economic drivers of our results, our ability to source very effectively on the generic side in this deflationary type environment has net net been supportive to our results.
Okay. That's helpful. And changing gears a little bit, on Rite Aid, you mentioned that you're using public Walgreens comments and your assumptions for the year on the portion that Walgreens is taking over. But how do you think of the rest of the business where there's also a part of that deal from pricing terms for the remainder of Rite Aid, should they continue to or would they want to use Walgreens. So the rest of the business, how are you thinking about it as to what the real estate options are?
Well, clearly, we're pleased for both Walgreens and Rite Aid that they've been able to find a new deal that they believe they'll be successful with. And obviously, we're also pleased that that new deal has some remainder of Rite Aid, not only the corporate side of the entity of Rite Aid, but certainly a large portion of their stores that will remain and that we've been a long term valued partner with Rite Aid and I certainly would hope and expect that relationship would continue. Clearly, the economics for both Rite Aid and McKesson changed with their smaller enterprise, and we've attempted to reflect to you what the full enterprise is worth to us in terms of revenue and earnings. So at least you have some boundaries as to how valuable the business is to us and what it might be to us going forward as you described. So I think we believe we compete very well with anything that our competitors would provide and we compete very well with anything that our other sourcing entities can provide from a value perspective and we're hopeful that we'll continue a long term relationship with Rite Aid well past the transaction with Walgreens.
Our next question comes from Steven Valiquette with Bank of America.
So just based on simple math, I mean, the SG and A seemed to be pretty high in the quarter with distribution gross profits growing 4% to 5%, but distribution EBIT down about 10% year over year. And just based on your comments, it seems like the biggest delta on getting that gross profit growth and EBIT growth closer to each other for the rest of the year is mainly acquisition integration. Is that an accurate assessment or are there other key factors there?
Well, I would say that there are more variables that are at play. It's really the combination of the opportunity for organic growth right across the businesses as well as the impact of acquisitions. And then obviously, we've discussed the ebbing of this lapping effect around the sell side independent pharmacy space. In terms of the expense side of the ledger, we've talked about how we've been looking to invest some in expenses, particularly focused around information technology investments in the coming year. On the other side of the client, one of the attributes that I was very pleased about in terms of the U.
S. Pharma performance in Q1 was the productivity efficiency that they were generating out of that part of the business as a result of our ongoing capital expenditure investments and other process improvements that they've made in that business. So we'll continue to invest in process improvements that we think can improve the competitiveness of our cost structure. That will take some incremental expense in the short run. We think that that will be worth it in the longer run.
Okay. And just a quick follow-up on
that, just on the M and A. I mean, you mentioned that some of the recent acquisitions were higher margin. It might be tough to answer this on the fly, but when we do look at that 4% to 5% gross profit growth in distribution solutions in the quarter, do you know how much of the acquisitions contributed to that growth versus what that growth might have been organically in the quarter? Is there any just rough assessment of that?
Well, we don't bring that out specifically, but obviously those acquisitions are going to build gradually. So I wouldn't want to overstate the impact of those acquisitions in the 1st year or so. When we've announced acquisitions like CoverMyMeds, for example, we noted that come year 3, we'd be driving between $0.30 $0.40 of accretion from that acquisition. But that builds gradually, particularly in that 1st year, where oftentimes there's some additional investment spending that goes into the equation for us to be able to really drive that accretion in the second, third year and so forth.
Our next question comes from Robert Jones with Goldman Sachs.
Thanks for the questions. I guess, just wanted to go back to the SG and A. James, I guess, I'm still just a bit confused. I think everyone was anticipating the headwinds in the quarter coming from the things that arose in 2Q last year, the branded pricing and the competitive environment. But really relative to expectations, the shortfall this quarter was from SG and A and in particular, it looks like from Distribution Solutions.
Could you just go back and maybe explain a little bit more what exactly happened in the quarter relative to operating expenses? And how should we think about those as we progress through the year?
Well, another item that is relevant on the expense side of the ledger is obviously that we reset our assumptions around various variable compensation programs and so forth. So that becomes an element of the equation. And in certain of our geographies, there are some additional expense resets around salaries and so forth. So a variety of different factors. But overall, we feel comfortable with the level of spend, the as I say, the focus on the investments to drive down expenses over time.
And right across the management team, we're very focused on improving our spend performance quarter by quarter.
And I'd also say, Robert, the spend level in the quarter was not something that was a surprise to us. It was factored into our planning when we gave you the full year guide. So I would say that the way the P and L has played out for us in the quarter is in line with what we expected it to be when we gave you the original guidance months ago. I mean that's the only additional cover I'd give you. It may be surprising to you, but we had factored this in because we could see the investment in the mix changes and the acquisition etcetera as we look at the quarter.
No, that makes sense John. I think we obviously were focused more on the headwinds that had come up last year and I think that's where it
probably differed in the model.
But I guess, Jan, just if I could go over to pricing, I wanted to get a better understanding of what you guys are seeing on generic pricing and in particular I'm thinking about the buy side part of the equation, how has that trended relative to expectations? And then probably more importantly, as you guys look forward, given some of the FDA's recent statements and goals of accelerating generic approvals, how do you foresee generic pricing playing out into the future?
Well, on the generic manufacturer side of things, we went into the year assuming a very nominal benefit from those molecules where we would be seeing price inflation and that's very much as things are playing out, very limited effects there. On the broader generic molecule spectrum, We've been talking earlier in one of our responses about the deflation environment. And net net, I observed that for our sourcing capabilities, our in house capabilities are such that we see this environment as a net driver of our overall economics. So we're happy with the situation there. In terms of the FDA and their path to drive more approvals and therefore potentially put greater numbers of manufacturers into a specific molecule.
Obviously, you've got an overall supply demand balancing equation there that will impact the pricing environment net net. It is a generic type marketplace after all. But I would just offer also that in some of those circumstances, the FDA is focused on a molecule where there's only one manufacturer today. And so they're interested in having 2 or 3 manufacturers and that can actually provide a helpful environment, again, for our sourcing capabilities to be able to drive better value for our customers.
Our next question comes from Ricky Golubacher with Morgan Stanley.
Yes, good morning. So first of all, just
a follow-up on the question on the SG and A. So just to clarify, going forward now that these acquisitions are part of the business, is that the split that we should model between COGS and gross profits versus operating expenses?
Well, I think it's fair to say that as John was alluding to, these figures were very much in line with our plan. And so as we're bringing on acquisitions in a year over year expense base, you're obviously going to see step function increases commensurate with bringing on those acquired expense bases. So but again, rest assured that we'll continue our ongoing focus on cost management. But directionally, yes, you'll see some step function increases as the likes of Rexel come into the P and L, for example.
Well, I think also, Ricky, one of the challenges from a P and L perspective is that the incremental profit delivered by the acquisitions even in the first order before we realized the synergies was vastly offset by the year over year lapping problem that James mentioned earlier related to independent price effects in the prior year. So when you think about why didn't we see a margin lift through the acquisitions and all we saw was the expense lift is because the margin lift from the acquisitions could easily be offset by the two dimensions that James mentioned. 1 is the lapping effect of independent pricing last year and the effect of our continued work from a manufacturer contracting perspective that we talked about previously.
So what would be really
helpful for us is if you can just help us quantify what's the magnitude of these headwinds that we're leaping when we think about just the combination of the price competition and independent and we call pharmaceutical pricing. So we can kind of like normalize that and kind of like run rate as we think about second half?
Yes, I don't have that for you on this call. We can certainly think through how we might articulate that effect going forward.
Our next question comes from Kevin Caliendo with Needham and Company.
Hi, good morning. Thanks for taking my call. A question on ClarusONE. Is there a cadence to ClarusONE in terms of the profitability over the course of the year? I'm assuming it will grow and become more profitable as the year progresses.
That's the first question, Clarus. And the second one is, you talked about other opportunities with Walmart and with Clarus 1. Is this the kind of relationship where you could get in and help the medical side of your business as well? Are you going to be able to get into products and the like there?
We'll let James talk about the cadence and I'll talk about the product portfolio. James?
In terms of the cadence, you're right. I would expect that to build profit contribution as the quarters of the year go by. And obviously, in the last few months, we've really just been getting started and we're very pleased with the momentum that, that team is building around sourcing results. So yes, I'd be absolutely looking for a steady build as the year goes along.
It's difficult for me to perhaps articulate what opportunities would be in front of us at Clarus because we have a partner there that needs to engage in that opportunity as well. So I'm not speaking on behalf of Walmart, but if you wanted to look at opportunities, you certainly could think about everything that a Walmart store in the U. S. Purchases today and think about what McKesson would also be purchasing for our clients, non Walmart clients and all of those would provide opportunities for us to move them to ClarisONE in a way that would be perhaps productive for both companies and our combined customers. I would also say that Clarisone is specifically focused on U.
S. So there might be other U. S. Walmart opportunities as well as global opportunities that both companies could bring together. And last, I would say on the medical side, we clearly are heavily focused on our medical business and private label and our global sourcing activity, which is outside of ClarusONE has been very effective at driving value for us on the medical products that are typically used in the alternate site settings that we focus on.
And I consider that separate and distinct from medical products that are sold at retail pharmacies like over the counter items, which would be closer to home to Clarus, but both are opportunities for us.
Great, thanks. And if I can do one quick follow-up. I'm a little confused on the impact of the manufacturer contracting and sort of how that works. Why would something like that become more profitable over the course of the year? Is there an exclusive on a product launch or a generic or something like that?
I just don't really understand how that would work.
Well, I won't be able to get into the specifics of these two particular contracts with some of the larger manufacturers, but it did create in essence a headwind for Q1 and we would look for a smoother introduction of contribution for us in the quarters remaining in the year, Q2 through Q4. So the net result,
which we're pleased about, is less variability around a manufacturer's pricing actions. Obviously, we don't take those decisions. So we're interested in smoothing out the impact on our P and L from the actions of others. Yes, I think that's absolutely accurate. And we once again, we had anticipated the outcome of these relationship changes when we provided the original guidance.
And I think it is a reflection on the disconnect. It really is our ability to articulate what we were doing in our business at the 2 major points we had an opportunity to articulate them apparently was not as clear as it could have been and that's why you guys look at this quarter and say, gee, it seems odd compared to what we expected. But I want to once again confirm and reaffirm what James said is that it's certainly in line with what we expected and we expect that the following three quarters will be in line with what we expect as well. Our next question comes from David Larsen with Leerink.
Hi. I think you mentioned that North American pharma revenue was up organically year over year. Can you talk a bit more about that? How much of that is being driven by price versus volumes? And if you're winning share in the market, any color around which channel it's coming from hospitals, retails, independents, doc offices?
Any more color on that growth would be very helpful. Thanks.
Thanks for the question. Clearly, we are pleased with the growth of our U. S. Pharmaceutical business and our position in the marketplace. As we have said in the past, we typically focus on gaining share of wallet within our existing customers where they are buying product that they are not buying from us or in some cases entering product categories or expanding their presence in categories where both of us are finding incremental revenues.
And then clearly, there's just flat out market growth. So I would not I don't think our revenue growth in our business is that far outside of what the market is growing if you think about specialty and just straight out demographics. So I think that clearly whatever price happens in the market flows through our business and the volumes are probably pretty typical with what the volumes are from a growth perspective at a baseline.
Okay, great. And then you also mentioned Tech Pharmacy Solutions. Is that like a new entity within your organization and like what is in that? And did that get classed in the distribution division? And is that like, I guess, group of assets driving up operating expenses in the quarter relative to last year?
So the business you're referring to is the coming together of 3 previous sub businesses, if you will. 1 that focuses historically on distributing technologies to pharmacies to help them manage their business. Then the Relay Pharmacy business, which is a switch business across which so many transactions between the pharmacy and the payer move and then also the new acquisition of CoverMyMeds. So I was alluding earlier in one of my answers to the opportunities that we're seeing for new improvements across these businesses. And I'm pleased that we've been able to bring them together under a single President to really drive the full opportunities that we think these assets provide.
I think they can be higher growth. John mentioned they are higher margin. So there will be
a particular focus on these businesses going forward. But as it relates to the change period over period, the biggest change is the movement of CoverMyMeds into McKesson and the movement out of MTS of our Relay Pharmacy business. And these businesses will carry a higher expense rate as it relates to revenue, but they carry a much higher margin as well. And once again, the margin impact to the segment was probably muted by the year over year lapping of the previous discussed independent pharmacy price challenges that we face. So if you have a situation where the expenses come in and the incremental margin got absorbed in the lap and that's why you have a more difficult compare.
Our next question comes from Brian Tanquilut with Jefferies.
Hey, good morning. Thanks for taking the question. Just digging deeper into branded pricing, especially since we're in July for mid year. So you talked about it being slightly above expectations. If you don't mind just giving some color on are we seeing that on the rate or is it the number of price increases?
And then if you don't mind just also giving us what percentage of your gross profit dollars
are still
tied to pricing? I think before you said it's around 10%. Thanks.
Yes, I'd say the contribution from our branded manufacturer partners is still around 90% on a fixed type basis, around 10 points of it coming from more variable measures around price increases that the manufacturers take. In terms of what's going on around the branded manufacturer pricing environment, we are seeing a little bit less of a frequency, it's fair to say, but also as we said in our text, the mix of which manufacturers take the price increases is important to our economics, because obviously we have a blend of contract structures. Some are entirely fixed and others offer us a portion of the economics that we can earn as a result of price increase activity.
I think we have time for one last question. Thank you. Our next question comes from Charles Guatrahi with Cowen.
Hi, it's Jean on for Charles. You mentioned earlier on the call that you're encouraged by recent developments in the pursuit of strategic alternatives for EIS. Can you elaborate on that, what new developments?
Well, thanks for the question. Clearly, we've been focused on making sure that we think about the strategic alternatives for our EIS business. We believe there were other places where that business might be able to grow more rapidly than inside of McKesson and we've been pursuing evaluation of those strategic alternatives. And my comments were nothing more than to reinforce the fact that we the process continues to be underway and that we're encouraged by the level of interest and alternatives that we're seeing and we hope to have more news here in the short term. I want to thank you, operator, for helping us today and thanks to all of you on your call on the call for your time.
McKesson is off to a good start for fiscal 2018 and I'm excited about the opportunities ahead of us. I want to recognize the outstanding performance of our employees and their contributions to help our customers improve lives and deliver opportunities to make better health possible. I'll now hand the call off to Craig for his review of upcoming events for the financial community. Craig? Thank you, John.
I have a preview of upcoming events for the financial community.
On September 12, we will present
at the Morgan Stanley Global Healthcare Conference in New York. We will release 2nd quarter earnings results in late October. Thank you and goodbye.