filings.toolsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
GENERAL
Management’s discussion and analysis of financial condition and results of operations, referred to as the Financial Review, is intended to assist the reader in the understanding and assessment of significant changes and trends related to the results of operations and financial position of the Company together with its subsidiaries. This discussion and analysis should be read in conjunction with the consolidated financial statements and accompanying financial notes in Item 8 of Part II of this Annual Report on Form 10-K. The Company’s fiscal year begins on April 1 and ends on March 31. Unless otherwise noted, all references to a particular year shall mean the Company’s fiscal year.
Certain statements in this report constitute forward-looking statements. See Item 1 - Business - Forward-Looking Statements in Part I of this Annual Report on Form 10-K for additional factors relating to these statements; also see Item 1A - Risk Factors in Part I of this Annual Report on Form 10-K for a list of certain risk factors applicable to our business, financial condition and results of operations.
We conduct our business through two operating segments: McKesson Distribution Solutions and McKesson Technology Solutions. Refer to Financial Note 29, “Segments of Business,” to the consolidated financial statements appearing in this Annual Report on Form 10-K for a description of these segments.
McKESSON CORPORATION
FINANCIAL REVIEW (Continued)
RESULTS OF OPERATIONS
Overview:
| (Dollars in millions, except per share data) | Years Ended March 31, | Change | |||||||||||||||||
| 2017 | 2016 | 2015 | 2017 | 2016 | |||||||||||||||
| Revenues | $ | 198,533 | $ | 190,884 | $ | 179,045 | 4 | % | 7 | % | |||||||||
| Gross Profit | $ | 11,271 | $ | 11,416 | $ | 11,411 | (1 | ) | % | — | % | ||||||||
| Operating Expenses | |||||||||||||||||||
| Operating Expenses Excluding Gain on Healthcare Technology Net Asset Exchange, net | $ | (8,109 | ) | $ | (7,871 | ) | $ | (8,443 | ) | 3 | % | (7 | ) | % | |||||
| Gain on Healthcare Technology Net Asset Exchange, net | 3,947 | — | — | — | — | ||||||||||||||
| Total Operating Expenses | $ | (4,162 | ) | $ | (7,871 | ) | $ | (8,443 | ) | (47 | ) | % | (7 | ) | % | ||||
| Income from Continuing Operations Before Income Taxes | $ | 6,891 | $ | 3,250 | $ | 2,657 | 112 | % | 22 | % | |||||||||
| Income Tax Expense | (1,614 | ) | (908 | ) | (815 | ) | 78 | 11 | |||||||||||
| Income from Continuing Operations | 5,277 | 2,342 | 1,842 | 125 | 27 | ||||||||||||||
| Loss from Discontinued Operations, Net of Tax | (124 | ) | (32 | ) | (299 | ) | 288 | (89 | ) | ||||||||||
| Net Income | 5,153 | 2,310 | 1,543 | 123 | 50 | ||||||||||||||
| Net Income Attributable to Noncontrolling Interests | (83 | ) | (52 | ) | (67 | ) | 60 | (22 | ) | ||||||||||
| Net Income Attributable to McKesson Corporation | $ | 5,070 | $ | 2,258 | $ | 1,476 | 125 | % | 53 | % | |||||||||
| Diluted Earnings (Loss) Per Common Share Attributable to McKesson Corporation | |||||||||||||||||||
| Continuing Operations | $ | 23.28 | $ | 9.84 | $ | 7.54 | 137 | % | 31 | % | |||||||||
| Discontinued Operations | (0.55 | ) | (0.14 | ) | (1.27 | ) | 293 | (89 | ) | ||||||||||
| Total | $ | 22.73 | $ | 9.70 | $ | 6.27 | 134 | % | 55 | % | |||||||||
| Weighted Average Diluted Common Shares | 223 | 233 | 235 | (4 | ) | % | (1 | ) | % |
Revenues for 2017 and 2016 increased 4% and 7% compared to the same periods a year ago primarily due to market growth and expanded business with existing customers within our North America pharmaceutical distribution businesses. Revenues for 2017 also increased due to our 2017 acquisitions including UDG Healthcare Plc (“UDG”), Biologics, Inc. (“Biologics”), Vantage Oncology Holdings, LLC (“Vantage”) and Rexall Health. Market growth includes growing drug utilization, price increases and newly launched products, partially offset by price deflation associated with brand to generic drug conversion.
Gross profit decreased 1% in 2017 and was flat in 2016 compared to the same periods a year ago. Excluding unfavorable foreign currency effects of 1% and 4%, gross profit remained flat in 2017 and increased 4% in 2016. Gross profit margin decreased in 2017 primarily due to weaker pharmaceutical manufacturer pricing trends, the competitive sell-side pricing environment, our mix of business and lower compensation from a branded pharmaceutical manufacturer from our U.S. Pharmaceutical distribution business. These decreases were partially offset by our acquisitions, LIFO inventory credits, higher cash receipts from antitrust legal settlements and benefits from our global procurement arrangements. Gross profit margin decreased in 2016 primarily due to a lower sell margin within our North America distribution business driven by increased customer sales volume with some of our largest customers, partially offset by higher buy margin including benefits from our global procurement arrangements, lower LIFO-related inventory charges and higher cash receipts from antitrust legal settlements. Gross profit included LIFO-related inventory credits of $7 million in 2017 and charges of $244 million and $337 million in 2016 and 2015. LIFO credits were recognized in 2017 primarily due to the impact of lower price increases. Gross profit for 2017 and 2016 also included $144 million and $76 million of cash receipts representing our share of antitrust legal settlements. During 2017 and 2016, our Distribution Solutions segment experienced weaker pharmaceutical manufacturer pricing trends, which are expected to continue in 2018.
McKESSON CORPORATION
FINANCIAL REVIEW (Continued)
Operating expenses decreased 47% and 7% in 2017 and 2016 compared to the same periods a year ago. Excluding favorable foreign currency effects of 2% and 5%, operating expenses decreased 45% and 2% in 2017 and 2016. Operating expenses decreased in 2017 primarily due to a pre-tax gain of $3,947 million (after-tax gain of $3,018 million) recognized from the deconsolidation of the majority of our Technology Solutions businesses (“Core MTS Business”), as further described below.
On June 28, 2016, we entered into a Contribution Agreement with Change, and others including shareholders of Change to form a joint venture, Change Healthcare. On March 1, 2017, the transaction closed upon satisfaction of all closing conditions pursuant to the Contribution Agreement. Under the terms of the Contribution Agreement, we contributed the majority of our Core MTS Business to the joint venture. We retained our RelayHealth Pharmacy and EIS businesses. We accounted for this transaction as a sale of the Core MTS Business and a subsequent purchase of a 70% interest in the newly formed joint venture. Accordingly, in the fourth quarter of 2017, we deconsolidated the Core MTS Business and recorded a pre-tax gain of $3,947 million (after-tax gain of $3,018 million). The pre-tax gain was calculated based on the difference between the fair value of our 70% equity interest in the joint venture, less the carrying amount of the contributed Core MTS Business’ net assets of $1,132 million and $1,258 million of promissory notes, a $136 million liability associated with a tax receivable agreement and transaction and other related expenses. The $1,258 million of promissory notes were subsequently repaid in cash from proceeds of Change Healthcare’s long term debt issuance. The gain is subject to final net working capital and other adjustments within 90 days from the transaction close date and is recorded in operating expenses within our Technology Solutions segment.
Our investment in Change Healthcare is accounted for using the equity method of accounting on a one-month reporting lag. We disclose intervening events at the joint venture in the lag period that could materially affect our consolidated financial statements, if applicable. In March 2017, our proportionate share of transaction expenses incurred by the joint venture is estimated to be approximately $80 million to $120 million. However, due to the timing of the transaction and the one-month reporting lag, no net income or loss from our investment was recorded in our financial results for 2017. Commencing April 1, 2017, our proportionate share of the net income or loss from the joint venture including these transaction expenses will be recorded in “Other Income, Net” in our consolidated statement of operations.
Refer to Financial Note 2, “Healthcare Technology Net Asset Exchange,” to the consolidated financial statements appearing in this Annual Report on Form 10-K for additional information.
Excluding the gain on Healthcare Technology Net Asset Exchange, 2017 operating expenses increased primarily due to a non-cash pre-tax charge of $290 million ($282 million after-tax) for goodwill impairment related to our EIS business within our Technology Solutions segment and higher expenses due to our 2017 acquisitions. In connection with the Healthcare Technology Net Asset Exchange, we are evaluating strategic options for our EIS business. 2017 operating expenses benefited from lower restructuring charges and cost savings associated with a cost alignment plan implemented in the fourth quarter of 2016 and ongoing expense management efforts. 2016 operating expenses decreased primarily due to pre-tax gains of $103 million from the sale of two businesses and lower acquisition-related expenses, partially offset by pre-tax restructuring charges of $203 million relating to the 2016 cost alignment plan. Additionally, 2015 operating expenses included a pre-tax and after-tax $150 million charge associated with the settlement of controlled substance distribution claims with the Drug Enforcement Administration (“DEA”), Department of Justice (“DOJ”) and various U.S. Attorney’s offices.
Income from continuing operations before income taxes increased in 2017 and 2016 compared with the prior years primarily due to lower operating expenses.
Our reported income tax rates were 23.4%, 27.9% and 30.7% in 2017, 2016 and 2015. Income tax expense for 2017 included discrete income tax benefits of $54 million related to the early adoption of the amended accounting guidance on share-based compensation. In 2017, we sold various software and ancillary intellectual property relating to our Technology Solutions business between wholly owned legal entities within the McKesson group that are based in different tax jurisdictions and recognized a net tax benefit of $137 million prior to the contribution of these assets to Change Healthcare.
Loss from discontinued operations, net of tax, for 2017 includes an after-tax loss from discontinued operations of $113 million resulting from the 2017 first quarter sale of our Brazilian pharmaceutical distribution business and for 2015, included pre-tax non-cash impairment charges of $241 million ($235 million after-tax) associated with the same Brazilian business.
Net income attributable to McKesson Corporation was $5,070 million, $2,258 million and $1,476 million in 2017, 2016 and 2015 and diluted earnings per common share attributable to McKesson Corporation from continuing operations were $23.28, $9.84
McKESSON CORPORATION
FINANCIAL REVIEW (Continued)
and $7.54. Diluted loss per common share attributable to McKesson Corporation from discontinued operations were $0.55, $0.14 and $1.27 in 2017, 2016 and 2015.
On April 3, 2017, we completed our acquisition of CoverMyMeds LLC (“CMM”) for $1.3 billion and up to an additional $0.2 billion of contingent consideration payable based on CMM’s financial performance through the end of 2019. CMM provides electronic prior authorization solutions and is headquartered in Columbus, Ohio. Refer to Financial Note 4, “Business Combinations” to the consolidated financial statements appearing in this Annual Report on Form 10-K.
Revenues:
| Years Ended March 31, | Change | ||||||||||||||||||
| (Dollars in millions) | 2017 | 2016 | 2015 | 2017 | 2016 | ||||||||||||||
| Distribution Solutions | |||||||||||||||||||
| North America pharmaceutical distribution & services | $ | 164,832 | $ | 158,469 | $ | 143,711 | 4 | % | 10 | % | |||||||||
| International pharmaceutical distribution & services | 24,847 | 23,497 | 26,358 | 6 | (11 | ) | |||||||||||||
| Medical-Surgical distribution & services | 6,244 | 6,033 | 5,907 | 3 | 2 | ||||||||||||||
| Total Distribution Solutions | 195,923 | 187,999 | 175,976 | 4 | 7 | ||||||||||||||
| Technology Solutions - products and services | 2,610 | 2,885 | 3,069 | (10 | ) | (6 | ) | ||||||||||||
| Total Revenues | $ | 198,533 | $ | 190,884 | $ | 179,045 | 4 | % | 7 | % |
Revenues increased 4% and 7% in 2017 and 2016 compared to the same periods a year ago primarily driven by our Distribution Solutions segment, which accounted for approximately 99% of our consolidated revenues.
Distribution Solutions
North America pharmaceutical distribution and services revenues increased over the last two years primarily due to market growth, higher revenues associated with our 2017 acquisitions including Biologics, Vantage and Rexall Health, and expanded business with existing customers. These increases were partially offset by customer losses. Market growth includes growing drug utilization, price increases and newly launched products, partially offset by price deflation associated with brand to generic drug conversion.
International pharmaceutical distribution and services revenues increased 6% in 2017 and decreased 11% in 2016. Excluding unfavorable foreign currency effects of 5% and 12%, revenues increased 11% and 1% in 2017 and 2016. Revenues increased in 2017 primarily due to market growth and our acquisition of UDG. Revenue growth for 2016 primarily reflected increased revenues in the United Kingdom due to a new distribution agreement with a manufacturer, which was almost fully offset by lower revenues in Norway associated with the loss of a hospital contract.
Medical-Surgical distribution and services revenues increased over the last two years primarily due to market growth. Revenues for 2017 also benefited from an acquisition and for 2016 were unfavorably affected by the sale of our ZEE Medical business in the second quarter of 2016.
Technology Solutions
Technology Solutions revenues for 2017 decreased primarily due to one less month of revenues from the Core MTS Business, which was contributed to Change Healthcare on March 1, 2017. Revenues decreased over the last two years primarily due to a decline in hospital software revenues, partially offset by higher revenues in our other businesses. Additionally, 2016 revenues decreased as a result of the sale of our nurse triage business and the transition of our workforce business within our International Technology business to a third party during the first quarter of 2016.
McKESSON CORPORATION
FINANCIAL REVIEW (Continued)
Gross Profit:
| Years Ended March 31, | Change | |||||||||||||||||||||
| (Dollars in millions) | 2017 | 2016 | 2015 | 2017 | 2016 | |||||||||||||||||
| Gross Profit | ||||||||||||||||||||||
| Distribution Solutions (1) (2) | $ | 9,856 | $ | 9,948 | $ | 9,937 | (1 | ) | % | — | % | |||||||||||
| Technology Solutions (2) | 1,415 | 1,468 | 1,474 | (4 | ) | — | ||||||||||||||||
| Total | $ | 11,271 | $ | 11,416 | $ | 11,411 | (1 | ) | % | — | % | |||||||||||
| Gross Profit Margin | ||||||||||||||||||||||
| Distribution Solutions | 5.03 | % | 5.29 | % | 5.65 | % | (26 | ) | bp | (36 | ) | bp | ||||||||||
| Technology Solutions | 54.21 | 50.88 | 48.03 | 333 | 285 | |||||||||||||||||
| Total | 5.68 | 5.98 | 6.37 | (30 | ) | (39 | ) |
bp - basis points
| (1) | Distribution Solutions segment’s gross profit includes LIFO credits of $7 million in 2017 and LIFO charges of $244 million and $337 million in 2016 and 2015. Gross profit for 2017, 2016 and 2015 also includes $144 million, $76 million and $3 million of net cash proceeds representing our share of antitrust legal settlements. |
| (2) | Gross profit for 2017 includes pre-tax credits of $4 million from the 2016 cost alignment plan within our Technology Solutions segment, and for 2016 includes pre-tax restructuring charges of $5 million and $21 million related to the 2016 cost alignment plan within our Distribution Solutions segment and Technology Solutions segment. |
Gross profit decreased 1% in 2017 and remained flat in 2016 compared to the same periods a year ago. Excluding unfavorable foreign currency effects of 1% and 4%, gross profit remained flat in 2017 and increased 4% in 2016. Gross profit margin decreased in 2017 and 2016. These changes were primarily due to our Distribution Solutions segment.
Distribution Solutions
Distribution Solutions segment’s gross profit decreased 1% in 2017 and remained flat in 2016. Excluding unfavorable foreign currency effects of 2% and 4%, gross profit increased 1% and 4% in 2017 and 2016.
Gross profit margin for 2017 decreased primarily due to weaker pharmaceutical manufacturer pricing trends, the competitive sell-side pricing environment and lower compensation from a branded pharmaceutical manufacturer from our U.S. Pharmaceutical distribution business, partially offset by LIFO inventory credits, higher cash receipts representing our share of antitrust legal settlements, higher global procurement benefits and our 2017 acquisitions. Gross profit for 2017 also reflects the impact of previously announced customer consolidation activity. Gross profit margin for 2016 decreased primarily due to a lower sell margin within our North America distribution business driven by increased customer sales volume with some of our largest customers, partially offset by lower LIFO inventory charges. Gross profit margin over the last two years was favorably affected by benefits from our global procurement arrangements and higher cash receipts representing our share of antitrust legal settlements. Buy margin primarily reflects volume and timing of compensation we receive from pharmaceutical manufacturers, including the effects of price increases of both branded and generic drugs. During 2017 and 2016, our Distribution Solutions segment experienced weaker pharmaceutical manufacturer pricing trends, which are expected to continue in 2018.
Our LIFO inventory credits were $7 million in 2017 and LIFO charges were $244 million and $337 million in 2016 and 2015. Our North America distribution business uses the LIFO method of accounting for the majority of its inventories, which results in cost of sales that more closely reflects replacement cost than under other accounting methods. The business’ practice is to pass on to customers published price changes from suppliers. Manufacturers generally provide us with price protection, which limits price-related inventory losses. A LIFO charge is recognized when the net effect of price increases on pharmaceutical and non-pharmaceutical products held in inventory exceeds the net impact of price declines, including the effect of branded pharmaceutical products that have lost market exclusivity. A LIFO credit is recognized when the net effect of price declines exceeds the net impact of price increases on pharmaceutical and non-pharmaceutical products held in inventory. Our annual LIFO charge is affected by changes in year-end inventory quantities, product mix and manufacturer pricing practices, which may be influenced by market and other external factors. Changes to any of the above factors could have a material impact to our annual LIFO credits or expense. LIFO credits were recognized in 2017 and LIFO charge decreased in 2016 compared to 2015 primarily due to the impact of lower price increases. As of March 31, 2017 and 2016, pharmaceutical inventories at LIFO did not exceed market.
McKESSON CORPORATION
FINANCIAL REVIEW (Continued)
Technology Solutions
Technology Solutions segment’s gross profit decreased in 2017 and remained flat in 2016. Gross profit for 2017 decreased due to one less month of gross profit from the Core MTS Business, which was contributed to the joint venture on March 1, 2017. This segment’s gross profit margin increased over the last two years.
Gross profit margin for 2017 increased primarily due to a decline in hospital software revenues, lower severance charges, ongoing cost management efforts and the prior year sales of businesses, partially offset by a lower margin from our hospital software business. Gross profit margin for 2017 also benefited from lower depreciation and amortization expenses related to the Core MTS Business’ assets, which were classified as held for sale since the second quarter of 2017. Depreciation and amortization related to the long-lived assets ceased as of the date they were determined as held for sale.
Gross profit margin for 2016 benefited from the sale of our nurse triage business, transitioning of our workforce business within our International Technology business to a third party, and higher pull-through of deferred revenue. These increases were partially offset by $49 million of pre-tax severance charges including charges associated with the 2016 cost alignment plan. Additionally, in 2015 we recorded a $34 million pre-tax non-cash charge representing a catch-up in depreciation and amortization expenses associated with our workforce business within our International Technology business. This business, which was previously designated as a discontinued operation, was reclassified to a continuing operation in 2015 when we decided to retain the business.
Operating Expenses:
| Years Ended March 31, | Change | |||||||||||||||||||
| (Dollars in millions) | 2017 | 2016 | 2015 | 2017 | 2016 | |||||||||||||||
| Operating Expenses | ||||||||||||||||||||
| Distribution Solutions (1) (3) | $ | 6,559 | $ | 6,436 | $ | 6,938 | 2 | % | (7 | ) | % | |||||||||
| Technology Solutions (1)(2)(3) | 1,148 | 951 | 1,039 | 21 | (8 | ) | ||||||||||||||
| Gain on Healthcare Technology Net Asset Exchange, net | (3,947 | ) | — | — | — | — | ||||||||||||||
| Corporate (1) | 402 | 484 | 466 | (17 | ) | 4 | ||||||||||||||
| Total | $ | 4,162 | $ | 7,871 | $ | 8,443 | (47 | ) | % | (7 | ) | % | ||||||||
| Operating Expenses as a Percentage of Revenues | ||||||||||||||||||||
| Distribution Solutions | 3.35 | % | 3.42 | % | 3.94 | % | (7 | ) | bp | (52 | ) | bp | ||||||||
| Technology Solutions | (107.24 | ) | 32.96 | 33.85 | (14,020 | ) | (89 | ) | ||||||||||||
| Total | 2.10 | 4.12 | 4.72 | (202 | ) | (60 | ) |
| (1) | 2017 includes pre-tax restructuring charges associated with the 2016 cost alignment plan of $19 million and $5 million within our Distribution Solutions segment and Corporate, and credits of $6 million within our Technology Solutions segment. 2016 includes pre-tax restructuring charges of $156 million, $30 million and $17 million within our Distribution Solutions segment, Technology Solutions segment and Corporate. |
| (2) | 2017 excludes the pre-tax gain on Healthcare Technology Net Asset Exchange, net, recorded within our Technology Solutions segment. |
| (3) | 2017 includes a non-cash pre-tax impairment charge of $290 million related to our EIS business within our Technology Solutions segment. 2015 includes pre-tax claim and litigation charges of $150 million within our Distribution Solutions segment. |
Operating expenses for 2017 and 2016 decreased 47% and 7% compared to the same periods a year ago. Excluding favorable foreign currency effects of 2% and 5%, operating expenses decreased 45% and 2% for 2017 and 2016.
2017 operating expenses benefited from a pre-tax gain of $3,947 million ($3,018 million after-tax) from the deconsolidation of the Core MTS Business within our Technology Solutions segment as previously discussed. 2016 operating expenses were favorably affected by pre-tax gains of $103 million from the sale of two businesses and lower acquisition-related expenses, partially offset by pre-tax restructuring charges of $203 million.
McKESSON CORPORATION
FINANCIAL REVIEW (Continued)
On March 14, 2016, we committed to a cost alignment plan, which primarily consists of a reduction in workforce and business process initiatives that will be substantially implemented prior to the end of 2019. We expect to incur a total of $250 million to $270 million of pre-tax charges under this plan, of which $243 million primarily representing employee severance costs had been recorded from the inception of the plan through March 31, 2017. Estimated remaining charges primarily consist of exit-related costs and accelerated depreciation and amortization, which are largely attributed to our Distribution Solutions segment. The 2016 cost alignment plan generated approximately $170 million to $190 million of net pre-tax savings during 2017. We anticipate the 2016 cost alignment plan to generate an incremental $70 million to $90 million of net pre-tax savings during the fiscal year ending March 31, 2018. Additional information on our cost alignment plan is included in Financial Note 6, “Restructuring” to the consolidated financial statements appearing in this Annual Report on Form 10-K.
Distribution Solutions
Distribution Solutions segment’s operating expenses increased 2% in 2017 and decreased 7% compared to the same periods a year ago. Excluding favorable foreign currency effects of 3% and 5%, operating expenses increased 5% in 2017 and decreased 2% in 2016.
Operating expenses increased in 2017 primarily due to our acquisitions and higher acquisition-related expenses and intangible amortization, partially offset by lower restructuring charges and cost savings associated with the 2016 cost alignment plan, ongoing expense management efforts, a pre-tax gain from the sale of a business recorded in 2016 and lower bad debt expense.
Operating expense decreased in 2016 compared to the prior year primarily due to lower acquisition-related expenses relating to integration activities for our acquisitions and the sale of our ZEE Medical business, including a pre-tax gain of $52 million. These decreases were partially offset by pre-tax charges of $156 million associated with the 2016 cost alignment plan, higher compensation and benefit costs and bad debt expense. Operating expenses for 2015 included a $150 million charge associated with the settlement of controlled substance distribution claims.
Technology Solutions
Technology Solutions segment’s operating expenses and operating expenses as a percentage of revenues decreased in 2017 primarily due to a pre-tax gain of $3,947 million (after-tax gain of $3,018 million) from the deconsolidation of the Core MTS Business. Excluding the gain on Healthcare Technology Net Asset Exchange, this segment’s operating expenses increased primarily due to a non-cash pre-tax charge of $290 million ($282 million after-tax) for the EIS goodwill impairment charge, partially offset by cost savings from the 2016 cost alignment plan and ongoing cost management efforts and one less month of expenses from the Core MTS Business.
Operating expenses and operating expenses as a percentage of revenues in 2016 decreased compared to the prior year primarily due to the sale of our nurse triage business in the first quarter of 2016, including a pre-tax gain of $51 million, and lower compensation and benefit costs. These decreases were partially offset by pre-tax charges of $30 million for the 2016 cost alignment plan as well as the write-off of internal-use software.
Corporate
Corporate expenses decreased 17% in 2017 compared to the prior year primarily due to lower restructuring charges and cost savings associated with the 2016 cost alignment plan, including lower compensation and benefit costs and outside service fees. Corporate expenses for 2017 also benefited from a pre-tax gain of $15 million from the sale-leaseback transaction of our corporate headquarters building. Corporate expenses increased in 2016 compared to the prior year primarily due to pre-tax charges of $17 million associated with the 2016 cost alignment plan, partially offset by lower acquisition-related expenses and a decrease in compensation and benefit costs.
McKESSON CORPORATION
FINANCIAL REVIEW (Continued)
Acquisition Expenses and Related Adjustments
Acquisition expenses and related adjustments include transaction, integration and other expenses that are directly related to business acquisitions and Healthcare Technology Net Asset Exchange including gain recognized from the transaction. In addition to a pre-tax gain of $3,947 million from the Healthcare Technology Net Asset Exchange, we recorded acquisition-related expenses of $151 million, $114 million and $224 million in 2017, 2016 and 2015. Expenses in 2017 were higher primarily due to our business acquisitions of UDG, Vantage, Biologics and Rexall Health, partially offset by a decline in expenses associated with our February 2014 acquisition of Celesio and February 2013 acquisition of PSS World Medical, Inc. (“PSSI”). Our integration of PSSI and Celesio were substantially completed in the first quarter of 2017.
| Years Ended March 31, | |||||||||||
| (Dollars in millions) | 2017 | 2016 | 2015 | ||||||||
| Cost of Sales | $ | 1 | $ | — | $ | 1 | |||||
| Operating Expenses | |||||||||||
| Gain on Change Healthcare Net Asset Exchange, net | (3,947 | ) | — | — | |||||||
| Transaction closing expenses | 30 | 10 | 6 | ||||||||
| Restructuring, severance and relocation | 25 | — | 57 | ||||||||
| Other (1) | 85 | 100 | 160 | ||||||||
| Total | (3,807 | ) | 110 | 223 | |||||||
| Other Income, Net | 10 | 4 | — | ||||||||
| Total Acquisition Expenses and Related Adjustments | $ | (3,796 | ) | $ | 114 | $ | 224 |
| (1) | These expenses primarily include outside service fees, costs associated with information technology conversions, closures of duplicative facilities including distribution centers and other integration activities. |
Acquisition expenses and related adjustments by segment were as follows:
| Years Ended March 31, | |||||||||||
| (Dollars in millions) | 2017 | 2016 | 2015 | ||||||||
| Cost of Sales | $ | 1 | $ | — | $ | 1 | |||||
| Operating Expenses and Other Income, Net | |||||||||||
| Distribution Solutions | 133 | 112 | 211 | ||||||||
| Technology Solutions | (3,936 | ) | — | — | |||||||
| Corporate | 6 | 2 | 12 | ||||||||
| Total | (3,797 | ) | 114 | 223 | |||||||
| Total Acquisition Expenses and Related Adjustments | $ | (3,796 | ) | $ | 114 | $ | 224 |
During 2016 and 2015, we incurred $9 million and $109 million of acquisition-related expenses for our acquisition of Celesio and $70 million and $110 million for our acquisition of PSSI. We did not incur any material expenses associated with these two acquisitions in 2017. These expenses primarily include restructuring, severance, employee retention incentives, outside service fees and other costs to integrate the business, and bridge loan fees. Additionally, our acquisition-related expenses for our PSSI acquisition include amounts associated with distribution center rationalization and information technology conversions to common platforms. Integration activities for our PSSI and Celesio acquisitions were substantially completed in 2017.
Amortization Expenses of Acquired Intangible Assets
Amortization expenses of acquired intangible assets in connection with acquisitions recorded in operating expenses were $440 million, $423 million and $483 million in 2017, 2016 and 2015. Amortization expenses increased in 2017 primarily due to our acquisitions of UDG, Biologics, Vantage and Rexall Health, partially offset by lower amortization expense related to Core MTS Business assets which were classified as held for sale since the 2017 second quarter. Amortization expense for 2016 decreased due to foreign currency effects and intangible assets that were fully amortized.
McKESSON CORPORATION
FINANCIAL REVIEW (Continued)
Amortization expense recorded in operating expenses by segment was as follows:
| Years Ended March 31, | |||||||||||
| (Dollars in millions) | 2017 | 2016 | 2015 | ||||||||
| Distribution Solutions | 418 | $ | 389 | $ | 442 | ||||||
| Technology Solutions | 22 | 34 | 40 | ||||||||
| Corporate | — | — | 1 | ||||||||
| Total | $ | 440 | $ | 423 | $ | 483 |
Other Income, Net:
| Years Ended March 31, | Change | ||||||||||||||||||
| (Dollars in millions) | 2017 | 2016 | 2015 | 2017 | 2016 | ||||||||||||||
| Distribution Solutions | $ | 64 | $ | 41 | $ | 48 | 56 | % | (15 | ) | % | ||||||||
| Technology Solutions | 1 | 2 | 3 | (50 | ) | (33 | ) | ||||||||||||
| Corporate | 25 | 15 | 12 | 67 | 25 | ||||||||||||||
| Total | $ | 90 | $ | 58 | $ | 63 | 55 | % | (8 | ) | % |
Other income, net for 2017 increased 55% primarily due to higher equity investment income within our Distribution Solutions segment. Other income, net for 2016 approximated the prior year.
McKESSON CORPORATION
FINANCIAL REVIEW (Continued)
Segment Operating Profit, Corporate Expenses, Net and Interest Expense:
| Years Ended March 31, | Change | |||||||||||||||||||
| (Dollars in millions) | 2017 | 2016 | 2015 | 2017 | 2016 | |||||||||||||||
| Segment Operating Profit (1) (2) | ||||||||||||||||||||
| Distribution Solutions | $ | 3,361 | $ | 3,553 | $ | 3,047 | (5 | ) | % | 17 | % | |||||||||
| Technology Solutions (3) | 4,215 | 519 | 438 | 712 | 18 | |||||||||||||||
| Subtotal | 7,576 | 4,072 | 3,485 | 86 | 17 | |||||||||||||||
| Corporate Expenses, Net (2) | (377 | ) | (469 | ) | (454 | ) | (20 | ) | 3 | |||||||||||
| Interest Expense | (308 | ) | (353 | ) | (374 | ) | (13 | ) | (6 | ) | ||||||||||
| Income From Continuing Operations Before Income Taxes | $ | 6,891 | $ | 3,250 | $ | 2,657 | 112 | % | 22 | % | ||||||||||
| Segment Operating Profit Margin | ||||||||||||||||||||
| Distribution Solutions | 1.72 | % | 1.89 | % | 1.73 | % | (17 | ) | bp | 16 | bp | |||||||||
| Technology Solutions | 161.49 | 17.99 | 14.27 | 14,350 | 372 |
| (1) | Segment operating profit includes gross profit, net of operating expenses, plus other income, net, for our two operating segments. |
| (2) | In connection with the 2016 cost alignment plan, we recorded pre-tax restructuring charges of $229 million in 2016. 2016 pre-tax charges were recorded as follows: $161 million, $51 million and $17 million within our Distribution Solutions segment, Technology Solutions segment and Corporate expenses, net. Segment operating profit for 2017 includes pre-tax restructuring charges of $19 million and $5 million in our Distribution Solutions segment and Corporate expenses, net, and pre-tax credits of $10 million associated with the 2016 cost alignment plan. |
| (3) | Technology Solutions segment’s operating profit for 2017 includes a pre-tax gain of $3,947 million from the deconsolidation of the Core MTS Business and a non-cash pre-tax impairment charge of $290 million related to our EIS business. |
Segment Operating Profit
Distribution Solutions: Operating profit margin decreased for 2017 primarily due to a decline in gross profit margin reflecting weaker pharmaceutical manufacturer pricing trends, the competitive sell-side pricing environment and lower compensation from a branded pharmaceutical manufacturer from our U.S. Pharmaceutical distribution business. Operating profit and operating profit margin in 2017 benefited from LIFO credits, our acquisitions, lower restructuring charges and cost savings associated with the 2016 cost alignment plan and higher cash receipts representing our share of antitrust legal settlements.
Operating profit and operating profit margin for 2016 increased due to lower operating expenses as a percentage of revenues, partially offset by a decline in gross profit margin. Operating profit and operating profit margin in 2016 includes $161 million of pre-tax charges associated with the Cost Alignment Plan, lower LIFO charges, and a $52 million pre-tax gain on the sale of our ZEE Medical business. Operating profit and operating profit margin for 2015 included a $150 million charge related to our controlled substance distribution claims.
Technology Solutions: Operating profit and operating profit margin increased in 2017 primarily due to a $3,947 million pre-tax gain from the deconsolidation of the Core MTS Business in the fourth quarter of 2017, which was partially offset by the non-cash EIS goodwill impairment pre-tax charge of $290 million. 2017 operating profit benefited from lower restructuring charges and cost savings from the 2016 cost alignment plan. Operating profit for 2017 was unfavorably affected by one less month of gross profit from the Core MTS business, which was contributed to Change Healthcare on March 1, 2017. Operating profit margin increased in 2016 primarily due to higher gross profit margin and a decrease in operating expenses as a percentage of revenue. Operating profit and operating profit margin for 2016 included a $51 million pre-tax gain from the sale of our nurse triage business and $51 million of pre-tax charges associated with the 2016 cost alignment plan.
Corporate: Corporate expenses, net, decreased in 2017 primarily due to lower restructuring charges and a pre-tax gain from a sale-leaseback transaction. Corporate expenses, net increased in 2016 compared to 2015 primarily due to higher operating expenses as previously discussed.
Interest Expense: Interest expense decreased in 2017 primarily due to repayments of debt, partially offset by an increase relating to the issuance of commercial paper. Interest expense decreased in 2016 primarily due to repayments of debt and certain foreign currency-denominated credit facilities.
McKESSON CORPORATION
FINANCIAL REVIEW (Continued)
Interest expense fluctuates based on timing, amounts and interest rates of term debt repaid and new term debt issued, as well as amounts incurred associated with financing fees.
Income Taxes
During 2017, 2016 and 2015, income tax expense related to continuing operations was $1,614 million, $908 million and $815 million, which included net discrete tax benefits of $82 million, $42 million and $33 million. Our discrete tax benefit for 2017 includes a tax benefit of $54 million related to the adoption of the amended accounting guidance on employee share-based compensation. Our reported income tax rates were 23.4%, 27.9% and 30.7% in 2017, 2016 and 2015. Fluctuations in our reported income tax rates are primarily due to changes within our business mix, including varying proportions of income attributable to foreign countries that have lower income tax rates, discrete items and for 2017 also due to the impact of the intercompany sale of software.
The non-cash pre-tax charge of $290 million to impair the carrying value of goodwill related to our EIS business within our Technology Solutions segment, described in Financial Note 3, “Goodwill Impairment,” had an unfavorable impact on our effective tax rate in 2017 given that the majority of this charge was not deductible for tax purposes.
On December 19, 2016, we sold various software and ancillary intellectual property relating to our Technology Solutions business between wholly owned legal entities within the McKesson group that are based in different tax jurisdictions. The transferor entity recognized a gain on the sale of assets that was not subject to income tax in its local jurisdiction; such gain was eliminated upon consolidation. An entity based in the U.S. was the recipient of the software and ancillary intellectual property and is entitled to amortize the fair value of the assets for book and tax purposes. For U.S. GAAP purposes, the tax benefit associated with the amortization of these assets is recognized over the tax lives of the assets. As a result, a net tax benefit of $137 million was recognized prior to the contribution of a portion of these assets to Change Healthcare as described in Financial Note 2, “Healthcare Technology Net Asset Exchange”.
On March 1, 2017, we contributed assets to Change Healthcare as further described in Financial Note 2, “Healthcare Technology Net Asset Exchange”. While this transaction was predominantly structured as a tax free asset contribution for U.S. federal income tax purposes under Section 721(a) of the Internal Revenue Code, we recorded tax expense of $929 million on the gain. The tax expense was primarily driven by the recognition of a deferred tax liability on the excess book over tax basis in our equity investment in Change Healthcare.
Significant judgments and estimates are required in determining the consolidated income tax provision and evaluating income tax uncertainties. Although our major taxing jurisdictions include the U.S., Canada and the United Kingdom, we are subject to income taxes in numerous foreign jurisdictions. Our income tax expense, deferred tax assets and liabilities and uncertain tax liabilities reflect management’s best assessment of estimated current and future taxes to be paid. We believe that we have made adequate provision for all income tax uncertainties.
We file income tax returns in the U.S. federal jurisdiction, various U.S. state jurisdictions and various foreign jurisdictions. During the first quarter of 2017, we reached an agreement with the Internal Revenue Service to settle all outstanding issues relating to the fiscal years 2007 through 2009. This settlement did not have a material impact on our provision for income taxes.
We received reassessments from the Canada Revenue Agency related to a transfer pricing matter impacting years 2003 through 2013. During 2016, we reached an agreement to settle the transfer pricing matter for years 2003 through 2013 and recorded a net discrete tax benefit of $8 million.
Loss from Discontinued Operations, Net of Tax
Losses from discontinued operations, net of tax, were $124 million, $32 million and $299 million in 2017, 2016 and 2015.
Loss from discontinued operations, net for 2017 includes an after-tax loss of $113 million related to the sale of our Brazilian pharmaceutical distribution business within our Distribution Solutions segment, which we acquired through our February 2014 acquisition of Celesio. In 2015, we committed to a plan to sell this business and the results of operations and cash flows for this business had been classified as discontinued operations since 2015. On May 31, 2016, we completed the sale of this business and recognized the loss primarily for the settlement of certain indemnification matters as well as the release of the cumulative translation losses. We made a payment of approximately $100 million related to the sale.
McKESSON CORPORATION
FINANCIAL REVIEW (Continued)
Loss from discontinued operations, net for 2015 included pre-tax non-cash impairment charges of $241 million ($235 million after-tax), which were recorded to reduce the carrying value of our Brazilian pharmaceutical distribution business to its estimated fair value, less costs to sell. Loss from discontinued operations, net for 2015 also included a pre-tax and after-tax loss of $6 million from the sale of a software business within our International Technology business.
Refer to Financial Note 5, “Discontinued Operations,” to the consolidated financial statements appearing in this Annual Report on Form 10-K for additional information.
Net Income (Loss) Attributable to Noncontrolling Interests: Net income attributable to noncontrolling interests for all periods presented includes the guaranteed dividend or annual recurring compensation that we are obligated to pay to the noncontrolling shareholders of Celesio AG under the profit and loss transfer agreement (the “Domination Agreement”). In 2017, net income attributable to noncontrolling interests also includes third-party equity interests in our consolidated entities including Vantage and ClarusOne Sourcing Services LLC, which was established between McKesson and Wal-Mart Stores, Inc. Noncontrolling interests with redemption features, such as put rights, that are not solely within the Company’s control are considered redeemable noncontrolling interests. Redeemable noncontrolling interests are presented outside of Stockholders’ Equity on our consolidated balance sheet. Refer to Financial Note 11, “Redeemable Noncontrolling Interests and Noncontrolling Interests,” to the consolidated financial statements appearing in this Annual Report on Form 10-K for additional information.
Net Income Attributable to McKesson Corporation: Net income attributable to McKesson Corporation was $5,070 million, $2,258 million and $1,476 million in 2017, 2016 and 2015 and diluted earnings per common share were $22.73, $9.70 and $6.27.
Weighted Average Diluted Common Shares Outstanding: Diluted earnings per common share was calculated based on a weighted average number of shares outstanding of 223 million, 233 million and 235 million for 2017, 2016 and 2015. Weighted average diluted common shares outstanding is affected by the exercise and settlement of share-based awards and in 2017 and 2016, the cumulative effect of share repurchases.
Foreign Operations
Our foreign operations represented approximately 17%, 17% and 20% of our consolidated revenues in 2017, 2016 and 2015. Foreign operations are subject to certain risks, including currency fluctuations. We monitor our operations and adopt strategies responsive to changes in the economic and political environment in each of the countries in which we operate. We conduct our business worldwide in local currencies including Euro, British pound sterling and Canadian dollar. As a result, the comparability of our results reported in U.S. dollars can be affected by changes in foreign currency exchange rates. In discussing our operating results, we may use the term “foreign currency effect”, which refers to the effect of changes in foreign currency exchange rates used to convert the local currency results of foreign countries where the functional currency is not the U.S. dollar. We present this information to provide a framework for assessing how our business performed excluding the effect of foreign currency rate fluctuations. In computing foreign currency effect, we translate our current year results in local currencies into U.S dollars by applying average foreign exchange rates of the corresponding prior year periods, and we subsequently compare those results to the previously reported results of the comparable prior year periods in U.S. dollars. Additional information regarding our foreign operations is included in Financial Note 29, “Segments of Business,” to the consolidated financial statements appearing in this Annual Report on Form 10-K.
Business Combinations
Refer to Financial Notes 4 and 17, “Business Combinations” and “Debt and Financing Activities,” to the consolidated financial statements appearing in this Annual Report on Form 10-K for additional information.
2018 Outlook
Information regarding the Company’s 2018 outlook is contained in our Form 8-K dated May 22, 2017. This Form 8-K should be read in conjunction with the sections Item 1 - Business - Forward-Looking Statements and Item 1A - Risk Factors in Part I of this Annual Report on Form 10-K.
McKESSON CORPORATION
FINANCIAL REVIEW (Continued)
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
We consider an accounting estimate to be critical if the estimate requires us to make assumptions about matters that were uncertain at the time the accounting estimate was made and if different estimates that we reasonably could have used in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, could have a material impact on our financial condition or results from operations. Below are the estimates that we believe are critical to the understanding of our operating results and financial condition. Other accounting policies are described in Financial Note 1, “Significant Accounting Policies,” to the consolidated financial statements appearing in this Annual Report on Form 10-K. Because of the uncertainty inherent in such estimates, actual results may differ from these estimates.
Allowance for Doubtful Accounts: We provide short-term credit and other customer financing arrangements to customers who purchase our products and services. Other customer financing primarily relates to guarantees provided to our customers, or their creditors, regarding the repurchase of inventories. We also provide financing to certain customers related to the purchase of pharmacies, which serve as collateral for the loans. We estimate the receivables for which we do not expect full collection based on historical collection rates and specific knowledge regarding the current creditworthiness of our customers and record an allowance in our consolidated financial statements for these amounts.
In determining the appropriate allowance for doubtful accounts, which includes general and specific reserves, the Company reviews accounts receivable aging, industry trends, customer financial strength, credit standing, historical write-off trends and payment history to assess the probability of collection. If the frequency and severity of customer defaults due to our customers’ financial condition or general economic conditions change, our allowance for uncollectible accounts may require adjustment. As a result, we continuously monitor outstanding receivables and other customer financing and adjust allowances for accounts where collection may be in doubt. During 2017, sales to our ten largest customers, including group purchasing organizations (“GPOs”) accounted for approximately 54.2% of our total consolidated revenues. Sales to our largest customer, CVS Health (“CVS”), accounted for approximately 20.2% of our total consolidated revenues. At March 31, 2017, trade accounts receivable from our ten largest customers were approximately 33.7% of total trade accounts receivable. Accounts receivable from CVS were approximately 17.8% of total trade accounts receivable. As a result, our sales and credit concentration is significant. We also have agreements with GPOs, each of which functions as a purchasing agent on behalf of member hospitals, pharmacies and other healthcare providers, as well as with government entities and agencies. The accounts receivables balances are with individual members of the GPOs, and therefore no significant concentration of credit risk exists. A material default in payment, a material reduction in purchases from these or any other large customers, or the loss of a large customer or GPO could have a material adverse impact on our financial position, results of operations and liquidity.
Reserve methodologies are assessed annually based on historical losses and economic, business and market trends. In addition, reserves are reviewed quarterly and updated if unusual circumstances or trends are present. We believe the reserves maintained and expenses recorded in 2017 are appropriate and consistent with historical methodologies employed. At this time, we are not aware of any internal process or customer issues that might lead to a significant increase in our allowance for doubtful accounts as a percentage of net revenue in the foreseeable future.
At March 31, 2017, trade and notes receivables were $14,717 million prior to allowances of $243 million. In 2017, 2016 and 2015, our provision for bad debts was $93 million, $113 million and $67 million. At March 31, 2017 and 2016, the allowance as a percentage of trade and notes receivables was 1.7% and 1.4%. An increase or decrease of a hypothetical 0.1% in the 2017 allowance as a percentage of trade and notes receivables would result in an increase or decrease in the provision for bad debts of approximately $15 million. The selected 0.1% hypothetical change does not reflect what could be considered the best or worst case scenarios. Additional information concerning our allowance for doubtful accounts may be found in Schedule II included in this Annual Report on Form 10-K.
Inventories: We report inventories at the lower of cost or market (“LCM”). Inventories for our Distribution Solutions segment consist of merchandise held for resale. For our Distribution Solutions segment, the majority of the cost of domestic inventories is determined using the LIFO method. The majority of the cost of inventories held in foreign locations is based on weighted average purchase price using the first-in, first-out method (“FIFO”). Technology Solutions segment inventories consist of computer hardware with cost generally determined by the standard cost method, which approximates average cost. Rebates, cash discounts and other incentives received from vendors relating to the purchase or distribution of inventory are considered as product discounts and are accounted for as a reduction in the cost of inventory and are recognized when the inventory is sold. Total inventories were $15.3 billion at March 31, 2017 and 2016.
McKESSON CORPORATION
FINANCIAL REVIEW (Continued)
The LIFO method was used to value approximately 70% and 74% of our inventories at March 31, 2017 and 2016. If we had used the FIFO method of inventory valuation, which approximates current replacement costs, inventories would have been approximately $1,005 million and $1,012 million higher than the amounts reported at March 31, 2017 and 2016. These amounts are equivalent to our LIFO reserves. Our LIFO valuation amount includes both pharmaceutical and non-pharmaceutical products. We recognized net LIFO credits of $7 million in 2017 and net LIFO charges of $244 million and $337 million in 2016 and 2015 within our consolidated statements of operations. A LIFO charge is recognized when the net effect of price increases on pharmaceutical and non-pharmaceutical products held in inventory exceeds the impact of price declines including the effect of branded pharmaceutical products that have lost market exclusivity. A LIFO credit is recognized when the net effect of price declines exceeds the impact of price increases on pharmaceutical and non-pharmaceutical products held in inventory.
We believe that the average inventory costing method provides a reasonable estimation of the current cost of replacing inventory (i.e., “market”). As such, our LIFO inventory is valued at the lower of LIFO or market. As of March 31, 2017 and 2016, inventories at LIFO did not exceed market.
In determining whether inventory valuation issues exist, we consider various factors including estimated quantities of slow-moving inventory by reviewing on-hand quantities, outstanding purchase obligations and forecasted sales. Shifts in market trends and conditions, changes in customer preferences due to the introduction of generic drugs or new pharmaceutical products or the loss of one or more significant customers are factors that could affect the value of our inventories. We write down inventories which are considered excess and obsolete as a result of these reviews. These factors could make our estimates of inventory valuation differ from actual results.
Business Combinations: We account for acquired businesses using the acquisition method of accounting, which requires that once control of a business is obtained, 100% of the assets acquired and liabilities assumed, including amounts attributed to noncontrolling interests, be recorded at the date of acquisition at their respective fair values. Any excess of the purchase price over the estimated fair values of the net assets acquired is recorded as goodwill. Acquisition-related expenses and related restructuring costs are expensed as incurred.
Several valuation methods may be used to determine the fair value of assets acquired and liabilities assumed. For intangible assets, we typically use the income method. This method starts with a forecast of all of the expected future net cash flows associated with each asset. These cash flows are then adjusted to present value by applying an appropriate discount rate that reflects the risk factors associated with the cash flow streams. Some of the more significant estimates and assumptions inherent in the income method or other methods include the amount and timing of projected future cash flows, the discount rate selected to measure the risks inherent in the future cash flows and the assessment of the asset’s life cycle and the competitive trends impacting the asset, including consideration of any technical, legal, regulatory, or economic barriers to entry. Determining the useful life of an intangible asset also requires judgment as different types of intangible assets will have different useful lives. Refer to Financial Note 4, “Business Combinations,” to the consolidated financial statements appearing in this Annual Report on Form 10-K for additional information regarding our acquisitions.
Goodwill and Intangible Assets: As a result of acquiring businesses, we have $10,586 million and $9,786 million of goodwill at March 31, 2017 and 2016 and $3,665 million and $3,021 million of intangible assets, net at March 31, 2017 and 2016. We maintain goodwill assets on our books unless the assets are considered to be impaired. We perform an impairment test on goodwill balances annually in the fourth quarter or more frequently if indicators for potential impairment exist. Indicators that are considered include significant changes in performance relative to expected operating results, significant changes in the use of the assets, significant negative industry or economic trends, or a significant decline in the Company’s stock price and/or market capitalization for a sustained period of time.
Goodwill impairment testing is conducted at the reporting unit level, which is generally defined as a component — one level below our Distribution Solutions and Technology Solutions operating segments, for which discrete financial information is available and segment management regularly reviews the operating results of that reporting unit.
McKESSON CORPORATION
FINANCIAL REVIEW (Continued)
The first step in goodwill testing requires us to compare the estimated fair value of a reporting unit to its carrying value. This step may be performed utilizing either a qualitative or quantitative assessment. If the carrying value of the reporting unit is lower than its estimated fair value, no further evaluation is necessary. If the carrying value of the reporting unit is higher than its estimated fair value, the second step must be performed to measure the amount of impairment loss. Under the second step, the implied fair value of goodwill is calculated in a hypothetical analysis by subtracting the fair value of all assets and liabilities of the reporting unit, including any unrecognized intangibles assets, from the fair value of the reporting unit calculated in the first step of the impairment test. If the carrying value of goodwill for the reporting unit exceeds the implied fair value of goodwill, an impairment charge is recorded for that excess.
To estimate the fair value of our reporting units, we use a combination of the market approach and the income approach. Under the market approach, we estimate fair value by comparing the business to similar businesses, or guideline companies whose securities are actively traded in public markets. Under the income approach, we use a discounted cash flow model in which cash flows anticipated over several periods, plus a terminal value at the end of that time horizon, are discounted to their present value using an appropriate expected rate of return. In addition, we compare the aggregate of the reporting units’ fair values to our market capitalization as further corroboration of the fair values.
Some of the more significant estimates and assumptions inherent in the goodwill impairment estimation process using the market approach include the selection of appropriate guideline companies, the determination of market value multiples for both the guideline companies and the reporting unit, the determination of applicable premiums and discounts based on any differences in marketability between the business and the guideline companies and for the income approach, the required rate of return used in the discounted cash flow method, which reflects capital market conditions and the specific risks associated with the business. Under the income approach, the fair value estimates in the goodwill impairment analysis are highly sensitive to the discount rates used in the discounting of expected cash flows attributable to the reporting units. The discount rates are the weighted average cost of capital measuring the reporting units’ cost of debt and equity financing weighted by the percentage of debt and percentage of equity in a company’s target capital. Other estimates inherent in both the market and income approaches include long-term growth rates, projected revenues, earnings and cash flow forecasts for the reporting units.
In 2016 and 2015, we concluded that there were no impairments of goodwill as the fair value of each reporting unit exceeded its carrying value. In 2017, we recorded a non-cash pre-tax charge of $290 million ($282 million after-tax) to impair the carrying value of our EIS business. Estimates of fair value result from a complex series of judgments about future events and uncertainties and rely heavily on estimates and assumptions at a point in time. Judgments made in determining an estimate of fair value may materially impact our results of operations. The valuations are based on information available as of the impairment review date and are based on expectations and assumptions that have been deemed reasonable by management. Any material changes in key assumptions, including failure to meet business plans, negative changes in government reimbursement rates, deterioration in the U.S. and global financial markets, an increase in interest rate or an increase in the cost of equity financing by market participants within the industry or other unanticipated events and circumstances, may decrease the projected cash flows or increase the discount rates and could potentially result in an impairment charge. Our Celesio reporting unit within our Distribution Solutions segment experienced a decline in its estimated future cash flows primarily driven by government reimbursement reductions in our U.K. retail business. The decline in estimated future cash flows resulted in the estimated fair value of this reporting unit exceeding the carrying value of the reporting unit by 13%. The goodwill balance of this reporting unit was $2,790 million at March 31, 2017 or approximately 26% of the total distribution segment’s goodwill balance. A further decrease in the estimated future cash flows, an increase in the discount rate and/ or a decrease in the terminal growth rate, could result in a goodwill impairment for this reporting unit. The discount rate and terminal growth rate used in our 2017 annual impairment testing for this reporting unit were 7% and 1.5%.
Currently, all of our intangible assets are subject to amortization and are amortized based on the pattern of their economic consumption or on a straight-line basis over their estimated useful lives, ranging from one to 38 years. We review intangible assets for impairment whenever events or changes in circumstances indicate that the carrying value of the assets may not be recoverable. Determination of recoverability is based on the lowest level of identifiable estimated future undiscounted cash flows resulting from use of the asset and its eventual disposition. Measurement of any impairment loss is based on the excess of the carrying value of the asset over its fair value. Assumptions and estimates about future values and remaining useful lives of our purchased intangible assets are complex and subjective. They can be affected by a variety of factors, including external factors such as industry and economic trends, and internal factors such as changes in our business strategy and our internal forecasts. There were no material impairments of intangibles in 2017, 2016 or 2015 within our continuing operations. Our ongoing consideration of all the factors described previously could result in impairment charges in the future, which could adversely affect our net income.
McKESSON CORPORATION
FINANCIAL REVIEW (Continued)
Supplier Reserves: We establish reserves against amounts due from suppliers relating to various price and rebate incentives, including deductions or billings taken against payments otherwise due to them. These reserve estimates are established based on judgment after considering the status of current outstanding claims, historical experience with the suppliers, the specific incentive programs and any other pertinent information available. We evaluate the amounts due from suppliers on a continual basis and adjust the reserve estimates when appropriate based on changes in factual circumstances. As of March 31, 2017 and 2016, supplier reserves were $201 million and $144 million. The final outcome of any outstanding claims may differ from our estimate. All of the supplier reserves at March 31, 2017 and 2016 pertain to our Distribution Solutions segment. An increase or decrease in the supplier reserve as a hypothetical 0.1% of trade payables at March 31, 2017 would result in an increase or decrease in the cost of sales of approximately $31 million in 2017. The selected 0.1% hypothetical change does not reflect what could be considered the best or worst case scenarios.
Income Taxes: Our income tax expense and deferred tax assets and liabilities reflect management’s best assessment of estimated current and future taxes to be paid. We are subject to income taxes in the U.S. and numerous foreign jurisdictions. Significant judgments and estimates are required in determining the consolidated income tax provision and in evaluating income tax uncertainties. We review our tax positions at the end of each quarter and adjust the balances as new information becomes available.
Deferred income taxes arise from temporary differences between the tax and financial statement recognition of revenue and expense. In evaluating our ability to recover our deferred tax assets, we consider all available positive and negative evidence including our past operating results, the existence of cumulative net operating losses in the most recent years and our forecast of future taxable income. In estimating future taxable income, we develop assumptions including the amount of future federal, state and foreign pre-tax operating income, the reversal of temporary differences and the implementation of feasible and prudent tax planning strategies. These assumptions require significant judgment about the forecasts of future taxable income and are consistent with the plans and estimates we use to manage the underlying businesses. We had deferred income tax assets (net of valuation allowances) of $1,156 million and $1,272 million and deferred tax liabilities of $4,806 million and $3,947 million at March 31, 2017 and 2016. Deferred tax assets primarily consist of timing differences relating to our compensation and benefit related accruals and for net operating loss and tax credit carryforwards. Deferred tax liabilities have been established primarily due to excess book over tax basis in inventory valuation (including inventory valued at LIFO), intangible assets and our investment in Change Healthcare. Valuation allowances of $503 million and $267 million exist at March 31, 2017 and 2016 against certain deferred tax assets, which primarily relate to state and foreign net operating loss carryforwards for which the ultimate realization of future benefits is uncertain. Changes in tax laws and rates could also affect recorded deferred tax assets and liabilities in the future. Should tax laws change, including those laws pertaining to LIFO, our tax expense and cash flows could be materially impacted.
In addition, the calculation of our tax liabilities includes estimates for uncertainties in the application of complex tax regulations across multiple global jurisdictions where we conduct our operations. We recognize liabilities for tax and related interest for issues in the U.S. and other tax jurisdictions based on our estimate of whether, and the extent to which, additional taxes and related interest will be due. If our current estimate of tax and interest liabilities is less than the ultimate settlement, an additional charge to income tax expense may result. If our current estimate of tax and interest liabilities is more than the ultimate settlement, a reduction to income tax expense may be recognized.
An increase or decrease of a hypothetical 1% in our 2017 effective tax rate as applied to income from continuing operations would result in an increase or decrease in the provision for income taxes of approximately $69 million for 2017.
Loss Contingencies: We are subject to various claims, including claims with customers and vendors, pending and potential legal actions for damages, investigations relating to governmental laws and regulations and other matters arising out of the normal conduct of our business. When a loss is considered probable and reasonably estimable, we record a liability in the amount of our best estimate for the ultimate loss. However, the likelihood of a loss with respect to a particular contingency is often difficult to predict and determining a meaningful estimate of the loss or a range of loss may not be practicable based on the information available and the potential effect of future events and decisions by third parties that will determine the ultimate resolution of the contingency. Moreover, it is not uncommon for such matters to be resolved over many years, during which time relevant developments and new information must be reevaluated at least quarterly to determine both the likelihood of potential loss and whether it is possible to reasonably estimate a range of possible loss. When a loss is probable but a reasonable estimate cannot be made, disclosure of the proceeding is provided.
McKESSON CORPORATION
FINANCIAL REVIEW (Continued)
Disclosure is also provided when it is reasonably possible that a loss will be incurred or when it is reasonably possible that the amount of a loss will exceed the recorded provision. We review all contingencies at least quarterly to determine whether the likelihood of loss has changed and to assess whether a reasonable estimate of the loss or range of the loss can be made. As discussed above, development of a meaningful estimate of loss or a range of potential loss is complex when the outcome is directly dependent on negotiations with or decisions by third parties, such as regulatory agencies, the court system and other interested parties. Such factors bear directly on whether it is possible to reasonably estimate a range of potential loss and boundaries of high and low estimate.
FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES
We expect our available cash generated from operations and our short-term investment portfolio, together with our existing sources of liquidity from our revolving credit facilities and commercial paper issuance, will be sufficient to fund our long-term and short-term capital expenditures, working capital and other cash requirements. In addition, we may access the long-term debt capital markets from time to time. We are in the process of acquiring certain businesses, and the cost of these acquisitions may be partially funded through the issuance of debt.
Net cash flow from operating activities was $4,744 million in 2017 compared to $3,672 million in 2016 and $3,112 million in 2015. Operating activities over the last three years were primarily affected by an increase in drafts and accounts payable reflecting longer payment terms for certain purchases and increases in receivables primarily associated with our revenue growth. Cash flows from operations can be significantly impacted by factors such as the timing of receipts from customers and payments to vendors. Additionally, working capital is primarily a function of sales and purchase volumes, inventory requirements and vendor payment terms. Operating activities for 2017 were also affected by $150 million of litigation settlement payment.
Net cash used in investing activities was $3,796 million in 2017 compared to $1,557 million in 2016 and $677 million in 2015. Investing activities for 2017 include $4,237 million of net cash payments for acquisitions including $2.1 billion for our acquisition of Rexall, $1,228 million of net payments received on Healthcare Technology Net Asset Exchange, $404 million and $158 million in capital expenditures for property, plant and equipment, and capitalized software, and $206 million of net cash proceeds from sales of businesses and other assets. Additionally, we prepaid $1.4 billion for acquisitions that closed subsequent to year end.
Investing activities for 2016 included $40 million of net cash payments for acquisitions, $488 million and $189 million in capital expenditures for property, plant and equipment, and capitalized software, and $210 million of cash proceeds from sales of our automation business and an equity investment. Investing activities for 2015 included $170 million of net cash payments for acquisitions, including $4,497 million for our acquisition of Celesio. Investing activities in 2015 also included $376 million and $169 million in capital expenditures for property, plant and equipment, and capitalized software, and $15 million of cash proceeds from sales of our automation business and equity investment.
Financing activities utilized $2,069 million, $3,453 million and $968 million of cash in 2017, 2016 and 2015. Financing activities for 2017 include cash receipts of $8,294 million and payments of $8,124 million from short-term borrowings. We received cash from long-term debt issuances of $1,824 million and made repayments on long-term debt of $1,601 million in 2017. Financing activities in 2017 also include $2,250 million of cash paid for stock repurchases and $253 million of dividends paid.
Financing activities for 2016 include cash receipts of $1,561 million and payments of $1,688 million from short-term borrowings. We made repayments on long-term debt of $1,598 million in 2016. Financing activities in 2016 also include $1,504 million of cash paid for stock repurchases and $244 million of dividends paid.
Financing activities for 2015 include cash receipts of $3,100 million and cash paid of $3,152 million from short-term borrowings. Long-term debt repayments in 2015 were primarily cash paid on promissory notes. Financing activities in 2015 also reflect a cash payment of $32 million to acquire approximately 1 million additional common shares of Celesio through the tender offers we completed in 2015. Additionally, financing activities for 2015 include $340 million of cash paid for stock repurchases and $227 million of dividends paid.
McKESSON CORPORATION
FINANCIAL REVIEW (Continued)
The Company’s Board has authorized the repurchase of McKesson’s common stock from time-to-time in open market transactions, privately negotiated transactions, accelerated share repurchase (“ASR”) programs, or by any combination of such methods. The timing of any repurchases and the actual number of shares repurchased will depend on a variety of factors, including our stock price, corporate and regulatory requirements, restrictions under our debt obligations and other market and economic conditions.
The Board authorized the repurchase of the Company’s common stock up to $4 billion in October 2016. In 2017, we repurchased 14.1 million of our shares through open market transactions and 1.4 million of our shares through an ASR program. In 2016, we repurchased 8.7 million of our shares through both an ASR program and open market transactions.
| Years Ended March 31, | |||||||||||
| (In millions, except per share data) | 2017 | 2016 | 2015 | ||||||||
| Number of shares repurchased (1) | 15.5 | 8.7 | 1.5 | ||||||||
| Average price paid per share | $ | 141.16 | $ | 173.64 | $ | 226.55 | |||||
| Total value of shares repurchased (1) | $ | 2,250 | $ | 1,504 | $ | 340 |
| (1) | Excludes shares surrendered for tax withholding. |
At March 31, 2017, the total authorization outstanding was $2.7 billion available under the October 2016 share repurchase plan for future repurchases of the Company’s common stock.
We believe that our operating cash flow, financial assets and current access to capital and credit markets, including our existing credit facilities, will give us the ability to meet our financing needs for the foreseeable future. However, there can be no assurance that continued or increased volatility and disruption in the global capital and credit markets will not impair our liquidity or increase our costs of borrowing.
Selected Measures of Liquidity and Capital Resources:
| March 31, | ||||||||||||||
| (Dollars in millions) | 2017 | 2016 | 2015 | |||||||||||
| Cash and cash equivalents | $ | 2,783 | $ | 4,048 | $ | 5,341 | ||||||||
| Working capital | 1,336 | 3,366 | 3,173 | |||||||||||
| Debt to capital ratio (1) | 39.2 | % | 43.6 | % | 50.3 | % | ||||||||
| Return on McKesson stockholders’ equity (2) | 54.6 | 26.0 | 17.0 |
| (1) | Ratio is computed as total debt divided by the sum of total debt and McKesson stockholders’ equity, which excludes noncontrolling and redeemable noncontrolling interests and accumulated other comprehensive income (loss). |
| (2) | Ratio is computed as net income attributable to McKesson Corporation for the last four quarters, divided by a five-quarter average of McKesson stockholders’ equity, which excludes noncontrolling and redeemable noncontrolling interests. |
Cash equivalents, which are available-for-sale, are carried at fair value. Cash equivalents are primarily invested in AAA rated prime, AAA rated prime money market funds denominated in Euros, AAA rated prime money market fund denominated in British pound sterling, U.S. government money market funds denominated in U.S. dollars, overnight repurchase agreements collateralized by U.S. government securities, Canadian government securities and/or securities that are guaranteed or sponsored by the U.S. government.
The remaining cash and cash equivalents are deposited with several financial institutions. We mitigate the risk of our short-term investment portfolio by depositing funds with reputable financial institutions and monitoring risk profiles and investment strategies of money market funds.
Our cash and cash equivalents balance as of March 31, 2017 included approximately $2.3 billion of cash held by our subsidiaries outside of the United States. Our primary intent is to utilize this cash in foreign operations and acquisitions. Although the vast majority of cash held outside the United States is available for repatriation, doing so could subject us to U.S. federal, state and local income tax.
McKESSON CORPORATION
FINANCIAL REVIEW (Continued)
Working capital primarily includes cash and cash equivalents, receivables and inventories net of drafts and accounts payable, short-term borrowings, current portion of long-term debt, deferred revenue and other current liabilities. Our Distribution Solutions segment requires a substantial investment in working capital that is susceptible to large variations during the year as a result of inventory purchase patterns and seasonal demands. Inventory purchase activity is a function of sales activity and other requirements.
Consolidated working capital decreased at March 31, 2017 compared to March 31, 2016 primarily due to a decrease in the cash and cash equivalents balance and an increase in drafts and accounts payable and deferred tax liabilities, partially offset by increases in receivables. Consolidated working capital increased at March 31, 2016 compared to March 31, 2015 primarily due to increases in receivables and inventories and a decrease in deferred tax liabilities, partially offset by an increase in drafts and accounts payable.
Our debt to capital ratio improved for 2017 primarily due to an increase in stockholders’ equity and for 2016 primarily due to a decrease in our debt.
In July 2015, the quarterly dividend was raised from $0.24 to $0.28 per common share for dividends declared after such date, until further action by the Board. Dividends were $1.12 per share in 2017, $1.08 per share in 2016 and $0.96 per share in 2015. The Company anticipates that it will continue to pay quarterly cash dividends in the future. However, the payment and amount of future dividends remain within the discretion of the Board and will depend upon the Company’s future earnings, financial condition, capital requirements and other factors. In 2017, 2016 and 2015, we paid total cash dividends of $253 million, $244 million and $227 million. Additionally, as required under the Domination Agreement, we are obligated to pay an annual recurring compensation amount of €0.83 per Celesio share (effective January 1, 2015) to the noncontrolling shareholders of Celesio.
Contractual Obligations:
The table and information below presents our significant financial obligations and commitments at March 31, 2017:
| Years | |||||||||||||||||||
| (In millions) | Total | Within 1 | Over 1 to 3 | Over 3 to 5 | After 5 | ||||||||||||||
| On balance sheet | |||||||||||||||||||
| Long-term debt (1) | $ | 8,362 | $ | 1,057 | $ | 1,514 | $ | 1,246 | $ | 4,545 | |||||||||
| Other (2) | 477 | 42 | 208 | 68 | 159 | ||||||||||||||
| Off balance sheet | |||||||||||||||||||
| Interest on borrowings (3) | 2,911 | 285 | 452 | 371 | 1,803 | ||||||||||||||
| Purchase obligations (4) | 3,250 | 3,196 | 41 | 13 | — | ||||||||||||||
| Operating lease obligations (5) | 2,633 | 477 | 729 | 495 | 932 | ||||||||||||||
| Other (6) | 324 | 190 | 24 | 18 | 92 | ||||||||||||||
| Total | $ | 17,957 | $ | 5,247 | $ | 2,968 | $ | 2,211 | $ | 7,531 |
| (1) | Represents maturities of the Company’s long-term obligations including an immaterial amount of capital lease obligations. |
| (2) | Includes our estimated benefit payments, including assumed executive lump sum payments, for the unfunded benefit plans and minimum funding requirements for the pension plans. Actual lump sum payments could significantly differ from the estimated amounts depending on the timing of executive retirements and the lump sum interest rate in effect upon retirement. |
| (3) | Primarily represents interest that will become due on our fixed rate long-term debt obligations. |
| (4) | A purchase obligation is defined as an arrangement to purchase goods or services that is enforceable and legally binding on the Company. These obligations primarily relate to inventory purchases, capital commitments and outsourcing service agreements. |
| (5) | Represents minimum rental payments for operating leases. |
| (6) | Includes agreements under which we have guaranteed the repurchase of our customers’ inventory and our customers’ debt in the event these customers are unable to meet their obligations to those financial institutions. |
The contractual obligations table above excludes the following obligations:
At March 31, 2017, the liability recorded for uncertain tax positions, excluding associated interest and penalties, was approximately $327 million. The ultimate amount and timing of any related future cash settlements cannot be predicted with reasonable certainty.
McKESSON CORPORATION
FINANCIAL REVIEW (Continued)
At March 31, 2017, we have recorded a $136 million noncurrent liability payable to Change Healthcare shareholders associated with a tax receivable entered into in connection with Healthcare Technology Net Asset Exchange. The amount is based on certain estimates and could become payable in periods after a disposition of our investment in Change Healthcare.
Our banks and insurance companies have issued $255 million of standby letters of credit and surety bonds at March 31, 2017. These were issued on our behalf and are mostly related to our customer contracts and to meet the security requirements for statutory licenses and permits, court and fiduciary obligations and our workers’ compensation and automotive liability programs.
The carrying value of redeemable noncontrolling interests related to Celesio was $1.33 billion at March 31, 2017, which exceeded the maximum redemption value of $1.21 billion. The balance of redeemable noncontrolling interests is reported at the greater of its carrying value or its maximum redemption value at each reporting date. Upon the effectiveness of the Domination Agreement on December 2, 2014, the noncontrolling shareholders of Celesio received a put right that enables them to put their Celesio shares to McKesson at €22.99 per share, which price is increased annually for interest in the amount of 5 percentage points above a base rate published by the German Bundesbank semiannually, less any compensation amount or guaranteed dividend already paid (“Put Amount”). The redemption value is the Put Amount adjusted for exchange rate fluctuations each period. The ultimate amount and timing of any future cash payments related to the Put Amount are uncertain.
Additionally, we are obligated to pay an annual recurring compensation of €0.83 per Celesio share (the “Compensation Amount”) to the noncontrolling shareholders of Celesio under the Domination Agreement, which became effective in December 2014. The Compensation Amount is recognized ratably during the applicable annual period. The Domination Agreement does not have an expiration date and can be terminated by McKesson without cause in writing no earlier than March 31, 2020.
Refer to Financial Note 11, “Redeemable Noncontrolling Interests and Noncontrolling Interests,” to the consolidated financial statements appearing in this Annual Report on Form 10-K for additional information.
Credit Resources:
We fund our working capital requirements primarily with cash and cash equivalents as well as short-term borrowings from our credit facilities and commercial paper issuances. Funds necessary for future debt maturities and our other cash requirements are expected to be met by existing cash balances, cash flow from operations, existing credit sources and other capital market transactions. Detailed information regarding our debt and financing activities is included in Financial Note 17, “Debt and Financing Activities,” to the consolidated financial statements appearing in this Annual Report on Form 10-K.
RELATED PARTY BALANCES AND TRANSACTIONS
Information regarding our related party balances and transactions is included in Financial Note 27, “Related Party Balances and Transactions,” to the consolidated financial statements appearing in this Annual Report on Form 10-K.
NEW ACCOUNTING PRONOUNCEMENTS
New accounting pronouncements that we have recently adopted, as well as those that have been recently issued but not yet adopted by us, are included in Financial Note 1, “Significant Accounting Policies,” to the consolidated financial statements appearing in this Annual Report on Form 10-K.
McKESSON CORPORATION
FINANCIAL REVIEW (Concluded)
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