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Executives

Ana Schrank - Vice President of Investor Relations

John H. Hammergren - Chairman, President and Chief Executive Officer

Jeffrey C. Campbell - Executive Vice President and Chief Financial Officer

Analysts

Lisa Gill - J.P. Morgan

Larry Marsh - Barclays Capital

Brett Jones - Leerink Swann

Ricky Goldwasser - UBS

[Charles Varedia] - Citi

Richard Close - Jefferies & Co.

Robert Willoughby - Banc of America Securities

Charles Rhyee - Oppenheimer & Company

Sandy Draper - Raymond James

Constantine Davides - JMP

Ross Muken - Deutsche Bank

McKesson Corporation (MCK) F3Q08 Earnings Call January 26, 2009 5:00 PM ET

Operator

Good afternoon and welcome to McKesson Corporation's fiscal 2009 third quarter conference call. (Operator Instructions)

I would now like to introduce Ana Schrank, Vice President of Investor Relations. Please go ahead, ma'am.

Ana Schrank

Thank you, [David]. Good afternoon and welcome to the McKesson fiscal 2009 third quarter earnings call. With me today are John Hammergren, McKesson's Chairman and CEO, and Jeff Campbell, our CFO. John will first provide a business update and will then introduce Jeff, who will review the financial results for the quarter. After Jeff's comments we will open the call for your questions.

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

Thanks, and here is John Hammergren.

John H. Hammergren

Thanks, Ana, and thanks, everyone, for joining us on our call today.

We're pleased to report an outstanding quarter, with particularly strong growth in our Distribution Solutions segment. For the quarter, we achieved total company sales of $27.1 billion and increased fully diluted earnings per share by 54%, excluding the $493 million charge related to our average wholesale price litigation.

Let me start with some observations on current market conditions. The recent financial turmoil and the economic environment have presented tremendous challenges. Nearly every business and every industry has been tested in ways that could not have been predicted or imagined. With that in mind, I'm particularly pleased with our performance in the third quarter.

Our results demonstrate that we operate in very attractive markets where there is long-term demand for the services and products we provide. Both of our segments - Distribution Solutions and Technology Solutions - are well positioned and continue to grow despite the economic slowdown. We have a strong track record of consistently delivering outstanding performance and this quarter was no exception.

Across all of the businesses within Distribution Solutions we performed exceptionally well in the third quarter, demonstrating the resilience of our core distribution model. And in Technology Solutions our third quarter performance was in line with the expectations we laid out after the end of the second quarter.

Before I talk about the specifics of the quarter let me remind you that in November we took a charge of $493 million related to our average wholesale price litigation. While the charge is included in our third quarter financial results, I do not want it to distract from our discussion and our overall strong operating performance, so the remainder of my comments will focus on our results excluding the charge.

Our solid quarter performance was driven by Distribution Solutions. Our success was led by the U.S. pharma business, but each of the businesses in this segment turned in strong results. In U.S. pharma, our mix of customers is very favorable and our customers have grown their business with us, which helped us achieve 8% growth in direct distribution revenues. Short term we do not view our distribution business as particularly sensitive to slowing prescription trends. In fact, our revenues this quarter demonstrate our view that we can grow steadily even with margin expansion in an environment like this.

Additionally, it is important to remember that one of the drivers of slower top line growth is the continued conversion of branded drugs to generics. While this has a dampening impact on revenues, it creates significant opportunities for us and is a major contributor to our recent margin expansion. We see the use of generics increasing in an environment like this, and we've been able to grow our generic penetration faster than the market using our customer-centric approach.

We add tremendous value for our customers when we bring them together with our generic suppliers. We help make a market where our customers get a great price, our supply partners get significant market share right out of the gate, and, most importantly, the end consumer enjoys considerable savings.

Again this quarter our success with generics benefited from two primary drivers - penetration of our customer base, which brings additional generic volume into the McKesson channel, and the continued steady pace of generic launches. As a result, sales of our proprietary generics program, OneStop, grew an impressive 45%, significantly outpacing market growth.

We've also benefited from our long-standing relationships with branded manufacturers, and we believe these relationships are as strong as they've ever been. We deliver a broad range of services to the manufacturers and provide them with tremendous value. As these arrangements have evolved over time, we have continually met and exceeded our partners' expectations. As we continue to perform, we earn their trust and deliver great value to them. The economics for both partners have continued to improve and we feel confident about these arrangements going forward.

Solid revenue growth combined with improving economics that drives margin expansion on the manufacturers side, along with good expense leverage, helped us deliver outstanding operating margin expansion. So overall, a terrific result from our team in U.S. pharma.

As I mentioned earlier, all the businesses in Distribution Solutions demonstrated resilience despite the economy. Canada distribution revenues increased a solid 9% on a constant currency basis as we continue to expand our footprint. We also had a positive result in our medical surgical distribution business, where we experienced strong demand across all customer classes, from physician offices to long-term care. The revenue growth rates in this business have held up, again demonstrating the resilience of the distribution model.

In summary, I'm pleased with the solid performance of Distribution Solutions. We have a terrific combination of assets and a seasoned leadership team that performs exceptionally well. I'm confident about our momentum in this segment.

Turning now to Technology Solutions, when we reported our second quarter results we told you that we anticipated the tight credit markets and slower economy would impact parts of our Technology Solutions segment. We believed some customers would delay their purchasing decisions, but we did not see this as a change in demand as much as a change in timing as some customers revisited their capital structure and their near-term capital deployment strategy.

We expected to see steady demand for the parts of our business that have stable or recurring revenues and do not require large capital investments from our customers. The nature of our business helps reduce our reliance on new software sales to hospital and physician office customers and helped us maintain some revenue growth and margin expansion despite the uncertainty in the market.

Our Technology Solutions segment has a diverse customer base and a broad set of solutions, many of which can positively impact the customer's cash flow and deliver a rapid return on investment. As a result, we saw demand for our products and services despite the tough economic cycle we find ourselves in.

A significant portion of our revenues are highly stable. For example, included in the services line on our income statement are revenues from ongoing parts of the business such as maintenance on our installed base of customers, our RelayHealth connectivity business, and our revenue cycle outsourcing business. We have terrific visibility into these highly stable revenues. Solutions like these and subscription revenues that we receive from our payer customers help mitigate the impact of slower software sales to hospitals and physician offices. Technology Solutions has a number of solutions that require little capital investment by the customers.

As we expected, there have been some delays on the hospital and physician office side relative to software commitments; however, new software sales have not come to a grinding halt and we have been successful in some very competitive situations. Several of the contracts delayed last quarter signed during our third quarter. Likewise, some contracts expected this past quarter actually will slide into the next.

However, when our customers review their capital budgets, our software  particularly our software that provides improved cash flow, rapid return on investment, and integration into a larger existing IT strategy - rise to the top of the customer's revised capital spending priorities. Suburban Hospital Healthcare System in Maryland, for example, recently committed to both Horizon Clinicals and Horizon Enterprise Revenue Management after we demonstrated the advantage of having an integrated clinical and financial solution, a great example of McKesson putting it all together for a large customer with a well-developed strategy.

We have solid improvement in operating profit in the third quarter due in part to the charges we took in the third quarter last year to streamline staffing and product lines. But it was also due to the fact that we followed a prudent course of action to position our technology business more conservatively until we had better visibility to the timing of the market's recovery. Since the economy took a turn, we have been increasingly focused on controlling costs and driving efficiencies through our organization.

Overall, we have a solid business today, but we're even more excited about the future, particularly in light of the discussions going on in Washington. McKesson was one of the first companies to meet with the new administration's health care transition team and we submitted our recommendations for health care information technology funding.

Since affordability is almost always cited as the primary barrier to widespread health IT adoption, many hospitals, physicians and pharmacies lack the financial capital to make the initial investment, so there needs to be a robust grant or loan or financing program to further stimulate the investment in infrastructure needed for long-term health care reform. These startup funds could enable physician practices to automate clinical, administrative and financial processes, hospitals to deploy proven technologies that support safer care delivery, retail pharmacies to automate their prescription management systems and facilitate e-prescribing technology, and consumers to become more involved in their own care through electronic connectivity with their physicians, hospitals and pharmacies.

We believe that health care technology can be delivered in a cost-effective manner that offers a great return on investment for our customers. Simple technology initiatives such as eprescribing are already available today, but not yet widely used. Electronic health records have been implemented in many areas, but could and should be more widely deployed. And patient safety is a top priority and is directly impacted by health care information technology. We have solutions for each one of these initiatives.

Given the challenging economic environment, the performance of our Technology Solutions business met our expectations and we are encouraged about the future of this business, particularly in light of the increased focus on health care information technology by the policymakers in Washington.

Now, it's also important to note that the health care initiatives currently under discussion in Washington have much broader implications for our company and our industry than in just the area of technology. The issue of access is clearly important for our Distribution Solutions segment. Policymakers are working on a plan to include everyone in the health care system. Greater access to health care should lead to increased use of pharmaceutical and medical products, so the future looks promising for continued success in Distribution Solutions.

In summary, we're pleased with the overall resilience that we've seen in both segments of our business during these tough economic times and we remain confident in the earnings potential of the company. Based on the positive year-to-date results, the momentum in our business and our anticipated tax reserve release that Jeff will discuss in more detail, we are raising our guidance to between $4.15 to $4.30 per fully diluted share from continuing operations for fiscal 2009. I look forward to reporting to you on our continued success.

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

Jeffrey C. Campbell

Well, thank you, John, and good afternoon, everyone.

As you've just heard, McKesson posted solid results this quarter given the continuing difficult economic environment. We continue to expect a strong finish to the year despite the limited slowdown we are seeing in small pockets of our businesses.

Before I begin reviewing our financial performance, let me point out that similar to John's comments, my discussion will exclude the impact of the AWP litigation charge for comparison purposes.

As always, I'll first review our consolidated results, providing more color when I discuss each segment in more detail. Consolidated revenues for the December quarter grew 2% to $27.1 billion, with both Distribution Solutions and Technology Solutions revenues up 2% from last year. While these growth rates may appear low, once you look into the details of the segment numbers, you'll see why we are relatively pleased with our revenue growth.

Gross profit for the quarter was up 12% to $1.3 billion, driven by the 15% growth in Distribution Solutions gross profit as we benefited from some timing shifts this year from our March quarter back into our December quarter.

Operating expenses in the quarter declined 2% to $904 million. We have embarked on cost containment initiatives across the company which have been successful in improving our operating leverage. While I'd remind you that the prior year number includes $38 million of pre-tax charges, even factoring in these charges, our expense growth rate was just 2%.

Operating income for the quarter grew 56% to $439 million from $282 million a year ago. Again after adjusting for $41 million in total pre-tax charges taken last year - $3 million of which hit gross profit, this is a solid performance, with both segments contributing to the significant operating income growth.

Moving below operating income, other income of $17 million was 45% below last year, primarily due to lower interest rates on short-term investments combined with our lower cash balances this year.

Interest expense - $33 million - was relatively unchanged from the prior year, though I'd remind you that the expense associated with the use of our receivables sales facility is reported as an administrative cost in operating expenses and does not show up in interest expense. In this year's December quarter, this administrative expense was approximately $5 million versus no expense in the comparable prior year quarter.

Moving to taxes, our effective tax rate of 31.2% primarily reflects our run rate, which remains at the 33% that we have been using all year plus $7 million in positive discrete tax items.

Before I move on, I would like to take a minute here to walk you through a discrete tax reserve adjustment that we expect to make in our March quarter. Let me remind you that in the past I have said that we do not include highly uncertain outcomes from settlements or other discrete tax items in our guidance. However, we are not confident that we will release a tax reserve in the March quarter of $22 million. Our outlook for the full year remains at a tax rate of 33% before considering the impact of this and other discrete tax items.

Net income in the quarter was $291 million, up 45% from the prior year while earnings per diluted share of $1.05 was up 54% from $0.68 a year ago. This EPS leverage was driven by the impact of the aggressive $1.1 billion in share repurchases we have made since our third quarter of last year which drove our diluted shares outstanding lower by 7% year-over-year to 276 million.

Moving on now to distribution solutions, our U.S. pharma revenues grew a solid 8% to $17 billion. About 2 points of this growth stemmed from our acquisitions of OTN and McQueary Brothers, with OTN lapping at the end of October 2008. That leaves 6% growth driven primarily by strong performance across our existing customer base.

Warehouse revenues declined 7% to $6.7 billion. As we've seen over the last few quarters now, the primary driver of the warehouse decline was the loss of a contract by a large warehouse customer coupled with decreased purchases from several other customers.

Canadian revenues on a constant currency basis grew 9%, driven by our continued success in securing new and expanded distribution agreements across our customer base. Canadian revenues were adversely impacted by a material weakening of the Canadian dollar relative to the U.S. dollar. Including a 21% unfavorable currency impact, Canadian revenues declined 12% to $2 billion.

Let me remind you that while a weak Canadian dollar hurts the U.S. dollar earnings of our Canadian distribution business, we have a large IT work force in Canada which is primarily part of our Technology Solutions segment and the expense of this work force creates a large offset and natural hedge against the profits of our Canadian distribution business. So our consolidated earnings have not been materially impacted by changes in the Canadian dollar exchange rate or, for that matter, by changes in other foreign currency exchange rates.

Returning to the revenue lines again, medical surgical distribution revenues were up 5% for the quarter to $680 million. I mentioned in last quarter's call that we had earlier flu vaccine sales this year which accounted for 2 to 3 points of growth in our September quarter. In the December quarter we correspondingly had lower flu vaccine sales versus the prior year, which was roughly offset by some new customer wins. The net of this is that our 5% growth represents what we see as the healthy market growth rate of our customers.

Gross profit for the segment was up 15% to $988 million on 2% revenue growth, representing a nice improvement in gross margin of 42 basis points. The increase in gross profit for the quarter was driven primarily by an improved mix of higher-margin products and services, particularly sales of OneStop generics, with some benefit also from the lower mix of warehouse sales.

Additionally, the volume and timing of when we receive compensation under our agreements with branded pharmaceutical manufacturers showed a solid increase year-over-year. As we've discussed in the past, the timing of such compensation can vary from quarter to quarter. We believe some of the current year third quarter benefit pulled forward from our fourth quarter, and year-to-date price increases have been pretty strong.

Our Distribution Solutions options expenses were flat for the quarter at $555 million. Here again, you see the results of our efforts across the company at cost containment and we are pleased by these trends. While I'd remind you that the prior year included charges totaling $16 million - $13 million for our settlement with the DEA and $3 million of restructuring charges  these were offset this year by new options expenses associated with acquisitions. So our cost control efforts in our ongoing business were strong.

Operating margin rate for the quarter was 166 basis points compared to 121 basis points in the prior year. We are encouraged by our solid third quarter and year-to-date operating margin. As a result, for the current fiscal year we now expect operating margin growth in this segment in excess of 10 basis points.

In Technology Solutions, revenues were up 2% for the quarter to $751 million. Services revenues, which account for approximately 77% of revenues in the segment, were up 4% in the quarter, while software and software systems revenues of $141 million in the quarter were down 6% from a year ago. Gross profit was up 3% from the prior year to $355 million, roughly in line with revenue growth.

Technology Solutions had total gross R&D spending of $99 million for the quarter. Of this amount, we capitalized 18%.

Operating profit in our Technology Solutions segment this quarter was $91 million, up 86% from a year ago. This performance reflects the fact that in this tough revenue environment, as John previously discussed, we are using aggressive cost containment efforts to manage to a strong bottom line. You see this in the 12% decrease in our operating expenses, which were down to $265 million. This year-over-year reduction was driven by our current year cost containment initiatives and the $22 million in prior year pre-tax charges.

Now we'll turn to the balance sheet, starting with our working capital metrics. Adding back the $350 million sale of accounts receivable at quarter end, our receivables increased 6% to $7.9 billion, which is a bit faster than our rate of sales growth. Our days sales outstanding, therefore, increased a day to 23 days. We have noticed a modest slowdown in how quickly some of our customers are paying us. While receivables have lengthened somewhat, these are mostly smaller customers across various businesses and therefore we expect no material impact to our overall performance.

In both inventories and payables we saw days sales drop one day from a year ago. As we called out last quarter, we did some of our normal seasonal inventory build for the winter a bit earlier this year. Looking at the quarterly cash flow data, this earlier build contributed to us generating approximately $680 million more in cash flow from operations in this year's December quarter than in the prior year December quarter. Even though this timing is a bit different than in prior years, we continue to have a target of cash flow from operations for the year in excess of $1.5 billion.

Capital spending was $151 million for the first nine months, $22 million above the prior year. Capitalized software expenditures were $137 million, up from $118 million last year. Our annual guidance for capital and software expenditures in the range of $350 to $400 million remains unchanged.

As you recall from our comments last quarter, we said we would take a more conservative approach to capital deployment and more specifically to share repurchases, which you saw during our third quarter. This strategy was driven primarily by three key factors. First was the uncertainty of the financial climate. Next, we were dealing with the uncertainty of the AWP litigation. Last, we were entering into our seasonal inventory build.

Since that time, we have begun to see better access to the capital markets, though there is still some uncertainty and we expect some continued ups and downs. We have reached an agreement to settle private party claims in the AWP litigation, and we have reached the peak of our inventory build. So as we gain confidence with all three of these factors, you should expect us to resume our portfolio approach to capital deployment, albeit in a way that reflects the more challenging economic and financial market climate.

Overall, we are pleased with our third quarter and year-to-date results. In light of these strong results, our continuing momentum and the favorable tax reserve adjustment that I spoke about earlier, we are raising our fully diluted EPS guidance from continuing operations to between $4.15 and $4.30, excluding the impact of the AWP litigation charge.

Let me take a moment to describe the drivers of this $0.15 increase to our EPS guidance. First, our view of Technology Solutions has not changed in the past 90 days. Second, we expect $0.08 from the $22 million discrete tax benefit. Last, the remainder of the approximate $0.07 increase is driven by the fact that we are more optimistic about our full year results in Distribution Solutions. This optimism is driven primarily by product mix, outstanding results from our OneStop program, and the fact that price increases are running a little ahead of our original guidance assumptions.

As for the EPS range, which we've kept at $0.15, we factored in among other things the current uncertain economic climate and, more specifically, whether we may find it prudent to incur any restructuring charges to position our businesses to appropriately meet the needs of the markets we serve.

In summary, we remain very positive on the health of our business and the industry in general. We have strength in our financial flexibility, which during these economically trying times allows us to create even great shareholder value.

Thanks and with that I'll turn the call over to the operator for your questions. David?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Lisa Gill - J.P. Morgan.

Lisa Gill - J.P. Morgan

Jeff, if we could start, I think that you talked about margins overall for drug distribution being up at least 10 basis points. I know that's a broad statement, but if we were to assume that for the full year that you're up 10 basis points, that would assume that the fourth quarter would be down year-over-year something like 15 basis points. Are you saying that the fourth quarter is expected to be less robust than the third quarter? I'm just trying to understand that.

And then secondly, John, can you maybe just give us some comment around the Pfizer-Wyeth deal, your expectations there? Last week Amerisource talked about the fact that they have signed a fee for service agreement with Pfizer and I'm just wondering if McKesson has done something similar.

Jeffrey C. Campbell

Great. Well, let me start, Lisa, and that's a good question to help me clarify on the quarterly volatility that we always struggle with a little bit in terms of communicating about our business.

So just to remind everyone, when we started the year we talked about getting margin expansion for the full fiscal year in our Distribution Solutions segment in sort of the mid single-digit kind of basis point range. And so our optimism today in seeing that in excess of 10 basis points, I think, is a real tribute to how strongly we feel that business is performing in the current economic climate.

Now there always is some quarterly volatility, so one of the things I mentioned in my remarks is that we hold out of the March quarter this year into our December quarter some of the compensation we get from branded manufacturers. There are also a number of other timing issues last year that last year drove a strong March quarter and a weaker December quarter. So you really need to look at this on a rolling 12-month basis, and it's on that basis that we feel pretty good about the guidance we gave for that period and the momentum we have in the business.

You're correct that mathematically that does mean that the margin may well be down a little bit in the March quarter. That's not reflective of any weakening of the business; it's just the variable nature of the timing quarter to quarter.

Lisa Gill - J.P. Morgan

And just as a follow up to that, Jeff, if I understood correctly, Pfizer actually took nicer price increases in January than we anticipated, so are you saying some of that was able to be pulled back to the December quarter or it was something else?

Jeffrey C. Campbell

Well, I don't - as you know, Lisa, we never comment on specific customers.

Lisa Gill - J.P. Morgan

I know, but I have to try.

Jeffrey C. Campbell

I know - manufacturers - and no one manufacturer, even the world's largest manufacturer like Pfizer, is large enough to offset all the other things that are going on in our business. So when you look at it in totality, clearly we had a relatively stronger December quarter this year versus March and, you know, it'll vary a little bit every year.

John H. Hammergren

And Lisa, on the second quarter, we've had a very positive ongoing relationship with both Pfizer and Wyeth and those relationships go back obviously decades. We've been very pleased with those relationships and we're confident that, if as planned the Pfizer and Wyeth deals go through, that we will continue to have solid relationships with the new company after the merger is complete.

So we feel really good about what's going on across the board with both generic and branded manufacturers, and we're pleased with how we're positioned to add value to their businesses.

Lisa Gill - J.P. Morgan

Any comments after Amerisource talked last week about signing a new fee for service relationship with Pfizer for McKesson?

John H. Hammergren

I'm going to stay on the same message platform that Jeff has. We tend not to talk specifically about customers or manufacturer partners. We're happy to have agreements or not have agreements as long as they support the underlying economics that our business requires, and so I wouldn't read a great deal into that other than the continued strength that the wholesalers have in the partnership with manufacturers to deliver sustainable and identifiable value in these relationships that can be measured and quantified. And that's how we earn the privilege of having these long-term relationships, so I'm really pleased with the progress we're making as an industry with the manufacturers.

Operator

Your next question comes from Larry Marsh - Barclays Capital.

Larry Marsh - Barclays Capital

I'd like to drill down a little bit on just two items and then one follow up question, if I could. You know, last quarter you talked about great progress in the generics program, I guess up 49%, this quarter you're talking about up 45%. Is there anything unique to this quarter that could have driven a particularly strong result in your generic performance this quarter versus, say, the past quarters, where we continue to see good results or is this just a fairly consistent performance there?

John H. Hammergren

Well, we obviously expect to continue to have very consistent and growing performance in the generic business, Larry, and we've got a track record of doing that. I think in this quarter that the only unusual events that I would add to our normal kind of momentum in the business is the addition of the Safeway business in our generic portfolio as well as the acquisition of [Aquarian]. Safeway we probably converted very quickly. The McQueary thing, that's sort of a customer by customer event that'll take some more time to complete, but both of those are adding momentum. But we've consistently grown above the market and we hope to continue to.

That was question one of three?

Larry Marsh - Barclays Capital

You got me. The other follow on, then, really is around the restructuring, obviously the healthy beat versus consensus and the take up not quite reflecting the full amount of the beat. And I think, Jeff, you alluded to the potential for restructuring charges that could meet the needs of the market in the fourth quarter. Just wondering if you could elaborate on the kinds of things that would be included in such a restructuring charge in the current environment?

John H. Hammergren

Well, I'll let Jeff chime in here, Larry, but I think that as you noticed in his conversation, we had very strong third quarter performance and I think all we've attempted to do is to say that the fourth quarter was slightly impacted by the strength of the third quarter and so you really have to think about the two of them kind of together. And I think his comment about restructuring was really more of a discussion around the range that we provided as opposed to directionally in terms of some significant event that we are planning or expect to have happen.

But as you might guess, we're always doing restructurings in our business and we also have work force realignments and programs that we're starting or stopping, and so I think that that will continue in the fourth quarter. But I think the biggest issue was really the third and fourth quarter comparison, how to sort of normalize for those.

Larry Marsh - Barclays Capital

And the final question, a consistent one from me, certainly a very large customer of yours in the Distribution Solutions business is up for renewal mid-year of calendar '09. I know in the past you say you don't talk about that relationship, but is there anything that has progressed or evolved in those current discussions or are you still in anticipation that you would make an announcement closer to that June 30th expiration of that key customer renewal?

John H. Hammergren

Well, about a third of our business every year, Larry, comes up in one of these contracts that is more formal, and we have consistently shown our ability as an industry to sort of renew our business and there isn't an awful lot of business that changes hands. I think incumbency has a great deal of value and service in sort of earning the relationship certainly has a great deal of value.

So I wouldn't expect a lot of changes as I look forward into next year just based on the history, regardless of which customers might be coming up for renewal. And I also have to tell you that sometimes these sort of date-certain events happen earlier or happen later and don't always happen in the way that people expect them to.

So I don't really have any new news on any of our customer renewals with respect to next year, other than that our anticipation with our organization is that in large we will renew our relationships and hopefully through those renewal processes increase our position with them, particularly when they're buying things on their own or performing services that we can perform for them that are less expensive. And an example would be last year's Safeway renewal, where we added a component of generic purchasing that they had done on their own. So I think that we'll continue to be optimistic about the quality of the service we deliver.

Operator

Your next question comes from Brett Jones - Leerink Swann.

Brett Jones - Leerink Swann

I was wondering if we could get into some detail on the level of cost savings that was achieved in the Technology Solutions business. I guess really just what were they focused on and is this related to the $25 million restructuring you took last year? Are we starting to see those savings materialize or is this from something else?

John H. Hammergren

Well, I think it's a combination of both last year's move to better position the business in combination with sort of best in class kind of cost controls this year as we saw things beginning to slow up a little bit on the software side. So I think it's something you have to do on an ongoing basis and watch the incremental spend and make sure that you're focused on all quote-unquote, historical spend to make sure it's adding the value that it needs to.

Brett Jones - Leerink Swann

I was just thinking that the way it materialized it seems like a lot of the cost savings seemed to appear this quarter as opposed to a couple of quarters have transpired since those restructuring charges were taken. I was wondering is there anything attributable to the Canadian employees in the Tech Solutions business since Jeff mentioned that as an offset?

Jeffrey C. Campbell

Well, sure, you are correct that there is a foreign currency good guy in the operating expenses of MTS to the extent they have a significant Canadian work force, which they do.

Brett Jones - Leerink Swann

Is there any way to quantify the impact to margins in this business from the Canadian employees or would you?

John H. Hammergren

Well, I guess the way you could think about it is we talk about the fact that as a company at the earnings line we are relatively hedged, and so if you take our - one way to size that is you take our Canadian distribution revenues, which we do disclose separately, and you can bounce against that some kind of reasonable distribution margin and we're about 80% hedged against that kind of earning level. And most of those expenses, though not all of them, are reported in the Technology Solutions segment.

Operator

Your next question comes from Ricky Goldwasser - UBS.

Ricky Goldwasser - UBS

Just a couple of clarifying questions. Just for the fourth quarter, so when you exclude the tax benefit, does the guidance imply an EPS of 106 to 121 range? Is my math correct there?

Jeffrey C. Campbell

Well, I'm looking, Ricky, to make sure I follow the math you were doing, because you were cutting out a little bit. I guess one way to think about it is we're giving guidance excluding the AWP litigation charge, so if you look at the first schedule attached to our press release you see a year-to-date EPS number of $3.05. So if you take that $3.05 and you take our $4.15 to $4.30 guidance, I guess that puts you at, what, $1.10 to $1.25.

Ricky Goldwasser - UBS

Right. And that includes the $0.08 of tax benefit?

Jeffrey C. Campbell

Correct.

Ricky Goldwasser - UBS

Okay, so if we take that out so it's $1.02 to $1.17?

Jeffrey C. Campbell

Yes.

Ricky Goldwasser - UBS

Normalized? Okay. That's helpful.

So then the follow up question is obviously you're a lot more optimistic about drug distribution than you were three months ago. Should we, as we update our models, should we assume the slowdown in the IT on a sequential basis in the March quarter?

Jeffrey C. Campbell

Well, let me repeat the question just to make sure of that because you're breaking up a little bit. I think you said should we assume a weakness sequentially in the MTS segment?

Ricky Goldwasser - UBS

Right.

Jeffrey C. Campbell

I guess what I'd say, I think what we - to be very clear - what we said is our view of technology is about the same today as it was 98 days ago. Now, historically in our Technology business, the March quarter of the four quarters is always their strongest quarter which is due to the nature of the way that business is structured and we'd expect it to be the strongest quarter of the four quarters of fiscal '09 again this year.

Ricky Goldwasser - UBS

Okay. But just the - with potentially different drivers compared to what you did last year?

Jeffrey C. Campbell

Correct. Clearly, you've seen a weakening of the revenue growth and we're working very hard to be smart about the way we manage the business in light of that slowing revenue growth to still get to the kind of operating profits that you saw this quarter, which we feel pretty good about in the overall environment.

Ricky Goldwasser - UBS

And just in terms of kind of like the visibility that your backlog provides you, how far out is your visibility?

John H. Hammergren

Well, that's a challenging question to answer, Ricky, because of course the strength of our Technology business is the diversity of the customer base and the diversity of the sources of revenue. So you've got subscription revenue, you've got revenue cycle management revenues that are ongoing. You've got a large payer software business that hasn't been particularly impacted. You've got outsourcing businesses, where we're managing services for people. You've got legacy maintenance. And then you've got a portion that's dependent upon new sales, in particular new sales into the hospital and physician office sector. It's in that sector where we have seen a noticeable slowdown in new sales, albeit we continue to sell stuff, it's just slower.

So it's that piece that causes our revenue growth to be at 2% this quarter, a lot slower than we would have expected when we started into this year nine months ago. We still feel actually pretty good about that number in the overall economic climate and see it as a testament to the diversity of our Technology business.

Operator

Your next question comes from [Charles Varedia] - Citi.

Charles Varedia - Citi

A question on the OneStop program. Can you share with us roughly how big this program has gotten and of the 45% growth, how much of that's conversion of existing customers to this program versus new customers to McKesson?

John H. Hammergren

Well, you know, clearly the OneStop program continues to grow faster than the marketplace and that growth is being driven by new business. The question of whether or not they're net new customers to McKesson overall is probably more difficult to describe. The example I would use would be Safeway on the chain side, where we have a long-standing relationship with Safeway that has lasted a long time on the branded side where we renewed the relationship and expanded it with the addition of generics.

Another example would be McQueary Brothers, where we actually acquired the company and the customer base, maintained the customer base. They probably purchased some generics from McQueary, but certainly not in a program where OneStop. And our progress there has been to go to each individual pharmacy over time and convert them to our program.

So I would say that a large portion of what we do is adding the program or building the compliance to the program in existing customers as opposed to major new customer adds that include both brand and generics as a brand new component of this business. This program has gained us significant market share in generics and that was the goal. It's not really designed to be a market share driver for the overall Distribution business.

Charles Varedia - Citi

And are you able to size it roughly for us at this point?

John H. Hammergren

Well, it's very significant to us, certainly from an earnings and momentum perspective, and it's very important to us from a profitability perspective. And it's our most important generic program. But we don't provide any more details beyond that.

Charles Varedia - Citi

Can you talk about sourcing and how much of the product is actually manufactured or packaged by McKesson versus sourced from other manufacturers?

John H. Hammergren

Well, you know, we have a very robust and well tuned generic organization. We are not a generic manufacturer and we do not intend to be a generic manufacturer, but we do intend to avail ourselves of the best and brightest in the manufacturing world and align ourselves with those partners that can deliver us the best products from a quality perspective, the supply that's necessary to feed the machine, and a cost that's competitive in the marketplace so we can continue to satisfy our customers' requirements to in turn be competitive in the markets in which they compete.

So I would say that we're pretty holistic in our approach, but we don't manufacture the product, Charles.

Charles Varedia - Citi

Just finally, the year-over-year growth you reported today. Can you bifurcate acquisition-related growth from organic growth?

John H. Hammergren

Well, that's pretty difficult to do. The only acquisition related growth in there is very small and it would be related to whatever you would consider to be legacy growth from McQueary Brothers. So we acquired a company that was primarily focused on independent branded distribution with a less-developed generic program, and we helped them convert that customer base to our generic program. But I don't know whether you call that organic or you call it acquisition.

Operator

Your next question comes from Richard Close - Jefferies & Co.

Richard Close - Jefferies & Co.

Just curious on the Technology Solutions area, talk a little bit about the service. You mentioned the [inaudible] subscription as good recurring revenue, but notice that that line item decreased sequentially from the second quarter of '09, albeit just a little bit. If you could give a little bit of commentary what you're seeing with respect to the services line, whether you're seeing any type of delays or lengthening of implementation cycles, I guess, in the hospital market.

John H. Hammergren

As you mentioned, the services part of our business has been holding up well and growing faster than the software portion of our business this year, and it does contain lots of different products and services, things like revenue cycle outsourcing, things like our RelayHealth transaction processing businesses, some of our other sort of recurring revenue pieces are in there.

I would say that there are some implementation services obviously that we provide to go along with software sales, and we probably did have some implementations that were delayed because customers' resources were not available. That is not an unusual occurrence.

I would say that the biggest change we're seeing in our services line is an increased interest in purchasing outsourcing services and revenue cycle management services from McKesson. I think our customers are more and more interested in offloading some of these more - less focused, less core tasks to people that are experts like us. I would say that our funnel in those areas is beginning to increase as people are looking for ways to streamline their in-house capabilities and activities.

Richard Close - Jefferies & Co.

And then just a follow up, I guess, on Charles' questions with respect to OneStop. I believe that you're doing the generics, if I'm not mistaken, for Target as well. You mentioned that, I think, a little over a year ago, possibly. Have we completely lapped that being part of the OneStop program?

John H. Hammergren

Yes, that's been part of our portfolio for quite some time. That doesn't mean we're not continuing to make progress in the program, but they've been a OneStop customer for some time.

Operator

Your next question comes from Robert Willoughby - Banc of America Securities.

Robert Willoughby - Banc of America Securities

Jeff, John, you did explain the uptick in the receivables and DSO here. What's the action plan to work those down again with the smaller accounts?

Jeffrey C. Campbell

Well, we are certainly, I say, Bob, invigorating our credit efforts. Some of you may know that Ana Schrank, who now runs IR for us, used to lead that group. But she has a capable successor and we are hard at work.

As I mentioned in my remarks, this is mainly about a lot of our smaller customers. I also think where it was the end of the calendar year you saw a little bit of people wanting to just wait until the first week of January to pay us. So in fact, from a reserve and bad debt perspective, we haven't seen any decline, but there's a little slowdown in payment so we are focused on it, expect it to clear up, and hopefully you won't hear about it again.

Robert Willoughby - Banc of America Securities

Is it IT or Distribution or both - all of the above?

Jeffrey C. Campbell

The commonality is across the businesses when you look at the smaller customers.

Robert Willoughby - Banc of America Securities

And just a quick one. The AWP litigation, you have not paid that as yet, correct?

Jeffrey C. Campbell

Correct. So last Friday the judge gave us preliminary approval. She hasn't yet set a date for the final approval hearing, but obviously that has to happen. I hate to hazard a guess  I'm not a lawyer - but I would guess we would probably pay it out perhaps some time this summer.

Robert Willoughby - Banc of America Securities

And that's a one-time payment?

Jeffrey C. Campbell

Yes, for the private party settlements.

John H. Hammergren

You might recall the charge had two components. One component was the private party and the other is yet to be sort of resolved.

Operator

Your next question comes from Charles Rhyee - Oppenheimer & Company.

Charles Rhyee - Oppenheimer & Company

Just a couple of follow ups. You know, getting back to, Jeff, you were talking about the backlog for the IT and the various components. Could you maybe at least maybe give us a sense of what percentage of your bookings in a given quarter are recognized in the current quarter, like a ballpark range, perhaps?

Jeffrey C. Campbell

Yes. You know, ballpark - and I don't know if I have that number handy; we used to talk about it  if you look at the software bookings, generally we defer around 80%, to use a round number, of all of the software revenues out of the current quarter into the future.

Charles Rhyee - Oppenheimer & Company

So the reverse thing, you recognized 20%, so that's what we're really talking about here as we think about if booking slows, it's really that 20% of the software line could be weaker. Is that the right way to think about it?

Jeffrey C. Campbell

Yes.

Charles Rhyee - Oppenheimer & Company

And then in terms of the visibility to the rest of your backlog, though, I mean, you talked about a lot of subscriptions, managed services, to sort of understand what percentage of maybe your next year's backlog is sort of contracted or do you have sort of visibility over?

John H. Hammergren

Well, you know, we don't give a specific number of recurring revenue because our business is just so diversified, you get into almost debates about how you want to define things. But if you focus, I think, on the kind of results and revenue growth we had this quarter in light of what is a clear slowdown we see in new physician office and hospital bookings, I think that gives you probably as good as anything some guideline to use as you think about the future.

Charles Rhyee - Oppenheimer & Company

And just to clarify, I think you said the credit markets have eased. Are you back in the commercial paper market?

Jeffrey C. Campbell

Our major short-term funding source is our accounts receivable sales facility, which in today's market climate funds at remarkably inexpensive rates. So we have been actively using that and you see that in our financial results in the $5 million of fees, which is what you call them, that show up in our operating expense line.

We do have access to the commercial paper market, however, as a Tier 3 issuer, that access is fairly expensive still and fairly limited, so it has not been our chosen market to use.

Operator

Your next question comes from Sandy Draper - Raymond James.

Sandy Draper - Raymond James

Just two questions. One, would it be possible to get some additional commentary? You mentioned that you saw a little bit of a pause in the hospital and the physician level on the hospital IT side. Can you separate a difference between the two? Is one greater than the other or are you seeing customers reacting differently?

And then maybe a follow up, have you - obviously the longer-term potential for some of the bills that are in the House and Senate are pretty significant for health care IT - have you seen any commentary or questions from your customers about any risk about them slowing down purchasing over the next couple of quarters while they're waiting to see what may or may not come out of Washington?

John H. Hammergren

Sandy, I think clearly the business base of McKesson from a size perspective is more heavily hospital oriented, and so just from a materiality perspective, the slowdown in the hospital is probably more significant on us than it would be on the physician side. I can't really give you like a percentage slowdown in the two categories. I'd say that there's anecdotal evidence that both of them have slowed a little bit.

But as I mentioned in my comments, the great thing is that we see these prior period contracts actually getting signed in this period, so I think it's sort of a rolling slowdown as opposed to a fundamental change in demand.

As to the long-term potential delivered through the $20 billion proposed in the stimulus package, we clearly see significant opportunity for our customers, both physicians and hospitals, to access those funds in a way that would be productive. There may be some customers that are, quote-unquote, sitting on the sidelines waiting for that bill to be passed, but I think it's a relatively new discussion and it's going to be hopefully over with relatively quickly, so I don't think this is going to be a significant issue for our customers.

Particularly on the hospital side, many of our customers are working against very long-term IT spending projects, and I'm not sure that they'll feel that they are either in front of benefit or that they can't access it through other investments as it goes on. If this was going to be something that was going to be debated from the stimulus for the next two years, it may be more worrisome to me, but I believe something will be done here in very short order.

Operator

Your next question comes from Constantine Davides - JMP.

Constantine Davides - JMP

One last follow up here, I guess, for Jeff. I know at the beginning of the year you'd guided to OTN being $0.05 or $0.06 dilutive to earnings this year and just wondering if that's switched into an accretive mode in the third quarter and if you can quantify that and does your guidance still contemplate that same full-year expectation?

Jeffrey C. Campbell

Yes, our guidance for the full year still contemplates the same kind of OTN performance. To remind everyone, I said that it would probably be $0.05 to $0.06 or so dilutive, more weighted towards the first half of the year. It depends a little bit, frankly, on just when some of the accounting charges come out of the restructuring, and so I'd say we're pretty much on track with that from a synergy perspective.

John H. Hammergren

Okay, Operator, we have time for one more question please.

Operator

Okay. Your last question comes from Ross Muken - Deutsche Bank.

Ross Muken - Deutsche Bank

Just one quick follow up to the previous question on sort of the health IT stimulus. To the degree to which you think the funds are going to eventually make their way to the hospitals and physicians, what do you think needs to be done in terms of sort of interoperability or standardization coming from, I guess, a legislative perspective in order for I guess those eventual purchases to be made, because there's been a lot of discussion that there needs to be this sort of set of standards or something put out by the government before kind of the eventual release of funds occurs.

John H. Hammergren

Yes, Ross, you're right, there's been lots of discussion about interoperability, and I would say that the other administration - the previous administration - was all over this issue as well and fortunately they came to the industry probably several years ago now and created several organizations to help set those interoperability standards, including CCHIT and a few others.

McKesson has participated in those standard-setting processes and actually there was, in addition to standard setting, there's been a certification process under way for physician applications in terms of their ability to interoperate. And McKesson has been privileged to have our products named as standard bearers, basically, in this interoperability, along with others in our industry, so I think we're well along our way to have standards already available for people to point to and for software companies to develop to allow the interoperability to exist.

As you might recall also, McKesson's invested heavily in RelayHealth. A portion of that business is our physician connectivity business, which clearly operates in a web-based sort of software as a service model, but it allows us to interact with foreign information systems outside of McKesson's platforms very easily doing simple things like e-prescribing or doing more complex things like moving medical records and lab results, etc., between the various systems.

So I think we've made a lot of progress, both on the standards but also, more importantly, also on the products that are available to date and make division of an integrated interconnected health care system a reality.

John H. Hammergren

I want to thank you all for your time and attention today. We remain very excited about our unique offering across all of health care and our ability to turn that into value for our customers and our shareholders. I'll now turn the call over to Ana for a few comments about our upcoming events. Ana?

Ana Schrank

Thank you, John. I have a preview of upcoming events for the financial community. On February 10th we'll present at the 2009 UBS Global Healthcare Services Conference in New York. On March 11th we'll present at the Barclay's Capital Global Healthcare Conference in Miami Beach. On April 6th at 8:30 in the morning we will host our traditional Boothside Briefing at the annual [HEMS] Meeting in Chicago. And we will release fourth quarter earnings results in early May.

We look forward to seeing you at one of these upcoming events. Thanks and good bye.

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Source: McKesson Corporation F3Q08 (Qtr End 12/31/08) Earnings Call Transcript
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