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Cardinal Health, Inc. (NYSE:CAH)

F2Q09 (Qtr End 12/31/08) Earnings Call

January 5, 2009 8:30 am ET

Executives

Sally Curley - Sr. VP of IR

Kerry Clark - Chairman and CEO

Jeff Henderson - CFO

George Barrett - Vice Chairman and CEO, Healthcare Supply Chain Services

Dave Schlotterbeck - Vice Chairman, Cardinal Health and CEO, Clinical and Medical Products

Analysts

Lisa Gill - JPMorgan

Jim Suva - Citigroup

Randall Stanicky - Goldman Sachs

Ricky Goldwasser - UBS

Ross Muken - Deutsche Bank

John Kreger - William Blair

Charles Rhyee - Oppenheimer

Larry Marsh - Barclays Capital

Leo Carpio - Caris & Company

Operator

Welcome to the second quarter fiscal 2009 Cardinal Health Earnings Call. My name is Becky and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference.

I would now like to turn the presentation over to your host for today's call, Ms. Sally Curley, Senior Vice President of Investor Relations. Please proceed.

Sally Curley

Thank you, Becky and welcome everyone to Cardinal Health call today. Today, we will be making forward-looking statements. The matters addressed in these statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected or implied. Please refer to our SEC filings in the forward-looking statements filed at the beginning of our presentation found on the investor page of our website for descriptions of the risks and uncertainties.

In addition, we will reference non-GAAP financial measures. Information about these measures is included at the end of the slides and a transcript of today's call is also posted on our investor web page at cardinalhealth.com.

Before, I could turn the call over to Kerry, I'd like to mention a few upcoming events. First, we will be representing next week at the UBS Healthcare conference on February 9th. On March 11th, we'll be presenting at the Barclays Healthcare conference and on June 2nd, I'm pleased to announce, we will be hosting an Analyst and Investor Day focused on new Cardinal Health in the morning and SpinCo or the Clinical and Medical products area in the afternoon.

Details of all of these events will be posted over time on the investor relations section of our website, so please make sure to visit that often for updated information.

Now, I'd like to turn the call over to Cardinal Health's Chairman and CEO, Mr. Kerry Clark.

Kerry Clark

Thanks Sally. Good morning everybody and welcome. I'm pleased to say our second quarter was solid with 8% revenue growth overall. Healthcare Supply Chain Services also grew revenue 8%. And despite the deferral hospital capital equipment purchases and some foreign exchange headwins, Clinical and Medical products posted solid revenue growth of 7%.

Overall, non-GAAP operating earnings for Cardinal Health grew approximately 7% leading to non-GAAP EPS of $0.93. And I'm happy to report that HSCS as a whole returned to profit growth this quarter for the first time in over a year.

Well, we are continuing to progress towards spinning off our Clinical and Medical products businesses, we are still very focused on delivering our financial and operational goals this year. Excellence in execution is the key, and that is what is reflected in our results this quarter.

For Healthcare Supply Chain Services, that means continuing to focus on the right programs, right channels and right profitability levels, while still making important investments for the future. While we are by no means declaring victory on the HSCS, we do feel good about the progress we've made so far.

For Clinical and Medical products, our focus is on delivering clinically differentiated products with a particular emphasis on safety. Despite the slowdown in hospital capital spending, the core business for CMP remains resilient with about 40% of that business coming from disposables.

For both businesses, we're taking the appropriate steps to deal with the current economic environment by making tough choices in spending, while ensuring we still invest in key programs for the future.

Turning to our plan to spinoff Clinical and Medical products, I would simply say that the strategic fundamentals behind the spinoff remain sound, and our execution is on track. We filed the private letter ruling request on the tax-free nature of the transaction with the IRS in last November. And we are on track to file the Form 10 registration statement with the SEC this quarter. We still anticipate an effective date for the spinoff around the middle of this calendar year.

As a reminder, the Form 10 will include the spinoff company's financials. Cardinal Health's pro forma historical financials, reflecting the spinoff will be available separately closer to the effective date of the spin.

Finally, we continue to monitor the financial markets carefully and we remain confident that we'll be able to complete the spinoff. Of course, conditions may change, but based on what we are seeing today, we continue to be optimistic. We are also continuing to monitor our separation costs very carefully and we believe they are reasonable and in line with benchmarks for similar transactions in other companies.

Now I'll turn it over to Jeff to provide you with an overview of our Q2 fiscal performance and more commentary around the credit markets. Jeff?

Jeff Henderson

Thanks, Kerry. Good morning, everyone and thanks for joining us. I'm happy to report a quarter of solid consolidated results, despite the unprecedented economic environment we're in. Although about one month ago, we did adjust our outlook for the remainder of the year, due to the impact of hospital deferrals on capital spending at CMP, the rest of the business remains on track and we continue to make progress in our priorities despite this economic climate.

Dave and George will discuss this in more detail in a few moments. I'm going to take you through the quarterly results including an update on our liquidity position and our outlook for the remainder of the year.

Now let's turn to the consolidated results for the second quarter. Please note that my comments will reflect the financial results from continuing operations on a non-GAAP basis. Consolidated revenues were up 8% to $25.1 billion. Operating earnings were up 7%, to $565 million, which reflects solid operating results across both primary reporting segments. Earnings from continuing operations were up 2% to $335 million, driven by the solid operating results.

Our non-GAAP tax rate for the quarter was a little over 33% versus just over 30% last year, which reflects a shift in income from lower tax to higher tax jurisdictions this fiscal year and the expiration of certain tax incentives we spoke about with our initial guidance, as well as a discreet adjustment that benefited the prior year.

We are on track for a fiscal 2009 tax rate of approximately 34%. Note that as in the past individual quarters may be higher or lower due to mix issues and unique items affecting any given period. Diluted EPS was $0.93 cents for the quarter, up 3% from the prior year. Operating cash flow for the quarter was $272 million, which reflects a $450 million draw on our accounts receivable sales facility.

As a reminder, facility is off balance sheet for accounting purposes. Accordingly draws on the AR facility are shown as a reduction in accounts receivable on the cash flow statement, which also may reverse with an increase in AR when the balance is repaid. Absent this transaction, we would have reported negative operating cash flow for the quarter.

I would like to remind you that Q2 is typically not a strong quarter for operating cash flow, due to the usual buildup of inventory that occurs during towards the end of the calendar year. Further, our strong revenue growth over the past few quarters has required some corresponding increase in working capital.

However, this year's Q2 was also negatively impacted by one of our large customers, which chose to bring down its own inventory levels in the December quarter, which resulted in us carrying more inventory than anticipated. This amount was really the difference between us reporting positive and negative operating cash flow for the quarter. We anticipate this excess inventory will be sold through during Q3 and we are making good progress on the sell-through now.

As we look at the current forecast for our full year operating cash flow, we now expect it will be closer to $1 billion than the $1.5 billion or so we spoke about earlier in the year. This change is really attributable to two major items, which we have or will discuss today. The reduction in earnings associated with our previously announced CMP guidance adjustment and the anticipated spinoff related costs that I will touch on in a few moments.

Now, let's dig down into a few working capital metrics. Sequentially, days sales outstanding or DSOs reduced by almost 3 days from our Q1 with about 1.5 days of improvement from the AR facility utilization. DSOs also declined versus the prior year, which was primarily a function of the accounts receivable sales facility drop. Day’s inventory on hand increased slightly from the prior fiscal year largely due to the one large customer issue I cited earlier.

We continue to be diligently focused on managing our investment in working capital. Our balance sheet remains strong. At quarter end, total debt to capital was 32%; well within our target range of 28% to 35% and we had $773 million in cash on the balance sheet.

Finally a comment on the credit markets. If you recall on the Q1 call, I mentioned that we were well positioned from an access to capital standpoint. I am very proud of our treasury team and our thoughtful approach to managing the balance sheet over the last several years continues to place us in a very strong position.

We've been very active in the commercial paper market with good access there and ample lines of backup liquidity. We are issuing multi-week tenures at very attractive pricing right now. Our AR facility can be drawn up to a totaling of $850 million, also at attractive prices.

Overall, I'm pleased to see the credit markets have opened up in the past six weeks, both for short and long-term issuances. This is a positive development for both Cardinal Health and corporations in general.

Now, turning to the next slide. During the quarter, special items totaled approximately $20 million, which negatively impacted GAAP EPS by $0.04. The $20 million includes $14 million of costs associated with the spinoff and several other items. Impairments and other totaled about $7 million in the quarter and negatively impacted GAAP EPS by one penny. The net of all of this was a negative $0.05 impact to GAAP EPS.

As a reminder, our guidance range excludes costs we will incur associated with the spinoff and separation of the two companies. As I mentioned to you last quarter, we'll be culling these costs out that are not captured in special items. You have complete transparency. We've also adjusted our non-GAAP financial metrics accordingly.

We currently anticipate that total expenditures associated with the spinoff and separation of the two companies could be in the range of $200 million to $230 million in the period up to and including the day of the spinoff, excluding any tax impacts.

The expenditures relate to three primary areas, employee related costs, such as severance, stand up costs for things such as IT and one-time transaction related costs. Overall, we believe these costs are appropriate to ensure that both companies, particularly SpinCo get off to the optimal start from the moment of spin.

Before I get into all the details of segment performance, I want to briefly update you on the critical investments that we plan to make in both segments that we referenced would total about $100 million this year. Given the economic environment, we have been very prudent in our spending with normal operating costs significantly below our plans for the year. However, we have maintained a substantial majority of our planned investment spend for this year, given the importance of that investment to the future of both segments going forward.

Now, I'd like to review the performance of the individual business segments on a year-over-year basis. Please recall that some of the businesses currently included as part of the CMP segment such as gloves, converters and fluid management will remain with Cardinal Health following completion of the planned spinoff.

We said when we announced the spinoff in September that these businesses represent roughly $800 million to $1 billion in the annual revenues. However, the segment results I'm about to give you reflect a current operating and reporting structure for the company, which is a reporting methodology we plan to use until the spinoff is completed.

Within HSCS, revenue for the second quarter increased 8% to $24.1 billion, driven by strong growth in the pharmaceutical supply chain and medical supply chain businesses. Specifically in the pharma business, we were able to achieve very good growth in number of areas. Revenue from bulk customers was up 15% on increased volumes from existing customers. Revenue from non-bulk customers was up 2%, driven primarily by growth in the hospital market and acquisition of Borschow in Puerto Rico.

We continue to make progress in this key area, as George will highlight for you in a few moments. On the medical side, the hospital supply business again grew revenue in the mid-single digits and above the market, while the lab business continues to grow well, despite the loss of its largest customer last year.

Now, turning to segment profit. I'm happy to report that HSCS achieved its first period of positive profit growth since Q1 of FY08, with an increase of 6% to $333 million. This is primarily driven by the strong revenue growth, increased profit dollars from generic products, branded price inflation and a strong quarter in nuclear pharmacy, where profit was up well over 20% over last year.

We're also pleased to report that we experienced strong earnings growth within our US medical supply chain business. All of these items allowed us to overcome the negative impact of previously announced customer re-pricings in pharma and the anti-diversion activities.

Now, turning to CMP; revenue was up 7% driven by organic growth in the dispensing, infusion and infection prevention categories and the Enturia acquisition, which contributed approximately 5%.

The change in foreign exchange rates year-over-year, partially offset the revenue growth, negatively impacting the rate by about 3%. Segment profit was up 16% on the revenue growth and the acquisition of Enturia, which contributed approximately 12%, and was significantly dampened by the change in foreign exchange rates, which negatively impacted the growth by about 11%, and the residual impact of the increases in the cost of raw materials.

In this last regard, as I have mentioned previously, it takes approximately six to nine months for much of the changes in the cost of oil and related raw materials to be realized in our income statement. We really would not begin to see the full benefit of the recent falling prices until the fourth quarter.

Now, turning to guidance. There are many more items on slides 9 and 10, that I will address in these prepared remarks. But I'm happy to take any questions on them during Q&A. I would just like to say that we are watching this turbulent economic environment carefully, but feel comfortable reaffirming our non-GAAP EPS in a range of $3.50 to $3.60 for the fiscal year.

With that, I'd like to turn it over to George to provide a few comments on HSCS. George.

George Barrett

Thanks, Jeff. Good morning, everyone. It's been quite sometime since we've been able to report year-over-year profit growth for our HSCS segment and I'm pleased to be able to do that this morning.

For Q2, our segment revenues grew by 8% and our contribution of profit grew by 6%. Although, we are far from where I'd like us to be and we will be relentless in pursuing our dramatic business improvement, I'm encouraged by our progress.

Our pharmaceutical distribution profits grew by nearly 10%. Our nuclear pharmacy franchise grew well over 20% and our medical distribution business, led by hospital supplies also grew at a double-digit rate.

Let me take a few minutes to provide more color on our performance. Our largest business, pharmaceutical distribution had a very solid quarter showing revenue growth of 8% and as I mentioned, profit growth by nearly 10% versus prior year. This is no small achievement for us given some of our well-documented challenges.

Our teams are making the right move to drive sustained business improvement. We have talked a lot about getting the basics right. To start, we now have all our licenses back and are shipping controlled substances from all of our distribution facilities.

Our direct store business, an area of increased focus for us, and an important contributor to improving margin mix is showing some signs of recovery.

Although our DSP business grew by only 2%, this includes a negative impact of certain business from one of our largest customers, which moved from DSP to bulk late in FY '08 and which depresses that growth rate by 5%.

Our operating margin on our pharma non-bulk business, which is comprised mostly of our direct store business was up near 10 basis points on a year-over-year basis.

As we look at a subset of our Direct Store Pharma distribution, our independent pharmacy business, we are seeing some early signs of recovery in a channel, which was the most dramatically affected by our controlled drug issues.

Our recent numbers suggest some reversing of the negative trend we were experiencing through the spring, summer and early fall of this past year. Further, it appears that we are winning with larger independent customers. Having said all of this, I will feel much better calling this a trend with three or four additional months of data under our belt.

We had solid generic numbers in the quarter, although I will not be satisfied until our generic program is growing at a steeper rate, but we're making progress there as well. Our generic sales grew by approximately 7% and our profit improved more dramatically, due to mix and purchasing efficiencies. We had solid growth in almost all classes of trade.

Our bulk business grew by 15% versus prior year, while our margin rate on this bulk business was stable. We continue to work closely with our large partners to find ways to create value for one another. This is all about efficiency and mutual value creation and we'll continue to focus not only on how to improve margins in this space, but how to drive improvements in our return on invested capital.

As relates to branded price inflation, we've seen a number of price increases over recent months consistent with our historical practices. So at this time, we don't really see any particular changing trends there.

Finally, on pharma distribution, several years ago Cardinal transitioned from a buy and hold model to a fee-for-service model. We believe that such a system is beneficial to us and to our pharma supplier partners. As most of you know, a few large pharma companies had not transitioned to a fee-for-service program.

Recently one of these companies took steps toward a fee-for-service model and we expect that beginning in calendar 2010 this company's business with us will be transacted using a fee-based approach. Although we expect the overall economics to be essentially the same, we will likely experience some unusual quarterly comps as the transition occurs.

Turning to our nuclear pharmacy business, as Jeff mentioned, we had a strong quarter and have had a very good first half. We had significant double-digit profit growth versus prior year. Although the launch of a generic product this year has changed some of the dynamics of the marketplace, we have adapted to the changes quite effectively.

We provide to our cardiac imaging customers a unique offering, which includes Cardiolite, Myoview and in the near future a lower cost test may be an alternative. We offer our supplier partners access to our customer-centric network of nearly 160 nuclear pharmacies. I should also note here, that we've taken steps with regard to generators to enhance our dual sourcing arrangements, which ensures supply and has allowed us to manage through a difficult generator shortage created by the global shortage of Molybdenum.

Our nuclear teams continue to develop our programs in PET Imaging agent manufacturing, distribution and support. And we're working closely with several large and intermediate size pharma companies in partnership under clinical trials to bring novel and innovative agents into the market. The PET area is relatively small for us we will regard this as a potential high growth area.

Turning to the medical businesses, we have taken a number of steps since we last reported, all directed at improving our customer responsiveness and our business performance as we move toward the planned spinoff. We have been assembling a new team, arguably, the most tenured and proven team in the Medical Products space covering commercial, operation and change management.

In addition, we have reorganized our operations around our medical businesses to increase accountability to the business strategies and to the specific customer segments. As it relates to the performance of our medical businesses, the quarter was solid - again, another good sign in our program to transform this business. Our revenues grew by over 5%, roughly in line to the market. However, through some careful expense management, we were able to achieve double digit profit contribution for our medical businesses. I continue to believe that we have considerable runway in front of us.

Our hospital supply business will continue to benefit as will our customers from our focus on operational excellence, which will drive margin improvement. Our ability to move share with self-manufactured and private-labeled products also represents an opportunity in this market.

Our lab business has been able to grow with the market, a noteworthy achievement given the loss of our largest customer, as Jeff mentioned. This reflects good organic growth with our existing lab customers.

In addition, our ambulatory business was solid this period, especially in surgery centers. I expect that all of our medical businesses will over time benefit from the infrastructure in IT investments we have and will continue to make.

Before I conclude, I thought I may just take a few minutes to make a comment on health care reform. This is an extraordinary time in Washington. And in spite of our economic challenges or perhaps because of them, there is still considerable appetite to take on the issue of healthcare.

The drivers are well known to you, but suffice it to say that the prospect of an increasing demand driven by an aging population and the imperative of assuring that all Americans have access to healthcare will continue to put pressure on our system.

Although specifics of healthcare reform proposals are still taking shape, we are beginning to see some recurring themes. First, there is a relatively broad consensus that having over 45 million Americans without health coverage is unacceptable. How we will include them in the system? Whether this comes through assuring the resources to buy insurance or from a more direct expansion of government program remains to be debated.

From our standpoint, what is clear is that as more people enter the system, demand will increase, as will the focus on efficiency on the system as we try to pay for it. As a very cost-efficient participant in the system, we feel we are well-positioned to contribute to help find this balance.

And second, many recognize the challenge in improving the cost efficiency of the system without looking at this in an integrated way. Pushing down on one part of the balloon may only serve to blow up another. Because we work across the channels of the health system and across the continuum of care, we are well-positioned to participate in a more integrated solution to our nation's healthcare woes.

In conclusion, we are focused on our priorities and committed to holding ourselves to clear goals as we move toward the planned spinoff and I'm pleased to say we're making good on that commitment.

And with that, I'll turn the call over to Dave.

Dave Schlotterbeck

Thanks, George. As Kerry and Jeff mentioned, results for the Clinical and Medical Products business were strong this quarter. As we said they would be on the January 8th call. We saw top and bottom line growth in our major product categories and we continue to manage the business well in a rapidly changing environment.

And before I talk about the second half of the year, which as you know will be challenging due to deferrals in capital spending by many of our hospital customers, let me provide some additional color on Q2.

As Jeff mentioned, CMP revenue grew 7% to $1.2 billion and segment profit was up 16% to $198 million. One item I'd like to call out in our results is the significant dampening effect of foreign exchange. Our revenue growth was lowered by 3% due to currency while our segment profit was lowered by 1%. So currency impact was meaningful, especially to the profit line.

Looking at our Clinical Technologies business in Q2, revenue and profit from infusion continued to grow over the prior year despite pressure on committed contracts. Installations were strong with a 60% increase in the number of channels we installed over the prior year period.

In addition, we won 86% of the deals in which we participated and by hospital nearly 60% of our wins were competitive conversions. One of the highlights was a very strategic multi-year agreement we reached with Sutter Health in Northern California. At approximately 8,000 channels, this is among the top three infusion contracts we have ever won and more importantly, it highlights the strength and value proposition of the Alaris product line.

We continue to demonstrate to our customers the value of our technology support and infrastructure through wins like Sutter Health. Our dispensing business also had a solid quarter in a very competitive environment. The deferral in capital spending is having less of an impact here as committed contracts were moderately behind last year. Still, we continued to expand our installed base and grow our book of business.

We introduced several new products and dispensing products during the quarter, all very well received at the American Society of Health-System Pharmacists meeting in December.

You've heard me talk about the importance of innovation and a strong product pipeline for the future of CMP and SpinCo. The new products we introduced further differentiate our gold standard offerings in the medication safety arena, including an industry first Performance Analytics Service and enhanced Pyxis MedStation.

Turning to our respiratory business, we performed above the prior year, despite first seeing the deferral in capital spending in this part of our business. We remain on track to deliver the new palm top ventilator this summer and our patient care disposables business continues to perform well.

In our Infection Prevention business, our acquisition of Enturia continues to perform very well with strong domestic and international growth. The ChloraPrep product line from this acquisition is highly differentiated in the market with our proprietary delivery technology and its effectiveness in the prevention of surgical and vascular site infections.

It's an excellent example of the standard we set for clinical differentiation in our products.

Also, in the infection prevention arena, MedMined had its strongest quarter ever in installations and another strong quarter selling new service accounts. Through the first half of FY09, we're already well ahead of the entire fiscal 2008; though we continue to build on the momentum we talked about last quarter.

Now, let me talk about the second half of the year. Everything we are seeing in the market is consistent with what I told you on January the 8th. We began to see some deferral in capital spending early in our fiscal year with a more rapid slowdown into Q2 that we expect will continue through calendar '09. As a result, we expect full year segment profit to be flat or better than FY 08.

Let me reiterate a couple of points about this outlook. First, we continue to see the deferral in spending, primarily affecting the capital equipment side of our business. Even there, it's concentrated in a couple of businesses. In infusion, we expect committed contracts to be down about 20% to 25% from last year. Of our four major capital equipment lines, we see much less of an impact on our medication dispensing products. Our respiratory business is in the best shape versus prior year.

As I told you on January the 8th, this is not to say that any of these product lines are meeting the expectations we had at the beginning of the year. However, I want you to have my current perspective on the most and least effective areas of the business.

We continue to see stability in our businesses that are linked to procedures and admissions. These are primarily disposable products that in total comprise about 40% of our business.

I also want to reiterate that we're not seeing any fundamental shifts in the competitive landscape. Underlying demand is still there and is expected to return as the credit markets begin to function in a more normal manner.

As you can tell, I'm not seeing any shifts in the market since our call last month. The environment will continue to be challenging through the balance of this fiscal year and we continue to take steps to mitigate the downside through disciplined expense management.

At the same time, we are not sacrificing R&D investments that will be key to our long-term growth. As I look ahead, there continues to be tremendous growth drivers for our Clinical and Medical Products business. I've mentioned innovation and clinical differentiation already, but let me highlight a few others.

First is scale. Of pure play medical technology companies larger than $2 billion in annual revenue, our size would put us near the top five or six companies worldwide. We serve customers in more than 120 countries today and we have the resources to continue to expand in a large and growing segment of healthcare.

This is noteworthy, because most large med tech companies have about 40% to 50% of their business outside the US. However, we are underpenetrated internationally, while most of our businesses are market leaders in the US today. We believe the opportunity here is substantial. If we were to grow all of our businesses to have 40% to 50% of their sales outside the US, we could conservatively add another $1 billion to $2 billion to the size of the company.

Next is our focus. We'll be the only med-tech company that is singularly focused on patient safety. In both the US and other developed markets, healthcare quality and in particular patient safety has become a clear mandate.

In the US, payers like CMS will no longer reimburse for certain lapses of quality in care called Never Events. This makes patient safety more than a moral obligation. For hospitals, it's an economic mandate. We will be uniquely positioned with products, services and expertise to address six of these 11 Never Events. And finally, our market leading portfolio is a strength today and a growth driver for tomorrow.

With leadership positions in infusion, dispensing, infection prevention, respiratory and neurocare, surgical products and data analytics, we are well positioned with our core customers and have a strong channel for new products and technologies. This innovation pipeline includes 45 new or enhanced products coming out over the next 18 months.

The market opportunities for our products remain large, global and growing. Let me give you a couple of examples. We are the market leader in dispensing, which is a $2 billion annual opportunity in the US alone and relatively untapped outside the US.

We are the market leader in infusion, which is a $3 billion global market. We are the market leader in ventilators and respiratory care for acute care hospitals, which we estimate to be about a $4 billion global opportunity.

By adding infection prevention where we intend to be the gold standard along with our other product categories, you quickly reach a $20 billion market opportunity for our products and services. All of these drivers tie to our rationale for the spinoff. We have a strong business and a growing segment of the market and the spinoff will enable us to become even more focused on our growth.

So, I'll close by saying that we remain committed to the spin and continue to be very optimistic about the future of clinical and medical products.

Now I'll turn it over to the operator for Q&A. Operator.

Question-and-Answer Session

Operator

And your first question comes from the line of Lisa Gill of JPMorgan. Please proceed.

Lisa Gill - JPMorgan

Thanks very much and good morning. Thanks, George, for all the detail around the distribution component of the business, but I'm just wondering, can you maybe just talk to us a little bit about direct store sales. You said they were up 10 basis points. What was the primary driver there, would be my first question?

And then secondly, as we think about Pfizer moving to a fee-for-service agreement and we look at Pfizer and Wyeth coming together, can you talk about any potential impact that you believe that those two entities coming together will have on what fee-for-service agreements will look like? So for example, what does Wyeth look like today and what do you think that the new agreement will look like?

And then just one last follow-up for Dave, you talked about the fact that Pyxis not seeing as much impact from a purchasing perspective and some of the other capital areas. Is that because of the price point or is there something else that is still driving hospitals to buy the Pyxis technology? Thanks.

George Barrett

Good morning, Lisa. Let me try to deal with the first two pretty quickly. Yeah, the growth in our operating margin related to our DSD business is largely about mix. It's a combination of the flow of generic products as well as the growth of larger independent accounts. As I mentioned, we're getting a little bit of shift in our business and some of that the independents that we're picking up are actually more robust than the ones that we've been losing. So it's a bit of mix shift is primarily what's going on and a real focus on dropping that business.

As relates to your second question, I can't give you, as it relates to a fee-for-service agreement with any specific company, I won't name companies. I don't think it's appropriate. What I can say as we look at the Pfizer or Wyeth transaction. Obviously these are both large and good partners of ours.

And it's premature to describe at this point what any impact might look like from the connection of those businesses -- but the combination of those businesses, but at this point, I would not expect this to be an extraordinary event for us.

Lisa Gill - JPMorgan

And then just to go back to your first comment, so DSD you said mix of generics as well larger independent customers. Is it fair to say though, George, I mean you look at the generic program, you said your sales were up 7%. Your two competitors appear to be growing faster than that. Is there a great opportunity for you to continue to improve your margin here as you continue to penetrate generics into your book of business?

George Barrett

Yeah, I think there is, Lisa. I said from the moment I arrived that I thought our programs could be a little bit better aligned throughout our retail system with probably greater transparency and more simplicity and I think we're beginning to move down that path. So I'm excited about the potential. We'll also be mix sensitive, so we've got to have the right customers working on the right programs, but I continue to see this as an opportunity area.

Sally Curley

Lisa, just in the interest of time if we can move on and just have Dave address your question.

Lisa Gill - J.P. Morgan Securities

Sure, no problem. Thanks, Sally.

Sally Curley

We can then move on to somebody else in queue. Thank you.

Dave Schlotterbeck

Yes, to your question, Lisa on the Pyxis being less impacted, it really has to do with the business model and the fact that the majority of our ongoing business is existing customers that have decided to continue doing business with Pyxis and continue on a leasing model.

And because they're leasing and because they're existing customers, it means that they bear no additional expense to install a new product. And that's really the basis for that business being less impacted than any of the others.

Operator

And your next question comes from the line of Charles Boorady of Citi. Please proceed.

Jim Suva - Citigroup

Hi, this is [Jim Suva] sitting in for Charles Boorady this morning. Just a follow up on an earlier question, regarding your generics program, can you just talk a little bit more about the strategy around generics and how you're trying to get more penetration with your customers. Because I'm trying to reconcile some competitor comments about some double-digit growth rate in some specific programs. I am just trying to compare that to your programs.

And also regarding your fee-for-service, if you could just offer more color as to what triggered the switch in this manufacture to convert to fee-for-service and what the unusual quarterly comps we might expect. Thank you.

Kerry Clark

Yes. Unfortunately I'm having a very difficult time hearing you through some distortion. I know there was a generic’s question. I don't know if the operator could hear that and help us with that. Anybody else hear that?

George Barrett

Yes, I'll tell you what I heard and you were getting a lot of static, which is why it was difficult to hear. But I think your question was could you give us more color around the strategy for your generics program and how you intend to achieve penetration and then the second question was fee-for-service, can you tell us why this large manufacturer might have been motivated to switch at this point.

Sally Curley

And perhaps if you're on a speakerphone, if you could just move your handset?

Jim Suva - Citigroup

Yes, I picked up the hand set. Apologies. I don't know if this is any better.

George Barrett

I'm going to try to answer the question. I'm not completely sure I heard all parts of it. I heard little pieces. So let me try this. A little bit about the question of what we're doing with generics and what we need to do. Part of it is making sure that we're getting the best share of wallet of our customers, the best penetration with each of our customers and I think over the past years maybe we've been sub-optimizing there a bit.

And I think as I mentioned earlier, it's a little about having programs that are very simple for our customers to understand in terms of economics that they look at other alternatives. And I believe our group has taken good steps to do that. And as it relates, I think you asked me about comparative to other companies.

First of all, it's very difficult for me to compare across companies. I don't know what's in whose numbers? Whether or not it is their specific programs or overall generics. So I don't think it would necessarily valuable for me to try to compare one program to the other, but rather speak about ours.

Again, ours is very driven by the mix of our customer base. As you know, some part of our customer base buys a lot of their generics directly, others are buyers through the channel and the key for us is getting the best position of that existing pie that we can. There are, of course, other customers who do a little bit of both and when we do both, we want to get as much of their direct business as we can. So we're working very hard at creating programs that are very transparent, but also very flexible.

Every customer, depending on where they're positioned, what their class of trade is, has different needs as relates to generics and the key is understanding their economics and I think we do that and are creating programs that are very flexible for them. So, as I said, I feel like there's an area for us of runway, but we've still got work to do. I hope I answered most of your question on generics.

Jim Suva - Citigroup

Yes. The other question was regarding fee-for-service. What eventually triggered the switch and what you expect of the remaining major brands manufacturer that’s not converting and the unusual quarterly comps we might expect.

George Barrett

I won't speak specifically for this company's motivation. Obviously it's one they should speak to. But generally speaking, there is a predictability that comes with a fee-based model and I think that's beneficial both to us and the supplier.

They don't have to do as much thinking about how to manage the inventory on price increases. So I think there's a predictability that comes from this model and that's probably our best assessment of it. My general sense is that this is a direction that's healthy for pharma manufacturers and healthy for us and I think that that trend in my view would probably continue.

Kerry Clark

And Charles, let me just elaborate a little bit more on the seasonal impact and just to speak about it generally. Generally in a buy and hold model, the bulk of the buy margin profit is realized in Q3 and Q4 just given the timing of when price increases usually happen over the course of a year. When one switches to a fee-for-service model, that high margin or fees are spread more evenly over the entire year.

Jim Suva - Citigroup

Thank you.

Sally Curley

Operator, next question.

Operator

And your next question comes from the line of Randall Stanicky of Goldman Sachs. Please proceed.

Randall Stanicky - Goldman Sachs

Great. Thanks for the questions. A couple of quick ones. First, Jeff, last quarter you talked about the IT investments in R&D giving us a sense of what was spent in Q1, we've talked about it being largely first half fiscal weighted. Can you give us a sense of as we work towards that $100 million, how far we've gotten towards that number?

Jeff Henderson

Sure. Thanks, Randall. I hope you're doing well. Yeah, first of all, let me reiterate what I said in the call, that we originally planned on about $100 million of that investment spend happening this year. As I said in the call, we're still preserving a substantial majority of that, which, translates into about $70 million to $80 million of the $100 million that we still expect to spend this year.

I would say, year-to-date we've probably incurred less than 35% of that. In the first quarter call, I said we incurred less than 20%. So we've seen a bit of shifting out toward the second half of the year. That’s not really because we've made any specific decision to shift it but as some of our IT programs have rolled out and been implemented, we've seen some of that cost impact more shift towards Q3 and Q4 rather than the first couple of quarters.

On the R&D side of things which more impacts CMP, I would say it's being more evenly distributed throughout the year.

Randall Stanicky - Goldman Sachs

That's helpful. One quick follow-up for George. I've actually asked you this before. Given some of the changes in the generic environment, whether it be challenges from some of the small cap manufacturers or the consolidation, any change in your strategic thinking about any interest in having some manufacturing capabilities around your generic program?

George Barrett

Good morning, Randall. Yes, it's a tough question to answer. I think fundamentally, we believe that the kind of market share that we can create for our partners on the generic side is very valuable, both to them and to our customers. You know, whether or not we'll continue to explore other avenues to create value is one that I couldn't comment on now, but fundamentally, we create a lot of value both upstream and downstream, when we can move share in the market and we'll continue to drive that.

Randall Stanicky - Goldman Sachs

Right. But there is some rationale to a vertical at some point there?

George Barrett

I don't think, I'd comment at this point.

Randall Stanicky - Goldman Sachs

Okay. I'll stop there. Thanks, guys.

George Barrett

Okay.

Sally Curley

Operator, next question.

Operator

And your next question comes from the line of Ricky Goldwasser of UBS. Please proceed.

Ricky Goldwasser - UBS

Hi, good morning.

Kerry Clark

Good morning.

Ricky Goldwasser - UBS

Just a couple of follow-up questions. First of all on the fee-for-service agreement, the new agreement that you signed, just to confirm, is that effective 1-1-09 and would that mean just maybe a lower benefit in the March quarter versus March quarter of last year?

Kerry Clark

No. We expect it will actually be effective next year and again I don't want to get into too many specifics out of respect to our partner. So, we expect the rest of our FY09 really be business as usual and this may have more of an impact on FY010, Ricky.

Ricky Goldwasser - UBS

Okay. And then one follow-up. It seems like there was strong contributions for generic product in the December quarter that, that may phase out in March, as some of these products are having multiple players. Should we still assume operating margin for the segment to be up sequentially at the same magnitude as we saw historically or should the uptick be more muted this time?

Jeff Henderson

Hi, Ricky, it's Jeff. You know, I don't want to get too specific on this. I really don't want to, you know, get into the quarterly guidance arena. You know, I would say that we did have a pretty strong generics quarter in Q2. Whether that will continue into Q3 remains to be seen. There are still a few uncertainties there. I think our general pattern of having a relatively strong Q3 should hold intact, but again, I don't want to get nailed down to specific basis points at this point.

Ricky Goldwasser - UBS

Okay. Thank you.

Sally Curley

Operator, next question.

Operator

And your next question comes from the line of Ross Muken of Deutsche Bank. Please proceed.

Ross Muken - Deutsche Bank

Good morning. Still, a lot has been discussed about sort of the impairment of the US consumer. Are we seeing anything different in terms of utilization across different drug classes or anything sort of unusual in the business in the last few weeks versus, say, the end of December or November timeframe? And then in terms of, when you look at your larger chains versus some of the smaller independents that you deal with anything different in how each is transacting business at this point. Whether it's from a credit terms perspective or in terms of the different flow levels you're seeing from each of the different players?

George Barrett

Yeah. Hi, Ross, it's George. I'll touch on this first and then if anybody else wants to jump in, please do. You know, we continue to see the data, external data that shows some change in consumer behavior as it relates to elective procedures or doctor visits and we follow that carefully.

I can't say right now that we're seeing a direct translation from that data to our business numbers. It's more at the moment, as Dave would certainly tell you about the hospitals. We're seeing in a very small part of our scientific products business on the instruments side, a little impact there, but it's a very small part of the overall portfolio.

So, in a general sense, I would not say that I'm seeing a noteworthy impact of consumer behavior impact showing up in our business.

Ross Muken - Deutsche Bank

And in terms of where we are with the recovery in the nuclear business, I mean obviously the results were encouraging and appreciate the commentary. Sort of what inning are we in, in terms of getting back to a normal run rate of profits in that business and given some of the other noise we've heard recently in sort of the end market. Do you think we're through most of the difficult period that that profit phased for much of the last 12 plus months?

George Barrett

Well, I don't know how to answer that one on nuclear as to the inning in this game. It's less about a 9 inning game than an industry that's had some discreet events. I think we've come through one particularly noteworthy event strategically and financially relatively well positioned. And I love our position in the marketplace.

I think we're very, very good at what we do. We pay tremendous attention to our customers and I feel like the value from those relationships in that network should be something that has a lasting value to us. But I tend not to see it in the same kind of continuing there as you're describing.

Ross Muken - Deutsche Bank

Okay. Thanks, George.

George Barrett

You are welcome.

Jeff Henderson

Ross, let me build on George's comment, because I think you also had a question about terms and credit conditions.

Ross Muken - Deutsche Bank

Yes.

Jeff Henderson

Obviously this is something that we all watch very closely in this environment and we have a very rigorous process with our business and financial people to make sure we're on top of this issue. Like I said in my prepared remarks, if you look at our bad debt percentages as a percent of accounts receivable, if you look at our delinquencies as a percent of accounts receivable. They're actually staying relatively stable, which is very good from a overall standpoint,

If you look at the customer segments where we're seeing an impact, the one area that we have seen some bankruptcies since the beginning of our fiscal year is in the hospital segment and we've seen about 15 small privately owned hospitals that declared bankrupt since the beginning of the year. Obviously that's a very tiny percentage of our overall hospital base and as I said, it's primarily our very small hospital customers. So it's had a relatively small impact on us from a credit exposure standpoint.

In the retail space, so far the retail customers seem to be holding up pretty well. We are seeing a few regional players with some pressure on them and then again we're watching them closely from a credit perspective. But I'd say all in all, our customers are holding up pretty well from a credit perspective so far and we're keeping a very close eye on our receivables and bad debts to ensure that our balance sheet stays robust.

Ross Muken - Deutsche Bank

Great. Thank you, Jeff.

Jeff Henderson

Thanks.

Sally Curley

Operator, next question.

Operator

And your next question comes from the line of John Kreger of William Blair. Please proceed.

John Kreger - William Blair

Thanks very much. Just a follow-up on that last question. Presumably your customers have a bit less access to cash than they did a year or two ago. Is that affecting their buying patterns from you at all or are you perhaps getting a broader opportunity to provide real time inventory management for example?

George Barrett

Yeah, let me touch on this. Again on the HSCS side, I would say we're not seeing any real change in buying patterns and as to the second part, I don't know, Jeff, if you want to touch on that.

Jeff Henderson

Actually, we were having some discussions with customers about getting more involved in their supply chains and I think it's during times like this that perhaps some of the expertise that we bring to the party can definitely help. But I can't say there's been a specific spike in business in that regard, but we'll continue to have those discussions.

The one change in buying patterns I cited during my prepared remarks, we did have a large customer that chose to bring down its own inventory levels in this environment and that had a temporary impact on us at the end of Q2. But that's really the only significant change that we've experienced.

John Kreger - William Blair

Great, thanks. And just two quick clarifications. Dave, I think you mentioned in your prepared remarks that, the flow of consumable purchasing really has been fairly stable. Just to clarify, are you saying the underlying demand has been stable or it has slowed, but you've been able to gain share to offset that?

David Schlotterbeck

No, I'm saying the underlying demand has been stable because most of our consumable products are related to procedures and admissions.

John Kreger - William Blair

Great. And then, George, lastly, I think you said you still have some key challenges remaining within the drug distribution side of the business. Can you just elaborate on what the two or three key ones might be?

George Barrett

Yeah. A couple. I think we've talked about sort of operational excellence and this is a big and complex business. The changes in profitability that come from operational effectiveness could be quite meaningful. And so, one of the things we're working very hard at is looking across the business, and trying to take complexity out and simplifying the way we do the work that we do and I think the value there when you look at the number of processes that we have actually, is quite meaningful. So that's certainly one area that we think is very important to us.

The second is, moving our mix in a more favorable way and I think we're showing some signs of doing that. Again, our DSP business is growing and when it grows, I think we get some favorable mix and, again, part of that ties to our effectiveness in generics, which is, again, getting every possible piece of share that we can from existing customers and finding new avenues of growth with those programs. So, those certainly are sort of key elements of the program to drive improvements to business.

John Kreger - William Blair

Thanks very much.

Sally Curley

Operator, next question.

Operator

And your next question comes from the line of Charles Rhyee of Oppenheimer. Please proceed.

Charles Rhyee - Oppenheimer

Yeah, thanks for taking the questions. Just a couple of quick clarifications. Jeff, when I look at the guidance, you talk about interest expense for the full year, a little over $200 million. Can you just remind us, why the interest expense will drop off given it's about $120 million or so, so far this year?

Jeff Henderson

That's a great question, Charles, thank you. It's because in our interest -- as you refer to the interest line, it actually includes interest and other, which means there's some impact of change in FX on certain of our quarter-end balance sheet accounts. We have to revalue some of those accounts and the gain or loss that we realize because of FX changes flows through that interest and other line. So, we have seen a fair amount of FX loss in the first half of the year given the dramatic changes in exchange rates, close to $25 million in total between the two quarters.

We don't assume that will reoccur in the second half of the year and that's probably, the biggest factor why you see interest and other not as high in the second half of the year. And then, in addition to that, we'll generate positive operating cash flow in the second half of the year and get some of the benefit of that as well.

Charles Rhyee - Oppenheimer

Okay, great. And then if I look on your cash flow statement, you haven't bought back any stock so far this year, but your share count still ticks down. How should we think about the share count over the balance of the fiscal year?

Jeff Henderson

We said we expect to haunch about 361 million shares for the year, Charles, and I would say that's still a very accurate number.

Charles Rhyee - Oppenheimer

Okay. And then lastly, you talked about the one bulk customer that worked down their own inventory. Can you give us a sense of how much of your ending quarter inventory was impacted by that?

Jeff Henderson

What I said, Charles, is if you look at our negative operating cash flow for the quarter, absent, that inventory bring down, it probably would have been slightly positive for the quarter, so that sort of defines the magnitude. As I said before, though, we are selling that through right now and expect to have most of it worked through in Q3.

Charles Rhyee - Oppenheimer

Great. Thanks a lot, guys.

Sally Curley

Operator.

Operator

And your next question comes from the line of Larry Marsh of Barclays Capital. Please proceed.

Larry Marsh - Barclays Capital

Thanks and good morning. Question for George and a quick follow-up for Dave. First, George, could you just reconcile a little bit your statement, I think you had said in your prepared remarks your drug wholesaling business was up 10% in profits. As a part of that is I guess nuclear up over 20% and I guess medical double digits in profit and your consolidated is up 6%. So what's not growing with that to kind of get us to that number for the full segment?

George Barrett

Fair enough. I probably can't give you a full reconciliation.

Larry Marsh - Barclays Capital

Sure.

George Barrett

If I would describe the parts that I'd love to see going a lot better, the primary challenge for us has been in pre sourced business. Our surgical kitting business is actually a very interesting business. It provides tremendous stickiness for us with our customers.

We've had some real challenges in recent years with it and fundamentally we're being hit by two things at the same time, one is increased commodity prices, which thankfully going forward we expect to correct, but certainly some price impact on our existing book of business.

We are working very hard, Larry, at rebuilding our position in that business and it's been a challenge, but I feel confident that we've got the right team on it and we'll drive that going forward. We’ve got a little bit of challenge in our Martin Dale business in the UK primarily related to FX, actually and we got hit there on exchange. But those would probably be the two that I would highlight that have been challenging us.

Larry Marsh - Barclays Capital

Okay. Just to follow to that point, as we all know your largest customer's business is up for renewal at the end of June, my question, do you still anticipate that renewal announcement close to that date and are you still view that given your recently renewed contract your pricing is already close to market?

Jeff Henderson

You're right, the contract does come up for renewal this summer. Right now, I guess, its our expectation that that's how this would play out. It's always possible that there's some changing to the timing, but my expectation today would be that we're going to move at normal course on this. As relates how it's going to come out, we said before, it's a relatively current contract, which gives us a better sense that if any adjustments have to be made, they will be tolerable, but we will have to see how this plays out in the coming months.

Larry Marsh - Barclays Capital

Okay, very good. And follow-up for Dave, I think you called out that FX impacted your profits in your segment 11% in the quarter. So do we think of that as adjusting for FX your number would have been up 27% and along with that, what sort of impact are you assuming for your full year, when you're talking about sort of flat profits for that segment?

Dave Schlotterbeck

Yeah, you are correct. We would have reported a 27% operating income increase had we not seen such a dramatic change in the strength of the dollar in Q2. We've assumed that that strengthening is going to continue throughout Q3 and Q4 and so that is in our guidance as it is today.

Larry Marsh - Barclays Capital

So it's fair to say that that was clearly one of the issues associated with why you took that number down back in January?

Dave Schlotterbeck

That's right.

Larry Marsh - Barclays Capital

No big deal. Okay. I'll follow-up. Thanks.

Sally Curley

And operator, I think we have time for one more question and then that will end the call.

Operator

Thank you. Your final question comes from the line of Leo Carpio of Caris & Company. Please proceed.

Leo Carpio - Caris & Company

Hi, good morning. My questions are kind of focused on hospital capital spending. In terms of hospital capital spending, are you seeing any concentration within a region or any particular hospital segment group and then in terms of the credit thorn that you seem to be indicating on your corporate paper program, can that filter back to the hospitals and help them out at some point in the second half of the calendar year?

Dave Schlotterbeck

Leo, we're seeing it across the board geographically. There's no particular area where there's a heavier concentration or not. Of hospitals that have actually told us that they are deferring spending, the vast majority of those are nonprofits and I think two things are going to need to happen before we'll see them begin to spend capital again.

One, the credit markets returning much more to their normal functioning and secondly, that they have better visibility of their own financial outlook.

Leo Carpio - Caris & Company

Okay. And then regarding the Pyxis new cabinet that you've rolled out, what has been the response so far from your customers? Has it been favorable and are you sponsoring the 3000 version in favor of this one?

Dave Schlotterbeck

We had been selling the MedStation 3500. This is the MedStation 4000. The response has been extremely positive by customers.

Leo Carpio - Caris & Company

Okay. Thank you.

Sally Curley

Okay. I think, operator, we'll turn the call back to Mr. Kerry Clark.

Kerry Clark

Well, thanks everybody for being with us today. We look forward to seeing some of you at upcoming investor conferences in February and March. There are several of these events coming up, so please make sure to visit the section of our website that provides the information and dates on these. And if you have any other questions coming out of this morning, please feel free to give our IR team a call.

So operator, that concludes our call. Thank you.

Operator

Thank you for your participation in today's conference. This concludes the presentation. Have a great day.

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Source: Cardinal Health, Inc. F2Q09 (Qtr End 12/31/08) Earnings Call Transcript
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