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Cardinal Health, Inc. (NYSE:CAH)

F3Q09 Earnings Call

April 30, 2009 8:30 am ET

Executives

Kerry Clark - Chairman and Chief Executive Officer

Jeffrey W. Henderson - Chief Financial Officer

George S. Barrett - Chief Executive Officer, Healthcare Supply Chain Services

David L. Schlotterbeck - Chief Executive Officer, Clinical and Medical Products

Sally J. Curley - Senior Vice President, Investor Relations

Analysts

Glen Santangelo - Credit Suisse

Lisa Gill - J.P. Morgan

John Kreger - William Blair & Co.

Randall Stanicky - Goldman Sachs

Ricky Goldwasser - UBS

Lawrence Marsh - Barclays Capital

Robert Willoughby - Bank of America-Merrill Lynch

John Ransom - Raymond James

Ross Muken - Deutsche Bank Securities

Operator

Good day ladies and gentlemen and welcome to the Cardinal Health third quarter fiscal year 2009 earnings conference call. My name is Michelle and I will be your coordinator for today. (Operator Instructions). 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.

Sally J. Curley

Thank you, Michelle and welcome to Cardinal Health third quarter fiscal 2009 conference call. 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 and the forward-looking statements filed at the beginning of our presentation which is found on the Investor page of our website for a description of those risks and uncertainties.

In addition, we will reference non-GAAP financial measures and the information about non-GAAP financial measures is included at the end of the slides. A transcript of today’s call is also posted on our Investor web page.

Before I turn the call over to Kerry, I would like to mention a few upcoming events. Representatives from Cardinal Health and/or CareFusion will be presenting and answering questions during several conferences during May and June. The Bank of America Conference on May 13th, the Robert Baird Growth Conference on May 14th, the Deutsche Bank Conference on May 18th, the Goldman Sachs Conference in mid June, and also on June 2nd, Cardinal Health and CareFusion will be hosting back-to-back events. For more information, please contact the IR Department.

That kept aside, also given tight time constraints, the large number of investor conferences in May, and our only analyst cum investor event on June 2nd, we will actually not be conducting any one-on-one meetings at the May conferences. Details of most of these events are or will be posted on the investor events section of our website at cardinalhealth.com; so please make sure to visit that site often for updated information.

Now, I would like to turn the call over to Kerry Clark, Cardinal’s Chairman and CEO.

Kerry Clark

Good morning everybody and welcome. I am going to keep my comments brief today. Jeff, George, and Dave will go into more detail. Overall, I am encouraged with our third quarter performance. We posted 9% overall revenue growth driven by strong top line performance from healthcare supply chain services. The strength of this segment during tough economic times gives us comfort that we are making progress. As previously forecasted, clinical and medical products continue to see the impact of the deferral in hospital capital spending and experienced headwinds from the Alaris related issues as well as foreign exchange, but we did experience a slight positive increase sequentially in customer orders in a couple of our capital equipment product areas. While this is still very preliminary, it may suggest that negative trends are moderate.

As in past quarters we continue to exercise discipline over total company operational expenses. In addition, we continue to monitor our separation costs related to the planned spin-off very carefully and believe they are reasonable and in line with benchmarks with comparable transactions.

We reached a major milestone in Q3 with the filing of CareFusion’s Form-10 in March. We are moving forward internally by organizing along the lines of the two separate companies. Our target remains for the planned spin-off to become effective this summer subject to the Form-10 being declared effective by the SEC, a favorable ruling from the IRS, investment grade credit ratings for both entities, and securing adequate financing. In the meantime, we’re still very focused on delivering our financial and operational goals this year. As I mentioned last quarter, excellence in execution is key.

Now, I’ll turn this over to Jeff to provide you with more details of our Q3 fiscal performance.

Jeffrey W. Henderson

Today I am going to take you through the consolidated and segment results for the quarter, update you on some key financial drivers, and spend some time going through our outlook for the remainder of the year. First, let me build on Kerry’s comments regarding the status of the spin. As you know, CareFusion files its Form-10 on March 31st thanks to the tremendous efforts from our team. Everyone continues to work hard to get ready to spin off CareFusion as targeted for this summer, from an organizational, business, legal, and systems perspective, and we’re great progress in those areas. Our treasury teams are working diligently to complete the necessary financing arrangements and complete our discussions with the rating agencies. I will touch more on that later in my talk. Finally, we’re also preparing the pro forma CareFusion financials and the pro forma recap financials for Cardinal Health, and I expect to have them available to you in the next month or so. I plan to walk many of you through them during our June 2nd investor day in Boston.

So in summary, we feel very good about our spin preparations and readiness plans. Now onto the third quarter results and a bit of other outlook.

Please note that my comments reflect the financial results from continuing operations on a non-GAAP basis. Consolidated revenues were up 9% to $24.9 billion. Operating earnings were down 10% to $553 million, reflecting stability in our HSCS segment, but dampened by the previously disclosed deferral in hospital capital spending, negative impact of foreign exchange, and costs associated with the remediation reserve and ship-hold on certain Alaris infusion products.

We continue to exercise very good discipline regarding operating expenses reporting total SG&A less than last year’s Q3. Headcount is down materially since the beginning of the year and will continue to decrease as the CMP reduction in force is still being implemented. All other expenditures are being watched extremely closely. Strong cost and capital management will be a key focus moving forward, both before and after the spin for Cardinal Health.

Net interest expense and other was $60 million for Q3, an increase of almost $30 million versus the prior year. This was primarily driven by the negative impact of foreign exchange in the current quarter as well as the favorable impact we experienced last year. Interest expense and other did end up higher than we had previously anticipated, due in large part to FX movements during the quarter.

Our non-GAAP tax rate for the quarter was 29% versus just over 33% last year. This reflects a favorable discreet adjustment in the current quarter that relates to a tax refund claim. This lowered the current quarter tax rate by roughly 5% points. Non-GAAP diluted EPS was $0.97 for the quarter, down 10% than the prior year.

I wish to pause for a moment on the EPS number. I recognize that there are a few unusual items in the quarter and let me try to call them out for you. The unusually low tax rate contributed about $0.06 to $0.07 of benefit in the quarter. We were also able to offset a headwind of approximately $0.06 related to the ship-hold and reserves for the Alaris products, as well as $0.02 of bad debt expense related to the bankruptcy of a few regional pharmacy chains.

We reported solid operating cash flow for the quarter of $821 million which reflects a good working capital management including the sale-through of excess inventory of one of our large customers that we mentioned on our last earnings call. In addition, we repaid the $450 million draw on our accounts receivables sale facility in Q3, which is shown as an increase in accounts receivables on the cash flow statement during the quarter, but year to date has an unusual impact to operating cash flow. Year to date we had generated almost $740 million of operating cash flow and as indicated last quarter we anticipate ending the year at around $1 billion.

Now, let’s take that into a few working capital metrics. Sequentially, day sales outstanding was flat from prior year, an increase by almost two days from our Q2, really due to our Q2 utilization of the AR facility and subsequent pay-down in Q3. Absent that, it was roughly flat. Days inventory decreased two days on a sequential basis, largely due to the one large customer inventory issue I noted earlier. Days inventory on hand was flat compared to the prior fiscal year.

Our balance sheet remains strong. At quarter end, total debt-to-capital was 30%, well within our target range of 28% to 35%, and we had $1.4 billion of cash on the balance sheet. Overall, management of working capital and a strong focus on our balance sheet will continue to be of paramount importance as we move forward. We’re also executing the important work on the balance sheet to position the company for the planned spin-off. We recently amended our core $1.5 billion revolving credit facility and expect to complete an amendment of the $850 million accounts receivable facility shortly which will include an increasing capacity of $100 million for a total AR facility of $950 million.

While on the topic I want to quickly mention that we’re currently doing significant work around finalizing the capital structure and with that capital deployment for the two organizations following the completion of the planned spin-off. For those of you that participated in recent investor interviews with third-party, we truly appreciate your taking the time to provide us with your input and the feedback is helpful to our decisions regarding capital structure and deployment. We plan to share some of our thinking in this regard on June 2nd.

Now, turning to the next slide, during the quarter special items totaled approximately $52 million, which negatively impacted GAAP EPS by $0.11 with the biggest contributor to this amount being costs associated with the planned spin-offs. Impairments and other totaled about $3 million a quarter and positively impacted GAAP EPS by $0.01 due primarily to some cash benefits associated with a past divestiture of PTS. The net of all those was a negative $0.10 impact to GAAP EPS.

As a reminder our guidance range of $350 million to $360 million does not include cost we will incur associated with the planned spin-off and separation of the two companies which were $39 million in the quarter and totaled approximately $50 million pre-tax year to date.

Before I get into the details of the segment performance, I wanted to give a brief update on the critical investments we plan to make in both segments that we originally referenced with total up to $100 million in this fiscal year. As the year has unfolded we stated that we would be prudent in our spending to offset the challenges we would be facing. In this regard we have announced specific actions to respond to current economic reality including a reduction in the work force of our CMP businesses and additional cost control measures implanted across the organization. However, importantly we continue to maintain the majority of our planned investments benefit this year. Specifically, we’re continued to invest in those IT and R&D projects most important to the future success 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 the following segment results reflect a current operating and reporting structure to the company and 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 spin-off.

Within HSCS, revenue for the third quarter increased 9% to $24 billion driven by strong sales growth in the pharmaceutical supply chain business. In the pharma business we’re able to continue the trend of good growth in a number of areas. Revenue from bulk customers is at 19% and increased volumes from existing customers. Revenue from non-bulk customers was up 3% driven primarily by organic growth across multiple channels and the acquisition of Borschow in Puerto Rico offset by the shift of certain DSP business to bulk with a large customer.

HSCS segment profit increased 2% to $384 million. This was primarily driven by solid revenue growth, cost controls, and a strong quarter in Nuclear Pharmacy where the profit was up more than 30% over last year. These were partially offset by the impact of customer mix and incremental bad debt reserves of approximately $15 million.

I think I mentioned bad debt a few time now. Let me spend a little more time on this. Unfortunately we had three regional chain customers declare bankruptcy during the quarter which make up the bulk of our incremental bad debt expense in Q3. However, our marking process remained very vigilant and overall we’re pleased with the payment situation of the majority of our customers given the environment. In fact, our delinquency trends as a percent of overall trade receivables have been relatively stable sequentially in Q3 and our DSOs adjusted for the AR facility remained effectively flat.

Now, turning to CMP, revenue was down 6% primarily driven by sales decline from the previously mentioned deferral in hospital capital spending as well as a change in foreign exchange rates year over year, which negatively impacted growth by almost 4% points. During Q3 the Enturia acquisition contributed approximately 4% points of sales growth.

Segment profit was down 22% primarily due to the deferral in hospital capital spending, the reserve associated with the remediation efforts for certain Alaris infusion products, and the impact from the ship-hold. In total during Q3, there was a total of $18 million of reserves made for Alaris remediation plans and about $13 million of lost profit due to the ship-hold. In addition, the change in foreign exchange rates negatively impacted the growth by about 8% points. The overall decline was partially offset by the acquisition of Enturia which contributed approximately 9% points of growth.

Now, just a quick comment on guidance. Even with the additional impact from the Alaris remediation reserve and ship-hold, we’re maintaining our previous guidance range of $3.50 to $3.60 per share, but expect to be at the low end of the range. As per our usual practice, this guidance does not include special items, impairments, or other costs associated with the spin-off of CareFusion nor does it reflect any decision to divest any of our businesses currently being reviewed for strategic fit, which could potentially go into discontinued operations at some point if a firm decision is made to sell any of them and they qualify for DO treatment.

We expect the tax rate for the year to average in the 32% to 33% range. Both interest and other expense is to be about $230 million and fully diluted shares outstanding to average about $361 million for the full year.

Now, let me also make a brief comment on LIFO expense since I know it’s come up in other companies’ calls. Right now we’re forecasting to end the year at a slight LIFO debit position which implies no LIFO charge in Q4, and that’s probably something we’ll be watching closely and it depends in part on brand engineered price movements during the remainder of the year.

Before passing it over to George, I’d also like to take a moment to set expectations around the providing of our outlook going forward. First, we expect to provide the long-term strategy and goals of both Cardinal Health and CareFusion during our investor day on June 2nd. At that time I’ll also walk you through the pro forma and recap financials for both CareFusion and Cardinal Health and discuss in more detail some of the one-time costs and negative synergies associated with the spin for both companies. Our expectation is to provide FY’10 guidance for the new Cardinal Health on a Q4 earnings call in August as we did last year. CareFusion will provide FY’10 guidance prior to the planned spin-off.

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

George S. Barrett

I am pleased to report that our HSCS segment fired up on our positive Q2 performance with a solid performance in Q3, and we did so in a very difficult environment. As Jeff mentioned, our segment revenues grew by 9% and our segment profit grew by 2%. We had excellent contribution from Nuclear Pharmacy, solid performance across a number of our medical operations, and results in pharmaceutical distribution which point to a continuing stabilization of our business. We remain focused on executing on our operating priorities, driving margin improvement, and on showing discipline in managing operating expense.

Let me take a few minutes to walk you through some of the highlights of the businesses for the quarter. Our pharma distribution continues its road to recovery. Year-over-year growth was approximately 10% driven largely by growth from our large chain bulk customers. Overall, bulk sales to customer warehouses grew by nearly 20%. This bulk growth reflects some new volume we picked up earlier this year and as we had mentioned in prior calls, the movement of certain business to bulk from one of our large customers which last year was reported in DSP sales until Q4. Of particular note, our retail independent business grew by 4% in the period. This was an encouraging piece of data in light of what IMS is reporting to be a flat to declining overall independent retail market. We’re beginning to see some signs of increased same-store sales and continue to build out our offerings to our more than 3000 leader stores. I’d like to highlight that the integration of the Borschow acquisition in Puerto Rico has done extremely well and we’ve retained 100% of our customers on the island.

Total DSP direct stores sales revenues were up 3%, a rate which was reduced by 3% points by the movement of the same business of DSP to bulk which I just mentioned. We did see the economy ticket stalling a few of our pharmaceutical distribution customers. As you heard Jeff mention, three of our regional chains filed for bankruptcy protection during Q3 negatively impacting our pharmaceutical operating margins by 6 basis points. Overall, our pharmaceutical distribution operating margins were down 13 basis points reflecting the impact of these three bankruptcies as well as the very high rate of growth in our lower margin of business.

While I have highlighted in the past some of the challenges presented by our customer mix, I will say that our partnerships with some very solid growing and well-positioned customers provides additional stability to our business during turbulent times.

It was a solid, but unspectacular quarter for our generic business. Although we made some progress with our independent retailers where we saw some improvement in compliance rates, the uplift from our generic business was dampened by the competitive position of a few our regional chain customers who have been reducing store count. Our year-over-year generic growth for the quarter was in the low single digits. Generics remain a high priority for us. While our base is strong with over 4000 customers benefiting from our Source generics program, we are repositioning our generic Source program along two dimensions. First, we’re moving our program away from the transactional to a more strategic orientation, one that creates more sustainable value for us and for our vendor partners. Second, we’re working on a downstream program creating an offering which is directed to the very needs of a very diverse pharmacy market and sold by a sales organization specifically trained to articulate the value of our offering. As I have told you in the past, this is a building process; I don’t expect every more to gain immediate traction. We’re laying a very critical foundation for transforming our generic business.

Our branded pharma distribution had a solid quarter with good performance in our fee for service business. As many of you know, the March quarter tends to be a relatively high quarter for price inflation, and this was true for this year as well with comparable numbers to last year. It has been a period of extraordinary merger activity and we will be working closer with our branded supplier partners to ensure that as we go forward, our service fees reflect the value we bring and the real cost of supporting the unique product lines of each of these newly combined branded suppliers.

Our Nuclear Pharmacy business had an outstanding quarter; our team has executed extremely well maintaining extraordinary service levels while expanding our product line and managing through some raw material shortages. Our contribution of profit grew by over 30% versus prior year and although the presence of a generic Cardiolite dampened revenues, pricing is generally stable and both of our major brands are performing well. The shortage of the raw material seems to be resolving and this will help us as we move forward. Overall, it was a really strong quarter for our Nuclear Pharmacy team.

Our medical supply chain businesses continued to show good results in spite of some very challenging market conditions. Collectively, these businesses contributed double-digit growth year over year in profit in Q3. This is particularly noteworthy given the pressures in the top line resulting from the slowdown in hospital admissions, elective surgeries, physician visits, and lab testing. It is something of an accomplishment that our revenues across these businesses were essentially flat.

With this as a backdrop we see the growth in profit contribution as a positive sign. This reflects our focus on product mix, purchasing economies, and continued expense management.

Once the spin-off is complete, these medical businesses are likely to contribute over a third of our new Cardinal Health profits, and we see significant upside as we look to the future. We believe that we offered a product range, a vertical scale, channel coverage, and the industry experience that gives us a competitive advantage. We’re refocusing on these businesses and making the moves to drive value. We continue to look at ways to use our footprint across channels and in particular leverage our access to data. We have taken recent steps to enhance our position in the operating room for example. We’ve entered into partnerships which help prevent the potential for retained foreign objects in surgery. We’ve upgraded our category management tools and finally, our investments in transforming the operational and IT footprint of these businesses, will put us in a great position to improve our margins over time, but just as important will give us the tools to help customers become more cost perceptive.

Ultimately, our ability to bring efficiency to healthcare will be valuable as healthcare reform takes shape. While it’s still early to predict the exact direction healthcare reform will take, it is clear that the spotlight will remain bright. We expect that we’ll see Congressional Committee meetings and hearings on various aspects of healthcare through the spring and the summer, and there will be significant pressure for legislation. We will be engaged as this unfolds.

Let me conclude by saying that we’re excited about getting to the completion of the spin-off of CareFusion and the launch of a new Cardinal Health. While we know that the work of putting this business in the right trajectory is far from done, we feel very positive about our mix of businesses which uniquely positions us to support the health system with a wide range of products and services across the continuum of care. We believe that this is a particularly important factor as the historical distinction between retail and institutional channels continues to blur. We’re refocused on our core and on our customer needs. We believe that we’re pulling on the right operational and strategic levers, managing the power of our balance sheet, and showing discipline in operating expenses, and most important, drawing on the talents and the renewed enthusiasm of our people. We look forward to seeing many of you at our June 2nd investor day where these topics will be covered in greater detail.

With that, I’ll turn the call over to Dave.

David L. Schlotterbeck

As I mentioned during last quarter’s earnings call, we did expect a decline in revenue and profit in the second half of the fiscal year due to the ongoing deferral of hospital capital spending. This was indeed what happened in the third quarter and it was compounded by the recall and ship-hold we currently have on certain Alaris products as part of the amended consent decree. To remind you, on March 12th we announced a ship-hold and a $6 million reserve to correct a software issue in our Alaris point of care unit and the Alaris patient-controlled analgesia module. We’re working towards FDA clearance this quarter to implement this software fix within our manufacturing operations which would enable us to release this ship-hold and install new units that were deferred from the third quarter.

In addition, last week we submitted our corrective action plan to the FDA. This was a requirement of the amended consent decree that we disclosed in February and resulted in an additional $12 million reserve we announced today for the remediation of products in the field. I won’t speculate on the timeframe to begin the remediation work on specific items in the plan or specific items in the plan, but I will say that we anticipate the FDA’s response to our plan by early June.

In total, we recorded reserves of $18 million in the third quarter for our infusion products. In addition, we have been on ship-hold longer than we anticipated in March and we’ll see a greater impact on the full year than the approximately $14 million we previously mentioned.

For a perspective, the Alaris system represents less than 10% of our segment revenue, but it is the main product in our infusion line and an important driver of our segment profit. It also carries fixed cost that when idle further hurts our profitability. The combination of these factors will have negative implications for our FY’09 segment profits. I now anticipate we will finish the fiscal year with segment profit down 7% to 11% falling below our flat or better goal for the year. This guidance does not include any new remediation items that FDA may propose under the amended consent decree. While I am disappointed to lower our segment guidance, there are clearly a number of factors that could have not been contemplated in January. We have seen some modest softening of our business outside the US, but the primary drivers of the guidance charge change and the reserves and the impact of the ship-hold.

The range this guidance implies that Q4 is largely dependent on when we can lift the ship-hold which will determine when we can install units with customers. So, what have we done to mitigate the downside? As you know, we took action in the third quarter to substantially resize our infrastructure. A small portion of the benefit from our restructuring will be realized in the current fiscal year, but we expect the majority of the benefit, more than 70%, to be realized in FY’10. As we reported on March 31st, we expect ongoing annual savings within two years of $110 million to $130 million.

We did make progress in the quarter in meeting our requirements of the amended consent decree. In addition to filing the corrective action plan, the third party certification audit of our Alaris infusion pump operations was completed and submitted to the FDA. This is an important milestone of the original consent decree and something it also meets part of the requirements of the amended consent decree. As I’ve mentioned before, I believe our new quality system will be differentiator for us. We have more work to do, but this is an opportunity and an obligation to bring to market products that are among the safest in the industry.

Now, let me go through our business results from Q3. As Jeff mentioned, CMP revenue declined 6% to $1.1 billion and segment profit was down 22% to $148 million. Foreign currency exchange significantly dampened our results on the revenue and segment profit lines again this quarter. Segment profit for example was lowered by 8% points due to the impact of foreign exchange.

For the quarter, the overall trends remained fundamentally the same. Our capital equipment businesses were affected by the deferral in capital spending while our businesses tied to admissions and procedures continued to hold their own.

Infusion continues to be the business most affected by the deferral in spending due to deal size and medication dispensing continues to be the lease affected. The capital portion of our respiratory business is also down, but this is not as large a business as infusion or dispensing, and therefore not as significant a contributor. We are seeing recent strong interest in our respiratory products related to concerns about the swine flu and we are monitoring closely.

Overall, capital equipment orders were down from Q3 of last year, but they improved sequentially from Q2 and were strong in March. As a reminder, any pickup in customer orders would not have an impact on the income statement for a couple of quarters given installation timelines.

In the infusion business, we are not seeing any substantial competitive challenges or market share changes. We won contracts in more than 80% of the accounts where we competed of which more than 50% were competitive displacements. This win rate is consistent with prior quarters. Our challenge was that the deal activity itself was down substantially from prior quarters by about 45%. We had significant installations at OhioHealth Riverside Methodist Hospital of about 1500 pumps and Harborview Medical Center in Seattle of nearly 1100 pumps.

We also received an important certification for the Alaris system from a group called Integrating the Healthcare Enterprise or IHE. IHE is a global initiative to implement data communication standards for devices and systems within healthcare. This is important to our customers and our strategies. For clinicians, higher level of data sharing helps reduce manual documentation, avoid medication errors, and enable faster response times through alerts and alarms.

In our dispensing business, we achieved an important milestone by regaining the spot at the top of MD Guidelines quarterly customer service report. We are now tied for number one. As many of you may recall, we set a long-term goal several years ago to rebuild our advantage in customer service after it had fallen significantly. This achievement reflects that multi-year commitment and is indicative of the focus we have on providing superior customer service.

In addition, just following the close of Q3, we were awarded one of our largest sole-source dispensing contracts for the year by Community Health Systems. CHS is one of the nation’s leading operators of acute care hospitals with more than 120 facilities in 29 states and approximately 18,000 beds. The multiple-year agreement displaces multiple competitors and we expect to upgrade the majority of sites to our Pyxis MedStation 4000 over the next 18 months.

In the respiratory business we remain on track to deliver our new Enve Palmtop Ventilator this summer. This is an excellent example of the innovative products we will continue to bring to market. At just 9-1/2 pounds we expect this will be smallest intensive care ventilator in the world. Most ICE ventilators weight about 80 pounds. So our product will make it easier for hospitals to transport ventilated patients for tests or other procedures within or outside the hospital, and it can reduce infection rates because the ventilator moves with the patient rather than being detached. Hospitals do try to reduce the number of times they break the supply circuit from the ventilator to the patient because it opens a direct channel into the lungs for potential infections. We really expect this product to be transformational because it will put the ICU wherever it needs to be.

Turning from capital equipment, I’ll remind you that a meaningful portion of our business is from products tied to procedures and admissions. Overall, these businesses continue to perform well led by ChloraPrep from the Enturia acquisition and the disposable products in our respiratory and infusion businesses.

We continue to deliver long-term measurable value to our global customers and have very clear opportunities for growth as an independent company. We filed our Form-10 at the end of this quarter which was a major milestone on our path to spin off as CareFusion later this year. I look forward to going through those growth opportunities in more detail at our June 2nd analyst meeting.

Now, I’ll turn it back over to the operator for questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of Glen Santangelo - Credit Suisse.

Glen Santangelo - Credit Suisse

I just have a quick question with respect to CVS, you didn’t comment at all on the upcoming re-negotiation; Kerry or George may be if you can give us a sense for where you are in that process and what you expect for timing that would be helpful?

Kerry Clark

Glen, as you know it is difficult for us to discuss that during the course of that process. So, I’m going to have to just let you know that the conversation obviously has been ongoing, has been very positive, and beyond that I think it is difficult to share any more at this time.

Glen Santangelo - Credit Suisse

George, is the contract up on June 30th and is there a chance we could go past the contract date?

George S. Barrett

Our contract actually I believe is July, but I think it is unlikely that we go past the contract date.

Glen Santangelo - Credit Suisse

And then if I could just ask one followup question; you suggested in your prepared remarks that the revenues were somewhat impacted by some store closures in mid-size chains, can you may be elaborate on that a little bit and may be discuss how much that impacted you in the quarter?

George S. Barrett

Yes, I can’t give you the exact number and it’s not something I am comfortable quantifying nor am I particularly comfortable talking about the relative health of each of our customers, but there are a few regional chains that in their competitive market had had to make some adjustments and are probably losing a little bit of share to some of the national players and so we see that dynamic in some of our markets.

Operator

Your next question comes from the line of Lisa Gill - J.P. Morgan.

Lisa Gill - J.P. Morgan

George, just following up on that line of questioning, can you talk about when a customer does file for bankruptcy or closes stores and the sales primarily moves to someone else, and in the case of Drug Fair, New Jersey where Walgreens buys it, how much of that volume do you generally pick up?

George S. Barrett

It’s a good question and the answer is that it would vary a lot case by case; so, in some instances business may move literally from one pocket to the other and it also depends on the nature of that particular customer; are they a customer that buys generics directly from a manufacturer for example or are they a customer that buys generics through the distribution channel. So, it’s hard to give a categorical answer in the case you described. Generally speaking, if business is moving to one of our major customers who are buying generics directly, we would expect over time that they are likely to move in that direction, and so in some cases it can be a negative to us and in some cases it is really neutral.

Lisa Gill - J.P. Morgan

Do you have some kind of percentage; for example, in this kind of case which it sounds like those are the kind of players that are filing for bankruptcy; is it we lose 40% of those sales, 50% of those sales as it moves to a national player just as we start thinking about as more bankruptcies probably come about in the next couple of years?

Jeffrey W. Henderson

It’s a difficult question to answer because everyone’s different and it depends on the type of liquidation that they do, but in the specific case of Drug Fair which has been very public and it is also very public that Walgreens is buying a significant portion of the assets, we sit on the credit committee as one of the major creditors of Drug Fair and those discussions are still being finalized, but expectation is that Walgreens will buy the majority of the stores from Drug Fair, but exactly what that number will be still remains to be finalized.

Lisa Gill - J.P. Morgan

And then just one followup, George, you talked about healthcare reform and you kind of laid out the time length, but you didn’t talk about what your expectations are for Cardinal around healthcare reform; can you maybe just give us 30 seconds on how you think it would impact Cardinal?

George S. Barrett

Probably the single most important issue is the inclusion of a large group of Americans who are today either uninsured or under-insured. So, I think net, the inclusion of those probably is now 50 million Americans and the assessment is probably a good thing for us. It is really hard to know exactly how this is going to take shape. I think the question of access is largely being accepted as a fact now even though we don’t know exactly how to do it; I think the access issue is almost no longer a debate, and the issue really moves towards cost and how do you do that; so, we’ve been watching very carefully to make sure that our voices are heard in that discussion. The good news for us is that our business is largely about cost efficiency and cost effectiveness, and we’re not exactly the natural target as you look at the pools that you would attack in the system; so, I think we’ll play an active role in this, I think our focus on efficiency is going to be positive and we’ll continue to reinforce that as we go.

Operator

You next question comes from the line of John Kreger - William Blair & Co.

John Kreger - William Blair & Co.

A question for both Dave and George about kind of your perspective on the macro environment; David, I think you said in the past you survey your customers weekly, perhaps could you just give us an update on what those survey results are showing and your perspective on when a turn in the capital equipment environment might happen; and George, similarly, as you look across your network of customers, are you seeing any change in underlying pharma consumption in your opinion?

George S. Barrett

John, from our standpoint, as you can see from our revenue numbers, consumption appears to be relatively robust. So, the fundamental demand in spite of some of the market data continues to look good, part of that has to do with again our unique customer mix, each of us in the system is a bit different. Clearly, we are watching carefully the total utilization numbers and watching how Americans alter their healthcare behavior as it relates to economic conditions, but right now, I would say we’re holding up relatively well. The place of course where we see a little bit more directly is in our hospital business and in our ambulatory business; it’s probably a more dulled impact than you would see for example in the capital equipment business, but we’ve seen certainly some data, as I mentioned in my comments, that hospital business and discharges are down, elective procedures are down, and so we see some of that on our business; we’ve done very well in this environment; it’s a sort of second-order effect to us, but right now, I don’t see anything notably deteriorating at this stage and we feel like we are relatively well positioned across the channels to weather this.

David L. Schlotterbeck

John, we do frequently survey our customers, and I think my summary would be they are indicating no change in their behavior at the moment; the majority of them see the next 12 to 18 months as the time period when they will continue to defer their capital spending. I will say that as we plan for the spin and we plan for FY10, we are taking that into account. It’s in fact one of the reasons that we did the restructuring announced at the end of the March. I think there was a report recently put out by the AHA which had some very recent data gathered in the month of March which indicated upwards of 80% of hospitals which have become very cautious about their capital spends, and I think that that correlates exactly with the customer feedback that we’re getting.

Operator

Your next question comes from the line of Randall Stanicky - Goldman Sachs.

Randall Stanicky - Goldman Sachs

One again for Dave and George, Dave just a followup to the last question, how should we think about the P&L flow when orders start to pick up on the system side, how is that going to convert to the P&L in terms of timing?

David L. Schlotterbeck

The typical delay in the infusion and the dispensing business which are reasonably large parts of our capital equipment offerings, typical delay is 4 to 6 months, and so, we wouldn’t really see any P&L impact until that kind of a time period went by after we saw orders beginning to grow; not true in respiratory; in the respiratory business the cycle from order to shipment and acceptance is very short, normally 2 weeks, and so that’s going to make the respiratory business a leading indicator of the turnaround.

Randall Stanicky - Goldman Sachs

So, understanding that there are higher margins in the meantime, is there a scenario where we would actually see profitability improve given mix of consumables versus system sales?

David L. Schlotterbeck

Well, theoretically it is possible but really only if you address the fixed and variable costs associated with running the business, and frankly, that’s part of what we tried to do in our March 31st restructuring.

Randall Stanicky - Goldman Sachs

Okay, understood and then a quick one for George; you talked about the generic growth, I think you said single digits, can you may be just touch on competitively, what do you need to do to drive better contribution from the generic program?

George S. Barrett

A couple of issues, one is a little bit about mix, and that’s part of the reason that I have wanted us to and we focused on driving our DSP business; that is probably the ingredient that has the most powerful impact as those stores can be very effective generic players and for our important target customers; it’s part of the reason why coming out of the issues that we had in controlled drugs is very important to us; so, again, it’s sort of all part of the same mix which is moving more heavily into that category, getting a higher percentage of their business, and making sure that as we come out of this controlled drug issues that we had, that our selling effort is very well directed, that we got tremendous alignment on the incentive systems designed to drive our generic programs. So, part of it as I mentioned, relates to the nature of our program on our sourcing approach. In my view, we have probably not taken full advantage of the position we have in the market; we probably had too many suppliers with not rich enough or deep enough strategic relationships and we’re working along that to mention as well. So, the key ingredients are the sales force effectiveness, penetration and the right mix and driving the right sourcing model, and I think that’s probably for us the primary focus.

Operator

Your next question comes from the line of Ricky Goldwasser - UBS.

Ricky Goldwasser - UBS

I have a couple of followup questions; first of all, on leaders, can you comment on what is the generic compliance rate, is it above or below the company average, and does this group represent the most needed opportunity for up-selling generics from your perspective? And then two other questions; first is, George you commented that independence grew about 4% for you this quarter, how does that compare to the last quarter and what was the sequential growth? And finally, just to confirm, you were saying no LIFO charge next quarter, does that mean that you are really not looking for much in terms of pricing action in the June quarter?

George S. Barrett

Ricky, let me see if I can capture all of those, Jeff probably should take the third piece of it; the leader program is important to us; we’ve not broken up quantitatively that program as it relates to compliance versus others, the rest of the our business; I’ll say that our leader customers are very good customers, they tend to be customers that value the broad range of services that we offer from the generic program to our inventory management tools to our reimbursement support; so, I would say on balance, those customers are ones we clearly believe understand the value that we offer in our programs, and we tend to do very well with them and we’re obviously on a regular basis trying to expand those offerings to them and expand the number of players in that program. Regarding the second question, I don’t actually have the number in front of me. We’re slightly favorable to the year-over-year comps that we showed you in Q2, Ricky.

Ricky Goldwasser - UBS

Okay, and do you have the data on the sequential basis?

George S. Barrett

We’ll followup with you on that, I don’t have it right in front of me.

Jeffrey W. Henderson

Ricky, let me answer your question regarding LIFO; first of all, let me spend a few seconds trying to simplify how the LIFO is actually calculated. It is an incredibly complicated calculation and I have to remind myself all the key drivers. Effectively, there are 4 major drivers in determining whether we have a LIFO charge or not, and to put it really simplistically, more branded inflation is bad for LIFO charge, more branded inventory at the end of the quarter is bad for the LIFO charge. On the flip side, generic deflation is good for the LIFO charge and more generic inventory is good for the LIFO charge, again to put it very simplistically. So, we have to make 4 assumptions as we forecast our LIFO, two of them are more controllable and that is the level of inventory that we have from both branded and generic products at the end of the years; and the second set of assumptions we have to make which are obviously less controllable are branded inflation and generic deflation during any period. I would say our expectations on those last two fronts for the remainder of the year are pretty much consistent with what we’ve seen so far this year, and specifically answering your question, we see branded inflation in Q3 about in line with what we saw last year and we expect that general trend to continue in Q4. Clearly if any of those assumptions differ, that could have an impact on LIFO during the quarter.

George S. Barrett

Ricky, I can followup on the other question, there were two parts to it as it relates to compare 3 versus 2 on a year-over-year basis we are favorable to past period. If you look at pure sequential, we’re roughly comparable to where we were last quarter.

Operator

Your next question comes from the line of Lawrence Marsh - Barclays Capital.

Lawrence Marsh - Barclays Capital

Three quick ones, hopefully, first for Jeff, Dave already touched on this but I just want to be clear; on CMP, I think you’re saying down 7% to 11% versus prior flat, are you keeping the other components of your guidance the same for this year both in supply chain and top-line for CMP?

Jeffrey W. Henderson

We didn’t comment specifically on the top-line for CMP, but we’re expecting it to be flattish for the year, Larry. For HSCS, our guidance is unchanged.

Lawrence Marsh - Barclays Capital

Okay, and then just may be a quick followup then for Dave, given the Alaris ship-hold, I assume that business could be down a good bit in the fourth quarter, it sounds like you’re saying in that division profits will be down another 25% year-over-year in fourth quarter; are the other pieces of the business, do we think of those as being down modestly, Enturia, Pyxis, Viasys, given the economy or not?

David L. Schlotterbeck

Respiratory and Pyxis are about where we had anticipated them to be if not a little better in dispensing and may be slightly worse in respiratory, and Enturia continues to exceed our expectations.

Lawrence Marsh - Barclays Capital

Second I guess for George, just the other topic of some broad commentary in the last couple of months sell-side margin pressure, you were saying today, a reasonable environment, particularly customer issues with bankruptcies, but any particular comments on the margin side of the equation from a pricing standpoint competitively?

George S. Barrett

As you know, obviously this is a competitive business but I would not be able to point to a significant systemic decline in prices. As you said, on a case by case basis, the competitive dynamic is unique.

Lawrence Marsh - Barclays Capital

And finally, I know you’re going to talk about more about this at the June 2nd Analyst Day, but you’re calling out some negative synergies of two separate public companies, besides the obvious things or anything else we should be thinking about as we start to model the two companies here in the next couple of months?

Jeffrey W. Henderson

Apparently nothing that we haven’t talked about before, but we are just going to sort of remind everyone of what we have said; clearly, there will be some negative synergies, particularly early on as we separate the two companies; there will also be one-time stand-up costs, some will be occurring before the spin, some will also occur after the spin as we complete the stand-up of CareFusion particularly related to the system. Some of the system’s requirements will be handled through a transition services agreement with Cardinal Health for the first couple of years, and during that period, we will be spending some additional money to complete the totally independent stand-up of CareFusion in that regard, and again, we’ll provide more detail on that on June 2nd. In terms of the capital structure, we’ve said before that we expect about 35% to 45% of the existing debt of Cardinal Health which is about $3.6 billion to eventually end up on CareFusion’s balance sheet. That remains the expectation, and again, we will give you an exact number in that regard when we issue the pro forma financials over the next month. I think those are some of the basic issues, and again, we’ll go into a little bit more detail on June 2nd.

Operator

Your next question comes from the line of Robert Willoughby - Bank of America-Merrill Lynch.

Robert Willoughby - Bank of America-Merrill Lynch

The CMP obviously has helped you at already strong cash position for Cardinal on the distribution side, and maybe just a question for George, can you tell us what near-term obligations you think you will have close to the spin for the cash, and then just maybe more broadly, what’s your philosophy on debt, do you repay or do you refinance, and just anything fundamentally difference in your preference for dividends versus share repurchases?

Jeffrey W. Henderson

Those are great questions, Bob; first of all, in terms of capital deployment which I really think is your first question, we’re spending a lot of time with our investors and internally sort of looking at our capital deployment strategy, matching it up with our business strategy and what we expect to be the capital structure of the business going forward and our clear desire to maintain an investment grade rating. So, those are all elements that are going to be key to it. I’ll just touch on a couple of highlights and then I’ll reserve the rest of it until after we have our board meeting next week and the June 2nd Analyst Day, but first of all, we will continue to invest in capital expenditures in the business. Right now, we target about 25% of our operating cash flow to go to capital expenditures. I expect it will be at least that in New Cardinal Health in part because we have some major transformations that we want to undertake particularly with respect to our systems and processes to really get a leg up on the competition; so, that will continue and that will be a big priority for us.

In terms of M&A, George will comment further on that, but I don’t expect initially that’s going to be a primary focus although we’ll continue to look at small tuck-ins that allow us to round out our portfolio.

George S. Barrett

There’s not a lot to add to that, we’ll talk a little bit about this in June, but obviously today, our focus is really on revitalizing these core businesses, but clearly, we’ll continue to look at the environment, particularly with an eye on whether or not there’s anything that we think again bolsters those core activities and so we’ll deploy capital accordingly, but the first part of what Jeff is saying is really important; this is an important time for us to reach out to all of you and get a sense for how you see this, and we’ll share more of our thoughts on that in June.

Jeffrey W. Henderson

And then on the issue of share repurchase, that’s a very important question, something that we’ll be discussion with our board and starting to share with you on June 2nd. I’ve said before we expect to have a meaningful dividend pay-out, exactly what meaningful means still remains to be seen and subject to the approval of our board, but I think that statement can. Bob, I know you asked a second question there, but it is so like me, I can’t remember what it was, maybe you can repeat it for me?

Robert Willoughby - Bank of America-Merrill Lynch

You’ve got most of it; George, personally, do you have a preference for dividends or share repurchases, one way or the other; I know the board is obviously going to make a decision but you have a preference one way or the other?

George S. Barrett

I probably will not answer that at this moment; I really like this to be one that we first discuss with our board and then of course we will be talking to you.

Operator

Your next question comes from the line of John Ransom - Raymond James.

John Ransom - Raymond James

One picky in-question and one more macro; looks like DNA dropped sequentially 6.7 million, is that the new sustainable number or is there something in that number?

Jeffrey W. Henderson

Yes, I can’t think of anything unusual that happened in that regard. We’re going to do some research on that and see if there’s anything particular there, but nothing major comes in mind that would indicate that was unusual.

John Ransom - Raymond James

Okay, and following along Rob’s questioning, having looked at your acquisition history, it looks like on average you paid 13, 14 times EBITDA for your businesses, and I think it’s fair to say that it’s been a mix track record. Going forward, is there a different way you’re going to think about acquisitions, particularly as we look at the supply chain business, it is going to be pretty de-leveraged and pretty cash rich kind of a mature business, and if you look in strategic targets, are we going to continue to be looking to pay high multiples for fast growth businesses or is it going to be a different way of thinking about strategic targets in the future?

George S. Barrett

We will take a very disciplined look; I come from an environment where that’s where I was trained and I know that that we have our primary focus right now on revitalizing a business that we really think has legs, and that’s going to be our focus. As we look out there and we think about whether or not there are acquisition opportunities, we will be very mindful of the way that those will be integrated if we do that way it will build strategic value, and so, you should assume that our approach will be with a rigorous and disciplined eye, and in the short term, really focused on the corrective actions.

Kerry Clark

I just would step back and say you should expect very different capital deployment strategies from both sides of the house, and in fact, that’s one of the drivers in deciding to separate out into two companies was that we did have different businesses with different needs and different requirements, and so, you can expect George and Dave to take very different approaches depending on the type of characteristics in the business. I think that your comment on mix track records I would say depends on what timeframe you’ve looked at; I think we have to say Alaris has been one of our most successful acquisitions ever, and I think we are very comfortable with the long-term future of CareFusion, MedMind, and Viasys in the CMP side, and we’ve had on the distribution side, an absolutely terrific track record on distribution and acquisitions over the year. So, I think we made a lot of progress improving the accountability of the company’s acquisitions to shareholders and we continue to be that way, and do expect different capital deployments strategies for both sides of the house.

John Ransom - Raymond James

And is there any change in your thinking about post-spin, what businesses will be retained at supply chain versus what businesses in a better credit environment might be let go of?

David L. Schlotterbeck

Our decisions on what businesses on which side of the house are clear and we haven’t made any changes on those since we’ve talked to you about that in the past.

George S. Barrett

Just two things I’d like to add on that; in the area of capital structure and capital deployment, our first and very significant priority is to ensure that we have both end of these start with and continue with a strong capital structure and more than ample liquidity, and I think we all know in this environment that that’s very critical and maintaining investment grade ratings will also be very important for both end of these. So, that will be a very high priority consideration for both management teams as we go forward. Again, I think you’d all agree in this environment that that has to be a big consideration.

Just following on Kerry’s comments about the portfolios of respective entities, the portfolio businesses in each entity remained what we said they were going to be 6 months ago; the one thing I would add to that though is as we’ve indicated before we’ll continue to conduct a strategic analysis of certain businesses within the HSCS portfolio to the extent that we decide at some point in the future they don’t fit, they could be candidates for sale, which I think may be was part of the question you were asking.

Operator

You next question comes from the line of Ross Muken - Deutsche Bank Securities.

Ross Muken - Deutsche Bank Securities

So, as we think about the transition here, obviously now you’ve started to communicate the two strategies pretty elegantly; if we think about the workforce, and I’ve asked this before, in terms of developing a corporate identity and kind of re-invigorating everyone after several years of being under a little bit of a malaise as performance wasn’t probably what everyone wanted to be, where would you say we are right now in terms of getting people internally buying for the new strategy, really kind of grasp the new direction you are going in and have you seen a change heading into the spin in terms of productivity or morale relative to the business, and in turn, you have something that has helped with execution, particularly on the supply chain side?

Kerry Clark

I’m feeling very good about how the organizations are not only physically aligning up behind the two businesses but also on a morale basis; we do conduct on an annual basis a Voice of Employee survey that allows us to get a good insight into how people are feeling about their level of engagement with the business, how they are feeling about manager effectiveness, how they are feeling about their alignment to business goals, and we recently completed that study sort of reflecting the full knowledge of where the company is going and we had a significant increase in employee engagement this year which tells us that our employees are more engaged than they have been for a while, they’re very much behind where we are going, they’re engaged behind the leaders of both businesses, they’re engaged in the mission. We got a lot of internal communication by both George and Dave to the organizations, and I would describe it as I think people on here are walking with a new spring in the step on both sides of the house.

Operator

That concludes the question-and-answer session. I’ll now turn it back to management for closing remarks.

Kerry Clark

Thank you very much for joining us and we look forward to seeing you over the next couple of weeks and particularly on June 2nd. So, thanks very much for speaking with us on this extended call.

Operator

Ladies and gentlemen thank you for your participation in today conference. This concludes the presentation.

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Source: Cardinal Health, Inc., F3Q09 (Qtr End 03/31/09) Earnings Call Transcript

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