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Executives

Ana Schrank – VP, IR

John Hammergren – Chairman, President and CEO

Jeff Campbell – EVP and CFO

Analysts

Lisa Gill – JPMorgan

Charles Rhyee – Oppenheimer Co., Inc

Glen Santangelo – Credit Suisse-North America

Larry Marsh – Barclays Capital

Robert Willoughby – BAS-ML

Tom Gallucci – Lazard Capital Markets

Charles Boorady – Citigroup

Eric Coldwell – Robert W. Baird & Co.

John Ransom – Raymond James

Randall Stanicky – Goldman Sachs & Co.

McKesson Corporation (MCK) F1Q10 (Qtr End 06/30/09) Earnings Call Transcript July 28, 2009 5:00 PM ET

Operator

Good afternoon and welcome to McKesson Corporation fiscal 2010 first quarter conference call. All participants are in a listen-only mode. (Operator instructions) Today's conference is being recorded. If you have any objections you may disconnect at this time.

And I'd now like to introduce Ms. Ana Schrank, Vice President, Investor Relations. Please go ahead ma'am.

Ana Schrank

Thank you, Melanie. Good afternoon and welcome to the McKesson fiscal 2010 First Quarter Earnings Call. With me today are John Hammergren, McKesson's Chairman and CEO and Jeff Campbell, our CFO. John will first provide a business update and we'll then introduce Jeff who will review the financial results for the quarter, after Jeff's comments we'll open the call for your questions. We plan to end the call promptly after one hour at 6:00 Eastern Time.

Before we begin I'll remind listeners that during the course of this call we will make forward-looking statements within the meaning of the Federal Securities laws. These forward-looking statements involve risks and uncertainties regarding the operations and future results of McKesson.

In addition to the company's periodic current and annual reports filed with the Securities and Exchange Commission, please refer to the text of our press release for a discussion of the risks associated with such forward-looking statements. Thanks and here is John Hammergren.

John Hammergren

Thanks, Ana, and thanks everyone for joining us on our call. Today we have reported a strong start to fiscal 2010. For the first quarter we achieved total company revenues of $26.7 billion and fully diluted earnings per share of $1.06.

Our strong earnings for the first quarter was driven by our ability to achieve operating leverage in both segments. In the distribution solution segment operating profit was up 12% and in the technology solution segment operating profit was up 56%. I'm very pleased that across the organization we maintained a disciplined focus on expense management to help drive significant operating margin improvement.

Before I turn the call over to Jeff for a detailed review of our financial results I'll highlight the trends in our business and the progress we are making to deliver sustained growth.

Distribution Solutions performed extremely well in the first quarter, with solid performances in all of our businesses. As we mentioned during our fourth quarter earnings call we lost two customer buying groups, one in the institutional segment and the other in the retail independent segment which will impact revenues for the full fiscal year. We also forecasted pressure on our sell margin in fiscal 2010.

As expected our sell margin did decline in the first quarter but we were able to somewhat offset it with disciplined expense management. In addition to the headcount reductions and cost initiatives we implemented late last year, we've put in motion other changes to our cost structure in the first quarter including the salary freeze for management, renegotiated terms with certain vendors and further cuts to discretionary spending. Therefore, operating expenses were down for the quarter and will be tightly controlled for the remainder of the year.

Besides the cost control initiatives, in the first quarter we have a strong contribution from our arrangements with the branded pharmaceutical manufacturers. Although it is early in the year our compensation of these agreements is trending positively.

We continue to have excellent performance with our generics program, where we also use our scale and experience to negotiate great savings for our customers which results in good margin expansion for our business. Our success with our generics results were the three primary drivers, retention and penetration of our customer base, increasing compliance with our customers to ensure their generic purchases are from McKesson and not alternative suppliers and a steady pace of generic launches.

Despite the linear launch schedule expected this year, and the loss of the two customers buying groups I mentioned earlier we anticipate continued profit growth in generics for fiscal 2010. Sales for our proprietary generics program, One Stop, grew 19% this quarter.

Our U.S. pharmaceutical distribution and services revenues include not only our U.S. pharmaceutical distribution business but also our specialty distribution business and our pharmacy automation business. As I mentioned at the beginning of the call we had solid performance in each of these, so I want to spend a few moments highlighting their contribution to the overall performance of our distribution segment.

Specialty Care Solutions delivered specialty pharmaceutical products to the clinical channels has a clear number two position in this rapidly growing segment of the market. Now that we have fully integrated oncology therapeutics network we have a heightened focus on improving our customers experience and building out our value proposition by leveraging our technology and clinical assets.

We have our link technology deployed in almost all of our community oncology practices. Link is a charge capture capability, inventory management and reporting tools. It can also include a web-based electronic medical record built specifically for oncology and other specific specialty practices. It helps physicians automate the treatment plan and coordinate care with other providers. We believe our Specialty Care Solutions portfolio of offering is a key differentiator and is becoming increasingly relevant to the success of providers.

Our pharmacy automation business which is known as McKesson Pharmacy Systems supplies pharmacy management software and automated dispensing solutions to retail, mail order and central fill pharmacies. It is a significant player in the retail pharmacy market and is closing in on our overall number one position with approximately 11,000 sites live or under contract.

McKesson's Pharmacy Systems is enjoying excellent market momentum for its next generation pharmacy management solution called Enterprise RX. As the industry's first software as a service system, it enables chains to benefit from the centralization of pharmacy operations. Earlier this year, we announced the Safeway would deploy Enterprise RX to all of its U.S. based pharmacy. Once fully deployed it will make McKesson the number one provider of pharmacy systems through the chain market.

In addition to its leading position in the chain space McKesson Pharmacy Systems also plays a critical role in providing retail operating systems to many of our independent customers, benefiting the customers in a number of ways. Most notably the systems fully integrated work flow which was designed by pharmacists, significantly reduces the incidence of prescription errors. This is just one example of the many products and solutions we have for our independent pharmacy.

Another example is our Health Mart franchise, which continues to enjoy considerable growth in store count. Health Mart levels the playing field for independent pharmacies by providing the resources and national strength they need to be successful in today's increasingly competitive marketplace. Health Mart includes consumer branding and advertising. Managed Care network that holds more than 9,000 plans with 54 pharmacy benefit managers, and programs that help pharmacists partner more effectively with industry associations and policy makers.

Turning to our other businesses and distribution solutions. Our medical surgical business, which has a leading position in the alternative site market benefited in the first quarter from the demanding I should say from the demand resulting from the H1N1 virus. We continue to expect top line in this segment will be somewhat impacted by the recession through the remainder of the fiscal year but we are diligently managing operating expenses to offset revenue softness. We are also focused on optimizing our sourcing at McKesson branded products to successfully position this business for an economic rebound.

As expected we had a solid performance in our Canadian distribution business, as the pharmaceutical market there is slightly stronger than in the United States. All of our programs or solutions available to U.S. pharmaceutical customers are also available to our customers in Canada and it clearly differentiates the value of our offering.

I'm extremely pleased with the first quarter performance in distribution solutions. We came into the year with modest revenue expectations and facing sell-side margin pressure but through strong cost containment activities, we continued success of our generics program, solid branded pharmaceutical relationships and an increase in demand related to the H1N1 virus as well as favorable operating trends in our Canadian business we were able to achieve a terrific start to the year.

Turning now to Technology Solutions. I want to start by spending a moment talking about Pat Blake, whom I recently promoted to lead the technology solution segment. Pat's entire career has been in healthcare. The last 13 years have been with McKesson in leadership roles both in U.S. pharmaceutical and more recently in the specialty care solutions business where he lead our acquisition and integration of oncology therapeutics network. Pat has an outstanding track record as a business leader and is very customer focused. He knows the operational, clinical and financial challenges that face healthcare organizations today and appreciates the role information technology can play to help them improve their performance.

Two weeks ago, Pat and Palmi Samuel, President of our Provider Technologies business along with other senior McKesson executives lead our Annual Executive Leadership Summit here in San Francisco. This year summit targeted CEOs and focused on public policy issues including the stimulus IT incentives. The summit drew more than 60 attendees from our hospital, health system and physician customers across the country. It followed seven regional CEO strategic forums that were conducted over the past six months including a forum in Washington D.C. with thought leaders and federal policy makers.

During the summit I had the opportunity to speak with many of the CEOs about their views on what is happening in Washington. They are watching the progress on healthcare reform and are excited about the prospect of stimulus money becoming available for healthcare IT.

However, they are concerned about the potential changes in reimbursement models in how to create more integration with physicians in their communities. For all of us involved the summit reinforced the urgency of the planning process. Reform is eminent and significant change is on the horizon. Providers need a partner they can count on McKesson is that partner.

Our strategy remains the same. We want to help providers reduce cost while improving quality, safety and efficiency through automation and connectivity. Ultimately the system needs to engage the patient as a consumer so we are all collaborating to achieve a common objective, care that patient centers, economically sustainable, high quality, safe, efficient and connected. McKesson has a comprehensive set of products and services to achieve this goal.

While the economy continues to affect provider purchasing, the stimulus is creating new energy in our customer base, with particularly strong interest in our clinical offering. Overall, interest in our solutions is at an all-time high and the pipeline is very strong. More than 50% of our health systems customers have completed their stimulus readiness assessment or are in the process of doing so and we are engaging them in the implementation planning.

We expect this interest will lead to increased contracting activity as this fiscal year progresses and on into Fiscal 2011. However we continue to believe the stimulus related buying will not impact our bottom line in significant amounts in fiscal 2010.

This recession has had an impact on software and hardware purchases, but the segments diverse portfolio and the fact that much of our revenue comes from predictable recurring streams has helped to mitigate the impact of the economy. A number of our solutions require little capital investment by the customer such as our RelayHealth Connectivity business or our Revenue Cycle Outsourcing business and the subscription revenues we receive from our payer customers. Additionally with the largest base in the industry we have stable revenues from maintenance on our installed solutions.

I'm pleased with the first quarter performance of Technology Solutions, particularly with the strong contribution from the cost containment measures we implemented beginning last fiscal year which helped us to offset flat revenues and achieve operating margin expansion.

The last few months I've spent more time focused on Technology Solutions and I've become even more convinced that we have the right team in place and an impressive set of products and solutions for our customers. I'm confident we are well positioned to extend our lead in healthcare information technology.

In summary, this is a terrific start to fiscal 2010. The cost control measures we implemented beginning last year had better than expected results. Compensation from our branded pharmaceutical agreements is trending well and we had excellent growth in generics despite recent customer losses.

We are encouraged by the level of interest among our customers and Technology Solutions driven by the stimulus and we expect this will lead to contracting activity as the fiscal year progresses. Several of our businesses experienced an increase in demand from the H1N1 virus including U.S. Pharmaceuticals, medical surgical, and our payer business, where inbound calls to our nurse triage centers increased during the quarter. Even fuel prices came in below our expectations. And strong cash flow generation early in the year coupled with improved stability in the financial market gave us comfort and an early start on our stock repurchases.

Across all of our businesses we executed on opportunities to control expenses and increase profitability giving us positive momentum for the remainder of the fiscal year. Because of this momentum we are raising our full year expectations and now expect earnings per diluted share of $4.15 to $4.30 for fiscal 2010.

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

Jeff Campbell

Well thanks, John, and good afternoon, everyone. As you just heard McKesson had an excellent start to the fiscal tear on the bottom line driven by effective cost controls and overall solid performances across the entire organization. Many things went right. We are pleased with our ability to get leverage to grow our earnings in this environment. As usual I'll begin by discussing our consolidated results and I'll provide additional color as I discuss each segment in more detail.

Revenues for the quarter were flat at $26.7 billion. I'd remind you of our assumptions for full year revenues which called for modest growth for the economy and the financial markets to show a modest uptick towards the end of our fiscal 2010. These assumptions still apply. So, on flat revenues for the quarter it was critical for us to get leverage. We did. Our gross profit for the quarter was up 3% to $1.3 billion, both segments contributed to this leverage with both achieving nice gross profit margins and expansion.

Moving below the gross profit line, our total operating expenses for the quarter were down 6% to $844 million. These lower operating expenses were the key driver of our strong earnings this quarter. The lower expenses were primarily driven by the cost containment effort we put in place beginning last year in response to the difficult economic environment. Our operating expenses also benefited from the stronger dollar as well as a legal settlement impacting the company's 401-K plan which I'll come back to later in my remarks.

Operating income for the quarter grew 24% to $459 million, $371 million a year ago. Moving below operating income, other income of $10 million or 52% below last year and primarily due to lower interest income resulting from lower prevailing interest rates. Interest expense for the quarter of $48 million increase due to the $700 million debt we issued in February.

Moving to taxes. our effective tax rate of 31.6% is roughly in line with the 32% run rate we expect for the full year and was lower than the 34.4% effective tax rate in the first quarter a year ago.

Net income in the quarter grew 23% to $188 million, $235 million in the prior year while earnings per share of $1.06 was up 28% from $0.83 a year ago. This leverage at the EPS line relative to net income was due to the cumulative impact of our share repurchases which lowered our diluted weighted average shares outstanding by 4% year-over-year to 272 million.

Let's now move on to Distribution Solutions. In this segment, revenue growth overall was flat compared to the same quarter last year. U.S. direct distribution and services revenues were 4% primarily due to market growth rates partially offset by the losses in fiscal 2009 of several customers that we have previously discussed.

Our direct revenues also benefited from a large customer shifting warehouse purchases to direct store delivery. This mix shift by the large customer was also the primary driver of the 9% decline in our sales to customer warehouse.

We are pleased with the growth in the Canadian business. On a constant currency basis revenues grew 10% driven by market growth rates and expanded distribution agreements. That said Canadian U.S. dollar revenues were affected by an unfavorable currency impact of 15% for the quarter. As I said in the past we are fairly hedged to the Canadian Dollar on a consolidated operating profit basis given our large IT workforce in Canada.

Medical surgical distribution revenues were up 9% for the quarter to $685 million growing roughly at market rate after considering the effect of some small acquisitions we made in fiscal 2009 and the impact of the H1N1 virus.

Gross profit for the segment was up 2% to $954 million from $934 million a year ago on flat revenues representing a nice improvement in gross margin of eight basis points. Several factors contributed to the increase in gross profit for the quarter. First, the volume and timing of when we receive compensation under our agreements of branded manufacturer showed solid improvement year-over-year. Next, we saw a better mix of higher margin products services including sales in One Stop generics and sales related to the H1N1 virus.

We also benefited from the lower mix of warehouse sales. Consistent with what we indicated during our last earnings call, but only partially offsetting these positives this quarter was a decline in the sell-side margin.

Our Distribution Solutions operating expenses were down 6% for the quarter to $531 million reflecting our continued focus on containing costs and a favorable foreign exchange rate impact resulting from a weaker Canadian Dollar. Operating margin rates for the quarter was 166 basis points compared to 148 basis points in the prior year.

In summary and before I move on to Technology Solutions, we are very pleased with the operating margin expansion of our business in the Distribution Solutions driven by the stronger than expected gross margin performance and sound expense management. We are off to a great start to fiscal 2010 in this segment.

In Technology Solutions, total revenues were flat for the quarter $743 million. Services revenues were up 4% in the quarter to $589 million reflecting more stable nature of the revenues. Software and software systems revenues of 130 million and hardware revenues of $24 million in the quarter were down in the prior year primarily due to lower booking of new technology purchases in our third and fourth quarters of fiscal 2009 in the hospital and physician office sectors.

On the flat revenues, Technology Solutions reported gross margin expansion, a bit over 200 basis points with gross profit for the segment up 4% to $349 million. I would remind you that our first quarter gross margin a year ago was off our historical trend line while this year's gross margin is more in line with our usual performance.

Technology Solutions operating expenses decreased 9% in the quarter to $247 million. These lower expenses are primarily due to lower employee compensation costs as well as broader cost containment efforts across the segment in response to the economic slowdown.

We do continue to innovate and spend in R&D to maintain our leadership position. For the quarter Technology Solutions that totaled gross R&D spending of $97 million which is roughly flat relative to the prior year. Of this amount we capitalized 18% compared to 14% a year ago.

Our operating profit in our Technology Solutions segment this quarter was $103 million, up 56% from the $66 million we reported a year ago. Operating margin in this segment was up to 13.86% for the quarter compared to 8.87% in the prior year. While we are pleased with this margin expansion, I will remind you of the margin volatility that is common in Technology Solutions quarterly results and that the prior year results were off the historical trend line.

Leaving our segment performance and turning briefly to the balance sheet and our working capital metrics. Our receivables were $7.5 million which is unchanged from the prior year after adjusting for the $325 million utilization of our AR sales facility in the first quarter of last year.

Days sales outstanding was 23 days, up slightly versus the prior year, but down of the 24 days we posted at the end of last quarter. As a result of our conscious decision to reduce inventory levels like last year, our day sales in inventory of 31 days and day sales payables of 43 days decreased two days and one day respectively compared to a year ago.

Our inventories were $8.6 billion on June 30, a 8% decrease over last year while our payables declined 2% to $12.2 billion from a year ago. Importantly, both DSI and DSP metrics showed a modest improvement from what we posted at the end of last quarter.

We are pleased with this improvement in all our working capital metrics this quarter. Considering the current environment we have been particularly focused on cash. These working capital improvements resulted in McKesson generating $907 million in operating cash flow in the first quarter.

Going forward, we continue to expect to generate approximately $1.5 billion of operating cash in fiscal 2010 excluding the AWP payment that we expect to make this quarter, but we are clearly off to a strong start.

As a result of this strong cash flow generation as well as our view that the financial markets continue to show improvement, we repurchased $275 million worth of shares in the quarter. Our share repurchases in the first quarter were accelerated from the pace we expected for our full year diluted outstanding share guidance. We would now expect our full year to come in a bit below the original guidance we provided of 272 million shares.

Property acquisitions were $42 million for the quarter reflecting our continued investments in our internal systems and distribution center network, capitalized software expenditures of $36 million, a year ago to $44 million and our annual guidance for capital and software expenditures in the range of $350 million to $400 million remains unchanged.

During the quarter we increased our accounts receivable sales facility commitment from $1 billion to $1.1 billion under terms similar to those previously. And we ended the quarter with $2.6 billion of cash and cash equivalents, up from 2.1 billion we held at year-end.

So, to now conclude, as John mentioned earlier we are raising our guidance on diluted EPS from continuing operations from $3.90 to $4.05 to a new range of $4.15 to $4.30. Let me take a moment and walk you through the increase to our new EPS guidance range.

There are two drivers of this guidance change. $0.15 from a positive legal settlement impacting our 401(k) and $0.10 from our overall confidence based on the strong start to the year this quarter represents.

So let me first review the legal settlement impacting the company's 401(k) plan that I mentioned earlier and let me start with some background. Historically, the company has made voluntary contributions to its profit-sharing investment plan or 401(k) plan. These contributions generally came from a 1980 employee stock ownership plan.

This ESOP contributed to the 401 (k) plan some relatively inexpensive shares, but began to run out of shares in fiscal 2008. As a result our 401 (k) expense increased from $13 million in fiscal 2008 to $53 million in fiscal 2009 and we originally expected approximately $60 million in fiscal 2010.

Now returning to the legal settlement as mentioned in our earnings release, our PSIP expects to receive settlement proceeds that will allow it to fund the company's 401(k) plan this year. Therefore, relative to our original guidance, we expect a favorable diluted EPS impact of approximately $0.15 due to the reduction in fiscal 2010 401(k) related expense. Four of the $0.15 impacted our June quarter. So that's the $0.15. The other $0.10 increase in our guidance range comes from our overall confidence based on the strong start to the year.

One way to think about this $0.10 is that our strong cash start should add $0.03 to $0.04 diluted EPS upside due to our accelerated share repurchases and the resulting benefit of lower expected diluted shares outstanding. The remaining $0.06 to $0.07 of EPS upside stems from the favorable trends that impacted our Distribution Solutions segment in our first quarter.

These include better than expected results from the cost control measures we implemented last year, higher compensation from our agreements with branded pharmaceutical manufacturers, excellent growth in generics despite recent customer losses and increased demand related to the H1N1 virus.

One implication of these two drivers of our guidance changes is around our operating margin expectations. We commented last quarter that our expectation for the year was for the Distribution Solutions operating margin to be flat to up a couple of basis points. Based on the changes I just discussed we would now expect Distribution Solutions operating margin to be a bit better.

And for our Technology Solutions businesses, despite the flat revenues in our first quarter, we continue to expect our cost control efforts, which should allow us to achieve operating margin expansion for the full year.

Looking forward to our quarterly progression, positive trends that helped drive our first quarter results still appear to be mostly in place. And we expect that this momentum will carry into our September quarter, so the September quarter should be stronger than we expected in our original guidance. This is very early in our fiscal year to raise guidance. We don't want to get too far ahead of ourselves.

The overall environment still is quite a bit of uncertainty, including the healthcare reform debate, volatile economy and an improving far from stable financial market, but if the positive trends continue for the remainder of the year, we would expect to be at the top end of our new rate. We will provide any further updates guidance only when we have the visibility to do so.

In closing we are pleased with the performance across all businesses and feel that McKesson is off to a solid start this year. Thanks. With that I'll turn the call over to the Operator for your questions.

Question-and-Answer Session

Operator

(Operator instructions) Our first question come from Charles Rhyee, your line is open.

Jeff Campbell

Charles?

Operator

I apologize. It looks like Charles just disconnected. Our next question comes from Lisa Gill. Your line is open.

Lisa Gill – JPMorgan

Hi, thanks very much and congratulations on the great quarter. Just had a couple of questions. On the shift from warehouse to direct store, can you maybe talk about the margin impact and is that some of what's playing into the operating margins, Jeff, as you look forward? And then secondly, as we think about generics, can you maybe give us an indication of what One Stop generics look like excluding the losses? I mean was it up substantially if you excluded the business that you lost?

Jeff Campbell

Well, on the warehouse shift, Lisa, as you know in our 10-K we talk about the fact that our warehouse sales have a significantly lower gross margin generally in the 50 basis points so it's a positive to our gross margin to have a shift from warehouse to direct. Now, of course, there's lots of other things going on this quarter with the strong performance on the branded manufacturer side, a great generics quarter and then the fact that because of some things that happened last year, we had a sell margin decline so those are all impacting what you see on the gross margin this quarter.

Lisa Gill – JPMorgan

And then what about on the generics side? If you were to exclude the loss of that business are you seeing your generic program grow substantially faster than the 19% you talked about?

John Hammergren

Yeah, Lisa, this is John. We did obviously have some impact particularly from the loss of the independent buying group that was more compliant with generics than other customers might normally be. So substantially better probably would be an exaggeration but it would have been better had we not lost those customers at the end of last year so we're really pleased with the performance and frankly, the continued success of our generic program as Jeff mentioned was one of the fuels to what was an outstanding quarter.

Lisa Gill – JPMorgan

And then, just one last follow-up. John, when you talked about the trends in IT, I think you talked about no impact for fiscal 2010, but you are starting to see contracting activity. Are those things you're can give us updates on as we move throughout the Fall, would you anticipate that hospitals will start making buying decisions as we move throughout the Fall and then it will be impactful to your 2011 fiscal year?

John Hammergren

Well, we in the past have used other metrics, we talked about bookings at one point in our past and we used a long time ago, our predecessors used to talk a little bit about funnels so I'm a little reluctant to go back to those things but I would say that we are seeing increased activity both from an interest perspective and from a contracting perspective. However, as you know the way we are reporting our financials, it really rolls into our results when we actually get customers live and successful so I would say that we are continuing to see interest and activity and we are optimistic that 2011 will be a good year for us in the technology business and we'll gain strength throughout this year and we should be able to continue to provide color as the year goes along and if we get any significant contracts of merit we may chat with you about them, but it's usually a lot of small things that add up to a successful feeling about 2011.

Operator

Our next question will come from Charles Rhyee. Your line is now open.

Charles Rhyee – Oppenheimer Co., Inc

Oh, thanks. Can you guys hear me?

John Hammergren

Yes, Charles.

Charles Rhyee – Oppenheimer Co., Inc

Okay, sorry, I had to dial myself back in there. I don't know if you talked on this already, Jeff, but just wanted to go back to the guidance real quick. Other than if we think about the $0.15 that's being funded is it fair to think that we wouldn't expect that for next fiscal year in fiscal 11?

Jeff Campbell

Yeah.

Charles Rhyee – Oppenheimer Co., Inc

Okay so it's sort of just we're getting the benefit this year because the settlement, you talked earlier about this 1980 ESOP program was running on shares, can you talk about the new plan that's in place and how well funded that is in terms of stock available for that and is it something that we should think that could happen again in the future?

Jeff Campbell

Well, the short answer to that is no, it won't happen again in the future, so this ESOP which was set up in the 1980s and funded with a bunch of shares back in the 1980s has been able to fund the company's 401(k) match but most of the last several decades you've seen a little gyration as I talked about in my script up and down as we got towards the end of that ESOP twice. this is clearly the end of its life this year, meaning going forward the Company will be making cash contributions and that run rate let's use a round number of $60 million a year is what you'll see starting next year.

John Hammergren

But you're correct Charles, that this conversation today was talking about the one-time event of the cash infusion coming from the settlement that offsets the company's normal requirement to make that $60 million contribution.

Operator

Our next question come from Glen Santangelo, your line is open.

Glen Santangelo – Credit Suisse-North America

Yeah, John and Jeff, thanks and good afternoon. I just wanted to follow-up with you, Jeff, regarding the guidance going forward. You typically gave us some things to think about when it comes to quarterly progression because if I look at your estimates now you basically raised on a fundamental basis by $0.10 but yet you basically beat this quarter by a fair amount more than that relative to at least what the street was expecting so kind of tells me that maybe at least the quarterly progression of what's out there on the street seems to be a little bit off and I was kind of curious as you look out over the next three fiscal quarters remaining in the year, is there something or anything big that we should be kind of thinking about, for example, when the timing of additional manufacture compensation might hit or the Pfizer fee-for-service agreement, that's coming online in January, any of those types of things to help us button down our quarterly progression I think would be helpful?

Jeff Campbell

Yeah, I think, Glen, to keep it fairly simple, we're only 90 days into our fiscal tear. Certainly it has not been our practice to raise guidance after just one quarter. We're still in a very uncertain economy so we are trying to balance all that uncertainty with the fact that we had a very strong first quarter. As I said in my remarks, it's July 28th so we're 28 days into the next quarter and right now, the things that made June real strong look like they are going to make September real strong, so relative to the directional guidance I gave 90 days ago I would expect a significantly stronger September quarter. Beyond that, boy, when you get to the back half of our year it's just too early for us to really make a lot of comments or to feel completely confident in reading our guidance to that part of the year.

Glen Santangelo – Credit Suisse-North America

Okay, fair enough and John, maybe if I could just ask one other question on the healthcare IT business. Sounds like you had a fair amount of meetings with some of your bigger clients. Could you maybe just give us a sense for where they're at in the process in terms of understanding the definition of meaningful use? Do you think the hospital CEOs you guys deal with are, are they trying to figure it out at this point or do you think they're kind of past that stage and where do you see the opportunity? Is it more in the software side or more in the professional services and consulting side of the business?

John Hammergren

Those are good questions. I think that the customers, all of them I would say are trying to figure this out and clearly we can make some estimates as to what criteria will be required and the products are going to implement and what meaningful use is actually going to mean but right now they're all guesses as these things haven't been fully defined, but we have a reasonable appreciation for where we might be headed so, as you might imagine we've been working with these customers to make sure that they're making progress towards these objectives and there are different levels of implementations that have already taken place or are under way, so we're trying to encourage our customers to start now if they haven't already started and to continue if they have started and not only in the planning phase but also the implementation phases, so I think without exception, Glen, it appears to me that our customers want to meet the requirements and it's a question of how are they going to fund these things short-term, what do they want to install first and second and third and where do they stand today in sort of a diagnostic way.

As to what they're going to buy, I think it's going to be obviously up to each customer but we think they are going to require not only software but also implementation support and services. Some of them are going to ask us to host these items for them and help them manage their data centers, they will have to be connected to other constituents in the system, we believe, and clearly, there's already a connection requirement for the health plan and to make things simpler and more efficient clearly doctors and other healthcare organizations are going to want to be connected so I think there's a really across the board opportunity for us to help our customers with these challenges. I just have to point out though this is a complex thing and it's going to take us to get these people up and running where they need to be up and running is going to take us into 2011 and as you might know also from the legislation, the government is not even expecting them to be in meaningful use until out so, that's really what they're focused on is what do I need to do to make it across the finish line in the most robust way.

Operator

Our next question will come from Larry Marsh, your line is open.

Larry Marsh – Barclays Capital

Thanks. Good afternoon. Couple of quick things. First, let me extend congratulations to Pat on his new role. I'm sure he will do a great job. Let me reconcile if you could, John, I know part of the catalyst for your changing leadership was a feeling of drift and concerns about time to market I think today you had communicated you felt like you have the right team in place to extend the lead in that business. Can you reconcile those two statements and when would you think you'd be in a position where you and Pat would be more specific in terms of where you want to take that business from here?

John Hammergren

Well as I mentioned before one of the keys to this business is to get revenue growth and to help our customers get these implementations live and to make them successful. I do think Pat is the right person for this task, but as I also mentioned there are actually five businesses inside MTS, all of which have leadership in place including MPT which is the focus of a lot of the stimulus money which was lead by Palmisano Samuel. So although we made some changes in Palmi's organization in certain areas we do think we have a good team and we have a good strategy in place, it should be successful and we're now investing more heavily frankly in our ability to help our customers be successful and to assist in the implementation process with our products and to make sure that it's more than just buying the software it's actually getting physician adoption, for example, and so I think there are some things we can do to improve the relationship our customers have with us and their success implementing our products with many constituents, not the least of which are the physicians. I think I would not anticipate major strategic changes in the business with the change in addition of Pat to the team. Pat and I have spent not only 13 years here together working together, but we work these businesses together as a collaborative team. All of our Presidents are involved in our quarterly reviews and our strategy reviews. He has a good familiarity with the business and people in the business and it's not as if he has to start from ground zero to get familiar with it so I think there are some things we can do that will help us from an execution perspective. You can see we've already made some changes to align our cost in a way that I think will help improve our ability to get to our target margins and so I'm excited about where we're headed but the key in the business is customer success which will lead to revenue for our Company.

Larry Marsh – Barclays Capital

Okay, great. And just a follow-up if I could, the compensation agreements with the manufacturers you mentioned being a bit ahead of plan in this fee based world it seems like some of that's going to be driven by volume, is your message today that your performance against some of those metrics is allowing you to overachieve on some of these compensation agreements or is there something from the manufacturers that are causing them to be more generous in the channel given this environment?

Jeff Campbell

I think that the manufacturers as a composite across all of our businesses, clearly are interested in increasing their relationship with us and further penetrating the channel through our sales organization, so our med surge business has gotten a very good relationship with the manufacturers and obviously all of our businesses are focused on doing a good job for the manufacturing partners and I mentioned the strength with generics. Specific to the branded manufacturers in our pharmaceutical business our agreements are well structured. I do think they are long term and we've performed against them over the long term and I think we'll continue to, so I think the strength in our business has been or the strengthen the performance of these agreements is related to not only our execution under the agreement but just frankly the markets in which the branded manufacturers continue to use prices as one of the vehicles to attain their objectives and then we maximize our performance on to the agreement.

Larry Marsh – Barclays Capital

Okay. Very good, just a quick clarification. I know the original guidance was such that management comp would only get paid out at like 50% of target. I think you had said you were disappointed at the original guidance. Is the new guidance point where you feel like if it attained management compensation would be triggered at the 100% rate or you are not commenting?

John Hammergren

Well we typically don't talk in detail about our compensation plans. Clearly the more we overachieve our original guidance more likely we are to move up in those compensation figures but this is all self-funded and we have to overachieve by enough to continue to fund the plans that we have in place. We have over 10,000 bonus eligible employees in our Company so people are keenly aware of the fact the plan we put in place was something we were not excited about and the management team was not only going to take huge measures to take costs out of the business, but also on a personal level not have a salary increase and we were going to also participate in a bonus reduction at least at those planned levels. So I think the encouraging news here is that we look like we are going to exceed the original expectations that we set forth and if we continue to perform the way that I expect we will, then our ability to achieve above those lower levels of bonus will be available to us, but I think the most important thing that our employees are focused on is making sure that we're delivering for our customers and that we hit the objectives that we tell our owners in the Company that we're going to hit and both those factors are very important.

Operator

Our next question will come from Robert Willoughby, your line is open.

Robert Willoughby – BAS-ML

Jeff or John, given some of the moving parts can you hairs to guess what the direct distribution business actually grew adjusted for some of the loss contracts and shift in warehouse sales?

Jeff Campbell

There's always a little bit of guess work even when we look at the numbers but our best estimate if you take out the ins and outs it's probably around 2% to 3% which is pretty consistent actually with our general guidance for the year of the overall revenues.

Robert Willoughby – BAS-ML

That's great. Thank you.

Jeff Campbell

Welcome.

Operator

Our next question will come from Tom Gallucci, your line is open.

Tom Gallucci – Lazard Capital Markets

Good afternoon. Thanks. Just a couple of quick ones hopefully. The shift from warehouse to direct is that a permanent shift or some sort of change in relationship with the customer or is that just a unique buying pattern for the quarter?

John Hammergren

This is a respect of circumstances, it's a permanent shift with a customer and it was part of the continued ability for us to add value in the relationship.

Tom Gallucci – Lazard Capital Markets

Okay. And then in the IT business, maybe can you detail a little bit where some of the cost savings have been and I guess what I'm getting at there is some of the things you described John, there, having to get to the market a little faster and being able to help the customers in an array of areas, I guess if you expect an increase in sales over time based on the increased activity you've seen is there a quarter that we should be thinking about maybe you'll have to start to ramp up some expenses as opposed to having cut over the last year?

John Hammergren

That's a good question. We did make some cuts last year in many areas, but I'd also say we made some investments in many areas. It was really an opportunity for us to focus the business on those key priorities that are important as we get to particularly the stimulus spending as well as our as you know we've been developing another financial product line, so those investments are important to us and we really made I think very careful moves not to impact those key priorities. As you know though, when we start helping our customers implement software we need people on the ground that know what they're doing and there is going to be sort of an advanced training and implementation phase of our hiring and getting people skilled before we put them in front of our customers. So as we said we think these implementations will begin to ramp up as we get to the end of this year and into next year, that's how we realize the revenue next year, and that will require us to have some investment in the back half of this year. I don't think it's significant in terms of the overall cooperation and because we have done a good job at controlling expenses thus far, I think our guidance contains the investment that we think is necessary

Tom Gallucci – Lazard Capital Markets

Okay. And just finally, on the cash usage, pretty aggressive on the buyback this quarter. $500 million or so left. How should we think about longer term cash deployment, Jeff? Thank you.

Jeff Campbell

Well, I think, Tom, we would just stand by our usual comment that we take a portfolio approach. We're always looking for acquisitions at reasonable prices, when they are not around we do a little bit more share repurchase and probably do a little bit more share repurchase than we've intended originally at the June quarter given the unusually strong start to cash as well as the general comfort level we have in the financial markets, but these are decisions we make on a real time basis that we'll look at all of the alternatives we have in the September quarter and make the decisions accordingly.

Operator

Our next question will come from Charles Boorady, your line is open.

Charles Boorady – Citigroup

Hi, thanks. Most of them have been answered but I just wanted to ask for a little bit more elaboration on the tech solution business in terms of just more details on the expense management initiatives and I'm trying to reconcile that with the growing backlog, the increase in demand which generally associate with making investments and bringing new people on to prepare for that coming demand, and so hearing about you mentioned salary freezes, discretionary spending cuts, and I'm wondering if you could just elaborate on them specifically, are there certain areas that you're cutting but other areas you're investing in because those don't sound like the kind of things you do if you're anticipating a strong growth in backlog.

Jeff Campbell

Well, I think those are good questions. We do anticipate a growth in the backlog and more implementation as we go into the year so I think the key is not to cut customer facing activity, not to affect the ability to deliver the software and get it operational. Clearly, it's a very large organization with lots of head counts and lots of payroll and lots of bonus eligible employees and lots of salary increases that didn't occur so that gives you a certain amount of ability to continue to invest in those key priorities when you are not inflating your salaries across-the-board by 4% or 5% so I think that we believe the business is being properly funded. The key here is not to have a lot of people hanging around with no work and on the other hand the key is to have the people available when you have the implementation ready to go, so it is a bit of a balancing act, but we think we have good transparency and that was one of the critical things that I've said in my prepared remarks which is we've been working with our customers and over 50% of them now have some kind of a plan we're trying to develop, it kind of road maps them to stimulus readiness and over time then we'll get a much better visibility and idea of what they're going to need from a resource perspective to bring their own sites live, so critical R&D investments are continuing to be made. The key product investments are being made and key people investments are being made relative to these areas.

Charles Boorady – Citigroup

Are some of these decisions related to integration of previous acquisitions or other things that might have been done previously and so while they're contemporaneous with the build pre-stimulus is it fair to separate these cost cuts from anything related to preparing for the growing demand?

Jeff Campbell

Well, I think we have had a history in this business at making acquisitions and those acquisitions would have certain one-time costs and things associated with them and certainly some drag in the early years but I think the key here was just really careful analysis of what resources we needed as we came into an environment where there was going to be slowed buying and that slowed buying continues through the third and fourth quarters of last year and frankly we're still in the process of getting customers back into the cycle of signing their names and writing checks so although we're optimistic we're cautiously optimistic on the remainder of this year, we think that 2011 is stacking up to be a very good year from a revenue perspective, certainly on a relative basis for this year.

Charles Boorady – Citigroup

Thank you.

Jeff Campbell

Yes.

Operator

Our next question will come from Eric Coldwell, your line is open.

Eric Coldwell – Robert W. Baird & Co.

Thanks. Just a couple of quick ones. First, can we get the LIFO adjustment for the quarter, I guess the nominal amount as well as the year to year comp? Number two, in price inflation I was hoping we could get some more detail on what you saw on the branded price inflation side of the market and maybe pars that out between what you're seeing in traditional drug company versus the specialty group if one area is stronger versus the other. Final question, I'm not sure but could you possibly quantify the H1N1 impact either for revenue or profit? Thanks.

Jeff Campbell

Well, let me take those in a couple, on price inflation as you'll recall, Eric, we gave guidance that we expected it would be overall level of branded price increases for the year to be roughly the same as they were last year. We're only 90 days into the year. I'd tell you for the June quarter we're certainly on track to be consistent with our guidance or maybe even a little better but it's very, very early. On H1N1, I guess what I'd say is if you look at the impact this has had on various other companies, we're in the range, so it's a nice boost to us at the bottom line. It's not particularly meaningful on the top line. And on LIFO, it's really remember an annual concept and any more significant adjustments that we generally make in the March quarter so year-over-year there is nothing significant in terms of change on the LIFO adjustment.

Eric Coldwell – Robert W. Baird & Co.

I'm sorry, John. Jeff, on the price inflation, we thought that price inflation was running a little bit ahead of target and I guess specifically we've heard that some of the price increases on the biotech and specialty side have been very strong recently and we've seen some buy-ins from some of your manufacturer partners. I'm just curious if you could pars out specialty group which got more attention on this call versus traditional distribution. Thanks.

Jeff Campbell

Well the short answer is no. That was not a materially different group for us this quarter and in general of course we would be sensitive to comment on specific manufacturers.

John Hammergren

Eric, back to your conversation about H1N1, the most significant impact on a relative basis probably was in the med/surge business. If you look at the revenue line of med/surge you'll see that it grew much faster than what we would have said the normal market growth rates are and as you know med/surge carries a slightly higher profit margin than our pharmaceutical distribution business so on a relative basis good revenue.

Eric Coldwell – Robert W. Baird & Co.

Right. And John, I guess what I am looking at is one of your closest competitors PSS put up 2.7% benefit from swine flu as they quantified it with a higher incremental margin so –

John Hammergren

And I think, Eric, the point is that we're consistent with that range in our medical surgical business, we also had a little bit of uptick from calls to our nurse triage centers in both Australia, New Zealand, (inaudible) Australia and New Zealand in the U.S. and you had a small uptick in sales of a few drugs you'd expect like Tamiflu in the U.S. pharma business.

Operator

Our next question will come from John Ransom. Your line is open.

John Ransom – Raymond James

Hi, it looks like your anxiety around sell-side margin was pretty high in early March. Relative to say, if that was the pick up has your concern moderated, stayed the same or gotten better?

Jeff Campbell

I missed the first part. Were you saying sell-side margin?

John Ransom – Raymond James

Yeah, you guys expressed some concern about it seems around the early March time frame you started expressing concern about sell-side margin pressure to investors. Has that gotten any better since early March?

Jeff Campbell

Well clearly, it has been and it continues to be something that we have anxiety about it and we have to manage the sell-side very carefully. All of the progress we can make across the rest of our business can be destroyed by not having discipline around the way we manage the sell-side. At the same time it's a very competitive market and always has been a competitive market and we have to remain competitive or we lose share and that will lose our scale. So I think we do whatever we can to stem the tide from a customer loss perspective and try to sell on value rather than selling on price. So I think it's too early to tell whether or not our ability to continue to convince our customers that we provide a better value all around without having to use price always is the solution so, we're working on that and I think we've had some success in certain areas of kind of holding our own which was clearly our goal as we came into the year but we did have two significant losses and we're going to have to deal with those losses all year long and we're going to have to lap those losses and we're going to have to be careful that those losses don't continue in the rest of our business.

John Ransom – Raymond James

Okay, thanks and couple other things. The ESOP, where would that be found in the P&L? Is that in G&A on the distribution business? Would it be lower G&A?

John Hammergren

It is in SG&A and to use real round numbers it's sort of roughly split between the distribution and technology business with a small portion in corporate.

Jeff Campbell

Operator, I think we have time for one more question.

Operator

Thank you. Our last question is going to come from Randall Stanicky. Your line is open.

Randall Stanicky – Goldman Sachs & Co.

Great. Thanks for the question. I'll just be quick with a follow-up on the generics business. Maybe Jeff, there's been a lot of focus on generic manufacturing concerns, has this at all helped you gain traction as you put up some pretty good numbers on your One Stop business and then when you talk about the three drivers compliance, retention of customers and launch schedule, can you maybe quantify going forward what's going to be the bigger one or two drivers there? Thanks.

Jeff Campbell

Well, the generic manufacturers continue to be good partners with us. We work with all of them and from time to time, there are people that earn the privilege of prime spots with us and there are times we earn the privilege of dealing with them so it's a two way street and we add value I think both parties add value to the customer at the end of the day which is the most important priority, how we make sure our customers get the right product at the right time and have a competitive price. As to the launch schedules we knew this year was going to be slightly lighter launch schedule than normal, so superior execution in terms of getting customers attracted to our programs, getting them compliant to the programs and they're doing a great job of sourcing has been critical and will remain critical and I think do a very good job of executing that environment so 19% growth rate is good and certainly we believe above the market particularly when we had this headwind with the loss customers to lap. So I'm hopeful we'll be able to build a strong performance throughout the year but as we look to next fiscal year we have a much better launch schedule lined up as well. So I think this momentum should continue.

I want to thank everybody for their time today on the call. I'm very pleased with our first quarter performance. I'm very excited about the opportunities that lie ahead in both of our segments and I look forward to continuing to chat with all of you as we progress throughout the year and I'll hand the call off to Ana for a review of our upcoming events for the financial community. Ana?

Ana Schrank

Thank you, John. I have a preview of upcoming events on September 11 we'll present at Thomas Weisel Partners Healthcare Conference in Boston, on November 12, we'll present at the Credit Suisse Healthcare Conference in Phoenix, on November 18, we will present at the Lazard Capital Markets Healthcare Conference in New York, we will release second quarter earnings results in late October. We look forward to seeing you at one of these upcoming events. Thank you and goodbye.

Operator

This does conclude today's conference. You may all disconnect at this time.

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Source: McKesson Corporation F1Q10 (Qtr End 06/30/09) Earnings Call Transcript
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