Good afternoon and welcome to McKesson Corporation fiscal 2010 second quarter conference call. (Operator Instructions) Today’s conference is being recorded. If you have any objections you may disconnect at this time and I would now like to introduce Miss Ana Schrank, Vice President, Investor Relations. Please go ahead ma’am.
Thank you Melanie. Good afternoon and welcome to the McKesson fiscal 2010 second quarter earnings call. With me today are John Hammergren, McKesson’s Chairman and CEO, and Jeff Campbell, our CFO. John will first provide a business update and will then introduce Jeff, who will review the financial results for the quarter. After Jeff comments we will open the call for your questions. We plan to end the call promptly after one hour at 6:00 PM Eastern Time.
Before we begin I 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.
Thanks Ana and thanks everyone for joining us on our call. I’m pleased with the continued momentum in our business.
Excluding the after tax adjustment to the litigation reserves, we achieved net income of $289 million or $1.07 per diluted share for the second quarter. Total company revenues were $27.1 billion. Our earnings were driven by strong execution in both segments. In the Distribution Solutions segment, operating profit was up 2% and in the Technology Solutions segment operating profit was up 63%.
As you might remember from our fourth quarter earnings call, we came into fiscal 2010 with some challenging trends to overcome. Revenues in Technology Solutions were being impacted by the slowing economy. Revenues in portions of our Distribution business were impacted by both the economy and the loss of two customers. And in our U.S. pharmaceutical business we knew that the sell side margin would be down as a result of the events that we experienced last year.
To maintain our business momentum we took actions to prepare for a challenging fiscal 2010. We aggressively focused on managing expenses while we looked for innovative new ways to increase our business opportunities or expand our relationships with existing customers. We’re two quarters into the year and I’m very pleased with the results. We have been successful with our cost control efforts across the company, resulting in significant margin expansion. Additionally we have looked for innovative ways to expand our business. For example, in U.S. PhRMA we are ramping up our recently launched plasma distribution business and we have secured agreements with two existing customers that expand our presence in this important segment.
And across several of our distribution businesses, we quickly moved into action when the Centers for Disease Control and Prevention called upon us to expand our existing relationship in the face of the H1N1 flu pandemic. Before I talk about the specifics of the quarter, I want to take a moment to highlight this partnership with the CDC. McKesson was selected by the CDC to handle the centralized distribution of the H1N1 flu vaccine to all 50 states and to the District of Columbia, making this one of the largest public health initiatives in the CDC’s history. Our distribution effort brings together the vaccines from five different manufacturers and involves shipping the doses to as many as 150,000 provider sites. As you know our Specialty Care Solutions business has a contract with the CDC for distribution of its public sector of vaccines through the Vaccines for Children Program.
When faced with the possibility that the H1N1 virus could become a pandemic, the CDC realized that the critical nature of the H1N1 vaccination program and the short timeline before deployment required them to leverage available tools and approaches to distributing the vaccine. The CDC determined that McKesson as the already established centralized vaccine distributor would be the logical choice to ramp up and begin distribution within the required 90 day window.
But our Specialty Care Solutions team could not do it alone. U.S. PhRMA and Medical Surgical partnered with Specialty to establish the logistics, staffing and information technology infrastructure that was necessary. And six times every day Relay Health provides anti-viral prescription data to the CDC for monitoring the H1N1 virus and other disease outbreaks. Truly, a one McKesson effort.
In just eight weeks we have created from scratch what amounts to a new business, with six new distribution centers, four of which are dedicated to distribution of the vaccine and two of which are dedicated to ancillary medical surgical supplies. We’ve put test orders through the system before product was available to insure the vaccines would be distributed without delay. We created a customer service support group, hired and trained service representatives and conducted internally driven test calls. We shipped the first orders beginning Sunday, October 4th. Although we are still in the early stages of the program, our efforts thus far have had terrific success.
Since the beginning, we’ve been delivering the doses to the identified providers in a fully compliant, temperature controlled way.
In addition to the H1N1 vaccine initiative, we anticipate a broader impact to McKesson from the flu season as we ship products such as Tamiflu and Relenza through U.S. Pharmaceutical, field calls to our nurse hotlines in our Health Solutions business and distribute an historically high number of flu test kits and other supplies through Medical Surgical.
We certainly expect to carry out all of our flu related distribution efforts successfully and I’m very proud of the way the organization continues to execute across the board. The precise financial impact of this year’s flu season is challenging to estimate at this early date, but we are expecting a positive impact on the company’s financial results.
Moving on to some of the specifics for the second quarter, Distribution Solutions performed well with solid contributions from all of our businesses. As I mentioned before Distribution Solutions revenues continued to be impacted by the loss of two customer buying groups in U.S. Pharmaceutical. So while we have experienced growth in our existing customer base, our top line will be impacted by the lost business for the remainder of our fiscal year.
The other dynamic in the U.S. Pharmaceutical business is that our sell side margin is down as a result of the events that we experienced last fiscal year. Consistent with comments we made in the fourth quarter, it will take us the full fiscal year to lap this impact. We had an excellent performance with our generics program, which we have developed into a highly attractive offering with a solid infrastructure, high fill rates and a sophisticated order entry system, making us very well positioned to meet the distinct needs of both our customers and our suppliers.
One stop sales were down a little because of last year’s loss of an independent buying group customer, but the team is focused on what we can control such as better compliance within our existing customer base and using our size and sophistication and sourcing. The team’s efforts allowed us to grow generic gross profit in the quarter, however.
Our U.S. Pharmaceutical Distribution and Services revenues include not only our U.S. Pharmaceutical Distribution business but also our Specialty Distribution business. And in the second quarter our Specialty Care Solutions business performed very well, benefiting from the launch of generic Oxaliplatin.
Turning to other businesses in the Distribution Solutions segment, our Medical Surgical business, which is a leading position in the alternate site market, had a solid contribution to the overall success of Distribution Solutions. As I mentioned previously, all of our businesses will likely benefit in the next quarter or two from the increased demand related to the flu season. But in this quarter, Medical Surgical’s operating results were driven by expense control measures, the successful integration of some newly acquired businesses and our focus on optimizing our sourcing of McKesson branded products.
Lastly, we had a solid performance in our Canadian Distribution business as the pharmaceutical market there has remained slightly stronger than in the United States. And through our global sourcing initiatives, we are realizing synergies across our North American Pharmaceutical Distribution businesses.
I’m extremely pleased with all the efforts we’ve made to control costs and find new business opportunities throughout Distribution Solutions. We achieved strong sales results despite the challenges we faced coming into the year, and we expect our momentum to continue for the remainder of this fiscal year.
Turning now to Technology Solutions. Technology Solutions diverse portfolio and the fact that much of our revenue comes from predictable, recurring streams has helped to mitigate the impact of the slower economy. This quarter revenues were up modestly and operating margin expanded considerably due to ongoing expense management initiatives and improving operating performance across the business. We never talk specifically about funnels and pipelines, but generally speaking I can report the pipeline continues to be strong and there is tremendous interest in our Solutions, much of which should convert to bookings. And as we compare our results to last year’s low base, software bookings are up modestly for the quarter.
But the financial landscape has not changed much since our last call. There is still tremendous pressure on healthcare providers and hospital economics have not improved. So while the stimulus continues to generate customer interest in our Solutions, particularly the clinical products and our Relay Health offering, we haven’t seen yet a significant shift in buying behavior.
Because the stimulus has focused providers on clinical solutions, the short term tradeoff for a company such as McKesson is there might be slower growth in non-clinical software. And with the definition of meaningful use delayed, even some clinical software buyers are on the sidelines. McKesson has a broad solutions set including financial and clinical offerings for hospitals, payers, pharmacies and physicians. We are well positioned to benefit from the healthcare information technology stimulus and the broader focus on healthcare reform.
In the second quarter our new comprehensive financial solution, Horizon Enterprise Revenue Management, became generally available. This was a milestone for McKesson because we’ve brought to the market a solution that applies a different approach for healthcare reimbursement. For decades, McKesson has been the leader in financial systems for providers with great product expertise and the largest customer base in the industry. But the financial systems that are installed in hospitals today are more than 20 years old and they were created at a time when healthcare reimbursement was different. So most of the work of these systems takes place after the patient leaves the hospital.
Horizon ERM redesigns the billing cycle by moving many of the billing functions to before or during the case. It enables consumers to become more active in their care by going online and comparing prices of procedures and pre-registering from home. It includes the collection of information that is valuable when treating the patient, meeting regulatory requirements and collecting full payment for services as they’re delivered.
Another great aspect to Horizon ERM is it is compatible with the clinical systems that have been installed over the past five to ten years. We built the architecture to be open to both McKesson and non-McKesson clinical systems. It has online connectivity between the provider, the payer and the patient. And the system incorporates other McKesson software and solutions such as [Intercall] content and Relay Health tools.
McKesson has the right products and solutions to help our hospital and physician customers prepare for the government’s definition of meaningful use. Therefore we are concentrating on achieving superior execution with implementations and maintaining a laser focus on our customers’ satisfaction.
Beyond the core clinical and financial solutions we have for hospitals and physicians, we also focus on solutions for the payer market through our health solutions business. As well as connectivity, it cuts across all healthcare constituents through our Relay Health business. McKesson health solutions uniquely combines expert technology with evidence based, clinical information to enable payers to manage their administrative and medical costs. Our payer customers have access to the industry’s most robust set of solutions to help them manage their financial, administrative and clinical processes and improve quality.
In Health Solutions our footprint is unparalleled. All of the top 25 managed care organizations and more than 90% of the Blue Cross Blue Shield plans depend on our solutions to help manage their business. Additionally, Intercall continues its decade long leadership for clinical decision support among quality improvement organizations for Medicare programs, Medicaid initiatives and private quality assurance programs.
Health Solutions just hosted its 22nd annual client conference in San Francisco. We spent four days speaking with over 170 organizations about how McKesson can help address their most pressing business issues. An important focus this year was innovation and we showcased several new products for the payer market.
In our Relay Health business we have both a comprehensive software as a service platform and an intelligent network that processes healthcare transactions. Relay facilitates the exchange of information among health systems, labs, pharmacies, payers, physicians, pharmaceutical manufacturers, government agencies and of course consumers. By linking together all constituents in the healthcare continuum, eliminating data silos and engaging the consumer, Relay Health is enabling more informed decisions, reducing costs and facilitating care coordination to reduce errors and drive better outcomes.
Capitalizing on our innovative programs we’ve processed nearly 13 billion clinical and financial transactions annually that improve cash flow, reduce cost and enhance patient outcomes. Ultimately our solutions will also help health systems and physicians meet interoperability criteria as outlined in the High Tech Act. The solutions have short implementation times, are easy to use and are low cost with no hardware to purchase or software license fees. As an established leader in pharmaceutical and supply distribution, McKesson is now establishing a leadership position in information distribution.
The Technology Solutions portfolio of products and services is unmatched in the industry. Rapid change is preventing and presenting a unique opportunity and we can extend our lead if we appropriately balance innovation with solid execution. I’m pleased with the second quarter performance of Technology Solutions, particularly the strong contribution from the cost containment measures we implemented beginning last fiscal year.
In summary, I’m confident that many of the positive trends from our first half of the year will continue and every business will maintain its focus on controlling discretionary expenses. Our first half results give us great momentum and because of this momentum and the anticipated positive impact from the increased demand from the flu season, we are raising our full year expectations and now expect earnings per diluted share of $4.45 to $4.60, excluding adjustments to the litigation reserves for fiscal 2010.
With that, I’ll turn the call over to Jeff and will return to address your questions when he finishes. Jeff?
Well thanks John and good afternoon everyone. As you’ve just heard McKesson continues to execute, to drive effective cost controls and to grow profit. McKesson has turned in another solid operational performance that resulted in a strong first half for the fiscal year.
Before I begin reviewing our financial performance, let me point out that our second quarter results have benefited from a $12 million after tax litigation reserve release of $0.04 per diluted share. My discussion for the quarter and the full year will be on the basis of our earnings excluding the litigation credit for comparison purposes.
As usual, I’ll begin by discussing our consolidated results. I’ll provide additional color when I discuss each segment in more detail.
Revenues for the quarter grew 2% at $27.1 billion, pretty much in line with our original expectations for the year. I’d remind you of our assumptions for the full year, which was for the economy and the financial markets to show a modest uptick towards the end of our fiscal 2010. These assumptions still apply.
Gross profit for the quarter was up 3% to $1.3 billion with both segments contributing to this growth. Moving below the gross profit line, our total operating expenses for the quarter were down 4% to $888 million. The lower expenses were driven primarily by the cost containment efforts we put in place beginning last year in response to the difficult economic environment. Our operating expenses also benefited from the sale of two businesses in our prior year, a stronger dollar, as well as the legal settlement we discussed in our July earnings call impacting the company’s 401(k) plan that will provide about $0.03 to $0.04 of year-over-year benefit each quarter this year.
Operating income for the quarter grew 17% to $447 million from $381 million a year ago. Recall this is $447 million excludes the benefit of the $20 million litigation credit.
Moving below operating income, other income was $4 million compared to $33 million in the prior year. The prior year benefited from the sale of our equity interest in Verispan, which resulted in a pretax gain of $24 million or approximately $0.05 per diluted share. The remainder of the decline in other income was primarily due to lower interest income resulting from lower prevailing [trest] rates.
Interest expense for the quarter of $47 million increased due to the $700 million in debt we issued in February.
Moving to taxes, our effective tax rate of approximately 29% benefited from $13 million of favorable discrete tax items but is otherwise roughly in line with the 32% run rate we continue to expect for the full year. Our effective tax rate in the prior year was just 13.7% and was impacted by $76 million in positive discrete tax items, equating to $0.27 per diluted share.
Net income excluding the litigation credit was $289 million and diluted earnings per share excluding the litigation credit was $1.07. To wrap up our consolidated results, this year’s EPS number was aided by the cumulative impact of our share repurchases, which lowered our diluted weighted average shares outstanding by 3% year-over-year to 271 million shares.
Let’s now move on to Distribution Solutions. In this segment, revenue growth overall was 2% compared to the same quarter last year. Direct Distribution and Services revenues were 7% due to market growth rates, partially offset by the losses in fiscal 2009 of several customers that we have previously discussed. Similar to the trend we highlighted in our last earnings call, 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 13% decline in our sales to customers’ warehouses.
Canadian revenues on a constant currency basis grew 9% for the quarter due to market growth rates. Including an unfavorable currency impact of 6%, Canadian revenues grew 3% for the quarter. As I’ve said in the past, given our large IT workforce in Canada we are fairly hedged on the Canadian dollar on a consolidated operating profit basis.
Medical Surgical Distribution revenues were up 5% for the quarter to $734 million, benefiting from the effect of some small acquisitions we made in fiscal 2009. Gross profit for the segment was up 1% to $960 million from $951 million a year ago, a modest revenue growth resulting in a reduction to our gross margin rate of 4 basis points. As we’ve talked about for a couple of quarters now, our sell margin was negatively impacted by customer renewals and the loss of customers that occurred late in our fiscal 2009. We are pleased however that year-over-year growth in our generics profit and compensation under agreements with our branded manufacturers offset much of the sell margin impact.
Our Distribution Solutions operating expenses were down 4% for the quarter to $546 million, reflecting the prior year sale of our specialty pharmaceutical business and our continued focus on containing costs.
Operating margin rate for the quarter was 158 basis points compared to 157 basis points in the prior year. But it’s important to note that the prior year sale of our equity interest in Verispan that I mentioned earlier benefited the Distribution Solutions segment. Excluding this sale from the prior year operating margin, our rate improved 10 basis points.
In summary and before I move on to Technology Solutions, we’re very pleased with our ability to mitigate the challenges we faced at the beginning of this fiscal year and to see the continued strength of our businesses within Distribution Solutions, driven by sound expense management, consistent execution and innovation.
In Technology Solutions, total revenues grew 4% for the quarter to $790 million. Contributing to this increase was the recognition of $22 million in previously deferred revenues triggered by the Horizon’s Enterprise Revenue Management Solution becoming generally available in the quarter. As the GA of Horizon ERM impacted each of the revenue lines, I’ll call out the relative benefit.
Services revenues increased 5% in the quarter to $613 million or 3% excluding the impact of the Horizon ERM GA. This 3% growth reflects the more stable nature of our service remedies.
Software and software systems revenues of $142 million increased 1% from the prior year and hardware revenues of $35 million in the quarter were down 13% from the prior year. Excluding the Horizon ERM GA impact, software and software systems revenues declined 2% and hardware revenues were down 25%.
Technology Solutions experienced gross margin expansion of 141 basis points with gross profit for this segment up 7% to $375 million. Approximately half of the basis point improvement came as a result of the Horizon ERM GA since some of the associated expenses were recognized as incurred in prior periods. The remainder of the gross margin rate improvement was primarily due to a favorable revenue mix.
Technology Solutions operating expenses decreased 8% in the quarter to $260 million. These lower expenses were primarily due to cost containment efforts across the segment in response to the economic slowdown.
We continue to innovate and invest in R&D to maintain our leadership position. For the quarter, Technology Solutions had total gross R&D spending of $102 million, which is actually slightly more than in the prior year. Of this amount, we capitalized 20% compared to 17% in prior year.
Our operating profit in our Technology Solutions segment this quarter was $116 million, up 63% from the $71 million we recorded a year ago. Our operating margin in this segment was up to 14.68% for the quarter compared to 9.32% in the prior year. Although we are pleased with this margin expansion, there are a number of factors driving it. We continued to see success with our cost containment initiatives, but there were certain other factors that contributed to the margin increase. We benefited from the impact of the Horizon ERM GA as well as the legal settlement impacting the company’s 401(k) plan, which in particular benefits this segment. Last, recall that the prior year operating margin rate was adversely impacted as a result of the financial crisis and its impact on our customers.
Leaving our segment performance now and turning briefly to the balance sheet and our working capital metrics. Our receivables were $7.8 billion which is up from the prior year balance of $7 billion. However, our days sales outstanding remained flat at 23 days after adjusting the prior year for the $497 million utilization of our AR sales facility.
Moving on to inventories, as a result of carefully managing our inventory levels, we continued to see improvement in our days sales in inventory. Additionally, last year we did some earlier buying for our normal seasonal build. As a result of these two events, our days sales in inventory was 30 days, a nice improvement of 3 days compared to last year. Our inventories were $8.6 billion on September 30, a 6% decrease over last year.
Our payables increased 5% to $12.7 billion from a year ago and days sales in payables increased to 44 days from 43 days last year. Importantly, both the DSI and DSP metrics showed modest improvement from what we posted at the end of last quarter.
These working capital improvements resulted in McKesson generating $1.5 billion in operating cash flow year-to-date. Based on this start, we now expect to generate in the range of $1.5 to $2 billion of operating cash in fiscal 2010, excluding the AWP payment.
This strong and early in our year cash flow generation contributed to McKesson posting a cash balance of $3.2 billion at September 30. Much of this balance is due to timing. As I just mentioned, our cash flow came in earlier this year. In addition, we had expected to make a $295 million AWP payment in the second quarter but it actually happened after the quarter ended. We also have $215 million in debt coming due in February.
We remain committed over the long term to our portfolio approach to capital deployment. To that end, we repurchased $299 million worth of shares year-to-date. Consistent with our update in our last earnings call, we continue to expect our full year average share count to come in a bit below the original guidance we provided of 272 million shares outstanding. And our capital spending continues to trend as expected at $350 to $400 million for the year.
Now let me turn to our outlook. As John mentioned earlier, we are raising our guidance on diluted EPS excluding this quarter’s $0.04 adjustment to our litigation reserves from $4.15 to $4.30 to a new range of $4.45 to $4.60. There are several contributors to this guidance change so I’ll walk through each one in turn.
First, we benefited approximately $0.05 from favorable discrete tax items recognized in our second quarter. Second, we will recognize in our third quarter approximately $0.05 related to the sale of our 50% stake in the joint venture of McKesson Logistics Solutions, a third party logistics provider in Canada. So these two items account for about $0.10 of our $0.30 increase in guidance. The remaining $0.20 is a mixture of two factors, our momentum from the strong operational start to the year and our expectations around the way that the flu season will impact us including our expanded relationship with the CDC.
There are many combinations of these two factors that might get us into our range and both factors are material. So let me comment in particular on the uncertainty surrounding the flu season and the resulting challenge that we have estimating its financial impact. We have many businesses that in varying degrees will be affected by the flu season. We have seen over the last six months and may expect to see in the next six months many things including increased call volumes at our nurse triage centers and our payer business, higher volumes of Tamiflu, Relenza and other flu related generic drugs that move through our U.S. Pharmaceutical business, more physician office visits that drive demand for ancillary medical supplies including flu test kits through our Medical Surgical distribution business, varying volumes of seasonal flu vaccines that we ship through both our Medical Surgical distribution business as well as through our longstanding contract with the CDC to distribute children’s vaccines, and various volume, timing and requirements that will ultimately drive pricing stemming from our exclusive relationship with the CDC to distribute H1N1 flu vaccine and related supplies.
We are fully prepared for what is to come but there is a great deal of uncertainty about this flu season, how severe, how pervasive across the country, the timing and duration. And separately there are questions about the timing and availability of the vaccine supply, the pull through of vaccine by the state health departments, the utilization by the public of the available H1N1 flu vaccine and what the final terms will be of the modifications to our existing relationship with the CDC. Therefore we have incorporated into our guidance what we believe to be a reasonable yet modest assumption related to the flu season.
The financial impact could be more or less and it could potentially have a material impact on our earnings that drives us above or below the range we are giving you today. As the year unfolds, we will help you understand the final financial impact of the flu on our fiscal year. We will do this once we have the full facts.
As one data point for you, in our September quarter results the overall impact of the flu on our earnings appears to be fairly flat year-over-year. We recognized a net $16 million of start up expenses in the September quarter on our CDC contract and this offset the year-over-year earnings upside we saw elsewhere in the company on the flu.
In the face of this uncertainty, my usual comments about our quarterly progression are also challenging. The positive trends that helped drive our first half results are continuing and we expect that this momentum will carry into our back half of the year. The flu is likely to impact us more in our December quarter than the March quarter. If this is correct, then we would still expect to see our fourth quarter as the strongest of the year but the December quarter could be very close to it.
In closing, we’re pleased with the performance across all our businesses and feel that McKesson has executed well through the first half of fiscal 2010.
Thanks and with that I’ll turn the call over to the operator for your questions.
Thank you. (Operator Instructions) Your first question comes from Charles Boorady - Citi Investment Research.
Charles Boorady - Citi Investment Research
You mentioned the $6 million start up costs for the CDC contract. I understood that was a cost plus contract so was that a $6 million net expense that you’re not getting reimbursed for or is there a timing difference on when you’d recognize revenues related to that?
It’s strictly timing, Charles. As you said all the outcomes are positive although we’re still working through the final terms with the CDC but the accounting does not necessarily follow the payment. And so the revenues will more be recognized along with shipments and the shipments started on October 4.
Charles Boorady - Citi Investment Research
And then on Tech Solutions, and I appreciate the additional time John spent talking about the business, and I wonder when do you think we’ll see the inflection point in revenues related to the increased demand that many of your competitors are talking about? You’ve been talking about post-stimulus and related to that, is there going to be a point where you need to ramp up your selling expense ahead of when you would recognize the growth in revenues? Or will the timing generally match between your revenue growth and selling expense growth in that business?
Well I think it’s a little bit early to say when is it actually going to hit an inflection point. I guess what I can say is that our field organizations are actively involved in a level of discussions with our customers that we haven’t seen for quite some time. And it’s along two paths. One is the discussion around implementation of product that might have already been purchased but we have not you know recognized the full opportunity because it hasn’t been implemented or installed fully. So even products like physician order entry products or Horizon Expert orders that might have been purchased several years ago, when these products are now desired for stimulus and for meaningful use, they’re focused on how fast can we get them in.
And then there’s a second track of discussion which are those customers who have not bought a complete enough solutions set to begin thinking about how can we get ready for stimulus and make sure that we’re making this happen. I think our sales investment is probably about where it needs to be. Frankly the investment in implementation support staff is commensurate really with our visibility to when customers are going to be ready to implement and want to implement. So you’ll probably see that investment continuing not only this year but also into next year as we think about what’s necessary to make it happen.
And clearly we’re excited about Horizon Enterprise Revenue Management. The launch of that product has stirred up a sense of interest in many of our customers who understand that the complexity related to the financial side of the business is going to continue to increase, and that individuals and consumer directed health plans are going to have more responsibility to pay for their own care, which increases the complexity of dealing with multiple parties related to recovery of payment for services that have been provided.
I think, Charles, overall we’re pretty optimistic. That inflection point clearly we see out beyond the end of this fiscal year in terms of meaningful impact from a revenue perspective and that’s why our guidance this year continued to be somewhat soft from a revenue perspective. But as we get closer to next year we’ll have a better feel for that.
Your next question comes from Glen Santangelo - Credit Suisse.
Glen Santangelo - Credit Suisse
Yes, John, just a couple of quick questions. You were talking about a lot of momentum in your business and you know people have been paying attention to physician office visits and all the flu data out there and the IMS data. Are you really seeing a swell in volumes here recently in the past month in your drug distribution business? Do you think these incremental physician office visits are translating into more scripts?
Well clearly we’re optimistic as we look forward that this flu season could have a positive impact on our business more than it has thus far. You know clearly September and October you began to see more media coverage about it and more interest. And I think that you know we really didn’t see a lot of effect in our businesses in the September quarter other than as Jeff mentioned I think we had flu test kits started to sell well in our Med Surg business. But remember that business also has a lot of other businesses in it. And so you know to the extent that the flu business might be impacting the physician side, we have Z Medical for example that sells into businesses which continues to suffer the take down in terms of employment, etc. So I think we’re optimistic as we look into the next couple of quarters but thus far we haven’t seen a significant bolus of new demand.
Glen Santangelo - Credit Suisse
And then just a quick question on the IT side. The deferred revenues you recognized in the quarter, when did they come from? Were they from last year or were they kind of recognized last quarter?
Jeff will talk about the revenue specific but you know the complexity of this business is that things like enterprise revenue management is a big word that encompasses lots of different products and lots of things that are tied into a large contract or a sale with a customer. So some of these sales might have taken place years ago. Jeff?
Correct. And in fact many of them did. And most of the revenues, Glen, that were recognized were actually not for the Horizon ERM product but they were for other ancillary products that the customer purchased as part of a bundled purchase that had been installed and customer’s been using for a long time. But the trigger for revenue recognition is completion of the final element in the contract which is the GA of Horizon Enterprise Revenue Management.
So although we sold a lot of the HERM product already, because it takes a while to implement it, actual HERM revenue will be more material as we think about the out year, I mean next year probably more so than this year. So this is stuff that was installed and hung up on the balance sheet until we can get it recognized.
Your next question comes from Thomas Gallucci - Lazard Capital Markets.
Thomas Gallucci - Lazard Capital Markets
I guess just first following up on Glen’s question there, given that you probably have some idea of the timing there, so did you anticipate already the benefit from that in your original guidance?
Thomas Gallucci - Lazard Capital Markets
And then I guess within the changes to the guidance, Jeff, you had mentioned sort of a general bucket of business momentum. What sort of are the key drivers that you’re thinking about when you sort of think about that bucket?
Well I’d really go back to the many things that John and I talked about across the business, Tom. It’s momentum across every aspect of what we do. I’d say a common theme is strong cost containment efforts that have gone frankly better than we had anticipated when we put together the plan. That’s probably the one common thing.
Thomas Gallucci - Lazard Capital Markets
I think you mentioned the one stop program was down a bit due to the client loss. Do you have what the adjusted number might be so we can get a sense of what the underlying business is doing?
I think it’s fair to say the underlying business is continuing to expand. You know it’s not the kind of rate of increase that you might have seen in years past, Tom, because we’re lapping things like Safeway that were big net incremental new customers. But we’re still very pleased with the progress we’re making in the generics business. And if you look at our total revenue growth in the corporation on the pharmaceutical distribution side, the fact that we were able to lose nearly $3 billion in revenue and still get some growth out of the business I think is a tribute to the strength of the market but also the strength of our ability to continue to execute with our customers and get more and more of their business driven through McKesson. So I think we’re well positioned there and I think we remain optimistic about the progress we’re making with generics.
Your next question comes from Randall Stanicky - Goldman Sachs.
Randall Stanicky - Goldman Sachs
John, one of the things that I missed highlighting was some potential inventory management that they’re seeing at retail. Have you seen anything from where you sit that would be contributing to their renewed focus or their renewed growth outlook on the mid single digits?
Yes, not to sound negative but we sometimes have a hard time explaining the nuances associated with IMS’s forecast. Certainly the direction that they take we typically agree with but the science behind the numbers is sometimes more of a challenge. So I think that we believe that there is continued to be some demand drivers here that are helpful to us but beyond that we probably don’t focus on a near term basis in terms of what IMS is saying. And I’d say that their projections as revised now are probably more reflective of what we thought the year was going to be anyway as opposed to their earlier guidance which was down I think. We just didn’t see it going negative.
Randall Stanicky - Goldman Sachs
How about from a sell side margin perspective, one of the things that obviously you talked about last quarter that you’re saying had improved was the outlook on that front. If you talk to customers here and clearly there’s a couple of customers out there as we look out for the next six to 12 months that won’t hurt to matter from a renewal perspective, are you seeing anything different from a pressure perspective on that front?
Well the market remains competitive, Randall. As I’ve said in the past I think we have to constantly look for ways to innovate with our solutions set to take the focus off of price and focus more on value and what we can deliver. And I think that we continue to deliver more value than we charge for from the service perspective. So typically our sell side pressure is driven by competitive activity, perhaps in addition to a customers interest to get a better deal. And we talked last year about the sell side pressure we experienced in the fourth quarter and frankly when we drew the line in the sand we lost $3 billion worth of revenue. So sometimes our attempt to hold the sell side in place is met with negative consequences.
We continue to believe though that the only way to continue to expand margins in our business is to have discipline around the selling process, to sell the full value of the company, and to obviously do great work in cost management and in things like generics that help drive margins on the positive side and reduce the bleeding as it relates to sell side margin degradation. So I don’t want you to believe in my comments that the sell side “has turned around”. I would say that what we’re suggesting is that the negative pressure we felt in the fourth quarter we built into the guidance this year has been experienced and we continue to manage aggressively against our customer’s expectations, the competitive activity and our ability to hold the line on price so that we can actually get margin expansion, which is our ultimate goal here. The key to softening revenues is to get gross profit expansion and that is critical to this model.
Randall Stanicky - Goldman Sachs
And even with some of the CDC north of some of the H1N1 noise, in the numbers we should expect to see margins continue to expand over the next couple of quarters?
You’re focused on operating margins, Randall? I mean on the operating margin side you’ll actually see a very significant expansion due to the flu. Because the mix of products is a little higher margin than normal and the CDC contract is a third party logistic contract. So we don’t recognize the product revenue that will drive the margin up. After the fact we’ll tell you what the impact is on all that. We do expect the operating margin in Distribution Solutions to go up for the year, even once you adjust for those items.
Your next question comes from Lisa Gill - J.P. Morgan.
Lisa Gill - J.P. Morgan
Jeff, just to come back to the guidance and you talked about the $0.20. Within that you said that CDC is in there. Is the entire CDC contract within that $0.20 or you’re not quite sure how it’s going to work out? Maybe can you just walk us through how you’re getting paid on this 3 PL contract? Is it based on the number of shipments you have? Is it based on just a contract that you signed overall with them?
Well remember we have a longstanding contract with the CDC on their Children’s Vaccine Program. And what we are actually doing is just extending that contract to cover what we’re doing on very short notice for H1N1. There are actually three components economically to that expansion, Lisa. One, covering the costs that I’ll call the set of costs of setting up fixed distribution centers and the technology and hiring a couple thousand people. Second component is a component to cover the monthly operating expenses of running that network. And the third component is a variable component that depends upon the number of doses actually shipped.
So our challenge in giving guidance of course is the tremendous variability I’d say right now on how many doses will be shipped. There’s tremendous variability on the timing of when those doses get shipped which also affects our economics. And then as the CDC and McKesson and other partners work together every day to figure out how to do this a little bit better, frankly what we’re doing for the CDC continues to evolve and that is reflected on pricing. So what we’ve tried to do in our guidance range is give you our best estimate, given all that uncertainty I just described, of what we think is a reasonable assumption for the economics this year on the CDC.
But as I said in my prepared remarks, there’s enough uncertainty here so I’d say we could be materially off in either direction. But we think we’ve been modest and reasonable in the range we’ve given you.
Lisa Gill - J.P. Morgan
I guess what I just want to understand is that you said you could be modestly off on either side, I don’t really understand how you could be off on the downside, right, though? Aren’t they covering the costs? So if the costs?
Yes. I’m sorry, Lisa. I’m just talking about on the downside relative to the guidance range we’ve given you. And we took our guidance range up a whole lot.
So we don’t expect that this will not be a financial benefit. It’s a question of the size of the benefit and that’s what Jeff was attempting to explain. So we won’t lose money on the deal regardless of what the outcome is.
Lisa Gill - J.P. Morgan
And I think what we’re trying to understand, John, is just you know the underlying fundamentals of the business so we pull out H1N1 and we just really try to understand what’s happening with McKesson. You’ve put up a number of really strong quarters, drug distribution, while margins were a little bit lower than what we expected you are building momentum there. We knew about some of the repricing of the contracts and maybe if you could talk about the conversion from warehouse sales over to direct store sales. I mean that should have a positive impact over time as well. Right?
Yes. We think that the drug distribution business and let’s not forget that H1N1 really hasn’t had any impact other than the set up costs in the quarter we just reported. So the strength you see in our financial results in Q2 were driven by the ongoing operations of the corporation without regard to sort of the H1N1 effect, with the exception of the ERM GA which is kind of the abnormal thing in the Technology Solutions segment that was more one time kind of related.
So I think we feel very strongly that the business is well positioned to continue to perform. We’re lapping this $3 billion loss and the price effect that that has had from a market perspective. And we’re continuing to innovate to try to deliver additional value. So I think we feel very positive about how we’re positioned in those businesses.
As to the transition between warehouse and direct store sales, I think that that is a continued indication of the value we deliver for our customers, that when they say listen we want you to ship to our stores directly as opposed to us using our warehouses as an intermediary, it certainly shows confidence that our logistics channel is as good or better for the customers. You know and generally speaking DXD business for us is more profitable than warehouse business and this most significant move that we’ve had with one of our larger customers, its still positive but perhaps not as positive as an independent direct store delivery model as opposed to you know a chain direct delivery model.
Lisa Gill - J.P. Morgan
I mean I know a bunch of people asked this, but sequentially the expectation is that drug distribution’s going to continue to get better. That’s correct over the December and March quarter just like we’ve seen historically? And that’s it for me.
Your next question comes from John Ransom - Raymond James.
John Ransom - Raymond James
Drug inflation this year has been low double digits, which is the strongest we’ve seen. And recognizing that your fee for service just how much of a benefit is that? And conversely if inflation fell say 300 or 400 points next year, how would this affect your hybrid deals and how should we think about that if at all?
Well I think we might have had some modest lift from the price patterns in the last two quarters, but as you suggested we have basically taken the variability out of this business to a large degree. Plus the price inflation depending on which manufacturers it falls on can have a immaterial effect or a material effect given the structure of some of our relationships. So I think that what we’ve experienced thus far and what we planned for for the balance of the year is generally in line with the expectation we had as we started the year.
And as we look to next year you know there might be an environment where price inflation is lower than what it is today or what we’ve experienced today. Because as I said it really depends on the mix of manufacturers that make those changes as well as how our arrangements with the manufacturers vary. And I think our ultimate goal is to make sure that we’re properly paid for the work that we do. And to the extent that there’s some significant change to the models as a result of behavior changes out of our control, we certainly would go back and adjust those models hopefully to reflect the fact that our work has remained the same.
Your next question comes from Robert Willoughby - BofA Merrill Lynch
Robert Willoughby - BofA Merrill Lynch
John or Jeff, are there any more IT revenue opportunities in any of these deferred revenues that might pop up in the second half that’s in your guidance and any material?
No. Horizon ERM is a uniquely scaled or large project. There’s nothing else anywhere close to that.
Robert Willoughby - BofA Merrill Lynch
And with the $3 billion in cash, you know what businesses under your roof stand to benefit the most either from internal investment or acquisitions?
Well you know clearly we have used a portfolio approach to the deployment of cash, Robert. And we will plan to continue that pursuit. At least that’s our current thinking. We use dividends, we use acquisitions and we use share repurchases as part of that portfolio. I think all of our businesses continue to have opportunities for us to make strategic acquisitions that fit in sort of the wheel house of the businesses. And I think we’ll continue to evaluate across the board. There are some that might be reaching points of competitive saturation which makes it difficult to find additional parties to roll in. But even in those larger businesses where there are only a few players left, the ability for us to make acquisitions that might serve more innovation opportunities for us are certainly present as well. So I think it really will be across the board.
Robert Willoughby - BofA Merrill Lynch
Can you possibly flush out? I mean I’m hard pressed to see where you can go from a distribution standpoint either Drug or Med Surg. I mean are there real avenues there that you’ve not yet tapped or explored?
Well I think distribution is a big sector for us and that we made acquisitions in our medical distribution business for example that have been successful in expanding our footprint. I don’t think that that market has been fully consolidated and whether it’s home health distribution or whether it’s physical therapy distribution or whether it’s nursing home distribution or physician office distribution, clearly that’s a big segment for us and there’s plenty of opportunity with smaller players that are privately owned where they’ll find a nice fit with us.
To your point though pharmaceutical wholesaling in North America has consolidated significantly and there may be fewer opportunities in that segment. But once again I think there’s places where we can find space to invest.
Your next question comes from Richard Close - Jefferies & Co.
Richard Close - Jefferies & Co.
Jeff, just wanted to be clear on not looking at this apples versus oranges here. When we look at your guidance from the coming out of the first quarter you said $4.15 to $4.30 and $0.15 from the legal settlement was in there. And now you’re saying $4.45 to $4.60 and then you say excluding an adjustment to the litigation reserves. So?
I’m sorry, Richard. We confused everyone. Its two different things. What we talked about in the July quarter is that the company’s 401(k) plan had actually reached a legal settlement. The net effect of that was about a $0.15 good guy for all of our fiscal year ’10. That was built into the $4.15 to $4.30 range and remains built into our new higher range.
Separately and totally unrelated, in the September quarter we settled and released a $20 million reserve on an old legal case that has to do with the HBOC acquisition. If you look at our income statement, if you look at Schedule 1 you’ll see a little table down at the bottom that builds you from a GAAP 111 EPS to a 107 EPS and we built our guidance off that 107. It’s a convention we’ve used for a number of years now to exclude some of the somewhat random noise around settlements relating to both the HBOC acquisition as well as the AWP litigation.
So when Jeff talked about the securities litigation or litigation matters, those are the two call outs that he’s referring to. Unless we say otherwise it’s either AWP or it’s the securities litigation from back in 1999.
Richard Close - Jefferies & Co.
And then when we think about the you know the operating margin and the progression, your comments there, you see improvement in the back half of this year. Is there anything you can note I guess the sequential decline from first quarter to second quarter that maybe we should be aware of? Obviously you have the start up costs on the H1N1. Anything else there?
Well when you think about operating margin and Distribution Solutions, Rich as you know we encourage people to only look upon it on a rolling four quarter basis. You can’t look at it sequentially. There’s quarterly volatility. So for the four quarters of fiscal year ’10 we would expect that operating margin rate in Distribution Solutions before any impact from the flu to be up by some single digit [safe] points. Now the flu if it occurs as we think it will, will have a quite dramatic impact on that rate in the third and fourth quarter because of the fact that that CDC contract is a third party logistics contract where we don’t show the full revenues of the product. But as we get there we’ll call that effect out for you as much as we can estimate it.
Richard Close - Jefferies & Co.
Any reason why operating margin in Technology Solutions would decrease as we progress through this year?
Well there’s also quarterly volatility. There so we’ve talked for a long time about a long term goal of having that operating margin in the low to mid teens, which means 13%. Our expectation for the full year this year is while we’ll get close to that 13% we probably won’t quite get into it.
And operator I think we have time for one more question.
Your last question comes from Lawrence Marsh - Barclays Capital.
Lawrence Marsh - Barclays Capital
Just a quick clarification for Jeff to make sure we’re all on the same page here. Last quarter you said maybe $0.06 or $0.07 benefit from better distribution momentum. In this quarter you guys are saying $0.20 from momentum and flu. So is it too simplistic to just split that in half with knowing all the caveats of that of flu? And then can we just split you know flu in half, say $0.05 from H1N1 and $0.05 from overall flu volumes, just based on your best case? Or am I off there?
It is variable but I suppose as a starting point yes, Larry. But remember the $0.20 is on top of what happened last quarter and half the $0.20 we said was probably, I didn’t say this but sort of a big piece of its flu and a big piece of it is the non-flu momentum of the business. So if for now you wanted to go $0.10 and $0.10 that’s not an unreasonable assumption.
Lawrence Marsh - Barclays Capital
And then I guess just execution. John, I know you’re a big advocate of executing in your businesses. One of the catalyst for changes in technology was some frustration there. I know last quarter you talked about Pat you know having a lot of individual business leaders but is there any evidence from where you sit that there’s you know any crisper execution under Pat and his team? Or are we still way off to determine that?
Clearly Larry it’s early. I think Pat’s been in his role for three months. And we also as I talked about on the last call created a Chief Technology Officer role and added it to the role of Randy Spratt as our Information Officer. I would say that there is growing evidence of not only the fact that we’re very well positioned in our product portfolios and well positioned to take advantage of this new sort of electronification of healthcare through our solutions sets but there’s also early indication that the team is responding well to a renewed focus on execution and a renewed focus on customer satisfaction.
We’ve invested heavily against those two parties. I would say that in addition to the CTO role, Pat and his team have put together a client service group that focused on successful implementation and getting the value. So beyond just selling the product and saying good luck, we are going to assist our customers in actually realizing the dreams that they had at the time they initiated the contracts with us to begin with, which goes much further than we have in the past. And I would also say that our most recent experience bringing our Horizon Enterprise Revenue Management product to a general availability status went to a very rigorous amount of effort with the teams inside of MTS as well as the CTO organization to have an aligned view on the fact that the product was ready to go to market, so that our customers wouldn’t have to deal with problems with the software after we began the implementation. So we’re very confident that we’re beginning to make those steps and that the organization is responding well, albeit we’re early into this stage.
So thank you, Larry, and thank you all for your questions today. And thank you operator. I really am pleased with our second quarter performance. I’m really excited about the opportunities that lie ahead. I think that as Jeff mentioned we’re not only doing a great job of executing in a heads down way to manage costs and control spending, we’re also continuing to innovate. And that simultaneous execution and innovation is the secret sauce of success. And I think our organization has a proven ability to do those things simultaneously.
So I’m going to hand it off to Ana and she’ll describe what we’re going to do in terms of upcoming events. Ana?
Thanks John. I have a preview of upcoming events for the financial community. On November 12 we will present at the Credit Suisse Healthcare Conference in Phoenix. On November 18 we will present at the Lazard Capital Markets Conference in New York. And on January 11 we will present at the J.P. Morgan Healthcare Conference in San Francisco.
We plan to release third quarter earnings results in late January. We look forward to seeing you at one of these upcoming events.
Thank you and good bye.
That does conclude today’s conference. Thank you for your participation. You may disconnect at this time.
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