Cardinal Health, Inc. F1Q10 (Qtr End 09/30/09) Earnings Call Transcript

Nov. 5.09 | About: Cardinal Health (CAH)

Cardinal Health, Inc. (NYSE:CAH)

F1Q10 Earnings Call

November 5, 2009 8:30 am ET

Executives

Sally Curley – Senior Vice President Investor Relations

George Barrett – Chairman and CEO

Jeff Henderson – Chief Financial Officer

Analysts

Atif Rahim – JP Morgan

Randall Stanicky – Goldman Sachs

John Kreger – William Blair

Eric Coldwell – Robert W. Baird

Larry Marsh – Barclays Capital

Ross Muken – Deutsche Bank

Colleen Lang – Lazard Capital

Steven Valiquette – UBS

Chris Smith – Sanford Bernstein

Blake Goodner - Bridger Capital

[Jaron] – Citi

Dana Hambly – Jefferies & Co.

Operator

(Operator Instructions) Welcome to the First Quarter Fiscal 2010 Cardinal Health Conference Call. Now I would now like to turn the conference over to your host for today, Ms. Sally Curley, Senior Vice President of Investor Relations.

Sally Curley

Welcome to Cardinal Health first quarter fiscal 2010 conference call. Today, we will be making forward looking statements. The matters addressed in these statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected or implied. Please refer to our SEC filings and the forward looking statement slide at the beginning of our presentation which is found on the investor page of our website for a description of those risks and uncertainties. In addition, we will reference non-GAAP financial measures; information about non-GAAP financial measures is included at the end of the slides. A transcript of today’s call is also posted on our investor web page.

Before I turn the call over to our Chairman and CEO, George Barrett, I’d like to remind you of a few upcoming investor conferences in which we will be participating this month. Notably, the Credit Suisse Healthcare Conference on November 12, and the Lazard Capital Markets Healthcare Conference on November 17. The details of these events are or will be posted on the IR section of our website at www.CardinalHealth.com so please make sure to visit that site often for updated information.

Now I’d like to turn the call over to Mr. George Barrett.

George Barrett

I’m very pleased with our progress in this first fiscal quarter as the new Cardinal Health. We posted a 6% increase in revenues and reported a non-GAAP EPS number of $0.54 for the quarter up 15% over last year’s quarter. Our overall operating performance was better then we originally anticipated with both of our segments performing well. Our Medical segment showed strong earnings growth and our Pharma segment performed somewhat better then expected.

Our Q1 numbers were boosted by the positive impact of few noteworthy items; these included an accelerated revenue recognition item in our Medical segment related to the spin-off and some early then expected price increased from a few brand manufacturers. The impact from restructuring, impairments and other costs associated with the spin-off of CareFusion did bring GAAP earnings from continuing operations to a loss of $62 million net of tax for the quarter with the main driver being $172 million tax charge for the anticipated repatriation of cash. Jeff will cover this in more detail later.

I continue to be encouraged by our progress and the renewed energy I seem among our employees. We remain focused on our priorities to sustain improved performance and we’re tracking well against the work we need to get done. We came into this transition year knowing what we needed to tackle and while I’m proud of what we’ve accomplished to date we recognize that there is still much to do.

As I walk you through our performance I’ll touch on many of the key initiatives we talked about in August. There are also three broad themes that you’ll hear throughout my comments this morning:

Building a customer centric organization

Driving performance management

Positioning the company for the future.

Our work to improve the customer experience in both our Medical and Pharmaceutical segments continues. We’re making investments and adapting our organization to better serve the customers and to reinforce a mindset that everything we do begins and ends with our customers. Having said this, we are taking a disciplined approach to customer profitability analysis, even though it resulted in a couple of lost customers in the quarter. The loss of these customers will dampen our revenue growth for the remainder of the year, although the impact on profitability is much less significant.

Our Pharma segment continued its progress in Q1. Sales increased by 5% versus prior year with profits down 2%, better then we had expected. As you know, we had anticipated a steeper year over year decline in the first quarter based on a number of factors the largest of which was the decline in generic launch value versus prior year. Our organization has done a good job of compensating for the headwind and we had the benefit of some earlier then expected brand price increases that cumulatively had a positive impact.

Our Pharma mix was again roughly 50/50 bulk to non-bulk. We did however see a more balance growth with bulk and non-bulk both growing at approximately 5% to 6%. I would point out that the rate of growth in our non-bulk business as well as growth in our non-bulk margins are encouraging signs of progress in our underlying business, particularly given the decline in generic launch value and generic deflation relative to last year’s Q1.

We have devoted considerable organizational resources to improving our generics business. While the particularly robust generic launch activity in Q1 of last year did create a difficult year over year comparison it does track with our expectations for the year and I’m pleased with the progress we are making here. Despite considerable generic deflation on certain key products launched last year our Q1 generic fills were up nearly 2% and in our retail independent business we saw sequential quarter growth in dollars and in generic compliance to our source program.

On the generic sourcing side we also decreased our number of generic supplier significantly from approximately 120 down to roughly 30 and we’re confident that our enhanced relationships with generic drug manufacturers will provide incremental value to our customers, to Cardinal Health, and to our generic partners. These sourcing changes will roll out through the course of the year as we conclude existing agreements and work with our customers to avoid any disruption downstream.

The restructuring of our Medicine Shoppe business model is ongoing and while it weighs on earnings this fiscal year we continue to see evidence that this model change is the right strategic move for us.

Our Nuclear business continued to deliver exceptional bottom line growth driven by an effective selling strategy, economies from our management of raw material costs, and tight expense management. The team has done an outstanding job managing through the generator shortage resulting from the temporary shut down of the Chalk River Reactor in Canada. Although this had an impact on our overall volume, we worked hard to manage the supply constraints by adjusting schedules with our customers.

According to the most recent report from the Atomic Energy of Canada the Chalk River Reactor is projected to be up and running in the first calendar quarter of next year. Our forecast for production assumes resumption in January so any delay past that time could further impact this business in the second half of fiscal 2010.

Turning now to Medical, this segment reported strong double digit profit growth, boosted by decreases in commodity prices, some upside associated with the demand for flu related products, and an immediate revenue recognition benefit from international sales to CareFusion that was triggered by the spin-off.

Overall, hospital sales were in line with our expectations. Our pre-source kitting business continues to improve showing a second consecutive quarter of earnings growth. This business plays an important role for hospitals by improving the efficiency of the OR supply chain, minimizing waste, and increasing compliance with recommended safety standards particularly critical given today’s healthcare environment.

In the quarter, we saw double digit revenue growth in both our Lab and Ambulatory businesses as well as in our private label medical portfolio. Additionally, our Lab business signed an important five year sole source contract with Novation. In Ambulatory care our investments to improve the customer experience and grow the business are progressing well. We’ve invested in technologies to support the sales force and enable reps to provide critical information to customers in real time at the point of care.

Canada performed extremely well posting more then 20% profit growth as the results of new supply agreements, new products and the impact of the demand for flu related products.

I’d like to take a moment to comment more broadly about this flu season. Clearly we’re in the middle of an intense flu season and our people are working with incredible dedication to support our customers. Given some supply shortages in the market for certain medical and drug products we’ve had to apply a fair share allocation process to ensure that all of our customers have access to supplies of the flu related products we have available. Increased demand for certain products has had an earnings impact of approximately $5 million in the quarter mostly affecting our Lab, Medical Distribution, and Canadian businesses.

Also of note, our work on our Medical business transformation is moving forward. We’ve completed the blueprinting stage of the project and are shifting to the design and implementation phase. Our Q1 investment spending rate wasn’t as high as we originally forecast but we expect that under spend to flow into Q2. Expense and capital management remain a key area of focus. We continue to maintain disciplined cost management, making sure our cost structure is lean and appropriately sized for our business going forward.

In spite of the investments we are making in Med transformation at our customer facing IT initiative we are able to reduce SG&A year over year. We are also managing our balance sheet carefully with a strong emphasis on our turning days of inventory. We continue to optimize our portfolio across the company with regular reviews to ensure that we are maximizing the potential of each business.

We anticipate that a divestiture of our Martindale and Special Scripts Pharmacy businesses will be occurring in the next two quarters. We’ve completed the acquisition of Biotech Pharmacy and cyclotron which increased our cyclotron production facilities in the test space. This is an area of strong growth potential within our nuclear business.

I would wrap up my comments about the quarter by saying that our year is off to a good start. Our core businesses are tracking well and we’re making good progress on our key initiatives.

Now I’d like to make a few comments about the remainder of fiscal 2010. Back in August we outlined for you the headwinds we expected to face in 2010 and at this stage there are no real changes to our perspective on the year. We’re making important investments in the business, we’re executing against our key initiatives and I’m encouraged by our progress. Based on where we are at this stage, we expect that our full year performance will likely come in toward the higher end of our non-GAAP EPS guidance range of $1.90 to $2.00.

Before I turn the call over to Jeff I’d like to mention a couple of other things. We have two important additions to our senior leadership team; Patty Morrison joined us in August as our Chief Information Office. Patty has served as CIO at Motorola and Office Depot and has extensive experience with large scale supply chain processes. Mark Blake joined us just last month from Medco Health Solutions as our Executive Vice President of Strategy and Corporate Development. Mark has extensive business development experience and also brings investment banking and consulting. We’re thrilled to have them both on board, completing our 10 member executive committee.

Our Board of Directors also recently added two directors with exceptionally strong backgrounds, Bruce Downey and Glen Britt. Bruce brings valuable healthcare experience from his time as Chairman and CEO of Barr Pharmaceuticals, and Glenn brings a wealth of leadership and financial expertise as the current Chairman and CEO and former CFO of Time Warner Cable. I look forward to working with Bruce, Glenn and the entire Board as we move forward.

Now let me hand the call over to Jeff for more details on the quarter.

Jeff Henderson

As George mentioned, we’re very pleased to report that our first quarter consolidated results were above our expectations driven by solid operating performance and supplemented by a few noteworthy items. The steps we began taking last fiscal year to drive performance improvement within the company can be seen in our first quarter results. From our presentation this morning I’m going to take you through the consolidated results for the quarter, update you con some key financial drivers and then spend some time going through our outlook for the remainder of the year.

Let me start with a few comments on our financial results from continuing operations on a non-GAAP basis. My comments will relate to slides four and five. Consolidated revenues were up 6% to $24.8 billion. Operating earnings were up 3.8% to $323 million reflecting excellent growth in our Medical segment and performance better then we anticipated in our Pharma business.

We continue to exercise good discipline regarding operating expenses. I’ve worked hard to mitigate the costs associated with the spin-off. For the quarter, we reported total non-GAAP operating costs almost 1% lower then last year’s Q1 and were able to absorb the considerable investments we are making in the business to prepare for the future.

Please note that we have begun to break out interest expense from other income expense in our financial statement presentation. Other income improved by about $10 million versus last year primarily due to deferred compensation asset gains and a credit adjustment related to FAS 157 mark to market accounting.

Interest expense increased slightly year on year to about $34 million. Our non-GAAP tax rate for the quarter was 35.4% versus 39.8% last year. The lower rate in the current quarter is attributable to a change in estimate for our deferred state tax accrual which is a discrete item for the quarter. Last year’s Q1 we also had a change to our state deferred tax accrual that moved it in the opposite direction. Overall, we’re still on track with our guidance for full year non-GAAP tax rate of 36% to 37%. Non-GAAP diluted EPS was $0.54 for the quarter up 14.9% from the prior year.

Moving to our cash flow statement and the balance sheet. For the quarter we reported total operating cash flow of $406 million. Because of the mid-quarter spin the allocation of these flows between continuing and discontinued operations is a little complex. Approximately $262 million of that is attributed to continuing operations versus the use of almost $500 million in the year ago period. This cash flow was driven by strong operating performance combined with excellent working capital management including a reduction of approximately three days of inventory versus the prior year’s Q1.

Our accounts receivable days are down slightly year on year and bad debt expense is tracking consistently with our expectations.

Turning to slide number six let me take a moment to walk you through the items that impacted the difference between our GAAP versus non-GAAP EPS numbers. These figures are on an after tax basis. Restructuring and employee severance was approximately $42 million primarily driven by restructuring charges related to the spin-off. Impairments and loss of assets were $16 million primarily due to an impairment charge related to specialty scripts.

Other spin-off costs totaled $198 million. The biggest items in this category included $172 million tax charge related to the portion of earnings in cash that would no longer be indefinitely invested offshore as well as approximately $26 million related to the tender in retirement of over $1.1 billion in debt as we reset our capital health capital structure post spin.

Let me spend a moment on the tax structure. With the spin-off complete and our business mix outside the US smaller it is unlikely that all of our offshore cash earnings will be invested indefinitely overseas. On August 18 we advised you that we anticipated taking an approximately $150 million charge related to offshore funds that would need to be repatriated at some point. Initially the charge will primarily be non-cash but could eventually translate into cash tax payments when we repatriate. We would anticipate any repatriation of cash to occur over the next several years.

Our prior estimate of $152 million tax charge related to this ABP 23 SS station came in as expected. In addition, we incurred $20 million of incremental interest resulting in $172 million total impact. Also please note that these charges are not reflected in the anticipated non-GAAP tax rate of 36% to 37% for the full year fiscal ’10. The total negative impact to GAAP EPS in these items was $0.71 or $256 million for the quarter.

Turning to slide seven I want to call out a few noteworthy items in our non-GAAP numbers. Our first quarter operating numbers were somewhat enhanced by some unusual or timing events. It was a spin-off related revenue recognition item in our Medical segment which was worth about $14 million of profit or $0.02 to $0.03. This was due to the acceleration of timing for recognition of revenue and profit on inventory being held by CareFusion’s international business at the time of the spin. Although we anticipated this it was slightly higher then our expectations.

In the Pharmaceutical segment we saw some earlier then expected price increases from some brand manufacturers that were not significant on an individual basis but collectively had an impact on the quarter. This shifted what we believe is about $15 million or $0.03 of pre-tax earnings from future periods, namely Q2 and Q3.

The impact of an early and strong flu season which increased demand for a number of our medical products was worth about $5 million or $0.01 of EPS. As I mentioned earlier, the difference in effective tax rates between this year and last was worth about $0.04. Finally, within other income and expense we had $0.01 to $0.02 of benefit compared to last year’s quarter driven by the items I mentioned earlier.

However, I should point out that although the deferred compensation issue, which is worth over $0.01 does show up in other income and expense, it had no net effect on the income statement as there is an offsetting adjustment through SG&A.

Turning to slide eight, I’d like to call out a few items on the balance sheet view that related to the spin-off. The book value of our ownership stake in CareFusion calculated assets minus liabilities as of September 1 totaled approximately $861 million. Mark to market on September 30 this equaled $902 million. This amount may be found on the line labeled investment in CareFusion. As mentioned in August, any mark to market fluctuations do not flow to the income statement until such time as we actually sell our shares in CareFusion.

Under Other Assets approximately $212 million of the $735 million is listed as a receivable from CareFusion with an offsetting tax liability. This is recorded per our Tax Matters Agreement with CareFusion.

Within the liabilities section of our balance sheet you will see a long term debt balance of $2.1 billion and another $350 million of debt in the current portion of long term obligations. That $350 million represents some floating rate notes that came due in October and were paid off. In conjunction with the debt tender and synthetic lease facilities were paid off in Q4. We’ve no reach our target debt structure for new Cardinal Health of $2.1 billion. $172 million repatriation related tax charged I discussed earlier flows to the deferred income taxes and other liabilities line.

Finally, note that the $3.7 billion dividend of CareFusion on September 1 was treated as a dividend to shareholders and therefore is deducted from retained earnings. Do note that retained earnings are lower by approximately that amount from last quarter.

Before we get to the segment results I want to answer a question we received regarding the accounting and tax treatment of any divestiture of our CareFusion stake. Specifically we’ve been asked whether we are subject to capital gains and losses from the sale of any CareFusion shares. The answer is yes we are subject to capital gains and losses for tax purposes. Also from an accounting perspective any equity sale of CareFusion would be recorded on the P&L as a gain or loss versus the book value at the time of spin.

Now let’s turn to segment performance and I’ll being referring to slides nine and 10. Pharmaceutical segment had a stronger start then we expected to FY10. Revenue increased 5.4% to $22.6 billion for the quarter driven by strong growth in pharmaceutical distribution. Revenue growth was balanced between bulk and non-bulk businesses at 5.6% and 5.3% respectively.

Segment profit at $208.4 million a decline of 2.3% compared to last year. This was primarily driven by the timing and reduction in new generic launched and price deflation as well as customer contract re-pricing and the impact of the Medicine Shoppe transition. However, we did have some significant positives of note in the quarter.

Our Nuclear Pharmacy business had strong growth in margin expansion despite some of the supply issues they are facing. We continue to perform very well under the DSA agreements that we have with our branded vendors. We made good progress in our generic sourcing and compliance initiatives as well as overall generic sales. As mentioned earlier, branded by margin timing shifts also helped the quarter within the pharma distribution. Finally, we continue to exhibit overall disciplined cost control across the segment.

One other item I wanted to cover relates to the bulk, non-bulk margin that we’ll be breaking in our 10-Q which is being filed in the next couple days. Within our Pharma business you will see nine basis points the segment profit margin improvement related to non-bulk customers, going from 1.73% in Q1 FY09 to 1.82% in Q1 FY10. Our bulk business reported what I would describe as an abnormally low segment profit margin of three basis points for the quarter.

I should mention that we have expected to see a full year decline in bulk margin in FY10 versus full year FY09 driven by major contract re-pricings, the mix of our expected brand price increases, and the year on year generic launch comparisons. That all said, there are also some unique items and seasonal impact on Q1 which together account for at least 15 basis points of the difference in bulk segment profit margin this quarter versus our expected full year rate.

A final comment on our bulk and non-bulk margins I think is important, although we did break out our margin by this classification in our 10-Q this is not really the way we price or view our business. We price and bid for business by customer not by business type. In other words, when we price contracts we look at the overall profitability and return on capital for that particular customer ensuring that we receive fair value for the overall basked of products and services we provide.

Turning now to our Medical segment, they had a very fall start to fiscal year ’10. Revenue increased 9.8% to $2.24 billion for the quarter driven by robust organic growth, the accelerated revenue recognition benefit I mentioned earlier, and demand for flu related products. Inventory, lab, and Canada have particularly good quarters. Many of the actions we began to implement with regard to pricing structures and customer outreach have started to take hold.

Segment profit was $114.9 million an increase of 17.4% over last year driven by organic growth, the spin-off revenue benefit, flu demand, and commodity price decreases, partially offset by medical transformation spend and a loss earnings associated with the divestitures of Tecomet and Medsystems. Overall, as George mentioned we are encouraged by the progress made over the quarter in both of our segments. Although we realize we have more work to do to position us for long term sustainable growth.

Turning to slides 12 to 15 let’s review our FY10 outlook. Our Pharmaceutical segment assumptions shown on slide 12 remain the same including many of the market factors, strategic moves which impact the full year. Two items I’d like to specifically call to your attention. First is our assumption around the raw material supply shortage in Nuclear. For now our forecast maintains our assumptions that the supply issue will be resolved in January. That is a potential risk for the second half of the year.

Second, our projection for full year revenue within Pharma remains at modest growth despite the relatively strong start we saw in Q1. That view on full year sales reflects the impact of a couple of customer’s losses that George spoke about earlier which begin to impact us in Q2.

Our Medical segment assumptions remain essentially the same as we outlined in August as shown on slide 13. Segment revenue growth may be slightly above the overall market driven by our mix and the accelerated revenue benefit that happened in Q1.

Regarding our overall EPS guidance range, as I mentioned a portion of our performance in Q1 was one timish in nature or a pull forward from future quarters, in particular Q2. Therefore we have readjusted our internal quarterly forecast for the remainder of the year to account for this. Taking into account these issues and given the good core performance we have seen so far we now expect non-GAAP earnings per share to be toward the higher end of our $1.90 to $2.00 guidance range.

As shown on slide 15 our corporate assumptions around tax rate, capital expenditures, and shares outstanding remain essentially the same. We now expect the combination of net interest expense and other to be approximately $120 million for fiscal ’10.

Finally, there are few upcoming events I’d like to highlight. The first is that we’ll be filing our 10-Q in the next few days that will detail our financial results for the quarter. Second, as I mentioned in August, we will be filing recast fiscal ’09 financials in a Form 8-K next week. This will include adjusted financials which reflect the impact of the CareFusion spin-off and will look similar to those included in our August 18 8-K filing.

Finally, I wanted to make you aware of a new format of our income statement. We’ve done some benchmarking and collected feedback from our investors and as a result have made some minor enhancements in an effort to improve clarity and transparency in certain disclosure of the income statement. We hope you find this slight change helpful.

With that I’ll turn it over to George for Q&A.

George Barrett

Now to the operator and we’re ready to take Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Atif Rahim – JP Morgan

Atif Rahim – JP Morgan

As we look at the earnings guidance you provided the run rate for this quarter implies you should be over $2.00 for the year but we recognize there are some items are going to be non-recurring. Could you perhaps quantify by EPS items that won’t be recurring in future quarters to give us a better picture of what the quarterly progression might look like going forward?

Jeff Henderson

I went through a little bit of this during my script but let me try to review some of these again and would be happy if there are any additional follow-up questions. First of all there was a unique acceleration of revenue and profit within Medical. Let me explain that in a little bit more detail. That was worth about $14 million of profit or $0.02 to $0.03.

The way it worked was basically as follows: when we owned both the domestic and international operations of our Medical business we did not recognize revenue or profit on sales until we sold to the end customer. Our domestic business would sell to our international business, our international business would hold those products in inventory and then when they eventually sold to an end customer we recognized that revenue and profit on the consolidated books of the company.

The moment we spun off CareFusion and they took the international business with them effectively they became a third party so any inventory they were holding at that moment of this spin-off effectively got reclassified as a sale of product and that revenue and income got accelerated into the quarter of the spin. As I said, that was worth about $14 million or $0.02 to $0.03 on and EPS basis.

In the Pharma segment as both George and I mentioned there were a number of price increases which individually weren’t significant but collectively represented a pull forward of about $15 million of income which is about $0.03 of earnings from future periods versus our original expectation most of that came from either Q2 or Q3. Again, I would view that as a pull forward from future quarters not necessarily out on the year.

The other unique item in Q1 was the early and strong flu season that impacted mostly within our Medical segment. As we said, that was worth about $5 million or $0.01 of EPS. I assume a follow up question to that would be wouldn’t you expect that to continue through the whole year. The answer is we don’t know. It’s obviously very hard to predict the flu season although we do expect to see continued flu related demand in Q2.

However, I would point out that that demand is dampened somewhat by the fact that we’re on allocation for a number of products from our manufacturers. The ability of that demand has necessarily flowed through as incremental earnings in Q2 and beyond is somewhat dampened. We may see a slight upside to our Q2 as a result. I would also mention that we planned for a flu season in Q2 and Q3 as we typically do. It was really the Q1 piece that was unplanned because of the early and stronger issues we’re facing.

Atif Rahim – JP Morgan

The Medical distribution and the revenue recognition that’s a one time event, you’re not expecting that to recur?

Jeff Henderson

That is correct, yes.

Atif Rahim – JP Morgan

Related to revenue that you lost from the customers, any way you could give us an idea what that’s around?

Jeff Henderson

They were fairly significant in terms of revenue in total we’re talking in excess of $1 billion of lost revenue for those customers which begins to impact us in Q2 and beyond. As George said, the impact on profitability from those same customers is much less significant.

Operator

Your next question comes from Randall Stanicky – Goldman Sachs

Randall Stanicky – Goldman Sachs

You talked about the Medical segment growing slightly above market. Can you remind us what your outlook for market growth there is?

Jeff Henderson

It depends on which market you’re looking at. Typically our expectations for the hospital market are for it to grow in the 2% to 3% range and that’s generally what we’re seeing this year as well. Ambulatory market growing more quickly, lab market growing more quickly driven in part by the flu related demand which disproportionately impact the lab market during times like this. The biggest market is hospital which is 2% to 3%.

Randall Stanicky – Goldman Sachs

Are we thinking just given the strength of the growth this quarter mid-single digit growth rate?

Jeff Henderson

We haven’t given a specific number but I would say ballpark that’s not an unreasonable assumption.

Randall Stanicky – Goldman Sachs

Given all the efforts on the generic sourcing side, I know you’ve got a lot of similar efforts on the sourcing side in the Medical business. Can you talk about as we think about the margins the magnitude of opportunity and then the timing of that opportunity in terms of how it should play through the P&L?

George Barrett

It’s a little bit of a tough question because as you might imagine the sourcing connects to the selling which connects to the flow of products into the system. Net, net we’ve said that during the course of the earlier part of 2010 we have some tradeoffs that are somewhat negative. Fundamentally though this is a driver of growth for us and of margin. I would say we’ll feel this more as the year goes on.

We have to flow these products into the system, as I mentioned in my comments earlier, there’s a transition stage where we have to honor existing commitments. I would say net, net this has gone extremely well, we’re really excited about it, I think its good for our customers and good for our suppliers and feeling very good about that program.

Randall Stanicky – Goldman Sachs

On Medicine Shoppe any change in terms of how you’re thinking about the break even timing for that business?

George Barrett

I still think that we’ll be working throughout 2010 to compensate for some of the lost fees by growing our business with each of those accounts. I think we’re doing a good job and I still think that as we get into 2011 that starts to feel like more of a positive driver for us.

Operator

Your next question comes from John Kreger – William Blair

John Kreger – William Blair

I think you mentioned at the beginning of the call that your generic supplier number had gone down to about 30. Do you expect that to be stable there or do you think you’ll drive it down further?

George Barrett

I think that’s probably about where we belong. Certainly, as you know, there are a relatively smaller number of manufacturers that have the broadest lines and the greatest flow of new products. Clearly those companies tend to be larger I think in the program. This is an enormous product line; you’re talking about several thousands of products. There’s a need to have enough suppliers in there to make sure that we have not only the products but we have backup suppliers as you know there are things that happen now and again in the system and we’ve tried to take care to make sure that we’ve got access to backup suppliers when there’s a disruption.

John Kreger – William Blair

Your latest timing, your thinking on when that will start to benefit the P&L is it the early half of your fiscal ’11?

George Barrett

It’s so hard the benefit to it, as I said; the generic program really is an integrated program. You have the sourcing and procurement part of it and then you have the selling part of it. In fact, one ties to the other. Certainly in the early part of the year we’re feeling a little bit more of the brunt of it. I would say its been modeled into our year. We’re feeling comfortable that it’s been modeled appropriately and I think we’re on track to deliver as we expected.

John Kreger – William Blair

If you look out over the next year for your Pharma business any key sell side customer in renewals that we ought to be thinking about or have the primary ones already been taken care of.

George Barrett

This year’s a relatively calm year as we get to the end of the year into next year; Kmart will come up for renewal and Kroger will probably be two of the larger companies that would come up for renewal.

Operator

Your next question comes from Eric Coldwell – Robert W. Baird

Eric Coldwell – Robert W. Baird

Have you discussed or will you discuss at all what your intensions might be with the CareFusion shares? I know there were some prepared comments on what happens in the P&L and balance sheet, when you decide to take some gains on that. Stock has been very strong, they just announced upside this morning. I’m curious whether that might spike some interest to take some money off the table.

Jeff Henderson

No, I haven’t commented on that. Let me tell you our current expectations. First of all, let me reiterate that in order to maintain the tax-free nature of this spin we are committed to divest our remaining ownership in CareFusion no later then the fifth anniversary of the transaction. However, our current expectation is that we’ll start our process of selling CareFusion shares over time within the next year or two including through Rule 144 sales. Those sales could actually commence as early as this quarter depending on market conditions and other factors. As we indicated, the onset of the spin we intend to do so in an orderly and responsible manner.

Eric Coldwell – Robert W. Baird

You’ve done a good job in Nuclear no doubt about it, very strong profit growth. I’m hoping you can give a little more detail on what’s the primary driver of the profit expansion in a period where I should hope supply is obviously challenged. Also, what happens in January if in fact the supply does not come back fully online, how should we think about the model impact and how you would respond to that?

Jeff Henderson

First of all I want to send out some kudos to the nuclear team who’s doing an outstanding job of managing through these supply situations. I will point out that we’ve been through these situations many times in the past and we have very specific procedures that we follow in order to maximize usage of the supply that we get and also manage the customer demand in such a way that we can allocate supply in a more orderly way when we have these supply shortages.

Despite that, as I said, we experienced some very strong growth and margin expansion and that’s really due to the impact of the generic event that happened last year together with the fact that we are now able to offer three different options for customers in terms of the raw materials going into the imaging agents and by offering that suite of products by pricing them appropriately and putting in place and effective selling and sourcing strategy we’ve really been able to expand margins over the past year and we expect to continue that trend going forward assuming that we don’t hit some additional snags from a supply standpoint.

I will point out that, as I said, the expectation is the Canadian Chalk River reactor will come onboard in January. If it doesn’t another wildcard will be what happens to the reactor in the Netherlands which is scheduled for maintenance in Q3. They are both down. That obviously would put a very significant crimp in the supply for the entire industry. If that’s the case and if we suffer the dual losses of supply in the second half of the year that potentially is a $0.03 to $0.04 downside for us for the second half of the year.

Operator

Your next question comes from Larry Marsh – Barclays Capital

Larry Marsh – Barclays Capital

On pricing you talked about $0.03 to $0.04 pull forward for manufacturers this quarter so think about that coming out of Q2, a little bit Q3. Could you reconcile the comments there to the structure fee for service relationships under those you don’t really have to think about when pricing occurs? Net, net for fiscal ’10 do you think pricing is a net positive relative to your earlier expectations given what you’re seeing so far?

Jeff Henderson

With the transition of Pfizer to a more typical fee for service arrangement we now see about 80% of our business being on a fee for service arrangement which obviously is a significant portion of our branded margin. That all said, there’s still that remaining 20% that’s subject to the variability of price increases. In any given quarter that 20% can have a significant influence on earnings and EPS which is why we still get some of these somewhat unusual timing issues or one time evens in the quarter. There are still a number of larger manufacturers but then a number of very small manufacturers that remain under the old model that can impact a particular quarter.

Regarding our overall views on branded price increases for the year, I would say at this point we still expect it to be largely in line with original plans for the year. It was slightly higher in Q1, as we said, by about $15 million then we expected. At this point we have no reason to believe that’s no simply a pull forward for the year. No material change for the overall year.

Larry Marsh – Barclays Capital

We’ve talk about a strategy there narrowing the manufacturers and you communicate that here today. Does the progress of your program of costs this year versus benefits next year are you more confident in that end result and do we think of Cardinal as being a bit differentiated versus the competitors here or more like its competitors. Is there an opportunity on some of the generic injectibles hitting the market, I know some of your competitors have talked about generic Eloxatin given their channels. Do you see that as an opportunity given your knowledge of the generics space?

George Barrett

The generic program transition for us has gone extremely well. Our team executed well, our generic partners have been really open to looking at new ways of doing business and we’re really pleased with the way its going. I would say I’m feeling very confident that the work that we’ve done has set us in a good place as it relates to creating value for our customers downstream and for our vendors upstream. I’m really feeling good about it, I think we’re on track to do exactly what we intend to do with that program.

As it relates to Eloxatin it certainly is a product that we are always excited to have a generic launch. It may be bigger for one company versus another depending on mix of downstream customers. For example, if you have a large oncology business it may be a more meaningful launch for you and less if oncology is a smaller piece. For us, oncology is not an enormous part of our business today so we’re glad to have the launch but I wouldn’t necessarily describe it as a huge mover of the dial.

You asked about the generic program and whether or not we were differentiated. I think the way to answer that is this; we have taken great pains to think about every one of our products and every one of the suppliers and what their strategies are and what they’re looking for in a distribution partner. My hope is that we’ve done that very effectively, I think we have. To that extent I think we’re very well positioned to compete in generics.

Larry Marsh – Barclays Capital

You mentioned CareFusion sales would be subject to capital gains. Do you have an idea what your cost basis is in CareFusion?

Jeff Henderson

It’s still something that’s being finalized because there are somewhat complex valuations that have to be done before we can come up with a final number. Our best estimate at this point is that our initial stake on a tax basis will be worth at least $820 million.

Larry Marsh – Barclays Capital

Roughly per share in terms of what you’re thinking is that $4.00 or $5.00?

Jeff Henderson

We’ll check and get back to you on that.

I do what to point out, as I said earlier, that we would be subject to gains or losses on any sale of those shares. Although whether we end up actually paying cash taxes or not will depend on any capital losses that are available at the time to offset that gain.

Operator

Your next question comes from Ross Muken – Deutsche Bank

Ross Muken – Deutsche Bank

Now that we’ve gone through the whole process and the work forces have been split and we’ve got the new Cardinal Health fully operating, what’s been the response from the work force? Have you seen anything different in terms of productivity, are there any specific things you’re measuring to see if you’re getting some of that benefit of the split on the new focus of the employee base? I’m trying to get a sense for what’s changed in terms of life at Cardinal.

George Barrett

Actually we feel great about the way our organization is responding to the spin-off. In some ways an event like this is a catalytic event. It’s really enabled us to recharge the organization to reaffirm our focus on improving the cost effectiveness in healthcare and help people understand how they play a part in that. I would say the organization is excited. We do a pretty routine measurement of our organization and we call it the voice of employee and what we’re looking at is engagement and we measure this in many ways.

If you look at our numbers today versus where they were a year ago there’s a dramatic improvement. It tell us our employees feel good about who we are, what our mission is, where we’re going, and what their role is. We’re seeing that in the daily performance of the organization. I would say anecdotally I’m very excited about what I’m seeing in terms of the attitude of our employees in terms of metrics. The data suggest pretty consistently that our organization is excited, focused, clear about priorities and performing at a high standard right now and I’m very pleased about it.

Operator

Your next question comes from Colleen Lang – Lazard Capital

Colleen Lang – Lazard Capital

Did you say the bulk margins were three basis points and that was negatively impacted by about 15 bps of unusual items?

Jeff Henderson

That’s in fact exactly what I said.

Colleen Lang – Lazard Capital

What’s your expectation for bulk margins for the year?

Jeff Henderson

We generally don’t give a forecast for specific parts of the business. I think the indication I gave regarding some of the abnormal events probably helps you get a little bit closer to what we would expect the full year rate.

Colleen Lang – Lazard Capital

Last quarter you talked a little bit about the opportunity for improved pricing through better governance and improving how you bundle service. Could you give us an update there?

George Barrett

This is obviously not a one time event this is really a thoughtful rethinking about our portfolio and the way we price our portfolio. As we mentioned on the call, we’re trying to take a very disciplined approach to analyzing our business and our customers. While I can’t say its something with a beginning point and an ending point it is really an ongoing process. I feel very good that the organization is built the tools to do this kind of work. We’re doing things that we need to do and force our own standards about pricing and how to analyze pricing; I’m feeling like we’re moving the right direction there.

Colleen Lang – Lazard Capital

We saw you guys have a new product for mail customers to help improve efficiency I think it’s called Easy Cart. Any color on that product and any other types of initiatives that you’re doing to help your customers?

George Barrett

This is an example; I won’t go into great detail, listening to the customers what their unique needs are. Each of our customer segments has very distinct needs and even within segments that we typically hear discussed in the public forum there are distinct needs customer by customer. Part of what we need to do as an organization is focus our business on the unique needs of each customer. In this particular case it was about better efficiency and stocking, particularly unique to the mail order segment. I think we’re doing a good job of listening and translating the listening into inventive ways to help customers compete and create value for them.

Operator

Your next question comes from Steven Valiquette – UBS

Steven Valiquette – UBS

My question was also on the branded drug price inflation fee for service which you touched on, trying to better understand this. Was this product where you were specifically loading up on inventory ahead of the price increases or was it just natural inflation on a normalized level of inventory that you were holding that it was material enough to move the deal? I’m still not sure mechanically how you know at this stage that this is a pull forward from future quarters, how do you know there won’t be more price increases from these manufacturers either on these products or different bundle of products?

Jeff Henderson

Larry let me go back to your question, the $820 million of tax basis that we had CareFusion works out to about a little under $19.50 per share.

Regarding your questions on the branded price increases, it was the latter of the two scenarios you described. We did not take on additional inventory in order to achieve the benefits of these price increases. Just natural price increases that the vendors took that we were able to realize the benefit of from our inventory levels. In fact, as I mentioned earlier, our days of inventory were rationally down three days year on year really reflecting some of the great efforts going on the Pharma distribution group to bring down our days of inventory and maximize cash flow.

Regarding your second question how we know for sure this is a pull ahead. I think the reality is we don’t. We make certain assumptions regarding the timing and amount of price increases from vendors based on historical patterns and once we see price increases we have to make judgments whether we think those are pull forwards or not. You question is a fair one; it could very well be that we’ll see price increases again later in the year and obviously that would be an upside if that occurred.

Operator

Your next question comes from Chris Smith – Sanford Bernstein

Chris Smith – Sanford Bernstein

Turning back to the generics program what percentage of customers are now buying generics from Cardinal?

George Barrett

I think the overwhelming percentage of our customers are buying generics from us, we’re talking about the Pharmaceutical segment. The overwhelming percentage of our customers buy generics from us in some form. That comes in different way. As you know, some of those customers are buying exclusively or semi-exclusively off our generic program. There are others for whom we are essentially serve as a prime vendor based on their contracts. In terms of number of customers the overwhelming majority of our customers buy generics from us in some form.

Chris Smith – Sanford Bernstein

Have you seen an increase in the amount of generics or the amount that they’re relying on Cardinal?

George Barrett

We are seeing, this is something you’ve probably heard me talk about in recent months, whether or you use the word penetration or compliance what we’re looking for is for our customers to buy certainly as much of their generics from us as possible. We are seeing sequential growth in the percentage of customer generic business that we’re getting and we’re very pleased about that we’ve been working hard at that and I think its an important driver for us.

Chris Smith – Sanford Bernstein

On the supply side with consolidation and also supply constraints in generics have you seen a stabilization of pricing or perhaps even increases in generic pricing?

George Barrett

It’s been episodic and certainly event driven. There have been some disruptions in supply really over the last year at various times. Those disruptions can cause volatility in demand but also a little bit in pricing. With some products prices have gone up or are quite stable and others look like a traditional competitive market. I would say the way to think of this is primarily event driven; it’s hard to give systemic trend as opposed to unique distinct items.

Chris Smith – Sanford Bernstein

Curious if you have an update regarding the level of negative synergies expected from the CareFusion spin relative to what was provided in June?

Jeff Henderson

No real update other then what we said over the past couple of months is that our intent has been and will continue to be to more then offset any negative synergies that result from the spin. In fact, we’re doing just that, our plans for the year were to more then offset those to reductions in our infrastructure and particularly holding down headcount and infrastructure within our corporate functions, we’ve achieved that as you can see by the 1% reduction in SG&A in the first quarter, we’ve been quite successful in doing it. I feel very good about our ability to offset those going forward.

Operator

Your next question comes from Blake Goodner - Bridger Capital

Blake Goodner - Bridger Capital

I know you tried to address this earlier I just want to make sure I understood it. On the non-bulk side it sounded like you had good performance up nine basis points, it sounds like if anything that’s a little ahead of your plan. On the bulk side the three basis points; can you again walk through the reasons why that was so far below the 20 bp target for the year?

Jeff Henderson

Q1 is always our lowest margin rate quarter of the year due to the somewhat seasonal nature of our business and when branded price increases happen which tend to be in the late Q2, Q3, Q4 periods. Historically Q1 is always our lowest margin period. Secondly, there were a few somewhat unique events, let me give you a couple examples.

We were subject to an excise tax in the State of Delaware that relates to the shipment that we make into Delaware to one of our mail order customers, this relates to a long standing dispute over the applicability of those excise taxes to our shipments into Delaware. As a result of a recent court ruling we decided to accrue for about $10 million of potential historical expenses related to these excise taxes because all mail order business appears in bulk that $10 million very disproportionately impacted our bulk margin.

Secondly, this is a little bit more complicated to explain. Depending on the exact vendors increase branded prices in any particular quarter they can disproportionately hit non-bulk or bulk. Again I won’t go into all the nuances and complexities of why that may be but it relates to the amount of inventory that we carry in those two businesses. As a result of the particular price increases we saw in Q1 the year on year comparison for bulk tend to be a little bit distorted. That’s really what makes up the difference in Q1 versus what we expect the full year rate to be.

Blake Goodner - Bridger Capital

My second question relates to free cash flow which the performance looked pretty good in the quarter. Any sense for more color on how you expect free cash flow to trend throughout the year. This quarter it would seem like you’re tracking towards around $850 million of free cash after CapEx. Any general color there that’ll come in versus your targets?

Jeff Henderson

We haven’t given specific guidance around cash flow projections for the year other then the last call I did say that we would expect operating cash flow for the year to be under $1 billion and I would say that’s still very much our expectation. Whatever operating cash flow does in for the year a substantial amount of that is already committed either through our capital expenditures which we expect to be $250 million for the year a bulk of that going into our IT systems improvements.

Then we have our dividend program and as you know we increased our dividend last quarter. Then the share repo that we’re doing which related to the offset of any equity over the year. A substantial portion of that operating cash flow is already spoken for. I think that’s pretty much the guidance we provide at this point.

Operator

Your next question comes from [Jaron] – Citi

[Jaron] – Citi

Last investor day you provided this slide with the major headwinds and tailwinds and I know you went through many of them. There are some that didn’t hear, apologies if we missed it. Can you update us on the rest of the headwinds and tailwinds; I don’t think I heard on some of the transformational investments, for example?

George Barrett

I think we’ve covered a good many but perhaps somebody didn’t provide enough clarify on. Certainly we talked about the year over year which the largest swing is the systemic swing which is the year over year generic comps for us and those and playing out pretty much as we expected. No particular change there, we’ve got relatively good visibility on that. We talked a little bit about the Medicine Shoppe transition and I would say that transition again continues to move forward and we’re feeling quite good that that’s the right strategic direction for us.

The Pfizer DSA switch is at this point something that comes in the future and we fully expect it’ll play out as expected. We have continued to invest in our Medical transformation, this is integral to our strategy for Medical business and really so important in terms of our ability to take advantage of what we think is a unique business model in which we have this tremendous channel footprint as well as the vertical capability. The Medical transformation is a very important initiative it’s ongoing, I mentioned that.

I’m trying to think what other drivers we did not touch. I think those really are the biggest ones. Hopefully that gives you some clarity.

Operator

Your next question comes from Dana Hambly – Jefferies & Co.

Dana Hambly – Jefferies & Co.

The inventory days is 23 days the right way to think about it now, is that a good run rate or is there something maybe timing that would have impacted that positively this quarter?

Jeff Henderson

I wouldn’t describe it as a timing issue. Our inventory days can fluctuate a little bit depending on the particular quarter that we’re in which is why I think always the year on year comparison is the best comparison versus a sequential. I think the three day reduction from last year is a pretty firm number. Do I think there’s additional opportunity over the coming years to bring that down some more? Yes I think to make a day or two improvement over the next couple years it’s still very much within our objectives and we have plans in place to go after that. I think the number you saw is indicative of some very solid work, there were no particular flukes of timing in there.

Dana Hambly – Jefferies & Co.

On the Medical segment a competitor called out a significant supplier price decrease is benefiting them in the quarter. Did you see anything similar?

Jeff Henderson

I just want to point out the difference between how our competitor accounts for their inventory versus us. My understanding they use the LIFO inventory method which means they will have potentially have LIFO credits or debits at the end of each quarter depending on supplier price changes during that quarter. Although we use the LIFO accounting method within our Pharma business, within our Medical business we actually use FIFO so we are not subject to the same credit or debit adjustments at the end of each quarter depending on supplier price changes.

Operator

At this time we have no further questions. I will turn the call over to Mr. George Barrett for closing remarks.

George Barrett

I’d like to conclude the call by saying we’re really pleased with our start to the year. We’d like to thank you for your time today. Our IR team, Jeff, and I will be available for questions and we look forward to speaking with you again soon.

Operator

(Operator Instructions) This concludes our conference for today. Thank you all for your participation. Have a nice day. All parties may now disconnect.

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