Omnicare, Inc. Q3 2009 Earnings Call Transcript

Omnicare, Inc. (OCR)

Q3 2009 Earnings Call Transcript

November 5, 2008, 11:00 am ET

Executives

Cheryl Hodges – SVP, IR

Joel Gemunder – President & CEO

Dave Froesel – SVP & CFO

Analysts

Anton [ph] – RBC Capital

Brendan Strong – Barclays Capital

A.J. Rice – Soleil Securities

Jason Gurda – Leerink Swann

Asif [ph] – JPMorgan

Steven Valiquette – UBS

Alan Fishman – Thomas Weisel Partners

Presentation

Operator

Good morning. My name is Carey, and I will be your conference operator today. At this time, I would like to welcome everyone to the third quarter 2009 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks there will be a question-and-answer session. (Operator instructions) Thank you. Ms. Hodges, you may begin your conference.

Cheryl Hodges

Thank you, Carey, and good morning, everyone. Welcome to Omnicare's third quarter 2009 earnings conference call. Here today from Omnicare are Joel Gemunder, President and CEO; Dave Froesel, Senior Vice President and Chief Financial Officer; and myself, Cheryl Hodges, Senior Vice President, Investor Relations.

Before we begin, let me remind you that as we conduct this call various remarks that we make concerning our expectations, predictions, plans and prospects, constitute forward-looking statements as a result of a variety of factors including those identified in this morning's news release and in our various filings with the SEC. You are also cautioned that any forward-looking statements reflect management's current views only, and that the Company undertakes no obligation to revise or update such statements, or to make additional forward looking statements in the future.

For simplicity sake and to focus on what we believe are the best indicators of our operating performance, we will discuss results from continuing operations and will also exclude the effects of certain accounting changes and special items for all periods in our discussion today.

A reconciliation of this non-GAAP information has been attached to our press release and is also available on our website.

Before I turn the call over Joel, I just like to point out that we’ve made a slight change to the format for this earnings call. In order to make our call more efficient for you, we are going to focus our prepared remarks on what drove our performance and our thoughts about the industry with the assumption that you can easily find information such as quarterly comparisons and the like in our press release on our website and in our 10-Q, which we have also filed today.

With that, let me turn the call over to Joel.

Joel Gemunder

Well, thank you, Cheryl, and good morning, everyone. Thanks for joining us today to discuss our results for the third quarter 2009. And we are pleased to report that third quarter earnings before favorable tax adjusted met Street consensus expectation. And we also generated exceptionally strong cash flow. This quarter’s performance is a reflection of the continued execution of our strategic initiatives and our ability to capitalize on the significant scale advantages we posses in the market. There were a number of factors that characterized the quarter including sequential and year-over-year net bed growth; certain favorable trends in the pharmaceutical marketplace; continued robust growth in our specialty pharmacy business; and favorable performance in the hospice pharmacy. Then a sizable ramp-up in savings from the Omnicare Full Potential Plan and further strategic sourcing savings from non-drug expenditures.

Sales for the third quarter of 2009 of $1.54 billion were higher sequentially, but modestly lower on a year-over-year basis. And while gross margin of 23.8% for the third quarter was also lower as compared to the year-earlier period, this was mostly offset by a sizable reduction in SG&A, which contributed approximately 140 basis points to operating margins compared to the prior year, I should say compared with the prior year.

This brought our operating profit for the third quarter 2009 to approximately $143 million or 9.2% of revenues. And as I mentioned earlier, aside from a favorable income tax item of $19 million, or $0.16 per share, our adjusted earnings per share were in line with Company guidance and Street consensus.

Now, with respect to our Pharmacy Services segment, sales of $1.5 billion were also up sequentially, and modestly lower year-over-year. We saw revenues per bed of $1,087 for the quarter follow the same pattern. And we continue to see robust drug price inflation during the quarter in the neighborhood of 7% annualized. We also saw a continuation of the trends in the nursing home market toward the use of higher acuity drugs such as hydrocele [ph], biologic drugs such as Copaxone and branded drugs with new indication such as (inaudible).

While these trends benefited our sales performance during the period, it was in part offset by the growing utilization of generics. In fact, our generic dispensing rate for the third quarter of 2009 reached 73.4%, a 280 basis points increase year-over-year. During the third quarter specifically, a modest number of drugs relevant to our business came off patent, including Casodex [ph], Frograb [ph], Rasodine liquid [ph], and the Canopres [ph] patch. So, clearly, year-over-year growth in our dispensing rate reflects the enormity of generic launches over that period.

Now, while generic drugs may reduce sales, they typically generate profitability greater than the branded counterparts throughout their life cycle. Even following the implementation of MACs and FULs. And reimbursement for generics generally declines after MACs and FULs are instituted. And as we discussed last quarter, there and FULs and MACs that has been recently instituted on certain important generic drugs, which were launched in prior period and that unfavorably impacted sales and margins when compared sequentially and on a year-over-year basis.

I can report, however, that we have had, that we have had two additional FUL cover since our last earnings call and neither is expected to have a material impact on our business.

We continue to make progress during the quarter in the execution of our sales and service strategies as reflected in yet another quarter of sequential net bed growth, and importantly the first year-over-year increase in net beds served in some time. And during the quarter, we added approximately 5,000 net beds to end September at 1,389,000 beds served and this compares favorably with both the 1,384,000 beds served at the end of June 2009, and the ,1387,000 beds served at the end of September of 2008.

Customer retention continued at a strong rate with a 36% reduction in bed losses on a year-over-year basis. Moreover, our retention rate expanded 370 basis points on a year-over-year basis to 93.4% and importantly, as adjusted for beds voluntarily foregone, it was 95.1%, up 260 basis points year-over-year. And this was achieved in an environment where we are changing our business model. So clearly our strategy to enhance service levels, customer service, and retention, are working.

And while this reflects the effects of our entire organization, our specialized customer retention team has made a substantial difference in improving our retention rate. This quarter alone they saved approximately 18,000 beds, which equates to 1.3% of total beds saved and represents nearly $100 million in revenues saved and it also represents the team’s highest quarterly contribution since its inception in December of 2006 over which time our retention rate has improved more than 500 basis points.

New contract signing by our sales force also remained solid during the quarter with a 12% increase in new beds signed versus the third quarter of 2008. On a year-to-date basis, even with our operating personnel highly focused on implementing our new hub-and-spoke business model, our new contract signings, excluding national accounts are up a healthy 16%.

We completed two acquisitions during the quarter, bringing our year-to-date total to six and these acquisitions are immediately and highly accretive given our scale and remain an important part of our growth strategy.

Now, with respect to our Full Potential Plan, in line with our objectives, we made a considerable ramp-up in the third quarter and achievable incremental savings of $8 million or $0.04 per share and this means we are now at an annualized run rate of approximately $78 million, up from $46 million in the second quarter of 2009. So, this reflects increases in productivity and reductions in labor cost, occurring largely in cost of sales this quarter and to a lesser extent SG&A as we move forward in the implementation of our hub and spoke operating model.

And we are also pleased with the progress of our drug purchasing team, which continues to execute effective drug sourcing strategies to lower our cost for both branded and generic drugs and with respect to the purchasing of non-drug items we remain keenly focused on utilizing the sheer size of our operations to further improve our sourcing efficiencies. This group performed well during the quarter and we now expect to exceed our goal of $25 million in annualized negotiated savings in 2009.

Our specialty pharmacy business continues to represent significant growth opportunities for Omnicare as evidenced by the performance of Advanced Care Scripts or as ACS as we call it, during the quarter. During the quarter, ACS generated sales that now annualize at $429 million, up 81% from an annualized $237 million in sales when we acquired in July of last year. Its return on capital is very high and this has proven to be an outstanding acquisition.

During the quarter, our hospice pharmacy business generated a 23% year-over-year increase in operating profit on a relatively modest increase in sales, reflecting operating efficiencies achieved over the past year.

So, all in all, we have been able to mitigate the spate of MACs and FULs occurring in the past 12 months as our Pharmacy Services business model has produced operating margins that are not only modestly lower than those of the prior year and prior quarter, more importantly, however, our pharmacy operating margins of 10.9% are 100 basis points higher than in the second quarter of 2008 prior to the major generic launches of the last 12 months, including Risperdal, Kapro [ph], Lamictal, and Solvan [ph].

Now, turning to our CRO business, like others in the industry, we continue to experience a difficult environment with sales and operating profits both lower sequentially and on a year over year basis. Our backlog stood at $236 million and our book-to-bill ratio was 0.8 to one in line with others in the industry. Now that said, we have taken a number of actions to right-size and reposition the business given its current revenue level and accordingly we believe that we will see an uptick in profitability here in the fourth quarter.

Importantly, we made a major management change during the quarter and appointed a new CEO Dr. James M. Pusey to lead the operation. And while it is difficult to call a turn in this environment, we are encouraged by the high energy leadership Dr. Pusey brings, which we believe will broaden the vista of this business and improve top line performance. And I anticipate we will become much more focused on our strategic orientation in this market. We are going to take a more aggressive approach to fully utilize and leverage our competencies in the geriatric specialty drug and informatics market to differentiate us in the CRO space.

And now, before I turn the call over to Dave for the last time, I want to recognize publicly the outstanding commitment he has demonstrated during the past 13 years as our Chief Financial Officer. Dave has been an integral part of the team that’s helped us grow from a $640 million Company to a $6.2 billion Company today. On behalf of all of us at Omnicare, we want to thank you, Dave, for your many contributions and wish you all the best on your retirement. And with that, I will turn the call over to you, for your final say.

Dave Froesel

Okay, thanks Joel. It’s been an honor to work at Omnicare and to contribute to the tremendous growth this Company has experienced. We have a great team here and I am very proud of what has been accomplished during my tenure. I’d also like to thank everyone on the call. It has been a pleasure to work with and get to know many of you.

As Joel mentioned, in terms of cash flow, the third quarter of 2009 was once again very strong. The $169 million we generated was our highest quarterly cash flow output to-date in 2009 and the third highest in our history. I’d also like to point out that this represented 283% of our GAAP net income before the tax adjustment.

We consistently exceed 100% of our earnings in cash flow and that’s not unusual for us. So, for the first nine months of 2009, we generated approximately $431 million in operating cash flow, and this along with our expectations for the fourth quarter leads us to raise our operating cash flow guidance for the full year 2009 to $500 million to $550 million, up from the $475 million to $525 million we projected earlier this year. Our guidance excludes one-time litigation payments.

Looking at working capital, our net receivables balance at September 30^th, 2009, was down about $96 million from the same quarter of 2008 and nearly $23 million sequentially. Similarly, our DSOs of 75 days in the third quarter of 2009 were lower by approximately three days compared with the 2008 third quarter and were also lower by nearly three days sequentially. Moreover, excluding the past due receivables associated with our previously disclosed customer litigation, our DSO of 69 days in the third quarter of 2009 marched [ph] our return to a level not seen since 2004 well before the implementation of Medicare Part D. This reflects the progress we have made, particularly, since 2006 in retooling our operating and billing processes to confirm to an entirely different and more complex reimbursement structure.

And with respect to Part D, this program represented 39.1% of our payor mix during the third quarter of 2009. The remaining composition of our payor mix during the quarter was Medicaid at 9.3%, private pay, third-party, and facilities at 47.4, and 4.2% other.

Our bad expense in the third quarter of $23.1 million declined 15% from the same period last year. As a percent of sales, bad debt expense was lower by approximately 20 basis points year-over-year and relatively flat sequentially at 1.5% of sales. The year-over-year improvement reflects greater efficiencies in our billing and collection processes, largely as a result of our hub and spoke operating model and greater focus on collection.

Our inventories for the third quarter were approximately 17% lower on a year-over-year basis and modestly higher sequentially to $346 million. Moreover, since the end of June, our days on hand are lower by nearly three days to 27 days. And, compared to the same period last year, our days on hand are lower by five days. This improvement reflects largely inventory management developments, ongoing efficiencies created by our hub and spoke operating model, and the shift toward lower-cost generic drugs.

Given these substantial improvements in working capital, our adjusted return on committed capital exceeded 42% or roughly 1,290 basis points above where it stood for the comparable year-earlier period.

With respect to uses of cash, we funded approximately $21 million for acquisitions, including deferred payments from prior-period acquisitions, which was $10 million higher sequentially, but significantly lower than the 2008 third quarter, which included our acquisition of Advanced Care Scripts.

Capital expenditures for the third quarter of 2009 were about $11 million, down approximately $7 million year-over-year, but up $4 million sequentially. The large year-over-year decline reflects the reduced level of capital expenditures attributable to our Full Potential Plan as most of the investments related to this initiative have already been made. Our previous forecast for 2009 CapEx was $40 million. We are now able to lower our forecast by $5 million to approximately $35 million for the year.

We also utilized our cash flow during the quarter to pay down another $75 million on our Term A loan, reducing our total Term A debt by $225 million in the first nine months of this year. we now have only $175 million remaining on our Term A loan that is due next July, with no borrowings on our revolver. And even after paying down debt we ended the quarter with a cash balance of $327 million, which was $51 million higher than our June 30^th, 2009 cash balance.

Our total debt to total capital ratio at the end of the third quarter improved 390 basis points to 36.1% from 40% at the end of the prior year quarter, reflecting our ongoing deleveraging. And on a net debt basis, this ratio would be 32.3% for the third quarter of 2009.

So, to summarize, our earnings performance coupled with significant improvements in working capital management allowed us to continue to invest in attractive growth opportunities while also further strengthening our financial position.

So, with that, I will turn it back over to Joel for his concluding remarks.

Joel Gemunder

Well, thank you, Dave, a better relief to be done with all of this. Now, I’d like to close with just a few comments on the prospective performance of the business. As all of you know, healthcare reform is still front and center in Washington, it’s a dynamic environment, and one which we believe will continue to evolve for some time. We are keeping a steady eye on the various proposals before congress and are monitoring the situation closely. Our Company and our industry are very active in Washington and are working very hard to make sure that the regulators and legislators alike understand the specials needs of the frail elderly in our country and the economics of meeting those needs.

Turning now to the more immediate future, you have likely read in our press release that we have tightened the range of our 2009 earnings guidance to $2.50 to $2.52 per diluted share as adjusted to exclude special items and accounting changes. Incremental to this is the favorable income tax item that benefited our third quarter results by $0.16 and we anticipate there will be an addition of approximately $0.10 in the fourth quarter. Our previous guidance excluded any effects of the September 26 rollback in average wholesale prices arising from the First DataBank-Medi-Span settlements.

Our new guidance simply incorporates the financial implications of this event and demonstrates that we have made a significant progress with our payors in restructuring pricing methodologies to mitigate the impact on our business. While we do expect some impact on our fourth quarter results, say, of roughly around $0.02 a share, we are simply adjusting the top end of our range to reflect this impact of the AWP rollback and in short we remain comfortable with the Street consensus of 2009.

And while we are not in a position today to provide specific guidance for 2010, I would like to comment on some of the drivers of our performance next year. In terms of certain pharmaceutical marketplace trends, we expect drug price inflation will continue in the mid-to-high single digits at least into 2010. We also expect the trend towards use of higher acuity and biological drugs to continue to move forward in the long-term care environment.

We anticipate additional generic launches relevant to the geriatric market, although we do not expect any blockbuster generic launches until the very end of the year. We expect the regularity of FULs and MACs to continue, but keep in mind that most of our significant generic drugs have already been impacted.

Regarding the reimbursement matters, with respect to the AWP rollback, we expect a continuing impact in 2010. We have maintained economic neutrality with the overwhelming majority of our payors, but state Medicaid departments have been slower to consider compensating changes in pricing methodologies, many of which require legislative action. And most state legislatures will not reconvene until January of 2010. State and national pharmacy associations are expected to lobby heavily for compensating changes and state reimbursement formulas.

Now, with respect to our Part D relationships, with most of our contracting for 2010 complete, we expect a relatively quite year in terms of the impact from contract renegotiations and the reassignment of dual eligibles.

We also believe we’ll continue to make progress in a number of operational areas. Top line growth will be a major focus. We believe we’ll be even more focused on this objective after having completed most of the heavy-lifting of our Full Potential Plan by year-end 2009. We plan to continue executing on our bed growth and customer development strategies as well as broadening the addressable market for our services.

Another of our key objective is the continued reduction in operating expenses, and as you know we expect to end 2009 with annualized run rate at the low end of our $100 million to $120 million. We have ramped up this Full Potential Savings Plan run rate throughout the year, which should result in lower year-over-year cost in 2010. Now, as we and I should add – let me say that – we see the opportunity for further savings as the Full Potential Plan matures next year.

Moreover, we have identified a number of new cost reduction initiatives for 2010 in both our purchasing of pharmaceuticals and in our strategic sourcing program. We also see continued growth opportunities in our specialty pharmacy and hospice pharmacy business. And while it is too soon to pinpoint a turnaround and restoration of top line growth in our CRO business, we believe that drug development is the life blood of both pharma and biotech companies, and outstanding services will be important as business models now require greater flexibility in their expense structures.

We will provide 2010 guidance in our – in conjunction with our fourth quarter conference call. And now we’d be happy to take your questions.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from Frank Morgan with RBC Capital.

Anton – RBC Capital

Yes, good morning it’s Anton [ph] for Frank. Wanted to discuss the bed growth you saw sequentially and year-over-year. Did you break out how much of that was organic versus acquired?

Joel Gemunder

We don’t – we have never broken that out and I just don’t have those numbers in spite here to give to you. We look at our growth – we don’t really distinguish between organic and acquired growth because acquisitions are part of our business model as they are highly accretive and grow along with the rest of our business. It’s important to note, I think, that we use internally generated cash to do this. And it’s almost a make or buy kind of decision. The returns we get in acquisitions some time exceed that which we can obtain on de novo growth because simply because we get the growth upfront immediate and faster. So, it is a joint model. We have been doing this now for say the 20 years or so that we’ve been, more than 20 years that we have been in the long-term care pharmacy business and that – and it’s part of our model. And we don’t see any need to break that up.

Anton – RBC Capital

Fair enough. Can you talk then about the acquisition environment, anything that’s changed over the past 12 to 18 months?

Joel Gemunder

I think we are finding that the market is stable. I would expect to some of the smaller companies next year as the – some of these issues bite in to increase the number of companies which are willing to consider a sale. This always happens in a period of change. People tend to ride waves of business, but when they come to a fork in the road, many of them decide to call it quits. And so change brings us increased acquisition opportunities.

Anton – RBC Capital

Okay. And can you update us on kind of where you are with regard to pruning the voluntarily foregone contracts and beds?

Joel Gemunder

Well, I think the best way to look at that is to look at what our retention rates are and our losses are now running at 36% better than they were a year – that means we are experiencing 36% fewer losses. I don’t think you ever get to the absolute and of some business we want to walk away from because changes occur in the nature of the – some of those clients. They have new management; they have other issues that affect their attractiveness to us from time to time. so, I don’t think we’ll ever completely get away from that, but I do think those numbers are becoming to decline. If you look at how many homes that we’ve walked away from in the past two years, I think you’ll see that for example in the most recent quarter I think we mentioned 5,500 beds that we waked away from, which is fewer – that number of beds that we’ve walked away from in prior quarters.

Anton – RBC Capital

So, I mean we should expect to see it continue to decrease with sort of excluding any major bumps?

Joel Gemunder

I think that it’s one of the things that harder to predict because we are not predicting what we are going to do. We are predicting our reaction to what happens to others. If – and I really couldn’t say, but I know in general we have dealt with a large number of the facilities we’ve found to be marginally profitable, to have been bad payors, and so on, and we are divesting ourselves from those accounts. And the total pool of those accounts that we see today is smaller, quite a bit smaller than it was in the past.

Anton – RBC Capital

Okay, thanks Joel.

Joel Gemunder

Right.

Operator

Your next question comes from Brendan Strong with Barclays Capital.

Brendan Strong – Barclays Capital

Hey, good morning, thanks for the taking the questions here. Maybe first, Joel, I really appreciated the comment at the end there on the generics versus the FULs and it sounds like we are in a period here for the next, call it three or four quarter where there is some stability there is not a lot benefit from new generics, but not a lot of negative impact from things heading FUL. I just want to make sure I am understanding that properly.

Joel Gemunder

Well, you’ve raised an excellent thought, I think. Your comment is very well taken. I think in October of last year, we had an investor day in which we said that we believe that the five-year movement of brands to generics would generate an incremental earnings for the Company of between $175 million to $200 million and after we saw the increased spate of FULs and MACs coming down, we took another look at those numbers and our conclusion was and are now to show the number is still at $175 million. So, that would add weight to the comment you just made.

Brendan Strong – Barclays Capital

Okay. And then in terms of like the next major drug, I mean are we really looking forward to Aricept in November of 2010 or is there something that might hit sooner than that?

Joel Gemunder

Well, certainly I think Dan Maloney is our expert in that area. I think we will see Aricept towards the end of this year, possibly – say again – next year. And there is always rumor that float that one drug or another will get out in front of the line on becoming available generically, but we have nothing that we care to report on it at the moment. So I think it’s going to be kind of a stable year this year until the very end of the year.

Brendan Strong – Barclays Capital

Okay, and then just last question some of the cost reduction initiatives. Based on your comments it sounds like we are looking at so $100 million in annualized savings by the end of this year from Full Potential, but probably maybe $65 million of that actually achieved in 2009, so maybe another $35 million additional incremental benefit in 2010 and plus maybe some additional savings that are incremental expected?

Joel Gemunder

I am not sure what – where you had calculated those numbers, it would be helpful if you talk to us offline so that we can compare our numbers. But we have announced the incremental numbers. We expect to see a very significant reduction in our dollar cost next year as we will be at a run rate of approximately $100 million in January. And we were zero in January of 2009 or close to zero. So, as the year goes by for most of the year, we are going to see those dollar benefit come into our P&L.

Brendan Strong – Barclays Capital

Okay, thanks a lot.

Operator

Your next question comes from A.J. Rice with Soleil Securities.

A.J. Rice – Soleil Securities

Yes, hello everybody, and Dave, want to wish you good luck on your retirement too and hope it goes well for you.

Dave Froesel

Thank you.

A.J. Rice – Soleil Securities

Joel, I just want to ask you about the settlement announcement from earlier in the week with the long-running Mariner related qui tam suit. So you’ve settled that. You have an ongoing dispute with them that’s tying up six days of receivables and a number of other things. Does the fact that you settled the qui tam litigation make it more likely that you can resolve the rest of your outstanding issues with Mariner over the near term or does it make it less likely given that there are still some ongoing individuals that they are going after on the Mariner side–?

Joel Gemunder

I don’t think that one has much to do with the other. I look at this fairly simply. The owe us money. They aren’t paying us. We are suing them and we intend to collect what they owe us and that is a completely separate issue from the issue that was raised and settled. I don’t think one has much to do with the other–

A.J. Rice – Soleil Securities

Is there any prospects for near term resolution on the other one?

Joel Gemunder

Well as you can see from the work that we’ve done and that Dave has spearheaded, we are going after some of these slow payors or payors simply for one reason or another haven’t paid us, then we are moving with the – I’d say vigor to get those issues settled and resolved. So, I’d say you can expect us to continue to move forward with that suit and move forward to move toward a resolution of that. It’s a very high priority for the Company.

A.J. Rice – Soleil Securities

Okay, and then I guess the other aspect in that, I now have one other question away from this, but it is obviously a greater corporate integrity agreement because of this settlement and I wondered in thinking about guidance for next year, is that incremental cost enough to be something that we should be aware of or is that something that’s ongoing–?

Joel Gemunder

No, as a matter of fact, we kind of welcome that because it enables us to know where the white lines are in the road and we can drive our vehicle safely. Healthcare law, as you know is quite a bit different than say securities law or tax law where the rules are set forth and people know where the white lines are. Healthcare law it kind of runs like you do what you want, we’ll let you know when we think you’ve stepped over the line. So, when we have these CIAs, it makes us our operating modalities much more secure. Our people are much more comfortable when they have specific guidelines, which we have to adhere to, and when gray areas are made clear. So, I don’t think it’s going to have any effect. In fact, I think it’s going to have a positive effect on our business.

A.J. Rice – Soleil Securities

Okay, you mentioned healthcare reform and thought monitoring was going on in that. One of the things sort of at least for me it was (inaudible) add to the whole discussion was this notion of faster dispensing rates to patients in general, particularly those in institutional settings. Can you give us some perspective on that? I don’t know how much ways you perceive there is in the – well pharmaceuticals that are dispensed to nursing homes, but that seems to be a target there, just give us your thoughts on that if you would?

Joel Gemunder

Well A. J, yes, you get the price. As Cheryl said in the beginning of our call that we had reduced the size of our comments because I was hoping someone would ask me that question because it takes a little while to answer it. The answer to question is this – as you say, eleventh hour thing came from CMS. It took a while to figure out what generated it but it came from someone at CMS who has no data on the wastage that would occur, and by wastage it would mean drugs that are not consumed in Part D.

I believe that they were referring to data in Part A. Part A and Part D are very different categories of patients. Part A patients are short-term stay patients whose reimbursement for pharmaceuticals are embedded in per diem rates that Medicare gives nursing homes. And these short stay patients have a fairly high turnover with the length of stay that is shorter than usually 21-22 days. So there you can have a lot of returns.

Part D, on the other hand, are long-term stay, stable patients who are largely on maintenance medications, which don’t change routinely from month to month. Occasionally, a patient will pass on. Occasionally, a patient will be readmitted to a hospital. Occasionally, there might be a need to alter the patient’s drug regimen. But, by and large, most of these patients are on long term maintenance medications with very few changes. And what we did when we saw this is I have the data on utilization of drugs in Part D because we maintain records on all returns to know which states require it to give credit for those returns and which drugs we – are required to be discarded.

And we looked at this data, we didn’t normally track it, but when this came up, we developed the reporting to pull it from our database and we had Pricewaterhouse confirm that our methodologies and the data portion [ph] which they have done and it looks as if the average prescription in Part D runs about $50.45 and the average returns or the average drugs that are returned amount to $1.78 per scrip. Now, if we were to go to say weekly rather than monthly dispensing, we would have to get additional dispensing fees, because it’s not – it’s expensive to prepare these prescriptions.

And we would be looking at our cost of running today to produce a scrip around $12, $12.50, but we get reimbursed about $4.70 some odd cents from the PDPs, which is less than our cost, but we can make that up in part by utilizing some of the spread we get between our purchase cost of drugs and the price that we are reimbursed. If we were paid our true cost for another three dispensings, we would be looking at $12.50 times three, which is what, Dave, make this your last analysis here, that’s what?

Dave Froesel

It’s $37.50

Joel Gemunder

$37.50 on $1.78 is how many times?

Dave Froesel

It’s about four times. No, it’s 20.

Joel Gemunder

20 times. You are slipping. The cost of the additional prescribing would be 20 times, and if you look simply at what they pay us, it would be eight times, in other words, it would cost the government $8 for every dollar they seem to – they think that is being wasted. Additionally, they talk about automated equipment. There is some automation kind of a patient based automation, which is – which are currently used in hospitals, but that – and we experimented with all of these types of equipment because we are technologically-driven Company.

And we found that those are unworkable, and here is why. First, each piece of equipment cost approximately $200,000 and has a maintenance fee of about $25,000. So, if you look at 16 and you need at least one in every nursing facility, so there are 16,000 skilled nursing facilities in the United States, which would require an investment of about $3.2 billion. I certainly don’t have $3.2 billion to invest, I don’t have half of that to invest in that new equipment, and wouldn’t. Moreover, that equipment only covers about 180 drugs out of the 6,000 drugs that we routinely dispense in our markets. And moreover, they cover – they do not allow the utilization of liquids, creams, ointments, opticals, audics [ph], injectables, or IVs, so you would be required to have two separate concurrent production lines, which would exactly increase cost.

So, to make a long story short, and I give this to A.J. only because you asked for – I think so that’s an explanation, I am sure this is more than you want to know about elephants. But the answer is they didn’t have the proper data. We have submitted our data through the offices of a number of people on the senate finance committee to the CBO, they are looking at our data, they are going to be talking to CMS about our data. We think – it’s hard to escape the conclusion that they were using assumptions and using data, which is not appropriate to the Part D patients.

A.J. Rice – Soleil Securities

Okay, thanks. That’s great.

Joel Gemunder

Thank you.

Operator

Your next question comes from Jason Gurda with Leerink Swann.

Jason Gurda – Leerink Swann

Hi, good morning, thanks everyone. Wanted to dig in a little bit about how far or for how long your main priority for use of cash is paying down debt? Is there is certain point that you want to reach and level off at and then maybe other priorities start to step up?

Joel Gemunder

Well, that’s a very interesting question. As you know, we have $175 million of a Term A loan, which is the only senior debt the Company has and that comes due in July of next year. So we want to get that off our books because it’s coming up. We certainly have the cash flow to do it and I think that’s a kind of an imperative for us to deal with. Beyond that, I don’t think we have any issues with respect to our balance sheet that are – that require any urgency. So once we have that behind us, we have debt paydown as more opportunistic than anything else.

And that would compete with purchasing – buying in our own stock or using it for – or using our cash for acquisitions or other investments. And I look at buying in our stock as money goes to the highest return and we allocate capital like most rational people by it’s highest return and if we see that that would come through our own shares, we would certainly do it.

Jason Gurda – Leerink Swann

Okay.

Joel Gemunder

That’s about all the guidance I can give you because these things change from time to time, but our immediate need is to get that debt off our books by July of next year and because we pass [ph] and we certainly – that’s $175 million and in the next 12 months we should be able to generate around $500 million easily, so that would – that gives us additional opportunities to do – a buy in to our shares or acquisitions or other things in addition to paying down our debt. But – so all options are on the table.

Jason Gurda – Leerink Swann

We have over $300 million in cash on hand, right, so–

Joel Gemunder

You are right, we do.

Jason Gurda – Leerink Swann

Very close to being there.

Joel Gemunder

Right, feels good too.

Jason Gurda – Leerink Swann

A question on the Full Potential Plan. What percentage, I am trying to think about the actual implementation down to the pharmacy level, is there a way to think about what percentage of your beds served are being served in some ways through the hub and spoke model?

Joel Gemunder

I am not sure I’ve gotten – thought that I am–

Jason Gurda – Leerink Swann

The way I understand it was that some of the various operations at your pharmacies around the country would sort of roll into the hub and spokes—

Joel Gemunder

Yes.

Jason Gurda – Leerink Swann

Is there a way to think about how far along you are in that case, and is that line-up pretty much with your cost savings estimates?

Joel Gemunder

Well, yes, as these – the spokes line up in to the hubs and transfer refills to the hub and the hub has to upsize it’s staffing, and that’s pretty much behind us, and the spokes have to downsize their staffing, which we are working our way through at the moment. And we are making progress. So, I think the point I want to get out, it’s a hard one to make, is the $100 million or so run rate that we will have at the end of this year, will turn into $100 million of real savings next year versus a small portion of those savings that have been realized in 2009. So there is a significant improvement in our cost structures coming around the corner, as we move into 2009 and it is beginning as we speak.

Jason Gurda – Leerink Swann

Okay. Well, thank you and I just wanted to say good luck to Dave.

Dave Froesel

Thank you.

Operator

Your next question comes from Lisa Gill with JPMorgan.

Asif – JPMorgan

Hi thanks. It’s Asif [ph] for Lisa. Joel, appreciate all the comments you made earlier. Most of the questions again have been answered, but I had a question for you on the AWP, I missed the—

Joel Gemunder

On the what?

Asif – JPMorgan

–number for the third quarter that you said the rollback cost and as you look forward, do you have a timeline of when that potentially gets narrowed down, and you said, they are going to be starting in 2010?

Joel Gemunder

Yes. I want to be certain we understand each other here. The AWP change was implemented on the 26^th of September, so it would have only a nominal effect in our third quarter. We estimate that the impact in our fourth quarter, current quarter we are in will be $0.02 a share. We also believe, but can't guarantee that as time goes on that number should narrow as the lobbying efforts in the states governments, with legislatures, which reconvene in January will have some effect, but how much of an effect, we are unable at this time to say.

But I think directionally we should see an improvement for our Company and for the others of us who participate in this industry, that there will some space that will adjust their AWPs and move to WAC pricing to compensate the pharmacies. And they have a good reason to do so. Many of them are concerned that some of the rural pharmacies will be put out of business and in the big cities where – inner cities where you have high Medicaid populations the margins of those pharmacies serving those populations would be severely hurts, and I am talking about retail mostly. And I think those kind of pressures will be brought to bear on the state Medicaid agencies. And we’ll just have to see. what the legislature in the various states do.

Asif – JPMorgan

Okay.

Joel Gemunder

But I think there will be some success.

Asif – JPMorgan

Understand. But as it stands today, could you give us any idea of what percentage of the states are with the (inaudible) if it is respected by states?

Joel Gemunder

There are, I believe, a handful of states, which have already acted to develop compensating reimbursement to neutralize the impact of the AWP legislation. I think those are what four or five states. Additionally, we know that the chain drugs store trade group, the NACDS has filed litigation or is about to file litigation in four additional states. And there will be very extensive lobbying pressure brought to bear on other state legislatures. And beyond that you now know everything I know.

Asif – JPMorgan

Alright. Thanks very much. Appreciate the color.

Joel Gemunder

Thank you.

Operator

Your next question comes from Steven Valiquette with UBS.

Steven Valiquette – UBS

Hi, thanks. Sounds like you’ve absorbed most of the impact of the FUL situation for the near term, but really just two quick questions in relation to it. You said you are trying to negotiate some contracts in relation to AWP, so I am curious, are you still trying to adjust anything in relation to FUL as well? You said you are expecting more of this stuff–?

Joel Gemunder

Well, it’s very interesting. The FUL we have had in the past 13 months, I believe, 10 FULs that has come down. Prior to the previous 13 months, in the prior 24 months that preceded this 13-month period, there were no FULs that were issued. So, in a sense, you are saying kind of a catch up for limited or no activity in the prior – two years prior to the year just ended, 13 months just ended. So I think going forward, there will be fewer fish to fry for the CMS because much of the catch up has already happened. So, we are hopeful that the FULs will kind of be – of a limited nature as we’ve seen in the last two FULs, we’ve said we’ll not a have a material impact on our business. So, if that’s what you are getting at I think you are correct–

Steven Valiquette – UBS

Okay. It does tie into the fact—

Dave Froesel

(inaudible) will be reduced, I believe.

Steven Valiquette – UBS

And that does tie into the second question on the subject. Just to clarify some of this. If you look at the FUL list that came out over the past let’s call it now three to six months, and there were a bunch of generics down there that were new introductions in the list and you mentioned that’s where you’ve taken a hit, but there are also were just a ton of older generic drugs with a price it has also recently been decreased. Any international launch they are going to announce six, seven years or something like that, so I was curious, was there any material impact on the pricing of those older generic drugs, or is it really just the–

Joel Gemunder

But there are – I would like to point out that there were a number of those prices that are actually increasing because when a generic drug gets (inaudible) for a while there is a tendency for those prices to increase with the general rate of inflation and with cost increases in the manufacturing process and the opportunity cost to continue making it. So I would say once you get over these blockbuster drugs, the impact of the FULs is I would say not material

Steven Valiquette – UBS

Okay. That’s helpful. Thanks.

Cheryl Hodges

Carey [ph], I think we have time for just one more question.

Operator

Your last question comes from Alan Fishman with Thomas Weisel Partners.

Alan Fishman – Thomas Weisel Partners

Thanks. Same question, it’s been asked and answered. Thank you.

Cheryl Hodges

Okay, thank you very much everyone.

Joel Gemunder

Thank you very much, ladies and gentlemen. We’ll talk to you again in – when is it, February?

Cheryl Hodges

Yes.

Joel Gemunder

Thank you.

Operator

This concludes today’s conference. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: [e-mail]. Thank you!