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Cardinal Health, Inc. (NYSE:CAH)

F2Q10 (Qtr End 12/31/09) Earnings Call

January 28, 2010 8:30 am ET

Executives

Sally Curley - Senior VP of IR

Jeff Henderson - CFO

George Barrett - Chairman and CEO

Analysts

Charles Boorady - Citigroup

Charles Rhyee - Oppenheimer

Tom Gallucci - Lazard Capital

Lisa Gill - JPMorgan

Randal Stanicky - Goldman Sachs

John Kreger - William Blair

Richard Close - Jefferies

Larry Marsh - Barclays Capital

Ricky Goldwasser - Morgan Stanley

Steven Valiquette - UBS

Blake Goodner - Bridger Capital

Operator

Good day ladies and gentlemen and welcome to the Second Quarter 2010 Cardinal Health Earnings Conference Call. My name is Anne and I will be your coordinator for today's call.

(Operator Instructions). As a reminder, this conference is being recorded for replay purposes. At this time, all participants are in listen-only mode. We will be facilitating a question-and-answer session following the presentation.

I would now like to turn the presentation over Sally Curley, Senior Vice President of Investor Relations. Please proceed.

Sally Curley

Thank you very much and welcome to Cardinal Health second 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 can be found on the investor page of our website for a description of those risks and uncertainties. In addition, we will reference non-GAAP financial measures and the information about non-GAAP financial measures is included at the end of the slides. A transcript of today's call is also posted on our investor page at CardinalHealth.com.

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. Notably the UBS Healthcare Services Conference in New York on Monday February 8, the Raymond James Annual Institutional Investors conference in Orlando Florida on Tuesday, March 9 and the Barclays Capital Global Healthcare Conference in Miami on Tuesday, March 23. The details of these events are or will be posted on our IR section of our website at cardinalhealth.com so please make sure to visit that often for updated information.

Finally I would like to ask you to please limit your questions to one with one follow up in order to allow for others to ask questions. Now I would like to turn the call over to George Barrett. George?

George Barrett

Thanks, Sally. Good morning everyone and thanks for joining us on our second quarter call. For those of you following along with the presentation materials, my comments today will largely connect with Slides 4 through 6 and Jeff will cover the others in his remarks.

Let me start by saying I am really pleased with our performance during the second quarter and throughout the first half of fiscal 2010. Our businesses across the enterprise, are executing well against our key initiatives and our people continue to demonstrate their commitment to doing the things necessary to drive long-term and sustainable value for our customers and our shareholders.

As a company, we reported a 3% increase in revenues for Q2 and a non-GAAP EPS number of $0.57 up 12% over the prior year period. Our overall operating performance was better than we originally expected, with the number of our key initiatives already taking hold and with Q2 numbers receiving some benefit from external factors that were more pronounced than we had anticipated.

Our medical segment has had particularly strong year-over-year performance, to date, and our pharmaceutical segment has continued its momentum, performing considerably better than we expected in the second quarter.

Having said this, we all recognize that this is a marathon not a sprint. And we have both opportunities and challenges in front of us. I do believe that we are clear about our course and we are making the progress I would hope to see. Customer focus remains the order of the day. As you have heard me say before we continue to work on further improving the customer experience and we are seeing these efforts show up in our customer loyalty scores with notable gains with the past four quarters in retail independent pharmacy and hospital supplies.

Before I talk about each segment specifically let me comment briefly on our overall results. Our results reflect strong performance, in our base business. And that was driven by a number of things including early positive results from our generic initiative, solid performance under our branded manufacturing agreement, expansion of our retail independent book of business, exceptional performance in nuclear, despite on going supply shortages, continued strong performance in lab and inventory in Canada.

More effective selling strategies across the enterprise and disciplined expense control. I should mention here that we did receive some significant benefit from external factors, which I will touch on in my segment discussion and that Jeff will cover in more detail during his remarks.

Now let me comment on each segment separately starting with pharmaceutical. Our Pharma segment continued its momentum in Q2. Sales increased by 3% versus prior year with segment profit down 1%. This decline was less than we expected. The segment profit decline was driven primarily by the impact of the medicine shop franchise model transition the drop in generic launch value versus the prior year period and the effect of contracted pricings.

These items were partially offset by the benefits we were seeing from our generic sourcing and selling initiatives, some earlier than expected brand price increases and excellent expense management.

Our Pharma segment sales mix in the quarter was 49% to bulk customers and 51% to non-bulk customers. We saw an up tick in sales growth to no-bulk customers at 7% versus the prior year period and a decline of 1% in sales to bulk customers. Within our bulk customer group we have renewed a multi-year contract with Express Scripts during the quarter to supply pharmaceuticals through mid 2012.

As you know, we have a large and very important business supplying national retail chain, and I am very pleased with the strength of those relationships. But if also indicated our desire to grow retail independent direct store business, this is an important group of customers for us and we have seen both sequential and year-over-year sales growth.

Additionally, generic sales to retail independent pharmacies were up 10% in Q2 versus the prior period. By the way our generic sales growth across all channels was also up 10%. And the generic penetration rate or as we call it share of wallet continued to expand, reaching at the highest level in 18 months. We were also very pleased to announce earlier this month a new multiyear agreement with American Associated Pharmacies or AAP, to remain the exclusive pharmaceutical distributor with nearly 2000 independent pharmacy members which includes the network of other associated pharmacies and united drugs.

On the generic sourcing side we are tracking well on the implementation of our redesign sourcing model under the source program. Which we believe provides incremental value to our customers, to Cardinal Health and to our genetic partners. You may remember from our call last August that we expected a difficult year-over-year comparison on generics primarily due to fewer generic launches in our fiscal 2010, and generic price deflation on certainty products. Our current full-year view is that we are running favorable to that projected impact. Jeff will cover this in more detail.

The restructuring of our medicine shop business model is on going. We did add new franchises, to the network, for the first time in a long time. However, the conversion rate of existing stores moving from the old model to the new model is still lower than I would like it to be. Despite the head wind as a transition from some franchisees from a royalty centric model to a deeper long-term partnership on the supply side. We continue to believe that this change is the right strategic move for our customers, and for Cardinal Health.

Our nuclear business performed very well in Q2, under extremely difficult circumstances. While raw material supply shortages had an impact on overall volume, the team continued to take care of customers and deliver excellent bottom line growth. Our nuclear team is very focused on the fact that there's an individual patient awaiting a critical diagnostic test connected to every dose they prepare and they work very closely with our customers to manage the supply constraints by staging orders and adjusting patient schedules where possible. Jeff will be providing an update on the nuclear generator supply situation in his remarks.

Also to know, we continue to build out our PET footprint and integration of the Cyclotron assets we acquired in Q1 from Biotech Pharmacy and Cyclotron is almost complete.

Turning to medical, the segment had an extremely strong quarter with revenue growth of 9% and segment profit growth of 38%. We continue to be excited about our unique capabilities in both category and channel management and the potential for our portfolio of brand, sub manufactured and private label products. While we are delighted with the Q2 result, the rate of profit growth was unusually high boosted by significantly higher commodity prices and some benefit from the demand for flu-related products.

That said, the underlying businesses are performing well. We saw another quarter of double digit revenue growth, and profit growth, in labs, as this channel continued its strong track record of performance helped somewhat by sales of flu related products. Ambulatory continues to pursue ways to grow both its customer foot print and share of wallet, and also saw another quarter of double digit revenue growth.

Additionally, our collaboration with Allscripts for electronic health record is progressing well with a strong lead pipeline and a number of deals closed today. Canada had another exceptional quarter posting both revenue and profit growth well in excess of 20%. New products and supplier agreements with some upside from foreign exchange and demand for flu-related products fueled this outstanding growth. We are also making solid progress in our kitting business with the third consecutive quarter of profit growth and strong profit growth versus prior year. We have devoted considerable energy to improving this operational performance, to a number of Lean Six Sigma projects.

In the quarter, we also signed a five year exclusive distribution agreement to coal market to SurgiCount, Safety-Sponge System. This system utilizes data matrix barcode to tag each item with a unique serial number to help prevent the retention of sponging and towels unintentionally left in patients during the surgical procedures. Sales and hospital supply were slightly positive and in line with our expectations. Margin improvement is a particular focus for this business; we continue to build out our preferred product category for brand, sub manufacturer, and private label products. This is an important strategic initiative and driver of margin improvement going forward.

To further improve our hospital penetration and support our customers we have established a dedicated nursing sales organization, focused on products used in the nursing professional and are beginning to see traction. And we are also on track to achieve the savings we targeted in our medical source initiatives. Our work on our medical business transformation continues to meet our time line and budget expectation and Q2 investment spending was in line with our forecast. We are quickly moving from the design stage to build stage of this project. This transformation forms an underpinning of our efforts to further reduce supply chain costs while driving substantial improvement in our customer and supplier experiences.

And we have some of our best and brightest assigned to this important work. At an enterprise level as I mentioned last quarter, expense in capital management remain key areas of focus. We are also managing our balance sheet carefully with a strong emphasis on reducing inventory days particularly in our pharmaceutical distribution business. And we have been able to do this while maintaining high service levels.

Jeff will cover the balance sheet in greater detail in a moment. Based on our performance in the first half of fiscal 2010 and our best assessment of the current environment, our review of the year has improved considerably. As a result, we increased our full-year guidance and now expect our non-GAAP earnings to be in the range of $2.08 to $2.18. Jeff will walk you through our core assumption underlying this. Before I turn the call over to him I would like to mention a few more things. First, our Board of Directors recently added another key director, Dr. James Mongan and Carrie Cox bringing the Board to 12 members.

Jim is a well known hospital CEO, most recently leading partners health care system until his retirement last month and a visionary leader and educator. Carrie brings a wealth of experience from her 30 years in bio-pharmaceuticals and healthcare, most recently serving as President of Global Pharmaceuticals Insurance Files. We have built an exceptional board and the additions we have made over the past six months bring additional expertise and perspectives from across many dimensions of health care including Pharma, biotech, generics and healthcare providers.

And I look forward to working closely with the entire board as we continue to move the company forward. Second on the top of the form it has been an extraordinary couple of months and an event for the last few weeks. I will say that the fundamental challenges that are healthcare system basis are no different today than they were last quarter.

We have a system capable of delivering superb medical care but we also have tens of millions of people in this country who are unable to access affordable health care. Whether the system evolves by market base forces or through the legislative process, we do believe that this issue will need to be tackled and we will continue to be deeply engaged in Washington as things move forward.

Third, I did want to comment briefly on the situation in Haiti. Like all of you we have observed the after math of the massive earthquake in Haiti with horror. We prefer not to say too much about our support but I do want to remind our shareholders that we take our responsibility as a healthcare company seriously and have acted immediately and directly with relief organizations, the department of defense and their partners to do our part to help address for critical needs.

I am proud that the people of Cardinal Health once again responded instantly and in meaningful ways and I would like to take this opportunity to acknowledge their tireless efforts.

Finally, let me end by saying that I feel good about our progress and we have accomplished to this point. Our organization is fully aligned around our strategic priorities with a strong focus on execution and improving the customer experience. And while the results are beginning to show, we know not to get too far ahead of ourselves, as there's still much to do.

With that, I will hand the call over to Jeff for more details on the quarter.

Jeff Henderson

Good morning, everyone and thanks for joining us. Let me begin by echoing George's comments. I am very pleased and encouraged by our results in the second quarter and the first half of our fiscal year. George provided a good overview of our Q2 results and key drivers. So rather than rehash all the financials I am going to focus my presentation this morning on providing some additional details related to Q2 and then spend some time going through our outlook for the remainder of the year.

First, some added comments on the business performance. As you may recall in the beginning of the year, we identified a couple of key performance metrics that we needed to focus our attention on in our later like fashion, margin expansion and working capital.

Due to a number of performance initiatives that George has already referenced including our generic programs, focus on retail independent growth and penetration, strong performance in nuclear medical businesses and expense controls and working capital efficiency, we have made some great progress, which I would like to elaborate on.

First, on margins and I will be the first to say that when our two quarters worth of margin trends doesn't necessarily tell a complete story. Particularly given the quarter volatility we can often see based on external factors. However margin trends and our key drivers remain an extremely closely monitored metric for us. So, I believe it is important to comment on our status here at this midpoint in our year.

Both sequential and year-over-year, we have seen gross margin rate and operating margin rate expansion as an overall company. In fact, consolidated gross margin and operating margin rates are up 5 and 4 basis points respectively versus last year. This is in spite of the fact that our very large Pharma bulk business which represents close to 50% of the Pharma segment has experienced declining margins due to large customer re-pricings.

Some of the biggest profit margin gains are being seen in our medical, nuclear and Pharma retail independent lines of businesses all of which have been key areas of focus. Medical segment profit is up almost 100 basis points to 4.59%, driven by both strong performance in number of our channels and by external factors such as raw material costs and the strong flu season.

Within the Pharma retail independent customer channel, segment profit margins are up 37 basis points versus last year. A very direct consequence of our focus on continuing to build that important business and increase generic penetration. Turning to working capital, we have continued to see the focus in this area pay dividends. Although sequentially days of inventory were up in Q2 due to the normal seasonal build at calendar year-end.

The year-on-year comparison, show the reduction of another day, due to the efforts of our Pharma distribution operating team and its remaining Six Sigma programs. At the same time, our accounts receivables days have reduced slightly. These combined with our earnings performance help to generate $524 million of operating cash flow in Q2, bringing our year-to-date number to $931 million. In summary, we are making some real progress with our performance initiatives and its showing in the key metrics we track.

Now, to continue on Q2, let me add a couple of additional details to what George covered. I will start with the business segments. As George said, we are pleased with the business and financial progress in our Pharma segment which was better than we anticipated. Revenue in the segment was up 3%, comprised of 7% growth for non-bulk and a 1% decline for bulk customers. The decline on bulk was driven by both timing of orders versus last year, and the impact of the large mail order customer that we have referenced in previous communications.

From a segment profit perspective, we are meaningfully benefited by the progress in our generic initiatives which helped to offset a portion of the headwind we experienced from the decline in value of generic launches versus last year. We also had a strong quarter from our branded by margin standpoint. As brand inflation in fee has contributed materially to growth, offsetting much of the negative impact on the medicine shop transition. Some margin erosion was largely as we originally modeled driven by some previous large contract re-pricings with some of the impact being later than originally anticipated. This last factor benefited the first half of the year including Q2. Finally due to strong expense controls SG&A in this segment was down over 4% year-on-year.

In the medical segment, in addition to strong business performance, our Q2 benefit from certain external factors, including commodity price changes which were worth close to $19 million of benefit in material cost versus last year. And a continued strong flu season which was worth about $6 million incrementally. These benefits largely offset the increase in segment expense during the quarter which was driven by our significant transformational project spend. Regarding the flu season, I will say that we are starting to see the impact moderate considerably as we go through January.

Finally at the overall corporate level, let me cover a few items. Non-GAAP operating expense is up over 3% from last year. Driven by our considerable investment spend, incentive compensation accruals and the impact of acquisitions. If you exclude those drivers which represent about 6 percentage points of growth, our core SG&A is down meaningfully, reflecting the continued focus we have in this area.

In our other income section of the income statement, you may note that we reported $6 million of non-GAAP other income, a fairly large improvement compared to last year's expense of almost $20 million. This favorable compare is somewhat unique to this quarter and is primarily due to the impact of deferred compensation and foreign exchange swaps in last year's Q2. Both these items were to slightly negative in FY '09 due to the extraordinary financial markets events that transpired that quarter.

Our non-GAAP tax rate for the quarter was 38.5%, versus 38% flat last year. A higher rate in the current quarter was charitable to changes in income mix in a couple of small discrete items. Also during the quarter we repurchased approximately $15 million of Cardinal Health shares under our current $500 million share authorization program, leaving average diluted shares outstanding for the quarter at 361 million.

On the balance sheet, we finished with over $1.7 billion of cash, approximately $400 million of which is overseas. Also we had a $350 million note come due during October which leaves us with our long-term debt balance of 2.1 billion.

Now let me turn you to slide 7 to take a moment to walk you through the items that accounted difference in our GAAP and non-GAAP EPS number. We had several items this quarter that caused our GAAP earnings to be higher than non-GAAP. All these figures are our review on an after tax basis. The biggest item in this category is a $20 million gain from sales of 5.5 million shares, of CareFusion stock. I will explain this item in more detail shortly. We also had $60 million in income from an insurance recovery there was a result of an escrow release from a previously settled lawsuit.

Restructuring and employee severance along with other spin off related costs made up approximately $12 million and partially offset the two gains I just mentioned. The total positive impact to GAAP EPS in these items was $0.07 for the quarter, taking our GAAP EPS and continuing operations up from $0.57 to $0.64.

Now, turning to Slide 8 and more detail on the CareFusion stake. As mentioned earlier during Q2 we sold 5.5 million shares that generated a $135 million of proceeds, and a gain of $20 million. We have accrued no tax on the proceeds of this sale. After these share sales we now hold l 35.9 million shares of CareFusion stock which had a value of $897 million at December 31. During Q2 we had a pretax unrealized gain on this remaining of ownership of a $115 million, which does not have an earnings impact until shares actually sold and capital gains or losses are recognized.

Having said in the past in order to maintain the tax free nature of this spinoff we need to get last of the remaining shares within five years in the spinoff date. We intend to complete this within the next 18 months, and are continuing to assess the best method and timing to do this based on market conditions and other factors.

Now let's review the FY '10 outlook. Before I turn to slides 10 to 13, let me begin with some framing comments about how we now view the full year from a forecast perspective, particularly given our strong financial performance in the first half of the year. Clearly we are off to a good start in the first half, much stronger than we anticipated heading into the year. This is being driven by two major categories of items. First we've had very good executions against our key initiatives in the first half of the year, including our generic programs, our progress in independence and strong performance in our medical businesses. I would fully expect that we continue that operational momentum into the second half.

We have also been benefited from certain external factors including generic launches that are happening at a higher value level than we had planned less deflation on a few specific generic products, compensation from our branded vendors relative to price increase of fee timing and the demand created from our stronger and early flu season.

For the full year, although we will get some net benefit from those we are assuming that they largely normalize out in the second half of the year. So in total, though some of these items is a considerable improvement in our view for the full year which is reflected in our guidance being raised.

However, we are also seeing a change in our distribution of earnings for the year. With the first half being disproportionately benefited from some of the external factors I just outlined. With that overall back drop let me provide some more specific assumptions by segment. Our pharmaceutical segment assumptions are shown on Slide 10. The market factors and head wins for the year are the same ones that we have spoken about previously, although as I indicated in the amount and timing of the realization, may have shifted somewhat.

First as I mentioned, earlier than anticipated branded by margin we realized in the first half represents what we believe to be a pull forward of $0.04 to $0.05 into the first half of our fiscal year from our second half.

The negative Year-on-year impact of generic launches and deflation was better in the first half than we anticipated. Again due to, several unplanned launches and the slower deflation on a couple of products launched, last year. We now expect the full year negative impact in this head win to be approximately $75 million.

This compares to the $100 million figure we spoke of on our August 2009 call. The financial impact of our medical shop transition is happening generally in line with our expectations. Finally, let me comment on the nuclear generator supply situation as we see it.

With the shut down of the Chalk River reactor in Canada, technician supply levels remain challenging and can range anywhere from 20% to 80% of normal supply levels. Based on recent reports from atomic energy of Canada, we expect that their reactor will not be fully operational until April.

At the same time, the reactor in the Netherlands is scheduled for maintenance beginning mid February and is expected to be down for approximately 108 days. We have aggressive action plans underway to mitigate its impact for our customers and their patients as much as possible. However, there will likely be some impact in this disruption and our updated guidance reflected unfavorable EPS impact of $0.01 to $0.02 in the second half.

Our medical segment assumptions on Slide 11 are largely unchanged from August 2009, when we first presented them first half actual results show segment revenue growth to be above the overall market, driven by our mix shifts and strong growth in Canada, ambulatory and lab.

We expect this to continue for the full year. However as you recall in Q1 we also benefitted from accelerated revenue and income recognition related to the CareFusion spend. Obviously that one-time benefit doesn't repeat itself. Also in the first half of 2010, we saw greater benefit from commodity raw material prices and flu related sales at a greater level than we had originally projected. These aren't expected to continue at the same rate into Q3.

In fact given oil price movements over the past 6 to 9 months second half year-over-year benefit from commodity prices will be significantly less than the realized in the first half of the year. A final important word in the earnings outlook for the medical segment during Q3. As you have seen the segment has reported robust growth for the first half of the year and is expected to finish the year with strong full year results.

However Q3 will be an anomaly in this regard as we are actually expecting the segment profit decline during this quarter, despite underlying improving fundamentals. This is driven by a particularly strong Q3 report last year. Related to one-time customer rebates and other items which improved our cost of goods sold, making for a tough year-on-year compare. This is (inaudible) by continued high investment spend in this year's Q3 and a lessened benefit from commodity prices that I previously mentioned. With that all said we do expect the medical segment to grow its Q3 earnings sequentially from Q2.

We have updated our corporate assumptions for fiscal 2010 on Slide 12. Note that we now expect to end the year with a non-GAAP tax rate north of 37% although we should point out that there could be a few isolated events each quarter that may affect it in either direction.

We expect weighted average shares outstanding to come in around $361 million. We now expect the combination of net interest expense and other to be approximately $110 million we continue to forecast our capital expenditures to be in the range of $200 to $250 million. Finally, although we don't generally give regular guidance on cash flow, I did want to update my answer to a question from earlier in the year where I indicated that FY '10 operating cash flow would be less than $1 billion.

Given the favorability in our cash flow during the first half of the fiscal year we now anticipate that number to be north of $1 billion. So taking all of these items into account as George referenced earlier we are changing our expected non-GAAP earnings per share to be in the range of $2.08 to $2.18. I know that was a lot of detail hopefully it was helpful. I will turn the call over to George now for Q&A.

George Barret

Operator, I think, we will leave it to you now to start the Q&A.

Question-and-Answer Session

Operator

(Operator Instructions). ). And our first question comes from the line of Charles Boorady with Citi. Please proceed.

Charles Boorady - Citigroup

Thanks. Good morning. A lot to ask about, I'll keep it to one, I'm wondering if you could elaborate on comments you made on medicine shop turnaround, Jeff mentioned it is going in line with expectations and if you can quantify a little bit for us how this existing stores are doing in any investments you are making to try to grow the franchise, so for the existing stores, maybe same-store sales trends, the retention rate of franchisees, or their stats you can share, and then are we starting to see any growth in the franchise yet and are you making any investments are we seeing any expenses in your G&A related to that?

George Barret

Good morning, Charles. It is George, I will start and certainly Jeff you can chime in here. I am not going to be able to provide a lot of that detail Charles. I will give you a sort of general sense of what we see. As Jeff mentioned economically we're about where we expected to be its actually coming out a little bit differently in terms of how we get there and largely what we're and its good news for us is an increase in stores that would like to be franchises. So we're seeing some increase there, that's good news for us. Our existing stores are doing pretty well. Where we have seen some underperformance such say would be the number of stores converting underperformance there meaning we would like to see more stores convert.

This is a very, it is a very personal decision for the franchisees and I probably add that, that each of these franchise is in a different situation and so we really worked at engaging them in a dialogue in terms of explaining what the opportunities are, so at this point there are some that have chosen not to convert or taken more time to consider that option. Generally I would say the program is going well, we have added some franchises, but the number of converting is a little bit lower than we modeled. Beyond that there's probably not a lot I can add.

Charles Boorady - Citigroup

Is there a chance or should we expect more revisions to the fee or other aspects of the relationship?

George Barret

No, I don't think I would expect anything different along that line.

Charles Boorady - Citigroup

Thanks.

George Barret

Yep.

Operator

And our next question comes from the line of Charles Rhyee with Oppenheimer. Please proceed.

Charles Rhyee - Oppenheimer

Yeah. Thanks for taking the question. George, you know you talked about and Jeff you talked about all of the factors benefiting you in the quarter and obviously some external, some internal. Can you maybe give us a sense, obviously the performance in this quarter, which probably benefited more as it; particularly I am interested on the generic sourcing. George you talked about changing the relationship on how you deal your generic manufacturers. Is the take away here that this part of your business, you are moving further along and at a faster pace, establishing this new type of model or is it just more than we had better generic introductions maybe last quarter?

George Barret

Thanks, Charles good morning. You know, we tend to talk about the generics and its pieces sourcing and selling the truth is that you have to think about it in an integrated whole and it is one of the things that we are actually doing much better. So, on a sourcing model change, we've made tremendous progress. You have heard me say that our goal is to move from a somewhat transactional approach to much more strategic approach, we have done that, that transition is going well and actually quite quickly. We're pleased with the way that's working. I want to clarify one thing that's very important because some folks have asked us about this. We have substantially reduced the number of generic suppliers in our source program. That is our preferred program. But I should also add that we continue to do business with all generic suppliers across the generic spectrum. So what we have done is really reduce the number of players in that particular program so number one I have to clarify that.

The second part is that having a great sourcing program is not effective unless you are selling in the right way and so we have tried to make sure that we are integrating our selling and sourcing model in a way that we think is valuable and I think we are making a terrific progress here, our compliance is going up, are on the right, the trend line is going in the right direction, our generic program is attractive, its flexible and our selling organization is better trained and better incentivized to drive the sales and articulate the benefits of the program. So I would say I've told this taken in entirety our generic effort is better from sourcing to selling and I think that's a component of our progress here.

Jeff Henderson

Yeah let me just move on that Charles by providing a few more details. As George said this is really part of an integrated package that we have to get right from sourcing all the way through to the end customer. But, that all said let me sort of break it down into three major components and just give you directional idea of how we did in Q2 and most of these we have already referenced. First of all on the sourcing side, I think we have made great strides in that partnership and I would say we are slightly ahead of schedule in that regard, and probably Q2 was the first quarter that we started to see some meaningful financial benefit from that revised sourcing philosophy.

On the sales side we experienced 10% generics growth during Q2 including 10% growth within, specifically within our retail independent channel and we also saw continued progress in penetration within our retail independent channel which also bodes well for generic sales both in Q2 and the future.

On the third element sort of launches, we did experience some launches in Q2 that we hadn't necessarily forecast and that provided us some unexpected benefit and I would also say that some of the deflation we had predicted based on some, last year's launches was not as steep as we might have feared which gave us some benefit and that was the reason why I said the total head win this year from the combination of generic launch compare and deflation had improved from what was previously about $100 million to about $75 million.

The last thing I will say about launches is that, it is not just about the launches, occurring it is about how well we can execute on them and we have done a much better job of executing on the launches and getting the products to market very quickly which is obviously a very important thing for both our pharmacy customers but also, our suppliers as well. So again we are seeing some great progress in all elements there.

Charles Rhyee - Oppenheimer

Great. Thanks a lot.

Operator

And our next question comes from the line of Tom Gallucci with Lazard Capital please proceed.

Tom Gallucci - Lazard Capital

Good morning and thanks for all the color, on some of those one-time type items, Jeff. On the generics again just a follow up there, I think you had talked about maybe a goal is improving purchasing compliance in the customer base by at least 10% this year. Any update on sort of where that stands and do you see any, potential to break into some maybe some of your mid size customers where you haven't done generics before?

George Barret

Good morning, Tom. It is George. As it relates to our goal, I would say we are squarely on track to meet our goal, the trend line is very good and I am encouraged by what I am seeing there. Yeah I think it is a dynamic environment. We have already, in many cases refined the programs that we have with different customers and we believe that there are still customers out there who can benefit from the flexibility and the value that we create toward our generic programs. So we will continue to try to make that offer across our channels. So it is, we talk about independence here, but it is also a long regional chain, mass merchants. Even in the GPO and hospital segment if you know it made some progress. So I think there are opportunities for us to expand that program and I would say generally, I am feeling good about the rate of progress that we have had in our efforts.

Tom Gallucci - Lazard Capital

Just on the follow up, cash flows are good. It seems like you have the house in order and the strategic programs are gaining traction. Any thoughts on cash flow deployment in the potential for acquisitions over time?

George Barret

Let me make a very quick general comment about acquisitions and then may be ask Jeff to talk a little bit about capital deployment. As you know we have really focused in this past year on strengthening our core businesses. And great progress has been made there. So as you look to the future we will continue to drive organic growth to take advantage of the tools that we have but we will continue to evaluate the most effective way to position our business and drive value for our shareholders. So we will certainly cheerfully consider acquisitions have to be part of that equation but it is really about strategic positioning and its about long term value for our share holders and we will evaluate that as we go but may be in a more general sense Jeff will comment a little about capital deployment.

Jeff Henderson

Sure first of I think as you would expect our first priority when we are evaluating both capital structure and capital deployment is assuring that we have sufficient liquidity to operate the business comfortably and that we maintain our investment grade rating which is very important to us.

I would say, second we do have certain commitments related to both capital expenditures and our considerable dividend payout and we obviously have a it both over $500 million of cash reserve for those two important items this year so beyond that you know we have to assess carefully what our strategic options could be and those can range from looking at acquisitions from time to time to our share repurchase and those are clearly tolls in the portfolio that we will consider as we continue to buildup cash.

Thanks for the question. Next question, operator?

Operator

And our next question comes from the line of Lisa Gill with JPMorgan. Please proceed.

Lisa Gill - JPMorgan

Thanks very much and good morning. I actually have a question on the medical supply distribution business. The revenue came in substantially better than what we were looking for.

Can you may be just talk about what the competitive landscape looks like right now in that marketplace or are you taking a lot of market share from some of the competitors and then secondly just as a clarification, Jeff when you talked about $6 million coming from flu, I assume that's on the operating profit side. Is that correct?

Jeff Henderson

Yes Lisa that's correct. Its operating profit.

Lisa Gill - JPMorgan

And so can you break down for us how much came on the revenue side I mean was that a big contribution to the quarter for medical, or was it competitive wins in the market place or are you taking market there to their existing customers and if you can just give us some ideas to it.

George Barret

Lisa let me jump in for just for a second and try to give you some color on how we see the market place right now most of all we are very pleased with the growth there the heaviest growth for us came really in our ambulatory business which is a business outside of a few care centers in our lab channel and really terrific the growth in Canada we were about in line with the expectations on that sort of traditional hospital supply business.

As it relates to market share I am not sure there have been large swings in market share one way or the other. I think I am relatively steady of a say on the med search side probably a little bit of expansion in ambulatory and lab in Canada but generally speaking it feels like good progress out there as you know the market is always competitive as it is in our other businesses. But we feel pretty good about our positioning and continue to mobilize around what we think our core competitive advantages which have to do with the breadth of our channel and the ability to manage categories across the huge product line. So feeling pretty good about that.

Lisa Gill - JPMorgan

Just one quick follow up George on the ambulatory care side, do you feel like you need to make an acquisition, I know that you are growing that business organically, and obviously you're saying its growing quickly but would an acquisition help you to really gain the market share you need in that area.

George Barret

Yeah, Lisa I wouldn't comment on whether or not an acquisition is necessary. I would say that we are getting very good organic growth, we are doing some things in terms of redeploying sales organizations to enable that, and I think continue to build capabilities that includes not only broader offerings but sort of customer facing things that we are investing in. So we are pleased about the rate of growth organically, of course we will continue to consider as we do with any of our businesses, whether or not some kind of external move repositions us or alters our positioning or our future in a meaningful way. So we will continue to look at those things but right now I would say feeling pretty good about the progress we are making here.

Lisa Gill - JPMorgan

Okay that's helpful. Thank you.

George Barret

Thank you.

Operator

And our next question comes from the line of Randall Stanicky with Goldman Sachs. Please proceed.

Randal Stanicky - Goldman Sachs

Hey great, guys thanks, just two questions first a follow up on the generic sourcing. George, what quarter or what time frame should with e think about as when you will see the full benefit from that initiative and then the follow up would just be on some of your customer renewals, you recently renewed express you have more mid-year, how do we think about timing and if you have any comments on renewal economics that would be helpful?

George Barret

Okay. Let me start on the sourcing side. Randall, it is a little bit to describe, it is difficult to describe this at the discrete moment in time. This is essentially a change not only in some suppliers but it is a change in the philosophy of the way that we source products. So it is really some of that creates value over the long-term. I will say it is already creating value for us and it's already I would say strengthening our relationships on the upstream side with our suppliers. So, we are pretty far down the path, in terms of executing and implementing the program. One of the things that we have to do of course is if when there were changes in supplier in the program, we wanted to do that gradually and make sure that there's a smooth transition for our customers downstream. So it is ruling out throughout the course of the year, but I would say that it's already generating benefit you shouldn't expect a single moment where suddenly it goes from black to white or white to black. I think it is a progressive effort but it is really the right course for us and I think we're well on track and probably ahead of track on what we expressed in that.

As it relates to renewals, yes we did announce two in effect in the last couple of weeks. Our basic approach modeling our renewals as we see renewals unless we have information to the contrary our operating assumption and built into our model is the assumption that we renew contracts. That's the way we approach unless we have information to the contract.

Randal Stanicky - Goldman Sachs

Okay, great. Thanks, guys.

Operator

And our next question comes from the line of John Kreger with William Blair. Please proceed.

John Kreger - William Blair

Hi. Thanks very much. My question relates to your mix within the Pharma distribution business. This is the first time that I think direct has out grown bulk in a long time. Do you think that's sustainable and can you remind us the margin differential between those two categories?

George Barret

Let me talk through first one and maybe Jeff will jump in. It is a noteworthy data point I am not sure that this single data point represents the trend. So I would be very cautious to advise you that this necessarily marks sort of a turning point for us. I think it is a piece of data, it is interesting, and well into our business, but again this can move from time to time, and so I don't want to make too much of this particular piece of data.

Jeff Henderson

John, just to answer your question about the relative margin, we will be putting those into our 10-Quarter, it will be filed next week. So let me just give you a preview of what those look like. The bulk segment profit margin percent that we will be reporting will be 22 basis points for Q2 and the non-bulk segment profit margin will be 169. Just to comment a little further on the bulk margin that 22 compares to, as you may recall a abnormally low rate of low single digits in the first quarter of FY '10. As I indicated at time on our last earnings call that bulk rate in Q1 was abnormally distorted on the low end by a couple of certain events including a state excise tax payment that we had to accrue for, and the pattern of certain branded purchases. So, I indicated time that probably decreased the bulk rate by about 15 basis points versus what I would consider a more normalized margins. So you can see the 22 basis points that we are reporting this quarter probably is more in line with that normalized rate that referenced before.

Operator

And our next question comes from the line of Richard Close with Jefferies. Please proceed.

Richard Close - Jefferies

Yes. Jeff, just really quick, wanted you to clarify one of the points with respect to the generics, when you were given your commentary; you said something about a $0.04 to $0.05 pull forward into the first half of the year. Can you just go over that again?

Jeff Henderson

First of all I just realized I had given an incorrect number for the non-bulk segment profit margin. It is actually 202 for the Pharma segment for non-bulk. And again that is 22 for the bulk segment profit margin. Regarding the pull forward, we had, I think it was a combination of both price inflation and some fees they got to full forward into the first half of the year and I quantified that as about $0.04 to $0.05 which really we really view it as a timing shift. In particular, there were certain price increases in the first half of the year, from branded vendors that we had assumed in our own forecast would happen in the second half of the year. There were both in line with the size that we expected them to be but they came a little bit early. So that is one of the key drivers of the $0.04 to $0.05 pull forward that I referenced.

George Barret

And Richard, I think you are into generics and I think it really is a brand and that is what Jeff is responding to.

Richard Close - Jefferies

Okay. Thank you for that clarification and then with respect to the contract re-pricings, did you make any comment in terms of what you thought the impact was in the first half of the year versus your initial expectations?

George Barret

I'm not sure I fully get your question. Let me just sort of give an answer I think answers your question. During the course of any year, we have contracts coming up, some of which are very large and may be in the public domain and ones that people see and ones that are very small. We typically model them in and so those are built in our forecast. The guidance that we provided you today reflects all of our thinking about any on going contracts that we have and contracts that we have signed.

So what Jeff may have mentioned earlier during his comments are that we did have some contract renewals that we implemented a slight different timing than we expected in Q1 but otherwise things are playing out from that standpoint as we naturally have one. And things are playing out as we expected and the modeling we have got for the balance of the year reflects our thinking of that renewal.

Richard Close - Jefferies

Okay. Thank you.

Operator

And our next question comes from the line of Larry Marsh with Barclays Capital. Please proceed.

Larry Marsh - Barclays Capital

Thanks and good morning. It was a very encouraging update here. I have a question and clarification if I could. First just to elaborate here on the second half guidance towards you know based on your much better performance to date as you and Jeff talked about looks like you are suggesting that the midpoint second half EPS down about $0.25 versus the second half last year after being up you know $0.12, $0.13 year-over-year in the first half. So, I know you were going through some of the pull forwards the nuclear head win flu and I am still getting drug down about 15% to 20% in second half year-over-year so that to me sees a little too crony and what else am I missing or underestimating?

George Barret

Let me first answer generally and then I will ask Jeff to run through a little bit of the detail but I will start by saying the important part. The underlying fundamentals of business, all of the things that we think are important in terms of driving the progress that we want to see all those things are going well. And so largely what we have been talking about is the shifting of some external factors primarily accounting for any differences but let me switch Jeff on to add anything to that.

Jeff Henderson

Sure. Good morning, Larry. You referenced a few on the pull ahead of by margin into Q1 the nuclear issue we are facing with respect to the supply situation you know we continue to have a negative compare with respect to generic new item launches and from the MSI transition.

So all of the headwinds that we had described earlier are still there and like I said the bi-margin one is a bit of a timing issue. The other one that I would add is the DSA transition that we spoke about at the beginning of the year, hits us in H2, it doesn't hit us in H1 because the second half of the year is typically when we would realize the most from we ran in price inflation and given the conversion to a cheaper service arrangement we take a direct hit in that compare in the second half of the year. The last thing I would say is that the year-on-year commodity price compare within the medical segment that was a very favorable compare in the first half of the year. That compare is much less favorable although still positive. It is much less favorable in the second half of the year and that is simply due to the movements of oil prices and the related commodities over the last six to nine months.

Larry Marsh - Barclays Capital

Okay. Thanks.

Jeff Henderson

One other thing I would mention Larry is that some of our investment spends has been pushed more into the second half of the year compared to the first half.

Larry Marsh - Barclays Capital

Okay. Just a clarification or two. So first on, since you mentioned the oil prices, it strikes me a little surprising to see that significant, you said $19 million benefit. Was that just the comp versus last year at the same time is how you are thinking of it?

Jeff Henderson

Yeah it is. And again it is always a little bit hard to follow up because delay is lagged by about 6 to 9 months but you may recall wasn't too long ago that we are seeing oil prices in $120 a barrel range and that hit us last year and then as we lapped that period this year, we are benefiting from oil prices that were down in the you know $60 range. And I think since that point, we have seen prices get closer to $90 a barrel range. So, that is why we you see that sort of fluctuation but the $19 million is sort of a quarterly year-on-year.

George Barrett

As we wanted to wrap up this one to uniform question Larry just to remind you that I think the general performance of the business for our second half is probably better than what I would have expected one year ago. We are actually going in the right direction, across all of the components of our business. So we will deal with some of these external issues as they happen, we'll take them as the pictures have turn at us but the general picture for us is I think on the right trend line.

Larry Marsh - Barclays Capital

Very good. And just a final clarification, looks like your cost basis on the CareFusion sale is closer to $21. Is that right; is it a little bit higher than you had thought last quarter, Jeff?

Jeff Henderson

Well it depends whether you're referring to our accounting cost basis or the tax basis, but the accounting cost basis is around $20.85, that was where it was at the time of the spin and then each quarter based on the prevailing market place we sort of mark that up on the balance sheet based on whether its stock was trading and that's where the unrecognized gain has come from. If your question is about tax basis, as you may recall in the last earnings call, I mentioned that we had a lot of analysis to do to come up with a final tax basis. Actually a pretty complex calculation requires the valuation, etcetera to be done. At that point, I said a minimum was in the $19 to $20 range. Based on the analysis we've done to date and we are still wrapping it up this quarter. I would say at a minimum that tax basis looks like it is $22 a share which is obviously favorable because that will reduce any capital gain that we realize.

Larry Marsh - Barclays Capital

Right. So you think probably I wouldn't have to pay taxes but should go on those gains given the other offsets you have.

George Barrett

Yeah. To the extent we saw above $22, we will recognize a capital gain but we do have some capital loss carry forwards which exceed $100 million that will be use to apply against at least the first $100 million of gains.

Operator

And our next question comes from Ricky Goldwasser with Morgan Stanley. Please proceed.

Ricky Goldwasser - Morgan Stanley

Yeah, good morning. Just to follow up on the question, for the second half of the year, we accounted in about $0.09 of the head winds in the second half versus the first half. So is it fair to say that about half of the improvement in your guidance is related to sort of turn around related metrics. And then are you looking for distribution margin in the third quarter to sequentially improve versus the second quarter?

George Barrett

Ricky I will answer your first question. I didn't quite hear your second question. So I might ask you to repeat. But let me start by saying in the first half of the year, our over performance versus what we expected, I would divide into about 75% being sort of external factors and 25% being over performance in terms of performance against our initiatives etcetera. That over performance that we saw in the first half of the year, we expect to carry through to the second half of the year. The external factors over performance as I said earlier we expect that largely to normalize out in the second half of the year. So we don't expect to recognize anywhere near that level in the second half of the year.

Ricky Goldwasser - Morgan Stanley

Okay and then the next question was on the distribution margin. Should we still see margin for the distribution segment up on a sequential basis?

George Barrett

Yeah, typically you will see that our, our Pharma segment will have its highest margins in the third quarter of the year. And that has been a historical pattern that is applied for many years in part because Q3 is generally where we realize the most price inflation, and we would expect that pattern to continue this year as you go to Q2 to Q3. The one thing I would say which is a bit of a caveat to that comment is as we continue to move more and more of our branded business to fee for service versus the old buy and hold price inflation model, that's sort of Q2 to Q3 seasonal increase that we typically have experienced, will continue to get more muted and particularly given the very large vendor that we are moving to fee for service that you are all aware of, we will see even more muting of the impact this year. But I will go back to what I initially said that we would expect sequential margin improvement in the Pharma segment Q2 to Q3 this year as well.

Operator

And our next question comes from Steven Valiquette with UBS. Please proceed.

Steven Valiquette - UBS

Sorry. I had it on mute. Yes it is the answer to my question but I was trying to figure out as well with the quote unquote largest branded manufacturer running fee for service, how much of that historically was still accounting for the big sequential improvement so if that goes away that sounds like that lot of what was happening actually you just covered it. Thanks.

George Barrett

You're welcome.

Operator

And our next question comes from Blake Goodner with Bridger Capital. Please proceed.

Blake Goodner - Bridger Capital

Good morning. Two quick questions, the first is when I look at the growth of the distribution business, you know bulk being down %1 and non-bulk being up 7%, you mentioned something about timing and then a customer lost. Just how does that trajectory change throughout the next year because obviously that has a swing the margins?

George Barrett

Yeah, Blake let me start. As I said earlier I'm not sure that we could necessarily take from those pieces of data a trend. We are always influenced by comps and an unusual bents and the bulk business as you know can move in large pieces. So, for example, the last year we had some business that went from (inaudible) to bulk. So I don't know if I can offer you a trend projection here. Part of this will depend on actually what happens with the customers which we do not control, their own growth rate. So what we can control is how we are going to improve the parts of the business that we influenced and our programs are direct at doing that.

Blake Goodner - Bridger Capital

Okay. And then the second question, George, just you know taking a step back you guys are ahead of plan or may be ahead of where you thought you might be and just in some of the sourcing changes and it seems like you are doing a good job on the generic front but can you just talk just a little bit about your vision for medical supply I mean that seems to get lost often just given where you came from and the focus on generics but on the medical supply side and just over the next couple of years can you just talk for a sec about bringing some of the dynamics to bare in that market that you know you sort of see may be props changing the way you sell and do business there similar to the way you are trying to change the way Cardinal sells on the distribution side?

George Barret

Sure. Glad to do that Blake. Yeah I know this is the medical segment is one we are excited about it is a very interesting collection of businesses and assets largely as we see the differentiated features we have an unusual footprint across channels very strong in acute care growing in ambulatory, very present in labs and so, as this system evolves and we have this confluence of some of the channels and movement across channels we really like the way we are positioned in that business we also have access to sort of what I would describe as a vertical capability tremendous capability for product management and category management.

We are able to source and in some cases produce our own products through global manufacturing and sourcing infrastructure and so this combination of category/product and channel we think is a very powerful tool. For the customer base, is under all kinds of challenges and pressure and we believe that we have got the tools that help improve their cost effectiveness and so we are really excited about where it is and we think we got the leadership throughout that business to drive us we think that the market has needs and that we have got tools that help address those needs and we are very excited about it and encouraged about its progress and we think there is a lot of potential in our medical businesses.

So again you will hear more from us, continuously on this and the evolving strategy but again think largely about channel footprint as well as category and products footprint. So that includes of course all of our branded supply systems but also, preferred product, our own source products and our own private label products and that combination we think is formidable and create a lot of value downstream for our customers.

Blake Goodner - Bridger Capital

Great. Thanks so much.

Sally Curley

Operator I think we have time for one more question and then we will.

Operator

There are no further questions. So this will conclude today's question-and-answer session. I would now like to turn the call back over to Mr. George Barrett, Chairman and Chief Executive Officer for closing remarks.

George Barret

Great thanks and thanks for all of the questions. I would like to end the call by just saying that we are encouraged by our performance and our rate of progress and while our first half was certainly boosted by some external factors the underlying business is moving in the right direction. There is a lot of work to do and we intend to get it done. So thanks to all of you for taking the time to listen in.

Operator

Ladies and gentlemen, we thank you for your participation in today's conference. This concludes the presentation. And you may now disconnect. Have a wonderful day.

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Source: Cardinal Health, Inc. F2Q10 (Qtr End 12/31/09) Earnings Call Transcript
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