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Cardinal Health (NYSE:CAH)

Q1 2011 Earnings Call

October 28, 2010 8:30 am ET

Executives

Company Speaker -

Jeffrey Henderson - Chief Financial Officer

George Barrett - Chairman, Chief Executive Officer and Chairman of Executive Committee

Operator

Good day, ladies and gentlemen, and welcome to the First Quarter 2011 Cardinal Health, Inc. Earnings Conference Call. My name is Janeda, and I will be your operator for today. [Operator Instructions] I would now like to turn the conference over to your host for today, Mr. John Frank, Director of Investor Relations. Please proceed.

Company Speaker

Thank you, Janeda, and welcome to Cardinal Health's First Quarter Fiscal 2011 Conference Call. Sally couldn't be with us today due to a death in her family, which is why I'm providing the introduction to today's call.

Today, we will be looking at 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 the SEC filings and the Forward-Looking Statement slide at the beginning of our presentation found on the Investor page of our website for a description of those risks and uncertainties. In addition, we will reference non-GAAP financial measures. Information about non-GAAP financial measures is included at the end of the slides.

Before I turn the call over to Chairman and CEO, George Barrett, I would like to remind you of a few upcoming investment conferences and events in which we will be participating and webcasting. Notably, the annual meeting of Cardinal Health shareholders on November 3 at the Cardinal Health headquarters in Dublin, Ohio; 2010 Credit Suisse Healthcare Conference on November 10 at the Arizona Biltmore in Phoenix; Lazzard Healthcare Conference on November 16 at the St. Regis Hotel in New York; Cardinal Health Investor Day and Analyst Day on December 7 at the Hudson Theatre in New York. The details of these events are or will be posted on the Investor Relations Events section of our website at www.cardinalhealth.com. So please make sure to visit the site often for updated information. We look forward to seeing you at the upcoming events.

Now I'd like to turn the call over to George. George?

George Barrett

Thanks, John, and our thoughts go out to Sally and her family during this difficult time.

Good morning, everyone, and thank you for joining us on our first quarter's call. Our fiscal 2011, or Q1 fiscal 2011, is up to a very good start. We reported revenues for the first quarter of $24.4 billion and a non-GAAP EPS number of $0.64, up 19% over the prior year period.

And while we had a slight decline in overall revenues on a year-over-year basis, we generated a healthy expansion in gross margins and held SG&A essentially flat to the prior year. Our strong operating performance in the quarter was driven by excellent results in our Pharmaceutical segment, offsetting an expected difficult year-over-year comparison in our Medical segment.

Overall, we continued our momentum coming out of fiscal 2010, strengthening the core of our business so we have a strong foundation from which to grow, with particular emphasis on margin expansion, disciplined management of working capital, growing generics at an accelerated rate and enhancing the customer experience.

Our customer work is beginning to produce results as we look at our record of contract wins and renewals in the Medical segment and a continued strength with our retail independent customer base. We have a very strong balance sheet and continue to manage it carefully. And during the quarter, we demonstrated our commitment to a balanced capital deployment strategy. We increased our quarterly dividend payment. We completed the acquisition of Healthcare Solutions, and we repurchased $250 million in shares. Our operating initiatives are on track, and we continue our progress in positioning our company to deliver sustained growth.

Now let me provide some additional color on each segment separately.

Performance in our Pharmaceutical segment, and in particular, our Pharma Distribution business, really drove the company's overall operating performance in the quarter. Segment sales were down 1% versus the prior year period due to a drop in sales to existing bulk customers and the impact from the previously disclosed loss of two large-revenue customers last year. We will begin to lap those losses in the second half of fiscal 2011. Despite the slight decline in revenue, segment profit was outstanding, up 42% versus the first quarter of last year. And our segment profit rate increased by a robust 41 basis points.

Our improved profitability was driven primarily by outstanding performance in our Generics business, various initiatives focused on improving margins and solid performance in our branded manufacturer agreements. We continue to build our capabilities and services to support our branded pharma partners. And as a result, these relationships are strong.

As I mentioned, we had an excellent performance across our generic activities, both on the sales and sourcing side. Let me take a moment to provide a little more color on our progress in these areas.

Our generic penetration continues to be a focus, and the team is executing exceptionally well in our source program across our retail independent customers and with our retail buying groups. The SOURCE program is our most comprehensive generics offering and includes nearly 4,000 generic drugs that make up, esentially, all of the retail pharmacies' product needs.

SOURCE revenues was up a robust 34% in the quarter versus the first quarter of last year. We have improved our execution on generic launches and have continued to enlist customers in our First Script auto shipment program. Success with these generic programs is resulting in value for our customers, for our suppliers and for us.

We also continue to make progress in our efforts to rebalance our business mix. Growth in our Retail Independent business continues to track ahead of the market, reflecting the emphasis we've placed in this channel in the past 18 months. And our churn rate at the end of the first quarter, which captures both controllable and non-controllable account losses, was the lowest it's been since we began measuring churn many years ago.

Turning to Nuclear. The raw material shortages we experienced through most of last year did resolve in the first quarter, and supply began to return to more normal levels after a long and difficult period of time.

Both the Chalk River reactor in Canada and the Petten reactor in the Netherlands were at full production by late September. Demand has not yet returned to pre-shortage levels, but we do expect to see this build over time. We have plans in place to help facilitate this ship with our customers in the coming months. In many ways, our relationship with our customers strengthened during the material shortages as we worked closely with them to ensure that the needs of the most critical patients were met first.

We continued to expand our position in molecular imaging. And in our positron emission tomography or PET unit, we are now working on clinical trials for 17 new compounds. We've made excellent progress in the three quarters since we launched this initiative, and we are well positioned to support this PET bio tracers through post commercialization. We will plan to give you a more complete view of our nuclear strategy at our Analyst Day in December.

We've made substantial progress on launching our new specialty division called Cardinal Health Specialty Solutions, which brings together all of our specialty capabilities within the Pharma segment, including specialty distribution, third-party logistics and cold chain management, drug development consulting and program management, regulatory and compliance services, risk mitigation strategies, medical billing and claims processing, sourcing and purchasing services and clinical pathways and treatment protocols.

We achieved an important milestone this quarter, closing on the acquisition of Healthcare Solutions or P4 as it is known in the oncology community. Our P4 integration is on schedule, and as indicated previously, we expect it to be substantially complete by the end of the next quarter.

We are building a world-class management team in our new specialty division, in addition to retaining the leadership of P4, including founders: Raj Mantena and Dr. Jeffrey Scott. We've attracted a great leader to run the overall Cardinal Health Specialty Solutions division. Meghan FitzGerald, our new President, has extensive healthcare industry experience focusing on specialty products. Her background includes senior roles in corporate development, strategy and international operations with companies including Medco, Pfizer and Merck.

Also joining us is Dr. Bruce Steinberg. Most recently, Bruce was President and CEO of Georgia Cancer Specialists, a Top 10 private cancer practice and leader in advanced cancer treatment and research. And the work we've done over the past month to build out our specialty physical infrastructure is largely complete.

We've also been working close with all stakeholders to solidify our partnerships and introduce Cardinal Health expanded specialty capabilities. Our value proposition connects patients, physicians, payors and pharmaceutical manufactures with the goal to improve access to efficient high quality care. A key component of our value proposition is P4 pathways, which brings together payors and practices. We believe this capability, in conjunction with the pharmacy management core competency we have within our pharmacy solutions unit, will give us a competitive advantage.

The timing is right for this important focus on integrated care. We continue to be very excited about our specialty strategy and our P4 acquisition, and we plan to show more details on our model in progress at our Analyst and Investor Day in December.

Now let me discuss our Medical segment. The quarter came in about as expected. Segment sales were down 3%, and segment profit was down 28% versus the prior year. Given the unusual comparisons in the quarter, I'll let Jeff walk you through the details, but let me give you an overall perspective on our progress.

We completed the rollout of our segment strategy around channel and category management during the quarter. This was an important change management staff to align the entire segment around the common goals for our customers and leverage our own strengths.

We continue to build out our preferred product portfolio and feel very good about our expanded global sourcing capabilities and our presence in Asia to drive this strategy. Our medical transformation initiative continues to progress and has moved into the build and test phase for the distribution solutions.

Our Ambulatory business, where we have made investments to grow our footprint, grew well ahead of the market. And the cross-selling effort with the Pharma segment continues to pick up speed.

I'd like to take just a moment to give you my observations on the demand side in our medical markets. Demand in the first quarter of fiscal 2011 was very similar to demand in the fourth quarter fiscal 2010. We have continued to see some sluggishness in elective procedure and doctor visits, both of which have an impact on the demand for our products and some of our medical businesses.

Having said this, I've spent a fair amount of time in recent weeks in the field, speaking to hospital executives. And I'm guardedly optimistic that procedural volumes will gradually recover. Granted, this is by no means a scientific example. We'll be following the situation closely, and we'll provide updates during our scheduled calls. We are taking a cautious approach and will continue to model a relatively soft market until we see these anecdotal observations begin to show up in the data.

Our recent account wins are giving us greater confidence that the actions we've taken over the last year to enhance the value we deliver to our customer are bearing fruit, and validate our channel and category strategy as well as our ability to execute.

We recently won a major multi-year product agreement with HPG, a group purchasing organization that supports nearly 1,400 acute care facilities. And in addition to a number of recent renewals and new account wins, we signed large multi-year contracts with Baylor Healthcare System and another renowned academic medical center that draws on the depth and beadth of our supply-chain offerings across our Medical businesses.

We are competing effectively in the Medical segment. We are positioned well, and we will continue to invest where we see opportunities for growth.

In summary, we're continuing the momentum we felt during the course of fiscal 2010. This was a strong quarter and a very good start to fiscal 2011. And I'm confident in our strategy and in our ability to perform.

15 reporting weeks into the year, there's plenty of games still to be played. But based on our performance in the first quarter and our progress on key initiatives in both segments, we've become more confident in achieving the higher end of the guidance range we provided in August.

Now let me hand the call over to Jeff, to provide more financial details.

Jeffrey Henderson

Good morning, everyone, and thanks for joining our call today. Like George, I am very pleased with the results of the quarter and the momentum we have carried over from fiscal 2010. Q1 is an excellent start to our year.

Let me add to George's remarks by expanding on some financial trends and drivers in the first quarter. I'll also provide some color to the full fiscal year outlook, including some of our key expectation from a corporate and segment standpoint.

Let's start with the consolidated results for the first quarter, summarized on Slide 4. Despite a slight revenue decline, we delivered 6% gross margin growth and with the benefit of relatively flat expenses, leveraged out into 15% non-GAAP operating earnings growth.

Non-GAAP operating expenses were up less than 1% as expense efficiencies largely offset the business expenses added to the net impact of acquisitions and divestitures.

The Non-GAAP tax rate was 37.1%, largely in line with our expectation for the full year, but above last year's rate of 35.4%. We benefited from the $450 million in share repurchases we have executed over the past two quarters, including $250 million in Q1, resulting in a significant reduction in share count to just under 352 million diluted shares outstanding.

Importantly, we continue to make real progress on our two key financial metrics: margin expansion and networking and capital optimization. At the consolidated level, the gross margin rate increased to 3.94%, which is an improvement of 27 basis points versus Q1 of FY '10 and 24 basis points sequentially versus Q4, driven by gains in our Pharmaceutical segment. The non-GAAP operating margin rate improved 22 basis points versus last year's Q1 to 1.52%.

We also saw further improvement in our networking capital days. Although inventory days have not come down this quarter, we reduced our day sales outstanding and realized a market improvement in days payable, driven by changes in one of our large vendor agreements. We continue to build on our Lean operational excellence initiatives to optimize working capital levels in fiscal '11, with the goal of sustaining and improving upon the gains achieved last year.

To summarize, we are making great progress with our performance initiatives, and it's beginning to consistently show in our key metrics. Although we'll always see some quarterly fluctuations and margin rate trends at working capital levels, due to the nature of our business and external factors, we feel we have the actions in place to continue to move these in the right direction.

Let me now provide a few other comments on segment performance in Q1, referring primarily to Slide 5 and 6 and starting with the Pharma segment. Revenue in the Segment declined 1%. This primarily reflects three major items. First, bulk sales for existing customers were down, driven by changes in ordering patterns in some of our large bulk customers, including the year-on-year impact of some large Tamiflu orders which occurred in fiscal '10. Second, as disposed previously, we continue to feel the impact of ending our relationship with two large revenue customers in the Mail Order and Grocery Chain Pharmacy segments, which dampens sales growth by approximately 1.2 percentage points in Q1. We will begin to lap this revenue losses by mid fiscal 2011. Third, we also had a dilutive effect on revenue mix from the conversion of certain brands to generics. In addition to driving down overall sales, these three items had a disproportionate impact on sales to bulk customers, which were down 8% for the quarter. However, I'm pleased to report that sales to non-bulk customers were up 6% for the period.

Within this customer category, revenues from retail independents grew 3%, continuing to grow at a rate above the market in this important classic trade. Our overall generics revenue growth was nearly 20%, driven by an impressive 34% growth in our generics preferred SOURCE program.

The Pharma segment profit margin rate increased by 41 basis points compared to prior year's Q1. In addition to the continued success of our generic sales and sourcing programs, we also saw more than expected benefit from new item generic launches during the quarter. Solid performance under our array of manufacturer agreements and brand inflation from our remaining price-contingent vendors were also positive drivers.

Please keep in mind that we benefited year-on-year from the impact of certain large pharma vendors, which transitioned to DFA agreements. Finally, I should point out that we had a change in estimated reserves related to DFA fees receivable from certain manufacturers, which contributed $9 million dollars for the quarter.

We realized margin expansion in both our bulk and non-bulk customer segments. For the quarter, the bulk segment profit margin rate was 37 basis points, and our non-bulk rate was 2.17%. Both of these rates are significantly above last year's first quarter rates and the annual average for fiscal 2010.

A reminder that we are not planning to provide a detailed bulk/non-bulk margin quarterly breakdown in our 10-Qs going forward. But we do want to make you aware of a fairly significant change in trend during this call. Bottom line, the segment had exceptional performance throughout and drove an increase in segment profit of 42% to $296 million.

Now turning to our Medical segment. As George mentioned, the first quarter had a bit of noise around it. But overall, we're pleased with where the business is heading. Revenue for the segment declined by 3% to $2.17 billion, primarily as a result of our prior year revenue recognition event that was triggered by the spinoff of CareFusion in the amount of $51 million, as well as a tough compare against an early and strong flu season in the first half of fiscal 2010 worth $28 million in the quarter. Excluding these two unique events, the segment would've experienced positive revenue growth. Importantly, our Inventory business grew at a rate of over 5%, which is significantly above market over the same time period.

Medical segment profit declined 28% to $83 million, mainly due to the combined effect of last year's unique items, namely, the CareFusion revenue recognition issue, which was worth about $14 million of profit and a flu impact of approximately $5 million. Increase in commodity prices also created a year-on-year headwind in our current-period cost of goods sold of about $15 million. All told, these items' total reduction in segment profit growth of 30 percentage points.

Net-net, despite the current short-term sluggishness we are seeing in the procedural market, our Medical business is gaining momentum. And we are continuing to invest in systems and strategy to drive longer-term growth and margin expansion.

Now let me turn to Slide 7, and take a moment to walk you through the items that accounted for the difference in our GAAP to non-GAAP EPS numbers. All these figures that I'll review our on an after-tax basis.

The biggest item in this category is a $75 million gain from the sale of 30.5 million shares of CareFusion stock in the quarter. This generated proceeds of $706 million and accounted for approximately $0.21 of GAAP EPS.

Please note that there is no tax impact associated with the sale due to the release of our previously established deferred tax valuation allowance. The sale of these shares complete the liquidation of our CareFusion stake.

The remaining items on this page, which is restructuring and severance, acquisition-related costs and other spin-off costs netted to approximately a $0.01 reduction. The net of all these items result in a GAAP EPS of $0.84 versus non-GAAP of $0.64.

Let's briefly shift our discussion to the balance sheet. Several significant items which impacted it are listed on Slide 8. We ended the quarter with $2.7 billion in cash, in which about $313 million is held overseas. We maintained a strong liquidity position in spite of over $750 million in total outflows related to share repurchases and our acquisition of Healthcare Solutions.

Our cash position was bolstered by the sale of our remaining CareFusion stake and $217 million in operating cash flow. One item of note, as you compare this year's operating cash flow to last year's figure, keep in mind that we had a $144 million of benefit in last year's number related to CareFusion's ongoing operation for the two months that it was still part of Cardinal Health.

Now to answer a question that I suspect is in many of your minds, let me reiterate our position regarding our capital deployment. Our first priorities are to maintain our differentiated dividend and ensure we are investing appropriately in our organic capital expenditures. In the latter regard, we expect to invest in the range of $250 million this year, about the same as last, but the majority of that in IT-related processes and systems.

Beyond that, we don't have a fixed formula. Our goal is to ensure that we are positioning for sustainable competitive advantage and to create shareholder value. Where those ends, we will continue to evaluate both acquisitions in select areas and share repurchases. We don't envision the paydown of our existing long-term debt balance in our current plans.

Now let's turn our discussion to fiscal '11 guidance. As George mentioned, we do only have one quarter behind us at this point, so there's still plenty of year left. However, given our performance and our progress in key initiatives, we become more confident in achieving the higher end of our previously announced non-GAAP EPS guidance range of $2.38 to $2.48.

Our overall revenue guidance remains unchanged at low single-digit growth despite a slightly more cautious view of Med/Surg market volumes.

Slide 10 outlines some of our key corporate expectations for the year. Let me focus on the items in red, which represent changes from our previous assumptions shared in our August call.

Our diluted weighted average shares outstanding are now projected to be approximately 352 million, reflecting the timing and per share acquisition cost of the $250 million of repurchases that were completed in Q1. Interest expense and other, should be $110 million or so. Our Q1 number is abnormally low due to the impact of interest rate swaps, FX and deferred compensation gains realized in the quarter.

Question-and-Answer Session

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