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Owens & Minor (NYSE:OMI)

Q2 2014 Earnings Call

July 29, 2014 8:00 am ET

Executives

Craig R. Smith - Chairman, Chief Executive Officer, Chairman of Executive Committee and Member of Strategic Planning Committee

Trudi Allcott - Director of Investor & Media Relations

James L. Bierman - President and Chief Operating Officer

Richard A. Meier - Chief Financial Officer and Executive Vice President

Analysts

Glen J. Santangelo - Crédit Suisse AG, Research Division

Eric W. Coldwell - Robert W. Baird & Co. Incorporated, Research Division

Robert P. Jones - Goldman Sachs Group Inc., Research Division

Lisa C. Gill - JP Morgan Chase & Co, Research Division

Robert M. Willoughby - BofA Merrill Lynch, Research Division

Sean Dodge - Jefferies LLC, Research Division

Steven Valiquette - UBS Investment Bank, Research Division

David Larsen - Leerink Swann LLC, Research Division

Operator

Good morning, ladies and gentlemen, and welcome to Owens & Minor's Second Quarter 2014 Financial Results Conference Call. My name is Janine, and I will be your operator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the presentation over to your host for today's call, Mr. Craig Smith, Chairman and Chief Executive Officer of Owens & Minor. Please proceed, sir.

Craig R. Smith

Good morning, everyone, and welcome to the Owens & Minor's Second Quarter 2014 Conference Call. After I introduce my colleagues on the call today, we will review our results and take your questions.

Here with me this morning are Jim Bierman, our President and Chief Operating Officer; Randy Meier, our Chief Financial Officer; and Grace den Hartog, our General Counsel.

Before we begin, Trudi Allcott will read a Safe Harbor statement. Trudi?

Trudi Allcott

Thank you, Craig. Our comments today will be focused on financial results for the second quarter 2014, which are included in our press release. In our discussion today, we will reference certain non-GAAP financial measures. Information about these measures and reconciliations to GAAP financial measures are included in our press release and in the second quarter supplemental slide presentation, both of which are posted on our website. Also, our call today will be archived on our website.

In the course of our discussion today, we may make forward-looking statements. These statements are subject to risk and uncertainty that could cause actual results to differ materially from those projected. Please see our press release and our SEC filings for a full discussion of these risk factors.

Finally, we'll be participating in several investor conferences in the fall. The R.W. Baird Health Care Conference, the Morgan Stanley Global Health Care Conference, and the Credit Suisse Health Care Conference in November. We look forward to seeing you on the road. Thank you. Craig?

Craig R. Smith

Thank you, Trudi. And before I turn the call over to Jim and Randy, I would like to comment on yesterday's succession announcement. As you may have seen, I will be transitioning from my position as CEO effective September 1. Jim Bierman, our President and Chief Operating Officer, will succeed me on that date and will also be appointed to the board. I will continue with the company as Executive Chairman and will remain actively involved in strategic planning and leadership development. I have devoted the majority of my personal -- professional life, it's like my personal life too, to Owens & Minor, and I have watched it grow from a regional distributor to a global $9 billion health care logistics services organization. I have been very fortunate to have great teammates around me over the last 25 years, and I am very proud of all that we have accomplished.

Now is the ideal time for me to step aside as CEO after 3 years of investment that have strengthened Owens & Minor's leadership position in our sector. We are continuing to focus on our strategy of connecting the world of medical products to the point of care. And we believe, we are well positioned to build on our proven core capabilities, history, and strong balance sheet to deliver long-term growth and value creation.

Jim has been a key executive at the company for the past 7 years, and has a skill and experience to lead Owens & Minor. He has a deep understanding of the company and its business. Jim has led our response to the changing home care landscape and is directing the investments necessary to drive long-term growth and value creation. I want to truly congratulate Jim as he takes on this new role, and I look forward to working with him in a new capacity.

Last, but not least, before I turn it over to Jim, I want to thank our customers, both manufacturers and providers, our investors, and most importantly, our teammates, for the support -- sorry, I knew, I wasn't going to get through this, you have all given me over the years. My time at Owens & Minor has been great and meaningful, and I want to thank you. And with that, I'll turn it over to Jim for his remarks.

James L. Bierman

Thank you for those kind words, Craig. I'm honored to have the opportunity to lead Owens & Minor at such an exciting time in its history.

As Craig mentioned, Owens & Minor has become a vital supply chain services provider to the healthcare industry and is well positioned to continue to grow and build on our proven core capabilities.

The company's solid foundation and bright future is due in large part to Craig's efforts over his 25 years at the company, including the last 9, as CEO. I look forward to working closely with him, and we are all pleased that the company will continue to enjoy the benefit of his experience and insight.

Turning to the business at hand, I will provide details on our domestic operating performance and then update on the pending acquisition of Medical Action Industries.

This was a highly productive quarter for our Domestic segment. We consolidated 2 of our facilities in the northeast, and we are in the process of establishing a second regional distribution center, this one in California, all of which will increase efficiency in our distribution platform.

Moreover, these are 2 of our larger facilities that serve significant customer accounts, and our investments include physical infrastructure upgrades, IT improvements, and new inventory stocking capabilities. These investments will not only allow us to further leverage our infrastructure, but also to better serve both our manufacturer and our provider customers now and into the future.

During the quarter, we also celebrated with one of our large IDN customers, the completion of their new facility. Together, we moved into a new strategic logistic center as part of their new state-of-the-art health services complex in the Cleveland area.

We continue to pursue our strategic initiatives, which are designed in part to help us improve operational efficiency. The results show that domestic SG&A declined this quarter for the second consecutive quarter, even as we incurred the costs related to the previously mentioned distribution center moves. We believe that our efficiency and productivity improvements are taking hold.

We witnessed solid revenue growth in the quarter. As we have seen for many consecutive quarters, the growth was strongest among the largest provider customers and weaker, or even declining, among the smaller provider customers. While our desire to meet the needs of our larger, more sophisticated provider customers drove the redesign of our sales and service model, we remained committed to serving all of our customers with our more complete and cost effective service.

Growth in revenue and expanding acceptance of our service offerings are evidence that our strategy is being validated in the healthcare market. As we have mentioned before, we are now fully engaged in the transition of a large for-profit healthcare system. This new customer has both acute and non-acute points of care. So we are excited about the potential for growth as our relationship matures.

After a delayed start, the conversion process is now underway. As is customary with all large customer conversions, we are incurring some on-boarding expenses ahead of the conversion. As revenues with this customer build throughout the year, we should be able to gain greater operational leverage.

Turning now to the pending acquisition. As we recently announced, we entered into an agreement in June to acquire Medical Action Industries, a leading domestic producer of custom procedure trays and minor procedure kits. The transaction is valued at approximately $208 million, including assumed debt net of cash. For their last fiscal year, which ended in March, Medical Action reported annual sales of $288 million, of which approximately 45% were sales to Owens & Minor. The transaction is expected to close in the fourth quarter of 2014 and is subject to customary closing conditions, including Medical Action shareholder approval.

We're pleased that we learned on Friday that the Federal Trade Commission has granted early termination of the HSR waiting period, so we are one step closer to closing the transaction.

This acquisition supports our strategy of connecting the world of medical products to the point of care. Medical Action's strong capabilities in tray assembly complement our existing ability to offer unitized delivery services to the provider market.

For those of you less familiar with this terminology, our unitized services involve providing a specific selection of products delivered to a unique stocking location for a particular patient procedure. The benefits for the provider and its patients are meaningful, and we are truly excited about the new ways we can serve both our provider and manufacture customers with the capabilities Medical Action affords us.

Our leadership position in health care logistics, coupled with Medical Action's dedicated clinical sales force, creates opportunities for enhanced growth in the domestic kit and tray market. While at the same time, Medical Action's strategy of providing product choice and flexibility to providers complements our logistics focus supply chain services. The acquisition also enhances our partnerships with manufacturers by providing continued market access and enhanced opportunities for products to flow through our unitized delivery services. In fact, over the past year or more, several of our manufacturing partners have been asking us to get into the kitting business. We are pleased to have signed a transaction with an industry leader as our solution to this opportunity.

We have a long history with Medical Action as their most significant channel partner, and we are confident in our ability to achieve the identified synergies and to unlock the value in the combination. Our 2 companies share similar cultures, and we look forward to welcoming the Medical Action teammates to the Owens & Minor family.

Finally, I want to reiterate our 3 areas of focus in the Domestic segment for 2014. First, the evolution of our physical network to meet the changing needs of our provider and manufacturer customers.

Secondly, the creation of a single platform, capable of serving both manufacturers and providers. And lastly, the expansion of our capabilities in the marketplace to help our customers achieve supply-chain efficiencies.

We are enthusiastic about our position in the healthcare market and about developing our service portfolio, and we strongly believe the adjustments we are making in our business should position us for profitable growth in the future.

Thank you. And with that, I will turn it over to Randy.

Richard A. Meier

Thank you, Jim, and good morning, everyone. Before providing a review of the quarterly results, I would like to say congratulations to Jim as he assumes this important position. In working with Jim, I found him to be a decisive visionary leader. I look forward to working with him and the team as we continue to build our company and expand our horizons.

I would also like to thank Craig for his leadership and vision in leading Owens & Minor for so many years. His many contributions have put Owens & Minor in a strong position for the future. I'm sure everyone on the team joins me in wishing Craig well as he embarks on his new phase of his life.

Turning to the business at hand, I would like to begin with a review of the financial results for the second quarter, and then I'll provide a briefing on the International segment.

First, let's look at revenues. Second quarter consolidated revenues improved 3.1% to $2.3 billion when compared to last year. The quarterly improvement was driven by 2% growth in our Domestic segment, which contributed revenues of $2.2 billion, as well as a 20% -- excuse me, 28% growth in the International segment, which contributed $118 million in revenues to consolidated results. As a reminder, fee-for-service business generally comprises approximately 2/3 of the International segment revenues.

As Jim mentioned, second quarter domestic revenues reflect stronger growth coming from our larger health care provider customers, offset somewhat by declines from our smaller providers. And looking at consolidated gross margins, we reported $283 million for the second quarter or 12.24% of net revenues, reflecting an $8.9 million increase when compared to last year. This increase came primarily from growth in the fee-for-service business in the International segment.

In the Domestic segment, quarterly gross margin declined largely due to lower benefits from supplier price changes when compared to last year, as well as lower margin on our new and renewed customer contracts. This reflects a continuation of the trends we saw in the first quarter.

As for operating expenses, consolidated quarterly SG&A expenses were $226 million or 9.79% of revenues, reflecting a 28-basis-point increase compared to last year. The increase in expenses resulted from the International segment, where we experienced higher cost to serve growing fee-for-service activity and increased cost to integrate and serve a significant new customer in the U.K.

As Jim mentioned, second quarter domestic SG&A was lower on both on a dollar and a percentage of revenue basis compared to the prior year. Adjusted quarterly operating earnings, excluding pretax acquisition related, and exit and realignment costs of $7.6 million, were $44.7 million or 1.94% of revenues.

On a segment basis, quarterly domestic operating earnings decreased nearly $3 million to $48 million. The International segment reported an operating loss of $3.6 million for the quarter due to the factors we have discussed.

For the quarter, pretax acquisition and related costs were approximately $3.5 million, while exit and realignment charges of $4.1 million resulted from the previously mentioned strategic initiatives in the International and Domestic segments.

In Europe, exit and realignment activities included initiating the closing of the Stuttgart office, as well as staff realignment actions, and the initiation of additional facility closures.

Actions taken in the Domestic segment were related to the strategic initiatives designed to streamline efficiency and improve productivity, including distribution center closures and the establishment of a second regional distribution facility, this one on the West Coast.

At this point in the year, we estimate that exit and realignment charges for the year will exceed our previous outlook, as we are taking more significant steps with our European operation given the recent performance. Our tax rate increased to 41.1% for the quarter, the increase was due to the impact of foreign taxes and certain acquisition-related costs that were not deductible. And we would expect that the rate will remain at a similar level for the remainder of the year.

Operating cash flow for the year-to-date period was $73 million. And on a consolidated basis, asset management metrics were stable, including inventory turns of 10.2x and DSOs of 20.6 days.

Turning to the bottom line, second quarter adjusted net income was $25 million or $0.40 per diluted share compared with $0.46 per share for the second quarter last year. For the year-to-date, adjusted net income was $52.7 million or $0.84 per diluted share compared with $0.90 for the same period last year.

With that update, I would like to turn to our financial guidance for 2014. Based on our financial and operational results, so far this year, and our expectations for the remainder of the year, we now expect revenue growth to exceed 2% and adjusted net income per diluted share to be within the range of $1.80 and $1.90 for the year, which excludes acquisition-related and exit and realignment costs, along with the impact of the Medical Action acquisition.

With that review of our financial results, let's turn to the International segment and the actions we are taking with the Movianto platform. The International segment posted a $3.6 million operating loss for the quarter, resulting from the U.K. operations. The continued integration of a large customer, plus reductions and other customer activity contributed to the operating loss.

During the quarter, the U.K. team, under the guidance of new Owens & Minor Europe leaders worked aggressively to stabilize operations with the new large customer. We made investments during the quarter in order to drive operational improvement in the second half of the year. So far, these efforts have been focused on further integration, stabilization, and overall cost control. We are seeing signs of performance stability with the large customer.

On a positive note, excluding the results of the U.K. division, Movianto was profitable for both the quarter and the year-to-date period. Based on the progress we are making, we anticipate that the Movianto platform will have a modest positive contribution during the second half of the year.

As you can see from exit and realignment charges incurred during the quarter, we are taking more aggressive steps to rationalize the European platform. During the quarter, we initiated the closing of the Stuttgart office, and we'll be moving key administrative functions, such as IT, Finance, and Human Resources to the U.K. We intend to use Owens & Minor Europe platform to expand our business overseas and integrate any future acquisitions. We expect the Owens & Minor European team to identify opportunities for expansion, while providing leadership and achieving improvements in efficiency and productivity throughout the European operations.

Ultimately, we believe Owens & Minor Europe will ensure consistency in our strategic and tactical efforts while establishing a greater brand and marketing presence.

Looking ahead to the rest of the year with our European segment, we continue to build our sales pipeline and we are planning it to on-board 3 new customers in the third quarter, and we are transitioning the Movianto team and operations to more fully align with the Owens & Minor structure. The entire team is now reporting to Charlie Colpo, one of our most experienced operational leaders.

While our near term efforts have been aimed at stabilizing the U.K. division as quickly as possible, we remained focused on the future as we prepare our platform across Europe for profitable growth opportunities. Consistent with our efforts in the Domestic segment, we are now focusing on 3 areas as we work to achieve sustainable profitable growth.

First, we continue to evaluate the physical network in Europe to ensure that it meets the needs of our customers and operates as efficiently as possible.

Second, we are evaluating the IT infrastructure needs of the European network to ensure that we have the right systems to efficiently serve our business needs. And finally, we are looking to align our global capabilities and cross-sell our services throughout the European platform.

Thank you. And with that, I'd like to turn the call over to Craig.

Craig R. Smith

Janine, let's open it up for questions please.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Glen Santangelo of Credit Suisse.

Glen J. Santangelo - Crédit Suisse AG, Research Division

Craig, best of luck to you in your new endeavors and, Jim, congrats on the promotion. So I just wanted to touch real quickly about the margins in both the segments. First, on the Domestic segment. I feel like the GPO renewals was really a 2013 story. And now you're blaming maybe worse than expected margins on customer renewals, and price inflation or lack of price inflation. I feel like we knew that, that the first half presented a difficult comp. And so I guess I'm really kind of trying to probe to figure out what really surprised you intra-quarter here that really led to the lower than expected margin result?

James L. Bierman

Yes, Glen. Let's talk a minute about the timing of the GPO renewals. And really as this business comes on, because I do think we are, as a quarter-to-quarter, year-over-year comparison, it takes 4 quarters to lap the comp from the prior period. And I think, although contracts were signed in the latter part of 2013, some of those contracts didn't actually take effect until the more -- closer to the beginning of 2014. And as we've talked about on numerous occasions, not all large provider customers within a GPO have their contracts coterminous with the GPO renewals. So I think we need to be careful about looking too literally at sort of the timing of a large GPO renewal and when the results continue to work their way through the system. That being said, going back to the essence of your question, which is, where does the margin compare or relate to what we were targeting as we thought about 2014? I guess my reaction to that is, quite candidly, we are lagging a little bit behind, not dramatically, but behind where we thought we would be. Some of that has to do with the manufacture side of our business. We are seeing unbelievable amount of interest in our offering from manufacturers -- the number of manufacturers I met with, over the course of this last quarter, was significant and the interest in our offerings are significant. But the timing on some of that is difficult to predict. And I think quite candidly, as we thought about 2014 back in December of 2013, our expectations were that the market would move towards us a little quicker with some of our offering. The last point I'd make, and I don't mean to belabor this, and -- but you know us well enough. Historically, if we had seen the relatively small gap in the provider margin, we would've been in position to reduce SG&A concurrently with that decrease, with that gap. I think right now, we're in a -- somewhat unusual position that we have challenges reducing that SG&A because of the commitment we have to on-board a large healthcare system. And so we are carrying a bit of excess capacity while we on-board of that system. As I said, in my prepared remarks, we expect to achieve a better, more optimal operational performance once the conversion is done. But it was a phenomenon that's kept us, in the first half of the year, from being able to reduce SG&A to match the more revised gross margin domestically.

Glen J. Santangelo - Crédit Suisse AG, Research Division

Jim, I appreciate all those comments. Maybe I will just follow up with one on the International segment. Last quarter, I think you commented that the on-boarding cost of the significant customer in the U.K. was $1.5 million, and I think that's what you spent in the first quarter. Is there a comparable number you can give us in the second quarter? And I'm just kind of curious, maybe if you could get a little bit more granular in terms of what the integration issue is because I feel like this is been kind of 6 months. And so I'm guessing what really surprised you with respect to the integration or is the pricing becoming an issue? If you could just talk a little bit more specifically because if you look at your new guidance, it still implies a reasonably significant ramp sequentially in the second half of the year which, I guess, you're assuming margins in both segments are going to recover in the second half, and without knowledge of the U.K. customer, I'm not sure what gives you confidence that, that's going to be the case.

James L. Bierman

That's a good question, Glen. Let me ask Randy to comment both on the guidance side of it. And then the U.K. margin issues.

Richard A. Meier

Sure, Glen. With regard to the European margin specifically, what's going on in the U.K., as we suggested in the first quarter, we had just began to on-board the customer in March. Those activities continued through the second quarter. And we had similar costs, if not even slightly higher costs, as we went through that process in the second quarter. We stabilized the situation with that customer. There was a fair amount of turmoil, not just on our side, but with the customer in question here. We're pretty pleased with all the activities and where we ended up at the second quarter, so we remained fairly confident that as we move into the second half of the year, broadly, we'll start to see contribution to the overall earnings in the second half of the year. I think one other comment with regard to the U.K., we also mentioned in the first quarter that we saw a reduction in customer activity even outside the single customer that we were on-boarding. That has continued to persist in the second quarter, and we are taking fairly aggressive actions as we look ahead to make sure that we've got the appropriate sized organization in the U.K. to manage our existing book of business. So I think, again, we'll be in a good position to improve overall performance in the second half of the year. I think with regard to the broader gross margin and how it impacts earnings, as we've indicated back on Investor Day and throughout the first half of the year, that in large part, this was going to be a second half of the year story. We continue to be reasonably confident that, that will materialize, as Jim indicated with a few larger customers coming on board in the second half of the year. We've completed all of the activities around bringing on board a number of the GPO contracts that we signed last year. And as we indicated on Investor Day that we would incur some costs throughout the first half of the year. And again, over in Europe, with the adding of 3 new customers in the third quarter and the ongoing efforts to improve the situation in the U.K., and as we noted in our remarks, the profitability that the rest of the network has, we feel fairly confident that we'll see positive contributions in the second half of the year.

Operator

And your next questioner is Eric Coldwell of Robert W. Baird.

Eric W. Coldwell - Robert W. Baird & Co. Incorporated, Research Division

Okay, let me reiterate the congratulations to both Craig and Jim, and good luck with all the future initiatives. Really, I want to dig into a couple of things here. First off, domestic growth. You made some comments and obviously we saw in the numbers, a little better domestic growth. You've said this quarter, as well as in the past, that larger clients are growing faster than smaller clients. And I think that's very consistent with what you've said. But what I'd like to parse out here is, are you really seeing any inflection in the market overall? Or is the better-than-expected top line growth in domestic this quarter more of a situation of perhaps OMI taking net market share. And I don't know if you can parse that out the way you've in the past, but you have been able to give us pretty good details in historic reports about what drove the revenue growth in the quarter.

James L. Bierman

Yes, Eric. Great question and one that we deliberate here ad nauseam. As -- let me give an anecdotal comments. As we've met with a number of our provider customers over the course of the quarter. Quite candidly, we're beginning to hear, in pockets of the United States, provider customers beginning to talk about an increase in utilization. The root cause of it is still somewhat speculative in that you have many forces coming together simultaneously. You have an improvement in the economy, which we have always said from the outset was critical to seeing the recovery in utilization. You certainly have the impact of the Affordable Care Act and the additional covered lives as being at least 2 of the drivers. And you have an element of pent-up demand coming out of the first quarter. Which of those are the 2 drivers? I'm not sure anyone will ever really know. The critical question you're alluding to is the sustainability of this. And is it -- are we -- the industry in position to make a call on this? We think it's premature. We think also, and Craig was sharing this with me the other day, based on his 25 years of experience, he was telling me that in similar economic downturns, what we've seen is about a 6-month delay from the time that utilization begins to pick up before we see a full return to normal buying behavior through our channel. Stated another way, I think there's going to be some unevenness as providers, and to a degree manufacturers, build up inventory once the trend becomes more sustainable. So long-winded answer to your question. We think and believe we are taking share. We think and believe that our large customers are taking share from smaller customers that's harder to specifically quantify. But I think it would be disingenuous for us to sit here and say that there aren't some underlying trends that are beginning to formulate within the industry.

Eric W. Coldwell - Robert W. Baird & Co. Incorporated, Research Division

Okay, that's helpful. And let me just shift gears quickly to Movianto with one additional question. It's nice to hear that Charlie is taking over more of the leadership activity there with Movianto. And I'm curious if any of the past leaders that have been announced to the Street or introduced to the Street. Have any of those actually left the business? Or are they simply somewhat repositioned at this point? And then what would be the company's views of the long-term leadership agenda in International? Is this going to be something that Charlie sticks with for the next 3, 5 years? Or is he simply spearheading the kind of the resurgence of that business and then there will be somebody who steps in full-time to lead International? I'm just curious what the long-term thinking is in that segment.

James L. Bierman

Yes, Eric. I think -- first of all, I think we are so fortunate to have someone with Charlie's both experience and trust factor within the company and his willingness to relocate to the U.K. to help work through this. So we truly appreciate his contribution. That being said, and you've known me -- and others on the call have known me long enough to know that I've worked through, in the history of my career, challenges in Europe before. I truly believe that Europe needs to be run by Europeans. And we will move forward with looking for a solution for that as it relates to the U.K. I think, as Randy said, the rest of the Movianto business and European part is really operating pretty well. And we're happy with the leadership and the efforts as it relates to Europe in general. But we do have a problem in the U.K. and we do need to solve that.

Operator

Your next question is from Robert Jones with Goldman Sachs.

Robert P. Jones - Goldman Sachs Group Inc., Research Division

Again, let me echo the congratulatory comments already made. I wanted to ask around the back half guidance, and specifically some of the comments around utilization. And even with the reduced outlook looks like the back half is implying somewhere around 20% growth over the first half. And I'm curious, Jim, based on maybe some of the early indicators you're seeing around a pickup in utilization, is there any piece of the back half that is predicated on utilization getting better? And I guess, if not, asked the other way, is there any upside in your mind to where you see the business in the back half if, in fact, this early signs of utilization taking hold actually continues?

James L. Bierman

Yes, good question, Bob. I'd say that the major driver in our thinking on the back half of the year domestically is the full conversion of this large healthcare system that we've spoken about. I think that's the major impact. So that being said, if utilization was to significantly increase, we would have upside in the back half of the year.

Robert P. Jones - Goldman Sachs Group Inc., Research Division

Okay, great. And then I guess just if I could take a step back and ask one big picture question. It seems like around the domestic business, pricing certainly has proven one tricky area to predict. But I think the broader backdrop over the last -- past several years has really been around mix shift towards the larger providers and consolidations obviously pushing that forward. Any sense you can give us today as you think about that evolution and where we are in it?

James L. Bierman

Yes, I -- this is just my personal view. I think we are still relatively early on in the consolidation affiliation play. Quite candidly, I think it will play out for a while to come. It may take a different form than what we've seen certainly initially, but I think there will continue to be consolidation in the marketplace. And I do agree with your premise at the outset that this is a bit of a mix issue as one looks at a shifting landscape between customers.

Operator

Your next question comes from Lisa Gill with JPMorgan.

Lisa C. Gill - JP Morgan Chase & Co, Research Division

My congratulations as well. And Craig, I'll really miss talking to you after all this years. I thought that maybe I would just start with some questions around the acquisition that you're actually making. Do you have any insights into the customer overlap between who you are serving today and Medical Action -- who they're actually selling their trays and kits to?

James L. Bierman

Yes, Lisa, I think, and this is off the top of my head, but the overlap is pretty good. We've enjoyed the relationships that we've had with Medical Action. Geez, I think Craig -- it's been 35 years, right? So it's a long-time relationship. And in contrast to other manufacturer of kits, they do not compete with us for distribution services. So we've always enjoyed working together with them with a very complementary customer base.

Lisa C. Gill - JP Morgan Chase & Co, Research Division

So I guess looking at it from another direction, though. Do you see a broad-based opportunity to increase the penetration of their medical kits into the rest of your existing base?

James L. Bierman

Well, I think what we've found, Lisa, is that as we have responded to opportunities that have existed in the marketplace, that we find ourselves occasionally at a disadvantage because we don't had -- have an offering in this space. And so I think, yes, we are viewing this as having significant upside and expanding the joint Medical Action/Owens & Minor offering in the marketplace. I would also point out, and I alluded to this a little bit in my opening comments, but the offering is just as important or critical to our manufacturing partners. They are asking for a solution in the marketplace for someone that truly is product-neutral relative to what goes into the kit. And our position as the distributor of choice for branded manufacturers definitely plays well with that. So we view it as the opportunity is being, yes, increasing the offering to the providers, but just as importantly, aligning ourselves with the manufacturers.

Lisa C. Gill - JP Morgan Chase & Co, Research Division

Okay, great. And then just second to your comments around utilization. Is there any way there to -- when you look at the utilization, is it broad-based across all of your customers today? Or are you seeing specific areas of the country where you're seeing this increase in utilization? Or is it big hospitals versus smaller hospitals? Is there any way for us to look at that more acutely?

James L. Bierman

Yes, and I think as I tried to allude before, I think it's pockets of the United States. And I'm not even sure that I can be as specific as saying it's a Southeast versus the Southwest. But it is pockets of the United States, and it is definitely the larger systems. We serve a large number of the for-profits. And I think their comments are, to a large degree, what we're seeing also through our systems on a broader scale.

Operator

And your next question is from Robert Willoughby with Bank of America Merrill Lynch.

Robert M. Willoughby - BofA Merrill Lynch, Research Division

I jumped on a bit late. I was just wondering, did you speak to what drove the inventory spike? Is that the new customer on-boarding efforts that you're anticipating? And if so can we reasonably expect the inventories to be converted to cash this year or will it take more time?

James L. Bierman

You know us too well, Bob. Yes, absolutely, we built inventories in anticipation for the beginning of July go-live with this large customer. Completing a conversion of that magnitude seamlessly is absolutely critical to us, and as you've seen in the past and alluded do, we will build inventories in anticipation of that and then we will drive those inventories down over the course of the remaining back half of the year. So that's exactly what you saw.

Robert M. Willoughby - BofA Merrill Lynch, Research Division

Okay. And with the Medical Action deal, you mentioned the cost savings opportunity. Are there any working capital requirements or investment that business may need? Or are you able to harvest any capital out of that business assuming it closes?

Richard A. Meier

Robert, this is Randy. I think, as we move forward, we don't see as having a significant working capital opportunity. Obviously, slightly different business than what we're in terms of the way we move inventory. Given that a fair amount of their product moves through our existing channel today, we don't see that as being a significant issue going forward. On the other side of the coin, though, I think we do have the opportunity to sort of manage this over the next 12 to 18 months in terms of integrating it into our overall system in a fairly seamless fashion.

Robert M. Willoughby - BofA Merrill Lynch, Research Division

No facilities opportunities, anything like that?

Richard A. Meier

We've got the one facility up in Brentwood, their headquarters building, that obviously would be duplicative to our efforts and certainly that's something that we're considering as we move forward.

Operator

Your next question comes from Sean Dodge with Jefferies.

Sean Dodge - Jefferies LLC, Research Division

So staying on the Medical Action acquisition, you mentioned $10 million to $12 million in synergies by the end of 2016. Could you put some book ends around how much of that you expect to achieve in 2015? Or maybe even how accretive to EPS you expect it to be next year?

Richard A. Meier

I think, right now, given where we are in the transaction, it's a bit premature to give you some of the specifics on when we might achieve things on a quarterly basis. I think where we are right now is, we do expect this transaction to close this year, and it would probably have very minimal impact on the overall earnings this year. We're confident on our ability to achieve an accretive transaction next year. And I think where we're trying to go with the $10 million to $12 million is we would be in a position by 2016 to fully realize that amount on a run rate. So I think you can sort of think about that in those terms.

Sean Dodge - Jefferies LLC, Research Division

Sure, okay. Then, Randy, on the international side, you've been doing a lot of work to still and right size capacity there. How close does the ramping of the large U.K. client and then the shuttering of the Stuttgart office get you where you want to be? Or I guess asking it differently, where will utilization stand once that client is up and running and Stuttgart is closed?

Richard A. Meier

Great question. I think the clarification on a couple of things. The Stuttgart office is purely an office facility. It wouldn't have any real impact to the overall capacity utilization rates. This was something that we recognized as far back as the acquisition. As we put our own structure in place and began to align the organization, it became a bit redundant. So we're taking steps to close that facility over the course of the next 6 to 12 months. In other areas, we continue to look at the network and take steps to rationalize capacity, particularly in the U.K. business. We've got a bit of 2 different situations. We've got the on-boarding of the new customer that we've been spending a lot of time with and have gotten stabilization, which certainly is contributing to improving the operating performance going forward. But we haven't run into a situation, particularly in the U.K., where we've seen a fairly significant slowdown in customer activity. Though we are in the process of evaluating our footprint and the network, and we expect to take some pretty significant steps in the second half of the year to rationalize some of those facilities, which will have an effect of improving overall capacity utilization. We are pleased, though, with the 3 new customers that we are on-boarding in the third quarter, and we should see, as we end the third quarter, some incremental improvement in our overall capacity utilization.

Operator

Your next question is from Steven Valiquette with UBS.

Steven Valiquette - UBS Investment Bank, Research Division

So Jim, congrats on the new role. And, Craig, congrats on a great career. So just for me -- also just a couple of questions here around the Medical Action deal. I guess, first, you mentioned that the revenue synergies are excluded from the accretion guidance. So I'm definitely curious just to hear more, I guess, at least just conceptually about potential avenues or revenue synergies. So that's question 1. But then, number 2, on the flip side, obviously 45% of the company's product sales are distributed through OMI. So you obviously know the company well, but also 20% of the revenues are distributed through Cardinal Health. So just curious, I just want to make sure there's no potential risk for lost revenue within Medical Action as a result of your ownership and hopefully there's no channel conflicts. I just wanted to hear about both sides of that.

James L. Bierman

Yes, good question, Steve. And let me talk about the more philosophical impact on revenue and revenue synergies and then answer the question on the channel issue. As I think -- as we think about the potential for revenue in Medical Action, I really go back to some of the comments I made earlier, which is the potential to partner with manufacturers to take our kitting opportunities to really a different level in the marketplace and really provide the acute care market with a different type of service. And I think we're excited about this as an opportunity. We're excited about bringing it together with what we used to call our SurgiTrack offering into a more fulsome, unitized delivery offering. And I think probably to do justice to it, we need to talk in a more expansive setting, which I would say would lend itself more to Investor Day. I think as we begin to pull together these pieces and feel more comfortable sharing the details with the investor community, I think, you will see why we're excited about this as a great opportunity going forward. On the second part of your question regarding the business that Medical Action that goes through other distributors, this isn't unusual. We have a situation certainly where other manufacturers who distribute certainly go through our channel, and we would expect the same courtesies that are extended in going through their channel.

Craig R. Smith

All right, operator, we have time for one more question.

Operator

Your next question is from David Larsen with Leerink Partners.

David Larsen - Leerink Swann LLC, Research Division

Jim and Craig, congratulations to both of you on your new roles. Can you maybe talk a bit about -- you said one of your strategies going forward is delivering new products and services to the provider community. Can you expand on that a little bit? And as care shifts to lower-cost settings, like for example doc offices, and alternate sites of care. Can you talk about any plans that may exist to meet that demand?

James L. Bierman

Absolutely. So I think there are 2 examples of the expansion of products and services to the provider community. And the first is the one that we've talked about today, related to the Medical Action acquisition. But I would characterize it as the ability to deliver unitized delivery, which fundamentally is the delivery of a product, either bundled with other products for a specific procedure, and the benefits to the provider customer include greater transparency on the cost associated with the products that are consumed or used in conjunction with a specific procedure. So I think, we're advancing down that path. And as it relates to expansion into the non-acute space, we've been very open that our strategy is to work with the large IDNs. As the large IDNs expand their footprint through the entire continuum of care. And we have positioned ourselves and fully intend to have capabilities to serve them as they expand. So we do have capabilities to reach medical office buildings and the doctors' practices, as well as the non-acute sector. But we tend to focus our efforts in those areas as it relates to the large IDNs and their expansion into the non-acute space.

David Larsen - Leerink Swann LLC, Research Division

Great. That's great. And then you mentioned there were 3 more clients coming on, I think in the third quarter. Was that in the International or in the Domestic segments? And then can you maybe just talk a little bit about costs that might be tied to them or revenue that might be tied to them? And then you mentioned there's a slowdown in activity in the U.K. Could you just describe sort of what's causing that?

James L. Bierman

Yes, specifically, the 3 new customers are European, and I'll have Randy, if he would, comment on that.

Richard A. Meier

Sure, David. We're going to be on-boarding 3 new customers, all 3 of which we've already been preparing for in terms of the activities that lead to on-boarding. We've got one significant one coming on in one of our German facilities, another one up in Denmark, and we are in the midst of having a long-delayed customer on-board in the U.K., which will help contribute to the improvement in the second half of the year. So we do expect to see again some nice recovery as we go to the second half of the year. In terms of where we are in the U.K. market, what we're alluding to is we've just seen in our fee-for-service, particularly in the U.K., some slowdown into the pallet utilization in some of our customers which has led to some softness in the gross profit area there. As a result of that, we're looking at the number of facilities and our cost structure to see if we can't right-size our asset base and network, which is fairly extensive in the U.K. to meet our current demand as we evaluate the ongoing business in the U.K. market.

David Larsen - Leerink Swann LLC, Research Division

Okay, that's great. And then one last one. For the acquisition, I think you had $288 million in revenue, with 45% of that in sales to Owens & Minor. I'm kind of assuming that Owens & Minor then turns around and sells those products to your customers. So in terms of incremental revenue, I mean, should it be about 55% of the $288 million?

Richard A. Meier

Precisely, exact math.

Craig R. Smith

All right, everyone, I want to thank you for calling in today. I want to thank you for your questions and we'll see you soon. Thank you.

Operator

Thank you for your participation in today's conference. This concludes the call, and you may now disconnect. Good day, everyone.

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Source: Owens & Minor's (OMI) CEO Craig Smith on Q2 2014 Results - Earnings Call Transcript

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