CareFusion's CEO Discusses Q2 2012 Results - Earnings Call Transcript

Feb. 2.12 | About: CareFusion Corporation (CFN)

CareFusion (NYSE:CFN)

Q2 2012 Earnings Call

February 02, 2012 5:00 pm ET


Jim Mazzola - Senior Vice President of Global Marketing and Communication

Kieran T. Gallahue - Chairman and Chief Executive Officer

James F. Hinrichs - Chief Financial Officer


Kimberly Weeks Gailun - JP Morgan Chase & Co, Research Division

Lennox Ketner - BofA Merrill Lynch, Research Division

Daniel Sollof - Barclays Capital, Research Division

David R. Lewis - Morgan Stanley, Research Division

Lawrence S. Keusch - Morgan Keegan & Company, Inc., Research Division

Amit Bhalla - Citigroup Inc, Research Division

David H. Roman - Goldman Sachs Group Inc., Research Division

Rajeev Jashnani - UBS Investment Bank, Research Division


Good day, ladies and gentlemen, and welcome to the Second Quarter 2012 CareFusion Corporation Earnings Conference Call. My name is Tayesha, 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 conference over to your host for today, Mr. Jim Mazzola. Please proceed.

Jim Mazzola

Okay, thanks, Tayesha. Thank you for joining us on today's call as we discuss CareFusion's results for our second fiscal quarter ended December 31, 2011, and provide updated guidance for fiscal 2012. We issued a news release with our financial result at 1 p.m. Pacific time today, which is posted on our website at and filed on Form 8-K with the Securities and Exchange Commission.

We also filed and posted several slides to accompany today's webcast. They are provided as a reference and include comparisons of our results in the prior year, our financial outlook and definitions of non-GAAP items with the reconciliation to their GAAP equivalent.

Joining me on today's call are Kieran Gallahue, our Chairman and CEO; and Jim Hinrichs, our CFO.

Before I turn the call over Kieran, I'd like to highlight that we will discuss some non-GAAP financial measures on today's call, including financial results on an adjusted basis. A reconciliation to GAAP measures can be found in today's release, our slide deck on the Investors section of our website. We believe these adjusted financial measures can facilitate a more complete analysis and greater transparency into CareFusion's ongoing results of operations, particularly in comparing underlying results from period to period.

Additionally, during today's call, we will be making statements that are forward-looking, including statements about our fiscal 2012 guidance. Our actual results could differ materially from those expressed in our forward-looking statements due to risks and uncertainties, including the risk factors in today's release and our filings with the SEC. We ask that you refer to these materials for a more detailed explanation of the inherent limitations of such forward-looking statements.

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

Kieran T. Gallahue

Thanks, Jim, and good afternoon, everybody, and thanks for joining us today. There are 2 main themes reflected in our second quarter performance that I'll cover on today's call. The first is about the steady growth and progress that we continue to drive in our Medical Systems segment even as we make the critical investments necessary for our future. This segment covers 60% of our business and is performing just as we planned for the year.

The second theme is about the lighter conversion rates in our Procedural Solutions segment, which led to the announcement of our preliminary results on January 9. I recognize and understand the uncertainty that this created in January. Our visibility was and is good in these businesses, and we'll spend plenty of time on the topic today.

There should be no surprises in today's announcement. We'll provide additional detail that neither the facts we laid out on January 9 nor our outlook for the longer term have changed for the past 3 weeks. Before I go any deeper into Procedural Solutions, I want to start at the top.

Consolidated revenue for Q2 grew 3% to $915 million, led by 9% growth in Medical Systems and contributions from several product lines in Procedural Solutions, including ChloraPrep and our MaxGuard, MaxPlus products. With revenue growth approaching 4% in the first half of the year and good visibility into our historically stronger second half of the year, we remain comfortable with the top line expectations we set back in August for 3% to 5% constant currency revenue growth this year.

In Medical Systems, we saw strong performance across our 3 product lines, including encouraging improvement in Ventilation. The team continues to execute well, leveraging capabilities across the segment and rapidly adding new value-added capabilities. That's the strategy and the reason we reorganized into the structure last summer.

We have a large and growing installed base of capital equipment, what we call the bricks in our foundation. They include our Pyxis dispensing, Alaris infusion and VIASYS Ventilation products. As our base grows, we have software, services and complementary products to add scale and stickiness. This is the mortar. The bricks-and-mortar combination is working well today and delivers even more value to customers and to our bottom line as we develop additional capabilities.

During the quarter, we released a major enhancement to the Pyxis line with the introduction of the Pyxis MedStation ES. And next month, we have multiple introductions planned at the largest annual gathering of hospital CIOs. So the strategy is taking shape and beginning to deliver results. Medical Systems increased segment profit by 12%, including the contribution from our Rowa acquisition. Jim will get into the business line details in just a few minutes.

In Procedural Solutions, as we said last month, revenue declined 5% or about 2% after adjusting out revenue from our OnSite divestiture in the prior year. The year-over-year decline was largely attributable to our Specialty Disposables business, which we indicated at the beginning of the year will be down in the high-single digits.

The primary issue in the Procedural Solutions segment was the profit impact from somewhat slower sales of higher-margin clinically differentiated products for our Infection Prevention business. Allow me to make a few points on this topic.

Number one, these products continue to grow above the market, just below our expectations. Both ChloraPrep and Medegen had steep conversion rates in fiscal '11. When we built our 2012 guidance, we naturally expected these conversion rates would slow somewhat as our overall penetration grew higher. The last quarter came in below those rates. When we talk about conversion rates, we mean converting from legacy patient prep or legacy infusion disposables to our ChloraPrep, MaxGuard or MaxPlus products.

Point number two. This does not mean we have hit saturation in the market. In the ChloraPrep Surgical and MaxGuard, Plus product lines, we believe we have converted 50% of the available market. We are not seeing the rest of the market go to other competitors, rather, it is primarily still legacy products. What we are saying is our speed of conversions into that available market is slow.

Point number three. The good news is that we had expected the next set of clinicians to convert would be more difficult to get to than the first set. As a result, we anticipated the need for additional clinical educators, and we knew we needed more focused sales resources to support growth during the next stage of market penetration. As we said during our call on January 9, we initiated changes to our sales and clinical education organizations in December that we believe will provide the right level of support through the next phase of growth.

We upgraded our sales teams with our best performers at both the rep and management levels. We reduced territory size and we increased total clinical resources. We had already made the decision to invest in these resources and therefore, are well underway in our ramp up.

Point number four. We are conservatively estimating our growth in the ChloraPrep line will continue through the rest of the fiscal year in the mid-single digits. I believe our guidance is prudent. You can be assured that our teams are aiming much higher.

We should note that we have good visibility into this business. We monitor daily sales reports to our distributors and sales tracings to our end customers. Growth moves with procedure volumes so slower procedure volumes in the first half of the year didn't help us. We overcome headwinds from procedural volumes because we continue to convert the market. That happened again in Q2, as we grew above the market rate, so we see no evidence of this trend changing. The clinical evidence is strong. We are not seeing competitive changes in our accounts or a reversion in practice among those surgical suites that have converted.

Just to summarize. We remain optimistic on these product lines and our innovation pipeline. Both ChloraPrep and MaxGuard address an issue near the top of every U.S. hospital's priority list, helping to reduce infection-causing bacteria. These are evidence-based products that lower cost and add value to healthcare systems. They continue to gain share, grow above market rates and importantly, distinguish their benefits compared to legacy products.

Over the long term, we also like the potential as we build the market outside the U.S. and introduce new offerings. These product lines remain investment areas for us. We'll be disciplined about those investments, especially as we manage through the current fiscal year, but I don't want to leave you with any impression other than that these are growth franchises.

On January 9, we announced the wide EPS guidance range for the year to allow us to finish our close process and determine the tax rate. Today as we committed, we are narrowing this range to $1.75 to $1.85. Nothing has changed in our operating income assumptions from what we said in January. We simply needed to leave the range wide until we made it through our full close process. As a result of our income mix, specifically more income moving through lower tax jurisdictions, our tax rate will be lower than our guidance range for the quarter and year. As we indicated 3 weeks ago, this will help recover some of the value we lost above the line in the fiscal year.

I remain as confident as ever about the goals we've established for the longer term. Our Q2 performance, both good and the challenging, reinforce my beliefs in our potential and in the imperative we have to address our underlying complexities. We continue to see ample opportunities on the gross and operating margin lines.

In gross margins, we are just underway with more strategic determined initiative, and we'll see the benefits as we move more higher-margin products through our P&L over time. This begins in fiscal year '12 as we start to shift from lower-margin infusion pump placements to a higher volume of infusion disposables. The shift continues to deliver gross margin benefits as we attach more software and services to our large Medical Systems base and transition the Procedural Solutions portfolio to a higher mix of clinically differentiated products.

On the operating margin line, we have about 2 dozen projects underway that simplify our business through fiscal year '14. This is the work we've discussed to reduce the number of disparate ERP systems, legal entities and overlapping infrastructure, to name a few examples. I personally monitor our progress against these initiatives through a detailed monthly review, with leaders assigned to each project working on a daily basis to ensure we deliver the value we know exists.

In the short term, during the second half of fiscal year '12, we have work to do to show progress against our operating margin goals. Our plan for fiscal year '12 was to achieve 100 basis point improvement from last year. Given the operating income shortfalls we've experienced, our revised guidance now assumes operating margins to be about even with last year. I want to be clear that we are not simply accepting this but again, want to guide to a conservative scenario.

Already, we have taken steps to recover some of our lost ground, through expense reduction targets in the second half of the year. We won't get all the way back to our original fiscal year '12 goal because we continue to invest in projects that deliver greater value through fiscal year '14. But we are in no way standing still. We are committed to improving our profitability and have clear opportunities to do so.

Which brings me to my final point. We are making progress against the long-term goals we've set. It's no fun to hit bumps in the road along the way, and we definitely hit a bump in Q2. But I consistently said this would happen. What is most important to me is how we respond to those bumps. Our leadership team remains resolved and confident in the path we've set and the progress we're making. This call marks my 1-year anniversary with CareFusion, and I'm pleased with the progress the team has made. During that time, we have aligned our core businesses with how our customers buy our products, reducing the number of operating segments to 2 in the process. This structure strengthens ties across the capital and consumable businesses, creating opportunities to add more differentiated value for customers and reduce our internal costs.

We have consolidated multiple distribution centers to drive efficiencies across our network. As we gain momentum with this transition, we see the benefits we will provide for customers and the costs we can eliminate.

We've transitioned our primary IT systems away from Cardinal Health, reduced 2 ERP systems and consolidate 10 other core operational systems. We have initiated the core IT work to further consolidate and reduce costs over the next 2 years.

In the current year alone, we have shifted nearly $20 million in SG&A from support organizations to higher-value projects, creating flexibility to fund initiatives without adding incremental expense. We continue to reduce and shift costs from our back office functions, putting the right resources in the front office where they add more value to our customers and ultimately, our investors.

And we divested 2 businesses that didn't fit with our strategic or financial goals. Since the spinoff, we've divested a total of 5 businesses: ISP, OnSite, Audiology, Research Services and MediQual. While acquiring 3 strategic assets: Medegen, Rowa and Vestara.

We also continue to make organizational investment shifts to align with our new segment structure. In both segments, we're beginning to see evidence of the benefits these changes are having in the eyes of our customers. Our R&D pipeline continues to improve from where it was 12 months ago, and I'm encouraged by our recent and upcoming introductions. Our plan for geographic expansion has taken shape and moved into execution mode.

I consistently set context for our growth in 3 phases. The first phase was standup, which was all part of completing the spinoff from Cardinal Health. We closed that phase as we exited fiscal year '11. The second is building our foundation, the phase that we're currently in. This phase reduces our complexity as we invest for growth and expand our margin through fiscal year '14 and beyond. This work is on track and getting us closer to phase 3, where our investments begin to accelerate top line growth domestically and importantly outside the U.S.

All of this work delivers value and helps us achieve our long-term goals of mid-single-digit-plus revenue growth, operating income growth of 11% to 15% and 20% operating margin as we exit the fiscal year of 2014.

We must continue to invest during the balance of this fiscal year. So while we'll accelerate some of our cost reduction efforts, at this juncture, we have the right plans in place to execute for steady improvements through our planning horizon, delivered in a way that makes us stronger.

I'm looking forward to taking your questions but first, let me turn it over to Jim for his comments on the quarter. Jim?

James F. Hinrichs

Thanks, Kieran. Today, I've got 3 things that I want to discuss: First, I'm going to walk through our quarterly results; second, I'll take some time to provide more data and context around our Infection Prevention business; and then finally, provide an update to our guidance for fiscal '12.

Before I do any of that, I want to take a moment to summarize what I think are the 4 key headlines from this quarter. First, our second quarter financial results were right in line with our preannounced guidance ranges. Second, our Medical Systems segment is really performing nicely, with our largest and most profitable businesses, Infusion and Dispensing, growing as expected and our Respiratory Technologies business showing year-over-year growth for the first time in 5 quarters. Third, our Procedural Solutions results were below our expectations as we discussed in our January 9 prerelease. Further analysis and actions that we've taken make us optimistic we can get these products growing faster again, we'll talk about that more later. And then finally, we're narrowing our full year EPS guidance range to $1.75 to $1.85, driven by our preannounced EBIT shortfall, which was partially offset by upside in the tax rate.

So if we turn to our second quarter financial results. Total revenue increased 3% on a reported and constant currency basis. Our Dispensing, Infusion and Respiratory businesses were the key drivers of revenue growth for us in the second quarter, and they were partly offset by weakness in our Procedural Solutions segment.

If you look at the gross margin line, we continue to make progress expanding gross margins in many of our businesses. However, as we indicated in our prerelease, consolidated gross margins declined by 30 basis points, primarily as a result of 3 things: first, the impact of discounted infusion pumps installed during the period that we had budgeted and were fully expecting; second, with margin pressure in our Specialty Disposables business that we talked about in January 9; and third was incremental investments that we're making in manufacturing and other processes improvement throughout the company.

These negative gross margin drivers were partly offset by margin expansions in several of our businesses, most notably Dispensing and Respiratory Technologies.

Moving down to P&L, R&D increased $4 million, 9%. Our R&D spend is growing, which is what we've said we'd do, and obviously that's good for the company's long-term growth. Adjusted SG&A expense of $267 million, that's 3% or $8 million higher than last year, essentially all of it was attributable to the Rowa acquisition. So if you back out Rowa's acquired operating expense, adjusted SG&A was basically flat. And within that flat SG&A line, we continue to see a meaningful shift away from corporate support functions and into more strategic areas that will drive revenue and income growth.

As a percent of revenue, adjusted SG&A was roughly even with last year and approximately 270 basis points better than the first quarter. We expect this improving sequential trend to continue through the year. And as Kieran mentioned, we are taking action to accelerate savings in the second half of the year to help ensure our operating margins end up at least at par with where they were last year.

Interest and other up $17 million benefited from an unforecasted $3 million gain on the sale of an investment that we made a number of years ago. So going forward, though, for the rest of fiscal '12, I'd expect interest and other to moderate back to the $20 million to $22 million per quarter range.

Moving down to the tax rate. Our lower tax rate in the second quarter was not driven by discrete one-time items but rather by income mix, which in part comes from more of our revenue moving through low tax rate jurisdictions. As a result of the income mix shift, which we expect to continue for the rest of the year, we're lowering our estimated full year reported tax rate guidance to 26% -- sorry, 24% to 26%.

Of course, this guidance does not reflect the impact of any discrete items that may arise during the remainder of the year, such as the settlement of the IRS audit, return to provision adjustments or any other taxable event. Finishing up, EPS -- adjusted EPS was $0.44 per share, that's an increase of 5% over last year.

Now if we move to the results of the segment. Medical Systems revenue for the first quarter came in at $571 million, that's an increase of 9% on a reported and constant currency basis. Adjusted segment profit increased $13 million or 12%. Both of these are the result of higher sales across-the-board in our Dispensing, Infusion and Respiratory businesses.

Within the Med Systems segment, Dispensing revenue grew 12%, driven by the Rowa acquisition and growth in the core business. The Rowa acquisition continued to do very well, we're seeing nice -- and we're also seeing nice organic growth within the Dispensing business, and we have good line of sight from a revenue perspective on the remainder of the fiscal year.

We're very encouraged internally by a strong first half in committed contracts, it's in fact -- committed contracts, in fact, it's the second strongest year -- first half, I should say in Pyxis' history, and we're also encouraged by the initial reception of the new MedStation ES platform, which was displayed at the ASHP conference and commercially released in January.

Infusion Systems grew 7% as we installed a record number of competitive channels during the quarter. We also continued to win incremental channels associated with the COLLEAGUE replacement opportunity, primarily from wins at 3 large IDNs.

As these newly won discounted pumps are installed, we now expect to see pressure on gross margins in this business through our fourth quarter. Although this pressure should be partially offset with the higher-value disposable point-through in the third and fourth quarters.

Now we've previously discussed this trend. The new information here is that we've won additional competitive business that will carry the trend into our fourth quarter. And obviously, as always, the economics of these discounted sales are still strongly value accretive for the company over the subsequent multiyear disposable, software and service revenue streams.

If we look a little bit more deeply into the competitive dynamics of the infusion market, excluding the specific accounts where we pre-authorize a volume-based price discount at the beginning of the year, we had another quarter of strengthening ASPs in this business. And while the sample size is still small, I'd say I'm pleased and encouraged by our sales team's effort in taking price back to the market as the COLLEAGUE opportunity winds down.

Finishing out the Med Systems segment, Respiratory Technologies grew 6%, which is the first period, as I mentioned, of year-over-year growth in a number of quarters and a positive sign for our business under new leadership. Demand for our center line critical care vents, that's AVEA and VELA, was strong globally and of particular note, was very strong demand in emerging markets for these products.

Moving to our Procedural Solutions segment. Revenue was $344 million, that's down 5% on an as-reported and constant currency basis. After backing out OnSite, which we divested in March of 2011, revenue declined 2%, and adjusted segment profit declined $13 million or 33%. The decline in Procedural Solutions revenue was due primarily to the divestiture of OnSite, as well as by the performance of our Specialty Disposables business. We actually expected a revenue decline in this business during fiscal '12 as a result of the changes in the way we sell our products after separating from Cardinal and from the competitive environment.

Just to refresh our memory on this part of the business, we have a variety of different types of products, including highly differentiated products that we have exclusive rights to distribute in the U.S. These products continue to perform well. We also sell less clinically differentiated products, which we self-manufacture as well as source, and we also have a small OEM business.

As we mentioned on January 9, we did see some pricing pressure in the less differentiated products, which caused revenue and profitability to decrease more than expected. The pricing pressure was limited to our non-GPO contracts, which accounts for about 30% of the business.

In addition, we incurred incremental customer, vendor and distributor costs that were associated with the final stages of our ERP implementation and separation from Cardinal Health. We do believe we'll continue to see some level of pricing and margin pressure in this business, but that pressure should moderate as the year progresses.

Medical Specialties and Infection Prevention were essentially flat during the quarter. I'd like to take a minute to build on what Kieran said about our Infection Prevention business. This business is comprised of a mix of highly differentiated as well as less differentiated products across 4 lines, that's ChloraPrep, Legacy Prep, Alaris nondedicated disposables and our MaxGuard, MaxPlus nondedicated disposables. Our most differentiated product within this line, which is the ChloraPrep and the MaxGuard, MaxPlus products combined to provide approximately 10% of the company's consolidated revenues. These 2 product lines are where conversion cycles slowed during the second quarter and the primary reason for our EBIT shortfall in preannouncement.

Digging just a little bit deeper, as you might expect, we review a wide variety of public and proprietary information in running these businesses, including our daily sales and our trace sales from distributors. In order to give a little more color around these businesses, I'll provide some of the trends that we've seen in the proprietary data. Because the data are proprietary, we do not intend to share this information in great detail or on a go-forward basis, but we did want to give you a glimpse into what we see, given our performance during the second quarter.

So first, clearly our daily sales data tied directly to revenue on our P&L. But these data can vary somewhat based on distributor purchasing patterns and seasonality. Our trace sales data reflect when a product is sold from a distributor to the end customer, and these tracings are more reflective of products moving through the channel and represent true underlying customer demand.

So in developing our revised growth rate for ChloraPrep for the rest of the year, we placed a significant weight on the trends in our historical tracing information, as well as a bottoms-up account-by-account analysis of our pipeline.

In the end, we concluded that a mid-single-digit growth rate was appropriately conservative for the remainder of fiscal '12. Historical tracing data for the trailing 6-month period helped to normalize some of the inherent lumpiness of sales to distributors and indicate a consistently strong demand for these products, which our pipeline validated.

We've also performed a similar analysis on the Legacy Alaris and MaxGuard, MaxPlus nondedicated infusion products, which also resulted in a downward adjustment to our growth estimates, although I will say the MaxGuard, MaxPlus products continue to exhibit strong double-digit growth albeit on a smaller overall sales base.

So as Kieran said, we remain optimistic about these products, and we'll continue to invest in them as growth franchises. We believe the changes in the field organization that we've already made will have an impact on shorting the conversion cycle. These changes will increase the clinician presence twofold, reduce territory sizes and commute times and effectively consolidate 4 sales teams into 2 based on common call points.

Finally, looking at our longer-term goals, we had previously forecasted slowing growth rates of these products in the out years of our 3-year strategic plan as they gained higher market penetration. Since we saw the second quarter results, we've run multiple new scenarios in our 3-year plan with lower ChloraPrep and Medegen growth rate, and we still feel confident in maintaining our overall corporate 20% operating margin goal exiting 2014, based on organic growth. So while we're optimistic that we can get these products growing faster again, I want to be clear that we still believe we can get to our 20% margin, just in a different way, if necessary.

Running out the other key elements of our financial statements. Operating cash flow was strong at $189 million for the second quarter. That's significantly higher than the first quarter, so that's $72 million higher than last year and in line with our estimate. We continue to make progress on the longer dated receivables and slowing the inventory build that you saw last quarter. Although the reduction in our full year estimated net income will have a minor impact on cash flow, we still believe we will hit our full year operating cash flow guidance of $600 million to $650 million. This range, of course, does not include the impact of potentially unpredictable one-timers such as the settlement of IRS audits or other such items.

To complete the cash flow discussion, capital spending totaled $23 million. Depreciation and amortization was $50 million, of which $20 million or $0.07 per share was intangible amortization related to acquisition. And at December 31, we had $1.3 billion in cash and $1.4 billion in debt.

Now let's switch over to our fiscal 2012 guidance. If you look at Slide 13 through 16 in the investor deck, you'll see the key items that we guide to for this year. Once again, our plan is to continue to provide annual guidance on certain P&L items and the assumptions that the reporting segment and business line levels.

On the top line, we continue to expect revenue to increase 3% to 5% on a constant currency basis. Growth will be driven by mid- to high-single digit increases in Med Systems revenue, probably with the bias towards the top end of that range. And the Procedural Solutions revenue will be flat to down low-single digits compared to last year. Just to remind you, we previously told you that we were assuming Procedural Solutions revenue would increase in the low- to mid-single-digit range, so this is the reduction and expectation for that segment.

Looking at each of the individual business lines, in Dispensing Technologies, we expect low double-digit growth, including 11 months of revenue from Rowa, and previously, we had guided to high single to low double-digit growth. In Infusion systems, no change, we continue to target growth in the mid-single-digit range, resulting from strong volume growth, offset by discounts on the pumps. In Respiratory Technologies, we continue to model this business to be flat year-over-year. Infection Prevention, as we indicated on January 9, we are actually lowering our expectation for Infection Prevention from high-single to a revised estimate of low- to mid-single-digit growth. Medical Specialties expectations are unchanged at low- to mid-single-digit growth and Specialty Disposables, we continue to expect this business will be down in the mid- to high-single-digit range.

As you remember, we expanded and lowered the bottom end of our fiscal 2012 EPS guidance range from $1.80 to $1.90 to a new range of $1.75 to $1.90 when we preannounced. As promised, we are now tightening that range to $1.75 to $1.85. Now that the close process is complete, we have greater visibility to our full year estimated tax rate.

The tax benefits that I discussed earlier on this call is expected to offset somewhat the reduced EBIT guidance that we communicated on January 9, which gives us the confidence to narrow our full year range.

I think in very broad terms, the best way to think about this new range, reconciling to the old range that was $1.80 to $1.90 is as follows: approximately a $0.10 reduction in EPS due to the operating income shortfall that we've already discussed for Procedural Solutions, offset by a approximately $0.05 of favorable tax rate.

From a calendarization standpoint, I'd like to remind everyone that historically, our business has been weighted significantly to the back half of the year, with a noticeable ramp in the fourth quarter. We anticipate this year to follow that pattern, with the third quarter that looks a lot like the second quarter and an increase in top line and greater leverage in the fourth quarter.

Finishing out our guidance. We're revising our operating margin estimates to be approximately flat with FY '11 or roughly 17% and leaving our capital expenditure expectations at $130 million to $140 million.

So clearly, we're committed to improving our operating leverage and we're taking the steps that we can to recover what we can in the second half of fiscal '12. While we will continue to invest in the areas which lay the foundation for future growth, we will absolutely be prudent in our spending decisions.

And with that, I'll conclude and I'll turn it back to Jim Mazzola.

Jim Mazzola

Great. Thanks, Jim. And to Tayesha, we're ready to take questions.

Question-and-Answer Session


[Operator Instructions] Your first question comes from the line of Mike Weinstein from JPMorgan.

Kimberly Weeks Gailun - JP Morgan Chase & Co, Research Division

It's Kim here for Mike. So first question I'd love to start with the organic mix, I guess the constant currency outlook for fiscal '12, which you maintained at the 3% to 5%, which by our estimates is about 2% to 4% organic. So if we look at the first half here, you did about 2.5% organic. So we don't need to see an organic pickup in the second half to hit your guidance range but we do need to see that to kind of get toward the upper end of the guidance range. So what we'd love to hear is if you could talk through the reasons that we can expect to kind of have second half pick up in organic growth. I think if you look at the organic -- and maybe bringing into that, that if we parcel out, looking at last year's numbers, there's actually a lot of headwind faced in the second half of fiscal. I guess fiscal '11 that don't repeat. So are we really looking for an underlying pickup and where is that coming from?

James F. Hinrichs

Good question, I'll take a stab at it, and, Kieran, if you want to jump in here. We are expecting a modest pickup in revenue in the back half of the year, some of which is driven by what would be sort of normal seasonality and the normal revenue build that we see generally through the year. In addition, in several of our businesses, we actually have slightly easier comps in some of the different businesses based on events that happened last year. And so as you mentioned, we may have a slightly easier comparison in a couple of the businesses. In addition, as I mentioned, Dispensing had just a terrific quarter and -- sorry, terrific first half in committed contracts. We've got good visibility to that revenue line item, which gives us confidence in the numbers that we're presenting to you, and that's our biggest and most profitable business. So again, I don't think there's anything significantly different that's happening. It's just a modest pickup due to easier comps and due to slightly better revenue build in the second half than we saw in the first.

Kieran T. Gallahue

Yes. The only thing I'd add is I think we had a lot of good momentum in committed contracts in our biggest businesses coming into the end of the year. And so I think we're well set up for the back end.


Your next question comes from the line of Lennox Ketner from Bank of America.

Lennox Ketner - BofA Merrill Lynch, Research Division

I guess for either Jim or Kieran. I'm just -- you gave a lot of good detail in the Procedural Solutions business, which is helpful, but I'm just struggling a little bit with what's driving the year-over-year decline in operating profit in that business. It was down about 32%, and I know you talked about the low -- ChloraPrep and Medegen growth being lower than you expected and some of the pricing pressures. But if -- I guess, so what I'm thinking about is if ChloraPrep and Medegen grew year-over-year and the rest of that business was down? Then those products can't be responsible for the decline in operating profit or operating margin. So is the way to think about it, is that 33% decline completely driven by the pricing that you're seeing in some of those other businesses?

James F. Hinrichs

Yes, it's a great question. I mean the first thing is this is a relatively small segment so -- small in terms of the operating earnings. So small changes to the OE line actually make a big difference from a percent -- on a percentage basis. You're right to assume that unless those products declined, they can't create a decline in operating earnings. What I would say is, first of all, our Specialty Disposables such as our Respiratory disposables business actually did decline quarter-over-quarter, and we did see margin pressure in those businesses. In addition, we were investing in parts of those businesses, improving, doing -- making process improvements around sourcing and process improvements in manufacturing in combination with that. So those are the things that drove down the gross margins and ultimately the operating margin on that side of the business. So -- and again, those small changes -- small absolute dollar changes can make a large difference, and the business doesn't descale well because it is relatively small. So the loss of those higher-margin products had a very big impact on the overall P&L for the segment.


Your next question comes from the line of Matt Taylor from Barclays Capital.

Daniel Sollof - Barclays Capital, Research Division

It's actually Dan, in for Matt. So you're -- looking -- I'm just looking at -- it looks like you guys took down your operating margin assumptions for the year, but I think you're still looking towards the 20% by fiscal '14. So can you just help us quantify that improvement? What percent of the projects come from what savings initiatives, just some more color there?

Kieran T. Gallahue

Yes, sure. I think -- Well first of all, I think what's important to note is what we've said today was consistent with what we said on January 9. [indiscernible] changed from that point. Yes, we've got a lot of good things going on. Some of these things, you can't really see from the outside because some of them happen right away but some of them take a little bit of time to be an asset. The key here is this phase of growth that we're in, which is building the foundation, is about reducing the complexity across the business, it's about gaining efficiencies in the way that we acquire product and therefore, the cost of the goods associated with it. It's about reengineering of products, and we already see that somewhat with the introduction of new Pyxis line in order to drive costs out of the system, makes service -- total cost of ownership whether it's the parts and pieces in it or whether it's the service requirements associated with it and how they need to be serviced. It's about getting into the systems consolidation, continue the ERP consolidation that reduces your complexity and therefore, reduces the amount of overhead that's required in order to support that complexity, not just IT overhead but a lot of the other functional support that's not customer-facing. So what you're hearing here is there's lots of projects, lots that are coordinated. There's lots of avenues that we can get after, and it really walks right down the P&L, right? So you've got opportunities for product development on the top line. You have reduction in cost of goods because of improvements in product development and because of the way that we're procuring product. You have improvements in our operating expenses because of systems consolidation, complexity reduction and therefore, a reduction in the amount of expenses associated with a given activity. So it really translates through the entire P&L and some of these things drop at different time. That's why we've laid out our goals in the fiscal year -- I mean as we're exiting fiscal year '14, because not all these things happen at once. They sequence in over time. Jim, do you have anything to add?

James F. Hinrichs

Yes. I mean I'll pile on here a little bit. This is obviously something that we spend a lot of time talking about and I'm passionate about, we're all passionate about, but I've got the job of putting a roadmap together that will get us to those numbers. And so from -- clearly, you're going to see improvement in gross margin as well as in expense leverage and SG&A. From a gross margin standpoint, it's all the things Kieran mentioned, it's the product mix, it's results from our strategic sourcing, from our strategic pricing. It's improvements in the cost of goods in the businesses due to next gen products coming out that are cheaper to manufacture, cheaper to service, cheaper to install. It's about looking at our manufacturing footprint, leaning out the overhead and also looking at the overall footprint in the network and optimizing it. And then on the SG&A line, we've clearly got, as everybody does in the industry, we've got this med device tax headwind. We think we can offset it essentially by doing the integration that we've needed to do for 7 years but just haven't had the bandwidth to do because we've been so focused on both the inbound and then the spinoff transactions. So it's things like simplifying our operating model, U.S. and OUS. It's integrating service and quality into the businesses more deeply and across the businesses. It's system harmonization, ERP reduction and that leads to a whole swathe of simplification and cost reductions like legal entity reductions and automating and consolidating manual processes and automating and consolidating order management and accounting and reporting and taxes and stat [ph] book filings. And then that allows us to then go even deeper, look at spans and layers within the organization. So there -- we have a multi-year plan with pages of...

Kieran T. Gallahue

Gantt charts.

James F. Hinrichs

Of Gantt charts and pages of projects that we're monitoring every -- pretty much on a monthly basis. So it's -- there's a lot of work going into this, a lot of energy from the organization.

Kieran T. Gallahue

And we're making very good progress. I've got to say, I'm very pleased and proud of the team's progress in this space.


Your next question comes from the line of David Lewis from Morgan Stanley.

David R. Lewis - Morgan Stanley, Research Division

So 2 questions, if I could. Maybe Kieran, I'll start with you strategically. I guess this quarter, I mean high-margin disposables have been a very important part of this company and the story. And this quarter leaves many investors with a perception that the company can't drive leverage in an environment where higher-margin disposables aren't growing at a certain rate. So in an environment where high-margin disposables are growing mid-single digits as opposed to double digits, help us understand sort of your confidence in delivering your operating margin targets. Is this a situation where you have enough SG&A offsets to get to those goals even in a low-single-digit or mid-single-digit environment? Or do you have a significant amount of confidence that you can reaccelerate these high-margin disposables to a double-digit type picture?

Kieran T. Gallahue

So all of the above, David, is the answer. So part of our planning process is modeling out life in different scenarios and identifying the trigger points where you take different actions in order to make sure that you can achieve the goals that you've established for yourself. Certainly, whenever you have growth double digit in high-value products, high-margin products, it makes life easier, right? And so the first thing you do is to try to double down your efforts to try to ensure that you can support the growth and export -- extend the number of products that you have that will be considered in that category. So there's a couple of things that we're doing to make that happen. We mentioned today that we had already anticipated that at some point in time, we're going to need to better focus our clinical resources and better focus our sales resources. So we had already started the action on that and implemented those actions beginning in December and rolling out here throughout January and February, where we shrunk territory sizes we increased the bag that the sales reps could carry. And in doing so, we organized them in a way that they could identify white spaces to not only sell what they have but also to be able to increase the bag even further and add other products, either organically or through other means of acquiring those products, with the eye towards focusing on clinically differentiated higher-value products. So first thing to do is you try to shore up your ability to continue those growth, and again, very fortunately, we've got a running start here because we had already begun that investment process. And we'll continue that investment process. On the flip side of that, you look at your businesses and you say, "Okay, if things don't happen the way you want them to happen or if things happen the way you want to but just have a different timing from when you want them to happen, what are the trigger points to identify what you do and then what are the actions you take?" We are very focused on getting our operating cost structure improved over the course of this year, over the course of next year and beyond. And I won't repeat what Jim went through. I thought Jim's description of line item detailed what we're doing are good examples of where we're not taking a single shot on goal, but rather, this is a multifactorial opportunity, and we're approaching this looking at each of those avenues and attacking them and sequencing them in an appropriate way. So the answer is always easier to get there when you get the top line, that what we're working towards in order to continue to grow but it is not the only way to get there and will be supported through other activities. Let's not forget also about the strength that we have in Medical Systems. We've got a -- 60% of our revenues are on the Medical Systems side of the business. They're highly profitable businesses as well, and we get great scale. And just the fact that we created Medical Systems allows us, as an example, to use our global customer support team. We've got 1,100 people out in the field, and these people can be used in a much more effective way. They can support our customers in a better way and we can use them in a much more efficient manner, shrinking to -- again, shrinking territory size, increasing the products that they work on, being able to support our customers in a more strategic manner. We've got that team working on creating the mortar, right, the services, the systems that all generate value and can support one another. So going into customers that are great Pyxis customers and saying, "How can we help you on your Infusion Systems?" We didn't leverage that as well as we could have in the past. Now we can because we've got the mortar of the informatics and decision-making software that can help with strength in that. And I could talk chapter and verse on that, but these new systems or the new segments help us both from an organic perspective and also from a cost side.

David R. Lewis - Morgan Stanley, Research Division

And Jim maybe just quickly, the 3 comments that are pressuring gross margins, the one that seemed most new to us obviously is in the Specialty segment. You did talk about some of those pressures, but it wasn't exactly clear specifically sort of what changed. It sounds like it was price. Any more information you could provide us on sort of the nature of that pricing pressure? And then more specifically, you said you think that pressure can moderate throughout the year. Maybe just kind of walk us through your visibility on why that would moderate throughout the year?

James F. Hinrichs

Yes, great question. First of all, yes, we did see price pressure in those nondifferentiated products in that particular business line, primarily in our non-GPO contracted parts of the business, which I consider about 30% of it. In addition, because of some of the customer disruption that we had fourth quarter of last year and spreading into first quarter this year that we talked about with our ERP implementation, we did provide incremental customer and vendor discounts as part of an ongoing program to sort of smooth things over after that. And that's part of what we believe we will be able to get back and will mitigate some of the pricing pressure that we'll see in the second half of the year. Because frankly, the customer disruption from that ERP implementation is over. I can tell you that the last 2 months, so November and December, we had a fully green dashboard on customer service metrics from that conversion. It means we're back to where we were before we started. I haven't seen the January dashboard yet, but I'm sure I'll be getting it in a day or 2, and I'm hopeful that, that trend will continue. So that's part of why we think it will mitigate.


Your next question comes from the line of Larry Keusch from Morgan Keegan.

Lawrence S. Keusch - Morgan Keegan & Company, Inc., Research Division

Kieran, just -- as we think about the top line growth that you guys are witnessing currently and obviously, we appreciate all the efforts that are going into accelerating that. But I'm wondering if -- how you think about the capital allocation in this environment, and also as you think about your goals for 2014? Maybe just remind us again how you're thinking about M&A, the $1.3 billion in cash sitting overseas, and again, how you might think about deploying that currently.

Kieran T. Gallahue

Sure, yes. And capital deployment, I think, is on the mind -- certainly on our minds, on the minds of our board and certainly on the minds of many investors, so I'm glad you asked the question. Look, there is -- our initial focus is on how we reignite the organic growth engines within this company. A lot of the operational metrics that we discussed earlier and actions we discussed earlier are all about creating a commercial organization that can accept new products, but it's organized in a way that's not around the SKUs of where they originally came from but rather are more organized around customer settings and applications. And then by their nature, it opens up white space. Or as an example with the way we set up the business segments, it too provides scale that allows us to append other businesses on, and that can take advantage of our size, our scale and our penetration within the marketplace. So job one is organic. But we also recognize that there's significant opportunities for M&A activity. And fortunately, much of our cash, as you said is OUS. That also happens to be where there are opportunities for us to continue to invest in growing our presence. I think a good example of that was the Rowa acquisition, which we completed over the summer. We had never, as a company, made much progress -- significant progress on the Dispensing side. This allowed us to take a leapfrog into doing that. And that, I can tell you, that acquisition has been going very well, great people, great team and it's been at the exact kind of transaction that we like. So we'll continue to look for appropriate M&A. We're not going to let money burn a hole in our pocket. We don't think that, that's the right thing to do. We're not going to chase deals that we think are inappropriately valued or we don't think have either the right attributes be it cultural, product, et cetera, technology-wise that we think are appropriate. But that would be our focus. We have mentioned too, I think on our January 9 call, I believe we mentioned that we've got a board meeting coming up next week or the next couple of weeks. I'm sure at that point, on the agenda, there will be a discussion about other forms of capital allocation such as buybacks and whether or not it's appropriate. So it's a top-of-mind discussion and subject and it's one that we take very seriously. Our bias is always to try to invest to grow, but we'll look at all avenues of creating value.


Your next question comes from the line of Amit Bhalla from Citigroup.

Amit Bhalla - Citigroup Inc, Research Division

Just 2 questions. On the Respiratory business, it looks like it picked up nicely. Can you talk a little bit about the performance in Respiratory, U.S. versus overseas? I believe overseas last quarter had some issues on the capital side? And just secondly on ChloraPrep, can you just give us an update on where you are on the next generation of ChloraPrep and how critical an overseas buildout of ChloraPrep is to hit your growth numbers for the rest of the year?

Kieran T. Gallahue

Yes. Well actually in Ventilation, we're seeing good progress in various parts of the world. One of those areas being China as an example, where we're seeing good solid progress in emerging markets. So I think the -- we're fortunate. That business is a bit more globally balanced than, let's call it, CareFusion in total. And so our infrastructure and our credibility, our name brand, et cetera are known in markets throughout the globe. So I'd say that Europe remains a little bit slower but what we're seeing in the Middle East, what we're seeing in China and even progress they're making in the U.S. are all quite encouraging, from the Respiratory business. So we feel like we're on a good bounce-back zone with that business. And so for us ChloraPrep, yes so the -- obviously, we never get detailed about next gen products just because that doesn't -- from a commercial and competitive perspective, is not something we'd like to talk about on any frequent basis. I can tell you we are working on next gen products as you would expect, both molecules and formats, et cetera, so we're looking at multiple forms of continuing to increase our product pipeline in that category, as well as looking at how to fill in the product category because it's not just about what products we have today but it's rather, again, reflecting back on the way that we've reorganized our commercial organization. It's about creating white space to continue to grow the valuable products that we can bring in as a constellation or as a solution set. And we continue to be engaged in that and leveraging the strength that we have. As far as overseas growth, this, at the moment, tends to be predominantly a U.S., a U.K. business. Other countries, you are -- just as you were in the beginning with the U.S., you're in missionary mode. So in many of those cases, we have assets in place in key markets. We're still in the early education mode, thought leader mode, and very hard to predict the exact timing of those kinds of activities, and I would hesitate to give specifics on that.


Your next question comes from the line of David Roman from Goldman Sachs.

David H. Roman - Goldman Sachs Group Inc., Research Division

I wanted to see if you could delve a little bit more into detail on the pricing front that you brought up both on this call and at the time of the pre-announcement. From your peers, it sounds as though some of the basic hospital suppliers are suggesting that pricing in the fourth calendar quarter actually improved versus what they had been seeing previously, although it sounds like in certain segments that, that was clearly not what transpired at CareFusion. Maybe if you could just give us some more perspective on what the mechanisms were that led to the step-up in pricing pressure? And anything that you can do proactively on a go-forward basis either to take price or look for ways to adjust the portfolio around those products, et cetera.

James F. Hinrichs

Yes. I think it's pretty clear, and I think we would agree with it that some of that pricing pressure, in fact, a lot of that pricing pressure was pretty specific to us. In that, we had a situation where we have had some disruption. We were giving greater discounts as we're trying to, like I said, trying to smooth things over. We have a very specific line of products that's a little bit different than our competitors and other comp's lines of products, so that may differ a little bit as well. And we've got a reasonable chunk of our, what I've discovered, is the less differentiated products, that are not on contract, which mean there is pricing flexibility and customers can put pricing pressure on us. So we responded to what was a negative situation from a customer disruption standpoint by trying to help smooth that over with pricing discounts. We also had a pricing -- effectively pricing discounts, and we worked with vendors that provide us and source those products for us. The combined effect of that after that model changed with Cardinal Health was margin pressure for that business. Again, I believe that is largely CareFusion-specific. I think we've got it isolated and I think we can start to take that back, which is why I've said I think we'll get a more moderation of that trend as we go forward in the second half of the year.

Kieran T. Gallahue

Just to highlight by the way, there is -- Jim mentioned on the call but just to highlight, there's different parts of that business. The businesses that we have that are highly differentiated, good example would be with our long-standing, very strong relationship with Fisher & Paykel. Those products are clinically differentiated. We continue to sell on the clinical differentiation. We continue to maintain both price and grow volume in that space. So it's a tale of a couple of different kinds of businesses that are all wrapped into that category.

David H. Roman - Goldman Sachs Group Inc., Research Division

Okay. And then maybe as a follow-up to the previous comments around M&A. As you think about your internal growth initiatives and some of the things that you laid out both last June when you presented a multi-year -- I think, last August, when you presented a multi-year plan and sort of as things go forward, how do you think about when you reassess the success of that, those internal reinvestment initiatives? How far you go down a path before redirecting course, et cetera, to a point where we might see inorganic growth move more into -- in more up and through the priority scheme?

Kieran T. Gallahue

Well I don't think -- well, let me -- big step backward, I would say that on a periodic basis, you always review what you're doing to make sure that the assumptions haven't changed, that there isn't some either opportunity costs or opportunity that would suggest that there is a better course of action. And I say that in the context, you don't change things every week because then, you'd get nothing done. But you do on a periodic basis, go back and review and make sure that you're comfortable that the limited assets that you're applying to any given area are best spent there. And I can tell you that we are very aggressive, and we'll continue to be ever more aggressive in making sure that we differentially invest in our businesses based on the returns that we expect from those businesses. There is always and has always been and will always be a process where we evaluate the make versus buy kind of decision. Does it make sense for us to do these things totally internally? Or are there opportunities to acquire? And sometimes, by the way, you may want to acquire and there's no assets available and other times, the other may exist. I think a great example of that is in our Dispensing business. I'll go back to that again. That's an example you can see from our product flow, that we've just released and will be releasing as we mentioned here at the trade show coming up, that we've got a great organic pipeline and still, we went out and acquired because that organic pipeline was oriented towards the markets that we addressed today, whereas the acquisition allowed us a whole new geography with which to begin and open up our market. So we don't isolate. For us, it's not an either/or although certainly from time to time, if we do have a choice of either/or, we'll make a decision based on opportunity costs and adapt, we can create.


Your last question comes from the line of Rajeev Jashnani from UBS.

Rajeev Jashnani - UBS Investment Bank, Research Division

Just I guess first, I had a question on margins and then one on capital, if I could. First, just back of the envelope, I'm trying to determine what the impact of the discounted pumps is on gross margin. I guess it's about 100 basis points. Understanding how much you get back of that is dependent on pricing recovery, should we expect a noticeable step up in gross margin next year as that headwind dissipates at least partially? And then on the operating margin, I think to get to 20% exiting '14, if we were to assume 19.5% for fiscal '14 and 17.1% this year, that's about 120 basis points per year. Is that a reasonable way to think about it?

James F. Hinrichs

Yes. I'll take this one. Short answer is on your margin question, your calculation on the impact of discounted infusion pumps is definitely in the ballpark. And yes, absolutely, we will see an increase in gross margin percentage next year as a result of the flip from installing this kind of pumps to pulling more high-margin disposables through that. Just -- it's a one word to answer: yes. Going from 17% to 20% as you mentioned that implies, if you use our 19.5% as full fiscal year, 120 basis points in each year, that's relatively reasonable. Again, we'll see a nice uptick next year from the swing to -- in gross margins. And likewise, we're going to keep pushing for SG&A leverage. So I wouldn't weight it much more heavily to '13 or '14 at this point. Again, we've got a multi-year plan but that gets refined as it gets closer.

Jim Mazzola

We're above the top of the hour now. Rajeev, do you have [indiscernible] other questions?

Rajeev Jashnani - UBS Investment Bank, Research Division

Yes, if I could, just on the Pyxis receivables, Jim, probably not a big surprise. But understanding the strategic importance of that asset, I guess from a naïve outsider's perspective, there would seem to be a reasonable middle ground whereby the company could retain the strategic benefits while using -- while also somehow using that asset to create value in some other ways, and I was just wondering if you could comment on that.

James F. Hinrichs

Sure. I mean first of all, that -- the Pyxis lease portfolio is something we absolutely talk about very frequently. And what the right way to think about is. The first thing I'll say is it's very, very integrated with our selling and business model as part of Pyxis, in fact, more so than you would see at other companies that have big financing operations. And those companies can vary from -- farm equipment companies like John Deere and Caterpillar to PC sellers like HP and Dell. And the financing and service as a part of our overall business model, I think based on the comparison and the research I've done, feels more integrated than it does with those -- with other similar kind of companies with similar kinds of set up. The other thing I'll say is if we were to monetize that lease portfolio, the rating agencies and generally think of that as debt essentially, and so we don't get a lot of credit for doing that from a balance sheet standpoint. Although admittedly, we certainly free up cash and would have the opportunity to do something else with it, and that's sort of why we continually have that dialogue here, as to what is the right way to think about it as part of the business and what is the right way to think about it in terms of what we can do with it if we were to free it up. For the moment, our conclusion has been and continues to be that it is an integral part of our business model. It provides competitive advantage for us. And therefore, we would choose not to do anything other than what we've been doing. I don't know, Kieran, do you have something...

Kieran T. Gallahue

No, I think that's it. Let me just -- maybe we can wrap it up now. I know we've gone a little bit over, so thanks for your continued attention, everybody. Again, I want to thank everybody for your time and attention. We feel real good about where the business is at now. We feel very comfortable on our ability to execute and hit our long-term targets. As always, I want to thank CareFusion employees throughout the globe. They've done an excellent job of keeping their head down and plowing through and creating a tremendous amount of value throughout the organization, some of which is visible to the outside world and some of which will become visible over the course of the next couple of years. So I want to thank them as always. So thanks again. We look forward to updating you next quarter.


Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day.

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