McKesson F1Q08 (Qtr End 6/30/07) Earnings Call Transcript

Jul.27.07 | About: McKesson Corporation (MCK)
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McKesson (NYSE:MCK)

F1Q08 Earnings Call

July 26, 2007 5:00 pm ET

Executives

John Hammergren - Chairman, Chief Executive Officer and President

Jeff Campbell – Chief Financial Officer and Executive VP

Larry Kurtz – Vice President, Investor Relations

Analysts

Lisa Gill – JP Morgan

Glen Santangelo – Credit Suisse

Tom Gallucci – Merrill Lynch

Eric Coldwell – Robert W. Baird & Co.

Steve Unger – Bear Stearns

George Hill – Leerink Swan

Larry Marsh – Lehman Brothers

Ricky Goldwasser – UBS

Robert Willoughby – Banc of America

Presentation

Operator

Good afternoon and welcome to McKesson Corporation Fiscal 2008 First Quarter conference call. All participants are in a listen-only mode. Today’s conference is being recorded. If you have any objections, you may disconnect at this time. I would now like to introduce Mr. Larry Kurtz, Vice President, Investor Relations. Please go ahead, sir.

Larry Kurtz

Thank you. Good afternoon and welcome to the McKesson Fiscal 2008 First Quarter conference call for the financial community. With me today are John Hammergren, McKesson’s Chairman and CEO; and Jeff Campbell our CFO. John will provide a business update and will then introduce Jeff, who will reveiew the financial results for the quarter. After Jeff’s comments, we will open the call for your questions. We plan to end the call promptly after one hour, at 6:00 p.m. EDT.

Before we begin, I caution listeners that during the course of this call, we will make forward-looking statements within the meaning of the federal securities laws. These forward-looking statements involve risks and uncertainties regarding the operations and future results of McKesson. In addition to the company’s periodic, current and annual reports filed with the Securities & Exchange Commission, please refer to the text of our press release for a discussion of the risks associated with such forward-looking statements.

Thanks, and here’s John Hammergren.

John Hammergren

Thanks, Larry, and thanks, everyone for joining us on our call today. McKesson is off to another solid start in Fiscal 2008, continuing our momentum of the past two years with revenues for the first quarter up 5% and earnings per diluted share up 28% to $0.77. We had a terrific performance in our Technology Solutions segment, where both revenues and operating profit were up strongly from continued progress across the business and the integration of our Per-Se Technology acquisition.

In Distribution Solutions, our U.S. pharmaceutical distribution business grew solidly and we continue to achieve operating margin expansion.

Across McKesson, we continue to focus on growing operating profit by leveraging our revenue growth through a combination of operating efficiencies, acquisitions, increased sales of value-adding products and services to our customers, and capital deployed for share repurchases. In the quarter, we had cash flow from operations of $432 million and we repurchased $257 million of our stock. Based on our performance in the first quarter and our positive view about the business, we are reaffirming our outlook that we expect to earn between $3.15 and $3.30 per diluted share for the full year.

I will briefly touch upon the business highlights and key trends before turning the call over to Jeff for a more detailed review of our financial performance.

Our Distribution Solutions segment, which is anchored by U.S. pharmaceutical distribution, had revenue growth of 4%. The market trends driving our revenue growth remain very positive. Our U.S. healthcare direct distribution revenues increased 6% in the quarter, but that includes the impact of our termination of the OTN contract in mid-May a year ago, which had annual revenues of $3.3 billion. Factoring out the impact of the OTN revenue loss, our direct distribution revenues grew about 10%.

Our warehouse sales, which represent business with a handful of large customers, can fluctuate and did so this quarter. Warehouse sales were up 2%. The Distribution Solutions segment also includes our Pharmaceutical distribution business in Canada and our alternate site and Medical-Surgical distribution business, both of which are leading physicians in their respective markets. Both of tehse businesses had one less week of sales this year versus last year. Normalizing for one fewer week, (inaudible) sales were up 6% and Medical-Surgical revenues were up 10%.

Taking all tehse factors into account, we are pelased with our Distribution Solutions revenue growth this quarter and our momentum for the remainder of the fiscal year.

Distribution Solutions operating profit was up 9% in the quarter and operating margin expanded by six basis points, driven in part by an improved mix of higher margined products and services. For example, our sales of OneStop generics programs were up 34% in the quarter; well above our market growth. Our goal is to continue to grow our generic sales faster than the market, through a combination of more customers entering our proprietary programs and increased buying compliance among our customers.

Increased level of compalince is being driven by the significant multi-year investment we made in Information Systems. We are now using the systems to manage not only our generics business, but our Pharmaceutical distribution business overall. We believe that our systems are a competitive advantage for McKesson.

We recently held our annual Pharmacy Strategies conference for independent retail customers where we feature the many value-adding programs we offer to improve their performance, including our OneStop program. Other parts of the offering include our Access Health Managed Care program, pharmacy automation technologies, our front end enhancements, which now include a diabetes support program, as well as a unique partnership with Proctor & Gamble. And, of course, our Health Mark franchise, which continues to grow and now numbers more than 1,600 pharmaceis.

These value adding products and services are a win/win/win for our customers, our supplier partners and for McKesson, and enable us to expand the dialogue about opportunities for mutual growth. At ouir Pharmacy Strategies event for the financial commuhnity, we provided some performance metrics for Health Mark customers, which underscore the impact we can have on their business. On average, a Health Mark pharmacy has annual sales of $2.7 million compared to $2.4 million for our other independent retail customers. The same store growth is 3% above the growth rate of our non-Health Mark independent pharmacies.

These customers are extremely loyal to McKesson. For example, the ratio of generic dollars spent to total Rx purchases is 15.8% for a Health Mark customer. Based on the share of revenues accounted for by generics in the overall U.S. pharmaceutical market, this ratio implies virtually 100% compliance to our Health Mark customers.

Two days before our Pharmacies Strategy confrerence began, CMS published the final details of the implementation of new metric – Average Manufacturer Price or AMP. AMP is scheduled to be used in reimbursing pharmacies for Medicaid prescriptions beginning January 1, 2008.

Although AMP will have no direct impact on McKesson, the final rule was in line with our expectations. We are continuing to work with our trade groups, our customers, our Washington constituents, all of which to ensure the best possible outcome for our customers. We are pleased to see that CMS is actively encouraging the states to provide increased dispensing fees for prescriptions to Medicaid patients, and a number of states have legislation underway to do just that.

The market changes such as AMP also create business opportunities. It’s far too early to predict how the new rule will impact our custoemrs, but to the extent that it pressures their profit margins, we can offer them a variety of strategies, including the Health Mark franchise program as a way to offset that impact and even improve their overall performance.

In summary, we see solid revenue growth across our customer base with favorable market trends driving the growth of our Health Mark franchise and the expansion of our generics programs. We continue to focus on productive relationships with our branded pharmaceutical manufactures, sales discipline and operating process improvements to deliver efficiencies; all of which are designed to achieve operating margin expansion.

Turning to our Technology Solution segment, we are already seeing the benefits from our acquisition of Per-Se Technologies into our existing healthcare information solutions business, which continues to make great progress. We see solid demand for our clinical information solutions, both inside and outside our traditional core hospital base. We had several major multi-product wins in the quarter and our go-lives and clinical installations were up 13% compared to a year ago to a record 234 sites, including a significant number of new installations of Horizon Expert Documentation, our highly rated solution for nursing. We also had strong sales of our Physician Office Management software, which has been a focus of our market expansion.

We continue to see strength and demand for medical imaging solutions. Our Horizon Medical Imaging product is doing well in the replacement market for first generation PAX technology. We are increasing our penetration of the small hospital and imaging clinic areas of the market. We see opportunities for growth with line extensions into departments such as cardiology, where our Horizon cardiology solutions are gaining traction.

The integration of our Per-Se acquisition is ahead of schedule. As I discussed on our previous call and as Pam Peir reviewed in depth at our most recent Investor Day, we combined the connectivity and claims processing assets of McKesson and Per-Se into a business that we branded Relay Health.

Relay Health is a unique and powerful integration of assets that has great growth potential. For example, we processed 2.27 billion transactions last quarter. We see an increasing demand for online health care transactions of all kinds, and during the quarter we announced a strategic partnership with JP Morgan Chase to offer an integrated set of electronic healthcare claim and payment processing solutions, beginning with the submission of the healthcare claim to the insurer, payment and detailed remittance back to the provider and an electronic statement to the patient. In addition, the relationship will support the management of payment, claim and enrollment content, and develop a single portal that can be accessed online by all key constitutents along the revenue cycle; simplifying access to key data that is highly fragmented today.

As part of our balanced approach to capital deployment, we continue to make strategic acquisitions that expand our offering into our large customer base to enhance our revenue growth. Shortly after the quarter ended, we announced an agreement to acquire Awarix and its enterprise patient care visibility system that provides color-coded, at-a-glance electronic whiteboards of the hospital’s floor plan stationed throughout the facility. The system identifies and helps to eliminate the bottlenecks that delay treatment and extend patient stays, thereby driving a high quality, efficient experience for each patient, while providing real-time feedback to the care team for better management of capacity and patient throughput.

Now this business isn’t big today, but we certainly think that through our sales force and our customer footprint, we’ll see great opportunities to pull additional revenue through our custoemrs.

Now it wouldn’t be a McKesson quarterly call if I didn’t provide an update on the latest product rankings from the class enterprises organization. The fact is, we are simply making continued great progress with this important indicator of customer satisfaction with our solutions. In the class mid-year top 20 report, McKesson had 19 products ranked in the top 3 in 24 categories, up from 16 in the top 3 a year ago. We had nine products named as category leaders; more than ever before.

Although we don’t expect to have a profit from our NHS contract until fiscal 2009, we continue to make great progress with our implementation. We now have more than two-thirds of the NHS sites operating with our new payroll and human resource information system, paying 830,000 healthcare employees in the United Kingdom.

Finally, our reorganization into two segments, including moving our McKesson Health Solutions Payer Software and Disease Management business from the distribution segment into Technology Solutions. The new organization more closely aligns the development of new offerings that connect the needs of payers and providers for information and financial flows. Both the software and disease management sides of the business are growing.

In disease management, under a number of contracts, we defer significant revenues into future periods, but we expense the costs as they are incurred. This quarter we recognized $21 million of revenues on a single contract, which helped further drive the dramatic margin expansion we saw for the segment as a whole.

Given the nature of the business that we acquired with Per-Se, growth of our NHS revenues and our expanding franchise in disease management, our service businesses and technology solutions have grown significantly, and provide McKesson with a strong base of recurrent revenues. The cash flow character of this business is also quite positive.

In summary, we’re off to a great start in fiscal 2008. Both of our segments are demonstrating their potential value creation. A strong balance sheet and a solid operating cash flow provide resources to further the creation of additional shareholder value.

On a final note, at our annual meeting held yesterday in San Francisco, stockholders voted their approval of our board of directors’ decision to declassify the board so that directors are now elected annually. The board made this recommendation in January at the same time that they amended the company’s charter to implement majority voting for the election of directors, and amended our shareholder rights plan so that it expired. These actions demonstrate our board’s continuing commitment to strong stockholder focused, contemporary corporate governance practices, which we believe are consistent with our goal of creating long-term, sustainable value from McKesson shareholders.

I look forward to reporting to you on our results as the year progresses. With that, I turn the call over to Jeff and we’ll return to address your questions when he finishes. Jeff.

Jeff Campbell

Thank you, John, and good afternoon, everyone. As you just heard, McKesson had a solid first quarter and is off to a good start for the new fiscal year.

The first quarter we continued with the integration of our newly acquired businesses, and broadened our value proposition to customers, while investing in the future growth of our businesses. We continued to generate significant cash flow from operations to pursue our balanced capital deployment strategy.

In my remarks today, I will first review our consolidated GAAP results, after which I’ll provide more details on our two segments. Finally, before going to the questions, I’ll review the balance sheet, our cash flows, and briefly comment on our fiscal 2008 guidance.

Consolidated revenues for the quarter grew 5% to $24.5 billion from $23.3 billion last year. Our overall revenue growth is, of course, driven by the grown in Distribution Solutions, which was up 4% from last year. But we are clearly pleased with the 49% revenue growth in our technology solutions segment, which included the first full quarter of Per-Se Technologies.

Overall, gross profit for the quarter was up 18% to $1.2 billion, a great result on the 5% revenue growth. Gross profit increased 7% in Distribution Solutions, and 57% in Technology Solutions, providing gross profit margin expansion in both segments.

Moving below the gross profit line, our total operating expenses were up 13% to $821 million for the quarter, compared to the 18% gross profit increase for the quarter. The expense growth primarily reflects normal growth rates in the business, the first full quarter of Per-Se operating expenses, and $11 million of incremental FAS-123 expenses.

Operating income for the quarter grew 31% to $356 million from $272 million a year ago. This was great leverage on the 5% revenue growth.

Moving below operating income, our interest expense of $36 million was $14 million greater than the prior year due to the $1 billion in additional debt, which we used to finance a portion of our Per-Se acquisition.

Moving to taxes, we implemented FIN-48 this quarter. Our reported tax rate of 34% this year was lower than the 35.4% reported rate in the first quarter a year ago. We do continue to expect an annual tax rate for the year that’s within our previously announced guidance range of 34% to 35%.

On the balance sheet this quarter you may have noticed a shift of approximately $400 million from our current other liabilities to the other non-current liabilities category. This shift is due to the new FIN-48 reporting requirements for classifying tax accruals.

Other income of $37 million was essentially flat from a year ago. Results from discontinued operations in the first quarter totaled an after-tax charge of $1 million, which was associated with its September 2006 sale of our acute care Medical-Surgical business.

This quarter we had net income of $235 million, or $0.77 per share, compared to $184 million, or $0.60 per share a year ago.

Our diluted EPS calculation this quarter is based on $304 million weighted average diluted shares outstanding, compared to $309 million in the prior year. The number of shares used in this calculation declined primarily due to the cumulative impact of our share repurchases. Let me remind you that we have repurchased a total of $2.2 billion of stock over the last nine quarters, including $257 million of stock repurchased in this year’s first quarter. We now have $743 million remaining on our current $1 billion share repurchase authorization.

Due to the strength of our operations and cash flows, we had a slightly lower sequential gross debt to capital ratio this quarter. We do remain committed to achieving, over time, a gross debt to capital ratio in the 30% to 40% range.

Let’s now move on to Distribution Solutions. In this segment, for the quarter, we achieved overall revenue growth of 4%, as compared to the same quarter of last year, the components of which John walked you through.

Our sales mix for the first quarter of fiscal year 2008 was 30% institutional, 23% retail chains, 13% independent, and 34% warehouse. That breakdown a year ago was 30% institutional, 22% retail chains, 13% independent, and 35% warehouse. Although we do not show a change in our institutional share year-over-year, our institutional segment includes both the mail order and hospital business, and we are seeing faster growth in the mail-order piece this segment. This does impact our margins, as mail order customers are among our largest, and therefore, as you would expect, somewhat lower margin customers.

Gross profit for the segment was up 7% to $822 million from $770 million a year ago on 4% revenue growth, representing a nice improvement in gross margin of eight basis points. The increase in gross profit for the quarter was due to an improved mix of higher margin products and services, including sales of one-stop generics, the impact of our agreement with branded pharmaceutical manufacturers, higher gross margin in medical/surgical products, and two anti-trust settlements, which totaled $14 million. Looking forward, we do not expect anymore anti-trust settlements for the remainder of this fiscal year.

The increase in gross profit was partially offset for this quarter by a marginally lower overall sell margin due to the evolving mix of our customers that I referenced earlier. Our overall gross profit a year ago included a LIFO credit of $10 million, and a $15 million charge associated with McKesson’s investment in Parada Systems.

Our Distribution Solutions operating expenses were up 6% for the quarter to $496 million, primarily reflecting growth in our pharmaceutical business. Our first quarter operating expenses a year ago included a $6 million charge associated with our investment in Parada Systems.

Operating margin rate for the quarter was 143 basis points, compared to 137 basis points in the prior year. In the quarter, our U.S. pharmaceutical margin rate expansion was somewhat offset by weaker operating results year-over-year in our medical/surgical business and our retail pharmacy systems and automation business.

In summary, and before I move on to technology solutions, we are very pleased with the revenue growth of our businesses within Distribution Solutions, and the margin expansion in our U.S. pharmaceutical distribution business. We expect greater contribution from our other businesses in the latter half of this fiscal year.

In technology solutions, our revenues were up 49% for the quarter to $730 million. With the acquisition of Per-Se, our progress with the NHS contract and the growth of disease management, the mix of our revenues has shifted to be much more heavily weighted toward services. As John noted, this shift provides a larger base of recurrent revenues with good margin and cash flow characteristics.

Service revenues, which now account for 76% of segment revenues, were up 67% to $553 million, due to a full quarter of Per-Se results in recognition of the $21 million of previously deferred revenue on a disease management contract.

Software and software systems revenues were up 16% to $138 million driven by strong demand and implementations of clinical software, as well as strong physician office software sales.

Gross profit margin in this segment was up 260 basis points to 48.6%. The primary driver of gross margin expansion was our acquisition of Per-Se, which has higher gross margins. Additionally, we are benefiting from our previous and continuing investments in R&D, sales, and marketing.

For the quarter, technology solutions had total gross R&D spending of $95 million, an increase of 32% from the prior year. Of this amount, we capitalized 21%, compared to 19% a year ago. This demonstrates our continued stepped up investment in R&D to continue on our strong growth trajectory.

Technology solutions operating expenses increased 34% in the quarter to $257 million, providing great leverage on the 49% sales increase. Higher expenses were driven by a full quarter of Per-Se and related integration costs, investments in R&D, and higher FAS-123 charges being allocated to this segment.

Our operating profit in our technology solutions segment this quarter was $100 million, up 178% from $36 million a year ago. While we are very pleased with this performance and the 13.7% operating margin, I would note that this quarter included the $21 million of disease management revenues recognized, for which the related expenses were previously recognized as incurred.

Our long-term goal, as we’ve discussed for some time, and most recently, at Investor Day, still remains, in this segment, to have annual operating margins in the low to mid teens. We will make significant progress towards that goal this fiscal year, but do not yet expect to be in the target range for the entire fiscal year.

Leaving our segment performance and turning briefly now to the balance sheet.

On the working capital side, our receivables were up 11% to $6.8 billion versus $6.1 billion a year ago. Our day sales outstanding increased one day from 21 to 22 days. Our inventories were $8 billion on June 30th, a 6% increase over last year. Our day sales and inventory of 31 was unchanged from a year ago.

Compared to a year ago, payables were up 7% to $11 billion. Our days sales and payables increased two days from a year to 43, reflecting primarily the growth of our generics business, which typically has longer payments terms.

In the quarter, we generated $431 million in operating cash flow. You can see an example this quarter of what we have been talking about for a while. With the change in our agreements with branded manufacturers, we are now able to grow our business with little to no incremental investment in working capital. This quarter, we actually reduced our working capital a bit.

Capital spending was $35 million for the quarter, $10 million higher than the $25 million a year ago. Capitalized software expenditures were down to $41 million from $48 million. Our annual guidance for capital and software expenditures in the $300 million to $350 million range remains unchanged.

We ended the quarter with $2.2 billion of cash and cash equivalents, up from the $2 billion we held at year-end, so overall, our first quarter results were solid and on track.

Our EPS guidance range remains $3.15 to $3.30 per fully diluted share. We continue to expect between $0.19 to $0.21 of share-based compensation, and full year cash flow from operations in excess of $1 billion.

Let me, once again, remind you that we focus on annual EPS in our guidance, as there are fluctuations in the (inaudible) for this quarter, the recognition of revenues under disease management contracts. But let me note that some differentials will have a particular impact on comparisons in the next three quarters. First, we continue to have seasonality of compensation from branded pharmaceutical manufacturers, and this is weighted more heavily to the March quarter. Second, last summer’s launches of generic Zocor and Zoloft had a positive on profit in the September and December quarters a year ago. The July 2006 launch of generic Plavix further boosted profits in the September quarter a year ago.

This fiscal year in contrast, while we expect a number of generic product launches, many of these are currently expected to come to market later in the year and financially impact mostly our fiscal fourth quarter.

Third, whereas we had LFO credits of $10 million and $18 million in the second and third quarters of fiscal 2007, we don’t expect the same level of LFO credits in those credits this year. Taken together, these factors create challenging comparisons for us in the upcoming second and third quarters, but should also drive a very strong fiscal fourth quarter.

We continue to feel that McKesson is on track for another good year in line with our guidance. Thank you.

With that, I’ll turn the call over the operator for your questions.

Question-and-Answer Session

Operator

Thank you, sir. We will now begin the question and answer session. (Operator instructions) The first question comes from Lisa Gill. Your line is open. State your affiliation, please.

Lisa Gill – JP Morganl

Hello. JP Morgan. Good morning. John or Jeff, I was wondering if maybe you could just address the disease management contract and if we back it out, the tech margins still look like they’re about 11.1% in the quarter, so just getting closer to that low teens number and turning much better than we expected. Can you just give us an idea of what’s driving that? Is it the Per-Se synergy capture coming on-line sooner than expected, or is there something else that’s driving that?

Secondly, John you talked about the fact that you signed a number of contracts that were multi-product on the IT side. Can you just talk about some of the cross-sell of the multi-products that you’re talking about, or what you’re seeing as far as the trend goes?

John Hammergren

Thank you for the questions. We have made significant progress in our technology solutions segment, even setting aside the disease management contract, as you noted, Lisa. We’re very pleased with that progress, and it’s really coming from a myriad of factors, and it’s coming in spite of a significant increase in research and development expenses and selling expenses and other investments we’re making into the business. So, I am pleased, and it’s really coming in multiple areas.

Clearly, the strength in our ambulatory products and resource management products in the quarter were very strong. As you might recall, we talked about the power of our clinical products for some time, and we began about two years ago to start talking about the building presence we have in outside the hospital, creating a healthcare information company as opposed to just a hospital information company. So you’re beginning to see strength in ambulatory, the physician office markets. You’re beginning to see strength in revenue cycle management. We talked about Relay Health on the call and the power of our transaction businesses that we’re building, and clearly having the integration of Per-Se go well and be ahead of schedule is also fueling growth. I would say across the board, we see strength in that business, and we continue to believe that the disease management business will be very strong. It’s just going to be a little lumpier than the rest of the business, by the nature of the recognition of these contracts.

On the second part of your question, which was related to the other big deals we have going, we actually have them going across the board, and in the hospital marketplace in particular, we’re seeing great strength. We’re selling multiple products at the same time in these hospitals, and I think that people talk about our business and think about it as a clinical software business, because that’s what we’ve talked about. But, with the acquisitions of things like Aware-X, we might be creating additional pull-through opportunities that outside of what we would normally have seen, and it shows that we’re continuing to innovate beyond the boundaries of the typical software business.

Clearly, automation is a pull-through for us in the hospital marketplace. Our automation business continues to perform very well, and we’re pulling through Distribution Solutions into these combined customers.

Frankly, we’re beginning to do the same thing on the retail pharmacy space with a more integrated approach to the market and more value to be delivered. Clearly, as I mentioned, the ambulatory side, if you think about a physician today, they can buy distribution services from us, they can buy software from us, both office management software, as well as clinical software, and now they can outsource the whole operation to us. Really, no other single company can provide that platform of products to a physician office, so we’re really pleased with the pull-through we’re getting across the board.

Lisa Gill – JP Morganl

Can you quantify that at all as far as the pull-through goes across your lines and products, whether it’s distribution or other IT products?

John Hammergren

I think it’s probably difficult to do on a finite basis, but what you’ve seen from us for several years now is higher growth rates in the market in some of these categories, and it’s not so much a taking share necessarily. It’s further penetration of those customers. For example, our generic businesses, the fuel in that is really taking existing McKesson customers and getting them to sign up to our one-stop program and then making sure that our one-stop program is being robustly implemented using our systems.

I really think that our ability to understand the operations of our customer, help them improve their performance and their profitability, and bring a complete one McKesson solution, basically, to the table, allows us to win more than our fair share of the deals.

Lisa Gill – JP Morganl

Thank you, John.

John Hammergren

You’re welcome.

Operator

The next question comes from Glen Santangelo. Your line is open. State your affiliation, please.

Glen Santangelo – Credit Suisse

Yes, with Credit Suisse. John, just a quick question, following up on Lisa’s IT question. I’m kind of curious, when you did the Per-Se deal last year, at the time you suggested that it would be mutual to slightly diluted to fiscal ’08 earnings. Just listening to what you’re saying now about the margins going forward and the results you reported tonight, and now that you’ve owned the business for a little while. Is it fair to say that maybe things are a little better than maybe you initially thought?

John Hammergren

Glen, I think they are better than what we originally thought and they’re ahead of the time schedule that we originally thought. But they really weren’t material to our results in the quarter in terms of getting the margin rate expansion and the other things that you’re seeing, although there’s some mix change there that Jeff noted that helps buoy the margins.

The business, frankly, is probably a little neutral to maybe a little marginally dilutive, as we said it would be. But the positive nature of the business in terms of its mix, and then, as we see the integration happening across the board in almost every one of the product categories, we see terrific momentum, and we see great interest from a customer-base perspective in some of these newer, more combined solutions.

I wouldn’t characterize our results in the quarter as being driven by Pro Se. I think it’s really the execution of the pre Pro Se businesses that really have driven a lot of our performance, with the exception of the ambulatory products. I think we probably are a little ahead in ambulatory physician software kinds of products in the quarter. Some of those platforms were made available to us, frankly, through the Pro Se acquisition in those small hospital market technologies.

Glen Santangelo – Credit Suisse

John, just one follow-up on the disease management revenues. I may have missed this, but I don’t know if you guys commented in your prepared remarks. Over how many quarters had you recognized the expenses that are related to those revenues?

Jeff Campbell

On this particular contract, Glen, there had been a buildup of expenses over a couple of years. There had also been some revenue recognized against those expenses, a fairly modest amount.

I think it’s important to realize we have quite a number of disease management contracts. They have varying components of risk and a very strong business trend, as we are slowly eliminating risk in most of these contracts. Frankly, in the one that we just drove the $21 million of revenue recognition. As we negotiated that final sign-off with the customer, we put in place an agreement going forward that has significantly less risk, which means that the revenue recognition will be less lumpy.

There are still a couple of customers where you will occasionally see a quarter where there’s some lumpiness, but, frankly, there’s nothing else out there that would be of quite the magnitude you saw this quarter.

Glen Santangelo – Credit Suisse

Thank you for the comments.

Operator

The next question will come from Tom Gallucci. Your line is open. State your affiliation, please.

Tom Gallucci – Merrill Lynch

Merrill Lynch. Good evening. I guess just a couple of quick ones here. You mentioned in the prepared remarks med/surg EBIT margin, or EBIT actual dollars were down a little bit year-over-year, baked within the distribution segment at this point. Can you give us any color on the activities in that business?

John Hammergren

I think we’ll continue to make progress in the med/surg business. You saw strength in the revenue line, which is an indication of the health of the business. At the gross margin level, the business is still extremely healthy. We did do some additional investing in this business as we were making the final execution of the implementation of the sale of that acute care business, and we’re continuing to invest in sales and marketing there to some extent as well. I think we’re very well positioned to get into the target EBIT margin ranges that we discussed a year ago, or so, in the back half of this year. But, as you know, we won’t be talking about the business in a discrete way.

I might mention that one of the reasons that it’s difficult for us to give a finite number from an operating income perspective in this business is we’re beginning to leverage the assets of our pharmaceutical distribution business. I know there have been some discussions and questions around our ability to take advantage of the opportunity in the pharmaceutical segment, directly into physician offices. Having a pharmaceutical distribution company tied with the medical/surgical alternate site company affords us a great deal of experience and understanding and a skill-base to penetrate the pharmaceutical opportunities that exist in the alternate site marketplace. So we’re well positioned for that as well.

I would say that we had some drag in the quarter reported in the distribution solution segment because of med/surg, but we’re not concerned about it, because all of the indicators are headed in the right direction.

Tom Gallucci – Merrill Lynch

Okay, and then branded price inflation sounded like a factor in terms of the earnings in the calendar second quarter versus the third quarter at AmeriSource this morning. I think Cardinal has talked a little bit about the rate of branded price inflation in the June quarter of this year versus last year. Can you talk about what you’ve seen there and if that helps or hurts your calendar second quarter versus the third quarter that’s coming.

John Hammergren

I’ll let Jeff talk a little bit about how this rolls into our business, but, from a philosophical perspective, I think it’s important to understand that I think we have a great deal of expertise and the management of our relationships with pharmaceutical manufacturers. We’ve been doing business with some of them for 100 years or more, and our team has been completely reenergized and focused around the value opportunities that exist in this customer class for us.

We think we did a great job in leading the way and establishing a new fee-for-service arrangements with these manufacturers. I think it’s also important to note that I don’t believe that all manufacturers behave the same way, or that their behavior with us is the same as a class of wholesalers all the time, or the comparisons that might go on. I think the point here is I’m not suggesting that we’re better or worse than anyone else from a performance perspective, but I do think that you’ll see occasional variability on a compare basis, or on a quarterly basis between players in this industry that may cause a little bit of noise in the channel. That’s, once again, one of the reasons why we talk about annual guidance, because we can’t forecast with certainty any of these things that happen. Jeff, you might want to provide some color as well.

Jeff Campbell

I would just add, Tom, we’ve talked for awhile about the fact that we focused on annual guidance, because there’s a number of things that we’re very confident of over a 12 month period, but we don’t always have complete control of what happens quarter to quarter. So we try to focus people on the annual numbers.

What I would say is we were really pleased by the June quarter in our U.S. pharmaceutical business. We had very nice margin expansion and the overall results came in about exactly as we had been planning.

Tom Gallucci – Merrill Lynch

Thank you very much.

Operator

The next question will come from Eric Coldwell. Your line is open. State your affiliation, please.

Eric Coldwell – Robert W. Baird & Co.

Hello, it’s Robert W. Baird. Two quick questions. My name must have been asked. First off, John, you mentioned the NHS contract and that’s coming back into visibility for profitability in fiscal ’09. Can you give us some sense on what the current dilution is and where you see that margin potential long-term on NHS? My other question is very much housekeeping. I just want to get a sense of U.S. direct sales growth if we back out the Pharmacare account acquisition. Thank you.

John Hammergren

On the NHS contract you did hear me correctly when I said that we were making great progress in its implementation. We’ve incurred the expenses almost on a straight line, ratable basis here. Whereas the revenue by the nuances of the contract will happen near the tail of the contract, so we expect in FY ’09 we’ll begin to feel a more positive effect from it.

It was probably more break even in the quarter than any significant fuel behind our results. Although I’m pleased with the progress, I didn’t want any of you to believe that our results were driven by some new activity with NHS.

As we look into next fiscal year, we do expect it to be profitable. It may not be additive to our margin, because it has a lot of revenue, but it will certainly be additive on a year-over-year basis compared to a breakeven. But it may not get to the low to mid teens kind of margin on that specific contract.

Eric Coldwell – Robert W. Baird & Co.

If I can jump in, John, I think at one point a couple of years ago when that was a more visible event, I think when you renegotiated, there was some commentary that potentially could get back to a 5% EBIT over time. Is that still ballpark for fiscal ’09, or could it be a little better?

John Hammergren

I think it should be better than that. I just think it will be dilutive to the low teen kind of numbers. I hate to give you some (inaudible)

Eric Coldwell – Robert W. Baird & Co.

And then on Pharmacare, what was direct sales growth if we back out that contract win?

John Hammergren

We have wins and losses every quarter and I don’t think that any of the wins or losses we’ve had in any of this is really material to our numbers. That’s why we really haven’t called any out. Actually, if you look at our customer base, it’s very stable and there are very few ins and outs that happen in our market with our customers. I don’t think we even have the number, if we did, I don’t think it would make any difference really to our growth rates. The guys are nodding at me around the table, so I am assuming that’s maybe a less than half a percent or something like that.

Eric Coldwell – Robert W. Baird & Co.

And just for clarification, you put that business in direct sales, correct?

Jeff Campbell

Yes, that is correct.

Eric Coldwell – Robert W. Baird & Co.

Okay, thanks guys.

Operator

Next question will come from Steve Unger. Your line is open, state your affiliation please.

Steve Unger – Bear Stearns

Hi, Bear, Stearns. Jeff, with one week less of sales in Canada in med/surge, am I correct in calculating that it equates to somewhere around $125 million to $130 million in revenue and maybe $15 million to $20 million in gross profit?

Jeff Campbell

The way I would look at it, I must admit, I haven’t dome the calculation exactly the way you just did. The way we think about it, if you adjust the revenues for that growth then you’ve got med-surg growth in the 10% range year-over-year. And, you’ve got Canadian growth, if you also adjust for foreign exchange year-over-year of about 6%, which we think is very healthy in the case of med-surg and around market. Yes, you can look at the gross profit contributions you would get from that and it would go straight to that line.

Steve Unger – Bear Stearns

For next quarter, would that be picked up? We have an extra week next quarter or no?

Jeff Campbell

No, this is a very head hurting subject which we could take offline, but the rest of the year you will have comparable size periods in both of those businesses in terms of costs.

Steve Unger – Bear Stearns

Lastly, what’s the status of OneStop generics in Canada?

John Hammergren

Our generic business in Canada, and clearly we have one and it is robust. I would say it has got a little different form than the U.S. business does and it is certainly profitable to us, but in that environment up there, it takes on a different character than it does here.

Steve Unger – Bear Stearns

Okay, Great. Thanks.

Operator

Next question will come from George Hill. Your line is open, state your affiliation please.

George Hill – Leerink Swan

Leerink Swann. John, maybe you could just comment a little bit on what you are seeing in the radiology business? You guys continue to have strong results there. However, the DRA seems to be impacting a lot of your competitors and potential buyers in that market, I guess what’s separating McKesson, and could you put some numerical color about how strong the results have been?

John Hammergren

Yes, George. Thanks for the question. We do have great momentum in our radiology business and I think our PACS system really took off and provided significant momentum for us right after we acquired it and built out our sales presence with it. A lot of that was in the community hospital space.

What we’ve done now, you’ve heard me talking and comment about the replacement market. There were a whole bunch of folks who bought these systems three or four or five years before we launched our product and there is a significant difference in the features and benefits of the early PACS systems versus the most recent McKesson Generation PACS. So we are selling replacement products now to people that have already digitized but want to upgrade the feature function of their software and they are using McKesson to do that. That would be one reason that we are growing, is that our system has significant advantages over the systems that are available from most of our competitor’s and significant advantages for customers who are already using other McKesson products to take out non-McKesson product and install McKesson’s PAC system.

In addition, we’ve talked about our deal with Toshiba, where we are now moving downstream into the diagnostic clinic market where they are using radiology and they are using our systems in conjunction with these smaller devices that are being installed there.

The third big opportunity for us is emerging really now in the small community market. You’ve heard me talk about the product called Paragon, which has been a complete reinvention of our small hospital information systems product lines where we’re beginning to sell PACS into those smaller hospitals and that’s also providing momentum. We think we are very well positioned. We’re a leader in that marketplace, and I think that some of the comments you are hearing from people about market problems are more related to the competitiveness of their products as opposed to a lack of demand in the marketplace.

George Hill – Leerink Swan

Okay. Maybe just one more comment. You commented on seeing strength in the payer market. Maybe you could talk just a second about what functionality payers are looking for and what you guys have to offer them? Maybe another comment about what’s in development?

John Hammergren

Well, we have a great set up payer products, probably 90% of the payers in America have one of our products installed or are using one of our services. We have great leading brands there, products like InterQual and others that have been used for decades to help manage the medical claims process and to provide analytics etc. into that space. Increasingly, I think what’s a real desire is the providers and the payers have a desire to work more closely together, and what’s great about McKesson’s position is there are no other technology companies involved the way we are on both sides of the aisle, actually, in all three: the ambulatory markets, the hospital market and the payer market. Increasingly, people are turning to us for a more integrated solution and a view on where that future might be as we continue to innovate in this area. I think our existing products are selling well, obviously, disease management is a whole other service line that is selling well for us, then you put the additional benefit of a total McKesson platform connected view using Relay Health as a transaction vehicle in the middle and you’ve really got a home run opportunity.

Operator

Our next question will come from Larry Marsh. Your line is open, state your affiliation please.

Larry Marsh – Lehman Brothers

Larry Lehman. Jeff, I just want to say your comments came in loud and clear this quarter. Nice job relative to some of the technical challenges last quarter. I just want to elaborate, Jeff, and then a follow up if I could. You said one of the biggest factors that you cited at the analyst meeting that kept you from even going down the road of quarterly guidance was the timing a price increases from manufacturers. You reiterated that today, I think you said at the time there was one big that could swing earnings several cents this quarter. Sounds like that was being deferred now to the September quarter. I am curious, wouldn’t that give you some offset to some of the communicated more challenging comps you talked about on the calls for September?

Jeff Campbell

Well, actually, I don’t think you did hear us today talk about any deferrals that really impacted our results in a significant way. In fact, when you look at our results for the June quarter, they were right about exactly on our plan. We’re really pleased. We had nice margin expansion and so I would say that our remarks for the rest of the year stand as they are.

Larry Marsh – Lehman Brothers

So there was no deferral of any anticipated increases relative to your expectations?

Jeff Campbell

Well, you know, Larry, we track hundreds of manufacturers and we have to for those manufacturers who still use price increases as a mechanism in our annual agreements, sure, we track lots of price increases and some happen early and some happen later, but on balance our quarter came in exactly like we thought.

Larry Marsh – Lehman Brothers

And just an elaboration, one of the big messages this year was the reassignment of Emad’s Group in the payer business and you’re calling out one particular contract where you know there is a mismatch between the costs and revenues. I think, Jeff, your comment you said don’t expect this too often. Just to help us understand, could you elaborate a little bit on the kind of relationship that would be such a significant one that would cause this kind of swing? Over the last several years, has there been anything even close to this and would you anticipate anything even close to this in the next year or so?

John Hammergren

Larry, this is John. Let me take a stab at that, but before I do, let me just make sure I am being clear about the comments relative to manufacturer price increases. I am just trying to deal with the potential inconsistency that may exist and the messages you might receive from players in the industry and highlight to you that differences do exist and differences may exist over time. I don’t think anyone is trying to suggest to you that those differences mean that anybody’s performance over an annual basis is going to be materially different. All it means is that our estimates are our estimates, and our competitors estimates are their estimates. Their prior year is their prior year and our prior year is our prior year. There are all kinds of moving parts to these things and so I just don’t want people on this call to assume that somehow we did something magical that was not done by others in our industry. I am just thinking that things fall differently for different people and people have different estimates about what might happen and what the timing might be around those happenings. So, let me turn my comments now to the payer business.

We did move Emad and his team into MTS and we are working on, I think as I mentioned, go-to-market synergies around the payer software businesses and the provider software businesses. And really, the only material payer thing that happened this quarter that was moving the needle around was the contract we called out in the disease management segment. The rest of the performance was driven primarily by prior MPT performance and Per-Se performance, just to be clear.

On that individual disease management contract, you might recall on previous calls, I’ve talked about state Medicaid agencies and the big contracts we have with these big state Medicaid agencies. I don’t want to specifically talk about this customer, but clearly, the magnitude of taking on four of five disease states for several years for a state and then reconciling all of the profit from that state program in one contract reconciliation could cause an artifact like this to occur with the expenses being readily realized as we delivered the service with the payment at risk to prove that we delivered the value that we said we would deliver. This has not happened to us before anywhere near this magnitude and nor do we really think that it’s going to continue as a pattern, but we wanted to call it out and tell people about it, because we didn’t want you to not understand what was one of the driving forces in what we think is stellar performance in our technology segment this quarter.

Taking that out, you still have terrific performance and the disease management business is still a terrific business, we’re just trying to normalize it a little bit more through our new contracting methods, reducing some of the risk for us and reducing as Jeff and I talked about, the lumpiness of the recognition. It has not really happened before and I don’t think we’ll see it at this magnitude as we go forward.

Larry Marsh – Lehman Brothers

Okay. That’s fair enough. I guess your message too is you really are not that anxious to take on these big risk taking contract in disease management anyway, but thanks for calling that out and elaborating on it.

John Hammergren

You’re welcome. I think the point is that it was difficult to tell the states that we weren’t going to take the risk when we didn’t have evidence of our results. Now we have terrific evidence of our results and we no longer have to take the risk and we no longer, frankly, have to charge the premium to take the risk either. So, the contracts can be developed in a more typical business fashion, where we can recognize revenues and expenses as we go through the implementation.

Larry Marsh – Lehman Brothers

Great. Thank you.

John Hammergren

You’re welcome.

Operator

Our next question will come from Ricky Goldwasser. Your line is open, state your affiliation.

Ricky Goldwasser - UBS

UBS. Just to further follow-up on Larry’s question regarding branded price inflation, just in terms of clarification as far as impact on distribution margin. I know that you don’t comment on specific manufacturers, but looking kind of at our list, in July both Pfizer and Glaxo did raise prices. We didn’t see that last quarter, and we didn’t see it the same time last year. The question there is, now that you know this, did these increases somewhat offset or offset the impact that you are seeing on margins from the earlier comparison on Plavix and Zocor? Can we see year over year margin actually being stabilized rather than being margined down because of this additional benefit?

Jeff Campbell

Ricky, I commend you for your focus on what’s happening in the industry. Clearly, we’re not comfortable commenting on our relationships with specific manufacturers and to John’s earlier point, what we had assumed in how the relationships work. What I would say is clearly we are off to a solid start for the year, but it is very early. We’ve left our guidance for the year as is and we continue, as I went through in my prepared remarks, to expect that the rest of the year will be particularly heavily weighted towards that March quarter. But, things will continue to evolve as the year goes on.

Ricky Goldwasser - UBS

So, just to clarify, when you are saying it’s going to be heavily weighted towards the March quarter, that’s based on the same assumption that you gave us when you provided guidance?

Jeff Campbell

Well, it’s based on everything we knew at the time and that we know today.

Ricky Goldwasser - UBS

Okay, and just again to clarify, I think you said earlier you don’t expect to be in target range for the full year for drug distribution? Again—

Jeff Campbell

No, I’m sorry. Let me be very clear. The only margin comments on segments that we’re making today are on the technology solutions segment. We have a goal that we’ve talked about for a while in the Technology Solution segment to being in the low to mid teens. Clearly, teens starts at 13 and we were right in that range this quarter. We had a 13.7% margin. We were really pleased by that and that’s where we’re going to be in the longer-term.

The only caveat I gave is when you think about the disease management contract that we just talked about a little bit, that really helped the margin in that segment this quarter. When we look at the full year, while we expect to get close, we probably won’t quite be into that low to mid teens range.

Ricky Goldwasser - UBS

Okay, but no comment on being, your range for the Distribution business?

Jeff Campbell

Again, we’ve said all along that we expect to be in the 150 to 200. Last year we made great progress and got over 150 and we expect to make continued progress this year. So we’ve really made no change to that discussion.

In fact, this whole discussion around pharma distribution we made no changes to anything we’ve said to you from the beginning of the guidance that we provided for this fiscal year, other than to emphasize the next two quarters we have difficult compares compared to last year and we don’t have as many new products coming into the marketplace in the next two quarters, so we see the fourth quarter as being a very strong quarter as we come out. So I think the message in Distribution Solutions should be, “Boy, just as these guys had told us,” the message on McKesson Technology Solutions is, “Wow, what a terrific quarter” and we’re trying to give you some color around the wow so that you understand we’re very pleased with it, but also give you a little color as to what the drivers were of it so that we’re all on the same page. We’re not going to probably repeat $20 million in revenue req on DM contracts for the next three quarters.

Does that help, Ricky?

Ricky Goldwasser - UBS

Yes, it does. Thank you.

John Hammergren

I think we have one more question and time for one more.

Operator

Our last question today comes from Robert Willoughby.

Robert Willoughby – Banc of America

I don’t know if you actually gave an organic growth rate for the Technology Solutions business. If you backed out that disease management contribution as well as Per-Se, any sense what that number was?

Jeff Campbell

Well I think it was still very healthy and double-digit growth rates, so we’re pleased with the momentum of the core Technology Solution segment. Setting aside DM, setting aside the changing of the segments and setting aside Per-Se, the business is very healthy and performing very well and growing at we think above market levels because our solutions are being more readily accepted.

Robert Willoughby – Banc of America

Have you made an effort to cut some of the value-added resellers on the physician software side and go more direct or is it still status quo there?

John Hammergren

Well I think if anything we probably tried to reinforce our position with the value-added resellers, Bob. We can’t cover these 100,000 small docs out there that have these systems as fluidly as we would like. What we’ve done to augment the services of the VARS is to make sure that the McKesson sales force on the distribution side, 500+ men and women that are out there knocking on the doors, are armed with enough knowledge to get our customers interested in IT. We’ve also put together a sales support line, call center kind of service to support the sale into these customers, but we have some terrific value-added resellers that do a great job of bringing our complete product line to the marketplace from a technology perspective. And frankly, they’re a resource for McKesson and for McKesson’s other sales channel folks to make it happen. And I think the strength in our inventory business this quarter, which I highlighted, is another example of our ability to not only understand how VARS work, but train them and facilitate their use so we can grow our business.

Robert Willoughby – Banc of America

Thank you.

John Hammergren

I want to thank you all for the call. We’re off to a very solid start I think in Fiscal 2008. We remain very excited about our unique offerings across healthcare and our ability to turn that into value for our customers and our shareholders. I’ll now hand the call off to Larry for his review of upcoming events for the financial community. Larry.

Larry Kurtz

Thanks, John. (Inaudible) in a conversation, I guess, is a better way to say it at the Thomas Wiesel Healthcare conference in Boston. On September 11th, we’ll present at the Bear Stearns Healthcare conference in New York City. On September 28th, we’ll be on a panel at the inaugural Goldman Sachs Pharmaceutical Supply Chain and Generic Symposium in New York City. And we plan to release our Fiscal 2008 second quarter results on October 30th, so we won’t spoil Halloween for you two years in a row.

Thank you and until we see each other at one or more of these events, goodbye and take care.

Operator

At this time that would conclude today’s conference. You may disconnect. Thank you.

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