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CareFusion (NYSE:CFN)

Q3 2012 Earnings Call

May 03, 2012 5:00 pm ET

Executives

Jim Mazzola - Senior Vice President of Global Marketing and Communication

Kieran T. Gallahue - Chairman and Chief Executive Officer

James F. Hinrichs - Chief Financial Officer

Analysts

Lennox Ketner - BofA Merrill Lynch, Research Division

David R. Lewis - Morgan Stanley, Research Division

Michael N. Weinstein - JP Morgan Chase & Co, Research Division

Jonathan J. Palmer - Credit Agricole Securities (NYSE:USA) Inc., Research Division

Joanne K. Wuensch - BMO Capital Markets U.S.

Rajeev Jashnani - UBS Investment Bank, Research Division

Matthew Taylor - Barclays Capital, Research Division

Kristen M. Stewart - Deutsche Bank AG, Research Division

Topher Orr - Goldman Sachs Group Inc., Research Division

Operator

Good day, ladies and gentlemen, and welcome to the Third Quarter 2012 CareFusion Corporation Earnings Conference Call. My name is Melanie, and I'll be your coordinator today. [Operator Instructions] As a reminder, today's meeting will be recorded. I would now like to turn the call over to Mr. Jim Mazzola, Senior Vice President of Investor Relations. Please proceed.

Jim Mazzola

Okay, thanks. And thanks, everyone, for joining us on today's call as we discuss CareFusion's results for our third quarter, ended March 31. We issued a news release about an hour ago with our financial results, which is posted on our website at carefusion.com and filed on Form 8-K with the Securities and Exchange Commission. We also filed and posted several slides to accompany today's webcast, which may be found on the carefusion.com with our earnings materials. While we won't review each slide on today's call, they can be used as a reference with the comparisons of our results to prior year period, a financial outlook for fiscal 2012 and definitions of our non-GAAP items with reconciliation to their GAAP equivalent.

During today's call, we will discuss some of these non-GAAP financial measures, including results on an adjusted basis. 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.

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

Before I turn the call over to Kieran, I'd like to remind you that during today's call, we will be making forward-looking statements. Our actual results could differ materially from those expressed in our forward-looking statements due to the risks and uncertainties, including the risk factors set forth in today's release and our filings with the SEC. We ask that you please refer to these materials for a more detailed explanation of the inherent limitations of such forward-looking statements.

With that, I'll now turn the call over to Kieran.

Kieran T. Gallahue

Great. Well, thanks, Jim. Good afternoon, and thanks for joining our Q3 call. Our global team executed well on the third quarter, delivering strong financial results as we continue to make investments in our future. We are operating the business with balance, becoming more efficient through our efforts to reduce complexity as we channel resources towards investments in longer-term growth. Jim and I will be talking more about the progress we are making on today's call.

So, let me start with our third quarter results. As I said, our team executed well, delivering a strong quarter of 9% growth on the top line and 19% growth in adjusted income from continuing operations. In particular, Medical Systems segment had another standout quarter. Revenue in this segment increased 19%, and adjusted segment profit rose 21%, with each of our 3 businesses in this segment delivering double-digit revenue growth.

There are multiple highlights that collectively reflect a clear strategy, disciplined execution and the strong value we are creating for customers across these businesses.

In Dispensing, our largest business, our team efficiently installed to our Q3 plan and then did a great job working ahead on Q4 installs. With a healthy backlog and large ramp planned in the back half of the year, we did a nice job balancing our install capacity by working ahead during our historically slower Q3. We won't always be able to do this, but when we have the customers ready to install earlier than scheduled, it is more efficient for us to use our resources and avoid the hockey stick we typically see in the fourth quarter.

Our Dispensing customers continue to upgrade at high rate during the quarter, and our new Pyxis ES platform continued to win favorable reviews. We closed on our acquisition of Phacts in April, which further differentiates the end medication management offering we deliver for customers, with new software and analytics capabilities.

This systems approach, pairing hardware, software and services to deliver a more complete and higher-value system for customers, is essential to our bricks-and-mortar strategy and a theme you'll see across our Medical Systems segment. We are pleased to have Phacts as part of CareFusion.

Outside the U.S., our Rowa acquisition continued to perform well and contributed $19 million in revenue during the quarter. With one quarter left in the fiscal year, we now expect Rowa to do better than the $60 million to $65 million in revenue we projected for the year.

Moving on to Infusion. We continue to install the large volume of Alaris infusion pumps we've previously discussed. Jim will talk about our progress in more detail, but this business performed as we expected and is on track for the year. We saw the anticipated volume increases and the associated pressure on gross margin, which will moderate as we enter fiscal '13. We also saw another quarter of disciplined pricing on the sale of new systems.

In Respiratory Technologies, I spoke last quarter about encouraging improvement, a trend that continued into Q3. Our growth came from solid single-digit increases in acute care hospitals and a significant contribution from a government order that we expect will continue to ship through March of next year. This business is benefiting from fresh leadership, with a new focus on the systems approach that I mentioned earlier. Our customers increasingly require the software, services and connectivity to their HIT systems that deliver actionable information or actionable intelligence, as we call it. CareFusion is uniquely qualified to provide this capability.

We also continued to make good progress managing our AVEA ventilator recall in this business and are on track to complete remediation this fall. We are 40% to 50% complete in North America and Asia and are opening repair facilities in Germany and Beijing to reduce cycle times and speed completion of the recall. As I've said before, product recalls are part of doing business in our regulated environment. We strive to have none, but with our large install base of products, we know that that's not always possible. The speed and completeness of our response is a core capability, and I want to recognize our quality, field service, sales and marketing teams for their work to minimize the impact to our customers.

Turning to Procedural Solutions. This segment performed in line with our expectations that we set when we reported Q2. The good news here is our Infection Prevention business, where we saw sales of ChloraPrep play out as we forecasted on the Q2 call, are doing slightly better in Q3 and staying on track to finish the fiscal year with the mid-single-digit growth we forecasted last quarter.

In addition, the operational challenges in Procedural Solutions segment we've highlighted in the past also progressed in a positive direction. The effects from the transition to our new logistics systems continued to dissipate, and we saw sequential strengthening of margins in our Specialty Disposables business as a result. Volume will remain a challenge in this distribution-oriented business, particularly in Q4, where we had a strong comparable quarter in the prior year. With the business operating on a stand-alone basis this year, and having undergone a substantial business model transition, we know we still have work to do to strengthen it for the long term.

Closing out Q3, the strength in Medical Systems helped us overachieve our plans for income from continuing operations and deliver adjusted EPS of $0.49. Within the P&L, I'm pleased with the 25% increase in our R&D spend. You recall last year, we said we just needed to make sure that we were spending smart with our R&D investments before we started spending more. We now have greater control and focus on our R&D initiatives, enabling us to accelerate investments for the future. You saw the effects of the strategy play out in Q3 and will repeat in Q4.

In addition, we hired an R&D leader for the Procedural Solutions segment during the quarter. This is a new position we've created to drive our segment-wide innovation strategy and product pipeline. As Jim will detail, we funded the increase in R&D through a steady decrease in SG&A from noncustomer-facing parts of our organization. The simplification initiative we launched last year continues to show in our income statement. I am proud of our support functions who have worked hard to become leaner and more focused to fund this type of transition during the course of 1 year.

Turning to Q4, and closing out fiscal year '12, we remain on track with our revenue and adjusted EPS guidance ranges, with revenue now expected to be at the higher end of our 3% to 5% growth range. We are also tightening adjusted EPS guidance to $1.75 to $1.80 to

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the divestiture of our Nicolet business and one quarter left in the year. Recall, we will have about $0.02 of dilution from the Nicolet sale that we absorbed in this range, and we will benefit about $0.01 from our stock buyback program.

Before Jim walks through the quarter in more detail, I'll share a few highlights that reflect progress against our 3-phase plan. First, as you know, during the past 12 months, we transitioned from Phase I, our spin-off and stand-up phase, to Phase II, which is all about building a foundation for growth. This is the phase we are in today and will be in through at least for the next fiscal year. The progress our team has made is putting us in the position to make the necessary adjustments for future growth. Remember, Phase II is not about [indiscernible] growth. It is about efficiencies, simplification and setting that foundation for growth.

We are well under way in all major projects to reduce complexity and increase our efficiency. We recently hired a Chief Procurement Officer from a major packaged foods manufacturer with strong experience in the technology sector. We are making good progress on our go-to-market strategy outside the U.S. and in cross-training our service organization. And we continue to lessen complexity by rationalizing our IT systems footprint.

Second, a key step as we began Phase II was the segment strategy we laid out at the beginning of this fiscal year. This structure is providing clarity to our Medical Systems and Procedural Solutions customers, improving our innovation roadmaps and creating landing zones for new technologies and geographic footprints.

We've already had a strong run of new product introductions this fiscal year, including the MedStation ES, our integrated ventilation system, new Infusion software and our take-apart laparoscopic instrument line, and I'm encouraged by the investments we're making in our pipeline.

Third, as an important aspect of Phase II is investing to grow our strong anchor franchise over the long term, organically and by acquisition, I am comfortable with the pipeline of external strategic assets that could complement our business. We have an enviable balance sheet and strong cash flows that provide important levers as we create a more valuable company.

I see us in the position to be more active in this area. You should expect us to be disciplined buyers while also maintaining flexibility in our deal models for transactions to have a greater strategic or long-term value.

Becoming more active on the M&A front will not deter our priority to return excess cash to shareholders in the form of share buybacks. We made good progress during the quarter under our initial $500 million buyback program, and as of April, or the end of April, we have already invested $100 million to repurchase nearly 4 million shares.

Finally, as we look ahead to Phase III in accelerating growth, we remain committed to and confident in our goal to achieve 20-plus percent operating margins exiting fiscal 2014.

We have said all along we'd hit bumps in our progress as we did in Q2. That's to be expected in transformation like these. But as this quarter demonstrates, we have the ability to move operating margins higher. All the rebalancing under way inside CareFusion prepares us for the future and delivers value to the income statement with each project we complete.

In summary, we had a strong quarter and are making good progress against the strategies we laid out at the beginning of the fiscal year. I'm looking forward to taking your questions. But first, let me turn it over to Jim for his comments for the quarter.

James F. Hinrichs

Okay, thanks, Kieran. Thanks, everyone, for joining today. I think we have a pretty straightforward and strong quarter. So I'm just going to jump right in.

Let me start off with what I think are the 4 key headlines from the quarter. First of all, revenue and adjusted EPS growth were very strong, at 9% and 17%, respectively, driven by double-digit revenue increases in each of the Medical Systems businesses and continued leverage from the SG&A line. Second, ChloraPrep growth, which was the topic of much discussion in the last 90 days, came in slightly better than the second quarter and remains on track to finish the year within the range that we forecasted last quarter. Third, we continue to be active in rebalancing our business portfolio with the announced divestiture of the Nicolet business and the closing of the acquisition of Phacts. Every quarter, the company looks more like what we want it to be long term as we progress through the foundation-building portion of our life cycle. Our systems and our processes are maturing post the final Cardinal separation, and we are confident that we have a stable landing spot for additional products and geographies that will hopefully be coming in at a faster rate.

Finally, fourth headline, when we revised our -- sorry, our fourth headline is we revised our full year adjusted EPS guidance to $1.75 to $1.80, which reflects in part a $0.02 reduction from the Nicolet divestiture.

So now if we turn to the third quarter financial results, our Dispensing, Infusion, Respiratory and Infection Prevention businesses were the key drivers of our 9% revenue growth. These were partially offset by the anticipated weakness that we saw in our Specialty Disposables, as well as the impact of our OnSite divestiture last year. As we discussed all year long, we did expect revenue growth acceleration in the second half, and we definitely captured that in the third quarter. And as you'll see from our guidance, we do not expect this high-single-digit growth rate to be sustained in the fourth quarter, but more on that later.

As expected, gross margins for the quarter declined by approximately 200 basis points, due primarily to the significant number of discounted infusion pumps that we installed during the quarter. If you move down the P&L, as Kieran mentioned, our R&D increased by $9 million or 25%. That's driven by accelerated spending on our next-generation Medical Systems products. This increase is really an important milestone for us. It's the first meaningful sustained increase in R&D spending since our spin-off from Cardinal. And importantly, it was funded through cost savings in the SG&A line. So to be clear about this, the increase that we saw was almost exactly what we had budgeted at the beginning of the year when we explained that R&D spend would grow at a multiple of sales growth for the full year.

Moving on down the P&L. Adjusted SG&A expense was $241 million. That's a decrease of $5 million. If we exclude the impact of the acquired SG&A that we got with Rowa, adjusted SG&A actually decreased $10 million. Just like the last few quarters, I'm pleased to see the progress that we're making in shifting spend away from administrative support functions toward growth-producing activities in sales and marketing and R&D.

Adjusted operating earnings of $125 million represented a 12% increase over last year. And even with the margin pressure that we saw from installing discounted Infusion pumps as well as the increased R&D spending, we did show a reasonable earnings leverage with adjusted operating margins of 18.8%, that's 40 basis points higher than last year and 210 basis points higher than the second quarter.

Interest and other were $21 million, that was in line with our estimates. We believe interest and other now will be approximately $86 million for the full year. Our adjusted tax rate was 26%, similar to second quarter and in line with our expectations and not particularly remarkable. We continue to believe that our full-year adjusted tax rate will be 24% -- in the 24% to 26% range. 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 IRS audits, return-to-provision adjustments or any other unusual taxable events.

Finishing up the P&L, adjusted EPS from continuing operations was $0.49 per share, that's an increase of 17% over last year.

So if we move to our segments. Medical Systems revenue totaled $591 million during the third quarter. That's an increase of 19% on a reported and constant currency basis. Adjusted segment profit increased 21% to $132 million. Both are the result of higher sales across each of the business lines in this segment. As our 2 largest and most profitable businesses, Dispensing and Infusion continued to perform well.

Dispensing revenue grew 24%. That was driven by 15% organic growth during the quarter and the contribution from our Rowa acquisition. As Kieran noted, Rowa added $19 million during the quarter and continues to exceed our deal model. The organic portion of the growth was driven by an increased volume of customer renewals as well as balancing our installations between the third and the fourth quarter. And as a result, we now expect only modest sequential growth between Q3 and Q4 in Dispensing.

Infusion Systems revenue grew 15% as we continue to install a significant number of competitive channels. Just to remind everybody, which I'm sure you'll all know, June 30 represents the FDA's deadline to remove the Baxter Colleague pumps from the market. So we're almost to the finish line with this opportunity. As we've mentioned, pricing on these channels were discounted due to the competitive dynamic of selling against highly discounted pumps, but these installations capture an undiscounted dedicated Disposables revenue stream which follows for approximately 5 to 7 years.

If we stick with Infusion for a minute, there've been a lot of questions and a lot of interest in how to model the Infusion market as we complete the Baxter opportunity and move into fiscal '13. There are really 2 primary factors to consider as we model the next several years.

The first is price. As we said in the past several quarters, we have a premium product and are committed to returning pricing to more normalized levels as we finish competing against the deeply discounted pumps that our competitor has offered as part of their recall. While we don't expect pricing to fully return to previous levels, we have seen encouraging improvement over the last 3 quarters in channel pricing and are working to make sure this trend continues.

The second factor to consider, of course, is volume. Our analysis indicates that quite a bit of volume was pulled forward as part of the Colleague recall, which means market demand will be down a bit for the next few years. And this will represent a consistent headwind in Infusion capital starting next fiscal year and likely lasting for the several years beyond that.

So after considering these factors, our preliminary analysis indicates a mid-single-digit decline in Infusion revenues next year. However, due to a shift in sales mix towards Disposables and an anticipated recovery in pump pricing, we do expect gross margin percentages, and, importantly, the gross margin dollars in this business, to increase next year.

Respiratory Technologies revenues increased $9 million, that's 13% during the third quarter. This is the second consecutive quarter of growth for the business. During the period, we began to fulfill a significant government contract which will continue through March 2013. Even without the government order, though, Respiratory Technologies revenues increased in the mid-single-digits. So they continue to show signs of a rebound after a couple of very tough years.

Moving to our Procedural Solutions segment, revenue was $328 million, down 5% on a reported and constant currency basis. After backing out OnSite, which we divested in March 2011, revenue declined 2%. Procedural Solutions adjusted segment profit was down 11%.

Looking deeper into the segment, Infection Prevention revenues increased $6 million or 4%, with ChloraPrep revenues increasing slightly better than the mid-single-digit range that we expected.

MaxGuard, MaxPlus revenues continued their strong growth trend as well. We continue to hear positive anecdotal evidence from the field with respect to the sales force realignment that we discussed at length last quarter, and we're encouraged, of course, by the results that we saw in these 2 product categories this quarter.

Medical Specialties revenue declined 2% to $80 million, and Specialty Disposables revenue declined $8 million or 10%. Both were generally in line with our expectations.

Rounding out the other key elements of our financial statements. Operating cash flow from continuing operations was strong at $158 million during the third quarter, that's $53 million more than last year. So after 9 months, we produced operating cash flow from continuing operations of $346 million. That's an increase of $130 million over last year. Capital expenditures for the quarter totaled $25 million. That brings us to $71 million for the 9 months. Based on current trends in capital spending, we now expect our capital expenditures for the full year to total approximately $100 million, and that's a reduction from our prior guidance that was $130 million to $140 million.

So what does this all mean for our full year cash flow targets? Well, as a result of the lower net income and a shift in sales mix towards Medical Systems and away from Procedural Solutions, with Medical Systems typically having a longer cash conversion cycle, we believe our full year operating cash flow from continuing ops will end up in the lower end of our $600 million to $650 million guidance range. However, the lower-than-expected capital spend that I just referenced should keep free cash flow at nearly the same level.

Finishing up third quarter, depreciation and amortization totaled $50 million, of which $19 million was intangible amortization related to acquisitions. At March 31, we had $1.4 million in cash, of which $1.1 million was outside the U.S. and we had $1.4 [Audio Gap]

debt.

Now moving over to our fiscal '12 guidance. If you look at Slides 13 to

[Audio Gap]

of the investor deck, you'll see key items that we guide to for fiscal 2012.

Before we dig into that, I want to be clear on the impact of our Nicolet divestiture on these slides and on our previously provided guidance. So the updated guidance that we're providing today excludes Nicolet, which has been moved to discontinued operations this year and last year. The previous guidance column that you see on Slide 13 is literally a carbon copy of what we presented in February, and, thus, it includes the Nicolet results. So the impact of moving Nicolet to discontinued operations on our previous guidance would be as follows: consolidated revenues are reduced by approximately $100 million last year and this year; the divestiture of Nicolet positively impacts operating margins, to be more specific, without Nicolet, FY '11 adjusted operating margins improved from 17.1% to 17.6% or approximately 50 basis points; the divestiture negatively impacts adjusted fiscal '12 EPS guidance by approximately $0.02 per share due to the loss contribution margin and the stranded overhead. That's pretty much it. No other metrics on our previous fiscal '12 guidance were meaningfully impacted by the Nicolet divestiture.

So now if we move to our revised fiscal year '12 guidance from continuing operations. On the top line, our expectation as we enter the year was for revenue to increase 3% to 5% on a constant currency basis. Based on current trends, revenues, we believe, now should come in at the upper end of that range, probably somewhere between 4% and 5%. Growth will be driven by high-single-digit increases in Medical Systems revenue, partially offset by Procedural Solutions, which we now expect to be down in the low single-digits, and that includes the impact, the $32 million impact resulting from the OnSite sale last year.

These ranges for each segment represent increased expectations for Medical Systems and tempered expectations for Procedural Solutions.

Now if you go deeper and look at the full year revenue expectations for the business lines, in Dispensing Technologies, we now expect low- to mid-teen growth that includes 11 months of Rowa. In Infusion Systems, we continue to expect mid-single-digit growth resulting from strong volume and partly -- which you know is partly offset by the discounted pricing on the pumps. In Respiratory Technologies, we're raising growth expectations from flat to the high single-digits. Third quarter was strong, fourth quarter looks even better, due in large part to our strengthening in the acute care market and the impact of that significant government order that I previously mentioned. In Infection Prevention, we continue to expect a low- to mid-single-digit growth. In Medical Specialties, we are now expecting this business to be flat based on slower surgical instrument sales. And in Specialty Disposables, we expect the revenues to be down high single-digits, which we [indiscernible] last quarter.

So as I said earlier, after reclassifying Nicolet into discontinued operations, our full year 2011 adjusted operating margins increased from 17.1% to 17.6%. We now expect that adjusted operating margins in fiscal '12 will be around 17.3% as a result of changing sales mix as we close out the year. Finally, we have narrowed our adjusted EPS guidance for fiscal '12 to $1.75 to $1.80, which includes the 2% reduction from Nicolet -- sorry, $0.02 reduction from Nicolet, a $0.01 benefit from the share repurchase program and a narrowing of the resulting range. Just to give you a quick update on the share repurchase program during the third quarter, we did repurchase approximately 2 million shares for $50 million. And further, during the month of April, we repurchased an additional 1.9 million shares for another $50 million. So we are $100 million into the $500 million authorization.

I do not anticipate that our repurchases will continue at this pace in May and June. We continue to look at our monthly cash flow forecast and set our purchase plans accordingly. As you all know, we have a number of a large U.S.-based cash outflows in the first quarter, more specifically, a $250 million debt repayment, a $40 million debt coupon payment and our annual management incentive plan payment. And so while we may make some additional purchases toward the end of the quarter, I wouldn't expect them to move the needle much on shares outstanding for the year. But based on what we've already done, we anticipate the impact of the share buyback will reduce the number of shares by approximately 1 million for the full year, which means full year EPS will be based on a share count of approximately 226 million shares.

Finally, before we open it up for Q&A, I want to take a minute to sincerely thank the CareFusion team around the world. We had a tough second quarter. We asked the team to work extra hard to drive performance in the third quarter. They accomplished this mission and then some, and it's worth more than just a little bit of recognition. So thank you to everyone around CareFusion. And with that, we can open it up for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Lennox Ketner with Bank of America.

Lennox Ketner - BofA Merrill Lynch, Research Division

Great. So I guess the first question is just -- in light of how strong the quarter was, I think a lot of the people are wondering why the lower guidance for the full year. It seems to imply, at least on the margin front, that you're expecting margins to be down sequentially. I'm wondering if you can maybe just talk to what would drive that sequential margin deceleration and kind of why the decision to lower guidance rather than maintain or raise it?

James F. Hinrichs

Well, so -- a great question. Thanks, Lennox. The short answer is, as we mentioned in our remarks, that the team pushed extra hard in the third quarter. We had a stronger third quarter than we expected a little bit, and it's stronger than we've seen in the past. The general level of seasonality in this company is to have a very large hockey stick in the fourth quarter. And so we're tempering that a little bit, because we did have a very strong third quarter. In addition, your assumptions about margins coming down a bit in the fourth quarter are correct. As we sort of closed out the year and we looked at our forecast for the back half of the year, we're certainly seeing a change in mix that will be driving margins coming down a little bit for the full -- for our full year expectations and into the fourth quarter. And so you sort of add all those things up and you get to a slightly -- a narrowing of the range that is sort of slightly below where the range might have been before but not a significant change.

Lennox Ketner - BofA Merrill Lynch, Research Division

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

David R. Lewis - Morgan Stanley, Research Division

Jim, maybe a quick question. Just a quick question for Jim and maybe one for Kieran. Jim, I wonder if you could comment on the final component of the TSA agreement with Cardinal. Just specifically, I wonder if the transition to online has become sort of EBIT-positive. And if not, when do you think that can happen? Is that something we should look forward to in fiscal '13? And now what do you think is sort of a revised target for what the synergies could potentially be?

James F. Hinrichs

It's a little hard to hear, David. The final component of the Cardinal TSA you're speaking of is the global trade TSA. Is that the one you're asking about?

David R. Lewis - Morgan Stanley, Research Division

That's correct.

James F. Hinrichs

So I mean, we have -- so just to set the context, we have one TSA with Cardinal Health left. It is around global trade, which is a system they use to make sure you're not selling to inappropriate customers around the world. That thing rolls off in 1.5 years. And with there -- which there shouldn't be any significant improvements in -- it's a relatively small TSA, so we wouldn't see any major improvements in that part -- in that expense line because of the coming off of that TSA. Is there something else you wanted to hear about?

David R. Lewis - Morgan Stanley, Research Division

Jim, I'm sorry if you can't -- if my connection is bad. I was trying to ask specifically about the Owens & Minor, the OMI transition? And what expected savings from OMI and where we are with that and are we now currently profitable?

James F. Hinrichs

Okay, great. Thank you. Yes, so that was one of the things we talked about -- we've been talking about. We had kind of a bumpy transition to OMI. We did see some customer disruption last year. We have seen some increased operating expenses, that's correct. Things have stabilized there. We've had now 2 quarters in a row of a green service dashboard. We have seen a reduction in overall expenses from the -- on a run-rate basis. We are still spending more than we initially planned. But we're now seeing improvements, fairly regularly and fairly steady improvements, and certainly this customer service has improved dramatically, and the cost is now starting to improve, not as dramatically, but still improving. So I think it's safe to say that from our lowest point where we were at our worst run rate, we have improved from that, and we continue to see improvements and should see improvements next year. It's hard to quantify that precisely right now. But certainly, it's in the millions of dollars that we'll see improvements in that relationship next year from an operating expense standpoint. Do you have a second question, David, for Kieran?

Operator

Our next question comes from the line of Mike Weinstein with JPMorgan.

Michael N. Weinstein - JP Morgan Chase & Co, Research Division

A couple of quick questions maybe just to get our arms a little bit more around the quarter. So really across Medical Systems, there was surprising strength. And it sounds like a couple of items were standout for you. The pickup of the ventilator order, sounds like the military helped you out. You obviously did a heavy installation quarter in Dispensing and Infusions. So can you give us a little bit of a sense beyond the commentary earlier? One, the degree to which you felt like the installations that occurred in the third quarter might have pulled from the fourth quarter? It sounds like that was part of it, but it's obviously hard for us to judge. And then, second, could you give us a sense, since we don't have the balance sheet, what DSOs looked like in the quarter?

Kieran T. Gallahue

Look, let me take the first part and -- so thanks for the question, Mike. I think the first thing to note is that the Medical Systems segment overall is just hitting on all cylinders. It's -- the team is performing extremely well. The ability for them to sell across the horizontal and to be able to get a systems orientation, as opposed to just selling one of the verticals, such as Dispensing or just selling Infusion or just selling Ventilation, they are more and more able to leverage or cross-leverage the strength across those different verticals as we execute on the bricks-and-mortar strategy. So there's an element of that system sale that's helping the business in general get a lift and perform at a higher level. You had mentioned the -- for instance, in Respiratory, the military order, that certainly helped. But that wasn't it, I mean, it was -- that's not the full picture. There was also, even when you look outside of that, and you look inside the acute care hospital setting, the team has been performing well and they've taken a business that, quite frankly, was struggling, and they've moved it to the right side of the ledger. So it's moving in a very positive way. Now as to your question about timing. When you look at the installations that were due, whether it's Q3 or Q4, that's not -- as you know, the customers don't necessarily live in that quarter-to-quarter. They live in a much more seamless sort of time period. The way that we looked at it was -- is how can we manage the capacity that we have over a 6-month period? So between January and June, are there ways that we can work with our customers so that we can do a better job of balancing the installation capability and capacity that we have in our organization? And so we had conversations with our customers about that. And you're not always able to be able to balance to your -- to our installation capability. In this case, we were. So I'm not sure I'd refer to it as a pull-forward, but I'd just say is, we manage this on a 6-month basis with our customers as opposed to looking at it more discretely on a quarterly perspective. Jim, did you want to...

James F. Hinrichs

I think the only thing that I would add to that particular comment is we had, as you know, a really great committed contract. We mentioned them in the first and second quarter, we rate committed contract results bookings in the first and second quarter. We started the third quarter with a tremendous backlog and did a great job of getting that backlog installed in a very expeditious way. And as Kieran mentioned, we do tend to look at it and our customers certainly look at it as more of a longer-term -- more along a 6-month horizon as opposed to a 3-month horizon. With respect to your specific question on DSOs, by my calculations, DSOs improved by a day in the third quarter, went from 46 in the second to 45 in the third. Mike?

Michael N. Weinstein - JP Morgan Chase & Co, Research Division

And you guys have never reported a backlog before, it's never really been a discussion point for us. But is there anything you can give us qualitatively, if not quantitatively, to give us a sense of how the backlog looks today versus not necessarily your comment at the end of the second quarter, but historically for this point in time? And just to give us a sense of how you're feeling about the order book going forward not just next quarter, but the next couple of quarters?

James F. Hinrichs

Okay. I'll answer the first part of that and then kick it over to Kieran on the second part. I will tell you that, as we mentioned earlier, second -- first and second quarter were tremendous committed-contract quarters for us. We entered with very large, in fact, record backlog, we kept talking about record backlogs. I would say that our backlog is, of course, is down from second to third quarter. On the -- but I would also say that it's still larger than normal is the way I would describe it.

Kieran T. Gallahue

Yes, I'd say we continue to have a really solid backlog.

James F. Hinrichs

Yes.

Michael N. Weinstein - JP Morgan Chase & Co, Research Division

Good. Let me sneak in one last one. CapEx, Jim, did you say why CapEx was lower for FY '12? If you did, I missed it.

James F. Hinrichs

No. We -- I didn't say specifically why. I mean, the biggest change is probably -- it is in our IT area. We've just hired a new CIO. He's actually taking -- he's slowed some things down, he's taking a slightly different approach to solving some of our system problems, a slightly more innovative approach to solving some of our systems problems. It looks -- and so we've slowed a number of big projects down in order to rethink about how we might tackle the bigger problems that we've got around multiple systems and the confusion and the complexity that, that creates. So it's more that than anything else. Mike?

Kieran T. Gallahue

Yes. And just to highlight, I think he's taking a very different look and approach to how to solve problems. So I don't want you think that it's just a timing issue. It's actually fundamentally looking at how we're solving these problems and doing it more efficiently.

Operator

Our next question comes the line of Jonathan Palmer with CLSA.

Jonathan J. Palmer - Credit Agricole Securities (USA) Inc., Research Division

Jim, I was wondering if you could talk through ChloraPrep a little bit more. On the last quarter, you had talked about the tracking you guys had done at the hospital level relative to the sales you're doing at the distributor level. Can you just talk qualitatively what you're seeing there?

James F. Hinrichs

Yes, sure thing. We do track what we call tracing data, which traces sales from the distributor to the end customer. Tracing sales continued to be steady. They continued to show good, solid demand for the product. Sales in the quarter kind of caught up to tracing, which is good for us, certainly, and shows that there's still -- tracing data are reliable, and there's still a healthy demand out there. So things look fairly steady on the tracing data, as we would've expected them to.

Kieran T. Gallahue

And just in general, you'll recall that we went through a sales force transformation towards the end of last quarter and coming into this. For me, it's was very comforting to see the continued strength in that business as we sort of lived that transformation process. We've been hearing a lot of very good anecdotal information from the field. It's always nice to see when results are consistent with the anecdotal feedback.

Operator

Our next question comes from the line of Joanne Wuensch with BMO Capital Markets.

Joanne K. Wuensch - BMO Capital Markets U.S.

A boring one at first. Did you have an extra day in the quarter?

James F. Hinrichs

Third quarter?

Kieran T. Gallahue

You mean vis-a-vis last year?

Joanne K. Wuensch - BMO Capital Markets U.S.

Yes.

James F. Hinrichs

Yes, I know -- it's a great question. I don't know the specific answer. But it was a leap year, so I assume the answer is yes.

Joanne K. Wuensch - BMO Capital Markets U.S.

Okay. And most people have been saying it's about 1.5% contribution to the top line growth rate. Is that the right way to think about it?

James F. Hinrichs

Again, not having the specific data in front of me, I couldn't tell you that, to be honest with you.

Joanne K. Wuensch - BMO Capital Markets U.S.

Okay. If we pull out -- you had a Rowa acquisition, you had the sale of Nicolet, I don't think you had any facts in the quarter, because that closed afterwards. What is the sort of ongoing organic revenue growth rate that we just saw?

James F. Hinrichs

Well, the company grew at 9% total. Organic growth rate was 8%. If you back out the 2, you back out the acquisition, you back out the divestiture, it nets to 1, it's 8%. One thing to mention, too, on the daily sales, which is an interesting question, actually. Since the bulk of our revenue is actually sort of unrelated to number of days in the quarter because we're -- it's a capital sale, which were driven more by installs, that tends to affect us a little bit less. Now on the Procedural Solutions side of the business, it definitely has an impact, there is no doubt. But that's 1/3 of our revenue. The 2/3, the biggest piece of our revenue, is less susceptible to changing number of days in the quarter. Just as an FYI.

Operator

Our next question comes from line of Rajeev Jashnani with UBS.

Rajeev Jashnani - UBS Investment Bank, Research Division

My question was on the Dispensing business. I think that there was, I guess, some benefit from pull-forward installs, but could you maybe help us understand where -- what's going on in that business? 15% organic growth, I think it was -- been about mid-single in the past couple of quarters. Maybe talk about the upgrade cycle in a little bit more color and help us understand how long this may persist for?

Kieran T. Gallahue

Well, I think just if you want some basic color commentary on Dispensing, it's a team that, quite frankly, a lot of it is around execution. We are at a good point in our product development cycle where we're in the midst of launching a new generation of product, which stimulates interest. I think the team actually did an effective job of avoiding the traffic that you often get in during new product introduction cycles, which is to get a lot of hold-off in orders. And I think that the team was very creative in the way that they addressed that with their customers and be able to create programs that could satisfy the -- both sides' needs and, in particular, with a very strong emphasis on the customers themselves. The other thing in Dispensing, as you recall, we've been building, really building that business from a systems perspective. So we not only have the sort of the classic boxes we've sold over time, but we continue to build around that with actionable intelligence, we build around that with our coordination engines. Certainly over the last year, you've seen acquisitions. Rowa would be, obviously, not organic in the base year, but you're seeing us build more of a system sell that helps us in our positioning of our products. So I'd just say, in general, the team is living the strategy and executing to the strategy, and it's been rewarded.

Rajeev Jashnani - UBS Investment Bank, Research Division

I just want to ask one follow-up, if I may. It sounded like there is a lot of activity going on with respect to business development and M&A and I was wondering if you could maybe just give us a little bit more flavor in terms of what we could expect in terms of a potential deal size, profitability of targets and so forth?

Kieran T. Gallahue

Yes. We get this question. I think there is concern or interest, saying are we going to go after some many, many billion-dollar acquisition? That's -- well, I would never say never to anything. But, look, that's not what we're focused on here. What we've said is we're using M&A as a means of building on our core, of leveraging the strength that we have in both Medical Systems segment and the call point that we're focusing on in the Procedural Solutions segment. We're using it to access technologies that we may not otherwise have or we want to accelerate. We're using it to, in some cases, redefine the relevant market. A good example of that would -- in Dispensing, as we acquired Vestara last year in medical waste side, and now with Phacts, we're broadening the relevant definition. So and then the third area we look at is geographic expansion. Typically in those areas where we may want to build a certain level of capacity or be able to get a critical mass within a given marketplace. So I think what you should expect is that we will look at all those. All of those deals will have something different about them. Some of them would be plug-and-play where you are -- basically there's a high level of synergy value in the operations. Others would be different than that. They'd be accessing new markets or new technologies. I think a good comparative would be the way that we handled our Vestara transaction versus the Rowa transaction. Rowa was a leader in an area that we didn't have a lot of physical presence, and we've been basically feeding that, and that's -- you're not looking for cost-side synergy. On the other side, with Vestara, within a very short time period, we entirely consolidated that operation within our current operations. So we look at it across those bounds. Jim, do you have anything to add to that?

James F. Hinrichs

No, nothing. Perfect.

Operator

Our next question comes from line of Matthew Taylor with Barclays.

Matthew Taylor - Barclays Capital, Research Division

Two quick ones. One, I guess, just looking at your organic margins from last year being 17.6% and the new guidance for this year, 17.3%. So I'm trying to understand what the puts and takes there are without Nicolet. And, of course, this always comes up, but can you talk a little bit about the expansion over the last couple of years and your confidence about getting to 20%?

James F. Hinrichs

Yes, sure. So that's a great question. And so, as we got ready, as we kind of finished up the forecast for the year and started thinking about where that would take margins, so a couple of things happening. We've seen a shift in mix, which you should completely be familiar with and everyone on the call should completely familiar with, we've seen pull-downs in some of the higher-margin products. Ventilation, for example has gone up, and that's driving more sales. And the net effect of mix on us as we kind of finished out the year, it looks like it's going to be slightly negative. In addition, we -- as I mentioned on the last quarter call and I think we talked about it this quarter, we continued to make investments that in our manufacturing plants around productivity and quality process improvements, and those are also consuming a little bit of gross margin dollars as well. And so we sort added all that up and said, "Okay, it looks like we're going to close the year out, more like 17.3%." So that's what's driving the change from -- the very minor change that we talked about from last quarter. When you think about the long term at the company, what's happening right now is not -- is relatively minor in the grand scheme of adding 300-or-so basis points to the operating margin, of which we still feel confident we can do over the next couple of years. And it's going to come, as I've mentioned in the past, from multiple, different places. So in general, once we get through this Infusion pump cycle, product mix is going to be our friend. It's going to be our friend for the next couple of years. We've got a new person that we've hired in charge of strategic sourcing. She is just getting up to speed and has got a big task ahead of her in terms of driving value on the strategic sourcing side. We've got new efforts and continued efforts on the strategic pricing side. We've got a number of new products being launched on the Dispensing side that should take down overall cost of goods as a lot of our work in R&D has been around driving cheaper than manufactured products. And we've got continued work going on in just general leaning out of the manufacturing footprint and manufacturing organization. And so those are all things that are happening at the gross margins line. On the SG&A side, we've got a lot of good things happening. We've also got one really big bad thing happening, called the medical device tax, so that will be a headwind for us. We certainly believe we can offset that medical device tax, and it's all the things we've been talking about and, frankly, you've been seeing this year. So we're going to drive 100 basis points of SG&A or approximately 100 basis points of SG&A leverage this year, and it's coming from simplifying our operating model and going down to 2 segments and all the work that goes into supporting that and looking both inside and outside the U.S. and simplifying infrastructure and -- in integrating service and quality in different ways. And then also, the longer-term stuff around system harmonization and legal entity reductions and all of the costs that go along with that. And the multiple-order-management groups that we've got and order-processing groups that we've got around the company. And all of the things that we've been talking about, all are still completely valid, and we're still right there behind that 20% operating margin goal in -- as we exit '14.

Kieran T. Gallahue

In fact, I'd say, as we look at the process last year and you look at how we've been executing to the strategy, which has been really just chopping wood, right? It's been going after it quarter after quarter, getting comfortable that we're spending smart, that we have control over the different areas, that we can gain efficiencies. One of the good signals, I think, for that is the fact that we began to release money into the R&D cycle and begin to improve that net spend there, because it is an investment. But what you saw from us was the discipline that we require of ourselves prior to doing that, and that's exactly the discipline that is being engaged in across the company that gives confidence in those numbers.

Operator

Our next question comes of the line of Kristen Stewart with Deutsche Bank.

Kristen M. Stewart - Deutsche Bank AG, Research Division

Just wanted to just go back on the -- or the restatement into continued operations. So net-net, that effectively just automatically increases your operating margin by 50 basis points. Is that correct?

James F. Hinrichs

That is correct.

Kristen M. Stewart - Deutsche Bank AG, Research Division

Okay. And so, I guess, how should we think about you guys getting to the 20%? I know you just kind of went through all the different options that you have from an organic, I guess, standpoint. Are you also -- should also consider that there may be additional divestitures that kind of help you get to that 20%? Because obviously, if you just get rid of a low-margin business that you can probably get to 20% pretty easily.

Kieran T. Gallahue

So the basic answer, as we look at each part of our business in a way about how do we manage that individually and how do we look at that across the portfolio itself, how does it contribute to the entire portfolio? And businesses where we think -- I mean Nicolet is a good example. It's a business that we absolutely had mechanisms to make that business more profitable. We had ways of increasing its contribution to all of our goals, including the goals. But what you have to do is periodically look at it and say that the effort that you're going to put it in there and the resources that you're going to put it there versus it being applied to other parts of the businesses, is that the right way to look at your investment strategy and the opportunity costs associated with it? So we have mechanisms whether we keep different parts of the portfolio or whether we decide to spin those and acquire others or grow other pieces, those are all part of the plan to get to that 20%. So I think the key thing, again, with the Nicolet, I would absolutely not think of that -- I hope you're not thinking of that as, well, this is just a sort of a quick way of trying to move a certain metric. We have ways of moving that metric with the Nicolet business. It's a good business, and I think that the buyer is going to do well with it. We just think that the time and effort and the opportunity costs associated with that, we will be better off using that energy in growing the attractiveness of other parts of our portfolio. So -- and that's how we look at every single business in the portfolio.

Kristen M. Stewart - Deutsche Bank AG, Research Division

Okay. And then just on the Infusion side, it is helpful to kind of walk through your expectations for the next couple of years. And I just want to make sure I heard you correctly. So you said that you would be down in the mid-single-digits, your expectation for that entire Infusion Systems next year, and would that level persist for the next several years?

James F. Hinrichs

We didn't go out in great detail for multiple years. But I will tell you that once we get past the bulk of [ph] slowdown of equipment and the -- we should start to moderate towards what would be a more normalized growth rate being driven by the Disposable sets. So I, again, I wanted to be specific about next year, because people were asking a ton of questions about next year, it's hard to know precisely what's going to happen given the competitive environment could change next year and into the future years. But just if you think about it sort of intuitively, as that pull-forward of capital sort of dwindles -- that divot that results sort of dwindles and the Disposables growth rate sort of takes over, you would expect some sort of moderation of that. But I wouldn't want to commit to that right now.

Kristen M. Stewart - Deutsche Bank AG, Research Division

Okay. And I guess I know you obviously give 2013 guidance later this year, but if you have the pressure on the Infusion side and the introduction of the device tax for at least half the year, I mean, should we think about -- it seems like linear growth of your 11% to 15% goal may be a little bit more difficult. Or are there other things that you think you have that can kind of offset some of those incremental pressures?

James F. Hinrichs

I mean, it's -- we certainly have a lot of levers we can pull, and we do have a headwind next year with the medical device tax. On the Infusion side, we're going to see -- or we're going to be in an unusual situation where we see revenue dollars declining, more than likely, but gross margin dollars increasing, more than likely. That's an unusual situation but that's the way the math works, which probably shouldn't surprise you. To get more specific than that on FY '13, it's premature to do that. We're in the middle of our strategic planning process, we're in the middle of our budgeting process, and we'll give a more fulsome update on FY '13 guidance in August.

Operator

Our next question comes a line of David Roman with Goldman Sachs.

Topher Orr - Goldman Sachs Group Inc., Research Division

It's actually Topher Orr in for David. A specific question about the SG&A line. It obviously, was a pretty sizable sequential step-down compared to fiscal second quarter. I was just wondering, first off, is that sustainable? And then second of all, if we're down $26 million versus Q2, it looks like R&D went up about $5 million, I know you previously talked about reinvesting the SG&A. Should we expect kind of a $20 million bump at some point going forward?

James F. Hinrichs

Yes. And this is -- it's a great question. This is just one of the sort of the unusual things in our company. So you should expect to see an increase sequentially in SG&A in that order of magnitude going into Q4. Q4, there's always a step-up in SG&A. It's around things -- some of the key drivers are things like incentive comp that happens for the sales force and for other parts of the organization, tends to be back-end loaded as things come through. Health and welfare accruals, property, insurance accruals, benefits accruals, things like that tend to be trued up in the fourth quarter. That can often drive an increase in SG&A. We have incremental spending. We're planning, as Kieran mentioned, on M&A projects where we're working through some of the integrations that we're doing and looking at other potential acquisitions. And then we're going to see an increase in R&D as well, and, more than likely, sequentially, probably small, but potentially an increase in R&D. So you add all that up, and these are sort of the normal drivers along with some of the things this year that you're seeing, and you should definitely see a fairly significant step up in SG&A in Q4.

Topher Orr - Goldman Sachs Group Inc., Research Division

Okay. And then second, and maybe I just missed this, but have you guys put out the restatement yet? And if not, when should we expect to see that?

James F. Hinrichs

Restatement?

Topher Orr - Goldman Sachs Group Inc., Research Division

Are you putting out a restatement regarding Nicolet? Or are you just talking to it in kind -- in the presentation as kind of pro forma, assuming that it's out?

James F. Hinrichs

It's -- I mean, discontinued operations are still part of our financials. We have a walk that we can help you out with. Yes, we -- but it hasn't been published yet. It's really -- if you think it's -- I want to be clear. It's not a -- I mean, sorry, this is, I know, technical. It's not a restatement. That has a very specific and not-so-pleasant meaning in the financial world, in the accounting world, as you know. It's a reclassification, really, of a business into discontinued operations. And so we have that reclassification, we have a walk that we haven't published yet that we can help you get through there. All the results that you're seeing show Nicolet in discontinued operations, so -- and for this year and for last. So you can kind of back into it on your own, but we have information that we can get to you that'll help you get there. Okay?

Kieran T. Gallahue

And, Topher, we've got a bit of walk in our presentation that's discontinuing operations over a period of time, so if you want to talk about that after the call, happy to do that.

Jim Mazzola

Okay, thanks, everyone. I think we're at the top of the hour. So think we're wrapped up. Certainly Bill and I are available for any questions after the call. Kieran, any last comments you want to make before we end the call?

Kieran T. Gallahue

Just -- I just want to thank everybody for their interest here today for CareFusion. It was, obviously, a very encouraging quarter and I think demonstrates the progress that we're making on living to the strategy that has been set for the company. But I wanted to particularly mention and thank the CareFusion employees throughout the globe and, very specifically, those in the functional areas, which had been driving efficiencies throughout the way that they operate in an attempt to be able to fund increases and growth drivers such as R&D. So they should feel very proud of what they've done. We're certainly very proud of them. And we look forward to updating you next quarter.

James F. Hinrichs

Great. Thanks, everyone.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. That does conclude the presentation. You may disconnect. Have a wonderful day.

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