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Owens & Minor Inc. (NYSE:OMI)

Q1 2008 Earnings Call

April 22, 2008 9:00 am ET

Executives

Craig R. Smith - President and Chief Executive Officer

James L. Bierman – Chief Financial Officer

Charles C. Colpo – Senior Vice President of Operations

Richard F. Bozard – Vice President and Treasurer

Olwen B. Cape – Vice President and Controller

Grace R. den Hartog – Senior Vice President and General Counsel

Trudi Allcott - Director of Investor and Media Relations

Analysts

Eric Coldwell – Robert W. Baird & Co., Inc.

David Veal – Morgan Stanley

Joel Ray – Davenport & Company of Virginia, Inc.

Larry March – Lehman Brothers

Robert Willoughby – Banc of America Securities

Arthur Freeman – JP Morgan

Operator

Good morning, ladies and gentlemen. Welcome to the Owens & Minor first quarter 2008 conference call. My name is Katie and I will be your operator for today. (Operator Instructions)

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

Craig R. Smith

Thank you, Katie, and good morning everyone. Welcome to the Owens & Minor First Quarter 2008 Conference Call. We will review our results and take your questions in a moment, but first let me introduce my colleagues on the call today: Jim Bierman, our Chief Financial Officer; Charlie Colpo, Dick Bozard, Olwen Cape, and Grace den Hartog.

Now before we begin, Trudi Allcott, our Director of Investor and Media Relations, will read a Safe Harbor statement. Trudi.

Trudi Allcott

Thank you, Craig. Our comments today will be focused on the company’s results for the 2008 first quarter, which are included in our press release. The press release, as well as the related presentation, can be found on our web site.

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

And finally, this conference call will be available on our web site for the next three weeks.

Thank you. Craig.

Craig R. Smith

Thanks, Trudi. Let me call on Jim to brief us on the financial results. Jim.

James L. Bierman

Thank you, Craig, and good morning everyone.

We are pleased with this quarter’s record earnings and the progress we have made with our operational initiative as we continue our efforts to position the company to achieve profitable, sustainable growth.

I will begin my remarks with an overview of the first quarter results. First quarter 2008 revenues were $67 million greater than revenues reported in the first quarter of 2007, an increase of 3.9%. The comparison to the first quarter of last year is impacted by the trailing effects of the McKesson acquisition. Some of these accounts, which were being served in the first quarter of 2007, were not retained during the year. Offsetting this was the net new business we added during 2007. Revenues associated with the McKesson accounts that were not retained approximated $30 million in the first quarter of 2007, decreasing to $3 million by the fourth quarter of 2007. Despite this, our first quarter results are within the range of our overall expectations.

First quarter 2008 gross margin was $187 million, an increase of $12 million from the first quarter of 2007 and significantly better than we had targeted for the quarter. As a percent of revenues first quarter gross margin increased 31 basis points to 10.67% compared to first quarter of last year. The improvement from the prior year is primarily due to our efforts during 2007 in bringing the McKesson accounts up to our pricing standards. Interestingly, when compared to fourth quarter 2007, gross margin increased $1.9 million, or 8 basis points.

As we discussed last quarter, we were expecting a sequential decrease in first quarter gross margin due to the seasonality of volume purchase incentives, as suppliers typically measure growth incentive programs at calendar year end. However, this quarter we did realize a greater than expected benefit from manufacturers’ price increases. In our industry there is a practice under which distributors receive the benefit of manufacturer price increases for amounts the distributor holds as inventory and for amounts on order. This profit is realized by claiming a larger rebate from the manufacturer when the product is sold. The impact on first quarter 2008 gross margin was approximately $3 million greater than the amounts we were targeting. We do not expect to see a similar benefit in the remaining quarters of 2008.

First quarter 2008 SG&A expenses were $137 million, a decrease of $5.7 million from first quarter 2007, and less than the levels we were targeting for the quarter. As a percent of revenues, first quarter SG&A expense decreased 65 basis points from the same period in the prior year to 7.82%. A significant aspect of the variance was the cost incurred in the first quarter of 2007 for transitioning the McKesson accounts, including transition-related payments to McKesson of $6.7 million. SG&A expenses in the first quarter of 2008 were also positively affected by decreased selling costs as we realigned our selling efforts during 2007. When compared to fourth quarter 2007 SG&A expenses decreased slightly, by $600,000, or 5 basis points.

As we discussed last quarter, we were targeting a slight seasonal increase in SG&A expense dollars when compared to fourth quarter 2007. The seasonal adjustments we targeted were recognized as expected. However, we did experience some delays in the spending we anticipated for certain operational initiatives we are undertaking. Naturally, we are expecting financial benefits from these initiatives to increase both revenue and operating margin in future periods. We are now targeting these initiatives to increase SG&A expenses towards the second half of 2008 with the financial benefits beginning to be realized during 2009.

First quarter 2008 operating earnings were $43.2 million compared to $24.8 million a year ago. Operating earnings as a percent of revenue was 2.46%.

Interest expense, a component of net income but not of operating earnings, decreased $3.7 million in the first quarter of 2008 compared to a year ago. The decline in interest expense resulted from the reduction in the average debt outstanding during the period, as well as decreases in interest rates.

The effective income tax rate for the quarter was 39%, affected by the statutory filing date for corporate income tax returns. Overall we are targeting the annual effective tax rate for 2008 to be 39.5%, which is consistent with the previous guidance in the prior year’s effective rate.

Net income for the quarter was $24.2 million compared to $10.8 million a year ago.

For the first quarter, diluted earnings per share were $0.59, improved from last year’s $0.27.

Again, to put comparisons in perspective, during last year’s first quarter we were engaged in the transition of an acquired business.

As you look at our first quarter asset liability management, we reported cash provided by operations of $108 million for the quarter. Contributing factors included: accounts receivable increasing by less than $1 million; inventory increasing by $26 million; and accounts payable increasing by $82 million. Cash used for capital expenditures was approximately $5 million and cash dividends paid were $8 million. We used cash to reduce our revolving credit facility by $76.5 million and drafts payable by $21 million.

Now turning to our direct to consumer business. We reported revenues of $25.4 million for the first quarter of 2008, a slight decline from $26.9 million for the same period of 2007. EBITDA, a non-GAAP measure, was $2.6 million. The DTC operating earnings for the quarter were positive, improved from last year when we posted a loss of $1 million.

Turning to our guidance for 2008. As Craig said in our press release, we are off to a good start for the year and the first quarter results put us within the range of our previously stated annual guidance.

Now let me turn it back over to Craig for his remarks.

Craig R. Smith

Thanks, Jim.

Now that Jim has provided you with some insight into the numbers let me take a few minutes to talk about the quarter, what we’re seeing in the marketplace and how we’re positioned for the year ahead.

As Jim said, we are obviously very pleased with our results this quarter. Historically speaking, this is the strongest quarterly earnings we have every reported. On top of that, we are pleased with ongoing operational improvement and with solid underlying performance in measures such as SG&A and asset management.

Preparing our quarterly results allowed me to reflect on where we were just a year ago. Now, at this time last year we had just completed a very hectic six months transition period for the McKesson acquisition. Bringing a billion dollars in new business into our network was no small feat. With these new customer accounts came new teammates, new facilities, and as we have said before, certain challenges. Pricing files were out of sync and supply chain management practices were different than ours. We worked very hard throughout the year to bring the pricing files into line and to accustom new customers to our way of managing the business.

As we demonstrated with each successive quarter, we have more than accomplished our goals in integrating this business into our distribution network and our systems. Although this took time, our fundamentals are greatly improved compared to a year ago. For example, we’ve paid down over $200 million on our long-term debt compared to last year. We lowered our net accounts receivable by $104 million. Our cap ratio at 25.3% is half what it was a year ago at 45.4%, and our return on assets and return on total equity are also greatly improved.

Turning back to this quarter on a reverse side, as Jim explained, we are about where we thought we would be for the quarter. Based on trends so far this quarter and our plans for the year ahead, we are comfortable with our annual guidance.

The opportunity for us this year is in penetrating our existing accounts. With the new business that came on board in late 2007 and the McKesson business, we see opportunity for further growth with these accounts. We have started to achieve success in selling value-added services, such as PANDAC, Wisdom Gold, and SurgiTrack, to our new customers.

This year we also expect to invest in our teammates and in our operations. We know that the key to strong customer relationships is the knowledge and expertise of our teammates, as well as the efficiency of our operations. For our teammates we are introducing an expanded leadership development program this year and as for our infrastructure we intend to invest in operational initiatives that we believe will lead to improvements in our warehouses and improved customer service.

Even with these investments this year, we see opportunity to improve expenses as a percent of revenue. We constantly have our eye on achieving efficiency gains and lowering operational expenses. As for what we are seeing in the market today, our customers continue to ask us for our help in improving their supply chain. Our challenge is to continue to serve our customers with the knowledge, supply-chain expertise, and product mix that can make a difference in the health care supply chain.

As we see our customers, our goal is to achieve continuous improvement as we also seek to expand our role in the health care arena. Our ability to partner directly with our health care customers and suppliers opens the door for us to provide advanced solutions, such as asset management, information management, and outsourcing. As pressures increase on our customers, we are well-positioned to help them. We are at the right place at the right time with the right tools, people, and infrastructure that can make the difference.

Just a couple of personal comments. We are obviously very pleased with this quarter. We are making very good progress in leveraging the McKesson acquisition. We managed our SG&A effectively, despite rising fuel costs. Asset management continues to be one of the cornerstones of the company. And we are very pleased with the quarter.

Thank you. Now we should be very happy to take your questions. Operator. Katie.

Question-and-Answer Session

Operator

(Operator Instructions)

Operator

Your first question comes from the line of Eric Coldwell from Robert W. Baird. Please proceed.

Eric Coldwell - Robert W. Baird & Co., Inc.

Thanks. Good morning. First off, just housekeeping. Jim, I missed your comments on the DTC business. Could you give us revenue and EBIT and patient account at the first quarter, please?

James L. Bierman

Sure. I don’t have the patient count, Eric, but let me give you the other numbers and I can give you directionally patient count. Revenues for the first quarter 2008 were $25.4 million. And that is compared to $26.9 million for the first quarter 2007. EBITDA for the first quarter of 2008 was $2.6 million. Operating earnings for the first quarter were positive and a year ago they were a loss of about a million. Directionally, there is a slight decrease in patient count, but I don’t happen to have that number here.

Eric Coldwell - Robert W. Baird & Co., Inc.

Okay. And the EBIT, you say it’s positive but I assume that’s immaterially so, given that you’re not giving the exact number?

James L. Bierman

Yes. Exactly.

Eric Coldwell - Robert W. Baird & Co., Inc.

Great. I guess, big picture, as we’ve listened to a couple of your suppliers’ calls recently—J&J and Abbott—we’re getting kind of conflicting messages from those suppliers in terms of market trends and whether or not the economy is weighing on their orders and what they’re seeing from distributor purchases. Can you give us some sense on your take on the difference in those calls? I know you guys have heard them and listened to them and I’m just interested in what your take is on what the manufacturers are saying today.

Craig R. Smith

Eric, let me take that one. You can pull numbers from a lot of different reports. Basically on the information we use, through February—and as you know a lot of the items we sell are consumed in the operating room—surgery trends seem to be what we would consider to be stable. So, you know, we don’t see a dramatic increase or decrease; they seem to be holding fairly well.

I can say, anecdotally—as you know, I’m out talking with a lot of CEOs every quarter—the first seven weeks of the year—and I was primarily in the Southeast and Northwest and the Southwest; I take these swings through different parts of the country. Now this was before the flu season hit in the third week of February. I was getting some information which I was not asking for; they were telling me is that their senses seem to be a little light—or their admissions seem to be a little light. I can’t really speak to that for the last four weeks of March and the first week of February.

But, the number we really look at is surgery trends and that seems to be stable at this point through the end of February.

Eric Coldwell - Robert W. Baird & Co., Inc.

Thank you very much. And the final question for now—and I might come back in later—is there were some comments about operating expense initiatives that are underway this year and how that might—if I heard you correctly—might lead to a little bit of a spike up in SG&A versus what you originally thought in the second half. Could you give us some sense on that directionally, what kind of an impact we might be looking for, and maybe some details on what those initiatives are?

Craig R. Smith

Sure, Eric. I think maybe directionally we were expecting on a dollar basis the SG&A expenses to increase towards the back half of the year, and as we said here a quarter ago, our hope was that some of these initiatives would be a little further along and we would be recognizing more of the expenses, even in the first quarter.

The initiatives have to do primarily with improving and increasing the automation capabilities and the process improvements that exist in the warehouse distribution system. And we’re pretty excited about this initiative and Charlie is leading the way in attempting to make sustainable improvements in the operating performance of the distribution network.

Eric Coldwell - Robert W. Baird & Co., Inc.

Jim, would you expect SG&A to sales ratios to still show some improvement versus the ratio in Q1 but maybe not as much as originally targeted, or are you actually signaling that you expect SG&A to be up as a percent of sales?

James L. Bierman

As a percent of sales we would tend to think that we remain comfortable with the overall guidance that we gave at the beginning of the year, where we would begin to see an improvement over the back half of last year’s performance. This was merely a directional guidance as to dollars quarter-on-quarter.

Eric Coldwell - Robert W. Baird & Co., Inc.

Okay. Thanks very much.

Operator

Your next question comes from the line of David Veal from Morgan Stanley. Please proceed.

David Veal - Morgan Stanley

Thanks. I’m just trying to understand a little bit further the kind of seasonality that we might expect for the balance of the year. Could you—you made mention that there was $30 million in McKesson business that was not retained in the first quarter, $3 million in the fourth. Can you give us round numbers for the second and third quarter? For mulling purposes.

Craig R. Smith

No, I don’t really have that at my fingertips. Again, it was to provide sort of the directional explanation as you looked at quarter-on-quarter, or similar quarters year-on-year, was what the notion was behind it.

David Veal - Morgan Stanley

Is it fair to say it is fairly linear, though?

Craig R. Smith

I think so.

David Veal - Morgan Stanley

And in terms of the gross margin line, so we’ve got $3 million in pricing benefits this quarter that won’t recur. Are there other items that we should be thinking about as the year moves along?

Craig R. Smith

No, other than we have said now in two successive quarters, there is a degree of seasonality with the volume purchase incentives because many of those programs are calendar-year based where you have to establish or reach a certain level of performance in order to qualify for the incentives. So there’s a bit of the second-half-of-the-year bias, or even a fourth-quarter bias, which, again, we had talked about last quarter as we finished up the fourth quarter.

David Veal - Morgan Stanley

Sure. Absolutely. And one last question and I’ll hop off. In terms of working capital management—obviously you’ve done a great job managing the DSOs down—what can we think about, or how should we sort of be thinking about the forecast? Is there room to take that lower? Can we squeeze out a few more dollars there?

Craig R. Smith

I think any potential that may exist may be more on the inventory side than the DSO side. I think we’re running out of room on the DSO side to continue to have the improvements that we’ve had.

David Veal - Morgan Stanley

All right. Thank you very much.

Operator

(Operator Instruction)

Your next question comes from the line of Joel Ray from Davenport. Please proceed.

Joel Ray - Davenport & Company of Virginia, Inc.

I would like to ask you a question if I could. We’ve had some developments on the whole issue of competitive bidding on the diabetes side. And I was wondering if you have had the chance to evaluate your strategies going forward for that business now that we know that there are some changes coming in July of this year?

Grace R. den Hartog

Joel, this is Grace den Hartog. And I’ve been following the competitive bidding results. We—Access was a wait-listed bid winner and what we are doing now, we are involved in several coalitions that are attempting to educate and inform the Congressional legislators of the impact of the bid results as we currently know them to be.

And I might add that the award winners have not yet been announced publicly and CMS does not intend to make that announcement until the second week of May so we’re still operating a little bit in the dark as to who the actual award winners will be. But we know enough to know the national players are working together in a variety of coalitions, as I mentioned, to educate the Congressional legislators to the potential consequences of the results as we now know them to be.

Craig R. Smith

And just to put a financial color on it, the initial round of bidding has a relatively insignificant impact on the base of business in our DTC business and consequently a relatively minor impact on what the potential financial effect could be this year, or even going forward, relative to this aspect. Obviously there’s a bigger component. And I think just the final point on this would be I don’t think the results, as they stand presently, have really changed our strategy related to this operation.

Joel Ray - Davenport & Company of Virginia, Inc.

I take it that from what you know today with what’s going on with the program, all of that is factored into your existing guidance?

Craig R. Smith

Yes.

Joel Ray - Davenport & Company of Virginia, Inc.

Okay. Good enough.

Operator

Your next question comes from the line of Larry March from Lehman Brothers. Please proceed.

Larry March - Lehman Brothers

Good morning. It’s always an honor to follow Mr. Ray. [laughter] And my questions will be as favorable. But I would like to ask two things. First, just the rebate call out in the first quarter. And you say about $3 million more than you would have thought. I’m just sort of reflecting back; I never recall a first quarter of rebate recognition of this magnitude and I’m just wondering what particular to this year would have, do you think, caused this? Is it a change in how you’re forced to recognize rebates? Is it just something unusual in the market or what would it be, do you think?

Craig R. Smith

Well, Larry, I’ve been doing this a long time and I would agree with you, it’s been quite a while since we’ve seen this in the first quarter. And I think it’s really related to price increase based on the rising fuel costs, latex is going up dramatically, and resins. And, as probably we’re seeing, we’re not quite sure where this is all going to end up in terms of price per barrel.

So I think really the manufacturers—I wouldn’t say their backs are to the wall, but the rise of transportation costs, the rise of resin and latex, I think really prompted several manufacturers which we’ve not seen.

I was saying this morning, I can’t remember when we’ve seen this number of price increases in the first quarter. It’s been a long time. And I think it was just to the point where the manufacturers really had to take the price increases and more or less let the chips fall where they may with the end user, which is the customer. So, I haven’t seen this, I was thinking, at least in five years and probably longer than that. So it did catch us a little bit by surprise that we saw this many price increases going into this year.

Larry March - Lehman Brothers

Interesting. So, as you think about it, I guess the offset of that might be some increase in your own fuel cost that you should have to absorb but it sounds like those are fairly modest in comparison to the take up in price. And net-net, as you think about it, Craig, I mean, rising fuel costs don’t seem to net positive to you but it certainly doesn’t seem like it’s a headwind, especially as you reflect upon these price increases.

Craig R. Smith

And I would look at first quarter. We did see fuel cost increases and we were able to absorb those by offsetting other parts of our SG&A. As you remember, a pretty big percentage of our business is on activity-based costing so there is an ability to pass that on. Some of our larger customers who are probably better educated on supply chain are allowing for pass-through on fuel. And of course, as we renegotiate contracts, obviously this is becoming much more of a sensitive issue as we move forward renegotiating or negotiating new contracts.

So I think over all, with the fuel increases that we had in the first quarter, we were still able to show really good improvement on the SG&A and absorb whatever fuel cost we had increased in the first quarter.

Larry March - Lehman Brothers

Okay. And the second, just to follow up with the question Eric had asked, which is just the sort of tone of the market. I mean, certainly anecdotally a lot of concern about funding costs for hospitals. You know, some back and forth on senses. Your point on surgical procedures don’t seem much of an impact but is there any thing from a customer standpoint that you could see that could catch you by surprise here as you go into the back half of this year that may be the result of some of these macro issues they’re facing?

Craig R. Smith

Well, I think the one thing I was a little surprised in the first three months and maybe it was a little bit of naivety on my part, but there is some pressure on Medicaid with cost cutting in different states. I think to some degree where you primarily hit around, there is some tie-in to the real estate challenges that we’re seeing in terms of tax dollars, so there is some pressure in some parts of the country.

Again, I believe, though, we’re in the right place with the right tools with our larger customers that are really focused on supply chain; they’re really working on improving their supply chain and I think we’re in the right place to help those customers.

So I don’t really, on the radar screen today, anticipate in the last six months anything coming out of left field at us but I was--in my discussions with a lot of the CEOs, there’s been some questions about Medicare but I think we’re well-positioned for that.

Larry March - Lehman Brothers

Okay. And two other quick things. Just back on diabetes here for a bit. It seems like, if you reflect back a year or so ago, your decision was really to kind of—I don’t want to say cut the cost infrastructure but not continue to invest in building that business in terms of share and I think Jim talked about some sequential reduction and patient count—with some of the outcome of competitive bidding, and you’re not one of them as it stands in terms of winning bidder, do you think there are more opportunities to cut costs in that business or do you think you’re about as far as you go? And even post-competitive bidding, are there other ways to sort of mix down your own supply costs there?

Craig R. Smith

Yes, we’re looking at that in a lot of detail and that is exactly where we are focused. You know, we are pleased that the entity is now EBITDA positive, cash flow positive, even though it’s maybe earnings neutral. The opportunity there is to look at ways to improve margin on the sort of mix of products that they have. We’ve seen a fair degree of variability on the respiratory suite of products, which we’re evaluating and looking at constantly.

As well as we’re looking at the way we go to market to obtain new patients, new customers. The advertising model has definitely gotten more expensive and we’re selectively using that model but supplementing it with a bit of a more direct sales force model that we can mitigate some of the risks associated wit it.

So I think the bottom line is we’ll continue to see improvement--sort of marginal improvement, if you will--in the overall performance of the entity in this environment.

Larry March - Lehman Brothers

Sure. And just, you know, if you sort of think about it strategically, it just seems like this is such a minor part of your business, given the strength of every thing else. You’re sort of breaking even. You’re obviously not building the business and getting changes. I’m just sort of wondering strategically what’s the rational for still being exposed in the industry.

Craig R. Smith

Well, right now we’re pleased we’ve turned it around operationally. We’re certainly aware of other changes that are happening in this space in the marketplace and I think we continue to look at various options going forward.

Larry March - Lehman Brothers

Okay. Finally, real quick—I don’t mean to hog the call—but just, Craig, you and Charlie, as you sort of think back—I mean, here we are with the McKesson business fully integrated here—is it fair to say that this has been a real success for you in terms of more repeat business that you thought and less hiccups than you thought, or would you just characterize it as this business has come in net-net about like you had thought. Because it certainly seems like it’s been a positive surprise on the repeat business side.

Craig R. Smith

I think that the biggest surprise for us, Larry, is the leveraging that we were seeing earlier in the year than we anticipated. I think there is still opportunity there, in the McKesson business, in terms of sales penetration and programs and services. I think if we were to say a reflection of that, looking back, we still see Charlie—sitting here to my right; he’s about ready to jump in here any second—but as I think with this business, the upside opportunity is to retain business.

As you know, and we talked about this publicly, is our ability to take a new account or existing account and penetrate it and I still think there is still some very good opportunity. We’re seeing our first PANDAC customer, our first SurgiTrack customer, our first Wisdom Gold customer; so we’re going to push that pretty hard.

And on the new business that came on in the third and the fourth quarter last year, remember, we had all this—not noise—but all the physical moves and the people we were adding and to just bring on that business along with the McKesson business—and I think people forget, we added hundreds of millions of dollars of new business in the third and the fourth quarter. There is still a huge upside opportunity on the new business that we brought in, now that the dust has settled. And I think the investments we’re making in the warehouse and customer service—we’re making some great investments in our customer service—is going to help us penetrate those accounts better.

Larry March - Lehman Brothers

Good deal. Thanks so much.

Operator

Your next question comes from the line of Robert Willoughby from Banc of America Securities. Please proceed.

Robert Willoughby - Banc of America Securities

Good morning. Ever living in Larry Marsh’s shadow here. [laughter] Actually, to Larry’s question, you know, why sort of be in that DTC business, assuming that you kind of stay there status quo. I mean, where else do you have to deploy the kinds of cash flow that you are generating? Are there new strategic directions here on the horizon?

James L. Bierman

Yes, I think, Robert, that certainly as we look at the opportunities that are out there in the marketplace, there are a significant number of them. You know, quite simply, we have an opportunity to deliver the suite of products that we have to different end users. So to expand the end-user base beyond our concentration in acute care hospitals, and without—you know, we don’t have the luxury of time here to go into a lot of detail—but that definitely is an opportunity that exists.

And then we also have an opportunity to expand the suite and characterization of some of the products that we have with existing customers as we move potentially into the, say, more of the clinical area.

I think those two strategic directions have us very excited and could generate a significant return on any capital.

Robert Willoughby - Banc of America Securities

Jim, to the first point, I guess—I’m assuming, though, you still want to stick with entities somehow affiliated with the hospitals. I mean, we’re not talking about new distribution that are completely removed from that hospital presence?

James L. Bierman

Exactly. I think that leveraging off of the incredible national footprint that we have with our acute-care relationships is really the key to success in this next step and we’ll be looking to accomplish that. Correct.

Robert Willoughby - Banc of America Securities

Okay. And just another issue, possibly for Craig. Looking at fuel costs you appear to be fairly well insulated from some of the increases there but obviously health care costs for the employers—a key issue we’re seeing some problems in the managed care sector today—what is Owens & Minor doing year over year to manage down that health care cost trend?

Craig R. Smith

Our health care costs? Or the hospitals’ health care costs?

Robert Willoughby - Banc of America Securities

Your own employees.

Craig R. Smith

Our own employees. We have instituted a wellness program, we have health screenings every quarter for all of our teammates, we give incentives for wellness, reduction in payment of insurance costs, we added a state-of-the-art workout room here that I can tell you is very heavily used from Monday through Saturday—we’re only closed on Sunday. We have experienced trainers and I would be amazed if we probably took all of our teammates here and counted the pounds reduction, I think it would be pretty dramatic, to be honest with you, year over year. You know, we have a no smoking policy, we give incentives to our teammates to quit smoking. We bid out on a regular basis our health care—our insurance companies.

I think the one challenge we have is we have about 4,600 teammates. We’re probably still considered a somewhat of a small entity to insurance companies, so really what we do is to prove to the insurance companies that we deal with that we’re improving our teammates health and their well-being. And so that is a very high priority for the company.

Robert Willoughby - Banc of America Securities

Interesting. And actually some of those things sounds like costs actually increased somewhat. I mean, can you speak . . .

Craig R. Smith

Well, I think overall if you look at the average of what other companies are going through, I would say that we are below that median so the investments that we have made have paid off. And I would say that overall our insurance costs--if you were to take all of the workout room and the trainers and the incentives versus what we’re paying on a monthly basis for insurance for our teammates—I would say that we are still under the national median for increases on an annual basis.

I mean, I’ve been very pleased. We use our insurance providers to come in and made recommendations, we’re working very aggressively on workman’s comp with safety programs, and so it’s not just to get the insurance costs down; it’s to get our overall liability and our insurance costs down across the board.

Robert Willoughby - Banc of America Securities

Great. Thank you.

Craig R. Smith

I’m glad you asked that question. We’re very proud of that. We don’t toot our horn very often on that.

Robert Willoughby - Banc of America Securities

Great. Thank you.

Operator

(Operator Instructions)

Your next question comes from the line of Lisa Gill from JP Morgan. Please proceed.

Arthur Freeman - JP Morgan

Hi, thanks, it’s Arthur Freeman for Lisa. I was just wondering if you could provide some more color on the SG&A costs, perhaps the magnitude of undercosts that you are expecting this quarter and then I have a second question related to revenues.

James L. Bierman

I’m not sure I can comment any further than directionally the way I did. You know, we were down on a dollar basis $600,000 compared to the fourth quarter of 2007. When we talked in terms of the first quarter 2008 a quarter ago we were expecting SG&A expense dollars to slightly increase. So we were slightly down; we had expected a slight increase and I think that kind of gives you a range of where we actually had come in.

Arthur Freeman - JP Morgan

Okay. So maybe go out a million higher is where you would have been? Is that off the ballpark?

James L. Bierman

It would be in the range.

Arthur Freeman - JP Morgan

Okay. And then secondly, on revenues, you’ve got to about 5.27% for the full year and this quarter was just under 4%. I think [inaudible] penetration is definitely one of the areas you are gunning for. Where does this mean you’re going to come from? Is it mainly just the McKesson business or is it within your existing [inaudible] and what’s the process for new competitive wins this year?

Craig R. Smith

Well, let me say again—and I think one of the comments that I had made earlier—it’s more than the McKesson business, it’s the $300 million-$400 million in new business I think that we brought on, so you’re really talking about $1.4 billion that we have the ability to penetrate at a higher percentage. So it would be the new business—you now, we continue to existing business back to Jim’s point of making the investments in the technology that we have in the hospitals. We still feel we’ve got an opportunity in existing hospitals to penetrate with some of the new technology and some of the new markets that we’re working in.

So, 5.27%, we came back and we said we’re comfortable with that and we think for the year that’s something that we’re still comfortable with and we do think that a lot of it will—you know, I think, as we have been asked year over year over year, you know, we have grown our existing business nicely and now we have this new book of business to put on top of that.

So, right now on the horizon, as you know, we’ve got the two GPOs up for bid later in the year; that’s progressing along. Not a whole lot on the radar screen. As soon as I say that then something comes up for bid. Basically we’re on the hunt all the time for new business, so we have this new enterprise sales force that basically is out working on competitive accounts every day. And so we’re not just counting on the existing or the new book or business. We want new customers. So we’re aggressively out in the marketplace going after that.

Arthur Freeman - JP Morgan

Okay, that’s great. And then, final question. You know, your activity base costs does give you some ability to pass along the fuel costs. Can you give us any numbers on what percentage of your existing customers are on activity-based costing and what’s the kind of projectory for bringing on the McKesson customers onto activity-based costing?

Craig R. Smith

We were tracking somewhere before McKesson, somewhere between 38% and 40%. Obviously when you add that much business on your percentage drops pretty dramatically. So we have an opportunity there with the activity-based costing with the new McKesson customers. I think that’s new concept for them. Really what we’ve worked on is operational improvements. We’ve got the service stabilized with them, now we have the opportunity to push the activity-based costing.

So it’s still a fairly significant piece of our business is on activity-based costing and most of our larger, more sophisticated customers use that as their pricing model.

Arthur Freeman - JP Morgan

Okay. Thanks very much.

Craig R. Smith

Okay, operator, we have time for one more question.

Operator

And your final question comes from the line of Eric Coldwell from Robert W. Baird. Please proceed.

Eric Coldwell - Robert W. Baird & Co., Inc.

Thanks for letting me jump back in. A couple of questions from the balance sheet and cash flow. You know, Jim, as I look at the very detailed press release from last night, we saw the increase in your LIFO reserve. I’m hoping you can help marry for us what’s going on. We’ve got a more than doubling of LIFO reserve in the quarter. How do we marry that with your comments on price increases that have transpired early this year? And then could you give us some color on what you’re expecting for LIFO reserves for 2008?

James L. Bierman

That’s an excellent question, Eric, and without getting into somewhat of the arcane rules around LIFO and inventory valuation, let me try to present sort of a broad overview.

With the extent and the nature of the manufacturer price increases that we experienced in the first quarter, in a perfect world with no changes in inventory amounts, you would see for every dollar of price increase a corresponding dollar of increase in the LIFO reserve. So there would tend to be a correlation between the two, on a one-to-one basis, in an environment where there are no changes within inventory.

You look at the first quarter of 2007 where the provision for LIFO reserve was $4.8 million and it increased to $10.5 million for the first quarter of 2008, that really speaks to the magnitude and the significance of the manufacturer price increase impact that we saw in the first quarter. And again speaks to why we hadn’t anticipated the increase any better than we did, and that I had already spoken about.

Again, assuming that there is little to no manufacturer price increases for the remainder of the year and assuming that the mix of inventory stays basically the same as it is at the end of the first quarter, you would not expect to see any significant change in the provision for LIFO reserve over the course of the year.

Eric Coldwell - Robert W. Baird & Co., Inc.

Thanks for the color and then just last question here. On the guidance, I think it was the commentary delivered in December at the investor day. There was some commentary about being a little more cautious in your internal modeling for the overall economic situation and hospitals financing pressures and some commentary about increasing your bad debt reserves, yet in Q1 bad debt reserves were actually down just fractionally versus Q1 2007. Can you give us some color of what’s going on there and what we should be looking at for bad debt reserves for the remainder of the year?

James L. Bierman

Yes. And again, the first quarter 2007 provisioned for losses on accounts receivable was $6.2 million and in the first quarter of 2008 it was $5.8 million. Reserve actually increased year-on-year but the provision is down marginally. I would say that tends to be normal fluctuation that we would see within a book of business and appears pretty reasonable and within expectations, at least as we are in here today. Remember, the provision for losses on those accounts includes a component for the DTC business as well as the core distribution business.

Eric Coldwell - Robert W. Baird & Co., Inc.

Right. So I guess on a quarterly basis should we be looking at about this trend continuing--this magnitude of reserves continuing for the remainder of the year?

James L. Bierman

I’m not sure I’m comfortable going that much further. I think within the totality of the SG&A guidance that we’ve given, we certainly have factored in what our expectations regarding the provision for bad debt and I would say that the first quarter is definitely within those expectations that serve the basis for the overall conclusion. That helps in another way.

Eric Coldwell - Robert W. Baird & Co., Inc.

Great. Thanks much. Good job on the quarter.

Craig R. Smith

All right. In closing let me just make a couple of comments here. We are making very good progress in leveraging the McKesson acquisition. We’ve managed our SG&A effectively despite rising fuel costs. Asset management has been outstanding. We felt we had a great quarter and we look forward to giving you our results at the end of the second quarter. Thank you.

Operator

Ladies and gentlemen, thank you for participation in today’s conference. This concludes the presentation. You may now disconnect. Have a wonderful day.

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Source: Owens & Minor Inc. Q1 2008 Earnings Call Transcript

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