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CareFusion (NYSE:CFN)

Q4 2012 Earnings Call

August 09, 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

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

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

Matthew Taylor - Barclays Capital, Research Division

Amit Bhalla - Citigroup Inc, Research Division

Rajeev Jashnani - UBS Investment Bank, Research Division

Lennox Ketner - BofA Merrill Lynch, Research Division

David R. Lewis - Morgan Stanley, Research Division

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

Operator

Good day, ladies and gentlemen, and welcome to the Fourth Quarter 2012 CareFusion Corporation Earnings Conference Call. My name is Tahisha, and I'll be your operator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes. I would now like to turn the conference over to your host for today, Mr. Jim Mazzola, Head of Investor Relations. Please proceed.

Jim Mazzola

Great. Thanks, Tahisha, and welcome, everyone. On today's call, Kieran and Jim are going to discuss CareFusion's results for our fourth quarter ended June 30, and we will provide guidance for fiscal 2013. We'll also discuss our long-term outlook through fiscal 2015.

We issued today 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 SEC. We also filed and posted several slides to accompany today's webcast, which may be found on the Investor homepage with our earnings materials. While we will not review each slide on today's call, they can be used as a reference and include 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 our ongoing results of operations, particularly in comparing underlying results from period to period.

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, including statements about our FY'13 guidance. Our actual results could differ materially from those expressed in our forward-looking statements due to risks and uncertainties, including the risk factors set forth in today's news release and our filings with the SEC. Please refer to these materials for a more detailed explanation of the inherent limitations of such forward-looking statements.

And with that, I'll turn the call over to Kieran.

Kieran T. Gallahue

Thanks, Jim. Good afternoon, and thanks for joining us. Our team executed well in the fourth quarter, delivering a strong finish to an important year of transition for us.

Our revenue and cash flow results for the year were at the top end of our guidance range, and adjusted earnings per share and adjusted operating margins were right in line with the expectation we set during the past 2 quarters.

I'm pleased with the trend in operating margins, which increased sequentially each quarter during the fiscal year.

For the fourth quarter, revenue rose 3% to $968 million, led by our Medical Systems segment. Each business in Medical Systems had a record or near-record performance in the quarter, contributing to an increase in adjusted segment profit of nearly 16% to $151 million.

We continue to make substantial investments in R&D, even as we reduced operating expenses from Q4 of last year. This provided a leverage to deliver adjusted operating margins of 18.9%, again, our strongest result this year.

Turning to our businesses. We saw a similar trend in the fourth quarter, as in the prior quarters this year. In Medical Systems, our Dispensing business finished a great year by growing revenue 10% and exiting the year with a healthy level of committed contracts that we'll install in fiscal '13.

Infusion grew slightly ahead of our expectations in the quarter to finish a record year. We also continue to see the impact of higher-margin consumables pulling through our larger install base of infusion pumps. This was a contributing factor in our corporate gross margins, moving about 0.5 point higher than in Q2 and Q3.

In Respiratory Technologies, we grew the business nearly 30% in the fourth quarter. About half this growth came from the government contract we told you about last quarter, the other half coming from organic growth in our core accounts. We feel good about the progress we continue to make in the business.

We're doing a much better job of executing and leveraging the strengths we have across CareFusion for the benefit of our customers. We're also benefiting from a recovery in ventilator sales 2 years after hospitals stockpiled for H1N1 preparedness.

In addition to the financial results, the Medical Systems team made good progress hitting internal milestones for our next-generation product platforms and realigning our service organization and in continuing to develop offerings that leverage our strengths across the product portfolio.

Increasingly, we see these cross-business-line offerings as key to our growth. We add more value for customers and differentiate CareFusion when we go to market with our medication management and critical care offerings, which cross multiple product lines within Medical Systems.

Our Procedural Solutions segment revenue declined 7% in the fourth quarter, completing a challenging transition year. Adjusted segment profit declined 35% to $32 million, due in large part to the strong Q4 of last year, when we had a higher distributor sales in advance of our business model transition. Procedural Solutions exits this year stronger and better-positioned with much accomplished and work still to complete in fiscal '13.

Our sales force realignment continues to go well. With more than 6 months behind us, our new surgical and vascular teams are gaining traction in their new territories and putting us in good position to add new, clinically differentiated products to our portfolio, something that we intend to capitalize on in future quarters.

Within the Infection Prevention business, sales of ChloraPrep finished the year where we expected, growing in the mid-single-digits in the second half of the year. We did not see a meaningful change in market conditions during the quarter.

U.S. hospital capital spending remains constrained, and customers continue to prioritize their spending. But we are comfortable with the deal flow we see across our capital product categories. Western European spending remains weak, although we are less exposed outside the U.S. We saw low growth but a generally stable environment in most markets.

In other strategic geographies, including the Middle East, Eastern Europe, Southeast Asia and the BRICS, our capital businesses continue to experience meaningful growth, albeit off a small base.

Closing out fiscal '12, the strength of our Medical Systems segment throughout the year helped us reach the high end of our revenue guidance range. Recall we guided at the beginning of the year to a range of 3% to 5% growth and finished the year with revenue of $3.6 billion, an increase of 5% over last year.

Adjusted earnings per share from continuing operations in the fourth quarter reached $0.51, putting us at $1.78 for fiscal '12 and in the middle of the $1.75 to $1.80 range we provided last quarter.

As I look back on completing my first fiscal year with CareFusion, I'm proud of the progress the team has made and encouraged by the opportunities that lie ahead. When we laid out fiscal '12 during our first quarter call, we talked about transitioning from our stand-up phase, which is all about separating from Cardinal Health, to the second phase in our transformation. This second phase is called Building the Foundation for Growth and sets us up to be more customer-focused and more efficient as we enter the third phase, which is to accelerate long-term growth.

Despite hitting some bumps during the year, we managed to substantially grow revenue, operating earnings and adjusted EPS while substantially decreasing our G&A expenses and redeploying those funds to invest in R&D.

During fiscal '12, we made our first real progress towards a meaningful increase in R&D funding since our spinoff in 2009. And I'm pleased to say that we're not just spending more, we are spending in a more targeted and planned manner.

Phase II began with the segment strategy we laid out at the beginning of this fiscal year. This structure continues to provide clarity to our Medical Systems and Procedural Solutions customers, improving our innovation roadmaps and creating landing zones for new technologies and geographic footprints.

An important aspect of Phase II is investing to grow our strong anchor franchises over the long term organically and by acquisition. We executed on 3 small transactions during the fourth quarter, 2 of which will feed our new product or technology pipeline and one that improves our scale in a key European market. I am comfortable with the pipeline of acquisition opportunities that could complement our business during fiscal 2013.

As I mentioned last quarter, we have an enviable balance sheet and strong cash flows that provide important levers as we create a more valuable company.

So to summarize, we made good progress in fiscal '12 that included, number one, exiting Phase I, the stand-up phase of our transformation, and entering Phase II, where we'll build the foundation for growth. As I mentioned earlier, this work to simplify our business is a critical step towards improving our operating margins to 20-plus percent, exiting fiscal '14 and creating the company we intend to be.

Number two, we acquired several companies and technologies that expanded our geographic reach, strengthen our technology base and help accelerate our growth. At the same time, we exited several non-core businesses, allowing us to simplify and focus on value-creating activities.

Number three, we established a cohesive, customer-focused organization structure that provides landing zones for new product innovation and newly acquired companies while reducing our cost structure. This structure is important to our organic growth plans and provides a clearer structure to more rapidly integrate acquisitions.

Number four, we simplified our go-to-market structure by consolidating and strengthening our selling, service and field clinical resources.

Number five, we initiated our first share repurchase program, a $500-million buyback under which we have already repurchased $100 million of CareFusion stock.

Number six, we continued to make substantial investment in our quality management system, even as we absorbed several recall-related charges.

Number seven, we strengthened the team with world-class additions that will help lead and guide us in the years ahead.

And number eight, as we forecasted, there were bumps this year, and it wasn't always pretty, but we delivered solid financial results by focusing on fundamental execution, a discipline that will serve us well over the long term.

As I look ahead to our goals for fiscal '13, we need to continue to manage conservatively, given the global environment and where we're at in our transformation.

Just as I said in fiscal '12, I expect we'll experience some bumps in the road in fiscal 2013. Despite these factors, our customers' emphasis on cost reduction fits well with our product and service offerings, so you will see us continue to emphasize how our solutions lower costs, improve hospital productivity and increase patient safety.

We will build scale and critical mass in key areas of our business and maintain our focus on expanding our operating margins. As we integrate the many disparate forms -- platforms we have internally, we are creating a leaner, more customer-focused and global company.

Over the longer term, our strong cash flow and use of our balance sheet create flexibility to deliver customer and shareholder value through a well-planned approach to capital deployment.

As Jim will discuss in more detail, we will do this without losing our discipline as buyers, while also maintaining flexibility in our deal models for transactions that have a greater strategic or long-term value.

We think a balanced approach between our organic growth plans, acquisitions and share buybacks will deliver strong returns to shareholders during the next 3 years.

I'm looking forward to taking your questions. But first, let me turn it over to Jim.

James F. Hinrichs

Okay. Thanks, Kieran. Today, everybody, I'm going to discuss our fourth quarter financial performance, our fiscal year 2013 guidance and our longer-term financial goals in the context of more specific capital deployment plans. I want to apologize in advance, there's a lot to cover. My prepared remarks are actually about 5 minutes longer than normal, but I want to make sure everything is very clear as I go through it. Before I get into the details, I want to start by highlighting what I think are the 3 most important takeaways from today's call.

Number one, we had a good strong finish to the year. We're closing our fiscal '12 in line with expectations despite absorbing an unforecasted $7 million recall charge during the quarter. Like the third quarter, our results continued to be driven by strength in our largest and most profitable businesses, Dispensing and Infusion, combined with excellent expense management.

Second, our fiscal '13 guidance doesn't contain any surprises from the trends that we've been talking about in the past, low-single-digit revenue growth, good leverage to the bottom line and EPS growth in the high single-digits to low teens.

Third, we are giving more insight into our longer-term capital plan and how, through a more intentional deployment of capital, we intend to use our strong balance sheet to drive greater EPS growth over the next few years. Partly as a result of these plans, we are modifying our presentation of adjusted EPS to exclude acquisition-related amortization.

Capital allocation in the form of M&A and share buybacks will play a significant role in our ability to achieve a compounded EPS growth rate of 12% to 14% through fiscal '15, and we feel that this new presentation gives the best insight into how well we're progressing toward that goal.

I'll spend most of my time today on our '13 guidance and our capital allocation strategy, but first, I'll quickly summarize our fourth quarter financial performance.

As Kieran mentioned, the quarter came in about where we expected. Revenue increased 3% on a reported basis, 4% on a constant currency basis. Adjusted diluted earnings per share from continuing ops were $0.51 versus $0.52 in the prior year quarter. Revenue growth was driven by continued strength in each of the Medical Systems business lines and offset by a decline in Procedural Solutions.

Our fourth quarter gross margins were 50.5%, that's a 50-basis-point sequential improvement over the third quarter, and on a year-over-year basis, gross margins declined by 140 basis points. About half of that decline was the result of the previously announced product recall charges that we incurred during the quarter and the remainder, largely attributable to Infusion capital pricing.

During the quarter and year, we did manage several product recalls in our Infusion and Respiratory businesses. As a note, we have not backed out these recall expenses from our adjusted earnings metrics. And just for your reference, these recall charges totaled $7 million during the fourth quarter and $17 million for the full year.

Let's take a minute to put these charges in context. I want to reiterate a few key points as it relates to product quality. As a regulated company, addressing product quality on an ongoing basis is an integral part of our operation. And as we said on our first quarter call, you should expect that we'll have recalls, particularly in some of our more mature platforms. And while we can never forecast these kind of events, it's not unlikely that recalls such as these will periodically occur. What's important to us is that we have the systems, the monitors and the controls in place to identify issues early, to take necessary remediation steps quickly and with as little disruption as possible to our customers. Patient safety is core to our mission, and we know we cannot become complacent with something so critical to our business. Therefore, we will continue to invest in our quality systems, and over time, we believe these investments will prove to differentiate CareFusion from our competitors in the area of product quality and safety.

Now moving to R&D. Fourth quarter R&D expenses again increased meaningfully, growing 21%. As we said last quarter, this level of R&D spend is the new baseline into the foreseeable future as we invest for growth and fund next-gen development activities.

Fourth quarter adjusted SG&A expenses decreased $11 million or 4% on a year-over-year basis. And if you exclude the impact of acquisitions and divestiture, adjusted SG&A actually decreased $19 million or 7% on a year-over-year basis. This decrease is the result of the work that we've been doing to simplify our internal business processes, reduce our corporate administrative footprint and redirect those savings to either the bottom line or toward growth-producing activities, such as sales and marketing and R&D.

Resulting adjusted operating earnings were up 2%, with margins of 18.9%, in line with our expectations. The fourth quarter adjusted tax rate of 28.7% and the resulting full year rate of 25.7% were toward the high end of our expected range due to year-end strength and high-tax-rate jurisdictions.

Adjusted diluted earnings per share from continuing ops decreased by $0.01 to $0.51 as compared to the prior year.

Now let's take a look at the segment revenue results. Medical Systems revenue totaled $646 million, growing 9% during the fourth quarter as compared to last year, driven by growth in each of its underlying businesses. More specifically, Dispensing revenue increased $27 million or 10%. Exclude the impact of rollout, revenue increased 2%. Given our very strong third quarter and the tough relative comp versus last year, we're pleased with these results.

Infusion Systems revenue increased 2% to $266 million as the team completed a record number of channel implementations. Pricing for our contracted pumps continue to improve in the fourth quarter as the industry transitions from the discounting that has been associated with the COLLEAGUE recall opportunity.

Respiratory Technologies revenue increased 29% to $88 million as it continue to benefit from improved execution, a general recovery in the global ventilator market and the significant government order that we discussed last quarter.

Procedural Solutions revenue declined $25 million or 7% in the fourth quarter on a year-over-year basis. Fiscal year '12 was a transition period for Procedural Solutions. It started in the fourth quarter of '11 as we divested certain businesses, implemented new IT systems and began to sell to Cardinal Health as a third-party distributor. We had initial inventory purchases associated with this transition during the fourth quarter of last year to create a difficult comparison for most of the PS businesses in the fourth quarter of this year. We have now lapped these unusual events. As we move into fiscal '13, the core results in this segment will become more transparent.

Moving now to cash flow. Operating cash flow for the full year was $645 million as compared to $331 million last year and at the high end of our $600 million to $650 million guidance range. The team made fantastic progress on reducing U.S. and European pass-through receivables, and that's what drove the strength in this metric.

Capital expenditures totaled $106 million, and free cash flow from continuing operations was $539 million, which represents approximately $2.40 per share on a diluted basis and about a -- which is about a 10% yield on our current share price.

During the quarter, we purchased $50 million of stock or 1.9 million shares. That brings our cumulative total under the $500 million authorization to $100 million or 3.9 million shares.

Before we get into the details of our 2013 guidance, I want to make sure that everyone understands the 2 presentation changes that we'll make prospectively as we report in 2013.

The first is the exclusion of M&A-related amortization expense from our non-GAAP adjusted earnings metric. Our guidance today is presented in both formats in order to ease the transition to the new metric. The second change is a reclassification of our Respiratory Diagnostics business from Procedural Solutions to Respiratory Technologies in our Medical Systems segment.

As you know, speaking of the change in adjusted EPS, we've contemplated the exclusion of deal-related amortization expense from our adjusted financial measures for some time now, and we've actually solicited feedback on this matter from many of you over the past year. We determined the change is appropriate now because it will provide the best and most comparable view into our results and is a better reflection of our cash-generating ability.

As Kieran said, we intend to remain disciplined in our approach to acquisitions. We continue to use ROIC as the primary metric to evaluate the financial performance of our targets. At the same time, of course, we remain flexible to the extent that a transaction provides meaningful strategic value.

To be clear, I want to make sure I'm clear, these statements and EPS presentations are not foreshadowing any large, transformative deal or even an imminent midsized acquisition. They simply represent the logical continuation of our previously discussed strategy. We do have an active deal pipeline, and we hope to be able to show progress on that front this year, but I want to make sure that everyone keeps our comments in the right context.

We have provided historical information to help you bridge your models to our new adjusted financial measures as well as the historical impact of reclassifying our Nicolet business to Discontinued Operations that starts on Page 10 of our investor presentation.

Now moving to 2013 guidance. As we've said consistently, we believe that CareFusion end markets are growing in the low single-digits. Fiscal '12's organic growth of 4% was a bit stronger, aided by the COLLEAGUE conversion and the government order in Respiratory. For fiscal '13, we're guiding to consolidated revenue growth of 1% to 3% on a constant currency basis, which is generally in line with the growth of each of our underlying markets.

As components of that corporate growth, we expect Medical Systems revenue will grow 1% to 3%, while Procedural Solutions revenue will grow between 0% and 2%.

We will continue to report business line revenue each quarter and provide commentary on the factors affecting results of each business, but we are no longer providing specific revenue guidance for each of the businesses.

Medical Systems revenue growth of 1% to 3% assumes growth in Dispensing Technologies and Respiratory Technologies, offset by the decline in Infusion Systems revenue that we discussed last quarter.

More specifically, we expect dispensing revenue growth will result from the successful launch of the MedStation ES platform, continued upgrades in our existing customer base and new product line extensions. Organic growth will moderate from this year's 7% toward the underlying market rates.

We expect Infusion Systems revenue to decline in the mid-single-digits in 2013, following the Baxter COLLEAGUE replacement opportunity. During this opportunity, we were able to achieve our aggressive goals and increase our leading share in the U.S. large-volume pump market, ending the year at approximately 50% of the install base.

We believe demand in the U.S. will decline in fiscal '13 until the COLLEAGUE replacement cycle normalizes. Expected improvements in domestic pump pricing and the volume of dedicated disposables resulting from the channel installs in 2012 will partly offset the decline in unit demand.

Pump pricing is an important variable in the Infusion revenue equation. We are closely monitoring the selling prices of our pumps, and our guidance contemplates a partial recovery toward historical levels, which is consistent with the data that we've seen in competitive accounts in the back half of fiscal '12. As the market leader, we're committed to maintaining rationality around this variable. But ultimately, pricing will depend on the competitive dynamics in the industry as the year progresses.

Respiratory Technologies revenue growth is expected to result from a continued rebound in the global ventilator market as well as our ability to sell horizontally to our customers based on the advantages of our enterprise solutions platform in the U.S.

So in summary, our assumptions for Med Systems are that Dispensing and Respiratory will grow above the segment average and for Infusion to decline in the mid-single-digits.

Moving to Procedural Solutions. We expect revenue growth of 0% to 2%, and that contemplates growth in the Infection Prevention and Medical Specialties that's partially offset by a decrease in Specialty Disposables. Our guidance for Procedural Solutions assumes, number one, that Infection Prevention growth will result from ChloraPrep, MaxPlus and MaxGuard customer conversion and continued penetration in the Western European market.

Two, that Med Specialties revenue growth reflect the continued success of our pleural drainage catheter franchise, our acquisition of U.K. Medical and new product releases of minimally invasive surgical instruments, partly offset by general weakness in open surgical instrumentation, which is a trend that we expect to continue.

Wrapping up the Procedural Solutions segment, Specialty Disposables will face continued pressure in fiscal 2013 from the transition in the business model. We're turning this business around, and progress will depend on product line extension, managing new and existing vendor relationship and driving additional volume through existing customer use agreement. We anticipate the business to slightly underperform the segment average during the year as we make progress on these initiatives.

So to recap Procedural Solutions, we expect Infection Prevention and Med Specialties to grow above the segment average and Specialty Disposables below.

Now moving to gross margin. We expect gross margin percentage to rebound approximately 100 basis points to the 51%-plus level in fiscal '13, driven primarily by Infusion System margin expansion.

We expect that adjusted operating margins, based on our revised non-GAAP metric which excludes deal-related amortization, will increase to somewhere in the 19.5% to 20% range next year. Just for the sake of comparison, this equates to an increase into the 18% to 18.5% range under our previous basis of presentation of adjusted operating margin. That implies a 60- to 110-basis-point margin expansion.

R&D expenses will increase to approximately 5% to 6% of revenue as we continue to fund the NexGen platforms we've previously discussed.

Continued leverage resulting from our internal simplification programs will help offset this R&D growth and the headwinds that's created by the medical device tax, allowing us to achieve our adjusted operating margin goals. Key areas of focus for us for fiscal '13 simplification are around sourcing and pricing, functional standardization and centralization, IT harmonization and continued work on our international go-to-market model.

We have recently repaid the $250 million August 2012 note, and we are conservatively modeling this year a similar amount of interest expense to what we paid in fiscal '12. At this point, we have not committed to additional financing. And if we ultimately choose not to do that at any additional financing, there would obviously be a few pennies of upside in the P&L.

Moving to the tax rate. We anticipate the adjusted effective tax rate to be 27% to 29%. That compares to a 26% to 28% range under our previous metric and the previous basis of presentation.

As you may remember, we had a number of tax discrete items that occurred throughout fiscal '12, which had a positive effect on our full year effective tax rate. When you back out the impact of the fiscal '12 tax discrete items, the anticipated fiscal '13 rate is comparable in nature to fiscal year '12.

We anticipate adjusted diluted EPS on our new basis of presentation, which excludes deal-related amortization, to be between $2.11 and $2.21 per share. This compares to a range of $1.92 to $2.02 using our old basis of presentation. That implies a growth rate of 8% to 13%.

Our estimate of weighted average diluted shares outstanding for '13, including planned buybacks, is $221 million.

Maybe just a quick comment on seasonality for '13. We'd expect the first and the second half results to split out a lot like fiscal '12, so somewhat more heavily weighted toward the back of the year. Additionally, I just want to remind everyone that we had a few discrete tax items in the first quarter. If you remember, most notably, a U.K. tax refund, that reduced taxes by about $5 million, or $0.02 to $0.03 a share. So those discrete items are obviously not expected to repeat, and Q1 earnings-per-share growth rates will be pressured by that unusual item.

Wrapping up fiscal '13 guidance, we anticipate cash flow from operations will be $525 million to $535 million. Capital expenditures will approximate $110 million.

Now I would like to turn to the longer term, specifically focus on our capital allocation goals and their impact on earnings per share. If you turn to Page 9 of the investor presentation, you'll see our 3-year plan that results and compounded annual growth and adjusted EPS of 12% to 14%.

As Kieran mentioned in his remarks, we recently concluded our planning process, and we believe we should be somewhat more conservative on organic growth rates over the longer term. We intend to use, though, our strong balance sheet to supplement our organic growth and operational leverage through M&A and share repurchases.

During the 3-year time horizon, we anticipate we'll generate approximately $1.5 billion of free cash flow from our organic operations, which will add to our existing $1.6 billion cash balance of June 30. Further, we believe we have considerable additional borrowing capacity that could be used, if necessary.

As I mentioned earlier, we're becoming increasingly confident in the progress we're making and building our foundation for growth. And at the same time, we continue to make excellent strides in improving our credit ratings and our visibility into our cash flows. Each of these factors contribute to our willingness to more aggressively deploy capital to supplement our growth.

So during this 3-year period, from fiscal '13 to fiscal '15, we're committed to deploying at least $2 billion of capital based on our stated objective and believe there are a multitude of scenarios that result in our ability to achieve 12% to 14% compounded growth and adjusted EPS through fiscal '15. For modeling purposes, I'd assume a fairly equal mix between acquisitions and share repurchases spread throughout the 3-year period.

Now we can look at how this impacts our long-term goals and expectations. First and foremost, I want to make sure that everyone knows we are fully committed to our previously stated 20% adjusted operating margin goal as we exit 2014. The change in our non-GAAP metric causes a mathematical change in the starting and ending point of this pursuit, so that 20% goal actually becomes 21.5%-plus as we exit '14. Given the significance of that target, we'll be happy to provide a detailed bridge of this metric after the call today.

Second, with respect to revenue growth, as noted earlier, we're taking a slightly more conservative stance and expect organic growth in the low to mid-single-digits or mid- to high single-digits when supplemented by M&A.

Finally, and importantly, we are targeting compounded growth in adjusted EPS of 12% to 14%, resulting from a mix of organic revenue growth, operating margin expansion, accretive M&A and share repurchases.

In summary, we continue to believe we have the ability to create a more valuable company, even as we take a more conservative outlook of our organic growth. We have a strong balance sheet. And over the next 3 years, we plan to augment our organic growth with at least $2 billion of value-accretive acquisitions and share repurchases.

During this time, you should expect us to act both deliberately and opportunistically to enhance our product offerings and gain global scale in each of our operating segments.

And with that said, it concludes our prepared remarks this afternoon. We'll open it up for questions.

Jim Mazzola

Okay, everyone. So we'll go to questions now. [Operator Instructions] And Tahisha, maybe you can give the instructions for what everyone needs to do to ask questions?

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Jonathan Palmer from CLSA.

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

I was wondering if you can just maybe provide a little more detail on this 3-year roadmap. How should we think about the tradeoff between M&A and the $1 billion in share repurchases? If you don't do the M&A, would that potentially be a larger share repurchase program going forward?

Kieran T. Gallahue

Jim, I'll start, and then I'll give it over to you. The -- yes, look -- I mean, those numbers are estimates. What we're trying to do is to give you some directional guidance to think about and that we will look to deploy the capital -- first opportunity is always to look at accretive acquisitions that fulfill our strategic objectives, that build on the critical mass that we have in some of our anchor businesses that allow us to expand geographically, that give us access to technologies, et cetera. That being said, what we mentioned is we're going to continue to be very disciplined in that approach, and we will supplement, as is -- the opportunity provides, with share buybacks. So our view on it is, for modeling purposes, easier to look at it as a relatively equal mix, and we'll execute on that over that period as opportunities arise.

James F. Hinrichs

Yes. I would concur with everything.

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

That's very helpful. And then just one quick follow-up for Jim. You mentioned $17 million of recall charges in the year. Can you tell us what that equaled in EPS?

James F. Hinrichs

Well, it's about $3.2 million of operating earnings per $0.01, so it's about $0.06 a share, $0.05 a share.

Operator

Your next question comes from the line of Michael Weinstein from JPMorgan.

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

It's Kim for Mike. So a couple of quick questions for us. Just with all this just kind of longer-term detail on the capital allocation, the share repurchase and acquisitions, nothing brand-new from what you've talked about before. But could you update us on, right now, kind of what percentage of your cash is overseas and maybe what percentage of free cash flow generated is in the U.S. versus overseas and how you think about your flexibility in light of that to kind of do U.S. acquisitions and/or repurchase?

James F. Hinrichs

Right. So good -- great questions. The -- first, the answer is where our -- of the $1.6 billion we've got right now, about $300 million or so at June 30 was in the U.S. and about $1.3 billion o U.S. And that ratio hasn't changed a lot since we spun. In terms of free cash flow generation, we've actually continued to tweak our corporate structure, and now we're in a situation where a slightly higher percentage of our cash flow, so slightly more than 50% of our cash flow, is actually coming into the U.S. So that's a positive progress on that front. With respect to how this changes opportunities for us from an acquisition and/or share repurchase, obviously, o U.S. cash is not and can't be used for share repurchase. But that o U.S. cash can be used for acquisitions. And depending on the structure of the target and the structure that we will have post acquisition, either more or less of that cash can be used depending on how we set up. So I would say right now, we do not see a lot of constraints on what we would like to do based on our current structure, but that always changes situationally. Anything to add, Kieran?

Kieran T. Gallahue

No.

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

Okay, great. And just a quick follow-up. On your margin improvement plans for next year, it sounds like you're calling for about 60 to 100 basis points of expansion. And if we look at the Procedural Solutions segment, that -- the numbers there came in a little bit below our expectations. But if we look at the margin breakout, we saw a little bit of the same, where it was down a bit sequentially. How should we think about the opportunities on that side of the business for improvement in '13?

James F. Hinrichs

Well, certainly, on that side of the business, there are a variety of places where there can be improvements. And so mix is a big factor there, and so we've got our more highly differentiated products that tend to be higher profitability growing faster. And so that will drive -- that should drive a nice mix factor there on Procedural Solutions. With respect to the rest of the corporation, a lot of the margin improvements that we're seeing are actually coming from efficiencies at the corporate center that actually get allocated to the segments. And so that's more dependent on what parts of the functional areas are being -- becoming more efficient and how they're allocated. A lot of the work in '12, as we've talked about, was focused on sourcing. It was focused on service leverage and reorganizing into 2 segments and doing some of the reorgs that we talked about at the corporate and admin level. In '13, the focus is going to stay on those things, but incrementally, we're focused on sourcing and pricing and continued centralization and standardization of functions. And a lot of those expenses actually get allocated out to each of the various segments. So it's not dependent on any one particular segment or business mix.

Operator

Your next question comes from the line of Matthew Taylor from Barclays.

Matthew Taylor - Barclays Capital, Research Division

Just a follow-up on that last question on leverage. I'm just wondering if you could help us a little bit in terms of the timing and magnitude of some of those programs. And also, considering this is a longer-term outlook, once you get through some of these initial SG&A leverage programs, do you see sort of programs of the same magnitude on the back of that where you continue to reduce SG&A leverage? I guess I'm trying to understand, longer term, where you think SG&A could go.

James F. Hinrichs

Yes. Well, first of all, the leverage on SG&A is going to be hindered a bit in the back half by the med device tax. So that's an obvious headwind that we've got, and it's a back-half headwind. So I think from a leverage standpoint, on a total corporate basis, you've got to expect the first half to show better SG&A leverage than the second half. With respect to some of things that I've mentioned, the programs we're working on are spread sort of evenly through the year. So there's not one particular bolus of upside or leverage that we're getting from any of these programs through the year. And many of them will actually extend into FY'14. We continue to expect to drive SG&A leverage into FY '14 and beyond. I wouldn't want to speculate on how -- what percent of sales it could go to. But certainly, we're aspiring for more leverage on the SG&A line as these businesses scale up.

Kieran T. Gallahue

And just, if I may, to add to that. The -- when you look at what we're investing in, as we're becoming more efficient overall in our operating expenses, what you're seeing us do is invest a large portion of that back in research and development. And as we look forward to future product generations, the ability for us to gain cost advantage, efficiencies, quality advantages in these new technologies as we update the platforms is quite substantial. And those kinds of savings roll through not just in cost of goods, they actually flow through the entire organization as you improve efficiencies and you gain the benefits of quality advantages in new platforms.

Operator

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

Amit Bhalla - Citigroup Inc, Research Division

Jim, can you talk a little bit more about the gross margin progression through fiscal '13 and where you expect to exit the year?

James F. Hinrichs

Well, as we mentioned, we're expecting about a 100-basis-point improvement over this year, so that implies a 51%-plus number...

Amit Bhalla - Citigroup Inc, Research Division

Right, for the full year.

James F. Hinrichs

For the full year, in terms of improvement versus prior year, I think second and third quarters were kind of our lower points for the year in FY '12. So you're probably going to see good improvement in the second and the third quarter and I think a steady progression of improved margins as some of the mix factors that we described about in Infusion and some of the faster-growing businesses. You have the run rate businesses at higher-margin growth through the year. You can expect improved margins through the year -- improved gross margins through the year as we get the mix factor kicking in from Infusion Disposables, the mix factor kicking in from some of the other run rate businesses, some of the improvements in manufacturing that tend to build through the year. I think you'll see a steady progression of improving margins through the year. At least that's our plan going in.

Amit Bhalla - Citigroup Inc, Research Division

So where do you think you exit?

James F. Hinrichs

I'd rather not be terribly specific about where we exit in the fourth quarter. But certainly, we would hope to exit at a "higher than our full year" rate, which, again, as we're saying, is going to be over 51%. So we'd hope to exit at a higher rate than that as we come out of the year.

Amit Bhalla - Citigroup Inc, Research Division

Okay. And just a quick follow-up on the M&A piece. You talked about having considerable additional borrowing capacity. Can you elaborate a little bit more on that? And what are the metrics that you're looking at? I mean, how high can you go up?

James F. Hinrichs

I mean, that's certainly, like I said -- as we said in the past, situational-specific. But if you just look at some of the very most basic leverage metrics and you think about a credit target that we're shooting for, which is a target credit rating in the BBB area, you usually look at companies that are around 2.5x EBITDA. Right now, we're less than -- we're right around 1, I should say. And so you got a turn, maybe, of EBITDA plus that you could do without sort of getting even near those limits. So yes, I wouldn't -- again, we tend to be very situational-specific depending on the use of the proceeds. That makes a difference. But certainly, one turn of EBITDA, which rounds up to $1 billion, is not a ridiculous number to start with.

Operator

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

Rajeev Jashnani - UBS Investment Bank, Research Division

Another question on M&A. And I was just wondering if you could just from a more strategic perspective, Kieran, maybe share some thoughts on where you really see the attractive areas broadly in terms of improving the growth profile of the company to something that's a little bit higher than the low single-digits, whether it's European infrastructure, emerging markets or new verticals in the U.S. Any additional color there would be helpful.

Kieran T. Gallahue

Sure, you bet. One of the things that I think is very powerful with CareFusion is that we have opportunities across the business segments. And it was very influential in the way that we designed our 2 business segments last year. When we went through the reorganization process and created Medical Systems and Procedural Solutions, it was because that's the way that customers buy product, and that's the way that we could create landing zones for innovation, whether that innovation comes from R&D or internal development or whether that innovation comes in the form of acquisitions of in-process R&D or companies that have substantial presence in different places. So when we look across our 2 business segments, we have opportunities that extend, number one, in technology settings; number two, in geographic expansion, right; and, number three, in the expansion of the relevant market that we're serving that allows us to leverage the core that exists. So those are very broad answers for you. But if we walk across -- give examples, Medical Systems, and you saw what we did last year with acquisition of Rowa, which has been extremely successful acquisition. We were able to expand geographically and expand technologically, right? At the same time, we're able to fold that into our cost structure, and so it was an efficient acquisition. That's exactly the kinds of targets that we would look for. Now on the other hand, we looked at U.K. Medical, which was a distributor that we forward-integrated into during the fourth quarter. It's a good example of where we saw an opportunity to expand critical mass that we could flow through current products as well as what we see in the product pipeline, and having feet on the street will allow us to leverage across those. You know that in the emerging markets, we tend to be under-penetrated. And so certain key emerging markets represent an opportunity for us to step function in either to buy technology that's appropriate for that market and/or buy a distribution channel which has already demonstrated success or to buy manufacturing capability, which can allow us to more effectively -- cost-effectively deliver into those marketplaces. So the good news is that we have opportunities in each of the segments. We always like to look at where we could grow core competencies, that we could use those competencies across multiple parts of our business, or geographic expansion where we can have a footprint and we could use that footprint, even though it starts with one part of the business, it could be leveraged into other parts. So you should expect in virtually all of these acquisitions -- not all, but virtually all, we will look for the opportunity to affect the business in multiple ways.

Rajeev Jashnani - UBS Investment Bank, Research Division

That's very helpful. And I guess one question on the product lines in Dispensing. I think you mentioned 7% organic in fiscal '12, and you're assuming more, it sounds like low-single-digits-type growth. Is that -- and I think you also mentioned that you have pretty good visibility into the order flow at this point. So I guess I'm just trying to parse out what's a reasonable level of conservatism just given the state of things these days or whether your order flow is actually suggestive of that type of deceleration.

James F. Hinrichs

I would say that our order flow has continued to be solid in that business, and it's more just taking a conservative stance given the way the world is. We have a great backlog going into this year. We have good visibility into -- as we usually do with that business, many months of scheduling and installations. So it's just more of a -- we had a stellar year in fiscal '12 organically and inorganically with Dispensing and expecting a moderation conservatively back to more market trends that you described.

Kieran T. Gallahue

And I think, just to expand on that, I think you can look at that in the longer term across all our businesses and look at the guidance that we've suggested over the last couple of years. We exit 2012 feeling more comfortable than ever with the strength of our products today and the product pipeline as we look forward. When we look at the global markets, we think it is prudent not to expect some high level of bullishness in the markets. That being said, we're preparing ourselves, right? We're investing in R&D. We're investing in the organization. And should the markets recover or should the markets show greater promise over time, we're ready to take advantage of it. We just feel the right way you run a business is that you're conservative in your forecasting, you continue to invest in R&D, you continue to invest in those areas where that can drive growth, but you don't bank on it, right, and build a cost structure that is not sustainable if you don't see rebounds in those global markets or the global economies.

Operator

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

Lennox Ketner - BofA Merrill Lynch, Research Division

I guess first one is for Jim on the R&D rate. I think you said to kind of assume that the rate you're at in the back half of year is kind of the new run rate for now. Should we take that to mean that, that kind of close to 5% of sales is kind of the long-term rate that you think is appropriate? Or do you feel like that should be higher over time?

James F. Hinrichs

It's probably 5% to 6% is the rate we'd be targeting toward. I mean, that's where we're kind of heading in that direction right now. You've seen us grow steadily from the low 4s up into the high 4s, and we're now headed towards the 5s. And so we're guiding 5% -- 5% to 6% this coming year. And for the long term, 5% to 6% feels like about the right level.

Lennox Ketner - BofA Merrill Lynch, Research Division

Okay. And then just one more on the operating cash flow for next year. I think you guided to $525 million to $575 million, but that metric has obviously jumped around a lot the past year. So is there -- are there any kind of onetime things impacting that for next year? Or should we think about that as kind of the right run rate going forward?

James F. Hinrichs

This actually feels like about the right run rate. So we had a really great year coming out of the gate as -- when we first spun off and took down working capital. We had a couple of onetime things that took us down in '11. '12, we got essentially all of that back, so we were at $645 million for operating cash flow. So we've gone up and down. I think the $525 million and $575 million feels like a pretty normalized level for us. So I'm assuming that that's going to continue going forward, growing in line with the business.

Operator

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

David R. Lewis - Morgan Stanley, Research Division

Jim, or maybe for Kieran, I just wonder if you could triangulate some of the underlying numbers in the strategic plan. I guess, the first is we think about the earnings growth of 12% to 14% and we you think about the buyback that you're assuming as well as the M&A accretion, do you think that kind of equates to something like an underlying continuing earnings or net income growth of perhaps 7% to 9%? Does that sound close?

James F. Hinrichs

Yes, that seems reasonable.

David R. Lewis - Morgan Stanley, Research Division

Okay. And then I guess with $1 billion of M&A, how should we think about in terms of revenue magnitude? If we sort of assumed, I don't know, $275 million to $350 million of incremental revenue over the strategic plan, is that sort of a decent estimation?

James F. Hinrichs

Yes, yes, that's not -- that's also in the right ballpark, for sure.

David R. Lewis - Morgan Stanley, Research Division

Perfect. And then I think, lastly, just thinking about this transition, Jim, to cash earnings at the same time that you're obviously talking about $1 billion of multiyear M&A. I guess, are you willing to kind of commit now that on any reasonably sized M&A transaction you would give us both the cash earnings accretion of that transaction as well as the potential returns that you expected from that deal? Is that something you feel confident in saying today?

James F. Hinrichs

I mean, I hate to commit to anything without knowing what I'm committing to. And so like I -- as I always like to say, these things are very situational. Having said that, we are committed to driving returns on invested capital. We're committed to using ROIC and returns as a primary metric for evaluating our deals. And certainly, that means we should be very comfortable explaining what we're planning to do. So conceptually, yes, I'd be happy to commit to that. But like I said, many of these things are very situational. So like I said, I hate to commit to anything that I don't know what I'm committing to.

David R. Lewis - Morgan Stanley, Research Division

I'll jump back in queue. Just one more quick one, and I may have missed it. As you think about fiscal '13, I thought your implied -- shares outstanding, implied maybe $300 million of buybacks, but I'm also thinking about the debt commitment in the first half. So can you just help us understand again how you can restructure the $250 million in the first half and still execute on the share repurchase plan?

James F. Hinrichs

So the share repurchase -- your numbers are directionally correct. You've done your math right, and I -- we think we can do that without any incremental borrowings. And so again, we haven't committed either one way or the other. We've conservatively guided to assuming that there's an equal amount of interest expense in '13 as there was in '12. Obviously, we don't refund that $250 million. That would create upside on the P&L in terms of interest expense. If we do refund that, it create a little more reason to do share repurchases that might be a little bit north of that.

Operator

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

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

Kieran, I was hoping you can provide a little bit more perspective on what's changed over the past year and really driven the revision, how you're think about the long-term growth. I think everyone is well familiar with the challenge that the overall industry is facing and the relatively difficult macro environment. But are you sort of making a statement that this is the new Med Tech normal where your organic growth rate is in the low-single-digit range, and getting above and beyond that requires acquisitions, and generating something like double-digit earnings growth is going to be more an exercise in financial leverage rather than operating leverage?

Kieran T. Gallahue

I think the way that I would characterize it is there's lots of ways to create value and that as an operating manager you need to be open to using all your avenues that can generate value for shareholders. You need to feel very comfortable pulling each of those levers, depending on the world around you and depending on the strength of the organization. So over the last year, the global environment hasn't exactly been bullish, right? We've seen a lot of insults to the economies across the globe. And I think, as individuals that are managing a global business, we have to look at that and say -- and be comfortable with whatever assumptions that we're designing. At the same time, I think it is incumbent upon us to continue to focus on the fundamentals, continue to focus on execution and continue to provide the organization the best opportunity for growth over the long haul. And so what we've done this year, we started fiscal '12 and we told the world this is about execution, right? That we fundamentally are going to redesign this company the way that you would if you designed a company from the ground up, that we were going to organize the way that customers buy product and the way that we can feed innovation. And during last year, it's exactly what we did. And during that time period, we also committed that we were going to get leverage on the parts of the P&L where we could gain leverage in order to support those areas which can fund long-term growth opportunities, right? So moving from, for instance, from SG&A over to R&D, moving from certain functions where we can get efficiencies and, instead, putting heads in -- commercial heads in places like China. And that's exactly what we did. We feel, at this point, as we look to the future, we've got a great balance sheet that offers us the opportunities for M&A and for buybacks, and we are building the organization to take advantage of any good developments that we see in the marketplace. We simply think it's prudent to operate and to recognize that all those levers can create value, and we need to be flexible enough to do that.

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

Okay, that's helpful. And then maybe secondly, Jim, you talked a little about ROIC as being a key driving factor and the way you think about M&A. Can you just remind us whether ROIC is part of the management compensation structure? And if not, do you think that will become a metric that the board considers in evaluating senior leadership?

James F. Hinrichs

ROIC is not currently part of any of our incentive comp plans. It's certainly something that comes up every year when we set incentive comp. And I would expect that it will be continued -- will continue to be discussed based on where we are in our life cycle.

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

Okay. And how -- maybe, how should we think about that in the context of greater M&A in the long-term outlook as well as the move to cash earnings?

James F. Hinrichs

I mean, the move to cash earnings is something we've been talking about for a while. We've talked to a number of people about it, including, I think, we talked to you about a little bit. It's basically -- we carry a lot of deal-related amortization based on the way we were put together. In addition, if we do start to get a little more intentional with our capital deployment around M&A, it's going to give us the best possible comparison as to how we're performing. We believe it's a better measure of our underlying cash-generating capability. So those are all the reasons why we did it. It's not done to signal anything. And certainly, when we think about doing acquisitions, ROIC is incredibly important. We are very aware of what drives shareholder value and what the more tightly correlated metric to total shareholder return is from a financial standpoint, and that is -- tends to be ROIC. So those are all -- that metric matters a lot to us. It matters a lot to me personally and Kieran personally. It matters a lot to the management team. We don't yet have the sophistication or the -- those metrics built into our compensation systems. But again, these are things that we're constantly looking at. So I wouldn't read anything into the change in cash EPS other than a continued evolution of what we've been saying we're going to do.

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

So as I said, just sounds like the move to cash EPS is not a correction but sort of a modification of legacy issues to better reflect the underlying performance of the business. Is that a fair way to look at it?

James F. Hinrichs

I think that is absolutely a fair way to look at it.

Jim Mazzola

I think we're about out of time, operator. Kieran, do you want to provide any kind of closing comments before we wrap up?

Kieran T. Gallahue

You bet. Well, once again, thank you, everyone, for your interest in CareFusion. I always like to take the opportunity to thank our team members throughout the globe, and particularly, at this point, as we look back on what was a real foundation-setting year for CareFusion. I'm very proud of the accomplishments that the team has made during this year. We leave fiscal '12 much more competitively aligned and very much stronger in our markets, and we are set for opportunities for growth ahead. So thank you for your interest, and we look forward to updating you throughout the next fiscal year.

Jim Mazzola

Great. Thanks, Kieran. And I apologize, we left a couple of you stranded in queue. We just ran out of time, so we'll make sure we get to you after the call. Thanks.

Operator

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

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