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Omnicare, Inc. (NYSE:OCR)

Q2 FY08 Earnings Call

July 31, 2008, 11:00 AM ET

Executives

Cheryl Hodges - Sr. VP, IR

Joel Gemunder - President, CEO, Director

David Froesel - CFO, Sr. VP

Analysts

Lisa Gill - JPMorgan

Jason Gurda - Leerink Swann

Adam Feinstein - Lehman Brothers

Charles Rhyee - Oppenheimer & Co.

Frank Morgan - Jefferies & Company

Operator

Good morning. My name is Regina and I will be your conference operator today. At this time I would like to welcome everyone to Omnicare's Second Quarter 2008 Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer session. [Operator Instructions]. Thank you.

Ms. Cheryl Hodges, you may begin your conference.

Cheryl D. Hodges - Senior Vice President, Investor Relations

Thank you, Regina.

Good morning, everyone, and welcome to Omnicare second quarter 2008 earnings conference call. Here today from Omnicare are Joel Gemunder, President and CEO; Dave Froesel, Senior Vice President and Chief Financial Officer; myself, Cheryl Hodges, Senior Vice President, Investor Relations.

Before we begin, let me remind you that as we conduct this call, various remarks that we make concerning our expectations, predictions, plans and prospects constitute forward-looking statements as a result of a variety of factors including those identified in this morning's news release and in our various filings with the SEC. You are also cautioned that any forward-looking statement reflects management's current views only and that the company undertakes no obligation to revise or update such statements or to make additional forward-looking statements in the future.

For simplicity's sake and to focus on what we believe are the best indicators of our operating performance, we will discuss the results today, excluding special items, and for the CRO business, reimbursable out-of-pocket expenses in all periods. A reconciliation of this non-GAAP information has been attached to our press release and is also available on our website under supplemental financial information on the Investors page.

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

Joel F. Gemunder - President and Chief Executive Officer

Thank you, Cheryl, and good morning, everyone. Thanks for joining us today to discuss our results for the second quarter of 2008.

I must say that we're pleased once again to open our call by noting that our adjusted earnings for the quarter to beat expectations, both the Street consensus as well as our own expectations by $0.07 per share. And these results are particularly gratifying, given the dynamic operating environment we faced over the past two and a half years. The strategic and operational initiatives we put into place over that time as well as our focus on driving the business forward, we believe are gaining traction.

This quarter's result at $0.46 per diluted share as adjusted with special items are also encouraging as they follow on our first quarter at $0.40 adjusted, which had the benefit of a strong flu season that was not present in the second quarter. We are also pleased to announce the completion of our $100 million stock buyback. We were able to repurchase about 4 million shares at an average price of $24.22 over a 16-day period in May. And given the timing, that helped... only helped diluted earnings per share by roughly $0.005 in the quarter, but will see the full impact beginning in the third quarter.

On looking further at the quarter's results, we're going to focus our remarks today largely on comparison between the second quarter of 2008 and the first quarter of 2008, because we believe the sequential results provides the most meaningful gauge of our recent performance. We recorded sales for the quarter at just over $1.55 billion, which also came in ahead of expectations. While sales were lower sequentially by about $9 million, less than 1%, owing largely to the increased penetration of generics, lower acuity and utilization related to the drop off of the flu season and modestly lower net debt [ph]. Much of this was offset by continuing strong drug price inflations, increased use of higher acuity drugs and biologic agents and growth in our CRO specialty pharmacy and hospice pharmacy business.

We're also pleased to see our gross margins moving in positive direction for the first time in the past four quarters. At 24.8% for the second quarter, our gross margins were 30 basis points ahead of last quarter, reflecting in part the benefit of generics. Our operating margins widened by approximately 50 basis points sequentially to 7.8%, reflecting the higher gross margin along with a relatively stable SG&A and lower bad debt expense.

And as Dave will tell you in a moment, our cash flow performance was again strong and ahead of expectations. As you saw in our press release, we served 1,438,000 beds at the end of June, including 70,000 patients and patients assistance programs. And when we break this down a bit, we see some encouraging trends.

Obviously, the specialty pharmacy patients grew by a 1,000 sequentially, and then looking at the institutional pharmacy side net bed served were down 9,000 sequentially, which on its face is a 40% improvement over the March quarter. But, of these 9,000 beds, a total of 7,900 beds were voluntarily foregone for pricing and payment terms or represent facilities sold or closed. So, had we not given up these beds or lost them due to fact outside of our control, we would have been about 1,000 away from breakeven. So clearly we're making progress on our initiatives to restore net bed growth.

Our total gross bed losses improved sequentially even with the inclusion of beds voluntarily foregone or facilities closed or sold. In fact, they were at their second lowest level in the last 11 quarters. This positive trend reflects both the effects of our pharmacy operating expense as well as the success of our specialized customer retention savings.

Now, the number of beds saved, including renewals of problematic accounts by this team for the second quarter was approximately 15,100, up roughly 10% sequentially and representing roughly $78 million of annualized revenue or an improvement in our retention rate of more than one percentage point. This also exceeds the total of number of beds renewed or saved under this initiative in all of 2007. Beds brought into service by our operating units were also up sequentially. Moreover, acquisition activity was robust, adding a substantially higher number of beds than in the first quarter, and the pipeline continues to look good for the balance of the year.

And I'm also very pleased about the trends in contract signings in the second quarter. First, our total new contract signings were up 56% sequentially. Our sales, including national accounts, was up 45% sequentially in new contract signings and up 92% on a year-over-year basis. So, the change in sales management in May of last year and the execution of our initiatives to increase the quality and size of our sales force and enhance its training and productivity are paying off. Moreover, our pharmacy operating staff despite the many other tasks on their plate at the moment also nearly doubled the number of new contracts they signed on a sequential basis, which also bodes well for trends in the second half.

On the cost side, our market improvements reflect our continuing focus on lowering our cost of pharmaceuticals as well as productivity initiatives and the headway we're making on our non-drug purchasing initiatives. We also continue to move forward with the outsourcing of repackaging activities at Cardinal Health. During the quarter we put in place some additional equipment to accommodate planned capacity in the number and quantities of drugs repackaged by Cardinal, as well as to allow bingo card production there as well. Following validation of testing activities, this equipment is now functional, and we will again be ramping-up productivity in the third quarter and we continue to work toward increasing our capacity here so that by year-end we will begin to see higher productivity as we migrate these activities out of our local pharmacies.

As you know, we’ve also broadened our growth platform by entering adjacent markets, and this strategy also paid dividend this quarter. First, we saw a substantial improvement in the results of our hospice pharmacy business on a sequential basis. As we've discussed for the last several quarters, this business has been challenged both by competitive pricing pressures and patient mix issues. And as we mentioned last quarter, an action plan has been initiated to address both top line cost issues, progress here is already an evidence. On a sequential basis, sales are already trending up moderately and operating profit margins... operated profit margins widened substantially producing operating profit that was up five fold from the March quarter.

Moreover, our specialty pharmacy services business continued its ongoing trend of robust sales and operating profit growth both on a sequential as well as a year-over-year basis. And the excellent performance we've seen in this business along with favorable growth outlook for the specialty pharmacy industry in general has allowed us to expand our presence here with the acquisition of Advanced Care Scripts which we announced earlier this month.

Based in Orlando Florida, Advanced Care Scripts or ACS provides specialty pharmacy and product support services. It dispenses via mail high cost oral and injectable medications directly to patients along with providing related clinical and administrative services. And this represents a lion's share of the business, but it also provides patient assistance programs, reimbursement support services, compliance monitoring, data management and other product support services for the pharmaceutical and biotechnology companies. And ACS currently focuses on neurology, largely MS and oncology.

It began operations in 2004 and based on the quarter ended June 30, it's generating annualized revenues in excess of $237 million today. We expect that it would be modestly accretive to our earnings in 2008 with accretion expected to increase in 2009. The ACS structure differs somewhat from our existing specialty business. ACS does buy inventory and sell or dispense, but the good news here is that it's working capital funding is minimal, with inventory days on hand of approximately 3 days, and a pre-adjudication of all claims prior to dispensary. So it produces a very attractive return on capital. And strategically, we see substantial revenue synergies and the growth opportunities.

Let me tell you about the first. Today ACS focuses on two therapeutic areas, neurology and oncology. These are two of the largest and fastest growing areas in specialty pharmacy, so we believe growth here looks favorable. However we see opportunities in expanding the number of disease states, which ACS addresses. For example, we currently address 11 disease states in our existing specialty business, and we see potential for cross-pollination here.

Second, ACS' business is concentrated in ten states, so geographic expansion should also drive growth. And third, we see a strategic fit developing between our specialty pharmacy and CRO businesses, particularly in outsourcing services to the biotechnology sector. Through an integrated approach, we are uniquely positioned to provide and to customize the vision for our clients. We can provide drug development, clinical trials, data submission, activities leading up to the product approval, process like CROs, and then we can provide reimbursement analysis, patient assistance programs and distribution through our specialty businesses, which can then be followed by Phase IV trials, safety monitoring and risk management, together by our CRO and specialty pharmacy services businesses. And we believe this one stock shop approach is a differentiating factor in our industry and one that would resonate with our customers.

So, we believe we have a substantial foothold in this arena from which to springboard growth and we already are deriving a meaningful contribution from these high-growth, high-return businesses, and we believe there is plenty of room left to go.

Speaking of our CRO businesses, performance here too was very favorable in the second quarter. As we indicated last quarter, we expected to see improving performance in our CRO business as the year progress and in the second quarter revenues excluding out of pocket expenses were up over 7% sequentially and with these higher revenues and vigilant expense control, margins widened and operating profit was up 28% sequentially. Moreover, backlog at the end of June was also at an all time high at just over $337 million, reflecting the highest quarterly level of new business wins in the last five years, capped by a $25 million project won at the end of June. So we continue to see this business as improving as the year progresses.

And with that let me turn the call over to Dave.

David W. Froesel, Jr. - Senior Vice President and Chief Financial Officer

Okay. Thanks, Joel.

As Joel already mentioned, not only are we seeing signs of stabilization and improvement in our business, our earnings exceeded expectations, so too did our cash flow. You will recall that our second and fourth quarters are the quarters in which we pay semi-annual interest payments on our outstanding senior notes in one of our convertible issues. So, operating cash flows typically trend lower than in the first and third quarters. As such, our cash flow from operations in the second quarter of 2008, up $86 million represents once again a very strong quarter, up 41% versus the second quarter of last year. This brings our year-to-date operating cash flow to $229 million, very close to the $236 million in cash flow we generated in the first half of 2007, a year in which we had the strongest operating cash flow in our history.

In view of this performance, coupled with trends we see for the balance of the year, we're once again increasing our cash flow guidance. Last quarter, we increased our full-year cash flow guidance to $350 million to $400 million, up from the $300 million to $375 million we originally established for 2008. Today, we see full-year cash flow coming in at $400 million to $450 million. On a sequential basis, our unadjusted or GAAP EBITDA was about 6% higher, and that of course contributed positively to cash flow. However, given the trending I mentioned earlier, it is probably more useful to look at the year-over-year comparison. Unadjusted EBITDA for the second quarter of 2008 was lower by 19% than in the second quarter of 2007. Yet, our operating cash flow was up 41%. So, clearly we are seeing substantial improvements in cash collections and working capital management.

For the fifth consecutive quarter, our net receivable balance declined sequentially. Our DSOs at the end of June were at 81 days, essentially even with the first quarter, but down 10 days since June of 2007. In part, this reflects the charge we took in the fourth quarter of 2007 as well as improved collections.

Our bad debt expense for the second quarter totaled $25.8 million, down $4.1 million versus the same quarter of 2007, and about $4.6 million sequentially. This is due primarily to improved collections as well as some recovery of previously uncollected co-pays and rejects, arising both in the normal course and as a result of favorable outcomes of certain litigation and arbitration activities we initiated with the PDPs in order to collect these amounts, particularly from the 2006 Part D transitional year. At June 30, 2008, we continue to have co-pays outstanding from PDPs of about $27 million relating to the 2006 and 2007 years and we are working to recover these amounts as well.

With respect to inventories in the second quarter of 2008, our inventories came down about $9 million sequentially, and about $48 million or 11% on a year-to-date basis. Our inventory days on hand were 32 days are down about two days sequentially, and down four days year-over-year. This is largely due to improved management of our inventory, reductions in inventory Risperdal in anticipation of this generic launch at the end of June, and continuing penetration of generics generally.

With respect to uses of cash, we funded approximately $55 million in cash outlays for acquisitions, which included a small amount of deferred payments from prior-year acquisitions during the quarter. These were all institutional pharmacy acquisitions that given the synergies, we believe we can achieve at the potential to produce very attractive returns on capital. Then two, we used $100 million to repurchase Omnicare stock. During the month of May, we executed on the previously announced stock buyback program, purchasing a total of 4,136,000 shares at an average price of $24.22, bringing our shares outstanding down to about $118.2 million at quarter end.

As Joel noted, given the timing, we saw only a partial impact during the quarter and we will see the full impact beginning in the third quarter. We also funded capital expenditures of about $16 million in the second quarter of 2008, up about $5.4 million from the same period of 2007 and about $3.6 million sequentially. We remain on track with our targeted $60 million in CapEx for the year, of which $40 million relates to the Omnicare full potential plan and $20 million for maintenance CapEx. After funding acquisitions, the stock buyback program and CapEx, we still ended the quarter with approximately $224 million in cash on the balance sheet. Our total debt to total capitalization stands at approximately 45.9%, down about 100 basis points versus the second quarter of 2007, and on a net debt basis, we are at 43.9%, down approximately 150 basis points versus the prior year.

Lastly, as we had discussed before, our tax rate is likely to move around a little on a quarterly basis due to tax-planning initiatives, our other changes in state tax methodologies. In fact, our results for the quarter were favorably impacted by a lower tax rate owing largely to this favorable affect of certain state tax benefits, including primarily a change in filing methodology for our state taxing jurisdiction. The net effect of these matters was an increase of about $1.5 per diluted share. At this point, we would expect our tax rate to go back up in the second half of the year and bounce around 39%.

To summarize, as we see it, we are working through many of the issues in front of us over the last two years. We have been focused on maintaining a strong balance sheet and managing for cash flow. And while this quarter benefited from a lower tax rate, a slightly lower share count and some bad debt recovery, even without the benefit of these items which accounted for about $0.03, our results were still up nicely on a sequential basis. So, we are demonstrating improved performance and continued financial strength and flexibility.

So with that, I'll now turn it over to Cheryl.

Cheryl D. Hodges - Senior Vice President, Investor Relations

Thanks, Dave.

Looking at our performance by segment, sales in our pharmacy services businesses of approximately $1.5 billion were lowered by about $13 million sequentially or less than 1%. The sequential results reflects primarily the continuing impact of generics on sales, seasonally lower acuity and other reductions in utilization and/or reimbursement for certain drugs and a lower net number of beds served.

Largely offsetting these factors, however, were continued strong drug price inflation related to brand drugs, and increased use of certain higher acuity drugs and biologic agents as well as sequential growth in our specialty pharmacy services and hospice pharmacy businesses. Our payor mix for the second quarter was consistent with the first quarter, Part D at 41%, Medicaid at 10%, private pay, third-party and facilities at 43%, and 6% other.

At June 30, 2008, we served long-term care facilities as well as chronic-care and other settings comprising 1,438,000 beds, including 70,000 beds served under patient assistance programs in our specialty pharmacy services business. The comparable numbers at March 31, 2008 were 1,446,000 including 69,000 specialty pharmacy services patients. The sequential comparison reflects a net decrease of 8,000, comprised of an increase of 1,000 specialty pharmacy patients, a net decline of 9,000 beds or less than 1% in our institutional pharmacy business. And as Joel mentioned, of this lower net number of beds served sequentially in the institutional pharmacy business, approximately 7,900 beds or 88% of the net decrease was represented by the voluntary withdrawal from business, and facility sales or closures.

Our overall revenues per bed for the second quarter were $1,038, again including the specialty pharmacy patients, down about one half of 1% from the March quarter, and up 1% from the June 2007 quarter. In our institutional pharmacy business, we saw revenues per bed remain even sequentially at $1,091, owing to lower seasonal acuity coming off the very strong flu season in the first quarter, the impact of generics and the other factors I mentioned earlier offset by the continuation of strong brand drug price inflation as well as increased use of higher acuity drugs and biologic agents.

Just to comment on the EPO related drugs, Procrit and Aranesp that we have been discussing over the past year, sales of these drugs dropped about $3 million sequentially. But more than offsetting this decline, were increases in utilization of certain high acuity drugs, including anticoagulants such as Lovenox, antibiotics for resistant infection such as zyvox, as well as a number of biologic agents used for progressive diseases such as rheumatoid arthritis or cancer. We also saw revenue increases from the movement back to brand oxy content from the generic version. IV sales for the second quarter totaled $63.1 million, down about $3 million from the first quarter of 2008. This reflects largely a trend in beds along with a sequential drop in acuity associated with the strong flu season in the first quarter.

Adjusted pharmacy EBITDA of $165.2 million for the second quarter of 2008 was up 4.5% sequentially, benefiting largely from the impact of generics on margins, drug price inflation, lower bad debt expense and sequential margin expansion in our specialty and hospital pharmacy businesses. Our CRO business, excluding reimbursable out-of-pocket expenses had revenue for the second quarter of $44.8 million, up 7% on a sequential basis. Adjusted operating profit for the CRO business of $4.4 million in the second quarter was up 28% sequentially and 39% versus the second quarter of 2007. Adjusted EBITDA of $4.9 million for the quarter followed a similar pattern and represented 10.8% of adjusted revenues. Lastly, at June 30, 2008, our book-to-bill ratio stood at 1.9 to 1 and our backlog stood at $337.4 million, up 7% year-over-year and up 9% sequentially.

Now I'll turn the call back over to Joel for his concluding remarks.

Joel F. Gemunder - President and Chief Executive Officer

Thanks, Dave, and thank you, Cheryl.

Before taking your questions, I want to wrap up with a few final thoughts around the balance of the year. With respect to the legislative and regulatory front overall, things appear relatively calm. Moreover, the physician fee veto that recently passed had several relatively positive components including among others, a requirements that PDCs update at least weekly the AWPs and other pricing benchmarks for drugs they use, and adjudicating client. Part D coverage for benzodiazepines and certain other excluded drugs will be paid for albeit in 2013.

A stop to the initial competitive bidding program for Part B DME products and services and the retooling and restart to presumably a more fair and equitable program. And lastly, a delay in the implementation of the AMP base pricing for the federal upper limit until September 2009. Of course, the whole matter of the implementation of AMP is a pricing benchmark here, it's still in the courts as well.

Now with respect to Part D generally, things seem relatively stable. Of course, we're still seeing incorrectly assessed co-pays on prescriptions [inaudible] and we and our entire industry are continuing to work with CMS and the PDP and even the Congress to seek solutions for this issue on the current and prospective basis.

And we are also continuing to work our way through the litigation and arbitration actions we initiated with a number of PDPs to repay funds in appropriately withheld on co-pays. Also relative to Part D and litigation our results continue to be impacted by the end results matter with UnitedHealth. The differential in rates between the originally negotiated contracts with United and the [inaudible] provider contract, we now operate under with PacificCare totaled about $24 million pre-tax for the quarter or about $0.12 per diluted share.

While this differential is lower given the reassignment by CMS of a portion of [inaudible] out of the United plan, the cumulative impact of the differential in rate since April 2006 has negatively impacted sales and operating profits by approximately $246 million pre-tax or $1.26 per diluted share. Our lawsuit against United is pending in federal court in the northern district of Illinois and is moving forward with the trial date set for October 14 of this year. We believe our antitrust and fraud claims are strong and we're looking forward to pursuing this plans on behalf of our shareholders and the residents we serve.

Next, I would like to comment on the movement towards generic in our marketplace, as is the trend here is significantly in 2008, particularly in the back half of the year. In the second quarter of 2008 our generic dispensing rate or percentage of our total scripts dispensed that were generic increased to 68.7% from 67.7% in the first quarter, or up a 100 basis points sequentially, and up 500 basis points from the June quarter of 2007, just one year ago, and of course this is not include several major drugs with generic launches occurring on or after June 30 such as Risperdal, Depakote, Lamictal, Keppra and Prozac 40, just to name a few.

With respect to risperidone or generic Risperdal, as I'm sure many of you know, the launch went off on June 30 as expected. We had managed down our inventory of brand Risperdal to six days was the fair minimum needed. Further, our conversion from Risperdal to risperidone has been highly successful. By the14 days following launch we had reached a run rate of over 90% in the conversion to Risperdal as a generic and we are at 95% today. The rate of conversion just two weeks, outpaced our average generic conversion rate, which is typically yielding at 90% conversion rate to the generic within four weeks. So we are indeed pleased with these results which served to significantly lower our payor and customer costs as well as our own.

Our guidance take into consideration our efforts that we discussed last quarter to narrow the gap in cost reduction between exclusivity and non-exclusivity for Risperdal by negotiating lower cost on a number of different drugs. And also since June 30, we have seen Lamictal and Depakote DR go generic, which will also result in saving for payers and customers and lower our cost as well. These and other generic launches along with the full quarter benefit of the second quarter launches of Requip IR, Wellbutrin, Wellbutrin SL, Paxil CR, Sonata and Percocet will help to step-up in earnings in the second half of the year.

And also a major factor for us in the latter half of 2008 is the implementation of the Omnicare Full Potential Plan. So let me give you a brief update on that. With respect to the hub and spoke phase, we now believe that only 30 hubs are necessary rather than 31. All 30 hubs ore regional support centers are in some stages of development. 12 hubs have finished construction up from 8 last quarter and the reminder continue in various phases of their construction process.

Today, 19 hubs are in the beginning stages of processing refills while performing order entries for certain of their local pharmacies and this is up from 11 last quarter. The delivery of equipment continues to go forward with MTS now having delivered 16 of 25 plant pieces of equipment and we are seeing that activity ramp up on many of them. We've also now taken delivery of seven auto label and verify our ALV generation II machine, up from three last quarter. You'll recall that this equipment uses our proprietary technology and on the last quarter call we were in the validation testing and performance qualification base of this equipment. So, I am pleased to report that we're now processing live scripts from the ALV for the first time. We have also been proceeding with the roll out of our customized document imaging technologies of all of our pharmacies and hubs that we had begun in March. We are now live in 28 locations, so we are moving forward at a brisk pace.

We continue to see the ultimate pre-tax savings and the full potential in the $100 million to $120 million range on an annualized basis. As we mentioned on the last call, we see that the timing achievement of those savings will be extended into 2009, owing to among other things the timing of the completion of facility built outs. And for an endeavor of this magnitude, we believe we're making substantial progress in a relatively short time period.

So, to conclude, I want to make a few comments relating to our guidance for the balance of the year. We now see sales coming in a bit higher at $6.2 billion to $6.3 billion. And as Dave indicated earlier, given our strong cash flow performance in the quarter, we are raising our operating cash flow guidance to $400 million to $450 million. With respect to earnings, we achieved results for the first two quarters of 2008. That on an adjusted basis, we're above our own internal forecast, as well as the Street consensus. And as I've already discussed, we see a step up from where we are in the second quarter, owing largely to the benefit of second half generic launches and drug price inflation and savings from the Omnicare Full Potential Plan, along with growth in our specialty pharmacy business including a positive contribution from the ACS acquisition, continued improvements in our hospital pharmacy business, and ongoing growth of our CRO.

Accordingly, we are now raising the low end of our guidance and now are in the range of diluted earnings per share for 2008 as adjusted with special items to $1.85 to $1.95 per share. Building off of second quarter's earnings of $0.46, we see mid-to-high single-digit improvement of $0.48 to $0.50 in the third quarter with the reminder of the ramp up in earnings occurring in the fourth quarter, due largely to the phase in of generic launches and the cumulative improvement in the other areas I just mentioned. So with strategies we have in place and the progress we're seeing today, we believe we're well positioned throughout the reminder of 2008. And heading into 2009, our focus now and for the reminder of the year is on the issues driving our business, those that will provide continued stabilization throughout, to reduce cost, increase productivity and above all restore shareholder value.

So now, ladies and gentlemen, I thank you for your attention, and will open the call for questions.

Question and Answer

Operator

[Operator Instructions]. Your first question comes from Lisa Gill with JPMorgan.

Lisa Gill - JPMorgan

Thank you, and good morning. I just have a couple of quick questions, Joel. First off, when we think about specialty pharmacy and the recent acquisition that you made and your continued growth in specialty pharmacy, can you just give us an idea of how many of your beds today utilize specialty pharmacy? Is it just that the number that you disclose or are those beds on top of current beds that you have for regular medication that you are serving, just so I understand that? And then secondly on the Full Potential Plan, when you talked about the benefits now going beyond 2009, should we still be looking at the benefit next year still being in that $100 million to $120 million range?

Joel F. Gemunder - President and Chief Executive Officer

Your first question was to what extend do we use biologic agents in our base business, if I understood the question correctly, and the answer is, it's a growing portion of our routine business in the institutional pharmacy setting, because the... of the new drugs being produced, the vast majority of these drugs that are being approved by the FDA are for treatments hitherto unavailable to patients, and many of these new treatments are in the form of large molecule or biologic... essentially proteins. And we're seeing that move is by no means the majority of our business today, but it is a growing robust element of our business because these diseases that these drugs are meant to deal with are largely found in the elderly population.

Lisa Gill - JPMorgan

Okay, and when we think about that opportunity, just in general terms, are the margins generally better around the specialty pharmacy than it is for your core book of business?

Joel F. Gemunder - President and Chief Executive Officer

I'd say it comprise of wide range, some are better, some are not as good as some other drugs. Remember there is a patented products and the pharmaceutical manufacturer really controls the margin in this business. So I would say, on average it's probably a little bit higher than our normal margin that's growing.

Lisa Gill - JPMorgan

Okay, and then--.

Joel F. Gemunder - President and Chief Executive Officer

Although that changes from month to month.

Lisa Gill - JPMorgan

Right, I understand that. And then just on the full potential plan, if you could comment on that? And then I just had one other question which is, as we look at generic Risperdal and some of the other products and your ability to narrow your guidance range towards the upper end of the range, is that because you are able to purchase products better than expected, is it because you're seeing better conversion rates? What's the driver of what you're seeing on the generic side? And I will stop there?

Joel F. Gemunder - President and Chief Executive Officer

Yes, let me answer the first one first. The… you're asking if we’re still confident…again understanding question correctly, you're asking if we're still confident of our $120 million positive impact of hub-and-spoke when the project is completed and the answers to that is yes.

Lisa Gill - JPMorgan

Okay.

Joel F. Gemunder - President and Chief Executive Officer

Secondly, with respect to... you are asking if how much of our earnings are attributable to lower cost of these new generic drugs. Certainly, a significant part of it, but I really don't want to get into how much it is, and how much is that, and I can tell you that the result for the quarter were compendium of large number of factors, both on the cost side, on the productivity side, on the sales side. Our sales group is doing an absolutely fabulous job. They are highly motivated, they are highly trained. This is very different sales effort than we've had in the past and I couldn't be more pleased about that.

So, there everybody is pulling on delivering more, and the most pleasing thing to me in the quarter was to see our operating unit managers now signing contracts on their own. They are about double where they were in the first quarter, if I remember correctly. And that given all the other things they have to do to accommodate the hub-and-spoke program is a very major sign. It's also an indication that our businesses has stabilized. So that's the answers that I can give you.

Lisa Gill - JPMorgan

Okay. Well, congratulations on a very solid quarter. And just as a clarification on the Full Potential Plan, I understand that it's still 100 to 120 million but did I hear your comments correctly that its going to be pushed out a little bit, is that correct as we think about the entire year 2009?

Joel F. Gemunder - President and Chief Executive Officer

Yes, you know anyone who has ever built a house knows that the contractors don't always show up at the appointed hour, and we've got the same issue many times over, and the construction sometimes gets delayed a little bit or postponed. You can't put in the machinery and the equipment when the electricity isn't there to run it, so we have to deal with that. We've got some very good people, very capable people, managing that process, and we are doing the best that's possible to do but sometimes these things reach over into 2009. But as you can tell, we are very anxious to move it forward to complete the program, but we have to deal with the reality of the situation.

Lisa Gill - JPMorgan

Okay, great. Thank you for the comments.

Operator

You next question comes from Jason Gurda with Leerink Swann.

Jason Gurda - Leerink Swann

Good morning.

Joel F. Gemunder - President and Chief Executive Officer

Good morning.

Jason Gurda - Leerink Swann

I think you touched upon this in the last question, but I was hoping to get a couple more details. On the improvement that's built in the back half of your guidance, besides the generic impact, is there any other sort of changes or improvements in the business that you're building in?

Joel F. Gemunder - President and Chief Executive Officer

Well, I'm going to let Dave talk to some of this specifics but we see... we have our specialty pharma business starting to produce well. Our hospice pharmacy business is now recovering from some challenges that it had early in the year. ACH has contributed nothing so far and will start to contribute effective July 1. And we're going to see a small amount of profitability from our hub-and-spoke system now. We are getting savings from hub-and-spoke but these are offset by training cost and the doubling up of these costs, where if you're going to train new people, you still have to have the old people... or not the old people, but the existing people working while you're training new people. And the way the accounting system works, all training costs have to be P&L-ed in, they can't be included in the... they cannot be included in restructuring reserves and cannot be capitalized. So, we're going through that now, but we will see net net some improvements in our earnings from that largely in the fourth quarter.

Jason Gurda - Leerink Swann

And Dave, we saw about a $4 million sequential improvement in bad debt expense this quarter. Your collections have been improving, the receivable balance has been coming down, is there any chance that that gets to approach the levels that it used to be, I think like 1.1% of revenue?

David W. Froesel, Jr. - Senior Vice President and Chief Financial Officer

That's a great question. Our objective over the next several years is to get the bad debt as a percent of sales down to that low one level, like 1.1%, 1.2%, and we're looking to get there sometime over the next one to two years maybe shorter.

Jason Gurda - Leerink Swann

Okay, thanks. And then just a final question. The special item expenses have been about $30 million a quarter for the last few quarters, is that the run rate we should expect for, I guess the rest of the year?

David W. Froesel, Jr. - Senior Vice President and Chief Financial Officer

Probably the majority of the special item expenses is related to the special litigation cost associated with United Healthcare and some other litigation matters combined with you're seeing some increases in restructuring costs associated with the full potential program as it continues to pick up forward momentum.

Jason Gurda - Leerink Swann

Okay, thank you.

Operator

Your next question comes from Adam Feinstein with Lehman Brothers.

Adam Feinstein - Lehman Brothers

Thank you. Good morning everyone.

Joel F. Gemunder - President and Chief Executive Officer

Good morning, Adam.

Adam Feinstein - Lehman Brothers

Just... I guess a few questions here, just in terms of your mix of product, can you just give us a number in terms of branded versus non-branded in terms of revenues in the scripts?

Joel F. Gemunder - President and Chief Executive Officer

I think it's in our presentation

Adam Feinstein - Lehman Brothers

I'm sorry, I might have missed it.

Joel F. Gemunder - President and Chief Executive Officer

It was up a 100 basis points in the quarter.

Cheryl Hodges - Senior Vice President, Investor Relations

Yes, 68.7% of our scripts are generic.

Joel F. Gemunder - President and Chief Executive Officer

Versus that's a 500 basis point change from June quarter of last year and a 100 basis points change from the first quarter. And you should bear in mind that none of these item includes these drugs which I mentioned that are going off in the second half like Risperdal, Keppra, Lamictal and so on and Depakote DR which would increase that percentage significantly by the end of the year. This is... we are now seeing a very different drug distribution business than was the case heretofore.

Adam Feinstein - Lehman Brothers

Okay. And I guess just wanted to go through and I think obviously you guys had a good quarter here relative to what you were thinking and to me what really stood out was the margins in the core business just getting better and even comparing it to the first quarter, margins were up on a lower revenue and the operating profit dollars were up also. So I know you spoke about a lot of the different initiatives but if we're going to just think about the different initiatives and how much of a benefit they provided, could you just walk back through and just help us think about what's driving the improved margins?

Joel F. Gemunder - President and Chief Executive Officer

Well, look, Adam, that is a great question, and I'm glad that you brought it up, because as I said, the business model is changing favorably for us, and that is giving us, what I call, a buy-side profit in generics. Branded drugs although in dollars they still represents the overwhelming bulk of our business, have margins pretty well set by the pharmaceutical manufacturers at somewhere between 16.7% and 20% prior to any rebate. Generic drugs are sold largely by volumes and generic drugs... but they.. it is not a linear curve, it is a curve with a very significant asymptote. It is a curve that looks like an L, and when you reach the lower asymptote, you're at a point where you are buying as well as any one does. So our ability to purchase on these 70% of our growth has improved our margins significantly vis-à-vis where they would have been if those drugs remained as a branded drug. And that is not just a short term factor. We’ve look at our top 200 drugs last year and looked at those that had come off patent for five years and at the end of the fifth, there were 57 drugs of that type, and of that amount 54 or 95% had higher gross profit per script than the branded drug did, including rebate. So this is a significant shift in our business model and it's one that for once is going to be favorable to our business.

Adam Feinstein - Lehman Brothers

Okay. And then just one more question. Just clearly, mortgages are moving the right way, if they stand still, not moving higher yet and may be that's the point in terms of just looking for more profitable business, but just curious in terms of your thoughts in terms of adding new customers, any newer big contracts that you guys anticipate in the coming months, any RFPs out there, so just curious as you think about this that the opportunity add to new business?

Joel F. Gemunder - President and Chief Executive Officer

For those… I'm glad you mentioned that, so for those of our key partner sales force that are listening in, I hope you heard the expectations of Wall Street. But I can say I'm very pleased with the way our sales efforts are going. We are getting very close to the breakeven point and as I said earlier this year, our hope was that we would show a modest improvement in bed... modest growth in bed growth for the year, and I still feel that way. We are getting very close to that point. Our sales force... our signings are way up there, 92% over where they were in the same quarter of last year. They are up, what, 50-some-odd percent from the first quarter.

We are... we are really putting it away and this, you have to understand… well I just I want to point out that our growth is coming not only from assisted living which is a growing market, but also from skilled nursing facilities of where the market is essentially stable. It's not growing, not declining. But, we are... we have been picking up, we have signed a significant number of larger accounts in the second quarter, which have not yet gone live. One of the issues you have with the larger national accounts is that they take a while to get into life because you have to work your way through the contracts with the on-scan [ph] regime, in other words with the prior provider. But we're very pleased, Adam, with where we are at this point, and then I hope I can share you even better results as we go further into the course of the year.

Adam Feinstein - Lehman Brothers

Okay. Thank you, Look forward to it.

Joel F. Gemunder - President and Chief Executive Officer

Thank you.

Operator

Your next question comes from Charles Rhyee of Oppenheimer and Company.

Charles Rhyee - Oppenheimer & Co.

I just have a couple of follow-up questions here. You spoke a bit about just now about the beds and you except some of that bed improvement to show up in the back half of the year. But yet even with the bed loss, you demonstrated some strong profitability per bed. Can you give us a sense, you gave us a generic build rate, can you talk about sort of what your volume in terms of prescription dispensed were in the quarter? May be and if not the exact number like what the growth trend was you saw?

Joel F. Gemunder - President and Chief Executive Officer

Yes, I will let Cheryl talk about that. She is the keeper of those statistics, but I would say that, the issue of scripts tends to be at this point a little volatile for a very good reason. We are seeing… last year when party started, the prior authorizations is began to increase very significantly on our switch and it was at the norm that we could not large number of our prescriptions get them out the geographers day because of the delay in the approval, the adjudication process that we would send out partials to cover the patients at two or three days, which the nursing homes would absorb, and their cost structure where we worked the prior authorizations with the insurance companies. Today, we have learned how to do that quite a did better. Putting with some of our very best clinical people into our clinical intervention centers where they're working directly with the insurance companies, to clear these prior authorizations. And as a result we have fewer partials going out add more singles. So, we had a partial for two days and another partial for 28 days accounted to script. Now we have one script and an increase in our revenues per script. So we would like ---we intend at some point to start they are releasing the script data on a quarterly basis. But before I do that I would like to be certain that we have it at a stable level where we can look at a data set that is meaningful from a trending point of view. So --.

Charles Rhyee - Oppenheimer & Co.

So when you keep processing the revenue per script would go up because the ---

Joel F. Gemunder - President and Chief Executive Officer

Yes, absolutely. And you saw that the revenue per script didn’t change despite a very significant decrease in revenues per script attributable to the big increase in generic drug. Generic drugs on average sell at about one fifth to one quarter of revenues of the branded drug. So, you are saying a pretty significant decline in the dollars of script but the dollars of margins go up because you don't have to recover in a generic script. The manufacturer... generic manufacturer does not have to recover the research cost in the generic drug, whereas a branded manufacturer has to recover not only the research cost of that particular drug but for the other drug that don’t make it.

Charles Rhyee - Oppenheimer & Co.

Certainly. Of the… just changing gears a little bit here, the $27 million, the outstanding co-pays related to '06 and '07, can you give us a sense of how much is still from '06? How much is from '07, and do you have a number for sort of the first half of ‘08?

Joel F. Gemunder - President and Chief Executive Officer

I'm going to let Dave answer that but in doing let me say that we are pleased generally with the recoveries that we are getting from our arbitration awards for '06. We have recovered a significant amount of dollars which in that process, but Dave if you want to give him --

David W. Froesel, Jr. - Senior Vice President and Chief Financial Officer

Sure. Of the $27 million in total for 2006-2007, a little more than half of the $27 million relates to 2006 and a little obviously less than half relates to 2007. But more importantly, all of the 2006 co-pays are fully reserved on our balance sheet and a substantial portion of the 2007 co-pays are also reserved.

Charles Rhyee - Oppenheimer & Co.

Okay, and do you have a sense on what's that number been so far in '08? I mean basically are we seeing that trending downwards? And can you give us a sense where we are at sort of --?

Joel F. Gemunder - President and Chief Executive Officer

Yes, with respect to 2008, we're seeing moderate improvement over 2007, both on a regular day-to-day basis. As we mentioned earlier, we're continuing to work with the PDP's not only as we mentioned arbitration of litigation but sharing [ph] of systems with them to make things smoother on a go forward basis.

Charles Rhyee - Oppenheimer & Co.

Okay, great. And last question, in relation to [inaudible] here, you’ve kind of given a number in the past on sort of where you are sort of ramped up in terms of the capacity utilization there. Can you give us a sense where we are at today? And I know Joel you made a comment that you expect by year end again higher productivity as we sort of move some of the resources out of pharmacies. Can you give a sense at this point what do you think that impact might be on some of your working capital here and --?

Joel F. Gemunder - President and Chief Executive Officer

Yes, as we approached the end of the event, we now have two element at Cardinal where we only had one before. We now have the ability prior today we were able to make their only our unit dose product, which are unit dose scripts in a box. Today we are able to do not only unit dose scripts, but also bingo cards as well. So, looking [inaudible] the unit dose product, we will be approaching a point where you never really get to a 100% of anything because you keep adding new SKUs for them to do, particularly as ranks of generic have been moved up. Now that Risperdal is now risperidone, you are going to see a quantum increase in the number of generic scripts written, and that will increase the load on our repackaging.

But if you look at where we were at our drug utilization at generic, say at the beginning of the year, we'll be approaching full capacity as we go to the end of the year but there are always new drugs we are throwing into the offer, so you never quite get there. Am I... it's not an easy concept. As the industry moves to a basically generic business, the repackaging strength of our business increases, because more and more drugs, most of the drugs, if not all of the drugs that we repackage are generics because the value of repackaging in relation to the ingredient cost is high, and the inventory carrying cost is relatively low. So that's where you make the... that's where you get the benefit.

Charles Rhyee - Oppenheimer & Co.

Quite so, I understand that. I guess my question was more... because, beforehand, as Cardinal's operations are ramping up for you, you are still doing a lot of repackaging in your pharmacies. I just wanted to get a sense on where that relationship is and at what point will we really start exiting sort of the repackaging in a major way out of the pharmacy?

Joel F. Gemunder - President and Chief Executive Officer

By the end of the year, on our units dose packaging with the exception of these new drugs, we’ll be pretty much be where we hopefully would be at the end of the year which is at full capacity. But the new capacity, new volume coming on because of the new drug, Risperdal, risperidone was our number three drug as a branded drug, which was made in the facility. Now that drug is going to go into our repackaging. And certainly at a point when it goes into multi… when it comes off exclusivity, we want to be careful with our days on hand while we go through these period with Risperdal, because there is... it has been a challenge by the Federal government as to the exclusivity period and we don't want to [inaudible]. So, when that is resolved fully, you're going to see a fairly significant ramp up in the amount of generic repackaging that we do, which is going to bring our cost down further, but when that's going to happen, I can't tell you, because I'm not the judge.

Charles Rhyee - Oppenheimer & Co.

Okay, great. Thanks for the comments.

Joel F. Gemunder - President and Chief Executive Officer

Okay.

Operator

Your next question will come from Frank Morgan with Jefferies & Company.

Frank Morgan - Jefferies & Company

Good morning. A couple of questions, I would like... can you give us a little more detail about the whole retention team concept, what's really going on there, what are you doing differently to retain these people? Is it just a matter of negotiating pricing or how are you... how are you managing to retain this business that you’ve been loosing? Secondly with regard to the improvement and assumptions about in the guidance for cash flow, how much of that's really driven by this whole resolution of co-pays, the arbitration there? And then the last question, what about the further share repurchases? Thank you.

Joel F. Gemunder - President and Chief Executive Officer

Okay. Let me see if I got it all. Your first question is what about our retention team. All I'm going to say about that, because that's what I would call competitively sensitive is that we have outstanding sales people moving into... of being certain that those accounts which we deem to be sensitive are attended to with a lot of attention, care, and we've been very successful. That’s all I really want to say about it.

Cheryl D. Hodges - Senior Vice President, Investor Relations\

Cash flows

Joel F. Gemunder - President and Chief Executive Officer

Cash flows, I believe that the amount of money we have retained while significant do not constitute anything close to the overwhelming reason why our cash flow has gone up.

David W. Froesel, Jr. - Senior Vice President and Chief Financial Officer

The assumptions regarding the improvement in the cash flow guidance assumes zero benefit from any collections of co-pays with respect to arbitrations in our legal settlements.

Joel F. Gemunder - President and Chief Executive Officer

And what was the third question?

Cheryl D. Hodges - Senior Vice President, Investor Relations

Further share buyback.

Joel F. Gemunder - President and Chief Executive Officer

Further share buyback.

Charles Rhyee - Oppenheimer & Co.

Out of the strong cash flow.

Joel F. Gemunder - President and Chief Executive Officer

Okay. What we could do, as I’ve said many times before is, we consider every quarter, the utilization of our cash, whether it will be for acquisitions, whether it be for debt repayment, or for share buyback. For example, when we did our analysis on whether go forward with be acquisition of ACS, we wanted to test, we put the finances through as whether or not the returns, the less would be better or worse than buying our shares. And in the case of ACS, it was very clearly better to do the acquisition than to buying our shares even at $24 [ph]. So, we look at this all the time. I can't tell you what the Board will do. I can promise you that we examine this carefully and make the best decision we can based on returns and increasing the intrinsic value of the shares. That's what we do.

Charles Rhyee - Oppenheimer & Co.

Thank you

Cheryl D. Hodges - Senior Vice President, Investor Relations

Okay. I think we've time for one more question.

Operator

Your last question comes from the line of Robert Willoughby with Bank of America Securities.

Robert Willoughby - Bank of America Securities

Question was just answered. Thank you

Cheryl D. Hodges - Senior Vice President, Investor Relations

Okay. Thank you, everyone. Thank you for your interest in Omnicare.

Operator

This concludes today's conference call. Thank you for participating. You may now disconnect.

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Source: Omnicare, Inc. Q2 2008 Earnings Call Transcript
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