美源伯根 (ABC) 2004 Q1 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the AmeriSourceBergen earnings conference call.

At this time, all participants are in a listen-only mode.

Later, we will conduct a question-and-answer session.

Instructions will be given at that time.

If you should require any assistance during the call, please press star followed by the zero.

As a reminder this conference is being recorded.

I would now like to turn the conference over to your host, Mr. Mike Kilpatrick, please go ahead.

Good morning, everybody and welcome to AmeriSourceBergen's conference call, covering fiscal 2004 first quarter results.

I'm Mike Kilpatrick, Vice President Corporate and Investor Relations, and joining me today are David Yost, AmeriSourceBergen's CEO, Kurt Hilzinger, President and Chief Operating Officer, and Mike DiCandilo, chief financial officer.

During the conference call today, we'll make some forward-looking statement about our business prospects and financial expectations.

We remind you there are many risk factors that could cause our actual result to differ materially from our current expectations.

For a discussion of key risk factors, we refer you to our SEC filings, including our 10(K) report for fiscal 2003.

Also AmeriSourceBergen assumes no obligation to update the matters discussed in this conference call, and this call cannot be taped without the permission of the company.

As in past quarters, on the AmeriSourceBergen web site, under investors relations, you will find a short slide presentation covering some of the points we will discuss today and you're welcome to follow along.

As always, those connected by telephone will have an opportunity to ask questions after our opening comments.

And here is Dave Yost, AmeriSourceBergen's Chief Executive Officer, to begin our comments.

Good morning and thank you for joining us.

Mike DiCandilo will cover the financials in detail, but let me hit the highlights.

We grew our total operating revenues in double digits.

Up over $1 billion to $12 billion for the quarter with the pharmaceutical distribution segment up 11%.

We continue to demonstrate discipline throughout our operations.

Total operating expenses decreased versus the same period last year and hit a historic low as a percentage of revenue.

Operating margins expanded in both the pharmaceutical distribution segment and PharMerica with PharMerica's operating margin exceeding 7% for the second consecutive quarter.

This is the ninth consecutive quarter we have expanded operating margins on a year-over-year basis.

Return committed capital, a key company metric, continued well above 20%.

A strong quarterly performance and good disciplined start to our new fiscal year.

Let me address a couple of pressing customer issues, the first being the VA.

Many of the listeners may have also listened to our call of January 5th, which occurred one workday after we received notice from the VA of the Rx distribution contract award to a competitor and before we had received our written and oral post award debriefing.

As you also probably know, on January 20th, we served notice to the VA and the award winner that we would file documents on January 21st to protest the award, which we have done.

Since our protest is now in active litigation, our lawyers have advised we say very little about this case but I want to share with you the reasons for the protest, an action we took only after very careful consideration.

In its simplest terms, our protest is based on the fact that our bid was not fairly evaluated and that the VA violated their own solicitation rules in making the award.

The protest process could be resolved quickly or could take months to resolve.

It is too early, in our opinion, to assess the market impact of the now-public VA bid as it relates to nonVA hospitals and clinics but VA hospitals and clinics are unique because of the very strong contract prices they receive from the manufacturers and it is important to note VA is only 2% or so of the total market.

The other customer issue is that of Advance PCS.

The public facts are simply that Advance PCS will be acquired by care mart in a transaction that is expected to close in March.

Our contract with Advance PCS expires on March 31.

We do not have any update on Advance PCS but public facts are simply that Advance PCS will be acquired by CareMark and that transaction is expected to close in March.

CareMark has selected a competitor as its drug wholesaler.

Our contract with Advance PCS expires on March 31st.

We do not have any update on Advance PCS but have no basis for optimism The loss of Advance PCS will not change our revised guidance of January 5th.

Let me change gears and move to several industry issues.

First, importation.

Importation or reimportation, particularly from Canada, is going to be a hot topic in the political arena from now through November at a minimum.

However, we continue to believe that the safety issues surrounding importation, the leadership of the FDA Commissioner on this topic, as well as limited supply to Canada by big pharma will prevail and importation will not get traction.

Second, counterfeit merchandise.

We think counterfeit merchandise is clearly related to importation.

We are taking a leadership role within the industry and working closely with manufacturers to prevent counterfeit product entering the market.

This is also a high priority issue with many manufacturers who are changing their distribution policies to work only with authorized distributors that are almost exclusively full-service wholesalers.

Ultimately, the so-called "secondary source market" will essentially evaporate and all product will move almost exclusively from manufacture to full-service wholesaler to provider.

Third, fee for service.

The industry is moving from a model of inventory appreciation, sometimes called "buy at whole", to IMAs, so-called "inventory management agreements", where wholesalers are often incentivized for not speculating on price increases for fee for service.

IMAs represent a better industry answer than buy and hold.

Frequently, the IMAs provide wholesaler compensation from the manufacturer in the event of a price increase.

That is, the manufacturer often incentivizes the wholesaler with the opportunity to earn similar dollars or hopefully, in ABC's case, more dollars than would have been made by the wholesaler in speculating on a price increase with, of course, no risk for inventory carrying cost.

The problem, however, can be that if the IMA payout is tied to a price increase, no price increase equates to no payment.

Another more fundamental problem is that often the IMA fails to recognize the wide array of value-added services that wholesalers bring to the manufacturer and does not eliminate fluctuations to earnings that can occur from quarter to quarter depending on when a price increase occurs.

Fee for service, on the other hand, delineates the various services the wholesalers can provide to manufacturing on a menu type basis, reflecting the services that add value to the manufacturer.

It provides both parties a more rational, predictable operating model that can be totally independent of price increases or lack thereof.

However, we will not be at a fee for service model overnight.

We are at the forefront of a change that will occur over many quarters, as manufacturer agreements, which are usually one to two years in duration, come up for renewal.

The fee for service will represent the value to the manufacturer for wholesaler services provided.

It will not be tied to previous speculation profits, especially if those profits do not reflect value delivered to the manufacturer in the eyes of the manufacturer.

Said another way, the speculation profits were accessive relative to wholesaler value delivered to the manufacturer that speculation profits may not be replaced.

As we have stated on numerous occasions, we expect the evolution to have less impact on ABC than our peers, since we have operated with lower inventory than our peers and we think our performance this quarter supports that premise.

But again, this is an evolution that may well occur over time and, as it occurs, the wholesaler inventory models will converge.

That is, it is reasonable to expect the large wholesalers to carry similar inventories as a percent of revenue adjusted for customer mix.

On a final news stream note, let me comment on industry pricing to the provider, our customers.

Historically wholesalers have decreased their operating expenses each year as a percent of revenue and passed on this savings to their customers and providers.

Though this has resulted in a gross margin decrease over time, operating margins have remained stable as the gross margin decline was offset, almost basis point for basis point in AmeriSourceBergen's case by operating efficiencies.

These operating efficiencies were driven in part by the consolidation in the industry, which only a decade or so ago had over 100 corporate entities.

The ability of wholesalers to achieve historic operating expense decreases as measured as a percent of revenue is clearly slowing for two basic reasons.

First. the industry consolidation is about over, with the three large wholesalers representing a huge market share.

Second, it is more difficult to decrease total operating expenses as they drop below the 2% revenue.

They drop below 2% of revenue.

Though ABC continues to have increased opportunities for operating efficiency, as we build out our new distribution network, we clearly understand the implications of the efficiency impact and will reflect it in our pricing to our customers.

Though there is much rhetoric in the industry regarding vendor margin, we think a larger issue is a lack of pricing discipline.

That's the primary cause of the margin pressure being reflected by peers.

Our proxy statement will be released later today in advance of our shareholder meeting to be held March 5th in Philadelphia.

I wanted you to know that Bob Martini, ABC's Chairman, will not stand for reelection to the Board.

Bob made this decision due to the S.E.C. and New York Stock Exchange standards on independent directors which established Bob as a nonindependent director and therefore, ineligible to sit on the major Board committees In Bob's judgement, not being able to sit on these committees seriously decreases his effectiveness as Chairman and as a Director.

Bob will continue in his current role as Chairman through the company's annual meeting in March.

Immediately following that meeting, a new chairman will be elected by the Board in accordance with our bylaws.

I'm pleased to say that Bob has agreed to be available to the company in a consulting role and I want to thank him for his many contributions to the industry and to this company.

While on the subject of the Board, I want to mention standing for election to the ABC board for the first time will be Kurt Hilzinger, our President and Chief Operating Officer, reflecting the continuing contribution and leadership Kurt demonstrates and the confidence the Board and I have in his abilities.

With that, I'll turn the floor over to Kurt.

Thanks, Dave, and good morning, everyone.

Today I'll touch on the performance of our key business units this quarter and briefly discuss our acquisition announcement this morning.

In our pharmaceutical distribution business, which includes the drug company and the Specialty Group we, again, posted strong results, driving both solid top line growth, up 11%, and solid operating income performance, up 13%.

Cost savings from our integration activities were, again, evident with continued leverage over operating expenses driving operating margin expansion, despite the industry changes Dave spoke about.

Once again, operating expenses in the drug company decreased in absolute dollars in the quarter versus year-ago levels, again, confirming our integration activities are working and our cost savings are real.

Noteworthy is the fact that inventory levels were virtually flat with September '03 levels and down fairly significantly from year-ago levels, reflecting the impact of manufacturer product allocation strategies under inventory management agreements.

Vendor margins on the whole, however, were in line with our expectations as higher IMA fee income offset, in large part, lower vendor margin contributions from price appreciation.

Work to build out our new distribution center network continues to proceed extremely well, on time and on budget.

As we indicated in our last quarterly call, we will complete three D.C. consolidations this year, with the first scheduled for completion during the March quarter.

We are actively reviewing our plans, looking for places to accelerate our activities in light of the VA news.

More of that to follow as we finalize our thinking and the outcome of the VA account is known.

Having said that, we remain committed to the deployment of the new warehouse automation management systems and the expansion of seven and construction of six new distribution centers.

Results from our early deployment activities have validated our efficiency, accuracy and cost-saving assumptions.

This, in combination with the continued expected strong growth in the pharmaceutical channel, the additional volume expected from the Medicare drug benefits and the opportunity to line our capacity to long-term geographic growth trends gives us great confidence that this overall capital program remains justified and will see substantial future benefit from the follow through of our original plan.

We remain on track with our first Greenfield D.C. in Sacramento this summer, construction is complete, All of the automation material and handling equipment is installed and we are actively testing all systems and interfaces.

Our second new facility in Columbus, Ohio, remains on schedule to open this fall.

Our original goal of merger cost savings of $150 million annually is on track for the end of this fiscal year and the completion of our new distribution center network will drive cost significant additional cost savings in the years ahead.

Now, let me turn to the Specialty Group.

The Specialty Group had another very solid quarter and continued its historical pattern of rapid growth and development with strong sequential growth over the September quarter.

Each of the businesses which make up the specialty group, again, exceeded our expectation on ever key measure.

The overall focus remained on the distribution of difficult to handle and administered biologic and other injectible type pharmaceutical to physicians around specific disease states and by providing an increasing array of services and solutions to pharmaceutical manufacturers.

Given the group's attractive growth and return characteristics, we'll continue to allocate capital to further build out the group's drug commercialization capabilities and assist biopharmaceutical manufacturers bring new products to market.

The Specialty Group is an attractive growth platform for AmeriSourceBergin with excellent positioning in a fast-growing, rapidly evolving marketplace remaining solidly on track to meet it's 2004 objectives.

In our packaging group, now comprised of American Health Packaging and Anderson Packaging, the integration of Anderson Packaging is now complete and the group reported a solid performance in the first quarter.

Key developments in the quarter include the launch of an expanded line of prepackaged unidose products for the long-term care and institutional markets.

Additional production capacity was added for expanding unit dose demand.

The new equipment is fully capable of printing reduced spaced and multi-dimensional bar code symbology to further enable patient safety initiatives.

Work began on a number of anti-counterfeiting packaging initiatives, including the capability for RFID tag packaging for pharmaceutical products.

A new multimillion dollar packaging project was launched on behalf of a large pharmaceutical manufacturer.

The contract provides patient compliance prompting packaging based on the proprietary Meade Westvay Co. dose pack child resistant technology.

The group was also awarded a multimillion dollar packaging project for launch in 2005 to provide blisted card for a major pharmaceutical manufacturer.

Our previous announcement of the 60,000 square foot expansion at Anderson's headquarters building was completed and occupied during the quarter.

And construction of the new 150,000 square foot production facility began during the quarter with completion schedule for mid-2004 bringing our total production capacity to over 1 million square feet.

Changing to our technology offerings for just a moment.

The acute shortage of skilled labor in the form of both pharmacists and technicians in combination with increased script volume and higher standards around patient safety is driving demands for solutions which automate the medication delivery and management process at every-increasing rates.

During the quarter, we organized our various technology-related businesses into a new operating group within the pharmaceutical distribution segment, The AmeriSourceBergen Technology Group.

The group is comprised of three business units, AutoMed, our highly scalable offering of automated dispensing equipment,.

Bridge Medical, our bedside point of care software offering and Choice Systems, our supply chain connectivity software offering.

Organization of the businesses in this manner will allow us to more effectively leverage our existing capabilities and technologies and more importantly increase of speed of our innovation cycle.

The group will be led by Rusty Lewis.

Rusty most recently served as President of Bridge Medical and will move to headquarters in Valley Forge and report to me.

He is a technologist by training, spending much of his career on the research and development side of the healthcare information technology industry.

Duane Chudy will remain in charge at AutoMed.

Earlier this morning we announced the acquisition of MedSelect, Inc.

MedSelect provides automated dispensing cabinets for both pharmaceutical and medical supplies in healthcare facilities.

The business will be integrated into AmeriSourceBergen Technology Group as a product line extension for AutoMed.

By including dispensing cabinets in our offering, we will be able to tie ABC's automated solutions in the pharmacy to the solutions offered at bedside closing a loop for patient safety and providing our customers an extremely attractive cost containment value proposition.

ABC will now be able to offer a less expensive, highly flexible cabinet solution that still addresses j-co and nursing needs when integrated with bedside point of care systems.

MedSelect's cabinets will be utilized in other parts of AmeriSourceBergen as well, particularly PharMerica long term care, augment patient care in certain care settings and in the Specialty Groups offerings to physician practices for the control and safe guarding of oncology and other high value injectible pharmaceuticals.

Now, let me turn to PharMerica.

While revenue growth was flat for the quarter, PharMerica drove better than expected operating income and operating margin performance, up 21% with operating margins above 7% for the second consecutive quarter.

In the long-term care division, PharMerica continued to drive further its operating expense efficiencies to focus on cost, the consistent application of best practices at the pharmacy level and continued emphasis on leveraging its clinical expertise.

Focus on asset management, particularly in the area of credit and collections, again, lowered our capital investment in the business and dramatically improved PharMerica's return on committed capital over year-ago levels.

PharMerica's continued focus on its expense and asset utilization efficiency is clearly paying dividends, making the business increasingly attractive to the whole of AmeriSourceBergin.

All in all, this quarter clearly highlights AmeriSourceBergen's disciplined approach to its business, we will remain focused on the long term, driving targeted returns greater than 20% in order to ensure the sustainability of attractive earnings growth and a cash generative business model to ensure our ability to enhance our value in the pharmaceutical supply chain.

We have a firm grasp on the changing dynamics of our earnings model.

We'll remain disciplined in pricing in light of those changes, while at the same time shoulder or responsibility by articulating our value proposition to our provider and manufacturer customers alike.

Now, I'll turn the call over to Mike for a review of the financials.

Thanks, Kurt.

Hello, everyone.

Our first quarter results include solid operating performance across business segments, highlighted by strong expense control which led to operating margin expansion in both segments.

Disciplined capital usage led to record-low interest expense driving EPS growth to 14% while our top-line growth was 10%.

Obviously, the loss of the VA contract caused a change in our EPS guidance during January. and I will address that guidance at the end of my comments.

My comments in year-over-year comparisons exclude special items representing a net charge tho the P&L of $1 million for the current year quarter and a net credit of .8 million in the prior year quarter related to facility consolidation and employee severance costs which are set out as a separate line in our operating statements.

Now, starting with the results for the consolidated company.

Operating revenue for the company was $12.3 billion for the quarter, up 10.4% over the prior year period.

Bulk delivery revenue was down approximately $240 million related to the company's prior year conversion of a portion of its bulk delivery business to being serviced through our warehouses.

Operating income was up 14% in total compared to last year's quarter with double-digit increases in both segments, resulting in consolidated operating margin expansion of 5 basis points.

The operating earnings growth for the quarter was positively impacted by ongoing merger synergies and a bad debt recovery which offset the impact of continued competitive pressure on sell-side margins during the quarter.

Lower inventory levels led to significantly reduced average borrowings and an 8% reduction in interest expense compared to last year.

As a result, earnings per share for the quarter increased 14% to 95 cents per diluted share before special items compared to 83 cents per share reported last year on the same basis.

Moving to the pharmaceutical distribution segment.

Operating revenue for the segment was $12.1 billion up 11% compared to last year's quarter.

The customer mix in the quarter, between institutional, which includes health systems, alternate site pharmacies, mail-order pharmacies and our Specialty Group at 60% and retail, which includes independents and chains, at 40% changed from the prior year as our institutional business grew a strong 20% while our retail business was flat compared to the prior year quarter.

The institutional growth was driven by the mail-order customer group as well as by the continued above market growth in our specialty distribution business.

The prior year conversion of both bulk delivery and direct business contributed 4% to the operating growth during the current quarter.

Our retail growth in the quarter was adversely impacted by the prior year loss of a large food and drug combo account.

Independent revenues continued their strong growth noted last quarter.

Regarding our "at risk" accounts, the VA accounted for nearly 8% of operating revenue during the quarter while Advance PCS contributed over 6% of operating revenue during the period.

In the pharmaceutical distribution segment, gross profit margins were down by 26 basis points compared to last year's quarter, primarily due to the continuing shift in mix to lower gross profit margin businesses such as mail order and the continuing competitive environment.

The sell-side decline offset the positive impact of our higher gross margin acquisitions which added approximately 15 basis points to gross margin in the quarter.

The rate of price increases in the quarter were consistent with our 5% expectation and profits from IMA agreements offset in part the decline in spec inventory profits.

With regards to LIFO accounting, we recorded a charge of $6 million this quarter compared to a charge of $8.8 million in the prior year first quarter.

Total operating expenses as a percentage of operating revenue of 1.81% improved by 29 basis points for the quarter compared to the same period last year and is a record-low percent for this segment.

Approximately half of this basis point improvement in the quarter related to the recovery of a previously reserved bad debt from a former customer.

In addition, the change in customer mix and ongoing merger synergies offset the adverse effect on expense margins from the acquisitions previously mentioned.

Importantly, excluding the bad debt benefit, our expense margin was still a record low, dropping under the 2% barrier for the first time.

Turning to PharMerica.

They, again, had a very strong quarter.

Revenues of $402 million were flat compared to last year's quarter, as expected, due to the prior year customer loss and the Workers' Compensation business and the discontinuance of the healthcare products business in long term care.

However, operating income was up a strong 21% as continued focus on expense reduction in both long term care and Workers' Comp resulted in a 245 basis point reduction in operating expenses, more than offsetting declines in gross margins, driving the operating expansion of 124 basis points.

We continue to expect single-digit operating revenue growth for PharMerica in fiscal 2004 and we expect EBIT growth to be in the mid to high teens with operating margins exceeding 7% for the year.

Turning, again, to the company as a whole.

Interest expense for the current year quarter was a record low $31.5 million compared to $34.4 million in the prior year, a decrease of 8%.

Net average borrowing in the first fiscal quarter of '04 decreased to $1.5 billion, compared to $1.8 billion in the prior year quarter and $2.2 billion in the fourth quarter of fiscal '03, due to lower average levels of inventory outstanding during the current year quarter.

The effective income tax rate for the quarter was 38.5%, lower than the 39.5% in the prior year quarter as expected and reflects the continuing impact of some of the tax planning strategies we implemented after the merger.

We continue to expect that the tax rate in fiscal '04 will be in the mid 38% range.

Turning to the balance sheet and cash flows.

For the pharmaceutical distribution segment, day sales outstanding for receivables were 16.9 days in the quarter, compared to 16.1 days in last year's first quarter.

The increase, similar to last quarter, was due to the strong growth in the speciality business.

The businesses within the Specialty Group generally have a significantly higher receivable investment compared to our core drug distribution business.

At PharMerica, DSO's were once again well under 40 days, dropping to a record-low 37.5 days from 40 days in the prior year -- quarter.

Continuing their strong performance.

Inventory of 5.7 billion at the end of December was flat with September '03 and decreased significantly from December of last year.

We continue to operate our business with significantly less inventory per sales dollar than our competitors.

Inventory turns in the quarter were 7.9 compared to 6.7 in the prior year quarter.

Inventory levels were lower due to the impact of IMA agreements, earlier than expected discontinuance of shipping by certain suppliers in advance of the holidays and less duplicate inventory on hand due to reduced distribution center consolidation activity during the quarter.

The benefits of reducing our D.C. network down to 38 facilities has also impacted inventory levels.

DPO's in the quarter were down by two days versus the prior year to 37.5 days, as a result of timing and lower than expected purchases in December.

Cap ex was $52 million during the quarter.

We continue to expect cap ex to be in the 150 to $200 million range for the year as we continue or network expansion plan in 2004.

Total debt of total capital at quarter end was a record low 30% compared to 39.2% at December 31st of last year.

Net debt to capital was 26.5% compared to 34.9% last year.

Cash used in operations for the quarter was $454 million compared to usage of $666 million in the prior year quarter.

We used less cash in the current year quarter due to the reduction in the inventory levels previously mentioned.

We continue to expect cash flow from operations of $350 to $400 million for the year with potential upside depending on whether or not the working capital freed up by the VA loss is redeployed into operations.

Return on committed capital, or ROCC, which you recall as one of our primary internal financial measures and is defined as EBITDA before special charges divided by receivables plus inventory plus PP&E less payables on a rolling 12-month basis was 24.4% for the quarter, well above our long-term goal of 20%, with each of our businesses once again exceeding 20%.

Regarding guidance, we reduced our EPS guidance to $4.10 to $4.20 per share as a result of the loss of the VA contract.

As we mentioned on our call in January, this 40-cent change reflects the impact of losing the VA gross profit contribution effective April 1st while having limited ability to take out costs in the six months following the loss of business.

As we stated, this is due to the fact the VA is an integral part of our infrastructure and affects every distribution center.

As a result, fixed costs need to be reduced to have a meaningful impact and we are assessing our D.C. network for opportunities to accelerate the reduction of those fixed costs.

In addition, cost reduction in our business means a reduction in human capital and the short term cost related to that reduction will not be classified as a one-time cost in our financials.

Finally, we expect that our cost reduction plans will have a meaningful impact in fiscal' 05 and the adverse EPS impact from the VA business loss in '05 will be significantly less than in fiscal '04.

Following the anniversary of the VA loss in April '05, we expect to return to a model consistent with our long-term financial goals, which include growing EPS at 15% or more annually.

I will now turn it back to Mike Kilpatrick for a few additional comments and questions.

Thank you, Mike.

We will now open up the call to questions.

I would ask you to limit yourself to one question only until we have all had a chance at the opportunity and then, if there is time, you can ask additional questions.

Go ahead, Shelly.

Thank you.

Ladies and gentlemen, if you would like to ask a question, please press star followed by the one on your touch-tone phone.

You will hear a tone indicating that you have been placed in queue.

If you wish to remove yourself from the queue, press the pound key.

Once again, press star one if you have a question and our first question will come from the line of Lisa Gill, please go ahead.

Thanks very much.

Good morning.

Good morning, Lisa.

Dave, I was wondering if you could talk about where you are in discussions with manufacturers.

You talked about the fact you'd have those discussions as contracts -- excuse me -- come up for renewal.

But are you being more proactive than that, can you give us an idea of the number of discussions that are going on?

And when I saw Kurt and Mike about a week ago at our conference, they had given us the indication that perhaps gross margins would still come down for the industry.

Just wondering what your thoughts are as to when they will. stabilize and what rate they will possibly stabilize at?

Thanks.

First of all, let me talk, Lisa about the fee for service model type discussions.

We have them going on with large numbers of manufacturers and yes, we are being very proactive with that.

I would say that we probably have two thirds or so of our distribution business under some kind of an IMA agreement.

Probably compared to maybe 50% where we were last year.

We are taking a very active role.

I think it is going to be an evolution.

It is not something we can accomplish in the next several weeks or even in the next quarter or two.

Do you want to talk about the gross margin, Mike?

As much as gross margin expectation, certainly the impact of the mix of business is going to continue it to have an impact on the gross profit margin going forward.

It had a significant impact this period.

Additionally from quarter to quarter, you're going to see fluctuations depending upon the level of price depreciation in any quarter, for example when you look at the first quarter this year versus last year, there were some healthy price increases, but they were fewer in number.

Particularly when you look at last year, if you remember, we had some significant generic price increases.

Some in the range of two, three and 400%.

Those type increases did not repeat themselves in this quarter this year.

But for the year, again, we remain very confident that price increases are going to be in the 5% range and are going to be strong in comparison to last year.

Mike, are you comfortable at all talking about where you think the range would be?

You came in this quarter at 3.33%.

Is this something that will get closer to 3%, or do you think it stabilizes somewhere closer to the range we saw this quarter?

I'm not sure I want to make that prediction, Lisa.

Obviously our customer mix, again, has a big impact on that and I think you'll see margins continue to decline as our expenses decline.

However, you know, over time, we expect that to slow down.

Okay.

Great.

Thank you.

Thank you.

We have a question from the line of Robert Willoughby with Banc of America.

Please go ahead.

Mike, can you run through your comments again down size of the bad debt reversal?

I missed that.

Dave, can you throw out a targeted inventory days outstanding number for the industry.

Several people are talking about them coming down.

Where could they realistically level out?

Let me hit the bad debt.

We said approximately half of the 29 basis point reduction in expenses was due to the bad debt recovery.

That equates to about $17 million.

However, I think it is important to remember that In any quarter, with a company of our size, there's a number of items that go both ways and effect our results.

When they are individually material like the bad debt reserve reversal, we disclose that but there are always a number of items going the other way as well.

In this quarter, for example, we had some impact from an increase in litigation reserves on a couple of minor cases we have, as well as some severance costs that were not reflected in our one time charge and we also had a write down in investment in some internally capitalized software.

All of those things manage to offset somewhat the impact of the bad debt recovery.

And I think if you look at our company over time, we've had a history of running all of our charges through our P&L.

The only charges we've really one timed are the costs of closing distribution centers and the things like cost of implementing our merger integration are reflected in our operating cost and that's the philosophy we've had.

Got you.

I think, Mike, as you look at the industry over time, I think the inventory levels with percent to revenue adjusted for mix for our peers, probably is going to equal where the AmeriSourceBergen model is.

We might pick up a little bit, but I think the biggest impact is they will probably converge to our model.

It might be low in the December quarter.

I think what you see with our December performance is probably similar to what you can see for the industry long term.

Okay.

Thank you.

Next question, please?

We have a question from the line of Tom Gallucci with Merrill Lynch.

Please go ahead.

Good morning.

Thank you.

In terms of your manufacturing conversations, I wonder if you can just give us a little bit more color there on the nature of those discussions?

And also, I think in your prepared remarks, you mentioned speciality and the growth there and some of the higher value, more hands-on type products you distribute.

Maybe can you talk about what your experience in speciality might offer you as you try to redo your more traditional relationships on the other side of the business and if that's maybe more akin to what you are looking at longer term?

I'll start off a little bit on the manufacturing discussions, Tom, and Kurt can talk about specialty, but, you know, discussions with the manufacturers are very, very positive and reflect the fact that where the industry is moving is a fee for service model.

Wherein we provide a value added set of services to the manufacturers and they pick and chose those valuable to them.

On occasion, they've brought us additional services they would like to have us do that we have not been previously doing.

So, I think it is a lot more rational way for the industry to work.

As I noted before, depending on price appreciation is not a good way because price appreciation is difficult to predict and, in fact, may decrease over time.

If you look at the span of the next five to eight years.

We think this fee for service model is definitely going to get traction.

Kurt is doing some work with our trade association to come up with some standards that we can provide to the manufacturers in terms of value that wholesalers in general provide.

So we continue to be very enthusiastic about it.

I will address the specialty's side.

Tom, it's Kurt.

Maybe one way to think about this is, you know, we're dealing with manufacturers that are younger, they are smaller in many cases.

And I think the success we're having with the specialty model in mixing logistics with manufacturer services is proving to be a very powerful combination and we're having a lot of marked success with it.

We're able to take reimbursement or third-party logistics in combination with the ability to distribute the products to physicians around disease states and put together a comprehensive commercialization model for young biotech manufacturers.

I think we're excited about it and we're excited about the opportunity it might foretend a little longer term for the rest of the drug distribution business.

That's the direction we think we would like to go with our large pharma partners.

Obviously, we need to demonstrate to them that our capabilities run deep within AmeriSourceBergin but we think we can offer that kind of value to them and we're in the process of putting those materials and those ideas together for them.

Thanks, Tom.

Thank you.

Next question, please.

Our next question will come from the line of Ray Filche with Bear Stearns.

Please go ahead.

Good morning, guys.

Question around the VA and sort of the next step in that process.

I'm curious as to what you're planning thoughts for consolidating the cost structure related to the VA.

You know, pending the resolution of your challenge and whether or not you may delay some of those efforts, pending this process or will this process be revolved by then?

And I thought I heard you say the '05 impact will be less than the '04.

Obviously it is two quarters are impacted.

I just want to make sure I understand, is it more a function you'll be able to close facilities by the time '05 begins and that's why it is less of an impact or is there something else going on?

The first, Ray, is we really can't start any process here, execute any process, until we get a final resolution from the VA situation.

We don't know when that is going to be.

It could be resolved quickly.

It could take months and months to resolve.

The planning is clearly going on and I will let Kurt comment on that.

We cannot execute until we have a final resolution.

So Kurt, maybe you can talk about some of the planning and Mike can talk about '05?

I think you made the point, Dave.

The planning is moving ahead.

We're planning as you'd expect for the worst-case scenario, and that is the business leaves us effective April 1st.

So, the planning is moving ahead and, depending on the outcome of the protest, we'll move on that plan on the timetable that makes sense for us.

Mike, why don't you give guidance on the earnings?

As far as the earnings, Ray, again, I think you hit it.

Fixed costs have to come out and our plan is to start taking out those fixed costs in '05.

As a rule of thumb, we'd be pretty disappointed if we couldn't take out 1% of the VA's revenues in expenses out of our portfolio of costs.

I mean, I think that's our target.

If you do the math, you can see that has a significant impact on next year.

We're talking about $4 billion worth of revenue, here so 1% is $40 million, we are talking about some big numbers.

To be clear, you said you're going to run severance, I believe, through the operating numbers.

Will more of the severance come in '04 versus '05 if you execute your plan as expected?

To the extent we eliminate overhead and specific provisions to the VA, that will come through in '04 when those positions are eliminated.

To the extent we have shutdowns, if we have a divisional shutdown, we'll continue to have those shutdown costs separately as a line item in your financials.

Thank you.

You bet.

Next question?

Our next question comes from the line of Glen Santangelo with Charles Schwab.

Please go ahead.

Yes, Dave, just two quick questions, specifically as it relating to your arrangements with the manufacturers.

Now, I'm guessing you would tell me all three companies here are talking about discipline or at least they are all preaching discipline.

I'm guessing you would tell me it is too early to see if you noticed any changes in the way your competitors are behaving.

What sort of sign posts should we be looking for as an investor and analyst, how do I get any comfort level in modeling gross margins for this industry going forward?

Secondly, I had a question question about PharMerica, the magnitude of the customer loss on the Workers' Comp side.

Let me talk about -- it is a difficult issue, Glen, to get a handle on because frequently it tends to be anecdotal.

There aren't any big contracts coming up that I can think of in the next six months or so.

But the key, I think though, is the preaching is not the key, it is the practice.

And, you know, we're not convinced that everyone -- quite frankly in the marketplace is showing the same discipline we are.

I'm not sure there is any specific thing we can hang our hat on.

Do you have any ideas?

Kurt, do you want to talk a little bit about --

Glen with regards to Workers' Comp, you know, the business that was lost was not that significant.

I characterize it less than 5% of the book of business there.

I would tell you the group is actively sourcing new contracts.

So that had a modest impact on the segment results, but not awfully large.

So for PharMerica, we should be modeling like a single digit revenue percentage growth rate?

I think that's right.

And we're going to anniversary this contract.

You should know, same-store sales, if you will, on the long-term care side continue to grow quite nicely in the December quarter.

So all of the metrics are moving in the right direction.

We've just got a couple of events we need to anniversary and the top line will be off with the statistics I think we'd all like to see.

Dave, if I could ask one quick follow-up, if there are no big contracts in the next six months, you're saying it is going to be a while before we have any idea whether the companies practice what they preach?

I think that's fair.

Our next question, please?

Our next question comes from the line of Larry Marsh from Lehman Brothers.

Go ahead.

Thanks and good morning, Dave, who is the Board going to be nominating to replace Bob as Chairman?

Is it going to be a nonexecutive chairman and is Kurt taking Bob's place on the Board?

Or is the Board going to be expanded to 11 people?

First of all, Larry, the Board will decide who the chairman is going to be when they meet following the annual meeting of shareholders in March.

But I would think that it would be a nonexecutive chairman.

That is, it will not be me.

It will be someone -- an independent director.

Last year, as part of the board's self evaluation, AmeriSourceBergen independently had an outside consultant and polled the directors and a majority of them thought the function between the chairman and CEO should be separated, which is pretty much recommended by most of the corporate governance guidelines.

Kurt coming on to the board is a separate and independent decision.

That has been made and recommended by the Board some time ago.

We will probably be conducting a search and end up with ten or eleven members on our Board going forward.

Certainly, Kurt on the Board is a great addition and well deserved.

Is there any change in Bob's lockup?

I mean -- in terms of his ownership with this change or any restrictions on his selling stock now?

You know, no, there are not.

He continues to be a very large shareholder, as you know.

It is very important to note he's going to continue to be available in a consultation role, not only for me personally and Kurt, but also to the board.

I think it is fair to expect that Bob will continue to have -- I will continue to look to Bob for some guidance from time to time.

As you know, he's really the industry icon.

Represents a large amount of experience.

We want to make sure we don't lose that total experience.

He'll be available for consultation when we need him.

Just a clarification, I guess, to Mike.

Is that $6 million LIFO charge annualized to about $24 million is that a moderation to what you were suggesting, you know, with the 4th quarter of roughly $30-35 million or is that in the same general ballpark?

I think we are in the same general ballpark, Larry, I think last year we were in the 30s.

And we said we would expect to see some moderation of that amount during this year as we move more to the IMA model.

And our inventory is less weighted by spec inventory.

I think that's starting to have its effect and we'll be seeing that the rest of the year.

Thanks, Larry.

Thanks.

Next question please.

Our next question will come from the line of Chris McFadden with Goldman Sachs.

Thank you.

Good morning.

Can you clarify, did you participate in the anti-trust settlement that your competitors participated in this recent period connected to a cardiac drug?

If so, can you talk about what impact that might have had in the reported results?

Yeah, Chris, we're subject to a lot of litigation, both favorable and unfavorable from time to time and when they are material, we disclose them.

We did not have a material impact this quarter from the litigation.

I guess I'm not sure exactly which cases our competitors were referring to but there is quite a bit of activity going on in this industry at this time with manufacturers and, you know, when those amounts become material, we will disclose them.

Just to be clear, there was or was not a settlement connected to a generic based class-action lawsuit in the cardiac therapeutic category?

If you're saying, did we have a significant recovery this quarter, the answer is no.

Secondly, you've obviously given and talked about getting back to an F 04 run rate in terms of a target, embedded in that must be expectation of some of your manufacture relationships that are either in some form of discussions today or how you expect those relationships to evolve over time.

Talk about what expectations you've built into your model in terms of what fee for service will look like, the pace at which these manufacturer relationships will be converted into new presumably slightly more favorable relationships we can understand and anticipate the development of this relations over time, again, kind of consistent with your internal model and expectations look like?

I'll take that.

We've all got an answer to this.

I think our expectations in terms of our internal modeling is that we would not have an increase in vendor margin from the manufacturer.

Now, that doesn't mean we're not going to give it our best effort to make a case for better vendor margin contribution and I think all of the major players in this industry are supportive of trying to get in front of the manufacturers and articulate our value proposition more effectively than we have historically.

And I think, when you really break down the economics of what it costs to do what we do, we'll be able to make a very effective case with the manufacturers that they have an awfully good deal for what we do for them today.

But for modeling purposes, both looking forward, we do not anticipate an increase in the vendor margin as part of our planning process.

I would just add to that, Chris, you could have changes within each-- specific manufacturers.

You could have some guys going up and some guys going down, based upon the fee for service and what we do for them, what they elect to have us do, the complexity of the products and the like but on average, I would agree.

We're all getting ready to answer.

Do you have anything to add?

No.

I think I'm right there with you guys.

Super.

Thanks, Chris.

Next question.

Our next question comes from the line of Michael Fitzgibbons with Morgan Stanley.

Please go ahead.

It sounded like the price increase environment with that 5% number was still pretty strong.

It wasn't quite I guess the spec opportunities were not quite what they had been last year or maybe what you expected.

You said for instance that acquisitions had a 15 basis point impact on gross margins.

Can you give us a similar sense on what the impact of reduced spec line opportunities was it in that range or something significantly above or below that?

Yeah, Mike, I don't think we want to get into a specific quantification of the impact of price increases.

One of the things we've said often, a month doesn't make a quarter and a quarter doesn't make a year with respect to price increases, we are subject to volatility in our earnings on a quarterly basis from price increases.

And that's why the guidance we've given has been on an annual basis and will continue to be.

I think I just wanted to give people a flavor that the number of price increases were down from last year.

It was primarily in the generic area were there were some unusually high price increases last year.

Could you clarify, which quarter do you tend to get the most profits, the most productive for you?

It's tended to be our March quarter.

Thanks.

Thanks, Michael.

Next question, please.

Our next question is from Eric Coldwell with Robert W. Baird & Company.

Please go ahead.

Thanks very much.

First off, I was hoping for a little more commentary specifically on the Specialty Group growth rate and also kind of from a more qualitative standpoint, do you expect issues with changing government funding related to Medicare and as a follow-up to a couple of questions on the call, I'm curious whether you can tell us specifically how many manufacturers have actually signed the true fee for service deals versus simply the kind of first generation IMAs?

Thank you so much.

I'll weigh in on the first one.

We think the fee for services is pretty competitive, Eric, so we don't want to get into a specific numbers game.

So we'll take a pass on that one.

Kurt, do you want to talk about speciality growth?

The area continues to be very strong.

The trend lines that you've heard us comment on as we reported, you know, what we do about the top line continued.

You know, I would characterize the businesses growing two X. The base distribution business, basically plus or minus a little bit but good solid growth.

You know, we continue to be actively engaged with Washington about some of the contemplated changes there.

There's a lot moving in Washington right now.

I think it is a little bit premature to speculate and try to come out with where we think this thing is going to come out.

I think probably caution on the part of the regulators in Washington is probably the watch word right now, they understand they are dealing with patients and care.

So I think things will go slower than what we've talked about in the past and we're actively engaged in Washington on it.

I would just chime in, Eric, I think this whole area of safety is taken the banner.

I think you're going to see a lot more of that going forward and this whole issue of safety is going to be a very prominent discussion topic in Washington.

Thanks very much.

You bet.

Our next question, please?

Our next question comes from Kevin Berg with CSFB, please go ahead.

Yeah, guys, can you assess your expectations for operating margins on a go forward basis over a longer time frame.

Obviously, gross margins have been going down forever in this industry and you have offset the operating margin line it seems like in large part through consolidation synergies, other synergies, vendor margin increases.

Vendor margins, I think in your words, let's say they stay stable, how are you going to or will you be able to generate operating margin or do you plan on generating operating margin increases?

Eric, this is Mike.

I think we've said often, and again, this is prior to the loss of the VA.

Our expectation was that we would have operating margin expansion and that was really going to be fueled by efficiencies from building our our DC network and we were going to continue to lower or costs and that would be also augmented by the value-added services we continue to add up and down the supply chain.

We expect the drug distribution business to be extremely competitive going forward.

Certainly the firming up of the margins over time would, I think, help those who have focused on their long-term expense structure and distribution network plans because the competition will be based on efficiency and service and that's why we're continuing to build the network we've talked about.

Kevin, we talked about the operating increases in a single basis point range.

So we don't want to get expectations too far out of line.

That's what we've historically said.

Do you guys make any changes in your capital return requirements for business or your EBIT margin requirements or are you guys staying the same as you have in the past?

Kevin, it is Kurt.

We are very committed to maintaining returns on our contract, on the drug distribution business of greater than 20%.

We do a lot of modeling here.

You need that kind of level against a long-term cost of capital assumption in order to have a cash generative portfolio of contracts. and a sustainable earnings growth model.

There is not much sense being in this business if you can't get those two things as a basic starting point and you redeploy the capital.

So we're committed to if.

It is the right place to be and we're going to keep very disciplined in how we approach the marketplace on this.

Thank you very much.

We've got time for one more question.

Operator?

And our last question will come from the line of Steve Hilper with Thomas Weisel, please go ahead.

Hi, good morning, since the VA contract award, can you tell us some of the discussions that you're having with your customers about sharing, less of the saving, raising prices, to the providers, those type of discussions?

I'll go first, anecdotally, we haven't had much, Steve.

It's only been a couple of weeks.

I've had conversations with a couple of customers but totally independent of that, Kurt how about you?

I would say that I think the marketplace is still trying to understand the VA.

The VA business trying to understand it is in fact a unique piece of business and obviously we've tried to articulate that not only to our customers, but also to our manufacturing partners who are trying to understand the bid levels that were made public.

So, you know, it is still early on to give you specifics to your question.

And then just one quick follow-up on the VA.

I guess you asked for a temporary injunction on the switch.

How soon would you be able to hear on that?

We think we'll hear on that in the next 30 days or so.

We don't know for sure.

Alright, great thanks.

Thank you all very much.

Appreciate you joining us today.

For those of you interested in hearing more about the AmeriSourceBergen story, we will be attending the Merrill Lynch Pharmaceutical Conference on February 3 and the UBS Global Healthcare Conference on February 4, both are in New York.

And now Dave would like to make final comments.

It's been a little bit longer call than usual.

I would close by saying we continue to be very very excited about our role in the channel and very very excited about the segment we're in, and the leadership position we have.

We look forward to sharing our results with you at the end of the next quarter.

Thank you all very very much.

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