美源伯根 (ABC) 2004 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by, and welcome to the ABC 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 assistance during the call please press star then 0.

As a reminder this conference is being recorded.

I would now like to turn the conference over to our host, Mr. Michael Kilpatric.

Please go ahead.

Good morning and welcome to AmerisourceBergen's conference call covering fiscal 2004 second second quarter results.

I'm Mike Kilpatric, VP Corporate and Investor Relations.

Joining me today are David Yost;

AmerisourceBergen CEO, Kurt Hilzinger;

President and COO, and Mike DiCandilo;

CFO.

During the conference call today we will make some forward-looking statements about our business prospects and financial expectations.

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

For discussion of some 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 express permission of the company.

As in past quarters, on the AmerisourceBergen website under Investor Relations, you will find a short slide presentation covering some 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's Dave Yost, AmerisourceBergen's CEO to begin our remarks.

Good morning and thank you for joining us.

Mike will cover the financials in detail but let me hit the high points.

We grew our total operating revenues over 10% to $12.3 billion, up over $1.1 billion for the same quarter last year.

Total operating expenses as a percent to revenue were 2.6%.

As we continue to capture operating synergies our actual expense dollars were lower this year than last year.

Operating expenses in Pharmaceutical Distribution were again below 2%.

Corporate operating margin was over 2%.

Interest expense was down 20%.

Return on committed capital, a key company metric, was over 25%.

We ended the quarter with the strongest balance sheet in our history and this month got rating agency upgrades.

Excluding special charges, EPS was $1.24, up over 18% from last year, and last year's EPS was up 38% over the year before that.

Clearly we have put strong performance on top of strong performance.

Let me hit customer issues head on.

This is the last full quarter we will enjoy the VA business, and it was strong this quarter, $986 million, almost $1 billion, and over 8% of total operating revenue.

The business will transition away from ABC on May 10th.

Aggressive cost reduction measures are currently being refined, which Kurt will highlight.

But let me put operating revenues in perspective.

We had strong balanced increases over a broad customer portfolio and demonstrated our ability to grow with a very attractive expanding market.

In July we will have our annual trade show, our selling exposition.

We expect as many as 7,000 people, representing several thousand retail drugstores, to attend.

This is the largest event of its kind in the industry by far and will showcase our many retail programs and will feature the largest offering of continuing education credits for pharmacist ever offered in one place.

We look for the Medicare card programs that will be operational in June to be a very positive driver on revenues for this segment.

We began receiving merchandise this month at our new Sacramento facility in anticipation of an early summer go-live date.

Sacramento is on time and on budget and the first of six new 300,000 square feet, highly automated DC's that will establish new standards of distribution efficiency in our industry.

We expect to open a new DC every six months or so.

We continue to experience gross margin pressure in Pharmaceutical Distribution due to continued competitive sell-side pressures and account concentration.

Though we have had to aggressively maintain our customer base, and will continue to do so, we would hope the sell-side margin will stabilize as we move forward.

The pharmaceutical distribution industry and ABC continues to evolve smoothly into an IMA, or inventory management agreement environment, at about the speed and with the impact we anticipated, which is borne out by our inventory decrease, cash generation and reduced interest expense this quarter.

To put this in perspective this quarter versus last year we generated $1.1billion more in revenue with $1.3 billion less in inventory.

Operating revenues were up 10% and inventory was down almost 19%.

About two-thirds of our dollar volume is now covered by IMAs.

We expect the evolution of IMAs to a fee-for-service model to be a one to two-year migration as our manufacturer agreements, which are usually one to two years in length, renew.

Discussion regarding fee-for-service are occurring daily.

While we anticipate the price appreciation environment to be annualized at the 5% or so level, it is important for the industry to continue its evolution to a fee-for-service model over time, so that the wholesalers buy side or vendor margin is not dependent on manufacturer price increases.

We continue to be very excited about our specialty business, which continues to grow at both the top and bottom line at rates well above those of the basic Pharmaceutical Distribution business.

The eight operating units that offer both specialty distribution and manufacturer services all continue to perform extremely well.

We also continue to be excited about PharMerica and its strong market position, as well as packaging and technology companies that continue to provide enhanced, value added solution to our customers and suppliers.

We can sum up our performance succinctly.

Customer demand for our value-added solutions continues to gain momentum and we continue to deliver strong results with good discipline.

Like you, we are closely monitoring the issue of drug importation.

Kurt provided testimony this month to HHS on the topic highlighting the key issue of product safety.

Importation, sometimes refused to incorrectly as reimportation, has become a very high-profile political issue.

There is no doubt that pricing differentials exist throughout the world and in Canada, but there is equally no doubt that embedded in this debate is a huge patient safety issue and channel integrity issue.

The problem, of course, may not be product that flows from authorized manufacturers into Canada and then from Canada into the U.S..

The problem is the product flowing into Canada or other countries from unauthorized sources from who knows where.

The only way the safety of the patient can be assured is with a closely controlled distribution channel.

Currently we have the world's best example of this in America, and that is the reason that although instances of counterfeit pharmaceutical product do occur in this country the instances are dramatically lower than any other place in the world.

Channel integrity and its correlation to patient safety is an issue on which we and the pharma manufacturer community are in total alignment.

Together we can assure that only FDA-approved manufactured product is reaching the patient.

Channel integrity and patient safety are easily maintained through a closed distribution system that involves only the authorized manufacturer and a small number of wholesalers.

Importation is not an appropriate mechanism to address pricing differentials.

Legalized importation could compromise channel integrity and patient safety.

ABC will work diligently to maintain channel integrity.

We continue to be very bullish on our industry and the role we play in that industry.

The industry fundamentals in Pharmaceutical Distribution, Specialty Distribution, Long-term Care Pharmacy, and our related business, continue to be very, very attractive.

Demographics are our friend.

The the older people get, the more drugs they take, the more drugs they take, the older they get.

New products from big pharma and generic introductions both provide us great opportunities.

Our disciplined execution is driving expenses down and capital out of the business.

And we have yet to realize the full impact of our consolidation synergies.

Our future is bright.

Here's Kurt to provide some added detail.

Thanks, Dave.

And good morning everyone.

Today I'll touch on the performance of each of our key business units as well as highlight our response to a few key industry issues.

In our Pharmaceutical Distribution business cost savings from our integration activities continued with operating expenses in absolute dollars down again from year-ago levels and ahead of internal expectations.

This in large part, offsets declines in gross margin, but not completely, reflecting the effects of the need to match price competition to maintain market share.

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

Noteworthy is the fact that inventory levels are down significantly from year again levels, reflecting impact of manufacture product allocation strategies under IMA agreements.

As we look back over the past six months inventory levels have remained virtually flat, which importantly reflect a sharp departure from historical industry trends of building inventory around calendar year end.

The benefits of this dynamic were principally reflected in the P&L through lower interest expense, which Mike will detail.

We will begin to anniversary this changed buy-side model at the vend this fiscal year allowing for easier comparisons in 2005 and beyond.

We were pleased to make the announcement this morning that Len DeCandia has joined AmerisourceBergen as Sr.

VP of Supply Chain Management.

Len will replace Doug Batezel, our Chief Procurement Officer since the merger, who has elected to return to California to retire.

Len has spent his entire career on the manufacturer's side of the pharmaceutical supply channel serving 14 years with Johnson & Johnson and the last five years with Hoffman-La Roche, managing enterprise wide supply chain, including materials purchasing, master planning, contract manufacturing and distribution.

Under Len's leadership Hoffman-La Roche has won numerous quality awards from various channel partners, including the big three wholesalers.

Our decision to bring someone of Len's background into ABC and design his scope of responsibilities more broadly than procurement, reflects our view that a collaborative process and value-driven approach with our manufacturer partners is essential to our industry going forward.

Much discussion has been occurring of late with regard to fee-for-service agreements with our manufacturers.

Let me just take a minute and outline some of the key elements we believe such agreements should entail.

First, agreements should be tailored to the unique and specific needs of each manufacturer.

Second, compensation to the distributor should reflect fair value for the services provided relative to the closest alternative.

Compensation should be periodic, volume and activity based, and not price increase event based.

In our view performance goals for the distributor should be integral to the arrangements.

Material improvements to the supply chain cannot occur without improved transparency.

We feel strongly that agreements should allow for greater data sharing, for greater visibility.

Lastly, incentives should be built in to drive proactive, collaborative management, of shared supply channel challenges such as counterfeiting, supply shortages, and the like.

Such an approach will be healthy to the overall supply chain lowering excess inventory, improving operating efficiencies and helping to better security supply chain integrity.

Changing gears for a minute, in response to the VA decision, we have identified a number of opportunities to eliminate both fixed and variable costs.

We now plan to accelerate our facility consolidation plan, increasing the number of consolidations this year from three to five.

The first of these closures was completed during the March quarter on time and on budget.

Likewise, variable costs and semi variable costs associated with the account have been identified and work plans are in place to begin eliminating those costs once we complete the contract term in mid-May.

As we indicated during the last conference call we remain committed to the deployment of the new warehouse automation management system as well as expansion of seven and construction of six new distribution centers.

Results from our early deployment activity have validated our efficiency, accuracy and cost savings assumptions.

This in combination with continued expected strong demand in pharmaceutical channel, additional volume expected from the Medicare drug benefit and the opportunity to line our capacity of long-term geographic growth trends gives us great confidence we will see substantial future benefit from follow-through of our plan.

As Dave mentioned, we remain on schedule to open our first new facility in Sacramento this summer, our second new facility in Columbus, Ohio remains on budget and on schedule to open this fall.

The remaining four new facilities, including our recently announced location in Chicago, Illinois, and Bethlehem, Pennsylvania, will come on line in approximately six-month intervals.

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

Now let me turn to our specialty group.

The specialty group had another excellent quarter with strong sequential growth with annual revenues now greater than $5 billion.

The group remained focused on the distribution of difficult to handle and administer biologic and other injectable-type pharmaceuticals to physicians around specific disease states and by providing an increasing array of integrated commercialization solutions for manufacturers.

A few highlights from the quarter include, [McBessy] Medical, sales expended greater than 30% in the quarter with the addition of the [Visudine] distribution program on behalf of Novartis Optometrics, beginning January 1st.

This was previously a manufacturer direct program.

The last group, our reimbursement consulting business, expanded its list of pharmaceutical and biotech manufacture clients over 100 for the first time.

In addition, Lash hosted a highly successful AWP reform conference in Washington in late January attracting key pharmaceutical executives from across the country, as well as Tom Scully the former commissioner of CMS.

Our oncology supply business unit set a number of new performance records exceeding our expectations in both revenue and operating income performance.

Our packaging group had a solid quarter as well, meeting our internal expectations.

American Health Packaging, our provider oriented packaging unit, introduced 30 new product for retail, health systems, and long-term care markets with a significant number of these being in unit dose, bar-code enabled format.

Anderson Packaging, our manufacture contract packaging unit, won two of the three top compliance packaging awards from the Healthcare Compliance Packaging Council, including the coveted Compliance Package of the Year Award.

Construction of the new 150,000-square-foot facility for Anderson remains on tract for completion during the summer bringing total capacity to over 1 million square feet.

In response to strong forecasted demand additional blistering and carting capacity was added both business units during the quarter.

The pipeline of new projects within the packaging group is strong and growing.

And we continue to expect new regulatory initiatives regarding bar coding and anticounterfeiting will drive significant growth opportunities for the packaging group in future periods.

Changing to our technology offerings for a minute.

AmerisourceBergen Technology Group continued to see its order backlog build throughout the quarter as investment in additional sales resources at the outset of the year and the need for pharmacy productivity tools continue to drive demand.

The need for automation both in the form of dispensing and work flow were key themes at last week's annual meeting for the National Association of Chain Drugstores.

Our recent acquisition of MedSelect, a provider of automated dispensing cabinets, we acquired last quarter, is gaining market traction faster than our internal expectation and has proved to be a valuable addition to our solutions based selling strategies in the institutional marketplace.

Now let me turn to PharMerica.

PharMerica had a solid quarter, driven principally through productivity improvements, which Mike will discuss in more detail.

We continue to like the business for a number of reasons.

First, long-term growth prospects are attractive and sustainable.

Second, the financial metrics of the business are attractive, particularly its margin composition and return on capital.

Third, further productivity improvements remain very achievable through the use of better practices, processes, and automation technologies.

Lastly, multiple cross-leveraging opportunities exist with other parts of AmerisourceBergen allowing for the creation of incremental earning streams.

All in all it was a good quarter, very much in line with our expectations.

We remain disciplined and demonstrated again that we have a firm grasp on the changing dynamics of our industry and earnings model.

I'll now turn the call to Mike for review of the financials.

Thanks, Kurt, and hello, everyone.

Our second quarter results include solid operating performance across business segments, highlighted by strong expense control, disciplined capital usage, and strong operating cash flow, which led to record low interest expense driving EPS growth of 18% well above our top-line growth of 10%.

My comments in year-over-year comparisons exclude special items representing a net charge to the P&L of $1.4 million for the current year quarter and $2.4 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 our results for the consolidated company.

Operating revenue for the company was $12.3 billion for the quarter, up 10% over the prior year period.

Both delivery revenue increased 7% from the prior year to $1 billion, operating income was up 8% in total, compared to last year's quarter, as Pharmaceutical Distribution EBIT grew 7% and PharMerica EBIT grew 17%.

The consolidated operating margin of 2.11% declined by 4 basis points from the prior-year quarter.

The operating earnings growth for the quarter was positively impacted by ongoing merger synergies and strong price appreciation, which offset the impact of continued competitive pressure on sell-side margins during the quarter.

The equity in income of affiliates and other line represents the company's share of a gain resulting from the sale of the assets of one of its technology equity investments.

Interest expense for the current year quarter was a record low, $30.9 million, compared to $38.4 million in the prior year quarter.

A significant decrease of 20%.

Net average borrowings in the second fiscal quarter of '04 decreased $1 billion, to $1.4 billion, compared to $2.4 billion in the prior year, due to lower average levels of inventory outstanding during the current year quarter.

The effective income tax rate for the quarter was 38.5%, consistent with Q1 and 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.

Earnings per share for the quarter increased 18% to $1.24 per diluted share before special items, compared to $1.05 per share reported last year on the same basis and were up by 19% to $1.23 per diluted share on a GAAP basis.

Moving to the Pharmaceutical Distribution segment, operating revenue for the segment was $12.2 billion, up 10.5%, compared to last year's quarter.

There was one additional business day in the current quarter compared to last year.

The customer mix in the quarter between institutional, which includes health systems, alternate site pharmacies, mail-order pharmacies and our speciality group at 60%, and retail, which includes independents and chains at 40%, changed from the prior year as our institutional business grew a strong 19% while our retail business was flat compared to prior year quarter.

The institutional growth was once again driven by 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 3% to the operating revenue growth during the current quarter.

Our retail growth in the current year quarter was adversely impact by the prior year loss of a large food and drug combo account and the below market growth of certain of our large regional chain accounts.

Independent revenues grew by over 10% continuing their strong growth noted last quarter.

We expect operating revenue growth to be in the mid single digits in Q3, in the low single digits in Q4 of fiscal 2004, reflecting the loss of the VA in May and solid growth from the rest of our business.

In the Pharmaceutical Distribution segment, gross profit margins were down by 31 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, primarily Anderson Packaging this quarter, which added approximately 5 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 the decline in speculative inventory profits from carrying lower inventories.

However, we continue to see a reduction in deal and other buy-side opportunities.

With regards to LIFO accounting we recorded a charge of $16 million this quarter, compared to a charge of $26 million in the prior year second quarter, reflecting the lower leveling of spec inventory in the current year.

Total operating expenses as a percentage of operating revenue of 1.89% improved by 26 basis points for the quarter compared to the same period last year.

This improvement was driven by the change in customer mix and the ongoing merger synergies as well as by an $11 million net reduction in expense accruals, primarily from a reduction in employee benefit costs.

The operating margin in the quarter was 1.91%, a 6 basis point decline from the prior year quarter.

Turning to PharMerica.

They, again, had a very strong quarter despite flat revenues.

Revenues of $392 million were down 1% compared to last year's quarter due to the prior year customer loss in the Workers' Compensation business and a discontinuance of the health quarter products business in long-term care, as well as the loss of a long-term care customer due to acquisition.

However, operating income was up a strong 17% as continued focus on expense reduction in both long-term care and Workers' Comp resulted in a 288 basis point reduction in operating expenses as a percentage of revenue, more than offsetting declines in gross margin driving operating margin expansion of more than 100 basis points.

Operating expenses in the second fiscal quarter actually declined $13 million from the prior year quarter, primarily from headcount reductions as well as improvements in bad debt performance.

We expect flat operating revenue growth for PharMerica in fiscal '04 and we expect EBIT growth to be in the mid to high teens with operating margins exceeding 7% for the year.

Turning to the balance sheet and cash flows, for the Pharmaceutical Distribution segment days day sales outstanding for receivables were 17.9 days in the quarter, compared to 17.3 days in last year's second quarter.

The increase similar to last quarter was due to the strong growth in the specialty business, which has significantly higher receivable investment compared to our core distribution business.

At PharMerica DSOs were once again under 40 days dropping to 39 days from over 40 last year, continuing their strong performance.

Inventory, a $5.6 billion at the end of March, declined by $52 million from December '03 and decreased by $1.3 billion dollars from March of last year.

Inventory levels were significantly lower than in the prior year quarter due to the impact of IMA agreements, which cover approximately two-thirds of our dollar volume, fewer deal opportunities, and the benefits of reducing our DC network down to 37 facilities.

Inventory turns in the quarter were 8.0, compared to 6.3 in the prior year quarter and with 45 days of inventory on hand, we continue to operate our business with significantly less inventory per sales dollar than our competitors.

Networking capital to operating revenue in the quarter was 6.5%, down significantly from 8.1% in the prior year.

Cap ex was $35 million during the quarter and $85 million for the six months.

We continued to expect cap ex to be in the 150 to $200 million range for the year as we continue our network expansion plans.

Total debt to total capital at quarter end was a record low 29%, compared to 36% at March 31st of last year.

Net debt to capital was 20%, compared to 33% last year.

We were upgraded by Fitch to investment grade during the quarter and we plan to call our $300 million, 7.8% toppers debt in the June quarter.

This will result in a book loss of $24 million in that quarter, but more importantly will result in a significant reduction in cash interest going forward.

In addition, in the June quarter we expect to realize a net gain of approximately 35 to $40 million from an antitrust litigation settlement with the supplier.

Our fixed to total debt ratio was 85% at the end of March, which positions us very well against rising interest rates going forward.

Cash generated from operations for the quarter was $476 million, compared to $51 million in the prior year quarter and for the last 12 months was just under $1 billion at $992 million.

We generated significant cash in the current year quarter due to the reduction in working capital levels previously mentioned.

We continue to expect cash flow from operations of 350 to $400 million for the year.

Return on committed capital, or ROC, which you recall is 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 25.6% for the quarter, well above our long-term goal of 20% with each of our business units also exceeding 20%, once again.

Our EPS guidance for fiscal '04 remains at $4.10 to $4.20 per diluted share, which includes special items, the toppers debt redemption, and antitrust litigation settlements.

Following the anniversary of the VA loss in May '05, we would 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 Kilpatric for a few additional comments and questions.

Thank you, Mike, very much.

And now I'll open up to questions.

I will remind you to limit yourself to one question only until we've had an opportunity for everyone else, then if there's time you can ask additional questions.

Go ahead, Lois.

Than you.

Ladies and gentlemen, if you wish to ask a question please press star 1.

You will hear a tone indicating you've been placed into queue and you may remove yourself from queue at any time by pressing the pound key.

If you are using the speakerphone, please pick up your handset before pressing the number.

Our first question will come from Tom Gallucci from Merrill Lynch.

Please go ahead.

Good morning, everyone.

My question would focus on the sell-side of the business.

Dave, I think you mentioned you're working to aggressively maintain your customer base and would you hope to see price stabilization moving forward.

Can you kind of maybe just frame that comment relative to what your thoughts were three or six months ago in terms of where we are in reaching stabilization on that front, and then comment to the degree you can on either the advanced PCS business and the Kaiser contract?

Thank you.

Thanks, Tom.

We really feel uncomfortable talking about any specific accounts but I will tell you we expect to maintain the business we've got now, we don't look to lose any of it, if we have to be aggressive to keep we will continue to do that.

The problem with trying to place it, Tom, versus six months ago, it tends to be anecdotal based upon what we heard from a specific sales rep yesterday or Friday night.

But, I will tell you we continue to be optimistic that the price environment is stabilizing as we go forward.

We're clearly being very disciplined as we go forward and we hope and expect our competitors to do the same.

Kurt, do you have anything to add?

No, I think that covers it.

Is there anything you can offer about advanced PCS, specifically, since we know that has been up in the air to some degree?

No,Tom ,we've got a contract that runs with them through September 30th.

I will tell you as they have just closed their deal they've got bigger issues on their plate rather than drug supply, so there's really nothing new for to us report on that account.

Thank you.

And our next question is from the line of Lisa Gill from J.P. Morgan.

Please go ahead.

Thanks very much.

Dave, I was wondering if you could talk a little bit about some of the discussions you're having with manufacturers right now and maybe, perhaps, just talk a little bit more about your new hire, Len DeCandia.

Will he be participating in these talks and what can he bring to the manufacturer as far as other opportunities for enhancing your margins?

Lisa, I think I'll let Kurt handle that.

I want to point out that we're going to have big confusion going forward because our new supply side person is DeCandia, and our CFO is DiCandilo, so we figure within our own organization we're going to have e-mail screwed up for at least the next six months.

Maybe I'll turn it over to Kurt.

Lisa, good morning.

As we mentioned this morning, we're pleased Len has joined the company.

I think he's going to bring a very nice perspective to our organization and allow us to connect more readily with our manufacturers over some of the challenges that we're working through right now, not only as it relates to compensation for the wholesaler but how do we make the channel more efficient so that both parties, ourselves and our manufacturing partners, can benefit and wring costs out of the channel and ultimately improve the integrity of the supply channel, which is obviously shared between both sides of the marketplace.

Len, we decided to go to the manufacturer side of the marketplace because we think that Len can be a very effective spokesperson for us.

With them, he knows their world.

These are large complicated organizations and I think Len will help us navigate some of those organizations, particularly the largest of the pharmas, so I think he's going to have an awful lot to offer the organization.

I think it does signal, again, just another moment where we say, look, our compensation should not be price-increase speculation-based, but based on what we in the value we provide the manufacturers and Len will be an articulate spokesman for us on that regard.

Kurt and I were just out at the National Association of Chain Drugstores and many of the large pharma manufacturers were there and we got very, very strong endorsement, both of the concept and the individual that we're bringing into that organization, so we're very excited about Len.

Do you anticipate, Dave, that, or Kurt, that any of these relationships will be moved forward more quickly oh do you still anticipate it's going to be just as they come up for renewal?

I think it will be as they come up for renewal, but I do think Len will allow us to articulate our value proposition in manufacturer's terms a little more effectively than we were able to do on our own.

He does provide that perspective to us.

So I think it's probably steady as she goes.

These contracts will evolve as the existing agreements expire and we bring new thoughts to bear with the manufacturers.

We're doing a lot of work internally here to make our case for the manufacturers of what our role and what our value is and Len's going to pick the ball up on that for us.

Thanks for your comment.

You're welcome.

Next question, please.

Robert Willoughby from Banc of America Securities.

Please go ahead.

Thanks, Dave, Kurt, or Mike, can you possibly detail your kind of needs for cash in the coming months and are we closer to share repurchases or any larger acquisitions with the debt upgrade?

This is Mike, Bob.

Certainly we're very happy with our operating cash performance again, generating just under a billion dollars over the last 12 months.

With that cash we've done a number of things.

One is continue to expand our network expansion program.

Number two, we have made acquisitions over the last couple of years and we expect to continue to do so as we go forward, again, looking at enhancing all aspects of our business both up and down the supply chain.

Obviously, we announced that we're going to use $300 million of that cash flow to pay off our toppers debt, and I think as we move more solidly into investment grade territory we would start to lift some of the restrictions we have today from our revolving credit facilities and open up the possibility of potential stock buybacks to the extent that does it not impact our current ratings.

That's great.

Thank you.

Thanks, Bob.

Next question, please.

That will come from the line of Glen Santangelo from Charles Schwab.

Please go ahead.

Dave, just two quick questions.

You talked about accelerating this distribution center rationalization from three up to five facilities by October.

Could you just sort of quantify or give us any type of idea what sort of incremental savings these two incremental distribution centers can drive and is that solely just a function as loss of the VA on why you're closing those additional two centers?

Secondly, Mike, as a follow-up to that last question can you sort of talk about, you know, what might be involved in terms of getting upgraded from some of the other rating agencies and finally having your debt be classified as investment grade and could that be a material opportunity in terms of lower interest expense going forward?

Thanks.

Hey, Glen, it's Kurt.

Maybe I'll comment on the first half of that with regards to facilities.

You know, we're not prepared to announce which ones we're moving on, for competitive reasons, but as a rule of thumb I would say the savings from each of those, you could probably range, from between $3 to 6 million, sometimes they're less, sometimes they're more than even that range, depending on the size of the distribution center that we're, in fact, closing.

So that's obviously a piece of the savings we want to get but there is obviously a lot more work we need to do as it relates to headcount reductions and other initiatives within the company, which we're actively engaged in at this point, and we still feel very confident we will get the expenses out that we need to for that account and yet continue to make the investments that are right for the business for the long term.

Thanks.

As far as the second half of that question, Len, we continue to have discussions with the other rating agencies.

They both have us on positive outlook and you may have noticed that Moody's even upgraded our short-term liquidity rating in the past week or so.

So we think we're making good progress.

Obviously a key metric for us is the end of December when our convertible debt becomes callable and if that goes as we anticipate we think that should be a big impetus to us becoming investment grade with all of the agencies.

Thanks for the comments.

Thanks, Glen.

Next question, please.

And that question will come from the line of Ray Falci from Bear Stearns.

Please go ahead.

Good morning, thanks.

I guess two questions related to the VA.

My first is on free cash flow or operating cash flow, however you want to answer it.

Do you have any thoughts on what that does to you in terms of freed up cash flow, and might we see that in the next quarter or two, just sort of directionally.

Secondly, on the operating margin side, as you anniversary the VA, just wondering if could you even directionally give us a sense for when you think you might get back to a point where operating margins are expanding in the pharma distribution segment.

Ray, this is Mike.

The VA, as the business goes away, there is a potential that we will have some cash free up and give us some potential up side.

Certainly, you know, it's happening in the middle of the year and we've got a lot of potential uses for that cash from an operating perspective, and I think that's our preferences that we would use that money to reinvest it in our business.

As far as operating margin expansion, we think once we anniversary the VA in May of '05, we would start returning back to our normal model, which talked about single-digit basis point operating margin expansion in the pharmaceutical distribution segment.

We don't see any impediments that once we anniversary the VA.

Great.

Thank you.

Thanks, Ray.

Next question, please.

That will come from the line of Larry Marsh from Lehman Brothers.

Please go ahead.

Thanks.

Just wanted to follow up a little bit, I guess for Mike DiCandilo, I won't screw that up yet, give me time, but which is the 11 million reduction in expense accruals, is that a one-time item or is that more of an ongoing opportunity to save costs?

Larry, there's a number of adjustments to accruals every quarter and I think what we've said is that when they are material we would let you know and we just happen to let you know, they are sort of the type of things that happen every quarter.

We had a number of items this quarter and the largest ones, again, relating to health benefits, just to give you an example of prior year change in our vacation policy resulted in a smaller accrual that we expect following the transition for that policy and we also had positive experience in the health claims area where processing lags decreased significantly from historic levels, again, leading to a smaller accrual.

So again, those type of things are there every quarter, and to the extent that they netted to a significant number, we brought it to your attention.

Got it.

Then the gain on the sale of assets in the technology business, I know that cumulated into the $3.6 million benefit but what was the specific gain?

We have an investment in a noncore software company that sold a majority of its assets during the quarter and our equity share of that gain is what's reflected in that equity income line.

I got it.

But was the gain $3.6 million or is that netted?

It was significantly most of that number.

I got it.

I'm sorry, you said the 35 to $40 million settlement with the supplier, that will show up in the second half sometime?

That will show up in the June quarter.

I'm sorry, that is part of your guidance or you said that's --.

No, no, our guidance specifically excludes that gain.

I got it.

Okay.

That explains it.

And then finally, just maybe a bit of clarification on PharMerica.

Dave, you said in the past this is a business where you could really grow it through adding beds and such.

Are you in a position for next year to reinvigorate that top line through addition of beds?

We are, Larry.

In fact, we're in the process of reinvigorating it right now.

I don't want to imply that it needs any reinvigoration.

I think it's going very, very well.

What happened was we had one of our large account was acquired by a company that did not do business with us so we took a loss as a result of that.

With that exception with feel like we're doing very well, we're getting good increases in the marketplace.

Again, we're very, very disciplined, as is demonstrated by our bad debt position, but we're very, very optimistic about that business, Larry, and we like it.

Thanks.

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

Please go ahead.

Thank you, good morning.

Two related questions, if I might.

One, could you talk a little bit about how would you look to manage some of the potential service-level implications of accelerating the distribution center closure framework that you've outlined here on the call, particularly since, as I understand it, the new facilities wouldn't come up any faster than it was originally blueprinted.

And then related to that you talked about the strong growth in the specialty distribution portion of your business.

Is there a threshold at which you would consider breaking that out as a separate segment and could you talk about U.S. bio services as a part of the performance in the specialty segment of the business and the quarter?

Thanks.

Chris, in terms of managing the service level, one of the things that gives us great confidence in our ability to be able to accelerate some of these closures is the good success we've had in the closure we've already done.

As you will recall, we started out with 51 distribution , we're now operating at 37, and we've made those closures without skipping a beat.

Literally what happens to us is we build up the inventory in the distribution center that's coming on line so at some point we run with dual inventories.

We reflected that number back to you a number of times to remind everyone that that happens.

In the case of Sacramento we're sitting here toward the end of April.

We're literally receiving merchandise in there as we speak.

It will be fully operational when we throw the switch to have it fully operational we will have duplicate inventory.

So we run with duplicate inventories to make sure the service level issue is maintained.

In terms of breaking out the specialty business, you know, we've elected not to do that.

A large portion of the dollars of that business, the revenue dollars, continue to be in the distribution business, that is oncology distribution, vaccine distribution, and the like.

So at this point we do not anticipate breaking out that separate P&L as as we go forward.

Dave, any change in fill rates or other internal service metrics that you follow closely over the last six months or so in light of some of the facility integrations you've already done?

I'll tell you, Chris, it really hasn't affected our service levels one iota. we watch it very,very closely.

I literally get a report on that every single day from every single distribution center.

I've got to tell you, we've done an outstanding job of maintaining service levels, and it has not been an issue with a single customer that I know of.

Great.

Thank you.

Next question, please.

That question will come from Eric Coldwell from Robert W. Baird & Company.

Please go ahead.

My main question was asked, so since I have the venue I'll go to another one.

You've add few weeks of the VA contract at a new pricing schedule.

I'm curious if you can give us some sense of your experience with profitability of that kind of contract under this new schedule.

And as a follow-on could you address the topic brought up in the management discussion about having to get a little more aggressive on pricing to maintain market share?

Thank you.

Eric, this is Mike.

Certainly we were happy to have the VA contract for a few more weeks.

We would have been happier if we had it at our old price or at our proposed price, and I think the price differential has offset the majority of the benefits from the additional time that we've had with that contract.

With regards to competitive pricing I guess I would just add that, as Dave said, we're going to continue to be -- you know, take the stance that we will preserve the business that we have today.

Having said that, the guiding principals for our organization are we want to drive returns on committee cap on those contracts north of 20% so this is a cash generative business over the long term, and that we continue to articulate the value that we provide to them and we are actively engaged on both those initiatives within the company.

So, I'm where Dave is.

We're hoping for a turn here, we're starting to see it a little bit, and hopefully we'll get some progress on the south side here in the months ahead.

Thank you, Eric.

Next question, please.

And that question is from the line of Ricky Goldwasser from UBS.

Good morning.

Two questions.

Can you quantify the impact of the LIFO adjustment on drug distribution margin.

And then earlier in the comments you said two-thirds off the drug distribution business is now under some IMA contract.

What percent is up for renewal over the next 12 months?

Ricky, this is Mike.

I'll hit the LIFO question.

As we said our charge in the quarter was down $10 million from this time last quarter, and as usual, again, that's a direct reflection of the decrease in the spec inventory profits we had on a LIFO basis.

Again, I caution people to look at that time LIFO charge on its own without considering the full impact of the price increases.

Ricky, in terms of what's up for the next 12 months, I don't know off the top of my head.

These are kind of rolling discussions and rolling contract, so I can't give you a hard number on that.

Maybe the only color we can add to that is these tend to have contract terms of a year to two years on average, so you can expect that kind of anniversary and that kind of rollover event in terms of renegotiation.

In terms of, just going back to the LIFO adjustment, I know that you do, when you do the year-end budget or the budget for the new fiscal year you take into consideration inventory levels and pricing.

Have you seen things changed over the last three to six months, so as to changes kind of happening in the fast rate that you budgeted originally?

I think the rate of price increase that we've seen over the first six months of the year is very consistent with our expectations and very much in line with historical levels.

I don't think we have any change to our estimate for the year.

I think I've said earlier that we think that our LIFO charge for the year may end up being slightly less than last year, again, due to the effect of the IMA's and the fact that we're going to have less spec inventory in our inventory, less appreciated inventory, that is, in our inventory at any point in time during the year.

And certainly as we said in the past, the snapshot is a very volatile snapshot and can be affected by price increases between today and the end of the year and can be affected by branded generic introductions amongst other factors.

So it remains a very dynamic calculation.

But, right now, I think appreciation has been in line with our expectations and we would look to a LIFO for the year slightly less than last year.

Thank you, Ricky.

Thank you.

Next question, please.

Thank you.

And the next question will come from Kevin Berg from Credit Suisse First Boston.

Good morning, it's actually Noah [INAUDIBLE] sitting in for Kevin.

Two quick ones.

After the distribution center buildout that you guys mentioned this morning, where will you be in terms of capacity compared to, I guess, today, and maybe if you can answer that exclusive of the VA contract and advance PCS for the business, that would be great.

Secondarily, I guess, Mike, as it relates to the single digit basis point expansion opportunities after May '05, can you guys give a little detail as to where you think those will come from maybe, you know, excluding acquisitions

In term of capacity, capacity is a little bit of unique issue in the Pharmaceutical Distribution business because what we do is we distribute, you know, very high-value products that have a very small cube.

So capacity is a little bit unique in our industry as opposed to a lot of other industries.

Having said that, I will tell you we've designed our distribution network to carry us easily seven to ten years past where we think the business will be when the network is completed.

We've built these 300,000-square-foot distribution centers with ability to expand by double.

They can go to 600,000 square feet.

It's difficult for to us imagine any kind of throughput in the industry that we would not be able to act com day.

We're highly confident that we'll be exactly where we need to be.

Noah, from an operating margin perspective, I think our operating margin expansion is going to continue to be driven as we go forward by operating expense leverage, both the natural or inherent leverage we've talked about, plus the fact that we're going to have a couple of our new facilities that we're very excited about up and running, adding to that.

In addition, I think we're hoping to see a period of stabilizing vendor margins as we anniversary the impacts of some of the reductions that we've seen in things like deals offered by the manufacturers and additionally we're very hopeful that customer margins will stabilize.

Okay.

Great.

On that operating expense, you guys have obviously done a good job.

The last, I guess, two quarters on year-over-year basis, on an absolute basis, SG&A has been down.

Should we expect that to continue or how should we sort of think about that?

Well, I think you should continue to see declines in our operating expense ratio consistent with what we've had the first couple of quarters.

We had a favorable receivable reversal in 1Q and some favorable things this quarter.

It may make it hard from an absolute dollar perspective but we certainly expect our operating expense ratios will continue to show the decline year to year.

Great.

Thank you.

Next question, please.

That will come from Andy Speller from A.G. Edwards.

Please go ahead.

I have a couple of questions.

First, with regard to the $300 million toppers you're going to pay that off in total, you are not going to refinance that?

That's correct.

And then secondly with regard to the two additional DC's, and the savings there, I think in the past, unless I'm making this number up, I think we were looking at anywhere from 30 to $50 million worth of additional costs with regard to the VA contract.

If closing these two DC's only gets you maybe $12 million, where are we going to see the rest of the expense reductions coming from?

Most of that, Andy, it's Kurt.

Most of that will come out of headcount reduction in those distribution centers that have been servicing that account.

Those are direct variable costs, as well as deliveries and so forth.

That's not included in just closing the facilities?

No, because that business is serviced throughout our entire network today.

And then clearly there are semi variable costs in terms of some of the administrative and corporate departments that we'll need to down size as well.

We are taking a look at that.

So again, we're looking broadly across the organization.

We feel confident that we can achieve that target and we're working aggressively toward it.

Andy, for the record, we talked in terms of the relative of $40 million roughly 1% of the $4 billion.

So not the 52 or the other numbers you were throwing around.

If I could follow up there, so in terms of timing on when all those costs will be out would they be out by November 1st of beginning of the new fiscal year or is it going to take time during the fiscal year to get those costs out?

Our target is to have most of those costs out for the full fiscal year.

Certainly the delay in the VA or the fact that the VA contract is going through May, delays that a short period of time, so I think the November time frame is probably a fair time frame.

Okay.

Thanks a lot.

Next question, please.

We've got time for two more.

The next question is from John Ransom from Raymond James.

Hi.

Good morning.

I'm just trying to get some of this historical comparison data straight.

Last year obviously you guys had three contracts go away.

This is excluding the VA.

Our notes and memory were they totaled about a billion dollar in total between anthem, tenant, and publics.

Could you just remind us, from a timing stand point, when those contracts ebbed away from your revenues over the past four to five quarters roughly?

They roughly anniversary the March quarter, John.

The three you talked about, tenant, anthem, and publics, were out in March.

So they ebbed away between March and June a year ago roughly?

No, they were roughly gone by the end of March.

Starting April 1st we've anniversaried them.

Okay.

Thank you.

You're welcome.

One more question.

Our final question will come from Steve Halper from Thomas Weisel.

Hi.

Just a point of clarification.

The 410 to 420 does that exclude the items that you mentioned during the call?

Yes, Steve that excludes those items.

It specifically excludes the antitrust litigation and it specifically excludes any loss on the redemption of the toppers facility.

Sure.

And just as a follow-up in the specialty business, could you give us a snapshot on what's going on with the medical oncology space given the changes in reimbursement there?

It sounds like your business continues to track despite some change in the environment.

Yes, Steve, it's Kurt.

The reimbursement environment is stable for the remainder of this calendar year and you're right, the business does continue to track at a very nice rate.

Obviously there's a lot of discussion about oncologist reimbursement levels starting for next calendar year, a lot of discussion about ASP and what kind of add-ons should be attached to ASP.

It's too early to know exactly how that's going to come out, but rest assured that we are working multiple strategies within our business units here for a different whatever type of reimbursement environment may come down the pike for next year we still feel very confident about the business unit.

Do you still think you're holding your margins in oncology today?

Yes, I would say we are holding our margins today, given the basket of service that we're providing to the physicians.

Last question, do you think you're gaining mark share in oncology?

Yes, we do.

Thank you all very much.

We'll now close questions.

Now I'd like to bring David Yost back , who would like to make some final comments.

We want to thank everybody for joining us on the call.

In the interest of everyone's time we'll cut it off.

But we continue to be very, very bullish in the industry.

As I mentioned, we think we've great a great value-added service program and we're very, very excited about our prospects and we look forward with sharing our June results with you in July.

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