美源伯根 (ABC) 2004 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the AmeriSourceBergen Third Quarter Earnings Conference Call.

[Operator Instructions]

And I'd like to turn the conference over to Michael Kilpatrick of AmeriSourceBergen.

Please go ahead, sir.

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

I'm Michael 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 Michael DiCandilo, Chief Financial Officer.

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 some 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 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 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 about our opening comments.

And here is David Yost, AmeriSourceBergen's CEO to begin our remarks.

Good morning, and thank you for joining us.

For the third quarter fiscal 2004 we delivered solid performance.

We had double-digit operating revenue growth excluding the impact of the VA.

We continue to focus on expenses with total corporate operating expenses below last year's level, even with our acquisitions and the pharmaceutical distribution segment continuing with total expense to revenue under 2%.

Corporate operating margin was impacted by the VA business, customer mix and competitive pressures.

We have strong cash generation for the quarter of well over $600 million and recurrent committed capital was over 27%, a key company metric and good barometer of our fiscal discipline.

Fully diluted EPS was $1.02 before special items several cents ahead of consensus estimates.

All in all, a solid quarter.

We just returned from our annual three-day meeting with our retail customers called the national healthcare conference and exposition in Las Vegas.

And it has emerged as the premiere meeting for pharmaceutical retailers.

This year we have almost 7,400 people in attendance representing thousands of retail customers, including independents as well as national and regional chain pharmacies.

We exceeded our internal goals for sale of product and services at the event, including automation equipment, diabetes shop and PROGEN generics.

We awarded over 11,000 certificates for continuing education to pharmacists, the largest number ever awarded in any such period by any organization.

We continually ran a video of our first new distribution center that went live in Sacramento last month and it generated great interest and comment.

I had the opportunity to visit with dozens of customers, was impressed with their entrepreneurial spirit, their confidence and their ability to compete and their optimism regarding their individual business and retail pharmacy in general.

We, likewise, continue to be very optimistic about our retail opportunities.

I'd like to hit a few broad industry and ABC topics.

First, IMAs.

Just to -- so there's no confusion, we are currently paid under IMAs and IMAs have been a good offset to the money AmeriSourceBergen was making on speculative purchasing as we anticipated.

Two issues continue to exist regarding IMAs.

And they are the trigger for the IMA payment and the amount of payment received under the IMA.

First regarding the trigger.

We do not think that the trigger or mechanism for payment under an IMA should be a price increase as is often the case today.

Tying IMA payments to price increases can cause volatility in the receipt of payment and does not match up the payment with the service provided.

We propose moving to a fee for service where we are paid for services we provide to the manufacturer as they are provided, independent price increases.

Second, regarding the amount of payment.

While the IMAs have been a good offset for the money we were making on speculation, it has not offset the total vendor margins we previously received as opportunities for deals and secondary source purchasing have decreased.

The value provided to the manufacturer by AmeriSourceBergen is literally a fraction of what it would cost the manufacturer to replicate the services.

We maintain, therefore, that upside exists in dollars received under fee for service arrangements and will be realized as a manufacturer understands the services we provide and their cost.

The evolution to fee for service will take time and generally occur as the IMA agreements that are usually one to two years in duration are renewed.

The evolution is progressing at about the speed we anticipated and previously articulated.

And Kurt will detail with you our strategy for getting to a fee for service environment.

IMAs have resulted in a more efficient distribution channel with total inventory in the channel being reduced.

The channel downstream from us to our customers is currently very efficient due to the prime vendor relationship, which is customer-driven.

In a prime vendor relationship, the customer buys substantially all of their product needs from the wholesaler receiving product literally hours after placing their order.

Our customers do not have the staff to order, receive and pay for product for multiple suppliers nor the space to stock more than a few days supply of inventory.

The prime vendor system has resulted in an extremely low inventory investment by our customers.

We continue to monitor the pharmaceutical importation issue coarsely and are considering all of our alternatives with the assistance of outside consultants to be sure our customers are not disadvantaged if such legislation is passed and implemented.

With over one million square feet of production capability and packaging and our extensive distribution network it is possible the importation could provide us new opportunities.

The devil will be in the details though.

And safety and security of the supply channel will be the key consideration for AmeriSourceBergen.

Earlier in the quarter we announced that the OIG issued a notice of action to PharMerica.

It is important to note that the alleged violation involves no billing discrepancies or patient care issues and does not involve any current procedures or policies.

No current PharMerica or ABC executives were present at the time of the alleged infraction.

The OIG is alleging that the amount paid for Hollins Manor in 1997 constituted a violation of anti-kickback statues.

It is important to note the time frame, 1997, which was two years before Bergen Brunswig bought PharMerica and, of course, long before the merger that created AmeriSourceBergen.

Without getting too granular, I will note that prices paid from properties often far accede tangible assets for good business reasons.

We think this case is totally without merit and will defend our position vigorously which could take several quarters.

We continue to be very enthusiastic about the long-term care sector and note that our position in this space and our strong, growing and diversified specialty pharma business differentiates us from our peers.

We are happy to renew our Kaiser relationship during this quarter.

You may recall our contract with Kaiser was due to expire in December of this year.

As we have noted previously, we have four tough quarters ahead of us as we strip out the costs associated with the VA and advanced PCS, and the ripple affect the VA award has had on the industry.

We are up for the task and the work has begun.

As we implement our optimized program, additional operating synergies are available to us and their capture remains on schedule and on budget.

We continue to be very optimistic about our role in the pharmaceutical distribution business and related businesses we participate in, including long-term care, specialty pharma distribution related support services, packaging and technology.

Our budgeting process for our new fiscal year that begins October 1 is in full swing.

And though we are not immune from market forces, absent the impact of the VA and advanced PCS, we expect to be affected less than our peers due to our different model.

We can and will deliver long-term replicable, sustainable earnings.

Now let me turn the floor over to Kurt for some details.

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 views on a few key industry issues as well.

In our pharmaceutical distribution segment, we saw solid performance across nearly all of our business units, in particular our specialty group and delivered near double-digit revenue growth despite the anticipated loss of the VA business in the quarter.

Our cross-selling capabilities continue to mature with key account wins in each customer segment, using offerings from our specialty technology and packaging groups to create differentiated solutions.

Savings from our integration activities continued with operating expenses down in absolute dollars versus year ago levels.

Margins, however, were impacted by the VA loss.

And the continued effects of the need to match price competition to maintain market share.

The precedent set by the recent VA pricing continues to be a point of discussion in the marketplace with both customers and manufacturers.

Importantly, vendor margins were in line with our expectations as higher IMA fee income offset, in large part, historical vendor margin contributions from price appreciation.

As a result of these agreements, inventory levels were again down significantly from last year, but, importantly, virtually flat for the past three quarters supporting stable comparisons in 2005.

For the third quarter the benefits of this dynamic were principally reflected through extremely strong cash flow and in the P&L through lower interest expense, which Mike will detail.

Much discussion continues regarding fee for service agreements with our manufacturer partners.

Let me take a minute and outline how we are approaching this change.

First, we are using a collaborative approach in working with our manufacturing partners.

Our manufacturer discussions are focused on educating them more thoroughly on the services we provide and identifying opportunities to improve practices, which lower costs and improve the overall efficiency of the pharmaceutical supply chain.

Ultimately, the agreements need to be tailored to the unique needs of each manufacturer based on these discussions.

Second, in terms of compensation, we've made clear the need to be paid fairly for the services we provide, and, importantly, share in the additional savings we are able to generate.

In the end, it is our expectation that compensation will be periodic, volume and activity based, not price increase event based.

We support the concept and incentives be built in to drive proactive management of shared supply channel challenges such as counterfeiting, supply shortages and the like.

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

Lastly, we view this as an important opportunity for us to discuss the unique service capabilities of our other group companies.

Our approach, built on the principles of collaboration and transparency, will be healthy to the overall supply chain, eliminating excess inventory, improving operational efficiencies, and helping to secure supply chain integrity.

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

As we showed in last quarter, we have accelerated the consolidation plan of our distribution center network.

Likewise, variable and semi-variable costs directly associated with the VA account have been identified and work plans are being executed to eliminate those costs.

Our current budgeting process is focusing on reducing broader, corporate costs in response to this business shift.

Deployment of the optimized program, our plan to complete a new, highly automated distribution center network, remains solidly on track.

Internal results during the June quarter continue to validate our efficiency, accuracy, and cost saving assumptions.

For example, with data now in, the implementation of our warehouse management system in one of our largest distribution centers has increased productivity beyond our original 40% target.

Importantly, also, we successfully opened the first of our six new Greenfield distribution centers in Sacramento.

This large, highly-automated facility came online on time and on budget and with no customer issues.

Our second new facility in Columbus, Ohio, remains on budget and on schedule to open this fall, and the remaining four will come online after that in approximately six-month intervals.

Importantly, during the June quarter, we achieved our original target of merger cost savings of $150 million.

This is one quarter ahead of our original timetable, and we remain confident that as we complete our new distribution network, we will drive significant additional cost savings beyond $150 million in the years ahead.

Now let me turn to the specialty group.

The specialty group had another excellent quarter of strong sequential growth.

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

A couple of highlights from the quarter include the group completed the acquisition of Imedex.

Imedex will provide accredited physician education programs designed for, specifically, physician practices currently serviced by the specialty group, as well as future potential practice areas.

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

And at the end of the quarter added a large and highly respected physician practice to industry-leading customer base.

An important issue on the horizon for the specialty group is a potential change in the federal government's reimbursement for oncology pharmaceuticals.

Currently, physicians are paid based on average wholesale price, which is set by the manufacturer, not us.

The government has changed to reimbursement system based on average selling price determined by a formula that is currently being developed.

The key for ABC is if divisions continue to receive adequate reimbursement from a combination of the drug price and other patient services so they will continue to administer the specialized pharmaceuticals in their offices and we will continue to distribute the products to them.

We are monitoring these issues in Washington very closely.

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

We continue to add capacity to both the American Health packaging and Anderson packaging business units during the quarter.

A pipeline of new projects within the packaging group is strong and growing, and we continue to expect the patient compliance needs and the new regulatory initiatives regarding bar coding and anti-counter fitting will drive significant growth opportunities for the packaging group in future periods.

Changing to our technology offerings for just a moment.

Our technology group continued to -- its focus on bringing two market solutions, which drive patient's safety and pharmacy efficiency.

The group's order backlog continues to grow during 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.

As a good indicator of demand, the technology group sold over $2 million of automation equipment during four hours at our recent health care conference, with another $3 million to be signed over the next few weeks.

Retail pharmacists have a growing appetite for our pharmacy automation technology, as they wrestle with reimbursement constraints, increasing script volume and a shortage of both pharmacists and pharmacy techs.

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 this business for a number of reasons.

First, the long-term growth prospects of this business are attractive and sustainable.

Clearly, we're disappointed in the business's top line performance this year.

But we have made adjustments to our sales and marketing approach, which is gaining traction in the marketplace.

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

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

Lastly, multiple cross-leveraging opportunity exits with other parts of AmeriSourceBergen allowing for the creation of incremental learning streams.

Finally, just a brief comment on the continued development of the AmeriSourceBergen executive team.

During the quarter, we announced internally that hiring of a new Senior Vice President and Chief Information Officer, Tom Murphy.

In that role, Tom will lead all IT activity for the entire corporation.

Tom is highly capable and energetic.

In 2002, Tom was named to Computer World's Premiere 100 list, which honors IT professionals who are considered to be exceptional leaders.

Tom will be located in Valley Forge, reporting to me, and will serve on the AmeriSourceBergen operating committee.

Tom has replaced Linda Burkett, who early in the year had made the decision to retire after 35 years with the company.

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

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

I will now turn the call over to Mike for a review of the financials.

Thanks, Kurt.

Good morning, everyone.

Our third quarter results reflect our ability to adjust to the changing business model in our industry, and were highlighted by strong operating cash flow, debt reduction, significantly reduced interest expense, and strong expense control, all of which contributed to offsetting in part of the adverse impact of the VA contract termination.

My comments in year-over-year comparisons will exclude the effects of the $38 million antitrust litigation gain, $23.4 million net of tax, which is reflected in cost to goods sold.

The $14.5 million net charge related to the Toppers debt redemption and the $1 million net charge to the P&L related to facility consolidations and employee severance costs.

As a reminder, in the prior year we had a $2.6 million net charge related to debt redemption and a $2.4 million net charge related to facility consolidations and employee severance.

Now, starting with the results for the consolidated company.

Operating revenue for the company was $12.1 billion for the quarter, up 6% over the prior year period due to the growth in our pharmaceutical distribution segment.

Bulk delivery revenue increased 2% from the prior year to $1 billion.

During the quarter the company changed its accounting for customer returns to reflect an accrual for estimated returns at the time of the sale to the customer.

Previously in accordance with industry practice, the company accounted for customer returns as a reduction to sales and cost to sales at the time of the return.

As a reminder, the company's customer return policy generally allows customers to return products only if the products can be resold at full value or returned to suppliers for full credit.

The impact to the quarter for this change is a one-time reduction to sales and cost to sales of $320 billion with a corresponding increase to inventory and a reduction to accounts receivable for the same amount.

There is no net earnings impact related to this change which was made in response to an SEC comment arising from their review of the company's September 30 2003, 10-K.

The company's accounting for returns was the only matter raised by the SEC in its review.

Operating income was down 8% in total compared to last year's quarter as pharmaceutical distribution EBIT declined 11% and PharMerica EBIT grew 15%.

The consolidated operating margin of 1.76% declined by 26 basis points from the prior year quarter, primarily due to the VA contract loss.

The $ 4.9 million of other income represents the company's receipt of a liquidating dividend from one of its technology, equity investments.

Interest expense for the current year quarter was a record low $26.8 million, compared to $37.2 million in the prior year quarter, a significant decrease of 28%.

Net average borrowings in the third fiscal quarter of '04 decreased to a record low $743 million compared to $2.7 billion in the prior year due to significantly 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 Q2 and lower than the 39.2% in the prior year quarter.

Earnings per share for the quarter decreased 1% to $1.02 per diluted share before the special items mentioned in my opening comments compared to $1.03 per share reported last year on the same basis.

And were up by 10% to $1.09 per diluted share on a GAAP basis.

Moving to the pharmaceutical distribution segment.

Operating revenue for the segment was $11.9 billion, up 6% compared to last year's quarter.

Excluding the accounting change for returns mentioned previously, operating revenue would have increased 9%.

The customer mix in the quarter between institutional, which includes health systems, alternate site pharmacies, mail order pharmacies, and our specialty group at 58%, and retail which includes independents and chains at 42%, changed slightly from the prior year as our institutional business grew 8% and our retail business grew 2% compared to the prior year quarter.

The institutional growth was once again driven by the continued above-market growth in our specialty distribution business.

The VA at over $400 million and advanced PCS at just under $600 million in sales during Q3 together accounted for 8.4% of pharmaceutical distribution sales in the quarter.

Our retail growth in the current year quarter was adversely impacted by the low market growth of a certain number of our large regional chain accounts.

However, independent revenues grew in double digits once again, continuing their strong growth noted last quarter.

We expect operating revenue growth to be in the low single digits in Q4 of fiscal 2004, reflecting the full quarter effect of the VA, the transfer of the advanced PCS business in mid-August, and solid growth for the rest of the business.

In the pharmaceutical distribution segment gross profit margins were down by 30 basis points compared to last year's quarter primarily due to the VA contract loss and the continuing competitive environment, which has led to a number of contract renewals over the last 12 months with reduced customer markups, as Kurt mentioned.

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 and deal in other buy-side opportunities.

With regards to LIFO accounting, we recorded a charge this quarter compared to a charge of $11.8 million in the prior year third quarter, reflecting the lower levels of spec inventory in the current year.

Total operating expenses as a percentage of operating revenue of 1.99% improved by 2 basis points for the quarter compared to the same period last year.

This improvement was again driven by ongoing merger synergies.

The operating margin in the quarter was 1.53%, a 28 basis point decline from the prior year quarter reflecting the reduction in gross margin previously discussed.

Turning to PharMerica.

They again had a very strong quarter despite lower revenues.

Revenues of $390 million were down 2% compared to last year's quarter due to the prior year customer lost and the worker's compensation business and the discontinuance of the products business and long-term care as well as the loss of a long-term care customer due to acquisition.

However, operating income was up a strong 15% as continued focus on expense reduction in both long-term care and workers' comp resulted in a 325 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 120 basis points.

Operating expenses in the third fiscal quarter declined $15 million from the prior year quarter, primarily from headcount reductions as well as improvement in bad debt performance including a $4 million recovery from a customer who emerged from Chapter 11 bankruptcy and sold their business.

Now, turning to the balance sheet and cash flows.

The changing business model in pharmaceutical distribution has had a dramatic positive impact on our working capital and cash flows over the last 12 months.

With IMA-type agreements now covering two-thirds of our total business and approximately 80% of our brand name pharmaceutical sales, our inventories have been reduced by $1.1 billion or 14 days, since June 30th of last year.

This dramatic reduction in inventory combined with strong operating results has produced $1.8 billion of cash from operations in the last 12 months.

Almost one-half of that amount, or $870 million, has been used to reduce debt, including over $300 million this quarter, primarily to retire our topper's debt and an additional $265 million have been invested in capital or acquisitions to grow our business.

With $900 million of cash on our balance sheet at the end of June, ABC has the highest level of financial flexibility it has ever had; and you can expect us to prudently deploy our capital to maximize returns for our shareholders.

Total debt to capital at quarter end was a record low 25% compared to 37% last year and net debt to capital was a record low 11% compared to 35% last year.

All of our credit ratios remain in strong investment grade territory, and as we move towards investment grade with all of the agencies, we would expect our financial flexibility to expand even further as certain covenants and other restrictions on capital usage are relaxed.

From a statistical standpoint, average inventory days on hand were 43 days during the quarter, compared to 57 days last year, and we would expect those days to drop into the high 30s over the next couple of years, as we complete our optimized program.

DSOs for pharmaceutical distribution were 17.7 days versus 17.2 days last year, reflecting the changing customer mix and above-average growth of the specialty business where DSOs are in the low 40s, and PharMerica DSOs were flat at 39 days.

Our days payable outstanding were flat at 40 days as well.

Net working capital to operating revenue in the quarter was a record low 5.4%, a significant reduction from last year at June 30th when working capital to operating revenue was at a record high 9% level.

CapEx was $59 million in the quarter.

We expect CapEx to be $175 million to $200 million for the year.

Cash generated from operations for the quarter was $634 million compared to usage of $177 million in the prior year quarter.

With over $650 million of cash generated from operations through nine months, and no dramatic changes in inventory expected over the next three months, cash flow from operations through the years should remain in excess of $650 million, well above our previous guidance of $350 million to $400 million.

Return on committee capitalm, or ROCC, which, you recall, is one of our primary internal financial measures and defined as the EBITDA before special charges divided by receivables plus inventory plus PP&E less payables on a rolling 12-month basis, was 27.7% for the quarter, well above our long-term goal of 20%, with each of our business units also exceeding 20% once again, as the dramatic reduction in working capital more than offset the EBIDA decline.

Once again, the change in model has produced exactly what we thought, consistent appreciation in dollars, less investment, lower interest expense and strong returns.

Our EPS guidance for fiscal '04 remains at $4.10 to $4.20 per share, which excludes special items, the loss on the Toppers debt redemption, and the antitrust litigation settlement.

And as mentioned in the press release, we are most comfortable with the middle of that range.

As usual, we will give '05 guidance in November when we report fiscal '04 results.

Following the anniversary of the VA loss in May '05, we would expect to return to return to a model consistent with our long-term financial goals, which include double-digit revenue growth and EPS growth of 15% or more annually.

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

Thank you, Mike.

We'll now open the call to questions.

I would ask you to limit yourself to one question only, until we've had an opportunity for everyone to get in the queue, and then, we will take additional questions if we have time.

Go ahead, Leah.

Thank you.

[Operator Instructions]

Our first question is from the line of Tom Gallucci from Merrill Lynch.

Please go ahead.

Good morning.

Thank you.

I wanted to explore the transition to our fee for service just a little bit more on two fronts.

First, I guess you expect more of these types of arrangements to go into place as you set IMA's that are currently out there expire or come up for renewal.

We have heard some manufacturers in the last few weeks talk about signing new IMAs, and they seem to be more of a hybrid type of an agreement, partially based on fees, partially based on price increases.

I'm wondering if you could comment kind of on where we stand in that area?

And then, I think, Kurt, you mentioned looking to be more activity-based, and I think you mentioned volume in there.

Do you still expect to get kind of paid on a percent of revenue by product or are you moving more towards volume or how do you see that developing?

I'll take the latter first, Tom.

I mean, we're talking to manufacturers, obviously, percent of revenue, because that would most closely assign the fee income to the services that were provided for them and it assures that our compensation levels remain adequate in future periods.

But you're right in your -- I think you're -- the feedback you're getting from the manufacturer is accurate here.

We're in discussions at different stages with all of our manufacturers.

And we do, in fact, have some hybrid models out there.

And I think it speaks to the fact that this is not a flip of the switch transition here.

This is an evolution over time, you know?

Importantly, we made this announcement last quarter.

I didn't comment on today in my prepared remarks, but Len DeCandia is starting to make significant inroads with our manufacturing partners and really engaging a level of dialogue we historically, here in this organization, have not had with our manufacturing partners, which was the intent of bringing Len on board.

Len was 22 years with large Pharma and most recently with Hoffmann-LaRoche.

So he has brought a level of perspective and intelligence and experience to this process that we really wanted, and he's been excellent for us.

So we continue to remain optimistic.

It's a very manageable transition that we're going through here, and we remain confident we'll get through this thing very nicely.

If I could ask Mike on the same topic, inventory, you said you're getting into the high 30's as a result of the optimized program.

Do you expect the fee for service transition to take the inventory data down even further over time or are you at a level you think is sustainable?

Yes.

We think the big drop, Tom, has really already occurred as a result of the IMA agreements.

And I don't think we expect a fee for service to drive the inventory down any further.

I think, you know, our customer mix and our efficiency as we continue the optimized build out will be the prime factors in driving down our inventory as we go forward.

Very stable -- kind of steady as she goes -- as we go forward, Tom.

Thank you.

You bet.

Thank you, Tom.

Next question please.

From Lisa Gill from JP Morgan.

Please go ahead.

Thanks very much.

Good morning, everybody.

I was wondering if perhaps, maybe, could you comment -- I think you had talked about the gross margins where some of your other customers are now coming back, looking for similar VA-type pricing.

Are we at a point now where you've had all of those discussions, and we really should have an inflection point now on the gross margins as this being the lowest level this quarter, especially to move forward with the manufacturers?

I think so, Lisa.

I think, you know, hopefully we will have, you know, bottomed out on it.

It's a function of the VA price being posted.

We're now six months into that -- that occurred first part of January.

So we hope that we will see stabilization in the market as we go forward.

No question, though, that the VA pricing has had a ripple effect throughout the industry, both with the manufacturers and with our customers as we predicted it would.

But we are optimistic that we will see stability as we go forward.

Now, even with the gross margins coming down it appears you've done a very job of controlling your cost.

Where do you think that ultimately the cost to revenue ratio can go to?

It's below 2%.

How much further could you bring that down?

Lisa, it's Kurt.

I mean we've got facilities today that we can drive down easily below 1.5%, close to 1%, and in some cases less.

So, we -- I would tell you we continue to be pleasantly surprised, which is encouraging, by the productivity improvements we're getting from some of the systems that we're installing.

So the investments are clearly paying for themselves, and, you know, we may be revising those statistics in a couple of years once we get everything installed and we understand exactly what we're capable of doing.

Let me kind of tie this all together then.

We would expect that probably margins from here could stabilize to start to improve as the cost structure is coming down and gross margins are somewhat stabilizing?

Is that a correct way to think about it?

Yes, I think that's, you know, effectively that's our long-term model, Lisa, and we expect that to happen, you know.

Obviously, the next couple of quarters we're going to have tough comparisons with the VA.

But I think outside of that, the rest of our business should do fine, and when we anniversary the VA, we'll return to that model that we've talked about a lot in the past.

Great.

Thanks very much.

Thank you.

Next question please.

The question is from Robert Willoughby from Bank of America Securities.

Please go ahead.

Thank you.

Dave, I guess to trust this "We know what to do with capital" approach really isn't going to work too much more for distributors here.

Can you at least give us some broad range, maybe three to five years down the line, what some of your ancillary businesses, what would you hope to see them contributing to overall operating income?

Well, Bob, our sweet spot in the past has kind of been that $100 million to $200 million acquisition.

We've made a half a dozen or so of them since 2001 when we put it together.

We're not opposed to doing a larger acquisition, if that presented itself.

But it's not burning a hole in our pocket, Bob.

We've got other alternatives that we consider going forward.

I guess the most important thing I would leave with you is that we do not see going far field from this pharmaceutical distribution channel.

The acquisitions we've made in the past have not only been a contributor on gross profit but have also enhanced our pharmaceutical distribution broad value-added services either up the channel or down channel or both, in the case of packaging.

So that's kind of where we are.

But we certainly don't feel, Bob, that it's burning a hole in our pocket, and we will be very, very prudent going forward.

Thank you, Bob.

Next question.

Next question is from the line of Larry Marsh from Lehman Brothers.

Please go ahead.

Thanks, and good morning.

I heard your conference last week was a big hit, so congratulations on that.

Thank you.

Sure.

Just wanted to clarify something quickly with Mike DiCandilo.

The other income was the liquidating dividend from the technology investment.

Is that a majority of other income and is there going to be any recurring nature to that?

Yes.

That was approximately 98% of that amount, Larry.

And on a go forward basis, we would expect to have very little activity in that account from other investments.

OK.

On the customer accruals, why wouldn't we think of that as also impacting last year's results from a comparison standpoint?

Well, the issue Larry came up with the SEC when they reviewed our September 30 10-K.

And again that was the only issue that they had brought up.

And as a compromise as to our position going forward, we agreed that we would start accruing on a perspective basis.

And they agreed to that.

And that's what we did in this quarter to post that accrual from a one-time perspective.

So it had the effect in the quarter of reducing sales and cost of sales.

As I said, it had no P&L impact and it also raised inventory and lowered receivables by the same amount.

But as we go forward that accrual will stay there being adjusted based on our actual experience.

Alright.

But it had no impact on past years.

Alright.

But obviously from a sales comparison standpoint, we probably ought to think about doing the same thing last year even though you're not?

From a sales comparison it reduced our sales increase by 3%.

OK.

We recorded 6% up and we would have been up 9% after this adjustment.

Right.

And your guidance for Q4, is taking that into consideration?

In other words, you're taking that out of your Q4 '04 number, but not Q4 '03?

Q4 '04 will not be impacted by that one-time adjustment.

It will merely be impacted by any change in that $20 million.

I got it.

OK so this is a catch up this is an adjustment.

OK.

Right.

And then finally just -- you're a little less than $31 million in LIFO choice through nine months, where do you think your years going to come in?

We expect to probably be in around mid-30 range or so, Larry, close to where we were last year.

As you know, it's a pretty dynamic number and a pretty dynamic calculation.

And it could change based on generics, brand name products coming off patents or different price depression in fourth quarter.

But it's a very dynamic number, but we expect to be in the 30s.

Got it.

OK.

Then finally, for Kurt.

You know, your thought on PharMerica.

Obviously the topline results being impacted by some of these customer thoughts.

When do you think we see a topline growth resumption in PharMerica?

Larry, most of those issues that we're kind of comping against right now anniversary in the December quarter.

So I would think when we get, you know, a quarter or so into FY'05 for us, you'll see the topline pick up and then be much more attractive.

Thank you, Larry.

OK.

Nextquestion, please.

Do we have another question.

One moment.

Operator.

One moment please.

OK.

And we move on to line of Christopher McFadden from Goldman Sachs.

Please go ahead.

Thank you, good morning.

Dave, did I hear something about a skirt in Las Vegas?

You did, Chris, but I'm not totally fessing up to it.

The rumor was -- around was that when we open up our trade show, one of the things we do to make sure we get all of the customers, any of the first timers, we have a little parade.

And this time it was a Scottish band.

Rumor has it the CEO had a Scottish kilt on, but that has not been confirmed at this point.

I understand, I understand.

Two questions, if I might.

First of all, is there any impact to your generic purchasing sort of influence with the manufacturer community net of any sort of loss of purchasing power from the VA?

Is that something that affects competitiveness for you in the retail market, particularly, thinking ahead to kind of late 2005, early 2006 when obviously we would anticipate another uptick in generic introductions?

And then, secondly, you -- despite, obviously, a slower rate of revenue growth forecasted for FY'04 into FY'05, you've stayed pretty consistent on kind of the scope and scale of the upgraded distribution network.

And I'm just -- I'm wondering, having had the chance now to rethink some of the cost takeout, is there any scenario in your mind operationally that would potentially reform or delay the buildout of these large new automated centers that you've mapped out for us?

Thank you.

Yes, Chris, I'll take the first and Kurt will take the second.

The VA really has no impact on our generic program at all, though, Chris.

Good question.

But the VA does their own contracting.

So it was totally independent of any of our generic programs and so we had, you know, we had no benefit from it at all.

Kurt you want to comment on the build out?

Chris, I understand the question and we obviously asked that question internally as well and took a hard look at it.

Our conclusion when it was all said and done was we would stay with the plan that was originally formulated.

At the end of the day, you know, the VA volume was important to us, but it will really be dwarfed by the amount of growth that we're going to have over the next 10 to 15 years in this industry, as a result of just continue aging population, the Medicare benefit coming down the pike.

Those buildouts were also important to us to realign our capacity to the faster geographic growth markets in the years ahead.

So there's a lot of reasons why we're going to stick with it.

And as I mentioned, in my prepared comments, the investments we're making there are yielding better results than what we expected.

So I'm confident the capital dollars are being well used here.

And then, finally, if I could ask a brief follow-up, would be just -- generally, you talked about what sounds like some sales activity in AutoMed in the conference in Las Vegas.

I guess just -- can you generally talk about the environment for AutoMed?

Obviously a well-positioned product.

But, I guess, to what extent is your customer as cash ready to go out and make those investments as you might have anticipated?

Thanks.

I would say it's a issuing point you raise.

The demand -- the interest in that product line was multiples higher at this conference than it was a year ago.

I think that's a function of, maybe, an education process we went through last year.

And then also, I think an increasing -- true increasing demand on the part of the pharmacist to try to reduce costs and get a little better quality of life in some cases.

You know, I would also say in the last year, we've also been much more creative in terms of our financing options.

We had more creative leasing opportunities for the customer base out at the trade show.

So that was helpful.

So, I think the fundamentals that are supporting that product lines are intact, and we remain very optimistic about it.

Thanks, Chris, very much.

Thank you.

Next call, please.

And we'll go back to the line of Glen Santangelo.

Please go ahead, sir.

Yes, Dave, just a quick question.

I was curious to, you know, talk a little bit about PharMerica.

I mean, could you comment at all on the competitive landscape there?

I mean, obviously everybody knows that Omnicare is making a competitive for -- a hostile bid here for NeighborCare and it's going to give -- if we make the assumption for a second that a deal ultimately gets consummated, it would obviously increase Omnicare's scale.

Now when you first merged with Bergen back in 2001, I think you referred to the PharMerica business.

I think you questioned the strategic nature of that business relative to your own business.

And now in Kurt's prepared remarks now the -- kind of the Company message is that you like the business.

If you could just kind of give us a sense for how that competitive landscape is evolving, what you're thinking, and maybe long-term what you think about -- are the growth opportunities for PharMerica?

We clearly like the space, Glen.

There's no question when we completed the merger, you know, three years ago we said we have to take a while to get to know the businesses.

We've gotten to know the business.

We like it very much.

We think the growth prospects are very good.

As Kurt talked about we think the cross-selling opportunities are very, very good.

So a space we like.

And PharMerica continues to perform very well.

It's a competitive -- it's clearly a competitive environment, you know, but we're used to competitive environments, and one of the great things about that business, like our pharmaceutical distribution business, is Father Time is our friend there.

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

It's a wonderful thing that the older they get, the more they're inclined to go into nursing homes as well.

So, you now, we think this aging population plays well to us and we like the space.

Comfortable in the space.

Thanks Glen, very much.

Next call, please.

It's from Andy Speller from AG Edwards.

Please go ahead.

Hi, thanks.

Just to follow up on the accrual issue.

That's a one-time setup for that change.

Is that correct?

That's correct, Andy.

OK.

So that, basically, 3% of revenue will change on a go forward basis as you see more or less returns?

That's correct.

We've established, you know, a $320 million accrual, you know, which is essentially based on returns in this industry of about 2% and a, you know, lag of a couple of months.

And to the extend those dynamics stay the same, I would expect that that return accrual would, you know, grow with our sales proportionally.

But we're not looking for big, you know, they're not going to be big adjustments going forward.

No, not at all.

OK.

And then I think you mentioned in, I guess, impacting, I guess, PharMerica in a positive way in the quarter was a $4 million, I guess, reversal of bad debt.

Is that right?

That's correct.

They had a recovery from a bankruptcy.

And a customer emerged out of bankruptcy, sold their business and we got paid for previously reserved bad debt.

Wonderful thing.

OK.

So I mean, that -- I mean, we wouldn't expect an 8%-type operating margins then on a go-forward basis for PharMerica.

It's a kind of one-time benefit to this quarter.

Right?

This was really kind of a onetime benefit to them and, you know, as with any business, they're going to struggle to grow their business in mid-teens, if their revenues are flat or slightly declining, and it's something that they are addressing.

They've put a lot of resources into the sales area.

They're out in the marketplace very strong right now, and we expect them to start getting that revenue curve back up.

And that's what's really going drive the earnings long-term.

OK, great.

And then, lastly, on, I guess, this other income line.

Is the JV, I guess, expense included in that line?

Has it been broken out previously?

Yes.

It was in that line and --

So basically that was almost breakeven then, that particular piece?

That's correct.

OK.

And that would be an expectation for that going forward?

You know, t would be a modest amount, either positive, you know -- probably positive, but not a big contributor to that line.

OK.

Thanks.

Thanks, Andy.

Next caller, please.

It's from Ricky Goldwasser from UBS.

Please go ahead.

Hello, good morning.

Good morning.

I have some follow up questions.

On the gross margins on drug distribution you talked about the stabilizations in margins.

In our model, we see it on the year-to-year basis we'll see the stabilization in September '05.

Can you give us some more color on that?

Are we too conservative in this assumption or is that kind of the time that you're looking at?

I think our response was more towards the marketplace, you know.

We have renewed, as we said, a number of contracts.

And those renewals are going to continue, you know, to affect us as those contracts go on forward.

However, we think that the marketplace is showing significant change.

There's been a lot of talk out their in the market price -- in the marketplace about customer pricing.

And there's an education process going on with customers so that we think that the rate of new agreements that are going to have reduced prices is going to diminish as we go forward.

And I think our customers are starting to understand where we are right now and the pressures that are on us from the buy side and that there's need to be a change in their thinking.

Thanks, Ricky.

Right.

Just a follow-up question on that.

I think we're talking here, really, about the sell-side margin, but obviously you did gross profit margin as kind of the contribution to both the sell side and buy side.

So assuming that you're receiving that stabilization on the sell side, what are the trends that you're seeing on the buy side, and in benefit (ph), what will be the year over year impact and when will we see stabilization there?

Yes.

I think what you've seen this year in our -- on our buy side is pretty clear.

I think you've seen that the IMAs have done a real good job of offsetting the spec profits we were making in the prior year.

But what we had been hit on on the buy side this year is the fact that there's been less deals offered by the manufacturers and there's been a reduction in the amount of secondary source opportunities.

And I think that's where we had been pressured on the sell side -- or, excuse me, on the buy side as well as the rest of the industry.

Now, you know, we did a lot less than some of the other players so I think we've been impacted less than others there.

But that impact as we move into fiscal 2005 is certainly going to start to anniversary itself.

Thanks, Ricky.

We need to move on.

Very good.

And we move on to Steve Halper from Thomas Weisel Partners.

Please go ahead.

Hi, good morning.

Have you given any thought to what you're going to do with your convertible sub debt, which is callable on December 3 of this year?

Yes.

You know, we -- right now our expectation is we are going to call that debt, certainly, and try to change that into equity.

Great.

Thanks.

(inaudible affirmative)

Next question, please.

It's from the line of Kevin Berg from Credit Suisse First Boston.

Please go ahead.

Just following up on the gross margin question, guys.

It seems like, you know, this quarter down 30 basis -- in the pharmaceutical distribution side down 30 basis points, maybe even 40 basis points without the accrual.

You know, is it reasonable to think that that rate of change might slow?

But I mean, still see that you guys have always said you expect to stay competitive price in the marketplace on the sell side.

Do you expect that competition, I assume, to continue going forward?

Kevin, you know, this quarter we're starting to feel the effects of the loss of the VA, which, I think, if you go back to our lowering our EPS estimate earlier in the year, I think that the decline in gross profit is consistent with the metrics we laid out as far as the impact of losing that VA business.

So I think that's the dynamic that's driving the largest part of that decline.

Wouldn't the VA contract be a low-gross margin contract?

I think we've said as a -- the VA contract as it was priced when we had the business was a higher than average gross margin contract.

OK.

Thank you very much.

Next caller, please.

David Veal from Morgan Stanley.

Please go ahead.

Hi, I'm just checking on the PharMerica inquiry by the OIG.

In terms of the customer impact there, are you getting any questions from your customers on that and are they changing their behavior at all?

And I'm just wondering what the next sort of milestone date is.

I think there's a hearing in August?

You know, it's presented a little unwanted noise in the marketplace, clearly, David.

But our customers have been very, very supportive of it.

We've carefully explained to them the ramp of the impact and the fact that it's got nothing to do with any of our current policies and procedures.

Nothing to do with any patient issues or the like and so they have been very, very supportive of that and very understanding of that.

And our next milestone is a request for a hearing, which will probably occur late summer, somewhere like that.

OK.

And if for some reason that doesn't go your way, do you have recourse to the federal courts then or how does that work?

We do.

There's a series of appeals associated with this.

And that's why, you know, we said, you know, it may not be resolved in the next few quarters because there's a -- this thing could go through a large number of steps.

OK.

Great.

Thanks very much.

Thank you, David.

Next questioner.

Eric Coldwell from Robert W. Baird & Company.

Please go ahead.

Thanks very much.

And thanks again for the great trip to Vegas last week.

Just wanted to kind of circle up with a question that I would rarely ask but I want to make sure I don't mischaracterize the quarter here.

If you back out your charges as well as the vitamin recovery and you look at the $1.02 and then subsequently back out an unexpected PharMerica bad debt recovery as well as the unexpected dividend on -- liquidation dividend in the equity and affiliates line, it looks to me as though your earnings for the quarter would have been more in the range of $0.97.

Is that a fair characterization?

Eric, you know, you have things that go back and forth in every single quarter.

I mean certainly the things you mentioned happened but, you know, there are quite a few things from an operating standpoint.

I mean bad debt recoveries, bad debt charges are things that happen to us on an ongoing basis.

So I certainly -- we're happy with our quarter.

I think you can try to break it down any way you would like.

But certainly those things hit us both ways.

Eric, if there is a problem -- there's an awful lot of moving parts, you know, in any quarter with a company of our size.

That's a very fair comment.

What I'm really trying to derive to, for the fourth quarter guidance or the full-year guidance, if you say you're comfortable with the midpoint of the range, which is a nice affirmation, and I'm going to assume that's 4.15 or thereabouts, and I assume I'm using year-to-date of 3.21.

Is that an accurate assessment?

So we are looking at around $0.94 for the fourth quarter?

I think that's correct, Kevin, in that range.

Our guidance in the fourth quarter is less than our third quarter results.

Not related to the items that you had mentioned previously, but really due to the fact that we'll have a full quart effect of the VA in Q4.

In addition, you know, some of those contracts that we renewed will impact us in Q4 a little bit more than they did in Q3.

That's very fair.

I just want to make sure we're all walking this tightrope between expectations and reality and I want to make sure that we're not too far out ahead of you into the next quarter.

But, thanks very much for the call.

Thanks Eric.

Appreciate it.

We've got time for one more question.

Very good.

And that's from Ray Falci from Bear Stearns.

Please go ahead.

Thanks, guys.

Two-part question.

One, just on the IMA discussion that you gave us some interesting date.

I think you said 80% of your branded volume and, I don't know, two-thirds of your overall volume covered by the IMAs.

I was wondering if any of them have transitioned to the next generation sort of fee to service and if not, where you are in some of those discussions and how you see that final economics sort of leveling off as that happens?

I know it's early, but can you give us any color around that?

Ray, it's Kurt.

I mean, I think we really don't want to get into a discussion on a manufacturer-by-manufacturer basis here and kind of who's in a fee-for-service bucket, who's in it an IMA bucket.

Because, you know, there's hybrids in there as well.

But, you know, the -- you know, we continue to make our case with the manufacturers on where we think this industry ought to go, how we ought to be compensated.

And again, I'll just affirm the fact that we're confident.

The manufacturers want us to do what we do.

They want to keep us healthy.

And we will ultimately come out of this thing paid fairly for what we do for them.

And, you know, we'll continue to communicate as things migrate along here.

But I can't do it on a manufacturer-by-manufacturer basis with you.

OK.

Fair enough.

And then just a brief follow up on the prior question on the fourth quarter and going forward.

I know you lose the Advanced PCS in mid-August and you said that should have nominal bottom line impact given the, I guess, the more cost variability.

I was wondering if that's still the way we should think about that coming out of the model or is there a little bit of incremental, you know, sort of, I guess, net income loss as that comes out of the model in this September quarter and then, I guess, a full quarter in December?

Yes, Ray, this is Mike.

You know, we often said that when we lost the Advanced PCS business, we wouldn't change our guidance because the impact of that business was well within our range and I think we will stick to that.

Certainly there is a little bit of profit element there, but it's not enough to change our picture.

OK.

Great.

Thanks.

Thank you, and thank you all very much for listening in your questions.

I'd like to turn it over to Dave Yost for some final comments.

Thank you very much.

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

But we appreciate very much you joining us today.

We're -- we think we delivered a strong, solid quarter and continue to be very optimistic about the pharmaceutical supply channel and the role we continue to play in it.

We look to continue to deliver long-term sustainable earnings and look forward to sharing our fiscal year end results with you next quarter.

Thank you very, very much.

[Operator Instructions]

That does conclude your conference for today.

Thank you for your participation.

You may now disconnect.