美源伯根 (ABC) 2004 Q4 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the ABC 4th quarter and year-end earnings conference call.

At this time, all the participant lines are in a listen-only mode.

However, there will be an opportunity for questions, instructions will be given at that time.

If you need any assistance, please press star, then zero and an operator will assist you offline.

As a reminder, today's call is being recorded.

I will now like to turn the conference over to Mr. Mike Kilpatrick, please go ahead sir.

Good morning, everybody and welcome to AmeriSourceBergen's conference call covering fiscal 2004 4th quarter and year-end results.

I'm Mike Kilpatrick, Vice President Corporate and Investor Relations, and joining me today are David Yost, AmeriSourceBergen's CEO, Kurt Hilzinger, President and Chief Operating Officer and 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 a discussion of some of the 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 always, those connected by telephone will have an opportunity to ask questions after our opening comments.

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

Good morning and thank you for joining us.

As noted in our press release this morning, operating revenues for the September quarter were just over $12 billion, up 4%.

This quarter reflected a full quarter loss of the VA and the loss of the advanced PCS in the first part of August.

Net of these loss, total operating revenues would have been up 14%.

Though total praising expenses were down 9% for the quarter and interest was down over 30%, gross profit was down more, for a fully diluted EPS of 81 cents, down 22% from last year.

Our return on committed capital, an important company metric, was over 27%, and we generated some $825 million in cash for the year.

For the quarter and the year, the management team and I are disappointed with the results.

And we have begun implementing a number of initiatives to correct the situation.

As you would expect, management bonuses will reflect this year's performance.

However, with numerous opportunities ahead, we remain very upbeat about the future.

While many of the challenges ABC is facing are characteristic of our industry, most are also temporary and we think 2006 will feature significant and positive developments, particularly for AmeriSourceBergen, including new incremental volume due to the Medicare modernization act, increased generic opportunities, and operating efficiencies from our new DC's network consolidation and a new warehouse management system.

Before I turn the microphone over to Kurt and Mike to detail some of our specific action plans, I want to provide some clarity on four issues.

Fee for service evolution, pharmaceutical inflationary trends, the competitive landscape, and possible drug importation.

First, the issue of fee for service.

It is important to note that the movement to fee for service is evolutionary and will over time result in a model that is a significant improvement for both manufacturers and distributors.

In its broadest perspective, this evolution is not about compensation for wholesalers from manufacturers.

Manufacturers are paying wholersalers now under inventory management agreements or IMAs, though some manufacturers are not paying for the full value we provide.

Fee for service is about the trigger for payment.

Under IMAs, the trigger is often a price increase, tying the monies earned to a difficult to predict price increase event.

Under fee for service, the wholesalers fees are earns based on the performance of services for the manufacturers that are uncoupled, that is, not dependent on a pricing event.

Dollars earned under the fee for service are predictable, match the money earned with the service provided, and reflect a logical method of compensation.

Our fee for service approach is collaborative, performance-based, and not contingent to price increases.

We are in multiple and extensive discussions with our manufacturer partners.

Fee for service is a high priority within our company and our strategy is beginning to yield good results.

Our goal remains achieving not just any agreement, but the right agreement that will create a strong relationship with our manufacturing partners and a sustainable model that we can build on for the future.

Next, I would like to address price inflation in our industry, particularly among brand-name products.

Like many of you, we closely monitor the political environment and would agree that big pharma is under a lot of scrutiny.

But of course, they've been under scrutiny before and prices continue to go up.

It is also important to note that what may have -- what may be a price increase to the wholesalers does not increase -- does not translate into a price increase to the manufacturer, due to rebates that are dependent on how wholesalers are compensated.

We continue to maintain that the pricing environment will not change dramatically when taken over a reasonable period like a year, not a quarter or two, and that changes, if any, will be gradual, not overnight.

It is our opinion that manufacturers' future growth and revenue models assume price appreciation because they need to pay for continuing new research and support marketing efforts and that manufacturers have pricing flexibility.

We continue to expect price increases in the 5% range for '05.

But as noted previously, fee for service will moderate the impact of price increases on wholesalers.

Thirdly, I would like to address the competitive landscape.

All of our business units operate in very competitive environments.

And this has had an impact on our margin, as we have said continuously throughout the year.

This quarter was no exception.

In competitive issues again had an impact on gross margins.

For the positive side, however, our impression is that our customers understand that the economic model is changing, and that the efficiencies we achieved in the past that resulted in lower cost of goods for them have largely been achieved and will not be replicated.

We are optimistic the pressure on sell-side margins will decrease as we move forward, and we are getting anecdotal evidence to that effect from the field.

Finally, on drug importation, since it continues to be such a hot political topic, if a drug importation bill is passed, the devil will be in the details.

You will recall that Dr. Shalayla, under the Clinton administration, could not overcome the safety issues, so importation in that administration were not implemented, though authorized.

The importation issue is really about price differentials on branded product worldwide and may ultimately be addressed in other ways.

We will continue to monitor the situation closely, and be prepared to act if needed.

As noted previously, we have several tough comparative quarters until next summer when we anniversary the $4 billion VA loss and the $2.5 billion advanced PCS loss.

We continue to be very optimistic about our industry, and the role we play in it. '06 features added volume through MMA, more generic opportunities and the near completion of our distribution network.

Here is Kurt to provide some details on our operations.

Thanks Dave.

And good morning, everyone.

I want to start by echoing Dave's disappointment with the quarter and year.

We're clearly in a state of transition our core drug distribution business and a number of our other businesses are in challenging environments as well.

Obviously what is important is how we respond to these changes and that's what I will spend my time on this morning.

The need to change our outlook for the 4th quarter was driven by a substantially reduced number of manufacturer price increases versus both year-ago levels and our internal expectations.

Dave spoke about our approach regarding fee for service and our need to move to noncontingent compensation arrangements to remove this exposure from our business model.

So I won't comment any further, but to say that the discussions with our manufacturers are progressing well.

We remain confident in our approach because all members of supply chain stand to benefit.

Manufacturers, distributors, and providers, as the total cost of healthcare distribution is reduced through better managing inventory, improving operating efficiency, and increasing supply chain integrity.

We are taking other steps as well to improve our gross margin.

We have a number of initiatives underway to improve our customer compliances to existing contracts, including generics and other our programs.

We are also firmly enforcing minimum price purchase requirements and the elimination of any backup wholesaler activities.

We have identified unprofitable and low profit customer counts, and are either improving them or eliminating them.

And lastly, we remain committed to maintaining pricing discipline in the marketplace.

Focusing on profit, rather than revenue growth.

Below the gross margin line, we have a number of key initiatives underway as well.

The optimize program continues on schedule and on budget.

The second of our six new Greenfield distribution centers began operations three weeks ago in Columbus, Ohio.

This large, highly automated facility came on line on time and on budget, with no major customer issues, and of course, we hope to see many of you there at our investor day in early December.

Two additional Greenfields, Dallas and Chicago, will go live in fiscal 2005, and five of the six will be operational by the end of calendar year 2005.

As these facilities come online, we will consolidate our older, less efficient facilities, driving significant efficiency gains in 2005 and beyond.

We started with 51 distribution centers in 2001, and today we are at 35.

Including the two new Greenfields.

We will complete six consolidations in fiscal year 2005, and now expect to have less than 30 in our final configuration in early 2007.

The other major components of the optimize program remain on track as well.

With the continued rollout of our new warehouse management system, in six of our largest facilities next year.

Substantial work is also underway to further align our sales and marketing activities to create differentiated solutions using offerings from our specialty, technology and packaging groups.

There is significant opportunity here to improve our value proposition to our provider customers.

And to be paid accordingly.

So having said all this, we remain optimistic that these initiatives, conversion to a fee for service compensation model, being disciplined on customer pricing and compliance, driving additional operating efficiencies through optimize, and creating unique solutions through cross-selling, will strengthen the operating margin in the drug distribution business in future periods.

Now, let me turn to the specialty group.

The group had another excellent quarter of strong sequential growth in both revenues and operating earnings.

And finished the year with annual revenues greater than 5.5 billion.

However, as we indicated last quarter, we expect 2005 performance to be negatively impacted by the proposed rule changes regarding the federal government's reimbursement for oncology pharmaceuticals, and the services provided by oncologists.

Unfortunately, the new regulations have not yet been finalized.

So there is nothing new to report here.

We continue to monitor the issues in Washington closely, but until more is known, we have chosen to take a conservative view on the outcome in terms of our guidance.

Overall, however, the specialty group continues to effectively build out its commercialization capabilities for new biological and other specialty-type products, and will continue to be an important growth platform for ABC in 2006 and beyond.

The packaging group enters 2005 with solid momentum at both American health packaging and Anderson packaging.

American health packaging launched 23 new products during the 4th quarter, received an award to provide additional packaging services to a large prominent generic manufacturer, and was awarded contracts for both unit dose and unit of use products from two group purchasing organizations.

After growing revenues greater than 20% in 2004, Anderson packaging finishes the year with a strong pipeline of new programs awarded from pharmaceutical manufacturers.

Eleven new packaging programs are forecast to launch in the 1st nine months of fiscal '05.

Half of which are compliance-prompting in nature, offering higher margins.

Construction of Anderson's new 148,000 square foot packaging facility was completed during the 4th quarter, and facility and process validations are proceeding as scheduled.

This facility brings the packaging group's total production capacity to a million square feet and will support continued growth in 2005 and beyond.

Just briefly, regarding our technology group of businesses, the group enters fiscal '05 with a solid order backlog, driven by additional sales resources we added during 2004, and the continued strong demand for pharmacy productivity tools.

The technology group services a number of rapidly growing markets which are being driven by a shortage of pharmacy professionals, increasing script volume, and continued reimbursement constraints.

To meet its rising demand, additional investments will be made in 2005 that properly resources the businesses that make up the group to meet its growing pipeline.

Particularly in the areas of customer implementation and call center operations.

This is a developing but potentially fast growth business platform for ABC in the years ahead.

Now, let me turn to PharMerica which had a disappointing quarter with revenues and operating income below our expectations, when adjusted for the impact of the sales and use tax expense reduction.

Intensified competitive pricing pressure and lower Medicaid reimbursement levels affected overall profitability during the quarter.

And likely in 2005 as well.

Importantly, the business has demonstrated an ability historically to align its operating costs with its existing pricing and reimbursement environment.

Which was the case this quarter, with operating expenses down substantially from year-ago levels.

The group has undertaken a number of cost reduction initiatives designed to positively impact the near-term and have a substantial positive impact over the longer-term.

Key 2005 initiatives include the further implementation of technology group automation solutions into PharMerica's long-term care pharmacies to drive down the cost of operations, and the consolidation of a number of pharmacy-level administrative activities into a handful of efficient regional service centers.

In order to grow market share in 2005, PharMerica will also deploy a number of customer facing technologies proven elsewhere in ABC, including an advanced hand-held customer order entry system, as well as a number of powerful online customer reporting tools.

All new to the long-term care industry.

In 2005, we will also step up our investment in PharMerica's IT infrastructure to further support the business in the years ahead.

Clearly, 2004 was a challenging year.

And 2005 will be as well.

As we both transition and invest in our various businesses.

We, however, remain confident in the attractive long-term growth dynamics of the markets we serve and look forward to returning to the historical growth rate in late 2005 and beyond.

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

Thanks, Kurt.

And good morning, everyone.

Our 4th quarter results reflect a difficult external and competitive atmosphere we are in as we continue to evolve our business model.

That changing business model has some very positive elements, as demonstrated by this quarter's very strong cash flow from operations which enabled us to lower debt and significantly reduce interest expense compared to the prior year and as a result our balance sheet has never been stronger.

Our improved capital structure enabled us to commence our $500 million stock buyback program during the quarter, and we have ample opportunities to deploy additional capital as we go forward.

However, our operating results were adversely impacted in the quarter by the VA contract termination as expected, and unexpectedly by the significant decline in the number of vendor price increases during the quarter.

These items more than offset significant expense reduction and strong returns on committed capital in the quarter, and I will get into more detail on each of these items and we will also discuss our guidance for fiscal year '05 that we released in early October.

Now, starting with the results for our consolidated company, operating revenue for the company was $12.1 billion for the quarter, up 4% over the prior year period, due to the growth in our pharmaceutical distribution segment.

Both delivery revenue increased 37% from the prior year to $1.2 billion, due to increased demand from our one large bulk customer.

Operating income was down 26% in total, compared to last year's quarter, as pharmaceutical distribution EBIT declined 31% and PharMerica EBIT grew 17%.

The consolidated operating margin of 1.41% declined by 55 basis points from the prior year quarter, primarily due to fewer manufacturer price increases and the VA contract loss.

Interest expense for the quarter was a record low $23.5 million compared to $34.7 million in the prior year quarter, a significant decrease of 32%.

Net average borrowings in the 4th quarter of '04 decreased to under $800 million, compared to $2.2 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%.

Bringing the effective rate for the year to 38.4%, slightly less than the 38.5% rate we recorded for the 1st nine months.

Earnings per share for the quarter decreased 22% to 81 cents per diluted share, compared to $1.04 per diluted share reported last year on a GAAP basis.

The facility consolidations and employee severance costs reduced the EPS by a penny in both the current and prior year quarters.

Moving to the pharmaceutical distribution segment, operating revenue for the segment was $12 billion, up 4% compared to last year's quarter, and was slightly higher than expected.

As Dave mentioned, the loss of the VA and advanced PCS accounts reduced sales growth by 10% in the quarter.

The customer mix in the quarter between institutional, which includes health systems, alternate site pharmacies, mail order pharmacies and our specialty group at 56% and retail which includes independents and chains at 44% changed from the prior year due to the previously mentioned customer losses.

Our institutional business grew 1% and our retail business grew 8% compared to the prior year quarter.

Independent pharmacy revenues grew in double digits once again, continuing their strong growth noted the last two quarters, and our high single digit chain growth was the highest of any quarter this year.

We are very excited about our progress in the retail sector.

The institutional segment growth was positive, despite the customer losses, as a result of the strong growth once again of our specialty group which exceeded $5.5 billion in revenue for the year.

In the pharmaceutical distribution segment, gross profit margins were down by 72 basis points compared to last year's quarter, primarily due to the reduction in manufacturer price increases, and the continuing competitive environment, including the loss of the VA, which has led to a number of contract renewals over the last 12 months with reduced customer markups.

The rate of price increases in the quarter was modestly less than our 5% expectation.

However, the number of increases was significantly less than our expectations as has been well documented throughout the industry.

As Kurt mentioned, we have a number of internal initiatives ongoing to lower our future reliance on price increases, on both the customer and manufacturer sides and I am excited about the enthusiasm with which our associates are addressing these issues.

However, we are still primarily in an IMA environment today, where our payments are triggered by price increases, leading to the earnings volatility we experienced this quarter.

With regards to LIFO accounting, we've recorded a credit of $27.4 million this quarter, compared to a credit of $13.7 million in the prior year 4th quarter.

As one would expect in light of significantly fewer price increases our LIFO true-up at the end of September produced a higher-than-expected offset.

Total operating expenses as a percentage of operating revenue of 1.98% improved by 11 basis points for the quarter, compared to the same period last year.

This improvement was driven by a reduction in compensation expense, due to the reductions in head count, associated with the progress of our optimize program, as well as a reduction in performance-based compensation across much of the company.

The operating margin in the quarter was 1.17%, a 60 basis point decline from the prior year quarter, reflecting a reduction in gross margin I just discussed.

Turning to PharMerica, we had a disappointing quarter as revenues of 390 million were down 4% compared to last year's quarter, again due to the prior year customer loss in the worker's compensation business, and a discontinuance of the healthcare products business in long-term care as well as the loss of a long-term care customer due to acquisition.

Operating income was up 17% as continued focus on expense reduction in both long-term care and worker's comp resulted in over a 5% reduction in operating expenses as a percentage of revenue, more than offsetting declines in gross margin, driving operating margin expansion of more than 150 basis points.

Operating expenses in the 4th fiscal quarter declined $26 million from the prior year quarter, from continued head count reductions and improvements in bad debt performance, similar to prior quarters.

In addition, as we mentioned in the press release, sales and use tax expense was reduced by $12 million, as favorable audit results and other settlements in this area led to a reduction in the liability.

Now, turning to balance sheet -- to the balance sheet and cash flow.

The changing business model, as I discussed earlier, has had a dramatic positive impact on our working capital and cash flows over the last year.

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 $600 million since last year end.

This dramatic reduction in inventory combined with our operating results has produced $825 million of cash from operations in the last year, well above last year's $355 million, and well above our beginning of the year guidance for '04 of $350 to $400 million.

This strong cash flow has enabled us to reduce debt to record low levels, fund our optimize program, make modest acquisitions, and commence our stock buyback program.

As of September 30, we had repurchased $145 million of our stock, and our $500 million program is approximately 80% complete currently.

With nearly $900 million of cash on our balance sheet at the end of September, we have the highest level of financial flexibility we have ever had.

The total debt to total capital at quarter end was a record low 24.9%, compared to 31% last year.

And net debt to net capital was a low 11.6%, compared to 20% last year, and once again, all of our key credit ratios remain in strong investment grade territory.

From a statistical standpoint, average inventory days on hand were 42 days during the quarter, compared to 50 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 optimize program.

DSOs for pharmaceutical distribution were 15.7 days versus 17 days in the prior year.

PharMerica DSOs were down a day to 37 days.

Networking capital to operating revenue in the quarter was a low 5.6%, a significant reduction from last year at September 30, when working capital to operating revenue was at the 7.7% level.

CapEx was $45 million in the quarter, and $189 million for the year, as expected.

Return on committed capital, or ROC, which you will recall is one of our primarily internal financial measures and is defined as EBITDA before special charges divided by receivables plus inventory plus TP&E, less payables on a rolling 12-month basis, was 27.6% for the quarter, well above our long-term goal of 20% as the dramatic reduction in working capital more than offset the EBIT decline.

Turning to our fiscal year '05 guidance which is consistent with our press release in early October, and as a reminder, is on a U.S.

GAAP basis, we expect consolidated operating revenue and income to be essentially flat compared to fiscal '04.

This assumes that the U.S. pharmaceutical market will grow at a low double digit rate, and that price appreciation will be in the 5% range for the year.

We expect that our specialty group will grow in line with the overall U.S. market growth, which is a reduction to their historical growth rate of two times the market, as a result of the new Medicare drug reimbursement regulations.

We expect PharMerica to grow revenue in the high single digits, with operating income below fiscal '04 levels, due to increased competition and the investment in IT and other customer-facing technology that Kurt described earlier.

The completion of our stock repurchase plan, combined with lower interest expense, will provide the financial leverage to grow EPS and we expect diluted EPS to be between $4.20 and $4.30 for the year.

Cash flow from operations is expected to return to more normal levels in the range of $375 to $475 million.

And CapEx is expected to be in the $175 to $200 million range, as we continue to open new distribution centers in fiscal '05.

While we do not provide quarterly earnings guidance, we would expect to have our most difficult comparisons to fiscal 2004 in the early part of fiscal 2005, and would expect to have EPS growth of 15% or more in the 4th quarter, as we anniversary the loss of the VA, feel the entire impact of the reduced shares under the stock buyback plan, and complete many of the profit-enhancing initiatives discussed by Kurt earlier.

You can continue to expect us to deliver highly disciplined execution in the drug business, continued innovation in the specialty business, and technology leadership in our PharMerica business, as we position ourselves for the future.

I will now turn it back to Mike 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 until everyone has had an opportunity and then if there's time, we can add additional questions.

Go ahead, John.

Thank you.

And ladies and gentlemen, if you would like to ask a question, please press the star, then one on your touch-tone phone.

You will hear a tone indicating you've been placed in the queue.

To remove yourself from the queue at any time please press the pound key.

Once again, if you have a question, please press star, one.

And first, we go to the line of Thomas Gallucci with Merrill Lynch.

Please go ahead.

Good morning.

Thank you.

I just wanted to explore the price inflation issue a little bit more if I could.

It seems like that that is a real key swing factor, at least in the next few quarters before you get to fee for service environment more fully, you said that price inflation was actually closer to where it has typically been, just a little bit lower, but it was a number of products that were not there in terms of price increases.

And you have 5% price inflation, or in that range, estimated for next year, where are you in terms of the number of products or the magnitude of price increases for next year on a more specific basis, kind of the way you were framing the quarter that we just passed?

Tom, this is Mike.

I mean we -- as I mentioned, we did have appreciation in the quarter that was at a rate slightly less than our 5%, in the mid 4% range, and we had a very few number of price increases during the quarter.

I know that we track this ourselves in our own way and a lot of you track this for the top 50 or 100 products, and notice the same trends.

As we look towards next year, we look to have a more normalized year.

I mean we expect price increases to be in the 5% range over the course of the year.

Certainly as Dave mentioned there is going to be a lot of pressure on the manufacturers and however, I think that pressure has been there for quite some time, and prices have continued to rise, and we think in the short term, at least, in the next fiscal year, they're going to continue to go up.

Certainly, as we move forward, beyond fiscal '05, there could be some moderation in price increases and that's why we're initiating the fee for service discussions that we're having today with manufacturers.

And all things being equal, this is obviously a lot of moving parts, but do you have any simple sensitivity, you know, 5% is what is in your expectations, if it was four or three, what that might mean?

Well, certainly, the way I've characterized it for people before is we have roughly a $5 billion inventory, and we're expecting 5% price increase, so from our -- from our every day inventory, we're anticipating, you know, $250 million of price appreciation benefit.

And to the extent that that's less than the 5%, each percentage point represents about $50 million.

Thanks Mike.

Our next question is from the line of Robert Willoughby with Banc of America Securities.

Please go ahead.

Thank you.

Mike, just the guidance, what was the share base at the end of the year?

What are you using for '05?

And can we assume the 100 million in 7.25 notes are gone at year end?

The 100 million dollars of notes that become due in '05, we expect to take those out with cash, Bob.

As well as the schedule of repayments on our term.

I think we've laid out the shares that we used in our calculation of EPS in the press release.

I believe on a diluted basis, we were at 100 -- let me get it here. 117 million for the quarter.

And that reflected a 1 million share benefit from our share repurchase program.

Certainly, as we complete that program in '05, on a weighted basis, you should have about a 7% reduction in the number of outstanding shares next year versus this year.

That's great.

Thank you.

Thanks, Bob.

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

Please go ahead.

Hi, this is Steven Postema for Larry.

Can you elaborate on your outlook for PharMerica?

You talked about pricing and Medicaid reimbursement pressures.

You can comment on which of those two issues are having a larger effect on the business?

And will you be in a position to add debt in 2005?

Thanks.

Steven, it is Kurt.

As we look at I would say probably the both factors, you know, the competitive pricing, and the reimbursement were in effect in spades here in '04.

I think the competitive pricing pressure is probably the more dominant effect right now, as we see it.

And so hopefully, hopefully that, you know, and we're adjusting our cost of operations to -- for that new environment.

You know, the group's -- the businesses intent for '05 is clearly to add beds.

We've got some fairly firm goals in place for the team down there, and we're confident with the new technologies we're bringing to market, some of the customer facing technologies I outline that have shown very high receptivity in the 4th quarter here, that we think those can be instrumental in getting some account wins in '05.

So we're looking forward to a good year for the group.

Thanks.

Our next question is from the line of Lisa Gill with J.P. Morgan.

Please go ahead.

Thanks.

And good morning.

I was wondering if perhaps you could give us some kind of metric around what you've been able to sign on a fee for service basis so far.

You did talk about the number of manufacturers you had on IMAs but where are you exactly in fee for service?

And are you still anticipating that it is going to take roughly another 18 months or so?

And then just secondly, to follow-up on Tom Gallucci's question around the drug price inflation, Michael DiCandilo, I was wondering if you could talk about anything you've seen thus far in October that gives you comfort that we are getting back to more normalized levels as far as the number of price increases.

Thanks.

Lisa, it is Kurt.

I will take the first part of the question.

In regards to the number of agreements, you know, I would say as -- as Dave outlined, we're in currently a number of discussions with our manufacturing partners, and we're still -- we have designed an approach here, we have contracts in the marketplace, as a template that we think makes sense for the industry and for ourselves going forward.

And we are actively working with our manufacturing partners to see the light here, and engage with us on the form of the model we want to put into the marketplace.

You know, I would not -- we're not going to comment really on how many contracts we've signed.

They're going to come in different shapes and forms over the next coming months.

But I would tell you, I think our hope and our approach here is that we have most of this in place by the end of calendar year '05.

And we will be well on our way in this new environment going into '06.

Lisa, in terms of the price in place, I would say -- I guess I would answer a little different way and saying we're not seeing anything in October or recently that would give us any indication that a 5% range is not good going forward.

We had a lot of discussions with manufacturers, we noted in our prepared remark, you know, we think that the manufacturers have built this in to their models going forward because they need it to fund their research and their marketing efforts, they clearly have a lot of flexibility, so we're clearly not seeing anything right now that would lead us to believe that the 5% range is a bad number for the future.

Next question, please?

And that's from the line of Andrew Weinberger with Bear Stearns.

Please go ahead.

Hi, guys.

A quick question on the PharMerica business.

If you add back the $12 million in the nonrecurring expense reduction it looks like your expenses were still, you know, near record lows or I guess at record lows for September quarter yet the operating margin was kind of like 5.6%.

I guess when should we expect that a normalized PharMerica margin at kind of the 7% goal, which you guys were kind of targeting for '04?

Yeah, I think Andy, you know, in our guidance next year, you know, we said that our operating income was going to be slightly less than what it was this year, and that we would grow the business in the high single digits and I think that speaks to a margin that's in the, you know, high 6 to 7% range.

Okay and then I guess for fiscal '06, we should expect kind of a target of a normalized EBIT margin for the PharMerica business above 7%?

We would expect that the initiatives that we're investing significant time and money into this year will provide us great benefits as we move forward, and we expect to continue to raise that operating margin as we go forward.

Okay.

Great.

Thanks a lot.

You bet.

Our next question is from the line of Eric Coldwell with Robert W. Baird.

Please go ahead.

Thanks very much.

Several of my questions have been answered already.

If we could maybe switch gears to a generics, we are going to get a big cycle over the next year or two.

Can you tell us what the competitive landscape is in generics and your discussions with those manufacturer, pricing, et cetera?

And just a quick housekeeping item, I noticed on the statement of cash flows there was a sell lease back in the quarter.

If you could address what that was related to and the impact on the model.

Thanks so much.

Eric, I would talk about the generic issue, we've got, you know, a lot of momentum going on, you know, with generics, it is one of the places where our size and scale, you know, really helps us.

We're getting a lot of traction with our customers.

You will recall that we do a large business with the independent retailers which is growing well along with the retail.

So we -- one of the reasons I highlighted generics in '06, we really think it is going to be, you know, very positive influence for us going forward.

Hey, Dave, if I can jump in, your two large competitors are still telling us that they're seeing pricing on generics at roughly three to five times the historic gross margins seen on branded drugs.

Are you still seeing pricing in that range?

Would you care to maybe give a little more color on what kind of gross margins you're seeing in the generics right now?

Yeah, we continue, you know, Eric, to enjoy very favorable margins on our generics.

I think it is important to keep in mind that you will have more expenses associated with generics as well but one of the things that really helps us with generics is, it allows us to differentiate our offer, our generic offer is different than our peer, it's got different items in it, different manufacturers and the like so it really does allow us to differentiate our offer.

We enjoy very attractive margins because in that business, we can stimulate demand and we can bring volume to the manufacturer, which is something we have a hard time doing in the brand business.

So you know, if we had a choice would we like to be all brand or all generic, I suppose we would probably pick all generics just because we have such a positive in flow over the marketing of it.

Eric, this is Mike.

As far as the sale lease back transaction that's reflected in the cash flow, I think it is around $15 million.

It relates to the financing of some of the equipment in one of our new Greenfields.

We had the ability to get some very attractive leasing rates, and therefore mechanically, we purchased the equipment, and then sold it, and leased it back, utilizing that favorable financing.

And if I can just ask one more question.

The Cardinal recently announced the launch a national logistics center which is somewhat similar to what Mckessen has done I believe in the Memphis area.

You guys have not talked in the bast of not having a sort of internally focused distribution network.

Have you revisited that concept as you look at your new infrastructure and would you consider building a an internally focused DC similar to your peers?

Thanks.

We constantly look at, it Eric.

I think one of the differentiators is our mix of business is a little different.

They are heavily into warehousing chains which could have an impact on that national distribution center but we will continue to take a close look at it as we move forward.

Next question, please?

And that's from Chris McFadden with Goldman Sachs.

Please go ahead.

Thank you.

And good morning, everyone.

Your competitors have been fairly straightforward about their intention to enforce some of their fee for service type agreements in early 2005.

By contrast, you've not set a similar deadline and have in fact talked about an extension of this process out into late calendar 2005.

And can you talk about, you know, what perhaps is the difference of opinion on this matter?

And could you talk just in mechanical terms about how you would anticipate the pharmaceutical supply chain operating if not all distributors were necessarily authorized distributors of all product, and other precedents in the market that you would point to in terms of how the supply chain would react to that type of situation?

Thank you.

Chris, it is Kurt.

You know, I think that there is a lot of to-ing and fro-ing on this and it is really not that meaningful.

The interest of the three wholesalers are very much aligned here and we're all very much engaged in the conversations with the manufacturers and working realtime trying to improve how we get compensated and the way we get compensated.

We're just -- we're dealing with tactics here which you pointed out, our approach is collaborative, we don't -- we think that that there are relationships that we put very high value on, that are important to us, to other elements of ABC, in the years ahead, and so we think there is enough value in what we do in the channel, and there is enough opportunity to educate our manufacturing partners that we feel that just sitting down, having a straightforward conversation, will allow us to break through here, and get to a model that makes sense for the industry going forward, and get off this price appreciation game we've been in.

So it is a different tactic, but we're very much in the game and our interests are very much aligned and I think that is clear to the manufacturing community.

With regards to where the model goes, you know, I would tell you, we continue to be very certain that the right way for this marketplace to operate is it remain a prime vendor marketplace, that all of the wholesalers maintain all manufacturer aligns into the marketplace, and so while it may be an issue in conversation here and there with the manufacturer, talk about something different, right now we don't see that being cost neutral or cost reducing to the overall pharmaceutical supply chain here in the U.S.

We run a very efficient industry today.

It operating in very complex regulated operating environments.

I think we've proven our worth.

And is a matter of us getting, you know, in front of the manufacturers and explain to them what we do and how we do it and how we manage the complexity so, you know, I think we're on it.

Thank you.

Next question?

And that's from Andy Speller with A.G. Edwards.

Please go ahead.

Hi, Mike.

You can remind us when those notes are callable?

Yeah, we have -- we have Andy, $300 million of 5% convertible notes that become callable in December, and they would be -- they would become callable initially at a strike price of about $54.11.

You know, we've said previously is our intent is to call those bonds at some point and convert them to equity.

When our stock price supports doing so.

As a reminder, those bonds are not due until December '07, so we have plenty of time to effect that conversion.

But as part of your guidance, you're assuming in '05 that those will be converted?

Well, it really is an EPS neutral transaction, because they are treated as if converted in the -- in our financials.

It would have an impact on the absolute interest expense dollars in our numbers, but would not affect EPS since it is already included in the diluted calculation.

Fair enough.

Thanks.

Thanks, Andy.

Next question, please?

And that is from Ricky Goldwasser with UBS.

Please go ahead.

Hi, good morning.

Just to follow-up on Eric's question regarding generic, obviously you're seeing positive margin contribution on the independent segment, where you are impacting market share, but you can quantify for us, what does it do for the rest of the business?

Which still accounts for more than 50% of the business, ie., the nonindependent where you have less of an impact in terms of market share, gross margin, and on EPS growth rates?

Well, Ricky, in terms of regional chains, very frequently, they behave exactly the same way as independents do.

That is, we handle the generics for them, and get very attractive you know, margins from them.

In the case of other pieces of our business, the hospital business and the like, you know, we handle the the generics as well, doesn't have, you know, quite the impact that there since we're not influencing the marketing decision quite as strongly but overall, you know, generics are very, very positive for us, not only in terms of the gross margin, but also in terms of the balance sheet.

Since the terms associated with the generics are negotiable.

Thank you.

Next call?

That's from Steve Halper with Thomas Weisel Partners.

Please go ahead.

Hi, good morning.

If you try to look ahead, you know, the 18 months that you talk about and you have all your fee for service agreements in place, and you've gone through your DC rationalization program, what would you say the target is for your operating margin?

Your two primary competitors suggest that the right number is 200 to 250 basis points, I was wondering if you had any thoughts on that?

Well, Steve, I think one of the issues I think you got to remember when you're looking at operating, you know, margins among our peers, is that they're not exactly the same.

That when you look at the three large distributors, and you compare our peers, they've got pieces in there like retail franchising or hospital, you know, management fees that are very, very high growth margin, so you really don't have apples to apples.

It is probably not best to compare the operating margins.

It is probably best to compare the movement.

Now clearly we think improving the margin is something that should happen and that we're working on, that moving to a 2% or greater goal, you know, should occur as we move out and get these fee for service squared away, our distribution network out, and our customers realizing the value we're providing to them.

Great.

Thanks.

Thank you.

Next question, please?

And that's from Kevin Berg with Credit Suisse First Boston.

Please go ahead.

Yeah, can you give some more clarity around the sell side margin?

You guys talk about it being competitive but some of the competition might not be as typical as it was in the past.

You can talk bur recent renewals and what type of pricing discounts you've given to your customers?

Kevin, we don't like to talk about specific, you know, customers but I think we've talked at some length the impact that some of the large public, you know, awards have had, but I would say that noise is settling down.

We just got back from the National Community Pharmacists Association and we're getting some very positive recognition there of the value that we're providing to independents and regional chains.

Our revenues are very strong there.

So you know, the problem with talking about pricing is it turns to -- it tends to be anecdotal.

It is kind of the last deal you've worked on or the last salesman you've talked to, but you know, we're not hearing the noise that we have heard of late, you know, compared to say six or eight months ago.

The only thing I would add to that, Kevin, is clearly with the performance of the public distributors this quarter, it is clear now to the marketplace, the cost of provider marketplace, that there is no more to give in the P&Ls.

From our side of the channel.

So, you know, we've backed up with performance what we have been saying in words here for the last nine months to the customer base, and so I think their expectations are starting to get pretty well reset at this point.

Is it fair to say you're not giving price -- you're not dropping sell side margins year-over-year like have you been for the past decade or 15 years?

I think it's fair to say that because we don't have the profitability to justify it.

Okay.

Thank you very much.

You bet.

Next question, please?

And that's from David Beal with Morgan Stanley.

Please go ahead.

Hi, thanks.

Good morning.

I'm just wondering if you can drill down to the specialty business a little bit, concerns there that returning to the growth to market rate, is that driven primarily by oncology or are there other key products that are risk there and can you also remind us how the 5.5 billion breaks down?

The key issue we have there, David; the oncology business, there is just a lot of uncertainties surrounding that until we find out how the oncologists are going to be reimbursed and then how they're going to react to that, when they find out what their new reimbursement is, so that is a key -- that is the key issue that we've got there.

About two thirds of our business is oncology, so it has a big impact.

And some of your competitors have sort of, you know, ventured a guess, at least, as to the impact, they've said, you know, down 15% in revenues as we see smaller oncologists move their business back into the hospitals.

Would you kind of elaborate a little bit on what you've baked into your guidance for '05?

Well, we've been more conservative than that.

And, you know, by probably about a fact or two in terms of our thinking, and it could prove to be conservative, David, but at this point, until we know otherwise, we don't think it is prudent to try to guess in an in between type way.

That's great.

Thank you very much.

Thanks.

Okay.

Next question, please?

And that's from John Ransom with Raymond James.

Please go ahead.

Hi, this is kind of picky, but I just wanted to ask about the $12 million add back at PharMerica.

Was that added on a an operating line basis or a reduction in taxes?

That is an operating number, John.

The issue is with sales and use and other nonincome taxes, not income taxes.

And so therefore, was it -- was that a taxed or was that a nontaxed benefit in terms of an earnings add-back?

If we were thinking about the $12 million, stripping it out, should we strip out 100% of it or only about 63% of it?

Yea, you would need to tax effect that.

The 12 million is a pretax that is tax effected.

It is tax effected?

Yes.

And in terms of LIFO, you had a $13 million pickup from LIFO this quarter.

Is a lower LIFO reserve going to benefit you in the early quarters next year?

Will you be taking less of an accrual given that you've kind of overaccrued in the last two years in the early quarters?

Certainly our experience this year and the fact that we have lower inventories overall, we will both contribute to us estimating a lesser LIFO expectation than we did early in fiscal '04.

I think our charge for the year is about $3 million and certainly I would expect a higher charge than the 3 million, but probably nowhere close to the 30 million we were starting out with last year.

So you ended up at only 3 million for the whole fiscal '04?

That's correct.

And what are you estimating for next year?

Probably under $10 million.

Okay.

So that was a big earnings pickup this year, but it will be a little bit of -- perhaps a little bit of a head wind next year?

That might be how we think about it?

Yeah, and again, it is an offset to the performance on the FIFO side, so --

Sure.

Again, I think you can't forget that direct reflection there.

I think the -- you know, the one issue that has also contributed to a little higher than expected LIFO credit was the fact that our inventory levels were down as well.

And that creates a little bit of a LIFO liquidation effect, which also impacted that credit.

Okay.

Thank you.

You betcha.

Next question, please.

And that's from Michael Maguire with Leerink Swan.

Please go ahead.

Thanks.

Most of my questions have been answered.

Just a quick follow-up in the specialty business as it relates to oncology, it sounds like you have a very conservative view I guess on the volume side.

How do you look at the margin profile going into '05?

And I guess could that change substantially given that you are still waiting on the final regulations?

Well, you know, the regulations are really, you know, around the oncology business today.

It is affecting how the physicians are reimbursed.

You know, what we have talked about with the investors in times past is that to the extent that that volume moves to a hospital-type care environment, and it happens to go to an AmerisourceBergen hospital customer, generally that will be service in a lower margin than what what we're achieving right now in the specialty business.

But the specialty business, the oncology business in of its own right has been fairly price competitive in the last 12 months but the reimbursement changes are more about shifting the revenues away from oncologists and other care settings than around the profitability model on that business as it stands.

So if you didn't see that shift, your assumption would that there is not necessarily a margin concern going forward given that there has been a little bit of pricing pressure over the last 12 months?

Is that fair?

I would say that's fair.

That kind of pricing pressure is manageable given the scale of the operations and our other capabilities there.

Great.

Thank you.

You're welcome.

Thank you.

Take one more question.

And that's from the line of Brian Flores with CIBC World Markets.

Please go ahead.

Hi, good afternoon.

You had mentioned you intend on calling the 5% convertible notes due that are callable December of this year?

Yeah, Brian, we said our intent is at some point to convert -- to call those convertible bonds, and take them from debt to equity.

However, that's dependent upon where our stock price is, and we will wait until the appropriate time.

What kind of cushion would you want above the strike price of the convert, if the convert -- if the strike price is I think $52.97, you know, what kind of hurdle above that?

Well, certainly, you know, we have a 30-day notice period and we need to be comfortable with somewhat higher than the -- and with the premium, the initial strike price is $54.11 so we would have to be somewhat above.

That I don't think I want to get into the specific amount, but certainly we would need a cushion to effect the call with that 30-day notice.

Okay.

But you wouldn't call the bonds for cash at 102?

Well --

You would prefer --

Certainly again we will take a look at our stock performance.

Our preference is to call the bonds and convert them to equity.

As we look forward, you know, we may have opportunities to refinance, or to pay cash at some point if that's what our situation dictates.

But our intent is still to convert them to equity at this time.

Okay.

Thank you.

Thank you, Brian.

And thank you, everybody.

Before Dave has some closing remarks, I wanted to share with everyone that AmeriSourceBergen will be holding its annual investors day on December 2 at our new distribution center in Columbus, Ohio.

As Kurt talked about.

The day will begin at about 11:00 a.m. and end about 3:00 p.m.

Besides the overview of the business, investors will also have an opportunity to tour our new facility.

Invitations will be going out soon.

And the conference will be webcast.

And I look forward to seeing you all there.

And now David would like to make some final comments.

I just want to thank you all for joining us.

As we mentioned we have several tough comparison quarters ahead of us until we work through this VA and advanced PCS business next summer but we continue to be very optimistic about our business.

Net of these two customer losses we have some good revenue momentum. '06 should feature an increased incremental volume from the Medicare modernization act.

We think there are going to be some good generic opportunities for us.

Completion of our DC network.

Like Mike, I look forward to seeing many of you at our December 2 conference in Columbus, Ohio where you can see our new DC and really get an insight into the future of the wholesale distribution.

Thank you all very, very much.

Ladies and gentlemen, this conference is available for replay.

It starts today at 2:30 p.m. eastern.

Will last until November 9 at midnight.

You can may access the AT&T executive play back service at any time by dialing 320-365-3844.

And the access code is 746975.

That number again, 320-365-3844.

And the access code is 746975.

That does conclude your conference for today.

And thank you for your participation.

And you may now disconnect.