美源伯根 (ABC) 2005 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by.

Welcome to the ABC quarterly earnings call.

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

Later, we will conduct a question and answer session and the instructions will be given at that time. [OPERATOR INSTRUCTIONS] As a reminder, today's call is being recorded.

I would now like to turn the conference over to our host, Mike Kilpatric at AmerisourceBergen.

Please go ahead.

Good morning, everybody.

Welcome to AmerisourceBergen's conference call, covering our March quarter results..

I'm Mike Kilpatric, Vice President, Corporate and Investor Relations, and joining me today are David Yost, AmerisourceBergen CEO, Kurt Hilzinger, President and Chief Operating Officer, and Mike 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 there are many risk factors that could cause our actual results to differ materially from our current expectations.

For discussion of some key risk factors, we refer to you our SEC filings, including our 10-K report for fiscal 2004.

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 after our opening comments.

And here is Dave Yost, AmerisourceBergen CEO, to begin our remarks.

Good morning, and thank you for joining us.

As noted in our press release, total operating revenues were just over $12 billion for the March quarter, down 1% versus last year.

Fully diluted EPS from continuing operations was $0.91, positively impacted by the $0.11 accounting change that Mike will discuss in detail.

We generated $1.1 billion in cash for the quarter and delivered a return on committed capital of over 26%.

Our balance sheet is the strongest it has ever been, with over $1.1 billion in cash at the end of March.

The quarter was clearly below our original expectation, though in line with our most recent guidance.

I want to put some of the numbers in perspective and deal with some industry issues.

First, regarding revenues, during the March quarter last year, we enjoyed $1 billion of VA revenue and about $500 million in AdvancePCS revenue, both of which we no longer serve.

That combined revenue equates to 12% of total operating revenue in last year's March quarter.

So taken in perspective, our total operating revenue growth net of the two account losses was clearly ahead of the market growth.

As you will recall, we lost the VA business in May of '04, so this is the last full quarter of VA impact.

One of the factors that distinguishes ABC from its peers is our strong specialty business, and that was in evidence this quarter, with especially strong oncology sales, as was true last quarter.

PharmAmerica's revenues were even with last year, and continue to be impacted by an extremely competitive market, strong regulatory -- state regulatory changes and the unsettling impact of a prolonged potential merger between two of the largest participants in a long-term care provider space.

As we transition through this fiscal year, a continuing word of caution regarding revenues is in order.

Uncertainty will continue to surround our oncology business until the physicians experience the full impact of their new reimbursement.

So we have not experienced a dramatic change in oncology revenues from the beginning of the calendar year and are encouraged by what we have seen to date, it still may be early to assess the impact.

Second, it is important to note that in both our operating segments, we are moving aggressively to discontinue doing business with accounts that did not meet our profitability standards, particularly in a non-prime vendor accounts remaining, or those accounts with an unprofitable mix.

Finally, the COX-2 category could effect future revenues.

Now I'd like to comment on some industry issues and reiterate our confidence in the balance of the year.

Regarding price appreciation: price appreciation for the quarter was in the high 4% range, slightly less than our original expectations.

We expect price appreciation for the balance of fiscal year to be at a similar level.

Our fee for service discussions continue with a high sense of urgency and we are pleased with both our strategy and progress.

We do not think it appropriate to publicize fee for service contract completions at this time, just as we do not publicize customer contract awards for the following reasons: First, publicity tends to encourage signing deals prematurely.

Secondly, where do you draw the line on the size of manufacture you announce?

Third, the account hybrid deals are only pure fee-for-service contracts that feature no price increase contingency.

The key issue here is that this is a transition in the way we do business with our suppliers and that the transition is proceeding in an orderly fashion.

We expect it to be completed largely by the end of the calendar year as we have maintained for some time.

On the competitive environment, I mentioned PharmAmerica's long term care business, previously.

Assessment of the pharmaceutical distribution market is somewhat anecdotal, since no large contracts have been publicly announced and the unsuccessful bidder is never really sure of the price and terms and conditions of the winner.

In spite of being a very competitive market, as it has been in my 30 years in the industry, the pharmaceutical distribution market remains stable with not much movement among accounts from wholesaler to wholesaler.

Since industry contracts tend to be two to three years, theoretically, one third of our business comes up for bid annually with very little switching.

The market is well over $200 billion and there are very few accounts over $1 billion.

I would describe the market as steady as she goes.

On April 7th, we disclosed we received a subpoena from the Office of the Attorney General of the State of New York requesting documents and information regarding pharmaceutical purchases from other wholesalers, often referred to as the alternate source market.

Subsequently, we have learned that others in our industry also receive subpoenas.

We expect to work cooperatively with the Attorney General, but do not have any additional information at this time regarding the subpoena.

It is important to note, however, that the issue of the alternate source market is an industry issue that effects the key participants in the pharmaceutical channel: manufacturers, wholesalers and providers, and relates to the key issue of safety of the pharmaceutical product within the pharmaceutical channel.

Today AmerisourceBergen purchases less than half of 1% of the pharmaceuticals we distribute from other wholesalers.

The purchases are made to maintain high service level when products may be in short supply, and on occasion to enhance our margin to allow us to offer lower service fees to our customers.

Purchases in the alternate source market are from less than 20 licensed wholesalers, which must adhere to AmerisourceBergen's product integrity program, which is more stringent than state licensing standards, begins with an extensive application process and background investigation, and includes ongoing monitoring and annual inspections.

We have been working closely with many manufactures to minimize the need for pharmaceutical purchases from alternate sources.

Our trade association Healthcare Distribution Management Association, which Kurt is the current annual Chairman, has also been very active in this-- in this issue as well as others of product safety.

AmerisourceBergen currently has over $1.1 billion in cash on its balance sheet after the completion of our share repurchase program.

In the past, we have used our generated cash to pay down debt, buy back stock, invest in our business and make modest acquisitions.

In the past 12 months, we have retired $800 million of long-term debt, repurchased well over $800 million of stock, and invested over $200 million in our infrastructure and made an acquisition of less than $20 million.

In the three and a half years of the history of AmerisourceBergen, we have spent about $500 million totally on acquisitions.

We have said the $100 to 200 million acquisition is our sweet spot, but have said that we would consider something larger if it made good sense.

We have an active corporate development program and continue to search for acquisition opportunities that meet our stringent acquisition criteria and provide a better risk adjusted return to our shareholders that are purchasing our stock.

Our acquisition criteria is straightforward.

Well-run companies in the pharmaceutical supply channel, with operational and/or managerial synergies, with attractive growth prospects, good margin and good return on committed capital are a strong pathway to that criteria.

We have never done a dilutive transaction.

Regarding our cash usage going forward, our past performance should be a good predictor of future activity.

We will continue to be very disciplined in this area.

Before I turn the floor over to Kurt and Mike for some granular detail, let me assure you that we are clearly on the pathway to return ABC to operating margins in the pharmaceutical distribution in the 100 to 110 basis point range for FY '05 with improvement in operating margin as we move into FY '06.

Our fiscal FY '06 which begins October 1 is shaping up to be a very strong year.

Kurt will deal with company-specific initiatives, but let me remind from you an industry perspective the MediCare Modernization Act, now about eight months from implementation will provide new incremental volume and an added emphasis on generics, sizably impacting the industry and AmerisourceBergen.

And '06 will be a strong year for new generic introductions.

The fundamentals of this industry continue to be excellent.

The industry growth continues to be strong and the value provided by distributors to both manufacturers and healthcare providers is being better understood every day.

The future looks very, very bright.

Here's Kurt.

Thanks, Dave, and good morning, everyone.

Many of the dynamics I spoke about last quarter remained in place during the second quarter.

We have been consistent in our message that 2005 would be a tough transition year, but that we were going aggressively respond to change in the markets we serve.

I'll address each of our business groups separately, but as an overall theme, I'm pleased to report that we are making excellent progress on the key management initiative we played out at the beginning of the year and our confidence is growing as we look toward 2006.

As we announced a couple of weeks ago, our overall shortfall in the quarter was principally due to lower than expected performance on the buy side margin of our drug distribution business, which was principally the result of lower than expected pharmaceutical inventory levels.

We consider this dynamic largely one time in nature, as the level of our inventory adjusts to new industry standards driven by our conversion to the fee-for-service compensation model, and away from our historical buy-and-hold model, which systematically created excess inventory in the channel.

We're not alone in this transition, as a number of other channel participants, including manufacturers and distributors, have cited similar effects over the past few weeks.

Importantly, we are making solid progress in our manufacture discussions and remain very much on track with our original timetable of completing implementation of this first generation of fee-for-service agreements by the end of 2005.

While this was clearly a challenge for us this quarter, as we look forward to the 2006 and beyond, we see increased stability and predictability of our P&L and increased returns on committed capital.

As we have highlighted over the past few quarters, we continue to take action on a significant number of other initiatives to improve our gross margin, including driving improved customer compliance to existing contracts, including generics and other programs, and firmly enforcing minimum purchase requirements.

We also continue to work aggressively to improve or eliminate low profit customer counts, and improve the margin contribution from certain product categories.

Lastly, we remain committed to maintaining pricing discipline with our customers, focusing on profit rather than revenue growth.

Below the gross margin line, we made solid progress on a number of other key initiatives as well.

The Optimize program, our $450 million distribution network modernization program, continued on schedule and on budget.

The third of our six new large highly automated distribution centers began operations in Dallas, Texas at the end of the March quarter, on time and on budget with no customer issues.

Looking ahead, one additional Greenfield in Chicago will go live in fiscal 2005 and we remain on track to have five of the six operational by the end of calendar year 2005.

As these facilities come online, we will consolidate our older, less efficient facilities to further drive efficiency.

In the first two quarters, we have consolidated three of these older facilities and we are on track to consolidate three more facilities by the end of fiscal 2005, setting the stage for solid gains in 2006.

The other major components of the Optimize program remain on track as well, with the continued rollout of our new warehouse management system.

Three installation were completed in the first two quarters and another three will be completed by the end of fiscal '05.

Documented productivity and quality improvements from these system investments continue to exceed our internal expectations.

Substantial progress continued on our Transform program, as we work to align our sales and marketing resources toward our most valuable customer segments, and create differentiated solutions using offerings from our specialty, technology and packaging groups.

There is a significant opportunity here to improve our value proposition to our provider customers and be paid accordingly.

So we remain optimistic that these initiatives, conversion to 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 of our drug distribution business in 2006 and beyond.

Turning to the specialty group, the group had another excellent quarter of strong sequential growth, especially its oncology-related businesses, again, driving revenues and operating earnings ahead of our internal expectations.

We entered 2005 with a relatively cautious stance regarding the potential impact of CMS's January 1 reimbursement rule changes for oncologists.

To date we have not experienced the detrimental impact from physicians moving patients to other care settings.

The performance of our oncology-related businesses remain strong in the March quarter, which gives us a cautiously optimistic view of the remainder of calendar year 2005.

Those of you who follow this area are aware, however, that more rule changes are likely next January.

We are actively involved in providing comments and feedback to CMS as they consider alternatives.

And as more is known, we will adjust our outlook if needed.

The other businesses of the specialty group had another solid quarter.

ICS, the group's third party logistics provider, opened a new 200,000-square-foot facility in Louisville to meet the needs of it's growing pharma- and biotechnology manufacture client base.

Latch, our manufacture reimbursement consulting business, signed the largest patient reimbursement support line contract in its history, with a top five pharma manufacture client.

ASD, the group's blood plasma distributor, enjoyed a record quarter in both growth and profitability.

Momentum remained strong in our packaging group during the second quarter as well with results better than our internal expectations.

At Anderson Packaging, results were driven by a record level of eight new product launches in the first six months and ten more products are scheduled for launch in the second half of the year.

American Health Packaging continued to evolve as an innovator in provider-oriented packaging solutions.

Further building out of high margin compliance prompting and unit dose product lines during the quarter.

Importantly, the packaging group also remained active in setting standards and testing various forms of electronic track-and-trace technologies to help combat the risk of counterfeit pharmaceuticals.

Turning to the technology group, during the quarter we took a small write-off of some intangible assets related to the group's acquisition investments.

Under accounting rules, we're required to make an evaluation of intangible assets on a periodic basis at a business unit level.

And we concluded a write-off was appropriate, given the fact that part of the group's business not met the growth assumptions we established at the time of the acquisition.

We have made a number of acquisitions in this area in the past two years.

And as a group, our investment continues to represent both an attractive growth platform and an important competitive differentiator of our offerings to the provider marketplace.

Turning to PharmAmerica, which had an improved quarter, with operating income up and returns on committed capital remaining strong.

On the revenue side, our workers compensation business continued to enjoy new business wins, building on the momentum we began to see last quarter, and setting the stage for a stronger 2006.

As has been the case for the past several quarters, our long-term care pharmacy business continued to face a difficult competitive environment with intense pricing pressure, driven in part by the possible industry merger, and continued reimbursement pressure from state Medicaid programs.

Importantly, though, we have made a disciplined approach to new business.

This in combination with the potential resolution of the merger activity gives us cause for more optimism as we head into 2006.

The business also continues to successfully execute the investment in cost reduction initiatives we outlined earlier this year, again, driving down operating expenses in the quarter.

During the quarter, long-term care nearly completed the consolidation of its pharmacy-level administrative activities into a handful of efficient regional service centers.

And additional work was completed to deploy automated prescription fulfillment equipment from our technology group, in order to drive down cost of operations at the pharmacy level.

PharmAmerica also accelerated the rollout of a number of customer-facing technologies, driving both new business wins and extending the contract terms with a number of existing key customers.

As you know, CMS released the final rules for the application of the Medicare Modernization Act to long-term care pharmacies at the end of January.

Since that farm, PharmAmerica has been extremely active, further studying the rules and proactively communicating and visiting with customers, pharmaceutical manufacturers and potential PDP contracting entities.

While it is still early in the process, we remain very confident that the unique value proposition of our long-term-care pharmacy business will continue to be recognized in the marketplace.

In the coming months, we will remain very active, further building out our service offerings as a subregulatory guidelines are refined.

Let me close by saying that as we indicated last quarter, we expected 2005 to be a challenging year as we both transition and invest in our various businesses.

We remain confident, however, in the attractive long-term growth dynamics of the markets we serve and we look forward to returning to our historical growth rates in 2006 and beyond.

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

Thanks, Kurt.

Good morning, everyone.

In the next few minutes, I'm going to provide some more insight on our second quarter earnings, detail our positive cash flow and balance sheet trends during the quarter, and lastly, review our fiscal '05 and preliminary fiscal '06 guidance, which is consistent with our pre-release in March.

Our results for the quarter were higher than the $0.75 to $0.85 range we gave at the end of March, due to a change in an accounting method.

So let me take a minute to discuss the accounting change.

The change relates to our accounting for cash discounts and other related incentives from our manufacturers.

Previously we recognized cash discounts as a reduction of cost of goods sold, when earned, which typically was when the related invoice was paid.

While this method has always been and still is appropriate, and has done an excellent job of aligning the cash discount with the inventory turnover in the past, we feel that with the business model transition going forward, better matching will be achieved by including all cash discounts as a component of inventory costs and recognizing those discounts into earnings when the related products are sold.

The impact of this accounting change method is to take a one-time cumulative effect charge of $10.2 million after tax as of the beginning of fiscal 2005, which is shown as a single line item below continuing operations in our six-month income statement ended March 31st.

In addition, we revised our December results to reflect the new accounting, which resulted in a $3.3 million net of tax, or $0.03 per diluted share charge to income from continuing operations in the December quarter.

Finally, the accounting change had the impact of increasing income from continuing operations in the March quarter by $12.2 million net of tax, or 11 cents.

I know this may be a bit confusing, so we've included a complete explanation of this change on our current year financials in our press release, as well as the pro forma effect on the comparable periods in the prior year, as if this new accounting method had been in effect.

Looking forward to the next six months, we expect the impact from the accounting change on continuing operations to be minimal, compared to the $0.08 benefit of the change on continuing operations in the first six months of '05, as we expect inventory levels to remain in the low to mid $4 billion range between March and September 30th of 2005.

Our consolidated results for the March quarter outside of the accounting change were very much in line with our pre-release.

Operating revenue of $12.2 billion was down less than 1% from the prior year March quarter.

EBIT fell 30%, primarily due to the byside shortfall in pharmaceutical distribution.

There were two other items of note in the quarter.

First, PharmAmerica's EBIT of $32 million was helped by a further reduction in their sales tax liability of $4 million, and second, unrelated to PharmAmerica, the consolidated other loss line of $4.9 million primarily related to a writedown of certain technology-related intangible assets.

Interest expense hit another record low this quarter at $14.5 million, less than half of the prior year interest expense of $31 million, reflecting the positive impact of the cash generated from our reductions in working capital.

Net average borrowings during the quarter were $322 million, down by over $1 billion from last March's average debt of $1.4 billion.

The effective tax rate for the quarter of 38.4% was unchanged from Q1 of '05 and is consistent with fiscal '04's full year effective rate.

Diluted EPS from continuing operations of $0.91 was down 26% from the prior year quarter.

Primarily due to the reduction in byside gross profit in the drug company.

Diluted average shares outstanding for the quarter were $110.2 million, down 7.7 million shares from the prior year quarter, reflecting the impact of the share repurchase programs over the last eight months.

However, note that the accelerated share repurchase of 5.3 million shares completed toward the end of March had a minimal effect on the shares outstanding during the March quarter, but will result in an approximately a 5% reduction in the average share count for the remainder of the year.

Moving to the pharmaceutical distribution segment.

Operating revenue for the segment was 12.1 billion for the quarter, and as expected, was essentially flat compared to the prior year.

The customer mix in the quarter was 56% institutional and 44% retail.

Our retail business grew a strong 9%, continuing its strong growth noted the last few quarters and our institutional business was down 7% and was obviously impacted by the prior year customer losses, without which it would have grown in the mid- teens.

Pharmaceutical distribution gross margins were down 58 basis points compared to the prior year quarter, with the majority of the shortfall on the buy side.

As we mentioned in our March release, while we are transitioning to a business model not contingent on price increases, our profitability during the transition period is still directly related to our ability to have as much of the right inventory on hand at the time of the price increase as possible, while complying with our current IMA agreements and positioning ourselves to take advantage of the new fee- for-service contracts.

We did not meet our internal expectations for managing these conflicting goals during the quarter, as our inventory levels were below expectations.

However, as both Dave and Kurt mentioned, our resolve has not wavered, and we continue to be very confident that we are making the progress we expected to make towards the fee-for-service model, and that model should produce the results we expect: more predictable earnings with less capital invested.

Operating expenses as a percentage of revenue were once again less than 2% in our operating margin in the quarter fell 66 basis points to 126 basis points, primarily as a result of the gross profit decline.

Turning to PharmAmerica, as Kurt mentioned, revenues of $391 million were flat compared to last year, but up sequentially from the December quarter.

Operating margins were strong, helped by the $4 million reduction in our sales tax liability, which accounted for the majority of the 99 basis point increase in our EBIT margin during the quarter.

Excluding the sales tax benefit, operating margins were still stronger than expected, due to vendor initiatives and expense control in both the long-term care and worker's compensation businesses.

We continue to expect our revenues for PharmAmerica to be flat for the year, but now expect EBIT margins to be in the high end of the 6 to 7% range.

Now, turning to the balance sheet and cash flows where the news continues to be positive, as we mentioned last quarter, the changing business model, in combination with operating results over the last two years, has helped us generate significant cash from operations, including $2 billion of cash generated from operations over the last 12 months.

We generated $1.1 billion of cash from operations in the quarter, compared to $476 million in the prior year quarter.

Again, primarily as a result of reduced working capital levels.

Our cash generation from operations guidance for the year remains at 900 million to $1 billion with inventory again expected to be in the low-to-mid $4 billion range.

During the quarter, we used the remaining $102 million of availability under our $500 million share repurchase program, announced in August 2004 to purchase an additional 1.7 million shares and we purchased the entire 5.7 million shares under our February 2005 share repurchase program to offset the shares issued from the redemption of our $300 million convertible debt facility in January.

CapEx for the quarter was $44 million and for the six months was 123 million and we continue to expect it to be in the $175 to $200 million range for the year.

And as a result of our significant cash flow, debt to capital was a record low 18.7% for the quarter, the first time we've been under 20% and down from 29% last year, and our net debt to capital ratio was less than zero.

Obviously this is below our target 30 to 35% ratio, providing us with continued financial flexibility and significant opportunity to deploy capital.

We do have a $100 million bond due in June that we will retire.

However, the remaining capital will be available for acquisitions and returns to shareholders as Dave discussed in some detail.

Finally, from a statistical standpoint, average inventory days on hand during the quarter dropped to 36 days, down 10 days from a year ago and down 22 days from two years ago.

DSO's continue to be strong at 16.4 days.

Now, turning to our guidance for the remainder of fiscal '05, we continue to expect diluted EPS from continuing operations before the cumulative effect of the accounting change to be in the $3.10 to $3.50 range on a GAAP basis with pharmaceutical distribution operating margins in the 100 to 110 basis point range.

Our early look at '06 is unchanged as well, with diluted EPS expected to be in the 360 to 440 range, with the bottom of the range, assuming no improvement in EBIT margins compared to fiscal '05, and the top of the range reflecting an improvement of 30 basis points in the pharmaceutical distribution EBIT margin, to 130 to 140 basis points, reflecting the benefits from our current year initiatives, with Optimize, Transform, our enhanced generic opportunities and our new fee-for-service contracts.

The guidance for '06 also reflects the full year benefit of our fiscal '05 capital deployment initiatives.

We continue to be very excited about the industry and our prospects and despite a tough transition, we are working very hard to return to the type of financial performance you expect from us.

With that, I'll turn it over to Mike Kilpatric for a few additional comments.

Thank you, Mike.

We'll now open the call up to questions.

I want to ask you to limit yourself to one question and a short follow-up until everyone has had an opportunity.

[OPERATOR INSTRUCTIONS].

We'll go first of the line with Lisa Gill of J.P. Morgan.

Go ahead.

Good morning.

Thanks.

Good morning, everyone.

Dave, I know that you talked about the fact that you don't want really want to talk about these fee-for-service agreements in any kind of detail, but I'm sure you're aware that many of the specialty pharmaceutical companies this week are talking about fee-for-service agreements being signed with the three wholesalers and blaming their inventories levels on these new agreements.

I'm wondering if you can perhaps give us any color as to, number one, is there inventory days that are within the fee-for-service agreements from your perspective?

Number two, if you can just give us an idea around hybrid versus non-contingent and lastly, as we look out for fee-for-service and your numbers for 2006, looks like every ten basis points is worth $0.26 to $0.28 to earnings.

Can you just talk a little bit about what your expectations are around the how fee-for-service looks from a margin perspective?

Any color you can give us at all would be great.

Thanks.

Okay, Lisa, I'll start and we'll let Kurt and Mike chime in as well.

We want to be very careful about not talking about specific companies, but in general, Lisa, sometimes we do have fee-for-service agreements that require us to maintain a certain service level, and so provide no incentives for us to provide high inventories.

There are clearly items, particularly within new specialty where we can maintain a lower inventory than is traditionally the case.

That is correct.

So you could see inventories, particularly in the specialty companies, affected by this, particularly with companies who have a good ability to maintain high service levels with low inventories as AmerisourceBergen has traditionally done.

Kurt, do you want to add any color to that?

I would just -- Lisa, I think the important thing for investors to keep in mind, and we made it in our comments this morning that, we really view this as kind of a one-time adjustment in nature.

The fundamental demand for these products hasn't changed.

That, we all understand.

What's happening is here we're just having an adjustment of the overall amount of supply of product that resides in the channel from the manufacturer down to the point of dispense.

And I think we're going to see more of what we've seen this last week, these last couple weeks from manufacturers making the announcements.

Recognize that the amount of inventory that's going to be residing in our facilities, and our peers' facilities is the result of really the manufacturer deciding how much product they want to have in the marketplace, and it is tailored, depending on the particular need of the patient base that they are trying to take care of here.

In some cases with certain maintenance drugs and so forth, where the demand is very predictable, you can run with fewer days of inventory in the channel.

In other type of patient care settings where it's more difficult to get the product to market, the product has special handling requirements, there's critical care elements, around patient livelihood and so forth, manufacturers will often decide to have more days on hand in the channel.

So our approach to this from the beginning has been to meet the needs of the manufacturer here.

Let them tell us how much they want to have in the channel, make sure their patients are beg properly serviced and cared for.

That's driving a lot of these inventories.

I think we'll see a little bit more of it going through the remainder of '05.

One thing is for sure, Lisa.

No one wants to miss a sale on this issue.

Clearly the manufacturers who have very, very high gross profits, of course they don't want to miss a single piece of merchandise not being sold, when it's demanded and we of course don't want to miss any sales either, so we're very motivated to have high service levels.

Maybe we'll let Mike talk about--

Yes, if you could talk about the expectations around on the margin side, if it's really tied to the service levels and if there's any tie-back in the amount of inventory you're carrying.

Yeah, I think, Lisa, just let me first answer your earlier question.

You had asked does each 10 basis point improvement in EBIT margins result in a $0.26 to $0.30 impact on EPS.

The answer is yes.

I think the guidance that we gave in our March call was that each 10 basis points of improvement is approximately $0.27 and that's what bridges the gap in our early '06 guidance between the 360 on the low end, which assumes no improvement in the EBIT margin, and the 440 on the high end, which assumes the 30 basis point improvement.

So just to clarify that, it's exactly as you said.

Okay.

I'm just tying to tie the two together, Mike.

I'm just trying to understand what it is that -- if it's specific agreements that's going to get us there between the difference of where you are today and get the additional 30 basis points.

Will have you more color around that in the fall as these fee-for-service agreements are signed or are there other initiatives we should be looking to?

The fee for service agreement is one of a number of the initiatives we have in place, Lisa, to bridge that gap.

You know, Kurt talked about a number of the initiatives under our transformed program to improve customer profitability.

I mean these are initiatives that are in place in '05, taking hold where we'll get the full benefit in '06.

We also talked about our progress in the generic area as well, which has taken hold again in '05 and will have an impact in '06.

So it's a combination of all of those initiatives that give us great confidence about that 30 basis point improvement, which you remember, we said is our minimum expectation.

Lots of moving parts there, Lisa.

We're moving ahead with all of them.

Great.

Thanks for the comments.

Our next question comes from the line of Tom Gallucci with Merrill Lynch.

Please go ahead.

Good morning.

David, I was just wondering if you could clarify your comment on price appreciation being in the high 4% range?

Is that a total inflation number or is that just branded?

Then also wondering if you could clarify, you said that you could move to eliminate some business where it's just not profitable or non-prime vendor-type business.

Could you at least put some kind of parameter around how much business that might be?

We really want to be careful about putting parameters around the amount of business, Tom, but we've got a very disciplined program right now where we're literally going through account by account.

It's one of the reasons we've been very conservative in our revenue numbers going forward because we really want to do business with customers that are profitable or have the potential to be profitable with the kind of mix of business in the kind of growth prospects we have.

A little uncomfortable putting a number on it, but I will tell you it's a very important program that Kurt's monitoring almost on a daily basis.

Our high 4% inflation number is an overall number that we're seeing.

And then could you break that down at all into what you're seeing on the branded side versus the deflation on the generic side?

We really, we really have not done that in the past.

I don't think we're comfortable doing that.

Thank you, Tom.

Next question, please?

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

Please go ahead.

Okay, great.

Thanks.

I'll ask one question and a brief follow up if that's okay.

First of all, on the inventory side, Dave, you talked about with your pre-release some frustration in this transition that you weren't able to buy as much inventory in the March quarter as you had hoped.

I was curious if you've gotten anymore data points.

I know you say you're very much still resolved to move toward the process.

Anymore data points from [Lindy Cameo] or his team from what happened or do you just chalk this up to transition issues?

I think some are transition issues.

Larry, I think there could be-- there are a lot of moving parts associated with this.

Clearly the revenue issue that we've got, our revenue's flat versus some of our peers could have an issue, could be a factor.

Our mix of business could be a factor.

We oh on oh the way we handle merchandise through all of our distribution centers as opposed to bringing into one place could be a factor.

A lot of moving parts at this point.

I'm not sure we've got anymore insight than we had before, but to think it's kind of a one-time phenomenon.

Larry, it's Kurt.

The only thing I would add to that is I know the quarter was painful and obviously it was a surprise, and we're paid not to have surprises around here, but I think I point to the upside to the change here and that is that to the extent we can get more of this adjustment into '05, the better off '06 is going to be.

And so we, we are moving to get our inventory levels in line with these contracts, both ones that are in place and some that we're anticipating being in place here before the end of the fiscal year and so there is an anticipation element to this as well.

We really have talked about '05 being a transition year.

So we can string this process out over a longer period of time, if we wanted to game the system here a little bit, but that's not the intent.

The intent is to get over to this new model.

It's a better model for us.

It's a better model for our manufacturing partners and we're working aggressively with them to get it done.

So that's the only other color I could probably provide on the transition here for you.

Okay.

Great.

Thank you.

You're welcome.

Just a quick follow up.

Just maybe for Mike DiCandilo, just the timing of the accounting changes this quarter, versus last couple quarters, what made sense from your own review of the inventory of discount recognition?

Larry, as you would expect with an accounting change, it's a long process and it's a process.

One, we evaluate all of our accounting policies on a continuous basis.

As we started entering into this transition to fee-for-service, we took a look at all the elements of our revenue recognition and what made sense in the new model, and it took a lot of time to gather that data, analyze that data, -- work with our outside accountants to come to this answer.

So we've been working for some time and finally got ourselves into a position where based upon the analysis, we felt that moving to this new method would be a better matching of the profits going forward under the fee-for-service model.

Okay.

Next question, please?

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

Good morning.

It's John Wooden in for Bob.

Mike, does your expectation have an average 5 million fewer shares in FY '06 versus FY '05 in your share base assume incremental repurchases?

It assumes minimal repurchases, additional repurchases, John.

I think you get close to that 5% weighted average, decline year to year just based upon what we've already done through fiscal '04.

We talked about having an incremental $500 million this year in cash from operations above our initial guidance of 375 to 475.

Now it's 900 to a billion.

There is an expectation that part of that 500 would be deployed towards share repurchases, but not the entire amount.

Okay.

Great.

When could we expect to see an announcement on that front?

Well, this is something that we take up at board meetings, John, so when we have-- when we've made a decision on that, we'll let you all know.

Thanks very much.

Next question, please?

Our next question is from the line of Andrew Weinberger with Bear Stearns.

Please go ahead.

Yeah, just had a quick question with regard to the go-forward cash flow generation rate of the company.

Once you get inventories down to the appropriate level, which seems like it's in the $4 to $4.5 billion range, should we take your initial cash flow guidance for fiscal '05 of that 375 to 475 million as sort of the appropriate operating cash flow run rate, I guess 120% of net income is what we should expect that operating cash going forward in '06, and '07 and beyond?

Andy, I want to tie it exactly to a percentage of net income, but certainly our expectation over the next couple of years is that inventories are going to come down a little bit more from where they are today for two reasons.

One is the completion of our Optimize program, which as you remember, Kurt mentioned was a $450 million program and was going to be funded by the efficiencies in our inventory.

Some of that still is yet to happen.

You know, secondly, again, as you move truly to a non-contingent price increase model from where we are today, the expectation is that there's some more room for that inventory to come down.

So I think what you'll run into next year, in the next couple years is depending upon revenue growth, there will probably not be a corresponding increase in working capital to revenues as we've seen in the past and that the cash flow from operations will closely parallel our net income.

And just real brief follow up on that, you mentioned that you want to be up debt to capital in the 30 to 35% range, which looks like an additional $2 to $2.5 billion of additional debt.

When do you think we could get further word on when you plan on raising that and potential uses of that?

Again, our target, our target ratio would be very comfortable in the 30 to 35 range.

That's one of our key credit metrics and we have-- there's four or five other metrics that we watch as well, Andy.

We are certainly are going to be disciplined in using that cash as Dave said.

It certainly -- we think we've put that cash to pretty good use over the last couple years as we outlined in reducing debt and buying back shares and reinvesting in our business.

And I think we're going to continue to do those things and certainly we'll get the benefit of that, but I don't want to put a timetable by any means on it.

Andy, those are the goals that we established early on, to be investment grade, and we continue to watch those, but we certainly don't feel any pressure or need to lever up to those for sure.

Great, thanks.

Thanks.

Next question, please?

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

Please go ahead.

Thank you, and good morning.

We talked about lower profit accounts.

Seems to be a little bit of a theme here.

How much emphasis, Kurt, do you think we'll hear going forward about that need to enhance sulfide margins of your business, and I guess what tools do you see at your disposal to allow you to do that?

And then as a connected question, you talk again in the release about your anticipation of volume from MMA in 2006.

And so to the extent that you had given preliminary FY '06 guidance, what types of assumptions have you used in that guidance for incremental volume from the Medicare Modernization Act?

Thanks.

I'll have Mike get with the guidance question, Chris, but just with regards to customer profitability, I would say we're in the early going here and what I mean by that is we're going through and looking at our customers on a very detailed basis and what we're clearly doing is those accounts that are not meeting minimum return on committee capital hurdle rate requirements or profitability targets, we're engaging and have been engaged in discussions now to get them back to a target level.

Now, what is the target level?

And that's where things are a little bit variable here because the target level today may be a different target level than what we need in the future, depending on the outcome of our fee-for-service discussions with our manufacturers.

That's why we're pushing so hard to get these agreements signed.

Because once we have the buy side component of our profitability fixed through this process, we will then know whether we have an earnings gap or whether we're in fairly good shape, in terms of our existing customer pricing, to support the returns and the growth that we want to get in this business long-term.

So we're doing some near-term cleanup work, and then we'll get through fee-for-service, and then we'll figure out whether or not we need to go out and make some adjustments from a pricing standpoint to our provider customer base.

We've got a lot of tools to do that.

One is, starting point is our own corporate profitability.

People understand that the wholesalers today are having a difficult time and they understand the world is changing, so there's an education element to the process.

But then we are doing other things as well.

We're adding other capabilities from around the four corners of ABC to come up with different value propositions to our customers.

We are dedicated to moving from being a provider of product at a price to being a provider of solutions and being paid based on the value we create.

Easy words to say, difficult to execute, but we've got -- our organization is marching in that direction.

There is a lot of value for someone like ABC to provide both up the channel and down the channel on the provider side and we've got our sights square on it right now.

Chris, as we look out to '07, we're looking at the market growing in the high single digits.

You meant '06.

I'm sorry. '06.

We're looking at growing in the high single digits.

You've got CMS out there talking about low double digits, IMS talking about high single digits, going forward you've got clearly the impact of MMA coming in, but you've also got a lot of generic conversions.

Some people have estimated well over $20 billion for the calendar year '06.

That's not going to happen January 1st, but they're having an impact, so we're in the high single digits.

I understand.

One quick follow up if I might.

Kurt, you highlighted ICS as an area of particular strength.

Maybe just comment on the extent to which you are successfully able to link some of ICS's capabilities, particularly the 3PL category to some of your fee-for-service discussions.

Thank you.

Well, it's a good question, Chris, and I would at the you the fee-for-service discussions are about, the distribution logistics service that we have provided historically, and -- with an existing manufactural relationship, ICS is a little bit of a sidebar conversation because ICS is really targeting young emerging companies in the marketplace today.

But we're going through fee-for-service discussions with all of our traditional manufacturer partners, but invariably what's happening is as we get through those discussions, we get into a discussion with them saying, they ask us often times, what else can you guys do for us?

We know we're facing a different world in the ineffective years.

We need to become more efficient.

We need to look at ways to operate better in the channel.

What else can you, ABC, do for us.

And, so you know, ICS is a good example of it, but there are a lot of other manufacturer services in ABC today, and that we'll be adding in the years ahead to build out that offering to our manufacturers to be, to allow them to become more efficient.

Thank you.

Thank you, Chris.

Next question, please.

Our next question comes from the line of Andy Speller with A.G. Edwards.

Please go ahead.

Thanks, just numbers question, Mike.

Was there a LIFO charge in the quarter?

Yes, Andy.

There was a LIFO charge in the quarter of $5.7 million versus a charge of $16 million in the same quarter last year.

As you would expect, the LIFO charge came down as our inflation profits were down.

I would assume that there would be a minimal charge on a go-forward basis with inventory basically being fairly flat?

Yeah, I think we're expecting right now probably in the $10 to 15 million range for the year.

All right.

Thanks very much.

Thank you.

Next question, please?

Our next question comes from the line of Eric Coldwell with Baird.

Please go ahead.

Thanks very much.

A bit of a leading question here, and maybe in two parts.

Our expectations would be that a couple of years out when we get more to a fee and activity-based model that days on hand would probably run around 28 to 30 days.

Just curious if you can kind of suggest if you're in the same category as I am on the days on hand issue and if so, would that also suggest that you have about six to eight days of speculative inventory still in your distribution network?

Thanks very much.

Eric, I think we had said we're obviously at 36 days right now and we expect some improvement over the next couple years, again, both because of our internal efforts and based upon the success of moving to non-contingent agreements.

I think you've got to realize that there's other inventory outside of brand name inventory that's impacted, or the brand name inventory, which is impacted by the fee for service agreements.

They are still-- 20% of our business is outside of brand name, and typically inventories for the non-brand name products are at a much higher level as far as the number of days than the brand names are.

So it's not a perfect equation that will be matched exactly to the fee-for-service progress.

Right, and if-- I understand that, and I guess what I'm driving to is regardless of whether the number's 28 or 32 at the end of this, you still have some speculative inventory in the network, of course, which you've suggested.

What I'm driving to is how much of whatever that delta is, how much of that is speculative inventory as opposed to perhaps still having excess inventory in hand as you complete the distribution network consolidation and optimization?

Yeah, I think-- that would be a little bit difficult for us to break out at that level.

I mean I think your general assumption is fair that, there's going to be a reduction and it's going to be due to both of those reasons and I think we're directionally correct, but trying to quantify it at any more detail think would be difficult at this time.

Okay.

Thanks a lot.

Thanks, Eric.

Next question, please.

Our next question comes from the line of Ricky Goldwasser with UBS.

Please go ahead.

Yes, good morning.

Thank you for taking my question.

You know, David, you talked about your-- growing faster in the market when you normalize the losses from last year and I think that that's kind of the phenomena that's been going on for a couple quarters now.

Now, it seems to me that in order to grow faster in the market, you really need, especially given the cleanup of kind of unprofitable accounts, you need to take market share.

Can you talk a little bit about gaining market share, in which segments of the market and have you been taking away share from regional players or from your national peers, and then just sort of a quick follow on that one, you also mentioned acquisitions in your preliminary remarks and on the acquisition side are you looking to acquire a company that would compliment your presence in the retail market and also what multiples are seeing out there and what multiples do you find be acceptable?

Well, first of all, let me just talk about the market growth, Ricky.

One of the reasons we've been able to grow a profitable market is because of the specialty businesses, which is a big differentiator for us.

We're very, very strong in the oncology business, as Kurt mentioned, had a big quarter in the blood business.

So what we're actually growing some of our-- one of the reasons that we're growing our business is we're in the specialty business, very strong in the specialty business where our two large peers are not very big players.

So we are not taking market share for them, but rather growing in places where they are not and that's a very corrective situation for everybody.

In terms of the acquisition, we continue to be watch the acquisitions very closely.

We have just seen of late acquisitions go at very, very high multiples of EBITDA, yet we have not not attractive to us particularly when compared to buying back our own stock.

So that's one of the reasons that we've had such an aggressive share buyback program, is that we think at this point our shareholders have best been served by that.

That certainly doesn't mean that we will not continue to be very active in of looking at acquisitions, as I mentioned, you know, we have a strong corporate development program, but we certainly don't have any, anything to announce at this point.

What--

Thank you, Ricky.

Next question, please?

Certainly.

Our next question comes from the line of Steve Halper with Thomas Weisel Partners.

Please go ahead.

On the change in accounting, the release talks about a $0.03 drag for the December quarter and then an $0.11 increase in the March quarter.

What was the-- what's the, what is the cumulative adjustment represent below the line for the six-month period?

The cumulative adjustment is really reflects the, just that.

The cumulative effect of all prior periods to fiscal '05.

So that's sort of the catchup for all prior periods and that's why it's below continuing operations.

That, that-- before-- before fiscal '05?

Right.

It's the cumulative effect as of the beginning of the fiscal year.

In our case, October 1.

So the cumulative effect up to that point comes through the P&L below continuing operations.

Okay.

In the period of the change.

And how far back did you have to go?

Well, it's as of.

It's as of that adjustment, as of that date on the balance sheet.

So it's cumulative.

Okay.

Really from the beginning of time.

Got it.

Okay.

And the-- just housekeeping question.

What was the actual share count at the end of the quarter?

The, the average shares?

Actual, actual.

We're looking at--

We'll get that.

Nobody's got it on the tip of their tongue and I clearly don't.

We'll look it up.

We'll give that to you in a second.

Okay.

Thanks.

Okay.

Next question, please?

Our next question is from the line of David Veal with Morgan Stanley.

Please go ahead.

Good morning.

This is [Aliyah El-Ameen] calling in for David Veal.

Had a quick question on the specialty business.

You mentioned that the oncology distribution business has gone well.

Recently with Cardinal's recent win of the distribution agreement with the National Oncology Alliance, do you feel that that will cause any market share shift in oncology distributions and what are your thoughts about the competitive landscape there?

This is Kurt.

No, I don't think that's going to, I don't think that's really going to change the dynamics in the marketplace.

They signed an agreement with [Noah], which is a GPO.

I'm sure, and we have a relationship with a GPO as well, and so I don't think that's going to -- Noah has relationships with physician practices and it's really a license to hunt and you make your business case.

You make your business deal with the oncology office itself.

So we don't see that changing things dramatically from our standpoint.

Okay.

One additional question.

You guys talked about the packaging business over the last few quarters.

Could you provide more detail as to what percentage of your revenues is due to packaging, as well as the percentage of operating earnings?

I-- we have not broken that out in the past.

It's included in our pharmaceutical distribution segment, but we have not broken out the revenues or the earnings contribution of that in the past.

Thank you very much.

Next question, and this will be the last one, please.

Certainly.

Our final question, then comes from the line of John Ransom with Raymond James.

Please go ahead.

We have slow fingers in Florida apparently.

I thought I was pretty quick.

A couple of questions on generics.

First of all, did your-- we calculated from NDC that the overall market and generics group almost mid-teens in the first quarter and that revenues grew in the low 20s.

Did your experience reflect those numbers on a contract, excluding the lost contracts?

Those are numbers that, John, we have not broken out in the past, but I will tell you our generic business continues to be very strong.

We're very happy with it.

We think we're getting excellent penetration with our customers.

One of the profit initiatives that Kurt talked about is monitoring our generic sales to individual accounts as a percentage of their total revenue.

We think we're increasing our penetration with accounts as we go forward, so we're very, very happy with that generic business.

One of the fears in investors have is this intermediation issue at the top end of the customer range.

With your contract enforcement efforts, are you-- can you provide any quantification of some [discerning mediation] to them.

Are you able to recapture 5% or is there some target you're shooting at there?

We try to tap into the customer range.

What type of customers are you talking about?

The larger ones tend to buy these directly, as you know.

Are you able with your contract compliance religion, are you able to stem some of that potential [discerning mediation] or get some of that back?

Clearly, John, there's kind of two different kinds of markets out there, and suppliers.

One is clearly the spot market, who's got product at a price at any given day.

Okay.

That's not really the business we're in.

We're in the continuity of product, providing good value day in and day out, continuity of color, size, shape of pill, from very reliable suppliers, and so you order the merchandise from us day in and day out and you get the product day in and day out, so that's really the business we're about.

We constantly tell our customers that they are far better off focused on selling merchandise, not purchasing merchandise from the spot market.

So we think our position with the generic, in the generic space is strong.

It's one of the reasons we're so excited about the generic opportunities in '06, which some have estimated to be a $20 billion opportunity in total market.

So we think that the continuity, the prime vendor program that we've got really best serves our customers and will continue to capture market share there.

And just one quick followup for Kurt.

As we look at '06, you don't have to comment on this number, but let's assume that for branded pharma, we're at about a 3% branded-- what is the goal of the company in terms of having exposure to inflation as regards that 3% gross margin?

Seems like you guys are taking a little more risk in your agreements, at least the way people are talking about these things, to inflation and it's just hard for us from the outside looking for to try to figure out what exactly that exposure might look like as you kind of march through this restructuring process.

It is an outstanding item as we go through this process.

But to answer your specific question, our goal is to have zero.

We would like to be on a pure fee-for-service basis and not be dependent at all on price increase events that are controlled entirely by our manufacturing partners.

That's where we want to be.

I made a comment in my prepared remarks where I talked about these contracts being first generation because we're not getting everything accomplished and ridding ourselves of that, of that component of contingency as we would like.

We're not going to be 100% out of that.

Hence, we have hybrid contracts as we refer to them.

I view ourselves as a first generation here.

I think as the manufacturers begin to appreciate the model we're putting in place, begin to understand the benefits to them that, I think we'll continue to move that to a smaller percent of contingency in the years ahead, but I can't answer for you where we are going to be by the time we get to the end of calendar year '05.

We could probably size-- if it's something we feel appropriate to disclose.

Thank you, John.

Thank you.

Just getting back to Steve Halper's question, the outstanding-- net outstanding shares net of the treasury shares at the end of the quarter were 104.2 million.

Thank you, Mike.

And now, Dave Yost would like to make some final remarks.

Yes, I would like to conclude by saying it's been a challenging year of transition, but we continue to be very, very disciplined, both in our operations and our use of capital.

We're very excited about the opportunities for '06 and we're doing all the things right now to get ready for those opportunities, which will include an expanded market due to the Medicare Modernization Act, as well as strong generic introductions so we're very, very excited about the future and we look forward to talking to you next quarter.

Thank you very much for joining us.

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