美源伯根 (ABC) 2006 Q1 法說會逐字稿

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

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

Later, there'll be an opportunity for questions and comments.

Instructions will be given at that time. [OPERATOR INSTRUCTIONS].

As a reminder this conference is being recorded.

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

Please go ahead.

Good morning, everybody, and welcome to AmeriSourceBergen's conference call covering fiscal 2006 first quarter results.

I'm Mike Kilpatric, Vice President Corporate and Investor Relations, and joining me today are David Yost, AmeriSourceBergen's CEO;

Kurt Hilzinger, President and Chief Operating Officer; and Mike DiCandilo, Executive Vice President and 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 a discussion of some key risk factors, we refer you to our SEC filings including our 10-K report for fiscal 2005.

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 Dave Yost, AmeriSourceBergen's CEO, to begin our remarks.

Good morning, and thank you for joining us.

As noted in our press release this morning, AmeriSourceBergen had a strong quarter.

Operating revenues were up 11% to a record 13.5 billion.

Operating margins expanded.

Interest expense was down significantly.

Diluted earnings per share from continuing operations was $0.47, up 47% over last year.

We finished the quarter with $1.5 billion in cash and had the strongest balance sheet in our history with no net debt.

We completed the first quarter of our fiscal year with positive momentum in a positive industry.

Since our fiscal year began on October 1st, we completed one modest acquisition and announced another.

While neither was significant from an EPS perspective for this year, both reinforced the strategic direction of AmeriSourceBergen.

In October, for about $80 million, we closed a transaction to acquire Trent, the third-largest wholesaler in Canada with annual operating revenues of about $500 million in U.S. dollars.

Our first quarter in Canada has been excellent, with strong endorsement by customers and suppliers.

Last Friday, Trent changed their name to AmeriSourceBergen Canada Corporation.

This acquisition, our first outside the U.S., reflects our commitment to Pharmaceutical Distribution.

This month, we announced a definitive $90 million agreement to purchase Network for Medical Communications and Research, or NMCR, a provider of physician-accredited continuing medical education, or CME, and analytical research for the oncology market.

Though modest in size, this acquisition reflects our commitment to our fast-growing specialty business and the oncology business in particular.

As we have noted on a number occasions, we like the oncology business, not only because of its current metrics, but also because of the product pipeline and the opportunity we have within the business to provide value-added services to both physicians and suppliers.

NMCR is a great example of that opportunity and will nicely complement our Imedex physician education business we purchased in May of '04.

Our strong balance sheet and cash provides us with great flexibility for acquisitions, internal investments, and returns to shareholders.

Regarding acquisitions, we will continue to be very disciplined as we have in the past.

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

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

Our acquisition criteria is straightforward.

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

We will review our dividend policy in FY '06 with our Board as we do every year.

We continue to expect to repurchase approximately $400 to $450 million worth of AmeriSourceBergen stock by the end of our fiscal year.

I assure you, we will continue to be very disciplined in our use of cash as we are in our operations.

The Medicare Modernization Act, or MMA, went into effect January 1st and has received a lot of media attention.

All dispensing pharmacists, including, of course, our customers and our long-term care associates in PharMerica have experienced new and unprecedented challenges as they have executed the largest public health policy change in 40 years.

Given the magnitude of the change, I think some bumps were to be expected.

As has been reported, pharmacists across the country demonstrated their integral role as health-care providers and on countless occasions went beyond the call to deliver medications to their patients in sometimes frustrating circumstances.

Clearly a lot still needs to be done, but last week with other industry executives, I met with senior administrative officials who expressed confidence in rapid improvements, and we have every confidence that things will work out.

We think the sustainable positive impact of MMA will be gradual over out fiscal year and into our fiscal '07.

Except for the dispensing issues associated with MMA, I would continue to describe the Pharmaceutical Distribution industry as stable.

It remains highly competitive, of course, but with no multimillion-dollar contracts up for bid and minimal customer changes, except those resulting from merger activities.

It is important to note that ABC enjoys less customer concentration than our peers.

Mike and Kurt will review operating details, but several trends are worth noting.

First, of course, revenues were very strong.

Though we benefited from some seasonal quarter end orders from some of our large customers, which will probably not be repeated at the March quarter end, it is important to note our revenues were strong across all customer segments and business units with continued strong performance from packaging and our specialty groups oncology and other distribution divisions.

Our operating margins trended up, due to improved gross margins driven by strong execution of our fee-for-service agreements.

As you will recall, many of our fee-for-service agreements are performance-based, and in the December quarter, our performance, relative to established metrics, was excellent, both for the quarter and calendar year.

Our balance sheet continues to be very strong as noted with our cash crossing the $1.5 billion mark for the first time.

The PharMerica segment, particularly the long-term care portion, continued to operate in a challenging environment and delivered results below the expectation of that management team in spite of extremely strong efforts, as Kurt will detail.

This is clearly a business in transition.

The impact of Medicare Part D is in its very early stages.

The competitive landscape with one large competitor being absorbed by another and the role of prescription drug plans, or PDPs, is unresolved.

We will continue to focus on improvements in this business.

As we look out to fiscal '07 and beyond, we continue to be very excited about the prospects for our industry and the role that AmeriSourceBergen will play in it.

Generics continue to offer great potential for our Company in terms of earnings, relative investment, and differentiation of our offerings.

Our generic program, called ProGen, is getting stronger and deeper market penetration month by month.

Our Optimiz distribution center rationalization program in the drug company will be about completed by this fiscal year end with benefits accruing in '07 and beyond.

Our last of six large new DCs will be operational by late spring.

We ended December with 30 DCs in the drug company down from 51 at the time of the merger in August 2001 with a few more consolidations to go.

Our market position with AmeriSourceBergen Speciality Group is a great example of being at the right place at the right time with the right human and capital resources.

We expect our Speciality Group to continue to experience strong growth and continue to expand its value-added services up and down the channel.

Our packaging business unit also had a very strong quarter and occupies excellent positioning in the channel.

We expect the pharmaceutical channel to experience strong revenue growth, increasing in our fiscal '07 as the impact of MMA and new products, particularly in the specialty segment are introduced.

The profit potential of an expanding generic market represents good upside in the years ahead.

It is important to note that the U.S. pharmaceutical industry continues to provide the safest and most secure pharmaceutical delivery system in the world.

You will recall that on October 1st, AmeriSourceBergen took a leadership position within the industry in further securing the safety of U.S. pharmaceutical supply channel when we announced we would purchase pharmaceutical product, both branded and generic, only directly from the manufacturer.

This policy has been enthusiastically endorsed by our suppliers and customers, and we look for it to be replicated throughout the industry.

Our strong balance sheet provides us unprecedented financial flexibility.

We are very bullish on the future.

Here is Kurt to drill down on some operating specifics.

Thanks, Dave, and good morning, everyone.

Today I'll touch on the performance of each of our key business units during the quarter and briefly review what we'll stay focused on for the remainder of 2006.

We are obviously pleased with our consolidated financial results for the quarter, which on most key indicators exceeded the high end of our internal targets.

Importantly, this is despite a weaker-than-expected performance at our PharMerica business unit, which I'll address later in my comments.

During the quarter we saw a very solid recovery in our core drug distribution business with stronger-than-expected revenue growth.

More importantly, however, we saw another quarter of improved gross margins as the key initiatives we have focused on continue to gain momentum.

Key elements of our improved gross margin performance are as follows -- First, we completed our fee-for-service contracting process in the December quarter as expected.

In addition, we drove excellent performance against those contracts, providing performance incentive payments greater than our internal expectations.

Second, generics were again an important driver.

Our efforts during the past year to increase our penetration of generics to improve customer compliance in combination with improved sourcing, drove additional margin dollars in the quarter.

Third, we remained focused on our efforts around Transform, by further aligning our sales and marketing resources toward our most valuable customer segments to drive better customer profitability and contract compliance.

As many of you know, AmeriSourceBergen has been a large supporter of independent pharmacies for many years, and as such, we enjoy a very large market share position with this class of pharmacy.

An example of some of the work coming out of our Transform initiatives was our announcement this Monday to enroll our Good Neighbor Pharmacy network of 2400 independent pharmacies as a founding member of Sure Scripts.

Sure Scripts is the nation's largest network provider of electronic prescribing services.

Under Part D of the new Medicare Modernization Act, pharmacies are strongly encouraged to support electronic prescribing.

This initiative will help ensure that our independent pharmacy customers will make a smooth transition to E-prescribing by providing them the tools to connect directly to the care physician, thereby enhancing clinical, economic and operational efficiencies for all involved.

Dave provided our perspective on some of the challenges related to the rollout of the Part D program.

Our pharmacy customers can continue to count on ABC's support.

With programs like Sure Scripts and others to help make their transition to Part D a successful one.

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

The Optimiz program continued on schedule and on budget.

As we reported previously, our new Kansas City Greenfield facility became fully operational in October, and a total of three distribution centers were consolidating during this December quarter, keeping us well on track for a total of six consolidations this year.

And our last and final Greenfield in Bethlehem, Pennsylvania, remains on schedule to open in late spring.

Operating expense as a percentage of revenues were flat with prior year levels as expected, as additional investment spending in sales and marketing and IT infrastructure costs all intended to drive better gross margin performance offset near-term productivity gains.

Importantly, in early December ahead of our internal schedule, we completed our migration to one IT platform in the drug company.

This will allow us to drive out additional cost and improve our ease of doing business with customers and manufacturers alike in the years ahead.

All other aspects of the Optimiz program remained on track.

So all in all, we still have more work to do.

We were pleased to see the level of recovery in the drug company, and we believe the trend lines we saw this quarter bode well for the remainder of year.

The Packaging Group had an excellent quarter, exceeding our internal expectations and making an ever-increasing contribution to the overall results of ABC.

During the quarter, we saw further strengthening in the group's operating margin driven by the continued launch of higher margin product lines. 22 new generic products at American Health Packaging and 4 new program launches on behalf of brand manufacturers at Anderson Packaging.

The pipeline of new product launches for both businesses remains strong, driven by what was perceived as an increasing demand for outsourcing services from both branded and generic manufacturers who are interested in driving lower cost while maintaining product quality through our well-controlled production environments.

As a reminder, we have approximately 1 million square feet of production capacity and packaging continues to be a possible area of expansion for us.

Now turning to PharMerica, which had another difficult quarter.

Revenues showed some improvement over recent quarters due to better customer retention and new business wins in both the long term care and worker's compensation business units; however, operating income was down, primarily due to a larger-than-expected bad debt expense in the long term care business, which Mike will detail, and the added cost of preparing for the implementation of Part D. While we are encouraged by the long-term care's top-line performance which was largely driven by new customer opportunities opening up, we have modified our operating margin expectations for the remainder of the year.

This change in outlook is largely driven by the impact business unit's transition to a new payer model under Medicare Part D.

As a quick reminder, in early November and then again in our investor conference in early December, we said that the profitability of our long-term care unit would remain uncertain until two things occur.

One, negotiations with manufacturers regarding rebates are complete, and, two, the final mix of PDP entities servicing PharMerica's patient base is known.

While we expect final clarity on this issue by the end of the second quarter, we now have a fairly clear view that for calendar 2006, the potential upside in reimbursement rates negotiated last summer with the PDPs, under any PDP mix scenario, will not offset the reduction in manufacturer rebates as we now complete those negotiations.

It is clear that long-term care pharmacies play a critical role in improving clinical outcomes through comprehensive drug regimen reviews and therapeutic interchange programs.

It is essential that these rebate dollars or equivalent amounts be returned to the long-term care pharmacy industry in the future for the industry to continue to provide the level of care required by America's seniors.

It will obviously be incumbent upon us to factor that into our negotiations with PDP entities beginning later this spring for calendar year 2007 reimbursement rates.

Lastly, turning to the Speciality Group.

The group had another excellent quarter of strong sequential growth, driving revenues past an $8 billion revenue run rate and operating earnings ahead of our internal projections.

The top line was driven by an especially strong performance by our oncology platform, supported by an ever-growing pipeline of new products that continue to grow ahead of the broader drug market.

Just a quick note on the CAP program in late December, we filed with CMS to be a CAP vendor beginning July 1st; however, our application made some very specific recommendations on changes we feel need to be made to make the program commercially viable.

We are actively engaged with CMS regarding our recommendations.

Importantly, the group's two other distribution businesses, ASD and Besse Medical, both enjoyed strong top-line and bottom-line performance in the quarter, driven by favorable market pricing dynamics for blood plasma products in the case of ASD and excellent market penetration of certain key physician-administered products at Besse Medical.

And our manufacturer services businesses lash group, ICS and Imedex, also had a solid quarter as a number of new programs were both awarded and launched to help manufacturers commercialize new products.

All in all, a solid quarter.

We clearly have more work to do to return our core drug distribution operating margins closer to historical levels, and we have more work to do in our long-term care pharmacy business.

But by and large, the overall trends bode well for the remainder of the year.

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

Thanks, Kurt, and good morning, everyone.

I'm very excited to present first quarter results that not only significantly exceeded prior year results at both the top and bottom lines, but were also above the high-end of our internal targets, reflecting the continued recovery of our core distribution business and the continuing solid growth and outstanding performance from our Speciality Group.

Before I get started with my review, as a reminder, all of my discussions regarding share or per share amounts will reflect the two-for-one stock split affected in December.

In addition, we had minor adjustments to our prior year disposals, which are reflected as a loss from discontinued operations of $709,000 in the current quarter.

Now starting with our consolidated results.

Operating revenue was up a strong 11% consistent with our recently revised guidance and driven by our Pharmaceutical Distribution segment, which I'll provide more detail on.

Consolidated EBIT was up a strong 24%, driven by the significant gross margin recovery in our Pharmaceutical Distribution segment which, as you remember, was impacted by fewer than expected price increases and other buy-side opportunities in the December quarter last year.

Included in our consolidated gross margin for the current year was a net benefit, pretax, of $18 million resulting from litigation settlements from manufacturer antitrust cases which compares to a similar amount of $18.8 million recorded in the prior year quarter.

Reflected in our consolidated operating expenses for the quarter were $8.8 million of facility consolidation, employee severance and IT transition costs which compares to similar costs of $5.1 million in the prior year.

Excluding litigation gains and the special charges, consolidated EBIT increased 31%.

We continued to expect that for the entire fiscal year '06, favorable litigation settlements will be largely offset by special charges.

Equity compensation expenses, which impacted the P&L for the first time this quarter as a result of the implementation of FAS 123R, were $2.6 million, or $0.01 per share.

Net interest expense for the current year quarter was again at a record low at $6.5 million, compared to $22 million last year, a significant decrease of over 70% reflecting the financial leverage from our net debt reduction over the past year, as once again our average net cash invested during the quarter exceeded our average borrowings.

The effective income tax rate for the quarter was 38.5%, about even with last year's 38.4%.

Diluted EPS from continuing operations of $0.47 was up a strong 47% from last year's $0.32 per share before the cumulative effect of the prior year accounting change, again driven by the recovery in buy-side profit from the drug company along with our continued strong growth in specialty and our outstanding financial leverage.

The net positive after-tax impact of special items in the current year quarter was $5.7 million or $0.03 per share, compared to a benefit of $7.8 million or the same $0.03 per share in the prior year.

Our fully diluted shares outstanding for the quarter were 210.3 million, down just under 13 million shares from the prior year resulting from our share repurchase programs.

Moving to the Pharmaceutical Distribution segment, which continues to show positive momentum resulting from a lot of hard work over the last several quarters.

Operating revenue for the segment was $13.3 billion.

For the quarter, again, a strong increase of 11% compared to the prior year.

As we mentioned in a press release earlier this month, this higher-than-expected increase was driven by a few large accounts, and as a result, we increased our operating revenue guidance for the year to a range of 7% to 9% from 6% to 8% which essentially keeps the next three quarters at the 6% to 8% level.

This guidance may be conservative based upon the first quarter, but we do not think at this point that the first-quarter increase is sustainable as most of the increase above our original expectations appears seasonal in nature.

Certainly, based upon our prior year quarterly revenue spread, we should have a more favorable revenue growth rate in the March quarter than in the last half of the fiscal year.

As expected, the Trent acquisition contributed 1% to our growth rate in the current year quarter.

Our bulk deliveries, while up 17% sequentially from the September quarter, declined 22% from last December, which was very strong, to $1.1 billion in the current quarter and there were no changes to either our customer base or the way we operate our bulk business during the period.

The customer mix in the quarter was 59% institutional and 41% retail, consistent with the September quarter.

Our institutional business growth was in the high teens, driven by another strong quarter from our Speciality Group and the growth of our large customers in the alternate site space.

Importantly, Pharmaceutical Distribution gross margins increased 24 basis points compared to the prior year quarter as we demonstrated strong performance under our fee-for-service contracts and we also realized the positive impact of our Transform and generic initiatives.

In addition, price increases returned to more normalized levels in the current year quarter compared to last year, which was unusually light from a buy-side perspective.

We had a $6.9 million LIFO charge in the quarter, up from the $2 million charge in the prior year quarter, reflecting the higher inflation rates and the increase in inventory levels since -- since September.

Operating expenses as a percentage of revenue were 1.93%, consistent with the prior year as investments in sales and marketing and IT infrastructure costs largely offset productivity gains as expected.

Our operating margin in the quarter increased 24 basis points to 104 basis points, directly attributed to the gross margin increase I just mentioned.

Turning to PharMerica.

Revenue of $409 million was up 6% compared to last year, our strongest top-line performance in quite some time.

We were disappointed, however, with our operating margin of 4.5%, which was down significantly from last year and below our estimates.

This margin reduction was primarily due to operating expenses which were up $12 million or 168 basis points compared to last year's quarter.

This increase in expenses was primarily due to an increase in bad debt expense of just under $9 million from a credit of $3.5 million in fiscal '05 to a charge of $5.4 million in fiscal '06.

And also due to costs related to preparation for MMA.

As Kurt discussed in detail, our current assessment of the impact of MMA on PharMerica's margins is negative for fiscal '06 and as a result we have lowered our operating margin guidance for PharMerica for the year to the 4% to 5% range from our previous guidance of 5% to 6%.

Now turning to the balance sheet and cash flows.

Cash generated from operations in the quarter was $231 million as increases in inventory levels at the end of December were more than offset by related increases in accounts payable.

Inventory of just under $5 billion was higher than expected, as manufacturer order fulfillment rates during the holidays exceeded what we've seen in the past.

This combined with our higher-than-expected sales growth and optimization of inventory levels under our fee-for-service agreements drove inventory levels higher at the end of December, but we expect the impact to be temporary and continue to expect inventory to end the year in the $4 to $4.5 billion range.

As a result, we also continue to expect cash flow from operations to be in the $5 to $600 million range for the fiscal year.

CapEx for the quarter was 28 million and our guidance for the year remains at a range of $125 to $150 million.

Our debt to capital ratio at the end of December was just under 20%, down from 23% last year, and with a cash balance at the end of December of over $1.5 billion, our net debt to capital ratio was less than 0 once again.

Obviously, this provides us with continued flexibility and significant opportunity to deploy capital.

During the quarter, we did repurchase $89 million worth of shares, leaving $661 million remaining under our share repurchase program.

As Dave mentioned, we continued to expect to repurchase between 400 and $450 million of shares during the fiscal year.

Finally, from a statistical standpoint, despite a high inventory balance at the end of December, average inventory days on hand during the quarter remained at 32 days, down 9 days from a year ago; and DSOs continue to be very strong at just under 17 days.

Overall, a very solid quarter driven by higher-than-expected top-line growth and strong execution on the buy side, under our fee-for-service business model, with more capital to be deployed as we move forward.

Our diluted EPS guidance from continuing operations for fiscal '06 remains unchanged at $1.98 to $2.13, as mentioned in our news release.

And with that, I'll turn it over to Mike Kilpatric for a few additional comments and Q&A.

Thank you, Mike.

We will now open the call to questions.

I would ask you to limit yourself to one question until we've had on opportunity for others to speak; and then if there's time, you can ask additional questions.

Go ahead, Tom.

[OPERATOR INSTRUCTIONS].

Robert Willoughby, Banc of America Securities.

Good morning.

Dave or Kurt, it's not clear to me why some of the challenges you face with PharMerica are really actually challenges.

I mean, I just don't quite understand how the changing competitive landscape of a few of the larger payers has really kind of hurt you negotiating with the PDPs.

Can you flesh that out a bit?

Yes, I think in this particular case, Bob, it is an issue of timing.

If you recall, we completed our negotiations with the PDPs last summer, and we were under the clear impression that the rebate streams that we had enjoyed for years for what we do would remain intact from the manufacturers.

CMS came out with some language late fall that gave the manufacturers some pause, and made them rethink exactly how much rebate moneys are continuing to flow to our side of the -- of the marketplace.

And so we've got a timing issue.

And so we need to go back -- as I mentioned in my comments, we need to go back and get that money back into the system with the next round of contracting.

So it's just a timing issue and we think it's one of those transitional things that we think affects '06 and we will recover from it in '07.

I mean, dramatically, no?

I'm sorry?

You would recover dramatically with fewer competitors out there, no?

Well, with fewer competitor in terms of the PDPs, or --?

No, just on the institutional pharmacy side.

The PDPs have a lot fewer choices now, no?

Well, I think that's -- I think that's right.

I think we've got -- but obviously we would need to make our case, and we need the monies back in the system. here's no doubt about that, and I think we can make a good case with the PDPs of the value we provide for the care of their patients.

Good question, Bob, thanks.

Thank you.

Lisa Gill, J.P. Morgan.

Thanks very much.

I was wondering if you could just talk a little bit about your distribution margins, clearly improving but still have a ways to go to where you ultimate goal is.

Can you just walk us through some of the drivers that will get us there over the next couple of quarters?

We, we've got several initiatives in place, Lisa.

Number one is clearly what we call our Transform program, which is focusing on those customers that have the best operating characteristics for us.

We're currently focusing on generics, which continue to have great opportunity for us and increasing opportunities as we go forward since starting this summer.

We'll have some big products coming off patent.

We continue to rationalize our distribution network.

That work will essentially be done by the end of this fiscal year, so it will give us some additional lift as we go forward.

Kurt, have I missed anything?

No, those are the major drivers.

It is all about execution at this point, Lisa, and the teams -- the teams are on it hard, obviously.

Are you guys willing to give any additional color, I mean, as to the breakdown of those?

If we look at this quarter it was 106 basis points.

I think your goal is 115 to 125 basis points, so that's basically 9 to 19 basis point improvement from here.

Is there any one area that we should be focused on that's really going to be the driver?

Well, Lisa, this is Mike.

I mean, we have not gotten into breaking down the individual components.

Certainly, as I think I spoke about in the December quarter, there are still some seasonal issues, and some of that boost is merely going to be because of the timing of price increases throughout the year, particularly when you take a look at the March quarter, which traditionally has been the strongest quarter, and we would expect that to -- to happen again.

And then I -- I think as we continue to -- to build our revenues, some of the other initiatives will continue to kick in as we move throughout the year.

We're clearly encouraged, Lisa, though, by what we've seen.

Appreciate the comment.

Great.

Thank you.

Next question, Tom.

Larry Marsh, Lehman Brothers.

Just a clarification in terms of expectations and sort of what you're suggesting in the market.

On your LIFO charge, obviously, higher than expected, assuming you saw a little bit stronger prices in the quarter.

What's your expectations for the full year and those same expectations for inventory?

Should we think about inventories continuing to come down, Dave and Mike?

Or do we think about sort of that 32-day range as being the right number?

Obviously, you're saying 4, 4.5 billion.

But over the next two years, would you anticipate that further coming down or do you think we're at a sustainable level?

Larry, this is Mike.

First off with LIFO, we continue to expect a charge in the 10 to $15 million range for the year.

The allocation to the quarters moved a little bit more towards the first quarter based upon the upside we saw from the price -- from a price appreciation standpoint, but I think we're still at the 10 to 15 for the year.

As far as inventory levels.

As I mentioned, I expect them -- despite the fact we were just under 5 billion at the end of December, to come down into the 4 -- to $4.5 billion range, and with our revenue increase that we have built into that, I think from a day perspective, you'll see that -- the days modestly decline from the 32 days or so we are right now down towards -- close to the 30-day level depending upon where we end up in a range.

And I think as we move forward, there's still some room for some modest improvements.

Certainly the consolidation of our distribution network, when we're fully up and running at full speed on our six Greenfields, that was all designed to take some working capital out of the system, so I think you'll see modest improvements in the future.

Super, thanks, Larry.

Thanks.

Tom Gallucci, Merrill Lynch.

Good morning, everyone.

On the inventory trends, just wondering if you can describe a little bit more what happened there, and maybe how that plays out into the seasonality of the earnings that you mentioned before, Mike.

And then on the revenue side, trying to figure out, was that more sustained throughout the quarter in terms of seasonality, or was it more of a year-end buying as people look towards January for Medicare reasons or other?

And to what degree might that cause a little bit of a let-down in the March quarter on the revenue side?

First, Tom, in terms of receiving inventory, we think how the holidays fell played a key role in that.

With the holiday being on Sunday, it really allowed us to get a lot better productivity out of our receiving docks with trucks coming in than we typically do if the holiday's on a Tuesday or Wednesday when you kind of leave -- when you kind of lose a day on each side of that, so we think the way the holiday fell clearly helped us with our service levels this year.

Mike, is there anything you wanted to --

No, I think that's right.

And that could have had some impact on the revenue increase.

You asked about the timing, the time was mostly in December and in the latter half of December.

Certainly, I think in our -- our guidance, we've reflected the fact that we do think that it's going to be somewhat less of a growth rate for the rest of the year. 7% to 9% for the year, which implies, again, 6 to 8 for the next nine months.

As I mentioned, I think the March quarter has a pretty favorable comparison.

If you look at the trend of revenues last year, you'll see that the first quarter and the second quarter operating revenues were relatively flat on a sequential basis, and we had big sequential jumps in Q3 and Q4.

So as I look at the next three quarters, certainly the -- the second quarter should compare favorably.

Great, thank you.

Thanks, Tom.

Thank you, Tom.

Chris McFadden, Goldman Sachs.

Thank you, and good morning.

Kurt, I was hoping you could provide a little bit more on kind of operational context around the PharMerica business.

We've heard a lot of chatter out of the retail pharmacies about some of the execution associated with enrolling patients in Part D. I recognize that you operate in a very different environment in your institutional pharmacy.

But nonetheless, I was hoping you could, perhaps, talk about some of the challenges from either a technology or an operations perspective that may have been reflected in the quarter and how you think that will play out over the next couple of quarters.

Thank you.

Thanks, Chris.

I mean, in terms of Med D and the December quarter, there was really no impact except for the fact we had additional expenses as we highlighted to get tuned up and ready to help the patients roll over to the new Med D program.

Since -- since January 1, obviously, like community pharmacy, long-care pharmacies had its challenges.

And -- but I think most of that, fortunately, is getting worked through the system pretty effectively.

Early on, we had a lot of point-of-sale denials because we could not get good matching of data to determine eligibility for particular patients.

So we started out with a pretty dismal statistic January 1, but today, kind of three and plus a handful of days into it -- three weeks and a handful of days into it, we're at 95% matching, in terms of data at this point.

So the point-of-sale denials that we were experiencing early on are rapidly working out of the system.

We just -- there's just a lot of pieces of the puzzle here and I think CMS, obviously, is putting a lot of effort into it.

We are -- our peer companies in this industry are putting a lot of effort into it in a very concerted way, and I -- as Dave said, I think we're confident we're going to work this through and we'll be looking back in a few month's time and saying, Gee, we did get through it pretty successfully as an industry and as a country.

And what is the mechanism for you to go back to the manufacturers as you said and sort of put some more dollars into the system.

Is that a -- is there going to be just an annual kind of renewal process, or is that to be more proactive on your part?

Well, I think we need -- we need to have a little bit more clarity with CMS in terms of exactly what they want the ultimate model to look like here, i.e., where do the rebates ultimately reside?

Do they reside at the provider level, which is our level, so that we can drive better clinical outcomes, or do they want them to reside at the PDP level?

We would strongly recommend and have recommended to CMS that they reside at our level with greater transparency.

That's what they want.

They want to understand how many rebeat dollars are in the system today because they're the payer today, so they want to know how much money's in the system.

And so we would support them on that.

But ultimately, we need -- so we need clarification from CMS, and then we will -- then we will have to go out either negotiate higher reimbursement rates from the PDPs this year, starting this summer, or reengage with our manufacturers and get some clarity that the rebate dollars will come back into the system from them as we go into their contracting process at the end of calendar year '06.

And then if I could -- just finally, are the generic substitution rates kind of -- and I know it's early in the process, but are they generally what you had experienced pre-1-1 of '06, or are there some variation there?

I got tell you, I think it's too early to give you an indicator on that at this point, Chris.

We can -- obviously, we'll -- we're watching it carefully and in a quarter or two we'll have some definitive views for you.

Thank you.

Thanks, Chris.

Eric Coldwell, Robert W. Baird.

Specific questions have been asked and answered.

There's been some chatter in the channel that some generics companies are starting to ask for fee-for-service deals similar to what the branded manufacturers have moved toward.

I'm curious if you're seeing any of this?

If so, what is it doing to the competitive landscape and the margin opportunities on generics?

Any color in that record will be great.

Thanks.

Eric, we're really -- we're really not getting any of that.

I think if you're getting that, that could be just a one-off anecdote.

We are clearly not seeing that and the whole relationship with the generic manufacturers is different because of the added services that we provide for them, not the least of which is creating demand.

So I really don't look for that -- the generic business to migrate as the brand --

And you're still seeing that at the present that you're negotiating manufacturer by manufacturer, pill by pill?

It's not quite pill by pill, but it's clearly therapeutic classes and manufactured by manufacturers.

Yes.

And we continue to provide great services both to our customers and to our manufacturer suppliers.

In the case of the customers, provide great value to them.

Search the market value.

Price and other factors considered.

A lot of generic alternatives, they look for us to make that decision for them.

In the case of the manufacturer, we provide a product that has continuity of color, shapes, size and pill and good value and create demand for them.

So great opportunity for us with generics and as we've pointed out on a number of occasion, also allows us to differentiate our offer because the generic offering that we have is market basket of a couple thousand products is not the exact same as our peers, so great opportunities for us as we go forward.

That's good to hear.

Thanks very much.

Thanks, Eric.

Glen Santangelo, Credit Suisse.

Glen, we got -- we know how your name really goes, Glen.

It's okay.

Thank you so much, Dave.

I just had a quick question around drug distribution operating margins.

We've talked in the past about the fee-for-service agreements either being a one- or two- or three-year duration.

And so assuming you've assigned some of these one-year deals in 2005, 2006 becomes a renegotiation year for you.

So I'm trying understand, is it a potential risk that maybe some of the people as you move into, for lack of a better term, renegotiation season, do some of these pharma companies, is there a risk that maybe they think the world is a little bit more negative this year than they thought last year, and they maybe try to nickel and dime you on the margin?

I mean, should I be -- should we be concerned at all about that, or how should I -- have you had any experiences as you go back to manufacturers the second time around?

How have those conversations progressed, if you've even had any at this point?

Yes.

Go ahead, Dave.

I would just say, Glen, I actually view it as upside.

I think as we continue to perform under these fee-for-service agreements that we have, many of which for us are performance-based, I think it's going to actually have an enhancement for us as we go forward.

So we're not at this point viewing that as a downside at all.

Have you had any negotiations the second time around?

Or no?

No.

We're just -- but we've got -- a lot of this work was done starting a year ago, so they're around the corner and in a handful of instances for us.

And, again, this is -- we've got a very strong business case here for what we do for the manufacturers.

We are very cost effective in how we get their products to market, and -- and they've all run the trap lines on what it would cost for them to do self-distribution and those things and that's really behind us as an industry now.

They understand they've got good value with us, and it's really getting paid fairly.

And we have said, look, we would like to be more successful in getting more performance-type measures into these contracts because when we have that, we do well.

We're good at what we do.

And a lot of the reason we performed well in the December quarter is because we achieved the high end of those performance indicators, so we would like to go back to these manufacturers and basically put more money into the contracts, but also put it at risk from a performance standpoint for ABC, and in that world we feel very confident we'll do well, and they'll get better economies themselves.

Okay.

Thanks for the comments, guys.

Andrew Weinberger, Bear Stearns.

Yes, hey.

I just wanted to get a little more color surrounding the -- what seems like the seasonal purchasing by some of your -- by some of your customers at the end of December.

Were you -- are you able to sort of isolate the SKUs that those purchases were made in, or were they across the board?

I guess what I'm trying understand, are customers trying to cherry pick forward buying opportunities out of -- out of your inventory, or do you feel it's sort of more across-the-board buying?

The answer is yes. [ LAUGHTER ] I mean, it is.

The pharmaceutical appreciation has been an component of the supply chain from a profitability standpoint all levels for a number of years.

And the challenge we've got as we've gone into fee-for-service agreements is get the proper governance mechanisms in place for outbound freight to our customers.

And that's part of the recontracting process we're going through with Transform to make sure that we're doing -- controlling that inventory properly on behalf of the manufacturers as we've committed to.

But, you're right.

That's -- that is the issue and it's not going to go away overnight, but I think the industry's on it.

And having said that, it's hard to tell when you get an order from a customer, what it's for, and so it's -- it's a tough thing to monitor.

Great, thanks.

Ricky Goldwasser, UBS.

Yes.

Hi.

Good morning and thank you for taking my question.

A quick question on the bulk deliveries.

As you said, they were down sequentially -- sorry, they were down year-over-year.

Are you seeing any shift from bulk to operating revenues similar to trends reported by others in the industry over the course of last year, or is it just that kind of one off your largest customers that usually does bulk had less purchases?

Well, Ricky, that's -- you're absolutely right.

As you know, we do a lot less bulk than the rest of the industry, and it's really concentrated in one main customer, and we have had no change at all in our practices with that customer.

There has absolutely no shift from our bulk business to our operating business.

One thing to keep in mind is the December level of last year bulk deliveries number of 1.4 billion had -- was up 32% from the prior year.

So it's more that the prior year number was unusual than the current year, which, as I mentioned was up from the September quarter.

So we shouldn't read of it that kind of that customer is now going -- doing more purchases direct?

No.

No, you shouldn't read anything into that, Ricky.

Thank you.

Andy Speller, A.G. Edwards.

Hi, Dave, I want to you clarify something you said about industry growth in 2007 being stronger.

I didn't know if you were talking about total pharma or just specialty?

We think that -- Andy, when we look out to '07, we think '07 is going to be a very strong market both for the industry and for us.

We think it's going to be heavily influenced by us for specialty products which reflects our strong specialty business.

So we're just trying to make the case that we think '07, as we look out beyond our fiscal '06, our '07 looks very, very good.

Do you want to quantify what you mean by "strong?"

I mean --

No, but I just want to give people confidence that we have confidence in the revenues going forward.

Clearly the issues that we've talked about with MMA are going to be fully resolved at that point.

You'll recall that the sign-ups don't even have to occur until May of this year, so we're going to get some -- some help from that.

We think new products are going to take issue, and with think that the whole generic issue -- we're -- will be very positive for us.

So I just wanted to telegraph was that we're very bullish on our fiscal '07.

You're saying generics are going to be positive for revenues?

Not for revenues [inaudible] our company, right.

Okay.

So -- I mean, so basically what you're trying to tell us is that revenues in '07 will be better than revenue growth in '06?

What we're trying to say is that we think '07's going to be a good year for us, and as we begin to start looking preliminarily at '07, we're liking what we see.

Okay.

And then if I could on the fee-for-service performance that you talked about in the quarter, can you give us some metrics around how you outperformed specifically to your agreements?

Well, they're very customized, Andy.

I mean, it's manufacturer by manufacturer.

We set up specific metrics for what is important to the manufacturer, and we've done a very good job of performing against that.

So you can't give us any examples?

I just -- I'll just throw in one thing, Andy.

This is Mike.

Certainly some of those contracts, we have ongoing monthly and quarterly metrics and some of them also have some calendar year metrics, and a lot of our contracts are calendar-year based, and we performed well against both the ongoing metrics and some of the annual metrics as well.

So just as -- so as we look at this, would you say that the calendar year period would be the biggest period in terms of beating those metrics because having that extra comparison, if you will, on -- on an ongoing basis?

Certainly the ongoing metrics are more important to us, but the performance on -- on a calendar year metrics helped us on the high end.

Okay.

All right.

Thanks a lot, guys.

Thanks, Andy.

John Ransom, Raymond James.

Hi, John.

Good morning.

I hope fatigue hasn't gotten up with you because I've got math question, so better get Mike on this.

Your guidance -- the number we should use for the first quarter is 47, correct, when we think about your year guidance, so we subtract the year from the 47.

So my question is, that obviously included some help from litigation.

What's your number for the year in terms of litigation net of some of these one-time severance costs that you mentioned in the quarter?

What's the total contribution from the net of those two?

We had a 3% contribution in the first quarter, John.

We would expect that 3% --

$0.03.

Excuse me, a $0.03 contribution from the litigation, net of special charges in the first quarter, and we would expect that to reverse over the next nine months and essentially be neutral for the year.

Said another way, [we'll have] special charges continuing, and we -- we do not have much in the way of anticipated receipts of further settlements.

So I think you're going to see that offset there, and I think as you look at our guidance for the rest the year, I think the other thing you'll have to factor in is our revised guidance on PharMerica, which, again, will take down our EBIT over the next three quarters and offset some of that upside we had in the third quarter, which is why we've kept the same range.

Okay.

See?

Good.

Good math question.

My second -- just quickly.

As we look at the pharma market, according at least to NDC which is one data source out there, the market has slowed down pretty dramatically to kind of a 5% growth.

You're reporting numbers above that and your outlook is for something above that.

Is that because you're more leveraged to specialty and to institutional?

And then would 5% kind of be a good number for where your independent pharmacy growth rate is currently, and I'll stop there, thanks.

Yes, you're absolutely -- it's a function of our mix.

The specialty business continues to enjoy above market growth, and we participate in that market very, very strongly.

So that's -- that's clearly growth -- that's clearly a big growth factor for us and the reason we think we can outperform the overall market and we're seeing our retail business and our expectation for the retail business to be in the mid single digits going forward.

All right.

Thanks a lot.

You bet.

Steve Halper, Thomas Weisel Partners.

Hi, good morning, just in terms of clarification on the rebates to your PharMerica, you negotiate your rates with the PDPs and did you underestimate -- walk us through why the rebates are down, and one would have assumed that you had some contracts with the drug manufacturers on these rebates.

Were those contracts just expiring at the end of the year and now the drug manufacturers are pulling back on those rebates?

Yes.

Again, it's a, Steve, it's really a timing issue.

Our contracts with the manufacturers tend to be annual and they tend to be with calendar year expirations.

So we were -- we were in rebate negotiations toward the end of calendar year '05 and into January.

So that's one side of the equation.

The other side of the equation is we negotiated with the PDPs during the summer and put those contracts in place with them.

We negotiated reimbursement rates with the PDPs assuming that -- that the rebate monies from the manufacturers would remain consistent in '06 versus '05.

And then we had some -- some language come out from CMS that gave the manufacturers pause as to whether or not they needed to continue to provide the level of rebate dollars going forward that they had historically.

And so we've had some rebate.

We've had rebate monies going out of the system, and that's -- it's really a timing issue and I think the industry's got its case and a very good case for why those monies need to come back in, and we'll obviously be on that case in '06 here as we -- as we turn the corner on '07.

Great.

That helps.

And then just one housekeeping item.

The litigation recovery.

You include that in revenue on the income statement?

The litigation?

Oh, no, that's a -- it's reflected in our cost of goods sold.

So it's -- so it's a reduction in cost of goods sold.

Right.

In consolidated.

In consolidated.

Right, right, right.

Thanks.

Tom, we'll take one more question.

Ross Muken, Deutsche Bank.

Hi, it's -- thanks for taking our question.

It's Barbara Ryan.

And I guess it is just a continuation of the PharMerica question, and I guess in thinking about what you said about the manufacturer rebates, it -- it obviously was a difficult process to get where you are today on the Rx side in drug distribution and theoretically could be just as difficult in the long-term care side.

It seems as though some of the major manufacturers are starting to benefit from the reduced rebates, and they may get used to that.

And you have obviously a competitor that theoretically now with consolidation is going to have some synergy benefit where their demands either on the client or the manufacturer side might be less.

So I guess what I'm wondering is, your points have been made as to guidance for this year, but to what extent is this just sort of the beginning of -- of a more difficult process that will take the next couple of years to work out as it relates to the pricing being wrong, both from the manufacturer and the customer side, separate from the one-time costs and integration of MMA that you've obviously discussed.

Yes, Barbara, it may be helpful to kind of frame the rebate number here a little bit so people understand exactly the pocket of money we're talking about.

Rebates have historically been about 2% of the PharMerica segment's -- 2% of revenues for the PharMerica segment.

The degradation of rebates for '06 is about 40% of that, and hence you get to approximately a 1% margin adjustment here.

Which is what you did on guidance, right?

That's what we did on the guidance, and so -- and I think based on what we know right now, that's -- that's the money we need to get back into the system.

Obviously, we've got all of calendar year '06 to go to work on this with negotiations starting with the PDPs in the spring and rest assured we will be sitting down with CMS, looking for a final clarification on how they want this thing to be resolved, and we will be sitting down with our manufacturer partners to understand exactly what their intent is once we get clarification from CMS.

So we've struggled with a lot of unknowns here that -- that -- and we've kind of gotten caught in the backwash, if you will, from not having really good clarity coming out of CMS on what they would like to see ultimately the model to be.

So that's where we're going to spend our time in '06, and we will -- we will make our case.

Obviously, we'll -- we'll let everybody know once we know more.

It's our hope and our expectation at this point that we've seen the worst of it, that we got kind of caught from a timing standpoint here.

It wasn't the intent of anybody to see the profit margins drop down in our business because there is a certain level of care that people expect from us.

And I think it's also important to note, Barbara, transitioning from one business model to another is something that we've had great experience with, and we will clearly manage our way through it.

Thank you.

Thank you.

You bet.

Thank you.

Thank you, Tom.

And thank you everybody.

I'd like to now turn it over to David again who'd like to make some final comments.

I just want to thank you all for joining us.

We're very excited about how our fiscal year has begun in our December quarter.

We've got good revenues.

We've got expanding margin.

We're in a very strong cash position.

No net debt.

We think we've got great momentum going in a great industry.

And we look toward to reporting our March results with you sometime in April.

Thank you very, very much.

And, ladies and gentlemen, this conference will be available for replay after 2:30 p.m. this afternoon until February 1st at midnight.

You may access the AT&T Executive Playback Service at any time by dialing 1-800-475-6701 and entering the access code of 813006.

International participants may dial 1-320-365-3844.

Those numbers once again are 1-800-475-6701.

International participants, dial 1-320-365-3844 and please enter the access code of 813006.

And that does concludes our conference for today.

Thank you for your participation and for using the AT&T Executive Teleconference service.

You may now disconnect.