美源伯根 (ABC) 2007 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by.

Welcome to the AmeriSourceBergen third quarter earnings conference call.

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

Later we will conduct a question-and-answer session.

Instructions will be given at that time.

(OPERATOR INSTRUCTIONS).

As a reminder, this conference is being recorded.

I would now like to turn the conference over to your host, Mr.

Mike Kilpatric.

Please go ahead.

Welcome to AmeriSourceBergen conference call covering fiscal 2007 third quarter results.

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

For a discussion of some of the key risk factors, we refer you to our SEC filings, including our 10-K report for fiscal 2006.

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 remarks.

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

Good morning, and thank you for joining us.

As we announced this morning, operating revenues in our pharmaceutical distribution segment were over $15 billion, up almost $1 billion and 7 % year-over-year.

Operating expenses in the segment were down as a percent to revenue and operating margin continues to improve as it has throughout the fiscal year, now up 10 basis points on a year-to-date basis.

Our cash generation continued to be robust and our returns on capital were strong.

On a GAAP basis, our diluted EPS was up 19% over the June quarter last year, and was up 21% on a yearly basis.

I would describe our financial performance for this quarter and this fiscal year as steady and solid in a stable and solid industry.

We are clearly on track to exceed the financial metrics for the year we discussed as our fiscal year began.

We have increased our estimates twice during the year and have increased our EPS range and cash flow estimates again this year -- this quarter.

Again, very steady performance.

Our big news of course is that next Wednesday, just four business days from today, we will complete the tax free spin of our institutional pharmacy business and simultaneously merge that asset with Kindred's institutional pharmacy business into a new company to be called PharMerica Corp.

that will be publicly traded on the New York Stock Exchange under the symbol PMC.

ABC will receive a $125 million cash dividend from the new entity, and initially, ABC shareholders will earn about 50% of PMC.

You will recall this transaction was announced last August 7th and while it has taken longer to close than originally estimated, we continue to believe that the spin merge go public alternative is the best for all PharMerica long-term care stake holders, customers, associates, suppliers and ABC shareholders.

The new PharMerica is well-positioned to generate significant shareholder value as the strong number 2 player of pharmaceutical and related services to the institutional elder care market.

You will recall that on March 28th, we announced our intention to acquire Bellco, a New York City pharmaceutical wholesaler primarily servicing independent drug stores in in the Metro New York area, with additional offerings in the generic telemarketing and dialysis business and total revenues of over $2 billion.

Regulatory approvals have been received and we expect to close the transaction before our fiscal year end of September 30.

As stated at the time of the announcement, we continue to expect the Bellco acquisition to be neutral to earnings in the first year.

Bellco is very consistent with our often stated acquisition strategy of acquiring well run companies in the pharmaceutical distribution or related space with potential operating and/or managerial synergies.

Our history has been medium sized acquisition in the $200 million range or less, but we would consider larger acquisition if it made good strategic sense.

Two industry developments bear mentioning.

The AMP or average manufacturer pricing regulations, because of our supplied independent regional chains and food/drug combos, and the anemia drug developments because of our strong supply of this class of drugs in both the physician, dialysis and hospital markets.

First, regarding AMP or average manufacturer price.

Those ABC does not buy or sell product using AMP, it is important to our customers because it will be used to establish the ceiling or federal upper limit FUL that CMS will use to reimburse the state and in turn our retail customers for generics dispensed under the Medicaid program.

The FUL will be 250% of the lowest AMP with some exclusions.

It is important to note we are only talking about product cost of some generics, those reimbursed by CMS and that product cost is only one of two components the retailer receives.

The other component, the dispensing fee, is set by the state.

AMP is currently set to be implemented in January '08.

But there currently is a six month comment period which implies that AMP regulations are not chiseled in stone yet.

Although CMS has made some positive changes to the proposed regulations as a result of industry input, the biggest controversy about AMP at this point is that mail order pharmacies will be included in the calculation.

We believe this is not appropriate because the cost and procurement profile of mail order is different from retail, and could represent acquisition prices not available to the retail class and trade.

We are actively engaged in the AMP process, and are optimistic an equitable solution will be reached before implementation.

The future utilization levels of anemia drugs continues to be uncertain, though we expect to get more clarity from CMS as early as September.

You will recall that last quarter, we reported approximately 7% of our total pharmaceutical distribution revenues are anemia products, about half in specialty, and half in broad line drug.

This quarter that percentage is 6%, down about 6% sequentially from last quarter, and also down 6% versus the prior year.

These decreases are less than market impact being reported by some, and reflect the strength of ABC and our customers in expanding market share.

It's important to note that almost all experts agree that anemia pharmaceutical products are extremely cost-effective therapy, particularly when contrasted to blood transfusion.

Also remember, our special group offering is not limited to one product class and is the broadest portfolio of biotech products and services to physicians in the industry.

The non anemia market continues to have a growth profile in the mid-to high teens.

Generics continue to be a focus of our organization and while dampening our top line growth in the quarter, roughly in the range of 2 to 3%, generics provide wholesalers great opportunity to provide value added services to both manufacturers and dispensers.

Our retail customer focus of independents, regional chains, and food/drug combos makes generics particularly attractive to ABC.

Our proprietary program, called Pro Generics, delivered a 30% revenue increase this quarter.

We just completed our national healthcare conference and exhibition at trade show for our retail customers.

This is the largest gathering of retail pharmacists in the country and this year's attendance exceeded last year's records.

We had over 8,100 attendees.

And we awarded 12,600 hours of continuing education.

We signed many customers to our key programs, including Pro Generics, Good Neighbor Pharmacy, now approaching 2,800 stores, Diabetes Shop, now over 1,000 stores, and our third pair network, now called Good Neighbor Pharmacy Performance Network with over 5,000 stores, the third largest in the country behind two national chains.

We introduced a new platform for our retail class of trade called Independent Edge which was extremely well-received.

Independent Edge reflected extensive market research and addresses the most pressing needs in this market segment, with front end marketing programs, profitability enhancement coaching and patient care services.

One great benefit of our conference is that our executives including me, get to interface with literally hundreds of customers.

My key take-away was the optimism and resiliency of this customer segment.

Time after time, this group has met market challenges with creativity and continued to compete and prosper.

As noted on previous occasions, at AmeriSourceBergen, we continue to focus on the basics.

We continue to expand our total service offering to the right customers in strong and stable markets, continue to expand our operating margin, and continue to be good stewards of our assets.

We continue to be very excited about our opportunities.

Here is Kurt to provide some color.

Thanks, Dave, and good morning, everyone.

Our consolidated results for the quarter were very much in line with our internal expectations, with strong pharmaceutical distribution performance and less than satisfactory performance at PharMerica.

Strong specialty and generics growth, in combination with operating efficiency improvement in both expenses and working capital drove the quarter.

We had better than expected cash flow and achieved a historic high for returns on capital deployed.

Importantly, the drug company, our broad line pharmaceutical distribution business, again experienced operating margin expansion, despite a much lighter price increase environment compared to a year ago.

This operating margin expansion was masked however, in our our pharmaceutical distribution segment results by the continued strong top line growth of our specialty group, where distribution businesses again grew faster than our service businesses.

While having a dampening effect on revenue growth, strong generic sales in the quarter positively impacted the drug company's gross margin and helped offset the weak price increase environment.

Pro Generic sales, our generic formulary, were up 30% in the quarter due to increased customer sign ups and our successful efforts to control customer leakage.

It's important to reiterate that our footprint in independent retail, small and mid-sized pharmacy chains and food/drug stores is a clear differentiator for us, as evidenced by the recent events in Las Vegas as Dave described.

These customers depend on us for their generic product selection.

As we highlighted in the past, due to an excess of generic manufacturing capacity worldwide, we are seeing an increasing number of new and attractive opportunities to source generic products from emerging international manufacturers who seek access to the U.S.

market and in particular, the customer channels we serve.

The Drug Company again executed well under its fee for service agreements.

Our performance here drove fee for service income from branded manufacturers and inventory turns above our internal expectations.

And importantly, our continued discipline around customer mix, pricing, and contract compliance helped to further stabilize sell side margins in the quarter.

Below the gross profit line as I mentioned, we continue to make substantial productivity improvements.

As expected, during the quarter we realized significant benefits from our warehouse and automation system investments under the optimize program.

In fact, total operating expenses for The Drug Company in absolute dollars were down from year ago levels, despite the strong increase in unit volume in the quarter, due to generic growth.

As a result, operating expenses as a percent of revenues came in well below our expectations and added to the operating margin expansion we experienced if the quarter.

And as planned, several additional automation implementations were completed in the quarter, which will drive similar productivity improvements in future periods.

So all in all, a solid third quarter performance by the drug company.

We expect a stronger performance in the fourth quarter as revenue growth returns to market rates and price appreciation strengthens.

The packaging group also had another solid quarter.

Anderson Packaging, our U.S.

contract packaging business for branded manufacturers, again grew strongly with six new program launches.

Year-to-date, Anderson has won a record amount of new business, driven by an increasing demand for outsourced services by large branded manufacturers, interested in driving lower costs, while maintaining product quality through Anderson's well-controlled and efficient production environments.

We expect solid growth again in the fourth quarter, with several new program launches scheduled.

As we announced previously, we broke ground in the June quarter on a new 260,000 square foot facility to accommodate Anderson's strong growth.

This is the second facility we have added to Anderson since we acquired the business in 2003.

Our business model transition continued at American Health Packaging with the expected reduction in its lower margin bulk to bottle business but the continued strong growth of its proprietary generic product offerings.

During the quarter, AHP launched 14 new generic items for various end use markets.

This favorable business transition again drove substantially improved operating margins and returns on capital versus year ago levels.

Now turning to PharMerica, which is comprised of our long-term care business and PMSI, our workers' compensation business.

First, with regard to long-term care, the big news of course remains the pending spend-off.

As Dave mentioned, this has been a long process for the PharMerica organization, and while we remain committed to running the business, we began to see the effect of the transaction this quarter, particularly on the revenue side, where sales were down both sequentially and from year ago levels.

This is primarily a result of prospective customer uncertainty around the transaction, and attrition in the sales force leading up to the spin-off.

Importantly, however, the business continued to capture market share against its largest competitor.

And its gross margin was up over a year ago levels on an improved patient acuity mix, both of which are strong positives.

Most of the units missed in terms of its EBIT target was due to an unusually high bad debt expense related to the clean-up of Medicare Part D transition issues and some transaction costs from the pending spin-off which were expensed in the quarter.

Despite this quarter's performance, we expect investors to take a strong interest in the new PharMerica.

There is a clear need for a strong alternative national player.

The new PharMerica has what it needs to be successful; the scale, the capabilities and the right executive talent.

These attributes in combination with a large synergy capture opportunity will give investors and attractive alternative for some time to come.

Now turning to PMSI.

PMSI is the nation's leading single source provider of cost containment solutions for worker's compensation and catastrophically injured populations.

The PMSI business has a market leadership position, with very attractive financial metrics and very good long-term growth fundamentals.

But as we have discussed during the past two calls, it's a business that's in active turn around.

For the quarter, revenues were up only slightly, and EBIT was down significantly versus the prior year.

We expected the second half of 2007 to be challenging due to the impact of first half customer price adjustments, which were a necessary response to new competitive pricing pressure.

In addition, the quarter's performance was impacted by costs related to a number of new investments needed to position the business for the future.

As a reminder, we recently rebuilt the management team, restructured the sales organization, and are implementing a number of significant enhancements to its technology platform to reduce costs and improve the unit's customer interface capabilities.

This is an attractive business with good prospects.

However, we expect the fourth quarter to again be challenging.

We're confident we're making the necessary changes to position the business for the future, and it's important to keep in mind this business represents less than 5% of ABC's consolidated EBIT.

Now turning to the specialty group.

The group had another quarter of above market growth, with revenues up 24% from prior year levels.

The top line was again driven by an especially strong performance by our oncology franchise, resulting from new customer wins, and an ever-expanding pipeline of new products that continue to grow ahead of the broader drug market.

The oncology business also continued to benefit from a semi exclusive distribution agreement with a major biotech manufacturer, for the distribution of certain products to the physician market, which was offset in part by the slowdown in anemia-related products which Dave discussed.

Importantly, other distribution businesses in the group again performed well in the quarter.

Besse Medical, which distributes vaccines and specialty products to non-oncology physician practices enjoyed strong top line and bottom line performance, driven by excellent market penetration of certain newer physician administered products.

As a reminder, to further build out its manufacturer service offerings, the group has completed three acquisitions in 2007.

Integration activities related to the first quarter acquisitions of IGG America and Access MD are now complete.

And in early April, we announced the acquisition of [Excenda], which will add to the group's capability by providing applied health outcome or pharmacoeconomic studies to both its branded and biotech manufacture client base.

Integration activities here are proceeding smoothly.

As expected, the specialty group's new headquarters location in Dallas opened as planned at the end of May, and will add to the group's efficiency by bringing related activities in closer proximity.

One of the keys to success in specialty has been the array of services we wrap around our core logistics capabilities.

Many of these services are unique, often proprietary and not readily replicated.

Add to this our existing scale, and it's clear we have an attractive market position.

So, all in all, a very solid quarter on top of a very strong quarter a year ago.

As we look to the fourth quarter and into 2008, we remain exceptionally well-positioned.

We have unique channel positions in the two most important product areas, generics and biotech.

The integration worked from the ABC merger, and its inherent risk is behind us but with meaningful efficiency benefits still ahead of us.

The fee for service model is fully implemented, which has improved earnings quality, lowered earnings risk and improved our returns on capital.

With stronger manufacturer relationships ever, stronger relationships with our manufacturer than ever, we're carefully building out our service offerings to them as they focus on their core competencies.

Finally of course, we have the financial resources to execute our strategies.

We look forward to a strong conclusion to our fiscal 2007.

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

Thanks, Kurt.

And good morning everyone.

Another solid quarter, particularly in the pharmaceutical distribution segment, and we continue to be on track to meet or exceed all of our key financial metrics that we set for the year.

After nine months, operating revenues are up 10%, consolidated operating income is up an impressive 16%, with pharmaceutical distribution EBIT increasing an even more impressive 20%, and EPS and cash from operations have both increased over 20% from the prior year nine month period.

From a quarterly perspective, strong top line growth in the specialty group and above market growth in our proprietary generic program in the drug company, more than offset a weak price increase environment during the quarter and poor performance in PharMerica.

We continue to do very well from a working capital management perspective, and we repurchased a significant amount of our shares, contributing to our EPS growth.

Last quarter, I made a point of reminding everyone that although fee for service agreements have substantially mitigated to historic volatility of the quarterly contributions from price increases, the 20% or so of our brand name business that is still subject to the timing of manufacturer price increases could have an impact on quarterly results.

We definitely have realized that benefit in the March quarter, however, the opposite was true this quarter as contributions from price increases were down both sequentially and compared to last year.

I'll talk more about the quarterly price increase impact when I discuss the pharmaceutical distribution results.

Before I begin my consolidated review, let me remind everyone that with the closing date of the long-term care transaction set for July 31st, the long-term care results continue to be reflected in Continuing Operations in our June financials.

When we present our September year-end results, the long-term care results will become Discontinued Operations and all historical financials, including our current year information, will be restated to reflect the spin.

We intend to file an 8-K prior to our November earnings release date, detailing the restated quarterly financial information for fiscal 2006 and 2007, so that you will have that information prior to our year-end earnings release.

We have adjusted our guidance for the year to reflect EPS with and without long-term care to help you with your analysis.

Now, turning to our consolidated results for the quarter, operating revenue was up 7% for the quarter, driven by our continued above-market growth in specialty.

Gross profit also increased 7% in the quarter, driven by pharmaceutical distribution, as well as by a significant increase from manufacture antitrust litigation settlements, which were $31.9 million in the current year quarter, compared to $4.6 million in the prior year quarter.

Those increases more than offset a decline in PharMerica segment gross profit.

Consolidated operating expenses grew 5% in the quarter, less than our 7% revenue growth and reflected in our consolidated operating expenses were $3.5 million of facility consolidation, employee severance and other costs, which compares to a net $86,000 credit reflected on this line last year.

Consolidated expenses in the quarter also include an increase in bad debt expense of $5 million, mostly in PharMerica.

An increase in equity compensation expenses of $2.4 million, and a reduction in incentive compensation related to certain business units of $8.6 million.

Operating income in the quarter increased 11%, driven by 8% growth in pharmaceutical distribution EBIT, and the increase in litigation settlements, the combination of which offset a significant decline in PharMerica's operating income.

Moving below the EBIT line, we had net interest expense of $6.3 million in the current year quarter, versus modest net interest income last year as average cash balances on hand during the quarter were significantly less than the prior year due to our share repurchase activity.

The other loss of $3.5 million primarily reflects a write-down in an equity investment.

Our effective tax rate for the quarter was 35%.

Compared to 36.9% last year, and benefited from $4 million of adjustments as well as the shift towards more tax free invested cash during the quarter.

Our effective tax rate going forward should continue to be in the 37 to 38% range.

Diluted EPS in the June quarter of $0.69 was up 19% from last year's $0.58.

The net positive after tax impact of litigation settlements and facility consolidation and employee severance costs was $17.6 million or $0.09 per share in the current year, compared to $2.9 million or $0.01 per share benefit in last year's June quarter.

Our average fully diluted shares outstanding for the current quarter were $188 million, down 19 million shares or 9% from last year, as a result of our share repurchase program, of course net of option exercises.

At the end of June, we had about 181 million shares outstanding.

Moving to the pharmaceutical distribution segment.

We had a 7% top line increase driven by our specialty business, which grew 24% and drug grew 3%.

The specialty business growth was strong despite the slowdown in anemia product sales that Dave mentioned earlier.

The specialty group's revenues were up 30% for the year and the group has continued to benefit in fiscal '07 from a semi-exclusive distribution agreement and the introduction of new physician-administered ophthalmology products, both of which began in late fiscal '06.

Both of these events will be fully annualized in the fourth quarter, which in combination with the anemia drug impact will moderate the specialty group's revenue growth in the fourth quarter.

We continue to expect that the specialty group's revenue growth for the full year will be in the mid-20% range.

The Drug Company grew its operating revenue 3% in the quarter and 6% for the nine months.

The quarterly increase was driven by our institutional business as retail sales were flat due to our discontinuance of service to a large lower margin retail customer that we mentioned earlier this year.

As we annualize two significant customer losses due to their being acquired in last year's fourth quarter, drug company revenue growth is expected to return to the 5 to 7% market growth range in the fourth quarter.

As a result, for the full year, we continue to expect the drug company revenue growth to be in the 5 to 7% range targeted at the beginning of the year.

We expect that consolidated operating revenue, which increased 10% through nine months will be in the 9 to 10% range for the year, excluding any impact from the Bellco acquisition.

Gross profit in the quarter increased 4% compared to the prior year quarter, reflecting the strong performance of our generic programs, which offset a reduction in gross profit related to manufacturer price increases.

Our generic revenue under our Pro Generics program once again increased in the 30% range, as we continued to add new customers and increased compliance under the program.

Price appreciation was down compared to last year's quarter, primarily due to one large top ten vendor that had a significant price increase during last June's quarter that did not have a similar increase this year during the June quarter, instead, raising prices in July which will benefit our fourth quarter of fiscal '07.

Our LIFO provision for the June quarter was a credit of $1.7 million, compared to a similar credit of $1.3 million in the prior year.

Reflecting fewer brand name price increases and continued generic price decreases.

Operating expenses in the quarter were up 2%, and as a percentage of revenue were 184 basis points, down 9 basis points from the prior year.

This decrease was driven by operating leverage in the Drug Company as well as the reduction in incentive compensation mentioned previously, which offset the higher expense ratios from our current year services acquisitions in the specialty group.

Operating margin in the quarter was 111 basis points, up one basis point from the prior year, and for the nine months was 124 basis points, up a strong 10 basis points over last year.

We continued to expect that the pharmaceutical distribution operating margin for the year will increase in the high single digit basis point range.

Now, turning to PharMerica.

Revenue for the quarter was flat compared to last June, as long-term care revenues of $307 million were down slightly from last year, and PMSI revenues of $117 million were up 1%.

Operating income declined substantially from last year, as LTC's June quarter EBIT of $6.4 million was down $4.6 million from the prior year quarter, with the majority of the decline due to an increase of $4 million in bad debt expenses related to continuing cleanup of Med D transition issues and certain problem accounts.

PMSI's operating income of $5.8 million was down sequentially from the March quarter's $8.6 million, reflecting incremental expenses of $3.2 million that we indicated last quarter would be incurred to support the IT infrastructure and customer initiatives that Kurt mentioned.

In addition, competitive market pressures reduced gross profit by approximately $3 million, compared to last June, and you may recall that our prior year June quarter also benefited by a $3.2 million reduction in PMSI sales tax expense.

Now, let's turn to our consolidated cash flows and the balance sheet where we once again had tremendous performance.

Cash generated from operations in the June quarter was $370 million, bringing our total cash generated for the nine months to $1.1 billion, well ahead of the $885 million generated from operations through the same nine months in fiscal '06.

Some of this increase continues to be from favorable working capital timing.

While we would expect to see some reversal of this trend in the September quarter, we are comfortable raising our free cash flow estimate for the entire year by $175 million, to a new range of 750 to $825 million.

This continues to be net of expected capital expenditures of 100 to $125 million for the year and after spending $26 million in the third quarter on CapEx, we have now spent $84 million through nine months.

The higher than expected operating cash is largely a function of greater than expected declines in inventory.

Average inventory days on hand during the quarter were 26 days, down two days from last quarter and three days from last year.

And as a function of continued strong performance under fee for service contracts, and strong inventory management.

Specialty's above market growths continued to impact all of our working capital statistics as that group has higher DSOs, lower inventory days, and higher DPOs than the drug company.

As a result, DSOs of 19.7 days were up two days from last year, and DPOs were up three days.

Again, in addition to the specialty mix, there is some favorable timing included in our payables.

Our debt to total capital ratio was 25%, up from 20% last year, reflecting our share repurchase program.

Our cash and short term investments totaled $1.4 billion at the end of June, and net of the end of period working capital benefit in maintenance cash of approximately $200 million, we have approximately $1 billion of cash to deploy.

We have committed a significant portion of that capital to our new $850 million share repurchase program and the pending Bellco acquisition.

During the June quarter, we purchased over $0.5 billion of our stock completing our $750 million repurchase program, and have now purchased $872 million of our stock year-to-date, well above our original guidance.

We had $730 million remaining under our $850 million program at the end of June, and expect to complete this program in fiscal 2008.

Now, back to our guidance.

Which is as usual is on a GAAP basis and continues to include long-term care as I stated earlier.

As we have only one quarter left in our fiscal year, we have increased our GAAP EPS guidance to a range of $2.60 to $2.68 per share.

This range includes the net $0.05 benefit for the year from special items.

Long-term care's fiscal '07 EPS guidance continues to be $0.09 to $0.11 per share, and is included in the $2.60 to $2.68 range.

After the long-term care spend, our guidance range for the year from Continuing Operations will be reduced by $0.10, and will be $2.50 to $2.58 per share.

This implies a fiscal fourth quarter EPS range from continuing operations of $0.58 to $0.66, excluding long-term care and including $0.01 per share of special charges.

Certainly, a lot of information, but the critical take away here is that our EPS forecast ,with or without long-term care, reflects a year with above market revenue growth, double-digit operating income growth, operating margin expansion, and free cash flow well in excess of net income, with a significant amount of that cash return to shareholders.

Our operating model has served us well, and continues to provide a solid growth platform.

With that, I'll turn it back to Mike Kilpatric.

Thank you, Mike.

We'll now open the call to questions.

As always, I would ask that you limit yourself to one question only until all have had an opportunity, and then if there's time you can ask additional questions.

Go ahead, Greg.

Thank you.

(OPERATOR INSTRUCTIONS).

Your first question comes from the line of Larry Marsh from Lehman Brothers.

Please go ahead.

Thanks and good morning, everyone.

Thanks for the detailed reviews.

As always.

My question really has to do with specialty growth and then how Bellco fits into that specialty business.

I know you guys talked about that excluding anemia slowdown this quarter.

Specialty volumes with oncology and other things that Kurt, you talked about growing 25 to 30%.

I know we're lapping some more difficult numbers.

But just as you think of the next couple years, is this still a business that is -- you think can continue to take market share in oncology and other areas and then I just want to follow up to be clear about how Bellco fits into that?

We think we can continue to make market share advances, Larry, but they're clearly going to be modest.

We've got a very large position in this business.

So taking more and more market share gets to be difficult.

But this is a market that continues to have good growth prospects.

We look for it to continue to grow in the mid-to high teens as a market.

A lot of the new products coming in come into this space, gives us the opportunity for a lot of value added service so we continue to be very, very bullish on this.

As we mentioned when we made the Bellco announcement, they have a dialysis business which will complement our specialty business.

We continue to be very, very excited about the sector.

Just to be sure on Bellco, tied into that, I know that you're saying you hope to close that by the end of this fiscal quarter.

And I know you have disclosed that there was a DEA suspension of some controlled substances of that.

Has that been resolved and would that change any purchase price consideration there?

It has been resolved, Larry.

Recently they have begun shipping a controlled merchandise.

So our situation is to monitor what impact, if any, that has had on their business and revisit the situation in the next several weeks.

Okay.

Thank you.

Your next question comes from the line of Glen Santangelo from Credit Suisse First Boston.

Please go ahead.

I had a quick question on the margins in the drug distribution business.

We saw the rate of margin expansion year-over-year decline.

I'm a little bit surprised by that, kind of given the lineup or magnitude of generics we've kind of had in this June quarter, versus a year ago.

As I look at the comps getting a little bit more challenging in the back half, should I assume that margins maybe should depress year-over-year in the back half, given how difficult the comps get?

Am I thinking about that progression correctly?

Glen, this is Mike.

Maybe I'll take that.

First, remember, the March quarter is always our strongest quarter, and benefits by an unusually large number of price increases in that quarter.

So we expect it to moderate from the March quarter to the June quarter from a gross margin perspective.

That moderation was a bit more than we expected, because as I mentioned in my comments, there was one fairly large top ten manufacturer that had a significant price increase in the June quarter last year that benefited last year's June quarter that did not raise prices during this June quarter.

They have subsequently raised prices in July, which will benefit our September quarter and is one of the reasons we have lifted our guidance for EPS in the fourth quarter.

So I think what you have seen is a shift of some price appreciation margin from 3Q to 4Q.

I think if you look at our numbers from sequentially from last year, you'll see that our gross margins went down about 13 basis points in pharmaceutical distribution from March to June.

This year, they've gone down 28, and while the total decline is not all of this specific item, it certainly is a big contributor to this.

To pile on a little bit, this is Dave.

To put it in perspective, when we began the year we said we would expand our operating margin the pharmaceutical distribution in the single digit basis points.

We're clearly on track to do that.

We're clearly at this point with three quarters done looking at the high end of that single digit basis point expansion.

So we're very comfortable with where we are on a yearly basis.

You've got fluctuations quarter to quarter which is one of the reasons we're uncomfortable with providing any guidance on a quarterly basis.

On a yearly basis, we're really steady as she goes.

Okay, thanks.

Your next question comes from the line of Robert Willoughby from Banc of America.

Please go ahead.

Was there any restriction a $2 billion number for Bellco numbers.

Secondarily, just the intersegment eliminations for PharMerica, should we be backing up about three quarters of those up into operating revenues, or is that a bulk revenue item?

Answer the first one, Bob.

No, degradation at all on the Bellco, just round numbers, north of $2 billion in revs.

Bob, this is Mike.

A significant amount of those intersegment eliminations will go away.

We will still have some intersegment elimination because the drug company also supplies some pharmaceuticals to PMSI.

In our revised quarterly numbers that we'll put out for everybody prior to our year-end earnings release, we'll detail those adjustments exactly but I think you're right directionally.

Is it operating or bulk though?

It's all in operating.

Okay, great.

Of course with the new PharMerica corporation, which is a combination of Kindred's assets and our assets, we will continue to maintain the drug distribution business with that of course.

Thank you.

Next question comes from the line of Tom Gallucci from Merrill Lynch.

Please go ahead.

Mike, as a follow-up to Glen's question, I was hoping if you could help put in perspective a little bit the leverage to price inflation generally.

You talked about inventories being down obviously, fee for service environment that we're in compared to a few years ago.

But then one manufacturer's price increase in one quarter seems to be fairly material.

Could you put that in broader perspective for us?

I think to put it in the broadest perspective, I think we said that about 80% of our brand name gross profit is not dependent upon price increases from the manufacturers, though, 20% still is.

I think to put that in perspective, think about the fact that we've got roughly a $4 billion inventory and that inventory is going to be subject to price increases.

Which traditionally have been in the 5% range or so and that's a fair approximation of the impact we have from price increases.

And of course, that's going to vary from quarter to quarter as Dave mentioned, which is why we don't give the quarterly guidance, but we're certainly on track for the full year.

Okay.

If I could ask just one other follow-up.

You're still talking about $0.09 to $0.11 on PharMerica contribution on the long-term care side.

But it seems like it's underperformed a bit.

So is it that high, or should we be thinking about it being a little less than that at this point?

No, I think that's still a fair approximation of the range.

I think PharMerica had a tough -- a little bit of a tough quarter with their bad debt expense, but on a year-to-date basis, only slightly behind the expectations we set out at the beginning of the year.

Okay, thank you.

Your next question comes from the line of Randall Stanicky from Goldman Sachs.

Please go ahead.

Dave, I wanted to follow up on something you talked about last quarter, given the focus on this call on generics and as you think about the -- as we think about the increased number that we're seeing of at risk launches on the generic side, and obviously the importance of procuring generics supply ahead of what's often a preliminary junction attempt.

Does that at all alter your view of your manufacturer relationship?

And then I have a quick follow-up.

It's Kurt.

I'll chip in on this a little bit.

I think obviously, this is a dynamic marketplace here.

It's moving very, very quickly.

We don't see things changing dramatically going forward, though, in terms of how we're making money on generics.

In fact, we see it the environment actually improving a little bit.

We've got a healthy branded generic conversion environment going on in '07.

A little bit less in '08.

'09 is going to be very strong again.

In addition to that, as I mentioned in my prepared comments we are seeing a really a large number of attractive new opportunities opening up from international manufacturers who want access to the market here.

Our responsibility on the generic side is to procure product that's the highest quality and lowest cost we can for our customers.

In doing that, we're garnering very good margin for our self.

We really don't see that dynamic changing anywhere in the near term.

How do we think about the impact if there's much at all on a Pfizer pulling the 303 patent and lodapine going multi-source from three suppliers in the calendar third quarter to multiple suppliers as we thing about the potential impact on your business for the distribution business in general.

It's hard to get into specific situation with you.

We've talked generally about the dynamics that we find to be favorable.

Normally, product that is difficult to manufacture where there are fewer generic manufacturer entrants in on that product, tend to be an optimal situation for us.

And that obviously, there's a very attractive period of time during that six month exclusivity period where the challenger has rights to produce that product.

There are two products in the market we tend to earn very good gross margins during that period of time.

In other situations, where it's an easy to manufacture product, and there's a lot of manufacturers that jump in on that product, the prices do drop and it's hard for us to make the kind of gross profit contribution in that situation that we make when it's just the brand.

On a whole, when we look at our entire portfolio, we generate more gross profit from brand to generic conversions than if it were just to remain in the brand side.

Thank you.

Your next question comes from the line of Charles Boorady from Citigroup.

Please go ahead.

Just to dove tail on the response that you just gave on generics and the greater profitability.

Is that during the 180 day exclusivity period, or does it extend beyond that as well?

The 180 day period is always a good period on a generic product introduction.

The profitability on that particular molecule is dependent after that on how many manufacturers and how much supply there is in fact in the market.

And what we tend to find is when it's a more difficult to manufacture molecule and there are fewer manufacturers, that tends to be a more profitable item for us.

Speaking of generics, the shift to generics have any impact at all on inventory days or are lower revenues and the lower cost of the inventories for generics fairly well matched?

Certainly the trend towards generics is very favorable as well from a working capital perspective.

Typically we carry some more days in inventory on generics than we do on brand names, but we offset that with some very favorable terms, generally, from suppliers.

So the net working capital reduction is a very good thing for us, from the generic --

How does it translate to the actual days calculation?

Would it have an impact on the days calc?

Not a significant amount of days has been impacted by the generics.

That drop has been much more from the brand name side.

Though I think what you'll see with some generic supplier consolidation and some more selectivity on our part, you'll see some of the benefits that we learned from the fee for service transformation on the brand name translate into the generic market and it could be a pretty good opportunity for us going forward.

It is important to keep in mind the generic market sides in dollar size versus brand name, where generics are in the 10 to 12% dollar range of the total market, and still heavily dominated by brand name product.

Do you expect a similar drop in inventory days next year and is the 750 to 825 in free cash flow a good jumping off point to model expectations for next year or are there other non recurring items or timing differences that would impact that range?

I think at this point I would caution people to look at our long-term model.

Our long-term model is where we expect free cash flow to approximate net income, which essentially says we'll have very little working capital build.

But I would not build in significant declines.

I think our decline this year was probably a little bit bigger than we anticipated and remember, when we're doing $200 million a day, it doesn't take a significant amount of improvement to have a big impact on that operating cash flow.

Every day drop in inventory is about $200 million extra for us and that's what really benefited this year's cash flow and we've taken that cash flow and obviously accelerated our share repurchase and given a lot of that back to our shareholders.

Thank you.

Could you just remind us what that long-term growth is or kind of reiterate the guidance on that that you referred to?

A good opportunity just to talk about our long-term operating model.

Our model is very much intact.

Our model is to grow our revenues in line with the market, which continue to be in the mid-to high single digits, have operating margin expansion in the single digit basis point range, which will bring our EBIT up into double digits, and then have cash flow, free cash flow, you know, net of CapEx, that approximates net income and we'll take that cash and reinvest it in either buying back shares or giving us some other financial benefits which will help accept rate our EPS growth to a 15% range or so.

That's our long-term model.

That's what we continue to expect.

Great.

Thank you.

Your next question comes from the line of Lisa Gill from JPMorgan.

Please go ahead.

Great.

Thanks and good morning.

You talked about revenue for drug distribution going back to a more normalized level in the fourth quarter of 5 to 7%, but could one of you just discuss the 3% in this quarter.

Was the difference between what we have seen historically or the overall trends in the farm industry, is that just because these two losses?

Were they the two to 400 basis points?

Was this the Medicare drug benefit impact now that it's starting to anniversary?

The impact of generics year-over-year as the start to see more impact for generics this year than last year?

So if you could just address that.

Secondly, if you could just address the wide range of guidance for the fourth quarter, if I remember correctly, Mike, in the past it's been a little bit more narrow than what you have right now for the fourth quarter.

Lisa, it's Kurt.

I think what we'll probably tag team this a little bit.

I think Dave briefly mentioned in his comments, we thought the generic growth this quarter had a two to 3% dampening effect on drug company's growth in the quarter.

And that's -- just to baseline that a little bit, I think the major chains have come out and said they've had an impact somewhere between 6 and 8%.

Generics are really mostly on the retail side in our books, so it was a 2 to 3% impact as best we can figure it here for the business.

We have known for some time because of the two accounts that Mike referenced that were acquired last year and moved to another Service Provider on distribution, and the one we walked away from that we were going to have all three accounts kind of impacting the June quarter, and then as Mike also mentioned, obviously we anniversaried those accounts from a year ago.

So based on everything we see right now, the fourth quarter we're going to spring back up to market growth rates of 5 to 7% in The Drug Company and so -- and again, for the full year, the full year will come right in line with the guidance we set out last November which was 5 to 7% for the drug company.

And Lisa, just about the range, I think the $0.08 is very much in line with what we have done historically.

I think you've got to keep in mind that we only have 180 million shares outstanding or so so each penny is about $3 million pretax.

So we're talking about plus or minus $12 million on either side of the midpoint for a company doing $16 billion in revenue.

So I don't think it's too wide at all.

Also, remember, in our fourth quarter, we continue to have a LIFO true up that has had some fluctuations in the past and we also have built into that our flu season, which again, can vary between the fourth quarter and the first quarter of the next year.

Okay.

Great, thank you.

We'll take one more question.

Your final question comes from Ricky Goldwasser from UBS.

Thank you for taking the question.

Just one point of clarification.

I think you talked in the prepared remarks on a manufacturer that didn't take price increase -- that did take price increase in June quarter last year but did not this year.

I know in the past we talked a lot about fee for service and how fee for service protects you from lack of price increase.

Is it that it had a negative impact in the June quarter, or is it that it really didn't have any impact in the June quarter but will have a positive impact in the September quarter?

I'm just trying to kind of understand it.

I know that in the past we said that price increase is really not going to have the $0.03 to $0.04 impact any more?

With this particular manufacturer they have what we would refer to is a hybrid agreement.

Part of their agreement is a fee based on a percentage of revenue and part of the agreement is rewards us whenever there is a price increase.

If we maintain certain inventory.

If we perform under that contract.

So that component of this particular contract is fairly substantial and because they raised prices during the June quarter last year, we realized a lot of that benefit during that June quarter because they raised prices in July of this year we'll realize a significant amount of that benefit in our fiscal fourth quarter this year.

Just to reiterate, Ricky, when you're looking at the business on a yearly basis, we have a good feel for what prices, what inflation will mean to our total business.

Trying to pinpoint it to an individual quarter, which can plus or minus a couple of weeks can make a difference is why we're very uncomfortable with quarterly guidance.

Very comfortable with the yearly guidance.

I didn't mean to cut you off.

I guess one follow-up question, then.

I think you mentioned this as a top ten.

What percent of top ten manufacturers have these type of hybrid agreements?

I think again, what I'll point you to is the best thing I can give you is that there's 20% that is not -- 20% of our profit that is still subject to price increases and that includes manufacturers like this, where there could be a component that is, again, purely percentage of revenue and another part that is subject to price increases.

So that's in that 20% bucket that we have often referred to.

The fee for service agreement that we talk about them in a lump, they're all unique.

They're very frequently the manufacturers incentivizing us to do things that are important for him.

Things that he wants to accomplish in the marketplace.

They're very, very customized to each individual manufacturer.

Thank you very much.

Thanks, Ricky and thank you to everybody for joining us on this call today on what we know is a very busy earnings day across the board in healthcare.

But I would like David Yost to make a few final comments.

Thanks.

With this quarter, we're three quarters through our fiscal year.

We're on track to deliver all the goals we discussed as the year began with solid performance in a very solid industry.

I point you to good revenue growth for the year, expanding operating margins, robust cash generation, continued focus on the basics with strong fiscal and operational discipline.

We continue to think it really is as easy as ABC.

Thank you very much for your continued interest.

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