卡地納健康 (CAH) 2003 Q2 法說會逐字稿

Good morning, my name is Dennis and I will be your conference facilitator today.

At this time, I would like to welcome everyone to the Cardinal Health Second Quarter Earnings Release conference call.

All lines have been placed on mute to prevent any background noise.

After the speakers' remarks there, will be a question-and-answer period.

If you would like to ask a question during this time, simply press star then the number one on your telephone keypad.

If you would like to withdraw your question, press the pound key.

Thank you.

Mr. Fischbach, you may begin your conference, sir.

Good morning and welcome.

Today, we'll discuss Cardinal's fiscal 2003 second quarter results and a portion of our remarks will be focused on the business segment attachment in the earnings release.

If you don't have a copy of the release, you may access it over the internet at our investor center at www.cardinal.com.

Speaking on our call will be Bob Walter, Chairman and CEO, Dick Miller, Executive Vice President and Chief Financial Officer, and George Fotiades, the Chief Operating Officer of our PTS Group, will share some thoughts about the Syncor transaction Their formal remarks--after their formal remarks, we will open the lines up for questions where we will also have available Jim Millar, President and COO of Pharmaceutical Distribution and Medical Surgical Products and Health Care Products and Services.

As always, as we get into questions, we ask that you limit yourself to only one question at a time.

Before we begin, please remember that today's call may include forward-looking statements which are subject to risks and uncertainties, which could cause actual results to differ materially from those projected or implied.

The most significant of those uncertainties are described in the Cardinal's form 10-k and 10-q reports and exhibits to the reports, Cardinal undertakes no obligation to update or revise any of those forward looking statements.

At this time, I'll turn the call over to Bob Walter to begin today's discussion.

Good morning, I'm happy to report to you another strong quarter for Cardinal overall where we met our goals and market expectations.

We positioned ourselves for a second half of fiscal 2003 that will allow us to deliver on a commitment of 20% earnings per share growth with the solid improvement and return on sales and capital and strong cash flow and -- cash flow in excess of $1 billion.

I'm going to spend some time this morning giving you a color commentary on each of the highs of the quarter in each segment.

Dick will get into the financial details, um, for each segment.

The most compelling thoughts that should come from the review of this quarter's performance is that our model is working.

The measure of our success is our rise and return on committed capital.

It reached nearly 36% for the corporation overall.

After all, our management's responsibilities to deploy our growing capital base and return well above Cardinal's cost to capital and to manage in a way that continues to increase our returns on that capital.

Our return on committed capital 10 years ago was 20%.

And it was just 18 months ago that we first hit a return on committed capital of 30%.

At that time, I said that we would set a new goal of 35%.

We're already there.

Those high internal returns are producing very strong free cash flow for use in investing internally in new growth initiatives, for acquisitions, and for repurchasing our stock.

We have and we will continue to do all three of those things.

Incidentally, our return equity is now above 20%.

I can't find many companies that have that kind of return on equity with only 16% debt to total capital.

The business models has continually changed over the past 30 years, and I think that is another responsibility we have as managers.

That is to constantly reevaluate the effectiveness of our strategy and execution.

Many times these changes are subtle but over the long-term, meaningful.

On the business models change somewhat, the underlying themes of strong growth, rising return and solid cash flow remain the same.

In a couple of weeks, we will be hosting an analyst meeting in New York, our business model including how we're driving rising returns on capital from cash flow and how we plan to deploy our capital to support new growth will be the primary themes for the meeting.

The fact is our models are changing a bit, frankly for the better and we want to you understand it.

First, I want to restate our business model because it's working.

First, a total focus on health care.

The very big and rapidly growing market with plenty of opportunities so we don't feel a need to wander around.

Second, delivers superior execution that drives scale and strong market positions and superior productivity.

Third, innovate to differentiate.

That's the only way you can protect your existing markets and enter new markets with favorable margins.

I will give you examples in our segments of this innovate-to-differentiate theme.

And fourth, [INAUDIBLE] of service and product offerings in each segment and across the corporation.

Diversifications of offerings is good for the customer and for our shareholders.

It allows us to bundle offerings to the customers to add value.

And it spreads risk in investment opportunities for shareholders.

The investments that we have made since 1995 when we first ventured beyond just pharmaceutical distribution are paying off for our customers and for our shareholders.

Look at the breath of our earning power today.

And last, strictly manage the assets and actively reinvest the cash internally and externally.

Sounds simple but it's working in delivering superior growth and returns.

Now, let me get to the facts of the quarter, and weave in comments about the second half.

I will discuss the overall drivers and Dick will cover the details.

I was very pleased with the quarter.

Revenue and earnings were in line with expectations but cash flow in return and committed capital was substantially better than I expected.

I will explain what is driving that in each of our segments.

The pharmaceutical distribution and provider service segment continued with above-industry revenue growth driven predominantly by a favorable mix towards change, up 17%, and alternate site up 20%.

Our volume growth, when you consider the negative impact of brand to generic conversions, was impressive beyond the reported rate.

Product inflation in branded products was strong in the quarter, and we expect it to continue going forward.

Our service level to customers has never been better and is key to driving new business wins for us.

In the quarter, we added new business that will result in over $2 billion of revenue beginning later this quarter.

And we have high expectations for other important wins in the months ahead.

Recognizing that we have experienced no meaningful losses, you will see a ramping up of volume as we exit fy03.

This bodes well for robust top line growth in our fiscal year starting this June.

One thing is for sure, pharmacy demand continues to remain strong in the industry.

In the gross margin areas, there are pluses and minuses, but generally in line with expectations for Q2.

First on the sell side, the market remains as competitive as always, we remain disciplined and continue to lead with value and service and not price.

On the vender margin side, I will split the discussion into describing the results for generics and branded products.

With generics, the opportunity remains the same as we told you in the past: There there is significant growth in generics at a pace faster than branded.

And margins continue to be substantially higher than branded products with less working capital investment required.

That is, less inventory and less, um, less accounts receivable to support the generic volume.

So, generics are helping increase a return on capital, and reduce the need for incremental working capital.

On the branded products side, inflation remains strong in the quarter, and we expect that to continue as manufacturers are funding their growing research and development efforts.

There was less product availability in the second quarter relative to a year ago as manufacturers drained some inventory from the channel, in an effort to better balance their future sales with a real patient demand in the marketplace.

This should return to normal in the first half of the calendar year.

Cardinal continued to enter into an inventory management agreements with manufacturers, whereby we are compensated on incentive basis to help manufacturers better match their shipments with market demand.

Activities in the generic and branded product areas have the effects of helping us reduce our investment and inventory, gain a similar level of profitability and consequently, add to our efforts to drive up our returns on capital in pharmaceutical distribution.

Note that we increased a return to almost 36% in this segment this quarter.

Of course, we're also helped by further improvements in our accounts receivable days outstanding.

This segment pharmaceutical distribution provider side, let's talk about the expenses.

We're doing really great.

And actually better than I anticipate at this time.

It should have been a positive surprise for to you see our actual dollar expenses down this quarter versus prior year.

This is the story about being in the final phase of our consolidation of facilities around the Bindley merger, about further investment in distribution center automation, and about just plain great execution.

A couple of facts for you: We entered the second quarter a year ago with 36 distribution facilities, pharmaceutical distribution facilities, and we exited this quarter with 25.

So we have significantly less facilities.

I'll give you another fact.

We have 8% less employees, and we're doing all this with excellent service levels, and we're pumping out 14% more sales.

During the quarter, we continued to invest in our infrastructure, and we protected, we fully protected our expense reserves, so the productivity improvements are real and baked into the future.

The other businesses, um, in the segment that is the specialty distribution and are provided service businesses also had great quarters driving earning growth and returns well above the corporate average.

So, bottom line for the PDPS segment is that we raised our return on sales to a new Q2 record and we drove a phenomenal 36% return on capital and a big improvement in cash flow.

As we move into the second half, we expect third quarter revenues in this segment to look a lot like this quarter and getting stronger that is into the mid-teens as we get into the fourth quarter.

I already mentioned that fiscal 2004 revenues will be strong.

Earnings in the second half for the segment will grow a little slower than in the first half, but with favorable revenue and expense trends, earning growth rates for fy04 will pick up over the second half of fy03.

Return on sales, capital and cash flow will be very strong.

Now, let me shift to the medical products and service area.

I really like what I see happening here.

Ron [Labram] and his team have really stepped up the momentum, and you will see it in our second half.

First, there is new leadership in the distribution business segment and a strong determination to grow our distribution volume.

And we are winning in the marketplace with some very important new contracts.

Our customer service has improved, the sales pipeline is in place to show higher second half growth and lead us into the strong fiscal, um, '04.

The distribution sales growth is important as it feeds the sale of self-manufactured products.

Our highest margin in return business.

Where we have distribution relationship with a hospital, we capture a much higher portion of the potential for self-manufactured products.

We're making our self-manufactured products more attractive to customers by improving our existing offering and developing new products.

Examples are a new synthetic surgeon glove changes to our converter line, a new biopsy device and a whole new product line of bone cement.

All of these new products have been received extremely well in the marketplace and we think this is fertile territory for us.

On the expense side, it's a similar story to the pharmacy distribution.

Automation, consolidation of facilities, and expense productivity.

We have consolidated 10 facilities and are operated with 800 fewer employees than a year ago.

We're improving our working capital turnover substantially.

Inventory levels are lower as a result of facility consolidations and better systems.

And days and accounts receivables have improved by two days, so based on improving sales, a favorable mix toward self-manufacturing and expense improvements, the second half of '03 will deliver a higher earnings growth rate and return on sales than in the first half and will have very strong cash flow.

Now, pharmaceutical technology and services.

It also had a solid performance for the quarter based on strong demand for products in our proprietary soft gel, quick dissolve, time release and sterile areas.

The biggest growth products were listed in the release.

[Amnesteem], the generic for [Isotrepnoine] was finally released for shipment late in the quarter.

This was an important margin product for us, and we will continue to benefit in the second half.

Offsetting the demand for our proprietary technologies, we saw a continued slowdown in our noncore health and nutritional business and had disappointing results from [Scherring Pluoghs] Claritan and delays in launch of Clarinex.

Most of this is now behind us.

Our gross margins were strong in all of our product lines, but expense comparisons run favorable to prior year as we continue to invest for capacity and incurred some unusual expenses in our packaging business.

A recent acquisitions in the analytical service in medical education areas are fully integrated and doing quite well individually and are adding to Cardinal's ability to offer a broad, cohesive offering to the pharmaceutical manufacturer.

We continue to build a broad and unique offering to -- for the biotech industry.

We are rapidly selling out our expanding capacity in our sterile manufacturing area.

In fact, we will be shutting down our entire Albuquerque facility for seven weeks this quarter to double the [INAUDIBLE] capacity in that plant to keep up with demand.

Shutting down production is something that we have not experienced before, but is necessary to support the current and future demand by our biotech clients.

Looking out to the second half, we have strong demands, our capacity is in place and our expense structure is rationalized.

Consequently, we're planning for a much higher earnings growth rate than in the first half confirming the momentum change that we are forecasting at the beginning of this fiscal year.

George will talk to you later about the nuclear pharmacy business, which will report into this segment.

Finally, let's deal with automation and pyxis.

This is a business hitting on all cylinders, revenue gross margin return on sales and return on committing capital.

I mentioned earlier about a need to innovate to differentiate.

This is a prime example of how we have done that.

Not just to benefit our automation product line, but in how we have been able to integrate pyxis with our distribution businesses in both pharmaceutical and medical-surgical products.

Our product and service offering is very unique in the industry.

Let's just call it high proprietary.

We have a large lead on our competition.

The metric for current demand and outlook for the future is our committed contracts.

As you know, we recognized future sales each quarter when the product is installed.

We draw product from installation out of our backlog of committed contracts.

New committed contracts for the quarter were 139 million, up 24% over the prior year and one of the best new contract quarters we have ever had.

So there is strong demand out there for our current lineup of products, both medstation and supplystation, and the demand is brought geographically and deep in the product line.

Installations, which turn into revenue, grew 18%.

So our backlog grew again this quarter up $19 million to $229 million, which bodes well for future performance.

But we didn't just drive volume and sacrifice margins.

Our gross margin in the segment were outstanding and a big improvement in the prior year.

This improvement came as a result of favorable sales mix of med station products, our highest margin product line, and as a result of the manufacturing improvements that we have been talking about for the last 18 months.

The demand for our bedside product line, specifically patient station is accelerating.

We made our first hospital-wide installation of patient station and a large midwestern hospital and are seeing a tremendous increase in new contract volume and interest in technology.

The recent announcement by Pfizer and soon from other pharmaceutical manufacturers to bar code unit dose products will support [Pyxis] initiative around patient station and other bedside administration products.

Expenses in the segment were up at a rate faster than sales, which is unusual for a Cardinal company, but this won't continue.

In the quarter, we were spending to build our capacity to install products so I'm comfortable we're headed in the right direction.

A return on sales for the quarter was 42.09%, another big improvement.

We'll note that our return on sales with Cardinal acquired [Pyxis] in 1996 with 32%.

And from everything I have said about demand and execution, you should be confident in a strong second half in our automation segment.

Wrapping up my comments, let me talk about cash flow.

Because of strong earnings and a less need for working capital investments, our free cash flow is excellent.

We're putting that cash flow to work in our existing businesses and also acquired businesses with this free cash flow.

As you know, we acquired Syncor on January 1, while we issued new shares to complete the transaction for Syncor, we also bought stock in the market over the past 12 months, roughly equivalent to Syncor's purchase price.

This is part of the plan.

Consequently in my mind, I'm bundling these two transactions together and, therefore, consider Syncor acquisition to be a cash purchase.

We move forward, Cardinal has plenty of opportunities to invest our capital both internally and through acquisitions and this will continue to build our company and secure our future.

I'll turn our call over to Dick Miller and then ask George to walk you through the progress of the nuclear pharmacy business.

Thank you, Bob.

This is another great quarter for Cardinal highlighted by record-breaking financial performance and 20% earnings per share growth.

Since you all have the numbers from the press release, I don't intend to go through them in detail.

Rather, what I would like to do is spend time-sharing my perspective of a few key matters.

Please note that all my comments exclude will impact of special items, which for the first time in my memory, represent additional earnings.

I will discuss these in detail later in my remarks.

Let me start with our financial model, which is working just as we expected.

It starts out with quality growth and focused asset management.

This is really demonstrated by our revenue growth of 13% and our operating earnings growth of 14%.

In three of our four segments, earnings grew faster than revenues.

Accounts receivable and inventory terms are two key metrics we use to assess our asset management, both of which saw substantial improvements in the quarter achieving record levels.

This kind of execution leads to rising sales and returns on capitals.

Our focus on operational excellence allows us to continue to expand our operating margins while at the same time, leveraging the capital needed to efficiently run our business.

Return on sales rose during the quarter to a second quarter record high 4.36% of revenues, with all-time record returns on committed capital and equities.

Importantly, return on sales increased in three of our four segments and our two largest segments delivered record returns on committed capitals.

This outstanding financial performance yields strong cash flow to fund investing opportunities.

In the second quarter, we delivered 373 million of operating cash flow.

That's an $839 million improvement over the procedure year, which provided funding for capital asset investments and $250 million of share repurchase.

Additionally, we committed $30 million of our current earnings to investment spending and activities that will fuel future growth.

That's 50% more than we spent the same quarter a year ago.

Now, our cornerstone of this whole financial model is the way we focus on capital productivity.

Consider for a minute the drivers of our phenomenal cash flow performance during the quarter, which were continued strong and growing earnings, combined with sound asset management.

While both are critical, I want to take a few minutes to discuss key developments, which are having a significant impact on our working capital requirement.

We continue to focus on managing receivables.

Accounts receivable days, sales outstanding were down 2 1/2 days both at the pharmaceutical distribution and provider services and medical products and services segment.

That drove our consolidated DSO down two days to a record low 17 days.

This reduction improved our cash flow by approximately $300 million in the quarter.

As Bob explained, we continue to see changing industry dynamics in pharmaceutical distribution, which is resulting in reductions in the amount of owned inventories required to operate efficiently, provide outstanding customer service levels while still maximizing profitability and financial returns.

These dynamics are being led by a couple of factors.

First, inventory management agreements.

These allow us to work creatively with our vendors to maximize our profitability while minimizing our inventory investments.

Second would be the increase in generic activity, which naturally reduces our inventory investment.

And in the third thing, it would be the significant synergies we have from the Bindley integration, because we have consolidated those distribution centers, we have achieved significant [INAUDIBLE] in scale our working inventory.

As a result of these trends and in inventory, our cash invested in owned inventories during the quarter declined by $300 million versus last year.

In the last item I mentioned on working capital is we continue to reduce our investment in low return [Pyxis] lead receivable, with the sales 200 million of the [Pyxis] lead portfolio completed this quarter.

Over the next several years, you should expect to see us continuing this strategy of harvesting low return capital for deployment in higher-return activities.

This will all focus on capital productivity is driving a dramatic reduction in our interest cost, providing significant earnings leverage.

In the current quarter, our average net debt outstanding throughout the quarter was down over $1 billion versus the same quarter last year.

This combined with slightly lower interest rates to yield a 19% reduction in overall costs.

Our capital productivity is driven our net debt total capital to a record low 16% and our return on equity to a record high 21.5%, while providing funding for our share repurchase activity, which, again, utilized $250 million in the quarter.

At today's stock price, and with our expectation for increasingly strong free cash flow, we continue to believe that our stock represents an excellent investment, so we intend to seek board approval to extend the share repurchase program into the second half of our fiscal year.

Now, let me just comment on a few highlights in each of our segments.

The key driver in delivering 18% operating earnings growth in pharmaceutical distribution and provider services was our expense management.

Operating expenses declined in both absolute dollars and as a percentage of revenues.

Expense energies from the integration of Bindley have increased dramatically since last year.

The final two DTS were closed during this quarter, building a total reduction of 60 CS since the same quarter in the prior year or 11 DCs since the beginning of the quarter in last year, the numbers that Bob gave you work out.

So because of our past investment scale and automation in the Cardinal distribution centers, this integration is actually occurring faster than we originally expected and with no compromise in our high customer service standards.

In addition to the expense drivers through the Bindley synergies, planned productivity and cost containment efforts across all businesses in this segment continue to deliver expense reductions.

Year over year, this segment has reduced its head count by 8%, that's a key driver of operating expense.

Medical products and service continue to see productivity enhancements as a result of the previously-announced operational restructuring and continued focus on efficiency.

Resulting an expanded return on sales of 39 basis points to 8.73%.

A key driver of this is the fact that head count in this segment is down over 800 positions since last year as we continue to rationalize our cost structure.

Pharmaceutical technologies and service experienced revenue and earnings growth consistent with our expectations for the slower first half of the fiscal year with acceleration in the second half.

The growth in this segment includes the impact of the acquisitions of Magellan [INAUDIBLE] and both completed late in the prior fiscal year.

As these businesses are fully integrated with the rest of the segment, it's very difficult to precisely carve out their impact; however, we estimate that the organic gross for this segment within the single digits for revenues and operating earnings.

However, if I factor out the impact of a couple one-time earnings items that were recorded in the prior year period, um, namely a milestone payment and a take or pay arrangement, the organics earnings growth for the segment is estimated to be right around 10%.

Automation and information services continues to experience strong demand for its full portfolio products as evidenced by a continued outstanding financial performance this quarter.

As Bob mentioned, our backlog extended contracts, which represent signed, noncancellable customer contracts awaiting installation, provides excellent visibility into future prospects.

We had the second strongest quarter ever in terms of additions to our backlog where we added $19 million during our current quarter to talk the backlog to 229 million.

Now that's up 30% from where it stood a year ago.

Let me just finish by providing some further detail on our special item.

We incurred $22 million of merger related charges primarily due to the continuing integration of Bindley, including the costs of closing their distribution centers.

Of greater interest, though, are our other special items, which provided $60 million of earnings.

There are two primary pieces netted in this number.

During the quarter, we completed settlements of substantially all of our remaining anti trust claims against certain vitamin manufacturers for amounts we overcharged in prior years.

This special income was approximately $90 million.

Net income was offset by restructuring and rationalization charges incurred during the quarter, primarily for the restructuring of the hard-shell business in our pharmaceutical technologies and services segment, as well as the continuation of the international manufacturing rationalization within medical products and services, which led to a decision to shut down plants in both Mexico and the Netherlands.

I now would like to turn the call over to George for his comments on the Syncor acquisition.

Thank you, Dick.

There are a lot of important things going on in pharmaceutical technologies and services, but I would like to focus this morning on our acquisition of Syncor.

As Bob mentioned, we finalized the acquisition on January 1, which is a date we all greeted with enthusiasm for a couple of reasons.

First and foremost, nuclear pharmacy services is a tremendous proprietary business.

I want to give you a bit of background first on what this service does.

This business compound and dispenses radio pharmaceuticals for diagnostic and therapeutic use by nuclear medicine departments of hospitals and outpatient clinics.

Essentially, radio pharmaceuticals are medicines that patients ingest to illuminate organs and tissues so physicians can identify diseases, track treatment progress, and help further recovery.

Because these compounds brake down quickly, in other words they have a shelf life that you can measure in hours, that I are mixed and distributed in realtime to provide locations through a network of nuclear pharmacies throughout the United States.

The key point here is that nuclear pharmacy is an indispensable link in the process that brings the product to market & in its final, usable and customized form for the patient, which can have application to other products as well, which I will come back to.

Cardinal Health has already been in this attractive market through our central pharmacy services group and doing quite nicely.

Syncor was the market leader, so through this acquisition, we now have a total of 170 pharmacies nationwide, positioning us to better realize the potential of this highly profitable and fast growing market that exceeds 13 million patient treatments annually.

Through the acquisition, we now offer health care providers the most comprehensive nuclear pharmacy services capability in the U.S.

The combined Syncor central pharmacy service center is now going to be referred to as the nuclear pharmacy services businesses of Cardinal Health, and as we mentioned in the report through the PTS segment.

The second strategic benefit to the acquisition is the synergy potential.

While the core domestic nuclear pharmacy service business is enough to be enthused about, the potential of integrating it with other Cardinal Health offerings proves more promise for the future.

In addition to compounding and distributing the radio pharmaceuticals, there is an enhanced value of potential for the manufacturer of drugs.

Through the PTS segment, we can provide the customers the broadest range of product development, commercialization and logistic solutions to the nuclear pharmaceutical manufacturer, or to the biotech customer for certain customized or complex products, which would require these kinds of value-added services just before patient use.

Bottom line is this is another proprietary way that we help manufacturers and their products reach the market faster and more efficiently, which is our basic value proposition at PTS, and why it made so much sense to include the nuclear pharmaceutical business in the PTS segment.

The last point on strategy I would make is we would continue growing the core domestic side of this business.

The previously announced sale of Syncor's imaging business will continue.

Earlier this month, we announced the sale of centers in Southern California to Insight, and more sales are expected soon.

The rationalization of the international operations also announced prior to the acquisition is progressing as well.

From an operational perspective, we are highly confident on what I'll describe is the cultural leadership and infrastructure front.

Through our do you diligence process and subsequent actions taken by and at Syncor, we're very confident this business will be run consistent with Cardinal Health's high ethical standards.

The integration of operations has accelerated and will go very smoothly in keeping our Cardinal Health tradition of fast and efficient absorption of acquisition into the corporate family.

This network of more than 170 domestic nuclear pharmacies, which serves about 800,000 customers, entails a little overlap between the former Syncor and Central Pharmacy Services location, so costs and customer synergies should be realized very quickly.

The management team couldn't be stronger.

Gordon Troop's decision to lead nuclear pharmacy services is a testament to the important we place on this business.

Gordon's an outstanding executive with a great appreciation for what it takes to integrate and grow a business at Cardinal health, and he's already selected a diverse management team that's made up equally of former Syncor management and CPSI or Cardinal Health management.

Let me conclude with a comment on the financial attractiveness of the acquisition of Syncor picking up on some of Bob's remarks.

Individually, the former Syncor and Central Pharmacy Services businesses were impressive financial performers.

And together, we expect they're going to be a highlighted segment performance, although the contributions for the balance of this fiscal year will neither be dilutive or accretive to earnings.

Traditionally, the Syncor core pharmacy business in the U.S. has grown revenues in the 15 to 18% range.

Importantly this business is not a consumer capital and will further enhance Cardinal Health's return on committed capital.

Expectations for returns on committed capital for this acquisition in year 1 is in the 80% range.

And return on invested capital of the Syncor acquisition will approximate Cardinal Health's cost of capital at the end of the first year, which is very impressive.

As you can tell, we're very optimistic about the future of the nuclear pharmacy services business and I look forward to talking more about its progress in the near future, and particularly at the upcoming investor's conference.

Operator, I think we'll take some questions now.

At this time time, I would like to remind everyone in order to ask a question please press star then the number one on your telephone keypad.

We'll pause just a moment to compile the Q&A roster.

Your first question comes from Glen Santangelo from Solomon Smith Barney.

Yeah thanks a lot, my question centers around the gloss margin erosion in the drug distribution business.

I'm trying to understand what is having the most negative impact on the gross margins.

Is it, you know, Bob, you tacked about less product availability in the channel or is it, you know, the pricing pressure around some of the contract movement or is it some of the inventory management agreements we're talking about.

And maybe if either you or Jim could assess the magnitude of the three issues and what is having the greatest impact, it would be helpful.

What should we expect for the gross margins for the rest of the fiscal year.

Let me first address it, um, first of all, we -- we can't, you know, we're not going to break down any one by percentage, you buy -- but I think it's a good question.

Let me give you directional answers to it.

This is just a number of pieces.

First of all, the business continues to move toward, um, towards a larger customers, which we talked about this for 10 years and that is a fact.

This reduces our gross margin, but -- but that -- then should be reflected if we say it's lower cost to ship, that should also be reflected in our low expense.

Um, before I cover all the other expenses, let me just say if you look back sequentially to a year ago and look at -- there is some seasonality in gross margin in general.

So the gross margin dropped this quarter, first quarter of this year versus, um, -- I'm sorry, second quarter this year versus the first quarter is almost identical to what it was a year ago.

So it's not -- and then our expense drop is about the same.

So it's -- they're running about the same.

Now, the only thing that I would say is really particularly unusual in this quarter, and it's not a huge magnitude, but it's worth mentioning is there was some draining of products out of the channel, which means there was some left product available, that broader investment down some.

Manufacturers were trying to balance the product in the channel, um, um, with the -- with demand, um, and so -- so that cost us some money.

But, you know frankly, that ebbs and flows and, um, we don't think long-term that is a significant item.

The individual managed, um, management agreements, um, will tend to lower our gross margin, but we're very good in calculating exactly what they do for us, and we won't enter agreements unless the net result is good for Cardinal.

So for example, if you as a manufacturer came to Cardinal and said, um, I would like to enter into an agreement that -- and provide incentives -- incentives to you to do certain things, part of that is it would reduce our cost, then the gross margin reduction on that contract would appear at the top-line, um, but we would get interest savings below the line.

So, um, Glen, I'd say there is a number of things going on.

I don't think it's troubling.

The competitive environment is about the same as it was before.

I think, you know, frankly, if we, um, if -- if our -- our gross margins have to be tied into our expenses also, and I think we're able to bring our expenses in line with where, um, gross margins are and I think that the industries are pretty well balanced.

Jim, any comments you want to make about gross margins?

I think you covered it pretty well.

Sorry.

I think you covered it pretty well, Bob, the only piece left to question was regarding what is happening on the selling side of it, and I think your comments initially as competitive as it's always been, we haven't really seen any precipitous drop.

There has been a steady over the several years, quarter-over-quarter change, now into the sequential numbers, so I think you covered pretty much all the pieces.

Okay, thanks for the comments, guys.

I appreciate it.

And you need to look at the seasonality of this also.

I think our gross margins in Q2 a year ago were down about 40 basis points and then Q3, which is normally a higher gross margin area.

You will see them rise again.

So, um, other questions?

Yes, your next question comes from Tom Galluci.

Just a follow-up to Glen's question.

I think he may have asked part of it.

As the expectations go forward first, in terms of some of the new customers that you're adding Express and [INAUDIBLE] um, I'm assuming that just historically that's naturally lower gross margin business, better leverage on the SG&A line.

How should we think about that as that business comes into the mix?

Jim, you want to comment on that?

I think, Tom, you hit it just right.

These are large customer relationships, and so they don't have the came kind of expense, um, that would be associated with a smaller, um, account like for example, an independent.

These are great opportunities for us.

They allow us to, um, certainly leverage off our inventories because they're a demand.

That's a good thing as we look forward on the buy margin side of the equation, but I think you hit it just right.

It's a -- it may have an effect, although remember, we have a $40 billion base of business that it's going to be effecting.

It may-- it may incrementally touch on the cell margin side of it, but should be positive in terms of what we should be able to earn on the buy side and lower expense ratios.

Okay, thank you.

Your next question comes from Larry Marsh from Lehman Brothers.

Thanks and good morning.

Bob, you know, I think you talked about the business continually evolving and such, and um, and I think some of your initial comments said that you would anticipate, um, you know, from a standpoint of capital invested, maybe a return to maybe more normal in the first half of calendar '03.

Obviously at period end, you showed helping improvement in inventories and I was wondering from a committed capital standpoint, um, which obviously came down year over year in drug, would you anticipate seeing it tick back up some, you know, the first half of calendar '03, um, and if you could just elaborate on that, that would be great.

Well, what I said was that the one element that -- on aspect that had was slight decrease on our inventory in the pharmaceutical distribution site.

Just one element of it was, um, a, um, a manufacturer's, um, holding back some of the product flow in the last two months to the quarter.

So, you know, that was just one element.

That's not, and I -- that will come back to more normal flow.

Um, the things that I think are more permanently in the equation now, um, which is lower need for working capital support generics, the inventory and receivables.

That will continue.

That is favorable to us because when we look at the whole equation, we're looking at it as what is our earnings and what's our investment in the product.

That's favorable to us.

Um, the lower inventory needs as a result of only operating 26 distribution centers instead of, -- I'm sorry, 25 instead of 37 of just a year ago, that will continue to be favorable to us.

As you go through, you need a lower proportionally, but you have less safety stock, and so we're operating as we pointed out to you, I think the time we did the Bindley merger, we started talking about that point more aggressively of how large our distribution centers are going to be in average sales per distribution center, and we're going to get leverage out of that, that's permanent.

The agreements we were entered into with manufacturers, this is a long-term trend around, um, um, inventory management agreement.

Long-term trend.

Those agreements, one aspect of it is that, um, that will allow us to have lower inventories.

Again, we're only willing to do that if we're able to have the whole equation work for us in terms of the total profitability of that product line.

I would say overall, the need for capital, committed capital in distribution will be proportionally less, but keep in mind, um, we're growing our top line.

I said that I expect our top line to be accelerating, moving out of the fourth quarter into '04, so there is still going to be plenty of demand for working capital growth, um, with those gross rates.

But what it means is with the return on capital, I never frankly dreamt, we could get to 36% return on capital in any quarter in pure distribution.

Um, it means we're throwing off more cash.

And, um, we will deploy that cash either initiatives in that segment, um, or initiatives in other segments or in acquisitions.

So, you know, most businesses would say these are good things, and I would say these are good things for us.

As you know, we're very financially disciplined and measure profitability, frankly, by products.

Um, and so I think that the, um, the prospects are bright.

Great.

Thank you.

Your next question comes from Lisa Gill from J.P. Morgan.

Great, good morning.

Bob, I wonder if you or Jim can comment on the trend that we've been seeing as far as the movement in bulk inventory sales, foreseeing that come into the channels or, um, if we're seeing that move somewhere else.

And then just secondly, I was wondering if you could comment on what the percentage of [Med/Surg] that's manufacturing today and what your expectations are.

Thanks.

LIsa, I didn't hear your second question.

Could you speak up?

Sorry about that.

The second question on the Med/Surg division, was wondering if you could talk about what percentage is manufacturing today and what your expectations are going forward.

Okay, um, Jim you want to deal with the first issue, which is about -- you want to deal with the first issue which is about one of the -- what are the trends of bulk sales.

Probably going to be -- and talk about probably how some of that sales is moving actually, um, --we're controlling it more so --

Yeah, um, the bulk sales-- a little bit of that on the trend line is a bit of a timing issue but, um, but there has always been -- you may have recollect, there may be a change in like our relationship with the Walgreens in terms of who is going to handle both products, would it normally be brokerage, Randalls on their recent announcement said they were going to go to a wholesaler rather than be trapped in the brokerage business.

There has been changes in whats going on with Express [scripts].

It's just a series of, um, of, you know, product shifts.

There is products that would be, um, moved through the normal distribution channel rather than into the warehouse of a manufacturer, um, it's a variety of different things that occurred in that.

There is also, I think if I recollect back, there is a timing issue in terms of CVS in terms of what we sold them in bulk as well.

It's a combination of a lot of different things in terms of how that product flows down.

It's a difficult time when you look at the end of the second quarter, because it's about product availability from the manufacturer, you know, the bulk is effected the same way as all other products is treated as it relates to, um, product put in the channel by the pharma companies.

Okay, let me talk about medical-surgical.

One of the comment on the bulk, um, obviously we reported we make no margin in bulk sales.

Whether it goes up or down doesn't effect our financial statement.

If it's an indicator, though, as we talked about, is moving product -- we make no margin on moving that through our distribution channels by, should be in the enquirer of the product and moving the product for our chain customers, that's positive.

That is one of the effects, that's one of the reasons you will see bulk sales over time go down.

On the medical-surgical side, um, I don't have exactly what our percentage is and actually, those percentages are moving all around.

Let me give you why.

We talked about the new products come out.

You will see our self-manufactured product lines like gloves growing.

On the other hand, we concluded there are some businesses, in fact, we don't want to manufacture anymore that we in fact could outsource, so we're not looking just at -- we're not -- our goal is not just to increase the percentage of self-manufactured but increase the profitability of the corporations.

So, in fact, in exam gloves, we're going to outsource some of the exam gloves to China.

They can actually do it at a rate lower than we can, and we decided we don't want a manufacturer there.

So, um, on products where we decided we have a competitive advantage and cost advantage, um, and design advantage some of aspect or, um, those products, those product aspects are growing and that's certainly one of the reasons you will see our overall gross margins go up in the segment.

In the segment in are the last two quarters, um, and I gave you some indication.

You should expect our top line to grow much faster in the second half.

It won't get reflected in higher gross margins in -- by the second half because, first of all, we're selling distribution, and um, as a -- once we have a distribution relationship we're much more likely to sell through our own self-manufactured at a high proportion.

So, but overtime, you will see our self-manufactured volumes move up also.

All right, thank you.

Next question.

Your next question comes from John Kreger from William Blair.

Thanks.

A follow-up question on IMAs.

You can talk a bit more about how they work and how the accounting will work.

And what I'm interested in is if the realization of profit on an IMA, the timing of that will differ from your traditional business where you might be buying inventory in the first half of your fiscal year and selling out in the second half.

First of all I don't -- you know, this is, um, one of those topics that sort of is catching fire that's kind of out of proportion, important to the company.

But the, um, IMAs, you know, just effects how we manage -- this effects, obviously, a big product category, which is our branded product category.

It's something that has been -- we have had IMAs that haven't been talked -- they have been described as that.

We have had that since I have been in the business.

We have had individual contracts with every manufacturer since 1980 and, of course, before that, I'm going to go into when we entered the market.

What I'm talking about is a new aspect to our Individual Management Agreement.

IMAs really, our Inventory Management Agreement, we will have an agreement with the branded manufacturer that describes all kinds of things.

What are our return policies, you know, how do we get, you know, margins and -- and what rights do we have to buy the product, the advance of price increase and all of that.

All that is happening is we, and our other two large wholesalers get more sophisticated.

We're tying down more details around opportunities with manufacturers and creating things that we do for them, um, so the IMAs have a performance aspect to this.

If you do x it's good for me.

They're individually negotiated.

We don't want to share exactly how we're doing ours, um, and, um, with the competitors, um, but there is no change of accounting for it, so we get -- if we get, um, if we -- they're subject to payment of margin to us.

You know, we buy the product, um, in the same way other than we might, um, we might buy -- we might buy product on a more even basis rather than building up product.

The only significant change to our Inventory Management Agreement, which has been in existence for 20 years.

The only significant change now is we're entered into more agreements that, um, that allow us the opportunity to reduce our inventory commitment for that line.

What I would tell you, if that doesn't come with the manufacturer offering us additional margins, opportunities that we wouldn't sign the agreement.

So, you know, our guys are very good at calculating, knowing exactly what the full product movements are of each one of our pharmaceutical manufacturers, and I'm quite confident that both [INAUDIBLE] and McKesson are able to do the same calculation and they may negotiate in different ways and have different objectives, but, um, we're all negotiating the same kind kinds of things.

That's how they work.

There is no unique accounting there's nothing unusual about them other than, you know, going to offer us opportunities to actually have--carry lower inventory.

Great.

Thanks.

Your next question comes from Ray Falci from Bear Stearns and Company.

Let me make another comment on this.

This kind of a trend is not all that different.

When you think about us putting capital up, it's not all that different than the trend that started about 15 years ago where instead of us having a standard payment program with customers, we started talking about customers if -- if you do this, in other words if you pay us early, we'll give you a lower -- we'll give you a lower fee, um, and so we started tying together, you know, when they pay us, you know, when they take product, all the rest of that stuff, um, and, um -- to help improve our distribution and that's one of the things that drives down a gross margin.

We're also driving down our expenses.

I look at it same way.

We're managing assets, managing relationships between us and the supplier, managing relationships between us and and the provider.

And that's one of the results of -- for anybody in the industry, I think our days outstanding in 1980 in pure drug distribution, um, with -- saying like 32 to 35 days in pure drug distribution today, um, were -- we're in single digits.

Um, and so all of that is reflected in better productivity, less investment for us.

Seen kind of phenomenon.

Ray --

It's Andy Weinberger, actually.

Andy.

Can you talk about the revenues in your trading business, given that you said there's less product in the channel?

Was that effected at all this quarter?

Yes, there is less product in the channel, we would have bought less product and we would of actually traded it out.

That is a fairly, where the dollar volumes are significant and not major, but they're significant.

That's a fairly low margin business and it's less critical to what I call -- it's less strategic.

We're buying products and a lot of times we really want to use it, -- the products, our own distribution channels and when we have excess product, we might sell to another wholesaler.

So, um, volume in that area was down pretty dramatically.

That probably took oh, um, probably took one or 2% off of the top line growth.

Okay, and just a quick follow-up question.

You had, um -- you're expecting probably about $750 million of additional revenue from new contracts, assuming they all get phased in toward the end of the third quarter or thereabouts, um, it seems that like at 2% operating margins given that some of its mail order, why would operating earnings growth decelerate in the second half of the year?

I'm just not seeing that correlation.

Why would what?

I think you said in the beginning of the prepared remarks the operating earnings growth in the pharma business is going to decelerate in the second half of the year.

Did you say decelerate or accelerate?

Decelerate.

[What]

Given your adding pretty big customers toward the end of the year, why would that growth decelerate?

No, I said our revenue growth rate will accelerate.

There are a lot of other things going on in the equation.

We're trying to give guidance about what you look for in the second half and what you look for '02.

So, um, you know, I -- you know, I'm very positive about revenues and, you know, I think we said really we're bringing on an -- on an annualized basis about $2 billion of new revenue, and we anticipate, we're very optimistic about other important revenues coming on board.

I just said our growth rate in the second half of this year versus our growth rate, this is just pharmaceutical distribution provider services, versus our growth rate in the second half a year ago, will be a slightly lower rate than the first half growth rate.

I also said our growth rate in '04 in, the segment, um, will be at a rate faster than in the second half.

And so this is just a lot of factors in here, you know, what was growth rate and -- a year ago and all of that.

I don't think this is a significant trend that you want to project anything off of.

Okay, great.

Thanks.

Trying to give you guidance.

I also confirmed that the growth rates in the other three segments, second half, will be at a pace faster than the growth rate in the other three segments, um, versus the first half of this year.

Um, so I'm just trying to give you guidance and also said that, um, I reaffirmed up front our commitment of the 20% earnings per share growth and with rising returns.

I'm just trying to give you a mix of what our business looks like second half profitability and how the formula comes together for us as a corporation.

Okay, great.

Thank you.

Your next question comes from John Souter from SG Cowen.

You mentioned the size of the share repurchase request that you've gone to the board with.

Hey, John, I can't hear you.

I'm sorry.

You can mention the size of the share repurchase request.

Um, hold on.

I have a lawyer here.

Are we allowed to say?

I guess we are allowed to say.

John, we have not gone to the board yet.

Obviously we have been in a in a quiet period relative to this earnings release.

All we stated in our release was the intent to go to the board, subsequent to the earnings release, and I would think about, you know, a size similar to what we did in the past.

Okay, let me talk about share repurchases.

First of all, I know all most of the board members, as you guys probably expect, I think they will favorably receive this, and we wanted to give an indication that's what we're going to do.

The whole issue of share repurchase, um, we're not trying to become a smaller company.

I basically think there are two things: Two things a great opportunity at our price, stock price, but on the other hand, I'm looking at prefunding equity transactions that have to be done for tax advantage reasons.

That's why we did it.

We, you know, we bought, um, we bought Syncor, issued new shares, but we clearly want to get our leverage up.

We clearly have great cash flow, and we could fund -- we could have funded and we effectively did, funded the Syncor acquisition in from our free cash flow the last 12 months.

So, you know, don't think of us as a company trying to buy all the shares in to shrink the size of our shares outstanding, um, you will see other acquisition opportunities along the line.

Okay.

And then--

One more question.

Yes, your final question comes from Sean Harrington from Credit Suisse First Boston.

Actually Robert Willoughby sitting in for Sean.

On the stronger accounts receivable managements in the quarter, was there any material tradeoff in the gross margin for the quarter?

Hey, Bob.

Um, I don't -- well, look to the accounts receivable would really, because it's the biggest revenue, would be in our pharmaceutical distribution and our medical-surgical areas.

Jim, I don't, you know, any comment?

It's a mix our business.

Part of it is there is probably some tradeoff.

It's larger customers paying us earlier.

Any comments?

Yeah, I think it's a slight impact on that.

You're right.

Shortened terms, it's a more aggressive discount associated with that.

The other side of it, too, is I think it's more in the, um, in the -- our aging and our risk portfolio associated with, you know, um, aged receivables.

That part -- that number is basically nominal.

As it relates to our portfolio, and um, so the quality of our entire AR portfolio has improved as a result.

Yeah, we have -- we look at, um, any receivables, um, past 30 days, past 60 days, past 90 days and then we look at our reserves and coverage for all of that, you know, we are in, by far the best we have ever been in in our -- in our 20 years of being public.

I mean, um, and so we're, you know, and -- and one of the biggest improvements, um, in management is really, um, a good credit to Ron's team,, and um, on the medical-surgical, they really put some good systems in, been diligent about it and brought it down dramatically.

That was improvement.

I think on the receivables side, we calculated they took out of, um, -- took out of receivables about $100 million on an annualized basis, and it's all in just better management of the receivable.

No -- no -- nothing complicated other than that, although it's hard to do.

Okay.

Okay, one last question on that, or more answer.

One other piece of it, Bob, on the AR piece of it, is the bulk that sales go out, the decline in bulk, that's 30 day sales also, had an impact on that as well.

Okay, um, this was a long conference call, and we, um, we wanted to remind everybody we have an investor's conference on February 3 -- February 13, sorry, and we will, um, at that time, have a chance to you know, roll out our formulas and, you know, talk about our business strategies and models for -- for, um, fy04, um, I'm very upbeat about where we stand as a company in our businesses, um, um, and very positive about our results as we move forward.

Thanks very much.

This concludes today's Cardinal Health second quarter earnings release conference call.

You may now disconnect.