卡地納健康 (CAH) 2004 Q1 法說會逐字稿

Good morning, my name is Kimberly and I will be your conference facilitator today. At this time I would like to welcome everyone to the Cardinal Health first quarter 2004 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers remark 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. I would now like to turn the call over to Mr. Steve Fishbach Vice President of Investor Relations. Please go ahead sir.

Thank you. Good morning and welcome. Today we'll discuss Cardinal Health fiscal 2004 first quarter. This portion of our remarks will be focused on the business segment attachment of our earnings release. If you have not received a copy of our earning release you can access it on the internet at our investor page at www.cardinal.com.

Speaking on your call today will be Bob Walter, Chairman and CEO and Dick Miller, Executive Vice President and Chief Financial Officer. After their formal remarks we will open the phone lines for your questions. As always when we get to questions we ask that you limit yourself to one question at a time. Before we begin, please remember that today's call may include forward-looking statements which are subject to risk and uncertainty which could cause results to differ materially from those projected or implied. The most significant of those uncertainties are described in Cardinal's 10K and form 10-Q report and exhibits to those reports. Cardinal undertakes no obligation to update or revise any forward looking statements. In addition, statements on this call may include adjusted financial measures governed by regulation G. For a reconciliation of these measures please visit the investor relations page at www.cardinal.com.

At this time I'll turn the call over to Bob Walter who will provide his comments on the quarter. Thank you.

Good morning. Cardinal Health first quarter performance was in line with our expectations and on track for our full year earnings and cash flow goals. Having said that our first quarter was [INAUDIBLE] below Cardinal Health historic growth rate. That is exclusively due to a challenging transition occurring in the drug distribution business. Which we began disclosing as early as the January earnings call following our December 2002 quarter. Merck highlighted in their earnings release yesterday, the transitions they're seeking. Merck’s announcement indicates a relationship exactly like what we are seeking and the timing is right on. Outside of Pharmaceutical Distribution, there is no change in prospects of our company or in our overall outlook. Our three other businesses are performing well and should accelerate their performance through the remainder of fiscal 2004. Cardinal Health fifth segment, our cashflow and capital deployment, is a key asset and will make meaningful growth and strategic contributions in FY '04 and beyond. Our balance sheet continues to afford great strategic flexibility. I'll focus my comments this morning in two areas. First, a discussion of our operations, and second discussion of our cashflow and capital deployment efforts. While I’ll certainly do a recap of Q1 results, I'll also be covering our full-year outlook business by business, as well as prospects in the capital deployment area. And those prospects are compelling. First, let me summarize and discuss the results of our operations, the concise summary of our Q1 results and '04 prospects is very straightforward. Our consolidated results for the quarter were as we expected, excellent top line growth of 16% speaks to the continuing strong demand for our products and services and our cashflow expense control and asset management performance was excellent. Medical products and services top line performance was exceptional. They have great momentum through the remainder of the year. Pharmaceutical Technologies and Services had very strong organic growth and will be our fastest growing business for the full year. Automation and Information Services continues to see strong demand for its traditional product lines, but even more compelling are the early returns and prospects for new products, especially PatientStation. Pharmaceutical Distribution provider services saw continued strong, top line demand but also continued challenges in vendor margins from pharma manufacturers. This challenge will remain with us for the remainder of FY '04. That's the reader's digest version of our quarter, now, let me add some color commentary. Medical products and services show great top line growth in both distribution and self-manufactured products. Contract wins from last year have fueled distribution growth, and we have begun to see the pull-through benefits in self-manufacturing product sales, but that full benefit is still ahead of us. In addition, recent contract wins with Health Trust Partner's Group and Broadlane (ph) provide similar upside potential over the next three quarters in both distribution and self-manufactured products and should also drive accelerating growth for the full year. We expect the best annual revenue growth performance in this business since being acquired by Cardinal Health nearly five years ago. The increase in new self-manufactured product sales in the quarter was equally significant. We tripled new product revenues in the quarter, driving over $30 million in incremental volume. In the margins we earn on self-manufactured products that have meaningful impact on the bottom line. And just this week we received FDA approval for yet another surgeon's glove innovation. A therapeutic glove treated with [INAUDIBLE] that help protect the skin and hands of our surgeon customers. This will be a significant addition to the already impressive market leading glove business growth story over the past few quarters. Incidentally, the condition agent in these gloves was co-developed with the sister division in our Pharmaceutical Technology business. With the improved sales mix of new and self-manufactured products and manufacturing cost improvements, the outlook for gross margins in medical products is excellent. Coupled with a focus on SG&A productivity, the return on sales on this business should improve for the full year. An effective asset management should continue to make the business a significant generator of operating cashflow. So the top to bottom formula is working. I'm particularly optimistic about the business development opportunities in the medical product business going forward. Medical and surgical products manufacturing and international expansion are two very attractive growth areas which we have targeted. Bottom line on medical products: good quarter, terrific momentum and the business we expect to continue to invest in going-forward. Now, Pharmaceutical Technology and Services, they delivered a quarter right on target with our expectations. Solid growth from our core drug delivery and manufacturing businesses drove high teens organic earnings growth. With the addition of a nuclear pharmacy business continuing its solid performance, earnings of this segment grew 47%. That performance was achieved despite the delay of two FDA manufacturing inspection approvals for expanded capacity in our sterile products area. This expanded capacity is needed for products already FDA approved with clear demand and signed contracts awaiting production capacity. Those inspection approvals are scheduled in the second quarter and should drive our biotech and sterile product business to be the fastest growing area in the PTF segment for the full year with very attractive returns on sales. For the first quarter, important revenue and earnings drivers were in our contract packaging and selected oral product manufactured areas. We began packaging after Zeneca's Crestore for cholesterol therapy in the quarter. That product is off to a good start. On the oral side, [INAUDIBLE] Prexa (ph) in [INAUDIBLE] formulation for the treatment of schizophrenia continues to do well. As recently announced, a proprietary [INAUDIBLE] drug delivery technology has been selected by Roche in a completed deal for the production of Clonopin for the treatment of anxiety disorders. Nuclear pharmacy services, since the acquisition of Sing Corp (ph) has continued to perform exceptionally well. This is a $1 billion business for us. Our integration efforts have continued ahead of schedule, and rationalization of operations in all overlap markets were completed during the quarter ahead of schedule. On the business development front, PTS completed the acquisition of the remainder of Gollar Biotech (ph). This strategic acquisition in the biotech [INAUDIBLE] antibiotic production area is an important addition in our technology and product development portfolio. The Pharmaceutical Technologies and Service business continues to be a primary area for business development for Cardinal Health with a particular focus on expanding our global technology and manufacturing capabilities. You should look for continuing acquisitions and investments in these areas. PTS in summary. Good organic growth, successful integration of Sing Corp (ph)., expanded capacity and demand in sterile technologies and a continued target area for investment going-forward. This will be our fastest growing segment for the full year. Now, let me discuss Automation and Information Services. The top line growth of 7% for the quarter in this segment belies the real demand for Pyxis products. This is true of both our established product lines as well as some exciting industry-leading patient/bedside systems known as PatientStations. At the risk of sounding like a meteorologist, in the quarter, revenues which is based on installation of committed contracts was impacted by installation delays on the East Coast due to Hurricane Isabel and delays among selected customers who [INAUDIBLE]'s were dealing with more general computer virus concerns. Our backlog of committed contract continues in excess of $200 million awaiting installation. I'm confident about the top line performance of the business for the remainder of the year in Q2 in particular, since it should see impressive sequential growth over the prior quarter, a similar pattern to what we saw in Q4 and Q3 last year. Despite installation delays, AIS posted a strong quarter. Gross profits were up, expenses were down and that leveraged to a 266 basis point improvement in return on sales. But the most important and positive element in the AIS story this quarter is more long-term in nature. The introduction of our PatientStation, and PatientStation SN product line are the most customer responsive and economically attractive products to be introduced by Pixas (ph) since Cardinal Health's acquisition of that company in 1996. Later, Dick Miller will explain the financial implications of the introduction of this product line to this segment going-forward. But let me give you a sneak preview. We've just begun installation of over 5,000 PatientStation units in 10 key customers in two, including significant total systemwide commitments by two highly regarded institutions with Miami Baptist in Miami, Florida. And Memorial Herman in Houston, Texas. These accounts once installed and contracted on an operating lease basis have a present value revenue potential of over $40 million. It's a new revenue model for Pyxis with two sources of revenue. First, guaranteed placement fees for the equipment for the hospital contract, much like how we were paid for Medstation or supply station today. Its first guaranteed placement fees and second usage fees from both the hospital and Cardinal Health as patients subscribe to the educational and entertainment capabilities of bedside technology. The reason this product is generating such rapid early acceptance is that it has features and benefits attractive to all hospital personnel. Doctors can use it for access to clinical information. Nurses can use its convenience, information, and patient safety features, and patients can use its education, internet, entertainment, and in-hospital communication features. And hospital administrators see an opportunity to provide incremental revenue to their financial equation. Close on the heels of the launch of patient's station, Pyxis PatientStation SN has also been introduced. PatientStation SN combines the new PatientStation product with the traditional Pyxis Medstation and supply station product line. But in a new and unique individual, in-room at-the-bed, at the patient bedside storage configuration. This 1-2 leap frog of information and automation to the bedside is the kind of new product stream which has become a trademark for Pyxis, it is also why we're so confident of this product line's growth potential and its proprietary nature. The full-year outlook for our automation business is what we expect -- is that we expect committed contracts to grow at historic levels, and installation volumes to grow sequentially throughout the year, driving revenue growth at historic levels for the full year, with continued productivity improvements, yielding higher return on sales. Now, let me turn to Pharmaceutical Distribution and Provider Services. Revenue in the quarter came in at a very strong 16% growth rate, particularly in light of the continuing decline in the mix of revenues through our Pharmaceutical Distribution trading company. So why did earnings grow at such a slower rate than revenues? This is an industry in which the profit model is changing and will be in transition for the entire year. So how does the industry in our profit model look going-forward? First of all, the industry continues to enjoy one of the best growth prospects of any industry in our economy, double-digit pharmaceutical demand will continue. The industry has consolidated and. the distribution infrastructure is more efficient than ever. The role of the distributor in the supply chain is essential and, therefore, secure. It is highly unlikely that the pharmaceutical manufacturer could or would choose to invest in distribution infrastructure rather than their core R&D competencies. It is even more unlikely that the highly fragmented provider industry could or would venture into this logistics area as the cost and barriers to entry are prohibitive. Within this attractive drug distribution industry, Cardinal Health is uniquely well positioned from a cross standpoint as a result of prior and continuing technology infrastructure investments. We're efficient and getting better, and our customers and vendor relationships, through drug distribution enable us to leverage our other businesses with key customers. Operationally, the distribution system just plain works. We are a leader in a consolidating and continuing growth industry with great customer and vendor relationships. I like the industry and I like our position even more. But there is little question that a sea change has occurred in this industry, and the past business model that was heavily dependent on inflationary vendor-margin opportunities can no longer support the profit growth objective for the industry or for Cardinal Health. So we moved to a new compensation model with more margin predictability and less capital required. As we've been saying, in our investor presentations over the last nine months, the industry is in transition, being driven by changing vendor needs and requirements. Merck's announcement yesterday is a clear and direct public acknowledgement of these changing vendor priorities from a highly respected manufacturer. We applaud it. I’d characterize the two most significant factors we see in our discussions with pharma manufacturers as follows. First, the vendors want to ensure that inventory levels in the distribution channel more closely match the in-patient prescription demand. We agree with that objective. And we believe it creates even more efficiency and visibility. Once the inventory management channel practices get redefined and the fee for service model fully adopted, the long-term growth prospects of this industry remain very attractive. We want to partner with our suppliers to get there as fast as possible. Second, we support the industry's goal to ensure the security and safety of the drug supply in the United States. Recently reported cases of counterfeiting and diversion require regulators and pharmaceutical retailers, manufacturers and wholesalers to join together to protect product integrity and safety. A better balance of industries in the distribution channel is a step in the right direction. Distributors that offer no real logistical benefit will be eliminated. That's great. This suggests that our historic trading company policies and practices will be changed. We intend to be an industry leader in sourcing directly from the manufacturer of the product. Helping ensure product integrity is part of what we'll be paid for by the manufacturer. What are the implications of these two changing vendor priorities to Cardinal Health? First, these manufacturers are valued suppliers and also valued customers for other parts of our company. We will work with them in a partnership mode to accomplish our objectives while at the same time establishing agreements that create a fair profit to Cardinal Health. Second, our infrastructure investments, our logistics expertise and our logistics efficiency make us even more valuable to our suppliers. We see no decrease in demand for what we do, albeit under a different business model. The third implication of the changing vendor priorities is a reduced dependency on vendor margin from price inflation, and an increased benefit from margins based on fee for service. Less variable, more fixed fees for service. This will result also in reduced capital requirements to support inventory in the channel. The fourth important implication of this change is that over time it will affect our historic pricing models to our provider customers. In the past, our pricing was predicated on inflationary vendor margin leverage and our cost structure. In the future, it will still be based on our cost structure, but on a different vendor margin formula. So the pricing models to providers will change, and selling margins must stabilize. So will we ever return to the old model? I don't think so. Nor do I think we should. What will require time and candid discussion with our vendors and customers, we are moving to a new model for this business. First we invented dialogue with most of our pharmaceutical manufacturer partners, and I'm pleased that Merck has come forward to move to an activity based fee for service structure and away from an inventory investment model. Such an arrangement would remove incentives to create inventory and balances and this can happen very quickly. Second, our fee for service arrangements with vendors will need to be customized to each vendor and even to each product category. For example, the fee for service will likely be different for drugs that require special handling like controlled substances, or drugs that are particularly temperature sensitive. Or for products with different activities like slow-moving products. Third, we will continue to drive down our costs as well as total systemwide costs, wherever possible. And fourth, we've already enacted changes to our alternate source vendor purchasing activities to support industry efforts to eliminate counterfeiting and the threat to our country's drug safety.

So what's the outlook for Pharmaceutical Distribution business at Cardinal Health? While we expect to see continued pressure on vendor margins and selling margins throughout the year. This year of transition, we do see improved second half performance in this business, and further opportunities to leverage the working capital required to support the business.

Less capital required in drug distribution, great operating cashflow and strong balance sheet brings me to our fifth segment. Capital deployment. The story here is all positive. During the 1st quarter, our year-over-year operating cashflow improved by over $300 million. Along with the $1.7 billion in cash on our balance sheet at our fiscal 2003 year end we were able to purchase $1 billion of stock during the first quarter and still end the quarter with nearly $1 billion in cash remaining on the balance sheet. We're on track to generate $1.3 billion in operating cash flow for the fiscal year. With low debt-to-total capital ratio and significant borrowing power, we plan on capital employment to contribute meaningfully to our earnings in the future. Our specific priorities for capital deployment are as follows. First, continue to invest in capacity in our existing high growth businesses opportunities like biotech and sterile technology, and in new products in Pyxis and medical product manufacturing. Second, execute our business development activities for the remainder of this year in some key targeted areas. Specifically, medical products, manufacturing, and international expansion and PTS global technology and manufacturing capabilities.

In closing, as you follow Cardinal Health for the remainder of this fiscal year, you can expect the following: Look for strong momentum and accelerated growth in our medical products, Pharmaceutical Technologies and automation areas. These three areas, coupled with our provider services, produce over 60% of operating earnings, but substantially more of the earnings growth for 2004 this year. Look for a transition to a new business model in drug distribution with continuing pressure on vendor margin, but improved performance in the back half of '04. Most importantly, look for a shift to an activity-based fee for service model over the long term. While Pharmaceutical Distribution accounts for about 40% of the total corporate operating earnings for this year, it will deliver only a small portion of the earnings growth for the full year. But in 2005, it will be back as an important contributor to Cardinal's total earnings growth. Look for strong cashflow and deployment activities to increase, and finally, look for the accelerated performance in our second half, including the benefits of capital deployment to produce the mid teens or better EPS growth we committed to you back in August. Now, I'd like to turn the call over to Dick Miller.

Thanks, Bob. Good morning, once again, Cardinal Health's first quarter, 2004 financial results demonstrated the strength and diversity of our complementary health care businesses. This was a solid performance, in line and consistent with our expectations for a slower first half this fiscal year. Strong, above market revenue growth in three of our segments coupled with our continued focus on productivity, yielded double-digit operating earnings growth during the quarter. Additionally, our ability to leverage the capital requirements of our businesses drove record levels of cashflow, and improvement in return on investor capitals. We invested $1 billion of our available cash into repurchasing common shares during the quarter. The combination of shares repurchased and cash balance of close to $1 billion. And a net debt-to-capital ratio of only 20 percent at the end of the quarter, we have a lot of capital flexibility as we look to the future. Today I'll briefly comment on the consolidated financial performance for the quarter, and then spend some time sharing my perspective on just a few key highlights in each of the business segments.

Let's look at our consolidated financial performance first. Revenue growth at 16%, resulted in operating earnings growth of 10%. Our revenue growth equals or exceeds the market growth rate in each of our segments, indicating the strong demand for our portfolio of products and services. However, the slower growth rate of our operating earnings, indicative of a lower return on sales is uncharacteristic of Cardinal Health's typical financial model. There's really only one item driving this anomaly. The changing profitability equation and drug distribution as Bob explained. With our largest segment growing revenues at 16% and operating earnings at 2%, the end result is a deleveraging impact on the entire corporation. This is a short-term trend that we anticipate. We have stated previously, it will be more printouts in the first half of the year, and then right itself as we move through the second half. Focused execution and asset management yielded an improvement on our capital which resulted in record cashflow. Our return on investor capital improved to 7.21% this year, versus 7.08% last year. Now, let me remind you that this is an after-tax metric that takes into account all of the investment capital in Cardinal health, including nearly $10 billion of unrecorded good will from past acquisitions which were accounted for as pooling transactions. This first-quarter performance has us right on track to achieve our return-on-invested-capital goal of exceeding our weighted-average cost of capital for the year. We generated $294 million of operating cashflow during the first quarter versus utilizing $14 million of cash in the prior year period. A similar improvement was achieved in free cashflow, which improved nearly $300 million to $205 million this year, versus a use of $80 million last year.

Earnings growth reduced investment in owned inventories and continued receivables management were the primary drivers of this performance. Our discipline around credit collection procedures resulted in reduction of day sales and accounts receivables to 18 days versus 19 days last year. And our delinquencies are at record-low levels. Based on our cashflow performance to date. We remain confident in our ability to achieve our cashflow goals of generating operating cashflow of approximately $1.3 billion. And free cashflow of approximately $900 million for the fiscal year. One important fact is that our strong cashflow is after fully funding additional investment in our current businesses. During the quarter we invested $78 million in additional fixed asset infrastructure, which is primarily related to expanding our sterile capacity and investing in technology to drive up productivity. Additionally, we continue to invest in spending. Our investment spending represents the charge that we take against income for R&D and other strategic projects that will provide future growth. This investment spending amounted to over $26 million for the quarter. Let me comment on just a few key take aways in our various operating segments, beginning with the Pharmaceutical Distribution and Provider Services segment. Excellent revenue growth of 16% was driven by strong growth across all customer classes. Particular strength was experienced with alternate sites and independent customers. Incremental revenue from new customers added in fiscal 2003 continued to gain traction and had a positive impact during the quarter. As we expected, declines in pharmaceutical vendor margins and customer selling margins negatively impacted the drug business during the quarter. That productivity leverage achieved a first quarter record of $2.56 of gross margin for every operating expense dollar. Overall, the segment return on sales declined 36 basis points during the quarter, at the expense leverage was unable to overcome the margin pressure. As we’ve previously stated, we expect the level of vendor margin pressure to continue through the second quarter of fiscal 2004. Once we move into the second half of our fiscal year, performance will improve as we face comparisons with quarters that reflect the beginning of the impact of the change that's occurring in the drug distribution industry. Why don’t we move to medical products and services, which had a strong quarter. With revenues increasing 9%, and operating earnings growth of 8%. Growth in distribution services remain strong, which continues to be a key operational strategy, allowing us the opportunity to enhance our long-term performance, with additional skills of our more profitable, self-manufactured product lines. New proprietary products continue to gain traction in the marketplace, and were a strong contributor to growth in the quarter. This segment was not able to achieve its normal expense leverage due to a mismatch in the timing of certain expense items in the comparative period. This caused the return on sales to be flat versus the prior year. For the remainder of the fiscal year, revenue growth will continue to be strong. And I would expect to see this segment return to the trend of raising its returns on sales. [INAUDIBLE] Pharmaceutical Technologies and Services, it bears repeating that the financial results include the year-over-year impact of the acquisition of (ph) International, which was acquired on January 1, 2003. Excluding the impact of the Syncor acquisition, the segment delivered an outstanding financial performance during the quarter, with operating earnings growth in the high teens. The integration of the nuclear pharmacy business has been completed, and it is achieving all of its performance objectives. [INAUDIBLE] Investments have been made to expand our sterile manufacturing capacity in this segment, which are expected to be online and positively contributing to the financial results of our segment, beginning in our second quarter. One important point about this expansion is that the additional capacity has already been allocated to specific new manufacturing contracts that will begin immediately upon receipt of the required regulatory inspection approval.

Now, last but not least, let me talk about automation information services. While installation and the resulting recording of revenue were affected by several external events in the quarter as Bob explained. The backlog of committed contracts remains robust at $208 million. We expect revenue growth to pick up dramatically in the second quarter and continue to expect mid to high teens revenue growth for the year. Our continued focus on operational improvement drove strong productivity gains, resulting in a first quarter record of$ 2.24 of gross margin for every operating expense dollar. This year with a return on sales of [INAUDIBLE] was 266 basis points. A key contributor to the productivity gain was the improvements that have been made in managing the [INAUDIBLE]portfolio. Improvements in customer credit, billing and collection processes have yielded significant reductions in customer receivables write-offs and delinquencies. All that allows us to adjust our reserve levels as we began the new fiscal year. We expect the core automation business to continue to perform at its historical high level which, in and of itself is a very positive factor. We're also extremely excited about the momentum that Pyxis[INAUDIBLE] is building in the marketplace and the financial implications of that offering. This unique patient/bedside offering is being marketed in a new way. Unlike our core automated offerings, 98% of which is sold to our customers under sales-type lease facilities that require immediate revenue recognition under generally accepted accounting principles. A much more flexible arrangement is appropriate for the Pyxis patient station product. Now, let me explain that. This is the first automation product that will have two revenue streams, one from our health care provider customer and one from the patient user. Our contracts are structured with a fixed component which we call guaranteed placement fees. As Bob mentioned, those are structured similar to our leases on our other Pyxis equipment. But also, a variable component which we call net usage fees. Guaranteed placement fees are generally structured to approximate the installed equipment cost, thus mitigating any risk of cost recovery. Net usage fees will be earned whenever the equipment is utilized and we expect these to be at least equal to the guaranteed placement fees over the [INAUDIBLE] Due to the variable nature of those net usage fees, they will be recognized as income in the period earned, similar to an operating lease. However, this income stream should compound over time as additional units are installed and utilization increases. We expect gross margins to increase overtime, to reach about the same level as the rest of the Pyxis automation project line. Due to the different nature of this product and its revenue stream we have not included anything in the backlog of committed contracts for PatientStation deals. This is the upside to our reported backlog. However, as Bob mentioned, we are in the process of installing over 5,000 units across 10 different accounts, which have guaranteed placement fees in excess of $20 million.

With regard to the financial impact, I expect it to be insignificant for fiscal 2004 as sales and installations ramp up during the year. However, I would expect PatientStation to begin having a meaningful financial impact in fiscal 2005. Obviously, we're very excited about the prospects for this new, unique product offering. Over time, this will add a consistent growing revenue stream that will be added to the already strong growth outlook for this segment.

Let me just conclude my comments by providing a little bit of color on our special items for the quarter. We incurred approximately $9 million in merger charges, primarily related to the continued integration of Syncor. In addition, we recorded approximately $5 million of net other special charges during the quarter, related primarily to the continued execution of restructuring and rationalization plans in two of our segments. [INAUDIBLE] and Medical Product and Services. These charges were partially offset by $2.7 million of additional recoveries from our vitamin litigation settlement. Thank you for your attention. I'd now like to ask the operator to open up lines for questions.

At this time I would like to remind everyone in order to ask a question, please press star then the number 1 on your telephone keypad. Your first question comes from Robert Willloughby of Bank of America.

Thank you. Dick maybe just a question, under the new distribution model, where can inventory day's actually go? They were 54 on a trailing 12-month trailing basis this quarter. About 43 days about 4 years ago. Can we get down to that lower level again?

It's difficult to tell at this point exactly how low it can go. Certainly, we'll work with the manufacturer, customers to, you know, it drive it as low as possible. Obviously, we're looking to make the supply channel positions as we can, but certainly we can get down to the lows we've seen historically.

I'd just say, you know, the model's really not changed, essentially, we put capital out in inventory, we expect a return. But as we work the model, Jim, I think you're talking about bringing 15 days out of inventory. Is that 10 to 15 days somewhere in that range?

It depends how it works out by vendor, but it will be a significant drop.

Other questions?

Your next question comes from Ray Falci of Bear Stearns.

Yes, good morning. Bob, when you talk about the two main roles or focus points of the drug manufacturers from the wholesale standpoint, channel transparency and product integrity, I was wondering on the second one which has become obviously more of a focal point in recent past, what you’re hearing out of all the relevant parties in terms of the role yourselves could play in terms of product integrity, and what profit implications it could mean for you both, sort of near term and long term.

I'll let Jim Millar address that.

I missed that, did you inquire specifically about the transparency or --

No, really more the second one, as we may go to more bar coding or whatever other things to verify product integrity. I imagine it could create a greater role for you guys, and I guess I'm focused on how that could role out, how you might get paid for it, and what the economic impact could be to you.

Obviously, what's important to us is equally important to the manufacturer as well as the provider and absolutely to the patient community. Is the product -- protection product securities -- you know, the whole pharmaceutical supply chain and how we're going to manage that. I think as Bob alluded to in his comments, that we have enacted some pretty restrictive steps in terms of how we operate in the alternate source vendor arena. I would also believe the manufacturers are working hard to narrow that type of trade. It seems to be the easiest point of access for counterfeit product. Obviously, we profit, on the, you know, [INAUDIBLE] on arbitrage play in the alternate-source vending, both as a buyer and a seller, that was our trading company, and so those are important pieces in the logistics side of the equation. As it relates to the product itself, how you identify a counterfeit product from a non-counterfeit product. Bar coding is one way to do that, but that is easily replicatable and can be counterfeited as well. There are other [INAUDIBLE] like RFID, electronic product codes that actually, the product has a micro chip in it, and it's put into the product by the manufacturer, and there’s a way of identifying and reading product in and reading information out of that. So those initiatives are under way and a number of the large pharma manufacturers are engaged in that. In that initiative as we are as well. So there's a number of ways we're working together, but as we trade off one piece our business equation to the benefit of other, we're going to work through the economic models.

I just want to wrap up with a couple quick things. One, I said a more restricted access on products. will eliminate vendors that play no significant role in the real logistics in the business, so there’ll be better efficiencies, but they were taking profits out of it. Those profits had to go from somewhere, and it was essentially margin that was being taken out of the system, so that will be eliminated. It will help assure more security in the system. That's good for the manufacturers, you've seen they've had to pay for recalls and things, they should be happy about this process, less vendors, more concentrated in a fewer number of vendors, and that overall thing is good for us, and we would expect to be paid for it. Next question?

Your next question comes from Larry Marsh of Lehman Brothers.

Thanks. Bob, just elaborating on your comments with Merck, clearly you've had discussions here for a period of months, and as you said, you've been talking about an evolving business model. It speaks to the sophistication of the supplier, you know, you already have your largest supplier that says that they match their inventories with, you know with scrip growth and it seems like a lot of other suppliers are not going to be as sophisticated to be able to administer some of these fee for service kinds of contracts. How do you think about that, and is it an educational process for you to go back to more of your suppliers, or is it going to be a mixed bag in terms of which suppliers want to do what?

A quick summary statement. One is that there is some educational aspect here. It's great; it’s forcing us to look at, costs related, actually down to the products, as I said in my talk. You do have some suppliers that are more sophisticated than the others. It's a good educational process all along the channel. We'll squeeze efficiencies out of this, we got a great secure distribution channel. The profit equation will work out for us, the reason I was excited about [INAUDIBLE] -- a couple elements. It's activity based, performance based, recognized us as a partnership. Let me shift over to Jim, and let him just kind of give you more of a general comment on this whole vendor relationship thing.

Larry, you bring up a good point here. There is to be an education process, I think the manufacturer is striving to kind of wring out the inefficiencies that operate [INAUDIBLE], and obviously, when we're bringing inventories in and doing it for purposes of profiting on inflation. It gives an erratic demand to them and product flows, and it just doesn't align to, actually, the consumption of the product. So obviously manufacturers want that to go away, and we want to help them in the process. Right now they are using, IMS projected data and that's not very accurate. We would like to work much more specifically with them. Work with them with their products. Understand what their needs are, and at the same time, educate them as to what the distributive services we provide are, because oftentimes it's just presumed that, you know, all products, probably economically run through the system equally. Which isn't the case, certain products have a different type of activity requirement to them. Such as if it's a frozen product or a controlled substance, or a cytotoxic product or something like that, we must handle that product in a unique way. And the distribution is expensive. And we need to look at our relationship with the manufacturer, in terms of, what is the economics around every product we sell not about a certain number of products we sell. I believe this is right up our alley, because we're pretty financially astute as an organization, and we're auguring in on these so we can craft a new partnership that is focused around these activities and what it actually costs to distribute because, as Merck said, they're willing to work with us, they want to pay us a fair fee for our services, and they have no intention of cutting our profitability at all. It's a matter of working together. And as a result, I wouldn't be surprised if all of our, all of us in the industry aren't working with the same type of initiative.

Next question.

Your next question comes from Tom Gallucci of Merrill Lynch.

Good morning, thank you. Two questions, one in terms of your discussion around drug integrity and changes in alternate source vendor arena. You had talked about 5 or $600 million in trading revenues this year. Should we be expecting even lower potentially given some of the changes you're talking about there? And then the other questions is, as you describe the transition in the business model it would seem to me that the sell side discipline and stabilization is the key to the whole equation in the long run, it's been a couple of months since your August announcement. What are the discussions like with customers since then on that topic? Thank you.

Let me deal with the first one, with regard to trading. Yes, trade volume will be down dramatically, even less than what we said before. I said we were going to be a leader in moving to doing business to providing, we're going to be a leader in acquiring product directly from the manufacturer of that product, and there's a -- and that is a benefit to the manufacturer, it will squeeze some inefficiencies out, and also protect the integrity of the product. Because they certainly trust us, and they know how we – that we handle the product accurately. The second thing with regard to sell side, we're not going to talk about any particular discussions, the sell side, these are transitions in buy side margins that, the transition of buy side margins, vendor margin, and how costs develop will certainly affect the model in which we develop pricing for the customer in the future. So you know, while there's a transition here, and while there’s a transition in vendor margins, there's certainly a transition in how we price and relate to our customers. We certainly have historically created more value for the customer every year, and we would expect to continue to create more value next year for our provider customers. Jim, did you want to add anything to that?

Just two quick comments on it. You know, our customer relationships are long-term contracts that we enter into, over the course of the past decade, there's been a fair amount of consolidation in this industry, as the industry has finally rolled up to about three major players, as we gained efficiencies with these consolidations, these mergers and stripping out the overhead, [INAUDIBLE] pricing to the customer as we pass those efficiencies on. You add to that some of the past practices by the manufacturers that allowed -- I won’t say excess –- but additional vendor margins to flow into the equation allowed us to put pricing to the customer that was a little more robust than might have been historical over a ten-year picture. Now, with the consolidation complete. It's been two years since I believe [INAUDIBLE] and so those consolidation efficiencies are not a lot there to pass on as a result. And the changes in the, with the announcements by several of the manufacturers in terms of the way they put deals in the system. That led to profitability on the vendor margin side has sort of gone away. Now we have to look at our pricing as it relates to the new vendor margin model. And we have to look at it in terms of our ability to gain efficiencies, and so what it probably portends is an environment where the decline or the increase in the amount of discounting is probably going to have to flatten out as the business model catches up with the customer pricing.

Next question?

Your next question comes from Michael Fitzgibbons of Morgan Stanley.

Good morning, in your margin expectations in the distribution segment, you have EBIT reduction of about 35 basis points this quarter. When you're saying that you're looking for improvement in the second half, are you talking about reducing the reduction in EBITDA margins or when you think about a [INAUDIBLE] are you saying EBIT margins go back to a point where they're actually increasing year over year?

Dick, why don't you comment on that.

Yeah, I think the way we see it, in the second half, we'll begin to counteract some of the impact of this. And we see the second half, you know being better than the first half, but I don't think in the second half half we’ll be back to the trend of return on sales increasing in that segment. (Audio difficulties)

Another question?

Your next question comes from Christopher McFadden of Goldman Sachs.

Thank you. And good morning. Could I ask you, Bob, to talk a little bit about trends in the PTS business. We saw a fairly sort of sharp decline quarter over quarter in that business, albeit off of peak revenue number in the June quarter and what we're thinking about in terms of revenue trends in that business. And then if I can get you to build on that, and just talk a little bit about the operating growth characteristics of the MedSurg business throughout the year. Are we still seeing some contribution from some of the centralization activities that you talked about in the 10K, and are you seeing any impact as is being discussed by some of the publicly traded hospitals in terms of bad debt and other sort of collections activities impacting your collections in that particular segment? Thanks.

Well, I'm going to ask Dick to chime in, because I'm a little bit confused on the first question. The trends in PTS are really positive. I don't know if there's a little bit of mismatch and acquisition came in or whatever, but I tried to – on Syncor we tried to give you guidance, of what our internal growth rate, we said, our internal growth rate in PTS, was in the high teens for the quarter, and operating earnings growth rate internally was above that. So good trends, and we also said that that was in spite of the fact that, you know, frankly some of our most highly profitable areas we got delays on bringing on additional capacity [INAUDIBLE]. So you know, you'll see a really strong second half, strong second half, strong second quarter, second half, et cetera, in PTS, things are going well in nuclear pharmacy business. Anyway, Dick can chime in with regard to MPS or the medical products area. Dick commented there's a little mismatch on expenses, but that company -- I mean, that segment of our business, we said will achieve the highest revenue growth rate for the year. We expect the highest revenue growth rate for the year that we've experienced since the company joined us, Cardinal. That's the first point.

Second, they have a history of being able to grow their distribution business, follow it up by growing their – pull through their self-manufacturing, they have new products online, they're getting more efficient in manufacturing, and all of that says -- and then their strict adherence to cost containment In the SG&A area says we expect that they're going to grow their bottom line faster than their top line. The summary for them is no change in the formulas that they've been demonstrating to us in the formulas, but the faster top line than what we've experienced in the past. Dick, any comments?

No, I think that's consistent -- [ INAUDIBLE]

One last question.

Your next question comes from Glen Santangelo of Sound View Technology.

Thanks. Bob, just a quick question. I want to talk a little bit about the organic revenue trends in the drug distribution business. It seems, if you look at some of the underlying data, things are getting a little bit better there lately. If you could just sort of comment on have we seen a change and if we have, what may be contributing to that inflexion point?

Jim, is there -- are you seeing a change?

Yeah.

You mean like an industry-wide change or with regard to Cardinal itself. Are you asking for an industry-wide assessment of pharmaceutical consumption or are you talking about Cardinal's internal growth?

Yeah, actually, there's been a little bit of freshening, I think it was probably most evident in the same store comps for the chains here in September. They started to see a pickup. Summer usually has its own slowing months in July and August, because of vacations, but certainly, the numbers are stronger today than they were say at the, upon entering the year, we were all concerned around January and February that in fact growth didn't seem to match up and scrip volumes were a little confusing, we see that momentum picking on not only our distribution business, but we also see that picking up in our medicine shop business because of the – obviously, we’ve got 1,000 stores here that we're looking at the activity in the retail world. So I would say maybe the momentums are getting a little bit better. One of the things that we're kind of getting away from too is, we suffered in the early part of the year, with the products that go -- they went from brand straight through to over the counter, and that really changed the -- it didn't really change it took a couple of percent of growth out of it, out of the market because the Claritins are not longer showing up as a pharmaceutical, but as an OTC and some of that activity. I think early on the impact of the -- I'm referring to earlier this year -- the impact of the three-tier co-pays as it related to the antihistamine products and such became an issue, and I think that we’re probably seeing better things. I hear that the pipelines are good for products that are coming to market, and the interesting thing also is, there has been a little bit of a slowing in terms of the generic launches, just kind of a --. I'm not going to say it's over, but we've kind of been in a lull since about last, the end of spring coming forward, and generic obviously is [INAUDIBLE] to generic. It has a dampening effect in terms of the revenue models. I think it's a combination of all the things that may be affecting the overall margin in very recent past by a couple of percents but now they have come around [INAUDIBLE]. So hopefully we're looking at a very robust market probably in the 10 1/2, 11 1/2, to 13 range.

Thanks for the comments.

Let me wrap-up quickly. One brief comment. The Merck announcement by itself has no impact on -- real impact on our short-term guidance, but it has a -- it's an interesting recognition of what we've been talking about, and I think an affirmation of the value of drug wholesaling and the attitude of a well-respected major manufacturer and their attitude and recognition of us as a partner, and the value we deliver. We've reaffirmed our long-term guidance of mid-teens or better, 60% of operating earnings are in areas with great upside momentum. Short-term, long-term, and great visibility. But 40% is the Pharmaceutical Distribution business which has a little less short term visibility but it has even greater long-term growth and stability. So, you know, I want to be aggressive about, I want to be aggressive about predicting the long-term economic position of Pharmaceutical Distribution as very positive. We'll work through this timing and change in the business model over the short-term. Cardinal's in a good position, good cash position, good cashflow, and great offerings for our customers. I look forward to our second quarter call in January. Thank you.

Thank you for participating in Cardinal Health's first quarter 2004 earnings conference call. You may now disconnect.