卡地納健康 (CAH) 2004 Q2 法說會逐字稿

The Cardinal Health earnings conference call will begin momentarily.

Ladies and gentlemen, this is the operator.

Today's conference is scheduled to begin momentarily.

Until that time, your lines will be again be placed on music hold.

Thank you for your patience.

Good morning, ladies and gentlemen.

My name is Paul and I will be your conference facilitator today.

At this time, I would like to welcome everyone to Cardinal Health's second-quarter fiscal year 2004 earnings 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 key pad.

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

Thank you.

I would now like to turn the conference over to Mr. Steve Fischbach, Vice President of Investor Relations.

Please go ahead, sir.

Thank you.

Good morning, and welcome.

Today we will discuss Cardinal Health's fiscal 2004 second quarter.

A portion of our remarks will be focused on the business segment attachment of our earnings release.

If you don't have a copy of that you may access it over the Internet on our investor page at Cardinal.com.

Speaking on our 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, as we get the questions we ask that you limit yourself to one 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 Cardinal's Form 10-K and Form 10-Q reports 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 Cardinal.com.

At this time, I will turn the call over to Dick for discussion of his comments on the quarter.

Dick?

Thanks, Steve.

Good morning.

As expected, Cardinal Health's second quarter 2004 financial performance was a clear demonstration of the composite value of the diversity of our complimentary health care businesses.

Strong revenue growth across all of our product and service offerings yielded record second-quarter earnings for the company.

We continue to focus on leveraging the capital requirements of our businesses, delivering strong levels of cash flow and returns on invested capital and equity.

It was a very solid performance, given the challenge that we faced in our drug distribution business this quarter.

The good news is that this quarter should mark the low point for the drug distribution business, which has been caused by the convergence of a strong quarter a year ago, with the inflection point in our transition to the new fee-for-service business model with our vendors.

Allow me to begin with our consolidated financial performance for the quarter.

Revenue growth of 11% resulted in operating earnings growth of 6%.

Let me acknowledge right now that this not is the financial formula that we strive to achieve, nor is it what have you come to expect from Cardinal.

Let me also assure that you that I firmly believe it is a short-term anomaly.

With our largest segment growing revenues at 9%, while experiencing an 8% decline in operating earnings, the end result is a deleveraging impact on the entire corporation.

The reason we are so confident that this trend will not continue is because the drug distribution business model transition is progressing quite well, as Bob will discuss in more detail.

Additionally, as we look to the second half of the fiscal year, comparisons for the pharmaceutical distribution and provider services segment become less challenging as we pass particularly strong performance that occurred during the first half of fiscal 2003, which really marked the beginning of the end of the robust vendor margins available under the old buy-and-hold business models.

Our focus on capital productivity continues to drive reductions in interest costs, providing significant earnings leverage.

Our category interest expense and other actually declined 38% this quarter, as a result of two factors.

Strong cash flow combined with generally lower interest rates to drive our interest costs down.

And then we also had a gain of $9 million from the sale of a nonstrategic business.

Our balance sheet is well positioned for continuation of this leverage as our net debt to total capital remains low at just 22%.

The combination of strong earnings and capital efficiency continues to generate significant operating cash flow.

We generated $254 million during the second quarter, bringing us to a total of $548 million in operating cash flow for the first six months of the fiscal year.

That's up significantly from $359 million in the first half last year.

As part of our ongoing program to redeploy low-return capital, we did sell another $165 million of Pyxis leases this quarter.

That's consistent with the $200 million we sold in the same period a year ago.

Similar improvement was achieved in free cash flow, which improved $158 million in the second quarter, to equal $363 million of free cash flow generated year to date.

Net earnings of $378 million was a key contributor to our cash flow performance in the quarter, but equally important was our working capital management.

In a quarter when our net earnings grew 12% sequentially, our receivables only grew 9% and our inventories only grew 3%.

When we compare against a year ago, our owned inventories have actually declined slightly, due primarily to the changing business model and drug distribution.

Based on this cash flow performance through the first six months, we remain confident in our ability to achieve our cash flow goals of generating operating cash flow of approximately $1.3 billion and free cash flow of approximately $900 million for the fiscal year.

Our returns on invested capital and equity remained stable during this transition period.

With our operating earnings growth at 6%, our ability to continue leveraging returns was limited in the current quarter.

As earnings growth improved in the second half of the fiscal year, you should expect us to return to our customary trend of rising returns on capital.

For the quarter, return on invested capital was down slightly, at 7.90% versus 7.96% a year ago.

Our average invested capital, which I would remind you includes nearly $10 billion of unrecorded goodwill, that invested capital grew 8%, reflecting additional investments in working capital, fixed assets and acquisitions, which were primarily Syncor and Intercare.

With the earnings improvement in the second half, I expect our return on invested capital for the full fiscal year to be at least 8.5%.

Return on equity was 20.5%, versus 21.5% a year ago.

In line with our guidance, I expect return on equity for the full year to exceed 20%.

Now let me comment on just a few key takeaways on our various operating segments, beginning with pharmaceutical distribution and provider services.

Excellent revenue growth was driven by strong growth across all customer classes.

In addition, incremental revenue from new businesses added during fiscal 2003 contributed to our growth.

As a result, our Direct Store Door sales increased over 23% during the quarter.

As we fully explained in our December investor newsletter with regard to operating revenues, the strong growth in Direct Store Door sales is being partially offset by a reduction in the amount of bulk from stock sales.

Those declined 57%.

Under our new just-in-time business model, there is no incentive to buy and hold bulk products.

So those transactions have moved to the category bulk deliveries to customer warehouses, which are not included in our operating revenues.

That category increased 66%.

Perhaps the best barometer of the downstream customer demand is to aggregate all of these sales which yields a year-over-year increase that exceeds 15%.

As expected, declines in pharmaceutical vendor margins, versus a strong quarter a year ago, and reduced customer selling margins, negatively impacted the drug business during the quarter.

Margin declines were partially offset by strong expense productivity leverage.

However, the overall segment return on sales declined 44 basis points during the quarter, as the expense leverage was unable to overcome the margin pressure.

Now, let me move to medical products and services, which had an outstanding quarter with revenues increasing 12% and operating earnings growth of 12%.

Our growth and distribution services remained strong, which bodes well for future profit improvement, as we seek to optimize the opportunity to further penetrate new customer accounts with our more profitable self-manufactured products offering.

While new proprietary products continue to gain traction in the marketplace, and were a strong contributor to this quarter's growth, the mix of business between distribution services and manufacturing revenues negatively impacted overall operating margin.

In addition, we experienced some increases in raw material costs, particularly for latex and resins, during the quarter.

Continued strong expense productivity and manufacturing efficiencies largely offset the effects of these items during the quarter, yielding a a flat return on sales.

In pharmaceutical technologies and services, you continue to see the impact of the acquisition of Syncor International Corp., which was acquired on January 1, 2003, and accounted for as a purchase.

There was strong demand across our full line of complimentary products and service offerings within this segment, with particular strength seen in nuclear pharmacy services, which I'm pleased to report is achieving all of its performance objectives.

We achieved double-digit organic earnings growth, despite the dampening effect of a delay in the startup of commercial manufacturing of key sterile products.

The manufacturing of those products is now anticipated to begin sometime during our third fiscal quarter.

Automation information services performed well during the quarter, in line with our expectations.

This was the second largest quarter in the history of automation, resulting in 14% revenue growth year-over-year.

Additionally, the segment achieved 31% revenue growth sequentially from the first quarter of fiscal 2004.

Customer demand remains strong across our entire line of market-leading automation products.

Our backlog of committed contracts, representing equipment to be installed in future periods, ended the quarter at $207 million.

Our continued focus on operational improvements drove strong productivity gains, delivering a return on sales expansion of 37 basis points during the quarter.

Let me conclude my comments by providing some additional details on our special items for the quarter.

We incurred approximately $8 million of merger charges, primarily related to the continuing integration of Syncor.

In addition, we recorded approximately $11 million of net other special income during the quarter.

This amount is made up of two items.

First, approximately $24 million of special income related to the receipt of our portion of a settlement in a class-action lawsuit arising from antitrust matters brought against certain pharmaceutical manufacturers relative to activities impacting the launch of certain generic products.

This income was offset by approximately $13 million of charges related to the ongoing restructuring and rationalization projects that are being executed in our pharmaceutical technologies and medical products segments.

I would like to thank you for your attention, and now I would like to turn the call over to Bob for his comments.

Cardinal Health's second quarter performance was strong, in line with our expectations, but below our historic growth rates and below what our management team expects we will move to in fiscal 2005.

This fiscal year, we are on track to meet our full-year earnings and cash flow goals.

As you know, over the past 10 years, we have built a broad offering of health care, creating significant value for our customers and for shareholders.

Our second quarter performance clearly demonstrates the power of this breadth.

Essentially, the quarter has two stories.

The first story is about the success of our medical products, pharmaceutical technology and automation businesses, which represents about two-thirds of our earnings.

Those businesses all had strong quarters in line with our expectations.

Good top-line growth, excellent productivity and strong returns on sales and capital.

The second story is about the transition of our drug distribution business.

While drug distribution delivered strong earnings, with industry-leading return on sales and capital, earnings declined versus the prior year.

Drug distribution is a very secure long-term position in the marketplace but, as you know, this industry is in transition and is moving from a buy-and-hold industry model to a more efficient just-in-time inventory model.

That transition created some mismatches in vendor margin in the quarter, which drove negative earnings growth for this business.

In the last several months, we have a made a tremendous amount of progress in accelerating the transition occurring in drug distribution.

In fact , since our last earnings call we have reached a number of important agreements with pharmaceutical manufacturers that demonstrates the move to a new type of pricing margin relationship with our manufacturer partners.

We still have work to do in pharmaceutical distribution, but we are clearly moving in the right direction, and position it for renewed earnings growth.

That's the overview.

Now, let me first give you more details by starting with the three segments that represent 60% of our earnings and drove all of our earnings growth for this quarter.

Medical products and services shows very strong top-line growth, particularly in distribution, and turned the growth into solid operating earnings growth.

This business has an offering that is attractive in its own right, but like each of our segments, medical products and services is benefiting from an integrated selling approach.

Through the integration of the medical products and services and automation, for example, we can show real labor savings for hospitals, driving meaningful business wins in each segment.

Each customer group, from acute and ambulatory care to laboratory, surgery centers and physician offices, experienced double-digit sales growth this quarter.

Contract wins have fueled distribution growth, but the full benefit is still ahead of us as we convert our distribution volume to a more favorable mix of self-manufactured product sales over the next several quarters.

This transition will have a meaningful impact on the bottom line.

Additionally, we're introducing new and unique products with attractive margins.

These products have been well received.

Our commitment to investment in R&D will continue to drive even more innovation.

We expect top line momentum in the second half to continue at least as strong as this past quarter, bolstered by the implementation of the broad lane and health trust agreements.

The growth will show an improving mix of self- manufactured products as we move customers to a higher mix of our proprietary products.

Needless to say, I'm happy with our performance in this business.

We did not leverage this business from the top to the bottom line as much as we would have liked to in the quarter, primarily due to higher distribution sales mix, and unusually high costs in raw materials, resin in particular.

I'm not concerned about our ability to drive strong earnings leverage in this business in the future.

The bottom line for MPS: a good quarter, strong gross-margin management, good expense productivity.

This is a business with terrific momentum and one that will receive more investment dollars as we go forward.

Pharmaceutical technologies and services delivered another solid quarter, with earnings up 33%.

Growth from our core oral manufacturing and package businesses drove double-digit organic earnings growth.

The nuclear pharmacy business continued to solid performance, as Dick mentioned.

The results were achieved despite the absorption of costs resulting from the delayed opening of new sterile manufacturing capacity.

This capacity is spoken for with contracts in place for products in high demand, already approved by the FDA and in the marketplace.

We have been investing in the expansion of our sterile capacity for some time, and are enthusiastic about the results we expect it to deliver.

We anticipate this new capacity to come on line this quarter, and provide significant earnings leverage as we move into the second half of the year.

Nuclear pharmacy services has continued to perform exceptionally well.

This is a business that provides compounding and delivery of complex pharmaceuticals, close to the site of care, for the 170 pharmacies nationwide.

We are the clear market leader.

The core business is strong, but this business also represents an opportunity to expand our infrastructure and introduce new services for our customers.

We have the capability to deliver complex pharmaceuticals within two hours from our pharmacies to the point of care.

There are a number of applications of this infrastructure to unique pharmaceuticals.

In fact, one service that we've already introduced provides unique logistical programs for hospitals to order blood products from the nuclear pharmacy that is normally shipped from our specialty distribution facility in Nashville.

This helps customers dramatically reduce investments and inventory losses, and improve the delivery of care to patients.

PTS in summary: good organic growth, growth, successful integration of Syncor, acceleration in demand for sterile technologies and a continued target area for investment going forward.

Now, let me discuss automation information services.

Strong sales in MedStation and SupplyStation, produced top line growth of 14%.

That's the second highest revenue quarter in our history, and it delivered performance that was in line with our internal expectations.

Our gross margin management was strong, and we were able to generate meaningful productivity improvement.

Return on sales and capital were up in the quarter, delivery good cash flow.

So this quarter, the formula worked from top to bottom in this business.

SupplyStation sales increased and were strong.

Growth in our total backlog was below our internal expectations.

This was an execution issue, primarily in one area of the country.

We have already moved aggressively in that region to ensure we execute in the future.

I expect our product mix to change over the next several quarters as we move closer to automation at the bedside.

Last quarter, we began the installation of over 5,000 patient stations, clinical inpatient entertainment units, in several large customer sites.

These installations are going well and the financial model of patient stations, which is more than annuity versus a one-time sale, should benefit the long-term income stream for the segment.

Looking ahead, our enthusiasm for continued demand for MedStation and SupplyStation, and industry focus on patient safety and strong growth from the patient station line, will drive long-term sustained growth in the segment.

Let me now turn to pharmaceutical distribution and provider services, a segment that has two distinct businesses, pharmaceutical distribution and a large provider service business that includes pharmacy franchising and clinical services and consulting to hospitals.

The clinical services and consulting business is scoring big wins and is one of the important integrated services that is propelling broad-based contract wins.

In pharmaceutical distribution, growth in direct store delivery volume, our basic business of shipping individual units directly to site of care, were very strong, growing at 23%.

As expected, overall operating revenue growth reflects a significant decrease in lower- margin revenue from bulk and wholesale trading sales.

Earnings growth from this business was limited as Cardinal continued to move through the transition from the buy-and-hold inventory model to a just-in-time model.

Last year, vendor margins were exceptionally strong.

The new just-in-time fee-for-service model will be more efficient for manufacturers and for Cardinal, and it will provide us higher returns in the future.

We've talked about the transition of this business for several quarters now, and I expect the transition to be with us for the entire fiscal year.

I believe we've turned the corner in pharmaceutical distribution business, and we've seen strong evidence this quarter to support that conclusion.

I'm not short-term oriented about pharmaceutical distribution.

It has long-term, strong top-line growth prospects, in a demonstrated service that is not replaceable by manufacturers or providers.

This is a business that will achieve outstanding financial results over the long term.

There are only three companies in the industry with the scale and geographic reach to service the entire marketplace.

I am confident in our opportunity to earn margins consistent with our critical role in the supply chain and consistent with the unique value that we bring to our customers.

Cardinal has a particular advantage over the other two national pharmaceutical distributors because of the breadth of the services that we offer.

The combination of our service offerings delivers unique value to the customers.

We made tremendous progress in the transition to a new inventory and service distribution model.

For some time, we have been studying the specific profitability of every manufacturer and each product from that manufacturer.

That analysis has revealed a lot about how we need to change the pricing of our services to manufacturers.

Frankly, some of the manufacturers will pay less than they've paid in the past to move product through our logistics system.

Other manufacturers will need to pay more, consistent with the characteristics of their products.

I've had some experience in food retailing, where the concept of a loss leader was a common appeal to attract the consumer.

There is no reason for us to distribute any product as a loss leader in pharmaceutical distribution.

All manufacturers need to pay a fair share to enjoy the benefits of the scale of our distribution network.

On balance, our objective is to achieve vendor margins, adjusted for carrying less inventory, that are equal to the vendor margins we achieved in prior years.

Today, we are in active negotiations with 47 manufacturers that represent the majority of the volume that moved through our channel.

A number of agreements have been reached in the past three months.

These agreements are largely fee-based arrangements that are good for both parties.

Less dependent on inflation.

Less inventory in the channel.

More predictable demand and inventory planning, and more consistent margins.

An excellent example of this is our recently-signed distribution service agreement with Merck.

We appreciate their leadership and recognize in the value of our distribution network, and the speed with which they move to a new model.

A number of other agreements with vendors that fit the new model represent some real momentum in moving through this transition.

While I expect the transition to be with us until the fall of this year, we will have more favorable comparisons as we move into fiscal 2005, so our operating margins should improve.

Long-term, the pharmaceutical industry continues to enjoy one of the best growth prospects of any in our economy.

Double-digit growth is expected to continue.

I'm confident that we can turn the strong revenue growth into equally strong earnings growth in the future.

Vendor margins should begin to show some improvement as we move into the 2005 fiscal year.

Meanwhile, discounts to the provider customer need to slow, and we're having those conversations with them.

We are committed to delivering value to each of our provider customers, but not at declining margins.

I also want to point out that efficiency has always been a key component of the profit equation for us.

Operationally, our performance is terrific.

Service levels are excellent, and continued productivity gains apparent.

Let me give you an example of a way to look at our productivity in pharmaceutical distribution.

Over the past three years, our unit shipments have grown at over four times faster than the growth in our dollar of expenses.

Now, that's real productivity improvement.

For in this year, our expenses in pharmaceutical distribution should be near flat.

We're efficient and getting better.

So what's the outlook for pharmaceutical distribution?

Well, we expect to see continued pressure on vendor margins and sell margins throughout the balance of this year.

We do see improved second-half performance in this business, with further opportunities to leverage the working capital required to support the business.

Less capital required in direct distribution contributed to a great operating cash flow performance in the quarter, and we are right on track to deliver on our commitment of $900 million of free cash flow this year.

As we completed the transition to pharmaceutical distribution, the reduction in inventory will also provide an additional $1 billion in cash flow over the next 18 months.

We've had a history of strategic capital deployment and I see a lot of opportunities to expand the scale and scope of Cardinal.

That brings me to a discussion of the execution of our strategy.

Cardinal Health strategy has five components.

Focus on health care, a passion for efficiency, achieving scale and leading market positions, a breadth of offering to the customer, and finally, making our offering more proprietary through innovation and the integration of our offerings.

First, you know we're focused on health care, the fastest-growing segment of the economy and one that is in need of solutions that can bring more innovation and efficiency.

Second is our focus on efficiency, which has driven our costs down and made the delivery of health care more effective.

The third element is scale.

Cardinal Health is a market leader in every one of our businesses.

We protect and enhance our existing scale by strong execution in our current businesses, and by frequent external investments in businesses that provide a level of scale that we couldn't achieve on our own.

In this past quarter, there were two examples of adding to our scale and market position.

The first was the acquisition of The Intercare Group, a leading European manufacturer of sterile pharmaceuticals.

Intercare was an important step for adding capacity and service infrastructure in Europe.

With plants in Belgium and U.K., our ability to service the European pharmaceutical manufacturer is dramatically enhanced with the addition of Intercare.

Intercare's new sterile capacity in Belgium, expected to obtain FDA approval this year, also provides additional needed sterile capacity for the U.S. market.

The second acquisition was Medicap Pharmacies, the second largest franchiser of independent pharmacies.

Medicap brings 179 franchises with system-wide sales of $350 million.

Total system-wide sales for Medicine Shoppe and Medicap combined will now exceed $2.5 billion.

This was a strong addition to our pharmacy franchise offering, and gives us more scale that will allow us to provide more effective purchasing and marketing programs for franchisees, and allow for leveraging of our expense structure to more customer locations.

Let me combine the fourth and fifth elements of our strategy.

The fourth element being a delivery of breadth of our offering to customers, and the fifth being a focus on being proprietary to the customer.

We continue to broaden our offerings with new services, either through those developed internally or through acquisitions.

And we focus on execution in each one of these individual services.

But it is the effective combination of these services that gives Cardinal a more proprietary offering to the customer than our competitors.

We are getting better at integrated marketing.

The concept is applicable both upstream to the manufacturer and downstream to the provider.

Our strategy is working and we will continue to execute for our customers and our shareholders.

The remainder of the fiscal year, you can expect the following.

First, look for drug distribution to experience more favorable comparisons in the second half of the year and to move more rapidly through the business model transition.

Good momentum in negotiating new vendor relationships will become more apparent as we move into fiscal 2005.

And the other business segments will continue to experience strong and sustainable earnings growth.

Second, cash flow will be strong for the remainder of the year and you should see more opportunities for capital deployment.

And finally, as we've said, since August, look for an accelerated performance in the second half to produce mid-teens or better earnings-per-share growth for the year.

No change in expectations, and right on track to delivery on our commitment.

Operator, we're now ready for questions..

I would like to remind everyone, if do you have any questions, press star, then the number one on your telephone key pad at this time.

Again, that is star, then the number one.

Our first question is from Larry Marsh with Lehman Brothers.

Bob, maybe if you could elaborate a little bit on the negotiations you're having with manufacturers.

You've talked about this the last six months.

You talk about 47 active negotiations.

And yet you say, you know, you have to customize those negotiations to the manufacturer.

How much of an education process is it to really educate the manufacturer on what your costs are versus what they think your costs are, and then what sort of progress do you feel you're making on bringing down inventories?

And obviously, we didn't see much in the way of change this quarter, but maybe a little bit of elaboration on that.

Okay.

Thanks, Larry.

Well, as you can appreciate, we're not going to discuss negotiations with any one manufacturer.

I would characterize the discussions as certainly requiring an education of the manufacturer because frankly, they have become just accustomed to the convenience and the efficiency with which they can just distribute product through our distribution network.

We are not in discussions about trying to prove to a manufacturer what our cost structure is.

What we are showing manufacturers is how effective our cost structure-- or how effective our network moves product for them, and what the alternative cost structure for them would be.

And so that's really a focus for Cardinal, and we're making sure they understand the breadth of the offerings that we have, the millions of customer service calls, and the way we process all their information.

And so it is-- frankly, it's an example of, you know, we probably should have marketed ourselves better to the manufacturer to have them appreciate us more.

The conversations are, you know, very upbeat.

Obviously, certain manufacturers are going to pay more.

And they -- I would tell you some of them have never thought about the fact that they have to compensate distribution to move the product.

They just haven't thought about it in those terms.

So I think the process is going well. 47 manufacturers discussions is a lot, but you know, you have to appreciate we're in discussions with them all the time.

So Larry, I don't knew know how to characterize it any different than that.

The manufacturer clearly understands the importance of our distribution network and the importance of the distribution network of some of our major competitors.

So I believe it is going well.

With regard to inventories, I will let Dick make some comment on inventory management.

Yeah, I guess, Larry, the key to the inventories is not so much to look at it in terms of absolute dollars, but to look at it in terms of the business growing and inventories not growing along with the business.

I think, you know, as I mentioned in my comments, compared to the same time last year, our own inventories are actually down this year versus last year, so it's not so much that are you're going to see a huge decline in the inventories as much as you're not going to see the inventories rising as the business continues to grow around them.

And is that going to just be an evolutionary process, Dick, over the next, you know, year or so?

We should expect inventories not to grow at the same rate as revenues for some period of time?

Yeah, it is definitely evolutionary and it may even have a longer time line than just a year, as we work through these, and work the inventories in conjunction with new vendor agreements.

Let me just ask Jim to make a couple of comments on-- really what we're doing is marketing to the manufacturer.

Which is really what we all should have been doing in the past.

And Jim, why don't you just give a , you know, kind of an explanation of the breadth of what we do for the manufacturer and how we need -- we should have been reminding them of this in the past and the value that they receive

All right, Bob.

Larry, you know, your question was the education process, and what it entails, and I think over the course of several years that there has been a disconnect in terms of what those activities are.

For example, Bob mentioned that, you know, we answer the phone and we process a lot of activities for them.

Let me clarify that.

We handle 11 million phone calls a year.

We handle a million phone calls on behalf of the customers each month, so that's an activity.

We process numerous returns that we do on behalf of the manufacturer, and this is probably that comes back to us and then we resell it, and therefore, the manufacturer doesn't have to take it back and destroy it.

There is the whole credit activity that's associated and the risk that we take with that.

There is all the charge-back activities that we do on behalf of the manufacturer, where we allow-- we actually administer their customized pricing to each type of customer, and even difference from like customers to one another.

So there is an innumerable number of issues here, and we haven't done a good job in terms of articulating those, but that's the education process we're involved in with these 47 manufacturers.

They all, frankly, are a little amazed because they've taken a lot of it for granted, and when you're in a business that operates in basis points and it is really pennies per item, a penny or two per item that we're making, for a gross margins or even really for returns, it's important to think that, gosh, if they had it themselves what they would physically have to go through.

And then if you figure out that you've got to mail an invoice and you figure the stamp is going to cost you 37 cents, you know, all of a sudden, you know, these -- all these activities really roll up into a lot.

So the process we're engaged in is doing a full breakdown of what it actually costs, and that is really to get respect for what vendor margins we receive.

To summarize quickly, we are happy to have this all customized by manufacturer, we have a form to take them through, to have them understand, because they really are not even in a position to analyze all this.

And so it is activity-based, by manufacturer.

If you require special handling, we are going to tell you what is going to cost.

It has to do with what your volumes are, how quickly we can turn your inventories, what your average prices of your items are.

All these kinds of things.

I didn't choose the words casually in my presentation about we're not going to have any loss-leader of manufactured products going through here.

We're not selling milk like you would in the supermarket at a loss-leader.

And so this has been a great opportunity for us and to recognize there have been a lot of products here that have gone through our distribution channel that are enjoying the benefits of our scale and not paying a fair price.

So, anyway, it's going well.

The transition, though, as I mentioned-- we expect to be through most of this education process by the fall of this year.

Second question?

Operator, is there a second question, please?

Our next question is from Robert Willoughby with Banc of America.

Thank you.

Bob, you mentioned an objective for an adjusted vendor margin reflecting the committed capital that would be equal to your prior experience.

That's the goal, anyway.

But how did the new Merck relationship turn out relative to your expectations for profit, as well as the capital contributions?

What was above or below?

Yeah, Bob, I said earlier, I'm not going to talk about any individual contracts.

I know you're not asking me to give the specifics on it.

What I will tell you is we're very pleased with the relationship-- we're very pleased with the outcome of the Merck agreement.

And it meets our financial formula as I outlined it.

Also, which are important-- this is obviously a very large manufacturer that on the front end recognized the value of distribution and was very proactive in working to an activity-based formula.

You know-- and so I said, you know, I was -- I think pretty direct in saying, in complimenting them, for moving quickly and recognizing the importance of our relationship.

Your third question?

Our next question is from Tom Galluci

I just wanted to follow-up on Larry's question.

I guess a simple question would be where do you expect day's sales and inventory to ultimately lead as you go through this transition?

It looks to us like to service the business in a traditional sense maybe you need only 35 to 40 days, as opposed to closer to the 60 that you're at.

I would appreciate any thoughts there, and then based on your conversations with these manufacturers, do you see them differentiating between the various major distributors?

And if so, you know, how do you differentiate yourself versus some of your competition from that perspective?

Let me cover it.

We are in a transition because there are some manufacturers that, you know, for a while, we will have a buy-and-hold strategy still being executed with them, but we want to move all manufacturers to a just-in-time.

And so that inventory-- calculating exactly where we will be with inventory days, I can't give you that right now.

What I would tell you is we think our total capital in this business over the next several years, even recognizing our expected revenue growth, that our total capital committed to this business will be flat.

So that means that our days in inventories are coming down.

And the capital required to support increased fixed assets or receivables is offset by the earnings, and the earnings from this facility and reduced inventories.

So it is totally -- it will be totally self-financing.

With regard to differentiating us, as you can appreciate, we have no idea what the manufacturers are doing with other distributors and how they're negotiating their agreements.

But, you know, we are -- we said clearly that we want performance-based agreements so we can differentiate ourselves.

And that's one of our objectives and, you know, we expect to perform for the manufacturer to outperform our competition for the manufacturer.

Jim, you want to just give a couple comments on the types of performance aspects that-- without getting into any detail on any manufacturer?

Just a couple of categories of the types of performance aspects of a manufacturer agreement?

It would include things that-- we would create activities that create efficiency in the flow of products from them to us, the transaction in terms of what do we do in terms of the economics, the paperwork, the billing process.

You know, you look at a transaction, there is all of the obvious when we buy the inventory and pay for it, but there is all the charge-back activity, which is enormous, and a tremendous amount of activity going on there.

It's information that is flowing back and forth between us and the manufacturer.

When you construct these agreements, you are really doing it around a design that says, "how can I provide the manufacturer with the greatest efficiencies in a way similar to how I provide efficiencies to my flow of customer on the provider side"?

This is about taking inefficiencies out and this is an area that has not been touched between the distributors and the manufacturers.

Obviously, the whole concept of buy and hold is about creating inefficiencies, so it is a different kind of perspective and a different balance of where you go to the market with them.

And the next question?

Our next question is from Ricky Goldwasser with UBS.

Hi, good morning.

Can you give us some color on what percent of the 47 agreements--

I'm sorry, we can't hear you.

Could you speak up, please?

Sure.

What percent of the 47 agreements, roughly, are activity-based, fee-for-service type agreements, versus (indiscernible) agreements that you used to have but with better terms to reflect the additional services or the detail that you provide the manufacturers.

And also, have you gotten any feedback from manufacturers post (indiscernible)-- the VA contract, and the price--

I'm sorry, excuse me, a second.

Whatever phone are you on, it is really-- we cannot hear you.

I'm really -- so you're going to have to-- really into the phone, if you could talk really loud.

Something with your connection.

Sure, did you hear the first?

Basically the first question was of the 47 agreements that you've signed with manufacturers, what percent, or is the bulk of it, is activity-based, fee-for-service type, versus IMA with better terms?

And the second one is have you had any discussions with manufacturers post the VA agreement, and kind of-- is there a feedback as to the pricing on the customer side versus the pricing on the supplier side?

Okay.

I think your question first of all is what percentage of our contracts are activity-based.

And we're just on the front end of that.

But that's our objective, to have all of our contracts be activity-based, and that's the negotiation that is going on.

Now, let's recognize that we have gotten in the past fees from manufacturers for activities also.

This is not a foreign concept.

But we want to move more of the margin, substantially more of the margin coming from manufacturers to be activity-based as opposed to buy-and-hold based, which means inflationary-based.

So, you know, I can't give you a percentage.

With regard to have we talked to manufacturers since the wording of the VA contract.

I think that's the question.

Of course, we have talked to the manufacturers since then, and that's not an issue with us in our discussions with them.

Next question?

Our next question is from Michael Fitzgibbons with Morgan Stanley.

Good morning.

I think in looking at your expected improvement over the next six months in drug distribution, I think it would be useful if you could tell us, were the vendor margin profit dollars that you generated in the drug distribution business in the first half of fiscal 2004 greater or smaller than the vendor margin profit dollars you generated in the second half of fiscal 2003 ?

Go ahead, Dick, what's the answer?

What was the question?

The question is was our vendor margin in the first half of 2004 greater than the second half of 2003?

Michael, is that your question?

That's right.

Well, I don't know whether it was greater or not greater.

And we don't look at-- we don't try and compare the first half of our fiscal year with the prior year's back half, and this is exactly on what the issues are with buy-and-hold.

As you know that our vendor margins were seasonal in the past.

And so as we're moving from a seasonal-- relating to when price increases happen, and so our vendor margins were always substantially greater from a buy-and-hold standpoint.

Substantially greater in the second half of our fiscal year, which is, you know, the January to June, than it was in the first half.

We are also-- so you would always expect, even if the model wasn't changing at all, that our vendor margins in the first half of the next fiscal year in dollars would be lower.

And on a same dollar-- or on a same volume basis.

So-- but in addition to that, we're going through a transition and so, you know, I don't think, Michael, that we can give you any comparison that would be helpful to you.

But one of the important things here is that moving to an activity-based model is-- our vendor margins will be steady and more level over the entire year rather than focused in a larger way during the-- in the biggest quarter, being the March quarter.

So that is one of the benefits of the way we're striking our relationship with the manufacturer.

Next question.

Our next question is from Christopher McFadden with Goldman, Sachs.

Thank you.

Let me follow-up on the previous question, if I might.

Bob, your comment on seasonality is an important one.

It would seem, in light of the changing from the buy-and-hold model, that it would be less seasonality in the industry and in your drug distribution business than there has been historically.

And, moreover, youve mentioned on this call a couple of times that you're still in some form of discussions with a number of manufacturers in terms of exactly how the specific economics of your renewed or restructured relationships are going to play out.

So, having said that, it looks by our estimation that you will need to get about 27% higher contribution, or I should say 27% higher EBIT growth in the pharmaceutical distribution and services segment in the second half of fiscal 2004 than you achieved in the first half of fiscal 2004 just to get back to a flat year-over-year fiscal 2004 versus fiscal 2003 operating profit contribution from that segment.

In light of that pretty strong second-half requirement, how do you kind of get to that level of conviction, again in light of some of the fluidity in the business that you've alluded to on this call?

Okay, let me deal with seasonality.

Chris, we are in a transition from a buy-and-hold to a just-in-time.

So some of our margins that will come in fiscal 2004 are seasonal.

So automatically, you know, it's not like those automatically go away.

I don't know-- I haven't run your calculations of the 27% calculation, or whatever, but what we will stand by is what our statement is about what our expectation for profitability is for the corporation for the second half, and about a growth in our profitability in drug distribution.

So we know how to do those numbers.

I don't know what your 27% is.

But there-- you know, why am I convicted-- or why do I have strong convictions what is going to happen in drug distribution?

Because I've been in the business for 20 years.

We're intimate on the numbers.

We know what's going on with the manufacturers.

We have very strong financial controls.

And we have been good at forecasting what's going to happen in the near term.

So that's why I have conviction.

Furthermore, I have extremely high conviction-- well I had convictions before, with the last statement-- but I have extremely high long-term conviction about the secure position of drug distribution.

Short-term, cut to the quick, pharmaceutical manufacturers cannot afford and can't put together the infrastructure to ship product direct.

Second, a provider can't afford and can't put together the infrastructure and don't want to put together the infrastructure and the required inventory level investment to buy direct.

Those are-- those are factors that nothing has changed there.

And so what we are-- we're in the process of going through a transition in how we price to the manufacturer.

They've never thought of it that way, of us pricing to them, in quite those same terms, but if they thought about it, or thought about how much margin they pass to us in a buy-and-hold, we're explaining that to them, and we're saying you need to give back that margin to us, in a different form.

So it's all based upon how confident we are about the role that we as a distributor, in Cardinal specifically, plays in the channel, in the fact that we cannot be replicated or disintermediated.

And that's why I have strong conviction about it.

Next question?

Our next question is from Glen Santangelo with Schwab.

Yes, thanks.

I just have two quick questions.

Bob, you talked a lot about, you know, these discussions with these 47 manufacturers.

I'm just curious, are these 47 guys calling you, or is Cardinal calling them to try to set up these meetings to have this education process?

So who is starting the dialogue?

And then secondly, you know, given all the noise in the marketplace regarding, you know, all these contracts, which is, you know-- how does the company prevent that from having an impact on your renegotiation discussions with your customers?

Because if I heard you correctly earlier in the call, you said you're going to, you know, continue to renegotiate with your customers, but not to a point where it has a negative impact on your sell margin.

So I'm just sort of curious how you prevent that.

Okay.

You're asking about-- first of all, I position drug distribution as providing a service to both the manufacturer upstream and the provider downstream.

And it is easy to think of it in that term because the provider downstream has to find a way to get product.

And if we can find a way to buy it through wholesale rather than direct more efficiently, then he's got to look at those economics.

The ladder downstream has been out of the sell-direct-distribution of product for a long time.

Let me deal with the dialogue with the manufacturers.

It isn't like we have to call them.

They are in our shop every week, because we work closely with them.

We are-- we are how they get product to market.

So it is not like we we don't have a relationship.

We have contracts with every manufacturer and have had various contracts with manufacturers for as long as I've been in the business, and certainly, way before that.

So these relationships exist.

Of course, we're the ones that are initiating a change.

Because we need to educate them about this.

First of all, we need to educate them about the change, so we initiated it.

We are having a conversation with them.

But I would suspect that our competitors, large and small-- our competitors in the distribution business, are facing the same issues that we are, and they're having similar conversations.

And whatever way they're having them-- but I would suspect, and I know the industry intimately, to understand how they go to market, and how they service the manufacturers.

So I would suspect they're having similar conversations and they have to do it in their own way, in whatever they're, you know, whatever their service offering is to the manufacturer, how they differentiate it-- they are having it.

So it isn't like the manufacturer doesn't know it is going on and isn't getting educated.

Cardinal-- we are talking to you about how we are educating them, but we have two smart competitors who can do the arithmetic also and they're doing their own education and they are in the process of doing it.

So manufacturers will get that.

That's on that side.

With regard to downstream, to the-- to our customers, this is not about renegotiating all of our relationships with the customers.

We start with the fact that we used to make more margin on buy- and- hold for the manufacturer and we're going to make a different margin on a just-in-time inventory to the manufacturer.

That doesn't change our service at all to the customer downstream, the provider.

So that has nothing to do with our customer downstream.

Now, our customer downstream may say we've gotten larger, there is more efficiency, we can provide-- could we do something different with you to get a lower cost, and we will sit and talk with them about that.

But what I said was-- is that the changing dynamics in how much margin we're going to get on the buy side will prevent us from offering any further increase in discounts to our provider customer.

That doesn't mean we are going to be inefficient.

Or, I mean, noncompetitive to our provider customer.

So we deliver value to them.

In the past, as we got more efficient, or as we gained more margin from the pharmaceutical manufacturers, we passed some of that along to the provider customer.

There will be less to pass on to the provider customer.

I believe that our competitors are facing that same dynamic.

I understand the industry well.

So we-- but we know what the dynamic is for us, and we are having these same conversations with our customers.

One more question, please.

Our next question is from John Kreger with William Blair.

Thanks very much.

Bob, as you look out a couple of years and you get more stability in the branded Pharma distribution model, do you anticipate changes occurring in either the generic side or even in your Medsurge model, or do you think you will have stability on both those fronts?

Okay.

This is about stability and I've heard people use that word a couple of times.

First of all, we have tremendous stability in all of our businesses, and drug distribution, I mean, you know, we've got tremendous stability in our customer base, growth, top-line growth, our operations are-- we don't have any operating issues in drug distribution.

Meaning ability to get product to market.

Ability to service either the manufacturer or the customer.

So there is tremendous stability there.

You know, we are going through a different model on how we are going to price to the manufacturer.

This isn't any different than what we went through 15 years ago in the industry.

How we price our service to the manufacturer for handling all of their chargebacks, which was a very complicated thing, but we will get through that.

And if you want to characterize it of having more stability in 2005 and beyond, that will be more stable.

With regard to the Medsurge business, you know, it's a very stable business, I guess.

The, you know, great relationships-- we know who our competitors are in that business.

It's three large competitors, again with about (indiscernible)% market share.

I believe that we know we have scale, we know we have unique offering, because we can combine product and service offerings in ways that our competitors can't.

And we know who the competitors are.

There is nobody else who is going to be able to achieve the kind of scale, so I think there is really good stability in that business.

And there is certainly stability in the rest of Cardinal.

Let me move-- let me end this by saying thank you for your participation.

On February 19, we will be hosting Cardinal's annual analyst conference in Chicago.

This will be a great opportunity for investors to see and touch the breadth of Cardinal's offering in health care.

Senior executives will present, and we will take investors through what we call our solutions center, which is an interactive gallery of products and services that we use for customers to demonstrate the combined value of Cardinal's offerings.

There is no better way to see how we differentiate ourselves in the market than at this meeting.

So, I hope to see everybody there.

Thank you very much.

Thank you again, ladies and gentlemen for your participation in today's call.

This concludes today's presentation.

You may now disconnect.