卡地納健康 (CAH) 2005 Q2 法說會逐字稿

Good morning.

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

At this time I would like to welcome everyone to the Cardinal Health fiscal-year 2005 second quarter 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 1 on your telephone keypad.

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

I will now turn the call over to the Vice President of Investor Relations, Mr. Jim Hinrichs.

Sir, please go ahead.

Thanks, Wade.

Good morning, everyone.

Welcome to Cardinal Health's second quarter earnings release conference call.

A portion of our remarks today will be focused on the business segment attachment of our earnings release, so if you don't yet have a copy of that, either the release or the attachment, you can access it over the Internet at our Investor Relations page at www.cardinal.com.

Speaking on the call today will be Bob Walter, Chairman and CEO;

George Fotiades, President and COO; and Mike Losh, Chief Financial Officer.

After their formal remarks we will open the lines for your questions.

As always, when we get to the questions, we ask that you please try to limit yourself to just 1 question at a time.

Before we begin, please remember that this call may include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected, anticipated, or implied.

The most significant of these uncertainties are described in Cardinal Health's Form 10-K, Form 8-K and Form 10-Q reports, including all amendments of those reports and the exhibits to those reports, and include those listed at the end of today's press release.

Cardinal Health undertakes no obligation to update or revise any forward-looking statements.

In addition, statements in this presentation may include adjusted financial measures governed by Reg G. A reconciliation of these measures is posted on the Investor Relations page at www.cardinal.com.

At this time, I'd like to turn the call over to Bob Walter, Cardinal Health's Chairman and CEO.

Bob?

Good morning and thank you for joining us.

I'm not going to say too much about the results for the second quarter as you have already been provided the financials and Mike plans to give you some specific financial comments, and George will follow along with a report on our progress and some key operating initiatives.

I would, though, say that the results were in line with our previous guidance, but as you and I know, the results were below our historic standards and certainly below our future potential.

I'm going to focus on the future by giving you a higher-level view of how things are developing overall at Cardinal, and a commentary on FY 2000 and 2006 guidance.

I will start off by telling you that I'm feeling pretty darn good as I can see the pieces falling in place to build the momentum necessary for our fiscal 2000 performance.

There are 2 parts to building that momentum.

First, eliminating the uncertainties that have plagued us in 2005 in some of our operations.

And second, accelerating the already strong performance of many of our other operations.

Some of the key initiatives that -- or some of the key uncertainties that have existed this year are around the following things.

First, Pharmaceutical Distribution business model and the fee-for-service.

Second, the manufacturing inefficiencies and delays in the sterile area.

Third, the delays in new product introductions and installation capability at Pyxis.

And the fourth, the margin pressures in the medical products area from product repricing and raw material costs.

And finally, the uncertainties that arise from potential disciplinary action as a result of the investigation by the Company's Audit Committee related to the financial statement issues identified in our most recent Form 10-K.

There are a tremendous number of great things happening within Cardinal.

I can say with confidence that there are well developed plans in place or events developed that will substantially reduce or eliminate these uncertainties and both restore growth, and importantly, predictability for 2006.

So mentally I'm racing toward 2006 and the results that it will show.

Meanwhile, we'll stay focused on the second half of this year.

Certainly, we're very disappointed by our inability to forecast for the second half our vendor margins and the exact timing of the implementation of fee-for-service in our Pharmaceutical Distribution business, and the installation delays at Pyxis -- installation delays of Pyxis contracts.

These lead us to reduced guidance for the balance of this year, but they don't affect our expectations for FY 2006.

Nonetheless, it's disappointing for us, and certainly for you.

My overview of Cardinal's position starts with strategy.

It is intact.

We are well positioned.

We like the businesses we own.

We are generally the market leader or in a very strong second place.

Our markets continue to have attractive revenue growth, generally in line with our expectations.

And other than at Pyxis, where frankly we have a self-inflicted non-fatal wound, our revenues are meeting our goals and are rising at rates faster than the comparative markets.

We have invested heavily by adding substantially to the senior leadership of the Company, noticeably at PTS at the top in its manufacturing areas; at Pyxis, at both the top level and throughout the customer installation area; and with the addition of Alaris, all of its senior management has stayed, and it's integral to the achievement of the planned merger synergies and improved Pyxis efficiencies.

We've added in manufacturing product ranks in the Medical Products area -- Medical Products and Services area, and we've added further leadership in many areas at the corporate.

3 key areas of focus, though, remain the same for Cardinal in order to improve our performance.

The Pharmaceutical Distribution model change to fee-for-service, regaining Pyxis' luster, and executing in sterile manufacturing.

Let me put these 3 areas of focus into perspective by categorizing all of Cardinal's operations into 3 buckets.

The 3 buckets are the -- first, the predictable growth bucket; the second, the model change bucket; and the execution issues bucket.

Cardinal has many businesses.

Certainly all in healthcare, but noteworthy is that there are 13 with annual operating earnings in excess of $50 million.

In the first bucket, the predictable growth bucket, there are 10 of those 13 operations.

These operations are in this bucket because you can describe them as in the "business as usual" category.

While there are always day-to-day challenges in each business, this group of companies are generally doing well, growing nicely in a predictable fashion.

These 10 businesses will account for approximately 50 percent of our operating earnings in fiscal 2005.

We don't talk much about these businesses, maybe because their reliability -- because of their reliability and predictability.

Some of these businesses are like Medicine Shoppe.

Frankly, all of MPS, including its distribution and manufacturing areas; oral technologies, which is our soft gels and Zydis businesses; nuclear pharmacies, our packaging; and certainly now, Alaris are some examples of those 10 businesses.

Certainly we invest in these businesses.

There is potential to accelerate their growth.

We'll talk about these individual businesses in much more detail at our Analyst Day in early May.

Now, the second bucket, the model change bucket.

This second category is for businesses that are undergoing a fundamental model change affecting them and their competitors.

This, of course, is Pharmaceutical Distribution, which accounts for approximately 40 percent of our fiscal 2005 earnings.

Incidentally, our Pharmaceutical Distribution business itself has 2 distinct product lines.

Branded pharmaceuticals and generics.

It is only the branded pharmaceutical portion which is undergoing a business model change.

Generic profitability is performing very well.

Branded pharmaceuticals account for a little more than 50 percent of the total Pharmaceutical Distribution operating earnings.

We're leading the industry-wide transition to a fee-for-service form of compensation for the branded manufacturer.

That transaction is happening.

It will work.

Our people are meeting every day with manufacturers, both large and strong -- and small.

The conversations over the past year have moved from a theoretical discussion of the value of services we provide, to an acceptance of the concept of the manufacturer paying unique, non-contingent fee-for-services, and now finally to concrete discussions on price.

Yesterday I read a comment by an analyst that said our, "Persevering stand on converting manufacturers to fee-for-service could begin to pay dividends over the next 6 months".

That analyst had the right idea.

But instead of saying "could pay dividends," I would have said "will pay big dividends."

So while we haven't called the exact timing in short-term costs of a hand-off from buy-and-hold to fee-for-service, as evidenced by our shortfall this year, it is happening, and the momentum is picking up as we forecast.

The third bucket.

Those where there are execution issues.

These businesses are delivering about 10 percent of our earnings this year, but honestly, should have delivered more than 20 percent.

This is a big miss.

Pyxis and sterile manufacturing fit into this bucket.

Imagine my frustration when customer demand in these 2 areas is still strong.

We simply have not executed on delivering on that demand.

At Pyxis we've revamped the entire top management team, begun the integration with a stable Alaris operation to achieve significant operating efficiencies, and launched the delayed MedStation 3000 product line.

MedStation 3000 replaces MedStation 2000, which is Pyxis' largest installed product line.

MedStation 3000 is being very well received in the field and sales momentum is growing.

So we are optimistic about our committed contracts and backlog growth for MedStation 3000 and our other product lines.

But we've had a set-back in converting these committed contracts to revenues.

Certain execution issues have occurred as certain sales and installation teams were pulled out of the field as a result of the impact of the Audit Committee's internal review that has been ongoing.

We're quickly replacing these people, but meanwhile, as they come up to speed, installations will drag behind new committed contracts.

So backlog will grow and revenues will be delayed during the second half.

In the sterile area, George will talk about the progress we are making in gaining manufacturing efficiencies, regulatory approval in Puerto Rico, and continued demand.

But suffice it to be said that good progress is being made.

The key take-aways from my discussion is as follows -- First, the uncertainties are going away, and better operating predictability is arriving.

Second, we have a large diverse group of operating companies with good solid predictable growth in cash flow.

We call these companies our predictable growth companies, and they comprise 50 percent of our earnings.

Last, the 3 areas of particular challenge remain the same as we discussed over the last couple of quarters.

It is Pharmaceutical Distribution, model change, Pyxis, and sterile.

All 3 have well developed programs in place to restore them to a position of high growth and high return with the required predictability.

We are making progress and are confident.

Let me talk more about guidance for 2005 and 2006.

For 2005, I'll repeat what has been said in order to be clear.

Our guidance has been reduced primarily for 2 reasons.

Pharmaceutical Distribution vendor models -- vendor margin expectation -- the guidance is being reduced primarily for 2 reasons.

First, Pharmaceutical Distribution and vendor margin expectations, and second, the pace of installations at Pyxis.

In Pharmaceutical Distribution, although our vendor margins on branded pharmaceuticals met our expectations in January, traditionally our largest month of the year, we have determined to be much more conservative in our expectations for price increases over the next 6 months, as we anticipate smaller but more frequent increases spread out over the entire calendar year.

And while they may average 5 percent over the entire year, we expect to lose price increases during the next 6 months and be substantially on a fee-for-service by June.

Additionally, we now expect to have less product available to us than forecast.

This all is evidenced why fee-for-service is critical to the financial health of Cardinal and the entire industry.

Fortunately, we are confident about that success and the timing of the switch to fee-for-service.

In this switch it has cost us margin in the short term.

Further affecting 2005 is a slowdown in installations of Pyxis-committed contracts.

So while this will create a larger backlog at June 30th, it will slow down revenue recognition, and therefore, earnings in the short run.

We expect this situation to be resolved by year end.

And so for fiscal 2005 our EPS -- our guidance is for EPS of $3.20 to $3.40 before special items and certain costs, primarily associated with our previously-announced global restructuring plan.

The width of the range reflect the uncertainty I discussed.

As we move into fiscal 2006, our guidance reflects the elimination or reduction of uncertainties that I mentioned at the start of my talk.

It reflects the momentum being realized in all of our businesses and the passing of many one-time unusual events that negatively affected 2005.

It also reflects a belief in our restructuring efforts in the One Cardinal Health initiatives.

Our guidance looks for 2006 EPS to grow at a rate considerably above Cardinal's stated long-term growth goal of mid-teens or better.

We will also benefit from the restructuring actions taken in FY '05 and One Cardinal Health.

One additional topic before I turn it over to Mike, and that is on the Audit Committee investigation.

As you saw in the press release and the Form 8-K that we filed this morning, the Audit Committee has reached conclusions regarding the assignment of responsibility for certain financial statement matters that were discussed in our most recent 10-K.

These conclusions have resulted in disciplinary actions for certain employees ranging from termination or resignation to required repayments for some or all of their fiscal 2003 bonuses to letters of reprimand.

These disciplinary actions affected senior financial and managerial personnel, as well as other personnel at the corporate level and in 4 business segments.

All affected employees have been notified.

No current corporate executive officers are in the group of disciplined employees.

With the exception of conclusions concerning the responsibility for matters relating to the accounting treatment for vitamin recoveries, which is being addressed by a separate committee of the Board, as detailed in the Form 8-K we filed this morning, the Audit Committee has completed its determinations of responsibility for the financial statement issues identified in our most recent Form 10-K.

The Audit Committee review, the separate vitamin review, and the previously announced investigation by the SEC and the U.S.

Attorney remain ongoing.

Now, let me turn it over to Mike to walk you through our first-half financial results.

Thank you, Bob.

Just a couple things to start off.

First of all, I'll be walking through some charts.

The charts were sent out over the web this morning.

I'm sure most of you have them, and if you don't, you can get access to them.

As I walk through, I'll talk to you about what page I'm on so we can kind of keep everybody focused the same way.

One other thing that I mention just by way of a preamble is a reminder that my comments are primarily related to financial results from continuing operations and exclude special items.

And at the end of the presentation I'll spell out for you what the special items are.

Just to pick up where Bob left off in his commentary on the quarter.

It certainly was a challenging quarter, but also the quarter clearly showed improvements from Q1 and it was in line with our previously revised most recently given guidance and improvement from Q1 and on track to continue improvement as we go through the year, as evidenced by the guidance that Bob talked to you, through the balance of the '05 fiscal year and into '06.

First chart I'm going to talk about is actually page 3 in the package that was sent out, and it talks about the overall second quarter results.

As you can see on that, revenues were up 13 percent to 18.6 billion, demonstrating the strong customer demand for the portfolio of healthcare products and services that we provide, as well as contribution from year-over-year impact of acquisition.

As you know, this revenue number includes bulk revenues for Pharmaceutical Distribution.

And just to give you a feel for what's happening there, that was bulk sales -- or bulk revenues were 5.8 billion in the second quarter of this year, versus 4.5 billion last year.

Operating earnings were down 27 percent to $424 million, and Bob has already discussed the significant performance drivers there.

Please note that these operating earnings include $83 million of impairment charges and other items, and these are primarily non-cash asset impairments related to the activities that we've undertaken under One Cardinal Health.

These type of charges are now presented on a separate line item on the income statement titled -- entitled "impairment charges and others" and that's a display that you will see from us in future quarters as well.

Interest expense increased during the period, primarily due to higher borrowing rates this year versus last, and that, obviously, contributed a little bit of negativity as you walk down the income statement from operating results to net income.

Net earnings for the quarter declined 26 percent to 275 million, and as a result, our diluted earnings per share were $0.63 a share.

Just -- I want you to note that these figures include the negative impact of impairment charges and other non-recurring items.

The net impact of these items serve to reduce earnings per share during the quarter by $0.10 a share, and in just a few minutes I'll provide some more detail on these items in my comments.

Cash flow for the quarter was strong, delivering $626 million of operating cash flow and over $500 million of free cash flow.

I do want to point out to you that this amount does include $300 million of net proceeds from securitizing accounts receivable during the quarter.

Our return on equity declined to 13 percent versus just a little over 20 percent in the prior-year period, as a result of the decline in earnings during the quarter.

The next page in the chart set, which is page 4, talks about the first half in total.

In this case, revenues were up 15 percent to 36.4 billion.

Operating earnings declined 26 percent to 814 million, and again, that includes impairment charges and other of $87 million.

The positive impact of a lower tax rate due to the mix of international and domestic earnings this year versus the prior year, that was favorable, as you move forward, that was offset by higher interest expenses again on a year-over-year basis and again primarily reflecting higher rates that we incurred.

Net earnings declined 27 percent to $513 million, and earnings per share declined 26 percent to $1.18 a share, with the decline being somewhat mitigated by the favorable impact of the share repurchase program that was completed during fiscal '04.

Once again, these amounts include the impact of asset impairments and non-recurring items which totaled $0.17 a share for the first half of the fiscal year.

As was the case with the quarter, when you look at the full half, cash flow was strong.

Operating cash flow $1.5 billion and free cash flow 1.3 billion.

And for this period, there was the favorable impact in both of those numbers of $800 million of accounts receivable securitization.

We're on track with our cash flow budget and expect to begin to executing our authorized share repurchase program during the second half of the fiscal year.

We haven't started that yet.

We've been in a quiet period, but we do expect to start it soon.

The reduction in net earnings year-over-year is reflected in return on equity, which ended the period again for the full first half, 12.4 percent versus 19 percent last year.

Now, this next chart, which is page 5 in your package, gives a fair amount of detail on the non-recurring items.

The reason we put this in, it's first of all, so you can understand what we're looking at as non-recurring items.

And then secondly, so you can do the math and come to the -- I think the appropriate conclusions, the conclusions that work for your particular models, to get a basis for how the business is operating on a run-rate basis.

The first item is impairment charges and other.

I've touched on this briefly.

They totaled $67.8 million for both the quarter and the year-to-date, and these charges primarily consist of asset impairments related to reduction in value of assets within the oral technologies business and primarily associated with some joint ventures that we have in Europe.

The minority interest and realized currency translation is impacted approximately $19.4 million, related to these impairments, and that's primarily pulling out the minority interest.

I mean, just to let you know the way it works, in the 67.4 -- excuse me, $67.8 million there's a -- that is sort of the full amount for the operation where we have determined to be an impairment, and then part of that is pulled out on the minority interest and other because it is a joint venture.

During the quarter, the Company also incurred asset impairments totaling $8.3 million on properties previously related to certain synthetic release -- certain synthetic lease agreements for real estate and equipment used in the operations of the Company.

And just to give you a little bit better feel for that, as these synthetic leases are renewed -- and actually you have to do it periodically, probably the best way to do it is on an annual base, you've got to look at the individual assets there, perform asset impairment tests, and if you come to a conclusion that the assets are impaired, you've got to step up to it.

And that -- we have been through that testing during the quarter and on a particular group of assets, and have come to the conclusion that there was an impairment of $8.3 million, and so that's what you see there.

The 6.9 million for the other category largely relates to a determined asset on an aircraft that we are in the process of selling.

So that walks you down to the total asset impairment charges.

When you get down below that, the items that I think are worth talking about, you see a line item for inventory adjustments at Alaris, this is a topic we talked with you about last quarter, and this is just the purchase accounting that you have to do when you make an acquisition these days to write up inventory-to-market values, which means has a favorable impact on the balance sheet at the time you do that, but then you have a high every cost of goods sold as you run those through the income statement.

That amounted to $3.4 million on -- for the second quarter, and for the first half, 23.6.

The latex litigation item we talked with you about last quarter, made provision for it then.

That's why it shows up in the year-to-date.

So you get down to the bottom and these are the items that add up to the $0.10 a share for the quarter, the $0.17 a share for the first half of the year that I alluded to in my remarks.

Just one last thing on this, because we're providing you the information on fiscal-year '05, it's also appropriate, we'll let you know what the impact would have been if we had displayed things on this -- called things out on this basis in '04, and essentially what you see there is 1 item of any consequence.

That's the non-strategic sale and other, and this is something that we talked with you about a year ago.

That's the gain on the sale of the paint ball business.

So that gives you all the information that you need to work with to look at non-recurring items on a this year and last year basis, and that's probably plenty said on that.

Now I'm going to briefly go through the segments of the business starting on page 6 that's in the package that was sent out to you, and that one deals with Pharmaceutical Distribution and Provider Services.

And in this case revenues were up 15 percent and operating earnings were down 9 percent.

As Bob mentioned, recent customer contracting activity demonstrates the demand for our services and the competitive nature of the marketplace, but as we have seen, margins are under pressure.

We are making progress in terms of converting to fee-for-service, but our pharmaceutical vendor margin is still dependent on pharmaceutical price increases, which are lower than they have been in past history and lower than we expected.

Expense efficiency in Pharmaceutical Distribution continues to improve.

SG&A as a percent of sales continues to decline, down from prior year.

Also working capital management has continued to work well in this segment of the business.

And one of the reasons for that is our National Logistics Center is in place.

I had a chance to go through it in December, and it is an impressive, high-efficiency, high-throughput facility, and it's in place and working well.

Page 7 talks about Medical Products and Services where revenues were up 6 percent and operating earnings were flat for the year, and this falls -- this operation, or this segment of the business, falls in the category that Bob talked about.

Steady performer, predictable performer.

We've got some things going on here.

Recent hospital and group purchasing contracts along with sales of new products are driving good top-line growth.

Margins continue to be pressured by competitive pricing on large customer contracts, and this is the one place in our business where we have had a negative experience as a result of increasing raw material prices particularly commodity.

Positive earnings contributions were delivered during the quarter from the growth in specialty surgical instruments and private-label products.

Page 8 shows the results for Pharmaceutical Technologies and Services.

In this case, revenues were up 7 percent, but operating earnings were down 10 percent.

Revenues were positively impacted by the inter-carrier acquisition, which was completed in December of '03, and by good sales growth in oral technologies and nuclear pharmacy services.

But earnings growth continues to be dampened by the sterile manufacturing issues that Bob touched on earlier.

Page 9 shows the results for Clinical Technologies and Services where revenues were up 38 percent and operating earnings were down 21 percent.

Alaris is performing to the kind of expectations that we had when it was acquired, and as you heard from Bob, our issues in this segment center around Pyxis and Pyxis' ability to get back on the installation capability pace that it has demonstrated in the past.

The last chart in my package, which is page 10 in the material that was sent out to you, is just a brief reminder of what some of the things are that in aggregate show up in corporate operating expenses.

They include the unallocated corporate administrative expenses, but the big things that show up there are the special P&L items and we -- I thought it was appropriate to just give you a quick call-out of what those represent in this category were $105 million that related to restructuring costs that qualify for special P&L treatment, $10 million of merger-related costs.

And also this is an area where this is where we book the favorable impact when we have it of litigation settlements and we did have $21 million that was received and recorded as income, primarily related to the settlement of pharmaceutical manufacturer anti-trust claims.

And within the second quarter, we incurred an additional $9 million of legal and other costs related to the ongoing accounting investigation and reviews.

So just to give you a little feel for what was there.

I will now turn things over to George to talk with you more about what's really going on in some of the parts of the business.

Thank you, Mike.

At our November analyst meeting I presented each segment's fiscal-year 2005 performance by first half and second half, focusing on the issues affecting the first half and the drivers that would lead to second-half improvements.

As a reminder, the issues by segment were as follows -- Pharmaceutical Distribution and Provider Services, of course, it's the branded buy margin and Medical Products and Services, it's the pressure on self-manufactured product margins, which is a result of a new GPO agreement and commodity prices.

In PTS it's around the sterile manufacturing operations.

And in Clinical Technologies and Services, it's about Pyxis' performance and the integration of Alaris.

As Bob pointed out, we're, in fact, making progress on each of these issues.

We are, in fact, improving performance in the second half versus the first.

Although at a level less than previously envisioned for reasons I'll explain as I walk through these segments.

I'm also going to give you an early indication of where we see this momentum leading to for FY 2006.

In PDPS for the first half, as expected, we saw year-over-year decline in operating earnings of 19 percent.

This is attributable to the slowdown in brand pharmaceutical price increases and available inventory, again, serving to reinforce the urgency of converting how we are compensated for our services to a non-contingent form.

Some margins have stabilized during this past calendar year and we've continued to be very disciplined in our approach.

The recent Department of Defense award is a case in point.

We stayed consistent to our return on committed capital and EBIT targets that support our long-term financial goals, and we're very pleased with the outcome.

While our results in the first half are obviously not what we aspire to, it's instructive to point out that, based on our detailed internal tracking, our return on sales and drug distribution consistently outperforms the balance of the industry in a range of about 50 to 100 basis points.

For the second half, we have been consistent in saying that performance was dependent on the rate of price increases for branded pharmaceuticals, available inventory, and how the hand-off is executed from contingent to non-contingent compensation.

While January has been a good month, it is still unclear exactly how this will unfold for the full second half.

To date we've seen a wide range of price increase levels, some surprisingly low and some as expected with an overall market average of about 5 percent.

The issue is around how these price increases are weighted by our available inventory positions.

And while we'll see demonstrable improvement in second-half performance versus first half, we are less optimistic that it will be where we thought it would be 2 months ago.

While this is not positive news in the short term, it's why we remain so resolved to make the transition to non-contingent compensation happen in a timely fashion.

With respect to the fee-for-service transition, it is gaining momentum for us and I believe we are leading the industry.

We've made important progress over the past 8 weeks.

The manufacturer respects and appreciates the discipline we are bringing to the process with our next-best alternative approach to help determine what represents fair market value for our services.

There is also growing appreciation for the integrated pharmaceutical supply chain, where we drive tremendous efficiencies and value to our retail and health system customers through the prime vendor model.

While from time to time we will have differences of opinion and certain discussions, our manufacturer partners know we are resolved to make the transition and achieve agreements that provide them with outstanding performance at a fair value on a non-contingent compensation basis.

Looking ahead to fiscal-year '06, we're very optimistic about the growth characteristics for Pharmaceutical Distribution.

We see continued strong revenue growth, further stimulated by the Medicare drug benefit, continued strong performance of generics, disciplined expense management, stable sell margins, and most importantly, predictable buy margin performance because of our plan to have approximately 85 percent of our branded buy margin transitioned to a non-contingent basis by start of fiscal-year '06.

In Medical Products and Services it's been a steady performer for us, demonstrated by very solid revenue growth in the first half of the year, as expected, earnings were weak because of margin erosion, particularly on self-manufactured products.

This was largely the result of contract repricing with a major GPO, as well as some pressure on commodity prices, such as latex and resins.

Looking ahead to the second half, nothing has changed from our earlier assessment of improved earnings performance for the second half.

This is helped by the fact that we start to anniversary the repricing actions as we move through the half, but more importantly, there are several initiatives that will contribute to this improved performance and continue to do so in FY '06.

We have initiated a plant optimization plan that will significantly improve our cost structure.

Our Singapore trading operation is well underway and gives us even more capability to source strategically from low-cost sources.

And we continue to expand our private label line as a means of providing a competitive and highly profitable offering to our hospital customers.

And finally, new products continue to do well.

Our lead in surgeons' gloves continues to expand and our higher manufacturing segment, what we call "medical specialties" is doing exceptionally well.

Looking into fiscal-year 2006, all these initiatives set us up to return MPS to earnings growth that will exceed its consistent above-market revenue growth.

In Pharmaceutical Technologies and Services, the story is largely around the performance of the sterile manufacturing operation.

The second quarter performance was impacted by poorer-than-expected efficiencies at our Albuquerque facility; the delay in upgrading our regulatory status in Humacao, Puerto Rico and the associated carrying costs; and a weakness in our blow/fill/seal operation.

This operation was significantly affected by the loss of volume for a single large branded product.

Despite this set-back the pipeline in blow/fill/seal is strong.

On an encouraging note, the Oral Technologies business, which includes soft gels, Zydis and other solid dosage forms performed very well this quarter, behind several of our main stay products.

Nuclear Pharmaceutical Services showed solid top-line growth.

Margins were weaker than expected because of short-term competitive pricing activity, but new customer initiatives and continued improvement in our efficiencies in this business will improve margins in the second half.

So the big driver in PTS for the second half is around steady improvement in sterile operations.

Albuquerque is now making consistent improvement efficiency and is the single largest contributor to sterile's progress.

We continue to focus on our quality improvement program in Humacao, Puerto Rico, and while this has taken considerably longer than we anticipated, we believe the investment will ultimately deliver great returns as a result of the pipeline of new product opportunities that are in queue.

The overall outlook for PTS in FY 2006 is very bright.

We have demand across our range of services.

We've got new and experienced leadership in place.

We expect that our core businesses in Oral Technologies, packaging services, and Nuclear Pharmaceutical Services will continue to be steady performers.

Our investment in sterile operations will finally begin to pay significant dividends in Albuquerque, in Puerto Rico, and with the opening of our North Raleigh facility in mid-2006.

We announced today also that we signed a letter of intent with VaxGen for the aseptic manufacturing and packaging of the anthrax vaccine.

It's subject to approval of the U.S. Government.

This will produce $100 to $150 million of revenue to PTS, a portion of which would be upside in fiscal-year 2006.

In Clinical Technologies and Services, let me first cover Alaris.

This acquisition is performing exactly to expectation.

The synergies are gaining momentum and they're on track to deliver what we expected.

Dave Schlotterbeck, Dwight Winstead, and the combined team have driven the integration with Pyxis and Clinical Services and Consulting to create a more potent, long-term offering around the patient and clinician practices.

As Bob pointed out, Pyxis is struggling this year, but I clearly view it as short-term.

Our issues here are two-fold.

First, we completely turned over the management team and are making changes to our business processes.

This is affecting our ability to install as we gradually improve our capability.

Second, the new MedStation 3000 launch was delayed 6 months to December to ensure we were better prepared to execute a well thought-out launch.

We have new leadership in place at Pyxis led by Dwight Winstead who led the successful turn around of our Owen business and created Clinical Services and Consulting.

We continue to have a massive installed base and we aren't losing customers.

While Pyxis' business will gain more momentum in the second half over the first half as a result of more organizational stability and the new MedStation product, its performance will continue to be weak versus year-ago until we get to FY 2006.

For FY 2006, we see a dramatically stronger performance as Pyxis' install capability improves, further penetration of the MedStation 3000 product, which is seeing very strong early acceptance, and improvement in efficiency through product rationalization at Pyxis.

In addition, we expect Alaris will continue to perform quite strongly, including continued momentum from the synergies with Pyxis and our MP&S business.

One last point I want to make that is central to our optimism for fiscal-year 2006, and that's our capital story.

We will continue to generate higher levels of cash flow from operations and will see growing returns on capital.

So in summary, our short-term results are disappointing, but we feel like we are now in the up-swing.

It's not about strategy.

We like how we are positioned.

It's about a business model transition and a few discrete execution issues which we have been discussing for several months.

Our sequential improvement shows progress and that progress will continue into the second half, and we will carry that momentum into fiscal-year 2006.

We're now prepared to take questions.

(Operator Instructions).

Your first question comes from Glen Santangelo with Jefferies & Company.

Yes, Bob, just 2 quick questions.

I'm curious about what you're seeing in terms of drug price inflation.

Sounds like you're taking a more cautious view, but you're the last of all your competitors to report and we heard sort of muted comments out of one, more bullish comments out of the other, and now I think we're hearing negative comments come out of you.

Could you kind of maybe triangulate all the different comments and kind of give us a sense for exactly what's going on and what your specific expectations are?

And then secondly, in the Pyxis business you talked about the implementation cycles seemed to be extended here and that's hurting your businesses.

Is it just a sheer coincidence that your primary competitor in this business is also having problems?

Have you seen any changes at all in terms of underlying demand or pricing for those products at all?

Any comments would be helpful.

Okay.

Thanks, Glen, and I guess out of fairness, nobody warned you just to ask 1 question, but I think what we're going to try and do is somebody just ask 1 question, I'd appreciate it.

I'll answer both yours, but if we could stick to 1 question that would be helpful so we can get this around.

First of all with regard to drug price, I don't know how to comment on exactly what our 2 competitors said.

Let me just kind of comment on what we believe.

Certainly, we all know that price inflation of products during the last, say, 6 calendar months of 2004 were substantially less than comparable periods, and there was a lot of reasons that were given for that, but, anyway, it was considerably less, and it was reflected in our profitability and our competitors'.

So there certainly was expectations of kind of a buildup expectation that there would be large increases coming.

And, as I said in my comments, January was okay.

And I think our competitors said the same thing about January.

After that I'm not sure exactly what their guidance was.

I'll tell you what we believe.

It looks to us like, frankly, that the manufacturers will be more cautious.

They're likely to be smaller increases.

Could be more frequent during the year, and we expect -- and frankly, it could average 5 percent.

And so I wouldn't read my overall comment on pharma price inflation relative to what the manufacturer might receive as reflecting on the manufacturer, but frankly, as it's spread out over the whole year and moved out of traditionally the largest price increase environment, which is really the first calendar half into -- some into the back half, we're not going to gain that in the back half, because we are going to be on fee-for-service.

And so we're less bullish about -- we're less bullish about the percentage increase a little bit.

That's not the biggest thing.

We're more expecting it to be moved further out.

And then the other element which I had said earlier is, we have less inventory available to us by the manufacturer, and that surprised us a little bit.

We're pretty good at tracking our inventory levels.

We're very good at it.

And so we're now assuming we're going to have less inventory committed.

Overall, that's good, I guess you'd say, we've got that capital available to do something else.

So that's our view on that.

Incidentally, when George mentioned we'll have 85 percent of our vendor margin on non-contingent fee-for-service, actually I just want to make sure, when people say you move to fee-for-service you can either be, okay, fee-for-service, but it could still be contingent upon price increases in the future.

But we're saying, yes, we will be the majority of all of our manufacturers business will be on fee-for-service when we enter the new year, but in addition, we're making the statement that, we're not going to have it be contingent on inflation in the future.

Now, some of our competitors may be willing to do that.

We're just not.

So his -- the point is that the result of moving to fee-for-service and making it non-contingent but a fixed fee is that we expect that at least 85 percent of our margin expectation for '06 will be defined as a percentage going into '06.

With regard to Pyxis, I don't know what the competitor -- reference to the competitors.

I know who the competitor is, but bottom line is, I believe there's strong demand, good attention by the manufacturer towards spending in areas of around patient safety, improving in their efficiency, and so I don't think there's a capital demand shortage.

It is not about lengthening our installation, it's about us having less capacity to install given all of the changes that we've had to make out there.

And it's also the consequences of the delay of the installation -- or the introduction of a major product line, the MedStation 3000.

Next question.

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

Good morning.

Bob, just on the point of fee-for-service, you talk about 85 percent by June.

I was a little bit surprised that you didn't talk about any additional contracts that have been signed, I'm wondering if maybe could you just give us a little bit of insight as to meeting the deadline of March 31st with the manufacturers, number 1.

And number 2, if you could also give us some insight as to where you expect the margins to fall out on these contracts.

I think at our conference you had talked about the fact that historically you were at a high of 2.38 percent on the operating margin side, so I'm just wondering if you can give us some idea of how these contracts -- I'm sorry, how these negotiations are going around the contracts.

Thanks.

Lisa, the -- with regard to the -- your questions about fee-for-service, let me -- what I'd say is I think the negotiations are going well.

We're making good progress.

There's a lot of momentum picking up on this.

The issue about us announcing who we'll announce and who we won't, it's a little more complicated than -- I mean, we may -- we may elect to not announce any more, not that we're not completing agreements, which we are.

Because one of the reasons is one of the manufacturers says, wait a minute, we completed an agreement with you, we -- that means your competitor immediately rushes to us and says, what's that agreement?

We want to negotiate it.

It doesn't help us, timing wise.

So, anyway, we know there's not much time left to complete it in the next 5 months anyway, so they'll happen.

I would, frankly, predict that we won't announce a lot of them.

That's my current thinking on it.

And -- but we're making progress on it.

The goal we set is that our -- that our peak return on sales, total sales, was between, as I said, 2 to 2.5 percent of sales.

I want to be careful with that, because as bulk grows -- could grow dramatically it can change that top-line number, and I'm going to have to try and give you a gauge in the future of how to measure our goals.

But, in any event, we're still standing by the statement we said before, which is that our objective would be to get our return on sales, total sales, back in that area.

We will not be there in 2006, and I'm not really today ready to tell you exactly where we expect to be, but at our analyst meeting -- at our analyst meeting in May we'll be able to better develop that as we lay out our growth expectations by area.

But, the negotiations are going fine, at least, some get difficult when you sit down and finally, you get through the discussion, yes, we understand why we have to pay and with those that we show them what they were paying before through a buy-and-hold and now they're fee for -- on a spareness [ph] basis, recognizing the cost of their line, if it's below what they were paying before, well, shoot, those discussions are easy.

You sit down and say to somebody, okay, he now gets the concept, but their fee is going to have to be a lot greater because either the nature of their product or the fact that there was no price increases before those discussions are obviously more difficult.

So there's not really a consistent with -- way to say which ones are easy versus more difficult.

What I would say to you is, there is significant progress in the fact that manufacturers have embraced the concept and understand why this must happen.

And what I'd say is, we are not lone wolves out there.

Our competitors have the same exact issues facing them.

That is, the dependency on price increases and how that dependency creates incredible uncertainty.

They have the same issues we have and so they're dealing with it in whatever way, but they have the same issues.

So I believe it will move along at -- move along in the time frame that we outlined over the last several quarters.

Next question.

Your next question comes from Steve Halper with Thomas Weisel Partners.

So, between -- Bob, you talked about the target margin of 2 to 2.5 percent, and I understand that there's an issue with the bulk and you have to look at where your negotiations fair.

But what's going to change between now and May at the analyst meeting so that you can give us more visibility on what you think the target margin is going to be?

Steve, we expect to complete a whole lot of fee-for-service negotiations.

And we have our objectives, and I've laid out what our long-term objective in this area is, and I want to be cautious.

I want to be cautious about trying to tell you where we think we're going to be towards achieving our long-term objective.

In '06, we're making -- the uncertainty of -- our inability to project -- predict our vendor margins for the last half of '05 is just a reflection of that uncertainty.

The timing of it and when we get it done, and what I would tell you is there is absolutely 0 uncertainty in my mind about whether this is going to happen.

Whether it's -- whether it's 5 basis points net higher or 5 basis points net lower in the -- when we go into '06 composite against all the manufacturers, I to date can't call it that close and those are significant numbers.

But what I would tell you is that over time we will work -- over time we will work towards that objective, which is the 2 to 2.5 percent return on sales.

This industry deserves it.

We're delivering that kind of value.

And frankly, what our customers -- our customers are saying is that this is the most -- this prime vendor model that's been developed and drug distribution industry is the most efficient method for getting product to them, and that's what they want.

That means, we're delivering value and we know we have the ability to ask to be paid for it.

So I think I've given enough guidance today and I'm going to be -- I think I've said also I want to be careful about calling the exact timing of all of this and so I've given you kind of a range.

That's where we are.

Next question.

Your next question comes from Dave Veal with Morgan Stanley.

I wonder if you could also just talk to the other half of the business, the generic side.

How does the revenue and the margin outlook there, how is that trending, and how do you see that shaping up over the next 6 months to a year?

On the generics, we're experiencing the same growth as -- that's reflected in the overall generic market.

We've had a well established generic sourcing program that we're very pleased, we're tracking in detail the overall composite margins in generics in all of our customer segments, meaning hospital, retail, institutional, and those margins -- those margins are very stable.

I mean, and we have no reason to believe that they won't stay stable with good top-line growth.

In fact, I'm confident that they will.

Okay.

The last comment I guess I'd make on generics is certainly that the revenues and profitability in generics are certainly growing faster than the market.

Next question.

Next question comes from Tom Galluci with Merrill Lynch.

Thank you.

Good morning.

You're clearly optimistic about achieving your goals in fee-for-service, Bob.

Just wondering, I think, the last few quarters you said you thought you would be largely done by March now it's substantially complete by June.

Just wondering what causes the slippage there.

I totally appreciate your not being able to predict the margin without the negotiations being done, but assuming you get as far as you want to get in June, why wouldn't fiscal '06 reach those peak margins?

Do the fees-for-service ramp up or is there some other variable there that it would take a couple of years?

First of all, I don't think I've changed my -- what we've said before.

We said the majority would be done by April and now I'm saying the vast majority or substantially all, and I've given this 85 percent target, will be done as we enter the new year.

So I have not changed the time frame at all.

We're in the same time frame, our people have the same dates.

I would tell you every week, they've got the list and they know who they need to complete by week.

They come back and say, I didn't get this one done this week, we're going to -- we think we're about there, but we've got the same problems as the rest of the world, which is there are lawyers that have to look at all this stuff and so that sometimes takes longer, but we are marching to a deadline, and we're not the slightest bit casual about that.

With regard to the margins, and we believe that over time that our fee-for-service margins will rise, and in some of our agreements, that is already being reflected.

So that is one of the reasons why we expect that the fee-for-service margin -- that's one of the reasons why we expect our return on sales in that area to rise and not be -- and certainly not peak in '06.

Next question.

Your next question comes from Larry Marsh with Lehman Brothers.

Thanks, Bob.

Yes, just a comment on PTS.

Let's see.

It doesn't sound like you're going to get -- we're going to get regulatory resolution in Puerto Rico this month.

I'm curious, is that still something you hope to get any month now?

And is -- is there going to be any sense of product line rationalization under Joe Papa, is that one of his mandates as he goes forward?

And if you could elaborate on that, that would be great.

Thanks.

Okay, Larry.

I'll ask George to take that on.

Larry, the -- I can't get into specific comments about what's going on in Humacao, our discussions with the FDA, but we are working with them, we know what we have to do.

There's a program in place.

There are people that are working against that program, and we've made the decision that we're going to follow that through to successful completion, and we expect that to be soon.

It's hard to make a prediction if it's this week or next month, but we're -- we're optimistic about it because of our commitment to it.

The reason why we remain committed to it is because we have, and continue to have, strong consumer -- customer interest in what we have there, and that will come into place once all the regulatory matters are satisfactorily addressed.

In terms of Joe Papa's focus, his most immediate focus is around the capacity utilization and sterile opportunity.

At the same time, as we go into fiscal-year '06, Joe has taken a fresh look at all of our offering and with particular emphasis on how we can market it better and also to address some of the businesses that we know can continue to improve.

We're looking at our Pharmaceutical and Development business and understanding how we can continue to improve its support of our existing technologies.

We're looking at healthcare marketing services, trying to understand where we can take that going forward to address its opportunity.

And given his marketing skill coming from the pharmaceutical side, he can be particularly valuable there.

So that's what Joe's focus is today going forward.

Next question.

Your next question comes from Eric Coldwell with Robert Baird.

Thanks a lot.

I think we're all going to be sitting here the rest of the day trying to figure out what the first half of the year really was that would get us to the second half of the year number of 320 to 340 and we're probably going to all come up with a different conclusion.

Can you just tell us what you're using as your imputed number the first half of fiscal '05 so we know what the delta is in fiscal -- the second half of the year?

Thanks.

Is your question that what are the items -- or what is our number that we're using to try and -- for one-time items and restructured items in the first half, that then leaves our -- what our expected adjustment is for second half, to in order to achieve this range of 3.20 to 3.40?

Is that the question?

Yes, just to walk it across.

First of all, we -- I think when you look at that one chart that I took some pains to walk through, that comes down to $0.10 for the second quarter, it comes down to $0.7 for the first quarter, total of $0.17, you'll need to go back and do the -- the addition/subtraction, whichever way you want to work it.

But I think you'll probably come to a conclusion that the Q2 number on an adjusted basis is about $0.73 a share, the Q1 number on an adjusted basis, $0.62 a share, and for the first half, $1.35.

So I think, all of you can add and subtract real well, and I think that's -- that's the kind of number that I would expect you to come to, and if for any reason you're not coming to that, talk to Jim, and he'll take you through it.

We're going to take one more question, but just before we do, I want to make a comment about fee-for-service and the complexity of all these negotiations and why you don't just -- there aren't just standard forms you roll out.

Each manufacturer is being treated individually, or as an individual negotiation because their product line is unique to them and they have different objectives as to how they may want to compensate you and so we are in discussions that are unique with each one of them.

Now, the principals under which we operate is that while we're willing to be paid in different ways and have -- we're not willing to have any manufacturer travel through our distribution channel in a less fair -- at a less fair cost than other manufacturers.

In other words, there should be a fair -- everybody should pay their fair share.

And the second thing is, is all of the -- all of them have to give us essentially the same kind of return, net returns on capital.

And so that means each one of these is a unique negotiation, and so when I made a reference to legal contracts and the requirements is, those all have to be documented, we just don't send out 1 standard form.

But we're making good process with it and we're on the time frame we talked about.

Last question.

Your last question comes from Cecil Godman with Highland Capital Management.

Yes, Bob, thank you.

I just wanted to go through, in the press release and make sure I understand what you're saying from this is that in the discussion for '06, you talked about the goal, the long-term goals, but you talked about fiscal '05 being substantially above your longer-term goals of mid to upper teens.

And later on you -- in the next sentence you say that your confidence behind that is the vendor margins, in the PTPS.

Does that mean that the other businesses don't have to get get fixed totally for you to achieve that because we're going to see such strong rebounds in there with what you put in place, or are you assuming the others get fixed in that period of time?

I'm -- you used the word '05, guidance for '05.

Were you talking about guidance for '06?

If I said that, I apologize.

Okay.

Well, I don't know what your -- well, I think -- look, I outlined what I thought some of the uncertainties were in my talk and the ones that we were -- and the plans were in place to overcome some of these, the things we've been faced this year.

And we cited things like the Pharmaceutical Distribution business model, we talked about Pyxis, we talked about sterile, and those are 3 significant things that we are confident we're making terrific progress and those are important contributors.

Obviously, we can't let other things deteriorate.

And I also was trying to say to you is, we have a lot of other good businesses that we just don't talk about needing to be fixed because they're fixed, or they're operating well, but they have opportunities, upsides, too.

So I was merely just citing 3 areas that I thought were particularly important, but I wasn't excluding other things that we're working on, but -- so hopefully that answers your question.

Okay.

We're going to wrap up.

This is a little bit longer than we normally go.

I appreciate everybody listening in.

Just to recap, I want everybody to understand that we've got great optimism as we move forward here.

We're dealing with the same 3 issues.

They're coming to resolution.

We're making good progress.

Historically, Cardinal has been characterized by high growth, high returns and predictability.

I'm going to see that we get the predictability back and the whole management team is committed to it, understands why we've -- we've had less predictability over these last several quarters and we're dealing with that.

We believe we'll be back with both high-growth, high returns, and also with predictability in the future.

So we look forward to moving through the second half and into, as I said in my call, mine is racing towards what we want to see us put in place for -- or the building blocks in place for '06 and we're confident about getting that done as we move to finish up our fiscal year.

We'll look forward to talking to you at the end of next call -- or next quarter.

Thank you.

This concludes today's conference call.

You may now disconnect.