卡地納健康 (CAH) 2005 Q3 法說會逐字稿

Good morning.

My nane is James and I will be your conference facilitator today.

At this time, I would like to welcome everyone to the Cardinal Health fiscal year '05 third 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 one on your telephone keypad.

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

Thank you.

Mr. Hinrichs, you may begin your conference.

Thank you, James.

Good morning and welcome to everyone to our Cardinal Health's fiscal 2005 third quarter earnings release call.

Our remarks today will be focussed on the company's consolidated and business segment results for the quarter and for the year-to-date.

Those items are included and those tables are included in the press release that we sent out and the attached financial tables.

If you don't have a copy of our earnings release or the financial attachment, you may access it over the internet on our Investor Relations page at www.cardinal.com.

In addition, there are a handful of slides that we'll be reviewing and those can also be found on the website.

Speaking on our call today will be Bob Walter, Chairman and CEO, George Fotiades, President and COO, and Mike Losh, the Chief Financial Officer.

After their formal remarks, we'll open up the phone lines for your questions.

As always, when we get to the question-and-answer period, we ask that you limit yourself to one 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.

Those 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, form 10-Q reports, including all amendments to those reports and 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 are posted on our Investor Relations at www.cardinal.com.

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

Bob.

Good morning, I have been looking forward to this call for two simple reasons.

First of all, our Q3 performance was better than in recent quarters, certainly on a sequential basis, and in comparison to prior year quarters.

Secondly is because this quarter was relatively uncomplicated, that relative to prior quarters, and it allows us an opportunity to focus more on a discussion of operations and more time for questions and answers at the end.

Regarding the performance in our third quarter, it was led by much better results in our pharmaceutical distribution business.

In fact, I expect that Cardinal's results in its pharmaceutical distribution business will be substantially better than the rest of the industries on an apples-for-apples comparison.

So, this is a positive indicator for '06.

I structured this call to allow more time for George to discussion operations and more time at the end for Q&A.

I will make a few comments followed by George and then Mike Losh will have just a few clarifying financial comments.

Incidentally, this is Mike's last call as the interim Chief Financial Officer.

Jeff Henderson will officially take the rein by mid-month in May and be available for the analyst meeting in June.

He's already on board and absorbing quite quickly.

So, Mike, thanks for coming to the rescue and for your talent and dedication and for your incredible hard work.

You have been great.

So, affective May 15, Mike moves back into his role as an Independent Director of Cardinal and Jim or Jeff, welcome on board.

I have three brief comments.

First, we are very operationally focused at Cardinal.

As you know, there have been three large challenges facing us all year long.

Pharmaceutical distribution model change and the poor performance or execution in both Pyxis and sterile operation.

The results in these areas have been substantially below our expectations and certainly more volatile than is tolerable.

We have done a poor job of calling the depth of the problems or challenges in the time required to rectify.

The good news is that we have confidence that we have identified the issues and the resolutions in timing, so all three of these will be better in FY '06 in growth and predictability.

The other operations, which is about 50% of our operating earnings, while there is pluses and minuses, relatively they have met our expectations.

And so they're generally in line.

So, we're setting ourselves up for a positive FY '06 with momentum in each segment.

My second comment is about our cash and capital position.

So the comment is our returns on capital are improving and capital required to support our operations are declining.

So cash flow is strong, it's growing and it's predictable.

We should expect about $1.5 billion or greater of free cash flow as we move forward.

I would remind you at the end of the quarter we had 1.5 billion in cash, that's after stock buyback over the last 18 months of 1.7 billion, after a cash purchase of $2 billion for Alaris in July of last year and with no increase in absolute debt in the same time period.

So, therefore, as our goal is not to de-lever this company and since we start out with strong cash balances and future cash flow that will be strong, we can conclude that there will be plenty of capital for incremental, internal and external investments, and for returning capital to shareholders.

But do not expect any substantial acquisitions in the near-term as we're very focussed on getting operations right.

My third comment relates to strategy.

It's fine, we're focused on healthcare, focused on developing and maintaining leading market positions, products and services, and creating unique solutions by combining this unparalleled breath.

So, let me turn this over to George and Mike.

But about '06, there is no change in what we have been saying recently about earnings growth substantially above mid-teen.

Remember that we are in the middle stages of completing our FY '06 planning and budgeting process.

By the analyst meeting in June 8th, we will be in a position to be much more definitive and detailed about next year.

Let me turn this over to George.

Thanks, Bob.

Before discussing the segments in detail, our summary analysis of the overall financial results is that pharmaceutical distribution and provider services was a bit stronger than expected.

Medical Products and Services was right about where we expected and the Clinical Technologies and Pharmaceutical Technologies and Services results continue to lag due to slower than expected improvements at Pyxis and sterile manufacturing.

Importantly, we're making progress on each of the three key operating issues that we have been discussing for the last six months, vendor margin conversion to non-contingent compensation, sterile manufacturing execution and Pyxis performance.

However, we didn't call the bottom of these issues with precision.

While the handoff from buy and hold to fee for service is progressing well, it has taken longer and has been more volatile than we initially hoped.

And additionally, the improvements at Pyxis and sterile are taking longer to realize than we originally thought.

We believe that the operating improvements at PTS and CTS will improve their results sequentially in the fourth quarter.

So as we enter 2006, we expect to be operating in a much improved fashion across all segments.

Let me turn and talk about each of the segments in detail.

PDPS, as you heard us say previously, operationally this segment is performing well.

All lines of the P&L except one, which is branded vendor margin, are doing great.

Our distribution margins are highest in the industry, and we have achieved this advantage by substantially better cost structure, stronger vendor margin and disciplined customer pricing.

Looking at the results, revenues were up 18%, a reflection of our customer mix and a continued trend to push more large-chain business through our distribution system.

As one example, we have a pilot program in place to convert a portion of a large warehousing customer's business from their own internal logistics system to distribution by Cardinal Health.

Generic profitability continues to be strong.

Our generic profits were up very significantly for the quarter, driven by strong revenues, good margin improvement and new generic product launches.

Expenses continue their positive trend, declining as a percentage of sales.

Our past investment in larger, more automated distribution centers has helped drive expenses in this segment to below 1.2% of sales, the lowest in the industry and in our history.

And finally, selling margin continues to be stable.

It's down only 5 basis points versus last year, and ahead of this year's plan with no significant customer repricings this quarter.

So, as we have said in the recent past, it's all about branded vendor margin that is causing challenges in this segment, which lead to the question how are we doing in the conversion of the branded margin from contingent to the non-contingent basis?

Before I describe where we are, I want to first define what we are measuring.

Our overall goal is to convert the substantial majority of branded vendor margin to a non-contingent basis.

Specifically, the metric we use to gauge our success is the percent of our forecasted branded vendor margin for fiscal year 2006 that is not contingent on price inflation.

This measure is important because we believe it's the best indicator of how well we will be able to predict our branded vendor margin next year.

If the substantial majority of it is non-contingent, then if we can forecast revenues we'll be able to forecast profitability.

The way we calculate the metric is very straightforward.

We add up our forecasted non-contingent vendor margins, which is based on contracts that we have already signed over(ph) a verbal agreement has been reached and then we divide that amount by our total forecasted branded vendor margin for fiscal year 2006.

This then gives us the percent of total branded vendor margin that we expect to be non-contingent next year.

The important thing is that the type of contract is irrelevant.

Whether it's pure feed, hybrid, guaranteed price because in the calculation we're only including the portion of each contract's margin that is not contingent on product price inflation.

We track the calculation closely and at this point, we do have agreements, either signed or in contracting, that convert the majority of our fiscal year 2006 branded vendor margin to a non-contingent basis, which also puts us well beyond halfway to our July 1st target of converting the substantial majority.

This is an important milestone for us.

The pharmaceutical distribution team has worked tirelessly on this effort and I want to acknowledge the leadership of these dedicated employees who are making this a reality for us.

I'm looking forward for PDPS to fiscal year '06, the future is definitely getting brighter and more visible.

We expect continued strong revenue growth, continued strong generic drug performance, more expense efficiencies, predictable branded vendor margin and rising returns on capital.

Now to Medical Products and Services.

They continue to be our steadiest performer, coming in right where we expected.

Their results show continued balanced improvement as they make the turn back to growth.

Driving this improvement were our distribution business, which continues to form -- perform very well across all customer segments and our new private label expansion continues to drive profitable growth.

This is partially offset by what is still a competitive pricing environment and slowing revenue growth as we lap the big distribution contract wins from last year.

On the manufacturing side, we have lapped or are lapping a number of fiscal year 2004 contract repricings, which will improve the comparables.

New products and medical specialties and surgeon's gloves continue to do very well, which are up 60% versus last year and are expected to improve our margins.

International sales and profit growth, helped by a strong Euro, were a very meaningful contributor and cost containment work, primarily facility and plant consolidations is now starting to take hold and be seen in the results.

Finally, our sourcing initiatives, being managed out of our new Singapore offices, are starting to bear fruit.

Looking ahead at MPS, nothing much is expected to change from our earlier assessment of continued improved performance.

All the areas that I just described are driving improvement in the third quarter and are expected to continue to improve results as we go forward into fiscal year '06.

PTS.

PTS is made up of several businesses.

The two largest, Oral Technologies and Nuclear Pharmacy are about two-thirds of PTS earnings, continue to perform in line with expectations.

Oral Technologies continued its solid performance this year behind several of our mainstay softgel and Zydis fast dissolve products.

And Nuclear Pharmacy showed solid top-line growth and saw good sequential improvement in margins despite the current competitive pricing environment.

These two businesses will be solid contributors to Q4 performance.

In PTS the story continues to be largely about the performance of the sterile manufacturing operations, which has driven the majority of the earnings this year.

At the start of fiscal year '05, we expected Sterile to be about 20% of PTS earnings.

Now, we forecast it will end up in the mid single-digits for the year.

For those that aren't familiar with the PTS Sterile business, it is comprised of a Blow/Fill/Seal facility in Woodstock, Illinois, a sterile liquid facility in Albuquerque, a companion facility in Albuquerque and Raleigh, which is scheduled to open in late fiscal year 2006, and their operation in Humacao, Puerto Rico, which has a small base of existing products and sterile capabilities that are not yet in operation.

Obviously, the big story is our decision to discontinue operations at the manufacturing plant in Humacao.

We have already begun working with customers in an effort to transition the few products we have there to other sites.

This was a very difficult decision, but in the end, I believe it's the right one.

Humacao has been an underperforming plant for quite sometime, in terms of both business performance, as well as the regulatory issues that we have been talking about.

Because of these issues, the plant has been operating below capacity and losing $5 million a quarter.

More importantly, it has been consuming significant senior operating resources in our quality and sterile manufacturing areas.

This decision does not affect any of our other operations in Puerto Rico or any of our other manufacturing plants around the world.

On the positive side, Albuquerque's sterile manufacturing productivity improved dramatically in the third quarter.

Demand for the products produced there continue to be robust.

Current projections indicate that we'll produce 50% more lots of Albuquerque's largest product in the second half of fiscal 2005 versus the first half.

Based on this higher through-put, March was the best month ever for the Albuquerque site.

And we're soon going to begin an upgrade to expand the liquid filling capacity, so we remain positive about the future contribution of Albuquerque.

Woodstock Blow/Fill/Seal operation, which has historically been a strong performer, has suffered this year from the volume reduction in a major branded product.

But the pipeline is promising.

We've got great capability, so we expect this business to continue to improve.

Looking forward for PTS, the big drivers will be improving our sterile operations as well as a major focus on operational excellence at our key PTS operations.

Demand remains very strong for Albuquerque and Woodstock, which is why we're so keen to focus our resources here and at our new Raleigh facility.

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

There is much more to talk about in PTS than we can possibly fit into this call, but we'll be covering PTS in more detail at our analyst meeting on June 8th, where our new leader of this segment, Joseph Papa, will give you a full update.

Now to CTS.

The Clinical Technologies and Services segment is comprised of Alaris, our consulting business and Pyxis.

First and foremost, Alaris is performing to our expectations.

The base business, pumps and disposables in the U.S. and international markets, is meeting our growth targets and the synergies we envisioned are real and being achieved.

Alaris continues to be the innovator in the industry and our Medley Medication Safety System sets the industry standard for clinical best practices in medication management.

The second arm of the CTS businesses, Clinical Services and Consulting, our contract pharmacy management and consulting business, performed in line with our expectations.

This business is becoming an important enabler of the CTS strategy to provide comprehensive medication management solutions to help hospitals improve clinical and operational performance.

Pyxis remains the challenge for CTS.

Third quarter for Pyxis was actually a bit weaker than the second, but at this point we believe the business has bottomed and will start improving from here.

Pyxis is a turnaround situation.

It has a variety of issues, all of which have been identified and are aggressively being worked on.

In the short-term, our new management team is working to improve operating and installation efficiency.

However, over the long-term, we know we need a much bigger focus on new product innovation, beyond our traditional medication and supply station products.

We know that hospitals will spend capital on products that improve operating efficiency and patient outcomes.

And we know that quality and greater functionality will command a premium price from our customers.

In fact, we essentially built the entire automation market around these premises, but we must continue to innovate to maintain our leadership position.

We are approaching this innovation from a market position of strength.

Pyxis and Alares have the largest installed base by a long way in this market.

But in order for us to really regain our luster, we need to innovate new solutions that will expand on the strength and the high visibility that we already have in the hospital with each of CTS's three individual businesses.

Dave Schlotterbeck, Dwight Winstead, and the entire CTS team are driving the integration of Pyxis, Alaris, and Clinical Services and Consulting and are working hard to create more potent offerings round the clinician practices and patient-safety.

And this will also be a focal point at our June 8th analyst conference.

Looking forward for CTS, we expect to see continued sequential improvement as Alaris and Clinical Services and Consulting continue their solid performance, and as Pyxis makes progress on its operating issues.

Further penetration of the new MedStation 3000, improvements in our installation process and better efficiency through aggressive cost reduction should drive sequential improvements in the fourth quarter and a return to growth in fiscal year '06.

Beyond that, we have a number of compelling new products and solutions that we're working on for launch in fiscal year '06 and '07 that will refuel long-term growth in this segment.

Before concluding, I want to provide a brief update on our One Cardinal Health program.

We continue to make excellent progress.

This is a comprehensive effort designed to strengthen our operating effectiveness both internally and around the customer, yielding over 500 million in annual savings benefit by the end of fiscal year 2008.

Over the last six months, we have created plans and work teams that are executing in the following areas -- The creation of a shared services organization; an expansion in our strategic sourcing capabilities; adoption of lean manufacturing in Six Sigma across our major manufacturing and assembly operations; and integrated logistics opportunities between our drug and medical/surgical distribution operations.

The effort also includes new approaches to our customer-facing resources at the hospital and in PTS, which are being rolled out in fiscal year 2006.

In summary, we're seeing signs of operational progress, which will become more visible as we enter fiscal year 2006.

It's not about strategy.

We like how we were positioned.

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

We're making the right discussions to improve results for the long-term.

We've got the right people in place to execute on our strategies.

And we look forward to talking to you about them in June.

I will now turn this over to Mike.

Thank you, George.

From a financial reporting perspective, the results for the most part stand on their own.

I do want to provide a quick overview of some of the highlights.

As I have done in past quarters, we have webcast some slides to you.

I will actually refer to those and, in fact, the first sheet that I'm going to talk about is what is in that package as page 4, which is the Q3 recap.

Looking at the Q3 results, just a reminder that my comments primarily are related to financial results from continuing operations and excludes special items.

I'll detail the special items for you at the end of the discussion.

When you look at the quarter, revenues were up 17% to 19.1 billion.

As all of you know, that number includes bulk revenues from pharmaceutical distribution and bulk revenues in the quarter were $6.2 billion this year and that compares with $4.4 billion in the third quarter of last year.

Operating earnings were down 7% to $628 million.

These results are consistent with the expectations that we have talked with you about of having improved results in the second half of our fiscal year compared with the first.

Just to remind you and put that in context, the down 7% in this quarter for operating earnings compares with numbers that were down 26% and 27% in the first and second quarters respectively.

Also, I know as soon as this call's over, all of you will start to look forward to the fourth quarter.

One thing that I just want to give you a heads-up on now, because many of you have different models, treat taxes differently as you work your way through to EPS, but one thing to keep in mind is that our fourth quarter tax rate last year, at the end of '04, was unusually low at 29.3%.

We don't expect that to happen this year in general.

This year's fourth quarter tax rate should be very similar to what our year-to-date rate has been, which has been about 32.5%.

Walking on down the income statement, interest expense increased during the period primarily due to increases in borrowing rates.

And I'm sure that comes as no surprise to any of you looking at what has happened with short-term rates during this period of time.

In part as a result, net earnings for the quarter declined 9% to $396 million and those delivered diluted earnings per share of $0.90 a share.

Please note that this figure includes the adverse impact of impairment charges and other non-recurring charges.

The net impact of these items serve to reduce earnings per share by about $0.04 a share and, again, I'll give you some detail on that in just a minute.

You heard Bob touch on it and certainly cash flow for the quarter was strong, delivering $532 million of operating cash flow and $460 million of free cash flow.

Year-to-date operating cash flow has been 2.1 billion and free cash flow, 1.7 billion.

Just a reminder, those year-to-date numbers include the net proceeds of $800 million of accounts receivable securitization that took place earlier in the year.

And in that vein, one of the things that's happened since the end of the quarter is actually we have paid down $250 million of that receivable facility.

We actually did that this week.

Also, as you know, we have been using cash to buyback shares.

As you saw in the materials, if you have had a chance to go through it, by the end of the quarter we had purchased $242 million worth of stock under that existing $500 million authorization that we have.

That has continued and by close of business today, we will have purchased about another 96 million or 338 million in total.

The next page that I want to call your attention to is really page 5 in the package.

It talks about the non-recurring charges.

And I just want to spend a few minutes helping you understand what is in those.

The first item is impairment charges and others, that totaled 16.2 million for the quarter.

These charges primarily consist of asset impairments related to the reduction in the value of certain assets in the packaging services business and the write-off of a particular corporate IT system.

That decision has been made.

We're not going to go forward and put that into full implementation and we're going to write-off the capitalized amount of that.

Other non-recurring items include an inventory evaluation adjustment of $7.2 million and this is part of the SKU rationalization within Pharmaceutical Distributions related to health and beauty products.

And just to remind you, this amount is included in the cost-of-goods sold in the income statement.

In total, these items decreased net earnings by 15.8 million during the third quarter and, when you look at the comparable non-recurring charges for the year-to-date, they are 88.4 million.

As a result, earnings for the share were reduced by the $0.04 per share that I motioned a minute ago and for the nine-month period, the impact is unfavorable to the tune of $0.20 a share.

Starting on page 6 in the package, just to quickly run through some of the highlights for the businesses.

With regard to pharmaceutical distribution and provider services, revenues were up 18% and operating earnings were up 8%.

As I mentioned, included within this segment is the adverse impact of the SKU rationalization.

One thing I think you are probably interested in, I'll answer this so nobody has to ask the question, there was no LIFO charge in the quarter and as we look at the full year, we would expect minimal, if any, LIFO adjustment for the full fiscal year.

The next page talks about medical products and services, page 7.

Revenues were up 7%, operating earnings up 3% compared with last year.

This has been the steadiest performer of our businesses.

Certainly they're dealing with cost pressures, but they do continue to show sequential improvement.

Page 8 has a few remarks on pharmaceutical technologies and services, revenues were up 3% but, unfortunately, operating earnings were down 28%.

George has pretty much given you the whys and wherefores there and, certainly, you are going to hear more when we have our analysts get together in June.

With regard to Clinical Technologies and Services, revenues were up 32%, but operating earnings were down 25%.

Alaris has positively impacted the segment's revenues and earnings, but it's Pyxis that has been the cause of the earnings decline on a year-to-year basis.

Just one small thing to remind you of.

We made the decision earlier in the year to stop recording the benefit in this segment of interest income on leases sold to third parties.

This has an impact on the year-to-year comparison because in last year's results, there was a favorable earnings impact of $6 million and that isn't there this year.

There is one other aspect of Pyxis that I want to talk with you about for a minute.

During the quarter, the new Pyxis management team went through a very detailed analysis of both their total backlog and their committed contract situation.

As a result of this review, they have removed from the second and third quarter backlog numbers for all contracts that are anticipated to be implemented beyond the end of our fiscal year 2006.

And essentially, what that's doing is it's setting a higher standard on what constitutes something that's in the backlog.

Those contracts may well turn out to be good contracts, but it's just we're taking a more restrictive view on what we consider to be in our near-term backlog.

The other thing is as you go through Pyxis on a quarter-by-quarter basis, there have always been contracts that have been modified as you go forward through time.

Past practice has been to make those adjustments in terms of their impact on backlog after the end of the quarter.

During this quarter we have switched and we now make those adjustments within the quarter.

The end result of both of these changes is that we ended the third quarter backlog -- or ended the third quarter with a backlog of $191 million and that represents a 6% increase over the prior quarter, which would have ended at the $181 million defined in a similar way.

Now, just to remind you, when we previously reported a backlog number for you, it was reported as $206 million, corresponding to that $181 million.

But we're viewing this with a tougher definition, higher hurdle to put something in backlog, so I wanted to make you aware of that.

But then I think the important takeaway is that Pyxis is on the right kind of trend and their backlog is increasing.

The last thing that I want to talk about is on page 10 in the material that was sent to you.

And that's simply a run-down of the items that are in special items.

And specifically for the quarter, there was $25.8 million of restructuring, there were $10.4 million of merger costs and there were -- continued to be $7.1 million of legal fees and other costs associated with the SEC investigation and the audit committee's internal review and related matters.

Just in closing, over the coming weeks I'll complete my transition and hand everything over to Jeff.

He's on board, fully engaged and we're going to do everything we can to make that go smoothly.

I am very pleased that Jeff is coming to Cardinal.

I'd also like to say that I've enjoyed working with all of you during this past almost year that it's been.

This is my fourth quarter of doing things.

And I very much look to returning to the board here at Cardinal.

The past 10 months has been both very satisfying and gratifying and I'm really pleased to leave at the last of these sessions on what I consider to be an up note, with some pretty positive results for the quarter.

And with that, I will turn things back to Bob.

Okay, we can open it up for questions.

And if I just remind you just if you could, whatever way do you, please try and restrict it to one question so that we can move through this and have time for everybody.

First question, please.

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

We will pause for just a moment to compile the Q&A roster.

Your first question comes from the line of Andy Speller with A.G. Edwards.

Thanks, guys.

Good morning.

I was hoping to get some color around the, hopefully the amount of sequential improvement we're going to see, especially at PTS and CTS.

How long's it going to take us to get back to more historical type margins or is it going to be more of a stairstep type improvement on a sequential basis?

I think it's going to be a gradual, sequential improvement.

I think you will start, as I mentioned, you'll start to see it in both of those businesses in Q4.

Each of them has, obviously, a different set of factors that are driving sequential improvement.

Pyxis' will be driven by a lot of focus on its gross margins and its cost through fiscal year '06 and the new MedStation 3000 product.

PTS will be driven, as I said, largely by the sterile business and a continued improvement in just efficiencies around PTS.

Without getting into specific numbers for the fourth quarter, what our forecast is, I can just say it will improve and I expect sequentially in each quarter as we move into fiscal year 2006 or through 2006.

And then along that same line for Mike, in terms of just interest cost, is there going to be a big change in terms of the capital structure with regard to interest expense?

No, there won't be a big change.

I think you heard Bob give an overview that we're not looking to de-lever the company.

I mean one of the things that has actually happened is we have had a tendency to do that in the course of this year because equity has gone up as we have generated retained earnings.

Debt has been relatively flat.

We do have some pieces of debt that mature in the near-term.

We're currently looking right now at what makes sense in terms of replacing that debt that is maturing.

But I think what you should expect from is near-term is approximately the same amount of debt outstanding as was the case a year ago.

I mean there is some fluctuation.

We're -- we were actually up a little bit at the end of the third quarter this year verses a year earlier.

What you're seeing is the biggest drivers of increased interest expense are the fact that rate is up and also, in some cases, we've got an income statement geography change whereas we've got some things that used to be on synthetic leases, where there were lease payments that showed up in -- up higher in the balance sheet.

That's now replaced in some cases by interest that is on -- excuse me, I said balance sheet, I meant income statement -- that is being -- used to show up as lease payments, now showing up as interest expense.

So that's -- and there is no real economic difference there.

It's just a difference in geography.

Okay, thanks.

Okay, can we restrict the next question to just one question, please.

Your next question comes from the line of John Kreger with William Blair.

Hi, thanks.

My one question, Bob, is can you talk about the pharma distribution growth rate?

It looks like you were able to grow that business by about double the market.

What is allowing you to do that and do we need to worry at all about any margin impact of bulk growing faster than the non-bulk revenue?

I'll let George make some comments, but, first of all, bulk revenue has its own different characteristics and economics, which, while it may have a lower return on sales, it has a very acceptable, other economics in terms of return on capital.

We do receive fee-for-services on -- on these products also.

I would also remind you that our total return, which is substantially above the industry's return on sales, includes that return on bulk, which is lower and includes the growth that we have seen there.

With regard to the growth in the other segments, we do have a skew towards chains and so that's -- and they're growing faster than the overall segment itself.

So that's positive to us.

The second thing is we've got a strong presence in the [Inaudible] hospital market, but not only in pharmaceutical in terms of the breadth of our other offerings and we think that gives us the strength in terms of a broader offering.

Our objective is not to steal markets -- gain market share clearly on price, but it's based on value and the breadth.

I think those are some of the dynamics.

George, anything you want to add to that?

No, Bob.

The only other comment is that Genaris[ph] contributed to that, although less so than your comments around chain and the health systems growth.

Okay.

Thanks, John.

Next question.

Your next question comes from the line of Andrew Weinberger with Bear Stearns.

Just also want to spend a quick minute on top-line growth in that pilot program you have with one of your chains.

Andy, what is the question about it?

-- were both dis(ph) store door as rates go up and self-warehousing costs increase.

Andy, you will have to repeat it because at this end, we lost your question.

All we heard was something about the pilot program.

I just wanted to understand if your customers are saying that as interest rates go up, is self-warehousing becoming a less attractive practice for your customers?

I guess the answer to that is when we describe it as self-warehousing, we really restricting that description predominantly to warehousing chains, because the rest of the industry doesn't have the capability, because their sites are so fragmented, and doesn't have the capability to warehouse.

So we're dealing with warehousing chains, which is just a subset of all of our customers.

And what we're finding here is that there are -- we continue to find that there are opportunities where the chain can leverage their internal logistical capabilities with ours and using more of ours and actually achieve more efficiencies.

So, with regard to the pilot project, which actually is fairly meaningful, I don't want to get into a description of that and what we're doing because -- for competitive reasons.

It's really all about we can deliver a more efficient logistical solution on certain of the products or to certain of the stores, more effectively than the chain itself can.

That's a, I think, a continual trend.

That doesn't mean it's for all products, but certainly it's a positive thing for us.

Great, thanks.

The next question.

Your next question comes from the line of Christopher McFadden with Goldman Sachs.

Thank you and good morning.

You talked about, in your prepared comments, that half or so of your branded volume was now covered under non-contingent agreements.

Directionally, could you comment on what the earnings and margin profile of the distribution business will look like based on the pricing embedded in those agreements compared to what we have seen over the last, call it, six months or so?

Just trying to understand directionally how much margin improvement these agreements, as they're being consummated, are likely going to mean to your Athlow(ph) 6 performance.

Thanks.

Okay, Chris, good morning.

I'll take a shot at this.

It's a very complicated -- it's a straightforward question but it's a really complicated answer.

Let me see if I can lay out some of the factors here.

First of all, because of the seasonality of when we made profits, seasonality during quarters, when we made profits from a buy-and-hold model to the non-seasonality and predictability of a fee-for-service, you're going to get variations in comparing this year's performance with '04s.

So you've got a quarterly difference.

The second thing that I would say to you is that at a recent conference, I reminded everyone that since '03 we will have taken out of our investment and inventory about 12 days, between 19 -- between fiscal '03, this is pharmaceutical distribution inventory, and so moving from one model to the other, we will have taken out about 12 days and at current sales volume, that amounts to about $2 billion in lower investment.

Using our weighed cost-to-capital on that 2 billion of less inventory, there is about 200 -- that means we need to make about $270 million less margin or across the current sales that's about 45 basis points.

Therefore, if you try and look at the comparable profitability and you have a less investment in one than you do -- in a fee-for-service than in a buy-and-hold, we need about 45 less days.

Now, let me shift to the next point, which is we have said -- George has reported where we are in terms of moving towards a fee-for-service.

We've talked before -- that is non-contingent.

We've talked before about moving to a substantial majority of our margin on a fee-for-service basis as we enter '06.

Having said those things, looking at where we are and where current negotiations are and our expectation is with remaining pharma manufacturers.

Our goal remains as to achieve a return on sales in excess of a 2% -- 2% return on sales, total sales.

That's with about 35 less days investment on hand.

That is our longer-term goal.

We will not be there in '06.

We do expect, though, to continue to drive towards that goal as we move out of '06 into '07.

Our goal -- we're not -- we haven't declared yet where we think we will be for '06.

We're in the -- we're looking at our -- we're in the final budget process but what our longer term goal is and that's probably the best way I can answer it for you right now.

Thank you.

Next question.

Your next question comes from the line of Lawrence Marsh with Lehman Brothers.

Okay, Pyxis is my question, Bob.

Maybe if you could just address and elaborate a little bit, I think, George, you mentioned that Pyxis had taken a bit of a step back this quarter.

Looks like sales were clearly down sequentially despite the introduction of the MedStation 3000.

Is this just a more conservative view of the market?

Is this just a timing issue.

And I know Dwight and Dave will talk a little bit more about this, but is the goal here to continue to really ramp up new product introductions or cut the current product line or both?

Larry, I would say all of the above.

There're several things going on in Pyxis now.

First, you've got a restructuring of the organization including the management team over the past few months.

You have a restructuring of the installation group over the past few weeks.

And so that's taking -- that takes time to get that -- to get that done right.

The MedStation 3000 product, which is a good product, is one that we got a late start to.

The acceptance is starting to pick up.

It's probably about a third today of our MedStation sales and continuing to increase.

We have said that we've got too many products in our portfolio and that we need to trim those back and become more efficient.

And at the same time we need new product innovation in Pyxis.

We've got a number of good ideas, a lot of them spawned by bringing Alaris and Pyxis and CTS together for a better patient-safety story which is really what's going to be driving their innovation program.

This essentially is a turn around situation at Pyxis.

These are always tough to calibrate.

You're in the midst of this.

But I think today, Dwight and Dave Schlotterbeck have great command of the issues and are putting into place the right things that will improve sequential performance in Pyxis.

The key thing is is we've got a great installed base.

We've got -- we've got good people in place today.

And there is a long-term need at the hospital for these kinds of products.

We just have to get the innovation and execution in place.

Thank you.

Larry, just with regard to your comment about sales being down on a sequential basis.

They're just down slightly and it followed basically the same seasonal pattern as in '04.

There really isn't anything -- there is nothing there particularly to give alarm.

As Mike said, committed contracts were up 6% and George's comment on the installation process.

All right, thanks.

Okay.

Any other questions?

Or next question, I'm sorry..

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

Thank you very much and good morning.

I was wondering if you could talk about the other side of the equation from fee-for-service, which is the sell side margin.

George, I think you made a comment about the fact that they were down just 5% versus last year or maybe 5 basis points versus last year.

What are your expectations going into '06.

Do you anticipate at some point that we should see stabilization there and potentially even improvement on the sell side?

It was 5 basis points, Lisa.

We expect, at least from our end, stabilization.

We are also working hard to be very disciplined in the way we have been approaching pricing.

We're working very hard on how we enforce our contracts.

And so as we -- as we look ahead, we expect there to be -- we expect there to be continued stabilization, much like we have seen emerge through most of this fiscal year.

Lisa, I would view 5 basis points as relatively stable, particularly given some of the mixed changes that are happening at Cardinal.

I think that's a positive sign Cardinal.

Bob, just to elaborate on that.

Would you say -- what would you say are the drivers behind that?

That you out negotiating with your customers or your other two competitors becoming more rational, just so I have a better understanding of that.

I would say for Cardinal, we certainly are very attentive to our pricing.

We -- there is not -- there certainly is less buying margin to essentially give away as -- or as -- yes, it's hard to call it giving away since your customers understand when our margins are up.

So there's less pressure on that.

I would say the industry recognizes the need to build our profitability as an industry and certainly Cardinal does.

There are certain areas where we have actually raised our margins, certain product categories, and I don't want to get too deep into that.

And certain customer areas we're more disciplined at enforcing contracts.

And in contract terms, we have eliminated areas where we think the profitability is inadequate, meaning customers where we think it's really inadequate.

So, I would say there is just for Cardinal, and while we have always felt we priced to value and priced appropriately into profitability, there's -- there is just an heightened awareness that we need to move our margins up.

That the discounting to customers has gone beyond where it should and we intend to stabilize our sell margins and in some areas actually raise our sell margin on certain products and certain customer classes.

Across-the-board.

Another question.

your next question comes from the line of Bob Willoughby with Banc of America.

Good morning.

What Zydis products were actually approved in the quarter and can you speak to the cumulative investment in the Puerto Rican operations that will close?

Will there be a charge in the fourth quarter for that?

Bob, the Zydis products I can't comment on a couple of the ones in particular, but we have a product launch in Japan that is, of an existing product, that has gone extremely well.

The core products in that business that we have got today are Zydis and Claritin.

But this particular one we're referring to is a product launch in Japan.

Puerto Rico, we're not yet in the position, Bob, to characterize the cumulative investment and what the cost treatment may be in the fourth quarter.

We're working on that as we speak and as we've got that information in hand, we will talk about it and certainly by the time we're at the June investor conference.

Okay, can we have -- we have time for one last question.

your final question comes from the line of Tom Galluci with Merrill Lynch.

Good morning, thank you.

Just wondering, George, you spoke about some of the progress of One Cardinal Health.

And I think the release said that you're on track for the 125 million this year of savings and looking for 200 next year.

Can you give us an idea of kind of which segments that skewed towards -- for this year's 125 and next year's 200.

Obviously, CTS and PTS being down sequentially in terms of operating profit.

Is it skewed toward the other segments earlier and those later?

Or can you talk about that a little more?

Well, yes.

If -- it impacts all segments.

I can't really speak to the -- the proportions by segment, but every segment has One Cardinal Health related activity going on.

The other factor that plays into it is that the timing of it is different by segments.

So it's hard to sort of look at each segment in a given quarter and figure out what amount is One Cardinal Health is impacting it.

Some of these were involved short-term efforts, others involve closing of plants that require a much longer lead time in terms of notification, then going through the plan to transition products and then ultimately seeing the benefit of the savings.

This is something you have to view over a -- over a total Cardinal perspective.

And, as I said, in fiscal year 2006 it amounts to a cumulative benefit of 200 million.

But there are other aspects that will extend all the way through, realization through fiscal year 2008.

Okay, thank you.

Thanks for attending the call.

As I said, I was looking forward to this call.

And I expect to be looking forward to the call at the end of our fiscal year with the same positive attitude.

I think there will be good positive momentum as we move into '06 and I look forward to talking with you about it at the time of our analyst call, or the time of the call in July.

We remind everybody we're having an analyst meeting on June 8th, and we expect to cover a lot more of these other details up-front.

Thank you.

Ladies and gentlemen, this concludes today's teleconference.

You may now disconnect.