卡地納健康 (CAH) 2005 Q4 法說會逐字稿

Good morning.

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

At this time I would like to welcome everyone to the fiscal 2005 fourth 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. [OPERATOR INSTRUCTIONS] Thank you.

Mr. Hinrichs, you may begin your conference.

Thank you.

Good morning everyone.

Welcome to Cardinal Health's fiscal 2005 fourth quarter earnings release call.

Our remarks today are focused on the Company's consolidated and segment results for the quarter and the year, which are included in the press release, and the attached financial tables.

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

Additionally there are a handful of slides that will be reviewed today in the call, which can also be found on our website.

Speaking on the call today is Bob Walter, Chairman and CEO, George Fotiades, President and COO, and Jeff Henderson, Executive VP and CFO.

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

And as always, when we get to the questions we ask you limit yourselves to one at a time.

Before we begin please remember 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, include all amendments to those reports, and exhibits to those reports.

They include those listed at the end of today's press release.

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

Statements in this presentation may include adjusted financial measures governed by Reg G. A reconciliation of these measures is posted at the IR 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.

Good morning and thanks for joining us today.

I'd like to start with a few high-level take-aways from this quarter.

First, we did what we said we would do with earnings for the year in the upper half of the range that we gave in early April.

Compared to where we were a year ago, in the beginning of a Pharmaceutical Distribution model change, execution problems in two other segments, and accounting issues that forced to us to delay our earnings release and 10-K filing, we're obviously in a significantly better position today.

Performance continues to get better each quarter and our execution is improving.

However, our performance is still below what we believe to be our potential and what we know we can achieve going forward.

There are still a number of challenges facing the Company.

We know our work is not done, but we have confidence and believe we have better visibility in our forecast for a variety of reasons, which I will discuss in a moment.

We're moving into fiscal '06 with good momentum in most businesses.

Our Clinical Technology area and Pharmaceutical Distribution are particular bright spots.

Medical Products and Services is often overlooked because of its steady performance also continues to do just that.

Perform.

They've done a great job managing through their challenging environment with respect to pricing and commodity costs, and we're counting on them to grow their earnings in FY '06 in-line with their performance over the past five years.

Finally, we made great progress on the accounting issues that we were dealing with over this past year.

We have enhanced new controls and installed a stronger new financial leadership.

We'll provide an update in our 10-K on the specifics of the progress we've made on these matters.

So as I said a moment ago, I feel much better today than a year or even six months ago and for fiscal '06 we have much better visibility to solid earnings growth and strong cash flow.

Our businesses all have strong market positions in a growing healthcare market.

Proper execution and the completed transition to a fee-for-service model in Pharmaceutical Distribution will eliminate the volatility we've experienced in this past year.

We're all working hard to return to the model of growth and predictability that you've expected at Cardinal Health.

Looking at the financial results there are some unusual puts and takes in the fourth quarter which essentially wash.

Jeff will walk you through them in detail.

My comments today will focus on the high level operational progress that we've made in this past year.

As you know in fiscal '05 we've been intensely focused on three important issues that negatively impacted our growth rate and contributed to earnings volatility last year.

They are, first, the Pharmaceutical Distribution business model transition to fee-for-service.

Second, the Pyxis recovery.

And third, execution issues in our sterile manufacturing business.

We've made progress on all three areas and the results are starting to show in two of the three.

First, Pharmaceutical Distribution fee-for-service transition.

The key take-away on this issue is that we have achieved our goal of converting the substantial majority of our branded vendor margin for fiscal '06 to a non-contingent, non-inflationary basis.

I'd like to recognize the tremendous accomplishments of our people in the Pharmaceutical Distribution who over the last two years have led this transition and in the last 12 months have essentially renegotiated with every one of their branded pharmaceutical vendors.

Looking beyond branded vendor margins, all of the other lines in the PD P&L performed very well.

Revenue growth up a very strong 15%, generic earnings grew even faster, sell margins were stable declining only 5 basis points, which was more than offset by SG&A cost reductions of 13 basis points.

Branded vendor margin has been overall restructured to provide a fair return for the services we provide, and will be much more predictable next year, due to our success in converting most of our forecasted branded vendor margin to a non-contingent, non-inflationary basis.

The transition took longer and was more unpredictable than we thought but we persevered and succeeded.

The first year of the transition to fee-for-service is now behind us.

If you remember I said last month that our branded manufactured fees in the aggregate came in about 10 basis points below where we thought we would be at this point.

We intend to continue to work with our branded manufacturers to realize higher margins as we fully achieve the performance incentives in some of our manufacturer contracts, and demonstrate more value to other manufacturers.

We're optimistic that branded vendor margins can rise over time for two reasons.

First, a number of contracts have built-in escalators in their fees.

Second, we expect to convince some manufacturers where we chose to have shorter term contracts to pay more for the value they are receiving.

We do not expect to negotiate lower fees for any manufacturer as we renew annual agreements.

Our price is based on the value we know we provide relative to the next best alternative.

Frankly, this is one of the major positives for this past year in Pharmaceutical Distribution.

It is the validation of the distribution system via the prime vendor model as the best most efficient way to get pharmaceuticals to market.

If that were not the case, some other method or alternative would certainly have come forth during the past year as a better alternative for the manufacturers to get to the market.

This was well tested over this past year.

The second area is Pyxis recovery.

The progress that Dave Schlotterbeck and Dwight Winstead have made in turning around Pyxis is now beginning to be seen in the results.

They created a new management team and have done some of the basic blocking and tackling work that's needed around customer service, product quality, productivity improvements in the installation process, and investments in R&D to bring new solutions to market.

Looking at the results this was the largest quarter for committed contracts in Pyxis' history. 70% of which were for the MedStation 3000 new product line.

As of June 30th, the Pyxis backlog was $260 million, also the highest it has ever been.

A good sign for future performance as this backlog is installed and recognized as revenue.

As we've said in the past, we believe fiscal '06 earnings growth at Pyxis will be driven by a solid MedStation 3000 performance, and continued productivity improvements with new products starting to drive further growth in fiscal '07.

So far we're off to the right start with respect to that strategy.

Another bright spot in CTS is Alaris.

The performance since acquisition has exceeded our expectation.

One reason for this is Alaris' product innovation and strong reputation for producing high quality reliable products that protect the patient.

As you may know the overall infusion market is getting much greater scrutiny by the regulators and hospital administrators as an area where significant patient harm can occur.

We believe products -- the Alaris products set the Gold Standard in patient safety and quality, that they are well positioned to continue to take market share based on this differentiation.

The third area, sterile execution.

Sterile continues to disappoint us.

It is a frustrating problem, a high-margin business with great demand and inability to execute.

You met the folks that are fixing the business, Joe Papa and Joe Lowry.

Like Dave and Dwight at CTS, they understand the issues, how to fix them, and the importance of success.

While they are making progress, it's taking longer than we thought.

Sterile clearly has the biggest negative impact in our fiscal '05 consolidated performance versus our expectations.

Importantly for '06, we have not made any heroic assumptions in our budget for fiscal '06 about the speed of the Sterile recovery.

Certainly it will happen.

But it's simply much less important in PTS' overall performance expectation for this year than it has been in the past with the expected contribution being less than 10% of our PTS internal budget versus 20% last year, and for Cardinal overall it's expected that earnings at Sterile will represent less than 2% of our total consolidated operating earnings.

So while we believe strongly that the Sterile business will be an important contributor to future long-term growth of the Company, you will not hear us talking much about it as an FY '06 contributor to any underperformance.

Outside of Sterile, PTS is doing reasonably well.

Oral technologies, Nuclear Pharmacy and Packaging which make up the vast majority of PTS earnings grew at a compounded 8% in the quarter.

Not the growth we aspire to or what we expect for the future, but still solid performance.

So to summarize my comments on the '05 results, I would say that they reflect the challenges we faced in '05, going forward we feel like we are in much better shape.

We're not declaring victory but we do feel much better about where we are in distribution and CTS.

MPS continues to perform and PTS should be significantly better this year.

Incidentally, victory is when we return this Company to a 12 to 15% earnings per share growth rate with little volatility in our results.

Let me talk about capital deployment.

A few comments on the balance sheet.

We ended the quarter with 1.5 billion of cash and short-term investments and net debt to total capital ratio of only 11%.

Strong cash flow continued in the fourth quarter with operating cash flow reaching $806 million.

This strong balance sheet and strong continued cash flow has allowed to us formalize a target return of cash to shareholders of 50% of operating cash flow, via dividend increases and share buy backs which we announced on June 27th.

Just to be clear at today's prices this new target implies an annual repurchase of 3 to 5% of the outstanding shares and an approximate four-fold increase in the dividend over the next several years.

So our strong cash flow will provide leverage to our operating earnings.

Finally, regarding the other uses of our cash, acquisitions, I'm going to reiterate what I said before.

We do not expect any major acquisitions, only tuck-ins, that have a clear complimentary home in one of our existing businesses.

So fiscal 2006 and beyond.

The outlook for the future.

Fiscal 2006 guidance is unchanged $3.30 to $3.55 per share, excluding special items and non-recurring charges and the impact if incremental equity compensation expense.

This represents a growth rate below our long-term growth goals of 12 to 15% growth in earnings per share.

Let me remind you our long-term growth goal is defined as over a rolling three-year period EPS in the 12 to 15% range.

That means to us that in order for us to achieve that long-term goal for fiscal '06 to '08, we must grow at the top of or above our 12 to 15% range for fiscal '07 and '08 as our rate in the first year is below the rate of that long-term goal.

Our three-year plan tells us that that can happen.

And that is the mission in which we -- to which we are committed.

The formula to get there is pretty simple.

PDPS, PTS, and CTS will grow their operating earnings right around or above the targeted earnings per share growth rate and generate solid cash flow to fund their growth and then some.

MPS will grow a little slower than the overall growth rate in operating earnings, but will generate significant cash that can be used to generate more growth through share buybacks or acquisitions.

Financial leverage below the operating earnings line will drive at least 2 percentage points more growth for the earnings per share.

Any segment that doesn't contribute as expected to this growth rate will be critically evaluated and changed dramatically, or eliminated if necessary.

I say this not because I'm trying to foreshadow anything or set any expectations.

I say it just to drive home the point that we are serious about these growth goals and are impatient to see the results, and will take the necessary action to achieve our short-term and long-term goals.

With that let me turn it over to Jeff.

I am pleased to announce that our fourth-quarter results came in just as anticipated with positive momentum going forward in most or all of our businesses driven by strong demand for our products and services, continued expense control and realization of One Cardinal Health efforts.

I want to provide an overview for both the results of the quarter and fiscal year and touch on a few of the items we view as important.

Let's start with fourth quarter results.

Please note that my comments will reflect financial results from continuing operations, and exclude special items, unless I indicate otherwise.

Revenues were up 15% to 19.5 billion.

This includes bulk revenues for Pharmaceutical Distribution of 6.6 billion compared to 4.8 billion for same quarter last year.

Operating earnings were 593 million, down 5% versus last year.

Increased interest expense in the quarter compared to the prior year primarily due to increased borrowings contributed to the decline in net earnings.

For the quarter net earnings were 339 million, down 20% over the prior year delivering diluted EPS of $0.78.

Please note these amounts include the impact of impairment and other nonrecurring charges, the net impact of which is to reduce EPS during the quarter by $0.11.

I'll provide more detail on these items, as well as special charges over the next few slides.

Cash flow during the quarter was very strong delivering over $800 million of operating cash flow which reflects $250 million used during the quarter to reduce borrowings under our accounts receivable securitization program.

Return on equity was 15.6% in-line with our stated long-term goal.

I would now like to quickly review the special items, impairment charges and other nonrecurring items.

During the quarter net special items totaled 61 million or 52 million after tax, impacting diluted EPS by $0.12 per share.

Remember, these items have been excluded from the results shown on the previous slide.

Included in this amount were merger-related costs, restructuring items, mostly related to our One Cardinal Health program which George will discuss in a few minutes, and other items.

Other items include SEC costs and those are offset -- more than offset by a $21 million litigation settlement, related to settlement of a pharmaceutical manufacturer antitrust claim.

Now let's turn to nonrecurring charges which include impairment charges as well as other nonrecurring items.

For clarity these costs are included in our diluted EPS of $0.78, discussed a few moments ago, and totaled $0.11 for the quarter.

Nonrecurring charges included asset impairment charms primarily related to synthetic lease impairment charges for various operating facilities.

A latex litigation related charge in MPS, an inventory write-down at PDPS related to continued HBC’s SKU rationalization, and a tax provision related to our plan to repatriate over $500 million of cash next year, part of the Homeland Investment Act.

I'd like to turn to the performance of the individual business segments.

At Pharmaceutical Distribution and Provider Services revenues increased 16% to 15.8 billion, driven by the strong demand of our customer mix.

Operating earnings for quarter were 326 million, up 18% over the prior year of 277 million.

These results include a $48 million LIFO credit primarily as a result of higher generic inventories and increased generic deflation.

Additionally we incurred a $15 million inventory reserve associated with a generic manufacturer’s bankruptcy.

Our transition to fee-for-service agreements associated with branded pharmaceutical manufacturers is on-track, and we are happy with the progress we've made to date.

This combined with generic growth, our continued stabilizing sell margin, and continued operating expense efficiency has led to improved operating performance.

Medical Products and Services, or MPS, generated revenue of 2.5 billion, up 5% over last year.

Distribution revenue growth is driven by strong lab and ambulatory sales, both at the physician's office and surgery centers.

Manufacturing revenue was driven by strong specialty product sales, including V.Mueller surgical instruments, offset by lower growth of certain products within our infection prevention product category.

Operating earnings for the quarter were 178 million, down 3% over last year's 184 million.

These reported earnings include a nonrecurring charge of $12 million to resolve outstanding insurance claims related to latex litigation.

In addition I want to point out that certain corporate costs totaling $4.5 million related to a financial processing center were re-allocated to the segment this quarter, although this had no effect on year-over-year growth comparisons.

Continued higher raw material and fuel costs also impacted earnings growth.

Partially offsetting these costs were continued expense control measures, and additional sourcing relationships.

Going forward several existing projects will continue to drive revenue growth and operating earnings.

New product growth including our new line of surgeon gloves, as well as the rollout of our IPF strategy, should contribute to increasing revenue growth.

Cost improvement efforts including One Cardinal Health distribution network rationalization and increased sourcing programs are intended to contribute positively to earnings performance.

In Pharmaceutical Technologies and Services, or PTS, revenues increased 6% to 782 million driven by growth in oral technologies, packaging services, and nuclear pharmacy services.

Combined these three businesses represent 76% of this segment's revenue.

Operating earnings were 85 million a 36% decline over prior year, which included an $8 million write-down of inventory and nearly $7 million in costs to operate our Sterile manufacturing facility in Humacao, Puerto Rico, that we previously announced will close later this year.

Excluding Sterile manufacturing the other businesses at PTS performed well during the quarter.

As Bob said earlier combined the earnings of oral, packaging and nuclear pharmacy grew earnings 8% over the prior year.

We expect solid performance in most of the PTS businesses moving into fiscal year 2006.

Within Sterile manufacturing, we are continuing to invest in our core facilities to improve operating efficiencies and increase capacity to meet this segment's strong demand.

These projects currently underway should begin to pay off in the second quarter results.

We are confident of this segment's ability to execute on our internal fiscal year 2006 plan.

Particularly as Sterile manufacturing earnings account for only about 10% of this segment's operating earnings plan.

Clinical Technologies and Services, or CTS, had an outstanding quarter as revenues increased 14% sequentially to 596 million.

Both Alaris and Pyxis’ products contributed to this growth, as the core Pyxis product MedStation 3000 continues to do very well.

During the quarter both Alaris and Pyxis saw a record number of new orders, operating earnings were $86 million up 32% sequentially.

Included in these results were $30 million in costs, primarily related to Pyxis inventory write-offs, as part of our comprehensive product line rationalization.

Earnings in the quarter were positively affected by ongoing merger synergies and operating improvements at Pyxis, including new processes in the field operations resulting in improved installation capability and predictability.

The Pyxis backlog increased to $260 million with more than 70% of orders signed during the quarter for its new flagship product the MedStation 3000.

During the fourth quarter Pyxis revenues increased 52% sequentially over the third quarter and are up slightly compared to the prior year.

Making this the first quarter this fiscal year where Pyxis saw an increase in revenue over the prior year, indicating to me that the turnaround specific to Pyxis, while still on-going is progressing nicely.

Alaris continues to see strong customer demand as well, as its IV pumps moved into market leading position during 2005.

Now I'd like to discuss our full fiscal year consolidated results.

Again as I mentioned earlier my comments will reflect the financial results in continuing operations, and exclude special items, unless I indicate otherwise.

Revenue for the fiscal year increased 15% to 74.9 billion compared to 65.1 billion last year.

Operating earnings were 2 billion, a 15% decline over the prior year.

Net earnings for the year declined 20% to 1.2 billion generating diluted EPS of $2.86.

Again, these earnings include the impact of impairment and other nonrecurring charges, the net impact of which was to reduce EPS during the year by $0.31.

Cash flow from operations was a strong $2.9 billion, which includes net proceeds of 550 million from an accounts receivable securitization program.

Return on equity for the year was 14.8% with significant improvements in the second half as compared to the first half of the fiscal year.

Now moving on to cash flow and capital deployment, as was previously discussed, fourth quarter and full year cash flow from operations was very strong.

Moving forward we expect operating cash flow to exceed 100% of net income in any given year.

Specifically for fiscal 2006 we expect to exceed this long-term goal as working capital continues to be a source of cash as Pharmaceutical Distribution inventory will likely continue to modestly decline.

Now, how will this cash be utilized?

Bob touched on this previously, but let me reiterate that in any given year we expect to return approximately 50% of operating cash flow to shareholders, through both share repurchases and increasing dividends.

Regarding dividends we expect to continue to increase our dividends as we look to reach a 20% payout ratio over time.

The balance of operating cash flow will be used for capital expenditures to support the organic growth of our businesses, and for strategic tuck-in acquisitions.

This next slide lays out our financial targets and goals, both long term and short term.

As I'm sure you recall I first showed this to many of you at our investor conference in New York, as I went through this in much detail at that time I won't do so today, however I want to point out a few things specifically related to fiscal year '06.

We expect consolidated revenue growth to be in-line with our long term growth of 8 to 10% growth.

Earnings per share excluding special items, nonrecurring charges and impact of incremental equity expenses are expected to be in the $3.30 to $3.55 per share range.

Just to comment on the equity point, at this point we expect incremental equity compensation to impact earnings by approximately 35% per share in fiscal 2006.

Now let me cover a few additional items including a couple of personal observations I have after three months on the job.

First, let me say that I am confident in the overall financial organization and the controls, policies and procedures that we now have in place.

I would also say that the broad organization is increasingly confident in their targeted results heading into 2006.

We've seen significant improvement in most of our operations, and others where we continue to significantly invest to perform well in the future.

Finally let me cover a few administrative items.

As I briefly discussed at the June investor conference, beginning in our first quarter fiscal 2006 there will be a modification to the way in which we allocate corporate costs in the business segment for the intent to better align corporate spending with the business segments based on benefits received.

In our presentation the first quarter results also include a reallocation of historical segment numbers for comparative purposes.

Finally one last item relates to our continuing use of nonrecurring charges during fiscal 2005. '05 was an unusual year as we managed to transition several businesses, which made it important to highlight these unusual items and exclude them from our financial goals.

Going forward my goal is to minimize or eliminate the use of these items to make a presentation and comprehension of our results must easier for all of our investors.

Now I'd like to turn the call over to George to discuss a few other significant Cardinal Health projects.

George.

Thank you, Jeff.

With Jeff involved, having amply covered the segment performance today, I'd like to switch my focus to discuss three important priorities that represent great opportunities to impact financial performance in fiscal year 2006 and beyond.

Like Jeff I am using a few slides which you can follow along with.

If you flip past the cover page my first content slide is just a repeat from our recent investor conference, that shows the top six operating priorities for fiscal year 2006.

You can see first three represent the key segment oriented priorities and the three I want to talk about represent examples of Cardinal Health's breadth and scale at work to drive innovation and incremental value.

That being Alaris, the launch of our integrated provider solution selling organization to the hospital and our global One Cardinal Health program.

Moving to the next slide let me talk about the Alaris integration.

This is a great example of our ability to deploy capital to achieve strategic goals and create long-term value.

Strategically, the Alaris acquisition accomplishes three things for us.

It is the market leader with a complimentary proprietary offering that expands our leadership and importance in the acute care market.

Second with 40% of its earnings outside the U.S., it provides us a platform for building our hospital presence internationally and third, combined with Pyxis and our clinical services and consulting business, positions us as a major player at the bedside in medication management patient safety.

These three businesses are not only a highly motivated operating segment, CTS, with a unified management structure, functional support and strategy.

Alaris is also a great example of executing rapidly and well to integrate a business.

At the time of the acquisition we identified revenue and efficiency synergies of 80 to $100 million by the third year.

In fiscal year '05 we achieved our expectations which creates even more momentum heading into ’06 for this business and we're on track for the three-year target.

So far synergies has come from things like eliminating redundant company costs, transfer of lean manufacturing processes to Pyxis, transfer of Alaris' disposable consumable sterilization to Medical Products and Services manufacturing, and more.

In FY '06 and beyond, the synergy opportunities are well underway.

For example the group has very ambitious plans for leveraging Alaris' sales and marketing strength in Europe for Pyxis products.

Second they're bringing together the offerings in this segment that create proprietary medication safety solutions.

Then of great significance they're creating unique capabilities and solutions to assist hospitals in the emerging pay-for-performance environment.

So in summary we have in CTS a platform for further investment and growth.

Next slide moves to our overall corporate worldwide integration effort, which is One Cardinal Health.

As I talked about in the past, it's an initiative about driving efficiency and organic growth through a very dramatic shift and focus on integration, both internally and externally.

Internally it's about improving operating discipline and functional excellence and capitalizing on our size and scale to reduce costs.

Externally it's about better integrating around customers and markets.

The ultimate financial goal is to drive $500 million or more of operating earnings improvements by fiscal year 2008.

We have the project in two phases.

Phase I, which we announced last December, was focused on driving 125 million in earnings improvements in FY '05 which annualizes to 200 million per year in '06.

Phase II, which the Board approved on Wednesday of this week, and which we announced this morning has longer-term focus on efforts like strategic sourcing, shared services, and logistics excellence, and will generate another 300 million plus in savings by fiscal year 2008, to support our growth plans.

So the next slide, where do we stand on the overall One Cardinal Health program?

This past year we achieved our goal with approximately 132 million in benefits realized.

We closed or initiated the closing of over 25 facilities.

We reduced headcount in every segment impacting a total of about 4,400 employees.

For '06 the goals are to annualize that 125 into 200 million of earnings.

Secondly, to begin to implement Phase II with investments in strategic sourcing, shared services, and IT finance, and human resources, fast track implementation of lean manufacturing and Six Sigma across our major operations, and consolidating and moving to common IT platforms.

Externally, we are embarking on our largest integration effort to drive greater customer value with the launch of integrated provider solutions, which I will explain on the next slide.

Integrated Provider Solutions, or IPS, essentially combines all of our resources that fell to the hospital from MTS, CTS, and PDPS into one organization, creating one truly integrated face and voice to the hospital customer.

We're focused on four end-to-end processes that our research tells us are important integrated solution opportunities.

This is procedure, delivery optimization, supply management, medication management, and patient throughput.

Using the full breadth and scale of our capabilities and connectivity with these hospitals, we're in a position to create a unique solution around these processes that cannot be replicated by any one of our competitors or customers, and allow us to create a significant advantage.

We're targeting this coming fall to be live with the first phase of our national roll-out.

We've got solid evidence this will deliver great value, we know from existing customers that are fully integrated customers, ones where we define where they're utilizing two or more of our products and services, those customers grow two to four times faster, are more profitable by an average of 120 basis points, and churn at one-third the rate of non-integrated customers.

So we know this works, and now we're organizing around this in a more effective way, to create unique solutions, and facilitate execution at the customer level.

This is a significant undertaking with very significant benefits, and is another great example of how we are integrating to better operationalize the value of the businesses we've brought together under the Cardinal Health umbrella.

I'd like to now open it up for questions.

[OPERATOR INSTRUCTIONS] We'll pause for a moment to compile the Q&A roster.

Your first question comes from Christopher McFadden with Goldman Sachs.

Thank you.

Good morning.

And Bob and George everyone thanks for the detail on the call.

First two housekeeping items and then I have a quick follow ups.

Relative to the drug distribution segment can you just clarify what was the LIFO impact in the year-ago period?

I think you mentioned credit, customer bankruptcy.

Could you just clarify what impact if any that had in terms of reported results, and then can you talk about, you know, thinking about the new agreements that you sound like you are at consummation or near consummation point, what impact you think that's going to have to run rate operating margins on a 2006 basis for the drug wholesaling segment, relative to maybe where we saw the second half of this fiscal year, then a follow-up?

Thank you.

Thanks for the question.

On your first question related to the LIFO credit as we said the credit in Q4 this year was 48 million, year ago for the same period it was a $1.6 million charge.

If you adjust for that by the way as well as for the inventory write-off we took with regards to our bankrupt generic manufacturer the adjusted growth rate for PDS is about 6%.

Could you repeat your second question, please?

Could you just talk about, now that you've gotten even relative to the investor meeting you held here in New York, now that you've got a number of your fee-for-service agreements fully consummated, or near consummation, could you talk about what you would expect to be the margin run rate in the drug wholesaling segment, perhaps in contrast to or in context of what we saw in the second half of this fiscal year?

I think as we said previously we would expect a slight decline on the order of 10 basis points in our operating margin in 2006 versus 2005 within the PD segment and nothing has changed, in terms of the recent agreements we've signed to change our view in that regard.

Then finally, and I appreciate very much Bob the context around how your views on Sterile are factored into the 2006 guidance that you provided, you have previously talked about Albuquerque, and some of the implementation dynamics there.

Can you just talk about what are the one, two, or three most important operational initiatives that John and his team are targeted on, in terms of helping to improve the performance there, I think we all recognize that the demand side of the Sterile business remains very robust, and I'm just not so much a financial question but really an operational question.

What are the key operating objectives that that organization is focused on for this fiscal year?

Thank you.

I'm going to turn this over to George to address that, then I'm going to come back and talk about PD growth rate.

But the -- first of all I will set it up by saying the person who is responsible for this is someone who has been with us for quite awhile, and that's John Lowry.

Certainly Joe Papa, but John has got the primary operating responsibility.

He has a strong operations background, specifically in manufacturing, and so, you know, that's background.

George, why don't you talk about some of the key operational things that he is doing that will improve the performance for Sterile.

Let me highlight three or four things that Joe and John are addressing right now.

First let me talk about Albuquerque.

A key project that's being addressed right now is a capacity expansion to the second floor of this facility that's very important for operating efficiency.

That's in-process right now.

It's being completed in the first quarter with the real benefits beginning to impact the second quarter.

Secondly in Albuquerque just an overall focus on several operating efficiency and quality-related opportunities that around the operation in Albuquerque, that have very clear process owners.

It's the lead candidate for our lean manufacturing initiative that's now underway where we've begun a significant amount of training.

So those are the two things that are happening at Albuquerque right now.

As I said, our expectation is that the benefit of these will begin to materialize in the second quarter.

That's how we budget it.

We try to be appropriately conservative around this, given our track record.

The other important thing in Albuquerque, as Bob mentioned, Joe and John are new to the scene in managing this, but also, you know, the individuals we have responsible for quality of manufacturing overall in PTS are new to managing the Sterile operation, so this is also additional factor in our confidence.

Other important milestones for us, of course, is efficient exit from the Humacao operation, which we will continue to report on, and finally our Woodstock operation which has full steel, which has historically been a profitable operation.

Went through a pretty tough transition, with a reduction of one customer's product, also some efficiency issues.

We have those efficiency issues behind us.

They've got a good pipeline and a good management team, so we expect to see improvement there so that is another thing that we will report on as a benchmark for evaluating Sterile's performance in '06.

Thanks very much for the detail.

Two comments.

We said that in our expectations for PTS performance for this year, Sterile as a component of PTS is only about 10% of PTS' earnings.

Than doesn't mean that we don't have higher expectations for it because they know that I personally expect with the potential we have there, and the capital that we have committed that that should be 20% of earnings.

That is not in our budget, which means, you know, but that's where we intend to drive it in the future.

With regard to your question on Pharmaceutical Distribution your specific question is how do we compare '06's growth rate -- or return on sales with the second half of '05.

I can't do that calculation right now, but what I'd say is that what Jeff said is that our '06's return on sales will be down a few basis points over '05's full year.

Now, one of the things that comes into '06 is we eliminate a lot of the seasonality, a lot of which happens in the second half of the year.

We eliminated a lot of seasonality because we've moved the substantial majority of our fee-for-service from inflation-based, which is dependent upon price increases and big inventory buildups to just a fee-for-service.

And so that has the effect of dampening that out.

Now, what this really means is our earnings next year, earnings growth in Pharmaceutical Distribution will grow at a slower rate than our return -- than our sales growth.

That is not, I repeat, not where we expect it to be.

I covered one of the ways we expect to get it back to where we intend it to be, is we intend for our earnings in Pharmaceutical Distribution to return to where it has historically been, which is to grow faster than our revenue growth.

We did that for 19 years in a row.

So we have optimism as we move into '07 and '08 that we are going to raise our returns on sales and but for the year we're looking at it will be at the '05 return on sales, or slightly below that.

Next question.

Your next question comes from Eric Coldwell with Robert W. Baird.

Thanks very much.

Two questions.

First, could we just get a little more detail on what the Sterile and Pyxis inventory write-down is specifically related to?

Second question is, just a little more detail on FAS 123 impact.

I'm curious why the company didn't take some steps to reduce the impact going into FY '06, like accelerated vesting.

Just any thoughts on that process.

Thanks very much.

Jeff will answer both of those questions.

With respect to the charges in both Sterile and Pyxis, first of all the Sterile primarily related to our Albuquerque operation, and it was a year-end review of our inventory and the physical inventory, and based on that review we determined there was some inventory in the system, that no longer made sense to carry on our books.

And that was predominantly what the write-down was for, was the Sterile.

Within Pyxis, we've been going through a process of rationalizing our product lines and made an assessment during Q4 based on that, that there was a significant amount of inventory on the shelves that no longer made sense to carry on our books.

So most of that $30 million charge within CTS related to write-down of inventory, obsolete inventory within Pyxis.

I am just curious.

What inventory are we talking about?

Was it MedStation 2000 type product?

Smaller handhelds?

Cabinets?

It predominantly relates to inventory with products we don't really see the growth rates or the kind of returns that we would expect at Pyxis, so I think we talked about rationalizing those so as we go through that, we said here's inventory here that we have a decrease in value on.

Second question, accelerated vesting, we view that as predominantly an optics move, with no real economic value to the Company by accelerating investing, so we didn't see a need to do that.

Next question.

Your next question comes from David Veal with Morgan Stanley.

I wonder if you could comment specifically on the outlook for the specialty distribution business with more reimbursement changes coming, capping pushed out, and the end of the US oncology contract.

George, you want to talk about that?

Our specialty distribution business has done well this past year.

The U.S. oncology business which, you know, we've known about for sometime is, of course, built into the forecast that we've provided for the second half of the year.

To date, there's not been any significant impact to the reimbursement.

If the reimbursement changed then whatever extent we think it's going to impact it's already part of what we have in our forecast today.

Great.

Thank you.

Next question.

Next question comes from Robert Willoughby with Banc of America Securities.

Thank you.

Bob or Jeff, historically you have added inventory in the September and December quarters.

Should we model increases this year, or with some of your seasonality comments can we just flat line that line item on the balance sheet for our cash flow models?

I'm not sure I can get into the specifics of the quarters.

I will say that our overall expectation for '06 is to moderately decrease days of inventory on hand, but specifically how it's going to play out quarter-by-quarter, I really don't have that information at this point.

The days inventory metric, is that a couple days improvement we're looking for there?

I would say in that ballpark.

Thank you.

Your next question comes from Andrew Weinberger, Bear Stearns & Company.

Hi.

Two quick questions, please.

First is with regard to Pharmaceutical Distribution.

The 15 basis points of SG&A leverage, is that something that continues to decelerate or is that a rate we could expect going forward for the next couple of years.

And the second question is with regard to the dividend, trying to get to that 20% payout ratio should we essentially assume the dividend will be doubled every year until we reach that ratio?

And that's it.

Thanks.

The -- I think what we indicated is that our SG&A ratio on an apples-for-apples basis in Pharmaceutical Distribution came down 13 basis points for the year.

We have further plans for reductions.

Actually some pretty creative things around automation and consolidation of facilities, things like that, and leveraging our current infrastructure, and we're in good shape with facilities.

We don't have any major additions happening here.

So you can expect something in that order of magnitude, maybe a little bit less than that.

Your second question was about dividends.

Dividend policy is a Board decision.

The Board reviews it periodically, but the Board has authorized some directional comments which really says that given what they understand today, and our goals would be to reach a 20% dividend payout ratio.

So how exactly we get there over the next three years, you know, the mathematics would say you'd have to double it every year to do that, and so I can't argue with mathematics, but the Board hasn't authorized at this point any specific dividends or ratio.

Just said, long term we -- over the medium term we expect to get to 20% dividend payout ratio.

Next question.

Thank you.

Your next question comes from Ricky Goldwasser with UBS Securities.

Good morning.

Couple of questions.

First, on Sterile manufacturing, accounting and internal budget for about 10% of operating earnings, can you give us the color of what percent of operating earnings was Sterile in the June quarter?

And also, is this a change from what was communicated in the analyst day as far as guidance assumptions, or is it the same assumptions from several weeks ago?

Okay, let me deal with Sterile.

Sterile is a big deal to us because it's got a lot of potential.

And we think it's going to add to growth.

But in terms of how important it is to the guidance we gave you for '06 what we try to say it's relatively minor, meaning it's only 2% of the overall corporation's earnings expectations for '06.

There is no change to where he thought it would be, and at the time we met, and that is -- means that it's less than 10% of the segment and 2% of Cardinal overall.

With regard to our fourth quarter, Sterile was minimal contribution to ‘02 PTS in our fourth quarter.

Next question.

Your next question comes from Lawrence Marsh with Lehman Brothers.

Thanks.

Bob, two quick follow-ups.

First on the option expense, I guess, Jeff, you're communicating about 220 million this year.

Have you disclosed what that figure is for '05, and what would be the reason for it to be up a good bit from fiscal '04?

Okay.

We've not yet disclosed what it is in fiscal '05.

I'm sure we will in our footnotes to our financial statements.

In terms of '06 the number actually was around 240 or $0.35 a share, which is total incremental stock related expense, and just a elaboration on that, we're actually going to be making some changes to our program going into 2006, from basically an all options program to a combination of options and restricted stock grants, so that amount includes the cumulative impact for both the options and the restricted stock grants that we're going to be utilizing in 2006.

In terms of it going up year on year, it simply reflects the cumulative impact of our programs over that time, although I would expect over a medium to longer period of time that number to reduce.

Okay.

Just clarification on the capital expenditures.

Just a little bit of elaboration on why the big jump in Q4 associated with synthetic leases and just remind us what we should expect for CapEx for fiscal '06.

First of all, of the total CapEx in Q4 about 138 million was related to equipment that was on synthetic leases that we brought back onto our balance sheet during the quarter, that was simply because those leases had expired and we made a financial analysis and determined that economically it made more sense to finance them with our existing balance sheet rather than renewing those synthetic leases.

Going forward, we made the comment that we expect in any given year for CapEx to be about under 25% of operating cash flow, and I think we'll be very consistent with that in 2006 as well.

Okay.

Just a final quick thing.

I know you had said at the Analyst meeting you weren't expecting to focus on quarterly sell-side numbers or whatever, and you communicated an up 6% full year, if you take the midpoint.

I guess my question is there's a wide range of Street expectations by quarter.

First quarter up 30%, third quarter down 2 or 3%.

Do you anticipate giving any update in terms of how the quarters will fall out, or will you just let the market do that?

We're going to let the market do that.

We have no intent of giving quarterly guidance any time during the year.

All right.

That's it.

Thanks.

Your next question comes from Lisa Gill with JP Morgan.

Sure.

Bob, you had talked about sell-side margins stabilizing.

Wondering if there were any contracts you could point to that have been signed recently for 2006, maybe just talk in generality what do they look like?

Are they down from where they've been historically but by a lesser extent?

Are you signing them at the same rates?

If you could give us some color there.

Secondly, George, if you could give us some thoughts around consolidation within the generics industry, and how you think that will impact your ability to negotiate with players, now that Teva is coming together with Ivax.

Thanks very much.

Let me cover the sell-side margin question.

As we said, we do expect sell-side margins to stabilize.

We did see that stabilization during '05, and we expect to see that heading into 2006.

As you know, we don't comment on specific agreements or contracts, either signed or in-process.

Nothing has happened that would change the statement that we expect sell margins to stabilize and what we're currently seeing in our contracts is reflected in the guidance that we've given.

The -- not surprised at the consolidation in the generic industry.

To be expected.

But continue to believe that generics will be a strong source of growth and profitability, specific reasons, one, there are a number of fairly significant products that will be coming off-patent perhaps impacting late in our fiscal year '06, but certainly in fiscal year '07, and even into '08.

That will certainly drive a lot of activity.

Second, the number of offshore or foreign competition that's now beginning to get into the market that's looking for a way to get to that marketplace, it's increasing with high quality and consistent supply.

That's certainly will generate competition, and, you know, third, while not in the short term, Medicare Modernization Act is certainly going to drive consumption and be a contributor here.

So those three combination of factors and there are others certainly say that the future for generic drugs is going to continue to be strong, and strong for us in particular.

One more question, please.

Your last question comes from Tom Galluci with Merrill Lynch.

Thanks.

Snuck in under the wire.

I'm going to ask a follow-up on each of those questions from Lisa.

On the sell-side margin trends, I know you've had some activities internally to contract compliance, things to improve the sell-side margins, so can you just differentiate a little bit between the sell-side pricing trends, and the margin trend, which I'm sure is benefiting from some of those initiatives?

Then on the generics, George, you said growth in profitability obviously generics have lower working capital requirements.

Are we just talking about higher margins, or higher profit dollars, too?

Thank you.

Your question is about differentiated between contract pricing and your improving increasing compliance -- that's not the only thing we're doing.

There are certain areas we are -- product lines we are raising prices for and services we're raising prices for.

So, you know, and there may be other things we're adjusting prices downward, but -- and so when you go to a customer, and he's going to pay more for a certain product category that in the past, that's a price increase.

It just happens to be part of the bundle you're offering to the customer.

I think what we really said Tom is that overall we think there's stability in sell-side margins.

You have to take into consideration when you look at the whole bundle of customers you have, the size of the customer and the mix, you know, the types and all the rest of that stuff for Cardinal, given the mix of business we have, given our pricing philosophy and what we think the environment is, we think there will be some stability in sell-side margin.

With regard to generics, generic absolute dollar profitability has grown substantially faster for us than our overall revenue growth.

So that's kind of probably a good way to answer the question about whether it's just dollars or percentages.

Obviously, generics sell at a lower price, but in a conversion from branded to generics, that is more profitable from a return standpoint and from a dollar standpoint.

Now, why is that?

It probably is because we, in fact, have even more pull over owning the channel.

Meaning the generics -- the value we provide to them they need to pay for shelf space, and so the wholesalers get even more influence in the choice of manufacturer, and that's one of the reasons we get paid more.

Let me close the call with a comment.

We have finished a challenging year, but the good news we've finished the challenging year on an up note.

We are not tired but we're invigorated.

I'm personally looking forward to '06 and looking forward to quarters when we perform like we have committed to the market to perform.

So we're finishing on that note, and we look forward to the next call after our first quarter results.

Thank you for attending.

This concludes today's Cardinal Health IR conference call.

You may now disconnect.