卡地納健康 (CAH) 2006 Q1 法說會逐字稿

Good morning.

My name is Dawn and I will be your conference facilitator.

At this time I would like to welcome everyone to the Cardinal Health first quarter 2006 earnings release 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 [Caller Instructions].

Thank you.

I'll now like to turn the call over to a Jason Strom.

You may begin your conference.

Good morning.

And welcome to Cardinal Health fiscal 2006 first quarter earnings release conference call.

Our remarks today will be focused on the company's consolidated and business segment results for the quarter which are included in the press release and attached financial table.

If any of you have not yet received a copy of our earning release or the financial attachment you may access it over the Internet at our Investor page at www.cardinalhealth.com.

Additionally there are a handful of slides that we will be reviewing which can also be found on the website.

Speaking on our call today will be Jeff Henderson, Executive Vice President and CFO.

Also available to address questions Bob Walter, Chairman and CEO and George Fotiades, President and COO.

Bob has asked that we slightly change the format of the call as Jeff will discuss the financial matters up front and Bob will lead the Q&A after Jeff's remarks.

The intent here is to allow more time for Q&A.

After Jeff's formal remark,s we will open the phone lines for your question.

As always, when we get questions, 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.

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 risks and uncertainties are described in Cardinal Health's filings with the Securities and Exchange Commission and include those listed at the end of today's press release in addition to statements in this presentation include adjusted financial measures governed by regulation G. A reconciliation of these measures is posted on the Investor Relations page at www.cardinalhealth.com.

At this time, I would like to turn the call over to Jeff Henderson, Cardinal Executive Vice President and CFO.

Thanks, Jason.

Good morning and thanks for joining us today.

As Jason indicated, the primary focus of our formal presentation this morning will be to explain the financial results of the company and the underlying issues driving them.

And I will make those remarks myself.

After my formal comments, both Bob and George will be available with me to answer your questions.

My intention is to keep up up front comments as limited as possible to allow adequate time for questions and answers.

Before we get to the numbers, I want to start with a few high level take aways from the quarter.

We ended our fiscal year 2005 with improved operating results and good momentum in three of our four operating segments.

As we expected, this momentum carried through our first quarter results.

Looking back to a year ago from today, we are faced with challenging operating business issues in three of our four operating segments; as well as other significant environmental issues.

Today, although we continues to face operating issues within our pharmaceutical technologies and services business segments, we believe that the majority of these challenges are behind us.

Our results during the quarter demonstrate that we have made great progress against our goals and objectives.

For my first slide today I want to set a stage for discussion by reminding all of you of our financial targets and goals.

In case you are worried nothing has changed on this chart.

It's what you've seen before and for the purpose of today's discussion I will frame our results around it and what we have previously told you.

Now let's turn to the first quarter results.

Please note that my comments will reflect the financial results from continuing operations.

And exclude special items unless I indicate otherwise.

Overall revenues were up 9% to 19.4 billion reflecting strong demand for diversified offering of products and services.

This includes both revenues for pharmaceutical distribution of 6.8 billion compared to 5.5 billion for the same period last year.

Operating earnings were 395 million, essentially flat with the prior year's earnings of 394.

Although it's important to understands what's now in this number for fiscal 2006 as I'll discuss in a few moments.

Net earning for the quarter were 249 million, a 3% increase over prior year results of 242 million.

Diluted EPS for the quarter was $0.58 compared to $0.56 last year.

Turning to the next slide, I want to try to simplify what is admittedly a complex financial presentation by pointing out to you specific items that had impact on current and prior year operating results and earnings per share.

Specifically special items, equity comps and non-recurring and other items.

First let me quickly review the special items.

During the quarter net special items totaled $22.7 million, or 14.5 million after tax.

Impacting diluted EPS by $0.04 per share.

Remember, these items have been excluded from the results shown in the previous slides.

Included in this amount were merger related costs, restructuring items, mostly related to our 1 Cardinal health program and other items including costs related to our ongoing SEC investigation.

This amount compared compares to $0.05 per share reflected in our fiscal year 2005 first quarter.

Now let's turn to non-recurring and other items.

For clarity these costs are included in our diluted EPS of $0.58 discussed a few moments ago.

And total $0.05 for the quarter compared to $0.06 last year in Q1.

Asset impairments to the quarter totaled $2.5 million.

Our only other significant charge in the quarter was a $31.8 million charge within our pharmaceutical distribution and provided services segment which I will discuss in more detail in a moment.

While we are trying to get out of the habit of discussing non-recurring and other items as a separate items we thought this was probably an appropriate one to call at this quarter.

Now regarding equity comps, the impact in the quarter was 82.9 million, or $0.12 per share.

Compared to less than a penny per share last year.

This amount includes approximately $33 million for the previously disclosed SAR Grant to Bob in August.

As you may recall an option grant given to Bob in 1999 was later found to be in excess of what the plan allowed to be granted to one individual in any particular year.

To correct the situation and to satisfy company's original intent and understanding with regard to this grant, the excess grant of what was allowed under the plan was replaced with the SAR during the first quarter of fiscal 2006.

For the full year we would anticipate the total impact of all equity compensation to be approximately 215 to 230 million, or $0.31 to $0.34 per share.

Going forward beyond our current fiscal year, we would expect this cost to materially decline year after year as we have made significant changes to our equity comp plans including a reduction in the overall number of options granted in a given year.

And for clarity as I think most of you know, we have chosen to follow the modified perspective method for recognizing equity comp expense and as such equity grants after July 1, 2005 will be recognized as compensation expense over the related investing period.

The remaining portion of all unvested equity grants at the date of adoption will be recognized over the respective investing period using the fair value previously calculated for proforma disclosure purposes.

And I know that some U.S. companies have decided to accelerate vesting in advance of each of these changes, but at Cardinal, we decided not to accelerate the vesting of previously granted options because we believe it just wasn't the right thing to do as it would effectively increase an employee benefit beyond what was the original intention.

The final note on comps when we provide our fiscal year 2007 guidance we will include equity compensation as part of that guidance.

Now let's turn to performance of the individual business segments.

As pharmaceutical distribution and provided services revenue increased 9% to 15.8 billion in line with our expectations.

Operating earning were 109.9 million an increase of 25% over the prior year.

Included in this amount is the charge of 31.8 million which I referenced earlier.

This charge in Q1 which is related to prior years was taken after conducting a system review of extended credit.

This charge is deemed necessary after reviewing the performance terms of contract and related to credit for a limited number of vendors who are obviously not processed and recorded during the prior period.

Of the total $31.8 million that I mentioned a little less than $15 million is related to our fiscal year 2005 results and approximately $11 million is related to our fiscal 2004.

Again for clarity this $31.8 million charge is included in our segment operating earnings of 199 million.

Despite this charge, earnings growth was a strong 25%.

Contributing to this growth was earlier than expected launches of new generic products, ongoing expense controls, and efficient inventory management related to our new distribution service agreements and our national logistics center.

Additionally as you may recall we faced a challenging quarter in the prior year which helped our year over year comparison.

Specifically, last year the industry was faced with significant challenges as we were going through a transition in the way we were compensated by our manufacturer vendors.

Today this transition is essentially complete which will result in less volatile earnings.

As I had previously stated our long-term operating earnings growth target within this segment is ten to 13%.

Please note that when I discuss segment long-term operating earnings growth goals today these goals exclude the impact of the change of corporate allocation methodology, nonrecurring and other items and equity comp expense.

For FY 2006 we will be below this long-term goal for the pharmaceutical distribution segment.

While our first quarter earnings were better than expected, we continue to believe that full year earning will be in line with our previously stated goal.

Primarily due to slower market growth, lower price inflation for branded pharmaceuticals, fewer generic product launches, and a lower starting point for branded by margin related to distribution service agreements.

In addition, earning growth rates will vary by quarter this year due to the variability of earnings in the prior year as we transition to new distribution service agreements with branded manufacturers.

Now moving on to medical products and services.

This segment generated revenue of $2.6 billion, an increase of 7% over the prior year.

Operating earnings for the quarter were 151 million, up 21% over prior year.

You might recall that results for this same period last year include a 16.4 million latex litigation charge.

Earnings drove this quarter was generated by good performance in both distribution and manufacturing operations.

Within distribution good growth in privately owned products contributed to earnings.

In our manufacturing operations infection prevention, medical specialties and presource all were important drivers.

Our international operation also continue to generate excellent results, contributing both strong revenue and earnings results.

Earnings growth within this segment was in line with our previously stated target for fiscal 2006 of earning growth in a range of 69%.

Consistent with this quarter we continue to expect full year results to be in line with our long-term goal for this segment.

Pharmaceutical technologies and service revenue increased 2% to 713 million while operating earning declined 42% to $45 million.

The performance in this segment continues to be impacted by operational issues we had previously identified and are addressing primarily within sterile manufacturing.

Additionally, weakness in the contract sales business at HMS and the expected counterization of certain nonproduct revenues in the oral technologies business impacted our first quarter results.

On the positive side here, the issues are not new items and we believe we have the appropriate resources in place to fully address them.

We have taken several specific actions to date which we believe will have an immediate impact on improved performance.

First we have classified our sterile manufacturing operations in Humacau, Puerto Rico as discontinued ops.

As you recall, this was costing approximately 5 to $7 million per quarter.

In Albuquerque we are essentially complete with the planned upgrade of the facility which is expected to double our capacity of production beginning in the second quarter.

Finally we have successfully implemented meaningful price increases on key sale accounts which will result in future incremental revenue.

Now while our current performance was certainly below expectations we are confident that the issues are being addressed and the appropriate changes are being made.

Moving forward for our second quarter we expect earnings to increase at least 50% sequentially over our first quarter and that our full year earning growth will be in line with our long-term goal of 12 to 18%.

Earnings growth for the year will be driven by the ongoing benefits of the actions identified above as well as significantly improved capacity within the sterile manufacturing and continued strong demand.

Additionally we will be faced with favorable comparisons for the prior year particularly in the second half of this year.

Clinical technologies and services had another very good quarter as segment revenue increased 10% over the prior year to 576 million.

Revenue growth was driven by exceptional performance from both Pyxis and Alaris.

Pyxis revenue increased more than 20% over prior year due in large part to continued strong demand for med patients resale.

And Alaris increased revenues in the mid teen due to continued strong demand for its market leading products.

Clinical services and consulting, our other business within the segment grew revenues in the low single digits during the quarter over the prior year.

Operating earning increased 88% over prior year to 78 million.

Strong earnings growth was generated by our sales mix and by this I mean higher growth in both Pyxis and Alaris as well as operational and quality improvements initiated last year, specifically at Pyxis.

I should also point out that our results last year including an Alaris purchase accounting inventory evaluation adjustment in the amount of 20.2 million.

In the past we have discussed various operating issues at Pyxis.

I'm happy to report that operational improvements at Pyxis which have been directed specifically at improving both the business profitability and customer satisfaction are working as we have seen continued improvement in profitability and customer satisfaction has not been higher in quite sometime.

Pyxis backlog ended the quarter at 247 million with committee contracts for the quarter coming in at approximately $20 million ahead of internal expectation, a strong indication of continued demand.

Similarly at Alaris, committee contracts for the quarter came in about 15% greater than planned.

Alaris just signed a two-year dual source agreement with Health Trust Purchasing Group which would provide Alaris access to more than 750 member acute care facilities with products.

Also during the quarter both Pyxis and Alaris issued several new products in the market.

For CPS, our fiscal 2006 earnings growth target is in the range of 15 to 20% and we continue to expect full year results to be in line with this previously stated target.

Cash flow for the quarter was 724 million, which compares to 895 million during the prior year and I should point out that that prior year included net proceeds of 500 million realized through an account receivable securitization.

Our strong cash flow is driven by increased earnings and continued working capital management as an additional day of inventory was reduced during the quarter when compared to our fourth quarter last year.

As we had previously announced it is our intention to use some of this cash flow to repurchase $1 billion of Cardinal shares during this fiscal year.

During the most recent quarter we did not repurchase any of our shares as we did not feel the timing was appropriate.

However we still fully intends to repurchase $1 billion of our shares during the current fiscal year.

Now I would like to go back to our financial targets and goals slide.

You'll note in this slide that I've highlighted the left side, our long-term goals, and I'm pleased to say that we have no changes in these goals.

They remain intact and we are off to a strong start on our way to achieving them.

Now let's discuss fiscal year 2006.

We see no change in our revenue and EPS targets for fiscal '06 otherwise as I've discussed earlier we now have better visibility into our equity compensation expectations which I've indicated here.

As I discussed what we are doing with segment results our fiscal '06 operating earnings growth targets have not changed, and we continue to expect return on equity in a range of 15 to 20% on an adjusted basis and operate cash flow to be strong.

Regarding our capital we doubled our dividends to $0.06 per share and expect to repurchase $1 billion of stock at fiscal year.

Finally regarding our credit rating we look for continued progress.

At quarter end our net debt to total capital was 5% providing for significant balance sheet flexibility.

Now in just a few moments I will open the call up for questions.

However I just want to make a few additional comments before we did that.

First as I had previously indicated we changed the methodology on how we allocate corporate expense as to our individual business segment this quarter.

We believe our revised approach better reflects our corporate resources as utilized by the businesses.

Going forward close to 100% expenses, excluding equity comp and special charges to be allocated to the individual segments.

Last week we provided historical quarterly information on a pro forma basis reflected in this change to better help you understand our business trends on a truly comparable basis.

Secondly, a few weeks back we announced a rather significant reorganization in several of our operating businesses.

While significant internal changes are already underway here including reporting structures and business responsibilities we will not begin to report the financial results in these new financial reporting segments until later this year.

As I mentioned before once we begin to report our results under the new financial reporting segment we will continue to provide transparency to allow clear visibility into the financial results for the various segments, in particular pharmaceutical distribution.

That ends my formal remarks but before I open it up to Q&A I want to address a question that may be on some of your minds.

Specifically given this $32 million charge we are taking within pharmaceutical distribution and in light of other recent events do I have any concerns about internal control within Cardinal?

As CFO of this company, this is a question I take very seriously and I want to be up front in my response.

Let me begin to address that by stating very simply that our fiscal '05 year end we did identify a limited number of significant deficiencies that we need to address but none of them rose to the level of material weakness and we still concur with that assessment.

However we are in the midst of addressing each of those deficiencies and making progress against them.

Part of that progress involves recruiting some new talent.

We redesigning some of our processes centralizing and scaling up certain functions across the company and closely examining our IT systems.

That work is going on and as we do it we will inevitably finds areas to fix.

Now although it did not arise directly from that work, this recent issue within pharmaceutical distribution is one such example.

We have thoroughly investigated this issue, taken a charge for our anticipated exposure and are pursuing actions to remediate the situation.

Now clearly it's unfortunate that it happened but I am comfortable that we are acting quickly to the address it and are making the necessary changes to minimize the chances of such reoccurrence in the future.

Now can I guarantee that nothing like this will happen in the future or that we won't find additional issues?

I'm not sure that any CFO of a company this size and complexity as Cardinal Health can provide that sort of assurance.

But I do believe that we don't have a material weakness at this time and that all necessary actions are being taken to address our identified significant deficiencies.

On the way we are keeping our audit committee very closely apprised of our progress.

Okay, thanks everyone.

Now let me turn it over to Bob to moderate our Q&A session.

Bob?

Okay.

Can we have the first question, please?

[Caller Instructions].

Your first question comes from the line of Ricky Goldwasser from UBS.

Yeah, hi, good morning.

That surprised me being the first one.

Thank you for the update.

The question I had is relating to Pyxis.

Obviously there's evidence that there's turnaround in Pyxis and there's a lot of momentum around med patients at Alaris.

My question is related to the margins and profitability.

You said the margins in the quarter were below the margins that you reported in the June quarter when you were adjusting for special charges.

The question there is do you think that you could go back to kind of historical margins off high teens, low 20s, or is this kind of on an ongoing basis mid teen type of business?

Let me try to address your question.

We refer to historical levels.

It's hard to refer to historical levels for all CTS.

This is a relatively new segment.

And I also want to point out that given a new corporate allocation where we are charging a significantly higher percentage of our corporate cost out to the segments comparability is a little difficult to make from one year to the next.

That all said we did not see a significant change in margins overall in the CTS segment.

We would expect margins to improve over time in that segment as we continue to drive demand and make operational improvement particularly within our Pyxis unit.

Now looking specifically at Pyxis, we have historically enjoyed very high margins within our Pyxis operation.

I'm not certain we will ever return to those historical levels given the unique market position we had there several years ago but I do anticipate that we will continue to increase margins in current levels as the operational improvements continue to take effect.

Next question, please?

Your next question comes from the line of Robert Willoughby from Banc of America Securities.

Hi.

Bob or Jeff, refresh my memory.

In a rising interest rate environment I thought you were incentivized to sell the balance sheet lease portfolio.

Is that the case and do you anticipate seeing that happen any time soon?

Bob, you are referring to our lease portfolio of Pyxis?

Yes.

Yeah, well, certainly we are.

It's a source of, it's a source of capital certainly to redeploy that.

We are looking at all kinds of issues about where we want to pull capital out of the balance sheet and reinvest it.

There's not a big incentive for us right now to raise capital because as you can see we are sitting on a lot of cash.

So effectively the yield on that lease portfolio is certainly better than what we can get on just having it sit on cash.

But if there's an opportunity to reemploy it over time into operations we would do that.

But we have a lease portfolio which is today, I'm just thinking the in the 700 to $800 million range, that is a very clean portfolio, well operated, and it certainly is a source of capital.

Just adding on to Jeff's comments about margins, that in CTS, CTS is three businesses.

You have Alaris, you have Pyxis and you have our clinical consulting business.

The lowest margin business is our clinical consulting business.

So as the mix of sales change one could grow faster than another you are going to get some margin changes.

But if you look at Alaris, it has got steady improvements in its margins, it has a very attractive return on capital.

And the same thing with Pyxis.

So one of the things I think is important when you look at margins is you say, well, why do you get strong margins?

And one of the reasons that you get strong margins is because you are delivering some unique solutions to the customer that delivers value.

And I would say we are very encouraged by the value of what we are delivering both at Alaris and at Pyxis and so I'm comfortable that we can expect rising margins.

We also have talked in the past about benefiting from the synergies of putting Pyxis and Alaris together and that's in our future.

And effectively, that will raises the overall segment margins as we achieve some benefits from combining manufacturing operations and other kinds of initiatives.

So I think we can look forward to rising margins in our CTS business.

Can we go to another question, please?

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

Thanks very much.

Question relates to pharmaceutical distribution.

Bob, as that business has now transitioned to fee based can you give us an update on how the experience is going in operating in that environment?

Are you having any trouble executing on your commitments and what are your latest thoughts about margin trends as we move through the year?

John, what do you mean our commitments just so I can clarify and answer your question.

The performance aspects of those fees I understand that you've made promises or commitments in terms of execution to those clients.

How are you executing on those commitments?

Yeah, actually, I'm really glad you asked that question because we have made a point of saying we do expect to differentiate ourselves from our competitors with regard to serving the manufacturers because we have made, we believe that we can execute better for the manufacturer and we have been willing to put in incentives in some of our contracts, fee for service contracts.

At this point we are very -- I don't like to put the qualifier at this point -- we are very confident about our ability to perform to those contracts.

So the environment is such that one, obviously we are taking more inventory out of our businesses which would make -- that in itself is making us more each efficient.

Jeff mentioned we had about another day drop in inventory.

Most of that comes in the PD side of it.

We measure ourself daily in terms of our performance against our manufacturing contracts and we are happy with the relationship.

So that's the summary I can give you.

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

Good morning.

Jeff, could I clarify in your current presentation of the segments, is compensation expense allocated to the segments or where does that show up within the income statement, please?

For the purpose of, Andy, for purpose of the presentation of our segments it's not allocated to the segments so it's being held to the corporate level for now.

Okay.

Thanks.

And then if I could just get some comments with regard to just the sequential movement within just the operating income at PTS.

I was very much surprised by the decline from the fourth quarter levels and just wondering what, is that just an expense issue in terms of just shutting stuff down and getting stuff ready to go as to why the profitability fell off so sharply there versus showing improvement from the fourth quarter level?

Let me try to address that question, Andy, and I will also try to clarify the entire year a little bit more explicitly with respect to PTS.

Because I understand it's a little bit difficult to understand given the first quarter results.

First of all let me talk about four major buckets of operations within PTS.

You've got the NPS and packaging units which make up about 45% of the first half earnings for PTS.

Both of those units continue to perform as expected.

They are stable.

They are growing and as a group will grow in line with our segment expectations for the year.

Let me look at oral which for the first half of the year we will make up about 40% of our earnings.

It's in line with internal expectations but it is down year over year in Q1 due to the impact of certain nonproduct earnings that benefited us last year and by nonproduct earning I'm referring to certain royalty and profit share opportunities we benefited from early last year.

However, new product launches this year specifically within our encapsulation and fast dissolve bursitis category will drive earning growth in 2006 as we go through the year.

That bring us to our last big bucket and that's sterile.

And although admittedly sterile is a drag on the PTS segment in Q1 and that is partly due to earnings to remediate some of these issues partly because while we are making those changes we weren't up to the full capacity as well, that does begin to change pretty markedly as we go through the year.

I will remind you that prior to fiscal '05 this was a business that generated more than $50 million in earnings with an operating margin of nearly 30%.

So clearly it does have potential to drive significant earnings.

But the fact is it didn't contribute to earnings in the first quarter.

And for the first half of the year it's going to represent basically 0% of the earnings for PTS.

Wasn't that the same in the fourth quarter, though, sterile?

Sterile didn't get sequentially worse, did it?

It didn't get sequentially worse but as I look for the remainder of 2006 we will begin to see the improvement that went into drive the last half of the year's growth.

This is driven by a number of actions we have taken.

We have significantly improved capacity within our Albuquerque operation.

We've shut down Puerto Rico and we still see very strong demand for all the products within sterile.

And finally we've just implemented some significant customer price increases in Q1 which again will drive our second half of the year and those price increases have an annualized benefit of at least $15 million.

So again we see the potential for significant improvement in the second half of the year and through a great degree it's going to be driven by sterile.

Is the main issue on a sequential basis from where you were during 2006 on a quarterly basis, is it a royalty issue?

Is that the main drop off, the change?

The primary issue between fourth and first quarter is the oral business performing lower than it customarily does on a quarter to quarter basis.

And the most significant issue there is sort of the change in timing of total contracts and one time payments that were there in a year ago period.

I mean as Jeff pointed out oral is still, the ongoing business is very predictable, stable, no significant changes from a customer perspective or demand perspective.

So in the balance of the year it improves sequentially and contributes to that progress.

But the biggest difference in the first quarter is related to that.

And also related marginally to our nuclear business but again that has been performing quarter to quarter pretty consistently.

So that's the difference in the first quarter in addition to sterile performance which isn't where it's supposed to be yet which contributed to the low absolute number.

Okay.

Next question.

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

Two quick questions, I think primarily for George around the PTS business.

The first, could you just give us a very sort of brief overview in terms of the size of the nuclear pharmacy business and sort of what the growth characteristics are of that business with as much detail as you can?

It's been tough to track that business.

And the second is with regard to the price increases in PTS especially sterile.

Is that what gives you confidence that the customers are still there, that you are able to raise price despite the lack of execution at that business?

Or I guess if you could kind of help us understand why you feel confident that customers are going to stick with you as you turn that business around?

Thanks.

Some of this will be a little bit repetitive to what Jeff articulated.

Business overall, nuclear is about 30% of the earnings of that business.

This is by and large since we acquired it it's been a predictable business that's growing in revenue in the 7, 8, 9% range.

There is some variability by quarter, some by seasonality but overall it's predictable.

Oral is, again depending upon how sterile has done, it averages between 30 to 40% of our business.

Again, it's predictable perform in the soft gel mezidis side.

Packaging likewise.

Very predictable.

In the sterile side, around customer demand.

Customer demand continues to be there, we really haven't lost customers.

We are not satisfying them to the degree we need to.

But related to our capacity but the issue and the opportunity in sterile is that it is complex manufacturing.

There is limited capacity industry-wide.

There is a clear need for people who can produce high quality, whether it's injectable or liofilized or sterile vile filling capability all of which we can provide and from a quality standpoint we continue to make significant improvements.

We have a very good track record from an FDA and European audit perspective.

And we continue, we continue to attract customers.

The pricing opportunities around the fact that as we learned, as we've learned more about the value of what we can provide we are beginning to seek appropriate value for what we can deliver.

And customers are willing to step up for that and we are gradually making improvement on our commitment which is why these price increases are sticking and will contribute particularly as they move through the balance of the year.

So fortunately despite the issues we have had in our operations in sterile we have maintained, we've maintained the customer base.

We have actually begun to increase a lot of the customer, the customers who are coming to us looking for capacity, particularly now that we are expanding into North Raleigh and we are about to open a facility in Brussels.

So that is why we continue to be steadfast in our belief that we will get this addressed and it will contribute to EPS.

Thank you.

Next question?

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

Thank you and good morning, everyone.

A couple of sub market questions.

Firstly obviously Baxter's had problems with the FDA in their infusion pump market.

Can you comment on what type of market opportunity you are seeing that create for Alaris, perhaps more tactically near term and perhaps longer term in terms of potential market share gain?

In addition relative to the medical products manufacturing area could you just give us a sense of how in what has obviously been an upturn in petroleum based product costs how those costs are impacting your manufacturing cost structure and the success you are having in terms of passing some of those costs through to customers in the form of pricing?

And then finally it looks like you guys picked up a small independent GPO, some incremental volume there.

Can you just talk broadly within wholesale drug distribution how would you characterize the kind of the climate generally particularly in the context of the pending part D., MMA implementation?

Thanks very much.

Chris, that is the most complicated question you've ever come up with but I am going to try to break it into three parts.

I will handle two of the three because I don't think I can handle them all.

But anyway, let me handle the first question, the issue about potential for Alaris.

So I think there's three areas, what's going on in the environment in PD., what's the potential for Alaris given the market environment and the other is what's going on with our product cost and related to petroleum

Exactly.

I am going to make George the petroleum expert here.

Let me handle Alaris first.

First of all Alaris, I would characterize them -- I would remind everybody that we had studied this market, studied Alaris and completed an acquisition of Alaris something like 15 months ago.

Alaris at that time was already a technology, what I call it a technology or an innovative leader in the market and a leader in the market what have I would call product safety.

And so they were gaining market share.

They had two businesses in which if you think of it simply the pumps and the disposables and the disposables do have higher margins than the pumps but they are connected to the pumps so you have to get the pumps.

They were gaining market share and are gaining market share at about 1% per year.

They have, in the 30 to 35% market share U.S. and worldwide.

So to gain 1% market share is really a big deal because if you place more pumps you are going to get all the renewal, the consumable business, a pump lasts about seven years.

The environment is very favorable for Alaris.

It has been recognized that they do have a competitively advantaged product.

So their product line is fresh.

It's on the basis of strong R&D investing and, prior to joining Cardinal and we've accelerated that.

Additionally Alaris now goes to market with Cardinal and so we have been instrumental in helping accelerate their marketing.

They have manufacturing excellence that we will give credit to Dave and his team out there and they have excess capacity.

So I would say their future is really quite bright and we feel good about where they are and we will be talking more as we go through the year in granular terms about the new patient safety offerings around Alaris and Pyxis combined.

So that's the Alaris story.

On the PD side I think you're referring to, we think there's big opportunities for us in the gaining market share in the independent segment and so we are doing some focus there and this is not around lowering prices, it's about selling value.

I think that the sell-side margins in that business are relatively stable right now and expect them to be and so the environment I think is fairly healthy.

We have got some good growth going on the hospital side.

We expect our growth to pick up on the independent side.

George, you want to address the petroleum market starting with the cost of oil from 1850?

Yeah, well, we are very encouraged by the progress in medical products and services this quarter both the manufacturing and the distribution businesses.

The manufacturing side of the business, we spent a lot of time over the past year to two years time building our sourcing capability.

It's becoming a significant contributor to reducing our COGS across a number of products in this segment.

It's also a contributor to building our private label line on our distribution side and we expect it to continue to grow quite significantly as we go forward.

We've also spent a considerable time in network optimization, a lot of restructuring and some of this has impacted of course by moving to lower cost areas for production as well as moving to increased sourcing.

So the combination of those two initiatives over the past two years have helped us offset the impact of petroleum prices and the resin increases.

We have also been looking at pricing and traditionally in this marketplace there hasn't been that same focus on taking price up to deal with such issues, but these are novel times and people have not seen oil at 60 to 70-dollar price range.

And so we are and have been over the past several months pursuing that option.

And it continues to be an ongoing effort.

Obviously customers aren't particularly happy about it but in the end ultimately we've got to deal with the market based reality so we are going to continue to push that where that makes sense.

But overall this is a business we are encouraged about.

It made progress from last year as we said it was and that's why we feel good about the guidance we have for the year.

George, Bob, thanks for the detailed response.

Just one clarification if I might on follow up which is Bob, do you think you are taking share, additional share in the pump market because of the obvious and very public issues Baxter is having with the FDA in terms of their product recall and do you think that accelerates that 1% per year market share gain going forward?

Yeah, Chris, I want to be careful not to focus too much on a potential weakness in one of our competitors that may come as a result of a Federal action; an FDA action.

They've been a competitor for a long period of time.

Certainly we have been selling, I mean Alaris has been selling their, the quality of our products, the safety of our products have been selling that for a long period of time but we are also selling some of the unique technology that we have.

And so I certainly believe the environment today is more favorable than it was six months ago, let me kind of put it that way.

So, and I think I went on to say that the potential, the potential in our business is very healthy there.

We have excess capacity.

We are not challenged with manufacturing problems in our own plants right now so I guess you have to read into that that we are pretty optimistic about the potential there.

But also this is not, it's not just an Alaris stand alone solution.

It is Alaris and Pyxis and coming together with our integrated provider solutions to provide unique solutions to the customer.

It goes beyond just an Alaris product.

And so frankly while we may see the short term as very attractive I would say the long-term is probably even more attractive for all of CTS.

Next question?

Larry, your line is open.

That may have been me, Larry Marsh.

Let me see.

Just wanted to first of all, Jeff, thank you for addressing the issue of the vendor charge and other issues.

That was question I did have so I appreciate that.

Let me address the question of reporting and option expenses.

What quarter have you suggested you are going to start to show and report into the full distribution supply chain services business?

I'm not sure I fully understand your question, Larry.

But let me try to address it and if I don't -- first of all we won't start pushing down the equity costs to this segment, so I would expect in fiscal year '07 at the same time that we started building that into guidance.

In terms of the question about, your question was when are we going to start giving more transparency into the pharmaceutical distribution results?

That comment was sort of related to the reorganization that we are going through that once we reorganize into our new larger distribution segment one of the things we are going to do in addition to obviously giving information about the total segment itself is give additional clarity into pharmaceutical distribution specifically.

So people can maintain some visibility into that.

Does that address your question?

Did we lose people?

Sir, do you have any closing remarks?

Larry, did you get your question answered?

Is my line still open?

Okay.

I'm sorry.

I just wanted to make sure I understood have you identified what quarter you will start to report the full supply chain services business separately?

We said starting in the second half of the year.

We haven't nailed it down to a specific quarter yet.

It will depend on a number of issues including separating the systems and getting all the financials in order but it will be sometime during the second half of the year.

Okay.

I got it.

And I apologize for not being more clear.

Jeff, I guess you are now suggesting equity compensation expense, it sounds like it's a little less than what you had suggested with the fourth quarter call.

So I want to confirm that, and you are suggesting that your fiscal '07 equity comp number will be substantially less than '06.

Is that right?

And are you giving us any sort of ballpark as to how much less that could be next year than this year?

Okay, let me try to address that.

First of all in the fourth quarter call I said around 240 million.

Now I'm saying for the full year somewhere between 215 and 230.

So, yeah, that is a slight decrease from what I anticipated three months ago.

Going into fiscal year 2007 there are two changes.

First of all obviously Bob's SAR in his totality wouldn't be reflected in that year and that's about 33 million that I referenced earlier.

You can take that off the number.

In addition to that there will be a reduction from the remaining amount as well as the impact of some of the changes to our equity comp programs go into effect.

I can't quantify it exactly yet but it will be a material reduction.

Okay.

That's all I have.

Thank you.

Let me wrap up by just giving you a quick summary.

Obviously we've gone through '05 with a number of challenges some of which were environmental.

What I define as environmental are regulatory kind of challenges which required us to focus additional efforts to improve there.

And also what I call a major kind of strategic challenge around pharmaceutical distribution.

I frankly think we made a good transition there, have done the transition of pharmaceutical distribution is pretty much completed and I think what we should conclude from that is we understood what was happening, certainly the transition was more volatile and happened more quickly but it did verify the importance of the drug wholesaler and servicing both the pharmaceutical manufacturer and the customer and did validate the importance of the prime vendor model.

So as we move into this year, I'm sorry, in '05 we also had execution issues and what I would say major issues around Pyxis and certainly in sterile and we can enumerate some other execution issues.

So where are we today?

As Jeff started out to say we feel that we've had good, good performance on the execution side as this quarter clearly demonstrates in our pharmaceutical distribution provider segment, continued good performance for medical products and frankly ahead of the kind of guidance I think we had given you and our clinical technology area.

In the PTS area we haven't demonstrated that to you yet.

So, yes, there's been a lot of questions around, how does this compare sequentially to prior quarters and how does it compare to the, sequentially our fourth quarter, how does it compare to the year ago.

And then why can we have confidence there.

What I would say to you is the following: you need to break that business down into we call nuclear pharmacy business and that's about 30% of the earnings for that segment and while there is some seasonality I am not going to try to compare this to our fourth quarter because there is seasonality to each one of these businesses, but nuclear pharmacy business is a solid business, continues to grow market share, good margins and we have confidence that business about 30% of our earnings.

Oral which is about 40% of our earning.

It is down on a sequential basis.

That's partly seasonal, it's partly just timing of royalty payments, et cetera, but there is nothing significant going on there in any negative way.

Frankly a lot of real upside opportunities, contracts in place, products that are coming to market or additional demand in our sterile -- I'm sorry, in our soft gel business.

Packaging is pretty much a steady business so we are dealing with sterile.

Sterile last year actually cost the company money.

So instead of it being a contributor it was a detractor, that segment.

And for the first half of this year will basically be a break even and will contribute very little.

We expect in the second half it will be more than 10% of the earnings of the business for the second half.

That's kind of the way we see the business.

We are very focused.

What's going on in sterile is we are finished with the expansion, we are finished vacating facilities that had been problematic, our productivity way up in Albuquerque and in Woodstock.

Demand for our product is still there.

I would remind you that manufacturers have filed products there and are, for production there and we have implemented price increases.

So that's kind of an overview of where we are.

We are confident about the balance of the year.

Thank you very much.

Are there any other remarks?

We are done, operator.

Thank you.

Thank you for participating in today's conference call.

You may disconnect at this time.