卡地納健康 (CAH) 2006 Q2 法說會逐字稿

Good morning, my name is Heather, I will be your conference facilitator today.

At this time, I would like to welcome everyone to the Cardinal Health second quarter 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 session. [OPERATOR INSTRUCTIONS] Thank you.

Mr. Strohm, you may begin your conference.

Thanks.

Good morning everybody, and welcome to Cardinal Health fiscal 2006 second quarter earnings release conference call.

Our remarks today will be focused Company's consolidated and business segment results for the quarter, included in the press release and attached financial statements.

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

Additionally, there are a handful of slides that we will be reviewing, which can also be found at the Website.

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

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

After Jeff's formal remarks we will open the phone lines to your questions.

As always, when we get to questions, we ask that you limit yourself to one question.

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 and anticipated or implied.

The most significant of these risks and uncertainties are described in Cardinal Health's filings with the Securities and Exchange Commission [inaudible, static].

In addition, statements in this presentation include adjusted financial measures, governed by Regulation G. A reconciliation of these measures is included at the end of the slide presentation, and is also post 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 and good morning everyone.

Thanks for joining us today.

My comments today will focus on the financial results of Company, and some of the underlying issues driving us.

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

Before we get to the numbers, I'd like to start with a few high level take-aways for this quarter.

We began our fiscal year 2006 with improved operating results and good momentum in three of our four operating segments, as reported in our first quarter earnings release in October.

I'm very happy to say this momentum continued in Q2, as we generated increased revenue and improved operating margins, both sequentially and year-over-year for the consolidated company.

Our focus on improved business fundamentals and good balance sheet management resulted in a very strong sequential increase in return on invested capital, increasing about 100 basis points over the prior quarter, including special items and equity comp.

We also fulfilled our commitment to return a substantial portion of our operating cash flow to shareholders.

To date, we have completed almost 600 million of our previously announced $1 billion share repurchase program.

On today's call I'll discuss our fiscal 2006 second quarter consolidated results, plus our segment results for the same period.

I'll also review our fiscal 2006 second half focus items.

These are items that we as a Company are focused on to provide incremental shareholder value.

I'll also provide an update to our financial targets and goals, and then briefly discuss a few other items.

Let's get started with the second quarter results.

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

Overall revenues were up 7% to 19.9 billion, reflecting strong demand for our diversified offering of products and services.

This includes bulk revenues in pharmaceutical distribution for 7.1 billion, compared to 5.8 billion for the same period last year.

Operating earnings were 505 million, an increase of 18% over last year.

Net earnings for the quarter were 321 million, a 15% increase over prior year results of 280 million.

Diluted EPS for the quarter was $0.74, compared to $0.64 last year.

Consolidated SG&A expenses for the Company increased approximately 14% over the prior year. 8% of which is related to equity compensation, or $56 million for the quarter.

The balance of the increase is largely driven by current investments in One Cardinal Health.

And significantly higher management incentive bonus accrual this year compared to last year, due to current operating performance.

This increase in overall spending, particularly at the corporate level has resulted in fairly large increases in our corporate allocation amounts in the individual business units, which have had a negative impact on segment operating earnings growth rate.

As I discuss the performance of the individual business segments, I'll point out this affect on earnings growth.

I should also note that this ramp-up in corporate spending is happening this year as as we increase our scale and capability in certain defined shared services.

Over the medium term, you'll begin to see the impact of this as a reduction in our costs in the segments, and overall moderation in SG&A expense.

Operating cash flow for the quarter was $661 million, and return on equity, excluding special items and equity comp was 16.2%. 280 basis points higher than the same period last year.

Up about 240 basis points sequentially, compared to our fiscal 2006 first quarter.

In the next slide, I want to try to simplify our financial presentation by pointing out to you specific items that had an impact on current and prior year operating results and earnings per share.

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

First let me quickly review the special items.

During the quarter, net special items totaled $21 million, or 17 million after tax, impacting diluted EPS by $0.04 per share, versus $0.16 per share in Q2 of '05.

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

Included in this amount were merger-related costs, restructuring items mostly related to our One Cardinal Health program, and other items including a $13.4 million antitrust litigation settlement gain, and a $10 million reserve related to the ongoing settlement discussions with the SEC, raising the total reserve for the matter to $35 million.

Our press release updates the status of the SEC investigation.

At this point, we're not in a position in this call to comment any further on this issue.

Now, let's turn to the nonrecurring and other items.

For clarity, these costs are included in our diluted EPS of $0.74, as discussed a few moments ago.

And totaled $0.01 for the quarter, compared to $0.10 last year in Q2.

Asset impairments for the quarter totaled $5.1 million.

Our only other item in the quarter was a $3.5 million credit taken within our Pharmaceutical Distribution and Provider Services segment, which was an adjustment related to the $31.8 million charge taken in our first quarter of this fiscal year.

After additional analysis, and a settlement with a vendor, we found it necessary to reduce the original charge.

Going forward as we continue to work with vendors, I would anticipate some additional minor adjustments to be made.

Regarding equity compensation, the impact in the quarter was 56 million, or $0.08 per share, compared to less than $0.01 per share last year.

For the full year, we would anticipate the total impact of all equity compensation to be approximately 220 to 230 million, or $0.32 to $0.34 per share.

Please note that this amount while still within our previously disclosed range, has increased slightly at the bottom end, due to the increase in the stock price, and its impact on the accounting for the outstanding [star] grants.

Going forward, beyond our current fiscal year, we would expect this cost to substantially decline year-over-year, as we have made significant changes to our equity compensation program, including our reduction in the overall number of options granted in a given year.

I would expect EPS impact to decline by approximately 20% each year, over the next few fiscal years.

For clarity on this issue, we've chosen to follow the modified perspective method for recognizing equity compensation expense.

As such, equity grants after July 1st 2005, will be recognized as compensation expense over the related vesting periods.

The remaining portion of all unvested equity grants at the date of adoption will be recognized over their respective vesting periods, using the fair value previously calculated for pro forma disclosure purposes.

I know that some U.S. companies have decided to accelerate vesting, but we have decided not to accelerate the vesting of previously granted options.

We believe that just wasn't the right thing to do, as it would effectively increase an employee benefit, beyond what was the original intention.

Now let me provide our fiscal year 2007 guidance, we will include equity compensation as part of that guidance.

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

At Pharmaceutical Distribution and Provider Services, revenue increased 8% to 16.2 billion, in line with our expectations.

Operating earnings were 240 million, an increase of 16% over the prior year.

These results include a $13 million LIFO credit, primarily as a result of increased generic deflation.

Contributing to this growth was continuing ongoing expense controls, the impact of our DSA agreements with branded manufacturers, and strong sales to retail chains and hospitals.

We continue to have the lowest cost structure in the industry, and through continued efficiency improvements, we hope to continue this lead going forward.

During Q2 we signed a sole source agreement with United Drug and are happy to say we're ahead of where we thought we'd be at this point, with an independent purchasing group.

I'd like to spend a few more minutes speaking about our DSA agreements that are now in place with our branded vendors.

One of the benefits of these agreements, now that they are substantially in place, is that they result in much less seasonal volatility, as the majority of our earnings are no longer contingent on price increases.

For '06 comparisons versus '05, this results in some asymmetrical growth patterns during the four quarters.

Specifically, we've seen strong growth in the first half of the fiscal year, driven in part by a weak pricing environment in the first half the last year.

We do not expect this growth trend to continue in the second half of this fiscal year, due to tougher comparisons from '05.

Looking forward our focus in this segment continues to be driving expense control, a focus on differentiating customer programs, such as unit-dose barcoding at the hospitals, and building unique marketing capabilities.

One such capability, our National Logistics center, remains ahead of our utilization projections as we added several significant customers during the quarter.

Medical Products and Services generated revenue of 2.6 billion, an increase of 7% over the prior year.

Operating earnings for the quarter were 153 million, down 1% over the prior year.

Earnings in the quarter were impacted by the allocation of increased corporate spending that I referenced earlier, which negatively impacted the operating earnings growth rate by approximately 7 percentage points.

During the quarter Medical Products acquired their remaining interest in Canadian distributor Source Medical, the Canadian operations have continued to perform well, which contributed to continued strong growth in markets outside of the United States.

Sales growth in private-label products were strong, and our lab instrumentation business continues to perform well.

Additionally, the company was recently awarded a new contract by the Department of Veteran Affairs, to distribute medical products to the majority of its 900 U.S.-based hospitals and health facilities.

Through this relationship, we saw an acceleration in our customer conversions and implementations, which drove positive results in our second quarter.

Also, as was announced last week, medical products entered into a new 3-year contract with Premiere, resulting in the continuation of a long-term relationship.

Pharmaceutical Technologies and Services revenue increased 1% to 760 million, while operating earnings declined 5% to 79 million.

The earnings decline was partially due to increased corporate costs, which impacted the segment's operating earnings growth by about 7 percentage points.

In addition, a $14 million payment was received from a continuing customer, related to one specific product.

This amount relates to both commitments through the current period from the customer, as well as a cancellation of future commitments for this product.

I should mention that these types of payments are received on a regular basis from customers, as a normal part of our business.

This particular one just happened to be larger than normal.

As I mentioned last quarter, it was our expectation that operating earnings in the segment would grow sequentially, at least 50%.

I'm happy to say that we accomplished this goal, due in large part to improvement made within our Sterile manufacturing operations and a strong quarter for oral technology.

Within our Sterile operations, as expected, our Albuquerque facility upgrade was completed, and we have seen significant improvements in output.

Clinical Technologies and Services had another very good quarter, as segment revenue increased 10% over the prior year, to 603 million.

Revenue growth was driven by exceptional performance from both of the manufacturing units within CTS, Pyxis and Alaris, which combined grew revenue over 14%.

The third leg of the CTS segment, Clinical Services and Consulting, we were at a more modest 8%.

Operating earnings increased 34% over prior years to 94 million.

Strong earnings growth was generated by our overall segment sales mix, from the higher margin products at both Pyxis and Alaris, and operational quality improvements initiated last year, specifically at Pyxis. [audio background noise] I should also point out that our results last year, include an Alaris purchase accounting inventory valuation adjustment in the amount of 3.4 million.

Pyxis backlog ended the quarter at 242 million, with committed contracts for the quarter coming in ahead of internal expectations.

A strong indication of continued demand.

Driving this strong demand continues to be our MedStation 3000 product. 75% of new orders were for this product.

Focus on customer initiatives are paying off, as customer satisfaction rates continue to improve.

Alaris products continue to see significant new customer opportunities as it grows its customer pipeline.

Approximately half of Alaris pump sales in Q2 were from competitive displacements, compared to about 25 to 30% historically.

The integration of Alaris and Pyxis is still going very well, as the management team drives focus on operational excellence initiatives.

We are well-ahead of our initial expectations generating 80 to $100 million in synergies over a three-year period, as these savings are being realized much faster than originally anticipated.

I want to take a few moments to share with you some items that we'll be focused on in the second half of this fiscal year to drive value.

Continued focus on improving business fundamentals will help drive organic revenue and margin enhancement across all business segments, which I'll expand upon in more deal in the next slide.

I would expect to see sequentially margin expansion in every business segment, in the second half of the fiscal year, compared to the first half.

This growth combined with lower capital requirements, particularly within our Pharmaceutical Distribution business, will continue to drive our returns on invested capital.

We will remain focused on good balance sheet management, with increasing return on equity, strong cash flow, and a focus on portfolio optimization.

We ended the second quarter at a net debt to total capital ratio of 4%, with over $2.2 billion of cash on the balance sheet.

We'll also continue to be disciplined around capital deployments.

As we previously announced, it is our intention to repurchase $1 billion of Cardinal shares during this fiscal year.

To date through January, we have spent about $586 million, to purchase nearly 8.8 million shares, and expect to complete the program by the end of the fiscal year.

Over the long-term, we maintain our commitment to return up to 50% of operating cash flow to shareholders, both from increasing dividends and share buyback.

On this next slide, I want to provide you a little more detail on specifically how we see these initiatives discussed above, will impact our financial performance.

The first column represents our actual first half fiscal 2006 results by segment, and on a consolidated basis.

To the right, I want to provide you, to see how the second half of fiscal 2006 compared to the first half of fiscal 2006 and the second half of fiscal 2005.

Compared to the first half, the second half should be higher in all of these metrics.

Compared to the second half of last year, with the exception of operating margins in PDPS, and the consolidated company operating margins, all metrics should be higher to stable as well.

As previously explained, the issue within PDPS is that during last year's second half, earnings within this segment benefited significantly from the impact of price increases.

A seasonal fluctuation which is much dampened this year, due to the fee-for-service agreements now in place, the performance within PDPS also impact our consolidated operating margins as well.

Now I'd like to discuss our financial targets and goals slide, you'll note in this first slide I've highlighted the left side, where there are no changes in our long-term goals.

Now, let's discuss fiscal year 2006.

We see no change in our overall revenue and EPS targets for fiscal '06.

While we continue to be confident in the consolidated results coming in-line with our original expectations, I would like to address some changes within the individual business segments.

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

Within the Pharmaceutical Distribution and Provider Services segment, we have made no change in our fiscal 2006 target.

We expect to be below our long-term operating earnings growth target within this segment of 10 to 13%.

As I stated earlier, the year-over-year comparison for PDPS will be much tougher in the second half of the year, due to the impact of our conversion to fee-for-services.

Medical Products and Services, we continue to expect operating earnings growth to be in-line with our long-term goal of 6 to 9%.

We expect revenue growth and improved operating margins within our Medical Products Distribution and manufacturing businesses, to offset the decline in earnings from our specialty business, due to the loss of a significant customer, U.S.

Oncology as of December 31.

Price increases on manufactured products implemented in our second quarter, should contribute to improved earnings growth going forward.

The Pharmaceutical Technology and Services we are lowering our fiscal 2006 growth target below our long-term operating earnings growth goal of 12 to 18%.

While we continue to see improvements within sterile manufacturing and oral technology, margin pressure within our nuclear pharmaceutical business and weakness in our health-care marketing services business, will dampen earnings growth for the year.

Overall for the segment, I certainly expect that we will see sequential improvement in earnings and margin in the second half, as compared to the first half.

Offsetting the decline at PTS, will be greater than originally anticipated performance at Clinical Technologies and Services.

We now expect that fiscal 2006 operating earnings will grow faster than our long-term operating earnings growth goal of 15 to 20%.

Driving the improved performance will be continued strong demand for both Pyxis and Alaris products, significant margin expansion at both Pyxis and Alaris, and continued integration benefits, which are being realized much faster than originally anticipated.

All other fiscal 2006 targets will remain the same.

We continue to expect return on equity to be in-line with our long-term goal of 15 to 20%, and operating cash flow to be greater than 100% of net income.

As I previously mentioned, we will return greater than $1 billion to shareholders this fiscal year, including both share buybacks and dividends.

One other item I wanted to cover with you before I wrap up here, as we stated before, we will soon change our financial reporting segments, to include Health-care Supply Chain Services, Medical Products Manufacturing, Pharmaceutical Technologies and Services, and Clinical Technologies and Services.

I want to provide you an update as to the timing here.

It's our intention to begin to report results for these new segments in beginning in our fiscal year 2007.

After the end of the fiscal year, we'll provide our historical results for the new segments by quarter for comparison purposes.

This will, I believe, allow a smoother transition and better understanding of this year's fiscal results, as well as our future results and the new segment format.

It also better reflects the transition we will be making internally as we go through a change, and is responsive to some of the feedback we received from many of you on this issue.

In just a few moments, we'll open up our call for questions.

First I want to make a few additional comments to wrap up my thoughts on the quarter.

I am very happy with the progress we have made to date.

We believe we are focused on the right things to drive incremental value in each of our businesses.

A strong focus on improving the fundamentals of our business will continue to drive growth, and our continued balance sheet management and focus on portfolio optimization, will continue to generate improved returns on capital, ultimately resulting in increased shareholder value.

We continue to be very focused on capital deployment, and building internal capabilities, including management talent and depth, and implementing operational excellence across all of our businesses.

Great, thanks everyone, now let me turn it over to Bob now to moderate our Q&A session.

Okay.

Could we open up the phones to questions, please?

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

Operator, do we have questions, please?

Your first question comes from Andrew Weinberger with Bear, Stearns.

Hi, a quick question with regard to the PTS business and the customer cancellation.

I mean, should we read anything into that longer term, whether there are some executional issues, which drove the customer to decide to cancel that contract, or I guess, what should we take from that data point?

Well, I'll let, thanks for asking that, Andrew, I'll jet George discuss it, it's not an executional issue, you have products that come and go.

But George, why don't you just comment on that.

It's an ongoing customer that we do business with, not only in the area that was impacted here but elsewhere, and nothing to do with execution at all, more a decision on their part to continue manufacturing the product in-house, rather than to move it outside.

And a lot of that has to do with their own expectations about that product's performance.

Let me also add to that, George, you know, those sorts of payments are a very normal part of our business.

In any given quarter, we do receive payments from customers related to products not being improved by the FDA, or decisions to in-source the product.

And again, part of our business is reserving capacity for certain customers, and when those capacity commitments get cancelled, we receive a payment.

So, again, this is a normal part of our business, this particular one just happened to be larger than normal.

This is a continuing customer, that we have a very good relationship with.

Thank you.

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

I want to follow up on that last question, if I could.

You said the payment was a little larger than I guess, you had anticipated.

I'm assuming in the guidance that you previously provided for us with the segment being up sequentially more than 50%, you assumed some sort of payment there from this one customer.

One, let me confirm that that's correct?

Hi, Andy.

Yes, we did.

As a matter of fact, a substantial portion of that payment was reflected in our 50% sequential expectation guidance.

It did come in a little bit higher than we expected, but a portion of it was reflected.

And if I could, with regard to the comments, I guess that you're making with regard to the nuclear business and the health-care marketing business within PTS there, what specifically is going on there to cause the softness, and how long do you think that's going to last?

Let me talk about the nuclear business first.

Just to talk about overall, this is, we've got a strong position in this business, from a strategic point of view it continues to be very important.

We obviously have a huge opportunity long term in this business with the generic Cardiolite business.

This is one that continues to be a strong business.

Short term, there's margin pressure that's tracing to Cardiolite price competition, there's also fairly competitive marketplace between Cardiolite and Myoview, there's also a short [term impact, inaudible-static] from the supply of generators that goes into putting these products together, which is being addressed, but it's impacting our costs short term, but we're addressing that with new contracts.

So our expectation is nuclear will improve modestly in the second half, and we're competing very aggressively, so that will have some impact on margin in the second half, but we expect to see improvement as we move into fiscal year '07.

On the health-care marketing services side of the business, just so remind people, this is largely the [Mallinckrodt] business.

Some of that traces to things which have changed in the medical education market that have impacted our business.

It's one that we are looking very carefully at, to understand how to manage this business going forward.

We will see improvement in the second half in this business, particularly as we pick up some new customer business.

The profitability is not what it used to be but it will improve.

Just let me add something.

These two businesses are not equivalent in earnings impact to the company, in other words, the nuclear business is meaningful to PTS, [and from the size of] HMS is really pretty small.

So let's go to the third question?

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

Thank you.

Can you tell me what the ownership percentage and source that was consolidated was?

Was there any impact that we should model in going forward on other income, or was there any synergy whatsoever, in terms of consolidating that asset, or is it strictly just bringing a percentage in-house?

The sources are distribution, medical/surgical products in Canada.

In which we owned, at the time, I believe slightly more than 50%.

So we acquired the slightly less than 50%.

Jeff, you want to just comment on any financial impact?

This is one of those below-the-operating line impacts, because it was carried as a minority interest adjustment, below the operating earnings line.

So there will be a slight improvement in that, but it will be fairly immaterial for this year.

We ran the business before, no big changes, just in terms of how it's run or anything else.

Okay, great.

Thank you.

Your next question comes from Christopher McFadden with Goldman Sachs.

Thank you, good morning everyone.

A couple questions on PTS, Jeff, could you quantify or just clarify, what was the amount of the milestone payment in the quarter?

Hi Chris, the amount of the payment was $14 million, and that related to both prior commitments up through Q2 of this year, as well as a portion of that related to a payment for the cancellation of future commitments, for the contract that we had with the manufacturer.

Again, the total was 14 million.

As I said, we get those sorts of payments every quarter, and just to reference, a year ago those payments totalled about $4 million in the quarter.

Q1 of this year, they were slightly under 4 million as well.

So we do receive them, and they vary in size.

This one happened to be bigger than normal.

Understand.

Secondly, in terms of Albuquerque, in a percentage perspective, how much incremental capacity were you able to bring on here at the end of the calendar year, and is there more capacity, and could you kind of directionally quantify what additional capacity might still be forthcoming there?

Chris, good morning.

Let me ask George to address that.

Well, the capacity addition in the second half essentially allows us to double production.

Going forward, you know, the productivity will continue to improve more as a function of just improving the process and quality in our throughputs in the operation.

But today we've got ample capacity to meet demand there.

But I should also mention that we are focusing additional capacity in the North Raleigh facility, which we expect to be able to address the demand that we see in fiscal year 2007.

And I should envision, George, that that probably came to fruition late in the fiscal second quarter?

Albuquerque, yes, the capacity upgrade got completed in the middle of that second quarter, so it was continuously improving, but the impact was more in the latter part of the quarter.

Understand.

And then relative to the guidance guidance for the sector, I understand the nuclear comments relative to the F '06 guidance, I want to be clear, though, are you, Jeff, or Bob, changing the long-term financial targets for PTS?

No.

No, you're not?

No, my comments only related to fiscal '06.

Got you.

And we have talked conceptually, I emphasize this is not a guidance question but a conceptual question, that the opportunity for that segment was to move margins back to mind of a mid teens level, which is not inconsistent with where the business was historically.

I assume there's not a reason to think that's not still a longer term opportunity for the segment?

I think that is in the range of where we see margins going in the future for PTS as we continue to expand them.

Understand.

What's that?

Chris, we got to be careful about asking too many, we're going to try and limit to one question, but go ahead with your last question, I'll try and see if we have people tee up just one question.

I appreciate that, I'm sorry to overstay.

Relative to drug distribution, we have heard some conversations from competitors about kind of performance events, or performance kind of geared agreements that might have had positive impacts at the end of the calendar 2005.

Could you just comment at a high level whether or not you have got your agreements structured in the same way, whether that contributed at all to the fiscal second quarter results?

We don't know how our competitors negotiate their agreements.

You know, all we know is what they say publicly.

What we have said is that because our agreements have performance characteristics in it, which we like, and with regard to achieving on those performance objectives, we're doing extremely well.

And so we're happy with the structure of those agreements, and you know, I don't know that there was anything unusual in the quarter we just finished, with regard to being paid on.

In other words, there's not a year-end, meaning calendar year-end event, or anything like that for us that would have resulted in some unusual payments in the quarter.

So for us, for our agreements, our performance versus the criteria in our fee-for-service agreements, we're doing quite well.

After the relationship, but there's nothing particularly seasonal about those payments.

Thank you very much for the detail.

Thank you, Chris.

Next question?

Your next question comes from Glen Santangelo with Credit Suisse.

Just a quick question about revenues in the drug distribution segment, clearly up 8%, but if you look at that, the bulk deliveries were up 22%, you back those out, your other revenues, excluding the bulk, was down about 1%.

Could you kind of give us a little bit more color from a mix perspective, what may be resulted in that shift, and how that might have impacted your profitability within that segment in the quarter?

Thanks.

We focus on total revenue rather than splitting them out.

But the bulk business for us is profitable business, it's good business, it's business that's grown with existing customers, which we'll look at our ability to be able to do it more efficiently than them, because we can capitalize on our scale [around because it can drive rate of return for the business, static] But it's I think overall [inaudible, static] that fact that we're where we're at, and where we see it going, we focus on giving the profitability of both [inaudible], and we're focused just on the total revenue line.

Let me just add to that, we define bulk revenues as all full case products basically.

So we may not define it the same way as everybody else.

And if you compare this quarter, one impact of this quarter, when you look at DSD, which is what's called non full case, is [static, inaudible] They repair and publish.

And so that had an impact upon our growth rate year-over-year, and [inaudible] that back up second half [inaudible].

Your next question comes from Thomas Gallucci with Merrill Lynch.

Thank you very much, I'm not sure if anyone else is hearing it but -- [inaudible].

There has been some terrible feedback on the line, so we missed some of your last answer there, Bob.

But in terms of my question, I'm thinking about the mid search segment, it seemed like first half results were a little below where expectations might have been.

But you're kind of maintaining your expectation for the full year.

Can you talk about some of the specifics of where we might see some acceleration as we get into [inaudible]?

Tom, this is Jeff, you're breaking up as well.

Related to med search.

First of all [inaudible] growth rate, to be substantially dampened by the impact of corporate expense growth, and our change in methodology related to that.

If you actually back that out, the growth is more like 6% for the quarter, which is much more in-line with longer term expectations.

In terms of our expectations for the second half, we've indicated that it would be margin expansion within that, it's going to be driven by the continued impact of some of our aggressive sourcing initiatives, as well as some price increases that are taken on our manufactured products with which we'll [inaudible] the second half of the year.

Just as we think about forecasting that then, should we be thinking about backing out the corporate expense issue, to get to your kind of goal for the year, or should we see a bigger acceleration on the actual reported line to get to that goal for the year?

I think both of those.

You should back out the impact of corporate allocation, which actually is going to have a bigger impact in the first half than the second half, but I'd back it out, and then as I said, we would be looking for some margin expansion beyond that.

Okay.

Thank you.

Your next question comes from Lisa Gill with JP Morgan.

I was wondering if you could talk a minute here on PTS, which had much better margins than with a we were looking for, I was just wondering, over the next several quarters, obviously you have already met your goal, what kind of additional margin expanse can we see?

And secondly, Jeff can you walk us through the reconciliation of what's in the backlog and if I remember last quarter it was 247 million, this quarter it's 242 million, but you said bookings were good.

And I was wondering if you could perhaps give us bookings number and we can realize what revenue you recognized this quarter?

First of all, Lisa, think of CTS of really having two components to it, we have a manufacturing component and a hospital management sort of the [old own] we manage hospitals, and have consulting service.

In the manufacturing side, you've got Alaris and Pyxis.

We think the significant margin improvement opportunity [inaudible, static] with regard to Pyxis still on a fix there, and we think there is some margin expansion continues at Alaris, driven by some new products and demand for those products.

And the third area of improvement is really synergies between Alaris and Pyxis that we had outlined.

And I just saw a report on this yesterday, we're rather handsomely ahead of where we thought we would be, and our outlook for being ahead of where we would be going into next year, and for next year is very positive.

And those are our biggest margin impacts, probably not much margin impact in their improvements, although some, but not on our hospital management.

Jeff, you want to address the other question?

Yes, regarding the backlog, for all intents and purposes the backlog stayed about level from the previous quarter.

I'm not going to get into specific committed contracts, et cetera.

What I will say, though, is that as we continue to work on improving our installation times, which has sped up our ability to go from order to getting product in the hospitals, we've also been able to keep our backlog [inaudible, static].

Next question?

Your next question comes from Larry Marsh with Lehman Brothers.

Thanks.

I'll give it a go.

Hopefully you can hear me.

Hey, Bob, even with your share repurchases this year this quarter, you finished the quarter with over 2 billion in cash.

You know, I've been following you for a number of years, one of your imperatives has been to build scale and scope with strategic additions.

You've communicated the last two years, that has not been your priority.

Obviously you're suggesting the SEC small payment will be sometime soon.

So is there a possibility you would consider looking to expand again with more active acquisition programs this calendar year?

And if so, what broad areas would you consider, and would you ever consider shedding anything?

Thanks.

Larry, I guess the question is around external growth, what are we going to do with cash.

Jeff did outline what our intentions are with regard to cash, we will be returning about a billion dollars a year, we expect to complete that this year.

A billion dollars.

And we will generate about $2 billion a year of free cash flow.

So we're going to build it up at a rate of a billion dollars

There will be small acquisitions that we'll make, and we're in a market to do that, and currently looking at things.

When I say, as in these are acquisitions, certainly not new platforms, but these are acquisitions that really will fit right in with what we're doing, either give us more scale, or add to the value of products or services we currently have.

We're not engaged in looking at anything that's major right now, and if that means if our cash builds up, then our cash will build up.

We are really focused on the fundamentals of our current businesses.

We've got great prospects.

We can do better.

Lisa asked about margin improvement.

We are very focused on margin improvement.

For years I have talked about rising earnings with rising returns, and that means rising returns on sales, and returns on capital.

So we're pretty focused there, there's a lot to be done, and there's lots of opportunities.

At this point, really, I don't want to kind of wander around what else we might look at.

It's likely that we're going, we'll be building up some cash over a period of time, and we'll evaluate what to do with that cash.

There's nothing to announce with regard to acquisitions.

With regard to will would we shed anything, I think that question is a good question, not that the other wasn't, Larry.

[laughter] I can take it.

This one is also.

But you know, we're going to evaluate things.

Either it's not strategic to us any longer, it's more important to someone else, or it hurts our focus on other things.

And we don't have operations that are losing money that, and that becomes an issue, it's really a question whether this interferes with our focus on improving the fundamentals of other businesses.

And we're actively looking at that.

Don't expect anything that is really large right now in that category.

But you know, we're actively looking, and I think Jeff has made an indication to that in the past, about looking at our portfolio and carrying that portfolio.

So hopefully that answers your question.

Absolutely.

Very good, thanks.

Clarify the $2 billion that Bob cited per year is an operating cash flow number, not free cash flow, but the point remains the same.

Next question?

Your next question comes from Ricky Goldwasser with UBS.

Good morning.

Jeff, on your prepared comments regarding margin improvement, I think you noted in the second half of fiscal year '06, we should expect to see sequential margin expansion in at least three business segments.

Should we take it if we look at PDPS, that we should look at the June margins to expand over March?

And is this benefit change to the seasonal pattern that we used to see?

And also just kind of to follow up to the comment on the bulk revenue, my question there is, is the growth and volume you're seeing is it new volume that was flowing direct between manufacturer and retailers before, and now is going through you, or is it volume that before was part of operating, and now the clients decided to move to bulk shipment?

I'll answer the last question first, and let Jeff handle the rest.

The bulk volume or increase you're seeing is new volume with our existing customers.

Previously they were taking direct, not replacing [inaudible, static]

On your first question, as we said, with the transition to the fee-for-service agreement, we do expect to see a lot of the historical seasonality taken out of our quarterly patterns, that all said, it's not going to totally eliminate it, because we still have some price-contingent business.

So you could expect to see some of that impact in Q3 of this year.

As I said, the second half of that comparison will be a tough one versus last year.

I think that's particularly relevant for Q3 of this year, given that's where we realized most of the price increases last year.

Regarding how Q4 compared to Q3, I don't want to get in to specifics of the quarters, other than to say, we still would expect some price seasonality in Q3, that will go through the season.

Next question.

Thank you.

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

Thank you very much.

I missed a little bit of this, so I'm going to maybe repeat a question.

In the PTS segment, I think, George, I heard you say that there was some tracer shortages.

I'm curious, did you say that was the technetium generator out of Mallinckrodt which we had heard about back in November and December, and if so, how that will be addressed?

And I do have a bigger picture question after that.

Thanks.

Yes, what I was referring to is exactly what you mentioned.

And it's being addressed by supply availability from the other generator supplier.

That's how it's being dealt with.

I can't comment on when the expectation is for Mallinckrodt to be back onstream, although they are working very aggressively to do so.

Okay, thanks.

A real big picture question here, we are hearing some of the manufacturers are starting to ask third-party consultants to audit the wholesalers' performance under the distribution service agreement.

I understand that a lot of the past performance, or at least in the first few quarters of adoption, the past performance was being audited in-house, sort of self-administered by the wholesalers.

I'm curious, are you seeing the same thing?

Is it becoming material?

Is it true?

If the manufacturers are asking third-party auditors to come in, when is that happening, and do you have any initial thoughts on the process?

Yes, Eric, I'll give you some thoughts on it.

I don't see it as any big trend.

We've had relationships with manufacturers for a long period of time.

That have complicated, like our chargebacks and things like that.

There may be some manufacturers that would audit this, it's actually incredibly simple to audit, and it would be an ongoing process if it happened.

And we'd welcome it, it's not anything in any way that we're fearful about.

And this would be the simplest audit that we would have in our dealings with manufacturers.

So I haven't really heard that as any issue from our pharmaceutical distribution guys.

I think we have time for one more question.

Your next question comes from Barbara Ryan with Deutsche Bank.

Good morning, thank you for taking my question.

Maybe for Bob or George, but just looking at the days in inventory, it looks like they continue to come down sequentially one day, as did your receivables, and I know that some of your relationships are still more of the traditional variety, where you may get paid on the arbitrage of price increases.

And at least one of your competitors has already reported and had DSIs go up as a result of that, and there were, in the pharmaceutical reporting, specifically Pfizer, took January 1st price increases across the board.

And one would assume reading the press, that they're not a fee-for-service customer.

And Bristol Myers, some large products that maybe had some modest buy-in, and that doesn't seem to be reflected in your results.

I'm just wondering if they're just offsetting that, a number of other moving pieces, and then the implications for that in terms of the next fiscal quarter sinks.

Thanks.

Barbara, I'm going to try and take a shot at that question.

Good morning.

Good morning.

I think we've said that about 70% of our manufacturer relationships are on a form of fee-for-service, meaning noncontingent.

Right.

On price increases.

Now, we could be paid by price-advantaged merchandise, but they're non-contingent.

That means the balance is contingent, and we're pretty happy it's where we want it to be.

I don't really want to talk about any particular manufacturer who's taken price increases or not, what our relationship is with that manufacturer because, you know,

I understand.

that's proprietary and I don't think you're asking that.

So the question is, there certainly will be some seasonality left in our third and fourth fiscal quarters.

And that really happens, as you know, Barbara, because the pharma manufacturers tend to concentrate their price increases around the January period of time.

We would expect that would remain the same, and you can get access to what manufacturers did for price increases.

So we haven't seen any significant change in the price increase environment, so that there's anything that we're particularly surprised about right now.

And so there will still be some seasonality that will affect on a positive sense, our reported profits for the third quarter, and all of this essentially was taken into consideration when we look at the profitability of each one of our manufacturer lines on a full-year basis.

So I think that's about the only way I would know how to answer that.

Thank you.

Okay.

Well, let's wrap up.

I think as Jeff said, we're pleased about the progress we're making.

I think Larry introduced a subject, that said are we looking to do a lot outside the Company right now, meaning external growth?

While there may be some smaller opportunities, I think the message we want to state clearly, is that there are really big opportunities to improve our internal operations, and that's where we're focused.

And we'll look forward to reporting to you our third quarter results.

Thank you.

This concludes today's conference call.

You may now disconnect.