卡地納健康 (CAH) 2007 Q1 法說會逐字稿

Good day, ladies and gentlemen, welcome to the first quarter 2007 Cardinal Health conference call. [OPERATOR INSTRUCTIONS] I would now like to turn this presentation over to your host for today's call, Mr. Jason Strohm, Vice President of Investor Relations.

Please proceed, sir.

Thank you.

Good morning and welcome to Cardinal Health's fiscal 2007 first quarter earnings 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 tables.

If any of you have not yet receive a copy of our earnings 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 Kerry Clark, President and CEO;

Jeff Henderson, CFO; and David Schlotterbeck, CEO of Pharmaceutical and Medical Products.

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

As always when we get to questions, please limit yourself to one question.

In the course of this call we will make forward-looking statements.

These statements are subject to risks to risks and uncertainties that could cause actual results to differ materially from those projected.

Please see our press release and other SEC filings for a full discussion of these risk factors associated with them.

In addition, we will reference adjusted financial measures governed Reg G. A reconciliation of these measures is included at the end of the slide presentation.

At this time, I'd like to turn the call over to Kerry Clark, Cardinal Health's President and CEO.

Kerry.

Thank you, Jason.

Welcome and thank you, everybody for joining the call.

In just a moment, Jeff will walk you through the details of the quarter but I'd like to start with our top line assessment of the results.

I believe we're continuing to make progress in strengthening Cardinal Health, with a focus on customer driven organic growth and leveraging our scale through integration.

I believe we're making the necessary choices and investments for the long term.

We're implementing the strategies we detailed at our investor meeting last month.

And while we were generally pleased with the overall results this quarter, we are quite dissatisfied with the lack of broad based growth.

Two of our reporting segments performed in line with expectations, but three did not, primarily due to executional reasons that we are addressing with a sense of urgency.

Generally speaking, we do need to improve our executional capability here and we're not going to be happy until we're firing on all five cylinders.

We also remain though, confident in the earnings per share guidance we set out for this fiscal year.

So just doing a top line of the segments,, I would start off with healthcare supply chain services pharmaceutical.

We executed very well here, which helped drive strong top and bottom line growth for the entire Company.

Generic mix and expense controls drove a double digit increase in operating earnings in the segment.

Our four other segments contributed more than 40% of our total operating earnings this quarter, reflecting the diversity of our Cardinal Health portfolio.

And we think this diversity remains a unique differentiator for both our customers and our shareholders.

Our medical products manufacturing segment had an excellent quarter of double digit revenue and earnings growth.

This segment had balanced results across this product line and made investments for future growth by launching our non-latex surgeon gloves in key regions outside the U.S.

In healthcare supply chain services medical, the transition to new customer service centers and new integrated hospice organization contributed to a weak quarter.

However, trends improved towards the end of the quarter and with a lot of hard work we should see recovery in the second half.

In clinical technologies and services, the delayed launch of two new products and the Alaris SE recall has slowed the momentum we had exiting fiscal '06.

The Alaris PCU Version 1.5 has now been released.

And the Pyxis MedStation 3500 is in the final stages of limited release and will be in full release in Q2.

We are making progress with the FDA on the Alaris SE recall issue and believe we have established an appropriate reserve for going forward.

Pharmaceutical technologies and services had a mixed quarter with strong results in oral meds and packaging services and continued weakness in sterile manufacturing.

Incidentally -- internationally, we saw good progress with sales up 11%, which is very favorable to our comparable businesses in the U.S, in other words total Cardinal Health excluding pharmaceutical.

However, international accounts for less than 2% of Company revenue, so we have lots of opportunity.

Our strategy is to be focused on key countries;

France, Germany, the UK and Canada.

With targeted products and services implemented in line with local market conditions.

Additionally, we're launching One Cardinal Health programs to leverage our scale in these countries.

We've begun with Canada and the recent deployment of David Lees and we expect to announce country leaders in the UK, France, and Germany shortly.

Overall, I'd still believe we have strong drivers for future growth in Cardinal.

We have the industry's most efficient supply chain, a broad portfolio of market leading products and services and great opportunities to make healthcare safer and more productive.

We're being selective and strategic with acquisitions such as Care Fusion, an industry leader in wireless, barcode enabled patient identification systems that we announced last week.

And MedMined, which we announced last quarter.

And we have others on the horizon.

Before turning it over to Jeff, I want to address one more topic.

Some of you have spoken directly to me about wanting more detail around our One Cardinal Health results and sterile manufacturing.

As we want to be viewed as both candid and transparent, I've asked Jeff to give you an update on One Cardinal Health in his section.

And Dave Schlotterbeck has joined us to provide an update on some of the key metrics in our sterile recovery plant.

Jeff?

Thanks, Kerry.

Good morning, everyone.

On today's call, I'll discuss our fiscal 2007 first quarter consolidated and segment results.

I'll also share with you our key value drivers and I'll review our fiscal 2007 financial targets and goals.

Finally, I'll conclude with some information regarding what we're doing internally through our Cardinal run generics and, as Kerry mentioned, provide an update on our One Cardinal Health.

Let's start with our consolidated first quarter results.

Please note that my comments will reflect the financial results in continuing operations on a non-GAAP basis.

The definitions at the end of the slide describe in detail how we are calculating these non-GAAP metrics.

Overall, revenues were up 11% to $21.4 billion, driven by very strong demand within our healthcare and supply chain services pharmaceutical segment, which increased over the same period last year.

Operating earnings were $490 million, an increase of 23% over the same period last year.

Earnings from continuing operations to the quarter were $320 million up 27% over prior year results of $253 million.

Diluted EPS for the quarter was $0.78, compared to $.59 last year, up 32%.

A contributing factor towards our operating and net earnings growth was total SG&A growth of only 2% in the quarter versus prior year.

Another contributing factor to this low increase in SG&A was the expected decline in equity compensation expense.

The core SG&A growth was only slightly higher than the consolidated 2% figure and obviously, well below 50% of overall growth.

I'd also point out that our effective tax rate in Q1 of this year benefited by $16.7 million or $0.04 per share, which is attributable to an adjustment in the Company's tax reserves, primarily as a result of the issuance of final our revenue report as recently disclosed in our fiscal 2006 10-K.

For the full year, we continue to expect our effective tax rate to be about 31.6%.

As you can see, there will be some variation in our effective tax rate over the course of the year.

Operating cash flow for the quarter was $722 million.

And return equity was 15.3%, up 380 basis points over the same period last year.

Turning to our next slide.

I want to try to simplify a financial presentation by pointing out to you specific guidance that had an impact on current and prior year operating costs and earnings per share.

Specifically special items, [inaudible] and non-recurring other items.

I hope you'll agree, that this presentation has continued to [satisfy] we have work to eliminate presentation of any non-recurring items.

First, let me quickly review the special items.

During the quarter special items totaled $24 million or $18 million after-tax.

Impacting diluted EPS by $0.04 per share versus $0.03 per share in Q1 of last year.

Included in this year's amount were costs associated with restructuring operations, efforts to integrate acquired companies, [inaudible] associated with litigation settlement, including a provision for a potential settlement related to the previously disclosed litigation and SEC investigation.

Impairment charges and other items, during the quarter impairment charges were $4 million or $3 million after-tax, impacting diluted EPS by 0.01 per share, and 0.01 per share in Q1 of last year.

These impairment charges in the quarter included several very small asset impairments.

Nonrecurring charges, I want to remind you that in our first quarter of last year we incurred a $32 million charge within our healthcare supply chain services pharmaceutical segment.

Clearly, these costs are included in our non-GAAP diluted EPS of $0.59 in Q1 of last year.

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

In healthcare supply chain services pharmaceuticals, revenue for the first quarter increased 12% to $18.5 billion.

Record growth within this segment was driven by strong growth in the distribution of pharmaceuticals, which increased revenue 16% over the prior year.

This revenue growth was due to both good organic growth within our core direct store delivery business, which was 14% and continued increases in bulk customer sales.

If you'll recall, this segment now includes our specialty pharmaceutical distribution business as well as Medicine Shoppe and nuclear pharma.

In 2006, we divested the majority of our specialty distribution business, which negatively impacted our growth rate in this segment over the prior year, as we saw revenue decline over $500 million in this business in Q1 versus last year.

Operating earnings for the segment are $301 million, an increase of 24% over the prior year period.

Results from the first quarter of fiscal 2006 include the $32 million nonrecurring charge related to vendor credits and higher [inaudible].

There was no LIFO impact in earnings on Q1 of this year or last year.

Now, a few words about a metric I introduced at our September investor conference, that I'll be referencing several times today, economic profit margin.

We've talked in the past about the need to consider both operating margins and capital efficiency when making operating decisions.

Specifically, we're taking a lower margin distribution business.

To that end, we have begun to utilize economic profit margin as a metric to combine both the impact of the income statements and the balance sheet as measure of our performance.

Going forward, we'll provide this metric for each of our healthcare supply chain services business segments.

Within healthcare supply chain pharmaceutical, economic profit margin increased 15 basis points to 0.76% in the quarter, compared to 0.61% in the prior year.

As indicated, this improvement was driven not only by an increase in operating earnings but also due to the lower tangible capital, as we continued to focus on driving capital out of this business.

Days of Inventory declined two days compared to the first quarter of last fiscal year.

Healthcare supply chain services medical segments review for the quarter was $1.8 billion, up 2% over the prior year.

While we saw good demand at Source Medical, our Canadian operation, and in the lab market, our hospital and Presource surgical kitting business negatively impacted overall revenue growth.

Within the hospital distribution business, the customer service consolidation and our new sales organization, IPS, have had an impact on our revenue growth.

While we were disappointed with the current impact that this is having on our business, we are extremely confident that these changes are the right moves for the organization.

And the outcome will improve customer service level and the new sales organization will significantly enhance our customer relationships with hospitals.

Presource was impacted by competitive pressures on sales price, which we are working to offset by a move to more standardized product selection within the surgical kit.

Operating earnings for the quarter were $74 million, a 10% decline compared to the same period last year.

Impacting earnings growth in the first half of this fiscal year, including Q1 as I discussed at our investor conference, is the impact of certain corporate allocations for this segment in particular.

While the impact here is against earnings growth in the first half of this year, it will provide a benefit to earnings growth in the second half of the year.

As we move into Q2 and the rest of the year, we clearly have some work to do to get our revenue growth in this segment back to expectations.

Through operational excellence initiatives to address their cost and capital requirements and the goal of the stable economic profit margins for the year.

Clinical technologies and services segment revenue for the quarter was $594 million, up 3% over the prior year.

And operating earnings were $68 million, down 14% [Inaudible.] Previously disclosed Alaris SE pump products impacted operating earnings in the quarter.

We took a $13.5 million charge for what we currently estimate the cost to fix the pump to be.

In addition to lost earnings of about $2 million in the sales so far.

New product launches and medication technologies also impacted revenue growth in the quarter.

Two of these products, Pyxis MedStation 3500 and the Alaris PCU Version 1.5 were both delayed in the quarter.

While it was unfortunate these costs and delays occurred, which will dampen earnings growth in the first half of this fiscal year, we remain confident in the outlook for this segment.

The Alaris product has been released in the market and the MedStation is in the final stages of limited release and will be fully released in Q2 of this year.

Our supply products business, which consists primarily of Pyxis supply products, performed very well with revenue growth of 13%.

As I recently discussed at our investor conference, the key driver to growth in this segment is product innovation.

During the quarter, despite the slow of revenue growth, we continued to make significant investments in R&D, including not only new product development spending but investments in infrastructure to report our new medicine solutions offer but is unique in the marketplace as it combines both our Pyxis and Alaris products, as well as consulting capabilities and other incremental product offering, such as the recently announced Care Fusion verification costs.

Also impacting earnings growth, were continued investments in product quality and customer service, which has resulted in meaningful improved customer service ratings.

As we're making progress here, as it is not only our internal metrics that have shown improvements but we are see being the same metric improvements from an independent third party.

Based on the most recent results from an independent research firn Pyxis products ranked Number Two in the market for the first time in about two years and saw meaningful improvements in of five of seven performance categories.

I don't think any of us would be completely satisfied until we rank Number One in quality, though we are certainly headed in the right direction.

In summary, we believe these continued investments R&D, quality and customer service, while negatively impacting this quarter, will help us sustain continued strong growth well into the future.

At pharmaceutical technologies and services, or PPS, revenues increased 10% and operating earnings increased 13% to $22 million.

We saw good performance in both the sterile manufacturing and packaging services business led by strong demand for our proprietary technologies, such as Zydis.

Operational excellence initiatives across the segments are being employed to drive improved performance.

For example, we're working to improve capacity for both our Zydis technologies and packaging services and we see continue strong demand, in addition to the continued projects to help address operational issues within our [oral] manufacturing operations.

Additionally, in oral manufacturing, the quarter was majorly impacted by volume declines on a high volume product related to the anticipation of a reduction of Medicare reimbursement levels and by flu vaccine levels.

As mentioned earlier in the call, Dave Schlotterbeck is here with us today to specifically address these issues and provide you an update as to our progress.

Despite the challenges in sterile, we continue to make progress at our new facilities in North Raleigh and Brussels .

As we previously disclosed, in early September we obtained FDA approval for the production of the first products at the North Raleigh Facility, which was slightly ahead of schedule.

We continue to expect that this site will be at a possible run rate by the end of this fiscal year and contribute positively to earnings in fiscal 2008.

Medical products manufacturing revenue increased 11% to $424 million.

And operating earnings increased 15% to $61 million.

Revenue growth was driven by competitive wins in respiratory products, new contracts for our Convertors infection prevention products and strong glove sales.

Particularly contributing to revenue growth was increased demand for infection prevention products, as customers prepare for the upcoming flu season.

Operational excellence initiatives and the impact of previously implemented facility restructuring also contributed to the strong earnings growth.

Integration of Denver Biomedical continues to be ahead of plan and is contributing better than expected to this segment.

As we had previously discussed, product innovation is a critical driver of growth in this segment and we continue to invest in new product innovations with increased R&D spending.

As an example, we recently launched our Esteem blue synthetic latex- free surgical glove, which is are used as an underglove.

We're also launching existing Esteem synthetic gloves in markets outside of the United States to broaden our global trend.

For those of you that say my presentation at our investor conference last month, this next slide should not be a surprise.

It outlines what we view as key value drivers for fiscal 2007.

For the most part this should be very consistent with what we have been talking about over the past 18 months or so.

First, is operating growth, which we led by strong revenue growth driven by good demand for our products and services as we saw in Q1.

Within the healthcare supply chain services segments, both pharmaceutical and medical, [inaudible] our scale capital efficiency and operational excellence will drive economic profit margin expansion.

In the pharmaceutical and medical products segment, MPM, CTS and PPS, operational excellence, product innovation and international expansion will drive operating margin expansion.

Additionally, we see SG&A moderation driven largely by our One Cardinal Health program and declining equity compensation, as I discussed earlier.

Next is style sheet management.

We continue to have an increasing focus on return on capital , economic profit margin and economic profit in total in our investment and operational decisions.

Not only is this the way we manage the business but it's one of the measures on which our Management team is compensated going forward, which we believe is critical to drive behavior.

I also mentioned continued portfolio innovation [Inaudible.] We made good progress in fiscal 2006 as I've stated many times this is a continual process of business portfolio review that [Inaudible.]

Finally, disciplined capital deployment.

Again, nothing new here.

I think it's very important to be completely transparent regarding our intention with our cash.

Consistent with last year, 25% of our operating cash flow will be utilized by internal capital investments, 20% or so for smaller tuck-in acquisitions and about 50% is to be expected to be returned to shareholders.

Now, we'll remind you that we want to maintain this flexibility that will allow us to make larger acquisitions in the medium term and make strategic sense for the Company.

But in the short term here, you should expect to see us deploy capital consistent with these parameters.

Our major actions in Q1 were right in line here.

In addition to internal capital employment, we repurchased just under $500 million of Cardinal stock and we acquired MedMined, which is great fit to enhance our existing patient and product offerings.

Now I'd like to discuss our fiscal 2007 financial targets and goal slide.

This slide is in the same format as we utilized throughout the fiscal year.

The only change being that we have modified our reporting segment and it's pretty much the same as I provided last month at our investor conference.

But while the consolidated Company goals have changed, we have lowered the fiscal 2007 operating earnings growth target within CTS to below range.

I will discuss this further in a few moments.

All changes have been highlighted in red on this chart.

In fiscal 2007 on a consolidated basis, we continue to expect revenue to be at or above the high end of our long term range of 8% to 10% driven by strong growth within healthcare supply chain services pharmaceutical.

Non-GAAP diluted earnings per share is expected to be $3.50 to $3.70 per share.

Remember, this now includes equity compensation expense.

Non-GAAP return on equity will be in line with our long term goal of 15% to 20%.

And operating cash flow will be consistent with our long term goal of greater than 100% of net earnings.

A quick look at our capital deployment expectations, which are in line with our long term goal.

I'll remind you that in August this year, we announced a $2 billion multiyear repurchase authorization and to date we have repurchased just under $500 million.

We also expect improvement in our credit rating with a goal of a strong investment grade.

We believe progress is being made here as S&P recently revised it's rating outlook to positive.

Looking at individual segments, fiscal 2007 guidance remains generally the same.

In healthcare supply chain services both pharmaceutical and medical we expect fiscal 2007 operating earnings growth to be within our long term range goals.

The medical products manufacturing, we expect we expect fiscal 2007 operating earnings growth to be above our 10 to 12% long term earnings growth.

At pharmaceutical technologies and services we continue to expect earnings growth to be at the low end of our long term earnings growth goal of [8% to 15%,] primarily due to the opening of our two new sterile sterile manufacturing facilities in North Raleigh and Brussels, as well as continued operational issues at Albuquerque.

At Clinical technologies and services, as I mentioned a few minutes ago, we now expect to be below range of fiscal 2007 when compared to our long term operating earnings growth goal of 15% to 20%.

This is due to $13.5 million charge we took this quarter, as our current estimated cost to fix the SE pump, which is substantially higher than previously anticipated amounts, reflecting our more recent interactions with the FDA, as well as the potential negative impact of our just announced Care Fusion acquisition. [Inaudible] could negatively impact CTS earnings by about $6 million.

A few final but important items I'd like to cover.

I want to take a few minutes to share with you some of the initiatives we currently have underway around generics and this is an area we get a lot of questions, as well as an update regarding our One Cardinal Health program.

As Kerry, briefly mentioned at the investor meeting, we've brought together a cross segment team of folks within Cardinal who will focus solely on generics, including sourcing, manufacturing, and selling and developing various operating strategies to fully maximize our capabilities across all Cardinal.

This organization will have a global focus that will leverage our scale and include worldwide sourcing of generic products, one of many capabilities we currently have in the generics space.

In addition to our strong generic sourcing capabilities, our existing capabilities include Martindale, our generic Company in the UK, which manufactures markets and sells generic drugs in the UK.

We're looking to broaden our focus in Europe beyond that country in the near term.

Also, earlier this year, we added unique selling capabilities with the acquisition of [Tarmed] a [unique] focused on selling generics and mostly retail and independent.

We also have our hospital pharmacy management group, Cardinal pharmacy management services, which participates in generic sourcing opportunities as it establishes generic product portfolios for its hospital clients.

[Inaudible] -- best possible price and increase our presence in the generic distribution channel by adding value for our customers and invest in selected strategic product ownership.

And as referenced earlier, our recent generic performance has been strong giving us a great base from with to continue to grow.

Revenue growth has been very good and particularly within our proprietary source program, as we've been successful in capturing new business and increasing existing customer contracts from clients.

Now, turning to One Cardinal Health.

I just have a few additional comments to make.

As we said before, this is about much more than a cost savings initiative.

It is truly about creating an integrated operating Company with shared culture and shared services.

We further positioned Cardinal for a long term profitable growth.

It is also about making it much easier for our customers to do business with us, in particular, our hospital customers.

As Kerry said, we do provide financial savings targets and I want to provide an update for you.

When we originally announced this program back in December 2004, we stated our financial goal was saving more than $500 million in annual operating income improvement by the end of fiscal 2008, which were an integral part in regaining the Company's long term growth goals.

The savings includes benefits from facility restructuring, shared services, unique sourcing, and operational excellence initiatives.

We have seen real tangible progress in multiple areas.

We have fully executed on the integration of both our back office customer service center and financial shared service centers.

We are currently outsourcing meaningful portions of both IT and HR and are well ahead of schedule in integrating our CTS.

Operational excellence programs have become a foundation of our operation, with over 190 black belts now trained in the organization, which compares to only about 50 just 12 months ago.

Finally, good progress has been made around facility restructuring and we are now seeing the benefit, in particular within our medical products manufacturing.

These benefits are included in our guidance assumptions and are pushed down to our business unit budget, which holds our management team accountable for reaching these targets.

We track our progress internally not only by tracking individual product savings but also by looking at consolidated SG&A trends, our gross margin trends within our pharmaceutical and medical products business segments, and total Company headcount, which is expected to be down about 5% by the end of fiscal year 2007 compared to where we were in fiscal 2005.

I'm confident that we are well on track with our savings goals.

In fact for fiscal '07 we expect to be in the range of 70% to 80% towards our FY '08 goal of greater than $500 million in annual benefit.

At the same time, we will have incurred about 60% of the original Board approved $415 million restructuring investment for this initiative.

So, [Inaudible], probably the same place we do.

Look at our earnings margin trends within PMP and overall SG&A as the percent of revenue and headcount trend.

But also keep in mind that a portion of this benefit, up to an estimated 20% to 30% is being plowed back into the business, in particular around new product innovations to drive long term growth.

And as I've stated before, these net benefits are baked into a long and short-term goals including our fiscal '07 EPS range.

Okay, thanks, now I'll turn it over to Dave.

Thanks, Jeff.

For those of you who attended our annual investors conference in September, I promised to give quarterly updates on key performance indicators for the PTS segment.

And the three progress indicators that I'll address are sales pipeline, on time delivery and operational excellence.

To improve the operational growth of the segment, we're focusing both on increasing top line revenue growth and improving operating margins, ultimately resulting in an accelerated earnings growth.

These indicators will help you measure PTS progress around both revenue growth through sales pipeline and on time delivery and margin expansion through operational excellence improvements.

So let me start by describing some metrics around the sales pipeline.

To help measure future business opportunities, which will drive top line growth, I'll be looking closely at our sales pipeline to insure that we have the right mix and sufficient prospects to grow the business the way that we think it should grow.

Top line growth in PTS results either from growth of existing customer products over their life cycle, which is tracked through our reported financial performance each quarter or by selling new products and services, which we track through the sales pipeline.

For Q1, the volume of new deals signed grew by 20% and the value of the deals grew by more than 6% compared to the same period last year.

So we continue to see strong demand for PTS' products and services and we expect the demand to accelerate as we realize the improvements from our recent reorganization.

We realigned our global sales team to more effectively execute selling the full PTS offering and changed the sales incentive program to place more emphasis on gross margin.

We have already seen clear evidence of this contributing to pipeline growth.

Next metric is on time delivery.

I expect to see 90% or better on time delivery from all of our businesses.

As you'll see from the baseline numbers I'll provide, performance for the quarter is mixed.

I plan to update this performance here each quarter so that you can see that we're making progress against this baseline report.

Our best performance has been from oral manufacturing, which reported 90% on time delivery for Q1.

Oral has been a steady performer for PTS, so this is no surprise.

Printed components also show consistent good performance over time and Q1 is no exception.

Again, with 90% on time delivery.

Strong growth in contract packaging, resulting in capacity pressures at their largest North American facility has been the primary driver in their 68% on time delivery performance for the packaging services business.

Investments in additional equipment and labor, made during this quarter, will alleviate the capacity pressure and we expect service levels to improve and for this improvement to continue throughout the rest of FY '07.

Packaging services continues to deliver solid financial contributions to the segment, so improvements will only help accelerate PTS' growth.

Finally, our sterile business reported 65% on time delivery.

We've told you about the issues we faced with this business, so this performance should not be surprising.

However, I am expecting we'll make meaningful improvements through Q2 and have a better story to tell next quarter.

I say this because of the results we see from our focus on operational excellence in this business.

I expect we'll make sequential progress improving delivery performance throughout the remainder of the fiscal year.

Now, let me move to operational excellence, our third performance indicator because the projects we have under way are accelerators for improved execution.

While the proof here will be in our performance, a leading indicator for future success is the number of trained black belts deployed in the organization to drive these projects.

Today, in PTS, there are 46 black belts fully deployed with a fiscal year end target of almost 100 people.

I'll briefly cite three examples of lean manufacturing deployments in PTS.

I'll start with sterile.

Our Albuquerque facility is focused on operational excellence for the past several months and has removed 20% of their annualized cost base.

This is a great example of using lean as a cost take out initiative.

This cost reduction is achieved through process simplification, streamlining, and removal of non-value-added process steps.

In Albuquerque, we've already reduced total process steps by 30%.

Through this dramatic reduction, we not only achieved cost savings but improved throughput, delivery performance, and quality.

Going forward, we still have work to do in Albuquerque and I'm expecting another 5 to 10 percentage points of cost improvement through the course of FY '07.

Second, is the St. Petersburg, Florida, soft gel encapsulation plant.

Where we recently initiated a lean product that we expect result in eliminating about 5% of their recurring annual cost.

An ideal application of operational excellence techniques is where demand outstrips capacity at a particular facility.

This third example, our Zydis fast-dissolve plant in the UK is just such a situation.

We have a real need for long term -- for near term capacity to meet our customers' recent significant growth in demand for our products.

Through our operational excellence initiative there, we expect to realize capacity improvements of 10% to 15% by the end of Q3 of this fiscal year, all without the need for capital investments.

And this will fill the gap while we bring new capacity online in Somerset, New Jersey, in Q1 of fiscal '08.

I'd like to make one final point about our sterile manufacturing business.

We have two new sterile facilities that we're bringing online this year, North Raleigh, and Brussels.

We've built both of these facilities from the ground up rather than retrofitting an existing site and that's an important distinction.

Our progress at these sites will be key indicators for the health of our sterile operation.

So we'll also provide updates on how we're progressing and ramping up both locations.

As Jeff said, we're planning that North Raleigh will be profitable by the end of this year.

So that's the PTS update for Q1.

My intention was to set the baseline for this quarter and report our improvements over future quarters.

There is work to do in all three areas but I'm holding the team accountable to deliver in what I believe are the key drivers for PTS growth.

Let me also comment then from a financial performance perspective, Q1 is seasonally the lowest quarter of the year and I expect meaningful sequential improvement in Q2.

So, let's open this call up now for questions, Operator.

Thank you, sir. [OPERATOR INSTRUCTIONS] Sir, your first question comes from the line of Lisa Gill from J.P. Morgan.

Good morning and thanks very much for all the detail.

I was wondering if one of you could just perhaps address some of the issues at CTS.

First off, you talked about having conversations with the FDA.

I'm wondering if you can maybe just give us an update on the timing as it pertains to Alaris SE?

And then secondly, as you have these new products rolling out, it looks like, Jeff, you said that now the expectation is that it will be towards the lower end of the range for the entire year but I'm just wondering what we should see sequentially over the next several quarters as it pertains to CTS?

I'll take that question, Lisa, and thank you for asking.

First, we have had numerous conversations with the FDA and the reason that we have increased the size of the refurb that Jeff discussed earlier is because there are additional models of the SE pump that they wish to have retrofitted.

I have to say that we agree with that.

We've taken the reserve and we continue to move forward with the technical fix.

I think Jeff mentioned to expect a much stronger second half than first half for CTS.

That is exactly the way that we see it.

And that is fundamentally the result of the problems in Q1 associated with the late product introductions and the FDA issues around the SC pump rolling over into Q2.

There are additional expenses that we expect to see in Q2 as a result of the work that we're doing with the FDA and some of the operational issues that this has caused.

And so we do expect a much stronger second half for CTS.

And then secondly, on the timing of the Medstation 3500, I think you talked about limited release.

When will you have a full release?

Will that later in the year as well?

That is expected to be this quarter, Lisa.

Okay, great.

Thank you very much.

Sir, your next question comes from the line of Christopher McFadden from Goldman Sachs.

Thank you.

Jeff, a couple of items, if you could.

First of all, can you just remind us what your full year tax rate guidance is taking out sort of the one-time adjustment to this quarter?

And then secondly, can you just touch on any FX effect at all?

In particular, any excess effect in the new medical products manufacturing business.

As I would think there's some potential for a greater kind of sensitivity there.

And then Kerry, you probably know the Wal-Mart organization as well as anyone on this call from your prior role, recognizing they aren't a customer.

And very large enterprises like Wal-Mart tend to buy a good portion of their generic pharmaceuticals direct from manufacturers.

But as you think about their behavior in a channel and how to think about product opportunities, how are you embedding, if at all, some of their recent pricing discussion into this expanded generic strategy that you're trying to put together on an enterprise-wide basis?

Thanks very much.

Okay, Chris.

Thanks.

Let me address your first two questions and I'll turn it over to Kerry.

And again, remind everyone we're trying to limit the questions to one, so we can get to as many people as possible.

First of all, the tax rate for the entire year, Chris, is expected to be 31.6% which includes the one-time adjustment that we made in Q1.

In terms of the FX impact on our overall results, I would describe them as positive but relatively minimal in the overall scheme of things.

Kerry, do you want to address the final question?

Yes, Chris, just talking a few things about the Wal-Mart situation.

And first of all, the generics that have been included in the pricing action so far, as I'm sure you know, are items that are very low cost from a sourcing standpoint.

And also there's been quite a lot of competitive reaction from different customers in the marketplace.

And so far, none of our customers have reported any significant shift in volume or change in volume for them in this space.

So at the moment, it's pretty much a marketing activity that is playing out in the marketplace.

But looking longer term, yes, I think that many companies and many retailers and others are looking to continue to improve their sourcing capabilities in generics.

And a large part of that is being able to aggregate demand and to be able to strike the right sort of sourcing agreements with our generic providers.

And I think that some of the things that Cardinal can do very well is aggregate demand and use that to find the best sourcing deals.

So I still think at the end of the day, companies like Cardinal can still bring an enormous amount of value here simply because of the tremendous breadth of volume that we can aggregate together.

So, I think we can continue to provide large opportunities here for our current and prospective future customers in generic sourcing.

Great.

Thank you.

Sir, your next question comes from the line of Glen Santangelo from Credit Suisse.

Jeff I just couldn't hear some of your comments that you were making on the PTS division.

You sort of suggested that some of the weakness was attributed to a volume decline due to a reimbursement change in I think one or more products.

If you could just give us some more color around that?

And you also suggested flu vaccine and also operational issues at Albuquerque as a reason for the weakness.

Could you just kind of give us a sense for how much each of these different issues kind of impacted your results and just clarity around the reimbursement and flu vaccine?

Thank you.

Let me address the first part of your questions, Glen, and then I'll turn it over to Dave to talk about some of the operational issues.

First of all, the product I was referring to, there were actually there are two things there that some of the flu vaccine has been delayed.

But the first one I mentioned to you, which was actually a much bigger impact, is the fact that a fairly significant product that one of our sterile plants, in fact our Woodstock steel plant, orders there were significantly curtailed by the customer.

Because that particular product is coming up for Medicaid reimbursement review and until that review is complete, they were reluctant to build out too much inventory.

And given that was a fairly major volume product for us, it had a significant impact on Q1 results, particularly related to that one site.

With that, let me turn it over to Dave to talk about some of the specific operational issues.

Well let me add also, Jeff, that the comment on flu vaccine is that there's a great deal of flu vaccine packaged in the Brussels plant, Brussels sterile plant.

And the manufacturer of the original vaccine was actually late in providing the vaccine to the plant.

They just weren't ready within their normal time frame, so we do expect to see that coming back in the second quarter.

There was an operational issue in Albuquerque.

It had to do with a specific piece of equipment that caused us to shut down one of the bottling lines for a number of weeks to track down the root cause of the problem.

We believe that we have -- or that we completely understand the problem now.

This is the first time it has been seen.

And I would say that within nine months, we have a 90% certainty that we can eliminate that problem recurring again.

There have been a number of other operational improvements that have been made in Albuquerque, which are really designed to increase the reliability of that whole manufacturing operation.

And I'm not going to go into those but I really look at what happened in Q1 as a one-off.

Sir, your next question comes from the line of Ricky Goldwasser from UBS.

Good morning.

Regarding drug distribution, what was the contribution of Plavix in the quarter?

And how many additional quarters of lower priced Plavix benefit do you expect?

And then also how much basis points improvement did the SG&A efficiencies contribute to the drug distribution margin?

Thanks, Ricky.

I'm not sure I totally heard the last part of your question but I'll try to answer it and if I don't get it, please add to it.

First of all, we don't talk about specific product or customer volumes, so I'm not going to give you any details on the Plavix situation.

Clearly, we did have an opportunity to sell previously purchased Plavix during the quarter.

We have some inventory left at the end of Q1, which will continue to be released into Q2.

Regarding SG&A impact, I would say it had a fairly significant impact in Q1.

We continue to work very aggressively on our overall cost profile within pharmaceutical distribution business.

As I think most of you know, we have traditionally had the best operating cost structure within the industry.

And we have every intent of continuing to maintain that advantage going forward.

And the focus for us, particularly as we look to integrate our supply chain services pharmaceutical and supply chain services medical operations together, we see continued opportunities for cost reductions as well as capital reductions in the respective operations.

Thank you.

Sir your next question comes from the line of Steve Harper from Thomas Weisel Partners.

Hi.

Relative to MedStation 3500, you indicated that you would be releasing that product this quarter.

What was the original timeline for that product because you indicated that it was delayed?

And what are the differences between 3500 and the 3000?

The 3500 was scheduled to be released in the early in the month of September and there was a limited release of the product.

Unfortunately, there just wasn't enough time to revenuize some of the installations that had actually taken place before the end of the quarter in a way that it's consistent with our accounting policies.

Some of the differences are that this product actually has an updated operating system, which provides some significant improvements for the hospital users.

First, in the expansion of how data is archived and hospitals now can use this product to feed other systems in terms of what medications were issued to what patients.

Not only is this an upgraded operating system built off of Windows XP but it's also updated to use the Windows 2003 Server platform.

And quite frankly, these provide the hospitals with an additional security features.

And this was something that was requested by the Department of Defense to accredit these products for sale to them.

So fundamentally, this is an incremental improvement to an existing product, which I think is going to sell reasonably well in the marketplace.

Thanks.

Sir, your next question comes from Robert Willoughby from Bank of America Securities.

Thank you.

Jeff, you did mention an economic profit margin improvement for the distribution business, something like 15 to 16 basis points.

Can you give us -- it's an impressive performance.

Can you give us more color in terms of what generics did do for you from an income statement and balance sheet perspective on that metric?

The question is following our economic profit margin closely.

I knew you would.

And it actually improved 15 basis points versus the prior year period.

Obviously, the right trend as we look to continue on that focus margin within the pharmaceutical business for the foreseeable future and in fact, all of our distribution businesses given what a key contributor both earnings and capital have to our operating and business decisions.

As I mentioned during the prepared remarks, there were two factors.

Obviously, the earnings increase was a big factor as well as the fact that we're continuing to drive inventory out of the system and bring it down about two days versus the prior year period.

If you look at the specific elements within the operating margin and the margin change year on year, some margin continues to be an area of some pressure for us but that was largely offset by good results within our generics business.

I'm not going to give you specific numbers for the quarter but I will say that the generic business were up considerably in Q1.

And we saw very strong growth driven by a number of new item launches during the quarter.

So we continue to be very favorably benefited by a lot of the generic launches that are currently going on.

Jeff, maybe a different way to ask the question.

What I'm trying to get at, was the generics a bigger driver of economic profits from a balance sheet perspective or was it from an income statement perspective?

In both regards but I would say it's probably even larger from an income statement perspective in Q1.

Okay, thanks.

Sir, your next question comes from the line of Andy Speller from A.G. Edwards.

Jeff, I didn't know if you addressed the interest expense number.

It's significantly higher than what I thought.

Can you kind of talk about why the increase this quarter?

Sure.

The bottom line is our net debt level over the course of the quarter was about $200 to $300 million higher on average than it was this past year.

That was driven in large part by the fact that a good chunk of our share repurchase was at the very beginning of the quarter.

As you may recall, we announced we repurchased about $395 million within the first week of the quarter.

So that tended to lower our average cash balances and increase our debt levels during the quarter.

The second factor is that short-term interest rates are up considerably versus last year and a good portion of our debt portfolio is loading to impact it as well.

But if I look at the net debt numbers you guys reported through most of last year, you're not that much different at period end.

[Inaudible]

Sir, your next question comes from the line of John Kreger from William Blair.

Great thanks.

Can you talk a bit more about the proprietary sourcing program for generics and just give us a sense of about how far you are in that process?

I don't know if you're willing to say but how many manufacturers or SKU's have you run through the program at this point?

And is the uptake by your customers, are you seeing that across-the-board or in particular, customer categories?

John, I don't want to get into specifics at this point.

Clearly, parts of our new generic strategy are just being ramped up.

But I would say that we had a very successful generics business for some time now, so I wouldn't describe this as something that's just happening.

I think what's unique is that we're beginning to organize now in a more focused way to put all of the parts of our generic business in one place.

We've had our source program for independent retailers for some time now and that continues to be very successful and we drive a fair amount of generics business through that program.

We believe as we continue to integrate all the different parts of the generic opportunities together into one organization, we can leverage all of the different parts including our sourcing capabilities, our manufacturing capabilities, and our demand aggregation capabilities.

How that will play out and how that impacts results I would say, it is too early to say but I can tell you that it's getting a lot of focus right now.

We have some of our best people working on it.

And I would expect it to continue to drive significant benefit for us for the foreseeable quarters and years.

That's about all I want to talk about in detail at this point.

Great thanks.

Sir your next question comes from the line of Larry Marsh from Lehman Brothers.

Thanks, this is Steven Postal for Larry.

Can you elaborate regarding the customer service transition in the medical distribution business?

How has service evolved in that business?

And to the extent you'll continue making investments in that business, how should we think about the margin and profit growth progression over the next few quarters given that you've retained your goal to see high single digit profit growth there?

Let me take a brief shot at that.

On the service center aspect, we previously had 28 different service centers largely associated with our distribution centers that were handling customer service questions.

Last spring, we consolidated these 28 centers into two central service centers in Kentucky and Arkansas.

We moved this very quickly and all at once.

We ended up having a number of challenges from not only -- including technical but also taking the time to ramp up the service center staff and to align in a way that it could effectively serve our customers and create the type of relationships that our customers wanted in both the med-surg and in the pharmaceutical distribution work.

But frankly, there's still a lot of orders taken by telephone.

As we get to the end of the first quarter, we're starting to make good improvements in terms of how we're aligning the organizations with our customers.

We're starting to get good signs that our customer service levels are reaching the stage that we want to.

Although, we still have probably another quarter of work to do.

But the real impact on this is not that we've actually have lost any of our major customers in that business but we lost a lot of what I might describe as the casual business on telephone orders.

And that has affected our med-surg business and that's reflected in the supply chain service medical products numbers that you see.

As I said going forward, we're feeling confident that we've made the right strategic call.

And I say that because one of the advantages in having two service centers is we're getting much better quality information on consumer needs and customer needs and how we can best serve them.

Our costs are down and we think over time we're going to do a better job of serving our customers.

So we're still feeling very good about it and we're just starting to see the power of that starting to come through.

I think as we head into the second half, we're feeling confident that we're going to be seeing improvements in our med-surg business.

And that's why we haven't changed our guidance on the quarter on our med-surg business.

We're still feeling that we've got a good program.

We have pretty good data that suggests our med-surg market share is going to improve in the second half because we have managed to secure some new customers that will be coming on board in the second half.

So we're feeling confident and sticking to our long term guidance on that med-surg business.

Despite the challenge we've had so far, we feel we're strategically on the right path and we're going to see it come back to us in the second half.

Thanks.

Operator, we're getting close to the end of the hour.

Why don't we take two more questions and we'll call it a day.

Your next question comes from the line of Eric Coldwell from Robert W. Baird.

Thanks.

Actually, you just addressed my main question, so I'll shift gears here.

We've had a lot of headline risk in the quarter, which included the recent AWP debate or fiasco, if you will.

I'm curious if you can help us put that debate to bed and really help us understand how AWP does or does not impact your business model next year?

And then if you can just add-on to that any color around other external market dynamics in the supply chain like Medicaid AMP pricing or other issues that you're focused ongoing into next year that might be cause for market concern?

Thanks very much.

Eric, this is Kerry, here.

First of all, let me start off by saying that we don't believe that any change to AWP will or should have a meaningful direct impact on our business.

None of our contracts with either our provider customers or with manufacturers are based on AWP.

So, I don't think it's going to have a significant direct impact.

But let me say that both AWP and AMP, these have everything to do with reimbursement rates but they aren't directly related to the buying and the selling of the actual drugs themselves.

So, there's no question there's going to be a fair amount of activity on reimbursement rates that effects our providers, but it doesn't necessarily affect the buying or the selling prices directly.

I'd also like to say, particularly with regards to generic products, where I think there will be a lot of activity on trying to find the right benchmark numbers for reimbursement, that companies like Cardinal make their money on generics from a number of different areas.

And obviously, on the buying and the selling, of course.

But also in the generic space, we derived quite a lot of income from the services we provide to generic manufacturers and bringing their products.

And as that space is very competitive and generic manufacturers are looking to bring their products to the marketplace, companies like Cardinal provide a lot of valuable services.

So while it's probably reasonable to say there's going to be a lot of uncertainty on where pricing -- where our reimbursement rates are going to take their cues from, I think in the end, for companies like Cardinal, this shouldn't have any direct impact on our business.

Thanks, Eric.

One more question, Operator?

Sir, your last question comes from the line of Christopher McFadden from Goldman Sachs.

Thank you for the follow-up.

Just two quick clarifications.

Jeff, just to be clear, you still believe that for F '08, the $500 million benefit is still the right target for the overall One Cardinal program?

And then secondly, any update at all you can provide us relative to the SEC matter?

Thank you.

Sure.

Let me just handle both of those, Chris.

First of all, yes.

We do believe the $500 million benefit target that we laid out some time ago is still the correct number for '08 given the update that we just went through and just communicated to you.

And as I said, a portion of that is going to be reinvested back in the business and the rest of that benefit is already reflected in our long term guidance.

Chris, regarding the FCC investigation, I really have nothing to add other than what we've previously disclosed.

It's still an ongoing discussion and we won't be commenting on the ongoing discussion until we have something to report.

So refer you to our most recent 10-K for the latest information that we have on that.

Jeff can you refresh where the reserve stands and have you made any adjustments to the reserve?

No.

The reserve stands at $35 million and we have not made any adjustments.

Very good.

Thank you.

Ladies and Gentlemen this ends our Q & A session.

I'd like to turn the call back to Jason Strohm for closing remarks.

Well, thank you very much.

This is Kerry.

Thank you very much for joining us.

Just in summary, I would say that we continue to feel very confident in our long term prospects.

We continue to feel very confident in the strategies we have taken overall and each of our individual business units.

We are disappointed with how we executed in three of the business units this quarter.

I want to assure you that we're putting a lot of effort in improving in those areas.

But we feel each of those areas the issues are understood.

And that we have programs in place for meeting them.

So we remain confident in the overall guidance we've given for the year.

And also for the longer term numbers we've provided.

So thank you very much for joining us today.

Ladies and Gentlemen, thank you for your participation in today's conference.

This concludes the presentation, you may now disconnect.

Have a good day.