麥卡遜 (MCK) 2006 Q3 法說會逐字稿

Good afternoon. Welcome to McKesson Corporation's fiscal 2006 third-quarter conference call. (Operator Instructions). Today's conference is being recorded. If you have any objections, you may disconnect at this time.

I would now like to introduce Mr. Larry Kurtz, Vice President Investor Relations. Please go ahead, sir.

Thank you, Colleen. Good afternoon and welcome to the McKesson fiscal 2006 third-quarter conference call for the financial community. With me today are John Hammergren, McKesson's Chairman and CEO, and Jeff Campbell, CFO. John will provide a business update with quarterly highlights and will then introduce Jeff, who will review the financial results for the quarter. After Jeff's comments, we will open the call for your questions. Time permitting, we'll address all questions. We plan to end the call promptly after 1 hour at 6 PM Eastern Time.

During the course of this call, we will make forward-looking comments. Please see our press release for a full discussion of the risk factors associated with those comments. Thanks, and here's John Hammergren.

Thanks, Larry, and thanks, everyone, for joining us on our call today. McKesson had an outstanding quarter led by excellent top-line revenue growth and bottom-line operating profit performance in our pharmaceutical solutions and our provider technology segments. Overall, revenues were up 9% and we earned $0.61 per diluted share, a 24% increase from the prior year, excluding our securities litigation charge a year ago from the comparison.

Our financial performance combined with great working capital management continues to generate strong cash flow. Operating cash flow was $1.48 billion year to date compared to 497 million a year ago. Our balance sheet provides significant financial flexibility to pursue shareholder value creation. We repurchased $290 million of stock during the quarter, leaving $129 million remaining on a share repurchase program authorized in December. This week, the Board of Directors authorized an additional $250 million in share repurchase, giving us a total current unused authorization of $379 million.

Through the first 3 quarters, we have deployed $1.2 billion against a mix of value-creating strategies, 574 million on acquisitions, 579 million to repurchase shares and $55 million to pay dividends. Now as we said last quarter, as the pending $960 million consolidated class action settlement is approved, we now plan to fund the payment from cash.

Turning to our segment results for the quarter, pharmaceutical solutions revenues were up 9% with direct revenues up 10% and warehouse sales up 6%. Our revenue growth reflects new and expanded U.S. distribution agreements, revenue growth in our Canadian operations and revenues from our acquisition of D&K Healthcare Resources in the second quarter. Canadian revenues were up 5% in the quarter after adjusting for the effect of currency.

Over the next several quarters, revenue growth in our pharmaceutical solutions segment should begin to slow to market growth rates adjusted for our mix of business as we lap the implementations of our new agreements and the D&K acquisition.

We believe that long-term, the impact of the Medicare drug benefit for seniors will be positive for the industry. But it is still too early to assess the near-term effect on our revenues. But it was apparent from the start that seniors found daunting the wide range of choices for crafting their coverage. This is a challenge to seniors and their pharmacists but an opportunity for McKesson to build stronger relationships with our customers and for our customers to reinforce their important role as healthcare providers.

Now, prior to and following the January 1st implementation of Medicare Part D, we provided a comprehensive support program involving website, hotline, fax updates, education and meetings for pharmacy customers. Now, this support equipped our customers with the tools they needed to play an active role for seniors navigating their choices. McKesson's access health-managed care service has also signed contracts with 8 of 10 Part D national plans and the majority of regional plans on behalf of more than 2,800 member pharmacies; many of which provided more favorable reimbursement rates than were originally presented.

It was a win-win all around. Confused seniors accessed better counsel and support, our pharmacy customers built stronger relationships with their senior patients and secured the best financial terms, and we strengthened our relationships with our customers.

Turning back to the quarter's results, pharmaceutical solutions' operating profit increased 26%, including a $37 million pre-tax gain from a previously-disclosed antitrust settlement; gross profit was up 25%, reflecting the antitrust settlement, an increased mix of higher margin generic products, our stronger relationships with manufacturers, and the stabilization of sell margins to customers, offset slightly by a lower LIFO credit in the quarter compared to a third quarter a year ago.

We continue to do very well with generics. We have initiatives underway to increase penetration of our proprietary U.S. generics programs in every one of our customer classes. Sales growth of our proprietary One Stop generics program once again exceeded the growth rate for branded pharmaceuticals and was up 25% in the quarter, helped by the launches of generic versions of Zithromax and [Lesaphin]. The growth in generic sales has contributed to recent margin expansion, but the opportunity in coming years is even greater. Between 55 and $60 billion worth of branded drugs face patent challenges and/or patent expirations over the next 2 years, which should give rise to the launch of numerous generic alternatives.

As we said in the past, we earn not only more gross profit margin but typically significantly more gross profit dollars on the generic version of the predecessor-branded drugs. So the scheduled wave of generic conversions should have a positive impact on our future segment earnings.

Pharmaceutical solutions' operating profit margin percentage in the quarter increased 20 basis points to 1.43%. The gross profit increase in the quarter was partially offset by increases in operating expenses, which were driven by D&K. Our plan to integrate the D&K operations and deliver operating efficiencies is well underway. We smoothly transitioned D&K San Antonio customers to other McKesson distribution centers, including our new Conroe, Texas facility. And we are on track for our goal to have D&K results accretive to EPS in fiscal 2007.

We continue to look for additional products and services to improve quality, safety and efficiency in the pharmaceutical supply chain. For example, 2 years ago, we pioneered the central fill concept, whereby we provide centralized prescription fulfillment services through a dedicated McKesson facility. That first facility for Giant Eagle in Northern Pennsylvania has had a positive impact on their ability to serve retail customers and as a result strengthened our relationship and our profitability. We are now implementing two additional central fill operations for Costco pharmacies in Oregon and Washington to our facility near Seattle and for Wegmans Food Markets in New York to our facility near Buffalo. These services provide next-day delivery and prescription refills, enabling pharmacists for both of these customers to focus their time on serving patients -- another win-win all around.

To summarize, our pharmaceutical solutions segment has had great momentum this year and a very strong quarter. Our momentum should continue from generic conversions and from the Part D drug benefit. And as a result of well-executed strategies and plans, both buy-side and sell-side margins have stabilized. We've made great early progress on the integration of D&K. As we finish this year, we will be on track to take out significant costs from unnecessary duplication in facilities.

Turning to medical/surgical solutions, revenues were up 11%, driven by strong growth among alternate site customers. As we forecast on a previous call, we had strong seasonal shipments of flu vaccine in the quarter. We are pleased that we have revenue momentum again in medical/surgical, particularly in the higher growth, higher margin alternate site sectors where we are well-positioned. Clearly, we are disappointed with the charge we took in the quarter, which has limited our ability to translate revenue growth into profit momentum. And we are focusing on new strategies to leverage that momentum into earnings growth as we go forward.

Finally, in provider technologies, we had another quarter of strong revenue and profit growth. Revenues were up 21% in the quarter, after being up 18% in the second quarter and 17% in the first quarter. Software and software systems revenues were up 38% in the quarter, after being up 32% in the second and 22% in the first. And operating profit was up 36% to 38 million -- just great momentum in this business.

Our results were once again driven by strong demand for our clinical and imaging software solutions and automation systems and increased implementations. We continued to improve the implementation process, which is reducing the time it takes to install our clinical products. Because of the faster time to installation, our clinical go-lives in the third quarter were 159 compared to just 85 a year ago. These are products for which the installations are complete and usage is active.

The nature of these go-live situations is also changing. As we discussed, our implementation of Horizon expert orders at Duke University Health System on a number of previous calls has been an important part of our success. The success at Duke with its hospital-wide implementation of expert orders has had several implications. First as a showplace, the validation of our decision support in order entry solution. We are experiencing increased sales activity in bookings from other customers, who see the Duke system in operation. Second, more customers are asking for the same kind of ambitious implementation. During the third quarter, we had three more successful go-lives for expert orders as well as four so-called big bang implementations, which is our term for simultaneous go-lives at multiple applications. Third, it has led to a deepening of our relationship with Duke. Following the go-live of expert orders, Duke signed an agreement for us to partner on the development of a best-practice clinical content-embedded solution.

Last week, we announced another agreement with Duke to provide electronic prescribing and electronic health records to approximately 80 health clinics and physician practices in the community surrounding Duke. This agreement will encompass 1,500 physicians and this initiative bridges in-patient and out-patient clinical care and documentation and represents a potential best practice model for ambulatory solutions for hospitals and health systems. I'm very proud of the relationship that McKesson and Duke have created together.

On our last call, I reviewed the increased interest in sales activity we were seeing, not only among our historical base of community hospitals with more than 200 beds but also among both large academic centers and hospitals with 100 beds or less. This quarter, I want to focus on another segment of the market profit, the for-profit sector. This week, Triad Hospitals announced a 10-year, $1.3 billion HIT initiative to install a suite of standardized world-class clinical financial and ERP applications across all 49 Triad Hospitals and their 10 ambulatory surgery centers. McKesson's role in this initiative is a $120 million software and services contract to provide our Horizon clinicals and revenue cycle solutions and to work with Triad and the other providers to implement our applications. This is the largest clinical and revenue cycle contract we've ever signed. As a result of our new agreement with Triad, McKesson is now the single most significant HIT vendor in the for-profit hospital sector.

Of the five largest chains as measured by number of acute care facilities, we are the sole source for HIT products in three and a dual source for either clinical or medical imaging products in the other two. We are also showing that this is a significant presence with automation products. For example, we are the sole source vendor for in-patient automation to a majority of the Triad Hospitals.

Now, each of these organizations is well-known for disciplined decision-making. Their decisions follow a very rigorous evaluation of all of the available products. Now, Triad chose McKesson based on our product functionality, ease-of-use, clinical value, and return on investment. Their decision is a strong endorsement of the power of our Horizon clinical solutions and our unique ability to deploy a cost-effective, multi-hospital model on a Linux platform. We believe that this contract is industry changing.

I'm equally proud of our growing leadership in HIT product quality. In the mostly recently-released Top 20 2005 Best in Class Year-end Report, McKesson had 20 products rated in the Top 3 in their categories, up from 12 last year. 2 McKesson solutions received best-in-class ratings -- Horizon Medical Imaging in the community sector and the combination of Pathways Materials Management and Pathways Financial Management, which was also rated number 1 in the financial ERP category for the third straight year.

Our results in the area of medication management technology to prevent drug errors are also strong. In the latest class report on closed loop medication management solutions, McKesson was the vendor most often considered for barcode medication administration.

Even more impressive are the customer metrics. We now have medication safety solutions in nearly 100 facilities. We are scanning 1.2 million bedside medication administrations weekly, preventing 96,000 errors. These demonstrable benefits have established that our medication safety solution is not only an effective and easy solution for clinicians but it also is scalable across the spectrum of institutions. I could not be more satisfied with the progress we are making in this business. It is clear that McKesson is well-positioned for growth based on our product leadership, the market's response to our offering and the increased demand we are seeing for healthcare information technology.

In conclusion, I'm very pleased with our outstanding quarterly results being delivered by our teams in pharmaceutical solutions and provider technologies. I'm also excited with the growing momentum in revenue in our medical platform. Our performance for the first 3 quarters of this year gives us great momentum as we go into the fourth quarter. Based on our positive year-to-date results and the continued progress in our business, we are raising our guidance for the year. For the fiscal year ending March 31, 2006, McKesson now expects to earn between $2.41 and $2.46 per diluted share from continuing operations, excluding any adjustments to the securities litigation reserve. And with $2.2 billion in cash and our strong cash flow from operations, we are well-positioned to create additional shareholder value.

With that, I will turn the call over to Jeff and look forward to addressing your questions when he finishes. Jeff?

Thanks, John. Good afternoon, everyone. Our third quarter was much like our second quarter, a solid quarter with revenue growth in all segments and strong operating performance in our pharmaceutical solutions and provider technology segments. As John noted, we continue to deploy our significant operating cash flow to generate shareholder value in multiple ways. I'll begin by reviewing the consolidated income statement.

We had revenue growth in the quarter of 9% to 22.6 billion with all three segments contributing nicely to this growth. The 9% revenue increase overall gross profit for the quarter up 18% to about $1 billion. This leverage was driven by the significant increase in gross profit and pharma solutions, which I'll come back to in a minute.

Moving below the gross profit line, our total operating expenses were up 14% to $690 million for the quarter, excluding from the comparison the securities litigation charge a year ago. The largest driver in this expense growth was the addition of the expenses of D&K in our pharmaceutical solutions segment. This segment was the only one in which we did not achieve operating leverage on revenue growth this quarter, as the mix of business operated by D&K requires higher operating expenses which are funded of course by a higher gross margin. And we are still in the early stages of our D&K integration to deliver synergies on return.

Included in our operating expenses were legal expenses of $3 million related to the shareholder litigation. Now, that's down considerably from $11 million in the third quarter a year ago and from 13 million and 10 million in the first and second quarters of this year respectively.

Of course, as you recall in the third quarter a year ago, we announced we had reached the $960 million settlement in the consolidated class action and we made $1.2 billion pretax reserve for that case and others or $810 million after-tax. Reports hearing on the fairness of the pending settlement has now been set for February 24th. Once the court enters a final approval order, pending any final appeals, we would fund the $960 million settlement. While the timing of our payment is still unresolved as John noted, we plan to make the payment using our existing cash balances.

We have also made great progress resolving the other outstanding individual cases. We had a $1 million additional securities litigation charge in the quarter, reflecting the resolution of a number of these remaining cases. This progress and the pending resolution of the consolidated class action are finally resulting in a reduction in related legal expenses. While we are making great progress, we do expect that some level of securities litigation legal expense will continue into the next fiscal year.

Returning now to our walk down the consolidated income statement, operating income for the quarter was up 25%, excluding the $1.2 billion securities litigation charge from a year ago. Below the operating income line, our strong cash flow and balance sheet continue to benefit us. Interest expense was down 23% to $23 million in the quarter, reflecting lower debt levels from the prior year. Other income increased 113% to $34 million for the quarter, primarily due to increased interest income on our higher cash balances.

Our reported tax rate for the quarter was 36.3% and included $3 million in discrete expenses related to tax adjustments and adjustments for various taxing authorities. As I said in my second-quarter comments, this rate is higher than we had originally forecast for the year, primarily as a result of the strong year we are having in U.S. pharmaceutical distribution and other factors that have lowered the proportion of our taxable income subject to lower tax rates in foreign countries. To wrap up the consolidated income statement, net income for the quarter was $193 million or $0.61 per diluted share, up 24% excluding the securities litigation charge a year ago from the comparison.

Our EPS calculation this quarter is based on 316 million weighted average diluted shares outstanding compared to just 294 million in the prior year, clearly a significant increase. Despite repurchasing 12 million shares so far this fiscal year, the number of shares used in this calculation has continued to rise. While our option grant rate has been declining, our people are now working off 6 years of option accumulations with very few exercises. With the increase in our stock price, option activities and exercises of late have been robust. And of course, our dilution calculation now reflects more in the money unexercised options with the rise in our stock price.

Over time, we have a goal of repurchasing shares to offset the dilution resulting from the exercise of stock options. As John noted, yesterday, the Board increased our share repurchase authorization by another $250 million.

Let's now move on to our three segments. In pharmaceutical solutions for the quarter, we achieved overall revenue growth of 9%. In the U.S. pharmaceutical distribution business, direct revenues were up 10%. The biggest factor driving the growth was the addition of the first full quarter of D&K revenues. Warehouse sales grew 6% and last as John noted, excluding these effects, revenue growth amongst our customer base has begun to slow in both the U.S. and Canada. In Canada, revenues were up 9% but that does include a 4% currency impact.

Our mix for the quarter for our U.S. pharmaceutical distribution business was 31% institutional, 22% retail chains, 13% independents, and 34% warehouse. That breakout a year ago was 34% institutional, 21% retail chains, 11% independents, and 34% warehouse. Primary factor driving the shift was the inclusion in our business of a full quarter of D&K revenues, substantially all of which are from independent pharmacy customers.

Gross profit for the segment was up 25% to $644 million for the quarter, a very strong performance with $37 million of the increase coming from the previously-disclosed antitrust settlement. Factoring out the antitrust settlement, gross profit would still be up a strong 18%. The key drivers were our strengthened relationships with manufacturers, increased profit from higher margin generics, the stabilization of the sell margin to customers. Included in gross profit this quarter is a $10 million LIFO credit compared to a credit of $20 million in the third quarter a year ago. Our pharmaceutical solutions operating expenses were up 24% for the quarter to 347 million, reflecting primarily the full quarter of D&K expenses.

These factors together drove operating profit of 306 million and an operating margin of 143 basis points, up 20 basis points from the prior year. Our long-term goal continues to be an operating margin in the 150 to 200 basis point range on an annualized basis. As we have discussed previously, while seasonality will continue to exist in our business, you should expect to see some continued smoothing of the seasonal highs and lows in future quarters.

Turning to medical surgical solutions, revenues were up 11% for the quarter to $814 million, reflecting growth across all sectors including 3% growth in the acute care sector and 15% growth in alternate sites. The strong alternate site revenue growth was driven primarily by our previously-forecast strong seasonal sales of flu vaccine. Revenue growth for alternate sites in the business in total should be a bit lower in the fourth quarter, in line with market growth adjusted for our mix of business.

Gross profit decreased 7% as gross margin rate fell, reflecting the $15 million charge to write off prepayments for a software product license from a third party and from pressure on vendor customer margins. Operating expenses increased just 3%. Including a charge, operating profit was down 67% in the quarter to $8 million. As John said, we are developing strategies for leveraging our market momentum that you see on the revenue line into operating margin gains.

Provider technologies achieved another strong performance with 21% revenue growth for the quarter to $401 million. Software revenues were up 38% to $90 million for the quarter with several factors contributing to the increase. We had strong software backlog pull-through, driven by the accelerating pace of clinical and imaging software implementations that John talked about. And our automation revenues were up 40% over the prior year as sales of our cabinet (technical difficulty) and patient safety solutions continue to be strong.

Our revenue deferral rate during the quarter was down to 70% compared to 82% in the third quarter a year ago, as our bookings mix included fewer large complex software contracts. For the fourth quarter, we'd expect to return to the higher rate typical of our recent experience. Provider technologies' operating expenses increased 16% in the quarter to $153 million. The major factors driving the increase were increased R&D to support continued new product development, higher compensation in the operating expenses of the Medcon acquisition. For the quarter, MPT capitalized $14 million of software R&D, representing 25% of their total expenditures compared to 26% a year ago. Total gross R&D spending was about 14% of revenues for the quarter, up from 13% in the third quarter last year.

Given our revenue growth, this translates into a $10 million increase in R&D spending in the quarter to $42 million, an indication of our view of the great growth potential of this business. Our operating profit in this segment of $38 million represents an operating margin rate of 9.5%, 102 basis point increase over the prior year. As I reviewed last quarter, our Medcon acquisition is negatively impacting our operating margin rate this year but should be accretive in fiscal 2007.

Leaving our segment performance and turning briefly now to the balance sheet and our cash flow statement. On the working capital side, our receivables were up 14% from the prior year to 6.4 billion and our day sales outstanding increased by 1 day to 23 days versus the prior year. Our inventories were 8.2 billion, a small decline from 8.3 billion a year ago despite the 9% sales increase, a reflection of our new agreement with manufacturers focused on greater inventory efficiencies. Our day sales in inventory of 34 days was down 4 days from (technical difficulty) 1 day from last quarter due to the normal seasonal build of inventories for the winter season. Compared to a year ago, our payables were up 15% to 10.2 billion, our day sales and payables of 42 days was up 2 days from last year.

These great working capital results and our strong operating performance this year together have generated year-to-date operating cash flow of 1.48 billion versus just $497 million a year ago.

Now, as I discussed on our last call, we had as much as $500 million of our $2 billion second-quarter operating cash flow stemmed from some timing issues we had at the quarter end in September that did in fact reverse in the December quarter. But we ended the December quarter with about $2.2 billion of cash, up from the $1 billion we held a year ago, and we remain on track to have a very strong year for cash flow.

As John noted, we repurchased $290 million of stock in the quarter and have now purchased $579 million year to date. With the Board's recent authorization of an additional $250 million of share repurchase, we now have a total current authorization of $379 million. Returning to our cash flows, capital spending was $138 million for the first 3 quarters of the year, higher than the $89 million we spent in the prior year. The largest driver of which was ongoing investments in our pharmaceutical distribution center network.

Capitalized software expenditures were $128 million for the first 3 quarters of this year, also up somewhat from the $92 million we spent the prior year, driven primarily by activity associated with MPT's project with the NHS in the UK. Reflecting the progress we are making resolving cases in the securities litigation, we've used $227 million for settlements year to date.

So overall, our third-quarter results were solid and on track. We've raised and tightened our guidance range for EPS from continuing operations to 2.41 to 2.46 per diluted share, excluding adjustments to the securities litigation reserve. This translates into a range for the fourth quarter of 0.65 to $0.70. Just to reiterate, this guidance also assumes a tax rate for the year of 35% and approximately 315 million shares used in the earnings per share calculation.

In conclusion, we feel very positive about our performance in the quarter and year to date. We have great moment in our pharmaceutical solutions and provider technology segments. Our strong balance sheet continues to be effective in generating shareholder value. Year to date, we have deployed $1.2 billion of capital on diversified shareholder value-enhancing options, which should provide both short-term and the long-term benefits for our shareholders.

Thanks. Now, I'll turn the call over to the operator for your questions.

(Operator Instructions). Larry Marsh.

Lehman Brothers. Just a clarification first on Q4 guidance; I guess this would be for Jeff. You're saying a 35% tax rate. Is that implying that the fourth-quarter tax rate will be much lower than what we've seen year to date, given you're now running a little over 36%?

Well, the 36% reported rate includes a variety of what we call discrete items, you know, adjustments as we file tax returns and true-up for various things. So the 35% is our forecast for what the final effective rate for the whole year will be.

So again, that could be a bit lower for the fourth quarter. And then are you suggesting any LIFO credit expectations for Q4? I know you had a $29 million credit last year. Have you any assumptions there?

Right. Well, it's just to refresh everyone's memory on the numbers, I think last year for the whole year, we had a $59 million credit. So far this year, we have taken $20 million, 10 million last quarter and 10 million this quarter. Our expectation pretty much remains what it was at the beginning of the year, which is while we will probably have some further LIFO credit to be taken in the last quarter, the number for the year will be down.

Okay, right. Then finally just in clarification, your litigation expectations for the full year now -- I know the third quarter was a good bit less than what you had been seeing. Are you suggesting what that could be now?

Well, I didn't give a number. I mean clearly we're very pleased by the fact that after running around 10 or $11 million a quarter, we got it down to 3 this quarter. I think you may see a little spike in that in the March quarter for us as we try to get down to the end on some of these cases. Certainly, as you get into FY '07 though, I'd expect while there'll still be a number, it will be a pretty small number.

Okay. And then just a question maybe for John or whomever. One of your larger customers, Albertson's, obviously has announced that they will be acquired and spit up. Can you comment, confirm that vending relationship you have? And are there any other larger customers up for renewal this spring or summer that you can discuss?

We don't typically talk as you know about customers publicly. Although I will say that we have a great relationship with Albertson's, and we've done a great job servicing their business for quite some time. We did make a press release in May of 2003. In that press release, we indicated the contract runs through 2008 and we certainly have no indication that that contract won't continue to be honored.

As I might also note, we had a very good relationship with CVS. CVS and when they acquired Eckerd continued the Eckerd volume through McKesson. And we've done business with virtually all the players in this industry over our last 170 years, so I'm hopeful that even when we get beyond 2008 that we will be able to maintain our relationships with the predecessor Albertson's stores.

Andrew Weinberger.

Bear Stearns. Solid quarter. Just had one quick question, trying to understand the run rate for corporate expenses once we get past all the legal expenses associated with the shareholder lawsuit. And then if you could just give a little more color on the med surg business. It seems even if you back out that $15 million charge, that operating income fell slightly. Is that just customers pressuring you on price or is there something more there?

Well, let me talk about the med surg question. This is John. And I will let Jeff handle the corporate expense discussion. Clearly, we're really excited with the position we have in med surg, particularly in the alternate site segment and you do see momentum there. However, the flu business does not come in at the same profitability as our typical alternate site business so that is part of a dilutive effect you can see in margins, which is typical when you these seasonal spikes in that business.

That being said, that business is a great business for us. It runs at a very high margin, and we're very pleased with our position in the marketplace. As you might know, we did get some -- finally after several years of struggling -- get some momentum in our acute care business and that is also a very positive aspect. We're spending a lot of money to support our acute strategies and making sure that we're properly positioned and investing properly.

The long-term -- yes, our expectation is that we will get margin lift in that business and we will get good positive drop from the revenue line to the bottom line. But clearly, this quarter, we're a little short of where we'd like to be ultimately.

On the corporate side, Jeff?

On the corporate side, I think the way I'd think about is you saw our number for this quarter down a little bit from the prior year -- 48 this quarter versus 54 in the prior year. Clearly, the biggest driver in that year-over-year decrease is the decline in the legal expenses related to the shareholder litigation. So the 48 is closer to a good baseline for you to use going forward. The only cautionary note I'd just remind you of is there's a little bit of volatility quarter to quarter on the corporate line because it's where we end up with a lot of things like benefits accounting and other things that can have a little bit of lumpiness. But that's a pretty good number to use for the run rate going forward.

Okay. I'm sorry. Then the corporate income I guess of $23 million, that's primarily -- is that interest income?

That's basically interest income, right. (multiple speakers) so that's why you see such a big increase year over year given the huge cash balances.

So when you cut the check, that goes away a little bit?

Well, our balance sheet is pretty robust. I don't know that I would say go away, but clearly when we (multiple speakers). 50 million goes away, yes.

Glen Santangelo.

Credit Suisse First Boston. John, I just had a quick question regarding the IT business. I mean the 38% revenue growth on the software side probably more than -- greater than what most people are looking for. And you cited in clinicals and imaging as kind of the two areas of focus. Given the Company's experiences with its ALI acquisitions and Medcon, do you think there's room to add to the product portfolio there? I guess, are you looking for more acquisition opportunities on the IT site? Do you think there's more that you can add to the product portfolio? Could you just kind of give us maybe a little bit of a longer-term strategic outlook for that division?

Absolutely. I think there's a couple of real terrific fundamental drivers in that segment for us. Certainly, the first is just overall demand for clinical products is booming and these decisions have yet to be fully made. So the buy cycle is still in front of us and certainly the revenue recognition of buy cycle is still in front of us. So that is a very positive phenomenon and one that we're extremely well-positioned to take advantage of.

To your point on the second part of the question, our platforms continue to extend and I think we've only scratched the surface in terms of the kinds of strategic acquisitions we can make in the IT sector that are pull-through opportunities for us given our great customer base and our terrific history at making these acquisitions successful. So there's a tremendous amount of innovation in the area of imaging as well as in other areas. The world of connectivity and between the various levels of providers and their patients and the payers is only beginning to happen, and McKesson will take that innovation whether it's developed internally or acquired in a small company way like the Medcon acquisition and leverage it through our reputation and our customer base and our ability to execute through high-quality implementations to deliver terrific value.

A great example of that would be the Duke relationship and the Vanderbilt one for example. We keep selling more products into these accounts after they get anchored on the clinical strategy and we continue to press forward. If you think long-term, many of these accounts not only need to make more clinical investments but will be making financial investments given that the financial architectures of these hospitals are a decade or 2 decades old in some cases.

So we think the buy cycle in IT is very robust and will continue to be so. And we think our proven ability to acquire the right assets, integrate them effectively and then pull them through with our sales muscle is an extremely positive factor in this environment.

Well, given the position of your balance sheet, should we expect additional acquisitions on that side of the business?

I think you should expect that we're going to carefully evaluate acquisitions across the myriad of healthcare opportunities that we have but you also should see as we've done in the past a disciplined approach. There clearly are some healthcare IT assets in particular that have impressive evaluations and multiples on their earnings. The only way we're going to make acquisitions in our business is if we can see ourselves to a path of a value-creating opportunity for our shareholders. And so although some of them would be attractive, they may be priced well beyond our range. But in the little ones where we can buy them inexpensively on a relative basis and blow the numbers away by putting them in our channel, that's certainly a great current source of opportunity. Long-term, we'll see how the rest of the sector shakes out.

John, you talked about impressive evaluations -- then I'll stop here. Do you need to have that IT business underneath the McKesson umbrella? It seems like there could be a significant value creation opportunity for shareholders if it were to be separated from the distribution business.

Well, our goal clearly is to build value for our shareholders and we do that in a myriad of ways. We think that our management teams and our businesses have found the magic to execution, and that's not easy to replicate even if we were to sell the assets to someone else or to spin them in a different direction. That being said, we have a responsibility to evaluate all opportunities on a regular basis and we do. You've seen us in the past sell businesses when we don't feel like we can add a lot of value. So I don't think you should expect anything near-term from a spend perspective but you should also see that over time like the water business or bio services or other kind of things that we do have a way to do it and we're not afraid to do it.

Lisa Gill.

JPMorgan. John, just to follow up with some questions around your IT business. I know in the past, you have talked about the number of hospitals that you have some type of life product in. Can you give us an update around that? You talked about Vanderbilt and you talked about Duke and the opportunity to continue to pull through product but just trying to get an understanding of how big the footprint is these days on McKesson.

Then secondly, as we look at IT -- or if I do my calculation correctly, it looks like it's about 11% of EBIT today. Where do you see this in the next 3 to 5 years as an overall percentage of McKesson's business?

Clearly, one of the big value points we have on our Company is our tremendous footprint from an IT perspective. We think that footprint is only growing today. Clearly, customers like Vanderbilt and Duke actually were not legacy customers of McKesson in a large way and became customers of McKesson as a result of the evaluation of the available alternatives. In fact, many of these for-profit chains that are very sophisticated in their evaluation of products were not bolted into McKesson kinds of customers and they chose to make the decision to buy for McKesson.

But to specifically answer the question, over 60% of the hospitals in America are McKesson customers in a pretty large way. And I would say that most of those accounts have yet to make the big decisions around clinical product purchases and platforms, and that's the sell cycle that we're in the middle of.

Jeff talked about our investment in R&D. Our investment in sales forces is equally impressive as we try to drive to capture that opportunity for our business. As it relates to what percentage of our earnings could this business ultimately be? Clearly, we expect it to be higher as a percentage of our total. It's growing much factor and it has a much better margin rate than our other businesses. That being said, our other businesses are pretty dog gone big and they're not growing in a slow way. So it's difficult to catch those businesses and make the IT business a material part overall of the total portfolio as a percentage. But clearly, it's an important, a very important part of our current strategy.

Is there an opportunity with this footprint to also pull through automation? A lot of these larger -- Duke for example, I mean is that a distribution client? Is it an automation client? Is there a continued opportunity on those sides as well?

Clearly, if you look at our financial results, we report software and software systems growth of 38% in the quarter. Part of that impressive growth is our technology business, our automation business that sits there. And we have talked specifically in the past about the close integration between the information technology platforms and the cabinets or the boxes or the robots. The ability to integrate that software and make it interoperable and make those devices user-friendly and connected to the entire IT infrastructure is a key part of our strategy. And we've seen a tremendous accelerant to our growth in our IT accounts as a result of bringing these businesses together more closely and managing them more strategically.

So Triad, we have a sole source arrangement for automation in many of those hospitals and those hospitals will see a significant benefit by now adding the McKesson technology IT platform on top of that automation investment. So we're very bullish on that as well and we continue to innovate there. I think many of you were at the ASHP meeting and continue to see I think impressive innovation from our automation team.

Ricky Goldwasser.

UBS. My question -- my first one relates to just common regarding the possibility of generics. I think you mentioned that it's not only that the percent margin is higher but also the dollar margin. Should we read into it that you're seeing generic pricing being solid and you're not seeing any kind of pricing pressure for generic? And then my second question is around the fee-for-service agreements. Were you positively impacted this year end by incentive payments from fee-for-service agreements?

The generic business continues to be an extremely important part of our total mix of offering to our customers. The revenue growth in generics alone in the quarter I think was in excess of 25% on our proprietary programs, and those proprietary programs as we have said are significantly more profitable both in margin and in margin dollars or margin rate and in margin dollars compared to the branded drugs that they are replacing. So we are extremely pleased with the performance of our generic portfolio and are even more bullish on the opportunity that exists in generics as we take $60 billion over the next couple of years and turn it into a McKesson channel opportunity as we bring value to the generic manufacturer and bring great value to our customers.

We do not see tremendous pricing pressure in that market. We are afforded an opportunity to work with the leading generic manufacturers to benefit them and our customers. And as it relates to the sale of generics to our customer base, largely as you know, our customers are in a prime vendor relationship and those prime vendor relationships are extremely strong. The service we provide is incredible and the ability to just tack on generics as a part of that prime vendor solution to our customers is an automatic pull through and a win-win for them and a win-win for us. So you don't -- at least we don't experience a lot of price competition for generics in our customer base. What we experience is a responsibility to make sure that our customers are competitive in the market with their peer groups, but we usually have an inside track based on the relationship that we already have built with those important customers.

As it relates to the fee-for-service agreements, the relationships we have with those manufacturers, we continue to optimize our experience and performance under those agreements. We are establishing agreements that make sense for ourselves -- or have established I should say agreements that make sense for ourselves and for the manufacturers. Now we're well into an environment where these agreements are mature and we continue to renew them, expand them, move them around as you would any long-term relationship. But it has been a positive transition as evidenced by the financial results of our industry.

Right. But you know, one of your peers kind of commented yesterday that they saw sort of a year-end incentive payment on fee for service, so I was wondering whether you've seen similar payments.

A year-end incentive payment? Well, we don't comment directly on how these agreements are structured. I can tell you that as we negotiate the agreements, we try to take advantage of the available opportunity and then we try to maximize our performance under those agreements to make sure that McKesson captures it. I believe that we have done an excellent job of capturing the opportunity. And if there were year-end payment opportunities in those agreements, then we would get them and that's been our focus. Next question, please.

Sandy Draper.

JMP Securities. Congratulations on a really nice quarter. I guess my question is sort of global. Obviously, you guys have been putting up really good numbers; you raised your guidance. But even looking at the fourth-quarter guidance, it seems like there's still a reasonable amount of conservatism. But Jeff maybe there are some places you can sort of highlight again. The trends that you saw in the third quarter were very, very strong. Some of that may not carry through. Your fourth quarter in distribution last year was tremendous with a big pickup. I would assume we would expect that to be down. But maybe walk me through some of the things that may not be quite as strong sequentially looking third quarter to fourth quarter. Because when I carry it through, the numbers to me you gave for the fourth quarter look pretty darn conservative.

Well, I think in many ways, you hit on the key thing, which is one of the things we've been talking about the last couple quarters -- is that an offshoot of the evolution in the way we work with manufacturers is a flattening of the traditional seasonality of the business. So if you took an average over the last couple years, what you would find is the March quarter is just by far the most profitable quarter. In fact, the December quarter is one of the weakest quarters. I'll remind you that last year in particular, the December quarter still had some challenges. While it got better towards the end, the first part of the December quarter last year was still pretty weak in terms of price increases. And then the March quarter last year was just a tremendously, unusually strong quarter even by historical standards.

So I think if you take all of that flattening of seasonality in general into account and also think back about the dynamics of last year's March quarter, then the kind of number that we are talking about should make a little bit more sense certainly in our minds as a continuation of the levels of performance we've achieved thus far this year and reflects nothing more than what we think is the newfound seasonality.

I think one additional thing is that we are obviously investing heavily as we take out the duplication in the D&K transition, which is not an unimportant impact on the short term which will turn into a real positive as we move into next fiscal year. And we're actually frankly investing in all of our businesses to make sure that we're properly positioned. But I think the biggest factor is that part of the strength in this quarter was driven by the seasonality smoothing that Jeff talked about, and that clearly is part of the fourth quarter.

But we are optimistic, and we've provided the guidance. I think we clearly take that responsibility seriously, and we are always focused on how can we even do better than our own expectations.

Okay. Well, great and again congratulations on a really nice performance.

Tom Gallucci.

Merrill Lynch. Just kind of a handful of follow-ups on various topics that you have gone into here. On the generics, you mentioned the 25% growth in the proprietary programs. How does that relate to your overall generics business just to make sure we understand? Is that just a piece of the overall, or is that kind of the term that you use for generics in general?

Well, it's the most important piece of our generic program, and it's the most profitable portion of our generic program. It's really the place where our customers have committed to buy. And as a result, they get a market basket price and we get a market basket margin that benefit both of us.

We do sell generics outside of our One Stop program. But those go to customers that aren't quite as committed to us perhaps as the One Stop customers. So it is a significant portion of our business and a significant part of our success but clearly not all of our business in generics.

Okay. Just getting back earlier to the conversation about the leverage and the cross selling maybe of HIT versus med surg versus drug distribution. Can you give us any kind of statistics or anecdotal data about how many customers cross two or more of your segments in terms of being customers?

Well, I would say a preponderance of our customers in the hospital sector buy from more than one of our businesses. And I think it would be -- if you go back and look at our early announcements after the acquisition of our technology business and look at our hospital business and the percentage of our total revenue coming from what we call institutional then versus what we call institutional today, you'll see a profound difference.

I have been here virtually from the beginning when this Company started the institutional business in pharmaceuticals, and I can tell you that it is significantly more today. And a part of that -- that's a large part of that is our ability to go to our customers with a complete solution that addresses multiple needs. And as you might imagine, one of the most complex needs they have is to make the decision on what drug to dispense and then to dispense it correctly through the system, which is in some cases 50 or 60 or 70 handoffs. And so I think our appreciation and understanding for the pharmaceutical use process from the selection to the dispensing and the bailing is probably world leading.

On the medical surgical side, we haven't been able to accomplish the same sense of integration and that's been one of the places we've been investing. It's been one of the things that we have been focused on. Frankly, we've not had as much traction there as I would have liked. But clearly in the rest of our businesses, we've got great opportunity and great momentum.

Right. Maybe just to finish up on the med surg side since you brought it up, what are some of the keys there? You mentioned investing on the acute care side; you mentioned also pressure on vendor margins. Can you explore those two topics a little bit more? Then I guess ultimately on the topic of shareholder value creation, is this necessarily a core business long-term given the cross selling that you're seeing? Or could you be just as effective if you didn't own it?

Clearly, our focus on med surg is to optimize our performance across all of our segments, and that includes both on the revenue and market share side but also on the margin side. As I mentioned in my comments, we're very pleased with our progress in alternate site and we have some work to do on the hospital side of our business.

As to the answer to the question about shareholder value creation, we look at all avenues for shareholder value creation and that includes buying and selling businesses. And it includes our portfolio. It includes the synergies between businesses, our corporate purchasing programs, Six Sigma that we put across all of our businesses, the one McKesson platform we've talked about in the past, and it also includes where those cross-selling opportunities outbound are to our customers. So I think that we have a responsibility and we continue to look at our portfolio and we will constantly look for ways to refine it to build shareholder value.

John Ransom.

Raymond James. Extracting what we think D&K did in the quarter, it looks like your pharmaceutical revenue growth was in the low single digit range, maybe as well as 2 to 3%. Was that an aberration? I know you talked about it slowing, but that was more of a slowing then I guess we would've thought.

As we've indicated in the past, we had expected our revenue growth rates to begin to slow and I think that's been a general industry trend. The continued acceleration of the generic business, albeit a negative from a revenue perspective has been a real positive from a margin perspective. And I think you've seen that also in the way the industry has talked about this. Clearly, having D&K has provided some revenue upside and I think Jeff did mention our revenue growth would've been obviously slower without the D&K business.

I don't where the market growth rates will ultimately settle out, but we certainly believe that we are well-positioned to continue to grow in line with the market for our mix of business. And part of that growth is dependent on our customers and their ability to grow with the market as well. So I think from time to time, you may see growth rates that are above or below what is professionally defined by the market by the pundits. But in general, we expect to stay at those market levels.

Okay. Are you seeing any impact from the first quarter at all from (indiscernible)? Or is it too early to tell?

It's probably too early to tell in terms of actual pull-through from a revenue perspective. Clearly, because we're already in the quarter, it is difficult for us to talk about the quarter. I can say though that the confusion on the way in created some real challenges for our customers and certainly for the seniors. It also, as I mentioned, created an opportunity for us because we provided a real clarifying force. We have the ability to really negotiate on behalf of our customers -- in this case 2,800 stores, who relied on us to go out and put them in these plans and negotiate reimbursement rates that were superior to what they would have had if they were trying to go on their own. And that delivers a long-term relationship to McKesson that is built on a solid foundation of trust and appreciation.

So as been our strategy in all of our businesses, we want to be more than just another distributor or another wholesaler and the ability to add value through programs like we implemented in the Part D implementation does exactly that. So I think that we will see revenue growth as a result of Part D. How much it will be, I don't know. And when we'll actually begin to realize it, clearly we've got to get some of the confusion done and get these seniors up on board.

Then just finally, in the fourth quarter other than the tough LIFO comparison you had last year, is there anything in the $0.65 to $0.70 that might be classified as non-recurring GAAP like the net $22 million you had his quarter? Is there anything in the fourth quarter that would reduce the comparability of those numbers (indiscernible)?

No, not in terms of the guidance we've given.

We have time for one more question.

Eric Caldwell.

Robert W. Baird. I guess I am playing clean up here. Most of my questions have actually been answered. I guess from a big picture perspective, John, you mentioned how you're really through the first wave of fee-for-service agreements and those are cracking pretty much to plan, in some cases ahead. As you analyze the first series of deals and start to look at where you stand with manufacturers, what kind of adjustments are you and the manufacturers agreeing on at this point? What kind of things are still up in the air?

I'll give you an example as a leading question. We've heard recently that there's so much data coming out of the wholesalers on a daily basis that nobody knows how to use it and it's causing some confusion in terms of how you ship data to the manufacturers and how they profit from that. So I'm just curious what you guys are working on with the manufacturers right now.

You know, you're exactly right. I think in the context of getting the first phase of this behind us, we actually have already renewed dozens of these agreements and relationships and are well into the cycle of making this just part of our base business. So I don't feel that there's any major changes to the negative or to the positive that would disrupt what we feel is our solid performance going forward. That being said, clearly we look for ways to optimize the relationship with the manufacturers just like we do with any customer. And where there's opportunities for us to add more value, we're going to do that. And to the extent that we can extract payment or certainly better margin rates for adding that value, we're going to do that.

So in the example of the data, not to confirm it or deny it because I'm not close enough to that, if there's an opportunity for us to take the data we provide and put it in a form that's more useful for the manufacturers, we'll certainly do that. To the extent that it costs us more, we'll ask to be paid. To the extent that it adds value to the manufacturer, we'll ask to share in that value. And that's the kind of relationship we've crafted with them.

So I think that the point is the relationships are going extremely well. All of the dust has settled. The acrimony and challenge is gone. Now, it's just business as usual. And we are on to making sure that our businesses are functioning as opposed to playing games in the backroom with the contracts. That a chapter that's closed.

That's great. And if I could just close out on -- last year, there was a loss of commentary about how the wholesalers might expect escalators on the second round of deals. I'm just curious if you're still seeing those kind of opportunities or if you're really having to add services to get paid more money?

Well, I don't think there's one answer to that question. It's probably all over the map depending on the relationships. I would tell you that our expectation is that these relationships will not become less profitable. It is our expectation that they will become more profitable over time just like it is for all of our business. And so our goal is to expand our margins. Jeff mentioned to you that our goal has continued to be in that 150 to 200 basis points at the bottom line. There's two major vehicles to drive that. Clearly, we have to control our expenses. But assuming that is a core competence, we have to continue to manage our sell margins and we have to manage the relationship with the manufacturers to make that happen. And we're heavily focused on delivering that. There is evidence obviously in our results that we've got the skill set to do so. So we're very optimistic that we'll just drive more and more value to our Company and to our shareholders through what we do in the marketplace.

Great. Let me add my congratulations on the nice progress you're making.

All right, thank you very much. I certainly want to thank all of you, and I want to thank you, Operator. Thanks to all of you on the call for your time today. Clearly, we are extremely pleased with our performance in the quarter. The momentum that we are taking into the fourth quarter is significant, and the upsides in our business provide tremendous opportunity to further enhance shareholder value creation. And I want to thank you again for your time, and now I'll turn the call back over to Larry for his review of the upcoming events for the financial community. Larry?

Thanks, John. On February 7th, we will present at the Merrill Lynch Healthcare Conference in New York City. On February 13th, we're hosting our annual booth side briefing at the HIMS Annual Meeting in San Diego. For those of you who have those questions about how our automation business is doing in terms of working together with the software business, this is a perfect opportunity for you all to come and get a full view of that business and how we're doing in the marketplace. On March 10th, we will present at the Lehman Brothers Healthcare Conference in Miami.

We plan to release our fourth-quarter financial results and hold our call after the close of market on Thursday, May 4th. That is our year end, so it's a little later than normal.

Thanks. Until we see each other at one more or more of these events, good-bye. Take care.