麥卡遜 (MCK) 2008 Q2 法說會逐字稿

Welcome to the McKesson Corporation fiscal 2008 second quarter conference call. All participants are in a listen-only mode. (OPERATOR INSTRUCTIONS). This conference is being recorded. If you have any objections, you may disconnect at this time. I would now like to introduce Mr. Larry Kurtz, VP, Investor Relations. Please go ahead, sir.

Thank you, Bridget. Good afternoon, and welcome to the McKesson Corporation fiscal 2008 second quarter conference call for the financial community. With me are John Hammergren, McKesson's Chairman and CFO and Jeff Campbell, our CFO. John will have provide a business update and then introduce Jeff, who will review the financial results for quarter. After Jeff's comments we'll open the call for you questions. We plan to end the call promptly after one hour at 6 p.m. eastern time. Before we begin, I caution listeners that during the course of this call we will make forward-looking statements within the meaning of the Federal Securities laws. These forward-looking statements involve risks and uncertainties regarding the operations and future results of McKesson. In addition to the company's periodic current and annual reports filed with the Securities and Exchange Commission, please refer to the text of our press release for a discussion of the risks associated with such forward-looking statements. Thanks and here's John Hammergren.

Thanks, Larry, and thanks everyone for joining us on our call today. McKesson continues to have positive momentum through the first half of fiscal 2008. In the second quarter revenues were up 9% and earnings per diluted share from continuing operations were up 24%. We're seeing the advantage of a broad cohesive offering that provides best in class quality with value-adding products and services sold into a strong and loyal customer base in a dynamic sector of the economy. As a public dialogue about improving healthcare access and cost gross, health care services continues to be a great place to be and McKesson is well-positioned to deliver solutions for our customers and create value for our shareholders. Both our segments are achieving steady balanced revenue growth which we can leverage into annual operating margin expansion. Our strong balance sheet, solid cash flow and diverse and flexible capital deployment strategy provide additional opportunities to grow EPS. I'm very pleased with the progress we continue to make across the company.

In Distribution Solutions our U.S. pharmaceutical revenues grew 9% in the quarter reflecting continued solid growth in both the market and in our customer base. I'm especially pleased with our revenue growth this quarter which reflects our attractive business model and our diversity of customers including our strong position in mail order segments which continues to be one of the fastest growing parts of the market. Our Distribution Solutions operating profit margin expanded four basis points over the last year. That is also an impressive performance considering that the second quarter a year ago included the positive effects of launchings of several major generic drugs, a $10 million anti-trust settlement and a $10 million LIFO credit none of which recurred in the second quarter of this year. Our results this quarter reflect our continued great relationships with our pharmaceutical manufacturing partners both branded and generic. Our teams continue to execute well to deliver benefits to both the manufacturers and our partners. Our agreements with branded manufacturers were particularly important driver of our strong profit growth this quarter. In addition replacing a significant amount of generic profit from the second quarter of a year ago was a challenge this quarter. Our team that manages our product acquisitions and relationships with generic pharmaceutical manufacturers executed very well and exceeded their goals for the quarter. Our generic programs are delivering great value to our customers and in turn were seeing increased participation and increased compliance. The number of pharmacies in our proprietary OneStop program increased 13% to 10,500 from 9300 in the second quarter a year ago, reflecting increased participation cross a wide range of customers with particular progress in our base of regional chains and hospital group purchasing organizations. For example our new agreements with Kinney drugs which has 90 stores in upstate New York and Vermont and Wegman's which has 71 stores in the Mid Atlantic states now include supplying generics in addition to branded pharmaceuticals. Shopko, a Wisconsin based chain with 135 stores in 13 states recently closed its warehouse and now uses McKesson for both branded and generic deliveries to its pharmacies. We also signed a division of Shopko called Pamida which has 126 pharmacies in the Midwest and mid south to a new contract that now includes generic supplies. We recently renewed our agreements with Costco and Target and they continue to purchase their generics from McKesson. I mentioned on our last call that the Broadlane hospital GPO now participates in generic plan for institutions as well as some other GPOs.

Our independent pharmacy customer base also continues to expand. These pharmacies by virtually 100% of their generic product requirements from McKesson and equally important they are among our best customers for the valuable higher margin products and services we provide to enable them to compete on a level playing field with much larger pharmacies. This expanding base of generics customers provides a strong foundation for our future growth. We continue to expect that over the next three years the large number of scheduled patent expirations for major branded pharmaceuticals represent a significant profit opportunity for the company. Of course to be able to provide the value-adding products and services such as generics, first our customers must have confidence that they are receiving the best possible service. We are currently achieving the highest service levels we have ever achieved, more than 95% of our orders are filled on an unadjusted basis the first time while inventory write offs and bad debts are at historical lows. Contract and chargeback accuracy is at a historic high. We believe we represent best in class operating performance in what is probably the most efficient and safest supply chain in the world.

Our customers appreciate this high level of quality. We were chosen Pharmacy Supplier of the Year and overall corporate supplier of the year for 2006 by CVS Caremark, the largest dispenser of prescription medicine in the United States and the nation's largest retail drug store chain, all for our inventory management capabilities and our commitment to customer service. Our relationship with CVS actually began in 1996 with a contract to supply the CVS pharma-care mail order operation. We've been the exclusive distributor of pharmaceuticals to Caremark since 2001 and we've been supplying CVS pharmacies since 2004 when they acquired the Eckerd Stores serviced by McKesson, and the chose to continue that relationship. Our relationship has since expanded when CVS acquired the Sav-on and Osco stores of Albertsons which were previously McKesson customers. Subsequently we were awarded distribution contracts for a portion CVS warehouse business and later for the pharma-care specialty business. CVS Caremark is now our largest pharmaceutical distribution customer. They are also one of our largest customers for our RelayHealth intelligent network and claims processing services.

As we look ahead to the longer term growth potential for the distribution segment McKesson is well represented in the North American pharmaceutical and medical surgery distribution markets. In the United States we have a balanced portfolio of pharmaceutical distribution businesses with a significant share of customers in national and regional retail drug chains, mass merchandisers and food and drug combos, mail order, long-term care, hospitals and independent pharmacies. We are also well-positioned in the fastest growth sectors of the medical surgical products market, physician offices, clinics, surgery centers, long-term care and home healthcare. In Canada our pharmaceutical distribution business is evenly balanced among the various classes of customers that are using distributors and we own 49% of the largest pharmaceutical distributor in Mexico.

Looking at the market one additional area we targeted strategically to the expand our position in is specialty distribution. Sales of specialty drugs are increasing rapidly, especially oncology drugs. More than 200 oncology drugs are in development cross the pharmaceutical and biotechnology industry representing more than 50% of the new drug pipeline. Between 2006 and 2010 sales of oncology drugs are forecasted by IMS health to increase from $30 billion to $60 billion.

Our specialty business has been growing rapidly but from a small base and a sub scale cost structure. By our recently announced acquisition of OTN and combining that acquisition with our existing specialty business, we now have an enhanced position in the fastest growing area of the market with a more competitive footprint of services and a more competitive cost structure. OTN is one of the nations's largest distributors of specialty drug products serving the need of more than 3500 oncologists, 1500 rheumatologists and many other providers with annualized revenues of approximately $3 billion. Because of its broad range of capabilities and position in the market OTN was a coveted asset. We will experience some marginal dilution as we restructure the combined business over the next 12 months but we feel it completes our balanced market participation with a much stronger products and services offering in this key area.

Now turning to Technology Solutions. We had revenue growth of 36% in the quarter driven by 52% growth in our services revenues, much of which was due to the acquisition of Per-Se Technologies. The integration of Per-Se, which is going very well and the move of our payor business into Technology Solutions this year reflect the portfolio approach we use to deliver sustained growth and margin expansion in this segment. Our goal over the long-term is to leverage our unique software and services technologies, broad offering a large install base of customers to deliver above market growth with more predictability and less risk. Before highlighting some of the individual accomplishments worth noting let me describe the focus of McKesson technologies solutions in four key areas to expand the market for healthcare information products and services. McKesson provider technologies addresses the needs of hospital and physician offices for clinical, financial, administrative and many other solutions to improve the quality and cost of healthcare. RelayHealth provides connectivity solutions to providers, pharmacies, and payers to align patient care with financial flows, McKesson Health Solutions provides commercial and government payers with software and services designed to optimize their operations and health out comes for patients. And our international group provides software and services to the European healthcare market. In every case we are providing customized solutions that combines parts of our offerings within or across the four areas of MTS. And for that matter across all the businesses of McKesson.

Now let me briefly review the major highlights within the McKesson Technology Solutions portfolio. The McKesson provider technologies our hospital customers are continuing to demand solutions to support clinical and patient safety initiatives and connectivity including Horizon Medical Imaging, Horizon Cardiology and Horizon expert orders but as more and more hospitals near the completion of the re-engineering of their clinical work flows with software and automation we already see them looking ahead to utilize the new data gathering capabilities of these clinical solutions to improve their performance. We are seeing increasing demand for newer solutions such as Horizon Performance Manager, our analytics tool which enables customers to use the data captured in their systems to make improvements in clinical organizational and financial performance. Now along the same lines our OR benchmarks collaborative has aggregated data for more than 2.5 million surgical cases from 350 participating hospitals cross the United States and Canada. This solution provides a Web-based dashboard that enables hospitals to measure and compare their operating room performance to that of similar facilities action cross all of North America. We are seeing continued demands among our physician customers for solutions that integrate practice management through electronic health records. We have a unique strategy to meet the demand in a way that responds to the financial needs of physicians which I will address shortly.

Now turning to RelayHealth. We are seeing growth and demand for solutions that leverage our overall customer relationships and connectivity assets. During the quarter RelayHealth signed a multi-year renewal of its agreement with Wal-Mart is stores to provide pharmacy network and value-added services reflecting quality and liabilities of our offering for this important customer. RelayHealth is also a key component of our new provider Technology Solutions for physician offices called Practice Partner Complete, which is a hosted services offering designed to remove the hurdle of capital investment by physicians which is obviously one of the barriers to adoption to electronic health records. It is our goal offer the time to increase our services revenue stream and this is a perfect opportunity. Practice Partner Complete combines our highly rated Practice Partner software and billing and accounts receivable management services from provider technologies with RelayHealth's electronic transaction processing. The attractiveness of Practice Partner Complete's business model is enhanced by the strong reputation for quality and track record for success of the component parts of the solution. The Practice Partner Suite which integrates EHRs with practice management systems received top rankings for the fourth consecutive year from the AC Group.

Now many of you know that we are already providing billing and collection services to approximately 17,000 U.S. physicians. That service received the North Face Score Board Award for the fourth straight year. This annual award recognizes organizations that is rated only by the customer existentially exceed expectations in the areas of customer service and support. Health care is being transformed by several factors that are together shifting more of the payment responsibility to the patient and creating the need to better manage a much larger number of high volume, low value financial transactions. A partnership of JPMorgan Chase was announced last quarter. RelayHealth has also signed a strategic partnership with the Bank of America who shares our commitment to delivering improved electronic payment processing and healthcare. Both of these partners are well respected financial institutions and have a large footprint of healthcare customers. Through these relationships together with relay headlights products and services we plan to integrate the administrative clinical and financial healthcare transactions to streamline, maximize and accelerate both payor and consumer payment flows. McKesson is the only company capable of providing such an integrated solution for healthcare. RelayHealth today processes more than $1 trillion in healthcare billing transactions annually on its intelligent network. Earlier today we announced a RelayHealth new payor-direct initiative focused on providing the most comprehensive connectivity for payors in the healthcare industry has now been launched. Our payer-direct initiative will remove the intermediate steps that exist today between payors and their provider networks in the financial transactions process. We expect this initiative will reduce costs and improve cash flow for both providers and insurers and accelerate our growth. Because we deliver more than traditional EDI, health plans will gain a competitive advantage by offering services that increase member and provider interaction and their satisfaction.

Now turning to McKesson Health Solutions. The focus is also on measuring and improving operating performance and on cost management. Our suite of claims performance products continues to sell very well and our disease management business continues to grow. In the second quarter McKesson Health Solutions renewed its agreement with the Pennsylvania Department of Public Welfare to provide disease management and primary care case management programs to the states eligible Medicaid children and adults who suffer with some of the most serious and costly chronic diseases. McKesson health solutions also renewed its agreement with the new Hampshire department of health and human services to provide disease management services to eligible New Hampshire Medicaid clients. Our program with New Hampshire recently received the 2007 Outstanding Government Program, Disease Management Leadership award from the Disease Management Association of America. While positive results cross the board including return on investment, reduction of emergency department admissions and high levels of beneficiary satisfaction.

Finally in our in international group we continue to make great progress with the implementation of our new payroll of human resources information system for the National Health Services at England and Wales. During the quarter we passed a milestone of 1 million employees receiving their paychecks through our system. We believe that our NHS Solution is the largest outsourced payroll system in the world and we are on schedule to have profitability from this contract beginning in fiscal 2009.

In summary we have great momentum cross McKesson through the first two quarters of fiscal 2008. Both Distribution Solutions and Technology Solutions are demonstrating their potential for value creation. Our strong balance sheet and solid operating cash flow provides resources to further the creation of addition shareholder value. Based on our results for our year to date and our momentum we are raising our fiscal 2008 guidance range to $3.22 to $3.37 for earnings per diluted share for the continuing operations excluding adjustments to the Securities Litigation Reserves and restructuring charges. I look forward to reporting to you on our results for the final two quarters. With that I turn the call over to Jeff and will return to address your questions when he finishes. Jeff?

Thank you, John, and good afternoon everyone. McKesson had a strong second quarter performance, especially in light of the challenging comparisons we faced from the second quarter a year ago. Great execution is driving our operating results and we are achieving good return from our capital deployment strategies to increase shareholder value. As always let me first begin by reviewing the consolidated income statement. Revenue for the quarter grew 9% to $24.5 billion, from $22.4 billion a year ago. Distribution Solutions revenues which, given their size, are always the primary driver for overall revenue growth, grew 9%. And our Technology Solutions revenues grew 36%, benefiting from the acquisition of Per-Se Technologies. Overall gross profit for the quarter was up 15% to $1.2 billion. While we had a nice increase in our Distribution Solutions gross margin, the primary driver of the 15% consolidated increase in gross profit versus our revenue growth of 9% was our higher Technology Solutions gross profit driven by the per se acquisition.

Moving below the gross profit line our total operating expenses were up 14% to $827 million for the quarter, excluding the impact of adjustments to our Securities Litigation Reserves. The 14% expense growth in the quarter primarily reflects the growth rate of the business and the impact of acquisition of Per-Se plus $12 million of incremental FAS 123 R expenses versus a year ago. Our results this year do include a positive pre-tax adjustment to our securities litigation reserves of $5 million, reflecting the net impact of several settlements. Our fiscal 2007 results included a similar credit of $6 million. One of this year's settlements resulted in the dismissal of Bear Stearns appeal of the McKesson settlement of the Federal Securities consolidated action. As a result of the elimination of this last condition to the McKesson settlement our December quarter financial statements will reflect the removal of $962 million of restricted cash reported on the balance sheet along with the related liability. Operating income of $359 million in the quarter was 17% above last year, great leverage on our revenue growth of 9%.

Moving below operating income, our interest expense of $36 million was $14 million greater than the prior year due to the $1 billion in additional debt which we used to finance a portion of our Per-Se acquisition. Other income of $36 million was little changed from a year ago. McKesson reported a tax rate of 31.2% in the quarter and our expected effective tax rate for the year is now 33%, a downward adjustment from the 34 to 35% range originally expected. The adjustment to 33% reflects the company's growing mix of foreign versus domestic income. The reported tax rate for the quarter primarily reflects a two quarter catch up to the new expected annual rate. On a GAAP basis this quarter we had net income of $247 million, or $0.83 per diluted share, compared to $229 million or $0.75 per diluted share a year ago. For the fiscal second quarter earnings per diluted share of $0.83 included the positive impact of the $5 million pretax credit to the Securities Litigation Reserves, or $0.01 per diluted share. Second quarter earnings per diluted share of $0.75 a year ago included an after tax loss from continued operations -- from discontinued operation of $0.19 per diluted share, primarily from the sale of McKesson's acute care medical surgical business and favorable adjustments to the Securities Litigation Reserves of $0.28 per diluted share primarily due to a credit to income tax expense resulting from an adjustment to a tax reserve.

Our income from continuing operations in the quarter excluding adjustments to Securities Litigation Reserves was $244 million or 22% above last year. In the quarter we had diluted earnings per share from continuing operations excluding adjustments to securities litigation reserves of $0.82, or 24% above last year's $0.66. Clearly a very strong performance. To wrap up our consolidated results in the quarter, our diluted EPS calculation was based on 299 million weighted-average diluted shares outstanding compared to 305 million in the prior year. The number of shares used in this calculation declined due to the cumulative impact of our share repurchases.

Let's now move on to our two operating segments. In Distribution Solutions for the quarter we achieved solid revenue growth of 9%, driven primarily by the 9% growth in our U.S. pharmaceutical direct distribution and services revenues which, as John discussed, we are particularly pleased with. Our Canadian revenues increased 15% for the quarter including a favorable currency impact of 8% given the record strength of the Canadian dollar. We continue to see great overall performance in our Canadian business. Medical surgical distribution revenues were up 11% for the quarter, primarily reflecting market growth. Our U.S. pharmaceutical sales mix for the quarter was 31% institutional, 23% retail change, 13% independents, and 33% warehouse, that break down a year ago was 29% institutional, 24% retail chains, 13% independence and 34% warehouse. Gross profit of $848 million was up 10% from $769 million in the second quarter a year ago. And as John mentioned gross profit in the second quarter a year ago included the positive impacts of an anti-trust settlement of $10 million and a LIFO credit of $10 million, excluding the $20 million impact from prior year results, gross profit would have increased 13% showing nice leverage on our 9% revenue growth. The key drivers to this gross profit result in the quarter were an improved mix of higher margin products and services including profit growth in our proprietary generics programs and the impact of the agreements with branded pharmaceutical manufacturers, the compensation from which as we've discussed in the past can vary unpredictably from quarter to quarter.

Our Distribution Solutions operating expenses were up 10% for the quarter to $491 million. Operating expenses in the segment were primarily driven by revenue growth but were also impacted by higher expenses in our retail pharmacy systems automation business as a result of our Per-Se acquisition. Operating margin for the quarter was 154 basis compared to 150 basis points in the prior year. Adjusting for the $10 million anti-trust settlement and $10 million LIFO credit in the prior year, operating margin increased 13 basis points.

Now turning to Technology Solutions. Revenues were up 36% for the quarter to $712 million reflecting the impact of Per-Se revenues and continued growth and implementations of software and imaging solutions for hospitals, clinics and physician offices. Service revenues which now account for 76% of total revenues in this segment, were up 52% to $538 million. Software and software systems revenues which now account for just 19% of revenues were up 4% to $139 million. Gross profit margin in the segment of 46.8% with 180 basis points below below last year largely due to a higher mix of service revenues. Technology Solutions expenses increased 31% in the quarter to $270 million. Higher expenses were driven by Per-Se operating expenses, incremental FAS 123 R expenses of $6 million compared to the prior year, and continued investments in new product development. The quarter, Technology Solutions had total gross R&D spending of $91.4 million, an increase of 18% for from the prior year. Of this gross amount, we capitalized just 11% this year compared to 21% a year ago. The lower capitalization rate in the quarter was primarily due to the write off of some software related R&D in our McKesson health solutions business without which our operating profit and operating margin rate would have been higher this quarter. Operating profit in Technology Solutions this quarter was $66 million, up 27% from $52 million a year ago. Our operating margin was 9.27% compared to 9.9% in the second quarter a year ago. Now I'd remind you that there is some quarterly volatility in our operating profit in this segment due mostly to the timing of revenue recognition across the segment, but we are still focused on our long-term goal of an annual margin rate in the low to mid-teens. While we don't expect to be in this range for FY 2008 we will begin to approach a significant improvement from the 9.2% rate for FY 2007.

Leaving our segment performance and turning briefly now to the balance sheet, on the working capital side our receivables increased 14% to $6.8 billion versus $6 billion a year ago, our DSO increased by one day going from 21 to 22 days. Our inventories were $8.3 billion on September 30, a 7% increase over last year, but below our sales increase of 9%. Our day sales and inventory of 32 was just one day lower than last year. Compared to a year ago payables were up 13% to $11.8 billion. Our day sales and payables increased by two days going from 44 to 46 days. Year to date driven by these positive working capital results we generated $1.3 billion in operating cash flow. We actually had a net reduction in working capital year to date and we are roughly flat versus a year ago despite our 9% revenue growth. This demonstrates the strong cash generating character of our evolved pharmaceutical distribution model. That said, I would remind you that there is seasonality in our use of working capital and we do tends to use cash in our third fiscal quarter. However, with the strong year to date results we are certainly comfortable that we will exceed our previously announced annual expectation of generating over $1 billion of operating cash flow for the fiscal year. Year to date capital spending was $83 million, higher than the $51 million a year ago, primarily due to distribution center updates and higher technology infrastructure spending. Capitalized software expenditures were $78 million, down from $86 million a year ago. We ended the quarter with $2.5 billion in cash, up $564 million from our fiscal year ends of March, 2007. Consistent with our portfolio strategy for capital deployment year to date we have repurchased $684 million of shares, invested $51 million in acquisitions, paid $36 million in dividends and made $161 million of internal investments. With the Board of Directors approving a new additional $1 billion share repurchase authorization, we now have $1.3 billion of share repurchase authorization outstanding. We ended the quarter with a gross debt to capital ratio of 23.4%.

After the quarter ended we completed our acquisition of OTN for approximately $575 million in cash which will now been reflected in our third quarter financial statements. So overall based on our strong year to date results we are raising our earnings guidance from continuing operations now expect to earn between $3.22 and $3.37 per diluted share for the fiscal year ending March 31, 2008. Our new guidance is based in part on the continued belief that we will have a strong fourth quarter tempered by the fact that we will now have dilution from the results of OTN for two quarters. Our guidance does not include the impact of any securities litigation reserve adjustments, any potential future acquisitions, divestitures, material restructurings or integration related actions. We remain very positive on the health of our business and the industry in general. We have great financial flexibility which provides us a good opportunity to continue our capital deployment strategy to enhance shareholder value. Thanks. And with that, I will turn the call over to the operator for your questions.

Thank you. (OPERATOR INSTRUCTIONS). Our first question will be from Lisa Gill of JPMorgan. Your line is open. You may now ask your question.

Great. Thank you, and good afternoon. Jeff, just walking back through some thoughts around the guidance you just gave, obviously you raised it by $0.07 In my estimate OTN will cost you maybe $0.03 to $0.04 which will put overall raise from the initial guidance in my mind of $0.10 to $0.11 of which about $0.06 is coming from tax. So as I kind of step back and say 4% to 5% of it is from operations and this quarter you beat consensus on an operations side by about $0.06, how should I be thinking about the next couple of quarters? Is there something that I am missing here? And when we think about drug distribution, is it the fact that the price increases came through in July and maybe we won't see as much in January? I know you don't like to answer questions about guidance but maybe if you can help me to better understand this.

No, Lisa in fact I think you have got the components fairly well laid out. The way I would go through it relative to our initial guidance is clearly we've had a strong first half performance, particularly in our U.S. pharmaceutical distribution business. And our view is that some portion of that strength is just timing. So it's borrowing from what we thought would happen in the back half and putting it into the front half and some portion of it is reflective of real continued strength that will show up in our year end results. You have to balance that against OTN which we closed frankly more quickly than we had initially thought. So we'll now have about two full quarters of dilution from OTN. And while there's lots of uncertainty there and our goal is to make the integration happen very quickly and get at the synergies the dilution in our estimate for fiscal '08 is probably more in the, around $0.06 range. And this number is probably somewhat similar for '09. Certainly our goal is to beat that but that's what's in our thinking as we go through rest of the year. And then as you say you've got the tax good guy which does add about $0.05. So it's the interplay of those effects that leads us to the range that we've given you.

Okay. Great. And then just as a follow up to that as we look at drug distribution in general our anticipation would have been that U.S. would have come in lower than the 9% that you produced in the quarter. Can you just maybe talk about the impact of the Medicare drug care benefit or other things that were positively impacting last year and what we should expect in the next couple of quarters, as we move into the doughnut hole should we expect that the growth won't be as great ino the back half of the year?

We see good momentum in our pharmaceutical distribution business. We actually have a pretty positive outlook on our view on the business and I think that the Medicare Part D up take has been largely I think laped by us although it's still a very good volume aspect in our industry, I don't know what effect the doughnut hole will have on us but we remain optimistic that we will continue to grow at or above the market levels because of our mix of customers that we think are frankly growing nicely and the second as we mentioned in this conversation today, we are increasing our position and our existing customers. We are taking on generic sales where they may not have purchased generics from us in the past and we are taking warehousing business where they may not have, they may have had their own warehouse in the past, I mentioned both of those examples in my prepared comments. So I think we are optimistic about the position we are in and the revenue growth outlook remains a positive.

Great. Thanks, John and Jeff and congratulations on the continued strong execution by McKesson.

Thank you, Lisa.

Our next question is from Glen Santangelo of Credit Suisse. Your line is open you may ask a question.

Yes, John, I just had two quick follow up questions on the IT division. It kind of says in the press release that you guys have spent over $160 million year to date investing in this business and capitalizing expenditures and capitalized software. Is that maybe a little bit more than you thought you would have spent maybe six months ago and how should I think about that level of investment spending as we move into the back half of the year?

Well, I think that we, other than a relatively small write down of some software in our McKesson health solutions business that Jeff mentioned in the call I think that our spend is pretty much on line with what we expected it to be. Maybe what's the difference here is we are combining all of this into one segment now called MTS And the second thing is we've got Per-Se in there. So the inflation in the numbers is probably driven by the consolidation of the sectors and the acquisition of Per-Se rather than a huge ramp in R&D spending.

Then kind of as a follow up to that, Jeff, maybe if you could talk about the magnitude of the write off this quarter in the software side?

Well, I think, Glen, the way I would probably think about it if you go back to the numbers that I sighted in my remarks, we spent gross R&D dollars of about $91 million this quarter. That itself was up 18% from the prior year. A part of that is the acquisition of Per-Se and part of it is the combination of the payor business, McKesson health solutions and MTS And part of it is just continued step up in spending. This year we only capitalized 11% of that total whereas in prior years you'd see, in prior quarters you'd see us running in the 20 to 25% range. So the simple math tells you that's about an $8 million to $10 million switch.

Okay. And then just my last question, Jeff, in terms of the guidance you were suggesting that we'll see the margin sort of gravitate not so much in fiscal '08 but move more in fiscal '09, is that the point you were trying to make?

You're talking about the Technology Solutions?

Yes, exactly.

So the point I'm trying to make there is that we continue to have our long-term goal of low to mid-teens. And that's an annual number because of the quarterly volatility in that margin. While we don't expect to get into that range for fiscal '08 we'll make tremendous progress and we'll begin to get closer, pretty darn close to the range when we look at the whole year calendar '08. We haven't given guidance yet beyond '08 but certainly as John really focused in his remarks, our goal in all of our businesses is to continually get operating leverage.

Okay. Thanks for the comments.

Thank you.

Next question.

Next question is from Tom Gallucci of Merrill Lynch. Your line is open.

Good evening, thanks. First, John, I just wanted to make sure when you talked about Kinney and Wegmans and a few of the others there was the implication that you hadn't done generics for those regional chains in the past and now you have, now you have the contract to do that?

That's correct.

Can you maybe just to generalize a little bit but what's sort of the trigger in this time frame to move that many, decent size customers over on to your generics program?

Well, as we've talked about in the past we've been heavily focused on moving up the food chain from a generic perspective, in other words getting more and more customers buying from our programs. And it's a combination of our ability to package the programs and position them properly in the customers eyes, a combination of our ability to source the product competitively and make sure they've got great pricing and probably lastly to the highlight to our customers the efficiencies they gain by basically doing away from their own sourcing for generics, the man power associated with it plus the logistics associated with managing their own buy. It's not inconsequential to have to by the stuff directly, manage it through their own warehousing schedules, get it out to their stores on time, deal with the service requirements on a store level. Most of our large retail customers are heavily focused on managing the front end of their stores and are increasingly saying to us, why don't you help us with the pharmacy operations in a wholistic way. The supply chain to the pharmacy, the transaction processing in the pharmacy, the automation in the pharmacy and McKesson really stands in a great position to completely envelop basically a total solution for the pharmacy operations to improve the financial performance and the quality of their output to their customer. So I think it's multiple things coming together at once and we expect the momentum in generics to continue. But once again I highlighted these are existing customers of McKesson's that are expanding their footprint with us.

Okay. And then just finally on the branded side, you stressed a few different times the importance of some of the arrangements with manufacturers. Can you just give us a little bit more color in terms of what happened this quarter that seemed to have some of that money kick in? Was it just price increases? Was it performance metrics that you sort of get paid off on? Just give us a bit more detail on what's going on there? Thanks.

As you know these agreements are each individually constructed and developed at the manufacturers. Clearly volume is a component of our performance. Good revenue growth, everything else also is impacted from a importance perspective. And the agreements are structured in such a fashion in many cases so we get the benefit of performing against the obligations and the opportunities under those agreements and I think there's some variability around performance from a manufacturer perspective. So we continue to believe that we execute very well. We developed agreements with our customers that provide a mutual benefit for both of us to win together as we perform. And it pays off in the ends. Now clearly price increases also are a component of the value that you see this quarter.

Thank you. Does that conclude your question?

Yes, thank you.

Thank you, next question is from Larry Marsh of Lehman Brothers. Your line is open.

Thanks and good afternoon. One broad question and then maybe a specific follow up. John, you know, maybe you could just remind us, there's been some commentary the last couple of months that a slow down in script growth in the drug industry has proceeded at a negative impact on the drug wholesalers which I wouldn't necessarily agree with. Obviously your results this quarter would show both top line growth and good margin trends. Could you comment about that and how we should think about changes in industry volume as relates to your business?

It's a good question, Larry. Clearly I received some of the same questions during the quarter due to some discussions that had taken place with various participants in the industry not the least of which was I think was IMS which had published data around script growth. We frankly don't look at the weekly, monthly and quarterly data as much as we look at sort of the annual trends in the forecast. And I think any, as you might guess anybody's forecast is always wrong, it's a question of which side they are wrong on. I believe that the industry is poised for continued solid growth. There's nothing from a demographic or from a public policy perspective that should put the breaks on the opportunities for us to continue to grow from a revenue perspective, as an industry. And furthermore I think if we are able to capitalize as distributors on the opportunity to bring more and more of that business that sits outside of our channel through the wholesaling business we stand in very good position to continue to grow in a nice balanced and profitable way. So I frankly, we don't, we don't sit down and have large group meetings over script volumes every quarter or week when we see them. We believe that the trends over the long haul continue to be very positive.

Thanks and just a clarification of some of the comments you made within the call about your being announced as the CVS Caremark Supplier of the Year. Congratulations. I guess the question I have, your biggest customer you acknowledged, you haven't disclosed outtake particularly but are there any opportunities to expand the relationship with this longstanding set of customers now under the CVS Caremark umbrella and is there any opportunity to try to extend the relationship before you hit the deadline of June of '09 or is that probably outside your control or set in stone?

You've been working with us for a long time, Larry. You know we never talk about what our customers are likely to do. We are privileged to have the opportunity to service them and we try to earn our position in our clients base every day and feel strongly that the decision is ultimately in their hands in terms of who they do business with. I guess the purpose of the discussion today was really to highlight because some of you had questions about our relationship with CVS. I think people believe that we were in a very small position at CVS and what I was trying to highlight is that we have a very significant position at the combined CVS Caremark and that had we perform very well for them. And those awards were not just for the pharmacy. Those awards particularly one of them as Supplier of the Year was not just a pharmacy award, it was for their entire business beating out the OTC and the front shop kinds of participants as well. So I just want to point out that we are recognized by CVS and their management team for the high quality we deliver and we clearly have other points of value that we are bringing in there today like our RelayHealth transaction processing capabilities and in the past we talked to CVS and Caremark about our automation capabilities and other kinds of services and we continue to work with them to continue to service their needs as we go forward.

Okay. And a clarification I guess for Jeff, you're communicating it looks like as you said $0.06 of dilution from OTN and maybe that's a couple cents more than what you had thought when you made the announcement back in early October. Is there any way to give us any clarification as to what some of your assumptions are around tangibles and length of amortization now that it's closed?

Well, the short answer, Larry, is no, because I don't know what the intangibles numbers yet. Obviously that builds an assumption into that $0.06. The only thing that's changed since we announced the acquisition is we were able to close it remarkably fast and so we had not initially expected to have much more than one quarter of results in '08 and now we are going to have pretty much two full quarters in fiscal '08. I was a little hesitant to give that $0.06 number just because we haven't, we won't even know what that intangible number is going to be for a little while for sure. But that's really the assumption that's built into the number that we've shared with you today.

Are you assuming any sort of closings consolidation in that or is that again too soon to tell.

Clearly we have two overlapping businesses where we intend to move very aggressively to create value and put together the strength of the two companies. That is liable to drive some one time kind of costs which are not included necessarily in the guidance. This is, the guidance is really meant to be for continuing ops and excluding one time sort of stuff.

Okay. All right. I will stop there. Thanks.

Thank you.

Thank you. Our next question is from Ricky Goldwasser of UBS. You may ask your question.

Thank you. A few follow up questions. Jeff, just to clarify on the question of what it looks like the outlook for the next couple of quarters, when we think about December quarter from a sequential perspective, should we assume the differences is one obviously OTN which seems to be about $0.03 diluted to the quarter and the other moving part that is impact after being a decision in from branded inflation?

Well, I will make a couple points. We of course don't provide quarterly guidance. We focused on annual guidance because that's the way we run the business and our ability to predict quarter to quarter numbers is in perfect because of the nature of the way our agreements work and are in our pharmaceutical distribution business because in our software and services businesses our view is we want to develop and maintain long-term customer relationships and we don't want to get into the game of having to close business on the last day of the quarter to make a number. Now all that said, our margin quarter has historically by quite of stretch been the company's strongest quarter and that's due to both the way most of our agreements work in the pharmaceutical distribution business and frankly the way sort of these sales structure and compensation programs are set in most of our software and services businesses, all of those things build towards a very strong March quarter and we expect that sort of back weighting today if you take what we've earned year to date, combine that with our annual guidance and then pretty heavily back end weighted for that March quarter in line with historical patterns.

And the growth we see with your proprietary generic program in the quarter given that it sounds like you have new customers or at least customers that are adding this program, that impact, that growth we should continue to see on a year over year basis and should be pretty similar sequentially?

Sure. But that doesn't impact necessarily any quarterly progression and clearly that's one of the strengths built into the guidance we've given you.

Okay. And then just to clarify I think you mentioned, I might have missed it, were there any one time benefits or offsets that are factored into the 1.54% of operating margins for drug distribution?

No.

Okay. Thank you.

Thank you, Ricky.

Our next question is from Brett Jones of Leerink Swann. Your line is open you may ask your question.

Hi, good evening, it's Bret Jones for George hill. I was kind of looking at the Technology Solutions revenue, the top line there looked a little bit weaker than what we were expecting. I was wondering if you guys could comment on the pack since we heard a lot of of the hardware in pack vendors consistently say they are feeling impact from the DRA and spilling over into the inpatient side and I was wondering if you guys were seeing a similar trend?

We are pleased with the progress we are making in our technology business and as Jeff mentioned it's difficult to predict every quarter what's going to close and how it's going to roll into revenues or into earnings in that business but we think we are very well-positioned and as also Jeff noted we are making great progress as our strategy has been directing us to move more and more of our focus on the services side of the business and less dependent on the quarterly flow contracts for software. As you know we have one of strongest packs products in the marketplace and we've now expanded that offering to include cardiology packs. The packs market clearly has been penetrated over the years but we believe there is still more buying going on and there also is a replacement cycle under way and the cardiology cycle I think is just beginning but we are optimistic. The growth rates have come down but the business is still growing.

Great. I was wondering can you break out the organic growth of Technology Solutions ex Per-Se.

That's almost impossible for us to do, Brett, given that that business inside of Per-Se, the businesses of Per-Se are now dismantled and inside of our various businesses inside of McKesson. I clearly the per se acquisition had an impact on services and other businesses where it was significantly larger than our current assets. But in many of the software areas where we combined surgery software or combined other services it would be almost impossible for us to go back and reconstruct the same store kind of growth.

All right. Fair enough. Thank you very much.

Thank you. Our next question is from Steve Halper of Thomas Weisel Partners. Your line is open you may ask your question.

Hi, could you provide a framework for us in terms of what you're thinking about the long-term operating margin for the Distribution Solutions you had previously before the pieces moved around talked of a range of 150 to 200 basis points. Is that still where you would like to be?

Clearly our goal hasn't changed or we probably would have said something about it. I think we continue to make progress against our expectations and we made progress again this quarter by four basis points and if you do it on an on apples for apples the growth in basis points it was more like 13. So I think that's great progress actually from an operating margin expansion and the base of business that we have. One of the clear challenges we have in margin expansion is the faster growth of our lower margin customers and the fact that we have to focus on that as an offset to the continued increase and up take of generics and more profitable products. So I think our guidance will remain unchanged on that factor and we feel like we are making progress.

And then just on the Per-Se pharmacy software business, is that a Distribution Solutions or is that, is that in Technology Solutions?

Yes, the -- Steve, the relatively small retail pharmacy software business is the one piece of Per-Se that is in Distribution Solutions. So it's small enough so are, for us, for simplicity we pointed out to people they can just model it as putting all of Per-Se into Technology Solutions. When I called it out today because when you look at just the operating expense line in distributions solutions and the change year over year, it's a small piece the retail pharmacy systems business is enough to add a couple points to that expense growth rate.

How is that business doing? I'm assuming you have a lot more muscle and clout into the retail pharmacy customer base, whereas Per-Se didn't have that area of expertise. So how are you doing with selling that software piece into your pharma-customers?

I think we are making very good progress. It hasn't impacted our operating profit in the pharmaceutical distribution segment yet. So the 150 to 154 was driven really by the distribution businesses performance. That said, we continue to invest heavily in the pharmacy systems business and we now have roughly 25% of the retail market, I believe, on a store basis running on our software behind the counter to operate these pharmacies. So we think of it as a significant opportunity for us to continue to grow our footprint. There's a significant opportunity for us to use the cross-selling that exists between our distribution sales force and our technology sales force to bring a more complete solution to our customer base and to effect the performance of our customers which is really our number one goal here is to make McKesson customers the most profitable customers in the business. And to answer the question on performance, those assets are performing well. We had a little bit of an issue, Steve, in our mail order software business which is a real small subpart of the systems businesses that we acquired and we've been investing heavily in that. That's part of the expense drag you've seen in the last couple of quarters has been our man power behind that mail order software product.

Next question, Eric Coldwell, Robert W. Baird. Your line is open.

Thanks very much. I want to follow up a little bit on Steves last question. John, your comments that pharmacy systems now has in the neighborhood of 25% of the market, I'm hoping you can help us get a better sense of what that market opportunity is today, perhaps size the market for us to help put that in perspective and then as follow on just trying to get a sense of retail pharmacy systems overall profit contribution? You talked about margin pressure given investment the recent comments here on the mail order piece. Where is that division in terms of operate operating profitability today within distribution solutions.

Eric I got that the question on the pharmacy software and I can address that, what was the second part of the question on margin pressure?

The last couple of quarters you I would that your Distribution Solutions margin might have been even a little bit better if it weren't for the OPEX within pharmacy systems. So I'm trying to get a sense, is pharmacy systems profitable today? There's a wide range of market competitors profitability in that space, anywhere from negative 20% EBIT to plus 15% EBIT. I'm trying to get a sense of where you stand in the market and how big that market really is.

I think the market unto itself would probably not have been something that McKesson would have been attracted to as a stand alone business opportunity, selling pharmacy software to retail pharmacy. As a part of McKesson we think it's another strategic asset that helps round out our portfolio and certainly rounds out our conversation with our customers. So on a per revenue per transaction basis that we get out of selling pharmacy systems software I'd have to tell you that it's really immaterial to us. In terms of the strategy it's more material because we can have this larger scale discussion with our customers. As to the reason why something that is somewhat immaterial to us financially is somewhat material for us on an expense perspective enough for us to talk about it is an investment, tens of millions, not hundreds of millions, in making these products world class and we think it's incumbent upon us if we want a longstanding high performance relationship with our customers to deliver software that fits their needs and maybe even that software investment won't get a great terrific short term return but the overall relationship with the customer will and that's why we are investing in it. We are probably spending more on the mail order software product than we would have otherwise if we weren't already in the mail order business in a big way from a distribution perspective. So that should sort of give you a sense about it.

You've given a lot of great granularity on the call today and we appreciate that. I'm trying to against a sense if you see that total retail pharmacy system market, is it $.5 billion in the U.S., is it a $1 billion opportunity in the U.S.? You did comment that you don't see it as a great stands alone business but I'm trying to get a sense on where you are in that market today.

If it was a $.5 billion software opportunity we would be pretty excited about it. I don't think it's quite that big. Clearly software businesses carry a larger margin and you can't compare those revenues to distribution revenues but I think you should thinking of it as a strategic asset for us that augments our overall retail pharmacy value offering as opposed to something that will move the needle for the corporation or even for the distribution segment. In terms of pharmacy systems revenue or pharmacy systems profit. As a part of the overall relationship, is it important? Absolutely. Is it something that we'll call out in a special page and say that drill of our numbers? I highly doubt it. The opportunity is pretty well understood by us and it's pretty bounded and I know there are other players in the market that are pretty small in this segment and I think the reason why we are attracted to it is because we are scaled in the systems business already and we are also scaled in pharmacy distribution and we have a footprint with these customers that's important in a moreover encompassing way.

That's fantastic. A quick follow you. You in the past have given some of the growth rates on your proprietary generic program and obviously you announced some nice wins this quarters and my assumption is its growing quite nicely. Can you give us the growth rate of the proprietary generics program this period? I talked about the growth and the number of stores that are using the product. Revenues in the business this particular quarter are little bit softer than we typically expect because we had a comparison to last year where you had Plavix, Zolcor, and Zoloft which are an inflating factor in generics but revenues grew nicely in generics. But I think overall we are pleased with the results but the issue of momentum in generics we knew we would have a couple of quarters that the momentum in generics was a lint softer compared to prior year and that's what we were talking about even before this year. Good job on the results.

Thank you.

Thank you. Our next question is from John Patrick Walsh of Wachovia Securities. Your line is open.

Good afternoon, thank you, guys. You answered my operational questions. A question on the balance sheet. Now that you have the restriction listed on the cash would your thoughts be to redeploy that cash kind of right a way? And I think longer term I would be curious to where you would like to keep the cash balance. Obviously it's been at a pretty high level here for awhile. Should we look to that trending back somewhere towards $1.5 billion something in that ballpark?

Let me make three comments, on the specific reference I made to the $962 million in restricted cash, that disappears off our balance and goes right into the hands of the plaintiff and ultimately the individual claimants in the class action relating back to HBOC.. That money is not available for our shareholders. Our target cash balance longer term in the $1 billion to $1.5 billion range. We continue to have a target capital structure of a gross debt to cap ratio in the 30 to 40% range versus our current 23%. Clearly those two groups of specifics tell you we still have more balance sheet strength to use to create value and we continue to be focused as a management team on making sure that we use that potential and get into our target capital structure and into more of a normalized cash balance range in the coming quarters.

Great. Just one more question kind of a 20,000-foot question, Obviously we're having here a political year and you have having all kinds of proposals on the healthcare front in terms of the un-insured and obviously if democrats take office you are probably going to have more scrutiny on the pharmaceutical companies, just kind of your sense right now in terms of how you look at the government potentially getting more involved in the business and how that might impact you and the overall outlook on the industry?

I'm pretty excited about the fact that the healthcare seems to be the number one debate item on the political circuit, setting aside clearly the War on Terror. We are excited about how we are positioned in the debate. Clearly healthcare IT remains one of the fundamental tools that will be used by other party to control cost and to improve quality. Clearly our financial transactions business will fare very well in an environment where you have the individual taking on more responsibility. And frankly I think the pharmaceutical industry should be somewhat out of harms way in this new environment. If you look at what's happened to them from a generic perspective the industry has been completely recast and changed and I can't think of any politician, maybe I shouldn't say that, I can't think it would be a very good argument to say that the pharmaceutical companies are doing great things from a financial perspective on the backs of our taxpayers. So I'm hopeful as we go through the cycle that the debate will be on the right things and that's how to engineer healthcare and if that's where it remains today McKesson is well-positioned for that debate.

Thank you.

Thank you. Our next question will be from Robert Willoughby of Banc of America. Your line is open.

Thanks. John or Jeff can you speak to the payor-direct initiative that you just announced today? With payers and providers maintaining interface what is actually incremental there? I'm not sure I understand that development there, because I thought you maintained a lot of these interfaces already.

We do have a large business there and roughly 60 or 70% of the volume that we manage already goes on a direct basis between us -- between the providers through us and on to the payers. We provide a value-add in those transactions because of the way the information is presented to both sides and that's why we have a roll as an intermediary. First, a subset of our customer base, there were actually other business partners involved in those transactions and what we are announcing today is that those other business partners will no longer be necessary in the channel and we will be able to eliminate the inefficiencies that are present as a result of their presence in those transaction channels. I think it's particularly good news for our customers both the providers and the payers to smooth line the transactions. Clearly there's a business opportunity for us hear today but I think our announcement today was really focused on making sure that our customers understood that we are out there trying to make it easier for them.

What is exactly an intermediary whos being removed, is it just another claims processor of some sort that's being mediated?

Other claims processors, some that are automated and some that do paper based claims processes that work on these transactions, our goal is to be close to 95% or better of these transactions running only through McKesson's RelayHealth network point-to-point.

And just to step up how do I think about that? That is removing a handful of these guys that are out there, it should ultimately be more profitable for you? I mean what's the, how do I think about the economics for you in that development?

Well clearly it should be more profitable for us and it also should safe people like Aetna money that don't have to pay others to be part of the transaction. I think it should be a win for us and certainly a win for our customers. Clearly the people that may be on the losing ends of it are people that are no longer necessary in the channel.

And you are viewing that as 30% or 40% of the transactions might have gone through some of these intermediators?

Probably more in the 20 to 25% range and there's still a bunch of manual transactions that we are in the process of automating.

That's great. Thank you.

Next question, Barbara Ryan, Deutsche Bank. Your line is open, you may ask you question.

Good afternoon, thanks for taking my question. Just a couple of bookkeeping things. I don't know whether you mentioned what the OneStop generics program was up in the quarter?

Our OneStop performance, not only did we sign new customers but we continue to grow the profitability of that program in the quarter so we are pleased with our results. We had a very difficult compare, though.

Right.

I want to point that out. And I think there were several, several positive things in the quarter our revenue momentum was strong. Our performance in our branded contracts were very strong and our performance in generics was stronger than we anticipated given that we had this difficult lag we had to accomplish. So we are very pleased with where we ended up.

So you are not going to give us an exact percentage, John, for the generics program in the quarter?

No, I'm not but--

Okay.

I think it was, it's moderately up.

Okay.

By comparison to the prior year.

Versus a really tough comparison, I understand. I'm just wondering if you can update us on the Health Mary program and what the numbers there are for stores, keeping track of that?

Health Mart continued to make progress and I think we probably picked up another 100, 150 stores in the quarter. That momentum is going to begin to slow as we penetrate those customers that are most suited for the program. We clearly still, so the total is in the 1800 to thereabouts kind of range. We still have certain thousand stores on Value Rite and then as I mentioned we have over 10,000 people buying stores, stores that are buying our generics, select generics programs. And people like Costco that might be on our generics program are probably not going tory brand their pharmacies Health Mart. So there's multiple points of value that we get out of the generics program including Health Mart franchises and others.

Thanks a lot. I appreciate it.

Thank you Barbara I really appreciate and I think we are out of time, operator. We've run a little bit over because I know we had some people that wanted some question. I want to thank all of you that were on the call today. I think we are a off to a very solid start to the first two quarters of the year. We remain extremely excited about our unique offerings cross healthcare and our ability to turn that into value for our customers and obviously value for our shareholders. We are well positioned as with finish this year and we look forward to continued strong performance. Now I will hand the call offer to Larry to talk about upcoming events for the financial community.

Thanks and we have a few to cover so bear with me. I know we wanted to go a little over here but we wanted to do address as many of those questions that we could. On November 6, we'll be at the CIBC Healthcare conference in New York City, on November 14, present at the CSFB conference in Phoenix, on November 27, we will present at the Merrill Lynch Healthcare Services conference at their offices in New York City; on December 3, we will host our traditional booth side briefing at the ASHP mid year meeting in Las Vegas. A number of you asked me about this because you didn't see the announcement. We are not having a briefing at the annual RSNA show as we did the past two years in Chicago. We are going to include a discussion of our medical imaging business a little longer discussion of it in our annual HIMS briefing. That will be February 25 in Orlando. That will come up again on our next call. On January 7 we will be at the JPMorgan Healthcare conference up the street from us here in San Francisco. And we plan to release and hold our call for the fiscal 2008 third quarter results in late January. So thanks for your patience. We didn't wreck your Halloween this year. Have a great evening and have a great Halloween tomorrow, thanks and take care.

Thank you, that concludes our call for today. You may now disconnect.