Owens & Minor Inc (OMI) 2009 Q3 法說會逐字稿

Good morning, ladies and gentlemen. Welcome to the Owens & Minor third quarter 2009 earnings conference call. My name is Carrie and I will be your operator for today. (Operator Instructions) As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the presentation over to your host for today's call, Mr. Craig Smith, President and Chief Executive Officer of Owens & Minor. Please proceed, sir.

Good morning, everyone. And welcome to the Owens & Minor third quarter 2009 conference call. We're going to review our results and take your questions in a moment.

But first, let me introduce my colleagues on the call today -- Jim Bierman, our Chief Financial Officer, Charlie Colpo, our Executive Vice President, Grace den Hartog, our General Counsel and Olwen Cape, our Controller. Now, before we begin, Trudi Allcott, our Director of Investor and Media Relations will read a Safe Harbor statement. Trudi?

Thank you Craig. Our comments today will be focused on Company results for the 2009 third quarter which are included in our press release. The press release as well as a related presentation can be found on our web site. In the course of our call today, we may make forward-looking statements. These statements are subject to risks and uncertainty that could cause actual results to differ materially from those projected. Please see our press release and our SEC filings for a full discussion of these risk factors. And, finally, this conference call will be archived on our web site.

Thank you. Craig?

Thank you, Trudi. Let me call on Jim to share the financial results with us. Jim?

Thank you, Craig. Good morning, everyone. Thank you for joining us today as we discuss third quarter financial results.

We reported record quarterly revenue while making progress on our strategic initiatives. The fundamentals of our business remain strong. As a result, our operating cash flow for the first nine months exceeded $161 million. Third quarter 2009 revenues exceeded $2 billion -- increased nearly $248 million or 14% when compared to last year's third quarter. Approximately 60% of the increase resulted from sales to the former Burrows company customers as well as other net new business. Remaining growth in revenue resulted from a net increase in sales to existing customers.

For the first nine months, revenues were just under $6 billion, increased 13.5% or $712 million when compared to 2008. Year-to-date revenue results were in line with our expectations. If you will recall, we completed the acquisition of the Burrows company on October 1, 2008. Therefore, the fourth quarter revenue growth should revert to more normalized levels.

Gross margin dollars increased over 14% to $204 million in the third quarter of 2009 when compared to $179 million in the same period of 2008. In comparing quarter to quarter, the increase in gross margin dollars resulted primarily from an increase in revenues. The increase of four basis points in gross margin as a percentage of revenue for the third quarter when compared to last year was primarily due to the positive impact of supplier price changes. As we indicated last quarter, one of our suppliers significantly reduced prices on a certain set of products during the third quarter. The effect of this price decrease, net of price increases from other suppliers, resulted in an $11.5 million credit for the provision for LIFO inventory valuation for the third quarter.

In addition, the gross margin percentage increased due to the recognition of revenue, net of deferrals related to customer contracts with performance targets, as a result of the Company achieving those targets. These increases were partially offset by lower gross margin as a percentage of revenue on sales to new customers including customers obtained from the Burrows acquisition and from supplier incentives. In addition, as a result of the Company changing its methodology for estimating the provision for sales returns and allowances, gross margin was $1 million less for the third quarter than it was in the same period of 2008.

When looking at year-to-date, gross margin dollars increased 12% to $586 million in the first nine months of 2009 compared to $524 million in the same period of 2008. The increase in gross margin dollars resulted primarily from increased revenues. For the first nine months, the decline of 15 basis points in gross margin as a percentage of revenue resulted primarily from lower gross margin on sales to customers including the Burrows customers and from supplier incentives. These decreases were partially offset by the effect of net supplier price decreases, resulting in a LIFO provision that was $5.5 million less than the same period in 2008.

Turning now to SG&A, third quarter 2009 SG&A expenses were $142 million. An increase of $13.5 million from third quarter 2008. As a percentage of revenue, third quarter SG&A expense decreased 21 basis points to 6.99% when compared to the same period last year. On a dollar basis, SG&A expenses increased as a result of the following factors. Compensation and occupancy costs associated with serving new customers as well as other integration expenses and also fees for outsourcing and consulting.

Year-to-date, SG&A expenses were $426 million, increased $45 million when compared to the same period last year. As a percentage of revenues, SG&A expenses for the first nine months of the year were 7.1% compared favorably to last year's 7.2% of revenues. For the third quarter of 2009, operating earnings were nearly $57 million, increased more than $10 million when compared to the same period in 2008. As a percentage of revenues, operating earnings were 2.79%, improved from 2.59% of revenues last year.

Interest expense, a component of net income but not of operating earnings was $3.2 million, decreased significantly from $6.3 million in the third quarter of last year. Looking back at last year's third quarter, interest expense included a $3.1 million loss from interest rate swaps that were terminated during the quarter. For the first nine months of the year, our effective interest rate was 6.4%, essentially unchanged compared to last year on average, borrowings of approximately $210 million.

For the quarter, the effective income tax rate was 35.2% and was 37.5% year-to-date. The lower effective tax rate resulted primarily from recognition of tax benefits totaling $1.7 million due to the conclusion of audits by the IRS of our 2007 and 2006 income tax returns. As a result, we're targeting the annual effective tax rate for 2009 to be approximately 38%, decreased from our previous guidance of approximately 39.5% in the prior year's effective rate.

Income from continuing operations for the third quarter 2009 increased by $9 million to $35 million when compared to the same period last year. The increase resulted primarily from an increase in gross margin of $26 million, partially offset by increases in SG&A expense of $14 [million] and income tax expense of $4 million. On a per share basis, income from continuing operations as well as net income per diluted share was $0.83 improved from $0.61 per diluted share last year.

As for asset liability management for the quarter, we reported operating cash flow of $161 million for the first nine months of the year, compared with operating cash flow of $119 million for the same period last year. Operating cash flow was positively affected by operating earnings and by increases in accounts payable and decreases in accounts receivable. Inventory turns in the third quarter were 10.5 compared to turns of 10.3 a year ago. Our receivable DSO was 23 days as of the end of the third quarter, essentially unchanged when compared to the same time last year.

Cash use for capital expenditures in the third quarter was $6.7 million, used primarily for investments in software, technology and warehouse improvements. During the quarter, cash dividends paid were $9.6 million. For the year-to-date, cash provided by discontinued operations was $74 million, including the $63 million we received from the January sale of certain assets of our DTC business. Combining the proceeds from the sale with operating cash enabled us to reduce long-term debt by $151 million year-to-date.

Turning to guidance, as we reflect upon the results of this quarter, we acknowledge that operating earnings excluding the effect of the LIFO provision was less than we were targeting. We experienced lower customer and supplier margins while SG&A was generally in line with targeted levels. We believe some of the gross margin deterioration may be temporary in nature. But an element relates to the new business we have added in 2009 including the Burrows customers. Improving the gross margin on this business may take longer than originally anticipated.

As we look to the future, we believe continued SG&A improvements will be the fundamental contributor to operating margin growth. As we approach the end of 2009, we continue to target revenue growth for the year in the upper end of a range of 8% to 12%. And income per diluted share from continuing operations in the range of $2.55 to $2.70, excluding the positive effect of the third quarter LIFO provision of $11.5 million or $0.17 per share.

Now, I will turn it over to Craig for his remarks.

Thank you, Jim. And now that Jim has reviewed the details, I would like to step back and take a look at the big picture.

I believe we would all agree that we have witnessed unprecedented market conditions over the past year. And, in fact, as I looked back a year ago to our 2008 investor day, we pointed to certain variability factors when we issued our guidance in 2008 -- or 2009. These variables included new business integration, customer credit quality, healthcare utilization trends, supplier stability in a recessionary market and a new presidential administration. Now, so far this year, we have felt the impact of three of these -- the integration of a large amount of new business including the Burrows acquisition, certain suppliers have put into place list pricing changes -- not seen,again, I said this once before -- but in all of my years at Owens & Minor. And with the new presidential administration, we're now actively monitoring the debate over national healthcare.

As for the remaining two factors, customer credit quality has remained relatively steady so far this year. I think we've done an outstanding job -- our team -- in terms of credit quality and the business that we choose to do with certain customers. And so far from our point of view, healthcare utilization trends have not changed dramatically even with a surge in unemployment and weakness in the economy. So, while we believe we are seeing some impact from the larger economy, we continue to demonstrate strength, resilience and I think growth -- good growth.

On the positive side this quarter were revenue growth, operating cash flow -- and even with surging revenue growth this quarter, our teams did, I think, just an outstanding job in lowering SG&A as a percent of revenue. We're very pleased with what we've achieved. Now, these results were consistent with our expectations for this point in the year. Despite these positive results, we remain focused on achieving operating margin improvement and to reach that goal, we're putting a high level of focus on gross margin and continued SG&A improvement, even as we keep a longer term focus on our strategic development.

Now, as we have said before, we can achieve SG&A improvement more quickly and I think historically, we have always proven that. And we believe our operational excellence initiative such as voice-pick technology is going to help us to leverage our expenses as we continue to grow our business. We are also targeting on-going reductions in spending for overtime and temporary help and we're actively reviewing our supplier strategy for opportunities.

As for gross margins, we recognize we have some work to do. During the quarter, our teams continued integrating a significant volume of new business including the Burrows business and there was a lot of cleanup attributed and around the Burrows business which is an important part of the integration process involving bringing the customer margin up to our standards. To that end, we're relying on approaches that worked well with the McKesson acquisition. Also, in looking at this business from the standpoint of operating margin improvement, we want to ensure that we have the appropriate level of expense associated with the type of business that we serve.

Another tactic we're using to achieve gross margin improvement is supplier and SKU rationalization. As we have learned many times in the past, acquisitions in business growth tend to drive up the number of suppliers and SKUs in our system. As we've done before, we intend to bring those numbers down to normalized levels. By working with suppliers that are more efficient and more willing to partner with us, we see opportunities to again improve our gross margins. As we've said before, improvement in operating margin will ultimately come from a combination of improved expense control in the shorter term and improved gross margins over the long-term. Our leadership team and our teammates are focused on doing what we need to achieve this goal.

I have to say, over the last four years, we have run very hard and moved a lot of business into our system. In that time, we have brought in more than $3 billion in additional business and I believe our teammates have done a phenomenal job in managing through this growth. However, now that the dust has settled, we have the time and resources to refocus on fundamentals -- blocking and tackle, margin improvement, expense controls and sustainable growth. When looking at the big picture, we're actively involved in the debate over national healthcare reform. It is our view that however healthcare reform plays out, we'll continue to serve our customers to the best of our ability. We believe that our focus on improving the supply chain and taking cost out of the system is consistent with the idea of reform no matter how it takes shape. But at the end of the day, we remain focused on serving our customers, running our business efficiently and achieving improvement in operating margin.

So at this point, I would like to thank you for listening and we would be happy to ask -- take any of your questions. Operator?

(Operator Instructions) Your first question comes from the line of Larry Marsh of Barclays Capital.

Thanks and good morning, everyone.

Hi, Larry.

Hi, Larry.

Good morning. Is there something that you have learned about the Burrows book of business here of late that is incremental to your thought process earlier this year? And I know you completed the systems conversion in the last couple of months and I know you had previously thought of that book as having lower margins but a great opportunity to migrate to private label and other programs. But, specifically, is there anything incremental that you've learned that has made you a bit more cautious on timing of gross margin improvement there?

Yes, Larry. As we moved in to the beginning of this quarter, in our original plan for the year, we had expected to begin to see some of the margin pick up in both the Burrows business and the significant amount of other new business that we had brought in at the start of 2009. And quite candidly, that didn't really manifest itself in this quarter. And as we drill down into some of the thinking on it and it is still evolving as we speak, I think that there is more difficulty in cross selling some of the products and services that we offer that we had anticipated would have been cross sold at this particular point in time with that particular book of business.

And some of that may be due to the fact, as we reflected on this experience vis-a-vis the McKesson experience -- if you reflect back on McKesson, it took a while to work through the margin related issues. In McKesson's case, those customers were already significant private label customers. And in the Burrows situation, as I think Charlie pointed out last quarter, those customers don't have a history of purchasing private label at least from Burrows. And so I think we found there to be a bit more difficulty in moving our products and services into that book of business than we had originally anticipated.

And finally, not to be lost on any of us, it has been a difficult environment economically and that may have some impact on the buying, purchasing decisions of some of the hospitals.

So, just to clarify, this sounds like it is more you learning additional information about that Burrows book of business and the timing around programs. And are you as confident as you were say three months ago that you were moved to, those cross-selling programs or less confident or about the same?

We think -- I think there are a couple of points and certainly, Charlie and Craig, to weigh in. But I think that we remain very optimistic and bullish on the concept of bringing our products and services to these new customers. Both Burrows customers and additional customers that we've added. In large part because we think they make compelling sense economically in that they help supply -- help decrease supply chain costs for those customers. That being said, the sales cycle in this environment is a little more challenging than I think we had originally anticipated.

The final point I would make and this relates to Craig's comments at the outset is that in some instances, the service level for some of these customers was contemplated to be a less expensive than it is for other aspects of our business such that on an operating margin basis, we ought to be able to see the improvement. That's really the thrust of the near term opportunity that we see and where we'll be focused.

Larry, this is Craig. I would just underscore what Jim's last points were is that we had budgeted a particular number on this other new business and as we have always said in the past, as we bring new business over, we have a tendency to basically blow the number out to some degree in terms of picking up more business from a competitor. And I think what we want to make sure is that we're putting the appropriate expense and the appropriate service to some of these lower customers. So, we're going to be reworking that and really focused on the overall operating margin on the Burrows business and on this new business that we brought in.

Okay. Second question, around the price change environment. Is it fair to say that the supplier you cited in Q2 dropped prices a good bit more than you thought to drive up that LIFO credit versus your expectations or was there something else specifically in the quarter that caused the number to be a lot higher than you thought, Jim?

No. I think the amount of the price decrease was definitely in line with our expectations. The difficulty is the nuances of a significant price change for a relatively small amount of inventory and its relative positioning or amount within the context of our total inventory outstanding. And therein laid the challenge that we were faced in trying to estimate what the amount was going to be for the quarter.

To a degree, there is a bit of a challenge there as to estimating the amount that it is going to be a year. And as we sit here now, we certainly have taken our best estimate at what we believe the impact could be. But if this LIFO is an annual calculation and in doing so, what -- the balance of this inventory at the end of the year does have a relevant factor in the calculation.

So, we've done the best we could at it. And taken the approach that by clearly isolating the amount so that everyone could consider it in whatever fashion they chose to, that was about the best we could do.

Just from an accounting standpoint, it creates challenges but from a cash flow standpoint, the amount really is irrelevant. And if you think about all of the big changes in price up and down this year. Apart from the issues of recognizing and reconciling your LIFO provision, has it impacted the way you do business negatively at all? Or is it really a nonevent from a true profitability standpoint as you think of it?

Larry, this is Charlie Colpo. It really has no impact at all on our operations either positively or negatively. It is just -- it's stock purchase price that really has very little bearing into what actually gets priced to the customer.

Okay. And then two other quick things then. To that point, I know one of our suppliers has announced publicly, they're going to defer price increase -- price increases from Q4 into Q1 so, in that vain, is that a nonevent for your fourth quarter as you think of it?

Well, as you will recall or as we know -- as you well know, we tend to see price increases in the fourth quarter and the first quarter tend to be the two times that they occur and correspondingly, at least over the last several years, we've tended to have provisions get recorded in the fourth quarter and the first quarter. So, a shift from that -- between those quarters wouldn't have a huge impact in what we would anticipate seeing in those particular quarters.

Okay. Finally, Jim, just from a timing standpoint, first quarter, you had talked about deferral of $4.4 million of revenues until later this year. I know you booked some of that in the second quarter. Sounds like you booked some of that in the third quarter. Is there any additional deferred revenues you anticipate recognizing for?

No, in fact, that's an excellent point. We deferred just over $4 million as you said in the first quarter. In the second quarter -- this is off the top of my head -- we did a net revenue of about $2.5 million. In this quarter, we recorded net revenue of about [$1.5 million]. So, we're fundamentally back to where we started. The amount of deferred revenue that will remain, I would say is in the normalized level and would be normal pluses and minuses going forward.

So, I'm sorry. I missed that. Again, this quarter was the difference between the $4.4 million and the $2.5 million in Q2?

No, this quarter was $1.5 million.

$1.5 million.

$1.5 million this quarter. $2.5 million last. Aggregates to $4 million fundamentally with the amount that was deferred.

Let me stop there. Thank you.

Thank you.

Thank you, Larry.

Your next question comes from the line of Glen Santangelo of Credit Suisse.

Yes, guys, I just had a couple more questions on gross margins. But first, Craig, I just wanted to follow up. You said you had about $3 billion in net new business wins, the past two plus years. I know McKesson was a little bit north of $1 billion and I think Burrows was, if I'm not mistaken, $600 million. It sounds like there is another $1.2 billion to $1.3 billion. Is that incremental business you've won competitively in the last 12 months to 18 months?

Actually, I think I said over the last four years. If you look at the $1 billion in McKesson and $0.5 billion in Burrows, that's about half of that business and there has been new business, sales growth, new product categories. So, it has been a combination of a lot of things, Glen, over the last four years. But basically, you can attribute maybe half of that. But all of the activity really, the reason why I brought that up is just because of the phenomenal growth we've had over the last four years.

And to put the numbers on the board and now what we're basically saying is we're going to stabilize things here, work on the expenses, work on gross margin and I might just say there is about 22 buckets of gross margin we manage on a quarterly basis. So, there is a lot of moving parts within that margin, some of it is timing, some of it is customer margin.

But, yes. Over the three years, about half of that has been acquisition and the rest of that is either taking business or new product categories or sales growth.

Here's what I'm confused about, Craig. You've owned Burrows for over a year now. You generated north of a 9.8% gross margin last quarter and even if you back out the benefit of some of the deferred revenues you recognized last quarter in June, you still had a pretty sharp sequential quarterly decline in your gross margin and so I guess the question is -- what's new in the last 90 days to trigger that sharp sequential quarter decline?

Now, Jim, if I heard you correctly, I think you talked about some supplier incentives or sales returns and allowances. I was unclear what you're saying. But I'm trying to understand what changed in the last 90 days.

Okay. Let me address that in one of two ways. As you look at the sequential performance, I guess let me illustrate some of the items that are different between the two.

You hit upon deferred revenue as being one and that's absolutely true. In the second quarter, approximately $2.5 million of revenue that had been deferred in the first quarter was recognized and in the third quarter, the quarter we've just ended, $1.5 million of revenue that had been deferred in the first quarter was recognized. So, there is an inherent difference there.

Another item of difference between the two quarters was that in this quarter, we changed our methodology for reserving for sales returns and allowances. And we -- in doing so, it had the effect of increasing our provision by $1 million or decreasing gross margin by $1 million. That did not exist in the prior quarter. So, it is another difference. There was a relatively small deterioration in the new business that we had brought on between quarters, not dramatically large but we did see a deterioration in that.

The bigger -- moving on to this second aspect of what your question you posed, what did we expect or what were we targeting 90 days ago. And I think there are two major items there. One was, as I answered before, was that we had expected to see some pickup in the new business margin and that includes Burrows in this quarter. In large part because we had completed the conversion and transition activity in the second quarter and we had been originally targeting to see some benefits coming through in this quarter and the next quarter. And that didn't manifest itself.

In addition, you will recall that the supplier incentives or supplier funding oftentimes on occasion can be seasonal. We've talked about that. And they're seasonal to the degree that we have calendar year programs that have either volume or performance-related incentives associated with these programs. And what we've seen historically is that we have, in the third quarter, usually begun to attain those performance criteria. And we begin to be able to recognize the revenue associated with that in the third and usually even more in the fourth quarter. That also didn't occur this quarter.

We had targeted that we would be at a higher level of supplier incentive funding than we are. And there are various reasons associated with aspects of that. But that explains the differences with both the second quarter sequential and our target amounts as we entered into the third quarter.

So, if I can summarize it, the three big components were the drop-off in deferred revenue, the change in your bad debt allowance and maybe you missed some supplier incentives. Is that a fair summary?

Yes.

Okay. And then I just had two other quick questions. You commented on the sales cycle in terms of selling some of your offerings into this new customer base. How long does this take? Do we measure that in quarters or do we measure that sales cycle in years?

Glen, this is Charlie Colpo. Yes, I think you can begin to measure it in quarters. It is going to have a longer cycle than what we experienced with McKesson. For the reasons that Jim explained earlier.

It is just that the Burrows company did not have those types of programs and services and not accustomed to it. But it is a gradual improvement that it would probably be about 12 months out before we would say we're getting to where we expect it to be.

Charlie, should this be the trough margin? And then I'll jump off.

I believe so. At this point. This is the low of the Burrows margins.

Thank you. Appreciate the comments.

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

Thanks. I think a lot of my questions have actually been addressed. But I might have missed this.

Did the company provide guidance on what the expectations are for either a LIFO credit or charge in the fourth quarter and I would love to get your philosophical thinking on policy about treating these LIFO credits in the future if we see continued price deflation among your vendors.

Eric, the Company hasn't given any additional guidance relative to LIFO for the fourth quarter. We would -- we believe that we have incorporated our current thinking within the context of the broader guidance that we've given for the year. It certainly isn't lost on anyone, the challenges we've had in trying to estimate what LIFO provision was going to be at any of the quarters over the course of the year. It has proved to be extremely challenging. In large part because we have limited visibility to these price changes and we are at the whim of the supplier for those changes.

That being said, if we go into another year with this type of fluctuations and variability, we will definitely consider how it is -- how our guidance is presented. And we'll reflect on the learning experience relative to really what has been an extremely unusual year of fluctuation as we move toward investor day and talk about 2010.

Thanks, Jim. Follow-up question. Your SG&A controls have been phenomenal and the last three years, you've averaged about 20 [bips] of improvement in SG&A to revenue. The rate of improvement, however, has decelerated over the last couple of years. I know it is early but is there any reason that we should not expect to see another strong year of SG&A improvement in 2010? I know that's part of your outlook for driving higher margin and higher earnings. But I guess what I'm trying to think of schematically is whether we could look at 2010 as being an average year or whether we should look at the deceleration in the improvement as more of a linear trend. So, some improvement but maybe not as much as in the past.

Yes. That's a great question. Again, I think we'll probably do better justice to it as we give 2010 guidance in its entirety in December. That being said, I go back to Craig's comments earlier which are that -- that the key to the short term -- and by that, we mean moving into 2010 -- results, are going to be to continue that dramatic improvement that we've historically posted in SG&A. And that is consistent with the significant investments we've made to leverage SG&A. And we need to realize those benefits going forward. So, the voice-pick, the LUM automation, all of that should -- the benefits of all of that should be realized as we go into 2010.

Great. My final question is just a housekeeping item. With the unexpected tax benefit here in the third quarter, you're guiding the full year to 38%. Is the long-term outlook still at that 39.5% level or should we think of future audit resolutions that could be coming in 2010 and beyond that might impact that number one way or another?

Yes. I think, we resolved -- well, let me back up and give -- put the comment within context. We had not anticipated the IRS completing its audit of the 2006 and 2007 years during this year. We thought that it would probably lapse into 2010 and be a 2010 event. So, consequently, our guidance for the year and the effective tax rate had not contemplated the completion of the audit. And the results that were received.

That being said, we have now completed 2007 and prior years. So, I think the opportunity for audit and consequently any adjustments be it either positive or negative are somewhat more limited. That being said, we have recently resolved a difference in methodology with the IRS as it relates to LIFO. And all of that is being worked through and will be incorporated in the next tax return we file. And more than likely, that will also be reviewed.

So, right now, I think we would revert back to historical norms and no, I'm not aware of there being any potential audit-related adjustments that would factor 2010.

Thanks for your comments.

Your next question comes from the line of Lisa Gill of JPMorgan.

Hi, thanks. This is Atif Rahim in for Lisa. Jim, thanks for the clarity on the reasons for the gross margin decline sequentially. If I could just dig into that a little bit deeper. And specifically, around the reserve methodology change.

If you had implemented this a quarter ago, could you give us what the number was, you said it was about $1 million this quarter. But just, for a better picture of the sequential decline what it might have been a quarter ago.

Yes, off the top of my head, I would say it was slightly greater than the amount we recorded this quarter. In it the range of about $1.2 million if I remember correctly.

Got it. Then on the Burrows acquisition, I think last quarter, you had provided the revenue from that, revenue contribution was from that. I don't recall you providing it this quarter.

No. We don't -- we haven't really done that. What we've talked about is in terms of the new business we've brought in which includes Burrows. And we've talked about it in terms of a percentage. And for this quarter, approximately 60% of the increase that we saw -- $248 million -- resulted from that new business and the Burrows business.

Okay. Got it. Then, finally, there was a jump on the D&A line that was somewhat higher than we had expected, also about a 10% plus jump sequentially. Anything that happened there that led to that increase?

Yes, I'm glad you asked that. I meant to comment on that. Two things occurred.

One is we brought online, some of the technology that we've invested in in some of the warehouses and in doing so, brought it online in the third quarter and began amortizing pieces of it. But the larger component of it is the finalization of the accounting for the Burrows acquisition. So, as you recall, fundamentally, over about a 12-month period from the time the transaction is consummated, you have an allowance to adjust some of your original estimates related to the transaction. Oftentimes, that is done in conjunction with an appraisal you may have to have an outside firm look at the valuation of your various intangibles. And that's exactly what we've done. We've come in at the end of this quarter to the end of that one year -- 12-month period -- and we have finalized the accounting for the Burrows transaction.

In doing so, there was a small increase in the intangible asset that is related to customer relationships. That is an asset that is amortizable. The offset was a decrease to goodwill and consequently, we have begun to amortize on the new basis and that's what's reflected in the quarter.

Okay. And is that going to be amortized over a several year period or --

Yes, that is amortized over what is estimated to be the life of the relationship which is upwards of 10 years.

Okay.

So, it would be a cost that we would expect to see going forward.

Got it. Perfect. Thanks very much.

Very good.

Your next question comes from the line of Randall Stanicky of Goldman Sachs.

Hi, it is Alex Pekler for Randall. Good morning. Just a couple of questions. Jim, you may have alluded to this. What is your updated expectation of when we start to see expansion in the gross margin for Burrows and some of the newer customers?

Yes, I think as we talked about it before, I'm not -- we haven't targeted a specific date. I think as we've said, we were originally targeting to see improvement in this quarter and it didn't manifest itself. And we would expect to see it as we move into 2010.

I would also shift focus just a little bit though if I could. I think the critical issue is the improvement of operating margin on that new business that we've brought in and that we expect to see in the beginning part of 2010. And that's where the immediate focus is. I think the gross margin is going to take longer than it is to improve the operating margin.

Got it. So, related to that, is there any time limit on when you think Burrows could reach their [allover minor] operating margins?

Yes. I would hope that we would be well underway throughout 2010.

Okay.

Yes.

Just a quick question. Have you seen any impact on the quarter from the early flu season and the incremental volumes that it has generated?

We've seen very little. This is Charlie Colpo again. In terms of increased sales. We have seen improved sales in mass hand sanitizers and some syringes and typical products like that. But it is not what I would -- what we would call material at all.

Do you expect to pick up in the fourth quarter?

I would expect marginal pickup, not again, not material. Again, these manufacturers today are on allocation of products. So, as the demand picks up, it is possible that we won't have an unlimited supply to meet that demand. So, that would tend to drive the opportunity down. So, really shouldn't have any real impact.

Got it. Thanks a lot.

Thanks, Alex.

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

Jim, what drove the change in the methodology for the sales returns? Are you seeing a different experience here in the tougher economy and maybe a related question, is there any change in hospital closure rates that you're seeing out there?

Yes, to the latter question, the answer is no. That being said, we've been very proactive at managing ourselves out of some relationships where we perceive there to be risks. And I guess after having managed our way out of those relationships, I've lost touch with what ultimately happened to the hospital. We've been proactive in that sense.

As to your first question, yes, I think it was -- the methodology change had more to do with new management coming in and looking at the treasury function. As you'll recall, Dick Bozard retired during this year in the first quarter. Mike Lowry has stepped in as treasurer. He's doing a great job.

Mike is challenging some of the thinking of the past. And this was one of the areas where he thought there were opportunities to enhance the methodology. And we considered it and looked at it and agreed with him. So, we've put the change in effect. We thought the timing in making the change was good in that there wasn't a series of difficult customers that was precipitating a change in methodology.

Okay. And just out of cure -- you're moving into your fourth quarter. The EPS guidance range is still quite broad. Why no effort to narrow that down a bit if you have a good beat on your revenue numbers and your SG&A experience. Couldn't that range have contracted a bit?

It could have. I think I'm -- I'm pretty well-worn now from the LIFO experience of the last three quarters. And I guess I'm reticent -- or we're reticent -- to get ahead of ourselves. It has been a challenging year on that front. And we thought -- we were comfortable reverting back to the range that we had originally established. And managing against it.

Okay. So, that is the big variable then whether or not LIFO issue happens again in the fourth quarter. Yes, I think it is margin-related issues, yes. Okay. And just -- out of curiosity, the working capital improvement from the Burrows deal, have we seen what you can do on that front? Or do you feel that there's opportunities to chop inventories or accounts receivable here?

Well, I'm going to let Charlie speak to parts of that. I definitely believe there are opportunities to improve. We're making small improvements in inventory but there's still room for improvement.

I would concur with Jim and wouldn't limit it to just the Burrows acquisition. Across the board we have the opportunity to do better in inventory.

Okay. Just incremental. But not --

Robert, we're going to start working on this. We're in the process of working on this supplier strategy and there ought to be some opportunities coming out of that as we start to do an SKU rationalization. And we start to really do a rationalization on the supplier. There ought to be some opportunities from that, too.

So, I wouldn't say it is just from the fact that we've been growing so dramatically over the last two or three years. I think it is also from the opportunity we probably have some abilities to drive our inventories down off of our supplier strategy.

That's great. Thank you.

Operator, we have time for one more question.

Your final question will come from the line of Richard Close of Jefferies & Company.

Great, thank you for fitting me in there. With respect to the Burrows and new business, not to beat this gross margin, do you have any sense of -- just to get comfortable -- that the new business [ex] Burrows that you're bring on isn't really that much lower margin? Maybe that pullback in the margin, is it primarily the Burrows business that came on?

Well, the new business, again, what I would say, Richard, is we need to look at the operating margin of this. And some of the new business comes in with low impact. Few services. What we would call bulk to the dock. So, we believe that that needs to be serviced appropriately and ought to be less. And so even though the margin is less, we would expect the corresponding SG&A to be less, too.

Okay. So, without layering on these higher margin, added on services, what -- what do you think was the biggest change, from the first six months to the third quarter. Why people maybe aren't taking up on these additional services.

Richard, let me try to take a real quick stab at that. It has been a challenging year for a lot of our customers. They're under the gun. And so, they're perhaps more price sensitive. They may not be looking for the additional services that they have in the past.

And I would say this book of business -- and I don't want to throw this all under the bus for Burrows. We have some new business. We have Burrows. We have some timing issues on some of the supplier pieces. And so it is a combination of several things.

But if you look at this new business, it is probably more bulk delivery twice a week to the dock. So, there might be some upside opportunity on margin but the opportunity really is on the SG&A and really working the operating margin on this book of business. It is a little bit bigger. It is bigger than what we thought it was going to be. We always pick up more sales because of the -- our ability to service better.

But I would look at this as not just the new business or the Burrows business or some timing issues on some other buckets of the margin. But also, we want to make sure that we're appropriately -- have the appropriate SG&A to the degree and the intensity of the service of that customer and what they're asking for. And partly in our culture, we have the ability to always please and overservice. And we need to make sure that we get paid appropriately for the service that we do or not overservice the customer.

I think that's really the bottom line for the third quarter is get back to the basics. Get paid for what you do. And continue to work on the margin and drive the SG&A down.

So, trying to sense the tone with respect to the comments on the economy, should we not really anticipate the ability to expand the gross margin until we see a turn maybe -- a noticeable turn -- to the upside in the economy and then your customers come back to maybe ratchet up on the higher value services?

I think -- I think it is a great topic and one that can be better explored and amplified at the December investor day. Because it really speaks to what our outlook for both 2010 and onward is going to be. I think Craig capsulized it perfectly.

The focus is going to be -- in the near term, and we haven't left this focus. The focus is on operating earnings. And the way we're going to get to operating earnings is through improving SG&A. And over the longer term, the focus -- the results of our programs and services will be represented in the gross margin and that will be a major contributing factor to continued improvement and operating results.

Okay. And then just one final. With respect to the commentary on this being the trough gross margin, might be the trough but are we -- is this U-shaped here?

Richard, let me take an opportunity to maybe -- I think what Charlie was talking about was not the trough on the total -- obviously we don't want to put a stake in the sand on something like that. I think we've seen the trough on the Burrows business, not -- our goal is always to continue to improve margin. And I don't think it would be prudent for us today to say whether it is a peak or a trough. But clearly, I think what Charlie was intimating and let me make this very clear -- (inaudible) that's primarily on the Burrows business.

Okay.

So, we're going to continue to work on margin again. It is like there are many, many buckets. So, it is not just again about the new business. It is about cash discounts, supplier incentives, the short pay reserve. There is a lot of things that we're look at.

So, the goal is is to really -- as I've been saying for a year now -- is to get back to an operating -- better improved operating margin and that is going to be a combination of continued focus on driving the SG&A down and then long-term working on the margin. All right. Thank you.

Okay, thank you, Richard. Thank you, everybody, appreciate you listening in and thank you for your participation.