Owens & Minor Inc (OMI) 2010 Q3 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to Owens & Minor's third quarter 2010 earnings conference call. My name is Christy, and I will be your operator for today. At this time, all participants are in listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference call. (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.

Thank you, Christy, and good morning, everyone. Welcome to the Owens & Minor third quarter 2010 conference call. We'll 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 Chief Operating Officer; Grace den Hartog, our General Counsel; and Drew Edwards, our Controller and Chief Accounting Officer. Before we begin, I'll ask 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 the Company results for the 2010 third quarter, which are included in our press release. This press release, as well as the supplemental slide presentation, can be found on our website. We will also archive a webcast of today's conference call on the website.

In the course of our discussion today, we may make forward-looking statements. These statements are subject to risk and uncertainties 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 keep in mind when comparing this year's results to 2009, we completed the sale of certain assets of our direct to consumer diabetes supply business in January 2009,and thus it is shown as Discontinued Operations in our consolidated financial statement.

Also when comparing results, keep in mind that during the first half of 2009 we were engaged in transitioning business acquired in the Burrows transaction. Also as a result of our three for two stock split on March 31 of this year, all per-share results presented have had been retroactively adjusted for the split.

As for our investor calendar for the rest of the year, we're participating in two investor conferences in November, and our Annual Investor Day is scheduled for December 2 at the Grand Hyatt New York. Details are included in our press release, and we look forward to seeing you on the road in coming weeks. Thank you. Craig?

Thanks, Trudi. And let me call on Jim to brief us on our financial results.

Thank you, Craig, and good morning, everyone. With three quarters behind us now, it is apparent that the trends we have seen all year, including low rates of hospital utilization, have affected our volumes through the third quarter. Consequently, as we look at our results for the year to date, we see the ongoing impact of sluggish economic conditions. However, during this period, we have continued to operate our business in a disciplined and efficient manner. For example, when compared to the same period last year, strong expense management improved operating earnings by 8% to $157 million for the year-to-date period.

Turning now to the details of our third quarter and year to date financial results. Third quarter 2010 revenues increased 1.4% to $2.06 billion when compared to last year's $2.03 billion. The increase in revenue resulted from a combination of growth in sales of products and services to existing customers of $46 million, a growth rate of 2.5%, and from sales to new customers, of $65 million. Partially offsetting this $111 million increase in sales was a decrease in sales to loss customers of $82 million. As we mentioned last quarter, we believe the comparative impact of this lost business will continue to lessen as we lap these account losses in the remaining months of the year.

When comparing the first nine months of 2010 to the comparable period last year, revenues increased $56 million to more than $6.05 billion. Revenue improvement for the first nine months was due to the combination of a 2.8% increase in sales of products and services to existing customers totaling $149 million, as well as an increase in sales to new customers of $167 million. Year to date revenue increases of $316 million were partially offset by a decrease in sales to loss customers of $260 million. The existing customer growth rate of 2.5% in the third quarter this year was a modest sequential improvement when compared to the 2.2% growth rate in this year's second quarter.

I would remind you that, as we said last quarter, the existing customer growth rates we have experienced all year are approximately 200 to 300 basis points lower than our recent historical experience.

Gross margin as a percentage of revenues decreased 46 basis points from the prior-year quarter to 9.58%. Gross margin dollars decreased by $6 million from last year's third quarter to $198 million for the third quarter of 2010. Gross margin in the third quarter of 2009 benefited from the positive impact of supplier price changes, which resulted in an $11.5 million credit in the LIFO inventory valuation provision. Gross margin also benefited from the recognition of previously deferred revenue of $1.6 million, resulting from the achievement of performance targets related to customer contracts. Adjusting for these factors, third quarter 2010 gross margin dollars increased due to greater sales to customers and from suppliers.

As for the year to date period, gross margin as a percentage of revenues declined 18 basis points to 9.59% when compared to the prior-year period. Gross margin dollars were $580 million, decreased $5 million when compared to the same period in 2009. The decrease was primarily due to an increase in the LIFO provision of $3.5 million, resulting from greater supplier price increases, and a reduction in gross margin dollars from our acute-care distribution customers. The decrease was partially offset by revenue from our third-party logistics business in the first nine months of 2010.

Turning now to our discussion of expenses. Third quarter 2010 SG&A expenses decreased 4.8%, or $7 million, to $135 million when compared to the third quarter of 2009. As a percentage of revenues, third quarter SG&A expense decreased 43 basis points to 6.56%. Quarterly SG&A expenses decreased $3 million for labor and incentive compensation costs, $3 million for information technology outsourcing and consulting costs, and less than $1 million in transition-related expenses from the Burrows acquisition. These expense decreases were partially offset by an increase of $1 million related to providing third-party logistic services.

When looking at the first nine months of the year, SG&A expenses decreased 5% to $404 million, a decline of just over $20 million when compared to the same period last year. As a percentage of revenues, SG&A expenses for the first nine months of this year were 6.68%, a 42 basis point improvement over last year. The continued strong improvement in SG&A resulted from lower labor and incentive compensation expense, lower IT outsourcing and consulting expenses, and spending last year for the Burrows integration. These expense improvements were partially offset by startup costs incurred for our third-party logistics business.

At this point in the year, we are very pleased with our SG&A improvement. As we look ahead to the rest of the year and our expectations for SG&A expense, we want to be clear that we plan to continue investing in our strategic initiatives, especially OM HealthCare Logistics. This will have a dilutive impact on 2010 results.

Operating earnings for the third quarter of 2010 decreased by $1.4 million to $55 million when compared to last year's third quarter. As a percentage of revenues, operating earnings were 2.68%, a decline of 11 basis points from operating earnings in the third quarter of 2009. The decrease in operating earnings in the third quarter was primarily due to a decrease in gross margin, partially offset by decreases in SG&A expenses. For the year to date period, operating earnings increased $11 million or 8% to $157 million when compared to the same period last year. As a percentage of revenues, operating earnings were 2.59%, an improvement of 16 basis points. The increase in year to date operating earnings was driven by lower SG&A, offset partially by lower gross margin, and higher depreciation and amortization.

Interest expense, a component of net income but not of operating earnings, was $3.8 million for the third quarter and $10.6 million for the first nine months of 2010, increased from $3.2 million and $9.8 million respectively for the same periods last year. For the first nine months of this year our effective interest rate was 6.7% on average borrowings of $210 million, compared to a rate of 6% from the same period last year, on average borrowings of $220 million.

For the quarter, the effective income tax rate was 38.9%, while for the year to date period, the tax rate was 39.2%. This compares to 35.2%and 37.5% respectively for the same periods of 2009. When you compare to last year, please keep in mind that lower tax rates in 2009 resulted primarily from the recognition of tax benefits, totaling approximately $1.7 million, due to the conclusion of audits by the IRS of our 2007 and 2006 income tax returns in the third quarter of 2009. Overall, we continue to target the annual effective tax rate for 2010 to be in the range of 39%, consistent with our previous guidance.

Net income for the third quarter of 2010 was $32 million, or $0.50 per diluted share, compared to net income of $35 million, or $0.55 per diluted share in the prior-year third quarter. Excluding the impact of the LIFO credit in the prior-year third quarter, adjusted net income per diluted share this quarter would have demonstrated a $0.06 per share improvement over the same period last year.

For the first nine months of the year, both income from continuing operations and net income were $89 million, increased by $4 million and by $17 million respectively from the prior year. On a per diluted share basis, both net income and income from continuing operations were $1.40 for the first nine months of 2010, increased from a $1.35 and $1.15 respectively for the same period last year.

As for asset liability management for the first nine months of the year, we reported cash flow from continuing operations of $214 million, compared to $161 million in the same period last year. Cash from continuing operations was positively affected by operating earnings and increases in accounts payable, partially offset by higher inventories. During the first nine months of this year, we contributed $8 million to our pension plan in conjunction with our Board-approved termination.

Inventory turns in the third quarter were 10.2 compared to turns of 10.5 a year ago, partially as a result of building inventories for new customer conversions. DSO was 21.3 as of the end of the third quarter, improved when compared to 23 days at the same time last year.

Capital expenditures in the first nine months of this year were $27 million, representing an additional $4 million in investment when compared to capital expenditures for the same period last year. So far this year, we have used cash for investments in our strategic and operational efficiency initiatives, including improvements for the OM HealthCare Logistics business. Relocations of three distribution centers as well as investments in voice pick systems and customer-facing technologies. Cash dividends paid were approximately $11 million for the quarter and were $34 million for the first nine months of this year. Cash used by discontinued operations was $1.5 million for the first nine months of this the year, compared with $11 million in cash received in the same period of 2009, resulting primarily from receivable collections, net of costs associated with exiting the direct to consumer business.

With that review of our results, I would now like to turn to the remainder of the year. As we move toward year end, please keep in mind that our new agreement with CareFusion requires that we incur certain start-up costs, including outfitting a new West Coast distribution facility and hiring additional teammates. These expenses are estimated to be dilutive to fourth quarter 2010 earnings by approximately $0.02 per share. Craig will talk more about this agreement in a minute.

So far this year, trends in our segment of the health care market have remained fairly consistent. Consequently, we continue to believe that our full-year revenue results will improve slightly when compared to the prior year. And we continue to believe that our earnings per diluted share will likely be at the lower end of the previously stated range of $1.93 to $2.03, excluding the anticipated impact associated with the CareFusion agreement. Now I would like to turn it over to Craig for his remarks.

Thank you, Jim, and thanks for the review of our numbers. Now that you have more insight into our quarterly financial results, I would like to provide an overview of our market, our business, and our strategic direction.

When looking at the health care market, we see a continuation of the trends we have seen all year. Our quarterly financial results reflected lower than usual hospital utilization rates nationwide. As we have been saying, we believe that the higher unemployment rates, the rising number of uninsured Americans, and the expiration of certain American government benefits have continued to be a factor. Many of the hospital executives I have talked to in recent weeks confirm this trend. While hospitals in some parts of the country are seeing improvement, others say they continue to experience weakness in admissions and procedure volumes. Now, because we're not in a position to influence health care utilization, we are responding to the current market conditions by serving our customers to the best of our ability, managing our business efficiently and effectively, and offering innovative supply chain services and solutions to the health care market.

As for our financial results for the quarter and the year to date, Jim provided us with a very thorough analysis. I would simply add that once you exclude the impact of last year's third quarter LIFO credit, and the IRS tax settlement, P&L results for the quarter demonstrated improvement on all fronts. Drilling further into the quarterly results, we also progress -- saw progress with key performance indicators, including lines per hour, stocking levels, sales per square foot, and picking and pricing errors, which are already among the industry's lowest. The investments we have made in automation equipment and voice pick technology are helping us to achieve our improvements in our distribution center operations.

On the customer front, as you may know, the Defense Department asked us to extend our existing contract with them for up to another 18 months, and we agreed to do so. Therefore you should consider our DOD contract to be business as usual.

Turning to our big news for the day, as you saw in our press release, we are very pleased that our OM HealthCare Logistics team has signed a five-year agreement with CareFusion to provide third-party logistic services. Under this fee per service agreement, OM HCL will provide warehousing, distribution, and transportation services. CareFusion is highly regarded for developing, manufacturing, and marketing essential health care equipment and supplies. They were seeking a long-term strategic relationship with a partner that would allow them to achieve best in class supply chain practices. We are all very excited about this significant agreement and look forward to onboarding this prestigious customer.

Now, in order to serve CareFusion, we are opening a second distribution facility on the West Coast, which is scheduled to be operational by the end of the year. We are currently installing equipment, racking, and IT systems, and we are right now presently hiring and training teammates for this facility. This a flagship customer will enable us to achieve scale in OM HCL and provide our throughput in the two distribution centers. As an added benefit, having a state-of-the-art 3PL facility on the West Coast will also open the door to additional health care manufacturers, especially those who import products from Asia through West Coast ports. Our OM HCL team has done a great job in launching this initiative and in winning this marquee customer. This is a significant expansion of our relationship with CareFusion.

Turning to the bigger picture, we remain focused on growing our business, developing our strategic initiatives and creating long-term value for our shareholders. One way we create value for our shareholders is through our dividend policy. Our Board has demonstrated a long-term commitment to dividends and just last week approved the fourth quarter dividend of $0.17 point-- that's tough to say -- $0.17 point seven cents per diluted share. With a dividend yield of nearly 2.5%, we believe this provides ongoing value for or shareholders.

Another way we have created value through our shareholders is through strategic acquisitions. We continually survey the market for suitable targets, but as we have said before, acquisitions must make sense for our Company and fit with our strategic direction.

In the near term our focus remains squarely on providing our customers with award-winning service they expect from us, maintaining operational excellence, continuing to manage our expenses, and creating solutions and services that will drive opportunity for us in the future. All of our teammates work with a high degree of commitment to our health care customers, providing service with excellence, integrity, and delivering the right product at the right place at the right time and at the right price. Our team is energized focused and prepared to serve the developing needs of the health care market.

Finally I would like to take this opportunity to invite all of you to our Annual Investor Day in New York on September 2. Please contact our Investor Relations team if you would like to join us. Thank you, and we would be happy to take your questions. Christy, you may open the line for questions.

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

Thanks, and good morning, everyone.

Hi, Larry.

I just wanted to say a big congratulations on the CareFusion announcement. I think that's a great validation. I know they're interested in reducing their footprint in their distribution network, so it seems to fit exactly with what you are trying to pitch. Just maybe a little bit of elaboration here. My understanding is this encompasses their interventional specialties and surgical instruments line out of one of those facilities, so I'm wondering how do we think of this? Was this a competitive bid? Was this a negotiation over a period of time? Can you talk about the potential upsizing over that 18 to 24 month period? Are you sizing the revenue through-put opportunity? And just why the new California facility? Thanks.

Okay. Larry, this is Charlie Colpo. And I'm going to attempt to answer all of those questions. If I miss one or two, please come back. It was a competitive bid, and we were selected by CareFusion, I believe, because of our past relationships, their belief that we can deliver the supply chain efficiencies that we -- that they were looking for, and so we're very pleased with the business. The -- in fact I probably would refer you to CareFusion over what pieces of the business were brought in, but it covers substantially most of their overall business, and we will begin to implement in early 2011 -- it will be early in the second quarter. And that transition over -- for their business will take place over an 18 month period.

Obviously we're very excited about the business. We are opening on the West Coast, as Craig alluded to. A company their size required an additional -- a bigger footprint, and we believe that in the West Coast, it helped maximize their supply chain costs, but it also opened the door for us to do business with other companies that are importing from Asia. And with that I'll take a break and make sure that I covered everything that you were asking.

You answered them all, and I guess just to put that in context, I know in the past you said you hoped to get the business up to a size where it would start to break even by next year. Is this kind of a confirmation that you are on track to do that? I know you are not giving specific guidance at this point yet.

Yes, Larry, this is Jim Bierman. It's interesting in -- this was a larger contract with a more prestigious strategic partner than I think we were contemplating when we were looking at the original financial model. We are accelerating the growth by several years from what we had originally anticipated by opening a new facility on the West Coast, and consequently I think we will be increasing the fixed cost component of the initiative. And we're still working on what the potential impact of this may be as we look towards 2011. I think probably the best answer is to defer until we get together at Investor Day and talk about this in greater detail, but we have increased dramatically the fixed-cost component in the short-term, with the expectation, obviously, that we are able to create operating leverage in this quicker than we had anticipated originally in our plan.

So it sounds like, with this, it gives you maybe a greater opportunity to expand that footprint quicker through this account, so it sounds like you also want to beef up your marketing efforts to focus on additional capacity, or it is really just first priority CareFusion?

No, absolutely. I think you characterized it appropriately. We feel now with the bicoastal capabilities that we have, that there is even greater appeal that we should have in the marketplace for additional customers.

Okay. Second question, I just -- for me -- and maybe I can defer talking about SG&A initiatives over the next couple of years. You'll talk about that at your analyst day. I'm sure others will ask the same thing, but really just wanted to ask about DOD. You extended this relationship yet again. It has been a long-standing relationship. It's a sizable customer. I know you said less than 10% of revs, but my guess is not much less. How do we think of this in terms of growth parameters, given the environment of the next couple of years? Is it continuing to grow for you? Do we think of this as kind of being scaled down over the next couple of years? Or it is too soon to think about that?

Larry, yes, I think that's a good question. This is Craig. I think if you put this in a bigger perspective, we have had a relationship with the armed forces -- and I would say armed forces, more than just DOD. As a matter of fact, we have a group of nine Army officers in here now today that we're training through OMU on supply chain logistics. So the relationship with the military I think is very strong. I think obviously as things hopefully wind down, I think there's still a huge opportunity with the hospital network here, and fortunately we'll be rewarded in 18 months, but I feel very solid about our overall relationship with all of the armed forces. We work with the Marines, we work with Navy, we work with the Army. So I expect that relationship to continue only because I think we have done a great job, to be honest with you, over the last several years, and there is just a lot of things we're working with them on versus just a straight vendor supplier contract.

Right. So it's not like something that would create a lot of volatility in revenues in the following years, given your long-standing relationship.

Yes. You know I'm pretty conservative. I would say if I were -- I'm very comfortable where we are right now working with the military.

Very good. Okay. I'll stop there. Thank you.

Thanks, Larry.

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

Thanks very much, and good morning.

Good morning, Lisa.

I just had a question around the SG&A. Jim, can you maybe just talk about what some of the key drivers of being able to bring SG&A down in the quarter and the sustainability of that going forward? And then secondly, as you look at the early parts of October, are you starting to see hospital or OR volumes start to pick up at all versus what we have seen in the first nine months?

I'll -- Lisa, I'll address the SG&A and then Craig can comment on what he has seen in the marketplace.

The SG&A improvements that we have seen that I would characterize as sustainable is the continuation of the efficiencies that we are gleaning from the investments in automation and technology that we have in the warehouse. So our voice pick technology continues to yield additional efficiencies, and we are seeing that, and would expect that to be sustainable. Obviously going forward, we may not see the dramatic improvement that we have seen over the last 12 months, but we believe there is still opportunity to continue to improve our efficiency.

The second major sustainable area is in information technology itself. We talked a year ago about our initiative to -- which we call the mainframe migration, which was to place our IT systems on a new platform, Microsoft-supported platform, and we believe that not only have we been able to avoid future investments and costs out in to the future by doing so, but we're seeing immediate savings in the current year.

The part that is not sustainable, I would point out, is that we are benefiting this year from our -- the performance levels of our incentive compensation plans. We are performing at a lower level than we have in the prior year, and we would anticipate, as we move towards 2011 and 2012, to reach more of a normalized performance. Let me turn to Craig for what he has seen in October --

But, Jim, before I let you go, so if I think about things that are sustainable versus potentially not sustainable next year, is there a number that you are comfortable with, where you say our SG&A -- that we have been able to take out 50 basis points or 100 basis points around these things that are sustainable, and then some other component of it is going to fluctuate, depending on how well we do, and therefore drive incentive compensation? Is there anything that we can think about as a metric?

Yes, I think there is, Lisa, as we move forward. I think the forum to do that best is going to be at our Investor Day, where we give guidance for 2011 and can talk about the various interrelationships of various initiatives and costs and expectations that we have. I think it has the potential to be misunderstood or misapplied if a number is just thrown out in this forum.

Okay. Great. I appreciate that.

Lisa this is Craig, and I think we have some opportunities on SG&A. We'll bring that up on December 2, but we -- again, we have made some pretty significant investments in the Company in the core on our three-pronged strategy, and we'll go a little bit more in detail on December 2.

On the revenues, as you know, I'm out a lot, Charlie has been out a lot over the last two or three months. I would say it is still relatively flat. We go through all of the journals and releases that everybody else does, and I would speak anecdotally. I have seen a little improvement in some parts of the country, but for the most part most of the hospitals are still about where they were last quarter for the year, and I wish I had a crystal ball on when this thing starts to kind of rev back up again. I'm the eternal optimist. I think it's going to come back. When, I'm not sure. But I would say it's still relatively flat.

Okay. Great. Thank you very much.

Thank you.

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

Yes, thanks. Craig and Jim, just two quick questions on gross margins. I was kind of curious. You have done a job of holding gross margin kind of flat this year, despite the lower than expected volume. Could you maybe just talk about how some of the rebates and manufacturing incentives work within your contracts? Particularly as we head in to the fourth quarter here, Craig, if you are suggesting that volumes are -- have not come back to date, at some point do you have -- do you have to think about the impact of lower volumes on the rebates you are currently receiving?

Glen, again, I think as you look across the board, we have several ways that we work with manufacturers in terms of incentives. Obviously some of them are for growth, some of them are for product-category growth, some of them are based on operational efficiencies, some of them are based on moving customers to CRP continuous replenishment, or suppliers to CRP, so it really is a mixed bag in terms of -- and I've talked about this in the past, there are about 35 buckets of margin that we manage on a day-to-day basis, so it's more than just utilization being flat. There are a lot of different ways that we work, and there is not a set program that we work with a supplier. One could be completely different than the other. It could be based on the size of that Company, whether it's big or small, what they are trying to accomplish during the year.

And so I do know fourth quarter sometimes we guide you towards that a little bit, but it is a number of things that we look at, and it is a mutual agreement. Just like we sit down with a customer -- provider -- is to come up with business objectives and goals that we want to try to accomplish on a year-to-year basis. So whereas sales might be off a little bit for everybody this year, everybody is working on costs, everybody is working on SG&A and efficiency and productivity, and so you can't really kind of throw it all in one bucket. It's really a wide range across the board.

So you are kind of suggesting there's not a huge correlation between volumes and gross margin. Is that fair?

No, I don't think Craig was saying that Glen. I think -- let me try characterizing it in a different way. When we spoke a year ago at Investor Day, and we spoke about how we -- the outlook for gross margin, we put forth a potential range of 9.60% to 9.75%. Year to date we're at the 9.59%, and I would say that performance, the lower end of that range, is certainly volume and utilization dependant and is an explanation of why we're in that range versus the higher end of the outlook that we had previously talked about.

Okay. Fair enough, and then if I could just ask one more quick question on gross margins for next year. I know you are going to give us a lot of details on analyst day, but I'm just kind of curious. I'm looking at -- is it fair to say you have to renegotiate all of your major GPOs at some point in the next 12 to 15 months? And if so, I'm just kind of curious if you could comment on the behavior you are seeing out of Cardinal Health. The last time you had to renegotiate all of those GPOs, arguably Cardinal was in a different state than maybe what they are today. Are you seeing any change in the competitive landscape, or is it just kind of status quo?

Glen, this is Charlie again. I believe Cardinal is a great competitor. I would not suggest there's any change in that behavior. We view them as a very tough competitor. You are right, there are some GPOs coming up for renewal next year, and we have gone through this process before. So we would expect the results to be similar; that we'll compete with Cardinal and the others that are out there, and that we will eventually -- ultimately, the customers will decide where to go.

Okay. All right. Thanks for the comments.

Thanks, Glen.

Your next question comes from the line of Richard Close with Jefferies & Company.

Yes. Jim, it -- I was wondering if you could go over the lost customers. I think you mentioned year to date it was $260 million, and if I just go back through the other reports from first and second quarter, I'm getting $255 million, and I just -- is that a rounding error there through the first three months?

Richard, you have me at a disadvantage. We're -- the difference that you have calculated is $5 million you say?

Yes, I just wasn't sure if there was an adjustment to the first and second quarter. Just making sure my numbers add up there.

No, I'm not sure -- I will say it is a fluid calculation in that -- to the extent a small customer notifies us that they are changing their distributor, that would occur in the time period that we are notified, and so there can be some components, I believe, that would represent that, but for the $5 million, to be honest, I'm not sure.

Okay, I'll check with Trudi after the call. But as it relates to losses on a go-forward basis, you have talked about that, I guess, decreasing as we lapse. I suppose here, the fourth quarter, when you began to maybe trim some of these customers that weren't meeting your profitability metrics, I was wondering is there any number that you could give us for last year's losses when you started this process so we can have a comparison? Or do you have any target for the fourth quarter so we can compare the up-coming quarter and last year?

No, other than the directional guidance that we have given, and that we have seen on a -- and we tend to look at this in a normalized situation, on more of a net basis of -- the net additions versus the net losses. I think what was significant about 2010 was that as we went into the fourth quarter of 2009, there were some business decisions made regarding the retention of some customers that, quite candidly, had lower profitability profiles than we found acceptable.

Profitability is but one issue that we look at in our customer retention. Certainly the potential growth of that customer and their expansion of our services is another factor we take in to consideration. But coming off of the third quarter of last year, we looked at -- quite seriously at the profitability of a book of business that we had and made some business decisions accordingly. And so what we have seen in 2010 through the third quarter is the playing out of that series of decisions, and as we have indicated and began to see this quarter, the net effect will continue to decrease, and we would expect it to decrease in the fourth quarter.

Okay. Craig, I was wondering if you could update us -- I think last quarter you talked about large customers experiencing 4% growth in the quarter. Your smaller customers, I believe the number was down 2%. Do you have any update in terms of how the third quarter shook out on those metrics?

Yes, Richard, obviously we did a lot of work last quarter, and when I say a lot of work, we had a lot of people across the Company working on that. I would say the third quarter was pretty consistent with what the second quarter was. We're still seeing the smaller and medium-sized hospitals from a procedure standpoint and a sales standpoint pretty dramatically off, and our larger systems doing better than the smaller and the medium ones. So it is -- when you have thousands of customers, to do that kind of detail of work, you have got to really drill down on it. I think what we're seeing is we're fairly comfortable with what we saw in the second quarter is continuing to happen in the third quarter.

Okay,thank you, and just one final one, a follow-up to Glen's question on the performance targets and the gross margin. I was wondering if you could let us know your thoughts -- were the performance targets, in terms of seasonality, what you thought would occur in the third quarter? I guess what I'm asking is, did you -- do you believe you met the performance targets, what your expectations were heading in to the quarter?

Yes, I think as we looked at the results for the third quarter, the actual results as it relates to gross margin were pretty close to our expectations or what we were targeting coming out of the second quarter call.

Okay. Thank you.

Your next question comes from the line of Steven Valiquette of UBS.

Hi, thanks. Some questions here. I guess just first on the accounting nuts and bolts around the CareFusion deal -- actually, just OM HCL in general. Just trying to clarify whether you are going to be booking additional gross product revenues or are you booking net warehousing and other service fees as part of the supplier service. Just trying to nail that down first.

Yes, Steven. Yes, that's a great question, and one that we will spend a couple of minutes on at Investor Day to make sure that everyone has a thorough understanding. We are not taking title to this product, so this is best looked at as a fee for service type of an arrangement, so consequently, revenue will be reported representing the fees associated with the contract. There will be no cost of goods sold, so that revenue will fall down to a gross margin line in our current kind of format, and then there will be all of the costs associated with serving CareFusion and distributing their product that will be reported as SG&A. So that will be how it will look, and if that is confusing to anyone on the call, we will clarify it with some illustrations at Investor Day.

Okay,that's helpful. Then -- so then does this agreement give you any exclusive rights to distribute certain products from CareFusion, or does every medical distributor out there still have full rights to distribute CareFusion products if their customers are demanding them?

Yes, there's no change in the current channel, so where manufacturers or CareFusion has chosen to go direct and sell directly to our end-user customers, they will do so, and as they choose to go through distribution, of which we are a distributor, then we will ship product to distributors. So there will be no disruption or no real change in the current channel on how CareFusion delivers products to its customers.

Okay, that'shelpful. Just two other quick ones. First, if I missed it,did you say there was or was not a change in the LIFO provision in the current quarter?

There was nothing of any significance, no.

Okay. And then final question here, the -- last quarter you talked about you had some business wins that were maybe going to come on July 1. Some of that got pushed out to January 1. Without quantifying anything right now, if we just think about January 1, 2011, starts versus stuff that you might be losing -- if you think about that net number, has that increased, decreased, or just stayed about the same over the last three months -- since the last call? Just trying to get a sense for that.

Nice try.

That wasn't the answer I was hoping for, was the burst of laughter, but that's okay.

Who wants to answer that?

I think I would say that we're feeling good as we position ourselves towards 2011, and that there would be greater clarity on our revenue targets as December -- on December 2.

Okay. All right, thanks a lot.

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

Yes, please don't laugh at me, but will the CareFusion product lines that you are working with all be brand new to you,or is there some redundancy with what you're working with already?

We currently act as a distributor for some CareFusion products, and so we are a step between CareFusion and the customer. And what we're doing, Robert, is taking a step back in the supply chain and managing CareFusion's business to the manner to which they expect us to, whether that be through distribution or direct to the customer.

But in terms of the incremental product you are bringing on, can you give us some ideas? Are these infusion pumps? I mean I don't think you are working with the Pyxis equipment really, are you?

Well, I think, Robert, we would do is guide you to CareFusion, and we're somewhat sensitive to the product lines that they are going to be giving to us. What I would kind of guide you back to is that we will be doing more with them tomorrow than we are doing with them today as a distributor. But I think specific product lines, it would probably be good that somebody refer to CareFusion on that.

And just any positive or negative exposure from a product recall under the new format? I would assume this gets easier for you, not harder.

Yes, we have handle thousands of product recalls today on a annual basis. We're pretty good at that. So I think it would probably be somewhat easier for us to pass that back through to the manufacturer.

And if I look at any potential new relationships coming on board, is it logical to assume there would be a similar charge with any new type of relationship of size -- of this size that you bring on board, or is this somewhat unusual with the second facility coming online.

Yes, I think your inference is probably right, Robert. I think it's a fact and circumstance situation. I think there -- certainly we could contemplate a customer for the OM HealthCare Logistics business of the size and scale that would require additional facilities, and in doing so, there would be significant revenue potential and profitability associated with it. I think right now our feeling is that we have the core infrastructure in place by being on both coasts, and that we can handle, certainly, any sort of mid-sized kind of opportunity. But we are -- we'll be opportunistic and look for strategic partners in this area that have great potential like CareFusion does.

And when you announced the initiative -- I thought it was earlier this year you had a facility up and running -- were there not plans for three facilities by year end,or am I not remembering that correctly?

No, the long-term strategy, Robert was as the business ramped up, we would look at other facilities. I think our belief always was to really be in this business we wanted to be on the West Coast, at least with the second center, but we were waiting, really , for a sponsor to be able to get us to open that up, and of course CareFusion allows for that. So this is a nice add-on that we can now go to other manufacturers who rely heavily on Asia, that we have a West Coast facility. So I think that's the third piece going back to what you were -- as a manufacturer comes to us, and if it's significant enough, obviously we would look at something else. But the real goal was to get the West Coast opened up as quickly as possible, and CareFusion has allowed us to

That's great. Thank you.

Christy, we have time for one more question.

Your final question comes from the line of Robert Jones of Goldman Sachs.

Thanks for sneaking me in. Just wanted to go back to the 3PL model, and understanding that you will be providing a lot more detail around the CareFusion deal at the Investor Day. But I was wondering if you could speak in general terms of the impact of these types of arrangements to the overall corporate margins?

Yes, we would certainly expect as we achieve more operating leverage that they would be accretive to our current or historical operating margin, so our historical operating margin that we have spoken of is around 2.5%. Again, as I -- we have mentioned earlier today, as you increase the fixed-cost component of our capabilities, we may not be initially at that optimal level of operating leverage. But once the business is up and running, we would expect it to be accretive to operating margins.

That's helpful. And I didn't hear you guys mention anything on MediChoice. I was wondering if you could provide an update there and maybe more specifically, given the economic backdrop, has there been an opportunity to push more MediChoice through the channels? Thanks.

I can say, Robert, is we were up to 2,700 products. As you might expect in a 1% sales growth, we've not grown at the same rates that we have done in prior years, but year-over-year we're still at double-digit growth.

There are no further questions at this time. I will now turn the call back over to Mr. Smith for his closing remarks.

All right, Christy. Thank you very much. Thank you for your interest today and your questions, and we look forward to seeing you at our Annual Investor Day in New York on December 2. Have a great day. Thank you.

Thank you for your participation in today's conference. This concludes the call. You may now disconnect. Good day.