Q2 2005 Cardinal Health, Inc. Earnings Conference Call - Final.

Original Source: FD (FAIR DISCLOSURE) WIRE

OPERATOR: Good morning. My name is Wade, and I will be your conference facilitator today. At this time I would like to welcome everyone to the Cardinal Health fiscal-year 2005 second quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer period. If you would like to ask a question during this time, simply press star then the number 1 on your telephone keypad. If you would like to withdraw your question, press the pound key. I will now turn the call over to the Vice President of Investor Relations, Mr. Jim Hinrichs. Sir, please go ahead.

JIM HINRICHS, VP, IR, CARDINAL HEALTH, INC.: Thanks, Wade. Good morning, everyone. Welcome to Cardinal Health's second quarter earnings release conference call. A portion of our remarks today will be focused on the business segment attachment of our earnings release, so if you don't yet have a copy of that, either the release or the attachment, you can access it over the Internet at our Investor Relations page at www.cardinal.com.

Speaking on the call today will be Bob Walter, Chairman and CEO; George Fotiades, President and COO; and Mike Losh, Chief Financial Officer. After their formal remarks we will open the lines for your questions. As always, when we get to the questions, we ask that you please try to limit yourself to just 1 question at a time.

Before we begin, please remember that this call may include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected, anticipated, or implied. The most significant of these uncertainties are described in Cardinal Health's Form 10-K, Form 8-K and Form 10-Q reports, including all amendments of those reports and the exhibits to those reports, and include those listed at the end of today's press release.

Cardinal Health undertakes no obligation to update or revise any forward-looking statements. In addition, statements in this presentation may include adjusted financial measures governed by Reg G. A reconciliation of these measures is posted on the Investor Relations page at www.cardinal.com.

At this time, I'd like to turn the call over to Bob Walter, Cardinal Health's Chairman and CEO. Bob?

BOB WALTER, CHAIRMAN & CEO, CARDINAL HEALTH, INC.: Good morning and thank you for joining us. I'm not going to say too much about the results for the second quarter as you have already been provided the financials and Mike plans to give you some specific financial comments, and George will follow along with a report on our progress and some key operating initiatives. I would, though, say that the results were in line with our previous guidance, but as you and I know, the results were below our historic standards and certainly below our future potential.

I'm going to focus on the future by giving you a higher-level view of how things are developing overall at Cardinal, and a commentary on FY 2000 and 2006 guidance. I will start off by telling you that I'm feeling pretty darn good as I can see the pieces falling in place to build the momentum necessary for our fiscal 2000 performance. There are 2 parts to building that momentum.

First, eliminating the uncertainties that have plagued us in 2005 in some of our operations. And second, accelerating the already strong performance of many of our other operations. Some of the key initiatives that -- or some of the key uncertainties that have existed this year are around the following things.

First, Pharmaceutical Distribution business model and the fee-for-service. Second, the manufacturing inefficiencies and delays in the sterile area. Third, the delays in new product introductions and installation capability at Pyxis. And the fourth, the margin pressures in the medical products area from product repricing and raw material costs. And finally, the uncertainties that arise from potential disciplinary action as a result of the investigation by the Company's Audit Committee related to the financial statement issues identified in our most recent Form 10-K.

There are a tremendous number of great things happening within Cardinal. I can say with confidence that there are well developed plans in place or events developed that will substantially reduce or eliminate these uncertainties and both restore growth, and importantly, predictability for 2006. So mentally I'm racing toward 2006 and the results that it will show. Meanwhile, we'll stay focused on the second half of this year.

Certainly, we're very disappointed by our inability to forecast for the second half our vendor margins and the exact timing of the implementation of fee-for-service in our Pharmaceutical Distribution business, and the installation delays at Pyxis -- installation delays of Pyxis contracts. These lead us to reduced guidance for the balance of this year, but they don't affect our expectations for FY 2006. Nonetheless, it's disappointing for us, and certainly for you.

My overview of Cardinal's position starts with strategy. It is intact. We are well positioned. We like the businesses we own. We are generally the market leader or in a very strong second place. Our markets continue to have attractive revenue growth, generally in line with our expectations. And other than at Pyxis, where frankly we have a self-inflicted non-fatal wound, our revenues are meeting our goals and are rising at rates faster than the comparative markets.

We have invested heavily by adding substantially to the senior leadership of the Company, noticeably at PTS at the top in its manufacturing areas; at Pyxis, at both the top level and throughout the customer installation area; and with the addition of Alaris, all of its senior management has stayed, and it's integral to the achievement of the planned merger synergies and improved Pyxis efficiencies. We've added in manufacturing product ranks in the Medical Products area -- Medical Products and Services area, and we've added further leadership in many areas at the corporate.

3 key areas of focus, though, remain the same for Cardinal in order to improve our performance. The Pharmaceutical Distribution model change to fee-for-service, regaining Pyxis' luster, and executing in sterile manufacturing. Let me put these 3 areas of focus into perspective by categorizing all of Cardinal's operations into 3 buckets.

The 3 buckets are the -- first, the predictable growth bucket; the second, the model change bucket; and the execution issues bucket. Cardinal has many businesses. Certainly all in healthcare, but noteworthy is that there are 13 with annual operating earnings in excess of $50 million.

In the first bucket, the predictable growth bucket, there are 10 of those 13 operations. These operations are in this bucket because you can describe them as in the "business as usual" category. While there are always day-to-day challenges in each business, this group of companies are generally doing well, growing nicely in a predictable fashion. These 10 businesses will account for approximately 50 percent of our operating earnings in fiscal 2005. We don't talk much about these businesses, maybe because their reliability -- because of their reliability and predictability.

Some of these businesses are like Medicine Shoppe. Frankly, all of MPS, including its distribution and manufacturing areas; oral technologies, which is our soft gels and Zydis businesses; nuclear pharmacies, our packaging; and certainly now, Alaris are some examples of those 10 businesses. Certainly we invest in these businesses. There is potential to accelerate their growth. We'll talk about these individual businesses in much more detail at our Analyst Day in early May.

Now, the second bucket, the model change bucket. This second category is for businesses that are undergoing a fundamental model change affecting them and their competitors. This, of course, is Pharmaceutical Distribution, which accounts for approximately 40 percent of our fiscal 2005 earnings. Incidentally, our Pharmaceutical Distribution business itself has 2 distinct product lines. Branded pharmaceuticals and generics. It is only the branded pharmaceutical portion which is undergoing a business model change. Generic profitability is performing very well.

Branded pharmaceuticals account for a little more than 50 percent of the total Pharmaceutical Distribution operating earnings. We're leading the industry-wide transition to a fee-for-service form of compensation for the branded manufacturer. That transaction is happening. It will work. Our people are meeting every day with manufacturers, both large and strong -- and small. The conversations over the past year have moved from a theoretical discussion of the value of services we provide, to an acceptance of the concept of the manufacturer paying unique, non-contingent fee-for-services, and now finally to concrete discussions on price.

Yesterday I read a comment by an analyst that said our, "Persevering stand on converting manufacturers to fee-for-service could begin to pay dividends over the next 6 months". That analyst had the right idea. But instead of saying "could pay dividends," I would have said "will pay big dividends." So while we haven't called the exact timing in short-term costs of a hand-off from buy-and-hold to fee-for-service, as evidenced by our shortfall this year, it is happening, and the momentum is picking up as we forecast.

The third bucket. Those where …