McKesson Corporation (MCK) Q3 2008 Earnings Report, Transcript and Summary

Good afternoon and welcome to McKesson Corporation Fiscal 2008 Third Quarter Conference Call. All participants are in a listen-only mode. [Operator Instructions]. Today's conference is being recorded. If you have any objections you may disconnect at this time. I would now like to introduce Mr. Larry Kurtz, Vice President, Investor Relations. Please go ahead, sir.

Thank you, Angie. Good afternoon, and welcome to the McKesson fiscal 2008 third quarter conference call for the financial community. With me today are John Hammergren, McKesson's Chairman and CEO; and Jeff Campbell, our CFO. John will provide a business update and will then introduce Jeff, who will review the financial results for the quarter. After Jeff's comments, we will open the call for your questions. We plan to end the call promptly after one hour, at 6:00 p.m. Eastern Time. Before we begin, I remind listeners that during the course of this call, we will make forward-looking statements within the meaning of the Federal Securities Laws. These forward-looking statements involve risks and uncertainties regarding the operations and future results of McKesson. In addition to the company's periodic, current and annual reports filed with the Securities and Exchange Commission, please refer to the text of our press release for a discussion of the risks associated with such forward-looking statements. Thanks, and here's John.

Thanks, Larry, and thanks, everyone for joining us on our call today. McKesson continued to have positive market momentum in our third quarter with revenues up 15%. Distribution Solutions revenues grew 14%, driven primarily by solid growth in new business from existing customers and the acquisition of Oncology Therapeutics Network, or OTN. Technology Solutions revenues increased 35%, driven by the acquisition of Per-Se Technologies, and continued expansion in software and services. Operating performance is also strong, given that we faced a difficult comparison versus the third quarter a year ago, due primarily to the timing of generic drug launches last year versus this year. Earnings per diluted share from continuing operations was $0.68 this year versus $0.79 a year ago. However, we took several actions in the quarter designed to improve future results, which reduced our third quarter EPS by $0.13, including $0.02 of dilution resulting from our acquisition of OTN. As you are probably aware, diversion of controlled substances has been an industry issue. Nothing is more important to our industry than the safety and integrity of the drug supply chain. McKesson has had strong productive relationships with regulatory authorities, focused on achieving this goal. We are in discussions with the Drug Enforcement Administration and the U.S Attorney Offices to resolve claims around certain customer orders for selected controlled substances. We have been implementing improvements to our comprehensive controls and reporting procedures to avoid future claims of this type. And we've recorded a legal reserve of $13 million during the quarter within our Distribution Solutions segment and believe this reserve is adequate for the claims. The reserve is not tax deductible. This charge and the expenses for the improvements we are making to our procedures and controls are absorbed in our annual guidance. Turning back to our outlook. Both our segments are achieving steady, balanced revenue growth. People continue to take drugs because of the health benefits they provide. When possible, they substitute generic drugs, which has a positive effect on our profitability. We are seeing a continued emphasis on the use of information technologies to reduce healthcare costs and improve health outcomes. We continue to be upbeat about our revenue growth across our business during the time when there are broader concerns about the growth of the economy overall. Based on our results to date and a strong performance in the fourth quarter, we expect that McKesson should earn between $3.22 and $3.32 per diluted share for fiscal 2008. Before I turn the call over to Jeff for a detailed review of our financial results, I will highlight the positive trends in our business and some of the specific progress we are making to deliver sustained growth and performance. Our strong Distribution Solutions revenue growth in the quarter reflects growing demand and expanding relationships among the most diverse and balanced customer base in the industry. We serve some of the largest and fastest growing pharmacy operators in both United States and Canada, including leading retail chains, mail-order pharmacies, mass merchandisers and food drug combos. These customers value the efficiencies and working capital savings our business model provides and have been rewarding us with new business that drives additional revenue growth. For hospital customers, we have a broad value proposition that addresses their key issues of safety and quality of care, which is driving revenue growth and creating stronger relationships. During the quarter, McKesson signed three hospital systems to one McKesson agreement that represent expansions of existing relationships or new multi-business contracts. For independent pharmacies, our key value-creating offering is our Health Mart franchise, which provides a menu of products and services designed to help our customers compete more effectively and profitably. McKesson now has about 1,800 Health Mart franchise stores, an increase of more than 400 during the first three quarters, as more and more independent pharmacies are now recognizing the value of Health Mart's end-to-end products and services. Health Mart pharmacies participate in our proprietary OneStop Generics program which delivers great value to our customers. There is an exceptional pipeline of higher margin generic product opportunities that are forecast for launch over the next several years. And we've grown our base of customers that rely on McKesson for access to these important drugs at competitive prices. The number of pharmacies in our proprietary OneStop program has been increasing, reflecting more participation across a wide range of customers, with particular progress among independents, regional chains, and hospital group purchasing organizations. Even more importantly, we've been expanding our programs focused on the rapid launch of products into the channel called ASAP and ASAP Plus which ensure that participating pharmacies will have adequate supplies to meet initial patient demands in the first days or months of our new generic product launch. Over the past year based on our track record for rapid customer penetration and shipment execution for generic drugs as they enter the market, the number of participating pharmacies in our ASAP program has grown 14% and the number in ASAP Plus has grown 40%. Our expanding base for generics and our ability to execute on generic product launches enhances our opportunities for stronger relationships with generic manufacturers. During the third quarter, McKesson was selected by Teva Pharmaceuticals as a strategy to launch partner for the generic version of Protonix, one of the leading treatments for erosive acid reflux disease. Teva launched generic Protonix after the close of business on December 21, and McKesson customers received their shipments the next business morning. In summary, generics continue to be a great opportunity at McKesson. This year we had a significant profit hole to fill from three major generic drugs, two of which had lower profit margins in the third quarter this year and one of which is no longer on the market. Overall the growth in our customer base and our great relationships with manufacturers enabled our generics team to fill that profit hole, an outstanding performance. Finally, our acquisition of OTN provides our participation in the rapidly growing market for specialty pharmaceuticals. Sales of specialty drugs are increasing faster than the market. It's a terrific opportunity for us, and we have begun executing on our plan to combine OTN with our existing specialty business to improve efficiencies and enhance our offering. Looking ahead, McKesson is strategically well positioned to deliver continued solid results in Distribution Solutions. The demographics of an aging population are driving increased use of pharmaceuticals across North America, and there is a great pipeline of significant generic product introductions on the horizon. We have a diverse customer base. We offer a broader value proposition. And we are expanding our base of generics customers, and we've enhanced our position in the fastest growing sector of the market, specialty distribution. We have a great business at a great time. Turning to Technology Solutions. We have tremendous opportunity for continued value creation. We have the most comprehensive set of software, services and automation systems for hospitals, physician offices, home healthcare, and payers. And we are winning in the market as shown by the recent decisions by Community Health Systems, Aetna and Cigna to expand their relationships. The continued expansion of our core hospital and physician business combined with our acquisition of Per-Se Technologies and the transition of our growing payor business into this unit has created the world's largest healthcare information technology company with sales that will approach $3 billion this fiscal year. Interest remains high in our clinical and imaging solutions, our payor software in disease management programs and our RelayHealth offering, inside and outside our customer base. We had an especially strong quarter for new sales of medical imaging, cardiology imaging, analytic solutions and automation systems, an indication that there is continuing market demand in these sectors. We continue to receive high marks from customers for product quality, implementation, and support. The 2007 year-end Top 20 best-in-class awards report has been released and seven of McKesson's products are either rated best-in-class or a solution category leader. Overall, 18 McKesson solutions are ranked in the top three for their categories in this report, the most of any company. Our integration of Per-Se continues to be ahead of schedule and provides McKesson with important new capabilities to meet growing needs for better connectivity and funds flow in the evolving healthcare environment. Our goal over the long-term is to use our unique software and service technologies, broad offering and large installed-base of customers to deliver above market growth with more predictability and less risk. Last year's acquisition of Per-Se and the transition of the payor business into the segment gave us the chance to reevaluate our combined product offering and organization. It is our strategy to continue to build and expand our offering, even when we have market momentum to ensure that we stay ahead of our customers needs. As a result of the new organization, during the quarter, we took several actions to streamline our staffing and product lines to improve efficiencies and deliver better customer solutions in the coming years. The charges associated with these actions reduced this quarter's MTS operating profit by $25 million. For the full year, including the P&L impact of these actions in the quarter, we expect to make significant progress toward our goal of low to mid-teens operating margin for the segment, solidly reaching double-digits. It's great that we can absorb those levels of charges and still meet or exceed our financial goals for the year. We take a similar approach with our corporate staff and organization to constantly rebuild and streamline our operations, taking advantage of our scale. Over the next nine to 18 months, we will transition 79 corporate information technology positions from Dubuque Iowa to other McKesson data centers in Atlanta and Rancho Cordova, California. Some media have misinterpreted this action as involving our Technology Solutions' operation in Dubuque, it did not. We employed 340 people there in our practice management and EDI operations, serving approximately 20% of the physicians in the country along with a significant number of hospitals, and additional payors. Over the next 12 months, they will be moving to a new modern facility in Dubuque, but they were not affected at all by our corporate IT transition. Here are some individual accomplishments that underscore the outstanding set of assets we have in Technology Solutions and how we are executing to drive value creation. During the quarter we expanded our relationship with Community Health Systems or CHS, the nation's leading publicly-owned operator of general acute care hospitals. We signed an agreement, whereby CHS will deploy McKesson's physician portal, electronic medical records and performance analytics tools across most facilities. The new agreement is larger in scope and size than our original agreement with Triad Hospitals, which reflects the strength of our Horizon Clinicals offering and the strategic relationship between McKesson and CHS. Earlier I mentioned three-one McKesson agreements signed this quarter. At both Baxter’s Health [ph] and ProMedica, we won new business because we can offer comprehensive integrated solutions from doc-side to bedside. In both cases, the customer chose One McKesson over a combination of two or three vendors. We see this trend towards single vendor solutions increasing, as our customers prefer to have a single point of contact and accountability for executing our complex implementations with ambitious clinical and business objectives. We see the same trend among payor customers. During the quarter, CIGNA HealthCare and Etna began expanding Internet access to physicians for their members, through services provided by McKesson's RelayHealth business. CIGNA and Etna are each pharmaceutical distribution customers for their mail order pharmacies and customers of our market leading software for payors. CIGNA is going nationwide with our web visit service, following the successful four-state pilot program. Web visit is a reimbursable online physician consultation service. At Etna, members and physicians in more than 30 medical specialty categories will now have nationwide access to web visit, following the successful three-state pilot. In addition, we had a successful implementation of our claims performance solution; claims extend under a five-year agreement with Etna, which was signed in August of 2007. During the quarter, we also signed an agreement with a large Midwest Health System and one of our strategic banking partners for a pilot project in healthcare banking. This project is designed to test and refine payment solutions for the complex issues and gaps that currently exist between the many parties involved and the healthcare settlement process, from coverage eligibility determination to final settlement. I'm excited about our Technology Solutions business and believe it will be a source of significant shareholder value creation in the coming years. Our core software and automation businesses continue to grow, helped by opportunities created by our One McKesson comprehensive offering. The size and scope of our organization will continue to enable us to streamline our common functions and align product development for innovation and economies of scale. We have increasing balance and predictability in our revenue stream. We are the market leader in emerging areas of healthcare information, financial connectivity and disease management. In summary, we have great momentum across McKesson through the first three quarters of fiscal 2008. Both Distributions Solutions and Technology Solutions have deep loyal customer bases, solid revenue growth, and opportunities for margin expansion. Our strong balance sheet and operating cash flow provide resources to further the creation of additional shareholder value. I look forward to reporting to you on our results for the fourth quarter, but with that, let me turn the call over to Jeff and I'll return to address your questions when he finishes. Jeff?

Well, thank you, John, and good afternoon everyone. As you just heard, McKesson had a solid quarter in line with our expectations for our ongoing business, despite facing difficult comparisons versus the third quarter a year ago and some charges we took in this quarter. This creates some complexity in the quarter, which I'll sort out as we walk through our financial results. Overall, one month into the fourth fiscal quarter, we continue to expect a strong finish to the year. Let me first begin by reviewing the consolidated income statement. We had revenue growth in the quarter of 15% to $26.5 billion, Distribution Solutions revenues, which given their size are always the primary driver for overall revenue growth, grew 14%, benefiting from increased sales to existing customers in our U.S. pharmaceutical distribution business into a lesser extent by the acquisition of OTN which we closed on October 29, 2007. Technology Solutions revenues grew 35%, continuing to benefit from the acquisition of Per-Se Technology, which closed a year ago, this week. On the 15% revenue growth, overall gross profit for the quarter was up 13% to $1.2 billion. We saw some decline in the gross margin in both segments, which I'll discuss in a few minutes, partially offset by the growing contribution of the higher-margin Technology Solutions segment due to the Per-Se acquisition. Moving below the gross profit line, our total operating expenses were up 24% to $922 million for the quarter. Operating expenses in the quarter were negatively impacted by $38 million in pre-tax charges, $13 million of which were non-tax deductible. As John mentioned, these charges primarily stem from actions taken to improve our future results. In addition, our operating expenses grew due to our acquisitions of Per-Se, OTN, and several smaller companies, normal growth to support our revenue growth, an incremental FAS 123 charges for the company of $11 million. Turning back and I walk down the P&L. Operating income of $282 million in the quarter was 11% below last year. However, excluding this quarter's charges of $41 million, $3 million of which hit gross profit. Operating income would have been 1.6% above last year. This performance keeps us in line with our expectations for the full year. In the prior year December quarter we had significant earnings from the launches of Generic Zocor and Zoloft, and the short-lived launch of generic Plavix. In addition, as said on last quarter's call, our strong September quarter results this year were helped by a shift of some of our expected profit from the December quarter back into the September quarter. For the year, we remain on track with our expectations, including our expectations for the year for both branded price increases and generics. Moving below operating income, our interest expense of $36 million was $13 million greater than the prior year, due to the $1 billion in additional debt, which we used to finance a portion of our Per-Se acquisition. Our capital deployment [inaudible] is more broadly give us lower cash balances this year. This resulted in lower interest income, which was the primary driver of other income of $31 million, being $8 million lower than the prior year. Our reported tax rate was approximately 28% both this year and in last year's December quarter. This year's effective tax rate remains unchanged at 33%. The lower reported rate of this quarter reflects $20 million of discrete tax benefits primarily related to the completion of our IRS audit for the years 2000 to 2002, offset in part by the $13 million non-deductible pre-tax charge. You will recall that last year's reported rate of 28% was due to some tax return true-ups and the cumulative effect of reducing our effective rate at the time from 35% to 34%. On a GAAP basis, this quarter, we had net income from continuing operations of $201 million or $0.68 per diluted share, compared to $243 million or $0.79 per diluted share a year ago, excluding the $41 million of pre-tax charges or $0.11 per diluted share McKesson's income from continuing operations would have been essentially flat year-over-year. Let me once again remind you that our earnings this quarter also include $0.02 of dilution from the acquisition of OTN and related integration costs. To wrap up, our consolidated results in the quarter, our diluted EPS calculation was based on 297 million weighted average diluted shares outstanding compared to 302 million in the prior year. The number of shares used in this calculation declined due to the cumulative impact of our share repurchases including $230 million of stock repurchase in the third quarter which brings our total share repurchase for the fiscal year to $914 million. Let's now move on to our two operating segments. In Distribution Solutions for the quarter, we achieved revenue growth of 14%, driven primarily by the 17% growth in our US pharmaceutical direct distribution and services revenues. And I mentioned earlier, these revenues benefited from increased sales to existing customers, the OTN acquisition, and one extra day of sales in the quarter. So excluding the OTN revenues and the one extra day of sales, our US pharmaceutical direct distribution and services revenues grew at about 11%. Canadian revenues increased 32% for the quarter including a large favorable currency impact of 18%, reflecting new and expanded distribution agreements and one extra day of sales in the quarter. Let me digress just for a minute here to clear up any confusion about the impact of the Canadian dollar exchange rate on our consolidated financial results. It is true that the strong Canadian dollar helps the US dollar earnings of our Canadian distribution business. However, we also have a large IT workforce in Canada, which is part of our MTS segment and the expense of this workforce creates a large offset or essentially a natural hedge against the profits of our Canadian distribution business. So our consolidated EPS results are not materially impacted by changes in the Canadian dollar exchange rate. Going back to the revenue lines now, Medical-Surgical Distribution revenues were up 3% for the quarter. We shipped flu vaccine earlier this year, which is reflected in our strong 11% growth, in the September quarter. Normalizing, we see ourselves growing at about markets rates for the year-to-date. For Distribution Solutions overall, gross profit was up 9% to $859 million for quarter. So while we lost a bit of gross margin this quarter versus the prior-year. We'd expect the full year to be fairly flat. While we grew our gross profit dollars from generics, our margin this quarter was down impacted by the tough year ago generic comps. In addition, as discussed on our last quarterly call a larger proportion of our branded manufacturer compensation was earned in our second quarter this year. In this quarter, we had a LIFO credit of $10 million versus a LIFO credit of $18 million in the prior year. Our Distribution Solutions operating expenses were up 20% for the quarter to $554 million. Third quarter operating expenses this year included charges totaling $16 million, 13 of which as we've discussed provides for a pending legal settlement, and $3 million of which was for restructuring charges. Operating profit of $312 million was down 8% from the prior year, excluding the $16 million in charges in this segment, the operating profit of our U.S. pharmaceutical distribution business was fairly flat year-over-year. We also had stronger operating performance year-over-year in Canada in Medical-Surgical, offset by continued investments in our retail automation and specialty businesses, including the OTN acquisition. For the entire year, we now expect that our GAAP operating margin in Distribution Solutions will dip a few basis points below our long-term target range of 150 to 200 basis points, as we absorb our continued investments in specialty distribution and OTN. Our margins in our core U.S. pharmaceutical business will be flat to down a few basis points for the whole year, considering this quarter's charges and the sharp decline year-over-year in our LIFO credit. Looking forward, while we will not be providing FY '09 guidance until our next earnings release, we have a clear goal and expectation that we will gain leverage in this segment in FY '09 and be back within our target range. In Technology Solutions, our revenues were up 35% for the quarter to $736 million. Revenue growth is being driven by the acquisition of Per Se and continued growth in software and services. Service revenues, which now account for 75% of revenue in this segment, were up 48% to $553 million in the quarter. Software and software systems revenues were up 14% to $150 million. Revenues from 74% of this quarter's bookings were deferred into future periods similar to the 76% deferred in the prior year third quarter. Gross profit increased 27% in this segment, providing a gross margin of 46.9%. Our acquisition of Per Se and our evolving mix of business has lowered this margin a bit, so these businesses should be additive to our operating margin over time. Driven by charges in the acquisition of Per Se, Technology Solutions expenses increased 43% in the quarter to $300 million. In the quarter, we had $22 million of charges composed of $18 million to streamline staffing and product lines, $4 million for legal settlements. Excluding these charges, operating expenses would have grown 32%, providing some leverage on our 35% revenue growth, despite incremental FAS 123R expenses of $7 million from the prior year and continued investments in new product development. To size this investment for the quarter, Technology Solutions had total gross R&D spending of $105 million, an increase of 25% from the prior year. Of this amount, we capitalized just 16% compared to 21% a year ago. Operating profit of $49 million was 22% below last year. However, excluding charges of $25 million in the quarter, but including $7 million in incremental FAS 123 expenses. Operating profit of $74 million would have been up 17% from a year ago. We continue to believe we are on target to reach our previous expectations of low double-digit operating margins on an annual basis this year, even including the $25 million in charges. Now turning briefly to the balance sheet. On the working capital side, our receivables increased 16% primarily due to our sales increase to $7.5 billion versus $6.4 billion a year ago. Our day sales outstanding were flat to 22 days. Our inventories were $9.6 billion on December 31, an 11% increase over the last year. Our day sales in inventory of 34, was one day below last year. Compared to a year ago, payables were up 14% to $12.4 billion, our day sales in payables were unchanged at 44 days. So year-to-date, we've generated $915 million in operating cash flow. While we used cash this quarter due to our typical seasonal buildup in working capital we are expecting strong cash flow in our fiscal fourth quarter. We now expect to generate more than $1.5 billion in cash flow from operations for the full fiscal year. Before I leave our cash flow, let me clarify one item from this quarter's cash flow statement, if you look at it closely. As you recall, we paid $962 million back in the fourth quarter of fiscal year 2006 to settle our consolidated securities litigation action. We have since shown this $962 million as restricted cash on our balance sheet pending the final resolution of all possible objections to the settlement. The good news is that we have now reached this point so the $962 million in restricted cash and the associated liability have been removed from our balance sheet this quarter. But somewhat confusing way, this is reflected in the cash flow statement is as both a use of operating cash and a source of investing cash. I would just focus on the fact that the net impact on our cash flows for the quarter and the year is zero. Turning now to capital spending, year-to-date we've spent $129 million higher than the $76 million a year ago, primarily due to some DC renovations and continued investments in our information systems. Capitalized software expenditures were $118 million similar to the $119 million we spent a year ago. We ended the quarter with $1.4 billion of cash consistent with our portfolio strategy for capital deployment. Year-to-date we've repurchased $914 million of shares, paid $53 million in dividends, invested $247 million internally and made $592 million of acquisitions. We still have approximately $1.1 billion of share repurchases authorization left. Our gross debt-to-capital ratio was 23% at December 31. So overall we've had three solid quarters and now expect that McKesson should earn between $3.22 and $3.32 per diluted share for fiscal 2008 excluding any adjustments to the securities litigation reserves. Now let me be explicit here and say that this guidance includes the $0.11 in charges we took this quarter. Said another way, for the first three quarters, McKesson had earnings per diluted share from continuing operations of $2.27 excluding any adjustments to the securities litigation reserves. Relative to where we were last quarter, we're absorbing $0.11 in charges in our full-year guidance. As we discussed last quarter, we are also absorbing $0.05 to $0.06 of dilution from OTN for the year, which includes some one-time integration costs. So our view of the recurring operating results of our businesses remain strong. Thank you. And with that, I'll turn the call over to the operator for your questions. Question and Answer

Thank you. [Operator Instructions]. Our first question comes from Randall Stanicky. Please state your company name and you may ask your question.

Great. Randall Stanicky, Goldman Sachs. John and Jeff, just you referred to Protonix being exclusive for the strategic provider in your press release. I guess, just two questions there. Will that extent to an additional launch or they are just on the initial launch from Teva? And then secondly, how do you view your current supply of your generic to provide customers at the current time? And then just a follow-up kind of more big picture question for John. Do you consider or see an opportunity going forward, a lot of conjecture in the marketplace for some average launch opportunities particularly as we look at fiscal year '08? Do you envision an opportunity or do you see an opportunity for the drug wholesalers to get more aggressive in partnering with the generic companies here that bring generics to market, in other words, perhaps indemnifying some of the risks, John, damages going forward?

Thanks for the question. I'll see if I can answer them and I'll ask Jeff to jump in here if I miss anything. On Protonix, clearly we had a very good relationship with Teva that allowed us to be in a good position for that launch. I don't think we've described it as an exclusive relationship for the launch. So let me just be clear there. I just think we had product for our customers very early, basically the data was available, it was in our customer shelves and we feel our customers benefited by our quick action there and access to the product. Relative to the supply of generics, we clearly try to purchase supply that matches demand in the event that we believe that demand is going to outstrip our supply, obviously, we try to get more than our fair share of the product that might be available once again benefiting our customers and benefiting our company. And on your third question, as it relates to at-risk launches, we clearly have an awareness about the fact that these can be value creating opportunities for the generic companies, if it's successful, as well as the wholesalers that are part of the distribution channel. McKesson, at least as far as I'm concerned, will never be involved in taking on the risk associated with those decisions. I don't think we're well positioned to do that, we don't have the knowledge base nor the resources too to put ourselves in that position. That doesn't mean we want to avail ourselves of the opportunity and we won’t try to bring our tremendous customer base to the table with the generic companies, so they get access to those customers in a quick efficient way and they get an immediate update for the product. So we're not planning on taking financial risk associated with that risk launches. And I don't know whether you talked about or not, but from a planning perspective we really don't look at at-risk launches as a component part of our publicly communicated expectations, and frankly even our internal planning. We know that these things can come and go and it's very difficult to predict them, and then I think that to the extent they happen, their upsides and opportunities for us into the extent they don't… we certainly don't want our head baked into our financial projections, something that is so far out of our ability to project, so Randall, I don't know if that answers your questions, but --.

I might just have one other clarification on Protonix, which is… because it was such a late launch in our quarter the financial impact of it for us is really the March quarter issue and had no material impact in the December.

Thanks.

Robert Willoughby. Please state your company name and you may ask your question.

I think that's me, Banc of America. Can you hear me?

Yes, yes.

Robert.

Unbelievably dam question. Is it your understanding that most folks will call out that $0.11 of non-operating kind of charge and push that fourth quarter estimate higher to get to the range that you put out there?

Well, you know that our philosophy is we try to be very clear about the drivers both on a recurring basis and on a non-recurring basis in our results. But we also really try to let you and our other investors make their own decisions about what's… how they want to view their results. Just to be clear, certainly we look at the $0.11 and view it as non-recurring, we also view it primarily, not exclusively, when you look at the legal issues, as things that we very consciously chose to do to better position our cost structure on our product lines for the future. So that's why we have in essence kept our guidance the same, while absorbing the $0.11 of charges, and for that matter also $0.05 or $0.06 of dilution from OTN, because we think it's clear for us to just provide the guidance on a GAAP basis.

That's above… just to reinforce what Jeff was saying. We only try to provide you GAAP numbers and then give you the make-up of those numbers. And I think the second thing is that we have had some successful sometime in our company and one of the things that we're absolutely focused on is never becoming complacent in our operations and taking for granted our continued performances. So we've encouraged our people to think about organization and structure and product lines in a very aggressive way to position the company for continued strong performance. And as we talked about in our previous comments, the creation of MTS created opportunities for us to leverage our scale and our assets and take additional cost out and streamline our products offering. So, we look at these things actually in a very productive way, the cost that we can get out now and aggressively position ourselves for the future and we encourage our teams to do it.

Lisa Gill. Please state your company name and you may ask your question.

Lisa Gill with J.P. Morgan. Good afternoon. Just in very simple terms, does that mean that the next quarter that we are looking at is… basically the range is $0.95 to $1.05?

Yes.

Okay. [inaudible]. Good. And then just secondly, John, can you maybe just talk about your revenue growth rates? I mean, clearly it is growing faster than the industry for quite some time now. You obviously have some big customers, but for your direct business to grow at 11%, can you talk about what some of the drivers are there? Are you taking business from your competitors? Is that expanded offering within your customer base? And then, as it relates to that and we think about distribution margins, I know there is charges and there is OTN, but as we think about the operating profit, are you sacrificing any margins to get additional revenue dollars?

Thanks for the questions, Lisa. I… we're really pleased with the progress we're making with our value proposition for our customers. And I think that our entire focus has been how do we deliver more value for our customers and in return get more value for us. So that it's not a price oriented discussion, but it's a value oriented discussion, and we're getting additional market share from existing customers from their spend, and I would tell you that, I'm not 100% aware of all of the revenue, but I would tell you that most of it is coming from revenue that they would have primarily purchased on a direct basis. So when we take out the generics volume from someone, most of that generics business was probably purchased direct, particularly at the mid-sized chains and some of the larger customers. But the smaller independent customers, they might be buying from Internet kinds of... fax marketing kinds of generic people, but largely the business we are enjoying is business that is incremental to us, and coming out of the source that would otherwise be direct. As to whether or not we'll be sacrificing price or margin to garner additional revenue growth, last I looked... it's very difficult to invest revenue or spend revenue. So we are very focused on growing earnings and expanding our margins. And so it's... if our incentive structures are working, people are growing earnings faster than they are growing revenues, they'd be very reluctant to give up price or margin to get revenue growth. And so what we are trying to do here is, always get positive drop in our businesses. So we are growing earnings faster than revenues and we're making great progress against that objective.

Great. Thank you.

Glen Santangelo. Please state our company name and you may ask your question.

Yes, John. I just had a quick question regarding the drug distribution margin this quarter versus where it was in September, you talked on last quarter's conference call about some of the mid-tier chains like [inaudible] as they use to buy direct, and all of a sudden, you're selling them generics and you kind of commented last quarter that that benefited your generic sales, which ultimately benefited your margin. Given that you are increasing your revenues, to these sort of mid-tier customers and increasing your generic compliance, could you just help me think about why the total op profit dollars were sort of declined from September to December?

Yes, absolutely I think that Jeff mentioned in his comments, one of the things he talked about was... how pleased we were that our team was able to fill the void created by the year-over-year comparison, third quarter a year ago we had three big generic launches, two of the products have dropped in price from that year to this year, and one of the products is no longer available on the market on a generic basis. So as we guided at the beginning of the year, we told folks that our second and third quarters are going to be difficult compares largely driven by those comparisons. And we also have been entirely focused on how do we gain additional market share in our existing generic business, in our existing customers... exactly like you described Wegmans and rest of those folks picking up that generic business helped us hold our operating profit relatively flat in our generic business, or in our distribution business, if you take out the charges and a flat comparison with that huge prior-year, is terrifically result for us. So I... I think that... if you study the industry, you'll find that our ability to continue to drive generic volume through our existing customers, sets us apart and has allowed us to come through what was a very difficult compare, which I think terrific result.

The one other thing, Glen, that I mentioned in my remarks is, if you go back a quarter, you'll recall that I pointed out that some of our branded manufacturer compensation which we had in our plans for the year, to be in December or March quarter events, clearly got pulled back into that September quarter. So it both made that September quarter look particularly strong this year and made this look a little weaker. Frankly when we added all up for the year, we were pretty much tracking to our expectation.

Thank you. Tom Gallucci, please state your company name and you may ask your question.

Merrill Lynch. I just had two things. Just following-up on that one Jeff, just as to be clear that, sequentially the change in, let's say, operating profit dollars in the distribution segment, you are pointing to branded price inflation or brand... earnings driven by price increases as a key to that. Maybe was it $38 million or $40 million sequential difference?

Well, yes. It is the short answer.

Is there any other things that we should be thinking about or just sequentially?

Tom, we will talk for a while about the fact that we feel we have a real good read now our branded manufacturer compensation over each contractual year to the manufacturer. But it… we don't know it is getting right quarter-to-quarter.

Yes. Sure, that is understandable. But there is no other major variable sequentially that we should be thinking about, okay.

Year-over-year comparison that on to generic side for the last December was pretty tough.

Sure, definitely. Well just one quick clarification, you said tax rate, 33%. You expected 33% for the fourth quarter or is it going to sort of average 33% for the year and then such that the fourth quarter is going to be higher than that sort of average out the low one in the third quarter?

The rate… our effective rate is 33% and it should remain that way for the foreseeable future. It is… of course each quarter there are some true-ups. This quarter because we had a pretty sizable and very positive settle plan or settlement within the IRS on our 2000 to 2002 audits, you had some one-time good guys that brought the 33 down to the 28. But 33 is the ongoing rate. That is what you need to expect for Q4.

Okay. And then [inaudible] LIFO, is there anything in this quarter that was material?

We took a $10 million LIFO credit this quarter versus the $18 million last quarter.

Okay, great. Thank you.

Charles Boorady, please state your company name and you may ask your question.

Citigroup. What was the revenue impact of OTN in the quarter?

The way I think about it is if you look at the US pharmaceutical direct distribution and services revenues, it was up 17% for the year. If you take OTN and the factory had one extra sales day this year out, you are in 11%. So I don't have them… you can do that math.

Yes, I can do that math, but that is great. And then the range of guidance… and thanks for doing the math on the fourth quarter. Some companies haven't been able to do that. But it is a pretty wide range, I am just wondering what things specifically could swing it to one side of the range versus the other, and is the midpoint of that range your best estimate?

Well in general the midpoint is... you should always assume it is going to be our best estimate. There is really two things that we don't have complete control over the timing of that material. One is, as we have talked about just a minute ago, the branded manufacturer price increases because our contract years are stagnate right. We don't have a March 31 contract years for all the manufacturers. So some of them, they could slip into the June quarter and we are still well within the contract. The second thing is of course we do have software businesses that sometimes recognize revenue in lumpy pieces and we have a couple of big lumps that could probably go either way and could drive the number by a couple of pennies.

Yes, got it. Okay, so it is not like this one $0.10 item that could come in the quarter or some following quarter... that makes sense. And then just finally on the last call you mentioned those, those four customers that are buying generics through you that were buying direct. And I'm wondering are you able to estimate or have they shared with you their estimate on the percent savings that they are able to achieve by making that switch?

Well, I don't know that they would necessarily share that with us. I guess the best way to think about at those are… there have to be a savings for them to move the business to us and the savings might have come in many different ways. Clearly the cost of the product sale, for the price we are charging versus the price they will pay if they sourced direct is a component of the total value we are delivering. Another component of the total value would be the people they normally employ, they do that negotiation and sourcing on their own and the third level of value that we deliver is obviously the ability to bundle the product from a service and a delivery perspective and an ordering perspective with McKesson's overall larger orders. So they are purchasing brand from us and getting it everyday, they wake up 5:30 in the morning, now they can throw their generic demand in that same order and pick up the same thing and probably have improved fill rates a single PO to pay or purchase... a single pay order to... PO to deliver and a single payment to make against an invoice. And all those have costs and efficiency ramifications and all told the reason we're gaining share on direct spend of generics and moving it through McKesson is because the total value proposition is superior as the customer reflects on what they have to do, they do it on their own. And then I have to admit that things like Protonix may not be available to some of those customers on a direct basis as fast as it was available from McKesson. And that certainly has to feed into their decision-making. A few extra days or a week or a month's worth of supply of a product that they otherwise couldn't get access to makes a big difference when they think about us as a partner.

That makes a lot of sense. Given that... and you mentioned some reasonable size chains. Is there a certain size above which you don't have a compelling pitch to a customer to hand that generic purchasing to you as opposed to doing it in-house, for example is somebody as big as Rite Aid, are they someone that you feel like give a chance to up sell to start doing the generics on their behalf, were they so big that you couldn't match what they could do on their own?

Being sort of a salesmen it is hard, I would tell you that there is no customer too big to hopefully be convinced by us that we are a better alternative. To be practical about it, clearly the bigger buyers of generics probably get close to our sourcing prices and then when you try to put our margin on top of that, we maybe a little bit difficult. We have to get a complete value prop consideration to offset the margin requirement that McKesson has frankly to handle the product. So there are some customers of certain sizes that are more difficult for us to create that value separation for them. But going back just a few years ago, I wouldn't have said the kinds of customers that we had today would be in the program. And as the snowball of McKesson's generic buy gets bigger and bigger when we roll down the hill, we have the ability to pick up more and more customers, and more and more volume, and more and more efficiencies. And the example I gave you on Protonix is a good one, is that... hopefully we will have advantages that sometimes they can't replicate and we'll continue to move upstream from a sourcing perspective.

Thanks.

Okay.

Thank you. Larry Marsh, your line is open. Please state your company name.

Thanks. This is Larry at Lehman. Just wanted to... maybe a clarification if I could from Jeff. It is interesting, the wording I guess you used in the press release about the tax rate. You're saying McKesson's expected tax rate for the year remains 33%. And I guess, I read that is saying you expect your effective tax rate for fiscal '08 to be 33%, but if I heard you correctly you're saying no, if you assume that you got a good guy this quarter, next quarter will be 33%. So your effective tax rate for fiscal '08 might be something like 31%, is that right?

It's a very good question, Larry, and I guess I'm confusing people with terminology. When we use the term effective tax rate, when you hear me use the term 33% that means that our tax rate for the year would be 33% if there were no unusual one-time items. If you take our pre-tax income, multiply it by 33%, bang, that's the tax rate. Now, the world it doesn't really work that way, because we have 1100 tax returns we filed… we are continually settling things with tax authorities. So, you have to each quarter in addition to booking that 33%, book whatever the one-time adjustments are, that you would incur in that quarter. So you could look at our year-to-date tax rate and I think if you look at our year-to-date tax rate of the press tables today, it's around 31.9% or so. So that tells you that 1.1-point differential is the net one-time good guy. For the fourth quarter we'll start by assuming we're going to book at 33% for the quarter. But we'll probably have some modest interruption in the fourth quarter as well. So I would call that 33.9% [inaudible] I would call it the reported rate versus the effective rate, if there were no one time items. So hopefully that clarifies it and doesn't confuse it more.

Okay. No. That does. And just in the… on that point, when you restricted the cash with the settlement in fiscal '06. You also segregated any income you would made off of that. Is that right? So you are not going to be impacted negatively, the fact that you have actually paid out the cash--.

All of the income accrued to the plaintiffs.

Right. Okay. And then I guess for John may be for Jeff another sort of thought process, let’s sort of step back four to five years for McKesson there was always a fair amount of predictability Q1, Q2 into Q3 and Q4 and obviously what you're saying is given the change in the market both with generics and now with the structure of these price agreements there tends to be more volatility quarter-to-quarter. Then I guess, we are… we would be used to seeing going back a couple of years. Is that a fair statement and as we sort of think about going forward the next year or two, is that going to increase or decrease given we're not going to have the massive new generics that we did with the three-year call out you gave us last year?

There are several questions there Larry, I think that the… if you actually look at us and the way we think about our business it is actually more predictable than it used to be particularly on an annual kind of a basis, these relationships that we have with manufacturers are much less sensitive to what they might do on their own with price announced to us. And what that does is it allows us to understand the stability of our business. So although it may look like we still have significant variation in our business, it's really driven today by two primary factors. One is the seasonality remains that we used to have, as that still remains one of the key timing points for our historical funding of both branded price increases in the past and the new agreements to date. And then… and so that seasonality is remaining. And the second thing is that on occasion manufacturers will change from historical behavior and that makes the sink with the prior period… prior year prior period out of whack and that's what we were trying to explain last quarter was that if you looked at the third quarter last year some manufacturers had increases in the second quarter this year that would have otherwise happened in the third quarter. And so those are the things that they can move around on us a little bit. But I actually think that the business is more predictable today. In the past we had to guess what the manufacturers are going to do with price increases and it had a propound effect on our business. Today the guess is more around when exactly will it happen as opposed to if it will.

Okay. And then I guess finally. I know I asked this last quarter as well, but you call that the fact that you were supplier of the year for CVS and obviously important relationship for the industry and I know you don't like to talk about specific customers but you as a manager would you hope to have some resolution of that long-standing agreement well before June of '09 or is that totally up to the customer, I should be asking Tom Ryan.

Yes, you know the answer to that. You should be asking Tom Ryan. Not speaking specifically about CVS, our goal is to have long-term relationships with all of our customers and to earn the privilege of continuing those relationships overtime. Sometimes they choose to go through a process where they reselect and sometimes they just basically sit down with you and over a handshake and a cup of coffee will renew relationships for a long period and it's too early to tell at least in my mind what… any specific customer that hasn't made that decision yet is likely to do. But our goal is to continue to earn the business day in and day out with all of our customers including CVS and to continue to earn the privilege of extending those relationships should they expire.

Thank you. John Ransom. your line is open and please state your company name.

Yes, hi it's Raymond James. Looking at your adjusted SG&A cost in your distribution segments for the quarter, is this kind of the new normal level? I mean, it was frankly a lot higher than what we were modeling, a lot higher sequentially but are there any… we took the $16 million out, but even after doing that the numbers were higher than where we were. Is this kind of the number we should look at more important considering OTN and some of the other things you're doing?

Well, I think the short answer is, yes. So you've got an addition to a lot of growth… 15% revenue growth in the US business. You also had a lot of growth and exchange rates in the Canadian business so that's the piece of it. And then, you've got OTN as well as our continued investment in retail automation. So, the only one of those that we don't control that might change is the Canadian dollar and that could bring it back down, but other than that I'd use it as a new base.

Well, I mean, if we do the math, if we just take your EBIT, now EBIT and then plough through the normal tax rate and interest, I mean, the numbers this quarter in our model were about $0.11 lower than what we were doing and all the delta was coming out of the SG&A line. So, the market did anticipate the SG&A step up, was the SG&A step up in line with your expectations but the markets just didn't catch on because that was really the big delta when you work through all the charges and all the tax rates, that EBIT numbers were lower really because of pharma SG&A jumped somewhat sequentially.

I don't know what your numbers are, and what the market expectation might have been. If you add back the unusual items including the non-tax deductible --

Yes, that's what… on the EBIT line, the taxes don't matter. So we added all the charges back and the operating profit numbers were lower and the delta all looks like it came out of the big jump sequentially in pharma and distribution EBIT and SG&A… excuse me, distribution SG&A. And that's were, I mean, I don't want to do the brain damage on the tax rate, but just the EBIT was lower than some of the models. And it look like just a big step up in distribution SG&A. And that were… after being flat for a couple of quarters sequentially it jumped up a lot and that's just where we were a little bit cut off relative to our own expectations.

It's hard to comment on the model. I think I'd just come back to if you were actually on track to a little bit above where we thought we'd be when we started this year and our guidance is above where we were when we started the year and that's even absorbing the $0.11 of charges, the $0.05, or $0.06 of OTN dilution. And there is a partial offset to those because our tax rate is a little lower than when we thought, thought at the beginning of the year, we have still one-time charges, but that $0.10 to $0.12 versus between the charges in OTN, you've got $0.17 or $0.18. So we feel pretty good about the operating results for the business relative to where we--.

And you're accepting this, you are expecting this to take sequential up tick in SG&A, in your expectation?

Again I guess… I would rather just look at the overall bottom line and say that we are comfortable and actually doing a little bit better than we thought we would be doing as we started the year.

I think maybe what's getting… because we have OTN in the business now and the expense associated with that business, perhaps that's where your model didn't have it and I don't know if you did... if you took the charges out and you put OTN in, then it is in line with what we had anticipated and with revenue growth as high as the revenue growth it drives incremental expenses. We can't offset all of that volume without incremental transportation expense and warehousing expense etcetera. So perhaps that's what's doing it. But if you actually look at the underlying cost structure of our distribution business, it's very well managed and we have great controls and we are getting great leverage in our back-office operations, on any one quarter you may see some noise in it, particularly because of these unusual things that flow through on occasion. But as Jeff mentioned, we are really pleased that our guidance can be where it is, after we have shown these purposeful negative hit status, like the restructurings and the conscious purchase of OTN, which all of those are drags in our performance and yet we are still really good… really in good position to finish strong for the year.

And my other question, going to the IT business, just a little more context, if you would on the charge you took and what's your... I know you have mentioned general comments about just aligning the businesses, but is this just trying to make per say better into the integrated whole and taking a chance to remove some duplication? I was just struggling to understand the restructuring charge there and exactly what you are after the longer-term?

You may recall that when we… as we were buying per se, we created a new segment called McKesson Technology Solutions and MTS is actually the combination of the old provider technology business, the creation that really help part of which is ex or old per say and the addition of the payor segment, moving it from distribution into this category. What that afforded us an opportunity to do is completely rethink our structure around management organization, around development activities, product construction, etcetera. And we purposefully said, always we wanted [ph] we're going to find ways to take cost out and take that overlap and streamline our processes. And so that's really what the charges resulted those continued views and some of that certainly might have been related to per se, but a lot of that was just related to the marginal look at the whole business to say what do we need, as we start to finish this year and try to enter '09 with a strong run at it.

Ricky Goldwasser. Please state your company name and you may ask your question.

UBS. And thank you for letting into the call. Just a few clarification questions, maybe I'm sorry [inaudible]. In fact, first of all, is this $3.22 to $3.32 of guidance is based on $0.68 in the quarter? And then secondly, if I look at an adjusted $0.79, are you backing the $0.11 back. Does that include a tax benefit, which we kind of calculated with $0.79. So it an ongoing basis, the adjusted number should really be $0.72 and then lastly, on Protonix I know it's been brought up a lot on this call. But I understand that you're not factoring interest conscious in your guidance, but now that you have the product in your warehouse, is Protonix now in this $3.22 to $3.32?

I think maybe we went backwards. Protonix is certainly in the guidance that we have just given you. The guidance is GAAP-based guidance, so it is based on the $0.68 this quarter and we think of the tax rate as… our expectation will be 33 for Q4, and we're pretty pleased by our efforts to work with the IRS and get some of the settlements we have. It's all in the GAAP results.

Our next and last question comes from Eric Coldwell. Please state your company name and you may ask your question.

It's Baird, being last I think everybody has covered my questions, so I'll bid you a good night. Thanks for the call.

Great. Thanks, Eric.

Thanks, Eric and thanks everyone for joining us on our call today. McKesson continued to have positive market momentum in our third quarter and with revenues up 15% and great progress across all of our businesses. We're really pleased with our excellent results for the first three quarters and we are now in our traditional strongest quarter. We remain very excited about our unique offering across healthcare and our ability to turn that into value for our customers and our shareholders. And I'll now hand the call over to Larry to give us a view of the upcoming events. Thank you.

Thanks, John. I have my usual preview of upcoming events, but first I'd like to make some personal comments. As many of you already know, I'll be retiring from McKesson early June after 11 years with the company. It's been a tremendous pleasure and terrific experience for me to work not only with my McKesson colleagues but also with all my friends in the financial community. I have great respect for the work you do to understand our company and our industry so that you can make informed recommendations and decisions for the people you advise and whose money you manage. Thanks to all of you for making the past 11 years. So, personally and professionally rewarding and so much fun. This is my last quarterly call as McKesson's Vice President of Investor Relations that's number 43 if you're counting. In mid-March Ana Schrank will succeed me as Vice President of Investor Relations. I will provide support and counsel to her during my final months here as she transitions into the position. Many of you know Ana from the three years she spent as Director of Investor Relations before moving on to her most recent position as Head of Credit for McKesson for the past four years where she made some very important contribution to the company. I know you will show her the same patience and respect that you've shown me these many years, and I wish both Ana and you continued great fortune. It's our plan to host a going-away party of sorts when we are in New York City in June for our Annual Investor Day and I look forward to seeing you all then to thank you personally for the support and good humor we've shared over the years. In closing, here are the upcoming activities we have for the financial community. On February 6th, we will present at the Merrill Lynch Global Pharmaceutical Conference in New York City; on February 25th, we will host our traditional Booth Side Briefing at the annual HIMSS meeting in Orlando; on March 19th, we will present at the Lehman Brothers Healthcare Conference in Miami. We plan to release and hold our call for fiscal 2008 fourth quarter results in the first week of May. Thank you and until we see each other in June, goodbye and take care.

Thank you. That concludes today's conference. You may now disconnect from the audio portion. Thank you for your participation.