Operator: Good day, ladies and gentlemen, and welcome to the Second Quarter 2010 Cardinal Health Earnings Conference Call. My name is Anne and I will be coordinator for today's call. (Operator Instructions). At this time, all participants are in listen-only mode. We will be facilitating a question-and-answer session following the presentation.
I would now like to turn the presentation over to Sally Curley, Senior Vice President of Investor Relations. Please proceed.
Sally J. Curley - SVP, IR: Thank you very much and welcome to Cardinal Health's second quarter fiscal 2010 conference call.
Today we will be making forward-looking statements. The matters addressed in these statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected or implied. Please refer to our SEC filings and the forward looking statements slide at the beginning of our presentation, which can be found on the Investor page of our website for a description of those risks and uncertainties.
In addition, we will reference non-GAAP financial measures. Any information about non-GAAP financial measures is included at the end of the slide. A transcript of today's call also will be posted on our Investor page, at cardinalhealth.com.
Before I turn the call over to our Chairman and CEO, George Barrett, I'd like to remind you of a few upcoming investor conferences in which we will be participating, notably the UBS Global Healthcare Services Conference in New York on Monday, February 8, the Raymond James Annual Institutional Investors Conference in Orlando, Florida on Tuesday, March 9, and the Barclays Capital Global Healthcare Conference in Miami on Tuesday, March 23. The details of these events are or will be posted on our IR section of our website, at cardinalhealth.com. So please make sure to visit that often for updated information.
Finally, I would like to ask you to please limit your questions to one with one follow-up in order to allow for others to ask questions.
Now, I'd like to turn the call over to George Barrett. George?
George S. Barrett - Chairman and CEO: Thanks, Sally. Good morning, everyone, and thanks for joining us on our second quarter call. For those of you following along with the presentation materials, my comments today will largely connect with slides 4 through 6 and Jeff will cover the others in his remarks.
Let me start by saying that I am really pleased with our performance during the second quarter and throughout the first half of fiscal 2010. Our businesses across the enterprise are executing well against our key initiatives and our people continue to demonstrate their commitment to doing the things necessary to drive long-term and sustainable value for our customers and our shareholders.
As a Company, we reported a 3% increase in revenues for Q2 and a non-GAAP EPS number of $0.57, up 12% over the prior year period. Our overall operating performance was better than we originally expected with a number of our key initiatives already taking hold and with Q2 numbers receiving some benefit from external factors that were more pronounced than we had anticipated.
Our medical segment has had particularly strong year-over-year performance to-date, and our pharmaceuticals segment has continued its momentum, performing considerably better than we expected in the second quarter. Having said this, we all recognize that this is a marathon, not a sprint, and we have both opportunities and challenges in front of us. I do believe that we're clear about our course and we're making the progress I had hope to see.
Customer focus remains the order of the day. As you've heard me say before, we continue to work on further improving the customer experience and we are seeing these efforts show up in our customer loyalty scores with notable gains over the past four quarters in retail independent pharmacy and hospital supply.
Before I talk about each segment specifically, let me comment briefly on our overall results. Our results reflect strong performance in our base business, and that was driven by a number of things, including early positive results from our generic initiatives, solid performance under our branded manufacture agreements, expansion of our retail independent book of business, exceptional performance in nuclear despite ongoing supply shortages, continued strong performance in lab, ambulatory and Canada, more effective selling strategies across the enterprise and disciplined expense control. I should mention here that we did repeat some significant benefit from external factors, which I'll touch on in my segment discussion and that Jeff will cover in more detail during his remarks.
Now, let me comment on each segment separately starting with pharmaceutical. Our pharma segment continued its momentum in Q2. Sales increased by 3% versus prior year with segment profit down 1%. This decline was less than we expected. The segment profit decline was driven primarily by the impact of the Medicine Shoppe franchise model transition, the drop in generic launch value versus the prior year period and the effect of contract re-pricing. These items were partially offset by the benefits we are seeing from our generic sourcing and selling initiatives, some earlier than expected brand price increases and excellent expense management.
Our pharma segment's sales mix in the quarter was 49% to bulk customers and 51% to non-bulk customers. We saw an uptick in sales growth to non-bulk customers at 7% versus the prior year period and a decline of 1% in sales to bulk customers. Within our bulk customer group, we've renewed a multiyear contract with Express Scripts during the quarter to supply pharmaceuticals through mid 2012.
As you know, we have a large and very important business supplying national retail chains, and I am very pleased with the strength of those relationships. But I've also indicated our desire to grow our retail independent direct store business. This is an important group of customers for us and we've seen both sequential and year-over-year sales growth. Additionally, generic sales to retail independent pharmacies were up 10% in Q2 versus the prior period. By the way, our generic sales growth across all channels was also up 10%. And the generic penetration rate, or as we call it 'share of wallet,' continued to expand, reaching its highest level in 18 months.
We were also very pleased to announce earlier this month a new multiyear agreement with American Associated Pharmacies or AAP to remain the exclusive pharmaceutical distributor for its nearly 2,000 independent pharmacy members, which includes the networks of Associated Pharmacies and United Drugs.
On the generic sourcing side, we are tracking well on the implementation of our redesigned sourcing model under the source program, which we believe provides incremental value to our customers, to Cardinal Health and to our generic partners.
You may remember from our call last August that we expected a difficult year-over-year comparison on generics primarily due to fewer generic launches in our fiscal 2010 and generic price deflation on certain key products. Our current full year view is that we are running favorable to that projected impact. Jeff will cover this in more detail.
The restructuring of our Medicine Shoppe business model is ongoing. We did add new franchises to the network for the first time in a long time. However, the conversion rate of existing stores moving from the old models to the new model is still lower than I'd like it to be. Despite the headwind, as we transition some franchisees from a royalty-centric model to a deeper long-term partnership on the supply side, we continue to believe that this change is a right strategic move for our customers and for Cardinal Health.
Our nuclear business performed very well in Q2 under extremely difficult circumstances. While raw material supply shortages had an impact on overall volume, the team continued to take care of customers and delivered excellent bottom line growth. Our nuclear team is very focused on the fact that there is an individual patient awaiting a critical diagnostic test connected to every dose they prepare and they work very closely with our customers to manage the supply constraints by staging orders and adjusting patient schedules where possible. Jeff will be providing an update on the nuclear generator supply situation in his remarks. Also of note, we continued to build out our PET footprint and the integration of the Cyclotron assets we acquired in Q1 from Biotech Pharmacy and Cyclotron is almost complete.
Turning to Medical, this segment had an extremely strong quarter with revenue growth of 9% and segment profit growth of 38%. We continue to be excited about our unique capabilities in both category and channel management and the potential for our portfolio of brand, self manufactured and private label products. While we're delighted with the Q2 results, the rate of profit growth was unusually high, boosted by significantly lower commodity prices and some benefit from the demand for flu-related products. That said, the underlying businesses are performing well. We saw another quarter of double-digit revenue growth and profit growth in lab as this channel continued its strong track record of performance helped somewhat by sales of flu-related products.
Ambulatory continues to pursue ways to grow both its customer footprint and share of wallet and also saw another quarter of double-digit revenue growth. Additionally, our collaboration with Allscripts for electronic health record is progressing well with a strong lead pipeline and a number of deals closed to-date. Canada had another exceptional quarter, posting both revenue and profit growth well in excess of 20%. New products and supplier agreements with some upside from foreign exchange and the demand for flu-related products fuelled this outstanding growth.
We are also making solid progress in our kitting business with the third consecutive quarter of profit growth and strong profit growth versus prior year. We've devoted considerable energy to improving its operational performance through a number of Lean Six Sigma projects. In the quarter, we also signed a five year exclusive distribution agreement to co-market the SurgiCount Safety-Sponge System. This system utilizes data matrix-bar codes to tag each item with an unique serial number to help prevent the retention of sponges and towels unintentionally left in patients during surgical procedures.
Sales in hospital supply were slightly positive and in line with our expectations. Margin improvement is a particular focus for this business. We continue to build out our preferred product category to brand, sub-manufacturer and private label products. This is an important strategic initiative and driver of margin improvement going forward.
To further improve our hospital penetration and support our customers, we've established a dedicated nursing sales organization, focused on products used in the nursing profession and are beginning to see traction here. And we're also on track to achieve the savings we targeted in our medical sourcing initiatives.
Our work on our medical business transformation continues to meet our timeline and budget expectations and our Q2 investment spending was in line with our forecast. We are quickly moving from the design stage to build stage of this project. This transformation forms the underpinning of our efforts to further reduce supply chain costs, while driving substantial improvements in our customer and supplier experiences, and we have some of our best and brightest assigned to this important work.
At an enterprise level, as I mentioned last quarter, expense and capital management remain key areas of focus. We are also managing our balance sheet carefully with a strong emphasis on reducing inventory days, particularly in our pharmaceutical distribution business, and we've been able to do this while maintaining high service levels. Jeff will cover the balance sheet in greater details in a moment.
Based on our performance in the first half of fiscal 2010 and our best assessment of the current environment, our view of the year has improved considerably. As a result, we increased our full year guidance and now expect our non-GAAP earnings to be in the range of $2.08 to $2.18. Jeff will walk you through our core assumptions underlying this.
Before I turn the call over to him, I would like to mention a few more things. First, our Board of Directors recently added another two directors, Dr. James Mongan and Carrie Cox, bringing the Board to 12 members. Jim is a well known hospital CEO, most recently leading Partners HealthCare System until his retirement last month and a visionary leader and educator. Carrie brings a wealth of experience from her 30 years in biopharmaceuticals and healthcare, most recently serving as President of Global Pharmaceuticals at Schering-Plough. We've built an exceptional Board and the additions we've made over the past six months bring additional expertise and perspectives from across many dimensions of healthcare, including pharma, biotech, generics and healthcare providers. And I look forward to working closely with the entire Board as we continue to move the Company forward.
Second, on the topic of healthcare reform, it's has been an extraordinary couple of months and an eventful last few weeks. I will say that the fundamental challenges that our healthcare system faces are no different today than they were last quarter. We have a system capable of delivering superb medical care, but we also have tens of millions of people in this country who are unable to access affordable healthcare. Whether the system evolves by market base forces or through the legislative process, we do believe that this issue will need to be tackled and we will continue to be deeply engaged in Washington as things move forward.
Third, I did want to comment briefly on the situation in Haiti. Like all of you, we've observed the aftermath of the massive earthquake in Haiti with horror. We prefer not to say too much about our support, but I do want to remind our shareholders that we take a responsibility as a healthcare company seriously and we have acted immediately and directly with relief organizations, the Department of Defense and their partners to do our part to help address critical needs. I am proud that the people of Cardinal Health once again responded instantly and in meaningful ways, and I would like to take this opportunity to acknowledge their tireless efforts.
And finally, let me end by saying that I feel good about our progress and what we've accomplished to this point. Our organization is fully aligned around our strategic priorities with a strong focus on execution and improving the customer experience. And while the results are beginning to show, we know not to get too far ahead of ourselves as there's still much to do.
With that, I'll hand the call over to Jeff for more details on the quarter.
Jeff Henderson - CFO: Good morning, everyone, and thanks for joining us. Let me begin by echoing George's comments. I am very pleased and encouraged by our results in the second quarter and the first half of our fiscal year. George provided a good overview over Q2 result and key drivers. So rather than rehash all the financials, I'm going to focus my presentation this morning on providing some additional details related to Q2 and then spend some time going through our outlook for the remainder of the year.
First, some added comments on the business performance. As you may recall, at the beginning of the year we identified a couple of key performance metrics that we needed to focus our attention on in a laser-like fashion; margin expansion and working capital. Due to a number of the performance initiatives that George has already referenced, including our generic programs, focusing on retail independent growth and penetration, strong performance in nuclear medical businesses, expense controls and working capital efficiency, we've made some great progress, which I'd like to elaborate on.
First, on margins, I'll be the first to say that one or two quarters worth of margin trends doesn't necessarily tell a complete story, particularly given the quarterly volatility we can often see based on external factors. However, margin trends and their key drivers remain an extremely closely monitored metric for us. So I believe it's important to comment on our status here at this midpoint in our year. Both sequentially and year-on-year we have seen gross margin rate and operating margin rate expansion as an overall Company. In fact, consolidated gross margin and operating margin rates are up 5 and 4 basis points respectively versus last year. This is in spite of the fact that our very large pharma bulk business, which represents close to 50% of the pharma segment revenue, has experienced declining margins due to large customer re-pricings.
Some of the biggest profit margin gains are being seen in our medical, nuclear and pharma retail independent lines of businesses, all of which have been key areas of focus. Medical segment profit is up almost 100 basis points to 4.95%, driven by both strong performance in a number of our channels and by external factors, such as raw material costs and the strong flu season. Within the pharma retail independent customer channel segment profit margins are up 37 basis points versus last year, a very direct consequence of our focus on continuing to build important business and increased generic penetration.
Turning to working capital, we've continued to see the focus in this area pay dividends. Although sequentially days of inventory were up in Q2 due to the normal seasonal build at calendar year-end, the year-on-year comparison show the reduction of another day due to the efforts of our pharma distribution operating team and its Lean Six Sigma programs. At the same time, our accounts receivables days have reduced slightly. These combined with our earnings performance helped to generate $524 million of operating cash flow in Q2, bringing our year-to-date number to $931 million. In summary, we are making some real progress with our performance initiatives and it's showing in the key metrics we track.
Now, to continue on Q2, let me add a couple of additional details to what George covered. I'll start with the business segments. As George said, we are pleased with the business and financial progress in our pharma segment, which was better than we anticipated. Revenue in the segment was up 3%, comprised of 7% growth for non-bulk and a 1% decline for bulk customers. The decline in bulk was driven by both timing of orders versus last year, and the impact of a loss of a large mail order customer that we have referenced in previous communications.
From a segment profit perspective, we are meaningfully benefited by the progress in our generic initiatives, which helped to offset a portion of the headwind we experienced from the decline in value of generic launches versus last year. We also had a strong quarter from a branded buy margin standpoint, as brand inflation and fees contributed materially to growth, offsetting much of the negative impact on the Medicine Shoppe transition. So, margin erosion was largely as we originally modeled, driven by some previous large contract re-pricings, with some of the impact being later than originally anticipated. This last factor benefited the first half of the year, including Q2. Finally, due to strong expense controls, SG&A in this segment was down over 4% year-on-year.
In the medical segment, in addition to strong business performance, our Q2 benefited from certain external factors, including commodity price changes, which were worth close to $19 million of benefit in material costs versus last year and a continued strong flu season, which was worth about $6 million incrementally. These benefits largely offset the increase in segment expense during the quarter, which was driven by our significant transformational project spend. Regarding the flu season, I will say we are starting to see that impact moderate considerably as we go through January.
Finally, at the overall corporate level, let me cover a few items. Non-GAAP operating expense is up over 3% from last year, driven by our considerable investment spend, incentive compensation accruals and the impact of acquisitions. If you exclude those drivers, which represent about 6 percentage points of growth, our core SG&A is down meaningfully, reflecting the continued focus we have in this area.
In our other income section of the income statement, you may note that we reported $6 million of non-GAAP other income, a fairly large improvement compared to last year's expense of almost $20 million. This favorable compare is somewhat unique to this quarter and is primarily due to the impact of deferred compensation and foreign exchange swaps in last year's Q2. Both these items were decidedly negative in FY '09 due to the extraordinary financial market events that transpired that quarter.
Our non-GAAP tax rate for the quarter was 38.5% versus 38% flat last year. The higher rate in the current quarter was attributable to changes in income mix and a couple of small discrete items. Also during the quarter, the repurchase of approximately $50 million of Cardinal Health shares under our current $500 million share authorization program, leaving average diluted shares outstanding for the quarter at $361 million. On the balance sheet, we finished the quarter with over $1.7 billion of cash, approximately $400 million of which is overseas. Also, we had a $350 million note come due during October, which leaves us with a long-term debt balance of $2.1 billion.
Now, let me turn you to slide 7 and take a moment to walk you through the items that accounted for the difference in our GAAP and non-GAAP EPS numbers. We had several items this quarter that caused our GAAP earnings to be higher than our non-GAAP. All these figures that I'll review are on an after-tax basis. The biggest item in this category is a $20 million gain from sales of 5.5 million shares of CareFusion stock. I'll expand on this item in more detail shortly.
We also had $60 million of income from an insurance recovery that was a result of an escrow release from a previously settled lawsuit. Restructuring and employee severance, along with other spin-off-related costs made up approximately $12 million and partially offset the two gains I just mentioned. The total positive impact to GAAP EPS in these items was $0.07 for the quarter, taking our GAAP EPS from continuing operations up from $0.57 to $0.64.
Now, turning to slide 8 and more detail our CareFusion stake. As mentioned earlier, during Q2 we sold 5.5 million shares that generated $135 million in proceeds and a gain of $20 million. We've accrued no tax on the proceeds of this sale. After these share sales, we now hold 35.9 million in shares of CareFusion stock, which had a value of $897 million at December 31. During Q2, we had a pre-tax unrealized gain in this remaining ownership of $115 million, which does not have an earnings impact until the share is actually sold and capital gains or losses are recognized.
As we've said in the past, in order to maintain the tax free nature of the spin-off, we need to divest the remaining shares within five years from the spin-off date. We intend to complete this within the next 18 months and are continuing to assess the best method and timing to do this based on market conditions and other factors.
Now, let's review our FY '10 outlook. Before I turn to slides 10 to 13, let me begin with some framing comments about how we now view the full year from a forecast perspective, particularly given our strong financial performance in the first half of the year. Clearly, we're off to a good start in the first half, much stronger than we anticipated heading into the year. This is being driven by two major categories of items.
First, we've had very good execution against our key initiatives in the first half of the year, including our generic programs, our progress in retail independents and strong performance in our medical businesses. I would fully expect that we continue that operational momentum into the second half. We've also had benefit from some certain external factors, including generic launches that are happening at a higher value level than we had planned, less deflation on our few specific generic products, compensation from our branded vendors relative to price increase and fee timing and the demand created from a stronger and early flu season. For the full year, although we'll get some net benefit from those factors, we are assuming that they largely normalize out in the second half of the year.
So, in total, the sum of these items is a considerable improvement in our view for the full year, which is reflected in our guidance being raised. However, we are also seeing a change in our distribution of earnings for the year, with the first half being disproportionately benefited from some of the external factors I just outlined.
With that overall backdrop, let me provide you some more specific assumptions by segment. Our pharmaceutical segment assumptions are shown on slide 10. The market factors and headwinds for the year are the same ones that we've spoken about previously, although, as I indicated, the amount and timing of the realization may have shifted somewhat.
First, as I mentioned, earlier than anticipated branded buy margin we realized in the first half represents what we believe to be a pull forward of $0.04 to $0.05 into the first half of our fiscal year from our second half. The negative year-on-year impact of generic launches and deflation was better in the first half than we anticipated, again, due to several unplanned launches and a slower deflation on a couple of products launched last year. We now expect the full year negative impact of this headwind to be approximately $75 million. This compares to the $100 million figure we spoke of on our August 2009 call. The financial impact of our Medicine Shoppe transition is happening generally in line with our expectations.
Finally, let me comment on the nuclear generator supply situation as we see it. With the shutdown of the Chalk River reactor in Canada, technetium supply levels remain challenging and can range anywhere from 20% to 80% of normal supply levels. Based on recent reports from Atomic Energy of Canada, we expect that their reactor will not be fully operational until April. At the same time, the reactor in the Netherlands is scheduled for maintenance beginning mid February and is expected to be down for approximately 180 days. We have aggressive action plans underway to mitigate its impact for our customers and their patients as much as possible. However, there will likely be some impact of this disruption and our updated guidance reflects an unfavorable EPS impact of $0.01 to $0.02 in the second half.
Our medical segment assumptions on slide 11 are largely unchanged from August 2009 when we first presented them. First half actual results show segment revenue growth to be above the overall market, driven by our mix shifts and strong growth in Canada, ambulatory and lab. We expect this to continue for the full year. However, as you recall in Q1, we also benefited from accelerated revenue and income recognition related to the CareFusion spin. Obviously, that one-time benefit doesn't repeat itself.
Also in the first half of 2010, we saw greater benefit from commodity raw material prices and flu-related sales at a greater level than we had originally projected. These are expected to continue at the same rate into Q3. In fact, given oil price movements over the past six to nine months, second half year-over-year benefit from commodity prices will be significantly less than we realized in the first half of the year.
A final important word on the earnings outlook for the medical segments during Q3. As you've seen, this segment has reported robust growth for the first half of the year and is expected to finish the year with strong full year results. However, Q3 will be an anomaly in this regard, as we are actually expecting a segment profit decline during this quarter despite underlying improving fundamentals. This is driven by a particularly strong Q3 we reported last year related to some one-time customer rebates and other items, which improved our cost of goods sold, making for a tough year-on-year compare. This is exacerbated by continued high investment spend in this year's Q3 and a lessened benefit from commodity prices that I previously mentioned. With that all said, we do expect the medical segment to grow its Q3 earnings sequentially from Q2.
We've updated our corporate assumptions for fiscal 2010 on slide 12. Note that we now expect to end the year with a non-GAAP tax rate north of 37%, although we should point out that there could be few isolated events each quarter that may affect it in either direction. We expect weighted average shares outstanding to come in around $361 million. We now expect the combination of net interest expense and other to be approximately $110 million. We continue to forecast our capital expenditures to be in a range of $200 million to $250 million.
Finally, although we don't generally give regular guidance on cash flow, I did want to update my answer to a question from earlier in the year where I indicated that FY '10 operating cash flow would be less than $1 billion. Given the favorability in our cash flow during the first half of our fiscal year, we now anticipate that number to be north of $1 billion. So, taking all these items into account, as George referenced earlier, we are changing our expected non-GAAP earnings per share to be in the range of $2.08 to $2.18.
I know that was a lot of detail. Hopefully, it was helpful. I'll turn the call over to George now for Q&A.
George S. Barrett - Chairman and CEO: Operator, I think we'll leave it to you now to start the Q&A.