UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K/A

(Amendment No. 1)

 

 

Commission File Number: 1-11373

CARDINAL HEALTH, INC.

(Exact name of registrant as specified in its charter)

 

 

(614) 757-5000

Registrant’s telephone number, including area code

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:

None.

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes þ     No o

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  þ     Accelerated filer  o     Non-accelerated filer  o

 

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes o     No þ

 

The aggregate market value of voting stock held by non-affiliates of the registrant on December 31, 2006, based on the closing price on December 29, 2006, was $25,526,961,564.

 

The number of registrant’s Common Shares outstanding as of August 23, 2007, was as follows: Common Shares, without par value: 364,529,773.

 

Documents Incorporated by Reference:

 

Portions of the registrant’s Definitive Proxy Statement to be filed for its 2007 Annual Meeting of Shareholders are incorporated by reference into Part III of this Annual Report on Form 10-K.

 

     Cardinal Health, Inc. (the “Company”) is filing this Amendment No. 1 on Form 10-K/A (“Amendment No. 1”) to amend its previously filed Annual Report on Form 10-K for the fiscal year ended June 30, 2007, as filed with the Securities and Exchange Commission (“SEC”) on August 24, 2007. The purpose of this Amendment No. 1 is to respond to a comment received from the staff of the SEC and amend the Company’s disclosures in Item 7 and Item 8 to remove references to the work of independent third parties as follows:

	•		The third paragraph under “Special Items” (page 31 of the original Form 10-K) was amended to remove a reference to an independent third-party appraisal.
	•		The first paragraph under “Business Combinations” (page 43 of the original Form 10-K) was amended to remove a reference to the Company utilizing third-party valuation experts.
	•		The second paragraph under “Business Combinations” (page 44 of the original Form 10-K) was amended to remove a reference to valuation experts.

	•		The fourth paragraph under Note 2, “Business Combinations” (page 69 of the original Form 10-K) was amended to remove a reference to an independent third-party appraisal.

•

The fourth paragraph (subtitled “IPR&D Costs”) under “Acquisition Integration Charges” under Note 3, “Special Items” (page 74 of the original Form 10-K) was amended to remove a reference to an independent third-party appraisal.

	•		The second paragraph under Note 4, “Investments” (page 77 of the original Form 10-K) was amended to remove a reference to a valuation performed by an independent third party.

     Except as described above, no other changes have been made to the Form 10-K, and this Amendment No. 1 does not amend, update or change any other information contained in the Form 10-K. Information not affected by the changes described above is unchanged and reflects the disclosures made at the time of the original filing of the Form 10-K on August 24, 2007. Accordingly, this Amendment No. 1 should be read in conjunction with the Company’s filings made with the SEC subsequent to the filing of the Form 10-K, including any amendments to those filings.

     In accordance with Rule 12b-15 promulgated under the Securities Exchange Act of 1934, as amended, the complete text of Item 7 and Item 8 is set forth herein, including those portions of the text that have not been amended from that set forth in the original Form 10-K.

 

The discussion and analysis presented below refers to and should be read in conjunction with the consolidated financial statements and related notes included in this Form 10-K. Unless otherwise indicated, throughout this Management’s Discussion and Analysis of Financial Condition and Results of Operations, discussion of matters in the Company’s consolidated financial statements refers to continuing operations. The Company’s discussion of results of operations is presented in four parts: Company Overview, Consolidated Results of Operations, Segment Results of Operations and Other Matters.

 

Company Overview

 

Strategic Overview

 

Cardinal Health is a leading provider of products and services that improve the safety and productivity of healthcare. The Company is one of the largest distributors of pharmaceuticals and medical supplies focusing on making supply chains more efficient. The Company distributes approximately one-third of all pharmaceuticals prescribed in the United States and also distributes or manufactures products that are used in approximately 50% of all surgeries in the United States. The Company develops market-leading technologies, including Alaris infusion pumps, Pyxis automated dispensing systems, MedMined^tm electronic infection surveillance, Viasys respiratory care products and the Care Fusion^tm patient identification system. The Company’s Pyxis and Alaris systems distribute approximately 8.5 million doses of medication every day. Customers include hospitals and clinics, some of the largest drug store chains in the United States and many other healthcare providers and retail outlets. The Company believes that its depth and breadth of products is unique in the industry and gives it a competitive advantage.

Cardinal Health’s mission is to make the practice and delivery of healthcare safer and more productive for healthcare providers. Over the last fiscal year the Company made three major changes to better pursue its mission:

 

 

First, the Company reorganized its reportable segments effective the first quarter of fiscal 2007 and began reporting its financial information within the following five reportable segments: Healthcare Supply Chain Services — Pharmaceutical; Healthcare Supply Chain Services — Medical; Clinical Technologies and Services; Pharmaceutical Technologies and Services; and Medical Products Manufacturing. This change in segment reporting resulted from a realignment of the individual businesses to better correlate the operations of the Company with the needs of its customers. This change had no effect on the Company’s reported net earnings or net earnings per Common Share.

 

Second, during the fourth quarter of fiscal 2007, the Company completed the sale of the PTS Business for approximately $3.2 billion in cash. The Company used the after-tax net proceeds of approximately $3.1 billion to repurchase its Common Shares. The Company recognized an after-tax book gain of approximately $1.1 billion from this transaction. The assets and liabilities of the PTS Business were classified as held for sale in prior periods and its operating results were classified within discontinued operations for all periods presented. See Note 8 in the “Notes to Consolidated Financial Statements” for additional information on the Company’s discontinued operations.

 

The Company’s remaining four segments after the sale of the PTS business align within two sectors: the Healthcare Supply Chain Services sector, which includes the Healthcare Supply Chain Services — Pharmaceutical and Healthcare Supply Chain Services — Medical segments, and the Clinical and Medical Products sector, which includes the Clinical Technologies and Services and Medical Products Manufacturing segments. The Healthcare Supply Chain Services sector focuses on delivering best-in-class distribution and logistics services to its customers. The sector generates 95% of total segment revenue, approximately three-quarters of total segment profit (as defined below in the “Segment Results of Operations” section) and consistent and reliable cash flow. The Clinical and Medical Products sector focuses largely on developing innovative products for hospitals and other providers of care. The sector, with its higher margin products and services and faster growing segment profit has grown to contribute approximately one-fourth of total segment profit.

 

Third, during fiscal 2007, the Company acquired Viasys, MedMined and Care Fusion along with other acquisitions. Viasys is a leader in respiratory care through the development and marketing of systems for critical care and diagnostic use and offers products and services directed at critical care ventilation, respiratory diagnostics and clinical services, neurological, vascular, audio, homecare, orthopedics, sleep diagnostics and other medical and surgical products markets. The value of the transaction, including the assumption of Viasys’s debt, totaled approximately $1.5 billion. Viasys is being integrated into the Medical Products Manufacturing segment. The Company also acquired MedMined, a leader in tracking and predicting infection management opportunities within major hospitals and Care Fusion, which focuses on bedside bar code utilization for tracking hospital samples. Both businesses are being integrated into the Clinical Technologies and Services segment. For further information regarding the Company’s acquisitions see “Item 1 — Business — Acquisitions and Divestitures,” “Other Matters — Acquisitions” below and Note 2 of “Notes to Consolidated Financial Statements.”

 

For further information regarding the Company’s business, see “Item 1 — Business” within this Form 10-K.

 

Financial Overview

 

Continued demand for the Company’s products and services in fiscal 2007 led to revenue of $86.9 billion, up 9% from fiscal 2006. Operating earnings, which were negatively impacted by special items ($772 million), decreased 26% to approximately $1.4 billion. The significant increase in special items related to reserves for litigation settlements ($655 million) and in-process research and development (“IPR&D”) expenses primarily in connection with the Viasys acquisition ($85 million). The year-over-year operating earnings comparison was

favorably impacted by increased gross margin ($431 million) partially offset by increases in selling, general and administrative expenses ($200 million). Net earnings, which included the gain from the sale of the PTS Business ($1.1 billion), were $1.9 billion and net diluted earnings per Common Share were $4.77.

 

Fiscal 2007 cash from operating activities decreased $898 million to $1.2 billion primarily due to the payment of litigation settlement reserves and government fines ($690 million) as discussed in the “Special Items” section below. Cash provided by investing activities was $1.5 billion due primarily to net proceeds from the PTS Business divesture ($3.1 billion) offset by cash paid for acquisitions ($1.6 billion). Cash used in financing activities was $2.6 billion due to the Company’s cash payments for treasury shares ($3.7 billion) offset by net proceeds from borrowings ($631 million) and issuance of shares ($553 million).

 

During fiscal 2007, the Company repurchased approximately $3.8 billion of its Common Shares under a $4.5 billion repurchase authorization of which $3.7 billion was settled prior to year-end. On August 8, 2007, the Company announced a new $2.0 billion share repurchase program which expires on August 31, 2009. See the table under “Item 5 — Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities” for more information regarding the share repurchases. Also during fiscal 2007, the Company paid $144 million in dividends or $0.36 per share. In the fourth quarter of fiscal 2007, the Board of Directors raised the quarterly dividend by 33% to $0.12 per share. The share repurchase activity (apart from the use of net proceeds from the PTS Business divestiture) and increased dividend payments support the Company’s previously stated long-term goal to return 50% of net cash provided by operating activities from continuing operations to shareholders and to increase its dividend payout to 20% of earnings per share.

 

Consolidated Results of Operations

 

The following table summarizes the Company’s consolidated results of operations for the fiscal years ended June 30, 2007, 2006 and 2005 (in millions, except per Common Share amounts):

 

 

 

 

 

Revenue

 

Revenue increased $7.2 billion or 9% during fiscal 2007 due to growth in each of the Company’s four reportable segments, including revenue growth of $6.5 billion within the Healthcare Supply Chain Services — Pharmaceutical segment, due primarily to growth in revenue from bulk customers ($4.0 billion). The increase in revenue from bulk customers was due to certain existing customers deciding to purchase a greater volume of product from the Company rather than directly from the manufacturer and to pharmaceutical price appreciation. The Company uses the internal metric “pharmaceutical price appreciation index” to evaluate the impact of pharmaceutical and consumer product price appreciation on revenue from the pharmaceutical supply chain business. This metric is calculated using the change in the manufacturer’s published price at the beginning of the period as compared to the end of the period weighted by the units sold by the pharmaceutical supply chain business during the period. The pharmaceutical price appreciation index was 6.3% during fiscal 2007. The Healthcare Supply Chain Services — Pharmaceutical segment represents approximately 86% of total segment revenue. Refer to “Segment Results of Operations” below for further discussion of the specific factors affecting revenue in each of the Company’s reportable segments.

 

Revenue increased $7.0 billion or 10% during fiscal 2006 due to increased revenue within each of the Company’s four reportable segments, including revenue growth of $6.4 billion within the Healthcare Supply Chain Services — Pharmaceutical segment, due primarily to growth in revenue from bulk customers ($5.8 billion). The increase in revenue from bulk customers was due to overall market growth and certain existing customers deciding to purchase a greater volume of product from the Company rather than directly from the manufacturer. The pharmaceutical price appreciation index was 5.6% during fiscal 2006.

 

Cost of Products Sold

 

Cost of products sold increased $6.8 billion or 9% and $6.6 billion or 10%, respectively, for the fiscal years ended June 30, 2007 and 2006. The increases in cost of products sold were mainly due to the respective 9% and 10% growth in revenue for fiscal 2007 and 2006. See the “Gross Margin” discussion below for further discussion of additional factors impacting cost of products sold.

 

Gross Margin

 

Gross margin increased $431 million or 9% for the fiscal year ended June 30, 2007 over the prior fiscal year. The increase in gross margin was primarily due to revenue growth of $7.2 billion. Factors favorably impacting gross margin included increased sales of clinical and medical products and related services ($204 million), increased manufacturer cash discounts ($193 million), generic pharmaceutical margin ($192 million) and distribution service agreement fees and pharmaceutical price appreciation (combined impact of $171 million). Gross margin was negatively impacted by the increase in customer discounts within the Healthcare Supply Chain Services — Pharmaceutical and Healthcare Supply Chain Services — Medical segments ($324 million) due to increased sales and competitive pricing pressures. Refer to the “Segment Results of Operations” below for further discussion of the specific factors affecting gross margin in each of the Company’s reportable segments.

 

Due to the competitive markets in which the Company’s businesses operate, the Company expects competitive pricing pressures to continue; however, the Company expects the margin impact of these pricing pressures will be mitigated through sales growth of higher margin manufactured products, effective product sourcing, realization of synergies through integration of acquired businesses and continued focus on cost controls.

 

Gross margin increased $354 million or 8% for the fiscal year ended June 30, 2006. The increase in gross margin was primarily due to revenue growth of $7.0 billion. Gross margin was favorably impacted by increased gross margin in clinical and manufactured products and related services ($211 million) and manufacturer cash discounts ($139 million) and distribution service agreement fees and pharmaceutical price appreciation (combined impact of $134 million) from the pharmaceutical supply chain business within the Healthcare Supply Chain

Services — Pharmaceutical segment. Gross margin was negatively impacted by increased customer discounts ($232 million) in the pharmaceutical supply chain business.

 

Selling, General and Administrative (“SG&A”) Expenses

 

SG&A expenses increased $200 million or 7% during fiscal 2007 primarily in support of revenue growth. Additional items impacting SG&A expenses included increases due to acquisitions ($72 million) and the Company’s charitable contribution to the Cardinal Health Foundation ($30 million). SG&A expenses were favorably impacted by the year-over-year reduction in equity-based compensation expense ($70 million). The reduction in equity-based compensation expense was due in part to changes made to the Company’s equity compensation program and the grant of stock appreciation rights in the prior year. Refer to “Segment Results of Operations” below for further discussion of the specific factors affecting SG&A expenses in each of the Company’s reportable segments.

 

The Company expects SG&A expenses to grow in fiscal 2008 in support of sales growth and new product and service offerings and as a result of the impact of acquisitions and continued investment in research and development projects and international expansion; however, the Company does expect to generate expense efficiencies through the integration of acquired companies and other cost controls.

 

SG&A expenses increased $385 million or 15% during fiscal 2006 primarily in support of the $7.0 billion revenue growth and as a result of increased equity-based compensation expense ($199 million), primarily due to the adoption of SFAS No. 123(R). See “Other Matters — Adoption of SFAS No. 123(R)” below and Note 18 of “Notes to Consolidated Financial Statements” for additional information regarding equity-based compensation. Additional items impacting SG&A expenses included increased incentive compensation expense ($36 million) due to improved operating performance, incremental expenses associated with the Company’s global restructuring program ($38 million) and increased legal expenses ($15 million) due to then-outstanding litigation.

 

Impairment Charges and Other

 

The Company recognized impairment charges and other of $17 million, $6 million and $38 million, respectively, for the fiscal years ended June 30, 2007, 2006 and 2005. See Note 3 of “Notes to Consolidated Financial Statements” for additional information regarding impairment charges and other.

 

Special Items

 

The following is a summary of the Company’s special items for the fiscal years ended June 30, 2007, 2006 and 2005 (in millions):

 

 

Fiscal 2007 special items charges primarily related to reserves for litigation settlements ($655 million) and IPR&D expenses ($85 million) primarily in connection with the Viasys acquisition. The Company recorded litigation charges and made payment of $655 million during fiscal 2007 related to the settlement of the Cardinal Health federal securities litigation ($600 million), Cardinal Health ERISA litigation ($40 million) and other matters. These charges were offset by $29 million of income related to pharmaceutical manufacturer antitrust litigation. In addition, the Company settled and made payment for the penalty associated with the SEC investigation ($35 million), which was reserved in fiscal 2006 and 2005. These settlements resolve some of the Company’s most significant outstanding litigation as well as the SEC investigation. In fiscal 2008, the Company expects to recognize approximately $58 million in proceeds as income from insurance policies upon final settlement of all claims in shareholder derivative actions. See Note 12 of the “Notes to Consolidated Financial Statements” for further discussion of these matters and other outstanding legal proceedings and regulatory matters.

During fiscal 2007, the Company recorded $85 million of IPR&D charges primarily associated with the Viasys acquisition. The IPR&D charges represent the estimated fair value of the research and development projects in-process at the time of the acquisition. These projects had not yet reached technological feasibility, were deemed to have no alternative use and, accordingly, were immediately charged to operating expense at the acquisition date.

 

Fiscal 2006 and 2005 special items charges primarily related to the Company’s restructuring programs, the SEC investigation and Audit Committee internal review, the integration costs of certain acquisitions and settlements received from vitamin antitrust litigation. See Note 3 of the “Notes to Consolidated Financial Statements” for details of the Company’s special items.

 

Operating Earnings

 

Operating earnings decreased $471 million or 26% during fiscal 2007, which includes increased special items charges ($692 million) and impairment and other charges ($12 million). Operating earnings were favorably impacted by gross margin growth ($431 million) and negatively impacted by increased SG&A expenses ($200 million).

 

Operating earnings increased $63 million or 4% during fiscal 2006. Operating earnings were favorably impacted by gross margin growth ($354 million) and the year-over-year decrease in special items charges ($61 million) and impairment charges and other ($33 million). Fiscal 2006 operating earnings were negatively impacted by increased SG&A expenses ($385 million).

 

Interest Expense and Other

 

Interest expense and other increased $17 million or 16% during fiscal 2007 primarily due to increased borrowing levels and interest rates. Interest expense and other decreased $13 million during fiscal 2006 primarily due to an increase in investment income ($7 million) and foreign exchange gains ($4 million).

 

Provision for Income Taxes

 

The provisions for income taxes relative to earnings before income taxes and discontinued operations were 32.9%, 33.2% and 35.9% of pretax earnings in fiscal 2007, 2006 and 2005, respectively. Generally, fluctuations in the effective tax rate are due to changes within international and U.S. state effective tax rates resulting from the Company’s business mix and changes in the tax impact of special items, which may have unique tax implications depending on the nature of the item and the taxing jurisdiction. The Company’s effective tax rate reflects tax benefits derived from increasing operations outside the United States, which are generally taxed at rates lower than the U.S. statutory rate of 35%. The Company has tax incentive agreements in several non-U.S. tax jurisdictions which will expire in fiscal years 2009 through 2024 if not renewed. The Company does not believe that potential changes from existing tax incentive agreements will have a material adverse effect on the Company’s financial position or results of operations.

 

The Company’s fiscal 2007 provision for income taxes relative to earnings before income taxes and discontinued operations was $412.6 million and the effective tax rate was 32.9%. The fiscal 2007 effective tax rate benefited by 0.2 percentage points from equity-based compensation expense, which is deductible at a tax rate higher than the average tax rate. The fiscal 2007 effective tax rate was adversely impacted by 0.75 percentage points due to the non-deductibility of certain special items and impairments, principally the IPR&D charge related to the Viasys acquisition.

 

With few exceptions, the Company is no longer subject to U.S. federal or non-U.S. income tax audits by tax authorities for fiscal years ending before June 30, 2001. The years subsequent to fiscal 2000 contain matters that could be subject to differing interpretations of applicable tax laws and regulations as it relates to the amount and/or timing of income, deductions and tax credits. The Internal Revenue Service (“IRS”) currently has ongoing examinations of open years from 2001 through 2005. Although the outcome of tax audits is always uncertain, the Company believes that adequate amounts of tax and interest have been provided for any adjustments that are expected to result for these years. While it is not currently possible to predict the impact of settlements or other IRS

audit activity on income tax expense or cash flows during the next 12 months, the Company does not expect any significant impact on financial position.

 

During the first quarter of fiscal 2007, the effective tax rate from continuing operations was favorably impacted by a $9.9 million adjustment to the tax reserves primarily due to the issuance of a final IRS Revenue Agent Report that related to fiscal years 2001 and 2002. During the second quarter of fiscal 2007, the effective tax rate from continuing operations was negatively impacted by a $7.3 million adjustment to the tax reserves related to an ongoing international tax audit. During the third quarter of fiscal 2007, the Company entered into an agreement with the IRS to close the fiscal years 1996 through 2000 federal audits. As a result, the Company reversed tax reserves of approximately $8.9 million.

 

The Company’s fiscal 2006 provision for income taxes relative to earnings before income taxes and discontinued operations was $577.1 million and the effective tax rate was 33.2%. The fiscal 2006 effective tax rate was adversely impacted by 0.2 percentage points due to the non-deductibility of certain special items.

 

A provision of the American Jobs Creation Act of 2004 (“AJCA”) created a temporary incentive for U.S. corporations to repatriate undistributed income earned abroad by providing an 85% dividends received deduction for certain dividends from non-U.S. subsidiaries. During the fourth quarter of fiscal 2005, the Company determined that it would repatriate $500 million of accumulated non-U.S. earnings in fiscal 2006 pursuant to the repatriation provisions of the AJCA, and accordingly, the Company recorded a related tax liability of $26.3 million as of June 30, 2005. The $500 million is the maximum repatriation available to the Company under the repatriation provisions of the AJCA. During fiscal 2006, the Company repatriated $494 million of qualifying accumulated foreign earnings in accordance with its plan adopted during fiscal 2005. An additional tax liability of $0.4 million was recorded during fiscal 2006 due to new state legislation with respect to the AJCA, bringing the Company’s total tax liability related to the repatriation recorded through June 30, 2006 to $26.7 million. Uses of repatriated funds included domestic expenditures related to non-executive salaries, capital asset investments and other permitted activities. See Note 11 of “Notes to Consolidated Financial Statements” for additional information.

 

Discontinued Operations

 

Earnings from discontinued operations, net of tax increased by $1.3 billion during fiscal 2007 primarily due to the after-tax gain on the sale of the PTS Business ($1.1 billion) and impairment charges from prior year ($185 million). See Note 8 in “Notes to Consolidated Financial Statements” for further information on the Company’s discontinued operations.

 

Segment Results of Operations

 

Reportable Segments

 

The Company’s operations are organized into four reportable segments: Healthcare Supply Chain Services — Pharmaceutical; Healthcare Supply Chain Services — Medical; Clinical Technologies and Services; and Medical Products Manufacturing. The Company evaluates the performance of the individual segments based upon, among other things, segment profit. Segment profit is segment revenue less segment cost of products sold, less segment SG&A expenses. Segment SG&A expense includes equity compensation expense as well as allocated corporate expenses for shared functions, including corporate management, corporate finance, financial shared services, human resources, information technology, legal and legislative affairs and the integrated sales organization. Corporate expenses are allocated to the segments based upon headcount, level of benefit provided and ratable allocation. Information about interest income and expense and income taxes is not provided at the segment level. In addition, special items, impairment charges and other and investment spending are not allocated to the segments. See Note 17 in the “Notes to Consolidated Financial Statements” for additional information on the Company’s reportable segments.

 

Revenue increased in each of the Company’s four reportable segments during fiscal 2007, including double-digit growth in the Medical Products Manufacturing (12%) and Clinical Technologies and Services (11%) segments. Segment profit increased in each of the Company’s four reportable segments, including double-digit

growth in the Medical Products Manufacturing (20%), Clinical Technologies and Services (20%) and Healthcare Supply Chain Services — Pharmaceutical (14%) segments.

 

The following table summarizes segment revenue for the fiscal years ended June 30, 2007, 2006 and 2005 (in millions):

 

 

 

 

The following table summarizes segment profit for the fiscal years ended June 30, 2007, 2006 and 2005 (in millions):

 

 

 

 

 

 

Healthcare Supply Chain Services — Pharmaceutical Performance

 

During fiscal 2007, Healthcare Supply Chain Services — Pharmaceutical segment revenue increased $6.5 billion or 9% primarily from revenue from bulk customers. Segment profit increased $157 million due to revenue growth, increased generic pharmaceutical margin and increased distribution service agreement fees and pharmaceutical price appreciation, offset by increased customer discounts and increased SG&A expenses. The pharmaceutical distribution market remains highly competitive and the Company expects that customer discounts will continue to increase. However, the Company expects that increased manufacturer cash discounts and distribution service agreement fees, both of which increase with revenue growth, combined with increased generic margin and continued pharmaceutical price appreciation will enable the Company to offset increased customer discounts. The Company’s results could be adversely affected if sales of pharmaceutical products decline, the frequency of new generic pharmaceutical launches decreases or pharmaceutical price appreciation decreases from its historical rate. Alternatively, the Company’s results could benefit if sales of pharmaceutical products increase, the frequency of new generic pharmaceutical launches increases or pharmaceutical price appreciation exceeds its historical rate.

 

Revenue from bulk customers, described below, increased $4.0 billion during fiscal 2007 with additional volume from existing customers ($2.7 billion) and new customers ($1.3 billion). Revenue from non-bulk customers increased $2.5 billion. Growth in revenue from non-bulk customers was driven by additional sales volume from existing customers and pharmaceutical price appreciation ($4.0 billion). The pharmaceutical price appreciation index was 6.3% for fiscal 2007. Acquisitions ($1.2 billion), mainly Dohmen and ParMed, also had a favorable impact on the year-over-year revenue comparison. Negatively impacting growth in revenue from non-bulk customers was the loss of existing customers due to competition ($1.0 billion) and the sale of a significant part of the specialty distribution business ($1.7 billion) in the fourth quarter of fiscal 2006.

Healthcare Supply Chain Services — Pharmaceutical segment profit increased $157 million or 14% in fiscal 2007. Gross margin increased segment profit by $202 million primarily due to the segment’s revenue growth and increased generic pharmaceutical margin ($192 million) due to new product launches and competitive vendor pricing. Gross margin also was favorably impacted by increased manufacturer cash discounts due to sales volume growth ($187 million) and distribution service agreement fees and pharmaceutical price appreciation (combined impact of $171 million). Gross margin was negatively impacted by increased customer discounts ($319 million) due to increased sales volume and competitive pressures. The Company expects continued customer discounting due to the competitive market in which it operates. Increases in segment SG&A expenses negatively impacted segment profit by approximately $45 million for fiscal 2007. Increases in SG&A expenses were in support of the increased sales volume and due to the impact of acquisitions ($37 million). Favorably impacting SG&A expenses was the reduction in equity-based compensation expense ($14 million). Segment profit was negatively impacted by the prior year sale of a significant portion of the specialty distribution business ($43 million).

 

The Company estimates that branded pharmaceuticals with industry-wide sales volume domestically of $21.8 billion and $4.4 billion came off of patent protection during fiscal 2007 and 2006, respectively, which allowed for generic pharmaceutical competition. The Company’s estimate of industry-wide branded pharmaceutical sales volume is internally developed using industry sales data for significant branded pharmaceuticals adapted for the Company’s fiscal period. Generic pharmaceuticals negatively impact revenue because they are offered at lower prices than branded pharmaceuticals; however, generic pharmaceuticals positively impact gross margin and operating earnings due to competitive vendor pricing. The Company generally earns the highest margins on generic pharmaceuticals during the period immediately following the initial launch of a generic product to the marketplace because generic pharmaceutical selling prices are generally deflationary. The Company expects a similar level of branded pharmaceuticals will come off of patent protection during fiscal 2008 compared with fiscal 2007.

 

During fiscal 2006, Healthcare Supply Chain Services — Pharmaceutical segment revenue increased $6.4 billion or 10%. Revenue from bulk customers increased $5.8 billion. Centralized warehouse and mail order customers contributed $5.0 billion and $0.8 billion, respectively, of the bulk customer revenue growth. The additional sales volume was due in significant part to certain existing warehouse customers deciding to purchase from the Company rather than directly from the manufacturer. Revenue from non-bulk customers increased $604 million based upon pharmaceutical price appreciation and additional sales volume from new and existing customers. Revenue growth was negatively impacted as a result of the decision of the specialty distribution business’s largest customer to begin self distribution on January 1, 2006 and the sale of a significant portion of the specialty distribution business in the fourth quarter ($190 million). The pharmaceutical price appreciation index was 5.6% for fiscal 2006.

 

Healthcare Supply Chain Services — Pharmaceutical segment profit decreased $81 million or 7% in fiscal 2006. Gross margin increased segment profit by $70 million due primarily to the segment’s revenue growth and increased manufacturer cash discounts ($139 million) due to increased sales within the pharmaceutical supply chain business. In addition, gross margin was favorably impacted by distribution service agreement fees and pharmaceutical price appreciation (combined impact of $134 million). Other factors favorably impacting gross margin included generic pharmaceuticals ($32 million) due to sales growth, competitive vendor pricing, the introduction of new generic pharmaceuticals within the pharmaceutical supply chain business, the addition of new vendors to the segment’s National Logistics Center ($27 million) and a last-in, first-out (“LIFO”) reserve reduction ($26 million) primarily due to price deflation within generic pharmaceutical inventories.

 

Increased customer discounts within the pharmaceutical supply chain business negatively impacted segment profit by $232 million due to increased sales volume and competitive pressures. Segment profit was also negatively impacted by an adjustment ($32 million), as described in detail below. Increases in segment SG&A expenses negatively impacted segment profit by approximately $151 million for fiscal 2006 compared to fiscal 2005. Increases in these expenses were in support of the increased sales volume and increased equity-based compensation expense ($67 million) due primarily to the adoption of SFAS No. 123(R).

 

As noted above, Healthcare Supply Chain Services — Pharmaceutical segment profit was negatively impacted by an adjustment recorded in the first quarter of fiscal 2006. The Company discovered it had inadvertently and

erroneously failed to process credits owed to a vendor in prior years. After a thorough review, the Company determined it had failed to process similar credits for a limited number of additional vendors. These processing failures, specific to a limited area of vendor credits, resulted from system programming, interface and data entry errors relating to these vendor credits which occurred over a period of years. As a result, the Company recorded a charge ($32 million) in the first quarter of fiscal 2006 reflecting its estimate of the credits owed to these vendors.

 

Bulk and Non-Bulk Customers.  The Healthcare Supply Chain Services — Pharmaceutical segment differentiates between bulk and non-bulk customers because bulk customers generate significantly lower segment profit as a percentage of revenue than non-bulk customers. Bulk customers consist of customers’ centralized warehouse operations and customers’ mail order businesses. All other customers are classified as non-bulk customers (for example, retail stores, pharmacies, hospitals and alternate care sites). Bulk customers include the warehouse operations of retail chains whose retail stores are classified as non-bulk customers. For example, a single retail chain pharmacy customer may be both a bulk customer with respect to its warehouse operations and a non-bulk customer with respect to its retail stores. Bulk customers have the ability to process large quantities of products in central locations and self-distribute these products to their individual retail stores or customers. Substantially all deliveries to bulk customers consist of product shipped in the same form as the product is received from the manufacturer, but a small portion of deliveries to bulk customers are broken down into smaller units prior to shipping. Non-bulk customers, on the other hand, require more complex servicing by the Company. These services, all of which are performed by the Company, include receiving inventory in large or full case quantities and breaking it down into smaller quantities, warehousing the product for a longer period of time, picking individual products specific to a customer’s order and delivering that smaller order to a customer location.

 

The Company tracks revenue by bulk and non-bulk customers in its financial systems. To assist the Company in managing its business, an internal analysis has been prepared to allocate segment expenses (total of segment cost of products sold and segment selling, general and administrative expenses) separately for bulk and non-bulk customers. The following table shows the allocation of segment expenses, segment profit and segment profit as a percentage of revenue for bulk and non-bulk customers for fiscal 2007, 2006 and 2005 (in millions):

 

 

 

 

 

 

 

The Company used methods that it believes provide a reasonable correlation to allocate the selling, general and administrative expenses for Distribution between bulk and non-bulk customers as follows:

 

 

 

The internal analysis indicated segment expenses as a percentage of revenue were higher for bulk customers than for non-bulk customers because of higher segment cost of products sold partially offset by lower segment SG&A expenses. Bulk customers receive lower pricing on sales of the same products than non-bulk customers due to volume pricing in a competitive market and the lower costs related to the services provided by the Company. In

addition, sales to bulk customers in aggregate generate higher segment cost of products sold as a percentage of revenue than sales to non-bulk customers because bulk customers’ orders consist almost entirely of higher cost branded products. The higher segment cost of products sold as a percentage of revenue for bulk customers is also driven by lower manufacturer distribution service agreement fees and branded pharmaceutical price appreciation and lower manufacturer cash discounts. Manufacturer distribution service agreement fees and manufacturer cash discounts are recognized as a reduction to segment cost of products sold and are lower as a percentage of revenue due to the mix of products sold. Pharmaceutical price appreciation increases customer pricing which, in turn, results in higher segment gross margin for sales of inventory that was on-hand at the time of the manufacturer’s price increase. Since products sold to bulk customers are generally held in inventory for a shorter time than products sold to non-bulk customers, there is less opportunity to realize the benefit of pharmaceutical price appreciation. Consequently, segment cost of products sold as a percentage of revenue for bulk customers is higher than for non-bulk customers and segment gross margin as a percentage of revenue is substantially lower for bulk customers than for non-bulk customers. Deliveries to bulk customers require substantially less services by the Company than deliveries to non-bulk customers. As such, the segment SG&A expenses as a percentage of revenue from bulk customers are substantially lower than from non-bulk customers. These factors result in segment profit as a percentage of revenue being significantly lower for bulk customers than for non-bulk customers.

 

The Company defines bulk customers based on the way in which the Company operates its business and the services it performs for its customers. The Company is not aware of an industry standard regarding the definition of bulk customers and based solely on a review of the Annual Reports on Form 10-K of other national pharmaceutical wholesalers, the Company notes that other companies in comparable businesses may, or may not, use a different definition of bulk customers.

 

During fiscal 2007, segment profit from bulk customers increased $35 million, or 0.1% of revenue from bulk customers, due to increased sales volume described above and the year-over-year increase in distribution service agreement fees and pharmaceutical price appreciation. Segment profit for non-bulk customers increased $148 million, or 0.2% of revenue from non-bulk customers, compared to fiscal 2006. This increase in segment profit from non-bulk customers was due primarily to the increase in sales volume described above and the impact of generic products which had a greater impact on the profitability of non-bulk customers due to the mix of pharmaceuticals distributed to non-bulk customers.

 

Fiscal 2006 segment profit from bulk customers increased $60 million, or 0.1% of revenue from bulk customers, due to increased sales volume described above and the year-over-year impact of new distribution service agreements and pharmaceutical price appreciation. The favorable impact of distribution service agreements and of pharmaceutical price appreciation had a greater impact on the profitability of bulk customers than on non-bulk customers in fiscal 2006 due to the mix of branded pharmaceuticals distributed to bulk customers. These positive factors were partially offset by an increase in allocated equity-based compensation expense of $10 million due to the adoption of SFAS No. 123(R). The fiscal 2006 segment profit for non-bulk customers declined $136 million, or 0.4% of revenue from non-bulk customers, compared to fiscal 2005. An increase in segment profit from non-bulk customers due to increased sales and new distribution service agreements was offset by increased customer discounts, an increase in segment SG&A expenses (which was largely due to sales growth and an increase in allocated equity-based compensation expense of $57 million due to the adoption of SFAS No. 123(R)), and a $32 million charge during the first quarter of fiscal 2006 reflecting credits owed to vendors.

 

Healthcare Supply Chain Services — Medical Performance

 

During fiscal 2007, Healthcare Supply Chain Services — Medical segment revenue increased $315 million while segment profit remained relatively flat. The Company remains focused on improving operating performance within this segment through continued investment in customer service and restructuring the business. In the fourth quarter of fiscal 2007, the Company announced its plan to combine the headquarters of the Healthcare Supply Chain Services — Pharmaceutical and Medical segments in order to promote sharing best practices and support functions to provide better service for its customers. Refer to “Other Matters — Global Restructuring Program” below for further discussion of the Company’s Healthcare Supply Chain Services — Medical restructuring program.

 

Healthcare Supply Chain Services — Medical segment revenue growth of $315 million or 4% during fiscal 2007 resulted primarily from increased volume from existing customers ($215 million) and new customer accounts ($100 million). Healthcare Supply Chain Services — Medical segment profit increased $4 million or 1% during

fiscal 2007. Gross margin increased segment profit by $27 million primarily as a result of revenue growth and the impact of increased manufacturer cash discounts ($6 million). Negatively impacting gross margin were increased customer discounts ($5 million) and trade receivable reserves ($7 million) related to the segment’s customer service and shared service transition. Increases in SG&A expenses decreased segment profit by $23 million primarily in support of revenue growth and increased transportation costs ($5 million). Favorably impacting SG&A expenses was the reduction in equity-based compensation expense ($14 million).

 

During fiscal 2006, Healthcare Supply Chain Services — Medical segment revenue growth of $376 million or 6% resulted primarily from increased volume from existing customers ($244 million) and new customer accounts ($115 million). Healthcare Supply Chain Services — Medical segment profit decreased $53 million or 14% during fiscal 2006. Gross margin increased segment profit by $53 million as a result of revenue growth and the favorable impact of the mix of private-label and branded products ($9 million) due to emphasis being placed on selling Company branded products and other focused product categories and new products with higher margins ($4 million). Increases in SG&A expenses decreased segment profit by $106 million in support of revenue growth and an increase in equity-based compensation expense ($45 million) due primarily to the adoption of SFAS No. 123(R).

 

Clinical Technologies and Services Performance

 

During fiscal 2007, Clinical Technologies and Services segment revenue grew $257 million or 11%. Revenue growth was favorably impacted by new products ($119 million), increased sales volumes to existing customers ($90 million) due to renewals and expansion of product lines and new customers ($35 million). Acquisitions also favorably impacted the year-over-year comparison ($18 million).

 

Clinical Technologies and Services segment profit increased $65 million or 20%. Gross margin increased segment profit by $132 million primarily as a result of revenue growth. Gross margin was negatively impacted by the estimated costs of the Alaris SE pump corrective action plan and related consulting expenses ($18 million) due to the product recall. Increases in SG&A expenses decreased segment profit by $67 million in support of the revenue growth and as a result of the impact of acquisitions ($22 million) and increased investment in product quality and research and development costs ($11 million). Favorably impacting SG&A expenses was the reduction in equity-based compensation expense ($14 million).

 

During fiscal 2006, Clinical Technologies and Services segment revenue growth of $241 million or 11% resulted primarily from revenue growth within the Pyxis and Alaris product lines. Pyxis products revenue increased $83 million due to higher unit sales resulting from increased demand for the Medstation^® 3000 product and improvements within the sales and installation cycles. Alaris products revenue increased $125 million due to competitive displacements driven by technological advantages and sales obtained through the Company’s other relationships. These revenue increases were tempered by slower revenue growth in the clinical and consulting services ($52 million).

 

Clinical Technologies and Services segment profit increased $82 million or 35% during fiscal 2006. Gross margin increased segment profit by $180 million primarily as a result of revenue growth. Factors favorably impacting gross margin included sales mix ($49 million) and manufacturing efficiencies ($12 million) driven by higher sales volume. Also favorably impacting the year-over-year comparison were the inventory valuation adjustments to fair value from the Alaris acquisition ($24 million) with the adjusted higher value inventory being sold during the first two quarters of fiscal 2005. Increases in SG&A expenses decreased segment profit by $97 million due primarily to an increase in equity-based compensation expense ($55 million) due primarily to the adoption of SFAS 123(R) and in support of the revenue growth. Estimated integration synergies from the Alaris acquisition ($54 million) favorably impacted both gross margin and SG&A expenses.

 

Medical Products Manufacturing Performance

 

During fiscal 2007, Medical Products Manufacturing segment revenue grew $203 million or 12%. Revenue growth was favorably impacted by increased sales volume ($74 million) from existing customers and new customers won through new GPO contracts and competitor exits. Revenue growth was also favorably impacted by new product launches ($50 million), including innovations in gloves, respiratory products, surgical instruments and software, and international revenue growth ($62 million), which includes the impact of foreign exchange ($18 million). Acquisitions, including Denver Biomedical and Viasys, favorably impacted the year-over-year

comparison ($37 million). Due to the acquisition of Viasys, the Company expects significant growth in the Medical Products Manufacturing segment.

 

Medical Products Manufacturing segment profit increased $33 million or 20% during fiscal 2007. Gross margin increased segment profit by $72 million primarily as a result of revenue growth. Factors favorably impacting gross margin included manufacturing cost reductions ($20 million) driven by strategic sourcing and expense control related to the Company’s restructuring program and the integration of acquisitions ($21 million), primarily Denver Biomedical. Increases in SG&A expenses negatively impacted segment profit by $39 million primarily in support of the segment’s revenue growth and from the impact of acquisitions ($13 million). Favorably impacting SG&A expenses was the reduction in equity-based compensation expense ($12 million).

 

During fiscal 2006, Medical Products Manufacturing segment revenue grew $96 million or 6% resulting from revenue growth from manufactured gloves and respiratory product lines ($45 million) due to new customer accounts ($14 million) and new products ($31 million) and international revenue growth ($16 million) from new customers.

 

Medical Products Manufacturing segment profit decreased $11 million or 6% during fiscal 2006. Gross margin increased segment profit by $31 million primarily as a result of revenue growth. Factors favorably impacting gross margin included manufacturing cost reductions driven by cost controls ($30 million) and expense control partially related to the Company’s global restructuring program ($12 million). Increased raw materials costs ($25 million) negatively impacted gross margin. Increases in SG&A expenses negatively impacted segment profit by $42 million primarily due to the increase in equity-based compensation ($41 million) and in support of the segment’s revenue growth. The latex litigation charge ($28 million) recorded during fiscal 2005 also favorably impacted the year-over-year comparison.

 

Other Matters

 

Acquisitions

 

During the fourth quarter of fiscal 2007, the Company acquired Viasys, which offered products and services directed at critical care ventilation, respiratory diagnostics and clinical services, neurological, vascular, audio, homecare, orthopedics, sleep diagnostics and other medical and surgical products markets. The value of the transaction, including the assumption of Viasys’s debt, totaled approximately $1.5 billion. In addition, during fiscal 2007, the Company completed other acquisitions that individually were not significant. The aggregate purchase price of these other acquisitions, which was paid in cash, was approximately $165 million. Assumed liabilities of these acquired businesses were approximately $22 million. The consolidated financial statements include the results of operations from each of these business combinations from the date of acquisition. Had the transactions, including Viasys, occurred at the beginning of fiscal 2006, consolidated results of operations would not have differed materially from reported results. For further information regarding the Company’s acquisitions see “Item 1 — Business — Acquisitions and Divestitures” and Note 2 of “Notes to Consolidated Financial Statements.”

 

During fiscal 2006, the Company completed acquisitions that individually were not significant. The aggregate purchase price of these acquisitions, which was paid in cash, was approximately $364 million. Assumed liabilities of these acquired businesses were approximately $149 million. The consolidated financial statements include the results of operations from each of these business combinations from the date of acquisition. Had the transactions occurred at the beginning of fiscal 2005, consolidated results of operations would not have differed materially.

 

During fiscal 2005, the Company completed acquisitions that individually were not significant. The aggregate purchase price of these acquisitions, which was paid in cash, was approximately $107 million. Assumed liabilities of these acquired businesses were approximately $27 million. The consolidated financial statements include the results of operations from each of these business combinations from the date of acquisition. Had the transactions occurred at the beginning of fiscal 2004, consolidated results of operations would not have differed materially.

 

The Company’s trend with regard to acquisitions has been to expand its role as a provider of services and innovative products to the healthcare industry. This trend has resulted in expansion into areas that complement the Company’s existing operations and provide opportunities for the Company to develop synergies with, and strengthen, the acquired business. As the healthcare industry continues to change, the Company evaluates possible

candidates for acquisition and considers opportunities to expand its role as a provider of services to the healthcare industry through all its reportable segments. There can be no assurance, however, that the Company will be able to successfully take advantage of any such opportunity if and when it arises or consummate any such transaction, if pursued. If additional transactions are pursued or consummated, the Company would incur additional acquisition integration charges, and may need to enter into funding arrangements for such acquisitions. There can be no assurance that the integration efforts associated with any such transaction would be successful.

 

Sale of the PTS Business

 

On April 10, 2007, the Company completed the sale of the PTS Business to Phoenix Charter LLC (“Phoenix”), an affiliate of The Blackstone Group, pursuant to the Purchase and Sale Agreement between the Company and Phoenix, dated as of January 25, 2007 as amended (the “Purchase Agreement”). At the closing of the sale, the Company received approximately $3.2 billion in cash from Phoenix, which was the purchase price of approximately $3.3 billion as adjusted pursuant to certain provisions in the Purchase Agreement for the working capital, cash, indebtedness and earnings before interest, taxes, depreciation and amortization of the PTS Business. The Company recognized an after-tax book gain of approximately $1.1 billion from this transaction. The Company used the after-tax net proceeds of approximately $3.1 billion from the sale to repurchase shares. The Purchase Agreement contained customary indemnification provisions for sale transactions of this type.

 

Global Restructuring Program

 

During fiscal 2005, the Company launched a global restructuring program with a goal of increasing the value that the Company provides its customers through better integration of existing businesses and improved efficiency from a more disciplined approach to procurement and resource allocation. On April 30, 2007, the Company announced a third phase of its global restructuring program to move the headquarters of the Company’s Healthcare Supply Chain Services — Medical segment and certain corporate functions from Waukegan, Illinois to the Company’s corporate headquarters in Dublin, Ohio. The Company expects this third phase to be substantially completed by the end of fiscal 2009. See the Company’s Form 8-K filed on April 30, 2007 for additional information.

 

Adoption of SFAS No. 123(R)

 

During the first quarter of fiscal 2006, the Company adopted SFAS No. 123(R) applying the modified prospective method. SFAS No. 123(R) requires all equity-based payments to employees, including grants of employee options, to be recognized in the consolidated statement of earnings based on the grant date fair value of the award. Prior to the adoption of SFAS No. 123(R), the Company accounted for equity-based awards under the intrinsic value method, which followed the recognition and measurement principles of APB Opinion No. 25 and related Interpretations, and equity-based compensation was included as pro forma disclosure within the notes to the financial statements. In anticipation of the adoption of SFAS No. 123(R), the Company did not modify the terms of any previously-granted options. See Note 18 of “Notes to Consolidated Financial Statements” for additional information regarding equity-based compensation.

 

Pharmaceutical Supply Chain Business Model Transition

 

Historically, a significant portion of the pharmaceutical supply chain business’ gross margin was derived from the Company’s ability to purchase pharmaceutical inventory, hold that inventory when a manufacturer increased prices, and sell that product at the higher price. Beginning in fiscal 2003, branded pharmaceutical manufacturers began to seek greater control over the amount of product available in the supply chain and, as a result, began to change their sales practices by restricting the volume of product available for purchase by wholesalers. In addition, manufacturers sought additional services from the Company, including providing data concerning product sales and distribution patterns. The Company believes that manufacturers sought these changes to provide them with greater visibility over product demand and movement in the market and to increase product safety and integrity by reducing the risks associated with product being available to, and distributed in, the secondary market. These changes significantly reduced the pharmaceutical price appreciation earned by the Company.

In response to these developments, the Company established a compensation system with branded pharmaceutical manufacturers that is significantly less dependent on manufacturers’ pricing practices, and is based on the services provided by the Company to meet the unique distribution requirements of each manufacturer’s products. During fiscal 2005, the Company worked with individual branded pharmaceutical manufacturers to define fee-for-service terms that compensate the Company based on the services being provided to such manufacturers. This transition was completed during fiscal 2006. These new arrangements have moderated the seasonality of earnings which have historically reflected the pattern of manufacturers’ price increases.

 

Under the fee-for-service arrangements, reflected in written distribution service agreements, the Company’s compensation for these services may be a fee or a fee plus pharmaceutical price appreciation. In certain instances, the Company must achieve certain performance criteria to receive the maximum fees under the agreement. The fee is typically a fixed percentage of either the Company’s purchases from the manufacturer or the Company’s sales of the manufacturer’s products to its customers. The Company continues to generate gross margin from the sale of some manufacturers’ products from pharmaceutical price appreciation without receiving distribution service agreement fees. If the frequency or rate of branded pharmaceutical price appreciation slows, the Company’s results of operations and financial condition could be adversely affected.

 

Distribution service agreements between the Company and certain branded pharmaceutical manufacturers generally range from a one-year term with an automatic renewal feature to a five-year term. These agreements generally cannot be terminated unless mutually agreed by the parties, a breach of the agreement occurs that is not cured, or a bankruptcy filing or similar insolvency event occurs. Some agreements allow the manufacturer to terminate the agreement without cause within a defined notice period.

 

Critical Accounting Policies and Sensitive Accounting Estimates

 

Critical accounting policies are those accounting policies that can have a significant impact on the presentation of the Company’s financial condition and results of operations, and require use of complex and subjective estimates based upon past experience and management’s judgment. Other companies applying reasonable judgment to the same facts and circumstances could develop different estimates. Because of the uncertainty inherent in such estimates, actual results may differ from these estimates. Below are those policies applied in preparing the Company’s consolidated financial statements that management believes are the most dependent on the application of estimates and assumptions. For additional accounting policies, see Note 1 of “Notes to Consolidated Financial Statements.”

 

Allowance for doubtful accounts

 

Trade receivables are amounts owed to the Company through its operating activities and are presented net of an allowance for doubtful accounts. The Company also provides financing to various customers. Such financing arrangements range from ninety days to ten years at interest rates that generally are subject to fluctuation. These financings may be collateralized, guaranteed by third parties or unsecured. Finance notes and accrued interest receivables are recorded net of an allowance for doubtful accounts and are included in other assets. Extending credit terms and calculating the required allowance for doubtful accounts involve the use of judgment by the Company’s management.

 

In determining the appropriate allowance for doubtful accounts, which includes portfolio and specific reserves, the Company reviews accounts receivable aging, industry trends, customer financial strength, credit standing, historical write-off trends and payment history to assess the probability of collection. The Company continuously monitors the collectibility of its receivable portfolio by analyzing the aging of its accounts receivable, assessing credit worthiness of its customers and evaluating the impact of changes in economic conditions that may impact credit risks. If the frequency or severity of customer defaults change due to changes in customers’ financial condition or general economic conditions, the Company’s allowance for doubtful accounts may require adjustment.

 

The allowance for doubtful accounts was $128.9 million and $126.4 million at June 30, 2007 and 2006, respectively. This allowance represented 2.2% and 2.6% of customer receivables at June 30, 2007 and 2006, respectively. The allowance for doubtful accounts as a percentage of revenue was 0.15%, 0.16% and 0.16% at June 30, 2007, 2006 and 2005, respectively. The allowance for doubtful accounts was reduced by $28.4 million,

$22.6 million and $21.2 million in fiscal 2007, 2006, and 2005, respectively, for customer deductions and write-offs and was increased by additional provisions of $24.0 million, $24.6 million and $7.7 million in fiscal 2007, 2006 and 2005, respectively. A hypothetical 0.1% increase or decrease in the reserve as a percentage of trade receivables and sales-type leases to the reserve at June 30, 2007 would result in an increase or decrease in bad debt expense of approximately $5.9 million.

 

Reserve methodologies are assessed annually based on historical losses and economic, business and market trends. In addition, reserves are reviewed quarterly and updated if unusual circumstances or trends are present. The Company believes the reserve maintained and expenses recorded in fiscal 2007 are appropriate and consistent with historical methodologies employed. At this time, the Company is not aware of any internal process or customer issues that might lead to a significant future increase in the Company’s allowance for doubtful accounts as a percentage of net revenue.

 

See Schedule II included in this Form 10-K which includes a rollforward of activity for these allowance reserves.

 

Inventories

 

A substantial portion of inventories (approximately 73% and 75% at June 30, 2007 and 2006, respectively) are stated at the lower of cost, using the LIFO method, or market. These inventories are included within the core distribution facilities within the Company’s Healthcare Supply Chain Services — Pharmaceutical segment (“core distribution facilities”) and are primarily merchandise inventories. The LIFO impact on the consolidated statement of earnings in a given year is dependent on pharmaceutical price appreciation and the level of inventory. Prices for branded pharmaceuticals are primarily inflationary, which results in an increase in cost of products sold, whereas prices for generic pharmaceuticals are deflationary, which results in a decrease in cost of products sold.

 

Under the LIFO method, it is assumed that the most recent inventory purchases are the first items sold. As such, the Company uses LIFO to better match current costs and revenue. Therefore, reductions in the overall inventory levels resulting from declining branded pharmaceutical inventory levels generally will result in a decrease in future cost of products sold, as the remaining inventory will be held at a lower cost due to the inflationary environment. Conversely, reductions in the overall inventory levels created by declining generic pharmaceutical inventory levels would generally increase future cost of products sold, as the remaining inventory will be held at a higher cost due to the deflationary environment. The Company believes that the average cost method of inventory valuation provides a reasonable approximation of the current cost of replacing inventory within the core distribution facilities. As such, the LIFO reserve is the difference between (a) inventory at the lower of LIFO cost or market and (b) inventory at replacement cost determined using the average cost method of inventory valuation. In fiscal 2007, the Company did not record any LIFO reserve reductions. The LIFO reserve reduction in fiscal 2006 of $26.0 million was primarily due to price deflation within generic pharmaceutical inventories.

 

The remaining inventory is primarily stated at the lower of cost, using the first-in, first-out (“FIFO”) method, or market. If the Company had used the average cost method of inventory valuation for all inventory within the core distribution facilities, inventories would not have changed in fiscal 2007 or fiscal 2006. In fact, primarily due to continued deflation in generic pharmaceutical inventories, inventories at LIFO were $55.8 million and $1.0 million higher than the average cost value as of June 30, 2007 and 2006, respectively. However, the Company’s policy is not to record inventories in excess of its current market value.

 

Inventories recorded on the Company’s consolidated balance sheets are net of reserves for excess and obsolete inventory which were $95.8 million and $112.2 million at June 30, 2007 and 2006, respectively. The Company reserves for inventory obsolescence using estimates based on historical experiences, sales trends, specific categories of inventory and age of on-hand inventory. If actual conditions are less favorable than the Company’s assumptions, additional inventory reserves may be required, however these would not be expected to have a material adverse impact on the Company’s consolidated financial statements.

 

Business Combinations

 

Assumptions and estimates are used in determining the fair value of assets acquired and liabilities assumed in a business combination. A significant portion of the purchase price in many of the Company’s acquisitions is assigned to intangible assets which require management to use significant judgment in determining fair value. In addition, current and future amortization expense

for such intangibles is impacted by purchase price allocations as well as the assessment of estimated useful lives of such intangibles, excluding goodwill. The Company believes the assets recorded and the useful lives established are appropriate based upon current facts and circumstances.

 

In conjunction with the review of a transaction, the status of the acquired company’s research and development projects is assessed to determine the existence of IPR&D. In connection with the acquisitions of Viasys and Care Fusion, the Company was required to estimate the fair value of acquired IPR&D which required selecting an appropriate discount rate and estimating future cash flows for each project. Management also assessed the current status of development, nature and timing of efforts to complete such development, uncertainties and other factors when estimating the fair value. Costs were not assigned to IPR&D unless future development was probable. Once the fair value was determined, an asset was established, and in accordance with FASB Interpretation No. 4, “Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method,” was immediately written-off as a special item in the Company’s consolidated statement of earnings. The Company recorded $83.9 million and $0.6 million as a special item in fiscal 2007 representing an estimate of Viasys’s and Care Fusion’s acquired IPR&D, respectively (see Note 3 of “Notes to Consolidated Financial Statements”).

 

Goodwill and Other Intangibles

 

The Company accounts for goodwill in accordance with SFAS No. 142 “Goodwill and Other Intangible Assets.” Under SFAS No. 142, purchased goodwill and intangible assets with indefinite lives are not amortized, but instead are tested for impairment annually or when indicators of impairment exist. Intangible assets with finite lives, primarily customer relationships and patents and trademarks, continue to be amortized over their useful lives. In conducting the impairment test, the fair value of the Company’s reporting units is compared to its carrying amount including goodwill. If the fair value exceeds the carrying amount, then no impairment exists. If the carrying amount exceeds the fair value, further analysis is performed to assess impairment.

 

The Company’s determination of fair value of the reporting units is based on a discounted cash flow analysis or a review of the price/earnings ratio for publicly traded companies similar in nature, scope and size. The methods and assumptions used to test impairment have been revised for the segment realignment for the periods presented. The discount rate used for impairment testing is based on the risk-free rate plus an adjustment for risk factors. The use of alternative estimates, peer groups or changes in the industry, or adjusting the discount rate used could affect the estimated fair value of the assets and potentially result in impairment. Any identified impairment would result in an adjustment to the Company’s results of operations.

 

The Company performed its annual impairment tests in fiscal 2007 and 2006, neither of which resulted in the recognition of any impairment charges. Decreasing the price/earnings ratio of competitors used for impairment testing by one point or increasing the discount rate in the discounted cash flow analysis used for impairment testing by 1% would not have indicated impairment for any of the Company’s reporting units for fiscal 2007 or 2006. See Note 9 of “Notes to Consolidated Financial Statements” for additional information regarding goodwill and other intangibles.

 

Special Items

 

The Company records restructuring charges, acquisition integration charges and certain litigation and other items as special items. A restructuring activity is a program whereby the Company fundamentally changes its operations such as closing facilities, moving a product to another location or outsourcing the production of a product. Restructuring activities may also involve substantial re-alignment of the management structure of a business unit in response to changing market conditions. Restructuring charges are recorded in accordance with SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” Under this Statement, a liability is measured at its fair value and recognized as incurred.

 

Acquisition integration charges include costs to integrate acquired companies. Upon acquisition, certain integration charges are included within the purchase price allocation in accordance with SFAS No. 141, “Business Combinations,” and other integration charges are recorded as special items as incurred.

Certain litigation recorded in special items consists of settlements of significant lawsuits that are infrequent, non-recurring or unusual in nature. The Company also classified legal fees and document preservation and production costs incurred in connection with the SEC investigation and the Audit Committee internal review and related matters as special items.

 

The majority of the special items related to acquisition integration and restructurings can be classified in one of the following categories: employee-related costs, exit costs (including lease termination costs), asset impairments and other integration costs. Employee costs include severance and termination benefits. Lease termination costs include lease cancellation fees, forfeited deposits and remaining payments due under existing lease agreements less estimated sublease income. Other facility exit costs include costs to move equipment or inventory out of a facility as well as other costs incurred to shut down a facility. Asset impairment costs include the reduction in value of the Company’s assets as a result of the integration or restructuring activities. Other integration costs primarily include charges directly related to the integration plan such as consulting costs related to information systems and employee benefit plans as well as relocation and travel costs directly associated with the integration plan. See Note 3 of “Notes to Consolidated Financial Statements” for additional information.

 

Vendor Reserves

 

The Company maintains reserves to cover areas of exposure with its vendors. In determining appropriate vendor reserves, the Company assesses historical experience and current outstanding claims. The Company has established various levels of reserves based on the type of claim and status of review. The Company researches and resolves various types of contested transactions based on discussions with vendors, Company policy and findings of research performed. Though the transaction types are relatively consistent, the Company has periodically refined its estimate methodology over the past few years by updating the reserve estimate percentages based upon historical experiences. Changes to the estimate percentages have resulted in a financial impact to the Company’s cost of products sold in the period in which the change was made.

 

Vendor reserves were $72.6 million and $112.4 million at June 30, 2007 and 2006, respectively. Approximately 61% and 73% of the vendor reserve at June 30, 2007 and 2006, respectively, pertained to the Healthcare Supply Chain Services — Pharmaceutical segment. Fluctuations in the reserve balance are caused by the variations of outstanding claims from period to period, timing of settlements and specific vendor issues, such as bankruptcies (significant events would be described above in “Management’s Discussion and Analysis of Financial Condition and Results of Operations”). Though vendor transactions remain relatively consistent from period to period, unforeseen events such as the deterioration in the financial condition of a large vendor or a settlement of numerous outstanding claims could cause the reserve to fluctuate, and thus, have a financial impact on the period’s financial results.

 

At any given time, there are outstanding items in various stages of research and resolution. The ultimate outcome of certain claims may be different than the Company’s original estimate and may require adjustment. However, the Company believes reserves recorded for such disputes are adequate based upon current facts and circumstances.

 

Self Insurance Accruals

 

The Company is self-insured for employee medical and dental insurance programs. The Company had recorded liabilities totaling $24.3 million and $24.1 million for estimated costs related to outstanding claims at June 30, 2007 and 2006, respectively. These costs include an estimate for expected settlements on pending claims, administrative fees and an estimate for claims incurred but not reported. These estimates are based on the Company’s assessment of outstanding claims, historical analysis and current payment trends. The Company records an estimate for the claims incurred but not reported using an estimated lag period. This lag period assumption has been consistently applied for the periods presented. If the lag period was hypothetically adjusted by a period equal to a half month, the impact on earnings would be $6.0 million. If the amount of claims, medical or dental costs increase beyond what was estimated, the reserve might not be sufficient and additional expense could be required. However, the Company believes the liabilities recorded are adequate based upon current facts and circumstances.

Medical and dental insurance expense was $174.6 million, $140.5 million and $140.4 million in fiscal 2007, 2006 and 2005, respectively.

 

Through a wholly owned insurance subsidiary, the Company has certain deductibles or is self-insured for various risks including general liability, product liability, pharmacist professional liability, auto liability, property and workers’ compensation. However, claims in excess of certain limits are insured with commercial insurers. The Company had recorded liabilities totaling $82.2 million and $76.3 million for anticipated costs related to liability, property and workers’ compensation at June 30, 2007 and 2006, respectively. These costs include an estimate for expected settlements on pending claims, defense costs, claims adjustment costs and an estimate for claims incurred but not reported. For certain types of exposures the Company uses third parties to assist in developing the estimate of expected ultimate costs to settle each claim which is based on specific information related to each claim. For claims incurred but not reported the liabilities are calculated by outside actuaries and are derived in accordance with generally accepted actuarial practices. The amount of ultimate liability in respect to these matters is dependent on future contingent events that cannot be predicted with certainty and may differ from these estimates. Although the Company believes that liability estimates are appropriate based on information available at June 30, 2007, it is possible, based on generally accepted actuarial analysis, that under adverse conditions the ultimate liability could exceed recorded expected liabilities as of June 30, 2007 by as much as $4.9 million. The insurance expense for general liability, product liability, pharmacist professional liability, auto liability, property and workers’ compensation was $70.4 million, $71.3 million and $66.5 million in fiscal 2007, 2006 and 2005, respectively.

 

Provision for Income Taxes

 

The Company’s income tax expense, deferred tax assets and liabilities and income tax reserves reflect management’s assessment of estimated future taxes to be paid on items in the financial statements.

 

Deferred income taxes arise from temporary differences between financial reporting and tax reporting bases of assets and liabilities, as well as net operating loss and tax credit carry forwards for tax purposes. The Company had net deferred income tax assets of $394.2 million and $461.1 million at June 30, 2007 and 2006, respectively. The Company also had net deferred income tax liabilities of $1.7 billion at June 30, 2007 and 2006. Net deferred income tax assets included net federal, state and local, and international loss and credit carry forwards at June 30, 2007 and 2006 of $178.2 million and $84.9 million, respectively. The Company established a net valuation allowance of $180.5 million and $34.4 million at June 30, 2007 and 2006, respectively, against certain deferred tax assets, which primarily relates to federal and state loss carryforwards for which the ultimate realization of future benefits is uncertain. The Company established a $127.1 million valuation allowance in fiscal 2007 related to capital loss carryforwards resulting from the PTS Business divestiture for which the ultimate realization of future benefits is uncertain. Expiring carryforwards and the required valuation allowances are adjusted annually. After application of the valuation allowances described above, the Company anticipates no limitations will apply with respect to utilization of any of the other net deferred income tax assets described above.

 

In addition, the Company has established an estimated liability for federal, state and non-U.S. income tax exposures that arise and meet the criteria for accrual under SFAS No. 5, “Accounting for Contingencies.” The Company prepares and files tax returns based on its interpretation of tax laws and regulations and records estimates based on these judgments and interpretations. In the normal course of business, the Company’s tax returns are subject to examination by various taxing authorities. Such examinations may result in future tax and interest assessments by these taxing authorities. Inherent uncertainties exist in estimates of tax contingencies due to changes in tax law resulting from legislation, regulation and/or as concluded through the various jurisdictions tax court systems.

 

The Company has developed a methodology for estimating its tax liability related to such matters and has consistently followed such methodology from period to period. The liability amounts for such matters are based on an evaluation of the underlying facts and circumstances, a thorough research of the technical merits of the Company’s arguments and an assessment of the probability of the Company prevailing in its arguments. In all cases, the Company considers previous findings of the Internal Revenue Service and other taxing authorities. The Company generally consults with external tax advisers in reaching its conclusions. Amounts accrued for a particular period are adjusted when a significant change in facts or circumstances has occurred.

The Company believes that its estimates for the valuation allowances against deferred tax assets and tax contingency reserves are appropriate based on current facts and circumstances. However, other people applying reasonable judgment to the same facts and circumstances could develop a different estimate and the amount ultimately paid upon resolution of issues raised may differ from the amounts accrued.

 

In addition to income mix from geographical regions, the significant assumptions and estimates described in the preceding paragraphs are important contributors to the ultimate effective tax rate in each year. Although not material to the effective tax rate for the three fiscal years ended June 30, 2007, if any of the Company’s assumptions or estimates were to change, an increase/decrease in the Company’s effective tax rate by 1% on earnings before income taxes and discontinued operations would have caused income tax expense to increase/decrease by $12.5 million for the fiscal year ended June 30, 2007.

 

In the first quarter of fiscal 2008, the Company is required to adopt the provisions of FASB Interpretation (“FIN”) No. 48, “Accounting for Uncertainty in Income Taxes.” FIN No. 48 clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes.” This standard also provides that a tax benefit from an uncertain tax position may be recognized when it is more likely than not that the position will be sustained upon examination, including resolutions of any related appeals or litigation processes, based on the technical merits. The amount recognized is measured as the largest amount of tax benefit that is greater than 50% likely of being realized upon settlement. This interpretation also provides guidance on measurement, derecognizing, classification, interest and penalties, accounting in interim periods, disclosure and transition. The Company is currently assessing the impact of FIN No. 48 on its consolidated financial statements.

 

Loss Contingencies

 

The Company accrues for contingencies related to litigation in accordance with SFAS No. 5, which requires the Company to assess contingencies to determine degree of probability and range of possible settlement. An estimated loss contingency is accrued in the Company’s consolidated financial statements if it is probable that a liability has been incurred and the amount of the settlement can be reasonably estimated. Assessing contingencies is highly subjective and requires judgments about future events. The Company regularly reviews contingencies to determine the adequacy of the accruals and related disclosures. The amount of ultimate settlement may differ from these estimates.

 

Equity-Based Compensation

 

During the first quarter of fiscal 2006, the Company adopted SFAS No. 123(R), “Share-Based Payment,” applying the modified prospective method. This Statement requires all equity-based payments to employees, including grants of options, to be recognized in the consolidated statement of earnings based on the grant date fair value of the award.

 

The fair values of options granted after the Company adopted this Statement were determined using a lattice valuation model and all options granted prior to adoption of this Statement were valued using a Black-Scholes model. The Company’s estimate of an option’s fair value is dependent on a complex estimation process that requires the estimation of future uncertain events. These estimates which are entered within the option valuation model include, but are not limited to, stock price volatility, the expected option life, expected dividend yield and option forfeiture rates. Effective with all options granted subsequent to the adoption of SFAS No. 123(R), the Company estimates its future stock price volatility based on implied volatility from traded options on the Company’s Common Shares and historical volatility over a period of time commensurate with the contractual term of the option grant (7 years). The Company analyzed historical data to estimate option exercise behaviors and employee terminations to estimate the expected option life and forfeiture rates. The Company calculated separate option valuations for three separate groups of employees with similar historical exercise behaviors. Once employee stock option values are determined, current accounting practices do not permit them to be changed, even if the estimates used in the valuation model are different from actual results. However, SFAS No. 123(R) requires the Company to compare its estimated option forfeiture rates to actual forfeiture rates and record any adjustments as necessary. See Note 18 of “Notes to Consolidated Financial Statements” for additional information regarding equity-based compensation.

Liquidity and Capital Resources

 

Sources and Uses of Cash

 

The following table summarizes the Company’s Consolidated Statements of Cash Flows for fiscal 2007, 2006 and 2005 (in millions):

 

 

Operating activities.  Net cash provided by operating activities from continuing operations during fiscal 2007 totaled $1.0 billion, a decrease of $847 million when compared to fiscal 2006. The decrease was a result of the decline in net income from continuing operations ($324 million) due to the litigation charges and cash settlements made in the fourth quarter of fiscal 2007 ($655 million). See Note 12 of “Notes to Consolidated Financial Statements” for information regarding the litigation settlements. The increase in trade receivables ($783 million) was based on the repurchase of trade receivables ($550 million) under the Company’s committed receivables program, as discussed in Note 19 of “Notes to Consolidated Financial Statements.” In line with the Company’s focus on capital deployment, inventory levels declined $217 million and accounts payable increased $224 million.

 

Net cash provided by operating activities from continuing operations during fiscal 2006 totaled $1.9 billion, a decrease of $625 million when compared to fiscal 2005. The decrease was primarily a result of the net proceeds received during fiscal 2005 under the Company’s committed receivables sales facility program ($550 million). See Note 19 of “Notes to Consolidated Financial Statements” for information regarding this program. During fiscal 2006, the accounts payable increase ($1.5 billion) was partially offset by increased inventories ($356 million) and increased accounts receivable ($895 million). The accounts payable, trade receivable and inventory increases were due to new sales volume from an existing large retail chain customer and the timing of inventory purchases from vendors in the Healthcare Supply Chain Services — Pharmaceutical segment.

 

Net cash provided by operating activities from discontinued operations during fiscal 2007 totaled $220 million. Net cash provided by operating activities from discontinued operations in fiscal 2007 was a result of earnings from discontinued operations ($1.1 billion) less the gain on the sale of the PTS Business ($1.1 billion).

 

Net cash provided by operating activities from discontinued operations during fiscal 2006 and 2005 totaled $271 million and $380 million, respectively. Net cash provided by discontinued operations in fiscal 2006 and 2005 was a result of the loss from discontinued operations ($163 million and $16 million, respectively), offset by the changes in the operating assets and liabilities from discontinued operations.

 

Investing activities.  Net cash used by investing activities for continuing operations of $1.6 billion during fiscal 2007 reflected cash used to complete acquisitions to broaden and enhance product offerings, including Viasys within the Medical Products Manufacturing segment, MedMined and Care Fusion within the Clinical Technologies and Services segment and SpecialtyScripts within the Healthcare Supply Chain Services — Pharmaceutical segment. See “Acquisitions and Divestitures” within “Item 1 — Business” of this Form 10-K and Note 2 of “Notes to Consolidated Financial Statements” for further information regarding the Company’s acquisitions. Proceeds from the sale of short-term investments classified as available for sale ($367 million) were offset by capital spending ($357 million) to develop and enhance the Company’s infrastructure including facilities, information systems and machinery and equipment. See Note 4 of “Notes to Consolidated Financial Statements” for information regarding the Company’s investments.

Net cash used in investing activities for continuing operations of $1.1 billion during fiscal 2006 reflected the Company’s purchase of short-term investments classified as available for sale ($399 million) and capital spending ($340 million). In addition, during fiscal 2006, the Company used cash to complete acquisitions ($362 million) which expand its role as a provider of services to the healthcare industry and are primarily associated with the acquisitions of Dohmen and ParMed within the Healthcare Supply Chain Services — Pharmaceutical segment, Denver Biomedical within the Medical Products Manufacturing segment and the remaining minority interest of Source Medical within the Healthcare Supply Chain Services — Medical segment.

 

Net cash used in investing activities for continuing operations during fiscal 2005 of $694 million reflected the Company’s capital spending ($340 million), the acquisitions of Alaris and Geodax ($273 million) and the purchase of short-term investments classified as available for sale ($100 million).

 

Net cash provided by investing activities for discontinued operations in fiscal 2007 of $3.1 billion reflected proceeds from the PTS Business divestiture ($3.2 billion) offset by capital spending ($108 million). Net cash used in investing activities for discontinued operations in fiscal 2006 and 2005 of $100 million and $182 million, respectively, primarily represents capital spending ($103 million and $214 million, respectively).

 

Financing activities.  Net cash used in financing activities for continuing operations of $2.6 billion during fiscal 2007 reflected the Company’s repurchase of its Common Shares ($3.7 billion) and dividend payments to shareholders ($144 million). See “Share Repurchases” below for additional information. The Company also used cash to repay long-term obligations ($784 million). Cash provided by financing activities included proceeds received from the issuance of long-term obligations, net of issuance costs ($1.5 billion) and proceeds received from shares issued under various employee stock plans ($553 million). See “Capital Resources” below for further discussion of the Company’s financing activities.

 

Net cash used in financing activities for continuing operations of $1.0 billion during fiscal 2006 reflected the Company’s repurchase of its Common Shares ($1.5 billion) and dividend payments to shareholders ($102 million). The Company also used cash to purchase certain buildings and equipment which were under capital lease agreements ($258 million) reflected in the reduction of long-term obligations. Cash provided by financing activities includes proceeds received from the issuance of long-term obligations, net of issuance costs ($497 million) and proceeds received from shares issued under various employee stock plans ($241 million).

 

Net cash used in financing activities for continuing operations of $1.7 billion during fiscal 2005 reflected the Company’s decisions to retire debt ($1.9 billion) and commercial paper ($551 million) assumed in the Alaris acquisition. The Company also used cash to repurchase its Common Shares ($500 million) and pay dividends to shareholders ($52 million) as authorized by its Board of Directors. Cash provided by financing activities include proceeds received from the issuance of long-term obligations, net of issuance costs ($1.3 billion) and proceeds received from shares issued under various employee stock plans ($111 million).

 

Net cash used in financing activities for discontinued operations in fiscal 2007, 2006 and 2005 reflected $39 million, $48 million and $22 million, respectively, in repayments on borrowings. Sources of cash for fiscal 2007, 2006 and 2005 were additional borrowings of $4 million, $29 million and $17 million, respectively.

 

International Cash

 

The Company’s cash balance of approximately $1.3 billion as of June 30, 2007 included approximately $707 million of cash held by its subsidiaries outside of the United States. Although the vast majority of cash held outside the United States is available for repatriation, doing so subjects it to United States federal income tax. See Note 11 of “Notes to Consolidated Financial Statements” for additional information regarding income taxes.

 

Share Repurchases

 

The Company repurchased approximately $5.8 billion of its Common Shares, in the aggregate, through share repurchase programs during fiscal 2007, 2006 and 2005. During fiscal 2007, the Company repurchased $3.8 billion of its Common Shares under a $4.5 billion repurchase program or 53.8 million shares at an average price per share of $69.79. This $4.5 billion repurchase program will expire on June 30, 2008. On August 8, 2007, the Company announced a new $2.0 billion share repurchase program which expires on August 31, 2009. The share repurchase activity (apart from the use of net proceeds from the PTS Business divestiture) supports the Company’s previously

stated long-term goal to return 50% of net cash provided by operating activities from continuing operations to shareholders.

 

During fiscal 2006 and 2005 the Company repurchased $1.5 billion and $500 million, respectively, of Common Shares. The Company’s fiscal 2006 and 2005 Common Share repurchases represent 22.0 million and 8.9 million shares at an average price per share of $68.39 and $56.76, respectively.

 

See “Issuer Purchases of Equity Securities” within “Item 5 — Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities” for further information regarding the Company’s most recent share repurchase program.

 

Capital Resources

 

In addition to cash, the Company’s sources of liquidity include a $1.5 billion commercial paper program backed by a $1.5 billion revolving credit facility and a committed receivables sales facility program with the capacity to sell $800 million in receivables.

 

The Company increased the commercial paper program from $1.0 billion to $1.5 billion on February 28, 2007. The Company had no outstanding borrowings from the commercial paper program at June 30, 2007.

 

On January 24, 2007, the Company amended certain terms of the revolving credit facility which is available for general corporate purposes. As part of the amendment, the amount of the facility was increased from $1.0 billion to $1.5 billion and the term was extended to January 24, 2012. At expiration, this facility can be extended upon mutual consent of the Company and the lending institutions. This revolving credit facility exists largely to support issuances of commercial paper as well as other short-term borrowings for general corporate purposes and remained unused at June 30, 2007, except for $79 million of standby letters of credit issued on behalf of the Company.

 

During the second quarter, the Company repurchased the aggregate $550 million of receivable interests outstanding under its committed receivables sales facility program with the capacity to sell $800 million in receivables. After these repurchases, the Company did not have any receivable interest sales outstanding under its receivables sales facility program. On October 31, 2006, the Company renewed the receivables sales facility program for a period of one year. See Note 19 in “Notes to Consolidated Financial Statements” for more information on the Company’s committed receivables sales facility program.

 

The Company also maintains other short-term credit facilities and an unsecured line of credit that allows for borrowings up to $131 million, of which $29 million was outstanding at June 30, 2007.

 

The Company entered into a $500 million short-term loan facility on March 30, 2007 and it was terminated on April 10, 2007. The Company also terminated a $150 million extendible commercial note program in the third quarter of fiscal 2007.

 

On October 3, 2006, the Company sold $350 million aggregate principal amount of 2009 floating rate notes and $500 million aggregate principal amount of 5.80% notes due 2016 in a private offering. The proceeds of the debt issuance were used to repay $500 million of the Company’s preferred debt securities, $127 million of the 7.30% notes due 2006 and other short-term obligations of the Company.

 

On June 8, 2007, the Company sold $300 million aggregate principal amount of 5.65% notes due 2012 and $300 million aggregate principal amount of 6.00% notes due 2017 in a private offering. The proceeds of the debt issuance were used to fund a portion of the purchase price of the Viasys acquisition and for general corporate purposes.

 

During fiscal 2001, the Company entered into an agreement to periodically sell trade receivables to a special purpose accounts receivable and financing entity (the “Accounts Receivable and Financing Entity”), which is exclusively engaged in purchasing trade receivables from, and making loans to, the Company. The Accounts Receivable and Financing Entity, which is consolidated by the Company as it is the primary beneficiary of the variable interest entity, issued $250 million and $400 million in preferred variable debt securities to parties not affiliated with the Company during fiscal 2004 and 2001, respectively. On October 26, 2006, the Company amended certain of the facility terms of the Company’s preferred debt securities. As part of this amendment, the Company

repaid $500 million of the principal balance with a portion of the proceeds of the October 2006 sale of notes discussed above and a minimum net worth covenant was added whereby the minimum net worth of the Company cannot fall below $5.0 billion at any time. The amendment eliminated a minimum adjusted tangible net worth covenant (adjusted tangible net worth could not fall below $2.5 billion) and certain financial ratio covenants. After the repayment, the Company had $150 million of preferred debt securities outstanding. These preferred debt securities are classified as long-term obligations, less current portion and other short-term obligations in the Company’s consolidated balance sheet.

 

See Notes 10 and 19 in “Notes to Consolidated Financial Statements” for more information about the Company’s capital resources.

 

From time to time, the Company considers and engages in acquisition transactions in order to expand its role as a leading provider of products and services that improve the safety and productivity of healthcare. The Company evaluates possible candidates for merger or acquisition and considers opportunities to expand its role as a provider of products and services to the healthcare industry through all its reportable segments. If additional transactions are entered into or consummated, the Company may need to enter into funding arrangements for such mergers or acquisitions.

 

The Company currently believes that, based upon existing cash, operating cash flows, available capital resources (as discussed above) and other available market transactions, it has adequate capital resources at its disposal to fund currently anticipated capital expenditures, business growth and expansion, contractual obligations and current and projected debt service requirements, including those related to business combinations.

 

Debt Ratings/Covenants

 

The Company’s senior debt credit ratings from S&P, Moody’s and Fitch are BBB, Baa2 and BBB+, respectively, and the commercial paper ratings are A-2, P-2 and F2, respectively. The Moody’s and Fitch rating outlooks are “stable” and the S&P outlook is “positive.”

 

The Company’s various borrowing facilities and long-term debt are free of any financial covenants other than minimum net worth which cannot fall below $5.0 billion at any time. As of June 30, 2007, the Company was in compliance with this covenant. A breach of this covenant would be followed by a grace period during which the Company may discuss remedies with the security holders, or extinguish the securities, without causing an event of default.

 

Interest Rate and Currency Risk Management

 

The Company uses foreign currency forward contracts and interest rate swaps to manage its exposure to cash flow variability. The Company also uses foreign currency forward contracts and interest rate swaps to protect the value of its existing foreign currency assets and liabilities and the value of its debt. See Notes 1 and 14 of “Notes to Consolidated Financial Statements” for information regarding the use of financial instruments and derivatives, including foreign currency hedging instruments.

Contractual Obligations

 

As of June 30, 2007, the Company’s contractual obligations, including estimated payments due by period, are as follows (in millions):

 

 

 

 

Off-Balance Sheet Arrangements

 

See “Liquidity and Capital Resources — Capital Resources” above and Note 19 in “Notes to Consolidated Financial Statements,” which is incorporated herein by reference, for a discussion of off-balance sheet arrangements.

 

Recent Financial Accounting Standards

 

See Note 1 in “Notes to Consolidated Financial Statements” for a discussion of recent financial accounting standards.

 

 

To the Shareholders and the

Board of Directors of Cardinal Health, Inc.:

 

We have audited the accompanying consolidated balance sheets of Cardinal Health, Inc. and subsidiaries (the “Company”) as of June 30, 2007 and 2006, and the related consolidated statements of earnings, shareholders’ equity, and cash flows for each of the three years in the period ended June 30, 2007. Our audits also included the financial statement schedule listed in the Index at Item 15(a)(2). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and the schedule based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company as of June 30, 2007 and 2006, and the consolidated results of their operations and their cash flows for each of the three years in the period ended June 30, 2007, in conformity with the U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

 

As discussed in Note 18 to the consolidated financial statements, the Company adopted SFAS No. 123(R), “Share-Based Payment” applying the modified prospective method at the beginning of fiscal year 2006.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of June 30, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated August 22, 2007 expressed an unqualified opinion thereon.

 

 

ERNST & YOUNG LLP

Columbus, Ohio

August 22, 2007

CARDINAL HEALTH, INC. AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF EARNINGS

 

 

The accompanying notes are an integral part of these consolidated statements.

CARDINAL HEALTH, INC. AND SUBSIDIARIES

 

CONSOLIDATED BALANCE SHEETS

 

 

The accompanying notes are an integral part of these consolidated statements.

CARDINAL HEALTH, INC. AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

 

 

The accompanying notes are an integral part of these consolidated statements.

CARDINAL HEALTH INC. AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

 

The accompanying notes are an integral part of these consolidated statements

CARDINAL HEALTH, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

 

Cardinal Health, Inc. is an Ohio corporation formed in 1979. Cardinal Health, Inc. is a leading provider of products and services that improve the safety and productivity of healthcare. References to the “Company” in these consolidated financial statements shall be deemed to be references to Cardinal Health, Inc. and its majority-owned subsidiaries unless the context otherwise requires.

 

The Company changed its reportable segments beginning with the first quarter of fiscal 2007. As of June 30, 2006, the Company conducted its business within the following four reportable segments: Pharmaceutical Distribution and Provider Services; Medical Products and Services; Pharmaceutical Technologies and Services; and Clinical Technologies and Services. Effective the first quarter of fiscal 2007, the Company began reporting its financial information within the following five reportable segments: Healthcare Supply Chain Services — Pharmaceutical; Healthcare Supply Chain Services — Medical; Clinical Technologies and Services; Pharmaceutical Technologies and Services; and Medical Products Manufacturing.

 

During the second quarter of fiscal 2007, the Company committed to plans to sell the Pharmaceutical Technologies and Services segment, other than certain generic-focused businesses (the segment, excluding the certain generic-focused businesses that were not sold, is referred to as the “PTS Business”). The Company completed the sale of the PTS Business during the fourth quarter of fiscal 2007. The following is an explanation of the fiscal 2007 changes, if any, from the Company’s reportable segments as of June 30, 2006:

 

Healthcare Supply Chain Services — Pharmaceutical.  The Healthcare Supply Chain Services — Pharmaceutical segment encompasses the businesses previously within the former Pharmaceutical Distribution and Provider Services segment, in addition to the nuclear pharmacy, third-party logistics support and certain generic-focused businesses previously within the former Pharmaceutical Technologies and Services segment and the therapeutic plasma distribution capabilities previously within the former Medical Products and Services segment.

 

Healthcare Supply Chain Services — Medical.  The Healthcare Supply Chain Services — Medical segment encompasses the Company’s medical products distribution business and the assembly of sterile and non-sterile procedure kits previously within the former Medical Products and Services segment.

 

Clinical Technologies and Services.  There were no changes to the Clinical Technologies and Services segment.

 

Medical Products Manufacturing.  The Medical Products Manufacturing segment encompasses the medical and surgical products manufacturing businesses previously within the former Medical Products and Services segment.

 

Basis of Presentation.  The consolidated financial statements of the Company include the accounts of all majority-owned subsidiaries, and all significant inter-company amounts have been eliminated.

 

During fiscal 2007, 2006 and 2005, the Company completed several acquisitions that were accounted for under the purchase method of accounting. The consolidated financial statements include the results of operations from each of these business combinations as of the date of acquisition. Additional disclosure related to the Company’s acquisitions is provided in Note 2.

 

Effective the second quarter of fiscal 2007, the Company reclassified the PTS Business to discontinued operations. Effective the third quarter of fiscal 2006, the Company reclassified a significant portion of its healthcare marketing services business (“HMS Disposal Group”) and its United Kingdom-based Intercare pharmaceutical distribution business (“IPD”) to discontinued operations. In addition, effective the first quarter of fiscal 2006, the Company reclassified its sterile pharmaceutical manufacturing business in Humacao, Puerto Rico (“Humacao”) to

 

CARDINAL HEALTH, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

discontinued operations. Prior period financial results were reclassified to conform to these changes in presentation. See Note 8 for additional information regarding discontinued operations.

 

During the second quarter of fiscal 2007, the Company changed the classification of certain immaterial implementation costs associated with the sale of medical and supply storage devices in the Clinical Technologies and Services segment from selling, general and administrative expenses to cost of products sold. Prior period financial results were reclassified to conform to these changes in presentation.

 

The preparation of financial statements in conformity with generally accepted accounting principles (“GAAP”) in the United States requires management to make estimates and assumptions that affect amounts reported in the consolidated financial statements and accompanying notes. Such estimates include, but are not limited to, allowance for doubtful accounts, inventory valuation, goodwill and intangible asset impairment, preliminary purchase accounting allocations including acquired in-process research and development costs (“IPR&D”), vendor reserves, equity-based compensation, income taxes, loss contingencies and restructuring charge reserves. Actual amounts may differ from these estimated amounts.

 

Cash Equivalents.  The Company considers all liquid investments purchased with a maturity of three months or less to be cash equivalents. The carrying value of these cash equivalents approximates fair value.

 

Short-term Investments.  The Company’s short-term investments at June 30, 2007 included $132.0 million in tax exempt auction rate securities. At June 30, 2006, the Company’s short-term investments included $208.9 million in tax exempt variable rate demand notes and $289.5 million in tax exempt auction rate securities. These short-term investments are classified as available-for-sale on the Company’s consolidated balance sheet. The Company’s investments in these securities are recorded at cost, which approximates fair market value due to their variable interest rates. See Note 4 for additional information regarding short-term investments.

 

Receivables.  Trade receivables are primarily comprised of amounts owed to the Company through its distribution businesses within the Healthcare Supply Chain Services — Pharmaceutical and Healthcare Supply Chain Services — Medical segments and are presented net of an allowance for doubtful accounts. See Note 5 for additional information.

 

Concentrations of Credit Risk and Major Customers.  The Company maintains cash depository accounts with major banks throughout the world and invests in high quality short-term liquid instruments. Such investments are made only in instruments issued or enhanced by high quality institutions. These investments mature within three months and the Company has not incurred any related losses.

 

The Company’s trade receivables, lease receivables, and finance notes and accrued interest receivables are exposed to a concentration of credit risk with customers in the retail and healthcare sectors. Credit risk can be affected by changes in reimbursement and other economic pressures impacting the hospital and acute care sectors of the healthcare industry. However, such credit risk is limited due to supporting collateral and the diversity of the customer base, including its wide geographic dispersion. The Company performs ongoing credit evaluations of its customers’ financial conditions and maintains reserves for credit losses. Such losses historically have been within the Company’s expectations.

 

The following table summarizes all of the Company’s customers which individually account for at least 10% of the Company’s revenue. The customers in the table below are serviced through the Healthcare Supply Chain Services — Pharmaceutical segment.

 

 

CARDINAL HEALTH, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

At June 30, 2007 and 2006, CVS accounted for 20% and 27%, respectively, and Walgreens accounted for 27% and 28%, respectively, of the Company’s gross trade receivable balance.

 

Certain of the Company’s businesses have entered into agreements with group purchasing organizations (“GPOs”) which act as purchasing agents that negotiate vendor contracts on behalf of their members. In fiscal 2007, 2006 and 2005, approximately 10%, 15% and 15%, respectively, of revenue was derived from GPO members through the contractual arrangements established with Novation, LLC and Premier Purchasing Partners, L.P., the Company’s two largest GPO relationships in terms of revenue. However, the Company’s trade receivable balances are with individual members of the GPO and therefore no significant concentration of credit risk exists with these types of arrangements.

 

Inventories.  A substantial portion of inventories are stated at the lower of cost, using the last-in, first-out (“LIFO”) method, or market. The remaining inventory is primarily stated at the lower of cost, using the first-in, first-out (“FIFO”) method, or market. See Note 7 for additional information.

 

Cash Discounts.  Manufacturer cash discounts are recorded as a component of inventory cost and recognized as a reduction of cost of products sold when the related inventory is sold.

 

Property and Equipment.  Property and equipment are primarily stated at cost. Depreciation expense for financial reporting purposes is primarily computed using the straight-line method over the estimated useful lives of the assets, including capital lease assets which are depreciated over the terms of their respective leases. The Company uses the following range of useful lives for its property and equipment categories: buildings and improvements — 1 to 50 years; machinery and equipment — 2 to 20 years; furniture and fixtures — 3 to 10 years. Depreciation expense was $252.2 million, $238.7 million and $239.7 million for fiscal 2007, 2006 and 2005, respectively. The Company expenses repairs and maintenance expenditures as incurred. Repairs and maintenance expense was $61.3 million, $52.2 million and $46.5 million for fiscal 2007, 2006 and 2005, respectively. The Company capitalizes interest on long-term fixed asset projects using a rate of 5.9%, which approximates the Company’s weighted average interest rate on long-term obligations. The amount of capitalized interest was immaterial for all fiscal years presented.

 

Goodwill and Other Intangibles.  The Company accounts for purchased goodwill and other intangible assets in accordance with Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets.” Under SFAS No. 142, purchased goodwill and intangible assets with indefinite lives are not amortized, but instead are tested for impairment at least annually. Intangible assets with finite lives, primarily customer relationships, patents and trademarks, continue to be amortized over their useful lives. SFAS No. 142 requires that impairment testing be conducted at the reporting unit level, which can be at the operating segment level as defined by SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” or one level below the operating segment. The Company has determined the reporting unit used for impairment assessment should be the operating segment level as the business units comprising the operating segments service a common group of customers, offer complementary products, and share a common strategy. In conducting the impairment test, the fair value of each of the Company’s reporting units is compared to their respective carrying amounts including goodwill. If the fair value exceeds the carrying amount, then no impairment exists. If the carrying amount exceeds the fair value, further analysis is performed to assess impairment.

 

The Company’s determination of fair value of the reporting units is based on a discounted cash flow analysis or a review of the price/earnings ratio for publicly traded companies similar in nature, scope and size. The methods and assumptions used to test impairment have been revised for the segment realignment for the periods presented. The discount rate used for impairment testing is based on the risk-free rate plus an adjustment for risk factors. The use of alternative estimates, peer groups or changes in the industry, or adjusting the discount rate could affect the estimated fair value of the reporting units and potentially result in impairment. Any identified impairment would result in an adjustment to the Company’s results of operations. The Company performed its annual impairment test in fiscal

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

2007 and 2006, neither of which resulted in the recognition of impairment charges. See Note 9 for additional information regarding goodwill and other intangible assets.

 

Income Taxes.  In accordance with the provisions of SFAS No. 109, “Accounting for Income Taxes,” the Company accounts for income taxes using the asset and liability method. The asset and liability method requires recognition of deferred tax assets and liabilities for expected future tax consequences of temporary differences that currently exist between tax bases and financial reporting bases of the Company’s assets and liabilities. Deferred tax assets and liabilities are measured using enacted tax rates in the respective jurisdictions in which the Company operates. In assessing the ability to realize deferred tax assets, the Company considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. Deferred taxes are not provided on the unremitted earnings of subsidiaries outside of the U.S. when it is expected that these earnings are permanently reinvested.

 

The Company repatriated $494.0 million of accumulated foreign earnings in fiscal 2006 pursuant to the repatriation provisions of the American Jobs Creation Act of 2004 (the “AJCA”) and had a total liability of $26.7 million at June 30, 2006. The maximum repatriation available to the Company under the repatriation provisions of the AJCA was $500.0 million. See Note 11 for additional information.

 

Accounting for Vendor Reserves.  In the ordinary course of business, vendors may challenge deductions or billings taken against payments otherwise due to them from the Company. These contested transactions are researched and resolved based upon Company policy and findings of the research performed. At any given time, there are outstanding items in various stages of research and resolution. In determining an appropriate vendor reserve, the Company assesses historical information and current outstanding claims. The ultimate outcome of certain claims may be different than the Company’s original estimate and may require adjustment. All adjustments to vendor reserves are included in cost of products sold.

 

Other Accrued Liabilities.  Other accrued liabilities represent various obligations of the Company including certain accrued operating expenses and taxes payable. For the fiscal years ended June 30, 2007 and 2006, the largest component of other accrued liabilities were net current deferred tax liabilities of approximately $650.0 million and $606.9 million, respectively. Other significant components of other accrued liabilities were current income taxes payable and employee compensation and related benefit accruals. For fiscal 2007 and 2006, current income taxes payable were $119.7 million and $222.8 million, respectively, while employee compensation and related benefit accruals were $377.5 million and $323.5 million, respectively.

 

Equity-Based Compensation.  During the first quarter of fiscal 2006, the Company adopted SFAS No. 123(R), “Share-Based Payment,” applying the modified prospective method. This Statement requires all equity-based payments to employees, including grants of options, to be recognized in the consolidated statement of earnings based on the grant date fair value of the award. The fair values of options granted after the Company adopted this Statement were determined using a lattice valuation model and all options granted prior to adoption of this Statement were valued using a Black-Scholes model. The Company’s estimate of an option’s fair value is dependent on a complex estimation process that requires the estimation of future uncertain events. These estimates include, but are not limited to, stock price volatility, the expected option life, expected dividend yield and option forfeiture rates.

 

The compensation expense recognized for all equity-based awards is net of estimated forfeitures and is recognized using the straight-line method over the awards’ service period. The Company classifies equity-based compensation within selling, general and administrative expenses to correspond with the same line item as the majority of the cash compensation paid to employees. See Note 18 for additional information regarding equity-based compensation.

 

Dividends.  The Company paid cash dividends per Common Share of $0.36, $0.24 and $0.12 for the fiscal years ended June 30, 2007, 2006 and 2005, respectively.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Revenue Recognition.  In accordance with U.S. Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin (“SAB”) No. 104, “Revenue Recognition,” the Company recognizes revenue when persuasive evidence of an arrangement exists, product delivery has occurred or the services have been rendered, the price is fixed or determinable and collectibility is reasonably assured. Revenue is recognized net of sales returns and allowances.

 

Healthcare Supply Chain Services — Pharmaceutical

 

This segment records distribution revenue when title transfers to its customers and the business has no further obligation to provide services related to such merchandise. This revenue is recorded net of sales returns and allowances.

 

Revenue within this segment includes revenue from bulk customers. Most deliveries to bulk customers consist of product shipped in the same form as the product is received from the manufacturer. Bulk customers have the ability to process large quantities of products in central locations and self distribute these products to their individual retail stores or customers. Revenue from bulk customers is recorded when title transfers to the customers and the Company has no further obligation to provide services related to such merchandise.

 

Revenue for deliveries that are direct shipped to customer warehouses from the manufacturer whereby the Company acts as an intermediary in the ordering and delivery of products is recorded gross in accordance with FASB Emerging Issues Task Force (“EITF”) Issue No. 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent.” This revenue is recorded on a gross basis since the Company incurs credit risk from the customer, bears the risk of loss for incomplete shipments and does not receive a separate fee or commission for the transaction.

 

Radiopharmaceutical revenue is recognized upon delivery of the product to the customer. Service-related revenue, including fees received for analytical services or sales and marketing services, is recognized upon the completion of such services.

 

Through its Medicine Shoppe International, Inc. and Medicap Pharmacies Incorporated franchise operations (collectively, “Medicine Shoppe”), the Company has apothecary-style pharmacy franchisees in which it earns franchise and origination fees. Franchise fees represent monthly fees based upon franchisees’ sales and are recognized as revenue when they are earned. Origination fees from signing new franchise agreements are recognized as revenue when the new franchise store is opened.

 

Healthcare Supply Chain Services — Medical

 

This segment recognizes distribution revenue when title transfers to its customers and the business has no further obligation to provide services related to such merchandise. This revenue is recorded net of sales returns and allowances.

 

Clinical Technologies and Services

 

Leasing revenue is accounted for in accordance with SFAS No. 13, “Accounting for Leases.” Revenue is recognized on sales-type leases when the lease becomes noncancellable. The lease is determined to be noncancellable upon completion of the installation, when the equipment is functioning according to material specifications of the user’s manual and the customer has accepted the equipment, as evidenced by signing an equipment confirmation document. Interest income on sales-type leases is recognized in revenue using the interest method.

 

Consistent with sales-type leases, revenue is recognized on operating leases after installation is complete and customer acceptance has occurred. Operating lease revenue is recognized over the lease term as such amounts become receivable according to the provisions of the lease.

 

Revenue for safety systems which contain software essential to the functionality of the product are subject to the provisions of the American Institute of Certified Public Accountants Statement of Position (“SOP”) No. 97-2

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

“Software Revenue Recognition.” The elements of safety system sales arrangements may contain some or all of the following: infusion devices, disposables, hardware, software, software maintenance programs and professional services. As a multiple element arrangement, total fees are allocated to each element based on vendor-specific objective evidence of fair value for each element or using the residual method, when applicable. Vendor-specific objective evidence is generally based on the price charged when an element is sold separately. Allocated fees are recognized separately for each element when it is delivered and there are no further contractual obligations with relation to that element. Perpetual software license revenue is generally recognized upon shipment to the customer. Software maintenance revenue is recognized ratably over the contract period. Vendor-specific objective evidence for software maintenance is determined based on contract renewal price for such maintenance. Rights to unspecified software upgrades (on a when-and-if available basis) are included in software maintenance. Professional service revenue is recognized when services are rendered. Revenues are recognized net of sales returns and allowances.

 

Pharmacy management and other service revenue is recognized as the services are rendered according to the contracts established. A fee is charged under such contracts through a capitated fee, a dispensing fee, a monthly management fee or an actual costs-incurred arrangement. Under certain contracts, fees for services are guaranteed by the Company not to exceed stipulated amounts or have other risk-sharing provisions. Revenue is adjusted to reflect the estimated effects of such contractual guarantees and risk-sharing provisions.

 

Medical Products Manufacturing

 

This segment records self-manufactured medical product revenue when title transfers to its customers which generally occurs upon delivery. Revenues are recorded net of sales returns and allowances.

 

Multiple Segments or Business Units

 

Arrangements involving multiple segments or business units, containing no software or software which is incidental to the functionality of the product or service, and those arrangements involving a single segment or business unit and multiple deliverables are accounted for in accordance with EITF Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables.” If the deliverable meets the criteria of a separate unit of accounting, the arrangement revenue is allocated to each element based upon its relative fair value and recognized in accordance with the applicable revenue recognition criteria for each element.

 

Savings Guarantees

 

Some of the Company’s customer contracts include a guarantee of a certain amount of savings through utilization of the Company’s services. Revenue associated with a guarantee in which the form of consideration is cash or credit memos is not recorded until the guaranteed savings are fully recognized. For guarantees with consideration paid in the form of free products or services, the cost of products sold related to those sales is increased by the amount of the guarantee.

 

Sales Returns and Allowances.  Revenue is recorded net of sales returns and allowances. The Company recognizes sales returns as a reduction of revenue and cost of products sold for the sales price and cost, respectively, when products are returned. The customer return policies generally require that the product be physically returned, subject to restocking fees, and only allow customers to return products that can be added back to inventory and resold at full value, or that can be returned to vendors for credit. Product returns are generally consistent throughout the year, and typically are not specific to any particular product or customer. Amounts recorded in revenue and cost of products sold under this accounting policy closely approximate what would have been recorded under SFAS No. 48, “Revenue Recognition When Right of Return Exists.” Applying the provisions of SFAS No. 48 would not materially change the Company’s financial position and results of operations. Sales returns and allowances were approximately $1.8 billion, $1.5 billion and $1.5 billion in fiscal 2007, 2006 and 2005, respectively.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Distribution Service Agreement and Other Vendor Fees.  The Company’s pharmaceutical supply chain business within the Healthcare Supply Chain Services — Pharmaceutical segment accounts for fees received from its distribution service agreements and other fees received from vendors related to the purchase or distribution of the vendor’s inventory as a reduction in cost of products sold, in accordance with EITF Issue No. 02-16, “Accounting by a Customer for Certain Consideration Received from a Vendor.”

 

Shipping and Handling.  Shipping and handling costs are included in selling, general and administrative expenses in the consolidated statements of earnings. Shipping and handling costs include all delivery expenses as well as all costs to prepare the product for shipment to the end customer. Shipping and handling costs totaled $305.8 million, $274.3 million and $275.7 million for fiscal 2007, 2006 and 2005, respectively. Shipping and handling revenue received was immaterial for all periods presented.

 

Research and Development Costs.  Costs incurred in connection with development of new products and manufacturing methods are charged to expense as incurred. Research and development expenses were $102.8 million, $96.8 million and $87.2 million for fiscal 2007, 2006 and 2005, respectively.

 

Translation of Foreign Currencies.  Financial statements of the Company’s subsidiaries outside the U.S. generally are measured using the local currency as the functional currency. Adjustments to translate the assets and liabilities of these foreign subsidiaries into U.S. dollars are accumulated in a separate component of shareholders’ equity utilizing period-end exchange rates, net of tax. Foreign currency transaction gains and losses calculated by utilizing weighted average exchange rates for the period are included in the consolidated statements of earnings in interest expense and other and were immaterial for the fiscal years ended June 30, 2007, 2006 and 2005.

 

Interest Rate and Currency Risk Management.  The Company accounts for derivative instruments in accordance with SFAS No. 133, as amended, “Accounting for Derivative Instruments and Hedging Activity.” Under this standard, all derivative instruments are recorded at fair value on the balance sheet and all changes in fair value are recorded to net earnings or shareholders’ equity through other comprehensive income, net of tax.

 

The Company uses forward currency exchange contracts and interest rate swaps to manage its exposures to the variability of cash flows primarily related to the foreign exchange rate changes of future foreign currency transaction costs and to the interest rate changes on borrowing costs. These contracts are designated as cash flow hedges.

 

The Company also uses interest rate swaps to hedge changes in the value of fixed rate debt due to variations in interest rates. Both the derivative instruments and underlying debt are adjusted to market value through interest expense and other at the end of each period. The Company uses foreign currency forward contracts to protect the value of existing foreign currency assets and liabilities. The remeasurement adjustments for any foreign currency denominated assets or liabilities are included in interest expense and other. The remeasurement adjustment is offset by the foreign currency forward contract settlements which are also classified in interest expense and other. The interest rate swaps are designated as fair value hedges.

 

The Company’s derivative contracts are adjusted to current market values each period and qualify for hedge accounting under SFAS No. 133, as amended. Periodic gains and losses of contracts designated as cash flow hedges are deferred in other comprehensive income until the underlying transactions are recognized. Upon recognition, such gains and losses are recorded in net earnings as an adjustment to the carrying amounts of underlying transactions in the period in which these transactions are recognized. For those contracts designated as fair value hedges, resulting gains or losses are recognized in net earnings offsetting the exposures of underlying transactions. Carrying values of all contracts are included in other assets or liabilities.

 

The Company’s policy requires that contracts used as hedges must be effective at reducing the risk associated with the exposure being hedged and must be designated as a hedge at the inception of the contract. Hedging effectiveness is assessed periodically. Any contract not designated as a hedge, or so designated but ineffective, is adjusted to market value and recognized in net earnings immediately. If a fair value or cash flow hedge ceases to

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

qualify for hedge accounting or is terminated, the contract would continue to be carried on the balance sheet at fair value until settled and future adjustments to the contract’s fair value would be recognized in earnings immediately. If a forecasted transaction was no longer probable to occur, amounts previously deferred in other comprehensive income would be recognized immediately in earnings. Additional disclosure related to the Company’s hedging contracts is provided in Note 14.

 

Earnings per Common Share.  Basic earnings per Common Share (“Basic EPS”) is computed by dividing net earnings (the numerator) by the weighted average number of Common Shares outstanding during each period (the denominator). Diluted earnings per Common Share is similar to the computation for Basic EPS, except that the denominator is increased by the dilutive effect of stock options, restricted shares and restricted share units computed using the treasury stock method.

 

Recent Financial Accounting Standards.  In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments” an amendment of SFAS No. 133 and SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” This Statement permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that would otherwise be required to be bifurcated from its host contract. The election to measure a hybrid financial instrument at fair value, in its entirety, is irrevocable and all changes in fair value are to be recognized in earnings. This Statement also clarifies and amends certain provisions of SFAS No. 133 and SFAS No. 140. This Statement is effective for all of the Company’s financial instruments acquired, issued or subject to a remeasurement event on or after July 1, 2007. The adoption of this Statement is not expected to have a material impact on the Company’s financial position or results of operations.

 

In July 2006, the FASB issued FASB Interpretation (“FIN”) No. 48, “Accounting for Uncertainty in Income Taxes.” This Interpretation prescribes a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of uncertain tax positions taken or expected to be taken in income tax returns. This Interpretation is effective for the Company at July 1, 2007. The cumulative effects, if any, of applying this Interpretation will be recorded as an adjustment to retained earnings as of the beginning of the period of adoption. The Company is currently assessing the impact of adopting this Interpretation.

 

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” This Statement defines fair value, establishes a framework for measuring fair value in GAAP and expands disclosures about fair value measurements. This Statement is effective for the Company on July 1, 2008, and interim periods within fiscal 2009. The Company is in the process of determining the impact of adopting this Statement.

 

In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans — an amendment of FASB Statements No. 87, 88, 106, and 132(R).” This Statement requires an entity to recognize in its statement of financial position an asset for a defined benefit postretirement plan’s overfunded status or a liability for a plan’s underfunded status, measure a defined benefit postretirement plan’s assets and obligations that determine its funded status as of the end of the employer’s fiscal year, and recognize changes in the funded status of a defined benefit postretirement plan in comprehensive income in the year in which the changes occur. This Statement requires balance sheet recognition of the funded status for all pension and postretirement benefit plans effective for fiscal years ending after December 15, 2006. This Statement also requires plan assets and benefit obligations to be measured as of a Company’s balance sheet date effective for fiscal years ending after December 15, 2008. The adoption of this Statement in fiscal 2007 did not have a material impact on the Company’s financial position or results of operations.

 

In September 2006, the SEC issued SAB No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” This Bulletin addresses quantifying the financial statement effects of misstatements, including how the effects of prior year uncorrected errors must be considered in quantifying misstatements in the current year financial statements. This Bulletin is effective for fiscal years ending after November 15, 2006 and allows for a one-time transitional cumulative effect adjustment to beginning retained

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

earnings in the fiscal year adopted for errors that were not previously deemed material, but are material under the guidance in SAB No. 108. The adoption of this Bulletin did not have a material impact on the Company’s financial position or results of operations.

 

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Liabilities — including an amendment of FASB Statement No. 115.” This Statement creates a fair value option under which an entity may irrevocably elect fair value as the initial and subsequent measurement attribute for certain assets and liabilities, on an instrument-by-instrument basis. If the fair value option is elected for an instrument, all subsequent changes in fair value for that instrument shall be reported in earnings. The Statement is effective for the Company on July 1, 2008. The Company is in the process of determining the impact, if any, of adopting this Statement.

 

 

Fiscal 2007.  On June 21 and 27, 2007, the Company completed the initial and subsequent tender offers for the outstanding common stock of Viasys, a Conshohocken, Pennsylvania-based provider of products and services directed at the critical care ventilation, respiratory diagnostics and clinical services, neurological, vascular, audio, homecare, orthopedics, sleep diagnostics and other medical and surgical products markets. Through the tender offers, a total of approximately 29.3 million shares of Viasys common stock were validly tendered for $42.75 per share, which represented approximately 88% of all outstanding shares of Viasys. On June 28, 2007, the Company acquired from Viasys a number of additional shares so that it would hold more than 90% of the outstanding shares on a fully diluted basis. The same day, Viasys merged with a subsidiary of the Company to complete the transaction.

 

The cash transaction was valued at approximately $1.5 billion, including the assumption of approximately $54.2 million of debt. Viasys employees with outstanding stock options elected to either receive a cash payment or convert their options into options to purchase the Company’s Common Shares. Certain Viasys employees elected to convert their options, which resulted in those employees receiving the right to purchase a total of approximately 0.1 million Common Shares of the Company.

 

The preliminary valuation of the acquired assets and liabilities resulted in goodwill of approximately $1.0 billion and identifiable intangible assets of $442.0 million. The Company valued intangible assets related to trade names, patents and customer relationships. The valuation is not yet finalized and subject to adjustment as the Company assesses the value of the pre-acquisition contingencies and certain other matters. The detail by category is as follows (in millions):

 

 

During fiscal 2007, the Company recorded a charge of $83.9 million related to the write-off of IPR&D costs associated with the Viasys acquisition. The portion of the purchase price allocated to IPR&D represents the estimated fair value of the research and development projects in-process at the time of the acquisition. These projects had not yet reached technological feasibility, were deemed to have no alternative use and, accordingly, were immediately charged to special items expense at the acquisition date in accordance with FIN No. 4, “Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method.”

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

In addition during fiscal 2007, the Company completed other acquisitions that individually were not significant. The aggregate purchase price of these acquisitions, which was paid in cash, was approximately $173.8 million with potential maximum contingent payments of $52.3 million. Assumed liabilities of these acquired businesses were approximately $22.4 million. The consolidated financial statements include the results of operations from each of these business combinations from the date of acquisition. Had the transactions, including Viasys, occurred at the beginning of fiscal 2006, consolidated results of operations would not have differed materially from reported results.

 

Fiscal 2006.  During fiscal 2006, the Company completed acquisitions that individually were not significant. The aggregate purchase price of these acquisitions, which was paid in cash, was approximately $364.0 million. Assumed liabilities of these acquired businesses were approximately $149.0 million. The consolidated financial statements include the results of operations from each of these business combinations from the date of acquisition. Had the transactions occurred at the beginning of fiscal 2005, consolidated results of operations would not have differed materially from reported results.

 

Fiscal 2005.  During fiscal 2005, the Company completed acquisitions that individually were not significant. The aggregate purchase price of these acquisitions, which was paid in cash, was approximately $107.0 million. Assumed liabilities of these acquired businesses were approximately $27.0 million. The consolidated financial statements include the results of operations from each of these business combinations from the date of acquisition. Had the transactions occurred at the beginning of fiscal 2004, consolidated results of operations would not have differed materially from reported results.

 

Purchase Accounting Accruals

 

In connection with restructuring and integration plans related to its acquisition of Viasys, the Company accrued, as part of its acquisition adjustments, a liability of $21.7 million related to employee termination and relocation costs and $6.4 million related to closing of certain facilities. No payments were made in connection with the employee related costs or facility closures during fiscal 2007.

 

In connection with restructuring and integration plans related to Syncor, the Company accrued, as part of its acquisition adjustments, a liability of $15.1 million related to employee termination and relocation costs and $10.4 million related to closing of duplicate facilities. As of June 30, 2007, the Company had paid $14.2 million of employee related costs, $8.7 million associated with the facility closures and $1.0 million of other restructuring charges.

 

 

Special Items Policy

 

The Company records restructuring charges, acquisition integration charges and certain litigation and other items as special items. A restructuring activity is a program whereby the Company fundamentally changes its operations such as closing facilities, moving a product to another location or outsourcing the production of a product. Restructuring activities may also involve substantial re-alignment of the management structure of a business unit in response to changing market conditions. Restructuring charges are recorded in accordance with SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” Under this Statement, a liability is measured at its fair value and recognized as incurred.

 

Acquisition integration charges include costs to integrate acquired companies. Upon acquisition, certain integration charges are included within the purchase price allocation in accordance with SFAS No. 141, “Business Combinations,” and other integration charges are recorded as special items as incurred.

 

Certain litigation recorded in special items consists of settlements of significant lawsuits that are infrequent, non-recurring or unusual in nature. The Company also classified legal fees and document preservation and