Business Context and Reporting Period
Company: McKesson Corporation
Filing Type: Form 10-K (Annual Report)
Period Ended: March 31, 2005
Business Overview: McKesson is a Fortune 15 corporation providing supply, information, and care management products and services to the healthcare industry. Operations are conducted through three segments: Pharmaceutical Solutions (95% of revenue), Medical-Surgical Solutions (4%), and Provider Technologies (1%).
Key Financial Metrics
| Metric | 2005 | 2004 | 2003 |
|---|---|---|---|
| Revenues | $80.5 billion | $69.5 billion | $57.1 billion |
| Gross Profit | $3.5 billion | $3.2 billion | $3.1 billion |
| Gross Margin | 4.30% | 4.67% | 5.43% |
| Operating Income (Loss) | ($190.5) million | $983.4 million | $933.0 million |
| Net Income (Loss) | ($156.7) million | $646.5 million | $555.4 million |
| Diluted EPS | ($0.53) | $2.19 | $1.88 |
| Operating Cash Flow | $1.5 billion | $595.2 million | $773.4 million |
| Total Debt | $1.2 billion | $1.5 billion | $1.5 billion |
| Working Capital | $3.5 billion | $3.6 billion | $3.3 billion |
Note: 2005 results include a $1.2 billion pre-tax charge related to securities litigation. Excluding this charge, 2005 Net Income would have been $653.3 million and Diluted EPS $2.19.
Material Changes vs. Prior Period
- Revenue Growth: Revenues increased 16% to $80.5 billion, driven primarily by the Pharmaceutical Solutions segment due to market growth and new customer acquisitions.
- Margin Compression: Gross profit margin declined 37 basis points to 4.30%. This was caused by lower sell margins due to competitive pressures, a shift in customer mix toward lower-margin institutional customers, and reduced "buy side" margins from pharmaceutical manufacturers.
- Securities Litigation Charge: The company recorded a $1.2 billion pre-tax charge in Q3 2005. This consisted of a $960 million settlement for the consolidated securities class action and a $240 million reserve for remaining litigation exposure.
- Segment Performance: Pharmaceutical Solutions operating profit increased to $1.08 billion. Provider Technologies operating profit decreased to $106.7 million due to lower gross margins and increased operating expenses.
Guidance, Outlook, Risks, and Contingencies
- Outlook: Specific 2006 financial guidance is referenced in a separate Form 8-K dated May 5, 2005. Management expects to complete restructuring of distribution agreements with pharmaceutical manufacturers by mid-2006 to shift toward a fee-based compensation model.
- Legal Contingencies:
- Securities Litigation: While a $960 million settlement was reached for the consolidated action, 91 lawsuits remain filed. The company believes the $240 million reserve is adequate but acknowledges the possibility of additional costs.
- Other Litigation: Pending cases include product liability claims (latex gloves, Vioxx, fen-phen), patent infringement suits (bar code technology), and asbestos claims (indemnified by Univar). A wrongful termination judgment of approximately $18.2 million (including punitive damages and fees) is under appeal.
- Contract Risk: A $500 million, 10-year contract with the UK National Health Services (NHS) has experienced delays. As of March 31, 2005, $114 million in net assets are invested. Failure to sign a tentative amendment or further delays could result in material losses.
- Customer Concentration: Sales to the ten largest customers accounted for approximately 50% of total consolidated revenues. The largest customer, Rite Aid Corporation, represented 10% of revenues.
Investor Verification Checklist
- Litigation Settlement Approval: Verify the final court approval status of the $960 million securities class action settlement and the $18.2 million ERISA settlement.
- NHS Contract Amendment: Confirm the execution of the tentative amendment with the UK NHS to ensure the recovery of the $114 million investment.
- Margin Stabilization: Monitor the progress of transitioning pharmaceutical manufacturer agreements to fee-based models to assess future gross margin stability.
- Customer Concentration: Review the financial health of the top 10 customers, particularly Rite Aid, given they represent half of total revenue.
- Stock-Based Compensation: Assess the impact of the upcoming adoption of SFAS No. 123(R) on future earnings, as the company anticipates a material impact starting in 2006/2007.