01—Abstract
Summary
Summary of the 10-K filed June 10, 2004. Cited figures are marked; the original filing is the authoritative source.
McKesson's fiscal 2004 10-K (year ended March 31, 2004) shows a company growing revenue rapidly while its margins compressed.
Revenues rose 22% to $69.5 billiona, driven almost entirely by the Pharmaceutical Solutions segment (over 90% of revenue), but gross margin fell 76 basis points to 4.67% as lower-margin sales to customers' warehouses grew and pricing pressure intensified in pharmaceutical distribution. Net income rose 16% to $646.5 million and diluted EPS rose 16% to $2.19, helped by lower operating expenses as a percentage of revenue, a $66.4 million reversal of Information Solutions customer settlement reserves, and a $23.2 million tax benefit. Return on equity improved to 13.4%, and net debt to net capital employed dropped to 12.9% from 17.7%.
The filing is dominated by risk disclosures. The most significant is the restatement-related securities litigation tied to the 1999 HBOC accounting scandal: 91 lawsuits are pending, a trial is scheduled for September 2005, and the company says it cannot predict the outcome, which could include material judgments or settlements. Other notable risks include a $15 millionb punitive damages judgment (Roby case), an NHS contract in the UK where about $76 million of net assets are at risk of impairment, and the concentration of revenue in large customers (the top ten account for about 50% of revenue, and Rite Aid alone for about 11%).
Management reports that disclosure controls are effective, and the company reported no changes in internal control over financial reporting during the quarter. For investors, the story is strong top-line and earnings growth, offset by thin distribution margins, heavy customer concentration, and a long tail of litigation and contract risk that management has not quantified.
02—Key points
Key Highlights
- Revenue up 22% to $69.5B in FY2004, with Pharmaceutical Solutions accounting for over 90% of revenue ($65.6B), including $21.6B in sales to customers' warehouses
- Gross margin contracted 76 bps to 4.67%, reflecting competitive pricing pressure, reduced vendor incentives, and a higher mix of low-margin warehouse sales
- Net income up 16% to $646.5M; diluted EPS of $2.19 vs. $1.88 prior year; effective tax rate fell to 29.1% from 34.0%
- Balance sheet strengthened: debt-to-capital ratio improved to 22.3% from 25.0%; stockholders' equity rose to $5.17B; $156.8M in share repurchases during the year
- Information Solutions segment operating profit more than doubled to $190.4M, aided by a $66.4M reversal of customer settlement reserves that is non-recurring in nature
- Ninety-one lawsuits remain pending over the 1999 HBOC accounting restatement; a securities trial is set for September 2005, and no loss accrual has been recorded
- Customer concentration is high: the ten largest customers represent about 50% of revenue and Rite Aid about 11%; a $30M bad debt provision was taken for a bankrupt pharmacy customer
03—Questions
Frequently Asked Questions
How profitable is McKesson's core distribution business, and is margin pressure getting worse?
Pharmaceutical Solutions' gross margin fell to 3.25% from 3.85%, and segment operating margin fell to 1.42% from 1.86%. Management attributes this to competitive selling-price pressure, manufacturers reducing vendor incentives and secondary-market inventory purchases, and a shift toward lower-margin sales to customers' warehouses. Management says it is renegotiating distribution agreements with manufacturers, but the filing gives no assurance that these efforts will offset the pressure.
How material is the HBOC restatement litigation to shareholders?
It is potentially the largest open risk. Ninety-one lawsuits, including a consolidated federal securities class action, several state actions (Oregon, Merrill Lynch, Georgia cases), and ERISA suits, are pending. Management states it cannot predict the outcome or estimate a loss range, and it has accrued nothing for these matters. Adverse outcomes could include judgments or settlements that are material to financial position, results, and cash flows. The federal class action trial is scheduled for September 2005.
Were FY2004 earnings boosted by one-time items?
Yes, in part. Results included a $66.4M reversal of Information Solutions customer settlement reserves, a $23.2M tax benefit from favorable IRS and other tax settlements, a $21.7M antitrust settlement receipt, and $14.8M in gains on surplus property sales. Offsetting charges included a $21.0M write-off of employee stock purchase loans, a $30.0M bad debt provision for a bankrupt customer, and a $27.9M LIFO charge. Management noted that an additional $41.2M antitrust settlement will be recorded in Q1 FY2005. Investors should consider the net effect of these items when evaluating run-rate earnings.
What other contingent liabilities should investors watch?
The Roby wrongful termination judgment (May 2004) totals $3.5M compensatory plus $15.0M punitive damages against the company, with post-trial motions and appeal planned. The NHS UK human resources and payroll contract carries about $76M of net assets at risk of impairment, with renegotiation expected in the second half of calendar 2004. The company is also under a U.S. Attorney investigation of enteral nutrition sales in Minnesota (two employees indicted) and is a defendant in latex and asbestos product claims, with the asbestos matters tendered to Univar for indemnification.
04—Continue