What drove the swing from a net loss in fiscal 2005 to strong net income in fiscal 2006?

The fiscal 2005 loss was driven by a $1.2 billion pre-tax Securities Litigation charge. In fiscal 2006 that charge fell to $45 million, and underlying results improved on higher revenue, better pharmaceutical distribution margins, and $95 million in antitrust settlement proceeds.

How concentrated is McKesson's customer base?

Very concentrated. Sales to the ten largest customers were about 53% of consolidated revenue in fiscal 2006, and the largest, Caremark RX, accounted for about 11%. Those customers also represented roughly 48% of accounts receivable, so a loss or payment default by a major customer could materially affect results.

Is the Securities Litigation behind McKesson?

Largely, but not entirely. The $960 million Consolidated Action settlement received final court approval in February 2006 and was paid into escrow. Bear Stearns has appealed the judgment, several state and Georgia cases remain pending, and the company carries a $1.01 billion accrual that management considers adequate.

What does the change in manufacturer compensation mean for future margins?

Many distribution arrangements moved from inflation-based compensation to a percentage of purchases, reducing reliance on drug price increases and raising buy-side margins in 2006. Some manufacturers still use the inflation-based model, and reduced price increases or limited inventory availability could pressure margins in those contracts.

MCK 10-K FY2006 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K filed May 16, 2006. Cited figures are marked; the original filing is the authoritative source.

McKesson Corporation's fiscal 2006 10-K (year ended March 31, 2006) reports record revenue of $88.1 billion^a, up 10% from $80.1 billion, driven almost entirely by the Pharmaceutical Solutions segment, which contributed about 95% of revenue.

Gross profit rose 12% to $3.9 billion^b, helped by a shift in manufacturer compensation toward percentage-of-purchase arrangements (reducing dependence on inflation-driven price increases) and higher antitrust settlement receipts ($95 million). Net income was $751 million, or $2.38 diluted EPS, a sharp rebound from the prior-year net loss of $157 million caused by a $1.2 billion Securities Litigation charge. Excluding the litigation charges, fiscal 2006 net income was $781 million ($2.48 per diluted share) versus $653 million ($2.19) in fiscal 2005.

Balance sheet and cash flow strengthened meaningfully. Operating cash flow rose to $2.7 billion^c from $1.5 billion, aided by better inventory alignment, and the debt-to-capital ratio fell to 14.4% from 18.7%. Net debt was negative (net cash position).

The company paid $960 million^d into escrow to settle the main HBOC-related securities class action, leaving a $1.0 billion accrual, and repurchased $958 million of stock during the year. The board approved an additional $500 million buyback in April 2006.

Key risks for investors include customer concentration (the ten largest customers were about 53% of revenue, and Caremark RX alone about 11%), thin pharmaceutical distribution margins (gross margin of 2.99% in Pharmaceutical Solutions), ongoing manufacturer compensation changes, unresolved securities and product liability litigation, and exposure to healthcare reimbursement policy. Management also flagged a 2007 share-based compensation expense increase under SFAS 123(R) of roughly $0.08 to $0.10 per diluted share.

02—Key points

Key Highlights

Revenue grew 10% to $88.1 billion, with Pharmaceutical Solutions contributing $83.4 billion (about 95% of total).
Net income rebounded to $751 million ($2.38 diluted EPS) from a $157 million loss in FY2005; excluding Securities Litigation charges, FY2006 EPS was $2.48 versus $2.19.
Gross profit increased 12% to $3.9 billion; the shift to percentage-of-purchase manufacturer compensation lifted buy-side margins in 2006.
Operating cash flow more than tripled? No: rose 78% to $2.74 billion, aided by lower net financial inventory.
Debt-to-capital ratio improved to 14.4% from 18.7%, and the company held net cash of about $1.15 billion.
Paid $960 million into escrow for the Consolidated Securities Action, leaving a $1.01 billion total Securities Litigation accrual; repurchased $958 million of stock in FY2006 and authorized another $500 million in April 2006.
High customer concentration: top ten customers were 53% of revenue and Caremark RX was about 11%.

03—Questions

Frequently Asked Questions

What drove the swing from a net loss in fiscal 2005 to strong net income in fiscal 2006?
The fiscal 2005 loss was driven by a $1.2 billion pre-tax Securities Litigation charge. In fiscal 2006 that charge fell to $45 million, and underlying results improved on higher revenue, better pharmaceutical distribution margins, and $95 million in antitrust settlement proceeds.
How concentrated is McKesson's customer base?
Very concentrated. Sales to the ten largest customers were about 53% of consolidated revenue in fiscal 2006, and the largest, Caremark RX, accounted for about 11%. Those customers also represented roughly 48% of accounts receivable, so a loss or payment default by a major customer could materially affect results.
Is the Securities Litigation behind McKesson?
Largely, but not entirely. The $960 million Consolidated Action settlement received final court approval in February 2006 and was paid into escrow. Bear Stearns has appealed the judgment, several state and Georgia cases remain pending, and the company carries a $1.01 billion accrual that management considers adequate.
What does the change in manufacturer compensation mean for future margins?
Many distribution arrangements moved from inflation-based compensation to a percentage of purchases, reducing reliance on drug price increases and raising buy-side margins in 2006. Some manufacturers still use the inflation-based model, and reduced price increases or limited inventory availability could pressure margins in those contracts.

04—Continue

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