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SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

Commission file number 1-13252

McKESSON CORPORATION

(415) 983-8300
(Registrant’s telephone number, including area code)

     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 x  No o

     Indicate by check mark whether the registrant is an accelerated filer. Yes x  No o

     Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

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McKESSON CORPORATION

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McKESSON CORPORATION

PART I. FINANCIAL INFORMATION

CONDENSED CONSOLIDATED BALANCE SHEETS

See Financial Notes

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McKESSON CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

See Financial Notes

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McKESSON CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

     See Financial Notes

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McKESSON CORPORATION

FINANCIAL NOTES

1. Significant Accounting Policies

     Basis of Presentation. In our opinion, these unaudited condensed consolidated financial statements include all adjustments necessary for a fair presentation of the Company’s financial position as of June 30, 2003, and the results of operations and cash flows for the quarters ended June 30, 2003 and 2002.

     The results of operations for the quarters ended June 30, 2003 and 2002 are not necessarily indicative of the results that may be expected for the entire year. These interim financial statements should be read in conjunction with the annual audited financial statements, accounting policies and financial notes included in our 2003 consolidated financial statements previously filed with the Securities and Exchange Commission. Certain prior period amounts have been reclassified to conform to the current period presentation.

     The Company’s fiscal year begins on April 1 and ends on March 31. Unless otherwise noted, all references to a particular year shall mean the Company’s fiscal year.

     New Accounting Pronouncements. In May 2003, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS No. 150 clarifies the definition of a liability as currently defined in FASB Concepts Statement No. 6, “Elements of Financial Statements,” as well as other planned revisions. This statement requires a financial instrument that embodies an obligation of an issuer to be classified as a liability. In addition, the statement establishes standards for the initial and subsequent measurement of these financial instruments and disclosure requirements. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003 and for all other matters, at the beginning of our second quarter 2004. We do not believe the adoption of this standard will have a material impact on our consolidated financial statements.

     In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS No. 149 amends SFAS No. 133 for decisions made as part of the FASB’s Derivatives Implementation Group process, other FASB projects dealing with financial instruments, and in connection with implementation issues raised in relation to the application of the definition of a derivative. This statement is generally effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. We do not believe the adoption of this standard will have a material impact on our consolidated financial statements.

     In January 2003, the FASB issued Interpretation (“FIN”) No. 46, “Consolidation of Variable Interest Entities.” This interpretation clarifies the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” in determining whether a reporting entity should consolidate certain legal entities, including partnerships, limited liability companies, or trusts, among others, collectively defined as variable interest entities (“VIEs”). This interpretation applies to VIEs created or obtained after January 31, 2003, and as of July 1, 2003, to VIEs in which an enterprise holds a variable interest that it acquired before February 1, 2003. We are currently in the process of evaluating the adoption of this standard; however, we do not believe that this standard will have a material impact on our consolidated financial statements.

     In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.” This statement amends SFAS No. 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. We adopted the disclosure provisions of this standard, as discussed below under Employee Stock-Based Compensation. We are currently assessing the fair value approach under SFAS No. 123 and the transitional provisions of SFAS No. 148.

     In November 2002, the FASB reached a consensus regarding Emerging Issues Task Force (“EITF”) Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables.” EITF Issue No. 00-21 addresses accounting for arrangements that may involve the delivery or performance of multiple products, services, and/or rights to use assets. The guidance provided by EITF Issue No. 00-21 is effective for us on contracts entered into on or after July

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McKESSON CORPORATION

FINANCIAL NOTES (Continued)

1, 2003. We do not believe the adoption of this standard will have a material impact on our consolidated financial statements.

     In June 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations,” which addresses financial accounting requirements for retirement obligations associated with tangible long-lived assets. In May 2002, the FASB issued SFAS No. 145, “Rescission of FASB Statements 4, 44, 64, Amendment to FASB Statement No. 13, and Technical Corrections as of April 2002.” SFAS No. 145 amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. SFAS Nos. 143 and 145 are effective for 2004 and do not have a material impact on our consolidated financial statements.

     Employee Stock-Based Compensation. We account for our employee stock-based compensation plans using the intrinsic value method under Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.” Had compensation cost for our employee stock-based compensation been recognized based on the fair value method, consistent with the provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” net income and earnings per share would have been as follows:

2. Acquisition and Divestiture

     In the second quarter of 2003, we acquired the outstanding stock of A.L.I. Technologies Inc. (“A.L.I.”) for an aggregate cash purchase price of $347.0 million. A.L.I. provides digital medical imaging solutions which are designed to streamline access to diagnostic information, automate clinical workflow and eliminate the need for film purchase and storage. The acquisition of A.L.I. complements our Horizon Clinicals™ offering by incorporating medical images into a computerized patient record. The results of A.L.I.’s operations have been included in the consolidated financial statements within our Information Solutions segment since the July acquisition date.

     The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition:

     The acquired intangibles represent technology assets and have a weighted-average useful life of five years. None of the amount assigned to goodwill is expected to be deductible for tax purposes. The aggregate purchase price was financed through cash and short-term borrowings. Pro forma results of operations for this business acquisition have not been presented because the effect was not material to the condensed consolidated financial statements.

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McKESSON CORPORATION

FINANCIAL NOTES (Continued)

     In September 2002, we sold the net assets of a marketing fulfillment business which was previously included in our Pharmaceutical Solutions segment. Net proceeds from the sale of this business were $4.5 million. The disposition resulted in an after-tax loss of $3.7 million or $0.01 per diluted share which was recorded in the second quarter of 2003. The net assets and results of operations of this business have been presented as a discontinued operation and, as a result, prior period amounts have been reclassified. Revenues and loss on discontinued operations were $4.8 million and $0.5 million for the quarter ended June 30, 2002.

3. Restructuring Activities

     We recorded net charges for restructuring activities of $1.3 million during the quarter ended June 30, 2003. These charges pertain to our planned consolidation of our Corporate enterprise-wide technology support departments and the closure of a distribution center in our Pharmaceutical Solutions segment, offset in part by $0.7 million in reversals of accruals pertaining to our 2002/2003 Medical-Surgical Solutions segment distribution center network consolidation plan. Approximately 196 employees were provided termination notices as a result of the 2004 restructuring programs of which 36 were terminated at June 30, 2003. Total anticipated costs for these consolidation programs, which are expected to be incurred over the next two quarters, are approximately $3.5 million.

     During the quarter ended June 30, 2002, we recorded restructuring charges of $4.5 million of which $2.5 million pertained to the planned closure of a distribution center and $2.0 million related to additional facility closure costs associated with a prior year’s restructuring activity within our Pharmaceutical Solutions segment.

     The following table summarizes restructuring activities for the quarter ended June 30, 2003:

     In addition to the above restructuring activities, we are still managing a 2000/2001 restructuring plan associated with customer settlements for the discontinuance of overlapping and nonstrategic products and other product development projects within our Information Solutions segment. Customer settlement allowances, which are included as a reduction of accounts receivable in the accompanying condensed consolidated balance sheets, were reduced by $0.3 million in non-cash settlements during the first quarter of 2004 to $86.6 million at June 30, 2003 from $86.9 million at March 31, 2003. Total cash and non-cash settlements of $43.2 million and $83.1 million have been incurred since the inception of the restructuring plan. Although the timing and final outcome of remaining customer settlements cannot be determined, we believe that any additional liability and related expenditures will not have a material adverse effect on our financial position, results of operations or cash flows.

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FINANCIAL NOTES (Continued)

4. Earnings Per Share

     Basic earnings per share is computed by dividing net income by the weighted average number of common shares outstanding during the reporting period. Diluted earnings per share is computed similarly except that it reflects the potential dilution that could occur if dilutive securities or other obligations to issue common stock were exercised or converted into common stock.

     The computations for basic and diluted earnings per share from continuing operations are as follows:

Approximately 43.4 million and 27.1 million stock options were excluded from the computations of diluted net earnings per share for the quarters ended June 30, 2003 and 2002 as their exercise price was higher than the Company’s average stock price.

5. Goodwill and Other Intangibles

     Changes in the carrying amount of goodwill for the quarter ended June 30, 2003, are as follows:

     Information regarding other intangibles is as follows:

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FINANCIAL NOTES (Continued)

     Amortization expense of other intangibles was $4.6 million and $3.9 million for the quarters ending June 30, 2003 and 2002. The weighted average remaining amortization periods for customer lists, technology and trademarks and other intangible assets at June 30, 2003 were: 7.3 years, 4.9 years and 4.9 years. As of June 30, 2003, estimated future annual amortization expense of these assets is as follows: $18.8 million, $18.2 million, $13.4 million, $13.2 million and $10.0 million for 2004 through 2008, and $10.3 million thereafter. At June 30, 2003, there were $13.6 million of other intangibles not subject to amortization.

6. Financing Activity

     In June 2003, we renewed our committed revolving receivables sale facility under substantially similar terms to those previously in place with the exception that the facility was increased by $150.0 million to $1.1 billion. The renewed facility expires in June 2004.

7. Convertible Preferred Securities

     In February 1997, the McKesson Financing Trust, a business trust sponsored by the Company, issued four million shares of preferred securities to the public and 123,720 common securities to us, which are convertible at the holder’s option into McKesson Corporation common stock. The proceeds of such issuances were invested by the trust in $206,186,000 aggregate principal amount of our 5% Convertible Junior Subordinated Debentures due 2027 (the “Debentures”). The Debentures represent the sole assets of the trust. The Debentures mature on June 1, 2027, bear interest at an annual rate of 5%, payable quarterly, and are currently redeemable by us at 102.0% of the principal amount.

     Holders of the securities are entitled to cumulative cash distributions at an annual rate of 5% of the liquidation amount of $50 per security. Each preferred security is convertible at the rate of 1.3418 shares of McKesson Corporation common stock, subject to adjustment in certain circumstances. The preferred securities will be redeemed upon repayment of the Debentures and are callable by us on or after March 4, 2000, in whole or in part, initially at 103.5% of the liquidation preference per share, and thereafter at prices declining at 0.5% per annum to 100% of the liquidation preference on and after March 4, 2007 plus, in each case, accumulated, accrued and unpaid distributions, if any, to the redemption date.

     We have guaranteed, on a subordinated basis, distributions and other payments due on the preferred securities (the “Guarantee”). The Guarantee, when taken together with our obligations under the Debentures, and in the indenture pursuant to which the Debentures were issued, and our obligations under the Amended and Restated Declaration of Trust governing the subsidiary trust, provides a full and unconditional guarantee of amounts due on the preferred securities.

     The Debentures and related trust investment in the Debentures have been eliminated in consolidation and the preferred securities reflected as outstanding in the condensed consolidated financial statements.

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FINANCIAL NOTES (Continued)

8. Stockholders’ Equity

     In 2001, the Company’s Board of Directors approved a program to repurchase up to $250.0 million of the Company’s common stock. During the quarter ended June 30, 2003, we repurchased 2.6 million shares having an aggregate cost of $75.3 million. Since the inception of this program, we have repurchased 7.0 million shares having an aggregate cost of $209.9 million. The repurchased shares will be used for general corporate purposes.

     Comprehensive income is as follows:

9. Financial Guarantees and Warranties

     Financial Guarantees. We have agreements with certain of our customers’ financial institutions under which we have guaranteed the repurchase of inventory at a discount in the event these customers are unable to meet certain obligations to those financial institutions. Among other limitations, these inventories must be in resalable condition. We have also guaranteed loans, credit facilities and the payment of leases for some customers; and we are a secured lender for substantially all of these guarantees. Customer guarantees range from one to ten years and were primarily provided to facilitate financing for certain strategic customers. At June 30, 2003, the maximum amounts of inventory repurchase guarantees and other customer guarantees were approximately $167.1 million and $65.0 million. We consider it unlikely that we would make significant payments under these guarantees and, accordingly, amounts accrued for these guarantees were nominal.

     At June 30, 2003, we had commitments to provide $6.1 million of cash contributions to Verispan (a joint venture in which we have an approximate 44% interest) and other equity-held investments and other commitments of $11.4 million, for which no amounts had been accrued. In addition, our banks and insurance companies have issued $47.5 million of standby letters of credit and surety bonds on our behalf in order to meet the security requirements for statutory licenses and permits, court and fiduciary obligations, and our workers’ compensation and automotive liability programs.

     Our software license agreements generally include certain provisions for indemnifying customers against liabilities if our software products infringe a third party’s intellectual property rights. To date, we have not incurred any material costs as a result of such indemnification agreements and have not accrued any liabilities related to such obligations.

     In conjunction with certain transactions, primarily divestitures, we may provide routine indemnification agreements (such as retention of previously existing environmental, tax and employee liabilities) whose terms vary in duration and often are not explicitly defined. Where appropriate, obligations for such indemnifications are recorded as liabilities. Because the amounts of these indemnification obligations often are not explicitly stated, the overall maximum amount of these commitments cannot be reasonably estimated. Other than obligations recorded as liabilities at the time of divestiture, we have historically not made significant payments as a result of these indemnification provisions.

     Warranties. In the normal course of business, we provide certain warranties and indemnification protection for our products and services. For example, we provide warranties that the pharmaceutical and medical-surgical products we distribute are in compliance with the Food, Drug and Cosmetic Act and other applicable laws and regulations. We have received the same warranties from our suppliers, who customarily are the manufacturers of the products. In addition, we have indemnity obligations to our customers for these products, which have also been provided to us from our suppliers, either through express agreement or by operation of law.

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FINANCIAL NOTES (Continued)

     We also provide warranties regarding the performance of software and automation products we sell. Our liability under these warranties is to bring the product into compliance with previously agreed upon specifications. For software products, this may result in additional project costs and are reflected in our estimates used for the percentage-of-completion method of accounting for software installation services within these contracts. In addition, most of our customers who purchase our software and automation products also purchase annual maintenance agreements. Revenue from these maintenance agreements is recognized on a straight-line basis over the contract period and the cost of servicing product warranties is charged to expense when claims become estimable. Accrued warranty costs were not material to the condensed consolidated balance sheets.

10. Litigation

     In our annual report on Form 10-K for the year ended March 31, 2003, we reported on numerous legal proceedings including, but not limited to, those arising out of our announcement on April 28, 1999 regarding accounting improprieties at HBO & Company (“HBOC”), now known as McKesson Information Solutions, Inc. (the “Accounting Litigation”). Since the date of that report the only significant developments in legal proceedings involving the Company were as follows:

     On June 17, 2003, plaintiffs in the previously-reported action Baker v. McKesson HBOC, Inc. et al., (N.D. Cal. No. C-99-20743-RMW), filed a Second Amended Complaint (“SAC”) against McKesson, HBOC, various current or former officers or directors of McKesson or HBOC, Arthur Andersen LLP (“Arthur Andersen”) and Bear Stearns and Co., Inc. The SAC asserts claims against McKesson and HBOC under Section 14(a) of the Securities and Exchange Act of 1934, for common law breach of fiduciary duty (McKesson only), misrepresentation, and detrimental reliance. The SAC seeks damages in an unspecified amount. By stipulation of the parties and order of the Court, the Baker action is stayed and the defendants are not currently required to respond to the SAC.

     On June 27, 2003, plaintiffs in the previously-reported action Merrill Lynch Fundamental Growth Fund et al. v. McKesson HBOC, Inc., et al., (S.F. Superior Court Case No. CGC-02-405792) filed a Third Amended Complaint (the “TAC”) against McKesson, HBOC, various current or former officers or directors of McKesson or HBOC, and Arthur Andersen. Like the prior complaints in the Merrill Lynch action, the TAC generally alleges that the defendants are liable under various statutory and common law claims in connection with the events leading to McKesson’s announcements in April, May and July of 1999. The TAC asserts claims against McKesson and HBOC under California Corporations Code § 25400(d)/25500, California Business and Profession Code § 17200 (HBOC only), common law fraud, negligent misrepresentation, conspiracy and aiding and abetting, New Jersey RICO (McKesson only), conspiracy to violate New Jersey RICO, Georgia’s securities laws, and conspiracy to violate Georgia RICO. The TAC seeks an award of restitution, compensatory damages and treble damages in an unspecified amount, and costs and expenses of litigation, including reasonable attorneys’ and experts’ fees.

     On July 25, 2003, McKesson and HBOC answered the Consolidated Complaint in the previously-reported action, The State of Oregon Public Employees Retirement Board v. McKesson HBOC, Inc. et al., (S.F. Superior Ct. Master File No. 307619), generally denying the allegations and any liability to plaintiffs. Also on July 25, 2003, McKesson filed cross-claims against all plaintiffs named in the Consolidated Complaint, alleging that if such parties exchanged HBOC shares in the Merger that were artificially inflated, as alleged by those parties in the Consolidated Complaint, then the exchange ratio for the Merger provided more shares to plaintiffs than would have otherwise been the case, and more shares than was just. The Company’s cross-claims against the plaintiffs seek judgments requiring plaintiffs to disgorge to the Company any “unjust enrichment.”

     We do not believe it is feasible to predict or determine the outcome or resolution of the Accounting Litigation proceedings, or to estimate the amounts of, or potential range of, loss with respect to those proceedings. In addition, the timing of the final resolution of these proceedings is uncertain. The range of possible resolutions of these proceedings could include judgments against the Company or settlements that could require substantial payments by the Company, which could have a material adverse impact on McKesson’s financial position, results of operations and cash flows.

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FINANCIAL NOTES (Concluded)

11. Segment Information

     Our operating segments consist of Pharmaceutical Solutions, Medical-Surgical Solutions and Information Solutions. We evaluate the performance of our operating segments based on operating profit before interest expense and income taxes. Our Corporate segment includes expenses associated with Corporate functions and projects, and certain employee benefits. Corporate expenses are allocated to the operating segments to the extent that these items can be directly attributable to the segment.

     Financial information relating to our segments is as follows:

(1)

Includes an $8.5 million gain on the sale of a surplus property in 2004.

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FINANCIAL REVIEW

Item 2. Management’s Discussion and Analysis of Results of Operations and Financial Condition

Financial Overview

     Revenues for the first quarter of 2004 grew by 21% to $16.5 billion from $13.6 billion for the first quarter of 2003. Net income increased 33% to $155.6 million in the first quarter of 2004 compared to the same period a year ago, and diluted earnings per share increased $0.14 to $0.53. Increases in net income and diluted earnings per share primarily reflect revenue growth and operating margin expansion in our Pharmaceutical Solutions segment.

Results of Operations

     Revenues: