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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
(In millions, except per share amounts)
(Unaudited)

See Financial Notes.

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McKESSON CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In millions, except per share amounts)
(Unaudited)

See Financial Notes.

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McKESSON CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In millions)
(Unaudited)

See Financial Notes.

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McKESSON CORPORATION

FINANCIAL NOTES
(Unaudited)

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 September 30, 2003, and the results of operations for the quarter and six months ended September 30, 2003 and 2002 and cash flows for the six months ended September 30, 2003 and 2002.

     The results of operations for the quarter and six months ended September 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 of 2004. The adoption of this standard did not 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 by the FASB’s Derivatives Implementation Group, other FASB projects dealing with financial instruments, and in response to 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. The adoption of this standard did not 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 (subsequently delayed until financial statements issued after December 15, 2003), to VIEs in which an enterprise holds a variable interest that it acquired before February 1, 2003. As currently proposed, FIN No. 46 is not anticipated to have a material impact on our consolidated financial statements, however, it may affect the consolidation of one of the Company’s VIEs, the McKesson Financing Trust, as described in Financial Note 8.

     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.

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McKESSON CORPORATION

FINANCIAL NOTES (Continued)
(Unaudited)

     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 contracts entered into on or after July 1, 2003. The adoption of this statement did not have a material effect 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 were effective commencing April 1, 2003 and did 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.

Acquisitions 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. complemented our Horizon Clinicals™ offering by incorporating medical images into a computerized patient record. Approximately $328 million of A.L.I.’s purchase price was assigned to goodwill, none of which is deductible for tax purposes. The aggregate purchase price was financed through cash and short-term borrowings. The results of A.L.I.’s operations have been included in the consolidated financial statements within our Information Solutions segment since its acquisition date.

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McKESSON CORPORATION

FINANCIAL NOTES (Continued)
(Unaudited)

     During the six months ended September 30, 2003 and 2002, our Pharmaceutical Solutions segment completed several smaller acquisitions. Pro forma results of operations have not been presented for these acquisitions, nor the acquisition of A.L.I., as the effects were not material to the condensed consolidated financial statements on either an individual or aggregate basis.

     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.

3.

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 38.4 million and 34.5 million stock options were excluded from the computations of diluted net earnings per share for the quarters ended September 30, 2003 and 2002 as their exercise price was higher than the Company’s average stock price. For the six months ended September 30, 2003 and 2002, the number of stock options excluded was 31.8 million and 27.3 million.

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McKESSON CORPORATION

FINANCIAL NOTES (Continued)
(Unaudited)

4.

Restructuring Activities

     We recorded net charges for restructuring activities of $0.5 million and $1.8 million during the quarter and six months ended September 30, 2003. These charges pertain to the consolidation of our Corporate enterprise-wide information network support departments and the closure of a distribution center in our Pharmaceutical Solutions segment. These charges were partly offset by reversals of accruals pertaining to prior year programs from all three of our operating segments. Approximately 167 employees were provided termination notices as a result of our 2004 restructuring initiatives of which 143 were terminated at September 30, 2003.

     During the quarter and six months ended September 30, 2002, we recorded net reductions in severance and exit-related accruals of $10.9 million and $7.4 million, and restructuring-related asset impairments of $0.3 million and $1.3 million. The net reductions in the accruals were the result of a modification to our Medical-Surgical Solutions segment’s distribution center strategy. Results for the six months ended September 30, 2002 also included $4.5 million of restructuring charges associated with the planned closure of a pharmaceutical distribution center and additional facility closure costs for a prior year restructuring plan.

     The following table summarizes restructuring activities for the six months ended September 30, 2003:

     In addition to the above restructuring activities, we are still managing a 2001/2000 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, decreased to $63.4 million at September 30, 2003 from $86.9 million at March 31, 2003. Reductions in the allowance were due to a reversal of $19.7 million of the allowance into operating expenses in the second quarter of 2004 due to favorable settlements and continued negotiations with affected customers, and $0.5 million and $3.3 million of cash and non-cash settlements. Total cash and non-cash settlements of $43.7 million and $86.1 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.

5.

Income Taxes

     During the quarter ended September 30, 2003, we recorded an income tax benefit of $15.3 million relating to favorable tax settlements with the U.S. Internal Revenue Service. These settlements pertain to amended tax returns for the years ended December 31, 1997 and 1998 filed by our subsidiary, McKesson Information Solutions Inc. formerly known as HBO & Company. The benefit of these tax assets was not previously recognized by the Company.

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McKESSON CORPORATION

FINANCIAL NOTES (Continued)
(Unaudited)

6.

Goodwill and Other Intangible Assets

     Changes in the carrying amount of goodwill for the six months ended September 30, 2003 are as follows:

     Information regarding other intangibles is as follows:

     Amortization expense of other intangibles was $5.1 million and $9.7 million for the quarter and six months ended September 30, 2003 and $4.6 million and $8.5 million for the comparable prior year periods. The weighted average remaining amortization periods for customer lists, technology and trademarks and other intangible assets at September 30, 2003 were: 7.2 years, 4.7 years and 4.9 years. As of September 30, 2003, estimated future annual amortization expense of these assets is as follows: $19.0 million, $17.8 million, $13.1 million, $12.8 million and $9.8 million for 2004 through 2008, and $10.4 million thereafter. At September 30, 2003, there were $13.8 million of other intangibles not subject to amortization.

7.

Financing Activities

     In September 2003, we renegotiated our 364-day revolving credit agreement. With the exception that the facility was increased by $100.0 million to $650.0 million, the terms of the new agreement are substantially similar to those previously in place. The renewed facility expires in September 2004.

     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.

     At September 30, 2003, $135.0 million of short-term borrowings were outstanding and $200.0 million was utilized under the revolving receivables sale facility. At March 31, 2003, no amounts were outstanding or utilized under any of our facilities. In addition, at September 30, 2003, we sold customer lease receivables from our Pharmaceutical Solutions segment for cash proceeds of $35.2 million. The sale of these receivables resulted in a pre-tax gain of $2.5 million which is included in Other Income in the condensed consolidated statement of operations.

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McKESSON CORPORATION

FINANCIAL NOTES (Continued)
(Unaudited)

8. Convertible Preferred Securities

     In February 1997, the McKesson Financing Trust (the “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 investments in the Debentures have historically been eliminated in consolidation and the preferred securities reflected as outstanding in the accompanying condensed consolidated financial statements. However, under the currently proposed FIN No. 46 (see Financial Note 1), the Company would no longer consolidate its investment in the Trust as it would not be designated as the Trust’s primary beneficiary. In accordance with this accounting standard, the Company would recognize the Debentures as long-term debt on its consolidated balance sheets in lieu of the preferred securities. Additionally, dividends on the preferred securities would be recharacterized as interest expense in the consolidated statement of operations. These changes would be adopted on a retroactive basis and are not anticipated to have a material impact on our consolidated financial statements, including diluted earnings per share.

9. 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 six months ended September 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. On October 30, 2003, the Company’s Board of Directors approved a new program to repurchase up to $250.0 million of additional common stock of the company.

     Comprehensive income is as follows:

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FINANCIAL NOTES (Continued)
(Unaudited)

10. 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 requirements, 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 September 30, 2003, the maximum amounts of inventory repurchase guarantees and other customer guarantees were approximately $160 million and $62 million of which approximately $9 million had been accrued for these guarantees.

     During the second quarter of 2004, one of our Pharmaceutical Solutions customers announced its bankruptcy. Accordingly, we reviewed all amounts owed to us from this customer as well as financial guarantees provided to third parties in favor of this customer, and as a result, we increased our provision for doubtful accounts by $30.0 million.

     At September 30, 2003, we had commitments to provide $5.4 million of cash contributions and $10.6 million of other commitments to our equity-held investments, for which no amounts had been accrued. In addition, our banks and insurance companies have issued $67.2 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 on 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.

     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 consolidated balance sheets.

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FINANCIAL NOTES (Continued)
(Unaudited)

11. Litigation

     In our annual report on Form 10-K for the year ended March 31, 2003, and in our quarterly report on Form 10-Q for the quarter ended June 30, 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 those reports the only significant developments in legal proceedings involving the Company were as follows:

Accounting Litigation

     In the previously reported action captioned In re McKesson HBOC, Inc. Securities Litigation, (N.D. Cal. Case No. C-99-20743-RMW) (the “Consolidated Action”), the parties are currently discussing a modification of the briefing and hearing schedule on the motion for class certification filed by lead plaintiff New York State Common Retirement Fund (“NYSCRF”).

     On August 13, 2003, the U.S. Court of Appeals for the Ninth Circuit affirmed Judge Whyte’s January 9, 2002, order dismissing our counterclaim against NYSCRF in the previously-reported action captioned McKesson HBOC, Inc. v. New York State Common Retirement Fund, Inc. et al., (N.D. Cal. Case No. C01-20021-RWM) (9th Cir. Nos. 02-15301, 02-16272).

     On August 29, 2003, Judge Whyte held a hearing on McKesson’s and HBOC’s motions to dismiss the consolidated and amended complaint in the previously-reported action captioned: In re McKesson HBOC, Inc. ERISA Litigation, (N.D. Cal. Case No. C-02-0685-RMW). Judge Whyte has not yet issued a ruling on that motion.

     On August 22, 2003, the court in the previously-reported action captioned Curran Partners, L.P. v. McKesson HBOC, Inc. et al., (Georgia State Court, Fulton County No. 00 VS 010801) granted our motion to stay the Curran action in favor of the Consolidated Action. However, in September 2003, the court lifted the stay and transferred the action to the judge presiding over the previously-reported action captioned Suffolk Partners L.P. et al v. McKesson HBOC, Inc. et al, (Georgia State Court, Fulton County No. 00VS010469A).

     On September 24, 2003, plaintiff Arlene Ash requested an order dismissing her from the case without prejudice and without any remuneration for herself or her attorneys in the previously reported action, Ash, et. al. v. McCall, (Civil Action No. 17132) filed in the Delaware Court of Chancery. Three other plaintiffs will remain in the case if Ash’s request is granted. On October 2, 2003, the three remaining plaintiffs filed a motion for leave to file a Fourth Amended Complaint.

     In the previously reported action captioned, Derdiger v. Tallman et. al., (Civil Action No. 17276), filed in the Delaware Court of Chancery, on August 4, 2003, the court issued an order dismissing the class action claims brought on behalf of persons other than the named plaintiff Howard Derdiger without prejudice in favor of the prior pending Consolidated Action pending in the U.S. District Court for the Northern District of California. The parties thereafter dismissed plaintiff Howard Derdiger’s individual claims with prejudice pursuant to a settlement.

     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)
(Unaudited)

Other Litigation, Investigations and Claims

     The U.S. Attorney’s Office for the Southern District of Illinois is conducting an industry-wide civil and criminal investigation into the marketing, sale and Medicare reimbursement of enteral nutritional products (“Products”). As previously disclosed, the U.S. Attorney’s Office has indicated that the Company and two of our employees are subjects of the investigation. Since the date of our last periodic report, the U.S. Attorney’s Office announced indictments of these two employees on charges of mail fraud, conspiracy, and violation of the anti-kickback statute. The two employees have been placed on leave pending resolution of the charges. As previously reported, the Products are sold, and the individuals are employed by the extended care business conducted by McKesson Medical-Surgical Minnesota Supply Inc., an indirect subsidiary of the Company. The Company remains a subject of the government’s investigation and we are continuing to cooperate with the U.S. Attorney’s Office.

12. 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 segments.

     Financial information relating to our segments is as follows: