SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

(Mark One)

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For quarter ended September 30, 2006

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     

McKESSON CORPORATION

(Exact name of Registrant as specified in its charter)

Delaware (State or other jurisdiction of incorporation or organization)		94-3207296 (IRS Employer Identification No.)
One Post Street, San Francisco, California (Address of principal executive offices)		94104 (Zip Code)

(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 þ      No o

     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer þ      Accelerated filer o       Non-accelerated filer o

     Indicate by check mark whether the registrant is a shell company as defined in Rule 12b-2 of the Exchange Act. Yes o      No þ

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

Class		Outstanding at September 30, 2006
Common stock, $0.01 par value		295,968,992 shares

 

 

TABLE OF CONTENTS

Item		Page
PART I—FINANCIAL INFORMATION
1. Condensed Consolidated Financial Statements
Condensed Consolidated Balance Sheets September 30, 2006 and March 31, 2006			3
Condensed Consolidated Statements of Operations Quarters and Six Months ended September 30, 2006 and 2005			4
Condensed Consolidated Statements of Cash Flows Six Months ended September 30, 2006 and 2005			5
Financial Notes			6
2. Management’s Discussion and Analysis of Results of Operations and Financial Condition			22-35
3. Quantitative and Qualitative Disclosures about Market Risk			35
4. Controls and Procedures			35
PART II. OTHER INFORMATION
1. Legal Proceedings			35
1A. Risk Factors			35
2. Unregistered Sales of Equity Securities and Use of Proceeds			36
3. Defaults Upon Senior Securities			36
4. Submission of Matters to a Vote of Security Holders			36
5. Other Information			37
6. Exhibits			38
Signatures			39
EXHIBIT 10.10
EXHIBIT 10.13
EXHIBIT 10.14
EXHIBIT 10.15
EXHIBIT 10.21
EXHIBIT 10.30
EXHIBIT 10.31
EXHIBIT 10.32
EXHIBIT 10.33
EXHIBIT 10.34
EXHIBIT 10.35
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32

McKESSON CORPORATION

PART I. FINANCIAL INFORMATION

CONDENSED CONSOLIDATED BALANCE SHEETS
(In millions, except per share amounts)
(Unaudited)

		September 30,				March 31,
		2006				2006
ASSETS
Current Assets
Cash and cash equivalents		$	2,254			$	2,139
Restricted cash			981				962
Receivables, net			5,983				6,247
Inventories			7,791				7,127
Prepaid expenses and other			293				522
Total			17,302				16,997
Property, Plant and Equipment, Net			634				663
Capitalized Software Held for Sale, Net			150				139
Goodwill			1,696				1,637
Intangible Assets, Net			132				116
Other Assets			1,565				1,409
Total Assets		$	21,479			$	20,961
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities
Drafts and accounts payable		$	10,426			$	9,944
Deferred revenue			813				827
Current portion of long-term debt			25				26
Securities Litigation			1,002				1,014
Other			1,664				1,679
Total			13,930				13,490
Postretirement Obligations and Other Noncurrent Liabilities			669				599
Long-Term Debt			959				965
Other Commitments and Contingent Liabilities (Note 14)
Stockholders’ Equity
Preferred stock, $0.01 par value, 100 shares authorized, no shares issued or outstanding			—				—
Common stock, $0.01 par value Shares authorized: September 30, 2006 and March 31, 2006 – 800 Shares issued: September 30, 2006 – 335 and March 31, 2006 – 330			3				3
Additional paid-in capital			3,444				3,238
Other capital			(33	)			(75	)
Retained earnings			4,248				3,871
Accumulated other comprehensive income			94				55
ESOP notes and guarantees			(17	)			(25	)
Treasury shares, at cost, September 30, 2006 – 39 and March 31, 2006 – 26			(1,818	)			(1,160	)
Total Stockholders’ Equity			5,921				5,907
Total Liabilities and Stockholders’ Equity		$	21,479			$	20,961

See Financial Notes

McKESSON CORPORATION

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

		Quarter Ended								Six Months Ended
		September 30,								September 30,
		2006				2005				2006				2005
Revenues		$	22,386			$	21,253			$	45,701			$	41,953
Cost of Sales			21,362				20,385				43,681				40,189
Gross Profit			1,024				868				2,020				1,764
Operating Expenses			724				642				1,448				1,232
Securities Litigation Charge (Credit), Net			(6	)			—				(6	)			52
Total Operating Expenses			718				642				1,442				1,284
Operating Income			306				226				578				480
Other Income, Net			32				35				67				62
Interest Expense			(22	)			(22	)			(45	)			(47	)
Income from Continuing Operations Before Income Taxes			316				239				600				495
Income Tax Provision			(29	)			(87	)			(129	)			(177	)
Income from Continuing Operations			287				152				471				318
Discontinued Operations, net			(6	)			2				(6	)			7
Discontinued Operations – gain (loss) on sale, net			(52	)			13				(52	)			13
Total Discontinued Operations			(58	)			15				(58	)			20
Net Income		$	229			$	167			$	413			$	338
Earnings Per Common Share
Diluted
Continuing operations		$	0.94			$	0.48			$	1.54			$	1.02
Discontinued operations			(0.02	)			0.01				(0.02	)			0.02
Discontinued operations – gain (loss) on sale, net			(0.17	)			0.04				(0.17	)			0.04
Total		$	0.75			$	0.53			$	1.35			$	1.08
Basic
Continuing operations		$	0.96			$	0.49			$	1.57			$	1.04
Discontinued operations			(0.02	)			0.01				(0.02	)			0.03
Discontinued operations – gain (loss) on sale, net			(0.17	)			0.04				(0.17	)			0.04
Total		$	0.77			$	0.54			$	1.38			$	1.11
Dividends Declared Per Common Share		$	0.06			$	0.06			$	0.12			$	0.12
Weighted Average Shares
Diluted			305				316				307				315
Basic			298				308				300				305

See Financial Notes

McKESSON CORPORATION

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

		Six Months Ended September 30,
		2006				2005
Operating Activities
Net income		$	413			$	338
Discontinued operations, net of income taxes			58				(20	)
Adjustments to reconcile to net cash provided by (used in) operating activities:
Depreciation and amortization			139				125
Securities Litigation charge (credit), net			(6	)			52
Deferred taxes			70				111
Other non-cash items			(15	)			(9	)
Total			659				597
Effects of changes in:
Receivables			256				58
Inventories			(635	)			262
Drafts and accounts payable			454				1,090
Deferred revenue			12				101
Taxes			33				12
Securities Litigation settlement payments			(6	)			(69	)
Proceeds from sale of notes receivable			—				28
Other			(88	)			(77	)
Total			26				1,405
Net cash provided by operating activities			685				2,002
Investing Activities
Property acquisitions			(51	)			(82	)
Capitalized software expenditures			(86	)			(65	)
Acquisitions of businesses, less cash and cash equivalents acquired			(95	)			(573	)
Proceeds from sale of businesses			175				63
Other			(38	)			5
Net cash used in investing activities			(95	)			(652	)
Financing Activities
Repayment of debt			(8	)			(20	)
Capital stock transactions:
Issuances			191				282
Share repurchases			(658	)			(289	)
ESOP notes and guarantees			7				9
Dividends paid			(36	)			(36	)
Other			29				(101	)
Net cash used in financing activities			(475	)			(155	)
Net increase in cash and cash equivalents			115				1,195
Cash and cash equivalents at beginning of period			2,139				1,800
Cash and cash equivalents at end of period		$	2,254			$	2,995

See Financial Notes

McKESSON CORPORATION

FINANCIAL NOTES
(Unaudited)

1. Significant Accounting Policies

     Basis of Presentation. The condensed consolidated financial statements of McKesson Corporation (“McKesson,” the “Company,” or “we” and other similar pronouns) include the financial statements of all majority-owned or controlled companies. Significant intercompany transactions and balances have been eliminated. 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, 2006, and the results of operations for the quarters and six months ended September 30, 2006 and 2005 and cash flows for the six months ended September 30, 2006 and 2005.

     The results of operations for the quarters and six months ended September 30, 2006 and 2005 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 2006 consolidated financial statements previously filed with the Securities and Exchange Commission (“SEC”).

     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. Certain prior year amounts have been reclassified to conform to the current year presentation.

     New Accounting Pronouncements. On April 1, 2006, we adopted Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share-Based Payment,” which requires the recognition of expense resulting from transactions in which we acquire goods and services by issuing our shares, share options, or other equity instruments. This standard requires a fair-value based measurement method in accounting for share-based payment transactions. The share-based compensation expense is recognized for the portion of the awards that is ultimately expected to vest. This standard replaced SFAS No. 123, “Accounting for Stock-Based Compensation,” and superseded Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.” Accordingly, the use of the intrinsic value method as provided under APB Opinion No. 25, which was utilized by the Company, was eliminated. We adopted SFAS No. 123(R) using the modified prospective method of transition. See Financial Note 4, “Share-Based Payment,” for further details.

     As a result of the provisions of SFAS No. 123(R), in 2007, we now expect share-based compensation charges to approximate $0.10 to $0.12 per diluted share, or an increase of $0.02 per diluted share from our previous expectations. These charges are now expected to be approximately $0.07 to $0.09 per diluted share more than the share-based compensation expense recognized in our net income in 2006. Our assessments of estimated compensation charges are affected by our stock price as well as assumptions regarding a number of complex and subjective variables and the related tax impact. These variables include, but are not limited to, the volatility of our stock price, employee stock option exercise behaviors, timing, level and types of our grants of annual share-based awards and the attainment of performance goals. As a result, the actual share-based compensation expense in 2007 may differ from the Company’s current estimate.

     In July 2006, the Financial Accounting Standards Board (“FASB”) issued Financial Interpretation (“FIN”) No. 48, “Accounting for Uncertainty in Income Taxes,” which clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes.” FIN No. 48 provides that a tax benefit from an uncertain tax position may be recognized when it is more likely than not that the position will be sustained upon examination, including resolutions of any related appeals or litigation processes, based on the technical merits. This interpretation also provides guidance on measurement, derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN No. 48 will become effective for us in 2008. We are currently assessing the impact of FIN No. 48 on our consolidated financial statements.

     In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” which defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. This standard applies under other accounting pronouncements that require or permit fair value measurements, but does not require any new fair value measurements. SFAS No. 157 will become effective for us in 2009. We are currently assessing the impact of SFAS No. 157; however, we do not believe the adoption of this standard will have a material effect on our consolidated financial statements.

McKESSON CORPORATION

FINANCIAL NOTES (Continued)
(Unaudited)

     In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans,” which requires us to recognize the funded status of our defined benefit plans in the consolidated balance sheets and changes in the funded status in comprehensive income. This standard also requires us to recognize the gains/losses, prior year service costs and transition assets/obligations as a component of other comprehensive income upon adoption, and provide additional annual disclosure. SFAS No.158 does not affect the computation of benefit expense recognized in our consolidated statements of operations. The recognition and disclosure provisions are effective in 2007. In addition, SFAS No. 158 requires us to measure plan assets and benefit obligations as of the year-end balance sheet date effective in 2009. We are required to apply the provisions of this standard prospectively. We are currently assessing the impact of SFAS No. 158 on our consolidated financial statements.

     In September 2006, the SEC staff issued Staff Accounting Bulletin (“SAB”) No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” This guidance indicates that the materiality of a misstatement must be evaluated using both the rollover and iron curtain approaches. The iron curtain approach quantifies a misstatement based on the effects of correcting the misstatement existing in the balance sheet at the end of the current year, while the rollover approach quantifies a misstatement based on the amount of the error originating in the current year income statement. SAB No. 108 is effective for our 2007 annual consolidated financial statements. We are currently assessing the impact of SAB No. 108; however, we do not believe the adoption of this standard will have a material effect on our consolidated financial statements.

2. Acquisitions and Investments

     In the first half of 2007, we acquired the following three entities for a total cost of $91 million, which was paid in cash:

–		Sterling Medical Services LLC (“Sterling”), based in Moorestown, New Jersey, a national provider and distributor of medical disposable supplies, health management services and quality management programs to the home care market. Financial results for Sterling are included in our Medical-Surgical Solutions segment;
–		HealthCom Partners LLC (“HealthCom”), based in Mt. Prospect, Illinois, a leading provider of patient billing solutions designed to simplify and enhance healthcare providers’ financial interactions with their patients; and
–		RelayHealth Corporation (“RelayHealth”), based in Emeryville, California, a provider of secure online healthcare communication services linking patients, healthcare professionals, payors and pharmacies. Financial results for HealthCom and RelayHealth are included in our Provider Technologies segment.

     Goodwill recognized in these transactions amounted to $60 million.

     In addition, in the first quarter of 2007, we contributed $36 million in cash and $45 million in net assets primarily from our Automated Prescription Systems business to Parata Systems, LLC (“Parata”), in exchange for a significant minority interest in Parata. In connection with the investment, we abandoned certain assets which resulted in a $15 million charge to cost of sales and we incurred $6 million of other expenses related to the transaction which were recorded within operating expenses. We did not recognize any additional gains or losses as a result of this transaction as we believe the fair value of our investment in Parata, as determined by a third-party valuation, approximates the carrying value of consideration contributed to Parata. Our investment in Parata is accounted for under the equity method of accounting within our Pharmaceutical Solutions segment.

     In 2006, we made the following acquisitions:

–

In the second quarter of 2006, we acquired all of the issued and outstanding stock of D&K Healthcare Resources, Inc. (“D&K”) of St. Louis, Missouri, for an aggregate cash purchase price of $479 million, including the assumption of D&K’s debt. D&K is primarily a wholesale distributor of branded and generic pharmaceuticals and over-the-counter health and beauty products to independent and regional pharmacies, primarily in the Midwest. Approximately $158 million of the purchase price has been assigned to goodwill. Included in the purchase price were acquired identifiable intangibles of $43 million primarily representing

McKESSON CORPORATION

FINANCIAL NOTES (Continued)
(Unaudited)

customer lists and not-to-compete covenants which have an estimated weighted-average useful life of nine years. Financial results for D&K are included in our Pharmaceutical Solutions segment.

–

Also in the second quarter of 2006, we acquired all of the issued and outstanding shares of Medcon, Ltd. (“Medcon”), an Israeli company, for an aggregate purchase price of $82 million. Medcon provides web-based cardiac image and information management services to healthcare providers. Approximately $60 million of the purchase price was assigned to goodwill and $20 million was assigned to intangibles which represent technology assets and customer lists which have an estimated weighted-average useful life of four years. Financial results for Medcon are included in our Provider Technologies segment.

     During the last two years, we also completed a number of other acquisitions and investments within all three of our operating segments. Financial results for our business acquisitions have been included in our consolidated financial statements since their respective acquisition dates. Purchase prices for our business acquisitions have been allocated based on estimated fair values at the date of acquisition and, for certain recent acquisitions, may be subject to change. Goodwill recognized for our business acquisitions is not expected to be deductible for tax purposes. Pro forma results of operations for our business acquisitions have not been presented because the effects were not material to the consolidated financial statements on either an individual or an aggregate basis.

3. Discontinued Operations

     Results from discontinued operations were as follows:

		Quarter Ended								Six Months Ended
		September 30,								September 30,
(In millions)		2006				2005				2006				2005
Income (loss) from discontinued operations
Acute Care		$	(10	)		$	3			$	(10	)		$	10
BioServices			—				—				—				2
Income taxes			4				(1	)			4				(5	)
Total		$	(6	)		$	2			$	(6	)		$	7
Gain (loss) on sale of discontinued operations
Acute Care		$	(49	)		$	—			$	(49	)		$	—
BioServices			—				22				—				22
Other			6				—				6				—
Income taxes			(9	)			(9	)			(9	)			(9	)
Total		$	(52	)		$	13			$	(52	)		$	13
Discontinued operations, net of taxes
Acute Care		$	(67	)		$	2			$	(67	)		$	6
PBI			5				—				5				—
BioServices			—				13				—				14
Other			4				—				4				—
Total		$	(58	)		$	15			$	(58	)		$	20

     In July 2006, we signed an agreement to sell our Medical-Surgical Solutions segment’s Acute Care supply business to Owens & Minor, Inc. (“OMI”) for net cash proceeds of approximately $160 million, subject to certain adjustments. This transaction closed on September 30, 2006. In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the financial results of this business are classified as a discontinued operation for all periods presented in the accompanying condensed consolidated financial statements. Such presentation includes the classification of all applicable assets of the disposed business under the caption “Prepaid expenses and other” and all applicable liabilities under the caption “Other” under “Current Liabilities”

McKESSON CORPORATION

FINANCIAL NOTES (Continued)
(Unaudited)

within our condensed consolidated balance sheets for all periods presented. Revenues associated with the Acute Care business were $274 million and $260 million for the second quarters of 2007 and 2006, and $573 million and $528 million for the first halves of 2007 and 2006.

     Financial results for this discontinued operation include an after-tax loss of $67 million, which primarily consists of an after-tax loss of $61 million for the business’ disposition and $6 million of after-tax losses associated with operations, other asset impairment charges and employee severance costs. The after-tax loss of $61 million for the business’ disposition includes a $79 million non-tax deductible write-off of goodwill, as further described below.

     In connection with this divestiture, we allocated a portion of our Medical-Surgical Solutions segment’s goodwill to the Acute Care business as required by SFAS No. 142, “Goodwill and Other Intangible Assets.” The allocation was based on the relative fair values of the Acute Care business and the continuing businesses that are being retained by the Company. The fair value of the Acute Care business was determined based on the net cash proceeds resulting from the divestiture and the fair value of the continuing businesses was determined by a third-party valuation. As a result, we allocated $79 million of the segment’s goodwill to the Acute Care business.

     Additionally, as part of the divestiture, we entered into a transition services agreement (“TSA”) with OMI under which we will continue to provide certain services to the Acute Care business during a transition period of approximately nine months. We also anticipate incurring approximately $6 million of pre-tax employee severance charges over the transition period. These charges, as well as the financial results from the TSA, will be recorded as part of discontinued operations. The continuing cash flows generated from the TSA are not anticipated to be material to our condensed consolidated financial statements.

     In the second quarter of 2007, we also sold a wholly-owned subsidiary, Pharmaceutical Buyers Inc. (“PBI”), for net cash proceeds of $10 million. The divestiture resulted in an after-tax gain of $5 million resulting from the tax basis of the subsidiary exceeding its carrying value. Financial results of this business, which were previously included in our Pharmaceutical Solutions segment, have been presented as a discontinued operation for all periods presented in the accompanying condensed consolidated financial statements. These results were not material to our condensed consolidated financial statements.

     Results for discontinued operations for 2007 also include an after-tax gain of $4 million associated with the collection of a note receivable from a business sold in 2003.

     In the second quarter of 2006, we sold our wholly-owned subsidiary, McKesson BioServices Corporation (“BioServices”), for net cash proceeds of $63 million. The divestiture resulted in an after-tax gain of $13 million. Financial results for this business, which were previously included in our Pharmaceutical Solutions segment, have been presented as a discontinued operation for all periods presented in the accompanying condensed consolidated financial statements. These results were not material to our condensed consolidated financial statements.

4. Share-Based Payment

     We provide various share-based compensation for our employees, officers and non-employee directors, including stock options, an employee stock purchase plan, restricted stock (“RS”), restricted stock units (“RSUs”) and performance-based restricted stock units (“PeRSUs”) (collectively, “share-based.”) On April 1, 2006, we adopted SFAS No. 123(R), as discussed in Financial Note 1, “Significant Accounting Policies.” Accordingly, we began to recognize compensation expense for the fair value of share-based awards granted, modified, repurchased or cancelled from April 1, 2006 forward. For the unvested portion of awards issued prior to and outstanding as of April 1, 2006, the expense is recognized at the grant-date fair value as the remaining requisite service is rendered. We recognize compensation expense on a straight-line basis over the requisite service period for those awards with graded vesting and service conditions. For the awards with performance conditions, we recognize the expense on a straight-line basis, treating each vesting tranche as a separate award. In 2006, 2005 and 2004, we reduced the vesting period of substantially all of the then outstanding stock options for employee retention purposes and in anticipation of the requirements of SFAS No. 123(R), either through acceleration or shortened vesting schedules at grant. We adopted SFAS No. 123(R) using the modified prospective method and therefore have not restated prior period financial statements. Prior to adopting SFAS No. 123(R), we accounted for our employee share-based

McKESSON CORPORATION

FINANCIAL NOTES (Continued)
(Unaudited)

compensation plans using the intrinsic value method under APB Opinion No. 25. This standard generally did not require recognition of compensation expense for the majority of our share-based awards except for RS and RSUs. In addition, as required under APB Opinion No. 25, we previously recognized forfeitures as they occurred.

     The compensation expense recognized under SFAS No. 123(R) has been classified in the income statement or capitalized on the balance sheet in the same manner as cash compensation paid to our employees. There was no material share-based compensation expense capitalized as part of the balance sheet at September 30, 2006. In addition, SFAS No. 123(R) requires that the benefits of realized tax deductions in excess of previously recognized tax benefits on compensation expense be reported as a financing cash flow rather than an operating cash flow, as was done under APB Opinion No. 25. For the quarter and six months ended September 30, 2006, $27 million and $36 million of excess tax benefits were recognized.

     In conjunction with the adoption of SFAS No. 123(R), we elected the “short-cut” method for calculating the beginning balance of the additional paid-in capital pool (“APIC pool”) related to the tax effects of share-based compensation. Under this method, a simplified calculation is applied in establishing the beginning APIC pool balance as well as determining the future impact on the APIC pool and our consolidated statements of cash flows relating to the tax effects of share-based compensation. The election of this accounting policy did not have a material impact on our consolidated financial statements.

     I. Impact on Net Income

     During the second quarter and first half of 2007, we recorded $16 million and $24 million of pre-tax share-based compensation expense, compared to $25 million and $32 million pre-tax pro forma expense for the comparable prior year periods. The share-based compensation expense for the second quarter and first half of 2007 was comprised of RS, RSUs and PeRSUs expense of $12 million and $20 million, stock option expense of $2 million and $3 million, and employee stock purchase plan expense of $2 million and $4 million. The amount for the first half of 2007 also included a credit of $3 million for a cumulative effect adjustment to reflect estimated forfeitures relating to unvested RS and RSUs outstanding upon the adoption of SFAS No. 123(R). We recognized tax benefits related to the share-based compensation of $6 million and $8 million in the second quarter and first half of 2007.

     The following table illustrates the impact of share-based compensation on reported amounts:

		Quarter Ended								Six Months Ended
		September 30, 2006								September 30, 2006
						Impact of								Impact of
						Share-Based								Share-Based
(In millions, except per share data)		As Reported				Compensation				As Reported				Compensation
Income from continuing operations before income taxes		$	316			$	16			$	600			$	24
Net income			229				10				413				16
Earnings per share:
Diluted		$	0.75			$	0.03			$	1.35			$	0.05
Basic			0.77				0.03				1.38				0.05

McKESSON CORPORATION

FINANCIAL NOTES (Continued)
(Unaudited)

     II. SFAS No. 123 Pro Forma Information for 2006

     As noted above, prior to April 1, 2006 we accounted for our employee share-based compensation plans using the intrinsic value method under APB Opinion No. 25. Had compensation expense for our employee share-based compensation been recognized based on the fair value method, consistent with the provisions of SFAS No. 123, net income and earnings per share would have been as follows:

						Six Months
		Quarter Ended				Ended
		September 30,				September 30,
(In millions, except per share data)		2005				2005
Net income, as reported		$	167			$	338
Share-based compensation expense included in reported net income, net of income taxes			2				4
Share-based compensation expense determined under the fair value method, net of income taxes			(16	)			(20	)
Pro forma net income		$	153			$	322
Earnings per common share:
Diluted — as reported		$	0.53			$	1.08
Diluted — pro forma			0.48				1.03
Basic — as reported			0.54				1.11
Basic — pro forma			0.50				1.06

     III. Stock Plans

     The 2005 Stock Plan (the “2005 Plan”) provides our employees, officers and non-employee directors share-based long-term incentives. The 2005 Plan permits the granting of stock options, RS, RSUs, PeRSUs and other share-based awards. Under the 2005 Plan, 13 million shares were authorized for issuance, and as of September 30, 2006, 5 million shares remain available for future grant. The 2005 Plan replaced the following three plans in advance of their expirations: 1999 Stock Option and Restricted Stock Plan, the 1997 Directors’ Equity Compensation and Deferral Plan and the 1998 Canadian Incentive Plan (collectively, the “Legacy Plans”). The aggregate remaining 11 million authorized shares under the Legacy Plans were cancelled, although awards under those plans remain outstanding. The 2005 Plan is now the Company’s only plan for providing share-based incentive compensation to employees and non-employee directors of the Company and its affiliates.

     In anticipation of the requirements of SFAS No. 123(R), the Compensation Committee of the Company’s Board of Directors (“Compensation Committee”) reviewed our long-term compensation program for key employees across the Company. As a result, beginning in 2006, reliance on options was reduced with more long-term incentive value delivered by grants of PeRSUs and performance-based cash compensation.

     IV. Stock Options

     Stock options are granted at not less than fair market value and those options granted under the 2005 Plan have a contractual term of seven years. Prior to 2004, stock options typically vested over a four-year period and had a contractual term of ten years. As noted above, in 2006, 2005 and 2004, we reduced the vesting period of substantially all of the then outstanding unvested stock options, either through acceleration or shortened vesting schedules at grant. It is expected that options granted in 2007 and future years will have a seven-year contractual life and generally follow the four-year vesting schedule. Stock options under the Legacy Plans, which are substantially vested, generally have a ten-year contractual life.

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FINANCIAL NOTES (Continued)
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     Compensation expense for stock options is recognized on a straight-line basis over the requisite service period and is based on the grant-date fair value for the portion of the awards that is ultimately expected to vest. We continue to use the Black-Scholes model to estimate the fair value of our stock options. Once the fair value of an employee stock option value is determined, current accounting practices do not permit it to be changed, even if the estimates used are different from actual. The option pricing model requires the use of various estimates and assumptions, as follows:

–		Expected stock price volatility is based on a combination of historical volatility of our common stock and implied market volatility. We believe that this market-based input provides a better estimate of our future stock price movements and is consistent with emerging employee stock option valuation considerations. Our expected stock price volatility assumption continues to reflect a constant dividend yield during the expected term of the option.
–		Expected dividend yield is based on historical experience and investors’ current expectations.
–		The risk-free interest rate for periods within the expected life of the option is based on the constant maturity U.S. Treasury rate in effect at the time of grant.
–		The expected life of the options is determined based on historical option exercise behavior data, and also reflects the impact of changes in contractual life of current option grants compared to our historical grants.

     Weighted-average assumptions used to estimate the fair value of employee stock options were as follows:

		2007				2006
Expected stock price volatility			27	%			36	%
Expected dividend yield			0.5	%			0.5	%
Risk-free interest rate			5	%			4	%
Expected life (in years)			5				6

     The estimated forfeiture rate, which reduces the expense, is based on historical experience. The estimated forfeiture rate at grant will be re-assessed at least annually and revised if actual forfeitures differ materially from those estimates. In addition, the forfeiture estimates will be adjusted to reflect actual forfeitures when an award vests. In the Company’s pro forma information required under SFAS No. 123 for the periods prior to 2007, we accounted for forfeitures as they occurred. We expect forfeitures to approximate 8% per annum. The actual forfeitures in the future reporting periods could be materially higher or lower than our current estimates. As a result, the share-based compensation expense in 2007 may differ from the Company’s current estimate.

     The following table summarizes stock option activity during the first half of 2007:

										Weighted-
										Average
						Weighted-				Remaining				Aggregate
						Average Exercise				Contractual				Intrinsic
(In millions, except per share data)		Shares				Price				Term (Years)				Value (2)
Outstanding, April 1, 2006			46			$	43.38
Granted			1				48.12
Exercised			(5	)			33.10
Outstanding, September 30, 2006			42				44.72				4			$	552
Vested and expected to vest (1), September 30, 2006			42				44.72				4				552
Exercisable, September 30, 2006			40				44.80				4				534

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FINANCIAL NOTES (Continued)
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     The total intrinsic value of stock options exercised during the second quarters and first halves of 2007 and 2006 was $69 million and $58 million and $92 million and $109 million. The total fair value of stock options vested in the second quarter and first half of 2007 was nil and $1 million. The weighted average grant-date fair value of stock options granted during the second quarters and first halves of 2007 and 2006 was $16.13 and $18.30 and $15.43 and $18.24. Cash received from the exercise of stock options in the second quarters and first halves of 2007 and 2006 was $117 million and $113 million and $167 million and $268 million, and the related tax benefits realized were $27 million and $29 million and $35 million and $48 million. Total compensation expense, net of estimated forfeitures, related to unvested stock options not yet recognized at September 30, 2006 was approximately $21 million, and the weighted-average period over which the cost is expected to be recognized is 3 years.

     V. RS, RSUs and PeRSUs

     RS and RSUs, which entitle the holder to receive, at the end of a vesting term, a specified number of shares of the Company’s common stock, are accounted for at fair value at the date of grant. The fair value of RS and RSUs under our stock plans is determined by the product of the number of shares that are expected to vest and the grant date market price of the Company’s common stock. The Compensation Committee determines the vesting terms at the time of grant. These awards generally vest in full after three years. The fair value of RS and RSUs with graded vesting and service conditions is expensed on a straight-line basis over the requisite service period. RS contains certain restrictions on transferability and may not be transferred until such restrictions lapse.

     Each non-employee director currently receives 2,500 RSUs annually, which vest immediately, and which are expensed upon grant. However, issuance of any shares is delayed until the director is no longer performing services for the Company. At September 30, 2006, 40,000 RSUs for our directors are vested, but shares have not been issued.

     PeRSUs are RSUs for which the number of RSUs awarded may be conditional upon the attainment of one or more performance objectives over a specified period. Vesting of such awards ranges from one to three-year periods following the end of the performance period and may follow the graded or cliff method of vesting.

     PeRSUs are accounted for as variable awards until the performance goals are reached and the grant date is established. The fair value of PeRSUs is determined by the product of the number of shares eligible to be awarded and expected to vest, and the market price of the Company’s common stock, commencing at the inception of the requisite service period. During the performance period, the PeRSUs are re-valued using the market price and the performance modifier at the end of a reporting period. At the end of the performance period, if the goals are attained, the award is classified as a RSU and is accounted for on that basis. The fair value of PeRSUs is expensed on a straight-line basis, treating each vesting tranche as a separate award, over the requisite service period of four years. For RS and RSUs with service conditions, we have elected to amortize the expense on a straight-line basis.

     The following table summarizes RS and RSU activity during the first half of 2007:

						Weighted-
						Average
						Grant Date Fair
(In millions, except per share data)		Shares				Value Per Share
Nonvested, April 1, 2006			1			$	37.09
Granted			1				48.17
Nonvested, September 30, 2006			2				43.82

     The total fair value of shares vested during the second quarter and first half of 2007 was $1 million and $4 million. As of September 30, 2006, the total compensation cost, net of estimated forfeitures, related to nonvested RS and RSU awards not yet recognized was approximately $33 million, pre-tax, and the weighted-average period over which the cost is expected to be recognized is 3 years.

     In May 2006, the Compensation Committee approved 1 million PeRSU target share units representing the base number of awards that could be granted, if goals are attained, and would be granted in the first quarter of 2008 (the “2007 PeRSU”). These target share units are not included in the table above as they have not been granted in the

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form of a RSU. As of September 30, 2006, the total compensation cost, net of estimated forfeitures, related to nonvested 2007 PeRSUs not yet recognized was approximately $53 million, pre-tax (based on the period-end market price of the Company’s common stock), and the weighted-average period over which the cost is expected to be recognized is 3 years.

     In accordance with the provisions of SFAS No. 128, “Earnings per Share,” the 2007 PeRSUs are not included in the calculation of diluted weighted average shares until the performance goals have been achieved.

     VI. Employee Stock Purchase Plan (“ESPP”)

     The ESPP allows eligible employees to purchase shares of our common stock through payroll deductions. The deductions occur over three-month purchase periods and the shares are then purchased at 85% of the market price at the end of each purchase period. Employees are allowed to terminate their participation in the ESPP at any time during the purchase period prior to the purchase of the shares, and any amounts accumulated during that period are refunded.

     The 15% discount provided to employees on these shares is included in compensation expense. The funds outstanding at the end of a quarter are included in the calculation of diluted weighted average shares outstanding. These amounts have not been significant.

5. Income Taxes

     During the second quarter of 2007, we recorded a credit to income tax expense of $83 million which primarily pertains to our receipt of a private letter ruling from the U.S. Internal Revenue Service (“IRS”) holding that our payment of approximately $960 million to settle our Securities Litigation Consolidated Action is fully tax-deductible. We previously established tax reserves to reflect the lack of certainty regarding the tax deductibility of settlement amounts paid in the Consolidated Action and related litigation.

6. Restructuring Activities

		Pharmaceutical								Provider
		Solutions								Technologies
(In millions)		Severance				Exit-Related				Severance				Total
Balance, March 31, 2006		$	6			$	30			$	—			$	36
Expenses			1				—				6				7
Cash expenditures			(4	)			(6	)			(4	)			(14	)
Adjustment to liabilities related to the acquisition of D&K			—				(14	)			—				(14	)
Balance, September 30, 2006		$	3			$	10			$	2			$	15

     During the first half of 2007, we recorded pre-tax restructuring expense of $7 million, which primarily reflected employee termination costs within our Provider Technologies segment. This segment’s restructuring plan was intended to realign product development and marketing resources. Approximately 125 employees were terminated as part of this plan.

     In connection with the D&K acquisition, in 2006 we recorded $10 million of liabilities relating to employee severance costs and $28 million for facility exit and contract termination costs. Approximately 260 employees, consisting primarily of distribution, general and administrative staff, were terminated as part of this restructuring plan. To date, $8 million of severance and $7 million of exit costs have been paid. In connection with the Company’s investment in Parata, $13 million of contract termination costs that were initially estimated as part of the D&K acquisition were extinguished and, as a result, the Company decreased goodwill and decreased its restructuring liability during the first half of 2007. At September 30, 2006, the remaining severance liability for this plan was $2 million, which is anticipated to be paid by the end of 2007, and the remaining facility exit liability was $7 million, which is anticipated to be paid at various dates through 2015.

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FINANCIAL NOTES (Continued)
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7. 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 are as follows:

		Quarter Ended								Six Months Ended
		September 30,								September 30,
(In millions, except per share data)		2006				2005				2006				2005
Income from continuing operations		$	287			$	152			$	471			$	318
Interest expense on convertible junior subordinated debentures, net of tax			—				—				—				1
Income from continuing operations – diluted			287				152				471				319
Discontinued operations			(6	)			2				(6	)			7
Discontinued operations – gain (loss) on sale, net			(52	)			13				(52	)			13
Net income – diluted		$	229			$	167			$	413			$	339
Weighted average common shares outstanding:
Basic			298				308				300				305
Effect of dilutive securities:
Options to purchase common stock			6				8				6				7
Convertible junior subordinated debentures			—				—				—				3
Restricted stock			1				—				1				—
Diluted			305				316				307				315
Earnings Per Common Share: (1)
Diluted
Continuing operations		$	0.94			$	0.48			$	1.54			$	1.02
Discontinued operations, net			(0.02	)			0.01				(0.02	)			0.02
Discontinued operations – gain (loss) on sale, net			(0.17	)			0.04				(0.17	)			0.04
Total		$	0.75			$	0.53			$	1.35			$	1.08
Basic
Continuing operations		$	0.96			$	0.49			$	1.57			$	1.04
Discontinued operations, net			(0.02	)			0.01				(0.02	)			0.03
Discontinued operations – gain (loss) on sale, net			(0.17	)			0.04				(0.17	)			0.04
Total		$	0.77			$	0.54			$	1.38			$	1.11

     Approximately 11 million and 12 million stock options were excluded from the computations of diluted net earnings per share for the quarters ended September 30, 2006 and 2005 as their exercise price was higher than the Company’s average stock price. For the six months ended September 30, 2006 and 2005, the number of stock options excluded was approximately 12 million and 17 million.

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FINANCIAL NOTES (Continued)
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8. Goodwill and Intangible Assets, Net

     Changes in the carrying amount of goodwill for the six months ended September 30, 2006 are as follows:

		Pharmaceutical				Medical-Surgical				Provider
(In millions)		Solutions				Solutions				Technologies				Total
Balance, March 31, 2006		$	495			$	672			$	470			$	1,637
Goodwill acquired, net of purchase price adjustments			(18	)			21				43				46
Translation adjustments			2				—				11				13
Balance, September 30, 2006		$	479			$	693			$	524			$	1,696

     Information regarding intangible assets is as follows:

		September 30,				March 31,
(In millions)		2006				2006
Customer lists		$	159			$	139
Technology			94				83
Trademarks and other			42				40
Gross intangibles			295				262
Accumulated amortization			(163	)			(146	)
Intangible assets, net		$	132			$	116

     Amortization expense of other intangibles was $11 million and $19 million for the quarter and six months ended September 30, 2006 and $6 million and $12 million for the quarter and six months ended September 30, 2005. The weighted average remaining amortization periods for customer lists, technology and trademarks and other intangible assets at September 30, 2006 were: 8 years, 4 years and 4 years. Estimated future annual amortization expense of these assets is as follows: $18 million, $28 million, $19 million, $11 million and $8 million for 2007 through 2011, and $28 million thereafter. At September 30, 2006, there was $20 million of other intangibles not subject to amortization.

9. Financing Activities

     In June 2006, we renewed our committed accounts receivable sales facility. The facility was renewed under substantially similar terms to those previously in place with the exception that the facility amount was reduced to $700 million from $1.4 billion. The renewed facility expires in June 2007. At September 30, 2006 and March 31, 2006, there were no amounts outstanding under any of our borrowing facilities.

10. Convertible Junior Subordinated Debentures

     In February 1997, we issued 5% Convertible Junior Subordinated Debentures (the “Debentures”) in an aggregate principal amount of $206 million. The Debentures were purchased by McKesson Financing Trust (the “Trust”) with proceeds from its issuance of four million shares of preferred securities to the public and 123,720 common securities to us. The Debentures represented the sole assets of the Trust and bore interest at an annual rate of 5%, payable quarterly. These preferred securities of the Trust were convertible into our common stock at the holder’s option.

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FINANCIAL NOTES (Continued)
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     Holders of the preferred securities were entitled to cumulative cash distributions at an annual rate of 5% of the liquidation amount of $50 per security. Each preferred security was convertible at the rate of 1.3418 shares of our common stock, subject to adjustment in certain circumstances. The preferred securities were to be redeemed upon repayment of the Debentures and were 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.

     During the first quarter of 2006, we called for the redemption of the Debentures, which resulted in the exchange of the preferred securities for 5 million shares of our newly issued common stock.

11. Pension and Other Postretirement Benefit Plans

     Net expense for the Company’s defined benefit pension and postretirement plans was $12 million and $23 million for the second quarter and first half of 2007 compared to $11 million and $22 million for the comparable prior year periods. In July 2006, we made a lump sum cash payment of $7 million from an unfunded U.S. pension plan. In accordance with SFAS No. 88, “Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits,” a $2 million settlement charge was recorded in the second quarter of 2007 associated with the payment.

12. 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 (primarily for our Canadian businesses), 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 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, 2006, the maximum amounts of inventory repurchase guarantees and other customer guarantees were approximately $214 million and $7 million of which a nominal amount has been accrued.

     At September 30, 2006, we had commitments of $2 million, primarily consisting of the purchase of services from our equity-held investments, for which no amounts had been accrued.

     In addition, our banks and insurance companies have issued $105 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.

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FINANCIAL NOTES (Continued)
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     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 which 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.

13. Contract Settlement

     During the second quarter of 2007, we entered into an agreement (the “Settlement Agreement”) that settled a patent infringement litigation brought by us against TriZetto Group, Inc. (“TriZetto”) and filed on September 13, 2004, McKesson Information Solutions LLC v. The TriZetto Group, Inc. (No. 04-1258-SLR). In the lawsuit, we alleged that sales of clinical editing functionality included in TriZetto’s Facets^®, QicLink^TM and ClaimFacts^® software products infringed one of our patents. As part of the Settlement Agreement, TriZetto will pay us a one-time royalty fee of $15 million (payable in two equal installments in October 2006 and September 2007) for a license for the relevant patent that covers past and future use of TriZetto products and services by all of their existing customers. TriZetto will continue to include its clinical editing functionality in versions of Facets^® sold to new health plan customers with 100,000 or fewer members and in versions of QicLink^TM sold to any new customers. TriZetto has also agreed to pay us a royalty fee of 5% of the net licensing revenue received from new sales of Facets^® and QicLink^TM containing its clinical editing functionality. Additionally, as part of the Settlement Agreement, TriZetto will no longer include its clinical editing functionality in versions of Facets^® sold to new customers with more than 100,000 members, beginning November 1, 2006. In these cases, new customers may choose their clinical editing solution from available third-party providers, including McKesson. The Company expects to amortize the $15 million settlement over the four-year term of the contract, commencing in the third quarter of 2007.

14. Other Commitments and Contingent Liabilities

     I. Securities Litigation

     In our annual report on Form 10-K for the year ended March 31, 2006 and in our Form 10-Q for the quarter ended June 30, 2006, we reported on numerous legal proceedings, including those arising out of our 1999 announcement of accounting improprieties at HBO & Company (“HBOC”), now known as McKesson Information Solutions LLC (the “Securities Litigation”). Although most of the Securities Litigation matters have been resolved, as reported previously, certain matters remain pending. Significant developments in the Securities Litigation and significant events involving other litigation and claims since the dates of those reports are as follows:

     As previously reported, in March 2006, we reached an agreement to settle all claims brought under the Employee Retirement Income Security Act of 1974 (“ERISA”) on behalf of a class of certain participants in the McKesson Profit-Sharing Investment Plan, In re McKesson HBOC, Inc. ERISA Litigation, (No. C-00-20030 RMW). Such settlement called for the payment of $19 million, plus certain accrued interest, minus certain costs and expenses such as plaintiffs’ attorneys’ fees. On September 1, 2006, the Honorable Ronald M. Whyte entered an order granting final approval to the proposed settlement. The net cash proceeds of the settlement were distributed in October 2006. The order of final approval, and the expiration of the time in which an appeal could have been taken from that order, concludes this matter.

     On September 22, 2006, in the previously disclosed actions brought by the Company against Arthur Andersen LLP (“Andersen”), McKesson Corporation et al. v Andersen et al., (No. 05-04020 RMW) and by Andersen against the Company, Andersen v. McKesson Corporation et al., (No. C-06-02035-RMW), a hearing was conducted on the motions of the Company to dismiss Andersen’s complaint, and Andersen’s motion to dismiss the Company’s complaint. The court has not yet ruled on either of those motions.

     In 2005, as previously reported, we recorded a $1,200 million pre-tax ($810 million after-tax) charge with respect to the Company’s Securities Litigation. The charge consisted of $960 million for the previously reported action in the Northern District of California captioned, In re McKesson HBOC, Inc. Securities Litigation, (No. C-99-20743 RMW) (the “Consolidated Action”) and $240 million for other Securities Litigation proceedings. During 2006, we settled many of the other Securities Litigation proceedings and paid $243 million pursuant to those settlements. Based on the payments made in the Consolidated Action and the other Securities Litigation proceedings, settlements reached in certain of the other Securities Litigation proceedings and our assessment of the remaining cases, the estimated accrual was increased by net pre-tax charges of $52 million in the first quarter of 2006 and $45 million for fiscal 2006. Additionally, on February 24, 2006, the Court gave final approval to the settlement of the Consolidated Action, and as a result, we paid approximately $960 million into an escrow account established by the lead plaintiff in connection with the settlement of the Consolidated Action. As of March 31, 2006,

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the Securities Litigation accrual was $1,014 million. The timing of any distribution of escrowed funds is uncertain in that it is conditioned on completion of the class claims administration process and also, the Company believes, on the final resolution of the pending Bear Stearns & Co. appeal.

     During the second quarter of 2007, our Securities Litigation accrual was decreased by a net pre-tax credit of $6 million representing the settlement of the ERISA claims as described above and a reassessment of another case. The Securities Litigation accrual also reflects a $6 million cash payment made in 2007 in connection with a settlement. As of September 30, 2006, the Securities Litigation accrual was $1,002 million. Additionally, as of September 30, 2006, amounts in escrow increased by $19 million to $981 million primarily reflecting cash transferred for the settlement of the ERISA claims. We believe our Securities Litigation reserves are adequate to address our remaining potential exposure with respect to all of the Securities Litigation matters. However, in view of the number of remaining cases, the uncertainties of the timing and outcome of this type of litigation, and the substantial amounts involved, it is possible that the ultimate costs of these matters could impact our earnings, either negatively or positively, in the quarter of their resolution. We do not believe that the resolution of these matters will have a material adverse effect on our results of operations, liquidity or financial position taken as a whole.

     II. Other Litigation and Claims

     As previously reported, a civil class action complaint was filed against the Company in the United States District Court, District of Massachusetts, New England Carpenters Health Benefits Fund et al., v. First DataBank, Inc. and McKesson Corporation, (Civil Action No. 05-11148), based on allegations that the Company, in concert with co-defendant First DataBank, Inc. (“FDB”), took certain actions to increase the “Average Wholesale Prices” (“AWPs”) of certain branded drugs in violation of the federal Racketeer Influenced and Corrupt Organizations Act and in violation of other statutory and common law requirements. On October 4, 2006, the plaintiffs and co-defendant FDB announced a proposed settlement, as to FDB only, which calls for downward adjustments to certain FDB published AWPs, a prohibition against all future changes to such AWPs and a prescribed timetable for the cessation of all publication of AWPs by FDB. On October 24, 2006, the Court heard plaintiffs’ petition seeking preliminary approval of the proposed settlement, establishment of a schedule for objections to the settlement, and requesting a hearing date for the Court to consider final approval of the settlement. The Court did not on that date grant preliminary approval of the settlement and did not set a date for a hearing on final approval of the settlement. The Court did order plaintiffs to seek certain amendments to the complaint as a prerequisite to any ruling on plaintiffs’ request for preliminary approval of the settlement. The schedule regarding the proposed settlement, including dates by which the settlement might be preliminarily or finally approved, is uncertain at this time. However, there has been no change to the previously scheduled April 12, 2007, hearing date for consideration of the plaintiffs’ motion for class certification, at which hearing the Company’s objections to class certification will be heard.

     As indicated in our previous periodic reports, the health care industry is highly regulated, and government agencies continue to increase their scrutiny over certain practices affecting government programs. From time to time, the Company receives subpoenas or requests for information from various government agencies. The Company generally responds to such subpoenas and requests in a cooperative, thorough and timely manner. These

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responses sometimes require considerable time and effort, and can result in considerable costs being incurred by the Company.

15. Stockholders’ Equity

     Comprehensive income is as follows:

		Quarter Ended								Six Months Ended
		September 30,								September 30,
(In millions)		2006				2005				2006				2005
Net income		$	229			$	167			$	413			$	338
Foreign currency translation adjustments and other			—				28				39				19
Comprehensive income		$	229			$	195			$	452			$	357

     The Company’s Board of Directors (the “Board”) approved share repurchase plans in October 2003, August 2005, December 2005 and January 2006 which permitted the Company to repurchase up to a total of $1 billion ($250 million per plan) of the Company’s common stock. Under these plans, we repurchased 19 million shares for $958 million during 2006 and as of March 31, 2006, less than $1 million of these plans remained available for future repurchases.

     In April and July 2006, the Board approved share repurchase plans which permitted the Company to repurchase up to an additional $1 billion ($500 million per plan) of the Company’s common stock. In the second quarter and the first half of 2007, we repurchased a total of 7 million and 13 million shares for $372 million and $656 million, and $345 million remains available for future repurchases as of September 30, 2006. Repurchased shares will be used to support our stock-based employee compensation plans and for other general corporate purposes. Stock repurchases may be made from time to time in open market or private transactions.

     As previously discussed, during the first quarter of 2006, we called for the redemption of the Debentures, which resulted in the exchange of the preferred securities for 5 million shares of our newly issued common stock.

16. Segment Information

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

     The Pharmaceutical Solutions segment distributes ethical and proprietary drugs, and health and beauty care products throughout North America. This segment also provides medical management and specialty pharmaceutical solutions for biotech and pharmaceutical manufacturers, patient and other services for payors, software and consulting and outsourcing services to pharmacies, and, through its investment in Parata, sells automated pharmaceutical dispensing systems for retail pharmacies.

     The Medical-Surgical Solutions segment distributes medical-surgical supplies, first-aid products and equipment, and provides logistics and other services within the United States and Canada.

     The Provider Technologies segment delivers enterprise-wide patient care, clinical, financial, supply chain, managed care and strategic management software solutions, automated pharmaceutical dispensing systems for hospitals, as well as outsourcing and other services to healthcare organizations throughout North America, the United Kingdom and other European countries.

McKESSON CORPORATION

FINANCIAL NOTES (Concluded)
(Unaudited)

     Financial information relating to our segments is as follows:

		Quarter Ended								Six Months Ended
		September 30,								September 30,
(In millions)		2006				2005				2006				2005
Revenues
Pharmaceutical Solutions		$	21,366			$	20,385			$	43,688			$	40,258
Medical-Surgical Solutions			580				508				1,157				985
Provider Technologies
Services			311				259				608				513
Software and software systems			93				66				172				128
Hardware			36				35				76				69
Total Provider Technologies			440				360				856				710
Total		$	22,386			$	21,253			$	45,701			$	41,953
Operating profit
Pharmaceutical Solutions (1) (2)		$	324			$	252			$	617			$	554
Medical-Surgical Solutions			23				20				45				41
Provider Technologies			33				26				68				57
Total			380				298				730				652
Corporate			(48	)			(37	)			(91	)			(58	)
Securities Litigation (charge) credit, net			6				—				6				(52	)
Interest Expense			(22	)			(22	)			(45	)			(47	)
Income from continuing operations before income taxes		$	316			$	239			$	600			$	495

		September 30,				March 31,
(In millions)		2006				2006
Segment assets
Pharmaceutical Solutions		$	14,149			$	13,737
Medical-Surgical Solutions			1,338				1,268
Provider Technologies			1,775				1,602
Total			17,262				16,607
Corporate
Cash and cash equivalents			2,254				2,139
Other			1,963				2,215
Total		$	21,479			$	20,961

     Revenues for the quarter ended September 30, 2006 grew 5% to $22.4 billion, net income increased 37% to $229 million and diluted earnings per share increased 42% to $0.75 compared to the same period a year ago. For the six months ended September 30, 2006, revenue increased 9% to $45.7 billion, net income increased 22% to $413 million and diluted earnings per share increased 25% to $1.35 compared to the same period a year ago.

     Increases in net income and diluted earnings per share primarily reflect higher operating profit in our Pharmaceutical Solutions segment and a decrease in pre-tax charges relating to our Securities Litigation. Net income and diluted earnings per share for 2007 were also impacted by an $83 million credit to our income tax provision relating to the reversal of income tax reserves for our Securities Litigation. This credit was partially offset by $58 million of after-tax losses associated with our discontinued operations. On September 30, 2006, we sold our Medical-Surgical Solutions segment’s Acute Care business for net cash proceeds of $160 million, subject to post closing adjustments. Second quarter 2007 financial results for this business were a loss of $67 million, which includes a $79 million non-tax deductible write-off of goodwill. Financial results for the Acute Care business have been reclassified as a discontinued operation for all periods presented.

McKESSON CORPORATION

FINANCIAL REVIEW (Continued)
(Unaudited)

Results of Operations

     Revenues:

		Quarter Ended												Six Months Ended
		September 30,												September 30,
(In millions)		2006				2005				Change				2006				2005				Change
Pharmaceutical Solutions
U.S. Healthcare direct distribution & services		$	13,232			$	12,719				4	%		$	26,710			$	25,027				7	%
U.S. Healthcare sales to customers’ warehouses			6,483				6,199				5				13,577				12,277				11
Subtotal			19,715				18,918				4				40,287				37,304				8
Canada distribution & services			1,651				1,467				13				3,401				2,954				15
Total Pharmaceutical Solutions			21,366				20,385				5				43,688				40,258				9
Medical-Surgical Solutions			580				508				14				1,157				985				17
Provider Technologies
Services			311				259				20				608				513				19
Software and software systems			93				66				41				172				128				34
Hardware			36				35				3				76				69				10
Total Provider Technologies			440				360				22				856				710				21
Total Revenues		$	22,386			$	21,253				5			$	45,701			$	41,953				9

     Revenues increased by 5% and 9% to $22.4 billion and $45.7 billion during the quarter and six months ended September 30, 2006 compared to the same periods a year ago. The increase primarily reflects growth in our Pharmaceutical Solutions segment, which accounted for over 95% of consolidated revenues.

     U.S. Healthcare pharmaceutical direct distribution and services revenues increased primarily reflecting market growth rates, expanded agreements with customers and the acquisition of D&K Healthcare Resources, Inc. (“D&K”) during the second quarter of 2006, partially offset by the loss of a large customer. U.S. Healthcare sales to customers’ warehouses increased primarily as a result of new and expanded agreements with customers, offset in part by a decrease in volume from a large customer. Additionally, revenues for our U.S. pharmaceutical distribution business were negatively impacted by one less sales day in 2007 compared to 2006.

     Canadian pharmaceutical distribution revenues increased reflecting favorable foreign exchange rates and market growth rates. Had the same U.S. and Canadian dollar exchange rates applied in 2007 as in 2006, revenues for the second quarter and first half of 2007 from our Canadian operations would have increased approximately 5% compared to the same periods a year ago.

     Medical-Surgical Solutions segment distribution revenues increased primarily reflecting above average market growth rates as well as the acquisition of Sterling Medical Services LLC (“Sterling”) during the first quarter of 2007. Sterling is based in Moorestown, New Jersey, and is a national provider and distributor of medical disposable supplies, health management services and quality management programs to the home care market. Additionally, revenues for the first half of 2007 include an extra week of sales compared to the same period a year ago.

     Provider Technologies segment revenues increased reflecting higher sales and implementations of clinical, imaging, and automation solutions. Growth in this segment’s revenues was not materially impacted by business acquisitions.

McKESSON CORPORATION

FINANCIAL REVIEW (Continued)
(Unaudited)

     Gross Profit:

		Quarter Ended												Six Months Ended
		September 30,												September 30,
(Dollars in millions)		2006				2005				Change				2006				2005				Change
Gross Profit
Pharmaceutical Solutions		$	650			$	565				15	%		$	1,293			$	1,159				12	%
Medical-Surgical Solutions			166				142				17				331				282				17
Provider Technologies			208				161				29				396				323				23
Total		$	1,024			$	868				18			$	2,020			$	1,764				15
Gross Profit Margin
Pharmaceutical Solutions			3.04	%			2.77	%			27	bp			2.96	%			2.88	%			8	bp
Medical-Surgical Solutions			28.62				27.95				67				28.61				28.63				(2	)
Provider Technologies			47.27				44.72				255				46.26				45.49				77
Total			4.57				4.08				49				4.42				4.20				22

     Gross profit for the second quarter and first half of 2007 increased 18% and 15% to $1,024 million and $2,020 million. As a percentage of revenues, gross profit margin increased 49 basis points to 4.57% for the second quarter of 2007 and 22 basis points to 4.42% for the first half of 2007. Gross profit margin increased primarily reflecting an increase in our gross profit margins in our Pharmaceutical Solutions and Provider Technologies segments.

     Gross profit margin for our Pharmaceutical Solutions segment increased during the second quarter of 2007 compared to the same period a year ago, primarily as a result of the benefit of increased sales of generic drugs with higher margins and the receipt of $10 million of cash proceeds representing our share of a settlement of an antitrust class action lawsuit. In addition, gross profit margin for this segment has experienced a stabilization of its U.S. pharmaceutical distribution business’ sell and buy side margins in 2007.

     Gross profit margin for our Pharmaceutical Solutions segment increased during the first half of 2007 compared to the same period a year ago, primarily as a result of:

•		the benefit of increased sales of generic drugs with higher margins, and
•		a last-in, first-out (“LIFO”) inventory credit of $20 million in the first half of 2007 compared with $10 million in the first half of 2006. These LIFO credits reflect our expectation of a LIFO benefit for the full fiscal year. Our Pharmaceutical Solutions segment uses the LIFO method of accounting for the majority of its inventories, which results in cost of sales that more closely reflects replacement cost than do other accounting methods, thereby mitigating the effects of inflation and deflation on gross profit. The practice in the Pharmaceutical Solutions distribution business is to pass on to customers published price changes from suppliers. Manufacturers generally provide us with price protection, which prevents inventory losses. Price declines on many generic pharmaceutical products in this segment over the last few years have moderated the effects of inflation in other product categories, which resulted in minimal overall price changes in those years.
		These increases were partially offset by:
•		a decrease in amounts of antitrust settlements. Results for the first half of 2007 and 2006 included $10 million and $51 million of cash proceeds representing our share of settlements of various antitrust class action lawsuits,
•		a decrease associated with a greater proportion of revenues within the segment attributed to sales to customers’ warehouses, which have lower gross profit margins relative to other revenues within the segment, and

McKESSON CORPORATION

FINANCIAL REVIEW (Continued)
(Unaudited)

•

a $15 million charge pertaining to the writedown of certain abandoned assets within our retail automation group. During the first half of 2007, we contributed $36 million in cash and $45 million in net assets primarily from our Automated Prescription Systems business to Parata Systems, LLC (“Parata”), in exchange for a significant minority interest in Parata. In connection with the investment, we abandoned certain assets which resulted in a $15 million charge to cost of sales and we incurred $6 million of other expenses related to the transaction which were recorded within operating expenses. We did not recognize any additional gains or losses as a result of this transaction as we believe the fair value of our investment in Parata, as determined by a third-party valuation, approximates the carrying value of consideration contributed to Parata. Our investment in Parata is accounted for under the equity method of accounting within our Pharmaceutical Solutions segment.

     Gross profit margins increased in our Medical-Surgical Solutions segment during the second quarter of 2007 compared to the same period a year ago primarily reflecting favorable buy side margins. For the first half of 2007, gross profit margins for this segment approximated that of the prior comparable period. Provider Technologies segment’s gross profit margin increased primarily due to a change in product mix.

     Operating Expenses and Other Income:

		Quarter Ended												Six Months Ended
		September 30,												September 30,
(Dollars in millions)		2006				2005				Change				2006				2005				Change
Operating Expenses
Pharmaceutical Solutions		$	333			$	321				4	%		$	695			$	621				12	%
Medical-Surgical Solutions			144				123				17				287				242				19
Provider Technologies			177				140				26				333				273				22
Corporate			70				58				21				133				96				39
Subtotal			724				642				13				1,448				1,232				18
Securities Litigation charge (credit), net			(6	)			—			NM					(6	)			52			NM
Total		$	718			$	642				12			$	1,442			$	1,284				12
Operating Expenses as a Percentage of Revenues
Pharmaceutical Solutions			1.56	%			1.57	%			(1	) bp			1.59				1.54	%			5	bp
Medical-Surgical Solutions			24.83				24.21				62				24.81				24.57				24
Provider Technologies			40.23				38.89				134				38.90				38.45				45
Total			3.21				3.02				19				3.16				3.06				10
Other Income
Pharmaceutical Solutions		$	7			$	8				(13	)%		$	19			$	16				19	%
Medical-Surgical Solutions			1				1				—				1				1				—
Provider Technologies			2				5				(60	)			5				7				(29	)
Corporate			22				21				5				42				38				11
Total		$	32			$	35				(9	)		$	67			$	62				8

     Operating expenses increased 12% to $718 million in the second quarter of 2007 (or 13% excluding the Securities Litigation credit) to $724 million and for the first half of 2007 increased 12% to $1,442 million (or 18% excluding the Securities Litigation charges and credits to $1,448 million). As a percentage of revenues, operating expenses increased 19 and 10 basis points to 3.21% and 3.16% for the second quarter and first half of 2007. Excluding the Securities Litigation charges and credits, operating expenses as a percentage of revenues increased 21 and 23 basis points to 3.23% and 3.17% for the second quarter and first half of 2007. Operating expense dollars, excluding the Securities Litigation, increased primarily due to additional costs to support our sales volume growth, our business acquisitions, and employee compensation costs associated with the requirement to expense all share-based compensation. Other income decreased slightly in the second quarter of 2007 and increased slightly in the first half of 2007 compared to the same periods a year ago.