The following discussion and analysis describes material changes in the financial condition of Owens & Minor, Inc. and its wholly-owned subsidiaries (O&M or the company) since December 31, 2008. Trends of a material nature are discussed to the extent known and considered relevant. This discussion should be read in conjunction with the consolidated financial statements, related notes thereto, and management's discussion and analysis of financial condition and results of operations included in the company's Annual Report on Form 10-K for the year ended December 31, 2008.

Results of Operations

Third quarter and first nine months of 2009 compared with 2008

Overview. In the third quarter and first nine months of 2009, the company earned net income of $34.7 million and $72.3 million, increased from $25.3 million for the third quarter of 2008 and decreased from $73.1 million for the first nine months of 2008. Net income per diluted common share was $0.83 for the third quarter of 2009 and $0.61 for the third quarter 2008. Net income per diluted common share declined to $1.73 for the first nine months of 2009 from $1.76 in the comparable period of 2008 due to losses from discontinued operations. For the third quarter of 2009, operating earnings were $56.7 million, or 2.79% of revenue, increased from $46.3 million, or 2.59% of revenue, for the third quarter of 2008. In the first nine months of 2009, operating earnings were $145.5 million, or 2.43% of revenue, increased from operating earnings of $132.4 million in the first nine months of 2008, or 2.50% of revenue. Operating earnings in the third quarter and first nine months of 2009 were positively affected by increased revenues from the acquired acute-care distribution business of The Burrows Company (Burrows) and other net new business.

Divestitures. In January 2009, the company exited its direct-to-consumer distribution business (the "DTC business"). Accordingly, the DTC business is presented as discontinued operations in the company's condensed consolidated financial statements, and all prior period information has been reclassified to be consistent with the current period presentation.

The following table presents highlights from the company's condensed consolidated statements of income on a percentage of revenue basis:

                                                  Three Months Ended          Nine Months Ended
                                                    September 30,               September 30,
                                                 2009           2008          2009           2008
Gross margin                                      10.04 %        10.00 %        9.77 %       9.92 %
Selling, general and administrative expense        6.99 %         7.20 %        7.10 %       7.20 %
Operating earnings                                 2.79 %         2.59 %        2.43 %       2.50 %
Income from continuing operations                  1.70 %         1.42 %        1.41 %       1.40 %

Revenue. Revenue increased 13.9%, or $247.9 million, to $2.03 billion in the third quarter of 2009, from $1.79 billion in the third quarter of 2008. Revenue increased 13.5% to $6.00 billion in the first nine months of 2009 from $5.29 billion in the comparable period of 2008. In comparing the third quarter and first nine months of 2009 to the same periods of 2008, approximately 60% and 65% of the increase resulted largely from the Burrows acquisition, as well as other net new business. The remaining revenue growth resulted from a net increase in sales to existing customers.

Gross margin. Gross margin dollars increased 14.3% to $204.3 million in the third quarter of 2009 compared to $178.7 million in the same period of 2008. In comparing quarter-to-quarter, the increase in gross margin dollars was primarily due to an increase in revenues. The increase of 4 basis points in gross margin as a percentage of revenue for the third quarter of 2009 as compared with the same period of 2008 was primarily due to the positive impact of supplier price changes, as one of the company's suppliers significantly reduced its prices on a certain set of products during the third quarter of 2009. The effect of this price decrease, net of price increases from other suppliers, resulted in an $11.5 million credit in the company's provision for last-in, first-out (LIFO) inventory valuation for the third quarter. In addition, gross margin as a percentage of revenue increased due to the recognition of revenue, net of deferrals, of $1.6 million related to certain customer contracts, as a result of the company achieving contractual performance targets. These increases in gross margin as a percentage of revenue were partially offset by lower gross margin as a percentage of revenue on sales to customers, including customers obtained from the Burrows acquisition, and from supplier incentives. In addition, as a result of the company changing its methodology for estimating the provision for sales returns and allowances, gross margin was $1.0 million less for the third quarter and first nine months of 2009 than in the same periods of 2008.

Gross margin dollars increased 11.7% to $585.7 million in the first nine months of 2009 compared to $524.3 million in the same period of 2008. The increase in gross margin dollars was primarily due to an increase in revenues. The decline of 15 basis points in gross margin as a percentage of revenue for the first nine months of 2009 was primarily comprised of lower gross margin as a percentage of revenue on sales to customers, including customers obtained from the Burrows acquisition, and from supplier incentives. These decreases were partially offset by the effect of net supplier price decreases, which resulted in a $5.5 million lower LIFO provision for the first nine months of 2009, compared to the same period in 2008.

The company values inventory for its healthcare provider distribution business under the LIFO method. Had inventory been valued under the first-in, first-out (FIFO) method, gross margin would have been 8 basis points greater in the first nine months of 2009 and 20 basis points greater in the first nine months of 2008.

Selling, general and administrative (SG&A) expenses. SG&A expenses were $142.2 million and $425.5 million for the third quarter and first nine months of 2009, as compared with $128.7 million and $380.4 million in the comparable periods of 2008. In comparing the third quarter of 2009 to the same period of 2008, SG&A expenses increased by $7.7 million for compensation costs and $0.8 million in occupancy costs, both of which are primarily related to serving new customers and the acquired Burrows business, $0.8 million in other transition expenses related to the Burrows acquisition, and $2.1 million for outsourcing and consulting services.

In comparing the first nine months of 2009 to the same period of 2008, SG&A expenses increased by $22.8 million for compensation costs and $3.9 million for occupancy costs, both of which are primarily related to serving new customers and the acquired Burrows business, as well as $6.0 million for outsourcing and consulting services, and $4.1 million in other transition expenses related to the Burrows acquisition.

Depreciation and amortization. Depreciation and amortization expense for the third quarter and first nine months of 2009 was $6.7 million and $18.6 million, increased from $5.7 million and $16.3 million in the comparable periods of 2008. The increases for the third quarter and first nine months of 2009 over the comparable periods in 2008 were primarily due to amortization of intangible assets related to the acquired Burrows business, depreciation of warehouse equipment and amortization of leasehold improvements and computer software.

Interest expense, net. Interest expense, net of interest earned on the company's cash balances, was $3.2 million for the third quarter and $9.8 million for the first nine months of 2009, decreased from $6.3 million for the third quarter and from $12.7 million for the first nine months of 2008. Net interest expense in the 2008 periods included a $3.1 million loss from interest rate swaps that were terminated in the third quarter of 2008. For the first nine months of 2009, the company's effective interest rate, excluding interest expense recognized related to the interest rate swaps, was 6.4% on average borrowings of approximately $209.9 million compared to 6.3% on average borrowings of approximately $206.8 million in the first nine months of 2008.

Income tax provision. The provision for income taxes was $18.8 million and $50.9 million in the third quarter and first nine months of 2009, compared to $14.7 million and $45.9 million in the same periods of 2008. The effective tax rate was 35.2% and 37.5% for the third quarter and first nine months of 2009, compared to 36.7% and 38.3% in the same periods of 2008. The lower effective tax rates in the 2009 periods are primarily the result of recognizing tax benefits totaling approximately $1.7 million due to the conclusion of audits by the Internal Revenue Service (IRS) of the company's 2007 and 2006 income tax returns in the third quarter of 2009.

Income from continuing operations. Income from continuing operations was $34.7 million and $84.8 million in the third quarter and first nine months of 2009, compared to $25.3 million and $73.8 million in the same periods of 2008. The improvement in the third quarter of 2009 was due to an increase in gross margin of $25.6 million, partially offset by increases in SG&A expenses of $13.5 million and income tax expense of $4.1 million. The improvement in the first nine months of 2009 over the comparable period of 2008 was due to an increase in gross margin of $61.4 million and a decrease in net interest expense of $2.8 million, partially offset by increases in SG&A expenses of $45.1 million, income tax expense of $5.0 million and depreciation and amortization expense of $2.2 million.

Loss from discontinued operations, net of tax. Loss from discontinued operations, net of tax, was $12.5 million in the first nine months of 2009, compared to $0.7 million in the same period of 2008. The increase in the first nine months of 2009 over the comparable period of 2008 was primarily due to pre-tax charges associated with exiting the DTC business. The loss in the first nine months of 2009 was partially offset by a $3.2 million gain on the sale of this business. Losses from discontinued operations, net of tax, were insignificant in the third quarter of 2009 and 2008.

Financial Condition, Liquidity and Capital Resources



  For the nine months ended September 30,                      2009         2008
  Net cash provided by (used for) - continuing operations:
  Operating activities                                       $  161.5      $ 119.1
  Investing activities                                       $  (14.0 )    $ (18.1 )
  Financing activities                                       $ (186.0 )    $ (88.0 )
  Net cash provided by discontinued operations               $   73.6      $   2.3

Financial condition. Accounts receivable, net of allowances, decreased 2.3% to $509.5 million at September 30, 2009, from $521.3 million at December 31, 2008. The decrease is primarily due to improved collections of accounts receivable and a net increase in the allowance for uncollectible accounts of $1.4 million. Accounts receivable days outstanding (DSO) were 23.0 days at September 30, 2009, and 24.5 days at December 31, 2008, based on three months' sales.

Merchandise inventories increased slightly to $679.5 million at September 30, 2009, from $679.1 million at December 31, 2008, primarily due to an increase in the volume of inventory held for new business. Average inventory turnover was 10.5 in the third quarter of 2009 and 10.3 in the third quarter of 2008, based on three months' sales.

Liquidity. In the first nine months of 2009, cash and cash equivalents increased by $35.0 million to $42.9 million at September 30, 2009. In the first nine months of 2009, the company generated $161.5 million of operating cash from continuing operations, compared with $119.1 million in the first nine months of 2008. Operating cash from continuing operations in the first nine months of 2009 was positively affected by operating earnings, compared to the same period of 2008, and by increases in accounts payable and decreases in accounts receivable, partially offset by an increase in inventory. Operating cash from continuing operations in the first nine months of 2008 was positively affected by increases in accounts payable and was negatively affected by increases in accounts receivable and inventory.

Cash used for investing activities decreased to $14.0 million in the first nine months of 2009 from $18.1 million in the same period of 2008. The decrease resulted from the company receiving cash related to the acquisition of the Burrows business and proceeds from the sale of property, offset by an increase in capital expenditures of $5.3 million. The increase in capital expenditures to $23.4 million for the first nine months of 2009 from $18.1 million in the comparable period of 2008 was related to investments in software, as well as technology for distribution center efficiency improvements and warehouse improvements for the integration of the acquired Burrows business. During the third quarter of 2009, $6.3 million of these investments were placed into service. In 2008, the company purchased land for future expansion of the company's headquarters.

Financing activities used $186.0 million of cash in the first nine months of 2009 and $88.0 million in the same period of 2008. In the first nine months of 2009, proceeds of $63.0 million from the sale of the company's DTC business, as well as cash from operating activities of continuing and discontinued operations, were used primarily to reduce the company's revolving credit facility by $150.6 million, pay dividends and reduce drafts payable. For the first nine months of 2008, cash was used primarily to reduce the company's revolving credit facility by $76.9 million and to pay dividends. Cash used to pay dividends was $28.8 million in the first nine months of 2009, increased from $24.7 million in the same period of 2008, as the company paid dividends of $0.69 per share in the first nine months of 2009, as compared with $0.60 per share in the first nine months of 2008.

Cash generated by the operating activities of discontinued operations during the first nine months of 2009 was primarily from the collection of accounts receivable, partially offset by the payment of costs associated with exiting the DTC business.

Capital resources. The company has $200 million of senior notes outstanding, which mature in 2016 and bear interest at 6.35%, payable semi-annually.

The company has a revolving credit facility with total borrowing capacity of $306 million and which expires in May 2011. The interest rate on the facility is based on, at the company's discretion, LIBOR, the Federal Funds Rate or the Prime Rate, plus an adjustment based on the company's leverage ratio, as defined by the credit agreement. The company is charged a commitment fee of between 0.05% and 0.15% on the unused portion of the facility, which includes a 0.05% reduction in the fee based on the company's investment grade rating. At September 30, 2009, the company had $11.0 million of letters of credit and no borrowings outstanding under the facility, leaving $295.0 million available for borrowing.

The company believes its available financing sources will be sufficient to fund working capital needs and long-term strategic growth, although this cannot be assured. Based on the company's leverage ratio at September 30, 2009, the company's interest rate under its revolving credit facility, which is subject to adjustment quarterly, will remain at LIBOR plus 50 basis points at the next adjustment date.

Recent Accounting Pronouncements

For a discussion of recent accounting pronouncements, see note 15 in the Notes to Condensed Consolidated Financial Statements, included in this Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2009.

Forward-looking Statements

Certain statements in this discussion constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Although O&M believes its expectations with respect to the forward-looking statements are based upon reasonable assumptions within the bounds of its knowledge of its business and operations, all forward-looking statements involve risks and uncertainties and, as a result, actual results could differ materially from those projected, anticipated or implied by these statements. Such forward-looking statements involve known and unknown risks, including, but not limited to:

• general economic and business conditions;

• changes in government regulations, including healthcare laws and regulations;

• the ability of the company to implement its strategic initiatives;

• dependence on sales to certain customers;

• the ability of customers to meet financial commitments due to the company;

• the ability to retain existing customers and the success of marketing and other programs in attracting new customers;

• dependence on suppliers;

• the ability to adapt to changes in product pricing and other terms of purchase by suppliers of product;

• changes in manufacturer preferences between direct sales and wholesale distribution;

• competition;

• changing trends in customer profiles and ordering patterns;

• the ability of the company to meet customer demand for additional value-added services;

• the ability to meet performance targets specified by customer contracts under contractual commitments;

• the availability of supplier incentives;

• access to special inventory buying opportunities;

• the ability of business partners and financial institutions to perform their contractual responsibilities;

• the ability to manage operating expenses;

• the effect of price volatility in the commodities markets, including fuel price fluctuations, on company operating costs and supplier product prices;

• the ability of the company to continue to obtain financing at reasonable rates and to manage financing costs and interest rate risk;

• the risk that a decline in business volume or profitability could result in an impairment of goodwill;

• the ability to timely or adequately respond to technological advances in the medical supply industry;

• the risk that information systems are interrupted or damaged by unforeseen events or fail for any extended period of time;

• the ability to successfully identify, manage or integrate acquisitions;

• the costs associated with and outcome of outstanding and any future litigation, including product and professional liability claims;

• the outcome of outstanding tax contingencies; and

• the ability to manage reimbursements from Medicare, Medicaid, private healthcare insurers and individual customers.