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Express Scripts Holding (NASDAQ:ESRX)

Q3 2013 Earnings Call

October 25, 2013 8:30 am ET

Executives

David Myers - Vice President of Investor Relations

George Paz - Chairman, Chief Executive Officer and President

Matthew D. Harper - Interim Chief Financial Officer, Vice President and Corporate Treasurer

Steven Miller - Chief Medical Officer and Senior Vice President

Timothy C. Wentworth - President of Sales & Account Management and Senior Vice President

Analysts

Glen J. Santangelo - Crédit Suisse AG, Research Division

Robert P. Jones - Goldman Sachs Group Inc., Research Division

Lisa C. Gill - JP Morgan Chase & Co, Research Division

Elizabeth Blake

Thomas Gallucci - FBR Capital Markets & Co., Research Division

Ricky Goldwasser - Morgan Stanley, Research Division

John Kreger - William Blair & Company L.L.C., Research Division

Charles Rhyee - Cowen and Company, LLC, Research Division

Steven Valiquette - UBS Investment Bank, Research Division

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the Third Quarter 2013 Earnings Call. [Operator Instructions] As a reminder, this call is being recorded.

I'd now like to turn the call over to our host, Vice President of Investor Relations, Mr. David Myers. Please go ahead, sir.

David Myers

Thank you, and good morning, everyone. Welcome to our third quarter conference call. With me today are George Paz, Chairman and CEO; Matt Harper, our interim CFO; Dr. Steve Miller, our Chief Medical Officer; and other members of senior management.

Before we begin, I need to read the following Safe Harbor statement. Statements or comments made on this conference call may be forward-looking statements and may include financial projections or other statements of the company's plans, objectives, expectations or intentions. These matters involve certain risks and uncertainties. The company's actual results may differ significantly from those projected or suggested in any forward-looking statement due to a variety of factors, which are discussed in detail in our filings with the SEC.

For clarity purposes, all financial numbers we talk about today will be on an adjusted basis. Please refer to the tables included in our press release for a reconciliation of GAAP to the adjusted numbers we will be discussing. The reconciliation of EBITDA to net income can also be found in our press release. The earnings release is posted on the Investor Relations section of our website.

This presentation will be posted on our website and includes an appendix with footnotes in the reconciliations of GAAP to adjusted numbers and EBITDA to net income.

At this point, I'll turn the call over to George.

George Paz

Thank you, David. Good morning, everyone. Today, we will cover 3 topics. First, Matt will review our third quarter performance and provide an update to our 2013 guidance. Second, Dr. Steve Miller will take a deeper dive into one of our clinical programs, formulary management. Formulary management is one of our key initiatives that leads to better decision, healthier outcomes and lower cost to our clients and members, while contributing to longer-term growth for our shareholders. Third, I will provide a business update including a discussion around health care reform and private exchanges.

At this time, I'll turn the call over to Matt.

Matthew D. Harper

Thanks, George, and good morning, everyone. Our third quarter results demonstrate solid operating and financial performance. Notably, client migrations remain on track, having migrated more than 80% of our clients with high levels of satisfaction. We generated $1 billion of cash flow from operating activities. We deployed $751.5 million of cash to repurchase 11.6 million shares of our stock. We continue to make progress in bringing our income tax rate back to historical Express Scripts levels, which added $0.01 to our earnings per share in the quarter. We delivered $1.08 per share in the third quarter as a result of our financial performance and a lower tax rate, and we increased the lower end of our full year earnings per share guidance range by $0.04.

Looking at the quarter in a little more detail, adjusted prescriptions for the quarter were 358.1 million, in line with our expectations. As anticipated, claims volume was negatively impacted by the continued roll-off of the UnitedHealth Group business.

Overall, other key metrics for the quarter were in line with our expectations. EBITDA was up 3% from last year and EBITDA per adjusted claim was up 13%. While the table reflects change on a year-over-year basis, I want to take a moment to discuss growth on a sequential basis.

Excluding the revenue from a large client that was skewed to the second quarter, all metrics showed improvement. Gross profit margin was up from 7.8% in Q2. Gross profit per adjusted claim was up 4% from Q2, and EBITDA per adjusted claim was up 4% sequentially. Included in the year-over-year decline in gross profit is the continued roll-off of UnitedHealth Group claims and the inclusion of Liberty's gross profit in last year's numbers. Liberty was sold in the fourth quarter of 2012 and is not included in this year's results. Notwithstanding these items, gross profit per adjusted Rx increased to $5.81 for the quarter, up $0.34 or 6% over last year. The decline in SG&A expense reflects efficiencies gained from integration of our Medco acquisition and the inclusion of Liberty's SG&A in last year's numbers.

We do expect SG&A expenses to increase in the fourth quarter as we prepare for new client implementations on 1/1 and health care reform.

As I previously mentioned, we generated $1 billion of cash flow from operations during the third quarter. As we discussed last quarter, our cash flow for the year has been impacted by the timing of payment cycles for the legacy Medco business. Part of our integration efforts include migrating Medco's legacy payment cycles to be consistent with Express Scripts.

We continue to make progress on migrating these cycles. However, we now think some of the cash flow benefits may be realized in early 2014 and not 2013. Therefore, due to this timing delay, we are adjusting our cash flow guidance range to $4.0 billion to $4.5 billion for the year. Our year-to-date cash conversion ratio stands at 1.4x GAAP net income, which is a healthy measure for cash generation.

During the quarter, we repurchased 11.6 million shares for $751.5 million, bringing our year-to-date purchases to 24.9 million shares for $1.6 billion.

We expect to continue our share repurchase activity in the fourth quarter, exceeding third quarter levels. We have 51.3 million shares remaining under our current repurchase authorization program. Over the long term, we expect to maintain our current debt-to-EBITDA ratio of approximately 2x and return the majority of our free cash flow to shareholders.

We are increasing the lower end of our guidance range by $0.04 as a result of continued solid operating and financial performance, including integration successes and the benefits of the lower tax rate expected for the year. We now expect full year 2013 adjusted earnings per share from continuing operations in the range of $4.30 to $4.34, reflecting growth of 15% to 16% over 2012. Based on year-to-date adjusted earnings per share of $3.21, this equates to a fourth quarter earnings per share range of $1.09 to $1.13. As outlined in the table, there are only a few other revisions to the guidance we provided last quarter. We are reducing depreciation slightly as a result of fewer projects being placed in the service during 2013. In addition, our effective income tax rate is now expected to be approximately 38.5% for the year.

On our second quarter call, we discussed our longer-term growth drivers and provided a framework for delivering long-term growth. We described the near-term potential in formulary management, home delivery, specialty pharmacy, network management and generics, which will create over $10 billion in client savings, generate $1.5 billion to $2.5 billion in EBITDA for Express Scripts and contribute to our targeted long-term earnings per share growth of 10% to 20%.

During the first quarter of 2014, we will hold an Investor Day, which will take a deeper dive into all of our growth drivers. For today's call, we want to discuss our formulary development process and describe the changes we are making to our National Preferred Formulary in 2014.

At this point, I'll turn the call over to Dr. Steve Miller, our Chief Medical Officer.

Steven Miller

Thanks, Matt. Due to environmental factors continuing to pressure our clients' drug trend, Express Scripts mission to make drugs safer and more affordable is as important as ever. With a generic fill rate that exceeds 80%, branded prescriptions still represent over 70% of our clients' spend on pharmaceuticals. Branded drug price inflation is growing at double-digit rates every year. When you add that to health care reform and the requirements of the essential medical benefits package, increasing specialty cost trends, direct consumer advertising and copay cards, plan sponsors and patients are looking at significant challenges in controlling drug spend.

These marketplace factors provide an important opportunity for Express Scripts to assist our patients and clients in lowering health care costs while driving better clinical outcomes. Obviously, our tools and programs to control costs are needed now more than ever. Over the last several years, we have successfully held down pharmaceutical costs by moving patients to lower-cost generic medications when possible, influencing our clients and patients to take advantage of lower-cost mail and retail network alternatives, assisting clients to manage the cost and quality of specialty care and developing innovative clinical solutions and plan designs to coordinate care, improve health, close gaps in care and lower costs.

Our formulary management tools are a fundamental component of controlling drug trend to offset many of these environmental factors. Before discussing the formulary changes we are implementing for 2014 with our National Preferred Formulary, I want to provide background on our formulary development process. At Express Scripts, we are very proud of our unique model in creating our formularies. Our National Pharmacy and Therapeutics Committee or P&T Committee is made up of 18 physicians and a pharmacist who represent both academic and private practices and come from across all the major subspecialties. They receive a stipend from us for their time, but none are employees of Express Scripts. They are fully independent. In fact, when a member leaves the committee, it is the committee that picks the replacement, not us. The other really unique aspect of the work is that their decisions are binding on the company, and they are not allowed to consider the cost of medications, only the clinical aspects of the drugs.

The P&T Committee considers all new drugs when they come to the market and all drugs on an annual basis. They make a determination of which of 3 categories the medication should be included. The first category is clinical includes. These products produce better outcomes, are unique in the market and must be included on our formulary. About 15% of drugs get into this bucket. At the other extreme would be clinical excludes. These products, while still in the marketplace, have no role in modern therapy and, thus, are excluded from the formulary. Less than 1% fall into this bucket. Therefore, 85% of products are determined to be clinical optional, that is, they can be substituted for by other drugs in the same category. An example would be penicillin. Our P&T Committee would demand that we get penicillin on the formulary, but they just do not believe that one is better than any other and it's up to the company to decide which to include on the formulary. How this process works is graphically demonstrated on this slide. The process begins with the P&T Committee's clinical determination. Second, an internal value assessment committee evaluates the optional drugs as recommended by the P&T Committee for net costs, market share to make a formulary design and placement recommendation. Next, the P&T Committee reviews and approves final formulary placement recommendations to ensure clinical appropriateness. Finally, we put in place support tools to minimize disruption and assist members, pharmacists and physicians to get patients on the most clinically sound cost-effective medication.

We accomplish this through a passionate team of pharmacists and patient care advocates who help patients through a one-on-one discussion, as well as an innovative team exploring prescription processes to provide the safest, most efficient and most convenient way to deliver medications to our patients.

Our National Preferred Formulary is now the largest formulary in the United States with more than 30 million members. We deploy this scale to negotiate deeper rebates from pharmaceutical manufacturers on behalf of our clients. In addition, the introduction of multiple brand drugs in a therapy class has provided the opportunity to encourage competition between pharmaceutical manufacturers for exclusive and preferred physicians on our formulary. This, coupled with the environmental factors described earlier, has driven us to be more aggressive in the design of our 2014 National Preferred Formulary. For the first time, we are recommending the plan sponsors exclude some drugs from coverage. We're maintaining a 3-tier structure, with the first tier, generic medications; the second-tier is preferred brand; and the third tier is non-preferred brands. However, we are now excluding 48 specifically chosen products, which means they are not included in any tier on our formulary. We maintain clinically equivalent lower-cost alternatives for every one of these excluded products. Our approach fundamentally changes the industry dynamic with pharmaceutical companies because access on our formulary has even greater benefit to them as it ensures larger market shares.

Thus, most pharmaceutical companies are shifting more dollars to the tightly managed benefit design. However, to combat our formulary design, pharmaceutical manufacturers use a variety of tactics. This includes copay cards. These cards are used to encourage the selection of higher-cost brand drugs, which unnecessarily drive up plan sponsors' costs. Because we are not covering these 48 products, 93% of which have copay cards, the cards cannot be used as a secondary form of coverage. Additionally, 5 clinical categories of excluded drugs were for specialty medications. This has resulted in dramatically increased rebates in the involved specialty classes and will have a long-term benefit to controlling specialty spend and inflation. By excluding these specific 48 products, which do not offer any incremental clinical value relative to other alternatives remaining on the formulary, we're impacting just 1% of the drugs included in our 2014 National Preferred Formulary. This will subsequently impact only 2.6% of members, which will all have access to clinically equivalent lower-cost formulary alternatives.

These changes result in over $700 million in annual savings for clients on our National Preferred Formulary. We believe this strikes the right balance between member impact and client savings, with the result being an approximate 3% reduction in our clients' costs for branded drugs. We are receiving great interest from clients on custom formularies, including health plans and large commercial clients, in what we're doing with our National Preferred Formulary and would like to piggyback on it. With our unmatched skill and expertise, we are uniquely positioned to manage clients' costs, create additional value in the pharmacy benefit, by driving to a more narrow formulary, our process prioritizes clinical outcomes that provide the best economics for our patients, payers and shareholders.

At this point, I'll turn the call back to George.

George Paz

Thank you, Steve. As Matt referenced earlier, we remain on track to complete our client migrations by 1/1/14, and have already moved 80% of our clients. Integration remains one of our core competencies. We move very aggressively to consolidation -- to consolidate adjudication platforms, rationalize our product offerings and optimize our organizational structures and footprint. This approach minimizes overall disruption for our clients and positions us well long-term.

We are encouraged at both our migration progress and the market's response to our combined offerings. As the selling season winds down, we continue to enjoy solid performance. Our sales and retention results remain substantially in line with our Q2 update. We are also encouraged by the pace of up-selling our innovative offerings to our combined book of business. With all the uncertainty and complexity surrounding enrollment in the public exchanges, we will provide 2014 prescriptions and earnings guidance with our fourth quarter results.

Based on discussion with our clients, we believe most employers are taking a wait-and-see approach to health care reform. Therefore, they will continue to offer health benefits to their employees. For newly insured lives and those employers who choose to drop coverage, we are well positioned through our health plan clients to successfully win lives on any public exchanges. Our health plan clients have a presence in approximately 40 states, representing about 90% of the available lives. Due to demands on plans participating in public exchanges to opt for affordable premiums, our health plan clients are increasingly taking advantage of our product offerings, including aggressive home delivery programs, narrow networks and formulary management tools to drive down premiums and attract membership.

The impact of the Affordable Care Act and, specifically, the impact of the exchanges on PBMs is receiving significant attention. While health care reform in an aging population will drive some change, including the millions of uninsured Americans who will obtain insurance coverage, overall, prescription coverage remains fairly stable.

On health plan clients -- our health plan clients provide us access to regulated markets such as Medicare, Medicaid and exchanges. These are high-cost, complex and fast-growing markets. Due to this high cost and complexity of maintaining compliance with federal and state regulations, our scale and continued investment on our regulated solutions provide a competitive advantage to our health plan clients. The other area of health care which has generated significant headlines recently is private exchanges. Currently, private exchanges represent less than 0.25% of prescriptions in 2013 and are projected to reach approximately 2% by 2016. While the long-term success of private exchanges remains unclear, PBMs will participate either through our health plan offerings or directly through pharmacy-only solutions. Due to our scale and product capabilities, we are well positioned to grow with our health plan clients and the public and private exchanges.

To summarize our third quarter performance, we delivered solid earnings results of $1.08 per share, increased the lower end of our guidance by $0.04, launched 2014 formulary management strategies to save our clients over $700 million annually, successfully migrated over 80% of our clients with an anticipated completion on 1/1/14, and continue to see a strong market response to our differentiated product offerings.

Operator, at this point, we'll be happy to answer any questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question is going to come from Glen Santangelo from Credit Suisse.

Glen J. Santangelo - Crédit Suisse AG, Research Division

George, I just want to follow-up with some of the comments you made regarding the private exchanges. There seems to be a lot of concern amongst the investors that a lot of the employers are going to migrate to these private exchanges. Could you maybe give us a sense for how your conversations with employers are going, and what your sense is in terms of what they may do? And then as a follow-up to that, I'm kind of curious if you could talk about sort of your pricing methodologies within both the private and public exchanges, because I think the investment community is clearly nervous that the profitability within these exchanges will be a lot lower than your traditional employer and managed care contracts, and so if you could comment around that, I think it'd be helpful.

George Paz

Sure, thanks. Thank you, Glen. First of all, I do get to spend a lot of time with many CEOs across the country. The commercial book represents a very large component of our overall business. And it would be misleading if we said one-size-fits-all is the simple answer to this equation. Like everything else in business, cost controls are extremely important to companies. So companies look at any way they can to reduce cost. But on the other side of that equation, quality components of a product are equally important to any employer. In other words, if you're making cars, you need the best designs, the best components and produce the best car. Likewise, if you're in a service industry or other components, you need great employees. At the end of the day, employees are the most important asset any of us as employers have. The drive initiative and passion of our employees to meet our needs and the needs of our shareholders and, in our case, patients and others, clients, is a critically -- a critical component of success. So let's take it apart a little bit here. If you have a very low wage, low-skilled employee base, the private exchanges offers a decent option. The reason that occurs is because many of those individuals when they go to the marketplace, they will receive a subsidy. If you think about an employer who's providing health coverage to a large group of low-skilled, close to minimum wage or slightly greater employees, the health care cost can be close to or equal to their overall compensation levels. So to relieve yourselves of that burden, you have to make the employee whole. If you're going to enter the exchanges, and the exchange then can offer a benefit, which basically is subsidized by the federal government, then the cost has gone down for both the employer and the employee. Those are the ones we think when we talk about growing from 0.25% to 2%, I think you'll see that. On the other hand, if you've got a high wage base, high wage employee base, and you're dependent upon their skill set, if you just turn off the coverage, what ends up happening is you have to pay a penalty, a non-tax deductible penalty, which is quite expensive then when you tax-effect that penalty. In addition to that, those employees then must go out to the marketplace and try to buy coverage. The reason most large employers use ASO plans is because they don't want to pay the cost of risk coverage. And so the idea is to relieve yourself of that, you pick up ASO. Once you put your employees in these pools, they're all buying insured products. So to subsidize your employees with enough money to make sure that's maintained, there's a cost to that. The other thing that happens, of course, is that the employer then loses coordination of the overall benefit. So you got a ton of employees that are going out there who may have made very few health care decisions in their lives trying to buy a policy, often those policies are bought today for ailments that aren't going to hit us for 5 to 10, 15 years. So trying to project out to the future of something somebody knows very little about isn't the easiest exercise in the world. When you look at private exchanges, it does offer the employer an opportunity to effectively outsource the benefit side of the program. So when they push those people into a private exchange, still, if I'm going to avoid the penalty, I have to provide the minimum coverage of 60% of the total cost. So when I do that, I've got to make sure that, in fact, those costs are making good enough money into the program so that they, in fact, aren't going to be -- aren't going to subject me to the penalties. The issue there then becomes today those -- the policies are being very well priced because people are trying to get market share. The question is as those costs increase, if the employer wants to continue to avoid the penalty, you're going to have to step up and continue to meet the 60% threshold in order to provide the coverage. So there's fairly a lot of uncertainty and certainly loss of control and a fair degree of risk. I can't tell you with any degree of certainty how all this is going to unfold over the next 2 to 5 years. But I will tell you today, most employees for their active workforces aren't -- at least what I'm hearing, aren't looking to drop their coverage today.

Glen J. Santangelo - Crédit Suisse AG, Research Division

George, I definitely appreciate all those comments. Maybe could you just follow up on the pricing methodology and profitability relative to your existing contracts?

George Paz

Yes, sure, exactly. I'll tell you what, if you don't mind, I'm going to turn that over to Tim. And Tim is with us today. As you know, he heads all of our sales and account management. I'll let him talk about our products' receptivity of the market and how we see it.

Timothy C. Wentworth

Sure, good morning, Glen, and thanks, George. If you take a look -- you asked about the private versus the public, obviously, in the public exchanges, we're playing through our health plan partners and in most cases, it's very early in the game still for a lot of them. But if you look at what they've built into their product suites and they put up in the market often across all the precious metals, it has been the kind of program that we have, for years, been successfully selling to carved out employers. Narrow networks, narrow formulary and a very high focus on home delivery. Given that, what that does is it takes the traditional health plan mix of business profitability and improves it quite dramatically if you compare it particularly to the employers that we're talking about who might move certain employee groups out into the exchanges, Glen. So while it's -- I can't give you a precise number, nor would I, what I can tell you is, directionally, it's attractive for us particularly when we factor in the fact over the long term, it adds additional lives to the business that we can actually take advantage of through our health plan partners. As it relates to the private exchanges, again, we play a number of -- there are several ways there and the dynamics are fairly similar. I think the difference is that there are some of those where, at least one particularly large one, where there is a carved-out PBM offering that looks remarkably similar to our profitability as we expected to see in any sort of medium to large employer. And so from our standpoint, again, we are -- I don't want to say we're indifferent to that, but from a financial standpoint, we largely are in an equivalent place as it relates to that. And in fact, I think over the long term, are advantaged because our consumer tools and our ability to work directly with those members who are now in plans that, if you will, are more up to them. Because if you talk to HR departments that have moved that direction, they're outsourcing essentially large pieces of what they were doing internally. And so from that standpoint, those employees and frankly, those employers who are in those exchanges look to us to help those employees make more rational choices and leverage their dollars.

Operator

Our next question will come from Robert Jones with Goldman Sachs.

Robert P. Jones - Goldman Sachs Group Inc., Research Division

I appreciate Dr. Miller's commentary on the formulary management changes, the changes to the national formulary. But I was hoping you could give us some perspective on the financial implications of this for Express. If I look back to your slides from last quarter, you highlighted that over $10 billion in client savings can drive $1.5 billion to $2.5 billion in EBITDA for Express. Is that the same type of relationship we should think about for the $700 million that you highlighted from these formulary changes?

George Paz

I'll take a crack at this, Steve, and if you want to chime in, please do. There's a couple of pieces here. There's a -- we have all different types of relationships with our clients. Some of them, they keep to the rebate; other ones, we get to keep them; and other ones, we share them. So it depends on how the plan designs work. Again, one size doesn't fit all. But let me also tell you, there's a lot of other impacts that occur throughout this process, which helps drive it to those levels that you're speaking off. So first of all, there is the sharing of the rebate, which is one piece. But the second piece, which is just as important, is the fact that now we have the opportunity to talk to that patient. And often, there's even a generic available in that class for the right indications. And so to the extent that we can push them down in the tiers, it helps improve our performance, helps improve client costs and helps patient costs come down, helps compliance, does a lot of great things for us and improves our shareholder profitability. And of course, when you have the opportunity to talk to a member, we can also talk about mail. So there's really not direct correlations between the formulary impact and the numbers you're referring to. But it all adds to that equation and this is one of the tools we will use to get to those levels of economics.

Steven Miller

Yes. George, the only thing I'll add is this actually furthers our model's alignment. We make money when we save our clients and patients money. And what we've done with the formulary is really a great thing for patients, payers and ourselves and our shareholders. And so we really are excited about what we are doing in this area.

Robert P. Jones - Goldman Sachs Group Inc., Research Division

That makes sense. And if I could just maybe take a step back and ask you one on the outlook. I know, George, you're not giving guidance today. But this time last year, you called out the Street as being kind of overly aggressive on our outlook. I know 2014 guidance will get next quarter, but I was just wondering if you look out today, Street around the midpoint of your long-term EPS range, any initial comments you have around your comfort level with how the Street is thinking about the growth prospects for Express Scripts?

George Paz

Well, this, in all honesty, if I answer that question, I'm basically giving you guidance. And what I would have preferred to do is give you a detailed guidance with the -- and show you the components of it and show you how it's composed. I think Matt referenced our long-term vision on earnings, and we're not changing that. I believe that we are executing according to plan. I would also tell you that there's just a tremendous amount of uncertainty that exists in the market today. It's hard to say because if we talk about opportunities for us in the uninsured market, but at the end of the day, the exchanges aren't working all that well. And so it's hard to sit here today and project when that going to get -- what the impact of that is going to be and what's going to happen. And I'm incredibly bullish on our industry, in our company, in our people. But I just don't feel we're in a position today to give you that guidance, and I would really prefer to wait until the first quarter of next year and do this right with going deeper on all of our growth drivers, explaining how each of those work as Dr. Miller did today with formulary management, and take the numbers apart for you. I think that's a better solution.

Operator

And our next question is going to come from Lisa Gill with JPMorgan.

Lisa C. Gill - JP Morgan Chase & Co, Research Division

George, somebody commented in term of a slightly different way today. And this -- your comment around the selling season, innovation, upselling to your clients, can you maybe talk about what they are buying for 1/1/14 versus what we saw in '13? And where you see those opportunities, whether it's '14, '15? Maybe if you can just give us some kind of projection or thoughts going forward as to how much deeper you can get with your clients? What are the incremental opportunities?

George Paz

Lisa, that's a great question. And again, we'll unpack that a lot on our first quarter guidance call. But we also -- in order to try to answer that, I will tell you that CEOs today, probably more than ever, with the uncertainties around the economy, the situation occurring in D.C., on and on and on. Companies are looking for ways to reduce cost, stay profitable and maintain their competitive edge in the global economy. So things held off the table, 5, 6, 7 years ago because people were afraid of disruption. The HR departments and certainly companies have become much more open to taking on additional products. And as you can see in Steve's slide, when we're talking about affecting a very, very few of your employees to get massive amounts of savings, and by the way, you're doing nothing to hurt clinical values, in fact, because you're driving down costs, you're more likely improving health outcomes while you drive down those costs. It's a great combination for us, our clients and our patients. I'll let Tim go deeper into the -- what the actual product mix is and what's taking place.

Timothy C. Wentworth

Yes. Thanks, Lisa. What I would say -- actually, just to add a little color to what George said before I get more specific there. If you think about the pieces of our book, we've got -- you just heard us say a few minutes ago, our large and mid-sized employer book, by and large, are not going to exchanges. And that's what we see. So they're staying in the game, and that means they want to continue to aggressively manage and move to bronze as we called it. We got health plans that, more than ever, actually need help managing risk, because the businesses that are growing for them are businesses where, clearly, it's a trickier path and they need a strong partner. And then you got states and unions and some others that are not really in a position to drop. And so, again, they're in the game and being very aggressive as well. So you have, really, all of our components of our book of business. Actually, if you take the Department of Defense on top of that, they again are very focused on managing their money well. And so what you see is a very broad piece of the marketplace going to aggressively manage tools. And that's what we see that we're heavily installing again for January 1. So what does that mean? We see more employers putting in CDH plans. And I would actually point to CDH plans as an interesting dynamic when we think back to private exchanges. 10, 12 years ago, when the CDH plan started, the thought was in audit [ph] prices, PBMs may not play long term, but that may be all just simply carved in and you couldn't get systems to talk to each other and do real-time debiting. And I can tell you CDH plans now are a growth plan design dimension for us, which brings into, again, play. Us, helping those members move to home delivery, move to generics, move to tighter retail networks, but also we win new business now in the result of having strong CDH capabilities. So I look at sort of where it started, this is where it finished. And I see opportunities even in the private exchanges, as over time, they morph. But we aren't seeing a lot of that today in terms of private exchanges. We are, in terms of CDH. We are, in terms of specialty management. And that's across-the-board whether it's utilization management. Steve mentioned that a significant part of our new formulary is actually now moving into the specialty space, and we're taking advantage of multiple opportunities there to create competition and drive down costs and provide access and good care for patients. Our formulary, Steve talked about it, it's impossible to talk about how important and large that is to our employer book of business and then moving into the health plan book as they look at what's working in the commercial book of business. And so, as Steve said, our employees are our secret weapon there across-the-board to positioning us to an incredibly high adoption rate. We'll talk more about that at our Analyst Day, I believe. But the adoption rate and the satisfaction rate of our clients, with what we brought to them in terms of our formulary initiatives, it was nearly as big for our book of business as what we did Walgreens a couple of years ago. And probably every bit, if not more important, to helping our employers and their health plan stay in the game and rationally manage their costs. Our clinical solutions such as our productive modeling and our intervention RationalMed program, very strong uptick particularly now that that's on our destination platform. Fraud, waste and abuse, huge amount of interest in that program. And so, again, it's probably not a surprise to you that across the book, we're seeing significant continued opportunity for us to go deeper. I think last quarter, we showed you that there was a lot of room to run in terms of all of our key programs, home delivery, generics, specialty, formulary and retail networks. And we continue to see -- there's a lot of room to run, but we are definitely over the next year or 2, going to see significant uptick in a number of other areas there.

Lisa C. Gill - JP Morgan Chase & Co, Research Division

And so would you say that it's fair to say, George or Tim, that in the past, investors always looked at who was the customer and certain customers were more profitable than others. But in the future, what will determine who's more profitable is how highly managed the account is, where you can put your programs in place? Is that the right way to think about it?

Timothy C. Wentworth

I think it's exactly the right way to think about it. When we put those programs in place, we guarantee them, so we take incremental risk and we get paid for delivering on that risk. And the return to clients for us taking that risk is very, very high.

Lisa C. Gill - JP Morgan Chase & Co, Research Division

Okay. And let me just sneak one other one in. George, you've done a great job over the years from an acquisition standpoint, we consistently get that question of what's the next thing that Express Scripts would potentially do? Can you just give us any high-level thoughts as to how you're thinking about things?

George Paz

Well, I really like to finish this one first. We have a -- 1/1/14 is our -- it's an anticipated completion date of our member migration, which is huge. The cost of maintaining multiple platforms and having a common product offering is so important. Our clients meet regularly whether it's in our forums, as advisory groups or in other forums where they happen to get together, health conferences and what have you. And if you don't have a common offering, if you -- one client can get something and another client can't because your systems don't have the same offerings, that's a real problem for us or for anybody in the business world. So getting all that done is really important. That's stage 1 or step 1, is to get that done. Some of the back office stuff, which is what Matt was talking about, that's ancillary but it's an add-on, but it's important. Cleaning up the accounting components and some other retail stuff and some of the other pieces, those don't touch the members so much, but they're important to get those cleaned too. And we'll continue to fix -- finish all that up during the first half into the early second half of next year. So we'll get all that done and behind us. We constantly look, even after we closed the Medco deal, Lisa, we started looking at where else it makes sense. We are -- we believe we have unique capabilities, both in IT architecture, systems, product execution, skills, I can go on about our execution in our core competencies, but the issue is, as you know, many components of health care don't work very well. And the issue is what is it that is a bolt-on, an add-on, an adjacency that we can do to actually help our plans better manage their overall drug -- overall health care costs. And we're very open to looking at what those plans might be. We're very interested in doing some seed planting and trying to make sure that, in fact, we are looking at new product portfolios, new offerings, other ideas, to bring things in. And that will remain a focus of ours. So this is very much top of mind in our company.

Operator

And our next question will come from Robert Willoughby with Bank of America Merrill Lynch.

Elizabeth Blake

This is Elizabeth in for Bob Willoughby. Just on share repurchases. Would you ever consider using a 10b5-1 program to purchase shares during a blackout period?

George Paz

We are always interested in managing our capital structure. We don't want to get into specifics of the different programs we use and the different ways we can execute, but we are -- we look at all the different options out there. We don't put anything as a no. We definitely looked at different components and then we deploy what we think is in our best interest and our shareholders' best interest to execute on a very managed capital structure.

Elizabeth Blake

Okay. And on that note, do you anticipate buying any stock during the first quarter? Or more kind of a back half of 2014 activity?

George Paz

Yes. Matt, referenced in his prepared comments that we would, in fact, continue to repurchase shares into the fourth quarter and in fact...

Elizabeth Blake

Sorry, I said the first quarter of 2014.

George Paz

The first quarter?

Elizabeth Blake

Yes.

George Paz

We'll provide that guidance. I'm sorry, I missed your question. Just to finish up, though, we will accelerate our purchases into the fourth quarter, so we'll stay on that path. As far as next quarter goes, we will do our Investor Day during -- right at -- some time around when the window is either opening or soon before so. We will disclose what we're going to do in the following year next year after we get all of our plans together. I don't think we're in a position today to discuss that.

Elizabeth Blake

Okay. And just a quick one, would your current tax rate for this quarter continue next year?

George Paz

I'll let Matt answer that, but let me just follow-up on one thing I did say. Matt did make a comment that we would deploy the majority of our free cash flow and try to, on a regular basis, return that to our shareholders. That stays one of the principles by which we will deliver our financial results. So we are committed to that and we'll just have to give you more guidance around that during our Investor Day. Matt, you want to talk about tax rate?

Matthew D. Harper

Sure, I'll comment on the tax rate. We're not prepared to really speak beyond 2013. We'll roll out our expectations for our tax rate for 2014 when we put together our 2014 guidance and talk about that first quarter of 2014. We're pleased that some of our tax planning strategies has come to fruition this year. But there's a lot of moving parts for next year and years beyond. We have additional strategies that we want to implement, but there's a lot of discussions at the state level around tax laws and the like. So we'll provide our direction and guidance on taxes in context of our total 2014 guidance in the first quarter.

George Paz

I will tell you, though, that taxes are very expensive component of our income statement, and so it is a focus of ours. And part of the negative of our buying Medco was some of their jurisdictions and their overall tax rate. So Matt and his team are -- and our controllership under Chris Knibb and his team, are very, very focused on driving down our overall tax rate. That goes straight to the bottom line, so that's important to us. And we don't want to get into specifics now, but just know that stays a focal point.

Operator

And our next question is going to come from Tom Gallucci with FBR.

Thomas Gallucci - FBR Capital Markets & Co., Research Division

I guess just first, on the quarter itself, it seemed like, at least versus what we are looking for, maybe the United Scripts rolled off a little bit more quickly. Can you help frame for people sort of the cost structure that's associated with that and your ability to tweak that down while the roll-off is happening versus what's sort of more fixed that you got to wait until it's over with?

George Paz

I'll take a stab at that. Matt, if you want to add anything, feel free. There's 2 pieces to it. As the actual claims roll off, you relieve yourself of the DPC cost, so to the extent a mail order script goes away, you carry less inventory, you carry less -- you don't process it. So you can take people down in staff functions as you reduce cost. The bigger question is when it's completely gone, which occurs at the end of this year. Then our plans are to look at our footprint and figure out what fixed cost can be removed. And we'll include that in our guidance for next year, we're going to give it. Because we can take a lot of variable costs, which you see in our financials, we could pay up some fixed costs as the business declines, but this is a very big client with a lot of scripts. And so we've got to -- we have reevaluated our footprint effort is gone and then make our decision around fixed costs platforms. Matt?

Matthew D. Harper

My only addition to that is, in 2013, we're focused on 2 key items or -- one is the client migrations on to the destination platform, but it's also managing our cost structure as this united businesses is rolling off. And as George alluded to, some of that is near-term cost savings that we can manage in conjunction if the claims are rolling off, and some of it is going to be more long term once the business is totally gone and that would be considered in the context of our 2014 guidance as well.

Thomas Gallucci - FBR Capital Markets & Co., Research Division

Okay. I think -- the other day on its call, WellPoint seemed to imply some escalators maybe in the contract that you all have, and I thought what was also interesting about it was they were talking about maybe some ways to reduce their costs. I think they pointed to maybe custom pharmacy networks, local areas and whatnot, Can you offer any color on either of those 2 topics and then what you're seeing there?

George Paz

WellPoint is a very great partner for us, and they -- we work very closely with them. And all the stuff Tim had talked to about earlier on is WellPoint is a very sophisticated client, they understand that their ability to be competitive in the marketplace is hugely important. And so utilizing the tools that we have to offer allows that to occur. So I don't want to get into specifics here, but they'd certainly understand the tools and are deploying tools to make sure they're on a competitive footing. I don't know, Tim, if you have anything you want to add or not?

Timothy C. Wentworth

No, nothing to add. I mean, it's a great partnership and we are engaged across their lines of business, because they've got geography and they got business lines. And we are neck-deep in opportunities to help them across all of those areas.

Thomas Gallucci - FBR Capital Markets & Co., Research Division

Okay. Last one, George. Just wondering if you had any update on your thoughts regarding the CFO slot?

George Paz

Sure. We did have a search going on as we speak. And so we will evaluate some candidates. I think it's interesting. When you talk about senior management, it's really about -- there's a lot of great players out there. The real issue is one that fits with the culture, the drive, the passion. And you want somebody that really understands finance, but it's just as important to me that they understand patient caring and empathy towards our clients and our patients. And so it's a very key role and we're not going to move fast on this, we're going to make a good, sound decision. And unfortunately, that takes a little while.

Operator

And our next question is going to come from Ricky Goldwasser with Morgan Stanley.

Ricky Goldwasser - Morgan Stanley, Research Division

George, you said on your prepared comment that the selling season is substantially in line with where you were in the second quarter. I think last quarter, retention rates were 95%, taking into account client consolidation. Is this still the number that we should be thinking of? And also can you give us some context as to the net number including the wins?

George Paz

I don't want to get into specifics there because, again, what we're then taking apart is next year's guidance. What I prefer to say is that we are in line with the numbers we gave during the second quarter, and we'll update those when we get into next year. So we'll give you a breakdown on the selling season, on our retention rates, on clinical upsells, our programs we're putting in place, the moves we're making, our SG&A forecasting and our long term -- our current year earnings targets. So I prefer to wait on that till next quarter.

Ricky Goldwasser - Morgan Stanley, Research Division

Okay. And then the job distributors have been talking a lot about generic inflation as a tailwind to their results. And we've been getting questions on what generic price increases mean to the PBM. So can you help us just then understand what's the impact, if there is one? And also, in line with kind of like the generic thinking, what you're seeing kind of like more move towards consolidation of the supply chain and convergence? Is there some sort of disadvantage for you if you don't participate in that sort of a joint venturer partnership?

George Paz

I think we're incredibly well positioned. When you think about it, we're spending $100 billion a year. And so I think we're a client that -- not only do we spend a lot, but in our situation, our purchases are very, very manageable and measured, they can be scheduled. So if you're a manufacturer and you're trying to fill your production cycles, you know exactly where we fit into those and how much quantity we're trying to -- we need. And I think it really fits well for them. So yes, we go out in advance and we secure pricing. I think generics remain a very important component of our ability to drive down costs. And it's a key driver in our profitability. We're not seeing -- there's always ups and downs. There's always product shortages. There's hard-to-get products and other things. But, overall, we're not seeing anything that's causing us any concern.

Operator

And the next question will come from John Kreger with William Blair.

John Kreger - William Blair & Company L.L.C., Research Division

Tim, a quick follow-up for you. When you survey your employer clients about this exchange issue, on a longer-term basis, do you get a sense about what percentage might consider an exchange if they work effectively?

Timothy C. Wentworth

Most of them will tell you they don't even know. But what I would say, generally, is the things that are causing them to wait and see are depending as much on external variables. So for example, when employers look at the idea of dropping lives and there are some that would say the private exchanges are a gateway drug to the public exchanges for certain populations as a way of kind of moving those out, the question then becomes, do you really believe that the $2,000 penalty stays $2,000? And as you do the math what you see is, for a great number of the employers, any long-term set of reasonable assumptions causes them to not only stay in short term, but longer term. And so what I'd say is it's very uncertain. I'm not going to sit here and tell you they're absolutely staying through '18 or whatever year you want to pick. But what I would say is, I don't see folks standing on the edge of the pool ready to jump quickly or even in the medium term, by and large.

John Kreger - William Blair & Company L.L.C., Research Division

Great. And a follow-up, can you remind us what percent of your book on a volume basis are represented by employers at this point?

Timothy C. Wentworth

So I think, generally, if you look across, broadly defined, it's approximately 30% of our book.

John Kreger - William Blair & Company L.L.C., Research Division

Great. And then maybe a quick follow-up, Dr. Miller, if you're still there. The formulary changes that you've made sounds like they've been a very effective mechanism. Are you finding that to be effective in specialty as well, given it seems like that's where the highest rates of inflation and utilization are?

Steven Miller

So one of really exciting points to this formulary change, as you know, is we actually exclude drugs in 5 specialty categories. This is really unprecedented in the industry and its providing our clients a lot of predictability for their specialty spend going forward. And so the enthusiasm the clients have had for the changes we made in specialty are really unprecedented.

Operator

And our next question will come from Charles Rhyee with Cowen and Company.

Charles Rhyee - Cowen and Company, LLC, Research Division

Maybe a question for Tim here. You talked about a lot of the tools that you have in the exchanges for consumers, particularly, as they're going to have to start shopping for their own health care. Can you talk about how your advertising -- how can you advertise that to consumers or employees as they go into these exchanges, whether public or private? So to know about that, particularly, whether you're carved out or you're carved in, how do you get your message out there?

Timothy C. Wentworth

So when it's carved in, which is where the predominant sort of volume is -- that we're talking about, we have the great fortune of having clients with great brands. And if you look at the Blues, for example, they're in tremendous position, as you know, as well as the number of our other regional health plans. So it's important we help or we're able to basically leverage their brand and their access to these patients. We embed ourselves in their websites, for example. We've worked with Blues to be part of their apps to the extent that their numbers use those sorts of tools, as well as having our member service advocates directly involved, or in some cases, having their membership as advocates using our tools to service their members. So it really varies depending on the individual Blue plan where it's carved in -- or a regional health plan where it's carved in, how we help them through them get to the member or directly get to the member based on our relationship with them. We're -- it's actually a carved out situation, then it's fairly straightforward for us. We employ all the usual tools that we wield, in terms of communicating with these folks, through all the channels using our consumerology to heighten engagement rates and outcomes and so forth. Again, our Web, which is just on redesign and about to be relaunched, is a tremendous tool for us and for our members to, not only transact, but to find the lowest cost alternatives. We push those messages out to them and so forth. Now that's a place where we've made significant investments and those investments really pay off for those consumers, again, whether it's a direct relationship or through our health plans.

Charles Rhyee - Cowen and Company, LLC, Research Division

So if I can just follow-up, a quick question on to -- about formularies again here. You talked about 1% of drugs excluded, you talked of 48 drugs in particular, what percentage of drugs on the national formulary are suitable for exclusion as well? And if we were to look at the reasons for exclusion, I mean is it as simple as something that is worth of twice daily to once daily? Going to once daily is not really enough to be included on the formulary anymore?

Steven Miller

As you know, there is more and more competition across the drug classes. This represents a great opportunity for us. And as you know, a lot of the products that are coming to the market are me-too product. And so we always put clinical first. The care of the patient has to be the #1 consideration. But when there are alternatives, they provide equally good, if not better clinical outcomes, it is our obligation to actually leave market share towards those products, give those manufacturers more market share and give bigger discounts to our patients and their payers. And so we look at the future as actually having additional opportunities. So while we've taken on these 5 classes today, we're already looking at other opportunities. And to be very frank, the pharmaceutical manufacturers have taken great notice of this. They are reaching out to our pharma services team. And already, are talking about what the future looks like. And so we think there's more to come, and we think it's going to lead to, not only lower cost but actually in the end, better access and better health outcomes.

Operator

And our next question will come from Steven Valiquette with UBS.

Steven Valiquette - UBS Investment Bank, Research Division

George, just a big picture question on PBM health plan partnerships which, obviously, seems more important than ever with the evolution of exchanges. We've all, obviously, seen the WellPoint, Cigna, Aetna, UNH strategies unfold over the past couple of years. When you think about the remaining landscape, which is still pretty large once you get beyond those 4, I guess the 2 questions I have kind of interrelated is, first, what's the current temperature for other health plans to still see potential PBM partnerships? And then maybe more importantly, is there any possibility we could see new PBM health plan partnerships just for exchange business, whether it's public or private? And to me that would see logical just in the evolving marketing efforts around the exchanges, but I'm just curious to get your thoughts on that.

George Paz

There's still a couple of health plans that offer their own PBM. There's not a lot anymore and there's also several that in source different components of it for a variety of reasons. So -- but I would say the majority of health plans, except the big ones, except for maybe United and Humana, have actually outsourced their PBM. And the question is always -- this is 90% of the transactions and 15%, 18% of the cost, and so from a health plan perspective, if you're looking at scale, size, all those pieces, at least in my mind, and I guess I'm a little biased here, but I think it makes a tremendous amount of sense for them to outsource. We outsource a lot of our back office things that don't add value to our clients. Here, we can actually add value to their clients by bringing a lot of scale and size and quality together for a very small health plan to get the ability to have the adjudication platform, the clinical tools, the expertise that goes into this. I think that would be tough to do. So I do think this is -- that we are very relevant today, becoming more relevant every day. So I like where we sit as far as the exchanges go. That's -- as Tim mentioned earlier, part -- as you know, one of our big attention items is to actually helping an individual manage. Although our client is the health plan sponsor, we put a tremendous amount of effort looking at every patient who uses Express Scripts services and try to optimize their spend and optimize their health outcome. And that's been our specialty. And I think that's somewhere we will continue to focus. So when you think about private and public exchanges effectively, these are becoming the individual as the consumer, and what's right for them. And as Tim mentioned earlier, I think this is an area where we have a one up expertise that nobody else in the industry has and I'm very happy with our positioning.

Timothy C. Wentworth

Being on a single platform, having to be industrial strength the way that we are, I think is going to create a tremendous amount of opportunity for us in the future to service either some populations or even have plans that are using other PBMs today. Take a good hard look at what we're doing because it is increasingly difficult to stay in that business and stay in a way that makes your plans feel that they're with the right player. And we are in a very, very good position as we look at our sales pipeline and the opportunities over the next 3 years that we think are coming our way. Being really sound where the growth is coming, which is this regulated section of the marketplace is going to serve us very well.

George Paz

Thank you, everyone, for joining us this morning. We really appreciate your questions. We look forward to getting with you in the first quarter of next year for our Investor Day. And if you have any follow-up questions or comments, please feel free to reach out to David Myers. He's available to answer any other questions you might have. So thank you all very much. And make sure tomorrow night at 7:00 Central Time, you watch the Cardinals beat the Red Sox for the second game, second win for us. So thank you very much and have a great weekend.

Operator

And that does conclude our conference for today. Thank you for your participation and for using AT&T Executive Teleconference service. You may now disconnect.

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