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Medco Health Solutions Inc. (NYSE:MHS)

Q4 2009 Earnings Call

February 23, 2010 8:30 am ET

Executives

Valerie Hartle – Vice President Investor Relations

David B. Snow Jr. - Chairman of the Board, Chief Executive Officer

Richard J. Rubino - Chief Financial Officer, Senior Vice President - Finance

Dr. Robert Epstein - Senior Vice President - Medical and Analytical Affairs, Chief Medical Officer

Steve Fitzpatrick - President of Accredo Health Group

Brian T. Griffin - Group President - Health Plans

Timothy C. Wentworth - Group President - Employer Accounts

Analysts

Ross Muken - Deutsche Bank Securities

Lisa Gill - JP Morgan

Charles Boorady - Citi

Robert Willoughby - Banc of America-Merrill Lynch

Lawrence Marsh - Barclays Capital

John Kreger - William Blair

Operator

Good morning, my name is Lori and I’ll be your conference operator. At this time, I would like to welcome everyone to the fourth quarter 2009 Medco Health Solutions earnings call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks there will be a question and answer session. (Operator’s instructions) Thank you. I will now turn the call over to Valerie Hartle, Vice President Investor Relations. Please go ahead.

Valerie Hartle

Thank you, Lori. Good morning everyone and thank you for joining on Medco’s fourth quarter and full year 2009 earnings conference call. With me today as speakers are Dave Snow, Chairman and Chief Executive Officer, and Rich Rubino, Chief Financial Officer. Also joining us for our question and answer session are Tom Moriarty, our General Counsel, Secretary and Senior Vice President of Pharmaceutical Strategies and Solutions, Dr. Rob Epstein, our Chief Medical Officer and newly named President of the Medco Research Institute, Steve Fitzpatrick, the President of Accredo Health Group and Brian Griffin, the President of our Health Plan Group. Joining us remotely is Tim Wentworth, the President of our Employer Group.

During the course of this call we will make forward looking statements as term is defined in private securities litigation reform act of 1995. No forward looking statement can be guaranteed and actual results may differ materially from those suggested. We undertake no obligation to publicly update any forward looking statement, whether as a result of new information, future events or otherwise. Forward looking statements made on this call should be evaluated together with the risk and uncertainties that effect our business, particularly those disclosed in our SEC filing. Copy of Medco’s filings are available from the SEC, the Medco investor relations department or the Medco website.

Medco intends to use the investor relations section of this website as means of disclosing material, non public information. And so complying with its disclosure obligations under SEC regulation FD. The copy rights for the contents of this discussion and the written material used on this earnings call are owned by Medco Health Solutions Inc. 2010. Slides to accompany our presentation which detail our financial and operating results and the guidance discussed on this call are currently available in the events section of the investor relations site on medcohealth.com. Additionally, please note that our 10K will be filed after the close of the market today.

At this time I would like to turn the call over to Dave Snow. Dave?

David B. Snow Jr.

Thank you, Valerie. And thanks to all of you for joining us this morning. I’m pleased to report that we closed 2009 with yet another quarter of strong growth as we continue to lead our industry apply clinical and technological innovations on behalf of the customers and members we serve.

Through our clinical initiatives and our advanced management tools we are proving that higher quality care is also less expensive care. That is the essence of true health care reform. And it resonates strongly with our customers and our members.

We call it making medicine smarter. And coupled with exacting execution our thought leading strategy has delivered measurable results in the market place.

We achieved record performance in the fourth quarter of 2009 and completed a record full year 2009. Further it is with confidence that we reaffirm our continuing strong growth in our 2010 guidance.

Now I’ll briefly recap our results. Our full year 2009 GAP diluted earnings per share reached a record $2.51 representing 22.5% growth over 2008. Our diluted earnings per share excluding the intangible amortization from the 2003 spin off reached a record $2.83, representing 21.5% growth year over year. Both exceeding the high end of our 2009 guidance range.

Our new client wins in 2009 surpassed $10 billion setting a new Medco sales record. Consequently driving our 2009 revenue to a record $59.8 billion, up 16.7% over 2008. Our revenues have increased by over 80% since 2002. Medco’s last full year before becoming a publicly traded company.

When adjusting for the fact that lower priced generics have become an ever increasing offset to our revenues over time as we delivered value to our client, 2009 revenues on a consistent basis have more than doubled since 2002.

Our 2010 year to date annualized (inaudible) climbed to $4.3 billion from the $4.1 billion we last reported. Net new sales for 2010 year to date rose to $4.2 billion from the previously reported $4 billion.

Our 2010 client retention rate based on drug spend currently stands at 99%. Our sales success coupled with our high retention rate demonstrates that our message resonates with clients and prospects and that we deliver what we promised.

Our 2010 scheduled renewals are now approximately 80% complete. We have no remaining scheduled 2010 client renewals with more than $500 million in annual drug spend.

At this point I would like to recognize and thank the thousands of Medco employees who at the expense of their personal life during the holidays ensured that our significant volume of January 1, 2010 new client installations and existing client benefit, changes were delivered with virtually flawless execution.

Highlighting some other important 2009 business metrics. Our total prescription volume adjusted for the difference in days supply between mail and retail increased by 12.9% over 2008 to a record 898.8 million. Mail order volume was in line with our expectations at 103.1 million prescriptions a 2.6% decline since 2008. That full year decline was attributed to an 8.6% decline in small molecule brands at (inaudible), where we do not earn margin. Making certain our model is completely aligned with our clients best interest.

Conversely, generics at mail where we are also aligned financially with our clients and members increased 2.4%. Year over year improvement in our generic expensing rate delivered more than $2.4 billion in incremental 2009 savings to our clients and members. For the full year our average generic dispensing rate increased 3.4 percentage points to a record 67.5%.

With heavy retail volumes associated with our significant 2009 business win, retail prescriptions grew 23.2% to a record $591.4 million.

Overall EBITDA climbed 11.8% to a record $2.8 billion. EBITDA for adjusted prescription was fairly consistent with 2008, declining 1% to $3.06 for the full year compared to $3.09 for the full year 2008. This again is associated with significant 2009 business wins with high retail utilization.

Our Accredo specialty pharmacy segment demonstrated strong continued growth in 2009 with record net revenues up 19.5% to $9.5 billion. Accredo’s operating income grew by 27% in 2009 delivering record full year operating income of $357.1 million.

I would like to highlight a few other full year 2009 metric reflecting our disciplined financial stewardship which Rich will cover in more detail. Gross margin dollars increased by 8%. SG&A expense increased by only 2.1%. Cash flow from operations increased 114% to a record $3.5 billion. And at yearend cash balance has exceed $2.5 billion even though we paid down $600 million in debt during 2009.

This strong performance gives us the ability to confidently evaluate and act upon investments opportunities. As we continue to build long term value for our shareholders. Medco’s investments in building a protocol driven evidenced based pharmacy practice are addressing the needs of patients with chronic and complex conditions. This is critical to improving patient outcomes while reducing total health care expenditures. Our publication and presentations of more than 12 Medco led clinical studies in 2009 further reveal our strategic intent and our ability to be part of the solution when it comes to health care reform in this country.

To help speed the transfer of critical scientific and clinical knowledge to practice setting we have formed a Medco Research Institute. Our chief medical officer, Dr. Rob Epstein now also serves as President of the institute. Rob and the Medco Research Institute will coordinate, extend and amply the Medco research that is already changing the way medicine is practiced in the United States and the world.

We’re excited about the significant new research Medco has scheduled with academic partners for 2010 and beyond. Please be advised that the results of our landmark study with Mayo Clinic on the effects of genetic testing around the blood thinning drug warfarin will be presented (inaudible) at the American College of Cardiology meeting on March 15. Shortly after March 15 we will post a web broadcast for investors on Medco.com featuring Dr. Rob Epstein who will explain the study and the implications of its results.

We have taken a very deliberate and strategic approach to personalized medicine. We have enrolled nearly 8 million members representing well over 200 clients in our growing portfolio of pharmacogenomics program. And we are now viewed as one of the world's leading organizations creating the future of pharmacy through personalized medicine.

To that end, we were pleased to announce three weeks ago that we acquired DNA Direct Inc. a leading edge health care company specializing in guiding payers, physicians and patients on a range of complex issues related to genomic medicine.

This acquisition enabled Medco to build a new generation of solutions that will deliver on the promise of what we’re calling precision medicine, improving safety and efficacy, enhancing clinical outcomes and lower costs. Already with over 2,000 genetic and molecular tests on the market this is an area of rapid innovations and significant growth.

Through our acquisition of DNA Direct, Medco has obtained proprietary algorithms and skilled geneticists enabling us to better guide decision making for all these tests.

Our research collaborations placed at (inaudible) developing the core science and validating it’s clinical value. Our business initiatives are taking these learnings to market. With value added services that convert the theory and science into a portfolio of differentiated offerings that benefit our current clients and members and help to drive our continuing new sales.

We are investing in innovations today that we believe represent real health care reforms. As we have said before, we expect these investments to grow over time into meaningful contributors to our long term success.

Our new and fast growing Medco Health Store now has more than one million registered members over first six months of operations. This means we have added over 300,000 new registered users since our analyst day in November. The Medco Store complements the perspiration based services we provide patients through our therapeutic resource centers by providing access to over the counter drugs, vitamins, supplements and other health care products.

Importantly, they will ultimately provide for hundreds of thousands of potential combinations of protection of the drug to drug interaction safety net that we take for granted in the realm of prescription medicine today. Our growing portfolio of international businesses in Sweden, Germany, and the United Kingdom leverage our innovation technologies and solutions in a manner that transcends geographic, political and cultural health care conventions in directing quality in cost issues abroad.

We remain committed to this winning strategy in 2010 and beyond. Looking ahead we are today reaffirming our strong 2010 diluted GAP per share guidance of $3.05-$3.15 which based on our actual 2009 earnings performance represents growth of 17%-21% over 2009.

Excluding the amortization of intangible assets from the 2003 spin off, we expect diluted earnings per share to be in the range of $3.28-$3.38 for a growth rate of 16%-19%.

In summary to our actions, Medco is lighting a path for real health care reforms through innovations that serve the needs of our clients, members and shareholders.

With that, I’ll turn the call over to our CFO, Rich Rubino who will discuss additional details behind our 2009 financial performance and our 2010 guidance. Rich?

Richard J. Rubino

Thank you Dave. Good morning. We are pleased to deliver another quarter and full year of strong financial and operating performance. I will begin my decision with a report on our balance sheet followed by a review of additional income statement highlights and some points to consider as you look ahead to the first quarter and full year 2010.

As Valerie mentioned, the slides on our website will prove helpful in following along with my commentary. Starting off on our balance sheet, we closed the fourth quarter with a cash balance of over $2.5 billion. Up significantly from the $938 million at the end of 2008 and the $2 billion at the close of the third quarter.

This is after paying down the remaining $200 million of our $600 million short term securitization debt facility. (Inaudible) saving more than $5 million annually with an interest expense with combined with the $400 million pay down in the third quarter.

Our cash flow from operations for full year 2009 achieved a record $3.5 billion. More than doubling the full year 2008 performance of $1.6 billion. The $3.5 billion in 2009 cash flow exceed our guidance of $3.2 billion. And reflects the success of our continuing efforts to improve working capital. (Inaudible) significant gains in 2009 cash flow we continue to expect a strong 2010 cash flow of $2.3 billion that was included in our previous guidance.

Our inventory levels declined from September 2009 by over $50 million to approximately $1.3 billion. This now represents a decreased of greater than $800 million or over 38% since the end of the second quarter of 2008, when our inventory reduction initiative first began.

As a result of our working capital management progress, Medco return on invested capital for 2009 reached a very strong 27.1%. This is up from the 20.1% we achieved in 2008. We continue to expect 2010 return on invested capital to grow even further and average well over 30%.

Our total debt declined from $4.2 billion as of September to $4.0 billion as of yearend, reflecting the pay down I mentioned earlier.

We now have untapped borrowing capacity of approximately $1.6 billion. Which includes $1 billion from our revolving credit facility and the $600 million from our asset securitization facility. Our leverage ratio or debt to EBITDA ratio now stands at 1.46.

One last comment on the balance sheet, our capital expenditures for full year 2009 totalled $238.8 million. In line with our guidance of approximately $235 million. Reflecting investments across the business.

We now expect capital expenditures for 2010 of approximately $225 million. A $10 million increase over our previous guidance to support our recent acquisitions and our other strategic initiatives.

With regard to our income statement performance, I will reframe from repeating the highlights Dave already provided to the full year, instead tele-focus on the quarter.

Our fourth quarter EPS results were very strong. Fourth quarter 2009 GAP related EPS of a record $0.70 exceed 2008 performance by 29.6%. Diluted EPS excluding the amortization of intangible from the 2003 spin off of a record $0.76 is higher by 28.8%.

Fourth quarter net revenues reached a record over $15.2 billion, representing growth of 17.6%. Looking at revenue (inaudible), our product revenue grew 17.6% while service revenue grew 16.3%. Product revenue growth reflects significant new business and price inflation on brand name drugs, partially offset by a higher representation of lower priced generics.

Service revenue growth reflects the expansion of our overall client base. It includes administrative fee and our significant resale values and many (inaudible) services.

In terms of volume, total fourth quarter prescription adjusted for the difference in (inaudible) supply between retail and mail, amounted to a record 227.4 million for an increase of 14.8% for the fourth quarter 2008.

Retail prescriptions in fourth quarter 2009 grew 26.9% to a record 150.1 million as a results of our 2009 business models. On mail order prescriptions reached 26 million in fourth quarter 2009, a 2.6% decrease from last year. Importantly similar to last quarter, this included increased generic mail prescription volumes over 2008.

For the fourth quarter of 2009 while small molecule brand mail order prescriptions which are primarily filled at (inaudible) decreased 8.5%, generic scripts at mail increased 2% as clients and members continued to pursue savings on their prescription medication.

As Dave mentioned, this is a popular dynamic for Medco as our profitability small molecule medicines, rest of generic mail order where client and members save the most.

With strong retail (inaudible) in our significant 2009 new business brought our fourth quarter adjusted mail penetration rate to 34.0% from 40.3% at fourth quarter 2008. For the full year 2009, the adjusted mail order penetration rate was 34.2% compared to 39.7% in 2008.

We continue to expect 2010 mail order volume to be in the range of 107-109 million prescriptions. With the growth over the 103.1 in 2009 spending largely from generics. It is important to remember that the new prescription volumes from our significant sales (inaudible) is still activated to have an average mail penetration rate of 25%. We also continue to expect our full year 2010 adjusted mail order penetration rate to increase slightly over the 2009 level of 34.2%.

Our other mail order volume counted as prescriptions which include OTC items and diabetes supplies reached 1.8 million units for the fourth quarter. 5.9% higher than our fourth quarter 2008 volume of 1.7 million units.

For full year 2009 our other volume increased 18.3% to 7.1 million units. The increase reflects growth and the acquisition the majority stake in (inaudible) in April 2008, continued growth in diabetes supply volumes from our Liberty Medical Brand and volumes from our newly introduced Medco Health Store. Which is available to our members.

In 2010 we expect to generate additional OTC volumes from (inaudible) recent acquisition of Shop (inaudible).com. (Inaudible) leading online OTC and health care product sites. (Inaudible) dispensing rates for fourth quarter 2009, reached a record at 68.3%. 3.4 percentage points higher than fourth quarter 2008.

Our retail generic dispensing rate reached 70% in the fourth quarter, 3 full percentage points higher than 2008. While the mail order generic dispensing rate for the quarter reached 58.3%, a 2.4 percentage point increase.

The growth in generics leads to material savings for our clients and members. For the fourth quarter of 2009 these higher generic dispensing rates yielded incremental savings of approximately $600 million for clients and members. And as Dave mentioned, saving over $2.4 billion on a full year basis.

As I indicated (inaudible) presentation in November clients are expected to save another $2.8-$3 billion in 2010 from higher generic contributions. A phenomenon that improved Medco’s profitability while also partially offsetting our (inaudible) drug.

Turning to rebates, we earned $1.4 billion for the fourth quarter and $5.4 billion for full year 2009. Both records. This represents 14.5% growth for the quarter and 20.8% growth for the year. Attributable to the (inaudible) and improved formulary contracts. It is also a testament to formula compliance at mail order.

Our fourth quarter 2009 rebate retention rate was 14.1%, compared to 15.9% in fourth quarter 2008. The full year 2009 our rebate retention rate of 13.7% was just slightly above our previous guidance.

Turning to gross margins, our strong retail volumes reduced our consolidated gross margin percentage in fourth quarter by 80 basis points, just 6.7% compared to 7.5% for fourth quarter 2008. For full year 2009, gross margin was in line with expectations at 6.7% compared to 7.3% in 2008. We now expect our 2010 gross margin percent to increase slightly over the 6.7% we experienced in 2009. Which is strong performance considering our 2010 retail volumes are thus far running ahead of our expectations while mail volumes remain on track with previous guidance.

Our fourth quarter 2009 gross margin dollars of $1.03 billion reflects 5.4% growth over fourth quarter 2008. For the full year 2009, gross margin dollars totalled at a record $4.03 billion. With all drivers of the Medco portfolio contributing to this growth. (Inaudible) and administrative expenses of $375.5 million for the quarter decreased $5.5 million or 1.4% from fourth quarter 2008.

For the full year SG&A expenses increased 2.1% to $1.45 billion. At the mid points of our guidance range of $1.45-$1.46 billion. This performance is a reflection of our ability to manage expenses while insuring the necessary investment levels to maintain a highly satisfied and ever growing client based and fuelling our leading edge clinical advances.

(Inaudible) the approach will continue into 2010. And we expect SG&A expenses to increase approximately 3%-4% to about $1.5 billion.

A total EBITDA for fourth quarter 2009 reached $695 million, representing growth of 10.5%. Full year EBITDA achieved year over year growth of 11.8% to a record of $2.75 billion. (Inaudible) to the EBITDA for adjusted script finalized, which were in line with our expectations. We continue to expect a 5%-10% increase in EBITDA for adjusted script for 2010.

Our (inaudible) amortization totalled $75.5 million at fourth quarter 2009, up from $73.9 million at fourth quarter 2008. For full year amortization a $305.6 million exceed the 2008 amount of $285.1 million as a result of (inaudible) to amortization. It was at the low end of the guidance range of $305-$310 million.

Our guidance for intangible amortization for 2010 remains unchanged at $280-$290 million.

(Inaudible) and net interest expense of $39.9 million in the fourth quarter of 2009 decreased from $57.6 million in fourth quarter of 2008. The full year 2009 totalled unused expense of $162.6 million decreased from $227.5 million for 2008. The result of lower interest rates in our debt, lower debt levels and increased cash balances.

For the $162.6 million in net interest expense for 2009 is slightly below our previous guidance range of $165-$170 million. Our 2010 guidance for net interest expense was previously indicated a range of $170-$180 million is now expected to the lower end of that range, at approximately $170 million.

As expected for our previous guidance, the fourth quarter 2009 affected tax rate was 36.3% compared to 40.0% of fourth quarter 2008. Reflecting a fourth quarter 2009 benefit for $22 million or approximately $0.04, primarily associated with previously planned state income tax items.

Our effective cash rate for the full year was 39.1% compared to 38.4% in 2008. Which included a previously reported third quarter 2008 state income tax benefit of $28 million. We continue to expect in 2010 effective tax rate in the range of 38.5%-39.5%.

Net income for the quarter increased 24.5% to a record $341.5 million from the $274.4 million reported for the fourth quarter of 2008. For the full year, net income increased 68.1% to a record $1.3 billion, from the $1.1 billion reported for 2008.

Moving on to share repurchases under our $3 billion authorization, we repurchased a total of 3.7 million shares during the fourth quarter of 2009 for $231 million and an average per share cost of $62.36. Which was funded entirely from free cash flow.

For the full year, we repurchased 27 (inaudible) shares at a total cost of $1.24 billion, with an average per share cost of $45.38.

For 2010 to date, as of last Friday, February 19, we repurchased 12.8 million shares for a total cost of $804 million and an item per share cost of $62.94. And have approximately 758 remaining under the current $3 billion share repurchase program.

(Inaudible) fully diluted share count of 487.2 million shares for the fourth quarter decreased 18.1 million shares compared to 505.3 million shares for the fourth quarter of 2008. For full year 2009, our weighted average fully diluted share count decreased by 28.6 million shares to 490.0 million shares from 518.6 million shares in 2008. In line with our previous guidance, but not reflecting share repurchases made throughout the year.

We finished the fourth quarter of 2009 with 475.2 million basic shares outstanding. (Inaudible) of approximately 10.7 million additional shares bringing the total fully diluted share count to approximately 485.9 million on December 25, 2009. The total diluted share count becomes the entry point for fiscal 2010.

We continue to expect that 2010 weighted average diluted share count to be in the range of 465-480 million shares.

We’ve already provided full year highlights for Accredo. Accredo revenue growth for the fourth quarter and full year were 17.7% and 19.5% repetitively. And operating income growth for the quarter and the year were 17.1% and 27.0% respectively. Accredo’s gross margin percentage was 7.0% for the fourth quarter, down 90 basis points from 7.9% in the fourth quarter of 2008.

For the full year 2009, Accredo’s gross margin percentage was 7.4%, down 50 basis points from 7.9% in 2008. These decreases in gross margin percentages for both periods reflects changes in (inaudible) from significant new business wins.

We except Accredo’s success to continue into 2010. And our guidance remains strong. Calling for revenue in excess of $11.0 billion and operating income of approximately $450 million. This represents (inaudible) in growth of over 15% and operating income growth of approximately 26% over 2009.

We continue to expense assessment (inaudible) market place as a direct provider for our own PDP, as a partner with leading health plan in collaboration with our (inaudible) clients. For fourth quarter 2009, Medco’s PDP revenues increased 78.2% to $259.8 million. For the full year, these revenues increased 75.9% to a record $1.1 billion from just over $600 million in 2008.

For full year 2009 (inaudible) dispensing rates for our PDP grew to 71.2%, with adjusted mail order penetration from 25.0%. And the last (inaudible) and for 2009 in particular, we expanded our Medicare business significantly. Primarily adding non (inaudible) ASO business to our increasingly diversified portfolio.

As Dave discussed, we are reaffirming our guidance for GAP diluted earnings per share in the range of $3.05-$3.15, representing growth of 17%-21% over 2009. Excluding the amortization of intangibles over 2003 spin off, our diluted EPS guidance remains in the range of $3.28-$3.38, representing growth of 16%-19% over 2009.

I have only walked you through many of the components of 2010 guidance. The additional components are as follows, first of all, our acquisition of DNA Direct is expected to be $0.01 dilutive to 2010 earnings. We continue to expect to renew approximately $15 billion of business in 2010, including scheduled and early elective renewals. With approximately 80% of the renewal price (inaudible) in affect in the first quarter of 2010, with the remainder primarily in the third quarter.

The impact of these generic introductions on 2010 EPS remains unchanged at $0.25. The estimated quarterly spread of the $0.25 also remains unchanged. At $0.03 in the first quarter, $0.06 in the second quarter, $0.08 in the third quarter and $0.08 in the fourth quarter.

Net revenues are expected to increase in 2010. However, when you model our evidence be sure to consider that the $4.3 billion in new name sales are in fact partially offset by the $2.8-$3 billion in (inaudible) generic effect I discussed earlier.

Pointing to the first quarter specifically, I would like to make the following observations. Further to the revenue modelling point I just made, first quarter 2010 net revenue compared to fourth quarter 2009 is expected to grow approximately 5%. Which includes the effect of (inaudible) generic drug. As I mentioned on analyst day, a quarterly (inaudible) earnings per share are expected to increase sequentially in 2010. As an anchor for your knowledge, assume the first quarter 2010 (inaudible) a slightly lower percentage of the full year 2010 earnings guidance from the first quarter of 2009 was to full year 2009.

Remember, as you model your quarterly EPS, about 54% of the (inaudible) is expected in the second half of 2010. So the EPS growth is weighted to the later quarters. The model EBITDA for adjusted script, we expect to see directionally what we have experienced last year. With the sequential decline from the fourth quarter to the first quarter. You will recall there’s a change of EBITDA for adjusted script from fourth quarter 2008 to first quarter 2009 was a decline of approximately 10%. For the fourth quarter of 2009 to first quarter 2010, we expect somewhat less of a decline in the high single digit percentage range.

Very importantly, and as I already mentioned, we continue to expect our full-year 2010 EBITDA per adjusted script to grow 5%-10% over 2009. In concluding our prepared remarks, we remain confident in our ability to continue to drive earnings growth by focusing on what matters most to our client and members; improve pinnacle outcomes and lower overall health care costs. We believe that this, combined with a disciplined financial strategy will, in turn, drive increased value to our shareholders.

Now, Dave and I would like to open the line for questions. Laurie?

Question-and-Answer Session

Operator

(Operator's Instructions) Your first question comes from the line of Ross Muken with Deutsche Bank.

Ross Muken - Deutsche Bank Securities

Good morning and congratulations on another great year. So you highlighted sort of the launch of this new Medco research institute. You have garnered a lot of interest across both your sort of core business line, but also outside in the scientific community with some of the studies that Rob has driven with his unit. What's sort of the goal of this new center? I mean, are you broadening out some of the types of things that you're doing or are you looking to get into a few different therapeutic areas? I know Rob highlighted some focus points at the analyst day, just a little bit more color on sort of the genesis of this and why you're sort of calling it out as sort of a separate entity.

David B. Snow Jr.

Yeah, let me start at a very high level, Ross, and then Rob is here with us today so I'll ask him to give you some more granular detail. But clearly Medco as a company is committed to the reform of this health care system and we feel fundamentally that making real knowledge available to practitioners, whether they be our pharmacists or whether they be physicians, is critical to moving from shotgun medicine to precision medicine.

We are discovering an awful lot. I will point to the Plavix PTI study. It's just one example from 2009. We're going to continue to do things like this and what we really want to do is eliminate 17-year gap that exists from the time landmark evidence is produced to the time it actually becomes the standard of practice in medicine. I mean, I think it is a noble cause number one, but it is fundamentally important for the members we serve and the clients we serve because by getting it right we really do see that we can improve outcomes and reduce costs, and that is behind everything we're doing here. And the Medico research institute is going to aggregate not only the studies in the pharmacogenomic space and the genetic space as we've done in the past, but we've got a large number of studies going on inside our therapeutic resource centers which we also believe will be fundamentally important to educating our country around the real things we can do to reform the health care system. And with that, Rob, why don't you add anything you feel I missed?

Dr. Robert Epstein

I think just to add a little tiny bit more color to the answer, we have been surprised at the client demands to participate in this kind of research quite frankly. The phone rings off the hook. We could have 30 clients as they sign up by numbers, tomorrow. And so actually we felt given the clients' demand and interest also, along with Medco's interest in really trying to make medicine work smarter by understanding what are the drivers of medications working well or not, that we would call it out and attract more interest and more research.

We're particularly interested in comparative effectiveness research. Our announcement last fall of the GeCCO study comparing (inaudible) plus genotypes Plavix drew an awful lot of attention from both the pharmaceutical industry and our client base to participate. So for all those reasons and everything that Dave mentioned, we're really excited about the fact that we now have a new entity, an opportunity to do more to translate science and to practice faster and just stand beyond genomics as Dave mentioned to many of the clinical issues inherent in the TRC.

Ross Muken - Deutsche Bank Securities

Great, that was extremely helpful. And maybe just a quick one for Rich. How do you followup a year where you pulled about $1.5 billion out of net working cap? You obviously put a lot of focus into this when you took over the role. Kind of as you look across the business, what's sort of the next key focus area for you that you're centered on that you think there's value to be driven? Obviously you've gotten the ROIC up quite significantly already, but sort of where's that next level of juice going to come from?

Richard J. Rubino

Well, there is more to come with regard to the inventory reductions. I'm expecting to yield another $300 million or so of working capital improvement by further reductions in inventory. I also remain focused on our manufacturer rebate receivable turns. As you know, we made great progress there in 2009. There is more to come in 2010. To your point, Ross, even though it's difficult year over year to yield these incremental levels of working capital improvement, very importantly they do drive your long-term return on invested capital which is why we're still pointing to well over 30% ROIC in 2010.

So I'd say we continue to focus on working capital. As you know, we've done a very effective job in managing SG&A. Basically driving efficiencies into the routine aspects of our SG&A operation while keeping significant fuel to drive our clinical programs and to ensure that our clients are maintained at the highest level of satisfaction. So I think we'll just see more of the same, and there is more to come.

Ross Muken - Deutsche Bank Securities

Great. Thank you very much.

Operator

Your next question comes from the line of Lisa Gill with JP Morgan.

Lisa Gill - JP Morgan

Hi. Thanks very much, good morning. Dr. Epstein, can you maybe just talk a little bit about your programs in pharmacogenomics, the level of proprietary algorithms to Medco, and what the value is that you can actually bring to your client? And then secondly, just so I have a better understanding of the lab tests that go with this, I don't know Dave, if you or Dr. Epstein want to explain this, but who makes that decision? Is that a Medco decision around what labs should be done or not done around the patient and the costs associated with that?

David B. Snow Jr.

Great. Thanks for the questions, Lisa. Our programs, as I've described before and prior to this DNA Direct have been direct around pharmacogenomics so they were setup to facilitate a test that would relate to a drug and decide whether the drug was the right one for you or not or the right dose or the right duration.

Since the acquisition of DNA Direct we've dramatically taken a leap ahead to all of genetic tests, whether they're pharmacogenomic or not and quite frankly, it was our embedded customer base who asked us to do that. They were satisfied with our pharmacogenomic support services, but said the whole field of genetic testing can do things both to our members and to our doctors, can you provide us a solution there? And DNA Direct was a great partner there because they have already been out doing it, not just thinking about it, but doing it. So they have the proprietary algorithm already built around roughly 2,000 genetic tests. They already have an embedded customer base of their own. They have a turnkey software solution platform that utilizes those proprietary algorithms. So we're delighted to have them within the Medco family.

With respect to laboratory tests and who decides whether to use them or not, I think you have to think about it the way you think about pharmacy benefits. So for employers and government plans, they look to Medco to do the intelligence around the lab tests to help them decide whether or not to advocate for a test. We have a separate independent lab and therapeutics committee just the way we have a pharmacy and therapeutics committee, outside people who look at labs and drugs and make a determination whether it's a good idea or a bad idea, but they go a second step and even evaluate the laboratory who does the test to make sure that they have the right analytic and clinical validity around doing the testing since there's some variability between these molecular diagnostic labs.

For our health plans, they have their own opinion about which lab tests they do and don't want to cover and we're there to support them in whatever decisions they make, just the way they do with formulary.

Lisa Gill - JP Morgan

And so just so I understand this, so it's still the plan sponsor that's making the decision around the tests? This isn't something that Medco's driving that decision? And then secondly, from a shareholder perspective, is this just an opportunity to win more business by having these programs in place or is this an opportunity around the margins of this business? And then just one last followup, I was just wondering, Rich, if you could just give us an update as to last quarter you talked about the fourth quarter having $0.01-$0.02 of implementation costs, and I just wanted to know if that number was correct or if it turned out to be higher in the quarter and I'll end there.

Richard J. Rubino

I'll answer that last question first, it was $0.02.

Lisa Gill - JP Morgan

Okay, thanks.

Dr. Robert Epstein

And the answer to the other questions, it is ultimately a plan sponsored decision of what they do and don't cover. That's just the way it works.

David B. Snow Jr.

But I want to add to that Rob, because my belief is that genetics and pharmacogenomics are relatively new sciences, and one of the valuable things Medco is doing right now is putting substantial scientific data on the table to support a protocol around these things. And when these protocols are out there and developed and the standard of practice is defined, it's going to move from a payer's individual decision to something that becomes standard of practice and I see that happening at an accelerating pace over time. And what Medco is building is an intel inside that helps drive and guide the appropriate decisions so that we can better manage the diseases that are driving the costs in health care.

Lisa Gill - JP Morgan

But at the end of the day, Dave, I mean, is this really about driving getting more clients interested because you're on the forefront, or is there an opportunity to improve margins because of being tied to some of this testing and what the margins look like in DNA Direct? I just want to understand it kind of from a shareholder perspective.

David B. Snow Jr.

From the shareholder perspective I think you have to look at it two ways. First of all, we're doing the right thing relative to our clients and the members we serve. That drives sales. It drives fundamental growth because we do the right thing on behalf of the payers and the patients so that's always first and foremost. Clearly secondarily there is an independent revenue source tied to this level of service that over time will become meaningful, but those are the priorities and the way I think about it.

Lisa Gill - JP Morgan

Okay great. Thank you very much. I appreciate it.

Operator

Your next question comes from the line of Charles Boorady of Citi.

Charles Boorady - Citi

Thanks, good morning. Just two questions; first one, can you tell us what you're seeing in terms of plan sponsors asking you to try to pull forward and do early renewals of contracts under pressure from their CFOs if they're looking for some near-term savings in exchange for locking in and giving you more visibility on contracts?

David B. Snow Jr.

Yeah. I'll give you a high level reaction across the groups and since we have Tim and Brian here, I'll ask them to give their thoughts because I think their two markets are a little different. But generally speaking, we have a lot of say in which ones we want to pull through early for a longer-term contract. It's not typically coming from the client. Sometimes it does, but it's not typically coming and I would say that generally speaking we haven't seen a real change in the ratio driven by our side versus driven by the other side, but I will ask Brian first. Brian, do you have anything specific for your group that you might want to point out?

Brian T. Griffin

Good morning, Charles. No. I'd actually echo Dave's sentiments on this as well. I think for the health plans within my group they're always focused on the bottom line and us creating value for them. I don't think that there's been a shift, in terms of to Dave's point, them asking for early renewal terms versus us in effect looking to lock up the business over a longer term. So I'd say that's pretty much business as usual and we continue through this renewal cycle to start looking at 2011 and 2012 at this point.

David B. Snow Jr.

Tim, do you have a different perspective in your market?

Timothy C. Wentworth

No, I completely agree. I think it's all driven by us. It's been very, very little of that. What we've seen much more of its clients wanting to collaborate earlier on for things like preferred-drug step therapy and other things that drive significant amounts of value, much, much more than they would even see with a pricing reset for a longer contract.

Charles Boorady - Citi

Tim, could those discussions lead to early renewal or early lock in, and I'm wondering if you think you'd get earlier visibility on 2011 this year than in previous years if your employer plan sponsors are trying to get visibility for themselves.

Timothy C. Wentworth

Sure. It really is on a case-by-case basis because when we show them these programs we are showing them longer-term savings than simply the current year and to the extent that it makes sense for both of us to look out further and tack them down, we're comfortable doing it, but it certainly hasn't been a strategy per say nor something that we've been putting in the place of having to respond to a great number of times.

Charles Boorady - Citi

Last question, and this may be aimed at Tim as well, but you've added as significant amount of new business that took effect January of 2010. Can you talk about how your account management and other staffing levels have grown with the growth in your customer base and how those implementations went and any service issues that came up?

Timothy C. Wentworth

Sure. We did install a large number across our company and in particular in the employer group. What I'd say is we just now started getting back installation surveys and to the survey, those have been very positive. Certainly as you go through installations, there are always things that you work through and this year was no exception. But our clients, we've heard from a very, very significant number of them already that they're very happy. We've had no glitches, and we've been staffing up every year in anticipation of growth. It's something that we do as a rule and are very, very comfortable with not only our current staff, Charles, but we are recruiting pretty much constantly ahead of our growth a little bit just to be sure that we're in good shape and we are in very, very good shape as it relates to continuing to provide service to our clients.

Charles Boorady - Citi

Thanks.

Operator

Your next question comes from the line of Robert Willoughby with Banc of America-Merrill Lynch.

Robert Willoughby - Banc of America-Merrill Lynch

Good morning. Rich, I think we asked a couple quarters ago whether there was anything structural that would limit your ability to grow the gross margin in 2010 and the answer then was no, but now it does seem there are some limiting factors here preventing you from moving that margin up, and I'm trying to figure out exactly what was incremental. I think you mentioned retail scripts heading track and above your expectations, but can you point to one or two other things that you feel are somewhat new here that you didn't anticipate earlier?

Richard J. Rubino

Not really. You hit the nail on the head, Bob. As you know I did point out in my prepared remarks to the fact that we do expect gross margin to expand slightly in 2010 and it really is a function of the retail volumes running slightly ahead of what we expected. Aside from that, there really is no additional variability that we're seeing at this point of the year.

Robert Willoughby - Banc of America-Merrill Lynch

So it's not a DNA Direct or any of the investments in the pharmacogenomics or anything like that dragging on you a bit?

Richard J. Rubino

No. I mentioned DNA Direct is very, very slightly diluted by about a penny, but that's not really affecting the overall gross margin performance.

Robert Willoughby - Banc of America-Merrill Lynch

Okay. I just had thought there might be a bigger step-up to the business you renewed last year. Is that still happening or is that just more muted than I would have anticipated?

Richard J. Rubino

Well, I don't know what you anticipated, but I can tell you that the mail penetration rates on the new accounts which were 9% last year are at about 10% already this year. So we are seeing an uptick in those mail penetration rates. So we're seeing the patterns that we normally see as lower male penetration clients mature through their contracts.

Robert Willoughby - Banc of America-Merrill Lynch

Okay. And just lastly, Rich, do you have an actual share base, a balance sheet share base currently?

Richard J. Rubino

As in that which we are entering the year?

Robert Willoughby - Banc of America-Merrill Lynch

You had a share repurchase update through February, I just take that off the year-end share base obviously?

Richard J. Rubino

Exactly, the number I gave you. And with regard to the to-go amount, we do have another $758 million to go under our $3 billion plan and we would expect to repurchase the majority of that remaining to go number.

Robert Willoughby - Banc of America-Merrill Lynch

Equally over the course of the year?

Richard J. Rubino

No, as I always predicted it would be more weighted toward the early part of the year, Bob.

Robert Willoughby - Banc of America-Merrill Lynch

Okay great. Thank you.

Richard J. Rubino

Okay just, Bob, I know you're off, but I'll just give you the quarter-end number that I gave during my prepared remarks. We had 475.2 basic shares plus 10.7 million dilutive shares bringing us to 485.9, so that's your entry point for share count in 2010.

Operator

Your next question comes from the line of Lawrence Marsh with Barclays Capital.

Lawrence Marsh - Barclays Capital

Okay. Thanks and good morning. I wanted to elaborate a little bit on Medicare Part D. Obviously the last two years it's been a big driver to net new sales for you as you help your payer clients save money under the participation in Part D. My question is really Washington, DC related. Given there's sort of a stalemate in the attempt to close the donut hole, are you seeing any more of the wait and see attitude with your payer customers and sort of thinking about a solution on Part D or even in your corporate customers thinking about retiree drug subsidy, or are you seeing as much of a movement in the marketplace as you would've thought here three months ago?

David B. Snow Jr.

Larry, this is Dave. I would tell you that for the most part it's wait and see right now because we, virtually, whether it be our health plan customers or our Fortune 500 customers, no one is really certain right now what direction this reform discussion will take. And until they know, it's really hard to make decisions. So it's steady as she goes right now and I think you're going to see that as this debate continues until we get some resolve and some final language that we all can work with. And I think it'll just remain this way until then.

Lawrence Marsh - Barclays Capital

Dave, given your connections in DC, are you optimistic that there's going to be some progress to something happening this year or are you more discouraged that it's going to be a complete stalemate for the entire year?

David B. Snow Jr.

No, I've always said that I feel we will get something done. I think everybody in Congress understands its importance for our country that we get something done, and you can call me a glass half full kind of person, but I honestly believe we're likely to get something that will really be structurally important relative to the cost and quality equation which creates something we call value, and I really believe Medco will have a nice role to play in that. So I think something will happen and I think that we — I'm sure many of you have already read President Obama's most current statements, and we are looking at the granular detail behind this. And there are some very good things in there, and the question is what will emerge? But we're going to certainly participate, we're going to support and watch this, but I think we will see something. I don't think it's going to be a revolutionary set of changes, but I do think they will be important evolutionary changes when we're done.

Lawrence Marsh - Barclays Capital

Okay, great. Second, just quick followup, I don't want to beat the DNA Direct message to death, but I guess my question is how quickly are you going to be able to roll this out to potentially new customers? And in terms of us tracking the progress, you talk about 200 clients already signed up for personalized medicine, are we going to see that number move meaningfully here in the next year? And then along that point, your biggest competitor says they're now in the same business so how do we think about that in terms of differentiation?

David B. Snow Jr.

Well we have already, as I mentioned before, an embedded customer base paying today of over 200 clients representing 8 million lives. We will be coming to them this spring with all of the products and services DNA Direct has to offer and they're looking for new solutions so it's just perfect in that sense. So what you'll hear from us later in the year, I presume, will be information around the uptake in DNA Direct products and services into our already embedded customer base.

Then, as you noted, we have other customers who haven't yet taken the leap into either the program or what DNA Direct has to offer, and quite frankly, I think some of them might find some of the decision-support services may be more meaningful to them than the individual program. So we're looking for expansion beyond the 200, but we're also looking at selling into the 200 the embedded customer base that we and only we have.

Dr. Robert Epstein

I would add to that. I would tell you that in the health plan world specifically, the services that DNA Direct provide are becoming increasingly important in the health plan world and we're actually seeing a number of specific RFPs right now that are focused on this area of benefit management. And I don't know, Brian, if you have any thoughts about that, but I do believe that these services are — as the number of tests grow and the dollars associated with that number of tests grows, you're going to see more and more and more interest in the kinds of services we can provide here.

Brian T. Griffin

Yeah, Dave. I'd actually just pick up on one of Rob's points because I think one of the big things that's selling in the marketplace now and that I think is driving the focus that Dave is alluding to is the fact that we can now, for the first time, offer a more comprehensive suite. So as opposed to what we've seen in the marketplace of major plans having to go to multiple locations, they can now go to one major source for a more comprehensive suite and I think that that's going to sell very well, particularly in the health plan market.

Lawrence Marsh - Barclays Capital

Right, okay. And final question, just timing, I know the Indiana facility, is that still rolling out midyear in 2010 or not?

David B. Snow Jr.

Yes, that is still our plan, Larry.

Richard J. Rubino

Still on schedule.

Lawrence Marsh - Barclays Capital

Very good, great. Thanks, guys.

Operator

Ladies and gentlemen, we do have time to take one more question. Your final question comes from the line of John Kreger of William Blair.

John Kreger - William Blair

Hi, thanks very much. Could you give us an update on your international initiatives? How are the three trending and is there an opportunity for those to be a contributor to the P&L this year?

David B. Snow Jr.

Yeah. Rich in his formal comments did talk about the non-prescription volumes and where they were coming from. The Medco Store was one, (inaudible) was another, Liberty was a third, and we're seeing nice growth in both the UK as well as our Germany operations. You know we acquired shop (inaudible) which is an additive to EAV and so you're going to see nice growth there. I'll defer to Rich relative to material growth. The kind of growth we're seeing, we're very encouraged by it. Whether it will actually be material to earnings this year I would say probably not, but Rich, if you want to give any thoughts about that feel free.

Richard J. Rubino

Sure. It is not material to 2010 earnings for sure. One thing that we are seeing very importantly in 2010 is meaningful relative growth in revenues, top line growth very important in these seed investments, but not yet a contribution to earnings that would really make your radar screen. I can tell you, as we've said before, the objective is for meaningful earnings contribution once we're in the 2013-2017 range. That's how we're basically feeding these investments and making these investments so that they are part of the next growth engine.

John Kreger - William Blair

Great, thanks. And then I had a quick followup, different topic. If you look at your existing book, how is the mail growing on sort of a same account basis? Are you seeing reasonable mail growth there or is it more stagnant?

Richard J. Rubino

No, we have historically on a same store basis seen growth, and as I mentioned earlier, even with the new accounts the last year that were at 9%, we're seeing them at approximately 10%. So on a same-store basis, clients are still recognizing the value of mail and it's visible in their individual mail penetration rates and it's also inherent in our strong mail volume guidance we've given for 2010.

John Kreger - William Blair

Great, thanks very much.

David B. Snow Jr.

Thank you and thanks to all of us for joining us today.

Operator

Thank you. That does conclude today's conference call. You may now disconnect.

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Source: Medco Health Solutions Q4 2009 Earnings Call Transcript

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