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Executives

Mark Thierer - President and CEO

Jeff Park - EVP and CFO

Analysts

Glenn Garmont - ThinkEquity

Tom Liston - Versant Partners

David MacDonald - SunTrust

Michael Baker - Raymond James

Charles Rhyee - Oppenheimer

Paul Steep - Scotia Capital

Amanda Murphy - William Blair

Constantine Davides - JMP

Tony Perkins - First Analysis

Michael Minchak - JPMorgan

Larry Marsh - Barclays Capital

Brooks O'Neil - Dougherty

Blair Abernethy - Thomas Weisel Partners

SXC Health Solutions Corp. (SXCI) Q1 2010 Earnings Call May 6, 2010 8:30 AM ET

Operator

Good morning. My name is Andrea, and I'll be your conference operator today. At this time, I would like everyone to the SXC Health Solutions Corporation first quarter results conference call. (Operator Instructions)

With this I'll remind you that portions of today's discussions may contain forward-looking statements that reflect current views with respect to future events. Any such statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected in the forward-looking statements.

For more information on the company's risks and uncertainties related to these forward-looking statements, please refer to SXC's annual 10-K report. I would like to remind everyone that this call is being recorded on Thursday May 6, 2010 at 8.30 a.m. Eastern Time.

I would now like to turn the conference over to Mr. Mark Thierer, President and Chief Executive Officer. Please go ahead, sir.

Mark Thierer

Well, thank you and good morning everyone. Thank you for joining us on today's call.

This morning, we issued our 2010 first quarter financial results by press release, and a copy of those results are available on our website. Today with me is Jeff Park, our EVP and our CFO. So I'll summarize the key events of the quarter, and then Jeff will review our financial results for Q1 and update our guidance for the balance of 2010.

I'll then close with a few comments, and we'll open it up for Q&A.

Well, we've started 2010 on a great position and with a clear focus to execute on our growth strategy. We're tracking against our growth plan in four core areas; first, winning new business; second, retaining our existing business; third, cross-selling services within our existing client base; and finally, driving cost containment and responsible expense management throughout our business.

In terms of winning new business, we implemented a number of new accounts on January 1, most notably, Spectral Solutions a $50 million health plan in Florida. The implementation of all our note counts went very smoothly. As part of our go live process, we always conduct a formal post implementation satisfaction survey. And the feedback and scores we receive from our clients were extremely positive. This speaks to how well our team can execute on new business.

Our detailed client knowledge, combined with the flexibility of our technology has earned SXC a reputation for implementing complex plans flawlessly. Our ability to deliver in this manner was a primary reason for winning a five year contract with Health Spring during the first quarter. Health Spring is one of the largest Medicare Advantage and Medicare Part D health plans in the United States, offering healthcare coverage across six states to nearly 500,000 Medicare beneficiaries.

Specifically, it was our domain expertise and our experience with Medicare Part D, combined with the flexibility of our programs that were the critical components that led Health Spring's decision to select SXC.

Well, we're under way right now with the implementation process for this account and in fact, have begun filling biotech prescriptions just last week for the early start of the specialty pharmacy services. The full plan as you know begins in January, 2011 and we continue to move along on schedule.

In addition to HealthSpring, for 2011, we also have a strong a pipeline of new opportunities that we are currently pursuing. As we enter the RFP season, our pipeline of new opportunities includes targets across each of our five target markets. The markets with particularly strong activity at this stage are the large managed care and health plans based and the small to mid-size employer market.

In addition, we continue to focus on building and expanding our relationships with the consultant community. These relationships along with the direct relationships we're building with perspective clients, have contributed significantly to the growth in our pipeline. In order to grow the business with these new opportunities we must first retain our existing client base and make certain that they're happy.

We've been very aggressive in proactively renewing our entire book of business. The contract renewal of Boston Medical Center is a great example of our ability to retain key accounts. DMC as you know manages more than 250,000 members with an annual drug spend of $150 million.

Our full-service customized program met their goals of improved outcomes in cost management. The five-year contract with BMC offers flexible service within a competitive pricing structure. Now with BMC renewal in place, I'm pleased to reiterate that we have no material renewal risk for the remainder of 2010.

Our retention goal is larger in just this calendar year. In an order to extend the remarkable growth that we've seen over the past 24 months, we've implemented a formal process within SXC that focuses on client retention and satisfaction. As part of this company initiative, we have rebuilt our internal measurement and reward systems around customer satisfaction and retention.

This internal focus to drive higher retention and higher client and member satisfaction has the additional benefit of driving excellent customer references. Building a strong and positive network of client references in turn will help fuel the top-line growth for our company.

We are continually working to understand our customers at all levels of their organization. It's this understanding and it begins with our account management and engages the entire organization in planning and developing relevant solutions. This level of expertise in our highly consultative approach drives our HCIT to PBM conversion success, as well as our other cross-selling opportunities.

We successfully converted two additional HCIT clients to our full-service PBM platform during the first quarter, and we're actively tracking a number of additional HCIT accounts that represent material conversion opportunities as we speak.

Mail order pull-through, specialty pharmacy pull-through and HCIT to PBM conversions form an important part of our organic growth plan as each of these initiatives will help drive incremental margin during calendar 2010.

Our ability to rapidly execute and scale up to meet the unique needs of our clients has enabled us to take on new significant mail service business on a very short notice. Due to an emergency capacity situation with another company's mail order operation, our mail facility stepped up on a moment's notice to take a significant new volume and helped solve some serious service issues all in an effort to help our clients rate very difficult situation. And I want to congratulate our account management and our mail service operations team on their speed and agility.

We continue to invest in our operations and in our people. Our processes have been structured to deliver offerings that provide unique and relevant solutions for our clients. We're scaling up our health outcomes and analytics area and delivering robust information and insights that reinforce the value of our services and provide a strong platform for up-selling opportunities.

Our business sets up very well to be a significant benefactor of the recently passed healthcare reform package. With the magnitude of the reform package, the actual impact on the U.S. healthcare system and in the PBM market in particular is something everybody in our business is working through.

What we do know, however, is that 32 million Americans who didn't have coverage previously will now be covered under the reform package. Moreover, the state Medicaid programs where SXC is a major player will be expanded to cover an additional 14 million lives. Medicare Part D expertise will be critical as new reporting requirements and compliance requirements come into play.

D.0, the industry's new mandated HIPAA standard has created new program requirements that are looming over every pharmacy benefit manager in this industry. And as the industry's technology leader, SXC is well ahead of schedule here. Our plan is to complete our D.0 upgrade this summer, a full six months before the HHS suggested the compliance state.

Similarly, our teams are working on the changes to Part D that will be in effect for January 1, including the gradual elimination of the coverage gap to various measures, including the system-based rebates provided at point-of-sale. Additionally, we also know that the pressure in our PBM space to support cost containment in a flexible and transparent nature is now greater than ever.

SXC is well positioned to take advantage of healthcare reform in virtually every segment in which we operate. Our ability to deliver customized and flexible programs that provide customers with transparent and aggressive cost savings truly sets SXC apart from other PBMs. We're in a strong position to deliver for the remainder of 2010 and well into the future.

And with that, I'll turn the call over to Jeff for a review of our financials.

Jeff Park

Thanks, Mark, and welcome everyone. Q1 was a solid quarter both on a year-over-year comparison and on a sequential quarterly comparison. As Mark indicated, we got off to a strong start and based on our improved yield and purchasing efficiencies have revised certain guidance upwards by $3 million. I'll review these changes shortly.

Our PBM revenues rose more than 59% year-over-year due to the addition of new business wins, HCIT to PBM conversions and increased mail penetration. We converted half a dozen HCIT clients in 2009 and another two more in Q1 2010. We're actively working on another four to eight potential candidates for conversion in the future.

Adjusted prescription claims volume for the informedRx division was $11.7 million in Q1, up from $11.1 million in Q4 '09 and $8.4 million in Q1 2009. Our mail penetration state is steady in the quarter at 11%. This takes into account our new planned launches which have lower mail penetration rates offset by solid growth in mail utilization rates for our existing clients.

In short, our mail order prescription volumes are up as compared to Q4. This will continue to be a key focus for us at SXC. Increased mail and specialty utilization from our customer base remains a key focus and opportunity in 2010, creating savings for our clients, and margin opportunities for SXC as we work towards the national average of approximately 22%.

Our generic dispense rate increased 2% in the quarter and we remain industry-leading at 74%. This increase is a function of more aggressive plan designs and step therapies that promote generic utilization in addition to our client mix. Plan type and average age impact the utilization rate for generics. We continue to use our clinical designs and our technology at the point of sale to drive high generic utilization.

With the pipeline of generics building, we continue to seek opportunities to increase generic prescription drug usage to help reduce overall prescription drug cost to our clients and their members.

In the HCIT segment, Q1 revenues increased by 6% compared to Q1 '09, even with more than half a dozen HCIT to PBM conversions during that period. HCIT revenue was down relative to Q4 '09, when you recall that we had a help from $1.5 million in Q4 related to certain professional services revenues that were unique in Q4. Transaction processing volume was $99.5 million in Q1, compared to $94.6 million in Q4 '09, and $96.8 million in Q1 2009.

When including the PBM paid claims process in 2009, SXC processed over 414 million transactions in the year. Overall, growth in transactions was mainly driven by expansion within our clients' book of business, as well as new client wins. Year-over-year, gross profit increased by more than 28%, but was down on a percentage of revenue basis, due to increased PBM revenues which carry a lower margin percentage as compared to HCIT revenues.

We continue to see sales momentum for our transparent PBM services, which is revenue, gross profit, and EBITDA accretive, but maybe dilutive to our gross profit margin percentage.

Gross profit per adjusted claim for the PBM business was $3.27 in Q1, compared to $3.47 in Q4 '09. Remember, gross profit for new contracts tend to be lower at the onset of the relationship and extend over time as we gain efficiencies in purchasing and operations relative to the account. Additionally, gross profit in Q1 was mildly impacted by plan members using up the deductibles in the start of the year, before receiving their fully funded benefits.

Q1 adjusted EBITDA was $27.7 million, compared to $30.4 million in Q4 '09, and $16.3 million in Q1 '09. On a year-over-year basis, this equates to an adjusted EBITDA growth rate of more than 70%.

Q1 adjusted EBITDA is down from Q4 '09. However, you'll recall that in Q4 2009, EBITDA benefited by approximately $3 million due to the unusually strong professional services I'd already outlined in the HCIT segment, along with certain recoveries for bad debt and other reserves due to improved collections and reduced employee benefits in our SG&A.

On the cash flow side, you'll notice that in Q1 we used $2.7 million of cash from operations, compared to cash generated from operations of $11.8 million in Q1 '09. The ability to generate strong cash from operations remains a key feature of our business model, and Q1's variance is largely a function of the timing of payments and receivables.

Accounts receivables were up in Q1 due to the increased PBM revenue, while rebate receivables were also up sharply due to new customer additions in addition to new deals with manufacturers completed in the quarter.

Over the course of 2010, the timing for payables and receivables are expected to normalize, with the result being that SXC continues to generate strong cash from operations as we have continually done in the past.

At the end of the quarter, our balance sheet remains solid. At March 31, 2010, we had more than $313 million in cash, compared to $304 million at December 31, 2009.

Now for a review of our 2010 guidance. We are reaffirming our revenue forecast at $1.9 billion to 2.0 billion for the year, and we are raising our consolidated gross profit target range for 2010 by 3 million to $198 to $208 million. The midpoint of the revised guidance range implies growth of 9% over 2009.

Our 2010 full-year target range for adjusted EBITDA also increased 3 million to $111 to $115 million. As you can tell by the range, we are expecting a modest rise in adjusted EBITDA on a quarter basis as we move through the year. The midpoint of the revised range would imply growth of 19% in 2010 over 2009.

In 2010, our full-year target range for our fully-diluted GAAP EPS is now $1.84 to $1.92, up from $1.79 to $1.87. The midpoint of our net income using in the revised EPS guidance would imply a 28% year-over-year growth. The guidance does imply a slightly reduced quarterly EPS as compared to Q1, due (modestly) on our tax rates through the rest of the year.

2009's effective tax rate was 32.3%. We expect 2010's effective tax rates to be approximately 34%, and our fully-diluted share count to be approximately 31.3 million shares. With respect to our Non-GAAP adjusted EPS guidance on a diluted basis for 2010, we are now estimating the range to be $1.96 to $2.05, up from a $1.92 to $2.00.

In summary, Q1 was a good start to the year with momentum continuing from 2009, and our outlook for future growth remains promising. We see upside to our 2010 guidance potentially coming from new business, other possible conversions in the year, our ability to further increase the mail and specialty utilization, and our ability to capitalize on purchasing efficiencies and other cost containment efforts. We look forward to providing you more visibility into these items as the year progresses.

With that, I'll turn it back to Mark for closing comments. Thank you again for your time and your continued support.

Mark Thierer

Thank you, Jeff. 2010 is shaping up to be a strong year for SXC. As Jeff just mentioned, we've increased our financial guidance to reflect the state of the business at the end of the first quarter. The HealthSpring win and the retention of BMC are two major achievements for the first quarter.

In order to stay ahead of change underway in the healthcare sector, we must continue to pursue growth aggressively. A one-size-fits-all approach in our business is yesterday's approach. We were using our technology and our domain expertise to deliver customized solutions to clients that will have a positive impact on their costs, and at the same time improve service to their members.

Our focus on organic growth is measured by winning new business, retaining our existing clients, driving our pull-through strategies, including mail order, specialty, and HCIT to PBM conversions, and at the same time, maintaining an aggressive and prudent management of our cost structure.

Our new internal focus that we have on the customer, coupled with our new measurement and compensation program will help us deliver on the first three elements of this strategy. Proactively working to drive higher customer attention and satisfaction will deliver better references, which in turn will continue to support the top line growth for our company.

In terms of our acquisitions strategy, we remain with a very strong balance sheet and continue to actively track a number of potential targets. And we're committed to being both vigilant and disciplined in terms of both valuation and fit within our existing business.

We have the scale, the skill and the capital to deliver on each of these priorities in 2010, and we continue to push our sales engine as we look for innovative in cost-saving strategies that we can deliver to both new and existing customers. So 2010 is already off to a strong start, and we look to carry that momentum throughout the balance of this year.

On a final note, on May 12th, at 5:30 pm Eastern Time, we'll be holding our annual meeting. The meeting information is available on our website, and we welcome you to join us either online or in person.

Well, thank you for your participation in today's call and for your ongoing support. And that concludes our prepared remarks for today.

So at this point, I'd like to open up the call to questions. Operator.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Glenn Garmont with ThinkEquity.

Glenn Garmont - ThinkEquity

Just two quick questions. I guess, Mark, on the M&A front, appreciate the update there, what would you characterize as the bigger of the two obstacles right now? Is it on the pricing side or is it on the kind of the flip side?

And then for Jeff, it sounds like, when you have an IT to PBM conversion, those transactions sort of fall out of your IT transaction volume. Now, I was just wondering, given that you had a handful of conversions last year, what the transaction volume or what the growth would have looked like on sort of a same contract basis in that IT business? Thanks.

Jeff Park

Yes, Glenn, this is Jeff. With respect to the acquisitions, to Mark's earlier comments, we continue to actively pursue these mid-market PBM targets. We are encouraged with the opportunities to really look at ways to accelerate the growth through these targeted acquisitions and just to reiterate, there's really three things that we're looking for with the acquisitions.

First of all, strategic fit; secondly, solid accretion and economies to scale that we can generate. And the third being, properly valued with respect to the comments around the things that maybe impactful to it. First of all, valuations certainly have moved up with the broader market and better access to capital has certainly increased some of the valuation components, and that's a factor, but not the main factor.

Secondly, as you know, we're currently in selling season and this can impact the timing of PBM sales. We continue to be very patient in this area, but very active. Your second comment, Glenn or question with respect to the accounts that are moving from IT to PBM conversions and the impact on transactions counts on the HCIT unit; I actually don't have that with me, Glenn.

We have certainly been pretty successful at converting those accounts over and as you can see from the HCIT revenues the unit is continuing grow. And that's really a function of the growth of our existing accounts. So, we have a number of health plans, mid-market PBMs, states that are continuing to see their book of business expand. And so, even though we're able to successfully convert accounts, we're still very pleased as you can see with the transaction growth in that segment.

Operator

Your next question comes from the line of Tom Liston with Versant Partners.

Tom Liston - Versant Partners

Just a broad question that maybe a bit challenging to answer, but as the consultants are recommending you more and more and newer opportunities, and talked about your robust pipeline, how do you manage that discipline of going after 'The right opportunities' for you, because obviously you may be brought into several opportunities, maybe just to beat up (the comment) on price or help with that dynamic.

So how do you utilize or maximize your resources to make sure that you keep that win rate fairly high given the increased pipeline?

Mark Thierer

Great question. This is an area where we've gotten better year-over-year over the last two or three years I think in a significant way. The first thing is, every Tuesday and Thursday, we have a formal underwriting meeting where the top 15 guys of the company sit around a table and evaluate every opportunity that comes through the door, whether that is a RFP-driven, consultant-driven or a direct-driven opportunity.

And we've become very disciplined of staying inside the curbs on the five market segments, with exactly the kind of targets that line up well for the company. And so, the fact of the matter is, in terms of the number of bids, our bid count is up year-over-year, but we have said 'no' to a good number of bids that don't fit well in the five segments that we've outlined. And so, one thing in terms of the maturation of our management process that I'm feeling good about is the discipline with which we chase the right opportunities.

And do we still get into the bid process where incumbents continue to have leverage and the business doesn't move? Yes, that happens all the time. But we are absolutely in a better place in terms of chasing the right opportunities and driving up our win rate.

Tom Liston - Versant Partners

Just some of the comments you made, some on mail and specialty and the pitch and leverage there, not that we're going to expect mail to move in your (other) quarter, but obviously it stayed roughly 5% to 11%. Can you talk about what the opportunities are there? And I don't think there was many comments around specialty. Can you update us on how you see that shaking out throughout the year?

Jeff Park

With respect to the mail penetration, we are focused on driving high utilization in mail in our current book of business. And that's really all throughout the account management, our sales opportunities, and the mail operations. We are very pleased with actually the growth we've been able to add. As mark outlined in the quarter, we started to bring on some significant new volumes into our mail facility.

Now the mail penetration percentage doesn't reflect that because we've been adding new accounts on the top-line, and some of those accounts don't have very high mail penetration. So although it may look like a steady mail percentage, the actual volumes are up very sharply.

From a specialty perspective, we have good relationships within our existing client base to manage their specialty components. And as you know, this is one of the fastest growing areas inside the pharmacy benefit management business. We look at clients that are using us exclusively for specialty, and those that are using us in an open network, where we're not an exclusive provider. And our focus is to move those clients that have us in an open network to more exclusive.

We believe it provides them better value from a pricing perspective, but also more importantly, better management of their current members. With respect to the activities underway for HealthSpring, we've been able to see some good momentum, with integrating into their different geographic locations and influencing and being able to speaking to docs about the opportunities, to be able to transfer some of those scripts over to us.

And so that's a big initiative we're just undertaking now. And as Mark outlined, we're starting to see some of those scripts beginning.

Operator

Your next question comes from the line of David MacDonald with SunTrust.

David MacDonald - SunTrust

I just want to follow up on HealthSpring. First, just on the specialty side as this starts to ramp up, anything that you guys need to do on the capacity side (of the summary) you find there. And then secondly, what is the timing in terms of when you would expect the mail to start coming on? I realize it's probably a small number, but just the timing on that first.

Mark Thierer

The specialty business at HealthSpring is pretty large in terms of the overall opportunity. And there is a ramp associated with it. And as you know, we're just getting started. But candidly, we've deployed dedicated resource to each of their geographic segments. We've deployed an outbound call center to call these heavy-writing docs. We've met with each medical director in each of their operating units. And we've got our full core press to drive that volume. So we've got high hopes for some pretty immediate volume pick up in the specialty facility.

And from a capacity standpoint, we're absolutely fine, and can load that factory with candidly all of HealthSpring's business without breaking a sweat). As you may recall, we made a pretty major investment in our specialty operation, a seven-digit investment from a system standpoint, and we are really operating much more efficiently there than we ever have in the past.

Your second question was around mail order, and I don't see mail order picking up until the beginning of next year.

David MacDonald - SunTrust

On the pipeline you talked about, couple of large managed care plans; and that being an area that's active, how much traction are you guys getting, frankly with the fact that you'll offer something on a cart, and a lot of the big guys won't or are less inclined to. And how much of a differentiator you think that could be in terms of winning some sizeable managed care business in 2010?

Mark Thierer

Yes, Dave, it's a good question. I didn't say that we had a couple; we have significantly more than a couple that we are chasing. But the fact is, there's been a sea change in the small to intermediate size and growing health plan market. And they are really evaluating their overall pharmacy operations. I mean, these health plans or MA plans and PDP plans are under tremendous rate pressure. They are looking for efficiencies in operation, cost of goods reductions, and they are looking for unique ways to manage pharmacy.

And that includes in some cases, containing or keeping the clinical management, the rebate management, in some cases, the network management. And our ability to sort of wrap our toolset and our services around a unique set of needs is the center of our sales pitch to these guys.

And I have to tell you, we just hired a new managed care executive with over 20 years of health plan experience at very senior levels for this very reason, and that is, we are busy trying to service the many opportunities that are in front of us. And I like our chances; they're setting up pretty well for us.

David MacDonald - SunTrust

And then you talked about a couple of potentially meaningful HCIT conversions. Can you put a little bit of a box around that? I mean, are these Presbyterian size opportunities, a little bit smaller than that? Just some sense there?

Jeff Park

Yes, with respect to the size, they are all different. Presbyterian was relatively large, $150 million, but with respect to probably a better view of what average would be, most of the sizes would be in that $50 million to $70 million size range.

David MacDonald - SunTrust

Okay, and of the 4 to 8 you're looking at, is there one or two Presbyterian-like opportunities in there?

Jeff Park

Yes, there's definitely some big ones in there, Dave.

David MacDonald - SunTrust

And then just last question; on the customer satisfaction/retention initiative, is any part of folks' comp tied to how those scores come back?

Jeff Park

Yes, Dave, it's part of an internal repositioning that we started with our national business conference, where our top 130 people came in. starting with every single manager in the company and everyone who is bonus eligible, we've put customer satisfaction and embedded it in their pay plan. So if our scores come in very strong, which is obviously the goal, everyone is going to benefit from a bonus standpoint. And similarly, it cuts both ways; if for some reason, we slip on the service side, everybody pays the price.

And so the whole goal is to get the entire company's head wrapped around the importance of client happiness. And you know, it an all-hands-on-deck drill. I'm feeling pretty good about our progress here. And we certainly have people's attention.

Operator

Your next question comes from the line of Michael Baker with Raymond James.

Michael Baker - Raymond James

Mark, you talked about opportunities that you're seeing in managed care as well as a small to mid-size employer. In the past, you kind of talked about state Medicaid fee-for-service. I was wondering if you could provide an update along those lines.

Mark Thierer

The state business continues to be very strategic for us, and we've added a new resource to help us manage that business just recently. I'll tell you that right now we have one large active fee-for-service Medicaid bid that's out, but the second half of the year is when the activity heats up. And candidly, 2011 is a very busy year for states coming out to bid. I mean, you've got good visibility as to which states are coming out and when. So, for us, we are kind of ramping to deal with the new business opportunities for next year, but we do have a couple in our crosshairs for the second half of this year.

Michael Baker - Raymond James

And then Jeff, you indicated that one thing that might affect the quarterly progression is obviously the tax rate. But I was wondering, should we be thinking, as it relates to start-up costs associated with HeathSpring be any meaningful ones in the second quarter?

Jeff Park

From an implementation perspective, we've certainly been able to get and staff some of that activity already. We're working on the implementation. We're on site with them, and particularly in their areas around Part D and from the specialty and IT operations perspective. We're going to be able to see some of those ramp as we move into the last half of the year, and particularly into the fourth quarter. But I don’t expect to see a significant spike in any one quarter. It's going to be pretty steady growth up into the Go Live for January of '11.

Operator

Your next question comes from the line of Charles Rhyee with Oppenheimer.

Charles Rhyee - Oppenheimer

Mark, maybe first for you here, appreciate all the comments you made about looking at the acquisition pipeline. But if I recall, back at the Analyst Day in November, I think you guys talked about looking at sort of six to nine month timeframe, hopefully to get something get done here. I feel like we're building on the edge of that timeframe now.

And I know the comments you made about what's happening here. But maybe, Jeff, you made that comment about going into the selling season and that's going to impact the timing, now that the selling season's in full swing here, is it more likely that we're going to have to wait till the 2011 selling season is mostly over before we can revisit this like a transaction?

Mark Thierer

Yes, Charles, this is Mark. So, with over $300 million on the balance sheet and no debt, we are obviously thinking about this full-time. And we are actively engaged in a good number of meaningful discussions, but the one thing I want to emphasize is, it's far better for us to leave the capital on the balance sheet than to make a bad decision and we're not going to do that.

And patience is important in this drill, we proved that the last time; we're going to be patient again this time and so, I'm not going to put a timeframe around on when we're going to pull trigger, but you can rest assured that when we find the right asset at the right valuation, we will act and execute on it in hopefully the same fashion we've done in the past.

Charles Rhyee - Oppenheimer

I definitely appreciate that. Jeff, can you remind me what we think about the conversions of the HCIT clients over to PBM contract, sort of the change in the profitability mix, maybe not directly but sort of directionally in magnitude and how does that compare relative if we were to look back at the NMHC transaction?

Jeff Park

Sure, if you look at the HCIT business, as you know on average if you take the total revenues per transaction, it's around $0.16 to $0.17. When you look at the gross margin for the PBM operation it's $3.27. So, from a contribution perspective, our ability to drive clients over from an HCIT business into the PBM business certainly can have a pretty meaningful impact on gross margin and revenue clearly as we move over to a gross reporting for all of the drug spend that we've taken on.

Each of the clients are different, each of the clients have unique requirements that we can address. So, the beginning margin profiles and the ultimate margin profiles for the clients can be different, but its magnitudes higher. This is one of the reasons why we think we're in a great position; we've got long-term relationships with our customers, we're embedded in their operations and their IT business, we know their clients and their support and their people, and we build the best way to support and service their needs.

This is really, from a client perspective, their ability to generate cost savings, and by leveraging our infrastructure either from a service perspective or by leveraging our capabilities in the network and operations to be able to help with better purchasing power.

So we continue to think, this is a great opportunity and really unique to SXC in our positioning.

Charles Rhyee - Oppenheimer & Company

And one last question for Mark. Last week, as your larger peers have been reporting, there have been some discussions about seeing aggressive pricing in the market. Can you give some comments on what you're seeing, and maybe how to interpret those comments as we think about the selling season this year? Thanks.

Mark Thierer

Yes, Charles, I listened to those comments. I don't share that view. Keep in mind we stay out of the big trees backyard; that is not the playground in which we compete. And my sense is maybe the pricing dynamics in that segment of the market must be different than what we're seeing. We continue to underwrite on our Tuesday and Thursday sessions at the same contribution levels we had in the past. I would characterize pricing as disciplined, and know are different than what I've seen in the past.

Operator

Your next question comes from the line of Paul Steep with Scotia Capital.

Paul Steep - Scotia Capital

Mark or Jeff, maybe you can talk just a bit the ramp of other Go Live through the rest of '10 and into '11, how that's going to sort of play out in terms of the numbers and capacities? Thanks.

Jeff Park

Well, we've got business that we're going to be bringing on. As you can imagine, in these five different market segments, we can have very different type of accounts. The large health plans that have large revenue contributions are usually relatively discrete events. And then we have a steady amount of employer business that we generate through our consultants. And our sales team, that kind of brings momentum through the year.

The other area that we add growth from a sales capacity and a support perspective is, as I was mentioning to Charles is through these conversions that we bring on throughout the year. So we believe we've got a nice footprint of growth in 2010. We have some nice plans that are going to be coming on in the second half of the year, and continue to see some of that momentum build through the quarters. But the question is more directly related to the conversions, and were there any sort of (long pulley shifts backed) in any particular quarter, but it sounds like it's relatively smooth.

Operator

Your next question comes from the line of Amanda Murphy with William Blair.

Amanda Murphy - William Blair

First, you guys have been fairly successful in driving up mail utilization relative to perhaps some of your competitors, and also have very high generic penetration rates. Can you just talk to some of the, I guess more unique clinical programs that you have that have any ability to be so successful there?

Mark Thierer

First of all, we've got the lot of small numbers at mail. I mean, we inherited the book of business that was under-penetrated and hadn't really been worked. And so it's fertile ground for pull-through programs. And in the area of mail, we really drive it on two fronts; first, plan design, and second, clinical initiatives.

From a plan design standpoint, we are aggressively pushing mandatory mail for clients who see the value there. Other plan design drivers, including retail mail campaigns, outbound letter, and phone calling campaigns to members basically delivering the value preposition of mail order. We're also using value-based and reference-based pricing from a plan design standpoint to drive mail order. And so plan design's the first place you go.

The second then becomes the clinical area, and this is where a little bit more high touch pharmacists making interventions with physicians' offices. And basically it's step and contingent therapy; it's kind of a (prior to off) process, but it's outbound, outreach based clinical initiatives that drive mail order operations. And so that's how we're driving successful mail order ramping. And we did see a couple of nice mandatory mail clients, including Hawaii and a number of labor union plans that have helped us drive that volume up.

So we're feeling pretty good about mail. Relative to generics and generic utilization, this is something we are very proud of. And it's the primary focus on the selling process; we do have an industry-leading generic utilization number at 74%. And what I'll tell you is, it is again driven through clinical and plan design, and it's also the mix of our business. With the heavy State Medicaid component, we do have a nice, generic mix coming through that book of business.

And so, kind of taken together, we do think the mail order cost savings and the higher generic cost savings set us apart when we're making the economic argument with our customers.

Amanda Murphy - William Blair

And also, you talked about purchasing efficiencies in the quarter. Curious, were you able to get better efficiencies there because of the HealthSpring volume, or did you still expect to get sort of additional efficiencies when HealthSpring comes online next year?

Jeff Park

We're constantly working on our cost of goods as we bring new plans live as the shift of generics also changes the landscape of pricing, almost on a daily basis. So I wouldn't suggest anything is attributed to bringing on any particular book of business like HealthSpring's. It's just a constant activity for us.

Amanda Murphy - William Blair

And the last one, it seems that there's been data out there suggesting that (inaudible) are down and scripts are down. In terms of the volumes in the quarter, were they sort of in line on the PBM side with what you've expected?

Jeff Park

Yes, they were.

Operator

Your next question comes from the line of Constantine Davides with JMP.

Constantine Davides - JMP

One quick follow up here on the acquisition front, guys. There seem to be, sort of at the low end of the market, it seems like a few more transparent PBMs. And I'm just wondering, can you talk a little bit about your preference in terms of maybe a transparent or traditional target? And then as you sort of think about your M&A strategy also, is it still your goal to maybe look at those clients on the HCIT side, or would you kind of widen the net at this point beyond that pipeline? Thanks.

Mark Thierer

So, for us, there are roughly 100 what I'll categorize as middle-market PBMs in the industry. And we don’t really bifurcate them as transparent versus traditional. I think really many of these PBMs service books of business with both. That's become a convention. So for us the most attractive targets are the targets today that are using our technology platform. Because just to remind you, the integration risk in the conversion opportunity is pretty immediate in terms of the accretion and synergies we can drive from clients who use our platform.

But we are very active of broadening the net and looking at PBMs that don’t use our platform. And I'll also say that in that 100 universe of companies, there's a mix of niche based PBMs that span workers compensation, hospice, long term care, cash card PBMs. And so, there's this niche-based segment of the middle market. That's also interesting to us, because as you know, our platform can service basically any of those operating models pretty well.

So we've kept a pretty wide net, Constantine.

Constantine Davides - JMP

Jeff, and then one follow-up on the cash flow. I know there's some receivable dynamics at work. But can you just remind us what your expectation is for the year, and how we should expect cash flow to progress?

Jeff Park

Yes, you look at historically Constantine, our EBITDA has basically been our cash from operations. We've been, probably for the last four years, almost identical to cash flow and EBITDA. So we don't really have different expectations for this year.

Operator

Your next question comes from the line of Tony Perkins with First Analysis.

Tony Perkins - First Analysis

One question, the gross margin for the PBM business itself was down about 180 basis points year-over-year, and I realized that new business bringing that online impacts that. But was there also increased pressure from the retail channel that contributed to the PBM gross margin drop?

Jeff Park

No, it's not that. We have been bringing on new accounts. As you said, you can see the revenues have grown significantly. The mix of business, when you bring on a new account has a lower margin. Additionally, as we go through and renew, re-price or re-sign up with our accounts, that has a margin percentage impact as well.

So this is a nice starting point for us as we start the year.

Tony Perkins - First Analysis

So from this point on, we could expect some increase in gross margin from the PBM segment?

Jeff Park

Yes, you look at the overall, you're going to see the guidance would suggest consolidated gross margins of around 10.5%.

Operator

Your next question comes from the line of Michael Minchak with JPMorgan.

Michael Minchak - JPMorgan

Just a couple of questions; first, I appreciate your comments on healthcare reform. One area that you didn't touch on was the changing tax status of the retiree drug subsidy. I was wondering if you could discuss two things; one, how many RDS lives you currently serve within your employer book? And two, how your offerings position you to take advantage of those opportunities down the road, including (around April) plans?

Mark Thierer

So, we do have a dozen or so RDS-based clients. I don't have the life count on me, but keep in mind the guys who have exposure for the tax change relative to RDS are the people who have a PDP offering that they market to individuals. And we do not have one. So the fact is, we do, through our HCIT business, service a good number of MA-PD and PDP plans.

But for us, the financial exposure to this tax change that might lead to lives moving off of an RDS plan, we don't have an exposure there. I will tell you that the notion of moving from an RDS plan to an EGWP plan is something that probably makes a lot of sense.

This tax change isn't going to come into impact in the near term, and so I think most of these guys who are PDPs with their own lives will be marketing an RDS to EGWP conversion. And that is actually something that through our clients we are talking about and through our Medicare Part D initiatives can offer out to our clients as well. So I don't see an impact on this tax change to SXC. And do think it will create an opportunity for us over the next couple of years.

Michael Minchak - JPMorgan

And then just secondly, following up on your comments on Specialty and Health Spring, can you remind us whether you'll be the exclusive pharmacy provider for Health Spring once that's contract fully implemented or whether you'll be one of the limited number of providers.

Mark Thierer

Right, we will be a preferred Specialty provider for Health Spring.

Michael Minchak - JPMorgan

And do you think there is the opportunity down the road to move that to an exclusive relationship?

Mark Thierer

I don't, it's a Medicare Part D plan, it'll be an open network, but what we're really focused on is really getting that tightly coupled referral network with the physicians and really creating a care model that draws these patients and these prescribing physicians into it. And so, we're working closely with Health Spring to make that happen.

Operator

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

Larry Marsh - Barclays Capital

Just a couple of quick follow ups, Mark and Jeff. First on health plans. You mentioned the sea change in this market around Med D and dealing with the R-cap world, has there been any other ramifications in terms of opportunities around ramifications of some value propositions given the NextRx transaction in terms of how people are thinking of their health plans, is the first part of that question.

And then secondly, you mentioned you don't compete in the world of the big free, so I find it a little bit hard to believe that none of these managed care plans are under the auspices of any of the big free currently. And then finally I guess, if you did win other pieces of business of size, confirm to us what would keep us from getting frightened about being able to install those Health Spring and some of these other books of business here in the next year?

Mark Thierer

I got three things there that you've asked, and let me take a swing at number one. These are kind of trends in the health plan business as a result of the ESI NextRx activity. What I'll tell you there is, I do think most health plans are evaluating the strategic fit of their pharmacy operations. And in fact we've seen a number of health plans put books together to evaluate that in a formal way, engaging bankers' etcetera. So I do think every health plan executive's evaluating what their strategy should be.

In terms of opportunity for us, what I see happening is, in the MA-PD and PDP plans, the commercial plans that support Medicare, there is a high degree of nervousness around issues surrounding compliance, readiness, reform changes, as you mentioned the (MLR Cap). And really, the whole notion of having a subject matter expert partner with an (all card) offering that you can wrap your service needs around is playing very well to SXC. So I do see that as an opportunity for us.

The second thing you asked was, do any of these health plans have a big three engine underneath them. Yes, some of them do. And it's not that we never see these guys; what I really mean to say, when we're not in their backyard is, we're not calling on Boeing and General Motors and CalPERS from a direct PBM standpoint. That is the big three backyard, and we do not bid on nor do we compete at that level.

So we see them from time to time. And in our segments, we do like our chances in the middle-market health planning segment. And then your last question was, how much can we bite off and chew and implement. I think HeathSpring is a great example; it's a 500,000 life plan doing over $1 billion of drug spend, and yet, it's a limited number of health plan offerings, a limited number of plan designs.

They do have a set of Medicare Part B offerings that they sell, but candidly, it's not too complex. And for us, we have 70 payer plans with all kinds of plan designs, a huge number of carrier account groups, really highly complex implementations. And so, the gating item for us is not implementation and how much can we take on. That's really not a factor for us.

Larry Marsh - Barclays Capital

Very well answered. And I guess a quick follow up. You mentioned, a logical target market for M&A for you would be those mid-market PBMs that already use your assistance. Without being too specific, you mentioned 100 as kind of a round number. In round numbers, how many of those 100 are already using your systems?

Jeff Park

25 or 30.

Operator

And your next question comes from the line of Brooks O'Neil with Dougherty.

Brooks O'Neil - Dougherty

I guess a follow-up on Larry's question, and maybe just to ask you sort of a broad-based question about sort of your feel for the state of the company. And I guess specifically, given the very rapid growth and all the things that are going on, does it feel to you like the wheels are coming off the bus, or about to, or you guys feel like the company is really on a strong foundation and ready to go to the next level?

Jeff Park

No, the wheels on the bus are fine, they're tightly affixed. We continue to staff selectively in certain areas to support the growth. But candidly, I would characterize the health of the company as hitting on all cylinders. I just don't see any significant potholes in front of us in the near to intermediate term, and the amount of opportunity each of these segments is chasing after is pretty substantial.

So you can't predict the future, but at this point, I would say, I characterize our opportunities as all systems go.

Brooks O'Neil - Dougherty

You talked specifically about opportunities in a number of your segments. I just want to complete the loop. And maybe you could just talk a little bit about what you're seeing in long term care, and maybe specifically, if there is a pipeline in the HCIT segment? Any comments there would be helpful as well.

Mark Thierer

The long-term care segment, just to characterize it, is our smallest segment in terms of overall opportunity, but it's one in which we have a commanding market share. Both Omnicare and PharMerica are growing customers in that segment, and our strategy there is to expand the work we're doing with those companies and there's great growth just in terms of run rate for those two clients. And then we have about a half dozen smaller to intermediate size long-term care companies that we are targeting.

We really like that market because today, this pre and post-adjudication model that we're out there as kind of the first mover in the long-term care PBM. There's a lot of room to grow in terms of clinical programs around other adjudication services that we've not yet even cracked.

So it is a smaller segment, but the margins are very nice and we have next to no competition. Your second question on the HCIT side, I would say it's been a pleasant surprise, because today we have a number of good-sized HCIT deals, net new deals that we are pursuing. And remember, these are long sell cycles. We're talking to people about gutting their adjudication engine. These are not trivial decisions, but we are at the table with a handful of major players, in earnest talking about just that HCIT swap out to an SXC platform. And so, that's part of our pipeline we're feeling very good about.

Brooks O'Neil - Dougherty

That's great. Obviously you guys are doing an unbelievable job on the generics. And we all know that generics typically carries slightly higher margins for you, but we also recognize the revenue dampening effect. Is there any way you can quantify the impact of adding another couple of percentage points to your generic penetration this quarter in terms of how much it might have cost you on the revenue line?

Jeff Park

I can give you a bit of a rule of thumb. The answer is, obviously depending on the type of plans, depending on the mix, and our mix of business. But when you look at generic dispense rates for roughly every percent, it's going to reduce revenues by around $1.00 per client. So we had close to $12 million claims in the quarter, so that will give you a perspective.

Brooks O'Neil - Dougherty

Mark talked about renewals and your excellent position with regard to renewals for 2010 which obviously leaves us sleeping well at night. But can you just give us a feel for what the renewal outlook is for 2011, particularly obviously with any significant customers?

Mark Thierer

Well, Brooks obviously, we're bringing on a huge block here with HealthSprings on a percentage basis. That's a five-year deal locked up for long term, and as is BMC. So I think it's good to just categorize every year on a kind of a one-third basis. That's a good rule of thumb for you. It may be slightly less than that for next year.

Brooks O’Neil - Dougherty

And then lastly, I was just curious; you mentioned the extraordinary job your mail people did in picking up that volume for a customer this quarter. I'm curious if you feel that you'll be able to retain that business, or if that's going to go back away now that it's up and going or something.

Jeff Park

As you know, when you invest time, energy, effort, to kind of get things stood up, obviously we want to have that investment pay off over a longer period of time than a few months duration. And so that's the way we've contracted for it.

Operator

Due to time constraints, your final question comes from the line of Blair Abernethy with Thomas Weisel Partners.

Blair Abernethy - Thomas Weisel Partners

Just a quick follow-up on the HIT side. Couple of things; I wonder if you can expand a little bit on the HIPAA changes, this D.0, and give us a sense of what this can mean for you in some professional services, revenue opportunities, or potentially, licensing?

Mark Thierer

I'm glad you asked, because it's important for the industry and it doesn't get a lot of airtime. I'm going to take a moment and sort of paint you a picture. Let me first tell you what it is. D.0 is the new NCPDP standard for HIPAA-covered transactions. And the final rule was published on January 16, last year 2009. And it impacted every PBM operating in the industry relative to their adjudication platform.

Here's some important dates; first, January 1, 2011 is when the Health and Human Services have recommended the compliance date, meaning you need to be ready to go. They will allow for calendar year 2011 for you to transmit claims in either NCPDP 5.1 or D.0. So you do have a grace here.

But on 01/01/2012, every PBM is required to have D.0 fully live. It's the only version that will be allowed. So why is this so hard for everyone? It's a little bit like Y2K, only for PBMs. There are many features that have been required to be embedded in the adjudication, including how you compound or excess, you need more data, consumer directed health, much better support and interfaces, special handling for COB, and the ability to handle pharmaceutical services outside the dispensing process.

So specifically to your question, what have we done? We have been working on this for over a year, planning and programming. We began our testing last fall. And keep in mind, because of our diverse client base in any segments, we really have a unique and I would say an awesome perspective on what needs to be done.

So we're going to complete this in the summer. And yes, we have opportunity to drive professional services revenue and increased licensing fees from the work that we're doing here. But I think what's really important is from a competitive standpoint. If you're an operation that has multiple platforms that you're running, you're going to go through multiple remediations to try and get D.0 up and live on each of these platforms.

And I can assure you, there is a lot of work and investment associated. This is not trivial. So we think that over the next 12 to 18 months, even though this feels like a really technology driven industry initiative, it's going to become a business driver for people making decisions around compliance regulatory requirement and we really like our position on this one.

Blair Abernethy - Thomas Weisel Partners

And also on the HIT side, what are current thoughts there on the M&A front, and new products you might be looking at?

Mark Thierer

We do have some targets on the M&A front, but candidly it's not sort of a discrete product. I mean we're looking at health outcomes in analytics, and as you know the Zynchros acquisition is paying nice dividends for us. And so, I would call it a secondary set of targets, Blair, rather than the primary PBM set of targets that we're evaluating.

Blair Abernethy - Thomas Weisel Partners

And just one other question, Jeff, on your guidance for 2010, are you including conversions of HIT customers in that number? And if you were also to characterize where we are at in the conversion cycle, are we at the mid-point, are we three-quarters of the way through? How can you characterize for us, give us some sense where that opportunity is?

Jeff Park

Yes, with respect to our guidance, we do have business that we've signed or have contracted for in there. New opportunities that we haven't contracted yet that we're working on would provide us with a good opportunity whether that's significantly impactful and then I guess would be determined. From a stage and status, I would characterize us currently as half-way in on the first stag, we have 70 different HCIT accounts and to date we've converted roughly eight or nine of them. So that means we still have a lot of opportunity now, obviously not all 70 of those are going to targets for conversion, but give you some perspective of our opportunities.

Operator

I would now like to turn the call back to Mr. Mark Thierer for closing comments.

Mark Thierer

Okay. Thank you, I think that wraps up the Q&A. I want to thank everybody for your time and good questions here on the call today, and we look forward to updating you in the coming months. Have a great day.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. You may now disconnect.

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Source: SXC Health Solutions Corp. Q1 2010 Earnings Call Transcript

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