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MedcoHealth Solutions (NYSE:MHS)

Q2 2010 Earnings Call

July 22, 2010 8:30 am ET

Executives

Valerie Haertel - IR

Timothy Wentworth - Group President of Employer Accounts

Brian Griffin - Group President of Health Plans

Thomas Moriarty - Senior Vice President of Pharmaceutical Strategies & Solutions, Secretary and General Counsel

Richard Rubino - Chief Financial Officer and Senior Vice President of Finance

Steven Fitzpatrick - President of Accredo Health Group Inc

David Snow - Chairman and Chief Executive Officer

Analysts

Lisa Gill - JP Morgan Chase & Co

Ricky Goldwasser - Morgan Stanley

Ross Muken - Deutsche Bank AG

Helene Wolk - Bernstein Research

Glen Santangelo - Crédit Suisse AG

Lawrence Marsh - Barclays Capital

Thomas Gallucci - Lazard Capital Markets LLC

Randall Stanicky - Goldman Sachs Group Inc.

John Kreger - William Blair & Company L.L.C.

Jeffrey Jonas - Gabelli & Company, Inc.

Operator

Good morning. My name is Wes, and I will be your conference operator today. At this time, I would like to welcome everyone to the MedcoHealth Solutions Second Quarter 2010 Earnings Conference Call. [Operator Instructions] I will now turn the conference over to Valerie Haertel, Vice President of Investor Relations. Please go ahead.

Valerie Haertel

Thank you, Wesley. Good morning, and thank you for joining us on Medco's Second Quarter 2010 Earnings Conference Call. With me today as speakers, the Chairman and Chief Executive Officer, Dave Snow; and Chief Financial Officer, Rich Rubino. Also joining us for our question-and-answer session are Kenny Klepper, President and Chief Operating Officer; Tom Moriarty, General Counsel, Secretary and Senior Vice President of Pharmaceutical Strategies and Solutions; Tim Wentworth, President of Employer Account Group; Brian Griffin, President of the Health Plans Group; and Steve Fitzpatrick, President of Accredo Health Group.

During the course of this call, we will make forward-looking statements as that term is defined in the Private Securities Litigations Reform Act of 1995. No forward-looking statement can be guaranteed, and actual results may differ materially from those projected. 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 risks and uncertainties that affect our business, particularly those disclosed in our SEC filings. Copies 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 its website as a means of disclosing material nonpublic information and for complying with its disclosure obligations under Regulation FD.

The copyrights for the contents of this discussion and the written materials used on this earning call are owned by MedcoHealth 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 we expect to file our 10-Q after the close of the market today.

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

David Snow

Thank you, Valerie, and thanks to all of you for joining us this morning. Today, we're reported strong second quarter 2010 earnings. As a result, we are narrowing to the upper end of our previous full year 2010 GAAP diluted earnings per share guidance. In addition, we are narrowing and raising our 2010 diluted EPS guidance, excluding the amortization of intangible assets. GAAP diluted earnings per share reached a record $0.77, representing 20.3% growth over second quarter 2009. Our diluted earnings per share, excluding the amortization of intangible assets from our 2003 spinoff, reached a record of $0.83, also a 20.3% increase over second quarter 2009.

Our continued strong net new sales growth drove our second quarter revenues to a record $16.4 billion, representing a 9.9% growth rate over second quarter 2009. For the 2010 selling season, our annualized new-named sales increased $700 million to $5.1 billion, up from our previously reported $4.4 billion. Our 2010 net new sales currently stand at over $5 billion, up from our previously reported $4.3 billion.

We have now completed nearly 95% of our planned 2010 client renewals, all accounts with drug spend over $500 million have been renewed, and our 2010 client retention rate remains at over 99%.

While it is still very early in the 2011 selling season, I'm pleased to report annualized new named and net-new sales of approximately $1 billion, up from the over $500 million we reported during the quarter. Our scheduled renewals for 2011 are approximately 45% complete, up from the 25% we reported last quarter, and our 2011 client retention rate remains at well over 99%. We continue to retain and win business at profitable levels, consistent with our disciplined sales approach.

Turning to other key performance metrics for the second quarter 2010. Our total prescriptions adjusted for the difference in days supplied between mail order and retail increased from the same quarter last year by 6% to $238.4 million. Mail-order script volumes for second quarter 2010 was quite strong, at a record 27.5 million mail-order prescriptions, a 6.2% increase from second quarter 2009.

While brand-name prescription volume at mail decreased 2.7%, generic prescription volume at mail grew 12.8%, as members continue to shift to generics for additional cost savings, consistent with our experience in recent quarters. We expect this trend to continue, given the historic wave of generics that will be available in the coming years.

In addition to strong mail-order volume this quarter, we also continued to see equally strong retail volume. Retail prescriptions grew by 6.2% to $156.7 million. The proportional growth in volume at mail and retail resulted in a relatively consistent mail penetration rate of 34.3% compared to 34.4% in the second quarter 2009.

This quarter, our generic dispensing rate increased 3.3 percentage points to a record 70.6% compared to 67.3% for second quarter 2009. The year-over-year improvement in our overall generic dispensing rate drove record incremental savings to our clients and members of approximately $870 million.

Turning to our Specialty Pharmacy segment. Accredo posted record second quarter results. Accredo's net revenues reached a record $2.8 billion, representing 18.1% growth over the $2.4 billion in the second quarter of 2009. Operating income grew by a strong 24.2% to a record $109.9 million for the quarter.

I would like to take a moment to provide an update on just a few of the initiatives that we expect to increasingly contribute to our earnings and catalyze our growth, both during and beyond the generic wave.

During the quarter, we took a significant step to advance the growth of our international business operations, announcing the creation, subject to the approval of regulatory authorities, of Medco Celesio B.V., a 50-50 joint venture with Celesio. This joint venture is designed to deliver, in a phased approach, our technology-enabled advanced clinical solutions, specialty pharmacy services and mail-order pharmacy services to as many as 29 countries in Europe.

We also announced our first client in Germany, a sick fund, which is analogous to a health plan in the United States, to deliver our technology-enabled advanced clinical services. We are excited to have a partner in Celesio with 175 years of history in Europe as well as a team of capable individuals on the ground to build this business.

It is important to point out that the combined economies of the 29 European countries represented in this joint venture is slightly larger than the U.S. economy. Similar to the healthcare challenges we faced in the United States, Europe is also struggling with healthcare inflation and in seeking advanced solutions to further reduce healthcare costs beyond drugs price controls. We recognize that each European nation's challenges are unique and will require a different set of solutions. Our joint venture will enable us to design customized solutions to meet those unique needs and deliver on the promise of Making Medicine Smarter in significant new markets.

Another promising new growth opportunity for Medco is to serve as a resource in the emerging areas of comparative effectiveness and inherent program. We are seeing high levels of interest in the activities of the Medco Research Institute on the part of our clients and the FDA, as examples. The institute's focus on driving adherence to better outcomes is important to all constituents in the healthcare continuum. This is evidenced by the over 20 research studies underway to our Medco Research Institute. We plan to report on those findings in the coming quarters, and we intend to incorporate them in our practice protocols, as appropriate, as part of our ongoing mission to make medicine smarter.

Client interest in our personalized medicine initiatives is particularly strong and growing, especially in light of the expanded decision support services we now offer through DNA Direct. Our personalized medicine programs have over 250 clients enrolled, up from the over 220 clients as reported last quarter, covering more than 11 million lives, up from the over 10 million lives we reported last quarter.

The Medco Health Store continues to grow, now reaching nearly 1.4 million registered users. The Medco Health Store complements the prescription-based services we provide for our patients through our therapeutic resource centers by making over-the-counter drugs, vitamins, supplements and other healthcare products available via our online store. More importantly, it incorporates an innovative safety net to screen for potentially dangerous interactions between prescription medications and other over-the-counter non-prescription products, a new feature for the store that is driving significant interest from our clients and members.

Over the last several years, we have built a platform that is unique in our industry and unique to the healthcare system to address the significant issues surrounding the care of patients with chronic and complex health conditions. We remain committed to identifying and developing innovative solutions in areas such as oncology and diabetes.

Today, we are narrowing our guidance range for 2010 GAAP diluted earnings per share and narrowing and raising our guidance range for diluted earnings per share excluding the amortization of intangible assets. Our full year 2010 GAAP diluted earnings per share guidance range was narrowed to $3.10 to $3.15, representing strong growth of 19% to 21% over 2009. Our previous guidance was in the range of $3.05 to $3.15 per share.

We are also narrowing and raising our full year diluted earnings per share guidance excluding the amortization of intangible assets from the 2003 spinoff, now expected in the range of $3.34 to $3.39, representing growth of 18% to 20%. Our previous guidance was in the range of $3.28 to $3.38 per share.

In conclusion, our approach to Making Medicine Smarter by delivering meaningful solutions that improve the quality of care while lowering overall healthcare costs for our clients and members remains a core catalyst of our continued marketplace success.

With that, I'll turn the call over to our CFO, Rich Rubino, who will discuss additional second quarter of 2010 financial performance details and provide you with additional color regarding our 2010 guidance. Rich?

Richard Rubino

Thank you, Dave. Good morning. Please excuse my voice. I have a bit of a cold. We are pleased to deliver another quarter of strong financial and operating performance. I will begin my discussion 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 third quarter and full year 2010.

Starting with our balance sheet. We closed the second quarter with a cash balance of nearly $1.2 billion, a decline from the nearly $1.6 billion at the end of the first quarter of 2010, primarily the result of $1.03 billion in share repurchases, offset by net cash inflows from operating activities.

Our cash flow from operations for the first six months of 2010 of $990.8 million, decreased from 2009, mainly as a result of our significant inventory reductions and strong retail claim volume growth in 2009. The company now expects cash flow from operations of over $2.4 billion for the full year 2010, up from our previous guidance of approximately $2.3 billion. Further, as a result of our working capital management progress, we now expect our return on invested capital to grow in 2010 to approximately 35%, up from our previous guidance of well over 30% for the full year.

Our total debt for the second quarter remains consistent with first quarter 2010 at $4.0 billion. Our capital expenditures for June year-to-date were $100.4 million compared to $98.1 million for year-to-date 2009. This increase reflects investments in our business to enhance efficiencies across the organization and to fund future growth. We still expect capital expenditures of approximately $245 million in 2010.

Moving on to the income statement. Our second quarter EPS results were records, with GAAP diluted EPS of $0.77 and diluted EPS excluding the amortization of intangibles from the 2003 spinoff of $0.83, both growing at 20.3% over the same quarter last year.

Second quarter 2010 results reflect an earnings per share benefit of approximately $0.03 associated with our receipt of a settlement award in a class-action antitrust lawsuit brought by direct purchasers of a brand-name medication. This earnings benefit was included in Medco's original full year diluted EPS guidance but was expected later in 2010. Nonetheless, excluding the $0.03 benefit, Medco's second quarter GAAP diluted EPS of $0.74 and diluted EPS excluding spinoff intangibles of $0.80 remain records.

Second quarter net revenues reached a record $16.4 billion, representing growth of 9.9%. Looking at revenue composition, our product revenue grew 9.7% reflecting our new business wins as well as higher prices charged by brand-name pharmaceutical manufacturers, primarily offset by a higher representation of lower-priced generics.

Service revenue grew 21.6%, reflecting the expansion of our overall client base and our Medicare Part D service fees.

Mail-order volume remained strong, as clients and members continued to choose the lowest-cost and most clinically effective channels. As such, we continue to expect mail-order volumes to be in the range of 107 million to 109 million prescriptions for the full year 2010 as we previously guided, up from the 103 million last year. Additionally, we continue to expect our full year 2010 adjusted mail-order penetration rate to increase slightly over the 2009 level of 34.2%.

Turning to rebates. We earned $1.4 billion for the second quarter. This represents 7.4% growth relative to second quarter 2009, attributable to new client wins and improved formulary contracting. Our second quarter 2010 rebate retention rate was 11.9% compared to 13.6% in second quarter 2009, as we continued to drive significant value to clients in a highly transparent manner.

Turning to gross margins. Our record second quarter 2010 gross margin of $1.06 billion reflects 4.5% growth over second quarter 2009. Our consolidated gross margin percentage of 6.5% for the quarter declined from the 6.8% in second quarter 2009. The year-over-year decrease reflects the impact of client renewal pricing, higher retail volumes and the decline in the Accredo gross margin percentage, partially offset by the quarter PBM's incremental second quarter contribution from new generics and the previously mentioned settlement award, which contributed slightly more than 15 basis points to our second quarter gross margin percentage. Sequentially, our margin percentage increased by 40 basis points compared to 6.1% in first quarter 2010.

We still expect the contribution from new generics to be heavily weighted toward the back half of the year, and we continue to expect our gross margin percentage to increase over the remainder of the year. As a result, we project a full year 2010 gross margin percentage that is consistent with the 6.7% achieved 2009.

Selling, general and administrative expenses of $376.4 million for the quarter increased $5.7 million or 1.5% from second quarter 2009, reflecting higher technology-related expenses associated with strategic initiatives. For 2010, we continue to expect SG&A expenses to increase approximately 3% to 4% over 2009 to about $1.5 billion.

Our total EBITDA for second quarter 2010 reached a record $730.2 million, representing growth of 5.9%. EBITDA per adjusted prescription decreased slightly year-over-year to $3.06 from $3.07 in second quarter 2009, resulting from the higher retail volumes. Sequentially, EBITDA per adjusted prescription increased 6.6% over the $2.87 in first quarter 2010, in line with expectation we set on our last call for growth in excess of 5%.

Our intangible amortization of $70.7 million in second quarter 2010 decreased from $75.9 million in second quarter 2009. Our guidance range for intangible amortization for 2010 remains unchanged at $280 million to $290 million.

Total net interest another expense of $32.5 million for the second quarter of 2010 decreased from $41.2 million in second quarter 2009, reflecting lower interest rates on debt and lower debt levels. Our 2010 guidance for net interest expense is now approximately $160 million, which is $10 million lower than our previous projection of $170 million.

The second quarter 2010 effective tax rate was 38.7% compared to 40.9% in the second quarter of 2009, reflecting our lower state income tax rate. We now expect a 2010 effective tax rate of approximately 39.0%, at the midpoint of the previous guidance range of 38.5% to 39.5%.

Net income for the quarter increased 14.4% to a record $356.9 million from the $312.1 million reported for the second quarter of 2009.

Moving on to share repurchases. During the second quarter of 2010, Medco completed the remaining $331.6 million in authorized share repurchases under the prior $3 billion program. In addition, under the new $3 billion share repurchase program approved by the Board of Directors in May 2010, Medco repurchased a total of 12 million shares for $696.5 million, with an average per-share cost of $58.14. In total, for the second quarter of 2010, Medco repurchased 17.6 million shares for $1.03 billion with an average per-share cost of $58.45. From July 2010 to date, Medco repurchased 8.7 million shares for a total cost of $489 million at an average per-share cost of $56.13.

We now expect the 2010 weighted average diluted share count of approximately 460 million shares to decline from the previous guidance range of 465 million to 480 million shares. While our expected dollar allocation for share repurchases associated with the new $3 billion authorization remains unchanged from the time we announced the new program, we were able to take advantage of lower share prices and, therefore, purchase more shares than we originally anticipated.

Turning to our Specialty Segment. As Dave already mentioned, Accredo achieved record results for second quarter 2010 for both revenue and operating income. We continue to expect full year Accredo revenues in excess of $11 billion and operating income of approximately $450 million.

Accredo's gross margin percentage declined to 7.0% in second quarter 2010, a decrease from the 7.4% from second quarter 2009. This decline reflects product, channel and new client mix, partially offset by higher margins associated with manufacturer price increases. For the six months of 2010, however, manufacturer price increases as a percentage of net revenues were lower than 2009.

Moving on to Medicare. We continued to experience growth in our Medicare PDP. For second quarter 2010, Medco's PDP revenues increased 31% to $370.1 million.

As Dave discussed, we are improving our guidance for 2010. We are narrowing the full year 2010 GAAP diluted earnings per share range to $3.10 to $3.15, representing growth of 19% to 21% over 2009. We are also narrowing and raising the full year 2010 diluted EPS range excluding the amortization of intangible assets from the 2003 spinoff to $3.34 to $3.39, representing growth of 18% to 20% over 2009.

Amortization of intangible assets increased from $0.24 per share to $0.23 per share as a result of the revised expectations for the lower 2010 average share count I mentioned earlier. This is the reason why the top end of GAAP EPS guidance did not change, while guidance for diluted EPS excluding intangible amortization from the spinoff increased by $0.01.

I have already walked you through many of the components of 2010 guidance. I would like to highlight some additional components.

We continue to expect to renew approximately $15 billion of business in 2010, which includes scheduled and early elective renewals. Approximately 80% of the 2010 renewal pricing already took effect in the first quarter of 2010, with the remainder expected primarily in the third quarter. The impact of new generic introductions on 2010 EPS remains at $0.25 that we previously guided, with approximately 64% weighted toward the back half of 2010. As a reminder, the estimated quarterly spread of $0.25 reflects a $0.03 first quarter contribution, $0.06 in the second quarter and an expected $0.08 in the third quarter and $0.08 in the fourth quarter.

The higher utilization of generics in 2010 is now expected to represent a full year revenue offset of approximately $3 billion compared to 2009, at the high end of the range I previously provided of $2.8 billion to $3 billion. For the full year of 2010, EBITDA per adjusted prescription to increase by a low-single-digit percentage over 2009, resulting from the higher retail volumes.

Our acquisition of DNA Direct in January is still expected to be approximately $0.01 dilutive to 2010 earnings.

Pointing to the third quarter, specifically, I would like to offer the following observations: Our overall gross margin percentage is expected to increase from the 6.5% reported for second quarter 2010 to a third quarter level in line with to slightly ahead of the 2009 full year average of 6.7%. Third quarter revenues are expected to reflect the seasonality from lower retail claims than we've experienced in prior years.

Third quarter SG&A expenses are expected to grow slightly from the second quarter and flatten out for the fourth quarter.

Our EBITDA per adjusted script for the third quarter is expected to grow in excess of 5% over the second quarter 2010 metric of $3.06.

As I have stated previously, we expect EPS from each quarter of 2010 to increase consecutively. We currently expect our third quarter 2010 EPS to increase at least 5% over the second quarter.

Lastly, there is a possibility that we will receive approval from Germany's regulatory authority in the third quarter and are, therefore, able to close on our joint venture with Celesio. Upon the closing, we would deconsolidate Europa Apotheek Venlo and contribute the EAV assets to the joint venture at fair value, with any difference from EAV's book value being recorded in our results of operations, which will result in a gain or loss on the transaction. At this point, we believe a gain is the more likely scenario.

The second financial outcome, once the transaction closes, is the recording of an exchange loss due to changes in the valuation of the euro relative to when we acquired EAV in April of 2008. At this time, we are not able to estimate the total net gain or total net loss from these two components of the transaction.

In concluding our prepared remarks, we remain confident in our ability to drive earnings growth, and we believe Medco is very well positioned to continue to deliver best-in-class financial and clinical value to our clients that will, in turn, benefit our shareholders.

Now Dave and I would like to open the lines for questions. Wes?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Lisa Gill of JPMorgan.

Lisa Gill - JP Morgan Chase & Co

Dave, last quarter, there was talk about competitive pricing in the marketplace and, obviously, since last quarter, there's been lots of talk in the marketplace around what pricing looks like. Can you maybe just give us an indication of what you're seeing? You've now renewed 45% of your book. Do you have any update as to what you're seeing the marketplace?

David Snow

Yes, Lisa, I would tell you that I'm feeling comfortable with the competitive marketplace, and I'm very comfortable that Medco's positioning in that competitive marketplace allows us to continue to maintain our discipline when it comes to our approach to the market. And I obviously have growing confidence in our ability to maintain the stability of our competitive position in the marketplace through the year. I feel very good about it, actually, at this point in time.

Lisa Gill - JP Morgan Chase & Co

And are you seeing any changes for 2011 around plan design? Are you seeing more step therapy or any comments around restricted networks or specialty? Anything you're seeing that's different in 2011 that perhaps when people are talking about price they don't understand that you're getting something in return?

David Snow

No, I think that we're continuing to see benefit designs that drive best price for the payer, whether that be -- we're continuing to have conversations around some form of mandatory mail, for example, and benefit designs that drive members to generics as appropriate. But I have both Tim and Brian here who are doing this every single day. So I want to ask Tim. Tim, do you have any thoughts about what your market's doing relative to benefit design?

Timothy Wentworth

No, I think you pretty much hit it, Dave, depending on what they're able to do. We've continued to talk with clients prior to the sort of restricted network question that came up in the market and have clients continuing to look at that. I wouldn't say that's dramatically changed. Our clients know that a lot of their spend is still on brand drugs, so we see a lot of preferred-drug step therapy and it's still being put into place. As we've of expanded the opportunity into the ARBs, for example, as new drugs come out patent. And I think that, finally, the big idea is our clients, a lot of them, are looking to have us wire up their broader healthcare consolation of providers and produce value that goes beyond what the PBM can do, and when you're about going beyond price, I think those conversations have been the most interesting and fruitful, Lisa.

Lisa Gill - JP Morgan Chase & Co

Okay, great. And then just one follow-up, Rich, when you talk about the settlement, the Pharma settlement, where was that included? Is that included in the gross profit, so it'd come out of the costs for the quarter?

Richard Rubino

Yes, it is in the gross profit percentage. And I mentioned in my prepared remarks that it contributed about 15 bips to the gross margin percentage in the quarter.

David Snow

Just to complete this, though, on Lisa's question. Brian, do you have anything to add relative to what Tim said, relative to what your customers are asking for?

Brian Griffin

I think just from the network perspective, as you can appreciate, and the health plan market, there really isn't much of a focus in terms of restricting networks because that affects their kind of competitive position relative to other health plans. So I think there hasn't been that focus, but there, clearly, has been a focus in terms of plan designs that drive mail service. So I think across the health plan book of business, where historically, that had not been a focus, it is becoming a real focus for them and they're competing on that basis. And then lastly, I think to Tim's point, the area that we're really winning in the marketplace is this idea of extending our TRC model, the clinical model, into our health plan partners' overall medical [indiscernible] (0:40:01.9) and that seems to be resonating quite a bit in the health plan marketplace.

Lisa Gill - JP Morgan Chase & Co

And I know it's too early to talk about 2011, but if I'm listening to what you're saying, you're definitely talking about more mail in your book of business for 2011, at least those are some of the plan design changes that you're seeing. So should we continue to see or expect to see continued mail utilization in the book above what we saw in 2010 for 2011?

David Snow

I mean, I would tell you if we weren't adding new business not knowing what the mix is, benefit design does favor mail, and I think we feel good about that. But I don't want to give guidance for '11 because we actually have to see what we win for '11 and see how that affects the ultimate mix of scripts. On a same-store basis, we feel very good about what our clients are doing relative to mail.

Operator

Your next question comes from Tom Gallucci of Lazard Capital.

Thomas Gallucci - Lazard Capital Markets LLC

Two housekeeping items: First, I just wanted to be clear. Rich, second quarter to third quarter, up at least 5%. I think that's similar to the commentary you gave from first to second. But I just want to make sure, that's off the $0.83 that you reported?

Richard Rubino

That's correct.

Thomas Gallucci - Lazard Capital Markets LLC

Okay. And then you mentioned retail volumes being greater than you expected for the year. Can you talk about the order of magnitude there?

Richard Rubino

Well, I'll give you an example, just referring to the second quarter. In the second quarter, we would have expected somewhere around 1.2% to 1.3% decline in retail volumes, this consistent with last year. And this year, we saw the decline which includes seasonality of actually shy of a point. It was about 0.9%. So that spread of about 30 bips when you apply the very significant retail volumes is pretty meaningful. And to the extent that trend continues with less seasonality drops and fundamental growth perhaps in the fourth quarter of the year, we adjust [ph] (42:07) the model a higher retail number than we originally expected.

Thomas Gallucci - Lazard Capital Markets LLC

Okay. And then just on Accredo, maybe I missed it in your comments there. Can you just discuss I guess some of the positives or negatives in that business and some of the trends? I think you mentioned price increases. I know that that's been a soft spot over the last couple quarters. What was it actually in this quarter? And then I guess just sort of the underlying trends if you can highlight them.

Richard Rubino

We did have, as I mentioned in my prepared remarks, in the second quarter of 2010 a benefit from price increases -- it altered the second quarter of 2009. Of course, on a year-to-date basis, we're still behind because the first quarter of 2009 was so strong with regard to price increases. If you look at what's driving Accredo's performance, there's huge top line growth, of course, and that's because that business continues to grow not only within our base from last year but obviously the new lens [ph] (43:05) that we put on the books this year are driving further Accredo revenue. There are some changes in mix, though, as you bring on these new clients. As you know, over the past couple of years, there's been more of a shift toward retail mix and I would say that the dynamic from the gross profit percentage of last year this year is in part driven by that mix retail versus mail. And also when you take on new clients that have different mixes of drugs that have different profitability profile. And that's really it. I think fundamentally, Accredo's performance remains quite strong. As I always like to see, their operating income is growing in a faster pace than revenue. And I'm fairly confident that at this point, we'll probably have gross margins in the 7% range, give or take, for the back half of the year. I don't expect too much volatility going forward.

David Snow

So we also have Steve Fitzpatrick here who is President of our Accredo operation. I don't know, Steve, if you want to add anything to what Rich said, but I'll give you the opportunity.

Steven Fitzpatrick

Sure, well I think Rich nailed it. You know the growth of our business and some our new accounts and retail mix and that the relative higher mix of some of our more basic injectable business which comes at a lower margin and that's what's that margin differential.

Operator

Your next question comes from Ross Muken of Deutsche Bank.

Ross Muken - Deutsche Bank AG

So the Celesio JV is an interesting anomaly [ph] (44:33) for you and for the European market. Maybe talk a bit about sort of the opportunity there and how you size that versus kind of the current book of business and when you think that inevitably could be somewhat incremental. And then I have a quick follow-up to that.

David Snow

When I look at the European opportunity, first of all -- and I said this in my prepared remarks -- the 29 countries that are represented in this joint venture actually have a GDP that is larger than the United States. So for me, that's actually fairly intriguing. When you think about what could an American company bring to Europe relative to health care cost improvement when you look at the relative cost per person per year, the European nations versus the U.S., some people would scratch their heads. But here's how you should think about Europe and what Medco might do. And in the United States, we have pretty much shunned price control of any kind. So therefore, we've depended on using robust data to manage episodes of care. In Europe, they had literally none of that, because they depended solely on price control. And what you see happening today is America is taking lessons learned from Europe and they are going into things like comparative effectiveness, which are very aggressively done over in Europe. So we're taking from them. But what Europe is actually interested in from us is the technology-enabled clinical capabilities that they just don't have. And so when you think about Medco, Medco has two different parts of the business. One is the PBM, where we use our large scale to drive best price with manufacturers as well as best price with retail, and we process claims for customers. The other part of our business is with this huge advanced clinical pharmacy that we operate. When you think about what Medco would do in Europe, it's really not the PBM because they've got price control, so they're not looking for someone with scale to negotiate price. It's those technology-enabled advanced clinical services that clearly resonates. Just like in Sweden, we took our technology, our software that does drug-to-drug interaction at point-of-care, at point of service or retail, and we actually translated it into Swedish, used their drug metrics, added the drugs that their approval authorities have put into play that our FDA has not. And we now license that technology to the Swedish government to wider retail in that country. That's just an example. We also in the U.K. are using the Accredo model with the National Health Service. The National Health Service has been historically administering biotech infusible drugs in a hospital setting. Our Accredo model does it in a home setting at far less cost than what the NHS has been doing, and that joint venture is working very well. In Germany, we have sold a client a health plan in Germany because quite honestly -- you can read about this every day over in Germany -- the health plans are having a very tough time making the premiums they receive work relative to the costs they are incurring for health care. And they had the same problems around the management of chronic and complex disease that you'd see in this country. In fact, all of the European countries have the problem where there's enormous wastage tied to noncompliance and omissions in care. So, our technologies are abilities to create actionable capabilities to improve medical loss ratio on the part of payers or think that do not exist over there. And we've had a great reception. So to your question about growth, obviously we need to get this joint venture management team in place and that will happen as soon as we get approval from the authorities relative to the joint venture. We already have a glide path in several countries, Germany being one of them and we will expand that over time. And to our point that we've made consistently over the past two years, our focus is that the European initiative will start contributing in a way that's meaningful to our EPS by 2015. And we feel fairly comfortable that that is what will happen.

Ross Muken - Deutsche Bank AG

And then we've seen the service gross profit line increasingly grow well above the business. I mean, as you sort of continue to evolve these clinical and technology-enabled services, is that a trend we should certainly expect to continue? And even though the revenue contribution as a whole is slightly less, the 70-plus percent gross margin, it seems like you're going to see a bit of business mix shift over the next 12, 24, 36-plus months.

David Snow

Yeah, that's a good point, Ross. So if you think about the PBM business as we run it in the U.S., it is a pill-centric model. In Europe, because we're taking our technology-enabled clinical solution capabilities, it is going to be very heavily a service model, not a pill-centric model. So it will very much tie to the service revenues in the rev-related margin that Rich always talks about every quarter.

Operator

Your next question comes from Larry Marsh of Barclays Capital.

Lawrence Marsh - Barclays Capital

I know you're not guiding to 2011, yet you said this morning that you have suggested repeatedly that we should expect a lower contribution from new generics next year. Are there any natural offsets as we think directionally for 2011 as we think about modeling before we get to '12? Or is it too early to comment on that? And is there anything that would cause you to change your view that '12 and 2014 could be meaningfully higher profit contribution from generics?

Richard Rubino

Yes it's, as you implied, too early to talk about 2011. We're just starting our operating plan process in detail now. So we'll give an update on that on the third quarter call. I will tell you that the mapping of the generic wave is as you stated. Next year is clearly a lighter year even though the biggest drug is in the year, Lipitor. It is not until the very end of November, so the majority of that benefit accrues to 2012. And there are many other significant drugs that are going to contribute to 2012 and '13. So relative to 2011, 2010, 2012 and 2013 will look very strong.

Lawrence Marsh - Barclays Capital

Quick questions for me around the Celeron [ph] (52:24) employees plan. I know earlier this year, the Lynch Bill [ph] (52:26) dictated some change and suggested ownership reporting [ph] (52:30) and transparency that in some cases, if implemented, would I think be beneficial to you. Do you guys still have a view that there won't be any real more FP changes in note this cycle? And when do you think you'll get clarification on that?

David Snow

I am going to have Tom Moriarty who's been looking at the Lynch Bill [ph] (52:51)specifically. And Tom also runs our Washington office to give you some thoughts about that and then Rich, if you have some add-on, that's great.

Thomas Moriarty

So I'll start. In terms of Lynch Bill [ph] (53:00) itself, we've obviously spent an awful lot of time down in Washington talking about this and working directly with the sub committee. We don't anticipate at this time that that proposed legislation will actually move forward. And so at this stage it's in a whole new pattern from our perspective.

Richard Rubino

The only thing I would add is, as you know, Larry, we have an extraordinarily transparent model currently. Different clients have different desires with the drug to have their contracts of price and that applies to the government as it does to any other contract. And we're totally willing to be transparent. Ultimately at the end of the day, we are a public company and we have to generate a shareholder return and that's the way it's got to be priced. And at the end of the day, that will result in the lowest cost to the government, considering the alternatives of it being done by the government would probably result in a substantial increase in cost. So I think we're going to be around for a while as a government provider and I believe we're going to be a profitable provider to the government.

Lawrence Marsh - Barclays Capital

All right. I guess it's too early to speculate as to whether the value proposition to be enhanced if there's really an integrated vendor in that situation.

Richard Rubino

There are many opportunities I think to enhance the value that goes to any client. We've talked many times about not only what we can do from a competitive pricing perspective but also from a drug-tran [ph] (54:31) management perspective. Also from an integration of clinical services perspective and the power of Therapeutic Resource Center and some of the things that can be done with regard to the wiring of health care. So there are huge opportunities for the government to save money and other payers as well.

Lawrence Marsh - Barclays Capital

Very good. Okay, and finally -- thanks for all that detail and clarification. It seems like you guys are being a great position to be maybe even more important vendor there. Just the antitrust [ph] (54:58) benefit which, I assume that shows up in the service gross profit line versus the product gross profit line, is that correct?

Richard Rubino

No that would be in the product gross profit line. And as I mentioned earlier, 15...

Lawrence Marsh - Barclays Capital

Right. So just to clarify then, why the disparity? I guess that would -- if you adjust that your gross profits and products would be down a couple of percent year-over-year and service up substantially, why the disparity?

Richard Rubino

Well service is a completely different phenomenon. It ties to what Dave was mentioning earlier. The service growth is a function of growth in our client base. Significant continued growth in our Medicare business which earns meaningful and profitable service fees. And our clinical programs are continuing to contribute at very high margins. So it has nothing to do -- the service margin growth has nothing to do with that benefit from the settlement. What is it that's causing the decline in the product margin? Well, it's what we've been pointing to which is we do have the effect of the old pricing, we do have the effects of Accredo's gross margin coming down from last year. But recovery expected very importantly, the back half of the year as we see 64% of the generic effect coming in the back half of the year, which, by the way, the fact that we're able to maintain a $0.25 contribution from new generics and think it's -- was not a very easy year to do that because there has been some choppiness in the supply of some of the new generics out there. So I think all in all, by the time you get to the end of the year, the fact that we're able to hold our gross margins in aggregate stable at 6.7% is a pretty good performance, especially on top of the revenue growth we're experiencing.

Operator

Your next question comes from Glen Santangelo of Credit Suisse.

Glen Santangelo - Crédit Suisse AG

David, just one more follow-up question on the current selling season. Can you maybe give us a little bit more color around the trends for early renewals? I'm kind of curious as to what that trend looked like this year versus last year?

David Snow

It's very much consistent with last year, Glen. There's really -- frankly, it's our decision and as we've always said, we are very strategic about those we choose to offer early renewal to. And I would say it's very consistent with virtually all the years since we've taken the company public.

Richard Rubino

You can see that directly, Glen, by just looking at the progression of the renewal number we've given. We've been giving a renewal number for this year of $15 billion since we first gave guidance.

Glen Santangelo - Crédit Suisse AG

Okay. All right and then maybe just a follow-up, I mean just a follow-up on the pricing question. I think obviously everyone's always focused on your two primary competitors. Are you seeing any behavioral changes from the smaller PBMs out there, potentially getting more aggressive? Or has that behavior been kind of consistent as well?

David Snow

The way I characterized the competitive environment is that individual companies, whether they be a client or the PBM, have unique strategic motivations when they come to an individual client. So you might see someone doing something more aggressive than you otherwise would think, but it often ties to a strategic thing that they have in their mind. But when I roll the environment up to the total sales a year and the total sales environment, I would tell you that it's very largely -- completely, it's competitive, but it's rational, and it makes sense. And I think you just got strategic motivations on -- for the most part I would tell you that the best and finals [ph] (59:14) I go to, I'm not seeing a lot of secondary PBMs in the mix at all. I'm really not. You may see a name pop up here and there but that's not really common at all.

Richard Rubino

Yeah, Glen, for the extent there was a question inside your questions related to some news that was out about an auto-manufacturer and their PBM business. There are some of auto-manufacturers' [ph] (58:43) business is broken into different pieces. And the piece that was being discussed was immaterial. So I don't want investors or analysts to think that there was anything significant in those discussions. It is a clearly immaterial piece of the broader auto-business.

Glen Santangelo - Crédit Suisse AG

And then Richard, if I can just ask you one quick item on the balance sheet. It looks like the debt has been pretty consistent for several quarters in a row, but yet we saw interest expense kind of get down this quarter, and you obviously took down full year assumptions on interest expense. Is that just lower rates? And I'm trying to figure out what changed sequentially to drive that, particularly given the share repurchases this quarter?

Richard Rubino

There certainly are lower rates, but you also see there are other income other expense items that are in that wide [ph] (1:00:34) also. So you will see some fluctuations in there from period-to-period because we do have JVs and so forth that flow through those lines.

Operator

Your next question comes from Ricky Goldwasser of Morgan Stanley.

Ricky Goldwasser - Morgan Stanley

Rich, on the gross margin line, I think I heard you say that gross margin in the second half of the year is going to be about 7%, but then in the third quarter, it's going to be slightly ahead of the 6.7%. So...

Richard Rubino

I think you misheard me. Let me be clear. Starting from the top, we expect our gross margin percentage for full year 2010 to be 6.7%, consistent with last year's full year percentage. With regard to looking forward, what I said in the third quarter is that I expected it to be at the 6.7% or slightly ahead of the 6.7%. I never mentioned 7%. The [indiscernible] (1:01:51.4) wouldn't work.

Ricky Goldwasser - Morgan Stanley

No, exactly, and that was kind of like the clarification. So in the fourth quarter, we should look for margins that are slightly higher than 6.7 in order to get to 6.7% for the year.

Richard Rubino

Yes, just looking at the back half of the year, I think you're going to find yourself in the 6.7%, 6.8% range, plus or minus 50 bips.

Ricky Goldwasser - Morgan Stanley

Okay. And it sounds like this year, in particular, is going to be not as second-half loaded, but mostly fourth quarter heavy. Can you just walk us -- what kicks in, in the fourth quarter that makes the fourth so much better than the rest of the year? Because when you give your generic guidance, it sounds like there's the same EPS impact from generic in third and fourth.

Richard Rubino

Yes, well there's a lot going on in the Medco machine. And what you're going to see, I believe, is continued productivity, for example, in our distribution piece of our business. We're obviously working our way through the start-up costs that we would have had in the early part of the year. I also believe that you're going to see some improvements from just a raw purchasing perspective and from a retail contracting perspective. So there are many arrows in our quiver with regard to our ability to drive earnings growth in the back part of the year. You're going to see, I think, as we have always been, quite a bit of cost consciousness in the way we manage this business. You saw that we had a very good SG&A performance for this quarter rather, that up 1.5%. I'm hopeful that we'll continue to be successful in managing those SG&A costs. Also, the effective tax rate was actually a bit higher in the first quarter than the second quarter. The tax rate you're seeing in the second quarter is one that we expect to experience for the rest of the year. In fact, it may even go down a little bit in the fourth quarter.

Ricky Goldwasser - Morgan Stanley

Okay. And then lastly, on the 2011 selling season, I think you said it's about 45% complete. Did you give, and if not, can you give, just a dollar number -- at this point, what's your dollar number that's up for renewal for 2011?

Richard Rubino

Well, the dollar number for 2011, it's a little early to tag yet because while we have a very good idea, as you would imagine, for the scheduled renewals, the early elective renewals aren't necessarily locked and loaded yet. But I would say barring any unusual early elective renewals, we should probably be in the zone we are this year.

Ricky Goldwasser - Morgan Stanley

So about $15 billion excluding any additional early renewals?

Richard Rubino

Yes, but I'm assuming some early renewals in that. It's very difficult to, at this early stage, determine what that total early renewal base will be. But I'm fairly comfortable in the $15 billion, maybe slightly over $15 billion range. And very importantly, 45% of the scheduled fees is done, and that's, I think, pretty good performance for the middle of the year.

Ricky Goldwasser - Morgan Stanley

So that's 45% of the $15 billion? Or...

Richard Rubino

45% of the scheduled.

Ricky Goldwasser - Morgan Stanley

Which is slightly lower than $15 billion?

Richard Rubino

That's correct.

Operator

Your next question comes from the Randall Stanicky of Goldman Sachs.

Randall Stanicky - Goldman Sachs Group Inc.

First, Dave, on the commentary that you had around the pricing environment, in the Q1 call you talked about some pricing pressures, and now you referred to unique competitors, strategic needs. Have the needs of that one competitor not -- are you seeing it no longer contribute to some of the pricing challenges going forward? In other words, is that a one-off?

David Snow

Yes, all I can say is that I'm feeling more comfortable now than I did a quarter ago.

Randall Stanicky - Goldman Sachs Group Inc.

Okay, good. And then, Rich, just quickly, we talk about the 2011 generic introduction, but can you just maybe comment on not necessarily the new introduction number that's sort of a discrete number that we look annually, but how are you thinking about the generic benefit to profitability? Because we have a lot of big back half weighted sizable generics that have limited or no competition, and that changes as we move into early '11 and I would have to think would be pretty meaningful as you think about EBITDA per script and so on and so forth.

Richard Rubino

For 2011, meaningful?

Randall Stanicky - Goldman Sachs Group Inc.

Yeah, I mean look at venlafaxine or Hyzaar, Cozaar, the host of drugs that have had exclusivity. As we move into next year, we're going to see a lot of competition, and that's got to have pricing implications, which, obviously, helps your margins.

Richard Rubino

Yes, I understand your question, Mike [ph] (1:06:58.5). So yes, you would normally see that. So you have the improvement in profitability as this year's [indiscernible] (1:07:04.9) goes to the multi-source. It's a natural event and we expect that to happen. I can't give you any indication at this early stage with regard to what the effect of that in aggregate might be. And your first observation is exactly right, which is with regard to the new generics next year, it is going to be a wider number weighted by Lipitor at the very end of the year. One point on Lipitor, by the way, I added a new dimension to how you should look at the impact of new generics by sharing with you our mail-order penetration rates on the drugs. So for example, as I mentioned last Analyst Day, we were averaging about 50% mail-order penetration for the 2010 new generics. Lipitor was actually closer to 60%. So it's a very high mail-penetration drug. And well we expect to see that benefit in 2012.

Operator

Your next question comes from John Kreger of William Blair.

John Kreger - William Blair & Company L.L.C.

Could you give us an update on the competitive bidding situation for diabetes supplies? And how that might affect your PolyMedica business and sort of what the next key steps are there?

David Snow

Yes, so as you know, the competitive bidding for this coming year is for 10 MSAs. It's not for the nation; it's for 10 MSAs. There are many issues with the way competitive bidding was managed and conducted, and there are many protests occurring right now relative to the way it was handled. If you recall, this was done two years ago, and after they went through a process, it was tabled because of the inappropriateness of the process. It was done again now, and the process was the same as last time. So I think it's a little early to tell you what the outcome will be. I can tell you that relative to the 10 MSAs that are envisioned in this current bidding process, we can mitigate, and we actually already have a plan to mitigate, cost and reimbursement. So we can handle that. Our focus really is 2013 and what the approach will be for the national competitive bidding situation. So the message here is we can handle the worst-case scenario that can be envisioned relative to the current 10-MSA bidding process. And there's a lot of conversation going on now whether or not that process, even for those 10 MSAs, is appropriate. And I think the decisions are likely to be made later on this year.

Jeffrey Jonas - Gabelli & Company, Inc.

Okay. So by year end, we should have much better clarity about when these changes would be rolled out nationally?

David Snow

Basically, yes. The current thinking is it will be in 2013, just so you know. But the methodology is the key here. The methodology that is used is the key. And there's a whole list of issues about why the methodology is not appropriate that I don't want to spend a lot of time on. But those are the things that are being looked at right now down in Washington.

John Kreger - William Blair & Company L.L.C.

Great, thanks. And then just one final follow-up on the environment. Now that the dust has settled a bit on the dispute between the big retail pharmacy networks in the quarter, did that really have an impact on the selling season from your perspective? Or was it resolved too quickly to really be meaningful?

David Snow

It was resolved more quickly than I had hoped. But I can say we did have a benefit from it, but it was smaller than it would have been had it dragged out. And Tim, you -- most of the acquisition was in his area. So...

Timothy Wentworth

We were having a strong year, thankfully. I think it created a couple of additional very fruitful conversation. And I do think it has a half-life that hasn't hurt us in some continuing conversations, both in terms of plan designs but importantly, in terms of the independent model that we represent in our clinical model while being able to sort of solve for some of the concerns, shall we say, that other clients have.

Operator

Our final question comes from Helene Wolk from Sanford Bernstein.

Helene Wolk - Bernstein Research

A follow-up on the 2011 selling season. I'm just trying to understand trends in terms of your $1 billion net-new around employer versus health plan and maybe where it's coming from in terms of the competitive dynamics, independent PBMs, captive PBMs, some of the smaller second-tier players, just a real understanding of the market sort of movements for 2011.

David Snow

No, it's actually, when you look at it, it's balanced relative to who it comes from. It's coming from all the players. In terms of what types of accounts we're winning, all of our market groups are participating. I would probably say that the biggest winner relative to our different market groups is our employer group this year. Our model actually works very nicely, because we have a health plan group, an employer group and a key accounts group, which is primarily government and labor. And it's funny how the winner, in terms sales volume, kind of rotates among them. It's very fruitful that way. Last year was clearly health plan's year. This year, clearly, is employer group. However, I will say the key accounts have had a couple of nice wins as well. So they're all doing well. I would say employer group is that strongest and it's coming from everybody.

Helene Wolk - Bernstein Research

Great. And as we try to understand a little bit more about the pricing environment, how many or how much of that $1 billion of net-new -- would you say you were the best price or the leading price versus some other factor that may have influenced the selection process?

David Snow

I really can't give you a percentage that would be accurate because I honestly don't know it. But I will tell you that we have been winning business where we're not the lowest priced. We're competitive, but we're not lowest priced.

Helene Wolk - Bernstein Research

And then I guess last question on SG&A growth. I think we were expecting for the second quarter, based on your comments from the first quarter call, that there would be significant uptick in year-in-year growth, just given your compensation cycle. And we didn't see that. And I guess I'm now trying to understand what drives the acceleration that you're projecting for the fiscal year or the full year from this point forward.

Richard Rubino

It's really two things: One is, as I mentioned earlier, we are focusing quite a bit on efficiency and managing our SG&A base. But very importantly, we must continue to invest in the business. And as part of that investment, you're going to see an uptick in the SG&A in the back half of the year.

David Snow

We appreciate everybody's time today. We hope we've given you the information you needed to feel as comfortable as we are with our prospects in our business and our performance. And we look forward to talking to you next quarter. Thanks, everybody.

Operator

And ladies and gentlemen, that concludes the MedcoHealth Solutions Second Quarter 2010 Earnings Conference Call. We appreciate your time. You may now disconnect.

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