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Express Scripts (NASDAQ:ESRX)

Q1 2014 Results Earnings Conference Call

April 30, 2014, 8:30 a.m. ET

Executives

David Myers - Vice President of Investor Relations

George Paz - Chairman and Chief Executive Officer

Tim Wentworth - President

Cathy Smith - Chief Financial Officer

Analysts

Glen Santangelo - Credit Suisse

Lisa Gill - JPMorgan

Ricky Goldwasser - Morgan Stanley

Robert Jones - Goldman Sachs

John Kreger - William Blair

Charles Rhyee - Cowen & Company

Bret Jones - Oppenheimer

Robert Willoughby - Bank of America Merrill Lynch

Steven Valiquette - UBS

Brian Tanquilut - Jefferies

David Larsen - Leerink Partners

Anthony Vendetti - Maxim Group

Eric Percher - Barclays

Garen Sarfian - Citigroup

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the first quarter 2014 earnings call. [Operator Instructions] I would now like to turn the call over to our host, VP of Investor Relations Mr. David Myers. Please go ahead.

David Myers

Thank you, and good morning, everyone. Welcome to our first quarter conference call. With me today are George Paz, our Chairman and CEO; Tim Wentworth, our president; Cathy Smith, our CFO; and other members of senior management.

Before we begin, I need to read the following Safe Harbor statement. Statements or comments made on this conference call may be forward-looking statements and may include financial projections or other statements of the company's plans, objectives, expectations or intentions.

These matters involve certain risks and uncertainties. The company's actual results may differ significantly from those projected or suggested in any forward-looking statement due to a variety of factors, which are discussed in detail in our filings with the SEC.

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

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

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

George Paz

Thank you, David, and good morning everyone. Today, we will cover three topics. First, I’ll provide a perspective on our near term outlook and integration efforts. Second, Cathy will review our first quarter financial performance and revised guidance, and Tim will bring up the end by providing a business update.

Before Cathy reviews our first quarter results and adjusted guidance, I want to provide some details on our business and outlook for the remainder of the year. Our migration of members to our destination platform was completed on 1/1/14. We’re now working on decommissioning the legacy platform.

Through the remainder of 2014, we will substantially complete the integration of back office systems, footprint rationalization, and pivot our resources to focus on organic growth. Tim will talk more about this in a few minutes.

Our first quarter results came in slightly below our expectations, resulting from lower adjusted prescription volume. This is due to later than expected enrollment in public exchanges, lower net new healthcare reform [lives], and persistent severe winter weather.

The severe winter weather lasted well into March in various parts of the country, which resulted in fewer prescriptions being refilled than expected. We have also taken our guidance for adjusted claims for the year down by 30 million claims, primarily due to two factors.

First, the largest driver of the volume shortfalls was delay of several client implementations from midyear 2014 to January 1, 2015. The delay is due to the client preference and operational complexities related to a midyear implementation.

Midyear implementations are always more complex than year-end implementations. This is due to several factors, including the midyear issuance of new cards, transitioning of accumulated balances, and prior authorizations in midyear status, just to name a few.

These complexities, coupled with healthcare reform, Medicare regulation changes, and Medicaid expansion, influenced clients to delay their implementation until 1/1/15 to ensure the least amount of member disruption. The remainder of the claim shortfall is attributable to in-group attrition, along with lower net new healthcare reform lives.

Although the gross increase in membership attributable to healthcare reform was in line with our expectations, the net increase was lower as approximately 40% of our enrollees were previously with an existing Express Scripts client. We are still bullish on healthcare reform, and over the long term as we and our health claim clients gain our fair share of newly insureds entering the marketplace.

Partially offsetting projected declining claims is an increase expected in guidance for EBITDA per adjusted claim in the range of $5.20 to $5.30, with collecting higher gross margin per claim and better expense controls. This increase in EBITDA per claim is a strong tribute to our product portfolio. As our clients implement our tools, they save money while we increase shareholder value.

Based on these adjustments, we are decreasing both the top and bottom end of our original guidance range by $0.06. Our revised 2014 guidance is $4.82 to $4.94, which reflects year over year growth of 17% to 20%, excluding United Health Group.

Looking forward, clients need our help more than ever to navigate a challenging environment, including drug price inflation, regulatory complexities, coverage expansion and rapidly increasing specialty costs. Our innovative solutions, including formulary management, specialty management, home delivery, and retail network tools, will provide significant savings to our clients, improve the health outcomes, and drive our organic growth.

I am excited about our company, our industry, and our future. At this point, I will turn the call over to Cathy for a review of our first quarter results.

Cathy Smith

Thanks, George. Good morning everyone. Let’s review the quarter. Our financial results for the quarter were impacted by the adjusted prescriptions, which came in below our expectations. Adjusted claims decreased 9% from last year, excluding United Healthcare.

As George mentioned, the shortfall in claims is attributable to a few things: persistent, severe winter weather; later than expected enrollment in public exchanges; and lower net new healthcare reform lives. While EBITDA was down 2% from last year, excluding United Healthcare, due to the decrease in claims volume. EBITDA per adjusted claim is up [3%].

The year over year decline in SG&A expense reflects efficiency gains from the integration of our Medco acquisition. EPS of $0.99 is within our guidance range, representing a growth of 8% over last year, excluding United Healthcare. In addition, we generated $454 million of cash flow during the quarter and repurchased 8 million shares for $618 million.

As of the end of March, we had 72.8 million shares remaining under the share repurchase authorization, and during April, we settled the ASR agreement and received an additional 0.6 million shares.

Now let’s talk about 2014 guidance. As George said, our revised projections for adjusted scripts is in the range of 1.27 billion to 1.33 billion claims, which represents a year over year decline of 4% to 9%, excluding United Healthcare.

Our new EPS range for 2014 is $4.82 to $4.94, which represents growth of 17% to 20%, excluding United Healthcare. The year’s expected EPS is at the top end of our longer term guidance range.

We are also adjusting a few other guidance ranges. We’re reducing EBITDA, reflecting the lower claims volume. However, EBITDA is still growing 6% to 9% year over year, excluding United Healthcare.

We’re decreasing SG&A expenses due to lower volumes, and being offset a little bit by better expense management, and increasing EBITDA per adjusted script to a range of $5.20 to $5.30, reflecting higher gross margin per claim, as well as better expense controls.

As a reminder, when we increase margins, our clients are saving money too. A great example is what we did with the National Preferred Formulary. We saved our clients over $700 million. Also, we have a balanced approach to growth. Tim will share in a minute how we are focused on growing script volumes. We are also focused on continuing to increase our earnings per script.

Our capex for the year remains at the same level, $400 million to $450 million. And finally, with regard to 2014 guidance, as a result of the lower claims count and revised earnings guidance, we are decreasing our forecast for cash flow from operating activity by $150 million to a range of $4.55 billion to $5.15 billion.

On a per share basis, using the midpoint of our earnings, cash, and share guidance, our free cash flow per share is $5.80, or nearly $1 greater than our midpoint of our EPS guidance of $4.88.

With regard to our second quarter projections, EPS is expected to be between $1.20 to $1.24, up 12% to 16% year over year, excluding United Healthcare. Also consistent with 2013, we anticipate earnings related to a large client contract will be realized in second quarter due to the structure of the contract.

Lastly, I’ll reiterate that while we are seeing fewer net new healthcare reform lives than anticipated, we are excited about the longer-term opportunity healthcare reform provides to insure more lives.

At this point, I’ll turn the call over to Tim.

Tim Wentworth

Thanks, Cathy, and good morning. Two years ago we embarked on a journey to build one of the most consequential companies in healthcare. During two challenging years, we have focused relentlessly on moving to a single platform in order to efficiently innovate and remain compliant in a complex environment.

We’re now focusing on driving best-in-class service for our clients and members and no other PBM is positioned with our scale, breadth of service, and ability to leverage a single robust platform.

Since I was named president three months ago, we have appointed significant new leadership and renewed our focus on operational and service excellence. Also, we are focused on ensuring strong retention of our existing book of business as we complete the integration George discussed, and as our new leadership takes hold.

We’ve had some significant early successes, including the seven-year renewal of the Department of Defense, as well as recently renewing two of our largest health plans, but we still have work to do, as it is still somewhat early in the season.

Our other area of focus has been on aligning our resources to begin to fully pivot to organic claims growth in the future. Again, while it is still somewhat early in the selling season, and our ability to win new business this year may be somewhat muted as we finalize our integration, we are well-positioned to grow organic claims volume longer term and have built a powerful platform and organization which will deliver long term claims growth.

As part of the resource alignment process, I evaluated our client service model and further structured our client service organization into four different market divisions, incorporating dedicated sales teams into each of these individual divisions and better aligning incentives with our overall growth strategies.

Over the next several years, through these divisions our growth will be primarily driven through five specific areas of opportunity. First, we are today working differently with clients in our strong health plan book of business, both in how we are collaborating to help them grow their commercial lines of business as well as how we are helping to drive their success in regulated markets: Medicare, Medicaid, and public exchanges. Our innovative constellation star rating consultative tool is just one example of a well-received targeted capability we had already delivered from our new platform to our Medicare clients.

Second, the recently announced end of year extension of our DoD relationship not only validated the strength of our capabilities, but provides a significant growth platform through such areas as expanding our already substantial home delivery program as well as expanding the reach into the military treatment centers worldwide.

Third, over the last several weeks, we’ve had the opportunity to meet literally hundreds of our direct employer clients through various advisory group meetings and our outcomes conference. In these meetings, as well as in our meetings with C suite leaders, it is clear our employers still see employees as their most important resource and are looking to continue to provide benefits, but at the same time, manage them more closely through leveraging our extensive suite of tools such as our National Preferred Formulary.

Fourth, with new sales generation embedded in our individual market facing divisions, we are positioned to drive a disciplined but aggressive approach to sales as our resources, which previously were focused on integration, free up. Importantly, our over 100 one-one implementations this year were 99% referenceable and serve as strong evidence of our ability to successfully win and install business onto our new platform.

Finally, all of our clients continue to be very focused on long term management of specialty pharmacy spend. Our Accredo specialty pharmacy is unique positioned to care for the broadest range of patients, leveraging the most effective management tools, to deliver the lowest cost of care for this growing population of patients. Accredo clearly represents an important long term growth driver for us and solution for our clients.

These areas of focus, along with our core growth drivers of mail, retail, formulary, and clinical programs, position us exceptionally well for long term growth over the next several years as we fully put our integration into the rearview mirror.

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

George Paz

Thank you, Tim. 2014 is a foundation year. We have spent the past two years integrating our two companies to create a new Express Scripts. No one provides the depth and breadth of solutions that we do on one easily accessible platform.

As Tim said, we are now positioned to [unintelligible] integration and now focus on driving organic volume growth. Our innovative solution’s ability to successfully manage healthcare reform and unmatched size and scale position us for long term organic growth as we better control client costs and improve patient outcomes.

This concludes our prepared remarks, and we’ll be happy to answer any questions. Operator?

Question-and-Answer Session

Operator

[Operator instructions.] Our first question comes from the line of Glen Santangelo from Credit Suisse.

Glen Santangelo - Credit Suisse

George, I just wanted to follow up on the guidance revision. Essentially, if I look over the past three or four years, I think it’s probably fair to say that the guidance communication, sort of post the Wellpoint acquisition, post the Medco acquisition, numbers have been kind of moving around a little bit, probably a little bit more volatile than I think you would have liked and I think ultimately maybe drove the CFO transition. And so I’m kind of looking at the guidance here again in the first quarter and I just want to get your take on your full year assessment. How do you think about the guidance at this point? Are you very confident that this is kind of it? Do you feel like the numbers aren’t conservative enough from where you sit? Just any perspective around the recent volatility and the change today, and how we should think about that going forward?

George Paz

You know, when you’re looking out to the future, you’re looking out over a year, as we did when we put up our original guidance. There’s just a lot of uncertainty. I think the uncertainty around healthcare reform, and you read every day about how many people are coming in, or how many people signed up. We’re up over 8 million, I guess, but they still can’t get hard numbers on how many of those people were actually uninsured before, which is really the important number. If it’s just cannibalization of the current book, that really isn’t driving net new for us in a meaningful way.

And I think that’s what kind of caught us a little bit by surprise, is that we saw the numbers coming in early in the year, but we didn’t have a methodology, because it was too early. All we were seeing was some enrollment forms coming through. But we didn’t have the ability to track back through at that point to determine that 40% of these people were already enrolled us. They were just going from our left pocket to our right pocket, if you will.

And so that was a little bit of a surprise to us. On the other side of the coin, the weather, I really didn’t think that the weather would have that sustainable of an impact either. When we were in January and February, we saw scripts slightly below budget, but we thought that those scripts would get refilled, and then in fact people would get to the drug stores and fill their scripts. And what ended up happening of course is that the weather persisted, and it’s pretty amazing how many people actually skipped a script all together and caused the delay to come in.

Now, fortunately, at the end of March and into early April, those numbers have come back stronger to where they’re more in line with the guidance we’re giving. So the question is, do I feel comfortable with the guidance? I absolutely do. Our best guess today is the midpoint of our guidance.

The clients that decided to not implement, that happened more recently as all of the changes were taken place and things in healthcare reform keep getting extended and rules were changing. Medicare regulations were on again, off again, and so there was just a tremendous amount of complexity in our industry.

And we couldn’t have anticipated that or seen that coming. And so we’re certainly not in a position to argue with the client. If they want to wait, and it’s in their best interest, we’re going to support them in any way possible. So we definitely will do that.

Again, I feel very good about our guidance. I feel like, again, at 17% to 20% growth, and for the size of our company, I think that’s pretty astonishing. When you look at the cash flow generation, I also think that’s quite good for a company of our size, managing through the transitions and everything else we have. So I’m very proud of our people, our company, what we do in the marketplace, and I feel good about our guidance.

Glen Santangelo - Credit Suisse

Maybe if I could just ask one follow up. I think I understand kind of what you’re saying on the retail side of things, but the mail order number was certainly a fair amount below what we had expected, and so kind of curious to get your perspective. Did the weather impact your mail order business as well? And as you think about mail order growth, looking out to the balance of the year, are you assuming some return to growth at that number? Because it feels like the growth of mail order has stalled.

And so I’m just kind of curious, as you think about looking at your business more strategically over the next couple of years, you obviously have a fair amount of cash flow, the leverage is now sub 2x, you’ve already brought back a bunch of stock. Is it maybe time to start thinking a little bit more strategically in terms of deploying that capital to maybe augment some of the existing growth drivers?

George Paz

Great question. And we do that, obviously, through our planning process. We look at where we believe we should be strengthening our approach to the marketplace, and we deploy capital accordingly. But I will tell you, your question is right on. It’s the question that we’ve been asking internally.

You know, in all my years, and I’ve been at this I think 16 years now, I’ve never seen weather really affect in a meaningful way mail. This is the first year it actually happened. And I think it’s because it was really cold outside. And if you live in the rural parts of America, which are often heavy mail users, even getting to the end of your street to get to a mailbox may have been a challenge for people. We’re doing a lot of research to figure out what’s going on.

But to your point, our refills in mail, which you wouldn’t have expected to come down, actually did come down through that period of February and March. And we did see it come back some in March. So we’re doing the analytics and trying to get into it and understand what actually took place there.

You know, longer term, I’m still a big believer in mail. I just think most people today, I believe, shop online. They like to buy commodity items at the most reasonable, accessible way possible. And I don’t know why mail would be any different. I do think that there’s some elderly people that probably are more comfortable still going to the drug store to get their 30-day script and having a nice conversation with the pharmacy tech behind the counter, but I think as you look at the population at large, we don’t see, across the country, internet sales declining. We see them growing.

And I’ve got to believe that that’s going to be where our industry, like most other industries, is headed. You get a cheaper price, a more accessible product, delivered directly to your home. And it’s safer, the air rates are much lower. Your follow up is a lot easier. You don’t have to stand behind the counter in front of a bunch of other people telling them about your disease state. You can do it in the privacy of your own home, in front of a computer, where one of our specialists in pharmacy can talk to you about your specific disease state.

You know, I’m selling you, Glen, but I think it really is the right answer here, that it’s got long term legs and it will grow. And we will compared to focus on it.

Glen Santangelo - Credit Suisse

And maybe just the capital deployment?

George Paz

Sure, we have generated a lot of capital. I don’t know, Cathy, do you want to talk about that?

Cathy Smith

Sure. Glen, it’s the same as we said at the investor day. Our priorities for capital deployment remain the same. We’re going to invest in ourselves first. We think that’s the highest return to shareholders. We’re going to secondly look for strategic acquisitions as you asked. We’re always evaluating data as a possible growth vehicle as well. And certainly we are committed to returning cash to the shareholders, as we’ve demonstrated in the past. So we’re still committed to those priorities, and we’ll continue to do that.

Operator

Our next question comes from the line of Lisa Gill with JPMorgan.

Lisa Gill - JPMorgan

Tim, I was wondering if I could ask just a couple of questions around the early parts of the selling season. You clearly talk about your great specialty offering. Can you talk about, one, what we saw in this first quarter? I know that Express Scripts made a big push around the hep C market and pushing patients off waiting for a new therapy to come to market. But is there positive trends on the specialty side of what we saw with Sovaldi and others?

And then secondly, you sound a little more cautious on the selling season than I’ve heard you talk about previously, that you still have some work to do. Can you maybe just give us an idea of how big the pipeline opportunity is out there this year, and some of the things you see beyond the piece of the business you have to renew?

Tim Wentworth

First of all, on Sovaldi and specialty, there’s no question that one drug has obtained a lot of attention. It’s sort of become the lightning rod for a much more significant issue that our clients are facing, which is a significant product pipeline, new products coming out at prices that are not sustainable for payers, either public or private payers.

You know, when we had our outcomes conference, we had clients representing over 40 million Americans literally shoulder to shoulder signing up to have us sort of take their names and take it forward to some of the manufacturers and indicate they are quite willing to manage these areas more directly. So what we see, we see continued strong interest in the [unintelligible] therapy areas.

And we’re right now in the middle of what we call our CPS season, which is our client annual reviews that are clinically based, but also financially underpinned. And we clearly are seeing that the 18% trends on inflation and the new drugs combine to really give clients a second and third look, even those that were a bit reluctant to manage this. And that obviously is going to work to our benefit.

We also saw international preferred formulary. We began to take specific actions in a number of specialty areas which again have worked out very, very well for clients and they’re going to see that coming through the results. And the [unintelligible] noise has been minimal. So the clients today would tell you, if you talked to our clients, we’re able to manage these areas more aggressively and at the same time execute with very minimal to no client noise.

I’m not going to talk specifically about Sovaldi, and Dr. Miller’s not here today, so I can’t put him on to do that, other than to say that’s an important area for us, and we’re going to execute a number of strategic alternatives there that will ultimately benefit our clients and the patients.

In terms of the selling season, it is early, although early mid I guess we would say. And we actually have a good number of very good prospects in place. I would tell you that it is not a huge pipeline once you remove the very large case that remains at CVS, the [FEP]. It’s a more normal year when you back that one out. But we are competing very, very well in some large employer spaces and in several health plan spaces.

And I’m not going to declare victory, because it is a very challenging year. It’s a key amount of focus on service and so forth, and I feel that we’re very well positioned, but it is still early.

Lisa Gill - JPMorgan

Just as a follow up on specialty, you talk about this being a nice benefit for you. Cathy or George, can you talk at all about how it impacted the numbers in the quarter? This is clearly part of an investment basis around the PBMs that are going to help control those costs, but it’s also going to be a profit driver. Clearly, big drugs in this first quarter, and your EBITDA per script coming in better. I know George you called out SG&A, but gross margin per script is also better. Are we starting to see the impact of specialty at all in the numbers?

Cathy Smith

Just to highlight, the [specialty] came in where we had expected for the quarter, but as you said, it is absolutely a growth area, continuing for many years.

George Paz

And just to make sure, when we talk about it came is as expected, understand that we were at the forefront of this drug when it was going through clinical trials, and we were talking to the manufacturers and our clients, because we were getting senses of where this drug was going to be priced.

And we had some early discussions with manufacturers and others about where they were pricing their drugs, and this drug in particular, so we knew it was going to happen. And so we came at this, and this drug, like all other specialty drugs, we do make a profit on them. The question is, what’s our driver? Our driver is to make sure we manage our clients’ trends, because we also make money by doing step therapies and prior authorizations. So our job is to make sure that the drug, when it’s prescribed, is being prescribed at the right time for the right person, for the right utilization.

And you know, the only area where the drug could hurt us, if you will, would be in our PDP. But that’s a very small piece of our overall book of business. It’s a sizable PDP, but relative to a gross profit and net income, it’s not all that meaningful to the rest of the book.

And quite frankly, because of Dr. Miller and his efforts, and knowing utilization trends and where it was going to go, we had a very low price into our product. So it didn’t have a negative impact on our PDP, and it was accounted for appropriately in our PBM results.

Operator

Our next question comes from the line of Ricky Goldwasser with Morgan Stanley.

Ricky Goldwasser - Morgan Stanley

First of all, just so we better understand the dynamics of the scripts for the year, can you help us understand how much of your new wins in 2014 were midyear starts? Just when we do some of the math, given the change in guidance, it seems that a lot of that incremental business was really kind of supposed to come in midyear, and now is being pushed out. Is that a fair assessment?

George Paz

No. The majority of the business starts up on January 1. It’s fairly uncommon to have sizable midyear starts. It does happen, but not very often. Sometimes, with a state plan, they’ll be on a fiscal year, and so their year-end actually occurs not necessarily midyear, but it could be midyear, first quarter, third quarter, depending on where they’re at.

So that occurs on occasion, but the lion’s share, most of the clients come in on 1/1. And for clients that have calendar years, this is a lot cleaner. Otherwise, you’ve got to transfer accumulated balances and if you have high deductible plans, the balances all have to come over. There’s got to be coordination between the medical provider and the PBM in order to make sure those balances are accurate on the day of the transfer.

Often, prior authorizations are tied to 1/1, when new scripts get filled for the first time, as they get into a calendar year cycle. And therefore you’re transferring active in-flight prior authorizations. So there’s a lot of things that go into this that really need companies for the most part to do year-end implementations.

Having said that, occasionally they do come in midyear. So this year is no different. As Tim talked about the 100 clients, all of those came in 1/1. And it just so happens that a couple or several are clients that were scheduled for midyear, and just decided to delay it.

Ricky Goldwasser - Morgan Stanley

Would you say that these couple of clients were just kind of bigger in terms of lives?

George Paz

These were not inconsequential, that’s why there’s a 30 million claim revision here.

Ricky Goldwasser - Morgan Stanley

And then Tim mentioned that you renewed two of your health plan clients already. When do you expect to hear renewal decisions on the rest of your health plan business this year, where you’re the incumbent?

Tim Wentworth

We would expect that we should hear, in the health plan space in particular, during the second quarter, during the quarter that we’re in right now, just because transitioning for those clients, particularly if they’re in regulated lines of business, is a more complicated piece of work that requires a little bit more lead time. And the flip side of it is the cases that we are actually working on to come our way, we expect those decisions to be made this current quarter as well.

Ricky Goldwasser - Morgan Stanley

And then lastly, obviously Wellpoint is a very large customer and you made some comments on the PBM business earlier in the year. Can you just give us some color on kind of the Wellpoint relationship and any price [checks] that are embedded in that contract?

Tim Wentworth

As you would expect, I’m not going to go into any detail. What I would say is we really, really value that relationship. We work at a number of levels inside the firm to create opportunities. We believe we’ve helped them grow, and I think they would say that we have worked very hard to help them grow and more importantly to help them manage their results.

And so from the standpoint of any comments beyond that, what I would just say is we have a lot of years left to work together. We are very aligned in terms of growing our relationship. And the more that we do that, the easier everything else will get. And so I feel very, very good about where we are with Wellpoint.

Operator

Our next question comes from the line of Robert Jones from Goldman Sachs.

Robert Jones - Goldman Sachs

Just wanted to go back and follow up on the question around the reduced script outlook just a little bit more. It sounds like the push out of these few clients represented you said about a 2% reduction that you’re making today. So if I take a step back and look at the revised script guidance, the midpoint of your new outlook seems to ultimately assume no net contribution from January 1 starts or ACA, given that your retention rate last year was I believe around 94%.

So am I thinking about those moving pieces correctly? And then I guess the only variable left would be in-group attrition. And is that really meaningful enough to offset what I would assume to be incremental with January 1 starts and ACA?

Tim Wentworth

Let me just jump in and say there are two other dynamics that are pretty fundamental when you’re trying to understand it. Then I’ll have George probably add any additional coverage. But one, as you know, we put in place in the Department of Defense exclusive home delivery for over 65s.

And we had certain projections on how fast that would be uptaken. And what I would say is that was a piece that was a bit slower than what we had initially thought. It’s showing good strength as we come into the second quarter, but it was a little bit softer in the beginning due to some of the implementation and the timing of that.

The other piece, as you may recall, CMS has some very specific regulations around home delivery, which have subsequently been clarified to the advantage of being able to take care of those patients that mail more seamlessly and smoothly. And we did see an effect of that. And you don’t get those scripts back, and in some cases, again, we’re out using our PRCs to bring those patients back into mail, but we did see, in the first quarter in particular, but some hangover as it relates to that as well.

And I think those two pieces together also add up to how you’re getting to the end number that you’re asking about.

George Paz

Does that suffice? Or would you like some more information?

Robert Jones - Goldman Sachs

No, I guess that’s helpful. It just seems like it’s kind of a net wash relative to the retention rate last year. And I think most of us would probably have thought there would be something incremental on top of that, given just new starts and ACA would be incremental year over year.

George Paz

I went to a forum in DC not too long ago, and there were well over 100 of the largest companies in America represented there. And you know, when you talk to the CEOs of other enterprises, except for some companies that may be in hospitality, people know the value of their employees. But quite frankly, there’s all different types of employees.

And if I think for the lower end wage jobs, I think management is more looking at what is the overall cost to deliver. And I think that what you’re seeing is that more and more jobs are going to be under 30 hours for noncritical positions, because think about the labor rate and the step function that occurs. If I’ve got people who are working 25 to 28 hours a week, I pay a certain price without healthcare. If I go to 30 plus, now I’ve got to factor in healthcare costs, and that is not insignificant.

And so I think you’re seeing quite a bit of that. That’s what the in-group attrition is doing to us. As we look across our commercial book of business, there’s quite a few lives that have dropped out. And it could be a softer economy, but I believe a lot of it is actually people managing their population and looking to see if they could push those lives out.

Now the question is, how effective is healthcare reform at bringing those people back into the marketplace? Probably short term it’s not very effective. Long term, it will be. Something will have to give there. People are going to go without insurance and without coverage forever. So that’s why I’m still bullish on this whole healthcare reform opportunity for us. I think it’s going to pay off. I think it’s just been a very rocky start, and we’ll see the benefits of this over time.

Robert Jones - Goldman Sachs

And I guess just to lead off then, as I think about ACA, I think the latest number, as you mentioned, 8 million gross lives on the public exchanges. And I recognize you guys have said that 40% of those seem to be going from one pocket to the other, but today, do you feel like Express Scripts is winning their fair share? Are you picking up around 30% of the net exchange lives that are available?

George Paz

Yeah, I think we actually picked up more. The problem is that it’s from one pocket to the other. That’s the biggest issue. And I think if you go net-net, when you look at in-group attrition and what we’re picking up, because what we can do is if you with [unintelligible] of X and go to [unintelligible] of Y, through healthcare reform, or you stay within your same plan, we can track you through pretty easy.

Where we have a little harder time, it’s a question of grinding through a lot of data, is if you were ABC Corporation and then you sign up for healthcare reform. It’s a lot harder to find you and track you back to your prior employment.

And so 40% may actually be a conservative number. It could be higher than that, as we refine all the data. So I do think what we’ve seen is we picked up more than our percentage share, but we’re also seeing that it’s just a cannibalization of our current book to date. Again, nobody’s come out with a number yet saying how many new lives are insured and how many of those people are actually paying premiums to stay in the enrolled as members. So we’ll see those numbers as the year progresses.

Operator

Our next question comes from the line of John Kreger from William Blair.

John Kreger - William Blair

Another volume question. Are you seeing any further reduction in per capita consumption as we get more and more of these HSA plans being adopted? Or has that stabilized from what you can tell?

George Paz

You know, it’s so hard to tell for the first quarter, because of the weather. And we saw a significant dropoff in February claims. Towards the end of the month, we saw those February claims come in when we closed the March books. And that number had dropped. And so that weather number was pretty tough. Again, I thought a lot of those would have come back during the course of March, but they didn’t. Well, they could have, I guess, but it may have been postponed out through the rest of the year.

You know, as far as overall utilization, the best we can tell, it’s staying flat, with virtually no growth. It’s nowhere near what we had in 2008.

John Kreger - William Blair

And I know it’s early to be thinking about 2015, but have you had an opportunity to figure out to what degree the Tricare contract can grow around the military treatment facility opportunity?

Tim Wentworth

You know, we’ve had the opportunity to work with a couple of the MTFs with our current relationship and what I would say is first of all, each one is quite different in terms of the patient mix and so forth. Some of them location wise, if you just talk about overseas as well as here. So the short answer is, it’s early in the process, but we believe that it is significant volume that we’re going to be able to help the DoD manage over the long term.

Operator

Our next question comes from the line of Charles Rhyee from Cowen & Company.

Charles Rhyee - Cowen & Company

Going back to the comments when you talked about the net new lives being below what you expected, and as you kind of go back through the enrollments you’re seeing, I guess a lot of it was from existing members going through the exchanges, can you talk about what the margins have looked like between the two groups, now that you can see that you had them before and now you’ve got them in another venue? Can you give us a sense of what that looks like?

Tim Wentworth

First of all, it’s early, because utilization patterns are still emerging as it relates to the healthcare reform lives. We certainly like the fact that over 40% of them are in plans where mail is incentive or even mandated. And this is also a potential muter of our mail service growth this year. In those where it’s not mandated, they often would not have been hitting the first opportunity to move into mail until the first part of April.

So what I would say is our anticipation is the margins will be as good or better than where those lives were, particularly those that swapped in, and also somewhat better where we are particularly managing the patient, than our typical health plan margins. But it’s still early to declare. We probably won’t break it out anyway, but early to declare how much more so.

But we like those lives, we want a lot of them. We love the fact that our clients disproportionately appear to be winning share, and over the long term we think that’s going to be very good.

Charles Rhyee - Cowen & Company

So are you kind of saying that the plans that they came from didn’t really push mail, and now they’re in plans that a large percentage have more incentives for mail?

Tim Wentworth

That’s right.

Charles Rhyee - Cowen & Company

And one other question around your Part D, and I think you might have addressed it a little bit earlier. When you look at the total lives that you’re managing, and obviously a lot of it is EGWP plans. Can you give us a sense of the total number that you’re actually actively managing?

Tim Wentworth

I don’t have that number off the top of my head. It’s a significant number of EGWP lives, as you say. We’ll have to get back to you on that one. I don’t have that number off the top of my head. Especially when you include the EGWP, it’s a significant number. When we post our information on the internet, we’ll make sure we answer that number in our posting.

Operator

Our next question comes from the line of Bret Jones from Oppenheimer.

Bret Jones - Oppenheimer

I was wondering, and you sort of touched on this a little bit, if you could talk about the utilization in the quarter from the 40% of ACA lives that already had coverage. Since you had that book of business before, could you talk about what you saw from a utilization perspective?

George Paz

You know, as Tim said, it’s very early to know yet, because a lot of these lives came on throughout March, and particularly in March there was a big drive. And so I don’t have good data on that yet. But the important point here is a lot of these have gone from open plans to where they’ve selected healthcare reform plans which are much more focused on cost containment. And the cost containment is what we do best, which is around our tools for formulary management, mail order, narrowing of networks, and things like that. So we don’t have good data for you on that today, but we’ll certainly track that, and hopefully on the next call we can provide better information.

Bret Jones - Oppenheimer

Do you know if there was any lapse in coverage as those lives transitioned between January and when they came on through the exchanges in March?

George Paz

I don’t have that in front of me. I do know we can track them. I suspect it probably was, but I don’t know that for a fact. So let us also look at that. I’m not sure we can get that data very quickly either, so that may take some digging.

Bret Jones - Oppenheimer

And referring to the 40% of ACA lives that already had coverage, can you tell us what percentage came from employers, and what percentage you were able to recapture through the exchanges?

George Paz

Yeah, that’s what I said earlier. Most of the lives we can track are from plan to plan. We do know that some of them are from employer to plan. We’ve seen some incidents of that, but we haven’t been able to track through all the [unintelligible] attrition lives to see whether or not they’ve surfaced inside of our covered plans, our healthcare reformed plans. So that’s analytics we still need to get done.

Operator

Our next question comes from the line of Robert Willoughby from Bank of America Merrill Lynch.

Robert Willoughby - Bank of America Merrill Lynch

Cathy or George, it’s tough to get to the share base targets without some assumption of a massive share repurchase effort maybe as early as next week. And I think given some of the challenges that you’ve had, meeting guidance, that Glen politely referenced, any chance you could give us any clarity on what your guidance assumes for the second quarter and for the year in terms of repurchases?

Cathy Smith

Our first quarter, of course we did repurchase 8 million shares. That was consistent with what we had intended. We still had the ASR out there, and we had a small window, so I think that’s why you’re seeing that. If you look at where our cash flow is, and if you look at our guidance of EBITDA growth at 6% to 9% and EPS growth, you’d have to assume some share repurchase in there, which is appropriate. So when our stock is down, and it’s a buying opportunity, we’ll try to be prudent for the shareholders, and we’ll stay committed to what we’ve already guided.

Robert Willoughby - Bank of America Merrill Lynch

That’s kind of like the standard answer, though. I mean, you really have to take a pretty big bite here to get to your targets for the year that you broke out, to the high end of 765 million shares. That implies a lot today.

Cathy Smith

You know that we’re not going to say, “We’re going to go out and buy tomorrow,” right? Because that would affect our stock price. So we’ll try to be prudent. We like the flexibility of having time, which we will. And we’re still committed to what we’ve guided.

Robert Willoughby - Bank of America Merrill Lynch

And George, just one reference on the subpoenas. I don’t really pay much attention to the pharmaceutical ones, but the U.S. Department of Labor here looking for five years of data on your clients. I mean, is that just a fishing trip by them? Any way to narrow down what they’re potentially looking at?

George Paz

You know, that’s a brand new subpoena that recently came in, and we are in compliance. You know, government has authority to ask for anything they want, and so we’ll comply and we’ll give them what they need, and we’ll see how this turns out over time. We’ll certainly keep you posted and update our disclosures as we get information, but today it’s way too early to understand what’s taking place here.

Robert Willoughby - Bank of America Merrill Lynch

And just lastly, the inventory moved down for the first time here post Medco close, the first big move. What’s the trajectory between now and the end of the year? I’m kind of wondering why maybe you had to bring cash flow guidance down.

Cathy Smith

Great question. We’re really pleased to see the progress in inventory. There’s still some opportunity and so those of you who follow legacy ESI, they’re really, really great at some of the cash management around inventory, [unintelligible]. So we have some opportunity to continue to press that, and we will. However, as George said in his remarks, this year we’re finishing up a lot of the back office integration, and that’s crucial to being able to sustainably extract some of the inventory.

Operator

Our next question comes from the line of Steven Valiquette from UBS.

Steven Valiquette - UBS

There’s been some talk on conference calls of other companies in the pharma supply chain about delay of some big generic launches this year. You have some impact in mail channel, some not so much. But just curious how you think about that within your guidance, if that moves the needle one way or the other.

George Paz

That’s a great question. There’s always so many moving parts, whether it’s new product launches or whether it’s patent challenges, or whether it’s actual weather. There’s exclusivity or nonexclusivity on a given drug. We do our best to try to calculate what the different options are and how that may impact.

And then to the extent that there’s a delay or if there’s other changes, we also try to do our best to have strategies around what happens. So if we anticipate a patent to roll off midyear, and it doesn’t, we usually have a plan B and other things we can do to try to manage around that drug and try to hold members on that drug and do things.

Because, you know, the worst thing that happens, and years ago this used to happen to us regularly, was patents would get delayed, there would be a patent challenge by the manufacturer, and meanwhile, the other manufacturers pick at that patent usage in order to get them into their branded drug, so when it ultimately goes generic, they have less of a generic pool.

So we have a lot of programs in place to try to make sure that we maximize generic pull through once it goes and then we also focused on making sure we can maximize our profitability during those periods. So without getting into a lot of detail, our guidance takes into consideration our best guess as to what’s going to happen, and then we have other plans built around them to try to make sure that we hit our numbers. So as I said earlier, we feel comfortable with where we’re at today.

Steven Valiquette - UBS

As far as the customer categorization of the implementation delays, did you mention whether that was more health plan partners or commercial customers? Or is that a mix of both, just in terms of those implementation delays?

George Paz

You know, I’d prefer just to keep that quiet. It was several clients, and we just don’t want to get into specifics about any client.

Operator

Our next question comes from the line of Brian Tanquilut from Jefferies.

Brian Tanquilut - Jefferies

One of your competitors talked about surveys that they’ve done on service levels, and I think PBMI came out with a survey as well recently. Tim, you mentioned something about service levels early on in your comments. I just wanted to hear what you guys are hearing from your clients as you discuss, in your [pitches], or when you try to renew your contracts, in terms of what’s changed this year and what people are looking for from you guys in terms of the service level area?

Tim Wentworth

What they’re looking for, obviously first and foremost, is really consistent and excellent member service, where they can put increasingly focused management programs in place and they work exactly as they’re supposed to work. And what I would say is that sounds easy, but as you see more step therapies, whether that’s on the CMS side or on the commercial side, particularly on the CMS side, your margin for error there is nothing, because you’ve got patients who are in need of the proper medication and our job is to get them that medication.

And we do a terrific job of that, but I can tell you that all the PBMs, I think [unintelligible], have been very pressured as it relates to the increasing complexity of that. Physicians hate it, because we’re chasing them to actually validate a particular prescription or potentially question something that they’ve done.

So that is a particularly high area of focus for us. It’s one of our key corporate initiatives, is to actually take us from the sort of standard of the industry to setting the standard as it relates to coverage reviews, for example. So those are the kind of things that we see clients looking at.

The very vast majority of our clients would say we’ve done a good job in that, and in servicing their members and servicing them generally. I’m sure that there are absolutely clients who, through the integration, we took through the ringer, and we have been in recovery mode with, and it doesn’t surprise me that there are some of those you would see. But that is certainly not even a small minority.

Brian Tanquilut - Jefferies

And just to follow up on that last portion of your comment, you sounded more cautious on winning new business this year, but what’s your sense or comfort level on retention? I know you’ve given guidance, but as we’ve gone further along on the selling season, has your view on retention changed from when you did the investor day in February?

Tim Wentworth

At this point, no. I would say that there’s not anything [unintelligible] from the retention. It is a challenging year, as you would expect it to be. We are very focused on it, and at this point, I would not tell you that we are concerned from the numbers that we gave you at analyst day.

Brian Tanquilut - Jefferies

Cathy, what kind of ramp have you guys assumed in terms of health insurance exchange, enrollment, and Medicaid enrollment or uptake in the guidance for the year? Because clearly, it sounded like we were a little optimistic in Q1. So just wanted to hear how you guys are viewing the ramp and net new lives for the rest of the year.

Tim Wentworth

So that’s behind us now. The deadline was the end of the first quarter. So we don’t see more lives coming in until 1/1 of next year, in any meaningful way. There could be some trickle, I guess, but that won’t really have any impact on our guidance.

Operator

Our next question comes from the line of David Larsen from Leerink Partners.

David Larsen - Leerink Partners

Tim, can you talk a little bit more about the change in your sales approach? When did that start? And just any more color you can provide around the region change that you mentioned earlier.

Tim Wentworth

As I talked about, we took advantage of a number of leadership changes. And one of the leadership changes we made was actually to take our head of sales and put him in as the head of our health plan division, because if you think about it, helping our health plans grow, as I mentioned, is a crucial part of our overall growth strategy.

As part of doing that, therefore, we took our sales force and we actually allocated it both to our health plan division as well as our federal and our employer/commercial division, in such a way as to better integrated it into those areas so that what you’re out there selling and delivering is all integrated under a single leader for each of those areas.

You also just have a more natural division of knowledge to the kind of things that the buyers in those various areas are looking for. So it was literally people being reassigned to new leadership.

Operator

Our next question comes from the line of Anthony Vendetti of Maxim Group.

Anthony Vendetti - Maxim Group

I was wondering if you could talk a little bit more about the opportunity with the TRCs. I think that’s a huge opportunity for you guys going forward. Obviously you mentioned at the analyst day that that was one of the reasons you bought Medco. Can you just quantify what that opportunity could be over the next three to five years, in broad terms?

George Paz

I’ll let Tim certainly chime in here, but as I did say on the analyst day, or investor day, that was one of the things that I thought Medco really excelled at and did well. When you think about, if god forbid you’re diagnosed with some kind of a disease, diabetes or whatever, chances are you don’t want to continue to go to your general practitioner for that special disease state. You want somebody that’s up to speed, understands the comorbidities, the interplay of the side effect profiles of the drugs you’re taking and the risks associated with your disease, and somebody that can really consult with you, especially when you get into the specialty products.

And I think it’s a really smart move, it’s a good thing, and I will tell you, over the last two years we probably have not come close to optimizing our position. Medco has gone a long way to building this out, and we’ve kind of held it still as we’ve been integrating. But now it’s time for that focus to come back in, so that we have pharmacists that are specialized in given disease states. And I’m very excited about how those actions will actually take place.

When you think about formulary management, and you think about trying to control costs, if you talk to a general pharmacist, they may not understand all the implications of the interactions of the different types of drugs. And so when they call a doctor who specializes in the disease state, and the pharmacist is as well-versed in those medications as the doctor is, the whole conversation, the ability to get people onto the right drugs, to save them money, the patient, to save the client money, and to have a better health outcome, raises exponentially.

So we’re excited about this. Tim?

Tim Wentworth

No, I think the only thing I’d add is, you know, in terms of how it actually shows through in the numbers, we don’t break it out, obviously. It certainly helps drive adherence, which is important. What’s hard to show you is how many scripts would we have lost if we didn’t actually have the credibility with those pharmacies reaching out to patients. Particularly, we talk about the weather. I can tell you that we had those folks working overtime to actually try to keep patients on their medications.

But I would also say, when you look at our EBITDA per script dynamics, we differentiate based on the PRCs and then hang programs off them that are very credible, that clients pay for, whether it’s a much more sophisticated fraud, waste, and abuse program that’s over the top of the traditional industry standard. We have a predictive modeling program in the PRCs, which clients pay us for, particularly health plan clients, because of what it does for their Star ratings.

And it gives clients additional confidence for putting in the programs that we sell, by virtue of the fact that we have those specialist pharmacists. They come and they see them, they see what we’re doing, and it actually drives a significantly better result for us.

Operator

Our next question comes from the line of Eric Percher from Barclays.

Eric Percher - Barclays

Question relative to the hep C market. I know we saw AbbVie’s product filed this quarter. If we look out, it appears that we might have an alternative at the end of the year. I know you’re looking at strategies to exert pressure on Sovaldi before we get to a point where we might have an alternative, but can you give us a feel for how that timing might work relative to formularies for next year?

George Paz

We are evaluating that very closely, and the whole idea here is to talk with the doctor about the status of the member. Keep in mind that a lot of these members are being paid for by Medicaid. And you hate to say it, but a lot of these, you look at the prison populations, there’s a very high incidence of this disease. And so taxpayers end up paying for this.

So the question is, what has to be administered today? How does the interplay of a new drug coming to market, what’s the timing of that. All that goes into our rationale and our discussions with our clients on how to best manage this until we get an alternative out there. And we’re working that very hard.

Eric Percher - Barclays

So the focus is as much on raising the gate for the population that could be treated as achieving discount today?

George Paz

You know, I’m not a doctor, and Dr. Miller’s not in the room with us today. Neither is Glen, who’s our product guy. But I will tell you that that I prefer a doctor get into that kind of detail, and we can certainly arrange for David for you to talk to. So I don’t want to step on a branch I shouldn’t be on.

But the way I understand it is, a lot of these people have waited for quite some time. Because the prior drugs had such severe side effects that a lot of docs have been putting these people on the shelf, waiting for this new drug to come out. So the question is, can they wait another year? And I’m not the person to make those types of decisions. Only a doc could make them. But they’re in consultation with our doc and our pharmacist, that often influence those decisions. So why don’t we arrange a discussion with you and Dr. Miller at some point?

Eric Percher - Barclays

That’s fair. The only quick follow up would be, I tend to not put a lot of worry into the subpoenas, but I did notice one relative to BETASERON, which was one of the products blocked. Has there been any challenge to your ability to block products via the formulary?

George Paz

No. You know, I’ll tell you, we have very strong components programs here at Express Scripts, and so I don’t know where all these things take us or what they’re looking for, but I feel good about what we do, and so we’ll just have to see how these things play out.

Operator

Our next question comes from the line of Garen Sarfian from Citigroup.

Garen Sarfian - Citigroup

First, not to beat this to death, but just to make sure I understand regarding the midyear implementation delays, was there anything related to Express Scripts that could have influenced their decision such as still working on the back office integration of Medco or anything else?

George Paz

No, it would be the opposite. The fact that we had gone to one platform, and we had pretty much done that last year. So any new implementations that were coming in throughout last year, all the ones that came up on 1/1, they went onto our new platform as it was built out and ready to go. So that would have gone without a hitch. We could have brought them up and been there. It was really a client preference issue that caused the delay.

Garen Sarfian - Citigroup

And are there any other major implementations throughout the year that could be at risk?

George Paz

We’ve taken all that into consideration, and we know what’s coming on, when it’s coming on. These were some big ones that happened to change our overall guidance, but we have clients start up at the first of every month. And so all those things are taking place, and they’re on track, and so we feel good about where we sit.

Garen Sarfian - Citigroup

Are you hearing some strategic shifts from these or other clients, then, regarding how they’re approaching reform? Just trying to figure out, at a broader level, is it influencing how you guys are thinking of health reform next year, and to sort of where to place your chips, whether it be private exchanges or just how you're approaching the ACA market for next year, based on what you’re seeing now?

George Paz

You know, as Tim said earlier, he can certainly chime in here, but our goal is to really work closely with our health plans in trying to make sure that they have the proper product offerings at the right prices to meet the market needs in their given geographic area. And that’s really our focus, and that will change each and every year as we go forward. So we are making sure that we’re bringing the drug side of the equation to them to couple with their medical side, and make sure we have an integrated offering that makes the most sense for our clients.

Tim Wentworth

The only thing I’d add is, to the question of their confidence in us, is being on a single platform and working toward being absolutely bulletproof is what’s going to help them focus their resources on growing their markets and us playing that supportive role. And we like the market a lot. We are investing extraordinarily heavily this year in the platform that we have to take it to the next level as it relates to providing services to these clients. And we clearly believe it is a long term growth driver for us.

George Paz

Before we close, I did want to thank David Meyers. He’s been with me for the last 14 years, and without his help and support and all he’s done to get us to this position, we wouldn’t have gotten to this position. He’s been an incredibly good friend, a strong leader of our investor relations group, and I think he’s helped propel Express Scripts to become a Fortune 100 company. So he’s about to retire. I envy him for that, but I’ll make sure he stays busy until that day comes. And just want to especially recognize him and all he’s done. So I thank all of you for joining our call today, and we’ll talk to you again at the end of next quarter. Thank you very much.

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