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Executives

Mark Thierer - President and CEO

Jeff Park - EVP and CFO

Analysts

David MacDonald - SunTrust Robinson Humphrey

Constantine Davides - JMP Securities

Tom Liston - Versant Partners

Amanda Murphy - William Blair

Glenn Garmont - ThinkEquity

Michael Baker - Raymond James

Michael Minchak - JPMorgan

Charles Rhyee - Oppenheimer

Presentation

SXC Health Solutions Corp. (SXCI) Q2 2010 Earnings Call August 5, 2010 8:30 PM ET

Operator

Good morning ladies and gentlemen. Thank you for standing by. Welcome to the SXC Health Solutions Corporation 2010 second quarter results conference call. At this time, all participants are in a listen-only mode. Following the presentation, we will conduct a question-and-answer session. Instructions will be provided at that time for you to queue up for questions. (Operator Instructions). Listeners are reminded that portion of today's discussions may contain forward-looking statements that reflect current views with respect to future events. Any such statements are subject to risks and uncertainties that cause actual results to differ materially from those projected in forward-looking statements.

For more information on the company's risks and uncertainties related to these forward-looking statements, please refer to SXC's annual information form. I would like to remind everyone that this call is being recorded on Thursday, August 5th 2010 at 8:30 am Eastern Time.

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

Mark Thierer

Thank you. Good morning everyone and thank you again for joining us on today's call. This morning we issued our 2010 second quarter financial results by press release and a copy of those results are available on our website sxc.com. With me today is Jeff Park, our EVP and CFO. I'll summarize the key events of the quarter and then Jeff will review our financial results for 2Q and update our guidance for 2010 fiscal year. I'll enclose with a few comments and open it up for Q&A.

The second quarter represented another strong quarter for us here at SXC. We posted significant growth in a number of our core financial metrics including revenue, EBITDA, net income all of which Jeff will address in a moment.

From a new business perspective, we are now in peak selling season with Q3 and early Q4, the primary decision making periods for new contracts. We have a robust pipeline of targets and have reached the final bid stage with a number of good opportunities. As in previous quarters, during Q2 we won a number of small employer contracts for which we do not intend to make individual announcements.

Over the course of the coming months, we expect to receive decisions from opportunities on our pipeline which primarily relate to larger managed care plans and employers with a number of smaller state fee for service Medicaid contracts. While it's impossible to predict our win rate, what we do know is that with certainty, this year we've reached the best and final process with the largest number of counts ever in our history.

Two of the reasons for this success are because of the improvements we've made in our sales coverage along with our competitive fitting process. We've allocated additional resources to the sales team to expand coverage and to ensure that we're well covered in each of our sales territories. We've been fortunate to add some exceptionally qualified new sales leadership and we really like our chances now at the best and final presentations.

In addition, we focus this year in particular on investing resources to evaluate the quality and messaging of our responses to the competitive bid processes. Under leadership of our marketing team and with input from recognized industry consultants, we're redefined and focused our messaging, emphasizing the flexibility and customization of the SXC service offering.

These improvements have provided us with what we believe are world class caliber RFP responses. We are now seeing the initial results of these improvements based on the number of best and final invitations we perceive during this year's selling season. We expect the combination of sales strength and our compelling message to yield favorable results for the organic growth of our business.

Obviously organic growth depends on wining new business, coupled with strong client retention. As I mentioned on previous calls, with the successful retention of Huawei and BMC over the past 12 months, we've essentially eliminated any retention risk for the remainder of 2010. In our informedRx trend report released in June, we highlight our best-in-class clients who use the full suite of informedRx services combined with strong plan designs. These clients have achieved an overall trend of 2.7% an aggressive trend number we're very proud of. Our overall book of business trend was consistent with the industry average of 5.2%. If you've not already read our trend report, I encourage you to visit the informedRx website at www.informedrx.com and download a copy.

As part of our retention strategy, we continually work with clients to create programs and interventions designed to address specific issues for their populations. Our experienced account management and clinical teams used their knowledge of the market along with our propriety IT tools to deliver analyses and insights to help guide decision making around programs.

A great example is our relationship with employer's occupational health, a specialty provider of worker's compensation insurance. Working collaboratively with employers, we implemented edits in our system, to identify patients who receive multiple controlled substance prescriptions from more than one provider. Employers and informedRx then work together to implement interventions to reduce the overuse and abuse issues as well as drug and drug interactions. In recognition of these efforts to promote patient safety, employers nominated this program for the year best practices award. As a finalist for this prestigious sector award, it demonstrates our ability to work with clients to take PBM services beyond just dollars and cents to address strategic issues that are important to their business.

We're also actively consulting with our clients to help them understand the impacts of healthcare reform and how they can maximize their savings. Specifically, relatively to Medicare Part D, SXC administers all three programs, the retiree drug subsidy, the Employer Group Waiver program and the full Medicare Part D program. With implementing changes around the tax treatment of RDS, we are working with our clients to evaluate the impact of their current program and determine the need for change. And because we run all three programs, SXC is well positioned and provides maximum flexibility.

Expansion of rebates for the state fee-for-service Medicaid programs under the Drug Rebate Equalization Act brings extraordinary and administrative implications for states and managed healthcare plans.

Both our state clients and managed care clients will require tools to administer the rebate programs effectively and SXC has the exiting technology solutions to meet their needs. These changes, as well as changes discussed on previous calls such as meaningful use of electronic health records and E-prescribing had very well for SXC, as we have technology programs and services in place today to take advantage of these opportunities.

Winning new clients and retaining our existing client's demands that we continue to innovate. As the industry leader in technology enabled pharmacy benefit management, we strive to set the standard for others to follow. Yesterday we announced that we completed development testing of software to support the new NCPDP standard, NCPDP version D.0.

The move to D.0 by the Department of Health and Human Services is meant to streamline the documentation required for transactions and address newer programs and developments such as Medicare Part D. D.0 is the next HIPAA standard for HIPAA covered transactions and will be the only HHS approved HIPAA standard in 2012. SXC took an industry leadership role in helping to define and develop the D.0 standard with the department and its stakeholders.

And now with yesterday's announcement, we are first PBM in the industry to comply with the new standard. Following robust internally testing as well as field testing with selective partners last fall, we've rolled out the introduction of D.0 to clients. We expect that all clients and partners will be using the software prior to January 2011 which is one full year ahead of the mandated requirement. And I would like to take this opportunity to publicly thank our application development team, on a job very well done. I truly believe SXC as the smartest and best development team in the business bar none.

From a margin standpoint, we continue to focus on HCIT to PBM conversions as well as mail order and specialty pharmaceutical cross selling opportunities. During Q2, we may continue progress by converting one additional HCIT client to our full service PBM offering and we are making good progress on a host of others.

On the mail order front, we continue to work with clients to increase mail penetration and we are currently at 11.5%. It's important to note that as we close out 2010 and initiate the full service contract with HealthSpring in 2011, we will be updating our mail order penetration target. Mail order unit volumes will continue to climb higher but the penetration percentage will be impacted as we add the HealthSpring business which has a relatively light mail order percentage today.

Improving HealthSpring's lower mail order penetration actually represents an opportunity for SXC in to the future. So, we are full stride today with the implementation of the HealthSpring contract which is on schedule to go live for January 1, 2011.

As I mentioned on the Q1 call, at that time we just begun filling specialty prescriptions. We have not ramped up the specialty form pharma service over the course of the last three months and were pleased with how that relationship is progressing. As in the side the HealthSpring win has garnered attention from several other large health plans and created a definite sentinel effect for us which is great recognition and a strong reflection on our business.

We continue to track our progress against the four pillars of our organic growth strategy. Winning new do business, retaining existing clients, cross selling and pull-through services to existing clients and driving cost containment and responsible expense management throughout the company. We are excited about the progress we continue to make against these performance indicators and we look forward to updating you over the course of the coming months in terms of the sales season, our ramp up through the Q3 reporting period.

Now with that, I'll turn the call over to Jeff to review our financials.

Jeff Park

Thank you Mark and good morning everyone. As Mark mentioned, Q2 was a strong quarter for SXC and it can traditionally be a soft seasonal period for prescription volumes. We posted record EBITDA and generated solid revenue in net income growth. Based on these progress, we are adjusting portions of our 2010 guidance upwards which I will cover in a moment. Our PBM revenues for Q2 period grew by more than 53% compared to Q2 2009 and 6% compared to Q1 2010.

The year-over-year growth is primarily due to new customer starts as of January 1st 2010, as well as the successful HCIT to PBM conversions over the second half of 2009 and the first half of 2010. Adjusted prescription claim volumes for the informedRx division was $11.8 million in Q2 which is relatively consistent with the $11.7 million recorded in Q1. Mail penetration for Q2 was at 11.5% compared to 8% in Q2 2009 and 11% in Q1 2010. As Mark mentioned, we continue to push more effective mail utilization as a way for client savings and medication adherence. We continue to lead the industry with the generic dispense rate of 75% for Q2 which has increased significantly compared to Q2 2009 which was 71% and 74% last quarter. Driving a high generic dispense rate at the point of sale is a key element of cost containment for our clients especially at the introduction of new generics continue to grow over the next few years.

In the HCIT segment, Q2 revenues increased by 14% compared to Q1. HCIT revenue grew in part due with $3 million increase in revenue, related to performance awards earned in the quarter, for achieving saving commitments and service level guarantees, such as cost in our metrics and generic utilization targets.

We recognized performance revenues when these targets have been achieved and this is a growing part of how we built contracts with these aligned incentives when we achieved great results for our clients we win. This approach is gaining traction for us, and you may recall from Q3 2009 period that we earned approximately $1.5 million in a similar fashion. We do not expect to recognize any further significant performance awards during the remainder of 2010.

Gross profit for Q2 grew by approximately 14% compared to Q2 2009 and 7% compared to Q1 2010. Gross profit margin in Q2 was 11.2% which is in line with Q1 but down from the 14.7% in Q2 2009. This is due to the overall growth in the PBM segment which carries a low margin percentage than the HCIT unit. As we successfully convert existing clients and add new clients to our full service PBM business, we will continue to experience accretive growth for revenue, gross profit, and EBITDA, but on a gross margin basis it may be dilutive.

As mentioned on previous calls, gross profits on new contracts tend to be lower in the early stages and then expand over the course of the contract as we gain efficiencies in purchasing in operations relative to the customer. Gross profit per adjusted claim for the PBM segment was $3 and $0.26 in Q2 which was consistent with Q1 2010. We recorded our highest ever adjusted EBITDA during Q2 growing 33% year-over-year to $31.5 million compared to $23.7 million in Q2 last year and $27.7 million in Q1 2010. Adjusted EBITDA benefited from the $3 million and performance awards from the HCIT segment as mentioned earlier. Excluding the performance awards, the year-over-year growth and adjusted EBITDA was due primarily to new contract wins, HCIT conversions and approved purchasing on prescription drugs.

From a cash flow perspective, we have a strong quarter resulting in $39.5 million in cash from operations during the quarter. The ability to generate strong cash from operations remain a key feature of our business model. During Q2 accounts receivable were down to approximately 20 days, sales outstanding and cash generated from operations on a year-to-date basis rose 16% in 2010 compared to 2009.

At the end of the quarter our balance sheet remained solid. At June 30th 2010 we had $353 million in cash compared to $304 million at December 31st 2009. As I mentioned earlier, we are adjusting certain portions of our 2010 guidance. Our revenue forecast remained consistent at $1.9 billion to $2 billion for the year representing 39% growth over 2009.

We are raising our consolidated gross profit target range. It is now $202 million to $210 million versus the prior estimate of $198 million to $208 million representing a $3 million increase mid-point to mid-point. The high end of the revised guidance range would result in growth of 13% over 2009. Our 2010 full year target range for adjusted EBITDA is $115 million to $117 million, up from a $111 million to $115 million. Again a $3 million increase mid-point to mid-point. We are expecting a modest rise in normalized adjusted EBITDA on a quarterly basis as we move through the year. The high-end of the revised range would result in growth of 24% over 2009.

The 2010 full-year target range for fully-diluted GAAP EPS is now $1.96 to $2.00, up from $1.84 to $1.92. The high-end of our net income guidance using the revised EPS numbers would result in 37% year-over-year growth. We expect 2010 effective tax rate to be approximately 33.5% compared to 32.3% recorded in 2009 and our guidance targets for EPS are based on a fully diluted share count of 31.4 million shares.

Finally, we have increased our fully diluted non-GAAP adjusted EPS to $2.09 to $2.13 versus the prior estimate of the $1.96 to $2.05.

Overall Q2 was a strong quarter. We generated increased PBM revenue, net income and record EBITDA. Year-to-date, we have generated health cash flow from operations and maintained a strong balance sheet with more than a $11 per share in cash on hand. We accomplished all this while maintaining a level SG&A which demonstrates the leverage available from the business model in our ongoing attention to cost control.

We look forward to the outcomes of this selling season and will provide you with further updates on our progress as we move through the year.

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

Mark Thierer

Thanks Jeff. We work hard to consolidate leverage, the gains we've made over the past two or three years. We continue to demonstrate organic growth by focusing on wining new business and expanding the scope of our relationships with our existing clients. We have achieved this while at the same time prudently managing our own cost as Jeff just mentioned. We progressed now at this stage where we are refining our sales approach and our messaging. The improvements we've made to our responses for competitive bids and our sales coverage have allowed us to achieve our highest number of best in finals, with solid opportunities in each of our key target markets.

We also continue to actively track acquisition opportunities and continue to view a wide number of attractive targets. As in the past, we'll remain vigilant and disciplined in terms of valuation and alignment and we do not feel pressured to move quickly on a target that does not meet these standards. Together with the skill and the capital we bring to the table, our performance has provided us now with the scale to deliver both for our clients and our shareholders alike. Make no mistake, the rate of change today in the PBM marketplace is accelerating. The flexibility and customization of our HCIT and PBM service offering allows us to aggressively pursue a diverse mix of clients and we look forward to updating you through the remainder of 2010.

So with that, I would like to open up this call up to questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions). And your first question comes from the line of David MacDonald from SunTrust. Your line is open.

David MacDonald - SunTrust Robinson Humphrey

Mark just on the new business I want to ask you a couple of questions. One have you seen any new potential wins because you talked about some benefits from the HealthSpring win. Have you seen any new potential wins or new potential contracts come to the table since HealthSpring that you guys are now bidding on in the finals on?

Mark Thierer

The HealthSpring contact has in fact generated a number of new opportunities that we didn't have in the pipeline and as reported last quarter that we had our largest [Health line] pipeline opportunities of since I joined the company. The fact of the matter is the leadership team that runs HealthSpring spring is known in the industry. This is a small industry and those guys selected SXC for a range of reasons. And bottom line is, it is creating a sentinel effect I mentioned in my opening comments and we are in fact getting more swings of the plate, as result of having won that business.

David MacDonald - SunTrust Robinson Humphrey

And then I guess with Jeff, just on to the HCIT performance awards, its fair to say Jeff that at least once a year we'll see this hit the P&L that's just kind of a matter of what quarter it hits on a year-to-year basis. Is that a fair way classify this?

Jeff Park

Yes David it is.

David MacDonald - SunTrust Robinson Humphrey

And then just on the mail, can you guys give us any sense and I don't know if you want to go here, because it's about '11. But can you give us any sense in terms of, just the underlying growth in scripts, because obviously the mail penetration rate number is going to get skewed dramatically by Healthsprings but how much growth can we expect on the mail side or is that some we need to kind of weight on, as we move into '11.

Jeff Park

No we're active Dave and driving more male utilization within our client base. I don't have to talk about the benefits in mail on this call, but it does provide really a win-win for our clients who are saving money, it doesn't provide better adherence schedules for managing these medications and we've been pretty clear with our objectives. We're looking to get our mail penetration up into the mid teens as we approached the end of the year, we're hopeful that we're going to be able to continue to see these mail penetration rates continue to increase and like you said, with Healthsprings coming on to the book of business in 2011, the mail penetration percentages across the book will have to be adjusted but its been really great progress for us.

David MacDonald - SunTrust Robinson Humphrey

Okay and then, look we've seen what looks to be a pretty meaningful trend towards managed care companies either outsourcing or selling their PBM business with another deal announced last night. And as you guys look at a pretty big debt of cash and you are out there obviously [indiscernible] the opportunities. Are you seeing this become a much more pervasive trend out there in terms of some of the bigger managed care folks or even mid-sized managed care folks who have a PBM offering looking to monetize that or looking to someone who frankly has more expertise in this area?

Mark Thierer

I would say that the activity level has been very high and you're just seeing a few pieces of fruit now fall off the tree in market. I am encouraged by what I am seeing both from a large a health plan standpoint and now as of yesterday kind of middle health plan.

Making selections and building business arrangements with PBM's basically is validating the model that pharmacy benefit managers have the best hands-on the tools to drive cost and improved quality even for the largest health plans in the country. So its an endorsement of our model and the fact of matter is many of the middle market companies that we're talking to, and these are wide ranging discussions that range from pure technology discussions where they want to keep the pharmacy benefit, to sort of a hybrid model where they are outsourcing a portion of it. I'd argue that, is what the (inaudible) model was about all the way to fully divesting the pharmacy benefit business is contained today captive inside some middle market health plans. I know you saw that night. So the activity level there is high and you can assume we're looking at every property that's available.

David MacDonald - SunTrust Robinson Humphrey

Okay. And then just last question. Can you give us a sense of how differentiated it is with the D.0 is done for you guys and where are other folks on this and does this create a potential opportunity on the HCIT side.

Mark Thierer

Well, this D.0 workout for us was tens of thousands of man hours on the development side and I have to tell you, I am just so proud of our team. It is going to differentiate SXC and the clients we service and I will tell you why. This is not a trivial drill. Making this a conversion to D.0 testing it and making sure you have got it right was Herculean effort on our part. Now the important dates here are, as of January 1st 2011, HHS is recommending compliance and during next year, you can actually run both 5.1 or D.0. But by 1.1.2012, there is only one transaction set that will get cleared and that's D.0.

So the reason is hard for people is there are many new features that get embedded into the engine that include compounded RXs, there is complicated consumer directed health support, there are COB claim requirements in special handling for multiple payers and now you have to be able in your claim to handle the billing of pharmaceutical services, cognitive services outside just the dispensing process.

So, these may sound like esoteric issues but they are big programming challenges. And the real challenge becomes, do you have multiple platforms that you are trying to remediate, because you've got to do it for every platform. So the punch line is, we are using this in the selling process, it is important and people are nervous about their ability to get there on time, I just feel great about the fact that we are out there and have it done.

David MacDonald - SunTrust Robinson Humphrey

Okay. And you said 1.1.12 markets when you have to be complaint.

Mark Thierer

That's it.

Operator

Your next question comes from the line of Constantine Davides from JMP Securities. Your line is open.

Constantine Davides - JMP Securities

Jeff the HCIT conversion you talked about, can you give us a sense for how meaningful that is from a revenue perspective and then when did that actually transition in the quarter?

Jeff Park

Yes, it was mid quarter Constantine and you if look at the revenues from Q1 to Q2, you can see a nice pickup. Now if you think about what happened in Q1, Q1 is generally has a higher number of transactions getting processed due to the seasonality Q4 and Q1 the cold and flu seasons, specialty meds are high. You see a lot more volumes in those quarters. So they see a spike up in the second quarter is really a sign of first of all some of the conversion activity but also some of the momentum across some of our other book in driving more penetration of our specialty services as well. So, I am not going to be too specific on the account but it was mid quarter.

Constantine Davides - JMP Securities

Okay and I guess a related question on that. We're seen some conflicting commentary at a couple of your larger competitors around script utilization. It sounds like things are fairly normal within your own book, but maybe you can just talk a little bit about what you're seeing in terms of same story utilization rate if you will.

Jeff Park

Yes so you outlined generally you are going to see Q2 have one of the lowest points on a natural basis for transactions or script volumes. They are certainly, those script volume changes are impacted by shifts away from mail order and into the 90 day sales because mail orders have a three times kind of multiplier effect from people who report transaction volumes. So I do think that has a little bit of an exaggerated impact in the quarters. But for us, in our book of business, we're seeing steady growth. As you know, when our clients are successful, it also drives momentum into our business and so, we're fortunate not only with our ability to drive these new clients, but also to have helped the customers.

Constantine Davides - JMP Securities

Okay and then just one last question Jeff on HealthSpring, I know you talked about bringing 30 or 40 people on board, have we started to see that or where are you in that process? Thanks

Jeff Park

We've been starting with supporting that their client already has a market outline with respect to some of the investment we have made in the specialty side as well some of the early beginnings of their filings to CMS that we're done back in March. But as we get closer towards the end of the year we'll be ramping up some of the additional supports in our call center operations etcetera, to get ready for that go live, so there will be some more still coming here, Constantine in the second half of the year.

Operator

Well our next question comes from the line of Tom Liston from Versant Partners. Your line is open.

Tom Liston - Versant Partners

Just a quick follow-on the previous two callers, just under the selling season right now, it been which appears with some of the comments but (inaudible) trading around many of the group, but in early days, can you comment on the 2011 selling season, why are you seeing if there is any themes that are emerging that you have to address and certainly comment on pricing pressure in that context as well. Again, I know its early days but what can you tell us?

Mark Thierer

I have said before, that I kind of view the market as a bifurcated market. There is the high end of this market with the largest customers who are heavy mail order driven clients. That's really the purview of the big three and I can't really comment on the pricing pressures that are going on there.

For us in the market's where we're focused our five target markets, this selling season has been the busiest in our history. And in terms of a pricing dynamic, it looks an awful lot like last year to me. And nothing in particular different from a competitiveness or price required to win the business. I would say a couple of dynamics though in the selling process. We are seeing smarter buyers, wanting to unbundled the service offering. We are hearing a lot about customization and flexibility and so for us the timing is good in terms of evolution of this market and our business model. I think they are coming together at just the right time. So those are my observations.

Tom Liston - Versant Partners

And related we did talk about this last call. But with the HealthSpring win you talked with David about the other big opportunities opening up. How do you maybe in some cases resist chasing after the big such shiny object and maybe you're focusing after further market type of customers. How do you balance those two going after the kind of home run ball versus your singles and doubles?

Mark Thierer

Yeah, Tom we don't really go after the big home run balls. We are building a very durable model and winning in the segments where we're focused and so to the extent that CalPERS comes out without bid in a traditional model, we are going to pass. And to the extent that the client wants to un-bundle and begin to look at a more unique implementation of a PBM model. We are going to be one of the best choices they could make. So, I would just say we are disciplined in our five segments and we are being opportunistic when larger opportunities come across. Its not that we'll say no to all of them, but we are not chasing a lot of flyers here.

Tom Liston - Versant Partners

Okay. And just a quick one for Jeff, HCIT conversion is one in the quarter. I think last quarter you said there is kind of (inaudible) in the pipe. Is that still the right number and on the gross profit side within that segment, I think it's the first its bumped up meaningful here. Is there any explanation for that?

Jeff Park

Sure, with respect to the conversion targets, yes it's the targets that we are continuing to pursue Tom, we are not changing that and with respect to the margin pickup in the HCIT segment, its related to that one time health in the quarter there where we had a $3 million pick up with respect to our performance incentive rewards and so that's really the one item you need to consider in that.

Tom Liston - Versant Partners

Most of that would be within HCIT.

Jeff Park

Yes, $3 million in the HCIT unit.

Operator

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

Amanda Murphy - William Blair

Hi, good morning. This is another follow-up on the selling season. I am curious you had mentioned the HealthSpring opportunity and you also planned out sort of customization flexibility, but I am curious, what specifically is resonating with clients this year that has allowed you to be in and have such a strong best and final opportunity work such as last year?

Jeff Park

You know I think Amanda, one of the big things is, we've just gotten a little recognition. People know who we are this year. We've just been asked to more bids and we've made it to more best and finals because in many respects, the company name and our capabilities are really starting to gain some traction. So that's a factor. But I think more importantly, it is our ability to put a and customized offering in front of clients and the people we've not got in our selling and clinical account management areas are very strong, lots of industry experience, many of them with big three backgrounds. And so we're focusing in two areas. Unique plan designs and advanced clinical programs and we're focusing on how to save money. So our model and obviously we're talking about prior off step therapies, three tier and reference based programs, value based designs. We are talking about 90 day retail programs where they make sense. We are coming in with an aggressive managed pharmacy approach using our expertise and unbundling the way these folks are looking at and buying the programs and so that at the heart of it is the reason I think we are getting quite a bit of attraction.

Amanda Murphy - William Blair

Okay and I think this s a follow up on the bundling comment. Are you seeing the larger players who are willing to unbundle weaker utilization environment potentially?

Jeff Park

Well not so much in the client settings where there is new business coming out. I mean I'd argue the (inaudible) transaction was rather unbundled transaction with a very large health plan and a very large combined retail and PBM model. So I think again that was an endorsement on this notion of smart buyers unbundling the PBM offering in a way that makes sense for them but that's our lead, this is what we're selling and I'm not sure anyone out there is actually leading with that as a value proposition.

Amanda Murphy - William Blair

Okay and then just last one on HealthSpring. As you sort of coming to (inaudible) a few months away, I mean you had any initial conversations with vendors that maybe give you some perspective or visibility in to sort of incremental efficiencies you might gain when your clients come online next year?

Jeff Park

What do you mean vendors?

Amanda Murphy - William Blair

I guess net loss, I should say from our purchasing standpoint.

Jeff Park

When we start moving the drug spend in 2011, is when we are going start seeing real cost of goods reductions in our supply chain, have we begun those discussions. I mean they all know we won. But you should look for any meaning cost improvement based on HealthSpring until next year. We are seeing a bit in specialty, but the bigger piece is next year.

Operator

Your next question comes from the line Glenn Garmont from ThinkEquity. Your line is open

Glenn Garmont - ThinkEquity

Yeas thanks good morning, just two quick ones. I guess Mark first, in your prepared commentary you talked about you know how you kind of sharpened up the messaging. You also made reference to some change you made with respect to the sales coverage. Now I was wondering if you're going to elaborate on that a little bit and then, as a follow-up Jeff, the $3 million of HCIT performance fees in the quarter, that was something that was always contemplated in your full year guidance is that correct?

Jeff Park

Sure Glen, no we didn't have the full amount of that contemplated in our guidance no, Glen.

Mark Thierer

And Glen I also wanted to address your question on sales team and sales coverage and if there is a combination here, we invested a lot of money in the messaging and how we actually respond to bids and I put our bid responses up against anybody in the industry at this point, I'm really proud of what we've done. But then secondly what are we selling, what are we saying and who's saying it in the best and finals. So kind of here is what blended, we are now at fighting strength. We have 10 full time informedRx sales executives. We just brought on a sales leader who has extensive managed care background in a big free environment. We've got a number of registered pharmacists in the selling team. We've got a dedicated HCIT focus as well as our state fee for service sales leadership. Seven people now in our specialty sales force and 40 "carrying account management folks, all in were north of 60 folks" drive new sales. And where were we need to be now in terms of talent and the messaging. So we're expecting it to pay dividends for us this year.

Operator

Your next question comes from the line Michael Baker from Raymond James. Your line is open.

Michael Baker - Raymond James

With respect to the managed care best in final opportunities, can you give us a sense as to what percentage include one of the big three versus other, what I will back in processors like Argus.

Mark Thierer

Yes, it's a good question Michael. We see the big three from time to time in what I call the middle market of the health plan space. And a company like Argus has had a long history in the blue segment and they are primarily a health plan only claims processor. So we see them a lot.

But we do see the big three from time to time in the middle market. And that's where we compete very well with everybody including them on a customized basis in the middle market. We can pay an awful lot of attention and deploy a talented team to these middle market accounts who don't always get the service that they like and that they deserve. So we can hold our own in that segment with anybody in the business and its competitive, you got to be out there hustling to win, but we are pretty well positioned.

Michael Baker - Raymond James

And then I was wondering on the acquisition front, obviously you are targeting a number of your PBM customers. I was wondering if you have seen any change in valuation expectations as other PBM's have talked about a pickup or they haven't talked about but there's at least been some talk about a pick up in increased competition out there.

Jeff Park

Yeah. Michael this is Jeff. We are continuing to see as Mark outlined in an earlier question, more properties coming to market in particular some of the captives or inside of a health plan as they look to find a different answer for their PBM. And valuations continue to move up with increased amount of access to capital in the credit markets opening up, its certainly continuing to allow more people to look and that can cause prices to go up but its not really, we're staying very disciplined with what we look at. I think markets move and you need to react in the context of those markets but when we look at our targets, we look first for a good strategic fit. Secondly, we need to make sure we see good synergies and the opportunities to integrate and then finally, it needs to be at a fair price. So, those are the three criteria we've continued to use and we continue to use today.

Michael Baker - Raymond James

So, at this point you are not seen downward pressure on their expectations of valuation as a result of competitive dynamics on the market place.

Jeff Park

No.

Operator

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

Tony Perkins - First Analysis

Good morning. Jeff if we backup the $3 million benefit in the HCIT segment we reach a gross margin of about 10.6% which is a sequential decline in margin, I was wondering I know the HCIT to PBM client conversion could impact that. Is there anything else driving that?

Jeff Park

Sure, well just with respect to gross margin, we've been pretty clear on what to expect. When we bring on new clients to our PBM, the margins for those can be suppressed as we bring on conversions although that's going to have some nice incremental pick up over time in the near term. It can impact our gross margin percentages, but if you look at the gross margin proclaimed Tony, from Q1 to Q2 its pretty consistent. So we feel pretty good about where we are with that. There's nothing really that was too surprising in the gross margin for me.

Tony Perkins - First Analysis

Great and Mark mentioned a little bit about specialty in HealthSpring beneficiary base, Mark can you give us maybe a little bit color on the traction that you're seeing right now and maybe what you expect for 2010.

Mark Thierer

You must mean 2011 Tony and the 2010 traction that we're getting is building the base and making the clinical connections that are going to be required to really drive the referral base next year. So we've given you some guidance as to 2010 being a ramp year and 2011 being a year where we've really target in excess of 50% of all that specialty volume. So our progress to date has been very good in terms of making those connections with the decision makers, including the CMOs, the Chief Medical Officers in each of Heath Springs MSA's that they work in. We've deployed on the ground talent to detail those doctors' offices and we've had an outbound telephonic campaign to the heavy writers as well and so we've got their full attention. One thing I am extremely happy with has been Healthsprings, not just cooperation but active leadership in helping us to make this conversion happen and so we're very optimistic about ramping this, but look for the bulk of the ramp in 2011.

Operator

The next question comes from the line of Michael Minchak from JPMorgan. Your line is open.

Michael Minchak - JPMorgan

First on the $3 million performance award, just to clarify that award is from one account.

Mark Thierer

No it's from the few accounts.

Michael Minchak - JPMorgan

Okay see he made the comment that instead of you look to structure your contracts with a line incentives, do the majority of your contracts on the outright you said have those opportunities for those awards or is that something that you're working to implement it as those contracts come up for renewal?

Jeff Park

Yes, I wouldn't say a majority of the accounts on the HCIT side, that's just something that we've been pre-actively pursuing with our clients and they see it as a success for them as well. Being able to drive client savings, being able to honestly put our money where our mouth is to a meet performance objectives is important to them and important to us, and we believe our ability to continue to do that and so having an aligned incentive which either on an HCIT side is important to us and you're going to see a growing amount of these type of contracts at least for us. I don't want a PBM side its important to us and you're going to see growing amount of these type of contracts at least for us.

Mark Thierer

Michael this is Mark, I just wanted to add one thing to Jeff's comments and that is, aside from this aligned incentive model which makes all the sense in the world and we've got a concerted effort on both side of our business. To reframe our contracts with that, we're also working toward longer-term contract. So we have a definite contracting strategy here that includes taking our margins up through our lined incentives and lengthening the term of our contracts. Those are two work streams that we are focused on.

Michael Minchak - JPMorgan

Okay great and then secondly just going back to the topic of (inaudible) PBMs. There's been a lot of speculation in the marketplace around Prescription Solutions and whether they would bring in a United Commercial business in house say after 2012. I know you had a long relationship with Prescription Solutions and as you signed a new license agreement back in '08. Are you having conversations with them regarding additional services you can provide going forward and how big of an opportunity do you think that can be for you?

Jeff Park

Yes, Michael Prescription Solutions has been one of our longest term clients in the company's history. And they utilize the bulk of our tools in their PSI, PBM to run their business. So they are very important clients as we have a great working relationship and we continue to support the expansion of their business.

Operator

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

Charles Rhyee - Oppenheimer

Maybe just going back to earlier, Jeff you were talking about actually the generic dispensing rate, 75%. What are you guys are doing differently, particularly through the retail network. Does that allow you to drive that much higher than what appears to be your peers?

Jeff Park

Sure Charles, there is really a few factors that are driving the generic dispense rate. First of all the type of population base that you support is an important facet. The second is Mark outlined earlier to Amanda, some of the clinical programs that we put in place with our clients, whether its step edits or therapies to basically drive savings clients are much more interested in plain design changes that are going to generate cost savings to them in these last few years. That's been very helpful where we are armed better with our clinical tools and our clinical account management strategy to help clients understand the impacts of drugs and what it will mean for them.

Also as you know with respect to the adjudication engine that we have, we are communicating with the pharmacy at the point of service and that allows us to have a very high generic substitution rate which shows that we're effective at distributing and dispersing these generic medications.

Charles Rhyee - Oppenheimer

So, really is the function there, the member come in with a prescription, your judication engine is able to complete the edit and report to the pharmacy, hey you got to use this drug instead. Is that how I should probably think about it because I would imagined if there's a generic available that automatically substituted but, for a therapeutic substitution or in a step therapy case, how's that sort of as you'd practically implement it?

Mark Thierer

Yes you have that right. So, its basically at the point of care where we're able to help make sure that those generics are dispensed. The other thing Charles, and this Mark, that is important, aside from the clinical and plan design interventions to drive generics, we talk to our clients about the outlook for generics in 2011, 2012, 2013 and we really focus on what drug spend is going to be doing into the future. And we model for them programs and what the saving could mean. I do want to comment on some of the debates that's been out there, relative to 2011 is going to be a down year for generics. I don't agree with that. First of all the way this business works is its much more important what generics actually went from branded generic in 2010 relative to the run rate in 2011 from an EBITDA standpoint.

The second point I want to make is that different PBMs and different business models are in fact affected differently and it has to do with your drug mix your mail order penetration and your client mix. And so if you stop and look at 2011 in detail you will see that a couple retail centric drugs including [levaquin] are due to move from brand generic early in the year, it's a heavy runner and its important in the network and its important to us. So we talked to our clients about the outlook in the out years, how we plan to save the money over the term of our contract and I think that's an important distinction.

Charles Rhyee - Oppenheimer

Great and then maybe another question of getting back to that performance, I think an earlier question asked was within the guidance and Jeff you said it really wasn't, but you kind of sound like you're saying that maybe Mark you expected part of that or was there a third thing that you didn't expect any of that?

Jeff Park

We have these performance targets. We achieved some last year, we do have expectation that we're going to continue to achieve targets and so we do model to have some of those achieved but this was certainly much higher than what we had expected.

Charles Rhyee - Oppenheimer

Okay so generally you look at what the contracts are expecting in terms of performance targets, what you are saying is here and this case is a little big bigger than you would have anticipated for the quarter, for the year?

Jeff Park

This is consistent with how we like to manage the business and the conservative approach that we take to all aspects of managing the business and we're pleased with the performance targets we hit on those clients.

Charles Rhyee - Oppenheimer

Okay and lastly just on the IT conversion I think Mark you talked about, you feel good about some more opportunities as we move through the year, do you feel you are still on target. I think you have said in the past about four to eight over the next 18 months or so do you still feel on track to that?

Mark Thierer

We are on track Charles.

Operator

You next question comes from the line of Brooks O'Neil from Dougherty & Company. Your line is open.

Brooks O'Neil - Dougherty & Company

I'd like to ask apparently one of your more important customers announced a significant acquisition last night that's catalyst acquiring future scripts. I am curious since you've had any chance to look at that and whether you see any integration challenges or if you can comment at all on how they might think about integrating IT for that client and then I guess, secondly would you comment on whether you looked at that acquisition as well.

Jeff Park

Yes, the first thing is obviously you're right about that catalyst as a long time important client for us and just keep in mind you know when catalyst wins and grows its good for us. We'll be clearing those 14 million or so transactions a year for them. Catalyst has a track record of successfully integrating acquisitions in high speed and getting along to our platform because that's the key part of their value prop. So I think it looks to me like a pretty solid acquisition and I have every expectation as in the past that's probably moving to our platforms sometime soon and to me it looks like a pretty solid transaction, as to whether we looked at that property, I don't want to comment on that Brooks.

Brooks O'Neil - Dougherty & Company

That's fair. Secondly, could you just update us on the pipeline in the state fee-for-service Medicaid business that historically has been good growth of segment for you and how are you feeling about that now?

Jeff Park

Yes, I'm feeling really pretty good about it. We have a couple right now that are active in the pipe that these are going to be decisions that will be made this year and in next year's pipeline there are in excess of six that were working on and aware of, for next year. So we're pretty bullish. The bigger opportunity too is just not arising with this DRE rebate issue relative to managed Medicaid and a lot of these states are going to need a way to manage the actual disbursement and collection of these rebates. Its hard to say exactly how it is going to come down, but our state team is talking to multiple states about kind of a transaction oriented solution to helping them solve on this DRE implementation and more to follow there but we think it is going to create opportunity for the company.

Brooks O'Neil - Dougherty & Company

That's great. As it relates to these performance incentives, if I am hearing you correctly, it would be reasonable to assume you'll continue to perform that the magnitude of your earning in that regard could grow overtime.

Jeff Park

Well I hope to be able to see continued over performance on our contracts, if that's your question with respect to the scope and size into the future. As you know we're now giving 2011 guidance, but this year we are able to achieve what we announced which was twice the size of last year's.

Brooks O'Neil - Dougherty & Company

That's great and then, I just want to be sure I heard you correctly. I know you have a very, very strong balance sheet and continue to generate strong cash flow. Did I hear you say anything about need for any additional capital?

Jeff Park

No, there is no need for additional capital, we are well funded.

Brooks O'Neil - Dougherty & Company

Yes, that's right but, and then lastly, could you just comment in my view your growth is pretty clear we're sustainable for the next few years, but would you be willing to comment at all on how you see the outlook for SXC over the next couple of years as it relates to sustainable growth?

Jeff Park

Yeah, Brooks, we really like the hand we've got here and we are playing it aggressively in the game. The game plan is to grow the business aggressively faster than the market and we should, we are a smaller company and we are moving very quickly. We're very agile and we're listening to clients and so I think you know we're expecting to grow Brooks.

Operator

At this time I turn the call back over to the presenters.

Mark Thierer

Well, I want to thank everyone for the good questions and will look forward updating you at our next quarterly call. Have a great day.

Operator

This concludes today's conference call, you may now disconnect.

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Source: SXC Health Solutions Corp. Q2 2010 Earnings Call Transcript
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