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MedcoHealth Solutions (NYSE:MHS)

Q3 2010 Earnings Call

November 02, 2010 8:30 am ET

Executives

Valerie Haertel - IR

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

Robert Epstein - Chief Medical Officer and President of Medco Research Institute

David Snow - Chairman and Chief Executive Officer

Analysts

Lisa Gill - JP Morgan Chase & Co

Ricky Goldwasser - Morgan Stanley

Ross Muken - Deutsche Bank AG

Steven Valiquette - UBS Investment Bank

Kemp Dolliver - Avondale Partners, LLC

Glen Santangelo - Crédit Suisse AG

Thomas Gallucci - Lazard Capital Markets LLC

Robert Willoughby

Lawrence Marsh - Barclays Capital

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

Operator

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

Valerie Haertel

Thank you, Cynthia. Good morning, everyone, and thank you for joining us on Medco's Third Quarter 2010 Earnings Conference Call. With me today as speakers are Dave Snow, Chairman and Chief Executive Officer; and Rich Rubino, Chief Financial Officer. Also joining us for our question-and-answer session are: Tom Moriarty, General Counsel, Secretary and Senior Vice President of Pharmaceutical Strategies and Solutions; Tim Wentworth, Group President of the Employer and Key Account; Steve Fitzpatrick, President of Accredo Health Group; Mary Daschner, Group President, Government CBM; Brian Griffin in his new role as President of International; and Rob Epstein, Chief Medical Officer and President of the Medical Research Institure.

We ask that you limit your questions to no more than two, in order to enable as many participants on the call to have as their questions answered.

During the course of this call, we will make forward-looking statements as that term is defined in Private Securities Litigation Reform Act of 1995. No forward-looking statement can be guaranteed, and actual results may differ materially from those projected. We undertake no obligation to publicly update any forward-looking statement, whether as a result of new information, future events or otherwise. Forward-looking statements made on this call should be evaluated together with the risks and uncertainties that affect our business, particularly those disclosed in our SEC filings.

Copies of Medco's filings are available from the SEC, the Medco Investor Relations Department or the Medco website. Medco intends to use the Investor Relations section of its website as a means of disclosing material nonpublic information and for complying with its disclosure obligations under Regulation FD. The copyrights for the contents of this discussion and the written materials used on this earning call are owned by MedcoHealth Solutions Inc. 2010.

Slides to accompany our presentation, which detail our financial and operating results and the guidance discussed on this call, are currently available in the events section of the Investor Relations site on medcohealth.com. Additionally, please note that we expect to file our 10-Q after the close of the market today. At this time, I would like to turn the call over to Dave Snow. Dave?

David Snow

Thank you, Valerie, and thanks, all of you, for joining us this morning. Today, we are reporting record third quarter 2010 earnings and raising and narrowing our previously improved full year 2010 guidance for GAAP diluted earnings per share and diluted earnings per share, excluding intangible amortization from the 2003 spinoff. In addition, we are providing solid 2011 diluted GAAP earnings per share guidance, projecting growth of 12% to 17%. Turning to the third quarter results. We achieved record results in all of the following measures: GAAP diluted earnings per share of $0.85, up 23.2% over third quarter of 2009; diluted earnings per share, excluding the amortization of intangibles from the spinoff of $0.91, up 21.3%; gross margin of $1.12 billion, up 7.6% with a strong gross margin percentage of 6.9%; EBITDA of $771 million, up 7.2%; EBITDA per adjusted script of $3.28, which beats our previous record that was set in the third quarter of last year; additionally, on a sequential basis, EBITDA for adjusted script increased 7.2% from $3.06 in the second quarter of 2010; net income of $371.5 million, up 10.7%; generic mail-order prescriptions of $17.1 million, up 15.5%; generic dispensing rate of 71.6%, up 3.9 percentage points, with the mail generic dispensing rate component increasing a substantial 4.7 percentage points; Accredo revenues of $2.9 billion, up 19.9%; and one final record of note, Accredo operating income of $112 million, up 19.8%; in addition, Medco's net revenues grew 10.3% to $16.3 billion, just $100 million below our previous record, which was achieved last quarter, reflecting normal retail seasonality; and finally, our mail penetration rate was identical to last year at 34.5%.

Our leadership in clinical innovation, combined with our deeply rooted focus on operational excellence, has enabled us to remain highly successful in the marketplace, both in gaining new customers and as importantly, keeping our valued customers at historically high retention rates. On that note, as has been publicly reported, CalPERS, a very sophisticated purchaser, conducted a competitive bidding process and again selected Medco as their PBM. CalPERS will be renewing their contract with Medco for a three-year term beginning January 1, 2012. Our 2010 annualized new-named and net-new sales remained strong at over $5 billion. For 2011, our annualized new-named sales increased to $1.7 billion, up from the previously reported $1 billion. And our net-new sales are now $1.4 billion.

Our client retention rates continued to be over 99% for both 2010 and 2011. This year, we achieved new heights in client satisfaction levels. In fact, our national account group, which is comprised of large Fortune 500 employers, achieved a client satisfaction score for the first time of 100%.

We continue to be deeply focused on taking Medco to even higher levels of clinical excellence to improve outcomes and lower total healthcare costs. Our most recent example of this focus is the addition of United BioSource to our growing portfolio of clinical assets. We believe UBC, combined with Medco's Research and Specialty Pharmacy capabilities, can fundamentally change the way drugs are introduced, delivered and monitored for both safety and economics, further expanding our ability to make medicine smart.

We are extremely pleased with the positive reception that this combination has received from our clients and UBC's customers. We plan to dedicate time in our upcoming Analyst Day to UBC and the way it complements and extends the value proposition of our business.

I would like to make one final point before I turn to guidance. We received all regulatory clearances and closed the Medco Celesio joint venture on September 10th, and are making significant progress in bringing its offerings to market in Europe. To lead this effort, this past quarter, we nominated one of our most successful executive leaders, Brian Griffin, to be CEO of our joint venture with Celesio, a position to which he has now been officially appointed. Brian will also have the Medco title of President of International. We are confident that Brian will provide outstanding executive leadership and continue to achieve great results in this large and exciting new market.

Turning to guidance. We are raising and narrowing our full year 2010 GAAP diluted earnings per share guidance to a range of $3.14 to $3.16, representing growth of 20% to 21% over 2009, up from our previous guidance of $3.10 to $3.15 per share. Our 2010 diluted earnings per share, excluding the amortization of intangibles from the 2003 spinoff, is raised and narrowed to a range of $3.38 to $3.40, representing 19% to 20% growth, up from our previous guidance of $3.34 to $3.39 per share. Our guidance for 2011 GAAP diluted earnings per share is in the range of $3.53 to $3.66, reflecting a growth rate of 12% to 17% over 2010. Though we will not record our earnings per share using this metric in 2011, our guidance for 2011 diluted earnings per share, excluding the amortization of intangibles from the 2003 spinoff, is $3.80 to $3.93, representing a 12% to 16% growth rate over 2010.

In 2011, we will change the non-GAAP diluted earnings per share measure to exclude all intangible amortization expense, not just the intangible amortization from the 2003 spinoff. We believe this is easier to understand and is more comparable with how our industry peer group reports. Of course, we will continue to report diluted earnings per share on a GAAP basis. The 2011 guidance for this new EPS measure, diluted earnings per share excluding all intangible amortization, is a range of $3.99 to $4.12, reflecting 12% to 17% growth over 2010 earnings per share when defined the same way.

Importantly, as you can see, the EPS growth trends are consistent across all measures. I would also like to point out that even though, from an incremental earnings perspective, scheduled new generic introductions for 2011 will be the lightest in the entire decade ending in 2020. Our business model is still expected to provide meaningful earnings per share growth. A generic wave overview slides we have shown in the past have correlated to our previous planning horizon through 2015. Having just completed a rigorous, detailed, strategic and financial plan for Medco that now extends to 2020, new and interesting observations have become clear. When you look at the generic wave from 2010 to 2020 and its alignment with Medco-specific drug by drug mail penetration, there are two significant outlier years: 2011 is the weakest new generic year, and 2012 is by far the strongest from an incremental earnings per share contribution standpoint. All of the other years for the remainder of this decade delivered solid and continuous incremental growth to earnings per share each and every year. We plan to share more detailed insight on this fundamentally important topic at our Analyst Day.

In addition, the incremental penetration of previously released generics in our base provide us with continuous opportunities to grow generic dispensing rates and increased narrowed penetration at mail, on top of the benefit from new generic introductions. This is before taking into account the increased likelihood for a new wave of biosimilar introductions that we believe will, over time, become another meaningful contributor to our earnings growth.

We remain confident in our ability to generate strong earnings per share growth on a compounded annual growth rate basis throughout this next decade. We look forward to seeing you at our Analyst Day meeting on November 19 in New York City, where we will discuss our continued strong growth strategy in greater detail.

In conclusion, making medicine smarter is our passion, and it defines our business model and our value proposition to clients and patients. With that, I'll turn this over to Rich Rubino, who will take you through some additional details on the financials for 2010 and 2011. Rich?

Richard Rubino

Thank you, Dave. Good morning. Dave already covered many of the highlights for the quarter. Plus, you can see all the details in our earnings release and the slides on the Web. So I will cover some of the other important financial highlights and observations and provide details on 2010 and 2011 guidance.

Starting with our balance sheet. We closed the third quarter with a cash balance of nearly $900 million. There were some significant closed to our cash balances this quarter, we acquired UBC for over $700 million and financed that acquisition with proceeds from $1 billion of senior notes, taking advantage of a very favorable interest rate environment. We closed on the senior notes offering in September, comprised of $500 million of five-year notes at a rate of 2.75%, and $500 million of 10 year notes at 4.125%, bringing our total debt to just over $5 billion.

We also took advantage of the equity market dynamics, spending $903.5 million to repurchase 17.1 million shares this quarter at an average per share price of $52.81. Our cash flow from operations for the first nine months of 2010 totaled almost $1.37 billion. As expected, cash flow from operations will not be as great as 2009 because of the significant inventory reductions in retail growth experienced last year. Nonetheless, we continue to further reduce our inventory balances.

Our inventory balances are the lowest they have been since we became a public company in 2003 at $998 million. You might recall in the second quarter of 2008, our inventory levels peaked at nearly $2.1 billion. In fact, our mail inventory for the core PBM business is the lowest it has been since 1998 on significantly higher mail volumes and without compromise to availability, or timely delivery to patients. The company expects cash flow from operations of approximately $2.4 billion for full year 2010.

Our capital expenditures for September year-to-date were $164.1 million compared to $154.3 million for year-to-date 2009. This increase reflects investments in our business to enhance efficiencies across the organization, prepare for healthcare reform implementation and to fund future growth. We expect capital expenditures of approximately $250 million in 2010.

Moving on to the income statement. Our third quarter EPS results were records, with GAAP diluted EPS of $0.85, representing 23.2% growth from the third quarter 2009; and diluted EPS, excluding the amortization of intangibles from the 2003 spinoff of $0.91, representing 21.3% growth over 2009. Total third quarter 2010 net revenues of $16.3 billion reflect growth of 10.3% over the third quarter of 2009. Our product revenue grew 10.1%, reflecting our new business wins as well as higher prices charged by brand name pharmaceutical manufacturers, partially offset by a higher representation of lower priced generics. In fact, a record generic effect of over $1 billion on this quarter's revenue alone.

Service revenue continued to be a very meaningful growth driver, increasing 26.4% over the third quarter of 2009. This strong performance reflects the expansion of our overall client base, our Medicare Part D service fees, as well as a few days of service revenue contribution from UBC. Mail-order volume remains strong as clients and members continue to choose the lowest cost and most clinically effective channel. We are updating our previous guidance for 2010 mail-order volume, which was 107 million to 109 million prescriptions. We are now guiding to the high end of that range, approximately 109 million mail-order prescriptions.

Additionally, we continued to expect our full year 2010 adjusted mail order penetration rate to be consistent with or slightly below the 2009 level of 34.2%. This is because of strong retail volumes on top of our already strong mail volumes, which as I just mentioned, are achieving the high-end of guidance.

Turning to rebates, we earned nearly $1.45 billion in rebates for the third quarter. This represents 6.9% growth relative to the third quarter 2009, attributable to new client wins and continuous improvements in forming our contract. The third quarter 2010 rebate retention rate was 12.8% compared to 14.1% in the third quarter 2009 as we continue to drive significant value to clients in a highly transparent manner.

Turning to gross margins. Our record third quarter 2010 gross margin of $1.12 billion reflects 7.6% growth over the third quarter 2009. Our consolidated gross margin percentage of 6.9% for the quarter declined 10 basis points from the 7.0% in the third quarter 2009 and was up 40 basis points over the 6.5% reported for second quarter 2010. Third quarter 2010 gross margin percentage is the second highest in the past seven quarters.

The strong sequential growth in gross margin percentage is attributable to the release of scheduled generics in the third quarter and further progress in driving improved discounts for Medco purchases across channels and products. Our gross margin benefited from record generic mail-order volumes of 17.1 million prescriptions for the third quarter, up 15.5% over the third quarter of last year, reflecting new generics and continued growth with previously released generics. Our retail volumes grew at a rate of 6.7%, which is slightly less than the overall mail-order volume growth of 7.1%, and our mail-order penetration rate held steady at 34.5%. We still expect the incremental EPS contribution from new generics in 2010 to be approximately $0.25, consistent with the guidance we gave one year ago. We now expect our full year 2010 gross margin percentage to be approximately 6.6%, down about 10 basis points from 2009, reflecting the higher retail volumes and lower than expected gross margin contribution from Accredo, which I will discuss shortly.

Selling, general and administrative expenses of $395 million for the quarter increased $26 million or 7.0% from third quarter 2009, reflecting higher professional fees and technology-related expenses associated with strategic initiatives and nonrecurring closing costs associated with the UBC acquisition. For 2010, now with UBC included, we expect SG&A expenses to be closer to the midpoint of $1.5 billion to $1.6 billion. Dave already discussed our record EBITDA for adjusted script performance, and I will add that we continue to expect the full year 2010 EBITDA for adjusted prescription percentage increase to be in the low single digits over the $3.06 for full year 2009. Our intangible amortization of $71.2 million in third quarter of 2010 decreased 9.2% from third quarter 2009. Our guidance for intangible amortization for 2010 is being revised to approximately $290 million, the high end of the previous range and part the result of the UBC acquisition.

Total net interest and other expense of $40.8 million for the third quarter of 2010 increased slightly from the $39.9 million in third quarter 2009, reflecting the new debt we added earlier in September 2010 that I already discussed. Our 2010 guidance for net interest and other expense is now in the range of $160 million to $165 million, including the interest on the new senior notes.

The third quarter 2010 effective tax rate was 39.3%, consistent with the same quarter last year. We continue to expect the 2010 effective tax rate of approximately 39.0%. We now expect the 2010 weighted average diluted share count of approximately 450 million shares, reduced from the previous guidance of 460 million shares and part because we were able to purchase more shares from the lower stock price experienced since our last update.

We expect our current $3 billion share repurchase authorization to be completed by early next year. As of the end of the third quarter, $1.4 billion of the current $3 billion authorization remains.

Turning to our Specialty segment, as Dave already mentioned, Accredo achieved record revenue in operating income results for third quarter 2010. We continued to expect full year Accredo revenues in excess of $11 billion. We now expect operating income in the range of $430 million to $440 million, a decrease from the $450 million we previously provided, driven primarily by reduced expectations for Accredo's full year 2010 gross margin contribution. Accredo's gross margin percentage declined to 6.8% in third quarter 2010 compared to 7.4% in third quarter 2009. The Accredo gross margin decline reflects product, channel and new client mix. We are not anticipating any meaningful uptick in manufacture of price increases for the remainder of 2010. We expect our 2010 Accredo gross margin percentage to be approximately 6.8% for full year 2010.

Moving on to Medicare. We continued to experience growth in our Medicare PDP. For third quarter 2010, Medco's PDP revenues increased 37% to 369 with $4 million. As Dave discussed, we are raising and narrowing our guidance for 2010 to briefly repeat our raised and narrowed 2010 guidance. Diluted GAAP EPS is now expected to grow 20% to 21% over 2009, in the range of $3.14 to $3.16. Diluted EPS, excluding the amortization of intangibles from the 2003 spin off, are now expected to grow 19% to 20% over 2009, in the range of $3.38 to $3.40. I have already walked you through many of the components of 2010 guidance. I would like to highlight some additional details.

We have completed virtually all of our 2010 renewals, approximating $15 billion of drug spends, which includes scheduled annually elected renewals. As of the third quarter, the vast majority of the 2010 renewal pricing is in effect. As I already mentioned, the expected incremental growth impact of new generic introductions on 2010 EPS remained at $0.25. As a reminder, the estimated quarterly timing of this incremental growth: $0.03 in the first quarter, $0.06 in the second quarter, $0.08 in the third quarter and then expected $0.08 in the fourth quarter. The high utilization of generics in 2010 is now expected to reduce revenues in 2010 by well over $3 billion, a new Medco record, driving very significant savings for our clients and members. We still expect that DNA Direct will be approximately $0.01 dilutive to our 2010 EPS.

Our acquisition of UBC is expected to be approximately $0.02 dilutive to 2010 GAAP EPS, including the non-recurring transaction cost I previously mentioned. This 2010 dilution from UBC is included in the raised and narrowed 2010 guidance. I would add here that UBC is expected to be accretive to our EPS in 2011.

Lastly, the contribution of Europa Apotheek Venlo to the Medco Celesio joint venture is now expected to take place at the end of fourth quarter 2010, instead of during the third quarter of 2010 as mentioned on our second quarter earnings call. As I discussed last quarter, there are some one-time financial items associated with the contribution of Europa Apotheek Venlo to the joint venture. At this time, we are not able to estimate the total anticipated net gain from the third valuation or the expected net foreign exchange loss from the transaction. But we do not expect the net transaction to be material. And therefore, they should not materially affect revised 2010 guidance. I will now take you through 2011 guidance.

Our full year 2011 GAAP diluted EPS is expected to grow 12% to 17% over the raised and narrowed 2010 guidance, to a range of $3.53 to $3.66. But we will not use this measure next year as a reference. Our diluted EPS for full year 2011, excluding the intangible amortization from the 2003 spinoff, is expected to grow 12% to 16% over the raised and narrowed 2010 guidance to a range of $3.80 to $3.93.

Very importantly, as Dave mentioned, we are changing our non-GAAP diluted EPS measure in 2011. Going forward, we will report diluted EPS, excluding all intangible amortization expense. This measure is easier to understand and it brings us in line with the reporting of our industry peers. This new diluted EPS measure for full year 2011, excluding all intangible amortization expense, is expected to be in the range of $3.99 to $4.12, representing 12% to 17% growth over the 2010 equivalent of $3.53 to $3.55.

Table 9 attached to our earnings release bridges the EPS measure. For 2011, the diluted EPS excluding all intangible amortization is currently $0.19 higher than diluted EPS, excluding intangible amortization from the 2003 spinoff, and $0.46 per share higher than diluted GAAP EPS.

As Dave mentioned, our 2011 growth rates over 2010 are substantially consistent regardless of the EPS measure used. There is no artificial benefit created by this change.

In conclusion, on this very important point, when you build your consensus models for 2011, please use the new diluted EPS, excluding all intangible amortization. The $3.99 to $4.12 number. So that is how we will report in 2011. For the fourth quarter and full year 2010, we should continue to model adjusted EPS only to exclude the spinoff intangible, consistent with the basis for our 2010 guidance.

Before I take you through the detailed components of our 2011 guidance, I would like to point out that 2011 will be a 53-week fiscal year. And our fiscal calendar will end on December 31, 2011. Our last 53-week year was in 2005. The impact of this extra week is not significant to earnings, but it does have an effect on our cash flow from operations based on the timing of our biweekly billing and payment cycles which I will address later.

The detailed components of our 2011 guidance are as follows: We currently expect to renew approximately $18 billion of business in 2011, including scheduled and elective early renewals, representing less than 1/3 of our total business. Over 60% of these 2011 renewals are already completed. As in previous years, we expect the majority of the renewal pricing will be in effect for the first quarter of 2011. Likely, 75% in the first quarter with the majority of the remainder in the third quarter.

Our mail-order prescription volumes for 2011 start in the range of 110 million to 112 million, demonstrating solid growth in our base business. From this 2011 mail-order prescription volume range, we are transferring approximately 2 million prescriptions associated with the integration of the Europa Apotheek Venlo volume with the Medco Celesio joint venture at the end of 2010. In addition, we are deducting approximately 1 million mail-order prescriptions, all generics, associated with fexofenadine. For planning purposes, we expect the generic prescription product fexofenadine, known previously under the brand name Allegra, to become available as an OTC product after the anticipated FDA approval of the switch from prescription to OTC sometime early in 2011.

With this 3 million prescription adjustment, our final expected 2011 mail-order prescription volume is in the range of 107 million to 109 million. Regarding patient drug utilization rates in terms of prescription per patient, particularly at mail-order, the level of overall utilization we are experiencing in 2010 is consistent with 2009 and is expected to remain consistent into 2011. Importantly, we are seeing increases in generic utilization, including the older generics and further declines in brand utilization.

The incremental contribution from new generic introductions on 2011 EPS is expected to be $0.09, with virtually all of the benefits in the second half of 2011. The quarterly effect of new generics in our 2011 EPS will be $0.00 in the first quarter, $0.01 in the second quarter, $0.02 in the third quarter and $0.06 in the fourth quarter. Again, 2011 is the lightest year for incremental new generic contribution through 2020.

In light of the 2011 generic effect and other factors, we expect the quarterly Medco EPS spread in 2011 to be even more backend loaded than we are experiencing in 2010. The generic form of Lipitor is only available for one month of 2011, in December. As it was mentioned, the contribution from new generics in the fourth quarter of 2011 is $0.06 per share. Lipitor contributes about one half of that $0.06. While this is expected to render the fourth quarter growth rate, the highest of 2011, more importantly, it provides meaningful insight into the expected robust incremental generic contribution to our 2012 EPS. As we benefit from a full year of Lipitor in 2012, along with generic introductions of other major drugs in the course of 2012, including Plavix, Singulair, Seroquel and Lexapro to name a few. The year 2012 is the strongest year for new generic contribution and the highest in our history.

SG&A expense for 2011 is expected to be in the $1.7 billion to $1.8 billion range, with virtually all of this expense growth stemming from UBC. We remain vigilant in driving the highest levels of efficiency to become an even more agile and efficient organization by leveraging our core competencies and fine-tuning our processes in order to further reduce our operating cost and expense growth. You will recall that last year, we were able to yield significant benefits from projects related to inventory reductions and accounts receivable consolidation. And heading into 2011, we continue to analyze our processes and identify additional opportunities.

Moving along, the intangible amortization expense for 2011 is expected to be in the $300 million to $320 million range. Net interest and other income and expense for 2011 are expected to be in the $225 million to $240 million range. The 2011 effective tax rate is expected to be in the range of 38.5% to 39.5%. Weighted average diluted shares, full year 2011, are expected to be in the range of 395 million to 410 million shares. At these levels, it is clear that we expect to return meaningful value to our shareholders in 2011 through share repurchases.

Accredo revenues are expected to be approximately $13 billion, and Accredo operating income is expected to approach $500 million in 2011. Accredo's gross margin percentage is expected to be in the mid-6% range. In 2011, Medco's overall gross margin percentage and EBITDA per adjusted prescription numbers are expected to be at least in line with 2010, with the probability of being higher. Again, UBC is expected to be accretive to our EPS in 2011. As I mentioned earlier, the 53-week year in 2011 impacts our cash flows from operation because the year ends in a different point in our two-week payment and receipt cycles.

This essentially reduces our cash flow from operations by approximately $500 million compared to what a normal 52-week year in 2011 would yield. Reported cash flow from operations for 2011 is expected to be in the range of $1.9 billion to $2.1 billion. Adjusted to reflect the normal 52-week year, cash flow from operations would be $2.4 billion to $2.6 billion.

Our capital expenditures for 2011 are expected to be approximately $325 million, reflecting a channeled investment in building an even more agile and clinicly focused enterprise, investments to ensure compliance with evolving and complicated CMS regulation related to healthcare reform implementation and investment in the UBC business.

I would like to close my 2011 guidance discussion by stressing the importance of return on invested capital performance. Our return on invested capital just two years ago, in 2008, was 20%. In 2009, it increased 27%, and for 2010, we are approaching 35%, when UBC is excluded. With UBC included in 2011, we still expect the return on invested capital in excess of 30%. We believe return on invested capital is a very important gauge of a company's ability to drive long-term shareholder value.

We have covered quite a bit of material today, and we will cover even more in our Analyst Day on November 19 in New York City. We will give you expanded insight into the continued growth of our business over the near term, as well as for the next decade.

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

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Lisa Gill with JPMorgan.

Lisa Gill - JP Morgan Chase & Co

Dave, as we start thinking about customers becoming more sophisticated, clearly understanding the value of generics, are you seeing any difference in the way that they're trying to negotiate and trying to keep more of the generic economics especially as we move into '12 and beyond? And then my second follow-up question, which is the -- my understanding is that there is a new small-molecule for hepatitis C and our analyst is forecasting that this is going to be a $2.5 billion drug. Is this going to be something that's going to be good for Accredo or for your existing PBM business?

David Snow

So I'll answer the first part, Lisa, on the generics, and then I have both Rob and Steve here for the second piece. So I'll give it to you, Rob, okay? Just relative to sophistication around generics, I think both clients and members are becoming more sophisticated around generics. And as we noted in our formal comments, we're actually seeing very nice year-on-year growth in generic dispensing rates beyond the year of introduction. And our clients have every reason to still want to continue to drive that generic uptake, and they also have very clear reasons to keep our interest aligned with driving that uptake. So the short answer to your question is, no, we have not seen additional push on the part of our clients. They are very comfortable with the competitive environment and they are also very comfortable with the way incentives are aligned. And they hope to see continued generic uptake year-after-year even in the old generics that have been out there for a while. And then Rob, why don't you take the new drug that Lisa mentioned?

Robert Epstein

Actually, there are several new products waiting to get approved in the hepatitis C space. It's really great news for patients because the current cure rates are in the 40% to 50% range with the current injectable drug. These new orals though, appear at this point to almost double the success rate in curing hepatitis C. So the marketplace is looking for new solutions. Our clients are excited about it and would be an important drug for Accredo. And we'll wait and see what the final data and when the approval happens.

Operator

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

Lawrence Marsh - Barclays Capital

Dave, it sounds like the most important message here today is your message around generics in the next six or seven years. And now that we sort of framed $0.15 to $0.25 of EPS contribution from $0.07 to $0.10, obviously, much lower in '11, much stronger in '12, and then stable from '13 to '20, I just want to make sure, is that the message? And are you talking about an absolute contribution or per share contribution? And then how do you communicate that to clients, to make sure they don't become irrational in asking for more than their fair share for '12?

David Snow

Well, I think what we maintain our ratios of what's returned to our customers and what we retained just as we have since 2003, I think that formula seems to work and our clients seem to be comfortable. To your bigger question, it's clearly a message. I think we have a lot of positive messages in what we are communicating today and will certainly have a lot of follow-on conversation at our Analyst Day on the 19th. But it was a kind of remarkable when we looked at those branded drugs scheduled to go off patent after 2015. Although the gross sales volume is relatively low compared to this wave between 2006 and 2015, we were really pleasantly surprised to see unique to Medco the enormous volume of these drugs that were going through our mail service and our mix, which means a very positive continued earnings growth, both on an EPS basis as well as on a gross basis through 2020. And by the way, it doesn't mean it's a clip in 2020, we just haven't analyzed beyond 2020. We feel as though a 10-year plan is probably not as far out as you want to go with any kind of credibility. But it is very encouraging. In fact, if you look at the years, '12 is by far the monster. '14 is large, '18 is the third-biggest year. 2018 is the third biggest year in the decade, which is kind of interesting. So anyway, it is an important message and I think on top of that, the growth in the other key parts of our business is also important. Because generics is not our only growth driver, and I hope that's a take away as well.

Lawrence Marsh - Barclays Capital

And I guess a quick obligatory follow-up, Dave, are you still of the view that you'd hope to resolve the contract expiration with your largest customers well before the '12 expiration?

David Snow

Well, yes. The end of '12. For reference, I'd call the expiration a 1/1/13 day. And if you look back at history, we've renewed this contract before. We would hope that we could resolve it one way or the other prior to that date.

Operator

Your next question comes from the line of Ross Muken with Deutsche Bank.

Ross Muken - Deutsche Bank AG

You had a consistent nice tick up in service-related gross profit. I know you've focused on a lot of sort of additional offerings, particularly on the clinical side, and you've had a lot of success and uptake with many of these new programs. Talk about sort of how you think about that evolving also into next year, in terms of the service related growth? Will that kind of continue to outpace the traditional business? And sort of how we think about that going forward?

Richard Rubino

That's right, Ross. When you look at recent history, the service revenue and service margins have grown very nicely. And to your point, that does include our clinical programs. Importantly, it includes fees for our Medicare Part D programs. And one thing that's going to be a very interesting growth driver as we get through next year is UBC. The headline for next year, as it relates to service revenue and margin is you're going to see meaningful service margin growth. Meaningful service revenue growth far beyond what you've seen in our recent history, driven by UBC. So I said many times, over the past few years, that service revenue and the associated margin holds great promise for our future. And UBC, as far as I'm concerned, is a homerun in achieving our long term service revenue and gross profit desires. So stay tuned. I'm going to talk a little bit more about our service revenue trajectory when we have our Analyst Day presentation later in the month.

David Snow

And by the way, Rob is going to give a lot of detail about the UBC acquisition and how it integrates with our core business. Because as you know, we've announced already that Doctor Epstein is responsible for that asset, as well as the Medco Research Institute. So he'll give you quite a bit of color on the 19th.

Ross Muken - Deutsche Bank AG

And one kind of small question, Rich. In terms of UBC for next year, just doing the sort of math on the amortization impact, am I right at assuming that it's about a $0.03 incremental hit from amortization roughly from UBC?

Richard Rubino

Well, I can give you some help on that one. Just hold on one second. If you look at our intangible amortization for next year, it's basically has a couple of items going in different directions. What we have is, we do have an incremental amortization from UBC. But we also have a decrease associated with PolyMedica, because the PolyMedica intangible happens to be on an accelerated basis. So what you have is essentially UBC intangible amortization estimated to contribute about, say, $40 million to $50 million in additional intangible expense for next year. But PolyMedica offsets a piece of that, down by about $20 million to $25 million from this year.

Ross Muken - Deutsche Bank AG

I'm just trying to tease out kind of what level of amortization was include in the middle range that's no longer going to be included going forward. Just so I can kind of understand what the incremental was there. So it's about $20 million to $25 million, that would have been in that middle range. That's now being added back to the lower range?

Richard Rubino

That's correct.

Operator

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

Robert Willoughby

Richard, did you mention what the EPS contribution from new generics in 2012 might be? What's the comparable number to the $0.09? And then just secondarily, maybe for you, Dave, can you remind us what your strategy in oncology is going to be? Do you see any impact from the McKesson deal yesterday with U.S. Oncology?

Robert Epstein

Bob, on your first question, I did not mention specifically the total incremental EPS effect from new generics in 2012. We are going to give you some color, some broad color with regard to how significant it can be at our Analyst Day. I did point to the fact, in my prepared remarks, that when you look at the $0.06 of incremental generic contribution in the fourth quarter of next year, $0.03 of that is Lipitor, and Lipitor for only one month. So that is a starting point recognizing all of those other drugs coming in. And I mentioned Plavix, Seroquel, Lexapro, et cetera

David Snow

And we will be sharing with you more information at Analyst Day relative to that, the generic wave through 2020. So stay tuned on that. As it relates to our oncology strategy, we are very familiar with the U.S. Oncology asset. And that acquisition by McKesson has no impact with us. I mean, it actually makes sense that McKesson would look at this asset as a distributor and the way the relationship works between buy and bill on the drug side and the distributors with the doctors. So we see that as making sense. We have our own oncology strategy, which we've been implementing for quite some time now. We've seen very nice growth within our Oncology business. By the way, we just opened our new Oncology Therapeutic Resource Center in our facilities out in Indianapolis, which are very impressive. So we're comfortable with that growth, and we will talk a bit about that growth of our Oncology business at our November 19 Analyst Day.

Operator

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

Ricky Goldwasser - Morgan Stanley

One broad question on the contribution of Lipitor. Maybe we can frame it in a more general way, but what is the magnitude of the difference between a contribution from a drug that's exclusive versus a drug that has multiple players? And then just another follow-up question on generics, does Concerta has any impact on your numbers, and is it included in guidance?

Richard Rubino

What was that drug?

David Snow

Concerta. Is that what I heard?

Ricky Goldwasser - Morgan Stanley

Yes.

Richard Rubino

To the extent -- I go through a pretty long list of the drugs that are affecting us. Concerta is, according to Doctor Rob, who's holding up his sign of ADHD, I wouldn't, at this point, want you to believe that's a material drug because I usually look at the top 20 and it doesn't appear to be in there. So the answer to that is no. With regard to the profitability of generics, when there is one manufacturer versus multiple, I think, essentially, it varies on a drug by drug basis. The objective is to drive value to our clients throughout the period from when there is exclusivity through when there are multiples. And we obviously do the best we can to get the best value as we acquire these drugs and drive the most value to our clients through the continuum of the availability of the drug.

Ricky Goldwasser - Morgan Stanley

So if we think about Lipitor and you talked about $0.03 for essentially one month in 2011 with only two players in the marketplace, what should we extrapolate then for drugs like Lipitor once you have multiple players?

Richard Rubino

I will give you some help in that regard when we have our Analyst Day. For now, I would recommend that you just start with what I gave you, which is quite an interesting nugget that is relatively easy math. And we'll give you some more insight on November 19.

Operator

Your next question comes from the line of Tom Gallucci with Lazard Capital Markets.

Thomas Gallucci - Lazard Capital Markets LLC

Rich, a lot of focus on gross margin and profitability earlier this year. It ramped nicely in the quarter. You mentioned a few items in your prepared remarks. Can you give us any more color or granularity on some of the drivers there and the sustainability of some of the things around purchasing or rather that you're doing?

Richard Rubino

Sure. So very importantly, our gross margin percentage this quarter was, what I would call, a natural quarter. It was earned and of the components of it are sustainable. So the first component, of course, is the generic effect, the incremental generic effect which is on schedule as you know. But also what we have is, when you think about our scale, over 100 million mail-order prescriptions, well over $65 billion in revenue this year, you have massive purchasing scale. And we -- our management team, I think, has done a terrific job in the course of this year in delivering planned savings when it comes to how we buy and how we contract across the spectrum. Mail, branded generics, retail, et cetera. So it really is across the board. And because of that, I'm comfortable saying that it is sustainable.

Thomas Gallucci - Lazard Capital Markets LLC

And then on utilization, I guess you're sort of implying similar trends that we've seen in '09 and '10. So some generic growth, some pushback on brands. Is that just sort of how you see the broader market growing and maybe the impact to the economy? Or can you talk about any other factors that might be at work there in your assumptions?

Richard Rubino

Well, I'm not blaming the economy for anything. Because actually, we did quite well through the weak economy. If you look at when the economy started to soften, that's when our generic volumes started to climb. So I'm not going to say that we are seeing less doctor visits or less utilization. I've heard others say that. But we are a growth company. We are net-new winners, and we are seeing growth, very importantly, in generic prescriptions. I think as the economy continues to suffer a 10% unemployment rate, which we're obviously going to be in probably for another year at least, patients are price sensitive. And patients is sensitive to not only spending as little as possible on their drugs, but making sure they're getting the best clinical care. And that's what we do. That's what we do for a living. And I don't expect any material changes in that for 2011.

David Snow

I think the other observation that Rich made in his formal comments is that the average number of scripts per patient has been relatively consistent. '08, '09, '10 and we're projecting into '11. And that relative stability is really tied to the age of the population we serve and the preponderance of chronic disease within that population. So the real driver, ultimately, in the average number of scripts per person will be the age of our population and the baby boomers moving into the Medicare zone where they tend to pick up more chronic and complex disease and have a higher average number of prescriptions per patients. So we're just reflecting upon the stability in our mix of ages right now and disease within our group of 65 million members.

Operator

Your next question comes from the line of Glen Santangelo with Credit Suisse.

Glen Santangelo - Crédit Suisse AG

Rich, if I can just follow-up on two questions, first on the gross margin side. You did hit a pretty nice inflection point this quarter of an additional 40 basis points of gross margin. And I think in your prepared remarks you said that, that was all increment generics. And I think, when you were answering Tom's question, you sort of suggested that it was better purchasing. I mean, could you clarify that a little bit more?

Richard Rubino

Yes, actually, I said both in my prepared remarks.

Glen Santangelo - Crédit Suisse AG

Oh you did? And so as I think about the gross margins for the fourth quarter and into the first quarter, given the generic contribution we should see, kind of a similar level of gross margin or should we ramp up again? And then I guess, as we look to the first quarter, given your repricing all those contracts, would we expect it to take a noticeable step down?

Richard Rubino

I'm not going to get into quarterly gross margin guidance here. I'll give you some pointers as we get deeper into the -- maybe on Analyst Day, and even get into our discussions on the year end call in early 2011. So I'm talking about first quarter gross margin percentage and the associated trends. I will tell you, on the shorter term, regarding the fourth quarter, we expect gross margin stability to compared to what we're seeing in the third quarter. To my earlier point of sustainability, as you know, I am guiding to a full year, 6.6% gross margin percentage for 2010.

Glen Santangelo - Crédit Suisse AG

And then maybe if I can just follow up on the Lipitor question. I mean, it's clear that it sounds like you're signaling about $0.03 for the month for Lipitor at the end of next year. Now obviously, Ranbaxy has a first to file on that. So I think the point was being made, that the drugs is going to be on exclusively for 180 days. So I guess, as we look at the profitability on that drug in the second half of 2012, when the exclusivity runs out, should the profitability take a noticeable step up after that?

Richard Rubino

Well, it was more than a signal. I actually gave the number, and I would tell you that usually, what happens in the lifecycle of a generic product is the more competitors you have making it, by definition, the better the pricing gets. It's just the way it works. It's like many other things in life. So I think your fundamental assumption is safe, Glen.

Operator

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

Steven Valiquette - UBS Investment Bank

Two questions, first on renewals and then the generic pipeline. So the renewals, you guys mentioned that 60% or so of the current $18 billion is renewed so far. I'm just curious of the majority of the 1/1/11 starts now completed. So do you have maybe a higher than average midyear renewals? Just trying to get a sense for that. And then question two, just to throw it out there for now I guess, I spent a lot of time myself trying to build out this generic pipeline through 2020. And just out of curiosity, when you guys are doing it, are you trying to make any attempts to adjust for brand price inflation and script growth for the various drugs between now and the back half of the decade through 2020? Are you still basing it on current year sales? That's where, I think, a lot of people tend to underestimate the true opportunity -- but just trying to get a sense for how you guys are doing that process?

Richard Rubino

I'm not going to give the specific percentages, but as you would imagine, since it's November, the vast majority of the first quarter renewals are basically locked and loaded. And those that would be open would be more the midyear ones. That's safe to say. Regarding the generic pipelines through 2020, as Dave mentioned in his prepared remarks, we did a detailed bottoms up strategic financial plan. It's basically doing an operating plan for 10 years. The first time we did it at that level of detail. So as a result, all of the assumptions that you mentioned in your question with regard to brand inflation et cetera, that's all baked in at a bottoms up level. It wasn't based on what we know today and just doing math based on 2010 numbers. This was a several month process and it factors in everything we would factor in a normal operating plan.

Steven Valiquette - UBS Investment Bank

Just back quickly on the renewal, do you have a preliminary number for how much we up for renewal next summer for the 2012 selling season?

Richard Rubino

No.

Operator

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

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

A couple of questions about healthcare reform, Dave. We've heard that some clients, in an effort to maintain the grandfather status, have been more hesitant than normal to make planned design changes or vendor changes. Are you seeing that, and has that affected your renewal rates?

David Snow

It hasn't affected renewal rates. I think what we have seen is clients are not making some of the benefit design changes. The in force clients are not making the typical number of year-over-year benefit design changes just because of the grandfather clause issue. And I do think that there's going to be a lot of lobbying down in Washington on the part of employers as it relates to the grandfathering clause. Remember, the rules underneath this thing aren't fully written yet, and it is very concerning to our customers that they're being asked to freeze themselves in time, which they need to be able to change with the changing environment and they need to be able to innovate within their benefit design. So when you think about things that are going to be widely discussed, as the rulemaking is proceeding down in Washington underneath the policy, this is one that I think is going to be hotly debated. And I'm actually fairly optimistic that some changes will be made to this grandfathering law. Because quite honestly, it makes no sense whatsoever. But people are being cautious right now until this gets resolved. So we've seen fewer changes, but I don't think I've seen any impact relative to RFPs going out in the normal procurement process. It's been a great year and that part is going fine.

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

As it's written now, do you expect to see any benefit from biosimilars? And when might that be? Or do we really need to see some changes in that legislation as well?

David Snow

I can tell you, and we're going to talk more about this at Analyst Day, but I can tell you that a large number of manufacturers are heading down a path to create biosimilars even before a pathway has been defined. And they're actually prepared to create biosimilars the good old-fashioned way, including clinical trials, Phase III, the whole 9 yards because monetarily, it works for them. So we are expecting, one way or another, to see competition within the classes of biotech drugs. And we think that will benefit both Medco and our clients. So it's on its way. And I think in the next two to three years, we're going to start seeing biosimilars. One way or the other. The pathway will perhaps bring the cost of making these biosimilars down some, which again would be beneficial to clients. But even if the pathway doesn't get fully written, you're going to still see them.

Operator

Your final question today comes from the line of Kemp Dolliver with Avondale partners.

Kemp Dolliver - Avondale Partners, LLC

Two questions. First is, do the renewal numbers you are talking about for next year, do those include contracts with price checks that are essentially multiyear but have price checks in between?

David Snow

Anything that was planned or anything we choose to electively renew is included in the numbers.

Kemp Dolliver - Avondale Partners, LLC

And the second question, relating to share purchase, Rich, is, what's the dollar -- you hinted at it, but what's the dollar amount range you're thinking of for share repurchase? And also, your interest expense assumption would imply some additional leveraging. Am I on the right path there?

Richard Rubino

With regard to the interest expense, and I know you did the math on the new bonds, there are other things in that fall in interest numbers. It's got other income and expense. So it also includes some of the impact of our JVs, our joint ventures where we used the equity method of accounting. So there's more than interest in there. The true interest effect is, I think, it's about $35 million of annualized interest expense on the new bonds. We're not expecting to lever up. I don't believe in borrowing to repurchase shares. I believe in using our free cash flow to repurchase shares. And as we look through the next four or five quarters, that's what we are going to do. So you can expect, as I alluded to in my prepared remarks, maybe $1 billion or so in the fourth quarter and maybe another couple of billion dollars in the course of next year, probably evenly spread in the course of the year 2011.

David Snow

So with that, we want to thank all of you for joining us today, and we do look forward to seeing all of you at our Analyst Day on the 19th. Thanks, again.

Operator

Ladies and gentlemen, this concludes today's conference. You may now disconnect.

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