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Express Scripts Holding Company (NASDAQ:ESRX)

Q2 2014 Earnings Conference Call

July 30, 2014 8:30 AM ET

Executives

Jamie Kates – Director, IR

Cathy Smith – EVP and CFO

Tim Wentworth – President

George Paz – Chairman and CEO

Steve Miller – SVP and Chief Medical Officer

Analysts

Glen Santangelo – Credit Suisse

Lisa Gill – JPMorgan

Robert Willoughby – Bank of America

Ricky Goldwasser – Morgan Stanley

Robert Jones – Goldman Sachs

Eric Percher – Barclays

John Kreger – William Blair

Steven Valiquette – UBS

Brian Tanquilut – Jefferies

David Larsen – Leerink Partners

Anthony Vendetti – Maxim Group

Charles Rhyee – Cowen & Company

Garen Sarfian – Citigroup

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Second Quarter 2014 Earnings Call. (Operator Instructions) As a reminder, this conference is being recorded. I would now like to turn the conference over to our host, Director of Investor Relations, Jamie Kates. Please go ahead.

Jamie Kates

Thank you. Good morning, everyone. Welcome to our second quarter 2014 earnings call. With me today are George Paz, Chairman and CEO; Tim Wentworth, President; Cathy Smith, CFO; and other members of our senior management.

Before we begin, I need to read the following Safe Harbor statement. Statements or comments made on this conference call may be forward-looking statements and may include financial projections or other statements of the company’s plans, objectives, expectations or intentions. These matters involve certain risks and uncertainties. The company’s actual results may differ significantly from those projected or suggested in any forward-looking statement due to a variety of factors, which are discussed in detail in the company’s filings with the Securities and Exchange Commission. We do not undertake any obligation to update, or otherwise release publicly any revisions to our forward-looking statements.

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

At this point, I will turn the call over to Kathy.

Cathy Smith

Thank you, Jamie. Today, we will cover three topics. First, I’ll review our second quarter financial performance and guidance. Second, Tim will provide a business update. And finally, George will address some raising questions we received from investors and provide an update on how we are positioned for the long-term growth.

During the quarter we made progress on rationalizing our footprint and delivered a quarter in line with our expectations. Adjusted claims were $324.5 million, in the middle of our guidance range. Home delivery and specialty claims increased sequentially from $30.5 million last quarter to $32 million this quarter, due to our continued focus on mail order program, a long list, the adoption of our aggressive mail programs by several of our clients for their healthcare reforms offerings.

Furthermore, we continue to see mail growth for client on a same-store basis. Once the patient starts on mail, we receive approximately 75% share of their script while our mail penetration currently stands at around 30%, our target continues to be 40%. We have the type of programs in place that will help drive our mail growth. Similar to the second quarter of 2013, this quarter reflects the $129.4 million in incremental revenue related to a client contract payment.

Year-over-year SG&A expense declined as a result of efficiencies gained from a net co-integration. As mentioned, we are making progress on decommissioning the legacy Express Scripts platform and rationalizing our operational footprint. As we announced in April, we are closing three operational sites, consolidating one contact center, and replacing the backend pharmacy in New Jersey. These savings are reflected in our 2014 guidance.

EBITDA exceeded $1.7 billion for the quarter and EBITDA for adjusted scripts was $5.35, up 10% over the prior year excluding UnitedHealth. Excluding the impact from the previously mentioned client contract statement, EBITDA for adjusted script would have been $4.95, up 9% over last year excluding UnitedHealth. We are realizing an improvement in EBITDA for adjusted script without a material increase in our junior excel rate. This improvement is attributable to supply chain performance, including the launch of our 2014 National Preferred Formulary, better management of ingredient cost, and productivity improvements. Importantly, these factors also result in significant cost savings for our client.

We reported earnings per share of $1.23 representing growth of 15% over last year excluding UnitedHealth. In addition, we generated $735.5 million of cash flow during the quarter, and repurchased 29.9 million shares for $2.2 billion. As of the end of June, we had 42.9 million [ph] revisions. During the quarter we also launched and priced a successful $2.5 billion bond offering across three tranches [ph] with a weighted average coupon of 2.55% and weighted average maturity of 6.6 years. We used the proceeds to prefund our $900 million 2.75% senior notes due November of 2014. We also reviewed all of our $1.25 billion 3.5% senior notes due 2016 at the Medco premium. The remainder of the funds will be available for our other general profit services which may include share repurchases under our share repurchase program.

As we look including the effective tax rate and diluted shares, our diluted share range now assumes approximately 28 million shares repurchased in second half of this year. With regards to our third quarter projections, earnings per share is expected to be between $1.27 to $1.31, up 22% to 26% year-over-year for UnitedHealth. All in all, is an in line quarter with some very positive trends.

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

Tim Wentworth

Thanks, Cathy, and good morning, everyone. Today I’ll begin by addressing two primary areas which go hand-in-hand, specifically service excellence and client retention.

At January 1 we successfully implemented over a hundred new clients who delivered the pharmacy framework in support of the healthcare reform business of our health claim clients, executed on a comprehensive new regulatory requirement and migrated over 9 million patients to our destination platform. The integration activity specifically resulted in some isolated challenges with some of our clients, and in response to these challenges we have revamped our leadership, strongly aligned our metrics to key service indicators, and redefined our commitment to service across the organization. These changes have produced significant and sustained results. Our operational indicators show that we are now performing at or above pre-integration and strong historical levels.

Now at the heart of our successful track record of involving acquisitions is our practice of combined best of all systems and building new and more effective leadership. However, this means change which despite of best efforts often includes the loss of some account management teams. In our comments, routines bind our relationship with our clients. In light of this change, clients naturally are going to evaluate alternatives and often test the market. Express Scripts has taken advantage of this dynamic in the past when our competitors have merged, and likewise competitors are attempting to take advantage of this situation now. Due to these dynamics the retention rate for 2015 is expected to be in the range of 92% to 93%.

This retention rate combined with strong organic growth and new sales will result in expected claims volumes slightly down, to down 1.5% in 2015. As you know, Ed Ignaczak, our Executive Vice President of Sales and Account Management, is retiring after 24 years and we will miss his strong leadership and the contributions that he made to help our organization grow. In the wake of that retirement, we are extremely excited to welcome David Queller to Express Scripts as the Senior Vice President of Sales and Account Management. David comes to us from Aetna, where he was Senior Vice President of National Accounts, and David deepens our knowledge significantly on both, Health plans and large direct payers, and is uniquely suited to lead our client facing organization.

We have built the most advanced, best positioned PBM in the industry and we believe we will improve retention and win a significant share of new business going forward. And we are confident about our future for three main reasons; those are scale, alignment, and innovation. First, scale; our scale is a terrific near and long-term advantage. A great example is what we have achieved for clients through our focused management initiatives, whether delivering over $700 million in client savings through our National Preferred Formulary in 2014, or eliminating 95% of wasteful spend on compound drugs, we continue to leverage our scale to drive client savings, and provide patients access to clinically effective cost effective options.

Alignment, our client service organization provides unrivaled specialized knowledge of our clients businesses, and our healthcare landscape. Experience account teams partner with our client to deliver on their specific needs whether it is the health or health plans grow their lines of business or help our commercial clients drive down costs. Our clinical specialization provides the best care for our patients, and as we lower cost for our clients and drive better health outcomes for our patients we also deliver the value to our shareholders.

Innovation, to our merger we brought together complimentary capabilities which enable us to uniquely address our clients’ needs for better decisions and healthier outcomes. We combine the advanced application of behavioral sciences together with the therapeutic resource centers which rely on specialist pharmacist to help patients make better decisions. In addition, two days ago we cut the ribbon on our 2.0 Innovation Lab, this dynamic and interactive workspace incorporates 3 of our 11 therapeutic resource centers, as well as decision designers, researchers, and other key employees who are focused on innovation. Our lab enables strong collaboration with clients to drive differentiated safety, savings, and health outcomes. Ultimately we’re driving down costs, reducing waste and improving health in ways no other company can, this makes us unique in the PBM marketplace.

And in fact, a result of the research completed in the lab we published a comprehensive peer reviewed report in this month’s Journal of Managed Care and Specialty Pharmacy which concluded that patients receiving their medications via RTRC led home delivery pharmacy had significantly greater adherence than those receiving their medications from any channel, including 90-day retail. The results were particularly strong in the Medicare population and adherence is one of the key drivers in the star ratings process for health plans that provide Medicare services.

We make unrivaled investments, hundreds of millions of dollars annually in our systems and processes to ensure that clients and patients have the industry’s safest, most effective, and innovative and convenient pharmacy experience. Our innovation matters to clients and patients. Every day we talk with our clients and it is clear that scale, alignment and innovation along with our singular focus is what makes Express Scripts unique. Our clients need us more than ever to navigate today’s complex and challenging healthcare environment.

Now switching gears to another growth driver, let me spend just a few minutes reviewing healthcare reform and its impact. One of our strengths is our large nationwide book of health plan clients. This present helps us grow with these clients in their regulated businesses including Medicare, Medicaid, and the ACA marketplace. In each of these markets we are well positioned to help our clients gain an ever increasing share of the new lives come into market. And we do not simply lied along with them as they grow, we collaborate with them closely to help them drive and manage their growth. We have managed care clients in states that cover 90% of the newly available healthcare reform lives, and our plans are taking advantage of our innovative tools in order to keep premiums lower and attract membership. Therefore, when a member moves from previous coverage in 2013 to an exchanged plan in 2014 for example, these lives are better managed which results in better health outcomes, lower costs, and increased shareholder value.

More specifically, 41% of Express Scripts sold plan added an aggressive home delivery program and 48% of Express Scripts health plans implemented more narrow pharmacy network. In a tighter managed plan, the need for a therapeutic resource centers and specialist pharmacist is greater than ever. It is important that when formularies are tightened and networks are narrowed for our patients, but they are able to get the help they need to manage therapies, adherence, and health outcomes and ultimately drive to a lower cost for our clients, and therefore greater value for our shareholders.

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

George Paz

Thank you, Tim and good morning, everyone. I’m speaking with many of you over the last several months, it is clear that there are a number of questions around the future of our business which I will address at this time.

First, regarding service, our merger with Medco resulted in change that people processed within systems which created isolated challenges for some clients. In response, we are taking clear and specific steps to improve both, the client and patient experience. And we continue to invest to enhance the service provided and optimized every patient touch point. I want to emphasize what Tim just said earlier. Our operational indicator show that we are now performing at or above pre-integration and strong historical levels.

With respect to our retention in new sales, we have always operated on a very competitive marketplace. Our focus has always been on growing shareholder value and maximizing our EBITDA growth to our model of alignment with our clients. Our retention rates which gets a lot of focus from investors is really a lagging indicator reflecting the impact of two years of integration activities. This retention rate is not the similar to previous integration years. As we after two years of integration activities we are emerging as a stronger PBM and few are even better positioned for the future to drive retention to normal level, gain market share and continue to increase shareholder value.

As we have discussed in the past, clients are different and we have always preferred to partner with clients who share our focus on managing trend, driving out waste, and improving health outcomes. Our scale, innovative tools, and alignment with these types of clients allows us to continue to grow EBITDA per reps [ph] and earnings despite lower claims of volumes.

Specialty is a primary driver of growth and it will continue to be so in the future. Our clients are facing a longing trajectory of specialty cost, including costs resulting from non-adherence, as well as significant ways. Our clinical specialization positions us to close gaps and care, drive to the most cost-effective drug, and encourage the use of the right therapy at the right time. Our comprehensive management is once again a differentiator no other company can replicate. As a result, we expect to continue to gain share in the specialty marketplace.

Regarding WellPoint, we have a strong and a well aligned relationship with WellPoint. They need our PBM innovative tools to be successful to marketplace and we grow as they grow. With 5.5 years remaining under the contract, we will continue to be – to provide a high level service and costs savings which will position us for as a continued healthy long-term relationship with WellPoint. They are our largest client and we are very proud to serve WellPoint. We expect that future organic earnings growth will come from several drivers. Our script volume is just one component. Other drivers include generic conversions, specialty pharmacy, formulary management, clinical programs, non-claims pharma services, and home delivery; all these leverage will drive EBITDA and earnings growth in the future.

I want to spend a few minutes talking about why I’m bullish on the PBM industry and in particular, our positioning. Being in line with our clients best interest is the fundamental part of our business model and such alignment has never been more important than it is now. With around 90 million members, we have a unique and meaningful opportunity to reshape our pharmacy benefit delivered, and to improve patient health. Increasingly our clients are relying on us to help navigate a complex and changing regulatory environment, drive solutions designed to control costs and provide a patient experience that is second to none. Through our innovative platform we combined world-class pharmacy operations, the Express Scripts lab, clinical specialization and pharmacy data of 90 million. We provide clients with access to the breadth and depth of solutions no one else on our space offers.

Let’s take a closer look at some of our key organic growth drivers. As we think about client challenges and our areas of opportunities, specialty is at the top of the list. While our clinical tools have helped hold the growth in specialty drug spend in 2013 to 14.1%, the lowest in our past six years. We forecast that specialty spend will increase an additional 63% over the next three years. The leading driver of this deep spending increase is Hepatitis C, and the introduction of costly new medications. Our clinical tools and clinical specialization will be of critical importance in taking advantage of the – as into biogenerics and competing therapies that emerge.

Another area unique to Express Scripts is our size and scale, and how we leverage it across the supply chain to manage cost for our clients. Tim talked earlier about our National Preferred Formulary. We introduce our clients to our National Preferred Formulary as a strategy to significantly lower cost while limiting member impact. The decision to implement this formulary was an important one for our clients. Over 90% of our commercial clients choose to implement this formulary. This choice was purely the choice of our clients. Our clients have expressed high levels of satisfaction, and we’ll see over $700 million of savings in 2014.

We will rule out our 2015 formulary in the coming days which I anticipate will drive significant additional savings bringing the 2015 annual savings well over $1 billion for our clients. Although our mail order growth has been impacted by our mix of clients, as the cost of healthcare continue to rise, our home delivery platform will be a fundamental differentiator allowing us to drive the power of our solutions to our clients, drive lower costs generics, and improve adherence. Plan sponsors are increasingly utilizing our broad range of home delivery programs as the safest and the most cost-effective channel for giving medication to their patients. We are also investing in consumer experience which will drive their use of our Express Scripts pharmacy as the preferred pharmacy.

Also contributing earnings growth will be our continuing focus on cost improvements from streamlining and simplifying our business processes. In addition, we will continue to redeploy our excess cash for share repurchase or strategic M&A. When we think about the impact that Express Scripts will have on the healthcare marketplace, we’re very optimistic that our scale, alignment and innovation positions us well for long-term growth.

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

Question-and-Answer Session

Operator

(Operator Instructions) And our first question comes from Glen Santangelo with Credit Suisse.

Glen Santangelo – Credit Suisse

Yes, thanks and good morning. Hey George, just wanted to follow-up on some of your comments. As you seem to suggest, Express Scripts has robust clinical tools that nobody else seems to have and I hear Tim’s comments regarding customer service level seemed to be a pre-Medco levels, it’s kind of inconsistent with the retention rate that we saw again this summer. And I’m just kind of curious if you can maybe reconcile some of those comments to give us a better sense for maybe what you saw this selling season, why maybe the retention rates were lower than what you would have liked, and maybe, if you can comment on pricing and is that playing any part within the selling season?

George Paz

Sure, thank you Glen. With pricing always plays a part, this is a very competitive market and price is incredibly important, we have very sophisticated buyers of our product and services. While price alone can’t solve the issue, it really is about drug trial management, if you take $0.50 to $1 out of prescription in the sales process, that is dwarfed by putting the right formulary employees, having the right clinical tools. Nobody else at our industry has done what we’ve done to try to understand the behavior of human beings and the interaction of that with specialized pharmacist. If you find yourself with a heart condition, a kidney failures, other types of things, you don’t go to a general practitioner, you go to see a specialist. What we’ve done – what Medco did historically, I wonder what I think the greatest assets we got from the company other than Tim was the fact that we were able to all of the TRCs which I think is really key for our future success. Having pharmacist who are trained in disease states that understand the condition of the patient, that understand the complications that family faces, at the same time trying to get the right regiment, help the doctor and the patient adhere to their medication therapies is incredibly important for our future, no other PBM has those tools and the combination of those tools with the data that we have on 90 million American steps us apart in this marketplace.

As far as retention numbers, retentions, when you think about sales – the sales that you’re seeing today are a result of what’s happened over the last two years – not sales but the retention rate. We did have some service flips because we lost some key account managers. When you model an M&A deal, you had to figure there is going to be disruption and change. We factored those into our numbers before we figured out what – when I make sure we could have our return hurdles and well positioned. We’re very, very pleased with our medical acquisition. But to think that every client was going to get the same – the exact, everything that they had before wasn’t going to be the case. We had to combine systems, we had to combine processes, people themselves when change occurs look for change, and so we lost employees, all those things combined reflect in the retention rates. Our comments were that our service levels – our call center performance, our mail performance, our specialty performance, all of our performance metrics that relate to member and high-end service levels are back to where they were. That doesn’t mean that there was some compliance, that didn’t have account management changes, that didn’t change from us during that period. We took advantage of that one when CVS was share marked [ph] several years ago and likewise, our competitors are trying to take advantage of that today.

I think the really good news here is the impact we’ve had on our selling season; our business model resonates and talks about our new lab and cutting the ribbon. The fact that we do offer programs that others don’t bring our clients in to see the lab, I think is a real testament to our future and speaks to our investment in the patient experience and making sure they get the right health outcome. We are extremely excited to help our health plans grow which is our organic growth and our new sales which has been very strong this year.

Glen Santangelo – Credit Suisse

I appreciate all that detail, maybe if I just ask one follow-up on the claims guidance that you gave, if you look at sort of the claims that you’re suggesting for fiscal ‘15, probably better than what we would have thought given that retention rate kind of where it is. And, so I’m wondering if you could just maybe discuss some of the assumptions that might bridge that gap between that retention rate and the guidance and I think if I heard Tim correctly, in his remarks seems to be that maybe your managed care clients are attracting some new memberships, I’m guessing that’s a piece of it and I’m sure there is some new business wins and matter of group [ph] in organic growth initiative. You can maybe just give us some qualitative comments how we should think about the claims as we move into 2015 to be helpful. Thanks.

George Paz

Yes, as our matter of group factors in over the course of this year and next year, both in the numbers, but it is the smaller portion of the overall growth. A lot of the growth is coming from just strictly new sales and our ability to help our clients grow their book of business. We have a lot of clients and we work our account teams and our sales and marketing people are out with our clients helping them grow their business. We feel good about our numbers and where we’re at. This isn’t – these are strong projections and there is – we do a lot of economic analysis around this and we feel good about what we said.

Tim Wentworth

So Glen, and obviously we can’t project that 2015 healthcare reform pick up yet so that would actually not be – and even, we’re talking about working with our health plans, our new main sales that grow their books of business that they will be installing for 71-91-11 next year and so forth, so that’s the key part of the organic growth.

Glen Santangelo – Credit Suisse

Okay, thank you.

George Paz

Thank you.

Operator

And our next question will come from Lisa Gill with JPMorgan.

Lisa Gill – JPMorgan

Thanks very much, good morning. I also had a question, as we think about EBITDA going into 2015 and any plan design changes that are going into FX for 1, ‘15. George you talked about incremental changes to your formulary driving an incremental billion dollars of savings for your customer but how do you anticipate that translates for Express Scripts, number one. And number two, did you see any increase in sale pick up around plan design changes or anything else that we should be keeping in mind around plan design changes for impact to EBITDA for 2015?

George Paz

That’s a great question Lisa, it’s way too early to come out on that yet but we are in the throes of those announces today. We haven’t released our 2015 formulary yet, that will help and we’re going to roll that out probably next week with our – with the consultants and then approach our clients, probably they are after the designs. And it really is going to be how many of them adopt the new, last year was a great year for us, 90% of our class opted into the new formulary and it was purely their choice. And the opportunity that savings and the member – the lack of member disruption really spoke heavily to the success of that program. We are hopeful we can get those kinds of numbers again for ‘15 but we don’t know that. And so we hit the market and you’re exactly right with new order programs, we got to go out and get all this in line and try to sell our clients over the next – the process has been going on but it’s really going to come ahead over the next month or so right before we open enrollment. All of these programs have to be designed and put in place for the open enrollment period and that’s coming up in September/October type timeframe. So it’s way too early to give guidance on EBITDA growth because the ultimate drivers of that is what’s happens over the next couple of months.

Lisa Gill – JPMorgan

Then – I guess just my second question which has been on pricing this year for things that you reviewed or any other new business that you were able to bring in for ‘15 George, can you just comment on the overall pricing environment first and what we’ve seen historically? I know there has been some concern in the marketplace that it was a little more aggressive this year?

George Paz

That’s really aggressive every year. I mean that it’s – but the real question is, how do you manage that aggression and what are you trying to solve for. If we do our jobs right then it should be a win-win. Clients are always concerned, it’s not comfortable when you see in your largest component of your drug cost which is specially growing at double digit numbers and – so, being able to put tools around that and help bring it in is critically important. And again like I said, PBMs are making a couple of bucks, $5 a script in EBITDA on these clients and you can cut $2 or $3 here or there. Before if I can convert a very expensive drug to a much cheaper drug, and especially in the specialty class where drugs often have a sticker [ph] price of $2,000 a month, the savings are astronomical. And that’s where we got to prove ourselves with our tools and our interventions on a regular basis.

So it is an aggressive market and so it’s interesting because we win and we lose. And when we lose, we always concern that we may not have understood the client right. When we win it’s because we have a very strong understanding of that client and their intentions, and where they want to go. If the client is fed up with certain components of their heath design programs and we can come in with a solution, it may look like incredibly less surprising, we hear sometimes that we’ve got aggressive pricing. The reality is its aggressive in our eyes because we know what the clients’ intents are, we know what they’re going to try to push, we put the right pieces of the pricing into the right components to maximize the outcome for the client, and the same time make a return for our shareholders. So the environment is tough, it’s always been tough, we’ve always told the businesses where we feel good about, where we’ve said we feel good about our tools and we feel good about our growth prospects.

Tim Wentworth

If I could add one other piece of color to that, which would be – as we look at our losses, because we examine ourselves hard as you can imagine. The one thing I would say is different is, it’s not about aggressive pricing but it may look that way. I think that there were several losses that we’ve had this year where typically you have incumbency value because of the money you’ve saved your clients, the programs you’ve put in place, the service you’ve delivered. And I think we had a handful of losses where incumbency value turned out to be zero, maybe even a little bit negative because of that and so that’s not irrational pricing that would take that away, that’s simply that we don’t have the opportunity to stay disciplined as we do, and at the same time keep the client based on what happened.

Lisa Gill – JPMorgan

Okay, great. Thanks for the comments.

Operator

And our next question will come from Robert Willoughby with Bank of America.

Robert Willoughby – Bank of America

Hi George, the current rate of share repurchase – you exit the public arena here in about six years, are there deals that you need to do here in near term to position for maybe opportunities you’re speaking to that might detract from that repo effort?

George Paz

You know share repurchase is important to us. We believe we need the support of our shareholders who produce a lot of cash, and we’ll continuously deploy that capital as we find a better use for that capital. And the best use is two-fold of course, one is the constant investment in our own full rams, because they will turn our own businesses strong, but that doesn’t take a lot, we’re not a capital intensive industry. And of course, the second use is key strategic opportunities. We have a group of people, including myself, and Tim, and Cathy that constantly look in for opportunities in the marketplace, there is a lot of healthcare that’s mismanaged, are not managed, and to the extent we can use our tools and our processes and our people to better manage an aspect of the marketplace. We will definitely take advantage of that, obviously, we can’t get into specifics here as we haven’t disclosed anything.

Robert Willoughby – Bank of America

And do you expect George to have any kind of formal presentation on your oncology strategy or is that something that gets rolled out as part of the broader, sort of specialty offering in there? Are you looking to distinguish that in anyway shape before?

George Paz

That’s a great question. We plan on doing an Investor Day again in the winter, so – yes, let us take that under advisement and see because specialty is as you are alluding to, most important part of our future growth and managing drug trend, so this is something we should probably get a little more detail and meet on the bone around.

Robert Willoughby – Bank of America

Okay, thank you.

Operator

And the next question is going to come from Ricky Goldwasser with Morgan Stanley.

Ricky Goldwasser – Morgan Stanley

Yes, good morning.

George Paz

Good morning.

Ricky Goldwasser – Morgan Stanley

What percent of the selling season is still pending decision? And Tim, I think you talked about incumbency values, so when we think about the Medco legacy business, what percent of legacy Medco contract has still not come up for renewal since the merger has been completed?

George Paz

Yes, so – what I would say, looking inside, give me the first part of your question again?

Ricky Goldwasser – Morgan Stanley

Just what percent of the selling season has – is still pending decision?

George Paz

Yes, it’s fairly small amount now. It’s alleged number of cases relatively speaking because it’s a lot in the middle market, but in terms of both, in our book, specifically in our book actually, it is predominantly now over as it worth. That being said, we actually have a very nice pipeline that we continue to pursue right now, collaborating with our health plans as well as in a direct basis with our mid-market sort of business but still is available. And I’m not going to get the real detail on the Medco legacy piece other than to say, we’ve been very successful this year with that and there is not a lot that we haven’t dealt with, we certainly have lost some of that as well but I would tell you that there is not a lot left there.

Ricky Goldwasser – Morgan Stanley

Okay. And then you highlighted that you’ve addressed the service levels and they took back, kind of, like your metric pre to Medco acquisition. So, when we think about the amount of SG&A investment required, are you happy with the size of your current sales force, are you looking to increase it? Should we think about additional SG&A investments or do you think that at this point you’re in good position?

Tim Wentworth

One of the things that I think is really important to understand that is that we through the last two years recognized the importance of account management and we did not – that was not the place we did any synergizing to speak up, we were really very focused on having that to be a strong part of our business and as George mentioned, unfortunately even in that context, we lost some folks. What I would tell you is particularly with David Queller joining us and bringing a whole new set of eyes to something I’ve managed for a long time and Ed did as well, we’re going to continue to look at it and figure out how to strengthen it. And if you take a look at account service, it’s not going to move the needle one way or the other on SG&A, that’s simply not the decision point that you really drive that. What we’re looking for is, what could we do to be more effective and set the standard in account service and that’s really where we’re at.

George Paz

I’m just have to pile on a little bit. If you ever ask me if I’m satisfied with my SG&A, the question will be no. We are – we always have a process improvement, so eliminating the waste, figuring out redundancies and where costs are being spent, that’s not adding value to our shareholders or our patience, and we eliminate those. And as we’re going through the final steps of our integration processes, that’s a key focus as ours as we’re consolidating footprint and we’re eliminating the legacy Express Scripts system and taking a lot of actions to reduce cost. However, we reinforce what Tim said, account touching the field force is not part of that, that’s neither been part of the equation, it’s all the support and outside of that area that’s the focus.

Ricky Goldwasser – Morgan Stanley

Okay, thank you.

Operator

And our next question comes from Robert Jones with Goldman Sachs.

Robert Jones – Goldman Sachs

Thanks for the questions. I just wanted to ask one on utilization. You guys have been calling for or calling out flat growth all year despite – few other data points pointing to a pickup in script growth. I guess, maybe just an update, what you guys are seeing today both from an ACA and a core utilization perspective, and then it be helpful if we could understand a little bit of what you’re factoring into that down slightly to down 1.5% as far as utilization?

George Paz

We’re not seeing growth in utilization, it’s been zero to slightly up, not anything of any magnitude, and we still haven’t seen those numbers change. So you know, what we’ve factored into our growth projections are – our claim counts were still flat, utilization – we don’t see those numbers changing.

Cathy Smith

Yes, and then as far – Bob, for healthcare reforms we’re seeing – consistent with what we’ve said, around 11 scripts per member, right now it’s pretty consistent.

George Paz

Which is just slightly lower than we referenced rest of the book, and it’s around 12 or so.

Robert Jones – Goldman Sachs

So not a lot of factor into that outlook, is that fair?

George Paz

Yes.

Cathy Smith

Yes, definitely.

George Paz

As Tim said, we haven’t really put any numbers in of any magnitude for healthcare reform for next year and we haven’t really factored in any utilization growth. If we can get utilization back up to 2% growth again, that would be a huge upside to our numbers.

Robert Jones – Goldman Sachs

That’s helpful. And then I guess just on the mail and specialty, it looks like up 7% growth sequentially in the mail pan [ph], increased nicely. Just on those two metrics, any more detail you can share behind what drove both the total sales growth and then the mail pan increase in the quarter?

George Paz

I said this in the first quarter, and I’m not sure people really took it to heart but we did see utilization drop in the first quarter and it didn’t smell in the second quarter. So we got the benefit of people coming back and getting their scripts, and we’ve been – during the last year we were aggressive selling our mail order programs, and the way a lot of those work as if you go to exclusive or preferred home delivery as you get – you get your first two scripts in retail, then you get converted into mail, that gives us a chance to make for an orderly easy transition without people missing their medication. So, something in the first quarter we also saw the retail effect of that as people were gearing up for the mail that came through in this quarter. So I would tell you it’s a combination of our mail order programs kicking in and stuff that Tim talked about, although it wasn’t a big number, healthcare reform, many of those eyes selected a more aggressive mail order programs and it’s – so we feel good about where we ended the second quarter.

Robert Jones – Goldman Sachs

Thanks so much.

Operator

Our next question will come from Eric Percher with Barclays.

Eric Percher – Barclays

Thank you, a question for Cathy. Now that you’ve been in the seat coming up on six months, so I’d be curious to hear a little bit of your effort to improve the process and financial systems and drive more work as precision.

Cathy Smith

Yes, I appreciate that. As we’ve shared in the past, we have a number of projects in progress right now with regards to consolidating our financial systems and in the – six or seven different projects, we’re going to take the bulk of this year and none of that happens overnight as you would imagine. And all of that will help us everything from a consolidation tool a forecasting tool, and then just more consistency around just a basic general as your cost account [ph] that kind of stuff. We’re in the middle of all of those projects right now, and the bulk of unfinished at the end – towards the end of this year with regards to our goals – some of those go into mid next year. And the combination of all of those will dramatically improve – my teams, they’re going to – they will turn more and more attention to analysis because it’s just a manual process we have to get through right now. So I’m really excited about what’s going to be as opposed to whether.

Eric Percher – Barclays

Thank you, that’s helpful.

Operator

And the next question will come from John Kreger with William Blair.

John Kreger – William Blair

Hi, thanks very much. George, in the past you’ve done a great job of articulating how your business model aligns very well with all your clients, particularly around generics. Do you feel like you’ve accomplished that at this point with specialty, or put another way, are you guys financially incented to drive specialty costs down overtime?

George Paz

That’s a great question, John. It would be so much better – and Dr. Miller [ph] spends a lot of time on that and with the administration in attempting to find better and easier pathways to bring biologic generics into the marketplace. When that occurs, that significant upside for us and significant upside for our clients, and this is going to improve adherence for our patients, less cost, less strain, less concern. So that’s a huge whole mark. Are we aligned, yes; many of our formulary decisions that we’ve made last year were in the specialty stage, just an easy example, is growth hormones. There is a lot of different alternatives out there, limiting access, other specialty classes we did the same thing. We’re focusing market share to certain manufacturers provides significant savings in those classes, so we are aligned from that regard as we move people into less expensive therapies and drive down cost. We would be better aligned if we had a generic alternative and we’ll continue to focus on that and drive it, and that would be a big win for our industry and for us in particular.

John Kreger – William Blair

Great, thanks. That is very helpful. One other thing just to clarify, given all the comments on the call around service levels, are you making that for incremental investments to further improve our service levels or do you feel like you’ve got appropriate resource staffing at this point for that?

George Paz

We’ve spend a lot of money, John, every year on service levels. The big challenges we face each and every year is to stay compliant with Medicare, so that’s one of our huge investments as we keep our platform, and our people, and our programs in line with Medicare requirements. So we’re always spending money there. Incrementally, I would say no, we’re not really increasing the spend, we’re actually taking out cost overtime because running two different platforms and two different environments was not inexpensive. And so we are taking those savings and we’re redeploying it, some of it back into our service operations, and a lot of it back to our shareholders. So our goal over the next, the remainder of this year is to eliminate those redundant platforms and processes, and drive out cost out of our systems.

John Kreger – William Blair

Okay, thank you.

George Paz

Thank you.

Operator

And our next question will come from Steven Valiquette with UBS.

Steven Valiquette – UBS

Thanks, good morning, George, Tim and Cathy. So I guess just a follow-up on the 2015 outlook. Over the past few years you guys have made some occasional late year references to in-group membership attrition within your existing customer base for the following fiscal year and that was sort of a negative surprise, but it sounds like for 2015 you’re already not expecting this which is obviously encouraging. So just curious, if there is any chance you can give some additional color on your early visibility on this for 2015? Thanks.

George Paz

I’ll take a step and Tim can certainly come in. I think what we saw was when healthcare reform was getting all the limb in the sales, there was a lot of people in the hospitality business and others that were either coming out, not – it shouldn’t say a lot, several though, cut out providing the health benefits to their membership. And at the same time a lot of employers took lower levels salary, less skilled jobs, and took them under 30 hours. I still think you’re seeing that, I still think you’re seeing a growing of under 30 hour work procrastination. And that of course affects us as they don’t provide, so – but I think a lot of that ships are lost – left to dock. We don’t – although it’s still happening, it’s not happening at the pace we saw it couple of years ago. What we’re seeing today though is a real desire by our heath plans to grow their books of business, and our partnership I think with bringing Tim on board a couple of years ago, the focus we’ve had on the clients, we’re excited about having David and all his experience in the health plan arena. We believe we can shell – when we’ve got a track record now of going out and helping our clients, target clients that aren’t theirs, and primarily the combined medical PBM program just to save money and that’s what you’re seeing is the fruits of that labor as we work closely with our health plans to try to grow. Our goal is to grow through that and help them be successful and that’s exactly what we’re doing.

Steven Valiquette – UBS

Okay.

Operator

And our next question will come from Brian Tanquilut with Jefferies.

Brian Tanquilut – Jefferies

Hey, good morning guys. George, one thing that you mentioned in your prepared remarks is how you thought that retention was a lagging indicator for your business. So, where you sit today plus all the progress you’ve had with the integration process, I mean would you say that we’ve seen the bottom of the retention rate at this point?

George Paz

You know, I – we haven’t given ‘15 guidance and we’re trying to make sure that we’re working our relationships with all of our clients. I don’t want to really give a strong number for next year yet, I don’t think I’m going to position or going through assessing all that. And – I like to think we’re at the bottom but we’ll figure that out over the next couple of – next quarter or so before we give you ‘15 guidance. I don’t know, Tim, you want to…

Tim Wentworth

No, I mean, the only thing I would add is, ‘15 to ‘16 is not a normally large year. We are – we know where those accounts are, we have obviously, great relationship with the majority of them, the ones that we know we’ve got – we’ve had work to do when it came through at migration for example, I think we’ve now got stabilized and we have to just continue to drive the results in the stability moving forward. In a couple of cases there are new account teams that were training on the new system, and those sorts of things. So I’m with George, I want very much to believe that this year – and I do believe this year is the bottom but I know I’ve said that last year and I got – I don’t look like I was right on that this year. So it’s too early to call, but I like everything that we’ve done and all the things that we we’re doing I think was very well positioned, both in terms of service. But really importantly, again, we’re going to be putting a new formulary out, our clients who have seen the benefit of that – both clients who are on it and clients who are not but have seen the way we managed – manufactured generally in a very high inflation environment, they see the differentiation. Even there are consultants who quite frankly, may have been the most critical as we finalized integration, said two things, as I went meet with them and talked to them, is they desperately want the integration behind us because they realized that it was an event that was big and challenging. But they saw that our model and our scale would differentiate and are focused, and so I actually – and strongly of the view that our renewals next year should reflect that.

Brian Tanquilut – Jefferies

And just a follow-up to that Tim, you’ve talked about inflation being high, so how do you – what are discussions like as it relates to generic inflation and how do you protect your margins as we see generic rates go higher, or generic prices go higher? Thanks a lot.

Tim Wentworth

I’ll let Cathy talk about some of our margins. What I’ll say is our clients have – we – generic is still the best place for them to be. The generic inflation has not been a driver of overall trend for them at all because as you know, the brand spend, even as the number of scripts that are generic is high, the brand spend is still well over half of the spend and then you add specialty to that, and quite frankly, generic inflation is a high class problem compared to the big things that we’re facing with our clients.

George Paz

You know the other side to that is, when you look at generics, we buy from our mail order which is really important that we buy on long-term contracts. And so we often can shield ourselves against those situations when those things are kicking in and look for other manufacturers that in fact we are getting hit with and we have enough lead time, so we better brace ourselves for that. Generic inflation really hasn’t been a significant issue for us today, there has been some effect but not material.

Brian Tanquilut – Jefferies

Got it guys, thanks.

Cathy Smith

And so the same way that we buy on long-term contracts and have protections there and the way it has not been a significant impact for us.

Brian Tanquilut – Jefferies

Okay, thank you.

George Paz

Thank you.

Operator

And our next question comes from David Larsen with Leerink Partners.

David Larsen – Leerink Partners

Hey guys, congratulations on a good quarter. Can you maybe just give your thoughts on clinical programs that you have at the retail? And can you maybe just touch on your Smart90 program or other programs that can compete effectively with making end choice or do you typically focus on clients where their incentives are aligned with mail? Thanks.

Tim Wentworth

Sure. What I would tell you, first of all, our clinical programs work across all the channels, that’s most important point that I can make. And they are strong continued element of what we see as we up sell, both in terms of our utilization and bundles our rational Med program increasingly prior offs and step therapies, and of course prior offs not only in the Medicare business but in other businesses and other long businesses as well. So all of that – formulary management, now interestingly, if you take a look at formulary management, mail versus retail, it’s 50% more effective and actually converting patients to preferred scripts. So, we certainly have clients that are continuing to be interested in mail and I believe overtime mail is going to re-emerge as an incredible important attribute to managing down the overall cost of drugs and gaining maximal rebates for those products which are rebuttable.

That being said, the other part of your question which is around the prevalence or sort of our view of the 90, as you probably know, we have two different approaches, both of which provide a retail maintenance alternative, one with Walgreens and then one with a different network, let’s say, and in both cases those – again, we overlay our clinical programs, our TRC pharmacists, if a patient is at the retail counter and they go home and they have a question, they can go on their phone and within one minute a specialist pharmacist from our pharmacy will call on that number. So we really have – we believe it’s a single integrated piece and we work with each client to make sure that they’ve got the network that works best for them to deliver care. We have not seen dramatic increases in the uptake of the maintenance – the retail maintenance programs, I would say it’s an arrow in the quiver [ph] rather than a fundamental strategy.

David Larsen – Leerink Partners

Great, thanks a lot.

Operator

And our next question will come from Anthony Vendetti with Maxim Group.

Anthony Vendetti – Maxim Group

Thank you. Actually I’m wondering if we can just – I know you said not much of the selling season is left but we could play a little more metrics on some of the new client wins or net new wins, or specifically, what – which large clients have left to give a guidance of 92% to 93% retention rate for 2015. Just a little more color around that would be helpful. Thanks.

George Paz

Well, we don’t mention client names. I think it’s not a good habit to get into people calling clients, these clients don’t necessarily want that. Some of them are public, the southern State of Florida, and Texas teachers, things like that are – those are all public deals so you can get those names, you can see those lots. But I think it’s important to note that for the losses we had or major big script comps, and if we were not lost those for, our retention rate would have been 96% plus. So those had big impacts, so I would also tell you though that – I’m not trying to cry over spilt milk here, or not reemphasize the issue because we don’t like to lose. But those clients being state-run auctioned processes are a lot different than a lot of other clients, and it’s wiser to say that these clients were at the lower end of our EBITDA ranges. So it’s – again, we don’t like to lose but it’s – we feel four of them had a big impact.

Anthony Vendetti – Maxim Group

Okay, thanks. That’s helpful.

George Paz

Thank you.

Operator

And our next question comes from Charles Rhyee with Cowen & Company.

Charles Rhyee – Cowen & Company

Yes, thanks for taking the questions guys. I’m wondering to talking a little bit about exclusion lists, in a couple of fashions. First, obviously, you may be announced a while back list of all the financial formulary – how did that affect your specialty pharmacy business, particularly for the part of business that’s in network with expressed transfers [ph] despite those other – even with clients that are using maybe a different PBM? And then more generally – there has been some noise about other drugs getting dropped off the – off your formulary here, if you could talk more generally, how you go about deciding what drugs get excluded? And then do you see more drugs overtime, because it seems like it’s something you’ve been talking about more over the last year or so, is this – do you see this as a new major tool for you in managing cost? Thanks.

Tim Wentworth

So let me just start with the facts, Sovaldi is on our formulary, it’s the only drug available in its class and so forth, so that’s important. That being said, we have been very vocal about Sovaldi and we are anxiously awaiting competitive products. In the broader sort of spirit of your question, let me have Dr. Miller talk about how we think about building a formulary, specifically with the clinical starting point because that is the most important message you can take away. So I’ll turn it over to Steve.

Steve Miller

Yes, thanks Tim. As you know, we always have the good clinical first. And so we are not only proud of the fact that we have a totally external P&T Committee that makes these decisions for us. So that P&T Committee is not employed by Express Scripts or they get a stipend from us, they are a clearly independent and their decision is binding on the company. The clinical decision is always placed first. And to your point, there are greater opportunities going forward to actually narrow formularies than ever before and we’ve seen this in the traditional oral solid side, but we’re now seeing a lot of competition across specialty drugs, even across oncology agents. So we really believe that in the future, we’re going to be able to narrow formularies, drive patients to the best clinical outcomes but also get phenomenal results for our plan sponsors and our members.

And so last year when we did our formulary, as you know, we had exclusions in five different specialty classes which truly leads the industry. And I think you’re going to see increasing opportunities going forward, so I think you should look out for us continuing to narrow other classes because we believe we can get the best clinical outcomes but also best economics for our patients and our plan sponsors.

George Paz

I think we have two more questions in the queue, so we’ll take those and then conclude.

Operator

Alright, the next question is going to come from Garen Sarfian with Citigroup.

Garen Sarfian – Citigroup

Good morning, everyone. Not to beat on the retention issue too much but I just have to ask on it again in a little bit different format. You guys have mentioned the retention issues based on the M&A and some service issues, I – we can appreciate that but at least on hind side, it sounds like – it doesn’t sound like there is anything sort of new to come out of that. So I’m just wondering what functions had you made because I’m assuming that of course, 100% as your goal, what functions had you made in terms of retention that sort of didn’t hold true, that led to perhaps, not as ideal of a rate that you guys have now?

George Paz

I think there is a couple of things. When we go into the retention process we try to evaluate the relationship that your account team has with that client. We also try to evaluate where the pricing and the market price is going to be. If you’ve got a great relationship and you’ve got an open dialogue, when you have the incumbency, you have the opportunity, you can handsomely talk to that client and get feedback and understand where you’re at and if they want you to win, the opportunity of win goes up significantly. If you have service issues or you have turnover and you had new account management or the account management team isn’t performing at the level they want, our business is no different than any other business, it’s still about people and relationships. And so, if we don’t have those then we lose. And that – if you asked us, I think going into this year we thought our relationships were better, we priced our products based on relationships and did what we could to try to retain and maintain shareholder value, at the same time deliver value to the patients and the clients. And quite frankly, we missed on several of them. And that’s – again, I do think when you look at quality of the account team, it’s an integral part of this process and we missed there.

Tim Wentworth

I think the other thing I would add is, and then even the best account team in a company that’s been merged together, that had two systems operating at the same time, some of whom were – had experienced one versus the other, just getting things done for your client, I think we may have – in a couple of cases, underestimate [ph] how difficult that was for specific account teams with specific clients. And so even terrific account teams can be made to look bad if you don’t really tap that down, and that’s why getting this migration done was painful as it was, doing in two years instead of the three that would have been a lot more luxurious with absolutely right answer because both of our member service abdicate on the phone having the target between the two systems, as well as our client facing folks who have been working inside of an organization that was still bound by two systems, it made it in some cases, a little more challenging than it should have.

Garen Sarfian – Citigroup

And you said that your operational metrics has improved, so the service aspect of it which Tim you just highlighted, you can sort of gauge that and measure that. But how about on the relationship side, obviously, do you guys put new retention bonuses now so that there is no further turnover within your sales teams or how do you – what do you do to sort of fix that for the next cycle?

Tim Wentworth

We would feel that we have stabilized our teams, again, we – the turnover that came was unfortunate and regrettable. But we do believe that is more than largely stabilized, our incentives are very level lined and very strong as it relates to service, satisfaction, which ultimately yields retention and retention is end result of all the other things as we have said before, and we feel very good about that. I think the last piece is, as George said, we are constantly reevaluating what we do in our cost structure and – that’s a lower cost but to be more effective, and the better job we do at that, the easier think we is for the teams to work across the organization on behalf of clients.

George Paz

We also pull our clients, so we have action survey to our clients and we have a very high response rate, and of course, if we see issues we jump on.

Garen Sarfian – Citigroup

Got it, I’ll stop there. Thank you.

George Paz

I think we have one last question in the queue, we’ll take that and then conclude.

Operator

That will come from George Hold [ph] with Deutsche Bank.

Unidentified Analyst

Hey, good morning guys, and I appreciate you squeezing me at the end. Tim, maybe a quick question for you, I’m going to hit the retention topic one more time. If we look at the client attrition, I guess, can you give us – can you talk to us directionally about whether you lost more clients from the legacy ESI side or the Medco side? And I’m thinking if the platform transition closed a lot of the client dissatisfaction, the clients on the Medco side should have been largely unaffected, I know it would have been the ESI clients that were dissatisfied. So I guess just more color as we think about the attrition from ‘14 into ‘15, kind of what’s driving it? And is there anything specific about the customers who are living that we can identify?

Tim Wentworth

What I would say is, the piece that I think you need to understand is, we’ve lost clients that were part of legacy – if I look back, sense the integration, sort of – it’s a pretty equal mix over the last two years. What I would say though is for different reasons, and so if you think about the legacy Medco accounts, their teams, if we didn’t retain them – then they get introduced to new teams, that was another reason to be a little bit less bound so forth. So even though we didn’t make a transition, we had teams come in and also have to learn in new organization that worked through. The flipside is to your point, on the legacy Express Script side, those clients migrated on a system and that went very, very well for 99% of the clients and for 1%, unfortunately, it didn’t and those are the ones that we have had to really, really focus on and have had some losses on. So I would tell you that really is across both the platforms and going forward, from where I’m sitting, we are positioned as a single company and as I look at that retention, ‘15 moving into ‘16, it’s going to be this Express Scripts company with a very solid account team and a very solid internal operational organization that is going to win and keep the clients, or not, but I believe well positioned to win and keep the clients.

Unidentified Analyst

Okay, I appreciate that. And then, maybe just a quick follow-up, I want to make sure that I heard George right, it seems like the client losses were relatively chunky and kind of X4 clients retention would have closer to a 97% number, is that correct?

Tim Wentworth

That is absolutely correct.

Unidentified Analyst

Okay.

Tim Wentworth

Four clients is nearly 50% of the total.

Unidentified Analyst

Okay, I appreciate the color. Thank you.

George Paz

Thank you. We thank everyone for joining us this morning. We are – as we said in our prepared comments, we are very big bullish on our business model, what we have top for our clients, we have under relenting focus on patient service and satisfaction, and add drives of the client service and satisfaction. So we’re excited about our future. And again, thank you for your time this morning. Everyone have a great day.

Operator

Thank you. And that does conclude our conference for today. Thanks for the participation and for using AT&T teleconference. You may now disconnect.

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Source: Express Scripts Holding's (ESRX) CEO George Paz on Q2 2014 Results - Earnings Call Transcript
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