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Executives

David Myers - Vice President of Investor Relations

Jeffrey L. Hall - Chief Financial Officer and Executive Vice President

Analysts

Lisa C. Gill - JP Morgan Chase & Co, Research Division

Express Scripts, Inc. (ESRX) The 30th Annual JPMorgan Chase Healthcare Conference January 9, 2012 12:00 PM ET

Lisa C. Gill - JP Morgan Chase & Co, Research Division

Good morning. My name is Lisa Gill, and I am the Healthcare Technology, Distribution and PBM Analyst for JP Morgan. We are going to have a little bit of a different format today for Express Scripts. With me this morning is Express Scripts, as you know, one of the nation’s largest PBMs. Due to JP Morgan's involvement in the Medco-Express Scripts transaction, I will not ask any questions related to the transaction. So what I've asked Jeff to do is just to give us a quick update in regards to where they stand with the FTC and anything else that's new around the transaction, and then we'll talk about basic fundamentals around the underlying company. So with that, let me turn it first over to David Myers. Everybody knows David, Head of Investor Relations, who will read the Safe Harbor. And then, Jeff will make some statements, and we'll get into the Q&A. Go ahead.

David Myers

Thanks, Lisa. Before we begin, I just need to say that statements we make today may be forward-looking and therefore involve risks and uncertainties. For a list of factors that could cause actual results to differ, those can be found in our recent SEC filings.

Jeffrey L. Hall

Great. Thank you, David. Thank you, Lisa. So just a high level on Medco. Obviously, we've done a lot of work, and we continue to be engaged with the Medco team since the announcement. I'd say on a positive side, we've definitely been very pleased with the quality of the management team there and all the employees, and we're excited about putting these 2 companies together.

In the 25 years that Express Scripts has been in business, our mission has been really simple, really clear: to make the cost of -- make the use of prescription drugs safer and more affordable. The more we get engage, the more confident that we are that the combination of these 2 companies will truly reduce the cost of healthcare, truly take waste out of healthcare and also make it safer. And we're excited about the product offerings that are going to come out as a result of this. We continue to be confident in the synergy estimates we put out there, and we still think this is going to close in the first half of 2012. We've been, obviously, in very detailed discussions. We’re binding a lot of data to the FTC. We continue think that this deal is pro-competitive and will get approved. And we're excited about getting this closed as quickly as possible.

Question-and-Answer Session

Lisa C. Gill - JP Morgan Chase & Co, Research Division

Great. So then, let's move on to the other big topic, and that would be Walgreens. Can you give us an update as to the prescription transfers you've seen thus far? And have you seen that really ramp up here in the first week of January?

Jeffrey L. Hall

Yes. So if I'd just step back at a little bit broader from that. Obviously, any conflict in the world is the result of 2 parties disagreeing on a key issue. And in the case with Walgreens, the conflict is really about the cost of healthcare. At Express Scripts, we believe that the cost of healthcare absolutely has to go down as we go forward. And unfortunately, Walgreens' position is that flat is good enough and we really couldn't disagree more. And our clients are absolutely aligned with us and also agree that the cost has to go down over time. As a result, our clients have been extremely helpful in working with us and moving business away from a more expensive participant in this network. And at the end of last year, we said we were confident that 95% of our script volume was going to continue into 2012 without Walgreens. We're a week now into the year. Obviously, a week doesn't make a year, but certainly, the trends we're seeing in the first week validate that, that we indeed are seeing the scripts move away. And we are even more confident now that 95% of script volume will continue without Walgreens.

Lisa C. Gill - JP Morgan Chase & Co, Research Division

And it appears that you have a nice relationship with CVS around transferring these prescriptions, whether it's the commercials we've all seen on TV or the big ad right down on Market Street. Can you maybe just talk about the CVS relationship? First off, are they giving you a better price as it pertains to these new scripts that are transferred? And then secondly, does this behold you to CVS going forward? So when the contract comes up next time, are they in a powerful position because you would need at least one national retailer going forward?

Jeffrey L. Hall

Yes. I think, I'll make it broader than CVS. Our relationship with virtually everybody else in this supply chain is very positive. I think validation of our position that the cost of healthcare has to go down, that reimbursement to pharmacies is going to go down, is really validated by the fact that every other supplier in this space is fighting for the Walgreens business at the rates we're talking about. So its -- everybody else understands that with brand inflation at 10% and with $60 billion of new generics coming out that there's more than enough incremental profit here to get the cost coming down. And so we're seeing that across the broad range of the pharmacy space. Obviously, we think that going forward, we would prefer to have Walgreens in the network. We think that eventually they will realize that their position is wrong and that the cost of healthcare does indeed need to come down, that flat is not good enough in the market environment we're in, and at which point, we'll settle very quickly and be able to move forward.

Lisa C. Gill - JP Morgan Chase & Co, Research Division

As far as the selling season goes, you obviously had a nice retention this year, 97%, if I recall, one of the higher percentage of retention for Express. Can you talk about what are you seeing as far as expectations from customers? And why do you think this was a successful year, even with the potential overhang of Walgreens?

Jeffrey L. Hall

Yes, that's right. We did -- we have a very successful retention of 97% and a good selling season. We had several large clients that we won and overall have positive growth from the selling season going into next year. And virtually, all of the selling season happened after the announcement of Walgreens, so that makes us increasingly confident that we can continue to sell effectively without Walgreens being in the network. As we look going forward, we think that will continue to be the case. Certainly, a large portion of our clients are very happy with the savings they are now realizing as a result of going to a narrow network. And I think, if history holds, once you realize the savings from, whether it be from a narrow network or a prior author or a step therapy kind of program or home delivery program, is that it becomes really difficult then to move back to the higher cost options. So historically, when people have moved to one of these things, we very seldom see them move back. So we would expect that to be the case in this situation.

Lisa C. Gill - JP Morgan Chase & Co, Research Division

What's been the percentage of clients that have adopted the narrow network for 2012?

Jeffrey L. Hall

We're still early. We don't -- I don't have a percentage. I think that's the discussion we're now having with all of our clients is: you're now without Walgreens in your network; if you sign up for a narrow network, we can deliver you some significant savings. And we're in the process of discussing that with all of our clients, but no number at the moment.

Lisa C. Gill - JP Morgan Chase & Co, Research Division

Over the last 10 years of following the PBMs, pricing is what most concerns people when they think about the PBMs. And every year, there's a lot of frenzy around what contracts are up for renewals, what's pricing going to look like. Can you maybe walk us through what pricing looks like today? And what do you think it'll look like over the next couple of years?

Jeffrey L. Hall

Yes, this has always been a competitive environment. We don't see that really changing going forward. It’s going to continue to be very price competitive. Although we kind of say pricing is really the ticket to enter a finalist meeting, so you've got to have your pricing in the relevant range to get invited to the finalist meeting. But then, once again invited to the finalist meeting, the discussion is really more around the service we can deliver, the differentiation we have. And I would say that the companies are more differentiated today than they ever have been. Everybody's got a slightly different spin on how they save money for clients, and that ends up being in discussion. What you believe in -- in finalist, anyone of 10 to 15 different competitors could be in a finalist meeting, and every one of us has a slightly different spin on how we save money and what service we're able to deliver. And at the end of the day, that's really what the clients are making it -- their decision based on, is that level of differentiation. But price is a key factor and will continue to be a key factor.

Lisa C. Gill - JP Morgan Chase & Co, Research Division

Generics have been a key factor in the profitability of the PBMs over the last several years. And as we look out over the next -- whether it was this selling season or moving forward, are payers starting to ask you for more of the generic profit? And if so, where do the new buckets come from so that we can continue to see profits grow for the PBM?

Jeffrey L. Hall

Yes, obviously, the $60 billion of new generics is well understood by everybody. And certainly, it's been a large component of discussion is how is that profit flowing to us, which really gets us back, maybe a little bit, to Walgreens. It's a good example on Walgreens is, how do we show up in front of the customer and say, LIPITOR's going generic. You got $60 billion of other new generics. And despite that, your trend is going to be flat. Right? It's just an argument that does not work. Everybody understands that the trend can be flat with all these new generics and brand inflation, everything coming out. So certainly, that's been a hot topic of debate as we talk about pricing going forward. We think that will continue to be there. We do think there are lots of other ways to continue to improve the overall profitability of the firm. At the end of day, Express Scripts exist to reduce the cost of healthcare. And as we reduce the cost of healthcare, our profit increases slightly. It's our business model of alignment that we strongly believed in; that we're motivated to do what's right for the client to help them save money and improve health outcomes, and when we do that, our profit incrementally goes up a little bit. So as we look into the next several years, we're the big drivers of cost. Certainly, brand inflation is going to be one of them. As we see more and more generics, we'll see, we think, increased inflation in the branded drugs. Specialty, there're a huge specialty pipeline that's coming to the fore, and that will certainly be a big increase in cost. The interesting side comment to that is that for the first time, really this year and a little bit in 2011, we're now starting to be able to do formularies in specialty drugs. There are enough new drugs for specific indications that we can do step therapies and prior auths and move people to first-tier, second-tier or third-tier drugs in the specialty space. It's just emerging, but that's going to be a big cost saver for our clients going forward. Another interesting product we have in specialty will help us get at the specialty spending. It's in the medical side of the benefits. So today, approximately half of the specialty drugs are actually getting expensed through the medical side of the benefit. To the extent we can get at that space and get it pulled into the pharmacy benefit, then we can save our clients a lot more money there. Home delivery is pretty flat, stuck in the low 20s percent, for us. We think that number ought to be in the 40s, if not higher. We have a lot of interesting programs there to help move people to mail. Those programs are doing well, but for the most part, the benefit being offset today by the poor economy. As we see people either lose their job or turn through different jobs or be afraid of losing their job, it tends to hurt mail, whether that is the fact that they stop taking their maintenance meds, or that when they change jobs, they end up out of Express Scripts into a different PBM, or when they come into a new Express Scripts-sponsored employer, then they end up in retail and we've got to convert them back. We do have some new programs that are helping us do that more effectively. And we're excited about the opportunity to move people to mail, especially as we hopefully get some improvement in the economy going forward. And lots of other things. So we were excited about the future of the PBM business. We love the core PBM business that we're a part of, and we think there's lots of opportunity going forward.

Lisa C. Gill - JP Morgan Chase & Co, Research Division

Can you maybe just -- let us dig in a little bit more around specialty because I do think specialty is going to be big driver over the next couple of years? If you look at your book of business today, how many of your PBM customers actually buy specialty from you in the overall level?

Jeffrey L. Hall

Specialty penetration for us is just north of 50%. 50%, 60% of our clients are exclusive with us through specialty. We think that number is growing as we're better able to prove that indeed, your best alternative is to go with us. We can guarantee you more cost savings. We can manage your members a lot better, and we have really world-class set of nurses and pharmacists that are reaching out to these specialty patients every day, explaining side effects, keeping them adherent, walking them through how to take their drugs, what's the most effective way to take their drugs. And as we can get in the clients and really explain how clinically, we are just world-class in the specialty space, our clients really get excited about that. And on top of delivering world-class clinical then, the cost actually goes down as well. So it really is kind of a double-win space for us. We would expect to be able to continue to grow this as time goes on.

Lisa C. Gill - JP Morgan Chase & Co, Research Division

Obviously, specialty drugs are substantially more expensive than your typical pharmaceutical. If you think about the margin structure in this business, how should we think about it compared to the PBM business? Is it bigger dollars with a lower margin but the EBIT dollar can be similar? Or is it higher margins? How should we think about that?

Jeffrey L. Hall

Yes, we don't break it out at that level of detail for a lot of different reasons. But clearly, the dollars are significantly larger. We're talking about instead of $150, $200 prescriptions, a lot of times talking about $2,000 prescriptions or potentially more. So in general, the margin percentage is lower, but the dollars tend to be there as well. But the counterbalance to that is we're obviously spending a lot more. So rooms full of nurses and pharmacists talking directly to these patients is a big investment in our part in driving the clinical behaviors that keep people adherent and keep people healthier and really driving towards the better outcomes that this is the key part of our mission.

Lisa C. Gill - JP Morgan Chase & Co, Research Division

WellPoint is, obviously, your largest customer. Can you talk about -- I think in mid-December, you disclosed that there's a dispute between you and WellPoint. Can you talk about the dispute? Can you talk about where you are around resolution? And how we all should be thinking about this?

Jeffrey L. Hall

Yes. So as most of you probably know, PBM contracts tend to be extremely complex, and the market is moving very quickly here through both regulation and changes in the market. So the net result of that is from time to time, we have disagreements with our clients on how to interpret different contractual clauses. We know WellPoint's in this thing. It's just to be clear, it's not about Walgreens. It's about contractual interpretation. It's similar to discussions that we have with other clients from time to time. Historically, we always solve these with our clients with no meaningful impact. You're right. WellPoint is an extremely point client to us. We're confident we'll be able to come to resolution. I think the only reason this has ever came to light is the fact that we were literally days away from a shareholder vote on the merger. As a result, the disclosure requirements were just abnormally high and we felt like it made sense to get this out, even though it was maybe a very small percentage that something bad would happen here. The net ramifications were just too high if something happened after a shareholder votes. We felt like the appropriate thing to do was disclose it. But we were very clear on our disclosure that we think that closing this, that we will be able to come to some meaningful resolution here, and we didn't expect it to be material to our overall business or cash flows or anything else.

Lisa C. Gill - JP Morgan Chase & Co, Research Division

Can you talk about the timeframe for when you'll give the 2012 guidance?

Jeffrey L. Hall

Yes, 2012 guidance is going to depend on where we are with the Medco transaction, quite frankly. So we're prepared to give our Q1 earnings in a normal calendar time, which will be mid-to-late February. So we haven't announced a date yet -- I'm sorry, Q4 earnings. So when we announce Q4 earnings mid-to-late February, as we normally do, if we think we're close to having the Medco approval or closure or if we've already closed, then we would probably give a combined guidance, either on that call or more likely a month or so after that call, when we have a chance to really see some of the numbers that we haven't been able to see yet. But we will expect to give combined guidance near that timeframe. If it looks like the transaction is going to be pushed out longer than that into the later part of the first 6 months, then we'll probably come out with some Express Scripts, some version of the standalone Express Scripts guidance, that people will have a good feel for where Q1 is, at a minimum. So it's really going to depend on how the Medco transaction is moving through the approval process. And our hope is that we will be, if not closed, very close to closed. And if we are, then we'll be very close to giving a combined guidance for the year.

Lisa C. Gill - JP Morgan Chase & Co, Research Division

How should we think about the numbers that we all saw on the proxy statement on a pro forma basis? I mean, is that where we should think about is the initial baseline? And then you’re going to give us a more clear guidance, or...

Jeffrey L. Hall

Yes, I think we were extremely clear that the numbers in the proxy should not be relied on and don't really represent what a combined entity would look like. And the reason being that it’s more about what the SEC requires to be disclosed in the proxy. And what the requirement is, is that you give a forward-looking, what the company would be if the transaction did not happen. It's obviously incredibly hard to go back and make up a whole new world where this transaction was never even contemplated. What would we have done differently? How our selling season have been different? How would our staffing levels be different? And so I'd really say it's not an accurate portrayal of what the company would look like combined, because you can't just turn back history like that. And the other side of that is, as you all know, our view of utilization and attrition and overall economy has changed since then. We've gotten a little more pessimistic that the poor economy might continue on longer that we had originally expected.

Lisa C. Gill - JP Morgan Chase & Co, Research Division

And when we think about that literal utilization causing you to lower the numbers for this year, for the first time, I think ever, right? Or at least in a very --- a year or two which, [ph], right? If we look at that, what are you doing to try to change utilization trends [ph] and trying to drive adherence? And have any of those programs started to bear any fruit?

Jeffrey L. Hall

Yes. So we were very excited about our offering around adherence. And primarily, the reason to drive adherence is first and foremost to get people healthier and improve health outcomes, and that really is why we're driving adherence so hard. The secondary benefit to that is as people get more adherent, they get healthier, their medical costs go down, but their prescription costs go up a little bit. So that's obviously positive to overall utilization, if we can drive the adherence. We've got a lot of new products coming out of our Consumerology lab. A lot of you have been there and seen it. If you haven't, we'd love to host you. It truly is world-class, and nobody else is doing anything like what we're doing in our Consumerology lab. And what we're doing around adherence is not really a new idea. What we're doing is trying to predict who's going to be non-adherent. So it's not unlike going and getting different kind of screenings for your overall health care. We're just saying upfront, based on your demographic data and a whole bunch of other things, we can predict who's going to be adherent and who's not going to be adherent. And then what that lets us do is focus on the people that we can really move. And so what happens is we run our model and it takes into account all kinds of demographic data. We really end up bucketing people into 3 categories: people that are just never going to take their drug no matter what we do, and there's not a lot we can do to drive adherence; the people that are really in the middle of the range that either will forget to take their meds or will have other reasons to be non-adherent; and then the people that are going to be extremely adherent just because that's the way they do. And so what that allows us to do is really focus our efforts on the people in the middle. And if we think you're going to be non-adherent, we'll start off with having a pharmacist call you and talk to you and explain the importance of staying on your drug med regimen, perhaps having our chief medical officer send you a letter saying how important it is to stay adherent. But we're also now sending out pieces of technology. So we may send you a cap, send your pill bottles with a cap that if you don't take your drug by 9:00 every day, the cap starts beeping. As we go on and on further down that line, we have other methods where we actually have a different cap, that if you don't take your meds, we'll send you a text message saying you didn't take your meds, or even more importantly, for some people, we'll send your spouse a text message that you didn't take your meds, or we'll send your mother a text that you didn't take your meds, or your mother didn't take her meds, really, is the way it works. And so we've got a lot of really exciting technology here, combined with the great work coming of our Consumerology lab that we're excited about from an adherence standpoint, and we're in the process of rolling that out to our clients.

Lisa C. Gill - JP Morgan Chase & Co, Research Division

Jeff, let's put the Medco transaction aside for just a minute. If you do not pick up Part D business with the Medco transaction, is Part D something that you would think expanding Express Scripts into that business? If you look today, CVS has a very big business. Obviously. Medco has a big business. Is that an area you would've been interested in had the transaction not come undone?

Jeffrey L. Hall

Yes, we made the decision several years ago to not go directly into the Part D business because we felt like that would be in direct competition with our managed care clients. That tends to be a space that they deal in. We still like that position. We think that supporting our managed care clients is really the primary focus here. As things change and Health Care Reform changes the environment, that's certainly something we're looking at is: How does health-care reform change the attractiveness of that market? And I think today, we can make arguments on both sides that Health Care Reform will make Part D more attractive, or we could make the opposite argument that Health Care Reform actually may make Part D a lot less attractive. So we're really working through that kind of strategy to figure out where we want to be. And we are very confident that the Medco transaction will close. So we don't spend a lot of time on strategy. What if it doesn't, but certainly, that would be one thing we'd have to consider.

Lisa C. Gill - JP Morgan Chase & Co, Research Division

Express Scripts and the PBM industry in general generates an enormous amount of cash flow. Can you talk about what you plan to do with your cash next year? So if that transaction closes, how should we think about the share repurchase versus pay down debt? And if it doesn't close, or isn't approved, how should we think about cash?

Jeffrey L. Hall

So if the deal is approved, all the cash flow is going to go to bringing down the debt levels. We're going to come out of this deal about 3x gross EBITDA to -- or gross debt to EBITDA. There's not going to be any buybacks until we're below that 2x. And when we say our debt-to-EBITDA target is 1x to 2x, we want to get the debt levels down below 2x before we start really doing more share buybacks or looking at other uses. If the deal does not close. we'll obviously be well below the 2x. And then certainly, buybacks would be possible. But in addition, we're looking at potential M&A and other tactics. So there really is 2 different views. And it really is driven by where our debt-to-EBITDA ratio is, and where we think the right use and the right capital structure is based on that.

Lisa C. Gill - JP Morgan Chase & Co, Research Division

What -- this is the last question, and we're going to take questions in the Georgian Room after this. What do you -- as we look at the PBM industry, what do you think the long-term growth rate is in this industry, call it over the next 5 years? I know that Medco, last year, put out their slide that they talked about growth between now and 2020. Is that a view that you back as well?

Jeffrey L. Hall

We've stayed out of this debate, and I'm not about to jump into it today. Medco issued their views, CVS has issued their view. We don't think it's helpful to put that long of a view out there. I'll go back to what I've been saying for a long time, which is: we love the PBM industry. We think the PBM industry has a lot of legs. We think -- we exist solely to take out cost. And right now, the nation is focused on taking out cost, so we're all very optimistic about this space long-term.

Lisa C. Gill - JP Morgan Chase & Co, Research Division

Thanks very much.

Jeffrey L. Hall

Thank you, Lisa. Thank you, everyone.

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