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Express Scripts, Inc. (NASDAQ:ESRX)

Q3 2007 Earnings Call

October 25, 2007, 10:00 AM ET

Executives

David Myers - VP, IR

Edward J. Stiften - CFO and Sr. VP

George Paz - Chairman, President and CEO

Analysts

Lawrence Marsh - Lehman Brothers

Glen Santangelo - Credit Suisse First Boston

Tom Gallucci - Merrill Lynch

Robert Willoughby - Banc of America Securities

Lisa Gill - JPMorgan

Randall Stanicky - Goldman Sachs

John Kreger - William Blair & Company

Kemp Doliver - SG Cowen

Charles Boorady - Citigroup

Operator

Ladies and gentlemen, thank you for standing by, and welcome to Express Scripts’ Third Quarter 2007 Earnings Release. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. [Operator Instructions].

I would now like to turn the conference over to Vice President of Investor Relations, Mr. David Myers. Please go ahead.

David Myers - Vice President, Investor Relations

Thank you, and welcome everyone to Express Scripts’ third quarter conference call. With me today, George Paz, our CEO and Chairman, and Ed Stiften our CFO.

Before we begin, I need to read the following statement. Statements or comments made on this conference call may be forward-looking statements and may include, but are not necessarily limited to 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 statements due to a variety of factors, which we’ve discussed in detail in our SEC filing. In addition, the reconciliation of EBITDA to net income and the net cash provided by operating activities can be found on our earnings release, which is posted on our website.

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

Edward J. Stiften - Chief Financial Officer and Senior Vice President

Thank you, David. Today, I am pleased to discuss Express Scripts’ third quarter performance. We reported record adjusted earnings per share of $0.60, representing a 43% increase over the $0.42 reported for the third quarter last year. For the quarter, we generated $247 million of cash flow from operations compared to $158.8 million last year. And we expect to be in the upper half of our previous guidance range of $750 million to $850 million for the year. During the quarter, we repurchased 6.1 million shares of common stock for $313.6 million. And year-to-date, we repurchase 23.1 million shares for $1.1 billion.

Our strong operating results were driven by record generic utilization and lower drug producing costs in the PBM segment. This strong performance in our PBM segment more than offset less-than-expected results in our Specialty and Ancillary Services segment. We recorded $18.5 million of non-recurring charges at the SAAS segment, the majority of which pertains to a charge to bad debt expense resulting from the insolvency of our specialty distribution client. This charge is unique because over the last three years bad debt write-offs had averaged only $0.5 million per year on revenues that have average of $1.3 billion an year. In fact, over the last decade bad debt expense in this business unit has averaged less than 0.1% of revenues.

Excluding these charges, SAAS operating income declined $1.3 million sequentially from the third quarter. This decline is attributable to our infusion business, which had an operating loss of $6.8 million for the quarter and has lost $12.5 million year-to-date. We recently announced plans to close six under-performing infusion sites and reduce overhead to improve operating performance of this business unit. While George will be providing further commentary on our SAAS segment, we believe we're positioned to deliver Specialty Pharmacy solutions for our clients and drive long-term growth for our stockholders.

Our comprehensive Specialty offering was also one of enablers of the strong operating performance of our PBM segment, which had an operating increase... operating income increase of 39% over the previous year. The savings we're generating for our clients through our PBM and Specialty business units resulted in a record high adjusted EBITDA, and on a per adjusted claim basis was $2.44, a 33% increase over last year. As a result of strong underlying PBM trends, we're raising our 2007 earnings guidance. Excluding non-recurring items, we're increasing guidance from a range of its $2.23 to $2.29 to a range of $2.28 to $2.32. The mid-point of our range reflects growth of 39% over 2006 on an adjusted basis. Our plans are to provide 2008 guidance later in November.

At this point, I would like to turn the call over to George Paz.

George Paz - Chairman, President and Chief Executive Officer

Good morning, everyone and thank you Ed. As we near the completion of another outstanding year, I want to take a few minutes to review some of the success we’ve achieved as well as opportunities for the future.

We're clearly disappointed with the performance of our SAAS segment. However, the disappointment is primarily related to the infusion business unit and our patient assistance programs. As we previously stated, patient assistance programs are declining due to the Medicare Part D. I've mentioned some near-term changes we're making to improve the performance of the infusion business. We'll continue to evaluate the strategic bit of this business.

Looking at our Specialty Pharmacy business, we continue to realize significant successes in selling specialty pharmacy services to our PBM clients. Specialty drugs are one of the largest drivers of drug trend and our Specialty Pharmacy business provides a cost-effective, single-source solution for our client. We believe our Specialty Pharmacy platform is the key to our recent successes in retaining as well as leaning new PBM business. In addition, much of our success in winning as well as retaining our book-of-business is attributable to our business model, which is based on alignment of interest with planned sponsors and their patients. This longstanding business model alignment has positioned as a trusted advisor to our clients. This helps us to promote the use of generics and lower cost preferred branded drugs.

Our industry-leading generic fill rate, which had a record 62.2% this quarter, demonstrates our value proposition. Our message that mix matters is ringing true to consultants and PBM clients who focus on the tools we offer to drive to lower cost solutions. We are moving to the next stage of alignment. We believe that there is tremendous opportunity to enable better health and value at the consumer level. We are learning how to unlock this value at the level of the individual consumer and unlocking that value means greater savings for our planned sponsors and better savings and health outcomes for our members.

Our recent acquisition of ConnectYourCare, one of the nation's leading consumer directed health plan account administrators is an example of our commitment to take our business model of alignment to the next stage. Our success in encouraging consumers to increase the use of generic drugs demonstrates that empowered, educated consumers, given convenient state-of-the-art tools can unlock great value in actively managing their health.

We are pleased with our overall results for the third quarter and excited about the opportunities to continue generating savings for our clients and patients, and strong growth for our investors.

That concludes our prepared remarks, and I will be happy to answer any questions. Operator?

Question and Answer

Operator

[Operator Instructions]. Our first question will come from the line of Larry Marsh with Lehman Brothers. Please go ahead.

Lawrence Marsh - Lehman Brothers

Thanks, George and Ed. I certainly can’t complain about the PBM business, another great quarter, so I will ask about infusion. Are you giving us any sense of how big that business is now from a revenue standpoint? And towards the end of the last quarter, you mentioned that you thought the infusion business was interesting, given the number and types of drugs in the pipeline. What's causing you to maybe change your view here? And do you just see this as company specific issues or is there anything industry-wide now that would cause you to re-evaluate the infusion exposure?

George Paz - Chairman, President and Chief Executive Officer

As you probably know, Larry, the infusion business is a very fragmented business and there are many, many providers in almost every given regional location. And therefore, a lot of the leverage exists on the side of the manage care plans and it's very difficult to gain the leverage that we need in order to drive our value proposition for our shareholders.

I do believe that there is a role for infusion as you look out in the future. I am not sure though that you have to have the nurses that actually go to the homes to ultimately have the solution for the specially drugs that are in the pipeline. We are currently evaluating that. It's painful believe me to watch our high-growth business being pulled back by our results from our infusion business. There is a very strong pipeline of infusible drugs, and a lot of these drugs are going to be more like the dialysis situation where you can go to an infusion suite and the people aren’t bedridden at home and have to have nurses come to their house. They can in fact just go to suites and have this business taken care of.

The infusion business today is very difficult because you spend a tremendous amount of time and cost and non-value added activities such as traveling to the patient's own, down time as you get the patients in from the clinics and the hospitals. So, there is a lot of administrative burden and costs that make this business very difficult. What we hope to do is continue to evaluate this over the next quarter or two and come back to our shareholders with a solution. We are not ruling things out, but we are actively analyzing what move us in the best interest of our shareholders.

Lawrence Marsh - Lehman Brothers

Okay. Are you giving us any size or a range for how big that is for you now?

George Paz - Chairman, President and Chief Executive Officer

Just what’s in there, just what we have disclosed in our Qs and Ks and the press releases.

Lawrence Marsh - Lehman Brothers

So, is it fair to say it's about $100 million of revenues or are you getting any more specific?

George Paz - Chairman, President and Chief Executive Officer

I don' t believe we have made any statements in that regard.

Lawrence Marsh - Lehman Brothers

Okay, and just another quick clarification. I know, Ed, last quarter you gave us some sort of a sense of update on sequential trends in scripts, you pretty much hit that. Is there any update in terms of what we should expect for full-year adjusted script growth or mail growth this year?

Edward J. Stiften - Chief Financial Officer and Senior Vice President

Yes. For the full year, we would expect it to be to approximately 2%, give or take a few tenths of a percent.

Lawrence Marsh - Lehman Brothers

Okay. All right. Very good. And then finally, I guess along that line, just bigger picture, and I know at the analyst day you talked about kind of vision of the benefit of Specialty and really growing your EBITDA per adjusted script and how you sort of see that opportunity… substantial opportunity I think as you defined it over the next 5 to 10 years. Does the re-evaluation of the infusion business change that? Are you going to try to replace that with other things where you can generate a reasonable return? Is that kind of the message here, take something our and maybe put something in here the next year or so?

George Paz - Chairman, President and Chief Executive Officer

It certainly doesn't change it and we are always open to ways of adding to our SAAS segment or our Specialty business if we can find businesses that are good complementary fits with what we have, we would happy to add those. We don't really feel like we have major holds right now, but we are constantly looking for opportunities to improve shareholder value through acquisitions if we can. But certainly, what we’ve presented in investor day is still what we believe.

Lawrence Marsh - Lehman Brothers

Okay, and finally just a clarification. Are you still anticipating to give '08 guidance in mid-November like last year or sometime later in the month?

Edward J. Stiften - Chief Financial Officer and Senior Vice President

We are going to give in November. We will put out some probably towards the second half of the month, but we will give you ample notice.

Let me also just clarify with respect to the Specialty business. When we bought Priority, it was one of the last remaining large specialty providers that were out there. As you know, Larry, when we bought CuraScript, it was a huge home run for us. We grew revenues by 300% during a fairly short period of time. But the problem we had quite honestly was CuraScript is a very small company and we are deficient in many key therapy classes. The Priority acquisition was incredibly important to us to round out our therapy classes. We now have product offerings, and 97% of the drugs that are out, there is only a handful of drugs that we don't have and these are very small, often orphan-type situations where it doesn't make economic sense to have multiple providers. So, our offering today is very robust and very full. I think the message we’re trying to say here is that we’ve got a couple of businesses that came with that and those businesses are a bit of an albatross. We are evaluating those and we're looking at them.

Keep in mind that the PAP programs are not part of that acquisition. It was part of our… of Express Scripts’ build-out. That was a very useful program before Medicare Part D in that it served people very much in need. Usually, there is a Means Test that occurs, and once you fail those Means Test, you’re under poverty levels or some multiple of that. And the access to very expensive drugs, these programs are life sustaining for people who need those drugs. We were the largest player, we continue to be the largest player in those products, but anybody that goes over 65 now has access to Medicare Part D. So, the pharmaceutical manufacturers have created an opportunity to their benefit… or the government is created an opportunity for them to move these people [inaudible] used to give the drug away and pay us an administrative fee. So, a product where now the person buys the drug, you may get paid for by the federal government and the individual still gets their drugs, but it comes… we are not part of that transaction. So, just to be clear, our Specialty business doing is doing quite well.

Lawrence Marsh - Lehman Brothers

Okay. Very good. Thanks.

Operator

And our next question comes from the line of Glen Santangelo with Credit Suisse. Please go ahead.

Glen Santangelo - Credit Suisse First Boston

Yes, thanks. Hey, George, I just want to quickly follow-up on the selling season for next year. You obviously gave a lot of details at the analyst day, but is there a sort of any update there? And in particular, I think you said at that analyst day that next year was a relatively light renewal season. But from my records, I think the big renewal you have on tap is TRICARE. And so, maybe if… given that it’s less that six months away, maybe if you could just give us an update on that situation that will be helpful?

George Paz - Chairman, President and Chief Executive Officer

Sure. At the analyst day, we said that many of the Fortune 500 companies have made their decisions, and Ed went through the numbers in the managed-care plans, most of the big employer groups have to have. Open enrollments is occurring as we speak for a lot of companies. So, those decisions have had to be made by now or are close to now.

The other piece of our business, which is the legacy Express Scripts business, is that small to medium-size of employer groups, that business often gets made and is done often through brokers and TPAs, and those decisions are being made as we speak and they’ll be… continue to be made all the way up till the end of the year. So, I don't have real good visibility to where that’s going to come in yet. When you are… it's usually the TPAs are out moving people to better offerings in their own portfolio. They may offer several PBM options. And so, we would hard with the TPAs and with the brokerage to get our message out in front of those smaller clients. What we will do is maybe as a part of the earnings guidance call, we will give you some more color on where that is. To be quite frank though, some of those decisions get made all the way into the very end of December and we find out about it in early January and we’re loading up eligibility files. So, that's more of a touch-and-go market.

Glen Santangelo - Credit Suisse First Boston

And you have that with respect to TRICARE?

George Paz - Chairman, President and Chief Executive Officer

TRICARE is a... they’ve postponed the bidding process. We haven't… we believe that the RFP is going come out sometime this quarter. There is no… we won’t know that for sure until we actually get it. So, they are still looking at that. The whole idea of AWP and pricing of drugs was a big issue as well as a few other things in the process and they’re trying to evaluate how to handle their program going forward. Keep in mind that the program doesn't start for… I think it is '09... I believe it’s--.

Edward J. Stiften - Chief Financial Officer and Senior Vice President

Yes, I think whether we’re renewed or whether there’s someone else, that it would take effect approximately the middle of '09.

George Paz - Chairman, President and Chief Executive Officer

Yes, the middle of '09. So, it still ways out there. But we will probably be working on that over the winter and in the spring getting ready for our bid on that program.

Glen Santangelo - Credit Suisse First Boston

Okay. Thanks for the update.

Operator

And our next question comes from the line of Tom Gallucci with Merrill Lynch. Please go ahead.

Tom Gallucci - Merrill Lynch

Good morning. Thank you. I guess first, just a follow-up on the infusion business. You are going to close some facilities there and reduce some overhead. Any color on the magnitude of the savings that you might see there or really how much can we save in terms of the losses that we have seen because of those efforts?

Edward J. Stiften - Chief Financial Officer and Senior Vice President

Yes. Tom, it's a little bit preliminary, but we think the actions that we're taking should improve the picture by roughly $0.5 million a month or $6 million a year but that is pretty preliminary. And so, what we're trying to do is get this thing down to a profitable core, but if we can’t get it to a profitable core then we would evaluate other strategic alternatives. But so far, what we have identified gets us sort of most of the way there. We're still looking at other things, but again it is pretty preliminary.

Tom Gallucci - Merrill Lynch

Sure. Okay. That helps. And then, you also mentioned… you have talked about in the past lower retail and mail drug purchasing costs and I think in your investor day you covered some of the dynamics there. Is that a pretty persistent theme through for a while? Can you give us an idea of where you think we are in sort of that revolution? Is there a lot of room to run as you look out into the future, just generally speaking, or have a lot of the opportunities been for reasons that may be behind us?

George Paz - Chairman, President and Chief Executive Officer

Couple of ways to answer that. I think it is our job to continue to drive down costs. That is what our plan sponsors pay us to do. If you think about AWP inflation on the branded side going up at 6% or 7% a year, flat-to-up in the generics side depending upon the drug itself, there is inflationary pressures that alone drives up the cost trends for our clients. We have got to try to recoup as much of those drug trends back on an annual basis for our clients or we are not doing our job, there is no reason for us to exist. So, our focus internally is to contribute to drive supply chain economics for the betterment of our patients and our clients.

Tom Gallucci - Merrill Lynch

Okay. Thank you for the color.

Operator

Our next question will come from the line of Robert Willoughby with Banc of America Securities. Please go ahead.

Robert Willoughby - Banc of America Securities

George, your trade association really only seems to pushing e-prescribing on its agenda. I don't see many other issues that they’re really advocating at the moment. And as yet, we haven't really heard any of the individual PBMs say anything. Are you just not perceiving this as a near-term opportunity? Is this something that follows biogenerics in terms of economic advantage for you?

George Paz - Chairman, President and Chief Executive Officer

Couple of things, Robert. First of all, Dr. Miller is on our staff as you probably know and he is one of… he is probably the leading expert on biogenerics, spends a lot of time in Washington DC working on this issue. A lot of the support for that program, obviously, Express Scripts is a big leader in this program, but it does come from PCMA as a group. So, to the extent that all the PBMs work together to open certain doors and we get Dr. Miller in front of them is a big opportunity for us as a group. I think one thing you really need to understand is that the retail pharmacists, especially the independent retail pharmacists, often have an agenda. Our economics, the value you are seeing that we are handing of our clients often comes out of the hands of the pharmacies and they don't like that. There is a lot of pushback. So, every year as we start the legislative cycle, there is constantly introductions of anti-PBM legislation that occurs, anti-mail order, any willing provider statutes, which of course eliminates competition. If everybody can play how do you get competition. So, they want free rein and they don't want competition obviously. So, those kinds of bills our PCMA groups up very hard to open up both at the state level to defeat that legislation as well as at the federal level to allow us access to make sure that we get the PBM message out and drive…. help sustain our business.

Robert Willoughby - Banc of America Securities

Are you assuming then that any prescribing opportunities just can help you near term, that it is much further out, and that likely a reality would be the biogenerics?

George Paz - Chairman, President and Chief Executive Officer

Well, yes. I think the problem is we’ve got two basic issues. I am going to go out on limb a little bit here, but I think that when you look at the retail drug store chains with the CuraScript and then you look at PBMs with Rx hub, you’ve got two different people trying to provide a solution. And then on top of that, you've got the doctors who are resistant to the whole process or program. So, there is a lot of obstacles that come down. Again, Dr. Miller works extremely hard and tirelessly to try to get this through the Medicare Part D program and there are some trial measures and things that exist. But we need to get this through Congress.

The reason the PBM business works so well is because as you probably recall, there was going to be legislated a drug benefit back in the ‘90s, early ‘90 and that got all the pharmacies to get online. We need either a threat of legislation or actual legislation to get this to work as way too many vendors… too many different processes are out there. You need a consistent standard to get something to work. I do believe that the value of e-prescribing is huge. There is no question about it, that if you look at all the hard work we do trying to contact doctors and form formularies, drive savings, with e-prescribing then think about prescriptionnaires. One of the hardest things to do is read a prescription. I don’t know if you’ve ever looked at one, but try to read that handwriting, it's terrible. And if we could get that all done into an electronic format that gets e-mailed to either a retail pharmacy or into our mail order, it’s electronically adjudicated, we take out a tremendous amount of the cost, add savings and more importantly add safety to the whole equation. So, this is a big opportunity for us, but we need a lot of stars to line up.

Robert Willoughby - Banc of America Securities

Yes, another question. Just one of your competitors struck an interesting deal one of the lab companies just to work together here promoting formularies with greater clinical integrity I guess. Where do you stand on some of those issues? Who are you interacting with on the diagnostics side, if anybody?

George Paz - Chairman, President and Chief Executive Officer

As you know, Tom Mac Mahon is on our Board. He is the Chairman of LabCorp., so we've pretty good relationships. We certainly know the people at Quest than the others and I think that often them there is dialog. I think that it’s clearly… in today's day and age, if you could put on a statin [ph], you go back a month later, two month later, supposed to be a month later, but since a lot of people don't do it, and you get your check done to make sure that your things are going right. Those are all important tests. I think it is in the future though that might hold a bigger promise, as we look out to the future and see that specialty drugs and the ability of the body to metabolize becomes key. The real question is, can you... does it help to link the two together or do you work just with everyone to make it happen, because you've to look at the customer base overlap, but we're actively involved in this space.

Robert Willoughby - Banc of America Securities

Okay, thank you.

Operator

And our next question will come from the line Lisa Gill with JP Morgan. Please go ahead.

Lisa Gill – JPMorgan

Thank you. Ed, I was wondering if maybe you could just touch on a couple of things for me. First, on the reserve for AWP, if I remember correctly, it was going to come out this third and fourth quarter. Can you just talk about it from an accounting perspective? Did it ever go into the numbers or was it only in guidance and therefore was it reversed or was it not?

And then, secondly, when we look at the EBITDA per scripts, I think last quarter you raised the expectations to 225 to 235. Can you give us an idea what your expectations are now going into the fourth quarter around that?

And then just lastly, on Specialty Pharmacy, can you just talk a little bit, either George or Ed, about the kind of growth rates that you're seeing in your core book of business? I think, George, you talked about the fact that this is an important component of you winning business and maintaining business. So, therefore, are you seeing it grow pretty much in line with industry, slower, faster, if you can just directionally tell us how it is going? Thanks.

Edward J. Stiften - Chief Financial Officer and Senior Vice President

Okay. Lisa, I'll start with the first one, and thanks for the opportunity to clarify, because I think there still might be just a little bit of confusion out there on the AWP. The AWP risk has never been a reserve on the balance sheet. It has always been a restraint in our guidance. So, our guidance would have otherwise been much higher had we not been concerned about that AWP risk. So, we have never put anything on the balance sheet, and of course since we never put anything on we never pull anything off. So, it's never been a reserve on the balance sheet.

With respect to the EBITDA per adjusted script for the full year now, we would bump it up just a little bit. We will probably tighten the range and move the bottom end of the range up. So, we would right now call it 228 to 235, so kind of the low 230s is where we think. So, it has bumped up just a little bit.

And then with respect to the core specialty growth, I think we will see an improvement there. We are getting better and better receptivity from PBM clients. We’ve put in some new initiatives and new products and new tools there. We're seeing some traction that we haven't seen inside the last 24 months. It is early, but we see some positive momentum building there. And maybe, George, you want to add to that or so forth, but--.

George Paz - Chairman, President and Chief Executive Officer

Yes. I think that there is two pieces to the Specialty business. When we bought CuraScript and Priority, keep in mind, they’ve sold just managed care plans because they were… they didn’t have a PBM per se. So, to the extent that we either retain or slowly over time lose that business, I think what we seeing mostly in the large employer group business and to some extent the labor unions and the medium employer group business is that the Specialty business is becoming a bundled offering into that business.

Now, there are still a lot of managed-care players out there and we are trying to upsell our Special solution into managed care. The growth rate we are achieving, the strong growth that we have in Specialty is part of our PBM component. We are upselling to our PBM clients to the extent that it was third party, like mail-only business, remember back in the late ‘90s and early 2000s, there used to be a lot of mail-only business and a lot of formulary-only businesses and people used to cut up their offerings into components, that doesn't exist too much any more. The economies of scale are better by bundling those pieces together. But similar to that, the specialty-only business was offered by those two independent companies before we bought them. That hasn't shown a lot of growth. I mean that piece is pretty stagnant. Once in a while, we win a new client, but most of our wins come from upselling to our PBM clients. Since we have 55 million members I think there's a lot of growth and a lot of opportunity for us inside of our book.

Lisa Gill - JPMorgan

George, are you actually seeing any of the business actually shift from the managed-care side to where… from they are shifting it from the medical side of the benefit to the pharmacy side of the benefit and therefore we call it stagnant or flat, is it actually declining and therefore the growth on the PBM side is actually even better than what we would think?

George Paz - Chairman, President and Chief Executive Officer

On the manage-care side, it is pretty flat on the third-party only business. I say that with the exception of one. We had a large, large client that… it was probably about two years ago we signed up and they stuck with us for a year, and then they pulled the business and they decided to do it on their own. So, it’s one of the top four manage care players of the country. So, that came out of our… we only had jacked up our revenues and our sales for a year and then it came back up. But other than that, the rest of business is pretty flat, but we're seeing significant growth on the PBM side.

Lisa Gill – JPMorgan

And then, if I can just ask one last question on 2008 plan design, are you seeing any changes from a mail perspective? Clearly, your mail scripts grew or penetration grew by 20 basis points in this most recent quarter. And I think that over the longer term your expectation is that kind of 1% to 2% per year. Is there any way that you think that we could see that accelerate in the next couple of years based on what people are doing with plan design?

George Paz - Chairman, President and Chief Executive Officer

I think that there is some opportunities, I think it's got to become more at the consumer level though. We've got to do a better job of informing the consumer about the savings and the opportunities, and the value of the convenience of mail. And I don’t think we as a PBM have done very good job of that and so we need to focus on doing a better job of that in the future.

Lisa Gill – JPMorgan

Great. Thanks for all the comments.

Operator

And our next question will come from the line of Randall Stanicky with Goldman Sachs. Please go ahead.

Randall Stanicky – Goldman Sachs

Great, thanks. Just two cash-related question. The first, now that you've trended above where you’ve talked about in terms of buyback, I think it was $1 billion plus an additional $100 million to $200 million, maybe just as a comment on thought process around buyback going forward. And then, secondly George, given your view on captive PBMs, are you hearing anything or seeing… I should say seeing anything in the marketplace that will lead you to believe that there may be some acquisition opportunities for you going forward here near-term?

George Paz - Chairman, President and Chief Executive Officer

Let me do the latter one first. Obviously, we can’t talk about M&A activity. So, you’re better off talking with the bankers about that one.

Edward J. Stiften – Chief Financial Officer and Senior Vice President

On the share buybacks, in the revised guidance for '07, we do not assume my additional share repurchases for the balance of the year. We wouldn't until guidance was out, and given that that will be fairly late we wouldn't be planning on doing much. So, I think in our guidance we’ve assumed zero. I think in your planning you should assume either zero or very negligible, because as you pointed out we're going to do $1 billion and then I think we mentioned that we might add another $100 million to $200 million of that and we've added a $140 million of that extra $100 million to $200 million already. So, we've pretty much accomplished what we wanted to do this year.

With respect to '08, again normal strategy for us, we'll try to find accretive acquisitions. Failing that, the vast majority of our free cash flow would likely go to share repurchases.

Randall Stanicky – Goldman Sachs

Got it. That's helpful. Thank you.

Operator

And our next question comes from the line of John Kreger with William Blair. Please go ahead.

John Kreger - William Blair & Company

Hi, thanks. One quick follow-up question on infusion. It seems like the losses have got a bit larger as you’ve progressed through this year. Can you just talk about why that is?

George Paz - Chairman, President and Chief Executive Officer

There is a couple of things, and I’ll let Ed chime in here as well. First of all, when we took over the business, we'd very high standards around compliance and process. And there were… some of the standards around process weren’t as strong as I would have liked. So, we actually tightened down some of the screws. What we did is in the old days, often they would accept the patients without having… in order to bill it you had to have a prior authorization code. There is a list of things that you have to have before you can actually bill and collect on a patient. Well, often what would happen is that we’d collect a couple of the pieces, they would go put the person on service, once you start servicing a member there is no way you can turn them off. And then the health plan doesn’t necessarily pay if you don't have a clean client. And so, now you spend the next several months trying to get the data for those clean clients together. So, we've really screwed that down. So, if we don't have all the data we need upfront then we’re not willing to put the member on service. So, we have been trying to manage fixed cost side of this as we’ve got our arms around the servicing process. And of course, as we were doing all these we’re realizing some bad debts on some of the previous sales that we made where we weren’t as clean as we should have been. I don’t know, Ed, if you want to add anything else.

Edward J. Stiften - Chief Financial Officer and Senior Vice President

I think George said it well. The biggest reason second and third quarter were worse than first quarter has been just a more accurate assessment of bad debt exposure, but in addition you may recall that we’ve closed six sites and we’re reducing overhead, and we obviously are going to engage a consultant to help us with some of those analyses. So, there's a little bit of non-recurring consulting expense in there, but it's small, it’s a fraction of a penny a share. So, that's a little bit of it is well.

John Kreger - William Blair & Company

Great, thanks. A different question, I realize that in this environment generics are really your client savings. But curious, are you seeing anything change in the branded rebate side of the business, any interesting trends in terms of your ability to get larger rebates from your clients? And also, are you seeing a trend and how much of those rebates are being passed along to your customers?

George Paz - Chairman, President and Chief Executive Officer

Rebates are a functional of quality or the ability of the PBM to drive trend and share. So, if the PBM is good at moving people into those second tier products, which are cost savings for our members, then we should realize higher rebates. So, we are excited about what we do for our clients because we often talk about generics, but what we try to throw into the messaging is really about generics and lower cost brands. Keep in mind that on a lot of branded products there could be a huge differential in the cost of the products between a third-tier and a second-tier product. So, we have seen some things, some clients that wanted to be more proactive can put like a flat solid co-pay on a second-tier product and a percentage co-pay on third-tier product, so that more of that what we call waste, extra costs on a less efficacious drug ends up not being borne by the plant, but instead by the person who is making maybe not as good a decision. And so, we have seen drives towards getting better formulary compliance and consequently driving rebates.

As far as the sharing perspective, that's a little bit of a mixed bad. Some of the clients… we see a lot of pass-through clients now where they pick a 100% of the rebate. Our other clients realize that to really get things to work there should be a sharing of economic arrangement. In other words, if… what’s the incentive of the PBM to take all the work of driving somebody from a third-tier product to a second-tier product if we don't realize any economic benefit out of it. [inaudible] we’ll do that and everybody else will say they are going to do it, but if you actually have a financial incentive to do it then there is a lot of value. So, a lot of our compliance still want to share the rebates with us, maybe on a smaller percentage of a larger number, but there is still a lot of that going. We still have clients we take a 100% of the rebate. For whatever the reason, the client doesn't want that, they’d rather have discounts at the pharmacy counter. So, there is a whole spectrum of solutions out there that we can offer, provided we are competitive with the pricing.

John Kreger - William Blair & Company

Great. Thank you very much.

George Paz - Chairman, President and Chief Executive Officer

You are welcome.

Operator

And our next question comes from the line of Kemp Doliver with SG Cowen. Please go ahead.

Kemp Doliver - SG Cowen

Hi. Thanks and good morning. First question is, when you all initially discussed the outlook for the third quarter, you have mentioned that generic launches were going to be pretty minimal. Yet the generic mix sequentially went up over 100 basis points, which is quite a nice move. Did anything change with regard to your expectations regarding launch or is there some underlying increase in generic mix that occurs even absent the availability of new generic products?

George Paz - Chairman, President and Chief Executive Officer

Hey, Kemp, that is a great question. At Express Scripts, we are totally focused on the generic solution. You met Pat McNamee at our investor conference and you met Ed Ignasiak who is… Pat is Head of Operations and Technology and Ed is in charge of product development, sales and marketing, and those two gentlemen work hand in glove in order to try to drive down the costs. At the end of the day, we have standard in front of our clients and explain to them what drug trends are overall versus what are the drug trends that they realize. They take that job very seriously as we all do here. And so, it is about the technology and the tools we give our call center associates and the work we do to actually drive those trends down. So, what you are seeing is the fruit of the labor of our investments and technology and call center associate training and development in order to… once you call in or you go online and there is a savings opportunity, you get popups, you get information sent to you about the savings opportunity that exist. If you like, we connect you to a pharmacist who will make the outbound calls to you doctor to help you fluctuate those cost saving changes. It’s always the doctor’s decision if it is a therapeutic interchange. So, we take those things very seriously as well, but I think it is the business model.

Kemp Doliver - SG Cowen

All right. And this is somewhat an academic question, but if there were no new generics out… I mean what is the generic opportunity within the existing book. Would you say you are 80% penetrated effectively, 40%, any sense of that?

George Paz - Chairman, President and Chief Executive Officer

As you may recall from our investor conference, Ed showed a slide where we have clients in the 75 to 80 range or a little top of 80, but we should be able in theory, pure theory, there is no reason you could… a plan couldn’t meet its needs with close to an 80% generic fill rate. So, we are at 62%, so you see there is a significant amount of opportunity there. There is lot of issues that come into play here, some plans still have two level co-pays, not big differentials between the first and the second level, so there is a lot of things that cause us to have difficulty making those moves happen. But I think as companies look at their ever-increasing cost of healthcare and they look at trying to compete in a global market, they are taking the bull by the horns and we still need more and more planned sponsors actively manage this drug and allowing us to help them actively manage their drug benefits to drive down their costs without ever compromising health outcomes.

David Myers - Vice President, Investor Relations

We only have time for one more question.

Operator

And that question will come from Charles Boorady with Citigroup. Please go ahead.

Charles Boorady - Citigroup

Hi. Thanks, good morning. Most were answered, but on the… to follow on the generic conversation, in addition to increasing the penetration with generics, what do you see as the long-term opportunity on pricing? Has it been going down in an 8% to 10%? Can that continue for a while?

George Paz - Chairman, President and Chief Executive Officer

Well, I think that there is… and I’ll let Ed chime in here when I get done, but I think obviously penetration is a big issue. As far as our pricing perspective is concerned, I think that this is a very competitive market. Ed showed some slides out there that showed the ROICs of the generic drug manufacturers and the profit margins that are being hedged throughout the space, whether it be retail or other generic manufacturers. But I think there is still room to run. We have disclosed any percentages or what we think those opportunities might be, but it certainly fits into our guidance and the information we give to our plan sponsors and to you as the shareholders.

Charles Boorady – Citigroup

And then just a question. Aetna had an earnings call today and they talked about the value of an integrated health benefit including an integrated PBM. And I'm wondering, Express Scripts, can you be integrated with the health plan, say the way, not a perfect analogy, but the way an Intel chip is integrated into an Apple computer, or is there some way that you'd be deficient in a partnership with a health plan versus what a health plan can accomplish by holding the PBM, and how?

George Paz - Chairman, President and Chief Executive Officer

We obviously… probably 40%, roughly of our book is managed care today. And I would tell you that we're very integrated. We do everything from plane label to use our name with those clients and it seamless, it’s very integrated. But let’s go to the other side, the Fortune 500 companies that choose to work with a big health plan, whether it’s United, CIGNA, Aetna, WellPoint, on and on and on, and they use us as their PBM. There, the plan sponsor has to be allowed to manage their overall health care costs and where appropriate manage the high utilizers. All that information exists very easily. Many of the health plans are out in the marketplace trying to sell the virtues of an integrated benefit.

I would tell you, the biggest thing you do, the best value get is to choose the best in breed in every class. There is great wellness programs out there, there is fantastic CDHC solutions out there, there is fantastic medical plans out there, there is great PBMs out there, and I think that to maximize your benefit the interchange is very easy today. You know what it’s like on the Internet and how easy it is to send an information around, all you got to do is to get the vendors to agree, and that's easy to do because it’s your data, to make sure that they interchange the data and you can get it. I don't think being owned by a medical plan offers any benefits that you can get by being a standalone PBM. As a matter of fact, our focus, our sole focus, our only focus is to drive drug trends down.

On the medical side, 85% of the costs are coming out of the medical side, where are they going to put their best people and their resources when they have issues. Our focus is clear. So, I think we're very well positioned to compete in this ness space and to continue to grow.

David Myers - Vice President, Investor Relations

Thank you very much for the questions. I thank everyone for your participation this morning. We’re excited about our third quarter results. We're very optimistic about the future of the prescription drug benefit programs. We look forward to talking to you in a few weeks about our guidance for 2008. So, thank you very much.

Operator

Ladies and gentlemen, we want to thank you for your participation and for using AT&T Executive Teleconference Service. You may now disconnect.

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Source: Express Scripts, Inc. Q3 2007 Earnings Call Transcript
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