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Executives

David Myers - Vice President of Investor Relations

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

George Paz - Chairman, Chief Executive Officer and President

Analysts

Glen J. Santangelo - Crédit Suisse AG, Research Division

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

Robert M. Willoughby - BofA Merrill Lynch, Research Division

Lawrence C. Marsh - Barclays Capital, Research Division

Ricky Goldwasser - Morgan Stanley, Research Division

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

Robert P. Jones - Goldman Sachs Group Inc., Research Division

Steven Valiquette - UBS Investment Bank, Research Division

Express Scripts Holding (ESRX) Q1 2012 Earnings Call May 11, 2012 9:00 AM ET

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the Express Scripts First Quarter 2012 Earnings Call. [Operator Instructions] And as a reminder, today's call is being recorded. With that being said, I'll turn the conference now to the Vice President of Investor Relations, Mr. David Myers. Please go ahead.

David Myers

Thank you, and good morning, everyone. Welcome to our first quarter call. With me today are George Paz, our CEO; and Jeff Hall, our CFO.

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, may include financial projections or other statements of the company's plans, objectives, expectations or intentions. These matters involve certain risks and uncertainties. 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 our recent SEC filing.

For clarity purposes, all numbers we talk about today will be on an adjusted basis. Please refer to the tables in our press release for reconciliation of GAAP to the adjusted numbers we'll be discussing. And the reconciliation of EBITDA to net income can also be found in our earnings release, which is posted on our website.

At this point, I'll turn the call over to Jeff, who'll discuss our first quarter results.

Jeffrey L. Hall

Thanks, David. On April 2, we completed the acquisition of Medco. In anticipation of closing, we maintained high levels of project spending to free up capacity for integration activities in the year and delayed cost savings opportunities, keeping staffing at higher levels to support integration planning. We also incurred additional expenses during the quarter to ensure a smooth transition for new clients and to accrue management bonuses which were not paid in 2011.

Despite this increased spending, gross profit was up 11%, gross profit margin was 7.1%, up slightly from 7% in the first quarter of 2011, EBITDA was up 7% over last year and EBITDA for adjusted Rx rose to $3.40, up 3%. First quarter earnings per share was $0.73, up 11% from prior year. Cash flow from operations was $530 million for the quarter, a 117% increase from $244 million last year.

Turning to guidance. We expect EPS for the year, excluding transaction, integration and amortization expenses, to be in a range of $3.36 to $3.66, representing growth of 18% over 2011 at the midpoint. Consistent with last year, EPS is more back-end-loaded due to timing of new generics, realization of synergies and client billings expected in the fourth quarter. Total adjusted claims are expected to be approximately $1.4 billion. Gross profit and gross profit margins are expected to improve sequentially as we move through the year. This guidance assumes that diluted shares outstanding will average 833 million for the next 3 quarters and total 750 million shares on a weighted average basis for 2012. This share count will be affected by the amount and timing of legacy Medco options and RSUs exercised. There are approximately 48 million outstanding, and we have assumed that about 1/3 of these are exercised over the course of the year. Since we issued shares in the second quarter to complete this transaction, earnings per share for each quarter will not add up to earnings per share for the year. The tax rate assumed in our forecast is 39% for the year. If the share count or tax rate changes from our assumptions, our EPS forecast would most likely change. I would also like to take this opportunity to confirm that our view on synergy and accretion has not changed. We continue to expect the transaction to be slightly accretive in the first full year and moderately accretive once fully integrated. That means we expect to achieve $1 billion of synergy in 2014 and that the transaction will be moderately accretive to standalone 2014 earnings per share.

And with that, I'll turn it over to George.

George Paz

Thank you, Jeff, and good morning, everyone. April 2 marked a truly defining moment in our history. After months of rigorous review, the FTC allowed our acquisition of Medco to proceed without any stipulation. This merger represents the next chapter of our mission to lower cost, drive outlays, improve adherence and deliver better health outcomes. Bringing our 2 companies together provides limitless opportunities to innovate and improve how health care is delivered. Our successful track record of acquisitions is based on a philosophy of taking the best in class of both organizations and combining them for the benefit of our clients, patients and stockholders. Building upon a platform of clinical expertise and applying our understanding of behavioral sciences, we have an unprecedented opportunity to improve patient outcomes, drive down the cost of prescription medications and eliminate the wasteful spending that burdens the pharmacy benefit. This will help us chart a course for continued growth with the creation of innovative solutions to address our country's most pressing health care challenges.

We are receiving great feedback from clients and prospects. Our breadth of services that span traditional PBM management, specialty management, Medicaid and Medicare is unmatched in the industry and positions us well for client retention and new sales opportunities. Just last month, I met with many of our clients at our annual Outcomes Conference, our first large event as a combined company. Overwhelmingly, our clients are supportive of our merger and share our enthusiasm about the enhanced services they will receive. Our clients also continue to voice strong support for our retail strategy. The conference highlighted our industry-leading Drug Trend Report, which provided cost -- cutting-edge solutions for most effectively managing a pharmacy benefit. This year, we focused on the $408 billion of waste due to suboptimal pharmacy-related behavior. Non-adherence contributes over $300 billion of this waste. This is enough to cover the cost of health care for nearly 45 million uninsured Americans. Our breakthrough adherence solution, ScreenRX, combines early detection with tailored interventions, improving outcomes and lowering cost. In the wake of our merger with Medco, ScreenRX is a prime example of where Express Scripts is headed, making it easier for patients to make decisions that improve their health and lower the cost of health care. We have an unprecedented opportunity to help make the use of medicine safer and more affordable. This is exactly what employers, health plans, unions and government agencies need now.

At this point, we'd be happy to answer any of your questions.

Question-and-Answer Session

Operator

[Operator Instructions] And first, we'll go to the line of Glen Santangelo with Credit Suisse.

Glen J. Santangelo - Crédit Suisse AG, Research Division

George, I just want to kind of get some of your preliminary comments on the selling season this year. It seems, based on your 1Q results, given your revenues and your claims growth, that it doesn't seem that the Walgreens issue is really having a big impact on your business. Maybe if you could comment on that and kind of give us some of your early perspectives on the selling season and how some of the conversations with some of the Medco renewals is going, it'd be helpful.

George Paz

Why don't we take a step backwards first and ask ourselves what is the job of a PBM? What are we hired to do at the end of the day? Our job is to take the waste out of this system. As I said in my prepared comments, there is billions and billions of dollars that are being wasted in the health care benefit. To the extent those dollars can be captured, we reduce the cost of health care, we improve health outcomes and, therefore, we deliver a better product. That is our job. So what are our clients looking for? They're looking to spend money where it matters and not spend money where it doesn't matter. So again, if a cutting-edge new cancer agent comes to market, very expensive, we put it on the formulary. We have to put it on the formulary. We want to put it on the formulary, because it's going to help our patients health outcomes improve. By the same token, those components of the health care system that only drive up cost and don't improve health outcomes, there's no place for that. Companies today are struggling in this economy. With the uncertainty of our global economy, other things that are going on throughout our country and the rest of the world, companies can't afford to spend money on things that don't matter. Pharmacists are a very important element of the health care delivery system. To the extent that they're helping to improve individuals' health outcomes by focusing on adherence, the right drug at the right time, with proper direction, that's all very important things, and that's what we want to pay for. Merely dispensing the drug itself is not a value-added endeavor. So again, to the extent somebody want to charge more money for that activity, there's no room in the equation for that, quite frankly. Those clients that want it, that want to pay for it, that want to have -- that are willing to pay for that convenience factor, they may want to do it and they may go somewhere else. But, quite frankly, we're very content in doing what our clients are asking us to do, and that is to take out those unnecessary costs out of the equation. And that's our focus. That message is very well received. We believe we are well positioned, as you see, our script counts grew last year, unlike some people thought they would decline. We're very well positioned. I think at the end of the day, the question is going to be on our ability to continue to innovate and deliver quality products that take out waste. And that's our mission, so we're pretty excited about that, Glen.

Glen J. Santangelo - Crédit Suisse AG, Research Division

Maybe if I could just ask Jeff a follow-up. Jeff, I wanted to talk quickly about the expenses. If I look at the expenses recorded by Express Scripts on the SG&A side, probably a little bit higher than what we'd modeled, and you said you're continuing to pull some projects forward to free up some capacity for the integration. And secondly, I look at the expenses on the Medco side, what they reported, the gross margins and out-margins were both below what we had expected. So SG&A was well above kind of where we had it modeled. And so I'm wondering if you could just elaborate on the expenses a little bit in the first quarter, because it seems like on both Express Scripts and Medco, both the expenses were higher than what we had modeled. So if you just give us some comments on that, it'd be helpful.

Jeffrey L. Hall

Sure. I think what you said is accurate. Both companies continue to spend on projects in anticipation of the acquisition closing. So we did see expenses up. And in addition, we kept people around. We always ramp up for 1/1, we kept those people around because now they're going to be working on integration-related activity, so that's extra cost in the quarter. I think what you'll see now as we add the 2 companies together, when we come out with Q2 -- obviously, now you're going to see combined Express Scripts/Medco numbers rolled up into Express, so we'll see those numbers come up in Q2, and then you'll see that the numbers start to decline over time as we begin to realize the synergies from this transaction.

George Paz

Let me just add on to that. As we look out to the future, we don't know how the Supreme Court decision is ultimately going to come through. But we've got to be nimble. And I think one of the qualities of Express Scripts is that we've been able to move quickly and do things efficiently. But there's a lot that's going to take place in '13 and '14 as we prepare for health care reform as the Supreme Court either upholds the current health care law, or even if they keep most of it, maybe the individual mandate, if that gets turned down and the rest of it stays, we're still going to have to be prepared for the exchanges. So I think what Jeff's saying is right. We certainly had a lot of ramp cost. Medco didn't know till towards the end of the quarter that the deal was -- when the deal was actually going to close. They had to be prepared to continue to operate and compete on a standalone basis, so there was a lot of cost being incurred on their side as we also tried to get ready for integration and the combination of the companies. But we still have to spend money in order to make sure that we have the premier offerings in 2014. So that's also included in our guidance, but it's something that we have to be prepared for.

Operator

Our next question is from Lisa Gill with JPMorgan.

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

George, just going back to the selling season for a minute. There have been some comments that the selling season is going to be to 2 to 3x what it's been historically because of your combination. Can you maybe just frame for us what you're seeing as far as what customers are doing in the Medco book? Are they utilizing the change of control, or are you seeing this more of a status quo here, and therefore, we're just going to see us going through more of a normalized selling season for your book and the Medco book?

George Paz

Well, I think any time you do an acquisition, if you remember back -- good morning, by the way, Lisa -- but as we look out, we look in the past and see our previous acquisitions. Remember, when we were -- after we closed the WellPoint transaction, our sales activity wasn't as robust as historical, because, again, people are a little less likely to want to look at you when you're in the middle of a transitional issue. Our job is to make sure that they feel comfortable with that, and that's what our sales people are engaged to do. But with the SXC-Catalyst merger, there's a lot more activity taking place this year on multiple fronts. So it's still too early. Remember, keep in mind, we've only been 5 weeks into this transaction. I know there's been a tremendous amount of misinformation given out there. Some people seem to think or seem to believe they know more about this business than we do, even though we own it. So there's very few contracts that actually have change-of-control provisions in them. But we're going through our process, and I don't want to get into specific client conversations. We usually aim to keep 95% of our business, for good reason. We think we had to continue to grow profits, and at times, our model doesn't necessarily always fit with the clients we have. We've never had a 100% share. By definition, we will lose some clients over the course of the year, and we'll gain others. And as the year unfolds and we get our arms better around the Medco situation, we'll be able to give much better guidance. We're just very early on into this process. Medco is big. We had our annual Outcomes Conference a couple of weeks ago. Medco's is next week, so we're headed down for that, and we'll get a better read then. But we feel very good about what we've seen. We've been in front of -- I personally have been in front of many, many of the Medco clients, and I think they're excited about what we have to offer.

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

George, going back but [indiscernible] reported in your Outcomes Conference, I think you talked about this new narrow network that will be tiered. Can you just maybe talk about how that works? Is that an incremental savings for the member? Or is it tiered based on what the plan sponsor will play? And then secondly, what's been the early reception to this kind of tiering program?

George Paz

We've just rolled it out. There a tremendous amount of interest. I think eliminating Walgreens from our network was better received, quite frankly, than even we expected, and the clients had virtually no disruption. So this was a very big home run for us, and I think that opened up the flood gates. And I think what we're seeing is opportunities for employers to form special networks that are centered around their employee bases. So if you've got 5,000 employees, you really need a 60,000-store network. And why not take advantage of concentrating all your employees into a given set of stores that are large in your area. You can protect it with a wrap, with a national network while are traveling, so they can still get it. It is a savings to the member, and it's also a saving to the plan sponsor. Keep in mind that we don't -- the plan sponsor is the one that ultimately controls the cost, so we tell them what the cost differentials are and what the options are. And so as we do that, we can then evaluate the differences of cost versus access, and then the plan sponsor can decide how much copay differential they want to allow the member to go to the premier stores and with that means for the plan sponsor.

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

Great. And then if I could squeeze one more with Jeff. When we look at this script volume in the quarter, Jeff, 3.6%, clearly better than that guidance that you gave of 0% to 2%. Should be still be thinking overall year being 0% to 2%? I think you gave a guidance number now, right, of 1.4 million claims? But what's the underlying utilization expectations, I guess, for that book of business when we think about what you did in the first quarter? And secondly, what was the primary driver of it coming in obviously materially better than what you expected?

Jeffrey L. Hall

So utilization still remains very low. Basically, we aren't seeing any, it's functionally flat. So all of the increase we saw was a result of net new business that we won over the course of the middle to end of last year, and that's what's driving the increase. As we move through the year, we did have a new client that came on in the September time frame, so we would expect to lap the compares on that towards the end of the year. But we remain very positive about the core or the legacy Express Scripts numbers. The volume is just there, we're seeing nice net new growth, and that's without any kind of utilization.

Operator

Our next question is from the line of Bob Willoughby of Bank of America Merrill Lynch.

Robert M. Willoughby - BofA Merrill Lynch, Research Division

George, when you guys did the DPS deal years ago, you threw out a number of the business that DPS did that you were targeting to retain. It was something in the neighborhood of a 90% number. Wouldn't you be better served or well served to kind of throw that kind of number out for the Medco book of business, what you expect to retain? Because, clearly, there's some work there, that they're doing, that probably doesn't meet your profit standards.

George Paz

That's a good comment. Back in those days, we didn't have nearly as good a CFO as we have today. So we're trying to struggle with how to get our arms around that, Bob. But, yes, that's a great point. But keep in mind the difference. Back in those days we were both relatively -- or much smaller PBMs relative to what we have today. So our due diligence work going into that acquisition was, quite frankly, a lot more thorough, because we could. This deal was in front of the FTC for an extended period of time, and our access to information was pretty limited. You're exactly right, though. There's clients that we have a way of doing things, and our business model has a certain manner. And some clients, that's not going to be right for. And other clients, it'll be good for. And the synergies will help us stay -- even become more competitive. So you're right. There is a number out there, and we should do that. I can't tell you I know what that is today. We're very early on here relative to where we stood with DPS. But that's a great point, and we'll definitely take it under advisement.

Robert M. Willoughby - BofA Merrill Lynch, Research Division

All right. That might be interesting to hear next call, then, possibly, before we start seeing business siphoned away.

George Paz

Bob, by the way, we did include in the synergy number a fairly uneducated, if you will, guess on loss of some clients. So that is -- the $1 billion is a net number. We'll try to get that better refined, though, as we get a chance to go through all the contracts.

Robert M. Willoughby - BofA Merrill Lynch, Research Division

Okay. And obviously, you mentioned no plans for the Medco pharmacy networks here. A, would you hazard -- do you have anything to say on that front? Or, B, if you do intend to make some changes, when do you actually need to notify clients?

George Paz

Well, it depends. I've met with a whole host of clients not too long ago, maybe 2, 3 weeks ago, and kind of explained to them the cost differentials by including Walgreens. There's some misnomers out there that -- somebody who runs a pharmacy chain up in Chicago is saying that $1 or $2 doesn't matter when it's only 20% of your total network. Well, it matters a lot. Because what that does is it sets a pricing level. And again, when you're paying one person a premium over others, you're, of course, putting price pressure on the entire network. So even if it's a few cents, it all matters. It's all relative to the value you're delivering. And I think that there's -- again, there's a pay-for-performance standard. If we can come up with ways to help actually drive down costs, improve adherence, do things that are out of the ordinary course of the book, we're willing to pay for those if our clients are willing to pay for those. But we're not just willing to pay for doing nothing special, for not doing anything different. So when we go out to the Medco clients, the Medco clients themselves as we're going through this process -- and again, we're very early on, here -- several of them have already selectively chosen to drop Walgreens themselves. That'll be occurring here shortly. And that's their decision. When that occurs, there doesn't have to be any notice, they just do it. If we were to decide to drop them, that would require notice, and we have to go through a process. We're still evaluating all that.

Robert M. Willoughby - BofA Merrill Lynch, Research Division

Okay. And then just the last one. Just, any plans, any insights yet on the mail footprint, what you will consolidate, what you will keep?

George Paz

We are going through that. As you probably know, that's a pretty -- those are tough calculations. There's everything from state tax credits to job credits to labor relations to supply a pharmacist, and those are big decisions. We are pretty far down that path, Bob. We've incorporated some of that into our guidance, but we still have a little bit of room to go there. But we are -- those things have to be done quickly. The employees need to know where we're headed. So rationalizing the footprint is an incredibly important part of our process. Pat McNamee and his team, led by David Norton, all play a very prominent role in this process, and we're pretty far down that path, and we'll continue to advance that ball.

Operator

Our next question is from Larry Marsh with Barclays.

Lawrence C. Marsh - Barclays Capital, Research Division

Now I'm wondering whatever happened to that CFO. I think I'm talking to him. He did okay. Just to elaborate a little bit, George, on a point. We met with, recently, the CEO of a health plan who suggests that while they're still using Walgreens they'll be very willing to have a conversation with you guys about saving money. So I guess that's consistent with what you've said. And you said that, for the time being, they remain in Medco's network. You're communicating that -- you're evaluating sort of your decision for 2013. Is there any way to sort of frame, if you were to make a decision about or go forward without one chain, would that be September, October? Or might we hear something before that?

George Paz

Larry, I don't want to speculate on that at this time. Again, because of our FTC process, Chris Houston and her team have been out running our supply-chain economics and putting the contracts side-by-side and understanding best practices and what opportunities we have. And this is still a little too early to go there, but we'll definitely keep you posted.

Lawrence C. Marsh - Barclays Capital, Research Division

Okay. And then just a quick -- as well as that and a quick follow-up for Jeff. On Medicare Part D, I guess, the same question. Obviously, you're growing your Part D business. Medco had a five-star rated product. Is it still too early to sort of think about combined strategy, or are you going to be rolling something out?

Jeffrey L. Hall

I'll enter even a little broader than that. Certainly, Med D is a growth area, and Medco had a great product there, so we're taking a good hard look at that in deciding what we want to do. But that applies to, really, all of the subsidiaries as well, right? We've inherited a bunch. We have some, and we're going through really detailed process right now to figure out what makes sense and what we want to continue and what we want to focus on and grow over the course of the next several years.

Lawrence C. Marsh - Barclays Capital, Research Division

Great. And just a quick follow-up, then. You're guiding at a midpoint to 18% growth, and it seems like your history, the performance to that midpoint has been outstanding, notwithstanding issues last year. Just remind us again, I know you get a tax rate and a share count, but it seems like it's a pretty wide range of $0.30, Jeff. And I know you're not talking about next year, but are there any major headwinds and tailwinds we should think about as we kind of think about growth for next year?

George Paz

Jump in on that, and then Jeff can also add in. Again, because we had limited opportunity to plow through all the things we normally do, that's why we have a wide range. We are hopeful that we can do synergy acquisition faster, and that could drive us to the higher end of the range. But also there's a lot of cost here. We'd also have a lot of Medicare, Medicaid and exchange uncertainties that are facing us, and that's what drives us to the lower end of the range. So we've got a lot of work to do, and I think it's only prudent at this early stage to give a wide range. As we go through the year and we get our network strategy better finalized and understand the different options that we have -- and your point on Medicare is right on. Medicare is a fast-growing area. We are incredibly excited that we brought in Tim Wentworth and Glen Stettin from the Medco team to be part of my senior management team. And Tim heads up all of the account management and sales programs, and he's an ex-Medco guy, so you probably know him. And he's a wonderful addition to our team, and he's very much focused on growing the business on a profitable basis. So he's going to help us rationalize the Medco business with our business and figure out what's in our best interest and our clients' best interest and our patients' best interest. And at the same time, Glen is going to run our product portfolio for us, and so, looking at Medicare and Medicaid, the exchanges and all the options, he's very well equipped. He's a doctor by education, so he's very well equipped to come to the table and help us get the right offering. So we're very excited with where we sit.

Lawrence C. Marsh - Barclays Capital, Research Division

And headwinds and tailwinds for '13, or is it too early to comment, George?

George Paz

Well, I think that's what I'm speaking to. The headwinds are really the uncertainty of the future right now. And there's always challenges. We're taking 2 systems and putting them together, we're going to start that process, we don't lollygag when it comes to this stuff. We think the best thing we can do is get to one platform rather quickly. I think that eliminates a tremendous amount of cost, it allows us to remain flexible, it gives us a standard offering across all of our books of business, investments that we are fixated and focused on. But there's always surprises when you start peeling those things back, and those are the headwinds. The tailwinds are a pretty powerful. We've got a tremendous synergy opportunity. Jeff talked about the $1 billion, and the timing of that gives us great tailwinds, and we've got a great product offering portfolio. We're taking our clinical, our combined clinical expertises combined with our understanding of behavioral economics is, I think, is just something that's unprecedented in our industry and something the entire country is thirsting for. So we're well positioned.

Operator

Our next question is from Ricky Goldwasser with Morgan Stanley.

Ricky Goldwasser - Morgan Stanley, Research Division

You showed very growth in your mail script account. Can you talk through what's driving the growth? And is the shift away from Walgreens helping in transitioning some members away from retail and toward mail?

George Paz

We are thankful on that one a little bit, again, to our friends up north. When they decided to withdraw from our network, that gave us a reason to outreach to all of our members on behalf of our client. And they had an option. They could either go to other retail drugstores or they could look at the convenience and efficiency and cost savings attributable to home delivery, so it helped drive home delivery up.

Ricky Goldwasser - Morgan Stanley, Research Division

Okay. And then following up on Larry's question around kind of growth rate in the future. And understanding kind of like the timing of integration and it takes time to transition to one system. But really, when we think about the opportunities over the next 2 to 3 years as the integration are completed, can we use that kind of like midpoint of this year figure of around 18% as our benchmark?

George Paz

You really think I'm going to answer that question? I mean, we have not given '13 or '14 guidance, and we don't intend to do that at this time. We're a couple of weeks into this acquisition, and we got a lot of work ahead of us. We're excited about where we sit. But keep in mind, there's a tremendous amount of uncertainty in our marketplace. We don't know how the Supreme Court is going to rule. I will tell you it was a travesty for so long that so many Americans did not have accessibility to our health care system. That had to change. It's changed now. Everybody is in '14 is going to get access, but we haven't addressed the cost side. The cost side alone is, both to the state and the federal government, could be huge. It will be huge. And we're going to have to address those issues. All those -- addressing of all those issues means significant changes to what we do today and how that's going to play out in the future. To the extent that we are nimble, that we are part of the solution, there is tremendous opportunity for us in the future. By the same token, though, we don't know how that's going to play out, so we just have to be positioned and ready, and we will keep you informed and give guidance as we go.

Operator

Our next question is from Tom Gallucci with Lazard Capital Markets.

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

I have a couple of follow-ups. George, I think you were talking before -- you maybe alluded to $1 or $2 a script is meaningful to clients. I know it varies by situation, but can you talk about average differences you're seeing for clients, either with and without Walgreens? And also, maybe as a result of your new advantage offering network?

George Paz

I don't want to get into the particulars, and again, you're right. I mean, it really depends. It depends on the mix of business and whether or not -- if you've got high utilizers of specialty drug, you're going to have a much different answer than if you've got a young population, if you're a professional firm which turns over young people rather frequently with a high density of young people, that's going to be a different answer. So I think every client is different, and so that's why one size doesn't fit all, and a PBM has to have the tools to be able to go out and evaluate that. I will tell you, though, some companies are very agnostic of regarding their offerings, and they've got -- we saw clients with two-tier products with almost no differential in price between the first and second tier with very open formularies and open access standards. And that's not our sweet spot. And those clients don't really -- we have a hard time providing much of a value to them, because we're not taking cost out of the equation. We're not actually improving their health outcomes. Our tools don't work as well there. So it's just depends on the situation. But again, from our perspective, we look at every drug on our formulary. We look at every access point in our network. And we look at every dollar we spend. I think any company that's well run looks at every penny it spends and determines whether or not that penny is adding value to its shareholders. If it is, you spend it. If it isn't, why spend it? There's too many great opportunity to save jobs, to grow companies, to improve margins. You don't spend money for nothing, and I think that's the message we have to our clients. Our clients, it resonates with, and it is proving fair dividend for us.

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

So it sounds like your thinking is there is savings, and whatever the amount, it's important.

George Paz

There are savings, and then for some clients, it's quite large. Other clients, it's not nearly as large just because of the demographics I talked about a minute ago.

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

Right. You mentioned before, sort of evaluating the situation with Medco and Walgreens and the network. Clearly, you still have an option now. Based on the current contract, though, between Medco and Walgreens, how long is that an option to keep Walgreens in the network, even?

George Paz

I tell you, we'll keep you posted as we go. I really don't want to discuss either drugs, networks, clients or any of that in an open forum. It's really our business with our clients and their decisions on how to meet the health care of their patients. And I know it's important to all of you, but quite frankly, it's very important to our clients and our clients shouldn't be hearing stuff here. We should be working with them to meet their needs, and we will keep you posted on those decisions as they unfold.

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

Okay, fair enough. Last one, if I could. On the integration, Jeff, I think you mentioned your synergy and your accretion expectations haven't changed. You were a little bit more detailed on the timing, I think, so I just wanted to make sure is there any changes in your views there? And can you remind us if there's any key steps or milestones that we can sort of watch for as you proceed on the integration?

Jeffrey L. Hall

Yes, absolutely no change. We tried to be a little bit more precise because now we actually have a closing date. Originally, we've been saying first full year post-close, one fully integrated, we've been saying the integration is 18 to 24 months. So now that we actually have a hard closing date of April 2, we can fill in the dates and fill in the time frames, which is why I was a little more precise today, saying we still expect it to be slightly accretive first full year and moderately accretive once fully integrated. And now I can say that what that means is that we expect $1 billion of synergy to be in '14 as $1 billion and moderately accretive to standalone would have been EPS for '14.

Thomas Gallucci - Lazard Capital Markets LLC, Research Division

Any key milestone that we should think about in terms of the process as you move forward?

Jeffrey L. Hall

Yes, I would tell you there are pages and pages of key milestones, probably none of which we're going to share externally. I think we'll give you updates on our quarterly calls. But, quite frankly, it's probably going to be hard for investors to see externally, other than what we're saying.

George Paz

The key to both the synergies and to positioning ourselves is getting the systems integrated. That's always the biggest thing, and that's comes in waves and over time, and we'll keep you all posted on how that's proceeding.

Operator

Our next question is from Robert Jones with Goldman Sachs.

Robert P. Jones - Goldman Sachs Group Inc., Research Division

Just a follow-on to the synergy question. It looks like, obviously, the total amount is unchanged. I know you've had a whole month to look under the hood. Any more perspective you can add on the sources of synergies? I know the systems you mentioned being a big part of it, but maybe just any more color of SG&A versus COGS?

George Paz

I don't think we've broken down sources.

Jeffrey L. Hall

Yes, we have not.

George Paz

No, but it's going to be from a combination of things. To the extent that Medco ran multiple formularies, we were more tighter around our formularies. We had to look at all that and see what is it clients are trying to accomplish and can we rein some of those in? That'll give us upside to the synergies. And so we've got a lot of work there, but part of the synergies will come from supply chain. Some of it will come from just getting the footprint right-sized. And then I think we bring a different approach to things. If you look at a lot of the acquisitions that Medco did over in the past and a lot of their spend, I'm not sure they used the same rigor and discipline that Express Scripts uses in how we set rate of return targets and the thresholds we're looking for. I think it's all about focus at the end of the day, and we've never lost our focus on our patients and our clients. And that is to improve the health care system by driving out cost and improving health outcomes. And everything's got to tie back to that, one way or another. Otherwise, it's really not in our bailiwick. So that's where we will continue to work.

Robert P. Jones - Goldman Sachs Group Inc., Research Division

Great. And just If I could follow on the tax, Jeff, understanding that it is your best estimate. At this point, I mean, can you maybe help us bridge the gap between your legacy rate, Medco's rate and the 39% that you provided? At this point, are there known items that maybe fall away in future periods?

Jeffrey L. Hall

No, it's just really early, and tax rate, it takes a while. We are, as you might imagine with a 39% tax rate, paying a full federal rate. And so what it comes down to is how do we -- what tax rates do we have state by state? And there's just a lot of work going into what the final footprint is going to be, how we're going to interact, how all that's going to be apportioned. So it really is early. What we've done is we've taken a look at our tax rates and our apportionment and Medco's and said that it probably is going to end up in the center somewhere. We used 39% for our guidance, and we're trying to be real transparent from that standpoint, saying, look, in my 351 midpoint, we used the 39% tax rate. To the extent the actual tax rate comes in different than that, that 351 midpoint is going probably to move.

George Paz

Can we just do one more question, please?

Operator

That'll be from the line of Steven Valiquette with UBS.

Steven Valiquette - UBS Investment Bank, Research Division

Congrats on the strength of some of the key metrics in the quarter. And I guess speaking to that, just curious on the first quarter gross profit strength. Two questions kind of interrelated. I guess to the extent that your cost of revenues no longer included a certain potentially higher-cost retail pharmacy provider, was that exclusion material enough to move the needle in the quarter? Or was it more a function of maybe you were able to get lower reimbursement rates to stick with all the other retailers of the pharmacy network? Just trying to get more color around the gross profit strength.

Jeffrey L. Hall

Yes. So the exclusion of the person you're talking about had no impact at all, on the gross margin in the quarter, no meaningful impact. Really, the strength is about the generic fill rate being up and mail being up, and it's in line with our model of alignment. We talk about it a lot. As we're able to save cost for our clients, our profitability tends to improve. And we saw a large increase in generics and we saw a nice increase in mail that we talked about earlier. Holding it back a little bit has been LIPITOR. Obviously, it's one of the big generics, and the pricing of generic LIPITOR just hasn't come down dramatically yet. On top of that, it's the additional spending on projects that we talked about, some of that's above the line. And then the 1/1, the headcount that I said is remaining on to now start working on integration. But network, no meaningful impact.

George Paz

Just to add on to that a little bit. When we talked about the Walgreens situation, it wasn't that we would come out of the chute. They wanted to hold their rates based on what they were in 2011 for the next 3 years. And as you know, branded drugs rise at 11% a year, and specialty drugs go up at over 14% a year. So we're one month into this. So the impact on this year's expense levels, cost of goods sold levels, isn't that great. It's what happens over a 3-year compounding of drug cost rising at over 10% for really doing nothing different than putting the same pills to the same bottle. That's what was intolerable, that's what caused the problem. And it was that and then the redefinition of generics to increase the price, effectively, for generics. Those items, if we would have taken them on, you would have seen our cost of goods sold rising at a much higher rate over time. None of that's really in the first quarter, just to make sure we're clear.

David Myers

Okay, well, again, thank you all very much for your time this morning. We're very excited about what this acquisition means to us, our patients and our clients and our shareholders. So thank you very much, and we'll keep you posted as we move down the integration path. Thank you.

Operator

Ladies and gentlemen, that does conclude your conference for today. Thank you for your participation. You may now disconnect.

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