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Express Scripts Inc (NASDAQ:ESRX)

Q2 FY08 Earnings Call

July 31, 2008, 10:00 AM ET

Executives

David Myers - VP of IR

Jeffrey L. Hall - EVP and CFO

George Paz - Chairman of the Board, President and CEO

Analysts

John Kreger - William Blair

Charles Boorady - Citigroup

Brian Tanquilut - Jefferies & Company

Robert Willoughby - Banc of America

Thomas Gallucci - Merrill Lynch

Glen Santangelo - Credit Suisse

Lawrence Marsh - Lehman Brothers

Michael Minchak - JPMorgan

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the second quarter 2008 earnings conference call. At this time all lines are in a listen-only mode. Later we will conduct a question-and-answer session, instructions to be given at that time. [Operator Instructions]. As reminder today's conference call is being recorded.

And with that being said, I would now like to introduce your opening speaker for today, Vice President of Investor Relations, David Myers. Please go ahead.

David Myers - Vice President of Investor Relations

Thank you and welcome everyone to our 2008 Second Quarter Conference Call. With me today are George Paz, our Chairman and CEO, and Jeff Hall, our CFO. Before we begin, I need to read the following statement.

Statements or comments made on this conference call may be forward-looking, 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 statement due to a variety of factors which are discussed in detail in our filings with the SEC. In addition, the reconciliation of EBITDA to net income and to net cash provided by operating activities can be found in our earnings release, which is posted on our website.

At this point, I'm going to turn the call over to, Jeff who will discuss our second quarter results.

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

Thank you, David. As I'm sure most of you already know from our press release and quarterly filings, Q2 was another strong quarter for Express Scripts. For the past few months, we've been telling you about how we're taking our business model of alignment to the next level with consumerology. Consumerology is the application of human behavior theory and behavioral economics to the pharmacy benefit.

It's rooted in the clear successes we have enjoyed, saving money for our clients by driving unprecedented market share shifts from high cost products to lower cost generics and formulary brands. One of the key pillars of consumerology is that when it comes to effective interactions with members, one size does not fit all.

As a result, by using technology to tailor our offerings and interactions to each individual, we believe we will be able to increase therapy adherence and lower cost of care, delivering lower costs and better health outcomes to our clients. Although, we are still early in the rollout of these tools and programs and there is still a lot of hard work to do, I am happy to say that the initial results are positive.

Many of our clients are excited about using these tools and we have several pilot programs already in place. These pilot programs are already saving money for our clients by increasing generic fill rates, therapy adherence and home delivery penetration. This performance helped to drive our overall generic fill rate in the quarter to 65.9%, up 4.8 percentage points from last year.

We are also seeing strong interest in consumerology from new clients and we have won many new accounts on the basis of the cost savings we can deliver for them and our model of alignment. In keeping with this model of alignment, that is we make money, even our clients save money, the cost savings our clients realize have also benefited us.

Gross margin grew 10.7%, or 504 million, up 15% from last year in the quarter. EBITDA was 341.9 million, up 18% from the prior year. EBITDA for adjusted script was $2.67, up 17% from the prior year, and earnings per share were $0.76, a 33% increase over $0.57 last year. As a result of the strong initial returns from our investments in consumerology, we have decided to accelerate our efforts and increase funding levels for these initiatives over the next few quarters.

Moving on to cash flows, cash from operations was 234.5 million in the quarter, compared to 96.4 million last year, as a result of our focus on driving cash flow. Year-to-date cash flow was $482.8 million or 73% of EBITDA. This strong cash flow allowed us to increase our repurchases in the quarter and complete the acquisition of MSC while slightly reducing our debt levels.

During the quarter, we repurchased 5.3 million shares for a total of $373 million. And as a result of the confidence in our business model and our future performance, our board authorized an increase in our share repurchase program by 15 million shares. We now have 21 million shares remaining authorized for repurchase.

Now let me turn to our guidance for the year. As a result of our strong performance and initial returns from our consumerology [ph] efforts, we are increasing our 2008 guidance for EPS, EBITDA per adjusted claim and cash flow. EPS for the year is expected to be $3.03 to $3.10. The midpoint of this range reflects growth of 29% over last year's EPS from continuing operation of $2.38. This guidance includes the MSC acquisition, which we expect to be neutral to EPS for the year.

EBITDA per adjusted claim for 2008 is now expected to be between $2.65 and $2.75, and our estimate for cash flow from operations is 1 billion to 1.1 billion.

Before I turn it over to George, let me give you a few more items you should consider when modeling the rest of the year.

Our forecast for claims for 2008 remains unchanged. We still expect that total adjusted claims for 2008 will be flat to slightly up compared to last year. And while adjusted claims are up 1% year-to-date, we expect retail claims in the second half to be approximately 2% below the same period in 2007, reflecting the mid-year roll off of lower margin claims we discussed with you last quarter and increased mail penetration.

Home delivery claims for the second half of 2008 should be slightly above the second half of 2007. Last quarter we told you that we expected SG&A expenses for the remaining quarters in 2008 would remain approximately flat with Q2. The increase in SG&A in Q3 was mainly the result of higher management incentive compensation, which is tied to corporate financial results.

Going forward, we expect SG&A to be down slightly in Q3 and trend up slightly in Q4 following the historical seasonality, as we integrate MSC, accelerate investments in consumerology, and prepare to bring our new clients in 2009. And as I told you last quarter, our best uses of cash are investing in internal growth platforms and good accretive acquisitions.

Our investments in consumerology and the acquisition of MSC are good examples of how we are executing to this plan. And going forward, we will continue to look for ways to invest and grow the company.

Net interest expense for the quarter was 13.7 million and was below last quarter's guidance due to lower interest rate. Going forward, we expect that net interest costs will increase to approximately 15 million in Q3 and Q4, reflecting lower levels of cash to the MSC acquisition and share repurchases.

And at this point, I'll turn the call over to George.

George Paz - Chairman of the Board, President and Chief Executive Officer

Thank you, Jeff and good morning everyone. Our last 30 days have been outstanding. During this period, we have renewed the DoD contract, our largest single client. We put the New York litigation behind us, and last night we released record earnings. Also importantly last night, in our lead, there is a class action case. The plaintiff's motion for class certification was denied and our motion for summary judgment was granted for all material issues.

We remain bullish about our proven business model alignment and our next generation strategic platform of consumerology, a more advanced understanding of consumer behavior. Both of these differentiating qualities will enable better health and value for our clients and their members.

Last quarter on our call, we focused on the rollout of our new strategic platform. This quarter I want to share some of the feedback and broad applications of our offerings. Along with members of my senior staff, I have personally been in front of some of our… of the nation's largest managed care plans and employers.

We understand that financial incentives and more education has its limits, is well understood. In addition, the enthusiasm from plan sponsors around what science has taught us about decision-making and behavior, and the realization of what that means for healthcare quite frankly has exceeded our expectations. So where are we? We have hundreds of thousands of members involved in pilot studies and we continue to document the proof points and institutionalize the capabilities.

The application of our learning's are far-reaching. We will begin to apply these strategies to a wide range of activities, including key levers such as generic utilization, the movement to lower cost brands, therapy adherence, and greater use of home delivery. Our value proposition will be more robust than ever. Winning the DoD confirms our position in the marketplace. Our focus on innovation, execution and member satisfaction, when combined with our proven business model alignment results in our strong financial performance.

Our beneficiary satisfaction rating of more than 97% is the highest service rating for any contractor servicing the DoD. The DoD was an important win for us. First, it is a great honor to continue servicing our men and women in uniform to work on their behalf, making use of prescription drugs, safer and more affordable.

Secondly, our new contract expands our relationship with the DoD and now includes specialty pharmacy, including care logic, our disease management platform for specialty therapies. DoD has validated our clinical approach to managing health and value, one consumer at a time.

We are still in the process of working through the selling season. We have fewer clients up for renewal this year and we're enjoying a strong renewal rate consistent with prior years. As, you know, we focus on the middle market, as well as large plan sponsors. Since we are in the midst of this middle market selling season, we are not prepared to discuss sales at this time. We will update you of our sales results when we provide 2009 guidance on our third quarter conference call.

The uniting of the country's two leading health information networks RxHub and SureScript will form a single secured nationwide network for ePrescribing. This combined network will accelerate the benefit to health plan sponsors and patients. This merger was important as we prepare for the broader adoption of ePrescribing, which continues to gain momentum with the passage of the Medicare improvement act and is provisioned to drive greater electronic prescribing.

We believe we are uniquely positioned to utilize the technological innovations that will be generated by ePrescribing, ePrescribing will allow us to take our model of alignment to the next-level. ePrescribing coupled with our contemplated report with our clients will deliver value through higher mailed penetration, formula of compliance and adherence and generic penetration.

Finally in the last few weeks, we have disposed of a number of legal matters that have been pending for quite sometime on terms favorable to the company. Our business model remains strong and the financial impact was immaterial. Just yesterday, we received an important ruling that we are not in our core business functions and our rest of fiduciary. So we're pleased to be putting these legal distractions behind us, allowing us to focus our full attention on serving our clients and members.

It is clear our model alignment resonates with our plan sponsors as we continue to reduce their drug traps, of course our model of alignment is important for our stockholders as well. The increased profits generated by our client savings activities results in higher cash flow to our stockholders. We are aligned with our stockholders by continuing to focus on our industry-leading ROIC. Our focus has been and will continue to be on delivering superior total return to our stockholders by driving higher profitability, cash flow, and return on invested capital.

This concludes our prepared remarks and I'll be happy to answer any questions. Operator?

Question and answer

Operator

[Operator Instructions]. Our first question comes from the line of John Kreger with William Blair. Please go ahead.

John Kreger - William Blair

Great, thanks very much. George, could you give us an update on the SAAS segment and how you feel about the various aspects of specialty these days?

George Paz - Chairman of the Board, President and Chief Executive Officer

Sure. I think it's... as we've told you over the last several calls, it truly is a focus of ours. Specialty is an important component of our business and at the end of the day, as you know there are several components in our reported SAAS segment. The one that gets our biggest attention, I think the driver of our futures, is our specialty pharmacy. That business has done well. The acquisition of Priority has rounded out our portfolio.

And I believe we are as competitive as anyone in the industry, if not more, with respect to specialty products and meeting the needs and demands of our patients and clients. So we continue to emphasize and focus that area of our business. You know, as we've said in the past there are still two other businesses that are combined in that group.

One's a distribution business where we provide oncology and other products to doctor's offices. That business is pretty... it's got lower margins, higher use of capital. But it's a... as the business itself is doing much better, now that we've got our some receivable issues under control. Likewise, our PAP programs continue to be a bit of an issue for us from our growth perspective.

Those businesses are doing fine. I think our pharma company clients are happy with the work we're doing. We like the mission internally because we believe it's important for those individuals who cannot otherwise afford medications, to have access to drugs as an incredibly important mission.

So it's an important business for us. But as, with the passage of the Medicare Part D programs, that business is running off. And we continue to see more and more people as they turn 65 and avail themselves for the Medicare program that business is under continuous pressure. The margins in that business are okay. But of course, we are faced with the challenge of a declining revenue stream, which makes managing profitability much harder.

But again, I think the program on its face is a good program and we're going to continue to administer it and just try to monitor it. Overall, I would tell you we're happy with, with the results we are gaining. We still have a ways to go and we'll absolutely keep you informed on our progress as the quarters unfold.

John Kreger - William Blair

Great, thanks, and just one additional question, George. As you look across your membership base and the clients statistics that you see on a daily basis. Do you... in your opinion is there... are you seeing any impact from the challenging economy on overall utilization or shifting to mail or generics, any impact there?

George Paz - Chairman of the Board, President and Chief Executive Officer

Well, we see utilization down slightly for the year over what we have originally projected. But I'm not sure, you know, our team under Dr. Miller is studying this and we're trying to get our arms around, how much of it may be economy related versus seasonality with drugs and flu situation, that being as strong as in some other prior years, in other situations that are occurring.

We haven't seen with a lot of people moving into Medicare Part D, and the impact that that has on the overall prescribing. We're trying to put all those pieces together, but we feel for the year that utilization will be slightly below what we have normally seen, but we're constantly monitoring it.

John Kreger - William Blair

Thanks very much.

Operator

And our next question is from Charles Boorady with Citi. Please go ahead.

Charles Boorady - Citigroup

Thanks, good morning. I'm wondering if you could share with us what your customers are experiencing in their drug trend. And the reason I'm asking that is, maybe you can also help me understand that you're reporting record profits while health insurers are pointing to higher drug trends as an issue contributing to worse results for them, including on Medicare prescription drug plans where their loss ratios are significantly higher year-over-year.

And so, I'm wondering if you can comment on in light of your strong results versus their weak results. Is this because you're better at managing drug trend than health plans are with their own personal PBMs? Or are we seeing a reflection of you profiting more at the expense of your health plan and other customers? And to help understand that, if you can share with us what the drug trend is that your customers are seeing, what are they paying for? That would be helpful. Thanks.

George Paz - Chairman of the Board, President and Chief Executive Officer

Thank you. That's a great question. We've been focused on this business since our inception and certainly as a public company 93/92 and our focus is always been on managing drug trends. We are extremely proud that many of our clients have had zero to negative trends this year as they've gotten their arms around generic utilization, mail penetration. We've seen some of the best results in our specialty area, while we are putting in our disease management programs to really execute on our specialty formularies and formulary execution to drive down overall trends. So those trends have been cut in half.

We are seeing across the board, zero trend in our book of business for our clients, and I think that resonates well. Some clients obviously, will have a higher trend, those that still have two-tier formularies or those that are not as proactive. But many, many of our clients are availing themselves of our thoughts around consumerology and driving higher generic utilization step therapy programs and other avenues to control those trends, and it's paying dividends.

I would tell you we are not taking advantage of our clients. In fact with those trend levels, we do make more money obviously because our step therapy programs and our mail penetration programs are formulary adherence programs, are driving better health outcomes, while at the same time driving lower cost for our clients and higher profitability for us.

On your first point, I will tell you, you've been our proponent of and I believe it is a good answer that the big health plans should focus on the medical side, that's where 85% to 90% of the total costs are, and leave the drug trend management to the PBMs.

And I like the idea of what those clients of ours that are managed care organizations; we work extremely well together in helping them drive lower and lower trends for their clients. I think managing that overall drug cost, it is our specialty. We are well equipped to do it. We have people that are 100% focused on it. And I think we are the right people to do that. So, I appreciate the question.

Charles Boorady - Citigroup

Thanks.

Operator

And our next question then comes from the line of Brian Tanquilut with Jefferies & Company. Please go ahead.

Brian Tanquilut - Jefferies & Company

Hi, good morning. Congratulations, guys. Hey George, just wondering on this whole consumerism push, it looks very promising, but I just want to hear your thoughts on where you think you can eventually take that strategy. I mean what's the sort of the end point strategy there?

George Paz - Chairman of the Board, President and Chief Executive Officer

You know, that's a great question. I'll tell you, it amazes me, I remember when we hired Dr. Miller and he really started digging through our results, I was shocked to see the level of noncompliance by diabetics. The level of noncompliance with people, they filled one or two prescriptions with their very high potency cholesterol level drugs. I think it's more than just trying to drive earnings results; this is a whole process to drive better health outcomes. As a country, we need to help our patients stay adherent to their medications and get the right treatments.

It's interesting about one out of every four, roughly 23%, 25% of all prescriptions never even get filled. Sometimes that's not such a bad situation, but often it's a critically important situation, people go undenial. And the whole idea if we contract those and that's where ePrescribing actually kicks in, if we can actually see those prescriptions being written and then reach out to the member, help them cope with the denial aspect, nobody wants to be a diabetic or find out they've got heart disease or whatever.

And so people go in to complete denial and they don't seek out the prevention and then of course, it costs your whole systems millions and millions of dollars through emergency room visits and hospitalizations. And I really do believe Dr. Miller often makes a statement that drugs are the scalpel of the future, as we have been able to push down invasive surgeries and instead improved health outcomes through the use of drugs, which are a much cheaper alternative. I think the idea of consumerology again is to really help people drive to the best choice. Dollars are getting tighter and tighter, the economy is owing to that.

It doesn't mean people have to be noncompliant. I mean they should spend their dollars smartly and then help to take care of their overall healthcare costs by being compliant with those drugs that are in fact life-sustaining. So that is truly the focus of this program and I think it has tremendous legs to run on.

Brian Tanquilut - Jefferies & Company

So how is that going to be integrated in to your programs going forward, is this going to be something that your clients are just going to see as part of your offering, or is this going to be a separate offering?

George Paz - Chairman of the Board, President and Chief Executive Officer

It's part of our overall offering. At the end of the day through our model of alignment, as you know, we position ourselves, and I'm very open and vocal with our clients that we make more money on generics. So we make more money on home delivery than we do at high price third-tier branded products through the retail. So the idea, that's a money absorber and an inefficient use of consumer... of the consumer's dollars and the client's dollars.

So the idea is though what can we do to take our business model to all new level of driving people from third-tier to second-tier and more appropriate to generic, and then in the mail order. And it's especially important in specialty where the cost of treatment is so extremely high. So, you know, the idea here is to tail our messages, some people are turned off.

The whole idea of managed care speaking to an individual about cost often people just shut down and they don't hear another word about it and therefore we can't drive the adoption of generics. So we can't drive things because they think we're putting our own interests first. The average person on the street doesn't has some negative views of managed care. And so our approach is to try to resonate a message to them that makes sense.

So in certain situations, it's a clinical message. In other situations, for me personally, I'm going to come by education, I like money. So I'll focus on cash. So my messaging would be around cash. But everybody is driven by different, by different messaging, and this is well proven. You can look at the big consumer companies, Coca-Cola, Procter and Gamble, on and on, they know how to do this and they do it well. We think there is a tremendous opportunity use that messaging with respect to healthcare and drive better results.

So when you log into the web, if you have a certain profile, a certain personality type, your messaging maybe completely different than the person sitting next to you, has a different type and the idea is to tailor the messaging to meet your needs. And that was a constant study, there are no end results.

The idea is to measure what's happening and see how do we drive performance to the next level. Web utilization is a great tool because we can constantly monitor what's working, what's not working by segments and tweak our offering to meet the needs of that segment to drive results. Therefore we've taken the spire population, 50 plus million members and broken it down into a workable group where we can measure results and then better refine our outcomes.

Brian Tanquilut - Jefferies & Company

Got you, thank you.

George Paz - Chairman of the Board, President and Chief Executive Officer

Thank you.

Operator

Our next question, then, is from Robert Willoughby with Banc of America. Please go ahead.

Robert Willoughby - Banc of America

George, how material can that workers' compensation opportunity be, is this kind of another Canadian business here that we won't hear much from, or will it get some air time on the calls going forward?

George Paz - Chairman of the Board, President and Chief Executive Officer

First of all go to Canada and you'll hear little bit more about US by Canada, that's not such a bad little business for us. That's pretty good. It's a different model up there, as you know, because of the government setting the price on that. We don't need to go down that path.

But I do believe workers' comp is an extremely important business, because as you know, when someone gets injured, there's often quite a bit especially in pain medications and other medications that are very costly to the overall benefit of the injured worker.

This is an important aspect of ours that has been not really a focus of many. But it's certainly a focus of ours to be a leader in this space. We are a leader in this space. And I think it's a great business with great growth opportunities.

Robert Willoughby - Banc of America

Can you size the market, though, George, or give us something on profitability per claim or any of the unique attributes to it?

George Paz - Chairman of the Board, President and Chief Executive Officer

Well Bob, we really don't do that. We don't speak to client profitability or profit per claim by client, obviously, they are all different. But the market is pretty big. There's a lot of big players out there. So, you know, I don't know that I'm prepared at this time to actually size the market for you. But let's, let's take a look at that and see what we want to give you going forward.

Robert Willoughby - Banc of America

And could you, just another question, George, could you have sort of guess ultimately, I mean you've consistently beaten our profit expectations. We're ultimately gain a gross margin in this, in your business level out and is are we five years away, or how do we think about the ultimate potential of the Express Scripts model?

George Paz - Chairman of the Board, President and Chief Executive Officer

Let me tell say, there twos ways to answer that question. The first one is and this is... when I was interviewing Jeff for the job of CFO, he had the greatest response to that. I asked him that question. Obviously, I wanted a CFO to start with our company that was going to be focused on profitability and see the opportunities to grow our business to the next level. So I asked him that question interviewing him and his comment, you know, was probably the best I ever heard, which is, you're never really at risk on your profitability until you quit adding value.

So in other words if the value creation to the client and the consumer is greater than what you're extracting from the system, it's a model that should continue to work, and I think that's what you see in our results. The value that we derive by pushing somebody from a third-tier branded product to a generic is so great to the clients that the profits we make are an after thought. You know, the profit... the EBITDA per script is, it's so small relative to the savings. So if we can do a therapeutic interchange, switch somebody from a $300 drug to a $30 drug, it's dwarfed.

And so as long as we can go in and show what the trends are in the nation, and show that we're beating those trends, that working with Express Scripts is a better answer than just the evolution of product on generic and all the other tendencies in the marketplace, then we will continue to drive value and I think that that model stays intact. The second way I would answer that is, keep in mind that what's driving a lot of the cost here, especially more recently, is in the whole area of specialty drugs. Now you're talking about a whole new level.

There is hemophilia X out there unfortunately, they are spending $500,000 a year in treatment. So the ability to manage those costs are huge again and the savings that we can deliver to plan sponsors by proper diagnosis, proper treatment, proper levels of medication is so critically important that again, the amount of value we can extract from the system by driving down overall costs is paled by the savings we can deliver. So I don't… I think there is quite a bit of room to run.

Robert Willoughby - Banc of America

I guess in terms of maintaining that value proposition and continuing to push that higher, I guess you're focused on the consumerism aspect here in near-term and the specialty. But what will take the big capital… what's the big capital commitment that you need to make over the next five years? Is there one, I don't know if I've seen it?

George Paz - Chairman of the Board, President and Chief Executive Officer

Well, it's all relative, right? I mean it's… our CapEx budget is not that great. So when we talk about increasing expenditures, it's all within relations to those numbers. So what I would tell you is that, I think, Jeff talked about $1 billion to $1.1 billion in operating cash flow performance. Those numbers are very bullish and very strong and that will continue to be our focus. We will take some of those dollars though, and invest.

And the idea is building out the systems to meet segmentation needs that we have so that in fact when you go on to the website, we have the ability to segment our customers and for different people with different leanings to see different messaging. And that's, again we're talking millions, not billions here. So it's… to your point, there is going to be plenty of cash flow available for doing strategic opportunities in the marketplace, as well as share repurchases.

Robert Willoughby - Banc of America

That's great. Thanks, George.

Operator

Thank you. Then our next question comes from Tom Gallucci with Merrill Lynch. Please go ahead.

Thomas Gallucci - Merrill Lynch

Thank you, good morning. Two quick ones. One, I wasn't sure at first, maybe I missed it but, where do you stand with supply on Protonix? And if a greater supply of that had anything to do with either better numbers in the quarter or for the year?

George Paz - Chairman of the Board, President and Chief Executive Officer

You know, we don't like to get into drug-specific conversations and the reason is because keep in mind there is… that's an authorized generic but there is a plethora of generic and OTC options available. We have clients that don't cover any PPIs, but they help… they give the OTCs at a reduced rate in order to drive down costs.

So we don't have a one-sized fits all here. We are truly focused on delivering the lowest cost acceptable to our clients and using the means and the tools to deliver that. Protonix, I don't want to speak too specifically because I don't want to get into drug-specific discussions, but I will tell you that there is a whole plethora of opportunities out there that we avail ourselves of, and we will continue to focus on those.

Thomas Gallucci - Merrill Lynch

Okay, fair enough. Then other question was, in the 10-Q I noticed a line that I don't think I've seen before. Overall it is positive in terms of trends but you mentioned that the positive trends would offset, I guess you said the negative impact of some forces effecting pricing and plan structure. So just sort of curious, one, if you could expand on what you mean by that, particularly the plan structure piece, I guess? And two, what were the impetus for putting that into the 10-Q? And I don't think I've seen it before.

George Paz - Chairman of the Board, President and Chief Executive Officer

Jeff you want to take that?

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

So, obviously as background 10-Qs have lots of review and lots offers, I would say over the top of that comment even not really meaningful overall. What we're trying to say is, there is lots of movement in what people are asking for and how we're doing business today, but net of all that, we still are incrementally positive on profitability in our business going forward.

Thomas Gallucci - Merrill Lynch

So there is nothing in terms of the current environment? That's different that prompted sort of putting that here?

George Paz - Chairman of the Board, President and Chief Executive Officer

Nothing.

Thomas Gallucci - Merrill Lynch

Okay, thank you.

Operator

Thank you. Our next question is from the line of Glen Santangelo with Credit Suisse. Please go ahead.

Glen Santangelo - Credit Suisse

Yeah George, I just had a follow-up question on gross margins. I mean obviously, a very strong gross margin this quarter, probably driven a lot by generics. But are you seeing any change in the behavior of the manufacturers with respect to maybe the levels of price increases or their rebating practices that could be benefiting margins as well?

George Paz - Chairman of the Board, President and Chief Executive Officer

Absolutely, that the whole idea is behind consumerology and the focus. As we move more and more people from third-tier product to second tier product in and of itself that creates higher rebates for our clients, which drives their costs down. And so as we continue that focus, we hope to get higher levels of second-tier formulary compliance, which also then increases our buying power and our clout when we go on a annual and a semi-annual… on a bi-annual basis to go negotiate rebate contracts.

So that's incredibly important. And as you might guess, when there is less product out there, then you have a better chance because if they want to be on formulary, they've got to have a quality product and got to compete. So it really is a win-win situation when you have a quality product and you're willing to help our clients control their costs, so it's a big piece of it.

Glen Santangelo - Credit Suisse

And then on the price inflation side?

George Paz - Chairman of the Board, President and Chief Executive Officer

You know, I think that's running pretty much in... go ahead, Jeff.

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

Yeah, this is Jeff. It's same as it's always been.

Glen Santangelo - Credit Suisse

Okay. So no real change there.

George Paz - Chairman of the Board, President and Chief Executive Officer

No.

Glen Santangelo - Credit Suisse

Okay. Thanks a lot, George.

George Paz - Chairman of the Board, President and Chief Executive Officer

Absolutely.

Operator

Our next question then is from Larry Marsh with Lehman Brothers. Please go ahead.

Lawrence Marsh - Lehman Brothers

Thanks, and congrats really on the great quarter and the TRICARE renewal, really just a couple quick follow-ups. First on specialty business, George, it sounds like you're communicating that maybe we've turned the corner here after a couple of disappointing years. And I guess my question is should we continue to see pretty steady improvement off the 13.7 million you reported, even the course about 1.5% margin and, you're a great bottomline guy.

I mean where do you want this business to go in the next three to four years? I know there was some discussion about the opportunity at the analyst meeting last year. But from a margin standpoint, what would you be satisfied with if look out in the next three to five years in the specialty business?

George Paz - Chairman of the Board, President and Chief Executive Officer

I'm going to take a stab at this and let Jeff chime in as well. I think part of what you'll see is that, the winter months because of certain drugs are heavier utilized. They are specialty categories than the summer months and are just in particular in some other situations. So, there is some seasonality that has to be contended with that you won't see in the third quarter, but you'll see in the fourth and first quarter. Jeff, do you have anything to add there?

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

I think we've got a good team in place, in specialty, and they know what they are out there trying to achieve. We're happy with some of the progress they've made. It's not a business that's going to turn around immediately and jump to where we want it. But good positive progress in the quarter, I call it kind of one step along the way, there are a lot more steps on that staircase. It's going to take certainly several more quarters. How high can it go? I certainly wouldn't want to put any limits on what our team can do. I have incredibly high expectations of what they can do and when they get there, we'll raise expectations again.

George Paz - Chairman of the Board, President and Chief Executive Officer

You know, Larry, I think it's important to remember that... not important to remember, but when we talked about last year was that one of the things that's been a bit of a revelation to me when we got into this business through the CuraScript acquisition, was that we looked at the incredible pipeline of drugs and we were used to working on the oral/solids base, so we're pretty good at measuring drugs as they worked their way through the clinical trials, ultimately to market.

I would tell you that the learning we've had over the last three years is that we're not as good at predicting on the specialty side. Many of those drugs never make it to market and there's a whole host of reasons for that. But, we've done a lot better under Dr. Miller's team we've brought in some specialists in this area. We are monitoring the pipeline and we are making sure that we're first in line to make sure we get our share of allocation and assist the manufacturers in coming to market.

So this is a big focus of ours and I think this business is very much evolving. And we shouldn't lose sight of all the work we're doing also from a Biosimilars perspective, as we're looking to try to get some generics into the space. And I think at the end of the day, the introduction of both new product and of Biosimilars could put a whole new, opportunities in this space for us.

Lawrence Marsh - Lehman Brothers

Okay. And certainly the feedback we get is its specialty problems getting worse, not better for your customer, which obviously creates a need. And on the TRICARE specialty addition, how big of a deal is that, and how is that being serviced previously, have you sized that?

George Paz - Chairman of the Board, President and Chief Executive Officer

I remember it was going through retail in the past, so the cost of that, as you know, is very high. So what the government is going to work with us in trying to push some more of that into the home delivery aspects of the contract, as well as we're appropriately using the proper disease management tools to help people stay compliant and meet their needs. So we haven't sized specific components of this. But it's a huge opportunity for us as we look out in the future.

Lawrence Marsh - Lehman Brothers

Okay. Now on the Part D... maybe get you to reflect under what circumstances would you be willing to really accelerate your involvement in Part D? And can you remind us again, some of the issues you talked about and the challenges of being in that business, not to say I told you so. But can you talk about sort of the issues that you've highlighted before that have made you hesitant?

George Paz - Chairman of the Board, President and Chief Executive Officer

When I was answering Charles question earlier, I said that I thought that the other managed care players should let us do what we do best. I also believe that we shouldn't do what managed care players are out there to do and that's potentially to be an insurer. I'm not interested in that component of the business. I think that the... that's just not our specialty. So we do have a really large managed care presence, I'm sorry, a Part D presence and that's done by helping our clients. So we have many, many clients who are managed care players who are big in this space and we're the back office to them.

So we help them stay competitive and deliver the lowest cost and the lowest… and the best trends so that they can price their products appropriately. That's where I like our space. That's where I think we do our best work. It's what we are accustomed to.

And I think it's a great opportunity for us to add value to the entire system by driving down trends, so the managed care players can then in fact offer a competitive product. So that's where we like to be and it's been… to be honest with you, it's been a great space for us because of our ability to help our clients grow their businesses. So as our clients grow, we grow. And you're seeing the profits of that coming through our financials.

Lawrence Marsh - Lehman Brothers

Okay, and finally just a quick clarification. On the consumerology rollout, I know in the past you talked excitedly about the… I think its David Lipson and his study about consumer behavior. Is that going to be a big deal in sort of opening people's eyes? And when do you hope that study to be out?

George Paz - Chairman of the Board, President and Chief Executive Officer

We're doing a lot of work here and we're using our… part of the idea having the center for what we're bringing all of these specialists is that they are very interested in understanding how consumer behavior works with healthcare. And so part of the deal is that we're using their expertise in this space and through that we hope to ultimately, through Dr. Miller's group do some publishing with these people as we find results and we'll keep you posted on that as we go forward. We have time for one more question.

Operator

Very good. The next question then will come from Lisa Gill with J.P. Morgan. Please go ahead.

Michael Minchak - JPMorgan

Thanks. It's actually Mike Minchak for Lisa, just a couple questions. First, you talked about it a little earlier in response to a question regarding the impact of the economy. But can you talk about the mail business specifically in terms of what you're seeing as the organic volume growth there, if we were to exclude some of the contract shifts that we've had? And then secondly, the increase to the cash flow guidance was a little greater than we saw on the EPS line. And maybe just wondering if you could talk about anything specific you're doing to drive the improvement there?

George Paz - Chairman of the Board, President and Chief Executive Officer

I'll let Jeff talk about the last piece and let me just quickly address the first piece. The reason we are so bullish on mail, and we think it works so well is that when we are the mail provider, we have… we're in constant communication with our membership. So we are following their adherence, we're following their compliance and that gives us a great opportunity.

So… and it gives us the opportunity to drive the lowest net cost products for them. So mail is an incredibly important component. And, you know, when people do get squeezed, things do have to come-off the table and one of the things we want to try to work with our plan sponsors to make sure is that people on life-sustaining drugs don't let that drop, because the overall cost to our economy and to that health plan, or to that plan sponsor is going to be so much higher in the long run.

And so we work in partnership with those clients to make sure that we in fact can help them, those members stay compliance, stay on top of their regimen. So mail's an incredibly important for us and we continue to focus on that. Do you want to talk to the cash flow?

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

Yes. I'd say first on mail, net of ins-and-outs, we are seeing organic growth in mail sequentially and year-over-year. On cash flow, we're up… our guidance on EPS has gone up $0.23 since we first gave guidance. And our cash flow at the midpoint has gone up about 120 million. So certainly there is a little bit of catching up and the increase in guidance this quarter. But the other thing I'll say is, certainly the whole finance team and a lot of the operations team comes in everyday thinking about cash flow.

It's one of the things that we think is really important to total shareholder return and in a lot of things we do, we're just focused on getting the cash flow in. In a business like ours, cash flow can certainly be lumpy. And we spend a lot of effort trying to make sure the lumps fall in our favor.

Michael Minchak - JPMorgan

Great. Thanks for your comments.

George Paz - Chairman of the Board, President and Chief Executive Officer

Thank you. Again, we thank everyone for joining us this morning. I think we are very pleased with our results, our most recent settlement, and wins in some of these legal proceedings. And we look very much forward to look talking to you in the near future about our third quarter results and our 2009 guidance. So everybody have a great day. And thank you very much.

Operator

And ladies and gentlemen, that does conclude our conference call for this morning. Thank you for your participation. You may now disconnect.

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Source: Express Scripts, Inc. Q2 2008 Earnings Call
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