HealthExtras, Inc. Q2 2008 Earnings Call Transcript

HealthExtras, Inc. (HLEX)

Q2 2008 Earnings Call

August 6, 2008 10:00 am ET

Executives

David T. Blair - Chief Executive Officer and Director

Hai Tran - Chief Financial Officer

Michael P. Donovan - Executive Vice President - Corporate Development, Treasurer

Analysts

Brooks O’Neil - Dougherty & Company, LLC

Glen Santangelo - Credit Suisse

David Macdonald - SunTrust Robinson Humphrey

K. Newton Juhng - BB&T Capital Markets

Glenn Garmont - Broadpoint Capital

Mark Arnold - Piper Jaffray

Tony Perkins - First Analysis Corp.

Robert Willoughby - Banc of America Securities

Larry Marsh - Lehman Brothers

Michael Baker - Raymond James

David Toung - Argus Research Company

Michael Minchak - JPMorgan

Presentation

Operator

Welcome to the HealthExtras second quarter investor conference call. (Operator Instructions)

This conference call contains forward-looking information. Forward-looking statements are made pursuant to the Safe Harbor provisions of the Private Securities Litigation Act of 1995. Forward-looking statements may be significantly impacted by certain risks and uncertainties described in the company’s filings with the Securities and Exchange Commission.

With that said I would now like to introduce the Chief Executive Officer of HealthExtras, David Blair.

David T. Blair

Thank you for joining our second quarter conference call. Also with me is Hai Tran our new Chief Financial Officer and Mike Donovan who continues to assist us with corporate development opportunities.

Overall it was a solid quarter for us. There are a couple of items I’d like to briefly run through with you before turning the call over to Mike to discuss the recent acquisition and then Hai will review the financial results.

On the sales front we continue to make steady progress towards our objectives. The vast majority of our focus now is on sales opportunities with 1/1/09 effective dates. We continue to pursue health plans, large employer groups, state and local governments, as well as union business. The announcement of AvMed Health Plans last week represents a terrific example of the types of clients we are pursuing. Clearly AvMed with its concentration of business in Florida was looking for a PBM to provide local market solutions, greater financial transparency, and innovative approaches to controlling pharmacy costs. Opportunities like AvMed with 240,000 lives were only possible because of the demonstrated success that we’ve had with larger groups over the past several years.

We always get asked to comment on the sales pipeline which is of course a difficult answer to quantify. Perhaps the best way to describe it, and as I’ve mentioned before, based on our [inaudible] activity and client proposals we certainly expect to reach the same level of sales success as we have in years past. We’re pursuing expanded market opportunities whether they come from pursuing larger accounts, different types of accounts, as well as businesses in new parts of the country.

Another area that I’d like to comment on is client retention. Typically we realize annual client retention rates in excess of 98% and we would expect this year to be no exception. In fact at this point of the year we already have over 97% of our existing business contracted for 2009 and that number should continue to increase as we secure additional client renewals.

Next let me briefly comment on our M&A activity. Clearly we were pleased to announce the acquisition of HospiScript during the second quarter. This transaction closed in May and by all accounts is exceeding our expectations. There are over 4,000 hospices across the country which can benefit from our pharmacy benefit management services whether it be access to a network of pharmacies, our clinical expertise, or data reporting and analytics. We expect to see growth in the hospice business and anticipate that HospiScript will pursue additional complementary lines of business as well.

Of course the most recent news and long-awaited news is the acquisition of IPS a first-class mail service pharmacy based outside of Cleveland, Ohio. I’ll comment on IPS from a strategic perspective and then let Mike provide you with some of the details. The acquisition of a mail service pharmacy is the natural evolution to our business model. It should be viewed as a continuation of our commitment to be the leader in pricing transparency and innovative programs to drive patients to the most care-effective cost-effective drugs. Clearly we’ll be in a better position to expand our generic advantage plan and route members to the lowest cost generic drugs. Through our mail facility health plans will have access to acquisition based pricing and we intend to push the same level of transparency at mail as we have done with retail claims and rebates.

Clearly we’ve anticipated acquiring a mail service for some time so in that respect we are well prepared. Our clients and vendors have been kept well informed of our intentions. We believe that our clients can benefit from a level of transparency and service that they will not be able to find elsewhere.

During the balance of the year we will be staffing up and making investments to expand the capacity of our mail facility and at the same time we will be engaging our clients in discussing specific plans to migrate their mail business. My expectation is that we will begin to transition mail business during the first quarter of 2009 and then it will ramp up over a 12 to 18 month period.

In summary, we absolutely believe that the acquisition of a mail pharmacy represents the right strategic move and presents both a margin expansion opportunity on existing business as well as a way to further differentiate our services and capture additional market share.

With that I’ll turn the call over to Mike to discuss IPS in a little bit more detail.

Michael P. Donovan

For those of you who follow the company this acquisition marks a meaningful execution milestone in our strategic plan. After several years of methodically working through our options of mail, the acquisition of IPS incorporates all the factors which we felt were critical to success in this line of business. Specifically IPS represents a profitable well-managed business where incremental investments in technology systems, personnel and scale should meaningfully improve results. IPS has a command of the issues related to mail that are comparatively new to us including member billing systems and AR management, direct drug sources, an automated Internet member outreach and refill systems. Because of these new areas of operational emphasis our integration exposure will be slightly greater than in a traditional PBM acquisition and we will be focused on a seamless integration for both clients and members.

IPS comes with an outstanding in-place workforce - executives, pharmacists and other professionals - who will mesh well with our corporate culture. The operation also has a modest specialty distribution platform and will be a foundation for us to accelerate our focus on specialty cost control initiatives including increased focus on disease management. We see great potential for this part of the business as well.

And just to reset the basic analytical framework we process about $1.6 million mail transactions annually. IPS currently handles approximately 600,000 scripts annually and could be upgraded in the same location to absorb all of our volume and more. As David mentioned earlier this acquisition positions us for several avenues of growth and profitability. Long term we think mail order is a 7%+ operation margin business and we can grow mail volume significantly even if we only approach broader industry benchmarks. I would add that this also provides an opportunity to streamline our existing limited mail order operations which are so modest in size that we don’t even separately disclose inventory in our public filings.

For the management team the challenge has been to identify and acquire a platform business with the right combination of scale, expertise, operating leverage, and technology and with this transaction we believe we’ve accomplished that objective.

We’ll now move on to a review of the financials for the quarter. As you know, Hai Tran has taken over the CFO position and for both me and David he has done an exceptional job in grasping the internal and external dynamics of our business and has already got a firm grasp of the key financial and operating drivers of our company. So with that I’ll introduce Hai Tran.

Hai Tran

First of all I would like to say that I’m pleased to have joined a differentiated company in a dynamic industry and I look forward to developing an active dialogue with the investor community in the coming months. I’d also like to especially thank Mike for his help and his patience during the transition and look forward to working with him on various strategic initiatives on a going forward basis.

With that said, let’s review the highlights of our financial performance in the second quarter. We are pleased with the performance in Q2 as revenue grew by 46% on a year-over-year basis from $421 million to $614.3 million and is in line with our expectation of $2.5 billion of revenue for the year.

Our script count for Q2 was 12.4 million compared to 9.6 million in the second quarter of last year. The number of scripts was slightly weaker than expected and we continue to monitor the trends. We now expect total scripts for the year to be in the 52 million to 53 million range with enhanced gross margins offsetting the lower-than-expected script count. As we look at the per script metrics, revenue per script was $49.38 compared to $43.96 last year and $45.84 last quarter. The principal contributor to the revenue per script growth is inflation on brand drugs.

Gross profit for the second quarter increased by $7.6 million to $34.1 million from $26.5 million in the prior year. Our gross profit margin percentage was 5.6% in Q2, a 30 basis point sequential improvement over the first quarter 2008 primarily due to our ability to generate share savings from generic utilization, realize contract performance incentives, leverage direct labor expenses, and modest contributions from HospiScript for part of the quarter. In Q2 2007 the gross profit margin percentage was 6.3% but bear in mind that the supplemental benefits margin contribution in the second quarter of last year was $3.6 million. Gross profit for script for Q2 was $2.74 compared to $2.77 last year and sequential improvement over the $2.43 from the first quarter of 2008. Year-over-year generic utilization increased from 58.3% to 62.3% and was flat on a sequential basis. Unadjusted mail order claims were approximately $397,000 for the second quarter a 24% increase over $320,000 unadjusted mail order claims from the second quarter of last year.

SG&A in the second quarter increased by $1.3 million to $15.9 million from $14.6 million in the second quarter of last year. Nearly all of this change or $1.2 million is attributable to consolidating HospiScript. This leverage in SG&A contributed to the growth of operating income to $18.3 million or 3% of revenue from $11.9 million or 2.8% of revenue last year. On a per script basis operating income per script increased by $0.22 over the prior year and $0.16 on a sequential basis.

From a cash flow perspective capital expenditures for the quarter were $2.5 million. During the quarter non-cash charges totaled $3.6 million including $1.5 million in non-cash compensation expense and $2.1 million in depreciation and amortization and other non-cash adjustments. We ended the quarter with $48.9 million of cash on the balance sheet and $5 million in operating cash flow. The cash balance was impacted by the HospiScript acquisition and the swing in operating cash flow from the first quarter due to a timing issue with regard to the payables for pharmacy. As such we will see the swing back in the third quarter.

As David mentioned earlier we are pleased to be able to announce the acquisition of IPS and we believe that this will position us strategically with regards to offering a truly unique, fully transparent alternative to the market. We are taking a long-term view with regards to this opportunity and we will look to invest $3 million to $5 million in the mail operation this year in terms of people, processes and systems particularly with regard to pharmacists, pharmacy technicians and call center staff as well as certain work flow automation and infrastructure enhancement initiatives. This investment will provide us with the ability to leverage IPS with increased volume in 2009 and beyond. The timing and amount of the expenditures will be largely dependent on the ongoing discussions with clients. As mentioned in the press release we expect the acquisition to be modestly dilutive in 2008 and accretive in 2009. We are looking to absorb the expected increased expenditures through various margin improvement initiatives and the leveraging of SG&A but we do believe that targeting the lower end of our EPS guidance range is more appropriate at this time.

David, with that I’ll turn the call back to you.

David T. Blair

We will open up the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Brooks O’Neil - Dougherty & Company LLC.

Brooks O’Neil - Dougherty & Company LLC

Hai, would it be appropriate to say that the dilution in the second half from the IPS acquisition might be in the range of a penny or two? Is that what you’re trying to communicate to us?

Hai Tran

Yes, I think that what we’re trying to communicate is that the lower end of the range is probably appropriate for us to target at this point in time. We’re working hard as I mentioned to absorb the expenditures given the leverage we’ve been able to demonstrate in managing our SG&A to date as well as the margin improvement. So I think that as part of the prepared remarks when I talked about targeting the lower half of our range, that’s where we think it’s probably going to come out.

Brooks O’Neil - Dougherty & Company LLC

Would it be accurate to estimate that the annualized revenues from IPS are somewhere in the range of $90 million to $100 million today?

Hai Tran

Yes.

Brooks O’Neil - Dougherty & Company LLC

You said that the HospiScript acquisition closed towards the end of May. Could you just help us frame the revenue and maybe gross profit contribution from HospiScript in the quarter? I understand that it’s a net revenue reporting company but I’m just trying to get a feel for whether there was much either revenue or gross profit contribution from that business this quarter?

Hai Tran

On the revenue side there was very minimal contribution. As you recall and as we’ve mentioned on previous public statements, HospiScript was already a customer of ours and to that extent from a claims count perspective and from a revenue perspective, we had already accounted for much of the numbers already. On the gross profit side, there was some impact but it was a modest impact from HospiScript in Q2 as they were only part of our company for a little over a month.

Brooks O’Neil - Dougherty & Company LLC

Could you guys just talk a little bit about the competitive environment you’re seeing out there? Are there any changes that you know from anybody in terms of either what people are promoting in terms of the competitive RFPs, pricing environment, features the customers are looking for in particular, etc.?

David T. Blair

From a marketing perspective our message hasn’t changed and we continue to seek out clients that are looking for a PBM that’s going to make a local commitment to physician and member education programs, clients that are looking for increased transparency and collaboration, so that hasn’t changed from our perspective. If you look at the broader industry and what’s going on in the competitive landscape, certainly you see the Caremark at CVS and what they’re trying to do with the integrated mail and retail model. But candidly that hasn’t affected our business to target the unique clients that are interested in our services.

Brooks O’Neil - Dougherty & Company LLC

Is anybody else out there doing anything radically different right now or is it pretty much the same old, same old for most people.

David T. Blair

It’s always been a competitive industry and it continues to be competitive but there are no substantial changes that I would note.

Operator

Our next question comes from Glen Santangelo - Credit Suisse.

Glen Santangelo - Credit Suisse

I just wanted to follow up on some of the comments you made on the mail order business. Mike, I think if I heard you correctly you sort of commented that you think mail order is about a 7% operating margin business. Were you sort of implying that that’s what you think HealthExtras can make in the mail order business or were you implying that that’s what you think others are making in the mail order business today?

Michael P. Donovan

It’s a little bit of both and I appreciate the question very much. I think that there is a scale opportunity in mail where I think if you look back the last couple years when we talked about why we were pursuing the strategy we were is that you need a certain level of scale to operate profitably and then you can start to capture some purchasing economics and productivity economics as you scale up. So I think we hit that target we talked about which was a business that was at a inflection point in profitability but that 7% business Glen is a longer term target. That’s not a short-term within the context of our existing volume. I think we can get there with some incremental volume. I would speculate that our large cap public competitors probably do maybe 100 basis points better than that; maybe 200 basis points better than that.

Glen Santangelo - Credit Suisse

So when I think about the way you guys are going to approach the business, it’s very different than your large-scale competitors that are pricing their business spreads off of [AWP]. It sounds like you’re trying to pursue a more transparent model. Would you expect to price and approach the mail order business very differently than the way your competitors are doing it?

Michael P. Donovan

As I mentioned earlier Glen we absolutely believe that we can bring a level of financial transparency to mail as we’ve done with retail and rebates. And that would include acquisition based pricing at mail and that will all be designed to drive the patients to the most care-effective cost-effective medications.

Glen Santangelo - Credit Suisse

Let me ask one more follow up on this. You said that there was some modest specialty capabilities. Could you elaborate on that a little bit more and is that potentially another avenue of acquisitions for you guys to build out a specialty business so the model becomes more fully integrated? Is that what your clients are looking for?

Michael P. Donovan

I think you’ve anticipated my answer completely with your question. It’s a place to start; it’s a foundation; and I think we could build on it organically and I also think that we would look for a complementary acquisition to drive some more volume and expertise and breadth of service offerings in that area. So I think it gives us a choice as to which of those two avenues we pursue. We’ve looked at a variety of specialty targets over the years and don’t be surprised if we don’t go with another acquisition of a modest size to kick start that part of the portfolio. But they do it today and they do it pretty well.

Operator

Our next question comes from David Macdonald - SunTrust Robinson Humphrey.

David Macdonald - SunTrust Robinson Humphrey

Mike, if you were to take the sounds like about $1.8 million between the two combined companies and move them all over onto the IPS platform, can you give us a sense of how much more capacity there is? Does that put their facility at 25% fill, 50% fill, just some type of ballpark number?

Michael P. Donovan

The facility there has the physical capacity with the addition of a shift or a second line that will handle significantly more than our combined volume today, but that would take some not insignificant capital investment certainly compared to what we’ve done historically here. I think one of the attractive attributes of this business was the deep bench of skilled people so I think the in-place workforce is incredibly valuable and we would believe that we could dramatically increase mail volume within the footprint of the facility that it’s in today.

David Macdonald - SunTrust Robinson Humphrey

I know you guys touched on a couple of areas of potential investment, but Mike when you look at the mail business that you guys just picked up what are maybe the one or two key areas where you can invest and significantly increase either the profitability or the return on investment of that business?

Michael P. Donovan

A couple of areas. One of them is purchasing economics and the ability to lever up. I just want to go back and reset the math. I think I mentioned they do about $600,000 scripts today and we do about $1.6 million so there’s a meaningful uptick in purchasing scale there so I think you’re going to see some margin expansion through the cost of goods sold line. There are also areas of productivity related to the technology on the floor there that we believe can be expanded over time; in fact some initiatives that they have underway today. I’d say those are really the two key drivers: Cost of goods sold and leverage of human capital or human resource influence.

David Macdonald - SunTrust Robinson Humphrey

Can you guys talk a little bit about the new business for 2009 that you have either won or think you’re in a good spot? Is that book of business a little more mail heavy than historically or is there an opportunity there?

Michael P. Donovan

It is. If you look at the types of business that we’re pursuing today, generally speaking the mail utilization is higher than what is our adjusted 9.5% penetration rate on mail.

David Macdonald - SunTrust Robinson Humphrey

And Hai, a couple of housekeeping questions. Can you give us the D&A number and can you just run me through the cash flow number again? I missed that the first time by.

Hai Tran

The D&A number net of some additional non-cash adjustments was $2.1 million. And from the cash flow perspective, if you look at our operating cash flow for the quarter, it was $5 million. But as I mentioned in my prepared remarks that that was impacted by a timing issue relative to some pharmacy payments.

David Macdonald - SunTrust Robinson Humphrey

Can you give us a sense of the magnitude of that working capital drag?

Hai Tran

Yes. If you adjust with the timing cash flow from operations, it was relatively consistent with Q1.

Operator

Our next question comes from K. Newton Juhng - BB&T Capital Markets.

K. Newton Juhng - BB&T Capital Markets

I did have a quick question around the Walgreens relationship. Can you just remind us when that contract is set to expire and is there a minimum amount of volume that needs to be serviced through that contract? And also on a follow up, do you think that at the point when the contract ends there will be a redefinition of the relationship?

David T. Blair

Let me comment on it from a broad perspective. We’ve always had a terrific relationship with Walgreens and I would expect that we will continue to have a relationship with them in one form or another for years going forward. I don’t know that we’ve disclosed the contractual terms that we have with Walgreens as it relates to the renewal of their mail business or their retail business but I don’t believe that would negatively impact what we’re trying to do as we pursue these strategic initiatives.

K. Newton Juhng - BB&T Capital Markets

And in terms of the contract expiration, can you provide us with that?

Michael P. Donovan

As David said, we’re not going to comment on the specifics of those arrangements. Most of these relationships in the PBM business whether they’re with manufacturers or retailers or mail order providers are relationships with fairly short out provisions if people aren’t satisfied with the relationship.

David T. Blair

Maybe just a point of clarification because maybe there’s some confusion. The relationships that we have with our clients are direct and we have contracts with these health plans and employer groups to be their PBM and that provides a broad range of services including both retail and mail. So in that respect we will look to route those members to the lowest-cost providers regardless of whether it’s our own mail facility or a different mail facility or a different retail provider.

K. Newton Juhng - BB&T Capital Markets

Thanks for that clarification. Why don’t we switch gears here. With regard to IPS, you talked a little bit about disease management capabilities. I was wondering if you could give us a little bit more on that front? Are there particular disease states that they like to work in? How exactly should we look at the capabilities that are kind of baked within that company right now?

David T. Blair

I think if you look at for instance rheumatoid arthritis would be an example of the areas that they’re involved in today. They really are not running a disease management platform so much as it is a capable fulfillment platform. And we have done some client specific initiatives with a couple of our larger health plan clients that we’ve been looking to make sort of a broader branding effort on our part for more of our clients, so I think it’s the fulfillment capacity now is one leg in the stool of how you start to offer a comprehensive disease management program. So that would be an example of an area where they’ve been involved.

K. Newton Juhng - BB&T Capital Markets

From the HealthExtras perspective, you’re going to be looking to expand upon that I guess as time goes on?

David T. Blair

Yes.

Operator

Our next question comes from Glenn Garmont - Broadpoint Capital.

Glenn Garmont - Broadpoint Capital

I’m still trying to understand the dynamic here between yourselves and Walgreens and some of the other mail vendors that you might use and the fact that you’ve acquired a mail facility. Does a contract need to expire before you can bring business in-house which is currently being outsourced to Walgreens or someone else or can you do that sort of intra-contract? And my second question changing subjects, any update on either Puerto Rico or California Healthcare Coalition that might be worth mentioning?

David T. Blair

Let me start with the mail question and the clarification of the mail order providers. One, we won’t comment on specific contracts that we have whether it’s a retail provider or a drug manufacturer or a mail provider. But as I mentioned earlier, the relationships that we have with our clients are direct and in that direct relationship we are responsible for providing them with access to retail, mail, specialty, etc. So no contract needs to expire for us to proceed with the strategic initiative that we’ve outlined, namely migrating business to our captive facility.

As it relates to the California Healthcare Coalition, I mentioned on the last call we now have an office in California. We are meeting with the various 44 different groups. We’re going one at a time. It’s taking longer than we expected. My guess is we’ll bring on one or two groups in the beginning of 2009 and we’ll be in a better position to share with you direct sales results during our third quarter conference call.

Operator

Our next question comes from Mark Arnold - Piper Jaffray.

Mark Arnold - Piper Jaffray

Most of my questions were answered but could we talk a little bit about the script count weakness and just what’s driving that on a sequential basis here? Any thoughts that you guys could provide.

Hai Tran

I think some of it is seasonality. If you look at last year’s script count for example, you saw a little bit of a dip in Q2 versus Q1. And the balance is some weakness kind of across the table. It was anything isolated to one account or one region per se. So we’re closely monitoring it and as we said we do believe however that a realistic target of script count is 52 million to 53 million.

Mark Arnold - Piper Jaffray

On the gross margin side, should we expect a little bit better margins in the second half both because of the HospiScript being in there for the full quarter and the mix of new business you’re bringing on here July 1?

Hai Tran

I think with regards to gross margin, what I’d say is we made a nice bump sequentially in terms of 30-day slowing improvement. I think we’ve done a pretty good job managing our max, leveraging our incentives that we have to be able to expand margins. However for the balance of the year I would guide you to be looking at the 5.6% as a target for the rest of the year.

Mark Arnold - Piper Jaffray

Somebody brought this up earlier, but that’s where HospiScript would have its impact is on the gross margin line, correct?

Hai Tran

Yes.

Mark Arnold - Piper Jaffray

So even with only a month it probably had some impact on that margin improvement there in Q2?

Hai Tran

That’s correct. It had modest impact in Q2.

Operator

Our next question comes from Tony Perkins - First Analysis Corp.

Tony Perkins - First Analysis Corp.

I think I heard this correctly but your strategy for the new mail facility is to phase in clients as opposed to bringing them on instantly as soon as that bandwidth has been opened up, is that fair to say?

David T. Blair

That’s right Tony. It makes sense to bring them on in a planned fashion over a period of time. It helps with the investment and as we ramp up that operational platform to bring it on in that manner.

Tony Perkins - First Analysis Corp.

On the script volume, I think Hai addressed it, are you seeing an impact due to the economy or should we view the script volume numbers in Q2 simply as a function of the fluctuations within the book of business?

Hai Tran

I think it’s a function of fluctuations at this point in time. If it was isolated to a specific region that was especially hit hard by the economy, I’d answer differently but that’s not what we’re seeing currently. And as I mentioned we’ll continue to monitor it.

Tony Perkins - First Analysis Corp.

On the operating margin that were up year-over-year, which snapped a trend. What would you contribute that to?

Hai Tran

I think it was a combination as I mentioned in my prepared remarks around two things. One is our ability to demonstrate some improvement at the gross level margin combined with our ability to demonstrate some leverage on the SG&A side. So the bulk of the year-over-year growth on the SG&A side was attributed to the consolidation of HospiScript.

Operator

Our next question comes from Robert Willoughby - Banc of America Securities.

Robert Willoughby - Banc of America Securities

David or Mike, I unclear. You mentioned that the Walgreens relationship would continue for years. They’re a mail fulfillment partner for you. Is there something more extensive that they are doing for you that does continue as the mail is pulled away?

David T. Blair

They’re also a key component of our retail network and our specialty offering.

Robert Willoughby - Banc of America Securities

Can you speak to the opportunity on the generic profit margin here? With that mail order capability in-house do we double that profit expectation for you or how do we think about that?

David T. Blair

I would refer back to Mike’s comment. We believe that that’s a 7% operating percentage business.

Robert Willoughby - Banc of America Securities

On the generic drug itself through the mail channel?

Michael P. Donovan

That’s an overall number Bob and I think the key is as mail has historically been a trailing performer in terms of generic utilization with a heavy dose of branded maintenance medications in the mix, but even that’s changing now. And we’re getting, and I’m looking at Hai now, we’re getting near that sort of 50/50 mail generic/brand utilization and I think if you look at the way that’s trailed over time, obviously one of the underlying trends in mail is more generic utilization over the next couple years is pretty much inevitable.

Robert Willoughby - Banc of America Securities

But there’s nothing in your contracts that preclude you from sharing in the profit margin that you will get the kind of margin that some of the bigger PBMs do get based on their contracts or do you lose that margin going forward in your mail business?

David T. Blair

There’s nothing to preclude us from capturing incremental margins on both generics and brand at mail. As I mentioned earlier, we view this as one, a margin expansion opportunity on our existing business but then also it’s going to differentiate us in the market place as we continue to be the leader in pricing transparency and innovative approaches to control drug costs.

Robert Willoughby - Banc of America Securities

Can you point to in the acquisition pipeline itself now with a dedicated mail capability presumably in place or in place here shortly, would the base of acquisitions pick up to help you leverage that initial investment or continue at sort of the same pace of one a year maybe that we’ve seen in the PBM sector for you?

David T. Blair

It’ll continue at a similar pace. It’s somewhat coincidental that we were able to get two done in the last several months, but the types of opportunities that we’re going to pursue are going to be whether they’re in mail to your point augment the existing business that we’ve purchased, specialties management, other wellness type programs. And we’re also continuing to look at other regional PBMs that we could fold into Catalyst Rx.

Robert Willoughby - Banc of America Securities

Did the deals like the HospiScript have maybe a different capability altogether? We’d see less of that. These would be more focused transactions, leveraging, existing PBM operations and/or mail and specialty capabilities?

David T. Blair

We’re going to be opportunistic. I think you’ll see both.

Operator

Our next question comes from Larry Marsh - Lehman Brothers.

Larry Marsh - Lehman Brothers

I just want to clarify a little bit on the 08 guidance how you’re basically calling it $3 million to $5 million of 08 costs associated with IPS which is roughly a nickel or so. Are there any incremental start-up costs associated with AvMed that are also included in your comments here today or was that already fully factored in? I guess it couldn’t have been fully factored into your prior guidance. Was there any additional cost there?

Hai Tran

The $3 million to $5 million was isolated purely for IPS but in terms of our guidance it’s already baked in in terms of any associated costs with AvMed. So what we’re saying is that $3 million to $5 million as you mentioned is a nickel but we’re offsetting that with some of the other stuff we’re doing to create leverage.

Larry Marsh - Lehman Brothers

So the offset if you will is not necessarily coming from HospiScript this year but it’s coming from other programs and you mentioned specifically utilization being below your expectations but higher gross profits. What does that mean? Is that just mix?

Hai Tran

It’s not only mix but it’s our ability to execute on managing our max aggressively; it’s our ability to execute relative to performance incentives and our ability to generate economics from the sharing and [inaudible] utilization increases.

Larry Marsh - Lehman Brothers

So you’re feeling like you’re doing a little bit better job of that year to date than you would have anticipated earlier this year?

Hai Tran

Yes.

Larry Marsh - Lehman Brothers

So just to be clear. The AvMed center of excellence that you’re staffing in Florida, that’s included in all of this and sort of ballpark is that hundreds of thousands of dollars or millions?

Hai Tran

The answer is yes. We don’t really break it out separately.

Larry Marsh - Lehman Brothers

On the IPS, that’s great to see it. I know Mike and Dave, etc. kicked a lot of tires of facilities, companies, so I’m curious. What were the things in this process that you learned? What was it that really stood out with this discount drug facility and what were some of the things if you can elaborate that may have soured you on other types of facilities that gives us confidence that your ability to integrate this will be hopefully somewhat seamless?

Michael P. Donovan

Larry I think for people who are familiar with mail order facilities the back-end operation, the fulfillment if you will, is something that people focus on. But in some respects that back-end, not to diminish the unique nature of some of what our competitors do, but that’s something that you can buy sort of off the shelf from McKesson or a variety of sources. So the fulfillment end of it is when you take a prospect or you take investors on a tour, that’s what they want to look at. But the real nuts and bolts operation of a mail order facility involves interaction with the member, interaction with the physician, all those types of - it’s essentially a retail operation. So the in-place work force front end to back end is a critical asset in this business and having enough momentum and enough depth of management expertise that we could be confident that we could bring on volume over the next 12 to 18 months as David described in a facility with people who know how to run that business.

And also equally important was in that continuum of volume where you are from a cost of goods sold standpoint. Where are you going to be able to deal with the wholesaler community and also where are you on that continuum of direct purchasing from manufacturers both on the brand side and the generic side. So those were the types of factors when we benchmarked this opportunity against what we’d seen previously and what our other options were, we felt like this business in terms of its current state today, people, technology, cost of goods sold was in a good position to lever it up over that 12 to 18 month period. So it was a combination of all of the above Larry: Good systems, good people, a place that can be scaled, so namely the footprint’s there to move pretty dramatically up over that period of time. Sort of all of the above in no particular order but when I mentioned all the attributes we looked for this was a really good balance of them.

Larry Marsh - Lehman Brothers

Thanks for the elaboration. And just maybe a little bit of further elaboration on when you pushed the idea for a Discount Drug Mart to in effect sell their mail capacity and then what sort of assurance do you have that they’re going to continue to help support that flow and won’t lose the 600,000 that they currently have in that facility?

David T. Blair

The Discount Drug Mart is a roughly 70-store chain operating primarily in Ohio. We know the management team there very well; we know the equity holders in the business very well. They are a key part of our network for the State of Ohio employees as an example. We’ve gone through the diligence process; we are very familiar with who all the underlying customers are on those 600,000 claims; and most of those relationships are in very good repair. Client retention and customer retention is a function of economics and service and they provide an exemplary level of service out of that facility so we feel very good about the corporate relationship that we have and have had historically with Discount Drug Mart. Naturally how we got to know these folks is that they were a network provider and I think for them the question was one of scale again, which is were they going to be able to grow their business to capture these incremental profits or was this an attractive win-win transaction where for us the upside going forward was pretty significant and for them they got some good value for the business they feel.

Larry Marsh - Lehman Brothers

And finally, maybe just a little bit of the back story on AvMed. This is I guess I would define your second big health plan customer that had been serviced by one of the Big Two and you sort of talk about David the innovative programs and transparency and such, but what was sort of the feedback you got from them that caused them to look to move the business to you and maybe what might have been their frustrations with their current vendor?

David T. Blair

This is something we increasingly see more of which is health plans looking for somewhat of a hybrid between turning over the keys to a PBM and outsourcing everything or in-sourcing everything. So when we sat down with AvMed as we have with other health plans, it was very much a collaboration. So things like formulary, network, clinical programs, those types of things we can allow the health plan to have significant influence over but then yet we can support them from whether it’s data analytics, reporting, our clinical programs, our pharmacists, those types of thing. So it’s a mixed model between the outsourcing and doing everything in-house and it seems to be catching on. I’d say the large health plan clients that we have all have adopted something similar to that.

Larry Marsh - Lehman Brothers

Is it fair to say that your reference site with Wellmark and I guess the success they’ve had was an important part of getting this new customer comfortable with how that model works?

David T. Blair

Yes, absolutely. And I’m pretty confident they’ve reached out to Well Mark directly but I imagine they contacted a number of our health plan clients before making the decision.

Larry Marsh - Lehman Brothers

Was your ability to perhaps have mail capacity in the future important in that decision-making or were they just focused on your ability to drive value regardless of whether you owned or rented capacity?

David T. Blair

As it relates to mail, we’ve been promoting the generic advantage plan which is essentially transparency at mail for over a year now. So that’s an important component. And the way we’ve described it previously to clients is that we think that we can do that with an outsource partner which we’ve been able to do but that we’d be better positioned if we were doing it ourselves because clearly there’s no restrictions as it relates to audit; there’s absolute disclosure; those types of things. So as I mentioned earlier our clients whether they were prospective clients or current clients have been kept well apprised of what we’ve wanted to do from a mail perspective. So we’re looking forward to engaging in dialogues with them now more specifically about how we can help them manage their costs and presumably get members to lower cost drugs.

Operator

Our next question comes from Michael Baker - Raymond James.

Michael Baker - Raymond James

My first question is on HospiScript. It’s my understanding they have a mail offering as well. I was wondering if that was contracted out or if you had an owned facility supporting that?

David T. Blair

We have a small mail facility in Montgomery, Alabama that supports the HospiScript business and certainly this is an opportunity to leverage those two facilities.

Michael Baker - Raymond James

So at this point your main focus is going to be on Ohio but over time you might rebalance things geographically?

David T. Blair

Yes.

Michael Baker - Raymond James

Just a question on VistaCare and where that might stand only from the perspective of does this recent acquisition actually position you more broadly to win the Odyssey business? I don’t know if exactly that’s a pipeline opportunity at this point but any color on that would be helpful.

David T. Blair

Unfortunately Michael I’m not going to be able to give you much color. We don’t comment on specific clients. Generally we’ll talk about overall client retention and satisfaction rates and we’ve demonstrated year over year that we have the highest retention in the industry. And the same can be true of HospiScript. So whether it’s VistaCare or any of our clients you can rest assured that we aggressively trying to retain those clients. And I think any initiatives we have whether they be in the male or disease management or specialty, will only serve to help retain clients.

Michael Baker - Raymond James

And just so I understand what’s baked into the $0.12 to $0.15 accretion that you outlined earlier, Vistacare would be baked in there but an expansion with Odyssey would not?

David T. Blair

Yes, correct.

Operator

Our next question comes from David Toung - Argus Research Company.

David Toung - Argus Research Company

I know you’ve taken a few questions on your margin but I just want to get a little bit more color on your year-over-year and sequential change in margin. Taking outside the HospiScript contribution, I think a while ago you talked about the contributions from new business in 2008 and any other mix changes in that picture?

Hai Tran

I think that what the new business does for us is continue to enable us to grow our gross margin from a dollar’s perspective at a very good clip but in terms of the margin percentage it’s consistent with what we’ve already said in our remarks earlier and that yes, HospiScript contributed modestly to Q2 because they were only with us for over a month and the rest of it was some blocking and tackling activities on our part.

David Toung - Argus Research Company

There was an earlier question about Puerto Rico. I’m not sure if you responded to that.

David T. Blair

And what was the question about Puerto Rico?

David Toung - Argus Research Company

I think a few quarters ago there was some concern about whether the situation in Puerto Rico was not doing as well; there were some issues there; and I don’t remember the exact content of the issues because it was a few quarters ago but I think the question was asked and I’m not sure if you responded.

David T. Blair

I think if you look at Puerto Rico, our claims count there has stabilized. I don’t think we’re seeing any further erosion at this point in time. A lot of that performance relative to our expectations was due to some impact from plan design so at this point we view it as relatively stabilized.

David Toung - Argus Research Company

Not all scripts are profitable or as profitable. When you look at new business or when you renew business are there considerations of how much profitable this business will be going forward even given your transparency model?

David T. Blair

Absolutely. We’re looking at both existing business on the client renewals as well as prospective business and we certainly understand what the profits are relative to our current margins.

David Toung - Argus Research Company

In the past it seemed that the priority was growing revenue and growing the top line. Maybe you can look at that with the coming on of the mail facility.

David T. Blair

Absolutely. We’re looking at both. We’re always looking at opportunities to demonstrate strong sequential growth on the dollars perspective on both the top line and the bottom line as well as demonstrating leverage in the model as well. And fundamentally some of the margin metrics are somewhat impacted with regards to the mix between our pass-through business versus our traditional business. So that adds an additional level of complexity and variability into our business model.

Operator

Our next question comes from Michael Minchak - JPMorgan.

Michael Minchak - JPMorgan

On IPS, following the acquisition will your strategies around plan design for your customers change and will you be working with them to incentive their members to drive greater use of the mail channels than what you’d been previously been doing?

David T. Blair

The plan design setups may change modestly to continue to try to route patients to again the most care-effective cost-effective drugs. So they’ll be on a client by client basis. But generally speaking I think our plan designs are pretty well set up today.

Michael Minchak - JPMorgan

And with respect to the SG&A expense, you called out the $1.2 million increase associated with consolidating the HospiScript results. Was any of that one time in nature as it related to the integration? And secondly, now that you have HospiScript and IPS I was wondering if you could provide some color on your expectations around SG&A in the next two quarters?

Hai Tran

With regard to HospiScript specifically the bulk of that impact is recurring in nature; it’s just the consolidating of their SG&A to our SG&A and therefore the increase. With regards to the back half of the year in SG&A we do expect some uptick in SG&A as we mentioned relative to the investments that we’re making for IPS which we’re working hard to offset.

Operator

Our next question comes from Brooks O’Neil - Dougherty & Company, LLC.

Brooks O’Neil - Dougherty & Company, LLC

I know we’ve beat all this into the ground but I was just curious on the IPS if their IT systems will integrate easily with the [Essex] CI claim system you use in the core business or what needs to happen to integrate the IT systems?

David T. Blair

Brooks it’s very straight forward because they’ll be set up as essentially a pharmacy in our network.

Brooks O’Neil - Dougherty & Company, LLC

I was curious if they currently operate a call center that interfaces with clients and physicians as you mentioned you were thinking in terms of scaling the DM type capability or will you need to build that out in the future?

Michael P. Donovan

As I mentioned it is a platform from which we see the potential to grow that line of business. And again as David mentioned, the real key here is the collaborative model with our health plan clients who are looking at the current and anticipated escalation in specialty spending as a real challenge in the sort of three to five year time horizon and trying to get in front of that with as David said these collaborative programs that maybe utilize some of our expertise, our now fulfillment expertise but also provide a lot of the solutions that are going to have to be locally based for a client like [Acnick] for instance looking for an opportunity to do something that differentiates the way they manage specialty spending in their market place. We intend to provide the fulfillment end of that for them but probably have the DM functionality at least partially reside in Gainesville for instance.

Brooks O’Neil - Dougherty & Company, LLC

I know you have often said that your business historically was operationally quite simple. Do you see any hurdles in managing a business like this that may have some level of incremental complexity?

Michael P. Donovan

In that respect we’re fortunate to be acquiring the management team in Cleveland. They’re terrific and we feel like they’ve got that business well under control so we’re confident from an operation perspective we’re in good hands.

Brooks O’Neil - Dougherty & Company, LLC

It looks like a great acquisition.

Operator

We have no further questions at this time.

David T. Blair

I just want to thank the investors for their participation today and we look forward to speaking with you at our next quarterly conference call.

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