Highlights From MHS's Q3 Conference Call: Improving FY09 Expectations and Strong 2010 Guidance

November 3, 2009 3:25 PM EST

Medco Health Solutions, Inc. (NYSE: MHS) reports Q3 EPS of $0.75, 3 cents better than the analyst estimate of $0.72. Revenue for the quarter was $14.80 billion, which compares to the estimate of $14.68 billion. Shares are up 2.3% today.

Highlights From MHS's Q3 Conference Call:

• Narrows FY09 EPS to $2.80 - $2.82.
  
• (CEO) We're announcing strong third quarter 2009 results, improved full year 2009 expectations and robust earnings guidance for 2010.
  
• Q3 GAAP diluted earnings per share reached a record $0.69, representing a 19% increase over third quarter 2008.
  
• Our diluted earnings per share, excluding the amortization of intangible assets from our 2003 spin-off, reached $0.75, also a 19% increase.
  
• Q3 revenues reached $14.8 billion, growth of 17.8% over Q3 2008. Our performance continues to be driven by the most comprehensive and scalable clinical capability in the pharmacy industry.
  
• Our 2010 sales year is actively underway with annualized new-named sales at $4.1 billion, up from the $2.8 billion we announced last quarter. Net-new sales for 2010 currently stand at over $4 billion with a record 99% client retention rate.
  
• We have generated over $20 billion in new-named sales since 2008 on a revenue base that is approaching $60 billion this year, clear proof of the unique and powerful value proposition we are building for the customers we serve.
  
• Looking at other key performance metrics, our total prescriptions adjusted for the difference in days supply between mail and retail increased from the same quarter last year by 14.1% to 220.2 million.
  
• Our mail order volume was in line with our expectations at 25.5 million prescriptions, a 2.3% decline from third quarter 2008.
  
• Specifically within the 2.3% overall mail volume decrease, brand mail volumes declined 7% while generic mail volumes increased by 1.4%. Our retail volumes continue to grow as a result of our 2009 business wins.
  
• Retail prescription volumes grew 25.4% to 144.3 million. The strong retail mix in our new business brought our adjusted mail penetration rate to 34.5% from 40.4% in the third quarter 2008 and brought our gross margin percentage to 7.0% from 7.4%.
  
• This quarter our generic dispensing rate increased 3.3 percentage points to a record 67.7% compared to 64.4% for third quarter 2008. The year-over-year improvement in our overall generic dispensing rate delivered incremental savings to our clients and members of approximately $560 million in the quarter.
  
• For Q3, EBITDA increased 16.7% to a record $719.3 million. EBITDA per adjusted script increased to a record $3.27 from the $3.19 in Q3 2008.
  
• Specialty Pharmacy segment, Accredo posted record sales results this quarter, with net revenues growing 19.2% to over $2.4 billion.
  
• Operating income grew 19.5% and reached a record $93.2 million for the quarter.
  
• Our Therapeutic Resource Center platform, which better manages patients with chronic and complex disease, is designed to reduce the $350 billion of waste in this country linked to noncompliance and omissions in care associated with chronic and complex disease.
  
• Today we are once again raising and narrowing our 2009 earnings guidance. Our revised 2009 GAAP diluted earnings per share guidance is now in the range of $2.58 to $2.60, representing year-over-year growth of 21 to 22%. Our previous 2009 GAAP diluted earnings per share guidance range was $2.54 to $2.59. Excluding the amortization of intangible assets from the spin-off, we now expect 2009 diluted earnings per share to be in the range of $2.80 to $2.82 for a 20 to 21% growth rate. You will recall that our previous guidance range was $2.76 to $2.81 per share.(Consensus is $2.80)
  
• Looking forward to 2010, we expect full year 2010 GAAP diluted earnings per share in the range of $3.05 to $3.15, representing growth of 17 to 22% over the 2009 revised guidance. Full year 2010 diluted earnings per share excluding intangible assets from the spin-off is projected in the range of $3.28 to $3.38, representing 16 to 21% growth over revised 2009 guidance.(Consensus is $3.28)
  
• (CFO) We closed Q3 of 2009 with $2 billion in cash on our balance sheet, consistent with the June balance. This is after paying down $400 million of our $600 million short-term securitization debt facility.
  This paydown saves more than $3 million annually in interest expense.
  
• Our cash flows from operations for year-to-date September 2009 amounted to $2.5 billion, a threefold increase over the same period last year. This already exceeds our full year 2008 cash flows, which totaled $1.64 billion. The increase reflects our continuing efforts to improve working capital.
  
• For full year 2009, we now expect cash flows from operations of approximately $3.2 billion, about two times our record 2008 performance.
  
• Our inventory levels have been managed further downward, from $1.5 billion as of June 2009 to $1.3 billion as of September 2009. This now represents a decrease of almost $750 million from June 2008, a reduction of over one third.
  
• Our total debt declined from $4.6 billion as of June to $4.2 billion as of September 2009, reflecting the paydown I mentioned earlier. Our September year-to-date capital expenditures of $154.3 million reflect investments across the business. We continue to expect capital expenditures of approximately $235 million for full year 2009.
  
• Turning to rebates, we earned a record of $1.35 billion for Q3, representing a 20.3% growth rate over third quarter 2008. This is the result of new client wins, continued improvements in formulary contracting and higher levels of formulary compliance, particularly at mail.
  
• Q3 2009 rebate retention rate was 14.1% compared to 18.2% for Q3 2008.
  
• We expect rebate retention to balance out for the year at approximately 13.5%. As always fluctuations reflect client mix and client preferences regarding the rebate sharing aspects of their overall pricing structure.
  
• Our gross margins include the beneficial effect of new generic introductions in 2009, which as previously guided contributed $0.04 per share in the third quarter and will contribute $0.13 per share on a full year 2009 basis. This includes a $0.045 per share contribution expected in the fourth quarter of 2009.
  
• Selling, general and administrative expenses of $369 million for the quarter increased $21.8 million or 6.3% over Q3 2008, while declining slightly from the $370.7 million we reported for Q2 2009.
  
• For the full year 2009, we continue to project EBITDA per adjusted script in line with the $3.09 we achieved in 2008. Note that this is an average for the full year and includes the first quarter 2009 EBITDA per adjusted script of $2.86 in addition to the fourth quarter startup expenses I mentioned previously.
  
• Total net interest expense of 39.9 million for the quarter decreased from $58.2 million in third quarter of 2008, a result of lower interest rates on our debt and increased cash balances. We now expect full year 2009 net interest expense of approximately 165 to $170 million.
  
• We continue to expect a lower effective tax rate in fourth quarter 2009, bringing our full year 2009 effective tax rate to the previously guided range of 39.0 to 39.5%. Record net income of $335.6 million for third quarter 2009 increased 13.5% over third quarter 2008.
  
• Medco's PDP revenues in the third quarter increased over 72% to $270 million. Generic expensing rate for our PDP grew to 71.5%, with adjusted mail order penetration of 24.5%.
  
• We currently expect to renew approximately $15 billion of business in 2010, including scheduled and early elective renewals, with approximately 75% of the renewal pricing in effect in Q1 of 2010, with the remainder primarily in Q3.
  
• The impact of new generic introductions on 2010 EPS is expected to be $0.25, with the estimated quarterly spread to be $0.03 in Q1, $0.06 in Q2, $0.08 in Q3 and $0.08 in Q4.
  
• SG&A expense for 2010 is expected to be approximately $1.5 billion, representing an estimated 3% growth rate over 2009.
  
• Net interest expense for 2010 is projected in the range of 170 to $180 million. The 2010 intangible amortization is expected to range from 280 to $290 million. The full year 2010 effective tax rate is expected to be in the range of 38.5% to 39.5%.
  
• Capital expenditures are expected to be approximately $215 million, reflecting lower expenditures related to the new automated pharmacy, partially offset by growth across the business and new compliance requirements, particularly associated with HIPAA and the stimulus package.
  
• (Q&A) In terms of the net-new business wins, another great year for Medco. Dave, can you give us some highlights sort of of what you saw in this selling season that surprised you? And in terms of some of the new programs that you've rolled out or some of the new strategies, what really kind of do you think was one of the - some of the top key drivers of another very successful year? (A)Ross, I would
  tell you that the selling season has not surprised me. We are seeing continued pricing stability in the marketplace and decisions are primarily being made around the value propositions that companies deliver on top of that fundamental pricing. So I would say the sales year would be characterized as another very strong and successful one largely because of our clinical innovation and the promise of really bending the curve - let's use a healthcare reform term - bending the curve in a positive direction when it comes to total healthcare costs. And the clients are now starting to see real results and I think the word of mouth is starting to get out there. So if you talk to our group presidents responsible for the various markets we serve, I think you'd hear unanimously that - and you will hear this at Analyst Day, that as we get better and better at what we're doing with the Therapeutic Resource Centers and with pharmacogenomics, clients are starting to actually see the results and it's very encouraging. So the renewals are very positive. You saw a 99% retention rate expected in 2010. That's because we have very satisfied customers. Obviously we're meeting their expectations on pricing and on service. But the clinical value proposition on top of this is really starting to take hold. (A)If I might interrupt for a second, just for the record, I think I may have misspoke when I referred to the 2009 adjusted mail-order penetration rate. I think I may have said 35.4% expected; it's actually 34.5% expected. My apologies.
  
• Rich, you've said for some time that given the impressive cash flow you certainly would like to deploy it but it's not sort of burning a hole in your pocket. But given the guidance for 2010 it seems like you need some new pants because it's quite an impressive number again. I think clearly the guidance sort of lays out the plan from a share repurchase perspective. But in terms of the other sort of potential uses and what you're seeing in the M&A market and what you're looking to do in terms of internal investments, what else should we be focused on for next year?(A)Well, you're exactly right, Ross, with regard to the share repurchases. So we do expect in this guidance to use the majority of the $3 billion authorization that expires at the end of next year. We are keenly focused on building the growth engine for 2015 and beyond. We are making significant internal investments in that regard. We are also looking constantly at acquisition opportunities. Many of them will be small, but they are sparks that will fuel that future growth.I can tell you that we are keenly focused on differentiating ourselves over the future. We're going to talk a lot about this on Analyst Day. But I am going to tell you one thing and, you're right, I am not going to let the cash burn a hole in my pocket. We are not going to go out there and make an investment just for the sake of investing our cash. There are a lot of investments out there that on day one may not be accretive to our very, very sizable return on invested capital, but we're not using that as an investment gauge. We realize that there will be acquisitions on day one that will in fact yield a lower ROIC than our impressive 25%. But we always have our eyes open. There could the bolt-on acquisitions out there that are consistent with our theme, which ultimately is generating shareholder value by driving additional value and savings for our clients.
  
• Just I guess first, Rich, can you talk a little bit about some of the key drivers in 2010? I think the $0.25 contribution from new generics sort of jumped out at me as fairly sizable. So maybe if you'd give a little bit more color there. And then how do you think about some of the other key drivers over and above generics within the company? (A) Well, I'll start by saying we still happen to be very focused on operational excellence, so to yield the kind of nominal SG&A growth that we are projecting for next year is a pretty darn good accomplishment when you consider in '08, '09 and '10 we've grown - we've added new business of over $20 million. But generics are clearly a strong driver for next year. Of course we do have a mail-order growth in the 107 to 109 million script range. And that is fueled by meaningful growth in generics. We see not only the benefit of the $0.25 from new generic introductions next year, but we also see continuation of increased generic substitution rates for the older generics; the simvastatins of the world continue to do very well, along with other what I'll call legacy generic products.
  Many I suspect will be surprised by the new generic contribution for next year because when you look at that slide that you see all the time that talks about new generic introductions in 2010 it's a slightly slower bar. However, as we've said all along, there are a couple of things to consider. One is the calendarization effect. Very importantly, you have to look at those drugs relative to their representation in Medco's book of business and their associated mail-order penetration.So let me give you a couple of statistics. The new generics in 2009 that yielded $0.13 contribution, in Medco's book they had an average mail penetration rate of just over 30%. When you look at the new generic introductions in 2010 you're actually seeing an approximately 50% mail-order penetration rate. So drugs like Flomax, Cozaar and Hyzaar, they're very strong mail-penetrated accounts in our book. So those are clearly the primary
  drivers to the growth next year, not to mention of course the profits yielded from our additional top line growth.

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