Medco Health Solutions (MHS) reported second quarter earnings per share (EPS) of 77 cents, up 20.3% from the year-ago quarter’s 64 cents. After adjusting for amortization of intangible assets (6 cents), the company’s EPS came in at 83 cents, surpassing both the Zacks Consensus Estimate of 79 cents and the year-ago quarter’s 69 cents. However, results for the quarter included approximately 3 cents associated with the settlement of a lawsuit.
 
Medco, the largest pharmacy benefit manager (PBM) recorded an increase of 9.9% in revenues, which came in at $16.4 billion, surpassing the Zacks Consensus Estimate of $16.2 billion. The increase in revenues was primarily driven by contributions from significant new client wins as well as price inflation on brand-name drugs, partially offset by a higher volume of lower-priced generic drugs.
 
Revenues from Medco’s specialty pharmacy segment, Accredo Health Group, increased 18.1% to $2.8 billion primarily due to a significant addition of new clients and organic growth.
 
During the reported quarter, the generic dispensing rate increased 3.3 percentage points to 70.6% compared with the second quarter of 2009. Net revenues of Medco were lower by approximately $870 million due to higher volumes of generics, which are cheap compared with branded drugs. Both the mail-order and retail generic dispensing rates increased 350 basis points to 61.2% and 330 basis points to 72.3%, respectively.
 
For the reported quarter, out of $16.1 billion of net product revenues, retail products accounted for $10 billion with mail-order products accounting for the rest. Both retail and mail order products recorded an increase of 9.6% and 9.9%, respectively, compared with the same period last year.
 
Total prescription volume (238.4 million) recorded a 6.0% growth compared with the second quarter of 2009 with mail-order volume increasing 6.2% to 27.5 million. Branded mail order prescription volume decreased 2.7% year over year to 10.7 million prescriptions,  while mail-order generic prescription volume increased 12.8% to 16.8 million.
 
Medco’s gross margin during the quarter declined 30 basis points to 6.5% driven by the effect of client renewal pricing, higher retail volume and a lower margin from Accredo, partially offset by contribution from new generics and the settlement award.
 
Medco exited the second quarter of 2010 with $1.2 billion in cash and cash equivalents, down from $2.5 billion at the end of December 2009. Debt level remained almost unchanged at $4 billion. During the quarter, the company repurchased 17.6 million shares for $1.03 billion.
 
Medco is witnessing an impressive selling season with high client retention rates. The company has recorded 2010 annualized new-named sales of $5.1 billion, up from $4.4 billion reported earlier and 99% client retention rate. Though at the initial stage, the 2011 selling season is quite satisfactory with a client retention rate of over 99%.
 
Outlook
 
Based on a strong quarter, Medco updated its outlook for 2010. The company narrowed its EPS range to $3.10 to $3.15 compared with the previous guidance of $3.05 to $3.15. This represents an annualized growth of 19% to 21%.
 
Additionally, after adjusting for amortization of intangibles, Medco raised the adjusted EPS guidance to $3.34 to $3.39 compared with the earlier guidance of $3.28 to $3.38, an increase of 18% to 20% compared with 2009.
 
Recommendation
 
An aging population coupled with the associated higher incidence of chronic diseases continues to drive demand and add to the escalating cost of new drug therapies. As a result, we expect the outlook for the PBM industry to remain positive.
 
We are currently Neutral on the stock.
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