The second anniversary of Medco's spin-off from Merck will give the pharmacy benefit management company additional flexibility to pursue strategic moves in anticipation of the Medicare prescription drug benefit.

Under the rules governing the tax-free spin-off of Medco to Merck shareholders, the company is limited in the types of transactions it can pursue for two years, Medco CEO David Snow noted during an Oct. 28 conference call. That period expires Aug. 20, 2005.

Like the other major PBMs, Medco is routinely asked about its intentions for using the cash generated by operations.

Medco is not telegraphing any major moves, but Snow pointed out that the company's options will expand once the spin-off-related constraints are lifted.

Snow reported that the PBM's board of directors is looking at the possibility of establishing a dividend or stock buyback program with the goal of having a proposal ready to take effect Aug. 20.

The company also continues to look at opportunities in the specialty pharmacy area, Snow said. Medco expanded its specialty offerings earlier this year under an agreement with Accredo, but the company continues to look for ways to further build that business line (¹ Also see "Medco Adds 15-20 Specialty Pharmacy Products Under Accredo Deal" - Pink Sheet, 16 February, 2004., p. 34).

Snow said Medco would also consider "other opportunities" for acquisitions that would enhance revenues, adding that the company is "not philosophically opposed" to a large deal.

"We do have some constraints around the debt covenants, which we can work with" if the right opportunity appears, Snow said.

The end of the two-year waiting period is one of several upcoming milestones for Medco ahead of the Jan. 1, 2006 start-up date for the Medicare program.

Medco continues to counsel investors to wait until after the elections for greater clarity on the likely impact of the drug benefit on its business.

The company expects that the outcome of the elections will help determine whether it has the opportunity to serve as a direct contractor with HHS on the benefit, or if it will have to reconsider its reluctance to provide a stand-alone, at-risk drug insurance product (² Also see "Medco Plans For Part D Will Be Formed After Election Day" - Pink Sheet, 20 September, 2004., p. 16).

Medco's immediate focus in the Medicare program is on managing the drug costs of approximately 775,000 beneficiaries that have enrolled in one of the company's discount card offerings.

Medco appears to be the leader in enrollees in its Medicare card offerings. The company estimates that the drug spend it manages under the program will be approximately $300 mil. in 2005.

However, Snow acknowledged that Medco does not expect the enrollment to grow significantly from its current levels. Heading into the fourth quarter, "enrollment is still coming, but it is slowing down."

Snow's analysis of the enrollment rates suggests that Medco does not have big expectations for the Centers for Medicare & Medicaid Services' auto-enrollment of low-income seniors into the card program for 2005. Medco may see a "small increase" in membership from that initiative.

CMS announced the auto-enrollment plan in September, but it appears that the agency significantly over-estimated the number of beneficiaries that it will be able to reach with that approach.

One strategic issue for Medco to consider in 2005 will be whether its card plan base is sufficiently large enough to allow it to transition into the full benefit.

Another potentially significant milestone for Medco would be the resolution of the pending False Claims Act case filed against the company by the U.S. Attorney in Philadelphia (³ Also see "Medco Prosecution Will Continue Under False Claims Act, Kickback Laws" - Pink Sheet, 27 September, 2004., p. 10).

The current timeline for the case would put Medco in the awkward position of going to trial just as the Part D benefit begins.

However, Snow stressed Medco's desire to resolve its legal issues as quickly as possible. Medco expects to complete the fact-witness discovery process in the case by Nov. 29, to be followed by expert witness discovery. The company then intends to file a motion to dismiss in early 2005.

"If the case is not resolved through the motions or settlement, then anything that survives would go to trial in late 2005/early 2006 depending on the final court schedule," Medco General Counsel David Machlowitz said.

Although the Philadelphia case is continuing, Medco sees its progress on legal issues thus far as a potentially significant transformation.

In reviewing the overall legal climate for the PBM sector, Machlowitz noted the recent high profile cases against Medco's biggest competitors, Caremark and Express Scripts. "We are enjoying our new-found status as the PBM with the lowest public litigation profile," Machlowitz said.

Medco's business model is also undergoing a quiet but important transformation: the company's profit stream is less and less dependent on manufacturer rebates.

Medco is now passing on about 60% of brand name rebates to clients, CFO JoAnn Reed said.

Medco disclosed for the first time the percentage of brand rebates that the company retains as profits. For the third quarter, Medco said it retained 40.5% of rebates. That figure is significantly reduced from the same period a year ago, when Medco retained 53.8% of rebates.

"We see the percentage being retained continuing to go down as more and more of our clients ask us to share in rebates," Reed said.

Medco said it is disclosing the rebate pass-through figures as part of its commitment to "transparency."

Under a settlement with state and federal prosecutors, Medco is required to provide clients with relatively straightforward calculations of revenues received from manufacturers. The intent is to make it easier for clients to understand Medco's rebate stream if they want to tap into it (⁴ Also see "PBM “Transparency” Defined In Medco Settlement" - Pink Sheet, 3 May, 2004., p. 26).

Reed maintained, however, that the change does not have an impact on Medco's overall profitability. When a client enters into a contract requiring pass-through of rebates, "in return for that we will charge them a management administrative fee."

"The clients can have all the rebates they would like, but we are going to ask for the same kind of return if we were to share in those rebates with them."

For the near term, Medco's mail order margins appear secure, thanks to steadily increasing generic dispensing rates. The decline in retained rebates during the third quarter was "more than offset" by the beneficial gross margin impact of increased use of generics, Reed said.

Medco Hopes For Greater Strategic Freedom, Lower Litigation Risk By 2006

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