UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number: 1-31312

MEDCO HEALTH SOLUTIONS, INC.

(Exact name of registrant as specified in its charter)

Delaware		22-3461740
(State or other jurisdiction of incorporation)		(I.R.S. Employer Identification No.)
100 Parsons Pond Drive, Franklin Lakes, NJ		07417-2603
(Address of principal executive offices)		(Zip Code)

Registrant’s telephone number, including area code: 201-269-3400

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes þ No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer þ		Accelerated filer o		Non-Accelerated filer o		Smaller reporting company o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

As of the close of business on October 24, 2011, the registrant had 387,059,463 shares of common stock, $0.01 par value, issued and outstanding.

 

 

MEDCO HEALTH SOLUTIONS, INC.

QUARTERLY REPORT ON FORM 10-Q

INDEX

PART I — FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets (Unaudited) — September 24, 2011 and December 25, 2010			1
Condensed Consolidated Statements of Income (Unaudited) — Fiscal Quarters and Nine Months Ended September 24, 2011 and September 25, 2010			2
Condensed Consolidated Statement of Stockholders’ Equity (Unaudited) — Fiscal Nine Months Ended September 24, 2011			3
Condensed Consolidated Statements of Cash Flows (Unaudited) — Fiscal Nine Months Ended September 24, 2011 and September 25, 2010			4
Notes to Condensed Consolidated Financial Statements (Unaudited)			5
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			16
Item 3. Quantitative and Qualitative Disclosures About Market Risk			40
Item 4. Controls and Procedures			40
PART II — OTHER INFORMATION
Item 1. Legal Proceedings			41
Item 1A. Risk Factors			41
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			42
Item 3. Defaults Upon Senior Securities			42
Item 4. (Removed and Reserved)			42
Item 5. Other Information			43
Item 6. Exhibits			45
SIGNATURES			47
Exhibit 10.1
Exhibit 31.1
Exhibit 31.2
Exhibit 32.1
Exhibit 32.2
EX-101 INSTANCE DOCUMENT
EX-101 SCHEMA DOCUMENT
EX-101 CALCULATION LINKBASE DOCUMENT
EX-101 LABELS LINKBASE DOCUMENT
EX-101 PRESENTATION LINKBASE DOCUMENT
EX-101 DEFINITION LINKBASE DOCUMENT

PART I — FINANCIAL INFORMATION

Item 1.		Financial Statements

MEDCO HEALTH SOLUTIONS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)

		September 24,				December 25,
		2011				2010
ASSETS
Current assets:
Cash and cash equivalents		$	161.5			$	853.4
Short-term investments			5.3				56.7
Manufacturer accounts receivable, net			1,859.8				1,895.1
Client accounts receivable, net			2,410.7				2,553.1
Inventories, net			788.1				1,013.2
Prepaid expenses and other current assets			69.7				75.8
Deferred tax assets			266.9				238.4
Total current assets			5,562.0				6,685.7
Property and equipment, net			1,027.1				993.6
Goodwill			6,957.7				6,939.5
Intangible assets, net			2,214.4				2,409.8
Other noncurrent assets			102.4				68.7
Total assets		$	15,863.6			$	17,097.3
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Claims and other accounts payable		$	2,960.5			$	3,495.4
Client rebates and guarantees payable			2,201.8				2,453.2
Accrued expenses and other current liabilities			940.0				910.2
Short-term debt			36.4				23.6
Current portion of long-term debt			2,000.0				—
Total current liabilities			8,138.7				6,882.4
Long-term debt, net			3,002.2				5,003.6
Deferred tax liabilities			972.2				985.1
Other noncurrent liabilities			200.1				239.4
Total liabilities			12,313.2				13,110.5
Commitments and contingencies (See Note 10)
Stockholders’ equity:
Preferred stock, par value $0.01— authorized: 10,000,000 shares; issued and outstanding: 0			—				—
Common stock, par value $0.01— authorized: 2,000,000,000 shares; issued: 672,492,493 shares at September 24, 2011 and 666,836,033 shares at December 25, 2010			6.7				6.7
Accumulated other comprehensive loss			(31.6	)			(53.5	)
Additional paid-in capital			8,760.0				8,463.0
Retained earnings			7,668.2				6,636.9
			16,403.3				15,053.1
Treasury stock, at cost: 285,620,728 shares at September 24, 2011 and 256,298,405 shares at December 25, 2010			(12,852.9	)			(11,066.3	)
Total stockholders’ equity			3,550.4				3,986.8
Total liabilities and stockholders’ equity		$	15,863.6			$	17,097.3

The accompanying notes are an integral part of these condensed consolidated financial statements.

MEDCO HEALTH SOLUTIONS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)

		Quarters Ended								Nine Months Ended
		September 24,				September 25,				September 24,				September 25,
		2011				2010				2011				2010
Product net revenues (Includes retail co-payments of $2,140 and $2,216 in the third quarters of 2011 and 2010, and $6,908 and $6,966 in the nine months of 2011 and 2010)		$	16,602.8			$	16,062.0			$	49,988.7			$	48,309.0
Service revenues			378.7				257.8				1,086.4				729.2
Total net revenues			16,981.5				16,319.8				51,075.1				49,038.2
Cost of operations:
Cost of product net revenues (Includes retail co-payments of $2,140 and $2,216 in the third quarters of 2011 and 2010, and $6,908 and $6,966 in the nine months of 2011 and 2010)			15,692.1				15,127.2				47,367.1				45,665.3
Cost of service revenues			122.3				73.1				365.3				198.9
Total cost of revenues			15,814.4				15,200.3				47,732.4				45,864.2
Selling, general and administrative expenses			455.6				395.0				1,263.0				1,121.9
Amortization of intangibles			73.2				71.2				219.6				212.5
Interest expense			52.2				43.4				156.4				123.0
Interest (income) and other (income) expense, net			(2.6	)			(2.6	)			1.7				(10.3	)
Total costs and expenses			16,392.8				15,707.3				49,373.1				47,311.3
Income before provision for income taxes			588.7				612.5				1,702.0				1,726.9
Provision for income taxes			233.3				241.0				670.7				678.0
Net income		$	355.4			$	371.5			$	1,031.3			$	1,048.9
Basic weighted average shares outstanding			388.0				429.9				397.0				450.2
Basic earnings per share		$	0.92			$	0.86			$	2.60			$	2.33
Diluted weighted average shares outstanding			394.9				437.1				404.7				459.3
Diluted earnings per share		$	0.90			$	0.85			$	2.55			$	2.28

The accompanying notes are an integral part of these condensed consolidated financial statements.

MEDCO HEALTH SOLUTIONS, INC.

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
(UNAUDITED)

		Shares of				Shares								Accumulated
		Common				of				$0.01 Par Value				Other
		Stock				Treasury				Common				Comprehensive				Additional
		Issued				Stock				Stock				Income (Loss)				Paid-in Capital				Retained Earnings				Treasury Stock				Total
Balances at December 25, 2010			666,836				256,298			$	6.7			$	(53.5	)		$	8,463.0			$	6,636.9			$	(11,066.3	)		$	3,986.8
Comprehensive income:
Net income			—				—				—				—				—				1,031.3				—				1,031.3
Other comprehensive income (loss):
Foreign currency translation gain and other			—				—				—				3.6				—				—				—				3.6
Amortization of unrealized loss on cash flow hedge, net of tax of $(1.0)			—				—				—				1.7				—				—				—				1.7
Defined benefit plans, net of tax:
Net activity due to curtailments, net of tax of $(11.6)			—				—				—				17.3				—				—				—				17.3
Amortization of prior service credit included in net periodic benefit cost, net of tax of $0.7			—				—				—				(1.1	)			—				—				—				(1.1	)
Net gains included in net periodic benefit cost, net of tax of $(0.2)			—				—				—				0.4				—				—				—				0.4
Other comprehensive income			—				—				—				21.9				—				—				—				21.9
Total comprehensive income			—				—				—				21.9				—				1,031.3				—				1,053.2
Stock option activity, including tax benefit			4,483				—				—				—				241.4				—				—				241.4
Issuance of common stock under employee stock purchase plan			339				—				—				—				18.9				—				—				18.9
Restricted stock unit activity, including tax benefit			834				—				—				—				36.7				—				—				36.7
Treasury stock acquired			—				29,323				—				—				—				—				(1,786.6	)			(1,786.6	)
Balances at September 24, 2011			672,492				285,621			$	6.7			$	(31.6	)		$	8,760.0			$	7,668.2			$	(12,852.9	)		$	3,550.4

The accompanying notes are an integral part of this condensed consolidated financial statement.

MEDCO HEALTH SOLUTIONS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

		Nine Months Ended
		September 24,				September 25,
		2011				2010
Cash flows from operating activities:
Net income		$	1,031.3			$	1,048.9
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation			154.9				135.6
Amortization of intangibles			219.6				212.5
Deferred income taxes			(97.6	)			(87.5	)
Stock-based compensation on employee stock plans			127.2				115.4
Tax benefit on employee stock plans			79.5				68.7
Excess tax benefits from stock-based compensation arrangements			(39.1	)			(36.1	)
Other			85.8				84.2
Net changes in assets and liabilities (net of acquisition effects):
Manufacturer accounts receivable, net			37.7				(99.1	)
Client accounts receivable, net			43.2				(31.0	)
Income taxes receivable			1.0				194.0
Inventories, net			225.4				286.3
Prepaid expenses and other current assets			5.0				(3.8	)
Other noncurrent assets			(32.8	)			(4.0	)
Claims and other accounts payable			(533.7	)			(678.1	)
Client rebates and guarantees payable			(251.4	)			214.5
Accrued expenses and other current and noncurrent liabilities			30.1				(55.2	)
Net cash provided by operating activities			1,086.1				1,365.3
Cash flows from investing activities:
Capital expenditures			(190.3	)			(164.1	)
Purchases of securities and other assets			(20.3	)			(32.3	)
Acquisitions of businesses, net of cash acquired			(15.1	)			(701.1	)
Proceeds from sale of securities and other investments			51.4				18.5
Net cash used by investing activities			(174.3	)			(879.0	)
Cash flows from financing activities:
Proceeds from long-term debt			10,327.2				3,498.7
Repayments on long-term debt			(10,327.2	)			(2,525.0	)
Proceeds from accounts receivable financing facility and other			1,150.8				303.0
Repayments under accounts receivable financing facility			(1,138.0	)			(300.0	)
Debt issuance costs			(0.3	)			(7.8	)
Purchases of treasury stock			(1,786.6	)			(3,161.4	)
Excess tax benefits from stock-based compensation arrangements			39.1				36.1
Net proceeds from employee stock plans			131.3				34.3
Net cash used by financing activities			(1,603.7	)			(2,122.1	)
Net decrease in cash and cash equivalents			(691.9	)			(1,635.8	)
Cash and cash equivalents at beginning of period			853.4				2,528.2
Cash and cash equivalents at end of period		$	161.5			$	892.4

The accompanying notes are an integral part of these condensed consolidated financial statements.

MEDCO HEALTH SOLUTIONS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

1. BASIS OF PRESENTATION

The accompanying unaudited interim condensed consolidated financial statements of Medco Health Solutions, Inc. and its subsidiaries (“Medco” or the “Company”) have been prepared pursuant to the Securities and Exchange Commission’s rules and regulations for reporting on Form 10-Q. Accordingly, certain information and disclosures required by accounting principles generally accepted in the United States for complete consolidated financial statements are not included herein. In the opinion of the Company’s management, all adjustments necessary for a fair statement of the unaudited interim condensed consolidated financial statements have been included, and are of a normal and recurring nature. The results of operations for any interim period are not necessarily indicative of the results of operations for the full year. The unaudited interim condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 25, 2010. The Company’s third fiscal quarters for 2011 and 2010 each consisted of 13 weeks and ended on September 24, 2011 and September 25, 2010, respectively.

On July 20, 2011, the Company entered into a definitive Merger Agreement with Express Scripts, Inc. (“Express Scripts”) and certain of its subsidiaries providing for the combination of Express Scripts and Medco under a new holding company, New Express Scripts. As a result of the transactions contemplated by the Merger Agreement, former Medco shareholders and Express Scripts shareholders will own stock in New Express Scripts. Subject to the terms and conditions set forth in the Merger Agreement, upon the closing of the transaction, each share of Medco common stock will be converted into the right to receive $28.80 in cash and 0.81 shares of New Express Scripts. Upon closing of the transaction, Express Scripts’ shareholders are expected to own approximately 60% of New Express Scripts and Medco’s shareholders are expected to own approximately 40%. The transaction is expected to close in the first half of 2012. The merger is subject to regulatory clearance and Express Scripts’ and Medco’s shareholder approvals and other customary closing conditions. Currently, Express Scripts and Medco are independent companies, and they will continue to be managed and operated as such until the completion of the pending merger.

The accompanying unaudited interim condensed consolidated financial statements include pre-tax merger-related expenses of $36.6 million for the third quarter and nine months of 2011 associated with the pending Express Scripts merger, with $35.6 million in selling, general and administrative (“SG&A”) expenses and $1.0 million in total cost of revenues.

The accompanying unaudited interim condensed consolidated financial statements include the operating results of United BioSource Corporation (“UBC”) commencing on the September 16, 2010 acquisition date.

Reclassifications. Certain prior period amounts have been reclassified to conform to the current period presentation. Specifically, on the unaudited interim condensed consolidated balance sheets, income taxes receivable has been combined with prepaid expenses and other current assets.

2. RECENTLY ADOPTED AND RECENTLY ISSUED FINANCIAL ACCOUNTING STANDARDS

Recently Adopted Financial Accounting Standard

Testing Goodwill for Impairment

In September 2011, the Financial Accounting Standards Board (“FASB”) issued an accounting standard intended to reduce the cost and complexity of the annual goodwill impairment test by providing entities an option to perform a qualitative assessment to determine whether further impairment testing is necessary. Under the amendments in this standard, an entity is not required to calculate the fair value of a reporting unit unless the entity determines that it is more likely than not that its fair value is less than its carrying amount. The amendments are effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. Early adoption is permitted, including for annual and interim goodwill impairment tests performed as of a date before September 15, 2011, if an entity’s financial statements for the most recent annual or interim period have not yet been issued. The Company’s early adoption of this standard in 2011 had no impact on its unaudited interim condensed consolidated financial statements included in this Quarterly Report on Form 10-Q.

The most recent assessment for impairment of goodwill for each of the designated reporting units was performed as of September 24, 2011. The goodwill was determined not to be impaired and there have been no significant subsequent changes in events or circumstances. The Company utilized the income approach methodology, which projects future cash flows discounted to present value based on certain assumptions about future operating performance. Discount rates were based on the estimated weighted average cost of capital at the reporting unit level and ranged from 8% to 13%. In order to validate the reasonableness of the estimated fair values, the Company performed a reconciliation of the aggregate fair values of all reporting units to market capitalization as of the valuation date using a reasonable control premium. If the Company determines that the fair value is less than the book value based on updates to the assumptions, the Company could be required to record a non-cash impairment charge to the consolidated statement of income, which could have a material adverse effect on the Company’s earnings. The Company periodically reviews the composition of its reporting units. Reporting units are revised due to changes in reporting structures and the manner in which the Company operates its business activities.

Recently Issued Accounting Pronouncement

Presentation of Comprehensive Income

In June 2011, the FASB issued an accounting standard with respect to the presentation of other comprehensive income in financial statements. The main provisions of the standard provide that an entity that reports other comprehensive income has the option to present comprehensive income in either a single statement or in a two-statement approach. A single statement must present the components of net income and total net income, the components of other comprehensive income and total other comprehensive income, and a total for comprehensive income. In the two-statement approach, an entity must present the components of net income and total net income in the first statement, followed by a financial statement that presents the components of other comprehensive income, a total for other comprehensive income, and a total for comprehensive income. The Company will be required to adopt this standard retrospectively for interim and annual reporting periods beginning after December 15, 2011. The Company does not expect the adoption of this standard in fiscal year 2012 to have a material impact on its consolidated financial statements.

3. FAIR VALUE DISCLOSURES

Fair Value Measurements

Fair Value Hierarchy. The inputs used to measure fair value fall into the following hierarchy:

Level 1: Quoted market prices in active markets for identical assets or liabilities.

Level 2: Observable market-based inputs or unobservable inputs that are corroborated by market data.

Level 3: Unobservable inputs reflecting the reporting entity’s own assumptions.

The Company utilizes the best available information in measuring fair value. The following tables set forth, by level within the fair value hierarchy, the Company’s financial assets recorded at fair value on a recurring basis ($ in millions):

Fair Value Measurements at Reporting Date

		September 24,
Description		2011				Level 1				Level 2
Money market mutual funds		$	80.0	(1)		$	80.0			$	—
Fair value of interest rate swap agreements			14.0	(2)			—				14.0

Fair Value Measurements at Reporting Date

		December 25,
Description		2010				Level 1				Level 2
Money market mutual funds		$	225.0	(1)		$	225.0			$	—
Fair value of interest rate swap agreements			16.9	(2)			—				16.9

The Company’s money market mutual funds are invested in funds that seek to preserve principal, are highly liquid, and therefore are recorded on the consolidated balance sheets at the principal amounts deposited, which equals the asset values quoted by the money market fund custodians. The fair value of the Company’s obligation under its interest rate swap agreements, which hedge interest costs on the 7.25% senior notes, is based upon observable market-based inputs that reflect the present values of the differences between estimated future fixed rate payments and future variable rate receipts, and therefore are classified within Level 2. Historically, there have not been significant fluctuations in the fair value of the Company’s financial assets.

Fair Value of Financial Instruments

The term loan and revolving credit obligations under the Company’s senior unsecured bank credit facilities have a floating interest rate and as a result, the carrying amounts of the debt, as well as the short-term and long-term investments approximated fair values as of September 24, 2011 and December 25, 2010. The Company estimates fair market value for these assets and liabilities based on their market values or estimates of the present value of their future cash flows.

The carrying amounts and the fair values of the Company’s senior notes are shown in the following table ($ in millions):

		September 24, 2011								December 25, 2010
		Carrying				Fair				Carrying				Fair
		Amount(1)				Value				Amount(1)				Value
7.25% senior notes due 2013		$	499.0			$	547.5			$	498.7			$	567.2
6.125% senior notes due 2013			299.4				318.1				299.2				327.1
2.75% senior notes due 2015			499.9				503.8				499.8				496.1
7.125% senior notes due 2018			1,190.9				1,451.3				1,190.1				1,412.2
4.125% senior notes due 2020			499.0				509.3				498.9				481.3

The fair values of the senior notes are based on observable relevant market information. Fluctuations between the carrying amounts and the fair values of the senior notes for the periods presented are associated with changes in market interest rates. Medco may redeem all or part of each of the senior notes at any time or from time to time at its option at specified redemption prices that may include “make-whole” premiums. See Note 8, “Debt”, to the audited consolidated financial statements included in Part II, Item 8 of the Company’s Annual Report on Form 10-K for the fiscal year ended December 25, 2010 for more information.

4. EARNINGS PER SHARE (“EPS”)

The following is a reconciliation of the number of weighted average shares used in the basic and diluted EPS calculations (amounts in millions):

		Quarters Ended								Nine Months Ended
		September 24,				September 25,				September 24,				September 25,
		2011				2010				2011				2010
Basic weighted average shares outstanding			388.0				429.9				397.0				450.2
Dilutive common stock equivalents:
Outstanding stock options and restricted stock units			6.9				7.2				7.7				9.1
Diluted weighted average shares outstanding			394.9				437.1				404.7				459.3

The Company treats stock options and restricted stock units granted by the Company as potential common shares outstanding in computing diluted earnings per share. Under the treasury stock method on a grant by grant basis, the amount the employee or director must pay for exercising the award, the amount of compensation cost for future service that the Company has not yet recognized, and the amount of tax benefit that would be recorded in additional paid-in capital when the award becomes deductible, are assumed to be used to repurchase shares at the average market price during the period. For both the quarter and nine months ended September 24, 2011, there were outstanding options to purchase 11.9 million shares of Medco stock, which were not dilutive to the EPS calculations when applying the treasury stock method. For the quarter and nine months ended September 25, 2010, there were outstanding options to purchase 10.3 million and 6.1 million shares of Medco stock, respectively, which were not dilutive to the EPS calculations. For all periods presented, the outstanding options which were not dilutive to the EPS calculations when applying the treasury stock method primarily reflect the share price being below the option exercise price. These outstanding options may be dilutive to future EPS calculations. The decreases in the basic weighted average shares outstanding and diluted weighted average shares outstanding for the quarter and nine months ended September 24, 2011 compared to the same periods in 2010 primarily result from the repurchase of approximately 285.5 million shares of stock in connection with the Company’s share repurchase programs since inception in 2005 through the end of the third quarter of 2011, compared to an equivalent amount of 240.4 million shares repurchased since inception through the end of the third quarter of 2010. The Company repurchased approximately 6.3 million and 29.3 million shares of stock in the third quarter and nine months of 2011, respectively, compared to approximately 17.1 million and 54.2 million shares in the third quarter and nine months of 2010, respectively. See Note 8, “Share Repurchase Programs,” to the unaudited interim condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for more information on the Company’s share repurchase programs. In accordance with the FASB’s earnings per share standard, weighted average treasury shares are not considered part of the basic or diluted shares outstanding.

5. ACCOUNTS RECEIVABLE

The Company separately reports accounts receivable due from manufacturers and accounts receivable due from clients. Client accounts receivable, net, is presented net of allowance for doubtful accounts and includes a reduction for rebates and guarantees payable to clients when such are settled on a net basis in the form of an invoice credit. As of September 24, 2011 and December 25, 2010, identified net Specialty Pharmacy accounts receivable, primarily due from payors and patients, amounted to $506.4 million and $524.5 million, respectively. The Company’s client accounts receivable also includes receivables from the Centers for Medicare & Medicaid Services (“CMS”) for the Company’s Medicare Part D Prescription Drug Program (“Medicare Part D”) product offerings and premiums from members. As of September 24, 2011 and December 25, 2010, the CMS receivable was approximately $241.5 million and $216.1 million, respectively, the majority of which is anticipated to be collected in the fourth quarter of 2011.

The Company’s allowance for doubtful accounts as of September 24, 2011 and December 25, 2010 of $179.7 million and $149.7 million, respectively, includes $98.2 million and $97.9 million, respectively, related to the Specialty Pharmacy segment. The relatively higher allowance for the Specialty Pharmacy segment reflects a different credit risk profile than the pharmacy benefit management (“PBM”) business, and is characterized by reimbursement through medical coverage, including government agencies, and higher patient co-payments. See Note 9, “Segment and Geographic Data,” to the unaudited interim condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for more information on the Specialty Pharmacy segment. The Company’s PBM segment allowance for doubtful accounts as of September 24, 2011 and December 25, 2010 includes $68.8 million and $38.2 million, respectively, related to the sale of certain diabetes supplies, which are primarily reimbursed by government agencies and insurance companies. The increase in the PBM segment allowance for doubtful accounts is reflective of slower account write-off activity than what has historically been experienced, which is expected to normalize in the fourth quarter of 2011. In addition, the Company’s PBM segment allowance for doubtful accounts reflects amounts associated with member premiums for the Company’s Medicare Part D product offerings.

6. DEBT

The Company’s debt consists of the following ($ in millions):

		September 24,				December 25,
		2011				2010
Short-term debt:
Accounts receivable financing facility		$	—			$	—
Other			36.4				23.6
Total short-term debt			36.4				23.6
Current portion of long-term debt			2,000.0				—
Long-term debt:
Senior unsecured revolving credit facility			—				1,000.0
Senior unsecured term loan			—				1,000.0
7.25% senior notes due 2013, net of unamortized discount			499.0				498.7
6.125% senior notes due 2013, net of unamortized discount			299.4				299.2
2.75% senior notes due 2015, net of unamortized discount			499.9				499.8
7.125% senior notes due 2018, net of unamortized discount			1,190.9				1,190.1
4.125% senior notes due 2020, net of unamortized discount			499.0				498.9
Fair value of interest rate swap agreements			14.0				16.9
Total long-term debt			3,002.2				5,003.6
Total debt		$	5,038.6			$	5,027.2

A complete description of the Company’s debt may be found in Note 8, “Debt,” to the audited consolidated financial statements included in Part II, Item 8 of the Company’s Annual Report on Form 10-K for the fiscal year ended December 25, 2010. The following provides recent updates:

Five-Year Credit Facilities. On April 30, 2007, the Company entered into a senior unsecured credit agreement, which is available for general working capital requirements. The facility consists of a $1 billion, 5-year senior unsecured term loan and a $2 billion, 5-year senior unsecured revolving credit facility. The facility matures on April 30, 2012, and therefore the Company has classified all outstanding balances related to the facility, representing $1.0 billion under the revolving credit facility and the $1.0 billion senior unsecured term loan, as current portion of long-term debt on the unaudited interim condensed consolidated balance sheet as of September 24, 2011. The Company anticipates refinancing the $2 billion unsecured revolving credit facility before it matures and repaying the $1 billion senior unsecured term loan at maturity.

There were draw-downs of $10,327.2 million and repayments of $10,327.2 million under the revolving credit facility during the nine months of 2011. As of September 24, 2011, the Company had $995.2 million available for borrowing under the revolving credit facility, after giving effect to prior net draw-downs of $1 billion and $4.8 million in issued letters of credit. As of December 25, 2010, the outstanding balance under the revolving credit facility was $1.0 billion and the Company had $993.5 million available for borrowing under the facility, after giving effect to prior net draw-downs of $1 billion and $6.5 million in issued letters of credit.

Accounts Receivable Financing Facility. Through a wholly-owned subsidiary, the Company has a $600 million, 364-day renewable accounts receivable financing facility that is collateralized by the Company’s pharmaceutical manufacturer rebates accounts receivable. During the nine months of 2011, we drew down $1,138 million and repaid $1,138 million under the facility, which resulted in no amounts outstanding and $600 million available for borrowing under the facility as of September 24, 2011. The Company pays interest on amounts borrowed under the agreement based on the funding rates of the bank-related commercial paper programs that provide the financing, plus an applicable margin and liquidity fee determined by the Company’s credit rating. This facility is renewable annually at the option of both Medco and the banks and was renewed on July 25, 2011.

7. PENSION AND OTHER POSTRETIREMENT BENEFITS

The Company maintains an unfunded postretirement healthcare benefit plan for a limited number of retirees. The net (credit) for these postretirement benefits amounted to ($0.1) million and ($0.3) million for the quarters ended September 24, 2011 and September 25, 2010, respectively, and ($30.9) million and ($1.1) million for the nine months ended September 24, 2011 and September 25, 2010, respectively.

In January 2011, the Company amended its postretirement healthcare benefit plan, discontinuing the benefit for all active nonretirement-eligible employees. The Company had previously reduced and capped the benefit through a 2003 plan amendment, the effect of which resulted in a prior service credit reflected as a component of accumulated other comprehensive loss in stockholders’ equity. The prior service credit is associated with the plan in place before the Company became an independent, publicly traded company in 2003. The elimination of the postretirement healthcare benefit for all active nonretirement-eligible employees was accounted for as a curtailment of the plan and resulted in a gain of $30.6 million, pre-tax, $22.6 million of which is reported in cost of product net revenues and $8.0 million of which is reported in SG&A expenses on the unaudited interim condensed consolidated statement of income for the nine months ended September 24, 2011.

The net (credit) cost for the Company’s pension plans amounted to ($1.3) million and $7.3 million for the quarters ended September 24, 2011 and September 25, 2010, respectively, and ($9.0) million and $21.9 million for the nine months ended September 24, 2011 and September 25, 2010, respectively.

In January 2011, the Company amended its defined benefit pension plans, freezing the benefit for all participants effective in the first quarter of 2011. After the plan freeze, participants do not accrue any benefits under the plans, and new hires are not eligible to participate in the defined benefit pension plans. However, account balances continue to be credited with interest until paid out. The plan freeze resulted in a gain of $9.7 million, pre-tax, recognized in the first quarter of 2011. The freeze of the defined benefit pension plans coincided with an enhanced 401(k) plan company match.

The pension and other postretirement benefits assets and liabilities recognized at September 24, 2011 and December 25, 2010 are as follows ($ in millions):

		Pension Benefits								Other Postretirement Benefits
		September 24,				December 25,				September 24,				December 25,
		2011				2010				2011				2010
Other noncurrent assets		$	19.8			$	—			$	—			$	—
Accrued expenses and other current liabilities			(0.1	)			(0.1	)			(0.6	)			(0.6	)
Other noncurrent liabilities			(1.2	)			(64.1	)			(2.6	)			(18.0	)
Total pension and other postretirement net assets (liabilities)		$	18.5			$	(64.2	)		$	(3.2	)		$	(18.6	)

At December 25, 2010, the accumulated benefit obligation for the defined benefit pension plans was $200.7 million, and the projected benefit obligation was $253.6 million. The projected benefit obligation was higher because it included projected future salary increases through expected retirement. Upon the freeze of the defined benefit pension plans in the first quarter of 2011, the projected benefit obligation decreased and became consistent with the accumulated benefit obligation. In addition, the remaining minimum pension funding requirement of $30.5 million under the Internal Revenue Code for the 2010 plan year was paid in the third quarter of 2011. These items resulted in a decrease to the related balance sheet liability from $64.2 million as of December 25, 2010 to a balance sheet net asset of $18.5 million as of September 24, 2011.

At December 25, 2010, the accumulated postretirement benefit obligation for other postretirement benefits was $18.6 million. As a result of the aforementioned plan curtailment, the related accumulated postretirement benefit obligation decreased to $3.2 million as of September 24, 2011.

Payments for pension benefits for the years 2011 to 2020 are estimated to be $157.0 million, a decrease of $92.1 million from the $249.1 million reported in Note 9, “Pension and Other Postretirement Benefits,” to the Company’s audited consolidated financial statements included in Part II, Item 8 of its Annual Report on Form 10-K for the fiscal year ended December 25, 2010. This decrease in estimated payments is primarily due to the impact of the plan freeze.

8. SHARE REPURCHASE PROGRAMS

Since 2005, when the Company commenced its first share repurchase program, the Company has executed share repurchases of 285.5 million shares at a cost of $12.8 billion and at an average per-share cost of $45.00 through the end of the third fiscal quarter of 2011. In February 2011, the Company’s Board of Directors approved a new $3 billion share repurchase program, authorizing the purchase of up to $3 billion of the Company’s common stock over a two-year period commencing February 24, 2011. During the third quarter of 2011, the Company repurchased 6.3 million shares at a cost of $350 million with an average per-share cost of $55.89, and during the nine months of 2011, the Company repurchased 29.3 million shares at a cost of $1,786.6 million with an average per-share cost of $60.93 under its share repurchase programs.

Pursuant to the Merger Agreement with Express Scripts dated July 20, 2011, the Company is not permitted to engage in share repurchases without Express Scripts’ prior written consent until the consummation of the merger or the termination of the Merger Agreement. Currently, the Company does not anticipate making additional share repurchases.

9. SEGMENT AND GEOGRAPHIC DATA

Reportable Segments. The Company has two reportable segments, PBM and Specialty Pharmacy. The PBM segment primarily involves sales of traditional prescription drugs and supplies, including diabetes testing supplies and related products, to the Company’s clients and members or patients, either through the Company’s networks of contractually affiliated retail pharmacies or the Company’s mail-order pharmacies. The PBM segment also includes the operating results of Europa Apotheek Venlo B.V., which primarily provides mail-order pharmacy services in Germany. Commencing on the September 16, 2010 acquisition date, the PBM segment includes the operating results of UBC, which extends the Company’s core capabilities in data analytics and research.

The Specialty Pharmacy segment includes the sale of specialty pharmacy products and services for the treatment of primarily complex and potentially life-threatening diseases, including specialty infusion services. The Company defines the Specialty Pharmacy segment based on a product set and associated services, broadly characterized to include drugs that are usually high-cost, developed by biotechnology companies and often injectable or infusible, and may require elevated levels of patient support. When dispensed, these products frequently require ancillary administration equipment, special packaging, and a higher degree of patient-oriented customer service, including in-home nursing services and administration. Specialty pharmacy products and services are often covered through client PBM contracts. Specialty pharmacy products and services are also covered through medical benefit programs with the primary payors being insurance companies and government programs, and patients for amounts due for co-payments and deductibles.

Selected Segment Income and Asset Information. Total net revenues and operating income are measures used by the chief operating decision maker to assess the performance of each of the Company’s operating segments. The following tables present selected financial information about the Company’s reportable segments, including a reconciliation of operating income to income before provision for income taxes ($ in millions):

Quarterly Results:

		Quarter Ended September 24, 2011												Quarter Ended September 25, 2010
						Specialty												Specialty
		PBM(1) (2)				Pharmacy				Total(1) (2)				PBM(1)				Pharmacy				Total(1)
Product net revenues		$	13,261.5			$	3,341.3			$	16,602.8			$	13,209.8			$	2,852.2			$	16,062.0
Service revenues			360.1				18.6				378.7				232.0				25.8				257.8
Total net revenues			13,621.6				3,359.9				16,981.5				13,441.8				2,878.0				16,319.8
Total cost of revenues			12,681.3				3,133.1				15,814.4				12,517.9				2,682.4				15,200.3
Selling, general and administrative expenses			387.9				67.7				455.6				321.8				73.2				395.0
Amortization of intangibles			62.7				10.5				73.2				60.5				10.7				71.2
Operating income		$	489.7			$	148.6			$	638.3			$	541.6			$	111.7			$	653.3
Reconciling items to income before provision for income taxes:
Interest expense											52.2												43.4
Interest (income) and other (income) expense, net											(2.6	)											(2.6	)
Income before provision for income taxes										$	588.7											$	612.5
Capital expenditures		$	74.4			$	4.8			$	79.2			$	60.0			$	3.7			$	63.7

Year-to-Date Results:

		Nine Months Ended September 24, 2011												Nine Months Ended September 25, 2010
						Specialty												Specialty
		PBM(1)(2)				Pharmacy				Total(1) (2)				PBM(1)				Pharmacy				Total(1)
Product net revenues		$	40,425.9			$	9,562.8			$	49,988.7			$	40,015.1			$	8,293.9			$	48,309.0
Service revenues			1,029.2				57.2				1,086.4				653.9				75.3				729.2
Total net revenues			41,455.1				9,620.0				51,075.1				40,669.0				8,369.2				49,038.2
Total cost of revenues			38,752.6				8,979.8				47,732.4				38,077.7				7,786.5				45,864.2
Selling, general and administrative expenses			1,056.3				206.7				1,263.0				899.5				222.4				1,121.9
Amortization of intangibles			188.1				31.5				219.6				180.4				32.1				212.5
Operating income		$	1,458.1			$	402.0			$	1,860.1			$	1,511.4			$	328.2			$	1,839.6
Reconciling items to income before provision for income taxes:
Interest expense											156.4												123.0
Interest (income) and other (income) expense, net											1.7												(10.3	)
Income before provision for income taxes										$	1,702.0											$	1,726.9
Capital expenditures		$	175.8			$	14.5			$	190.3			$	145.1			$	19.0			$	164.1

Identifiable Assets:

		As of September 24, 2011												As of December 25, 2010
						Specialty												Specialty
		PBM				Pharmacy				Total				PBM				Pharmacy				Total
Total identifiable assets		$	12,346.5			$	3,517.1			$	15,863.6			$	13,360.3			$	3,737.0			$	17,097.3

Geographic Information. The Company’s net revenues from its foreign operations represented less than 1% of the Company’s consolidated net revenues for the quarters and nine months ended September 24, 2011 and September 25, 2010. All other revenues are earned in the United States.

10. COMMITMENTS AND CONTINGENCIES

Legal Proceedings

In the ordinary course of business, the Company is involved in litigation, claims, government inquiries, investigations, charges and proceedings, including, but not limited to, those relating to regulatory, commercial, employment, employee benefits and securities matters. The significant matters are described below.

There is uncertainty regarding the possible course and outcome of the proceedings discussed below. Although it is not feasible to predict or determine the final outcome of any proceedings with certainty, the Company believes there is no litigation pending against the Company that could have, individually or in the aggregate, a material adverse effect on the Company’s business, financial condition, liquidity and operating results. However, there can be no assurances that an adverse outcome in any of the proceedings described below will not result in material fines, penalties and damages, changes to the Company’s business practices, loss of (or litigation with) clients or a material adverse effect on the Company’s business, financial condition, liquidity and operating results. It is also possible that future results of operations for any particular quarterly or annual period could be materially adversely affected by the ultimate resolution of one or more of these matters, or changes in the Company’s assumptions or its strategies related to these proceedings. The Company continues to believe that its business practices comply in all material respects with applicable laws and regulations and is vigorously defending itself in the actions described below. The Company believes that most of the claims made in these proceedings would not likely be covered by insurance.

In accordance with the FASB’s standard on accounting for contingencies, the Company records accruals for contingencies when it is probable that a liability will be incurred and the amount of loss can be reasonably estimated. These assessments can involve a series of complex judgments about future events and may rely heavily on estimates and assumptions that have been deemed reasonable by management. Due to the uncertainty surrounding the issues involved in each of the below matters and based on the facts and circumstances of each matter known to date, the Company believes that an estimate of any loss or range of loss that may be incurred cannot be made at this time.

Government Proceedings and Requests for Information. The Company is aware of the existence of three qui tam matters—two are sealed and in the third, the government has declined to intervene and the complaint has been unsealed. The sealed first action is filed in the Eastern District of Pennsylvania and it appears to allege that the Company billed government payors using invalid or out-of-date national drug codes (“NDCs”). The sealed second action is filed in the District of New Jersey and appears to allege that the Company charged government payors a different rate than it reimbursed pharmacies; engaged in duplicate billing; refilled prescriptions too soon; and billed government payors for prescriptions written by unlicensed physicians and physicians with invalid Drug Enforcement Agency authorizations. The Department of Justice has not yet made any decision as to whether it will intervene in either of these matters. The matters are under seal and U.S. District Court orders prohibit the Company from answering inquiries about the complaints. The Company was notified of the existence of these two qui tam matters during settlement negotiations on an unrelated matter with the Department of Justice in 2006. The Company does not know the identities of the relators in either of these matters. The Company is not able to predict with certainty the timing or outcome of these matters.

The third qui tam matter in which the government has declined to intervene, relates to PolyMedica Corporation, a subsidiary of the Company acquired in the fourth quarter of 2007. This matter is progressing as a civil litigation, United States of America ex. rel. Lucas W. Matheny and Deborah Loveland vs. Medco Health Solutions, Inc., et al., in the U.S. District Court for the Southern District of Florida, although the government could decide to intervene at any point during the course of the litigation. The complaint largely includes allegations regarding the application of invoice payments. In July 2010, the U.S. District Court for the Southern District of Florida dismissed the action without prejudice. The plaintiffs re-filed the complaint and upon a motion to dismiss, the U.S. District Court for the Southern District of Florida dismissed the complaint with prejudice in October 2010. The matter is currently on appeal.

In April 2010, the Attorney General for the State of California requested information from the Company about a former consultant who was engaged by the Company in 2004 and again later in a year-to-year contract that ended in 2009. The Company has been, and will continue to voluntarily provide information related to this request, including providing various documents and making certain current and former employees available for depositions. In March 2011, the Company received a subpoena from the SEC’s Los Angeles Regional Office staff requesting the production of documents relating to an ongoing investigation of the California Public Pension Funds. The Company is cooperating with both the SEC and the California Attorney General’s office. The Company is not able to predict with certainty the timing or outcome of these matters.

In July 2011, Medco received a subpoena duces tecum from the United States Department of Justice, District of Delaware, requesting information from Medco concerning its arrangements with Astra Zeneca concerning four Astra Zeneca drugs. The Company is cooperating with the inquiry. The Company is not able to predict with certainty the timing or outcome of this matter.

ERISA and Similar Litigation. As disclosed in Note 14, “Commitments and Contingencies,” to the Company’s audited consolidated financial statements included in Part II, Item 8 of its Annual Report on Form 10-K for the fiscal year ended December 25, 2010, the Gruer series of lawsuits were settled on a class action basis in 2010, however, the plaintiffs in two of the remaining actions in the Gruer series of cases, Blumenthal v. Merck-Medco Managed Care, L.L.C., et al., and United Food and Commercial Workers Local Union No. 1529 and Employers Health and Welfare Plan Trust v. Medco Health Solutions, Inc. and Merck & Co., Inc., elected to opt out of the settlement. In June 2010, the Company filed for summary judgment against both of these plaintiffs. In June 2011, the Court issued its opinion dismissing several of the plaintiffs’ fiduciary claims while letting others survive pending further discovery. Plaintiff, United Food and Commercial Workers Local Union No. 1529 and Employers Health and Welfare Plan Trust, subsequently filed a motion with the Court asking it to reconsider its dismissal of one of the fiduciary claims. In September 2011, the Company settled both of these matters for a de minimus amount.

The Company does not believe that it is a fiduciary under ERISA (except in those instances in which it has expressly contracted to act as a fiduciary for limited purposes), and believes that its business practices comply with all applicable laws and regulations.

Antitrust and Related Litigation. In August 2003, a lawsuit captioned Brady Enterprises, Inc., et al. v. Medco Health Solutions, Inc., et al. was filed in the U.S. District Court for the Eastern District of Pennsylvania against Merck & Co., Inc. (“Merck”) and the Company. The plaintiffs, who seek to represent a national class of retail pharmacies that had contracted with the Company, allege that the Company has conspired with, acted as the common agent for, and used the combined bargaining power of plan sponsors to restrain competition in the market for the dispensing and sale of prescription drugs. The plaintiffs allege that, through the alleged conspiracy, the Company has engaged in various forms of anticompetitive conduct, including, among other things, setting artificially low reimbursement rates to such pharmacies. The plaintiffs assert claims for violation of the Sherman Act and seek treble damages and injunctive relief. The plaintiffs’ motion for class certification is currently pending before the Multidistrict Litigation Court.

In October 2003, a lawsuit captioned North Jackson Pharmacy, Inc., et al. v. Medco Health Solutions, Inc., et al. was filed in the U.S. District Court for the Northern District of Alabama against Merck and the Company. In their Second Amended Complaint, the plaintiffs allege that Merck and the Company engaged in price fixing and other unlawful concerted actions with others, including other PBMs, to restrain trade in the dispensing and sale of prescription drugs to customers of retail pharmacies who participate in programs or plans that pay for all or part of the drugs dispensed, and conspired with, acted as the common agent for, and used the combined bargaining power of plan sponsors to restrain competition in the market for the dispensing and sale of prescription drugs. The plaintiffs allege that, through such concerted action, Merck and the Company engaged in various forms of anticompetitive conduct, including, among other things, setting reimbursement rates to such pharmacies at unreasonably low levels. The plaintiffs assert claims for violation of the Sherman Act and seek treble damages and injunctive relief. The plaintiffs’ motion for class certification has been granted, but this matter has been consolidated with other actions where class certification remains an open issue.

In December 2005, a lawsuit captioned Mike’s Medical Center Pharmacy, et al. v. Medco Health Solutions, Inc., et al. was filed against the Company and Merck in the U.S. District Court for the Northern District of California. The plaintiffs seek to represent a class of all pharmacies and pharmacists that had contracted with the Company and California pharmacies that had indirectly purchased prescription drugs from Merck and make factual allegations similar to those in the Alameda Drug Company action discussed below. The plaintiffs assert claims for violation of the Sherman Act, California antitrust law and California law prohibiting unfair business practices. The plaintiffs demand, among other things, treble damages, restitution, disgorgement of unlawfully obtained profits and injunctive relief.

In April 2006, the Brady plaintiffs filed a petition to transfer and consolidate various antitrust actions against PBMs, including North Jackson, Brady, and Mike’s Medical Center before a single federal judge. The motion was granted in August 2006. These actions are now consolidated for pretrial purposes in the U.S. District Court for the Eastern District of Pennsylvania. The consolidated action is known as In re Pharmacy Benefit Managers Antitrust Litigation. The plaintiffs’ motion for class certification in certain actions is currently pending before the Multidistrict Litigation Court.

In January 2004, a lawsuit captioned Alameda Drug Company, Inc., et al. v. Medco Health Solutions, Inc., et al. was filed against the Company and Merck in the Superior Court of California. The plaintiffs, which seek to represent a class of all California pharmacies that had contracted with the Company and that had indirectly purchased prescription drugs from Merck, allege, among other things, that since the expiration of a 1995 consent injunction entered by the U.S. District Court for the Northern District of California, if not earlier, the Company failed to maintain an Open Formulary (as defined in the consent injunction), and that the Company and Merck had failed to prevent nonpublic information received from competitors of Merck and the Company from being disclosed to each other. The plaintiffs further allege that, as a result of these alleged practices, the Company had been able to increase its market share and artificially reduce the level of reimbursement to the retail pharmacy class members, and that the prices of prescription drugs from Merck and other pharmaceutical manufacturers that do business with the Company had been fixed and raised above competitive levels. The plaintiffs assert claims for violation of California antitrust law and California law prohibiting unfair business practices. The plaintiffs demand, among other things, compensatory damages, restitution, disgorgement of unlawfully obtained profits and injunctive relief. In the complaint, the plaintiffs further allege, among other things, that the Company acted as a purchasing agent for its plan sponsor customers, resulting in a system that serves to suppress competition.

Other Matters

In the ordinary course of business, the Company is involved in disputes with clients, retail pharmacies and suppliers, which may involve litigation, claims, arbitrations and other proceedings and the Company is subject to government audits and recoupment demands. Although it is not feasible to predict or determine the final outcome of any proceedings with certainty, the Company does not believe that any of these disputes could have, individually or in the aggregate, a material adverse effect on the Company’s business, financial condition, liquidity or operating results. In addition, the Company entered into an indemnification and insurance matters agreement with Merck in connection with the Company’s spin-off in 2003, which may require the Company in some instances to indemnify Merck.

Twenty-two lawsuits have been filed since the announcement of the merger on July 21, 2011 described in Note 1, “Basis of Presentation,” to the accompanying unaudited interim condensed consolidated financial statements that name as defendants the Company, the Company’s Board of Directors, and Express Scripts. The purported class action complaints allege, among other things, a breach of fiduciary duty in connection with the approval of the pending Merger Agreement between the Company and Express Scripts.

Purchase Commitments

As of September 24, 2011, the Company has contractual commitments to purchase inventory from certain biopharmaceutical manufacturers associated with the Company’s Specialty Pharmacy business, and are either contracts for fixed amounts or contracts for fixed amounts plus a variable component. The contracts for fixed amounts include firm commitments of $82.8 million through 2012. The contracts with fixed amounts plus a variable component include firm commitments of $22.5 million for 2011, with additional commitments through 2012 that are subject to price increases or variable quantities based on patient usage. The Company also has purchase commitments for diabetes supplies of $37.1 million, technology-related agreements of $28.4 million and advertising commitments of $0.7 million.

Insurance

The Company maintains insurance coverage with deductibles and self-insurance that management considers adequate for its needs under current circumstances, including commercial professional liability coverage of $85 million per individual claim. Such coverage reflects market conditions (including cost and availability) existing at the time coverage is written. In addition to the Company’s commercial professional liability insurance policies, the Company has a retained liability component requiring certain self-insurance reserves to cover potential claims. The Company currently processes any claims included in self-insured retention levels through a captive insurance company. The Company’s PBM operations, including, for example, the dispensing of prescription drugs by its mail-order pharmacies, may subject the Company to litigation and liability for damages. Historically, the Company has not had any professional liability claims that have exceeded its insurance coverage amount, and any claims have not been material. The Company believes that its insurance coverage protection for these types of claims is adequate. However, the Company might not be able to maintain its professional and general liability insurance coverage in the future, and insurance coverage might not be available on acceptable terms or adequate to cover any or all potential professional liability claims. A successful professional liability claim in excess of the Company’s insurance coverage, or one for which an exclusion from coverage applies, could have a material adverse effect on the Company’s financial condition and results of operations.

11. UNITEDHEALTH GROUP INCORPORATED

On July 21, 2011, the Company announced that its pharmacy benefit services agreement with UnitedHealth Group Incorporated (“UnitedHealth Group”) would not be renewed. For both the third quarter and nine months of 2011 and 2010, UnitedHealth Group, the Company’s largest client, represented 17% of the Company’s net revenues. The UnitedHealth Group contract expires on December 31, 2012. The UnitedHealth Group account has a lower than average mail-order penetration and, because of its size, steeper pricing than the average client, and consequently generally yields lower profitability as a percentage of net revenues than smaller client accounts. In addition, with respect to mail-order volume, which is an important contributor to the Company’s overall profitability, the mail-order volume associated with this account represented less than 10% of the Company’s overall mail-order volume for both the third quarters and nine months of 2011 and 2010. The pending expiration of the UnitedHealth Group contract does not impact goodwill or intangible asset carrying amounts, or the expected useful lives of the intangible assets. None of the Company’s other clients individually represented more than 10% of the net revenues in the third quarter and nine months of 2011 or 2010.

Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Quarterly Report on Form 10-Q contains “forward-looking statements” as that term is defined in the Private Securities Litigation Reform Act of 1995. These statements involve risks and uncertainties that may cause results to differ materially from those set forth in the statements. No forward-looking statement can be guaranteed, and actual results may differ materially from those projected. We undertake no obligation to publicly update any forward-looking statement, whether as a result of new information, future events or otherwise. Forward-looking statements are not historical facts, but rather are based on current expectations, estimates, assumptions and projections about the business and future financial results of the pharmacy benefit management (“PBM”) and specialty pharmacy industries, and other legal, regulatory and economic developments. We use words such as “anticipates,” “believes,” “plans,” “expects,” “projects,” “future,” “intends,” “may,” “will,” “should,” “could,” “estimates,” “predicts,” “potential,” “continue” and similar expressions to identify these forward-looking statements. Our actual results could differ materially from the results contemplated by these forward-looking statements due to a number of factors, including those set forth below.

	•		Competition in the PBM, specialty pharmacy and broader healthcare industry is intense and could impair our ability to attract and retain clients;
	•		Failure to retain key clients and their members, either as a result of economic conditions, increased competition or other factors, could result in significantly decreased revenues, harm to our reputation and decreased profitability;
	•		Government efforts to reduce healthcare costs and alter healthcare financing practices could lead to a decreased demand for our services or to reduced profitability;

	•		Failure in continued execution of our retiree strategy, including the potential loss of Medicare Part D-eligible members, could adversely impact our business and financial results;
	•		If we or our suppliers fail to comply with complex and evolving laws and regulations domestically and internationally, we could suffer penalties, be required to pay substantial damages and/or make significant changes to our operations;
	•		If we do not continue to earn and retain purchase discounts, rebates and service fees from manufacturers at current levels, our gross margins may decline;
	•		From time to time we engage in transactions to acquire other companies or businesses and if we are unable to effectively integrate acquired businesses into ours, our operating results may be adversely affected. Even if we are successful, the integration of these businesses has required, and will likely continue to require, significant resources and management attention;
	•		New legislative or regulatory initiatives that restrict or prohibit the PBM industry’s ability to use patient identifiable information could limit our ability to use information critical to the operation of our business;
	•		Our Specialty Pharmacy business is dependent on our relationships with a limited number of suppliers and our clinical research services are dependent on our relationships with a limited number of clients. As such, the loss of one or more of these relationships, or limitations on our ability to provide services to these suppliers or clients, could significantly impact our ability to sustain and/or improve our financial performance;
	•		Our ability to grow our Specialty Pharmacy business could be limited if we do not expand our existing base of drugs or if we lose patients;
	•		Our Specialty Pharmacy business, certain revenues from diabetes testing supplies and our Medicare Part D offerings expose us to increased billing, cash application and credit risks. Additionally, current economic conditions may expose us to increased credit risk;
	•		Changes in reimbursement, including reimbursement for durable medical equipment, could negatively affect our revenues and profits;
	•		Prescription volumes may decline, and our net revenues and profitability may be negatively impacted, if the safety risk profiles of drugs increase or if drugs are withdrawn from the market, including as a result of manufacturing issues, or if prescription drugs transition to over-the-counter products;
	•		Demand for our clinical research services depends on the willingness of companies in the pharmaceutical and biotechnology industries to continue to outsource clinical development and on our reputation for independent, high-quality scientific research and evidence development;
	•		PBMs could be subject to claims under ERISA if they are found to be a fiduciary of a health benefit plan governed by ERISA;
	•		Pending litigation could adversely impact our business practices and have a material adverse effect on our business, financial condition, liquidity and operating results;
	•		Changes in industry pricing benchmarks could adversely affect our financial performance;
	•		We are subject to a corporate integrity agreement and noncompliance may impede our ability to conduct business with the federal government;

	•		The terms and covenants relating to our existing indebtedness could adversely impact our financial performance and liquidity;
	•		We may be subject to liability claims for damages and other expenses not covered by insurance;
	•		The success of our business depends on maintaining a well-secured pharmacy operation and technology infrastructure. Additionally, significant disruptions to our infrastructure or any of our facilities due to failure to execute security measures or failure to execute business continuity plans in the event of an epidemic or pandemic or some other catastrophic event could adversely impact our business;
	•		Business process and technology infrastructure improvements associated with our agile enterprise initiative may not be successfully or timely implemented or may fail to operate as designed and intended, causing the Company’s performance to suffer;
	•		We may be required to record a material non-cash charge to income if our recorded intangible assets or goodwill are impaired, or if we shorten intangible asset useful lives;
	•		We are subject to certain risks associated with our international operations;
	•		Anti-takeover provisions of the Delaware General Corporation Law, our certificate of incorporation and our bylaws could delay or deter a change in control and make it more difficult to remove incumbent officers and directors; and
	•		As described elsewhere in this Quarterly Report on Form 10-Q, we have entered into a Merger Agreement with Express Scripts, Inc. (“Express Scripts”). Express Scripts and the Company may be unable to obtain stockholder or regulatory approvals required for the merger contemplated by the Merger Agreement or may be required to accept conditions that could reduce the anticipated benefits of the merger as a condition to obtaining regulatory approvals; the length of time necessary to consummate the pending merger may be longer than anticipated; a condition to closing of the merger may not be satisfied; problems may arise in successfully integrating the businesses of Express Scripts and the Company; Express Scripts may be unable to realize the synergies expected from the merger; the merger may involve unexpected costs; the businesses may suffer as a result of uncertainty surrounding the pending merger and the industry may be subject to future risks that are described in Securities and Exchange Commission (“SEC”) reports filed by Express Scripts and the Company.

The foregoing list of factors is not exhaustive. You should carefully consider the foregoing factors and the other risks and uncertainties that affect our business described in our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q (including Part II, Item 1A, “Risk Factors,” of this Quarterly Report on Form 10-Q) and other documents filed from time to time with the SEC.

Overview

We are a leading healthcare company that is pioneering the world’s most advanced pharmacy^® and our clinical research and innovations are part of Medco making medicine smarter™ for more than 65 million members. Medco provides clinically-driven pharmacy services designed to improve the quality of care and lower total healthcare costs for private and public employers, health plans, labor unions and government agencies of all sizes, and for individuals served by Medicare Part D Prescription Drug Plans. In 2010, Medco’s national Medicare Part D Prescription Drug Plan (“PDP”) received the first and only five star rating from the Centers for Medicare & Medicaid Services (“CMS”). Our unique Medco Therapeutic Resource Centers^®, which conduct therapy management programs using Medco Specialist Pharmacists who have expertise in the medications used to treat certain chronic conditions, combined with Medco’s personalized medicine capabilities through the Medco Research Institute™ and genomics counseling services, as well as Accredo Health Group, Medco’s Specialty Pharmacy, represent innovative models for the care of patients with chronic and complex conditions. Additionally, Medco has capabilities and expertise in post-approval safety and economics outcomes research such as Risk Evaluation and Mitigation Strategies for biotechnology and other pharmaceutical drugs through our subsidiary, United BioSource Corporation (“UBC”).

Our business model requires collaboration with payors, retail pharmacies, physicians, pharmaceutical manufacturers, CMS for Medicare, and, particularly in Specialty Pharmacy, collaboration with other third-party payors such as health insurers, and state Medicaid agencies. Our programs and services help control the cost and enhance the quality of prescription drug benefits. We accomplish this by providing PBM services through our national networks of retail pharmacies and our own mail-order pharmacies, as well as through Accredo Health Group, which we believe is the nation’s largest specialty pharmacy based on reported revenues. We also provide a suite of diabetes care supplies and services under our Liberty brand.

The complicated environment in which we operate presents us with opportunities, challenges and risks. Our clients and members are paramount to our success; the retention of existing clients and members and winning of new clients and members poses the greatest opportunity to us and the loss thereof represents an ongoing risk. The preservation of our relationships with pharmaceutical manufacturers, biopharmaceutical manufacturers and retail pharmacies is very important to the execution of our business strategies. Our future success will be largely dependent on our ability to profitably drive mail-order volume and increase generic dispensing rates in light of the significant brand-name drug patent expirations expected to occur over the next several years. In addition, our future success depends on our ability to continue to provide innovative and competitive clinical and other services to clients and members, including through our active participation in the Medicare Part D Prescription Drug Plan (“Medicare Part D”) benefit, our growing specialty pharmacy business, including the growth in biosimilars, our Therapeutic Resource Centers, as well as the growing service revenue businesses that include our clinical research business capabilities through UBC, our personalized medicine services and our international services.

Additionally, our future success will depend on our continued ability to generate positive cash flows from operations with a keen focus on asset management and maximizing return on invested capital (“ROIC”). We are very focused on managing our ROIC to ensure we drive significant returns to our shareholders. We believe there is a close correlation between strong ROIC and long-term shareholder value and as such, we include ROIC as a component of our annual performance bonus grid.

Our financial performance benefits from the diversity of our client base and our clinically-driven business model, which we believe provides better outcomes at lower costs for our clients. We actively monitor the status of our accounts receivable and have mechanisms in place to minimize the potential for incurring material accounts receivable credit risk. To date, we have not experienced any significant deterioration in our client or manufacturer rebates accounts receivable.

On July 20, 2011, we entered into a definitive Merger Agreement with Express Scripts and certain of its subsidiaries providing for the combination of Express Scripts and Medco under a new holding company, New Express Scripts. Subject to the terms and conditions set forth in the Merger Agreement, upon the closing of the transaction, each share of Medco common stock will be converted into the right to receive $28.80 in cash and 0.81 shares of New Express Scripts. Upon closing of the transaction, Express Scripts’ shareholders are expected to own approximately 60% of the combined company and Medco’s shareholders are expected to own approximately 40%. The transaction is expected to close in the first half of 2012. The merger is subject to regulatory clearance and Express Scripts’ and Medco’s shareholder approvals and other customary closing conditions. Currently, Express Scripts and Medco are independent companies, and they will continue to be managed and operated as such until the completion of the pending merger.

Our third fiscal quarters for 2011 and 2010 each consisted of 13 weeks and ended on September 24, 2011 and September 25, 2010, respectively.

When we use “Medco,” “we,” “us” and “our,” we mean Medco Health Solutions, Inc., a Delaware corporation, and its consolidated subsidiaries. When we use the term “mail order,” we mean inventory dispensed through Medco’s mail-order pharmacy operations.

Recent Acquisition

In September 2010, we extended our core capabilities in data analytics and research with the acquisition of UBC. UBC is a leader in serving life sciences industry clients and is focused on developing scientific evidence to guide the safe, effective and affordable use of medicines. UBC has the capability to conduct post-approval research in strategic locations worldwide, including North America, Europe and Asia.

Key Indicators Reviewed by Management

Management reviews the following indicators in analyzing our consolidated financial performance: net revenues, with a particular focus on mail-order volumes and revenue; adjusted prescription volume; generic dispensing rate and generic volumes, particularly for mail order; service revenue; gross margin percentage; cash flow from operations; return on invested capital; diluted earnings per share; diluted earnings per share, excluding all intangible amortization; Specialty Pharmacy segment revenue and operating income; Earnings Before Interest and Other Income/Expense, Taxes, Depreciation, and Amortization (“EBITDA”); and EBITDA per adjusted prescription. See “—EBITDA” further below for a definition and calculation of EBITDA and EBITDA per adjusted prescription. We believe these measures highlight key business trends and are important in evaluating our overall performance.

Financial Performance Summary for the Quarter and Nine Months Ended September 24, 2011

Our diluted earnings per share were $0.90 for the third quarter and $2.55 for the nine months of 2011, and include expenses associated with the pending merger with Express Scripts. The merger-related expenses, which include banker fees, legal fees and employee retention expenses, amount to $36.6 million pre-tax for the third quarter and nine months of 2011, with $35.6 million included in selling, general and administrative (“SG&A”) expenses and $1.0 million included in cost of product net revenues. Excluding these merger-related expenses, our diluted earnings per share increased 12.9% to $0.96 for the third quarter of 2011, and 14.0% to $2.60 for the nine months of 2011. Excluding all intangible amortization and the merger-related expenses, our diluted earnings per share increased 12.6% to $1.07 for the third quarter of 2011, and 14.5% to $2.93 for the nine months of 2011. These earnings per share increases primarily reflect higher generic dispensing rates and mail-order generic volumes, a decrease in the diluted weighted average shares outstanding, increased service margin, and growth in the Specialty Pharmacy business, partially offset by the effect of client renewal pricing and increased SG&A expenses. The increase for the nine months also reflects a first-quarter 2011 benefit associated with changes to the employee postretirement healthcare benefit plan of $30.6 million included in gross margin and SG&A expenses, partially offset by a second-quarter 2010 benefit of approximately $27 million associated with our receipt of a settlement award in a class action antitrust lawsuit brought by direct purchasers of a brand-name medication. For the nine months ended September 24, 2011, we generated cash flow from operations of $1,086.1 million and had cash and cash equivalents of $161.5 million on our consolidated balance sheet at September 24, 2011.

The diluted weighted average shares outstanding were 394.9 million for the third quarter and 404.7 million for the nine months of 2011 compared to 437.1 million for the third quarter and 459.3 million for the nine months of 2010, representing decreases of 9.7% and 11.9%, respectively, resulting primarily from our share repurchase programs.

Our total net revenues increased 4.1% to $16,981.5 million for the third quarter, and increased 4.2% to $51,075.1 million for the nine months of 2011. Product net revenues increased 3.4% to $16,602.8 million for the third quarter, and 3.5% to $49,988.7 million for the nine months of 2011, which reflects higher prices charged by brand-name pharmaceutical manufacturers, as well as higher prescription volume for the nine months, partially offset by a greater representation of lower-priced generic drugs and higher client price discounts. Additionally, our service revenues increased 46.9% to $378.7 million for the third quarter and 49.0% to $1,086.4 million for the nine months of 2011, reflecting higher manufacturer service revenues primarily driven by the contributions from UBC, which was acquired in September 2010. Also included in the higher service revenues are increased client and other service revenues primarily driven by increased formulary management fees and higher claims processing administrative fees.

The total adjusted prescription volume, which adjusts mail-order prescription volume for the difference in days supply between mail order and retail, decreased 0.7% to 233.6 million for the third quarter reflecting lower retail volumes, partially offset by higher mail-order volumes. Total adjusted prescription volume increased 0.7% to 717.6 million for the nine months of 2011 reflecting higher retail and mail-order volumes. The increases in mail-order prescription volume for the third quarter and nine months of 2011 are driven by increases in generic volumes, as brand-name volumes were lower than in the third quarter and nine months of 2010. The adjusted mail-order penetration rate was 34.8% for the third quarter and 34.3% for the nine months of 2011, compared to 34.5% for the third quarter and 34.2% for the nine months of 2010.

Our overall generic dispensing rate increased to 73.8% for the third quarter and 73.4% for the nine months of 2011, from 71.6% for the third quarter and 70.6% for the nine months of 2010, reflecting the impact of the introduction of new generic products in and subsequent to the third quarter of 2010, heightened use of previously released generics, and the effect of client plan design changes promoting the use of lower-priced and more steeply discounted generics. Higher generic volumes, which contribute to lower costs for clients and members, resulted in reductions to net revenues of approximately $700 million and $2,700 million for the third quarter and nine months of 2011, respectively.

Our overall gross margin percentages were 6.9% for the third quarter and 6.5% for the nine months of 2011, consistent with the third quarter and nine months of 2010, primarily reflecting increased generic dispensing rates and mail-order generic volumes, as well as a higher mix of higher margin service revenues, offset by the effect of client renewal pricing. Also contributing for the nine months of 2011 is the margin component of the aforementioned first-quarter 2011 benefit associated with the postretirement healthcare benefit plan of $22.6 million, offset by the aforementioned second-quarter 2010 settlement award of approximately $27 million.

SG&A expenses were $455.6 million for the third quarter of 2011 and $1,263.0 million for the nine months of 2011 including merger-related costs of $35.6 million. Excluding the merger related costs, SG&A expenses of $420.0 million for the third quarter of 2011 increased by $25.0 million, or 6.3%, from the third quarter of 2010. SG&A expenses of $1,227.4 million for the nine months of 2011 increased by $105.5 million, or 9.4%, from the nine months of 2010. These increases primarily reflect UBC SG&A expenses and higher stock-based compensation expenses. Also contributing for the nine months of 2011 are higher professional fees and technology-related expenses associated with strategic initiatives, partially offset by the SG&A component of the aforementioned first-quarter 2011 benefit associated with the postretirement healthcare benefit plan of $8.0 million. Excluding UBC and the merger-related expenses, SG&A expenses increased by 1.7% and 3.7% from the third quarter and nine months of 2010, respectively, reflecting efficiencies across the company.

Amortization of intangible assets of $73.2 million for the third quarter and $219.6 million for the nine months of 2011 increased $2.0 million and $7.1 million from the third quarter and nine months of 2010, respectively, primarily reflecting higher intangible amortization from the acquisition of UBC, partially offset by lower intangible amortization from scheduled accelerated amortization of certain customer relationships in the prior periods.

Interest expense of $52.2 million for the third quarter and $156.4 million for the nine months of 2011 increased $8.8 million and $33.4 million from the third quarter and nine months of 2010, respectively, primarily reflecting higher expense as a result of increased borrowings of $1 billion from our September 2010 senior notes issuance associated with the acquisition of UBC.

Interest (income) and other (income) expense, net, of ($2.6) million of income for the third quarter of 2011 was consistent with the third quarter of 2010. Interest (income) and other (income) expense, net, of $1.7 million of expense for the nine months of 2011 decreased $12.0 million from ($10.3) million of income for the nine months of 2010. The decrease in interest (income) and other (income) expense, net, for the nine months primarily reflects losses in the start-up period for certain of our joint ventures and a foreign currency gain that was recognized in 2010, as well as decreased interest income.

Our effective tax rate (defined as the percentage relationship of provision for income taxes to income before provision for income taxes) was 39.6% for the third quarter and 39.4% for the nine months of 2011, compared to 39.3% for the third quarter and nine months of 2010.

Key Financial Statement Components

Consolidated Statements of Income

Our net revenues are comprised primarily of product net revenues and are derived principally from the sale of prescription drugs through our networks of contractually affiliated retail pharmacies and through our mail-order pharmacies, and are recorded net of certain discounts, rebates and guarantees payable to clients and members. The majority of our product net revenues are derived on a fee-for-service basis. Our Specialty Pharmacy product net revenues represent revenues from the sale of primarily biopharmaceutical drugs and are reported at the net amount billed to third-party payors and patients.

In addition, our product net revenues include premiums associated with our Medicare Part D Prescription Drug Plan risk-based product offerings. These products involve prescription dispensing for beneficiaries enrolled in the CMS-sponsored Medicare Part D prescription drug benefit. Our two insurance company subsidiaries have been operating under contracts with CMS since 2006, and currently offer several Medicare PDP options. The products involve underwriting the benefit, charging enrollees applicable premiums, providing covered prescription drugs and administering the benefit as filed with CMS. We provide two Medicare drug benefit plan options for beneficiaries, including a “standard Part D” benefit plan as mandated by statute, and a benefit plan with enhanced coverage that exceeds the standard Part D benefit plan, available for an additional premium. We also offer numerous customized benefit plan designs to employer group retiree plans under the Medicare Part D prescription drug benefit.

The PDP premiums are determined based on our annual bid and related contractual arrangements with CMS. The PDP premiums are primarily comprised of amounts received from CMS as part of a direct subsidy and an additional subsidy from CMS for low-income member premiums, as well as premium payments received from members. These premiums are recognized ratably to product net revenues over the period in which members are entitled to receive benefits. Premiums received in advance of the applicable benefit period are deferred and recorded in accrued expenses and other current liabilities on the consolidated balance sheets. There is a possibility that the annual costs of drugs may be higher or lower than premium revenues. As a result, CMS provides a risk corridor adjustment for the standard drug benefit that compares our actual annual drug costs incurred to the targeted premiums in our CMS-approved bid. Based on specific collars in the risk corridor, we will receive from CMS additional premium amounts or be required to refund to CMS previously received premium amounts. We calculate the risk corridor adjustment on a quarterly basis based on drug cost experience to date and record an adjustment to product net revenues with a corresponding account receivable from or payable to CMS reflected on the consolidated balance sheets.

In addition to PDP premiums, there are certain co-payments and deductibles (the “cost share”) due from members based on prescription orders by those members, some of which are subsidized by CMS in cases of low-income membership. In 2011, non-low-income members receive a cost share benefit under the coverage gap discount program with pharmaceutical manufacturers. The coverage gap cost share program covers 50% of the member co-payment in the coverage gap for participating brand-name drugs. For subsidies received in advance, the amount is deferred and recorded in accrued expenses and other current liabilities on the consolidated balance sheets. If there is cost share due from members, pharmaceutical manufacturers or CMS, the amount is accrued and recorded in client accounts receivable, net, on the consolidated balance sheets. After the end of the contract year and based on actual annual drug costs incurred, cost share amounts are reconciled with CMS and the corresponding receivable or payable is settled. The cost share is treated consistently as other co-payments derived from providing PBM services, as a component of product net revenues on the consolidated statements of income.

For further details, see our critical accounting policies included in “—Use of Estimates and Critical Accounting Policies and Estimates” and Note 2, “Summary of Significant Accounting Policies,” to our audited consolidated financial statements included in Part II, Items 7 and 8, respectively, of our Annual Report on Form 10-K for the fiscal year ended December 25, 2010. In 2011, premium revenues for our PDP products, which exclude member cost share, were $157 million for the third quarter, or less than 1% of total net revenues, and $557 million for the nine months, or 1% of total net revenues. In the third quarter and nine months of 2010, premium revenues for our PDP products, which exclude member cost share, were $173 million and $536 million, respectively, or 1% of total net revenues.

Our agreements with CMS, as well as applicable Medicare Part D regulations and federal and state laws, require us to, among other obligations: (i) comply with certain disclosure, filing, record-keeping and marketing rules; (ii) operate quality assurance, drug utilization management and medication therapy management programs; (iii) support e-prescribing initiatives; (iv) implement grievance, appeals and formulary exception processes; (v) comply with payment protocols, which include the return of overpayments to CMS and, in certain circumstances, coordination with state pharmacy assistance programs; (vi) use approved networks and formularies, and provide access to such networks to “any willing pharmacy”; (vii) provide emergency out-of-network coverage; and (viii) implement a comprehensive Medicare and Fraud, Waste and Abuse compliance program. We have various contractual and regulatory compliance requirements associated with participating in the Medicare Part D benefit. Similar to our requirements with other clients, our policies and practices associated with executing our PDP are subject to audit. If material contractual or regulatory non-compliance was to be identified, monetary penalties and/or applicable sanctions, including suspension of enrollment and marketing or debarment from participation in Medicare programs, may be imposed. Additionally, each calendar year, payment will vary based on the annual benchmark that applies as a result of Medicare Part D plan bids for the applicable year, as well as for changes in the CMS methodology for calculating risk adjustment factors.

Service revenues consist principally of administrative fees and clinical program fees earned from clients, sales of prescription services to pharmaceutical manufacturers, performance-oriented fees paid by Specialty Pharmacy manufacturers, revenues from data analytics and research associated with UBC, and other non-product-related revenues.

Cost of revenues is comprised primarily of cost of product net revenues and is principally attributable to the dispensing of prescription drugs. Cost of product net revenues for prescriptions dispensed through our networks of retail pharmacies is comprised of the contractual cost of drugs dispensed by, and professional fees paid to, retail pharmacies in the networks, including the associated member co-payments. Our cost of product net revenues relating to drugs dispensed by our mail-order pharmacies consists primarily of the cost of inventory dispensed and our costs incurred to process and dispense the prescriptions, including the associated fixed asset depreciation. The operating costs of our call center pharmacies are also included in cost of product net revenues. In addition, cost of product net revenues includes a credit for rebates earned from brand-name pharmaceutical manufacturers whose drugs are included in our formularies. These rebates generally take the form of formulary rebates, which are earned based on the volume of a specific drug dispensed, or market share rebates, which are earned based on the achievement of contractually specified market share levels.

Our cost of product net revenues also includes the cost of drugs dispensed by our mail-order pharmacies or retail network for members covered under our Medicare PDP product offerings and are recorded at cost as incurred. We receive a catastrophic reinsurance subsidy from CMS for approximately 80% of costs incurred by individual members in excess of the individual annual out-of-pocket maximum of $4,550 for both coverage years 2011 and 2010. The subsidy is reflected as an offsetting credit in cost of product net revenues to the extent that catastrophic costs are incurred. Catastrophic reinsurance subsidy amounts received in advance are deferred and recorded in accrued expenses and other current liabilities on the consolidated balance sheets. If there are catastrophic reinsurance subsidies due from CMS, the amount is accrued and recorded in client accounts receivable, net, on the consolidated balance sheets. After the end of the contract year and based on actual annual drug costs incurred, catastrophic reinsurance amounts are reconciled with CMS and the corresponding receivable or payable is settled. Cost of service revenues consists principally of labor and operating costs for delivery of services provided, as well as costs associated with member communication materials.

SG&A expenses reflect the costs of operations dedicated to executive management, the generation of new sales, maintenance of existing client relationships, management of clinical programs, enhancement of technology capabilities, direction of pharmacy operations, and performance of reimbursement activities, in addition to finance, legal and other staff activities, and the effect of certain legal settlements. SG&A also includes advertising expenses associated with diabetes supplies, which are expensed as incurred.

Interest expense is incurred on our senior unsecured bank credit facility, accounts receivable financing facility, other short-term debt, and our senior notes, and includes net interest on our interest rate swap agreements on $200 million of the $500 million of 7.25% senior notes due in 2013. In addition, it includes amortization of the effective portion of our settled forward-starting interest rate swap agreements and amortization of debt issuance costs.

Interest (income) and other (income) expense, net, includes interest income generated by cash and cash equivalent investments, and short-term and long-term investments in marketable securities, as well as other (income) expense from the effect of foreign currency translation and our joint venture activity.

For further details, see our critical accounting policies included in “—Use of Estimates and Critical Accounting Policies and Estimates” and Note 2, “Summary of Significant Accounting Policies,” to our audited consolidated financial statements included in Part II, Items 7 and 8, respectively, of our Annual Report on Form 10-K for the fiscal year ended December 25, 2010.

Consolidated Balance Sheets

Our primary assets include cash and cash equivalents, short-term and long-term investments, manufacturer accounts receivable, client accounts receivable, inventories, fixed assets, deferred tax assets, goodwill and intangible assets. Cash and cash equivalents reflect the accumulation of net positive cash flows from our operations, investing and financing activities, and primarily include time deposits with banks or other financial institutions, and money market mutual funds. Our short-term and long-term investments include U.S. government securities that are held to satisfy statutory capital requirements for our insurance subsidiaries.

Manufacturer accounts receivable balances primarily include amounts due from brand-name pharmaceutical manufacturers for earned rebates and other prescription services. Client accounts receivable represent amounts due from clients, other payors and patients for prescriptions dispensed from retail pharmacies in our networks or from our mail-order pharmacies, including fees due to us, net of allowances for doubtful accounts, as well as contractual allowances and any applicable rebates and guarantees payable when these payables are settled on a net basis in the form of an invoice credit. In cases where rebates and guarantees are settled with the client on a net basis, and the rebates and guarantees payable are greater than the corresponding client accounts receivable balances, the net liability is reclassified to client rebates and guarantees payable. When these payables are settled in the form of a check or wire, they are recorded on a gross basis and the entire liability is reflected in client rebates and guarantees payable. Our client accounts receivable also includes receivables from CMS for our Medicare PDP product offerings and premiums from members. Additionally, we have receivables from Medicare and Medicaid for a portion of our Specialty Pharmacy business, and related to the sale of certain diabetes supplies.

Inventories reflect the cost of prescription products held for dispensing by our mail-order pharmacies and are recorded on a first-in, first-out basis, net of allowances for losses. Deferred tax assets primarily represent temporary differences between the financial statement basis and the tax basis of certain accrued expenses, stock-based compensation, and client rebate pass-back liabilities. Fixed assets include investments in our corporate headquarters, mail-order pharmacies, call center pharmacies, account service offices, and information technology, including capitalized software development. Goodwill and intangible assets for the PBM segment are comprised primarily of the goodwill and intangibles that had been pushed down to our consolidated balance sheets and existed when we became an independent, publicly traded company in 2003, and, to a significantly lesser extent, goodwill and intangibles recorded upon our acquisitions subsequent to 2003. Goodwill and intangible assets for the Specialty Pharmacy segment include goodwill and intangible assets recorded primarily from our acquisition of Accredo Health, Incorporated in 2005.

Our primary liabilities include claims and other accounts payable, client rebates and guarantees payable, accrued expenses and other current liabilities, debt and deferred tax liabilities. Claims and other accounts payable primarily consist of amounts payable to retail network pharmacies for prescriptions dispensed and services rendered by the retail pharmacies, as well as amounts payable for mail-order prescription inventory purchases and other purchases made in the normal course of business. Client rebates and guarantees payable include amounts due to clients that will ultimately be settled in the form of a check or wire, as well as any residual liability in cases where the payable is settled as an invoice credit and exceeds the corresponding client accounts receivable balances. Accrued expenses and other current liabilities primarily consist of employee- and facility-related cost accruals incurred in the normal course of business, as well as income taxes payable. Accrued expenses and other current liabilities are also comprised of certain premiums, and may also include cost share, and catastrophic reinsurance payments received in advance from CMS for our Medicare PDP product offerings. Our debt is primarily comprised of a senior unsecured term loan facility, a senior unsecured revolving credit facility, and senior notes. We anticipate refinancing our $2 billion unsecured revolving credit facility before it matures and repaying the $1 billion senior unsecured term loan at maturity. In addition, we have a net deferred tax liability primarily associated with our recorded intangible assets. We do not have any material off-balance sheet arrangements, other than purchase commitments and lease obligations. See “—Commitments and Contractual Obligations” below.

Our stockholders’ equity includes an offset for purchases of our common stock under our share repurchase programs. The accumulated other comprehensive loss component of stockholders’ equity includes: unrealized investment gains and losses, foreign currency translation adjustments resulting primarily from the translation of the assets, liabilities and results of operations of Europa Apotheek Venlo B.V. (“Europe Apotheek”), unrealized gains and losses on effective cash flow hedges, and the net gains and losses and prior service costs and credits related to our pension and other postretirement benefit plans.

Consolidated Statements of Cash Flows

An important element of our operating cash flows is the timing of billing cycles, which are generally two-week periods of accumulated billings for retail and mail-order prescriptions. We bill the cycle activity to clients on this bi-weekly schedule and generally collect from our clients before we pay our obligations to the retail pharmacies for that same cycle. At the end of any given reporting period, unbilled PBM receivables can represent up to two weeks of dispensing activity and will fluctuate at the end of a fiscal month depending on the timing of these billing cycles. A portion of the Specialty Pharmacy business includes reimbursement by payors, such as insurance companies, under a medical benefit, or by Medicare or Medicaid. These transactions also involve higher patient co-payments than experienced in the PBM business. As a result, this portion of the Specialty Pharmacy business experiences slower accounts receivable turnover than in the aforementioned PBM cycle and has a different credit risk profile. Our operating cash flows are also impacted by timing associated with our Medicare PDP product offerings, including premiums, cost share, and catastrophic reinsurance received from CMS. In addition, our operating cash flows include tax benefits for employee stock plans up to the amount associated with compensation expense. In the nine months of 2010, our operating cash flows reflected a benefit of $194.0 million for the collection of income taxes receivable from the IRS and certain states associated with the approval of a favorable accounting method change.

Ongoing operating cash flows are associated with expenditures to support our mail-order, retail pharmacy network operations, call center pharmacies and other SG&A functions. The largest components of these expenditures include payments to retail pharmacies; mail-order inventory purchases, which are paid in accordance with payment terms offered by our suppliers to take advantage of appropriate discounts; rebate and guarantee payments to clients; employee payroll and benefits; facility operating expenses and income taxes. In addition, earned brand-name pharmaceutical manufacturers’ rebates are recorded monthly based upon prescription dispensing, with actual bills rendered on a quarterly basis and paid by the manufacturers within an agreed-upon term. Payments of rebates to clients are generally made after our receipt of the rebates from the brand-name pharmaceutical manufacturers, although some clients may receive more accelerated rebate payments in exchange for other elements of pricing in their contracts.

Ongoing investing cash flows are primarily associated with capital expenditures, including technology investments, as well as purchases of securities and other assets, and proceeds from the sale of securities and other investments, which primarily relate to investment activities of our insurance companies. Acquisitions will also generally result in cash outflows from investing activities. Ongoing financing cash flows primarily include proceeds from employee stock plans, the benefits of realized tax deductions in excess of tax benefits on compensation expense and historically, share repurchases.

Clients

We have clients in a broad range of industry categories, including various Blue Cross/Blue Shield plans; health plans; insurance carriers; third-party benefit plan administrators; employers; federal, state and local government agencies; and union-sponsored benefit plans. For the third quarter and nine months of 2011, our ten largest clients based on revenue accounted for approximately 46% of our net revenues, including UnitedHealth Group Incorporated (“UnitedHealth Group”), our largest client, which represented approximately $2,800 million and $8,500 million, or 17%, of our net revenues, respectively. For the third quarter and nine months of 2010, our ten largest clients based on revenue accounted for approximately 48% and 47% of our net revenues, respectively, including UnitedHealth Group, which represented approximately $2,700 million and $8,200 million, or 17%, of our net revenues, respectively. The UnitedHealth Group account has a lower than average mail-order penetration and, because of its size, steeper pricing than the average client, and consequently generally yields lower profitability as a percentage of net revenues than smaller client accounts. In addition, with respect to mail-order volume, which is an important contributor to our overall profitability, the mail-order volume associated with this account represented less than 10% of our overall mail-order volume for both the third quarters and nine months of 2011 and 2010. None of our other clients individually represented more than 10% of our net revenues in the third quarter and nine months of 2011 or 2010.

On July 21, 2011, we announced that our pharmacy benefit services agreement with UnitedHealth Group would not be renewed. The UnitedHealth Group contract expires on December 31, 2012.

Segment Discussion

We have two reportable segments, PBM and Specialty Pharmacy. The PBM segment primarily involves sales of traditional prescription drugs and supplies, including diabetes testing supplies and related products, to our clients and members or patients, either through our networks of contractually affiliated retail pharmacies or our mail-order pharmacies. The PBM segment also includes the operating results of Europa Apotheek, which primarily provides mail-order pharmacy services in Germany. Commencing on the September 16, 2010 acquisition date, the PBM segment includes the operating results of UBC, which extends our core capabilities in data analytics and research.

The Specialty Pharmacy segment includes the sale of specialty pharmacy products and services for the treatment of primarily complex and potentially life-threatening diseases, including specialty infusion services. We define the Specialty Pharmacy segment based on a product set and associated services, broadly characterized to include drugs that are usually high-cost, developed by biotechnology companies and often injectable or infusible, and may require elevated levels of patient support. When dispensed, these products frequently require ancillary administration equipment, special packaging, and a higher degree of patient-oriented customer service, including in-home nursing services and administration. Specialty pharmacy products and services are often covered through client PBM contracts. Specialty pharmacy products and services are also covered through medical benefit programs with the primary payors being insurance companies and government programs, and patients for amounts due for co-payments and deductibles.

The PBM segment is measured and managed on an integrated basis, and there is no distinct measurement that separates the performance and profitability of mail order and retail. We offer fully integrated PBM services to virtually all of our PBM clients and their members. The PBM services we provide to our clients are generally delivered and managed under a single contract for each client. The PBM and Specialty Pharmacy segments primarily operate in the United States and have relatively small activities in Puerto Rico, Germany and the United Kingdom. Additionally, UBC has the capability to conduct post-approval research in strategic locations worldwide, including North America, Europe and Asia.

As a result of the nature of our integrated PBM services and contracts, the chief operating decision maker views Medco’s PBM operations as a single segment for purposes of making decisions about resource allocations and in assessing performance.

For segment financial information, see “— Segment Results of Operations” below and Note 9, “Segment and Geographic Data,” to our unaudited interim condensed consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q.

Consolidated Results of Operations

The following table presents selected consolidated comparative results of operations and volume performance ($ and volumes in millions):

		Quarter												Quarter				Nine Months												Nine Months
		Ended												Ended				Ended												Ended
		September 24,												September 25,				September 24,												September 25,
		2011(1) (2)				Variance								2010(1)				2011(1) (2)				Variance								2010(1)
Net Revenues
Retail product(3)		$	10,095.2			$	194.6				2.0	%		$	9,900.6			$	30,643.8			$	692.4				2.3	%		$	29,951.4
Mail-order product			6,507.6				346.2				5.6	%			6,161.4				19,344.9				987.3				5.4	%			18,357.6
Total product(3)		$	16,602.8			$	540.8				3.4	%		$	16,062.0			$	49,988.7			$	1,679.7				3.5	%		$	48,309.0
Client and other service			249.0				40.8				19.6	%			208.2				704.5				104.6				17.4	%			599.9
Manufacturer service			129.7				80.1				N/M	*			49.6				381.9				252.6				N/M	*			129.3
Total service		$	378.7			$	120.9				46.9	%		$	257.8			$	1,086.4			$	357.2				49.0	%		$	729.2
Total net revenues(3)		$	16,981.5			$	661.7				4.1	%		$	16,319.8			$	51,075.1			$	2,036.9				4.2	%		$	49,038.2
Cost of Revenues
Product(3)		$	15,692.1			$	564.9				3.7	%		$	15,127.2			$	47,367.1			$	1,701.8				3.7	%		$	45,665.3
Service			122.3				49.2				67.3	%			73.1				365.3				166.4				83.7	%			198.9
Total cost of revenues(3)		$	15,814.4			$	614.1				4.0	%		$	15,200.3			$	47,732.4			$	1,868.2				4.1	%		$	45,864.2
Gross Margin(4)
Product		$	910.7			$	(24.1	)			(2.6	)%		$	934.8			$	2,621.6			$	(22.1	)			(0.8	)%		$	2,643.7
Product gross margin percentage			5.5	%			(0.3	)%							5.8	%			5.2	%			(0.3	)%							5.5	%
Service		$	256.4			$	71.7				38.8	%		$	184.7			$	721.1			$	190.8				36.0	%		$	530.3
Service gross margin percentage			67.7	%			(3.9	)%							71.6	%			66.4	%			(6.3	)%							72.7	%
Total gross margin		$	1,167.1			$	47.6				4.3	%		$	1,119.5			$	3,342.7			$	168.7				5.3	%		$	3,174.0
Gross margin percentage			6.9	%			—								6.9	%			6.5	%			—								6.5	%
Volume Information
Generic mail-order prescriptions			17.7				0.6				3.5	%			17.1				53.2				3.1				6.2	%			50.1
Brand mail-order prescriptions			9.7				(0.5	)			(4.9	)%			10.2				29.5				(2.4	)			(7.5	)%			31.9
Total mail-order prescriptions			27.4				0.1				0.4	%			27.3				82.7				0.7				0.9	%			82.0
Retail prescriptions			152.2				(1.8	)			(1.2	)%			154.0				471.6				2.8				0.6	%			468.8
Total prescriptions			179.6				(1.7	)			(0.9	)%			181.3				554.3				3.5				0.6	%			550.8
Adjusted prescriptions(5)			233.6				(1.6	)			(0.7	)%			235.2				717.6				4.9				0.7	%			712.7
Adjusted mail-order penetration(6)			34.8	%			0.3	%							34.5	%			34.3	%			0.1	%							34.2	%
Generic Dispensing Rate Information
Retail generic dispensing rate			75.4	%			2.3	%							73.1	%			75.0	%			2.7	%							72.3	%
Mail-order generic dispensing rate			64.8	%			2.0	%							62.8	%			64.3	%			3.2	%							61.1	%
Overall generic dispensing rate			73.8	%			2.2	%							71.6	%			73.4	%			2.8	%							70.6	%