Mhs 2010

Important disclosures appear on the last page of this report.

October 18, 2010 HEALTH SERVICES (DRUGS WHOLESALE)

Henry Fund Research

MedcoHealth Solutions (MHS) Investment Recommendation BUY

Jared Plotz, Healthcare Analyst [email protected]

Current Price $53.33

Target Price Range $64-68

Source: http://yahoo.investor.reuters.com

Key Stock Statistics 52-Week Price Range $43.45-66.94

Market Capitalization (B) $23.1

Shares Outstanding (M) 433.6

Institutional Ownership 79.3%

60-Month Beta 0.76

Dividend Yield 0.0%

Price/Earnings (ttm) 18.8

Price/Book 4.73

Price/Sales 0.37

ROA (ttm) 8.7%

ROE(ttm) 25.6%

Projected 5-Year Growth 16.9%

EPS ($) Year 2007 2008 2009 2010E 2011E 2012E EPS 1.66 2.17 2.66 3.14 3.72 4.30 All earnings represent earnings from operations and have been filtered

from net nonrecurring gains.

Valuation Models Discounted Cash Flow $70.31

Economic Profit $70.31

Relative P/E $45.89

Dividend Discount Model $68.61

INVESTMENT THESIS MedcoHealth Solutions provides clinically-driven pharmacy services designed to improve the quality of care and lower total healthcare costs for its clients and their members. The company has maintained impressive revenue and earnings growth over the last 7 years and we recommend acquiring the company below $58, for the following reasons:

� (+) Generic drug utilization has and will continue to grow as additional brand name drugs come off patent in future years, physicians’ willingness to prescribe generics increases, and patients’ desire for lower cost generic drugs increases.

� (+) International expansion in Europe using Medco’s services model, will increase sales while increasing margins. Service margins garner 7+% gross margins compared to 5.5% product gross margins. Medco is expanding into 29 countries through a 50-50 joint venture with Celesio.

� (+) Mail-order drugs are gaining acceptance, especially among patients with chronic conditions. Chronic or complex diseases affect 50% of the US population. 96% of drug costs treat these conditions. Poor management of chronic and complex diseases can lead to $350 billion of excess total healthcare costs. Mail-order will decrease costs and raise compliance.i

� (+) Medco’s gross, operating and profit margins are below competitor Express Scripts, meaning there is plenty of room to grow. Revenue is now growing faster than SG&A (9.9% versus 1.5% in 2Q2010), which should result it operating margin expansion.

� (+) The acquisition of Accredo Health in 2005 has seen 20% plus CAGR in revenues and operating income and maintains a gross margin above 7%.

� (-) Healthcare reform has eliminated the Retirement Drug Subsidy (RDS) tax advantage and could cause clients to drop coverage.

� (-) Competitors are starting to undercut prices to steal market share. This could cause price erosion in management fees.

� (-) Express Scripts acquired WellPoint’s pharmacy benefit management business and will now have the scale needed to effectively compete with Medco.

� (-) Walgreens is starting to offer 90 day prescriptions in its pharmacy stores, which will cut into the competitive advantage that Medco’s online pharmacies provide.

Henry Fund Research

EXECUTIVE SUMMARY MedcoHealth Solutions is a Fortune 50 company that was spun off from Merck in March 2003 and has maintained a 20% CAGR in earnings per share over the following 7 years. It is the largest of the 3 big pharmacy benefit managers (PBMs) by drug spending and has over 65 million members.

While Medco’s competitors have maintained shortoutlooks and have undercut Medco prices in recent years to gain market share, they have fallen behind significantly in their value proposition. Not only has Medco drive growth and profits like its competitors, but at the same time, Medco has invested heavily in growth drivers for 2014and beyond. Medco is now well positioned to succeed long after the current generic growth wave slows in 4

We have initiated a Buy recommendation with a 12 month price target of $64-68 for Medco’s stock, representing upside over Medco’s current trading price. We believe in the growth strategies that Medco is pursuing and believe that it has the ability to drive out its competitors and possibly consolidate the industry in years to come. The company was not significantly negatively impacted during the recession and should experience positive growth regardless of the economic environment going forward.

COMPANY DESCRIPTION Medco is a pharmacy benefit management services company that provides prescription drug benefit programs designed to moderate the cost and enhance the quality of pharmacy health care.

“Medco’s products and services include benefit design and management, pharmacy network management, clinical management, specialty pharmacy solutions, diabetes management, home healthcare products and Medicare specialists and client services. It offers a wbenefit design options for appropriately sharing costs between plan sponsors and enrollees, and provides proper incentives for encouraging preferential use of more costtreatments (OTC and generics) and pharmacies (Inretail, mail-order, and special care).”ii

The company operates nine PBM mail-order facilitiescall center pharmacies. Medco’s Therapeutic Resource Centers meet the complex needs of people with chronic medical conditions including diabetes, cancer, heart disease, and asthma. Medco employs more than 1,000 specipharmacists in these centers.

Product revenues contributed 98.5% of revenueswhile service revenues contributed the other 1.5%. Of product revenues, 62% are sold through retail pharmacies, while 38% are sold via Medco’s mail-order pharmaciesCompetitor Express Scripts sells 65% of prescriptions through retail, and 35% through mail order. A further breakdown of revenues is attached to this report.

Medco is the nation’s largest purchaser of generic drugs.Medco’s primary wholesaler, AmericsourceBergen Corp. accounted for approximately 62% of overall 2009 drug purchases. The rest of drug purchases come directly from pharmaceutical manufacturers.

Henry B. Tippie School of Management

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MedcoHealth Solutions is a Fortune 50 company that was spun off from Merck in March 2003 and has maintained a 20% CAGR in earnings per share over the following 7 years. It is the largest of the 3 big pharmacy benefit managers

and has over 65 million members.

While Medco’s competitors have maintained short-term outlooks and have undercut Medco prices in recent years to gain market share, they have fallen behind significantly in their value proposition. Not only has Medco continued to drive growth and profits like its competitors, but at the same

avily in growth drivers for 2014 and beyond. Medco is now well positioned to succeed long after the current generic growth wave slows in 4-5 years.

ave initiated a Buy recommendation with a 12 month for Medco’s stock, representing 20-27%

upside over Medco’s current trading price. We believe in the growth strategies that Medco is pursuing and believe that it

rive out its competitors and possibly The company was

not significantly negatively impacted during the recession and ess of the economic

Medco is a pharmacy benefit management services company that provides prescription drug benefit programs designed to moderate the cost and enhance the quality of pharmacy

Medco’s products and services include benefit design and management, pharmacy network management, clinical management, specialty pharmacy solutions, diabetes management, home healthcare products and Medicare

ices. It offers a wide spectrum of haring costs between

plan sponsors and enrollees, and provides proper incentives for encouraging preferential use of more cost-effective treatments (OTC and generics) and pharmacies (In-network

order facilities and six Medco’s Therapeutic Resource

Centers meet the complex needs of people with chronic medical conditions including diabetes, cancer, heart disease,

Medco employs more than 1,000 specialty

revenues in 2009, e other 1.5%. Of

ues, 62% are sold through retail pharmacies, order pharmacies.

Competitor Express Scripts sells 65% of prescriptions through A further breakdown of

largest purchaser of generic drugs. Medco’s primary wholesaler, AmericsourceBergen Corp. accounted for approximately 62% of overall 2009 drug purchases. The rest of drug purchases come directly from

Source: Medco 2009 Annual Report

In 2007, Medco acquired Liberty Medical Supply, Inc. to tap into the growing diabetes care services market. Diabetes patients represent 8% of the US population and account for 15 percent of overall drug spending.iii

The company currently has international exposure in Sweden, Germany, and the UK, and will soon be expanding to Italy, France, and Spain. The company’s new joint venture with Celesio will eventually expand service to all of the EU27 member nations, Norway, and Sweden.

RECENT DEVELOPMENTS Earnings Report

In the second quarter of 2010, Medco reported record EPS of $0.77 versus $0.64 in the same quarter last year, reflecting an increase of 20.3%. Diluted EPS was $0.83, also a 20.3% increase. Net revenues for the quarter were $16.4 billion, a 9.9% increase over last year.

The company has secured more than $5 billion in netsales in 2010 and has completed roughly 95% of the 2010 planned renewals as of July 22. The company still maintains a 99%+ client retention rate which is driven by the company’s high customer satisfaction rate. Competitor Express Scripts has completed more than half of its 2011 client renewals, but is only experiencing a 95% client retention rate, indicating inferior service quality or value proposition compared to Medco.

The company has also secured $1.0 billion in 2011 netsales, and completed roughly 45% of its scheduled 2011 renewals as of July 22. The company’s generic dispensing rate was 70.6% in the quarter up from 67.3% in the same quarter last year. Adjusted prescripti6.0% and its mail-order penetration declined 0.1%.

The increased use of generics in 2Q2010 translates into record savings to clients and membermillion, as well as increasing average margins for Medco.

The earnings report was not spectacular, given that they still have significant pressure to fill their 2011 book in the next two quarters, but it was not bad either. The fact that their retention rate has not declined indicates that a large portion of their long-term contract renewals will come in the 2the year.

Share Repurchases

Medco completed its prior $3 billion stock repurchase program in the quarter, and has repurchased $696.5 million of the company’s new $3 billion repurchase program started in May 2010. The company purchased more than anticipated

THE UNIVERSITY OF IOWA Henry B. Tippie School of Management

Liberty Medical Supply, Inc. to tap into the growing diabetes care services market. Diabetes patients represent 8% of the US population and account for

The company currently has international exposure in Sweden, ny, and the UK, and will soon be expanding to Italy,

France, and Spain. The company’s new joint venture with Celesio will eventually expand service to all of the EU27 member nations, Norway, and Sweden.

In the second quarter of 2010, Medco reported record EPS of $0.77 versus $0.64 in the same quarter last year, reflecting an increase of 20.3%. Diluted EPS was $0.83, also a 20.3% increase. Net revenues for the quarter were $16.4 billion, a

The company has secured more than $5 billion in net-new sales in 2010 and has completed roughly 95% of the 2010 planned renewals as of July 22. The company still maintains a 99%+ client retention rate which is driven by the company’s

Competitor Express Scripts has completed more than half of its 2011 client renewals, but is only experiencing a 95% client retention rate, indicating inferior service quality or value proposition compared to

y has also secured $1.0 billion in 2011 net-new sales, and completed roughly 45% of its scheduled 2011 renewals as of July 22. The company’s generic dispensing rate was 70.6% in the quarter up from 67.3% in the same quarter last year. Adjusted prescription volumes were up

order penetration declined 0.1%.

The increased use of generics in 2Q2010 translates into record savings to clients and members of approximately $870 million, as well as increasing average margins for Medco.

report was not spectacular, given that they still have significant pressure to fill their 2011 book in the next two quarters, but it was not bad either. The fact that their retention rate has not declined indicates that a large portion of

contract renewals will come in the 2nd half of

Medco completed its prior $3 billion stock repurchase program in the quarter, and has repurchased $696.5 million of the company’s new $3 billion repurchase program started in

010. The company purchased more than anticipated

Henry Fund Research THE UNIVERSITY OF IOWA


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stock in the quarter due to the lower share prices. In 1Q2010, the company repurchased at an average stock price of $45.38. In 2Q2010, the company repurchased at an average stock price of $58.14. After the company finishes its latest buyback program, it will have repurchased 23% of outstanding shares over 3 years.

Margins and Cash

Gross margin declined in the quarter due to client renewal pricing, higher retail volumes, and a decline in the Accredo subsidiary’s gross margin, partially offset by generic growth and a litigation settlement. Gross margin for the second half of the year should be slightly higher than 6.7% and should average 6.7% for the FY2010.

Cash on the balance sheet has declined because of stock repurchases. Cash flow from operations has declined due to significant inventory reduction and strong retail claim volume growth in 2009.

While we may see a soft 3rd quarter due to seasonality in the business, we expect a strong finish to 2010 with record EBITDA and operating margin improvement of 8 basis points.

The company has revised its FY2010 EPS guidance upwards to $3.10-3.15/share, from $3.05-3.10/share previously. Our model forecasts earnings of $3.14/share in 2010.

Healthcare Reform

Healthcare reform does not significantly hurt Medco’s business operations. The expanded coverage of 30 million additional Americans will provide increased demand (volume) for Medco’s services. Additionally President Obama’s push for low-cost healthcare and efficient healthcare solutions will prove beneficial to Medco’s positioning strategy.

In the Medicare space, the newly enacted reform stripped away the tax advantage of the Retiree Drug Subsidy (RDS), which could cause some clients to drop or limit retiree prescription drug coverage. However 1/3 of current RDS clients are tax-exempt entities, therefore only 2/3 are at risk of dropping coverage.

INDUSTRY TRENDS “PBMs emerged in the 1980s, primarily to provide cost-effective drug distribution and claims processing for the healthcare industry. The PBM industry further evolved in response to the significant escalation of healthcare costs in the 1990s, as benefit plan sponsors sought to more aggressively contain costs. PBMs developed strategies to effectively influence both supply and demand.

On the supply side, PBMs leverage their buying power (size of networks) to negotiate purchase discounts and rebates from manufacturers, and discounts from distributors and retail pharmacies.

On the demand side, PBMs educate clients, members and physicians on cost-effective prescription medications and apply various techniques to encourage members to make cost-effective choices, such as the use of less expensive generic drugs and the more efficient mail-order channel. Generic substitution for drugs on which patents have expired is a significant and growing factor in reducing costs.”iv

Generics have driven Medco’s leading industry drug trend, drug trend being decreasing drug costs. Below is Medco’s revenues and dispensing rate for generic drugs over the last 5 years:

v MedcoHealth Solutions 2009 Annual Report

Revenues continued to maintain their healthy climb during the economic recession, partly due to a rise in the generic dispensing rate (which garner higher margins for Medco), and $17 billion in net new revenue in the last 3 years.

This rise in generic dispensing rate will continue in the next 4-5 years as additional brand name drugs come off patent as demonstrated in the chart below. This trend will enable generic dispensing rates to continue to climb, as well as Medco’s margins, due to higher rates on generics.

vi MedcoHealth Solutions BMO Capital Market Presentations Materials

Medco is on the forefront of industry innovation, distancing itself from its competitors and positioning itself as a complete solution for its clients’ members’ needs. The company is the leading specialty pharmacy and mail-order pharmacy in the world. It is also a leader in clinical innovation, leveraging its therapeutic resource centers and research in drug-to-drug and drug-to-OTC interactions.

The company is best-in-class and will continue to define the industry and be the leader in industry innovation going forward.



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MARKETS AND COMPETITION There are three main competitors in the PBM space: Medco, Express Scripts, and CVS Caremark. Express Scripts purchased WellPoint’s PBM business to become roughly the same size as Medco. Medco and Express Scripts both ate into CVS’s market share in the last few years, but CVS looks to take back some of what it lost, in the 2011 selling season.

In addition to competing with the other two big PBMs, Medco competes with a wide variety of market participants, including regional and local PBMs, Blue Cross/Blue Shield plans, insurance companies, managed care organizations, large retail pharmacy chains, large retail stores and supermarkets with in-store pharmacy operations and Internet pharmacies. Its main competitors are Aetna Inc., CIGNA Corporation, CVS Caremark Corporation, Express Scripts Inc., Humana Inc., UnitedHealth Group, Walgreen Co., and Wal-Mart Stores Inc.

Medco competes primarily in designing and administering programs and services that provide flexible and high quality prescription drug benefit management to clients and members at competitive pricing to the plan sponsor.

Medco believes that its commitment to differentiating itself from its competitors will drive success after the generic wave passes. Its competitors do not have an international presence, an online store and personal drug management system, or real-time drug-to-drug and drug-to-OTC safety checks, among other competitive advantages.

Below are tables of operating and valuation statistics for Medco’s competitors, as well as a table comparing Medco to a select industry average.

vii The highlighted competitors above are used in the Select Average below.

Medco is on par with the Select Average in price, but falls short of the average in operating and profit margins. We believe this will change as Medco increasingly leverages its services business, which maintains 7+% gross margins compared to roughly 5.5% for its product business.

ECONOMIC OUTLOOK The economic outlook for the US is neutral due to high unemployment, decreased per capita wealth resulting from continued trouble in the housing market, and high federal and state budget deficits.

While the healthcare industry traditionally remains stable in times of economic distress, which was seen at the bottom in March 2009, the industry has lagged the overall sideways market since the beginning of 2010.

The passage of President Obama’s healthcare plan lifted some uncertainty in the sector, but has also resulted in increasing costs to companies.

Outlined below is a list of economic drivers that have an effect on the healthcare industry:

Unemployment

Source: FactSet Economic Chartbookviii

Unemployment has declined slightly from its high of 10.1% in October 2009, but has steadily remained above 9.5% over the last 62+ weeks. A slight increase of 0.1% month over month in August indicates that high unemployment is showing no signs of abating. Henry Fund consensus estimate is for unemployment to stay at approximately 9.4% for the next 6 months and in the 8-9% range for the next 2 years. High unemployment is bad for all aspects of consumer spending, including healthcare. However it increases the need for cost reduction practices and services provided by Medco.

GDP Growth

Source: FactSet Economic Chartbook

Company Market Cap (B) Revenue (B) P/E (ttm) P/E (fye)Aetna 12.81 34.65 8.71 9.65

CIGNA 9.64 19.71 7.95 7.73

CVS Caremark 42.44 98.23 11.99 10.38

Express Scripts 26.20 36.26 27.57 15.28

Humana 8.61 32.44 7.50 8.89

UnitedHealth 38.62 89.94 9.24 9.76

Walgreen 32.66 67.42 16.05 11.76

Wal-Mart 197.86 416.66 13.97 12.39

Company P/S P/B Op. Margin Profit MarginAetna 0.37 1.24 7.30% 4.46%

CIGNA 0.49 1.62 10.29% 6.27%

CVS Caremark 0.44 1.21 6.49% 3.73%

Express Scripts 0.72 7.20 5.08% 2.68%

Humana 0.26 1.30 5.94% 3.55%

UnitedHealth 0.43 1.54 7.97% 4.77%

Walgreen 0.48 2.26 5.13% 3.10%

Wal-Mart 0.47 3.07 6.08% 3.54%

Industry Average Industry Median Select Average MedcoMarket Cap 46.11 29.43 33.77 22.82Revenue 99.41 51.84 67.30 62.76P/E (ttm) 12.87 10.62 18.54 18.56

P/E (fye) 10.73 10.07 12.47 13.39

P/S 0.46 0.46 0.55 0.36

P/B 2.43 1.58 3.56 4.72

Op. Margin 6.79% 6.29% 5.57% 3.75%

Profit Margin 4.01% 3.64% 3.17% 2.16%

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Real GDP growth, a barometer for the health of the economy and the deciding indicator of expansion or contraction, has declined from its peak at 5.00% Y-o-Y growth in December 2009. In June 2010, growth stood at 1.6%, and we see 2H2010 growth of 1.5%. This is bad news for the general market as the speed of the recovery is slowing and fears of slipping back into negative growth are still present. These fears could cause customers to once again cut back expenditures, increasing drug non-compliance.

Consumer Spending/Confidence


Consumer spending has thus far seen a V-shaped recovery. After bottoming in April of 2009, the US consumer has aggressively purchased goods. This purchasing is partly due to federal stimulus, including President Obama’s Cash for Clunkers automobile program and his First-time Home Buyer Credit. Both of these programs have ended, and yet spending has not seen the fall that some experts predicted. This will be a key indicator to watch going forward. Any signs of a decrease in spending could indicate more trouble to follow, but may actually increase the use of generic drugs, a key Medco strategy.

Inflation


Inflation has been very tame throughout the last year. Inflation has established itself in the 2% range for most of 2010. Fears of deflation have yet to be founded and runaway inflation has yet to be seen.

As of now, it appears that inflation in the 1.5-2.5% range should be expected going forward. This has no significant effect on Medco’s operations. In terms of industry pricing, the healthcare sector has seen vast differences. Drug pricing has been declining. Medco is part of this decline as they push for drug trend. At the same time as some of Medco’s competitors, such as CVS Caremark, have been cutting

management fees to gain market share. This could hurt the PBM space going forward.

US Dollar


The US dollar has fallen from its highs in March 2009. As international investors braced for the worse, money poured into the US dollar, considered the safest currency and government bonds available. But as the recovery has gathered steam and US stimulus activities have widened the national debt, investors have slowly left the dollar. We see the dollar remaining weak for the next 2 years. In a weak dollar environment, multinational companies based in the US benefit the most. At the same time, domestic companies also fare well. Multinationals can trade their foreign sales for more US dollars, while domestic companies see an increase in exports, due to increased demand for the now cheaper goods.

Both of these aspects should help Medco, especially in relation to their competitors. Medco’s new joint venture with Celesio should provide favorable currency exchange profits. Forward estimates of the direction of the dollar are unreliable and so we will have to wait and see.

Housing


After showing a strong recovery in late 2009, 2010 has seen a severely sharp decline in the housing market. Not only do housing prices continue to fall, but existing home sales and new home sales continue to fall as well, and foreclosure rates hit an all-time decade high in August 2010. The stimulus effects of the First-time Home Buyer Credit have elapsed and subsequently the housing market has fallen.

The housing market is showing few signs of turning around and many economists see further declines. While this economic driver doesn’t directly affect Medco’s business

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lines, the housing market affects almost all aspects of the economy indirectly. Until a sustained turnaround in the housing market is seen, we expect GDP, consumer spending, and investor confidence to continue crawling sideways. This means that demand for drug trend (cost reductions) will increase and subsequently demand for Medco’s services.

CATALYSTS FOR GROWTH Current Drivers

� Financial Strategy: Medco has squeezed significant cash out of the balance sheet, is increasing ROIC, and can pay interest payments 15 times with current cash.

� New Business: A lot of high retail Medicare business; $1.0 billion in net new sales for 2011 and 45% of renewals already completed. Retention rate above 99%.

� Mail-Order: Medco is the largest mail-order pharmacy in the world. They already have two distribution facilities in Las Vegas and New Jersey, and are opening a third in Indianapolis this year. Each facility is capable of filling 1 million prescriptions/week, meaning they now have capacity to fill 156 million prescriptions/year.

Mail-order will revolutionize the drug distribution for chronic conditions. 50% of the US population has chronic and complex diseases. 96% of drug costs treat these conditions. ix 75% of medical expenses in the US are spent on chronic conditions.x And for 88% of chronic and complex diseases, drugs are the 1st choice.xi

Mail-order will significantly decrease the costs for patients with these chronic conditions. This will help close the gaps in non-compliance. There are up to 50% non-compliance rates after one-year of therapy in many disease categories. Costs are a major contributor to this since these drugs cost patients thousands of dollars a year. This will save healthcare billions of dollars.

As compliance rates increase, costs per user decrease, as shown in the following chart:

xii MedcoHealth Solutions BMO Capital Market Presentations Materials

� Generics: Generics have a strong pipeline of drugs coming off patent in the next 5 years, especially in 2012. Medco encourages plan members to utilize generic drugs. There has been an increase in physicians’ willingness to prescribe and patients’ willingness to take and keep taking generic drugs. Generic dispensing rates at Medco are

increasing steadily around 300 basis points per year and Medco earns a higher margin on generics.

Generics sales grew 12% in 2Q2010 and the dispensing rate grew 330 basis points. Generics likewise encourage compliance among patients by decreasing drug costs.

� Specialty Pharmacy: Accredo has seen tremendous success over the last 5 years. It is a key in profitability for the company (contributing $450 million to net income in 2010) and in its breadth of services (making Medco all-encompassing). Clients like using Accredo and have incentives to use Accredo. Not only is Accredo’s care superior to competitors, but it is also cheaper.

Future Drivers

� MedcoHealth Store: Medco’s online store provides a virtual channel for patients to purchase non-prescription products, with the ability to utilize mail delivery while utilizing Medco’s safety analysis in interactions between prescription drugs and OTC drugs, vitamins, and supplements.xiii

� International: In addition to the previous strategies in Germany and the UK, Medco is in Sweden and is soon to be in 29 different countries in Europe through its 50-50 joint venture with Celesio. In Sweden, Medco transformed its software to Swedish, converted drug metrics, and has licensed its software to the Swedish government to wire drug retail in the country.

Europe has price controls, and so Medco’s joint venture will focus on its service model. Medco’s service model currently maintained gross margins of 7+%, and so any expansion in service revenues will greatly expand the company’s overall margins.

Europe is interested in technology enabled clinical capabilities that they currently don’t have. Medco will improve the quality of care and lower overall healthcare costs for payors through the joint venture. The 29 countries have a combined GDP greater than that of the US.

� ePrescribing: Medco is transforming what the web experience means to a consumer. In the future, Medco plans on putting applications on the iPhone and Verizon’s Blackberry that will allow for e-prescriptions. This will transform what a patient and a physician do in the office.

� Clinical Innovations: Through 15 Medco Therapeutic Resource Centers, customers can interact with Medco specialist pharmacists in their exact disease condition. If a patient receives a warning that two drugs they are planning on taking or have been prescribed should not be taken together or should be watched more closely, the patient will get a warning message and ask the patient if they would like a phone call to discuss. If the patient enters their phone number, a pharmacist that specializes in the patients’ precise conditions will call within 60 seconds and give real-time advice to the patient.

� Comparable Effectiveness: In 2009, the company established the Medco Research Institute, which will coordinate, extend, and amplify their internal genomics research initiatives and increase collaborations with



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institutions and organizations such as the Mayo Clinic, LabCorp,Harvard University, and the FDA.xiv

ADDITIONAL INVESTMENT POSITIVES � Medco has completed its prior $3 billion share repurchase

program and is currently aggressively using cash to pursue its new $3 billion program that was instigated in May 2010. Also Medco is buying back shares in the $45-58 range, suggesting that the stock is undervalued at current levels.

� Demand for cost reduction in medicine has grown with the downturn in the economy as well as healthcare reform’s emphasis on low-cost generics and overall cost reductions. This emphasis perfectly aligns with Medco’s strategy and value proposition.

� New regulatory pathway for the approval of generic biologics will create savings for clients, but will not be impactful for a few more years.

� New healthcare reform will also provide additional coverage for 30 million Americans, increasing demand for Medco services.

� Germany has a healthcare sector of approximately $346 billion, including a $40 billion drug industry. There is enormous wastage in noncompliance and omission of care in Germany, and as a result the country is having troubles covering costs with premium paid. Medco recently acquired Europa Apotheek in Germany to tackle this problem and close gaps.

� Medco is using its Accredo model in collaboration with the National Health Service to administer biotech infusible drugs in a home setting instead of a hospital setting at far less cost than NHS has previously been doing.

� Medco can offer 90 days worth of drugs compared to 30 days for retail pharmacies, although this may be changing soon.

ADDITIONAL INVESTMENT NEGATIVES � Product gross margin declined from 5.93% of sales in

2Q2009 to 5.44% in 2Q2010. This happened at the same time that generic penetration increased roughly 3%, meaning savings from increased generic utilization may be being passed through to customers and represent a more competitive pricing environment.xv

� UnitedHealth, Medco’s biggest client, representing 19% of company revenues is up for contract renewal in 2012. Although UnitedHealth did decide to renew their contract in 2008, there is a chance that they may wish to bring their PBM services in-house in 2012 due to their size and ability to still bargain with drug suppliers.

� Medco has not filled its 2011 sales book as quickly as competitor CVS Caremark, and CVS has acquired $10 billion in net new sales.

VALUATION

Medco hit a 2 year low in its price to earnings ratio in September but has since rebounded to slightly below its 2 year average, suggesting it is currently trading at a fair value. Medco’s price to cash flow ratio has declined significantly in the last few years and demonstrates the increasing cash flows reaped from years of capital investment.

Medco’s price to sales ratio hit a 2 year low in September, but has rebounded hence. Its price to book ratio has shot up sharply and could makes Medco appear overvalued on this basis.

Based on the attached relative valuations and discounted cash flow (DCF) model our target price for Medco is $64-68. The top end is derived from the DCF and economic profit models, and assumes the competitive environment remains stable among the “big 3” PBM’s. The lower range of $64 is incorporates relative valuation metrics, our dividend discount model, and reflects the risk of competitors undercutting Medco’s prices.

Our DCF model assumes 9.2% revenue growth in 2010, but revenue growth slowly falling to 3% per annum by 2015, and 2% growth thereafter. Gross margins are expected to grow from 6.7% in 2009 to 8.75% in 2015. Profit margins are assumed to grow from 2.14% in 2009 to 3.42% in 2015, reflecting the expansion of Medco’s services revenues as a percent of total revenues, and their subsequent 7+% gross margin versus 5.5% for product revenues.

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16

18

20

22

24

26

28

Medco Health Solutions Inc. (MHS)MHS 58405U102 2954019 NYSE Common stock19-Nov -2008 to 19-Nov -2010 (Daily ) Average: 22.1 High: 27.2 Low: 15.4 Lates t: 20.3

Price to Earnings

1/09 4/09 7/09 10/09 1/10 4/10 7/10 10/100.5

1

1.5

2

2.5

3

3.5

4

©FactSe t R esearch Sy stemsData Source : Fac tSe t Fun damentals,

Average: 1.42 High: 3.63 Low: 0.89 Lates t: 1.34Price to Cash Flow - Relativ e to FDSAGG United States / Health Serv ices -SEC

0.25

0.3

0.35

0.4

0.45

0.5

0.55

0.6

Medco Health Solu tions Inc. (MHS)MHS 58405U102 2954019 NY SE Common s tock19-Nov -2008 to 19-Nov -2010 (Daily ) Av erage: 0.4 High: 0.6 Low: 0.3 Lates t: 0.4

Price to Sales

1/09 4/09 7/09 10/09 1/10 4/10 7/10 10/101.8

2

2.2

2.4

2.6

2.8

3

3.2

©FactSe t R esearch Sy stemsData Source : Fac tSe t Fun damentals,

Average: 2.27 High: 2.97 Low: 1.96 Latest: 2.97Price to Book - Relativ e to FDSAGG United States / Health Serv ices -SEC



8

Earnings per share are expected to grow 14-17% per year over the next 5 years. ROIC is assumed to be roughly 34% in 2010 and 35% on a continuing basis after 2015, reflecting the cash-flow rich nature of the PBM industry and the relatively low need for ongoing capital investment once significant scale is attained.

We currently rate the stock a Buy with 20-27% upside over the next 12 months. If larger managed-care customers, such as UnitedHealth decide to bring PBM services in-house, we would revise our estimates downward by 20% and the stock would be fairly priced in the $53-56 range. However, we don’t expect this to happen as WellPoint’s decision to exit the PBM space with its sale of its PBM business to Express Scripts demonstrates the acknowledgement of the value-proposition that the integrated PBM’s provide.

If customer-retention slides below 98% or if Medco fails to fill its 2011 scheduled client renewals book, we would revisit our DCF model and accompanying assumptions and possibly change our recommendation. Likewise, if Medco’s non-core strategies (including its Therapeutic Resource Centers, mail-order delivery, and specialty pharmacy) fail to be met by customer demand, we may change our recommendation to reflect the wasted capital expenditures in these areas.

IMPORTANT DISCLAIMER This report was created by a student(s) enrolled in the Applied Securities Management (Henry Fund) program at the University of Iowa’s Tippie School of Management. The intent of these reports is to provide potential employers and other interested parties an example of the analytical skills, investment knowledge, and communication abilities of Henry Fund students. Henry Fund analysts are not registered investment advisors, brokers or officially licensed financial professionals. The investment opinion contained in this report does not represent an offer or solicitation to buy or sell any of the aforementioned securities. Unless otherwise noted, facts and figures included in this report are from publicly available sources. This report is not a complete compilation of data, and its accuracy is not guaranteed. From time to time, the University of Iowa, its faculty, staff, students, or the Henry Fund may hold a financial interest in the companies mentioned in this report.

REFERENCES i MedcoHealth Solutions 2Q2010 Conference Call and BMO Capital Markets Conference, slide 13 ii Life Science Analytics, Company Profile: MHS, September 13, 2010, Business description taken from MedTRACK iii MedcoHealth Solutions Company Website iv MedcoHealth Solutions 2009 Form 10-K, Industry Overview, page 4 v MedcoHealth Solutions 2009 Annual Report, page 7 vi MedcoHealth Solutions, Presentation Materials for BMO Capital Markets Conference, slide 7 vii Yahoo Finance, Key Statistics for each competitor viii FactSet Economic Chartbook ix Medco Research x Center for Disease Control xi Medco Research xii MedcoHealth Solutions BMO Capital Market Presentations Materials, slide 15 xiii MedcoHealth Solutions 2009 From 10-K, Industry Overview, page 5 xiv MedcoHealth Solutions 2009 Annual Report, page 4 xv Morningstar Report by Matthew Cofina and Karen Anderson, September 15, 2010

Henry Fund Research

THE UNIVERSITY OF IOWA


9

MedcoHealth Solutions Inc. 0.151707294 0.166729096 0.091896556 0.062787136 0.031700288 0.04 0.035 0.03

Revenue Decomposition

Fiscal Years Ending December 26 0.150457898 0.165793397 0.090891668 0.061168679 0.030126775 0.04 0.035 0.03

(in thousands) 65300000 69400000 71600000 74464000 77070240 79382347.2

64320500 68254900 70311200 72974720 75297624.48 77278715

2007A 2008A 2009A 2010E 2011E 2012E 2013E 2014E 2015E

Net Revenues

Retail Product 26,424,000 28,613,500 36,596,400 38,592,300 40,952,940 42,186,720 43,784,832 45,178,575 46,367,229

Growth 8.3% 27.9% 5.5% 6.1% 3.0% 3.8% 3.2% 2.6%

Mail-Order Product 17,537,800 21,962,700 22,365,000 25,728,200 27,301,960 28,124,480 29,189,888 30,119,050 30,911,486

Growth 25.2% 1.8% 15.0% 6.1% 3.0% 3.8% 3.2% 2.6%

Total Product 43,961,800 50,576,200 58,961,400 64,320,500 68,254,900 70,311,200 72,974,720 75,297,624 77,278,715

Client and Other Service 391,000 502,200 685,000 812,985 973,335 1,121,256 1,325,459 1,613,080 1,935,342

Growth 28.4% 36.4% 18.7% 19.7% 15.2% 18.2% 21.7% 20.0%

Manufacturer Service 153,300 179,600 157,800 166,515 171,765 167,544 163,821 159,535 168,291

Growth 17.2% -12.1% 5.5% 3.2% -2.5% -2.2% -2.6% 5.5%

Total Service 544,300 681,800 842,800 979,500 1,145,100 1,288,800 1,489,280 1,772,616 2,103,632

Total Net Revenues 44,506,100 51,258,000 59,804,200 65,300,000 69,400,000 71,600,000 74,464,000 77,070,240 79,382,347

Cost of Revenues

Product 41,402,600 47,308,200 55,523,100 60,589,911 64,159,606 65,951,906 68,304,338 70,327,981 72,023,762

Service 158,300 221,400 254,100 298,439 345,460 383,657 440,358 522,364 617,806

Total Cost of Revenues 41,560,900 47,529,600 55,777,200 60,888,350 64,505,066 66,335,562 68,744,696 70,850,345 72,641,568

Gross Margins

Product 5.82% 6.46% 5.83% 5.80% 6.00% 6.20% 6.40% 6.60% 6.80%

Service 70.92% 67.53% 69.85% 69.53% 69.83% 70.23% 70.43% 70.53% 70.63%

Total Gross Margin 6.62% 7.27% 6.73% 6.76% 7.05% 7.35% 7.68% 8.07% 8.49%

Volume Information

Retail Prescriptions 465,000 480,200 591,400 703,221 735,852 747,506 759,594 772,353 783,656

Mail-Order Prescriptions 94,800 105,800 103,100 108,000 118,952 128,451 137,312 146,742 155,114

Total Prescriptions 559,800 586,000 694,500 811,221 854,804 875,957 896,906 919,096 938,770

Adjusted Prescriptions 748,452 796,542 899,669 1,026,141 1,091,519 1,131,574 1,170,157 1,211,113 1,247,446

Adjusted Mail-Order Penetration 37.87% 39.71% 34.26% 31.47% 32.58% 33.94% 35.09% 36.23% 37.18%

General Dispensing Rate Information

Overall Generic Dispensing Rate 59.7% 64.1% 67.5% 70.0% 71.0% 74.0% 76.0% 78.0% 80.0%

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MedcoHealth Solutions Inc.

Annual Income Statement

Fiscal Years Ending December 26

(in thousands)

2007A 2008A 2009A 2010E 2011E 2012E 2013E 2014E 2015E

Total net revenues 44,506,200 51,258,000 59,804,200 65,300,000 69,400,000 71,600,000 74,464,000 77,070,240 79,382,347

Total cost of revenues 41,560,900 47,529,600 55,777,200 60,888,350 64,505,066 66,335,562 68,744,696 70,850,345 72,641,568

Gross Profit 2,945,300 3,728,400 4,027,000 4,411,650 4,894,934 5,264,438 5,719,304 6,219,895 6,740,779

Selling, general & administrative expenses 1,114,100 1,425,000 1,455,500 1,554,140 1,651,720 1,704,080 1,772,243 1,834,272 1,889,300

Amortization of intangibles 228,100 285,100 305,600 278,500 259,800 251,200 246,700 244,100 242,000

Interest expense 0 233,700 172,500 160,000 201,260 207,640 215,946 223,504 230,209

(Interest income) & other income expense, net 99,800 -6,200 -9,900 53,114 56,449 58,238 60,568 62,688 64,568

Income Before Provision for Income Taxes 1,503,300 1,790,800 2,103,300 2,365,896 2,725,705 3,043,279 3,423,847 3,855,332 4,314,702

Provision for income taxes 591,300 687,900 823,000 922,699 1,063,025 1,186,879 1,335,300 1,503,579 1,682,734

Net Income 912,000 1,102,900 1,280,300 1,443,196 1,662,680 1,856,400 2,088,547 2,351,752 2,631,968

Weighted average shares outstanding-basic 550,200 508,600 481,100 460,000 447,051 431,660 418,650 407,700 398,640

Year end shares outstanding 535,939 493,325 474,493 455,575 438,526 424,795 412,506 402,894 394,387

Net Earnings Per Share-Basic 1.66 2.17 2.66 3.14 3.72 4.30 4.99 5.77 6.60

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11


Common Size Income Statement


(in thousands) 44,506,200 51,258,000 59,804,200 65,300,000 69,400,000 71,600,000 74,464,000 77,070,240

2007A 2008A 2009A 2010E 2011E 2012E 2013E 2014E 2015E

Product net revenues 98.78% 98.67% 98.59% 98.50% 98.35% 98.20% 98.00% 97.70% 100.27%

Service revenues 1.22% 1.33% 1.41% 1.50% 1.65% 1.80% 2.00% 2.30% 2.73%

Total net revenues 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 103.00%

Cost of product net revenues 93.03% 92.29% 92.84% 92.79% 92.45% 92.11% 91.73% 91.25% 93.45%

Cost of service revenues 0.36% 0.43% 0.42% 0.46% 0.50% 0.54% 0.59% 0.68% 0.80%

Total cost of revenues 93.38% 92.73% 93.27% 93.24% 92.95% 92.65% 92.32% 91.93% 94.25%

Gross Profit 6.62% 7.27% 6.73% 6.76% 7.05% 7.35% 7.68% 8.07% 8.75%

Selling, general & administrative expenses 2.50% 2.78% 2.43% 2.38% 2.38% 2.38% 2.38% 2.38% 2.45%

Amortization of intangibles 0.51% 0.56% 0.51% 0.43% 0.37% 0.35% 0.33% 0.32% 0.31%

Interest expense 0.00% 0.46% 0.29% 0.25% 0.29% 0.29% 0.29% 0.29% 0.30%

(Interest income) & other income expense, net 0.22% -0.01% -0.02% 0.08% 0.08% 0.08% 0.08% 0.08% 0.08%

Income Before Provision for Income Taxes 3.38% 3.49% 3.52% 3.62% 3.93% 4.25% 4.60% 5.00% 5.60%

Provision for income taxes 1.33% 1.34% 1.38% 1.41% 1.53% 1.66% 1.79% 1.95% 2.18%

Net Income 2.05% 2.15% 2.14% 2.21% 2.40% 2.59% 2.80% 3.05% 3.42%

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12


Annual Balance Sheet

Fiscal Years Ending December 26 44,506,200 51,258,000 59,804,200 65,300,000 69,400,000 71,600,000 74,464,000 77,070,240 79,382,347

(in thousands) 1,114,100 1,425,000 1,455,500 1,567,200 1,665,600 1,718,400 1,787,136 1,849,686 1,905,176

2007A 2008A 2009A 2010E 2011E 2012E 2013E 2014E 2015E

Cash & cash equivalents 774,100 938,400 2,528,200 2,247,708 2,656,185 4,486,016 3,626,570 4,970,799 6,346,571

Short-term investments 70,300 64,000 20,100 77,314 82,168 84,773 88,164 91,250 93,987

Accounts receivable, net 2,856,500 3,539,400 3,828,800 4,167,132 4,428,774 4,569,168 4,751,934 4,918,252 5,065,800

Income taxes receivable 216,000 213,400 198,300 194,300 190,300 186,300 182,300 178,300 174,300

Inventories, net 1,946,000 1,856,500 1,285,300 1,720,827 2,072,723 2,390,009 2,616,431 2,708,006 2,789,246

Prepaid expenses & other current assets 285,400 326,600 67,100 255,489 291,553 317,856 347,571 375,961 407,839

Deferred tax assets 154,400 159,200 230,800 343,990 396,305 442,478 497,811 560,547 627,337

TOTAL CURRENT ASSETS 6,302,700 7,097,500 8,158,600 9,006,760 10,118,008 12,476,601 12,110,780 13,803,114 15,505,081

Noncurrent income taxes receivable 0 0 0 0 0 0 0 0 0

Property & equipment, net 725,500 854,100 912,500 1,055,418 1,121,685 1,157,243 1,203,532 1,245,656 1,283,026

Goodwill 6,230,200 6,331,400 6,333,000 6,333,000 6,333,000 6,333,000 6,333,000 6,333,000 6,333,000

Intangible assets, net 2,905,000 2,666,400 2,428,800 2,936,476 3,315,902 3,622,253 3,976,429 4,115,604 4,239,072

Other noncurrent assets 54,500 61,500 82,600 86,667 92,109 95,029 98,830 102,289 105,357

TOTAL ASSETS 16,217,900 17,010,900 17,915,500 19,418,321 20,980,704 23,684,125 23,722,571 25,599,662 27,465,536

Claims & other accounts payable 2,812,900 2,878,900 3,506,400 3,860,954 4,103,372 4,233,450 4,402,789 4,556,886 4,693,593

Client rebates & guarantees payable 1,092,200 1,658,700 2,106,900 2,300,517 2,444,960 2,522,466 2,623,364 2,715,182 2,796,637

Accrued expenses & other current l iabilities 624,100 660,400 718,600 859,882 913,872 942,842 980,556 1,014,875 1,045,321

Short-term debt 600,000 600,000 15,800 0 0 0 0 0 0

Current portion of long-term debt 0 0 0 0 0 2,000,000 400,000 400,000 0

TOTAL CURRENT LIABILITIES 5,129,200 5,798,000 6,347,700 7,021,353 7,462,204 9,698,758 8,406,709 8,686,943 8,535,552

Long-term debt, net 2,894,400 4,002,900 4,000,100 4,253,128 4,695,346 4,228,069 4,378,683 4,437,727 4,642,984

Deferred tax liabilities 1,167,000 1,065,300 958,800 1,101,257 1,170,401 1,207,503 1,255,803 1,299,757 1,338,749

Other noncurrent l iabilities 152,000 186,800 221,700 235,270 250,042 257,969 268,288 277,678 286,008

TOTAL LIABILITIES 9,342,600 11,053,000 11,528,300 12,611,009 13,577,994 15,392,299 14,309,482 14,702,105 14,803,293

Common stock 7,559,400 7,795,400 8,163,300 8,296,016 8,428,733 8,561,449 8,694,165 8,826,882 8,959,598

Accumulated other comprehensive income (loss) 6,400 -63,800 -44,200 0 0 0 0 0 0

Retained earnings 2,826,400 3,929,300 5,209,600 6,652,796 8,315,477 10,171,877 12,260,424 14,612,176 17,244,144

Shareholders' equity before treasury stock 10,392,200 11,660,900 13,328,700 14,948,813 16,744,209 18,733,326 20,954,589 23,439,058 26,203,742

Treasury stock, at cost 3,516,900 5,703,000 6,941,500 8,141,500 9,341,500 10,441,500 11,541,500 12,541,500 13,541,500

TOTAL SHAREHOLDERS' EQUITY 6,875,300 5,957,900 6,387,200 6,807,313 7,402,709 8,291,826 9,413,089 10,897,558 12,662,242

TOTAL LIABILITIES & SHAREHOLDERS' EQUITY 16,217,900 17,010,900 17,915,500 19,418,321 20,980,704 23,684,125 23,722,571 25,599,662 27,465,536

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13


Common Size Balance Sheet


(in thousands)

2007A 2008A 2009A 2010E 2011E 2012E 2013E 2014E 2015E

Cash & cash equivalents 1.74% 1.83% 4.23% 3.44% 3.83% 6.27% 4.87% 6.45% 7.99%

Short-term investments 0.16% 0.12% 0.03% 0.12% 0.12% 0.12% 0.12% 0.12% 0.12%

Income taxes receivable 0.49% 0.42% 0.33% 0.30% 0.27% 0.26% 0.24% 0.23% 0.22%

Inventories, net 4.37% 3.62% 2.15% 2.64% 2.99% 3.34% 3.51% 3.51% 3.51%

Prepaid expenses & other current assets 0.64% 0.64% 0.11% 0.39% 0.42% 0.44% 0.47% 0.49% 0.51%

Deferred tax assets 0.35% 0.31% 0.39% 0.53% 0.57% 0.62% 0.67% 0.73% 0.79%

TOTAL CURRENT ASSETS 14.16% 13.85% 13.64% 13.79% 14.58% 17.43% 16.26% 17.91% 19.53%

Noncurrent income taxes receivable 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%

Property & equipment, net 1.63% 1.67% 1.53% 1.62% 1.62% 1.62% 1.62% 1.62% 1.62%

Goodwill 14.00% 12.35% 10.59% 9.70% 9.13% 8.84% 8.50% 8.22% 7.98%

Intangible assets, net 6.53% 5.20% 4.06% 4.50% 4.78% 5.06% 5.34% 5.34% 5.34%

Other noncurrent assets 0.12% 0.12% 0.14% 0.13% 0.13% 0.13% 0.13% 0.13% 0.13%

TOTAL ASSETS 36.44% 33.19% 29.96% 29.74% 30.23% 33.08% 31.86% 33.22% 34.60%

Claims & other accounts payable 6.32% 5.62% 5.86% 5.91% 5.91% 5.91% 5.91% 5.91% 5.91%

Client rebates & guarantees payable 2.45% 3.24% 3.52% 3.52% 3.52% 3.52% 3.52% 3.52% 3.52%

Accrued expenses & other current l iabilities 1.40% 1.29% 1.20% 1.32% 1.32% 1.32% 1.32% 1.32% 1.32%

Short-term debt 1.35% 1.17% 0.03% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%

Current portion of long-term debt 0.00% 0.00% 0.00% 0.00% 0.00% 2.79% 0.54% 0.52% 0.00%

TOTAL CURRENT LIABILITIES 11.52% 11.31% 10.61% 10.75% 10.75% 13.55% 11.29% 11.27% 10.75%

Long-term debt, net 6.50% 7.81% 6.69% 6.51% 6.77% 5.91% 5.88% 5.76% 5.85%

Deferred tax liabilities 2.62% 2.08% 1.60% 0.00% 1.69% 1.69% 1.69% 1.69% 1.69%

Other noncurrent l iabilities 0.34% 0.36% 0.37% 0.36% 0.36% 0.36% 0.36% 0.36% 0.36%

TOTAL LIABILITIES 20.99% 21.56% 19.28% 19.31% 19.56% 21.50% 19.22% 19.08% 18.65%

Common stock 16.99% 15.21% 13.65% 12.70% 12.15% 11.96% 11.68% 11.45% 11.29%

Accumulated other comprehensive income (loss) 0.01% -0.12% -0.07% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%

Retained earnings 6.35% 7.67% 8.71% 10.19% 11.98% 14.21% 16.46% 18.96% 21.72%

Shareholders' equity before treasury stock 23.35% 22.75% 22.29% 22.89% 24.13% 26.16% 28.14% 30.41% 33.01%

Treasury stock, at cost 7.90% 11.13% 11.61% 12.47% 13.46% 14.58% 15.50% 16.27% 17.06%

TOTAL SHAREHOLDERS' EQUITY 15.45% 11.62% 10.68% 10.42% 10.67% 11.58% 12.64% 14.14% 15.95%

TOTAL LIABILITIES & SHAREHOLDERS' EQUITY 36.44% 33.19% 29.96% 29.74% 30.23% 33.08% 31.86% 33.22% 34.60%

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14


Annual Cash Flow Statement

Fisca l Years Ended December 26

(in thousands)

2007A 2008A 2009A 2010E 2011E 2012E 2013E 2014E 2015E

OPERATING ACTIVITIES

Net Income (loss ) 912,000 1,102,900 1,280,300 1,443,196 1,662,680 1,856,400 2,088,547 2,351,752 2,631,968

Add: Depreciation and amortization 397,000 442,800 484,600 460,445 420,284 416,682 408,519 404,461 402,093

(Increase) in receivables -30,000 -682,900 -289,400 -338,332 -261,642 -140,393 -182,767 -166,318 -147,548

(Increase) in inventories -269,200 89,500 571,200 -435,527 -351,896 -317,286 -226,422 -91,575 -81,240

(Increase) in prepaid expenses and other current assets -12,000 -41,200 259,500 -188,389 -36,064 -26,303 -29,714 -28,390 -31,879

(Increase) in income taxes receivable -3,100 2,600 15,100 4,000 4,000 4,000 4,000 4,000 4,000

Increase in cla ims & other accounts payable -71,300 66,000 627,500 354,554 242,418 130,078 169,338 154,098 136,707

Increase in cl ient rebates & guarantees payable 206,100 566,500 448,200 193,617 144,443 77,506 100,899 91,818 81,455

Increase in accrued expenses & other current l iabi l i ties -32,100 36,300 58,200 141,282 53,990 28,970 37,714 34,319 30,446

Increase in deferred taxes -42,700 106,500 178,100 -29,266 -16,830 9,072 7,033 18,783 27,798

Increase in other non-current l iabi l i ties 121,900 34,800 34,900 13,570 14,772 7,926 10,319 9,390 8,330

CF from Operating Activities 1,176,600 1,723,800 3,668,200 1,619,151 1,876,155 2,046,653 2,387,465 2,782,338 3,062,130

INVESTING ACTIVITIES

(Increase) in ST investments 1,900 -6,300 -43,900 57,214 4,854 2,605 3,391 3,086 2,737

Less : Capita l Expenditures -236,100 -265,100 -185,200 -245,000 -226,751 -201,040 -208,109 -202,484 -197,462

Less : Capita l i zation of intangible assets -381,900 0 0 -507,676 -379,426 -306,351 -354,176 -139,175 -123,468

Less : Acquis i tion of bus inesses -1,530,600 -126,500 0 0 0 0 0 0 0

(Increase) in other assets 253,100 -179,400 -210,900 -387,696 -256,062 1,714,600 -1,881,666 -300,686 -714,470

CF from Investing Activities -1,893,600 -577,300 -440,000 -1,083,158 -857,384 1,209,813 -2,440,560 -639,260 -1,032,663

FINANCING ACTIVITIES

Proceeds/Payment of notes payable & LT debt 2,424,900 1,143,300 -552,100 250,799 456,990 -459,351 160,933 68,434 213,588

Proceeds from issuance of common shares 0 0 0 0 0 0 0 0 0

Net proceeds from employee s tock transactions 208,300 60,600 152,200 132,716 132,716 132,716 132,716 132,716 132,716

Repurchases of ordinary shares -1,960,600 -2,186,100 -1,238,500 -1,200,000 -1,200,000 -1,100,000 -1,100,000 -1,000,000 -1,000,000

CF from Financing Activities 672,600 -982,200 -1,638,400 -816,485 -610,293 -1,426,635 -806,351 -798,849 -653,696

BS Cash, beginning of period 818,500 774,100 938,400 2,528,200 2,247,708 2,656,185 4,486,016 3,626,570 4,970,799

BS Cash, end of period 774,100 938,400 2,528,200 2,247,708 2,656,185 4,486,016 3,626,570 4,970,799 6,346,571

Net increase (decrease) in Cash -44,400 164,300 1,589,800 -280,492 408,477 1,829,831 -859,446 1,344,229 1,375,772

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15


Weighted Average Cost of Capital Calculation

Market Value of Debt 4,159,933 Includes short-term debt and operating leases

Market Value of Equity 24,977,800

Tax rate 39.00%

Beta Levered 0.76 Taken from Bloomberg, 5-year weekly average vs. S&P500

Return on Market 8.25%

MRP 4.50% Henry Fund consensus estimate

Weight of Equity 85.72%

Cost of Equity 8.93% Adjustment made to CAPM

Weight of Debt 14.28%

Cost of Debt, after tax 4.20% Yield on longest maturity MedcoHealth debt is 3.8%, added a premium since debt is variable interest rate

Risk Free Rate 3.75% 30-year treasury bond

WACC 8.02%

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16


Value Drivers

Fiscal Years Ended December 26(Dollars in thousands)

2007A 2008A 2009A 2010E 2011E 2012E 2013E 2014E 2015E

EBITA 1,603,100 2,018,300 2,265,900 2,579,010 2,983,414 3,309,158 3,700,361 4,141,523 4,609,479

Less: Taxes on EBITA

Marginal Tax Rate (Effective) 39.3% 38.4% 39.1% 39.0% 39.0% 39.0% 39.0% 39.0% 39.0%

Total Income Tax Provision 591,300 687,900 823,000 922,699 1,063,025 1,186,879 1,335,300 1,503,579 1,682,734

Plus: Tax Shield on Interest Expense 0 89,741 67,448 62,400 78,491 80,980 84,219 87,166 89,781

Less: Tax Shield on Interest Income 39,221 -2,381 -3,871 20,714 22,015 22,713 23,621 24,448 25,182

Taxes on EBITA 552,079 780,022 894,318 964,385 1,119,501 1,245,146 1,395,898 1,566,298 1,747,334

Plus: Change in Net Deferred Taxes -42,700 106,500 178,100 -29,266 -16,830 9,072 7,033 18,783 27,798

NOPLAT 1,008,321 1,344,778 1,549,682 1,585,358 1,847,083 2,073,084 2,311,496 2,594,008 2,889,943

INVESTED CAPITAL

Operating Working Capital:

Plus: Normal Cash (3% of sales) 774,100 938,400 1,794,126 1,959,000 2,082,000 2,148,000 2,233,920 2,312,107 2,381,470

Plus: Receivables 2,856,500 3,539,400 3,828,800 4,167,132 4,428,774 4,569,168 4,751,934 4,918,252 5,065,800

Plus: Inventory 1,946,000 1,856,500 1,285,300 1,720,827 2,072,723 2,390,009 2,616,431 2,708,006 2,789,246

Plus: Prepaid Expenses 285,400 326,600 67,100 255,489 291,553 317,856 347,571 375,961 407,839

Plus: Income Taxes Receivable 216,000 213,400 198,300 194,300 190,300 186,300 182,300 178,300 174,300

Less: Accounts Payable 2,812,900 2,878,900 3,506,400 3,860,954 4,103,372 4,233,450 4,402,789 4,556,886 4,693,593

Less: Rebates & Guarantees Payable 1,092,200 1,658,700 2,106,900 2,300,517 2,444,960 2,522,466 2,623,364 2,715,182 2,796,637

Less: Accrued Expenses 624,100 660,400 718,600 859,882 913,872 942,842 980,556 1,014,875 1,045,321

Net Operating Working Capital 1,548,800 1,676,300 841,726 1,275,395 1,603,146 1,912,574 2,125,447 2,205,682 2,283,104

Net PP&E (CapEx) 725,500 854,100 912,500 1,055,418 1,121,685 1,157,243 1,203,532 1,245,656 1,283,026

Net PV of Operating Leases 123,447 133,343 144,033 155,579 168,051 181,523 196,075 211,794 228,772

Other L-T Operating Assets 2,959,500 2,727,900 2,511,400 3,023,143 3,408,010 3,717,282 4,075,259 4,217,893 4,344,429

Other L-T Operating Liabilities 152,000 186,800 221,700 235,270 250,042 257,969 268,288 277,678 286,008

NET INVESTED CAPITAL 5,509,247 5,578,443 4,631,359 5,744,806 6,550,936 7,226,591 7,868,601 8,158,702 8,425,339

ROIC (NOPLAT/Beg. Invested Capital)

NOPLAT 1,008,321 1,344,778 1,549,682 1,585,358 1,847,083 2,073,084 2,311,496 2,594,008 2,889,943

Invested Capital (Beginning) 4,524,585 5,509,247 5,578,443 4,631,359 5,744,806 6,550,936 7,226,591 7,868,601 8,158,702

ROIC 22.29% 24.41% 27.78% 34.23% 32.15% 31.65% 31.99% 32.97% 35.42%

FREE CASH FLOW

NOPLAT 1,008,321 1,344,778 1,549,682 1,585,358 1,847,083 2,073,084 2,311,496 2,594,008 2,889,943

Net Investment (change in IC) 984,662 69,196 -947,084 1,113,447 806,130 675,655 642,010 290,101 266,637

FREE CASH FLOW (NOPLAT-Net Invest) 23,660 1,275,582 2,496,766 471,912 1,040,953 1,397,428 1,669,486 2,303,907 2,623,306

ECONOMIC PROFIT

Invested Capital (Beginning) 4,524,585 5,509,247 5,578,443 4,631,359 5,744,806 6,550,936 7,226,591 7,868,601 8,158,702

ROIC 22.29% 24.41% 27.78% 34.23% 32.15% 31.65% 31.99% 32.97% 35.42%

WACC 8.02% 8.02% 8.02% 8.02% 8.02% 8.02% 8.02% 8.02% 8.02%

EP (Invested Capital*(ROIC-WACC)) 645,605 903,126 1,102,482 1,214,082 1,386,546 1,547,924 1,732,171 1,963,217 2,235,895

NON-OPERATING ASSETS

Cash on Hand 774,100 938,400 2,528,200 2,247,708 2,656,185 4,486,016 3,626,570 4,970,799 6,346,571

"Normal" Cash 774,100 938,400 1,794,126 1,959,000 2,082,000 2,148,000 2,233,920 2,312,107 2,381,470

Excess Cash - - 734,074 288,708 574,185 2,338,016 1,392,650 2,658,691 3,965,101

Short-term Investments 70,300 64,000 20,100 77,314 82,168 84,773 88,164 91,250 93,987

NON-OPERATING ASSETS 70,300 64,000 754,174 366,022 656,353 2,422,790 1,480,814 2,749,941 4,059,088

Henry Fund Research



17


Fiscal Years Ended December 31

DCF Model 2010E 2011E 2012E 2013E 2014E CV

Period 1 2 3 4 5 5

FCF 471,912 1,040,953 1,397,428 1,669,486 2,303,907 45,321,006

PV of FCF 436,888 892,175 1,108,813 1,226,369 1,566,798 30,821,067

Total PV of FCF 36,052,111

+ PV of non-operarting assets 366,022

- PV of Debt 4,015,900

- PV of operating leases 144,033

- PV of ESOP 750,840

- PV of Und. Fund Pension 82,500

PV of Equity 31,424,860

Shares Outstanding 474,493

Target 2009 Price 66.23

Target Adjusted Price 70.31 As of 10/9/2010

EP Model

ROIC 34.23% 32.15% 31.65% 31.99% 32.97% 35.42%

EP 1,214,082 1,386,546 1,547,924 1,732,171 1,963,217 37,162,304

PV of EP 1,123,978 1,188,375 1,228,226 1,272,416 1,335,108 25,272,649

Total PV of EP 36,052,111

+ PV of non-operating assets 366,022

- PV of Debt 4,015,900

- PV of operating leases 144,033

- PV of ESOP 750,840

- PV of Und. Fund Pension 82,500

PV of Equity 31,424,860

Shares Outstanding 474,493

Target 2009 Price 66.23

Target Adjusted Price 70.31 As of 10/9/2010

Discounted Cash Flow (DCF) and Economic Profit (EP) Model Valuation

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18

Sensitivity Analysis

70.31 0.005 0.01 0.015 0.02 0.025 0.03 0.035 70.31 0.005 0.01 0.015 0.02 0.025 0.03 0.035

0.0652 78.38 84.12 91.00 99.40 109.90 123.38 141.32 0.264 58.74 61.64 64.99 68.90 73.51 79.05 85.81

0.0702 70.93 75.61 81.14 87.76 95.86 105.97 118.96 0.294 58.85 61.89 65.38 69.46 74.28 80.06 87.12

0.0752 64.55 68.41 72.92 78.24 84.62 92.42 102.16 0.324 58.95 62.08 65.70 69.92 74.91 80.89 88.19

0.0802 59.02 62.25 65.97 70.31 75.43 81.58 89.08 0.354 59.02 62.25 65.97 70.31 75.43 81.58 89.08

0.0852 54.19 56.91 60.01 63.59 67.77 72.70 78.62 0.384 59.09 62.39 66.19 70.63 75.87 82.16 89.83

0.0902 49.93 52.23 54.85 57.84 61.28 65.30 70.05 0.414 59.14 62.50 66.38 70.90 76.24 82.65 90.48

0.0952 46.14 48.11 50.33 52.85 55.72 59.04 62.90 0.444 59.19 62.61 66.55 71.14 76.57 83.08 91.03

70.31 0.005 0.01 0.015 0.02 0.025 0.03 0.035 70.31 0.0390 0.0410 0.0430 0.0450 0.0470 0.0490 0.0510

0.074 75.04 80.29 86.54 94.11 103.48 115.35 130.90 0.0255 102.68 97.53 92.81 88.46 84.44 80.72 77.26

0.079 69.01 73.44 78.64 84.86 92.40 101.77 113.69 0.0295 93.97 89.53 85.43 81.63 78.11 74.82 71.76

0.084 63.71 67.48 71.86 77.02 83.20 90.73 100.10 0.0335 86.44 82.56 78.97 75.63 72.51 69.59 66.86

0.089 59.02 62.25 65.97 70.31 75.43 81.58 89.08 0.0375 79.85 76.45 73.27 70.31 67.53 64.92 62.47

0.094 54.84 57.62 60.81 64.49 68.78 73.87 79.98 0.0415 74.05 71.03 68.20 65.56 63.07 60.72 58.51

0.099 51.09 53.51 56.25 59.39 63.03 67.28 72.33 0.0455 68.89 66.20 63.67 61.29 59.05 56.93 54.92

0.104 47.71 49.82 52.20 54.90 58.00 61.60 65.81 0.0495 64.29 61.87 59.59 57.44 55.41 53.48 51.66

70.31 0.005 0.01 0.015 0.02 0.025 0.03 0.035 70.31 0.0743 0.0793 0.0843 0.0893 0.0943 0.0993 0.1043

0.0285 67.97 72.25 77.27 83.26 90.50 99.45 110.79 0.0330 95.99 86.43 78.36 71.46 65.49 60.27 55.68

0.0315 64.77 68.65 73.18 78.54 84.96 92.81 102.63 0.0360 95.36 85.90 77.91 71.07 65.15 59.98 55.42

0.0345 61.79 65.33 69.43 74.24 79.96 86.89 95.45 0.0390 94.73 85.38 77.46 70.69 64.82 59.68 55.16

0.0375 59.02 62.25 65.97 70.31 75.43 81.58 89.08 0.0420 94.11 84.86 77.02 70.31 64.49 59.39 54.90

0.0415 55.61 58.47 61.76 65.56 70.00 75.28 81.64 0.0450 93.50 84.34 76.58 69.93 64.16 59.10 54.65

0.0455 52.48 55.04 57.95 61.29 65.17 69.74 75.18 0.0480 92.90 83.83 76.15 69.55 63.83 58.82 54.39

0.0495 49.61 51.89 54.48 57.44 60.85 64.82 69.51 0.0510 92.30 83.33 75.72 69.18 63.51 58.53 54.14

Rf

CV Growth Rate Re

Rf

Rd

CV Growth Rate

Wac

c

CV

RO

IC

CV Growth Rate MRP

CV Growth Rate

Re

Henry Fund Research



19

Ticker Company Price EPS 2010E EPS 2011E P/E 2010 P/E 2011

AET Aetna 30.69 3.2 3.18 9.59 9.65

CI CIGNA 35.42 4.42 4.58 8.01 7.73

CVS CVS Caremark 31.25 2.71 3.01 11.53 10.38

ESRX Express Scripts 48.3 2.5 3.16 19.32 15.28

HUM Humana 50.85 6.35 5.72 8.01 8.89

UNH UnitedHealth 34.35 3.6 3.52 9.54 9.76

WAG Walgreen 33.98 2.51 2.89 13.54 11.76

WMT Wal-Mart 54.41 4.01 4.39 13.57 12.39

Average 14.49 12.45

MHS MedcoHealth 52.62 3.14 3.72 16.77 14.15

Implied Value Relative to Express Scripts

Relative P/E (EPS10) 45.46$ 60.61$

Relative P/E (EPS11) 46.32$ 56.85$

Average 45.89$ 58.73$

**Only highlighted competitors used in P/E analysis**


Relative P/E Analysis

Henry Fund Research



20

MedcoHealth Solutions, Inc.

1 2 3 4

CV Growth Rate 2.00% 2010E 2011E 2012E 2013E 2014E CV

Cost of Equity 8.04% EPS $3.14 $3.72 $4.30 $4.99 $5.77

CV ROE 24.15% PE Multiple 15.19

Future Cash Flows* $0.00 $0.00 $0.08 $0.16 $0.20 $87.62

PV of Future Cash Flows $0.00 $0.00 $0.06 $0.12 $0.15 $64.31

FY2009 P/E Target Price $64.64

Adjusted Target Price 68.61$

**Assuming that Medco begins using cash flow to pay dividends in 2012**

Fundamental P/E DDM

Health & Medicine

Mhs 2010