##### Table of Contents

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



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(Mark One)

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



For the quarterly period ended September 25, 2004



OR



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



For the transition period from  to



Commission File Number: 1-31312



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MEDCO HEALTH SOLUTIONS, INC.

(Exact name of registrant as specified in its charter)



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|                                               |  |                                     
|---------------------------------------------- |  | ------------------------------------
|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



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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  x    No ̈



Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).    Yes ̈No  x



As of the close of business on
October 25, 2004, the registrant had 272,495,769 shares of common stock, $0.01 par value, issued and outstanding.



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##### Table of Contents

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 25, 2004 and December 27, 2003                                              |  | 1 
|                               |  |                                                                                                                                          
|                               |  | Condensed Consolidated Statements of Income (Unaudited)  Fiscal Quarters and Nine Months Ended September 25, 2004 and September 27, 2003 |  | 2 
|                               |  |                                                                                                                                          
|                               |  | Condensed Consolidated Statement of Stockholders Equity (Unaudited)  Fiscal Nine Months Ended September 25, 2004                        |  | 3 
|                               |  |                                                                                                                                          
|                               |  | Condensed Consolidated Statements of Cash Flows (Unaudited)  Fiscal Nine Months Ended September 25, 2004 and September 27, 2003          |  | 4 
|                               |  |                                                                                                                                          
|                               |  | Notes to Condensed Consolidated Financial Statements (Unaudited)                                                                          |  | 5 
|                               |  |                                                                                                                                          
|Item 2.                        |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                                                     |  | 17
|                               |  |                                                                                                                                          
|Item 3.                        |  | Quantitative and Qualitative Disclosures About Market Risk                                                                                |  | 29
|                               |  |                                                                                                                                          
|Item 4.                        |  | Controls and Procedures                                                                                                                   |  | 29
|                               | 
|PART II  OTHER INFORMATION    |  |                                                                                                                                          
|                               |  |                                                                                                                                          
|Item 1.                        |  | Legal Proceedings                                                                                                                         |  | 30
|                               |  |                                                                                                                                          
|Item 2.                        |  | Unregistered Sales of Equity Securities and Use of Proceeds                                                                               |  | 30
|                               |  |                                                                                                                                          
|Item 3.                        |  | Defaults Upon Senior Securities                                                                                                           |  | 30
|                               |  |                                                                                                                                          
|Item 4.                        |  | Submission of Matters to a Vote of Security Holders                                                                                       |  | 30
|                               |  |                                                                                                                                          
|Item 5.                        |  | Other Information                                                                                                                         |  | 30
|                               |  |                                                                                                                                          
|Item 6.                        |  | Exhibits                                                                                                                                  |  | 30
|                               | 
|SIGNATURES                     |  | 31                                                                                                                                       



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##### Table of Contents

PART I - FINANCIAL INFORMATION



Item 1. Financial Statements



MEDCO HEALTH SOLUTIONS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(UNAUDITED)

(In millions, except for
share data)



|                                                                                                                                                                             |  |                   |          |   |                  |   |          |  
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------- | -------- | - | ---------------- | - | -------- | -
|                                                                                                                                                                             |  | September 25,2004 |          |   | December 27,2003 |  
|ASSETS                                                                                                                                                                       |  |                   |          |   |                  |   |          |  
|                                                                                                                                                                             |  |                  
|Current assets:                                                                                                                                                              |  |                   |          |   |                  |   |          |  
|Cash and cash equivalents                                                                                                                                                    |  | $                 | 1,000.5  |   |                  | $ | 638.5    |  
|Short-term investments                                                                                                                                                       |  |                   | 57.5     |   |                  |   | 59.5     |  
|Accounts receivable, net                                                                                                                                                     |  |                   | 1,589.2  |   |                  |   | 1,394.0  |  
|Inventories, net                                                                                                                                                             |  |                   | 1,204.1  |   |                  |   | 1,213.4  |  
|Prepaid expenses and other current assets                                                                                                                                    |  |                   | 80.2     |   |                  |   | 95.5     |  
|Deferred tax assets                                                                                                                                                          |  |                   | 191.9    |   |                  |   | 359.4    |  
|                                                                                                                                                                             |  |                   |          |   |                  |   |          |  
|Total current assets                                                                                                                                                         |  |                   | 4,123.4  |   |                  |   | 3,760.3  |  
|                                                                                                                                                                             |  |                  
|Property and equipment, net                                                                                                                                                  |  |                   | 664.8    |   |                  |   | 757.3    |  
|Goodwill, net                                                                                                                                                                |  |                   | 3,310.2  |   |                  |   | 3,310.2  |  
|Intangible assets, net                                                                                                                                                       |  |                   | 2,185.6  |   |                  |   | 2,320.5  |  
|Other noncurrent assets                                                                                                                                                      |  |                   | 127.3    |   |                  |   | 114.7    |  
|                                                                                                                                                                             |  |                   |          |   |                  |   |          |  
|Total assets                                                                                                                                                                 |  | $                 | 10,411.3 |   |                  | $ | 10,263.0 |  
|                                                                                                                                                                             |  |                   |          |   |                  |   |          |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                         |  |                   |          |   |                  |   |          |  
|                                                                                                                                                                             |  |                  
|Current liabilities:                                                                                                                                                         |  |                   |          |   |                  |   |          |  
|Claims and other accounts payable                                                                                                                                            |  | $                 | 2,168.6  |   |                  | $ | 1,988.2  |  
|Accrued expenses and other current liabilities                                                                                                                               |  |                   | 342.0    |   |                  |   | 567.1    |  
|Current portion of long-term debt                                                                                                                                            |  |                   | 80.0     |   |                  |   | 50.0     |  
|                                                                                                                                                                             |  |                   |          |   |                  |   |          |  
|Total current liabilities                                                                                                                                                    |  |                   | 2,590.6  |   |                  |   | 2,605.3  |  
|Noncurrent liabilities:                                                                                                                                                      |  |                   |          |   |                  |   |          |  
|Long-term debt, net                                                                                                                                                          |  |                   | 1,194.3  |   |                  |   | 1,346.1  |  
|Deferred tax liabilities                                                                                                                                                     |  |                   | 1,047.0  |   |                  |   | 1,177.5  |  
|Other noncurrent liabilities                                                                                                                                                 |  |                   | 58.3     |   |                  |   | 54.1     |  
|                                                                                                                                                                             |  |                   |          |   |                  |   |          |  
|Total liabilities                                                                                                                                                            |  |                   | 4,890.2  |   |                  |   | 5,183.0  |  
|                                                                                                                                                                             |  |                   |          |   |                  |   |          |  
|Commitments and contingencies (See Note 11)                                                                                                                                  |  |                   |          |   |                  |   |          |  
|                                                                                                                                                                             |  |                  
|Stockholders equity:                                                                                                                                                        |  |                   |          |   |                  |   |          |  
|Preferred stock, par value $0.01authorized: 10,000,000 shares; issued and outstanding: 0                                                                                    |  |                   |         |   |                  |   |         |  
|Common stock, par value $0.01authorized: 1,000,000,000 shares; issued and outstanding: 272,224,089 shares at September 25, 2004 and
270,532,667 shares at December 27, 2003 |  |                   | 2.7      |   |                  |   | 2.7      |  
|Accumulated other comprehensive income                                                                                                                                       |  |                   |         |   |                  |   |         |  
|Additional paid-in capital                                                                                                                                                   |  |                   | 5,002.2  |   |                  |   | 4,913.4  |  
|Unearned compensation                                                                                                                                                        |  |                   | (4.0     | ) |                  |   | (7.4     | )
|Retained earnings                                                                                                                                                            |  |                   | 520.2    |   |                  |   | 171.3    |  
|                                                                                                                                                                             |  |                   |          |   |                  |   |          |  
|Total stockholders equity                                                                                                                                                   |  |                   | 5,521.1  |   |                  |   | 5,080.0  |  
|                                                                                                                                                                             |  |                   |          |   |                  |   |          |  
|Total liabilities and stockholders equity                                                                                                                                   |  | $                 | 10,411.3 |   |                  | $ | 10,263.0 |  
|                                                                                                                                                                             |  |                   |          |   |                  |   |          |  



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



1



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##### Table of Contents

MEDCO HEALTH SOLUTIONS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(UNAUDITED)

(In millions, except for
per share data)



|                                                                                                                                                                                  |  |                   |         |                   |   |                   |  |                   |          |  |   |          |  
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------- | ------- | ----------------- | - | ----------------- |  | ----------------- | -------- |  | - | -------- | -
|                                                                                                                                                                                  |  | Quarters Ended    |         | Nine Months Ended |  
|                                                                                                                                                                                  |  | September 25,2004 |         | September 27,2003 |   | September 25,2004 |  | September 27,2003 |         
|Product net revenues (Includes retail co-payments of $1,631 and $1,686 in the third quarters of 2004 and 2003, and $5,121 and $5,030 in the
nine months of 2004 and 2003)         |  | $                 | 8,615.3 |                   | $ | 8,447.9           |  | $                 | 26,201.6 |  | $ | 25,003.6 |  
|                                                                                                                                                                                  |  |                   |         |                  
|Service revenues                                                                                                                                                                  |  |                   | 81.3    |                   |   | 76.1              |  |                   | 237.1    |  |   | 259.0    |  
|                                                                                                                                                                                  |  |                   |         |                   |   |                   |  |                   |          |  |   |          |  
|Total net revenues                                                                                                                                                                |  |                   | 8,696.6 |                   |   | 8,524.0           |  |                   | 26,438.7 |  |   | 25,262.6 |  
|                                                                                                                                                                                  |  |                   |         |                   |   |                   |  |                   |          |  |   |          |  
|Cost of operations:                                                                                                                                                               |  |                   |         |                   |   |                   |  |                   |          |  |   |          |  
|Cost of product net revenues (Includes retail co-payments of $1,631 and $1,686 in the third quarters of 2004 and 2003, and $5,121 and $5,030
in the nine months of 2004 and 2003) |  |                   | 8,238.7 |                   |   | 8,087.5           |  |                   | 25,068.9 |  |   | 24,012.6 |  
|Cost of service revenues                                                                                                                                                          |  |                   | 32.2    |                   |   | 47.7              |  |                   | 95.7     |  |   | 140.9    |  
|                                                                                                                                                                                  |  |                   |         |                   |   |                   |  |                   |          |  |   |          |  
|Total cost of revenues (see Note 9 for a description of transactions with Merck)                                                                                                  |  |                   | 8,270.9 |                   |   | 8,135.2           |  |                   | 25,164.6 |  |   | 24,153.5 |  
|Selling, general and administrative expenses                                                                                                                                      |  |                   | 170.8   |                   |   | 184.8             |  |                   | 506.6    |  |   | 515.5    |  
|Amortization of intangibles                                                                                                                                                       |  |                   | 45.0    |                   |   | 23.6              |  |                   | 134.9    |  |   | 70.7     |  
|Interest and other (income) expense, net                                                                                                                                          |  |                   | 12.6    |                   |   | 8.7               |  |                   | 48.0     |  |   | (3.4     | )
|                                                                                                                                                                                  |  |                   |         |                   |   |                   |  |                   |          |  |   |          |  
|Total cost of operations                                                                                                                                                          |  |                   | 8,499.3 |                   |   | 8,352.3           |  |                   | 25,854.1 |  |   | 24,736.3 |  
|                                                                                                                                                                                  |  |                   |         |                   |   |                   |  |                   |          |  |   |          |  
|Income before provision for income taxes                                                                                                                                          |  |                   | 197.3   |                   |   | 171.7             |  |                   | 584.6    |  |   | 526.3    |  
|Provision for income taxes                                                                                                                                                        |  |                   | 79.2    |                   |   | 71.4              |  |                   | 235.7    |  |   | 218.8    |  
|                                                                                                                                                                                  |  |                   |         |                   |   |                   |  |                   |          |  |   |          |  
|Net income                                                                                                                                                                        |  | $                 | 118.1   |                   | $ | 100.3             |  | $                 | 348.9    |  | $ | 307.5    |  
|                                                                                                                                                                                  |  |                   |         |                   |   |                   |  |                   |          |  |   |          |  
|Basic earnings per share:                                                                                                                                                         |  |                   |         |                   |   |                   |  |                   |          |  |   |          |  
|Weighted average shares outstanding                                                                                                                                               |  |                   | 272.1   |                   |   | 270.0             |  |                   | 271.4    |  |   | 270.0    |  
|                                                                                                                                                                                  |  |                   |         |                   |   |                   |  |                   |          |  |   |          |  
|Earnings per share                                                                                                                                                                |  | $                 | 0.43    |                   | $ | 0.37              |  | $                 | 1.29     |  | $ | 1.14     |  
|                                                                                                                                                                                  |  |                   |         |                   |   |                   |  |                   |          |  |   |          |  
|Diluted earnings per share:                                                                                                                                                       |  |                   |         |                   |   |                   |  |                   |          |  |   |          |  
|Weighted average shares outstanding                                                                                                                                               |  |                   | 274.2   |                   |   | 270.2             |  |                   | 274.2    |  |   | 270.1    |  
|                                                                                                                                                                                  |  |                   |         |                   |   |                   |  |                   |          |  |   |          |  
|Earnings per share                                                                                                                                                                |  | $                 | 0.43    |                   | $ | 0.37              |  | $                 | 1.27     |  | $ | 1.14     |  
|                                                                                                                                                                                  |  |                   |         |                   |   |                   |  |                   |          |  |   |          |  



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



2



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##### Table of Contents

MEDCO HEALTH SOLUTIONS, INC.

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS EQUITY

(UNAUDITED)



|                                                                |  |                                |  |                                            |     |                                            |   |                           |  |                      |         |  |                  |      |                          |  |   |       |  |   |        
|--------------------------------------------------------------- |  | ------------------------------ |  | ------------------------------------------ | --- | ------------------------------------------ | - | ------------------------- |  | -------------------- | ------- |  | ---------------- | ---- | ------------------------ |  | - | ----- |  | - | -------
|                                                                |  | Number ofShares (In Thousands) |  | ($ in millions, except for per share data)
|                                                                |  | Common Stock                   |  | $0.01Par ValueCommonStock                  |     | AccumulatedOtherComprehensiveIncome (Loss) |   | Additional Paid-inCapital |  | UnearnedCompensation |         |  | RetainedEarnings |      | TotalStockholdersEquity
|Balances at December 27, 2003                                   |  | 270,533                        |  | $                                          | 2.7 |                                            | $ |                          |  | $                    | 4,913.4 |  | $                | (7.4 | )                        |  | $ | 171.3 |  | $ | 5,080.0
|                                                                |  |                                |  |                                            |     |                                            |   |                           |  |                      |         |  |                  |      |                          |  |   |       |  |   |        
|Net income                                                      |  |                               |  |                                            |    |                                            |   |                          |  |                      |        |  |                  |     |                          |  |   | 348.9 |  |   | 348.9  
|                                                                |  |                                |  |                                            |     |                                            |   |                           |  |                      |         |  |                  |      |                          |  |   |       |  |   |        
|Total comprehensive income                                      |  |                               |  |                                            |    |                                            |   |                          |  |                      |        |  |                  |     |                          |  |   | 348.9 |  |   | 348.9  
|                                                                |  |                                |  |                                            |     |                                            |  
|Issuance of common stock for options exercised                  |  | 1,503                          |  |                                            |    |                                            |   |                          |  |                      | 45.2    |  |                  |     |                          |  |   |      |  |   | 45.2   
|                                                                |  |                                |  |                                            |     |                                            |  
|Issuance of common stock under the Employee Stock Purchase Plan |  | 172                            |  |                                            |    |                                            |   |                          |  |                      | 5.1     |  |                  |     |                          |  |   |      |  |   | 5.1    
|                                                                |  |                                |  |                                            |     |                                            |  
|Restricted stock unit activity                                  |  | 16                             |  |                                            |    |                                            |   |                          |  |                      | 0.2     |  |                  | 3.4  |                          |  |   |      |  |   | 3.6    
|                                                                |  |                                |  |                                            |     |                                            |  
|Adjustment to deferred taxes existing as of the spin-off date   |  |                               |  |                                            |    |                                            |   |                          |  |                      | 38.3    |  |                  |     |                          |  |   |      |  |   | 38.3   
|                                                                |  |                                |  |                                            |     |                                            |   |                           |  |                      |         |  |                  |      |                          |  |   |       |  |   |        
|Balances at September 25, 2004                                  |  | 272,224                        |  | $                                          | 2.7 |                                            | $ |                          |  | $                    | 5,002.2 |  | $                | (4.0 | )                        |  | $ | 520.2 |  | $ | 5,521.1
|                                                                |  |                                |  |                                            |     |                                            |   |                           |  |                      |         |  |                  |      |                          |  |   |       |  |   |        



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



3



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##### Table of Contents

MEDCO HEALTH SOLUTIONS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

($ in millions)



|                                                                                  |  |                   |         |   |                   |   |          |  
|--------------------------------------------------------------------------------- |  | ----------------- | ------- | - | ----------------- | - | -------- | -
|                                                                                  |  | Nine Months Ended |        
|                                                                                  |  | September 25,2004 |         |   | September 27,2003 |  
|Cash flows from operating activities:                                             |  |                   |         |   |                   |   |          |  
|Net income                                                                        |  | $                 | 348.9   |   |                   | $ | 307.5    |  
|Adjustments to reconcile net income to net cash provided by operating activities: |  |                   |         |   |                   |   |          |  
|Depreciation                                                                      |  |                   | 157.5   |   |                   |   | 139.1    |  
|Amortization of intangibles                                                       |  |                   | 134.9   |   |                   |   | 70.7     |  
|Deferred income taxes                                                             |  |                   | 75.3    |   |                   |   | (11.8    | )
|Other                                                                             |  |                   | 24.5    |   |                   |   | 24.4     |  
|Net changes in assets and liabilities:                                            |  |                   |         |   |                   |   |          |  
|Accounts receivable                                                               |  |                   | (197.2  | ) |                   |   | 175.4    |  
|Inventories                                                                       |  |                   | 9.3     |   |                   |   | (51.1    | )
|Other noncurrent assets                                                           |  |                   | (16.1   | ) |                   |   | 18.4     |  
|Current liabilities                                                               |  |                   | (44.7   | ) |                   |   | 493.9    |  
|Other noncurrent liabilities                                                      |  |                   | 2.1     |   |                   |   | 18.5     |  
|Other                                                                             |  |                   | 15.3    |   |                   |   | (2.3     | )
|                                                                                  |  |                   |         |   |                   |   |          |  
|Net cash provided by operating activities                                         |  |                   | 509.8   |   |                   |   | 1,182.7  |  
|                                                                                  |  |                   |         |   |                   |   |          |  
|Cash flows from investing activities:                                             |  |                   |         |   |                   |   |          |  
|Capital expenditures                                                              |  |                   | (65.0   | ) |                   |   | (99.7    | )
|Purchases of securities and other investments                                     |  |                   | (49.2   | ) |                   |   | (128.3   | )
|Proceeds from sale of securities and other investments                            |  |                   | 45.6    |   |                   |   | 121.1    |  
|                                                                                  |  |                   |         |   |                   |   |          |  
|Net cash used by investing activities                                             |  |                   | (68.6   | ) |                   |   | (106.9   | )
|                                                                                  |  |                   |         |   |                   |   |          |  
|Cash flows from financing activities:                                             |  |                   |         |   |                   |   |          |  
|Proceeds from long-term debt                                                      |  |                   | 800.0   |   |                   |   | 1,396.0  |  
|Repayments on long-term debt                                                      |  |                   | (920.0  | ) |                   |   |         |  
|Net proceeds under accounts receivable facility                                   |  |                   |        |   |                   |   | 100.0    |  
|Debt issuance costs                                                               |  |                   | (4.2    | ) |                   |   | (19.1    | )
|Proceeds from employee stock plans                                                |  |                   | 45.0    |   |                   |   |         |  
|Dividends paid to Merck                                                           |  |                   |        |   |                   |   | (2,000.0 | )
|Intercompany transfer from Merck, net                                             |  |                   |        |   |                   |   | 231.8    |  
|                                                                                  |  |                   |         |   |                   |   |          |  
|Net cash used by financing activities                                             |  |                   | (79.2   | ) |                   |   | (291.3   | )
|                                                                                  |  |                   |         |   |                   |   |          |  
|Net increase in cash and cash equivalents                                         |  | $                 | 362.0   |   |                   | $ | 784.5    |  
|Cash and cash equivalents at beginning of period                                  |  | $                 | 638.5   |   |                   | $ | 14.4     |  
|                                                                                  |  |                   |         |   |                   |   |          |  
|Cash and cash equivalents at end of period                                        |  | $                 | 1,000.5 |   |                   | $ | 798.9    |  
|                                                                                  |  |                   |         |   |                   |   |          |  



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



4



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##### Table of Contents

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. (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, which include adjustments of a normal recurring nature necessary for a fair presentation
of the financial position, results of operations and cash flows at the dates and for the periods presented, have been included. 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 consolidated financial statements and notes thereto as of December 27, 2003 included in the Companys Annual Report on Form 10-K. The
Companys fiscal third quarters ended on the last Saturday of September and consisted of 13 weeks for both 2004 and 2003.



2. ACCOUNTS RECEIVABLE, NET



Accounts receivable, net includes billed and estimated unbilled receivables from manufacturers and clients. In addition, rebates payable to clients are
estimated and accrued as a reduction in accounts receivable, net, based upon the prescription drugs dispensed by the pharmacies in the Companys retail networks, or dispensed by the Companys mail order pharmacies. Unbilled receivables
from manufacturers are generally billed beginning 30 days from the end of each quarter. Unbilled receivables from clients are typically billed within 14 days based on the contractual billing schedule agreed upon with each client. At the end of any
given reporting period, unbilled receivables from clients will 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. As of September 25, 2004 and December
27, 2003, respectively, unbilled receivables from clients and manufacturers amounted to $1,883.4 million and $1,279.1 million. Accounts receivable are presented net of allowance for doubtful accounts of $5.6 million and $6.4 million at September 25,
2004 and December 27, 2003, respectively. When rebates payable to clients exceed the accounts receivable from clients, including unbilled receivables, the net liability is reclassified to claims and other accounts payable.



3. STOCK-BASED COMPENSATION



Prior to the spin-off from Merck & Co., Inc. (Merck) on
August 19, 2003 (the spin-off), the Companys employees had participated in Merck stock option plans under which employees were granted options to purchase shares of Merck common stock at the fair market value on the date of grant.
These options generally were exercisable in three to five years and expired within five to 15 years from the date of grant. Certain Merck stock options granted in 2002 and 2003 converted to Medco options upon the spin-off (the Converted
Options). The rate of conversion was determined based on a formula that preserved the economic position of the option holder immediately before and after the spin-off. Subsequent to the spin-off, the Company granted Medco options to employees
to purchase shares of Medco common stock at the fair market value on the date of grant.



The Company accounts for employee options to purchase stock, and for employee participation in the Medco Health Solutions, Inc., 2003 Employee Stock Purchase Plan (2003 ESPP) and the Medco Health
Solutions, Inc., 2001 Employee Stock Purchase Plan (2001 ESPP), under the intrinsic value method of expense recognition in Accounting Principles Board No. 25, Accounting for Stock Issued to Employees (APB 25), as
permitted by Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (SFAS 123). Under the intrinsic value method, compensation expense is the amount by which the market price of the
underlying stock exceeds the exercise price of an option on the date of grant. Employee stock options are granted to purchase shares of stock at the fair market value on the date of grant. Accordingly, no compensation expense has been recognized in
the Companys unaudited interim condensed consolidated statements of income for the Medco options, Merck options, 2003 ESPP or the 2001 ESPP.



5



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##### Table of Contents

If the fair value method of accounting for the Medco options, Merck options, 2003 ESPP and the 2001 ESPP
had been applied, net income in the periods during 2004 and 2003 would have been reduced. The fair value method requires recognition of compensation expense ratably over the vesting period. Prior to December 28, 2003, pro forma compensation expense
utilizing the fair value method of accounting for the Companys stock options had been calculated using the Black-Scholes model based on a single-option valuation approach using the straight-line method of amortization. In January 2004, the
Company revised the assumptions utilized by the Black-Scholes model in determining pro forma compensation expense, based on current option exercise data, such that the expense is determined using separate expected term assumptions for each vesting
tranche, with the expense attributed under the method prescribed in Financial Accounting Standards Board (FASB) Interpretation No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans
(FIN 28). As a result, beginning in January 2004, the Company has calculated pro forma compensation expense for any stock options granted since that time using the FIN 28 methodology. For the quarter and nine months ended September 25,
2004, this change in methodology resulted in an increase of $3.0 million, net of tax, and $6.8 million, net of tax, respectively, in the pro forma compensation expense over the amount calculated had the single-option value straight-line method of
amortization been utilized.



The pro forma effect on net income
and earnings per share if the Company had applied the fair value method for recognizing employee stock-based compensation to the Medco options, Merck options, 2003 ESPP and 2001 ESPP is as follows ($ in millions, except for per share data):



|                                                                      |  |                   |       |   |                   |   |       |                   |  |   |                   |   |  |   |       |  
|--------------------------------------------------------------------- |  | ----------------- | ----- | - | ----------------- | - | ----- | ----------------- |  | - | ----------------- | - |  | - | ----- | -
|                                                                      |  | Quarters Ended    |       |   | Nine Months Ended |  
|                                                                      |  | September 25,2004 |       |   | September 27,2003 |   |       | September 25,2004 |  |   | September 27,2003 |  
|Net income, as reported(1)                                            |  | $                 | 118.1 |   |                   | $ | 100.3 |                   |  | $ | 348.9             |   |  | $ | 307.5 |  
|Medco stock-based compensation expense, net of tax(2)                 |  |                   | (24.1 | ) |                   |   | (11.9 | )                 |  |   | (68.2             | ) |  |   | (20.3 | )
|                                                                      |  |                   |       |   |                   |   |       |                   |  |   |                   |   |  |   |       |  
|Pro forma net income including Medco stock-based compensation expense |  |                   | 94.0  |   |                   |   | 88.4  |                   |  |   | 280.7             |   |  |   | 287.2 |  
|Merck stock-based compensation expense, net of tax(3)                 |  |                   |      |   |                   |   | (75.7 | )                 |  |   |                  |   |  |   | (98.3 | )
|                                                                      |  |                   |       |   |                   |   |       |                   |  |   |                   |   |  |   |       |  
|Pro forma net income including all stock-based compensation expense   |  | $                 | 94.0  |   |                   | $ | 12.7  |                   |  | $ | 280.7             |   |  | $ | 188.9 |  
|                                                                      |  |                   |       |   |                   |   |       |                   |  |   |                   |   |  |   |       |  
|Basic earnings per common share:                                      |  |                   |       |   |                   |   |       |                   |  |   |                   |   |  |   |       |  
|As reported                                                           |  | $                 | 0.43  |   |                   | $ | 0.37  |                   |  | $ | 1.29              |   |  | $ | 1.14  |  
|Pro forma                                                             |  | $                 | 0.35  |   |                   | $ | 0.05  |                   |  | $ | 1.03              |   |  | $ | 0.70  |  
|Diluted earnings per common share:                                    |  |                   |       |   |                   |   |       |                   |  |   |                   |   |  |   |       |  
|As reported                                                           |  | $                 | 0.43  |   |                   | $ | 0.37  |                   |  | $ | 1.27              |   |  | $ | 1.14  |  
|Pro forma                                                             |  | $                 | 0.34  |   |                   | $ | 0.05  |                   |  | $ | 1.02              |   |  | $ | 0.70  |  

---

Notes

|(1) | Subsequent to the spin-off in August 2003, the Company granted 474,300 restricted stock units to key employees and
directors. The restricted stock units generally vest over two or three years. Additionally, in April 2004, the Company granted 14,000 restricted stock units to directors which vest over one year and amounted to $0.5 million recorded within
stockholders equity. The Company recorded unearned compensation within stockholders equity at an amount equivalent to the market value on the date of grant, and is amortizing such amount to compensation expense over the vesting period.
Net income, as reported, includes stock-based compensation expense related to the restricted stock units for the quarter and nine months ended September 25, 2004 of $0.7 million ($1.1 million pre-tax) and $2.1 million ($3.6 million pre-tax),
respectively. For both the quarter and nine months ended September 27, 2003, compensation expense related to the restricted stock units was $0.2 million ($0.3 million pre-tax). At September 25, 2004, the net unearned compensation recorded within
stockholders equity is $4.0 million.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | For the quarter ended September 25, 2004, the Medco pro forma stock-based compensation expense, determined using the fair
value method for stock-based awards, net of tax, includes $15.6 million ($26.1 million pre-tax) for the Medco options, $8.3 million ($13.8 million pre-tax) for the Converted Options, as well as $0.2 million ($0.3 million pre-tax) for the 2003 ESPP.
For the nine months ended September 25, 2004, the Medco pro forma stock -
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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based compensation expense, determined using the fair value method for stock-based awards, net of tax,
includes $42.9 million ($71.9 million pre-tax) for the Medco options, $24.7 million ($41.5 million pre-tax) for the Converted Options, as well as $0.6 million ($1.0 million pre-tax) for the 2003 ESPP. Prior to the spin-off, the Converted Options
were valued with option assumptions applicable to Merck and upon spin-off were re-valued using the SFAS 123 fair value method assumptions applicable to Medco. The resulting increase in the fair values of the Converted Options is recognized ratably
over the remaining vesting period of the option grant.

|(3) | The Company is reflecting the Merck stock-based compensation for its employees in the pro forma net income for the periods
the Company was wholly-owned by Merck. Upon spin-off from Merck, the Companys employees had no remaining service requirements to Merck and the Merck stock options became fully vested, with the third quarter 2003 compensation expense of $75.7
million reflecting the accelerated vesting. Therefore, there has been no impact on the Companys post spin-off pro forma earnings, nor will there be any impact on future pro forma earnings relating to the Merck options.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The fair value was estimated using the Black-Scholes option-pricing model based on the weighted average market price on the grant date and weighted average assumptions specific to the underlying option. The Medco volatility assumption is
based on the volatility of the largest competitors within the pharmacy benefit manager (PBM) industry because of Medcos short history as a publicly traded enterprise. The historical Merck assumptions relate to Merck stock and were
therefore based on Mercks valuation assumptions. The assumptions utilized for option grants during the periods presented are as follows:



|                                                                  |  |                   |   |  |                   |   |  |                   |   |  |                   |  
|----------------------------------------------------------------- |  | ----------------- | - |  | ----------------- | - |  | ----------------- | - |  | ----------------- | -
|                                                                  |  | Quarters Ended    |   |  | Nine Months Ended |  
|                                                                  |  | September 25,2004 |   |  | September 27,2003 |   |  | September 25,2004 |   |  | September 27,2003 |  
|Medco stock options Black-Scholes assumptions (weighted average): |  |                   |   |  |                   |   |  |                   |   |  |                   |  
|Dividend yield                                                    |  | 0                 | % |  | 0                 | % |  | 0                 | % |  | 0                 | %
|Risk-free interest rate                                           |  | 2.9               | % |  | 3.0               | % |  | 3.1               | % |  | 3.0               | %
|Volatility                                                        |  | 45.0              | % |  | 45.0              | % |  | 45.0              | % |  | 45.0              | %
|Expected life (years)                                             |  | 3.1               |   |  | 4.7               |   |  | 5.5               |   |  | 4.7               |  
|Merck stock options Black-Scholes assumptions (weighted average): |  |                   |   |  |                   |   |  |                   |   |  |                   |  
|Dividend yield                                                    |  | N/A               |   |  | N/A               |   |  | N/A               |   |  | 2.6               | %
|Risk-free interest rate                                           |  | N/A               |   |  | N/A               |   |  | N/A               |   |  | 2.4               | %
|Volatility                                                        |  | N/A               |   |  | N/A               |   |  | N/A               |   |  | 31.0              | %
|Expected life (years)                                             |  | N/A               |   |  | N/A               |   |  | N/A               |   |  | 5.1               | %



4. EARNINGS PER SHARE
(EPS)



The following is a reconciliation of
the number of weighted average shares used in the basic and diluted EPS calculation for all periods presented (amounts in millions):



|                                                      |  |                   |  |                   |  |                   |  |                  
|----------------------------------------------------- |  | ----------------- |  | ----------------- |  | ----------------- |  | -----------------
|                                                      |  | Quarters Ended    |  | Nine Months Ended
|                                                      |  | September 25,2004 |  | September 27,2003 |  | September 25,2004 |  | September 27,2003
|Weighted average shares outstanding                   |  | 272.1             |  | 270.0             |  | 271.4             |  | 270.0            
|Dilutive common stock equivalents:                    |  |                   |  |                   |  |                   |  |                  
|Outstanding stock options and restricted stock units  |  | 2.1               |  | 0.2               |  | 2.8               |  | 0.1              
|                                                      |  |                   |  |                   |  |                   |  |                  
|Weighted average shares outstanding assuming dilution |  | 274.2             |  | 270.2             |  | 274.2             |  | 270.1            
|                                                      |  |                   |  |                   |  |                   |  |                  



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For the quarter and nine months ended September 25, 2004, there were outstanding options to purchase 7.0
million shares and 1.4 million shares, respectively, of Medco stock where the exercise price of the options exceeded the average stock price, which is calculated as the average of the NYSE price for each trading day in the fiscal period.
Accordingly, these options are excluded from the diluted EPS calculation.



5. INTANGIBLE ASSETS



Intangible assets,
principally comprised of the recorded value of Medcos customer relationships at the time of Mercks acquisition of the Company in 1993, are as follows ($ in millions):



|                              |  |                   |         |   |                  |   |         |  
|----------------------------- |  | ----------------- | ------- | - | ---------------- | - | ------- | -
|                              |  | September 25,2004 |         |   | December 27,2003 |  
|Cost                          |  | $                 | 3,172.2 |   |                  | $ | 3,172.2 |  
|Less accumulated amortization |  |                   | (986.6  | ) |                  |   | (851.7  | )
|                              |  |                   |         |   |                  |   |         |  
|Intangible assets, net        |  | $                 | 2,185.6 |   |                  | $ | 2,320.5 |  
|                              |  |                   |         |   |                  |   |         |  



During 2003,
intangible assets associated with the acquisition of the Company by Merck in 1993 were amortized on a straight-line basis over a weighted average useful life of 35 years. Effective December 28, 2003, the Company revised the weighted average useful
life to 23 years, which resulted in an annual amortization expense increase of $85.6 million, or $21.4 million per quarter. Aggregate intangible asset amortization expense for each of the five succeeding fiscal years is estimated to be $180 million.



6. REFINANCING AND INTEREST RATE SWAP AGREEMENTS



On March 26, 2004, the Company completed a refinancing of its senior secured
term loan facilities which resulted in an extinguishment of the pre-existing $900 million term loan facility and the establishment of a new $800 million facility. The refinancing resulted in a one-time charge in the first quarter of 2004 to write
off $5.5 million for deferred debt issuance costs associated with the original term loans. During the fiscal third quarter of 2004, the Company made a $20 million term loan installment payment as required under the provisions of its credit
agreement.



The Company also entered into five interest rate
swap agreements in February and March of 2004. These swap agreements, in effect, converted $200 million of the $500 million of 7.25% senior notes to variable interest rates. The swaps have been designated as fair value hedges and have an expiration
date of August 15, 2013 consistent with the maturity date of the senior notes. The fair value of the derivatives outstanding was a net payable of $2.0 million as of September 25, 2004 and is recorded in other noncurrent liabilities, with an
offsetting amount recorded in long-term debt, net. This is the amount that the Company would have had to pay to third parties if the derivative contracts had been settled. Under the terms of the swap agreements, the Company receives a fixed rate of
interest of 7.25% on $200 million and pays variable interest rates based on the six-month London Interbank Offered Rate (LIBOR) plus a weighted average spread of 3.05%. The payment dates under the agreements coincide with the interest
payment dates on the hedged debt instruments, and the difference between the amounts paid and received is included in interest and other (income) expense, net. Interest expense was reduced by $1.4 million and $3.3 million for the quarter and nine
months ended September 25, 2004, respectively, as a result of the swap agreements.



The weighted average LIBOR rate associated with the swap agreements was 1.50% for the quarter and 1.31% for the nine months ended September 25, 2004. On September 28, 2004, which is included in the fiscal fourth
quarter of 2004, the Company paid down $80 million of the term loan facility, $20 million of which was a required installment payment.



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##### Table of Contents

7. PENSION AND OTHER POSTRETIREMENT BENEFITS



Net Pension and Postretirement Benefit Cost. The Company and its subsidiaries have various plans covering
substantially all of their employees. The Company uses its fiscal year-end date as the measurement date for the majority of its plans. The net cost for the Companys pension plans, principally the Medco Health Solutions Cash Balance Retirement
Plan, consisted of the following components:



Medco Health
Solutions Cash Balance Retirement Plan ($ in millions):



|                                         |  |                   |      |   |                   |   |      |                   |  |   |                   |   |  |   |      |  
|---------------------------------------- |  | ----------------- | ---- | - | ----------------- | - | ---- | ----------------- |  | - | ----------------- | - |  | - | ---- | -
|                                         |  | Quarters Ended    |      |   | Nine Months Ended |  
|                                         |  | September 25,2004 |      |   | September 27,2003 |   |      | September 25,2004 |  |   | September 27,2003 |  
|Service cost                             |  | $                 | 3.8  |   |                   | $ | 3.9  |                   |  | $ | 11.6              |   |  | $ | 11.7 |  
|Interest cost                            |  |                   | 1.2  |   |                   |   | 1.3  |                   |  |   | 4.2               |   |  |   | 3.9  |  
|Expected return on plan assets           |  |                   | (1.9 | ) |                   |   | (1.7 | )                 |  |   | (5.7              | ) |  |   | (5.2 | )
|Net amortization of unrecognized amounts |  |                   | (0.1 | ) |                   |   | 0.5  |                   |  |   | 0.3               |   |  |   | 1.6  |  
|                                         |  |                   |      |   |                   |   |      |                   |  |   |                   |   |  |   |      |  
|Net pension cost                         |  | $                 | 3.0  |   |                   | $ | 4.0  |                   |  | $ | 10.4              |   |  | $ | 12.0 |  
|                                         |  |                   |      |   |                   |   |      |                   |  |   |                   |   |  |   |      |  



The Company maintains
an unfunded postretirement healthcare benefit plan for its employees. The net cost of these postretirement benefits, other than pensions, consisted of the following components ($ in millions):



|                                     |  |                   |      |                   |                   |   |                   |  |   |                   |   |  |   |     
|------------------------------------ |  | ----------------- | ---- | ----------------- | ----------------- | - | ----------------- |  | - | ----------------- | - |  | - | ----
|                                     |  | Quarters Ended    |      | Nine Months Ended
|                                     |  | September 25,2004 |      |                   | September 27,2003 |   | September 25,2004 |  |   | September 27,2003
|Service cost                         |  | $                 | 0.6  |                   |                   | $ | 4.2               |  | $ | 1.6               |   |  | $ | 12.5
|Interest cost                        |  |                   | 0.7  |                   |                   |   | 1.8               |  |   | 1.7               |   |  |   | 5.4 
|Amortization of prior service costs  |  |                   | (1.1 | )                 |                   |   | 0.6               |  |   | (3.3              | ) |  |   | 1.8 
|Net amortization of actuarial losses |  |                   | 0.6  |                   |                   |   | 0.5               |  |   | 1.8               |   |  |   | 1.5 
|                                     |  |                   |      |                   |                   |   |                   |  |   |                   |   |  |   |     
|Net post-retirement benefit cost     |  | $                 | 0.8  |                   |                   | $ | 7.1               |  | $ | 1.8               |   |  | $ | 21.2
|                                     |  |                   |      |                   |                   |   |                   |  |   |                   |   |  |   |     



In the fourth quarter
of 2003, the Company amended the postretirement health benefit plan. The amendment included changes to age and service requirements, introduction of limitations on company subsidies to be based on 2004 costs, and reduced subsidies for spouses and
dependents.



Employer Contributions. For the
quarter and nine months of 2004, contributions of $2.8 million were made to the Companys cash balance retirement plan. The Company is presently evaluating additional funding strategies and anticipates making additional 2004 contributions in
the range of $5 million to $10 million to achieve certain funding objectives.



8. RESTRUCTURING COSTS



The Company made
decisions in 2003 to streamline its dispensing pharmacy and call center pharmacy operations, including the closure of some sites and the re-balancing of other facilities, and also to reduce resources in some of its corporate functions. These
decisions resulted in additional period expense recorded in the unaudited interim condensed consolidated statements of income of $7.4 million and $26.6 million in the third quarter and nine months of 2004, respectively, and $23.8 million and $50.2
million in the third quarter and nine months of 2003, respectively. The 2004 expenses are comprised of non-cash expenses representing a reduction in estimated depreciable asset useful lives to complete the depreciation by the date of the facility
closure, as well as other facility closing costs. The 2003 expenses are primarily comprised of severance and accelerated depreciation. The following table provides a summary of accrued severance activity during the nine months of 2004 ($ in
millions):



|                         |  |                   |       |  
|------------------------ |  | ----------------- | ----- | -
|                         |  | Accrued Severance |      
|As of December 27, 2003  |  | $                 | 27.9  |  
|Payments                 |  |                   | (19.2 | )
|Adjustments              |  |                   | (2.2  | )
|                         |  |                   |       |  
|As of September 25, 2004 |  | $                 | 6.5   |  
|                         |  |                   |       |  



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9. TRANSACTIONS WITH MERCK



The Company was a wholly-owned subsidiary of Merck from November 18, 1993 through August 19, 2003, the spin-off date. For
the year-to-date through August 19, 2003, selling, general and administrative expenses included $0.4 million in expense allocations related to various services that Merck provided to the Company during the first quarter of 2003. Subsequent to this
date, there are no allocated costs included in selling, general and administrative expenses. The following table presents a summary of the additional transactions with Merck for the third quarter and year-to-date through August 19, 2003 ($ in
millions):



|                                          |  |                                 |       |                                   |   |      
|----------------------------------------- |  | ------------------------------- | ----- | --------------------------------- | - | -----
|                                          |  | Quarter Ended September 27,2003 |       | Nine MonthsEndedSeptember 27,2003
|Sales to Merck for PBM and other services |  | $                               | 18.7  |                                   | $ | 78.0 
|Cost of inventory purchased from Merck    |  | $                               | 223.0 |                                   | $ | 930.4
|Gross rebates received from Merck         |  | $                               | 74.2  |                                   | $ | 301.1



Inventory purchased
from Merck was recorded at a price that the Company believes approximated the price an unrelated third party would pay.



For further information relating to agreements with Merck and the associated risks, refer to the Companys Annual Report on Form 10-K for the fiscal
year ended December 27, 2003.



10. INCOME TAXES



During the second quarter of 2004, the Company completed a study of its
state tax position for the apportionment of its income, based on its business activities and tax strategies existing as of the spin-off date as a stand-alone tax payer. The study included formalization during the second quarter of its state income
tax position through rulings from and discussions with taxing authorities in key selected states. As a result of the outcome of the study, the Company has determined that its income taxes as a stand-alone tax payer should be provided at a lower
effective rate than the rate it used as a member of the Merck consolidated group.



For all periods presented, the Companys balance sheet reflects a net deferred tax liability, which arises from its deferred tax liabilities, principally on its intangible assets being only partially offset by
its deferred tax assets, principally on client rebates payable and other accruals. Accordingly, a reduction in the Companys effective tax rate results in a benefit from the reduction of that net deferred tax liability. This net deferred tax
liability was originally recorded on the Companys financial statements through an intercompany transaction with Merck that became part of the Companys additional paid-in capital.



The Company expects to settle its net deferred tax liability as a stand-alone
tax payer at an effective rate lower than it expected to settle as a member of the Merck consolidated group. As a result, the Company in the second quarter of 2004 reduced its net deferred tax liability existing as of the spin-off date, and recorded
the benefit as a $38.3 million credit to additional paid-in capital. The Company also adjusted its net deferred tax liability in the second quarter of 2004 for temporary differences arising since the spin-off through income tax expense, the impact
of which was not material.



11. COMMITMENTS AND CONTINGENCIES



In the normal course of business, the Company enters into
purchase commitments covering inventory requirements of its mail order pharmacies for periods of generally up to one year. These commitments generally reflect the minimum purchase requirements of these pharmaceutical manufacturers and distributors.
As of September 25, 2004, contractual obligations for these purchase commitments totaled $9.7 million for the remainder of 2004.



Government Proceedings and Requests for Information. On September 29, 2003, the U.S. Attorneys Office for the Eastern District of
Pennsylvania filed a complaint in the U.S. District Court for the Eastern District of Pennsylvania,



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alleging violations of the federal False Claims Act and asserting other legal claims. The complaint alleges, among other
things, that the Company canceled and later re-entered prescriptions in order to avoid violating contractual guarantees regarding prescription dispensing turnaround times in its mail order pharmacies; dispensed fewer pills than reported to the
patient and charged clients based on the reported number of units dispensed; favored the products of certain manufacturers, including Merck, over less expensive products; and engaged in improper pharmacy practices. On December 9, 2003, the U.S.
Attorneys Office filed an amended complaint that adds two former employees of the Company as defendants and, among other additional legal claims, asserts a claim against the Company under the Public Contracts Anti-Kickback Act for allegedly
making improper payments to health plans to induce such plans to select the Company as a PBM for government contracts. The Commonwealth of Massachusetts and the State of Nevada intervened in the action.



The U.S. Attorneys Offices filing of the complaint and the
amended complaint followed its June 23, 2003 filing of a notice of intervention with respect to two pendingqui tam, or whistleblower, complaints originally filed in February 2000 under the federal False Claims Act and similar state laws.
Thequi tam actions are currently pending. In one of the actions, Merck is named as a defendant.



On December 19, 2003, the Company filed a motion to dismiss the U.S. Attorneys Offices complaint and the twoqui tam actions discussed
above. On September 23, 2004, the court granted the Companys motion with respect to the governments claims for active and constructive fraud, and dismissed that count with prejudice. The court denied the remainder of the Companys
motion. In addition, on October 12, 2004, the whistleblower plaintiffs voluntarily dismissed the States of Florida and Illinois, the Commonwealth of Virginia, and the District of Columbia from their complaint.



On April 26, 2004, the Company entered into a settlement of the U.S.
Attorneys lawsuit with regard to the governments claims for injunctive, or non-monetary, relief. Under the settlement, the Company has agreed, among other things, to assume certain disclosure obligations to clients, physicians and
patients, primarily concerning therapeutic interchanges and rebates. In connection with this settlement, the Commonwealth of Massachusetts and the State of Nevada, both of which had previously intervened in the U.S. Attorneys lawsuit, have
released the Company of any claims. There have been no negotiations with the U.S. Attorneys Office with regard to a monetary settlement. In its lawsuit, the U.S. Attorneys Office seeks, among other things, to impose monetary damages and
fines that could have a material adverse impact on the Companys results of operations and financial condition.



The Company continues to believe that its business practices comply in all material respects with applicable laws and regulations and it will continue to
vigorously defend itself in these actions.



On June 1, 2004,
the Company received notification from the U.S. Attorneys Office for the Eastern District of Pennsylvania that the U.S. District Court for the Eastern District of Pennsylvania had granted a motion filed at the Companys request allowing
the Company to publicly disclose the existence of a separatequi tam action in which the Company is named as one of various defendants (the Complaint).



The Complaint remains under seal. The Company has not seen the Complaint and does not know the identity of the relator or
the other defendants or the time period at issue. The government has not requested any information or action from the Company with respect to the Complaint. The Company does not know when the government will decide whether to intervene in support of
any or all of the allegations.



According to the U.S.
Attorneys Office, the Complaint, which was filed under seal on September 26, 2003, contains the following primary allegations. The relator alleges that the Company conspired to defraud the Medicare and Medicaid programs in violation of the
False Claims Act, 31 U.S.C. §§ 3733,et seq., as well as various state laws relating to false claims. Specifically, the relator alleges that the Company, and other defendants, caused false claims to be presented to federal Medicaid
and Public Health Services entities by falsely reclassifying rebates and discounts on certain prescription drugs as data or service fees, or educational grants.



The relator further alleges that, under the Medicaid Rebate Program, drug
manufacturers are required to pay quarterly rebates to the forty-eight states that participate in such program. According to the relator, such quarterly rebates are based in part on the best price available for a manufacturers
covered outpatient drugs. The relator alleges that the Company,



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and other defendants, inflated manufacturers best prices and undervalued the quarterly rebates paid to
Medicaid states by failing to include all cash discounts, free goods that are contingent on any purchase requirement, volume discounts, and rebates offered by the manufacturer during a given rebate period.



The relator alleges that the Company and other defendants offered and paid
kickbacks to third parties to induce the placement on formularies and promotion of certain drugs. The letter from the U.S. Attorneys Office does not identify the alleged kickbacks, recipients and/or drugs.



No further information with regard to the Complaint has been made available
to the Company. The U.S. Attorneys Office has not indicated whether it intends to intervene in the matter, and has not as yet requested any information from the Company with regard to the Complaint. Accordingly, the Company is not in a
position to evaluate the Complaint or speculate on the timing of any related proceedings in the matter.



The Company believes that its business practices are in compliance in all material respects with applicable laws and regulations and intends to defend the
action vigorously.



On December 22, 2003, the Board of the
State Teachers Retirement System of Ohio (STRS), a former client, filed a complaint against Merck and the Company in the Ohio Court of Common Pleas. STRS alleges, among other things, that the Company overcharged STRS on mail order dispensing fees;
charged more for generic drugs filled through mail order than retail pharmacies charge for the same drugs; canceled and re-entered prescription orders in order to meet contractual performance guarantees regarding turnaround times; undercounted
pills; and engaged in other unlawful pharmacy practices. Many of the allegations appear to be taken directly from the complaint filed by the U.S. Attorneys Office first discussed above. STRS asserts claims against the Company for breach of
contract, against Merck for tortious interference with contract, and against both Merck and the Company for breach of fiduciary duties, violation of state consumer protection and deceptive trade practices laws, unjust enrichment, and fraud. In July
2004, the court denied Merck and the Companys motions to dismiss the complaint.



ERISA and Similar Litigation. On December 17, 1997, a lawsuit captionedGruer v.Merck-Medco Managed Care, L.L.C. was filed in the U.S. District Court for the Southern District of New York
against Merck and the Company. The suit alleges that the Company should be treated as a fiduciary under the provisions of ERISA and that the Company has breached fiduciary obligations under ERISA in connection with the Companys
development and implementation of formularies, preferred drug listings and intervention programs. After theGruer case was filed, six other cases were filed in the same court asserting similar claims; one of these cases was voluntarily
dismissed. The plaintiffs in these cases, who are individual plan members and claim to represent the interests of six different pharmaceutical benefit plans for which the Company is the PBM, contend that, in accepting and retaining certain rebates,
the Company has failed to make adequate disclosure and has acted in the Companys own best interest and against the interests of the Companys clients. The plaintiffs also allege that the Company was wrongly used to increase Mercks
market share, claiming that under ERISA the Companys drug formulary choices and therapeutic interchange programs were prohibited transactions that favor Mercks products. The plaintiffs have demanded that Merck and the Company
turn over any unlawfully obtained profits to a trust to be set up for the benefit plans.



In December 2002, Merck and the Company agreed to settle theGruer series of lawsuits on a class action basis to avoid the significant cost and distraction of protracted litigation. Merck, the Company, and the
plaintiffs in five of these six cases filed a proposed class action settlement with the court. On May 25, 2004, the court granted final approval to the settlement, ruling, among other things, that the settlement was fair, reasonable, and adequate to
members of the settlement class. On June 28, 2004, the court entered a Final Judgment dismissing the class actions with prejudice. Under the settlement, Merck and the Company have agreed to pay $42.5 million, and the Company has agreed to change or
to continue certain specified business practices for a period of five years. In September 2003, the Company paid $38.3 million to an escrow account, representing the Companys portion, or 90%, of the proposed settlement. If the settlement
becomes final, it would resolve litigation by pharmaceutical benefit plans against Merck and the Company based on ERISA and similar claims, except with respect to those plans that affirmatively opt out of the settlement. The plaintiff in the sixth
case discussed above,Blumenthal v. Merck-Medco Managed Care, L.L.C., et al. has elected to opt out of the settlement. The release of claims under the settlement applies to plans for which the Company has administered a pharmacy benefit at
any time between December 17, 1994 and the date of final approval. It does not involve the release of any potential antitrust claims. The settlement becomes final only after all appeals have been exhausted. Two appeals are pending.



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Similar ERISA-based complaints against the Company and Merck were filed in eight additional actions by
ERISA plan participants, purportedly on behalf of their plans, and, in some of the actions, similarly situated self-funded plans. The complaints in these actions relied on many of the same allegations as theGruer series of lawsuits discussed
above. The ERISA plans themselves, which were not parties to these lawsuits, have elected to participate in the settlement discussed above. Under the Final Judgment discussed above, the court dismissed seven of these actions. On May 21, 2004,
however, the court granted the plaintiff in the other action,Betty Jo Jones v. Merck-Medco Managed Care, L.L.C., et al. permission to file a second amended complaint. In her Second Amended Complaint, the plaintiff in theJones action
seeks to represent a class of all participants and beneficiaries of ERISA plans that required such participants to pay a percentage co-payment on prescription drugs. The effect of the release under the settlement discussed above on theJones
action has not yet been litigated. In addition, a proposed class action complaint against Merck and the Company has been filed by trustees of another benefit plan, the United Food and Commercial Workers Local Union No. 1529 and Employers Health and
Welfare Plan Trust, in the U.S. District Court for the Northern District of California. This plan has elected to opt out of the settlement. TheUnited Food action has been transferred and consolidated in the U.S. District Court for the
Southern District of New York by order of the Judicial Panel on Multidistrict Litigation.



On April 2, 2003, a lawsuit captioned Peabody Energy Corporation v. Medco Health Solutions, Inc., et al. was filed in the U.S. District Court for the Eastern District of Missouri. The complaint, filed by one of
the Companys former clients, relies on allegations similar to those in the ERISA cases discussed above, in addition to allegations relating specifically to Peabody, which has elected to opt out of the settlement described above. The complaint
asserts that the Company breached fiduciary duties under ERISA, violated a New Jersey consumer protection law, improperly induced the client into contracting with the Company, and breached the resulting agreement. The plaintiff seeks compensatory,
punitive and treble damages, as well as rescission and restitution of revenues that were allegedly improperly received by the Company. On October 28, 2003, the Judicial Panel on Multidistrict Litigation transferred this action to the U.S. District
Court for the Southern District of New York to be consolidated with the ERISA cases pending against the Company in that court.



On December 23, 2003, Peabody filed a similar action against Merck in the U.S. District Court for the Eastern District of Missouri. The complaint relies
on allegations similar to those in the ERISA cases discussed above and in the case filed by Peabody against the Company. The complaint asserts claims that Merck violated federal and state racketeering laws, tortiously interfered with Peabodys
contract with the Company, and was unjustly enriched. The plaintiff seeks, among other things, compensatory damages of approximately $35 million, treble damages, and restitution of revenues that were allegedly improperly received by Merck. On August
5, 2004, the Judicial Panel on Multidistrict Litigation transferred this action to the U.S. District Court for the Southern District of New York to be consolidated with the ERISA cases pending against Merck and the Company in that court.



On March 17, 2003, a lawsuit captionedAmerican Federation of State,
County and Municipal Employees v.AdvancePCS et al. based on allegations similar to those in the ERISA cases discussed above, was filed against the Company and other major PBMs in the Superior Court of California. The theory of liability
in this action is based on a California law prohibiting unfair business practices. The plaintiff, which purports to sue on behalf of itself, California non-ERISA health plans, and all individual participants in such plans, seeks injunctive relief
and disgorgement of revenues that were allegedly improperly received by the Company.



On June 11, 2002, a lawsuit captionedMiles v.Merck-Medco Managed Care, L.L.C., based on allegations similar to those in the ERISA cases discussed above, was filed against Merck and the Company in the
Superior Court of California. The theory of liability in this action is based on a California law prohibiting unfair business practices. The plaintiff, who purports to sue on behalf of the general public of California, seeks injunctive relief and
disgorgement of the revenues that were allegedly improperly received by Merck and the Company. The Miles case was removed to the U.S. District Court for the Southern District of California and, pursuant to the Multidistrict Litigation order
discussed above, was later transferred to the U.S. District Court for the Southern District of New York and consolidated with the ERISA cases pending against Merck and the Company in that court.



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On October 25, 2002, the Company filed a declaratory judgment action, captionedMedco Health
Solutions, Inc. v.West Virginia Public Employees Insurance Agency, in the Circuit Court of Kanawha County, West Virginia, asserting the Companys right to retain certain cost savings in accordance with the Companys written
agreement with the West Virginia Public Employees Insurance Agency, or PEIA. On November 13, 2002, the State of West Virginia and PEIA filed a separate lawsuit against Merck and the Company, also in the Circuit Court of Kanawha County, West
Virginia. This action was premised on several state law theories, including violations of the West Virginia Consumer Credit and Protection Act, conspiracy, tortious interference, unjust enrichment, accounting, fraud and breach of contract. The State
of West Virginia and PEIA sought civil penalties; compensatory and punitive damages, and injunctive relief. In March 2003, in the declaratory judgment action, PEIA filed a counterclaim, and the State of West Virginia, which was joined as a party,
filed a third-party complaint against the Company and Merck, raising the same allegations asserted by PEIA and the State of West Virginia in their November 2002 action described above. The Company and Merck filed a motion to dismiss the November
2002 action filed by the State of West Virginia and PEIA, and also filed a motion to dismiss the counterclaim and third-party complaint filed by the State of West Virginia and PEIA in the Companys declaratory judgment action. On November 6,
2003, the court granted the motion to dismiss the Consumer Protection Act claims and certain other state law claims, including the claims for conspiracy and tortious interference. The court also dismissed without prejudice the various fraud claims.
The court denied the motion to dismiss with respect to the claims for breach of contract, accounting and unjust enrichment. On December 2, 2003, PEIA filed an amended counterclaim and third-party complaint against Merck and the Company, seeking to
reassert its fraud claims and restate certain of its other claims. The court has not yet ruled on the amended counterclaim.



On July 21, 2003, a lawsuit captionedGroup Hospitalization and Medical Services v.Merck-Medco Managed Care, L.L.C., et al. was filed
against the Company in the Superior Court of New Jersey. In this action, the Companys former client, CareFirst Blue Cross Blue Shield, asserts claims for violation of fiduciary duty under state law; breach of contract; negligent
misrepresentation; unjust enrichment; violations of certain District of Columbia laws regarding consumer protection and restraint of trade; and violation of a New Jersey law prohibiting racketeering. The plaintiff demands compensatory damages,
punitive damages, treble damages for certain claims, and restitution.



The Company does not believe that it is a fiduciary, and believes that its business practices comply with all applicable laws and regulations. The Company has denied all allegations of wrongdoing and is vigorously defending all of the
lawsuits described above, although the Company has proposed to settle some of them as described above. Many of these lawsuits seek damages in unspecified amounts, which could be material, and some seek treble or punitive damages or restitution of
profits, any of which could be material in amount.



Antitrust Litigation. On August 15, 2003, a lawsuit captionedBrady 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 and the Company. The plaintiffs, which seek to represent a national class of retail pharmacies that have 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. In November 2003, Merck and the
Company filed motions to dismiss the complaint. On August 2, 2004, the court denied the motions.



On October 1, 2003, a lawsuit captionedNorth 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. The plaintiffs seek to represent a national class of independent retail pharmacies that have contracted with the Company. In February 2004, Merck and the Company
filed motions to dismiss the plaintiffs amended complaint. However, prior to ruling on the motions, the court granted the plaintiffs permission to file a second amended complaint, which the plaintiffs filed on July 23, 2004. In their Second
Amended and Consolidated Class Action Complaint, the plaintiffs allege that Merck and the Company have 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 have 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 have engaged in



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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. On October 13, 2004 the court denied Merck and the Companys motions to dismiss the Second Amended
Complaint.



On January 20, 2004, a lawsuit captionedAlameda
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 have
contracted with the Company and that have 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 has failed to maintain an Open Formulary (as defined in the consent injunction), and that the Company and Merck have failed to prevent nonpublic information received from competitors of Merck and the Company
from being disclosed to each other. The complaint also copies verbatim many of the allegations in the Amended Complaint filed by the U.S. Attorney for the Eastern District of Pennsylvania, discussed above. The plaintiffs further allege that, as a
result of these alleged practices, the Company has 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 have 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 April 2004, Merck and the Company filed motions to dismiss the complaint. On September 2, 2004, the
court ruled in Merck and the Companys favor, but granted the plaintiff permission to amend its complaint. On September 17, 2004, the plaintiff filed its Amended Complaint. In its Amended Complaint, the plaintiff repeats many of the same
allegations made in the original Complaint, and further alleges, among other things, that the Company acts as a purchasing agent for its plan sponsor customers, resulting in a system that serves to suppress competition. On October 22, 2004, Merck
and the Company filed motions to dismiss the Amended Complaint.



The Company denies all allegations of wrongdoing and intends to vigorously defend theBrady, North Jackson Pharmacy, andAlameda Drug Company cases. However, the outcome of these lawsuits is uncertain, and an adverse
determination in any of them could result in material damages, which could be trebled, and could materially limit the Companys business practices.



There remain approximately five lawsuits on behalf of fewer than ten plaintiffs, to which the Company is a party, filed by retail pharmacies against
pharmaceutical manufacturers, wholesalers and other major PBMs, challenging manufacturer discounting and rebating practices under various state and federal antitrust laws, including the Robinson-Patman Act. These suits, which were a part of a
consolidated Multidistrict Litigation, captioned In re Brand-Name Prescription Drug Antitrust Litigation, allege that the Company knowingly accepted rebates and discounts on purchases of brand-name prescription drugs in violation of the federal
Robinson-Patman Act. These suits seek damages and to enjoin the Company from future violations of the Robinson-Patman Act. Merck has agreed to indemnify the Company for any monetary liabilities related to these lawsuits. However, any adverse
judgment or injunction could significantly limit the Companys ability to obtain discounts and rebates.



Securities Litigation. The Company and Merck are named as defendants in a number of purported class action lawsuits, all relating to the
Companys revenue recognition practices for retail co-payments paid by members of plans for which the Company provides PBM services. The class action lawsuits were consolidated and amended to assert claims against Merck and the Company and
certain of the Companys officers and directors relating to the Companys revenue recognition practices for retail co-payments, rebates received by the Company, and the Companys independent status. On July 6, 2004, the court granted
the defendants motion to dismiss the consolidated and amended class action complaint and dismissed the case with prejudice. The ruling is being appealed.



On July 31, 2003, a shareholders derivative complaint was filed in the U.S. District Court for the District of New Jersey against Merck and the
Company, certain of the Companys officers and directors, and Arthur Andersen LLP. The lawsuit is based on allegations relating to the Companys revenue recognition practices for retail co-payments, and it further alleges that certain
individual defendants breached their fiduciary duty by failing to prevent such practices from occurring and also failing to prevent the conduct at issue in the Gruer complaint and related actions, the antitrust claims



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pending in the Northern District of Illinois, and thequi tam actions in which the U.S. Attorneys Office for
the Eastern District of Pennsylvania has intervened, each of which is described above. The complaint seeks monetary damages from Merck and the Company in an unspecified amount, as well as injunctive and other relief. Merck and the Company have filed
a motion to dismiss the complaint. On August 20, 2004, the court granted the defendants motion to dismiss the complaint and dismissed the action with prejudice. The ruling is being appealed.



General. In connection with the Companys spin-off from
Merck, the Company entered into an indemnification and insurance matters agreement with Merck. To the extent that the Company is required to indemnify Merck for liabilities arising out of a lawsuit, an adverse outcome with respect to Merck could
result in the Company making indemnification payments in amounts that could be material, in addition to any damages that the Company is required to pay.



The various lawsuits described above arise in an environment of rising costs for prescription drugs and heightened public scrutiny of the pharmaceutical
industry, including the PBM industry and its practices. This public scrutiny is characterized by extensive press coverage, ongoing attention in Congress and in state legislatures, and investigations and public statements by government officials.
These factors contribute to the uncertainty regarding the possible course and outcome of the proceedings discussed above. An adverse outcome in any one of the lawsuits described above could result in material fines and damages; changes to the
Companys business practices (except in those proceedings where non-monetary issues have been settled); loss of (or litigation with) clients; and other penalties. Moreover, an adverse outcome in any one of these lawsuits could have a material
adverse effect on the Companys business, financial condition, liquidity and operating results. The Company is vigorously defending each of the lawsuits described above, except that it has proposed to settle, or has settled, some of them as
described above.



Although the range of loss for all of the
unresolved matters above is not subject to reasonable estimation and it is not feasible to predict or determine the final outcome of any of the above proceedings with certainty, the Companys management does not believe that they will result in
a material adverse effect on the Companys financial position or liquidity, either individually or in the aggregate. It is possible, however, that future results of operations for any particular quarterly or annual period could be materially
affected by the ultimate resolutions of these matters, or changes in the Companys assumptions or its strategies related to these proceedings. The Company believes that most of the claims made in these legal proceedings and government
investigations would not likely be covered by insurance.



The
Company is also involved in various claims and legal proceedings of a nature considered normal to the Companys business, principally employment and commercial matters.



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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. The forward-looking statements are not historical facts, but rather are based on current
expectations, estimates, assumptions and projections about our industry, business and future financial results. We use words such as anticipates, believes, plans, expects, future,
intends, may, will, should, 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. These factors include:



| |  | Competition in the pharmacy benefit manager (PBM) industry and in the healthcare industry generally;
| | - | ------------------------------------------------------------------------------------------------------



| |  | Pressure on discounts and rebates from pharmaceutical manufacturers and margins in the PBM industry;
| | - | ----------------------------------------------------------------------------------------------------



| |  | The impact on our business and competitive position of our managed care agreement with Merck & Co., Inc. (Merck);
| | - | -------------------------------------------------------------------------------------------------------------------



| |  | Our ability to obtain new clients and the possible termination of, or unfavorable modification to, contracts with existing key clients;
| | - | ---------------------------------------------------------------------------------------------------------------------------------------



| |  | Possible contractual or regulatory changes affecting pricing, rebates, discounts, or other practices of pharmaceutical manufacturers;
| | - | -------------------------------------------------------------------------------------------------------------------------------------



| |  | Risks associated with our indebtedness and debt service obligations;
| | - | --------------------------------------------------------------------



| |  | Governmental investigations and governmental and qui tam actions filed against us;
| | - | ----------------------------------------------------------------------------------



| |  | Liability and other claims asserted against us;
| | - | -----------------------------------------------



| |  | Risks related to bioterrorism and mail tampering;
| | - | -------------------------------------------------



| |  | Developments in the healthcare industry, including the impact of increases in healthcare costs, changes in drug utilization and cost patterns and the introduction of new
brand-name and/or generic drugs;
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | New or existing governmental regulations or legislation and changes in, or the failure to comply with, governmental regulations;
| | - | --------------------------------------------------------------------------------------------------------------------------------



| |  | The possibility of a material non-cash charge to income if our recorded goodwill is impaired;
| | - | ---------------------------------------------------------------------------------------------



| |  | The possibility of a material non-cash charge to income if our recorded intangible assets are impaired or require accelerated amortization from a change in the remaining useful
life; and
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | General economic and business conditions.
| | - | -----------------------------------------



The foregoing list of factors is not exhaustive. You should carefully consider the foregoing factors and the other uncertainties and potential events
described in the Risk Factors section of our Annual Report on Form 10-K filed with the Securities and Exchange Commission (SEC File No. 1-31312).



Overview



We are one of the nations largest pharmacy benefit managers, and we provide sophisticated programs and services for our clients and the members of
their pharmacy benefit plans, as well as for the physicians and pharmacies the members use. Our programs and services help our clients control the cost and enhance the quality of the prescription drug benefits they offer to their members. We
accomplish this by providing pharmacy benefit management services through our national networks of retail pharmacies and our own mail order pharmacies. We have a large number of clients in each of the major industry categories, including Blue
Cross/Blue Shield plans; managed care organizations; insurance carriers; third-party benefit plan administrators; employers; federal, state and local government agencies; and union-sponsored benefit plans.



We operate in a competitive market as clients seek to control the growth in
the cost of providing prescription drug benefits to their members. Prescription drug costs have risen considerably over the past several years, largely as a result of



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inflation on brand-name products, increases in the number of prescriptions utilized, and the introduction of new products
from pharmaceutical manufacturers. These prescription drug cost increases, known as drug trend, have garnered significant attention throughout the United States as they contribute significantly to the rise in the national cost of healthcare. Our
business model is designed to reduce this level of drug trend. The drug trend rate for our clients was 7.9% for the nine months of 2004 compared to 10.5% for the same period of 2003.



The complicated environment in which we operate presents us with opportunities, challenges and risks. Our customers are
paramount to our success; the retention of these customers and winning new customers poses the greatest opportunity, and the loss thereof represents an ongoing risk. The preservation of our relationships with pharmaceutical manufacturers and retail
pharmacies is very important to the execution of our business strategies going forward. In addition, in large part because of the current political focus in the United States on the cost of prescription drugs, we are occasionally the subject of
lawsuits and negative press, even though our primary mission is to curb the costs at issue.



We were acquired as a wholly-owned subsidiary Merck on November 18, 1993, and were spun off as a separate publicly traded enterprise (the spin-off) on August 19, 2003.



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 revenue; adjusted prescription volume; generic penetration; gross margin percentage; diluted earnings per share; Earnings Before Interest Income/Expense, Taxes, Depreciation,
and Amortization (EBITDA); and EBITDA per adjusted prescription. See Liquidity and Capital ResourcesEBITDA further below in Item 2.



We believe these measures highlight key business trends and are important in evaluating our overall performance. These
measures are also reflective of the success of our execution of strategic objectives.



Financial Performance Summary for the Quarters and Nine Months Ended September 25, 2004 and September 27, 2003



Our net income increased by 17.7% to $118 million in the third quarter of 2004 and by 13.5% to $349 million in the nine months of 2004 from the same
periods in the prior year. Diluted earnings per share increased 16.2% to $0.43 for the third quarter and 11.4% to $1.27 for the nine months of 2004. Our 2004 EBITDA per adjusted prescription increased 21.5% to $1.81 in the third quarter and 24.7% to
$1.82 in the nine months of 2004, largely as the result of higher mail order penetration, increased generic dispensing rates and improved service margins.



Price increases from pharmaceutical manufacturers drove our net revenue increase of 2.0% for the third quarter and 4.7% for the nine months of 2004, to
$8,697 million and $26,439 million, respectively, despite decreases of 7.2% for the quarter and 5.6% for the nine months of 2004 as a result of client terminations. Mail order volumes increased 14.4% for the third quarter and 12.0% for the nine
months of 2004, primarily as a result of client plan design changes encouraging the use of mail order. The impact of client terminations and the transition to mail order contributed to the declines in retail prescription volume of 9.8% for the third
quarter and 7.3% for the nine months of 2004. Mail order penetration on an adjusted basis reached 40.1% for the third quarter of 2004 and 38.6% for the nine months of 2004, compared to 34.6% in the third quarter of 2003 and 34.3% for the nine months
of 2003.



Our percentage of prescriptions dispensed that were
generics increased to 46.8% in the third quarter and 45.7% in the nine months of 2004 compared to 43.7% in the third quarter and 43.6% in the nine months of 2003. Brand pharmaceutical rebates were consistent for the third quarter of 2004 and
increased for the nine months of 2004 reflecting improved formulary management, offset by lower brand-name prescription volume due to increased generic utilization. The increased generic dispensing rates and improved formulary management reduce the
net prices we charge to our customers in the form of steeper price discounts and guarantees, as well as increased rebates passed back to clients, while also contributing to our profitability. Additionally, the third quarter and nine months of 2004
reflect improved service margin as compared with 2003 as a result of lower costs.



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As a result of these factors, while our total net revenues grew by 2.0% for the third quarter and by 4.7%
for the nine months of 2004, our total cost of revenues increased at lower rates of 1.7% and 4.2%, respectively. This resulted in a gross margin percentage improvement to 4.9% in the third quarter of 2004 from 4.6% in the third quarter of 2003, and
to 4.8% in the nine months of 2004 from 4.4% in the nine months of 2003. Our total cost of revenues reflect severance, additional depreciation and other facility closing costs primarily associated with management decisions in 2003 to realign
pharmacy operations to retire older facilities and rebalance volume to facilities closer to our members. These charges amounted to $7 million and $25 million, respectively, for the third quarter and nine months of 2004, and $10 million and $32
million, respectively, for the third quarter and nine months of 2003. Our gross margin improvement contributed $37 million to our pre-tax earnings growth for the third quarter and $165 million for the nine months of 2004.



Selling, general and administrative expenses for the third quarter of 2004
decreased $14 million compared to the third quarter of 2003, reflecting lower corporate severance costs as $13 million was recorded in the third quarter of 2003. Selling, general and administrative expenses for the nine months of 2004 decreased $9
million compared to 2003, driven by a $16 million benefit for the favorable closure of an operating tax exposure recorded in the second quarter of 2004 and $18 million of corporate severance costs recorded in 2003. These are partially offset by $21
million recorded in the first quarter of 2004 for the April 2004 settlement with various state Attorneys General.



Intangible asset amortization expense increased $21 million for the quarter and $64 million for the nine months of 2004 from a change in the weighted
average useful life from 35 years used in 2003 to 23 years used in 2004. Interest and other (income) expense increased $4 million for the third quarter of 2004 resulting from interest expense on the debt incurred upon the spin-off in August 2003.
The $51 million increase for the nine months of 2004 resulted from the interest on the debt in addition to an $11 million one-time gain recorded in the first quarter of 2003 from the sale of a minority equity investment in a nonpublic company.



Key Financial Statement Components



Consolidated Statements of Income.Our net revenues are
comprised primarily of product net revenues and are derived 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 rebates and
guarantees payable to clients. For further details see our critical accounting policies included in Use of Estimates and Critical Accounting Policies and Note 2 to our consolidated financial statements, both in our Annual Report on
Form 10-K for the fiscal year ended December 27, 2003.



Cost of
revenues is comprised primarily of cost of product net revenues and is derived from the dispensing of prescription drugs. Cost of product net revenues for prescriptions dispensed through our network of retail pharmacies includes the contractual cost
of drugs dispensed by, and professional fees paid to, retail pharmacies in the networks. 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 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.



Selling, general and administrative expenses reflect the costs of operations dedicated to generating new sales, maintaining existing customer
relationships, managing clinical programs, enhancing technology capabilities, directing pharmacy operations and other staff activities.



Interest and other (income) expense, net primarily includes interest expense, net of interest rate swap agreements, on debt incurred as a result of the
spin-off in 2003, partially offset by interest income generated by short-term investments in marketable securities.



Consolidated Balance Sheets.Our key assets include cash and short-term investments, accounts receivable, inventories, fixed assets,
deferred tax assets, goodwill and intangibles. Cash reflects the positive cash flows from our operations. Accounts receivable balances primarily include amounts due from pharmaceutical manufacturers for earned rebates and other prescription
services. The accounts receivable balances also represent amounts due from clients for



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prescriptions dispensed from retail pharmacies in our networks or from our mail order pharmacies, including fees due to
us, net of any rebate liabilities or payments due to clients under guarantees. If the rebate liability balance is greater than the customer accounts receivable balance, the net liability is reclassified to claims and other accounts payable.
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. Fixed assets include investments in our corporate headquarters, mail order pharmacies, call
center pharmacies, account service offices, and information technology, including capitalized software development. Deferred tax assets primarily represent temporary differences between the financial statement basis and the tax basis of certain
client rebate pass-back liabilities and accrued expenses. The net goodwill and intangible assets are comprised primarily of the push-down of goodwill and intangibles related to our acquisition in 1993 by Merck.



Our primary liabilities include claims and other accounts 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, and amounts payable for
mail order prescription inventory purchases. 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. In conjunction
with the spin-off in 2003, we incurred debt, the proceeds of which were paid to Merck in the form of a dividend in August 2003. In addition, we have a net deferred tax liability primarily associated with our recorded intangible assets. We do not
have any off-balance sheet arrangements.



Consolidated
Statements of Cash Flows.An important element of our operating cash flows is the timing of billing cycles, which are two-week periods of accumulated prescription administration 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 receivables will 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. We pay for prescription drug inventory in accordance with payment terms offered by our suppliers to take advantage
of appropriate discounts. Effective mail order inventory management generates further positive cash flows. Earned pharmaceutical manufacturers rebates are recorded monthly based upon prescription dispensing, with actual bills generally
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 pharmaceutical manufacturers.



Prior to the spin-off, Merck managed our cash, which was reflected in our
consolidated statements of cash flows in intercompany transfer from (to) Merck and in our consolidated balance sheets as Due from Merck, net. We have managed our own cash and investments since the spin-off. Our cash primarily includes
demand deposits with banks or other financial institutions. Our short-term investments include U.S. government securities that have average maturities of less than one year and that are held to satisfy statutory capital requirements for our
insurance subsidiaries.



Ongoing cash outflows are associated
with expenditures to support our mail order and retail pharmacy network operations, call center pharmacies and other selling, general and administrative functions. The largest components of these expenditures include mail order inventory purchases
primarily from a wholesaler, retail pharmacy payments, rebate and guarantee payments to clients, employee payroll and benefits, facility operating expenses, capital expenditures, interest and principal payments on our debt, and income taxes.



Client-Related Information



Revenues from UnitedHealth Group, which is currently our largest client,
amounted to approximately $1,611 million and $4,805 million (or 19% and 18% of our net revenues) in the third quarter and nine months of 2004, respectively. In 2003, revenues from UnitedHealth Group amounted to approximately $1,522 million and
$4,459 million (or 18% of our net revenues) in the third quarter and nine months, respectively. On January 12, 2004, we announced an early renewal agreement to provide PBM services to UnitedHealth Group effective January 1, 2004, for an initial
five-year term. At UnitedHealth Groups option, the agreement may be extended for three additional years through 2011. None of our other clients individually represented more than 10% of our net revenues in the third quarter and nine months of
2004 or 2003.



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Segment Discussion



We conduct our operations in one segment, which involves sales of prescription drugs to our clients and their members,
either through our networks of contractually affiliated retail pharmacies or by our mail order pharmacies, and in one geographic region which includes the United States and Puerto Rico. We offer fully integrated PBM services to virtually all of our
clients and their members. The PBM services we provide to our clients are generally delivered and managed under a single contract for each client.



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



Results of Operations



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



|                                   |  |                               |         |   |                    |   |        |                               |  |       |                                   |  |   |                    |   |  |                                   |          |   |  |   |         |   |  |       |    |  |   |          |  
|---------------------------------- |  | ----------------------------- | ------- | - | ------------------ | - | ------ | ----------------------------- |  | ----- | --------------------------------- |  | - | ------------------ | - |  | --------------------------------- | -------- | - |  | - | ------- | - |  | ----- | -- |  | - | -------- | -
|                                   |  | QuarterEndedSeptember 25,2004 |         |   | Increase(Decrease) |   |        | QuarterEndedSeptember 27,2003 |  |       | Nine MonthsEndedSeptember 25,2004 |  |   | Increase(Decrease) |   |  | Nine MonthsEndedSeptember 27,2003 |         
|Net Revenues                       |  |                               |         |   |                    |   |        |                               |  |       |                                   |  |   |                    |   |  |                                   |          |   |  |   |         |   |  |       |    |  |   |          |  
|Retail product(1)                  |  | $                             | 5,216.2 |   |                    | $ | (402.3 | )                             |  | (7.2  | %)                                |  | $ | 5,618.5            |   |  | $                                 | 16,248.7 |   |  | $ | (437.9  | ) |  | (2.6  | %) |  | $ | 16,686.6 |  
|Mail order product                 |  |                               | 3,399.1 |   |                    |   | 569.7  |                               |  | 20.1  | %                                 |  |   | 2,829.4            |   |  |                                   | 9,952.9  |   |  |   | 1,635.9 |   |  | 19.7  | %  |  |   | 8,317.0  |  
|                                   |  |                               |         |   |                    |   |        |                               |  |       |                                   |  |   |                    |   |  |                                   |          |   |  |   |         |   |  |       |    |  |   |          |  
|Total product(1)                   |  | $                             | 8,615.3 |   |                    | $ | 167.4  |                               |  | 2.0   | %                                 |  | $ | 8,447.9            |   |  | $                                 | 26,201.6 |   |  | $ | 1,198.0 |   |  | 4.8   | %  |  | $ | 25,003.6 |  
|                                   |  |                               |         |   |                    |   |        |                               |  |       |                                   |  |   |                    |   |  |                                   |          |   |  |   |         |   |  |       |    |  |   |          |  
|Manufacturer service revenues      |  |                               | 46.0    |   |                    |   | 5.5    |                               |  | 13.6  | %                                 |  |   | 40.5               |   |  |                                   | 136.8    |   |  |   | (8.4    | ) |  | (5.8  | %) |  |   | 145.2    |  
|Client and other service revenues  |  |                               | 35.3    |   |                    |   | (0.3   | )                             |  | (0.8  | %)                                |  |   | 35.6               |   |  |                                   | 100.3    |   |  |   | (13.5   | ) |  | (11.9 | %) |  |   | 113.8    |  
|                                   |  |                               |         |   |                    |   |        |                               |  |       |                                   |  |   |                    |   |  |                                   |          |   |  |   |         |   |  |       |    |  |   |          |  
|Total service                      |  |                               | 81.3    |   |                    |   | 5.2    |                               |  | 6.8   | %                                 |  |   | 76.1               |   |  |                                   | 237.1    |   |  |   | (21.9   | ) |  | (8.5  | %) |  |   | 259.0    |  
|                                   |  |                               |         |   |                    |   |        |                               |  |       |                                   |  |   |                    |   |  |                                   |          |   |  |   |         |   |  |       |    |  |   |          |  
|Total net revenues(1)              |  | $                             | 8,696.6 |   |                    | $ | 172.6  |                               |  | 2.0   | %                                 |  | $ | 8,524.0            |   |  | $                                 | 26,438.7 |   |  | $ | 1,176.1 |   |  | 4.7   | %  |  | $ | 25,262.6 |  
|                                   |  |                               |         |   |                    |   |        |                               |  |       |                                   |  |   |                    |   |  |                                   |          |   |  |   |         |   |  |       |    |  |   |          |  
|Cost of Revenues                   |  |                               |         |   |                    |   |        |                               |  |       |                                   |  |   |                    |   |  |                                   |          |   |  |   |         |   |  |       |    |  |   |          |  
|Product(1)                         |  | $                             | 8,238.7 |   |                    | $ | 151.2  |                               |  | 1.9   | %                                 |  | $ | 8,087.5            |   |  | $                                 | 25,068.9 |   |  | $ | 1,056.3 |   |  | 4.4   | %  |  | $ | 24,012.6 |  
|Service                            |  |                               | 32.2    |   |                    |   | (15.5  | )                             |  | (32.5 | %)                                |  |   | 47.7               |   |  |                                   | 95.7     |   |  |   | (45.2   | ) |  | (32.1 | %) |  |   | 140.9    |  
|                                   |  |                               |         |   |                    |   |        |                               |  |       |                                   |  |   |                    |   |  |                                   |          |   |  |   |         |   |  |       |    |  |   |          |  
|Total cost of revenues(1)          |  | $                             | 8,270.9 |   |                    | $ | 135.7  |                               |  | 1.7   | %                                 |  | $ | 8,135.2            |   |  | $                                 | 25,164.6 |   |  | $ | 1,011.1 |   |  | 4.2   | %  |  | $ | 24,153.5 |  
|                                   |  |                               |         |   |                    |   |        |                               |  |       |                                   |  |   |                    |   |  |                                   |          |   |  |   |         |   |  |       |    |  |   |          |  
|Gross Margin(2)                    |  |                               |         |   |                    |   |        |                               |  |       |                                   |  |   |                    |   |  |                                   |          |   |  |   |         |   |  |       |    |  |   |          |  
|Product                            |  | $                             | 376.6   |   |                    | $ | 16.2   |                               |  | 4.5   | %                                 |  | $ | 360.4              |   |  | $                                 | 1,132.7  |   |  | $ | 141.7   |   |  | 14.3  | %  |  | $ | 991.0    |  
|Product gross margin percentage    |  |                               | 4.4     | % |                    |   | 0.1    | %                             |  |       |                                   |  |   | 4.3                | % |  |                                   | 4.3      | % |  |   | 0.3     | % |  |       |    |  |   | 4.0      | %
|Service                            |  | $                             | 49.1    |   |                    | $ | 20.7   |                               |  | 72.9  | %                                 |  | $ | 28.4               |   |  | $                                 | 141.4    |   |  | $ | 23.3    |   |  | 19.7  | %  |  | $ | 118.1    |  
|Service gross margin percentage    |  |                               | 60.4    | % |                    |   | 23.1   | %                             |  |       |                                   |  |   | 37.3               | % |  |                                   | 59.6     | % |  |   | 14.0    | % |  |       |    |  |   | 45.6     |  
|Total gross margin                 |  | $                             | 425.7   |   |                    | $ | 36.9   |                               |  | 9.5   | %                                 |  | $ | 388.8              |   |  | $                                 | 1,274.1  |   |  | $ | 165.0   |   |  | 14.9  | %  |  | $ | 1,109.1  |  
|Gross margin percentage            |  |                               | 4.9     | % |                    |   | 0.3    | %                             |  |       |                                   |  |   | 4.6                | % |  |                                   | 4.8      | % |  |   | 0.4     | % |  |       |    |  |   | 4.4      | %
|                                   |  |                               |         |   |                    |   |        |                               |  |       |                                   |  |   |                    |   |  |                                   |          |   |  |   |         |   |  |       |    |  |   |          |  
|Volume Information                 |  |                               |         |   |                    |   |        |                               |  |       |                                   |  |   |                    |   |  |                                   |          |   |  |   |         |   |  |       |    |  |   |          |  
|Retail                             |  |                               | 99.3    |   |                    |   | (10.8  | )                             |  | (9.8  | %)                                |  |   | 110.1              |   |  |                                   | 311.5    |   |  |   | (24.4   | ) |  | (7.3  | %) |  |   | 335.9    |  
|Mail order                         |  |                               | 22.2    |   |                    |   | 2.8    |                               |  | 14.4  | %                                 |  |   | 19.4               |   |  |                                   | 65.4     |   |  |   | 7.0     |   |  | 12.0  | %  |  |   | 58.4     |  
|                                   |  |                               |         |   |                    |   |        |                               |  |       |                                   |  |   |                    |   |  |                                   |          |   |  |   |         |   |  |       |    |  |   |          |  
|Total volume                       |  |                               | 121.5   |   |                    |   | (8.0   | )                             |  | (6.2  | %)                                |  |   | 129.5              |   |  |                                   | 376.9    |   |  |   | (17.4   | ) |  | (4.4  | %) |  |   | 394.3    |  
|                                   |  |                               |         |   |                    |   |        |                               |  |       |                                   |  |   |                    |   |  |                                   |          |   |  |   |         |   |  |       |    |  |   |          |  
|Adjusted prescriptions(3)          |  |                               | 165.9   |   |                    |   | (2.4   | )                             |  | (1.4  | %)                                |  |   | 168.3              |   |  |                                   | 507.7    |   |  |   | (3.4    | ) |  | (0.7  | %) |  |   | 511.1    |  
|                                   |  |                               |         |   |                    |   |        |                               |  |       |                                   |  |   |                    |   |  |                                   |          |   |  |   |         |   |  |       |    |  |   |          |  
|Adjusted mail order penetration(4) |  |                               | 40.1    | % |                    |   | 5.5    | %                             |  |       |                                   |  |   | 34.6               | % |  |                                   | 38.6     | % |  |   | 4.3     | % |  |       |    |  |   | 34.3     | %
|                                   |  |                               |         |   |                    |   |        |                               |  |       |                                   |  |   |                    |   |  |                                   |          |   |  |   |         |   |  |       |    |  |   |          |  
|Generic dispensing rates           |  |                               | 46.8    | % |                    |   | 3.1    | %                             |  |       |                                   |  |   | 43.7               | % |  |                                   | 45.7     | % |  |   | 2.1     | % |  |       |    |  |   | 43.6     | %
|                                   |  |                               |         |   |                    |   |        |                               |  |       |                                   |  |   |                    |   |  |                                   |          |   |  |   |         |   |  |       |    |  |   |          |  

---

|(1) | Includes retail co-payments of $1,631 million and
$1,686 million in the third quarters of 2004 and 2003, and $5,121 million and $5,030 million in the nine months of 2004 and 2003.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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|(2) | Defined as net revenues minus cost of revenues.
|--- | -----------------------------------------------

|(3) | Estimated adjusted prescription volume equals mail
order prescriptions multiplied by 3, plus retail prescriptions. The mail order prescriptions are multiplied by 3 to adjust for the fact that mail order prescriptions include approximately 3 times the amount of product days supplied compared with
retail prescriptions.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(4) | The percentage of adjusted mail order prescriptions
to total adjusted prescriptions.
|--- | ------------------------------------------------------------------------------------



Net Revenues. The $402 million decrease in retail net revenues in the third quarter of 2004 was attributable to volume decreases of $551 million, partially offset by net price increases of $149 million, which reflect inflation
on brand-name prescription drugs net of steeper price discounts offered to clients. The $438 million decrease in retail net revenues in the nine months of 2004 was attributable to volume decreases of $1,210 million, partially offset by net price
increases of $772 million. Retail volume decreased 9.8% for the third quarter of 2004 and 7.3% for the nine months of 2004 compared with the same periods in 2003. The 2004 retail volume reflects declines of 10.9% for the third quarter and 8.8% for
the nine months resulting from client terminations and lower prescription drug utilization from plan design changes in support of mail order, partially offset by increases of 1.1% for the quarter and 1.5% for the nine months of 2004 resulting from
volumes from new clients. The net price increase amounts for the quarter and nine months of 2004 principally relate to inflation resulting from higher prices charged by pharmaceutical manufacturers, including greater representation of new and
higher-cost brand-name drugs. These price increases are partially offset by steeper price discounts including higher rebates offered to clients, reserves for client disputes, as well as the higher relative mix of generic drugs, which are more
steeply discounted for our clients than brand-name drugs. The net decrease in retail net revenues for the nine months of 2004 also reflect increased client performance guarantee costs compared to 2003.



The $570 million increase in mail order net revenues in the third quarter of
2004 was attributable to volume increases of $406 million and net price increases of $164 million, which reflect inflation on brand-name prescription drugs net of steeper price discounts offered to clients. The $1,636 million increase in mail order
net revenues in the nine months of 2004 was attributable to volume increases of $997 million and net price increases of $639 million. Mail order volume increased 14.4% in the third quarter of 2004 and 12.0% in the first nine months of 2004 compared
with the same periods in 2003. The 2004 mail order volume reflects higher utilization from plan design changes encouraging the use of mail order, as well as volumes from new clients, and is net of decreases of 3.6% for the third quarter and 4.3% for
the nine months of 2004 resulting from client terminations. Client plan design changes drove mail order penetration on an adjusted basis from 34.6% in the third quarter of 2003 to 40.1% in the third quarter of 2004, and from 34.3% in the nine months
of 2003 to 38.6% in the nine months of 2004. For the quarter and nine months of 2004, the net price increases were principally due to inflation resulting from higher prices charged by pharmaceutical manufacturers, including greater representation of
new and higher-cost brand-name drugs, as well as days supply increases and lower client service guarantee charges. These are partially offset by a higher relative mix of generic drugs, which are discounted more steeply for our clients than
brand-name drugs, as well as overall steeper price discounts, higher rebates offered to clients and the favorable closure on a terminated client guarantee recorded in the third quarter of 2003.



Our percentage of prescriptions dispensed that were generics increased to
46.8% in the third quarter and 45.7% in the nine months of 2004 compared to 43.7% in the third quarter and 43.6% in the nine months of 2003. This increase reflects the impact of client plan design changes promoting the use of lower-cost and more
steeply discounted generics, our programs to further support generic utilization, and the introduction of new generic products during these periods.



Service revenues increased $5 million in the third quarter of 2004 as a result of higher manufacturer service revenues of $5.5 million resulting primarily
from certain nonrecurring administrative fees earned. Service revenues declined $22 million in the nine months of 2004 as a result of lower client and other service revenues of $14 million and lower manufacturer service revenues of $8 million. The
decrease in client and other service revenues is primarily due to lower client administrative fees resulting from decreased fees on a per prescription basis and lower retail volumes, offset by other client program revenues, management fees
associated with external claims and Medicare administrative and enrollment fees. The lower manufacturer service revenues are primarily due to the execution of our strategy to terminate various manufacturer contracts in the second half of 2003.



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Gross Margin. Our client contracts include several pricing variables, such as price
discounts for brand-name drugs and generic drugs, separate price discounts for mail order and retail prescriptions, administrative fees for various services, and terms regarding levels of rebate sharing and other guarantees. Clients have varied
requirements regarding the pricing model best suited to their needs, and we negotiate these variables to generate in aggregate an appropriate level of gross margin. As an example, certain clients may require a transparent model whereby all rebates
are passed back in exchange for higher fees or lower discounts, while others may prefer steeper price discounts in exchange for lower rebates. We experienced year over year declines in rebate retention reflecting changes in the pricing composition
within our contracts, which also included changes in the other aforementioned pricing components. Gross margin reflects these changes as well as increases in the relative mix of generic drugs in our prescription base and higher mail order
penetration.



Our product gross margin percentage improved to
4.4% in the third quarter of 2004 from 4.3% in the third quarter of 2003, and to 4.3% in the nine months of 2004 from 4.0% in the nine months of 2003, reflecting increases of 2.0% and 4.8%, respectively, in product net revenues as discussed in the
above net revenue analysis compared with corresponding increases in cost of product net revenues of 1.9% and 4.4%, respectively. The lower rate of increase in the cost of product net revenues compared with product net revenues is principally due to
higher mail order volumes and greater utilization of lower-cost generic products, as well as operational efficiencies resulting from management decisions in 2003 to realign pharmacy operations and our investments in Internet technology. Also
contributing is improved formulary rebate management on a lower volume of brand-name prescriptions, which reflects the greater utilization of generic products.



Rebates from pharmaceutical manufacturers, which are reflected as a reduction in cost of product net revenues, totaled $754 million in the third
quarter of 2004 and $757 million in the third quarter of 2003, with formulary rebates representing 45.5% and 50.3% of total rebates, respectively. We retained approximately $305 million or 40.5% of total rebates in the third quarter of 2004 and
approximately $407 million or 53.8% in the third quarter of 2003. The consistent level of rebates earned in the third quarter of 2004 and 2003 reflect lower brand-name prescription volume due to greater generic utilization, offset by the achievement
of certain market share requirements in pharmaceutical manufacturer rebate contracts. Rebates totaled $2,284 million in the nine months of 2004 and $2,189 million in the nine months of 2003, with formulary rebates representing 47.2% and 48.9% of
total rebates, respectively. Of total rebates earned, we retained approximately $1,018 million or 44.6% in the nine months of 2004 and approximately $1,190 million or 54.4% in the nine months of 2003. The increase in rebates earned in the nine
months of 2004 reflects the achievement of certain market share requirements in pharmaceutical manufacturer rebate contracts, partially offset by lower brand-name prescription volume due to greater generic utilization, which increases our
profitability. The increase in generic utilization, particularly in mail order, more than offsets the impact of lower rebate retention on brand-name prescriptions. The rebates that are retained, as well as the margins on generic prescriptions,
enable us to fund steeper client price discounts and our overall cost of operations, which include our mail order pharmacies, call center pharmacies, customer account servicing and other corporate functions.



Also reflected in our cost of product net revenues are severance, additional
depreciation and other facility closing costs primarily associated with management decisions in 2003 to realign pharmacy operations to retire older facilities and rebalance volume. These charges amounted to $7 million and $24 million, respectively,
for the third quarter and nine months of 2004, and $10 million and $32 million, respectively, for the third quarter and nine months of 2003.



The service gross margin percentage improved to 60.4% in the third quarter of 2004 from 37.3% in the third quarter of 2003 and to 59.6% in the nine months
of 2004 from 45.6% in the nine months of 2003, reflecting service net revenue increases of 6.8% for the third quarter and decreases of 8.5% for the nine months, as discussed in the above net revenue analysis. The service gross margin percentage also
reflects decreases in cost of service revenues of 32.5% and 32.1% for the third quarter and nine months of 2004, respectively. The decreases in cost of service revenues reflect lower information acquisition costs and lower program costs. In
addition, the service gross margin percentage in the third quarter of 2003 reflects commencement of the execution of our strategy to terminate various manufacturer contracts.



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The following table presents additional selected comparative results of operations ($ in millions):



|                                             |  |                               |       |                    |   |       |                               |  |                                   |    |                    |   |       |                                   |   |         |  |   |       |   |  |      |    |  |   |         |  
|-------------------------------------------- |  | ----------------------------- | ----- | ------------------ | - | ----- | ----------------------------- |  | --------------------------------- | -- | ------------------ | - | ----- | --------------------------------- | - | ------- |  | - | ----- | - |  | ---- | -- |  | - | ------- | -
|                                             |  | QuarterEndedSeptember 25,2004 |       | Increase(Decrease) |   |       | QuarterEndedSeptember 27,2003 |  | Nine MonthsEndedSeptember 25,2004 |    | Increase(Decrease) |   |       | Nine MonthsEndedSeptember 27,2003 |  
|Gross margin                                 |  | $                             | 425.7 |                    | $ | 36.9  |                               |  | 9.5                               | %  |                    | $ | 388.8 |                                   | $ | 1,274.1 |  | $ | 165.0 |   |  | 14.9 | %  |  | $ | 1,109.1 |  
|Selling, general and administrative expenses |  |                               | 170.8 |                    |   | (14.0 | )                             |  | (7.6                              | %) |                    |   | 184.8 |                                   |   | 506.6   |  |   | (8.9  | ) |  | (1.7 | %) |  |   | 515.5   |  
|Amortization of intangibles                  |  |                               | 45.0  |                    |   | 21.4  |                               |  | 90.7                              | %  |                    |   | 23.6  |                                   |   | 134.9   |  |   | 64.2  |   |  | 90.8 | %  |  |   | 70.7    |  
|Interest and other (income) expense          |  |                               | 12.6  |                    |   | 3.9   |                               |  | 44.8                              | %  |                    |   | 8.7   |                                   |   | 48.0    |  |   | 51.4  |   |  | NM   | *  |  |   | (3.4    | )
|                                             |  |                               |       |                    |   |       |                               |  |                                   |    |                    |   |       |                                   |   |         |  |   |       |   |  |      |    |  |   |         |  
|Income before provision for income taxes     |  | $                             | 197.3 |                    | $ | 25.6  |                               |  | 14.9                              | %  |                    | $ | 171.7 |                                   | $ | 584.6   |  | $ | 58.3  |   |  | 11.1 | %  |  | $ | 526.3   |  
|Provision for income taxes                   |  |                               | 79.2  |                    |   | 7.8   |                               |  | 10.9                              | %  |                    |   | 71.4  |                                   |   | 235.7   |  |   | 16.9  |   |  | 7.7  | %  |  |   | 218.8   |  
|                                             |  |                               |       |                    |   |       |                               |  |                                   |    |                    |   |       |                                   |   |         |  |   |       |   |  |      |    |  |   |         |  
|Net income                                   |  | $                             | 118.1 |                    | $ | 17.8  |                               |  | 17.7                              | %  |                    | $ | 100.3 |                                   | $ | 348.9   |  | $ | 41.4  |   |  | 13.5 | %  |  | $ | 307.5   |  
|                                             |  |                               |       |                    |   |       |                               |  |                                   |    |                    |   |       |                                   |   |         |  |   |       |   |  |      |    |  |   |         |  

---

|* | Not meaningful.
|- | ---------------



Selling, General and Administrative Expenses.Selling, general and administrative expenses for the third quarter of 2004 of $171 million
decreased from the third quarter of 2003 by $14 million, or 7.6%. This decrease is primarily associated with lower corporate severance costs as $13 million was recorded in the third quarter of 2003 to streamline certain corporate functions. Selling,
general and administrative expenses for the nine months of 2004 amounting to $507 million decreased from the nine months of 2003 by $9 million, or 1.7%. This decrease is driven by a $16 million benefit for the favorable closure of an operating tax
exposure recorded in the second quarter of 2004 and $18 million of corporate severance costs recorded in 2003. These are partially offset by $21 million recorded in the first quarter of 2004 for the April 2004 settlement with various state Attorneys
General. After consideration of the aforementioned factors, the consistent amount of selling, general and administrative expenses in 2004 compared to 2003 is reflective of managements ongoing efforts to optimize corporate operating
efficiencies.



Amortization of Intangibles.
Amortization of intangible assets was $45 million in the third quarter of 2004 and $135 million for the nine months of 2004, increasing $21 million and $64 million, respectively, from a re-evaluation of the useful life of the intangible assets that
arose in connection with our acquisition by Merck in 1993. In February 2004, we were notified of client decisions to transition their business to other PBMs by the end of 2004. Because these clients were in our customer base at the time of the Merck
acquisition and therefore were included in the recorded intangible assets, we re-evaluated the weighted average useful life of the assets. Effective as of the beginning of the 2004 fiscal year, the weighted average useful life was revised from 35
years to 23 years, with the estimated annual intangible asset amortization expense increasing to $180 million in 2004 from $94 million in 2003.



Interest and Other (Income) Expense, Net. Interest and other (income) expense, net for the third quarter of 2004 increased $3.9 million from
the third quarter of 2003. For the third quarter of 2004, interest and other (income) expense, net was $12.6 million and includes $15.0 million in interest expense on the debt incurred associated with the spin-off in August of 2003, offset by $(2.4)
million of interest income from positive cash flows and the associated cash balances. This interest expense was reduced by $1.4 million as a result of interest rate swap agreements. For the third quarter of 2003, interest and other (income) expense,
net was $8.7 million, including $9.9 million in interest expense on the debt, offset by $(1.2) million of interest income.



Interest and other (income) expense, net for the nine months of 2004 increased $51.4 million from the nine months of 2003. For the nine months of 2004,
interest and other (income) expense, net was $48.0 million and includes $48.2 million in interest expense on the debt incurred associated with the spin-off in August of 2003. This interest expense was reduced by $3.3 million as a result of interest
rate swap agreements. The nine months of 2004 also include a $5.5 million write-off of previously deferred debt acquisition costs as the original term loan debt was extinguished and refinanced in March of 2004, partially offset by $(5.7) million of
interest income from positive cash flows and the associated cash balances. For the nine months of 2003, interest and other (income) expense, net was $(3.4) million and includes an $(11.0) million gain, recorded in the first quarter, associated with
the sale of a minority equity investment in a nonpublic company and interest income of $(2.4) million. These are partially offset by $10.0 million in interest expense primarily on the debt for the nine months of 2003.



24



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##### Table of Contents

The weighted average borrowing rate of the debt outstanding was approximately 4.5% and 4.6% for the third
quarter and nine months of 2004, respectively.



Provision
for Income Taxes.Our effective tax rate (defined as the percentage relationship of provision for income taxes to income before provision for income taxes) decreased to 40.1% in the third quarter of 2004, compared with 41.6% in the third
quarter of 2003. This reduction results from the completion during the second quarter of 2004 of a post spin-off study of our state tax position for the apportionment of our income based on our business activities and tax strategies existing as of
the date of the spin-off as a stand-alone tax payer. The study included formalization of our state income tax position through rulings from and discussions with taxing authorities in key selected states.



Net Income and Earnings Per Share. Net income as a percentage
of net revenues was 1.4% in the third quarter and 1.3% in the nine months of 2004, compared to 1.2% in the third quarter and nine months of 2003, as a result of the aforementioned factors.



Basic earnings per share increased 16.2% for the third quarter and 13.2% for
the nine months of 2004. The weighted average shares outstanding were 272.1 million and 271.4 million for the third quarter and nine months of 2004, respectively, and 270.0 million for both the third quarter and nine months of 2003. Diluted earnings
per share increased 16.2% for the third quarter and 11.4% for the nine months of 2004. The diluted weighted average shares outstanding were 274.2 million for both the third quarter and nine months of 2004, and 270.2 million and 270.1 million for the
third quarter and nine months of 2003, respectively.



Transactions with Merck



We were a
wholly-owned subsidiary of Merck from November 18, 1993 through August 19, 2003, the spin-off date. For the year-to-date through August 19, 2003, selling, general and administrative expenses included $0.4 million in expense allocations related to
various services that Merck provided to us during the first quarter of 2003. Subsequent to this date, there are no allocated costs included in selling, general and administrative expenses. The following table presents a summary of the additional
transactions with Merck for the third quarter and year-to-date through August 19, 2003 ($ in millions):



|                                          |  |                                 |       |                                   |   |      
|----------------------------------------- |  | ------------------------------- | ----- | --------------------------------- | - | -----
|                                          |  | Quarter Ended September 27,2003 |       | Nine MonthsEndedSeptember 27,2003
|Sales to Merck for PBM and other services |  | $                               | 18.7  |                                   | $ | 78.0 
|Cost of inventory purchased from Merck    |  | $                               | 223.0 |                                   | $ | 930.4
|Gross rebates received from Merck         |  | $                               | 74.2  |                                   | $ | 301.1



Inventory purchased
from Merck was recorded at a price that we believe approximated the price an unrelated third party would pay.



For further information relating to agreements with Merck and the associated risks, refer to our Annual Report on Form 10-K for the fiscal year ended
December 27, 2003.



25



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##### Table of Contents

Liquidity and Capital Resources



Cash Flows



The following table presents selected data from our unaudited interim condensed consolidated statements of cash flows ($ in millions):



|                                                 |  |                                     |         |   |                    |   |        |                                     |  |   |         |  
|------------------------------------------------ |  | ----------------------------------- | ------- | - | ------------------ | - | ------ | ----------------------------------- |  | - | ------- | -
|                                                 |  | Nine Months EndedSeptember 25, 2004 |         |   | Increase(Decrease) |   |        | Nine Months EndedSeptember 27, 2003 | 
|Net cash provided by operating activities        |  | $                                   | 509.8   |   |                    | $ | (672.9 | )                                   |  | $ | 1,182.7 |  
|Net cash used by investing activities            |  |                                     | (68.6   | ) |                    |   | 38.3   |                                     |  |   | (106.9  | )
|Net cash used by financing activities            |  |                                     | (79.2   | ) |                    |   | 212.1  |                                     |  |   | (291.3  | )
|                                                 |  |                                     |         |   |                    |   |        |                                     |  |   |         |  
|Net increase in cash and cash equivalents        |  | $                                   | 362.0   |   |                    | $ | (422.5 | )                                   |  | $ | 784.5   |  
|Cash and cash equivalents at beginning of period |  | $                                   | 638.5   |   |                    | $ | 624.1  |                                     |  | $ | 14.4    |  
|                                                 |  |                                     |         |   |                    |   |        |                                     |  |   |         |  
|Cash and cash equivalents at end of period       |  | $                                   | 1,000.5 |   |                    | $ | 201.6  |                                     |  | $ | 798.9   |  
|                                                 |  |                                     |         |   |                    |   |        |                                     |  |   |         |  



Operating
Activities. The decrease in net cash provided by operating activities for the nine months of 2004 amounting to $673 million primarily reflects a $373 million decrease in cash flows from accounts receivable, net, principally resulting from
the timing of collections of rebates receivable from pharmaceutical manufacturers. Also contributing to the decrease were lower retail pharmacy accounts payable due to lower retail volumes in 2004 compared to 2003 and the establishment of income
taxes payable post spin-off in 2003, which were previously reflected in the intercompany transfer to Merck, net, under financing activities. In addition, net cash provided by operating activities for the nine months of 2003 reflect increased cash
flows from pharmaceutical manufacturers associated with revised agreements effective in 2002, which upon initiation had required greater time for bill preparation and resulted in collections in 2003. During the third quarter of 2004, we reduced our
deferred tax asset for client rebates payable to reflect accelerated tax deductibility, with an associated reduction in income taxes payable, having no effect on net cash provided by operating activities for the nine months of 2004.



Additionally, net cash from operating activities for the nine months of 2003
excluded various items paid to or by Merck on our behalf, such as tax payments made by Merck, and other items, which are reflected in the intercompany transfer from Merck, net, in our cash flows from financing activities. Amounts so reflected for
taxes paid by Merck, which represent our federal income tax provision and state income tax provision in states where Merck filed a unitary or combined return, were $115 million for the nine months of 2003. Accordingly, our net cash from operating
activities does not fully reflect what our cash flows would have been had we been a separate company during the full nine months of 2003. Subsequent to the August 19, 2003 spin-off date, tax payments are reflected in our net cash flows from
operating activities.



Investing Activities. The
decrease in net cash used by investing activities for the nine months of 2004 amounting to $38 million primarily results from reduced capital expenditures in 2004, which reflects operational leveraging of historical capital investments. We
anticipate 2004 capital expenditures will not exceed $115 million. Purchases and proceeds from securities and other investments, which relate to investment activities of our insurance companies, were balanced in the nine months of 2004 and 2003.



Financing Activities. The decrease in net cash
used by financing activities for the nine months of 2004 amounting to $212 million primarily results from 2003 activity associated with the spin-off, including the payment of $2.0 billion in cash dividends to Merck, net proceeds from long-term and
short-term debt of $1,496 million and the settlement of the intercompany receivable from Merck. These transactions were partially offset by a $100 million pay down of outstanding debt in conjunction with the debt refinancing in the first quarter of
2004 and a $20 million scheduled principal payment made in the fiscal third quarter of 2004. On September 28, 2004, which is included in the fiscal fourth quarter of 2004, we paid down $80 million of the term loan facility, $20 of which was a
required installment payment.



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In the first quarter of 2004 we entered into interest rate swap agreements on $200 million of our fixed
rate senior notes. These transactions were entered into as an effective hedge to (i) convert a portion of the senior note fixed rate debt into floating rate debt; (ii) maintain a capital structure containing desired amounts of fixed and floating
rate debt; and (iii) lower the interest expense on these notes in the near term.



For the quarter and nine months ended September 25, 2004, the weighted average interest rate on our indebtedness was 4.5% and 4.6%, respectively. Several factors could change the weighted average annual interest rate,
including but not limited to a change in reference rates used under our credit facilities and interest rate swap agreements.



Total cash and short-term investments as of September 25, 2004 were $1,058 million, including $1,000 million in cash and cash equivalents. Total cash and
short-term investments as of December 27, 2003 were $698 million, including $639 million in cash and cash equivalents.



Our debt covenants limit our ability to pay dividends and repurchase our own common stock, and our Tax Responsibility Allocation Agreement with Merck
imposes conditions on our ability to repurchase shares of our common stock for a two year period subsequent to the August 2003 spin-off. The Companys management is evaluating plans to repurchase shares of the Companys common stock and/or
pay dividends within the parameters allowed by the Companys agreements and will review its recommendations with the Board of Directors. However, we have no immediate plans for stock repurchases or dividend payments.



We believe that our future cash flows from operations will be sufficient to
fund capital expenditures and working capital requirements for the foreseeable future.



EBITDA



We calculate
and use EBITDA and EBITDA per adjusted prescription as indicators of our ability to generate cash from our reported operating results. These measurements are used in concert with net income, and cash flows from operations, which measures actual cash
generated in the period. In addition, we believe that EBITDA and EBITDA per adjusted prescription are supplemental measurement tools used by analysts and investors to help evaluate overall operating performance and the ability to incur and service
debt and make capital expenditures. EBITDA does not represent funds available for our discretionary use and is not intended to represent or to be used as a substitute for net income or cash flows from operations data as measured under U.S. generally
accepted accounting principles. The items excluded from EBITDA but included in the calculation of our reported net income are significant components of our unaudited interim condensed consolidated statements of income, and must be considered in
performing a comprehensive assessment of our overall financial performance. EBITDA, and the associated year-to-year trends, should not be considered in isolation. Our calculation of EBITDA may not be consistent with calculations of EBITDA used by
other companies.



The following table reconciles our reported
net income to EBITDA and presents EBITDA per adjusted prescription for each of the respective periods (in millions, except for EBITDA per adjusted prescription data):



|                                         |  |                   |       |                   |   |                   |  |   |                   |     |  |   |       |    
|---------------------------------------- |  | ----------------- | ----- | ----------------- | - | ----------------- |  | - | ----------------- | --- |  | - | ----- | ---
|                                         |  | Quarters Ended    |       | Nine Months Ended |  
|                                         |  | September 25,2004 |       | September 27,2003 |   | September 25,2004 |  |   | September 27,2003 |    
|Net income                               |  | $                 | 118.1 |                   | $ | 100.3             |  | $ | 348.9             |     |  | $ | 307.5 |    
|Add (deduct):                            |  |                   |       |                   |   |                   |  |   |                   |     |  |   |       |    
|Interest and other (income) expense, net |  |                   | 12.6  |                   |   | 8.7               |  |   | 48.0              | (1) |  |   | 7.6   | (2)
|Provision for income taxes               |  |                   | 79.2  |                   |   | 71.4              |  |   | 235.7             |     |  |   | 218.8 |    
|Depreciation expense                     |  |                   | 45.7  |                   |   | 47.1              |  |   | 157.5             |     |  |   | 139.1 |    
|Amortization expense                     |  |                   | 45.0  |                   |   | 23.6              |  |   | 134.9             |     |  |   | 70.7  |    
|                                         |  |                   |       |                   |   |                   |  |   |                   |     |  |   |       |    
|EBITDA                                   |  | $                 | 300.6 |                   | $ | 251.1             |  | $ | 925.0             |     |  | $ | 743.7 |    
|                                         |  |                   |       |                   |   |                   |  |   |                   |     |  |   |       |    
|Adjusted prescriptions(3)                |  |                   | 165.9 |                   |   | 168.3             |  |   | 507.7             |     |  |   | 511.1 |    
|                                         |  |                   |       |                   |   |                   |  |   |                   |     |  |   |       |    
|EBITDA per adjusted prescription         |  | $                 | 1.81  |                   | $ | 1.49              |  | $ | 1.82              |     |  | $ | 1.46  |    
|                                         |  |                   |       |                   |   |                   |  |   |                   |     |  |   |       |    

---

|(1) | Includes a one-time write-off of deferred debt
issuance costs amounting to $5.5 million in the first quarter of 2004 associated with the debt refinancing.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------



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|(2) | Excludes a one-time gain of $11 million from the
sale in the first quarter of 2003 of a minority equity investment in a nonpublic company.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Estimated adjusted prescription volume equals mail
order prescriptions multiplied by 3, plus retail prescriptions. The mail order prescriptions are multiplied by 3 to adjust for the fact that mail order prescriptions include approximately 3 times the amount of product days supplied compared with
retail prescriptions.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



EBITDA per
adjusted prescription increased by $0.32 or 21.5% and $0.36 or 24.7% for the third quarter and nine months of 2004, respectively, compared with the third quarter and nine months of 2003. Net income for the third quarter and nine months of 2004
exceeded the third quarter and nine months of 2003 by 17.7% and 13.5%, respectively. The growth rate for EBITDA per adjusted prescription for the quarter and nine months of 2004 exceeded the related net income growth rates primarily as a result of
additional intangible asset amortization from the revised useful life, interest expense associated with the debt incurred in conjunction with the spin-off, as well as accelerated depreciation associated with aforementioned management decisions to
realign pharmacy operations.



Contractual Obligations



As of September 25, 2004 we had contractual cash
obligations for purchase commitments of $9.7 million for the remainder of 2004, which relate primarily to contractual commitments to purchase pharmaceutical inventory from a manufacturer. We lease pharmacy and call center pharmacy facilities,
offices and warehouse space throughout the United States under various operating leases. In addition, we lease pill dispensing and counting machines and other operating equipment for use in our mail order pharmacies and computer equipment for use in
our data center.



The following table presents certain of our
contractual obligations as of September 25, 2004, as well as our long-term debt obligations, including the current portion of long-term debt ($ in millions):



Payments Due By Period



|                                                         |  |       |         |      |   |           |  |           |       |            |   |       |  |   |      
|-------------------------------------------------------- |  | ----- | ------- | ---- | - | --------- |  | --------- | ----- | ---------- | - | ----- |  | - | -----
|                                                         |  | Total |         | 2004 |   | 2005-2006 |  | 2007-2008 |       | Thereafter
|Long-term debt obligations, including current portion(1) |  | $     | 1,280.0 |      | $ | 20.0      |  | $         | 160.0 |            | $ | 600.0 |  | $ | 500.0
|Interest expense on long-term debt obligations(2)        |  |       | 355.4   |      |   | 13.9      |  |           | 104.8 |            |   | 90.1  |  |   | 146.6
|Operating lease obligations                              |  |       | 90.8    |      |   | 8.0       |  |           | 52.3  |            |   | 15.0  |  |   | 15.5 
|Purchase obligation                                      |  |       | 9.7     |      |   | 9.7       |  |           |      |            |   |      |  |   |     
|                                                         |  |       |         |      |   |           |  |           |       |            |   |       |  |   |      
|Total                                                    |  | $     | 1,735.9 |      | $ | 51.6      |  | $         | 317.1 |            | $ | 705.1 |  | $ | 662.1
|                                                         |  |       |         |      |   |           |  |           |       |            |   |       |  |   |      

---

|(1) | Long-term debt obligations exclude the $3.7 million
unamortized discount on the senior notes and the fair value adjustment of $2.0 million associated with the interest rate swap agreements on $200 million of the senior notes.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | The variable component of interest expense for the
term loan facility and interest rate swap agreements is based on the London Interbank Offered Rate (LIBOR) at September 25, 2004.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



As of September 25, 2004, we had letters of credit outstanding of $88.0 million, of which $85.5 million were issued under
our senior secured revolving credit facility.



In addition, on
September 28, 2004, which is included in the fiscal fourth quarter of 2004, we paid down $80 million of the term loan facility, $20 million of which was a required installment payment.



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Pending Accounting Pronouncements



In March 2004, the Financial Accounting Standards Board (FASB) issued an exposure draft, Share-Based
Payment  an amendment of FASB Statements No. 123 and 95. Included in the exposure draft is a requirement whereby the compensation expense from stock options granted to employees is included in the consolidated statements of income. On
October 13, 2004, the FASB held a meeting to discuss the exposure draft and agreed to delay the effective date of the final statement to interim or annual periods beginning after June 15, 2005. We will comply with the final statement when issued.



For further information regarding Medcos stock-based
compensation, please refer to Note 3 to the unaudited interim condensed consolidated financial statements included in this Quarterly Report on Form 10-Q.



Item 3. Quantitative and Qualitative Disclosures About Market Risk



We have floating rate debt with our credit facilities and investments in marketable securities that are subject to interest rate volatility. We also have
interest rate swap agreements on a portion of our fixed rate senior notes that is subject to interest rate volatility. A 25 basis point change in the weighted average annual interest rate relating to the credit facilities balances outstanding and
interest rate swap agreements as of September 25, 2004, which are subject to variable interest rates based on the LIBOR, would yield a change of approximately $2.5 million in annual interest expense.



We operate our business within the United States and Puerto Rico and execute
all transactions in U.S. dollars and therefore, we have no foreign exchange risk.



Item 4. Controls and Procedures



The Companys management, with the participation of its Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the Companys disclosure controls and procedures. Based on their evaluation, as of the end
of the period covered by this Quarterly Report on Form 10-Q, the Companys Chief Executive Officer and Chief Financial Officer have concluded that the Companys disclosure controls and procedures (as defined in Rules 13a-15(e) and
15d-15(e) under the Securities Exchange Act of 1934, as amended) are effective. There have been no significant changes in internal control over financial reporting for the period covered by this report that have materially affected, or are
reasonably likely to materially affect, the Companys internal control over financial reporting.



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PART II - OTHER INFORMATION



Item 1. Legal Proceedings



A
description of certain legal proceedings to which the Company is a party is contained in Note 11 to the unaudited interim condensed consolidated financial statements included in Part I of this Quarterly Report on Form 10-Q. Such description includes
the following recent developments:



On September 23, 2004, in
connection with the previously disclosed action alleging violations of the federal False Claims Act filed by the U.S. Attorneys Office for Eastern District of Pennsylvania, the court granted the Companys motion to dismiss with respect to
the governments claims for active and constructive fraud, and dismissed that count with prejudice. The court denied the remainder of the Companys motion.



On August 20, 2004, in connection with the previously disclosed shareholders derivative action filed against Merck,
the Company and certain other defendants in the U.S. District Court for the District of New Jersey, the court granted the defendants motion to dismiss the complaint and dismissed the action with prejudice. The ruling is being appealed.



Item 2. Unregistered Sales of Equity Securities and Use of Proceeds



Not applicable.



Item 3. Defaults Upon Senior Securities



Not applicable.



Item 4. Submission of Matters to a Vote of Security Holders



Not applicable.



Item 5. Other Information



Not
applicable.



Item 6. Exhibits



|       |  |                                                                                                                                                   |  |                         
|------ |  | ------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------
|Number |  | Description                                                                                                                                       |  | Method of Filing        
|31.1   |  | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                |  | Filed with this document
|       |  |                                                                                                                                                  
|31.2   |  | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                |  | Filed with this document
|       |  |                                                                                                                                                  
|32.1   |  | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |  | Filed with this document
|       |  |                                                                                                                                                  
|32.2   |  | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |  | Filed with this document



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##### Table of Contents

Signatures



Pursuant to the
requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.



|                       |  |                              |  |                                   
|---------------------- |  | ---------------------------- |  | ----------------------------------
|                       |  | MEDCO HEALTH SOLUTIONS, INC.
|                       |  |                             
|Date: November 2, 2004 |  | By:                          |  | /s/ David B. Snow, Jr.            
|                       |  | Name:                        |  | David B. Snow, Jr.                
|                       |  | Title:                       |  | Chairman, President and           
|                       |  |                              |  | Chief Executive Officer           
|                       |  |                             
|Date: November 2, 2004 |  | By:                          |  | /s/ JoAnn A. Reed                 
|                       |  | Name:                        |  | JoAnn A. Reed                     
|                       |  | Title:                       |  | Senior Vice President, Finance and
|                       |  |                              |  | Chief Financial Officer           



31



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##### Table of Contents

Index to Exhibits



|       |  |                                                                                                                                                  
|------ |  | -------------------------------------------------------------------------------------------------------------------------------------------------
|Number |  | Description                                                                                                                                      
|31.1   |  | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                               
|       | 
|31.2   |  | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                               
|       | 
|32.1   |  | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
|       | 
|32.2   |  | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002