EXPRESS SCRIPTS, INC.

INDEX

Signatures

Index to Exhibits

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

EXPRESS SCRIPTS, INC.
Unaudited Consolidated Balance Sheet

See accompanying Notes to Unaudited Consolidated Financial Statements

EXPRESS SCRIPTS, INC.
Unaudited Consolidated Statement of Operations

¹ Excludes estimated retail pharmacy co-payments of $1,363,991 and $1,326,022 for the three months ended September 30, 2004 and 2003, respectively, and $4,148,590 and $3,995,580 for the nine months ended September 30, 2004 and 2003, respectively. These are amounts we instructed retail pharmacies to collect from members. We have no information regarding actual co-payments collected.

See accompanying Notes to Unaudited Consolidated Financial Statements

EXPRESS SCRIPTS, INC.
Unaudited Consolidated Statement of Changes in Stockholders’ Equity

          See accompanying Notes to Unaudited Consolidated Financial Statements

EXPRESS SCRIPTS, INC.

Unaudited Consolidated Statement of Cash Flows

See accompanying Notes to Unaudited Consolidated Financial Statements

EXPRESS SCRIPTS, INC.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Note 1 – Summary of significant accounting policies

        Certain of our significant accounting policies are described below. Other financial statement note disclosures, normally included in financial statements prepared in conformity with generally accepted accounting principles, have been omitted from this Form 10-Q pursuant to the Rules and Regulations of the Securities and Exchange Commission. However, we believe the disclosures contained in this Form 10-Q are adequate to make the information presented not misleading when read in conjunction with the notes to the consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2003, filed with the Securities and Exchange Commission on February 25, 2004. For a full description of our accounting policies, please refer to the Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2003.

        We believe the accompanying unaudited consolidated financial statements reflect all adjustments (consisting of only normal recurring adjustments) necessary to present fairly the Unaudited Consolidated Balance Sheet at September 30, 2004, the Unaudited Consolidated Statements of Operations for the three and nine months ended September 30, 2004 and 2003, the Unaudited Consolidated Statement of Changes in Stockholders’ Equity for the nine months ended September 30, 2004, and the Unaudited Consolidated Statements of Cash Flows for the nine months ended September 30, 2004 and 2003. Operating results for the three and nine months ended September 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004.

REVENUE RECOGNITION

        Revenues from our pharmacy benefit management (“PBM”) segment are earned by dispensing prescriptions from our mail pharmacies, processing claims for prescriptions filled by retail pharmacies in our networks, and by providing services to drug manufacturers, including administration of discount programs (see also “—Rebate Accounting”).

        Revenues from dispensing prescriptions from our mail pharmacies, which include the co-payment received from members of the health plans we serve, are recorded when prescriptions are shipped. At the time of shipment, our earnings process is complete: the obligation of our customer to pay for the drugs is fixed, and, due to the nature of the product, the member may not return the drugs nor receive a refund.

        Revenues related to the sale of prescription drugs by retail pharmacies in our networks consist of the amount the client has contracted to pay us (which excludes the co-payment) for the dispensing of such drugs together with any associated administrative fees. These revenues are recognized when the claim is processed. When we independently have a contractual obligation to pay our network pharmacy providers for benefits provided to our clients’ members, we act as a principal in the arrangement and we include the total payments we have contracted to receive from these clients as revenue, and payments we make to the network pharmacy providers as cost of revenue in compliance with Emerging Issues Task Force (“EITF”) Issue No. 99-19, “Reporting Gross Revenue as a Principal vs. Net as an Agent.” When a prescription is presented by a member to a retail pharmacy within our network, we are solely responsible for confirming member eligibility, performing drug utilization review, reviewing for drug-to-drug interactions, performing clinical intervention, which may involve a call to the member’s physician, communicating plan provisions to the pharmacy, directing payment to the pharmacy and billing the client for the amount they are contractually obligated to pay us for the prescription dispensed, as specified within our client contracts. We also provide benefit design and formulary consultation services to clients. We have separately negotiated contractual relationships with our clients and with network pharmacies, and under our contracts with pharmacies we assume the credit risk of our clients’ ability to pay for drugs dispensed by these pharmacies to clients’ members. Our clients are not obligated to pay the pharmacies as we are primarily obligated to pay retail pharmacies in our network the contractually agreed upon amount for the prescription dispensed, as specified within our provider contracts. In addition, under most of our client contracts, we realize a positive or negative margin represented by the difference between the negotiated ingredient costs we will receive from our clients and the separately negotiated ingredient costs we will pay to our network pharmacies. These factors indicate we are a principal as defined by EITF 99-19 and, as such, we record ingredient cost billed to clients in revenue and the corresponding ingredient cost paid to network pharmacies in cost of revenues.

        If we merely administer a client’s network pharmacy contracts, to which we are not a party and under which we do not assume credit risk, we record only our administrative fees as revenue. For these clients, we earn an administrative fee for collecting payments from the client and remitting the corresponding amount to the pharmacies in the client’s network. In these transactions we act as a conduit for the client. Because we are not the principal in these transactions, drug ingredient cost is not included in our revenues or in our cost of revenues.

        In retail pharmacy transactions, amounts paid to pharmacies and amounts charged to clients are always exclusive of the applicable co-payment. Under our pharmacy agreements, the pharmacy is solely obligated to collect the co-payment from the member based on the amount we advise them to collect. We have no information regarding actual co-payments collected. As such, we do not include member co-payments to retail pharmacies in our revenue or in our cost of revenue. Retail pharmacy co-payments, which we instructed retail pharmacies to collect from members, of $1.4 billion and $1.3 billion for the three months ended September 30, 2004 and 2003, respectively, and $4.1 billion and $4.0 billion for the nine months ended September 30, 2004 and 2003, respectively, are excluded from revenues and cost of revenues.

        We bill our clients based upon the billing schedules established in client contracts. At the end of a period, any unbilled revenues related to the sale of prescription drugs that have been adjudicated with retail pharmacies are estimated based on the amount we will pay to the pharmacies and historical gross margin. Those amounts due from our clients are recorded as revenue as they are contractually due to us for past transactions. Adjustments are made to these estimated revenues to reflect actual billings at the time clients are billed; historically, these adjustments have not been material.

        Certain implementation and other fees paid to clients upon the initiation of a contractual agreement are considered an integral part of overall contract pricing and are recorded as a reduction of revenue. Where they are refundable upon early termination of the contract, these payments are capitalized and amortized as a reduction of revenue on a straight-line basis over the life of the contract.

        Revenues from our non-PBM segment, Pharma Business Solutions (“PBS”), are derived from the distribution of pharmaceuticals requiring special handling or packaging where we have been selected by the pharmaceutical manufacturer as part of a limited distribution network, the distribution of pharmaceuticals through Patient Assistance Programs where we receive a fee from the pharmaceutical manufacturer for administrative and pharmacy services for the delivery of certain drugs free of charge to doctors for their indigent patients, sample fulfillment and sample accountability services. Revenues earned by PBS include administrative fees received from pharmaceutical manufacturers for dispensing or distributing consigned pharmaceuticals requiring special handling or packaging and administrative fees for verification of practitioner licensure and distribution of consigned drug samples to doctors based on orders received from pharmaceutical sales representatives. We also administer sample card programs for certain manufacturers and include the ingredient costs of those drug samples dispensed from retail pharmacies in PBS revenues, and the associated costs for these sample card programs in cost of revenues. Because manufacturers are independently obligated to pay us and we have an independent contractual obligation to pay our network pharmacy providers for free samples dispensed to patients under sample card programs, we include the total payments from these manufacturers (including ingredient costs) as revenue, and payments to the network pharmacy provider as cost of revenue. These transactions require us to assume credit risk.

REBATE ACCOUNTING

        We administer two rebate programs through which we receive rebates and administrative fees from pharmaceutical manufacturers. Rebates earned for the administration of these programs, performed in conjunction with claim processing and mail pharmacy services provided to clients, are recorded as a reduction of cost of revenue and the portion of the rebate payable to customers is treated as a reduction of revenue. When we earn rebates and administrative fees in conjunction with formulary management services, but do not process the underlying claims, we record rebates received from manufacturers, net of the portion payable to customers, in revenue. We record rebates and administrative fees receivable from the manufacturer and payable to clients when the prescriptions covered under contractual agreements with the manufacturers are dispensed; these amounts are not dependent upon future pharmaceutical sales.

        With respect to rebates based on actual market share performance, we estimate rebates and the associated receivable from pharmaceutical manufacturers quarterly based on our estimate of the number of rebatable prescriptions and the rebate per prescription. The portion of rebates payable to clients is estimated quarterly based on historical and/or anticipated sharing percentages and our estimate of rebates receivable from pharmaceutical manufacturers. These estimates are adjusted to actual when amounts are received from manufacturers and the portion payable to clients is paid.

        With respect to rebates that are not based on market share performance, no estimation is required because the manufacturer billing amounts and the client portion are determinable when the drug is dispensed. We pay all or a contractually agreed upon portion of such rebates to our clients.

COST OF REVENUES

        Cost of revenues includes product costs, network pharmacy claims payments and other direct costs associated with dispensing prescriptions, including shipping and handling (see also “—Revenue Recognition” and “—Rebate Accounting”).

CASH AND CASH EQUIVALENTS

        Cash and cash equivalents include cash on hand and investments with original maturities of three months or less. We have banking relationships resulting in certain cash disbursement accounts being maintained by banks not holding our cash concentration accounts. As a result, cash disbursement accounts carry negative book balances (representing outstanding checks not yet presented for payment) have been reclassified to claims and rebates payable or to accounts payable. The reclassification restores balances to cash and current liabilities for liabilities to our vendors which have not been defeased. No overdraft or unsecured short-term loan exists in relation to these negative balances.

RECEIVABLES

        Based on our revenue recognition policies discussed above, certain claims at the end of a period are unbilled. Revenue and unbilled receivables for those claims are estimated each period based on the amount to be paid to network pharmacies and historical gross margin. Estimates are adjusted to actual at the time of billing. In addition, revenue and unbilled receivables for rebates based on market share performance are calculated quarterly based on an estimate of rebatable prescriptions and the rebate per prescription. These estimates are adjusted to actual when the number of rebatable prescriptions and the rebate per prescription have been determined and the billing to the manufacturers has been completed. Historically, adjustments to our estimates have been immaterial.

INVENTORIES

        Inventories consist of prescription drugs and medical supplies that are stated at the lower of first-in first-out cost or market.

PROPERTY AND EQUIPMENT

        Property and equipment is carried at cost and is depreciated using the straight-line method over estimated useful lives of seven years for furniture and five years for equipment and purchased computer software. Leasehold improvements are amortized on a straight-line basis over the term of the lease or the useful life of the asset, if shorter. Expenditures for repairs, maintenance and renewals are charged to income as incurred. Expenditures that improve an asset or extend its estimated useful life are capitalized. When properties are retired or otherwise disposed of, the related cost and accumulated depreciation are removed from the accounts and any gain or loss is included in income. Research and development expenditures relating to the development of software for internal purposes, are charged to expense until technological feasibility is established. Thereafter, the remaining software production costs up to the date placed into production are capitalized and included as Property and Equipment. Amortization of the capitalized amounts commences on the date placed into production, and is computed on a product-by-product basis using the straight-line method over the remaining estimated economic life of the product but not more than five years. Reductions, if any, in the carrying value of capitalized software costs to net realizable value are expensed.

GOODWILL

        Goodwill is evaluated for impairment annually or when events or circumstances occur indicating that goodwill might be impaired. In accordance with the provisions of Financial Accounting Statement No. (“FAS”) 142, “Goodwill and Other Intangible Assets,” we perform our annual impairment testing during the fourth quarter of each year. No impairment test performed to date has indicated any impairment.

OTHER INTANGIBLE ASSETS

        Other intangible assets include, but are not limited to, customer contracts, non-compete agreements, deferred financing fees, trade names and certain advance discounts paid to clients under contractual agreements. Other intangible assets, excluding customer contracts, are recorded at cost. Customer contracts are valued based on discounted cash flows over the expected life of the intangible asset. Excluding trade names, which have an indefinite life, other intangible assets are amortized on a straight-line basis over periods from two to 20 years.

IMPAIRMENT OF LONG-LIVED ASSETS

        We evaluate whether events and circumstances have occurred that indicate the remaining estimated useful life of long–lived assets, including intangible assets and the loan to Pharmacy Care Alliance (described in Note 2), may warrant revision or that the remaining balance of an asset may not be recoverable. The measurement of possible impairment is based on the ability to recover the balance of assets from expected future operating cash flows on an undiscounted basis. Impairment losses, if any, would be determined based on the present value of the cash flows using discount rates that reflect the inherent risk of the underlying business. No such impairment existed as of September 30, 2004 and December 31, 2003. Absent events or circumstances indicating an impairment of goodwill, we perform an annual goodwill impairment test during the fourth quarter.

SELF-INSURANCE RESERVES

        We maintain insurance coverage for claims that arise in the normal course of business. Where insurance coverage is not available, or, in our judgment, is not cost-effective, we maintain self-insurance reserves to reduce our exposure to future legal costs, settlements and judgments. Self-insured losses are accrued based upon estimates of the aggregate liability for claim costs in excess of our insurance coverage using certain actuarial assumptions followed in the insurance industry and our historical experience (See Note 8). It is not possible to predict with certainty the outcome of these claims, and we can give no assurances that any losses, in excess of our insurance and any self-insurance reserves, will not be material.

EMPLOYEE BASED COMPENSATION

        We account for employee stock options in accordance with Accounting Principles Board No. (“APB”) 25, “Accounting for Stock Issued to Employees.” Under APB 25, we apply the intrinsic value method of accounting and, therefore, have not recognized compensation expense for options granted, because we grant options at a price equal to market value at the time of grant. FAS 123, “Accounting for Stock-Based Compensation” prescribes the recognition of compensation expense based on the fair value of options determined on the grant date. However, FAS 123 grants an exception that allows companies currently applying APB 25 to continue using that method. We have, therefore, elected to continue applying the intrinsic value method under APB 25. The following table shows stock-based compensation expense included in net income and pro forma stock-based compensation expense, net income and earnings per share had we elected to record compensation expense based on the estimated fair value of options at the grant date for the nine months ended September 30, 2004 and 2003 (see also Note 9):

⁽¹⁾     Net income, as reported, includes stock-based compensation expense for the three months ended September 30, 2004 and 2003 of $1,122 ($1,818 pre-tax) and $1,359 ($2,198 pre-tax), respectively, and for the nine months ended September 30, 2004 and 2003 of $3,860 ($6,252 pre-tax) and $3,069 ($4,962 pre-tax)), respectively, related to restricted shares of Common Stock awarded to certain of our officers and employees.

⁽²⁾     The decrease in pro forma compensation expense is due to the forfeiture of options during the year which resulted in expense reductions of $283 and $3,473 during the three and nine months ended September 30, 2004, respectively.

NEW ACCOUNTING GUIDANCE

        In January 2003, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. (“FIN”) 46, “Consolidation of Variable Interest Entities.” FIN 46 requires a variable interest entity be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or entitled to receive a majority of the entity’s residual returns or both. The consolidation provisions of FIN 46 were originally effective for financial periods ending after July 15, 2003. In October 2003, the FASB issued Staff Position FIN 46-6, “Effective Date of FIN 46,” which delays the implementation date to financial periods ending after December 31, 2003. In December 2003, the FASB published a revision to FIN 46 (“FIN 46R”) to clarify some of the provisions of FIN 46, and to exempt certain entities from its requirements. We do not have any variable interest entities requiring consolidation under FIN 46 and FIN 46R. Therefore, the adoption of these standards did not have a material impact on our consolidated financial position, consolidated results of operations or our consolidated cash flows.

        In January 2003, we adopted FAS 143, “Asset Retirement Obligations.” FAS 143 addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. FAS 143 requires the capitalization of the fair value of any legal or contractual obligations associated with the retirement of tangible, long-lived assets in the period in which the liabilities are incurred and the capitalization of a corresponding amount as part of the book value of the related long-lived asset. In subsequent periods, we are required to adjust asset retirement obligations based on changes in estimated fair value, and the corresponding increases in asset book values will be depreciated over the useful life of the related asset. As required by FAS 143, we recorded an asset retirement obligation ($3.1 million at January 1, 2003) primarily related to equipment and leasehold improvements installed in leased mail-order facilities in which we have a contractual obligation to remove the improvements and equipment upon surrender of the property to the landlord. For certain of our leased facilities, we are required to remove equipment and convert the facilities back to office space upon surrender of the property. We also recorded a net increase in fixed assets (net of accumulated depreciation) of $1.4 million and a $1.7 million ($1.0 million, net of taxes) loss from the cumulative effect of change in accounting principle. The $1.4 million asset is being depreciated, on a straight-line basis, over the remaining term of the leases, which range from seven months to ten years.

Note 2 – Changes in business

        On January 30, 2004, we acquired the outstanding capital stock of CuraScript Pharmacy, Inc. and CuraScript PBM Services, Inc. (collectively, “CuraScript”), for approximately $333.2 million which includes a purchase price adjustment for closing working capital and transaction costs. CuraScript is one of the nation’s largest specialty pharmacy services companies and will enhance our ability to provide comprehensive clinical services to our clients and their members. CuraScript operates seven specialty pharmacies throughout the United States and serves over 175 managed care organizations, 30 Medicaid programs and the Medicare program. The transaction was accounted for under the provisions of FAS 141, “Business Combinations.” The purchase price has been preliminarily allocated based upon the estimated fair value of net assets acquired at the date of the acquisition. A portion of the excess of purchase price over tangible net assets acquired has been preliminarily allocated to intangible assets, consisting of customer contracts in the amount of $28.7 million and non-competition agreements in the amount of $2.7 million, which are being amortized using the straight-line method over estimated useful lives of ten years and three years, respectively. These assets are included in other intangible assets. In addition, the excess of purchase price over tangible net assets and identified intangible assets acquired has been preliminarily allocated to goodwill in the amount of $284.8 million and trade names in the amount of $1.3 million, which are not being amortized. The purchase price allocation is subject to refinement in the future pending finalization of intangible asset valuations and final assessment of deferred taxes at the acquisition date. The $333.2 million purchase price was financed with $210.0 million of cash on hand and the remainder by adding $125.0 million in Term C loans through an amendment of our Bank Credit Facility. Our PBM operating results include those of CuraScript from January 30, 2004, the date of acquisition.

        In January 2004, we entered into an agreement to provide PBM services for the Medicare discount program of Pharmacy Care Alliance, Inc. (“PCA”), a nonstock, not-for-profit entity jointly controlled by the National Association of Chain Drugstores (“NACDS”) and us. Our PBM services include the negotiation of discounts from individual retailers and pharmaceutical manufacturers, the enrollment of cardholders and the processing of prescription claims.

        During the first quarter of 2004, we entered into a lending agreement with PCA, whereby we committed to lend up to $4.0 million to PCA in the form of a revolving line of credit available over the next 18 months. Requests for borrowings on the revolving line of credit require the unanimous consent of PCA’s board of directors, which consists of representatives from NACDS and from our management team, or its designated representatives. PCA will utilize the revolving line of credit to fund its operating expenditures. NACDS has agreed to guarantee the lesser of $2.0 million or 50% of the amounts outstanding on the revolving line of credit.

        In the second quarter of 2004, we signed an amended credit agreement with PCA which increased the revolving line of credit available to PCA from the initial $4.0 million to $17.0 million. The additional $13.0 million will be unsecured and used to fund PCA’s operating expenditures, as well as the start-up expenditures associated with the enrollment of cardholders by PCA and by us. As of September 30, 2004, we have loaned PCA $14.3 million, which is included in other long-term assets on the Unaudited Consolidated Balance Sheet.

         In regard to the extended revolving line of credit, the collectibility of any unsecured borrowings will be a function of PCA’s success in enrolling new members for its Medicare discount program. Through September 30, 2004, enrollment has fallen short of expectations, with approximately 200,000 members enrolled to date. We continue to enroll new members and we believe our enrollment goals can be attained if membership for the Medicare Discount Card program builds, or if the Medicare Discount Card program is extended beyond 2005. However, if enrollment continues to fall short of expectations, it is possible that a portion, or all, of any unsecured borrowings under the line of credit could be written off in future quarters.

Note 3 – Receivables, net

        Included in receivables, net, as of September 30, 2004 and December 31, 2003, is an allowance for doubtful accounts of $32.1 million and $28.6 million, respectively. The increase in the allowance for doubtful accounts is primarily due to the inclusion of CuraScript opening balances as a result of our January 2004 acquisition.

        As of September 30, 2004 and December 31, 2003, unbilled receivables were $592.2 million and $603.5 million, respectively. Unbilled receivables are billed to clients typically within 30 days of the transaction date based on the contractual billing schedule agreed upon with the client.

Note 4 – Goodwill and other intangibles

        The following is a summary of our goodwill and other intangible assets (amounts in thousands).

        The aggregate amount of amortization expense of other intangible assets was $6.9 million and $5.7 million for the three months ended September 30, 2004 and 2003, respectively, and $27.0 million and $18.9 million for the nine months ended September 30, 2004 and 2003, respectively. The future aggregate amount of amortization expense of other intangible assets is approximately $7.1 million for fourth quarter of 2004, $26.5 million for 2005, $22.9 million for 2006, $17.6 million for 2007, $17.2 million for 2008, and $15.8 million for 2009. The weighted average amortization period of intangible assets subject to amortization is 17 years in total, and by major intangible class is 20 years for customer contracts and six years for other intangible assets.

Note 5 – Earnings per share

        Basic earnings per share is computed using the weighted average number of common shares outstanding during the period. Diluted earnings per share is computed in the same manner as basic earnings per share but adds the number of additional common shares that would have been outstanding for the period if the dilutive potential common shares had been issued. The following is the reconciliation between the number of weighted average shares used in the basic and diluted earnings per share calculation for all periods (amounts in thousands):

The above shares are all calculated under the “treasury stock” method in accordance with FAS 128, “Earnings per Share.”

Note 6 – Financing

        In early February 2004, we borrowed $50.0 million on the revolving credit facility under our then existing credit agreement and on February 13, 2004, we refinanced our entire credit facility. We negotiated an $800.0 million credit facility with a bank syndicate which includes $200.0 million of Term A loans, $200.0 million of Term B loans and a $400.0 million revolving credit facility. The proceeds from the $800.0 million credit facility were used to prepay borrowings on the revolver, Term B and Term C loans outstanding under our previous credit facility. In June and September 2004, we made scheduled payments on our Term A and Term B loans totaling $10.0 million and $1.0 million, respectively. As of September 30, 2204, we had net borrowings of $50.0 million under our revolving credit facility.

        Our new credit facility requires us to pay interest periodically on the London Interbank Offered Rates (“LIBOR”) or base rate options, plus a margin. The margin on the Term A loans and on amounts outstanding under the revolving credit facility is dependent on our credit rating and our ratio of debt to earnings before interest, taxes, depreciation and amortization (“EBITDA”). The Term B loan interest is based on the LIBOR or alternative base rate options plus a margin of 1.5% or 0.25% per annum, respectively. To alleviate interest rate volatility, we have an interest rate swap arrangement (see Note 7). Under our new credit facility we are required to pay commitment fees on the unused portion of the $400.0 million revolving credit facility ($350.0 million at September 30, 2004). The commitment fee will range from 0.2% to 0.5% depending on our credit rating and our consolidated leverage ratio. The commitment fee is currently 0.25% per annum.

        At September 30, 2004, the weighted average interest rate on the new facility was 3.11%. Our new credit facility contains covenants that limit the indebtedness we may incur, the common shares we may repurchase and dividends we may pay. The covenants also include a minimum interest coverage ratio and a maximum leverage ratio. At September 30, 2004, we are in compliance with all covenants associated with our credit facility.

        During the second quarter of 2004, we redeemed all of our outstanding Senior Notes ($204.4 million) at a redemption price of 104.8125% by using internally generated cash and a portion of our $400 million revolving credit facility. As a result of the redemption, we recorded in interest expense charges of approximately $12.3 million ($7.6 million after-tax) representing a redemption premium of $9.8 million and the write-off of unamortized deferred financing fees.

        The following represents the schedule of current maturities for our long-term debt at September 30, 2004 excluding the deferred gain ($0.1 million at September 30, 2004) from the restructuring of an interest rate swap agreement in 2000 (amounts in thousands):

Note 7 – Derivative financial instruments

        We use an interest rate swap agreement to manage our interest rate risk on future variable interest payments. At September 30, 2004, our swap agreement fixes the variable interest rate payments on approximately $20.0 million of debt under our credit facility. Under our swap agreement, we agree to receive a variable rate of interest on the notional principal amount of approximately $20.0 million based upon a three month LIBOR rate in exchange for payment of a fixed rate of 6.25% per annum. The swap will mature in April 2005.

        Our present interest rate swap agreement is a cash flow hedge which requires us to pay fixed-rates of interest, and which hedges against changes in the amount of future cash flows associated with variable interest obligations. Accordingly, the fair value of our swap agreement, $0.6 million at September 30, 2004, is reported on the balance sheet in other liabilities. The related deferred loss on our swap agreements, $0.4 million at September 30, 2004, is deferred in shareholders’ equity as a component of other comprehensive income. This deferred loss is then recognized as an adjustment to interest expense over the same period in which the related interest payments being hedged are recorded in income. The loss associated with the ineffective portion of this agreement is immediately recognized as an expense. For the three and nine months ended September 30, 2004 and 2003, the gains and losses on the ineffective portion of our swap agreement were not material to the consolidated financial statements.

Note 8 – Contingencies

         We accrue self-insurance reserves based upon estimates of the aggregate liability of claim costs in excess of our insurance coverage. Reserves are estimated using certain actuarial assumptions followed in the insurance industry and our historical experience (see Note 1, “Self-insurance reserves”). The majority of these claims are legal claims and our liability esimate is primarily related to the cost to defend these claims. We typically do not accrue for settlements, judgments, monetary fines or penalties until such amounts are probable and estimable in compliance with FAS 5, “Accounting for Contingencies.” Under FAS 5, if the range of possible loss is broad, the liability accrual should be based on the lower end of the range.

         As we reported for the second quarter, we are a defendant in litigation involving our contract to provide prescription drug benefits for the State of New York Empire Plan and we have received civil investigative demands from the Attorneys General of 22 states and the District of Columbia. In light of these developments, we previously disclosed that we would increase legal reserves in the third quarter by $15.0 million to $20.0 million. Subsequently, several shareholder class action lawsuits and additional class action lawsuits were filed against the Company (see “—Legal Proceedings”). Based on these developments, we recorded a $25.0 million increase in legal reserves during the third quarter period. We accrue legal reserves for costs in excess of our insurance coverage to defend legal claims. Reserves are estimated using certain actuarial assumptions followed in the insurance industry and our historical experience (see “—Critical Accounting Policies”).

         While we believe that our services and business practices are in compliance with all applicable laws, rules and regulations in all material respects, we cannot predict the outcome of these matters at this time. An unfavorable outcome in one or more of these matters could result in the imposition of judgments, monetary fines or penalties, or injunctive or administrative remedies. We can give no assurance that such judgments, fines and remedies, and future costs associated with these matters would not have a material adverse effect on our financial condition, our consolidated results of operations or our consolidated cash flows.

Note 9 – Stock-based compensation plans

        We apply APB 25 and related interpretations in accounting for our stock-based compensation plans. Accordingly, compensation cost has been recorded based upon the intrinsic value method of accounting for restricted stock and no compensation cost has been recognized for stock options granted as the exercise price of the options was not less than the fair market value of the shares at the time of grant. If compensation cost for stock option grants had been determined based on the fair value at the grant dates consistent with the method prescribed by FAS 123, our net income and earnings per share for the three months ended September 30, 2004 and 2003 would have been $60.9 million, or $0.78 per diluted share and $62.7 million or $0.79 per diluted shares, respectively, and our net income and earnings per share for the nine months ended September 30, 2004 and 2003 would have been $194.9 million or $2.48 per diluted share and $175.0 million or $2.20 per diluted share, respectively (see also Note 1).

        The fair value of options granted (which is amortized over the option-vesting period in determining the pro forma impact) is estimated on the date of grant using the Black-Scholes multiple option-pricing model with the following weighted average assumptions:

        A summary of the status of our fixed stock option plans as of September 30, 2004 and 2003, and changes during the periods ending on those dates are presented below.

        The following table summarizes information about fixed stock options outstanding at September 30, 2004:

Note 10 – Segment reporting

        We report segments on the basis of services offered and have determined that we have two reportable segments: PBM services and non-PBM services. Our PBM operating results include those of CuraScript from January 30, 2004, the date of acquisition. Our domestic and Canadian PBM operating segments have similar characteristics and as such have been aggregated into a single PBM reporting segment. Effective in December 2003, our self-injectibles business unit became part of our domestic PBM operating segment and our remaining service lines (Specialty Distribution Services (“SDS”) and Phoenix Marketing Group (“PMG”)) merged into a single Non-PBM operating segment, Pharma Business Solutions. Our 2003 data has been recast to reflect the change in our operations and reporting segments.

        Operating income is the measure used by our chief operating decision maker to assess the performance of each of our operating segments. The following table presents information about our reportable segments, including a reconciliation of operating income to income before income taxes, for the three and nine months ended September 30, 2004 and 2003:

        PBM product revenue consists of revenues from the dispensing of prescription drugs from our mail pharmacies and revenues from the sale of prescription drugs by retail pharmacies in our retail pharmacy networks. Non-PBM product revenues consist of revenues from certain specialty distribution activities. PBM service revenue includes administrative fees associated with the administration of retail pharmacy networks contracted by certain clients, market research programs and informed decision counseling services. Non-PBM service revenue includes revenues from certain specialty distribution services, and sample distribution and accountability services.

        Revenues earned by our Canadian PBM totaled $6.2 million and $5.4 million for the three months ended September 30, 2004 and 2003, respectively, and $19.2 million and $15.6 million for the nine months ended September 30, 2004 and 2003, respectively. All other revenues are earned in the United States. Long-lived assets of our Canadian PBM (consisting primarily of fixed assets and goodwill) totaled $34.2 million and $33.9 million as of September 30, 2004 and December 31, 2003, respectively. All other long-lived assets are domiciled in the United States.

Item 2.             Management’s Discussion And Analysis Of Financial Condition And Results Of Operations

        Information that we have included or incorporated by reference in this Quarterly Report on Form 10-Q, and information that may be contained in our other filings with the Securities and Exchange Commission (“SEC”) and our press releases or other public statements, contain or may contain forward-looking statements. These forward-looking statements include, among others, statements of our plans, objectives, expectations or intentions.

        Our forward-looking statements involve risks and uncertainties. Our actual results may differ significantly from those projected or suggested in any forward-looking statements. We do not undertake any obligation to release publicly any revisions to such forward-looking statements to reflect events or circumstances occurring after the date hereof or to reflect the occurrence of unanticipated events. Factors that might cause such a difference to occur include, but are not limited to:

        See the more comprehensive description of risk factors under the captions “Forward Looking Statements and Associated Risks” contained in Item 1 – “Business” of our Annual Report on Form 10-K for the year ended December 31, 2003.

OVERVIEW

        As one of the largest full-service pharmacy benefit management (“PBM”) companies, we provide health care management and administration services on behalf of our clients, which include health maintenance organizations, health insurers, third-party administrators, employers, union-sponsored benefit plans and government health programs. Our integrated PBM services include network claims processing, mail pharmacy services, specialty mail pharmacy claim fulfillment, benefit design consultation, drug utilization review, formulary management, disease management, and drug data analysis services. We also provide non-PBM services, through our Pharma Business Solutions unit, which include distribution of specialty pharmaceuticals requiring special handling or packaging where we have been selected by the pharmaceutical manufacturer as part of a limited distribution network; distribution of pharmaceuticals through Patient Assistance Programs where we receive a fee from pharmaceutical manufacturers for administrative and pharmacy services for the delivery of certain drugs free of charge to doctors for their indigent patients and verifying practitioner licensure and distribution of drug samples.

        We report two segments, PBM and non-PBM. We derive revenues primarily from the sale of PBM services in the United States and Canada. Revenue generated by our segments can be classified as either tangible product revenue or service revenue. We earn tangible product revenue from the sale of prescription drugs by retail pharmacies in our retail pharmacy networks and from dispensing prescription drugs from our mail pharmacies. Service revenue includes administrative fees associated with the administration of retail pharmacy networks contracted by certain clients, market research programs, informed decision counseling services, certain specialty distribution services, and sample fulfillment and sample accountability services. Tangible product revenue generated through both our PBM and non-PBM segments represented 98.4% of revenues for the three months ended September 30, 2004 as compared to 98.7% for the same period of 2003 and 98.6% for the nine months ended September 30, 2004 and 2003.

        On January 30, 2004, we acquired the outstanding capital stock of CuraScript Pharmacy, Inc. and CuraScript PBM Services, Inc. (collectively, “CuraScript”), for approximately $333.2 million which includes a purchase price adjustment for closing working capital and transaction costs. Consequently, our PBM operating results include those of CuraScript from January 30, 2004.

RECENT DEVELOPMENTS

        During the quarter, we were named a defendant in litigation involving our contract to provide prescription drug benefits for the State of New York Empire Plan and we received civil investigative demands from 22 states and the District of Columbia. In addition, several shareholder class action lawsuits and additional class action lawsuits were filed against the Company (see “—Legal Proceedings”). We have, accordingly, re-evaluated the adequacy of our legal reserves and recorded an additional charge of $25.0 million in the third quarter for the estimated cost of defense of our legal proceedings.

CRITICAL ACCOUNTING POLICIES

        The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Our estimates and assumptions are based upon a combination of historical information and various other assumptions believed to be reasonable under the particular circumstances. Actual results may differ from our estimates. Certain of the accounting policies that most impact our consolidated financial statements and that require our management to make difficult, subjective or complex judgments are described below. This should be read in conjunction with Note 1, “Summary of Significant Accounting Policies” and with the notes to the consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2003, filed with the SEC on February 25, 2004.

REBATE ACCOUNTING

ACCOUNTING POLICY
We administer a rebate program based on actual market share performance in which rebates and the associated receivable from pharmaceutical manufacturers are estimated quarterly based on our estimate of the number of rebatable prescriptions and the rebate per prescription. The portion of rebates payable to clients is estimated quarterly based on historical and/or anticipated allocation percentages and our estimate of rebates receivable from pharmaceutical manufacturers. With respect to our market share rebate program, estimates are adjusted to actual when amounts are received from manufacturers and the portion payable to clients is paid.

FACTORS AFFECTING ESTIMATE
The factors that could impact our estimates of rebates, rebates receivable and rebates payable are as follows:

UNBILLED REVENUE AND RECEIVABLES

ACCOUNTING POLICY
We bill our clients based upon the billing schedules established in client contracts. At the end of a period, any unbilled revenues related to the sale of prescription drugs that have been adjudicated with retail pharmacies are estimated based on the amount we will pay to the pharmacies and historical gross margin.

FACTORS AFFECTING ESTIMATE
Unbilled amounts are estimated based on historical margin. Historically, adjustments to our original estimates have been immaterial. Significant differences between actual and estimated margin could impact subsequent adjustments.

ALLOWANCE FOR DOUBTFUL ACCOUNTS

ACCOUNTING POLICY
We provide an allowance for doubtful accounts equal to estimated uncollectible receivables. This estimate is based on the current status of each customer’s receivable balance.

FACTORS AFFECTING ESTIMATE
We record allowances for doubtful accounts based on a variety of factors including the length of time the receivables are past due, the financial health of the customer and historical experience. Our estimate could be impacted by changes in economic and market conditions as well as changes to our customer’s financial conditions.

SELF–INSURANCE RESERVES

ACCOUNTING POLICY
We accrue self-insurance reserves based upon estimates of the aggregate liability of claim costs in excess of our insurance coverage. Reserves are estimated using certain actuarial assumptions followed in the insurance industry and our historical experience. The majority of these claims are legal claims and our liability esimate is primarily related to the cost to defend these claims. We typically do not accrue for settlements, judgments, monetary fines or penalties until such amounts are probable and estimable, in compliance with Financial Accounting Standard No. (“FAS”) 5, “Accounting for Contingencies.” Under FAS 5, if the range of possible loss is broad, the liability accrual should be based on the lower end of the range.

FACTORS AFFECTING ESTIMATE
Self-insurance reserves are based on management’s estimates of the aggregate liability of the costs of legal claims, consisting primarily of the estimated costs to defend such claims. We do not have significant experience with certain of these types of cases. As such, differences between actual costs and management’s estimates could be significant. In addition, actuaries do not have a significant history with the PBM industry. Changes to assumptions used in the development of these reserves can affect net income in a given period. In addition, changes in the legal environment and number and nature of claims could impact our estimate.

OTHER ACCOUNTING POLICIES

In addition, we consider the following information about our accounting policies important for an understanding of our results of operations:

RESULTS OF OPERATIONS

PBM OPERATING INCOME

        Network claims increased by 11.4 million and 7.9 million claims, respectively, in the three and nine months ended September 30, 2004 over the three and nine months ended September 30, 2003. The increase in network claims for the third quarter of 2004 as compared to 2003 is primarily due to the implementation of our contract with the DoD TRICARE Retail Pharmacy (“TRICARE”) program in June 2004. Note that revenues for the TRICARE program are included in service revenue (see discussion below). For the nine months ended September 30, 2004 as compared to the same period of 2003, the increase in network claims due to the implementation of our TRICARE contract was partially offset by client specific reductions from the third quarter of 2003. One client, emerging from bankruptcy, discontinued providing retiree benefits, one client was lost through a competitive bidding process, and a one-year contract with a state agency expired, as expected, as future claims will be processed by the state.

        Mail order claims increased by 1.8 million and 5.3 million claims, respectively, in the three and nine months ended September 30, 2004 over the three and nine months ended September 30, 2003 due to the acquisition of CuraScript in January 2004, the implementation of new clients and due to the increased usage of our mail order pharmacies by members of existing clients. In addition, the increase in claim counts for the nine months ended September 30, 2004 as compared to the same period in 2003 is also due to the implementation of our contract with the DoD TRICARE Management Activity Program in March 2003.

         Network pharmacy revenues increased $81.7 million, or 3.7%, during the three months ended September 30, 2004 as compared to the same period of 2003, primarily due to net increases in the average revenue per network pharmacy claim. Increases in average revenue per network pharmacy claim were caused by drug price inflation and by the transition of one of our clients from use of their network to an ESI retail pharmacy network in the first quarter of 2004. As mentioned in our Critical Accounting Policies, when we merely administer a client’s network pharmacy contracts, drug ingredient cost is not included in our revenues or in our cost of revenues. These increases were partially offset by a higher mix of generic claims and an increase in the average co-payment per retail pharmacy claim. Generic claims made up 52.6% of total network claims(excluding TRICARE claims for which revenues are included in service revenues rather than network pharmacy revenues) for the three months ended September 30, 2004 as compared to 48.0% of total network claims for the same period of 2003. The average co-payment per retail pharmacy claim increased by 3.2% in the third quarter of 2004 as compared to the same quarter of 2003. As mentioned in our Critical Accounting Policies above, we do not include member co-payments to retail pharmacies in revenue or cost of revenue.

         Network pharmacy revenues increased $292.9 million, or 4.4%, during the nine months ended September 30, 2004 as compared to the same period of 2003. Among the factors affecting the increase in network pharmacy revenues are the following:

        The $410.9 million, or 41.7%, increase in mail pharmacy revenues for the third quarter of 2004 as compared to the third quarter of 2003 is attributable primarily to the following factors:

        The $1,024.8 million, or 35.1%, increase in mail pharmacy revenues for the nine months ended September 30, 2004 as compared to the same period of 2003 is attributable primarily to the following factors:

        PBM service revenues include amounts received from clients for therapy management services such as prior authorization and step therapy protocols and administrative fees earned for processing claims for clients utilizing their own retail pharmacy networks. The $13.7 million, or 92.1%, increase in PBM service revenues in the third quarter of 2004 as compared to the third quarter of 2003 is primarily due to the implementation of our contract with the DoD TRICARE Retail Pharmacy (“TRICARE”) program in June 2004. The increase from the implementation of the TRICARE contract was partially offset by the elimination of revenues from pharmaceutical manufacturers in support of certain clinical programs. This funding was completely phased out as of October 1, 2003.

        The $18.1 million, or 35.2%, increase in PBM service revenues in the nine months ended September 30, 2004 as compared to the nine months ended September 30, 2003 is partially due to a payment of $5.5 million received in the first quarter of 2004 in connection with the early termination by a client in 2001 as well as the implementation of the TRICARE contract in June 2004. These increases were partially offset by elimination of revenues from pharmaceutical manufacturers in support of certain clinical programs, as mentioned above.

        PBM cost of revenues increased $476.9 million, or 15.9% and $1,287.4 million, or 14.2%, in the three and nine months ended September 30, 2004 as compared to the same periods in 2003 primarily as a result of the following:

        Our PBM gross profit increased $29.5 million, or 15.3%, and $48.5 million, or 8.1%, respectively, for the three and nine months ended September 30, 2004. Increases in revenues from network inflation and higher mail order volumes were partially offset by inflationary increases in cost of revenues and margin pressures arising from the current competitive environment. Gross profit for the nine months ended September 30, 2003 was negatively impacted by a non-recurring reduction of $15.0 million relating to previously collected pharmaceutical manufacturer fund which we decided to share with our clients.

        Selling, general and administrative expenses (“SG&A”) increased $39.4 million, or 44.5%, and $24.2 million, or 8.3%, respectively, in the three and nine months ended September 30, 2004 over the same periods of 2003, primarily due to a $25.0 million increase in legal reserves recorded during the third quarter of 2004 (see below) and due to the acquisition of CuraScript in January 2004 which increased SG&A by $7.6 million and $18.8 million in the three and nine months ended September 30, 2004, respectively, as compared to the same periods of 2003. SG&A for the third quarter of 2004 as compared to the third quarter of 2003 also increased as a result of higher bad debt expense. In the third quarter of 2003, we reversed a portion of a reserve established during 2002, which had been recorded for a large client then in bankruptcy. As of the third quarter of 2003, we had received payment on this client’s obligations to us and determined such reserve was no longer necessary. These increases in SG&A for the three and nine months ended September 30, 2004 were partially offset by cost saving measures implemented during 2003 and 2004 which reduced SG&A by approximately $9.7 million and $28.8 million for the three and nine months ended September 30, 2004. In addition, the nine months ended September 30, 2003 was negatively impacted by $4.8 million in costs incurred to facilitate start-up of our operations supporting the DoD TRICARE Management Activity mail pharmacy service.

        As we reported in our Form 10-Q for the second quarter of 2004, we are a defendant in litigation involving our contract to provide prescription drug benefits for the State of New York Empire Plan and we have received civil investigative demands from the Attorneys General of 22 states and the District of Columbia. In light of these developments, we previously disclosed that we would increase legal reserves in the third quarter by $15.0 million to $20.0 million. Subsequently, several shareholder class action lawsuits and additional class action lawsuits were filed against the Company (see “—Legal Proceedings”). Based on these developments, we recorded a $25.0 million increase in legal reserves during the third quarter period (see “—Critical Accounting Policies”).

        PBM operating income decreased $9.9 million, or 9.5% in the three months ended September 30, 2004 over the same period of 2003, and increased $24.2 million, or 8.0%, respectively, in the nine months ended September 30, 2004 over the same period of 2003.

NON-PBM OPERATING INCOME