CVS Health Corp (CVS) 2008 Q2 法說會逐字稿

Good morning.

My name is Brandy and I will be your conference operator today.

At this time, I would like to welcome everyone to the CVS Caremark Corporation second quarter earning's conference call.

All lines have been placed on mute to prevent any background noise.

After the speaker's remarks, there will be a question and answer session.

(OPERATOR INSTRUCTIONS) Thank you.

I would now like to turn the call over to Nancy Christal, Senior Vice President, Investor Relations.

Please go ahead.

Thank you, Brandy.

Good morning, everyone, and thanks for joining us today for the second quarter earnings call.

I'm here with Dave Rickard, Executive Vice President and CFO of CVS Caremark .

Dave will provide a business update, a financial review of the second quarter and guidance.

I'm happy we have two other key executives with us today: Larry Merlo, President of CVS Pharmacy - Retail, and Howard McLure, President of Caremark Pharmacy Services.

Both Larry and Howard will participate in the question and answer session.

For your information, we expect to file our 10Q late by late today and it will be available through our website at investor.cvs.com.

This morning we'll discuss some nonGAAP financial measures in talking about our company's performance mainly free cash flow, EBITDA and adjusted EPS.

Free cash flow is defined as earnings after taxes plus noncash charges, plus changes in working capital, plus net capital expenditures.

So free cash flow excludes acquisitions, dividends and discontinued operations.

EBITDA is defined as operating profits plus depreciation plus amortization.

Adjusted EPS is defined as diluted EPS from continuing operations, eliminating the effects of amortization only and assuming our overall effect tax rate for the amortization.

As usual, we will provide guidance today using adjusted EPS which is the metric used in first call consensus.

In accordance with FCC regulations, you can find the reconciliation of the nonGAAP I mentioned to comparable GAAP measures on the investor relations portion of our website at investor.CVS.com.

As always today's call is being simulcast on our website, it will also be archived there for a one month period following the call to make it easy for all investors to access the call.

Following our remarks, we'll have a Q&A session and we ask that you limit yourself to one to two questions including follow-up so we can get to as many analysts and investors as possible.

Now, before we continue, our attorneys have asked me to read the Safe Harbor statement.

During this presentation we will make certain forward-looking statements that are subject to certain risks and uncertainties that could cause actual results to differ materially.

Accordingly for the forward-looking statements, we claim the protection of the Safe Harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995.

We strongly recommend that you become familiar with the specific risks and uncertainties that are described in the risk factor section of our most recently filed annual report on Form 10K.

And now I'll turn this over to our CFO,

Thanks, Nancy, and good morning, everyone.

I'm always pleased to have the opportunity to talk about another great quarter for CVS Caremark.

We posted strong second quarter results including record sales, record operating profit and profit margins, record net earnings and record earnings per share.

I'll run through those in detail.

But first I want to touch briefly on the areas of our business where we've recently gotten the most questions from investors.

They include the PBM selling season and our client's growing enthusiasm for our unique new product offerings, the trends we're seeing in our retail pharmacy business, our progress with MinuteClinic and our new store program.

So, first an update on the PBM.

On the last call we told you that we had already renewed more than half of our business that's up for renewal in 2009.

As mentioned previously, those renewals included accounts such as AT&T, Bank of America, 3M and the State of Connecticut.

Today I can report that our scheduled renewals for 2009 are already over 70% complete.

We're very pleased with our progress.

As previously reported, we did lose the med D contract with Coventry due in large part to price.

That represents approximately $2.5 billion in revenues and was largely retail oriented, so it's not significant to the bottom line.

In addition, you may recall that it was announced back in 2006 prior to the merger that Caremark's contract with Empire would expire at the end of 2008.

This expiration is part of Empire's planned strategy to take this business in house as part of its merger with Wellpoint.

The contract represents approximately $1 billion in revenues and similar to the Coventry med D business, this account is largely retail.

Outside of these two big health plans, we're experiencing one of our best selling seasons ever.

Importantly, our client retention in our employer segment is in excess of 99%.

So what about new PBM business?

Great news there.

On the last call, we said we had won the right to serve about 40 clients, which, in total, should have first 12-month revenues of about $3 billion.

That included the previously announced contracts to service the employee retirement system of Texas, the BellSouth portion of AT&T and GE.

Since then we've won $1.3 billion in additional new business.

So our new contracts in total, season to date, are expected to have first 12-month revenues of $4.3 billion represented by over 50 accounts.

Some of these start as early as September of 2008.

So the $4.3 billion is not -- excuse me, not the increment for 2009.

And there is still some business which is not yet been awarded.

So we'll be more specific about the net expected impact on 2009 on the third quarter call.

By then, the selling season will be largely wrapped up and we'll provide a specific number for total net new business.

For now, keep in mind that the two health plan contracts that I noted will expire at the end of this year had single digit mail penetration, while the new business we won is well over 30% mail.

In fact, many of them are in excess of 40% mail, as these clients had mandatory mail or significant mail drivers with the previous PBM.

This is an obvious profitability driver for the business and the signals the traction we're getting with the Maintenance Choice offering which I'll talk more about in a moment.

Although we're losing two large retail health projects, we were recently awarded the mail service for a significant health plan customer and we have expanded our mail offering specialty services for a large blues plan.

Many investors have asked us about the pricing environment.

While it's safe to say that it remains competitive as it always has been, price will always be an important factor in every contract decision.

But as evidenced by our solid business wins, we believe our award winning service and our new model are key differentiators for CVS Caremark

At our analyst day on May 21st in New York City, we told you about some of our unmatched offerings which only at PBM and retail combination like CVS Caremark can offer.

Our new proactive pharmacy care model is increasingly resonating in the marketplace and we're told by clients that it's been an important factor in their PBM process.

Clients have expressed their enthusiasm for products like Maintenance Choice and proactive pharmacy care at retail because they understand that we can lower their overall costs while improving access, convenience and health outcomes for their members.

As I said, we're beginning to see Maintenance Choice create a real market differential.

This offering lets the patient choose where they serve their 90-day medication while maintaining the same economics to the payer and the patient.

The concept of preserving the economics of mail service while expanding consumer choice and access has resonated in the marketplace and led to several key wins in the 2009 selling season.

Proactive pharmacy care at retail is well underway.

Our retail pharmacists are speaking with Caremark members who have gaps in care, and we are already beginning to deliver incremental scripts as we aim to improve adherence rates to prescribed drug regimines.

That will both keep people healthier and lower overall health care costs.

Our ExtraCare health card provides a discount on CVS brand flexible spending account OTC products to Caremark members who want to participate, especially given the current economic climate.

Clients are viewing it as an exciting new benefit they can offer their employees at no incremental cost.

We are still on target for reaching about 10 million members by early next year.

The offering is resonating with clients as a unique way to provide services to members and we continue to roll out new cards each month.

And, finally, our first specially pickup at retail client is scheduled to go live on September 2nd and all systems and processes are in place for a broader rollout next year.

Overall our new offerings are make steady headlines in the marketplace and are being clearly recognized as a differentiator for CVS Caremark.

Our momentum in this PBM selling season is excellent.

We're feeling very good about our competitive position.

Now, let me touch on the retail pharmacy side of our business.

We had another solid quarter with pharmacy same-store sales growing 3.7%.

Sales of new generics negatively impacted this number by 280 basis points.

So if adjusted for the impact of new generics, pharmacy comps would have been 6.5%.

The generic dispensing rate in our retail segment was 67% in the second quarter, up about 460 basis points from last year and up about 40 basis points sequentially.

Although there is some headwinds impacting pharmacy growth across the industry, such as Rx to OTC switches and a weak brand drug pipeline, CVS continues to grow and gain market share.

Our script growth in the second quarter in year to date is nicely ahead of all other chain stores and we continue to gain on independence as well.

In fact, if you adjust for calendar differences, our pharmacy same store sales have led the industry every month for the past six months.

Many have asked if the economy is having an impact on script trends.

It's difficult to know for sure, but we see no hard evidence of it.

In fact, we did an analysis of both retail and mail.

We looked at the number of days between refills of maintenance medications.

If people were doing more pill splitting, the number of days between pills would go up.

The study found absolutely no increase in days.

As for the front end, comps increased 1.8% in the second quarter.

Adjusting for the negative impact of the Easter shift, front end comps increased 2.9%.

We're seeing a pickup of increases from suppliers which we've been able to pass through, but it has had a minimal impact on comps through June as many are effective in the second half of the year.

Our average front-store ticket continues to increase.

It was up notably versus the second quarter of last year.

We believe that's a testament to the strength of our ExtraCare loyalty card program which encourages our customers to aggregate their purchases at CVS.

In fact, more than 65% of front end sales across the store base used the ExtraCare card.

So despite the economy, we continue to grow and take the greater share of the wallet with the help of our highly successful program.

I'll also note that our front store margins continued to improve significantly.

One important driver of improved margins is the use of the Extracare card program to drive more profitable sales.

In contrast with some competitors, we have not had to become more promotional this year.

What we have seen is increased vendor participation in ExtraCare offers to our customers, given the success of our previous targeted offers.

Additionally, our front store margins are benefiting from a notable increase in private label sales.

Private label made up 15% of front end sales, up 114 basis points from last year.

That's the largest increase in organic private label sales that we've seen in memory.

We think it reflects not only our continued efforts to grow private label, but also more people trading down due to the economy.

And how does all this stack up relative to the competition?

Well, I'm pleased to report that we continue to grow share in the key front store categories that make up the vast majority of our sales: over the county, beauty, private label and digital photo.

In fact, we experienced share gains versus food, drug and mass competitors in categories representing 80% of our front store sales volume.

Now let's move on to an update on our MinuteClinic business.

MinuteClinic continues to evolve as the nation's largest and most geographically diverse retail health care clinic system.

We currently operate 520 clinics, more than all of our competitors combined and we continue to build our leads in the markets in which we operate.

We also expect to open MinuteClinics in a few key new markets in the second half of this year.

Consistent with comments made on our last call, we expect to end the year with between 550 and 600 clinics, resulting in the addition of approximately 100 clinics in 2008.

That equates to about 20% growth in the number of clinics, still a very healthy pace of growth.

On our last earnings call we told you that we were slowing growth in order to better focus our efforts on expanding services, contracting with additional third-party vendors and working with PBM clients to offer new products and services.

Let me briefly touch on our progress in these areas.

New products continue to play an important role in MinuteClinic's strategic future.

Recent new product offerings include camp physicals, tuberculosis screening and an integrated behavioral modification and pharmacy based smoking cessation program.

Additionally, MinuteClinic initiated enrollment of patients into Google's personal health record product and is uploading records at our patient's request.

We're pleased with the increasing designation of MinuteClinic as as in network provider by health plans.

Year to date, 26 health plans have added MinuteClinic to their networks impacting 12 million Americans.

We expect this trend will continue as we further leverage our PBM relationships at convenient CVS pharmacy locations.

We believe MinuteClinic will play an increasingly important role in providing consumers easier access to high quality, lower cost health care.

We are well positioned for long-term growth as our clients and consumers continue to realize the value of our MinuteClinic offering.

Before I move on to the financial review, I want to give you a brief update on our real estate program.

In the second quarter we opened 88 stores, including 49 new and 39 relocations.

We closed eight others.

So we added 41 net new CVS Pharmacy stores in the quarter.

For 2008, our plan remains to open 300 to 325 stores, about 175 to 185 will be new and the rest will be relocations.

And we expect to achieve approximately 3 .5% retail square footage growth.

Many of you have asked if we plan to change our store growth strategy, and the simple answer is no.

We have been on a successful path of controlled appropriate growth and intend to continue on that path.

Now, let me turn to the details of our financial performance in the fine quarter we reported today.

After that, I'll provide guidance for the third quarter as well as the remainder of the year.

So let's turn to our second quarter income statement.

Total revenues on a consolidated basis increased 2.1% to $21.1 billion.

This figure is net of intersegment eliminations of $1.3 billion.

In our retail drug store segment, revenues increased 4.6% to $11.8 billion.

Same store sales for the quarter were up 3.1%.

I spoke earlier about the comp trends in both the front and the pharmacy and the drivers behind them.

So I won't repeat that discussion here.

And how about the PBM segment.

Net revenues of $10.7 billion increased 1% over the 2007 second quarter.

Adjusting that growth rate for the impact of generics, net revenues would have grown 8.4% for the PBM.

The impact of the change in PharmaCare's revenue recognition method on the second quarter was the addition of $667.6 million in reported revenues before inter company or $521.7 million after eliminations.

So what drove the growth of PBM revenues?

Total retail network revenues were $6.9 billion, rising 10.3% from 2007 levels.

Setting aside the increase from PharmaCare's revenue recognition change, retail network revenue was essentially flat to last year due to the significant increase in generics.

The PBM's retail generic dispensing rate increased to 65.5% compared to 61.2% in the second quarter of 2007.

At the same time, retail network claims grew 2.7%.

This was primarily driven by new business, including the growth spurt in our PDP and add on lives.

As expected, mail claims decreased for the quarter by 18.9%.

As with the first quarter, the impact of new clients was more than offset by well known terminations during 2007, namely the FEP mail business, the State of New York and Ohio State teacher's retirement system.

Total mail revenues declined 13.2% to $3.6 billion.

And within total mail revenues, PBM mail was down 22.4% compared to the second quarter of 2007, while our specialty mail revenues increased 4.4%.

If you exclude the FEP business from last year's data, total mail revenues increased 3.2% and specialty revenues grew 14.4% in the second quarter.

The mail generic dispensing rate rose to 54.5% from 47.6% a year ago or 690 basis points.

Our overall mail penetration rate decreased approximately five percentage points from 2007 second quarter to 23.5%.

Again, this was largely a result of the absence of the FEP mail business.

Moving on to gross profit margin for the total company, the overall business expanded by 60 basis points over the second quarter of 2007 to 20.7%.

And we had great results in both segments.

Within the retail segment, gross profit margins were up 60 basis points improving to 29.9%.

The primary drivers of this were these, first the increase in the retail generic dispensing rate.

Second, the merger related purchasing synergies.

Third, improved shrink.

Fourth, increased private label penetration, and finally the benefits from the ExtraCare card that result in a lower percent of products sold on promotion.

Gross profit margins in the PBM segment came in at 8.0%, that's down 20 basis points versus the 2007 comparable second quarter.

However, excluding the 53 basis point drag from the conversion of PharmaCare's contracts, the gross margin and the PBM would have been up 33 basis points.

The PBM pharmacy margin benefited from some of the same factors that helped the retail business, namely an increase in the use of generic drugs and the purchasing synergies derived from the merger.

And what about expenses?

Overall operating expenses by a percent of sales improved by approximately 10 basis points due to solid expense control in both segments of the business.

In the retail segment, operating expenses decreased as a percent of sales from 22.8% to 22.6%.

This was driven by disciplined expense control and improved expense leverage in the Savon and Osco stores we acquired back in 2006.

That was somewhat offset by the significant growth in generics which pressure sales dollars while improving profitability.

In the PBM segment, comparable operating expenses as a percentage of revenue improved by 17 basis points to 2.2%.

This was largely driven by the absence this year of integration and other merger-related expenses that we saw in last year's second quarter.

All things considered, we saw significant expansion of our operating margins, specifically in the retail segment.

The operating profit margin in the retail segment grew by 80 basis points to over -- that is over the 2007 level to a record 7.3%.

The PBM segments operating profit margin was flat with 2007's comparable results at 5.8%.

Caremark's industry leading EBITDA per adjusted claim increased to $3.97 in the second quarter or 3.7% over last year's comparable $3.83.

Excluding the FEP mail business, we, again, would have had double-digit growth in EBITDA per adjusted claim, so the underlying growth of the business remains robust.

Moving on to the rest of the income statement, we saw a quarterly net interest expense on the consolidated income statement increase slightly to $115 million.

That was virtually flat as a percentage of revenues year-over-year.

Sequentially, however, this represented a reduction of approximately $16 million, reflecting a decrease in our short-term debt levels during the second quarter.

Our tax rate was 39.6% in the quarter, in line with expectations.

And our diluted share count was 1.47 billion shares.

That's down considerably from last year's second quarter due to our $5 billion share buy back program last year that subsequently completed earlier this year.

During the second quarter of 2008, we repurchased 550,000 shares.

That was the beginning of our most recently announced $2 billion share buy-back program.

That represents roughly $23 million worth of stock.

As I said in our analyst day, we intend to repurchase shares during the remainder of this year and complete the buy back during 2009.

Before I move on to earnings per share, I want to discuss a new line item on the income statement.

Namely, discontinued operations.

During our analyst day in May, I highlighted the recent developments at Linen 'n Things, which was a subsidiary of Melville Corporation, the former parent company of CVS.

As many of you know, Linen 'n Things filed for bankruptcy.

At the time of the Melville restructuring CVS Corporation consumed a contingent liability for leases of several former Melville businesses, including Linens.

These businesses have been classified as discontinued operations for accounting purposes.

Linens has told us that they intend to close a number of locations, several of which have leases guaranteed by us.

there are also some other net expenses associated with the leases.

Our real estate team has research the site's market value and assessed the expected costs of satisfying these lease guarantees.

The loss from discontinued operations of $48.7 million you see on our income statement represents our determination of the impact of these closings, net of income tax benefits.

That's the state of knowledge as we have it now.

We have fully provided for all obligations as best they can be determined.

However, like any bankruptcy which is not worked its way through to reemergence or a wind down, this situation is fluid.

And there could be more news to come.

But even in a worst case scenario, this is simply not big enough to throw CVS Caremark off track.

It's inconvenient and there is some cash impact, but that's it.

Going forward, keep in mind our guidance excludes any possible impact from Linen 'n Things.

So if we put the discontinued operations aside, what did all of this mean for EPS.

Adjusted EPS from continuing operations rose 17.1% to $0.60, up from $0.51 in 2007.

GAAP diluted EPS from continuing operations rose 19.5% to $0.56 to the quarter compared to $0.47 in the second quarter of 2007.

Turning to the other financial statements, we generated $161 million in free cash flow in the quarter and $506 million year to date.

Our strong free cash flow combined with the use of $200 million in carbon hand allowed us to reduce our total debt by more than $360 million during the second quarter.

So we continued to strength en our balance sheet and improve upon our credit ratios.

Net capital expenditures were $491 million in the quarter which reflected proceeds from sale lease back transactions of $64 million, netted against the gross capital spend.

Now, let me turn to guidance for the Third Quarter and full year 2008.

I'll start by saying that given the continued strength across our businesses, we remain optimistic about our growth for the full year.

While a couple of the elements within our expectations have changed a little, we are maintaining our previous annual guidance of $2.44 to $2.50 for adjusted EPS for continued operations.

Let me walk you through the elements of our current guidance.

I'll start by providing initial guidance for the third quarter.

We expect third quarter revenue growth for the total company to be 3% to 5%.

We expect PBM revenues to be down slightly in the third quarter and we expect retail revenues to be up 5% to 7%.

We anticipate third quarter adjusted EPS from continuing operations of between $0.58 and $0.61 per diluted share up from last year's $0.50 per share.

That equates to adjusted EPS growth of 16% to 22%.

GAAP EPS from continuing operations is expected to be in the range of $0.53 to $0.56 per diluted share, up from last year's $0.45 per share.

Now let's look at the full year.

We still expect revenue growth for the total company of about 13% to 16% for the full year after inner company eliminations of somewhat over $1 billion per quarter.

For the PBM segment on a comparable basis, we still expect revenues to be about flat with 2007.

And we expect reported revenue growth of well over 20% for the year since the merger closed in late March of 2007.

For the retail segment, we still expect full year revenue growth to be 7% to 10%.

Same store sales are expected to be in the range of 4% to 6% for the retail segment for the year.

That's a slightly narrower range than before.

We've gotten a lot of questions from investors about our revenue expectations for the retail business.

In the second half, we still expect revenue growth to be stronger than in the first half.

That's largely due to somewhat easier year-over-year comparisons as well as the incremental revenues we expect from our new offerings.

These include the proactive pharmacy care at retail, ExtraCare health and specialty at retail.

And despite the economy, we're seeing very solid performance on the retail side of our business as we continue to gain share from weaker competitors.

I feel very good about the retail business, and I think these revenue growth projections are realistic.

By the way, in the month of July, our comps accelerated to 4.2% overall.

Pharmacy comps in July increased to 4.5%.

And that's with an even higher new generic impact than we had in the second quarter, and front store comps increased to 3.5%.

So we're off to a good start in the third quarter.

Now let's turn to margins for the total company gross profit margins are still expected to be down modestly due to the mix impact as we average in a full 12 months of Caremark.

However, the gross margin of our two business segments will be somewhat different than our previous guidance.

The PBM segment will be a bit lighter than we thought.

This will be offset by better than expected performance in our retail segment.

Let me walk you through that.

The change in our margin expectations for the PBM relates to two key areas.

First, our mail penetration rate is running a little softer than we thought.

That's primarily due to downsizing in large employer clients, for example, in the auto industry.

There has also been an impact on utilization from the Rx to OTC switch in the allergy category, similar to what we've seen in the retail side of the business.

As you know, mail order scripts are the most profitable scripts for the PBM, so our gross margin will be affected by the change in mix.

In addition, while we still expect profitability from the med D business and the PBM to be better in the second half than it was in the first half, we now expect slightly lower margins in the med D business due to utilization and mix.

So while we had previously thought that gross margin for the PBM would increase for the year, we now expect PBM gross margin to be marginally down from last year's rate.

In contrast, gross profit margins on the retail side of our business are now expected to improve even more than we originally forecast, so the news there is quite good.

We now expect gross margins for the retail segment to increase by at least 75 to 100 basis points.

This improvement is driven by terrific performance in several areas.

These include better than expected margins in both the pharmacy, as well as the front store driven by improved GDR, increased private label sales and reduced shrink.

I'm delighted by the strength of our retail business across the board.

As we said in the past, our gross margin will be helped by purchasing synergies and there is no change there.

We still expect more than $700 million in total cost synergies in 2008, the great majority of which is from purchasing.

That's up from cost synergies of about $400 million in 2007.

As for expenses, we still expect total company operating expenses as a percent of revenues to improve.

That's largely due to mix Total operating expenses as the percentage sales for the PBM segment on a comparable basis is still expected to be in the neighborhood of last year's number as a reduction of integration expenses and good expense discipline should be directionally offset by the 2008 start-up cost of the new business Howard and the team have been bringing in.

The retail segment has no such headwind and also continues to exercise disciplined expense control.

So we still expect it to show moderate improvement.

We expect total consolidated amortization for 2008 to be approximately $400 million and depreciation of about $850 million.

All of that will lead to solid improvement in operating profit margins for the total company.

I said on the last call that we could nicely exceed 6 .5% for the total company, our current operating margin high watermark which we achieved back in 2000.

That's still very much in prospect.

We forecast net interest of about $475 million to $500 million and a tax rate approaching 40%.

Net capital expenditures are still expected to be in if the range of $1.3 million to $1.4 billion for 2008, and free cash flow is still expected to be around $3 billion.

As you can see, despite a few tweaks in the details of our guidance, our business is very strong and we remain optimistic about 2008 and beyond.

So in summary, we reported very solid second quarter results across the board and we're well positioned for the future.

We delivered healthy sales growth and record breaking margin expansion in the second quarter resulting in 17% adjusted EPS growth.

Our retail business is outperforming the industry and gaining market share.

Our momentum in this PBM selling season is excellent and we're winning significant new business as clients embrace our proactive pharmacy care model.

Payers increasingly understand that we can improve access, convenience and health outcome from the members while lowering their overall health care costs.

Our MinuteClinic business is evolving its offerings to maximize long-term growth as more clients and consumers are recognizing the value of our offering.

And our guidance confirms our continued confidence in the remainder of the year.

With that, I'll now open it up to questions.

(OPERATOR INSTRUCTIONS) We'll pause for just a moment to compile the Q&A roster.

Your first question comes from the line of Scott Mushkin with Jefferies & Company.

Hey, guys.

Good morning, Scott.

Hey.

A couple questions here.

Maintenance Choice you hit on, Dave, in your -- I guess going over the quarter and the selling season.

What percentage of the Caremark member base will be exposed or accounts will be exposed in 2009 to this program?

And I guess does Texas have it?

The program is being offered to people with mandatory mail and incentive structures that promote a large percentage of mail participation.

I don't know what percentage that will represent in 2009.

Obviously we're still selling.

But it's gotten good uptake And there are a couple of contracts that we've won primarily because of it.

So it clearly is gaining good initial acceptance.

And I noticed you didn't mention it as a driver for retail and it seems when we look at it could be a pretty significant driver for retail.

Is there any reason you excluded it?

I think you're right.

I think it will be a good driver for retail.

We don't have much data yet so it's a little bit early to be talking about that, but we will report on that ultimately.

And I guess one last question.

I'm sure people are going to ask this too.

The gross margins on the PBM, other PBMs have been seeing up side.

You guys really aren't.

I know there is some extenuating circumstances.

Do you have any other reasons why the gross profit may be a little more subdued with you guys versus the other PBM competitors?

Yes.

I can't report on the competitors.

But obviously our gross margins are effected by the loss of the FEP mail.

That was a very large contract and it was mail order in nature.

And we talked about some med D higher utilization numbers affecting our margins to an extent versus original expectation.

So I guess I would point to those as two operational things.

And then, of course, in addition, the Pharmacare grossup has an impact on the percentage margins we report.

You gave basis points on PharmaCare.

Do you have any numbers on FEP?

Not that we're disclosing.

Thanks.

I'll turn over.

Thanks very much.

Okay, Scott.

Your next question comes from the line of Lisa Gill with JPMorgan.

Good morning, Lisa.

Good morning.

Just maybe following up on the part D aspect of Dave, as we now look at the back half of the year my expectations is these members got into the doughnut hole that there would be a nice ramp-up for med part D.

Can you maybe just explain why the tempered outlook on the gross margin?

And then, secondly, when we look at the new clients that are brought on, the additional 1.3 billion, can you maybe just give us some indication around specialty pharmacy and some of the other services you're selling?

Are you selling through MinuteClinic?

I think you're talking about the entire business having very good mail utilization trends, but I'm just curious to some other things you're selling them.

I'm going to turn this one over to Howard.

On the part D component of this, some of this is really just utilization mix.

We added a number of utilized in the part D business.

And we're just seeing some increased utilization and some increased mix, like others have seen in it this business.

We will see it pick up about a half.

So, Howard, then your initial expectations for what you thought you underwrote the business for, is it coming out to be less for that?

So therefore when you get to the doughnut hole there's not going to be as much of an impact because of the utilization you're seeing right now?

No.

It's coming in largely the way we underwrote it.

We'll see that moving the way we thought it would.

It's not -- it's a little heavier than we thought it was in the first half because of the accounting that you go through with that.

But, you'll see some -- we'll see some people moving into the doughnut hole and some of that lift in the fourth -- third and fourth quarter from the way we have in the past.

We're still looking at a very nice improvement, second half versus first half.

Yes.

As it relates to new clients, we are bringing specialty into those new clients.

We see that as coming in most accounts that we are.

We -- as Dave mentioned, a couple of them made their decision because of Maintenance Choice, so that's a new product that we will be selling into those accounts.

And we were talking to a number of them about adding that.

We still see the self through the clinical programs and good uptake on a lot of these things, as well as the interest in the proactive pharmacy care solution that we talked about at the investor day.

And then can you just lastly remind us where you are with specialty in your book of business as far as how penetrated it is, percentage of clients or percentage --

Yes.

We're about 50% penetrated throughout the book of business.

About 40% of the specialty revenues come from PBM.

Okay.

Great.

Thank you.

Thanks, Lisa.

Your next question comes from the line of Eric Bosshard with Cleveland Research.

Good morning, Eric.

Good morning.

On the retail side, the optimism for progress in the second half of the year on the revenue line and the gross margin line, I know you picked off some of the factors leading to that.

But in the softer retail environment, can you just give us a little more insight into your conviction into why the margin and especially the sales progress is going to continue or even improve?

Well, I think what I said in the opening remarks on the sales trends is really pretty much the story.

That is, we were up against tougher comparisons in the first half.

They get easier in the second half.

But importantly, our new products from the combined entity are insignificant in the first half of the year and will become moreso in the second half of the year.

In addition to that, we have underlying strength of the ExtraCare program and share gains pretty much across the board.

That has been evident in the first half.

It's going to -- it's my expectation that that's going to continue in the second half.

The gross margin trends are driven by, again, a number of factors.

And I should also include in that leverage of Osco Savon.

We're seeing better and better shrink results, better and better sales results.

And so at the margin, that can be influential in both of those comparison sales and gross margin.

And within the new products, what is the most significant?

These are programs that I know you've rolled out in the last 60 days or so.

Which are having the most material impact on the revenues so quickly that you have this confidence then?

Well, proactive care, I guess, is the most important thing in the very, very short term here because it can have an effect, the first day that we put it in place.

That is, ensuring adherence among consumers.

If we get them restarted on their meds, we get an extra script that day.

Secondly, we're just taking share, and taking share builds business.

Okay.

Thank you, Dave.

Okay.

Your next question comes from the line of Tom Gallucci with Merrill Lynch.

Good morning, Tom.

How are you.

Just a couple quick questions here.

I guess on the part D, first just to confirm, that will still be net profitable for the year?

It's just a matter of the accounting swing throughout the year, or --

Absolutely.

Absolutely right.

It will be net profitable.

Okay.

Is it possible to get some sort of magnitude of the swing that you're seeing in terms of the profits, versus second half up?

We don't break that out.

But I can tell you that there is a meaningful up swing second half versus first.

Okay.

And something else -- I'm trying to get some perspective on the numbers.

You mentioned the synergies in your prepared remarks.

Some idea of the relative idea of the benefit going towards the retail side versus the PBM side would be helpful.

Again, we haven't broken that out.

It is meaningful on both sides of the business.

But we haven't attempted to break that out.

Okay.

I guess last one as sort of a follow-up on some other questions that we've seen here, but I know you mentioned Maintenance Choice and some other things, Howard, that newer clients are signing up for.

Do you have an idea out of the 50 or so new clients that you have won starting, I guess, in September and into next year, how many have signed up for just a new product as a result of the combined company?

I would say right off the top of my head at least three that come to mind.

Two, Maintenance Choice they said was instrumental in their decision, very important.

One was a specialty customer who signed up for the in-store delivery of specialty products.

That is just right off the top of my head, Tom.

I can think of three instances.

Howard, that's three that had as a primary reason for signing up the fact that we had these products.

I think what he was getting at was how many of the 50 were signing up for the products whether it was a primary factor in their decision or not.

Sure.

Okay.

Well, people are coming -- this is resonating very well for the new offer here and people are coming in.

Whether they're signing up first of the year for new products, they're seeing the potential here.

They understand the ability that this entity, this combined entity is going to be able to bring.

And the tools that are going to be able to bring to bear to help them control their pharmacy trends.

And I think people are really excited about it.

The sales force is very excited about it and getting a lot of interest in not only Maintenance Choice but the pharmacy care programs, the ability to use MinuteClinics to help serve their members, not only for ongoing care, but also for purposes of helping training for specialty injection services.

Those types of things.

This is just a significant amount of buzz around all of these products and all of the things we can do.

So of the 50, I would say probably, I don't know, I would say probably more than half --

The majority.

-- had signed up for new products.

That's my sense as well.

And I also know of situations where people have said we're interested in that new product, we would like to see some experience with somebody else before we actually sign up for it.

But if we can take it in a year or two, we'd be interested in doing that.

So I think that number will grow.

All right.

Thanks.

Your next question comes from the line of John Heinbockel with Goldman Sachs.

Dave, a couple of things.

Given what's happened and your experience with the PDP business this year, does that have any -- what do you do differently next year in terms much of the bid process?

Are the numbers different enough where you would change your approach or not really?

No.

We're talking fine tuning here.

And this certainly doesn't affect the approach.

It effects, perhaps, the way we forecast a bit.

Okay.

Secondly, if you look at that upswing, second half versus first half on PDP, if you look at SEP and that impact similarly, how does that look second hand versus first?

The same or do you think the impact mitigates a little bit?

It will have a similar seasonality I guess to what the overall business has.

But I see no reason where it would mitigate.

I mean, if you guys look at adjusting for SEP and PDP and sort of back into a Caremark growth rate in EBIT, is there any since what that looks like?

Because obviously the reported numbers don't look as strong as what they are on an underlying basis.

What's the sense of -- that we're looking at mid teens EBIT growth ex these factors or what?

Without getting into EBIT growth, take a look at probably one of the more important things and that's script.

And if you look at the script, from Q1 to Q2, it's up 16%.

Okay.

So that kind of gets out of the 3.7% year for year has an SEP impact which they said would be double digits without that.

But looking at that growth, that sequential growth, you still see the strength in this company and the strength and ability to drive generics, the strength and the ability do things to help these trends.

So I think if we look at it sequentially, you'll see the strength.

Okay.

And then, finally, where do we stand with synergies?

What kind of run rate are we running towards at this point?

$700 million plus, cost synergies.

Likely to be a lot plus?

It's likely to be north of $700 million.

I'm not going to give you a new number.

Okay.

Thanks.

Your next question comes from the line of Matt Perry with Wachovia Capital Markets.

Good morning, Matt.

Good morning.

If I look at the second half guidance that you've given for better same side sales, better revenue growth in total, how much of that is due to the synergies from the new offerings?

And I guess what maybe what I'm really asking is, are you still thinking about $800 million in revenue synergies for the year and how much of that will occur in the second half?

Yes.

I think the $800 million is still intact.

It may be a bit better than that based on PBM results.

But, we were gearing for a little over $400 million on the retail side, and that still looks like a good call, and almost all of that is in the second half.

Okay.

Larry, do you want to add to that?

Well, I think it's that combined with some of the programs that Dave alluded to earlier.

the strength that we're seeing from the Osco Savon acquisitions, as well as the fact that there is evidence that we're picking up market share from some of the weakened competitors, and we expect that will continue.

And if I think about the 4% to 6% same store sales, does any part of that or anything within that range predicated on an improvement in the economy?

No.

Our assumption on the economy is it's not going to get any better and it's not going to get a lot worse.

Okay.

So that's the range we're in.

And then last question, maybe for Howard, if we listen to comments from the two independent PBMs, they keep talking about the positive reaction their customers and their potential customers have to the independent model.

And I just wonder if you have an update on what -- the feedback you're getting from your customers and your potential customers on the vertical model?

I mean, any change in the last three months, or just any update there?

Well, I think we've signed $4 billion in new business this year and it's not -- there is no large mega accounts in there.

This is I think the statement of -- the best statement of that math that we are signing business.

We're in front of a lot of business.

And people are not bothered by this fact.

People are looking at -- they're making decision on price, but they're also making decision on service, and they're looking at the service that we're able to bring to bear.

Things like [bridge] supplies.

No one else can do that.

And they see that.

They see the benefit of that.

We've gotten just -- I've gotten letters from individuals saying this is great.

This is a fantastic thing that you can do for me.

Thank you for helping.

So I don't think that people are -- the independent model is there.

The competitors are good competitors.

They're good companies.

They do a good job.

We'll believe that we'll be able to bring to bear service, price, service and trends, and that we'll be unmatched in the industry once we get these programs fully in place.

And just lastly for me, if you think of the 50 account wins, is there any place that share -- specific place that share is coming from in the big independent PBMs, smaller PBMs, HMO owned PBMs?

It's coming from across the board.

Okay.

Thank you.

Okay, Matt.

Your next question comes from the line of David Magee with SunTrust Robinson Humphrey.

Good morning, David.

Good morning, Dave, guys.

A couple of things, please.

One, do you care to give any thought or prediction as to when you might have a better tailwind for the pharmacy side of business as we lap some of the facts that you mentioned?

Do you think we'll see better trends this year as far as the industry is concerned?

Well, I think the -- are you talking retail pharmacy or are you talking PBM pharmacy?

Retail pharmacy.

Just the sector of weakness that we've seen out there for the last say six months.

Yes.

I guess you have to look at the pieces of that and think about how they affect it.

But, for example, we'll be cycling the Zyrtec effect going OTC in the first quarter of '09.

The absence of positive lifts from med D will certainly be baked in by then.

So I guess, absent any significant new products being introduced by the pharma manufacturers, I would say first quarter of '09 is probably the first time we get a meaningful change in that trend.

Larry, would you agree with that?

Yes, I would.

Okay.

Thanks.

And then, secondly, with regard to the script growth that you are showing and the fact that you're gaining a share, at this point are we seeing the meaningful deviation between the older core CVS stores and those that you've acquired in the last five years?

Well, yes.

I mean, as is almost always the case, following acquisition we spruce them up and advertise them and get them moving a little bit better than they were, and that's certainly the case.

It continues to be the case in the southern assets of Eckerd businesses.

They are both growing faster than core CVS.

And then just a last one, maybe for Howard.

Thinking about the longer term growth rate of care more, I don't know if you could bit a number on EBIT growth over time and what you would expect.

But I'm wondering if you have top line versus profit margins, further expansion of the profit margin there?

Well, as generics continue to get introduced, that reduce the revenue.

It also enhances the profitability.

So as you move forward, you can look historically back at what the growth rates would have been had generics not been in place and see how that does impact revenue.

I don't know the number off the top of my head that impacted it this time.

I believe Dave gave it in his speech.

Revenue would have been 8%, I believe.

Yes, 8.5%.

So those factors generics -- the increase in generics and particularly I guess in 2011 some additional generics come out, there is a lot of -- there is drag on the revenue and -- profitably.

So for the next three years we should expect, the same type of break down in terms of the relative drivers?

Howard, are you?

Yes.

I'm sorry.

Could you repeat that, please.

David, could you repeat the question.

I'm sorry.

I'm afraid we dropped it.

I think we dropped David.

Okay.

Next question.

Your next question comes from the line of David Veal with Morgan Stanley.

Good morning, David.

Good morning.

Thank you.

It's been a couple of months on the legislative front.

I'm wondering if you could give us your perspective on a couple of things, maybe the impact of prompt pay and med D on both sides of the business, and also what the opportunity around you prescribing might look like in '09.

Well, the impact of prompt pay on med D will depend on regulations which have not yet been promulgated.

If we look at the legislative intent or the apparent legislative intent, it obviously has different affects on the PBM side of the business and the retail side of the business.

Net-net it, again, subject to final regulations, it looks like it might be very modestly positive on an overall basis for CVS Caremark.

In terms of e-prescribing, that will be helped by the legislation that has been passed.

But it also is helped by the many initiatives that we and others are doing.

You are familiar with our iScribe product and the effect that that has in accelerating the growth of e-prescribing.

You know that we have about a 17% share of retail pharmacy right now and we do about 30% of all e-prescribed transactions.

So we're very much at the forefront of this and very much in favor of it.

It helps accuracy, it helps health care, and is far more efficient than the old-fashioned handwritten prescription process.

And just to follow-up on that, one of your [retailer] in particular says you can save as much as $2 per new prescription.

Is that in the right zip code for you folks, do you think?

We would say that's in the right zip code, yes.

Great.

Thank you.

Your next question comes from the line of Deborah Weinswig with Citi.

Good morning and congratulations on a great quarter.

Thank you.

So I'm very intrigued with the new pharmacy system, RxConnect.

Can you talk about if it's still on track to be implemented by the end of the year, and also stores where it has been implemented, how are the pharmacists reacting to the new system and have you seen an increase in adherence in customer satisfaction as of result of freeing up pharmacists time to interact with customers?

I'll turn this over to Larry.

Yes.

We are -- we completed our beta.

We're now in our pilot phase and everything has been extremely positive.

Pharmacists absolutely love this system.

So we will begin the rollout in another few weeks and we are on track for the schedule that we reviewed at our analyst day.

So we'll be completed early in '09.

And any differences that you're seeing in stores that have the system versus stores that don't?

In terms -- our service metrics have improved slightly and I will tell you that the satisfaction level of our pharmacists has been outstanding.

Thank you, Deb.

Your next question comes from the line of John Ransom with Raymond James.

Good morning, John.

Looking at the third quarter and your guidance and thinking about what you just posted in the second quarter, other than seasonality and the pickup you're going to get from the part D accounting, is there anything that's going to be happening in the third quarter that wasn't happening in the second quarter we ought to be thinking about?

Well, we'll start to get a measurable amount of top line synergy volume on the retail side of the business.

Other than that, I can't think of anything offhand.

Okay.

And I guess the sequential of you're saying $0.58 to $0.61 and you just did $0.60, the sequential down take is just seasonality then?

Well, I would say that's pretty consistent number as opposed to characterizing it as a down tick.

I mean, the range covers exactly the number we just reported.

Sure.

$0.60 to a range of $0.58 to $0.61.

Yes.

And is there anything on the cost synergy side that will be accelerating in the third quarter or the back half of the year versus the first half of the year?

because I'm assuming you're continuing to move through your $700 million plus opportunity.

We are.

And, again, most of that, the great majority is purchasing synergy.

And almost all of that was in place as we exited '07.

So there isn't a great deal of seasonality to it, other than any swing in volume that takes place.

Got you.

And then my other question, would you hazard a guess, there is some controversy with some of the data sources, NDC and INS, about pharmacy script trends.

Do you think we're still on a positive script environment?

And I guess we'll just talk retail.

And I know you're taking share.

But if you X all of the factors out, do you think we're in a positive or kind of a flat script environment as we speak?

Well we're in a positive script environment certainly.

We're seeing growth.

I know the controversy that you're referring to and the data sources and that makes it hard for everybody to understand kind of what all is going on.

But our business is growing and I believe the overall industry is growing.

All right.

We'll take two more questions, Brandy.

Your next question comes from the line of Meredith Adler with Lehman Brothers.

Good morning, Meredith.

Hello.

A couple of questions.

First, can you answer -- let us know what is happening with generic volumes in the second half of the year versus the first half.

Do you think the impact will be as great on sales as it was in the first half?

Yes.

As a matter of fact, when we gave initial guidance for the year six months ago and then, again, I think in the last call, our expectation is that the third quarter was going to be the biggest quarter for generic conversions in this year.

And that remains our view.

Okay.

Great.

And then maybe can you talk about the impact that specialty has on earnings?

I think others have talked about how much it contributes.

I don't know if you guys will ever talk about that.

Well, we don't break it out.

It obviously is the highest priced set of things that we sell.

And it carries with it representative margins.

So the absolute dollar contribution is significant.

Great.

I was wondering if you could also comment about Medicaid and the outlook for reimbursement cuts.

I know that in California a court has put a stay on the cuts that they had proposed or actually had implemented.

What are your views about what could happen in other states, and do you think that the law will prevent much in the way of cuts?

Well, I think as in other parts of our business, there is continual rate pressure and Medicaid reimbursement, and that has certainly been the case over the past 18 months.

I think it was made more of a focus by the fact of the controversy over [AMP] and so forth.

And I think states have accelerated their rate pressure on us as an industry, not us as a company.

So we have seen rate erosion there.

And not more than we expected, but certainly significant.

And you don't think that gets worse because the states' budgets are in such bad shape?

Well, there are things the states can do other than hacking away at our rates that can improve their health care costs, and we would recommend to them programs that stimulate the use of generics and so forth.

Tighter defined formularies.

So there are a number of things they can do other than hack away at our reimbursement.

But that seems to also have been on the table.

Okay, Brandy, I'm going to take one more question.

Your final question comes from the line of Robert Willoughby with Bank of America.

Good morning, Robert.

Assuming that you will have net membership in the PBM business that will actually be up with the revenues that you have, correct me if I'm wrong there, is there any change to your stance on the adjudication systems, or do you continue to maintain the systems, or will there be a move to consolidate them?

Howard, do you want to answer the first part of that?

Well, we will see increases in membership as we move through.

We'll see some organic growth in some of our existing accounts.

And we'll probably expect next year to have more members than we do this year.

And in terms of adjudication systems, as we laid out in our analyst day, the strategy there is to maintain the availability of preferred front-end on each of our adjudication platforms while combining the underlying feeder systems.

That has the advantage that our customers aren't disrupted and yet we get the economic essentially of a single adjudicated platform.

And do you have a sense when that process will be completed?

I don't have a specific date I can give you.

I will say that it will go on over the next several quarters, maybe as much as two or three years.

Okay.

Thank you.

Okay.

Thank you all very much.

This concludes today's CVS Caremark Corporation second quarter earnings conference call.

You may now disconnect.