CVS Health Corp (CVS) 2011 Q4 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the Q4 CVS Caremark earnings conference call.

During the presentation all participants will be in a listen-only mode.

Afterwards we will conduct a question-and-answer session.

(Operator Instructions)

As a reminder, this conference is being recorded Wednesday, February 8, 2012.

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

Please go ahead, ma'am.

Thank you.

Good morning everyone and thanks for joining us today.

I'm here with Larry Merlo, President and CEO, who will provide a business update, and Dave Denton, Executive Vice President and CFO, who will provide a financial review.

Per Lofberg, President of our PBM business, and Mark Cosby, President of CVS/pharmacy, are also with us today, and they will participate in the question-and-answer session following our prepared remarks.

During the Q&A, please limit your questions to one or two, including follow-ups, so we can provide more analysts and investors the chance to ask their questions.

During this call, we will discuss some non-GAAP financial measures in talking about our Company's performance, namely free cash flow, EBITDA, and adjusted EPS.

In accordance with SEC regulations, you can find the definitions of the non-GAAP items I mentioned, as well as the reconciliations to comparable GAAP measures, on the investor relations portion of our website.

Please note that we also posted slides and supplemental financial schedules on our website this morning that summarize the information on this call as well as key facts and figures around our operating performance and guidance; so you may want to check those out.

As always, today's call is being simulcast on our website, and it will be archived there following the call for one year.

Finally, please note that we expect to file our Form 10-K by the close of business on February 21 and it will be available through our website at that time.

Now, before we begin, 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 risks and uncertainties that could cause actual results to differ materially.

Accordingly, for these 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 Factors section of our most recently filed annual report on Form 10-K and that you review the section entitled Cautionary Statement Concerning Forward-looking Statements in our most recently filed quarterly report on Form 10-Q.

And now, I will turn this over to Larry Merlo.

Well, thanks, Nancy, and good morning, everyone.

Hopefully you have had a chance to read through our press release this morning.

We're obviously very pleased with the strong financial results we posted, along with the great progress we made across the enterprise last year.

Our accomplishments in 2011 set a solid foundation for future growth; and as we outlined for you at our Analyst Day in December, we look forward to an even better year in 2012.

We reported adjusted earnings per share from continuing operations of $0.89 for the fourth quarter, $2.80 for the full year, with Retail results in line with our guidance and PBM results exceeding our guidance.

Overall, we generated about $700 million in free cash flow in the quarter bringing the 2011 total to $4.6 billion, which beat our goal.

Dave will provide the details of our results as well as guidance during his financial review.

So, with that let me address what I know is the number-one question on everyone's mind.

What benefit is CVS/pharmacy seeing from Walgreens no longer participating in the Express Scripts retail network?

Well, as we have said previously, the benefit was not material to our results in the fourth quarter, although it did start to ramp up late in the year.

Since the start of this year, we are seeing a significant number of transfers from Walgreens into CVS.

In fact, the amount is a bit more than we anticipated.

We have spent the last several weeks focused on ensuring that Express Scripts members have uninterrupted, convenient access to pharmacy care and excellent customer service, and the feedback to date from our new customers has been excellent.

Our pharmacy teams have been doing a terrific job in making sure that the transfer process is as easy as possible, and we will continue to do as much as we can to provide superior service to these new customers.

With that in mind, we have made investments in store labor and marketing that we believe will enhance our success in capitalizing on this significant opportunity.

Now, based on the early results, we believe we are gaining more than our fair share of this business.

In light of this, we are now projecting that earnings per share will benefit by approximately $0.03 per share in the first quarter, should the situation remained unresolved for the duration of the quarter.

As you are aware, that is a penny higher than the estimate provided at Analyst Day.

As a result, we are increasing our guidance for the first quarter and full year to reflect this first-quarter benefit, and we now expect to achieve adjusted EPS for 2012 in the range of $3.18 to $3.28.

As I said, Dave will review the specific details.

But that said, please note that we are not increasing our guidance for the remaining quarters of the year, as the situation is fluid and is not within our control.

And as everyone is aware, Walgreens and Express Scripts could come to an agreement at any point in time.

So, we are taking this one quarter at a time.

We would encourage you to only include the benefit in your models for the first quarter.

We will report the estimated impact from this impasse to you on a quarter-by-quarter basis throughout the year if it remains unresolved.

So, with that, let me turn to a brief business update and I will begin with PBM.

The 2012 selling season continues on a positive trajectory; and with 90% of the contracts scheduled for renewal in 2012 completed, our retention rate stands at 98%.

As for new business, our net new business wins now total $7.2 billion.

That is up from the $6.8 billion provided on Analyst Day.

We won some new accounts, and our estimate for the number of new Medicare Part D lives for 2012 has increased to 200,000 lives.

That is predominantly driven by the auto-assign beneficiaries, and that brings our PDP lives up to approximately 3.6 million to date.

Now in addition to net new business wins, recall that we expect another $5.5 billion in revenues associated with CVS Caremark becoming the PBM for the PDP acquired from Universal American in 2011 and with Universal American's Medicare Advantage plan.

Another PBM was serving these plans; that relationship terminated at the end of '11.

So after adding this to our net new business to date, our 2012 impact revenues are currently $12.7 billion, and that is up from the $12.3 billion projected on Analyst Day.

So obviously there is a lot to be pleased with these results of our 2012 selling season.

And again, we believe that driving top-line growth will be an important component of successfully growing our operating profit over time.

I think as everyone is aware the 2013 selling season is underway.

It is very early in the game, so we will report on that in future quarters.

Now, we talked at length on Analyst Day about our integrated offerings that capitalize on what we are calling our integration sweet spots.

These are the products and services that are extremely difficult for standalone PBMs or standalone pharmacy retailers to replicate.

As illustrated by the results of our 2012 selling season, our flagship programs, Maintenance Choice and Pharmacy Advisor, are resonating in the marketplace and they continue to deliver great results for clients and their members.

We currently have approximately 10.2 million lives covered under 835 plans that have implemented or committed to implement Maintenance Choice through March of this year; and that is up from 9.9 million lives at our last update.

I think it's interesting to note here that 59% of the clients using Maintenance Choice in 2012 had voluntary mail plans prior to adoption.

If you compare that back to 2009, when the product was first introduced, that number was only 20% back then.

The former voluntary mail clients adopting Maintenance Choice back in 2009 saw their 90-day utilization increase from about 37% to 65% and, as a result, recognized significant savings.

So, armed with this compelling data, we continue to demonstrate that Maintenance Choice has been successful in broadening access while reducing costs and improving prescription drug adherence.

Now, with our anticipated launch of Maintenance Choice 2.0, we expect the number of clients taking advantage of this offering to increase dramatically over the next few years.

Recall that this next-generation product will enhance the member experience for all legacy and new Maintenance Choice clients.

Moreover, Maintenance Choice 2.0 does not require clients to adopt restrictive benefit designs, so we expect that more clients will try 2.0 to recognize at least some of the savings associated with Maintenance Choice.

We believe these enhancements will provide a transformative member experience that further differentiates CVS Caremark in the marketplace.

This program will be rolled out on a limited basis this year, and we expect to make it broadly available beginning in January of '13.

As you may have seen in their press release, one of our new clients with a July 12 implementation, the Pennsylvania Employees Benefit Trust, actually cited Maintenance Choice 2.0 as one of the primary reasons for selecting CVS Caremark as their PBM.

As for Pharmacy Advisor, we have also experienced additional uptake.

Our data has demonstrated that we are identifying important opportunities for cost savings while improving adherence and closing gaps in care.

We have 15.9 million lives covered by almost 900 clients committed to implement Pharmacy Advisor for diabetes thus far, and that is up from over 12 million lives at year-end.

Again, as we announced on Analyst Day we are expanding Pharmacy Advisor to one new disease state this year and to several other targeted disease states in 2013.

We are doing this through a comprehensive initiative that we are calling Pharmacy Advisor 3.0.

We are excited to report that we have already signed up 344 clients covering 8.8 million lives for Pharmacy Advisor for cardiovascular disease, and that will be available in the spring of this year.

Additionally, have made very significant opportunities to expand the program by offering Pharmacy Advisor to other major client segments.

A case in point here is Aetna.

We have the opportunity to offer the program to Aetna's 8 million commercial lives as they begin the migration to our systems this year.

And we plan to offer Pharmacy Advisor to our Medicare clients for 2013 implementations as well.

Now, among other cost-savings programs, we continue to encourage adoption of plan designs to improve generic dispensing rates.

Today, 355 clients representing about 8.4 million lives have adopted generic step therapy plans.

That is a 23% increase in lives from our last update.

Then moving on to some of the highest growth areas for the PBM, we saw significant growth in our specialty pharmacy business, with revenues increasing a very strong 31% this quarter.

That was driven by healthy underlying growth as well as the addition of the Aetna specialty business.

As you know, we're also very committed to growing our Medicare Part D business.

This is in light of prescription utilization trends of seniors as well as the potential displacement of lives due to a larger number of employers who may decide to shift their retirees to an EGWP program or simply into the open PDP marketplace as we approach the elimination of the RDS tax subsidy in 2013.

With that in mind, we recently agreed to acquire Health Net PDP.

We expect the deal to close in the second quarter.

That will shift from our PBM to our PDP about 400,000 lives, bringing our total PDP lives to approximately 4 million.

We have had a long-standing relationship with Health Net, having served as their PBM for the past 12 years, and we expect to transition various services from the closing -- again, in the second quarter -- through 2013.

Now before turning to Retail, let me touch briefly on the PBM streamlining initiative which is proceeding on track.

We expect the benefit from the initiative will outweigh the costs this year, and we continue to expect the hit the run rate of annual savings of between $225 million and $275 million in 2014.

As we have said previously, through this initiative we are streamlining PBM operations to improve productivity, rationalizing capacity, and consolidating our adjudication platforms to one destination platform with enhanced capabilities.

On January 1, we migrated our larger health plan clients to the destination platform.

As we sit here today, all of our Medicare Part D business is now on that platform as well, and we expect to migrate additional clients throughout the year.

So I think it is pretty clear that our PBM is performing well, making continued great progress, and is fully expected to return to healthy operating profit growth this year.

Let me turn to our Retail business, which is certainly in the midst of an exciting industry-driven opportunity.

As I noted earlier, in the first several weeks of this year we are posting strong pharmacy comps at levels that we have not seen in quite a while.

In the fourth quarter, our same-store sales increased 2.5%.

That was at the high end of our guidance range.

Late in the year we did begin to see some incremental growth from the stalemate between Walgreens and Express.

Our pharmacy comps increased 3.6% in the fourth quarter, with script comps up 4.4% on a 30-day supply basis.

Our script unit comps continue to outpace all of our primary competitors, and our pharmacy share grew by approximately 75 basis points nationally, 85 basis points in the markets in which we operate versus a year ago.

Our pharmacy comps were negatively impacted by approximately 235 basis points from new generics in the quarter.

In addition, pharmacy comps benefited from the continued growth of Maintenance Choice, which added approximately 160 basis points on a net basis.

Furthermore, despite a very weak flu season, flu shots administered by CVS pharmacists nearly doubled versus the prior year, which also helped to drive our pharmacy comps.

Now, turning to the front store, our market share increased 39 basis points in our class of trade, 11 basis points in food-drug mass channel versus last year.

Traffic turned positive in the fourth quarter, with front store comps increasing slightly in the quarter.

Christmas sales were a bit slower than we had planned, and flu-related front store sales were impacted by the weak flu season.

Store brand and proprietary products made up 17.9% of front store sales in the quarter; that was up 10 basis points from a year ago as consumers remain value conscious.

We continue to make progress on our clustering initiatives.

420 urban cluster stores were completed by year-end.

We expect to add approximately 50 more this year.

Also this year we are expanding our efforts to develop and test additional clustering concepts that came out of our trip segmentation work.

We believe these efforts around localization are a key component to optimizing the return on capital of our remodel program.

As for our real estate program, we opened 29 new or relocated CVS stores.

We closed one, resulting in 23 net new stores for the quarter.

For the full year we open 247 new or relocated stores, closing 16, resulting in 145 net new stores; and that equates to Retail square footage growth of 2.6%.

Let me touch briefly on MinuteClinic, which continues to grow and achieve its targets.

We ended the year with 657 clinics in 25 states and the District of Columbia, and we have cared for more than 11 million patients since the company's inception.

We added about 100 clinics in 2011.

We believe our plans to double our clinic count over the next several years will position us well to play an important role in providing care to the newly insured beginning in 2014.

Now, despite the very weak flu season, MinuteClinic revenues increased nearly 40% in the fourth quarter versus last year.

We continue to add new services and raise awareness.

Just as one example, with the new Texas law requiring college students to be vaccinated against meningitis prior to the January school start, we actually launched a marketing campaign in our three Texas markets that resulted in a 50% increase in vaccinations.

MinuteClinic continues to enhance its role as a collaborator with integrated health networks.

During the fourth quarter we entered into several additional affiliations with prominent healthcare systems including Emory Healthcare, the Carolinas HealthCare System, and UMass Memorial Health Care.

MinuteClinic now has affiliations with 14 of the nation's leading health systems, which will help position us well for future growth and clinical collaboration.

So, with that, let me turn it over to Dave for his financial review.

Thank you, Larry.

Good morning, everyone.

Today I'll provide a detailed review of our fourth-quarter financial results.

I'll also update our 2012 guidance for the first quarter as well as the full year.

Now, first let me start with a wrap-up of our 2011 capital allocation program.

We paid approximately $670 million in dividends last year, which was an increase of 41% over 2010 levels.

At our Analyst Day we announced that our quarterly dividend would increase this year by another 30%, our ninth consecutive year with an increase.

Given our earnings expectations for this year, we anticipate a payout ratio of 21% to 22%, placing us comfortably on track to achieve our targeted payout ratio of 25% to 30% by 2015.

In regard to share repurchase, during the fourth quarter we completed the buyback associated with the 2010 authorization for which we had approximately $450 million left at the end of the third quarter.

With this we repurchased a total of 12.6 million shares.

We also settled the final balance of our August accelerated share repurchase transaction, adding another 1.6 million shares to our treasury stock.

In total, we repurchased 83.7 million shares at an average cost of $35.85 per share, and we spent approximately $3 billion in 2011.

So, between dividends and share repurchases, we returned more than $3.5 billion to our shareholders last year.

It is my expectation that, at a minimum, the remaining $3 billion on the 2011 repurchase authorization will be used in 2012 and that we will allocate roughly $3.8 billion to enhancing shareholder value through both repurchases as well as dividends.

Our capital allocation program will remain a vital component to driving shareholder value, taking advantage of powerful cash flow generation capabilities of CVS Caremark both now and in the long run.

As Larry said, we generated $4.6 billion of free cash last year, with our inventory initiative helping us to surpass the high end of our guidance range by more than $300 million.

In the fourth quarter we generated approximately $700 million of free cash, a decrease of more than $830 million over the same period of last year.

This decrease was primarily driven by the timing of CMS funds received in September associated with premiums and subsidies for Medicare Part D which were earned in October.

On our last call, I mentioned this was the main driver behind the third quarter's free cash flow increase; so this is merely the equal and opposite impact from the reversal in the fourth quarter.

Partially offsetting this was the inventory improvement that resulted from our 2000 initiative that targeted a $1 billion reduction in Retail inventories.

And I am happy to report that during the fourth quarter we reduced our related Retail inventories by another $690 million, bringing the full-year total to approximately $1.5 billion, surpassing our $1 billion inventory reduction goal.

As with prior quarters, you can see the improvements we've made in accounts payable and inventory on the balance sheet as well as an our strong cash flow.

Inventory days within the Retail segment is nearly six days better than it was at the end of last year; and DPO has improved by nearly two days.

We have reduced our Retail cash cycle by more than eight days and we have identified some additional opportunities for improvement.

The team has set an inventory reduction target of $500 million in 2012 as we continue to make process improvements.

That reduction target is above and beyond the net impact of inflation and generic conversions on our inventory levels.

So working capital improvements are expected to continue to enhance our cash generation capabilities well into the future.

Net capital spending in the fourth quarter was $123 million, an improvement from $243 million last year due to the increased amount of sale-leaseback proceeds during the quarter.

We completed approximately $580 million in sale-leasebacks in the fourth quarter versus approximately $380 million in the prior year.

For the full year, our net capital spending was approximately $1.3 billion or about $200 million less than the prior year.

Turning to the income statement, adjusted earnings per share was $0.89 for the quarter, while GAAP diluted EPS from continuing operations came in at $0.84 per share.

On a consolidated basis, revenues in the fourth quarter increased by more than 15% to $28.3 billion.

Drilling down by our segments, net revenues grew by 32% in the PBM to $15.9 billion.

The majority of the increase from last year was driven by the addition of the Universal American and Aetna businesses to our book.

However, we did see higher revenues than expected due to stronger volumes from new managed Medicaid client starts during Q4 as well as some higher than usual stocking up by members at the end of last year.

PBM pharmacy network revenues in the quarter increased 41% from 2010 levels to $10.9 billion, while pharmacy network claims grew by 46%.

Total mail choice revenues increased by 18% to $4.9 billion, while mail choice claims expanded by 8%.

Our overall mail choice penetration rate is 20.8%, down approximately 530 basis points versus LY.

This decrease was driven entirely by the addition of Aetna and the Universal American Med D businesses, both of which have lower mail penetration rates than the average book of our business.

In our Retail segment, we saw revenues increase 4% in the quarter to $15.5 billion.

This increase was primarily driven by our same-store sales increase of 2.5% as well as net revenues from new stores, relocations, and MinuteClinic, which accounted for approximately 150 basis points of the increase.

Larry talked about our pharmacy and front store comps in some detail, so I won't repeat it here.

Turning to gross margin, the consolidated Company reported 19.6% in the quarter.

While gross margin contracted approximately 260 basis points compared to Q4 '10, it improved approximately 115 basis points since Q1 of '11.

Within the PBM segment we saw sequential gross margin improvement of approximately 20 basis points, but gross margin was down approximately 75 basis points versus last year's fourth quarter.

This was better than expected, as our cost of goods sold benefited from better purchasing.

The decline versus last year mainly reflects the price compression associated with contract renewals as well as the impact of the addition of the Aetna business.

Partially offsetting these was the positive margin impact from the 220 basis point increase in the PBM's generic dispensing rate, which grew from 72.8% to 75%, as well as better purchasing.

Gross margin in the Retail segment was 29.7%, up approximately 45 basis points sequentially, mainly due to the higher mix of front store purchases associated with the holiday season.

Gross margin at Retail decreased approximately 140 basis points versus last year.

As we expected, we saw gross margin pressure from pharmacy reimbursement rates, the growth of Maintenance Choice, and planned holiday promotions.

However, the weaker than expected holiday sales caused margin to decline a bit more than we had forecasted.

These unfavorable factors were partially offset by the benefit from various front store initiatives, increased store brand penetration, and increased generic dispensing rates, with retail GDR increasing by 210 basis points to 75.9%.

Total operating expenses as a percent of revenues improved by approximately 230 basis points versus the fourth quarter of '10.

The PBM segment's SG&A rate improved by 30 basis points to 1.8%.

This is primarily due to expense leverage gained by the addition of the large Aetna contract, which was partially offset by the impact of our acquisition of the Universal American Med D business.

In the Retail segment, SG&A as a percent of sales improved by approximately 160 basis points to 20.4%.

This improvement expense leverage was driven by solid sales growth and continued discipline around expense control.

Within the Corporate segment, expenses were down approximately $15 million to $152 million, or less than 1% of consolidated revenues, improving by approximately 15 basis points versus the same period of last year.

With the change in gross margin more than offsetting the improvement in SG&A as a percent of sales, operating margin for the total enterprise declined by approximately 25 basis points to 6.9%, as we expected.

Operating margin of PBM was 4.6%, down about 40 basis points; while operating margin at Retail was 9.4%, up about 15 basis points.

Retail operating profit, which makes up more than two-thirds of our consolidated operating profit, achieved continued healthy growth.

It increased 5.9% above the midpoint of our guidance range.

PBM profits increased 21.2%, which was well above our guidance range.

Going below the line on the consolidated income statement, we saw net interest expense in the quarter increase by approximately $11 million to $147 million versus last year.

Additionally, our effective income tax rate was 39.3% and our weighted average share count was 1.31 billion shares.

Now, let me update you on our guidance for the first quarter and full year of 2012.

With the exception of some tweaks to reflect the impact from the Walgreens-Express Scripts impasse as well as the improved working capital expectations, our guidance remains essentially unchanged from Analyst Day.

You can find the details of our guidance in the slide presentation we posted on our website; but today I will focus on the highlights.

We currently expect to deliver adjusted EPS in '12 of between $3.18 and $3.28 per share and GAAP diluted EPS from continued operations of between $2.96 and $3.06 per share, reflecting very healthy year-over-year growth of 13.5% to 17%.

This includes the $0.03 benefit we expect to see during the first quarter only resulting from the Walgreens/Express Scripts impasse.

As Larry said, we are assessing the impact on a quarter-by-quarter basis and will update our guidance as needed as we move throughout the year.

Taking into account the impact from the prescription transfers, we currently expect consolidated net revenue growth of between 12% and 13.5%.

This is a reflection of strong revenue growth across the enterprise, but especially in the PBM following another great selling season.

Recall that our estimates include one extra day in 2012 versus '11 for leap year.

Within the Retail segment, we now expect revenues to increase year-over-year by 3% to 4%, reflecting an impact from the impasse of about 100 basis points.

Gross margin in the segment is expected to be moderately up over 2011 levels, while operating expenses as a percent of revenues should modestly delever.

As a result, operating profit in the Retail segment is expected to grow between 8.5% and 10.5%.

Guidance within the PBM segment remains unchanged from Analyst Day.

We still expect PBM operating profit to increase between 11% and 15%.

For the first quarter, adding the $0.03 benefit from the impasse, we now expect adjusted EPS of between $0.61 and $0.63, reflecting growth of 7.5% to 11% over the same period of last year.

GAAP diluted EPS from continuing operations is expected to be in the range of $0.55 to $0.57 in the first quarter.

Consolidated revenues are expected to increase 17% to 18.5%.

In the Retail segment, revenues are expected to increase 8% to 9% versus the first quarter of '11.

Same-store sales growth expected to be in the range of 6.5% to 7.5%, and same store script growth is expected to be in the range of 5.5% to 6.5%.

While the majority of the top-line increase is due to the benefit from the script transfers from Walgreens, we also have added some growth to reflect an increase in drug inflation which is helping to offset some of the deflation from new generic introductions.

We assume that we will see this through the first quarter, but we are not including any expectations that this will last beyond Q1.

Operating profit in the Retail segment is now expected to grow between 14% and 16% during the fourth quarter, an increase from the 8% to 10% we guided on Analyst Day.

Guidance for the PBM segment remains unchanged for the quarter.

In addition, we are increasing our free cash flow guidance to the range of $4.6 billion to $4.9 billion, up about $300 million from our previous guidance.

Part of the increase is due to the flow-through of the additional $0.03 associated with the script transfers; but the bulk of the increase reflects greater optimism around our ability to improve working capital management, especially in accounts payable.

This is above and beyond the improvement we are targeting in Retail inventory.

I am very pleased with our significant and growing cash flow generation capabilities, which as I said will play an important role in driving shareholder value both now and well into the future.

And with that, I will turn it back to Larry Merlo.

Well, thanks, Dave.

Let me just summarize here.

I think we closed out 2011 with a very good quarter, earnings solidly in line, and free cash flow ahead of target.

Once again we delivered on our promises.

I think as you heard, 2012 is off to a great start; and today we have increased our earnings and cash flow guidance to reflect the industry opportunity we are capitalizing on, as well as greater confidence around our working capital management.

We absolutely remain focused on driving shareholder value, and our productive long-term growth, significant cash generation, and disciplined capital allocation will continue to be important drivers of returning value to our shareholders.

So, with that, let's open it up for your questions.

(Operator Instructions) Deborah Weinswig, Citigroup.

Hi, this is Shane on the line for Deb today.

Just wanted to talk about the front end a little bit.

Obviously, it seemed a little bit weaker than expected and you had mentioned that.

I am just looking at trends in January; and how has that changed?

Or has there been any differences that you have seen?

Yes, Shane, I think as we outlined in our remarks, we saw some weakness in the flu season, which impacted our front store growth, as well as disappointing holiday sales around the Christmas products.

That element of it is behind us; and I think as we outlined our comp guidance for the first quarter, we are expecting to see stronger front store trends than we saw in Q4.

And is that something that you are seeing currently, or is that what you are --?

No, we are seeing that currently.

Yes.

Then just looking ahead to the PBM selling season.

Obviously, you guys seem to have a pretty strong negotiating position.

How are you guys trying to position yourselves with Walgreens and Express and all that, all the other things that are going on in the industry?

It's still very early in the season, as you guys know, and there are a number of RFP processes that are underway and a number -- many more that we expect to begin in the next couple months.

I don't think the Express-Walgreens issue per se is a particularly significant factor.

I think there will be a lot of opportunities for us to feature our set of solutions and our integrated capabilities and so forth.

I do think that there will be an interest in comparing the cost savings and the benefits from restricted networks going forward, and that is probably to some extent prompted by the Express-Walgreens impasse.

But that will be just one factor that people will be interested in.

Shane, at the same time, we are expecting to see more RFPs out in the marketplace this year.

The benefit consultants are driving that with the Express-Medco deal on the horizon.

So we do see more activity coming; but as Per mentioned, it is very early, especially on the employer side of the selling season.

If I could just do one quick follow-up, on that restricted network, what types of savings are you guys hearing that clients or people are -- would like to -- if you can -- are looking to get from a more restricted network?

If you are allowed to talk about that or are able to talk about it.

I think you probably have to show savings of at least a couple of percent for it to be a meaningful benefit to a customer and to justify the disruption that is inevitable when you change the network.

Obviously, the more restrictive the network is, the deeper the savings are that you can propose.

So it is sort of a sliding scale.

Thank you very much.

Sorry?

Thanks.

Lisa Gill, JPMorgan.

Thanks very much.

Good morning.

Just a follow-up on that line of questioning, Per or Larry.

Are you seeing more interest in narrow networks because of this dispute, number one?

Then number two, Larry, I know you mentioned that you thought there would be more business out to bid.

Can you maybe just help us to frame the amount of business that you have out to bid for 2013?

Yes, Lisa, I will take the second question and I will ask Per to comment.

We have about $16 billion up for renewal in this selling season, and that would exclude the Med D business which, as you know, is kind of up for renewal every year.

Right, right.

Lisa, just on the -- just to elaborate a little bit on the restricted networks, I think the -- our expectation is that we will frequently be asked to quote on different network configurations and we will be asked to provide different levels of savings for different sizes of networks.

And all of our discussions with the benefit consultants indicate that that will probably be one of the variables that will be in play this year.

Per, have you been surprised that there hasn't been more noise around the exclusion of Walgreens and Express Scripts network?

As you know, we talk to lots of consultants and plan sponsors, and it doesn't appear to us that there has been a lot of disruption because of this.

Obviously maybe it is because CVS has done such a great job of taking over the scripts.

But can you talk about your experience?

Are you hearing from any of these clients that say -- I want to switch because I don't -- I do want Walgreens in my network?

Nothing of that, Lisa.

I have to actually tip my hat here to our competitor, Express; I think they have done an excellent job really making this change very smooth for their customers.

And many of the plans that I have spoken to that actually have gone through this, they have been very clear that this has not really been a big deal for them.

I guess then just one follow-up to you, Larry, would just be that, if they did come to some kind of resolution, generally speaking how sticky are the scripts that have moved?

So those people that have moved in January, how much of that business would you anticipate that you could retain if they ever came to a resolution?

Lisa, that's a great question, and we really don't have a benchmark against this.

As I have said in the past, we know that that pharmacy customer is the hardest person to lose; but once you lose them, it is the hardest person to get back.

I believe the longer this goes on, the more sticky the customer will be, especially as they have the opportunity to refill the prescription a few times and get to know the pharmacist and the staff in the store.

Obviously, our Retail teams are doing a great job in terms of doing everything that they can to engage those new customers.

Okay, great.

I appreciate the comments.

John Heinbockel, Guggenheim Securities.

Hey, guys, a couple of things.

So, Larry, the improvement on the front end, are you seeing anything that you can tie to the Walgreen benefit, or really not very much?

Yes, John, there is a little bit there; but you know, as we were just talking with Lisa's question, the focus right now is making sure that that transfer process and the administrative tasks associated with that, that is front and center in terms of what our store teams are focused on executing.

We are just beginning the process of getting these new customers enrolled in ExtraCare, as an example.

So I think it is going to take several weeks to really shake out what the front store impact of this will be.

Mark can talk a little bit about some of the investments that we are making with that in mind.

Well, clearly when the whole impasse began we set up a plan to address what the opportunity could be, and we had several initiatives in the way.

We had several on the marketing front, both in terms of our circular and our TV.

And we did a lot in terms of staffing, and in terms of the resources by store, and in terms of inventory that we deployed by store to be ready for it.

But the biggest push was around service, making sure that every new customer they came into our store had a great experience.

And that continues to be our biggest push.

As we go forward, it is now about retention, so putting programs in place to make sure that the folks that do come into our store have a great experience and they stay with us.

And now, the $0.03 benefit is net of whatever investment you are making in staffing and marketing, right?

That's correct, John.

So, do you still think -- because that is frontloaded, do you still think that if this thing goes on for the rest of the year there is a bigger benefit in the back half after those investments moderate, or no?

Well, yes, I think we will have to -- well, I want to play it quarter by quarter, John, but we are very focused on executing at the store level today, making sure that the transfers -- that we give the best service possible.

And we will assess it after we get a few more weeks under our belt.

And as you look at that windfall, and I asked you at the analyst meeting, is there anything you can find where you can invest some of this one-time windfall in the business, either PBM or Retail, to strengthen the franchise and take advantage of this windfall?

Or not really?

Well, John, at the end of the day, we look at all the cash generation capabilities of the Company and look to invest that money with the highest possible return possible for our shareholders.

So we won't assess this any other way than that.

So we will keep looking for projects to either invest in our core business that has a high return on investment for it, or we will look to dividends and share repurchases to enhance value as well.

Well, I meant more, can you add labor in the stores or put it into pricing on the PBM?

Or not capital so much, but operating expense so the benefit to the P&L would be less, but maybe more lasting, may be more of an annuity.

Yes, I think we look at those in the same way, John.

All right.

Then one final thing.

How does the whole Medco/Express, kind of in limbo here, impact the timing of selling season decisions?

Maybe it is too early; maybe that has to go on another month or two.

But is that impacting anything you see in terms of how people are making decisions or the timeline?

I don't think it's affecting the timing very much, John.

The timing of RFP processes is basically very much driven by the contract term and the time it takes to transition accounts.

Health plan accounts take longer to transition than employer accounts, and therefore they tend to start a little earlier.

I don't think that the Express/Medco merger per se is affecting the timing.

I do think that the uncertainty around that certainly has given fuel to benefit consultants to really recommend that clients go out to bid; and we will certainly see market activity as a result of that.

Dane Leone, Macquarie Group.

Thank you for taking the questions.

This one for Per.

As we think about the 2013 selling season, I think we had a case example recently where a large plan reversed course from a prior decision in terms of favoring the financial bid over the technical bid.

Are we seeing some change in how plans view the bidding process, given maybe a longer economic recovery than some people had previously thought back in 2011?

I am not sure I know exactly what you are talking about, but I really don't think there is a significant change in the emphasis.

People go out to bid first and foremost because they want to get the best possible economics they can get for their drug programs.

And that I think has not really changed at all.

Clearly, though, the integrated programs that we have have made a difference here this past year, and we expect to see that continue as there is broad adoption of these programs and longer track records in terms of the customer experience with them.

So Maintenance Choice and Maintenance Choice 2.0, the Pharmacy Advisor program and so on that Larry referenced in his speech, those are really good features that allow us to really highlight how we can add value through our enterprise.

Great, thank you.

Then on the MinuteClinic side, could you give us an idea of how profitability is expected to ramp up through the course of 2012?

Yes, Dane, I think as we have communicated in the past, in the fourth quarter MinuteClinic actually hit a breakeven status for the first time at what we define as the enterprise level.

We will expect that to continue even as we expand the MinuteClinics going forward.

So we are very pleased with what we are seeing there.

And the role that MinuteClinic plays, as Per was talking about our integrated programs, there is an important MinuteClinic component to many of those.

Thank you.

Scott Mushkin, Jefferies & Company.

Hey, guys.

Thanks for taking my questions.

Really two.

First to Per, how important is the Retail Pharmacy network when a client is looking at a proposal?

I assume it is one of the top 10; but where does it rank, in your estimation, as people look at proposals?

Well, it's very important.

The primary thing people look at is basically access.

So they look at where their employees and dependents, where they live and what geographies have to be covered, and the access that they can get to the network configuration that you are proposing.

So it definitely is important.

And at the end of the day, as you know, you can meet access standards very successfully with much less than 65,000 pharmacists around the country.

So there is a trade-off to evaluate in terms of how many pharmacies you have in the network and the kind of economics you can offer up.

So that trade-off is very real.

But it certainly is a very, very important component of the PBM offering.

Thanks for that.

I assume though it's among several things that people look at.

Or is it top one or two in your estimation?

No, it's one of let's say five major variables.

The mail order program and in our case the Maintenance Choice program is a very important component that adds additional savings opportunities.

The formulary and the rebates that are generated.

Generic programs that maximize the use of generics, that also offer additional savings.

Those are probably the four or five major items that go into the calculation.

Perfect.

Thanks for that.

Then I wanted to switch gears to Retail and also bring in the free cash flow.

As I look at what is going on with your business, there is clearly going to be a -- and it is already starting -- a bubble of, looks like over the next 18 months, of just an enormous amount of traffic into those Retail stores.

So that just smacks to me of opportunity.

We haven't seen a real big change in the format of the Retail stores or a big re-merchandising effort.

I was wondering, as you look at the opportunity here -- maybe this is more for Larry -- how do you see at?

To me it seems like there is just a massive opportunity to grow maybe earnings a little bit faster in that Retail segment as you harvest this, and also show nice improvements on return on invested capital as a lot of capital is tied up in the Retail segment.

So maybe you can comment on that.

Yes, Scott.

Let me make a few comments and then I will ask Mark to comment on some of the initiatives that he has underway that I think addresses that question.

But I think as we heard earlier, we are focused on making sure that these customers have just a terrific experience and that they continue -- and we continue -- to ensure that there is no interruption of their pharmacy care.

As we have talked many times in the past, we will continue to use ExtraCare as a differentiator in terms of how we can add value for those patients, as well as, quite frankly, how we communicate with those customers.

I will ask Mark to talk about some of the work that he has underway around clustering and what future store may have in store, if you will.

It's a twofold answer really.

There's a number of things short-term that we are doing between improving the effectiveness of our promotion, looking at the productivity of our space within our store, particularly the high-traffic areas in our store.

And then we have a number of things where we are empowering our store teams to take more accountability for sales.

Those are some of the short-term things.

The longer-term things that Larry alluded to, the biggest thing we probably have in the works is this clustering initiative.

We had success this past year and the year before with the urban initiative, and we have a number of different clustering options that we are looking at right now which we think will have some play in the second half of this year in a test mode and then in a rollout mode as we go into 2013.

The broader one that Larry alluded to was around what we are calling the store of the future.

So we do have a project underway where we are relooking, everything that we do within our store from the pharmacy to the front of the house, in terms of how do we really capitalize on the opportunity that is in front of us.

We do plan to have some test stores in place in the front part of next year, which I think we will learn a lot both in terms of for new stores as we go forward but also for remodel opportunities down the road.

Scott, I think the issue around this is that these are not new ideas.

We have talked about these -- many people have talked about this in years past.

I think what is different today is that we have the information and we have the technology to execute it.

That was always the barrier to entry, if you will.

So I think this is going to take some time, but I think the prize here in terms of doing it well is pretty big.

Tom Gallucci, Lazard Capital Markets.

Thanks, good morning.

A couple of quick follow-ups.

Just first, back on the restricted network idea, two questions there.

One, how deep do you have to restrict to get toward that 2% type of a savings that you mentioned earlier that might be important for customers to consider it?

And is there any, I guess, strategy around maybe preferred-type networks as opposed to just simply restricting them or narrowing them down?

Where you can go to any network, but one is more than expensive than another one, pharmacy is more expensive than another one.

Yes, to your first question, Tom, I think you have to get to -- to get to like a 2%, 3% saving you have to make a pretty significant change in the network.

Maybe bring it down by 20%, 30% or something like that to be able to approach those benefits.

It is obviously driven by the value that accrues to people who remain in the network and the increased volume that they can project, and the improved pricing that you can derive from that.

So that is sort of a ballpark.

With respect to the preferred networks, that's primarily been an opportunity recently in the Med D segment.

You may have seen that last year Humana came out with a program where Wal-Mart was the preferred retailer.

It was a pretty successful program.

They got good traction with that.

This year, there were a number of other participants that had similar types of programs, including Aetna together with CVS/pharmacy.

So there you have the ability to meet all of the access standards that CMS requires and at the same time offer significant co-pay advantages if members use the preferred retailers.

Do you think the preferred type of a strategy is something that could leak into the private sector?

Or there it would be more just narrowing it?

It's a good question.

I haven't seen much activity around that on the commercial front, but there is no real fundamental reason why that couldn't happen there as well.

Okay.

Then just the other follow-up was -- I think you mentioned some better generic purchasing.

I was wondering if you could expand there.

Did that more relate to certain new drugs that were launched, or is it older drugs?

Or any other color you can offer would be great.

Thanks a lot.

Yes, I think what we -- I would just say that the team from a purchasing standpoint has just done a fabulous job throughout 2011 and we continue to push improvements to improve our cost of goods sold outlook.

And that is just kind of us continuing to work pretty diligently in that space.

So it is kind of across the generics but also on the branded side as well.

Edward Kelly, Credit Suisse.

Yes, hi.

Good morning.

I got kicked off the call quickly, so if somebody asked this question, just tell me and we will move on.

But your gross margin on the Retail business is something that I want to just ask about.

The 140 basis point decline, it is a little bit of a surprise, I think, to us even though you guided it down and you had said it was a little disappointing.

Can you help us parse out the individual items there?

How much were reimbursements, how much were promotions?

And then how much of that continues going forward into next year?

Yes, Ed, when we provided guidance for fourth quarter, we expected margin to be down.

We talked about continued pressures on pharmacy reimbursement.

What we saw that was incremental to that was largely in the front store as it related to -- as we mentioned in the prepared remarks -- a disappointing Christmas selling season.

As you know, those products are at a higher margin, and we also incurred some incremental markdowns.

That is a one-time event in nature and is behind us.

So, we don't need to worry about that as we migrate into Q1.

The other issue really ties to a weaker flu season, which in the front end, in the OTC categories, that is heavily penetrated by store brands, which again higher margin.

So that pressured margin; and again that is seasonal in nature, so we don't see that occurring going forward as well.

And just on the reimbursement side, how much should we be concerned about that?

Well, as we talked, the reimbursement issues are what we have been managing through for several years now.

We don't see that abating.

And at the same time we are comfortable in terms of our abilities to manage that going forward.

If Express closes on Medco, how does that impact your thought on reimbursements?

Is there risk there?

I guess what I am getting to is -- what have you factored into guidance related to that?

Well, Ed, again as we said back at Analyst Day, we have worked very hard on the Retail side to position ourselves as a good partner, a good long-term partner, okay?

As well as being a low-cost provider.

We have worked with all the major PBMs with those guiding principles, and we see no reason to change that as we go forward.

Okay.

Then just last question for you.

SG&A down about 3.5% in Retail.

It's a pretty big number.

Can you just help us understand where it all came from?

Yes, this is Dave.

We have been very focused from a cost containment perspective throughout the Retail division.

So there is no one initiative that drove that.

I would say that again we have just continued to put in technologies and processes, primarily in the pharmacy, that have driven productivity gains across the enterprise.

And that is really what continues to drive it.

Ed, going forward, we will continue with that level of focus; but again as we have discussed previously, because of the impact of generics, that SG&A leverage that we have seen in the past will be muted to some degree as a result of that.

Larry Marsh, Barclays Capital.

Well, thanks and good morning.

Just two quick ones.

One, in January you announced that you had settled a two-year investigation by the FTC, a 24-state task force for $5 million, after a lot of complaints by independent pharmacies and consumer groups after the merger of CVS and Caremark.

Based on the feedback you got, was the message from the FTC that in their analysis the PBM-Retail combination clearly didn't drive up costs?

Or that there was clearly no evidence of conflict of interest in a limited network?

Or was there some other message that you got from that?

Well, Larry, thanks for asking that question, because we are very pleased to have reached an agreement with the FTC that ends a very comprehensive and very expensive review of all of our business practices, along with the innovative and differentiated products and services that we are bringing to market.

We are very pleased that there were no allegations of antitrust violations, no allegations of anticompetitive behavior related to any of our business practices, products, or service offerings.

So we are full speed ahead in terms of the focus that we have, in terms of bringing differentiation that improves health and lower costs.

So that is my sermon, okay?

The other thing that I would acknowledge is that the $5.5 million settlement that related to legacy RxAmerica practices was prior to the acquisition of Longs Drugs.

So we were again very pleased with the outcome of that and we believe it is validation of our business model.

To the validation, is your message that scale in this case can actually drive down costs and create product innovation?

Or is it just -- no, let's just not be too broad; this is really just about CVS and Caremark?

No, I think this is about CVS and Caremark.

And I think quite frankly it speaks to Per's comments earlier in terms of the fact that you have to be priced competitively in the marketplace, but our products and services are allowing a form of differentiation for CVS Caremark that is allowing us to win disproportionately in the marketplace.

Very good.

A quick follow-up just on Medicaid.

I know you called out some fourth-quarter start-up costs.

There has been a lot of discussion about states moving more to managed care plans, both for duals and those covered under CHIP.

I know, Per, you have called out the opportunity.

Are you able to elaborate a little bit on the opportunity, potential benefit of Texas moving to MCOs in March of this year?

In that market, how able are you to run restricted retail networks?

Thanks.

We expect to participate in the Texas conversion because we have a number of existing clients down there that will benefit from the move of lives into managed Medicaid.

I certainly would expect what Texas is doing and what Ohio and New York has done and so on, that that will be replicated by many other states in the years to come.

There are pretty significant cost savings associated to -- associated with those conversions.

And as you alluded to, restricted networks are possible in the managed Medicaid arena.

So we participate in a number of states with a number of customers where we have restricted networks in place.

Matt Fassler, Goldman Sachs.

Thanks a lot and good morning.

Two quick questions for you.

First of all, as you look at the Retail top line and at the front end in particular, and you think about the magnitude of your inventory declines, which are quite impressive, do you feel like the inventory position or the in-stock could at this point, given the very sharp declines, be having some impact on your Retail sales?

No, Matt, we don't believe that's the case, and we have monitored that very closely.

There were a few isolated geographic issues that were process-related, that were very short in duration, and those were remedied.

So we are very focused and very careful that it is not at the expense of service levels to our customers.

Got it.

Then my second question, if you think about the Express/Walgreens dispute and the possibility that at some point perhaps this is resolved, what kind of efforts are you implementing to try to ensure that the business that you win through this dispute is sustainable business for you and that these customers can become long-term customers for you, not just temporary customers, if you will?

Well, thanks.

This is Mark again.

As I said up front, a big push that we had from the get-go was to make sure that we are providing a great experience to each new customer that walked in the door.

And we believe that is the number-one thing that we can do to retain them over time.

We do have a number of other things that we can do both in the front store and in the pharmacy, including ExtraCare, to try to -- and really pushing that program to encourage more loyalty over time.

But it's probably as big a priority as we have right now is how do we make the experience as good as it can be and retain those customers over time.

Ricky Goldwasser, Morgan Stanley.

Good morning.

I have a couple follow-up questions.

First, on the market-share gains from Walgreens, can you quantify for us what percent of the business that you gained you would categorize as maintenance scripts?

Do you think that maintenance scripts could be more sticky than overall scripts?

Ricky, recognizing that this situation is -- we are four, five weeks into this now, we don't have that level of detail at this point in time.

As I mentioned earlier, our focus is getting those customers enrolled in our systems and making that transfer process as seamless as we can.

Now I think it's intuitive that the maintenance customer has the potential to be a stickier customer, because they are using the pharmacy on a regular basis versus the individual that has an acute episode that may use the pharmacy once or perhaps twice a year.

I think a lot of the things that Mark alluded to will be focused on those maintenance customers.

Okay.

Then one other follow-up on the specialty business.

What was the specialty growth once you exclude the benefit from Aetna?

I don't think we have provided that breakout.

We did have very strong growth in specialty, as was the reported earlier.

A significant component of that was Aetna, for sure.

But the category itself is growing because of just increased utilization; and we have had some additional PBM growth that added to it.

Steven Valiquette, UBS.

All right, thanks.

Good morning, Larry and Dave.

Just trying to get a little bit better feel for the marketing battle behind the scenes for the Walgreens business that is up for grabs.

I guess my two questions are, is there any sense of a tug-of-war between CVS pushing these customers to Retail versus maybe Express trying to push them to mail order?

And do you have any sense of whether the mail order industry overall is picking up any share, or do you think that retail scripts are basically just staying in the retail channel?

Thanks.

Yes, Steve, our Retail organization has worked very well and very closely with Express in terms of how we can make this as seamless an experience as possible.

Quite frankly, as Per mentioned earlier in terms of giving Express a compliment in terms of how they have handled this, I too believe they have done a terrific job with both their clients as well as working with -- and I am sure it is not just CVS.

It's other retailers as well in terms of working closely to make it as seamless as possible for their members.

John Ransom, Raymond James.

Just looking at your PBM business, do you anticipate at some point that the revenue growth and the operating income growth will sync up?

Or do you think this is a business that you will see better revenue growth than operating income growth for the intermediate term?

I think you know what our long-term guidance has been on that subject, and we have talked about it at Analyst Day.

So certainly for the foreseeable future over the next several years we expect revenues to grow at a higher rate than the operating income.

Okay, we will take one more question.

Thank you.

Go ahead, John.

Just one other thing.

Any comments on Lipitor?

Are you indifferent as to who has market share on the manufacturing side given your dual PBM-Retail structure?

John, what we are seeing over the last few months is Lipitor is behaving as we had forecasted.

In our Retail business our substitution rate is in the mid 70s at this point in time, and we expect that that will continue to increase and probably have an acceleration once the exclusivity period expires in late May, early June.

Okay, one more question.

Eric Bosshard, Cleveland Research Company.

Good morning.

Two questions.

First of all, on Walgreens, the $0.03, can you split at all the benefit, even roughly, that you think you're seeing in the pharmacy relative to the front end?

Eric, we covered that or we touched on that a little earlier, that it is very early in the game.

We are -- we believe some of the front store lift that we have seen in January is attributable to that, but we will -- I think over the next several weeks we will be able to do a better job of quantifying that as we are able to get these customers enrolled in ExtraCare and so on.

Eric, I think in the short term here at least for the first quarter, you think about it dominant in pharmacy versus front.

Then secondly, I think you touched on this a little bit, but in terms of PBM profits growing faster than you thought in 4Q, and I know you didn't do anything different with the '12 PBM profit expectation, what was in 4Q that helped?

And is there a potential that that continues in '12?

Well, I think we have had through 4Q, we did see some accelerated utilization in the quarter, and I think we are very focused on delivering on our expectations in 2012 and the guidance we provided at Analyst Day.

We feel very comfortable in where we stand.

So I don't know if there is anything that is going to wrap, if you will, into 2012 specifically, related on trends in the fourth quarter.

But we are very confident in where we stand today.

Okay.

Well listen, we want to thank everyone for your interest and your time this morning, and I am sure we will talk to many of you soon.

Ladies and gentlemen, that does conclude the conference call for today.

We thank you for your participation and ask that you please disconnect your lines.