CVS Health Corp (CVS) 2013 Q1 法說會逐字稿

Ladies and gentlemen, thank you for standing by.

Welcome to the CVS Caremark first quarter 2013 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, May 1, 2013.

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

Please go ahead, ma'am.

Thanks, Susie.

Good morning everyone and thanks for joining us.

I'm here with our President and CEO, Larry Merlo, who will provide an update on the business.

After Larry, our Executive Vice President and CFO, Dave Denton, will review financial results and guidance.

John Roberts, President of PBM, and Mark Cosby, President of our Retail Business, are also with us today and will participate in the question-and-answer session following our prepared remarks.

During the Q&A, please limit yourself to no more than two questions so we can provide more callers with a chance to ask their questions.

Just before this call we posted a slide presentation on our website that summarizes the information you'll hear today as well as key facts and figures regarding our operating performance and guidance.

I encourage you to take a look at that.

Additionally, we plan to file our quarterly report on form 10Q by the close of business today and it will be available through our website at that time.

During this call we'll use some non-GAAP financial measures when 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 these non-GAAP items as well as reconciliations to comparable GAAP measures on the investor relations portion of our website.

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

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

During this presentation, we'll 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 in our upcoming quarterly report on Form 10-Q.

And now I'll turn this over to Larry Merlo.

Thanks, Nancy.

Good morning everyone and thanks for joining us today.

Let me begin by saying that we are very pleased with the strong first quarter results.

As expected, the influx of new generic drugs was a key driver of our year-over-year profit growth across the enterprise, and that said, both our Retail and PBM segments delivered operating profit growth well above our expectations for the quarter.

This out performance was driven by stronger than expected script volumes, due in large part to the strong flu season, strong specialty growth, and favorable purchasing and rebate economics.

Adjusted earnings per share from continuing operations for the quarter came in at $0.83, that's $0.03 above the high end of our guidance and we also generated $1.3 billion in free cash flow.

And we remain committed to our disciplined approach to capital allocation, continuing to focus on returning significant value to our shareholders through dividends and share repurchases.

Now, given our strong results in the first quarter and the fact that it is still very early in the year, we are narrowing our guidance range for 2013 by raising the low end of the range $0.03.

And Dave will provide the details of our guidance during his financial review, but please note that this guidance takes into account the expected impact on our Medicare Part D business from sequestration, and it also includes costs in our Med D business associated with resolving issues that arose following planned consolidation at the beginning of the year.

We now expect to achieve adjusted EPS for '13 in the range of $3.89 to $4.

And with these first quarter results, the year is off to a great start.

So with that, let me provide a business update and I'll start with the PBM.

As it relates to the 2014 selling season, it's still too early to provide a specific update at this time.

From what we've seen to date, pricing remains competitive, yet rational, and we continue to be confident that we are in a great position in the marketplace with our unique products and services.

Client interest in our Maintenance Choice offerings continues to increase.

We now have about 16.3 million lives covered by more than 1,200 plans that have implemented or committed to implement our Maintenance Choice offerings and that's up from 15.8 million lives at our last update, and up from 10.5 million lives this time a year ago.

Since we've introduced Maintenance Choice 2.0, a majority of this new growth is coming from this new plan option.

As clients continue to look for ways to manage and control costs, Maintenance Choice continues to be an attractive option, generating savings of up to 4%.

Our flagship clinical program, Pharmacy Advisor, is succeeding in moving a significant portion of PBM members to optimal levels of medication adherence.

And our recent study showed that about half of members who were non-adherent before participating in Pharmacy Advisor actually became adherent within a year of being in the program.

In addition, there was a 5.8% decrease in the prevalence of gaps in care for diabetics and we know that improving adherence to prescription regimens can lead to significant savings and better health.

A recent CBO report late last year estimated that a 1% increase in the number of prescriptions filled by Medicare beneficiaries would lead to a 20 basis point reduction in overall healthcare costs.

In 2012, we saved clients more than $643 million in their overall healthcare spend as a result of improved medication adherence for chronic conditions, and our Maintenance Choice and Pharmacy Advisor programs contributed to these improved adherence rates and cost savings.

Now, with all the change on the horizon, what are we hearing from our clients?

Well, we just completed our recent client advisory forum a few weeks ago.

We had an opportunity to spend time with about 800 clients.

Obviously, they're very focused on the implementation and administration of the changes resulting from the Affordable Care Act, while continuing to look for innovative ways to both lower costs and improve outcomes.

And with our integrated breadth of assets across Retail Pharmacy where we interact with 5 million customers a day, our PBM as well as our MinuteClinics, we can engage with patients through our unique clinical programs to help drive better outcomes.

And we are very well aligned with the goals of health reform and well positioned to be an important part of the solution.

Our clients are also looking for help in effectively managing the rapidly growing costs in specialty pharmacy.

As we talked many times, it's projected that spending on specialty drugs will grow 20% annually, double from 2010 to '16 to more than $120 billion.

And through a combination of technology, process, clinical programs, we are able to provide a variety of solutions to help our clients effectively manage their specialty spend, while continuing to ensure access to these medications for the patients who need them the most.

As an example, our new specialty medical benefit program aims to apply effective drug management for that portion of specialty flowing through the medical benefit.

This is an area which has been largely unmanaged in the past due to the lack of transparency and it poses significant challenges to both employers and health plans.

We recently acquired a technology platform that helps us identify, capture cost savings opportunities for specialty drugs billed under the medical benefit, and our focused specialty cost management will apply clinical, accurate drug pricing, prior authorization and other targeted recommendations, including the most cost effective site of care.

In addition, growing competition in pharma across many of the specialty categories that represents another key opportunity for us to help manage client spend.

You look at categories such as growth hormone, Hepatitis C, rheumatoid arthritis, MS, we have opportunities to manage formularies and rebates so that our clients benefit.

I'm happy to report that our specialty pharmacy business continued its healthy growth in the quarter with revenues increasing nearly 20% versus the same quarter last year.

And this specialty growth was driven by new PBM clients, new product launches, along with drug price inflation.

We've talked about the CMS sanction on our Medicare Part D prescription drug plan during our last earnings call.

We have been working closely with CMS to resolve the issues that arose after plant consolidation at the beginning of the year.

We submitted a plan of action to CMS and we are making great progress against that plan.

Now, the sanction means that we cannot enroll new individual SilverScript members or market our SilverScript plan to potential individual members until the sanction is lifted.

And the sanction will be lifted when CMS is satisfied that the issues are fixed, not likely to recur, and clearly our goal is to have the sanction lifted before the next open enrollment period in the fall and, again, the timing of that decision lies with CMS.

Moving on to our Retail business.

We had another very strong quarter.

Our goal was to retain at least 60% of the scripts gained during the impasse between Walgreens and Express Scripts and we are pleased with our results which are exceeding our expectations.

In fact, our retention rate has not changed much for the past several months, so at this point we believe we have essentially achieved our steady state retention rate and we remain very confident that we will continue to retain at least 60% of the scripts in 2013.

During the quarter, total same store sales decreased 1.2%, and that was largely due to the significant impact from new generics on the revenue line.

Pharmacy comps decreased 2.3%.

However, script comps increased 2% when counting 90 day scripts as one and increased 4.7% when counting 90 day supplies as three scripts.

New generics had a negative impact of about 925 basis points on pharmacy comps in the quarter.

And on the flip side, we had a notable benefit from a very strong flu season, from both flu related scripts and flu shots, which positively impacted pharmacy same store sales in the quarter by about 90 basis points.

As for the front store business, comps increased 1.4%.

The absence of leap day had a negative impact on the front store comps of about 120 basis points, while the timing of Easter had a positive impact of about 65 basis points.

During the quarter, front store traffic was down slightly while the average front store ticket increased notably.

The latest data shows that CVS has continued to gain front store market share versus a year ago.

When compared to drug and multi-outlet competitors, our front store share growth in the first quarter was 120, and 10 basis points respectively.

Turning to our real estate program.

We opened 52 new or relocated stores, closed 9, resulting in 28 net new stores in the quarter, and this puts us on pace to achieve our 2% to 3% square footage growth target for the year.

MinuteClinic recorded exceptional revenue growth in the quarter.

Sales were up 50% versus the same quarter last year, and this was of course bolstered by the very strong flu season that we referenced earlier.

And in addition to treating acute patients in the quarter, we continued to develop wellness programs, along with programs aimed at monitoring chronic conditions.

And the growth that we've experienced in MinuteClinic's non-acute services is helping to reduce the seasonality of the business.

We opened 9 net new clinics in the quarter, ending the quarter with 649 clinics in 25 states and the District of Columbia and our expansion plans call for the opening of 150 clinics this year and to end 2013 with just under 800 clinics.

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

Thank you, Larry and good morning everyone.

Today I'll give a detailed review of our first quarter results, then I'll provide guidance for the second quarter and update our full year 2013 outlook.

But before I get to that, I want to highlight how we've been enhancing shareholder value through our disciplined capital allocation program.

During the first quarter we paid approximately $277 million in dividends, and given our continued strong earnings outlook this year, we remain on track to achieve our targeted payout ratio of 25% by the end of this year.

Two years ahead of our original schedule.

Additionally, we repurchased approximately 7.4 million shares for approximately $393 million, at an average price of $53.24 per share.

And we still expect to complete $4 billion of share repurchases for the full year 2013.

So between dividends and share repurchases, we returned approximately $670 million to our shareholders in the first quarter alone, and we continue to expect to return approximately $5 billion for the full year.

We generated approximately $1.3 billion of free cash in the first quarter, and we've made excellent progress in reducing our cash cycle.

In fact, through the first quarter, we have taken nearly two weeks out of our cash cycle over the course of the last nine quarters.

The improvement has been greatest within inventory, but all drivers have benefited from our increased commitment to extracting value from our balance sheet.

We remain committed to further improvements as we look into the future.

Now, given the issues we experienced following our Medicare Part D consolidation earlier this year, we may have some timing issues with respect to CMS payables and receivables that affect our free cash flow delivery for this year.

While we are maintaining our guidance for free cash flow of between $4.8 billion and $5.1 billion this year, we are working to offset this headwind to our free cash target and we'll update you on our progress on future earnings calls.

Now turning to the income statement.

Adjusted earnings per share from continuing operations came in at $0.83 per share, approximately $0.03 above the high end of our guidance.

GAAP diluted EPS was $0.77 per share, and as Larry mentioned, the EPS beat was driven primarily by the higher than expected prescription volumes, due in large part to the intense flu season, strong growth in specialty, and favorable rebate and purchasing economics.

These positive drivers were partially offset by some below the line items including higher than expected interest, a slightly higher tax rate, and more shares outstanding.

These were also partially offset by the impact of the previously announced Medicare Part D sanctions and the measures we have taken to resolve some of the issues we experienced following our Med D plan consolidation on January 1st.

Let me quickly walk you through the results.

On a consolidated basis, revenues in the first quarter declined by 0.1% or approximately $35 million to $30.8 billion.

Revenues were essentially flat which compared very favorably to our guidance for revenues to be down 2.5% to 4%.

The increase in revenue in the PBM and Retail segments were offset by significant increase in intersegment activity, primarily driven by the increased adoption of our Maintenance Choice program.

Within the segments, PBM net revenues increased 0.1% or approximately $11 million to $18.3 billion.

This growth was approximately 180 basis points above the high end of our guidance.

The out performance was driven by higher than anticipated claims volume, again primarily from flu, and Maintenance Choice.

Specialty pharmacy was also a key revenue driver, primarily due to new clients, new products, and drug cost inflation.

This was mostly offset by the significant impact from new generics.

In fact, the PBM's generic dispensing rate increased nearly 400 basis points versus the same quarter last year to 80%.

Revenues in the Retail business increased 0.2% in the quarter or approximately $27 million to $16.1 billion.

New generic introductions also negatively impacted Retail sales with our Retail GDR increasing approximately 310 basis points versus the first quarter of '12 to 81%.

The heavy incidence of flu and greater Maintenance Choice volumes drove the out performance in Retail sales.

Now turning to gross margin.

We reported 18.1% for the consolidated Company in the quarter, an increase of approximately 155 basis points compared to Q1 of '12.

Within the PBM segment, gross margin increased by approximately 85 basis points versus the same quarter last year to 4.2%, while gross profit dollars increased approximately 25% year-over-year.

This increase year-over-year was primarily driven by the large increase in GDR, higher volumes, and better acquisition costs and rebate economics.

These positive margin drivers were partially offset by client price compression and costs in our Medicare Part D business associated with the issues that arose following planned consolidation at the beginning of this year.

Gross margin in the Retail segment was 30.9%, up about 230 basis points over LY.

As with the PBM, this improvement was driven primarily by the increase in GDR.

Additionally, gross profit dollars increased 8.3% year-over-year within the Retail business.

The improved GDR also had an impact on expense leverage, which was optically negative while growth of expense dollars was in fact within normal parameters.

Total operating expenses as a percent of revenue increased approximately 60 basis points from Q1 of '12 to 12.6%, while total SG&A dollars grew by 4.7%.

The PBM segment's SG&A rate was flat to LY at 1.5%.

This was primarily driven by benefits and lower costs from the streamlining effort.

Partially offsetting these favorable items were investments in Med D related to our ongoing remediation efforts.

In the Retail segment, SG&A as a percent of sales increased by approximately 85 basis points to 21.3%, while expenses grew by 4.3%.

As expected, this too was mainly due to the deleveraging effect of the growth in generics.

Within the Corporate segment, expenses were up approximately $31 million to $199 million, primarily due to increased legal costs.

Now, adding it all up, operating margin for the total enterprise improved approximately 95 basis points to 5.5%.

Operating margin in the PBM improved approximately 80 basis points to 2.7%, while operating margin at Retail improved about 150 basis points to 9.6%.

For the quarter, we beat our growth estimates for operating profit in both the Retail and PBM segments.

Retail operating profit increased a very healthy 18.5%, exceeding expectations by approximately 7 percentage points.

The PBM business' operating profit was once again very solid, growing 42.9%, nearly 12 percentage points above our guidance range.

Going below the line on the consolidated income statement, net interest expense in the quarter declined approximately $6 million from last year to $126 million in the quarter.

The debt refinancing we did in the fourth quarter was the primary driver of this decrease.

Additionally, our effective tax rate was 39.2%, which was slightly higher than we expected.

Our weighted average share count was 1.24 billion shares, also a little higher than anticipated.

Combined, the variance versus our expectations and interest, the tax rate and the share count offset the over performance of the segments by about a penny.

Now, let me update you on our guidance.

I'll focus on the highlights.

You can find additional details of our guidance in the slide presentation we posted on our website this morning.

As we stated in the press release, we narrowed our EPS ranges to reflect our strong first quarter performance.

Our revised guidance also reflects the costs in our Medicare Part D business associated with resolving issues that arose following planned consolidation at the beginning of the year as well as the estimated impact on our Medicare Part D business from sequestration.

With respect to sequestration, our understanding is that the 2% cuts affect the direct subsidy payment received from CMS for plan members including both LIS and EGWP members.

However, the cuts only impact our captive fully insured PDP business which represents about 3.6 million of our SilverScript Medicare Part D lives.

All things considered, we raised the low end of our guidance by $0.03.

We currently expect to deliver adjusted EPS in '13 in the range of $3.89 to $4 a share, reflecting excellent year-over-year growth of 13% to 16.5%, after removing the impact in 2012 related to the early retirement, extinguishment of debt.

GAAP diluted EPS from continuing operations is expected to be in the range of $3.64 to $3.75.

We've increased our top line outlook and now expect consolidated net revenue growth of 1.75% to 3%.

This guidance reflects the solid performance across the enterprise year-to-date, and the range is 100 basis points higher than our previous guidance due to better volumes as well as specialty inflation.

Guidance for operating profit growth in our Retail segment has been raised while we have brought up the low end of the range in the PBM segment.

We now expect Retail operating profit to increase 7% to 8.5% year-over-year, and PBM operating profit to increase 11% to 14%.

We now expect corporate expenses to be between $745 million and $760 million, a bit higher than our previous guidance due to higher legal expenses.

However, it is in line as the percent of consolidated revenue to our prior guidance, given the increase in revenue expectations.

We are increasing our expectations for net interest expense for the year by approximately $20 million to account for some capital leases and we now expect between $495 million and $505 million of net interest expense.

We are increasing our weighted average share count forecast slightly to 1.22 billion shares, up from 1.21 billion shares.

And as I said previously, our free cash flow guidance for the year remains in the range of $4.8 billion to $5.1 billion.

However, we are working to manage through some cash flow headwinds, largely due to Medicare Part D. And I'm very pleased with our significant cash flow generation capabilities which should continue to play an important role in driving shareholder value, both now and well into the future.

In the second quarter we expect adjusted earnings per share to be in the range of $0.94 to $0.97, reflecting growth of 16.25% to 20.25% versus the same period of LY.

GAAP diluted EPS from Continuing Operations is expected to be in the range of $0.88 to $0.91 in the second quarter.

Within the Retail segment, we expect revenues to increase 0.75% to 2.25% versus the second quarter of LY.

The revenue increase will be driven by solid volume growth, dampened somewhat by the continued growth in generic utilization.

We expect same store sales to be essentially flat with guidance for total same store sales in the range of negative 0.25% to positive 1%.

Script comps are expected to increase in the range of 1.5% to 2.5%.

In the PBM, we expect revenue growth of between 0.5% and 1.5%, also impacted by volume growth that is dampened somewhat by generics.

Operating profit in the Retail segment is expected to grow 7.25% to 9% in the second quarter while operating profit in the PBM segment is expected to grow 26.5% to 32.5%.

So expect another very solid quarter as we look ahead.

And with that, I'll turn it back over to Larry Merlo.

Okay.

Thanks, Dave.

And I think as you just heard, as Dave described, this was a very solid quarter with strong financial results across the board and, again, the year's off to a great start.

We continue to be excited by the opportunities to bring meaningful solutions to today's healthcare challenges and we strongly believe we are very well positioned to do so.

And with that, why don't we go ahead and open it up for your questions.

(Operator Instructions)

Dane Leone, Macquarie.

Hi.

Congrats on a great quarter.

Thank you for taking the questions.

I was just wondering if you could put out a ballpark EPS hit from sequestration just to help us understand how that hit flows through the P&L and the direct reflection into the guidance update that you gave today.

Yes, this is Dave.

I can answer that generally.

We're not going to give a specific number to that.

I think what's important is that it doesn't affect all of our lives.

It only affects those lives that are directly subsidized by the Federal Government and part of our capitated program which is about 3.6 million members.

Okay.

I guess we can work through the math there.

This is more of a high level question, so not to anyone specifically, but food for thought.

We've seen a very tepid employment recovery in the US.

Sequestration is posing additional headwind.

We've seen the overall unemployment rate hold steady but the labor participation rate's been dropping, essentially implying that there would be more individuals on insurance population right now and that's actually increasing.

When you speak about the 50% rise in MinuteClinic, are you seeing a higher amount of uninsured come through that clinic that's driving up demand volume there?

And I guess maybe any broader color on how you see the cyclical swings in unemployment impacting the business would be great.

Yes, as it relates to MinuteClinic, actually it's the opposite.

We're seeing a growing number of MinuteClinic visits accompanied by some type of health insurance, which I think is really representative of the fact that it becomes a high quality, lower cost option for employers, for health plans, and I remember in the early days we had about 20% of visits that were covered by some type of insurance.

That number is approaching -- it's not there yet, but it's approaching 90%.

In terms of the unemployment, I think we continue to see on the Retail side a cautious consumer and we continue to look for differentiated ways to bring value to that consumer through our ExtraCare program.

On the PBM side we have projected that utilization would be relatively flat and that's pretty much what we're seeing.

Okay.

Great.

I'll yield there.

Thank you very much.

Okay.

Thanks.

Robert Willoughby, Bank of America-Merrill Lynch.

Larry or Dave, can you comment just on the renewal process for Caremark's pharmacy agreements with Walgreens, what's really changed in the dynamics here, what do you bring that's new to that table that might afford you some leverage?

Well, you know, Robert, I think that while we don't talk about specific contracts, okay, I think that we have continued to work with all of the providers in terms of bringing value to the overall equation in terms of providing access and at the same time ensuring that we are working on behalf of our clients to make pharmacy care affordable.

And I think that our Management team has done a very effective job in that regard.

Any sense of how big Walgreens is in your pharmacy networks today from a volume perspective versus three years ago?

Yes, we don't -- we're not going to get into those specifics.

We haven't disclosed that.

All right.

Thank you.

Thanks.

Matthew Fassler, Goldman Sachs.

Thanks a lot, good morning.

Two quick questions if I could on the PBM side.

First of all, you maintained your claims guidance for the year I think despite a somewhat better first quarter.

If you could talk about the drivers there.

I don't think sequestration would really factor into volumes but any color there would be great.

This is Dave.

Sequestration will not factor into volumes.

I think as you saw, we had a very solid first quarter from a volume perspective.

I think we're only a few months into the full year, so I think our trends look promising but we don't see these trends as changing substantially other than the fact that we again had a very solid flu season for the first January, February period.

Got it.

That's helpful.

And then secondly, just any updated views on the selling season to date and any impact that healthcare reform might be having on your clients as they think about switching, renewing, et cetera.

Yes, Matt, this is John.

As we talk to our employer clients they're clearly focused on the administrative requirements for healthcare reform.

As an example, tracking hours for part-time employees.

So I think as a result of that we're actually seeing fewer RFPs in that part of the marketplace than we did a year ago.

But when you look at the overall dollars that have come to the market, it's actually up a little bit.

Understood.

Thanks a lot, guys.

Appreciate it.

Okay, Matt.

Thanks.

Steven Valiquette, UBS.

Thanks.

Good morning, guys.

Couple of questions here.

First, just curious on the moratorium on the marketing for Part D, just to clarify, does that apply just to SilverScript individual Part D or does that potentially impact some of the group Part D EGWP as well in.

It applies to the SilverScript and keep in mind that we manage for our health plan customers, their products, and this does not apply to that segment.

Okay.

And then also just --

I'm sorry, this is John.

The other thing I would add is on EGWP clients they have people aging into their plans throughout the year and so we are able to administer that and enroll those people in Medicare.

Sorry.

Just a quick question on the Medicare eligibles within the employer clients.

The RDS, retiree drug subsidy conversions to -- I'm assuming you would probably convert either to EGWPs or to individual Part D just given your footprint.

Curious kind of where we stand on that process, whether most of that may have already occurred by January 1, 2013, or is some of that still ahead of us for January 1, 2014.

This is John, Steve.

So we did see some migration in '13 to EGWPs.

I think with the advent of healthcare reform, I think employers are going to continue to -- or will take a wait and see attitude to see how the exchanges perform.

But over time, we do expect to see a subset of the employer market either continuing to move their members into EGWPs or moving them potentially directly into the exchanges.

Okay.

That's helpful.

Okay.

Thanks.

Steve, just to add one further point of clarity as it relates to your Med D question around SilverScript.

We continue to work with employer customers who have an EGWP or who are planning to implement an EGWP to keep them updated on the status of the sanction.

We cannot market to those EGWP clients until the sanction is removed.

Right.

But most of those conversions presumably would happen on January 1, 2014, right, so as long as you resolve this sometime in the next call it three to six months like you've talked about, it shouldn't really impact the business at all as long as there is a decent lead time before January 1, 2014.

Is that the way to think about that?

That's correct, Steve.

And as we mentioned in our prepared remarks, we have made great progress on our plan and that's exactly our goal, working closely with CMS.

Okay.

Got it.

Okay.

Thanks.

Tiffany Kanaga, Citigroup.

Hi.

Thanks for taking my question.

I'm calling from Deborah Weinswig's team.

What do you expect for the cadence of share repurchases for the balance of the year in order to hit your $4 billion full year target?

Tiffany, this is Dave.

We're very committed to returning significant value to our shareholders, both in the form of dividends and share repurchases.

I think our share repurchases were a tad light in the first quarter.

We said that generally speaking that the cadence would follow the same pattern as last year.

So I would anticipate if you just looked out, looked at last year, that cadence and compared it to kind of what's left of the remainder of this year is probably the best way to model it at this point in time.

Can you give us an update on how digital initiatives are driving top line and margins and how your strategy's evolving now that you appointed Brian as Chief Digital Officer?

This is Mark Cosby.

I'll come from a couple of angles.

Overall digital, the number of new things that have come into play over the course of the last little while, at the end of last year as you know we updated our digital site itself and that's significantly easier to use.

We've also done a couple of things from a mobile standpoint that have been big drivers for us.

We launched a five star rated mobile application towards the tail end of last year that is performing very well for us and then most recently this last month we came out with a version for the iPad which is essentially a virtual store.

If you haven't used it, I would encourage you to get on and try it.

It is also coming out with some rave reviews.

All of these things in addition to some other initiatives we have coming forward are enabling personalization.

Digital is just one mechanism that we're using to drive that effort.

Thank you so much.

Tiffany, I just have one point.

I think that some of the things that Mark is alluding to has really advanced our digital capabilities more from a utility or utilization point of view versus a product point of view.

And we've gotten very high marks on -- from consumers on some of the more recent releases in terms of how this is making it easier for them to shop, both in the front of store, as well as the pharmacy.

Thanks.

John Heinbockel, Guggenheim Securities.

Good morning, guys.

Thanks for the question.

Two things, Larry.

So when you think about the renewal of the wholesale relationships with McKesson and Cardinal, what was the thought process behind that, pretty basic, but the thought process, what you might be doing differently in those contracts that you weren't before.

And then promise of daily delivery, and then whether you're playing around with that today.

Yes, John, as you know, we remain one of the largest purchasers of pharmacy in the country.

We essentially buy all of our generics directly from manufacturers and consolidate the vast majority of brand purchases with our wholesalers and then engage them for deliveries to our stores between fill-in deliveries from our own distribution centers.

And we're pleased with the result of the wholesaler RFP, and as was announced last week, we have contracts with both Cardinal and McKesson.

They both do a great job for us and we feel that we're getting the best economics this way.

It allows us to create I'll say the most efficient distribution network and it also provides for us a safe continuous and cost effective supply chain.

So we have always looked at ways in which we can provide further innovation and I'm sure that we've got some pilots that are in the planning process and, again, we are always open to ways in which we can take costs out of the supply chain and we'll continue to push the envelope around that.

Is daily delivery a thing of interest to you?

John, we've experimented with that in the past and we -- keep in mind that the arrangements with our wholesalers provide daily delivery today and so quite frankly, we're pretty pleased with the process that exists today.

But again, we'll continue to push the envelope and look for new ways or perhaps changes in the marketplace that create new opportunities.

All right.

Lastly, just on the front end, would it be fair to say front end grows basically flat and if you then think going forward, because we keep hearing rumblings, competitive activity picking up a little bit, a lot of people aren't happy with their traffic.

What do you see now and where do you think that goes if traffic remains light for a lot of these guys, a lot of your competitors?

Look, John, I mean, I'll -- maybe I'll start here and then ask Mark to jump in.

The first quarter was, on front traffic, it was probably a little lumpy.

We had acknowledged it was down overall.

We got some benefits from the flu season early in the quarter, but that was compromised by a lot of uneven weather patterns and then of course we were going up against having an extra day last year from leap day.

And I'll let Mark talk about some of the things that his team is working on, acknowledging that we continue to have this cautious consumer who's looking for value.

I think the other thing, just to add, Larry had it in his comments was that the share, we picked up share both in drug world as well as outside in the multi unit world.

So from that perspective it was good.

The number one thing we're working on in the front to get traffic into a better place falls under the headline of personalization.

I mentioned a few things when we talked about digital earlier.

But it's all about providing unique engagement to customers for all the ways that they use us, from service product to promotion.

ExtraCare is the piece, really the centerpiece of all that.

As you know we have a 15 year history with that program.

It's very effective.

And we know through that 15 years that it's more than just issuing cards.

That's the easy part.

It's about the data that we use and how we engage with customers, given what we know.

And been very successful over the years but not resting on our laurels.

We had a couple of programs coming out over the course of the last couple of years that have been effective for us, Beauty Club that launched has been very effective.

We also two months ago launched a pharmacy and health rewards program which is about encouraging adherence, retention and acquisition.

The biggest thing that we're doing that we talked about at Analyst Day was this program we call Conversion which is customer specific opportunities to drive frequency, basket and profit growth.

Two real drivers there, what we call pure conversion is getting customers who are in our stores today to buy more broadly across the store.

And then the other piece that we call share of wallet which is about getting people to buy deeper within categories that they already purchase in.

Both of those types of offers started a couple months ago and have been extremely successful for us.

As a subset of that we're looking at ways to deliver more opportunities to our customers.

We've doubled the number of e-mails that we send out to customers, both from a subscription perspective and in terms of an offer perspective.

And probably the biggest headline is what we're doing with this ExtraCare coupon center or what our bloggers call the magic red coupon machine.

The reason customers love this program is they get the coupons before they shop as opposed to after they shop which leads to three to five times the redemption of a normal receipt at the end of a transaction, and actually 15 times the redemption of what a normal FSI coupon would drive.

And that has led to 40% increase in the number of offers and engagements of our customers within the store.

So all of this falls under the headline of personalization, that's just a tidbit of what we're working on but those are the big things that we believe will drive both sales and profits, provide true differentiation versus what other folks are doing and will allow us to build on it over time.

Hey, John, let me just underscore one point.

We've gotten a lot of questions because the loyalty space is a lot more active today than it was a couple years ago and Mark mentioned that issuing the cards is the easy part and we know that because we've probably issued more than 300 million cards over the life of ExtraCare.

But what's a lot harder is driving real changes in consumer behavior.

And I think that Mark outlined an awful lot of activities that we have under way that really allow us to optimize our promotion and maximize incremental sales to drive share in a very effective and efficient pattern.

And we have not seen any declines in our ExtraCare activity as a result of some of our competitors getting into the loyalty space.

Okay.

Thanks.

Next question, please.

Ricky Goldwasser, Morgan Stanley.

Yes, good morning.

Have a couple questions.

First of all on the selling season, John, I think you talked about the fact that the overall dollars are up a little this year despite the fact that RFPs are lower.

So can you talk a little bit more, can you expand on what type of clients are you seeing this year, and yesterday it was reported that you won Blue Cross Blue Shield contract.

Are you expecting to see more movement within the managed care side?

Yes, Ricky, so we have seen some health plans early on.

I'm not sure you'll see a lot more moves this late in the season, but CareFirst was a good example of a very sophisticated health plan, very pleased to have been awarded the business for a January 1, 2014 start and it's a full service contract for retail, mail and specialty.

So that being said, it's still early in the season and we'll have more to say on our next call about how things are going.

But fewer contracts, I think the contracts that are out there are obviously bigger if the dollars are slightly up.

So should we assume that it's just bigger contract or not necessarily, a large employer but more --

I think you could assume that.

Okay.

Ricky, I think one of the things that we heard at the client forum that I alluded to was that clients are very consumed with doing all the things that need to be done as part of the implementation of the Affordable Care Act in January.

I think we walked away with a sense that maybe there's some -- people have a lot on their plates right now.

Okay.

And then one technical question.

When we model the impact from sequestration and the costs that are associated with Part D, how should we think about it kind of like where would it flow through your P&L?

Does it flow through the PBM segment and if so, should we adjust kind of the top line for sequestration and then cost of goods for Part D?

It does, Ricky.

Keep in mind that it was effective I think April 1st so it's really a nine month effect to it.

I would say it's -- from a modeling perspective, it's probably -- you're probably not going to see it.

It's just not big enough to call out that much.

Okay.

So based on the numbers that you gave at the beginning of the call, we kind of did back of the envelope and got somewhere around kind of $0.02 to 0 $0.05 range.

Are we in the ballpark or is the impact even more muted than that?

Ricky, I can't comment on that.

I think what would be important to do is kind of go back and understand the fact that it covers nine months.

It affects only the direct subsidy that we received from the Federal Government for our SilverScript plan and if you just kind of went back and look at the national bid, look at the member premiums and kind of did the math, you could kind of get into the amount that's affected by the 2%.

So I would encourage you to maybe do that math.

Okay.

Thank you.

Yes, thank you.

Ross Muken, ISI Group.

Thanks.

So you guys have had a number of sort of new innovative solutions on the PBM side over the last couple months with the 2.0 program and sort of what you're doing around specialty and specialty retail.

Where are you seeing the most interest from the customer base, particularly on the employer side for some of these offerings?

And then also on the exchange side, as you think about some of the sort of reform coming down the line, how do you feel like MinuteClinic is kind of playing into that piece and do you feel like that strength there gives you any advantage for that sort of opportunity?

Yes, Ross, let me start here and then John will jump in.

Again, just coming back from our client forum a few weeks ago, I was very excited in terms of some of the things that you mentioned, whether it's the Maintenance Choice 2.0, all of the specialty initiatives that we have under way and as well as the interest in MinuteClinic.

I came back and said the things that we're working on are very much aligned with what clients are most worried about and looking for solutions and I'll let John pick it up from there to get a little more specific.

So when we talked to clients on what their priorities are, it's obviously managing costs for both the plan and the members so I think that's why Maintenance Choice has been so -- been embraced by the marketplace and Larry talked about the growth from where we were in '12 up to 16.3 million members in '13.

And combined with Maintenance Choice, we're seeing interest in narrow networks, preferred networks.

Again, I think clients are looking for ways to manage their direct costs.

The other thing that clearly is a top priority is specialty.

And we've talked about the trends in specialty, the clients are seeing that.

It's becoming a bigger part of their overall drug spend and half of it is somewhat hidden under the medical benefit.

So as we talk to clients about our capabilities to manage specialty across both pharmacy and medical, there's a high level of interest and we actually have employer clients that are working with us with their health plans to move programs forward to manage that.

And I think the last thing I'll mention is employers get the value of keeping their members on medication and lowering overall healthcare costs.

So that's really our Pharmacy Advisor program and everything we're doing around adherence, the fact that we've expanded, we now have 10 conditions in our Pharmacy Advisor program.

We now have Pharmacy Advisor in Medicare to help our clients with their Stars program.

And then just to add to what Larry said around MinuteClinic, for our clients we can offer a reduced co-pay or a zero co-pay for their members.

So we're able to extend the benefits to their members at no additional cost, make primary care more accessible for them, so it's really a win-win-win.

That's what we're hearing from our clients around what their priorities are.

Great.

Thanks, guys.

Thanks, Ross.

Lisa Gill, JPMorgan.

Great.

Thanks.

Good morning.

Larry, I was wondering if could you maybe give us your initial thoughts around ACA from the drug retail side and maybe if Mark wants to chime in, are you signing early preferred type relationships on the Retail Pharmacy side, whether it's with managed care entities or some of the private exchanges?

How should we think about Retail in 2014, 2015, as these exchanges are rolling out?

Well, Lisa, it's a great question and obviously there are an awful lot of discussions taking place and I would talk about the fact that those discussions are being had at CVS Caremark.

We can do much more than just provide a retail distribution point for exchanges and their members.

And it really picks up where John left off in terms of an awful lot of very robust conversations in terms of the role that Retail Pharmacy plays, along with the role that our MinuteClinics play when you think about providing primary care and chronic care support.

So I think we're probably still a little early to talk about anything definitive, but an awful lot of interest in terms of what CVS Caremark can offer.

I think specifically as you think about Retail, I think that if you go back to the implementation of Medicare Part D I think pharmacists across the country played a key role in terms of educating and helping seniors enroll in the Medicare Part D program.

And I certainly see a role that our pharmacists can and will play around education and information for members or potential members as they think about what it is that they're going to need to do to enroll in exchanges.

And we're certainly looking to be very active from an education and information perspective.

So Larry, would you anticipate that we will see -- we have talked to some of the managed care guys that have said hey there's 68,000 retail pharmacies, we probably don't need that many.

They can envision doing half of the retail pharmacies and having someone like a CVS as an anchor.

Are those the conversations that you're having at this point and do you think that's the direction it will move in or is it too early to say because we're very early in the discussion?

I think it's still too early.

I think that the discussions that we've had probably cross the gamut of all different possibilities.

My sense is that at least for this first year, it's going to be a learning laboratory for everyone and I think that there's probably -- my sense is that there will probably be a little more conservatism in terms of how people think about it, until some of those learnings kick in and people can be perhaps a little more definitive in terms of where the market's headed.

Okay.

Great.

I guess my second question just would be around specialty.

Clearly great growth in specialty, continues to be something that plan sponsors are looking for.

Can you help us understand how many of your customers buy specialty from you today on the PBM side, so what are the future opportunities?

One, is it expansion to the rest of your PBM customers?

Two, opportunities for restrictive networks around specialty?

How do we think about that opportunity over the next couple of years?

Thanks.

So Lisa, I would think about it in two buckets.

One is with our employer clients, the vast majority of employer clients have exclusive arrangements with us around specialty so all of their specialty spend is going through our channel.

With health plans, they tend to take an approach of having several specialty providers and we work with those health plans to make sure that we're getting not only our fair share, but with our capabilities, more than our fair share.

And then -- so they may limit it to two providers to half a dozen providers.

And then you have the open market where those members can really go really anywhere and I think that links in to what we're doing with our integrated specialty solution.

And we've got people that are calling on these specialty physicians, talking about our capabilities and working with them to get those referrals into our channels because we're easy to do business with for the physician and for the member.

So I think you're going to see -- we think specialty's going to be one of the fastest growing areas because if you look at the drug pipeline in 2016, 8 of the top 10 drugs by revenue are going to be specialty.

That's clearly where pharma's focused from a pipeline perspective.

And I think you're going to see not only new drugs in the same categories but I think you're going to see the expansion of drugs into new categories with specialty.

So I see tremendous growth which is why we are as focused as we are on a holistic approach and solution to specialty so that we can manage the member as they progress in their disease state from a pharmacy benefit to a medical benefit, and managing appropriate care, appropriate therapy and making sure they're getting their specialty meds at the most cost effective site.

Okay.

Great.

Thank you.

Meredith Adler, Barclays Capital.

Thank you very much for taking my question.

I think I'm still a little bit confused about the things you expect to happen in Medicare Part D at the end of the year.

Obviously there's sequestration.

I think you've been clear about which of your members will be impacted by it.

I guess I'm a little less clear about the guidance you've given and how -- what that reflects in terms of the sanction from CMS.

Is there something in your guidance that is assuming some probability that you don't get this resolved before the next selling season?

Or are there just other costs associated with that in the numbers?

Meredith, first and foremost, I think that is largely a 2014 topic as it relates to our ability to accept auto assignees in the back half of the year.

So it's not really a '13 issue.

It's more of a '14 issue.

Clearly, our guidance is comprehensive of all the costs and effort that we think is required to, one, correct the situation and, two, ensure the situation will never happen again.

And three, go through any remediation effort that we need to get done to make sure that our members are served appropriately and CMS is satisfied that we are fully in compliance and we have no issues.

And finally, it does assume that we're not adding any additional lives because we at this point in time cannot market from a SilverScript perspective, so there's no lives being added to our book.

In fact, lives due to attrition are slightly declining month over month.

And maybe, Meredith, the sequester -- sequestration question keeps coming up.

Maybe I'll take a step back and give you a little bit of color on that.

And just to put this in perspective.

Sequestration as it relates to our SilverScript insurance business for the nine months is probably going to impact us to the tune of $0.01 to $0.02, somewhere in that ballpark is probably a good estimate at this point in time, as it relates -- again, the effect of the government sequestration on our business for this year.

So I guess I'm just still struggling to understand.

You've had a fantastic first quarter and congratulations, and guidance for the second quarter is above where the Street is.

So I'm just kind of struggling to know why the year didn't change.

It's not very big impact from sequestration unless you think the cost in terms of the sanctions are going to go up substantially.

Meredith, a couple things.

First and foremost, we've said very clearly that our performance for this year is going to be somewhat front half loaded versus back half loaded due to the influx of generics and the timing of the break-open status of those generics.

So you're seeing that play out.

Secondly, we do, as we said, we do have some costs in the back half of the year.

And the first half, certainly through the first quarter, a lot of that was related to the incidence of flu volume being pretty high and driving volume.

We're, again, just a few months into the year, I think our outlook looks very solid.

But I think it's just too early to predict kind of how the rest of the year's going to play out.

We're very comfortable with where we stand but we're -- I think as you know, we're one quarter in to a four quarter year and we're going to play this out.

That's very helpful.

Meredith, as you know, we have not raised guidance based on first quarter results, okay, for the reasons that Dave mentioned in terms of we still have most of the year still ahead of us.

And as Dave mentioned, we remain very confident in our guidance and outlook for the year.

But that's something that we'll continue to obviously talk about as we get more of the year behind us.

Thank you.

That's really helpful.

Much appreciated.

Okay.

Thanks, Meredith.

Thank you, Meredith.

Edward Kelly, Credit Suisse.

Hi, good morning, and nice quarter.

Thank you.

Dave, just to start off, a quick question for you on the free cash flow guidance.

I guess the tone of your voice sounds like maybe there is a little risk around that, if you can't mitigate the CMS stuff.

Is that fair?

Are we talking about a material number or is it small?

Well, I think as you know, we had -- we're not changing our guidance from a cash flow perspective.

I mean, as we said, clearly at the first of the year we had some systems issues that affected our Medicare Part D business and the result of that is really changing kind of where we anticipated our receivables and payables to be at the end of this year with the Federal Government.

And so it's really more of a timing issue as it relates to '13 versus '14.

I'd say we're working hard to offset those and we're optimistic that we can do that but I just want to make sure that everybody understands where we stand at this point in time.

Okay.

Great.

And then Larry, just a question for you on adherence, you talked about the savings.

My question for you is sort of how do you really measure that?

How do you market that to clients and actually get paid for it?

Is it just in your scripts or is it in additional PBM wins or is there some other way?

Yes, Ed, let me start and then, again, John will jump in here.

We have built a pharmacy care economic model where we can actually evaluate on a client by client basis, looking at claims, the opportunities that we believe we have to improve adherence and a corresponding benefit in terms of overall healthcare costs.

And we're actually beginning to guarantee savings associated with that, and quite frankly it's very consistent with what you're seeing in the star ratings in the Medicare program, okay, in terms of this aspect of clinical, if you will, being a component of that evaluation.

And just -- this is John.

To add to that, PBMs traditionally have managed bad trends and we continue to do that and clients want us focused on that.

They also realize that good trend or having their members take more medication lowers overall healthcare costs.

So we're able to, as Larry said, go into a specific client and with the pharmacy care economic model show what -- where their members are, what the opportunity is and if we get them in here, what their medical savings are.

There's buy ups for certain programs and we guarantee returns for their investments and, clearly, when you say are we seeing more wins in the market, as the market moves to taking more risk for overall healthcare costs, we believe this program offers a competitive advantage.

And we publish our results around Pharmacy Advisor in peer-reviewed journals.

Troy Brennan I think has done a terrific job, our Chief Medical Officer, in validating our activities and publishing those results so that they are credible from a client perspective.

So I think that does lead to more wins in the marketplace, particularly for those clients that are assuming more risk with healthcare reform.

And Ed, I think what we're talking about here is really the beginning of what will be a new, I'll call it reimbursement model, okay, that really ties to outcomes management, people have been talking about this for years but no one's figured out a way to quantify it.

And we believe -- not believe, we know we're on the leading edge of actually building the underpinnings with which to do that as we go forward.

And I think that we're probably in the first or second inning of a nine inning game here, but we believe that this is a big idea and where the market needs to head when you think about the rising costs of healthcare, and what clients are expecting from us, and quite frankly, what they pay us to do for them and their members.

Great.

Thank you.

Maybe take two more questions I think.

Tom Gallucci, Lazard Asset Management.

Good morning, guys, thanks for sticking around for those of us at the end of the queue here.

First question is on the purchasing and the rebate economics.

I'm not sure I heard you really get into what some of those drivers were.

Are we talking about some of the formulary changes that you made or other benefit design changes that the clients are making.

Can you help us understand where that's coming from?

Again, we continue to -- this is Dave.

I'll ask John to chime in here a little bit.

We continue to push each and every day on how to lower costs for the clients, the members that we serve.

Part of that is through how we go back and work with either branded manufacturers or generic manufacturers to lower cost or increase the rebate yield and I think we continue to be pretty successful in that area.

It's probably not one answer at the end of the day.

There's a lot of things that are across our business that we're doing.

Whether that be changes in our formulary, whether that be changes in our UM program, whether it be how we tailor our programs to drive value in this area.

So there's two ways to drive value.

One is through rebates which the vast majority of that value gets passed to our clients and we do that through our formulary strategy which has been very successful, and making sure appropriate branded drugs are available.

But we negotiate very aggressively with manufacturers to bring the net costs down for our clients.

The other thing is with all the generics that have come to the market over the last couple years, there are now in most therapeutic categories enough generics to provide appropriate level of care.

So we also have available for our clients what we describe as a value formulary which limits even further branded drugs that are available and boosts the overall generic fill rate across that client's book of business and delivers savings in that way.

So we offer programs that have a lot of flexibility that deliver a lot of savings and value for our clients and we continue to work very hard to bring them new value each and every year.

Okay.

Thank you.

And then another topic, you've touched on a little bit but I was wondering if you could go a little more in depth.

Hearing a lot more out there especially with some of the competition about sort of having the medical benefits and the pharmacy benefits under one roof to more effectively manage particularly the specialty area.

I thought it was interesting, I think in CareFirst's release, they talked about your supported integrating pharmacy data and their data.

Can you talk about some of your capabilities and how you sort of sell against the in-house model in this area?

Yes.

So our capabilities allow us -- and I'll talk about CareFirst because we think supporting our clients in this integrated model makes a lot of sense and PBMs have traditionally managed specialty under the pharmacy benefit and the health plan has managed specialty under the medical benefit.

And as that member moves across those benefits, there's hand-offs that have taken place.

So our capabilities you now allow us on behalf of CareFirst to manage that specialty part of their spend and those members much more effectively than they were in the past.

I think as a standalone PBM, we can do the same thing and we can integrate with employers' health plans to do the very same thing.

So it really -- with large employers they have multiple health plans, so we think our model resonates because they have one provider managing that overall spend.

With the smaller employers that may have a single health plan, we think partnering with our health plans to provide those same services makes sense for that book of business too.

So we can support both ways and we think both ways are very effective.

Thank you.

Let's take our last question, please.

Eric Bosshard, Cleveland Research.

In your prepared remarks you talked a couple times about favorable rebate economics.

I'm curious if you could give us a little bit of color, or further color, on what that is referring to.

And also interested if the generic payback period, and where that trend goes from here in terms of the generic benefit, how that should play out from here as we work through this year and into next year.

Well, this is Dave, Eric, maybe I'll kick it off and ask John.

Again, I think from a rebate perspective, again, it's a lot of little things that we're doing across our book of business to drive favorable economics for our clients and this is -- gets back to very specifically focusing on the formulary, very specifically focusing on the UM, leveraging all the programs that we have in place to drive value for our members and the clients.

And that is -- that drives, again, rebate performance, that drives back a little bit to reducing cost of goods sold for our clients and we share in some of that.

I think from a generics perspective, we're in a very heightened time period in which the generic utilization continues to expand.

Those -- the generic pipeline still looks robust quite frankly for the next several years.

We're working very effectively across our book of business, not only to drive economics in generics but also improve performance from a generic penetration adherence perspective, and I think all of those drive value for us and for our clients.

Eric, let me just add one point to what Dave mentioned.

And it goes back to the formulary.

Because we still get questions every now and then.

We had a lot of noise two years ago when we made the formulary changes, but as we've acknowledged many times that the strategy was absolutely spot-on, and I think that your question is really an extension of what clients are now experiencing as a benefit of that strategy.

I think what we had acknowledged was right strategy.

We needed to do a better job from an execution point of view, largely tied to the timing of the communication so the clients have certainty around the new plan year and all the changes that would take place.

So that was a good learning for us, but I think that we're seeing the financial benefits of that as we speak.

Great.

Thank you.

So listen, I'll just wrap up here and certainly appreciate everyone's time today.

Appreciate the questions.

I think the questions have been very much aligned with where we're making investments in the business, investments that are aligned with our clients' expectations and needs.

While we know we have many challenges ahead of us in the healthcare space, we are certainly excited by the opportunities that we have to bring meaningful solutions.

Thanks for your time again this morning and we'll talk to 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.

Have a great day.