CVS Health Corp (CVS) 2015 Q1 法說會逐字稿

Ladies and gentlemen, thank you for standing by, and welcome to the CVS Health first-quarter earnings call.

(Operator Instructions)

As a reminder, this conference is being recorded today, Friday, May 1, 2015.

It now gives me pleasure to turn the conference over to Nancy Christal, Senior VP, Investor Relations.

Please go ahead.

Thank you, Mulladin.

Good morning, everyone, and thanks for joining us.

I'm here this morning with Larry Merlo, President and CEO, who will provide a business update; and Dave Denton, Executive Vice President and CFO, who will review our first-quarter results, as well as guidance for the second quarter and year.

Jon Roberts, President of PBM, and Helena Foulkes, President of the Retail business, are also with us today, and they will participate in the Q&A session following our prepared remarks.

(Caller Instructions)

Just before this call, we posted a slide presentation on our website.

The slides summarize the information you'll hear today, as well as some additional facts and figures regarding our operating performance and guidance.

Additionally, our Form 10-Q will be filed later this afternoon and it will be available on our website at that time.

Please note that, during today's presentation, we will make forward-looking statements within the meaning of the Federal Securities Laws.

By their nature, all forward-looking statements involve risks and uncertainties.

Actual results may differ materially from those contemplated by the forward-looking statements for a number of reasons, as described in our SEC filings, including the Risk Factors section and Cautionary Statement Disclosures in those filings.

During this call, we'll also use some non-GAAP financial measures when talking about our Company's performance, including free cash flow 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.

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

Okay, thanks, Nancy.

Good morning, everyone.

Thanks for joining us to hear more about the strong first-quarter results we posted this morning.

Adjusted earnings per share increased 12.2%, to $1.14 per share, and that's $0.05 above the high end of our guidance range.

Operating profit in the Retail business declined 1.3%, in line with expectations, reflecting the tougher comparison due to the tobacco exit.

Operating profit in the PBM increased 14.6%, well ahead of our expectations.

We generated approximately $1.6 billion of free cash during the quarter, and we continued to return significant value to our shareholders through our disciplined capital allocation practices.

It's still early in the year, but given our outperformance in the first quarter, we are narrowing our adjusted EPS guidance range for 2015 to $5.08 to $5.19, and Dave will provide the details of our guidance during his financial review.

Let me turn to the business update, and I'll start with the 2015 PBM selling season.

The expected revenue impact for 2015 has grown since our last update.

Gross new business currently stands at $7.5 billion, with net new business of $4.1 billion.

That's up about $0.5 billion on both the gross and net lines from our last update.

The increase was driven primarily by the growth in membership within some health plan clients, as well as some additional wins.

Turning to the 2016 selling season, I would describe pricing in the industry as competitive, yet rational.

To date, we've completed about one-third of our client renewals, which is typical at this time of year.

And while it's too early to give you specific data points for 2016, I will note that the selling season is off to a good start.

Our integrated model allows us to provide differentiated products and services that continue to provide savings for our clients while providing better health outcomes and convenience for our members.

These unique products and services continued to resonate strongly in the market, and as we typically do, we'll provide a more quantitative update on our 2Q call in August when we have a more complete picture.

Our recently released Insights report highlights our efforts to manage trend for our clients.

In 2014, gross trend was 12.7%, and that's up from 3.8% in 2013.

Importantly, the report demonstrates that there are solutions to bend the cost curve.

With brand price increases, the accelerating growth in specialty, we are finding more clients receptive to these types of solutions.

Our report identifies high-performing clients, what we call our trendsetters, and the solutions that they are using to improve the cost trend.

We shared these results with our clients at our recent client forum last month, and let me take a minute and give you just a couple of examples.

First, formulary management solutions, our trendsetter solution -- we call it the Value formulary -- and it promotes lower cost generics and provides limited access to brands.

We employ category-specific management using drug exclusions, step therapies, prior authorization, and quantity limits.

And with a 12.7% gross trend for our overall book of business, our clients using the value formulary achieved a gross trend of only 0.5%, more than 1,200 basis points better than the overall book.

A second example is in managing specialty.

Our book of business trend in specialty was 32.4%, nearly one-half of which can be attributed to the surge in prescribing for the new Hep C therapies.

Our underlying principles for our management solutions include condition level management, a broader approach to clinical care, and a breakthrough specialty patient experience.

Our trendsetter solutions for specialty include our Advanced Specialty Formulary, Specialty Connect, and Specialty Guideline Management.

You'll recall that Specialty Connect provides choice to receive a member's specialty script at CVS pharmacy or through our mail channel, while preserving the central clinical expertise that leads to better health outcomes.

The trendsetter result?

23.9% specialty trend, nearly 1,000 basis points better than the overall book.

So, as I said, there are solutions, and we expect more clients to adopt these cost-management tools.

Speaking of specialty, our specialty revenues continued on a very strong growth trajectory in the quarter, increasing 46%, and that was driven by volume, new products, inflation, and the impact of Specialty Connect.

Our infusion capabilities through Coram are another significant differentiator with clients, and we're experiencing healthy growth in the business.

In fact, the number of infusion patients we serviced in the quarter jumped 15.7% from the prior year, and that's after adjusting for the timing of the Coram deal close.

Site of care management, another important component of managing costs for specialty patients, and we offer clients solutions to effectively manage these costs.

As we previously discussed, we've been using our leading formulary strategies to effectively manage the high-cost Hep C category, and we envision employing similar tools to manage the anticipated new PCSK9 inhibitors, which are expected to enter the market later this summer.

However, given the significant number of people being treated for high cholesterol that can be treated quite successfully with lower-cost statins, we envision robust prior authorization guidelines to help control costs, while insuring that the appropriate population gets access to these newer therapies.

Before turning to Retail, let me touch a minute on biosimilars.

With the first biosimilar approved, this is just the beginning of a pipeline that could unlock additional savings and provide options to our clients.

We expect discounts to be available, but they will likely vary by product.

For the foreseeable future, we expect biosimilars will behave more like brands than the traditional generics.

And, as a result, we expect to employ our formulary strategies to generate savings for our clients.

Our Retail business, it produced results that were in line with our expectations.

Pharmacy same-store prescription unit volumes increased 5.1%, and that's on a 30-day equivalent basis, and we continued to gain pharmacy share.

Our Retail Pharmacy market share was 21.5% in the quarter, and that's up about 50 basis points versus the same quarter a year ago.

Pharmacy same-store sales increased 4.2% and reflect a positive impact of about 70 basis points, related to the incidence of flu.

Pharmacy same-store sales also include the negative impacts of about 280 basis points due to recent generic introductions and another 190 basis points from the implementation of Specialty Connect, which, as I mentioned earlier, transfers specialty scripts from our retail to our PBM segment.

Our initiative to unlock adherence continues to make good progress, and we anticipate launching some new products later this year that will be available to both patients and their caregivers, in order to help patients stay adherent to their medication.

Turning to the front store, our performance in the quarter was very solid, and while front-store comps were down 6.1%, if you adjust for the tobacco impact, front-store comps would have been up about 2%.

The impact of the tobacco exit was around 800 basis points, and that's about 100 basis points less than originally anticipated.

We saw solid growth in our core health and beauty categories, including the strong cough/cold season, and we gained share in health and beauty in both the drug and multi-outlet markets.

While we experienced a decrease in front-store traffic, that decrease was partially offset by an increase in the average customer basket.

Our front-store journey to position ourselves as a leading health and beauty destination continues.

This year, we are launching Phase I of our healthy foods rollout, offering customers more healthy choices in a select group of stores.

Our beauty elevation program is also launching in several thousand stores, and we continue to test a multitude of changes to further enhance our front store clustering efforts, including a number of store resets that leverage the knowledge that we are gaining from the Navarro acquisition.

ExtraCare continues to be an important driver of profitable front-store growth, as about 80% of our sales now goes through our loyalty program, providing us a longitudinal view of the customer.

We've developed new internal tools to ensure that promotional investments are driving the right economics while delivering value for our customers.

These tools have allowed us to further develop our personalization efforts.

Digital, and specifically mobile, are also important tools in powering up our personalization reach.

Just as one example, today we know that customers using our mobile app with ExtraCare are spending 4 times more than our average customer.

So we're encouraged by these results and believe that there's more opportunity for further innovation.

Our front-store margins in the quarter continued to benefit from these efforts, as well as the tobacco exit.

On a comparable basis to last year, including adjusting for the tobacco elimination, front-store margins improved notably.

And this underlying improvement in the front reflects our highly personalized promotional strategies, along with the continued growth in store-brand sales.

In fact, we made good progress in store-brand penetration in the quarter, with store brands increasing to 20.9% of front-store sales.

That's up about 330 basis points from last year, two-thirds of the improvement reflecting the removal of tobacco from our mix, and one-third of the improvement reflecting underlying progress in our store-brand penetration as we continue to make progress toward our 25% goal.

Turning to store growth in the quarter, we opened 38 new stores, relocated 12, closed 10 -- resulting in 28 net new stores.

We plan to add about 150 net new stores for the full year, equating to an anticipated increase in retail square footage growth of around 2%.

As for MinuteClinic, we opened 15 net new clinics in the quarter, and we ended the quarter with 986 clinics across 31 states plus the District of Columbia.

Continuing on its very strong growth trajectory, MinuteClinic's revenues increased about 21% versus the same quarter last year.

And 84% of MinuteClinic visits were paid for by third parties, with MinuteClinic included in most payer networks as an accessible and cost-effective provider.

The rollout of the EPIC electronic medical records system remains on schedule.

We're expected to be complete with that by mid-year.

Additionally, we've now seen more than 13,000 patients since the initiation of our TeleHealth pilots in California and Texas, with very high levels of customer satisfaction.

We're continuing to test various uses for TeleHealth and believe it can be part of a care model that improves access and lowers overall healthcare costs.

Just a quick note on Red Oak Sourcing, our venture with Cardinal Health.

We continue to be extremely pleased with the progress the team is making.

They continue to execute very well.

The expertise that Red Oak provides, along with the simplicity of the business structure, has enabled Red Oak to make great strides.

They've been working with suppliers on strategies that create value for all parties, and have now transitioned nearly all suppliers to Red Oak within a relatively short time frame.

So, we couldn't be more pleased with their performance and results.

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

Thank you, Larry, and good morning to everyone.

Today I'll provide a detail review of our first-quarter results, followed by an update on our guidance.

However, before I do that, and as I often do, I want to highlight the ways in which we are using our strong free cash flow to enhance shareholder value through our disciplined capital allocation program.

During the first quarter, we paid $399 million in dividends.

Our dividend payout ratio now stands at 28.7%, and we remain well on track to achieve our target of 35% by 2018.

Additionally, in January, we entered into a $2-billion accelerated share repurchase program.

At that time, in exchange for $2 billion, we received approximately 16.8 million shares, at a price of $94.49 per share, which represented 80% of the notional amount of the ASR.

The program concluded yesterday, and we expect to receive approximately 3 million shares today, making the average share price of the ASR $100.64 per share.

For the full year, we still expect to complete $6 billion of share repurchases.

So, between dividends and share repurchases, we've returned more than $2 billion to our shareholders in the first quarter alone, and we continue to expect to return more than $7 billion for the full year, more than a 30% increase over last year's levels.

As Larry mentioned, we generated approximately $1.6 billion of free cash in the first quarter, and we continued to expect to produce free cash of between $5.9 billion and $6.2 billion this year.

Now, turning to the income statement, adjusted earnings per share from continuing operations came in at $1.14 per share, $0.05 above our guidance range, and up a solid 12.2% over LY.

GAAP diluted EPS was $1.07 per share.

The Retail segment performed within expectations, while we saw strong results from the PBM segment, which posted profit growth above the high end.

The outperformance in the quarter was primarily driven by stronger-than-expected prescription volumes, as well as favorable purchasing and rebate economics in the PBM segment.

On a consolidated basis, revenues in the first quarter increased 11.1%, to $36.3 billion.

In the PBM segment, net revenue growth surpassed expectations as revenues increased 18.2%, to $23.9 billion.

This growth was driven by specialty pharmacy, as well as increased volumes in pharmacy network claims, largely from the addition of new clients.

Partially offsetting this growth was an increase in our generic dispensing rates, which grew approximately 150 basis points versus the same quarter of LY to 83.5%.

We saw strength in the top line versus our guidance, due primarily to higher-than-expected volumes, drug price inflation and mix, including the new Hep C drugs.

In our Retail business, revenues increased 2.9% in the quarter, to $17 billion, at the high end of our guidance.

This growth was driven primarily by solid pharmacy same-store sales growth, despite the transition of specialty revenues into the PBM segment, due to Specialty Connect.

Higher volumes in the pharmacy were fueled by a strong flu season and an uptake in 90-day prescriptions.

Turning to gross margins, we reported 17% for the consolidated Company in the quarter, a contraction of approximately 120 basis points compared to Q1 of 2014, and, again, consistent with our expectations.

The decline is due in part to a mix shift in our business, as our lower-margin PBM business is growing faster than our Retail business.

Within the PBM segment, gross margins declined approximately 35 basis points from Q1 of 2014, to 4.3%.

This was primarily driven by price compression, which was partially offset by the improvement in GDR, as well as favorable purchasing and rebate economics.

Despite the decline in gross margin rate, gross profit dollars were up 9.8% year over year, given volume increases and mix.

Gross margin in the Retail segment was 31.2%, down approximately 20 basis points from LY.

The continued pressure on reimbursement rates, as well as the continuing mix shift towards pharmacy were partially offset by a number of positive factors.

These positive factors include a 150-basis-point increase in retail GDR, to 84.4%; the benefit to fronts for margins from the tobacco exit; and the increased store-brand penetration.

And while gross margin rates were down, gross profit dollars increased 2.1% in the quarter.

Total operating expenses as a percent of revenues notably improved from Q1 of 2014, to 11.1%.

The PBM segment's SG&A rate improved by approximately 25 basis points, to 1.2%, with operating expense dollars coming in a little lower than expected despite the overdelivery of revenues.

As reported, SG&A as a percent of sales in the Retail segment increased by approximately 20 basis points, to 21%.

However, the increase continues to be driven by the reduction in retail sales, which is directly related to our decision to exit the tobacco category, as well as the impact of Specialty Connect, again shifting sales from our Retail segment to the PBM.

It's important to note that on a comparable basis, SG&A as a percentage of sales at retail actually improved approximately 50 basis points.

Within the Corporate segment, expenses were essentially flat to LY, at $189 million, and lower than expected.

Operating margin for the total enterprise declined approximately 35 basis points in the quarter, to 5.9%.

Operating margin in the PBM declined approximately 10 basis points, to 3.1%, while operating margin at Retail declined by approximately 45 basis points, to 10.2%.

As Larry noted, Retail operating profit decreased 1.3% in the quarter, and was within our expectations.

On a comparable basis, excluding tobacco, Retail operating profit increased approximately 1.7%.

PBM operating profit increased 14%, greatly exceeding our expectations.

So now, going below the line on the consolidated income statement, net interest expense in the quarter decreased approximately $24 million from LY, to $134 million, due primarily to lower average interest rates on our debt.

Additionally, our effective tax rate was 38.9%, slightly lower than expected.

The tax rate drove less than $0.01 of the EPS beat.

Our weighted-average share count was 1.1 billion shares, again, in line with our expectations.

With that, now let me update you on our guidance.

I'll focus on the highlights here; you can find the additional details of our guidance in the slide presentation that we posted on our website earlier this morning.

As Larry said, given our outperformance in the first quarter, we are narrowing our 2015 EPS range by raising the bottom of the range by $0.03.

While we are pleased with where we are year to date, it is still very early in the year.

Our core business is performing well.

We now expect to deliver adjusted earnings per share in 2015 in the range of $5.08 to $5.19 per share, reflecting strong year-over-year growth of 13% to 15.5%, after we remove the impact in 2014 related to the loss on the early extinguishment of debt.

GAAP diluted EPS from continuing operations is expected to be in the range of $4.80 to $4.91 per share.

Consolidated net revenue growth is still expected to be 7% to 8.25%; however, we narrowed our top-line outlook in the PBM.

We now expect PBM revenue growth of 11.25% to 12.25%, 25 basis points higher than our prior guidance on the low end.

This revised guidance reflects our expectations for stronger growth within specialty, fueled by a combination of inflation and new product mix, as well as the impact of the higher net new business.

We continue to expect Retail revenue growth of 1.25% to 2.5% year over year, and inter-Company revenue eliminations are now expected to be approximately 10.8% of segment revenues.

Given the narrowing of the PBM's top line, as well as the favorable purchasing of rebate economics that we've seen, we are also narrowing guidance for operating profit growth in the PBM segment.

We now expect PBM operating profit to increase 7.75% to 10.75% year over year, an increase of 100 basis points on the low end.

Retail operating profit growth expectations remain in the range of 4.75% to 6.5%.

As I said before, our free cash flow guidance for the year remains in the range of $5.9 billion to $6.2 billion.

With that, now let me provide guidance for the second quarter.

We expect adjusted earnings per share to be in the range of $1.17 to $1.20 per share in the second quarter, reflecting growth of 3.25% to 6% versus Q2 of 2014.

GAAP diluted EPS from continuing operations is expected to be in the range of $1.10 per share to $1.13 per share in the second quarter.

Within the Retail segment, we expect revenues to increase 0.5% to 2% versus the second quarter of LY.

Adjusted script comps are expected to increase in the range of 4.25% to 5.25%, while we expect total same-store sales to be down 1.25% to up 0.25%.

The impact of the move of specialty scripts to the PBM via Specialty Connect will be very muted this quarter, given that we began this shift in May of last year.

Additionally, recall that we expect the tobacco exit to have approximately 800 basis points negative impact on front-store comps in the second quarter.

In the PBM, we expect second-quarter revenue growth of between 11.25% and 12.5%, driven by continued strong growth in specialty and volumes.

We expect retail operating profit to decrease 2% to 4%, and PBM operating profit to increase 5% to 9% in the second quarter.

Keep in mind that margins in last year's second quarter benefited from the finalization of California's Medicaid reimbursement rates.

Recall that this finalization of the benefits benefited Retail gross margins by $53 million in the quarter and PBM gross margins by $60 million in the quarter.

After removing the impact of that from last year's results, operating profit growth in the PBM would be approximately 200 basis points higher.

And on a comparable basis, excluding the California Medicaid impact from last year's results, as well as tobacco, Retail operating profit growth would be approximately 490 basis points higher.

Again, starting with analyst day, over the past several months, we've been highlighting several timing factors that affect the cadence of profit deliveries, throughout this year: the timing of break-open generics, our tobacco exits, and the investments that we've made in the PBM's welcome seasons were the factors expected to impact our cadence the most.

While we delivered a very strong first quarter, the cadence of profit growth is still expected to be back-half weighted.

All things considered, we expect a strong back half of the year.

In closing, let me leave you with three key thoughts: first, we posted solid comparable growth this quarter, and we're off to a very good start for the year; second, our 2015 outlook for both businesses, as well as the enterprise overall, is strong and we continue to benefit from the unique solutions we are delivering to the marketplace; and, finally, we expect to continue to generate significant free cash, and we are committed to use this capability to maximize the value we return to our shareholders through a disciplined capital allocation program.

With that, let me turn it back over to Larry.

Okay, thanks, Dave.

Again, we are very pleased with our solid start to the year and our strong competitive position.

Our distinctive channel-agnostic solutions are resonating strongly in the marketplace.

Before we open it up for your questions, just a couple comments that we've all witnessed the unfortunate events unfold in Baltimore over the past several days, and as you know, we operate countless stores in major cities and urban centers all across the country.

Despite these acts of violence, we remain committed to these markets.

We look forward to working together with community and business leaders in the rebuilding process.

I want to take a minute and pay a special thanks to our colleagues who have worked tirelessly this past week to ensure that Baltimore residents continue to have access to needed medications and prescriptions.

All of us are very proud of the job that they've been doing in a very difficult environment.

With that, let's go ahead and open it up for your questions.

(Operator Instructions)

Our first question comes from the line of George Hill, Deutsche Bank.

Go ahead.

Hey, good morning, Dave and Larry, and thanks for taking the question.

Where I would start off first is the cost containment in SG&A and the PBM has been pretty impressive and the cost cuts are pretty good.

How much room should we think is left there to do considering the growth in the higher touch specialty medications?

And how should we think about how much lower SG&A can go?

George, I'll start and Jon will jump in as well, but keep in mind that we had embarked upon a pretty sizeable initiative as part of our platform consolidation that was targeted to deliver well over $200 million in annual SG&A savings, and we have largely completed that initiative.

Obviously, we're always looking to be more efficient and identify opportunities and I'll let Jon pick up from there.

Yes, George, the way we're thinking about our cost structure in the PBM is continuous improvement, so how can we leverage automation, technology, streamline processes to make those processes more predictable and deliver them faster and at a lower cost?

Specialty is an opportunity as we look forward.

The PCSK9s are coming to the market.

They are going to be lower cost than typical or the average specialty drugs in the market today, so we're actually looking at a delivery in a more efficient way than generally specialty, which is higher touch, higher cost than what we see in [mail], so we're continuing to focus on it and we make progress every year.

Okay, that's helpful.

And maybe a couple quick housekeeping items.

Larry, did you say that $4.1 billion, that was net wins for 1/1/16 starts?

No, that was for 2015, George.

That was a true-up of the 2015 selling season, and as I mentioned it's up, about $0.5 billion from our update on our fourth-quarter call.

And there were some late new wins that got added to 2015 and probably for the most part mid-year introductions.

Okay.

I wrote that down wrong.

And then the adjustment for the California Medicaid comp, that was combined Retail PBM or just the Retail side?

On the Retail side, between California and tobacco, is about 490 basis points, just in Retail.

It is about 200 basis points as it relates specifically to the PBM in the quarter of operating profit.

Of operating profit.

That's helpful.

Thank you very much guys.

Thanks, George.

Our next question comes from the line of Edward Kelly, Credit Suisse.

Go ahead.

Yes, good morning, guys.

Nice quarter.

Good morning.

I wanted to ask a question actually about the PBM and EBIT growth.

You actually -- you meaningfully exceeded your guidance this quarter.

Could you maybe just talk a little bit more about the drivers outside there relative to your expectation?

And then just a question on the outlook, because you only raised the low end of the outlook in the PBM, as well as for the Company in terms of EPS.

Is that just conservatism or is something else we should be thinking about there?

Ed, this is Dave.

Maybe I'll touch upon that.

As you know, we obviously had a very solid -- we're off to a very solid start of the year, quite frankly, in both businesses and certainly within the PBM versus our expectations.

Just a couple things.

Obviously, volumes in the PBM continued to be strong and we've continued to be pleased with that.

Secondly, we've worked hard both from a cost of goods sold perspective and some of the buy-side economics, as well as the rebate yield has been productive for us.

As you know, the vast majority go back to our clients in the form of lower cost into their pharmacy benefit, and so that's really produced the overdelivery in the first quarter.

As we look through the balance of the year, it is very early.

We've gone through a quarter.

We had a great quarter.

Our core businesses are performing well and nicely.

There's, as you know, we have a philosophy of looking through the full year.

We're still focused on delivering a very solid year.

Continually, there tends to be shifts in the market place as relate to timing of certain aspects of our business, primarily the introduction of generics, and so we'll continue to monitor that as time goes on.

Okay great and just one quick follow-up.

You did mention reimbursement rate pressure in the release this quarter.

I don't think you typically put it in there.

Is there something new or different or more intensive about that or is it -- are we just reading too much into that?

Ed, this is Dave.

We continually talk about that so there's nothing new or unique about that at this point in time.

Great thank you.

Thank you.

Our next question comes from the line of John Heinbockel, Guggenheim Investments.

Go ahead.

Larry, a strategic question.

Obviously, you have the financial wherewithal to do a lot of things, but when you think about footprint in the US versus where you are globally, is there a priority you'd like to fill in -- and I'm thinking different kinds of businesses -- but fill in, in the US, as opposed to accelerate the global footprint, or they are of equal priority?

John, as you know we've talked a lot about, we feel very good about the opportunities that we still have here domestically.

We've been talking about that for the last couple of years and we continue to feel good about it.

As you think about international, again as we've alluded to in the past, we wanted to understand and build some -- I'd describe it as muscle -- in terms of what it takes in terms of being successful as a global operator.

That's what lead to the Brazil decision and we've been at it about two years now.

We've gotten very good learnings.

Any next steps there would be pursued with the same financial discipline that we've demonstrated in the past.

And just going back to the PBM EBITDA issue, most of the time, you're right, in the last 2.5 years, you've exceeded expectations.

In the rare quarter where you haven't, you've been in line, but have exceeded pretty significantly and that dovetailed with volume.

Is it really that simple, that if you can beat on the volume side, you'll handily beat on the bottom line, and does that speak to the incremental flow-through margin is simply that high?

John, this is Dave.

I don't know that, that's exactly true.

As you know, within the PBM business, obviously volume certainly helps but there's a lot of factors that drive profitability in that business and I'll just take a good example.

Medicare Part D within our insurance company, additional volumes and category there actually hurt profitability from an insurance perspective, so there's a lot of different levers there.

I'll just conclude with saying that we've had a great first quarter.

Our outlook for the year remains extremely strong within the PBM, and quite frankly, within Retail.

Okay thanks.

Thanks, John.

Our next question comes from the line of David Larsen, Leerink.

Please go ahead.

Hi.

Congratulations on a very good quarter.

Can you just talk about the 2016 and 2017 selling seasons?

Where are you?

Is the 2016 selling season -- are you largely through it?

Have most health plans made most of their decisions?

And what are they looking for this year that's maybe new relative to last year?

Thanks.

Dave, it's Larry.

I'll go ahead and start and I'm sure others will jump in.

But, Dave, we've mentioned this in the past, that if I start with our renewals, we said that this 2016 renewal season was typical, recognizing we didn't have the big FEP contract.

We said it was around $14 billion to $16 billion, and as I mentioned in our prepared remarks, we're about one-third of the way through the renewal process, which is typical at this time of the year.

I would say the selling season again has gotten off to a solid start.

We're seeing RFP activity pretty similar to what it was last year, which was a big increase over the prior year, recognizing that two years ago there was a lock-down, as people were preparing for all of the administrative responsibilities of the Affordable Care Act.

So we certainly have a long way to go in the 2016 selling season and we'll have a lot more to talk about on the second-quarter call.

David, just to build on what Larry has said.

This is Jon.

We're through most of the health plan, large health plan opportunities, probably half way through the large employer opportunities, and then you move into the balance of the market.

As far as what people are looking for, they are obviously looking for us to be competitive on price, and we have to be delivering good service to our members and clients.

So the fact that we've had two very successful welcome seasons has helped us from a service reputational standpoint, and obviously, we continue to be competitive yet rational on price.

And then you add to that all the things that we can do that are unique to our model, that quite frankly is supports our clients with where healthcare is going.

The fact that we've integrated assets and can deliver capables like Maintenance Choice, Specialty Connect, MinuteClinic, our leadership position in specialty, so our ability to manage specialty spend not only under the pharmacy benefit and the medical benefit, and this is, as we've talked about a very fast growing part of the overall spend.

And then third, our leadership in consultative and services and Medicare Part D. So as I'm out talking to clients, they're looking for somebody that they know can deliver great service, deliver savings, and then all these unique offerings we bring has really had a lot to do with our success.

2017, we're beginning to see some activity in 2017, again large health plans, but I'd say we're very, very early with any 2017 opportunities.

Thanks a lot.

David, I'll just emphasize one other point.

We had our client forum back in April.

We had record attendance.

There was an extremely high level of engagement, recognizing, as I mentioned clients have seen cost trend go from around 4% to double-digits, so to Jon's point, we have solutions for them.

There was an awful lot of engagement and education and understanding in terms of what that can specifically mean for their respective business.

So there's certainly a lot of follow-up work from the client forum but we feel very good about the tools and products and services that can be an important part of the solution for our clients.

Terrific, thank you.

Our next question comes from the line of Meredith Adler, Barclays.

Please go ahead.

Hey, thanks for taking my question, and great quarter.

I was wondering if there's any update you can give us on whether Specialty Connect has lead to an increase in volume.

Are people responding?

I know you're talking about everybody -- the customers liking everything you're doing but can you identify anything specific from Specialty Connect?

Well Meredith if you look at our specialty revenues, we are growing faster than the market, even after adjusting for Corum.

We believe Specialty Connect is delivering additional share and it is outperforming our initial expectations and we already have more than 50,000 patients, new patients that are utilizing the Specialty Connect product.

Great.

And then I was just wondering if you could talk about what the benefits so far, if you seen anything, from eliminating tobacco.

Have you seen a meaningful change in either the partnerships or the dialogue you're having with physician and hospital groups?

Meredith, the answer to that is yes.

I've said in some of those meetings where we're talking about things that we can do and then, historically, the question would come up about, but you guys sell tobacco products, don't you?

And it literally just swept all the energy out of the room.

It's reflected in the fact that, since the announcement just over a year ago now, we've been able to accelerate the partnerships that have been established with leading health systems across the country.

We're approaching 60 of those affiliations, and while it's a category of one at this point, it did get some publicity.

We've talked about pharmacy networks migrating to more performance-based networks and we had one particular client, the City of Philadelphia, that decided to, as a nucleus of that performance network, tie it around pharmacy providers that do not sell tobacco products.

So we see some tangible benefits that they're probably more qualitative than quantitative at this point in time, but we all believe that it will lead to further differentiation of our business model as we go forward.

Great.

Thank you very much.

Thanks, Meredith.

Our next question comes from the line of Priya Ohri-Gupta with Barclays.

Go ahead.

Hey, thank you so much for taking the question.

Dave, you guys have been pretty clear about your lease-adjusted leverage target and you continue to have some capacity in the balance sheet to manage towards that, but can you just remind us about how much flexibility you might have around moderating some of your future share repurchase activity, were you to engage in some sort of strategic activity that might temporarily take you above that leverage target in order to maintain your current rating?

Yes, that's a great question.

We, as you know, have been very focused on our leverage target at 2.7 times adjusted debt to EBITDA.

We currently have been cycling a bit below that target, so we have additional capacity as we sit here today.

We, as you know, have continued many dialogues with the rating agencies.

We are very focused on maintaining our BBB rating status.

We do think we have flexibility over time to move our leverage target, if strategically it made sense to be a tad over that, as long as we commit to get ourselves back down to that level.

We will be very focused over time to make sure that our balance sheet maintains its leverage target of 2.7 times and we work aggressively to get there.

We think it's important that we maintain that rating.

Thank you so much.

You're welcome.

The next question comes from the line of Lisa Gill, JPMorgan.

Go ahead.

Thank you and good morning.

I just wanted to follow-up on a couple of things.

First, you had talked about earlier, Larry, about the formulary management and the trend there.

Can you or Jon just give us any indication as to the penetration that you have currently with your client base around these kinds of programs just to get an idea of how much future opportunity there is?

Yes, Lisa, it's a great question.

Today, we've got about probably about one-half of our book that is in our formulary program.

At the same time, there are -- and by the way that's largely in the employer space -- there are health plans that adopt components of the formulary program, so there is certainly white space for that to grow.

As our program continues to evolve and further develop and drive additional savings, there is already additional dialogue on those programs.

And then, Lisa, this is Jon.

Larry talked about our trends for 2014, at 12.7%.

About 60% of that trend is really driven by branded inflation.

The best way for our clients to manage overall trend of branded inflation is through formulary, so we believe the marketplace is going to get much more aggressive, our clients are going to get much more aggressive in adopting even more aggressive formulary strategies beyond what they already have.

It's probably the best way to manage their benefit.

And so would you expect that uptick as we go into 2016?

I know, I saw Jon recently, we talked about your client forum and people really focused on where costs are going and what we're seeing as far as price increases go from the manufacturers, so should we see some inflection in 2016, if you're having the conversations today, or is it -- you think it's going to be a several year play-out around increase in penetration?

Yes, Lisa, that's a good question.

As Larry said, our employers which is one-half our book of business, the vast majority of those, 80% of those, have adopted our template formulary strategy that we introduced back in 2012.

So they've actually taken a big step forward.

Then there are other opportunities for them to even get more aggressive.

With health plans, the majority of our health plans have adopted our Med D formulary strategies, which again are very tightly controlled.

So the market is primed, and coming off this double-digit trend year of 2014, I have never seen people more open to understanding what opportunities they have to manage.

As I said, formulary is going to be a big part of that.

So we're talking to people now.

We will see -- I do think it's going to take a few years to play out, just like everything in our space, so I don't know that there's going to be a single inflection point, but I do very strongly believe that this is going to be a significant lever for our clients to manage this trend.

If I could just understand -- if you think about -- you called out rebates in the first quarter.

If I remember correctly, it's usually on a lag, so should we expect rebates to get better as we move throughout the year, based on the programs that Jon's talking about?

Just trying to figure out the timing.

The rebates we saw in the first quarter, was that primarily from things you initiated in the back half of 2015 and is that part of the driver for the back-half results and then I'll stop there?

Yes, Lisa it's a great question.

I'm not going to get into too much detail there.

I'd just tell you that as we think about the long-term view of our business, we've been very focused on, from a buy-side economics perspective, what can we do to further reduce the cost to our clients, and think about that as our procurement efforts around generics.

And then secondly, how do we reduce cost and continue to control costs in the branded category, and that continues to be a focus from a rebates perspective and formulary management.

I expect those to be continued, to be drivers for this business at some level in the longer-term.

Okay, great.

Congratulations on a great quarter.

Thank you.

The next question comes from the line of Robert Jones of Goldman Sachs.

Go ahead.

Thanks for the questions.

Maybe just move over to the Retail side, David.

I know you walked through the Retail gross margin pushes and pulls in your prepared remarks, but I wanted to make sure I understood the dynamics in the quarter, especially relative to your full-year guidance for this margin to be flat.

So I know tobacco would have been a good guy year-over-year for the margins, so I was hoping you could maybe just walk through again what weighed on the margin in the quarter.

Was there anything abnormal with pharmacy reimbursement, promotional activities, just looking for a little bit more insight there?

No.

I don't think there's anything that's really unique in the quarter from that perspective.

As we've said many times is that the cadence of profit delivery would be back-half weighted versus front-half weighted, and most of that ties to obviously, the tobacco exit and how we overlap that, the California Medicaid comparison in Q2 of 2014, but probably more importantly, the delivery of break-open generics and the timing of that, driven really more back-half weighted versus front-half weighted.

Okay, and then just one more on a timing technical side.

I was wondering if there was anything between 1Q and 2Q that maybe pulled 1Q up as far as the timing around EPS?

I know the force of that headwind from the California Medicaid reimbursement benefit a year ago will make 2Q a little bit worse off, but anything else that we should be aware of as far as just timing between 1Q and 2Q?

No I don't think there's anything of any material nature there.

Okay, great, thanks.

You're welcome.

Our next question comes from the line of Scott Mushkin, Wolfe Research.

Hey, guys.

Thanks for taking my questions.

Wanted to follow-up a little bit on John Heinbockel's question, but a little bit different take on it, not necessarily acquisitions, but looking internally, Larry.

When you look at opportunities in front of you with your current assets, where do you think there is the biggest potential to improve what you're already doing?

Obviously, the business is humming along, but where do you see some of the levers to get things even better?

Well, Scott, we're always looking to do better, whether it's to be more efficient with our business in terms of attempting deliver high levels of service at the lowest possible cost.

And we're always focused on opportunities there and we continue to be focused on share growth opportunities.

We've gotten some tractions in terms of some of the things that we've been able to do through our partnerships, whether it's with health plans or other providers.

Obviously, there's a lot that we can do when we happen to be the PBM, but those opportunities are not limited to employers or health plans where we have to be the PBM and we've gotten some traction there.

Scott, this is Dave.

We've been talking a lot on the call about the PBM and some of the growth engines around pharmacy.

Maybe we'll just spend a minute and I'll ask Helena to talk a bit about what we're doing to drive growth in front of our Retail business.

One of the things that I'm encouraged by, and it goes back to Meredith's question, as well is, since we announced our exit of tobacco, the marketplace is seeing a real focus that we have around driving health and beauty.

We talked about this at analyst day in December, but the journey that we're on to really reposition ourselves as a leading health and beauty destination.

When we met in December, we talked about five key themes as part of that growth: one was better health made easy, elevating beauty, our customer-driven personalization, my CVS store, and digital innovation.

I'm really pleased, we're making a lot of progress on each of these areas.

Just a couple examples.

This year we're launching Phase I of our healthy food rollout.

We've got expanded fresh offerings and healthy snacks.

We also have a beauty elevation program, which is launching across several thousand stores this year, and really there, we're in the process of repositioning CVS is as the leader in beauty.

We've always had a leading market share, but we're really doubling down on the in-store experience and differentiating for our customers.

We talk a lot about personalization.

Larry mentioned it in his speech, but there's even more opportunity there to grow share and be more relevant for consumers and ultimately drive traffic and profitable sales.

Then we have a focus, this year we're resetting 500 stores with something we call take high higher and these take several of these elements together.

We have expanded beauty, we've got this healthy food set, and so this really starts to take the old photo department out and put in healthy food and give customers a very different feel.

Those stores are performing well.

We've also, within this my CVS store piece, really been looking at different clusters, and the thing we're very excited about is the Hispanic dominant cluster.

We're starting to learn from our Navarro experience, and we've actually started to reset CVS stores to take those learnings into place.

And then we continue to invest in digital and innovation, see a lot of opportunity, as Larry mentioned, there, to drive adoption and have people using both our stores and digital asset.

So a lot of things happening that we haven't talked about so much since December analyst day, but I'm really proud of the team.

Both the merchants and the operators have a very strong focus on how we want to be unique and different and really own health and beauty.

That's perfect.

Thank you for such a detailed answer

The next question comes from the line of Steven Valiquette, UBS.

Go ahead.

Thanks, good morning.

Just for me, obviously the 46% revenue growth in 1Q in specialty is pretty impressive.

How do you think that stacks up versus your estimation of industry growth in specialty pharmacy in early 2015?

And also, beyond Hep C, are there any other therapeutic categories worth mentioning that were growth drivers?

Steve, we actually see it outperforming the market growth, and as I mentioned earlier, in one of the questions, even after adjusting for Coram, acknowledging that Coram was not comparable for the full quarter.

We closed towards the end of January.

So we're pleased with the results that we're seeing and some of it's coming from new customer growth, some of it's coming from our unique products, and I'll ask Jon to comment on therapeutic classes.

What we have seen over the last three years is over 100 new indications for existing specialty drugs, so we're seeing growth really across all categories.

Obviously Hep C is the poster child for growth, but we're seeing growth in RA and oncology, as an example.

And the other factors is as the population gets older, the older population uses 6 times as many specialty drugs as the balance of the population.

So we're just seeing really tremendous growth across the entire spectrum of specialty and that's going to be fueled even further by new drug introductions, 88 new drugs over the last three years, and we're going see the PCSK9s be introduced later this year.

While we think that's going to be a slow ramp, we think one in four people that are on statins today could be candidates for these new therapies that are, quite frankly, more expensive than the generic statins that are available today, so we really view specialty as a growth driver, as we look forward.

Steve, I'll just conclude this question a bit with maybe just a data point.

As you said, specialty in the first quarter grew by about 40%, 46%.

It's not just Hep C. If you take away Hep C and you look at our underlying growth in specialty, it's in the mid-30%s, so we continue to perform well at the core in this business.

Okay that's helpful.

The one quick tie-in to this, I forgot if you disclosed this at the analyst day or not, but within the PBM, I forgot, are you disclosing just a rough range of what percent of the total PBM that you categorize as specialty?

I'm guessing it's somewhere maybe in the 20%, 25% range, but is that just a good approximation?

There is a chart in Jon Roberts' presentation and/or Alan Lotvin's presentation that shows that number, last year's number which I believe is around [$31 billion] moving to $37 billion was our expectations for this year.

Steve, just to add on to that, because those are a couple important slides, we talked about the addressable specialty market.

We described it as excluding infused oncology, and in 2014, we estimated that market at $86 billion growing to more than $150 billion by 2018, so we see a lot of opportunity for growth, even without including the oncology space.

Okay.

That great.

Thanks.

Our next question comes from the line of Ricky Goldwasser of Morgan Stanley.

Go ahead.

Yes, hi.

Good morning and thank you for taking my question.

I had two follow-up questions here.

First of all, about the membership growth, the script growth.

Obviously, very strong claim growth.

What percent of the growth is coming from your PBM members?

Ricky, are you talking about on the Retail side?

No, I'm talking about pharmacy network claim?

Ricky, maybe we are not following the question because we would (multiple speakers)--?

In that in the past, you gave some details on Caremark membership accounting for 34% or 35% off your pharmacy scripts.

When you think about the growth that you've seen year-over-year, obviously it's pretty impressive, what percent of it is coming from your PBM client?

Just trying to assess a share gain within Caremark versus the rest of the market?

Yes, we report that on an annual basis, because we monitor it, but we report it on an annual basis, because when we win a client typically, we then -- the work begins in the sense of understanding how to help that client become more productive and manage their costs better.

Part might be introducing a product and/or narrowing a network into one of our channels.

So that grows over time.

We've chosen to do that on an annual basis because of that.

I will say, just from a Caremark perspective, one thing that we do disclose and you can see it in the press release and you'll also see it in the Q later today, is that we do talk about just the network claims volumes that we process on a quarterly basis.

So you can see that within those releases.

Ricky, we had shown in the past that if you looked at, on the Retail side of the business, if you looked at the script growth and the share growth, about one-half of it was coming from the Caremark book of business and the balance from the rest of the marketplace.

Okay, that's very helpful.

Then one follow-up on the specialty side, when you think about your membership, what percent of your PBM clients managed their specialty spend through you and what percent carving out, just to understand the opportunity there, in terms of penetration?

Yes, Ricky, today it's about 60%.

Okay.

And that 60% of the employers or 60% of the total?

Of the total.

Thank you.

Thanks, Ricky.

Our next question comes from the line of Mark Wiltamuth, Jefferies.

Go ahead.

Hi, good morning.

Wanted to dig in a little bit on the generic drug margin swing factors you see over the next couple of years, and maybe if could let us know how you feel relative to your December analyst pronouncements because it seems like Nexium launched earlier than you expected, and I'm curious where you stand on [Abilify], and just in general, how are you feeling about the break-open pipeline?

Mark, this is Dave.

Obviously, as we discussed a little bit earlier, the generic launch dates continue to obviously move around a little bit.

I'll just characterize this as not a matter of if these drugs are going to be productive for us from a break-open status, just more an issue when they become productive from a generic break-open status.

Our main thesis, as we talked about the three categories of drugs, be it branded drugs, limited supply generics, and break=open generics, our thesis over the long term continues to hold.

As you increase both savings to customers and clients, when you move down that spectrum, but also increase profitability to us as you move down that spectrum.

Okay and just on generics, maybe give us an update on Red Oak.

You said you've transferred the sourcing over to Red Oak.

Where do you stand on achieving cost savings there?

That's the right question.

We have transitioned all of that into Red Oak.

We now have virtually all of our generic manufacturers on our program and we continue to be very excited about where we are, but also the opportunity over time to continue to derive value from that program.

Beyond that, we don't disclose much more than that from a buy side's perspective.

Mark, I'd just reiterate, we've talked about this, the three ways in which value is extracted from Red Oak.

One is the fixed payment schedule from Cardinal, which began in Q4 last year.

The second ability is through some established achievement of milestones that have been established between the two parents.

And then the third is just further reductions in our overall cost of products, so as Dave mentioned, we've framed it up under that umbrella, but we haven't gotten more granular.

And on that third point, on the achieving of actual cost savings, is that something that ramps over a two- to three-year period or does it happen pretty quickly?

Well, Mark, you're never done in terms of how to make the supply chain more efficient, so it's something that will be ongoing.

Okay, thank you.

Okay, thanks.

We'll take one more question please.

Our final question comes from the line of Ross Muken, Evercore.

Go ahead.

Thanks, guys.

I'm going to ask a big picture question to close.

Larry, lots going on in your industry.

One of your competitors is attempting to mimic your model at a smaller scale; another one of your competitors is moving more in the direction of retail and beauty; and one of your PBM competitors was acquired; another is declaring its independence.

As you think about CVS's positioning and strategy and how you continue to evolve the model, what are the things you're looking for as the industry changes that give you further confirmation that the share gains you've enjoyed are sustainable and that you have all of the assets and pieces you need to continue to do what you've done, which is put up tremendous results for many years here?

Well Ross, you did a really good job of summarizing the marketplace, but we have always believed that the integrated PBM retail model, we think is the optimal model.

That gets further highlighted by the fact that we're entering an era of -- we've been describing as the retailizations of healthcare, others are talking about it in terms of an era of consumer-directed healthcare.

You think about our model, it's really the only one that has deep connections and expertise in dealing with both payers of healthcare, as well as consumers of health care.

We've talked about and we've reiterated it on the call today, all the different ways in which we can help solve this cost quality access conundrum that our health care system faces.

As I mentioned earlier, we believe that we're in a great place, and at the same time, we're always looking for ways that we can be more efficient and speak to payers and customers in a more surround-sound fashion and we see opportunities domestically to continue to do that.

Great, thanks, guys.

Okay, thanks, everyone for your ongoing interest in CVS.

As always, if you have any follow-up questions, you can reach Nancy.

Ladies and gentlemen, this concludes the conference for today.

We thank you for your participation.

Have a great rest of the day, everyone.