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CVS Corporation (CVS)

Q1 2006 Earnings Conference Call

May 4, 2006 8:30 a.m. EST

Executives

Dave Rickard - Chief Financial Officer

Nancy Christal - Vice President, Investor Relations

Analysts

Mark Husson - HSBC

John Heimbockel - Goldman Sachs

Meredith Adler - Lehman Brothers

John Ransom - Raymond James

Mark Wiltamuth - Morgan Stanley

Ed Kelly - Credit Suisse

Eric Bosshard - Midwest Research

David McGee - SunTrust Robinson-Humphreys

Presentation

Operator

Good morning. My name is Michelle and I will be your conference operator today. At this time, I would like to welcome everyone to the CVS Corporation first-quarter earnings conference call.

(Operator Instructions)

I would now like to turn the conference over to Ms. Nancy Christal, Vice President of Investor Relations for CVS Corporation. Ms. Christal.

Nancy Christal

Thank you. Good morning, everyone, and thanks for joining us today for our first-quarter 2006 conference call.

I am here with Dave Rickard, Executive Vice President and CFO. Dave will be providing highlights of our business in the first quarter, followed by a financial review and earnings guidance.

Before I turn it over to Dave, I have a few items to cover, including a review of April sales results, which we announced this morning in a separate press release. First, an important reminder, our 2006 analyst and investor meeting will be held on Wednesday, May 24th at the Mandarin Oriental Hotel in New York City. Consistent with past practice, we are planning a half-day event with several speakers from our senior management team. We are already expecting a big crowd this year, so if you have not already responded to the invitation that we e-mailed to you on March 20th, please do so at your earliest convenience. If you need any additional information, you can contact Adriana Vasquez at 914-722-4073.

Now, because our annual analyst and investor meeting is less than three weeks away, we are going to provide a somewhat condensed business update today, along with our usual financial review. For a more detailed update, please join us either in person or via webcast at our upcoming meeting on May 24th.

We do hope you attend in person, however, as this is the one time during the year when you can have direct exposure to executives beyond our usual spokespeople.

Second, as you know, we plan to acquire 700 standalone Sav-on and Osco drug stores. Our current expectation is for the closing to occur in the first half of June. I want to make you aware that from the time of closing until the systems integration is complete, we expect to report monthly sales results on a slightly later schedule than we do today. That is due to sales systems incompatibility that we will be working around initially.

For example, if the deal closes in early June, we will report June comps on Monday, July 11, rather than on Thursday, July 6. That is basically two to three business days later than our usual practice. Once the systems are integrated, we will shift back to reporting sales on our current schedule.

As for the timing of our quarterly earnings, we will let you know if there is any reason to shift that once the deal closes.

To make it easier for you to know when information will be available, note that we post our upcoming monthly sales and quarterly earnings reporting dates on our Investor Relations website at investor.cvs.com.

Third, in order to be able to take as many people's questions as possible, I would ask that you limit yourselves to one or two questions including your follow-up. If you have more than that, you can get back in the queue, and we will get to you as time permits.

Next, I want to remind you that today's call will be simulcast on our IR website. It will also be archived there for a one-month period following the call to make it easier for all investors to access the call. Note that this call may not be rebroadcast without prior written consent from CVS.

I also want to remind you that in light of Regulation FD, we will only accept analyst models for review within the one-month period following the quarterly earnings call. This review and comment will be limited to suggesting changes based on information disseminated to the public on the call. During this period, we will simply check analyst models for appropriate interpretations of what we said.

In addition, please note that during this call we will discuss one non-GAAP financial measure in talking about our company's performance, namely free cash flow. We find it a good way to understand operational cash flow being generated by the business. Free cash flow is defined as earnings after taxes plus non-cash charges, plus changes in working capital, less net capital expenditures. So free cash flow excludes acquisitions and dividends.

In accordance with SEC regulations, you can find the reconciliation of free cash flow to comparable GAAP measures on the Investor Relations portion of our website at investor.cvs.com.

Now, as we typically do on these calls, our attorneys have asked me to read the Safe Harbor statement. During this presentation, we will make certain forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially. For these 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 we have outlined for you under the caption “Cautionary Statements Concerning Forward-Looking Statements” in our annual report on Form 10K for the 2005 fiscal year ending December 31, 2005.

This morning's press release is also available on our website, which should be reviewed along with the information on this call.

Now, let me turn to April sales. We had terrific results this morning. Total comps were up 9.7%, with pharmacy comps up 8.1% and same-store comps up 13.4%. In 2004, acquired stores boosted our comps by about 160 basis points in April. Store pharmacy comps increased 6.8% in April, while pharmacy comps in the former Eckerd stores increased 15.5%. We continue to benefit from the turnaround of those assets. Note that our April pharmacy comps overall were flat to 210 basis point negative impact from the recent generic introduction.

Front-end comps were very solid in both the core business and the acquired stores as we saw 11.3% front-end comps before CVS, and 24.7% front-end comps in the former Eckerd stores. Front-end comps in April reflect the benefit of the timing of the Easter holiday, which boosted front-end comps by 680 basis points.

Now if you look at March and April combined in order to compensate for the Easter shift, same-store sales increased 8.2% with pharmacy comps up 8.7% and front-end comps up 7.1%. Easter sales climbed 11% versus last year, and sell-throughs were terrific.

April was clearly a very strong month. We saw excellent customer traffic and significant growth in both the pharmacy and the front-end, and we saw strength pretty much across the board in the front-end, particularly in the health, beauty, general merchandise, edibles, greeting card and digital photo categories.

As always, please feel free to call me with any follow-up questions after the call.

Now, I will turn this over to our CFO, Dave Rickard.

Dave Rickard

Thank you, Nancy, and good morning, everyone. Well, 2006 is clearly off to a great start. In fact, I think it's fair to characterize the first quarter as one in which a lot of things went our way.

Some of you were concerned about the rollout of Medicare Part D, as well as the difficult flu comparison with 2005's first quarter and the Easter shift, and you worried about what that might mean for our performance this quarter.

Well, I am pleased to say that despite those challenges, the first quarter was even a little better than we had expected. We had solid sales growth in both the front-end and the pharmacy in both our core business and the 2004 acquired stores. Our same-store sales came in at the high end of our expectations for the quarter. We experienced significantly improved gross margin rates. Generics came in a little faster than we had anticipated, and we had slightly less margin pressure from PharmaCare's Medicare related insurance business.

As a result, we delivered diluted earnings per share of $0.39. That was a $0.01 above the high end of our earnings expectations -- a nice quarter indeed.

Let me quickly provide an update on the planned Albertsons acquisition that we announced on January 23. As you know, we have a definitive agreement to acquire approximately 700 standalone Save-on and Osco drug stores in the Southwest and Midwest, as well as the La Habra, California distribution center.

The transaction provides instant market leadership in Southern California, while also strengthening our market share in other important states, such as Illinois, Indiana, Missouri and Arizona. We remain highly optimistic about what the deal means for the long-term growth of the company. Gaining a meaningful presence in the highest growth markets in the country has been a key strategic element of both the 2004 acquisition, as well as this one.

In March, we announced that the waiting period under the Hart-Scott-Rodino Act has expired without a request for additional information. The HSR waiting period also expired for Albertsons proposed transaction with Supervalu, and a consortium led by Cerberus Capital, so that is behind us. Keep in mind though that the closing is also subject to other customary closing conditions, as well as approval by the shareholders of Albertsons and Supervalu.

We understand that all of that is going fine and a June close is the outlook. Whenever it is, we will be ready. Hold on just one second here.

I am sorry, excuse the interruption, I just had a suggestion on the speech on the fly. Let me go on.

We plan to spend some time discussing our integration plans for the acquisition at our May 24th meeting, but I will say that our experienced integration team has been busy preparing to hit the ground running the moment we close the deal.

We have already had numerous meetings with the Osco Sav-on field and store management teams, and we look forward to working with that talented group. When I review our overall guidance a little later, I will also remind you of our guidance for the acquisition’s impact on our financials.

Before delving into our financial results, I want to touch on the business trends behind our strong first-quarter numbers. First, I will review the front store business. Front-end comps increased 4.7% in the quarter. The core business increased 1.6%, while the 2004 acquired stores increased an outstanding 21.8%.

Recall that the shift in the timing of Easter had a negative impact of approximately 200 basis points on the front-end comps in the quarter. While you will hear more detail on this at our meeting on the 24th, I would like to provide some quick front-store highlights.

Despite the negative impact of the shift in the timing of the Easter holiday, customer counts have been increasingly strong across the chain, and we saw broad strength in the health, beauty, general merchandise and personal care categories this quarter.

Our seasonal sales for Valentine's Day were also up a solid 11.5% versus last year, giving us an excellent sell-through.

You know CVS focuses on health and beauty. The story right now on the health side is that we have seen a strong start to the allergy season. That drove growth and sales in over-the-counter allergy remedies. In addition, our recent launch of our proprietary line of vitamins under the Life Fitness brand exceeded our early expectations.

As a side note, we’ll have a display of these products with a knowledgeable spokesperson available at our analyst meeting on May 24th so you can see the range of offerings and learn more about Life Fitness products at CVS during the breakfast and the break.

On the beauty side, the exclusive Lumene line of skincare and cosmetics continues to experience double-digit sales growth. One key driver is the new Lumene product line for customers aged 50 and over, called Premium Beauty.

We have done targeted marketing through ExtraCare, as well as a focused PR campaign that has generated over 80 million consumer impressions. All of that is helping us achieve this level of success with the Lumene line.

In addition, the new Skin Effects line by renowned dermatologist, Dr. Jeffrey Dover, has been well-received by our customers to date. We also plan to have Dr. Dover with us on May 24th to chat with you about his products, which of course can only be found at CVS.

I'm happy to report that higher margin sales of CVS brands as a percentage of front-store sales continue to gain traction. Now representing 13.4% of front-end sales across the chain, sales of CVS brands make up 13.7% of front-end sales for the core business, up 100 basis points from last year. CVS brands make up 12.6% of the front store sales in the 2004 acquired stores, up from less than 9% when we bought them.

We continue to innovate with exclusive products that have superior performance attributes which can only be found at CVS.

Finally, our ExtraCare Loyalty Program continues to provide a competitive edge for us. We are gaining better and better insight into which offers customers find most compelling. That enables us to generate profitable sales and build a loyal customer base. So our recent innovations in the front of the store are clearly paying dividends.

Now let's take a look at the pharmacy business.

First-quarter pharmacy comps rose 6.8%. The core business generated a healthy 5.9% pharmacy comp, but the 2004 acquired stores experienced an 11.7% surge in Rx comps. That’s up from the 8.7% pharmacy comp the acquired stores achieved in the fourth quarter of last year, and the 7.0% pharmacy comp the acquired stores achieved in the third quarter of last year. This is obviously building momentum. We're delighted with the growth we're seeing from the turnaround.

Recall that the former Eckerd stores were posting double-digit negative comps when we acquired them in August of 2004. We have come a long way, but the good news is that much of the opportunity still lies ahead of us.

Like the front-store, our pharmacy business is experiencing excellent consumer traffic counts. IMS data shows our total scripts growth at 4.8% in the first quarter and we continued to gain share, particularly from certain chain drug competitors, independents and food players.

Nationally, our retail pharmacy market share increased to 14.1%, up 39 basis points from the first quarter of last year. In markets where we operate, our share is just over 20%, up 59 basis points from the first quarter of last year.

Generics continue to play an important role in pharmacy. New generics depressed pharmacy comps by about 200 basis points in the first quarter. Generics overall represented 57.6% of scripts in the quarter, up 350 basis points from 54.1% in last year's first quarter.

During the first quarter, we saw a number of new generics, including versions of the widely prescribed anxiety drug, Xanax, and the nasal steroid, Flonase, among others. Given the blockbuster branded drugs losing patent protection in the coming months, like Pravachol, Zocor and Zoloft, I expect generics to have a growing importance to our results, most notably in the second half. As you know, while generics have a negative impact on sales, they are helpful to margins.

Our pharmacy business was also helped by the strong start to the allergy season, which is expected to continue in the coming months and, of course, by the launch of Medicare Part D. As you know, the new Medicare Prescription Drug Benefit was launched by the government on January 1st. The government recently reported that over 30 million people now have prescription drug coverage under Medicare Part D. An estimated 8 million of the enrolled beneficiaries represent those who have new or better coverage today under Medicare Part D than before January 1st .

As we approach the May 15th deadline, we expect to see further increased sign-ups. As expected, we experienced reduced margin rates from the dual-eligibles shifting from Medicaid to Medicare coverage, and of course, since these people already had coverage, utilization did not change.

However, early analysis of our results tells us we are seeing incremental scripts filled at CVS from Medicare Part D. That is driven by both increased utilization and market share gains. Utilization is up among CVS customers who now have Medicare coverage, and we have gained share and are seeing new customers in our stores. At the end of the first quarter, Medicare Part D represented 10% of prescriptions filled at CVS, and that number is on a steady climb.

According to IMS, we're gaining share in the 65 and older segment since the third quarter of 2005, when we began marketing to seniors. Much of the share gains are in the Florida markets. As the snowbirds come back to the Northeast and Midwest, we may well see gains there.

On the retail side of our business overall, as we expected at this early stage of the program, the increased utilization was not quite enough to offset the margin decline from the dual-eligibles, but the trends are in the right direction, certainly.

Now let me talk about Medicare Part D's impact on the PBM side of our business. PharmaCare's Medicare partner, Universal American, has approximately 400,000 members to date, similar to the number the major public PBM’s have. Having said that, these numbers are less than what we originally anticipated. As a result, we will take down our sales projection for PharmaCare a bit for the year, and it will have a less negative impact on our consolidated CVS gross margin rate.

I will cover all this when I give guidance. Even though a bit smaller, the Medicare Part D program was still accretive to PharmaCare's first-quarter results. So, as we expected in the first quarter, the Medicare '06 program was slightly dilutive to the retail business, slightly accretive to the PBM business, and slightly dilutive to the corporation overall.

We still expected to have a modest impact overall for the full year. We will keep you posted as the program continues to take shape.

We got a lot of questions on the expected cuts to Medicaid reimbursement slated to begin in 2007. As it stands now, the Deficit Reduction Act that was passed in early February by both the House and the Senate contains all the final Medicaid cuts. The President's proposal to further cut the markups on average manufacturer price, or AMP, was not taken up by Congress. The reimbursement cuts are focused on multi-source generics, which account for only 20% of the overall pharmaceutical spend.

We will begin to have some visibility to the new pricing benchmark AMP this summer. AMP itself remains undefined. We have had high-level discussions with both CMS and OIG as to the nature of what will be posted, but the plans for the government's posting of AMP prices are still not clear. It may be a limited posting.

While we would prefer to gain clarity on the definition of AMP prior to the posting, perhaps the posting will serve as a catalyst for discussions that will lead to a true AMP definition for retail. In the meantime, we have initiated conversations with some states regarding increased dispensing fees to offset the lower ingredient cost reimbursement at the federal level.

It is still too soon to tell where all this shakes out, since there are several unknowns, including visibility and a lack of clear definition of AMP and state dispensing fees. But as far as we can tell, worst-case, all of this shouldn’t amount to more than a few cents per share for us next year. It will not affect 2006.

Now let me turn to our new store growth.

During the first quarter, we opened 75 stores. That included 35 new stores and 40 relocations. We closed 23 others, resulting in a net unit growth of 12 stores. We're tracking right in line with our plan. For the full year, we expect to open 250 to 275 stores, about 140 to 150 of which will be new, the rest will be relocations.

With closings, we expect net unit growth of 100 to 125 stores. That will produce organic square footage growth of a little over 3% again this year. Throughout this year, we expect to continue to expand our presence in our newer high-growth markets like Florida, Texas, California, Phoenix, Las Vegas and Minneapolis. We will also continue to dense up in some of our core markets where we see opportunities for incremental share gains. We will discuss that further at our meeting later this month.

In addition to new stores and relocations, we also continue to do file buys, where we purchase the pharmacy files from independents that are looking to retire and roll them into a nearby CVS pharmacy. We completed 27 in the first quarter on pace with our plan.

As the government changes the Medicaid reimbursement in 2007, it will become increasingly difficult for independents to operate profitably. I would not be surprised to see file buy opportunities accelerate. Of course, they will be worth less due to the Medicaid change, so we will pay less for them.

Now let me provide a brief update on our PBM PharmaCare.

Greg Weishar, President of PharmaCare, will talk more about the business at our meeting on May 24th. In the first quarter, PharmaCare's total sales were up 28% versus the first quarter last year. This significant growth was largely driven by the new Medicare Part D insurance business and the State of Connecticut PBM contract that took effect late last year.

Operating profit for the first quarter was $57.4 million, up 10.8%, despite the pressure from the PBM side of the business. The decline in PBM margins reflects the quarterly impact of the new risk-based business. The first half of the year is lowered with the benefit in the back half.

Also, operating profit as a percentage of sales was 7.8% in the first quarter. That was down 310 basis points from the first quarter of last year. As I said on our last earnings call, the new risk-based business at PharmaCare has a lower margin rate than PharmaCare's traditional business.

The decline in operating margin reflects the lower gross margin rate on a fast-growing sales base. As I said, this is a high return business and will be additive to profitability over time, but at a lower margin rate than PharmaCare's traditional business.

In early March, we announced that PharmaCare had been selected by Daimler Chrysler to provide PBM services to their 280,000 employees, their dependents, and retirees. Effective July 1, 2006, PharmaCare will provide the Chrysler group with fully integrated PBM services, including a retail network, mail service, specialty pharmacy services, and a variety of clinical and patient-centric programs. This win reflects PharmaCare's stellar service record and ability to price competitively. We were awarded this multi-year agreement following an eight-month review by Chrysler.

In addition, PharmaCare recently won a contract to provide PBM services to the Oregon Teamsters Employee Trust, covering 30,000 lives. Following on the heels of our contract to provide integrated PBM services to employees of the State of Connecticut, which covers 190,000 lives, these major wins demonstrate that PharmaCare is well positioned for future opportunities in the large employer market.

In fact, I'm pleased to report that we are actively involved in many large customer RFP’s at the moment. That is due in part to our successful integration of the EHS business that we acquired from Eckerd in 2004, and in part to our recent high-profile contract wins.

We look forward to keeping you posted on PharmaCare's progress, and you will hear more about that at our upcoming analyst meeting.

Now I will provide a more detailed review of our first-quarter financial results. After that, I will provide initial guidance for the second quarter and update guidance for the remainder of this year.

Let's turn to the first quarter income statement. Sales increased 9% to $10 billion in the quarter -- our first ever $10 billion sales quarter. This year's figure, of course, does not include the majority of Easter seasonal sales due to the timing of the holiday that I discussed earlier.

Pharmacy sales represented about 71% of the total sales in the first quarter, essentially the same as last year's percentage. Third-party sales accounted for about 94% of pharmacy sales, again in line with 2005's first-quarter percentage.

Our overall gross margin increased by 62 basis points in the quarter to 26.6%. The gross margin rate once again benefited from the increase in the amount of generic drugs dispensed. Despite the weak flu season relative to last year, flu was not down as much as we had expected. The over-indexing of generics within the flu category therefore helped our overall pharmacy margin to increase throughout the quarter.

Continued progress on shrink reduction was also a positive factor this quarter, and in addition, our gross margin rate benefited from the absence of last year's Easter markdowns, due to the shift of Easter into the second quarter.

These positive influences on our gross margin, however, were partly offset by the increase in the insurance-related products offered by PharmaCare. Additionally, as I noted earlier, the dual-eligible population shifting from Medicaid to Medicare had a negative impact on margin rates. Keep in mind, however, that increased utilization should help offset that over time.

Now let me turn to SG&A. Our total SG&A expense as a percentage of sales, including depreciation and amortization, increased year over year in the first quarter by 44 basis points to 20.9%. Contributing to this increase was of course the expense associated with stock compensation due to our adoption of FAS 123-R during the quarter. This amounted to about $15.5 million, or 15 basis points.

The increase in generics also continued to reduce our sales leverage.

After all this then, operating margin was 5.6% in the first quarter. This was up 18 basis points versus last year's first quarter, driven by the improvement in sales mix and gross margin. Net interest expense was $21 million in the quarter. Versus last year's first quarter, net interest decreased $7 million, which was largely driven by the decrease in debt year over year, reflecting our cash flow generation through the last four quarters.

Our tax rate was 38.9% in the quarter, and our diluted share count was 849 million shares. As I said earlier, diluted earnings per share were $0.39, up from $0.34 in last year's first quarter. This includes the impact of our adoption during the quarter of FAS 123-R, which amounted to about $0.01 for the quarter.

Now let's turn to the balance sheet and cash flow. In the first quarter, inventories increased by only 3% versus last year, while sales rose 9%. That is helping us move back toward industry-leading inventory turnover, now that we have digested the former Eckerd stores. Gross and net capital expenditures were both $284 million, as there was no sale leaseback activity during the quarter.

As for free cash flow, we experienced an outflow of $112 million during the quarter. This was an improvement of $156 million over the first quarter of 2005, the largest factor being less of a build in inventories net of the corresponding accounts payable. The better inventory and AP figures reflect the fact that we no longer need to infuse extra inventory into the acquired Eckerd stores, as we did during last year's first quarter to address in-stocks.

Now I want to provide some guidance for the second quarter and the full year of 2006. Let me start by saying that because the acquisition of the Osco and Sav-On stores is not expected to close until June, I'm going to provide guidance separately for the CVS business without the stores we are about to acquire, as we did on last quarter's call. Then I will review and update our expectations for the acquisition.

For the second quarter, we expect comp store sales growth between 6% and 8%. Remember that April front-end sales were positively impacted by the Easter shift, which is one factor to consider as you model second quarter comps.

We expect second quarter 2006 EPS to be in the range of $0.38 to $0.40 per diluted share, up from last year's split-adjusted $0.33 per share. Like the first quarter, this guidance includes about $0.01 for the impact of expensing stock options.

For the full year, total sales are expected to increase by about 8% to 10%. This is down slightly from our total sales guidance given on the fourth quarter call, and mainly reflects the current estimate for revenues from PharmaCare's insurance-based Medicare business that I discussed earlier. We fully expect to see continued strength in our core business and in the sales turnaround in the former Eckerd stores.

While top line growth expectations are slightly reduced, due to the revised estimates on the Medicare business at PharmaCare, we still expect total comp store sales of 5% to 7% for the year, consistent with our initial guidance. PharmaCare’s insurance-based Medicare business is not in our comps, so lowering it does not lower comps.

Thanks to the greater-than anticipated utilization of generic drugs that we now foresee this year, and given the diminished negative impact on margin rate from PharmaCare’s Medicare growth, we now expect our overall gross margin rate to slightly improve versus last year. The expansion in pharmacy margins from generic drugs along with an improved front-end mix and continuing progress on shrink is now expected to out-weigh any negative influences on our gross margin rate this year.

Within SG&A, we will continue to benefit from increased sales leverage from the turn-around at the former Eckerd stores. We will also capture meaningful synergy savings again this year while reaping the ongoing benefits of the improvements to the acquired stores, as well as from our systems and workflow enhancements.

In addition, the full-year impact of FAS 123-R on SG&A and earnings is expected to be approximately $0.05. When you aggregate all the puts and takes to SG&A as a percentage of sales this year, we still expect to see a modest improvement.

Full year 2006 operating margin therefore should improve upon 2005’s operating margin, reflecting both the improvement in gross margin and the improvement in SG&A.

Net interest is still expected to be close to $100 million, although I’m not including the impact of the Osco Sav-on acquisition in this guidance. Of course, our interest will increase once we take on additional debt to finance the Albertsons transaction.

We continue to expect our tax rate to be around 39%, and our diluted share count is expected to be about 855 million shares for 2006.

With the improvement I noted in our inventories, we expect inventory turns to get back toward industry leading levels, certainly above five times by the end of the year.

Capital expenditures, net of sale leaseback transactions are projected to be close to $900 million in 2006 before the inclusion of capital related to the acquisition of the Sav-on and Osco stores. Free cash flow will handily exceed $500 million.

So including the impact of FAS 123-R, we now expect 2006 earnings per share in the range of $1.55 to $1.59, an increase $0.01 to both the bottom and the top of our previous range. This of course is driven by the over-performance that we saw in the first quarter, and our continued confidence in gross margins for the remainder of the year.

Now let’s move on to the stand-alone Albertsons Drugstores. From a guidance standpoint, there is very little to update as the deal has not yet closed. We still expect the acquisition to be about $0.10 dilutive this year. that dilution will take our net guidance range down to $1.45 to $1.49 this year. Free cash flow this year from the Albertsons deal is likely to be a use of about $150 million, so that would modify our free cash flow guidance to an expectation of over $350 million.

In 2007, the Albertsons deal is expected to generate incremental free cash flow of about $100 million to $150 million, with an increasing amount of free cash flow thereafter.

So in summary, this was a great quarter indeed. We achieved healthy sales growth in our core retail and PBM businesses, as well as the 2004 acquired stores. Significant gross margin improvement, solid earnings growth, and we readied ourselves for the start of the Osco Sav-on integration, which is expected to close in June. So 2006 has started very well.

We look forward to seeing many of you at our analyst’s meeting on May 24th, where we will speak in more detail about our growth opportunities.

Now I would be happy to take some of your questions -- one or two per person, please.

Question-and-Answer Session

Operator

(Operator Instructions)

Your first question comes from Mark Husson of HSBC.

Mark Husson - HSBC

Good morning. On the risk-sharing business that you have, or businesses that you have, can you tell anything about the way consumers are approaching Medicare Part D? Are they trying to get all their prescriptions filled earlier in the year to get into the doughnut hole and out of it as quickly as possible? How does that affect the way you think about providing for risk control in the quarter?

Dave Rickard

Mark, I would not say that we have seen that kind of behavior in the data. Now bear in mind that we do not have any year ago data to compare with, but we have not seen a rush to the drugstore. In fact, there are a fair number, close to 100,000 customers who have not, as of the end of March, gotten their first prescription. So I don’t think we have seen that.

Mark Husson - HSBC

People you have who were your cash customers, and who now have some kind of coverage, have you noticed that their cash expenditure has gone down dramatically, and the percentage of cash in total, has that gone down?

Dave Rickard

That is one of the funny things in the data right now. The cash business is not down much. We have tracked some specific cash customers who now have coverage and are participating in this program, but you will recall that I said that our third-party business was 94%, the same that it was a year ago. So the cash customers have not, as a general matter, gone away yet. We do not know quite what that means. It is obviously not bad news.

Mark Husson - HSBC

It just means Viagra is not covered.

Dave Rickard

Well, that is part of it.

Mark Husson - HSBC

Thank you.

Operator

Your next question comes from John Heimbockel at Goldman Sachs.

John Heimbockel - Goldman Sachs

Two things, with respect to the generic trends here over the next few months, what will the Zocor situation and that quasi-exclusivity, what impact will that have, and do you see more of that? What is the risk of pre-mature [macking] of generic as plans get visibility on generic profitability?

Dave Rickard

Well, in terms of Zocor, we do not know anything more than you know about its status. It looks like there will be, at least as is currently understood, one authorized generic and one generic producer, so two people producing it at once, and what that will do to the economics, I really do not want to speculate on.

This is just one of several thousand drugs out there.

In terms of early [macking], you have to be careful about cutting off your nose to spite your face. Everyone in the system other than branded manufacturers is benefited by the availability of generics. It lowers the nation’s cost of medicine. It lowers every employer’s cost of medicine, and it slightly improves our profitability. For employers or third party players to put extraordinary pressure through early [macking] on generics is really self-defeating behavior. Fortunately, we have not seen a lot of that and I would hope that we will not see a lot of that.

John Heimbockel - Goldman Sachs

Secondly, what do you think is the likely pace of square footage growth over the next three or four years, and when do you think, or do you think, you will get up to a 6% or 7% growth rate eventually?

Dave Rickard

I would invite you to ask our company’s expert on that, who is Tom Ryan, at the May 24th meeting. It is an excellent opportunity to get updated. We have been running in the 3% to 4% range here for the last few years, and I am just going to continue to expect that that is about where we are going to be, but if Tom has additional thoughts, you will have the opportunity to hear them.

John Glass - CIBC

Thank you.

Operator

Your next question comes from Meredith Adler of Lehman Brothers.

Meredith Adler - Lehman Brothers

Good morning. I would like if you could walk us through some of these numbers on PharmaCare again. I feel like I still do not know that business very well. Did you report what the total revenues were for the quarter? I wrote down a number that I think was operating margin or operating profit, but I’m not sure. Can you just run that through us? And then what is the impact of the addition of the risk-based business, and how much less of it do you think you will have for the year?

Dave Rickard

The PharmaCare revenues are about $898 million, up strongly from a year ago. The number of people signed up at Universal American is about 400 million. We had thought it could be as much as 700 million. What else did you ask?

Meredith Adler - Lehman Brothers

Hundred-thousand.

Dave Rickard

I’m sorry, hundred-thousand, excuse me.

Meredith Adler - Lehman Brothers

What was the operating profit?

Nancy Christal

The operating profit was $57.4 million, which was up 10.8%.

Meredith Adler - Lehman Brothers

Okay, and then could you just talk about the business you are winning, the PBM business, is obviously higher margin than the risk-based business. Can you just talk about the differences at all on average for regular PBM business?

Dave Rickard

Yes, well, I am going to spend some time on this exact question at the May 24th meeting, Meredith, so in part, let me ask you to defer until then. But I will say this, that the insurance business is essentially a insurance premiums received, offset by the costs to service claims. It is inherently a thin-margin business. It is designed to be that way. We also account for it, necessarily, on a gross basis because we are actually handling full claims and so forth, and we are getting full premiums. Whereas in our PBM business, we account on a net basis. We only count the spread that we get from the transactions with drugs, so the margins, because of the net basis of sales recording are necessarily higher.

I will go through all of this in some detail on May 24th.

Meredith Adler - Lehman Brothers

I just have a follow-up question about if you could just remind us some of what was happening last year, right after you were doing stuff at Eckerd’s, you changed all the names, you started doing some promotional events. Could you just talk about the timing? How much of that impacted the first quarter of last year? I think we had expected SG&A to be a bit lower in this first quarter, so…

Dave Rickard

As I recall, we were heavily into the Florida conversions in the first quarter of last year. We did the grand reopening promotions in the second quarter in most of Florida, and then moving into Texas did those in July-August, principally. So it was still early days, but it was a very active time.

In terms of the SG&A, it has come in about where we expected it to be.

Meredith Adler - Lehman Brothers

Okay, great, thank you very much.

Operator

Your next question comes from John Ransom of Raymond James.

John Ransom - Raymond James

Good morning. Talking about the second quarter, is there going to be any effect from Albertsons, given that you are going to only own it for a short period of time?

Dave Rickard

Yes, it will have some effect. Some of the one-time costs are immediate, so we will have some effect of that.

John Ransom - Raymond James

In thinking about it, and not to get too fine a point on this, but thinking about your $0.38 to $0.40 guidance for the second quarter, how much should we take away for Albertsons to get that number for the following quarter?

Dave Rickard

That’s a good question, and you are right to ask it. There will be a small impact of the Albertsons transaction within the quarter. So I would look at something in the $0.01 to $0.02 area.

John Ransom - Raymond James

Okay, that’s helpful. Secondly, thinking about that, do you have anything you might share with us about how that business is tracking this quarter, relative to your expectations?

Dave Rickard

You mean the acquired business?

John Ransom - Raymond James

No, the Albertsons Sav-on, as you look at the first quarter results from that business, do you see any impact from the sales profits? Is there any fatigue there that is going you are going to have to address that is greater than you thought? Or is the business tracking like you think?

Dave Rickard

I do not think we have seen any massive deviation from what we expected. Obviously we expected some slow-down in the business because of the sales process, and I think that has occurred.

John Ransom - Raymond James

Thirdly, as we think about Medicare Part D, just anecdotally, there are horror stories early on in the industry about people now knowing who their insurance companies were, people queuing up and long waits. As that gotten clearer better over the past couple of months, relative to January, February, is there any benefit we should think about? If so, where would that show up on the income statement?

I frankly was a little surprised you did not have a little more impact from that from an earnings standpoint in the first quarter.

Dave Rickard

Well, the dynamic there was people walking in not really knowing what they were asking for, and our pharmacists trying very, very hard to help them out. So it was not like we were making people angry. The situation was making people angry, but it was not directed at our pharmacists, who did a fabulous job, by the way, overall.

I think that we will see another little crunch here as people scurry in to beat the May 15 deadline. We may have a few more of those stories in some of the press. But if you go back to the last couple of months, it has actually been very smooth in the stores. So where do you see that? I expect that you would see that in increased sales volumes and the benefit that flows from that.

John Ransom - Raymond James

Is there any way you could tangibly see what has happened with pharmacist productivity? Was it impacted by the extra time they were having to spend with these customers?

Dave Rickard

We actually staffed up a bit for that. We have a specific plan that we executed, so we know quite well what it did to us. We are not discussing it publicly.

John Ransom - Raymond James

Okay. I think that is it. Thank you.

Operator

Your next question comes from Mark Wiltamuth of Morgan Stanley.

Mark Wiltamuth - Morgan Stanley

Good morning. I just wanted to see if you could talk a little bit about this new plan for the average manufacturing price disclosure. Are you going to have to report on a company basis or is there going to be a national clearing house for average manufacturing prices? Do you think this could lead to other conventional third-party payers revisiting their margin thoughts and maybe reimbursement rates?

Dave Rickard

Well, first of all, we do not have AMP data. That is manufacturer data that is shared with some PBM’s, as I understand it, as a basis of determining some rebates. The disclosure, I would expect, although again, this is still somewhat a cloudy subject, will come from the government. They will put some numbers out there, and then we will all get to look at them. I imagine we will have some healthy debate about whether they are properly defined and useful or not.

I think that this is going to be an active and confusing time here for a while. We do not have any obligation under the current program to publish anything of a company-specific nature. In other words, CVS specific data, and I wouldn’t expect we will.

I do not expect that this is going to lead to incremental rate pressure. We are always under rate pressure, but it seems to me this is a highly controversial and non-indicative set of numbers that are going to be out there, at least initially, so I really do not expect it is going to pressure the business unduly.

Mark Wiltamuth - Morgan Stanley

Thank you.

Operator

Your next question comes from Ed Kelly of Credit Suisse.

Ed Kelly of Credit Suisse

Good morning. The Oregon Teamster contract, was that a big-three contract that you won?

Dave Rickard

A big-three?

Ed Kelly of Credit Suisse

Yes, what it a contract of the big three?

Dave Rickard

No, I don’t think so.

Ed Kelly of Credit Suisse

Okay. You have obviously had some large customer wins on the PBM side. Is PharmaCare now in a position here to win a few major contracts a year going forward? If the answer to that is yes, where do you stand in terms of mail-order capacity, given that Daimler Chrysler was 60% mail. Would you have to open up a mail-order facility any time over the next few years?

Dave Rickard

I think the answer is yes. I think that PharmaCare has shown that it can deliver what is needed by major customers, and I think that the practice these days is to include PharmaCare in most of the large contract RFP processes, so PharmaCare has a fair shot. As they have shown here a handful of times, they can take advantage of that. So yes, I am expecting that they will land some of these contracts from time to time throughout all of the future that we are looking at.

In terms of mail-order capacity, we still have plenty of capacity. If we should have to open an additional mail-order facility, that can be done without a great amount of expense. But at the moment, we still have capacity, so if any of you employers are out there listening, please send your RFP’s to Greg Weishar.

Ed Kelly of Credit Suisse

Just one last question for you. Accounts receivable was up a bit. Can you just talk about that?

Dave Rickard

That is just a reflection of the business. I mean, the size of the business -- we’ve grown.

Ed Kelly of Credit Suisse

Okay. Thank you.

Operator

Your next question comes from Eric Bosshard at Midwest Research.

Eric Bosshard - Midwest Research

Two things. First of all, Eckerd. Can you talk a little bit about where we are in the progress in improving the operating margin there? The sales gains have been great, but our assumption was that you were probably at 300 basis point gap in the margin at the end of ’05. How much progress are we making this year and how much more do we have to go, if you could just give us some framework for that progress?

Dave Rickard

I would say this -- we are making progress. We are trying not to disclose it regularly and periodically each quarter, again, back to my desire not to be reporting two businesses instead of one. On the other hand, I will go into some of that on May 24th. But I can tell you that progress is being made.

Eric Bosshard - Midwest Research

Secondly, SG&A you commented for the year that SG&A will be better. For the quarter, it was 50 basis points or 30 basis points worse. Why does it get better 2Q to 4Q to offset the increase that took place in 1Q?

Dave Rickard

It is just the timing of the programs that we are running, Eric. We did a little more broadcast media in the first quarter than we did a year ago, correspondingly. There is nothing really special there.

Eric Bosshard - Midwest Research

Lastly, in terms of guidance with a strong month of April, the second quarter sales guidance seems a little bit conservative. I guess also the earnings guidance, it seems like 2Q is a bit bullish, the second half it remains somewhat conservative. Is there anything other than you just being conservative in those two areas, the sales guidance and the earnings considerations for the second half?

Dave Rickard

Let me remind you of a couple of things. Number one, we got the Easter shift benefit in April, and so obviously that is an above trend performance within that individual month, and we will go back to a more normal year to year comparison as we get into May and June, and the guidance does reflect that.

In terms of the second quarter, I think that is a fair estimate of where we are going to come in. It is the initial guidance that we have given for the quarter. We are not upping or downing that particular quarter. That is just where we see it coming in.

I try to be realistic as opposed to conservative.

Eric Bosshard - Midwest Research

Very good. Thank you.

Dave Rickard

We will take one more question.

Operator

Your final question comes from David McGee of SunTrust Robinson-Humphreys.

David McGee - SunTrust Robinson-Humphreys

Good morning. Just a quick question with regard to your comment earlier about the Medicaid reimbursement cut next year having an impact on the magnitude of maybe a few pennies. What is your assumption now with regard to the dispensing fee portion of the negotiations? Are you expecting any wins there?

Dave Rickard

I think that we will likely have some progress on that side. I think it is unrealistic it will fully offset the hit we will take at the federal level, but it seems that some states do recognize what has gone on here and do recognize that on a fairness basis, they ought to be willing to more fully compensate our dispensing costs, so I think we will have a little bit of progress there. How much we will have to see.

I think that also it will not become very clear until quite late in the year, when we get down to very, very specific negotiations. Right now, it is general talk.

David McGee - SunTrust Robinson-Humphreys

You sound a little more bullish about that, though, then maybe last time when we spoke.

Dave Rickard

I think I am a little more bullish because we have heard some positive comments from some of the states that we had not heard before.

David McGee - SunTrust Robinson-Humphreys

Thank you. Good luck.

Dave Rickard

Thank you.

Operator

Ladies and gentlemen, this concludes today’s conference call. You may now disconnect.

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Source: CVS Corporation Q1 2006 Earnings Conference Call Transcript (CVS)
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