Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message| ()  

CVS Corporation (CVS)

Q2 2006 Earnings Conference Call

August 3, 2006 8:30 am ET

Executives

Nancy Christal - IR

David Rickard - CFO

Analysts

Mark Husson - HSBC

John Heinbockel - Goldman Sachs

Meredith Adler - Lehman Brothers

John Ransom - Raymond James

Mark Wiltamuth - Morgan Stanley

David Magee - SunTrust Robinson Humphrey

Ed Kelly - CSFB

Scott Mushkin - Banc of America Securities

Robert Summers - Bear Stearns

Presentation

Operator

At this time I would like to welcome everyone to the CVS Corporation second quarter 2006 earnings conference call. (Operator Instructions) I would now like to turn the call over to Ms. Nancy Christal, Vice President Investor Relations for CVS Corporation.

Nancy Christal

Good morning everyone and thanks for joining us today for our second quarter 2006 conference call. I'm here with Dave Rickard, Executive Vice President and CFO. Dave will be providing highlights of our business in the second quarter followed by a financial review and earnings guidance.

But before I turn this over to Dave I have a few administrative items to cover. First, just a reminder that we will be announcing July sales on Monday, August 7. As I mentioned on our last quarterly call we will report monthly sales results on a slightly later schedule than we have in the past. That is to due to our recent acquisition of 700 Albertsons stores and is related to systems incompatibility that we are working around initially. Once the systems are integrated we will shift back to reporting sales on our previous schedule, which is typically two business days earlier.

Second in order to be able to take as many questions as possible today I would ask that you limit yourself 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 try to get to you as time permits.

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

Fourth, please note that during this call we will discuss one non-GAAP financial measurement 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 IR portion of our website at investor.cvs.com.

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 risk 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 you become familiar with the specific risks and uncertainties that we've outlined for you under the caption Cautionary Statement Concerning Forward-Looking Statements in our annual report on Form 10-K for the 2005 fiscal year ending December 31, 2005 and in our quarterly report on Form 10-Q for the quarter ended April 1, 2006.

This morning's earnings press release is also available on our website which should be reviewed along with the information on this call. If you have any further questions, as always, following the call please don't hesitate to contact me. Now I'll turn this over to our CFO, Dave Rickard.

David Rickard

Thanks, Nancy. Good morning everyone and thanks for joining us to hear about another outstanding quarter for CVS. During the quarter we completed the acquisition of approximately 700 Sav-On and Osco stores from Albertsons, creating a 6,200 store chain. We also negotiated an agreement that was recently announced to acquire the Minute Clinic Company. More about that in a few minutes. Finally, we delivered record-breaking financial results in the quarter. This reflects the latest acquisition but really centers around the continued momentum of our core business across all of our markets.

Here are the highlights for the quarter:

Total revenues increased 15.8%, same-store sales jumped 8.8%. That was above our expectations. Pharmacy comps were up 9.1%, and front store comps were up 8.1%. Gross profit as a percentage of sales improved 43 basis points.

Total operating expenses were essentially flat despite the initial integration costs associated with the acquired stores. Net earnings increased 22.5%, and diluted earnings per share rose 21.2% to $0.40. That number includes a negative impact of approximately $0.015 per share of dilution associated with the acquisition of the Sav-On and Osco stores, which was completed on June 2.

Our expectations for the quarter was to achieve diluted EPS in the range of $0.38 to $0.40 excluding the Albertsons' dilution. So all in, we exceeded the high end of our guidance by about $0.01 per share. Obviously we're pleased with that. The business continues to fire on all cylinders.

Now let me provide a business update. We've gotten a lot of questions lately about the Albertsons integration, so I'll start with that.

First, we've made considerable progress in store systems conversions. As with the Eckerd integration, we initially established a bridge to the new stores and distribution center. That runs from our Rhode Island headquarters through the existing Albertsons, or now SuperValu, headquarters computer systems. Then we began the process of installing all of the CVS store systems and linking them directly to our headquarters. This includes EPIC, PSI, AIM, VIPER, CVS Select, POS and ExtraCare. We expect that by implementing CVS store systems we will improve pharmacy service and efficiency, in stock levels, inventory control, shrinkage control and customer service tracking. As of today we have converted about one-third of the stores to CVS systems. We expect to complete the systems conversions by the end of September. That is less than four months from closing the deal.

Second, we plan to close approximately 60 Sav-On Osco stores by the end of September. That is in line with the expectations we had when we negotiated the transaction. 40 of these are already done. These are primarily stores that are located too close to existing CVS stores, plus a few that are just low performers. Only three of these are in California.

Third, we began the remerchandising process. Initially we are operating the acquired stores more or less as they are with respect to product mix. Having said that, all of the newly acquired stores have had some limited remerchandising to date. Over time we will analyze sales trends and further optimize the use of space beyond what Albertsons did historically.

Fourth, as for remodeling the stores we will physically convert the stores to the CVS look and feel. The remodel will reduce shelf heights, reset merchandise layouts, install our hallmark CVS carpet, enhance the lighting, and improve the signage, basically make the stores CVS easy for our customers to use. We expect to remodel the vast majority of the stores acquired before Christmas, and the remainder will be completed by March 2007.

Now what about current trends in the former Sav-On and Osco stores? Well, they've been basically in line with expectations. Sales growth on the West Coast is holding while we are still seeing some softness in sales growth in the Midwest. Financially they are on track with the guidance we gave you back in May.

Once we complete the systems conversion, remerchandising and remodeling we will introduce the CVS brand to our customers. At that time the stores will have become, in effect ,brand new CVS Pharmacy stores. These stores are operationally in better shape than the stores we acquired in 2004. Having said that, we believe now that there is room for sales and profitability improvement across these stores.

Now let me get back to the balance of the business. I will review our progress in the front store first. As a reminder our front store comps do not yet include the 700 stores acquired from Albertsons. They will be included in our comps once we anniversary the completion of the transaction beginning in July of 2007.

The consumer slowdown being reported in the business press does not seem to have affected CVS. It may be that our convenient locations more than outweigh the high cost of gasoline. Our 8.1% front store comp for the second quarter benefited from the shift in the timing of the Easter holiday. The Easter shift had a positive impact of approximately 200 basis points in our front store comps.

In the second quarter we saw strength across our markets with front store comps at the core business up 6.4% and front store comps for the 2004 acquired stores up 17.2%.

Both Florida and Texas are really cooking. Customer counts have been increasing solidly while the average front store transaction size has also continued to grow. Our average front store ticket of about $11 reflects steady growth versus last year.

We continued to see broad strength in all categories, but especially the health, beauty, seasonal, general merchandise, consumables and digital photo segments of our business.

We've talked in the past about the success of the ExtraCare loyalty program. Now ExtraCare is used in over 63% of our front store sales across core CVS and the 2004 acquired stores. Our ExtraCare customers shop more often and spend more per trip. So it's one of the drivers of the growth in our average front store transaction size.

Increasingly, the ExtraCare program enables us to promote more efficiently to help drive sales. We know who our best customers are and we're able to offer targeted promotions to appeal directly to them. I think our strong comps and our increasingly efficient promotions validate the unique competitive advantage we derive from ExtraCare. Of course we will roll out ExtraCare in the acquired Sav-On Osco stores and look forward to cementing a loyal customer base there, as well.

Our private-label and proprietary brands continue to perform well, and now represent over 13% of front store sales in our core business. The exclusive to CVS Playskool line of baby care products will launch in the third quarter. Our other recent exclusive rollouts, such as Life Fitness vitamins and Dr. Dover's Skin Effects continue to pick up steam. So I expect continued growth here.

I also expect growth in the digital photo business. Although we continue to see a structural change in the industry away from film and related film processing, CVS continues to outperform the market in the overall category, as well as in the fast-growing digital business. Our latest digital offering is the launch of a new upload online, print at store capability. This enables customers to quickly get their prints; initial results have exceeded expectations.

Now I'll turn to the pharmacy business. Second quarter pharmacy comps rose 9.1%. Core business improved 7.9% while the 2004 acquired stores experienced a very strong 16.1% pharmacy comp in the second quarter. That is up from 11.7% in the first quarter of this year, 8.7% in the fourth quarter of last year and 7% in the third quarter of last year. So we continue to build growth momentum in the second quarter. The 2004 acquired stores continued to deliver strong front store results in 2006, and now we are making progress on the pharmacy side.

As we said in 2004, the pharmacy customer takes a little longer to acquire than the front store customer. But I'm happy to report that our pharmacy business is growing each and everyday across both Florida and Texas. We're very pleased with the growth in our pharmacy customer counts.

As Nancy often says, the turnaround of the former Eckerd stores is like the gift that keeps on giving. One of the factors driving our pharmacy growth across CVS is the new Medicare Part D prescription drug benefit. Scrip growth from people aged 65 plus has been outpacing growth from those under 65 since we launched our marketing and outreach activities in the fourth quarter of last year. This growth is due to both increased utilization and market share gains.

Generics also continue to play an important role in pharmacy. New generics had a negative impact of approximately 210 basis points on pharmacy same-store sales in the second quarter. Generics overall represented over 57% of scrips in the quarter, up about 300 basis points from last year's second quarter. We saw a number of new generics introduced in the second quarter, including generic versions of Pravachol, Proscar and most notably, Zocor, which launched during the last week in June.

In the third quarter thus far we have seen a few significant introductions, including generic versions of Zithromax Suspension, Biaxin and Mobic. The other notable expected generic launch is the antidepressant, Zoloft, which should be available in a few weeks.

Another recent development was our announcement that we've entered into a definitive agreement to acquire Minute Clinic. Minute Clinic is the pioneer and largest provider of retail-based health clinics in the U.S. We expect to complete the transaction late this summer.

Minute Clinics, which are staffed by certified nurse practitioners and physicians assistants offer treatment for common family illnesses. Some examples are strep throat, ear infections, poison ivy and pink eye. They also provide some common vaccinations including flu shots. There are currently 83 Minute Clinics in 10 states, 65 of them are located within CVS Pharmacy stores providing convenient, timely, cost-effective and high quality care.

We're very enthusiastic about the long-term opportunity we see. Minute Clinic pioneered this concept and key management is staying with the business. They have a proven ability to work collaboratively with the physicians and deliver quality care.

With this acquisition we will be able to deliver this valued health care service to our customers nationwide, and will do it at a pace of expansion that is matched to the opportunity. This may entail investments early on so that we can fully realize the opportunity in the medium and longer term. We will provide more details of our plans in the future. But history shows that it is smart to align with the largest and best provider, which we have done. The acquisition reflects our belief that this concept makes sense for patients, payors and providers.

Now I will turn to our organic new store growth. During the second quarter we opened 56 stores. That included 26 new stores and 30 relocations. We closed five others resulting in net unit growth of 21 stores. Year-to-date we've opened 131 stores including 61 new and 70 relocations. We closed 28 others, resulting in net unit growth of 33 stores.

Our plan for the full year is to open 250 to 275 new 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 about 3.5% again this year.

We will continue to expand our presence in our newer, high-growth markets such as those in Florida and Texas as well as Minneapolis, Phoenix, Las Vegas and Southern California. We will also continue to dense up in our core markets where we see opportunities for incremental share gains.

Now I'll provide a brief PharmaCare update. In the second quarter PharmaCare's total revenues were up 23.5% versus the second quarter last year. This strong growth was primarily driven by the Medicare Part D insurance business as well as the ramp up of the State of Connecticut contract. PharmaCare's Medicare partner Universal American has 445,000 members currently. The program continues to go well and to be accretive to PharmaCare.

Operating profit for the second quarter was up 30.7%, reflecting healthy trends in all aspects of the business and good sales leverage.

In early March, we announced that PharmaCare was selected by DaimlerChrysler to provide comprehensive PBM services to their 280,000 employees, dependents and retirees following a very competitive bidding process. We began providing services this month, and the process has gone quite smoothly. This now serves as an excellent demonstration of PharmaCare's ability to service large contracts. We're currently actively involved in several other RFPs and we will keep you posted on our future progress.

Now let's take a more detailed look at our second quarter financial results. After that I'll provide initial guidance for the third quarter and comment on guidance for the remainder of this year.

Turning to our second quarter income statement, as I said earlier total revenues increased 16% to $10.6 billion. The acquired Sav-On and Osco businesses accounted for approximately one-third of that increase, while the quarter also benefited from a later Easter which shifted more holiday sales into the second quarter.

Our overall gross profit as a percentage of revenues increased by approximately 40 basis points in the quarter to 26.9%. The gross profit rate benefited from these key factors: strength in front store margins, a mix shift toward the higher margin front-end, the increase in the amount of generic drugs dispensed and the initial synergies from the Sav-On Osco acquisition.

As we saw last quarter, these positive influences on our gross profit were partly offset by degradation in margin rates attributable primarily to the dual eligible population shifting from Medicaid to Medicare, as well as the increase in the insurance related products offered by PharmaCare.

Increased utilization should help offset that over time, and of course our third-party paid business in the pharmacy continued to increase as a percentage of pharmacy sales. Third-party sales accounted for a little over 94% of pharmacy sales, up 40 basis points from last year's second quarter.

Turning to expenses our total operating expenses which include depreciation and amortization as a percentage of revenues, were virtually flat year-over-year in the second quarter at 21.3%. We continued to invest solidly in marketing the CVS brand and our exclusive products.

For example, our broadcast media spend more than tripled versus the same quarter last year. Interestingly though, when the integration costs that we incurred in connection with the Sav-On Osco acquisition are removed, our core operating expense as a percentage of revenues improved by over 20 basis points. That is due in large part to the expanded sales leverage we experienced in the quarter despite pressure from generics.

The improvement even includes the additional expense associated with stock compensation due to our adoption this year of FAS 123 R. This amounted to about $13.8 million or 13 basis points in the quarter.

After all this then, operating profit was 5.6% of revenues in the second quarter. This is up about 40 basis points versus last year's second quarter driven by the improvement in sales, mix and gross profit.

Net interest expense was $38 million in the quarter versus last year's second quarter net interest increased $10 million. This was driven primarily by the increase in debt used to finance the Sav-On and Osco acquisition; partially offset by our strong cash flow generation through the last four quarters.

Our tax rate was 39.3% in the quarter within expectations, and our diluted share count was 851 million shares. As I said earlier, diluted earnings per share were $0.40, up from $0.33 in last year's second quarter.

Now let's turn to the balance sheet and cash flow. In the second quarter inventories increased by 24% versus last year, a growth rate higher than that of sales. This was due primarily to the addition of the Sav-On Osco business and the planned initial infusion of inventory into these stores. We continue to move back toward industry-leading inventory turnover in the core business. As you know we are rolling out our inventory systems into the Sav-On Osco stores as part of the systems conversions I spoke about earlier. We anticipate that once we fully convert those stores into CVS Pharmacies our inventories will normalize over a period of about 18 months.

Gross and net capital expenditures were both $379 million, as there was no sale leaseback activity during the quarter.

As for free cash flow, we generated nearly $173 million during the quarter. This was an improvement of about $28 million over the second quarter of 2005 or about 19%, in line with earnings. The largest positive factors were the increase in earnings and the slightly lower level of capital expenditures. This was in line with expectations.

Now I want to provide some initial guidance for the third quarter and revised guidance for the full year 2006. The last time I provided guidance we had not yet closed on the Albertsons transaction, so I provided an earnings estimate for our ongoing business with a separate estimate of the dilution related to the Albertsons acquisition. Because the deal is now closed, I will provide guidance for the combined entity today.

For the third quarter we expect comp store sales growth between 6% and 8%. As Nancy said, we will report July comps on Monday, but sales for the third quarter are off to a great start. At the same time, remember that we reached the anniversary of the former Eckerd stores entering the comp base this August, so the front store comparisons get tougher. That is one factor to consider as you model third quarter comps.

Our initial guidance for the third quarter is for EPS of $0.28 to $0.30 per diluted share, more or less in line with last year's split adjusted $0.30 per share. That includes our estimates around the dilution from the integration of the Sav-On Osco business. To put the dilution into perspective we saw $0.015 of dilution in the second quarter, and we expect another $0.085 to $0.105 for the remainder of the year. That will be somewhat more weighted to the third quarter than the fourth. Like previous quarters this year, this third quarter guidance also includes about $0.01 for the impact of expensing stock options.

For the full year, including the newly acquired stores, total revenues are expected to increase by about 17% to 18.5%. We fully expect to see continued strength in our core business and in the sales turnaround in the former Eckerd stores.

Given the strength we've been seeing in both pharmacy and front end same-store sales we now expect total comp store sales of 6% to 7.5% for the year.

Thanks to the generic conversions we are experiencing favorable front end mix and purchasing synergies we're realizing as a result of the Sav-On Osco acquisition, we now expect our overall gross profit rate to moderately improve over last year.

As for operating expenses, given that we are in the midst of integrating the newly acquired stores, we will have some one-time integration expenses as well as one-time marketing expenses related to grand re-openings. We'll also have increased depreciation related to the remodels as well as increased amortization related to the file bys and favorable leases from the transaction.

Those negative influences on our operating expenses will be partially offset by the sales leverage and operating efficiencies we're achieving from the turnaround of the former Eckerd stores.

When we aggregate all of this and then add the full-year impact of FAS 123 R which is expected to be approximately $0.05 on earnings, we expect to see a moderate increase in operating expenses as a percentage of revenues. As a result, full year 2006 operating profit as a percentage of revenues should slightly decline from last year's level.

Net interest is expected to be close to $215 million. This includes the impact of the Sav-On Osco acquisition, which is expected to be about $120 million. We continue to expect our tax rate to be around 39% and our diluted share count is expected to be about 850 million shares for 2006.

When projecting capital expenditures and free cash flow we are excluding from the calculation the sale leaseback associated with the properties we bought from Albertsons. The properties were acquired, not built, and therefore the proceeds are more appropriately treated as cash related to acquisitions. Therefore capital expenditures net of our typical sale leaseback transactions are projected to be close to $1.2 billion in 2006. This includes about 90% of the $300 million we intend to invest in capital related to the systems conversion and remodeling of the Sav-On and Osco stores. The remaining 10% or so will be spent next year as we complete the integration.

Free cash flow on this basis should exceed $350 million including the dilutive impact of the Sav-On and Osco stores.

At our May Analyst Meeting we told you we expected earnings per share in the range of $1.55 to $1.59 before the impact of the recent acquisition. We also said that we expect $0.10 to $0.12 of dilution from Albertsons. So combined that implied earnings per share guidance of $1.43 to $1.49.

Today, including the impact of the Sav-On Osco dilution we now expect 2006 earnings per share in the range of $1.47 to $1.51, an increase to both the bottom and the top of our previously implied range. We are raising guidance to reflect the over-performance we experienced in the second quarter as well as our continued confidence in the remainder of the year.

So in summary, the second quarter was outstanding in two very significant ways. First, it was an outstanding quarter financially. Total revenues were up 15.8%. Comps increased 8.8%. Gross profit improved 43 basis points. Net earnings grew 22.5%. Diluted EPS rose 21.2% and we delivered over $170 million of free cash flow.

Second, it was an outstanding quarter in terms of building the business. The 2004 acquired stores continue to strengthen. The Sav-On Osco acquisition is complete, and the integration is on schedule. Our persistent organic new store growth continues unabated. The acquisition of Minute Clinic is underway; and we did all this while strongly supporting the core business.

These are the building blocks of continued strong future growth. Thanks for your attention and now I would be happy to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Mark Husson, -HSBC.

Mark Husson - HSBC

Good morning. My one question is on shrinkage. I think maybe you didn't mention it last quarter but for several quarters before you talked about core improvements in shrinkage and also improvements in the Eckerd business. You didn't talk about that in gross margins; does that mean that rich steam is now over or just less impactful?

David Rickard

We're enjoying very good shrink performance and did in the second quarter. Our target this year, as you know, was to achieve about 150 basis points in the Eckerd front store business. We're achieving that. Our target for the core business was more modest improvement, and we're achieving that. So we are pleased with the performance.

I think we will end the year in the Eckerd front store at a level that still provides some opportunity for further improvement, and I think we will see that as we go through next year.

Mark Husson - HSBC

How does it look for Sav-On Osco, even though you've only had it for a few weeks?

David Rickard

It's early days yet. I think there is some modest opportunity there. It's not of the same magnitude as it was at Eckerd.

Mark Husson - HSBC

Thank you very much.

Operator

Our next question comes from John Heinbockel - Goldman Sachs.

John Heinbockel - Goldman Sachs

Two things. With regard to Sav-On Osco, I know the magnitudes are going to be different, but how do you think the timetable on sales improvement will compare to Eckerd front end versus pharmacy? Just speed of recovery? Obviously the magnitude is going to be less.

David Rickard

Yes, I think obviously we need to make the changes to make the stores CVS easy. We will have a lot of that done before Christmas, certainly in key markets, and the rest of it done early next year.

As these things are completed we will begin our marketing grand reopening activity. So I think what I would hope we will see is some good results over the Christmas season and then a build through next year.

John Heinbockel - Goldman Sachs

California, the competitive environment, does that alter the fact there is so many players there, does that alter the thought process particularly on pharmacy recovery?

David Rickard

Well front store should recover faster than pharmacy, as it always does. The pharmacy customers are stickier. I think we'll also see some difference here between California and the Midwest. The California stores are performing better today, putting some top spin on that is probably a little bit easier proposition than lifting more wobbly trends in the Midwest.

John Heinbockel - Goldman Sachs

Just one final thing on Minute Clinic, this does look to me when you look at the model that this can noticeably move the dial on pharmacy comps in the stores that they are in. I know you have about 1,000 to 1,500 stores. Is that all or could this ultimately be in a lot more, 50% or more of the store base?

David Rickard

Minute Clinic is not a scrip play. It is a health service to our customers, and as such we are not going to have it in comp store sales. Now if we end up with tag along business because people are in the stores for other reasons, that will be helpful. But this is primarily a matter of putting an additional health credential in the CVS store to service customers better.

John Heinbockel - Goldman Sachs

Thanks.

Operator

Our next question comes from Meredith Adler - Lehman Brothers.

Meredith Adler - Lehman Brothers

A couple quick questions. Is it fair to assume that as you remodel stores at Sav-On and Osco the marketing will be done on a market-by-market basis the way you did it with Eckerd?

David Rickard

Yes, it will be a similar approach. It seems to have worked.

Meredith Adler - Lehman Brothers

I don't know whether you guys are prepared to talk about this, but is there something else like Minute Clinic that makes sense to add to your stores? Have you looked at putting in labs at all? Is that something you're thinking about? And is there anything else in the world of health care that you see as a logical extension of your existing PBM and specialty pharmacy business?

David Rickard

There really isn't anything, Meredith, that I can think of that is like Minute Clinic, in terms of a pretty obvious major opportunity from an add-on service. You know, some retailers in the global marketplace have tried a host of different services with, at best, mixed success. So there aren't a lot of models of people who have done lab work or various kinds of personal services being profitable and it working out.

I think we are going to maximize the opportunity with Minute Clinic and be happy with that.

Meredith Adler - Lehman Brothers

And outside of the store level? Any comments at all about what is a logical extension to your existing health care businesses?

David Rickard

I am going to leave that to our strategic planners. There is nothing on the horizon right now.

Meredith Adler - Lehman Brothers

I have just one final question; we have definitely seen a pickup in pharmacy scrip volumes, really across the board in the industry. Can you, do you have any sense of what is driving that? Is it all Part D, or are there other things going on that seem to be improving scrip volumes?

David Rickard

Yes, I think it is a majority Part D. When new populations get new coverage they tend to increase utilization fairly dramatically, and I think maybe that is what's going on here. We also see the results of service improvements in CVS and therefore we're seeing some share gains. But there's nothing in terms of allergy or flu that would explain an overall pickup.

Operator

Our next question comes from John Ransom - Raymond James.

John Ransom - Raymond James

As you look out for the margins in PharmaCare, what will you see this quarter representative of what we will see? Or when you roll in Chrysler is that going to have a dampening effect? Thanks.

David Rickard

The margins that we achieved in the second quarter this year are very, very good versus history in the PharmaCare business, so we're very pleased with these margins.

Whether we will repeat exactly at this level I don't know, but I will say that so long as the Medicare Part D business is roughly the size that it is today, assuming that each of the businesses within PharmaCare continues to operate as they are operating, there is no reason that we shouldn't see operating margins pretty close to where they are now, at least for the present.

We had expected, as you recall, that we would see a decrease in their operating margins based on Medicare Part D, because we thought it was going to be a much larger business than it turned out to be.

John Ransom - Raymond James

I know you went over this and you talked faster than I could type but, could you review again just the two or three drivers, it is a fairly sharp sequential decrease in earnings. I know you get a full quarter obviously of Albertsons in there, but other than the ABS dilution what would you say are the two or three main drivers for the sequential earnings outlook for the third quarter? Thanks.

David Rickard

The Albertsons dilution, and I think I said that the expectation is for another $0.850 to $0.105 per share over the balance of the year, but that will be more than half in the third quarter. It will be weighted to the third quarter. In addition to that, the other sort of unusual thing is the adoption of 123 R which is hitting that for another $0.01. So if you set those aside the year-to-year trends are not bad, and certainly consistent with a spectacular year.

John Ransom - Raymond James

So ABS may be $0.05 or $0.06 and another $0.01 for 123 R, so maybe $0.06 or $0.07 would be just the effect of those two factors, is the way to think about it?

David Rickard

Yes, and put that on top of a $0.30 base and you're looking at numbers over 20%.

John Ransom - Raymond James

With third quarter as some of these new generics come in, particularly we are thinking Zocor, is that going to have a noticeable effect on both comps and earnings? I mean comps being a little softer but earnings being a little bit higher or is one drug not enough to move the needle?

David Rickard

I think we are anticipating favorable economics around that. Is it going to be individually enough to be meaningful? Probably not. But in combination with others that are coming alongside it, certainly it is a big influence on what we are forecasting.

John Ransom - Raymond James

Okay. Thanks very much.

Operator

Our next question comes from Mark Wiltamuth - Morgan Stanley.

Mark Wiltamuth - Morgan Stanley

Good morning. I wanted to dig in a little bit on your 90-day retail volumes. With many of these new Medicare programs accepting the 90-day retail and some of your new larger wins on the PharmaCare side, I would think your 90-day retail volumes are growing. If you could just give us maybe a percentage of your total scrip volumes or maybe the percentage of total sales.

David Rickard

We actually don't break that out, Mark. I will say that it is fairly small. It is less than 5%, and it is growing.

Mark Wiltamuth - Morgan Stanley

Can you give as an update on the process on determining what the average manufacturing price is in terms of disclosing that on the websites with the new Medicaid legislation?

David Rickard

Again, we are anxiously awaiting and we are in contact with CMS both directly and through the NACDS, our trade association. But at this point there isn't any further information on that. I don't know when anything is going to be put out, and we certainly at this point don't know the definition that they are going to finally settle on. So I'm sorry, I just don't have information on that.

Mark Wiltamuth - Morgan Stanley

Okay, and just on Medicare Part D, you've got a rising volume story here. Has it been enough to offset the margin drag from the dual eligibles yet?

David Rickard

No, it hasn't, but I think we are still fairly early days here. This population will learn to work with this new program and volumes will grow. So we are on track with where we thought we would be, let's put it that way.

Mark Wiltamuth - Morgan Stanley

Thank you.

Operator

Our next question comes from David Magee - SunTrust Robinson Humphrey.

David Magee - SunTrust Robinson Humphrey

Good quarter. A couple of quick questions. One is as we look at the Minute Clinic's business and the rationale behind that, I guess there may be some pressure to do that concept because others are doing it, as well at retail. Can we get any comfort that the productivity of that space, the profitability of the space would be equal to what you had in that area within the store, so it is seen as an opportunity above and beyond just the defensive aspect of it?

David Rickard

Yes, it will be profitable business. The model has been logically laid out and those stores that today are over two years old are bearing out the model. We are talking about 100 to 150 square feet, so it's not going to be a major change to the economics of the store.

But with CVS being first to market in the markets that we've entered I think we are going to establish ourselves as the company people think of for their total health care needs. But there is no reason to think that this will be less productive than the space today.

David Magee - SunTrust Robinson Humphrey

Secondly, as we look at the generic business over the next couple years, is there anything happening now that gives you any pause with regard to the expected profitability of that business relative to history?

David Rickard

Well, it's always a negotiated thing, and has been and will be so we'll see. It takes pretty good management every day to get good margins in this business. Obviously the Medicaid change, the rate change is going to potentially be damaging beginning in 2007. So we'll just have to keep working away at it.

David Magee - SunTrust Robinson Humphrey

But no major change here in thinking regarding the non-Medicaid business on the generic side?

David Rickard

No, nothing changes our thinking in any kind of structural way. On the matter of Medicaid, I should mention that Louisiana has actually passed legislation now to increase the dispensing fee to a level which will enable us to deliver that service even with the reduced federal reimbursement rates. So they are the first state, and it is good to see, we hope that is the beginning of a trend.

David Magee - SunTrust Robinson Humphrey

Thank you, Dave.

Operator

Our next question comes from Ed Kelly - Credit Suisse.

Ed Kelly - CSFB

Good morning. Congratulations on a good quarter. A couple questions for you on the guidance. If I think about what you've said in terms of the third quarter I get the impression that dilution from Sav-On may be more in the $0.06 to $0.07 range than the $0.05 to $0.06 range. Is that a fair assessment?

David Rickard

Ed, I am not going to give you that. We are not going to break it out. I will say it is more than half of the anticipated dilution for the balance of the year.

Ed Kelly - CSFB

Then in thinking about the full-year number which it looks like you brought up in line with the upside in the second quarter -- which I guess would imply that your expectations for the second half remain unchanged. Is that just because you don't see a reason now to bring the second half up, despite the fact the second quarter was better than what you had planned?

David Rickard

We brought the bottom of the range up $0.04 and the top of the range up $0.02 having beat the quarter by about a $0.01. So I would argue that we've done a little more than that. We are quite optimistic about the year. We're happy with what we've got behind us and looking forward to what is in prospect.

Ed Kelly - CSFB

Lastly for you, you did mention that you see a little bit more room for sales and profit improvement at Sav-On. Could you just go into a little bit more detail in terms of why that is?

David Rickard

Certainly on the sales side we have a bigger opportunity than we thought we would have in the Midwest. Also initial consumer feedback in Southern California market and some of the Southwestern markets is stronger than we thought it would be. So I think there is a sales opportunity there.

We also have obviously the ExtraCare card and our private label products that are blossoming these days. We will put emphasis on beauty and health and that traditionally has given us good results.

We have our various systems that I talked about that we will put in place which lead to convenience for customers and therefore CVS easy conditions. We have found that that will be more of a difference than we originally thought.

Our core categories are performing well across the chain right now. No reason to think that they won't in these new stores, and there is, we believe, a greater opportunity for SKU optimization than we initially thought. Now still early days, and we will work through all those things as time goes on.

In terms of profitability, again as one of the earlier callers talked about, there is a little more shrink opportunity than we thought initially there might be. We have found already purchasing synergies that are greater than we initially planned on. I talked about that back in the May meeting. So we are more bullish about this in the medium term than we originally were.

Ed Kelly - CSFB

Is some of this increase bullishness even post what you thought back at the May meeting?

David Rickard

Sure.

Ed Kelly - CSFB

All right, great. Thanks, Dave.

Operator

Our next question comes from Scott Mushkin - Banc of America Securities.

Scott Mushkin - Banc of America Securities

I just wanted to ask a question about the Minute Clinic. It is my understanding there are some issues in certain states regarding corporations and scrip writing in that type of thing. I wanted to understand a little bit about California, it is one of the states I hear that they have certain rules that you may have to work around.

David Rickard

There are no showstoppers, but different states do have different regulations and that can affect, for example, whether we directly employ the nurse practitioners or whether they are employed by someone else and we buy the service, that kind of thing. But at this point there are no states that I know of where we are going to have an inability to operate. It just would be the legal form we use.

Scott Mushkin - Banc of America Securities

Would California be one of the states you would target, since you have a little more square footage out there, or you are not really to that point yet?

David Rickard

Well, we haven't started there, but certainly that is a huge opportunity.

Scott Mushkin - Banc of America Securities

Just going getting back to the last question on Sav-On Osco, we did a tour down in Southern California and came away and we did some research thinking you guys have a huge opportunity down there in sales per square foot and also maybe margins. As you guys have the asset value figures available to you and there seems to be a lot of work on the remerchandising front, too, I just wanted to know where you are in that process. I know you said you'd started it, but is there a lot more to be done there?

David Rickard

Well first of all, I wouldn't disagree with you. There is opportunity there both on the sales side and on the margin side. We will be getting at it as quickly as we can. I gave you the rough timetable overall. Obviously Southern California is a priority market for us, so we will move as quickly as we can reasonably to get that opportunity moving in the right direction.

But the timetable, here we are in August. We're probably talking later part of this year before we are really doing what we would like to be doing in Southern California. It just takes a little bit of time.

Scott Mushkin - Banc of America Securities

Do you think it is going to take you longer than you thought to clear out some of that merchandise? We saw glass figurines and small appliances, I mean that stuff I assume is all going to go, right?

David Rickard

I hope you bought some.

Scott Mushkin - Banc of America Securities

I have a little glass forest.

David Rickard

We're on pace in Southern California. I can't tell you specifically when glass figurines will change, but we're on pace to where we wanted to be in Southern California.

I am going to take one more question.

Operator

Our final question comes from Bob Summers - Bear Stearns.

Robert Summers - Bear Stearns

On the Minute Clinic would it be reasonable to expect that as you get into the recently acquired stores there, as you touch them this would be a really add on and that is the vehicle to rapidly expand the footprint?

David Rickard

Well, I think that we are thinking about the Minute Clinic expansion more from the standpoint of market opportunity than which kind of store it goes into. The markets are prioritized based on population and need. So yes, we will put Minute Clinic in some of the new stores, and we will expand Minute Clinics in some core CVS stores. But it is based on a market assessment more so than a need to fill space in those stores.

Robert Summers - Bear Stearns

Separately just on the gross margin, if you listed the sources of the expansion in order of magnitude, the generics you listed; would you expect that to move up? The margin expansion that you picked up in general pharma store margin productivity, along with the favorable mix, would you expect that to be retained?

David Rickard

What I try to do is mention the most important factors in margin change, and we don't break them out. We don't give you the quantification of each one. Therefore the order in which I present them isn't necessarily the order of their importance. But having said that, would I expect mix change and generics to be important features going forward? I certainly would.

Robert Summers - Bear Stearns

Thanks.

David Rickard

Thank you very much.

Operator

We have reached the end of the allotted time for questions and answers. Are there any closing remarks?

Nancy Christal

No thanks. We're all set.

Operator

Thank you ladies and gentlemen. This concludes today's conference call. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: CVS Q2 2006 Earnings Conference Call Transcript (CVS)
This Transcript
All Transcripts