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CVS Caremark Corporation (NYSE:CVS)

Q2 2013 Earnings Conference Call

August 6, 2013 08:30 AM ET

Executives

Larry J. Merlo - President and CEO

David M. Denton - EVP and CFO

Jonathan C. Roberts - EVP and President - CVS Caremark Pharmacy Services

Mark Cosby - EVP and President - CVS/pharmacy

Nancy Christal - SVP, Investor Relations

Analysts

John Heinbockel - Guggenheim Securities

Lisa Gill - JPMorgan Chase & Co.

Scott Mushkin - Wolfe Research

Zack Sopcak - Morgan Stanley

Edward Kelly - Credit Suisse

Dane Leone - Macquarie Research

Eric Bosshard - Cleveland Research

John Ransom – Raymond James & Associates, Inc.

Frank Morgan - RBC Capital Markets

Robert Willoughby - Bank of America Merrill Lynch

David Magee - SunTrust Robinson Humphrey

Meredith Adler - Barclays Capital

Operator

Ladies and gentlemen, thank you for standing by and welcome to the CVS Caremark Second Quarter Earnings Conference Call. During the presentation, all participants will be in a listen-only mode. Afterwards we will conduct a question-and-answer session. (Operator Instructions) As a reminder, this conference is being recorded, Tuesday August 6, 2013.

I’d now like to turn the conference over to the Senior Vice President of Investor Relations, Ms. Nancy Christal. Please go ahead.

Nancy Christal

Thank you, Frank. Good morning everyone, and thanks for joining us. I’m here with our President and CEO Larry Merlo, who will provide an update on the business. After Larry, our Executive Vice President and CFO, Dave Denton, will review financial results and guidance. John Roberts, President of PBM, and Mark Cosby, President of our retail business, are also with us today and will participate in the Q&A session following our prepared remarks.

During the Q&A, please limit yourself to no more than two questions so we can provide more callers with the chance to ask their questions. Just before this call, we posted a slide presentation on our website that summarizes the information you will hear today, as well as key facts and figures regarding our operating performance and guidance. I encourage you to take a look at that. Additionally, we plan to file our quarterly report on Form 10-Q by the close of business today and it will be available through our website at that time.

During this call, we’ll use some non-GAAP financial measures when talking about our Company’s performance, mainly free cash flow, EBITDA and adjusted EPS. In accordance with SEC regulations, you can find the definitions of these non-GAAP measures as well as reconciliations to comparable GAAP measures on the Investor Relations portion of our website. And, as always, today’s call is being simulcast on our website and it will be archived there following the call for one-year.

Now I have one key date to announce this morning. Please note that we will host our Analyst Day on the morning of Wednesday December 18, in New York City. At that time, we will provide 2014 guidance as well as a comprehensive update on our growth strategy. In addition to Larry and Dave, you will have the opportunity to hear from additional members of our senior management team.

We plan to send invitations with more specific details via email by next week. So please save the date. Again, that’s Wednesday December 18th. If you don’t receive an invitation and would like to attend, please contact me at your earliest convenience.

Now before we continue, our attorneys have asked me to read the Safe Harbor statement. During this presentation we’ll make certain forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially. Accordingly, for these forward-looking statements, we claim the protection of the Safe Harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. We strongly recommend that you become familiar with the specific risks and uncertainties that are described in the Risk Factors section of our most recently filed Annual Report on Form 10-K and in our upcoming quarterly report on Form 10-Q.

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

Larry J. Merlo

Well, thanks Nancy. Good morning everyone and thanks for joining us today. Let me begin by saying we’re very pleased with our strong operating results enterprise wide in the second quarter. Operating profit increased 15% overall, with the PBM growing about 32% and the retail business growing nearly 9%.

Adjusted earnings per share from continuing operations for the quarter came at $0.97, that’s at the high-end of our guidance and we also generated a substantial amount of free cash, totaling $1.7 billion for the first half of ’13 and we remain committed to our disciplined approach to capital allocation, continuing to focus on returning significant value to our shareholders through both dividends and share repurchases.

Now considering our strong operating results to-date and all other factors affecting our outlook for the remainder of the year, we’re narrowing our earnings guidance for 2013 to a range of $3.90 to $3.96. And that’s from our previous range of $3.89 to $4. And while Dave will provide more details around the drivers of our revised guidance during this financial review, I do want to mention that a key driver of lowering the high-end of our guidance range is a higher than forecast weighted average share count.

Now as we announced last week, we’ve reached an agreement in principle with the SEC to resolve its investigation of various Company matters that occurred back in 2009. During the second quarter we engaged in extensive settlement negotiations with the SEC and as a result we suspended our share repurchase activity until we’ve reached the agreement in principal.

Now that it has been reached, we plan to resume our repurchasing efforts this quarter and we still expect to complete the $4 billion in share repurchases that we had planned for this year. So if you do the math with our share repurchase is now back half way then as opposed to recurring ratably throughout the year as we had originally anticipated. This timing shift is estimated to dampen the accretive impact of the share repurchase program for the year by as much as $0.04.

Now despite this timing shift in share repurchases, our updated guidance for ’13 equates to excellent adjusted EPS year-over-year growth in the range of 13.5% to 15.25%. So we’re still anticipating a very successful 2013.

Now let me provide a brief business update and I will start with the 2014 PBM selling season. Our model continues to resonate well in the marketplace and we’re very pleased with our results to-date. Gross wins for 2014 are $4.4 billion to-date, while net new business stands at $1.7 billion. And that’s despite lower RFP activity this season.

We’ve been successful across all segments and this net new business excludes any impact on our Med D PDP business, which I will come back to in a minute. There are still some modest opportunities remaining for 2014, most of those are on the employer side and work is already underway for the ’15 selling season. As for renewals, we’ve completed almost 50% and have a retention rate of 97%, so overall again we’re very pleased with our selling season to-date and confident that we continue to be well positioned in the marketplace with our unique products and services.

So I thought I'd just spend a minute touching on what clients have been focused on this selling season, and one area of both employer and health plan client concern is managing their specialty spend across the pharmacy and medical benefits. And as a result, we are seeing interest across our entire suite of specialty capabilities including utilization management programs, specialty guideline management, formulary strategies as well as our site of care and medical claims added in products, and we believe our differentiated approach to specialty is driving lower overall costs while improving health and providing value for both payers and patients.

Our specialty revenues grew 19% year-over-year in the second quarter and that was driven by drug price inflation, utilization, new product launches and new PBM clients. At our continued focus on managing specialty cost per client will help us continue to drive our share of specialty going forward. Now in addition to managing specialty costs, our clients are also focused on the changes resulting from the Affordable Care Act and we continue to believe that Medicaid expansion and individual small group coverage and the public exchanges will be a long-term secured growth trend, resulting in a significant amount of new coverage for people who have previously been uninsured.

Now details around the exchanges including planned participants, planned designs and rates, they continue to emerge and we believe we are very well positioned given our retail footprint along with our existing relationships with health plans and managed Medicaid plans. We've had a lot of dialogue with health plans about collaborating with us on innovative programs that support their overall exchange strategy and these discussions often encompass how they can partner with us across our retail touch points while tapping into our direct-to-consumer marketing expertise to attract and retain members.

We also discussed our medic clinic in support care management and wellness programs for the newly insured and how a plan can maximize the benefits from all of the unique clinical and member engagement programs that we can offer through our CVS pharmacy network, and we believe all of the activity around the exchanges will serve as a catalyst for broader collaboration opportunities with our health plans.

I do want to touch briefly on the PBM streamlining initiative which, as you're aware, launched in late 2010 and is near completion. We are on track to achieve the expected annual savings run rate of 225 million to 275 million in 2014. And as for the consolidation of adjudication platforms, we have now completed 11 waves of migration and we continue to leverage our resource and technology investments to refine our processes and improve efficiencies resulting in moving more clients and limiting potential disruption in each of those successive ways. 85% of our business is scheduled to be on the destination platform by yearend, so overall the streamlining initiative has been very successful.

So let me turn to our Medicare Part D business and just a quick review, we currently serve 6.8 million members in our Medicare Part D business and we do that through the health plans we serve as well as our individual Silver Script PDP including EGWP. Our individual PDP currently serves approximately 3.4 million of our 6.8 million members. Now last week we received the preliminary benchmark results from CMS for 2014 and we're pleased with the outcome. Silver Script was below the benchmark or within the de minimis range in 31 of the 34 regions.

We missed the benchmark only in one small region in which we qualified today where we have about 2,000 lives that will be subject to reassignment to another plan. So aside from any normal attrition, these benchmark results should enable us to retain the vast majority of the auto-assigns we currently serve.

Let me update you on where we stand with respect to the sanction imposed by CMS earlier this year. And as you know, the sanction prevents us from marketing our Silver Script PDP or enrolling new members. And as we've said, our goal has been to complete our remediation efforts so that the sanction would be listed before the annual enrollment period begins for the '14 plan year.

Now given some additional complexity that we uncovered while working to resolve the issues along with our strong commitment to ensuring that we are ready to operate at best-in-class levels, we have revised our plan and expanded the timeline for remediation. And based on our latest estimate, we now expect our remediation efforts will be completed sometime near the end of the year. Once our remediation has been completed, CMS will conduct its review to determine whether the issues have been fixed, are not likely to recur, and when the sanction will be removed.

So what does all that mean? Well given this current timeline, we do not expect that we will be able to participate in the 2014 annual enrollment period when it begins in October. In addition, until the sanction is lifted, we do not expect to receive new auto-assigns from CMS for 2014 in the regions where we qualify. The sanction primarily affects our individual Silver Script PDP which as I mentioned has about 3.4 million lives. It does not affect the Medicare Part D business through the health plans we serve and as a reminder, our EGWPs are also not affected by the sanction since we continue to operate under a limited waiver from CMS that allows us to enroll newly eligible retirees into our existing plans.

So let me put some parameters around the situation. First of all, assuming that sanction is not listed prior to the end of the year, here are a few factors that we can roughly estimate at this point. First, based on the preliminary results of our bid, we do expect to be able to retain the vast majority of our current 2.5 million low income subsidy enrollees. Second, based on the historic competitiveness of our products we do expect to retain a majority of our 900,000 non-low income subsidy chooser lives and these enrollees have previously chosen Silver Script as their PDP.

Third and consistent with a typical Medicare Part D plan, there will be some normal attrition of our enrollees due to death, relocation and other normal member eligibility factors and we estimate this attrition will continue at the rate of roughly 25,000 lives per month. And in January, rates of attrition are generally a bit higher after they have gone through their typical decision processes during the annual enrollment period.

So to put some preliminary numbers around this, again using historical attrition rates we estimate our PDP lives could decrease by about 350,000 lives leaving us with approximately 3.1 million lives in our individual Sliver Script PDP by the end of January '14. So clearly the sanction limits our ability to expand our Med D lives for '14 and we will continue to work diligently to have the sanction lifted as soon as possible in order to be able to enroll new members and participate in the individual age-in process next year in the regions where we have qualified.

Now obviously we take this issue very seriously. We have devoted additional resource to fully meet the needs of this important customer base. And while this does present a challenge for '14 in our Medicare Part D business, it's important to note that we still see significant opportunity to grow our Med D business over the long term and the remediation steps that we are taking will allow us to do just that.

Now moving on to the retail business, we had another very solid quarter. Total same-store sales increased 0.4%, revenue growth was muted by the impact from new generics which had a 670 basis point negative impact on pharmacy comps in the quarter. Pharmacy same-store sales increased 0.8% with pharmacy same-store scripts increasing 1.8% when counting 90-day scripts as one and increasing 5% when counting 90-day supplies as three scripts. We have seen a greater than historical rate of conversion to 90-day from 30-day scripts which is driven by the strong growth in our maintenance choice programs.

Our retention of the scripts gained during the impasse between Walgreens and Express Scripts continues to exceed our expectations. And as you know our goal is to retain at least 60% of the scripts gained during the impasse and given our outperformance to-date, we remain very confident that we will continue to retain at least 60% of the scripts in '13.

As for the front store business, comps decreased 0.4%. It was impacted largely by the shift in the Easter holiday from April of '12 to March of '13 which had a negative impact to front store comps of about 65 basis points. And during the quarter pharmacy traffic was up while the front-store traffic was down, and at the same time average front-store ticket continued to increase.

And I think it's important to note that despite the slight decrease in front-store comps our front-store margins expanded nicely in the quarter and we continue to focus on driving more profitable sales through the target of promotions we offer to extra care cardholders, and we’re focused on increased personalization to accomplish this.

And to gain a bigger share of wallet we have identified customer specific opportunities for increasing frequency of both the shop and the basket size and to drive this conversion we continued to dramatically expand our personalized offers that are delivered at the point of sale and in the second quarter alone we issued more than three billion such offers and we’ve also significantly expanded our personalized offers that we deliver via email.

So extra care provides extraordinary precision due to the scale of customer engagement along with the 15 years of data that has provided us unique insights into customer behavior trends and we continue to use these valuable insights from our extra care program to drive the evolution of how we tailor our stores to better meet local needs. And our latest data shows that we continue to gain market share.

Our front-store market share growth in the second quarter versus a year ago was 71 basis points and 8 basis points and that’s when compared to drug and multi-outlet competitors respectively. As for new stores we opened 47 newer relocated stores, we closed one during the quarter resulting in 22 net new stores in the second quarter and this puts us on pace to achieve our 2% to 3% square footage growth target for the year.

Let me turn briefly to MinuteClinic which once again recorded exceptional revenue growth with sales up 32% versus the same quarter last year. We opened 35 net new places in the quarter and in Q2 with 684 clinics in 25 states in the District of Columbia. Our expansion plans called for the opening of 150 clinics this year and to end ‘13 with just under 800 clinics with around 30% of our expansion this year in new markets.

Our longer term goal is to create a national primary care platform to provide integrated high quality care that is convenient, accessible and affordable and new services will continue to be developed to address the shortage of primary care physicians and to support patients impacted by the epidemic of chronic disease and our positioning further supports that primary care medical home model along with connectivity through electronic health records to numerous health system alliances.

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

David M. Denton

Thank you, Larry and good morning everyone. Today I’ll provide a detailed review of our second quarter results and then I’ll provide guidance for the third quarter and update our full-year 2013 outlook. But first I’d like to highlight how we have been enhancing shareholder value through disciplined capital allocation program. During the second quarter, we paid approximately $276 million in dividends bringing our year-to-date payout to $553 million. Given our continued strong earnings outlook this year we remain on track to achieve our targeted payout ratio of 25% by the end of this year. And as a reminder that is two years ahead of schedule that we laid out back in 2010.

Additionally, we repurchased approximately 6.4 million shares for approximately $355 million in the quarter at an average price of $55.39 per share. And as Larry indicated we ended the quarter with more shares outstanding than we had planned because of our decision to suspend share repurchases until we were more fully certain of the outcome of our negotiations with the FEC. And despite our slower pace in the second quarter we still expect to complete $4 billion of share repurchases in ’13 consistent with our original plan and note that the guidance we're providing today assumes the $4 billion of share purchases will be completed this year.

So between dividends and share repurchases, we have returned more than $1.3 billion to our shareholders through just the first half of this year and we continue to expect to return approximately $5 billion for the full-year. We have generated approximately $1.7 billion of free cash in the first two quarters of ’13 and improving our cash generation capabilities by enhancing our working capital management remains an area of focus for us, and we have made excellent progress over the past several years in reducing our cash cycle.

As I pointed out on our last call we have taken nearly two weeks out of our cash cycle over the course of the last 10 quarters. Inventory has seen the greatest amount of improvement but all areas have benefited from our focus on extracting value from our balance sheet and we remain committed to further improvements as we look further into the future.

And as previously highlighted on our last earnings call we noted that we may have some timing issues with respect to CMS payables and receivables that may affect our free cash flow delivered for the year given the issues we experience following our Med D plan consolidation. While we're maintaining our guidance for free cash flow between $4.8 billion and $5.1 billion this year we're still working to offset this headwind through our free cash flow targets and will continue to update you on our progress as we go forward.

Turning to the income statement, adjusted earnings per share from continued operations came in at $0.97 per share at the high end of our guidance. GAAP diluted EPS was $0.91 per share and as we’ve said weighted average share count was higher than planned but the impact of that in the second quarter was negated by a slightly more favorable tax rate and good expense management within the corporate segment.

Now let me quickly walk you through our results. On a consolidated basis, revenues in the second quarter increased 1.7% or approximately $534 million to $31.2 billion. This was near the top of our guidance range. Solid increases in revenues in both the PBM and retail segments were offset only slightly by the increase in inter-segment activity versus primarily driven by the increase in adoption of our Maintenance Choice program.

Within the segments, PBM net revenues increased 2% or approximately $377 million to $18.8 billion. This growth was approximately 55 basis points above the high end of our guidance. The out-performance was driven by higher than anticipated claims volume, primarily from Maintenance Choice and Medicare Part D utilization.

Claims growth year-over-year was driven by new client wins and increased membership within our existing book of business, especially pharmacy was also a key driver. This was largely offset by the significant impact from new generics. The PBMs generic dispensing rate increased nearly 275 basis points versus the same quarter of last year to 81%. Note that the year-over-year increase is down sequentially from last quarters year-over-year increase by about 125 basis points and this is the trend that should continue throughout the year given that fewer generic conversions are expected for the remainder of this year versus last year.

Now revenues in the retail business increased 1.9% in the quarter or approximately $294 million to $16.1 billion. New generic introductions also negatively impacted retail sales with our retail GDR increasing approximately 280 basis points versus the second quarter of ’12 to 82%. Now offsetting that phenomenon was the growth of our Maintenance Choice program was contributed to sales performance coming in near the higher end of expectations.

Turning to gross margin, we reported 18.7% for the consolidated company in the quarter, an increase of approximately 95 basis points compared to Q2 of ’12. Within the PBM segment, gross margin increased by approximately 90 basis points versus the same quarter of LY to 5.1% while gross profit dollars increased approximately 24% year-over-year.

This increase year-over-year was primarily driven by increasing in GDR, higher volumes from new clients and new members and better acquisition costs and rebate economics. These positive margin drivers were partially offset by price compression and remediation and operating cost in our Medicare Part D business.

Gross margin in the retail segment was 31% also up about 90 basis points over LY, as with the PBM this improvement driven primarily by the increase in GDR and also by improvement in front-store margins. Additionally gross profit dollars increased 4.8% year-over-year within the retail segment. Expense leverage was also impacted by the growth in GDR while the de-leveraging was optically negative the growth of expense dollars was within normal parameters.

Total operating expenses as a percent of revenues increased approximately 20 basis points from Q2 of ’12 to 12.4%, while total SG&A dollars grew by just 3.4%. The PBM segments SG&A rate was essentially flat to LY at 1.5%. The benefits from PBM's more efficient cost structure versus the same quarter last year was basically offset by the deleveraging effect of an improved GDR and cost related to remediation efforts within Medicare Part D.

From the retail segment, SG&A as a percent of sales increased to approximately 25 basis points to 21.1%. And as expected, this too is mainly due to a deleveraging effect of the growth in generics. Overall, SG&A expenses grew by 3.2%. Within the corporate segment, expenses were virtually flat year-over-year at $176 million.

Now adding it all up, operating margin for the total enterprise improved to approximately 75 basis points to 6.3%. Operating margin of the PBM improved by approximately 80 basis points to 3.6% while operating margin at retail improved about 60 basis points to 9.9%.

For the quarter, we were comfortably within the high end of our guidance for operating profit growth in both retail and the PBM segment. Retail operating profit increased a very healthy 8.6% while PBM operating profit was once again solid growing at 32%.

Now going below the line of a consolidated income statement, net interest expense in the quarter declined approximately $5 million from last year to $127 million and the debt refinancing we did in the fourth quarter last year was the primary driver of the decrease.

Additionally, our effective tax rate was 39.1% which is slightly better than expected. And as we discussed our weighted average share count was higher than anticipated, about 1.24 billion shares for the quarter.

Now let me update you on our guidance. I'm going to focus on the highlights here but you can find additional details of our guidance within the slide presentation we posted on our website early this morning. As previously stated, we narrowed our EPS range for the full year of '13 to reflect our strong operating results and to incorporate our current plans with timing of share repurchases.

We are taking down the top end of the PBM operating profit forecasted growth to reflect some incremental remediation costs related to our Medicare Part D sanction. However, these costs are expected to be more than offset by the increase in our retail operating profit growth forecast, all of which is reflected in our revised guidance.

All things considered, we've raised the low end of guidance by $0.01 and lowered the high end by $0.04. We currently expect to deliver adjusted earnings per share in 2013 in the range of $3.90 to $3.96 per share reflecting excellent year-over-year growth of 13.5% to 15.25% after removing the impact related to the early extinguishment of debt in 2012.

GAAP diluted earnings per share from continuing operations is expected to be in the range of $3.65 to $3.71 per share. We've narrowed our top line outlook and now expect consolidated net revenue growth of 2% to 3%. This guidance reflects the solid performance across the enterprise year-to-date driven by better volumes as well as inflation.

We've raised the PBM segment's revenue guidance to 2% to 3% growth while narrowing retail's expected revenue growth to 2.25% to 3.25%. We expect total comp stores same-store sales of 1% to 2%. We are maintaining our prior guidance for script comps of 1.5% to 2.5%.

Now we are also introducing a new guidance metric, adjusted script comps, adjusting 90-day fills for the 30-day equivalents. Given the high rate of conversions from 30-day fills to 90-days fills, we believe this is a better indication of pharmacy performance and we expect adjusted script comps to be in the range of 4% to 5%.

As I said, guidance for operating profit growth in our retail segment has been raised while we have brought down the high end of the range for the PBM segment. We now expect retail operating profit to increase 9% to 10% year-over-year and PBM operating profit to increase 11% to 13%.

We now expect net interest expense between $500 million and $510 million, a slight increase over our prior guidance. We are increasing our weighted average share count forecast to 1.23 billion shares up from 1.22 billion. And as I said previously, our free cash flow guidance for the year remains in the range of $4.8 billion to $5.1 billion.

In the third quarter, we expect adjusted earnings per share to be in the range of $1 to $1.03 per share reflecting growth of 17% to 21% versus the same period of LY. GAAP diluted EPS from continuing operation is expected to be in the range of $0.94 to $0.97 in the third quarter.

Within the retail segment, we expect revenues to increase 4% to 5.5% versus the third quarter of last year. The revenue increase will be driven by solid volume growth while we expect a sharp decline and a dampening effect from new generic introductions.

We expect same-store sales of 3% to 4.25%. Script comps are expected to increase in the range of 1.25% to 2.25% while adjusted script comps are forecasted to be 3% and 3.75% to 4.75%. Within the PBM, we expect revenue growth between 4.5% and 5.5% driven by volume growth and inflation and also benefiting from the decline in the effective new generics.

Operating profit in the retail segment is expected to grow 7.5% to 9% in third quarter while operating profit in the PBM segment is expected to grow 19% to 23%. So again, we expect another very solid quarter.

And before I turn it back over to Larry, I want to touch on the quarterly flow of profits in the back half of '13 and particularly within the PBM. If you take the full year and third quarter guidance that I've just laid out and plug that into your models, you might note that our implied Q4 operating profit growth in the PBM is anemic. Here are few points you should keep in mind that should help you better understand why Q4 is somewhat atypical this year.

First, we've consistently stated the positive impact of new generics in 2013 will be front half loaded given the timing of break open generics in 2012 and the resulting lap affect into the first half of '13. We'll be lapping the impact of the substantial amount of break open generics, so the comparison year-over-years are tough.

Second, the timing of Medicare Part D profits in '13 is turning out to be different than 2012 due to a number of factors. These include the impact of a sanction, changes in earned rebates in the mix of the business across our choice versus basic products. And as a result of these factors, we are seeing a shift to profitability this year from Q4 which has historically been our most profitable Med D quarter into Q3.

So while the year and even the back half of this year remains very profitable, the comparison year-over-year in the third and fourth quarters are not expected to be typical. And I hope this helps put in context the full profits in both Q3 as well as Q4.

So in summary, the second quarter was a very strong quarter and we continue to expect strong earnings growth for the year. And I want to assure you that we remain committed to utilizing our substantial cash generation capabilities to deliver shareholder value.

With that, I'll turn it back over to Larry.

Larry J. Merlo

Okay, thanks Dave. Again, we're very pleased with our strong operating performance this quarter along with our strong outlook for the 2013 year. And despite the near-term challenges in our Med D operations, we do remain excited about the long-term opportunity for the growth in the Medicare business.

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

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). Our first question comes from the line of John Heinbockel from Guggenheim Securities. Please proceed.

John Heinbockel - Guggenheim Securities

So, Larry, two things I wanted to touch on, the first is the health personalization effort. Where do you guys stand with that in terms of being fully functional? And then what are you seeing with regard to redemption of your offers and vendor support for that program? And then finally, do you think that has a greater impact will have a greater impact on top line or gross margin?

Larry J. Merlo

Yeah, John let me take the second half of your question and then I will ask Mark to come back to your first points. And John, I think consistent as we have talked many times, and as I mentioned in my prepared remarks, we’ve continued to use ExtraCare to create value for customers and to gain a bigger share of wallet. And we’re always experimenting and working to find that appropriate balance in terms of driving profitable sales and so there is a sales margin equation there and we continue to finance our strategy with the goal of we’re not going to chase empty sales out in the marketplace.

I will say in response to your second question that I think that the way we use ExtraCare benefits margin as much as sales, because you’re not going to target the cherry pickers in terms of your ExtraCare offering. So I think that over time, the supplier community has grown to appreciate the value that ExtraCare brings them in terms of their ability to target specific customers based on whatever the product is and whoever they define as the user for their products. So, they find ExtraCare as a very effective tool versus some of the other tools that are available in the marketplace, like the free standing, coupon inserts. And as a result I think that we’ve been able to demonstrate to them a higher return on their investment as a result of higher redemption rate. So, I will let Mark talk a little bit about where we’re at this personalization and some things we’ve coming online later this year.

Mark Cosby

Thanks, Larry. One of our founding truths really within the retail world is personalization and most of our initiatives are geared around bringing that to life. The foundation of that is ExtraCare as Larry talked about earlier, we do have the biggest program by a long shot, but issuing cards really is the easiest part. The tough part is behavior change and that’s where the 15 years of history that we have in place has really helped us with improving the productivity of the program over time. We know it works, we know it doesn’t work and that helps us improve the sales and profits over time. I think the other thing you all know, we do track our ExtraCare program religiously versus our competition in all of our customer satisfaction scores from a loyalty perspective are higher.

With that said, we’re not resting on our laurels. Earlier this year we did rollout pharmacy and health rewards program, 3 million folks now enrolled in the program. It’s very distinct from what you find out in the open market. It’s an opt-in program where we can motivate our highest value customers. Its individual based versus household based. So it’s powerful for encouraging adherence and retention and all of our customers can participate in the program regardless of the payment structure.

The biggest thing that we do earlier this year around personalization is a program we talked conversion. Its customer specific offers with two big goals in mind. They’re what we call conversion offers, which encourage customers to shop broadly across the store. So, if they shop on a couple of categories, we try to work on them across the entire store and then we have it called share of wallet offers where we encourage our customers to spend more on the categories that they already shopping it. And every customer receives both of these types of offers. This program is new this year and has been very successful for us.

Also doing a lot to try and improve how we deliver the offers, our email program is up 2x more it was, at this point last year. We also rolled out earlier this year a big program against our ExtraCare center, which is what our bloggers call, our Magic Coupon Machine. We’ve a lot of programs in place that have led to a 40% improvement in the usage of that program and it is one of our biggest conversion drivers because the coupons come out in advance of the transaction, not after the transaction, leading to a 15 times increase in redemption versus a standard coupon.

And then later this year, probably the biggest thing we’ve coming out is what we’re calling our personalized circular, which will take our traditional mass circular approach and do a circular for each individual customer and we will deliver that mechanism both online and via mobile application. So tremendous amount happening in the personalization front, it is one of our foundation principles and we’ll continue to take it to the next level.

John Heinbockel - Guggenheim Securities

Okay.

Larry J. Merlo

And John, just in terms of your other question around what do we think around redemption. We are seeing redemption on a per customer basis, up year-over-year.

John Heinbockel - Guggenheim Securities

Okay. Okay, thank you.

Operator

Our next question comes from the line of Lisa Gill from JPMorgan. Please proceed.

Lisa Gill - JPMorgan Chase & Co.

Thanks very much and good morning everyone.

Larry J. Merlo

Good morning, Lisa.

Lisa Gill - JPMorgan Chase & Co.

I just had some questions around the selling season. Larry or if Jon is there, can you just talk about your expectations for 2014, your ability to sell Maintenance Choice 1.0, 2.0? And I think Larry you’ve talked about specialties specifically in the quarter. Can you talk about where you’re on penetration for specialty and where you see the opportunity as we move into 2014?

Jonathan C. Roberts

Yeah. So, Lisa as we look at the selling season, and if you disaggregate the overall healthcare spent, that a payer see, so they disaggregate inpatient spending, outpatient spending, pharmacy spending – pharmacy is now one of largest categories of cost and those is a high priority for payers. When you look at pharmacy, specialty is an increasing focus and it is now one of the top priorities that we’re – and we’re seeing trends of around 20% and in some cases it’s higher.

So our capabilities in specialty are resonating extremely well, with both our existing clients as well as prospective clients and have led to some of our success of selling season. So we’ve capabilities to manage the specialty spend not only in the pharmacy benefit, but also in the medical benefit and as you’re aware about half of the specialty spend is covered in the pharmacy benefit and the other half is covered in the medical benefit. In our new integrated specialty model also has appeal similar to Maintenance Choice and we rolled out across all of our CVS stores, beginning early next year.

So you combine these capabilities with all of our integrated capabilities such as Maintenance Choice Pharmacy and MinuteClinic, payers are seeing the value of our integrated model. So specifically with Maintenance Choice we’re at about 16.5 million members. We introduced Maintenance Choice 2.0 this year. We see a runway to grow that to 30 million members. So, we’re very excited about that. When we look at our penetration in specialty, when you look at our employer book of business, we have most of their specialty spend. We are looking to expand our reach into the medical side that today we see as mostly unmanaged. When you look at our health plan space, they have multiple providers and we think with our capabilities we can get them to reduce the number of providers they have and grow our shares. So, we’re very excited about both of those products and all of our capabilities or we’ve had a lot to do with our success on the selling season and also in retention of our existing clients.

Lisa Gill - JPMorgan Chase & Co.

So Jon, when we think about the 2014 selling season in specialty, are you doing anything around the formulary? I know you’ve been successful on the formulary side for just regular chemical compounds, but what are you seeing on the specialty side? Are you trying to see whether you can have multiple manufacturers competing against each other for a class and therefore that’s something that you can bring to the table? I mean, clearly prices keep going up on specialty, but what are some of the things that you’ve won business on that you’re a little bit differentiated in the marketplace. It sounds like one of the things has been able to pick up the prescription at a CVS store, but what are some of the other things?

Larry J. Merlo

Yeah Lisa, I think as it relates to formulary and specialty, we have begun that process. If you look at category like growth hormone, we have brought a formulary process that exits in the traditional spend to specialty in that regard and I think the opportunities there will continue to grow over time as more products enter the marketplace that do not have clinical differentiation.

Lisa Gill - JPMorgan Chase & Co.

Can that drive the profit – is that a profit drive over the next couple of years? I mean, clearly it’s a saving driver for your customer, but is it also a profit driver for CVS?

Larry J. Merlo

Yeah, I think it’s – I mean as you know Lisa the client gets a disproportionate share of those rebates and – but well that’s the case and that definitely a cost savings for the client. There is enhanced profitability for the business as well.

Lisa Gill - JPMorgan Chase & Co.

Great. Thank you.

Larry J. Merlo

Thanks, Lisa.

Operator

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

Scott Mushkin - Wolfe Research

Hey guys. Thanks for taking my questions. I really wanted to delve into the free cash flow, if I could for a little bit, we’re kind of behind this year Dave, and I was wondering if you can maybe walk me first to how we get to about 5 billion, maybe there's some timing issues there? The second question is with the CMS issues and other things, it sounds like maybe we won't get there and I guess my question around that is that's just a timing issue? Will that money show up eventually or is it more of a permanent factor? And then the third thing on cash flow is if CMS and the way things are going with that and kind of hurting cash flow a little bit, does that have impacts as we look into '14?

David M. Denton

Okay. Thanks. Great question. Just a couple things. First and foremost, as you looked kind of year-over-year through the first half of this year compared to last year, if you recall last year, the timing of payments for CMS happened right on the quarter end kind of in advance of the next quarter. So there was – last year for the first half, free cash flow was somewhat inflated compared to a normal trend. So you have kind of tough comparisons from that standpoint. So that's just a flip between first half, second half. So that's no big deal, if you will. Keep in mind as we think about free cash flow yield for this year will not change our guidance of 4.8 to 5.1. And there's kind of two items that are kind of in play here. The first is from a CMS payment cycle is a bit longer for closed plans and upon the first of this year, we consolidated our plans at the beginning of this year and the result of that is one of our historical plan is considered closed. So this is just simply a timing issue. As we think about that receivable probably flowing not into '13 but probably into the first half of '14. The second item is due to our service challenges in the first of the quarter where we wanted to insure that all members had adequate access to pharmacy despite some of the system issues that we were experiencing. So to ensure that that access happened with all of our members, some additional utilization took place or issues putting pressure on our cash flow delivery. Having said all that, most of that is a timing issue and we're working hard to make sure that we get within our guidance range this year. So I hope that puts that in context, Scott.

Scott Mushkin - Wolfe Research

Yeah, and it even sounds like it doesn't have real much impact – I mean timing issues aside, '14 is really not impacted by these same issues or is that…?

David M. Denton

That is correct, Scott.

Scott Mushkin - Wolfe Research

Okay, so that's perfect. That would be great and I really appreciate the clarity there. And then the second question I had was for Mark. It seems like we have lots of flow into or traffic that's going into these pharmacies likely to pick up again next year with how you guys are positioned with the Affordable Care Act. So I guess what I'm looking for and I think if I was going to say that the front end was a little weaker than we anticipated, how do you harness all that traffic into maybe above – not same, profits are good but getting those people to utilize the front end and maybe drive incremental profit as we look to '14? And then I'll yield. Thank you.

Mark Cosby

Scott, I mean I think the answer around that is consistent with what you've heard us talk about in the past. As we introduce new customers to CVS pharmacy and if that point of introduction comes from the pharmacy first, we have a unique opportunity to introduce them to the other products and services available across the entire store. So getting them enrolled in extra care, okay, a prime example of that and I think that that kind of becomes the pathway to engaging those customers in a differentiated way that allows us to harness some front store impact.

Scott Mushkin - Wolfe Research

Thanks everybody, appreciate it.

Larry J. Merlo

Thanks, Scott.

Operator

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

Zack Sopcak - Morgan Stanley

Hi. Good morning. Thanks. This is Zack for Ricky and thanks for the color. I wanted to ask another follow-up question on the front store. The negative for traffic in the quarter, I was just curious, is this a trend that you see continuing? And was this in line with your expectations given that you were expecting to trade for some bigger basket size? And also some color around your market share on the front store for the quarter?

David M. Denton

Yes, Zack, in terms of customer traffic it was pretty much in line with what we expected recognizing that there was a calendar shift with Easter that negatively impacted traffic. And I think as both Mark and myself had mentioned earlier, we are certainly mindful of how we manage that balance between driving traffic and managing promotional spend with those sales and margin in mind. And we look to bring I'll say a surgeon's knife so to speak in terms of finding that right balance. So, we continue to see a very cautious consumer out there and we don't see that changing throughout the balance of this year.

Zack Sopcak - Morgan Stanley

Okay, great. Thank you. And on a completely separate topic, there have been some rumors about the quarter of you guys being tied up and being interested in a European partner without, I guess, addressing those specific rumors. Could you just refresh us after having expanded a little bit in Brazil what your thoughts are on global and particularly in the European market?

Larry J. Merlo

Yeah, Zack, we're not – I mean as you know we have a policy of not commenting on rumors on the marketplace, but as we've discussed in the past around our international strategy, it was not a question of – it was more of a question of when and where. And as you know with this share we acquired an operating retail pharmacy chain in Brazil and we're six months into that and we're very pleased with how that's going in terms of the learnings that we're getting and the opportunities that we see to bring synergies with our U.S. operations and we're opening some stores this year. We'll accelerate our openings next year. And so far so good and we will use those learnings to further our agenda internationally where it makes economic sense. And again as we've talked in the past, we will approach that with financial visibility.

Zack Sopcak - Morgan Stanley

Great, thank you.

Operator

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

Edward Kelly - Credit Suisse

Hi. Good morning. Nice quarter. Larry, could I just – I want to just clarify what you said about the Med D business and the impact for next year. It seems like the mass should be about 350,000 lives year-over-year that you would be down on. Is that correct, I guess first, to make sure that's right? And then as we think about the impact, should we be thinking about average revenue probably just under $1,000 per member per year and maybe a mid single digit type unit margin on that business?

Larry J. Merlo

I'll take the first part and probably the second part, maybe Dave will jump in here as well. But your takeaway in terms of the lives impact was right, in terms of we're expecting a year-over-year compression in the range of 350,000 lives for the reasons that we had mentioned. And we do not disclose the revenue or profit per life in the Med D business for competitive reasons. I would also again back to the earlier comments that the 350,000 life adjustment represents about 10% of our overall individual Silver Script PDP lives and right around 5% of our total in Med D lives.

Edward Kelly - Credit Suisse

Okay.

David M. Denton

This is Dave. I just want to clarify just one point is that what we had said is that as you roll forward from where we are today to, I'll say, January 14 that's our estimate of 350,000 lives coming out at that point.

Edward Kelly - Credit Suisse

Okay, perfect. And Larry just a similar follow-up on the idea of generic procurement and the opportunities available for things like partnerships. Could you just give us an update on how you're thinking about the opportunity out there for CVS in this area? Obviously you don't want your competitors to see a lot of opportunity and just to get your updated thoughts on this area and the potential for you to generate savings at some point going forward is there?

Larry J. Merlo

Yeah, Ed, I think as everyone's aware, we've renewed our wholesaler agreements with Cardinal and McKesson a few months ago and, and we’re very pleased with the results of that, and we believe that the relationship that we have with both of those wholesalers, first of all they both do a great job and we believe that, that makes the most sense for us from both an economic as well as an efficient distribution network. Now we are certainly constantly evaluating opportunities on the market place, and if we thought that there were further opportunities for us to enhance our efficiency from both a cost as well as a distribution network point of view we certainly wouldn’t hesitate to pursue those opportunities. And so I think that’s something that we’re watching closely, and we will continue to evaluate.

Edward Kelly - Credit Suisse

Great. Thank you.

David M. Denton

Thanks, Ed.

Larry J. Merlo

Thank, Ed.

Operator

Our next question comes from the line of Dane Leone from Macquarie. Please proceed.

Dane Leone - Macquarie Research

Hi, thank you for taking the questions. So, maybe I’ll ask the topical question of Medicare PDP a different way, and I appreciate that over the past year or two you’ve focused your strategy over to overall EBITDA growth versus EBITDA prescript growth and with the PDP headwind going into 2014 and thinking about the optionality you have with the balance sheet, could you just update your strategy of what you see in the areas of organic versus inorganic EBITDA growth as consolidation rolls through the entire industry, but in the context of the plan and obviously a disappointment with CMS? Thank you.

David M. Denton

This is Dave, I guess first and foremost let me just point out that we -- from using our capital structure we’ve been very disciplined and in the program that we have in place to kind of drive value for our shareholders. First, kind of in three areas, one increasing our dividend but probably more importantly in this aspect investing back in our business that we see good line of sight from a return on investment perspective and we’ll use our balance sheet to do that. Further more our cash flow yield in generation is pretty substantial, so we’ll continue to use that to drive our share repurchase program that will continue to work to enhance shareholder value. So, we’ll -- and if you keep in mind we said very clearly that our adjusted debt to EBITDA target were 2.7 times, we’re a little better than that at this point in time which gives us some additional flexibility as we think about using our balance sheet to drive value for our shareholders and we’ll continue to do that both as you just heard through this year but certainly into next year as well.

Dane Leone - Macquarie Research

Okay, great. Thank you.

Operator

Our next question comes from the line of Eric Bosshard, Cleveland Research. Please proceed.

Eric Bosshard - Cleveland Research

Good morning. Curious on the PBM growth outlook as you think about an even frame where you think we are in terms of generic benefits to profitability in the PBM relative to sure penetration of 90 day and the efforts that you’re making with the formulary. I am curious how you would mix all that together and think about the growth curve of PBM profits over the next 12, 24, 36 months?

David M. Denton

Well, Eric this is Dave. I don’t know if I can get you really specific here, but I think in general as we’ve talked about there is a few things that are driving kind of growth in our business over time. Clearly our ability to garner lives and share in the PBM space has been pretty important to us, and as you’ve even seen this year is very successful selling season as we continue to get more lives into the PBM is pretty important to us. But the question then is, how do we make sure those lives; we increase our share of dispensing across both of our channels of distribution, both within the PBM but also in the retail segment. And clearly generics while the -- over time we are in the -- I can’t say the peak of the generic introductions, as we look forward there’s still plenty of run, we’re on for newer generic introductions over the next three to five years, despite it being somewhat a slower pace than what it has been over the last year and half or so. So, all those components that we put in place are things that we look to drive value for our clients and for our members, but also by profits for ourselves.

Larry J. Merlo

Yeah, and Eric its Larry. Just on the generic piece that Dave mentioned as we keep in mind we got $15 billion on average over the next three years $15 billion worth of branded product coming off patent. And then just one additional point, you mentioned the formulary and while that’s got in a lot of discussion and with tension over the last couple of years, what we refer to as our template formulary it has today about 50% penetration with clients. So, we continue to see opportunity for further adoption especially as clients will be looking for additional ways to reduce costs and then we talked about specialty earlier as a key growth driver as well.

Eric Bosshard - Cleveland Research

Great, and then if I could just circle back on the front end growth with was a little slower, just wondering if you could characterize why that business is slower I appreciate the focus on profitability, but if you would frame what's different in terms of the growth rate in the front end being a little bit slower.

Larry J. Merlo

Well, Eric I don’t know that there is anything new from what we’ve talked about in the past, but I think that we’re continuing to see cautious consumers. I think as you look across some of the external data available in the second quarter whether it's IMS or some of the other data, it did show some consumer spending slow down in the quarter. So, I think it has to do as much about that as anything else.

Eric Bosshard - Cleveland Research

That’s helpful. Thank you.

Larry J. Merlo

Thanks Eric.

Operator

Our next question comes from the line of John Ransom from Raymond James. Please proceed.

John Ransom – Raymond James & Associates, Inc.

Hi, I just wanted to get into the weeds a little bit with specialty, a couple of questions, one is are you distributing more and more of your specialty drugs out of your retail locations, or is it still primarily a mail order business, do you see advantages to doing it more retail. And then secondly I am curious about oncology because it's direct-to-physician drug it flows on the medical benefit, and I just wondered if there is any emerging strategies that might to attain that [beast] just given all the drugs in the pipeline. Thanks.

Jonathan C. Roberts

Yeah, hi John this is John, so specialty primarily is distributed by or specialty pharmacies via mail order. There is some specialty revenue that flows through retail. I talked earlier about our integrated specialty strategy which is really providing access for members across all 7,400 CVS retail locations but leveraging our clinical, our billing and our fulfillment capabilities on the backend. So, we will be rolling that model out next year and in a pilot that we’ve done what we’ve seen is that about half of the patients like to have their specialty script mail to their home and about half of the patients like to pick up their specialty script at their local CVS pharmacy. So, we believe we’re going to be able to grow specialty fulfillment in retail, but we’re not going to have to actually house the inventory in the retail stores because we want to deleveraging our back in and then we’re also going to leverage our billing and our clinical capabilities.

As far as oncology you’re right, that’s a buy-and-bill that is done by the oncologist in their office. I would say that, it's not well managed today and the incentives are aligned for physicians to actually utilize the higher cost oncology medications. So there are solutions that are in the market place that we have and others have where we look to realign the incentives for physicians and incentivize them to utilize the most cost effective combination of oncology drugs that, that patient needs. So that, I am not sure in the near future you will see a movement away from that buy-and-bill model, but I do think there is an opportunity to more effectively manage it.

John Ransom – Raymond James & Associates, Inc.

I guess, my other question, are you seeing, I mean I guess, potentially by ’15 or ’16 we could be back into a pretty high top-line drug trend, are clients focused on those and practically speaking I mean, how much can you really help them take say a 9% drug trend and turn it into a 7% drug trend or something or what do you see as specialty comes to be the lion’s share of the growth and spend?

Jonathan C. Roberts

Yeah, John so when you think of drug trend you think of there’s inflation, there’s utilization, and then there is mix changes because of the new drug introduction, so we’re actually seeing trends today around 20%, so it clearly is becoming a very, very high priority for our client. And we have solutions that can help them manage it, its utilization solutions, its formulary solutions, it's consolidating where they purchased their specialty products through our channels that provides them better economics. So we believe there are a lot of solutions that take a higher level of sophistication than what we see in the commercial space, but we've made significant investments and we believe we have best-in-class capabilities to enable our clients to more effectively manage this spend. So we're very bullish in this space and believe that not only will it continue to grow but that our tools will distinguish us in the marketplace and allow us to grow disproportionally.

John Ransom - Raymond James & Associates, Inc.

Thank you.

Larry J. Merlo

Thanks, John.

Operator

Our next question comes from the line of Frank Morgan from RBC Capital Markets. Please proceed.

Frank Morgan - RBC Capital Markets

Good morning. Dave you mentioned the tail off and the operating profit in the PBM segment in the fourth quarter. That was a good explanation there, but I'm curious I think the offset mentioned there would be a ramp up in the operating profits on the retail that would offset that. Could you talk just conceptually about what you expect to see specifically on the retail side in the fourth quarter? Thanks.

David M. Denton

Good question. I think as we continue to work from a retail perspective, we continue to see very solid volume growth both was particularly within the pharmacy segment. As you think about where we started this year and our expectation for script retention within the pharmacy business, that continues to hold steady and we continue to drive performance there. Also from a front store perspective we have been very diligent on managing, I'll say volume and margin, so as we pointed out during the call, our front store margin continues to progress nicely. We continue to obviously balance, if you will, the top line front store growth outlook with our expectations for margin. So we continue to be more efficient across most of our outlook around the country. I would say that one thing that's important to think about our business and we've talked about this in the past is we can continue to progress from a financial perspective very nicely with fairly modest, I'll say, 1% comp growth in the front of our business. That consistency is probably more important than driving our market growth, if you will. I hope that helps, Frank.

Frank Morgan - RBC Capital Markets

Thank you.

Operator

Our next question comes from the line of Robert Willoughby, Bank of America Merrill Lynch. Please proceed.

Robert Willoughby - Bank of America Merrill Lynch

Just a clarification. Does the 1.7 billion in new PBM business, does that include any adjustment for the Medicare losses that you mentioned? And then just secondarily, maybe Jon, can you speak anecdotally to what you found here, what incremental work do you need to do for that CMS sanction to be lifted? I wonder why this might not have been identified at your first pass at this.

Larry J. Merlo

Yeah, Bob, it's Larry. In terms of the business that we called out on both a gross and net basis that does not include the Medicare Part D business, okay. And in terms of the second question, as we went and conducted our own audit, okay, of the success of the remediation efforts, we did uncover some additional elements that need to be completed that insure that we have our systems and processes working at best-in-class levels. And that's what we need to continue and to finish up on the remediation. So, it's that straightforward.

Robert Willoughby - Bank of America Merrill Lynch

Okay, thank you.

Larry J. Merlo

Okay. We'll take two more questions please.

Operator

Our next question comes from the line of David Magee from SunTrust. Please proceed.

David Magee - SunTrust Robinson Humphrey

Hi. Good morning. Two questions. First has to do with what you're seeing with the cost of consumer that you referenced earlier. Are you seeing that situation getting any better at all as the year progresses and are you seeing any differences with regard to geography or demographics in that regard? And then my second question has to do with generic benefits being more muted in the second half of this year. At what point next year do you expect that to swing positive again in terms of comparisons? Thank you.

Larry J. Merlo

Well, why don't I start with the generics a little bit? As you said, really what's happening here as you look back in really last year, the back half of last year, those break open generics accelerated, so you saw that comp itself into the first half of this year. So now we're facing pretty tough comparison in the back half. I think as we think about moving forward, there's still plenty of opportunities for break open generics over the next several years, the timing of which quite frankly is probably a little too early to give you kind of a sense of specifically how '14 will shape up from that perspective kind of year-over-year. But rest assured if you look ahead to the next two to five years, generic introductions are still pretty robust despite the fact that we're in a peak at this point in time. From a consumer perspective, maybe I'll ask Mark to comment on that a bit.

Mark Cosby

Yeah, so we are seeing some divergence of results based on where our stores are and most notable between lower income, higher income areas where we see the most difference. And it's most noticeable in those areas between – mostly on the front versus the pharmacy which tends to be more flat. So we are doing some things in those lower income area to try to help the value perception and we'll begin lowering those out in the second half of this year.

David Magee - SunTrust Robinson Humphrey

Okay, great. Thank you.

Larry J. Merlo

Okay, last question.

Operator

Our last question comes from the line of Meredith Adler from Barclays. Please proceed.

Meredith Adler - Barclays Capital

Hi. Thanks for taking my question. I guess I'd just like – two questions. First is, you talk about losing the 350,000 lives. The remediation costs seem like they were noticeable in so far this year. Do you expect that cost to continue at the same level or to be higher in the second half and are you likely to be any cost next year as well?

David M. Denton

Meredith, this is Dave. We haven't broken out those costs specifically. I'll just say that all those costs are baked into our outlook for '13 and I think we're pretty confident that we have our hands around the cost spend for that. But I guess as we cycle into '14, it's probably just a little too early at this point in time to give you some clarity around that specifically at this point. But clearly as we said our expectation is to have the remediation effort complete, if you will, kind of nearly into the year so that would say that most of those costs would not continue.

Meredith Adler - Barclays Capital

Okay. And then I have a question about reimbursement for generics. I was recently talking to Walgreens and I know that they have chosen to sign slightly different contracts with payers in order to spread out the benefit from generics. And so instead of being very, very high in the front and then dropping very sharply at some point, there were kind of spreading it out. I think you guys have always said that the best profit comes when you have three suppliers, but have you looked at all about smoothing out the benefit from generics in terms of gross margin?

Larry J. Merlo

Meredith, this is Larry. We have – I think there's been a lot of dialogue around the use of, I'll call it market basket or capped generic effective rates over the last 12, 18 months and from a CVS pharmacy perspective, we started using those a few years back. And from our perspective not much has changed. And I think that we continue to think about the cadence of generic reimbursement very consistent with how we [cross manage] in the past and how you mentioned it. And I think it's important to note that despite the dialogue around these things, this does create more predictability from a forecasting and a budgeting point of view. It does not alleviate the fact that there continues to be ongoing reimbursement pressure across the business.

Meredith Adler - Barclays Capital

I guess I'm still not clear. Did you say that you haven't made any changes at all, you still sort of have this pattern of dropping at a certain point?

Larry J. Merlo

Yeah. Meredith, I'm saying that – what's been talked about in the marketplace we started doing several years ago.

Meredith Adler - Barclays Capital

I see, okay.

Larry J. Merlo

So from our perspective, we haven't seen a change.

Meredith Adler - Barclays Capital

Got it, okay. And then my final question, I think, is for Jon. There was a question before about managing the oncology spend and doctors [buy and build]. You had a program that you were working on that had to do with getting doctors to call a certain pathways and generally keeping their reimbursement at the same, but encouraging them to use the lowest cost oncology treatment. I was wondering if – you did mention it today and I’m wondering if that test is still there, and whether you feel like you’re getting traction with physician is without getting a bit of pushback from them in terms of that program?

Jonathan C. Roberts

Yeah Meredith, so we still have that program. It’s out in the marketplace. I would say that the payers are probably a little more reluctant to take on oncology and they’re focused on other areas that are less sensitive. But we still believe that the oncology space needs a solution and we think the solution and the approach that we’re taking is the most prudent approach and delivers savings without creating patient and physician disruption. So we’re still committed to that program.

Meredith Adler - Barclays Capital

And when you say the payers are attacking other things, are you talking about mostly the pharmacy benefit or they also looking at other areas funded under the medical benefit?

Jonathan C. Roberts

Yes, they’re looking at both.

Meredith Adler - Barclays Capital

Both?

Jonathan C. Roberts

So formulary and utilization programs across both pharmacy and medical benefits and they’re coming to ask and asking us to take our capabilities that we’ve demonstrated on the pharmacy side of the specialty spend and extend that into the medical spend. So, again it’s a capability that we’ve that we think not only make sure that the right drug gets utilized, but the billing is appropriate medical claims, systems don’t have good edit – editing capabilities on them, so we provide that editing capability and make sure that the appropriate charges are paid. So, lot of interest in the space. Again, half the spend is on the medical side and you’re seeing specialty grow faster than any other part of the pharmacy business.

Meredith Adler - Barclays Capital

Great. Thank you very much. I appreciate the help.

Larry J. Merlo

Okay. Thanks, Meredith and let me just thank everyone for their time this morning and your interest in CVS Caremark and if there are any further questions which you have, you can reach out to Nancy Christal. Thanks.

Operator

Ladies and gentlemen, that does conclude the conference call for today. Have a great day everyone.

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