At this time I would like to welcome everyone to the CVS Corporation third quarter earnings conference call. (Operator Instructions) At this time I would like to turn the conference over to Ms. Nancy Christal, Vice President of Investor Relations. Please go ahead, ma'am.
Thank you. Good morning, everyone. Thanks for joining us. I'm here with David Rickard, Executive Vice President and Chief Financial Officer of CVS. Given all the activity associated with our announced merger with Caremark, this earnings review has been recorded.
We appreciate you joining us for this review of our very strong third quarter 2006 and October sales results. We understand that our earnings may have been somewhat overshadowed by the industry-changing news regarding our agreement to merge with Caremark. However, we would like to take this time to quickly highlight our robust results for the quarter and our expectations for the year.
First I'll touch on the highlights of our strong October sales results. Total comps were up 9.3% with pharmacy comps up 10.3% and front store comps up 5.8%. The 2004 acquired stores continue to deliver very strong results with total comps up 13.9% in October, once again, reflecting solid results in both the front store and the pharmacy. We saw strength across all of our core categories.
Before I turn this over to Dave, I have a couple of administrative items to cover. First, today's call is being simulcast on our IR website and it will also be archived there for a one-month period following the call.
Second, please note that during this call we'll discuss one non-GAAP financial measure in talking about our company's performance, namely free cash flow. It's defined as earnings after taxes, plus non-cash charges, plus changes in working capital, less net capital expenditures; so free cash flow excludes acquisitions and dividends. In accordance with SEC regulations, you can find the reconciliation of free cash flow to comparable GAAP measures on the Investor Relations portion of our website at investor.cvs.com.
Third, our attorneys have asked me to read the Safe Harbor statement. During this presentation, we will make certain forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially. For these statements we claim the protection of the Safe Harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. We strongly recommend that you become familiar with the specific risks and uncertainties that we've outlined for you under the caption “Cautionary Statements” 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 July 1, 2006.
Now, I will turn this over to our CFO, Dave Rickard.
Thanks, Nancy and good morning, everyone. Once again, we delivered record-breaking results for the quarter. So despite all the exciting news of yesterday, we hope you take the time to notice that. These results reflect continued momentum of our business across our markets. Importantly, we made significant progress on the integration of the stores we purchased from Albertsons on June 2. We also completed the acquisition of Minute Clinic, the pioneer in retail-based health clinics, and the leader in it's sector, now with over 100 clinics across 15 states. Our PBM PharmaCare continued to make good progress as well. And on top of all that, we negotiated our planned merger with Caremark which will create the leading integrated pharmacy services company in America.
Let me provide the financial highlights of the quarter for the total company. Total sales increased 25% to a record $11.2 billion. Same-store sales jumped 9.1%. This was more than a percentage point above the high end of our expectations. Pharmacy comps were up 10.2% and the front store comps were up 6.4%.
Total revenues at our PBM PharmaCare were up 24% versus the third quarter last year, while operating profit was up 70%, largely driven by our Medicare Part D business. Gross margin as a percentage of sales for the company improved a meaningful 72 basis points, reflecting the introduction of several significant generics. We expected a sizeable gain here. This was more than we expected. I guess the generic wave is upon us.
Total operating expenses increased as a percentage of sales, as expected, due to the costs associated with integrating the Savon and Osco stores. Net earnings increased 12% and diluted earnings per share rose 11% to $0.33. That number includes a negative impact of approximately $0.05 per share of dilution associated with the Savon and Osco acquisition. Obviously, we're very pleased with these third quarter results which came in well ahead of our original expectations for diluted EPS of $0.28 to $0.30.
The out-performance was driven by sales exceeding expectations as well as greater gross margin improvement than we originally anticipated. Gross margin improvement was largely driven by the availability of new generic drugs, as well as improved front store margins due to increased private label penetration and a better mix of products sold.
Now let me provide a brief business update, followed by our usual financial review. Our core business continues to deliver stellar results. As for the pharmacy business, we continued to build momentum in the third quarter. Our pharmacy business is achieving excellent customer traffic growth. One of the factors driving our pharmacy growth is the new Medicare Part D prescription drug benefit. This growth is due to both increased utilization and market share gains.
Our strategy has been centered on convenience and we have made significant progress over the years in furthering that goal. Today, more than 60% of our 6,200 stores are freestanding. Most of those with drive-thru pharmacies, and over 65% of our stores are open 24 or extended hours, providing access and convenience to pharmacy customers which few competitors can match.
We track transfer activity in pharmacy to and from various competitors, including mass merchants. We continue to see more transfers in from leading mass merchant competitors than transfers out. As for Wal-Mart's recent rollout of a $4 generic drug program, we're seeing an immaterial impact in their first market, Tampa, and the impact on all of Florida since they expanded their program is even less than the early results in Tampa. Recall that our transfer data in Tampa suggested that we lost less than one script per store per day post-Wal-Mart's announcement. Across Florida, we're seeing even less of an impact. So the impact is very small, just as we expected.
Many people have asked about what impact we're seeing from people who have entered the donut hole in the Medicare Part D program. To date, we haven't seen an impact on utilization. In fact, our average weekly Medicare volume in September is higher than that in August. I would expect the donut hole to affect behavior. We just haven't seen it yet.
Generics continue to play an important role in pharmacy. New generics had a negative impact of approximately 270 basis points on pharmacy same-store sales in the third quarter, but helped improve margins. Generics overall represented 59.4% of scripts in the quarter. That's up about 400 basis points from last year's third quarter and up from 57.5% in the second quarter.
We saw a number of new generics introduced in the third quarter, including generic versions of the popular antidepressant Zoloft and Mobic anti-inflammatory. And of course, we saw the first full quarter of generic Zocor as well as the temporary launch of generic Plavix. We expect the balance of 2006 to remain strong from a generic introduction standpoint, so as we saw this quarter, we'll see growing pressure on pharmacy comps from generics with benefits to margins from these new generic launches.
On the branded blockbuster front, Pfizer's smoking cessation product, Chantix, is off to a great start and Merck's Januvia is currently on its way to our stores. This item, known as a DPP-4 inhibitor will represent the first in a new class of diabetes medicine that work by increasing the level of hormones that help lower blood sugar or blood glucose levels in the body.
In the front store, customer counts have also been increasing solidly while the average front store transaction size has also continued to grow. Our average front store ticket is currently about $11.
In addition to our advantages around convenience and our strong comps, our increasingly efficient promotions speak volumes about the unique competitive advantage we derive from ExtraCare. Over 63% of our front end sales use ExtraCare as we continue to build a loyal customer base. We've already done a soft launch of ExtraCare in the acquired Savon Osco stores and we'll begin to introduce it in earnest in the coming quarters. We expect to cement a loyal customer base there as well.
While our core business continues to fire on all cylinders, the Albertson's integration has been proceeding right on track. We completed the system's conversions at the end of September, less than four months from the closing of the deal. This included Epic, PSI, AIM, Viper, CVS Select, POS, and ExtraCare. By implementing CVS store systems, we've addressed pharmacy service and efficiency, in-stock levels, inventory control, shrink, employment screening, customer tracking, and customer loyalty rewards.
As for remodeling the stores we're in the process of physically converting the stores to the CVS brand. In addition to the systems integration, these changes we're making include reducing shelf heights, resetting merchandise layouts, installing our hallmark CVS carpet, enhancing the lighting and improving the signage --basically making the stores CVS-easy for customers to use. We've completed nearly 300 stores to-date, and we are on pace to complete nearly 500 stores by year end. The early customer feedback on the remodeled stores has been extremely positive. All of the stores will be completely remodeled by the end of February.
Now, what about current trends in the former Savon and Osco stores? Well, they've been basically in line with expectations. We will begin to reintroduce the stores to consumers in the fourth quarter in markets where the remodels are complete. At that time, the stores will have become, in effect, brand new CVS pharmacy stores. That's when we expect to see sales trends pick up as they did when we relaunched the 2004 acquired stores.
As I've said in the past, while these stores are operationally in better shape than the stores we acquired in 2004, there is clearly opportunity to improve the merchandise assortment, to improve category focus, and to leverage the ExtraCare card.
Let me touch on the former Eckerd stores. They continue to post very strong sales in the third quarter. Total same-store sales in the former Eckerd stores were up 13.7% in the quarter with front store up 8.6% and pharmacy up 16.1%. Those comps are already cycling strong comps from the previous year, making them even more impressive. While we expect comps in the 2004 acquired stores to moderate some from these exceptionally strong levels, we still expect them to continue to generate same-store sales higher than our core business for the foreseeable future. Our continued success with the 2004 acquired stores gives us great optimism for improved results from the 2006 acquired stores once we complete the integration process.
Another recent development was the completion of the Minute Clinic acquisition. Minute Clinic is the pioneer and largest provider of retail-based health clinics in the U.S. The clinics, which are staffed by certified nurse practitioners and physician assistants, offer treatment for common family illnesses such as strep throat, ear infections , poison ivy and pink eye. They also provide some common vaccinations, including flu shots. As I said earlier, we currently have 105 Minute Clinics in 15 states. 87 of them are located within CVS pharmacy stores providing convenient, quick, cost effective, high quality care. By way of comparison, the next closest competitor to Minute Clinic has less than 20 clinics currently operating. History shows that it's 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, payers and providers, and with our planned merger with Caremark, there are clearly significant long term possibilities around the use of these clinics in the areas of disease management and other value-added services. We expect to rollout Minute Clinics to our customers nationwide at a pace of expansion that's appropriate to the business opportunity. This will entail investments early on, especially in 2007, so that we can fully realize the opportunity in the medium and long term. We'll provide more specific details of our plans in the fourth quarter call.
Now I'll turn to our organic new store growth program. During the third quarter we opened 57 stores. That included 32 new stores and 25 relocations. We closed eight others, excluding the Albertson's closings, resulting in organic net unit growth of 24 stores. Our plan for the full year is to open approximately 260 new stores, about 145 of which will be new. The rest will be relocations. With CVS closings, we expect net unit growth of approximately 100 stores. That will produce organic square footage growth of about 3.5% again this year. When you factor in the net effect of the Osco Savon acquisition, this year, square footage growth will be almost 24%.
We continue to expand our presence in our newer high-growth markets such as those in Florida and Texas, as well as Los Angeles, San Diego, Phoenix, Las Vegas, and Minneapolis. All of our new stores in these markets are running at or above plan with both front store and pharmacy performing well. It's interesting to note that our organic new stores in LA have been doing exceptionally well recently, which we believe is due to the added name recognition from our recently acquired stores in Southern California. So we continue to be pleased with our steady organic store growth.
Now let's take a more detailed look at our third quarter financial results. After that, I'll provide initial guidance for the remainder of this year and comment generally on our expectations for 2007.
Turning to our third quarter income statement, as I said earlier, total revenues increased 25% to $11.2 billion. The acquired Savon and Osco businesses accounted for a little over half the increase. Our overall gross margin increased by approximately 70 basis points in the quarter to 27.5%. The gross margin benefited from these key factors:
- The increase in the amount of generic drugs dispensed.
- The initial synergies from the Savon Osco acquisition.
- The mix shift toward the higher margin front end.
Of course, there were also some downward factors. We saw a negative impact on margin rates attributable to the dual eligible population shifting from Medicaid to Medicare. In addition, there was an increase in volume in the insurance-related products offered by PharmaCare. And finally, our lower margin third-party pay business in the pharmacy continued to increase as a percent of pharmacy sales. Third party sales accounted for over 94% of pharmacy sales, up 60 basis points from last year's third quarter. Overall, obviously the pluses substantially out weighed the minuses.
Turning to expenses, our total operating expenses which include depreciation and amortization as a percentage of revenues increased by about 80 basis points in the third quarter to 22.7%. This was largely due to the integration costs that we incurred in connection with the Savon Osco acquisition. The additional expense associated with stock compensation due to our adoption this year of FAS 123 R also played a role in the increase. This amounted to about $16.3 million or about 15 basis points in the quarter.
After all this then, operating profit was 4.8% of revenues in the third quarter. This was down about 10 basis points versus last year's third quarter, driven by the one-time expenses associated with the integration. Net interest expense was $75 million in the quarter versus last year's third quarter, net interest increased $48 million. This was driven primarily by the increase in debt used to finance the Savon Osco acquisition.
Our tax rate was 38.4% in the quarter, in line with expectations, and our diluted share count was 855 million shares. As I said earlier, diluted earnings per share were $0.33, up from $0.30 in last year's third quarter, even while funding the acquisition dilution.
Now let's turn to the balance sheet and cash flow. In the third quarter, inventories increased by 23% versus last year. This compares favorably to the 25% growth in sales we saw. Of course, both increases were due primarily to the addition of the Savon Osco business. We continue to move back toward industry-leading inventory turnover in the core business. As you know, we rolled our inventory systems out into the Savon Osco stores as part of the systems conversions. 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 $453 million. This is nearly $205 million more than last year's third quarter due to the absence of a sale leaseback this year. Last year, we took about $160 million worth of stores to the sale leaseback market in the third quarter. All of our sale leaseback activity is expected to occur in the fourth quarter this year.
As for free cash flow, we utilized approximately $185 million during the quarter, in line with our expectations. The largest factors were the increase in capital spending related to the integration of the stores, as well as the timing of sale leaseback activity between the third and fourth quarters. Again, this was in line with expectations.
Now I want to provide initial guidance for the fourth quarter and update our guidance for the full year 2006. For the fourth quarter, we expect comp store sales growth between 6% and 8%. This includes, of course, the great performance posted in October and reported this morning. Additionally, we expect fourth quarter diluted EPS of $0.41 to $0.43 in line with last year's $0.42 per share.
Our expectation includes estimates around the dilution from the continuing integration of the Savon Osco business. To put that dilution into perspective, we've seen about $0.07 of dilution so far this year and we expect another $0.03 to $0.05 for the remainder of the year. Like previous quarters this year, this fourth quarter guidance also includes about $0.01 for the impact of expensing stock options.
For the full year, total revenues are expected to increase by about 17.5% to 18.5%, a slight increase in our view of the bottom of the range, given our out-performance in the third quarter. We continue to foresee strength in our core business as well as in the sales turnaround in the former Eckerd stores.
Overall, we now expect total comp store sales of 7.5% to 8% for the year. Thanks to the strength of the generic conversions we've seen, the continuing favorable front end mix and the Savon Osco purchasing synergies, we still expect our overall gross profit rate to moderately improve over last year.
As for operating expenses, the integration of the newly acquired stores will continue so we'll have some one-time integration expenses as well as one-time marketing expenses related to the grand reopenings. 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 still expect to see a moderate increase in operating expenses as a percent of revenues. As a result, full year 2006 operating profit as a percent of revenue should be only slightly down from last year's level.
Net interest is expected to be up to $215 million. This includes the impact of the Savon Osco acquisition. Our tax rate should be around 39% and our diluted share count is expected to be about 855 million shares for 2006.
When projecting capital expenditures and free cash flow, we're excluding from the calculation the sale leaseback associated with the properties we bought from Albertson’s. The properties were acquired, not built, and therefore the proceeds are more appropriately treated as cash related to acquisitions. On this basis, 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 Savon and Osco stores. The remaining 10% or so will be spent next year as we complete the integration.
Also, we've been able to more quickly reduce some of the levels of extra inventory we put into the newly acquired stores, so at this time, we expect to see better levels of inventory as well as accounts receivable at the end of the year. Combined with increased expectations on earnings, we now estimate that free cash flow should exceed $400 million, up from our earlier expectation of something over $350 million.
We still expect 2006 earnings per share in the range of $1.52 to $1.54 as we stated in our September sales release. This reflects the over-performance we experienced in the third quarter as well as our continued confidence in the remainder of the year.
So in summary, it was an outstanding quarter. We had record sales, improved gross profit margins, and strong earnings growth. Importantly, we also made significant progress on the Albertson's integration, completed the acquisition of Minute Clinic, and last, but certainly not least, we negotiated the merger with Caremark that we announced last night. Our planned merger will create the premier pharmacy services company and provide us a solid platform for future growth.
As Nancy said, in view of all of the activity associated with our earlier announcement yesterday, this call here has been recorded so we are unable to take questions at this time. Please call Nancy Christal's office if you need any further information or clarifications. Thanks very much for your attention.
Ladies and gentlemen, that concludes today's CVS Corporation third quarter earnings conference call.
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