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Executives

Nancy Christal - Senior Vice President, Investor Relations

Thomas M. Ryan - Chief Executive Officer, President, Director

David B. Rickard - Chief Financial Officer, Executive Vice President, Chief Administrative Officer

Howard A. McLure - President, Caremark

Analysts

Edward J. Kelly - Credit Suisse

Lisa Gill - J.P. Morgan

Meredith Adler - Lehman Brothers

Matthew Perry - Wachovia Securities

Deborah Weinswig - Citigroup

John Ransom - Raymond James

Neil Currie - UBS

Mark Husson - HSBC Securities

John Heinbockel - Goldman Sachs

Scott Mushkin - Banc of America

Eric Bosshard - Cleveland Research

CVS Caremark Corporation (CVS) Q3 2007 Earnings Call November 1, 2007 8:30 AM ET

Operator

Good morning. My name is Cynthia and I will be your conference operator today. At this time, I would like to welcome everyone to the CVS Caremark Corporation third quarter 2007 earnings conference call. (Operator Instructions) I would now like to turn today’s call over to Nancy Christal, Senior Vice President, Investor Relations. Please go ahead, Madam.

Nancy Christal

Thanks, Cynthia. Good morning, everyone, and thanks for joining us today for our third quarter earnings call. I am here with Tom Ryan, President and CEO of CVS Caremark, and Dave Rickard, Executive Vice President and CFO of CVS Caremark. This is the second full quarter of results for the combined CVS Caremark and we are happy to have the opportunity to update you on our progress.

For your information, our 10-Q is expected to be filed late today but we’ll provide details of our performance by business segment during this call.

Today we’ll discuss some non-GAAP financial measures in talking about our company’s performance, namely free cash flow, EBITDA, cash EPS, and adjusted EPS. Free cash flow is defined as earnings after taxes plus non-cash charges plus changes in working capital less net capital expenditures. So free cash flow excludes acquisitions and dividends.

EBITDA is defined as operating profit plus depreciation plus amortization. Based upon requests from the investment community on our first quarter call, we began to provide earnings guidance for GAAP EPS as well as cash EPS, which is defined as diluted EPS eliminating the effect of both depreciation and amortization. So in a sense, cash EPS adjusts for non-cash investments on both the retail and PBM sides of our business.

Some of our shareholders have asked us to adjust diluted EPS only for acquisition-related amortization, which primarily relates to the PBM side of our business. So we’ve decided to also provide guidance for that metric, which we will all adjusted EPS. Adjusted EPS is defined as diluted EPS eliminating the effect of amortization only.

While our financial leadership, namely our CFO, considers himself a GAAP guy, we’ll provide these metrics for your use as you see fit in order to improve our comparability with various competitors that you monitor. Of course, we’ll continue to provide guidance on a GAAP basis.

In accordance with SEC regulations, you can find the reconciliation of the non-GAAP items I mentioned to comparable GAAP measures on the investor relations portion of our website at investor.cvs.com.

As always, today’s call is being simulcast on our IR website. It will also be archived there for a one-month period following the call to make it easy for all investors to access the call.

In addition, throughout our remarks this morning, we’ll attempt to address head-on the key questions we’ve been receiving from the investment community. Following our remarks, we’ll be happy to take any questions you may have. During the Q&A session, we ask that you limit yourself to one to two questions, including follow-ups, as we have a large constituency of healthcare and retail analysts and investors to accommodate.

Let me quickly provide one other important note; we expect the date for our annual analyst and investor meeting to be held this spring. It will take place on the morning of Wednesday, May 21st at the Mandarin Oriental Hotel in New York City. More details will be forthcoming on future quarterly calls but please save the date. This is the one time per year that we provide broad access to an extended group of our senior management team, so we hope you can be there.

Before we continue, 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. These risks and uncertainties relate to, among other things, general industry conditions, such as the competitive environment for retail pharmacy and pharmacy benefit management companies, regulatory and litigation matters, legislative developments, changes in tax laws and the effective changes in general economic conditions. 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 we’ve outlined for you under the caption Risk Factors and Cautionary Statement Concerning Forward-looking Statements in our Annual Report on Form 10-K for the 2006 fiscal year ending December 30, 2006, and under the caption Cautionary Statement Concerning Forward-looking Statements in our quarterly report on Form 10-Q for the quarter ended June 30, 2007.

Now, let me review October same-store sales for CVS Pharmacy which were also announced this morning in a separate press release. Total same-store sales were up 4.6%, with pharmacy comps up 4.5% despite being negatively impacted by approximately 420 basis points due to recent generic introductions. Front-store comps were up 4.8%. On a two-year stack basis, total same-store sales were 13.9%, with pharmacy comps 15.2% and front-store comps 10.6%.

On the pharmacy side, keep in mind that we are comparing against last year’s ramp-up of the Medicare Part D business, and we also saw a decline in flu related scripts.

On the front-store side, comps were solid but less than we’ve experienced recently. The primary reason is the sharp decline in over-the-counter cough and cold remedies, perhaps due to the unusually mild weather in October and the low instance of flu. Other than that, we experienced solid growth across our core front-store categories in October, especially beauty, personal care, general merchandise, and digital photo. This was the fourth month that the Save-On and Osco stores we acquired from Albertson’s last year are included in our comps and I’m happy to say that the trends there are marching nicely in the right direction.

We estimate the inclusion of the 2006 acquired stores had a 95 basis point positive impact on our overall front-store comps in October and an 8 basis point positive impact on our overall pharmacy comps in October, and a 35 basis point positive impact on our overall comp.

Customers continue to respond very favorably on the transition of these stores to include elements like improved product offering, store layout and environment, and most importantly, service.

And now I will turn this over to our President and CEO, Tom Ryan.

Thomas M. Ryan

Thanks, Nancy and good morning, everyone. Obviously I am very pleased with our solid third quarter results. Our performance once again reflects healthy results across both our retail and PBM segments of our business.

As you know, Dave will review the financials in detail but just let me give you some of the highlights of the quarter. Our strong sales were coupled with significant improvements in gross margins across the company, with generics continuing to be the major profitability driver. Gross margins showed healthy improvement across all our pharmacy business. In addition, we experienced improvement in front-store retail margins.

Operating margins expanded by 140 basis points. Diluted EPS on a GAAP basis for the company increased 37%, exceeding the high-end of our guidance. Our free cash flow was positive and dramatically improved from last year’s third quarter, so I couldn’t be happier with the continued execution across all lines of business.

Let me give you an update on the merger and then provide some color on the PBM and the retail side of our businesses. As I said in the last call, we are operating as one company, aligned with a single vision, mission, and set of values. I am pleased that we’ve completed the integration of both the organization and our back-end systems quickly and successfully, and we continued to expect at least $660 million of synergies in ’08.

People always ask me if there are any surprises since the merger. I guess there are two, and there are two positive ones. First, and the most pleasant, is the fact that the people throughout the Caremark organization are even of higher quality than I anticipated. Second, we have retained basically all the key executives across the Caremark organization -- in our sales teams, our account teams, our call centers, specialty pharmacy, mail-ops, marketing and underwriting.

One thing our clients have told me that’s really not a surprise is that even during the first few months of the merger and all the integration activity, our PBM has maintained the high level of service that they’ve come to expect.

Now, I’ve been spending a lot of time with clients to listen and understand what new capabilities and products they are looking for. Clients to me we continue to be the service leader and they like what they are hearing from our sales and account teams.

Of course, first and foremost, clients want the best in pricing. As the largest purchaser of pharmaceuticals in this country, we are clearly well-positioned to provide that. But beyond that, clients are searching for solutions that will recognize and involve the consumer in healthcare decisions.

We have the ability to broadly influence consumer healthcare behaviors that will improve outcomes, lower costs, because we can touch the consumer by mail, by phone, by the Internet, and most importantly by face-to-face contact.

Just take this, for instance; when you consider 30% of the people with a chronic condition are not even aware of their condition and therefore not necessarily on medications at all. They are not on the necessary medications to control it. Another 50% stop taking their maintenance medication within the first year of treatment. Clients know if they don’t manage healthy people to prevent the progression of common disease states, as well as those with chronic ailments, their healthcare costs will spiral out of control over time.

Appropriate pharmaceutical care is the safest, most effective and lowest cost line of defense against rising healthcare costs. As I said, we are well-positioned given our broad offering, multiple consumer touch points to help clients lower cost complexity and improve outcomes.

Our PBM clients also have a great deal of interest in minute clinics. We are working with clients to design tailored programs for their members and we are piloting programs that use minute clinic to monitor health assessment and screen for illnesses that would otherwise go untreated.

We are growing minute clinic as fast as we can. We started the year with just over 140 clinics in about 18 states, and our clinic count now stands at 350 clinics in 24 states. All but 23 clinics are located in CVS stores.

We have five times the number of clinics than our next largest competitor and I believe we have a significant competitive advantage in this space for two reasons: one, we’re the market leader and we are first to market; and two, there’s a significant opportunity to use minute clinic with our Caremark clients.

So let me just say we are actively engaged with clients in developing new products and services, integrating our PBM capabilities with our strong consumer connections through our retail business, and as I stated on the call, there are obvious competitive sensitivities around disclosing specific plans, so we won’t be discussing more specifics until we have had several months so that we can have a good read on the progress and the effectiveness, but know for now we have several pilots underway with existing clients.

So please don’t look for a grand announcement or a puff of white smoke regarding these new offerings. This will be an evolutionary, measured process that we will continue to pick up steam in ’08 and beyond. But I will say that we are extremely enthusiastic about our new capabilities and I can tell you they are resonating with clients and prospective clients.

As you know, given all the headlines on the high profile contract changes, last quarter we tried to give you a preliminary update on the 2008 selling season. You’ll remember we said we had already won $1 billion of new business and since our last call, we did win an additional $600 million of new business, bringing total new business for 2008 to $1.6 billion. This includes obviously new PBM contracts as well as some new Medicare Part D business.

Many discussions with clients include our new value proposition. I believe our new model is playing into some of the success of our selling season, even at this early period.

As for Med D, our proprietary PDP, SilverScript and the Universal American product, w have had successful bid processes where SilverScript has qualified for five additional regions and Prescription Pathways has qualified for two additional regions.

Given this success, we anticipate growth in covered lives of about 20% in ’08. We’ll be serving over a million enrollees in over 30 regions in both SilverScript as well as our Universal American joint venture.

Since our last update, we have completed the vast majority of renewal activity and our retention rate excluding the government losses we talked about was 96%. We achieved 100% retention rate for our national employers. We do expect some reduction in 2008 revenues from existing health plans that either lost some clients, lost share, or were acquired. In addition to that, we also termed some small low profit clients that no longer meet the hurdles for returns.

So in 2008, with the loss of three government contracts offset by additional new accounts, net revenues are projected to drop by close to $2 billion. However, we still expect solid earnings growth in the PBM line of our business that will be driven by increased use of generics, increased use of mail penetration, growth in our specialty business, as well as the appropriate SG&A adjustments based on those sales losses, and the merger-related synergies.

Looking ahead, about a third of our business will be up for renewal in 2009 and I believe we are in great shape and I feel confident, based on many client discussions, that our new value offering, along with our unique offering, are resonating with these clients.

We are also looking forward to the potential for new business in 2009. This is clearly a big opportunity for our company. In fact, there will be significantly more opportunity than in recent years and we are confident that we will get our fair share.

Now, I know most of you are interested in the merger and the PBM side of things but I do want to spend some time on 55% of our business, namely retail. We had an extremely good quarter. We kept our eye on the ball, we’ve maintained focus on our customer service, as well as expense control.

Pharmacy comps for the quarter were up 4.3%, even though we were cycling against 10.2, which we achieved in last year’s quarter because of the benefit of Med D. In addition, while pharmacy revenue growth rate is increasingly restrained by the increase of new generic products, our profitability per script is higher than ever before.

Since the rollout of Med D last year, we continue to gain share in the 65-plus population. Our script growth for people 65 and older continues to outpace all others. September year-to-date scripts 65 and older increased 8.1%, while scripts for people under 65 grew 4.6%.

So while the pharmacy comp has been pressured slightly from the comparison with last year’s ramp-up, we still have a nice growth overall.

Now let me take this opportunity to address the pharmacy reimbursement issue around generics. We’ve obviously got a lot of questions lately and it’s been a big topic of discussion. There has been little change in the recent reimbursement change for generic drugs. For well over a year, we’ve been talking about the fact that while new generics and increased penetration of old generics will help drive profits, there will be some pressure on generic reimbursement, and these are from a number of factors that we’ve talked about, including the government, AMP, additional generic manufacturers that drive down the price, some [macking] earlier than in previous years, but the growing penetration of generics still drives incremental profitability.

I would also note that the reimbursement on generic Zocor hasn’t changed since January, so we’ve had ample time to build this into our financial plans. While some generic drugs are ending up on [mack] lists a little earlier than they would have historically, we are not surprised by that trend given the popularity of these drugs and the interest on the part of multiple generic manufacturers to compete, thereby driving down acquisition cost.

The cost savings to payers derived from generics and the resulting profitability to retailers, to PBMs, and to customers will continue to benefit all participants. We continue to expect benefit from the growth of generic introductions and increased penetration.

As for the pending changes in reimbursement on Medicaid for generics, as you know, the implementation was pushed to January of ’08. Congress, they don’t do everything right but they’ve recognized the fact that these ANP as published doesn’t really reflect the true costs, especially in the retail channel. We’ve had a lot of discussions, CVS alone and ACDS, our trade association on the retail side of the business has spent time with Senator Max Baucus as the Chairman of the Senate Finance Committee, and representative and Congressmen Frank Pallone as Chairman of the House and Energy Sub-committee to work closely with them to redefine ANP to more closely reflect the costs to retailers.

We also continue to have dialog with states around dispensing fees, and while some states have indicated they will make some movement, I think most states are waiting to see what actually happens out of the federal government.

Keep in mind that this is largely a retail issue and on the retail side of our business, Medicaid only represents 7% of our total pharmacy business.

Now let me shift gears to the front store. Our front-end business, as Nancy said, continues to lead the industry. Front comps increased 6.5 in the quarter, that’s against 6.4 last year. We continue to grow share in our categories of OTC, health, beauty, private label, digital photo. Customer traffic on a comp basis continues to run up in the a 2 to 4 range, while our average ticket continues to increase.

Our private label business remains a strong area of focus. It represents about 14% of our core business, which now includes the Eckerd stores, and we’ve increased the penetration of Save-On Osco stores to about 13%. So across the company, we’re about 13.7%. We remain comfortable with the goal of 18% to 20% of our front-store sales coming from private label and proprietary brands in the next three to five years.

We talked a little bit about Osco Save-On in the last call and as Nancy said, it has had a positive impact on our comps in October in both front and pharmacy. As many of you know, we eliminated some low return front-store SKUs and categories. As a result, our front-store margins in these stores are improving significantly and in fact, they are at near core CVS levels. And pharmacy margins continue to improve, also approaching core CVS, resulting from improved execution around generic dispensing in particular.

I said on our last call I was confident that these stores will both be a sales and margin driver in the second half. We’ve already begun to see the benefit. I am pleased with the progress and I believe that we’ll see a continued benefit to sales and margins from these acquisitions for the foreseeable future.

Let me touch briefly on our real estate program. In the third quarter, we opened up 78 stores, 37 new, 40 relos and closed seven others, so we have 29 net new. Our plan, as you know, is to open up approximately 275 stores, 140 of which will be new, 135 relos, and we expect net growth of about 100 stores, which is about 3%.

So in summary, overall we had really a solid quarter across all business lines on sales, margin and expense control. I couldn’t be happier. I think the company is on pace to have a great year and also a great ’08 and beyond.

So now I’ll turn it over to Dave for the financial review.

David B. Rickard

Thank you, Tom and good morning, everyone. Let me walk you through the financial results with an emphasis on the segment details.

On a consolidated basis, revenues increased 83% over the prior year to $20.5 billion. This includes $1.1 billion of inter-segment eliminations produced as a result of Caremark clients filling their prescriptions on CVS pharmacy stores.

In our PBM segment, progress is best measured if you assume Caremark and PharmaCare were combined in both years. On that basis, net revenues were up 5.7%, hitting $10.7 billion. Adjusting that for the impact of our improved generic dispensing rate, net revenues would have grown 10.7% for the PBM. If you further adjust for the change in PharmaCare’s revenue recognition method, net revenues would have grown 8.3% for the PBM.

As I mentioned on our last call, and as more fully described in our SEC filings, we changed to the gross method from the net method for recognizing service revenue at PharmaCare. That was due to the conversion of the PharmaCare retail contracts to the Caremark contracts structure effective September 1st.

The impact on the third quarter was the addition of approximately $240 million in reported revenues before inter-company eliminations, or about $190 million after eliminations.

We expect the 2007 full year impact on reported revenues to be $960 million before eliminations and $760 million net of eliminations. It will equate to about $2.9 billion in revenues on an annualized basis before inter-company eliminations, or about $2.3 billion after eliminations.

However, given a parallel increase in annual cost of goods sold during each period, there is no impact on operating profit.

Growth of PBM revenues on a comparable basis was driven by an increase in mail sales, including specialty mail. Our overall mail penetration rate decreased 10 basis points from last year’s third quarter to 28.4%, primarily due to client mix.

Mail revenues were $4.2 billion, representing an increase of 7.9%. Within our total mail revenues, PBM mail revenues excluding specialty grew 3.2% with mail claims growth of 1% in the quarter. This was primarily driven by the net impact of client additions and terminations, as well as significant add-on business with existing clients year over year.

The mail generic dispensing rate rose to 49.0% from 44.8% a year ago, and our specialty pharmacy mail revenues increased a healthy 18.5% compared to the third quarter of 2006.

PBM retail revenues were $6.4 billion, up 4.2% from last year. The retail generic dispensing rate increased to 61.6% compared to 58.0% last year.

Retail claims grew 1.1% compared to the same period last year. That was primarily driven by utilization as well as an increase in lives in 2007.

So how did we do on gross profit? We did well. On a comparable basis, gross profit margins for the PBM segment were up over 130 basis points despite the 20 basis point drag from the conversion of PharmaCare’s contracts. The primary drivers of this were the margin expansion we experienced from the increased utilization of generics, as well as purchasing synergies.

Gross profit margin in the retail segment expanded about 160 basis points over last year’s third quarter to 29.8%. Like the PBM segment, our retail pharmacy margin continued to benefit from a substantial increase in the sale of generic drugs, as well as cost synergies derived from the merger.

In addition, front-store margins improved. This reflected an improved product mix in our acquired stores, as well as the continued benefits of the Extra Care card. And as I noted earlier, higher margin front-store sales increased as a percentage of total sales by 60 basis points to 31.6% of total retail sales.

These gains were offset somewhat by continued pressure on generic reimbursement rates in light of the significantly increased utilization of generic drugs that Tom mentioned. There was also an increase in the percentage of pharmacy sales handled by third-party insurance.

Okay, what about expenses? Right on track. In the PBM segment, comparable operating expense as a percentage of sales improved by seven basis points to 2.5%. In the retail segment, operating expenses were within expectations, despite the increase as a percent of sales from 23.9% to 24.1%. Generic conversions were largely responsible for the increase. If not for new generics, the rate would have improved by approximately 70 basis points.

Given all of the above, highlighted by healthy top line growth, the continued benefits of generics, and solid expense control, we continued to make excellent progress on operating margins across the board.

The PBM segment’s operating profit margin improved by nearly 140 basis points over last year’s comparable results. Our PBM’s industry-leading EBITDA per adjusted claim increased to $4.22, excluding merger costs in the third quarter, or 28.7% over year’s $3.28, and the retail segment’s operating profit margin grew by more than 130 basis points over last year to 5.6%.

Net interest expense in the quarter of $128 million reflects additional net interest associated with our increased debt position. Furthermore, this year’s third quarter experienced a 130 basis point rise in the effective income tax rate to 39.7%, as expected. This is due to the addition of several higher rate states in which Caremark operated but CVS did not.

Our weighted average diluted share count was 1.52 billion shares.

GAAP diluted EPS rose 37% to $0.45 for the quarter. This compares to $0.33 in 2006 and is $0.01 above the high-end of our guidance. Cash diluted EPS rose to $0.57. This compares to $0.47 last year. So even with the financing costs and slightly higher tax provisions, our earnings were strong year over year.

Looking at free cash flow, year-to-date through September we generated $678 million in free cash flow as compared to an outflow of $123 million for the same period last year. We are on track to deliver about $2 billion in free cash flow for the year. This is after the $1.3 billion in net capital we plan to spend this year.

We ended the third quarter with net debt of $8.4 billion, up about $4 billion from the end of 2006. Contributing to the increase was $2.9 billion in share repurchases, as well as regular dividend payments and the one-time dividend paid by Caremark to complete the merger. These increases were offset in part by the net free cash flow of $678 million.

Net capital expenditures amounted to $441 million in the third quarter. The PBM segment spent $28 million of capital in the third quarter.

As most of you know, in May we entered into a $2.5 billion accelerated share repurchase agreement with one of our banks. Through the end of the second quarter, we had paid $2.5 billion to them in exchange for the delivery of 61.7 million shares of common stock to us. I can report today that the ASR program concluded on October 5th and resulted in us receiving an additional 5.8 million shares of common stock. At an average share price of approximately $37, I consider this piece of our buy-back quite successful.

The aggregate 67.5 million shares of common stock they delivered to us are now reflected in our books as treasury shares. However, note that the additional shares received in October were not delivered to us until the fourth quarter, so you will see these reflected in our year-end statements.

As you know, we have in place board authorization to repurchase an additional $2.5 billion worth of stock as part of the balance sheet restructuring we announced during the merger process. We are currently executing an open market repurchase program. We will update you on the program again in the fourth quarter call. Our goal remains to do this quickly and realistically. That means completion in the first quarter of 2008, given the length of time the initial ASR took.

So where will earnings come out this year? As you’ve heard, both segments of the company have produced strong results, so today we are increasing our full year guidance to reflect that.

For the PBM segment on a comparable basis, we expect revenue growth of between 1% and 3% for the full year. For the retail segment, we expect revenue growth of between 11% and 13% for the full year. Same-store sales are expected to be in the range of 5% to 7% for the retail segment for the full year. For both segments, generics will play a role in dampening top line growth.

For the total company, we expect revenue growth of roughly 70% to 75% for the full year. Also for the total company, gross profit margins are expected to decline due to the mix of our business by approximately 550 to 600 basis points. The improvement over our prior guidance is due mainly to generic conversions. Gross margin will increase for both the PBM and retail segments, however.

At the same time, we forecast that total company operating expenses as a percent of revenues will improve by 600 to 650 basis points, also due to mix. In combination, we continue to expect solid, full-year operating margin expansion for the total company.

With net interest of about $425 million to $450 million, and the tax rate a bit below 40%, we now anticipate GAAP earnings per diluted share for the full year to be between $1.89 and $1.92. For calculating cash EPS, the expected impact of D&A, which should be added back to your GAAP forecast, is about $0.49 per diluted share for the year.

For calculating adjusted EPS, the expected impact of amortization that should be added back to your GAAP EPS forecast, is about $0.17 per diluted share for the year.

Our 2007 guidance reflects the over-performance we posted in the third quarter as well as our expected steady execution during the remainder of this year. It also reflects the impact from our share repurchase program, of course.

Many people have asked when we will be providing 2008 guidance. Our practice has been to provide guidance for the upcoming year on our fourth quarter earnings call and this year, that will be no different. Our fourth quarter call will take place on January 31st.

But while it is still too early to provide guidance for 2008, I am reiterating the accretion guidance we confirmed in the last call for the merger of CVS and Caremark. We continue to expect accretion to diluted EPS in 2008 of $0.08 to $0.10 on a GAAP basis.

So in summary, in the third quarter we saw healthy sales growth, expanding gross margins, excellent expense control, improving operating margins, very significant earnings growth, and outstanding free cash flow. I am very satisfied with our financial performance in the quarter.

With that, I will now turn this back over to Tom.

Thomas M. Ryan

Thanks, Dave. I’ll open it up for questions, but before I do, I asked Howard McLure to join us for the Q&A part of the segment. As you know, Howard McLure is the President of our Caremark business and given where we are in the integration and the merger, I thought it might be helpful for him to be on this call to answer some of your questions directly.

I will say this though -- going forward in ’08, we’ll go back to the standard CVS model that we’ve used in the past, where Nancy and Dave will do the earnings calls and I will come on for the yearly earnings call.

With that, I will open it up for Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Ed Kelly with Credit Suisse.

Edward J. Kelly - Credit Suisse

Good morning. Congratulations on another very solid quarter. My first question relates to your go-to-market strategy for next year and I was hoping you could potentially provide some more color on that, I guess particularly since Howard is here as well. You are clearly achieving significant synergies from the Caremark deal, so to what extent will you use these synergies to price business more aggressively? And then, on the other side of that, the differentiated services that you plan on offering as a combined entity, how much of that will you actually be able to roll out next year versus the year after? And is it enough to make a difference, in your mind?

Thomas M. Ryan

Well, listen, we’re not going to get into particulars on how we are going to go and price each particular client, but I will say that we are really optimistic on our existing client base because of the discussions that we’ve been having with them. And to my point earlier about not waiting for the puff of smoke or some grand silver bullet to come down, these programs are going to be evolutionary. So to your point, some of the programs will be implemented in ’08, some are more near-term, some are easier to do across our book of business, some require less technology investment, and others will be longer term in the end of ’08 or into ’09.

So these contracts, as you know, are three and four years. We have discussions with the client around them and we’ve made commitments that we are going to get some of these done. These are not just wish lists that we are going to talk about with the clients, and we have some performance clauses that we talk about that we are going to hit in the upcoming year.

So without getting into particulars, but you’ve heard us talk about a lot of these in the past around flex bill and bridge supplies and health promotions and screenings and the use of minute clinic, and making it easier for the customer to get their medication when they want it and how they want it and still lower costs for the payer.

And it really does vary. It varies depending on the health plan, depending on the size of the employer, but on a go-forward basis, we believe that we’ll be selling that obviously in ’08 and then implementing it in ’08 and ’09.

Edward J. Kelly - Credit Suisse

Last question for you, Wal-Mart indicated at their analyst meeting that they plan to get even more aggressive about adding new generics to their list as they are launched. Is there a point that we need to get concerned about that program at all, or do we just consider it a non-event, no matter how big the list gets?

Thomas M. Ryan

Well, the list is pretty large now and it’s a relatively non-event for us. I think you have to keep in mind that their customer base is different. I mean, they have -- a fair amount of their customers are cash customers. If you look at our business, 95% of our business is third-party. A fair amount of the prescriptions, certainly around the seniors, are less than the $5 or less than $6, so there is not that much savings around it.

Listen, we are always -- to say you don’t -- you are deaf and blind on a competitor I think is a bad thing to say. We are always looking at competition and what they are doing, whether it’s Wal-Mart or whether it’s insurers or other PBMs and we’re in the healthcare business.

I don’t want to downplay it but I don’t think we should be overly alarmed about it because it hasn’t gained that much traction from where we are today.

Edward J. Kelly - Credit Suisse

I agree. Thank you.

Operator

Your next question comes from Lisa Gill with J.P. Morgan.

Lisa Gill - J.P. Morgan

Thanks and good morning. I’m going to take the opportunity to ask Howard a question here, since he is on the call. Howard, I’m just wondering if you could just give us some indication as to what’s going on in the specialty pharmacy side. You continue to grow faster than where the peers are. And maybe you can just talk about what expectations are around clients, especially as it pertains to specialty pharmacy.

And maybe Tom then you can jump in and talk about maybe some of the combined opportunities over the next couple of years as it pertains to specialty. If someone walks into the pharmacy, they have a specialty script, is this an opportunity to convert them over to Caremark? And opportunities to then enhance that relationship, maybe you could talk a little bit about that.

And then just lastly, I know in the past Caremark has talked about clinics in the corporate setting. Is this still an opportunity within minute clinic to put some of these in corporate settings for Caremark customers? Thank you.

Howard A. McLure

The specialty pharmacy continues to grow as we number one, continue to bring in new product offerings, new products that come along but also in new therapy groups. For example, we began a fertility program about 14 months ago that we’ve gotten very good traction in.

Customers continue to look at the value of the service offering and the clinical things that we are able to do that don’t happen without some sort of expertise. Additionally, the fact that we are able to bring our offering to market at a little better price, as well as provide a broad offering, not only are those things [in the drug benefit] but also to in particular our health plan customers. Those things are in the major medical benefit and help the look at and control those costs as well.

Additionally, the oral oncology marketplace has grown significantly over the last year and that’s been a big driver also of our growth in specialty products. So I think it’s beyond -- it’s new product offerings from us, it’s new products coming into the marketplace, it’s the clinical expertise that we bring to this and the recognition by a lot of our clients that the clinical expertise is there. This has been where Caremark got its start. We’ve been doing this longer than anyone else. We do it better than anyone else, we believe, and provide a higher level of customer service and that gets recognized in the market.

Lisa Gill - J.P. Morgan

Do you think that people are recognizing that for the selling season going into next year, Howard?

Howard A. McLure

I do. In addition, the merger brought us retail apothecary stances that the PharmaCare had. The pro care pharmacy adds a completely different, two different pipelines, HIV and transplant therapy into the mix, as well as just a different service model that we are able to allow and bring to market. We will be able to offer our customers the ability to walk in one of the apothecaries and have face-to-face hands-on injection treatment for new interest into this market, or new users, [inaudible] users apart.

We are going to be able to offer them a retail component that we believe will provide some of the ability to get that special care that they are used to seeing from the specialty pharmacy, as well as still having the ability to access the mail order component.

Thomas M. Ryan

Lisa, to your point, there’s a fair amount of leakage in the specialty business just across the industry. In our stores alone it’s probably, I don’t know, $2.5 billion roughly plus, where a patient comes into the store, we may fill it once and then they go elsewhere, or we can’t fill it in the store because obviously we can’t stock it across our entire 6,000 plus stores.

So we have the opportunity to tie them in now with our specialty business because one, we have a more robust product offering than we did as PharmaCare. We have the full mail service, a full therapeutic range and we have what we call retail pull-through to our specialty business. So to Howard’s point, to have the retail and the mail together is resonating with clients.

As far as the clinics in corporate settings, people are really -- they are reaching out for it and everybody wants it but there are some economics around it and it has to be an appropriate size client. We are looking at perhaps working with clients to put clinics near or in close proximity to some of their facilities where one, the client would get some kind of special attention in addition to the general public being able to use it. So we are looking at all the opportunities as we go forward but they are definitely reaching out for minute clinic because quite simply, it just works.

Lisa Gill - J.P. Morgan

Just as a follow-up to that, are you seeing minute clinic being included as part of the PBM offering, or this is a completely separate offering that you are having discussions with the planned sponsors, just so I can understand that?

Thomas M. Ryan

It’s both, actually. We are using minute clinic in our PBM offering where we may be doing some, using the clinic for health assessments for a client. We may be using the clinic for different screenings for the client.

So without getting into all the details, it’s going to perform more than what it does with just treating everyday illnesses for the general public, so it’s direct to the client in most cases.

Lisa Gill - J.P. Morgan

Great. Thank you for all the comments.

Operator

Your next question comes from Meredith Adler with Lehman Brothers.

Meredith Adler - Lehman Brothers

Thanks very much. I was wondering if you could talk a little bit more about what some of the systems requirements will be to accomplish these goals. Is there a lot of systems work that needs to be done and do you anticipate that your capital spending on systems will go up significantly in the next couple of years?

Thomas M. Ryan

No, there is not a lot. I mean, we are going to do obviously some platform consolidation around the PBM side of our business with PharmaCare and Caremark, and that’s being worked on now. That’s kind of almost a separate track from these new offerings.

No, there is not a lot to do but you want to make it as easy as possible for all providers to perform the service, and by providers, I’m talking about our pharmacists, I’m talking about our call centers, I’m talking about our clinical pharmacists, our retail pharmacists, our nurse practitioners. We want to get it so that it’s easy as possible and some of it requires some changes in software and some changes in program, but it’s not this monumental Y2K effort or anything like that.

Meredith Adler - Lehman Brothers

Okay, great and then another question; when you look at the contracts at the new business that you brought in and compare it on the PBM side and then compare that to the big government contracts that were lost, how would you say the profitability compares?

Howard A. McLure

Well, the profitability of the contracts that were lost, whenever you lose a contract, you are losing it in the third or so year of its inception. As a PBM contract moves through year one, year two, year three, profitability increases. So trying to compare a third year of a contract to the profitability of a new contract is a little difficult. They will, by their nature, the contracts are more profitable in their third year than they are in the first.

Thomas M. Ryan

Having said that, a fair amount of the -- excluding FEP, which is obviously the mail side of the business, some of the other contracts we lost, they were more retail side, retail live and retail book of business, which is less profitable than the mail side for the PBMs. So that’s offset a little to Howard’s point.

David B. Rickard

And you have to remember that we retain about 90% of the contracts, so you don’t have a lot of that switching.

Meredith Adler - Lehman Brothers

Just a final question about that, is there much government business left? And is that at risk?

Thomas M. Ryan

What’s our mix of government business now, is --

Meredith Adler - Lehman Brothers

Yes.

Thomas M. Ryan

If you take out FEP, it’s probably 17% or so, backing out FEP. And there will be different government contracts that come up. The FEP business changed over the years from a few PBMs, so it goes back and forth and then obviously there are other government contracts out there, but right now it’s about 18% of our business and we think that’s fairly stable.

Meredith Adler - Lehman Brothers

Great. Thank you very much.

Operator

Your next question comes from Matthew Perry with Wachovia Capital Markets.

Matthew Perry - Wachovia Securities

Good morning. Maybe a question for Howard; I know it’s too early to talk about ’09 or how much new business the PBM side might win next year for ’09, but wondering if, based on your years at Caremark standalone, whether you’ve seen any kind of increase in interest from prospective clients, increased activity or earlier activity now that you can talk to them about a combined offering?

Howard A. McLure

Well, we’ve seen a lot of activity and a lot of interest in this new offering that we have. We’ve seen a number of people coming and talking to us, both existing clients as well as prospects, asking questions about the model and how we see it. We see this as a lot of enthusiasm for this model and we see that there is a lot of interest in what power this combination can do.

I think we are starting to see -- we see this year a number of prospects that are coming up from our competitors that have taken an interest in what we can do and what they think the power of this combination is.

I’m very excited about the prospects going forward for the upcoming sales season. That being said, we are still going to have to be a tough competitor and our competitors are also very good in their own right, so we will not be handed over business but we will earn business and I feel confident that we have the ability and the tools and the people on both sides, the PBM side and the retail side, to be a very, very different and unique competitor in this business.

Matthew Perry - Wachovia Securities

Thanks. Secondly, you talked a little bit about the Medicare drug benefit in the prepared remarks. Can you just talk about maybe the -- it seems like you are going to pick up a fair number of members for ’08, so should that make a larger contribution to the bottom line, or are those new members maybe offset a little bit by lower revenue?

Howard A. McLure

You’re right. I think that as you go through this process and you continue the bid process and as this rationalizes itself, premiums get a little bit more rational. People understand a little bit more about what’s going on, but obviously it will be a good contributor for us. It’s been a good line of business and it will be a good piece of business for us next year.

Matthew Perry - Wachovia Securities

If I could just squeeze one last thing in, have you talked about how much incremental SG&A you can remove from an ongoing basis from the FEP? Because as I understand it, it had a separate mail facility.

Howard A. McLure

It did have a dedicated facility and a dedicated group of about 700 employees and obviously, we lost that one piece of business but we gained some other pieces of business and what has to happen is an assessment has to take place where we don’t release all the dedicated people and go out and try to hire them again for another contract.

So at year-end, we’ll make an assessment and we’ll make a final determination but there will be an adjustment to the staffing related to the size of business. There has to be.

Matthew Perry - Wachovia Securities

Great. Thanks a lot.

Operator

Your next question comes from Deborah Weinswig with Citigroup.

Deborah Weinswig - Citigroup

Good morning. Tom, you provided some details on minute clinic. Can you talk about what you are seeing in terms of traffic and ticket differences between stores that have them and stores that don’t?

And then also, as you continue to increase the penetration of these in a market, what happens to the break even time?

And then lastly, we recently heard some concerns, which I was shocked to hear, over saturation. Can you also maybe discuss that as well?

Thomas M. Ryan

We don’t see saturation at all. In fact, we are trying to roll out quicker in markets. Our biggest challenge is some state regulatory hurdles that are being put in our path but we are working through those, so saturation is the least of our problems.

We don’t get into specifics on each clinic and what is happening but I can tell you there is a significant growth and the longer obviously the clinic is open, the more exposure it has on the market, the more brand recognition it has on the market, the more business we get. We know that when we dense up the clinics in a market, we have better penetration and better utilization by the consumer.

So we continue to see growth. Our challenge around the clinic obviously is one, making sure that we get them open as quick as we can; two, we make sure that there’s fixed cost in these clinics and they are great for our brand, they are great for overall go-to-market strategy around retail and PBM. The challenge is, which is what we are working on, is the so-called slow season of June, July and August that we need to make sure that we are using these nurse practitioners in the right way and that’s what our teams are working on now.

And there is so much opportunity now with clients, and we kind of alluded to that a little earlier, that we wouldn’t have had before without the broad base of clients that we have now that we can do some things with the clinics.

We continue to be very enthusiastic about the clinic and we continue to roll it out as fast as we can.

Deborah Weinswig - Citigroup

Do you think that eventually the clinics will be able to be utilized for infusion type services?

Thomas M. Ryan

We are going to utilize the clinics for some other opportunities. The infusion business is a tough business. It takes a huge infrastructure to home infusion business, which is why we’re really not in -- it takes a huge investment in infrastructure, it’s labor intensive with nurses going to the home. We think there is something in between where we could possibly use some of our assets, I’ll say, to do something in the clinics and maybe help the chronic infused patient.

Deborah Weinswig - Citigroup

Okay, and then just one quick question for Dave; you had alluded to the cost synergies as being a significant driver of gross margins in the quarter. Can you provide some additional color around that?

David B. Rickard

We don’t actually break out the pieces of gross margin, so -- we told you that in ’08 we expect it to exceed $660 million. We are obviously ramping up now and getting toward that run-rate, but we are not all the way there, obviously.

Deborah Weinswig - Citigroup

If you could provide any additional color -- is anything coming in faster than you would have expected or are you getting it from different buckets than you had originally expected?

David B. Rickard

Yeah, I think we’ve said before that both on the overhead side and on the purchase cost side, we are getting a little bit more and a little bit faster than we expected. We found that the two companies work together extremely well, have communicated extremely well, and things just happen faster than we otherwise would have reasonably expected.

On the purchase side, we have told you before that the approach that we took to quantification really just took lower list cost and obviously there is some ability to negotiate beyond that and we’ve started to do that.

Deborah Weinswig - Citigroup

Well, congratulations again on a great quarter.

Operator

Your next question comes from John Ransom with Raymond James & Associates.

John Ransom - Raymond James

Good morning. Your retail gross margin numbers were certainly a lot stronger than your big competitor in Chicago. I wondered if you might help us think about how much the early purchasing synergies might have contributed to that number in addition to all the other stuff that you mentioned. Thanks.

David B. Rickard

Are you talking about our retail gross margins?

John Ransom - Raymond James

Yes, retail gross margin numbers were year over year up a lot more than what we are seeing from some of your competitors and we’re just trying to figure out how much of that is coming from some of the early purchasing synergies from the merger.

David B. Rickard

Well, once again, we don’t break out the pieces. There is synergy in there. That’s an important component. There is also generic conversions that are higher and I would say of the two, generics are the more important piece.

Thomas M. Ryan

Generics and front -- we’re talking about total retail, right? You’ve got front-store also here. Our front-store margins continue to expand and I don’t think you should discount that. We’ve worked hard to do that around private label, proprietary, extra care programs. I mean, we’re not buying sales here on the front-end of our business and people are working hard around that, around product mix to David’s point and promotional mix. So that combined with generics, obviously on the retail side and just overall better buying in general. But we don’t break out the pieces on the synergy.

John Ransom - Raymond James

My other quick question is looking at your total mail order, combining the two PBMs and looking at your total mail order infrastructure, as we look out two or three years, not just next year, is there an opportunity to do any kind of big bang? I guess there’s some thought out there that maybe one of your bigger competitors has a more consolidated back-end processing arrangement, has some cost advantages on some of these very cost sensitive contracts. Is there something we could look for on a big bang basis? Or is it going to continue to be run as three pieces from a technology and processing standpoint?

Thomas M. Ryan

I understand the question. We won’t be looking at any big bang here. We have a situation and we are going to continue to look to rationalize and look at our overall cost structure in the company, whether it’s retail distribution or whether it’s mail order distribution, whether it’s call centers. We continue to look at how we can get more productive in the company.

But it’s not clear to me -- everybody touts what they have because they have it and it’s not clear to me to have two big centers is better than having multiple centers. You could make a case around either emergency situations or -- so we can spread out some of our flexibility, labor scheduling. I mean, you think about FEP, what we’re able to do and consolidate that into one plan, to someone’s earlier question, one particular facility essentially, you can carve it out easier. And then all the clinical work we do.

So we are comfortable. We are never satisfied where we are. Obviously there’s some opportunities like there are whenever you put two companies together but we won’t have any big bang here.

John Ransom - Raymond James

Okay. Thanks a lot.

Operator

Your next question comes from Neil Currie with UBS.

Neil Currie - UBS

Good morning and thank you for taking my questions. The first one is about the synergies. You announced $160 million synergies this morning but you haven’t raised your accretion guidance for ’08. Is there a reason behind that?

David B. Rickard

The offset, and actually we announced it on the last call, is in the amortization of good will, which came in higher due to a higher valuation of amortizable pieces of our intangibles, principally the value of the contracts.

Neil Currie - UBS

That’s when I was away. Thank you. The other question is that we saw a very interesting deal between Alliance and Cardinal Health, which looks to combine some buying power on generic drugs. It seems to be becoming more of a global business, the buying of generic drugs, as well as the manufacturing of generic drugs. Do you see CVS Caremark going that way in the future, either in an informal or a more formal way?

Thomas M. Ryan

We are always looking for those opportunities around purchasing opportunities, especially in generics. I will say this, that CVS standalone was looking at those opportunities, Caremark standalone was looking at those opportunities, so I can assure you that together, we are exploring both of the opportunities, either ones that we had originally talked about individually or ones we are talking about new collectively.

So it is intriguing. There is obviously a lot of challenges around it, making sure the source of supply, the quality of supply is good. But we are doing a lot of work around that and we think there are some opportunities for us.

Neil Currie - UBS

And in terms of the retail gaps that you still have remaining in Northern California and Pacific Northwest, are you happy just to get in there in a piecemeal, on an organic basis? Or would you consider further acquisitions?

Thomas M. Ryan

Well, if you look at our history, we’ve grown both organically and through acquisitions, so we will continue to do both. And if there are appropriate acquisitions, then we’ll look at them. If not, we’ll grow organically in the market and we think obviously we have the wherewithal to do it now.

Given the fact that we have a fair amount of coverage nationally and it’s really to your point, Northern California and the Pacific Northwest, and it’s two states up there, so I think we can probably handle that organically, if in fact there’s no acquisition activity.

Neil Currie - UBS

Thank you.

Operator

Your next question comes from Mark Husson with HSBC.

Mark Husson - HSBC Securities

Good morning. I would just like to ask about the revenue synergies that you had talked about at the time of the bid for Caremark. If I remember rightly, $800 to $1 billion of revenue synergies over a period of time. Could you refresh that number for us?

And then secondly, talk a little bit about progress. I know it’s a bit early for that but if we look at the inter-segment sales line, will that give us some kind of clue as to how those revenue synergies are coming along?

David B. Rickard

Yes, $800 to $1 billion is what we talked about. What we are experiencing at the moment is that we are talking to customers and prospective customers about things that we can do for them that no one else can do, and that is resonating and so there is no question that’s positively influencing those discussion.

We are going to have to make an assessment once the season is underway and we see some actual results and we’ll come back to you on that. But there is no question that we are starting to see some positive movement on those things.

I don’t think the inter-company eliminations are going to be very related one way or the other to this kind of thing. I mean, it took a question of winning a contract that we otherwise wouldn’t have won on the PBM side. Some piece of that will get serviced in CVS stores and there will be some reflection in the inter-company elimination but I don’t think analyzing the inter-company elimination is going to lead you to a better understanding of how much of this we are achieving.

Mark Husson - HSBC Securities

So you wouldn’t be expecting to drive more Caremark business through CVS doors? Wasn’t that really part of the revenue opportunity, or was it never?

Thomas M. Ryan

Look at this way; we talked about it as a 50-50 split and the idea was that we would obviously pick up some new PBM contracts, and it shouldn’t be discounted that we were going to enhance our ability to retain some contracts.

I mean, the fact that the offering that we have, I can tell you has been the positive in retaining and renewing some contracts in the selling season.

So yeah, there will be some, obviously, if the consumer -- if we have the offering that we have and that we plan on having and some of the things I talked to earlier, we believe the consumer will react to that and we should see it in some store movement, absolutely.

Mark Husson - HSBC Securities

And then finally, two scary things; first thing, there’s been recent talk about the pharmacist shortage and cost. For those who have been covering CVS for a long time, that’s a scary thought. And then secondly, how was Halloween?

Thomas M. Ryan

Great transition. I don’t know if they go together, but we --

Mark Husson - HSBC Securities

It wasn’t 2001.

Thomas M. Ryan

No, I know. I got the message. We are not seeing a grave shortage at all. I mean, we are still seeing the normal pockets of problems in the normal areas. Actually, when you look at it, we think we have a better offering and people are actually coming to us. When we go to college recruiting, people see the opportunities that they have professionally around CVS and Caremark and the opportunities across both books of our business. And we are excited about it but it’s the normal -- it’s the normal fight that you have with pharmacists.

I will say this, that we are opening up -- and when I saw we, I mean industry as a collective and the profession -- opening up a number of new pharmacy schools, so the number of graduates are increasing. So it’s continued normal pressure but it’s nothing like reliving that in ’01 at all.

As far as Halloween goes, we’re up almost 8% to LY for the month and it’s pretty strong. I was talking to someone last night and they went into our stores and they said we couldn’t get any Halloween candy and I said perfect. The last thing you want to have is Halloween candy on November 1st. So I think the sell-through has been good. I think the warm weather actually in the Northeast helped a little bit with Halloween because kids go out more.

Mark Husson - HSBC Securities

Thanks so much. The candy’s all at my house, by the way.

Thomas M. Ryan

That’s good. That’s where it should be.

Operator

Your next question comes from John Heinbockel with Goldman Sachs.

John Heinbockel - Goldman Sachs

A couple of things; Tom, talk about the [macking] process a bit in terms of the pace of that. It sounds like the pace has not picked up appreciably in the last year. Do you think there comes a point when it does, and when would that be? And does retail I assume gets [macked] a lot quicker than mail does, or is that not right?

Thomas M. Ryan

That’s true. Retail is [macked] quicker and there is obviously discussions one has with all our networks around that. Some of it is in contracts, some of it is not.

I guess the [macking] really people talked about Zocor, that was the big one that kind of got [macked] relatively quickly, just because of -- just the substitution and penetration that that had when that came out generically.

The trend hasn’t been that dramatic in the change in [macks]. People are obviously looking to control costs and when costs go down, the pay earnings to benefit -- at the end of the day, this is all about helping the payer lower costs and improve healthcare, so we are going to obviously look at that and apply it equally across all books of our business. But we don’t see anything dramatically changing on that.

John Heinbockel - Goldman Sachs

Do you think the payer begins to focus on either retail or mail generic profitability when we get to 80%, 75% generic penetration? It won’t happen until then, and then it happens? Or not even then?

Thomas M. Ryan

Well, like I said, I think the payer looks at the whole offering. I mean, you have to look at administrative fees. You have to look about pass-throughs. You have to look at appropriate use of medication, about compliance programs, about clinical programs or people using some psychotropic drugs too often, so are we monitoring the diabetic patients -- so it’s not just generics. Obviously generics are a big piece of the business but generics are profitable and the last thing a client wants to do is take our incentives away to drive generics.

I don’t think it’s going to be that big a problem and it’s obviously at launch at single source versus the multi-source generics at launch. They may have some challenges but I don’t see a dramatic shift, John, if that’s your question.

John Heinbockel - Goldman Sachs

And then finally, the $1.6 billion that you picked up this year, the new business, next year with the top line synergy, does that number by definition, should it be higher than the 1.6 or is there less business out there because Medco brought a lot of contracts forward?

Howard A. McLure

There is we think a stronger pipeline this year than there has been in recent years out there. We would like to see -- we believe, we are very enthusiastic and we believe our performance is going to be a lot better next year than it was this year.

John Heinbockel - Goldman Sachs

The 1.6, you’ll exceed that next year is your hope?

Howard A. McLure

We’re not giving any guidance right now, so -- John, if you are talking about ’09 wins, we would expect them to be at least as strong as this year.

John Heinbockel - Goldman Sachs

And when you talk about the $800 million to $1 billion, say half of that is Caremark, do you think that is more new contracts or more selling new products to existing contracts?

Howard A. McLure

A combination of both. It’s getting more specialty spend across the business, it’s getting more healthcare and disease management across the lives. It’s a combination of both, in addition to new lives. I mean, we are obviously going to be aggressive but it doesn’t go unnoticed that two of our competitors did a fair amount of early pricing and aggressive gross margin pricing and investment for ’09 business, so we’ll fight that.

John Heinbockel - Goldman Sachs

Okay, thanks.

Thomas M. Ryan

Two more questions.

Operator

Your next question comes from Scott Mushkin with Banc of America.

Scott Mushkin - Banc of America

That last answer kind of dovetails into what I wanted to ask you about; so the concern we are hearing more about lately is how a price ware is avoided in the PBM business for the ’09 selling season. CVS Caremark clearly has to show outsized PBM wins to prove I guess to some people in the market that the acquisition makes strategic sense, and to get rid of the conglomerate discount. Clearly, as Howard was mentioning, some competitors obviously don’t want this to happen and have been somewhat irrational already. So how do you do this? How do you win more contracts while avoiding a price war?

Thomas M. Ryan

I’ll start and then Howard can jump in, but I mentioned this earlier. It’s obvious prices is a key component of any contract win, but then it’s also service and it’s not just -- you know, when you think about it, when we talk to clients, and especially the sophisticated ones and the larger ones, they are looking at us to help lower their healthcare costs. It is their medical costs that are going up. It’s not -- the use of generic drugs is not driving up the cost of healthcare in this country.

And CVS Caremark is 190,000 people, so we are a big payer of healthcare and it’s the medical side of the business that is driving cost and the specialty component in particular.

So while price is always an issue -- I mean, it’s an issue whether it’s in retail or in PBM, and it’s the entrance to the door and our goal is to lower the cost of healthcare for the payer.

So we look at it a little differently, and did some people take what I would call some billboard clients that go aggressively at it? Yeah, probably. Competitors for their own reasons, and you’d have to ask them, but I don’t see a price war here. I think it’s more who has the better offering around lowering overall healthcare costs in the long-term and providing the appropriate service and involving the consumer in the plan. This is the key here. I mean, the key is to involve the consumer because we pushed a lot of buttons and a lot of levers in healthcare. We’ve got to get the consumer involved in this and that’s why we think we have an advantage, and we are seeing that advantage.

Howard A. McLure

I think Tom, you summarized it very well. The unit cost to buyer, quite frankly, there’s a lot of unit cost buyers in years past, and those unit cost buyers are starting to come back to the value buyer. I can think of the one account that started for us in 2007, the health plan account --

Operator

Your next question comes --

Thomas M. Ryan

No, we’re not done answering yet. Hold on.

Howard A. McLure

A unit cost buyer that has come back to a value, this business we picked back up in 2007. I think Tom stated it well. The value player is not necessarily concerned about the unit price. He's concerned about his overall costs and the investment that he is making with his pharmaceutical spend and how that’s going to impact positively his major medical costs.

Thomas M. Ryan

Okay, we have one more question.

Operator

Your final question comes from Eric Bosshard with Cleveland Research Company.

Eric Bosshard - Cleveland Research

Good morning. Two questions for you; first of all, Howard, as you look at the opportunity in rolling out this new plan, do you think that you get more of a benefit or pay back from your existing book of business, or do you think you get more of a benefit from winning business in the early years of this?

Howard A. McLure

I think we get benefit from both sides [of the coin]. Our existing customers, many of them who are the value buyers, look at it and see the value behind the offering. New accounts or prospective customers look at the value that we can bring together as a combined entity and they like what they see, and they have the ability to see that this is a better model. So we think this is going to help us from a retention prospect. We certainly believe and our sales force is very excited about what’s going to happen from a new business front with this combined offering.

As Tom said in his remarks, this offering is resonating with clients, both prospective and existing.

Eric Bosshard - Cleveland Research

Do you think within retaining business that the new offerings, that you’ll be able to benefit from the savings, a component of the savings that are generated from the new offering with retained business? Or do you think you have to take those savings and give those to the customer in order to retain the business?

Thomas M. Ryan

It’s going to be a mix. I mean, we are in the business of saving customers money. We have to save clients money. There is no mistake about that in this company and we have obviously a number of customers.

We are in the business of working with our clients, whether they are managed care players or the government or large corporations, to save them money on their healthcare costs and it starts with prescriptions and then it expands from there. So we have the opportunity to do it in a number of ways and one of the ways is the way you mentioned.

Eric Bosshard - Cleveland Research

Secondly, for 2008, it was helpful for you to give some guidance about how to think about the PBM business with the FEP loss. But in terms of the profitability next year, if you do not have additional synergies from the combination of the companies, do you think that the SG&A reductions and the improvement in the underlying business would allow you to have flat profits, considering the losses of the business?

Thomas M. Ryan

We are not going to give that but I wouldn’t go down that road. I mean, we are working hard at a lot of things in this company and flat profits is not one of them. So we’ll give you guidance later on on it.

David B. Rickard

You understand that profits are expected to be up, and that includes the benefit of synergies and it includes the benefit of SG&A management and everything else?

Eric Bosshard - Cleveland Research

Yes, all I’m trying to get an understanding of is how much of the loss of FEP you have the ability to mitigate by taking SG&A out of the business. That’s what I was trying to --

Thomas M. Ryan

Fair enough. It’s a fair question and to Howard’s point earlier, the FEP business was the most -- it’s obviously towards the end of it, which is the most profitable. But variable cost performance just is automatically removed and then, to the point I made earlier, because we have a lot of facilities and we allocated most of the FEP into one or two facilities, we can carve it out. So that’s going on as we speak and then it will be offset by some others.

I want to be clear on that, because it’s a good question, Eric. Our PBM business is going to be profitable. It’s not a situation where because we have lost this business, we are not going to be profitable. Our profitability will increase in the PBM business for a variety of reasons, which I mentioned earlier, and when David goes over the guidance on the next call, you’ll see the breakdown.

Eric Bosshard - Cleveland Research

That’s helpful. Thank you.

Thomas M. Ryan

Okay, thanks a lot and as usual, if you have any calls, call Nancy. Thanks.

Operator

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

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Source: CVS Caremark Q3 2007 Earnings Call Transcript
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