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

CVS Corporation (CVS)

Q4 2005 Earnings Conference Call

February 2nd 2006, 8:30 AM.

Executives:

Nancy Christal, Vice President, Investor Relations

Thomas Ryan, Chairman, President and CEO

David B. Rickard, Executive Vice President and CFO

Analysts:

Mark Roberto, Midwest Research

John Ransom, Raymond James

Mark Husson, HSBC

Meredith Adler, Lehman Brothers

Mark Wiltamuth, Morgan Stanley

Edward Kelly, CSFB

John Heinbockel, Goldman Sachs

Nancy Christal, Vice President, Investor Relations

Good day everyone, and thanks for joining us today for our Fourth Quarter 2005 Conference Call. I am here with Tom Ryan, Chairman, President and CEO and Dave Rickard, Executive Vice President and CFO. Tom will be providing highlights of our business in the fourth quarter and year, and then Dave will provide our fourth quarter financial review, as well as our initial guidance for 2006. Before I turn this over to Tom, I have some administrative items to cover and I will also review January sales results, which we announced this morning in a separate press release. First, please mark your calendar for our 2006 Analyst and Investor Meeting, which will be held on Wednesday, May 24th at the Mandarin Oriental Hotel in New York City. Consistent with our meetings in the past we are planning a half-day event with several speakers from our senior management team. An invitation with all the details will be sent via e-mail in March, but please save the date.

While we are likely to webcast the meeting, we hope you will attend in person, as this is one time during the year and you can have direct exposure to executives beyond our usual spokespeople. Second, we sent an e-mail to everyone currently on our investor relations distribution list. It was sent on January 26th at about 9:30 in the morning requesting that you respond by February 10th if you wish to remain on our list. We are trying to ensure that our list is up-to-date, but please remember to respond by then if you want to remain on the list. Please note that today's call will be simulcast on our website at www.investor.cvs.com. It will also be archived on our website for a one month period following the call, to make it easy for all investors to access the call. Note that this call may not be rebroadcast without prior written consensus from CVS.

Now I will quickly rattle through the usual administrative items in light of Regulation FD, we will only accept analyst models for review, within the one week period following each quarterly earnings call. This review in common will be limited to suggesting changes based on information disseminated to the public on the call. During this period, we will simply check analyst models for appropriate interpretations of what we've said. In addition, please note that during this call, we will discuss one non-GAAP financial measure in talking about our Company's performance mainly free cash flow. We define free cash flow as earnings after taxes, plus non-cash charges, plus changes in working capital, plus net capital expenditure. But free cash flow excludes acquisitions and dividends. We find our measure of free cash flow to be a good way to understand the operational cash flow being generated by the business.

In accordance with SEC regulations, you can find the reconciliation of free cash flow to comparable GAAP measure on the investor relations portion of our website at www.investor.cvs.com. As we typically do on these calls, our attorney's have asked to read the safe harbor statement.

During this presentation, we will make certain forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially. For these statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. We strongly recommend that you become familiar with the specific risks and uncertainties that we have outlined for you under the caption “Cautionary Statement Concerning Forward-Looking Statements" in our Annual Report on Form 10-K for the 2004 fiscal year ending January 1, 2005 and in our Quarterly Report on Form10-Q for the 2005 third quarter ended October 1, 2005. And this morning's earnings press release is also available on our website, but should be reviewed along with the information on this call.

Now let me turn to January sales. Total comps were up 5.4% with pharmacy comps up 4.8% and front stores comp up 6.7%. Core pharmacy comps increased 3.8% in January, while the 2004 acquired stores pharmacy comps increased 9.3% as we continue to benefit from the turn around of those assets.

There are a couple of things to note about our January pharmacy comps. First, we had a 230 basis point negative impact from recent generic introduction. Second, we were probably up against a very strong flu season last year, and we also had a shift in the timing of the New Year's holiday. Together the flu and the holiday shift had an impact on January comps of over 200 basis points, that's on January pharmacy comps. Front-end comps were very solid in both the core business and the acquired stores, as we saw a 3.2% front-end comps for core CVS and 27.8% front-end comps in the acquired stores. And that's despite the fact that the cost in core category is also down notably from the prior year reflecting the absence of flu. Other than weaker cost in wholesales, we saw strength across all of our core category. Please feel free to call me with any questions after the call, and now I will turn this over to our Chairman, President and CEO Tom Ryan.

Thomas Ryan, Chairman, President and CEO

Thanks Nancy and good morning everyone. Bear with us, we have a lot to cover this morning with the results, as Nancy said from our fourth quarter and the year, and we talk some more about Medicaid and Medicare, the Albertson's deal, and then some guidance. As you know, on January 23, we announced a definitive agreement to acquire the 700 Stand-Alone Sav-on and Osco Drugstores, as well as the La Habra, California, drug stores distribution center. This transaction will be accretive to earnings and cash flow in the first full year. It also, obviously, has significant strategic value to us, as it provides instant leadership in southern California, while strengthening our market share in other important states such as Illinois, Indiana, Missouri, and Arizona. So, we are clearly optimistic about the deal long-term, and as you know, we expect the deal to close sometime in June. We'll touch on – Dave will touch more on this a little later.

Let me talk about the fourth quarter and our year-end results. Well, '05 was certainly a year of accomplishment for our Company. Total sales climbed 21% to a record $37 billion. Same-store sales increased 6.5%, as we continued to gain share both in front and pharmacy. Pharmacy comps were up 7% for the year, while front-end comps rose a strong 5.5%. We completed the Eckerd, and retail and PBM integration in 12 months that was certainly unbelievable, by any measure the acquisition and integration is a homerun for our Company. At the same time, we opened up 300 new or relocated stores adding 3.6 retail square footage.

We also broke ground for another state-of-the-art distribution center in Vero Beach, and believe me this is in the far west part of Vero Beach, where land is cheap. And that should be up and running by the end of this year. We also quickly expanded our NSDC facility to accommodate the acquired stores and importantly this was accomplished without any disruption to our business.

And the thing that pleased me the most, throughout all this activity, we never lost focus on our core business. Excluding the Eckerd stores that we acquired, total comps for core CVS were up a solid 6%, pharmacy comps up 69, and front-end comps up 39.

In '05, our PBM's PharmaCare hit new highs, achieving total sales of just under $3 billion. PharmaCare won important new PBM in specialty business in '05, and is prepared to capitalize on the growth opportunities we see in Medicare Part D, and I have more on PharmaCare later.

So in the end, we delivered diluted earnings per share of $1.45, up 32% from $1.10 in '04, which included about $0.07 one-time items. In addition, we generated over $0.5 billion in free cash flow. And on top of all the numbers, we continue to strengthen the people in our organization by promoting and adding talented individuals in the IS (ph) area, pharmacy area, supply chain, merchandising, and PharmaCare.

Let me touch on the fourth quarter, total sales were up 9% to a record $9.7 billion. Comp sales increased 6.7 in the quarter, pharmacy comps were up 6.3, and front-end comps were up, an impressive 7.7. The acquired stores benefited total comps by about a 150 basis points that helped front-end comps by about 374 and it helped pharmacy comps by about 42. So in the quarter, diluted EPS was up $0.48, up 60% from last year's split adjusted $0.30, which once again includes about $0.07 from one-time items in '05.

Let me give you a kind of overview of the business, and what's behind the numbers. As I said, our front-end business remained strong. We've seen continued growth in the customer traffic across our chain. We continue to gain share across all categories. Front-end comps, as I said were up 77 in the quarter, it is important to note that they were very strong both in the core business, and the acquired stores. Front-end sales were broad based, our health, beauty, consumable, seasonal, general merchandise, digital photo were extremely strong. Private label business was once again strong, and the category now accounts for 30% of our front-end sales and about 12% in the acquired stores. We believe there are – there is significant opportunity to grow our private label business over the next three-to-five years and of course obviously this will be introduced into the stores we are acquiring in June. Our digital photo sales were up notably in the fourth quarter, volumes sky rocketed to 90% in the fourth quarter versus the same period last year. So we continue to meet and exceed our targets for the digital photo business.

We are building a loyal base in the acquired markets, in fact 67% of sales come from ExtraCare card users and we know that ExtraCare card data, we know that from the data from ExtraCare card, these folks shop more often and spend more per trip. So I am extremely pleased with our front-end strategy, it's definitely producing results. We are using a combination of the ExtraCare card, smarter promotion that work harder, new proprietary products and the ladies are focused on customer service in our stores. This is the heart of our strategy for the front.

Now let's take a look at the pharmacy business. Our pharmacy shares continue to increase. We hold a 14 share of retail nationally, up 48-basis points from the fourth quarter. Our share in these markets grew 82 points from the fourth quarter last year. Our script volume has exceeded IMS growth rate for food drug and mass. We saw script volume growth of 4.9% in the quarter. Our growth out paced food drug and mass by 210 basis points. Our pharmacy comps have been consistently solid. As I said total pharmacy comps were up 63 in the fourth quarter as in the front we saw continued strength in the core business with pharmacy comps up 59.

Do you know Generic Drugs continue to play an important role in pharmacy. They've depressed pharmacy comps by about a 190 basis point in the fourth quarter. This was up considerably from last year and we expect generics to have a growing importance in the second half of '06 and beyond. As popular drugs such as Zocor, Provocol and Zoloft become available. And once again we've talked about this before, this is clearly something that will be back end loaded in the second half of the '06.

In our Medicare Part D, now this is another factor that started to influence in '05 but really will have an influence in '06. We expect the program to increase utilization in our stores. And government recently reported that 24 million people now have prescription drug coverage under Medicare Part D. There was a surge, since December 13th actually, the surge increased 2.6 million newly covered in release. So as of January 30th there are approximately 3.5 million people in the U.S. that are newly covered seniors. In total CMS as they are enrolling about 50,000 seniors a day.

Now as you know there has been a lot of press about Medicare beneficiaries having trouble getting their medications and that clearly was an issue and continues to be to some degree today. Most of the difficulties involve the dual eligibles and to simplify this it was a simply a case not of enough lag time between when the individual was enrolled and when they became eligible for the benefit. So their information didn't get into the system. Someone can be enrolled in January 30th and come into our stores on February 1st well the information wasn't in the planned systems. So because of eligibility problems it caused higher co-pays for some of these people, who were already having to adjust the paying of co-pay at all.

Another difficulty was just getting through to call centers. We have been in constant communications with health plans and claim processes and in fact CMS to work through these issues. It's getting better each day, we have put in work around in place to deal with these problems, at the end of that day our first responsibility is to our patients and we are making sure that they get the medication and we will get properly paid for it as we go forward.

We are continuing to provide information to our stores to help those seniors who are still looking to signup. We will certainly continue to see transition problems, it's inevitable on any program of this size. But we are working with CMS, our folks have been in contact, our industry has been in contact. I personally met with secretary Levitt on this issue. So, we think that those programs will start -- the problems will start to subside. The early polling results tell us we are seeing new customers every week and by noon, I mean a combination of customers who did not have pharmacy coverage and customers would did not previously fill prescription at CVS even if they had coverage. Now as you know we are seeing Medicare Part D from both sides as a retailer and also as a PBM that serves PDP Universal American. PharmaCare is responsible for all claims processing formulary management, rebase et cetera for universal. Universal American currently has about 400,000 members, but still early in the program their number of enrollees quite frankly is a little less than we had anticipated but we expect to see additional enrolment through May. We will keep you posted as the program continues to take shape but we still feel as the Medicare ‘06 program will be slightly dilutive to the corporation in the first half and slightly accretive to the entire corporation for the full year.

Let me switch gears now and turn to real estate, obviously we don't think that gets enough attention from the organic side of our growth, because of obviously the acquisitions we do. But keep in mind, despite the acquisitions we have continued to add organic square footage growth. And all of our market development efforts are yielding results at or much better than planned. During the fourth quarter, we opened 50 stores that included 24 new and 26 relocs. We closed 14 of it resulting in the net unit growth of 10 stores. For the full year, we opened up 297 stores including 67 new and 130 relocs.

We closed 70 others that equates to 96 net new stores for the year. So our retail square footage increased by about 3.6%. This is once again on top of the acquisition. During '05, we continued to expand our presence in the high growth Florida and Texas markets opening up 31 stores in Florida and 27 in Texas. We also continued to open stores in Minneapolis adding seven more this year for a total of 15 stores and we continue to add stores in Phoenix, Vegas and Chicago. Our plan for ‘06 is to open up 250 to 275 stores, about 140 to150 would be new, the rest will be relocs. With closing, we expect the new unit growth to be about a 100 to 125 net new stores for the year. Once again producing growth of over 3%.

Let me talk a little bit about PharmaCare, for the full year PharmaCare's total sales were up 58%, these numbers are obviously helped by the fact that we included the acquired PBM for five months, when we saw terrific growth in the fourth quarter with sales up 24%. Operating profit for the full year was $222 million, up 66%. In the fourth quarter alone, operating profit grew 17%. With the integration complete, we continue to build our mix to PBM client, one just by growing new clients, the two by adding and the use of specialty services to these clients. In 2005, we added new specialty pharmacies in Denver, Dallas, Berkley, California, and Columbus, Mississippi.

PharmaCare currently operates 51 specialty stores in clinic pharmacies, more than any one in the U.S. While we have had few contract terminations in '05 from the EHS book to business, we've also won other new contracts to replace them. Some of these include Consolidated Energy, Adventist Health Systems, Sonic Automotive and the State of Connecticut, which has over the 190,000 lives alone. With these new contracts along with incremental business from Medicare Part D I am optimistic about PharmaCare's growth for the future. So we had a very good year in '05 and now I will turn it over to Dave to give you a financial review of the numbers.

David B. Rickard, Executive Vice President and CFO

Thanks Tom, good morning everyone. As you said first I will review our fourth quarter and full year 2005 financial results in some detail. Then I will provide initial guidance for the first quarter as well as the full year 2006. Let's go to the fourth quarter income statement, fourth quarter was the first full quarter we've completed since the anniversary of the Eckerd acquisition. As Tom said sales increased 9% to $9.7 billion in the quarter and 21% to $37 billion for the full year. Let me provide little more detail around those numbers. Pharmacy sales represented about 69% of total fourth quarter sales and about 70% of total sales in the full year, that's up approximately 20 basis points from last year. Third party percent of pharmacy sales remained virtually unchanged at 94%. Our overall gross margin increased by a 129 basis points in the quarter to 27.8% and most significant drivers were the absence of last year's Eckerd name change events and the continued migration towards generic utilization.

Generic scripts as a percentage of total scripts dispensed increased by almost 400 basis points in the quarter. Gross margin increased by 51 basis points for the full year to 26.8%. The key drivers were the increase in the amount of generic drugs dispensed and an improvement in shrink. The percentage of script sales using a generic drug increased by over a 400 basis points for the full year.

Now I'll turn to SG&A, total SG&A expense as a percentage of net sales improved year-over-year by 103 basis points to 21.6% in the fourth quarter, and improved 20 basis points to 21.3% for the full year. Recall that in the fourth quarter of 2004, we recorded a one time non-cash lease adjustment of approximately $66 million in SG&A. So in 2004 SG&A expense was abnormally high due to this non-recurring event. Keep in mind that this year's results include about $15 million of favorable litigation settlements, which yielded a one time benefit to diluted earnings per share of $0.01.

Analysts may want to adjust the numbers for these non-recurring items. Regulation G makes it cumbersome for me to do it for you. As we expected, chief among the drivers of this quarter's improvement was the absence of integration costs that were in last year's numbers. Our SG&A was further helped by the enhanced sales leverage, which being from the first sales turnaround in the acquired stores. Partially offsetting these benefits were increases in depreciation resulting from the improvements that we have made in the acquired certain assets, as well as the investments in customers' service we are making in labor hours and expanded store hours. So, good trends overall.

Operating margin was 6.2% in the fourth quarter. This was up 232 basis points versus last year's fourth quarter. I would also note that it improved 31 basis points from 2003's fourth quarter, which was of course prior to our 2004 acquisition. For the full year, the adjusted operating margin was 5.5%, an expansion of 70 basis points from last year and 11 basis points from 2003. Again these figures include the impact of the one time items previously discussed. But nonetheless the comparable trends are going in the right direction even versus pre-acquisition levels.

Net interest expense decreased by nearly $2 million year-over-year in the fourth quarter to $26.9 million and increased $52.2 million for the year to $110.5 million. This was driven primarily by having 12 months of the debt used from the Eckerd acquisition versus debt over five months in 2004 partially offset by our positive cash flow.

As expected our tax rate was 38.6% in the fourth quarter before a non-recurring benefit that impacted the quarter. Recall that in the fourth quarter of 2004, we recorded a favorable cash adjustment of $60 million. I had mentioned during our last two earnings conference calls that we thought we had another non-cash tax benefit in store for 2005. While, we did indeed and therefore the tax reserve release of $52.6 million, yielding a one time non-cash benefit to diluted earnings per share of $0.06. The benefit primarily resulted from the resolution of certain state tax matters. There could be some similar, but smaller adjustments as we move through 2006. But the bulk of this is now behind us.

Our weighted average diluted share count was 843 million shares in the fourth quarter and 842 million shares for the year. And diluted EPS was $0.48 for the quarter and $1.45 for the year, which includes about $0.07 from the one time items in the quarter and full year.

Now let's take a look at balance sheet and cash flow. In the fourth quarter, inventories remained virtually flat to the third quarter as its customary increasing by only $23 million. This represents an increase of 5% versus last year. The growth rate lower than the 9% growth in revenues, we experienced during the quarter. So we are making good progress on returning to industry leading inventory turnover.

Fourth quarter net capital expenditures were actually an inflow of $18 million. Gross capital expenditures of $355 million were offset by approximately $373 million of sale-leaseback activity during the quarter.

For the year, net capital expenditures were $956 million, including the effect of sale-leasebacks. Gross capital expenditures of $1.5 billion were offset by sale-leasebacks totaling about $540 million. So for the full year 2005 mainly on the strength of our earnings, we generated free cash flow of $657 million well over the $0.5 billion I had set as a minimum in the guidance we gave throughout 2005. Now I want to provide some guidance for 2006, let me start by saying that because the acquisition of the Osco and Sav-on stores was just announced and it's not expected to close until midyear. I am going to provide guidance separately for the CVS business without the stores we are about to acquire. Then I will review the dilution we expect from the acquisition, so you can model the year assuming that deal closes midyear.

So, excluding the recently announced acquisition for the full year total sales are expected to increase by about 9% to 11%. We expect to see continued strength in the sales turnaround currently underway in the former acquired stores. At the same time we also expect the large wave of generic drugs coming in to the mix this year to dampen the top line growth or be it with higher margins. Given all this, we also expect total comp store sales of 5.5% to 7.5%. Now you may notice that the spread between total sales growth and comp sales growth is a bit wider than it has been in the recent past. In significant part this reflects the insurance premiums related to our Universal American arrangements and one of the other contracts in PharmaCare. These revenues are largely offset our insurance claims, but they do boost sales notably.

Gross margin rate for the retail business is expected to improve due to the generic conversions and improved front-end mix and continued improvement in shrink, but as our pharmacy business continues to grow faster than the front-end it has a negative mix effect on gross margin. In addition, PharmaCare's participation in the new insured products for Medicare Part B and its contract with the State of Connecticut will compress PharmaCare's margins streak. We declare, PharmaCare sales and EBIT will grow significantly as a result of this new business. However the sharp top line growth in PharmaCare's business will compress its overall margin rate. So for the total company these mixtures will offset the benefits from an improved front-end margin and higher generic utilization likely resulting in a slight decline in our overall gross margin rate for 2006.

How about SG&A, the integration cost and infusion of labor and hours into the acquired stores is behind us. We are beginning to cycle those costs. Now we can expect to reap the ongoing benefit from these improvements, as well as from our systems and workflow enhancements. As the sales turnaround continues, we will also seeing increased sales leverage throughout the chain and of course we will continue to capture meaningful synergy savings this year. On the other hand as you all know, we are adapting FAS-123R, which requires the expensing the stock options beginning in the first quarter.

We expect the full year impact of this on SG&A and earnings to be approximately $0.05 versus the pro forma $0.05 in 2005. So, full year 2006 SG&A as a percent of sales should reflect all of these and thereby improve some even after the inclusion of stock option expensing. Therefore on this basis, full year 2006 operating margin should improve upon last years operating margin. Net interest should be moderately lower in 2006, as we expect about a $100 million. Remember I am not including the impact of the Osco Sav-on acquisition in this guidance, but of course our interest will increase once that deal closes and we take on an additional $2.9 billion in debt. Our tax rate is expected to be around 39% depending on which tax legislation passes and our diluted share count is expected to be about 855 million shares for 2006. With the 2004 acquired store resets behind us, and out of stock and shrink issues under control in these stores, we anticipate that inventory returns will return to levels of over 5 times by the end of the year.

Capital expenditures, net of sale-leaseback transactions are projected to be close to $900 million in 2006. This reduction year-over-year, reflects the absence of integration capital, slightly offset by an increase in other capital projects that have been placed on whole, while we integrated the acquired stores. Again this is before the impact of the new acquisition. Free cash flow in 2006 is expected to again handily exceed $0.5 billion. So including the $0.05 impact of FAS 123(R) we expect 2006 earnings per share in the range of a $1.54 to $1.58.

As I mentioned on our last earnings call there are several factors to keep in mind when laying out your quarterly models. First, while the expected wave of new generic drugs should be helpful for the full year, some of the industries biggest blockbusters are expected to loose patent protection in the second half of 2006. So this impact will be backend loaded. In fact in the first quarter, it looks like the conversions will actually be less than the first quarter of 2005. Second, as Tom mentioned the Medicare Part D Program was implemented in January, as the dual eligible population shifts from Medicaid to Medicare, margins will be somewhat reduced, however utilization should help offset that over time. And we have seen the rest of the potential beneficiaries starting to enroll now, which we expect will continue throughout 2006 and beyond. As Tom said, we anticipate a modest benefit to the year overall from Medicare Part D, but again backend loaded. If the program takes out quicker than anticipated, then we will enjoy those benefits earlier than planned. Third, recall that we had an exceptionally strong flu season in the first quarter of last year, which will make for more difficult comparison in the first quarter. We haven't seen the same so far this year. And fourth, given the timing of the Easter holiday, we expect a negative impact from the Easter shift in the first quarter and a positive benefit in the second quarter.

So in total, we expect the first quarter of 2006 total sales growth to be in the range of 8% to 10%, and first quarter same-stores sales to be in the range of 4.5% to 6.5%. We expect first quarter EPS to be in the range of $0.36 to $0.38 per diluted share, up from last years split adjusted $0.34 per share. This year's number includes about $0.01 for the impact of expensing stock options, and it recognizes the absence of last year's strong flu season. On a split adjusted basis that added about two and half cents to last year's first quarter.

Now let's move onto our newest acquisition Stand-Alone Albertson's drug stores. There is some confusion among certain analysts around the preliminary guidance we provided last week for the impact of the deal on our financials. Let me try here to outline in slightly more detail why the deal will be nearly $0.10 dilutive this year.

First, we will have the stores under our management for about half a year depending on the actual closing date. What this means is, that we will only see about half of the annual earnings benefits from the stores, while recognizing nearly all the integration and one-time expenses associated with the acquisition. These costs are expected to be around a $120 million in total including the systems integration cost, store reset, and remodel expenses, and name change advertising among others. We are planning – well, essentially all of that can be incurred in 2006.

Second, while we expect that 2006 sales will be around $5.5 billion, we do anticipate a slightly negative impact on the acquired stores this year during the somewhat disruptive store resetting process.

Third, during last week's call, Tom had indicated that 2005 unaudited EBITDA of the deal was a tad under $300 million. He also stated that this figure did not include any corporate overhead allocations. Now, we will of course retain and add personnel at the field level, and we will also hire some additional personnel at the corporate level to support these stores. We know that we will be able to substantially reduce the amount of corporate overhead associated with these assets from the levels that we are inherent in Albertson's numbers. So you should still assume that there will be approximately $30 to $35 million in corporate overheads supporting these stores on an annual basis or about half that for the six months of 2006. Finally many analysts appeared to have under estimated depreciation and amortization here are the key elements to consider.

First, there is of course the depreciation the business has today. Secondly, acquisitions that involve the purchase of pharmacy files required that record the value of those files on our books and amortize them over the life of the files. Third, there is a favorable lease intangible, which will be amortized over the remaining life of the respective leases. Fourth and finally there is the depreciation on the initial capital, but we were infused to convert these stores to the CVS look and feel. All of this depreciation and amortization together for the half year should amount to something like $60 million or about 2.2% of sales.

Obviously there are other cost and tax impacts as well, but the things I have mentioned seemed to be the most difficult for analyst to estimate. So, I tried to provide additional clarity on them. Hopefully this will allow you to get close to $0.10 dilution in your models. We continue to believe that the deal will be $0.02 to $0.04 accretive to diluted EPS in 2007 and $0.05 to $0.10 accretive to diluted EPS in 2008. By the way some of you have compared our accretion expectations with those derived from our 2004 acquisition. Obviously unlike the 2004 acquisition this is not a major turnaround, but if you do choose to compare the accretion please remember that since the time of the previous acquisition we spilt our stock two-for-one. So you would have to double our accretion expectations related to the Albertson's transaction in order to put the numbers on a comparable basis with the 2004 acquisition.

Now for completion let me comment on the impact on free cash flow from the Albertsons deal. In 2006, it's likely to be a use of about a $150 million. In 2007, it's expected to generate incremental free cash flow of about a $100 to $150 million with an increasing amount of free cash flow there after. The deal is also quite attractive on a purely cash economics basis and that's all are providing significant long-term strategic value for our Company. With that let me this back to Tom.

Thomas Ryan, Chairman, President and CEO

Thanks David. David did a tremendous job given that he is a little under the weather. So by any measure 2005 was really an outstanding year for CVS. I am equally optimistic about 2006. I expect to see continued growth in our core business as well as PBM business. We see – we expect to see continued turnaround in sales and profit in the acquired stores in Florida and Texas. Continue organic growth as we add a 100 to a 125 net new stores, we think the acquisition of the 700 additional stores from Albertsons would further solidify us as the number one pharmacy in America and it's the – we are in a great industry with favorable demographics and as you know an influx of new generic drugs. So we are well positioned and to capitalize on the trend and once again to strengthen our position as the leading pharmacy retailer in the U.S. With that I will open it up for questions.

Questions-and-Answer Session

Operator

Thank you. Operator Instructions. Your first question comes from Eric Bosshard of Midwest Research.

Q – Mark Koznarek

Good morning this is actually Mark Koznarek for Eric. First in regard to Medicare Part D can you add a little bit more color on why you expected to be dilutive in the first half and then slightly accretive in the second half and then within that tell me your assumptions regarding market share for 2006?

A – Tom Ryan

Mark, essentially we are looking at it from you – to break down to corporation, we are looking at Medicare '06 to be slightly dilutive to retail side of our business and then slightly accretive to the PBN side of our business. So it's slightly positive for the entire year. The real difference between first and second half is just kind of enrolment and utilization, we are just trying to understand how fast people are actually coming in to the program, so that's really the difference.

Q – Mark Koznarek

Okay, could you comment on what you guys are expecting or what's you are assuming for your share in 2006?

A - Tom Ryan

Share of –

Q – Mark Koznarek

You guys had commented on, I think, 82 basis point improvement in share, for 2005?

A - Tom Ryan

Well, we don't – we looked at it, we continue to, and we are looking – when you look at the share piece, we are looking backwards on the IMS data. So, we don't have share goal that we look at. We continue obviously to run our business and give offerings both to the walk-in customer and also the corporate payer or insure that allows us to take more share on an ongoing basis from a variety of people in the trade channel. So we don't have an actual share number that we shoot for.

Q – Mark Koznarek

Okay, fair enough. What progress up to this point have you seen with the shrink at Eckerd? And then, can you give your expectations for what you will see in 2006?

A - David Rickard

Yeah, Mark we saw a sharp improvement in Eckerd's fund start to shrink down from just over 5%, down about a 150 basis points, and we are going for a similar improvement in '06. If we get that, we will have the line share of the over industry amount, then what we need to do is bring it down to the core CVS levels.

A - Tom Ryan

Thanks Mark.

Q – Mark Koznarek

Okay, thank you.

Operator

Your next question comes from John Ransom of Raymond James.

Q - John Ransom

Hi, good morning, I just wanted to clarify kind of a pro forma, I guess for ‘07, Albertson's number, I think you mentioned in the last call that you saw about a $100 million in synergy. So if we take that and these are round numbers, but if you take the $300 million, you add the 100 and you subtract, what, $30 million to $35 million in pro forma, corporate additional overhead, are you looking kind of at a run rate '07 in the 375 range, is that math correct?

A - David Rickard

There are plenty of additional cost in that John, the – you know, we looked at a number of models that came out and the model seem to stamp their toe on the areas that I pointed out –

Q - John Ransom

Okay.

A - David Rickard

SG&A and overhead, but you know, I didn't mention – but obviously there is substantial interest associated with it, and other normal cost, I mean, I wouldn't try to bring it down to three big numbers, I guess, that's what I am saying, you have to model the whole thing.

Q - John Ransom

No, I understand that, we are just looking at EBITDA, you start with your 300, you are still – are you still comfortable with the $100 million in synergies to that $300 million?

A - David Rickard

Yeah, we are still comfortable with $100 million in cash synergies.

Q - John Ransom

Okay, is that – so therefore you've got the store level EBITDA 400, but then your additional, you know, excluding interest and depreciation, but your traditional operating cost would be in the $35 million range, so you take that 400 so you are – if we think about a purchase price, you are paying $3 billion after lease or so roughly 375 of EBITDA, is that a reason? Just trying to get it, you know, --

A - David Rickard

Well, I think, you can do that, but what I would encourage you to do, John, is go ahead and do your model and send it in, we'll look at it, anything that comes in the next week, we will give you comments on it.

Q - John Ransom

Okay.

A - David Rickard

Alright.

Q - John Ransom

And then secondly, the House bill passed last night, so we've got the bill shift, and we got the Medicaid cuts, how much – have you guys had a chance to, in your reimbursement or look at the effect of that? I know you are not allowed a pie Medicaid margin stake but if you had a chance to quantify the effect of that?

A - David Rickard

We – we are doing some work on that, John, the issue is that, as you said, just past last night, there is no, there seems to be no clear definition of what ANP is, so that one of the big issue that we need to get a better understanding around, then this issue around the Medicare folks, you know, shifting or Medicaid folks shifting to Medicare, what does that run rate look like, and then obviously the state dispensing fees. So, you know, as we said, there is clearly going to be a margin – a margin notation based in '07, but we are not at this point, we are not ready to quantify the number, we need to have some more discussions.

Q - John Ransom

Okay, thank you.

A - David Rickard

Thanks John.

Operator

Your next question comes from the line of Mark Husson with HSBC.

Q - Mark Husson

Yeah, I just wanted – if you could just guide us through again the impact on sales from the new Medicare business that you have grossed on, and just take away down through the gross margin and the SG&A, and at what stage would it be sensible as you break out SG&A and gross margin separately from that business as well as operating profit?

A - Tom Ryan

From break out the – from Medicare mark?

Q - Mark Husson

No, from the – for the PharmaCare businesses…

A - Tom Ryan

Oh, for PharmaCare?

Q - Mark Husson

We are getting a better sense of the mix as between those business particularly it is growing at a slightly different rate here and quite nicely?

A - Tom Ryan

Well, yeah it's growing at a obviously it is a little lumpy, because of the acquisition, as I said, we did lose some business of the EHS book and we all set back with acquiring new businesses. So I think the difference and – or all I would say is if you go through it again, but the real difference in PharmaCare is around the risk in the insurance piece of the business that's what's given you some and given others some, I guess, pause around the margin issue, so –

Q - David Rickard

Let me –

A - Tom Ryan

David, why don't you just take them through those?

Q - David Rickard

Yeah, let me do that. First of let me just say that we do break it out in our segmental reporting, so you do get the sales and operating profit and you know, each quarters we report. But this unusual business, its new business for us, which is of an insurance nature, has as recording the insurance premiums as sales revenue, and then has as reporting as expense, the claims against that and there is a claims accrual that goes against that so that we don't hold the report income early on and then suffer big pain later on. The claims against that business will almost, but not quite equal the revenues that we get in premiums that's the nature of that kind of business, you don't have a huge spread between your revenues and your claims. The claims hit gross margin, obviously so what we have is a very high sales number, a very high in effect cost of goods number and that drives down the gross margin and it drives down the operating profit for the aggregated business. It adds profit; it adds cash as well, but it does have a substantial effect on gross margin and operating margin, 700 basis points.

Q - Mark Husson

The explanations is clear – I am not sure that the numbers will be for a little while and the second question I have is on generics, can just – give your comments on trends in generic margins, it's out I guess I suppose the generic margin mix, the more generics come on the best of the margin mix initially from the big surge in generics, is that fair?

A - Tom Ryan

That is fair and, you know obviously there has been – the generics remain on the market, they become, you know, there is competition for them and they also become math, which is something that has been happening for years and years in the industry, that subsequently offset by, you know, new generic drugs coming off patent, but clearly the generics drugs are positive for our margins and profits.

Q - Mark Husson

That is helpful thanks very much.

A - Tom Ryan

Thanks.

Operator

And your next question comes from Meredith Adler of Lehman Brothers.

Q - Meredith Adler

Good morning, it's a couple of question. I know that there are still a lot of moving parts on Medicaid, but I did recently hear that they are not talking about moving to ANP for branded drugs, just for the generics and I wonder just –originally you talked about going to the States and trying to get a bigger percent in fees for generics because otherwise you are intend to go with branded, does the new regulation, change how you are going to approach these negotiations? And how soon can you start negotiating, given how much or how little clarity there is on you know where all these meet?

A - Tom Ryan

It is just there, and we would – I guess we start negotiations, we've been negotiating directly and indirectly for probably six months to a year, I mean, part of the discussions that we have with the secretary Levitt and also McClave of CMF is around this issue. I mean, if you look at what retail pharmacy has done in areas like Katrina and areas like Medicare '06 and what we have done for patients they understand the need for retail pharmacy, they also understand that they can't arbitrarily cut margins too much on generics because from your point, Meredith, there will be an incentive to in fact the sense of branding ultimately 80% of the cost of this program from a drug side is around the brand. So we are -- there is -- without going into all the details, there is movement and there is issues around once legislation is passed or once regulation is passed. So we are working with the agency on the regulatory proceedings, you know, what would be required for price surveys, what would be required for price updates, there is a bunch of issues, so you know, we have been negotiating for a quite a while and we think we will have some success, but you know, make them to think about it, there will be some, you know, margin degradation with generics on this particular program and the question is how big, you know, will this program be for us. I mean, it's going to be smaller than it was now because people are going to the Medicare programs. So all of that began to affect us – we will give you some numbers hopefully later on.

Q - Meredith Adler

Okay great, another question I have for you is, you did say that you're seem to seeing new customers in the pharmacy because of Part D, I don't know what you have done, any comments? Focused groups of customer surveys? Do you have a sense that people who were shopping strictly for price are now coming to CVS because it's more convenient, and you know, sort of any sense about how that plays out?

A - Tom Ryan

Yes. It's really too early, any surveys that we do with seniors right now, they're just basically complaining about the program, too many choices, and all the administrative issues, I talked about earlier. So there is a lot of noise out there now, but we are getting – we do in fact know we are getting new customers now, whether they are coming from other mask layers or other trade channels because of service issues, we are not clear on that, but it's really too early to tell. I also should point out on the Medicaid issue, this is something as you know, will not take place till 2007, so we'll have a little time here to, kind of, flush it out.

Q - Meredith Adler

Right, and along with the question about taking share in the pharmacy – is it your expectation that you will see the front end go up, do you see if you are getting new customers in your pharmacy or do you think you'll have a lot of those seniors shopping with you already in the front end?

A - Tom Ryan

Up just from the Medicare side? Medicare '06 side?

Q - Meredith Adler

Yes.

A - Tom Ryan

Yeah, we think, obviously if they are coming in for prescriptions, we are going to see some lift in the front-end. It's going to – two have to go hand-in-hand, and we have seen it, once they get the prescription card, get him into the store, we will get him on the ExtraCare card and then, you know, that will continue to signup additional people there, so, yeah, we think it's a benefit. I mean, you can see what's happening in our front-end sales, they're pretty strong.

A - David Rickard

You know, and our comp – customer comps were strong in January, which indicates there are some new customers' even beyond those that not have been shopping us in the front.

Q - Meredith Adler

Alright, I have one final question, that's about limited network –

A - Tom Ryan

Yeah, okay, go ahead.

Q - Meredith Adler

Any quick comments about changes on limited network?

A - Tom Ryan

Not a lot of movement on limited networks, we haven't been excluded out, obviously, of any big ones given our size. And, you know, what you see is from the PBM side, this talk about limited networks – there is some rhetoric about it, there may be some movement but there is not a lot of action right now, okay.

Q - Meredith Adler

Okay great, thank you.

A - Tom Ryan

Thanks Meredith.

Operator

Your next question comes from Mark Wiltamuth of Morgan Stanley.

Q - Mark Wiltamuth

Hi, good morning all, first question is on the Medicaid costs. Could you just give us some indication on why you are comfortable in getting some increased dispensing fees from the States? For the States, Medicaid has been one of their biggest budget problems and they are probably not going to be that excited about, given your increased spends in fees?

A - Tom Ryan

Yeah, they are not – right, they are not going to be overly excited, it depends. Because they are obviously operates in the same kind of the crunch so it depends on what kind of relief they are going to get from the Federal Government. So you know they are looking at the entire program and trying to understand they move people throughout the Medicaid rolled on to Medicare. So that's given them some relief, but you know I don't want to give you the impression that their Governors out there just waiting to increase our dispensing fees and you know this is some thing that we battle and we look at, but at the end of the day its in fact we don't have an incentive to dispense generics, its going to be a problem and they understand the economics. So will have to I think its going to flush itself out but it will be a battle and we are going to fight it you know state-by-state basis.

Q - Mark Wiltamuth

And the AMP pricing effects all drugs or just the generics, or just the generic is where you're feeling most of the margin thing?

A - Tom Ryan

The AMP right now is just on the generics. Right so you had to look out at you know think about what percentage of business is generic and then what percentage of our business is Medicaid. So as right now we are just a generic, which is an interesting discussion in and out itself.

Q - Mark Wiltamuth

Okay and then let me switch over to the fourth quarter, I was really surprised at the magnitude of the gross margin gain in the fourth quarter since we are in this low of new generics in terms of conversions to generic. Can you just comment on why the strength was so for pronounced in the fourth quarter?

A - Tom Ryan

Well we had good mix both front end pharmacy, we did make further progress in the shrink and the acquired stores, we did have positive generics, so is number of factors. Its also the big seasonal portion of front end obviously with Christmas selling season, a lot more general merchandise were up. Front-end margins were pretty high, add that to continued growth of private level, the continued growth of the proprietary. What is interested in the season you know people were little concerned about Christmas selling season, we really saw a lift in the last two weeks of the season, which begins to tell you about how consumers are shopping and how is our trade channel and how we're well positioned from the convenience stand point for those consumers.

Q - Mark Wiltamuth

Okay thank you.

A - Tom Ryan

Thanks, Two more questions.

Operator

Your next question comes from Ed Kelly of CSFB.

Q – Edward Kelly

Good morning congratulation on a good quarter.

A - Tom Ryan

Thanks.

Q – Edward Kelly

I would like to ask a question on Eckerd, is actually still a larger opportunity here to get the productivity of these stores and the margin up to the course CVS level. How much of the future gains at Eckerd will be driven by you know certain basic blocking, and tackling versus other initiatives like you know store relocations and play you know particularly in Texas?

A - Tom Ryan

We still think there is upside and you know the blocking and tackling, I think is you know we are confident. We continue to look for improvements I think we have made enormous progress on our merchandising mix or marketing program, the store operations folks. So you know it will continue to keep driving the sale and it's a combination of lot of visiting new customers each day in the stores. So even though our stores have been remodeled, the store is up, but it's not just far as operations and customer service and pricing, you know people still walking in and say “you know I haven in and felt some change.” So it's a constant and then to your point you know as we continue to relocate stores both in Florida and Texas, we continue to see upside. So it could be you know I think they are over dramatized but we couldn't be more happier with this acquisition and performance and the continued performance that we see you know even in January of this year.

Q – Edward Kelly

Alright great and then one more question on dual audible and partakes (ph) you talked a little about destruction that its caused in terms of the actual job of the pharmacist, is there any kind of sales impact in January and what about on the expense side I know the January is already a busy month because a lot of people change insurance plan so we need to adapting?

A - Tom Ryan

Our – you know it's easier as I am sitting here to say this there is no impact. Our pharmacist did an outstanding job you know we had planned for staffing. We knew at anytime you're going change this many people it was one big acquisition you know you are moving people from France on top of the issue of France changing themselves in January. So our folks are field supervisors or store pharmacist are people in here just did an outstanding job preparing people, but let me tell you it was bit rough on our folks because you know that's the person the senior complaints to. They can't see the government, they can't see the plan, they see the pharmacists and that's the one you know they trust and deal with and I'll tell what I think our pharmacist are actually have built more trust if that's possible with the seniors and the seniors get it . So you know we have the cost baked in, we didn't have any additional cost, we have probably more waiting time that we want it, but at the end of the day we had worked around we did plans we were pretty you know proactive and in this field. We are doing the best we can, and we think we are doing it pretty well.

Q – Edward Kelly

Alright great, thank you.

A - Tom Ryan

Thanks. One more.

Operator

Your last question come from John Heinbockel, of Goldman Sachs.

Q -- John Heinbockel

Hi Tom, couple of for you sir, has anybody been able to flip the CBO as commenced for the Medicaid cuts to reality, you know you guys I don't want to raise that issue. May be you have been able to do that and get a sense of what the impact is – they make sense or briefly?

A - David Rickard

Yeah the CBO is a – you need to have an eye on that discussion lets say it's a black box that got -- God knows where they get it some of this information. So you know I actually talked to Senator first about this and you know we said we can't really understand how they get it. You remember this is the same CBO they came out and estimated cost on this program that we are probably 40% off. So we are pulling that information we have it, we are analyzing it, but at the end of the day we just need to get one clear understanding of AMP, a clear understanding of what they are going to do around price updates, clear understanding of what's going to happen with States better understanding of where the Medicaid program is going to shift as far as percentage of hopes, percentage of scripts after this Medicare and then we are going to do our own number John the CBO numbers I mean the Senate side had one savings and the House side has another so.

Q – John Heinbockel

So the actual impact would be quite a bit different than what they are coming up with?

A - David Rickard

Yeah absolutely, it's going to depend on how much you know not like we said earlier but initially there was some movement on brand and that was just generic but you know there is going to be an impact but the question is you know of the scale.

Q – John Heinbockel

With respect to Sav-on and Osco how you guys built-in or thought about generic Part D Medicaid is -- the numbers incorporate a lot of that or you sort a left that to the side for now and see how that plays out?

A - David Rickard

Yeah, we left that to the side John, because you know there are so many variables in an acquisition you know obviously we have done them with fair amount and we have a pretty descent rigger and discipline. We don't put anything into the formulae that we can't depend and you know some of these we just didn't know, we know it is a general positive overall but we didn't break in to numbers. So it's on the side and you know by we also want to sure when the deal will get closed John.

Q – John Heinbockel

Alright finally given your record sales or is it fair to think that you know when you initially laid out the Eckerd attrition two years ago you know that we are tracking kind of high end of what you thought you would get out of Eckerd or logic with sort of big teeth back in where the sales are but is that fair or incorrect?

A - Tom Ryan

Yeah it's basically on track for what we thought John maybe slightly better.

A – David Rickard

Whatever it takes it's right on track.

Q – John Heinbockel

Okay.

Thomas Ryan, Chairman, President and CEO

Alright, thank you all very much and if you have obviously any questions you can call Nancy Christal, thank you very much.

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

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

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

Source: CVS Corporation Q4 2005 Earnings Conference Call Transcript (CVS)
This Transcript
All Transcripts