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Executives

Nancy Christal - Senior Vice President, Investor Relations

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

Howard A. McLure - President, Caremark

Analysts

John Heinbockel - Goldman Sachs

Lisa Gill - J.P. Morgan

Edward J. Kelly - Credit Suisse

Eric Bosshard - Cleveland Research

Mark Wiltamuth - Morgan Stanley

Neil Currie - UBS

Meredith Adler - Lehman Brothers

Deborah Weinswig - Citigroup

David Magee - Suntrust Robinson Humphrey

CVS Caremark Corporation (CVS) Q1 2008 Earnings Call May 1, 2008 8:30 AM ET

Operator

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

Nancy Christal

Thank you, Amanda. Good morning, everyone, and thanks for joining us today for our first quarter earnings conference call. I am here with Dave Rickard, Executive Vice President and CFO of CVS Caremark, who will provide a business update, a financial review of the first quarter, and guidance. Also with us is Howard McLure, President of Caremark Pharmacy Services, who will participate in the question-and-answer session.

First I’ll note that we expect to file our 10-Q by the end of the day today and it will be available through our website at investor.cvs.com.

This morning we will discuss some non-GAAP financial measures in talking about our company’s performance, namely free cash flow, EBITDA, 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. Adjusted EPS is defined as diluted EPS eliminating the effect of amortization only and assuming our overall effective tax rate for the amortization. We will provide guidance today using adjusted EPS, as we did on our last call.

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.

Following our remarks, we will have a Q&A session and we ask that you limit yourself to one to two questions, including follow-up, so that we can get to as many analysts and investors as possible.

Let me quickly touch on a couple of items before turning this over to Dave. First, a reminder that our annual analyst and investor meeting will take place on the morning of Wednesday, May 21st at the Mandarin Oriental Hotel in New York City. We’ve had an enormous response to the meeting and we look forward to seeing several hundred of you there. If anyone else would like to attend and needs the specifics on the meeting, please call my office and we’ll do our best to fit you in. The presentations will also be available via webcast.

This is the one time per year that we provide broad access to an extended group of our senior management team, so we do hope you can be there in person. Given that we have our big meeting in a few weeks, today’s business update will be somewhat more brief than usual. We will focus primarily on the quarter’s results.

There is one item that I would like to address with respect to disclosure going forward. Many of you have asked me what our practices will be with respect to announcing PBM contract wins and I want to share with your our intentions in that regard.

First of all, keep in mind that many clients do not give us permission to announce or discuss the details of our contracts publicly, so we will provide summary updates on our overall selling season on our quarterly earnings calls. We will generally not provide information regarding contractual wins and losses between calls. However, in rare instances, we may make an exception between quarters and announce a contractual event for unusually large contracts that are the subject of market rumors or speculation that may affect our share price. Hopefully that gives you some sense of our intentions.

Now, before we continue, our attorneys have asked me to read our 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. Accordingly, for these forward-looking statements we claim the protection of the Safe Harbor for Forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. We strongly recommend that you become familiar with the specific risks and uncertainties that are described in the Risk Factors section of our most recently filed Annual Report on Form 10-K. And now I will turn this over to our CFO, Dave Rickard.

David B. Rickard

Thanks, Nancy and good morning, everyone. I hope you’ve all had a chance to read through the terrific financial results we reported this morning. If you did, you may have noticed that we posted record first quarter sales, operating profit, operating profit margin, net earnings, and diluted earnings per share.

Before I run through these results in detail, I want to touch on a few key areas we’ve been getting questions on. These include the PBM selling season, Minute Clinic, pharmacy and front-store trends in our retail business, and our new store program.

So how’s the PBM doing? Well, the 2009 selling season is going very well and we are pleased with our progress to date. As most of you know, about a third of our contracts come up for renewal each year. For 2009, we’ve already renewed more than half of our business that’s up for renewal this year. These include some marquee accounts, such as AT&T, Bank of America, 3M, and the State of Connecticut.

As previously announced, in the case of AT&T, we picked up some incremental business as well, as they consolidated all of their PBM business with CVS Caremark instead of having the BellSouth piece separately contracted.

Our clients are telling us that we’ve kept our focus on service, which was their primary concern following our merger. They’ve also expressed their enthusiasm for our new model because they understand that our unique combination can lower their overall cost while improving access, convenience, and health outcomes for their members. We will provide many more details on our new value proposition at our May 21st analyst meeting.

So our retention thus far has been terrific. What about new PBM business? Well, we’ve already had some early successes this selling season as well. It was previously announced that we won the PBM contract to service the employee retirement system of Texas, or ERS, and the BellSouth portion of the AT&T contract. Those two contracts together are worth nearly $1 billion in annual revenues.

In the aggregate, we’ve already won the right to serve about 40 other clients, most beginning in January of 2009. I am delighted to report that these new contract wins to date in total should have first-year revenues of about $3 billion.

Included in that number I am very pleased to note, we’ve been selected to provide specialty pharmacy services for a large top 10 Blues Plan, beginning during the second quarter of 2008. We will provide a fully integrated specialty model, including not only specialty mail, specialty retail and disease management programs, but also access to care through CVS Retail pharmacies. They’ve chosen this integrated approach as an enhancement to their current solution.

We will use the vast resources of our enterprise to help them control their specialty pharmacy costs most effectively, improve patient access, and deliver better health outcomes.

Overall, our progress and momentum in this PBM selling season are just what we would like. It is very clear that our new model is resonating in the marketplace.

Let me move on to an update on Minute Clinic. We treated 300,000 patients during the first quarter alone and customer feedback on our clinics continues to be highly positive. We are providing quick and cost-effective access to high-quality healthcare professionals for everyday common illnesses. Minute Clinic leads the industry and has 350 clinics more than our nearest retail clinic competitor. We operated 510 clinics at the end of the first quarter.

Our initial goal for the Minute Clinic business was to gain first mover advantage, building our lead in selected markets, and we’ve done that. Now we’ve made the strategic decision to reduce the number of clinics we add this year so that we can better focus our efforts in 2008 on expanding services, contracting with additional third-party payers, and working with PBM clients to offer new products and services. We now expect to add approximately 100 clinics in 2008 and end the year with between 550 and 600 clinics compared to the approximately 700 we previously forecast. Also, we may close some clinics not currently in CVS stores or Caremark client locations.

We remain very optimistic about the prospects for Minute Clinic and believe we are taking the right steps to best position it for long-term success.

Now let me touch on the retail pharmacy side of our business and again, it’s a good story. IMS data shows CVS steadily gaining share. We are up again this quarter versus the fourth quarter of 2007. We hold a 17% national retail market share and a 22 share across the markets in which we operate. Our script growth in the first quarter versus the fourth quarter of ’07 is ahead of all other chain stores.

Pharmacy comps for the first quarter were 3.7%. That included approximately 450 basis points of negative impact from new generics, so adjusting for new generics, we would have reported 8.2% pharmacy comps.

The flu had a negligible impact on pharmacy comps in the first quarter. Our generic dispensing rate in our retail segment was 66.6%, up from 61.7% last year. Pharmacy comparisons were influenced negatively by the deceleration of Med D growth compared to last year when it was still ramping up. In addition, the switch of Zyrtec from a prescription to an over-the-counter product obviously reduced prescriptions filled.

On a positive note, however, we had a private label over-the-counter version immediately available upon the switch, so the overall impact of the Zyrtec change, while negative to pharmacy, was beneficial to front-store sales and especially margins.

Our front-end business continued to demonstrate healthy growth in both customer traffic counts and average dollars spent per transaction. Front store comps increased 4.3% in the first quarter. That included a benefit from the Easter shift of approximately 115 basis points.

I would like to touch on our same-store sales results for the combined March/April period in light of the Easter shift, which of course impacts front-store sales in the second quarter as well as the first quarter.

For the combined March/April period, front-store comps were 3.4%. In March, front-store comps were 6.5% and in April, front-store comps were minus 0.2% due to the impact of the earlier Easter. So you should factor that in when building your models for second quarter sales.

We’ve told you in the past that the front-store business now makes up only about 15% of our revenues and profits and that only 20% of that is considered discretionary. Many of you have been asking what if any impact we are seeing from the softer economy on our front-store business and I can report that we recently looked at the discretionary versus non-discretionary categories to evaluate whether there was any change in trend.

Our data shows no evidence of a consumer slowdown based on this analysis. My interpretation is that consumers are making tough choices on big ticket purchases but they aren’t yet focused on Snickers bars.

And how does all of this stack up relative to the competition? Well, I am pleased to report that we continue to grow share in the key front-store categories that make up the vast majority of our sales, OTC, beauty, private label and digital photo. In fact, we experienced share gains versus food, drug, and mass competitors in categories representing more than 90% of our front-store sales volume.

In addition, our private label business continues to grow across our store base. In the first quarter, private label made up 14.8% of total front-store sales. That’s up 90 basis points versus the prior year. We continue on our path to achieve our goal of private label and proprietary brands to represent 18% to 20% of front-store sales in the next three to five years, and that will help drive margins.

In both the front-store and the pharmacy, comps in the former Osco Save-on stores acquired in 2006 continued to outpace our core stores in the first quarter, so we are very pleased with the continued good progress in our acquired stores.

I will also note that our front-store margins continued to improve. That’s importantly driven by the use of our extra care loyalty program to drive more profitable sales. More than 65% of our front-end sales across the store base currently use the extra care card. We have well over 50 million active cardholders and we continue to find more ways to use the data to drive better results.

Before diving into the financials, I’ll touch briefly on our real estate program. In the first quarter, we opened 94 stores, including 41 new and 53 relocations. We closed 19 others, so we added 22 net new CVS pharmacy stores in the quarter. For 2008, our plan remains to open 300 to 325 stores; about 175 to 185 will be new and the rest will be relocations, and we expect to achieve approximately 3.5% retail square footage growth.

Now let me turn to the details of our financial performance in the first quarter that we reported today. After that, I’ll provide guidance for the second quarter as well as the remainder of the year.

I’ll start by reminding you that we lapped the one-year anniversary of the merger of CVS and Caremark at the end of March, so the March 2008 quarter is the last quarter in which the absence of Caremark in the reported prior-year results skews our growth statistics. Going forward, our reported results will be apples-to-apples comparisons, with the exception of integration and other one-time costs.

Now let’s turn to our first quarter income statement -- total revenues on a consolidated basis increased 62% to $21.3 billion. This figure is net of inter-segment eliminations of $1.3 billion. In our retail drugstore segment, revenue increased 5.4% to $11.8 billion. Same-store sales for the quarter were 3.9%, in line with our guidance.

And how about the PBM segment? Well, net revenues of $10.8 billion increased 2.3% over the comparable 2007 first quarter figure. Adjusting that growth rate for the impact of generics, net revenues would have grown 10.6% for the PBM. The impact on the change in PharmaCare’s revenue recognition method on the first quarter was the addition of approximately $710.5 million in reported revenues before inter-company eliminations, or about $555.4 million after eliminations.

So on a comparable basis, what drove the growth of PBM revenues? Total retail network revenues were $7 billion, rising 12% from 2007 levels. Setting aside the increase from PharmaCare’s revenue recognition change, retail network revenue increased 0.6%. At the same time, retail network claims grew 5.7%. This was predominantly driven by new business, including the growth spurt in our PDP, which experienced healthy growth in Med D lives this year.

The PBM’s retail generic dispensing rate increased to 65.2% compared to 59.9% in the first quarter of 2007. This significant increase in the generic dispensing rate explains the disparity between retail network revenue growth and retail network claims growth.

As expected, mail claims decreased for the quarter by 17.7% on a comparable basis. The impact of new clients was more than offset by previously announced terminations, namely FEP, State of New York, and Ohio State Teachers Retirement System.

As a reminder, the portion of the FEP business that we no longer service is the mail order piece, including PBM mail and specialty mail. We continue to service FEP’s retail networks.

Total mail revenues declined 12.4% to $3.6 billion and within total mail revenues, PBM mail was down 21.1% compared to the first quarter of 2007, while our specialty mail revenues increased 4.6%. If you exclude the FEP business from last year’s data, total mail revenues increased 4% and specialty revenues grew 14.4% in the first quarter.

The mail generic dispensing rate rose to 52.8% from 45.8% a year ago. That’s a healthy 700 basis points of growth. Excluding FEP, the increase drops to 600 basis points, still very significant. Our overall mail penetration rate decreased five percentage points from 2007’s first quarter to 23.1%, again largely as a result of the absence of the FEP mail business.

Moving on to gross profit for the total company, the overall business did extremely well thanks to strong performances within both segments. Within the retail segment, gross profit margins were up 200 basis points over the first quarter of 2007 to 29.6%. The primary drivers of this on the pharmacy side continued to be the substantial margin expansion we experienced from the increased utilization of generic pharmaceuticals as well as merger related purchasing synergies.

At the same time, front store margins improved. That reflected not only an improved product mix and reduced shrink in our acquired stores, but also the benefits of the extra care card that result in a lower percent of products sold on promotion.

Offsetting these gains somewhat was continued pressure on generic reimbursement rates, as well as an increase in the percentage of pharmacy sales handled by third-party insurance.

Gross profit margins in the PBM segment on a comparable basis expanded to 7.3%. That’s up 10 basis points versus 2007’s first quarter, and includes the 52 basis point drag from the conversion of PharmaCare’s contracts.

Like the retail segment, our PBM pharmacy margin continued to benefit from the purchasing synergies derived from the merger, as well as an increase in the conversion of branded drugs to generic equivalence. And as I mentioned on our last call, we anticipate a greater impact from new generics in the second half of the year. In addition, recall that I also told you that our PBM would see higher profitability later in the year from the Med D business in light of the widened risk corridors and the related accounting.

So what about expenses? Overall operating expenses as a percentage of sales improved due to the change in mix between retail and PBM. In the retail segment, operating expenses increased as a percent of sales from 22.1% to 22.5%. This was primarily caused by the significant growth in generics, which pressure sales dollars while improving profitability.

Adjusting for the growth in our generic dispensing rate at retail, operating expenses as a percentage of sales for the retail business actually improved by more than 80 basis points.

In the PBM segment, comparable operating expense as a percentage of revenues improved by 10 basis points to 2.3%. So I am very pleased with our continued solid expense control in both our retail and PBM segments.

All things considered, we saw a notable expansion of our operating margins, particularly in the retail segment. The retail segment’s operating profit margin grew by 150 basis points over 2007 to 7.1%, while the PBM segments operating profit margin improved by 20 basis points over 2007’s comparable results.

Our PBM’s industry-leading EBITDA per adjusted claim increased to $3.41 excluding integration costs in the first quarter, or 6.9% over last year’s $3.19. Excluding the FEP mail business, we would have had double-digit growth in EBITDA per adjusted claim, so the underlying growth of the business is excellent.

Moving on to the rest of the income statement, we saw quarterly net interest expense on the consolidated income statement increase to $131 million, reflecting additional interest from our increased debt position due to the merger, as well as our balance sheet restructuring.

Our tax rate was 39.6% in the quarter, in line with expectations, and our diluted share count was 1.47 billion shares. Of course, that’s up significantly from last year’s first quarter since last year’s first quarter shares were only weighted with merger-related shares for the final 10 days of the quarter.

So what did all this mean for EPS? Well, adjusted EPS rose 18.3% to $0.55, up from $0.46 in 2007, and at the high end of our guidance. So we produced solidly robust earnings year over year despite the additional financing costs. GAAP diluted EPS rose 17.4% to $0.51 for the quarter compared to $0.43 in the first quarter of 2007.

Turning to the balance sheet and cash flows, we generated $346 million in free cash flow in the first quarter. Net capital expenditures were $395 million in the quarter, which reflected proceeds from sale leaseback transactions of $5 million netted against the gross capital spend.

Now during our last conference call, I announced that in November we had entered into a $2.3 billion accelerated share repurchase agreement, which we expected to complete during the first quarter. We did just that and while the outflow of cash happened entirely during the fourth quarter, we received an additional 5.7 million shares in the first quarter to complete the transaction. So we have placed those shares into our treasury account. We are now finished with the authorized repurchase programs that were born of the merger.

Now let me turn to guidance for the second quarter and full year 2008 -- in the second quarter, we expect revenue growth for the total company to be in the range of 3% to 5%. We expect PBM revenue to be up slightly in the second quarter and we expect retail revenues to be up 5% to 7%. On the retail side, we had the positive impact of the Easter shift in the first quarter so of course in the second quarter, we get the reverse effect of that in our front-store sales.

We anticipate second quarter adjusted EPS of between $0.59 and $0.61 per diluted share, up from last year’s $0.51 per share. That equates to adjusted EPS growth of 16% to 20%. GAAP EPS is expected to be in the range of $0.55 to $0.57 per diluted share, up from last year’s $0.47 per share.

Given the continued strength across our businesses, we remain optimistic about our growth for the full year. Let me walk you through our current guidance assumptions.

For the total company, we expect revenue growth of about 13% to 16% for the full year, after inter-company eliminations of approximately $1 billion per quarter. For both segments, generics will play a role in dampening top line growth.

For the PBM segment on a comparable basis, we expect revenues to be about flat with 2007. This is an improved outlook and reflects some contract wins starting later this year, as well as a higher level of price inflation than we originally anticipated. But we expect reported revenue growth of over 20% for the year since the merger closed in late March of 2007. Remember, this revenue estimate also includes an impact of approximately $2 billion year over year from the change in PharmaCare’s revenue recognition methodology from the net to the gross basis and for the full year as opposed to a partial year.

For the retail segment, we expect revenue growth of between 7% and 10% for the year. Same-store sales are expected to be in the range of 4% to 7% for the retail segment for the year.

For the total company, gross profit margins are still expected to be down modestly due to the mix impact as we average in a full 12 months of Caremark. However, gross margins are expected to increase by roughly 25 to 50 basis points for the PBM segment on a comparable basis despite the gross-up of the PharmaCare contracts. And we now expect gross margins for the retail segment to increase 50 to 75 basis points. In part, that is due to the delay in implementation of the Medicaid A&P cuts.

As we said on the fourth quarter call, we are assuming fewer new generic introductions in 2008 than in 2007. We also continue to believe that these introductions will be back-end loaded. As such, we won’t see the bulk of them until the third quarter, so our 2008 outlook assumes that generics do help our gross margins but are less favorable to margins than they were in 2007.

Additionally, our gross margin will be helped by purchasing synergies. We still expect more than $700 million in synergies in 2008, much of which is from purchasing.

As for expenses, we still expect total company operating expenses as a percentage of revenue to improve significantly. That’s largely due to mix. Total operating expenses as a percentage of sales for the PBM segment on a comparable basis may be in the neighborhood of last year’s numbers as general good housekeeping to be directionally offset by the 2008 start-up costs of all that new business Howard and his team have been bringing in for 2009. The retail segment has no such headwind and we still expect it to show moderate improvement.

We expect total consolidated amortization for 2008 of approximately $400 million and depreciation of about $850 million. All of that again leads to solid improvement in operating profit margins for the total company, as well as for each segment. As I said on the last call, we could nicely exceed 6.5%, our current operating margin high water mark which we achieved back in the year 2000.

We forecast net interest of about $475 million to $500 million and a tax rate approaching 40%. We expect approximately 1.49 billion weighted average shares for the year and no further share repurchases are included in this guidance.

All things considered, we are raising the low-end of our full year guidance range by $0.01. We currently expect to deliver adjusted EPS of $2.44 to $2.50 and GAAP EPS of $2.27 to $2.33. That represents growth of 18% to 21% on both an adjusted and GAAP EPS basis.

Net capital expenditures are expected to be in the range of $1.3 billion to $1.4 billion for 2008. Free cash flow is expected to be around $3 billion, driven largely by the strong earnings growth we expect to deliver in 2008.

As you can see, our business is very strong and we remain optimistic about 2008 and beyond.

So in summary, in the first quarter we delivered strong revenue growth, significant margin expansion, 18% adjusted EPS growth, and healthy free cash flow. Our retail business continues to grow strongly and gain market share in the front-end and in the pharmacy. The PBM selling season is off to a great start and shows every indication of a terrific year. Our new offerings are catching on. Payers increasingly understand that we can improve convenience and access for their members while lowering their overall healthcare costs, and our guidance confirms that our confidence and continued robust business growth and financial performance.

Now we’d be glad to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question is from John Heinbockel with Goldman Sachs.

John Heinbockel - Goldman Sachs

I wanted to drill down a little bit on retail and PBM EBIT, because retail looked incredibly good and PBM looked a little light. Just on the retail side to start, last year I would assume had a modest but not overwhelming benefit. Is that fair? And did you -- it looks like you are continuing to see a fairly good generic environment, despite the comparisons.

David B. Rickard

The Easter period, because it was several days shorter than last year, we had actually planned to be down and it was down but not as much as we planned, so you could say it had a benefit in the way it played out versus our expectation. We had a good sell-through. We had a good season but it was simply a shorter number of days.

As far as generics, yes, we had good -- very good performance in generics in both the retail and the PBM side.

John Heinbockel - Goldman Sachs

Did it surprise you on the retail side how good the lift was from generic or it’s pretty much what you thought?

David B. Rickard

Actually, on both sides of the business, we were generally in the territory that we expected to be.

John Heinbockel - Goldman Sachs

All right and then on the PBM, was there any adverse hit from FEP and New York State that would be abnormally large because it’s the first quarter and you are transitioning away from that business, or was that not much of an impact?

David B. Rickard

Well, I’d say this -- you have to keep in mind that FEP, the mail side of FEP was in the third year last year, 2007, so third year is always the most profitable year in a PBM contract, and so the comparison is tough for that reason. It was also a substantial specialty business, so again that means that it had more profitability than some. And simply the absence of that in comparison obviously is a year to year reduction.

Now, had we bid and won the contract, we would have had a significant reduction anyhow because of the fact of new rates and so forth in a new contract. But nonetheless, the absence of it was a significant factor.

I would say though that we didn’t have a substantial number of incremental costs in the first quarter related to stepping away from that. We obviously to the degree that we had obligations and announced terminations and such provided for those by accrual in the fourth quarter of last year, so there wasn’t any clutter in the first quarter, if that’s your question.

John Heinbockel - Goldman Sachs

Well, I’m just trying to get at how representative is -- was the one quarter performance for Caremark because the margin and the EBIT just looked light relative to trend. I wanted to see is it -- you know, what was impacting the performance versus where we were coming out of ’07, and is the first quarter representative? And I guess it’s kind of representative but you think, for a variety of reasons, the margin is going to get a lot better as the year goes on.

David B. Rickard

I’d say the one factor that we talked about importantly when we gave the initial guidance for the first quarter was that the Med D program was evolving as CMX intended it to and as everyone knows that it was going to, and an important part of that was the widening of the risk corridors. Given the fact that we have to account for the insurance piece of the business in each quarter as if it were a full year, we can’t -- we end up recording our worst performance in the first quarter when we have many costs and not as much revenue pro rata. So the pattern of earnings gets worse when you add insurance business or you add risk to an existing insurance business, which we did this time.

A third factor that impacts -- and that we talked about some on the last call -- a third factor that impacts us significantly is the pattern of generic conversions and -- whereas we did have some in the first quarter, we also expected and still expect that the big quarter this year is going to be the third quarter. Last year we had proportionately more in the first quarter, so there were two or three things here that structurally would have resulted in the pattern that you’ve seen.

John Heinbockel - Goldman Sachs

Okay, thanks.

David B. Rickard

Now obviously we came in $0.01 better than the midpoint of our range and we were very happy with that financial outcome.

John Heinbockel - Goldman Sachs

Thank you.

Operator

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

Lisa Gill - J.P. Morgan

Thanks very much for the detail. First, a follow-on, Dave, just so we understand on the Part D side -- are you really talking about bringing up your reserves around Part D because of the change in the risk corridors for this year and therefore as we move throughout the year, you can potentially start to take down those reserves? Is that how we should think about that component of the business?

David B. Rickard

Well, it’s not -- it’s not a voluntary change in reserves. It’s a mandatory accounting that in effect says that all of the revenues and all of the costs get booked within each quarter discretely as if it were a full year. Many other parts of accounting allow you to look at the full year and take a pro rata portion. This particular accounting has its own specific rule that we have to abide by and that’s how we have to account for it, so the up-shot is we can’t smooth higher loss ratios that are incurred early in the program before we get into the donut hole.

Lisa Gill - J.P. Morgan

Okay, great. And then just a couple of quick PBM questions -- when you talked about the $3 billion of new business, is that on a net basis or on a gross basis for 1/1/2009?

David B. Rickard

That’s on a gross basis. What I’m trying to help you to understand is how the year is going but we are not yet at a point where we have a very, very clear fix on what 2009 is going to be, and so I would encourage you not to fire up the model for 2009 based on these very, very early results.

Lisa Gill - J.P. Morgan

But is that the plan over time, to do -- you know, to give us a net number --

David B. Rickard

Yeah, we’ll give you as much shape as we can in the third quarter call, as we usually do. That’s when we know 95% of what is going to happen and we can give you an accurate read. All we can do right now is just indicate how the year is going and it is going quite well.

Lisa Gill - J.P. Morgan

Okay, great. And then just lastly, I know you haven’t done this in the past but do you want to give us any kind of guidance as to how we should be thinking about EBITDA per script? I think what John was trying to get at is that most of us were pretty far off in the first quarter and obviously I think FEP being in the third year was more profitable than many of us thought it was. Any way we should be thinking about that as we go throughout the year? It sounds like it’s going to get better as it progresses but is there anything else that is unusual as we move throughout 2008?

David B. Rickard

Well, obviously that is also affected by a mix of contracts and so forth, and that is still evolving, so it is a little bit of a shot in the dark, but I would expect that you should expect pretty consistent improvement in that as we go through the year. But that’s a general expectation and I could well be wrong.

Lisa Gill - J.P. Morgan

Okay, and then just one last follow-up; when you talk about clients and new clients that you’ve signed on, we’ve all been waiting to hear about some of the programs that they are really looking forward to. Can you maybe just give us some color around some of the things AT&T liked or some of these new four-day clients that you’ve signed on that they’ve really liked about the combination of the two entities? Thanks very much.

David B. Rickard

Yeah, I can do that but Howard can do it better. I’m going to ask Howard to take the podium here.

Howard A. McLure

That analyst meeting that Nancy referenced, we’ll have a lot more detail on and without talking about what any specific client found meaningful, I think what clients are seeing resonating is the value proposition from the unique and integrated health model that we are putting together. One thing that is in the marketplace today is what we call an ability -- oftentimes clients or participants don’t get their mail order prescriptions in on a timely basis and they can’t -- they get turned around, consequently they are left with a gap in care.

One of the products we have introduced, we introduced April 1st, is an ability for them to go to a CVS store and get that five-days worth of medication, no incremental cost to either the patient or the participant, or excuse me, or the client. So those are the types of programs and you’ll hear more about them in May, so I don’t want to go into a lot of detail on them today. But those are the types of programs that are out there that clients are seeing.

The component that we’ve all talked about, that you’ve heard over and over again is the ability, the consumer-facing ability that we have that is really unique to our PBM retail model.

Lisa Gill - J.P. Morgan

Thank you.

Operator

Your next question comes from Ed Kelly with Credit Suisse.

Edward J. Kelly - Credit Suisse

Dan, could you just give us some color on the decision to cut back on the Minute Clinic growth, just providing more details on the variables that led to that decision? And then, is there any real meaningful EPS benefit from not opening up as many clinics this year?

David B. Rickard

I’m sorry, I didn’t get the second part of your question. Can you repeat that?

Edward J. Kelly - Credit Suisse

Is there any meaningful EPS benefit relative to your prior guidance --

David B. Rickard

Okay. Well, I’d say this -- in any new business, you learn as you go and you adjust priorities accordingly. Early on we focused on expanding the footprint. We’ve now brought it to a point where we think we have a basis for a very good business and now we really need the team to focus on enriching the platform while it continues to expand at a more balanced rate. Also, the management team needs to finalize agreements with some plans in certain markets and continue our marketing efforts.

So it’s more an enrichment now than it is expansion, although we will continue to expand. And in terms of the financial effect, we are actually -- this strategy change is actually going to be a little bit more expensive than the original strategy, as it turns out.

But we think it’s the right thing and we think it’s much more likely to lead to a terrific successful little business that’s an important adjunct to our PBM efforts than simply the land grab that we were in for a while there.

Edward J. Kelly - Credit Suisse

Have staffing issues anything to do with this?

David B. Rickard

We haven’t run into any significant staffing issues yet. That’s not to say that we won’t. We would expect to down the road, especially as our competitors also are expanding quickly. But that hasn’t yet been an issue.

Edward J. Kelly - Credit Suisse

Okay. And your retail gross margin obviously was very strong this quarter, up 200 basis points. You know, Walgreen’s gross margin was flat. Your front-end gross margin is up. Theirs was down. You know, this might not be a fair question but could you maybe help us understand how you are producing strong results when your biggest competitor is not?

David B. Rickard

Well, I don’t want to comment too much on my competitor’s results but I understand that they have said that they are finding a need to spend more promotionally. We are finding the reverse of that. We are not having to expend as much promotionally. We also have favorable mix change, the growth in our private label is a good example of that. So we’ve got a lot of things going positively in that business.

And you know, extra care is a unique weapon. It’s something we have and they don’t have and it permits us to manage our promotional spend much more precisely and to much greater effect than broad campaigns or circulars. We’ve known that for years and it’s an advantage we have in our business. It’s structural.

We also are getting some benefits in purchasing that they may or may not be getting, so all I can tell you is that the programs that we have in place are working and I don’t know really any details about their progress.

Edward J. Kelly - Credit Suisse

Thank you, David.

Operator

Your next question comes from Eric Bosshard with Cleveland Research.

Eric Bosshard - Cleveland Research

A follow-up on Minute Clinic -- is the terminal or long-term target for Minute Clinics any different and can you give us any reminder of the concept of what that number might be?

David B. Rickard

You know, we’ve said early on that we expected about 1,500 to 2,500 Minute Clinics across the system. We really haven’t revisited that, so I don’t have new news on that. We still would expect it will be something like that. But you know, we’ll solve the very long-term in due course. Right now we want to make sure we are having as great an impact as we possibly can with the model.

Eric Bosshard - Cleveland Research

So this would suggest that you are maybe going slower but still going in that direction -- is that the right way to think about this?

David B. Rickard

I think that’s the right way to think about it. Obviously we are expanding the services that we are offering, so it’s going to be a richer content as we roll it further, but we also have to back-fill now with that richer content into the first 500 stores.

Eric Bosshard - Cleveland Research

Secondly, in terms of pharmacy profitability, I know there was a lot of talk on the last call about changes in the pace of drugs being macked and generic reimbursements. Can you give us an update of what you see going on in terms of underlying pharmacy profitability, especially on the generic side of the business?

David B. Rickard

I’d say that what we have been experiencing for the last several quarters continues, with no acceleration or change, really. But the last several quarters are faster macking than a few years ago. But that trend continues. It’s not accelerating.

Eric Bosshard - Cleveland Research

And then lastly the cash flow targets you gave out suggest a significant amount of free cash flow this year. Can you give us a sense of what the board is thinking or management is thinking in terms of using that cash flow?

David B. Rickard

Well, I think that we don’t have any new announcement to make today on new programs there. Obviously it’s a lot of cash. I’ve said before that we wanted to put ourselves in a little bit more flexible position from a strategic standpoint relative to cash capacity, but after that it would be appropriate to find appropriate ways to get it to shareholders.

Eric Bosshard - Cleveland Research

Thank you.

Operator

Your next question comes from Mark Wiltamuth with Morgan Stanley.

Mark Wiltamuth - Morgan Stanley

I wanted to dig in a little more on those new PBM contract victories. There’s a lot of chatter out there in the marketplace that these were just price focused wins. Is there anything you can really relate to us to indicate that that is not the case, that there were actual attributes that they liked about the new combined offering?

David B. Rickard

You know, it’s been my experience as we’ve gotten more deeply into PBM dynamics that the loser of contracts always says that, and there have been a lot of losers out there. We think that the reality is that we do have to be competitive in terms of price but that what we are bringing to the table is value. We are bringing a better product that we can uniquely deliver because of our structure and our customers certainly are cognizant of that and are very enthusiastic about that.

So I think what we are seeing here is the beginnings of what we expected to see when we talked about this combination of CVS and Caremark originally -- that is, the ability to add service and convenience and ease for customers, improve outcomes, and lower costs for clients. And that is what we are doing and they are responding.

Mark Wiltamuth - Morgan Stanley

And did those contracts include any discounts on the front-end or any flexible prescription capabilities or anything like that yet?

David B. Rickard

Howard is saying that they don’t. I know that before the merger, we had a couple of programs like that. We had a feature like that in the State of Connecticut contract and the Daimler Chrysler contract, so it is certainly something that is available to us as a tool. But it is not a primary tool.

Mark Wiltamuth - Morgan Stanley

And just to ask about the prescription trends out there, we have seen some softening in the prescription volume trends across the industry. Can you give any insights on what is going on there and do you think there is any component of this that is consumers reacting to the economy?

David B. Rickard

We don’t see at this point evidence or market research that would suggest that consumers are changing behavior -- more pill splitting or things like that. We do monitor that. The Zyrtec phenomenon certainly is a piece of it. The absence of the growth that we had in last year’s numbers due to Med D is a piece of it. But the PBM utilization rate is up and our share is up, so we are still seeing reasonable trends on the pharmacy side.

I’m not going to rule out the possibility that consumers will start to adapt differently to a new economy but we just haven’t seen it yet.

Mark Wiltamuth - Morgan Stanley

Okay. Thank you very much.

Operator

Your next question comes from Neil Currie with UBS.

Neil Currie - UBS

I wonder if you can just give us some color on the synergies that you’ve been getting, because the retail performance really was outstanding against expectations and I wonder if you could walk us through how you allocate those synergies on an accounting basis. Is it somehow skewed more towards the retail part of the business over and above the make-up of retail as a percentage of sales?

David B. Rickard

Well, first of all the way that those synergy benefits come through the P&L is simply by having lower prices on purchased goods as each retail and PBM use the inventory. So it isn’t an allocation decision. It’s not something that we sit here and say okay, now how much should we put there and how much should we put there. It just flows through cost of goods like any other cost or benefit. So it’s not an allocation.

Both retail and PBM therefore are getting very, very substantial benefits out of the purchasing synergies, which is as you know the bulk of the $700 million. On the overhead piece, the $100 million or so, goes disproportionately to the PBM because it just so happens that there were call centers and things like that were able to be closed and those were on the -- those were costs of the PBM and so those floated the PBM disproportionately, but the purchasing goes both ways.

Neil Currie - UBS

Would it be fair to say then in the inventory that was ordered in the first quarter, that the retail side of the business benefited more from the lower costs as a result of the synergies than the --

David B. Rickard

You know, I wouldn’t have said that. I don’t believe that’s the case. Remember that you have the big PharmaCare gross-up in sales that has no profit impact and you did have the FEP contract, and if you factor in those two things, you pretty much can explain the trends that we are looking at here.

Neil Currie - UBS

It just seemed such an outstanding first quarter for the retail side and I was just looking for any sort of simple explanation between the -- what you did against expectations, so congratulations on that.

David B. Rickard

I will pass along your thoughts to Larry Merlo. I am sure he will appreciate them.

Neil Currie - UBS

In terms of the Save-on Osco stores, how much do they help to contribute as well to an improved performance, and are you looking now to accelerate more aggressively into Northern California, Pacific Northwest mountain regions, and will that be organic or will you consider acquisitions?

David B. Rickard

Osco Save-on outperformed core CVS both in sales and in margins. It has the advantage that it started with a shrink opportunity that we are rapidly capturing and so that’s helping the margin comparisons and simply the sales is the result of really bringing the CVS discipline to the way those stores are run. It’s a mature base now -- the management, the systems, everything is in place and it is working better.

In terms of Northern California, we are anxious to be in Northern California but it is an extremely tough real estate environment and we will be doing and are doing now the groundwork necessary for organic expansion, so if we stumble across some acquisition along the way, certainly we’d want to consider it but right now, our view and our plan is to do it organically.

I should point out -- let me circle back to the Osco Save-on question. I don’t want to over-emphasize the size of that; recall that it was 700 stores in total and so --

Neil Currie - UBS

It’s just that when you look at the population per store of the Save-on Osco stores, it’s twice that of the CVS average, yet the scripts per week seem to be quite similar. I’m just wondering what -- you know, do you see a significant opportunity for those stores to exceed the average because of the population densities?

David B. Rickard

Well, the actual sales per square foot overall are lower than core CVS by a meaningful amount, and so yes, we do see a very substantial opportunity there, both front and pharmacy. And we are getting it -- I mean, it’s coming along.

Neil Currie - UBS

Thank you.

Operator

Your next question comes from Meredith Adler with Lehman Brothers.

Meredith Adler - Lehman Brothers

Thanks very much. I wonder if you could just talk to us a little bit about what impact the PharmaCare gross-up has had on the PBM numbers. You made a comment just now but it would be helpful if you just sort of flesh that out. Is that one of the reasons that it optically you seem to see better results in retail than in the PBM?

David B. Rickard

Yes, I think that’s absolutely true, Meredith. It’s an increase in sales without a corresponding increase in profitability at any line, so it is going to have an optical effect that would appear to make the PBM results less impressive than they actually are. Couple that with the Med D phenomenon and you have a very -- you have two very sort of non-operational negatives, if you will, in the first quarter for the PBM. PharmaCare gross-up by itself cost 52 basis points in reduction to margins, so had it not been for that, you would have seen the margins 50 basis points higher.

Meredith Adler - Lehman Brothers

And I know that you didn’t change the accounting for PharmaCare like the day you closed the transaction, so how long do you think we should expect that that will be a dampening effect? And would you also say -- I mean, my understanding of the PDP is you might actually have another quarter where it’s -- the accounting forces it to be the drag as well.

David B. Rickard

Well, you are quite right. The second quarter will have a similar phenomenon and actually if you’ll recall, we did the conversion of those contracts and therefore the accounting starting in September of last year, so it will have a full quarter effect in the second quarter and a partial quarter effect in the third quarter.

Meredith Adler - Lehman Brothers

Okay, and then another question I have is just to talk a little bit about the start-up costs for the new contracts in the PBM. I don’t know too much about what kind of magnitude we should be thinking about.

David B. Rickard

Well, when you think about the nature of those costs, if a contract, as typically is the case, calls for a call center, you have to have that call center ready to go on day one. Typically January 1 contracts so you are hiring and training, you are providing for the space needs, you may have to rent additional space, depending on the circumstances. You have to hire some medical professionals within the mix of that. You need to put in place a management structure to manage it. So these are the kinds of costs and of course, we are talking about contracts which in the aggregate are in the billions of dollars, so there is a lot of activity and there is going to be a lot of bodies associated with servicing those contracts.

We also, with this kind of expansion, would expect that we will need more client service people and they tend to be higher cost professionals, if you will. So there are those kinds of costs. So on $3 billion plus of additional revenue, you certainly should expect several million in costs to get ready.

Meredith Adler - Lehman Brothers

Okay. And then a question maybe if you could talk about -- I mean, you explained that the slowdown in script growth is not a function so far that you can see of changes in consumer behavior, but we have seen a slowdown and I was wondering if you have any sort of view or opinion about what might be causing that slowdown.

David B. Rickard

Well, again we don’t see any major individual factor for that. We’ve talked about Zyrtec going OTC. That affects us on the margin. That affects the percentage disproportionately. Absence of new product introductions of any size is certainly a factor.

But we’ve also seen IMS data that shows a slowdown in the past that didn’t turn out to be as much of a slowdown as we actually thought at the time, so this could be one of those little dips as well -- hard to know.

All I can tell you is we have decent trends in our business, we are happy with the share growth that we’ve achieved and overall, we are satisfied and tracking at a level that we were quite comfortable with and within the ranges of our plans.

Meredith Adler - Lehman Brothers

Okay, and I just have one more --

David B. Rickard

I’m going to take two more questions.

Operator

Your next question is from Deborah Weinswig with Citigroup.

Deborah Weinswig - Citigroup

Good morning, Dave and congratulations on a great quarter. You talked about increases in terms of the specialty mail revenue growth -- can you elaborate on that? And also, anything new on the disease management side?

David B. Rickard

Well, specialty mail as I said on a comparable basis adjusting for FEP, grew about 14.5%. That is in the neighborhood of where it has been growing but I suppose a couple hundred basis points lower than at about this time last year, but it is still a very high growth attractive market for us.

Did you have a second part to that question? I’m sorry.

Deborah Weinswig - Citigroup

Yes, anything new on the disease management side, which also kind of -- I know it’s been a big focus in terms of driving specialty revenues. Can you also just elaborate on what you are doing there?

David B. Rickard

I’m going to ask Howard to jump in on that one.

Howard A. McLure

Well, there is nothing necessarily new on the disease management front other than the capabilities that we are getting out of bringing together the two entities. We are starting to see some folks who are -- you know, Dave talked about this specialty revenue that we have -- one of the big factors there was an ability to bring the retail environment into helping manage the care of these individuals. These individuals are using very high priced medications [and a number of different] [inaudible], so that’s an area that we think one of the reasons we looked at this transaction and like it was the consumer-facing component of this and we saw that in this particular contract discussion, that people really were pleased with the availability of brining that together.

David B. Rickard

Thank you, Howard. Operator, we’ll take one more question.

Operator

Your final question is from David Magee with Suntrust Robinson.

David Magee - Suntrust Robinson Humphrey

Good morning. Just a quick question about the retail side -- you mentioned you are not seeing the consumer impact. Is that true for all the regions, including Florida? And then a second part of the question would be just given the success you are seeing in retail right now, it sounds like it is being driven by the extra care card to a large degree, and the cash flow you are generating this year -- can we see maybe a bump up in the growth rate organically over the next year or so?

David B. Rickard

On the first question, one of the frustrations in looking at the data for me is that several people are saying Florida and California are the markets in which the consumer slowdown has occurred most or fastest, or most visibly. And of course those for us are newer markets and so we are still enjoying the extra growth that you get from being relatively young in a marketplace and so we are not seeing weaker trends in those markets than the overall business. So I can’t help you there and it may well be that a slowdown is being experienced there but it is simply masked by the vibrant growth of the relatively young fleet that we have in both of those cases.

In terms of acceleration of growth as we go into ’09 and ’10, it’s hard to judge that from here. It’s hard to know how long this economy is going to wobble, as it has been doing here. We do think that a major influence on our economic well-being is going to be the pace of generics. 2009 may be similar to 2008 and it is broadly expected and I expect that 2010 and 2011 are going to be pretty big years.

So I guess right now as I sit, 2009 looks like a very solid year. It probably is going to be economically a bit better on average than 2008 on average, so I look at 2009 with moderate optimism.

David Magee - Suntrust Robinson Humphrey

But for the time being, we should just expect 3.5% organic square footage growth until we hear differently but --

David B. Rickard

I think that is absolutely right -- 3.5 is our comfort zone and we haven’t obviously done our plan for 2009 at this point but if I were laying a base assumption, that is certainly the one I would use.

David Magee - Suntrust Robinson Humphrey

Great, thanks, Dave. Good luck.

Operator

At this time, there are no further questions. I’ll turn it back over to management for further remarks.

Nancy Christal

Thanks, everybody and we look forward to seeing many of you on May 21st.

Operator

Thank you for participating in today’s conference call. You may now disconnect.

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Source: CVS Caremark Q1 2008 Earnings Call Transcript
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