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CVS Caremark Corporation (NYSE:CVS)

Q2 2008 Earnings Call

July 31, 2008 8:30 am ET

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

Larry J. Merlo - Executive Vice President and President - CVS/Pharmacy - Retail

Analysts

Scott Mushkin - Jefferies & Company

Lisa Gill - J.P. Morgan

Eric Bosshard - Cleveland Research

Thomas Gallucci - Merrill Lynch

John Heinbockel - Goldman Sachs

Matthew Perry - Wachovia

David Magee - Suntrust Robinson Humphrey

David Fill - Morgan Stanley

Deborah Weinswig - Citigroup

John Ransom - Raymond James

Meredith Adler - Lehman Brothers

Robert Willoughby - Banc of America

Edward J. Kelly - Credit Suisse

Mark Wiltamuth - Morgan Stanley

Neil Currie - UBS

Operator

Good morning. My name is Brandi and I will be your conference operator today. At this time, I would like to welcome everyone to the CVS Caremark Corporation second 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.

Nancy Christal

Thank you, Brandi. Good morning, everyone, and thanks for joining us today for our second quarter earnings call. I am here with Dave Rickard, Executive Vice President and CFO of CVS Caremark. Dave will provide a business update, a financial review of the second quarter, and guidance. I’m happy to inform you that we have two other key executives with us today: Larry Merlo, President of CVS Pharmacy Retail; and Howard McLure, President of Caremark Pharmacy Services. Both Larry and Howard will participate in the question-and-answer session.

For your information, we expect to file our 10-Q by late 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, dividends, and discontinued operations.

EBITDA is defined as operating profit plus depreciation plus amortization. Adjusted EPS is defined as diluted EPS from continuing operations, eliminating the effect of amortization only and assuming our overall effective tax rate for the amortization. As usual, we will provide guidance today using adjusted EPS, which is the metric used in First Call consensus.

In accordance with SEC regulations, you can find the reconciliation of the non-GAAP measures 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.

Now, before we continue, our attorneys have asked me to read the Safe Harbor statement. During this presentation, we will make certain forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially. 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 am always pleased to have the opportunity to talk about another great quarter for CVS Caremark. We posted strong second quarter results, including record sales, record operating profit and profit margins, record net earnings, and record earnings per share. I’ll run through these results in detail, but first I want to touch briefly on the areas of our business where we’ve recently gotten the most questions from investors. They include the PBM selling season and our clients’ growing enthusiasm for our unique new product offerings, the trends we are seeing in our retail pharmacy business, our progress with minute clinic, and our new store program.

So first an update on the PBM; on our last call, we told you that we had already renewed more than half of our business that’s up for renewal in 2009. As mentioned previously, those renewals included accounts such as AT&T, Bank of America, 3M, and the State of Connecticut. Today I can report that our scheduled renewals for 2009 are already over 70% complete. We are very pleased with our progress. As previously reported, we did lose the Med D contract with Coventry, due in large part to price. That represents approximately $2.5 billion in revenues and was largely retail oriented, so it’s not significant to the bottom line.

In addition, you may recall that it was announced back in 2006, prior to the merger, that Caremark’s contract with Empire would expire at the end of 2008. This expiration is part of Empire’s planned strategy to take this business in-house as part of its merger with Wellpoint. The contract represents approximately $1 billion in revenues and, similar to the Coventry Med D business, this account is largely retail.

Outside of these two big health plans, we are experiencing one of our best selling seasons ever. Importantly, our client retention in our employer segment is in excess of 99%.

So what about new PBM business? Great news there. On the last call, we said we had won the right to serve about 40 clients, which in total should have first 12-month revenues of about $3 billion. That included the previously announced contracts to service the employee retirement system of Texas, the BellSouth portion of AT&T, and GE.

Since then, we won $1.3 billion in additional new business, so our new contracts in total season to date are expected to have first 12-month revenues of $4.3 billion, represented by over 50 accounts. Some of these start as early as September of 2008, so the $4.3 billion is not the increment for 2009.

And there’s still some business which has not yet been awarded, so we’ll be more specific about the next expected impact on 2009 on the third quarter call. By then, the selling season will be largely wrapped up and we’ll provide a specific number for total net new business.

For now, keep in mind that the two health plan contracts that I noted will expire at the end of this year had single-digit mail penetration, while the new business we won is well over 30% mail. In fact, many of them are in excess of 40% mail, as these clients had mandatory mail or significant mail drivers with their previous PBM.

This is an obvious profitability driver for the business and signals the traction we are getting with our maintenance choice offering, which I’ll talk more about in a moment.

Although we are losing two large retail health plan contracts, we were recently awarded the mail service business for a significant health plan customer, and we have expanded our mail offering and specialty services for a large Blues plan.

Many investors have asked us about the pricing environment. Well, it’s safe to say that it remains competitive as it always has been. Price will always be an important factor in every contract decision, but as evidenced by our solid new business wins, we believe our award-winning service and our new model are key differentiators for CVS Caremark.

At our analyst day on May 21st in New York City, we told you about some of our unmatched new offerings, which only a PBM and retail combination like CVS Caremark can offer. Our new proactive pharmacy care model is increasingly resonating in the marketplace and we’re told by clients that it has been an important factor in their PBM selection process. Clients have expressed their enthusiasm for products like maintenance choice and proactive pharmacy care at retail because they understand that we can lower their overall cost while improving access, convenience, and health outcomes for their members.

As I said, we are beginning to see maintenance choice create a real market differential. This offering lets the patient choose where they receive their 90-day maintenance medication while maintaining the same economics to the payer and the patient. The concept of preserving the economics of mail service while expanding consumer choice and access has resonated in the marketplace and led to several key wins in the 2009 selling season.

Proactive pharmacy care at retail is well underway. Our retail pharmacists are speaking with Caremark members who have gaps in care and we are already beginning to deliver incremental scripts as we aim to improve adherence rates to prescribed drug regimens. That will keep -- both keep people healthier and lower overall healthcare costs.

Our extra care health card provides a discount on CVS brand flexible spending account OTC products to Caremark members who elect to participate, especially given the current economic climate. Clients are viewing it as an exciting new benefit they can offer their employees at no incremental cost.

We are still on target for reaching about 10 million members by early next year. The offering is resonating with clients as a unique way to provide savings to members and we continue to roll out new cards each month.

And finally, our first specialty pick-up at retail client is scheduled to go live on September 2nd, and all systems and processes are in place for a broader rollout next year.

Overall, our new offerings are making steady headway in the marketplace and are clearly being recognized as a differentiator for CVS Caremark. Our momentum in this PBM selling season is excellent, so we are feeling very good about our competitive position.

Now let me touch on the retail pharmacy side of our business. We had another solid quarter, with pharmacy same-store sales growing 3.7%. Sales of new generics negatively impacted this number by 280 basis points, so if adjusted for the impact of new generics, pharmacy comps would have been 6.5%. The generic dispensing rate in our retail segment was 67% in the second quarter, up about 460 basis points from last year and up about 40 basis points sequentially.

Although there are some headwinds impacting pharmacy growth across the industry, such as RX to OTC switches and a weak brand drug pipeline, CVS continues to grow and gain market share. Our script growth in the second quarter and year-to-date is nicely ahead of all other chain stores and we continue to gain on independence as well. In fact, if you adjust for calendar differences, our pharmacy same-store sales have led the industry every month for the past six months.

Many have asked if the economy is having an impact on script trends. It’s difficult to know for sure but we see no hard evidence of it. In fact, we did an analysis of both retail and mail. We looked at the number of days between refills of maintenance medications. If people were doing more pill splitting, the number of days between fills would go up. The study found absolutely no increase in days.

As for the front-end, comps increased 1.8% in the second quarter. Adjusting for the negative impact of the Easter shift, front-end comps increased 2.9%. We’re seeing a pick-up in price increases from suppliers, which we’ve been able to pass through, but it has had a minimal impact on comps through June, as many are effective in the second half of the year.

Our average front-store ticket continues to increase. It was up notably versus the second quarter of last year. We believe that’s a testament to the strength of our extra care loyalty card program, which encourages our customers to aggregate their purchases at CVS. In fact, more than 65% of front-end sales across the store base use the extra care card.

So despite the economy, we continue to grow and take a greater share of wallet with the help of our highly successful loyalty program.

I’ll also note that our front-store margins continued to improve significantly. One important driver of improved margins is the use of the extra care loyalty program to drive more profitable sales. In contrast with some competitors, we have not had to become more promotional this year. What we have seen is increased vendor participation in extra care offers to our customers, given the success of our previous targeted offers.

Additionally, our front-store margins are benefiting from a notable increase in private label sales. Private label made up 15% of front-end sales, up 114 basis points from last year. That’s the largest increase in organic private label sales that we’ve seen in memory. We think it reflects not only our continued efforts to grow private label but also more people trading down due to the economy.

And how does all this stack up relative to the competition? Well, I’m pleased to report that we continued to grow share in the key front-store categories that make up the vast majority of our sales -- over-the-counter, beauty, private label, and digital photo. In fact, we experienced share gains versus food, drug, and mass competitors in categories representing 80% of our front-store sales volume.

Now let’s move on to an update on our minute clinic business. Minute clinic continues to evolve as the nation’s largest and most geographically diverse retail healthcare clinic system. We currently operate 520 clinics, more than all of our competitors combined, and we continue to build our lead in the markets in which we operate.

We also expect to open minute clinics in a few key new markets in the second half of this year. Consistent with comments made on our last call, we expect to end the year with between 550 and 600 clinics, resulting in the addition of approximately 100 clinics in 2008. That equates to about 20% growth in the number of clinics, still a very healthy pace of growth.

On our last earnings call, we told you that we were slowing growth in order to better focus our efforts on expanding services, contracting with additional third-party vendors, and working with PBM clients to offer new products and services. Let me briefly touch on our progress in these areas.

New products continued to play an important role in minute clinic’s strategic future. Recent new product offerings include camp physicals, tuberculosis screening, and an integrated behavioral modification and pharmacy based smoking cessation program. Additionally, minute clinic initiated enrolment of patients into Google’s personal health record product and is uploading records at our patients’ request.

We’re pleased with the increasing designation of minute clinic as an in-network provider by health plans. Year-to-date, 26 health plans have added minute clinic to their networks, impacting 12 million Americans. We expect this trend will continue as we further leverage our PBM relationships and convenient CVS pharmacy locations.

We believe minute clinic will pay an increasingly important role in providing consumer easier access to high quality, lower cost healthcare. We are well-positioned for long-term growth, as our clients and consumers continue to realize the value of our minute clinic offering.

Before I move on to the financial review, I want to give you a brief update on our real estate program. In the second quarter, we opened 88 stores, including 49 new and 39 relocations. We closed eight others, so we added 41 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.

Many of you have asked if we plan to change our store growth strategy and the simple answer is no. We have been on a successful path of controlled, appropriate growth and intend to continue on that path.

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

Total revenues on a consolidated basis increased 2.1% to $21.1 billion. This figure is net of inter-segment eliminations of $1.3 billion. In our retail drugstore segment, revenues increased 4.6% to $11.8 billion. Same-store sales for the quarter were up 3.1%. I spoke earlier about the comp trends in both the front and the pharmacy and the drivers behind them, so I won’t repeat that discussion here.

And how about the PBM segment -- net revenues of $10.7 billion increased 1% over the 2007 second quarter. Adjusting that growth rate for the impact of generics, net revenues would have grown 8.4% for the PBM.

The impact of the change in Pharmacare’s revenue recognition method on the second quarter was the addition of $667.6 million in reported revenues before inter-company eliminations, or $521.7 million after eliminations.

So what drove the growth of PBM revenues? Total retail network revenues were $6.9 billion, rising 10.3% from 2007 levels. Setting aside the increase from Pharmacare’s revenue recognition change, retail network revenue was essentially flat to last year, due to the significant increase in generics.

The PBM’s retail generic dispensing rate increased to 65.5% compared to 61.2% in the second quarter of 2007. At the same time, retail network claims grew 2.7%. This was primarily driven by new business, including the growth spurt in our PDP and add-on lives.

As expected, mail claims decreased for the quarter by 18.9%. As with the first quarter, the impact of new clients was more than offset by well-known terminations during 2007, namely the FEP mail business, State of New York, and Ohio State Teachers retirement system.

Total mail revenues declined 13.2% to $3.6 billion, and within total mail revenues, PBM mail was down 22.4% compared to the second quarter of 2007, while our specialty mail revenues increased 4.4%. If you exclude the FEP business from last year’s data, total mail revenues increased 3.2% and specialty revenues grew 14.4% in the second quarter.

The mail generic dispensing rate rose to 54.5% from 47.6% a year ago, or 690 basis points. Our overall mail penetration rate decreased approximately five percentage points from 2007 second quarter to 23.5%. Again, this was largely a result of the absence of the FEP mail business.

Moving on to gross profit margin for the total company, the overall business expanded by 60 basis points over the second quarter of 2007 to 20.7%, and we had great results in both segments.

Within the retail segment, gross profit margins were up 60 basis points, improving to 29.9%. The primary drivers of this were these -- first, the increase in the retail generic dispensing rate; second, the merger related purchasing synergies; third, improved shrink; fourth, increased private label penetration; and finally, the benefits from the extra care card that result in a lower percent of products sold on promotion.

Gross profit margins in the PBM segment came in at 8.0%. That’s down 20 basis points versus the 2007 comparable second quarter. However, excluding the 53 basis points drag from the conversion of Pharmacare’s contracts, the gross margin in the PBM would have been up 33 basis points.

The PBM pharmacy margin benefited from some of the same factors that helped the retail business, namely an increase in the use of generic drugs and the purchasing synergies derived from the merger.

And what about expenses? Overall operating expenses as a percent of sales improved by approximately 10 basis points due to solid expense control in both segments of the business. In the retail segment, operating expenses decreased as a percent of sales from 22.8% to 22.6%. This was driven by disciplined expense control and improved expense leverage in the Save-on and Osco stores we acquired back in 2006. That was somewhat offset by the significant growth in generics, which pressure sales dollars while improving profitability.

In the PBM segment, comparable operating expenses as a percentage of revenues improved by 17 basis points to 2.2%. This was largely driven by the absence this year of integration and other merger related expenses that we saw in last year’s second quarter.

All things considered, we saw a significant expansion of our operating margins, specifically in the retail segment. The operating profit margin in the retail segment grew by 80 basis points to over -- that is, over the 2007 level to a record 7.3%. The PBM segment’s operating profit margin was flat with 2007’s comparable results at 5.8%.

Caremark’s industry leading EBITDA per adjusted claim increased to $3.90 in the second quarter, or 3.7% over last year’s comparable $3.83. Excluding the FEP mail business, we again would have had double-digit growth in EBITDA per adjusted claim, so the underlying growth of the business remains robust.

Moving on to the rest of the income statement, we saw quarterly net interest expense on the consolidated income statement increase slightly to $115 million. That was virtually flat as a percentage of revenues year over year. Sequentially, however, this represented a reduction of approximately $16 million, reflecting a decrease in our short-term debt levels during the second quarter.

Our tax rate was 39.6% in the quarter, in line with expectations, and our diluted share count was 1.47 billion shares. That’s down considerably from last year’s second quarter due to our $5 billion share buy-back program last year that subsequently completed earlier this year.

During the second quarter 2008, we repurchased 550,000 shares. That was the beginning of our most recently announced $2 billion share buy-back program. That represents roughly $23 million worth of stock. As I said in our analyst day, we intend to repurchase shares during the remainder of this year and complete the buy-back during 2009.

Before I move on to earnings per share, I want to discuss a new line item on the income statement, namely discontinued operations. During our analyst day in May, I highlighted the recent developments at Linens and Things, which was a subsidiary of Melville Corporation, the former parent company of CVS. As many of you know, Linens and Things recently filed for bankruptcy. At the time of the Melville restructuring, CVS Corporation assumed a contingent liability for leases of several former Melville businesses, including Linens. These businesses have been classified as discontinued operations for accounting purposes. Linens has informed us that they intend to close a number of locations, several of which have leases guaranteed by us. There are also some other net expenses associated with the leases.

Our real estate team has researched the sites’ market values and assessed the expected cost of satisfying these lease guarantees. The loss from discontinued operations of $48.7 million you see on our income statement represents our determination of the impact of these closings net of income tax benefits.

That’s the state of knowledge as we have it now. We have fully provided for all obligations as best they can be determined. However, like any bankruptcy which has not worked its way through to reemergence or a wind-down, this situation is fluid and there could be more news to come. But even in a worse case scenario, this is simply not big enough to throw CVS Caremark off track. It’s inconvenient and there is some cash impact, but that’s it.

Going forward, keep in mind that our guidance excludes any possible impact from Linens and Things.

So if we put the discontinued operations aside, what did all of this mean for EPS? Adjusted EPS from continuing operations rose 17.1% to $0.60, up from $0.51 in 2007. GAAP diluted EPS from continuing operations rose 19.5% to $0.56 for the quarter compared to $0.47 in the second quarter of 2007.

Turning to the other financial statements, we generated $161 million in free cash flow in the quarter and $506 million year-to-date. Our strong free cash flow combined with the use of $200 million in cash on hand allowed us to reduce our total debt by more than $360 million during the second quarter. So we continued to strengthen our balance sheet and improve upon our credit ratios.

Net capital expenditures were $491 million in the quarter, which reflected proceeds from sale lease-back transactions of $64 million netted against the gross capital spend.

Now let me turn to guidance for the third quarter and full year 2008. I’ll start by saying that given the continued strength across our businesses, we remain optimistic about our growth for the full year. While a couple of the elements within our expectations have changed a little, we are maintaining our previous annual guidance of $2.44 to $2.50 for adjusted EPS from continuing operations. Let me walk you through the elements of our current guidance.

I’ll start by providing initial guidance for the third quarter. We expect third quarter revenue growth for the total company to be 3% to 5%. We expect PBM revenues to be down slightly in the third quarter, and we expect retail revenues to be up 5% to 7%.

We anticipate third quarter adjusted EPS from continuing operations of between $0.58 and $0.61 per diluted share, up from last year’s $0.50 per share. That equates to adjusted EPS growth of 16% to 22%.

GAAP EPS from continuing operations is expected to be in the range of $0.53 to $0.56 per diluted share, up from last year’s $0.45 per share.

Now let’s look at the full year. We still expect revenue growth for the total company of about 13% to 16% for the full year after inter-company eliminations of somewhat over $1 billion per quarter.

For the PBM segment, on a comparable basis we still expect revenues to be about flat with 2007, and we expect reported revenue growth of well over 20% for the year since the merger closed in late March of 2007.

For the retail segment, we still expect full year revenue growth to be 7% to 10%, same-store sales are expected to be in the range of 4% to 6% for the retail segment for the year. That’s a slightly narrower range than before. We’ve gotten a lot of questions from investors about our revenue expectations for the retail business. In the second half, we still expect revenue growth to be stronger than in the first half. That’s largely due to somewhat easier year-over-year comparisons, as well as the incremental revenues we expect from our new offerings. These include the proactive pharmacy care at retail, extra care health, and specialty at retail. And despite the economy, we are seeing very solid performance on the retail side of our business as we continue to gain share from weaker competitors. I feel very good about the retail business and I think these revenue growth projections are realistic.

By the way, in the month of July, our comps accelerated to 4.2% overall. Pharmacy comps in July increased to 4.5% and that’s with an even higher new generic impact than we had in the second quarter. And front-store comps increased to 3.5%, so we’re off to a good start in the third quarter.

Now let’s turn to margins. 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, the gross margin performance of our two business segments will be somewhat different than our previous guidance. The PBM segment will be a bit lighter than we thought. This will be offset by better-than-expected performance in our retail segment. Let me walk you through that.

The change in our margin expectation for the PBM relates to two key areas: first, our mail penetration rate is running a little softer than we thought. That’s primarily due to downsizing in large employer clients, for example, in the auto industry. There’s also been an impact on utilization from the RX to OTC switch in the allergy category, similar to what we’ve seen in the retail side of the business. As you know, mail order scripts are the most profitable scripts for the PBM, so our gross margin will be affected by the change in mix. In addition, while we still expect profitability from the Med D business and the PBM to be better in the second half than it was in the first half, we now expect slightly lower margins in the Med D business due to utilization and mix.

So while we had previously thought that gross margin for the PBM would increase for the year, we now expect PBM gross margin to be marginally down from last year’s rate.

In contrast, gross profit margins on the retail side of our business are now expected to improve even more than we originally forecast, so the news there is quite good. We now expect gross margins for the retail segment to increase by at least 75 to 100 basis points. This improvement is driven by terrific performance in several areas. These include better-than-expected margins in both the pharmacy as well as the front-store, driven by improved GDR, increased private label sales, and reduced shrink. I am delighted by the strength in our retail business across the board.

As we’ve said in the past, our gross margin will be helped by purchasing synergies and there’s no change there. We still expect more than $700 million in total cost synergies in 2008, the great majority of which is from purchasing. That’s up from cost synergies of about $400 million in 2007.

As for expenses, we still expect total company operating expenses as a percent of revenues to improve. That’s largely due to mix. Total operating expenses as a percent of sales for the PBM segment on a comparable basis is still expected to be in the neighborhood of last year’s numbers as a reduction of integration expenses and good expense discipline should be directionally offset by the 2008 start-up costs of the new business Howard and the team have been bringing in.

The retail segment has no such headwind and also continues to exercise disciplined expense control, so we still expect it to show moderate improvement.

We expect total consolidated amortization for 2008 to be approximately $400 million and depreciation of about $850 million. All of that will lead to solid improvement in operating profit margins for the total company.

I said on the last call that we could nicely exceed 6.5% for the total company, our current operating margin high watermark, which we achieved back in 2000. That’s still very much in prospect.

We forecast net interest of about $475 million to $500 million and a tax rate approaching 40%. Net capital expenditures are still expected to be in the range of $1.3 billion to $1.4 billion for 2008, and free cash flow is still expected to be around $3 billion. As you can see, despite a few tweaks in the details of our guidance, our business is very strong and we remain optimistic about 2008 and beyond.

So in summary, we reported very solid second quarter results across the board and we’re well-positioned for the future. We delivered healthy sales growth and record-breaking margin expansion in the second quarter, resulting in 17% adjusted EPS growth. Our retail business is outperforming the industry and gaining market share. Our momentum in this PBM selling season is excellent and we’re winning significant new business as clients embrace our proactive pharmacy care model. Payers increasingly understand that we can improve access, convenience, and health outcomes for the members while lowering their overall healthcare costs.

Our minute clinic business is evolving its offerings to maximize long-term growth as more clients and consumers are recognizing the value of our offering, and our guidance confirms our continued confidence in the remainder of the year.

With that, I’ll now open it up to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Scott Mushkin with Jefferies & Company.

Scott Mushkin - Jefferies & Company

A couple of questions here; maintenance choice, you hit on, Dave, in your -- I guess going over the quarter and selling season. What percentage of the Caremark member base will be exposed or accounts will be exposed in 2009 to this program? And I guess with -- does Texas have it?

David B. Rickard

Well, the program is being offered to people with mandatory mail and incentive structures that promote a large percentage of mail participation. I don’t know what percentage that will represent in 2009. Obviously we’re still selling but it’s gotten good uptake and there are a couple of contracts that we’ve won primarily because of it, so it clearly is gaining good initial acceptance.

Scott Mushkin - Jefferies & Company

And I noticed you didn’t mention it as a driver for retail and it seems when we look at it, it could be a pretty significant driver for retail. Was there any reason you excluded it?

David B. Rickard

I think you’re right. I think it will be a good driver for retail. We don’t have much data yet so it’s a little bit early to be talking about that but we will report on that ultimately.

Scott Mushkin - Jefferies & Company

And I guess one last, I’m sure people are going to ask this question too -- the gross margins on the PBM, other PBMs have been seeing upside. You guys really aren’t. I know there’s some extenuating circumstances. Do you have any other insights on why the gross profit may be a little bit more subdued with you guys versus your other PBM competitors?

David B. Rickard

I can’t report on the competitors but obviously our gross margins are affected by the loss of the FEP mail. That was a very large contract and it was mail order in nature, and we talked about some Med D higher utilization numbers affecting our margins to an extent versus original expectation, so I guess I would point to those as two operational things. And then of course, in addition the Pharmacare gross-up has a meaningful impact on the percentage margins that we report.

Scott Mushkin - Jefferies & Company

You gave basis points on Pharmacare. Do you have any numbers on FEP?

David B. Rickard

Not that we’re disclosing.

Scott Mushkin - Jefferies & Company

Thanks. I’ll turn over. Thanks very much.

Operator

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

Lisa Gill - J.P. Morgan

Good morning. Just following up on the Part D aspect of things, Dave; as we now look at the back half of the year, my expectation was that these members got into the donut hole, that there would be a nice ramp for Medicare Part D. Can you maybe just explain why the tempered outlook on the gross margin?

And then secondly, when we look at the new clients that are brought on, the additional $1.3 billion, can you maybe just give us some indication around specialty pharmacy and some of the other services that you are selling? Are you selling through minute clinic? I think you had talked about the entire new book of business having very good mail utilization trends but I’m just curious as to some of the other things that you are selling them.

David B. Rickard

I’m going to turn this one over to Howard.

Howard A. McLure

On the Part D component of this, some of this is really just utilization in mix. You know, we added a number of new lives in the Part D business and we’re just seeing some increased utilization and some increased mix, like others have seen in this business. We will see some pick-up in the back half.

Lisa Gill - J.P. Morgan

So Howard, then your initial expectations for what you thought you underwrote the business for, is it coming out to be less than that, so therefore when you get to the donut hole there’s not going to be as much of a positive impact because of all the utilization you are seeing right now?

Howard A. McLure

No, it’s coming in largely the way we underwrote it. We’ll see that moving the way we thought it would. It’s not -- it’s a little heavier than we thought it was in the first half because of the accounting that you go through with that, but you’ll see some -- you’ll see some people moving into the donut hole and some of that lift in the third and fourth quarters from that, the way we have in the past.

David B. Rickard

We’re still looking at a very nice improvement, second half versus first half.

Howard A. McLure

As it relates to new clients, we are bringing specialty into those new clients. We see that as coming in most accounts that we are. We, as Dave mentioned, a couple of them made their decision because of maintenance choice, so that’s a new product that we will be selling into those accounts and we were talking to a number of them about adding that.

We still see the sell-through of the clinical program and good uptake on a lot of these things, as well as the interest in the proactive pharmacy care solution that we talked about at the investor day.

Lisa Gill - J.P. Morgan

And then can you just lastly just remind us of where you are with specialty in your book of business as far as how penetrated it is -- you know, percentage of clients or percentage of --

Howard A. McLure

We’re about 50% penetrated throughout the book of business. About 40% of the specialty revenues come from [inaudible].

Lisa Gill - J.P. Morgan

Okay, great. Thank you.

Operator

Your next question comes from the line of Eric Bosshard with Cleveland Research.

Eric Bosshard - Cleveland Research

Good morning. On the retail side, the optimism for progress in the second half of the year on the revenue line and the gross margin line, I know you ticked off some of the factors leading to that but in this softer retail environment, can you just give us a little more insight into your conviction into why the margin and especially the sales progress is going to continue, or even improve?

David B. Rickard

Well, I think what I said in the opening remarks on the sales trends is really pretty much the story; that is, we were up against tougher comparisons in the first half, they get easier in the second half but importantly, our new products from the combined entity are insignificant in the first half of the year and will become more so in the second half of the year. In addition to that, we have underlying strength of the extra care program and share gains pretty much across the board. That’s been evident in the first half. It’s going to -- it’s my expectation that that’s going to continue in the second half.

The gross margin trends are driven by again a number of factors and I should also include in that the leverage of Osco Save-on. We’re seeing better and better shrink results, better and better sales results, and so at the margin, that can be influential in both of those comparisons, sales and gross margin.

Eric Bosshard - Cleveland Research

And within the new products, what is the most significant? And these are programs I know you’ve rolled out in the last 60 days or so -- which are having the most material impact on revenues so quickly that you have this confidence in?

David B. Rickard

Well, proactive care I guess is the most important thing in the very, very short-term here because it can have an effect the first day that we put it in place -- that is, ensuring adherence among consumers. If we get them restarted on their meds, we get an extra script that day.

Secondly, we’re just taking share, and taking share builds business.

Eric Bosshard - Cleveland Research

Very good. Thank you, Dave.

Operator

Your next question comes from the line of Tom Gallucci with Merrill Lynch.

Thomas Gallucci - Merrill Lynch

Just a couple of quick questions here; I guess on the Part D, first just to confirm -- that will still be net profitable for the year? It’s just a matter of the accounting swing throughout the year, or --

David B. Rickard

Absolutely right. It will be net profitable.

Thomas Gallucci - Merrill Lynch

Okay. Is it possible to get some sort of magnitude of the swing that you are seeing in terms of the profits, first half drag versus second half up or --

David B. Rickard

We don’t break that out but I can tell you that there is a meaningful upswing second half versus first.

Thomas Gallucci - Merrill Lynch

Okay, and something else, just trying to get some perspective on the numbers; I guess you mentioned the synergies in your prepared remarks. Some idea of the relative percent of the benefit going toward the retail side versus the PBM side would be helpful.

David B. Rickard

Again, we haven’t broken that out. It is meaningful on both sides of the business, but we haven’t attempted to break that out.

Thomas Gallucci - Merrill Lynch

Okay. I guess last one as sort of a follow-up on some other questions that we’ve seen here, but I know you mentioned maintenance choice and some other things, Howard, that newer clients are signing up for. Do you have an idea out of the 50 or so new clients that you’ve won, starting I guess in September and into next year, how many have signed up for just a new product as a result of the combined company?

Howard A. McLure

I would say right off the top of my head at least three that come to mind. Two maintenance choice they say was instrumental in their decision, very important; one was a specialty customer who signed up for the in-store delivery of specialty products. That’s just right off the top of my head, Tom, I can think of three instances.

David B. Rickard

Howard, that’s three that had as a primary reason for signing up the fact that we had these new products. I think what he was trying to get at was how many of the 50 have signed up for a new product, whether it was a primary driver in their decision or not.

Howard A. McLure

Okay, so if people are coming -- look, this is resonating very well with people, the new offer here, and people are coming in, whether they are signing up first year for a new product, they are seeing the potential here and they understand the ability that this entity, this combined entity is going to be able to bring and the tools they are going to be able to bring to bear to help them control their pharmacy trends. And I think people are really excited about it. I mean, the sales force is very excited about it and getting a lot of interest in not only maintenance choice but the proactive pharmacy care program, an ability to use minute clinics to help serve their members, not only for ongoing care but also for purposes of helping training for specialty injection services, those types of things. This is just a significant amount of buzz around all of these products and all these things that we can do.

So of the 50, I would say probably -- I don’t know, I’d say probably more than half had signed up for new products.

David B. Rickard

That’s my sense as well, and I also know of situations where people have said we’re interested in that new product, we’d like to see some experience with somebody else before we actually sign up for it but if we can take it in year two, we’d be interested in doing that. So I think that number will grow.

Thomas Gallucci - Merrill Lynch

Great, thanks.

Operator

Your next question comes from the line of John Heinbockel with Goldman Sachs.

John Heinbockel - Goldman Sachs

Dave, a couple of things; given what’s happened, your experience with the PDP business this year, does that have any -- what do you differently next year in terms of the bid process? Are the numbers different enough where you would change your approach, or not really?

David B. Rickard

No, we’re talking fine-tuning here and this certainly doesn’t affect the approach. It affects perhaps the way we forecast a bit.

John Heinbockel - Goldman Sachs

Okay. Secondly, if you look at that upswing, second half versus first half on PDP, if you look at FEP and that impacts similarly, how does that look second half versus first? Same or do you think the impact mitigates a little bit?

David B. Rickard

You know, it will have a similar seasonality, I guess, to what the overall business has but I see no reason why it would mitigate.

John Heinbockel - Goldman Sachs

If you guys look at adjusting for FEP and PDP, and sort of back into a Caremark growth rate in EBIT, is there any sense of what that looks like? Because obviously the reported numbers don’t look as strong as I guess they are on an underlying basis. What’s the sense of -- are we looking at kind of mid-teens EBIT growth ex these factors, or what?

Howard A. McLure

Well, without getting into EBIT growth, take a look at probably one of the more important things [inaudible] script, and if you look at [inaudible] script from Q1 to Q2, it’s up 16%. So that kind of gets out of the 3.7% year over year, has an FEP impact, which Dave said would be double-digits without that. But looking at that growth, that sequential growth there, you still see the strength in this company and the strength and the ability to drive generics, the strength and ability to do things that are going to help people [inaudible]. So that’s I think -- if we look at that sequentially, you’ll see the strength.

John Heinbockel - Goldman Sachs

Okay, and then finally, where do we stand with synergies? What kind of run-rate are we running toward at this point?

David B. Rickard

$700 million plus, cost synergies.

John Heinbockel - Goldman Sachs

Likely to be a lot plus or --

David B. Rickard

It’s like to be north of 700 and I’m not going to give you a new number.

John Heinbockel - Goldman Sachs

Okay, thanks.

Operator

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

Matthew Perry - Wachovia

If I look at the second half guidance you’ve given for better same-store sales on the retail side, better retail revenue growth in total, how much of that is due to the synergies from the new offerings? And I guess what I’m maybe really asking is are you still thinking about $800 million in revenue synergies for the year, and how much of that will occur in the second half?

David B. Rickard

Yes, I think the 800 is still intact. It may be a bit better than that, based on PBM results but we were gearing for a little over $400 million on the retail side and that still looks like a good call. And almost all of that is in the second half.

Matthew Perry - Wachovia

Okay.

David B. Rickard

Larry, do you want to add to that?

Larry J. Merlo

Well, I think it’s that combined with some of the programs that Dave alluded to earlier, you know, the strength that we’re seeing from the Osco Save-on acquisitions as well as the fact that there is evidence that we are picking up market share from some of the weakened competitors.

David B. Rickard

And we expect that will continue.

Matthew Perry - Wachovia

And if I think about the 4% to 6% same-store sales, does any part of that or anything within that range predicated on an improvement in the economy?

David B. Rickard

No. Our assumption on the economy is it’s not going to get any better and it’s not going to get a lot worse, so that’s the range we’re in.

Matthew Perry - Wachovia

And then last question, maybe for Howard; if we listened to comments from the two independent PBMs, they keep talking about the positive reaction their customers and their potential customers have to the independent model, and I just wonder if you have an update on the feedback you are getting from your customers and your potential customers on the vertical model -- any change in the last three months, or just any update there?

Howard A. McLure

Well, I think we’ve signed $4.3 billion in new business this year and it’s not -- there’s no large mega accounts in there. This is -- I think the best statement of that, Matt, that we are signing business [in front of] a lot of business and people are not bothered by this fact. People are looking at -- they are making decisions on price but they are also making decisions on service and they are looking at the service that we are able to bring to bear, things like bridge supplies -- no one else can do that. And they see that, they see the benefit of that. I’ve gotten letters from individuals saying this is great, this is a fantastic thing that you can do for me, thank you for helping. So I don’t think that people are -- the independent model is there, the competitors are good competitors, they’re good companies. They do a good job. We believe that we will be able to bring to bear service, price, and trends and that we’ll be unmatched in the industry once we get these programs fully in place.

Matthew Perry - Wachovia

And just lastly for me, if you think of the 50 account wins, is there any place that share -- specific place that share is coming from, you know, the big independent PBMs, smaller PBMs, HMO owned PBMs?

Howard A. McLure

It’s coming from across the board.

Matthew Perry - Wachovia

Okay. Thank you.

Operator

Your next question comes from the line of David Magee with Suntrust Robinson Humphrey.

David Magee - Suntrust Robinson Humphrey

A couple of things, please; one, do you care to give any thought or prediction as to when you might have a better tailwind for the pharmacy side of the business as we lap some of the factors that you mentioned? Do you think we will see better trends later this year, as far as the industry is concerned?

David B. Rickard

Well, I think the -- are you talking retail pharmacy or are you talking PBM pharmacy?

David Magee - Suntrust Robinson Humphrey

Retail pharmacy, just the sector weakness that we’ve seen out there the last say six months.

David B. Rickard

I guess you have to look at the pieces of that and think about how they affect it, but for example, we’ll be cycling the Zyrtec effect going OTC in the first quarter of ’09, the absence of positive life from Med D will certainly be baked in by then, so I guess absent any significant new products being introduced by the pharma manufacturers, I would say first quarter of ’09 is probably the first time we get a meaningful change in that trend.

Larry, would you agree with that?

Larry J. Merlo

Yeah, I would.

David B. Rickard

Okay.

David Magee - Suntrust Robinson Humphrey

Thanks. And then secondly, with regard to the script growth that you are showing and the fact that you are gaining share, at this point are we seeing a meaningful deviation between the older core CVS stores and those that you’ve acquired in the last five years?

David B. Rickard

Well, yes. I mean, as is almost always the case following acquisition, we spruce them up and advertise and get them moving a little bit better than they were, and that is certainly the case, continues to be the case in the southern assets of Eckerd and also very much so in the Save-on and Osco businesses. They are both growing faster than core CVS.

David Magee - Suntrust Robinson Humphrey

And then just lastly, and maybe for Howard, thinking about the longer term growth rate of Caremark, what would you -- I don’t know whether you could put a number on EBIT growth over time, what you would expect, but I’m curious what you think about the relative contributions of top line versus profit margin, further expansion in the profit margins there.

Howard A. McLure

Well, as generics continue to get introduced, that reduces the revenue. That also enhances the profitability, so as you move forward, you can look historically back at the -- what the growth rates would have been had not generics been in place and see how that does impact revenue. I don’t remember the number off the top of my head, the impact of it this time but I believe Dave gave it in his speech -- revenue would have been 8%, I believe.

David B. Rickard

Yeah, 8.5.

Howard A. McLure

So those factors, generics, the increase in generics and particularly I guess when 2011, some additional generics come out, there is a lot of -- there is drag on the revenue, lift on the profitability.

David Magee - Suntrust Robinson Humphrey

So in terms of the next year or two, we should expect the same type of breakdown in terms of the relative drivers?

David B. Rickard

Howard, are you --

Howard A. McLure

I’m sorry. Could you repeat that, please?

David B. Rickard

David, could you repeat the question? I’m sorry, I’m afraid we dropped it. I think we dropped David.

Nancy Christal

Okay, next question.

Operator

Your next question comes from the line of David [Fill] with Morgan Stanley.

David Fill - Morgan Stanley

Good morning. Thank you. It’s been a big couple of months on the legislative front. I wonder if you could give us your perspective on a couple of things, maybe the impact of prompt pay and Med D on both side of the business, and also what the opportunity around e-prescribing might look like in ’09.

David B. Rickard

Well, the impact of prompt pay on Med D will depend on regulations which have not yet been promulgated. If we look at the legislative intent or the apparent legislative intent, it obviously has different effects on the PBM side of the business and the retail side of the business; net net, it -- again, subject to final regulations -- it looks like it might be very modestly positive on an overall basis for CVS Caremark.

In terms of e-prescribing, that will be helped by the legislation that has been passed but it also is helped by the many initiatives that we and others are doing. You are familiar with our I-Scribe product and the effect that that has in accelerating the growth of e-prescribing. You know that we have about a 17 share of retail pharmacy right now and we do about 30% of all e-prescribed transactions, so we are very much at the forefront of this and very much in favor of it. It helps accuracy, helps healthcare and is far more efficient than the old fashioned hand-written prescription process.

David Fill - Morgan Stanley

And just to follow-up on that, one of your -- Medco in particular said that it may save, e-prescribing could save as much as $2 per new prescription. Is that in the right zip code for you folks, do you think?

David B. Rickard

We would say that’s in the right zip code, yes.

David Fill - Morgan Stanley

Great. Thank you.

Operator

Your next question comes from the line of Deborah Weinswig with Citigroup.

Deborah Weinswig - Citigroup

At the analyst meeting, I was very intrigued with the new pharmacy system, RX Connect. Can you talk about if it’s still on track to be implemented by the end of the year? And also stores where it has been implemented, how are the pharmacists reacting to the new system and have you seen an increase in adherence and customer satisfaction as a result of kind of freeing up pharmacists’ time to interact with customers?

David B. Rickard

I’ll turn this over to Larry.

Larry J. Merlo

We are -- we completed our beta. We’re now in our pilot phase and everything has been extremely positive. Pharmacists absolutely love the system, so we will begin the rollout in another few weeks and we are on track for the schedule that we reviewed at our analyst day, so we’ll be completed early in ’09.

Deborah Weinswig - Citigroup

And any differences you are seeing in stores that have the system versus stores that don’t?

Larry J. Merlo

Our service metrics have improved slightly and I will tell you that the satisfaction level of our pharmacists has been outstanding.

Operator

Your next question comes from the line of John Ransom with Raymond James.

John Ransom - Raymond James

Looking at the third quarter and your guidance and thinking about what you just posted in the second quarter, other than seasonality and the pick-up you are going to get from the Part D accounting, is there anything that’s going to be happening in the third quarter that wasn’t happening in the second quarter we ought to be thinking about?

David B. Rickard

Well, we’ll start to get a measurable amount of top line synergy volume on the retail side of the business. Other than that, I can’t think of anything offhand.

John Ransom - Raymond James

Okay. And I guess the sequential -- if you’re saying 58 to 61 and you just did 60, just the sequential down-tick is just seasonality then?

David B. Rickard

Well, I’d say that’s a pretty consistent number as opposed to characterizing it as a down-tick. I mean, the range covers exactly the number we just reported second quarter to third quarter, $0.60 to a range of $0.58 to $0.61, yeah.

John Ransom - Raymond James

And is there anything on the cost synergy side that will be accelerating in the third quarter or the back half of the year versus the first half of the year? Because I assume you are continuing to move through your $700 million plus opportunity.

David B. Rickard

We are and again, most of that, the great majority is purchasing synergy and almost all of that was in place as we exited ’07, so there isn’t a great deal of seasonality to it other than any swing in volume that takes place.

John Ransom - Raymond James

And then my other question, would you hazard a guess -- there’s some controversy with some of the data sources, NDC and IMS, about pharmacy script trends. Do you think we’re still on a positive script environment? And I guess we’ll just talk retail. I know you’re taking share but if you ex all the factors out, do you think we’re in a positive or kind of a flat script environment as we speak?

David B. Rickard

Well, we are in a positive script environment, certainly. We’re seeing growth. I know the controversy that you are referring to on the data sources, and that makes it hard for everybody to understand kind of what all is going on, but our business is growing and I believe the overall industry is growing.

All right, we’ll take two more questions, Brandi.

Operator

Your next question comes from the line of Meredith Adler with Lehman Brothers.

Meredith Adler - Lehman Brothers

A couple of questions; first, can you answer, let us know what’s happening with generic volumes in the second half of the year versus the first half? Do you think the impact will be as great on sales as it was in the first half?

David B. Rickard

Yes, as a matter of fact, when we gave initial guidance for the year six months ago and then again I think in the last call, our expectation is that the third quarter was going to be the biggest quarter for generic conversions in this year, and that remains our view.

Meredith Adler - Lehman Brothers

Okay, great. And then maybe can you talk about the impact that specialty has on earnings? I think others have talked about how much it contributes. I don’t know if you guys will ever talk about that.

David B. Rickard

Well, we don’t break it out. It obviously is the highest priced set of things that we sell and it carries with it representative margins, so the absolute dollar contribution is significant.

Meredith Adler - Lehman Brothers

Great. I was wondering if you could also comment about Medicaid and the outlook for reimbursement cuts. I know that in California, a court has put a stay on the cuts that they had proposed, or actually had implemented. But what are your views about what could happen in other states and do you think that the law will prevent much in the way of cuts?

David B. Rickard

Well, I think, as in other parts of our business, there is continual rate pressure in Medicaid reimbursement and that has certainly been the case over the past 18 months. I think it was made more of a focus by the fact of the controversy over AMP and so forth and I think states have accelerated their rate pressure on us -- on us as an industry, not us as a company.

So we have seen rate erosion there, and not more than we expected but certainly significant.

Meredith Adler - Lehman Brothers

And you don’t think that gets worse because the states’ budgets are in such bad shape?

David B. Rickard

Well, you know, there are things the states can do other than hacking away at our rates that can improve their healthcare costs and we would recommend to them programs that stimulate the use of generics and so forth, tighter defined formularies, so there are a number of things that they can do other than hack away at our reimbursement. But that seems to also have been on the table.

Okay, Brandi, I’m going to take one more question.

Operator

Your final question comes from the line of Robert Willoughby with Banc of America.

Robert Willoughby - Banc of America

Assuming that you will have net membership in the PBM business that will actually be up with the revenues that you have but correct me if I’m wrong there, and I guess is there any change to you stance on the adjudication systems? Will you continue to maintain the separate systems or will there be a move to consolidate them?

David B. Rickard

Howard, do you want to answer the first part of that?

Howard A. McLure

Well, we will see increases in membership as we move through. We will see some organic growth in some of our existing accounts and we will probably expect next year to have more members than we do this year.

David B. Rickard

And in terms of adjudication systems, as we laid out in our analyst day, the strategy there is to maintain the availability of preferred front-end on each of our adjudication platforms while combining the underlying feeder systems. That has the advantage that our customers aren’t disrupted and yet we get the economics essentially of a single adjudication platform.

Robert Willoughby - Banc of America

And do you have a sense when that process will be completed?

David B. Rickard

I don’t have a specific date I can give you. I will say that it will go on over the next several quarters, you know, maybe as much as two or three years.

Robert Willoughby - Banc of America

Okay. Thank you.

David B. Rickard

Okay. Thank you all very much.

Operator

This concludes today’s CVS Caremark Corporation second quarter earnings conference call. You may now disconnect.

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Source: CVS Caremark Q2 2008 Earnings Call Transcript
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