CVS Caremark's CEO Discusses Q4 2012 Results - Earnings Call Transcript

| About: CVS Health (CVS)
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CVS Caremark (NYSE:CVS) Q4 2012 Earnings Conference Call February 6, 2013 8:30 AM ET


Nancy Christal – SVP, IR

Larry Merlo – CEO, President

David Denton – CFO, EVP

Mark Cosby – EVP, President of CVS Pharmacy

John Roberts – Evp, President of CVS Caremark


Dane Leone – Macquarie

Robert Willoughby – Bank of America

Steven Valiquette – UBS

Eric Bosshard – Cleveland Research

Matthew Fassler – Goldman Sachs

Greg Hessler – Bank of America Merrill Lynch

Lisa Gill – JPMorgan

John Ransom – Raymond James

John Heinbockel – Guggenheim

Edward Kelley – Credit Suisse

Ross Muken – ISI Group

Meredith Adler – Barclays Capital

Tom Gallucci – Lazard Capital

Ricky Goldwasser – Morgan Stanley

Deborah Weinswig - Citigroup


Ladies and gentlemen, thank you for standing by. Welcome to the CVS Caremark fourth quarter earnings call. During the presentation, participants will be in a listen-only mode. Afterwards we will conduct a question-and-answer session. (Operator Instructions)

As a reminder, this conference is being recorded Wednesday, February 06, 2013. I would now like to turn the conference over to Nancy Christal, Senior Vice President Investor Relations. Please go ahead, ma’am.

Nancy Christal

Thanks, (Suzzy). Good morning, everyone, and thanks for joining us today. I’m here with Larry Merlo, President and CEO, who will provide a business update, and Dave Denton, Executive Vice President and CFO, who will review our financials. John Roberts, President of Caremark, and Mark Cosby, President of CVS Pharmacy, are also with us today and will participate in the question-and-answer session following our prepared remarks.

During the Q&A, please limit yourself to one or two questions so we can provide more analysts and investors the chance to ask their questions. Please note that we posted slide presentation on our website this morning and it summarizes the information on this call as well as key facts and figures around our operating performance and guidance, so I recommend that you take a look at that.

Additionally, note that we plan to file our annual report on Form 10-K later this month and it will be available through our website at that time.

During this call, we’ll discuss some non-GAAP financial measures in talking about our company’s performance, mainly free cash flow, EBITDA and adjusted EPS.  In accordance with SEC regulations, you can find the definitions of the non-GAAP items I mentioned, as well as the reconciliations to comparable GAAP measures, on the Investor Relations portion of our website. And, as always, today's call is being simulcast on our website, and it will be archived there following the call for 1 year.

Now, before we begin, our attorneys have asked me to read the Safe Harbor statement. During this presentation, we'll 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 that you review the section entitled Cautionary Statement Concerning Forward-Looking Statements in our most recently filed quarterly report on Form 10-Q.

And now I'll turn this over to Larry Merlo.

Larry Merlo

Well, thanks Nancy.  Good morning everyone, and thanks for joining us today.  Obviously we’re very pleased with the strong results we posted in the fourth quarter and full year 2012, with solid performance across the enterprise.

If you exclude the one-time cost of $0.17 per share related to the early extinguishment of debt, adjusted earnings per share from continuing operations for the fourth quarter and full year were $1.14 and $3.43 respectively, demonstrating very healthy underlying growth of 28% for the quarter, 23% for the year.

Now, you’ll recall that in December we retired some long term debt, replacing it with debt at lower interest rates, and that refinancing and the associated one-time cost was not included in our guidance.  So our fourth quarter results reflect strong performances at the high end of our expectations in both the retail and PBM segments.

In addition, below the line benefits from a lower effective tax rate and fewer shares than expected drove the outperformance, with the quarter exceeding the high end of our guidance by $0.03 per share.  We also generated $1.1 billion in free cash flow in the quarter, bringing the 2012 total to $5.2 billion, which also exceeded our goal for the year.

Now, in addition to posting better-than-expected 2012 results, this morning we’re raising our guidance for 2013, taking into account the anticipated accretion from the debt refinancing.  We now expect to achieve adjusted earnings per share for ’13 in the range of $3.86 to $4.00, and that’s up $0.02 from our previous range of $3.84 to $3.98.  And Dave will provide the details of our guidance during his financial review.

So with that, let me provide a brief business update, and I’ll start with our PBM.  Since our analyst day in mid-December, there has been no material change in the 2013 selling season.  And with nearly 85% of our client renewals completed to date, our retention rate stands at 96%.

Now, on analyst day we reported net new business wins for ’13 of about $400 million, and while we have had some additional wins since the analyst day, we expect the impact of the recent CMS sanction, which I’ll speak about shortly, to basically offset those recent wins.  So, again, our net new business for ’13 stands at about $400 million.

Now, it’s obviously very early in the 2014 selling season, but efforts are well-underway, and our differentiated offerings continue to gain attention in the marketplace.  Client interest in our unique Maintenance Choice offerings continues to be robust, and we now have about 15.8 million lives covered by more than 1,100 plans that have implemented or committed to implement our Maintenance Choice offerings.  And that number is up from 14.5 lives at our last update, and looking forward, we see the potential to increase the number of lives to an even higher level.

We are enrolling new lives into both of our Maintenance Choice offerings, with some clients opting for the 1.0 offering and others opting for the new 2.0 design.  Most of the lives are coming from plans that previously had voluntary mail plan designs, so these clients can now begin to experience the cost savings Maintenance Choice offers.

Pharmacy Advisor, our flagship clinical offering, has also made strong advances.  Five new disease states have been successfully implemented as of January 1, including asthma, COPD, depression, osteoporosis, and breast cancer.  And as we said on analyst day, we expect to have about 900 clients with about 16 million members enrolled in all, or some of our available
programs, and we have seen a very positive response from clients to the newly expanded offerings.  

We also began offering Pharmacy Advisor to our Medicare clients on January 1, and we’re excited about future opportunities to support these clients as they strive to improve their star ratings.

And I think these are two great examples of how we’re capitalizing on our integrated assets, and these programs are helping to lower healthcare costs while improving the health of those we serve.

Let me talk more about the recent CMS sanction on our Medicare Part D subscription drug plan.  The sanction means that we cannot enroll new individual SilverScript members or market our Silver Script plan to potential individual members until the sanction is lifted.

However, current SilverScript members are not affected by this action, including our EGWPs along with the new individual members that enrolled at the beginning of this plan year.  Our clients’ EGWP plans and their members are also not affected by the sanction.  This sanction relates only to our SilverScript plan and does not affect Medicare Part D plans offered by our health plan clients.

Now, that said, let me acknowledge my disappointment in these circumstances.  Our goal is to execute flawlessly across the organization every day, and in consolidating the Medicare Part D enrollment systems for SilverScript, we did not deliver on that goal.  So we’re working to resolve these issues as expeditiously as possible.  The sanction should be lifted when CMS is satisfied that the issues are fixed, and not likely to recur.  Now, let me assure you that we are highly focused on working with CMS to bring these issues to resolution as soon as possible.

So with that, I’ll turn to three important PBM growth drivers: the fast-growing specialty pharmacy business, our streamlining initiative, and the Aetna relationship.  Now, the specialty pharmacy business continued on pace, with revenues increasing more than 31% versus the same quarter of last year.  And this specialty growth was driven by new PBM clients, new product launches, along with drug price inflation.

And given that specialty costs are growing rapidly, our clients are looking for help to better manage this trend.  And our specialty guideline management program continues to garner a great deal of interest with some significant new clients adopting the program late last year.

We’re also seeing a lot of interest in our specialty medical benefit management program, especially among our health plan customers.  And we have multiple pilots underway.  We expect to close and implement several other customers during the 2013 year.  So specialty pharmacy will continue to be a key area of focus for us going forward.

As for the streamlining initiative, we are on track with our efforts to reorganize PBM operations to improve productivity, rationalize capacity, and consolidate our adjudication platforms to one destination platform with enhanced capabilities.  We now have about two-thirds of our business on the destination platform, and we expect to increase that to 85% by the end of this year.

As for the other transformation activities, we anticipate being more than 95% complete by the end of April.  So we’re on track to deliver significant cost savings from the streamlining efforts, and we expect to hit the full  run rate of annual savings - that being $225-275 million - beginning in ’14.

And then, as for the Aetna relationship, the client systems conversion continues to proceed successfully.  We have further migrations scheduled throughout this year.  And once a client’s migration is complete, we can then begin to offer our differentiated products and services.

We have had a successful selling season as Aetna has added more than 1 million pharmacy lives to their book, and we have seen interest within the Aetna client base to implement Maintenance Choice and Pharmacy Advisor, and we believe this is further enhanced at this competitive position in the marketplace.

So we’re very optimistic as to what lies ahead, as we continue to work with the Aetna team to drive cost savings for their clients.

With that, let me turn to our retail business.  We had a very strong quarter, with same-store sales increasing 4%.  Pharmacy comps also increased 4% in the quarter, with front-store comps increasing 3.9%.  

New generics had a negative impact of about 1,100 basis points on pharmacy comps, and you may recall that’s up from about 900 basis points in the third quarter.  Script cost increased 11% on a 30-day supply basis, and 9% when counting 90-day supplies as one script.  We had a slight benefit in the quarter from flu-related scripts and flu shots increasing during December.

In addition, our retention of scripts gained during the Walgreens Express impasse was also a factor.  As expected, we retained at least 60% of the scripts gained during the impasse, and we estimate the impact added about 340 basis points to our script comp, equating to about 5.5 to 6 million scripts.  And we remain confident that we will continue to retain at least 60% of the scripts in 2013.

Now, as for the front-store business, both customer traffic and the average front-store ticket increased notably in the quarter.  I’m sure you’re not surprised to hear that we saw particular strength in cough and cold, allergy, and flu-related sales.  Private label sales represented 18.1% of front-store sales in the quarter.  That’s up about 20 basis points year over year.  And we also continued to see solid sales and share growth in the beauty category, driven by skincare and cosmetics.

In addition, we estimate that the Walgreens Express impasse positively impacted our front-store comp by about 150 basis points in the quarter.  And as for the Christmas season, seasonal sales came in close to, but just below, our expectations.

When you look at market share, the latest data shows that CVS has gained front-store share versus a year ago.  Our share growth in the drug channel was 226 basis points, and against multi-outlet competitors, 17 basis points.

Now let me touch on our ExtraCare program, because it continues to be a key differentiator for us, with the scale of our program increasing dramatically in 2012, even with competitive activity in the loyalty space.

Both front-store and pharmacy transactions with the ExtraCare card increased.  We issued more personalized offers, and we saw 19% growth in the number of offers redeemed, with many now coming from the ExtraCare coupon centers.

In addition, increased engagement of our ExtraCare members is driving meaningful results.  As an example, we have doubled our email program to more than 15 million active participants.  They have received over 60 million personalized email offers.  That’s up 69% versus the prior year.  Beauty Club participation grew by 21% to 11 million customers, affording targeted promotion and profitable sales growth.

And just last week, we launched an enhanced ExtraCare program for pharmacy and health rewards. Now, this is an opt-in program, and individual enrollment versus household participation allows for more personalized communication.  We can offer members a wider range of rewards for healthy behaviors that can result in improved adherence.  So this program will be a great tool for driving prescription adherence, script consolidation, and customer retention.

And while ExtraCare has been in the marketplace for 15 years, I think these are examples of how we’re not sitting still.  These enhanced programs are geared to our higher-value customers and it enables us to focus and tailor our rewards along with enhancing the productivity of our investments.

With that, let me turn to our real estate program.  We opened 45 new or relocated stores.  We closed two, resulting in 35 net new stores in the quarter.  And for the year, we opened 150 new or relocated stores, closed 19, resulting in 131 net new stores with 2.1% retail square footage growth.

Now, before turning to MinuteClinic, I want to touch on a recent transaction.  Late last week, we closed on the acquisition of Drogaria Onofre, a privately held retail drugstore chain in Sao Paolo, Brazil with 44 stores.  This transaction is not financially material to our company.  However, it is our first foray into the international drugstore space, and we wanted to provide a little color this morning.

As you know, we have been exploring opportunities for possible international expansion, and we’ve said many times that our approach would be measured, and that we would exercise financial discipline.  We believe this acquisition is a great example of that strategy in action.

Onofre has a strong reputation in the marketplace.  They do a great job in tailoring their stores to market to different customer segments.  And we view Brazil as an attractive market, given that healthcare and pharmacy are expected to grow double digits for the next decade.  And while chains are prevalent, it is still a highly fragmented market.  So we see nice opportunities to grow the business over time.  And as we’ve said, we will continue to take a measured approach to our international growth plan.

So with that, let me turn to MinuteClinic, which recorded very strong revenue growth in the quarter.  On a comparable basis, sales were up more than 38%.  This was the same quarter last year.  And as we headed into January, with a strong flu season, our patient visits at MinuteClinic reached unprecedented daily levels.

In addition to treating [acute visit] patients in the quarter, we continued to work on wellness programs along with programs aimed at treating chronic conditions.  For example, we’ve developed a provider education program with the American Heart Association to support our hypertension evaluation visits.  And we’re also piloting enhanced smoking cessation and weight management programs, and the strong growth we’ve experienced in MinuteClinic’s non-acute services is helping us to reduce the seasonality of the business.   

We opened 31 net new clinics in the quarter, and we ended 2012 with 640 clinics in 25 states and the District of Columbia.  And as Andy Sussman noted on Analyst Day, we’re ramping up our expansion plans, and we expect to open another 150 clinics this year, ending ’13 with just under 800 clinics.

MinuteClinic is also expanding its affiliations with many of the nation’s leading health systems.  And it’s also increasing its collaboration with our PBM clients.  And through all of these efforts, we will help to transform the delivery of primary care in the U.S. as our healthcare system continues to evolve.  So with that, let me turn it over to Dave for the financial review.

David Denton

Good morning.  Thank you, Larry.  Today I’ll provide a detailed review of our fourth quarter 2012 results, and review our 2013 guidance.  But let me begin with a wrap up of last year’s capital allocation program, and how we’re using our strong free cash flow to return value to our shareholders.

In the fourth quarter, we finalized the accelerated share repurchase program that we began in September, and we also repurchased approximately 7.1 million shares for approximately $329 million in the open market.  So for all of 2012, we repurchased approximately 95 million shares for $4.3 billion, averaging $45.58 per share.

Additionally, we paid approximately $202 million in dividends in the fourth quarter alone, bringing our total for the year to $829 million.  We finished the year with a payout ratio of 21.3%, and our strong earnings outlook this year combined with a 38% increase in the dividend we announced at our analyst day puts us on track to achieve our targeted payout ratio of 25% by the end of 2013, two years ahead of our schedule.

So between dividends and share repurchases, we’ve returned more than $5.1 billion to our shareholders just in 2012, and our expectation is that between dividends and share repurchase, we will return approximately $5 billion again to our shareholders in 2013.

We generated $5.2 billion of free cash in ’12, and $1.1 billion in the fourth quarter alone, up $419 million from the same period of last year.  This was driven by our earnings outperformance as well as improved receivables and payables management and the timing of certain payments.

Regarding the balance sheet, over the course of 2012 we continued to make great strides in improving our cash cycle, especially within the retail segment.  Inventory days within retail improved by more than 3.5 days in 2012, and we reduced our retail cash cycle by more than 5 days throughout the year.

The retail team was able to reduce inventories by approximately $450 million through process improvements and while just short of our $500 million goal, we remain committed to further inventory reductions as we move forward.

In the fourth quarter, gross capital expenditures of $716 million were offset by a $102 million of sale leaseback activity.  For the year, our net capital expenditures were $1.5 billion, which included $2 billion of gross capex, offset by $529 million in sale leaseback proceeds.

As for the income statement, adjusted earnings per share from continuing operations came in at $1.14 per share, approximately $0.03 above the high end of our guidance, after you adjust for the impact of the debt refinancing.

GAAP diluted EPS was $0.90 per share, and as Larry said, the EPS beat was driven primarily by better than expected below the line performance.  But both the PBM and retail segments performed at or above the high end of expectations as well.

So let me quickly walk down the P&L statement.  On a consolidated basis, revenues in the fourth quarter increased 10.9% to $31.4 billion.  Within the segments, net revenues increased 17.4% in the PBM to $18.6 billion.

The significant number of new client starts in 2012 drove substantial growth over last year, while Medicare Part D was also a key growth driver.  Acquisitions such as Universal American and Health Net, as well as organic member growth are responsible for volume increases in Medicare Part D.

And we continue to see some drug price inflation, particularly in our specialty business, which helped to grow revenues over last year.  These positive revenue drivers were partially offset by the growth in the PBM’s generic dispensing rate, which increased 500 basis points versus the same quarter of last year to 80%.  In our retail business, revenues increased 5.1% in the quarter to $16.3 billion, driven primarily by strong same-store sales growth.

Turning to gross margin, we reported 20.1% for the consolidated company in the quarter, an increase of approximately 45 basis points compared to Q4 of ’11.  Within the PBM segment, gross margin increased by 75 basis points versus Q4 of ’11 to 7.2% while gross profit dollars increased 16% year over year.

The increase year over year was primarily driven by the big increase in GDR, higher volumes, and better acquisition cost economics.  These positive margin drivers were partially offset by client price compression.

Gross margin in the retail segment was 31.3%, up 155 basis points over last year.  This improvement was again driven primarily by the 400 basis points increase in retail GDR to 79.9%.  Additionally, we saw our private label sales as a percentage of front-store volume increase by 20 basis points to 18.1%.

Total operating expenses as a percent of revenues were essentially flat to Q4 of ’11 at 12.7%.  The PBM segment’s SG&A rate improved approximately 25 basis points to 1.6%.  This was primarily driven by strong revenue growth as well as improvements derived from the streamlining effort.

In the retail segment, SG&A as a percentage of sales increased by approximately 125 basis points to 21.6% while expenses grew by 11.6%.  As expected, this was mainly due to the deleveraging effect of the growth in generics as well as the fact that we are comparing against disproportionately lower spending in Q4 of last year.

Within the corporate segment, expenses were up approximately $30 million to $182 million.  And given all that, operating margin for the total enterprise improved 40 basis points to 7.3%.  Operating margin in the PBM improved approximately 100 basis points to 5.6% while operating margin at retail improved by about 35 basis points to 9.7%.

For the quarter, we beat our growth estimates for operating profit in both the retail and PBM segments.  Retail operating profit increased a solid 8.9%, exceeding expectations by approximately 90 basis points.

PBM operating profit grew a very healthy 42.9%, some 185 basis points above our guidance range.  Both segments benefited from the positive impact of generics and the increase in GDRs.  Additionally, the PBM also benefited from the increasing profitability as we move through the year in the Medicare Part D as well as the increasing benefits derived from the streamlining effort.

Now, going below the line on the consolidated income statement, net interest expense in the quarter increased approximately $12 million from last year to $159.  Additionally, our effective tax rate was 37.1%, lower than expected related to a nonrecurring item.  Our weighted average share count was 1.25 billion shares, approximately 12 million shares lower than anticipated due to our opportunistic repurchase of additional shares on the open market once the ASR completed.  

Question-and-Answer Session


(Operator Instructions) Your first question comes from the line of Dane Leone – Macquarie.

Dane Leone – Macquarie

When we think about the coming year, I know it’s early to really start speaking about the 2014 PBM selling season, I’m just curious with where you’re gotten into the PBM streamlining initiative along with the additional conversions to the destination platform.

Fundamentally, how do you compare going into this year and the capacity for the organization to take on new business versus where you were last year heading into April?

Larry Merlo

We see no barriers and no limitations around that. Keep in mind that I had mentioned that about two-thirds of our business is already on the destination platform and any new business automatically goes onto that platform, so there’s no conversion activity associated with that.

John Roberts

The other thing I would add is we have a separate team that is working on the conversion process totally separate than the teams that implement new business and we’ve implemented $24 billion of net new business over the last three years, so we think we’re very well positioned to continue to add new business and grow as we move forward.

Dane Leone - Macquarie

Then one additional question on the Silver Script resolution with CMS. Could you add any additional color on specific steps that need to be taken or specific timeline when that could be resolved?

John Roberts

Yes, well, as Larry talked about, we had to consolidate our enrollment systems from two acquisitions, which was Universal American PDP Healthnet and Silver Script, on the one system, which unfortunately led to issues with Silver Script’s enrollment and claims processing in the January timeframe and an unanticipated increase in call volumes.

So this sanction is focused on Silver Script’s enrollment process. Our remediation plan was submitted to CMS on January 23rd and work is underway to implement the appropriate corrective action.

We have successfully operated these enrollment systems since the inception of Medicare Part D and continue to expect to do so now that the system consolidation is complete and we’re very focused on working with CMS to correct the issues and to have the sanction lifted as soon as possible and we are confident in our ability to address these issues quickly.


Your next question comes from the line of Robert Willoughby – Bank of America.

Robert Willoughby – Bank of America

Any change in philosophy on retail store openings in the US? What are your targets there? And just comment briefly what, if any, synergies you expect to derive from Brazil from a cost standpoint.

Larry Merlo

Yes, Rob, in terms of – your first question, in terms of our retail gross strategy, we have no change in our strategy there. We’ve talked the last several years about 2% to 3% square footage growth and our pipeline falls within those boundaries and we continue to see opportunities for retail growth here in the US.

As far as synergies go, it will be very minimal. As I mentioned in my remarks, this transaction is not financially materially. We’re talking about 44 stores and I think it’ll be a great learning opportunity for the organization.


Your next question comes from the line of Steven Valiquette – UBS.

Steven Valiquette – UBS

So you mentioned that you obviously retained at least 60% of the RX from Wallgreens in the fourth quarter. Obviously that’s the guidance for 2013 as well, I guess whatever the actual rate is.

I think you mentioned previously you expected it to stick about the same in early ’13 as it was exiting ’12 and that the rollover of the calendar year wouldn’t really change anything or trigger anything to change the run rate.

So I’m just curious now without giving any specific numbers is that indeed the case now that you have probably some read on January?

Larry Merlo

Yes, Steve. I think as we’ve talked about this over the last several months, we had talked about the fact that we didn’t see this as being a 12 to 18 month event, that we believe that we would reach a steady state run rate.

Towards the end of the year I think we had acknowledged that it could trickle into the first quarter of this year and, quite frankly, our retention is actually performing as we had outlined. So we don’t see any change to the comments that we made in the past.


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

Eric Bosshard – Cleveland Research

On the retail side of the business, the SG&A growth increased or accelerated a little bit in 4Q versus the prior couple quarters. I’m interested if you can give a little bit of color on that and then strategically what you’re doing with the drug store with the retail business to sustain good performance and further improve market share in ’13, if you’re doing anything different for marketing or for merchandising from a promotional perspective.

Dave Denton

Really, the growth in SG&A in retail for Q4 was driven by our comparisons in Q4 of LY, so if you look at Q4 of ’11, the growth of SG&A was very modest. We’re bumping up against some tough comparisons, so we knew that was going to be case as we cycled into Q4 of ’12.

And so it performed as we expected, so nothing really new there. And with that, maybe I’ll turn it to Mark to talk a bit about the retail business.

Mark Cosby

Well, the biggest headline that we talked about in the analyst day was around personalization and that was really the headline for the quarter and it’s really the headline as we go into ’13.

So our whole goal is to move away from the mass approach and to customize our approach to each individual customer. We’re doing that through how we are clustering our stores, which means personalizing the assortment within each store.

That was played out to our urban initiative over the last couple years. We have a number of initiatives coming up in 2013 to take that to a new level, which we talked about a little bit at the analyst day.

The other big play coming out of personalization is obviously through our extra care program. As Larry outlined in his comments, that has been a strength for us for many years, 15 years, and we have a very engaged customer set as evidenced by the 68% of our transactions and 85% of our sales going through the program.

We ramped that up in a big way in the fourth quarter and we’re taking that into 2013. Larry through out a couple of numbers earlier and I think they’re indicative of that improved engagement, first the fact that we increased the number of offers redeemed by 19% over the course of the quarter.

That also led – was driven by a big increase in the number of offers that came through from our email program. We’ve more than doubled that program to $15 million and increased the number of offers that went through our email program at 69% to over 600 million offerings.

We also had some advancements on the (BD) club front, which were all about a year ago that that dramatically improved with some new features that we rolled out. We increased that by 21% to $11 million.

And as Larry mentioned in his comments, significant amount of work going through our differentiated extra care center where we’re able to deliver customized, personalized messages to our customers and that will play out as we go into ’13 with an initiative that we call conversion which allows our customers to shop broadly across the store.

Just most recently, you probably read a little bit. We just introduced this pharmacy in healthy rewards program, which we had in place. Just a little fact, we’ve had a reward in place for our pharmacy customers for the last several years as part of our extra care program where we had $1 for every two prescriptions.

But this most recent program is really different in the fact that it customizes the message to individuals as opposed to households. We came up with this program over a year ago. It was tested in five markets and just launched this past week.

The big difference, as I mentioned, it’s tied to individuals, not to households. We can then trigger the messages directly to customers and customize the message as such. We have also slightly modified the program. Ten prescriptions equals five extra (bucks) and we have many different ways for our customers to earn those extra bucks just beyond (awards) themselves.

The big advantages for our customers is more value communicated directly to them. We also believe it will help their adherence. It’s also a great way for us to communicate and retain our most important pharmacy heavy user customers.

So extra care, the answer to your question, would be personalization through our conversion program, through our clustering programs as well as through our taking extra care to a new level.

Eric Bosshard – Cleveland Research

Then if I could just follow up, the retail comp in 4Q was quite solid. What you’ve talked about for ’13 would be a moderation from that. Could you just square those two facts?

Larry Merlo

Well, keep in mind as you cycle into ’13 you’ve got a couple things happening. First and foremost, you have continued generic (NYSE:GER) expansion, number one. And number two is you’re comping against some share gains, high share gains as we move into 2013 versus what we gained in 2012. And then finally you have one less day in ’13 than you have in ’12 due to leap year.


Your next question comes from the line of Matthew Fassler – Goldman Sachs.

Matthew Fassler – Goldman Sachs

First of all, just following up on the changes to extra care as related to the inclusion or the change in the inclusion of prescriptions. Can you talk about what the break even is or some sense thereof for the share gains you need to generate because presumably some of the extra care bucks that are going to be rewarded are for customers that you’re already doing business with?

So what kind of share gain would you expect you need to generate for this to start to deliver the kind of financial outcome you’re looking for?

Larry Merlo

Yes, Matt, I think if you go back to some of the comments that I had made in my prepared remarks and combine that with what Mark just talked about, through this effort of personalization we’re able to get more granular in terms of where do we make the investments on a customer-by-customer basis.

And so, quite frankly, the break even point is very, very low. And it’s – you can think of it as reallocating the investment to where it’s going to matter the most. So it makes the investment very productive from a profitability point of view.

Matthew Fassler – Goldman Sachs

And then secondly, a modeling question, as we think about the impact of intersegment eliminations on EBIT, that was a number that increased quite sharply over the course of 2012.

How should we think about – you gave us pretty firm guidance on the revenue impact for 2013. How should we think directionally about the impact on (technical difficulty) income for 2013?

Dave Denton

Clearly the (InterSoft) company eliminations are being driven by the successful maintenance choice program, so the more adoption of that program drives additional eliminations for the company.

Secondly is the growth in the elimination is also driven strongly by the generic penetration in 2012. As you know, Lipitor is a very large maintenance drug and that drug was used extensively within the mail order centers, so therefore, it’s a drug that’s used heavily within the maintenance choice product.

And so that disproportionately drove the eliminations in ’12. I would not expect to see the same type of growth as you cycle into ’13. But I think you take our, what we said from a guidance perspective and walk your way back, you can come up with an estimate of what the intercompany segment elimination might be.

Matthew Fassler – Goldman Sachs

But you would expect EBIT – because this year you’ve had the EBIT impact more than double. The revenue (half) was 19%. You’d expect those two numbers to be closer in sync directionally? And of course, we’ll go back and do the math this period.

Dave Denton

Yes, that’s right.


Your next question comes from the line of Greg Hessler – Bank of America Merrill Lynch.

Greg Hessler – Bank of America Merrill Lynch

As I look at the balance sheet, leverage at year-end was just below 2.5 times, which is below your 2.7 times target. And then based on 2013 guidance, this number should continue to come down next year as well.

So my question is has anything changed from a financial policy or capital allocation standpoint?

Larry Merlo

No, it has not. I think we’ve been very clear from a capital allocation standpoint of how we’re going to use our free cash flow. One, to drive value for our shareholders in really three ways: one, investing in our business with the appropriate return on invested capital targets and hurdles; two, increasing our dividends; and three, doing share repurchases that are value-enhancing.

And we’ve said we’re going to do that in the context of maintaining an adjusted debt to EBITDA capital structure of 2.7 times. And while that’s our target, we know at times we fluctuate higher or lower to that. We’ll stay within that range.

And it would be our expectation that we would continue to focus to have our balance sheet and our capital structure within those tolerance levels as we go forward.

Greg Hessler – Bank of America Merrill Lynch

Just in terms of the rating, are you guys – are you still committed to the high BBB credit rating as well in conjunction with those goals?

Larry Merlo

Very much so. We think it’s important for us to maintain our high BBB rating both as we think about financing the company long term but also from a short-term basis. We access the commercial paper market typically on a daily basis and that’s a very efficient means for us to finance the company’s working capital and I think having a BBB rating is important for that.

And also we think about sell leaseback activities. I think BBB is also important for that function as well. So we’re very much committed to that and certainly it’s our target.


Your next question comes from the line of Lisa Gill – JPMorgan.

Lisa Gill – JPMorgan

Larry, I know you said it’s early talk about the 2014 selling season but can either you or John maybe just, one, size what you have up for renewal and, two, maybe just characterize that the 2014 selling season, would you call it a normal season?

And the discussions that you’re having, obviously reform is coming in 2014. We have exchanges coming in 2014. What are your current clients thinking around both reform and exchanges as you start to think about 2014?

Larry Merlo

As it relates to the ’14 selling season, the amount of business that we have up for renewal is similar to prior years within about $11 billion to $12 billion up for renewal. And as we’ve all acknowledged, it is early. I’ll let John touch on what his sense of the market is and what he’s hearing from clients around the exchanges and how they’re thinking about their employee base.

John Roberts

Yes, so Lisa, when I – and I have to separate my response in two segments. When I talk to employers and how they’re thinking about the exchanges, I think most of them are in a wait and see attitude, particularly the large employers, which we deal with. So I don’t – I think they’re going to wait and see how these public exchanges shake out. The private exchanges are seeing some activity primarily in the retiree space.

When we talk to our health plan clients, they’re obviously gearing up to participate in the exchanges, so they’re interested in our assistance around formulary. They like our CVS retail stores and the ability to the market there, their brand to consumers and that all of our differentiated offerings that we have – maintenance choice, pharmacy advisory, the ability to do preferred or even restricted networks.

So a lot more discussion around health plans as they gear up to compete in the space and that’s where you’re going to see most of the growth is with …

Lisa Gill - JPMorgan

Do you think competitively, John, does that help you to win health plan business and do you see any large pieces of health plan business that are up for renewal for others in 2014 that you say that this is something I’m going to target because we think we have something differentiated that we can go to them as they’re building out their exchanges?

John Roberts

We’re seeing a lot of interest from health plans where we’re the (NYSEMKT:PBM) but we’re also seeing interest from health plans where we’re not the (PBM) because of all of our assets. A little early to talk about what we’re seeing from specific health plans coming to the marketplace and looking for bids.

There may be some activity where health plans have a particular (PBM) but maybe looking for different partners as they evolve their exchange strategy. So you could see some activity there.

Lisa Gill - JPMorgan

And then I just had an accounting question, Dave. If I look at the potential impact for Medicare MLR regulation to the PVP in 2014, how will that impact your PVP business?

Dave Denton

Quite frankly, it’s probably a little early to be able to answer that. Some of the regulations aren’t quite solid yet. I would say that at the end of the day we’re watching closely and we’ll update as we see that regulation evolve at this point.


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

John Ransom – Raymond James

Dave, as you think about your 2013 PBM margin comparisons to 2012, what’s the impact on say the ramp of the (AETNA) contract versus say the streamlining efforts? How should we think about that?

Dave Denton

That’s a tough question. I think in general, listen, we know that both from an (AETNA) perspective and from streamlining perspective we’re very focused on enhancing our performance in both those areas as we think over time.

Certainly from a streamlining effort, we continue to make nice progress on improving the SG&A structure of the organization and aligning from a service perspective the metrics that organizations deliver day in and day out on the service commitment that we have.

Also, I guess, from an (AETNA) perspective, (AETNA) cycles into ’13. They are a net share gainer and adding additional (lives), which will drive additional economics for us.

So at the end of the day, as they are successful in a marketplace working with us, that is really the opportunity that we have to broaden our partnership and drive value for them and for us and for the customers that they serve.

John Ransom – Raymond James

Maybe another way of asking about it, I remember you provided some initial accretion targets when you signed that big contract. Are those still in the ballpark? Are they better? Are they worse?

Dave Denton

Those are stale. We said quite some time ago that those were stale in that there was a lot of moving parts back then. So those are not good numbers at this point. We are very focused and very pleased with our relationship with (AETNA) and how it’s progressing but you can’t look at that.

John Ransom – Raymond James

Then the other question, just looking at your front end on the retail side, pretty big delta between your large public customers. What’s the impact, do you think, of getting 24 million scripts from (NYSE:ESI)? Do you think there’s been some bleed over from those customers and will some of that weigh in this year? Or do you think it’s disconnected to that?

Larry Merlo

Well, John, we acknowledged that earlier that in the fourth quarter we believe it positively impacted the front end cost by about 150 basis points and that was consistent with what we had seen in prior quarters as well.


Your next question comes from the line of John Heinbockel – Guggenheim.

John Heinbockel – Guggenheim

So guys, a couple things on maintenance choice, of the 15.8 million lives, how does that break down between one and two? And I know two is new, so is two less than 10% of that?

Larry Merlo

Yes, John, we’re not going to break that out going forward. We’ll continue to report on how we continue to grow the maintenance choice population but we’re not going to delineate between 1.0 and 2.0.

John Heinbockel - Guggenheim

Well, do you think 2.0, at least near term, does that generate the bulk of the growth in maintenance choice or no?

Larry Merlo

Well, John, I think as we have outlined, I think at the analyst meeting a year ago, we saw 2.0 as being a key factor in our ability at the time to triple the number of lives that would be appropriate for a maintenance choice type program.

And I think over the past year we have seen our lives grow by about 5 million from ’11 to ’12 and now we’re sitting here saying that we still believe we can double the number of lives that we have. And it’s going to be a combination of the various designs that we have out there.

John Heinbockel - Guggenheim

If somebody signs up for 2.0, how quickly do you think they migrate to 1.0? They don’t have to wait for the next contract.

John Roberts

Yes, they can migrate to 1.0 really at any time and we’ve seen some of that activity and we think that as people get experience with maintenance choice 2.0 they actually have an opportunity to deliver or to generate more savings by moving up to 1.0 as they move more of their maintenance volume into the maintenance choice channel.

So we think 2.0 is a good entrée point for where we are, particularly with health plans where we’ve had pretty low penetration of maintenance choice. They traditionally have liked open access. We think this really will play well with the health plans.

John Heinbockel - Guggenheim

And then lastly, John, given that there are now very distinct models out there in the PBM side and two of your bigger competitors are still sort of involved in integrations, are you more optimistic about ’14 selling season than you might have been a year ago or, no, that’s reading too much into it?

John Roberts

Yes, listen, it’s – we’re focused on obviously ensuring when we’re going to the marketplace we’re talking about our differentiated offerings. We think they’re resonating in the market.

You look at our success over the last three years, 24 billion in net new business. But it still remains a very competitive market and we’re seeing pricing is – continues to be very competitive, no real change over the least few years but still rational. So we’ll see how it goes.


Your next question comes from the line of Edward Kelley – Credit Suisse.

Edward Kelley – Credit Suisse

Larry, I just wanted to confirm one thing and then ask you my real question. But on the express scripts lost customers, has the pace of the customer loss diminished over the last couple of months or has it been steady? I’m just trying to clarify (technical difficulty).

Larry Merlo

Yes, I think as I had acknowledged earlier, it has – the migration that we have seen has been pretty much in line with what we’ve expected. And you see more attrition in markets where we don’t have the concentration of stores, where – which we were talking about that six months ago that would likely be the case when an agreement was reached.

So we’re seeing those dynamics and, as I mentioned, it’s pretty much on target with how we’ve thought about it and modeled it.

Edward Kelley – Credit Suisse

And then my question for you is really related to Brazil. I know it’s small and I certainly appreciate the measured approach to international but it’s a big opportunity, I guess. So can you walk us through why you chose this country over others for your first initiative overseas, how this market is different than the US? And if you’re successful here, how do you grow? Is this an organic opportunity? Is it further M&A?

Larry Merlo

Yes, as I had acknowledged earlier that it’s a maturing marketplace, it has – it’s expected to have continued strong growth for the foreseeable future. As people move up the economic ladder, they’re spending more on healthcare as well as education and with increased access to healthcare and pharmacy both are expected to grow over the next several years.

I think one of the other keys for us is the market is recessive to chain pharmacy. Chains are pretty prevalent in the Brazil market but at the same time it’s still fragmented. I think the largest player has about a 9% share.

So we see the opportunity for growth and (inaudible) has an organic growth plan that we will certainly be looking to execute on and there may be other opportunities acquisition-wise as we move down the road.


Your next question comes from the line of Ross Muken – ISI Group.

Ross Muken – ISI Group

As you look at where you’ve been with Wallgreen’s retention over the last two months or so, as you look at the places where you’ve done better versus worst, is it geographically disbursed? Is there a percentage where if someone signs up for an extra card they’re much more likely to stay in the store? I’m just trying to get a sense for where you feel like you’ve outperformed and areas where you’ve ceded maybe more share and what the key drivers of that have been.

Larry Merlo

Yes, Ross, I don’t – I’m probably a little redundant now with these comments. But I think you hit on some of the key points that as we talked about a year ago, the acquisition strategy was developed with a retention component.

So we work very hard to et those maintenance users enrolled in extra care and I think if you reflect on some of Mark’s comments earlier, the ability to communicate with them in a very personalized way is a key element around retention.

And then as I just mentioned a minute ago, we certainly recognize the convenience and locale also becomes part of that retention strategy. So I don’t know that there is anything out of the ordinary that I could add to your question.

Ross Muken – ISI Group

And maybe just quickly a modeling question on the pharma services business. As you look at the first quarter guidance implies a bit more deflation versus the rest of the year. What’s driving the step up of where we’re given the script guidance of where we’re going from a more significant decline to an increase by the end of the year?

Is there a portion of the year where you’re assuming, given mix, something is changing from deflation to inflation? I’m just trying to get a little more clarity.

John Roberts

You’re cycling through the first couple of months of the introduction of large generics in last year primarily, especially (inaudible). And so that’s what’s driving that inflation/deflation cadence, if you will.

Larry Merlo

So Ross, keep in mind that to Dave’s point on Lipitor, we cycle that in June 1st, so the first almost two quarters.


Your next question comes from the line of Meredith Adler – Barclays Capital.

Meredith Adler – Barclays Capital

I want to go back to just questions about maintenance choice 2.0. It’s probably very early but I’m just wondering what kind of feedback – because it is something really unique for these patients. Is there any feedback coming so far about how they’re responding to it or is it really just too early?

John Roberts

Yes, Meredith, so maintenance choice from a member perspective, maintenance choice 2.0, will perform the same way as our original maintenance choice product, maintenance choice 1.0.

So the member has a choice to either go to CVS retail or to go to mail to get a reduced co-pay. They get a 90-day maintenance script. The client gets mail pricing.

And so we see about half the members like to go to CVS retail for their maintenance choice prescriptions and the other half like to go to mail.

And if you look at the penetration for these voluntary mail customers that move in the maintenance choice, we see it’s on average around 15%. And so as we get this new benefit, we think that that penetration will grow beyond 15%, so that will generate more savings for the client and offer a benefit to the members at no charge, actually a savings for the client.

The other thing we’re working on is continuing to improve the member experience with 2.0, so the move between mail and CVS retail can be more seamless. It’s more of a binary choice now. We see people go to either retail or mail and stay and we’re going to evolve our ability to allow them to move much more seamlessly. People are moving around the country much more now than they used to.

So very positive response, members love it and clients love it and it’s a win-win-win for everybody.

Meredith Adler – Barclays Capital

And then I have a question about specialty. Obviously specialty costs are just going up and up and up and I think there has been more effort by health plans and payers generally to push more costs onto patients.

Are you – what are you hearing from your customers about that and do you think that will have any kind of impact on the growth of specialty?

John Roberts

Well, if you look at specialty trends, both on the pharmacy side and the medical side, it’s growing at 20%. If you look at the pipeline, it’s dominated by specialty. And if you look at eight of the top 10 drugs by 2016, it’s going to be specialty.

So as we move out of this big generic wave, which is deliver tremendous savings, and you combine that with a specialty trend in the double digits that I described, specialty is becoming the highest priority for our patients.

PBMs have traditionally managed specialty on the pharmacy side. We’ve expanded our capabilities to manage it on the medical side where really half of the specialty spend is. And we’re really going to focus on really three areas to manage costs for the members, utilization, unit cost and drug mix.

So our clients want us to manage trend. They want appropriate utilization but I think you’re going to continue to see significant growth in specialties as we move forward and we’re expanding the piece of the pie that we’re managing for our clients as we move into managing the medical side.

Larry Merlo

Meredith, we talked a little bit about some of the initiatives that we have underway there and some of them are in pilot as we speak. I think that we’re all very excited about the ability for these pilot programs to bring some meaningful solutions to what clients are worried about. And we’re certainly talk about that as we move forward throughout the year.


Your next question comes from the line of Tom Gallucci – Lazard Capital.

Tom Gallucci – Lazard Capital

My first one is a lot of attention lately on the PDP area within Medicare, drug benefit and some of the plans that have preferred retail design. I know you’re in some of those I guess mostly yourself and (AETNA), your plan and (AETNA)s and some of the others are in more of the plans out there.

Can you talk about your thoughts around preferred retail networks I guess both within Medicare and within the private sector and some of your strategy there over and above maintenance choice obviously?

Larry Merlo

Yes, Tom, I think it’s probably important just to level set a little bit in terms of start with the difference between preferred and narrow/restricted networks and I think it’s – because everybody knows the narrow – in a narrow/restricted network, there are pharmacies that are excluded. In the preferred network, all pharmacies can participate.

But the customer is incentivized to use one pharmacy over another in the form of a reduced co-pay. And then when you start peeling back the onion, all preferred networks are not equal from a co-pay differential.

If you look in the (Med D) space, it could vary anywhere from $1 to $10. And within the (Med D) population, there are no restricted networks. There are only preferred networks.

So as you mentioned, there are plans where we’re identified as a preferred pharmacy and then there are plans where we’re not. It’s clear that there is going to be some movement between pharmacies. I think it’s pretty early to measure the specific impact but we’re not seeing anything at this point that we didn’t expect too see.

And I think from a retail point of view, we are well positioned to be a participant more often than not and we’ll go from there.

Tom Gallucci – Lazard Capital

The other question I had I think is a minor one but I guess news today, the postal service sounds like it’s finally going to stop delivering on Saturdays. Can you just talk about any impact or how you think about that from a mail order standpoint?

John Roberts

Yes, Tom, I saw that as well. So we see a small percentage of our mailings deliver on Saturday, so obviously for those deliveries they’re not going to have them. They’re going to be pushed to Monday.

I will say that anything that does require Saturday delivery for a member, we have other ways of making that delivery happen. We do that today and will continue to do that. So net-net I think it’s a small impact overall, maybe an extra day for members but generally mail members aren’t waiting until the last day to get their mail prescriptions and I think the cost impact is negligible.


Your next question comes from the line of Ricky Goldwasser – Morgan Stanley.

Ricky Goldwasser – Morgan Stanley

I had a follow-up on the specialty question. I know you mentioned that you are moving into managing the medical side. Can you share with us what’s driving this? Is it your clients that are asking you to expand what you’re doing with them or is it coming from the health plans that are reaching out to you and asking for your help given (inaudible) like your expertise?

John Roberts

So we’re actually hearing from both health plans and employer clients and what they see is particularly on the medical side specialty spend just isn’t being managed. So there’s an opportunity to leverage our capabilities to help manage what I talked about earlier, which is utilization, unit cost and drug mix.

So significant interest and we’re moving rapidly to expand and help our clients in these areas.

Ricky Goldwasser – Morgan Stanley

Then one additional question, your distribution contract is up for renewal this year. Any thoughts on when you expect to make a decision on that?

Larry Merlo

Ricky, I think as we mentioned in the past, as a matter of policy we won’t comment on individual contracts and I think it’s widely known we have relationships with both Cardinal and (Maketsson) and just say that both of those organizations do a terrific job in servicing the CVS Caremark business.


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

Deborah Weinswig – Citigroup

So you talked a lot today about extra care and a lot of work you’ve done on the card and can you refresh your capital allocation priorities coming off of such a strong quarter and how should we think about your investments in tech whether in retail or the PBM side, especially in light of the increase within personalization?

Dave Denton

I guess from a capital allocation perspective I can assure you that we have adequate capital to invest in the digital and extra care space as needed to drive value for our company, for our shareholders.

And we’ve laid out I think a fairly clear roadmap over the next several years of how we’re going to enhance all of those performances associated with those products and services and ways in which we engage members and customers more fully.

And we will continue to push in this area. I think it’s an area that we see opportunities over time to drive a lot of value.

Larry Merlo

And Deb, I’d just add that that technology roadmap is very much aligned to the strategic growth framework that we laid out on analyst day and in terms of the support that those initiatives would require.

Deborah Weinswig - Citigroup

And then how are you capitalizing on the customers who came into visit Minute Clinic and then also the impression in number of daily levels of flu shots that are ministered in terms of new patients and how might you get them to the more regular customers?

Larry Merlo

Yes, I think Deb, it’s consistent with things that we’ve talked about in the past. I don’t know if we’ve looked at this lately but we knew that a large percent of Minute Clinic patient visits had not had a prescription filled out of CVS. That could be based on need or demand but certainly there is nothing more convenient than being seen by a nurse practitioner and then getting the script filled while you’re there.

And then we have the opportunities to engage that patient at the point of care in terms of getting them enrolled in the programs. And I think our refill teams do a pretty good job in terms of identifying those new patients and letting them know the advantages that CVS has to offer.

Listen, everyone, thanks for your time this morning and thanks for your continued interest in our company.


Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your lines. Have a great day.

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