CVS Health Corporation (CVS) Q1 2011 Earnings Report, Transcript and Summary

Good morning. My name is Celeste, and I will be your conference operator today. At this time, I would like to welcome everyone to the CVS Caremark First Quarter 2011 Earnings Conference Call. [Operator Instructions] I would now like to turn today's call over to Ms. Nancy Christal. Please go ahead, ma'am.

Thank you, Celeste. Good morning, everyone, and thanks for joining us today. I'm here with Larry Merlo, President and CEO; Dave Denton, Executive Vice President and CFO; and Per Lofberg, President of our PBM business. [Operator Instructions] I want to make sure you're all aware that we posted slides on our website this morning that summarize the information on this call. The slides also include some key facts and figures that you may find helpful, which we won't have time to review on the call. I also want to announce the date for our 2011 Analyst Day. It will be held on the morning of Friday, October 7 in New York City. More details will be forthcoming, but please hold the date. This morning, we'll discuss some non-GAAP financial measures in talking about our company's performance, namely 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. As always, today's call is being simulcast on our website, and it will be archived there following the call. Please note that we expect to file our Form 10-Q by the end of today, and it will be available through our website at that time. Now before we continue, our attorneys have asked me to read the Safe Harbor statement. During this call, 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.

Thanks, Nancy, and good morning, everyone. I'm very pleased to report that 2011 is off to a good start with results slightly above guidance for both our Retail and PBM businesses. We reported adjusted earnings per share from continuing operations of $0.57 for the first quarter, just above the high end of our guidance range. And we generated $1.6 billion in free cash flow, more than double what we generated in last year's first quarter. As you know, last week, we announced that we completed the acquisition of the Universal American's Part D business a bit earlier than expected. The addition of the Universal book to our own Med D business makes us a very strong #2 player in this fast growing space, and we continue to expect the acquisition to be approximately $0.08 accretive to our adjusted earnings per share this year. So with our solid results for the quarter, I am pleased to reaffirm the guidance we provided on our last call for the full year '11. We continue to expect to deliver adjusted EPS from continuing operations of between $2.72 and $2.82 while generating between $4 billion and $4.2 billion of free cash, and Dave Denton will talk more on guidance during his financial review. Now before getting into the business review, let me address the speculation with regards to the future direction of our company, speculation that has been publicized in both the press and the investment community. I want to hit this topic head on to clarify any misperceptions in the marketplace and set our story and our focus straight. Now despite conjecture in the marketplace, there are no plans to split up the company. We strongly believe that we have the right assets in place to ensure our long-term success in this changing health care environment. Our world-class Retail business that makes up about 2/3 of our company's operating profit is expected to achieve continued healthy growth for years to come. We are shifting the role of our 20,000 Retail pharmacists from primarily dispensing prescriptions to also providing services, and our integrative Pharmacy Services model enables us to enhance access to care while lowering overall health care costs and improving health outcomes, which fits extremely well with the goals of health reform along with the goals of payers. Over the past few years, we have introduced breakthrough products that capitalize on the benefits of our integrated model, which continue to gain traction in the marketplace. These unique products and services cannot be easily replicated through a partnership or an alliance. Products such as Maintenance Choice, Pharmacy Advisor, the Patient Care Initiative are already improving the health of our members while reducing costs. Additionally, we have achieved more than $700 million in annual purchasing synergies and overhead savings from the Retail PBM combination, and we've made the necessary investments to facilitate future growth. At the same time, we know that growth in our PBM segment has been disappointing, and we are keenly focused on returning to healthy operating profit growth. As we've stated in the past, the decline in our PBM's operating profit performance has had nothing to do with our integrated model, and we have taken several steps to address outstanding issues. In short, there are 5 key elements of our plan. First, achieve continued momentum in new business wins and strong client retention. Second, continue to develop and upsell our unique clinical offerings. Third, drive growth in 90-day mail choice and generic dispensing rates. Fourth, focus on high-growth areas especially Medicare Part D, specialty Pharmacy and Aetna. And fifth, execute successfully on the PBM streamlining initiative, and I'll provide an update on each of these 5 important points in a few minutes. That said, I believe we have the right plan being executed by the right people, supported with the right processes and technology to deliver on the full potential of this business over the long term. In addition to the anticipated benefits from this plan, 2012 begins the generic wave, a generic wave that will carry through the next few years with over $90 billion of branded products coming off patent. So I am confident that 2012 will be the year that our PBM breaks trend and demonstrate healthy operating profit growth. We believe that improving the performance of our PBM is the most effective and fastest way to increase shareholder value. And that breaking up the company would be a step in the wrong direction for plan members, Retail customers and certainly, our payers. Now I'd also like to address the recent press reports detailing some accusations by some special interest groups of anti-competitive behavior. The reality is that we have a business model that is challenging the status quo, and some competitors are threatened by our innovative solutions. For more than 2 years, certain well-funded special interest groups with specific agendas, agendas unrelated to the protection of consumers have been making false, unfounded and misleading accusations regarding CVS Caremark to the media and to government officials. Their goal is to pressure us to change certain elements of our business practices and service offerings, and I can unequivocally say that these changes would not benefit consumers. They would instead result in reduced choice and increased prices for payers and consumers. Our offerings such as Maintenance Choice afford consumers greater choice and improved health outcomes, while reducing costs in a highly competitive Retail and PBM marketplace. And we do this without improperly steering members to CVS Retail pharmacies, a false accusation that remains unfounded. These accusations continue to be repackaged and repeated by special interest groups in the media and in letters to regulators. But none of the accusations have ever been substantiated, and we remain highly confident in the integrity of our business practices. So with that said, let me turn to our business update, and I'll start with the PBM. And I'll begin by addressing our progress on each of the 5 key elements of our PBM plan for growth that I just referenced. The first key element of our plan is to achieve continued momentum on new business wins and client retention. As you know, we had a terrific 2011 selling season, including the landmark long-term contract with Aetna. We won $8.9 billion in net new business for '11, slightly less than our previous report, primarily due to Aetna having fewer logs under management. And from a retention perspective, we've completed more than 90% of the renewals for '11, and our retention rate remains at 97%. The 2012 selling season is off to a good start, including some significant renewals. Industry pricing remains competitive but rational, and we'll have a lot more to say about renewals as well as new business, as we get further along in the selling season. But I can tell you that our sales team is highly enthusiastic. They're engaged. They're optimistic about our prospects and so am I. The second key element of our plan is to continue to develop and upsell our unique clinical offerings. Our latest breakthrough offering, Pharmacy Advisor, launched in January, and our pharmacists welcome the opportunity to consultations. And early results point to nearly 80% of the people who received a gap in care intervention subsequently filling their gap medications. We find that members are responding quite favorably to the opportunities to improve their health, and that doctors are also responding favorably because we're helping them make more informed decisions about the care of their patients. Approximately 10 million patients are active in the program today, with another 2.5 million more members committed for 2011 implementations. So the program has been extremely well received, and it's continuing to grow. In 2012, we expect to take our learnings and launch Pharmacy Advisor for 4 key cardiovascular conditions, and we'll continue to expand to other conditions over time. The third key element of the plan: aggressively drive growth in mail choice and generics. Our Maintenance Choice population now totals 630 clients, representing 7.8 million lives, and we continue to see a shift toward more new clients, as well as more former voluntary mail programs adopting Maintenance Choice. In fact, 54% of the lives adopting Maintenance Choice in 2011 came from voluntary mail plans compared to less than 16% in 2009. Savings on the total drugs spent for these clients range anywhere from 2% to 4%, and our data shows that 30% more members stay on therapy with Maintenance Choice versus a traditional mandatory mail program. In addition, our members save approximately 33% in out-of-pocket costs on an annual basis, and we're beginning to see the stickiness of clients who were early adopters of Maintenance Choice, which speaks volumes to the value that clients see in our integrated offerings. Now recognizing the upcoming generic wave, we continue to encourage the adoption of plan designs to improve generic dispensing rates. More than 200 of our clients, representing about 5.7 million lives, have adopted generic Step Therapy plans. Clients with high performance generic plan designs have seen a 360 basis point improvement in their GDR. Through this program, many clients have seen overall Pharmacy savings in the range of 4% to 6%. Now given our strong alignment, these generic Step Therapy programs translate into significant savings for clients and enhanced profitability for us. So what you're seeing here is increasing evidence that all of these programs together are yielding superior results. It's about getting the medicine right and getting the behavior right, and both are needed to improve health and reduce total costs. The fourth key element of our plan is a focus on the high-growth areas especially Med D, Specialty and Aetna. I already noted that we closed on the acquisition of Universal American's Med D business, and our integration work now begins. Another area of significant growth is the rapidly growing Specialty Pharmacy sector. In order to help our clients appropriately manage utilization in high-cost areas, we recently announced a new medical benefit drug management service that will be available to clients beginning in January of 2012. The offering provides a comprehensive solution for oncology patients and providers. Today, more than 50% of Specialty spend flows through the medical benefit and is largely unmanaged. Through this effort, we can provide our clients with an opportunity to better manage these expensive drugs while also improving the quality of care for their members. And then the third high-growth area is capitalizing on the long-term upside potential of the Aetna contract. We're currently in the implementation phase, and it is proceeding according to our plan. We recently began dispensing Aetna Specialty prescriptions, and the mail service transition will begin early in the third quarter. We are also working closely with Aetna on their sales strategy and value proposition for 2012 and beyond. We've leveraged our analytic and enterprise expertise to build an Aetna-specific personalized opportunity analysis, so they can present savings to their clients to support expansion of our unique CVS Caremark products as part of their 2012 value proposition. Our goal is to help them service their clients and build their client base by providing innovative solutions that deliver low-cost, high-quality care for their members. And then the fifth key element of our plan: successfully execute on the PBM streamlining initiative, and I'm happy to report that it's moving forward nicely. We recently announced the closing of one of our 7 call centers. And as you know, we are also upgrading our technology platforms, enabling rapid implementation of new and unique product offerings while eliminating redundancies within our IT environment, and that allows us to reduce costs over time. Now some investors have expressed concern about potential client disruption as we migrate to a more efficient environment. So let me put that concern to rest. We recently concluded the first wave of platform migrations with 0 disruption to our clients and members. Our team has a process in place to test the accuracy of the adjudication process prior to the switchover, which dramatically minimizes the opportunity for human error. This process has worked as designed during the first wave, which bodes well for seamless transition of future client conversions. And keep in mind that more than 50% of our client volume is already on the destination platform. So I'm confident that the platform migration will be a win-win for both us and for our clients. Now let me turn to the Retail business. Our same-store sales increased 2.6% in the quarter, well within our 1% to 3% guidance range, and we continued to gain share. Pharmacy comps increased 3.7%, with script comps up 3.9%, and that's reflecting 90-day prescriptions equaling one script. When you convert 90-day scripts into 3 scripts, our script unit comps increase to 6.0%. Front store comps increased 0.4% in the quarter, and as expected, front-end comps were negatively impacted by approximately 45 basis points due to the Easter shift, along with an additional 65 basis points related to the absence of sales associated with the grand reopening of the Longs stores in the prior year. Now given these tougher comparisons, front store traffic has been somewhat flat with the average front store ticket increasing to about $13 in the quarter. We saw a strength in the number of categories especially cough and cold, consumables, the Valentine season, as well as store brands. In fact, store-branded proprietary products now account for 17.5% of front-end sales, up 100 basis points from the prior year as we see consumers remaining value conscious. We launched more than 500 new items in the quarter, including our new value brand, Just the Basics, which has price points geared to consumers seeking deeper savings. Turning to the Pharmacy. Our Pharmacy comps were negatively impacted by approximately 260 basis points from new generics in the quarter and positively impacted by the stronger flu season in January and February versus the prior year. In addition, Pharmacy comps benefited from the continued growth of Maintenance Choice, which added about 170 basis points on a net basis. As you'll recall, we completed the Pharmacy technology rollout in the fall of last year. And our RxConnect system coupled with the Consumer Engagement Engine builds important information into our Pharmacy workflow, enabling our Pharmacy teams to provide higher levels of patient care. And this is certainly evident in our recent customer service scores, which are better than ever. Now let me give you a brief update on our store clustering initiatives, which helped fuel the top and bottom line. We are now into the second year for the urban rollout. We have plans to complete another 220 stores this year on top of the 200 that we completed last year. And we continue to see strong sales and margin growth in the urban remodeled stores. As for the Pharmacy dominant cluster, we are focused on re-merchandising stores that are shopped primarily for pharmacy and related products. And we've seen exciting results from our first wave of test stores that we completed late last year, demonstrating that it is possible to significantly reduce SKU comp inventory while growing sales and margin. We are being very careful and deliberate to find the right balance. We're conducting lots of customer research, so we'll test this format longer than others. We're going to be expanding the tests to an additional group of stores in the second half of this year, and we hope to scale the model beginning in 2012. And as you know, across our Retail chain we have targeted $1 billion inventory reduction for 2011. And our efforts are gaining traction, but I would also note it is not at the expense of customer service. We've already achieved a $225 million reduction in inventory in Q1, putting us well on track to achieve our $1 billion goal for the year. As for our real estate program, we opened 106 new relocated stores and one specialty store. We also closed 13 Retail pharmacies, resulting in 44 net new stores in the quarter. We are on track to open approximately 150 net stores for the year and deliver Retail square footage growth of 2% to 3%. Now before turning it over to Dave, I want to touch on MinuteClinic for a minute. Since its inception, our MinuteClinic nurse practitioners have now provided care to more than 9.4 million patients, and we continue to see healthy growth in the business. With the higher levels of flu-related illness this year, patient visits were up 24% on a comp basis in the quarter. We've made progress on reducing our dependency on seasonal-related acute illness by providing a variety of non-acute care services, including convenient health condition monitoring for patients with diabetes, high cholesterol and hypertension. We're also developing a wellness model with a focus on chronic disease management. And during the quarter, we launched our sports physicals campaign, our Facebook page and added 2 new services, vitamin B12 injections and HPV vaccinations. We opened 8 new clinics in the quarter, and we're on track to add about 100 clinics annually over the next 5 years, which will position us well to play an important role in providing care to the 32 million newly insured beginning in 2014. So with that, I'll turn it over to Dave for the financial review.

Thank you, Larry. Good morning, everyone. Today, I'll provide a detailed review of our first quarter financial results. I'll also review our 2011 guidance for the full year and provide guidance for the second quarter. Let me first begin by talking briefly about our capital allocation. Enhancing shareholder returns remains a high priority for us, and our strong cash flow outlook should enable healthy growth in dividends and value enhancing share repurchases. In the fall of last year, I laid out the significant cash generation capabilities of the company over the next 5 years, and the discipline we will utilize when deploying the substantial cash we generate to achieve the highest cost return for our shareholders. Based on achieving our 5-year growth targets, there could be approximately $30 billion available to enhance shareholder returns over that time frame. Recall that we set a targeted dividend payout ratio of approximately 25% to 30% by 2015. Early this year, we took the first step towards this goal by raising our quarterly dividend by 43%. Based on our expectations this year, this implies a payout ratio for 2011 of between 19% and 20%, so we have taken a big first step, but there's still plenty of room to continue to grow the dividend. We'll continue to use the additional cash to invest in high ROIC efforts and apps in internal projects perhaps $3 billion to $4 billion on average of annual value enhancing share repurchases could be executed under normal conditions. Of course, the amount of free cash we will generate annually is expected to accelerate with our earnings in 2012, coupled with continued improvements in working capital management. We are targeting an adjusted debt to EBITDA ratio of approximately 2.7x, and this year at a minimum, we expect to complete a $2 billion buyback authorization, the financing of the Universal American Med D acquisition and the refinancing of our upcoming 2011 debt maturities, all while maintaining our target capital structure. So let me summarize our capital allocation for the first quarter. First, we paid a dividend of more than $170 million to our shareholders. Additionally, we repurchased 14.2 million shares at a cost of approximately $467 million for a little less than $33 per share. So we are well on our way to completing the $2 billion buyback authorization this year. Between dividends and share repurchases, we returned over $638 million to our shareholders in the first quarter. Given our strong free cash flow outlook, our ability to return significant value to our shareholders should continue. As Larry said, we expect to generate between $4 billion and $4.2 billion of free cash flow this year. And in the first quarter alone, we generated $1.6 billion, a $900 million increase over the same period last year. We've made great progress on our inventory initiative, and you can see the results and improvements we've made in accounts payable, and inventory on the balance sheet and in our strong cash flow. Both DPO and inventory days within the Retail segment were approximately one day better than the end of the year last year. Gross capital spending during the quarter was $309 million, down from $401 million last year, mostly due to the timing of store construction costs, which will be more back-end loaded this year. Given sale-leaseback activity of $11 million in the first quarter, our net capital spending was $298 million. Turning to the income statement. Adjusted earnings per share was $0.57 for the quarter, $0.01 above the top end of our guidance range. GAAP diluted EPS came in at $0.52 per share. On a consolidated basis, revenues in the first quarter increased by 9% to $25.9 billion. Drilling down by segment. Net revenues grew by 18% in the PBM to $14 billion. The majority of the increase from last year was driven by the addition of the Aetna business to our book. PBM Pharmacy network revenues in the quarter increased 22% from 2010 levels to $9.4 billion, while Pharmacy network claims grew by 19%. Total mail choice revenues increased by 11% to $4.5 billion, while mail choice claims expanded by 13%. Our overall mail choice penetration rate decreased by approximately 75 basis points versus last year to 24.1%. This is also largely driven by the addition of Aetna. Aetna had a significantly lower mail penetration rate, so it had a dilutive effect on our overall mail choice penetration. In our Retail business, we saw revenues increased by 4.4% to $14.6 billion in the quarter, within our guidance range. This increase was primarily driven by our same store sales increase of 2.6% as well as net revenue from new stores and relocations, which accounted for approximately 190 basis points of the increase. Pharmacy revenues continue to benefit from the incremental prescription volume associated with our Maintenance Choice product. Maintenance Choice had a net positive impact of 170 basis points on our Pharmacy comps this quarter. A higher generic dispensing rate negatively impacted pharmacy revenue growth. Turning to gross margin. Compared to the first quarter of 2010, we saw enterprise-wide margins shrink by approximately 160 basis points to 18.4%, slightly better than our expectations. Within the PBM segment, gross margin was down about 205 basis points. This mainly reflects the price compression associated with contract renewals, including the one-year extension of the FEP contract, which became effective in September of last year. It also reflects the impact of the addition of the Aetna business. Partially offsetting this was the positive margin impact from the 340 basis point increase in the PBM's generic dispensing rate, which grew from 70.4% to 73.8%. Gross margin in the Retail segment was 28.4%, down only 10 basis points from last year. It was negatively impacted by continued pressure on Pharmacy reimbursement rates. The growth in Maintenance Choice was compressed as Retail gross margin that helps the overall enterprise, and the continued shift in our mix of business towards Pharmacy. These negative factors were mostly offset by increased generic dispensing rate with Retail GDR increasing by 310 basis points to 75.2%, the benefits we are seeing from various front-store initiatives and increased store brand penetration. Overall, operating expense improved by approximately 75 basis points as a percentage of revenues versus last year's first quarter, again, in line with expectations. The PBM segments SG&A rate improved by approximately 35 basis points to 1.7%. This is primarily due to expense leverage gain by the addition of the large Aetna contract, which was partially offset by the cost related to the streamlining initiatives of about $0.01. The Retail segment also saw improvement in SG&A leverage. Its ratio improved by approximately 25 basis points to 20.9%, more or less in line with our expectations. Within the Corporate segment, expenses were $147 million or less than 1% of consolidated revenues, in line with last year. The increase in expenses primarily related to higher payroll and benefit-related costs, increases in depreciation and legal costs. With the change in gross margin more than offsetting the improvements in SG&A as a percentage of sales, operating margin for the total enterprise declined by about 85 basis points to 5.1%, better than expected. Operating margin in the PBM was 2.8%, down about 170 basis points, while operating margin in the Retail business was 7.5%, up about 15 basis points. Our EBITDA per adjusted claim was $2.39 in the quarter. The decline was primarily driven by the addition of a large Aetna contract, as well as the impact of contract renewals including the FEP extension. Retail operating profit, which makes up about 2/3 of the company's overall profits, achieved continued healthy growth increasing approximately 7% and exceeding our guidance range. PBM profits decreased 26%, but were slightly better than our guidance range. This decline includes the streamlining expense as well as the pricing compression associated with FEP and other renewals. Going below the line on the consolidated income statement. We saw net interest expense in the quarter increase by approximately $7 million to $134 million, again, in line with our expectation while our effective income tax rate was 39.4%. Our weighted average share count was just over 1.37 billion shares. As I mentioned earlier, we did repurchase approximately 14.2 million shares during the quarter. Now let me touch upon our guidance for the full year 2011. We are reaffirming our guidance for the year. Adjusted earnings per share from continuing operations is expected to be in the range of $2.72 to $2.82, while GAAP diluted EPS is anticipated to be between $2.52 and $2.62. These estimates assume the completion of the $2 billion share repurchase authorization this year, as well as the inclusion of the Universal American Med D business. Consistent with our previous statements, we expect PBM revenue growth of 23% to 26% and operating profit to decline by 5% to 9% for the year. For the Retail segment, we expect revenue growth of 4% to 6%, same store sales growth of 2.5% to 4.5% and operating profit growth of 6% to 8%. So our world-class Retail drugstore chain, which makes up, again, about 2/3 of the company's overall operating profit and EBITDA, is expected to achieve strong growth this year and continued healthy growth for many years to come. I won't go into the rest of the details underlying the high level EPS ranges, as our full year guidance was laid out on our last earnings call. Those details are reaffirmed here with only a couple of minor exceptions. With the closing of the Universal American transaction, that had taken place 2 months earlier than planned, we'll incur additional interest expense to fund the deal. I'm not changing the interest guidance, but I'll point out that our expectation is for the interest expense to come in closer to the top of the $560 million to $570 million range. This will be offset to some degree within adjusted EPS by an expected increase in amortization for this field. Our expectation now is that consolidated amortization will be approximately $460 million for the full year. And of course, we also expect to see an increased amount of adjusted claims due to the earlier timing. Turning to the second quarter. We expect to deliver adjusted EPS from continuing operations in the range of $0.63 to $0.65. GAAP diluted EPS is anticipated to be between $0.58 and $0.60. Growth in enterprise-wide revenues is expected to be between 10% and 12%. For the PBM segment, we expect operating profit to decline by 23% to 26% and revenue growth of 23% to 26%. Like the first quarter, gross margin in the second quarter is expected to decline significantly due to the impact of the renewal pricing on FEP and other contracts and the addition of the Aetna contract and the streamlining initiatives. We expect the performance in the PBM to steadily improve, as we continue to move throughout the year for several reasons. First, we'll cycle the impact of the FEP renewal pricing by the end of August, resulting in easier comparisons in September through December. The profitability of our Med D business is generally back-end loaded, and the Universal American Med D business will also be additive. The net impact of the streamlining costs and benefit will improve as the year progresses. As a result, the first quarter was the weakest quarter of the year for the PBM, and we expect the fourth quarter to be the strongest quarter of the year. In fact, the improvement from the third to the fourth quarter is expected to be the most dramatic sequential improvement in the year for the PBM. For the Retail segment, we expect another great year and another great quarter, with our operating profit improving 9% to 11% for the quarter, revenue growth of 3.5% to 5.5% and same store sales growth of 2% to 4%. And with that, let me turn it back to Larry Merlo.

Great. Thanks, Dave. Well as I said, we're pleased with our start to the year, and we are certainly very focused on ensuring that we execute well on our operating plan and achieve our financial targets. So why don't we go ahead and open it up for your questions?

[Operator Instructions] Your first question comes from the line of Meredith Adler with Barclays Capital.

Thanks very much for taking my question. I was wondering whether it's really too early to talk at all about the selling season? Is there anything you can give us? I mean, you talked about momentum and that the customers are responding very favorably to your combined offering. Maybe you can talk a little bit more about that?

Yes, let me start, Meredith, and I'm sure Per will jump in here. We just had our client formed, I guess, about 2 weeks ago. We had about 800 of our clients there, and I was very excited in terms of the level of interest in our products and equally important, the level of satisfaction that our clients have in the services that we're providing to them. So it was great to be able to hear that firsthand in an unfiltered way from our clients. And I walked away very encouraged that they're looking for us to provide solutions for them and fill a void that no one is out there filling. So there was lot of enthusiasm and a lot of engagement for what we're doing.

And at this time of the year, as you guys probably know, is sort of the real kind of high season for a lot of the contract negotiations that are going on out there. So we have a number of important successful renewals under our belt already. And we're kind of in the final stages of negotiations with a substantial number of customers, both existing customers and potential new customers. So that should play out over the next month or 2 to kind of to get to the finish line. The dialogue is actually very positive. Our team is doing a great job, and the response we get from our customers from just both the PBM offering, as well as the broader set of capabilities that CVS Caremark brings to the table, is also very encouraging. So I think we're off to a great start, and I hope we can report more specific details to you later on in the year.

Right. And then I just have one more question about upselling. And I know that the incentive have changed a little bit for some of the account reps at the PBM. Just maybe talk about what the process is to take an existing customer and upsell them? Is that something that can be done?

Yes, absolutely. I mean, we kind of instituted a management tool in the tail end of last year, which basically kind of allows us to manage each account at the P&L level. So it gives us a good mechanism to really develop client-specific strategies in terms of the specific programs that are sort of applicable to all the customers out there. And the sales organization has an incentive program to really kind of drive those results, and that process is well underway, and we have significant set of milestones in the course of the year to deliver incremental results as a result of that.

And, Meredith, from my perspective, there are some analogies to be made in terms of what was done in the Retail business some years ago when the P&Ls were introduced for field managers. And being able to outline for any individual whether on the Retail side or the PBM side in terms of where there are opportunities to create a win-win because those opportunities identify savings for the clients, for the payers, and at the same time, they see the benefits to the business and how that flows through to the P&L. So I think we're all very encouraged in terms of the level of reception that is being received by the sales teams.

Your next question comes from the line of Larry Marsh with Barclays Capital.

Just follow-up with Meredith. I'd like to ask about Part D. I think Larry mentioned, second-largest provider and really the biggest share gain in the country this year behind Humana. Now Per, you talked about this being a fast growth market through 2020. How do you think about share gain and going forward, and how do you compare that to your own EGWP growth? I guess and how do you think about confidence in margins given your acquired dual eligible population?

Yes, there are several subsegments that you alluded to, Larry, the existing Caremark business as well as the Universal American business is very much focused on the auto signed business where you basically bid against the benchmark and you get assigned a low-income subsidy numbers as a result of that. We believe with the combination of UAM and our distinct capabilities that we're in a good position to be very competitive and continue that process for the next several years. The EGWP transition that you talked about is really sort of gathering steam over the next couple of years. We had a couple of significant EGWP transitions at the beginning of this year and a number of big ones that are sort of in negotiation right now. And we really kind of expect 2013 to be the real tidal wave of EGWP transitions from our existing customer base. So those are major sort of transitions going on in our book, but we are very much focused on that as both a transition aspect of our business as well as growth opportunity for the company.

Right.

And, Larry, I mean, keep in mind also that this is a first big step with UA, and as Per mentioned, it's a growing segment. And the fact that we just closed the transaction last week while we've had some meetings leading up to the closing and now it's all hands on deck, with a focus on 2012 recognizing that the bids are due in another 30, 40 days. So that's the focus right now is.

It sounds like you're hoping to continue to gain market share there. And I guess a follow-up on FEP there, I know in February mentioned 3 contracts along with an integrated bid option we would hear sometime in the spring. It seems like to me most likely here in early June. Is that still a reasonable expectation? And then can you confirm that you would anticipate to be the sole vendor now in CalPERS, given what's happened?

I can tell you that with FEP, the process is essentially concluded. But as you alluded to, I think we'll hear the final disposition of that before the end of the second quarter.

And then, Larry, in terms of CalPERS, we can't comment beyond confirming that we were one of the other finalists during the initial selection process.

When do you hope to hear, Larry?

They haven't given us sort of a definitive timetable in terms of how they're going to wrap up this year's process.

Okay. Very good.

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

Larry, a couple things. Can you talk about pricing both in the PBM and Retail? On the PBM side, do you think that you're trying to establish a new model, obviously, your French competitors are really trying to prevent it from getting established. Do you think -- has that created that dynamic, created more price competition in the last couple of years? And as the model is established, and even though it's clear it's not going anywhere, does that then lead to more rationality with regard to pricing? And then on the Retail side, how happy are you with where your pricing is there, specifically, HBA OTC?

John, I'll start with the PBM question first. I mean, as we said, pricing remains competitive but we believe rational. And as I also mentioned, there is a lot of excitement in terms of the unique products that we're bringing to market. And as we move forward, I believe that we'll see some stickiness with clients as a result of those unique offerings. On the Retail side, John, I think there's a lot of noise out in the marketplace in terms of some cost increases that you're hearing from CPG companies. We started the year probably comparable to what we've seen in the last couple of years in the way of cost increases. But that has ramped up over the last few weeks in terms of both the number of cost increases that we're seeing, as well as the magnitude of that. And we will be looking to pass those on at Retail, at the same time, making sure that we stay true to our pricing strategies. And as you know, we do a lot of price shops in those core categories that you mentioned. OTC, HBA, beauty, and our goal is to always to make sure that we are pricing our products so that we maintain our strategy.

Going back to the Med D. Do you think that because you're introducing a new model, that you had to be a little more aggressive than you'd like to either to retain business, or in some cases, to get new business and that becomes less of a need as the model is clearly established and very attractive to your existing base?

There's no realtime about -- the Maintenance Choice offering is basically being [ph] by consultants that's a mail order offering. And it doesn't really kind of change the trend in terms of the nature of the competition.

All right, by the order of magnitude, Specialty growth in the quarter, top and/or bottom line, is there any general sense of how fast that business grew?

Yes, John. We don't break that out other than to say that it's acknowledged that it's the fastest-growing component within Pharmacy.

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

I guess my first question was on the PBM side of the business sort of the Retail and the mail script trends versus what we are looking for. Retail was a little lighter, mail was fairly stronger, and I saw you pointed out in the press release that mail choice claim volume was driven by Aetna. So just curious where the mail and the Retail script volume came in versus your expectations, if it was lower or higher in either side, what you're seeing there?

I think, one thing that you said, I don't think there's no specific effect on Maintenance Choice driven by the Aetna contract.

Okay, so I think in the press release you said mail claim choice volume was driven by Aetna contract. There's nothing unusual about the Aetna trend though is what you're saying.

No, there's not. This is Dave. The volume within the PBM segment, both from a network perspective as well as a mail perspective, was very much in line with our expectations for the quarter.

And going forward, with respect to Aetna, we certainly expect Maintenance Choice to be one of the growth drivers of the Aetna relationship long term, but that's not something that's in the numbers right now.

Okay, good. Larry, I think you mentioned seeing some stickiness as a result of Maintenance Choice is becoming apparent. Can you expand on sort of what you're alluding to there?

Well, I think what -- and it goes back to the client conference that I alluded to that an awful lot of comments from those clients that have the Maintenance Choice benefit that they are extremely satisfied with the product, that their members or employees are very happy with the service that it provides, and they're seeing the savings as a result of it. So we remain optimistic that we're going to see some stickiness from those clients that have adopted Maintenance Choice as we move down the path when their contract comes up for renewal.

Okay, and then just last one, Larry, also in your prepared remarks, you came out pretty strongly in defense of some of the things that have been said about the company relative to anti-competitive that are alleged. Any update on when we might get some resolution on the FTC inquiry that's been going on?

No. You know what, Tom, we don't have a timetable on that, and we have cooperated in every fashion in terms of providing written information, documents, as well as face-to-face interviews. And we can't estimate the time frame or outcome of that other than the fact that we remain very confident in our business processes.

Tom, let me just cycle back a little bit your question around mail choice and the penetration rate. What we saw was contraction a bit in the mail penetration rate -- in mail choice penetration rate, and that was only due because Aetna was now part of our book, and it carries a lower mail penetration rate in total, so it blends down the average.

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

Two questions. The first relates to your Retail guidance. So this quarter, your sales were up 4.4% in total, and EBIT grew up 6.4%. So I guess I'm wondering, what do you see improving within the P&L that gets you to a higher profit growth rate in the second quarter on a similar rate of sales growth?

Yes, Matt, I think we've got a couple of things going on. First, the Easter shift from Q1 to Q2, that's a higher margin business for us as you know. And the second thing is we continue to see the traction of many of our initiatives that will support or maximizing our margin performance, and at the same time, reducing costs.

So is it feasible that gross margin turns as move through the year?

Yes, I mean, I think the comments that Dave alluded to, in terms of we saw in the first quarter margin down only 10 basis points. There's a lot of things that supported that, that we expect to continue as we go through the remaining quarters.

And my second question relates to the PBM business. Can you talk about progress in your analytical processes and framework just to improve the predictability of that business, if you would? Thank you so much.

Yes. Let me start with that, Matt, and I think probably Per and Dave will want to tag onto that. But we have done a number of things around it. I'd put them under the heading of process related that allows us to have a more holistic view of the business in realtime versus managing components of the business and then looking at it on a quarterly or even in some cases, on an annual basis for a more consolidated roll-off. So we're doing a lot of those things in realtime that allows us to stay much more closer to the trends that exist in the business.

Yes, this is Dave. Matt, late in last quarter in Q4 of last year and early this year, we implemented some new tools that Per alluded to earlier that allows us to more deeply and specifically trend and understand the components of client profitability. And additionally, the added benefit from that tool is we now have -- that tool allows us to assign accountability deeper in the organization from a sales and account management perspective. So those professionals are very aligned to managing their clients and offering opportunities to both save money for the client but also generate additional profit for us.

And just one follow-up question if I could. Your expense performance to PBM was obviously excellent as your expense dollars were actually down on the revenue increases that you saw. Was there anything unusual about the cost experience that you had, or would you actually expect that momentum to build in the PBM?

Well, we did go through one phase of the streamlining work late last year, which had to do with basically a reorganization, where we took out some layers of management. We made the organization flatter with greater sort of accountability and so on, and that was a very good sort of reorientation, both to save money but also to create just a much more efficient decision-making process in the business.

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

The PBM revenues came in at the high end of the guidance range. It sounds like that was driven more by the base business as opposed to the Aetna, so I just want to confirm that. And then on the Aetna contract, even though it's early stages, just curious if the $0.01 to $0.03 EPS accretion you originally expected still seems like the right range for 2011.

I'm not going to -- I can speak a little bit to the kind of transition we're in. I mean we're going through a sort of staged transition of the whole Aetna relationship, where in January we moved them over to our Retail contracts. And just actually at the beginning of this month, we turned on the Specialty mail dispensing for the Aetna contract. And in August, we will take on the mail order dispensing and then the risk indication [ph] will happen in 2012. So it's following kind of the plan that we have to go through this staged transition processes. As you probably know, consistent with Aetna's own disclosures, we ended up with slightly lower volume at the beginning of the year than we had anticipated and that Aetna had anticipated. In part, that's the result in the Med D business, and that's obviously, lowering the outlook a little bit, but it's not to limit here as far as the year is concerned.

Okay, so you're still on track for the accretion you expected at the bottom line? Okay. All right.

Your next question comes from the line of Mark Wiltamuth with Morgan Stanley.

Per, on the PBM, if you're looking at the Maintenance Choice offering, you're saying it's offering about 2% to 4% savings for payers, is that versus straight mail? And I'm just curious what are the clients saying who are not adopting Maintenance Choice right now?

Well, Maintenance Choice -- I'll just start with the latter part of your question, Maintenance Choice works obviously very nicely for plans where there is a significant penetration of the CVS Retail stores. So that's sort of the -- that's kind of the core target for us where we can give the members the added flexibility of using CVS Retail for the members, as a complement to the mail order pharmacies. And whether customers adopt Maintenance Choice or not in a given year is in part driven by the savings. And the savings are obviously determined by the plan design, they already have, but it's also determined by the other priorities that they're working on in terms of their overall benefit programs. So many times, they are interested in it, but they have so much going on that they can't do it this year. They will defer it to the next year, and that sort of things. So it's an ongoing process to really explore the appropriate timing and the economic benefits of the client. It isn't just one sales call that leads in a yey or ney. It's a process, and sometimes they go fast, sometimes they take a little longer. But overall, their reception and the interest level continues to be very, very high in the Maintenance Choice offering.

And, Mark, I think as we go forward, and we shared some numbers this morning in terms of not just client savings but consumer savings in terms of their out-of-pocket expense, as well as what it's doing for adherence, and there is a downstream benefit to improving the health of the members or the employees. So we have an opportunity as we move further and have more and more data that demonstrates the value that we're bringing through lowering costs and improving health. I think that we have an opportunity to make it even a more compelling product.

And 630 clients, what percentage of your book is that right now?

We are just shy of 8 million members in our books, approximately with that, and they're around 6 million to 8 million [ph].

So 40%.

So, Mark, we've said over time, if you look at the addressable population where we think Maintenance Choice is a great opportunity for clients that we could double the client base that adopts that product.

Okay. Thank you very much.

Your next question comes from the line of Kemp Dolliver with Avondale Partners.

My question relates to the new product you're going to roll out for Specialty, the Specialty medical benefit next year, and could you just talk briefly about how it solves that problem of the claims that go through the medical benefit because that 50% statistic I think has been around for a decade despite everyone's efforts to penetrate it. So that's my first question.

Yes, it's a good topic, Kemp. So there are basically -- kind of 2 important components to what we're trying to do there. One is to create a sort of a decision support tool for the oncologist to really help them understand and navigate through the different pathway alternatives that are available to treat a particular type of cancer. So that's the kind of -- that's the computer-based application that allows the physician to basically find the appropriate treatment options for a given patient. The second component has to do with the financial incentives for the physician. And part of the problem in that area, as you may know, is that this decision's basically, buy the drug, they inject them in the clinic, and then they bill the medical plan. Many times that creates sort of an incentive for the physicians to go to the more expensive drugs when there are less expensive drugs that could be just as appropriate from a clinical standpoint. So we have set up a sort of an incentive compensation system that really rewards the physicians for picking the most cost-effective solutions. And that is a true up at the end of each quarter where we look at how the physicians really kind of followed the cost-effective guidelines that are really proposed by the decision support system. And then we provide essentially an incentive compensation arrangement to reward them if they have followed the more cost-effective choices to better align the payer incentives with the physician incentives.

Great. The second question relates to your progress on inventory reduction this quarter. What actions specifically resulted in that progress?

Yes. Kemp, it really goes back to the plan that we outlined at the beginning of this year that part of it is leveraging some technology that we implemented or completed last year that would allow us to reduce our dependency on safety stock, as well as better visibility into the business that allows us to make some process changes. And so we're off to a great start, and everything is working as we planned it.

Your next question comes from the line of Scott Mushkin with Jefferies.

Thanks for taking my questions. Larry, I was really glad to hear your spirited defense of I guess both the business as combined and also against your detractors. I guess, I wanted to know, as we get into the heart of the selling season, what we've seen traditionally is some of these special interests. We see a lot of stories and news. I've been down to Florida last year, and I think they ran a whole expose on your “bad practices”. So I guess, Wal-Mart faced this type of pressure back 2 years and hired a guy named Leslie Dach and really kind of nipped it. Now what are you going to do as you get into the selling season to make sure what I think is -- it looks like it could be a good one that these people don't do what they've done the last couple of selling seasons and really up the pressure?

Well, Scott, I'll answer that question in 2 parts. First is as we've alluded to a couple of times, we had an opportunity to talk with our clients, get the clients informed about this. I think that there was some intrigue. I can tell you talking to a lot of the clients firsthand, they were absolutely focused on -- we have some of those same things that go on in our businesses. We know how that works, and we're focused on the solutions that you're bringing for me as a health planner or as an employer. So I did not sense a great concern among clients, as long as we're doing the things that are helping them manage costs and improve health outcomes. Part 2 to that is I do think we can do a better job of telling our story to the various stakeholders about the products and services that we are bringing to market. And as we've mentioned many times how they're improving the health of those we serve and lowering costs. So I'm sure you saw the announcement that we made a few weeks ago that we've made some organization changes that bring corporate communications, government affairs, health care strategy under one umbrella, that is being led by Helena Foulkes. And I believe that she will lead a renewed focus in terms of how we'd be a little more proactive in terms of telling our story, recognizing that we are now getting tremendous data about the value that we're bringing. And we don't have to talk about it in a qualitative fashion. We can go out and talk about it in a very quantitative fashion, and you're going to see us do more of that as we go forward.

That's great color, Larry, and I look forward to seeing those changes over the next 6 months. I mean, anyway, second question is to the front end on Retail. I think there was obviously an Easter calendar shift that took that down a little bit. But I wanted to explore the idea that maybe inventories in the first half of the quarter were not exactly where you wanted it to be, and maybe you corrected it at the end. Any comments on that? And do you feel like the inventory positions you have at Retail are correct?

Yes, Scott. Let me comment on that because that is an important metric that we're tracking as part of our inventory plan. And I can tell you that our metrics are on target in terms of our service levels to the customer. If we look at it compared to last year, it is a few basis points less than it was a year ago. However, if we adjust for some of the supplier issues that are out in the marketplace in the form of recalls and some product availability issues, we would actually be in a better position than we were a year ago.

And do you feel like that was consistent through the whole quarter, or do you think it improved at the end?

No, I think that was pretty consistent throughout the quarter.

Okay. Thanks for taking my questions.

Your next question comes from the line of Bob Willoughby with Bank of America Merrill Lynch.

Larry, I agree your PBM results should be much better in 2012, but the growth rate will still lag that of your competitors by what should be a considerable margin, and that may continue to weigh on the valuation here. I guess is the message here that the board is okay with the valuation discrepancy relative to the group? Or is there some breaking point you can point to that shows the board is sensitive to this?

Well, Bob, let me reiterate that the board certainly supports the operating plan that we have, and that we have been transparent in terms of outlining our priorities and how we're going to get there. And we'll continue to report on how we're doing against that. And we are confident that, that will deliver the financial results that everyone is looking for. And as long as we continue to execute against that plan, there's really no reason to consider any alternatives.

Well, I guess given that level of optimism and the cash flow numbers you've thrown out there, I mean, how is it possible the buybacks are not more material today versus 5 years from now?

Well, I think -- this is Dave. I guess, if you look over the next 5 years what we have from a cash flow perspective a significant opportunity to both increase the dividend and do what we consider value enhancing share buybacks at very significant levels. I would say that if you look through 2011, we're in the process of doing several things. One is we had completed the $2 billion authorization. We've just now funded the acquisition of the Universal American Med D acquisition, and then finally, we have some debt maturities coming available later in the year that we're going to address. So all in the spirit of also being very focused to our adjusted debt-to-EBITDA ratio, our target capital structure of 2.7x. That's very important that we maintain that level such that it gives us nice access to both the commercial paper market and to the sale-leaseback market. That's also a source of funds for us to finance the company.

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

The front end, Retail front end comp in the quarter and just it looks like you're gaining some share in the pharmacy. I'm just interested on what your thoughts are on the front end growth and the front end share performance, and any initiatives you have to improve the front-end sales growth of the business.

Well, Eric, I mean, as we mentioned, we continue to pick up share in the front end. We acknowledged some of the headwinds that we saw in the first quarter with the shift in Easter, as well as the comparison to the grand reopening events of Longs last year. We're continuing as we've talked many times, and we touched a little bit on the clustering initiative that's underway. But we've also talked about how we continue to use ExtraCare in a way in which we can drive profitable growth, acknowledging that the customers continue to look for value. We don't see that changing. And we're not going to chase sales that don't have a flow through, and we continue to look for ExtraCare to be the driver to do that.

And so the kind of core 1.5 front end comp in the quarter, that's kind of in line with what you're looking for. Is that sort of what we should expect to see sustained through the year? Is that kind of what the front end should do in this type of environment?

Well, I think there'll be some ebbs and flows, Eric, within that based on seasonality and comparisons to last year.

And then the second question in that area is, I just wanted to be clear as a question earlier on the subject but with the inflation coming from your suppliers, how do you expect that to play out relative to your gross margin as you go through the year?

Well, Eric, as I mentioned, we expect to pass those increases on at Retail. We will make sure that through our price shops and in the tools that we use to manage pricing in the front end that we stay true to our strategy. But we believe that it will have a neutral impact to our gross margin for the year.

Okay. Perfect.

And your final question comes from the line of Lisa Gill with JPMorgan.

I guess just a couple of quick follow-on questions. Larry or Per, can you talk about the upsell, can you maybe talk about how you get paid for that? Are you seeing any of your customers now asking for you to take any kind of risk metrics in the marketplace where you're perhaps sharing in some level of the savings? Or is it a direct increase in the amount or willingness of them to increase the profitably? Maybe just help me to understand that. And then secondly, Larry, I know you commented that '12, obviously, is going to be a better year for everyone. But I would think that with CVS Caremark being the largest purchaser of generics in the United States today, you should have some kind of advantage versus both your Retail and PBM counterparts around any products that maybe there will be limited availability or even using some of your pricing power. So can you maybe talk a little bit about how you anticipate generics and generic pricing and whatnot as we start thinking about '12.

So, Lisa, let me take the generic question, and then Per will take your first question. So as you think about generics, I think everybody knows the variables that come into play in terms of the exclusivity periods that the number of suppliers in terms of when we've really hit the sweet spot, acknowledging that generics are good for our business, are good for the consumer, they're good for the payer. And from an acquisition cost point of view, we believe that we maximize our leverage when there are 3 suppliers at the marketplace.

So, Lisa, on the risk question, I do think that, that's going to be a growing dimension in terms of how we work with customers going forward. As we gather more and more outcomes data from a number of these programs that we now have in place, and we have sort of a strength and confidence in the actual results that we can deliver to customers and the health care savings that they will result in, we do have the opportunity to enter into interesting share gain type of arrangements that can both help the client and benefit ourselves. So I would expect that to be an expanding part of our repertoire, even though today it's not a major percentage of our business.

Okay, and then just going back your comment, Larry, of around 3 suppliers around the product. So that's your sweet spot. If there's more, is that still okay, or if there's less, I mean, is there any kind of equation we can think about, if 3 is the best, is there a time when if there's 10 suppliers that the product, the profitability would be the same or less than the branded? Is it ever less than the branded? We just want to try to get our head around this, as we think about this going into next year.

Lisa, this is Dave. Just in general, once you hit the 3-supplier mark, that's typically the best. I don't think -- expanding it maybe improves it marginally, but it doesn't impact it greatly after that.

Okay. Well, this is it. Thank you for your time this morning. We appreciate your interest, as well as your questions, and that concludes the call.

Ladies and gentlemen, this concludes today's CVS Caremark first quarter 2011 earnings conference call. You may now disconnect.