CVS Health Corporation (CVS) Q3 2012 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by. Welcome to the Third Quarter CVS Caremark Earnings Call. [Operator Instructions] As a reminder, this conference is being recorded Tuesday, November 6, 2012. I would now like to turn the conference over to Ms. Nancy Christal, Senior Vice President, Investor Relations. Please go ahead.

Thank you, Silvanna. 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. Per Lofberg, Executive Vice President of CVS Caremark; Jon 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. [Operator Instructions] I have a couple of quick reminders today. First, we'll host our 2012 Analyst Day on the morning of Thursday, December 13 in New York City. At that time, we'll provide 2013 guidance, as well as a comprehensive update on our growth strategy. In addition to Larry, Dave, Per, Jon and Mark, you'll also have the opportunity to hear from Dr. Troy Brennan, our Executive Vice President and Chief Medical Officer; and Dr. Andy Sussman, our President of MinuteClinic and Associate Chief Medical Officer. If you haven't received an invitation and would like to attend, please contact my office. Expect a big crowd, and look forward to seeing many of you there. For those of you who can't attend in person, the meeting will, of course, be webcast. Second, we posted a slide presentation on our website this morning, which summarizes the information on this call, as well as key facts and figures around our operating performance and guidance. I recommend that you take a look at the slides. Additionally, please note that we plan to file our Form 10-Q before the close of business today, 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, 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. 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 continue, 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.

Okay, thank you, Nancy. Good morning, everyone, and thanks for joining us today. As Nancy said, we have our Analyst Day coming up next month. So our business update this morning will be a bit more compact than what you typically hear on our quarterly call. Now that said, we're very pleased with the strong third quarter results we announced today. Adjusted earnings per share from continuing operations were $0.85. That's up 21% from the same quarter last year and $0.02 above the high end of our guidance. Results were strong across the enterprise. Operating profit in our Retail segment was up 16.1%, within the expected range, while operating profit in our PBM was up 19.4%, well ahead of our expectations. Now in addition to posting strong third quarter results, we're raising and narrowing our guidance for the full year. We now expect to achieve adjusted EPS for 2012 in the range of $3.38 to $3.41. That's up from our previous range of $3.32 to $3.38. Our revised guidance reflects the overperformance in the third quarter along with the anticipated $0.01 per share benefit from the accelerated share repurchase program announced in September. Additionally, it reflects our optimism about exceeding our initial goal related to the Walgreens-Express dispute. For year end, we now expect to retain at least 60% of the scripts we picked up during the impasse. So obviously, we're very pleased with the continued upward trend in our expectations. And Dave will provide the details of our third quarter results, as well as guidance for the fourth quarter during his financial review. Now before we get to that, let me provide a brief business update, and I'll begin with our PBM. Now since our last call, we continued to make good progress on the 2013 selling season. Now with about 75% of our client renewals completed to date, our retention rate stands at 96%. As for new business, the numbers haven't changed materially from the second quarter update, and we'll provide a detailed review of the '13 selling season on Analyst Day. And by then we will also be able to provide a good estimate of the net effect of the Medicare Part D selling season, which includes the assignment of low-income subsidy lives along with the results of the open enrollment period, which ends on December 7. And as we noted on our last earnings call, we qualified in 30 of the 33 regions that we participate in today. Now during the selling season, we continued to demonstrate superior value with our differentiated offerings, which continue to gain traction with existing clients, as well as help us attract new ones. So let me briefly review the progress on our 2 unique integration sweet-spot programs, Maintenance Choice and Pharmacy Advisor. We now have approximately 14.5 million lives covered by 1,040 plans that have implemented or committed to implement our Maintenance Choice offerings through Q1 of '13. Now that number is up from 10.7 million lives at our last quarterly update, and it includes plans that have adopted our new 2.0 offering. We continue to see more of our new clients adopting one of our Maintenance Choice offerings right out of the gate, and we believe that the rollout of 2.0 will ultimately improve adoption into the Maintenance Choice program once payors and their members begin to experience some of the savings and benefits of the program. And as we've discussed in the past, Pharmacy Advisor capitalizes on our integrated assets to lower health care costs and improve the health of those we serve. We currently have over 900 clients representing 16.3 million lives enrolled in the diabetes program and just under 600 clients with 11 million lives enrolled in the cardiovascular program. Now we expect to offer 5 more Pharmacy Advisor programs for additional chronic diseases in 2013, and we're also excited to announce the launch of Pharmacy Advisor to Medicare clients beginning next year. Now let me touch on a few of our key growth drivers. Most notably, our Specialty Pharmacy business continued to achieve significant growth with revenues increasing a very strong 34% year-over-year. This Specialty growth was driven by new PBM clients, new product launches along with drug price inflation. Just a quick update on Aetna. The client migration onto our platform is accelerating and it's proceeding very nicely. We have successfully transitioned multiple waves of Aetna clients, and we have further migration scheduled for the remainder of this year and into 2013. And then as for our streamlining initiative, we remain on track to deliver over $1 billion of cumulative cost savings through 2015. Now we expect to hit the full run rate of annual savings, $225 million to $275 million, beginning in '14. And as we've talked in the past, this initiative is streamlining PBM operations to improve productivity, rationalizing capacity and consolidating our adjudication platforms to 1 destination platform with enhanced capabilities. We just launched our final migration wave for 2012, and we anticipate that approximately 2/3 of our clients will be on that destination platform by the end of this year. Let me now turn to the Retail business. In the third quarter, our same-store sales increased 4.3%. Pharmacy comps increased 5.3% in the quarter with front store comps increasing 2.2%. Now Pharmacy comps were negatively impacted by more than 900 basis points from the rapidly growing impact of generics, and that's up from about 500 basis points in the second quarter, and it's expected to grow to more than 1,000 basis points in Q4. Script comps increased 11.1% on a 30-day supply basis, 8.7% when counting 90-day supplies as 1 script. Our script growth reflects healthy underlying growth across all major drug classes, as well as an increase in new related scripts. And the key drivers of improved script growth trends across the industry include an uptick in physician visits, we're seeing accelerating growth in Medicare Part D, along with improved adherence to maintenance medications driven by the greater use of generics. Our strong script growth also reflects a significant benefit from the Walgreens-Express dispute. Now similar to last quarter, we estimate that the impasse added 400 to 430 basis points to our script comp in the third quarter, equating to about 6.5 million to 7 million scripts. Now we had expected a $0.05 per share benefit in the third and fourth quarters combined. And in Q3, we realized about a $0.035 benefit. Now we have been tracking ahead of our retention expectations in the 7 weeks since Walgreens reentered the broadest Express Scripts network. So in the fourth quarter, we now expect at least another $0.025 benefit. And the new estimate assumes that we retain, as I mentioned earlier, at least 60% of the prescription volumes gained from the dispute in Q4, and that's up from our previous estimate of at least 50%. And again these estimates are net of the projected investments we are making to maximize retention, and we will certainly share more specifics with you at our Analyst Day as it relates to the 2013 outlook. Now as for the front store business, both customer traffic and average front store ticket increased in the quarter. We estimate that the Walgreens-Express impasse positively impacted our front store comp by about 150 basis points in the quarter. Now we also saw strength in allergy, as well as flu-related sales in the front end. I think it's important to note that the latest data shows that CVS has gained front store share versus a year ago. And when compared to drug and multi-outlet competitors, our market share growth in the quarter was 103 and 6 basis points, respectively. Now our ExtraCare loyalty program continues to be a key differentiator. And with 15 years of history, 70 million active cardholders, we have a significant lead on our competitors, and we deliver value to our customers every time they shop. Year-to-date, our ExtraCare members have received $2.7 billion, that's billion with a B, in value from savings and ExtraBucks rewards. And we have opportunities to make it even better. For example, we're enhancing our digital capabilities to improve the in-store, online and mobile experiences for our customers. And our digital strategy that's powered by the personalization of ExtraCare gives us a tremendous opportunity to bring truly customized communications and offers to our customers. And while we don't believe our loyalty program is a customer acquisition tool, it is an excellent customer retention tool. And approximately 85% of our new, high-value Express Scripts customers have enrolled in ExtraCare, adding to our confidence in the retention estimates. As for our real estate program, we opened 63 new or relocated stores, closing 3. That resulted in 42 net new stores in the quarter, and we remain on track to increase our retail square footage by approximately 2% to 3% for the year. Let me touch briefly on MinuteClinic. MinuteClinic continued its strong growth trajectory with revenues increasing 43% versus the third quarter last year. Now we opened 25 net new clinics ending the quarter with 609 clinics in 25 states and the District of Columbia. Now building on our record for clinical quality, MinuteClinic was reaccredited by the Joint Commission, that's the independent certifying body for more than 19,000 health care organizations across the country. In addition, we continue to enhance MinuteClinic's role as a health care collaborator, adding 2 new affiliations, the UCLA Health System and the Oklahoma University Physicians, bringing us to 20 health system affiliations. And Andy Sussman will speak more about all of this on Analyst Day. Now before I turn it over to Dave, I do want to touch on the estimated impact on our business from Hurricane Sandy. At the peak of the storm, more than 1,100 stores in the affected areas were closed, all but 20 have since reopened and about 15 stores have suffered extensive damage. And we do not have dates as to when they will reopen at this point in time. All things considered, we're estimating a potential $0.01 per share negative impact to our EPS in the fourth quarter from Sandy, which is contemplated in the low end of the guidance range that Dave will provide for Q4. Now I also want to acknowledge those on this call that are probably still dealing with the aftermath. We certainly appreciate your time today and hope that your life is returning to normal. And I also want to thank our colleagues across the company, who have done extraordinary things to get our stores operational, in addition to helping the communities most affected. So with that, let me turn it over to Dave for the financial review.

Thank you, Larry, and good morning, everyone. This morning, I will lead you through a quick review of our third quarter results. I'll also finish up with a look at our guidance for the full year of 2012, as well as our guidance for the fourth quarter specifically. I'll start with a summary of how we're using our strong free cash flow to return value to our shareholders. In September, we announced that our board authorized another $6 billion of share repurchases. We quickly commenced an accelerated share repurchase program that completed our prior authorization and utilized $1 billion of this new authorization. And between open market repurchases on our prior authorization and the ASR, we repurchased a total of 30.1 million shares for approximately $2 billion in the third quarter at an average cost of $45.69 per share. Additionally, we paid approximately $207 million in dividends. We still anticipate a payout ratio of approximately 21% this year and are on track to achieve our targeted payout ratio of 25% to 30% by 2015. So between dividends and share repurchases, we've returned more than $2.2 billion to our shareholders just in the third quarter alone. Our expectation is that between dividends and share repurchases, we will return more than $4.8 billion to our shareholders throughout 2012. Going forward, we expect to continue to generate very substantial free cash flow, and our disciplined approach to capital allocation will remain a vital component of our efforts to drive shareholder value. We generated $4.1 billion of free cash flow year-to-date and $854 million in the third quarter, down about $650 million from the same period a year ago. As expected, this was driven by the timing of payments from CMS associated with our Medicare Part D business. We essentially benefited from an earlier payment in Q3 of last year, which did not recur this year, the impact of which was about $1 billion favorable in 2011. And now this does not affect the yearly cash flow, and we're well on track to reach our free cash flow target range for the year of $4.6 billion to $4.9 billion. Inventory days within the Retail segment have improved by more than 3 days from the end of last year. Combined with gains in DPO and DSO, we have reduced our Retail cash cycle by nearly 5 days thus far this year. As we continue to make process improvements, the Retail team remains committed to its inventory reduction target of $500 million for the full year. And working capital improvements such as these are expected to continue to enhance our cash generation capabilities. We had a fair amount of sale leaseback activity in the third quarter with net proceeds of $427 million. With gross capital expenditures of $496 million, net capital expenditures were $69 million for the quarter. As for the income statement, adjusted EPS and GAAP diluted EPS from continuing operations came in $0.02 above the high end of our guidance at $0.85 per share and $0.79 per share, respectively. The EPS beat was driven primarily by the overperformance in the PBM, and I'll address that in a moment. But first, let me quickly walk down the P&L. On a consolidated basis, revenues in the third quarter increased more than 13% to $30.2 billion. Within the segments, net revenues increased 22% in the PBM to $18.1 billion. The majority of growth over last year was driven by the significant number of new client starts along with increased volumes in Medicare Part D. The Medicare Part D growth was driven by both previous acquisitions and members gained in 2012. Additionally, PBM revenue growth was driven by drug price inflation, particularly in our Specialty business. Partially offsetting these factors was the increase in the generic dispensing rate, which climbed 500 basis points higher in the quarter versus the same quarter of LY. In our Retail business, revenues increased 5.5% in the quarter to $15.5 billion. This growth was driven by our 4.3% same-store sales increase, as well as growth from new stores, relocations and MinuteClinic. Turning to gross margin. We reported 18.7% for the consolidated company in the quarter, a contraction of approximately 75 basis points compared to Q3 of '11. As with prior quarters, the decline is mainly a mix issue given that the PBM revenue growth outpaced Retail growth. As you know, the PBM business has lower gross margins than Retail, hence the decline at the enterprise level. Within the PBM segment, gross profit dollars increased 18.3% year-over-year. The increase was considerably better than expected due to favorable GDR performance, as well as rebates. Gross profit margin was down approximately 20 basis points versus last year's third quarter. The positive effect of the 500 basis points increase in the PBM's generic dispensing rate was more than offset by price compression and changes within the PBM mix of business. Gross margin in the Retail segment was 30.1%, up approximately 85 basis points over LY. This improvement was driven primarily by the 420 basis point increase in Retail GDR. That benefit was partially offset by continued pharmacy reimbursement pressures. Total operating expenses as a percent of revenue improved by approximately 80 basis points versus the third quarter of '11. The PBM segment's SG&A rate improved approximately 10 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 percent of sales was essentially flat to last year at 21.7% while expenses grew by 5.8%. Within the Corporate segment, expenses were up approximately $15 million to $169 million in the quarter. So at the enterprise level, operating margin for the total enterprise was roughly flat, improving by approximately 5 basis points to 6%. Operating margin in the PBM was 4.3%, down only 10 basis points, while operating margin at Retail was 8.4%, up about 75 basis points. Retail operating profit increased a very healthy 16.1% within our guidance range. PBM operating profit exceeded our expectations, increasing 19.4%. That was driven by outperformance in gross profit. And as I noted earlier, that was a result of better generic utilization and rebate performance. Going below the line on the consolidated income statement. Net interest expense in the quarter declined approximately $21 million from last year to $134 million. Additionally, our effective income tax rate was 39.8%, higher than expected primarily due to an increase in reserves for state income taxes. Our weighted average share count was 1.27 billion shares, approximately 5 million shares lower than anticipated due to the commencement of the ASR in September, which had no material impact on our earnings for the quarter. Now let me turn to our 2012 guidance, which we both raised and narrowed this morning. We currently expect to deliver adjusted earnings per share of $3.38 to $3.41 and GAAP diluted earnings per share from continuing operations of $3.15 to $3.18 per share. This equates to growth of approximately 21% to 22%. Our revised guidance reflects our strong performance throughout the first 9 months of this year, as well as our confidence in our outlook. Embedded in this guidance are share repurchases totaling $4 billion for the year. This includes the $0.01 per share accretive impact of the $1.2 billion accelerated share repurchase we announced in September. It also reflects our optimism about retaining in the fourth quarter at least 60% of the scripts we picked up during the Walgreen-Express Scripts impasse. Furthermore, the low end of our guidance contemplates a $0.01 per share negative impact to our EPS in the fourth quarter from Sandy. This includes storm damage, as well as any business interruption related to the significant storm. Now let me walk you through the fourth quarter. We expect adjusted earnings per share to be in the range of $1.08 per share to $1.11 per share, reflecting growth of approximately 21% to 24% from the $0.89 we reported last year. GAAP EPS from continuing operation is expected to be in a range of $1.02 to $1.05 per share. Keep in mind that due to the significant amount of repurchase activity in the last 4 months of the year and its effect on our weighted average share count, the sum of our reported quarterly EPS results is not expected to add up to our reported full year EPS. As it stands right now, the year should be about $0.01 less than the sum of the quarters. This is simply mathematical rounding. So please take that into account when modeling your expectations. We expect the PBM segment's operating profit to increase 38% to 41% in the fourth quarter. As expected, we are benefiting from a normal progression of increasing profitability as we move through the year in our Medicare Part D business. In addition, this strong growth expectation reflects the improvements in the net impact of the streamlining cost and benefits, as well as the positive impact of generics on our results. We expect the Retail segment's operating profit to increase 6% to 8% in the fourth quarter. This growth is expected to be driven by solid performance in the underlying business. This includes the positive impact of new generics, as well as a strong start to the cough and cold business. It's also driven by the combined benefits -- the continued benefit we expect from the Walgreens-Express impasse. For the PBM segment, we expect revenues to increase 15.5% to 16.5% in the fourth quarter. For the Retail segment, we expect revenue to increase 3% to 4%, same-store sales to increase 2% to 3%, and same-store scripts to increase 7% to 8% in the fourth quarter. As a result, for the total enterprise in the quarter, we expect revenues to be up approximately 9.25% to 10.25% from 2011 levels. This is after intercompany eliminations, which are projected to equal about 9.75% of the combined segment revenues. For the total company, gross profit margins are expected to be notably up from last year's fourth quarter as both the Retail and the PBM segments will experience expansion. Expectations are that gross margin in the Retail segment will be significantly up due to the substantial amount of new generics that have been introduced throughout the year while gross margin in the PBM segment will be notably up, also mostly due to new generics, partially offset by some price compression. For the total company, operating expenses are expected to be approximately 13% of consolidated revenues in the fourth quarter. The PBM should show modest improvement as we reap the benefits from streamlining. As I noted on the second quarter call, Retail expense leverage should deteriorate significantly due to the impact of generics, the fact that we are comparing against disproportionately lower spending in Q4 of last year and the investments we're making in the business to drive longer-term performance. And we expect operating expenses in the Corporate segment to be approximately $180 million. As a result, we expect operating margin for the total company in the quarter to be moderately up from last year's fourth quarter. We expect net interest expense of between $135 million and $140 million and a tax rate of approximately 38.6% in the fourth quarter. We anticipate that we'll have approximately 1.26 billion weighted average shares for the quarter, which would imply approximately 1.28 billion for the full year. In the fourth quarter, we expect total consolidated amortization to be approximately $120 million. Combined with estimated depreciation, we still project approximately $1.7 billion in D&A for the full year of '12. As for capital spending for the year, we continue to expect net capital expenditures of between $1.5 billion and $1.6 billion with proceeds from sale leasebacks of between $500 million and $600 million. We expect to generate cash flow from operations in the range of $6.2 billion to $6.4 billion for the year and free cash flow in the range of $4.6 billion to $4.9 billion. As we've demonstrated throughout this year, we are keenly focused on enhancing our cash flow through solid working capital and capital expenditure discipline. The working capital improvements we've achieved and continue to drive, specifically within inventory, will continue to drive our free cash flow performance, building upon our strong year-to-date results. Again, we are focused on using our strong free cash flow to drive shareholder value now and as well into the future. And with that, I'll turn it back over to Larry.

Okay. Thanks, Dave. As I said, we're certainly very pleased with our strong enterprise-wide results this quarter. And before we open it up for your questions, I just want to briefly acknowledge that with Election Day finally here, today's outcome will certainly have an impact on the direction of health care over the next several years. And that said, I believe that our business is well positioned regardless of the outcome of today's election. But we certainly know the issues around cost, quality and access facing our nation's health care system. And we are confident in our ability to provide innovative solutions to help address them however health care reform takes shape, and we'll certainly talk a lot more about that on Analyst Day. So with that, we'd be happy to take your questions.

[Operator Instructions] And our first question comes from the line of Deborah Weinswig with Citi.

If we look at the news on Monday from one of your competitors and from last night, both your pharmacy and PBM seemed to really be outperforming. What does that tell you about the competitive landscape at this point in the game?

Well, Deb, I think it's reflecting many of the things that we've been talking about that we believe are differentiators in our business. And whether it's the retention that we're seeing from the Walgreens-Express customers, as well as some of the programs that we have that are improving medication adherence. And we do have some favorable industry trends driving pharmacy performance as well. And we talked about physician visits being up over the past 6 months, as well as Med D scripts being up. We think that, that is being driven by more generics in the market making prescriptions more affordable, as well as seniors beginning to get some relief from the doughnut hole. And I think we also mentioned that we are seeing an uptick in flu-related prescriptions. But we're very happy with our performance. And we see again the programs that we have in the market making a meaningful difference.

With such a unique positioning in the competitive landscape and as you continue to do more from a digital perspective, how do you think that you can continue to enhance your relationship with your customer?

Well, Deb, as we've often talked about, I'll kick it off, and then flip it over to Mark to provide some -- a few examples. But being in the loyalty card business for more than 15 years and having 70 million active cardholders, we have learned an awful lot from our customers about what they value, how they shop and how we can help to improve that experience. And I'll flip it over to Mark, and he can add some color to that.

Our loyalty program and personalization is a huge piece of our past. It's also a big part of our future. As Larry said, we do have the most successful and largest program in the country. 300 million cards issued, 70 million active, 15-year history. During that time, 6 billion personalized message delivered. So we know what our customers want, and we know how to deliver it. And we become smarter every year with how to drive those results across time. And one unique feature of the card is that we do deliver value every time that a customer purchases with us, and that has led to over $2.7 billion of savings for our customers this year. So we've rolled out a bunch of initiatives over the course of the last year, and we will continue to do so. The 2 biggest innovations around the loyalty campaign are our Beauty Club and our digital program. On the beauty front, this is the second year of the program, 10 million active members. They spend $50, they get $5 back. And it's a big contributor to why our beauty share is up over the course of the last year. And to your question, the other big piece that's happened within our loyalty program is a lot of innovation around digital. We've launched this past year a search to send card, where rewards are sent directly to the cards versus customers needing to use paper. We have a new digital application that allows our customers to scan the ExtraCare card, and they can use that as opposed to bringing their card around with them. We've done quite a bit around our circular to try to make that more personalized. So we can now deliver messages to customers, personalized to their spending history and to their spending future. So we have a comprehensive mobile strategy that we've developed, and we'll talk more about that when we get to the analyst meeting, as well as a number of personalization features that we feel very strong about coming into the future. So a very strong and successful loyalty program, big focus for our future. And game plan is to maintain our competitive advantage both on the digital front, as well as on the loyalty front in the coming years.

And I'll throw one quick one out there. I didn't know if it was also helping with the retention of the Walgreens customers, if there's anything you guys were doing in terms of medication adherence from a digital perspective, if that was helping as well.

Well, Deb, as we've talked, we've been able to enroll about 85% of the new customers that we've seen as a result of the impasse in ExtraCare. That allows us again, as Mark mentioned, to communicate in a very personalized fashion. And we're beginning to explore some of the opportunities around Refill Reminders digitally.

Our next question comes from the line of Lisa Gill with JPMorgan.

I just had a couple of questions around -- on the PBM side around the selling season. I know you're going to give a lot more detail in December. But Per, Larry, Jon, if someone can maybe talk about what are the trends that you're seeing. It sounds to me like retention was very strong this year, that perhaps as you went in, you renewed clients, you were upselling them to Maintenance Choice, given the Maintenance Choice numbers you're talking about. Can you talk about what you saw around narrow networks? And also what are you seeing around group member attrition as we start to move forward? Do you see that plans are trying to make decisions as they think about 2014 in anticipation of the Affordable Care Act?

Lisa, this is Jon. So in the selling season, which it was an active selling season, we saw our fees up 7% over last year, we saw a lot of interest in low-cost channels and a lot of interest in low-cost products. So low-cost channels being mail service, Maintenance Choice and limited networks. With mail choice, Larry talked about 2013 and what we're going to expect to see from a growth. And that's a reflection of our Maintenance Choice 2.0 combined with our traditional Maintenance Choice. And we'll give more details about that as we get to Analyst Day. So as far as what's happening with group members, we really haven't seen a lot of activity there. And what we have seen is companies moving their retirees into EGWP, so we're seeing activity there. But they're essentially moving their entire block of retirees into EGWP plans, which we provide all the capabilities to service them. So all in all, a successful selling season. Haven't seen much of a change in the dynamics, but we have seen a lot of interest in our programs and a lot of adoption of our programs right out of the gate.

And Lisa, you asked about 2014, and it's obviously very early. Like most forecasts, I mean, we fully expect that there would be employers, probably mid-sized and small employers, who will begin to phase out their benefit programs and move people into exchanges where they will shop for individual coverage. And we're gearing up to deal with that transition, although I think it will probably be at least another year or so before we'll see any real activity in that area.

So you're not seeing any activity today, Per, in 2013, where you're seeing people start to move individuals away from providing benefits in 2013 in anticipation that they're going to be able to picked up in '14? So is it right to characterize that 2013 should still be a pretty status quo year around membership utilization and that the real opportunity for CVS Caremark is the fact that you've been able to move people into programs that are beneficial to them but also more beneficial to you from an earnings perspective, whether it's Maintenance Choice, narrow networks, getting more people into a CVS store? Is that the right way to characterize it?

Yes, I think the EGWP trend that Jon spoke about will probably, in all likelihood, continue into 2013 and beyond. But the exit of small and mid-sized employers from providing health coverage is probably a little further out than that.

And Lisa, as far as the economic climate, this is not a new issue, okay? As we all know, we've been dealing with this for a couple of years now in terms of a challenging economic environment. And as we move into '13, we don't see that environment changing materially from today, either getting better or getting worse.

[Operator Instructions] Our next question comes from the line of John Heinbockel with Guggenheim Securities.

So Larry, if you look at some of the unique engagement initiatives you guys have, can you maybe give us a little color in terms of the degree to which you're raising compliance and the degree to which you are lowering the run rate in medical costs, just generally speaking? And at what point does that become, if it becomes a game changer, in being able to win new contracts that are out there? Or do you think it doesn't become a game changer for a while?

Yes, John, it's a great question. And we'll provide -- we'll go into a fair amount of detail on this at Analyst Day, and we'll actually quantify some of the benefits that we're seeing in terms of improving the medication possession ratio. I think we are beginning to see some of the step changes in terms of the importance. If you think about the Star ratings around some of the Medicare programs, that, prescription adherence and some of the clinical outcomes that we're working on and talking about make up a big portion of the evaluation of those Star ratings. So I think it is beginning to happen as we speak. I don't think it's years away. I think it's here today, and it will only grow from here.

John, this is Jon. I just wanted to add, as we're out talking to clients, we talk about managing the bad trend, which PBMs have traditionally done, but we also talk about managing good trend. And we've developed a pharmacy economic model that we can run against a client's member base and we can show them by therapeutic class that if they're able to improve their adherence with their members up to the 80% medication possession ratio, which is considered adherent, what the medical offset will be. And so we've seen a lot of interest from our clients in this and that's why the adoption of Pharmacy Advisor, which is really targeted around adherence, has really taken hold in the marketplace.

Okay. And then secondly, so Larry, if you think a little bit longer term in the Retail business, as your EBIT margin has sort of crept to some record levels here and generics will kind of go by the wayside at some point or will be less of a driver in the next year or 2, what do you think -- as you put your strategic hat on, what do you guys think you need to do to keep driving EBIT margin higher on the Retail side? Is it more cost-related? Is it more mix-related? Things you're not selling, you should be selling? What do you think about that?

Yes, John, let me -- if you look at our operation, okay, and as we think about utilization, that next prescription becomes the most profitable one as it relates to leveraging the fixed costs we have in the Retail stores. And I think that's a little bit of what we're seeing this year, okay, as we've capitalized on the Walgreens-Express dispute and something that we'll continue to be focused on. And I think I'll flip it over to Mark to talk about some of the opportunities that we have around store brands, and that will be more to the margin side of things.

Thanks, Larry. Well, certainly growth is the primary thing. So we have a number of issues that we'll review at the Analyst Day to drive growth. But also a piece of the puzzle is to drive the margin and continue to focus on the margin. As Larry said, one of our big front store components that we will continue to push forward is on the store brand front. We have a number of new launches that will come into 2013. And then we're working on a plan as we speak that would take the number significantly above where we are today, both from a sales perspective but even more from a margin perspective.

John, I think the other one I mentioned, Dave talked a little bit about our inventory performance at Retail. That is still an opportunity for us. Even though we've made some improvements over the past 2 years, we still have more opportunity there. And that will also help from a productivity and efficiency point of view.

Our next question comes from the line of Ross Muken with ISI Group.

Can you talk a bit about some of the underlying trends on sort of the front end? I mean, can you tease out sort of what we've been seeing in terms of net benefit from more bodies in the store vis-à-vis the Express-WAG pickup versus some of the kind of changes you've made and strategic investments you've made on that side of the business in terms of either boosting traffic or basket, et cetera?

Yes, Ross. We have seen an increase in both customer traffic, as well as the average ticket. And again, at the risk of being redundant, I think that we continue to see ExtraCare as the differentiator that drives some of the shared growth that we're seeing. I think we have also done a number of things around promotion as we think about making our promotional program more efficient from an expense and a margin point of view. And we're pleased that those things are working.

I would just add in addition to ExtraCare and the personalization efforts that we have there, we've done quite a bit with our field team to try to enhance their focus around growth and around sales. And we've given them a number of tools to empower them and to help them be successful in driving their results. And I think if you walk our stores, you'll see a much greater focus there that will help us today and will help us into the future.

And maybe on Specialty, it seems like that continues to come, at least from an inflation basis, higher than expects and continues to be kind of a pain point for drug trend at the customer level. Could you talk a bit about sort of the conversations you had during the selling season or how you're thinking about that as we sort of transition into the next year and into the next few years just based on whether you think that moderates how you're delivering sort of a differentiated solution in that market and in total, how you're thinking about sort of the growth trajectory of that piece?

Yes, Ross. This is Jon. So great question. And when you look at Specialty trend, which is running in the high-teens, it's really driven by really 3 components. One is price inflation, which is pretty similar to what we see in the commercial space. But the 2 components that are driving it even higher are mix. So as new drugs come to the market and they're more expensive, that drives the average cost of specialty for a payor. And then the third thing is utilization. We're seeing utilization. So a new hepatitis C drug came on the market, boceprevir, and that was additive to the therapy that somebody with hepatitis C gets treated with. So you're seeing an increase in overall spend in that category, as an example. So it is first and foremost on the minds of our clients, and they're looking to us for help. And we have many programs that can help actually manage that trend. So things like our Specialty Guideline Management program, where we make sure that patients that are prescribed specialty drugs that it's appropriate for them to get the drugs. And then we manage it carefully around the guidelines that are provided to make sure that the dosage is right and the frequency of utilization is appropriate. And then we have other programs that help manage preferred drugs within the specialty categories, and then we have exclusive programs, where we manage through our channels. So all in all, we have programs that can deliver and take -- reduce trend by 20%. And so we think this is an important area. When you look at the pipeline, half the pipeline is specialty. So it's going to be a continued focus for our clients. And we think it's a significant growth opportunity for us moving forward.

And Ross, clients are also worried about that portion of specialty that's flowing through the medical benefit. And we'll look forward to sharing some information on some pilots that we have under way to manage that component of specialty that -- I know I've heard it from some clients that, "Hey, you guys have done a great job managing the traditional spend, okay? And how do we bring some of those same tools to that component of specialty that's flowing through the medical benefits?" So you'll hear more about that next month.

Our next question comes from the line of Meredith Adler with Barclays.

I was -- I'd like to maybe talk a little bit about the comments that Express Scripts made yesterday. And also I maybe didn't understand some of the comments about gross margin in the PBM for the third quarter and the outlook for the fourth quarter because I think they seemed to be different, more positive in the fourth quarter. And I don't know if that's related to what Express Scripts said. But maybe you could talk about pricing pressures and other things like that in the PBM.

Meredith, it's Dave. Maybe I'll start with kind of the gross margin in the PBM. First and foremost, there's kind of 2 things driving gross margin performance in Q3, and we see that continuing into Q4. As we look at Q3, which really driven around higher-than-anticipated generic utilization trends, and secondly, our performance from a branded manufacturer rebate yield perspective. And we've been very focused on that, as you know, over the past several periods. And both of those outperformed our expectation. As we cycle into Q4, those trends continue plus we continue to step ourselves into the period of time from a Medicare Part D perspective, where the profitability accelerates in the back half of the year. So that is also a trend that from a PBM perspective that trends into Q4 that's driving our gross profit performance in that business. So we're very pleased with our progress there.

Meredith, let me just add one other point because we've talked an awful lot over the last couple of years about EBITDA per script. And the fact that, that is not a good measure of performance, you can get false positives and false negatives. And so even though the number is now better than it was a year ago, we're still saying the same thing. We don't believe that, that is the right measure of performance, that at the end of the day, it's about operating profit growth. And we're seeing that number favorable. Dave talked about the generics. We're also going to benefit later in the year as it relates to the Med D business. And that's why we, for the last couple of years, have been saying, "Look at operating profit year-over-year growth as a measure of performance." Meredith, your first question. I mean, I think I addressed that earlier in terms of as it relates to the economic climate, we don't see it changing materially from where we sit today. And I think that's really the only comment we have on that.

Okay. And then I guess, I would like to just ask a little bit about just kind of a simple question, I think, about the retention of the former Walgreens customers. Obviously, with the Department of Defense not bringing Walgreens back into the network, there was naturally going to be an increment to you. But it sounds like the 60% retention is better. Can you maybe talk about how much Department of Defense would have benefited you? And then -- which I guess would lead us to believe that you're just generally doing better.

Meredith, this is Dave. Maybe I'll address that real quickly. I mean, clearly, there's some clients within the Express' book has continued to go forward on, I'll say, a smaller network that might not include Walgreens, and Department of Defense TRICARE was one such client. Having said that, we knew there were some portions of that book that would occur as we cycled into Q4. I would just say that at the end of the day, when we look at our retention performance, we're doing better than we thought. We're actively engaging those customers on a day-in and day-out basis. And we think that our outlook's positive here. And I can't give you a specific around TRICARE, what it would or would not have been depending upon their choice.

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

Two quick ones. I think, first, on Part D. I was wondering how you sort of view that business as a retailer. Specifically, there seems to be more traction, at least some newer plans that have preferred networks. I know you're in some, you're not in all. So can you tell us a little bit more about the strategy on that front? And then second, Larry, I know there's been some headlines out west, in particular on sort of your auto refill program and maybe some other retailers. And I wasn't sure if you wanted the opportunity to at least give your two cents on that.

Yes, 2 good questions. I'll take the Med D one first. I think, as we all know, preferred relationships under Med D are not new. And keep in mind that different than a restricted or a narrow network, the customer can still choose the pharmacy with a co-pay differential in place. And there are plans out there with CVS as a preferred provider or a SilverScript plan, the Aetna CVS/pharmacy offering, along with a number of other options. And there are plans where we're not in a preferred position. We believe that over time, we are well positioned in the Med D space to gain market share. Tom, in terms of your second question about some of the articles in the L.A. Times, we do not believe that, that article accurately characterizes our ReadyFill program or our business practices for that matter. And our primary concern is to help people on their path to better health. And if the core of that is a business-wide initiative, as we've been talking about this morning, that is promoting prescription adherence among patients. And everybody on this call knows the statistics here that nonadherence to medication is costing our health care system nearly $300 billion a year in unnecessary health care costs. And our programs are working to help patients take their meds as directed by their physicians. And we've created several innovative services that do that. Some as simple as the pharmacists speaking with the patient face-to-face, proactive outreach phone calls to support therapy continuation, and then ReadyFill, which is an opt-in program that helps patients stay on their meds by scheduling their enrolled prescriptions to be filled when due, and then notifying patients to pick them up at their convenience. And this -- we think this is pretty important because there are a number of reasons why people don't take their meds. Forgetfulness is just one of them. So these programs are popular with patients. They align with our clients' goals of increasing adherence and continuing to work to control overall health care costs. So thanks for the opportunity to add my three cents on that topic.

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

So my first one is on Maintenance Choice. Obviously, good growth. Back when you started the program, you had some big gains interyear. And I was wondering if 2013, we could see that. The second part of the Maintenance Choice question is you don't have full coverage in Retail. Is that something you would desire to continue to grow that program? So that's question one. My second question, it goes to the PBM. I guess, and not to be -- because it's such a great quarter, so it's hard to even point out anything negative here. But it seems like the growth in new accounts for '13 maybe was a little bit under what we thought, given the competitive environment. I'm wondering if we could have some comments on what maybe the hangups were so far at least with the data you've given us on the PBM selling season.

Yes, Scott, I'll address '13, and then we'll come back to the Maintenance Choice question. I mean, I think as I've mentioned and Jon mentioned earlier, we'll provide a detailed review of '13 selling season. As we mentioned, the numbers have not changed materially from our last update. And keep in mind that earlier in the year, everyone was talking about this was going to be a banner year for RFPs because of disruption in the marketplace and so on and so on. And that really never materialized as it was perhaps being talked about earlier in the year. We saw RFPs up 7% year-over-year. I think it was a pretty normal year from that regard.

And Scott, this is Dave. As it relates to Maintenance Choice, maybe I'll say the uptake of Maintenance Choice throughout 2013, we are constantly in front of our existing client base in identifying ways in which they can improve their performance, either control cost or improve adherence. Maintenance Choice is one such program that allows them to do that. And so it will clearly depend upon, one, which clients have new programs in place that start mid-year; and two, the receptivity to those innovative programs. So probably more to come on that, Scott. We'll keep you updated as time progresses through 2013.

And then Scott, this is Jon. Let me address the question of fill-ins. Obviously, our clients would like CVS retail stores in every state. We've got great coverage. And they ask us about our growth plans, and we talk about where we plan to add stores. But that has not been an obstacle to them adopting Maintenance Choice. And I think that's reflected on what we've seen because if you don't have a CVS retail store, they can go to mail. And that's more of a priority to get the savings on a lower-cost channel as opposed to the few areas where we don't have CVS retail stores, so really hasn't been an issue for us.

And our final question comes from the line of Steven Valiquette with UBS.

Let me say, first, I'm glad to hear that you're not expecting any in-group member attrition in your PBM for 2013. But separately, you've also discussed in the past that the EPS contribution from new generics for the PBM could be even greater in 2013 than what it is in 2012, just given the calendar timing of launches. And I'm just curious if that's still seen to be somewhat likely for '13 the way you see things currently.

Yes, this is Dave. I mean, our outlook for generics has not materially changed, given that we kind of last year gave a progression or an outlook of what we thought was going to happen from a generic break-open perspective over the next several years. I'll encourage you to go back and look at the slide at Analyst Day last year within my presentation that talks about the amount of new generics that are coming to the market, as well as the amount of -- cumulative amount of break-open generics that are available both now and into the next several years. And our outlook to those is still consistent with those expectations. And we'll give a little bit more clarity to that as we cycle into 2013 and the guidance that we'll provide for both the consolidated enterprise but also the PBM and Retail businesses.

So I just want to thank everybody for joining us this morning. And we look forward to hopefully seeing all of you on December 13. And as Nancy mentioned, we've got, I think, a great agenda to include providing our guidance for 2013. So we'll see you then. Thanks.

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.