CVS Caremark Corporation (CVS) Q2 2013 Earnings Conference Call August 6, 2013 8:30 AM ET
Larry J. Merlo - President and CEO
David M. Denton - EVP and CFO
Jonathan C. Roberts - EVP and President - CVS Caremark Pharmacy Services
Mark Cosby - EVP and President - CVS/pharmacy
Nancy Christal - SVP, Investor Relations
John Heinbockel - Guggenheim Securities
Lisa Gill - JPMorgan Chase & Co.
Scott Mushkin - Wolfe Research
Zack Sopcak - Morgan Stanley
Edward Kelly - Credit Suisse
Dane Leone - Macquarie Research
Eric Bosshard - Cleveland Research
John Ransom – Raymond James & Associates, Inc.
Frank Morgan - RBC Capital Markets
Robert Willoughby - Bank of America Merrill Lynch
David Magee - SunTrust Robinson Humphrey
Meredith Adler - Barclays Capital
Ladies and gentlemen, thank you for standing by and welcome to the CVS Caremark Second Quarter Earnings Conference Call. During the presentation, all participants will be in a listen-only mode. Afterwards we will conduct a question-and-answer session. (Operator Instructions) As a reminder, this conference is being recorded, Tuesday August 6, 2013.
I’d now like to turn the conference over to the Senior Vice President of Investor Relations, Ms. Nancy Christal. Please go ahead.
Thank you, Frank. Good morning everyone, and thanks for joining us. I’m here with our President and CEO Larry Merlo, who will provide an update on the business. After Larry, our Executive Vice President and CFO, Dave Denton, will review financial results and guidance. John Roberts, President of PBM, and Mark Cosby, President of our retail business, are also with us today and will participate in the Q&A session following our prepared remarks.
During the Q&A, please limit yourself to no more than two questions so we can provide more callers with the chance to ask their questions. Just before this call, we posted a slide presentation on our website that summarizes the information you will hear today, as well as key facts and figures regarding our operating performance and guidance. I encourage you to take a look at that. Additionally, we plan to file our quarterly report on Form 10-Q by the close of business today and it will be available through our website at that time.
During this call, we’ll use some non-GAAP financial measures when talking about our Company’s performance, mainly free cash flow, EBITDA and adjusted EPS. In accordance with SEC regulations, you can find the definitions of these non-GAAP measures as well as 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 one-year.
Now I have one key date to announce this morning. Please note that we will host our Analyst Day on the morning of Wednesday December 18, in New York City. At that time, we will provide 2014 guidance as well as a comprehensive update on our growth strategy. In addition to Larry and Dave, you will have the opportunity to hear from additional members of our senior management team.
We plan to send invitations with more specific details via email by next week. So please save the date. Again, that’s Wednesday December 18th. If you don’t receive an invitation and would like to attend, please contact me at your earliest convenience.
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 in our upcoming quarterly report on Form 10-Q.
And now I’ll turn this over to Larry Merlo.
Larry J. Merlo
Well, thanks Nancy. Good morning everyone and thanks for joining us today. Let me begin by saying we’re very pleased with our strong operating results enterprise wide in the second quarter. Operating profit increased 15% overall, with the PBM growing about 32% and the retail business growing nearly 9%.
Adjusted earnings per share from continuing operations for the quarter came at $0.97, that’s at the high-end of our guidance and we also generated a substantial amount of free cash, totaling $1.7 billion for the first half of ’13 and we remain committed to our disciplined approach to capital allocation, continuing to focus on returning significant value to our shareholders through both dividends and share repurchases.
Now considering our strong operating results to-date and all other factors affecting our outlook for the remainder of the year, we’re narrowing our earnings guidance for 2013 to a range of $3.90 to $3.96. And that’s from our previous range of $3.89 to $4. And while Dave will provide more details around the drivers of our revised guidance during this financial review, I do want to mention that a key driver of lowering the high-end of our guidance range is a higher than forecast weighted average share count.
Now as we announced last week, we’ve reached an agreement in principle with the SEC to resolve its investigation of various Company matters that occurred back in 2009. During the second quarter we engaged in extensive settlement negotiations with the SEC and as a result we suspended our share repurchase activity until we’ve reached the agreement in principal.
Now that it has been reached, we plan to resume our repurchasing efforts this quarter and we still expect to complete the $4 billion in share repurchases that we had planned for this year. So if you do the math with our share repurchase is now back half way then as opposed to recurring ratably throughout the year as we had originally anticipated. This timing shift is estimated to dampen the accretive impact of the share repurchase program for the year by as much as $0.04.
Now despite this timing shift in share repurchases, our updated guidance for ’13 equates to excellent adjusted EPS year-over-year growth in the range of 13.5% to 15.25%. So we’re still anticipating a very successful 2013.
Now let me provide a brief business update and I will start with the 2014 PBM selling season. Our model continues to resonate well in the marketplace and we’re very pleased with our results to-date. Gross wins for 2014 are $4.4 billion to-date, while net new business stands at $1.7 billion. And that’s despite lower RFP activity this season.
We’ve been successful across all segments and this net new business excludes any impact on our Med D PDP business, which I will come back to in a minute. There are still some modest opportunities remaining for 2014, most of those are on the employer side and work is already underway for the ’15 selling season. As for renewals, we’ve completed almost 50% and have a retention rate of 97%, so overall again we’re very pleased with our selling season to-date and confident that we continue to be well positioned in the marketplace with our unique products and services.
So I thought I'd just spend a minute touching on what clients have been focused on this selling season, and one area of both employer and health plan client concern is managing their specialty spend across the pharmacy and medical benefits. And as a result, we are seeing interest across our entire suite of specialty capabilities including utilization management programs, specialty guideline management, formulary strategies as well as our site of care and medical claims added in products, and we believe our differentiated approach to specialty is driving lower overall costs while improving health and providing value for both payers and patients.
Our specialty revenues grew 19% year-over-year in the second quarter and that was driven by drug price inflation, utilization, new product launches and new PBM clients. At our continued focus on managing specialty cost per client will help us continue to drive our share of specialty going forward. Now in addition to managing specialty costs, our clients are also focused on the changes resulting from the Affordable Care Act and we continue to believe that Medicaid expansion and individual small group coverage and the public exchanges will be a long-term secured growth trend, resulting in a significant amount of new coverage for people who have previously been uninsured.
Now details around the exchanges including planned participants, planned designs and rates, they continue to emerge and we believe we are very well positioned given our retail footprint along with our existing relationships with health plans and managed Medicaid plans. We've had a lot of dialogue with health plans about collaborating with us on innovative programs that support their overall exchange strategy and these discussions often encompass how they can partner with us across our retail touch points while tapping into our direct-to-consumer marketing expertise to attract and retain members.
We also discussed our medic clinic in support care management and wellness programs for the newly insured and how a plan can maximize the benefits from all of the unique clinical and member engagement programs that we can offer through our CVS pharmacy network, and we believe all of the activity around the exchanges will serve as a catalyst for broader collaboration opportunities with our health plans.
I do want to touch briefly on the PBM streamlining initiative which, as you're aware, launched in late 2010 and is near completion. We are on track to achieve the expected annual savings run rate of 225 million to 275 million in 2014. And as for the consolidation of adjudication platforms, we have now completed 11 waves of migration and we continue to leverage our resource and technology investments to refine our processes and improve efficiencies resulting in moving more clients and limiting potential disruption in each of those successive ways. 85% of our business is scheduled to be on the destination platform by yearend, so overall the streamlining initiative has been very successful.
So let me turn to our Medicare Part D business and just a quick review, we currently serve 6.8 million members in our Medicare Part D business and we do that through the health plans we serve as well as our individual Silver Script PDP including EGWP. Our individual PDP currently serves approximately 3.4 million of our 6.8 million members. Now last week we received the preliminary benchmark results from CMS for 2014 and we're pleased with the outcome. Silver Script was below the benchmark or within the de minimis range in 31 of the 34 regions.
We missed the benchmark only in one small region in which we qualified today where we have about 2,000 lives that will be subject to reassignment to another plan. So aside from any normal attrition, these benchmark results should enable us to retain the vast majority of the auto-assigns we currently serve.
Let me update you on where we stand with respect to the sanction imposed by CMS earlier this year. And as you know, the sanction prevents us from marketing our Silver Script PDP or enrolling new members. And as we've said, our goal has been to complete our remediation efforts so that the sanction would be listed before the annual enrollment period begins for the '14 plan year.
Now given some additional complexity that we uncovered while working to resolve the issues along with our strong commitment to ensuring that we are ready to operate at best-in-class levels, we have revised our plan and expanded the timeline for remediation. And based on our latest estimate, we now expect our remediation efforts will be completed sometime near the end of the year. Once our remediation has been completed, CMS will conduct its review to determine whether the issues have been fixed, are not likely to recur, and when the sanction will be removed.
So what does all that mean? Well given this current timeline, we do not expect that we will be able to participate in the 2014 annual enrollment period when it begins in October. In addition, until the sanction is lifted, we do not expect to receive new auto-assigns from CMS for 2014 in the regions where we qualify. The sanction primarily affects our individual Silver Script PDP which as I mentioned has about 3.4 million lives. It does not affect the Medicare Part D business through the health plans we serve and as a reminder, our EGWPs are also not affected by the sanction since we continue to operate under a limited waiver from CMS that allows us to enroll newly eligible retirees into our existing plans.
So let me put some parameters around the situation. First of all, assuming that sanction is not listed prior to the end of the year, here are a few factors that we can roughly estimate at this point. First, based on the preliminary results of our bid, we do expect to be able to retain the vast majority of our current 2.5 million low income subsidy enrollees. Second, based on the historic competitiveness of our products we do expect to retain a majority of our 900,000 non-low income subsidy chooser lives and these enrollees have previously chosen Silver Script as their PDP.
Third and consistent with a typical Medicare Part D plan, there will be some normal attrition of our enrollees due to death, relocation and other normal member eligibility factors and we estimate this attrition will continue at the rate of roughly 25,000 lives per month. And in January, rates of attrition are generally a bit higher after they have gone through their typical decision processes during the annual enrollment period.
So to put some preliminary numbers around this, again using historical attrition rates we estimate our PDP lives could decrease by about 350,000 lives leaving us with approximately 3.1 million lives in our individual Sliver Script PDP by the end of January '14. So clearly the sanction limits our ability to expand our Med D lives for '14 and we will continue to work diligently to have the sanction lifted as soon as possible in order to be able to enroll new members and participate in the individual age-in process next year in the regions where we have qualified.
Now obviously we take this issue very seriously. We have devoted additional resource to fully meet the needs of this important customer base. And while this does present a challenge for '14 in our Medicare Part D business, it's important to note that we still see significant opportunity to grow our Med D business over the long term and the remediation steps that we are taking will allow us to do just that.
Now moving on to the retail business, we had another very solid quarter. Total same-store sales increased 0.4%, revenue growth was muted by the impact from new generics which had a 670 basis point negative impact on pharmacy comps in the quarter. Pharmacy same-store sales increased 0.8% with pharmacy same-store scripts increasing 1.8% when counting 90-day scripts as one and increasing 5% when counting 90-day supplies as three scripts. We have seen a greater than historical rate of conversion to 90-day from 30-day scripts which is driven by the strong growth in our maintenance choice programs.
Our retention of the scripts gained during the impasse between Walgreens and Express Scripts continues to exceed our expectations. And as you know our goal is to retain at least 60% of the scripts gained during the impasse and given our outperformance to-date, we remain very confident that we will continue to retain at least 60% of the scripts in '13.
As for the front store business, comps decreased 0.4%. It was impacted largely by the shift in the Easter holiday from April of '12 to March of '13 which had a negative impact to front store comps of about 65 basis points. And during the quarter pharmacy traffic was up while the front-store traffic was down, and at the same time average front-store ticket continued to increase.
And I think it's important to note that despite the slight decrease in front-store comps our front-store margins expanded nicely in the quarter and we continue to focus on driving more profitable sales through the target of promotions we offer to extra care cardholders, and we’re focused on increased personalization to accomplish this.
And to gain a bigger share of wallet we have identified customer specific opportunities for increasing frequency of both the shop and the basket size and to drive this conversion we continued to dramatically expand our personalized offers that are delivered at the point of sale and in the second quarter alone we issued more than three billion such offers and we’ve also significantly expanded our personalized offers that we deliver via email.
So extra care provides extraordinary precision due to the scale of customer engagement along with the 15 years of data that has provided us unique insights into customer behavior trends and we continue to use these valuable insights from our extra care program to drive the evolution of how we tailor our stores to better meet local needs. And our latest data shows that we continue to gain market share.
Our front-store market share growth in the second quarter versus a year ago was 71 basis points and 8 basis points and that’s when compared to drug and multi-outlet competitors respectively. As for new stores we opened 47 newer relocated stores, we closed one during the quarter resulting in 22 net new stores in the second quarter and this puts us on pace to achieve our 2% to 3% square footage growth target for the year.
Let me turn briefly to MinuteClinic which once again recorded exceptional revenue growth with sales up 32% versus the same quarter last year. We opened 35 net new places in the quarter and in Q2 with 684 clinics in 25 states in the District of Columbia. Our expansion plans called for the opening of 150 clinics this year and to end ‘13 with just under 800 clinics with around 30% of our expansion this year in new markets.
Our longer term goal is to create a national primary care platform to provide integrated high quality care that is convenient, accessible and affordable and new services will continue to be developed to address the shortage of primary care physicians and to support patients impacted by the epidemic of chronic disease and our positioning further supports that primary care medical home model along with connectivity through electronic health records to numerous health system alliances.
So with that let me turn it over to Dave for the financial review.
David M. Denton
Thank you, Larry and good morning everyone. Today I’ll provide a detailed review of our second quarter results and then I’ll provide guidance for the third quarter and update our full-year 2013 outlook. But first I’d like to highlight how we have been enhancing shareholder value through disciplined capital allocation program. During the second quarter, we paid approximately $276 million in dividends bringing our year-to-date payout to $553 million. Given our continued strong earnings outlook this year we remain on track to achieve our targeted payout ratio of 25% by the end of this year. And as a reminder that is two years ahead of schedule that we laid out back in 2010.
Additionally, we repurchased approximately 6.4 million shares for approximately $355 million in the quarter at an average price of $55.39 per share. And as Larry indicated we ended the quarter with more shares outstanding than we had planned because of our decision to suspend share repurchases until we were more fully certain of the outcome of our negotiations with the FEC. And despite our slower pace in the second quarter we still expect to complete $4 billion of share repurchases in ’13 consistent with our original plan and note that the guidance we're providing today assumes the $4 billion of share purchases will be completed this year.
So between dividends and share repurchases, we have returned more than $1.3 billion to our shareholders through just the first half of this year and we continue to expect to return approximately $5 billion for the full-year. We have generated approximately $1.7 billion of free cash in the first two quarters of ’13 and improving our cash generation capabilities by enhancing our working capital management remains an area of focus for us, and we have made excellent progress over the past several years in reducing our cash cycle.
As I pointed out on our last call we have taken nearly two weeks out of our cash cycle over the course of the last 10 quarters. Inventory has seen the greatest amount of improvement but all areas have benefited from our focus on extracting value from our balance sheet and we remain committed to further improvements as we look further into the future.
And as previously highlighted on our last earnings call we noted that we may have some timing issues with respect to CMS payables and receivables that may affect our free cash flow delivered for the year given the issues we experience following our Med D plan consolidation. While we're maintaining our guidance for free cash flow between $4.8 billion and $5.1 billion this year we're still working to offset this headwind through our free cash flow targets and will continue to update you on our progress as we go forward.
Turning to the income statement, adjusted earnings per share from continued operations came in at $0.97 per share at the high end of our guidance. GAAP diluted EPS was $0.91 per share and as we’ve said weighted average share count was higher than planned but the impact of that in the second quarter was negated by a slightly more favorable tax rate and good expense management within the corporate segment.
Now let me quickly walk you through our results. On a consolidated basis, revenues in the second quarter increased 1.7% or approximately $534 million to $31.2 billion. This was near the top of our guidance range. Solid increases in revenues in both the PBM and retail segments were offset only slightly by the increase in inter-segment activity versus primarily driven by the increase in adoption of our Maintenance Choice program.
Within the segments, PBM net revenues increased 2% or approximately $377 million to $18.8 billion. This growth was approximately 55 basis points above the high end of our guidance. The out-performance was driven by higher than anticipated claims volume, primarily from Maintenance Choice and Medicare Part D utilization.
Claims growth year-over-year was driven by new client wins and increased membership within our existing book of business, especially pharmacy was also a key driver. This was largely offset by the significant impact from new generics. The PBMs generic dispensing rate increased nearly 275 basis points versus the same quarter of last year to 81%. Note that the year-over-year increase is down sequentially from last quarters year-over-year increase by about 125 basis points and this is the trend that should continue throughout the year given that fewer generic conversions are expected for the remainder of this year versus last year.
Now revenues in the retail business increased 1.9% in the quarter or approximately $294 million to $16.1 billion. New generic introductions also negatively impacted retail sales with our retail GDR increasing approximately 280 basis points versus the second quarter of ’12 to 82%. Now offsetting that phenomenon was the growth of our Maintenance Choice program was contributed to sales performance coming in near the higher end of expectations.
Turning to gross margin, we reported 18.7% for the consolidated company in the quarter, an increase of approximately 95 basis points compared to Q2 of ’12. Within the PBM segment, gross margin increased by approximately 90 basis points versus the same quarter of LY to 5.1% while gross profit dollars increased approximately 24% year-over-year.
This increase year-over-year was primarily driven by increasing in GDR, higher volumes from new clients and new members and better acquisition costs and rebate economics. These positive margin drivers were partially offset by price compression and remediation and operating cost in our Medicare Part D business.
Gross margin in the retail segment was 31% also up about 90 basis points over LY, as with the PBM this improvement driven primarily by the increase in GDR and also by improvement in front-store margins. Additionally gross profit dollars increased 4.8% year-over-year within the retail segment. Expense leverage was also impacted by the growth in GDR while the de-leveraging was optically negative the growth of expense dollars was within normal parameters.
Total operating expenses as a percent of revenues increased approximately 20 basis points from Q2 of ’12 to 12.4%, while total SG&A dollars grew by just 3.4%. The PBM segments SG&A rate was essentially flat to LY at 1.5%. The benefits from PBM's more efficient cost structure versus the same quarter last year was basically offset by the deleveraging effect of an improved GDR and cost related to remediation efforts within Medicare Part D.
From the retail segment, SG&A as a percent of sales increased to approximately 25 basis points to 21.1%. And as expected, this too is mainly due to a deleveraging effect of the growth in generics. Overall, SG&A expenses grew by 3.2%. Within the corporate segment, expenses were virtually flat year-over-year at $176 million.
Now adding it all up, operating margin for the total enterprise improved to approximately 75 basis points to 6.3%. Operating margin of the PBM improved by approximately 80 basis points to 3.6% while operating margin at retail improved about 60 basis points to 9.9%.
For the quarter, we were comfortably within the high end of our guidance for operating profit growth in both retail and the PBM segment. Retail operating profit increased a very healthy 8.6% while PBM operating profit was once again solid growing at 32%.
Now going below the line of a consolidated income statement, net interest expense in the quarter declined approximately $5 million from last year to $127 million and the debt refinancing we did in the fourth quarter last year was the primary driver of the decrease.
Additionally, our effective tax rate was 39.1% which is slightly better than expected. And as we discussed our weighted average share count was higher than anticipated, about 1.24 billion shares for the quarter.
Now let me update you on our guidance. I'm going to focus on the highlights here but you can find additional details of our guidance within the slide presentation we posted on our website early this morning. As previously stated, we narrowed our EPS range for the full year of '13 to reflect our strong operating results and to incorporate our current plans with timing of share repurchases.
We are taking down the top end of the PBM operating profit forecasted growth to reflect some incremental remediation costs related to our Medicare Part D sanction. However, these costs are expected to be more than offset by the increase in our retail operating profit growth forecast, all of which is reflected in our revised guidance.
All things considered, we've raised the low end of guidance by $0.01 and lowered the high end by $0.04. We currently expect to deliver adjusted earnings per share in 2013 in the range of $3.90 to $3.96 per share reflecting excellent year-over-year growth of 13.5% to 15.25% after removing the impact related to the early extinguishment of debt in 2012.
GAAP diluted earnings per share from continuing operations is expected to be in the range of $3.65 to $3.71 per share. We've narrowed our top line outlook and now expect consolidated net revenue growth of 2% to 3%. This guidance reflects the solid performance across the enterprise year-to-date driven by better volumes as well as inflation.
We've raised the PBM segment's revenue guidance to 2% to 3% growth while narrowing retail's expected revenue growth to 2.25% to 3.25%. We expect total comp stores same-store sales of 1% to 2%. We are maintaining our prior guidance for script comps of 1.5% to 2.5%.
Now we are also introducing a new guidance metric, adjusted script comps, adjusting 90-day fills for the 30-day equivalents. Given the high rate of conversions from 30-day fills to 90-days fills, we believe this is a better indication of pharmacy performance and we expect adjusted script comps to be in the range of 4% to 5%.
As I said, guidance for operating profit growth in our retail segment has been raised while we have brought down the high end of the range for the PBM segment. We now expect retail operating profit to increase 9% to 10% year-over-year and PBM operating profit to increase 11% to 13%.
We now expect net interest expense between $500 million and $510 million, a slight increase over our prior guidance. We are increasing our weighted average share count forecast to 1.23 billion shares up from 1.22 billion. And as I said previously, our free cash flow guidance for the year remains in the range of $4.8 billion to $5.1 billion.
In the third quarter, we expect adjusted earnings per share to be in the range of $1 to $1.03 per share reflecting growth of 17% to 21% versus the same period of LY. GAAP diluted EPS from continuing operation is expected to be in the range of $0.94 to $0.97 in the third quarter.
Within the retail segment, we expect revenues to increase 4% to 5.5% versus the third quarter of last year. The revenue increase will be driven by solid volume growth while we expect a sharp decline and a dampening effect from new generic introductions.
We expect same-store sales of 3% to 4.25%. Script comps are expected to increase in the range of 1.25% to 2.25% while adjusted script comps are forecasted to be 3% and 3.75% to 4.75%. Within the PBM, we expect revenue growth between 4.5% and 5.5% driven by volume growth and inflation and also benefiting from the decline in the effective new generics.
Operating profit in the retail segment is expected to grow 7.5% to 9% in third quarter while operating profit in the PBM segment is expected to grow 19% to 23%. So again, we expect another very solid quarter.
And before I turn it back over to Larry, I want to touch on the quarterly flow of profits in the back half of '13 and particularly within the PBM. If you take the full year and third quarter guidance that I've just laid out and plug that into your models, you might note that our implied Q4 operating profit growth in the PBM is anemic. Here are few points you should keep in mind that should help you better understand why Q4 is somewhat atypical this year.
First, we've consistently stated the positive impact of new generics in 2013 will be front half loaded given the timing of break open generics in 2012 and the resulting lap affect into the first half of '13. We'll be lapping the impact of the substantial amount of break open generics, so the comparison year-over-years are tough.
Second, the timing of Medicare Part D profits in '13 is turning out to be different than 2012 due to a number of factors. These include the impact of a sanction, changes in earned rebates in the mix of the business across our choice versus basic products. And as a result of these factors, we are seeing a shift to profitability this year from Q4 which has historically been our most profitable Med D quarter into Q3.
So while the year and even the back half of this year remains very profitable, the comparison year-over-year in the third and fourth quarters are not expected to be typical. And I hope this helps put in context the full profits in both Q3 as well as Q4.
So in summary, the second quarter was a very strong quarter and we continue to expect strong earnings growth for the year. And I want to assure you that we remain committed to utilizing our substantial cash generation capabilities to deliver shareholder value.
With that, I'll turn it back over to Larry.
Larry J. Merlo
Okay, thanks Dave. Again, we're very pleased with our strong operating performance this quarter along with our strong outlook for the 2013 year. And despite the near-term challenges in our Med D operations, we do remain excited about the long-term opportunity for the growth in the Medicare business.
So with that, let's open it up for your questions.
Earnings Call Part 2: