CVS Caremark (CVS) Q3 2013 Earnings Conference Call November 5, 2013 8:30 AM ET
Larry Merlo - President and CEO
David Denton - EVP and CFO
Jonathan Roberts - EVP and President - CVS Caremark Pharmacy Services
Mark Cosby - EVP and President - CVS/pharmacy
Nancy Christal - SVP, Investor Relations
Robert Jones - Goldman Sachs
Robert Willoughby - Bank of America Merrill Lynch
Eric Bosshard - Cleveland Research
John Heinbockel - Guggenheim Securities
Meredith Adler - Barclays Capital
Lisa Gill - JPMorgan Chase & Co.
Scott Mushkin - Wolfe Research
Mark Wiltamuth - Jefferies
Ross Muken - ISI Group
David Magee - SunTrust
Ladies and gentlemen, thank you very much for standing by and welcome to the CVS Caremark third quarter earnings conference call. [Operator instructions.] As a reminder, today’s conference is being recorded on Tuesday November 5, 2013. Is now my pleasure to turn the conference over to Nancy Christal, senior VP, investor relations. Please go ahead, Ms. Christal.
Thank you, operator. Good morning everyone, and thanks for joining us. I’m here this morning with Larry Merlo, president and CEO, who will provide a business update, and Dave Denton, executive vice president and CFO, who will review our third quarter results and guidance. John Roberts, president of PBM is also with us today and will participate in the question and answer session following our prepared remarks. Mark Cosby, president of the retail business, was planning to join us, but is under the weather and not able to be here today.
During the Q&A, please limit yourself to no more than one question with a quick follow up so we can provide more callers with the chance to ask their questions.
I have one important reminder today, on Wednesday, December 18, we’ll host our 2013 analyst day in New York City. At that time, we’ll provide 2014 guidance and some longer term financial targets as well as a comprehensive update on our strategies for achieving those growth targets.
You’ll have the opportunity to hear from several members of our senior management team about our PBM, specialty, retail, and MinuteClinic businesses, along with numerous enterprise wide initiatives that will capitalize on the evolving healthcare landscape and drive future growth. If you didn’t reply to your invitation, please let us know if you plan to be there, as space is filing up quickly. The meeting will be webcast for those unable to attend in person, but we do hope to see many of you there on December 18.
Turning to this morning’s news, we posted a slide presentation on our website just before this call which summarizes the information you will hear today, as well as some additional facts and figures regarding our operating performance and guidance. I encourage you to review the slides. 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 and adjusted EPS. In accordance with SEC regulations, you can find the definitions of these non-GAAP items 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 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.
Thanks, Nancy. Good morning everyone, and thanks for joining us today. Now, given that our analyst day is next month, our business update this morning will be brief. However, I do want to take some time to cover some of the topics that I know are top of mind in the marketplace, such as the impact of the Affordable Care Act.
But before we get to that, let’s kick things off with today’s earnings, because we’re pleased to report that we posted solid third quarter results across the enterprise. Overall operating profit increased more than 15%, with the PBM and retail businesses growing approximately 28% and 8% respectively.
And it’s important to note that excludes the benefit from a legal settlement that was finalized during the third quarter. That settlement related to a prescription drug antitrust lawsuit with a drug manufacturer. We recorded a $72 million gain within operating expenses, which equates to a $0.04 per share benefit in Q3.
Now, that said, adjusted earnings per share excluding the legal settlement came in at $1.05 for the quarter, and that’s $0.02 above the high end of our guidance. We also generated a substantial amount of free cash and year to date the total now stands at $3.1 billion and consistent with our goal at the beginning of the year, we remain committed to returning about $5 billion to our shareholders this year through both dividends and share repurchases.
Considering our strong operating results to date, along with our outlook for the remainder of the year, we are raising and narrowing our earnings guidance for full year ’13 to a range of $3.94 to $3.97, and that’s a change from our previous range of $3.90 to $3.96. And again, that’s excluding the $0.04 benefit from the legal settlement. Dave will discuss our results and guidance in more detail during his financial review.
With that, let me address some of the topics of interest that I alluded to earlier. I think as everyone knows, the healthcare environment is changing rapidly, and there are certainly a number of moving parts, from the Affordable Care Act to the private exchanges, and collectively we expect changes within this environment to be a net positive for our business in 2014.
So let me walk you through the multiple ways that we’ll continue to grow our business in this evolving landscape. First, we’ll participate in coverage expansion and the public exchanges, as well as Medicaid. Second, we’ll participate in the private exchange market for both active employees and retirees. And I think it’s important to remember that our opportunities to participate are not limited to just our PBM, but span across our entire enterprise to include both our retail pharmacies, along with our MinuteClinic businesses.
So let’s drill down a little further through our PBM, because we’ll participate in the public exchanges through our health plan clients on a carve-in basis, where the health plan offers integrated medical and pharmacy benefits and we provide the PBM services. In fact, our health plan client footprint spans 25 states covering nearly 70% of the eligible exchange population.
In addition, as the number one PBM player in the managed Medicaid space, we’re also very well positioned to gain share through Medicaid expansion, and we certainly understand what these clients require.
Moving to the private exchanges, we’ll participate through both a carve-in basis - again through our health plan clients - as well as on a carve-out basis as a standalone PBM where we have direct prescription benefit offerings on the exchange products. And we are well-positioned to win lives on the exchanges given our unique products and services as well as our trusted brand and name recognition.
Within the private exchanges, we’ll also play an important role in providing coverage to retirees through our Silver Script prescription drug plan, as well as our health plan clients’ PDP and MAPD businesses.
Now, there’s certainly been a lot of speculation about what various employers are going to do with their populations, recognizing and acknowledging that large employers cannot participate on the public exchanges until 2017.
Well, the fact is that less than 1% of covered lives are expected to move to private exchange products in 2014. And based on conversations we have had with our PBM clients and private exchange partners, we believe that most large employers are taking a wait and see approach to private exchanges, particularly with their active employees.
Now, we recently had a meeting with our client advisory group, and they told us that they feel they can manage costs effectively in their own environment while still maintaining both control and flexibility.
That said, large employers may consider moving their retirees to the exchanges over time, and we may see more movement to private exchanges by smaller employers over the next few years, because the exchanges do offer a way to reduce administrative burdens. However, I want to emphasize the point that we are very well positioned to gain lives and market share in the exchange products.
Recently, you have also been asking about the impact all of this will have on PBM margins. And as we’ve stated previously, we do expect to see some churn in PBM lives as some members may move from the employer bucket to the health plan bucket, and although this may result in margin compression in some instances, we expect this will be mitigated by cost management tools such as narrow networks, our proprietary Maintenance Choice offering, narrow formularies, step therapies, and the list goes on. And as a result, we do not expect a material impact on PBM margins in the foreseeable future.
In addition to tighter pharmacy management tools, we also expect share gains from both market expansion and market churn as an additional lever to help offset PBM margin compression. And as I mentioned again, we’re well-positioned to win lives on the exchanges given our unique products and services, along with our trusted brand and name recognition.
Now, I also mentioned it’s important to remember that the opportunities from healthcare reform go well beyond our PBM, because our consumer expertise in the new business to consumer world of healthcare is being welcomed by health plans across the country, and leveraging our retail footprint, we can support healthcare marketing initiatives ranging from limited pilot marketing programs to full-scale educational programs.
In fact, over the next six months, we expect health plans to host more than 6,000 marketing events in more than 1,000 of our stores across 20 states. Some of these health plan partnerships also include participation in preferred or restricted retail pharmacy networks and many are taking advantage of the convenient and affordable MinuteClinic services as well as cost-saving PBM services and programs to better manage the specialty pharmacy segment.
And on top of these opportunities, our retail business will obviously benefit from the expansion of coverage along with our ability to drive incremental scripts through our fixed retail cost structure.
So while there are a lot of moving parts, all things considered, we’re very well positioned and we’ll certainly provide more specific context around our assumptions for the newly covered lives and pharmacy utilization that we expect from reform when we provide our guidance next month at analyst day.
So with that, let me quickly review some highlights on the PBM business. We’ve had a strong 2014 selling season, despite the fact that the number of RFPs were down year over year. To date, we’ve completed 75% of renewals, and we have a retention rate of 96%. Our gross sales wins currently total $5.1 billion, with net new business of about $1.8 billion. And remember that this net new business excludes any impact from attrition in our Medicare Part D PDP business.
Now with regard to the sanction imposed by CMS earlier this year, as we’ve talked about previously, it has prevented us from marketing our Silver Script PDP or enrolling new members. And recall that the sanction primarily affects our individual Silver Script prescription drug product.
Today we have about 3.3 million Silver Script lives and we expect to have roughly 3 million lives in our individual Silver Script PDP by the end of January ’14. On our last call, we said that we expected our remediation efforts to be complete sometime near the end of the year, and we expect to meet that target. And once complete, the next step will be for CMS to conduct its review to determine whether the issues have been fixed, are not likely to recur, and ultimately CMS will determine when the sanction will be lifted.
While we’re obviously disappointed that we have not been able to participate in the open enrollment period, it is important to remember that we still see significant opportunity to grow our Med D business over the long term. And we believe that the changes that we have made to strengthen the Med D management team, along with the remediation steps that we’ve taken will allow us to do just that.
Now, on the heels of a successful 2014 selling season in our commercial PBM business, work has already begun on the 2015 selling season, and as all of you know, we have a long term strategic agreement with Aetna to provide their PBM services. And I’m happy to report that we have successfully completed the 2015 market check with Aetna, and we look forward to continuing our strong and mutually beneficial relationship.
I’m also very pleased that we have successfully completed the migration of Aetna’s commercial business to the CVS Caremark platform. That’s pretty significant, since it means that more clients will have access to CVS Caremark’s differentiated offerings.
Our joint efforts with the Aetna sales team have been successful to date, with numerous clients adopting our unique offerings, like Maintenance Choice, like Pharmacy Advisor, and we’re also working closely with Aetna to implement and administer their exchange offerings and other government programs resulting from the Affordable Care Act.
Now turning to our specialty business, growth was strong. Revenue’s up approximately 22% year over year. This growth was driven by drug price inflation, utilization, new product launches, and new PBM clients.
At our recent client forum, many of our clients expressed concerns about the rapid growth in specialty pharmacy costs, and they are increasingly open to new ideas and solutions that address the escalating growth in specialty, and we certainly view this as a significant opportunity. And you’ll hear more about our strategies to help clients manage the specialty trend next month at analyst day.
Moving on to the retail business, we had another solid quarter. Total same-store sales increased 3.6% while pharmacy same-store sales increased a very healthy 5.7%. Pharmacy same-store sales were negatively impacted by about 320 basis points due to recent generic introductions, and that’s about half of the 670 basis point impact that we saw in Q2.
Pharmacy same-store scripts increased 1.4% when counting 90-day scripts as one. It increased 4.5% on a 30-day equivalent basis. And we have seen a greater than historical rate of conversion to 90-day from 30-day scripts. And that’s being driven by the continued strong growth in our Maintenance Choice programs.
I’m also pleased to report that the retention of scripts gained during last year’s impasse between Walgreens and Express Scripts continues to exceed our expectations. As you know, our goal was to retain at least 60% of those scripts this year and we are ahead of that goal.
As for the front store business, comps decreased 1%, reflecting a decline in traffic. At the same time, we saw continued increase in basket size, as well as modestly higher front store margins. Our ExtraCare loyalty card continues to enable us to personalize our offers, creating more value for customers and gaining a bigger share of their wallet.
In fact, this quarter we launched the My Weekly ad, a first of its kind personalized digital circular experience that taps into ExtraCare insights. And the My Weekly ad provides a unique weekly circular for every customer that’s geared to their shopping preferences, saving them both time and money. We hope you’ll log on and give it a try and we’ll speak more about this on analyst day.
As for new stores, we opened 71 new or relocated stores, closed one during the quarter, resulting 48 net new stores in Q3, and this keeps us on track to achieve our 2-3% square footage growth target for the year.
Let me turn briefly to MinuteClinic, which posted a revenue growth of 18% versus last year’s third quarter. We opened 42 net new clinics in the quarter, including clinics in two new states, Hawaii and Louisiana, ending Q3 with 726 clinics in 27 states and the District of Columbia. And our long term goal is to create a platform that supports primary care by providing integrated, high-quality care that is convenient, accessible, and affordable. And we’ll talk more about that next month as well.
With that, let me turn it over to Dave for the financial review.
Thank you, Larry. Good morning everyone. Before turning to our results and our guidance, I want to highlight how our disciplined capital allocation program continues to enhance shareholder value. And during the third quarter, we paid approximately $276 million in dividends, bringing our year to date payout to $829 million.
Additionally, we repurchased approximately 25.8 million shares for $1.5 billion in the quarter, at an average price of $58.98 per share. Year to date, we’ve repurchased 39.6 million shares for approximately $2.3 billion, again at an average price of $57.33.
As you can see, the pace of buybacks accelerated throughout the third quarter, and we remain on track to complete approximately $4 billion of share repurchase in ’13, which is also included in our guidance.
So between dividends and share repurchases, we have returned more than $3.1 billion to our shareholders through the first three quarters of this year alone and we continue to expect to return approximately $5 billion for the full year.
We’ve also generated approximately $3.1 billion of free cash flow through September of this year. Improving our cash generation capabilities through improved working capital management remains an area of focus for us.
And over the past several years, we’ve made excellent progress in reducing our cash cycle. As previously noted, we have some timing issues with respect to CMS payables and receivables that may affect our working capital and delivery of free cash flow for the year. Even so, we are maintaining our guidance of free cash flow of between $4.8 billion and $5.1 billion this year, while we work to offset this headwind to our target.
As for the income statement, third quarter adjusted earnings per share from continuing operations of $1.05 per share was approximately $0.02 above the high end of our guidance, after removing the pre-tax gain of $72 million from the legal settlement.
GAAP diluted EPS was $1.03 per share, including the $0.04 from the legal settlement. Earnings were higher than expected, primarily due to the outperformance in the PBM, a favorable tax rate, and a weighted average share count that was slightly lower than planned.
Now let me quickly walk you through our results. On a consolidated basis, revenues in the third quarter increased 5.8% or approximately $1.7 billion to $32 billion. This exceeded the top of our guidance range, again driven by the PBM.
PBM net revenues increased 7.8%, or approximately $1.4 billion, to $19.5 billion. This growth was more than 225 basis points above the high end of our guidance, and was driven by higher than anticipated claims volume, primarily from Maintenance Choice, as well as higher inflation within our specialty business.
Script utilization trends were consistent with prior periods, and we saw increased utilization of the retail network and in Maintenance Choice claims, offset by declining trends in core mail order. Claims growth year over year was driven by net new client wins and increased membership within our existing book of business. Specialty pharmacy was also a key driver.
Slightly offsetting these positive revenue drivers was a strong GDR, which is obviously good for the bottom line. The PBM’s generic dispensing rate increased 170 basis points versus the same quarter of last year to 81%.
Note that starting with Q1 of this year, the sequential year over year rate of increase continues to slow from the high point of approximately 500 basis points in Q4 of last year to 170 basis points this quarter. This trend is expected to continue throughout Q4 of this year, given that fewer generic conversions are expected for the remainder of this year versus last year.
Revenues in the retail business increased 5% in the quarter, or approximately $780 million, to $16.3 billion. As with the PBM, Maintenance Choice adoption was better than expected and helped drive overall performance to near the higher end of expectations. Like the PBM, new generic introductions negatively impacted retail sales, with our retail GDR increasing approximately 160 basis points versus the third quarter of ’12, to 81.5%.
Now turning to gross margins, we reported 18.9% for the consolidated company in the quarter, an increase of approximately 20 basis points compared to Q3 of ’12. Within the PBM segment, gross margins increased by approximately 65 basis points versus the second quarter of last year to 6.6% while gross profit dollars increased approximately 20% year over year.
The increase in margin rate year over year was primarily driven by better acquisition cost, rebate economics, timing of our Medicare Part D PDP margins, as well as the increase in GDR. The increase in margin dollars was driven by higher volumes from new clients and new members and higher specialty volumes versus the third quarter of last year as well as the shift of Medicare Part D profitability from Q4 into Q3 of this year.
These positive drivers were partially offset by price compression as well as remediation and operating costs within our Medicare Part D business. Gross margin for the retail segment was 30%, down about 15 basis points from last year, while gross profit dollars increased 4.5% year over year.
Given that pharmacy growth was stronger than front store growth in the quarter, pharmacy revenues as a percentage of total retail revenues increased by about 135 basis points. This shift in the business mix was the main driver of the climb in the overall retail margin rate since gross margins in the pharmacy business are lower than that in the front. Partially offsetting this was the increase in GDR as the continued increase in front store margins.
Excluding the positive impact of the legal settlement, total consolidated operating expenses as a percentage of revenues improved versus the third quarter of ’12 by approximately 35 basis points to 12.3% while total SG&A dollars grew by 2.9%.
The PBM segment SG&A rate improved by about 15 basis points to 1.5%, excluding the benefit of the $11 million settlement. PBM expenses declined approximately $4 million from the third quarter of last year, and this reflects reduced spending on the streamlining initiative as the project nears completion.
In the retail segment, solid expense control resulted in an improvement in SG&A as a percentage of sales of 40 basis points to 21.3%, excluding the $61 million from the legal settlement. Overall retail SG&A expenses grew by about 3.1%. Within the corporate segment, expenses increased by approximately $10 million to $179 million. As a percentage of consolidated revenues, operating expenses were flat.
Adding it all up and excluding the impact of the legal settlement, operating margins for the total enterprise improved approximately 55 basis points to 6.5%. Operating margins in the PBM improved 80 basis points to 5.1% while operating margin at retail improved by 25 basis points to 8.7%.
For the quarter, we were comfortably within the high end of our guidance for operating profit growth in the retail segment, while we exceeded our expectations in the PBM. Excluding the benefit from the legal segment, retail operating profit increased a very healthy 8.2% while PBM operating profits increased a very strong 27.7%.
Going below the line on the consolidated income statement, net interest expense in the quarter declined approximately $12 million from last quarter, to $122 million. The debt refinancing we did in the fourth quarter of last year continues to be the primary driver of the year over year decrease each quarter. Additionally, our effective tax rate was 38.2%, which was slightly better than we expected, and our weighted average share count was slightly lower than anticipated, at about $1.23 billion shares for the quarter.
So now let me turn to our 2013 guidance, which we both raised and narrowed this morning. Excluding the impact of the legal settlement in the third quarter, we currently expect to deliver adjusted earnings per share of $3.94 to $3.97 for 2013, reflecting strong year over year growth of 14.75% to 15.75%, after removing the impact in 2012 of the early extinguishment of debt to make the numbers more comparable.
GAAP diluted EPS from continuing operations is expected to be in the range of $3.73 to $3.76 per share. Our revised guidance reflects our solid performance for the first nine months of this year as well as our confidence in our outlook.
Embedded in this guidance are share repurchases totaling approximately $4 billion for the year, including shares from a $1.7 billion accelerated share repurchase program that we began on October 1. The details of the program will be available in our 10-Q, which will be filed later today.
Now let me walk you through our fourth quarter guidance. We expect adjusted earnings per share to be in the range of $1.09 per share to $1.12 per share, down 1.5% to 4.25% from Q4 of ’12 after removing the impact from last year’s fourth quarter resulting from the early extinguishment of debt.
GAAP EPS from continuing operations is expected to in the range of $1.03 per share to $1.06 per share. As I said on our last quarterly call, we expect the fourth quarter to be somewhat atypical this year, driven mostly by the timing of break open generics and by Med D profits in the PBM.
With respect to Medicare Part D, as I noted on our last earnings call, we are seeing a shift of profitability within the business from Q4, which has historically been our most profitable Med D quarter into Q3. A number of factors are affecting this, predominantly changes in earned rebates and the mix of the business across our Silver Script Choice versus our Silver Script Basic plan, as well as the impact of the sanction. As such, we expect the PBM segment’s operating profit to decline by 15% to 18% in the fourth quarter.
We expect the retail segment’s operating profit to increase 2.75% to 4.5% in the quarter, driven by gains in both the front store as well as the pharmacy. For the PBM segment, we expect revenues to increase 3.5% to 5% for the fourth quarter and adjusted claims to be between $262 million and $265 million.
For the retail segment, we expect revenue to increase 3.5% to 5%, with same-store sales to increase 2.25% to 3.75%. Same-store scripts are expected to increase 0.5% to 1.5% while adjusted script comps are forecasted to be between 3% and 4%.
And now as a result, for the total enterprise in the quarter we expect revenues to be up approximately 2.75% to 4.25% from the fourth quarter of ’12. This is after intercompany eliminations, which are projected to equal about 10.6% of combined segment revenues.
For the total company, gross profit margins are expected to be down significantly from last year’s fourth quarter, as both the retail and PBM segments will experience contraction. Expectations are that gross margin in the retail segment will be notably down due to fewer new generics available to offset continued reimbursement pressure.
Gross margins in the PBM segment will be significantly down, due in large part to the timing of Medicare Part D profitability, but also due to fewer break open new generics to offset pricing pressures.
These trends are occurring as expected, as we lap a large amount of break open generics in 2012. For the total company, operating expenses as a percentage of revenues are expected to moderately improve in the fourth quarter. PBM operating expenses should show modest improvement, driven in part by a reduction of streamlining costs year over year.
Retail expense leverage should notably improve, and upturn from recent trends largely due to the fact that there are fewer new generics and therefore less deleveraging of expenses. And we expect operating expenses from the corporate segment to be between $190 million and $195 million.
We expect operating margin for the total company in the quarter to be down 60 to 70 basis points from last year’s fourth quarter. We expect net interest expense of between $130 million and $135 million, and a tax rate of approximately 39% in the fourth quarter.
We anticipate that we will have approximately 1.2 billion weighted average shares for the quarter, which would imply approximately 1.23 billion for the year. And as I said, we continue to expect to generate free cash flow in the range of $4.8 billion to $5.1 billion, and we remain focused on using our strong free cash flow to drive shareholder value now as well as into the future.
And with that, I will turn it back over to Larry Merlo.
Thanks, Dave. And just to sum things up, obviously we’re pleased with our strong third quarter results, and optimistic about the outlook for this year and next. We see the evolving healthcare environment as an opportunity for growth, and we believe we’re very well positioned to gain market share across the enterprise.
So with that, let’s go ahead and open it up for your questions.
Earnings Call Part 2: