CVS Health Corporation
Q2 2006 Earnings Call Transcript

Published: 3 Aug 2006

[Operator:]

At this time I would like to welcome everyone to the CVS Corporation second quarter 2006 earnings conference call. (Operator Instructions) I would now like to turn the call over to Ms. Nancy Christal, Vice President Investor Relations for CVS Corporation.

[Nancy Christal:]

Good morning everyone and thanks for joining us today for our second quarter 2006 conference call. I'm here with Dave Rickard, Executive Vice President and CFO. Dave will be providing highlights of our business in the second quarter followed by a financial review and earnings guidance. But before I turn this over to Dave I have a few administrative items to cover. First, just a reminder that we will be announcing July sales on Monday, August 7. As I mentioned on our last quarterly call we will report monthly sales results on a slightly later schedule than we have in the past. That is to due to our recent acquisition of 700 Albertsons stores and is related to systems incompatibility that we are working around initially. Once the systems are integrated we will shift back to reporting sales on our previous schedule, which is typically two business days earlier. Second in order to be able to take as many questions as possible today I would ask that you limit yourself to one or two questions, including your follow-up. If you have more than that you can get back in the queue and we will try to get to you as time permits. Third, I want to remind you that today's call is being simulcast on our IR website. It will also be archived there for a one-month period following the call to make it easy for all investors to access the call. Note that this call may not be rebroadcast without prior written consent from CVS. Fourth, please note that during this call we will discuss one non-GAAP financial measurement in talking about our Company's performance, namely free cash flow. We find it a good way to understand operational cash flow being generated by the business. Free cash flow is defined as earnings after taxes plus non-cash charges, plus changes in working capital, less net capital expenditures. So free cash flow excludes acquisitions and dividends. In accordance with SEC regulations you can find the reconciliation of free cash flow to comparable GAAP measures on the IR portion of our website at investor.cvs.com. As we typically do on these calls our attorneys have asked me to read the Safe Harbor statement. During this presentation we will make certain forward-looking statements that are subject to risk and uncertainties that could cause actual results to differ materially. For these 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 you become familiar with the specific risks and uncertainties that we've outlined for you under the caption Cautionary Statement Concerning Forward-Looking Statements in our annual report on Form 10-K for the 2005 fiscal year ending December 31, 2005 and in our quarterly report on Form 10-Q for the quarter ended April 1, 2006. This morning's earnings press release is also available on our website which should be reviewed along with the information on this call. If you have any further questions, as always, following the call please don't hesitate to contact me. Now I'll turn this over to our CFO, Dave Rickard.

[David Rickard:]

Thanks, Nancy. Good morning everyone and thanks for joining us to hear about another outstanding quarter for CVS. During the quarter we completed the acquisition of approximately 700 Sav-On and Osco stores from Albertsons, creating a 6,200 store chain. We also negotiated an agreement that was recently announced to acquire the Minute Clinic Company. More about that in a few minutes. Finally, we delivered record-breaking financial results in the quarter. This reflects the latest acquisition but really centers around the continued momentum of our core business across all of our markets. Here are the highlights for the quarter

[Operator:]

(Operator Instructions) Our first question comes from Mark Husson, -HSBC.

[Mark Husson:]

Good morning. My one question is on shrinkage. I think maybe you didn't mention it last quarter but for several quarters before you talked about core improvements in shrinkage and also improvements in the Eckerd business. You didn't talk about that in gross margins; does that mean that rich steam is now over or just less impactful?

[David Rickard:]

We're enjoying very good shrink performance and did in the second quarter. Our target this year, as you know, was to achieve about 150 basis points in the Eckerd front store business. We're achieving that. Our target for the core business was more modest improvement, and we're achieving that. So we are pleased with the performance. I think we will end the year in the Eckerd front store at a level that still provides some opportunity for further improvement, and I think we will see that as we go through next year.

[Mark Husson:]

How does it look for Sav-On Osco, even though you've only had it for a few weeks?

[David Rickard:]

It's early days yet. I think there is some modest opportunity there. It's not of the same magnitude as it was at Eckerd.

[Mark Husson:]

Thank you very much.

[Operator:]

Our next question comes from John Heinbockel - Goldman Sachs.

[John Heinbockel:]

Two things. With regard to Sav-On Osco, I know the magnitudes are going to be different, but how do you think the timetable on sales improvement will compare to Eckerd front end versus pharmacy? Just speed of recovery? Obviously the magnitude is going to be less.

[David Rickard:]

Yes, I think obviously we need to make the changes to make the stores CVS easy. We will have a lot of that done before Christmas, certainly in key markets, and the rest of it done early next year. As these things are completed we will begin our marketing grand reopening activity. So I think what I would hope we will see is some good results over the Christmas season and then a build through next year.

[John Heinbockel:]

California, the competitive environment, does that alter the fact there is so many players there, does that alter the thought process particularly on pharmacy recovery?

[David Rickard:]

Well front store should recover faster than pharmacy, as it always does. The pharmacy customers are stickier. I think we'll also see some difference here between California and the Midwest. The California stores are performing better today, putting some top spin on that is probably a little bit easier proposition than lifting more wobbly trends in the Midwest.

[John Heinbockel:]

Just one final thing on Minute Clinic, this does look to me when you look at the model that this can noticeably move the dial on pharmacy comps in the stores that they are in. I know you have about 1,000 to 1,500 stores. Is that all or could this ultimately be in a lot more, 50% or more of the store base?

[David Rickard:]

Minute Clinic is not a scrip play. It is a health service to our customers, and as such we are not going to have it in comp store sales. Now if we end up with tag along business because people are in the stores for other reasons, that will be helpful. But this is primarily a matter of putting an additional health credential in the CVS store to service customers better.

[John Heinbockel:]

Thanks.

[Operator:]

Our next question comes from Meredith Adler - Lehman Brothers.

[Meredith Adler:]

A couple quick questions. Is it fair to assume that as you remodel stores at Sav-On and Osco the marketing will be done on a market-by-market basis the way you did it with Eckerd?

[David Rickard:]

Yes, it will be a similar approach. It seems to have worked.

[Meredith Adler:]

I don't know whether you guys are prepared to talk about this, but is there something else like Minute Clinic that makes sense to add to your stores? Have you looked at putting in labs at all? Is that something you're thinking about? And is there anything else in the world of health care that you see as a logical extension of your existing PBM and specialty pharmacy business?

[David Rickard:]

There really isn't anything, Meredith, that I can think of that is like Minute Clinic, in terms of a pretty obvious major opportunity from an add-on service. You know, some retailers in the global marketplace have tried a host of different services with, at best, mixed success. So there aren't a lot of models of people who have done lab work or various kinds of personal services being profitable and it working out. I think we are going to maximize the opportunity with Minute Clinic and be happy with that.

[Meredith Adler:]

And outside of the store level? Any comments at all about what is a logical extension to your existing health care businesses?

[David Rickard:]

I am going to leave that to our strategic planners. There is nothing on the horizon right now.

[Meredith Adler:]

I have just one final question; we have definitely seen a pickup in pharmacy scrip volumes, really across the board in the industry. Can you, do you have any sense of what is driving that? Is it all Part D, or are there other things going on that seem to be improving scrip volumes?

[David Rickard:]

Yes, I think it is a majority Part D. When new populations get new coverage they tend to increase utilization fairly dramatically, and I think maybe that is what's going on here. We also see the results of service improvements in CVS and therefore we're seeing some share gains. But there's nothing in terms of allergy or flu that would explain an overall pickup.

[Operator:]

Our next question comes from John Ransom - Raymond James.

[John Ransom:]

As you look out for the margins in PharmaCare, what will you see this quarter representative of what we will see? Or when you roll in Chrysler is that going to have a dampening effect? Thanks.

[David Rickard:]

The margins that we achieved in the second quarter this year are very, very good versus history in the PharmaCare business, so we're very pleased with these margins. Whether we will repeat exactly at this level I don't know, but I will say that so long as the Medicare Part D business is roughly the size that it is today, assuming that each of the businesses within PharmaCare continues to operate as they are operating, there is no reason that we shouldn't see operating margins pretty close to where they are now, at least for the present. We had expected, as you recall, that we would see a decrease in their operating margins based on Medicare Part D, because we thought it was going to be a much larger business than it turned out to be.

[John Ransom:]

I know you went over this and you talked faster than I could type but, could you review again just the two or three drivers, it is a fairly sharp sequential decrease in earnings. I know you get a full quarter obviously of Albertsons in there, but other than the ABS dilution what would you say are the two or three main drivers for the sequential earnings outlook for the third quarter? Thanks.

[David Rickard:]

The Albertsons dilution, and I think I said that the expectation is for another $0.850 to $0.105 per share over the balance of the year, but that will be more than half in the third quarter. It will be weighted to the third quarter. In addition to that, the other sort of unusual thing is the adoption of 123 R which is hitting that for another $0.01. So if you set those aside the year-to-year trends are not bad, and certainly consistent with a spectacular year.

[John Ransom:]

So ABS may be $0.05 or $0.06 and another $0.01 for 123 R, so maybe $0.06 or $0.07 would be just the effect of those two factors, is the way to think about it?

[David Rickard:]

Yes, and put that on top of a $0.30 base and you're looking at numbers over 20%.

[John Ransom:]

With third quarter as some of these new generics come in, particularly we are thinking Zocor, is that going to have a noticeable effect on both comps and earnings? I mean comps being a little softer but earnings being a little bit higher or is one drug not enough to move the needle?

[David Rickard:]

I think we are anticipating favorable economics around that. Is it going to be individually enough to be meaningful? Probably not. But in combination with others that are coming alongside it, certainly it is a big influence on what we are forecasting.

[John Ransom:]

Okay. Thanks very much.

[Operator:]

Our next question comes from Mark Wiltamuth - Morgan Stanley.

[Mark Wiltamuth:]

Good morning. I wanted to dig in a little bit on your 90-day retail volumes. With many of these new Medicare programs accepting the 90-day retail and some of your new larger wins on the PharmaCare side, I would think your 90-day retail volumes are growing. If you could just give us maybe a percentage of your total scrip volumes or maybe the percentage of total sales.

[David Rickard:]

We actually don't break that out, Mark. I will say that it is fairly small. It is less than 5%, and it is growing.

[Mark Wiltamuth:]

Can you give as an update on the process on determining what the average manufacturing price is in terms of disclosing that on the websites with the new Medicaid legislation?

[David Rickard:]

Again, we are anxiously awaiting and we are in contact with CMS both directly and through the NACDS, our trade association. But at this point there isn't any further information on that. I don't know when anything is going to be put out, and we certainly at this point don't know the definition that they are going to finally settle on. So I'm sorry, I just don't have information on that.

[Mark Wiltamuth:]

Okay, and just on Medicare Part D, you've got a rising volume story here. Has it been enough to offset the margin drag from the dual eligibles yet?

[David Rickard:]

No, it hasn't, but I think we are still fairly early days here. This population will learn to work with this new program and volumes will grow. So we are on track with where we thought we would be, let's put it that way.

[Mark Wiltamuth:]

Thank you.

[Operator:]

Our next question comes from David Magee - SunTrust Robinson Humphrey.

[David Magee:]

Good quarter. A couple of quick questions. One is as we look at the Minute Clinic's business and the rationale behind that, I guess there may be some pressure to do that concept because others are doing it, as well at retail. Can we get any comfort that the productivity of that space, the profitability of the space would be equal to what you had in that area within the store, so it is seen as an opportunity above and beyond just the defensive aspect of it?

[David Rickard:]

Yes, it will be profitable business. The model has been logically laid out and those stores that today are over two years old are bearing out the model. We are talking about 100 to 150 square feet, so it's not going to be a major change to the economics of the store. But with CVS being first to market in the markets that we've entered I think we are going to establish ourselves as the company people think of for their total health care needs. But there is no reason to think that this will be less productive than the space today.

[David Magee:]

Secondly, as we look at the generic business over the next couple years, is there anything happening now that gives you any pause with regard to the expected profitability of that business relative to history?

[David Rickard:]

Well, it's always a negotiated thing, and has been and will be so we'll see. It takes pretty good management every day to get good margins in this business. Obviously the Medicaid change, the rate change is going to potentially be damaging beginning in 2007. So we'll just have to keep working away at it.

[David Magee:]

But no major change here in thinking regarding the non-Medicaid business on the generic side?

[David Rickard:]

No, nothing changes our thinking in any kind of structural way. On the matter of Medicaid, I should mention that Louisiana has actually passed legislation now to increase the dispensing fee to a level which will enable us to deliver that service even with the reduced federal reimbursement rates. So they are the first state, and it is good to see, we hope that is the beginning of a trend.

[David Magee:]

Thank you, Dave.

[Operator:]

Our next question comes from Ed Kelly - Credit Suisse.

[Ed Kelly:]

Good morning. Congratulations on a good quarter. A couple questions for you on the guidance. If I think about what you've said in terms of the third quarter I get the impression that dilution from Sav-On may be more in the $0.06 to $0.07 range than the $0.05 to $0.06 range. Is that a fair assessment?

[David Rickard:]

Ed, I am not going to give you that. We are not going to break it out. I will say it is more than half of the anticipated dilution for the balance of the year.

[Ed Kelly:]

Then in thinking about the full-year number which it looks like you brought up in line with the upside in the second quarter -- which I guess would imply that your expectations for the second half remain unchanged. Is that just because you don't see a reason now to bring the second half up, despite the fact the second quarter was better than what you had planned?

[David Rickard:]

We brought the bottom of the range up $0.04 and the top of the range up $0.02 having beat the quarter by about a $0.01. So I would argue that we've done a little more than that. We are quite optimistic about the year. We're happy with what we've got behind us and looking forward to what is in prospect.

[Ed Kelly:]

Lastly for you, you did mention that you see a little bit more room for sales and profit improvement at Sav-On. Could you just go into a little bit more detail in terms of why that is?

[David Rickard:]

Certainly on the sales side we have a bigger opportunity than we thought we would have in the Midwest. Also initial consumer feedback in Southern California market and some of the Southwestern markets is stronger than we thought it would be. So I think there is a sales opportunity there. We also have obviously the ExtraCare card and our private label products that are blossoming these days. We will put emphasis on beauty and health and that traditionally has given us good results. We have our various systems that I talked about that we will put in place which lead to convenience for customers and therefore CVS easy conditions. We have found that that will be more of a difference than we originally thought. Our core categories are performing well across the chain right now. No reason to think that they won't in these new stores, and there is, we believe, a greater opportunity for SKU optimization than we initially thought. Now still early days, and we will work through all those things as time goes on. In terms of profitability, again as one of the earlier callers talked about, there is a little more shrink opportunity than we thought initially there might be. We have found already purchasing synergies that are greater than we initially planned on. I talked about that back in the May meeting. So we are more bullish about this in the medium term than we originally were.

[Ed Kelly:]

Is some of this increase bullishness even post what you thought back at the May meeting?

[David Rickard:]

Sure.

[Ed Kelly:]

All right, great. Thanks, Dave.

[Operator:]

Our next question comes from Scott Mushkin - Banc of America Securities.

[Scott Mushkin:]

I just wanted to ask a question about the Minute Clinic. It is my understanding there are some issues in certain states regarding corporations and scrip writing in that type of thing. I wanted to understand a little bit about California, it is one of the states I hear that they have certain rules that you may have to work around.

[David Rickard:]

There are no showstoppers, but different states do have different regulations and that can affect, for example, whether we directly employ the nurse practitioners or whether they are employed by someone else and we buy the service, that kind of thing. But at this point there are no states that I know of where we are going to have an inability to operate. It just would be the legal form we use.

[Scott Mushkin:]

Would California be one of the states you would target, since you have a little more square footage out there, or you are not really to that point yet?

[David Rickard:]

Well, we haven't started there, but certainly that is a huge opportunity.

[Scott Mushkin:]

Just going getting back to the last question on Sav-On Osco, we did a tour down in Southern California and came away and we did some research thinking you guys have a huge opportunity down there in sales per square foot and also maybe margins. As you guys have the asset value figures available to you and there seems to be a lot of work on the remerchandising front, too, I just wanted to know where you are in that process. I know you said you'd started it, but is there a lot more to be done there?

[David Rickard:]

Well first of all, I wouldn't disagree with you. There is opportunity there both on the sales side and on the margin side. We will be getting at it as quickly as we can. I gave you the rough timetable overall. Obviously Southern California is a priority market for us, so we will move as quickly as we can reasonably to get that opportunity moving in the right direction. But the timetable, here we are in August. We're probably talking later part of this year before we are really doing what we would like to be doing in Southern California. It just takes a little bit of time.

[Scott Mushkin:]

Do you think it is going to take you longer than you thought to clear out some of that merchandise? We saw glass figurines and small appliances, I mean that stuff I assume is all going to go, right?

[David Rickard:]

I hope you bought some.

[Scott Mushkin:]

I have a little glass forest.

[David Rickard:]

We're on pace in Southern California. I can't tell you specifically when glass figurines will change, but we're on pace to where we wanted to be in Southern California. I am going to take one more question.

[Operator:]

Our final question comes from Bob Summers - Bear Stearns.

[Robert Summers:]

On the Minute Clinic would it be reasonable to expect that as you get into the recently acquired stores there, as you touch them this would be a really add on and that is the vehicle to rapidly expand the footprint?

[David Rickard:]

Well, I think that we are thinking about the Minute Clinic expansion more from the standpoint of market opportunity than which kind of store it goes into. The markets are prioritized based on population and need. So yes, we will put Minute Clinic in some of the new stores, and we will expand Minute Clinics in some core CVS stores. But it is based on a market assessment more so than a need to fill space in those stores.

[Robert Summers:]

Separately just on the gross margin, if you listed the sources of the expansion in order of magnitude, the generics you listed; would you expect that to move up? The margin expansion that you picked up in general pharma store margin productivity, along with the favorable mix, would you expect that to be retained?

[David Rickard:]

What I try to do is mention the most important factors in margin change, and we don't break them out. We don't give you the quantification of each one. Therefore the order in which I present them isn't necessarily the order of their importance. But having said that, would I expect mix change and generics to be important features going forward? I certainly would.

[Robert Summers:]

Thanks.

[David Rickard:]

Thank you very much.

[Operator:]

We have reached the end of the allotted time for questions and answers. Are there any closing remarks?

[Nancy Christal:]

No thanks. We're all set.

[Operator:]

Thank you ladies and gentlemen. This concludes today's conference call. You may now disconnect.