Ladies and gentlemen, thank you for standing by. Welcome to the CVS Health Q1 Earnings Call. During the presentation all participants will be in a listen-only mode. Afterwards, we will conduct the question-and-answer session. As a reminder, the call is being recorded Tuesday, May 3, 2016.

And I'd now like to turn the call over to Nancy Christal, Senior Vice President of Investor Relations. Please go ahead..

Thank you, James. Good morning, everyone and thanks for joining us. I'm here this morning with Larry Merlo, President and CEO; and Dave Denton, Executive Vice President and CFO.

John Roberts, President of CVS Caremark; and Helena Foulkes, President of CVS Pharmacy, are also with us today and will participate in the question-and-answer session following our prepared remarks. During the Q&A, please limit yourself to no more than one question with a quick follow up so we can provide more people a chance to ask their questions.

Please note that we posted a slide presentation on our website before the call. It summarizes the information in our prepared remarks as well as some additional facts and figures regarding our operating performance and guidance. Later this afternoon, we'll be filing our Form 10-Q and it will also be available on our website at that time.

In addition, note that during today's presentation, we'll make forward-looking statements within the meaning of the Federal Securities Laws. By their nature, all forward-looking statements involve risks and uncertainties.

Actual results may differ materially from those contemplated by the forward-looking statements for a number of reasons as described in our SEC filings, including the risk factor section and cautionary statement disclosures in those filings.

During this call, we'll use some non-GAAP financial measures when talking about our company's performance, including free cash flow and adjusted EPS. In accordance with SEC regulations, you can find the reconciliation of these non-GAAP items 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. And now, I'll turn this over to Larry Merlo.

Well, thanks Nancy. Good morning, everyone, and thanks for joining us to hear about the solid first quarter results we posted today. Adjusted earnings per share increased 4% to $1.18, that's $0.01 above the high end of our guidance. And total company revenues increased a very healthy 19%, also above our high-end guidance number.

Excluding acquisition-related integration costs and the true-up of a legal charge, operating profit increased 5% enterprise-wide, with operating profit in the Retail/Long Term Care segment in line with our expectations, and operating profit in the PBM notably exceeding expectations.

We generated $1.8 billion of free cash during the quarter and continued to return significant value to our shareholders through both dividends and share repurchases.

Now it's still early in the year, so we are maintaining our adjusted EPS guidance range that we provided to you at our December Analyst Day, and Dave will get into the details of our results and guidance in his remarks. So let me turn to the business update, and I'll start with the PBM selling season.

Since our last update, the expected revenue impact for 2016 has grown. With gross new business at $15.2 billion, net new business of $13.1 billion, both up about $400 million from our last update. And the vast majority of this increase relates to a new health plan client, which will increase our revenues in both 2016 and 2017.

We also closed out the 16th selling season with the retention rate of 97.3%. Now, turning to the 2017 selling season, it's early, but we are off to a very good start. To-date, we have completed just over a third of our client renewals, which is pretty typical for this time of year.

As for new business, our integrated model continues to resonate strongly and we've already had some nice wins. Prospective clients value our strong service and execution, competitive pricing, unmatched products and services, along with our ability to meet their unique needs.

Now many of you've asked about the magnitude of the 2017 selling season, and at this point we are seeing more RFPs and potential revenues in the marketplace than we did at the same time last year. But keep in mind that it ebbs and flows throughout the season, and some of that could simply be timing.

Now, given that it's still early and consistent with our past practices, we will provide a quantitative update on our next earnings call once we have a more complete picture of the selling season.

Now, we held our client forum in late March, which was attended by about 900 people, and clients acknowledged that their top concern is cost management, with service running a close second. And I'm pleased to report that we have been able to deliver on both fronts.

Now in this environment of rising healthcare costs, clients are looking to us for proactive cost management solutions that anticipate market changes that impact trend. And they are adopting more aggressive strategies, particularly formulary design and specialty management, to mitigate these trend drivers.

Now, we believe we are offering our clients the most comprehensive suite of formulary choices to achieve their savings goals, while addressing member impact and transition to new therapies.

In addition, specialty drug management has been emphasized in the plan design elections, and clients are looking for solutions for managing specialty in both the pharmacy and the medical benefits.

Among our unique specialty management programs, we are seeing a growing interest in our infusion and site-of-care services as well as our medical claims management services. In addition, innovations in specialty include indication-specific pricing where the cost to the payer is aligned with a drug's effectiveness for a specific indication.

In the first quarter, specialty revenues increased 23%, and our volumes continued to outpace the market. So through our unique suite of specialty capabilities, we remain highly focused on helping our clients manage costs and improve outcomes.

Now let me turn to the Retail/Long Term Care segment, and I'll start with an update on the integrations of Target and Omnicare.

The integration of the acquired Target pharmacies and clinics is proceeding according to plan, and as of the end of April about half of the 1,670 acquired pharmacies have been successfully converted to the CVS Pharmacy brand and systems. As planned, we expect that all store conversions will be completed by the end of this summer.

And as the stores are converted and rebranded, we are launching our additional core pharmacy offerings, and these include Specialty Connect, ExtraCare Pharmacy Rewards, and our digital tools, and this is in addition to Maintenance Choice, which has been available since the transaction closed.

So we're pleased with our early progress and remain very enthusiastic about this opportunity to drive growth. Turning to Omnicare, the Long-term Care Pharmacy business performed in line with our expectations, as we benefited from some of the anticipated costs and sourcing synergies.

Currently, we are working to combine operational infrastructures and further develop programs to improve work-streams and enhance service delivery, and we're on track to complete the vast majority of the Omnicare integration activities by year end. Now, in addition to the integration work, we have several initiatives underway.

We piloted and have already rolled out the use of CVS pharmacies as an extension of the Omnicare pharmacies to speed the delivery of first fills or emergency order prescriptions in the skilled nursing facilities.

We're also currently piloting an integrated service offering to the assisted and independent-living communities where we can offer residents enhanced medication delivery options based on their preference and acuity level, all supported by our high-touch patient care teams.

And with a targeted marketing approach that focuses on when people enter these facilities, along with our name-brand recognition, we are confident that we can increase our penetration in these segments. And pending the pilot results, this program will begin to roll out later this year.

So with the combination of CVS and Omnicare, we remain very excited about our enhanced ability to serve seniors along their continuum of care.

Now, moving on to first quarter results in the retail business, total same-store sales increased 4.2% and were positively affected by approximately 125 basis points due to the additional day related to leap year. Pharmacy same-store sales increased 5.5%.

This was negatively impacted by approximately 360 basis points due to recent generic introductions and about 50 basis points related to the softer flu season. And the flu was pretty soft in the first two months of the quarter, but strong in March, somewhat mitigating the quarterly impact.

Pharmacy comps were positively impacted by about 130 basis points related to the extra leap day, and pharmacy same-store prescription volumes increased 5.9% on a 30-day equivalent basis, continuing to outperform overall market growth.

And our retail pharmacy market share on a 30-day equivalent basis was 23.9% in Q1, and that's up about 245 basis points versus the same quarter a year ago. And while the primary driver of share growth is the addition of the Target pharmacies, we continued to experience strong organic share growth as well.

Now an important driver of script growth has been our clinical outreach programs, which have allowed us to continue to improve adherence and provide patients helpful reminders. Part of the strength of these programs has been the integration of our digital tools.

And today, nearly 19 million people receive text alerts from CVS on a variety of topics, all of which help to enhance the service experience. Among other recent pharmacy innovations, ScriptSync at Retail is expected to continue to improve medication adherence and patient satisfaction.

Since the launch, more than two-thirds of the patients offered ScriptSync have adopted the service. And with nearly 350,000 patients enrolled in ScriptSync during the first quarter, we now have more than 1 million patients enrolled since its launch in the third quarter of last year.

In the front store business, comps increased 0.7%, and this includes the benefit of the extra day from leap year of approximately 105 basis points, as well as the shift of the Easter holiday from April last year to March this year, positively impacting front store comps by about 80 basis points.

And the negative impact of a late flu season was immaterial to the front store in the quarter. Now, we've continued to pull back on broad-based promotions, which has resulted in fewer visits from lower-value customers.

Front store margins once again increased notably in the quarter, benefiting from these efforts to rationalize our promotional strategies, along with growth in the higher-margin health and beauty businesses. So we continue to test, learn and refine strategies to achieve the optimal balance between traffic and profitable growth.

Now, ExtraCare continues to reward our loyal customers with savings and we continue to leverage our ExtraCare data to create even more relevant and personalized communications.

And we know that our top customers drive a disproportionate amount of our sales and margin, so while store traffic overall is down, our loyal customers are shopping frequently and driving our front store sales and margins. As for store brands, they represented 21.9% of front store sales in the quarter.

That's up 100 basis points from the same quarter last year. And there remain significant opportunities to expand our share of store brand products by building on core equities in health and beauty and seeking opportunistic growth in other areas where we can provide customers a superior value.

Among our recent front store innovations, we recently announced the partnership with Curbside to bring a new level of convenience to our customers. CVS Express is the industry's first retail solution that integrates Curbside's market-leading technology right into the CVS Pharmacy app.

Customers can make mobile, in-app purchases from their local CVS Pharmacy and have the products directly delivered to them when they pull up to the store, all in about an hour with no added costs. This service is currently available in select markets including San Francisco, Charlotte, and Atlanta.

And pending a successful pilot, our goal is to roll out the program to the majority of our markets later this year. This exciting new initiative really embodies the digital mission of CVS Health to make healthy lifestyles more accessible and convenient for our customers all across the country.

Now turning to store openings, in the first quarter, we opened 24 new stores, relocated 14 others, closed five, resulting in 19 net new stores, and we expect to open about 100 net new stores for the full year.

As for MinuteClinic, the Target integration was completed in 24 clinics, converting them to MinuteClinic's branding, electronic health records, systems and health offerings. And we expect the balance of the clinics to be converted by the end of the summer.

We now operate 1,136 clinics across 33 states plus the District of Columbia and including Target, MinuteClinic's revenues increased 17.7% versus the same quarter last year, despite the mild and late flu season.

Another digital innovation is what we call the hold my place in line online queuing tool that was launched nationally at MinuteClinic in late March, and this tool enhances convenience by allowing patients to view wait times online and hold their place in line through any digital channel.

So MinuteClinic continues to advance in innovative ways to increase convenience and access to care. 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 provide a detailed review of first quarter results, followed briefly with an update on our guidance. And as always, I'll start first with a summary of the various ways we continue to enhance shareholder value through our capital allocation program.

Throughout the quarter, our quarterly cash dividend increased by 21% per share, and we paid approximately $470 million in dividends. Our dividend payout ratio currently stands at 31.9%, and we remain well on track to achieve our target of 35% by 2018. In addition, we have continued to repurchase our shares.

In the first quarter, we repurchased approximately 22.4 million shares for $2.1 billion, or approximately $98.52 per share. So between dividends and share repurchases, we've returned approximately $2.5 billion to our shareholders in the first quarter alone.

Looking forward to remainder of the year, we continue to expect to repurchase an additional $1.8 billion worth of our stock, completing the planned $4 billion in repurchases for the full year. Our expectation is that we'll return more than $5 billion to our shareholders in 2016 through a combination of both dividends and share repurchases.

As Larry mentioned, we generated approximately $1.8 billion of free cash in the first quarter, and we continue to expect to produce free cash of between $5.3 billion and $5.6 billion this year. Turning to the income statement, adjusted earnings per share came in at $1.18 per share, $0.01 above the top our guidance range and 4% over LY.

GAAP-diluted EPS was $1.04 per share. The Retail/Long Term Care segment delivered solid earnings within expectations, while the PBM segment posted profit growth above the high end of our guidance. The outperformance in the quarter was primarily driven by stronger-than-expected volumes and better purchasing economics within the PBM.

With that, let me quickly walk down the P&L. On a consolidated basis, revenues in the first quarter increased 18.9% to $43.2 billion, and the PBM segment net revenues increased 20.5% to $28.8 billion.

Given the large amount of new business that came on board on 1/1, this growth is attributable to the increased volume in pharmacy network claims, as well as growth in specialty pharmacy. Overall, PBM adjusted claims grew 19.4% in the quarter, partially offsetting the sales growth was 170 basis point increase in our generic dispensing rate to 85.2%.

In our Retail/Long Term Care business, revenues increased 18.6% in the quarter to $20.1 billion, driven primarily by the addition of Omnicare and the Target pharmacies. Solid pharmacy same-store sales contributed as well.

This revenue growth was just below our guidance range, while script unit growth remained strong, the mix of branded drugs differed slightly from our plan, resulting in a lower average script price. To be clear, we have not seen a change in the level of branded drug inflation, it was simply mix that affected the weighted average script price.

In addition, front store revenues were impacted by our promotional strategies in our non-health and beauty categories, as we gave up some lower-value customer traffic to drive an increasingly profitable front store sales mix. GDR increased by approximately 125 basis points to 85.7%.

Turning to gross margin, operating expenses, operating profit and the tax rate, the numbers, I'll cite, exclude non-GAAP adjustments, mainly amortization, acquisition-related costs, and a legal charge where applicable. Keep in mind that our guidance for the quarter also excluded these items.

We reported gross margin of 15.6% for the consolidated company in the quarter, a contraction of approximately 135 basis points compared to Q1 2015. Gross profit dollars increased a healthy 9.5%, in line with our expectations. Within the PBM segment, gross margins contracted by approximately 45 basis points versus Q1 of 2015 to 3.8%.

Primarily due to the mix of new business and price compression, partially offset by the GDR improvement and favorable purchasing economics. However, gross profit dollars increased 7.4% year-over-year, due in part to strong volumes, specialty pharmacy, the improvement in GDR, and again favorable purchasing economics.

Partially offsetting these drivers was continued price compression. Gross profit dollars increased approximately 10% year-over-year in the Retail/Long Term Care segment, while gross margin declined approximately 225 basis points to 29%.

Now about 40% of the decline in the gross margin rate was mix driven, due to the inclusion of the Omnicare and Target businesses that we acquired. The decline in gross margin was also due to continued reimbursement pressures.

Gross margin was positively impacted by the increase in GDR, as well as increased front store margins due to our continued rationalization of our promotional strategies and improved mix of the products that we sold. Turning to expenses, we saw strong improvement in total operating expenses as a percent of revenues from Q1 of 2015 to 10.4%.

The PBM segment's SG&A rate improved about 10 basis points to 1.1%, benefiting from the additional sales leverage. SG&A as a percent of sales in the Retail/Long Term Care segment improved significantly by approximately 120 basis points to 19.9%.

This too was driven by leverage from revenue growth, as well as the addition of the Omnicare business, which carries a lower SG&A relative to sales. Within the Corporate segment, expenses were up approximately $20 million to $209 million, slightly better than expectations.

Operating margin for the total enterprise decreased approximately 70 basis points in the quarter to 5.2%. Operating margin in the PBM decreased approximately 35 basis points to 2.7%, while operating margin at Retail/Long Term Care decreased approximately 105 basis points to 9.1%.

For the quarter, operating profit growth in each segment was in line with or better than expectations, with the PBM increasing 6.6% and Retail/Long Term Care growing 6.4%. Going below the line on the consolidated income statement, net interest expense in the quarter increased approximately $149 million from LY to $283 million.

This is due primarily to the debt associated with the acquisitions that we took on last year. Our effective tax rate in the quarter was 39.3%, and our weighted average share count was 1.1 billion shares. Now let me update you on our guidance.

I'll focus on the highlights and you can find the additional details of our guidance in the slide presentation that we posted on our website earlier his morning. As Larry said, we are confirming our 2016 adjusted earnings per share guidance range of $5.73 to $5.88, which reflects strong year-over-year growth of 11% to 14%.

We are very pleased with our strong performance year-to-date and it's still early in the year. With respect to GAAP diluted EPS, we are revising our full-year guidance to reflect the integration costs and the legal charge that we saw in the first quarter, which we explicitly excluded from our initial guidance.

So we now expect GAAP-diluted EPS to be in the range of $5.24 to $5.39. Keep in mind that our GAAP guidance for future periods excludes the impact of acquisition-related integration costs and we will update for these costs that we incur throughout the year.

In the PBM segment, with the better-than-expected increase in network volume from our new business in Q1 expected to flow throughout the full year, we are increasing revenue guidance by 150 basis points to a range of 21.75% to 23.25%. This increase takes into account lower-than-anticipated volumes of the Hep C and PCSK9 therapies.

As a result of this, along with stronger expected purchasing economics, we are narrowing and raising the midpoint of the PBM's operating profit guidance by taking the lower end up 125 basis points, resulting in a new range of 11% to 13.25%.

In the Retail/Long Term Care segment, we are lowering our revenue growth guidance and maintaining our operating profit growth guidance.

The reduction in our revenue growth expectations reflects several factors, including our decision to discontinue certain RxCrossroads programs to more fully align this business with our focus on cost, quality, and access.

Additionally, the reduction in revenue growth reflects the shift in the mix of branded drugs along with the earlier-than-anticipated launch of generic Nasonex, as well as slightly weaker front store sales trends as we continue to execute on our targeted promotional strategies.

We now expect Retail/Long Term Care revenue growth of 13% to 14.25%, a reduction of 125 basis points on both ends. And we now expect total cost of 1.75% to 3%, while continuing to expect script comps of 3.5% to 4.5%.

Despite the revenue change, we remain confident in our prior operating profit expectations, given the immaterial impact the changes I noted are expected to have on profitability. Consolidated net revenue growth is now expected to be 17.5% to 19%.

With the increase in network volume and a higher GDR, intercompany revenue eliminations are now expected to be approximately 11.4% of segment revenues. And as the mix of generics increases within our Maintenance Choice product, we expect higher intercompany profit eliminations. This change essentially offsets the improvement in PBM operating profits.

And as I said before, our free cash guidance for the full year remains in the range of $5.3 billion to $5.6 billion. And with that, now let me provide guidance for the second quarter which excludes all acquisition-related integration costs.

We expect adjusted EPS to be in the range of $1.28 to $1.31 per share in the second quarter, reflecting growth of 4.75% to 7.5% versus Q2 of 2015. GAAP-diluted EPS is expected to be in the range of $1.17 to $1.20 per share in the second quarter.

Starting with Analyst Day and continuing over the past several months, we have been highlighting several timing factors that will affect the cadence of profit delivery throughout this year. I want to take a moment and remind you of those factors.

The introduction and timing of break-open in generics, the timing of profitability in our Medicare Part D business, the timing of the benefits from our strategies to drive growth in their front end, and the timing of share repurchases and certain tax benefits were all factors expected to impact the cadence the most.

And while we delivered a strong first quarter slightly above our own expectations, the cadence of profit growth is still expected to be very much back-half weighted. Our EPS guidance for the second quarter is very much in line with our budget and what we said at Analyst Day.

All things considered, we see a ramp-up in growth and we still expect a strong back half of the year. Within the retail segment, we expect revenues to increase 15.5% to 17% versus the second quarter of LY, driven in part by the addition of the acquired businesses.

Adjusted script comps are expected to increase in the range of 3% to 4%, while we expect total same-store sales to be up 1.25% to up 2.5%. The Easter shift out of Q2 is expected to have about a 20 basis point impact on comp growth.

In the PBM business, we expect second quarter revenue growth of between 22% and 23.25%, driven by continued strong growth in both volumes and specialty. Consolidated revenues are expected to grow 18.5% to 20%. We expect retail operating profit to increase 5% to 7% and PBM operating profit to increase 4% to 8% in the second quarter.

Consolidated operating profit is expected to grow 3.75% to 6.5%. In closing, I'm very pleased with our solid first quarter results and remain confident in our full-year outlook. As we noted when we gave guidance at Analyst Day, our growth this year will be back-half weighted and that is playing out just as we anticipated.

We continue to expect to deliver solid growth in our core businesses, along with the anticipated benefits from our acquisitions and more importantly our growth will be very strong at the enterprise level.

This growth will help us maintain and generate substantial free cash flow and we'll continue to execute on our commitment to return significant value to our shareholders through both dividends and share repurchases. And with that, I'll now turn it back over to Larry..

Okay. Thanks, Dave. Again, I think as you heard from Dave and myself, we're off to a solid start in 2016 and our distinctive channel-agnostic solutions are resonating strongly in the market as they continue to control patient and client costs, while improving health outcomes.

And we continue to believe that we have the right strategy for success in this evolving healthcare marketplace. And with that, let's go ahead and open it up for your questions..

Thank you. And our first question is from the line of Peter Costa from Wells Fargo Securities. Please proceed..

Thanks for the question, guys. I'd like to get to understand a little more about the second quarter guidance and some of the factors that you mentioned seem to mostly argue for improving dynamics over the course of the year towards the back half, but yet you showed stronger growth in Q1 relative to what you're sort of projecting for Q2.

Can you help me understand what's making the pressure on Q2 or is it just some earnings move from Q2 into Q1? Help me understand what's going on there..

Yeah, Peter. This is Dave. I would say that our budget and our cadence of profit delivery in Q2 is essentially on plan with what we created at the beginning of the year. There's been no movement from that perspective. Again, all the factors that I cited are really first half versus second half versus first quarter versus second quarter.

So again, our plan remains largely intact. Our EPS guidance for the second quarter is very consistent with our budget and our outlook as we created our plan for 2016..

Okay..

Next question?.

Our next question is from the line of Charles Rhyee from Cowen. Please proceed..

Yes. Thanks for taking the question. I just had a question around the Target stores and what you're seeing in terms of the traffic into the stores now that – in the ones that you've now rebranded in CVS relative to sort of what the volumes they were doing before.

Have we seen a sort of a pickup there? Well, what do you see in terms of traffic around other stores, regular CVS stores outside of the Target areas?.

Well, Charles, I'll start and then I'll flip it over to Helena. But keep in mind that, as I mentioned in our prepared remarks, we're about halfway through the heavy lifting part where we're rebranding the system conversion, everything to create the look and feel of a CVS, along with all the products and services that we offer.

So, as I mentioned earlier, that work won't be done until the end of summer. And I'll flip it over to Helena to pick up from there..

Yeah, I would say we're pleased so far with the performance. I would start, actually, with the fact that we have a retention rate of those Target employees of over 98%. So the first thing we know when customers come into those stores is they want to know that their Target pharmacists are still with them, and so we feel very good about that.

The store conversions are going well, as Larry and Dave said, and our service scores are strong. So we're coming out of these resets feeling good about the service experience. I would say it's too soon to see any impact on script trends. We're continuing to phase in our clinical programs, and we'll see more of that in the second half of the year..

And, Charles, keep in mind that you won't see any broad-based marketing until we've completed the integration activities. So in terms of awareness and all of those things that ultimately drive utilization, you won't see that until the fall timeframe..

Yeah, I just wanted to see what the early kind of signals were, and is the purchasing seamless? Like if someone just bought like a wellness product that might be still under Target? Can they still pay for it at the pharmacy desk?.

Yes, absolutely..

Okay..

It feels very similar to what it was before. We wanted to make sure that those Target guests have a great experience, and I would say our pharmacists in those stores are still out in the aisles and talking to patients and customers and so the feedback so far has been very good..

Great. Thank you..

Our next question is from the line of Robert Jones from Goldman Sachs. Please proceed..

Hi. This is Nathan Rich on for Bob this morning. Dave, I just wanted to go back to your comment on generic Nasonex coming a little bit earlier than expected. And it seems like there's a pretty kind of healthy calendar of new launches coming over the next several months.

Just wanted to ask around the profitability of those launches; is there any reason why the profitability of the new generics that are coming this year would be any different than what we've seen in past years or maybe even a little bit better now that you guys are able to buy through Red Oak?.

Yeah, Nathan. The profitability is, I wouldn't say better or worse, I think it's dependent upon how those products are launched. Many of those products are single-sourced generics and have an exclusivity period typically of several months.

So during that exclusivity period, those products behave more like a branded product versus a break-open generic product. And again, our profits are maximized once those products break open. So if you just look at the cadence of delivery this year, a lot of those products as they come to market are in the exclusivity period..

Okay.

So the break-open period would probably be more kind of late this year and into 2017 for those drugs that are launching?.

That's correct. You would see it happen late in the year, which is part of the cadence of our profit delivery, number one, and you'll see that wrapped into 2017..

Okay, makes sense. And then if I could just ask one follow-up going back to your comments on the selling season. You guys highlighted an increase in RFP activity.

Should we think about this kind of mainly coming from health plans, given where we are in the selling season at this point? And any color on kind of what you think is driving this kind of overall increase in RFP activity his year?.

Yeah, Nathan, this is Jon. So, health plans are pretty much completed. They've made their decisions and we saw similar activity the prior years. So we're in the process of working through employer and government. It's really too early to say whether overall RFP activity is going to be up or it's just the cadence and the timing.

But we feel pretty good about our value prop, and as we're out with clients, our integrated model continues to resonate. And you combine that with our high levels of service, it creates a compelling value proposition. So, as Larry said, we'll give you more details in August on our Q2 earnings call..

Great. Thanks so much..

Our next question is from the line of George Hill from Deutsche Bank. Please proceed..

Good morning, Larry and Dave, and thanks for taking the question.

Maybe just talking about the retail pharmacy business for a second, two questions; first is, can you talk about the demand that you're seeing from the retail pharmacy side as it relates to preferred pharmacy networks and the impact on pricing? And then the second question is, post the close of the Target acquisition, have you guys seen any positive lift on reimbursement rates in the Target pharmacies now that they're owned by you guys?.

Yes, George, it's Larry. I'll start with your first question and in terms of the preferred Med D networks, George, I don't think there's anything new to reference from what we've talked about in the past.

From a contracting perspective, we look at the makeup of the Med D population in terms of the, we call them the choosers versus the low-income subsidies and evaluate potential share shift against margin pressure as a determinant of our desire to participate in the preferred network.

And from a consumer perspective, that carries the fact that the low-income subsidies are not subject to the co-pay differentials that you see in the chooser market and the fact that the Med D plans have a variety of options in terms of what those deltas are.

So, I would say, at this point, we're not seeing anything that would surprise us from those guiding principles that I just referenced..

Larry, I'm sorry if I misspoke. I didn't mean to say Med D, I was thinking more about the commercial book and what's happening in the growth of some of the (39:56) exchange business and the Medicaid business versus Med D. I'm sorry..

I don't know that – George, this is Dave. I don't know if you've seen anything substantially different. The commercial business is probably hasn't adopted, I'll say, a narrow or preferred network as rapidly or as completely as Medicare has.

In the Medicaid market, it's a little bit more narrow network focused and that's really where we as CVS Health from a PBM and a retail and a MinuteClinic perspective can really plugs into these Medicaid programs – managed Medicaid programs in a pretty meaningful way. And so I think it's a little bit of a sweet spot for us right now..

Okay..

And George, on the second question, I'd just simply say that as we think about contracting, our retail pharmacy group is contracting for CVS Pharmacy in totality, which would include the Target pharmacies as well as our Long Term Care pharmacies..

Okay. Thanks for the color..

Thanks..

Our next question is from the line of John Heinbockel from Guggenheim Securities. Please proceed..

Hey, guys. So two things; you said the 40% of the retail margin pressure was the new business mix.

I don't think the other 60% was reimbursement pressure or was that right? And just how would you characterize the reimbursement compression say versus a year ago?.

Yeah, John, this is Dave. As I said, obviously 40% of the downdraft in the margin was related to the mix of the business which we acquired..

Right..

The remainder of that is largely the effect of the reimbursement pressure within the marketplace. So that is in fact the case.

You think about, we have been focused from a front store perspective on really, I'll say, tailing our promotional strategies to drive improvements in front store margin rate, and we've seen that play out at the – I guess at the detriment of probably some top-line trade off..

And John, keep in mind as you've heard us reference that margin compression in pharmacy is – you really have two drivers behind it. You've got the mix change into some of the lower-margin businesses, principally Medicare and Medicaid.

Again, very productive on top line, okay? And then you have on an apples-to-apples basis just the sheer step-down in profitability. So you've got both of those forces creating some downward pressure..

Okay.

And then secondly, different topic; when you think about creatively other ways for you to work with Target? And you're already obviously collaborating a little bit on with respect to the pharmacy, but you think about whether it be HBA, OTC, loyalty, are there any other ways creatively to – for you guys to work together, either kind of drive success in pharmacy versus HBA or is that – it really will end up being limited to pharmacy alone?.

Well, this is Helena. It's something we talked a lot about with the Target folks, and essentially what we've agreed to is for right now all hands on deck and making sure that the pharmacy conversion goes really well. And as I said before, we're happy with where we are.

There's a lot of work that goes into converting all of those pharmacies over and having a great experience. But we certainly think there are other opportunities for both of us when we think about, for example, loyalty, we think about different categories in the front where we have relative strength or Target has relative strength.

And we haven't gone into the specifics of those because again we wanted to focus on the pharmacy, but those things could come down the road..

Okay. Thank you..

Thanks, John..

Our next question is from the line of Ricky Goldwasser from Morgan Stanley. Please proceed..

Yeah, hi. Good morning. When you talked about kind of like the top line results in the retail segment, you talked a lot about kind of like the generic comps. But was wondering what you're seeing in the marketplace in terms of branded inflation, because there's some conflicting data points in the marketplace that we are hearing. That's one.

And second of all, from your seat and all this data you see both kind of like the PBM side and the retail, so you have a very unique perspective.

How do you think – what do you think we'll see in terms of just kind of like the branded price increases in the environment for the remainder of the year? And maybe even into 2017 in light of the controversy and the very public debate around the gross versus net trend..

Yeah, Ricky, it's Larry. I mean on the branded side, we're really not seeing anything out of the norm from – I mean, if you go back and look historically, this industry has seen branded inflation in the low-to-mid double digits, and so far this year, we're not seeing anything different than that.

And really don't anticipate seeing anything different based on our view of the marketplace. I think what Dave was alluding to in his remarks in terms of brand mix that, again, no change in the inflation or in the assumptions that we've made around that.

And we may be seeing the impact of consumer-directed health plans in terms of driving some mix changes within brand where you can say that the patient is becoming more of a payer until they reach their out of pocket max deductibles. And this is really driving patients to lower cost brand options where a generic is not available.

And that's why what we see is simply an impact on revenue, but not an impact on prescription unit growth or profitability..

Okay.

And do you expect any kind of like changes in the gross product versus rebate dynamic on more of the longer term aspect?.

Well, Ricky, this is Dave.

I do believe as you've seen over the past several years, Jon and his team in the PBM have really introduced a pretty comprehensive formulary management strategy, and with the exclusionary strategy, you've seen us improve our rebates and therefore essentially as you know the vast majority of those rebates go back to our clients in the form of a buy down in cost, and I think we will continue to innovate in that category and that process to continue to drive value for our clients..

And Ricky, just to add to this, this is Jon. I mean obviously we've demonstrated we can move market share based on access when we introduced our formulary strategy back in 2012. That has created a significant amount of value.

But we've also evolved this strategy to begin to negotiate price protection so that as manufacturers raise prices, a portion of that comes back to our clients in the form of a rebate. And I think some of the next things we're beginning to see is contracting by disease state.

So, as an example, in the autoimmune category, we might have one rate for drugs that treat rheumatoid arthritis where you have 13 drugs that can treat that condition and a different rate for those same drugs that are prescribed for Crohn's disease where there is only four drugs in that category. So – and we see similar opportunities in oncology.

So I think we're going to continue to see these negotiations and opportunities evolve, and we believe we're very innovative in this area and actually leading the industry..

Thank you..

Our next question is from the line of Scott Mushkin from Wolfe Research. Please proceed..

Hey. Good morning, everyone. This is Mike Otway in for Scott. Thank you for taking the questions. I guess first question, I think mail choice was up 6.6% in the quarter, driven mostly by Maintenance Choice.

Are you guys seeing some initial success with the health plan clients in adoption of the company's proprietary programs like Maintenance Choice or Pharmacy Advisor? I think, Larry, you said the new business won since the last update was a health plan.

I'm just wondering what's driving that and what are you guys seeing?.

Yeah, Mike, it's Larry. I'll start and then Jon I'm sure will jump in. But if you go back and look at the new business, almost half of the new business adopted one of the Maintenance Choice programs.

And I think consistent with what we've talked about in the past, we have begun to see some uptake of Maintenance Choice in the health plan segment, recognizing that that lifecycle is longer for the reasons that we've got to sell those programs through the sales organization and I think Jon's team has done a good job in terms of creating more alignment across all the stakeholders so that we have shared goals and incentives in that regard..

And then, Mike, this is Jon. So we have begun to see health plans adopt this. I would say it's still slower than what we would like to see, so we think there continues to be significant opportunity to see even more adoption and a good place for health plans to start is Maintenance Choice 2.0 that has been very successful in the marketplace.

And as clients get experience with Maintenance Choice 2.0, we see them move up to the Maintenance Choice 1.0 product that moves more the volume through the Maintenance Choice channel. So we're still very bullish on this plan design..

Okay. That's helpful. Thank you both. And I guess the next one probably for Helena. It sounds like the front end traffic is negative in the quarter and you guys pulled back on some promotions, targeted promotions. It's clearly a much smaller portion of the overall business these days, but to some extent it's how consumers see CVS.

You guys have invested in Curbside, but Helena can you talk about the longer-term strategy in the front end to make sure that you guys are still continuing to stay relevant given things like online incursion and I guess ultimately what's your vision for how you want consumers to interact with the front end and with CVS?.

Yeah, it's a great question, something we spent a lot of time thinking about because ultimately we see the role of the front store as essentially a door into the pharmacy. This is where consumers get connected to CVS, and ultimately over time, they start using us for prescription.

So it's a very important part of the business is consumers think about us. And it's why we've been shifting more and more of our focus towards health and beauty. Because when our customers think about healthcare, obviously they think pharmacy first, but they think health and beauty.

And so we're in the process essentially of putting more and more effort around the health and beauty businesses and our top customers. Those have been the thrust of the two places we spent time and energy. And I'm actually quite pleased with where we are.

And if you look at our health and beauty category, for example, we continue to grow share across the marketplace in health and beauty.

Now, where we're pulling back are the categories Dave was speaking to earlier, it's the promotional business where it might be edibles or general merchandise, not categories we need to win in from the consumers' perspective as we think about healthcare. So I think that piece of it is sort of generally how we're thinking about the role of the front.

Connected to that is the role of ExtraCare and loyalty and personalization. So we know 30% of our customers drive 80% of our sales and profit. Again, we're focused on those customers, giving them more value, more reasons to shop. And we're very happy so far. We continue to see more trips and more sales and more profit from those customer segments.

And then as you said, we certainly are looking very hard at the world of digital. We know that the consumer is living in an omni-channel world and we need to be relevant. We're excited about Curbside because we thought to ourselves we don't need to out-Amazon Amazon.

We certainly have an e-commerce play, but we really wanted to take advantage of 7,800 convenient locations and the fact that when the consumer needs health and beauty aid products or some milk on the way home from work or diapers, we're the convenient go-to location for her.

So the fact that she can order online, let's say, from the office and pick it up on the way home and not have to get out of her car, we think is a very big winning proposition. And as Larry said, we're still in the early stages of testing that in some markets, but the research we've done with consumers is really quite encouraging..

And just one other point to emphasize that when you drop the two acquisitions into our revenue denominator, the front now represents about 11% of our revenues. So it really affords us the opportunity to think about the front store in a very differentiated way with a different set of goals and objectives as Helena outlined..

That's really helpful. I appreciate the time. Thank you..

Our next question is from the line of Ross Muken from Evercore ISI. Please proceed..

Good morning, gentlemen.

So, as we think about just going back to the selling season, are you seeing any change in competitiveness within certain segments whether it be health plan or government or employer or any notable trends that are different year-on-year relative to benefit design requests or interest in one service versus another or some new program you have that's maybe garnering more traction? I'm just trying to get a feel for how all of the RFP interest in sort of your recent success can kind of translate to the ultimate outcome here?.

Ross, it's Larry. I'll start and then flip it over to Jon. But I'll just share my observation from our client forum an if you go back to our Analyst Day and remember the tool that Jon demoed, our RX insights tool that can provide real-time meaningful data for clients in terms of kind of where they're at and what they can do to bend that cost curve.

There was a lot more discussion around that at the client forum. And my observation was a tremendous amount of excitement and enthusiasm in terms of the ability to make that very, very actionable and to serve as a decision tool for payers in terms of the options and choices that they have..

Ross, this is Jon. The other thing I would add is, pharmacy is a meaningful piece of the overall healthcare cost now. So I think what's changed is the C suite is much more involved in the process than what we have seen historically.

And I think what that's translated to is, very focused on cost, very focused on service, and that means that they're looking for a PBM that can implement plan designs and move their members to either new channels or new therapies, so much more of a focus on their members or their employees.

And so as we're out in the marketplace, our integrated assets really position us to work with their employees or their members through all the touch points that we have to communicate and transition them to the new plan design. So this is really resonating I think to an even greater degree today than what we've seen historically.

So I think from a competitive standpoint, not much change in what we've seen historically. But from a capability perspective, people are much more interested in what we can do to help them manage cost and deliver great service to their members..

That's helpful. And just maybe quickly, can you just update us, last year you had a very successful health plan selling season. One of the big focus points is sort of converting some of those new members into the drugstore into a Maintenance Choice-like program.

How does that sort of progress? What are the key sort of benchmarks we should be looking at to sort of judge how much progress you're making there?.

Yeah, well, so if we start with employers, I mean, no surprise there. They continue to move faster to these solutions. We've seen that historically. We continue to see that. I think health plans are much more interested than what we've seen in the past, but they do continue to make decisions at a slower pace.

And they have to sell to their downstream clients. So we've done a lot to work with them on educating them on the programs, as well as incentivizing their teams to sell our products and services to their downstream clients. And it's a win for them if health plans can help their clients save money.

It turns into a retention tool for them if they're doing a good job on their clients' behalf and it's a win for us. As they implement plan designs, we will generally see more share. So, I think the metrics that we've shown at Analyst Day around enterprise share will continue to be how we'll measure our success in this area..

I do think as you think forward and if you look at the contributions from generics, okay, through a payer lens, the fact that they will still contribute but the year-over-year benefit is not going to be what it's been for the last couple years.

I do think it's going to very much align to what Jon was talking about in terms of people looking at some of the things that have been available, but maybe I didn't need to go there because I had another avenue to achieve my objectives.

So I do think that it will be looked at differently as we go forward, and I think the point that was made earlier in terms of we've worked hard to create more alignment around goals and incentives, I think we're in a good place with that in mind..

Makes total sense..

Next question..

Our next question is from the line of Lisa Gill from JPMorgan. Please proceed..

Hi. Thanks very much. I just wanted to follow up as to one of your comments, Larry, where you talked about more aggressive plan design, formulary, et cetera.

Do you see incremental opportunities for mid-year plan design changes where it could actually impact the back half of this year? Or is that what you're seeing that was implemented for 01/01/2016 or is that your future thoughts on 2017?.

Well, Lisa, I'll start and flip it over to Jon. I do think, Lisa, there is the option for that to happen, largely because that design tool that I referenced earlier, it gives people real-time data.

I do think that there are going to be some employer groups that are going to find that probably more challenging or difficult, especially if they have a bargaining unit, as an example. I don't think it would happen there, for obvious reasons.

And I think that would break the paradigm that has existed within employers in terms of they've kind of got their cycle of when information goes out and then it gets updated on an annual basis. But there may be an opportunity to make some subtle changes along the way that I think could be meaningful..

So, one example, Lisa is, particularly around as it pertains to formulary, we now are rolling out programs on a quarterly basis. So in April, we rolled out a dermatological bundle that really focused on UM programs to manage the cost in this area.

So, I would say that helps clients manage their cost much more effectively, and they're willing to do that throughout the year as opposed to just once a year. And we'll continue to look for opportunities not just around therapeutic categories, but even specific drugs that we think we need to take action against.

I think the broader moves, network moves, as an example, will probably still happen on the cadence that we've historically seen them occur. It's a little more disruptive, and they like to do that when they're making all the other changes..

And then I guess my second question would really be around the new Optum Walgreens Boots Alliance offering in the marketplace.

Can you just comment, Jon, do you think that's going to have any impact this year's selling season, them trying to replicate or emulate something that you have at CVS? And secondly, Helena or Larry, do you see any of that impact in their ability to be able to shift scripts away from your CVS stores?.

Well, Lisa, it's Larry. I'll go ahead and start and then others may jump in. But I think, as you know, this is not the first time that a competitor has tried to create a Maintenance Choice-like program. And we've been able to effectively compete against those programs in the past.

We're still the only ones with a fully integrated product, and you think about that integration, it applies both clinically as well as operationally. And Maintenance Choice is the only 90-day program that is truly channel-agnostic with the ability to realize the same enterprise economics regardless of the channel that the patient chooses.

And our offering is becoming even more relevant with the addition of Target's 1,600 pharmacies into the Maintenance Choice network.

And I guess just one other example of that clinical and operational integration, as you know, as we've talked about Specialty Connect, which is a more recent rollout, we've simply defined that as a Maintenance Choice product for the specialty patients.

So, I think that's another proof point in terms of the real integration that exists that does provide elements of differentiation from those other programs that are attempting to mimic Maintenance Choice..

Great. Thank you..

Thanks, Lisa..

Our next question is from the line of Robert Willoughby from Credit Suisse. Please proceed. Robert Willoughby - Credit Suisse Securities (USA) LLC (Broker) Hi. Just one. Larry or Dave, you mentioned that the CVS retail and mail penetration of the PBM volume had been in the 40% range. It obviously comes down after the big selling season you had last year.

But could you hazard a guess maybe where that stands and how quickly you could ratchet that back up to the 40% range and any longer term target you might have for that metric?.

Yeah, hey, Bob, it's Dave. We'll update that more broadly at Analyst Day coming up in December. I will say that as Jon indicated earlier, clearly we have a lot of programs that have been adopted pretty completely within our employer book, and that continues to resonate. The opportunity we have really is in our health plan book.

And not all health plans are created alike.

Those health plans that are largely Medicare focused will have a different solution set and product offering that we will sell into that group of health plans that will likely not have all the mechanisms to aggressively move share compared to health plans that are more, I'll say, commercially focused that can sell in Maintenance Choice as an example.

So, they will happen over different cadences. I think clearly with the adoption of and the onboarding of a bunch of new clients on 1/1, our first job was to get them onboard, get their service levels at very stable levels, and then work to sell them new programs as we cycle into 2017, so probably more to come on that, Bob.

Robert Willoughby - Credit Suisse Securities (USA) LLC (Broker) And would there be a general rule of thumb I could think about, though, if you win X amount of business one year by the end of year three you'd kind of be at that range or is it just absolutely impossible?.

I think it's impossible and the reason being is each one of those health plans, they have very different business models and they compete in very different business segments. And so again a Medicare dominated health plan, the share is going to move very slowly compared to a commercially dominated health plan.

Robert Willoughby - Credit Suisse Securities (USA) LLC (Broker) Right. Okay. Thank you..

Our next question is from the line of David Larsen from Leerink. Please proceed..

Hey, guys. Congratulations on a good quarter. Can you talk a bit more about your indications pricing capabilities? It sounds to me like that gives you a bit of a head start with this proposed Part B rule that was recently published. And also can you talk about ScriptSync? Exactly what is that and how does that serve your client base? Thank you..

Yes, David, this is Jon. So we're – I talked about the autoimmune opportunity RA for – where there's more drugs that treat that disease state, so more competition, we believe we can get better rebates versus Crohn's disease. I think there are similar opportunities in oncology. So we're still early, but we're working on that.

I think again there's been a lot of talk about outcomes-based contracting. We think that is a good idea, but practically very challenging. So EHRs don't communicate with each other. Members move between health plans. The information often doesn't move with them.

But we believe with the tools and capabilities we have that we're best situated to make progress in this area, and we're continuing to look at it and work it then – and we'll be able to talk more about it we believe on Analyst Day..

And then I'll pick up on ScriptSync.

So this program is really as you can imagine the million people who signed up for it are basically those patients who are filling roughly four prescriptions or more per month, and as we did our research with them, what we saw and heard is their number one pain point is they've got a lot of complexity healthcare wise in their lives.

The pharmacy is a piece, but there's other elements of it. So, they're making lots of trips to the pharmacy and that's hard for many of them. So a big solve for them is consolidating all of it. The way it works is we help those patients, and we line them up to one date per month, which they can come in.

It sounds simple, but as you can imagine with all of the insurance plans out there, we've got to work behind the scenes to get them synced up. So that's sort of the hard part behind the solution from a consumer perspective.

I think what's exciting for both the patients and the plans that we're serving is that ultimately this leads to very high consumer satisfaction and much higher levels of adherence. And that's ultimately the healthcare outcome that we were looking for as we developed ScriptSync..

Great. Thank you..

Our next question is from the line of Steve Halper from FBR. Please proceed..

I appreciate your comments on the Target pharmacies, but one point of clarification.

Would you suggest that the performance of the Target pharmacies at least on a volume perspectives are equal to where they were before the acquisition?.

Steve, I guess you have to look at that based on timing from a seasonal perspective given year-over-year overlap with the flu. I would say we've not seen a material change in the volumes at this point in time absent that..

Of course. Thank you..

Yep..

Next question?.

Our next question is from the line of Mohan Naidu from Oppenheimer. Please proceed..

Thanks for taking my questions. This question maybe is for Jon or Larry.

So given the focus from clients on the costs and an increasing mix of the specialty prescriptions, how are you guys seeing the change in the PBM landscape, especially with the smaller PBMs who presumably cannot impact the specialty drug cost as much as you guys can do? Is this coming up in an ongoing selling season with the clients?.

Well, Mohan, there's no question that size and scale in this business matters probably more today than it ever has, with costs in mind. And I do believe that, as we go through the RFP process, it starts with price and service, and you've got to be right there.

And then we can certainly add to our offering with the differentiation that we provide in the marketplace. So, yeah, I do believe that if it is harder, if one is lacking size and scale to effectively compete..

And then, Mohan, this is Jon. So, clients' biggest concern when they think about cost they're really thinking about specialty. And about half of their specialty spend is in the pharmacy benefit, which PBMs historically have managed.

And the other half of the specialty spend is under the medical benefit, which is not being managed very well today by the health plans. The platforms that they manage specialty medical on just weren't built for managed drugs. So we actually have a capability to manage that benefit across the pharmacy in medical benefit.

And we think about unit cost, Larry talked about that. And so size, scale, and capabilities really make a difference there. And we're seeing specialty drugs come to market and be limited to a few providers. So our capabilities enable us to have access to those limited distribution drugs.

The other side of it is, what can we do clinically to manage the 3% of our clients' patients that are driving 25% of their overall healthcare costs.

And so we've integrated a capability that allows us not to just manage the specialty prescription, but to manage that patient, not just with their specialty condition, but with all their comorbidities and we've demonstrated that we can reduce overall healthcare costs.

So, as we tell that story to clients, it resonates and it's a – I think it's a key decision point for them as they're making a selection in the marketplace..

Thank you so much, Jon and Larry..

Okay. Thank you. And we'll take one more question, please..

And our final question is from the line of Mark Wiltamuth from Jefferies. Please proceed..

Thank you. So wanted to ask a little bit for, Helena, on the front-end margins, do you think there's a case to be made for more margin discipline for the industry in general? You're clearly working a margin strategy here. Walgreens is trying to enhance their margins.

And I'm also just curious if right aid has been behaving any differently while we're waiting for their deal to close?.

Yeah, I think we're seeing a pretty rational marketplace, especially in the drugstore business. We haven't seen any major moves, I would say, the last six months or so. It may be even longer among our key drugstore competitors.

And so I feel like it allows us to continue to focus on what I said before, which is driving profitable growth, focusing on that 30% of our customers where we really are seeing some nice sales and margin growth and being aware of the marketplace, but being rational as you said in terms of our approach here..

And, Mark, probably one thing that is a little different with CVS is just given our tenure and the depth of expertise we have from the loyalty card program, we know who our best customers are. We're engaging with them. And we design strategies that's allowed us to really tailor our market programs and our promotional offers to them.

So we're probably in a different spot than some of the other industry participants at this point in time. I think we have the ability, if you will, and you saw it through this quarter to trade off a little bit of top line, but really focus our promotional dollars on those customers that really matter to drive margin expansion in the front..

And Walgreens is also emphasizing cosmetics and beauty. Do you feel that at all? You mentioned your share is still gaining there.

But have you noticed them changing things and has that affected your sales at all?.

No, I think that we continue to watch them. They're doing a nice job. But it's a big marketplace, and as I said, we're growing share in that category..

Okay. Thank you..

Okay. Everyone, thanks for your time this morning, and again, we appreciate your ongoing interest in CVS Health. And if you have any follow-up questions, you can reach out to Nancy or Mike..

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. Thank you..