CVS Health Corp (CVS) — Q2 2015 Earnings Call Transcript

Thank you, LaTonya. Good morning, everyone, and thanks for joining us. I'm here this morning with Larry Merlo, President and CEO, who'll provide a business update; and Dave Denton, Executive Vice President and CFO, who will review our second quarter results as well as guidance for the third quarter and year. Jon Roberts, President of the PBM; and Helena Foulkes, President of the retail businesses are also with us today and they'll participate in the question-and-answer session following our prepared remarks. Now I have one key date to announce this morning. We plan to host our annual Analyst Day in New York City on the morning of Wednesday, December 16. At that time, you'll have the opportunity to hear from several members of our senior management team, who'll provide 2016 guidance as well as a comprehensive update on our strategies for growth. We plan to email invitations with more specific details later this month, so please save the date. Again, that's Wednesday, December 16, and if you don't receive an invitation by early September and would like to attend, please contact me. Also, please note that we posted a slide presentation on our website just prior to the start of this call. The slides summarize the information you'll hear today as well as some additional facts and figures regarding our operating performance and guidance. Additionally, our Form 10-Q will be filed later this afternoon, and it will be available on our website at that time. Please 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 Factors section and cautionary statement disclosures in those filings. During this call, we'll also 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 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 1 year. And now, I'll turn this over to Larry Merlo.

Well, thanks, Nancy. Good morning, everyone, and thanks for joining us, and I'm very pleased to have the opportunity to discuss the strong second quarter results we posted today. Adjusted earnings per share increased 7.7% to $1.22. That excludes $0.03 of acquisition-related transaction and financing costs, and it's $0.02 above the high end of our guidance range. Operating profit in the retail business declined 1.4%, coming in better than expectations while reflecting the tougher comparison to last year. And operating profit in the PBM increased 7.1%, in line with expectations. We generated $523 million of free cash during the quarter and more than $2.1 billion year-to-date, keeping us on track to achieve our full year free cash flow goal and to continue to return significant value to our shareholders. Now given our outperformance this quarter, along with the previously announced acquisition-related decision to reduce this year's share repurchases by $1 billion, we are, once again, narrowing our guidance range. Excluding acquisition-related transaction and financing costs, we currently expect to achieve adjusted EPS for 2015 of $5.11 to $5.18, and that compares to our previous range of $5.08 to $5.19. And Dave will discuss this guidance in more detail during his financial review. Now let me provide a brief update on the status of our pending acquisitions before reviewing the performance of our business. In May, we announced we entered into an agreement to acquire Omnicare, the leading provider of pharmacy services to long-term care facilities. The Omnicare acquisition provides a new pharmacy dispensing channel for us, enhancing our ability to provide continuity of care for patients as they transition through the healthcare system, and we remain very excited to assume leadership in this adjacent space. Omnicare also has a complementary specialty business that will augment our capabilities. Now as you know, the transaction is subject to approval by Omnicare shareholders as well as other customary closing conditions, including regulatory approval. Now we currently expect the deal to close prior to the end of this year, perhaps as early as the third quarter. However, for financial modeling purposes, we are still assuming the transaction closes near the end of 2015. In June, we announced that we entered into an agreement to acquire Target's more than 1,660 pharmacies and approximately 80 clinics. This transaction enables us to reach more patients. It adds a new retail channel for our unique offerings, and it expands convenient options for consumers. The acquisition will expand our retail presence in new markets and enhance the healthcare experience for Target guests. So we're very excited to be partnering with Target, another iconic brand with complementary strengths and culture. And like the Omnicare deal, this transaction is also subject to customary closing conditions, including necessary regulatory clearance, and the timing of the close of the Target transaction is uncertain as it could fall into 2015 or '16. Now turning to the business update, and I'll start with the 2016 PBM selling season. The marketplace has been active. Overall RFP volume is consistent with last year, and I'm pleased to report that we are having a very successful selling season. Gross wins currently stand at approximately $12 billion, with net new business standing at approximately $11 billion. Now these new business numbers include estimated revenues based on current enrollment from the previously disclosed transition of the Coventry Med D business. These net new numbers do not include any impact from our individual Medicare Part D PDP, which I'll touch on in a few minutes. Now while our win span across client segments, a significant portion is in the health plan segment, demonstrating that our model is resonating strongly in that space. It's also important to note that the gross win revenue estimates for the health plans we've been awarded may be updated as a result of their Med D bid in open enrollment. So the revenue numbers I cited could change a bit based on those results. To date, we have completed nearly 60% of our client renewals for '16, that's pretty typical for this time of the year, and we have seen strong retention. Our specialty pharmacy suite of services continues to gain share. Our differentiated specialty offerings provide a high level of clinical support to patients while allowing us to effectively manage trend for our clients. And with brand price increases and the accelerating growth in specialty, we are finding more clients receptive to our solutions that bend that cost curve. In the second quarter, we continue to grow faster than the market with specialty revenues increasing a healthy 28.4%. Now this growth is very robust and more than doubled the market growth rate, but less than recent quarters as we have cycled the addition of Coram and have seen a flattening in the utilization trend of the new Hep C drugs. Our unique Specialty Connect offering continues to experience strong increases in prescription volumes, along with high satisfaction scores with patients, payers, and providers. And you'll recall that Specialty Connect provides our patients with the choice to receive their specialty scripts either at a CVS pharmacy or from our mail center while receiving the central clinical expertise that leads to better health outcomes no matter which channel they choose. And as a reminder, regardless of the delivery channel patients choose, all specialty revenues now flow through the PBM segment since that is where the actual fulfillment occurs. As you're aware, we've developed a comprehensive set of programs to effectively manage specialty trend. One important component is our leading formulary exclusions strategy, and we expect to employ similar strategies to manage the new class of cholesterol-lowering agents, the PCSK9 inhibitors. The potential size of the PCSK9 market is larger than any specialty product available today, and it's our job to deliver the lowest possible price and to help ensure that the right patients are receiving these medications. So we've developed a comprehensive approach to the management of this product class to ensure appropriate utilization and cost management for our clients and their members. And with our unmatched suite of assets, we can provide a completely integrated specialty patient experience in the most cost-effective way possible. Now let me also touch on our formulary strategy more broadly, as our approach for traditional drug therapies also continues to be enhanced. Yesterday, we notified our clients that we will be removing 26 additional products from the 2016 standard formulary. Our guiding principles around formulary management include maintaining clinical integrity, reducing pharmacy costs for plan sponsors, and effectively transitioning members onto the formulary. And our rigorous approach to formulary management has resulted in billions of dollars in savings for our clients. Our medical claims management capability through Novologix is also receiving notable interest. To date, we have about 18 million lives installed for editing or repricing with a significant amount of others being implemented or in discussion. Our infusion capabilities through Coram remain a significant differentiator with clients. Site of care management is a key component of managing costs for specialty patients, and we offer clients various solutions to help successfully manage those costs. Before turning to retail, let me touch briefly on our Med D PDP, SilverScript. We currently have about 3.4 million captive lives in our individual PDP, about 1.1 million captive EGWP lives, and we serve another 3.4 million lives through our health plan clients. So in total, we currently serve about 7.9 million Medicare Part D lives. Late last week, we received the preliminary benchmark results from CMS for 2016, and I'm pleased to report that SilverScript, once again, qualified in 32 of the 34 regions. And these strong benchmark results should enable us to retain the vast majority of the auto assignees we currently serve, and it positions us well for future growth. So obviously, we're very pleased with these results. Now moving on to the retail business. Pharmacy same-store prescription volumes increased 4.8%, and that's on a 30-day equivalent basis, and we continue to gain pharmacy share. Our Retail Pharmacy market share was 21.6% in the quarter, and that's up about 60 basis points versus the same quarter a year ago. Pharmacy same-store sales increased 4.1% and were negatively impacted by about 370 basis points due to recent generic introductions and another 80 basis points from the implementation of Specialty Connect, which, again, transfers specialty scripts from our retail to our PBM segment. In the front store, comps were down 7.8%, and on a comparable basis, front store sales would have been essentially flat after adjusting for the tobacco impact. And while we experienced a decrease in front store traffic, that was partially offset by an increase in the average customer basket. And once again, we gained share in our core health and beauty categories in both the drug and multi-outlet markets. We continue to focus on positioning ourselves as a leading health and beauty destination to drive profitable growth. And to date, we've expanded healthy snack food options in about 275 stores and our plan is to complete the healthy food rollout in about 450 stores by year-end. Now we are also upgrading the beauty departments in several thousand stores this year with the goal of positioning CVS as the leader in beauty. Early results in these stores have been very positive and we plan to expand our healthy food and elevated beauty programs in 2016. We've talked a lot about ExtraCare, and ExtraCare continues to be an important driver of profitable front store growth. On a rolling 12-month basis through Q2, customers redeemed savings and ExtraBucks totaling more than $4 billion. Now we've been focused on delivering the right offer to the right customer at the right time and in the right channel. Digital, and specifically mobile, are important tools in powering up our personalization efforts. We have an industry-leading, highly rated mobile app with the new and improved ExtraCare experience. And to date, more than 10 million customers have downloaded that app. Our front store margins in the quarter continued to benefit from the tobacco exit, along with an improved product mix. And on a comparable basis to last year, even after adjusting for the tobacco elimination, front store margins, once again, improved notably. Our store brand penetration continues to increase in the quarter, reaching 20.9% of front store sales, and that's up about 265 basis points from last year, with about 120 basis points of that growth resulting from tobacco being excluded from the denominator. And we continue to see broad-based opportunities for further store brand penetration as we continue to make progress toward our 25% goal. Turning to our store growth for the quarter. We opened 25 new stores, relocated 16, closed 5, resulting in 20 net new stores, and we plan to add about 150 net new stores for the full year, equating to an anticipated increase in retail square footage growth of around 2%. As for MinuteClinic, we opened 11 net new clinics in the quarter, ending the quarter with 997 clinics across 31 states, plus the District of Columbia. Our revenues increased about 21% versus the same quarter last year, and we successfully completed our Epic electronic health record rollout to all MinuteClinics. And I think as you know, Epic enables us to interact with major health systems across the U.S., and it also supports the expansion of services as we can broadly expand access to patients with both minor and chronic conditions. And then just last month, we completed the first anniversary of our Red Oak Sourcing venture with Cardinal Health. Since its launch, Red Oak has established a best-in-class sourcing program. With its unparalleled expertise, the simplicity of its business structure and combined purchasing volume, the venture has enhanced supply chain efficiencies and helped spur innovative purchasing strategies with generic manufacturers. Folks at Red Oak are focused on the continuity of relationships with suppliers, which should serve as a strong foundation for the future. Now you may have heard on Cardinal's earnings call last week, due to the achievement of certain milestones, the quarterly payment from Cardinal to CVS Health will increase by $10 million in the third quarter of this year. This was contemplated in our guidance range, and we remain extremely pleased with the results. So with that, let me turn it over to Dave for the financial review.

Thank you, Larry, and good morning, everyone. As I typically do, I'll begin today by highlighting how our disciplined approach to capital allocation continues to enhance shareholder value. I'll then follow that with a detailed review of our strong second quarter results as well as an update on our 2015 guidance. As you know, we announced 2 acquisitions and issued $15 billion in long-term debt just since our last earnings call. And as a result, there are many different numbers circulating in the marketplace. It's my goal this morning to provide you with some additional clarity with regard to the pending acquisitions in order to help you with your modeling in both the short and the medium term. So as it relates to our capital allocation program, let's begin with our dividend payout. We paid $395 million in dividends in the second quarter and $794 million year-to-date. Our dividend payout ratio stands at 28.1% over the trailing 4 quarters after excluding the impact of nonrecurring items in both years. We remain well on track to achieve our target of 35% by 2018. The $2 billion accelerated share repurchase program that we entered into during the first quarter concluded during Q2. In addition to the 16.8 million shares we've received in January, we received 3.1 million shares in May to conclude the agreement. In total for the first half of the year, we repurchased approximately 28.9 million shares for approximately $2.9 billion or $101.33 per share. For the full year, as we have noted, we expect to complete $5 billion of share repurchases. This reflects an increase of approximately 25% versus 2014 despite the $1 billion acquisition-related reduction to our share repurchase plans for this year. So between dividends and share repurchases, we have returned more than $3.7 billion to our shareholders in the first half of 2015 alone. And we currently expect to return more than $6 billion for the full year. As I said, we recently issued a series of senior notes totaling $15 billion. The tranches are well laddered. The terms range from 3 years to 30 years, and there is no 1 year in which the maturities are especially large. And despite rising interest rates over the past couple of months, we're able to secure the debt at a favorable blended rate of approximately 3.75%. So obviously, we're very pleased with the placement, and as we said previously, the net proceeds will be used to fund both our acquisitions, and any remaining proceeds will be used for general corporate purposes. This new debt increases our leverage ratio to approximately 3.2x adjusted debt to EBITDA, and we are committed to getting back to our target of 2.7x. While we have not set a specific timeline for achieving that level, our strong cash generation should enable us to do so in a reasonable amount of time. Moving on, we have generated more than $2.1 billion of free cash in the first six months of the year. We continue to expect to produce free cash of between $5.9 billion and $6.2 billion this year, excluding the impact of acquisition-related costs. Now turning to the income statement, I want to note that we did incur some acquisition-related costs throughout the quarter. In the areas where these costs were incurred, I will quantify their impact on earnings per share. They are mainly within the Corporate segment and the interest expense line. So adjusted earnings per share from continuing operations, excluding acquisition-related costs, came in at $1.22 per share, $0.02 above our guidance range and up 7.7% over last year. We incurred approximately $0.03 of deal-related transaction and financing costs within the quarter. GAAP diluted EPS was $1.12 per share. The retail segment posted profit above the high end of expectations. The Corporate segment's expenses came in better than expected, and the PBM segment posted solid numbers within our expectations. Much of the outperformance throughout the quarter was driven by lower-than-expected intercompany profit eliminations due to the mix of our business as well as a favorable tax rate. So with that, let me quickly walk you down the P&L. On a consolidated basis, revenues in the second quarter increased 7.4% to $37.2 billion. In the PBM segment, revenues increased 11.9% to $24.4 billion. This increase was driven largely by growth in specialty pharmacy as well as an increase in pharmacy network claims. In addition to inflation, the growth in specialty was driven by increased claims due to new products, new clients, and the impact of Specialty Connect. Partially offsetting this growth was an increase in our generic dispensing rate, which grew approximately 150 basis points versus the same quarter of last year to 83.9%. In our retail business, revenues increased 2.2% in the quarter to $17.2 billion, just above the high end of our guidance. This growth was driven primarily by solid pharmacy same-store sales and healthy script growth despite the transition of specialty revenues into the PBM. Retail's generic dispensing rate also increased by approximately 150 basis points to 85%, which, as you know, dampens revenue growth. We saw strength on the top line at retail versus our guidance due primarily to the mix of pharmacy scripts. Turning to gross margin, we reported 17.2% for the consolidated company in the quarter, a contraction of approximately 105 basis points compared to Q2 of '14, but also in line with our expectations. In addition to each segment's performance, the decline is due in part to a mix shift in our business as our lower-margin PBM business continues to grow faster than our retail business. Keep in mind that margins in last year's second quarter benefited from the finalization of California's Medicaid reimbursement rates, and this intensifies the year-over-year decline. Recall that the finalization of these rates benefited retail gross margin by $53 million and PBM gross margins by $16 million in the second quarter of last year. Within the PBM segment, gross margin declined 40 basis points from Q2 of '14 to 5.1%. This is driven by the tough comparison with last year's second quarter due to the finalization of California's Medicaid rates as well as ongoing price compression. Those factors were partially offset by the improvement in GDR as well as favorable purchasing and rebate economics. Despite the decline in gross margin rate, gross profit dollars were up 3.8%. Gross margin in the retail segment was 30.9%, down approximately 55 basis points from last year. This was driven by the tough comparison with last year's second quarter due again to the finalization of California's Medicaid rates, the continued pressure on pharmacy reimbursement rates, and the continuing mix shift towards pharmacy. This margin pressure was partially offset by a number of positive factors, including the increase in GDR, favorable pharmacy purchasing economics, the benefit from front store margin rate from the tobacco exit, and changes in the mix of front-end sales. And while gross margin rate was down, profit dollars did increase slightly in the quarter despite the impact from the tobacco exit. Total operating expenses as a percent of revenues improved by approximately 75 basis points from Q2 of '14 to 11.1%. The PBM segment SG&A rate improved by approximately 20 basis points to 1.2%, with growth in operating expense dollars in line with our expectations. As reported, operating expenses as a percent of sales in the retail segment improved by approximately 20 basis points to 21.1%. This improvement occurred despite the reduction in retail sales related to our decision to exit the tobacco category as well as the impact of Specialty Connect, which, as you know, shifts sales from our retail segment into the PBM segment. On a comparable basis, our sales leverage at retail actually improved approximately 60 basis points. Within the Corporate segment, expenses grew 4.6% to $215 million, driven by the acquisition-related transaction costs that were incurred throughout the quarter. These acquisition-related costs were approximately $0.01 dilutive to earnings per share. Excluding these costs, corporate expenses were better than expected, improving year-over-year. So with that, adding it all up, operating margin for the total enterprise declined approximately 30 basis points in the quarter to 6.1%. Operating margin in PBM declined approximately 15 basis points to 3.8%, while operating margin at retail declined approximately 35 basis points to 9.7%. As Larry noted, retail operating profit decreased 1.4% in the quarter and was better than our expectations. On a comparable basis, excluding the California Medicaid impact from last year's results as well as tobacco, retail operating profit growth would have been approximately 490 basis points higher, increasing approximately 3.5%. PBM operating profit increased 7.1%, in line with expectations. On a comparable basis, again, excluding the California Medicaid impact from last year's results, operating profit in the PBM would have been approximately 200 basis points higher, increasing more than 9%. Now going below the line on the consolidated income statement. Net interest expense in the quarter increased approximately $8 million from last year to $166 million, again due primarily to the acquisition-related financing costs that were incurred throughout the quarter. These costs were associated with the bridge loan facility that we entered into in connection with the Omnicare transaction. In total, we paid approximately $52 million in fees, which were capitalized and amortized as interest expense over the period the bridge facility was outstanding. The facility expired in July when we issued $15 billion of senior notes. As a result, we reported amortization of the bridge loan fees of $36 million during the second quarter, and the remaining amount will be recorded in the third quarter. Our effective tax rate was 39.3%, slightly lower than expected. The tax rate drove less than $0.01 of the EPS beat. Our weighted average share count was 1.1 billion shares, again in line with expectations. So with that, now let me update you on our guidance. I'll provide the highlights as well as some additional clarity on the impact of the pending acquisitions. You can find the additional details of our guidance in the slide presentation that we posted on our website earlier this morning. Given our outperformance in the second quarter and the reduction in the share repurchases planned for this year, we are narrowing our range for 2015 adjusted earnings per share by raising the bottom of the range by $0.03 and bringing the top end down by $0.01. So we now expect to deliver adjusted earnings per share in '15 in the range of $5.11 to $5.18 per share, excluding any acquisition-related transaction and financing costs. This guidance reflects strong year-over-year growth of 13.75% to 15.25%, again, after removing the impact in 2014 related to the loss on the early extinguishment of debt. As Larry said, for modeling purposes, we assume that the Omnicare acquisition closes near the end of 2015. The timing of the close of the Target transaction is a bit more uncertain as it could fall into 2015 or into 2016. There are a couple of important points to consider regarding this guidance. First, it accounts for the $1 billion reduction in share buybacks this year. Second, it does not include any operating results from Omnicare or the Target asset, nor any integration costs we may incur. Additionally, it excludes any deal-related transaction and financing costs. There are several factors to review, and it might be helpful to look at Slide #29 from the slide deck we posted this morning, which summarizes these elements. Currently, we have recorded about $0.01 in transaction costs and expect to incur another $0.03 to $0.05 this year, depending on the year the Target acquisition is finalized. We have also incurred roughly $0.02 in financing costs related to the bridge facility. Furthermore, we are forecasting another $0.13 in net interest expense tied to the bridge and the placement of senior notes last month. Overall, this guidance excludes $0.19 to $0.21 in deal-related transaction and financing costs. My goal with the pending acquisitions is to provide guidance that includes these businesses after each deal closes, once we have a clearer understanding of their underlying performance. So our core business is performing well, and this revised guidance reflects just that. All-in GAAP diluted EPS from continuing operations is expected to be in the range of $4.64 to $4.71 a share. Net revenue growth is expected to be a bit stronger in both the PBM and retail segments. As a result, consolidated net revenue growth is now expected to be 7.5% to 8.5%. We expect PBM revenue growth of 11.5% to 12.5%, 25 basis points higher than our prior guidance. This revised guidance reflects our expectation for stronger network volumes, so we are also increasing our adjusted claims expectation to a range of 1.15 billion claims to 1.16 billion claims. Additionally, we have increased our expectations in the retail segment, and now expect revenue growth of 2.5% to 3.25% year-over-year. This guidance mainly reflects our revised expectations for a slightly lower generic dispensing rate for the full year due to some timing shifts in the generic marketplace. Given PBM performance to date and higher volumes, we are also narrowing and increasing guidance for operating profit growth in our PBM segment. We now expect PBM operating profit to increase 10% to 12% year-over-year, an increase of 225 basis points on the low end and 125 basis points on the top. And given that the increase in retail revenue outlook is due largely to fewer generics than expected, we're trending our operating profit growth expectations to a range of 4.25% to 5.5%. And as I said before, we continue to expect to produce free cash of between $5.9 billion to $6.2 billion this year, excluding the impact of acquisition-related costs. So with that, let me provide guidance for the third quarter. We expect adjusted earnings per share to be in the range of $1.27 to $1.30 per share in the third quarter, reflecting year-over-year growth of 10.5% to 13.5%, after removing the impact in Q3 of '14 related to the loss on early extinguishment of debt. As with the full year, this excludes all deal-related costs. GAAP diluted EPS from continuing ops is expected to be in the range of $1.13 per share to $1.16 per share within the third quarter. Within the retail segment, we expect revenues to increase 2.75% to 4.25% versus the third quarter of last year. Adjusted script comps are expected to increase in the range of 4.75% to 5.75%, while we expect total same-store sales to be up 1% to 2.5%. On September 3, we'll mark the anniversary of our exit from tobacco, so we'll see a negative impact on front store comps during the first 2 months of the quarter. So sequentially, revenue growth is expected to improve. We expect the negative impact on front store comps in the third quarter to be approximately 500 basis points. In the PBM, we expect third quarter revenue growth of between 9% and 10.25%, driven by continued strong growth in specialty and network volumes. We expect retail operating profit to increase 4% to 6% and PBM operating profit to increase 2% to 6% within the third quarter. During the course of the year, we have been highlighting several timing factors that affect the cadence of profit delivery throughout this year. Factors that are expected to impact the cadence the most include the timing of break-open generics, our tobacco exit, and the investments we made in the PBM's welcome season. And while we delivered a very strong first half, quite frankly, above our own expectations, the cadence of profit growth is still expected to be back-half weighted. So all things considered, we continue to expect a strong back half of the year and especially the fourth quarter. So in closing, I'll leave you with 4 key thoughts: First, we posted very strong growth year-to-date. Second, our 2015 outlook for each business and the enterprise overall is strong, and we continue to benefit from the unique solutions we're delivering in the marketplace. Third is our pending acquisitions supplement our base businesses and set us up nicely for continued strong growth well beyond 2015. And finally, we expect to continue to generate significant free cash, and we are committed to using these assets to maximize the value we return to our shareholders through a disciplined approach to capital allocation. And with that, I'll turn it back over to Larry.

Okay, thanks, Dave. Well, I think you can hear that we're certainly pleased with our continued strong performance in the second quarter, the outlook that we have for the rest of the year, and certainly, the opportunities the announced acquisitions will present for future growth. And with that, let's go ahead and open it up for your questions.

Obviously, another great PBM selling season. Larry, if you or Jon can maybe just talk about 2 things around that, the selling season. One, Larry, I think you characterized it as being fairly typical from what you've seen over the last few years, but you continue to win a lot of business. Can you talk about maybe what's helped you to win this year? And then secondly, just help us to understand how do we think about the setup going into 2016 as it pertains to plan design. Are we seeing more people adopt your formulary? Are we seeing more people adopt specialty? Like, how do we think about it as we're thinking about how that sets up for 2016?

Yes, Lisa, I'll take the first question and I'll ask Jon to comment in more specifics around your second question. But yes, Lisa, I think the success that we're continuing to see, it really reflects our integrated model. And I think as we've talked in the past, you have to be right on price, you have to be right on service, but once we get past that, we've got an awful lot of differentiation that is resonating for clients across all the sectors. And I mentioned in our prepared remarks that the success this particular selling season has been more skewed with the health plan segment; those health plans probably represent around 80% of the gross business wins of the $12 billion. And obviously, we're pleased with those results. And I'll ask Jon to take a deeper dive in terms of more specifics.

Yes, so Lisa, let me start by discussing health plans. They consist of various lines of business: commercial, Medicare, Managed Medicaid, and exchanges. We observe different priorities depending on the health plans' composition of these four lines. Health plans aim to remain competitive in the market, seeking competitive pricing and high service levels, areas in which we have consistently excelled over the last few years. We have maintained predictability, consistency, and stability, which is crucial as health plan clients assess their market options. The primary challenge for most health plans lies in the government sector, where we offer significant expertise in both Medicaid and Medicare. We also deliver advisory and consulting services that assist them in managing and developing competitive government programs. For instance, we provide support for their Star measures and aid in designing formularies and benefit options for Medicare. Another key focus for health plans is specialty, and we offer the most comprehensive array of solutions to manage their expenditure and specialty members under both pharmacy and medical benefits. We have previously discussed solutions like Specialty Connect, Coram, Novologix, Accordant, and MinuteClinic. Additionally, we provide various robust clinical programs that integrate into their clinical strategies, ultimately helping to manage overall medical costs. Thus, we offer value that goes beyond just managing pharmacy costs. We have also found success in the employer and state government sectors, where clients appreciate our integrated model and the value we deliver to them and their members. Therefore, we continue to thrive in the market, securing new business due to the value and support we provide to our clients and their members. If we talk about what we are seeing from a plan design, maybe I'll focus on the new business wins that we're bringing on this year. And if we start with the employers that are coming on board, we're seeing very high adoption of our programs, such as Maintenance Choice, exclusive specialty with Specialty Connect, formulary program with exclusions. And we're also seeing very strong adoption of our integrated offerings as well as our cost management solutions. Health plans, which Larry mentioned, is about 80% of our gross wins. We see a very different dynamic across those 4 lines of business that I mentioned. For Medicare, we see very strong alignment with our Med D formulary and preferred network options. For Managed Medicaid, we see adoption of narrow networks. For commercial plans, they pretty much bring them over as is because they need to work with their downstream clients or state insurance commission, so there's more of a lag, but we do see interest in Maintenance Choice, formulary, narrowing of their specialty providers and in some cases, narrowing their networks. But it usually takes a year or 2 to implement. And for exchanges, we see adoption of our formulary and strong interest in network solutions. So with double-digit trend combined with the need to be competitive in the B2C lines of business for health plans, we expect to see high levels of interest and adoption for our programs across our book of business.

Lisa already addressed my question, but I want to discuss Target specifically for Jon. Can you explain your thought process regarding the integration of pharmacies and how that relates to the PBM side of the business? Additionally, what impact do you anticipate this will have as you approach the 2017 selling season?

Well, Scott, it's Larry. When we announced the Target acquisition, we mentioned that it expands our reach into new areas, particularly west of the Mississippi and in the Pacific Northwest. From a PBM perspective, this significantly improves our geographic presence, filling an important gap. Additionally, it creates another channel for consumers and enhances the ways we can deliver our unique and integrated clinical programs, such as Pharmacy Advisor. We've discussed our successes in improving access, and we are also focused on reducing overall costs. Therefore, we view this acquisition as a crucial solution to the current challenges in our healthcare system regarding access, quality, and cost.

As a follow-up, the intercompany eliminations you mentioned, Dave, seemed to contribute to the strong revenue we saw, but profitability appears to be lacking. One of CVS's successes lies in its integrated model. How should we view the impact of intercompany eliminations on profits? Is this a concern, or is it simply part of the business's normal rhythm?

Scott, this is Dave. This is just the cadence of the business. We forecast this on a quarterly basis, and quite frankly, it's just the mix of scripts and how they move through the PBM and retail, which is slightly off. So there's no underlying concern there. No worries.

Should we key more in the revenue line given the changes that are taking place, especially with the specialty going over to the PBM?

Yes. I think you need to consider both factors because inflation might give misleading results. We could experience uneven share capture, but the influx of generics could slightly influence that aspect, so I would suggest looking at both points.

I wanted to return to the net new number. It's a significant season, even considering the Coventry contribution. Larry or Dave, do you have any additional insights on where this business is originating? Are these clients mainly from the health plan side? Are they transitioning from other PBMs, or are you observing any shifts in behavior, like more clients carving out the pharmacy benefit? I'm trying to understand the sources of all the net new business for you.

Bob, it's Larry. You're correct that around 80% of our gross wins are coming from the health plan segment. Most of this is due to clients switching their pharmacy benefit manager. Jon mentioned some key points earlier about the health plan business and its various components, such as commercial, Medicare, Medicaid, and exchange products. We are able to offer tailored solutions for each of these segments in the health plan sector. Once again, our model is resonating with these clients because we can address specific needs within their health plan business.

I guess, as my quick follow-up then on the PBM. If I look at the profit from this quarter, up 9%, Dave, you mentioned in your remarks that you guys are guiding for gross profit growth in the 2% to 6% range, I believe, for 3Q. Just curious, what's driving that slowdown? Anything that was already kind of thought of in guidance as far as the cadence of profit growth from quarter-to-quarter?

Yes, really, there's a couple of things that happened. As you know, that our profits in the PBM have typically been a little lumpy quarter-over-quarter based on how we performed in Medicare. So you see the timing shift a bit based on where we hit the reinsurance levels, number one. And that's kind of common and it's hard to predict, number one. Number two, as we ramp into the back half of this year, we're overlapping the introduction of Hep C and overlapping the rebate performance in that category and other categories within specialty.

So Larry, your success in the selling season obviously doesn't go unnoticed. I mean, have you seen any behavioral changes this season from competition that might be worth mentioning at all?

Ed, there's nothing that is top of mind when you ask that question. I mean, as we've talked for the last couple of years, the marketplace remains competitive. And as I just mentioned in response to Lisa's question, you got to be right on pricing services, the ticket to the game. And then, I think our differentiated model comes into play in a very healthy way after that.

All right. As a quick follow-up, you have been quite active on the M&A front lately. Larry, could you take a moment to evaluate your current position following the Omnicare and Target acquisitions in relation to where you want to be in the long term within the changing landscape? Are there still gaps or opportunities to consider?

Well, Ed, as we've discussed regarding our strategy, which Nancy mentioned during Analyst Day and we'll elaborate on in December, we believe we have a unique opportunity as healthcare becomes more consumer-directed. Considering our extensive capabilities today, including retail, PBM, specialty, infusion, medical claims management, MinuteClinic, and soon, long-term care, we can effectively manage the consumer and patient throughout their healthcare journey. So Ed, we're feeling quite optimistic about our current position, and we plan to continue expanding the ways we can serve patients and connect the various aspects of care.

Curious on the reimbursement rate environment on the pharmacy side of the business, what trends you're seeing there. And as we look forward, what your outlook is on gross margin on the retail side.

Eric, this is Dave. I want to discuss a few factors impacting our performance. Regarding gross margin, as I mentioned earlier, there has been a notable shift in the availability of generic drugs that are in a break-open status, which has slightly affected our gross margin in both the first half of the year and, more importantly, the latter half. Additionally, as we have frequently stated, there is ongoing pressure from reimbursement trends in the marketplace. We do not anticipate this pressure easing and expect it to persist not only this year but also into the future. Looking at our 5-year targets, we have consistently communicated that revenue growth is expected to outpace operating profit growth, indicating margin compression. Part of this situation stems from the intensity of reimbursement pressure in the marketplace, which we believe will continue.

Great. And if I could have just one follow-up. You worked through the exit from tobacco pretty effectively to continue to do what you're doing with profits in that business with less sales. Curious if there's any plans as we move forward incrementally for what to do with that space? Or if there's anything else in the front end that you're aspiring to move towards as you move away from that or as you've moved away from that?

Sure, this is Helena. We've been focused on becoming the leading health and beauty destination. When we announced our exit from tobacco, it made us reevaluate our goals for the consumer and where we want to succeed. As a result, we've created a 5-part strategy. First, we aim to make health more accessible, which relates to the healthy food section that Larry mentioned. Second, we focus on enhancing beauty, which Larry also noted. Third, we plan to drive customer personalization, leveraging our ExtraCare program, but we see significant potential to become even more relevant and targeted in our future approach. The fourth part of our strategy involves what we call myCVS Health, which is about customizing our offerings based on local market needs. For instance, following our acquisition of Navarro last year, we've learned a lot and have already reset 12 CVS stores in Miami based on that experience, showing promise in attracting Hispanic customers. Finally, the fifth component emphasizes digital innovation. The team has done an impressive job of stepping back to envision our future and strategize on how to succeed. In the 275 stores where we've updated them with healthy foods, you can really see a glimpse of our path forward. The atmosphere in the front of our stores regarding healthy food feels different, and we've elevated the beauty experience significantly.

So one other question here just on the PBM selling season. Obviously, $12 billion gross wins' a pretty monster number. The WellCare group at their analyst meeting back in February, they disclosed their PBM spend was exceeding $6 billion and approaching $7 billion. And then the PBM on the other end of the Coventry book has suggested that Medicare piece is worth about $3 billion. So just curious whether you share those views or if you have different numbers. And then also, with your comment about the health plans being roughly 80%, or maybe over 80% of the total, just curious if you isolate just your results in the commercial market, just want to confirm whether or not your wins were net positive for 2016.

Steve, maybe I'll start here. We're not at liberty to talk about revenue per client, so I can't really confirm that at this point in time. But obviously, the bulk of our wins, as we cycle into '16, are within the health plan segment, and our products and services continue to resonate there. On the commercial side, I guess you're asking from a commercial standpoint if we have net wins versus net losses. Is that's the question?

Is that in the employer segment, Steve, you're talking about?

Yes, just employer. You're correct, yes.

It's still early because we still are 60% through the renewal season, so we'll talk about that in December Analyst Day and talk about the makeup of our wins and losses. And then you'll be able to net it out at that point, yes.

But as we stand here today, just to be clear, as we stand here today, we are in a net win position within the employer/commercial market.

Okay. One other real quick one. Just the 2016 formulary was obviously just only announced. And I'm curious though, if you do go back several years ago, it did seem that formulary changes used to be viewed maybe with some mixed emotions by clients, maybe even a bit of negativity. But I'm just curious now, do you think clients are more receptive to these formulary exclusions today versus historically because perhaps clients are more conscious of the savings potential. Just kind of curious to get your thoughts on that. Now it seems like these are viewed more positively than negatively versus history.

I completely agree with you, Steve. It's important to remember that we were the pioneers of the formulary strategy. You're correct that it was initially received with mixed feelings. However, over the past four years, we have shown clients and their members that this strategy not only presents a cost-saving opportunity but also enables us to manage their members smoothly. Importantly, this approach does not disrupt the continuity of care. I believe we are becoming more focused on this, and as more opportunities arise in the specialty area, it enhances the conversation.

Larry, I'd like to discuss Retail Pharmacy consolidation. We've seen rapid consolidation in managed care across the industry, and now the PBM industry has essentially merged into three major vendors. Your recent move with the Target transaction was intriguing. I'm curious about your thoughts on the potential for further consolidation in retail pharmacy. Is it possible for the market to consolidate to a point where there's a competitive balance between retailers and payers?

Well, George, when you look at the retail pharmacy landscape, remember that there are still over 60,000 pharmacies operating across the country. This number has remained relatively stable over the past few years, including the growth of independent pharmacies. For us, the Target acquisition presented an exciting opportunity to enhance our geographic presence in a very capital-efficient manner. We are enthusiastic about the potential this brings.

Okay, I guess, maybe then a quick follow-up would just be, do you expect more opportunities like Target to present themselves? And then, given what you guys know, if you look at the companies that compete in the pharmacy space outside of the big retail pharmacies, given that Target was losing money, can you imagine that any of these guys are making much money in pharmacy?

George, this is Dave. It's kind of hard to speculate on that. I would just say that our focus, first and foremost, is to execute against the pending acquisition, roll out our products and services in a way that puts our clinical programs into the hands of more members as they shop this new and exciting channel. And to work, as Larry said before, to reduce costs, to improve access, and to improve the health outcomes of the patients that we serve. And that continues to be our focus right now.

A specific one for Jon. We heard from a competitor last night who pointed to continuing opportunities in open specialty pharmacy networks. But with your $12 billion of gross PBM wins, have you noticed any interest in narrowing the specialty pharmacy networks, in particular?

When we examine the successes with employers, most of them choose us exclusively for specialty services. Although health plans usually work with multiple vendors, we are observing a trend where they are starting to reduce that number from three, four, or five to fewer options. This consolidation allows them to achieve better pricing and improved execution of clinical programs. We are engaged with several health plans where we provide stand-alone specialty services without being the pharmacy benefit manager, and that segment of our business continues to expand, which we plan to actively pursue.

Okay. And just as it relates to the Cardinal relationship, what opportunities do you see to expand the areas in which you're working?

Well, Bob, it's Larry. As I've mentioned, I think the team has done an awful lot of work in a pretty short period of time in the first year. And certainly, we're always looking to work in terms of how we can create additional value for the business and our customers. And I don't know that there is anything on the horizon that we can talk about right now. But certainly, I think the Red Oak team will have an ongoing focus in terms of how they can create additional value.

Just maybe one just quick clarification from Dave. Just in the guidance, just to be clear, you're excluding the financing cost. But we are including just the incremental fixed expense from the new issuance on the debt, right?

No, I'm excluding both. I'm excluding both the bridge facility cost as well as the incremental debt that we took on in relation to financing the acquisitions. In effect, Slide 29 gives that nice little, I'll say, walk forward of all those components.

Dave, I think this is a question that I continue to get, and it would be helpful if you could maybe give us a little bit more color in terms of how we should be thinking about a reasonable amount of time for you to get back to 2.7x. Should we be thinking about a sort of 2- to 3-year timeframe? Or should we potentially be thinking about 3 to 5 years?

That's a great question. I haven't specified a specific timeline, and unfortunately, I won't do that today. I do expect that we are currently at 3.2x, and our goal is to reach 2.7x. We plan to do this in a reasonable and modest way to return to that range. However, I haven't established a specific timeline and don't expect to do so. I will keep the market updated as we make progress and ensure there's clarity on our status.

So 2 things on the selling season. Number one, can you tell how much the ongoing consolidation in the PBM space may have helped you this selling season with the health plans? And if not, does that lie in front of us for next year? And then secondly, if you look at the first year margin right on the $11 billion and how that would compare to prior years, is it very similar? Or just because of the magnitude of some of these plans, maybe it's a bit lower than prior years.

Yes, John, it's Larry. I'll address the first part, and then I'll have Dave provide insights on the second question shortly. Regarding the timing of the selling season, I believe this particular 2016 season was largely unaffected by the M&A activities that took place. Therefore, we see that opportunity in front of us as we approach 2017, especially considering some of the health plan clients currently in the market.

As it pertains to the profitability or margins of new clients, typically, when they start as a new pharmacy benefit manager, they come with very low margins. Our long-term goal is twofold: to implement our programs and products that enhance performance within the pharmacy benefit manager, and equally important, to establish adherence programs in one of our dispensing channels to ultimately improve patient and member outcomes. Therefore, while they may start with thin margins, we anticipate growth over time, and we expect this trend to persist as we enter the selling season and implement it in 2016.

All right. Looking at pharmacy traffic compared to the front end, pharmacy is clearly growing at a faster rate. I know you are implementing various merchandising and marketing efforts. Regarding the conversion of pharmacy customers to the front end, is there an opportunity to increase this conversion during their visits, whether through operational changes or other methods? Or is that not plausible due to factors like drive-through services?

Yes, I think there always is. I mean, look, when I said before that we're really focused on health and beauty, health is critical because when the consumer thinks about us, she's really thinking about all her healthcare needs. And so, in particular, we look at people who are chronic customers and think about all the ways that we can serve them in our stores. For example, the work that we're doing on store brands is really important to people who have a lot of health issues and are worried about how to maintain good health and save money with high-quality products. So I think a big part of our focus and effort is on how to make the front store an extension of the pharmacy experience. And obviously, the outcome of that is driving higher sales as it relates to serving those patients.

Just want to get a little update on your thoughts on the generic wave into 2016. We've now had some of the wildcards on multi-source break opens resolved. And also, if you could give a little update on what you're seeing on generic cost inflation?

I'll share some insights on the availability of generics. It's currently not as plentiful as we anticipated, and we expect this trend to continue in the upcoming periods. This situation is primarily influenced by the presence of break-open generics with multiple suppliers in the market, which helps us lower our cost of goods sold. We anticipate this pattern will continue into the latter half of this year and possibly into 2016. We will provide more updates during Analyst Day when we have a clearer view of 2016. Regarding generic inflation, the overall market for generics has remained deflationary this year, and we expect this trend to persist for the remainder of the year. In general, we've seen modest generic inflation this year compared to the same time last year.

So you're saying on the availability break up is that it's a little softer now, and you're going to cycle out of that and a better outlook into 2016.

I’m not certain about 2016 at this moment. It’s unclear how the new generics will enter the marketplace. We’ll provide more details on this during Analyst Day when we have a clearer understanding of the timing.

Can you please talk about your relationship with Aetna and a potential Humana transaction, and sort of the incremental value you might be able to bring to the combined enterprise? And then just any thoughts on Humana's relationship with Walmart and their low-priced PDP plan.

David, it's Larry. We cannot discuss Humana's relationship with Walmart, but regarding your first question, we have a 12-year strategic agreement with Aetna that lasts until December 2022. Aetna can terminate the agreement starting in January 2020, as previously mentioned. Our relationship with Aetna is strong, and we work closely together, providing value to their business and clients in a unique way. Our focus on pharmacy, along with the innovation we offer, our scale as the largest purchaser of generics, and our integrated model that enhances access, quality, and outcomes, positions us very well. While there might be considerations for insourcing their pharmacy benefit management, taking all these factors into account suggests that it would create a less favorable situation for them.