CVS Health Corp (CVS) — Q4 2016 Earnings Call Transcript

Thank you, Nelson. 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. Jon 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 with the chance to ask their question. Please note that we posted a slide presentation on our website before this 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-K and it will also be available on our website. 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 use some non-GAAP financial measures when talking about our company's performance. In accordance with SEC regulations, you can find the reconciliations 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. The solid fourth quarter results we posted today nicely wrap up our 2016 year. And for the full year, consolidated net revenue increased 15.8%, with operating profit growing 8.3% and adjusted earnings per share increasing 13.2% with strong results across the enterprise. The growth rates I'm citing are on a comparable basis and you can find the non-GAAP adjustments on the slides we posted on our website. Now, as expected, enterprise growth in the fourth quarter was solid with consolidated net revenues increasing 11.7%, operating profit increasing 4.6%, and adjusted EPS increasing 11.8% to $1.71, a penny above the high-end of our guidance. In the fourth quarter, operating profit in the Retail/Long Term Care segment was in line with expectations and operating profit in the PBM segment was ahead of expectations. We generated approximately $1.5 billion of free cash during the quarter and $8.1 billion for the full year, above the high-end of our guidance range. And we'll continue to be thoughtful and disciplined with respect to using our strong cash generation capabilities to return value to shareholders. For 2017, we are confirming the EPS and cash flow guidance we provided at our Analyst Day in December, and Dave will review the guidance details in his remarks. Now, before turning to the business update, I want to touch on a few areas of investor interest. And let me start on the topic of DIR within the Medicare Part D program, so we can correct some false and misleading statements in the marketplace which suggested that DIR performance network-based fees represent a material risk to our company; a statement that could not be further from the truth. So here's what you need to know about DIR. First, DIR includes any rebates, any discounts or other price concessions that are unknown at the point-of-sale; and DIR, ultimately, is utilized to reduce the net cost of the Med D program. The second point; DIR performance network fees charged to pharmacies are allowed under CMS regulations. They're fully passed through from the PBM to their clients. They are fully disclosed as part of the annual bid process. And, again, are ultimately used and reflected to help lower member premiums. As a matter of fact, member premiums over a five-year period have increased at a CAGR of just 1.7%. So you can see the positive impact this is having on controlling costs. The third point, and for the reasons just mentioned, CVS Caremark does not keep or profit from performance network-based DIR. And as a reminder to everyone, both CVS Pharmacy and CVS Specialty participate in the same performance network programs being called into question. The fourth point, network pharmacy providers are proactively informed of, and educated on, program details including their forecasted financial impact in advance of program implementation. And the fifth and final point, any suggestion that Part D plans favor high-priced drugs to drive people through the benefit and into catastrophic coverage faster is erroneous, and the data proves that. In fact, the percentage of our beneficiaries reaching the coverage gap and ultimately catastrophic coverage has decreased over the past several years and is a relatively small percentage of our overall population. Now, we don't think DIR is likely to go away given its effectiveness in helping to lower premiums. But hypothetically, if it were to go away, there would be a level playing field, we would remain quite competitive, and we would not expect any material impact on our business. So I hope this clears up the gross misunderstandings surrounding DIR with the simple statements of fact. So with that, let me move on to the topic of the potential repeal and replacement of the ACA. We believe it's important to provide affordable coverage for all Americans, which both Democrats and Republicans have acknowledged. However, at this point, it's extremely difficult for us to comment on the possible scenarios that may play out in the coming months. And that said, CVS Health can pivot to address policy changes, help reduce healthcare costs, and bring meaningful solutions to the marketplace. I also want to address the ongoing rhetoric around drug pricing. And whether it's new launches at elevated price points or increasing prices of older drugs, those contributing to a sense that government interventions are necessary and any suggestion that PBMs are causing drug prices to rise is simply erroneous. We are the solution and not the problem. And that's why both public and private payers continue to count on PBMs as indispensable partners that help to manage their drug trend. Numerous evaluations from the FTC, or the Congressional Budget Office and other government agencies have consistently concluded that PBMs operate in a highly efficient market and drive real savings to the healthcare economy. Our CVS Caremark solutions have helped reduce client costs from an unmanaged gross trend of 11.8% to a managed trend of 3.3%; and those results are for the first three quarters of 2016. In addition, a recent industry study showed that every dollar invested in PBM services returned $6 in savings for clients and members. So the value of PBMs is quantitatively pretty clear. An additional topic that we've received a lot of questions about centers on the potential impact of corporate tax reform. As you know, we are at the highest end of corporate tax payers given our domestic profile, with an effective tax rate around 39%. The details of tax reform certainly will matter, and today, while there's a lot of discussion, nothing has been reduced to writing. Suffice to say that a fairer tax code that includes a meaningful reduction in the effective corporate tax rate would allow CVS to unlock even greater economic opportunities. We certainly look forward to continuing to engage in the dialogue around all of these issues that may impact our industry, our business, and the clients and customers that we serve. Let me turn now to the business update, and I'll start with the 2017 PBM selling season. Our gross and net client wins are slightly higher than at Analyst Day with gross wins totaling nearly $7.9 billion, net new business around $4.4 billion and a client retention rate of around 97%. These numbers exclude enrollment results from our SilverScript PDP, which I'll touch on shortly. I'm pleased to say that we have had an outstanding welcome season, continuing our record of strong implementations over the last few years. We processed significantly more transactions during this year's welcome season, and client satisfaction showed continued improvement across all business lines reaching record performance levels. While we remain committed to improving and advancing every day, we continue to believe the investments we made in quality, automation, and customer focus are delivering measurable value to our clients year after year. Looking ahead, we have about $23 billion up for renewal in 2018, which is comparable with prior years from a percent of business perspective. As for new business, it's pretty early to gauge the full extent of RFP activities in the 2018 selling season. Our strong service history, our size and scale, and our unique suite of capabilities give us the tools we need to be successful in retaining business and winning in the marketplace as opportunities arise. As we've discussed many times, top of mind for our clients continues to be managing their rapidly growing specialty trend. We offer a comprehensive set of solutions and continue to see solid growth in specialty. Specialty revenues increased 12% in the fourth quarter, continuing to outpace the market. Our Medicare Part D business, SilverScript, wrapped up another successful annual enrollment period and retained its position as the number one PDP spot. We began the 2017 plan year with more than 5.5 million captive PDP lives which includes EGWPs, that’s up about 10% from January of the prior year. Adding the Med D lives we manage for our health plan clients, the non-captive lives, the total rises to 12.3 million Med D lives under management. You can find a reconciliation of the Med D lives in the posted slides. Moving on to the fourth quarter results and the Retail/Long Term Care business, same-store prescription volumes increased 2%. That's on a 30-day equivalent basis. Total same-store sales decreased 0.7%, with pharmacy same-store sales up 0.2%. Our pharmacy comps were negatively impacted by about 380 basis points due to recent generic introductions. They were also negatively impacted by the decision to restrict CVS out of the TRICARE network. As we mentioned on our last call, that network change was communicated in early October with a December 1 effective date. We saw these scripts begin to migrate out of our stores during the fourth quarter and in line with our expectations. Let me briefly touch on the CVS pharmacies within the Target stores. Now that the integration is behind us, we're seeing improving script performance versus prior quarters; this is being driven by the strength of our patient care programs and Maintenance Choice. The Target pharmacies have also exhibited a solid operational foundation providing high levels of service to our patients. We're making good progress since completing the integration activities and moving in the right direction. In our Long Term Care pharmacy business, we continue to target the significant growth opportunities we see in the Assisted and Independent Living markets. We're focused on creating better solutions that meet the needs of senior living communities and their residents. We're taking advantage of all of our enterprise assets, including CVS Pharmacy, our infusion properties, and MinuteClinic. We launched some new programs in these settings during 2016; we’re piloting others in early 2017, and we'll have more on these programs in the coming quarters. Before turning to the front store, I want to highlight our recent announcement on generic epinephrine. Given the urgent need in the marketplace for a less expensive epinephrine auto-injector for patients with life-threatening allergies, we partnered with Impax to purchase their product at a price lower than similar brand or authorized generic products. We now have available at all CVS Pharmacy locations the authorized generic for Adrenaclick at a cash price of about $110, which is 80% lower than that of the brand competition in the market. This move is consistent with the fact that increasing competition within therapeutic drug classes is a way to reduce the cost of prescription drugs, and we're leveraging our capabilities and our scale to do just that. Turning to the front store business, comps decreased 2.9% as a result of softer customer traffic, combined with our continued focus on increasing personalization and rationalizing our promotional strategies. At the same time, front store gross margin once again improved in the quarter versus last year. Keep in mind that our front store business accounts for about 11% of our enterprise revenues, and these personalization efforts are allowing us to invest our promotional spend in a differentiated way producing margin flow-through. We have started to further reduce mass promotion in 2017 to better serve our loyal customers and continue driving profitable front store sales. We continue to focus on growing our beauty, healthcare, and personal care businesses, and recognizing the growing presence in the digital market, we've focused on enhancing our online capabilities to create an integrated health and pharmacy experience that only CVS can provide. CVS Curbside is now live in about 4,000 CVS Pharmacy stores, providing a fast, seamless shopping experience with customers ordering products on their mobile devices and then picking them up at a CVS store without getting out of the car. We also introduced CVS Pay which allows customers to pick up prescriptions, use ExtraCare, and pay for front store items, all with one scan of their CVS app. This year, we plan to enhance our online shopping tool and further integrate personalization into digital platforms to increase engagement with health and beauty shoppers. We're continuing to roll out store resets to improve our health and beauty leadership. Our focus is on scaling our healthy food selection and optimizing our key categories in the health quadrant while elevating our beauty offerings and improving shopability. Finally, Store Brands remain an area of strength and opportunity. Our Store Brands represented 23.7% of front store sales in the quarter and that’s up about 160 basis points from the same quarter a year ago. Before turning it over to Dave for the financial review, I want to again acknowledge the near-term headwinds in the retail business this year given the unexpected network changes we highlighted late last year. As previously outlined, we have a plan in place to return to more robust levels of earnings growth. Let me summarize this four-point plan in response to the near-term market dynamics. First, we’ll leverage our enterprise capabilities and CVS Pharmacy’s compelling value proposition to partner more broadly with other PBMs and health plans to deliver the greatest overall healthcare value. Our partnership with Optum, which starts with a 90-day solution, is a great example and we look forward to discussing other long-term opportunities to bring together complementary capabilities that provide greater convenience and value for our clients and customers. Second, we will continue to innovate to bring new integrated PBM products to market that capitalize on the benefits inherent in our unique integrated model while meeting the ongoing needs of our clients and members. Third, as we discussed on Analyst Day, we’ve begun work on a new multi-year enterprise streamlining initiative. Through these efforts, we expect to achieve nearly $3 billion in cumulative savings by 2021. Fourth, we have significant cash generation capabilities that provide us with a variety of ways to grow and return value to shareholders. We remain confident that we can achieve solid operating profit growth across the enterprise in the years ahead. Our substantial cash flow affords us opportunities to bolster that growth, either through strategic acquisitions to supplement our existing asset base or through value-enhancing share repurchases. So with that, let me turn it over to Dave for the financial review.

Thank you, Larry. Good morning, everyone. This morning, I'll provide a detailed review of our 2016 fourth quarter results, and I'll briefly touch upon our 2017 guidance, which remains materially unchanged from what we outlined back in December. First, I'll start with a summary of last year's capital allocation program. Maximizing shareholder value continues to be a major focus of CVS Health. The key areas we focus on to do this are: driving productive long-term growth, generating significant levels of free cash flow, and remaining disciplined in our approach to capital allocation. In summary, for the year of 2016, we delivered adjusted earnings per share growth on a comparable basis of more than 13%, generated more than $8 billion in free cash, and returned a very significant $6.3 billion to shareholders through both dividends and share repurchases. I think this clearly demonstrates how we've continued to use our strong free cash flow to drive shareholder value. With that, let's walk through some of the details. We continue to drive steady state improvement in our dividend payout ratio. Recall that back in 2010 our payout ratio was approximately 14%. We finished 2016 with a payout ratio of 34.6%, more than double 2010's level and 450 basis points higher than 2015. Keep in mind that this ratio is artificially high as it includes the integration cost related to both Omnicare and Target, as well as other items described in our non-GAAP reconciliation on our website. So there's still room for growth. We paid approximately $1.8 billion in dividends in 2016 and $456 million in the fourth quarter alone. Our earnings outlook this year, combined with the 18% increase in the dividend we announced at Analyst Day, keeps us well on track to achieve our targeted payout ratio of 35% by 2018. Along with a significant increase in our dividend, we've continued to repurchase our shares. For all of 2016, we repurchased approximately 48 million shares for about $4.5 billion, averaging $96.78 per share. In the fourth quarter, we repurchased approximately 6.1 million shares for $461 million, averaging $75.20 per share. At the end of 2016, we had $18.2 billion left in authorizations for share buybacks, and we continue to expect to repurchase $5 billion this year. Our expectation is that we will return more than $7 billion to our shareholders in 2017 through a combination of both dividends and share repurchases. Given the dislocation of our stock price recently, we entered into two accelerated share repurchase transactions totaling $3.6 billion, and we've repurchased 36.1 million shares at a price of $80.34 per share in January. This represents 80% of the total value of the transaction which will close by the third quarter. We generated $1.5 billion of free cash in the fourth quarter. For all of 2016, we generated approximately $8.1 billion of free cash, which exceeded the high-end of our guidance by about $1 billion. The outperformance was primarily driven by the timing of PBM cash receipts and payables. Keep in mind that some amount of this beat is timing within Medicare Part D as we will end 2016 in a payables position with CMS and will need to settle this obligation in 2017. At the same time, we improved our cash cycle by nearly 3.5 days driven by improved inventory and payables management. We remain committed to further improvements in working capital as we look forward. For the year, our gross capital expenditures were approximately $2.2 billion, about $145 million lower than last year. This was due to our expected reduction in store openings as we integrated the Target pharmacies. With $230 million in sale-leaseback proceeds, our net CapEx for the year was approximately $2 billion. As for the income statement, adjusted earnings per share came in at $1.71 per share, one penny above the high-end of our guidance range, up 11.8% over last year. This is on a comparable basis, and the reconciliation of the adjusted earnings per share from GAAP can be found in our press release, as well as on the Investor Relations portion of our website. GAAP diluted EPS was $1.59 per share. On an adjusted basis, results within the PBM were slightly above expectations, while Retail/Long Term Care was in line with our expectations. So with that, let me provide you some more details as I quickly walk down the P&L. On a consolidated basis, revenues in the fourth quarter increased 11.7% to nearly $46 billion. In the PBM segment, net revenues increased 17.9% to $31.3 billion. As we've seen all year, this growth was attributable to increased volume and pharmacy network claims, as well as growth in specialty pharmacy. While very strong, this top line growth was slightly below our guidance range, primarily driven by lower inflation and drug mix versus our expectations. Partially offsetting the sales growth was an approximate 170 basis point increase in our generic dispensing rate to 85.4%. PBM adjusted claims grew by 19.9% in the quarter. We finished the year with 1.39 billion adjusted claims, at the top end of our expectations. I want to mention that for 2017 we're changing our methodology for counting pharmacy network claims in order to keep script counts consistent across our operating segments. Going forward, 90-day prescriptions filled within our pharmacy networks will be adjusted to a 30-day equivalent basis, just as we've been doing within the Retail/Long Term Care segment for several years. This change will also make us more comparable to one of our competitors, who recently made a similar change. The supporting schedules posted to our website this morning provide the historical adjusted script counts. With the change to methodology, our PBM adjusted claims grew 24.6% in the fourth quarter. In our Retail/Long Term Care business, revenue increased 4.7% in the quarter to $20.8 billion. This was in line with our expectations and driven primarily by strong pharmacy same-store sales script growth, partially offset by a decline in front store same-store sales. During the quarter, GDR increased by approximately 120 basis points to 85.2%. Turning to the gross margin, excluding acquisition-related integration costs recorded within the Retail/Long Term Care segment, we reported 16.6% for the consolidated company in the quarter, a contraction of approximately 115 basis points compared to Q4 2015. This was consistent with our expectations and primarily driven by a mix shift as the lower margin PBM is growing faster than the Retail segment. Within the Retail segment, gross margin declined approximately 40 basis points versus Q4 of 2015, to 5.2%, while gross profit dollars increased 9.6% year-over-year. The increase in gross profit was primarily due to increases in volumes, the improvement in GDR, and favorable rebate and purchasing economics. Partially offsetting these drivers was the impact of continued price compression. We outperformed versus our expectations due to lower utilization within the Medicare D PDP, as well as more efficient expense management within cost of sales. The decline in gross margin rate in the PBM was primarily due to continued price compression and the timing of Med D margins, partially offset by improved cost of sales management. Gross margin in the Retail/Long Term Care segment was 29.8%, down 40 basis points from last year, excluding acquisition-related integration costs. This decline was primarily driven by continued pressure on reimbursement rates. Partially offsetting this was the increase in GDR and the strong front store margin improvement, aided by the continued rationalization of our promotional strategies and improved product mix. Gross profit dollars increased 3.4% in the quarter. Turning to operating expenses, operating profit and the tax rate, the numbers I am citing on a comparable basis also exclude the items noted on the slides. Total operating expenses, as a percent of revenues, notably improved from Q4 2015 to 10%. The PBM segment SG&A rate improved approximately 25 basis points to 1.1%, thanks to improving efficiencies. SG&A, as a percent of sales, in the Retail segment remained relatively flat to last year at 19.5%. Within the Corporate segment, expenses were up approximately $20 million to $236 million, above our expectation. This was primarily driven by higher severance associated with our continued focus on cost improvements. Operating margin for the total enterprise declined approximately 45 basis points in the quarter to 6.6%. Operating margin in the PBM declined approximately 20 basis points to 4.2%, while operating margin at Retail declined approximately 40 basis points to 10.3% on an adjusted basis. For the quarter, operating profit growth in the PBM was above expectations for the reasons I provided earlier, while Retail/Long Term Care was in line with our expectations. The PBM increased a solid 13.3%, and Retail/Long Term Care grew 0.8%, again, on an adjusted basis. Going below the line on the consolidated income statement, net interest expense in the quarter decreased approximately $34 million from last year to $242 million, due primarily to paying down debt and a lower average interest rate on the debt that remains outstanding. Our effective tax rate in the quarter was 38.5%, and our weighted-average share count was 1.1 billion shares. For the year, our effective tax rate was 38.6%. The tax rate was lower than expected for the quarter and the year due to certain permanent items that were recognized during the fourth quarter. So let me now touch on our 2017 guidance. I’ll remind you that 2017 is expected to be a rebuilding year of sorts, but our goals remain clear and we fully intend to get back to healthy levels of growth going forward. I’ll focus on the highlights of our guidance here, but you can find all the details in the slide presentation that we posted on our website earlier this morning. In 2017, we continue to expect to deliver adjusted earnings per share in the range of $5.77 to $5.93, and GAAP diluted EPS from continuing operations in the range of $5.02 to $5.18. Note that the growth rates have been adjusted slightly to reflect the actual Q4 2016 jump-off point, which you can see on our slides. Let me point out that we are now including an estimate of $35 million of Omnicare-related integration costs in the GAAP guidance. Recall that we have been excluding those costs when we provided guidance last year, given our inability to reasonably forecast their magnitude and timing. But with the integration winding down and the small amount of expected costs in 2017, we can now reasonably estimate these costs. As you can see in the non-GAAP reconciliation, these costs were expected to be offset by minor changes in other non-GAAP adjustments resulting in no change to our GAAP guidance. We have reduced our top line growth expectations in both the Retail/Long Term Care and the Pharmacy services segments, while at the same time maintaining our dollar estimates for operating profit within each segment. Both segments are being impacted by lower inflation than what we had originally forecasted. Additionally, we're reducing script growth expectations at Retail to account for some softness that we're seeing in our business. As a result, we now expect revenues to be down 1.75% to 3.25% in the Retail/Long Term Care segment, with same-store sales down 2.75% to 4.25% and same-store scripts down 0.25% to up 0.75%. Top line growth of 7.5% to 9.5% is now expected in the PBM, while claims growth remains unchanged except for the change in methodology that I laid out before. Under the new methodology, we expect adjusted claims of $1.76 billion to $1.78 billion. We expect consolidated net revenue growth of 2.5% to 4.25%. As I mentioned earlier, our expectations for operating profit generated in 2017 remains unchanged. After updating the baseline for Q4, we continue to expect Retail/Long Term Care operating profit to decline by 7% to 9.5%, and expect PBM growth of 5.75% to 8.75%. This results in a decline of 2.5% to 5.25% in the consolidated operating profit. Moving on to first quarter guidance, we're making similar adjustments to the top line expectations to account for the same factors. We expect a decline of revenues in the Retail/Long Term Care segment of between 3.25% and 5%, with same-store sales down 4.25% to 6% and same-store scripts down 1% to 2%. We now expect PBM revenues to grow 6.25% to 8%, and consolidated net revenues to grow 1% to 2.75%. As you may recall, we highlighted several timing factors at Analyst Day that affect the cadence of profit delivery throughout this year, which is expected to be significantly back half weighted. With that in mind, in the first quarter we continue to expect adjusted earnings per share to be in the range of $1.07 to $1.13 per share, a decline of 4.75% to 9.75%. GAAP diluted EPS from continuing operations is expected to be in the range of $0.82 to $0.88 per share. Additionally, our free cash flow guidance for the year remains in the range of $6 billion to $6.4 billion. I'm very pleased with the company's continued ability to generate significant cash flow, which will continue to play an important role in driving shareholder value over the longer term. So with that, I’ll now turn it back over to Larry.

Okay. Well, thanks, Dave. We remain confident that we are well-positioned as the healthcare market continues to evolve. We continue to have the most extensive suite of integrated enterprise assets, and on a stand-alone basis each one would be market-leading. What really sets them apart lies in our ability, largely through technology, to integrate pharmacy care from the payer to the provider and ultimately to the patient. These capabilities help us to deliver on our goal of driving more affordable, more accessible, and more effective care. Now, let's go ahead and open it up for your questions.

Thanks very much, and thank you for all the color. Larry, how do we solve for this problem of the perception that PBMs are part of the problem and not the solution? Is there a way to provide more transparency, maybe as an industry is there a way to provide more transparency on Medicare Part D? I appreciate, clearly, everything that you had to say today, but I think that the rhetoric continues because of that lack of transparency. So any comments that you have around that, number one. And number two, as this discussion is going on in D.C., are you and the other PBMs part of this discussion?

Well, Lisa, it's a great question. First of all, I think it is important that the story be told in a succinct and factual way, starting with the key policymakers and decision-makers, and that starts in D.C. We've certainly been having those discussions in an effort to separate fact from fiction. For the reasons that I alluded to in my prepared remarks, we need to deal with this issue today. The PBM industry has dealt with this issue in the past and has gone through a series of reviews, as I alluded to earlier, whether it was through the FTC, the Congressional Budget Office, or other governmental agencies that have quantified not just the role that PBMs play, but the value that PBMs bring to the healthcare economy. It’s important that we start there. At the same time, we’re having a lot of discussions with our clients. As we talk about transparency with them, I believe that they understand the role that we bring for them. In this environment where benefit plan designs continue to evolve and change, we're doing more to share with them what we see as best practices across the industry, especially as you think about the growth of consumer-directed health plans and what it means to provide the value of those rebates or discounts at the point of sale and what it means to have a preventive drug list where there's zero out of pocket expense for their members. Those are just two examples. So, Lisa, I don't think there's a single answer other than, which I think is where you were going, it needs to be a surround-sound dialogue with a variety of constituents.

And, Jon, since he's in the room, as we move through the early parts of the selling season, are people asking for different things? We clearly just heard what Larry talked about, high-deductible health plans, having more visibility. Do you hear from your clients that they have the transparency that they want and, therefore, this is more of an outside type of event where the rest of us sitting here on the outside don't have the level of transparency we'd like, but your customers are happy and feel like they're getting what they need out of their PBM? Over time this will solve for itself? This is really the biggest issue right now as we think about the PBM industry going forward.

I mean, Lisa, those are all good points. At the end of the day, our clients hire us to manage their pharmacy benefit. The trend that we've seen through the first three quarters of the year is 3.3%. We’ll be looking at our final number for 2016 in a couple of weeks, and we think that number could potentially come down a little bit. They're very happy with the cost of their overall benefit relative to the price increases they're seeing in the market with branded prescriptions. Secondly, on the transparency issue, our clients do have audit rights with rebate and network contracts. They have the level of transparency they need while protecting our ability to negotiate and ensure that they get the best economics in the marketplace. Part of the challenge is just the complexity of the pharmacy pricing model. There's no easy answer for that, but we're continuing to work on it.

Lisa, it's Larry again. When I hear you ask that question, I think about the rhetoric from those selling the drugs versus those buying the drugs. When you hear that, it gives me pause in terms of taking a step back and really asking the question, why are we in this position to begin with? Looking back, nearly $100 billion of branded drugs have lost patent protection in the last four to five years, which has created headwinds for the pharmaceutical industry. You have new products entering the market that I describe as me-too products at inflated price points with no incremental effectiveness over existing therapies. This raises questions about why sponsors of care should pay for those higher-priced drugs, especially the ones that have hefty advertising costs. Connecting the dots on the rhetoric and understanding what has changed in the marketplace helps drive this dialogue.

Larry, just last thing. If it were to change and we go from gross to net, with some model changes, do you think this has a substantial impact on your model? Or is there still value to what you bring from a PBM perspective?

Lisa, I'll start, then I think Jon will want to jump in. As we've talked many times, as we underwrite the business we do so with an overall level of profitability, and there are many things we do that create value for clients. So the answer would be no. Many other things create value for our clients and their members.

And, Lisa, the other thing I would add is that if branded products were to move from a gross to net model, it would look more like the generic market where we would get discounts on the buy side. We believe we’re in a great position to negotiate favorable economics and continue to deliver value to our clients, so that doesn’t concern me at all.

Okay. Thank you so much.

Thanks, Lisa.

So, Larry, on the topic of partnering more broadly, how broad might you be thinking? Talk about the dialogues you're having today in managing the tension between being partners and competitors simultaneously. Does that limit where you think you can take this?

Yeah, John. Let me start, and then Helena will jump in. Looking at the industry broadly, I think for many stakeholders across the supply chain, the lines are blurry in terms of competition and partnership. Everybody is kind of learning their way around that. There are many examples of that out in the marketplace. We shared some of those beyond the CVS Pharmacy business. You look at our Med D business where we have SilverScript, and we’re managing the Med D benefit for about 40 of our health plan clients. Health plan growth for our clients has been faster than the market. That’s a great example of creating a win-win situation. So, the answer in terms of how broadly we think, quite frankly, it’s with all the PBMs we do business with. I’ll turn it over to Helena to elaborate on those conversations.

We started talking about this at Analyst Day, and I think we’re making nice progress. The change in strategy is that we used to go to PBMs and health plans just as a retailer talking about rate. Now, we're broadening that conversation, marrying the other assets within the CVS Health suite, bringing capabilities like MinuteClinic and Omnicare. This change is transforming the dialogue from rate-only to one where we bring even more value. We're having those conversations with all the PBMs we do business with, and as we mentioned at Analyst Day, 65% of prescriptions we fill are with other PBMs, making those important partners for us, along with health plan partners where there's great upside potential. It’s early in this game, but I’m encouraged by the conversations we’re having.

Lastly, you talked about softness in the retail script business, and it might be a little beyond the network exits. If that's true, could you offer insights into where that might be coming from? I assume you’re still getting some flu benefit from last year; it would be apart from that, correct?

Yeah. John, it's Dave. I think flu is probably at the early stages from a trend perspective, so I haven’t seen much of that compared to last year. What I would say is that the network changes are tracking very consistent with what our expectations were. We are seeing some soft script volume as we entered the year. I believe there was probably some utilization that flowed a bit into December at the expense of January, based on where patients are in their days of supply. There’s no specific issue driving that at this point.

Regarding flu, it hasn’t been a particularly strong flu season. We’re seeing increases mostly in over-the-counter cold products, but not so much flowing through to the script side.

Okay. Thank you.

Next question?

What more do you think can be done on the consumer side to educate individuals about the value-add and provide better visibility into what they are actually paying for regarding drug prices? Obviously, this is key as individuals aren’t seeing the full rebate value at the counter, as we saw with the EpiPen situation, which caused significant uproar. How can you help educate consumers regarding the value-add and the true costs given your toolkit?

Ross, it's a great question. I think part of it goes back to the earlier point I made, looking at how we can work with clients on the PBM side regarding best practices around plan design. The story for that consumer at the pharmacy counter changes dramatically if rebate value is flowing through at the point of sale, and not diluted across the overall plan design. The epinephrine situation is a great example of what can happen with increased competition within a therapeutic class, even if a similar brand isn’t an A/B rated generic. It does often require an intervention with physicians. The medical community is becoming more aware of price as a variable for care quality and continuity. By the way, we play that role at retail and in the PBM's role with formularies, so I think it’s an evolving answer and an important question.

On a long-term strategic level, many years ago, Caremark and CVS merged, which was a transformational transaction favoring the equity. How are you thinking about your vast offerings and relationships across the healthcare system? What dialogues are you having with healthcare leaders? How can you utilize your breadth of delivery and impact the consumer and your equity?

Ross, it's another great question. I think I'll take us back to our Analyst Day presentation where we discussed the different assets we operate. The common thread is that they deliver that last mile of care to the patient, regardless of where they are in the healthcare supply chain. This growing awareness underscores our role, especially given the demands for changing consumer behavior. Addressing your first question, the importance of collaboration with our partners highlights the value we can provide through our combined assets.

Excellent. Thanks, Larry.

Thanks, Ross.

Good morning, guys, and thank you for all the details. I want to get back to Lisa's question about the PBM selling season. Over the last couple of years, we’ve seen evolving competition, mergers, and changing dynamics in the market. As you approach selling season, what resonates differently in your pitch to health plan and employer communities? What does your historical experience tell you, given that some solutions haven’t proven to work?

Michael, this is Jon. The PBM industry is very dynamic and continues to evolve. When I speak to health plans or employers, I emphasize that they have three distinct models to choose from. We detail our capabilities, focusing on getting the best unit cost but also on lowering overall healthcare costs by influencing consumer access through initiatives like Specialty Connect and MinuteClinic. Our success in these areas, alongside managing total healthcare costs, has resonated with clients. Over the last three years, we've generated $31 billion in new business, which validates our model, and the market is voting with its selections.

Michael, it’s Larry. I’ll just add that we should focus on our pharmacy data to provide integration similar to combined medical and pharmacy benefits. There's a wealth of information we can leverage for diagnostics, enhancing our capabilities and value.

Great. Thanks, guys.

Thanks, Michael.

Thanks. Good morning, everybody. It seemed pretty positive that you grew the Medicare Part D captive membership by over 10% for 2017. My question is, without any specifics, what are investors wondering regarding the margin profile of the SilverScript Part D business for 2017? Are the margins expected to be similar to 2016? What are the general margin trends for your Part D business over 2-4 years?

Steve, this is Dave. As we look at our Medicare Part D product, one, it’s a successful product in the market and we've done quite well there. From a margin perspective, I would say that it’s probably a similar profile for 2017 as we move into 2016. This is a competitive market; you rebid this process and recreate the product every year, which affects dynamics. We're also working hard to reduce costs, and our product has proven efficient at doing that.

Okay, great. I’ll keep it at one question as well. Thanks.

Great. See you soon. Take care.

Thanks, Steve.

Great. Thanks for the questions. Going back to the updated guidance, it looks like you're dialing back some of the segment level assumptions. Could you share what specifically changed from Analyst Day to now that prompted you to adjust? What are the implications for revenue and profit growth for retail and PBM?

Just to be clear, Bob, it's Dave. We did not adjust operating profit guidance; the dollars remain the same. We updated from a growth perspective based on our Q4 results. What you’re seeing from a revenue perspective is largely due to inflation dynamics. While we are seeing the same number of inflationary events, the magnitude of each has been slightly softer than we planned. There’s been a lot of dialogue about this topic, and while concerns about inflation exist, our profits remain unchanged.

Bob, I want to emphasize Dave's comments. Recently, we've seen pharmaceutical companies revealing their versions of a social contract. Typically, pricing activity occurs in January; while we’ve seen similar activity, it’s been at a lower rate. The impact on our profit guidance reflects modest changes in inflation and how that impacts overall profitability.

Got it. Thank you.

Thanks, Bob.

Hey, Dave, just a quick one. You mentioned some upside to cash flow for the year. Was there any timing issue around that? And, Larry, on the front end, I understand the focus on traffic and basket size. But doesn't that front end number have to grow, or is that not something we can really expect from the model?

On cash flow, certainly for 2016, we performed well at generating over $8 billion in free cash. Part of this is timing, as we built a payables position with CMS that we’ll settle in 2017. The year-over-year decline in free cash flow is a factor of that. I commend our team for improving working capital terms, driven by enhanced inventory management, while also being shaped by PBM efficiencies.

I'll hand your second question over to Helena.

I believe we’ve been proactive in looking at our mix of spend on mass versus targeted efforts. We've likely been more aggressive than others in reducing unprofitable promotions while focusing on driving profitable growth. Although we’ve encountered performance challenges in certain product categories due to our pullback in spending historically, we’re seeing growth in health and beauty—our key focus. While I maintain optimism about the trajectory, our targeted capabilities are ramping up, and 2017 adjustments in mass promotions will provide further opportunities.

Thank you.

Thanks, Bob.

Hi. Do you have a program like Express Scripts SafeGuardRx where you guarantee trend in certain therapeutic classes and work with manufacturers to share in risk?

Yes, David. We have price protection in 90% of our pharma contracts. If manufacturers raise their prices over a negotiated threshold, clients receive compensation in the form of rebates. We can establish certain guarantees in therapeutic classes; I mentioned diabetes at Analyst Day. Our performance is measured by how well we manage our clients' overall healthcare costs.

David, we also have programs that we discussed previously on indication-based pricing, which is a version of that. This is aimed primarily at specialty, and we’re working with pharma on a different basis that focuses on patient outcomes.

Okay, great. And one more quick one. If DIR fees returned to last year’s levels, would that affect your P&L or would they all pass through to CMS?

Passed through.

All those are passed through to CMS. They affect our cost of goods sold, reflecting the pricing of our insurance product. That's how it's underwritten.

Great. Thank you.

Thank you. Regarding the selling season, I know it’s early, but have we reached a point where the low-hanging fruit has been plucked or does that opportunity still remain? Will that also apply to Part D?

Eric, it's Larry. Those opportunities are more often tied to the timing of existing contracts and the RFP process. The health plan mergers were a concern during those discussions—they’re now in the past. We still see value in smaller regional players. Hopefully, we can further solidify our relationship with Aetna as a key partner moving forward.

I would add that I don’t believe health plans represent plucked low-hanging fruit—more well-executed transitions are an opportunity. Past hurdles with moving could be less disruptive, and automation along with seamless transitions have become critical. I’ve spoken with two health plan CEOs that we onboarded just before this year’s welcome season. They expressed appreciation for the job we did, which affirms our capability to support health plans with their costs and engagement.

Thank you for that. Also, for the ASR, can you tell us the timing for the impact from when it was initiated versus the closure?

It started early in January and is expected to settle by the third quarter.

Will there be an initial amount versus the total at the end?

Yeah. I’d encourage you to review our filings later today; the specifics will be in there.

Okay. Thank you.

Thanks, Eric. Next question, please?

A couple of follow-ups here. First, regarding implied scripts for the year, what are you assuming for the cadence of losing DoD in Prime? What would that mean for implied script growth for 1Q?

There are a little more than 40 million prescriptions transitioning out of our business. TRICARE began on December 1, and Prime started January 1. You can adjust the impacts on script volume accordingly over the quarters. That should give you a normalized basis for considering script growth.

Does this imply around 2% to 3% script growth for the rest of the business?

I haven't accounted for that specifically. You can calculate that by taking the 40 million scripts and prorating them over the quarters for an implied growth number.

Just trying to understand if it reflects additional losses not announced or a broader market slowdown?

I don't believe that is the case. You’re seeing a reduced trend from prior years, but it primarily reflects expanded Medicaid programs. That’s driving a softer script growth as we cycle into 2017.

Thank you very much.

Thank you.

How would you characterize the savings experienced from Red Oak versus previous expectations? Where are we in terms of achieving savings targets through this venture?

We’re pleased with not just launching Red Oak but the health it brings to the supply chain. While incremental year-over-year benefit has moderated as we've established it, the team continues to seek efficiency, and we’re optimistic about our trajectory.

Great. One last question. How would you describe the competitive pricing environment in the last quarter and this year? Is it still rational?

We haven't observed material changes. It's a competitive, yet rational market, as you've noted.

Thank you very much.

Next question, please.

Larry and Jon, a follow-up. Are you seeing anything disruptive from larger players in the PBM selling season, be it in pricing, sales models, or offerings? And for Dave, any guidance on interest expense for 2017?

As far as new or disruptive factors in the selling season, it remains pretty consistent with past years. Nothing new to report.

In our posted deck, we included guidance for interest expense this year.

Okay. Thank you for your participation. We appreciate your time today. As always, Nancy and Mike are available for follow-up questions.