CVS Health Corp (CVS) — Q4 2018 Earnings Call Transcript

Good morning, everyone, and thank you for standing by. Welcome to the Conference Call to discuss CVS Health's Fourth Quarter 2018 Results and 2019 Outlook. As a reminder, this call is being recorded on Wednesday, February 20th 2019. I'm Mike McGuire, Senior Vice President of Investor Relations for CVS Health. I'm joined this morning by Larry Merlo, President and CEO; and Eva Boratto, Executive Vice President and CFO. Following our prepared remarks, we'll host the question-and-answer session. In order to provide more people with the chance to ask their questions during the Q&A, please limit yourself to no more than one question with a quick follow-up. In addition to this call and our press release, we have posted a slide presentation on our website that summarizes the information in our prepared remarks as well as some additional facts and figures regarding our operating performance and guidance. Our 10-K will be filed later this month and that too will be available on our website once filed. I have one announcement this morning. Our Annual Investor Day has been scheduled for Tuesday, June 4th in New York City. You'll have the opportunity to hear from our Senior Management Team who will provide a comprehensive update of the execution of our strategic vision and an in-depth review of our strategies for driving long-term growth and creating shareholder value. We plan to send the invitations via email with more specific details in this spring, but please save the date. Again, that's Tuesday June 4th. Please note that during this call, we will make certain forward-looking statements that reflect our current views related to our future financial performance, future events and industry and market conditions, and forward-looking statements related to the integration of the Aetna acquisition, including the expected consumer benefits, financial projections and synergies. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from what may be indicated in the forward-looking statements. We strongly encourage you to review the information in the reports we file with the SEC regarding these specific risks and uncertainties, in particular, those that are described in the Risk Factors section of our Annual Report on Form 10-K and the cautionary statement disclosures in our Quarterly Report on Form 10-Q. You should also review the section entitled Forward Looking Statements in our earnings press release. During this call, we will use non-GAAP financial measures when talking about our company's performance and financial condition. In accordance with SEC regulations, you can find a discussion of these non-GAAP measures and the comparable GAAP measures in the associated reconciliation document we posted on the Investor Relations portion of our website. And as always, today's call is being webcast on our website where it will be archived for one year following today's call. Now, I'll turn this over to Larry Merlo.

Thanks Mike. Good morning, everyone, and thanks for joining us today. We achieved strong performance in the fourth quarter, and in full-year 2018. And importantly with the completion of our merger with Aetna, we have positioned CVS Health to excel in a market that is undergoing profound and rapid transformation. In recent years, it has become increasingly evident that the path to long-term growth and value creation lies in the establishment of new integrated health care models that provide consumers with better care convenience at a lower cost. And since closing the Aetna merger, we are increasingly confident in the synergistic potential of this powerful combination to build and deliver shareholder value. CVS Health is in a superior position to lead the change needed in the fragmented U.S. Health Care System with our compelling fully integrated health care offerings, our unmatched local community assets, proven pharmacy care leadership and a commitment to collaborating with health care providers to achieve the very best outcomes for the patients and clients we serve. In 2018, we delivered on our financial expectations as set with Aetna, laying a strong foundation for a successful combination. We generated significant cash flows with nearly $7 billion of free cash for full-year 2018, consistent with our expectations, and we returned $2 billion back to shareholders through dividends and later deployed the cash we raised in early 2018 to fund the Aetna merger. So in short, 2018 was a milestone year both tactically and strategically as we successfully completed our transformational merger with Aetna. Now, we also delivered our key foundational steps for growth in health care services. This includes making more than 80% of primary care services available to consumers at MinuteClinic, while also increasing home visits by Coram for infusion services by more than 15%. Importantly, we began effective implementation of our integration strategy and took important steps toward building the integrated health care model that will bring substantial value to our various stakeholders. Now we expect 2019 to be a year of transition as we integrate Aetna, and focus on key pillars of our growth strategy, creating a more consumer-centric health care experience. As an example, our first three concept stores were unveiled earlier this month. And you probably saw press coverage last week. And there's a lot of excitement around the consumer engagement and response. Now it's still early as we're in the learning phase and working to define a hub-and-spoke approach, but it's an example of the work underway. And I'll share additional progress on achieving our vision in just a few minutes. Now, that said, we're also fully aware of the need to address the impact of certain headwinds that are having a disproportionate impact in 2019 when compared to prior years. Many of these issues we've talked about previously and the most significant is the ongoing pharmacy reimbursement pressures in our businesses and the reduction in offsets to those pressures. What we're experiencing in 2019 is the declining benefit from new generics, lower brand inflation and the ongoing questions around rebates, along with some structural and CVS-specific challenges in the long-term care space. And while these factors will negatively affect the business in the short term, I want to outline the comprehensive actions we have taken in response. In our Retail business, we are continuing to develop product and service initiatives that will accelerate top line revenue and profitability. We are winning from a growth perspective and we expect to continue on those positive trends. In the front store, this includes introducing new product lines in the health and beauty areas along with the expansion of higher margin service offerings. In the Pharmacy, we will continue to deliver market leading top line growth through our network relationships and clinical care programs. Additionally, we are developing a new retail contracting strategy that better aligns reimbursement to the value our clinical products provide enabling adherence improvements and star enhancements, while saving patients money, to name just a few. Second, in the PBM, we've created a new contracting model that provides for more transparency, and simplicity for and alignment with our clients. The guaranteed net cost pricing model is an innovative way to approach the market by allowing us to maximize all cost control tools at our disposal. In this model, clients will receive 100% of rebates while we leverage our core strengths of contracting expertise and utilization management to drive lower net costs for clients and members without compromising on the quality of care. Now, this is a win-win. Clients will benefit from the simplicity of one guaranteed price per claim that's focused on lower net costs and not discounts and rebates. Now we've introduced this approach to clients and benefit consultants, and we will have a small number of clients adopting the model this year. We expect a more rapid adoption in 2020 and beyond. Third, back in August, we outlined a 4-point plan to get the long-term care business back on track. And while progress is being made in the identified areas, the benefits are being offset by the external factors impacting the skilled nursing business. Work is underway to accelerate the action plan timeline to achieve the benefits more quickly. We've already begun to see some progress realizing nearly $80 million in process improvement savings with more to come. Fourth, in early January, we began planning a new cost reduction effort across the enterprise going beyond the previously announced productivity initiatives of the legacy companies and targeting opportunities that neither company would be able to accomplish as a standalone. This separate is in addition to the near-term synergy work tied to the $750 million target, which we are on track to exceed. If we look across the new combined enterprise, there are significant streamlining opportunities in member enrollment, claims processing and customer service, as well as through the use of robotics and advanced analytics. Additionally, we are focused on aggressively managing working capital, especially through the reduction of inventory and improvement of terms within our payables. We'll have more details for you on our May earnings call. And finally, we continue to evaluate our assets and the roles they play in enabling the core strategies of our new company. We'll provide updates to the actions we have underway as we execute our vision in a strategic, innovative, yet practical, realistic, and carefully prioritized way. We understand acutely the importance of balancing near-term execution with longer-term vision, and we are confident that these actions will position us well in 2020 and beyond. Now, several key pillars that we are executing on today will drive above market growth going forward in this rapidly changing health care environment. A few key initiatives that underlie the ongoing execution of our strategy are as follows. First, we are growing membership. We are working to expand the reach of our government business with Medicare positioned to lead the way. Medicare advantage top line growth is being driven by the addition of new membership and existing markets and continued geographic expansion. Driving excellence in STAR ratings continues to be a primary focus for our business. By enhancing our clinical model products and capabilities, we are expanding our offering to take care of higher acuity and complex members, including dual eligibles, that critically important set of beneficiaries, when bending the cost curve. Our success and building the largest Medicare Part D plan, SilverScript, while simultaneously becoming the partner of choice for more than 40 Health Plan Part D clients, gives us the confidence that we can further expand upon the success of both organizations. Looking ahead, we see a strong and growing pipeline of new business opportunities within Group Medicare for 2020, and we see opportunity as well within Medicaid building upon the success we've had with recent wins in Kansas and Florida. And of course, we are actively working to strengthen our commercial offerings. Now success in all of these areas requires the use of our full breadth of capabilities, comprehensive data, predictive analytics and our unparalleled intervention points with consumers to drive behavior change and improve health outcomes. Both Aetna and CVS Caremark have very successful employer businesses, and we're working on opportunities to create new products and services to meet the needs of these payers. We are creating differentiated products and services at the community level, driving meaningful value for both consumers and payers, while improving the bottom line. This reflects our broad base of consumer-facing assets that is highlighted by our nearly 10,000 CVS pharmacies. And I touched on the first concept stores earlier, but importantly, our assets extend well beyond our pharmacies, when you think about the role and the value that MinuteClinic, Coram, Accordant, and other ancillary businesses can play. While our community assets have the power to improve outcomes and reduce costs, they also contribute to enterprise revenue and earnings growth. Third is the role of partnerships in accelerating innovation. Our recent announcement with Apple on the development and springtime rollout of Attain by Aetna is just one example. Applying new technologies will be a component of our consumer-centric approach to improving health. Finally, we are establishing the optimal structure and go-to-market strategy for our health services offerings. We've been very clear about our vision of creating an open platform model that will serve the needs of all payers. To support this goal, we are integrating existing capabilities with new products and services that will benefit all Aetna and Caremark clients and their members. We are on track to have this in market for the 2021 selling season. So, we're more excited than ever about our progress and the opportunities that lie ahead. We also have a good understanding of the factors that impact our business in the near term and are actively working to address them. We view 2019 as a bridge for the future, and we expect our businesses to strengthen meaningfully from the integration of CVS and Aetna's core capabilities. I'm also pleased to introduce the leaders of our businesses: John Roberts, Chief Operating Officer; Kevin Hourican, President of CVS Pharmacy; Karen Lynch, President of Aetna; and Derica Rice, President of CVS Caremark. They'll be joining us for the Q&A after our prepared remarks. Our senior leadership team is energized by the prospects of our new company and together with all of our colleagues across the enterprise we are laser-focused and fully committed to delivering on the vast potential of this combination. So let me turn the call over to Eva to walk through key items from '18 and the details of our '19 financial outlook.

Thanks, Larry, and good morning, everyone. Before I get into the details of our results and guidance, please note there is a significant amount of information in the presentation we posted to our website this morning to help you understand the changes to our financials for both 2018 and 2019. Regarding 2018, while the face of the P&L is different, definitions of the non-GAAP are consistent with legacy CVS. However, interest income is shifting from net interest expense to revenues to conform to insurance company presentation. With that, I'll provide some key highlights for 2018. As Larry stated, CVS Health generated significant free cash of nearly $7 billion for the full-year 2018. We used it in addition to the cash on hand to repay $5.5 billion in debt, of which $3.5 billion were scheduled maturities and $2 billion was a voluntary early repayment of a 5-year term loan. We also delivered $2 billion to shareholders through our dividend. We delivered adjusted EPS of $7.08 at the high end of our guidance range, reflecting the addition of Aetna, with all of our businesses performing at our expectations. On a standalone basis, CVS Health's adjusted revenue grew 2.3% in 2018, at the top end of our full-year guidance range. With the addition of 34 days of Aetna's operations, which are now embedded in our new Health Care Benefits segment, adjusted revenues grew 5% to $194 billion, with HCB contributing an additional $5.1 billion after considering elimination. In 2018, the Retail/Long Term Care segment delivered adjusted script growth of 8.8%, driven by our pharmacy clinical programs comprised of increased adoption of the 90-day program as well as the successful partnering with PBMs and health plans via network relationships, including additional preferred positions in a number of Med D networks. Adjusted operating income declined by 1.2%, driven by our decision to invest a portion of the benefits we've realized from tax reform into wages and benefits. Additionally, we continue to experience underperformance in the long-term care pharmacy business. Excluding those two items, standalone retail pharmacy adjusted operating income grew solidly by about 5% over full-year 2017. Notably, our market-leading script growth increased our pharmacy market share to a record 26% in December. In the PBM, adjusted claims increased 6.1% over full-year 2017, driven by net new business wins and continued adoption of maintenance choice. PBM operating income was up nearly 1%, as expected. The formulary and cost management strategies Caremark has developed effectively mitigated drug costs increases in 2018. Prices for non-specialty medications decreased 4.2% for commercial clients, while we also held price growth on specialty products to just 1.7%, despite even higher list price increases. We also worked to improve health outcomes and reduce member costs successfully driving the average cost per script for plan members down for a third year in a row. Finally, the Health Care Benefits medical membership was 22.1 million. Government programs represented approximately half of HCB's insured membership at year end 2018 positioning the segment to drive future growth. Overall, HCB operations performed as we expected. Medicare advantage membership growth materially outpaced the market fueled in part by our strong STAR performance. Our clinical care and service programs expanded their reach in 2018, resonating in the marketplace and strengthening the value proposition of our commercial offerings. Adjusted gross margin for legacy CVS Health was 15.6%, up 20 basis points compared to full-year 2017. This was due to mix given that the higher margin retail business grew faster than the PBM. Total adjusted operating expense dollars increased 12%, largely driven by the addition of Aetna's business as well as investments from a portion of the tax reform benefits into the retail business and cost to support pharmacy growth. As noted in our press release this morning, due to continued industry-wide and operational challenges, in Q4, we've recorded a $2.2 billion goodwill impairment charge on the long-term care business. Transitioning to our 2019 guidance, there are a few key changes to note. Beginning in 2019, we are realigning our segments for changes to our operating model that I'll detail shortly. Our adjusted operating income guidance reflects the adoption of Aetna's legacy definition, which excludes intangible amortization. We maintain the same definition for adjusted EPS, which excludes intangible amortization and transaction and integration costs, which were consistent across both companies. A summary of the changes is included in the slides we posted to our website along with the full GAAP to non-GAAP reconciliation. For 2018, it has been adjusted for comparability as appropriate. As stated in our press release, consolidated full-year adjusted EPS is expected to be in the range of $6.68 to $6.88, down from the $7.08 we reported in 2018. We expect consolidated full-year 2019 adjusted operating income between $14.8 billion to $15.2 billion with consolidated revenue in the range of $249.9 billion to $254.3 billion. For the segments, we expect operating income in the Retail/Long Term Care segment to be in the range of $6.6 billion to $6.7 billion and the Pharmacy Services segment in the range of $4.8 billion to $4.9 billion. We expect that HCB segment operating income to be in the range of $5.1 billion to $5.2 billion. Significant synergies will be generated by the combined business this year stemming from elimination of duplicative corporate and operational functions, purchasing efficiencies, and some medical cost savings including formulary alignment. These synergies are expected to be between $300 million and $350 million in 2019, and we are on track to exceed our goal of $750 million in 2020. Additionally, there will be investments and initiatives designed to set the foundation for future new product offerings. Investments are being made to further our analytics and digital capabilities, develop new programs such as chronic kidney care, and enhance Aetna's clinical platform. We expect our incremental investment spending to be between $325 million and $350 million in 2019. Integration costs of approximately $550 million are excluded from our non-GAAP guidance. We expect to deliver between $9.8 billion to $10.3 billion of cash flow from operations. We remain committed to our capital allocation priorities. After the payment of our shareholder dividend, capital retention to support our insurance operation and growth capital expenditures of $2.3 billion to $2.6 billion, we'll use the remaining cash available to continue to pay down debt. As we stated, when we announced the Aetna acquisition, while we intend to maintain our shareholder dividend, we will not restart share repurchases or engage in large M&A transactions until we achieve our leverage targets. We expect to pay down our maturities this year as they come due and have other sources of pre-payable debt available to us. We expect leverage to modestly improve, and we will pay down debt in line with previous expectations. Moving on to the segments, for the year, we expect Retail/Long Term of revenue to be between $85.3 billion and $86.8 billion with adjusted operating income down about 10%. Retail is expected to continue to deliver strong adjusted script growth in the range of 4.5% and 6.8% due to continued successful execution of our pharmacy clinical care program that drives improved adherence and patient retention. Additionally, we will experience growth in the Medicare partnerships we formed in 2018, as well as a few new regional preferred relationships in 2019. The contraction in adjusted operating income reflects the annualization of tax reform investments and expected performance of long-term care. These factors are expected to contribute nearly half of the contraction. Continued reimbursement pressure without the full benefits of traditional offsets is also causing contraction. Historically, reimbursement pressure has been primarily offset by growth in generics as well as inflation on branded pharmaceuticals. We will experience a larger year-over-year headwind from a lower contribution from break-open generics and diminished return on generic dispensing increases. The front of store is expected to drive margin with a focus on winning in our health and beauty businesses through improved customer personalization and consumer engagement. Front store margin rate and dollars are expected to expand year-over-year. As we look to the future, we believe CVS Retail is best positioned in the market to deal with the challenges we see. Our best-in-class clinical programs will allow us to continue to gain market share. We have strong partnerships with payers, including incentives to drive dispensing into our CVS channel. Finally, we will continue to drive efficiencies in our pharmacies through the use of technology and productivity improvements. Now, let me turn to the PBM. This segment's 2019 reported figures will be affected by two important reporting changes. First, our Individual SilverScript PDP will move from the PBM segment to the Health Care Benefits segment enabling us to rapidly create the best products for seniors in advance of the 2020 bid season, in this important part of our business. We have restated 2018 results for comparability, and this information is also available on our website. Second, we will consolidate the pharmacy operations of Aetna into the PBM to enable us to rapidly drive efficiencies. For the PBM segment, in 2019, we expect revenue to be in the range of $136.5 billion to $139 billion with adjusted operating income down low-single-digits. There are a few key elements driving 2019 PBM performance to note. As we have stated previously, price compression continues to be a factor in the marketplace, exacerbating the impact is the cumulative effect on rebate guarantees due to lower branded inflation. Second, the net benefits from the 2019 selling season are expected to be modest. We expect Anthem to remain a stronger headwind given the investments required to onboard the business on its accelerated timeline. The onboarding is expected to begin in the second quarter of this year. As a reminder, the revenue for this contract will be recorded on a net basis. Our retention rate stands at a strong 98% for 2019. In addition, Centene has notified us of their intent to move their business to their PBM partner RxAdvance. It is expected to begin in 2019, although the exact timing is not clear at this point. The retention rate I mentioned excludes any impact from this transition. Additionally, the PBM will benefit from the segment's shift. On a like-for-like basis, operating income will be down mid-single digits versus 2018. It is clear that the PBM industry is in the middle of an environmental change given the dialogue around rebate. However, it is also clear that the PBM brings tremendous savings and value to the clients we serve. The importance of size, scale and customer relationships will continue to be paramount, and we remain focused on delivering the value our clients expect. Finally, in the Health Care Benefits segment, we expect revenue between $67.7 billion and $68.7 billion in 2019. We expect continued strength in our government programs with top line increases, driven by industry-leading Medicare growth as well as the key Medicaid wins in Kansas and Florida. We expect to end the year between 22.7 million and 23 million medical members as we expect strong commercial ASC membership teams to complement our government program growth. A handful of other dynamics will impact HCB results including: year one deal synergies will disproportionately benefit the HCB segment; second, incremental investments will be deployed in 2019 to accelerate growth, enhance infrastructure and drive market differentiation; third, the suspension of the Health Insurer Fee in 2019 will impact certain operating ratios, while the after-tax impact of this suspension versus 2018 is immaterial. Finally, certain one-time benefits realized by Aetna in 2018 are not expected to repeat in 2019, and the HCB segment will be negatively affected by the segment movements discussed earlier. Excluding the segment news, the incremental investments we're making in 2019 to accelerate growth and the impact of the HIF suspension, HCB operating income is expected to grow modestly. Turning to operating efficiencies, both CVS and Aetna have had a strong history of successful cost productivity initiatives. As we begin integrating the two companies, we are seeing the opportunity to accelerate our cost savings across the enterprise even further than originally expected. As Larry stated, we are embarking upon an aggressive cost reduction initiative. The savings this will generate will help offset the competitive dynamics we have experienced, drive the creation of more affordable products for our customers and provide capacity that will help us achieve our financial targets as we continue to invest in our strategic and transformational initiatives. We are confident that these initiatives will help drive longer-term growth in the combined business beyond 2019. Before I wrap up, I want to touch on expectations for the first quarter and the remainder of the year. In Q1, we expect to deliver adjusted EPS of $1.49 to $1.53, and GAAP EPS of $1.4 to $1.8. As you look at the spreads for the remainder of the year, you can assume that the seasonality of our expected results this year will closely resemble that of our reported results in 2018. Year-over-year growth of consolidated adjusted operating income will be highest through the first three quarters as we wrap the addition of Aetna. In the legacy CVS business, Retail, Long Term Care and PBM, we expect to see our greatest level of year-over-year deterioration in Q1 with operating income growth in those segments improving as we move throughout the year. Adjusted operating income within HCB is expected to be greatest in Q1 and lowest in Q4. At our Investor Day in June, we will provide you a more detailed roadmap to long-term growth. We will provide you with our long-term targets, including more specifics around the innovative products and services we plan to bring to market. We'll also outline our capital structure and allocation plan to provide you with more visibility into the timeline for returning more capital to shareholders, while also continuing to invest in the business. With that, I'll turn the call back to Larry.

Alright. Thanks, Eva. Well, CVS is much better positioned to provide value to our customers and the broader community through our new enterprise model. Our diversified company is providing our stakeholders with a highly effective ability to make health care more local, more simple, and less costly, while reducing our dependencies on dispensing revenue and maximizing the benefits from value-added services. We have a number of unique offerings being piloted or launched in the coming months. Those capabilities utilize enterprise assets in a differentiated way with the goal of increasing consumer engagement while improving health outcomes and lowering costs. As an example, expanding MinuteClinic services and incorporating CVS community assets in conjunction with Aetna analytics around the member's next best action will allow us to help individuals achieve a better health outcome. We see tremendous opportunities ahead, whether it's improving adherence, closing the gaps in care, engaging high-risk members through care managers or providing new approaches to complex disease management. Take the mitigation of hospital readmissions. We understand the contributing factors to readmission and we can now bring solutions to those factors. Aetna had about 470,000 hospital discharges in 2017, and about 47,000 of those were readmitted at an average cost of $14,000. If we're successful in cutting that number in half, we remove more than $300 million of costs while creating a better patient experience. The list of opportunities goes well beyond the few examples mentioned. Importantly, many of these unique service offerings will ultimately be available to our health plan clients creating value across the health care system. It's this combination of assets and capabilities that will ultimately drive enterprise growth and create significant shareholder value. With that, let's go ahead and open it up for your questions.

Larry, Eva, if we think about all the headwinds, in particular, that you outlined going back to your conference presentation last month, I guess, relative to then, what was bigger than you expected? And I guess, most importantly, as you think about all of the big ones, whether it's Omnicare, Anthem, Centene transition, etc., what do you view as the most transitory, in particular, what you have the most confidence in their transitory that'll be able to reverse itself or at least improve in '20 and beyond?

Yes, Mike, it's Larry. Good morning. Thanks for the question. Mike, as you look at the transitory nature of the headwinds, you think about the impact of the investments in tax reform. That rolls off mid-year of this year. You look at the inflation impact on our rebate guarantees. That peaks in 2019 and rolls off at the end of 2020. We certainly expected Omnicare performance to stabilize and improve. As you think about the contribution of generics, as we've talked many times, there are going to be peaks and valleys that can occur in any given year. As we sit here today and look at what that looks like for 2020, we expect that to improve, so many of these headwinds are transitory in nature. Also keep in mind that there are parts of the business that have momentum, growth in Medicare, growth in the commercial business. We've got momentum at retail, just in front store growth and pharmacy growth as well. We're really pleased with the speed with which we're executing the integration activities.

And, in addition to what Larry mentioned, we also see further opportunities to continue managing our costs and reduce our core to help alleviate these challenges as we move forward.

Let me revisit the guidance again. Examining the various segments compared to our street numbers, it’s clear that retail is facing the most significant headwind year-over-year. Larry, when you mentioned temporary issues, it’s evident that Omnicare is not one of them. Is that the primary factor influencing retail? You mentioned a new reimbursement model that you believe will gain traction in 2020, leading to improved reimbursement outcomes. I’d like to understand how we anticipate retail will recover as part of my first question. Secondly, how do we assess the $3 billion cost-cutting initiative you discussed a few years ago? What impact do we see from that in the numbers and how is it progressing?

Hi, Lisa, this is Eva. I'll start, okay. As you think about the performance in Retail, contracting about 10%, the impact of Omnicare as well as the tax reform investment that it represents about half of the contraction. Clearly the next most significant driver is what Larry described around lower benefit from generics in 2019. In terms of the streamlining efforts, that is on track, and we're delivering in line with our expectation. It's reflected in both the PBM and the Retail segments.

Good morning, Lisa, this is Kevin. I can also talk about the longer-term component. Our plan to improve profit outlook in Retail is focused on three very important things. First is to grow the top line. Increasing the script volumes enables us to leverage the highly fixed-cost nature of retail pharmacy fulfillment. That's the first. The second is to lower our fixed and variable costs. As Eva just spoke through, there are significant productivity improvements, namely automation within the pharmacy fulfillment process as well as continued reduction in cost of goods sold through Red Oak. The third, and Larry mentioned this in his prepared remarks, is the migration to a new and improved third-party peer contracting model. We will align incentives with payers to lower overall health care costs and begin to reduce the pressure over time on the actual core pharmacy reimbursement rates.

And then, just as a follow-up to that, is Omnicare strategic to the company going forward? I mean, if I listen to you, Omnicare has been a headwind last year. Even you just talked about it being half of the headwind for 2019. Is this a strategic asset for CVS going forward?

Lisa, it's Larry. The growth opportunity with Omnicare was always focused on the independent and assisted living spaces. Those opportunities still exist and are consistent with our strategy of putting the customer at the new place of transforming care. The challenges that we have in that business are really around the skilled nursing facilities, which have performed worse than we originally expected.

I understand the general commentary, but could you provide a breakdown of the challenges in each category you mentioned? It would help clarify the numbers and the impact of each challenge.

Yes, Ralph, this is Eva. I attempted to break down the components. Regarding Retail, which has the most significant effect, the consequences of Omnicare and the annualized effect of the tax reform investment account for nearly half of the decline in the Retail business. The remaining factors are largely due to the absence of generics as the primary contributor. On the PBM side, the cumulative effects of the rebate guarantees impacted by lower inflation are also a considerable factor. Additionally, as we mentioned, we observed some effects in 2018, but the new aspect is that this is a key element pushing us to the lower end of our guidance range. We anticipate that this will continue into 2020.

And then just maybe a quick follow-up, you had a little more time to digest the HHS rebate proposal. Any updated thoughts there, and particularly, if it gets implemented for 2020? And then more broadly, you mentioned the new PBM sort of net pricing model. You expect, I think, you expect to see a small number initially and more rapid adoption beyond 2022. I guess, how do you drive that change, particularly if employees like the legacy model? Do you see yourselves perhaps moving to just that net pricing model and moving away from rebates altogether? Thanks.

Yes, Ralph, it's Larry. Maybe I'll take the first part and flip it over to Derica and talk about the new pricing model. But as you look at the rebate role, we fully support the administration's objectives where reducing drug prices and out-of-pocket costs for consumers. CVS has pioneered a number of innovative solutions that hit delivered against that goal. Unfortunately, we see the rebate role taking us backwards, not forwards. We've been very public about the fact that 100% of rebates are turned over in the Medicare business and have been utilized to down premiums. You look at that dynamic, premiums will increase; some actuarial reports have it growing as much as 52%. We took a step back and looked at today's Part B program. We went back to 2009; monthly premiums were $29, 10 years later, $32. At the same time, you look at generics, they represent about 90% of all Part D scripts that are dispensed. Those are two important data points that absolutely point to premiums increasing for everyone. A small percentage of seniors may benefit, but again, actuaries estimate as many as 70% of beneficiaries are going to be worse off. We'll have fewer beneficiaries signing up for Part D, and we're looking at an estimated cost of that at $200 billion over 10 years, putting taxpayers at risk while branded pharma has a profit windfall. Readily available solutions in the commercial space can be applied to Medicare. We work with commercial clients to reduce out-of-pocket costs with point-of-sale rebates and the utilization of a preventive drug list. Programs like that can help significantly more than the proposed rebate rule. We also have discussed the real-time benefits tool in Caremark. Kevin's got a similar program in our retail pharmacies, and both of those tools have reduced out-of-pocket costs for consumers. We're certainly laying in during the comment period, with our concerns with the rebate role, but more importantly, what we believe the appropriate solutions are to address the root costs of what we're trying to solve for.

Good morning, Ralph, this is Derica. In regard to our new pricing model, what we're calling the guarantee net cost model, we've had two clients adopt for 2019. In addition to that, we've already provided to all of the benefit consultants draft contract language. They've been able to walk through and see all of the elements in terms of the fine print and the details. The feedback thus far has been very positive. So we will look to continue to drive more rapid adoption through the remainder of 2019 and more specifically for the 2020 period. In terms of rebates, whether we have them or discounts, what we really want is still the opportunity to execute formulary management, which is the methodology we've been able to free historically to be able to create value for our clients and our members. As long as we have access to that where we have to be able to do that with the manufacturers, we will be able to execute the GNC model. What this means is getting to the lowest net costs. It is not a focus on aggregate rebate value.

First, I wanted to discuss rebate guarantees and break-over generics. I'm trying to understand their performance in 2020. Larry, you mentioned that break-over generics improve in 2020 compared to 2019. Can you provide any specifics on that? Similarly, regarding rebate guarantees, it seems like they peak in 2019. Do you believe they will improve in 2020? Could you elaborate on the adjustments you have made in your guidance concerning rebate guarantees?

Yes, Justin, this is John. I'll take the generic question first. The overall dollar amount of generic launches in '19 is similar to what we saw in '18, but there are some key differences. You heard us talk about less value from break-open generics in '19 compared to '18. That's primarily due to the timing of the launches leading to slower progress in '19 to break-open status. But there are also more generics launching in '19 compared to '18 that are single-source generics, where we're unable to optimize our profitability during that exclusivity period. As a result, these generics for the most part are headwinds in '19. As we look forward to 2020, based on what we know today, we see 2020 improving from where we were in 2019.

In regards to the rebate guarantees exposure, just recall from both Eva and Larry's remarks that we anticipate that the rebate exposure peaks in 2019. We anticipate that it will go down over the 2020-2021 period. We've also adjusted our underwriting models to now assume a mid-single-digit inflation rate.

That was a standalone legacy CVS, PBM. I'd say it's in the same zip code, if you will, in terms of that overall two to three percentage points.

My question was about the health benefits aspect. You mentioned that the experience-rated book would lead to a reset in the medical loss ratio, which is a bit higher than we expected. Is this a one-time occurrence? Can you discuss the implications for membership in terms of retention and new growth? When are you planning to launch the Aetna and Caremark books together? Will that be mid-year this year, with one month of training, or possibly later?

Ana, this is Eva. I'll start. As you look at our guidance for the MLR, it's about 84%. There are a couple of things that I would call out. First, obviously, the mechanics of the HIF, as well as if you look at the mix of our business, we have very material growth in the government services business, which increases that MLR. It's early in the year, and we feel it's important to be proven as we look at these estimates.

Ana, just to answer your question on when we'll go-to-market with Caremark, look, obviously, we're in the process of evaluating where we have opportunities. We're rapidly looking at where we have medical and pharmacy and vice versa, working very closely with Derica. We're building product and service capabilities so that we can go to market. You should expect us to see go to market later this year, early in 2020.

If I could just sneak in a follow-up on that, also on the tax reform. Aetna had seen some pressure on MLR rebates. Will this combination help you on that? Will that start in 2020? Also, you talked about enterprise value in your last communications both closed. Is that going to impact how you price your Aetna book because you do have value that's created now from the PBM and Retail that wasn't there earlier?

Yes, relative to pricing we will factor all that and consider that in our pricing. But, Ana, what I would tell you is, we'll continue to maintain pricing discipline on our commercial book, but we'll take the value of a combined organization or the value that we expect to capture some additional services in consideration when we do price our book.

So for the HCB segment, the slides include their comment that excluding segment shift impacts, incremental investments, and the impact of the HIF, the operating income is expected to grow modestly over 2018. I think some investors might have been expecting that profit growth to be a little bit stronger in '19, just given the robust Medicare Advantage membership growth for Aetna, actually both last year and this year. I know there's a general notion that new MA lives aren't that profitable in year one. Maybe you can just give a little more color high level around the Medicare Advantage membership growth in 2019. Maybe just frame it in terms of top line growth versus profit growth within HCB? Thanks.

Yes, Steve, this is Eva. I think a key aspect is we noted in our prepared remarks that we're making significant investments in terms of transformation. There's some of that affecting the HCB segment. So the modest growth is obviously taking into account that that impact.

Regarding the general growth in Medicare for 2019 and 2020, we are outpacing the industry. It's important to differentiate between individual and group segments in our Medicare business, as they have different margin profiles. For 2020, we are very pleased with the growth we've achieved so far. As you may have noticed, we are exceeding industry growth, which reflects years of investment in Medicare, our STAR performance, our expansion into various geographic counties, and effective management of our benefit products. For growth expectations on January 1, consider it to be evenly split between group and individual segments.

Larry, going back to the HHS rebate rule, I understand the questions that you raised, but assuming that the rule is finalized effective January 1, 2020, it seems that there's going to be a change to the business model as we know it today. So, one, can you fully offset with premium increases an impact on the PDP business; two, what would be the implications for your commercial, that is based on past experience, how long does it take before we see the spillover effect to commercial changes; and three, you're in the hole on the commercial book on rebate guarantees. Is the new rule a material enough change that will allow you to go back to your commercial customers and trigger a change in current contractual terms that can help offset that?

Ricky, it's Larry. Regarding your first question about offsets, we would evaluate that using different assumptions, as I mentioned earlier. The main concern is whether individuals might opt-out of a Part D program due to the rise in monthly premiums. Our extensive research indicates that beneficiaries prioritize this aspect, and SilverScript has managed to grow by keeping its monthly premium low for the reasons I previously discussed. Your second point about commercial clients reflects that they generally seek the same benefits as those in the Medicare Part D program. They prefer to utilize rebates and discounts to reduce the monthly premium. I don't anticipate a quick shift in the commercial sector for this reason. Additionally, it's important to note that Caremark launched a new plan called Allure this year that applied rebates at the point-of-sale. However, only a small number of seniors, about 20,000, enrolled in that plan, and we believe the increase in monthly premium played a significant role in that low enrollment.

Okay. So, a follow-up question here. If the change happens, can you go back and change some contractual terms? Secondly, it's obviously 2019 is a transition year, and you're going to give long-term guidance on your Analyst Day, but it's been over a year since you gave us a year two accretion goal. Can you give us any update there, or what type of growth should we expect next year?

Ricky, regarding your question about whether we can revisit client agreements in the event of a significant change in the program structures, the answer is yes. However, we won’t be providing a 2020 outlook at this time. We are actively working on this, and we acknowledge the considerable progress made in the integration efforts linked to our synergy objectives. As you consider the regulatory process, it’s important to note that we were only able to start the transformation work earnestly at a late stage. We are pleased to report that we have concept stores operational, a number of pilots in the market, and several additional initiatives ready to launch for testing and learning, which is our main focus. We aim to complete more of this work so that by June, we can provide a long-term outlook.

I actually just want to follow up on Ricky's question because I do think 2020 is important because when you closed the deal, you did give some directional guidance of mid-single digits, and if you adjust for tax reform, it would suggest a mid-$8.00 range. The reason I bring it up is because that's where your consensus estimate is now, so I know you don't want to comment on it, but what do you think that we should consider in our models as the biggest change to your business model since you gave that guidance in December of 2017, I believe? That's one. Secondly, on the Retail operating profit decline, if you exclude the Omnicare and, I think you said, the tax reform investment, it's down 5%. I know you say it's because break-open generics are less of an offset, but I still think that's very low. Can you give us some more detail on what's happening there so we put it in our models going forward? Because it just seems a bigger decline than I would think.

This is Kevin. I'll take the Retail question and then Eva will talk about 2020. The primary headwind in the Retail profitability, excluding Long-Term Care and the tax investment, is in pharmacy reimbursement. It's impacting small operators and big operators. It's a secular headwind impacting everyone. What we talked about is a tailwind that typically is utilized to help us blunt that reduction is the generic wave, and John covered well that that value year-over-year is down. Eva also mentioned in her prepared remarks that there's benefit from branded inflation that helps that blunting as well, and that number is down year-over-year. We're seeing a consistent headwind. It's the two tailwinds themselves that reduced in value year-over-year, and as I mentioned a few moments ago, our plan to address that for 2020 and beyond is to accelerate our top-line growth. The good news in our retail business is we are winning in the top line. We're taking market share in both the front and pharmacy business. We're resonating with consumers, growing share of wallet with consumers, and taking market share. What we need to do more of for 2020 and beyond is increase the year-over-year value of productivity improvement. We have compelling innovations coming in technology improvements that can help automate things that are currently done manually within the pharmacies, and I'll just repeat: The most important thing we need to do is pivot in our third-party payer contracting. We're going to lead the change there to migrate to a new method of doing pharmacy contracting. We're going to start with ourselves. By owning a large insurer and the largest PBM, we can lead that change by structuring a contracting relationship that if we can lower overall healthcare costs, we can take some of the burden off of the annual reimbursement reform.

I'll revisit your question about 2020. As Larry mentioned, it’s still quite early to provide guidance or expectations for 2020, but I’ll do my best to offer some insight. Regarding the accretion numbers shared when the deal was announced, it is challenging to comment on those at this time. Given when the deal closed, it requires blending different time periods and considering changes due to tax reform. What is certain is that Aetna is performing at or above our expectations. We fully support the estimates regarding the value created by the deal, and as mentioned, we are ahead of our second-year synergy target for 2020. The elements impacting what I refer to as the legacy CVS business will either improve or phase out as we look toward 2020; the tax reform investment has been completed, the effects of the rebate guarantee peaked in 2019 and are diminishing in 2020, and we anticipate improvements in Omnicare and generics in 2020.

Just to follow up there on the synergies, it clearly sounds like you're still on track. One of the other sides of it that was a little bit larger than I think we would have expected was the incremental spending in order to achieve those synergies. So just on the numbers that you provided for this year, could you talk a little bit about what that spend is exactly? Eva, I know you said that HCB would disproportionately benefit from the synergies this year. Is that safe to assume where the incremental spend would also come?

As we consider the additional investment spending, it's estimated to be in the range of $325-350 million. This spending can be categorized into two main areas. The first is supporting transformation, which involves investing in our clinical platform to engage members more effectively, our chronic care initiatives, and other projects aimed at improving outcomes and reducing costs. The second area where we are continuing to invest and increasing our investment is in digital, enhancing the digital and mobile experience for our members and customers across all our businesses, along with investments in our Health Cloud software platform. A significant portion of these investments will impact the businesses, and when comparing, it's important to note that there was no spending in 2019 to use as a reference point.

It's safe to assume, Eva, that as we roll beyond 2019, these costs should reduce? That would just be the quick follow-up. Then, the other question I had was just more housekeeping. As we look at the guide for HCB housekeeping, is prior-period development included or excluded from that guidance? Thanks.

Bob, I'll address your last question first. Consistent with Aetna's legacy practices, our guidance does not include any prior-period development. Regarding investments in the business, I believe that while these investments will gradually decrease over time, we will continue to invest in our business as we adapt to our new model, which focuses on the consumer.

Bob, just keep in mind that as we've discussed regarding the Retail side, we have the opportunity to repurpose capital that we would have spent in other areas for our activities here, which is why you don’t hear us discussing it in that context.

I want to revisit Omnicare briefly. You've essentially written off perhaps more than half of the initial value considering the debt incurred. You're discussing two aspects: the independent assisted living market that interests you, and the skilled nursing facility (SNF) market. When you mention the turnaround, do you anticipate growth initiatives will boost the assisted living sector, or do you believe the declines in the SNF market will begin to slow down? You've been addressing this for some time—what makes you confident that a turnaround is expected as we approach 2020?

Charles, it's Larry. Just one quick comment on that, and then I want to flip it over to John. As you look at the Omnicare business, don't lose sight of the fact that there was a specialty component of that business, which has been fully integrated and quite successful for the business. So, I don’t want to lose that element of the acquisition.

We are confident that we can stabilize the long-term care, specifically in skilled nursing facilities. Our investment in account management personnel has led to higher service levels at these facilities. We have observed significant improvements in our service levels and a notable increase in retention rates. Additionally, we are implementing technology that enhances communication between the facilities and the pharmacy. We believe that improved service directly contributes to retention, and we have achieved significant progress in this area. We are also optimistic about our growth potential in assisted living. We have introduced a new service model called 'community care centers,' which provides a single point of contact for senior living staff. This was not the case in previous years. We have also rolled out attractive tools for these facilities, such as multi-dose packaging that surpasses standard market offerings with barcode scanning. Furthermore, we are utilizing our CVS retail pharmacies for staff deliveries to these facilities, allowing for quicker response times and fostering local relationships alongside Omnicare pharmacies. We expect to increase our penetration rate in assisted living facilities, and we are already seeing existing clients entrust us with more of their facilities due to the enhancements we have made in our services.

We'll take one more question, please.

I have a question about the Aetna Health Benefits business. Could you share what Aetna would have looked like on an apples-to-apples basis, excluding any cost shifts that may have been made? What should we expect from that? Additionally, can you discuss the scale of the Centene loss? Should we anticipate a revenue decline from that and how it will affect the PBM margins moving forward?

Kevin, this is Eva. I'll handle the first question regarding Aetna's performance without considering the shifts. The clearest insight I can provide is that we anticipate modest growth. The business has favorable conditions due to increasing membership in both the commercial and government sectors, which is benefiting from synergies. However, we are also making investments. Therefore, on a consistent basis, we expect modest growth on the bottom line, while adjusting for the impact of the health insurance fee.

Hi, Kevin. This is Derica. In regard to Centene, keep in mind that it will be a multi-year migration. We anticipate that it will start in 2019, likely hit the peak in 2020, and there will probably be a residual impact in 2021. As Centene is migrating, they're looking to move to their own PBM platform, RxAdvance.

And, Kevin, just to add one thing to Derica's point, while the exact timing with these large changes is uncertain, within our guidance range, we have made estimates regarding our expected migration.

So, we know this was a long call. We know there was a lot of information, a lot of questions, and as is always the case, Mike and his team will be available for any follow-ups, and I'm sure we'll see many of you soon. Thanks.