CVS Health Corporation — Q1 2018 Form 10-Q
Reporting period: Three months ended March 31, 2018; comparisons are with Q1 2017 unless noted. CVS Health operates Pharmacy Services, Retail/LTC and Corporate businesses. Financial statements are unaudited; the independent accountant performed a review, not an audit.
Financial performance
| Metric | Q1 2018 | Q1 2017 | Change |
|---|---|---|---|
| Net revenue | $45.693 billion | $44.514 billion | +2.6% |
| Gross profit | $6.859 billion | $6.571 billion | +4.4%; gross margin 15.0%, up about 25 bps |
| Operating profit | $1.946 billion | $1.793 billion | +8.5% |
| Net income attributable to CVS Health | $998 million | $952 million | +4.8% |
| Diluted EPS | $0.98 | $0.92 | +6.5% |
| Net operating cash flow | $2.355 billion | $3.533 billion | Down $1.178 billion |
| Capital expenditures | $482 million | $457 million | — |
| Interest expense, net | $473 million | $252 million | Up $221 million |
Revenue growth reflected higher claim and prescription volumes and brand inflation, partly offset by price compression, generic dispensing and reimbursement pressure. Lower taxes helped earnings: the effective tax rate was 32.1%, versus 37.3%, primarily reflecting the Tax Cuts and Jobs Act. Interest costs rose notably, including $161 million of bridge-facility fee amortization and interest on acquisition-related borrowing.
Segments and operating trends
- Pharmacy Services: Revenue of $32.218 billion, up 3.2%; operating profit of $761 million, versus $757 million. Claims processed rose 6.4% to 468.8 million; generic dispensing was 87.6%, versus 87.0%. Management cited new business, volume and purchasing economics, offset by price compression and increased sharing of manufacturer rebates with clients.
- Retail/LTC: Revenue of $20.432 billion, up 5.6%; operating profit of $1.624 billion, versus $1.433 billion. Prescription volume rose 8.5%; pharmacy same-store sales increased 7.3%. Segment gross margin declined to 29.0% from 29.4%, reflecting pharmacy reimbursement pressure. Results included an $86 million pre-tax loss on the RxCrossroads sale; prior-year operating profit included a $199 million store-closure charge.
- Corporate: Operating loss was $264 million, compared with $221 million, including $40 million of Aetna transaction and integration costs.
Comparability is affected by the RxCrossroads divestiture, prior-year store-closure costs, and a revised allocation of shared costs to segments. CVS adopted the new revenue recognition standard on January 1, 2018; it reduced opening retained earnings by $13 million after tax, and management expected the ongoing impact on revenue and net income to be immaterial.
Balance sheet, liquidity and financing
- At March 31, cash and cash equivalents were $42.023 billion, versus $1.696 billion at December 31, 2017. The increase largely reflects financing raised for the proposed Aetna acquisition, not operating cash generation.
- Total debt carrying value was $65.094 billion, including $61.552 billion long-term and $3.542 billion current; debt principal totaled $65.875 billion. At year-end, carrying debt was $27.002 billion. CVS issued $40 billion of notes in March, receiving about $39.4 billion net, and had no commercial paper outstanding at quarter-end.
- Current assets were $71.798 billion and current liabilities $30.248 billion. Operating cash flow was $2.355 billion; financing cash inflow was $38.140 billion. The company attributed lower operating cash flow mainly to timing of receipts associated with new client activity.
- CVS paid $508 million in dividends and made no share repurchases in the quarter. It reported compliance with debt covenants and no borrowings under its backup credit facilities. S&P lowered its long-term rating to BBB in March; CVS reported Moody’s Baa1 rating, with its outlook then under review.
Outlook, key risks and unusual items
- Aetna acquisition: The proposed cash-and-stock transaction was valued at about $69 billion, or approximately $77 billion including Aetna debt. It remained subject to regulatory approvals; DOJ issued a second request in February. CVS had raised acquisition financing. Certain notes require redemption at 101% plus accrued interest if the deal is not completed by September 3, 2019, or is terminated earlier under specified conditions. CVS could owe Aetna a $2.1 billion termination fee depending on why the transaction fails.
- Management said pharmacy reimbursement pressure and PBM pricing competition could constrain margins; it expected the generic dispensing rate to continue rising, but more slowly. Retail results benefited from Easter timing and seasonal cough-and-cold sales in the quarter.
- CVS identified LTC business challenges, including reimbursement pressure, lower skilled-nursing occupancy, customer financial weakness and retention. The LTC goodwill reporting unit had only about 1% valuation headroom in the prior-year impairment test; management said underperformance could result in a material impairment.
- The company described numerous ongoing legal matters and government investigations, including opioid-related litigation and inquiries involving pharmacy pricing, PBM fees, controlled substances and Medicare/Medicaid claims. It said existing legal accruals were not material, but generally could not estimate potential losses beyond amounts accrued.
- No specific full-year financial guidance or numerical earnings outlook is provided in the supplied filing text. CVS stated that operating cash flows, its commercial paper program, sale-leaseback program and potential borrowings were expected to support needs and initiatives.
Investor verification priorities
- Track Aetna regulatory review, closing conditions, integration plans, financing costs and any consequences of a delayed or failed transaction.
- Assess the sustainability of operating cash flow and the effect of substantially higher debt and interest expense; distinguish acquisition financing cash from recurring liquidity.
- Monitor PBM price compression, rebate sharing, retail reimbursement rates, generic mix and pharmacy claim-volume trends.
- Reassess LTC performance and goodwill impairment assumptions, especially occupancy, customer credit quality and retention.
- Review developments in opioid litigation and other government investigations, since potential outcomes are not clearly quantified in the filing.