CVS Health Corporation — Q2 2018 Form 10-Q
Reporting period: Three and six months ended June 30, 2018; balance-sheet figures are as of June 30, 2018, compared with December 31, 2017. CVS Health operates Pharmacy Services, Retail/LTC and Corporate segments. Financial amounts below are in U.S. dollars; income-statement and cash-flow amounts are in millions unless stated otherwise.
Financial performance
| Metric | Q2 2018 | Q2 2017 | Six months 2018 | Six months 2017 |
|---|---|---|---|---|
| Net revenue | $46,708 | $45,685 | $92,401 | $90,199 |
| Gross profit | $7,201 | $6,926 | $14,060 | $13,497 |
| Gross margin | 15.4% | 15.2% | 15.2% | 15.0% |
| Operating income (loss) | $(1,587) | $2,117 | $359 | $3,910 |
| Net income (loss) attributable to CVS Health | $(2,563) | $1,098 | $(1,565) | $2,050 |
| Diluted earnings (loss) per share | $(2.52) | $1.07 | $(1.54) | $1.98 |
- Revenue grew 2.2% in Q2 and 2.4% year to date. Gross profit increased 4.0% and 4.2%, respectively. Management attributed growth to prescription volume, purchasing economics and brand inflation, partly offset by reimbursement pressure, pricing compression and generic dispensing.
- The $3.921 billion goodwill impairment charge drove the reported operating and net losses. The charge related to the Long-Term Care (LTC) reporting unit and was not tax deductible. Q2 net interest expense rose to $475 million from $247 million; six-month expense was $948 million versus $499 million.
- Cash flow: Operating cash flow was $5.289 billion for the first half, versus $5.532 billion a year earlier. Capital spending was $912 million. Investing cash outflow was $752 million, including $573 million for acquisitions and other investments; this was partly offset by $725 million of proceeds from the RxCrossroads sale. Financing provided $37.620 billion, principally reflecting the March debt issuance.
- Liquidity and debt: Cash and cash equivalents were $43.815 billion, up from $1.696 billion at year-end. Total debt carrying value was $65.109 billion, versus $27.002 billion at year-end; long-term debt was $61.569 billion. The company issued $40 billion of notes in March, receiving approximately $39.4 billion net, to fund the proposed Aetna acquisition. No commercial paper or backup-facility borrowings were outstanding at quarter-end. CVS reported compliance with debt covenants.
- Shareholders’ equity was $35.611 billion, compared with $37.695 billion at year-end. Dividends declared were $0.50 per share for Q2 and $1.00 for the first half. No shares were repurchased in the first half.
Segment trends and material changes
- Pharmacy Services: Q2 revenue rose 2.8% to $33.247 billion; first-half revenue rose 3.0% to $65.465 billion. Segment operating profit was $1.088 billion in Q2 and $1.849 billion for the half, down from $1.112 billion and $1.869 billion. Claims volume increased, while average revenue per claim declined and price compression continued.
- Retail/LTC: Q2 revenue increased 5.7% to $20.672 billion; first-half revenue increased 5.7% to $41.104 billion. Reported segment operating losses were $2.225 billion for Q2 and $601 million for the half, primarily reflecting the LTC impairment. Pharmacy same-store sales rose 8.3% in Q2; front-store same-store sales fell 1.0% in Q2.
- The LTC impairment followed weaker forecasts, lower client retention and skilled-nursing occupancy, deteriorating customer financial health, and reimbursement pressure. Higher discount rates and lower peer-company market multiples also contributed. Remaining LTC goodwill was approximately $2.7 billion; management warned that further material impairment was reasonably possible if forecasts are not achieved.
- CVS sold RxCrossroads to McKesson on January 2, 2018 for $725 million and recorded an $86 million loss on the divestiture in the first half. The prior-year comparison included a $135 million goodwill impairment related to RxCrossroads and $205 million of store-closure charges in the first half.
Outlook, transaction, risks and unusual items
- The filing provides no specific earnings or revenue guidance. Management said it expects generic dispensing to keep increasing, though at a slower pace, and stated that operating cash flow, financing sources and potential future borrowings should be sufficient for expected needs and initiatives.
- The proposed Aetna acquisition remained subject to regulatory approvals and other closing conditions. The agreed consideration was $145 per Aetna share in cash plus 0.8378 CVS shares; the filing valued the transaction at approximately $69 billion, or approximately $77 billion including assumed Aetna debt. If the deal fails under specified circumstances, CVS could owe a $2.1 billion termination fee. Certain acquisition-related notes would require redemption at 101% of principal if the deal is not completed by September 3, 2019 or is otherwise terminated; the 2048 notes are excluded.
- CVS reported a $3.9 billion remaining bridge facility and a $5 billion term loan in connection with acquisition financing. The notes’ proceeds were being held for the transaction, contributing to elevated cash and debt. Standard & Poor’s lowered the long-term debt rating from BBB+ to BBB upon the notes issuance; CVS said debt ratings affect borrowing costs and access to capital.
- Other material risks include continuing PBM and retail reimbursement pressure, pricing and competitive dynamics, client retention, LTC business challenges, regulatory and government-program changes, and the possibility of further goodwill impairment. The filing describes opioid-related litigation, pricing and reimbursement claims, and multiple government inquiries; CVS said accrued legal matters were not material, but it could not reliably estimate possible losses beyond recorded accruals in many matters.
- CVS adopted the new revenue-recognition standard in 2018; the first-half net-income effect was immaterial, and the adoption reduced opening retained earnings by $13 million after tax. The company expects the new lease standard, effective in 2019, to materially affect its consolidated balance sheet; its effect on operations and cash flows was still under evaluation.
Most important facts for investors to verify
- Whether the Aetna acquisition closes, its final financing and purchase price, regulatory conditions, and any integration or synergy outcomes.
- Whether LTC performance stabilizes and whether additional goodwill impairment is required, given the narrow valuation cushion and management’s stated risk of further impairment.
- Cash deployment and debt reduction after the acquisition financing, including interest costs, credit ratings and leverage.
- Whether claim-volume growth can offset ongoing PBM and retail reimbursement pressure, price compression and generic-drug mix effects.
- Developments in opioid litigation, government investigations and other legal matters, including any losses or business-practice changes not estimable in this filing.
The interim financial statements were reviewed by Ernst & Young LLP; the review was not an audit.