CVS HEALTH Corp quarterly report, Q2 FY2019

CVS Health Corporation — Q2 2019 Form 10-Q

Reporting period: Three and six months ended June 30, 2019. The filing is unaudited; the independent accountant performed an interim review, not an audit.

Business context and reporting period

CVS operates Pharmacy Services, Retail/LTC, Health Care Benefits and Corporate/Other. Results include Aetna from its November 28, 2018 acquisition, so comparisons with 2018 are not like-for-like: Aetna contributed substantial insurance revenue and operations in 2019 but was not included in the comparable 2018 reported period. CVS had approximately 9,900 retail locations, 1,100 walk-in clinics, more than 102 million PBM plan members and an estimated 38 million health benefits customers.

Financial performance and liquidity

Metric	Q2 2019	Q2 2018	Six months 2019	Six months 2018
Total revenue	$63.431B	$46.922B	$125.077B	$92.665B
Operating income (loss)	$3.332B	($1.373B)	$6.022B	$0.623B
Net income (loss) attributable to CVS	$1.936B	($2.563B)	$3.357B	($1.565B)
Diluted EPS	$1.49	($2.52)	$2.58	($1.54)
Operating cash flow	Not separately provided	Not separately provided	$7.286B	$5.289B

Q2 revenue rose 35.2%; six-month revenue rose 35.0%, primarily reflecting Aetna, alongside growth in Pharmacy Services and Retail/LTC. Products revenue declined 0.3% in Q2 and 0.9% year to date.
Adjusted operating income, a non-GAAP measure, was $4.031B in Q2 versus $2.599B and $7.626B for six months versus $4.892B. These comparisons also reflect Aetna and exclude specified items; they should not be treated as GAAP results.
Q2 operating margin was 5.3% (operating income divided by revenue); the filing reports adjusted segment margins but not a consolidated adjusted margin. Health Care Benefits reported an 84.0% medical benefit ratio in Q2 and year to date. Retail/LTC adjusted operating income fell 8.3% in Q2 and 13.6% year to date; Pharmacy Services adjusted operating income increased 9.7% and 3.5%, respectively.
Six-month net cash provided by operations increased $1.997B year over year, attributed principally to Aetna and timing of collections. Investing used $1.801B; financing used $3.442B, versus $37.620B provided in the prior-year period, which included acquisition-related borrowing.
At June 30, cash and cash equivalents were $6.063B; current assets were $46.901B and current liabilities $49.376B. Total debt on the balance sheet was approximately $71.3B, including current and short-term debt, down from approximately $73.4B at year-end. Operating lease liabilities were $20.642B, shown separately from debt. CVS repaid the remaining $1.5B term-loan balance on July 31, 2019.
CVS had $446M of commercial paper outstanding, no borrowings under its backup revolving facilities, and reported compliance with debt covenants. Long-term debt ratings were Baa2 from Moody’s and BBB from S&P.
The quarterly dividend declared was $0.50 per share. No common shares were repurchased in the first half of 2019.

Material changes versus the prior comparable period

The 2018 comparison includes a $3.921B goodwill impairment charge for the LTC reporting unit. Its absence is a major reason reported operating income and net income improved; it should not be read as equivalent underlying growth.
Aetna’s acquisition added the Health Care Benefits segment and materially increased premiums, benefit costs, operating expenses and debt. Q2 premiums were $15.791B versus $751M in 2018; six-month premiums were $32.073B versus $2.057B.
Interest expense increased to $772M in Q2 from $689M and to $1.554B for six months from $1.212B, primarily due to acquisition financing and assumed Aetna debt.
CVS adopted the new lease accounting standard on January 1, 2019, recognizing $20.865B of operating lease right-of-use assets at June 30 and $20.642B of lease liabilities. The adoption materially affected the balance sheet but did not materially affect operating results or cash flows.
Retail/LTC prescription volume grew, but its adjusted income weakened amid reimbursement pressure, LTC challenges and higher wage and benefit investment. Pharmacy Services benefited from higher claims volume and purchasing economics, partly offset by price compression.

Outlook, commentary, risks and unusual items

Management characterized 2019 as a transition year while integrating Aetna and said CVS was on track to exceed its 2020 Aetna synergy target. The filing provides no specific full-year earnings or revenue guidance.
Management cited expected pressure from retail pharmacy reimbursement, PBM pricing compression, fewer traditional offsets from generic introductions, LTC industry and company-specific challenges, and the annualization of wage and benefit investments. Planned responses include new products, a new PBM client contracting model, an LTC performance plan and enterprise cost reductions.
Management projected 2020 Medicare Advantage benchmark rates would increase funding for its Medicare Advantage business by approximately 2.0% versus 2019, excluding the health insurer fee.
The LTC reporting unit had approximately $431M of goodwill remaining. Management warned that failure to meet forecasts could lead to another material impairment; key sensitivities include retention, nursing-facility occupancy and customer financial health, reimbursement, execution and valuation assumptions.
CVS recorded a $135M store rationalization charge in the first half, primarily for impairment of lease right-of-use assets associated with plans to close 46 underperforming retail pharmacies.
On July 1, 2019, CVS sold its Brazilian subsidiary, which operated 50 stores, for an immaterial amount and expected to record an approximately $200M loss in Q3, primarily from foreign-currency translation adjustments.
Health care costs payable were $6.889B at June 30, including approximately $5.1B of incurred-but-not-reported claims and expected development. Prior-year estimates declined by $489M in the first half as settled claims were below prior estimates.
Contingencies include opioid-related litigation and investigations, PBM pricing and rebate inquiries, pharmacy usual-and-customary pricing claims, Medicare risk-adjustment audits and other regulatory matters. The company generally could not estimate potential losses beyond accrued amounts; adverse outcomes could be material. A Texas Medicaid pricing case reached a settlement in principle during trial; other identified matters remain unresolved.
Aetna purchase accounting remained preliminary, with income-tax accounting a significant open item. CVS also noted the consent decree for the acquisition remained subject to court approval.
CVS identified no material change in market-risk exposures from year-end and reported disclosure controls as adequate and effective. Aetna’s internal controls were still being integrated.

Important facts for investors to verify

How much of reported growth and earnings improvement reflects Aetna’s inclusion and the absence of the 2018 LTC impairment, versus underlying comparable performance.
Progress against Aetna integration and synergy targets, and the amount and duration of integration costs and acquisition-related intangible amortization.
Whether Retail/LTC reimbursement and LTC operating pressures, and Pharmacy Services pricing compression, continue to reduce segment profitability.
Debt reduction, interest costs, liquidity and credit ratings, including the treatment of substantial operating lease obligations.
Development of LTC forecasts and goodwill impairment risk; medical-cost reserve adequacy and potential CMS risk-adjustment refunds.
Outcomes and potential financial exposure from significant litigation, audits and regulatory investigations, plus the expected Q3 loss from the Brazil divestiture.