CVS Health Corporation — Q3 2015 Form 10-Q
Reporting period: Three and nine months ended September 30, 2015. CVS Health operates pharmacy benefit management, retail pharmacy, specialty pharmacy, clinics and, following its August acquisition of Omnicare, long-term-care pharmacy and related services. The interim financial statements are unaudited and were reviewed by Ernst & Young, not audited.
Financial results
Amounts in millions, except per-share data and percentages.
| Metric | Q3 2015 | Q3 2014 | Nine months 2015 | Nine months 2014 |
|---|---|---|---|---|
| Net revenue | $38,644 | $35,021 | $112,144 | $102,312 |
| Gross profit | $6,661 | $6,468 | $19,227 | $18,734 |
| Operating profit | $2,331 | $2,246 | $6,725 | $6,478 |
| Income from continuing operations | $1,237 | $948 | $3,730 | $3,323 |
| Net income attributable to CVS Health | $1,246 | $948 | $3,739 | $3,323 |
| Diluted EPS | $1.11 | $0.81 | $3.29 | $2.82 |
- Q3 revenue rose 10.3% and nine-month revenue rose 9.6%. Growth reflected specialty pharmacy, higher pharmacy claims and same-store pharmacy sales, new stores, and Omnicare; higher generic dispensing rates also affected reported revenue.
- Gross profit increased 3.0% in Q3 and 2.6% year to date, while gross margin fell about 120 basis points in both periods, to 17.2% and 17.1%. Management cited business mix shifting toward lower-margin Pharmacy Services and moderate margin declines in both segments.
- Q3 operating profit increased 3.8%; nine-month operating profit increased 3.8%. Operating expenses grew more slowly than revenue. Net interest expense rose to $261 million in Q3 from $153 million, and to $562 million for nine months from $469 million, largely reflecting acquisition financing and bridge-facility fees.
- Q3 diluted EPS from continuing operations was $1.10, versus $0.81; nine-month diluted EPS from continuing operations was $3.28, versus $2.82. The 2014 comparison included a $521 million debt-extinguishment loss, so reported year-over-year earnings comparisons reflect that unusual prior-year charge.
- Nine-month operating cash flow was $4.841 billion, versus $4.714 billion. Investing used $11.000 billion, principally reflecting the Omnicare purchase; financing provided $6.576 billion, including debt issuance. Cash increased $409 million to $2.890 billion.
- At September 30, cash and short-term investments totaled $3.011 billion. Debt principal was $27.455 billion; balance-sheet long-term debt was $26.771 billion, with $451 million of current long-term debt and no commercial paper outstanding. Total assets were $92.362 billion and current liabilities were $21.434 billion.
Material developments and segment trends
- Omnicare: Acquired August 18 for $9.645 billion of consideration and assumed debt with fair value of approximately $3.1 billion. The acquisition added $710 million of revenue and a $3 million net loss through September 30, including severance and accelerated stock compensation. Preliminary purchase accounting recorded $9.035 billion of goodwill; valuation of certain items remained open.
- Pharmacy Services: Q3 revenue grew 13.3% to $25.528 billion, while segment operating profit rose to $1.162 billion from $1.087 billion. Gross margin declined to 5.8% from 6.2%, reflecting price compression and competition, partly offset by volume and purchasing/rebate economics.
- Retail/LTC: Q3 revenue grew 6.9% to $17.912 billion and operating profit rose to $1.643 billion from $1.527 billion. Pharmacy same-store sales increased 4.6%; front-store same-store sales declined 5.8%, primarily due to the decision to stop selling tobacco and softer traffic. Retail/LTC gross margin declined to 30.0% from 31.3%.
- CVS issued $15 billion of senior notes in July, receiving approximately $14.8 billion net, to fund Omnicare and the proposed Target transaction. It repaid approximately $2.4 billion of Omnicare debt during Q3. Long-term debt was rated Baa1 by Moody’s and BBB+ by S&P, both with stable outlooks at quarter-end.
- CVS repurchased 37.8 million shares for approximately $3.9 billion and declared dividends of $0.35 per share in Q3, versus $0.275 a year earlier. The remaining authorization under the 2014 program was $8.8 billion.
- The proposed purchase of Target’s pharmacy and clinic businesses was priced at $1.887 billion, subject to regulatory approval and other conditions; timing of closing was uncertain.
Outlook, risks and unusual items
- The filing provides no specific numerical earnings or revenue guidance. Management said operating cash flows, credit facilities and potential future borrowings should be sufficient for near-term needs and long-term initiatives.
- Management expected generic dispensing rates to continue increasing, but at a slower pace, and cited favorable pharmacy-industry demand trends. It also warned of ongoing PBM competition, rebate sharing, reimbursement pressure, retail pharmacy pricing changes and possible margin pressure.
- Front-store same-store sales were affected by the removal of tobacco products; excluding tobacco and estimated related basket sales from the prior-year comparison would have made the reported declines substantially smaller. Generic-drug introductions and lower generic selling prices also weighed on pharmacy revenue growth.
- CVS changed front-store inventory valuation to weighted-average cost effective January 1, 2015, affecting about 36% of consolidated inventory. The change increased nine-month 2015 continuing-operations income by $10 million versus the former method; the filing estimates diluted EPS would have been about $0.01 lower without the change.
- Legal and regulatory matters include a securities-related class action seeking approximately $3.2 billion, with trial scheduled for February 2016; the company said it could not estimate potential loss beyond recorded accruals. CVS also paid a $22 million fine in a May 2015 Controlled Substances Act settlement and disclosed ongoing investigations and audits. Management said accrued legal matters were not material individually or in aggregate, but outcomes remain uncertain.
- Goodwill impairment testing found no impairment. Management noted that a proposed lease-accounting standard could materially affect the balance sheet if finalized, though it could not yet quantify the impact. Omnicare was excluded from the company’s 2015 internal-control effectiveness evaluation while integration work continued.
Important facts for investors to verify
- Whether Omnicare integration, synergies and final purchase-accounting values support the acquisition’s expected returns.
- How the increase in debt and interest costs affects earnings, leverage, ratings and capital allocation, including repurchases and dividends.
- Whether PBM and retail pharmacy reimbursement and competitive pressures continue to reduce gross margins.
- Whether the Target transaction closes on expected terms and adds value after financing and integration costs.
- Developments in the disclosed litigation, government investigations and controlled-substance compliance matters, including any material change in estimated exposure.
- Whether operating cash flow remains resilient as acquisition-related working-capital needs and other cash uses evolve.