CVS Health Corporation — 2014 Q3 Form 10-Q
Business context and period: Quarterly report for the three and nine months ended September 30, 2014; comparisons are with the same 2013 periods. CVS Health operates Pharmacy Services, Retail Pharmacy and Corporate segments. The interim financial statements are unaudited and were reviewed by Ernst & Young, which did not express an audit opinion.
Financial performance
| Metric | Q3 2014 | Q3 2013 | Nine months 2014 | Nine months 2013 |
|---|---|---|---|---|
| Net revenues | $35.0 billion | $31.9 billion | $102.3 billion | $93.9 billion |
| Gross profit | $6.47 billion | $6.03 billion | $18.73 billion | $17.44 billion |
| Operating profit | $2.25 billion | $2.15 billion | $6.48 billion | $5.82 billion |
| Net income | $948 million | $1.25 billion | $3.32 billion | $3.33 billion |
| Diluted EPS | $0.81 | $1.02 | $2.82 | $2.70 |
| Operating cash flow | Not separately presented for quarter | $4.71 billion | $4.25 billion |
- Q3 revenue increased 9.7%; nine-month revenue increased 8.9%. Growth reflected specialty pharmacy, Coram, higher pharmacy network claims and retail pharmacy sales.
- Gross margin was 18.5% in Q3 and 18.3% for the nine months, down about 40 and 30 basis points, respectively. CVS cited lower Pharmacy Services margins and faster growth in that lower-margin segment.
- Q3 net income and diluted EPS were lower year over year, principally reflecting a $521 million pretax loss on early debt extinguishment. Excluding that item, the filing does not provide a directly comparable adjusted earnings figure.
- Nine-month net income was broadly flat. Operating profit rose despite a $72 million legal-settlement gain in the 2013 comparison period.
- Operating cash flow was $4.71 billion; investing cash outflow was $3.53 billion, including the Coram acquisition; financing cash outflow was $4.13 billion. Cash declined to $1.13 billion from $4.09 billion at year-end 2013.
- At September 30, cash was $1.13 billion; short-term debt was $775 million, current maturities of long-term debt $572 million, and long-term debt $11.71 billion. The filing reports $12.3 billion carrying value for total long-term debt and $13.1 billion estimated fair value. Commercial paper outstanding was $775 million at a 0.25% weighted-average rate; backup credit facilities were undrawn.
- Dividends declared were $0.275 per share for Q3 and $0.825 for the nine months. CVS repurchased 37.2 million shares for approximately $2.8 billion during the nine months.
Material changes and segment trends
- Pharmacy Services: Q3 revenue increased 15.7% to $22.5 billion; nine-month revenue increased 14.1% to $64.6 billion. Specialty growth, Coram and pharmacy network claim volume contributed. Q3 gross margin declined to 6.2% from 6.6%, while nine-month margin increased to 5.5% from 5.4%. Traditional mail claims declined; network claims grew.
- Retail Pharmacy: Q3 revenue increased 3.1% to $16.7 billion; nine-month revenue increased 3.5% to $50.1 billion. Q3 and nine-month gross margins rose to 31.3% and 31.4%, respectively. Pharmacy same-store sales grew, but front-store same-store sales fell 4.5% in Q3 and 2.9% for nine months. The tobacco exit, softer traffic, weather and a milder flu season were cited as factors.
- CVS acquired Coram in January for approximately $2.1 billion cash plus contingent consideration of about $0.1 billion. Preliminary purchase accounting included $1.6 billion goodwill; the valuation and tax-related items remained subject to change.
- In July, CVS and Cardinal Health established Red Oak Sourcing, a 50/50 generic-drug sourcing venture. Cardinal is to make 39 quarterly payments of $25.6 million beginning October 2014; qualifying additional payments may begin in Q3 2015.
Outlook, risks and unusual items
- No specific earnings or revenue guidance is stated in the supplied filing text. Management said operating cash flow, commercial paper, sale-leasebacks and potential borrowings were expected to be sufficient for anticipated payments and long-term initiatives.
- Management expected generic introductions to continue, though at a slower pace, and warned that PBM competition, client demands, reimbursement pressure and reduced retail network “spread” could weigh on margins. CVS also cited third-party payor pressure, regulatory changes and client retention as risks.
- The $521 million debt-extinguishment charge followed a $2.0 billion tender offer; it comprised a $490 million premium, $26 million of deferred financing write-offs and $5 million of fees. The company also recorded a $25 million charitable contribution as operating expense.
- CVS received a $69 million benefit to nine-month gross profit and revenue from California’s final Medicaid reimbursement decision. A separate $72 million legal-settlement gain benefited the 2013 comparison period.
- Legal exposures include government inquiries and litigation. CVS settled a Medicaid claims-processing matter in September without admission of liability and continued discussions with the OIG on other issues. A class action seeks approximately $3.2 billion; other investigations involve government-program claims, pharmacy practices and controlled substances. The company said legal accruals were not material and it could not estimate possible losses beyond accrued amounts for the matters discussed.
- The filing identified possible future effects from a proposed lease-accounting standard, which management believed could materially affect the balance sheet if finalized as drafted. The company reported no material market-risk exposure and no material changes in internal control over financial reporting.
Investor verification priorities
- Assess underlying earnings excluding the one-time $521 million debt-extinguishment charge and compare with reported results.
- Track Pharmacy Services margin, mail-choice volumes, specialty growth, and the economics of Red Oak and Coram integration.
- Monitor retail pharmacy reimbursement trends, tobacco-related front-store sales, and the sustainability of generic-related margin benefits.
- Review cash conversion and capital allocation, including continued repurchases, dividends, acquisition spending and debt levels.
- Follow the Coram purchase-price allocation and tax attributes, as well as legal and regulatory matters whose outcomes or potential losses remain uncertain.