CVS Health Corporation — Q3 2018 Form 10-Q
Reporting period: Three and nine months ended September 30, 2018; filed November 6, 2018. CVS Health operates Pharmacy Services, Retail/LTC and Corporate segments. The interim financial statements were reviewed by Ernst & Young, not audited.
Financial performance
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Revenue | $47.3B | $46.2B | $139.7B | $136.4B |
| Gross profit | $7.3B | $7.1B | $21.4B | $20.6B |
| Operating profit | $2.4B | $2.5B | $2.7B | $6.4B |
| Net income (loss) attributable to CVS Health | $1.39B | $1.29B | ($175M) | $3.34B |
| Diluted EPS | $1.36 | $1.26 | ($0.17) | $3.24 |
| Gross margin | 15.5% | 15.4% | 15.3% | 15.1% |
- Q3 revenue rose 2.4%; management cited higher pharmacy claim and prescription volumes and brand inflation, partly offset by price compression, reimbursement pressure and generic dispensing.
- Q3 operating profit fell about 6%, while net income increased; higher interest expense was a significant offset to operating performance.
- Nine-month operating profit and earnings were weighed down by a $3.9B noncash goodwill impairment in LTC. The charge was nondeductible for tax purposes, contributing to a 113.3% effective tax rate and the reported net loss.
- Nine-month operating cash flow was $6.4B, down from $8.1B. Management attributed the decrease primarily to timing of payments from CMS. Investing cash outflow was $1.4B, including $1.5B of capital expenditures; financing provided $34.9B.
- At September 30, cash and cash equivalents were $41.6B. Total debt principal was $63.6B; balance-sheet current and long-term debt totaled $62.9B carrying value. Debt rose substantially after $40B of notes were issued to finance the proposed Aetna acquisition. No commercial paper or backup-facility borrowings were outstanding.
Segment trends and material changes
- Pharmacy Services: Q3 revenue increased 2.6% to $33.8B and operating profit was $1.35B versus $1.33B. Claims processed increased 5.7% overall; generic dispensing was 87.2%. Average revenue per claim declined amid pricing pressure.
- Retail/LTC: Q3 revenue increased 6.4% to $20.9B, but operating profit fell to $1.49B from $1.58B. Pharmacy same-store sales rose 8.7%; front-store same-store sales rose 0.8%. Retail/LTC gross margin contracted to 27.9% from 29.0%, primarily due to pharmacy reimbursement pressure.
- The LTC unit faced lower client retention and skilled-nursing occupancy, customer financial weakness and reimbursement pressure. After the $3.9B impairment, LTC goodwill was about $2.7B; its fair value exceeded carrying value by only approximately 2% at the third-quarter annual test. Management warned another material impairment was reasonably possible if forecasts are not achieved.
- CVS sold RxCrossroads on January 2, 2018 for $725M and recorded an $86M pretax loss on the divestiture.
- CVS adopted the new revenue recognition standard in 2018; the initial transition reduced retained earnings by $13M after tax. The company expected the ongoing impact to be immaterial.
Acquisition, outlook and risks
- The proposed Aetna acquisition was valued at approximately $69B for equity, plus assumed debt, under the merger agreement. On October 10, 2018, CVS and Aetna reached a DOJ consent decree permitting the transaction to proceed subject to Aetna divesting its standalone Medicare Part D plans, covering approximately 2.2M members. State insurance approvals and other customary conditions remained; CVS expected closing in Q4 2018 and said it had sufficient cash and borrowing capacity.
- If the deal is not completed under specified circumstances, CVS could owe Aetna a $2.1B termination fee. Certain acquisition-related notes require redemption at 101% of principal plus accrued interest if the deal fails to close by September 3, 2019 or is otherwise terminated; the 2048 notes are excluded.
- The filing provides no specific earnings or revenue guidance. Management expects generic dispensing to continue increasing, though at a slower pace, and describes ongoing reimbursement and pricing pressures.
- Other stated risks include PBM and LTC client retention, Medicare Part D competition, regulation and reimbursement changes, competition and margin pressure, information security, acquisition integration and financing risks, and pending litigation and government investigations. The company reported numerous opioid-related matters and other healthcare, pricing and pharmacy investigations; it said recorded legal accruals were not material. A $20M Omnicare securities matter was agreed to be resolved with insurance proceeds, subject to court approval.
- Management said disclosure controls were effective and reported no material changes in internal control over financial reporting during the quarter.
Investor verification priorities
- Confirm whether and when the Aetna acquisition closed, the final purchase price and share issuance, and completion and economics of the Medicare Part D divestiture.
- Track post-transaction debt, cash deployment, interest expense, ratings and progress toward any debt-reduction plans; the filing does not provide a formal deleveraging timetable.
- Assess whether LTC operating trends and forecasts improve, given the narrow impairment-test cushion and potential for another material goodwill charge.
- Monitor Pharmacy Services claim growth against falling revenue per claim, and Retail/LTC reimbursement trends and gross margin.
- Review subsequent developments in opioid litigation, government investigations and other contingencies, as well as the final tax effects of the Tax Cuts and Jobs Act.