CVS Health Corporation — Q2 2015 Form 10-Q
Reporting period: Three and six months ended June 30, 2015. Financial statements are unaudited; the independent accountant performed an interim review, not an audit. CVS operates Pharmacy Services (PBM and specialty pharmacy), Retail Pharmacy, and Corporate businesses.
Financial performance
| Metric | Q2 2015 | Q2 2014 | Six months 2015 | Six months 2014 |
|---|---|---|---|---|
| Net revenue | $37.169B | $34.602B | $73.501B | $67.291B |
| Gross profit | $6.402B | $6.324B | $12.566B | $12.266B |
| Operating profit | $2.262B | $2.208B | $4.394B | $4.232B |
| Net income | $1.272B | $1.246B | $2.493B | $2.375B |
| Diluted EPS | $1.12 | $1.06 | $2.19 | $2.01 |
| Operating cash flow | — | $3.021B | $3.069B |
- Revenue increased 7.4% in Q2 and 9.2% year to date; net income rose 2.1% and 5.0%, respectively. Diluted EPS increased 5.7% and 9.0%, aided by lower weighted-average share counts following repurchases.
- Gross margin fell to 17.2% in Q2 from 18.3%, and to 17.1% year to date from 18.2%. Operating margin was approximately 6.1% in Q2 versus 6.4%, and 6.0% year to date versus 6.3%.
- Pharmacy Services revenue grew 11.9% in Q2 and 15.0% year to date, driven by specialty pharmacy and higher claim volumes. Segment operating profit rose to $940M in Q2 and $1.675B year to date, while gross margin percentages declined.
- Retail Pharmacy revenue grew 2.2% in Q2 and 2.5% year to date. Segment operating profit declined to $1.681B in Q2 and $3.408B year to date. Pharmacy same-store sales rose, but front-store same-store sales fell 7.8% in Q2, mainly reflecting the decision to stop selling tobacco and softer traffic.
- Six-month operating cash flow was $3.021B, versus $3.069B. Investing used $1.090B, compared with $3.185B, largely because the prior-year period included the Coram acquisition. Financing used $3.167B, including $2.934B of share repurchases and $794M of dividends.
- At June 30, cash and equivalents were $1.244B, short-term investments $160M, and short-term debt $1.488B. Long-term debt was $11.633B; current liabilities totaled $20.386B and current assets $26.401B. Commercial paper outstanding was approximately $1.5B.
Material changes and unusual items
- Q2 revenue growth reflected specialty pharmacy, pharmacy network claims and retail pharmacy sales. Generic dispensing increased, supporting gross-profit dollars but typically reducing selling prices; mix shift toward the lower-margin Pharmacy Services segment also weighed on consolidated margins.
- Retail pharmacy same-store pharmacy sales increased 4.1% in Q2, while front-store same-store sales decreased 7.8%. Management said front-store comparisons would have been substantially stronger excluding tobacco and associated basket sales from the prior-year period.
- Effective January 1, 2015, CVS changed front-store inventory valuation to weighted average cost, affecting approximately 36% of consolidated inventory. The cumulative transition reduced inventory by $7M and retained earnings by $4M. Without the change, reported net income would have been $12M lower for Q2 and $8M lower year to date.
- Corporate operating loss included $21M of transaction costs related to proposed acquisitions. Q2 interest expense also included amortization of bridge-facility fees.
- CVS repurchased approximately 28.9M shares for $2.9B in the first half and declared dividends of $0.70 per share, versus $0.55 in the prior-year period.
Outlook, acquisitions and risks
- The filing provides no specific numerical earnings or revenue guidance. Management expects continued growth in generic dispensing, though at a slower pace, and anticipates ongoing PBM pricing and retail pharmacy reimbursement pressure. It also cites favorable pharmacy demand trends, including aging demographics and expanded health coverage.
- CVS agreed to acquire Omnicare for approximately $10.6B in cash and assume about $2.3B of debt, subject to shareholder, regulatory and other approvals. It also agreed to acquire Target’s pharmacy and clinic businesses for $1.887B, subject to approvals and customary conditions.
- After quarter-end, CVS issued senior notes on July 20, 2015, generating approximately $14.8B net proceeds intended primarily to fund the acquisitions. Certain notes require redemption at 101% of principal plus accrued interest if the Omnicare transaction does not close by the specified deadline or is terminated. The filing does not state that either acquisition had closed by the filing date.
- Key risks include acquisition approval, completion and integration; PBM client retention and competitive pricing; reimbursement reductions; generic and brand-drug market changes; government regulation and investigations; and litigation. The company reported a $22M settlement payment in May 2015 relating to alleged Controlled Substances Act violations, and said related DEA audits and discussions remain ongoing.
- CVS disclosed numerous legal matters and investigations. It stated that legal accruals were not material individually or in aggregate, but said it could not reliably estimate possible losses beyond amounts accrued for certain matters. A putative Alabama class action seeks approximately $3.2B plus unspecified damages; the case was proceeding.
- Management said operating cash flows, commercial paper, sale-leaseback activity and potential borrowing were expected to be sufficient for future payments and initiatives. Debt ratings at June 30 were investment grade with stable outlooks; the company cautioned ratings could change.
Investor verification priorities
- Confirm acquisition closing status, regulatory conditions, final funding needs, integration plans and expected benefits.
- Track post-quarter debt issuance, total debt and leverage after acquisition funding, and the effect of financing costs on earnings and liquidity.
- Assess whether Pharmacy Services growth can offset PBM price compression and declining segment margin rates.
- Monitor retail pharmacy reimbursement, script growth, tobacco-related comparisons and front-store sales trends.
- Review the outcomes and potential financial or operational effects of government investigations, litigation and compliance matters.
- Evaluate cash conversion and capital allocation, especially working-capital changes, share repurchases and dividends.