01—Abstract
Summary
Summary of the 10-K filed March 31, 1999. Cited figures are marked; the original filing is the authoritative source.
CVS Corporation's 1998 Form 10-K (filed March 31, 1999) shows a company that grew sharply in revenue but is still digesting two large pooling-of-interests mergers.
Net sales rose 11.1% to $15.3 billiona, and the company says it is the largest U.S. drugstore chain by store count (4,122 stores in 24 states plus D.C.). Pharmacy now makes up 58% of sales, and third-party payors account for 84% of pharmacy sales, a mix that management notes is steadily compressing gross margin (comparable gross margin fell to 27.1% from 27.6%). Reported operating profit was $772.2 million, but after excluding the $158.3 million Arbor merger charge and the $10.0 million inventory markdown, comparable operating profit rose 20.7% to $940.5 million (6.2% of sales).
Reported diluted EPS was $0.98b, versus $1.26 on a comparable basis. Note that the Revco and Arbor mergers were accounted for as poolings, so prior-year figures are restated and year-over-year comparisons are affected by one-time charges in both 1997 and 1998. Balance sheet and liquidity look solid.
Shareholders' equity grew to $3.11 billionc, and total debt to capitalization was 25.4%. Operating cash flow was only $221.0 million, however, because inventory rose $315 million and accounts receivable rose $198 million. Short-term borrowings increased to $771.1 million, funded partly by commercial paper, and in February 1999 CVS issued $300 million of 5.50% senior notes due 2004 to repay commercial paper.
Management says the company does not use derivatives and has no material market risk exposure. Remaining risks include a $1.1 billiond contingent lease-guarantee exposure tied to about 1,600 former stores, pending drug-pricing antitrust litigation where CVS may recover a significant amount, and Year 2000 remediation, which is about 85% complete for critical IT systems.
Leadership is also changing: Thomas Ryan becomes Chairman and CEO and Charles Conaway becomes President and COO effective April 14, 1999. For investors, the central questions are whether the Arbor and Revco integrations deliver the promised synergies, whether pharmacy-driven margin pressure can be offset by front-store and relocation gains, and whether operating cash flow catches up with reported earnings.
02—Key points
Key Highlights
- Net sales rose 11.1% to $15.27 billion in 1998; same-store sales grew 10.8%, with pharmacy same-store sales up 16.5%.
- Reported operating profit was $772.2 million (5.1% of sales); comparable operating profit, excluding merger charges, was $940.5 million (6.2% of sales), up 20.7%.
- Reported diluted EPS was $0.98; comparable diluted EPS, excluding non-recurring items, was $1.26, up from $1.05 in 1997.
- Gross margin is under pressure: comparable gross margin fell to 27.1% from 27.6%, as pharmacy (58% of sales) and third-party payor business (84% of pharmacy sales) grow faster than higher-margin front-store sales.
- Operating cash flow was only $221.0 million, weighed down by a $315 million inventory increase and a $198 million rise in receivables; short-term borrowings rose to $771.1 million.
- Balance sheet remains sound: equity of $3.11 billion, total debt-to-capitalization of 25.4%, and a new $300 million 5.50% senior note issue (February 1999) that refinanced commercial paper.
- Contingent exposure: CVS guarantees leases on about 1,600 former stores, which management estimates could cost roughly $1.1 billion if all purchasers became insolvent (considered highly unlikely).
03—Questions
Frequently Asked Questions
How large is CVS and how is the business mix changing?
CVS operated 4,122 stores in 24 states and D.C. at year-end 1998, making it the largest U.S. drugstore chain by store count, with about 97,000 employees. Pharmacy sales were $8.8 billion, or 58% of total sales, up from 55% in 1997, while front-store sales grew 3.9% to $6.5 billion. The shift toward pharmacy adds volume but generally lowers gross margin.
What did the Arbor and Revco mergers cost, and what synergies are expected?
The Arbor merger (completed March 31, 1998) produced a $158.3 million charge plus a $10.0 million inventory markdown, and CVS reports about $20 million of savings in 1998 with at least $30 million expected in 1999. The Revco merger (May 1997) produced a $411.7 million charge plus a $75.0 million markdown. CVS says the Revco integration is complete and has reached its goal of at least $100 million in annual cost savings.
Is the company's cash generation keeping pace with earnings?
Not in 1998. Net earnings were $396.4 million, but operating cash flow was $221.0 million, reduced by a $315 million inventory build (partly to support Revco store conversions, which management says are now back to normal levels) and a $198 million receivables increase. Capital expenditures were $502.3 million, so free cash flow was negative and the gap was financed with short-term borrowings.
What are the main risks flagged in the filing?
Key risks include continued margin erosion from third-party prescription reimbursement and managed care pressure, the ability to integrate Arbor and Revco and sustain operating performance, Year 2000 remediation (about 85% of critical IT systems were complete, with non-IT systems about 30% complete), the creditworthiness of buyers of former businesses whose leases CVS guarantees, and the uncertain timing and amount of antitrust recoveries in drug-pricing lawsuits. The company also says that a failure by itself or key partners to fix Year 2000 issues could have a materially adverse effect.
What leadership changes were announced?
Chairman Stanley Goldstein is retiring as chairman effective April 14, 1999, and will remain a director. Thomas Ryan, currently President and CEO, will become Chairman and CEO, and Charles Conaway, currently EVP and CFO, will become President and Chief Operating Officer.
04—Continue