UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
Quarterly Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
Commission File Number 001-01011
CVS CORPORATION
(Exact name of registrant as specified in its charter)
One CVS Drive, Woonsocket, Rhode Island 02895
(Address of principal executive offices)
Telephone: (401) 765-1500
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check One):
Large accelerated filer x Accelerated Filer ¨ Non-acccelerated Filer ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
Common Stock, $0.01 par value, issued and outstanding at August 3, 2006:
821,421,000 shares
INDEX
Consolidated Condensed Statements of Operations (Unaudited) -Thirteen and Twenty-Six Weeks Ended July 1, 2006 and July 2, 2005
Consolidated Condensed Balance Sheets (Unaudited) -As of July 1, 2006 and December 31, 2005
Consolidated Condensed Statements of Cash Flows (Unaudited) -Twenty-Six Weeks Ended July 1, 2006 and July 2, 2005
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Part I
CVS Corporation
Consolidated Condensed Statements of Operations
(Unaudited – See accompanying review report of KPMG LLP)
In millions, except per share amounts
July 1,
2006
July 2,
2005
Net revenues
Cost of goods sold, buying and warehousing costs
Gross profit
Selling, general and administrative expenses
Depreciation and amortization
Total operating expenses
Operating profit
Interest expense, net
Earnings before income tax provision
Income tax provision
Net earnings
Preference dividends, net of income tax benefit
Net earnings available to common shareholders
Basic earnings per common share:
Weighted average basic common shares outstanding
Diluted earnings per common share:
Weighted average diluted common shares outstanding
Dividends declared per common share
See accompanying notes to consolidated condensed financial statements.
2
Consolidated Condensed Balance Sheets
In millions, except share and per share amounts
December 31,
Assets:
Cash and cash equivalents
Accounts receivable, net
Inventories
Deferred income taxes
Other current assets
Total current assets
Property and equipment, net
Goodwill
Intangible assets, net
Other assets
Total assets
Liabilities:
Accounts payable
Accrued expenses
Short-term debt
Current portion of long-term debt
Total current liabilities
Long-term debt
Other long-term liabilities
Shareholders’ equity:
Preference stock, series one ESOP convertible, par value $1.00: authorized 50,000,000 shares; issued and outstanding 4,077,000 shares at July 1, 2006 and 4,165,000 shares at December 31, 2005
Common stock, par value $0.01: authorized 1,000,000,000 shares; issued 842,537,000 shares at July 1, 2006 and 838,841,000 shares at December 31, 2005
Treasury stock, at cost: 23,118,000 shares at July 1, 2006 and 24,533,000 shares at December 31, 2005
Guaranteed ESOP obligation
Capital surplus
Retained earnings
Accumulated other comprehensive loss
Total shareholders’ equity
Total liabilities and shareholders’ equity
3
Consolidated Condensed Statements of Cash Flows
In millions
Cash flows from operating activities:
Cash receipts from revenues
Cash paid for inventory
Cash paid to other suppliers and employees
Interest received
Interest paid
Income taxes paid
Net cash provided by operating activities
Cash flows from investing activities:
Additions to property and equipment
Proceeds from sale-leaseback transactions
Acquisitions (net of cash acquired) and other investments
Proceeds from sale or disposal of assets
Net cash used in investing activities
Cash flows from financing activities:
Additions to/(reductions in) short-term debt
Dividends paid
Proceeds from exercise of stock options
Excess tax benefits from stock based compensation
Additions to long-term debt
Reductions in long-term debt
Net cash provided by financing activities
Net increase in cash and cash equivalents
Cash and cash equivalents at beginning of period
Cash and cash equivalents at end of period
Reconciliation of net earnings to net cash provided by operating activities:
Adjustments required to reconcile net earnings to net cash provided by operating activities:
Stock based compensation
Deferred income taxes and other noncash items
Change in operating assets and liabilities, providing/(requiring) cash, net of effects from acquisitions:
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Notes to Consolidated Condensed Financial Statements
Note 1
The accompanying consolidated condensed financial statements of CVS Corporation and its wholly-owned subsidiaries (“CVS” or the “Company”) have been prepared without audit, in accordance with the rules and regulations of the Securities and Exchange Commission. In accordance with such rules and regulations, certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted, although the Company believes that the disclosures included herein are adequate to make the information presented not misleading. These consolidated condensed financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in Exhibit 13 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2005.
In the opinion of management, the accompanying consolidated condensed financial statements include all adjustments (consisting only of normal recurring adjustments), which are necessary to present a fair statement of the Company’s results for the interim periods presented. Because of the influence of various factors on the Company’s operations, including certain acquisitions, holidays and other seasonal influences, net earnings for any interim period may not be comparable to the same interim period in previous years or necessarily indicative of earnings for the full fiscal year.
Note 2
On January 1, 2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share-Based Payment,” using the modified prospective transition method. Under this method, compensation expense is recognized for options granted on or after January 1, 2006 as well as any unvested options on the date of adoption. Compensation expense for unvested stock options outstanding at January 1, 2006 is recognized over the requisite service period based on the grant-date fair value of those options and awards as previously calculated under the SFAS No. 123 pro forma disclosure requirements. As allowed under the modified prospective transition method, prior period financial statements have not been restated. Prior to January 1, 2006, the Company accounted for its stock-based compensation plans under the recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. As such, no stock based employee compensation costs were reflected in net earnings for options granted under those plans since they had an exercise price equal to the fair market value of the underlying common stock on the date of grant.
Compensation expense related to stock options, which includes the 1999 Employee Stock Purchase Plan (“ESPP”) for the thirteen and twenty-six weeks ended July 1, 2006 totaled $13.8 million pre-tax ($9.7 million after-tax, or about $0.01 per diluted share) and $27.5 million pre-tax ($19.5 million after-tax, or about $0.02 per diluted share), respectively. Compensation expense related to restricted stock awards for the thirteen and twenty-six weeks ended July 1, 2006, totaled $2.5 million pre-tax and $4.3 million pre-tax, respectively, compared to $1.1 million and $2.6 million pre-tax for the thirteen and twenty-six weeks ended July 2, 2005. Compensation costs associated with the Company’s share-based payments are included in selling, general and administrative expenses.
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The following table includes the effect on net earnings and earnings per share if stock compensation costs had been determined consistent with the fair value recognition provisions of SFAS No. 123 for the respective periods:
Net earnings, as reported
Add: Stock-based employee compensation expense included in reported net earnings, net of related tax effects(1)
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects
Pro forma net earnings
Basic EPS: As reported
Pro forma
Diluted EPS: As reported
The Company’s 1997 Incentive Compensation Plan (the “ICP”) provides for the granting of up to 85.8 million shares of common stock in the form of stock options and other awards to selected officers, employees and directors of the Company. All grants under the ICP are awarded at fair market value on the day of grant date. The fair value of stock options is estimated using the Black-Scholes Option Pricing Model and compensation expense is recognized on a straight-line basis over the requisite service period. Options granted prior to 2004 generally become exercisable over a four-year period from the grant date and expire ten years after the date of grant. Options granted during and subsequent to fiscal 2004 generally become exercisable over a three-year period from the grant date and expire seven years after the date of grant. As of July 1, 2006, there were 19.6 million shares available for future grants under the ICP.
SFAS No. 123(R) requires that the benefit of tax deductions in excess of recognized compensation cost be reported as a financing cash flow, rather than as an operating cash flow as required under prior guidance. Excess tax benefits of $17.9 million were included in financing activities in the Company’s consolidated condensed statement of cash flow for the twenty-six weeks ended July 1, 2006. Cash received from stock options exercised, which includes the ESPP, totaled $21.8 million and $83.2 million and the related tax benefits realized were $7.4 million and $17.9 million during the thirteen and twenty-six weeks ended July 1, 2006, respectively. Cash received from stock options exercised totaled $26.4 million and $130.6 million and the related tax benefits realized were $9.0 million and $33.9 million during the thirteen and twenty-six weeks ended July 2, 2005, respectively.
Following is a summary of the Company’s stock option activity for the twenty-six weeks ended July 1, 2006:
Shares in thousands
Outstanding at December 31, 2005
Granted
Exercised
Forfeited
Expired
Outstanding at July 1, 2006
Exercisable at July 1, 2006
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The total intrinsic value of options exercised during the thirteen and twenty-six weeks ended July 1, 2006 was $19.0 million and $49.0 million, respectively, compared to $24.5 million and $92.6 million in the comparable periods in 2005. The fair value of options exercised during the thirteen and twenty-six weeks ended July 1, 2006 was $39.7 million and $106.4 million, respectively, compared to $50.5 million and $208.4 million for the comparable periods in 2005.
The fair value of each stock option is estimated using the Black-Scholes Option Pricing Model based on the following assumptions at the time of grant:
Dividend yield (1)
Expected volatility (2)
Risk-free interest rate (3)
Expected life (in years) (4)
Weighted-average grant date fair value
As of July 1, 2006, unrecognized compensation expense related to unvested options totaled $75.9 million, which the Company expects to be recognized over a weighted-average period of 1.7 years.
The ICP allows for up to 7.2 million restricted shares to be issued. The Company’s restricted awards are considered nonvested share awards as defined under SFAS 123(R). The restricted awards require no payment from the employee and compensation cost is recorded based on the market price on the grant date, for which compensation expense is recognized on a straight-line basis over the requisite service period. The weighted average per share grant date fair value of restricted shares granted during the second quarter and six months ended July 1, 2006 was $28.71, compared to $24.80 for the second quarter and six months ended July 2, 2005. The weighted average per share grant date fair value of restricted stock units granted during the second quarter and six months ended July 1, 2006 was $29.39, compared to $22.45 for the second quarter and six months ended July 2, 2005. As of July 1, 2006, unrecognized compensation costs related to nonvested shares and stock units totaled $1.5 million and $26.8 million, respectively, and is expected to be recognized over a weighted-average period of 1.8 and 3.6 years, respectively. The total fair value of shares vested during the thirteen weeks and twenty-six weeks ended July 1, 2006 was approximately $5.7 million, compared to $12.5 million for the respective periods in 2005.
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Following is a summary of the restricted share award activity for the twenty-six weeks ended July 1, 2006:
Weighted Average Grant
Date Fair Value
Nonvested at December 31, 2005
Vested
Nonvested at July 1, 2006
Following is a summary of the restricted unit award activity for the twenty-six weeks ended July 1, 2006:
Units in thousands
The ESPP provides for the purchase of up to 14.8 million shares of common stock. Under the ESPP, eligible employees may purchase common stock at the end of each six-month offering period, at a purchase price equal to 85% of the lower of the fair market value on the first day or the last day of the offering period. During the first six months of 2006, 1.1 million shares of common stock were purchased at an average price of $22.64 per share. As of July 1, 2006, 11.1 million shares of common stock have been issued since the inception of the ESPP.
The fair value of stock compensation expense associated with the Company’s ESPP is estimated on the date of grant (i.e., the beginning of the offering period) using the Black-Scholes Option Pricing Model and is recorded as a liability, which is adjusted to reflect the fair value of the award at each reporting period until settlement date.
Following is a summary of the assumptions utilized in valuing the ESPP awards for the thirteen and twenty–six weeks ended for each of the respective periods:
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Note 3
On June 2, 2006, CVS acquired certain assets and assumed certain liabilities from Albertson’s, Inc. (“Albertsons”) for $4.0 billion. The assets acquired and the liabilities assumed included approximately 700 standalone drugstores and a distribution center (collectively the “Standalone Drug Business”). CVS financed the acquisition of the Standalone Drug Business by issuing commercial paper and borrowing $1.0 billion from a bridge loan facility. During the third quarter of 2006, CVS expects to refinance a portion of the commercial paper borrowings with longer term financing. During the fourth quarter of 2006, CVS expects to sell a substantial portion of the acquired real estate through a sale-leaseback transaction, the proceeds of which will be used in retiring the bridge loan facility. The results of the operations of the Standalone Drug Business from June 2, 2006 through July 1, 2006, have been included in CVS’ consolidated statements of operations for the thirteen and twenty-six week periods ended July 1, 2006.
THE FOLLOWING ALLOCATION OF THE PURCHASE PRICE AND ESTIMATED TRANSACTION COSTS, AS OF JUNE 2, 2006, IS PRELIMINARY AND IS BASED ON INFORMATION THAT WAS AVAILABLE TO MANAGEMENT AT THE TIME THE CONSOLIDATED CONDENSED FINANCIAL STATEMENTS WERE PREPARED. ACCORDINGLY, THE ALLOCATION WILL CHANGE AND THE IMPACT OF SUCH CHANGES COULD BE MATERIAL.
Property and equipment
Intangible assets
Total assets acquired
Accrued expenses(1)(2)
Short-term portion of capital leases
Other long-term liabilities(2)
Long-term capital leases
Total liabilities
Net assets acquired
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THE FOLLOWING PRO FORMA COMBINED RESULTS OF OPERATIONS HAVE BEEN PROVIDED FOR ILLUSTRATIVE PURPOSES ONLY AND DO NOT PURPORT TO BE INDICATIVE OF THE ACTUAL RESULTS THAT WOULD HAVE BEEN ACHIEVED BY THE COMBINED COMPANIES FOR THE PERIODS PRESENTED OR THAT WILL BE ACHIEVED BY THE COMBINED COMPANY IN THE FUTURE:
Pro forma:(1)(2)
Net sales
Basic earnings per share
Diluted earnings per share
On July 31, 2004, the Company acquired certain assets and assumed certain liabilities from J.C. Penney Company, Inc. and certain of its subsidiaries, including Eckerd Corporation (“Eckerd”). The acquisition included more than 1,200 Eckerd retail drugstores and Eckerd Health Services, which includes Eckerd’s mail order and pharmacy benefit management businesses (collectively, the “Acquired Businesses”). The final purchase price, including transaction costs, was $2.1 billion.
In conjunction with the acquisition, during fiscal 2004, the Company recorded a liability totaling $54.7 million for the estimated costs associated with terminating various Eckerd contracts that were in place at the time of acquisition. As of July 1, 2006, $43.1 million of this liability has been settled with cash payments. The $11.6 million remaining liability will require future cash payments through 2009. The Company also recorded a $10.5 million liability for the estimated severance, benefits and outplacement costs for 1,090 Eckerd employees that have or will be terminated. As of July 1, 2006, $8.0 million of this liability has been settled with cash payments. The $2.5 million remaining liability will require future cash payments through 2007. In addition, the Company recorded a $349.8 million liability for the estimated costs associated with the non-cancelable lease obligations of 299 Eckerd locations that the Company does not intend to operate. As of July 1, 2006, 285 of these locations have been closed and $123.2 million of this liability has been settled with cash payments. The $234.1 million remaining liability, which includes $13.5 million of interest accretion, will require future cash payments through 2030. The Company believes that the remaining liabilities discussed above are adequate to cover the remaining costs associated with the related activities.
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Note 4
As of July 1, 2006 the Company operated 6,205 retail and specialty drug stores in 44 states and the District of Columbia. The Company currently operates two business segments, Retail Pharmacy and Pharmacy Benefit Management (“PBM”). The Company’s business segments are operating units that offer different products and services and require distinct technology and marketing strategies.
As of July 1, 2006 the Retail Pharmacy segment included 6,153 retail drugstores and the Company’s online retail website, CVS.com®. The retail drugstores are located in 41 states and the District of Columbia and operate under the CVS® or CVS/pharmacy® names.
The PBM segment provides a full range of pharmacy benefit management services to managed care providers and other organizations. These services include mail order pharmacy services, specialty pharmacy services, plan design and administration, formulary management and claims processing, as well as providing reinsurance services in conjunction with prescription drug benefit policies. The specialty pharmacy business focuses on supporting individuals that require complex and expensive drug therapies. The PBM segment operates under the PharmaCare Management Services and PharmaCare Pharmacy® names and as of July 1, 2006, includes 52 specialty pharmacies, located in 22 states and the District of Columbia.
The Company evaluates segment performance based on operating profit before the effect of non-recurring charges and gains and certain intersegment activities and charges, including pharmacy revenues reported by the retail segment that are directly related to premium revenues that are reported by the PBM segment.
Following is a reconciliation of the Company’s business segments to the consolidated condensed financial statements as of and for the respective periods:
Retail Pharmacy
Segment
PBM
Intersegment
Eliminations
Consolidated
Totals
13 weeks ended:
July 1, 2006:
July 2, 2005:
26 weeks ended:
Total assets:
July 1, 2006
December 31, 2005
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Note 5
The Company accounts for goodwill and intangibles under SFAS No. 142, “Goodwill and Other Intangible Assets.” As such, goodwill and other indefinite-lived intangible assets are not amortized, but are subject to annual impairment reviews, or more frequent reviews if events or circumstances indicate there may be an impairment. During the third quarter of 2005, the Company performed its required annual goodwill impairment test, which concluded there was no impairment of goodwill.
The carrying amount of goodwill was $3,464.6 million as of July 1, 2006, compared to $1,789.9 million at December 31, 2005. The increase in goodwill during the twenty–six weeks ended July 1, 2006 was primarily due to the acquisition of the Standalone Drug Business. There has been no impairment of goodwill during the twenty-six weeks ended July 1, 2006.
Intangible assets other than goodwill are required to be separated into two categories: finite-lived and indefinite-lived. Intangible assets with finite useful lives are amortized over their estimated useful life, while intangible assets with indefinite useful lives are not amortized. The Company currently has no intangible assets with indefinite lives.
Following is a summary of the Company’s amortizable intangible assets as of the respective balance sheet dates:
Gross
Carrying Amount
Customer lists and Covenants not to compete
Favorable leases and Other
The increase in the gross carrying amount of the Company’s amortizable intangible assets during the twenty-six weeks ended July 1, 2006 was primarily due to the acquisition of the Standalone Drug Business. The amortization expense for these intangible assets for the thirteen and twenty-six week periods ended July 1, 2006 was $36.1 million and $68.5 million, respectively. The anticipated annual amortization expense for these intangible assets is $154.9 million, $167.2 million, $158.3 million, $149.8 million, $140.4 million and $132.0 million in 2006, 2007, 2008, 2009, 2010 and 2011, respectively.
Note 6
Accumulated other comprehensive loss consists of a minimum pension liability and market value adjustments on hedge instruments. The minimum pension liability totaled $117.0 million pre-tax ($73.4 million after-tax) as of July 1, 2006 and December 31, 2005. The unrealized loss on derivatives totaled $24.5 million pre-tax ($15.5 million after-tax) and $26.7 million pre-tax ($16.9 million after-tax) as of July 1, 2006 and December 31, 2005, respectively. Unrealized gain on derivatives totaled $7.0 million pre-tax ($4.3 million after-tax) as of July 1, 2006.
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Following are the changes in comprehensive income:
Other comprehensive loss:
Unrealized gain on derivatives
Recognition of unrealized loss on derivatives
Total comprehensive income, net of taxes
During the third quarter of 2006, the Company expects to refinance a portion of the short-term borrowings used to finance the acquisition of the Standalone Drug Business with longer-term financing. To manage a portion of the risk associated with changes in market interest rates, the Company entered into forward starting pay fixed rate swaps, (the “Swaps”) with a notional amount of $750 million, during the second quarter of 2006. The Company expects to settle these Swaps during the third quarter of 2006 in conjunction with the placement of the longer-term financing. The Company accounts for derivatives of this type, in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 133 “Accounting for Derivative Instruments and Hedging Activities” as modified by SFAS No. 138 “Accounting for Derivative Instruments and Certain Hedging Activities”, which requires the resulting gain or loss to be recorded in shareholders’ equity as a component of accumulated other comprehensive income. Any unrealized gain or loss will be amortized as a component of net interest expense over the life of the related long-term financing. As of July 1, 2006, the Company had no freestanding derivatives in place other than the Swaps.
Note 7
Following are the components of net interest expense:
Interest expense
Interest income
Note 8
The Company previously disclosed in its consolidated financial statements for the fiscal year ended December 31, 2005 that it expected to make contributions of $16.4 million to the defined benefit pension plan during the next fiscal year. During the twenty six-weeks ended July 1, 2006, the Company made no cash contributions to the pension plan, but continues to believe it will make contributions of approximately $16.4 million during the remainder of fiscal 2006.
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Following is a summary of the net periodic pension costs for the defined benefit and other postretirement benefit plans for the respective periods.
Service cost
Interest cost on benefit obligation
Expected return on plan assets
Amortization of net loss
Net periodic pension cost
Settlement gain
Note 9
Basic earnings per common share is computed by dividing: (i) net earnings, after deducting the after-tax Employee Stock Ownership Plan (“ESOP”) preference dividends, by (ii) the weighted average number of common shares outstanding during the period (the “Basic Shares”).
When computing diluted earnings per common share, the Company assumes that the ESOP preference stock is converted into common stock and all dilutive stock awards are exercised. After the assumed ESOP preference stock conversion, the ESOP Trust would hold common stock rather than ESOP preference stock and would receive common stock dividends ($0.155 and $0.145 annually per share in 2006 and 2005, respectively) rather than ESOP preference stock dividends (currently $3.90 annually per share). Since the ESOP Trust uses the dividends it receives to service its debt, the Company would have to increase its contribution to the ESOP Trust to compensate it for the lower dividends. This additional contribution would reduce the Company’s net earnings, which in turn, would reduce the amounts that would have to be accrued under the Company’s incentive compensation plans.
Diluted earnings per common share is computed by dividing: (i) net earnings, after accounting for the difference between the dividends on the ESOP preference stock and common stock and after making adjustments for the incentive compensation plans, by (ii) Basic Shares plus the additional shares that would be issued assuming that all dilutive stock awards are exercised and the ESOP preference stock is converted into common stock. Options to purchase 11.8 million and 9.3 million shares of common stock were outstanding but were not included in the calculation of diluted earnings per share for the thirteen and twenty-six weeks ended July 1, 2006, respectively, because the options’ exercise prices were greater than the average market price of the common shares and, therefore, the effect would be antidilutive. Similarly, options to purchase 6.9 million shares of common stock were outstanding but were not included in the calculation of diluted earnings per share for both the thirteen and twenty-six weeks ended July 2, 2005.
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Following is a reconciliation of basic and diluted earnings per common share for the respective periods:
Net earnings available to common shareholders, basic
Dilutive earnings adjustments
Net earnings available to common shareholders, diluted
Weighted average common shares, basic
Effect of dilutive securities:
Restricted stock units
ESOP preference stock
Stock options
Weighted average common shares, diluted
15
The Board of Directors and Shareholders
CVS Corporation:
We have reviewed the consolidated condensed balance sheet of CVS Corporation and subsidiaries as of July 1, 2006, and the related consolidated condensed statements of operations and cash flows for the thirteen and twenty-six week periods ended July 1, 2006 and July 2, 2005. These consolidated condensed financial statements are the responsibility of the Company’s management.
We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures to financial data and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should be made to the consolidated condensed financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles.
We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of CVS Corporation and subsidiaries as of December 31, 2005 and the related consolidated statements of operations, shareholders’ equity, and cash flows for the fifty-two week period then ended (not presented herein); and in our report dated March 14, 2006 we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated condensed balance sheet as of December 31, 2005, is fairly presented, in all material respects, in relation to the consolidated balance sheet from which it has been derived.
/s/ KPMG LLP
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Management’s Discussion and Analysis of Financial Condition and Results of Operations
Introduction
Our company is the largest retail pharmacy in the United States based on store count. We sell prescription drugs and a wide assortment of general merchandise, including over-the-counter drugs, beauty products and cosmetics, film and photo finishing services, seasonal merchandise, greeting cards and convenience foods through our CVS/pharmacy® retail stores and online through CVS.com®. We also provide pharmacy benefit management, mail order services and specialty pharmacy services through PharmaCare Management Services (“PharmaCare”) and PharmaCare Pharmacy® stores. As of July 1, 2006, we operated 6,205 retail and specialty pharmacy stores in 44 states and the District of Columbia.
The retail drugstore and pharmacy benefit management businesses are highly competitive. We believe that we compete principally on the basis of: (i) store location and convenience, (ii) customer/client service and satisfaction, (iii) product selection and variety and (iv) price. In each of the markets we serve, we compete with independent and other retail drugstore chains, supermarkets, convenience stores, pharmacy benefit managers and other mail order prescription providers, discount merchandisers, membership clubs and Internet pharmacies.
The following discussion explains the material changes in our results of operations for the thirteen and twenty-six weeks ended July 1, 2006 and July 2, 2005 and the significant developments affecting our financial condition since December 31, 2005. The performance of the Standalone Drug Business, as defined below, from June 2, 2006 through July 1, 2006 is reflected in our results of operations for the thirteen and twenty-six weeks ended July 1, 2006. We strongly recommend that you read our audited consolidated financial statements and footnotes and Management’s Discussion and Analysis of Financial Condition and Results of Operations included as Exhibit 13 to our Annual Report on Form 10-K for the fiscal year ended December 31, 2005 along with this report.
Acquisition
On June 2, 2006, we acquired certain assets and assumed certain liabilities from Albertson’s, Inc. (“Albertsons”) for $4.0 billion. The assets acquired and the liabilities assumed included approximately 700 standalone drugstores and a distribution center located in La Habra, California (collectively the “Standalone Drug Business”). Approximately one-half of the drugstores are located in southern California. The remaining drugstores are primarily located in our existing markets in the Midwest and Southwest. We believe that the acquisition of the Standalone Drug Business is consistent with our long-term strategy of expanding our retail drugstore business in high-growth markets. CVS financed the acquisition of the Standalone Drug Business by issuing commercial paper and borrowing $1.0 billion from a bridge loan facility. During the third quarter of 2006, CVS expects to refinance a portion of the commercial paper borrowings with longer term financing. During the fourth quarter of 2006, CVS expects to sell a substantial portion of the acquired real estate through a sale-leaseback transaction, the proceeds of which will be used in retiring the bridge loan facility.
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Results of Operations
Thirteen and Twenty-Six Weeks Ended July 1, 2006 versus July 2, 2005
Net revenues ~ The following table summarizes our revenue performance for the respective periods:
Net revenues (in billions)
Net revenue increase:
Total
Pharmacy
Front Store
Same store sales increase(1):
Pharmacy percentage of total revenue
Third party percentage of pharmacy revenue
As you review our performance in this area, we believe you should consider the following important information:
18
Gross profit, which includes net revenues less the cost of merchandise sold during the reporting period and the related purchasing costs, warehousing costs, delivery costs and actual and estimated inventory losses, as a percentage of revenues was 26.9% for the second quarter of 2006, compared to 26.5% of net revenues for the second quarter of 2005. Gross profit for the first six months of 2006 was 26.7% of net revenues, compared to 26.2% of net revenues in the first six months of 2005.
19
Total operating expenses, which include store and administrative payroll, employee benefits, store and administrative occupancy costs, selling expenses, advertising expenses, administrative expenses and depreciation and amortization expense remained consistent at 21.3% of net revenues for the second quarters of both 2006 and 2005. Total operating expenses for the first six months of 2006 were 21.1% of net revenues, compared to 20.9% of net revenues in the first six months of 2005. Total operating expenses increased during the second quarter and first six months of 2006, as a result of the adoption of the Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share-Based Payment”. In addition, the company began to incur increased costs related to the integration of the Standalone Drug Business during the second quarter of 2006.
Interest expense, net consisted of the following:
The increase in interest expense for the thirteen and twenty-six weeks ended July 1, 2006 was due to a combination of higher interest rates and higher average debt balances resulting from the acquisition of the Standalone Drug Business.
Income tax provision ~ Our effective income tax rate was 39.3% and 39.1% for the second quarter and first six months of 2006, respectively, compared to 38.6% for the comparable 2005 periods. The increase in our effective income tax rate was primarily due to the implementation of SFAS No. 123(R), as the compensation expense associated with our employee stock purchase plan is not deductible for income tax purposes.
Net earnings for the second quarter of 2006 increased $62.0 million (or 22.5%) to $337.9 million, or $0.40 per diluted share, compared to $275.9 million, or $0.33 per diluted share, in the second quarter of 2005. Net earnings for the first six months of 2006 increased $101.9 million (or 18.0%) to $667.5 million, or $0.78 per diluted share, compared to $565.6 million, or $0.67 per diluted share, in the first six months of 2005.
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Liquidity and Capital Resources
We anticipate that cash flows from operations, supplemented by commercial paper and long-term borrowings, will continue to fund the growth of our business.
Net cash provided by operating activities increased to $723.6 million during the first six months of 2006, compared to $601.1 million during the first six months of 2005. The increase in net cash provided by operations during the first six months of 2006 primarily resulted from an increase in cash receipts from revenues.
Net cash used in investing activities increased to $4.6 billion during the first six months of 2006. This compares to $652.0 million used during the first six months of 2005. The increase in net cash used in investing activities was primarily due to the acquisition of the Standalone Drug Business.
During the first six months of 2006, we acquired 701 stores, opened 61 new stores, relocated 70 stores and closed 28 stores. For the remainder of 2006, we plan to open 120-145 new or relocated stores. As of July 1, 2006, we operated 6,205 retail and specialty pharmacy stores in 44 states and the District of Columbia.
Net cash provided by financing activities increased to $3.9 billion during the first six months of 2006, compared to $72.7 million during the first six months of 2005. The increase in net cash provided by financing activities was primarily due to an increase in short-term borrowings related to the financing of the acquisition of the Standalone Drug Business. This increase was offset partially by the repayment of the $300 million, 5.625% unsecured senior notes, which matured during the first quarter of 2006.
As of July 1, 2006, we had $3.5 billion of commercial paper outstanding at a weighted average interest rate of 5.3% and $1 billion in outstanding borrowings against the bridge facility at a weighted average interest rate of 5.46%. In connection with our commercial paper program, we maintain a $675 million, five-year unsecured back-up credit facility, which expires on June 11, 2009, and a $675 million five-year unsecured backup credit facility, which expires on June 2, 2010. In preparation for the consummation of the acquisition of the Standalone Drug Business, we entered into a $1.5 billion 364-day unsecured back-up credit facility, which will terminate upon the placement of longer-term financing and a $1.4 billion, five-year unsecured back-up credit facility, which expires on May 12, 2011. We also entered into a bridge facility with an aggregate loan value of up to $1.0 billion, which will terminate on December 31, 2006. The credit facilities allow for borrowings at various rates depending on our public debt rating.
Our credit facilities and unsecured senior notes contain customary restrictive financial and operating covenants. These covenants do not include a requirement for the acceleration of our debt maturities in the event of a downgrade in our credit rating. We do not believe that the restrictions contained in these covenants materially affect our financial or operating flexibility.
We believe that our cash on hand and cash provided by operations, together with our ability to obtain additional short-term and long-term financing, will be sufficient to cover our working capital needs, capital expenditures and debt service requirements for at least the next twelve months and the foreseeable future. During the third quarter of 2006, the Company expects to refinance a portion of the short-term borrowings issued to finance the acquisition of the Standalone Drug Business, with longer-term financing. To manage a portion of the risk associated with changes in market interest rates, during the second quarter of 2006, the Company entered into forward starting pay fixed rate swaps, (the “Swaps”) with a notional amount of $750 million. The Company expects to settle these Swaps during the third quarter of 2006 in conjunction with the placement of the longer-term financing. There were no hedge instruments outstanding as of December 31, 2005.
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Our liquidity is based, in part, on maintaining investment-grade debt ratings. As of July 1, 2006, our long-term debt was rated “Baa2” by Moody’s and “BBB+” by Standard & Poor’s, and our commercial paper program was rated “P-2” by Moody’s and “A-2” by Standard & Poor’s. Both Moody’s and Standard & Poor’s have placed our ratings on a stable outlook. In assessing our credit strength, we believe that both Moody’s and Standard & Poor’s considered, among other things, our capital structure and financial policies as well as our consolidated balance sheet, our acquisition of the Standalone Drug Business, and other financial information. Although we currently believe our long-term debt ratings will remain investment grade, we cannot guarantee the future actions of Moody’s and Standard & Poor’s. Our debt ratings have a direct impact on our future borrowing costs, access to capital markets and new store operating lease costs.
Off-Balance Sheet Arrangements
In connection with executing operating leases, we provide a guarantee of the lease payments. We finance a portion of our new store development through sale-leaseback transactions, which involve selling stores to unrelated parties and then leasing the stores back under leases that qualify and are accounted for as operating leases. We do not have any retained or contingent interests in the stores, nor do we provide any guarantees, other than a guarantee of the lease payments, in connection with the transactions. In accordance with generally accepted accounting principles, our operating leases are not reflected in our consolidated condensed balance sheet.
In connection with certain business dispositions completed between 1991 and 1997, we continue to guarantee the lease obligations of approximately 360 former stores. The respective purchasers are required to indemnify CVS for these obligations. If any of the purchasers were to become insolvent and failed to make the required payments under a store lease, we could be required to satisfy these obligations. However, management believes that it is unlikely that any such liability would have a material effect on our financial position, results of operations or future cash flows. We refer you to the “Notes to Consolidated Financial Statements” on page 40 of our Annual Report to Stockholders included as Exhibit 13 to our Annual Report on Form 10-K for the fiscal year ended December 31, 2005 for a detailed discussion of these guarantees.
Critical Accounting Policies
We prepare our consolidated financial statements in conformity with generally accepted accounting principles, which require management to make certain estimates and apply judgment. We base our estimates and judgments on historical experience, current trends and other factors that management believes to be important at the time the consolidated financial statements are prepared. On a regular basis, we review our accounting policies and how they are applied and disclosed in our consolidated financial statements. While we believe that the historical experience, current trends and other factors considered support the preparation of our consolidated financial statements in conformity with generally accepted accounting principles, actual results could differ from our estimates, and such differences could be material. We refer you to the “Notes to Consolidated Financial Statements” on pages 30 through 32 of our Annual Report to Stockholders included as Exhibit 13 to our Annual Report on Form 10-K for the fiscal year ended December 31, 2005 for a discussion of our significant accounting policies. We believe the following accounting policies include a higher degree of judgment and/or complexity and, thus, are considered to be critical accounting policies. The critical accounting policies discussed below are applicable to both of our business segments. We have discussed the development and selection of our critical accounting policies with the Audit Committee of our Board of Directors and the Audit Committee has reviewed our disclosures relating to them.
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Impairment of Long-Lived Assets
We account for the impairment of long-lived assets in accordance with SFAS No. 144, “Accounting for Impairment or Disposal of Long-Lived Assets.” As such, we evaluate the recoverability of long-lived assets, including intangible assets with finite lives, but excluding goodwill, which is tested for impairment using a separate test, whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. We group and evaluate long-lived assets for impairment at the individual store level, which is the lowest level at which individual cash flows can be identified. When evaluating long-lived assets for potential impairment, we first compare the carrying amount of the asset group to the individual store’s estimated future cash flows (undiscounted and without interest charges). If the estimated future cash flows are less than the carrying amount of the asset group, an impairment loss calculation is prepared. The impairment loss calculation compares the carrying amount of the asset group to the individual store’s estimated future cash flows (discounted and with interest charges). If required, an impairment loss is recorded for the portion of the asset group’s carrying value that exceeds the individual store’s estimated future cash flows (discounted and with interest charges).
Our impairment loss calculation contains uncertainty since we must use judgment to estimate each store’s future sales, profitability and cash flows. When preparing these estimates, we consider each store’s historical results and current operating trends and our consolidated sales, profitability and cash flow results and forecasts. These estimates can be affected by a number of factors including, but not limited to, general economic conditions, the cost of real estate, the continued efforts of third party organizations to reduce their prescription drug costs, the continued efforts of competitors to gain market share and consumer spending patterns.
The net book value of our long-lived assets, including intangible assets with finite lives, covered by this critical accounting policy was approximately $7 billion as of July 1, 2006. During 2005, 2004 and 2003, we recorded pre-tax impairment losses totaling $27 million, $20 million and $22 million, respectively. Although we believe we have sufficient current and historical information available to us to record reasonable estimates for impairment losses, it is possible that actual results could differ. In order to help you assess the risk, if any, associated with the uncertainties discussed above, we believe the $7 million pre-tax difference between the high and low end of the three-year impairment loss range would be a reasonably likely annual increase or decrease in the impairment of long-lived assets.
We have not made any material changes to our impairment loss assessment methodology or impairment loss estimates during the past three years.
Closed Store Lease Liability
We account for closed store lease termination costs in accordance with SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” As such, when a leased store is closed, we record a liability for the estimated present value of the remaining obligation under the non-cancelable lease, which includes future real estate taxes, common area maintenance and other charges, if applicable. The liability is reduced by estimated future sublease income.
The initial calculation and subsequent evaluations of our closed store lease liability contains uncertainty since we must use judgment to estimate the timing and duration of future vacancy periods, the amount and timing of future lump sum settlement payments and the amount and timing of potential future sublease income. When estimating these potential termination costs and their related timing, we consider a number of factors, which include, but are not limited to, historical settlement experience, the owner of the property, the location and condition of the property, the terms of the underlying lease, the specific marketplace demand and general economic conditions.
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Our total closed store lease liability covered by this critical accounting policy was $518 million as of July 1, 2006. This amount is net of $287 million of estimated sublease income that is subject to the uncertainties discussed above. Although we believe we have sufficient current and historical information available to us to record reasonable estimates for sublease income, it is possible that actual results could differ. In order to help you assess the risk, if any, associated with the uncertainties discussed above, a ten percent (10%) pre-tax change in our estimated sublease income would increase or decrease our total closed store lease liability by about $29 million as of July 1, 2006.
We have not made any material changes in our closed store lease reserve methodology or closed store lease liability estimates during the past three years.
Self-Insurance Liabilities
We are self-insured for certain losses related to general liability, worker’s compensation and auto liability although we maintain stop loss coverage with third party insurers to limit our total liability exposure. We are also self-insured for certain losses related to health and medical liabilities.
The estimate of our self-insurance liability contains uncertainty since we must use judgment to estimate the ultimate cost that will be incurred to settle reported claims and unreported claims for incidents incurred but not reported as of the balance sheet date. When estimating our self-insurance liability, we consider a number of factors, which include, but are not limited to, historical claim experience, demographic factors, severity factors and valuations provided by independent third-party actuaries. On a quarterly basis, we review our assumptions with our independent third party actuaries to determine that our self-insurance liability is adequate.
Our total self-insurance liability covered by this critical accounting policy was $273 million as of July 1, 2006. Although we believe we have sufficient current and historical information available to us to record reasonable estimates for our self-insurance liability, it is possible that actual results could differ. In order to help you assess the risk, if any, associated with the uncertainties discussed above, a ten percent (10%) pre-tax change in our estimate for our self-insurance liability would increase or decrease our self-insurance liability by about $27 million as of July 1, 2006.
We have not made any material changes in our self-insurance liability methodology or self-insurance liability estimates during the past three years.
Inventory
Our inventory is stated at the lower of cost or market on a first-in, first-out basis using the retail method of accounting to determine cost of sales and inventory in our stores, and the cost method of accounting to determine inventory in our distribution centers. Under the retail method, inventory is stated at cost, which is determined by applying a cost-to-retail ratio to the ending retail value of our inventory. Since the retail value of our inventory is adjusted on a regular basis to reflect current market conditions, our carrying value should approximate the lower of cost or market. In addition, we reduce the value of our ending inventory for estimated inventory losses that have occurred during the interim period between physical inventory counts. Physical inventory counts are taken on a regular basis in each location (other than one newly constructed distribution center, which performs a continuous cycle count process to validate the inventory balance on hand) to ensure that the amounts reflected in the consolidated financial statements are properly stated.
The accounting for inventory contains uncertainty since we must use judgment to estimate the inventory losses that have occurred during the interim period between physical inventory counts. When estimating these losses, we consider a number of factors, which include but are not limited to, historical physical inventory results on a location-by-location basis and current inventory loss trends.
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Our total reserve for estimated inventory losses covered by this critical accounting policy was $102 million as of July 1, 2006. Although we believe we have sufficient current and historical information available to us to record reasonable estimates for estimated inventory losses, it is possible that actual results could differ. In order to help you assess the risk, if any, associated with the uncertainties discussed above, a ten percent (10%) pre-tax change in our estimated inventory losses would increase or decrease our total reserve for estimated inventory losses by about $10 million as of July 1, 2006.
We have not made any material changes in our inventory loss reserve methodology or inventory loss estimates during the past three years.
Although we believe that the estimates discussed above are reasonable and the related calculations conform to generally accepted accounting principles, actual results could differ from our estimates, and such differences could be material.
Recent Accounting Pronouncements
In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation (“FIN”) No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109.” FIN No. 48 clarifies the accounting and disclosure for uncertain income tax positions, which relate to the uncertainty about how certain income tax positions taken or expected to be taken in regard to income tax returns should be reflected in the financial statements before they are finally resolved with the taxing authorities. FIN No. 48 is effective for fiscal years beginning after December 15, 2006. We are currently assessing the impact that FIN No. 48 may have on our consolidated results of operations and financial position.
Cautionary Statement Concerning Forward-Looking Statements
The Private Securities Litigation Reform Act of 1995 (the “Reform Act”) provides a safe harbor for forward-looking statements made by or on behalf of CVS Corporation. The Company and its representatives may, from time to time, make written or verbal forward-looking statements, including statements contained in the Company’s filings with the Securities and Exchange Commission and in its reports to stockholders. Generally, the inclusion of the words “believe,” “expect,” “intend,” “estimate,” “project,” “anticipate,” “will,” “should” and similar expressions identify statements that constitute forward-looking statements.
All statements addressing operating performance of CVS Corporation or any subsidiary, events or developments that the Company expects or anticipates will occur in the future, including statements relating to sales growth, earnings or earnings per common share growth, free cash flow, debt ratings, inventory levels, inventory turn and loss rates, store development, relocations and new market entries, as well as statements expressing optimism or pessimism about future operating results or events, are forward-looking statements within the meaning of the Reform Act.
The forward-looking statements are and will be based upon management’s then-current views and assumptions regarding future events and operating performance, and are applicable only as of the dates of such statements. The Company undertakes no obligation to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise.
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By their nature, all forward-looking statements involve risks and uncertainties. Actual results may differ materially from those contemplated by the forward-looking statements for a number of reasons, including but not limited to:
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The foregoing list is not exhaustive. There can be no assurance that the Company has correctly identified and appropriately assessed all factors affecting its business. Additional risks and uncertainties not presently known to the Company or that it currently believes to be immaterial also may adversely impact the Company. Should any risks and uncertainties develop into actual events, these developments could have material adverse effects on the Company’s business, financial condition, and results of operations. For these reasons, you are cautioned not to place undue reliance on the Company’s forward-looking statements.
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Item 3. Quantitative and Qualitative Disclosures About Market Risk
The Company believes its exposure to market risk associated with changes in interest rates in its debt portfolio is not material.
During the third quarter of 2006, the Company expects to finance a portion of the short-term borrowings issued to finance the acquisition of the Standalone Drug Business, with longer-term financing. To manage a portion of the risk associated with changes in market interest rates, during the second quarter of 2006, the Company entered into forward starting pay fixed rate swaps, (the “Swaps”) with a notional amount of $750 million. The Company expects to settle these Swaps during the third quarter of 2006 in conjunction with the placement of the longer-term financing.
As of July 1, 2006, other than the Swaps, the Company had no derivative financial instruments or derivative commodity instruments in place and does not believe interest rate fluctuations through the settlement date of the Swaps will have a material impact on the Company’s consolidated results of operations or financial position.
Item 4. Controls and Procedures
Evaluation of disclosure controls and procedures: The Company’s Chief Executive Officer and Chief Financial Officer, after evaluating the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Exchange Act Rules 13a-15 (f) and 15d-15(f)) as of July 1, 2006, have concluded that as of such date the Company’s disclosure controls and procedures were adequate and effective and designed to ensure that material information relating to the Company and its subsidiaries would be made known to such officers on a timely basis.
Changes in internal control over financial reporting: There have been no changes in our internal controls over financial reporting identified in connection with the evaluation required by paragraph (d) of Rule 13a-15 or Rule 15d-15 that occurred during the second quarter ended July 1, 2006 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
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Submission of Matters to a Vote of Security Holders
The following matters were submitted to a vote of security holders at our Annual Meeting of Stockholders, which was held on Thursday, May 11, 2006 in Woonsocket, Rhode Island:
Broker
Non-Votes
1.
W. Don Cornwell
David W. Dorman
Thomas P. Gerrity
Marian L. Heard
William H. Joyce
Terrence Murray
Sheli Z. Rosenberg
Thomas M. Ryan
Alfred J. Verrecchia
2.
3.
4.
5.
6.
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Exhibits
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Signatures:
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Quarterly Report on Form 10-Q to be signed on its behalf by the undersigned thereunto duly authorized.
(Registrant)
/s/ David B. Rickard
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