EX-13 17 ex13portionsofannualreport.htm EXHIBIT 13 EX 13.Portions.of.Annual.Report '14


Exhibit 13
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
The following discussion and analysis should be read in conjunction with our audited consolidated financial statements and Cautionary Statement Concerning Forward-Looking Statements that are included in this Annual Report.

Overview of Our Business
 
CVS Health Corporation, together with its subsidiaries (collectively “CVS Health,” the “Company,” “we,” “our” or “us”), is a pharmacy innovation company helping people on their path to better health. At the forefront of a changing health care landscape, the Company has an unmatched suite of capabilities and the expertise needed to drive innovations that will help shape the future of health.

We are currently the only integrated pharmacy health care company with the ability to impact consumers, payors, and providers with innovative, channel-agnostic solutions. We have a deep understanding of their diverse needs through our unique integrated model, and we are bringing them innovative solutions that help increase access to quality care, deliver better health outcomes, and lower overall health care costs.

Through our 7,800 retail pharmacies, more than 900 walk-in medical clinics, a leading pharmacy benefits manager with more than 65 million plan members, and expanding specialty pharmacy services, we enable people, businesses, and communities to manage health in more effective ways. We are delivering break-through products and services, from advising patients on their medications at our CVS/pharmacy® locations, to introducing unique programs to help control costs for our clients at CVS/caremarkTM, to innovating how care is delivered to our patients with complex conditions through CVS/specialtyTM, or by expanding access to high-quality, low-cost care at CVS/minuteclinicTM.

We currently have three reportable segments: Pharmacy Services, Retail Pharmacy and Corporate.

Overview of Our Pharmacy Services Segment
 
Our Pharmacy Services business generates revenue from a full range of PBM services, including plan design and administration, formulary management, Medicare Part D services, mail order, specialty pharmacy and infusion services, retail pharmacy network management services, prescription management systems, clinical services, disease management services and medical spend management.
 
Our clients are primarily employers, insurance companies, unions, government employee groups, health plans, Managed Medicaid plans and other sponsors of health benefit plans, and individuals throughout the United States. A portion of covered lives primarily within the Managed Medicaid, health plan and employer markets have access to our services through public and private exchanges.
 
As a pharmacy benefits manager, we manage the dispensing of pharmaceuticals through our mail order pharmacies, specialty pharmacies and national network of more than 68,000 retail pharmacies, consisting of approximately 41,000 chain pharmacies (which includes our CVS/pharmacy® stores) and 27,000 independent pharmacies, to eligible members in the benefit plans maintained by our clients and utilize our information systems to perform, among other things, safety checks, drug interaction screenings and brand to generic substitutions.
 
Our specialty pharmacies support individuals that require complex and expensive drug therapies. Our specialty pharmacy business includes mail order and retail specialty pharmacies that operate under the CVS/caremarkTM, CarePlus CVS/pharmacy® and Navarro Health Services® names. Substantially all of our mail service specialty pharmacies have been accredited by The Joint Commission, which is an independent, not-for-profit organization that accredits and certifies health care organizations and programs in the United States. In January 2014, we enhanced our offerings of specialty infusion services and began offering enteral nutrition services through Coram LLC and its subsidiaries (collectively, “Coram”), which we acquired on January 16, 2014. We completed the roll out of Specialty ConnectTM in May 2014, which integrates our specialty pharmacy mail and retail capabilities, providing members with disease-state specific counseling from our experienced specialty pharmacists and the choice to bring their specialty prescriptions to any CVS/pharmacy location. Whether submitted through our mail order pharmacy or at CVS/pharmacy, all prescriptions are filled through the Company’s specialty mail order pharmacies, so all revenue from this specialty prescription services program is recorded within the Pharmacy Services Segment. Members then can choose to pick up their medication at their local CVS/pharmacy or have it sent to their home through the mail.
 

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We also provide health management programs, which include integrated disease management for 17 conditions, through our Accordant® rare disease management offering. The majority of these integrated programs are accredited by the National Committee for Quality Assurance.
 
In addition, through our SilverScript Insurance Company (“SilverScript”) subsidiary, we are a national provider of drug benefits to eligible beneficiaries under the federal government’s Medicare Part D program. We currently provide Medicare Part D plan benefits to approximately 4.4 million beneficiaries through SilverScript, including our individual and employer group waiver plans.
 
The Pharmacy Services Segment operates under the CVS/caremarkTM Pharmacy Services, Caremark®, CVS/caremarkTM, CarePlus CVS/pharmacy®, RxAmerica®, Accordant®, SilverScript®, Coram®, CVS/specialtyTM, NovoLogix® and Navarro® Health Services names. As of December 31, 2014, the Pharmacy Services Segment operated 27 retail specialty pharmacy stores, 11 specialty mail order pharmacies, four mail order dispensing pharmacies, and 86 branches and six centers of excellence for infusion and enteral services located in 40 states, Puerto Rico and the District of Columbia.

Overview of Our Retail Pharmacy Segment
 
Our Retail Pharmacy Segment sells prescription drugs and a wide assortment of general merchandise, including over-the-counter drugs, beauty products and cosmetics, personal care products, convenience foods, photo finishing, seasonal merchandise and greeting cards through our CVS/pharmacy®, CVS®, Longs Drugs®, Navarro Discount Pharmacy® and Drogaria OnofreTM retail stores and online through CVS.com®, Navarro.comTM and Onofre.com.brTM. Our Retail Pharmacy Segment derives the majority of its revenues through the sale of prescription drugs, which are dispensed by our nearly 24,000 retail pharmacists. The role of our retail pharmacists is shifting from primarily dispensing prescriptions to also providing services, including flu vaccinations as well as face-to-face patient counseling with respect to adherence to drug therapies, closing gaps in care, and more cost-effective drug therapies. Our integrated pharmacy services model enables us to enhance access to care while helping to lower overall health care costs and improve health outcomes.
 
Our Retail Pharmacy Segment also provides health care services through our MinuteClinic® health care clinics. MinuteClinics are staffed by nurse practitioners and physician assistants who utilize nationally recognized protocols to diagnose and treat minor health conditions, perform health screenings, monitor chronic conditions, and deliver vaccinations. We believe our clinics provide high quality services that are affordable and convenient.
 
Our proprietary loyalty card program, ExtraCare®, has approximately 70 million active cardholders, making it one of the largest and most successful retail loyalty card programs in the country.
 
As of December 31, 2014, our Retail Pharmacy Segment included 7,822 retail drugstores (of which 7,765 operated a pharmacy) located in 44 states, the District of Columbia, Puerto Rico and Brazil operating primarily under the CVS/pharmacy®, CVS®, Longs Drugs®, Navarro Discount Pharmacy® and Drogaria OnofreTM names, 17 onsite pharmacies primarily operating under the CarePlus CVS/pharmacy®, CarPlus® and CVS/pharmacy® names, and 971 retail health care clinics operating under the MinuteClinic® name (of which 963 were located in CVS/pharmacy stores), and our online retail websites, CVS.com®, Navarro.comTM and Onofre.com.brTM.

Overview of Our Corporate Segment
 
The Corporate Segment provides management and administrative services to support the Company. The Corporate Segment consists of certain aspects of our executive management, corporate relations, legal, compliance, human resources, corporate information technology and finance departments.


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Results of Operations
 
Summary of our Consolidated Financial Results
 
 
Year Ended December 31,
In millions, except per common share amounts
2014
 
2013
 
2012
Net revenues
$
139,367

 
$
126,761

 
$
123,120

Cost of revenues
114,000

 
102,978

 
100,632

Gross profit
25,367

 
23,783

 
22,488

Operating expenses
16,568

 
15,746

 
15,278

Operating profit
8,799

 
8,037

 
7,210

Interest expense, net
600

 
509

 
557

Loss on early extinguishment of debt
521

 

 
348

Income before income tax provision
7,678

 
7,528

 
6,305

Income tax provision
3,033

 
2,928

 
2,436

Income from continuing operations
4,645

 
4,600

 
3,869

Loss from discontinued operations, net of tax
(1
)
 
(8
)
 
(7
)
Net income
4,644

 
4,592

 
3,862

Net loss attributable to noncontrolling interest

 

 
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Net income attributable to CVS Health
$
4,644

 
$
4,592

 
$
3,864

Diluted earnings per common share:
 

 
 

 
 

Income from continuing operations attributable to CVS Health
$
3.96

 
$
3.75

 
$
3.02

Loss from discontinued operations attributable to CVS Health
$

 
$
(0.01
)
 
$
(0.01
)
Net income attributable to CVS Health
$
3.96

 
$
3.74

 
$
3.02

 
Net revenues increased $12.6 billion in 2014 compared to 2013, and increased $3.6 billion in 2013 compared to 2012. As you review our performance in this area, we believe you should consider the following important information:
 
During 2014, net revenues in our Pharmacy Services Segment increased 16.1% and net revenues in our Retail Pharmacy Segment increased 3.3% compared to the prior year.
 
During 2013, net revenues in our Pharmacy Services Segment increased by 3.8% and net revenues in our Retail Pharmacy Segment increased 3.1% compared to the prior year.
 
The increase in our generic dispensing rates in both of our operating segments continued to have an adverse effect on net revenue in 2014 as compared to 2013, as well as in 2013 as compared to 2012. In 2014, the Pharmacy Services Segment had a greater impact from net new business as compared to 2013.
 
Please see the Segment Analysis later in this document for additional information about our net revenues.
 
Gross profit increased $1.6 billion, or 6.7% in 2014, to $25.4 billion, as compared to $23.8 billion in 2013. Gross profit increased $1.3 billion, or 5.8% in 2013, to $23.8 billion, as compared to $22.5 billion in 2012. Gross profit as a percentage of net revenues declined to 18.2%, as compared to 18.8% in 2013 and 18.3% in 2012.
 
During 2014, gross profit in our Pharmacy Services Segment and Retail Pharmacy Segment increased by 12.6% and 5.8%, respectively, compared to the prior year. For the year ended December 31, 2014, gross profit as a percent of net revenues in our Pharmacy Services Segment and Retail Pharmacy Segment was 5.4% and 31.4%, respectively.
 
During 2013, gross profit in our Pharmacy Services Segment and Retail Pharmacy Segment increased by 11.3% and 5.3%, respectively, compared to the prior year. For the year ended December 31, 2013, gross profit as a percent of net revenues in our Pharmacy Services Segment and Retail Pharmacy Segment was 5.6% and 30.6%, respectively.
 
The increased weighting toward the Pharmacy Services Segment, which has a lower gross profit than the Retail Pharmacy Segment, resulted in a decline in consolidated gross profit as a percent of net revenues in 2014 as compared

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to 2013. In addition, gross profit for 2014, 2013 and 2012 has been negatively impacted by the efforts of managed care organizations, pharmacy benefit managers and governmental and other third-party payors to reduce their prescription drug costs.
 
Our gross profit continued to benefit from the increased utilization of generic drugs (which normally yield a higher gross profit rate than equivalent brand name drugs) in both the Pharmacy Services and Retail Pharmacy segments for 2012 through 2014, offsetting the negative impacts described above.
 
Please see the Segment Analysis later in this document for additional information about our gross profit.

Operating expenses increased $822 million, or 5.2% in the year ended December 31, 2014, as compared to the prior year. Operating expenses as a percent of net revenues declined to 11.9% in the year ended December 31, 2013 compared to 12.4% in the prior year. The increase in operating expense dollars in the year ended December 31, 2014 was primarily due to incremental store operating costs associated with a higher store count, as well as legal costs and strategic initiatives as compared to the prior year. Additionally, the year ended December 31, 2013 included a $72 million gain on a legal settlement. The improvement in operating expenses as a percent of net revenues in 2014 is primarily due to expense leverage from net revenue growth and disciplined expense control.
 
Operating expenses increased $468 million in the year ended December 31, 2013 as compared to the prior year. Operating expenses as a percent of net revenues remained flat at 12.4% in the year ended December 31, 2013. The increase in operating expense dollars in the year ended December 31, 2013 was primarily due to incremental store operating costs associated with a higher store count as compared to the prior year, as well as strategic initiatives. The increase was partially offset by a $72 million gain on a legal settlement.
 
Please see the Segment Analysis later in this document for additional information about operating expenses.
 
Interest expense, net for the years ended December 31 consisted of the following:
 
In millions 
2014
 
2013
 
2012
Interest expense
$
615

 
$
517

 
$
561

Interest income
(15
)
 
(8
)
 
(4
)
Interest expense, net
$
600

 
$
509

 
$
557

 
Net interest expense increased $91 million during the year ended December 31, 2014, primarily due to the issuance of $4 billion of debt in December 2013 and $1.5 billion of debt in August 2014. During 2013, net interest expense decreased by $48 million, to $509 million compared to 2012, which resulted from lower average interest rates during 2013.

Loss on Early Extinguishment of Debt - During the year ended December 31, 2014, the Company completed a $2.0 billion tender offer and repurchase of certain Senior Notes. The Company paid a premium of $490 million in excess of the debt principal in connection with the repurchase of the Senior Notes, wrote off $26 million of unamortized deferred financing costs and incurred $5 million in fees, for a total loss on early extinguishment of debt of $521 million. During the year ended December 31, 2012, the Company completed a $1.3 billion tender offer and repurchase of certain Senior Notes and incurred a total loss on the early extinguishment of debt of $348 million. See Note 5 to the consolidated financial statements.
 
Income tax provision - Our effective income tax rate was 39.5%, 38.9% and 38.6% in 2014, 2013 and 2012, respectively. The effective income tax was higher in 2014 than in 2013 primarily due to certain permanent items in 2014. These same items were the principal factors for the increase in the effective income tax rate in 2013 compared to 2012.
 
Income from continuing operations increased $45 million or 1.0% to $4.6 billion in 2014. Income from continuing operations increased $731 million or 18.9% to $4.6 billion in 2013 as compared to $3.9 billion in 2012. The 2014 and 2013 increases in income from continuing operations were primarily related to increases in generic dispensing rates and increased prescription volume for both operating segments. In addition, as discussed above, income from continuing operations included a $521 million and $348 million loss on early extinguishment of debt in 2014 and 2012, respectively, which positively impacted the growth rate in 2013 and negatively impacted the growth rate in 2014.
 


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Loss from discontinued operations - In connection with certain business dispositions completed between 1991 and 1997, the Company retained guarantees on store lease obligations for a number of former subsidiaries, including Linens ‘n Things, which filed for bankruptcy in 2008. The Company’s loss from discontinued operations includes lease-related costs required to satisfy its Linens ‘n Things lease guarantees. We incurred a loss from discontinued operations, net of tax, of $1 million, $8 million and $7 million in 2014, 2013 and 2012, respectively.
 
See Note 1 “Significant Accounting Policies - Discontinued Operations” to the consolidated financial statements for additional information about discontinued operations and Note 11 “Commitments and Contingencies” for additional information about our lease guarantees.

Net loss attributable to noncontrolling interest of $2 million for the year ended December 31, 2012 represents the minority shareholders’ portion of the net loss of our subsidiary, Generation Health, Inc. (“Generation Health”). We acquired the remaining 40% interest of Generation Health in June 2012 and as a result, there was no longer a noncontrolling interest in Generation Health for the years ended December 31, 2014 and 2013. For the year ended December 31, 2014, the Company had immaterial noncontrolling interests in two consolidated entities.
 
Net income attributable to CVS Health increased $52 million or 1.1% to $4.6 billion (or $3.96 per diluted share) in 2014. This compares to $4.6 billion (or $3.74 per diluted share) in 2013 and $3.9 billion (or $3.02 per diluted share) in 2012. As discussed previously, the 2014 increase in net income attributable to CVS Health was primarily related to increased generic drug dispensing and increased prescription volume in both operating segments. The increase in net income attributable to CVS Health per diluted share was also driven by increased share repurchase activity in 2014 and 2013. The increase in net income attributable to CVS Health and per diluted share in 2014 includes a $521 million loss on early extinguishment of debt, which negatively impacted the net income growth rate in 2014.


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Segment Analysis
 
We evaluate the performance of our Pharmacy Services and Retail Pharmacy segments based on net revenues, gross profit and operating profit before the effect of certain intersegment activities and charges. The Company evaluates the performance of its Corporate Segment based on operating expenses before the effect of discontinued operations and certain intersegment activities and charges. The following is a reconciliation of the Company’s business segments to the consolidated financial statements:
 
In millions 
Pharmacy
Services
Segment(1)(2)
 
Retail
Pharmacy
Segment(2)
 
Corporate
Segment
 
Intersegment
Eliminations(2)
 
Consolidated
Totals
2014:
 

 
 

 
 

 
 

 
 

Net revenues
$
88,440

 
$
67,798

 
$

 
$
(16,871
)
 
$
139,367

Gross profit
4,771

 
21,277

 

 
(681
)
 
25,367

Operating profit (loss)
3,514

 
6,762

 
(796
)
 
(681
)
 
8,799

2013:
 

 
 

 
 

 
 

 
 

Net revenues
$
76,208

 
$
65,618

 
$

 
$
(15,065
)
 
$
126,761

Gross profit
4,237

 
20,112

 

 
(566
)
 
23,783

Operating profit (loss)
3,086

 
6,268

 
(751
)
 
(566
)
 
8,037

2012:
 

 
 

 
 

 
 

 
 

Net revenues
$
73,444

 
$
63,641

 
$

 
$
(13,965
)
 
$
123,120

Gross profit
3,808

 
19,091

 

 
(411
)
 
22,488

Operating profit (loss)
2,679

 
5,636

 
(694
)
 
(411
)
 
7,210

 

(1)
Net revenues of the Pharmacy Services Segment include approximately $8.1 billion, $7.9 billion and $8.4 billion of Retail Co-Payments for 2014, 2013 and 2012, respectively. See Note 1 to the consolidated financial statements for additional information about Retail Co-Payments.
 
(2)
Intersegment eliminations relate to two types of transactions: (i) Intersegment revenues that occur when Pharmacy Services Segment customers use Retail Pharmacy Segment stores to purchase covered products. When this occurs, both the Pharmacy Services and Retail Pharmacy segments record the revenue on a standalone basis, and (ii) Intersegment revenues, gross profit and operating profit that occur when Pharmacy Services Segment customers, through the Company’s intersegment activities (such as the Maintenance Choice® program), elect to pick-up their maintenance prescriptions at Retail Pharmacy Segment stores instead of receiving them through the mail. When this occurs, both the Pharmacy Services and Retail Pharmacy segments record the revenue, gross profit and operating profit on a standalone basis. The following amounts are eliminated in consolidation in connection with the item (ii) intersegment activity: net revenues of $4.9 billion, $4.3 billion and $3.4 billion for the years ended December 31, 2014, 2013 and 2012, respectively; and gross profit and operating profit of $681 million, $566 million and $411 million for the years ended December 31, 2014, 2013 and 2012, respectively.


























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Pharmacy Services Segment
 
The following table summarizes our Pharmacy Services Segment’s performance for the respective periods:
 
 
Year Ended December 31,
In millions 
2014
 
2013
 
2012
Net revenues
$
88,440

 
$
76,208

 
$
73,444

Gross profit
$
4,771

 
$
4,237

 
$
3,808

Gross profit % of net revenues
5.4
%
 
5.6
%
 
5.2
%
Operating expenses
$
1,257

 
$
1,151

 
$
1,129

Operating expenses % of net revenues
1.4
%
 
1.5
%
 
1.5
%
Operating profit
$
3,514

 
$
3,086

 
$
2,679

Operating profit % of net revenues
4.0
%
 
4.1
%
 
3.6
%
Net revenues(1) :
 

 
 

 
 

Mail choice(2)
$
31,081

 
$
24,791

 
$
22,843

Pharmacy network(3)
$
57,122

 
$
51,211

 
$
50,411

Other
$
237

 
$
206

 
$
190

Pharmacy claims processed(1) :
 

 
 

 
 

Total
932.0

 
902.1

 
880.5

Mail choice(2)
82.4

 
83.3

 
81.7

Pharmacy network(3)
849.6

 
818.8

 
798.8

Generic dispensing rate(1) :
 

 
 

 
 

Total
82.2
%
 
80.5
%
 
78.2
%
Mail choice(2)
74.6
%
 
72.6
%
 
68.9
%
Pharmacy network(3)
83.0
%
 
81.3
%
 
79.1
%
Mail choice penetration rate
21.4
%
 
22.6
%
 
22.7
%
 
(1)
Pharmacy network net revenues, claims processed and generic dispensing rates do not include Maintenance Choice, which are included within the mail choice category.
 
(2)
Mail choice is defined as claims filled at a Pharmacy Services mail facility, which includes specialty mail claims, as well as 90-day claims filled at our retail stores under the Maintenance Choice program.
 
(3)
Pharmacy network is defined as claims filled at retail pharmacies, including our retail drugstores, but excluding Maintenance Choice activity.
 
Net revenues in our Pharmacy Services Segment increased $12.2 billion, or 16.1%, to approximately $88.4 billion for the year ended December 31, 2014, as compared to the prior year. The increase in net revenues was primarily due to growth in specialty pharmacy, including the acquisition of Coram and the impact of Specialty Connect, and increased pharmacy network volume. Conversely, the increase in our generic dispensing rate had a negative impact on our revenue in 2014, as it did in 2013.
 
Net revenues increased $2.8 billion, or 3.8%, to $76.2 billion for the year ended December 31, 2013, as compared to the prior year. The increase in 2013 was primarily due to drug cost inflation in specialty pharmacy. Additionally, the increase in our generic dispensing rate had a negative impact on our revenue in 2013, as it did in 2012.

As you review our Pharmacy Services Segment’s revenue performance, we believe you should also consider the following important information:
 
Our mail choice claims processed decreased 1.1% to 82.4 million claims in the year ended December 31, 2014, compared to 83.3 million claims in the prior year. The decrease in mail choice claims was driven by a decline in traditional mail volumes, which was mostly offset by growth in our Maintenance Choice program and specialty pharmacy. During 2013, our mail choice claims processed increased 1.9% to 83.3 million claims. The increase in mail choice claim volume was primarily due to specialty claim volume and increased claims associated with the continuing client adoption of our Maintenance Choice offerings.
 
During 2014 and 2013, our average revenue per mail choice claim increased by 26.8% and 6.5%, compared to 2013 and 2012, respectively. This increase in 2014 was primarily due to the acquisition of Coram and drug inflation particularly in

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specialty pharmacy, partially offset by increases in the percentage of generic prescription drugs dispensed and changes in client pricing. This increase in 2013 was primarily due to drug inflation particularly in specialty pharmacy, partially offset by increases in the percentage of generic prescription drugs dispensed and changes in client pricing.

Our mail choice generic dispensing rate was 74.6%, 72.6% and 68.9% in the years ended December 31, 2014, 2013 and 2012, respectively. Our pharmacy network generic dispensing rate increased to 83.0% in the year ended December 31, 2014, compared to 81.3% in the prior year. During 2013, our pharmacy network generic dispensing rate increased to 81.3% compared to our pharmacy network generic dispensing rate of 79.1% in 2012. These continued increases in mail choice and pharmacy network generic dispensing rates were primarily due to the impact of new generic drug introductions, primarily in 2012, and our continuous efforts to encourage plan members to use generic drugs when they are available. We believe our generic dispensing rates will continue to increase in future periods, albeit, at a slower pace. This increase will be affected by, among other things, the number of new generic drug introductions and our success at encouraging plan members to utilize generic drugs when they are available and clinically appropriate.

Our pharmacy network claims processed increased 3.8% to 849.6 million claims in the year ended December 31, 2014, compared to 818.8 million claims in the prior year. This increase was primarily due to net new business and growth in Managed Medicaid, partially offset by a decrease in Medicare Part D claims. Medicare Part D claims were negatively impacted by the CMS sanctions that were in place during 2013. See “Regulatory and business changes relating to our participation in Medicare Part D” in Part I, Item 1A, Risk Factors within our Form 10-K for the year ended December 31, 2014 (“2014 Form 10-K”), for additional information. During 2013, our pharmacy network claims processed increased 2.5% to 818.8 million compared to 798.8 million pharmacy network claims processed in 2012. This increase was primarily due to higher claims activity associated with our Medicare Part D offering.

Our average revenue per pharmacy network claim processed increased 7.5% in the year ended December 31, 2014 as compared to the prior year. This increase was primarily due to drug inflation and changes in the drug mix, partially offset by increases in the generic dispensing rate. During 2013, our average revenue per pharmacy network claim processed decreased by 0.9%, compared to 2012. This decrease was primarily due to increases in the generic dispensing rate.

We completed the roll out of Specialty ConnectTM in May 2014, which integrates the Company’s specialty pharmacy mail and retail capabilities, providing members with the choice to bring their specialty prescriptions to any CVS/pharmacy® location. Whether submitted through our mail order pharmacy or at CVS/pharmacy, all prescriptions are filled through the Company’s specialty mail order pharmacies, so all revenue from this specialty prescription services program is recorded within the Pharmacy Services Segment.

The Pharmacy Services Segment recognizes revenues for its pharmacy network transactions based on individual contract terms. Our Pharmacy Services Segment contracts are predominantly accounted for using the gross method. See the “Revenue Recognition” description under “Critical Accounting Policies” later in this section for further information on our revenue recognition policy.

Gross profit in our Pharmacy Services Segment includes net revenues less cost of revenues. Cost of revenues includes (i) the cost of pharmaceuticals dispensed, either directly through our mail service and specialty retail pharmacies or indirectly through our pharmacy network, (ii) shipping and handling costs and (iii) the operating costs of our mail service dispensing pharmacies, customer service operations and related information technology support.
 
Gross profit increased $534 million, or 12.6% to $4.8 billion in the year ended December 31, 2014, as compared to the prior year. Gross profit as a percentage of net revenues decreased to 5.4% for the year ended December 31, 2014, compared to 5.6% in the prior year. The increase in gross profit dollars in the year ended December 31, 2014 was primarily due to volume increases, higher generic dispensing and favorable purchasing economics, partially offset by price compression. The decrease in gross profit as a percentage of net revenues was due to price compression, partially offset by favorable generic dispensing and purchasing economics. In addition, gross profit dollars and margin for the year ended December 31, 2014, were positively impacted by $16 million related to the favorable resolution of previously proposed retroactive reimbursement rate changes in the State of California Medicaid program.

During 2013, gross profit increased $429 million, or 11.3%, to $4.2 billion in the year ended December 31, 2013, as compared to the prior year. Gross profit as a percentage of net revenues was 5.6% for the year ended December 31, 2013, compared to 5.2% in the prior year. The increase in gross profit dollars and gross profit as a percentage of net revenues in the year ended December 31, 2013 was primarily due to an increase in generic dispensing.
 

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As you review our Pharmacy Services Segment’s performance in this area, we believe you should consider the following important information:
 
Our gross profit dollars and gross profit as a percentage of net revenues continued to be impacted by our efforts to (i) retain existing clients, (ii) obtain new business and (iii) maintain or improve the rebates and/or discounts we received from manufacturers, wholesalers and retail pharmacies. In particular, competitive pressures in the PBM industry have caused us and other PBMs to continue to share a larger portion of rebates and/or discounts received from pharmaceutical manufacturers with clients. In addition, market dynamics and regulatory changes have impacted our ability to offer plan sponsors pricing that includes retail network “differential” or “spread”. We expect these trends to continue. The “differential” or “spread” is any difference between the drug price charged to plan sponsors, including Medicare Part D plan sponsors, by a PBM and the price paid for the drug by the PBM to the dispensing provider. The increased use of generic drugs has positively impacted our gross profit margins but has resulted in third party payors augmenting their efforts to reduce reimbursement payments for prescriptions. This trend, which we expect to continue, reduces the benefit we realize from brand to generic product conversions.

We review our network contracts on an individual basis to determine if the related revenues should be accounted for using the gross method or net method under the applicable accounting rules. Our Pharmacy Services Segment network contracts are predominantly accounted for using the gross method, which results in higher revenues, higher cost of revenues and lower gross profit rates.

Our gross profit as a percentage of revenues benefited from the increase in our total generic dispensing rate, which increased to 82.2% and 80.5% in 2014 and 2013, respectively, compared to our generic dispensing rate of 78.2% in 2012. These increases were primarily due to new generic drug introductions and our continued efforts to encourage plan members to use generic drugs when they are available. We expect these trends to continue, albeit at a slower pace.
 
Operating expenses in our Pharmacy Services Segment, which include selling, general and administrative expenses, depreciation and amortization related to selling, general and administrative activities and retail specialty pharmacy store and administrative payroll, employee benefits and occupancy costs, decreased to 1.4% of net revenues in 2014 compared to 1.5% in 2013 and 2012.

As you review our Pharmacy Services Segment’s performance in this area, we believe you should consider the following important information:
 
Operating expenses increased $106 million or 9.2%, to $1.3 billion, in the year ended December 31, 2014, compared to the prior year. The increase in operating expenses is primarily related to increased costs associated with infusion services due to the 2014 acquisition of Coram, as well as an $11 million gain from a legal settlement during the year ended December 31, 2013. The slight decrease in operating expenses as a percentage of net revenues was primarily due to expense leverage from net revenue growth.

During 2013, the increase in operating expenses of $22 million or 1.9%, to $1.2 billion compared to 2012, is primarily related to costs associated with the remediation of Medicare Part D sanctions and coverage determination issues discussed below. Operating expenses as a percentage of net revenues remained relatively flat.
 
Medicare Part D - The Company participates in the Medicare Part D program by (1) providing Medicare Part D-related PBM services to our health plan and other clients that have qualified as Medicare Part D plans, and (2) offering Medicare Part D pharmacy benefits through the Company’s SilverScript prescription drug plan (“PDP”), which offers benefits to individual members and through employer group waiver plans. At the beginning of the 2013 Medicare Part D plan year, the Company implemented an enrollment systems conversion process and other actions to consolidate its Medicare Part D PDPs into the Company’s SilverScript PDP. These consolidation efforts impacted certain enrollment and coverage determination services the Company provided to SilverScript enrollees following commencement of the 2013 plan year. Effective January 15, 2013, the Centers for Medicare and Medicaid Services (“CMS”) imposed intermediate sanctions on the SilverScript PDP, consisting of immediate suspension of further plan enrollment and marketing activities. On December 20, 2013, the Company announced that CMS completed its review of the corrective actions taken to address the enrollment processing and related issues resulting from the Company’s plan consolidation efforts and the sanctions were removed. SilverScript began to enroll new choosers with effective dates starting in February 2014 as they aged into Medicare. The low income subsidy (“LIS”) auto-enrollment and annual reassignment exclusion was lifted on February 21, 2014 and SilverScript began receiving LIS enrollees again with effective dates May 1, 2014 and forward. 


9



Retail Pharmacy Segment
 
The following table summarizes our Retail Pharmacy Segment’s performance for the respective periods:
 
 
Year Ended December 31,
In millions 
2014
 
2013
 
2012
Net revenues
$
67,798

 
$
65,618

 
$
63,641

Gross profit
$
21,277

 
$
20,112

 
$
19,091

Gross profit % of net revenues
31.4
 %
 
30.6
 %
 
30.0
%
Operating expenses
$
14,515

 
$
13,844

 
$
13,455

Operating expenses % of net revenues
21.4
 %
 
21.1
 %
 
21.1
%
Operating profit
$
6,762

 
$
6,268

 
$
5,636

Operating profit % of net revenues
10.0
 %
 
9.6
 %
 
8.9
%
Retail prescriptions filled (90 Day = 3 prescriptions) (1)
935.9

 
890.1

 
845.8

Net revenue increase (decrease):
 

 
 

 
 

Total
3.3
 %
 
3.1
 %
 
6.8
%
Pharmacy
5.1
 %
 
4.1
 %
 
7.6
%
Front Store
(2.5
)%
 
1.0
 %
 
5.1
%
Total prescription volume (90 Day = 3 prescriptions) (1)
5.2
 %
 
5.2
 %
 
11.0
%
Same store sales increase (decrease):
 

 
 

 
 

Total
2.1
 %
 
1.7
 %
 
5.6
%
Pharmacy
4.8
 %
 
2.6
 %
 
6.6
%
Front Store
(4.0
)%
 
(0.5
)%
 
3.4
%
Prescription volume (90 Day = 3 prescriptions) (1)
4.1
 %
 
4.4
 %
 
10.0
%
Generic dispensing rates
83.1
 %
 
81.4
 %
 
79.2
%
Pharmacy % of net revenues
70.7
 %
 
69.5
 %
 
68.8
%
Third party % of pharmacy revenue
98.6
 %
 
97.9
 %
 
97.5
%
 
(1)
Includes the adjustment to convert 90-day, non-specialty prescriptions to the equivalent of three 30-day prescriptions. This adjustment reflects the fact that these prescriptions include approximately three times the amount of product days supplied compared to a normal prescription.
 
Net revenues increased approximately $2.2 billion, or 3.3%, to $67.8 billion for the year ended December 31, 2014, as compared to the prior year. This increase was primarily driven by a same store sales increase of 2.1% and net revenues from new and acquired stores, which accounted for approximately 110 basis points of our total net revenue percentage increase during the year. Net revenues increased $2.0 billion, or 3.1% to $65.6 billion for the year ended December 31, 2013, as compared to the prior year. This increase was primarily driven by a same store sales increase of 1.7% and net revenues from new stores, which accounted for approximately 130 basis points of our total net revenue percentage increase during the year. Additionally, in 2014, 2013 and 2012 we continued to see a positive impact on our net revenues due to the growth of our Maintenance Choice program.

As you review our Retail Pharmacy Segment’s performance in this area, we believe you should consider the following important information:
 
Front store same store sales declined 4.0% in the year ended December 31, 2014, as compared to the prior year. The decrease is primarily due to the Company’s decision to stop selling tobacco products, softer customer traffic and a less severe flu season than the prior year and extreme weather conditions across much of the United States during the first quarter of 2014. The decrease was partially offset by an increase in basket size. Front store same store sales would have been approximately 350 basis points higher for the year ended December 31, 2014 if tobacco and the estimated associated basket sales were excluded from both the years ended December 31, 2014 and 2013.
 
Pharmacy same store sales rose 4.8% in the year ended December 31, 2014, as compared to the prior year. Pharmacy same store sales were positively impacted by same store script growth of 4.1%, partially offset by the impact of the increase in generic dispensing and reimbursement pressure. Pharmacy same store sales for the year ended December 31, 2014 were negatively impacted by approximately 140 basis points from the implementation of Specialty Connect. Specialty Connect transitioned all specialty prescriptions to the Pharmacy Services Segment, as they are being processed through the

10



Company’s specialty mail order pharmacies. The implementation of Specialty Connect had a greater effect on revenues than on prescription volumes due to the higher dollar value of specialty products. Pharmacy same store sales were also negatively impacted by a lower incidence of flu compared to last year’s strong flu season and extreme weather conditions across much of the United States in the first quarter of 2014, which led to fewer physician visits and prescriptions written.
 
Pharmacy revenues continue to be negatively impacted by the conversion of brand name drugs to equivalent generic drugs, which typically have a lower selling price. Pharmacy same store sales were negatively impacted by approximately 160 and 540 basis points for the years ended December 31, 2014 and 2013, respectively, due to recent generic introductions. The decrease in the impact from 2013 to 2014 was primarily due to a smaller impact from new generic drug introductions. In addition, our pharmacy revenue growth has also been affected by continued reimbursement pressure, the lack of significant new brand name drug introductions, as well as an increase in the number of over-the-counter remedies that were historically only available by prescription.
 
As of December 31, 2014, we operated 7,822 retail stores compared to 7,660 retail stores as of December 31, 2013 and 7,458 retail stores as of December 31, 2012. Total net revenues from new stores contributed approximately 1.1%, 1.0% and 1.1% to our total net revenue percentage increase in 2014, 2013, and 2012, respectively.
 
Pharmacy revenue growth continued to benefit from increased utilization by Medicare Part D beneficiaries, our ability to attract and retain managed care customers and favorable industry trends. These trends include an aging American population; many “baby boomers” are now in their fifties and sixties and are consuming a greater number of prescription drugs, as well as expanded coverage from the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act (collectively, “ACA”). In addition, the increased use of pharmaceuticals as the first line of defense for individual health care also contributed to the growing demand for pharmacy services. We believe these favorable industry trends will continue.
 
Gross profit in our Retail Pharmacy Segment 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.
 
Gross profit increased $1.2 billion, or 5.8%, to $21.3 billion in the year ended December 31, 2014, as compared to the prior year. Gross profit as a percentage of net revenues increased to 31.4% in year ended December 31, 2014, from 30.6% in 2013. Gross profit increased $1.0 billion, or 5.3%, to $20.1 billion for the year ended December 31, 2013, as compared to the prior year. Gross profit as a percentage of net revenues increased to 30.6% for the year ended December 31, 2013, compared to 30.0% for the prior year.

The increase in gross profit dollars in the year ended December 31, 2014, was primarily driven by increases in the generic dispensing rate, same store sales and new store sales, as well as favorable purchasing economics. The increase in gross profit dollars for the year ended December 31, 2013, was primarily driven by increases in the generic dispensing rate, same store sales and new store sales. The increase in gross profit as a percentage of net revenues in 2014 and 2013 was primarily driven by increased pharmacy margins due to the positive impact of increased generic dispensing rates and increased front store margins, partially offset by continued reimbursement pressure. The increase in gross profit as a percentage of net revenues in 2014 was also driven by the removal of tobacco products from our stores.
 
As you review our Retail Pharmacy Segment’s performance in this area, we believe you should consider the following important information:
 
Gross profit dollars and margin for the year ended December 31, 2014 were positively impacted by $53 million related to the favorable resolution of previously proposed retroactive reimbursement rate changes in the State of California’s Medicaid program.

Sales to customers covered by third party insurance programs are a large component of our total pharmacy business. On average, our gross profit on third party pharmacy revenues is lower than our gross profit on cash pharmacy revenues. Third party pharmacy revenues were 98.6% of pharmacy revenues in 2014, compared to 97.9% and 97.5% of pharmacy revenues in 2013 and 2012, respectively.

Front store revenues as a percentage of total net revenues for the years ended December 31, 2014, 2013 and 2012 were 28.8%, 30.5% and 31.2%, respectively. The decline in front store revenues as a percentage of total net revenues in 2014 was largely due to the removal of tobacco products and the estimated associated basket sales. On average, our gross profit on front store revenues is generally higher than our gross profit on pharmacy revenues. Pharmacy revenues as a percentage of total net revenues increased approximately 120, 60 and 50 basis points in the years ended December 31, 2014, 2013 and

11



2012, respectively. This shift in sales to the pharmacy had a negative effect on our overall gross profit for the years ended December 31, 2014, 2013 and 2012, respectively. The negative effect was offset by increasing generic drug dispensing rates and increased store brand penetration.

During the year ended December 31, 2014, our front store gross profit as a percentage of net revenues increased compared to the prior year. The increase is primarily related to a change in the mix of products sold, including the removal of tobacco products from our stores, and higher store brand sales.
 
Our pharmacy gross profit rates have been adversely affected by the efforts of managed care organizations, pharmacy benefit managers and governmental and other third party payors to reduce their prescription drug costs. In the event this trend continues, we may not be able to sustain our current rate of revenue growth and gross profit dollars could be adversely impacted. The increased use of generic drugs has positively impacted our gross profit margins but has resulted in third party payors augmenting their efforts to reduce reimbursement payments to retail pharmacies for prescriptions. This trend, which we expect to continue, reduces the benefit we realize from brand to generic product conversions.
  
ACA made several significant changes to Medicaid rebates and to reimbursement. One of these changes was the proposed revision of the definition of Average Manufacturer Price (“AMP”) and the reimbursement formula for multi-source drugs. Changes in reporting of AMP or other adjustments that may be made regarding the reimbursement of drug payments by Medicaid and Medicare could impact our pricing to customers and other payors and/or could impact our ability to negotiate discounts or rebates with manufacturers, wholesalers, PBMs or retail and mail pharmacies. See “Efforts to reduce reimbursement levels and alter health care financing practices” in Part I, Item 1A, Risk Factors within our 2014 Form 10-K, for additional information.
 
Operating expenses in our Retail Pharmacy Segment include store payroll, store employee benefits, store occupancy costs, selling expenses, advertising expenses, depreciation and amortization expense and certain administrative expenses.
 
Operating expenses increased $671 million, or 4.8% to $14.5 billion, or 21.4% as a percentage of net revenues, in the year ended December 31, 2014, as compared to $13.8 billion, or 21.1% as a percentage of net revenues, in the prior year. Operating expenses increased $389 million, or 2.9%, to $13.8 billion, or 21.1% as a percentage of net revenues, in the year ended December 31, 2013, as compared to $13.5 billion, or 21.1% as a percentage of net revenues, in the prior year. Operating expenses as a percentage of net revenues remained consistent from 2012 through 2013 primarily due to disciplined cost control, despite the negative impact of generics on net revenues. Operating expenses as a percentage of net revenues increased in 2014 primarily due to reimbursement rate pressure, the implementation of Specialty Connect, which reduced net revenues, and higher legal costs. The increase in operating expense dollars in 2014 and 2013 was the result of higher store operating costs associated with our increased store count, as well as higher legal costs. The results for the years ended December 31, 2014 and 2013 include gains from legal settlements of $21 million and $61 million, respectively. Additionally, in September 2014, the Retail Pharmacy Segment made a charitable contribution of $25 million to the CVS Foundation to fund future charitable giving. The foundation is a non-profit entity that focuses on health, education and community involvement programs.
 
Corporate Segment
 
Operating expenses increased $45 million, or 6.0%, to $796 million in the year ended December 31, 2014, as compared to the prior year. Operating expenses increased $57 million, or 8.3%, to $751 million in the year ended December 31, 2013. Operating expenses within the Corporate Segment include executive management, corporate relations, legal, compliance, human resources, corporate information technology and finance related costs. The increase in operating expenses in 2014 and 2013 was primarily due to increased strategic initiatives, benefits costs, facilities management and information technology costs.
 
Liquidity and Capital Resources
 
We maintain a level of liquidity sufficient to allow us to cover our cash needs in the short-term. Over the long-term, we manage our cash and capital structure to maximize shareholder return, maintain our financial position and maintain flexibility for future strategic initiatives. We continuously assess our working capital needs, debt and leverage levels, capital expenditure requirements, dividend payouts, potential share repurchases and future investments or acquisitions. We believe our operating cash flows, commercial paper program, sale-leaseback program, as well as any potential future borrowings, will be sufficient to fund these future payments and long-term initiatives.





12



The change in cash and cash equivalents is as follows:
 
 
Year Ended December 31,
in millions
 
2014
 
2013
 
2012
Net cash provided by operating activities
 
$
8,137

 
$
5,783

 
$
6,671

Net cash used in investing activities
 
(4,045
)
 
(1,835
)
 
(1,849
)
Net cash used in financing activities
 
(5,694
)
 
(1,237
)
 
(4,860
)
Effect of exchange rate changes on cash and cash equivalents
 
(6
)
 
3

 

Net increase (decrease) in cash and cash equivalents
 
$
(1,608
)
 
$
2,714

 
$
(38
)

Net cash provided by operating activities increased by $2.4 billion in 2014 and decreased by $0.9 billion in 2013. The increase in 2014 was primarily due to increased net income and increased accounts payable due to payables management and timing. The decrease in 2013 was primarily due to increased accounts receivable due to the timing of payments from CMS in connection with our Medicare Part D operations, partially offset by improved inventory management.
 
Net cash used in investing activities increased by $2.2 billion in 2014 and remained relatively flat from 2012 to 2013. The increase in 2014 was primarily due to the $2.1 billion in cash consideration paid for the acquisition of Coram in January 2014 and an increase in capital expenditures.

In 2014, gross capital expenditures totaled approximately $2.1 billion, an increase of $152 million compared to the prior year. During 2014, approximately 42% of our total capital expenditures were for new store construction, 21% were for store, fulfillment and support facilities expansion and improvements and 37% were for technology and other corporate initiatives. Gross capital expenditures totaled approximately $2.0 billion during 2013 and 2012. During 2013, approximately 45% of our total capital expenditures were for new store construction, 25% were for store, fulfillment and support facilities expansion and improvements and 30% were for technology and other corporate initiatives.
 
Proceeds from sale-leaseback transactions totaled $515 million in 2014. This compares to $600 million in 2013 and $529 million in 2012. Under the sale-leaseback transactions, the properties are generally sold at net book value, which generally approximates fair value, and the resulting leases generally qualify and are accounted for as operating leases. The specific timing and amount of future sale-leaseback transactions will vary depending on future market conditions and other factors.
 
Below is a summary of our store development activity for the respective years:
 
 
2014(2)
 
2013(2)
 
2012(2)
Total stores (beginning of year)
7,702

 
7,508

 
7,388

New and acquired stores(1)
187

 
213

 
150

Closed stores(1)
(23
)
 
(19
)
 
(30
)
Total stores (end of year)
7,866

 
7,702

 
7,508

Relocated stores
60

 
78

 
90

 
(1)         Relocated stores are not included in new or closed store totals. 
(2)         Includes retail drugstores, onsite pharmacy stores and specialty pharmacy stores.
 
Net cash used in financing activities increased by $4.5 billion in 2014 and decreased by $3.6 billion in 2013. The increase in 2014 was primarily due to the repayments of long-term debt and lower borrowings than in 2013. The decrease in 2013 was primarily due to greater net borrowings than in 2012.
 









13



Share repurchase programs — The following share repurchase programs were authorized by the Company’s Board of Directors:
Authorization Date
Amount of Authorization
In billions
 
December 15, 2014 (“2014 Repurchase Program”)
$
10.0

December 17, 2013 (“2013 Repurchase Program”)
$
6.0

September 19, 2012 (“2012 Repurchase Program”)
$
6.0

August 23, 2011 (“2011 Repurchase Program”)
$
4.0


The Repurchase Programs, which were effective immediately, permit the Company to effect share repurchases from time to time through a combination of open market repurchases, privately negotiated transactions, accelerated share repurchase (“ASR”) transactions, and/or other derivative transactions. The 2014 and 2013 Repurchase Programs may be modified or terminated by the Board of Directors at any time. The 2012 and 2011 Repurchase Programs have been completed, as described below.
 
Pursuant to the authorization under the 2013 Repurchase Programs, effective January 2, 2015, we entered into a $2.0 billion fixed dollar ASR agreement with J.P. Morgan Chase Bank (“JP Morgan”). Upon payment of the $2.0 billion purchase price on January 5, 2015, we received a number of shares of our common stock equal to 80% of the $2.0 billion notional amount of the ASR agreement or approximately 16.8 million shares at a price of $94.49 per share.At the conclusion of the ASR program, the Company may receive additional shares equal to the remaining 20% of the $2.0 billion notional amount. The ultimate number of shares the Company may receive will fluctuate based on changes in the daily volume-weighted average price of the Company’s stock over a period beginning on January 2, 2015 and ending on or before April 26, 2015. If the mean daily volume-weighted average price of the Company’s common stock, less a discount (the “forward price”), during the ASR program falls below $94.49 per share, the Company will receive a higher number of shares from JP Morgan. If the forward price rises above $94.49 per share, the Company will either receive fewer shares from JP Morgan or, potentially have an obligation to JP Morgan which, at the Company’s option, could be settled in additional cash or by issuing shares. Under the terms of the ASR agreement, the maximum number of shares that could be received or delivered is 42.0 million. The initial 16.8 million shares of common stock delivered to the Company by JP Morgan were placed into treasury stock in January 2015.
 
Pursuant to the authorization under the 2012 Repurchase Program, effective October 1, 2013, we entered into a $1.7 billion fixed dollar ASR agreement with Barclays Bank PLC (“Barclays”). Upon payment of the $1.7 billion purchase price on October 1, 2013, we received a number of shares of our common stock equal to 50% of the $1.7 billion notional amount of the ASR agreement or approximately 14.9 million shares at a price of $56.88 per share. The Company received approximately 11.7 million shares of common stock on December 30, 2013 at an average price of $63.83 per share, representing the remaining 50% of the $1.7 billion notional amount of the ASR agreement and thereby concluding the agreement. The total of 26.6 million shares of common stock delivered to the Company by Barclays over the term of the October 2013 ASR agreement were placed into treasury stock.

Pursuant to the authorizations under the 2011 and 2012 Repurchase Programs, on September 19, 2012, we entered into a $1.2 billion fixed dollar ASR agreement with Barclays. Upon payment of the $1.2 billion purchase price on September 20, 2012, we received a number of shares of our common stock equal to 50% of the $1.2 billion notional amount of the ASR agreement or approximately 12.6 million shares at a price of $47.71 per share. We received approximately 13.0 million shares of common stock on November 16, 2012 at an average price of $46.96 per share, representing the remaining 50% of the $1.2 billion notional amount of the ASR agreement and thereby concluding the agreement, and completing the 2011 Repurchase Program. The total of 25.6 million shares of common stock delivered to us by Barclays over the term of the September 2012 ASR agreement were placed into treasury stock.

During the year ended December 31, 2014, we repurchased an aggregate of 51.4 million shares of common stock for approximately $4.0 billion under the 2013 and 2012 Repurchase Programs. During the years ended December 31, 2013 and 2012, we repurchased an aggregate of 66.2 million and 95.0 million shares of common stock for approximately $4.0 and $4.3 billion, respectively, under the 2012 and 2011 Repurchase Programs. As of December 31, 2014, there remained an aggregate of approximately $12.7 billion available for future repurchases under the 2014 and 2013 Repurchase Programs, $2.0 billion of which was used for the ASR effective January 2, 2015 described above. As of December 31, 2014, the 2012 and 2011 Repurchase Programs were complete.


14



Short-term borrowings - We had $685 million of commercial paper outstanding at a weighted average interest rate of 0.55% as of December 31, 2014. In connection with our commercial paper program, we maintain a $1.25 billion, five-year unsecured back-up credit facility, which expires on February 17, 2017, a $1.0 billion, five-year unsecured back-up credit facility, which expires on May 23, 2018, and a $1.25 billion, five-year unsecured back-up credit facility, which expires on July 24, 2019. The credit facilities allow for borrowings at various rates that are dependent, in part, on the Company’s public debt ratings and require the Company to pay a weighted average quarterly facility fee of approximately 0.03%, regardless of usage. As of December 31, 2014, there were no borrowings outstanding under the back-up credit facilities.
 
Long-term borrowings - On August 7, 2014, the Company issued $850 million of 2.25% unsecured senior notes due August 12, 2019 and $650 million of 3.375% unsecured senior notes due August 12, 2024 (collectively, the “2014 Notes”) for total proceeds of approximately $1.5 billion, net of discounts and underwriting fees. The 2014 Notes pay interest semi-annually and may be redeemed, in whole at any time, or in part from time to time, at the Company’s option at a defined redemption price plus accrued and unpaid interest to the redemption date. The net proceeds of the 2014 Notes were used for general corporate purposes and to repay certain corporate debt.

On August 7, 2014, the Company announced tender offers for any and all of the 6.25% Senior Notes due 2027, and up to a maximum amount of the 6.125% Senior Notes due 2039, the 5.75% Senior Notes due 2041 and the 5.75% Senior Notes due 2017, for up to an aggregate principal amount of $1.5 billion. On August 21, 2014, the Company increased the aggregate principal amount of the tender offers to $2.0 billion and completed the repurchase for the maximum amount on September 4, 2014. The Company paid a premium of $490 million in excess of the debt principal in connection with the tender offers, wrote off $26 million of unamortized deferred financing costs and incurred $5 million in fees, for a total loss on the early extinguishment of debt of $521 million. The loss was recorded in income from continuing operations in the condensed consolidated statement of income for the year ended December 31, 2014.

During the year ended December 31, 2014, the Company repurchased the remaining $41 million of outstanding Enhanced Capital Advantage Preferred Securities (“ECAPS”) at par. The fees and write-off of deferred issuance costs associated with the early extinguishment of the ECAPS were immaterial.

On December 2, 2013, the Company issued $750 million of 1.2% unsecured senior notes due December 5, 2016; $1.25 billion of 2.25% unsecured senior notes due December 5, 2018; $1.25 billion of 4% unsecured senior notes due December 5, 2023; and $750 million of 5.3% unsecured senior notes due December 5, 2043 (the “2013 Notes”) for total proceeds of approximately $4.0 billion, net of discounts and underwriting fees. The 2013 Notes pay interest semi-annually and may be redeemed, in whole at any time, or in part from time to time, at the Company’s option at a defined redemption price plus accrued and unpaid interest to the redemption date. The net proceeds of the 2013 Notes were used to repay commercial paper outstanding at the time of issuance and to fund the acquisition of Coram in January 2014. The remainder was used for general corporate purposes.

On November 26, 2012, we issued $1.25 billion of 2.75% unsecured senior notes due December 1, 2022 (the “2012 Notes”) for total proceeds of approximately $1.24 billion, net of discounts and underwriting fees. The 2012 Notes pay interest semi-annually and may be redeemed, in whole at any time, or in part from time to time, at our option at a defined redemption price plus accrued and unpaid interest to the redemption date. The net proceeds of the 2012 Notes were used for general corporate purposes and to repay certain corporate debt.
 
Also on November 26, 2012, we announced tender offers for any and all of the 6.6% Senior Notes due 2019, and up to a maximum amount of the 6.125% Senior Notes due 2016 and 5.75% Senior Notes due 2017, for up to an aggregate principal amount of $1.0 billion. In December 2012, we increased the aggregate principal amount of the tender offers to $1.325 billion and completed the repurchase for the maximum amount. We paid a premium of $332 million in excess of the debt principal in connection with the tender offers, wrote off $13 million of unamortized deferred financing costs and incurred $3 million in fees, for a total loss on the early extinguishment of debt of $348 million. The loss was recorded in income from continuing operations on the consolidated statement of income.
 
Our backup credit facilities and unsecured senior notes (see Note 5 to the Consolidated Financial Statements) 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 the restrictions contained in these covenants materially affect our financial or operating flexibility.
 
As of December 31, 2014 and 2013, we had no outstanding derivative financial instruments.
 

15



Debt Ratings - As of December 31, 2014, our long-term debt was rated “Baa1” by Moody’s with a stable outlook and “BBB+” by Standard & Poor’s with a stable outlook, and our commercial paper program was rated “P-2” by Moody’s and “A-2” by Standard & Poor’s. 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 historical acquisition activity 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/or 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.
 
Quarterly Dividend Increase - In December 2014, our Board of Directors authorized a 27% increase in our quarterly common stock dividend to $0.35 per share effective in 2015. This increase equates to an annual dividend rate of $1.40 per share. In December 2013, our Board of Directors authorized a 22% increase in our quarterly common stock dividend to $0.275 per share. This increase equated to an annual dividend rate of $1.10 per share. In December 2012, our Board of directors authorized a 38% increase in our quarterly common stock dividend to $0.225 per share. This increase equated to an annual dividend rate of $0.90 per share.
 
Off-Balance Sheet Arrangements
 
In connection with executing operating leases, we provide a guarantee of the lease payments. We also 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 generally qualify and are accounted for as operating leases. We do not have any retained or contingent interests in the stores, and we do not 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 on our consolidated balance sheets.
 
Between 1991 and 1997, we sold or spun off a number of subsidiaries, including Bob’s Stores, Linens ‘n Things, Marshalls, Kay-Bee Toys, This End Up and Footstar. In many cases, when a former subsidiary leased a store, the Company provided a guarantee of the store’s lease obligations. When the subsidiaries were disposed of, the Company’s guarantees remained in place, although each initial purchaser agreed to indemnify the Company for any lease obligations the Company was required to satisfy. If any of the purchasers or any of the former subsidiaries were to become insolvent and failed to make the required payments under a store lease, the Company could be required to satisfy these obligations.
 
As of December 31, 2014, we guaranteed approximately 72 such store leases (excluding the lease guarantees related to Linens ‘n Things), with the maximum remaining lease term extending through 2026. Management believes the ultimate disposition of any of the remaining lease guarantees will not have a material adverse effect on the Company’s consolidated financial condition or future cash flows. Please see “Loss from discontinued operations” previously in this document for further information regarding our guarantee of certain Linens ‘n Things’ store lease obligations.

Below is a summary of our significant contractual obligations as of December 31, 2014:
 
 
Payments Due by Period
In millions
Total
 
2015
 
2016 to 2017
 
2018 to 2019
 
Thereafter
Operating leases
$
27,282

 
$
2,279

 
$
4,341

 
$
3,868

 
$
16,794

Lease obligations from discontinued operations
51

 
16

 
24

 
6

 
5

Capital lease obligations
810

 
47

 
94

 
96

 
573

Long-term debt
11,879

 
563

 
2,276

 
2,494

 
6,546

Interest payments on long-term debt(1)
5,173

 
484

 
867

 
689

 
3,133

Other long-term liabilities reflected in our
    consolidated balance sheet
652

 
48

 
254

 
100

 
250

 
$
45,847

 
$
3,437

 
$
7,856

 
$
7,253

 
$
27,301

                                          
(1)
Interest payments on long-term debt are calculated on outstanding balances and interest rates in effect on December 31, 2014.
 

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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 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.
 
Our significant accounting policies are discussed in Note 1 to our consolidated financial statements. We believe the following accounting policies include a higher degree of judgment and/or complexity and, thus, are considered to be critical accounting policies. 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.
 
Revenue Recognition
 
Pharmacy Services Segment
 
Our Pharmacy Services Segment sells prescription drugs directly through our mail service dispensing pharmacies and indirectly through our retail pharmacy network. We recognize revenues in our Pharmacy Services Segment from prescription drugs sold by our mail service dispensing pharmacies and under retail pharmacy network contracts where we are the principal using the gross method at the contract prices negotiated with our clients. Net revenue from our Pharmacy Services Segment includes: (i) the portion of the price the client pays directly to us, net of any volume-related or other discounts paid back to the client, (ii) the price paid to us (“Mail Co-Payments”) or a third party pharmacy in our retail pharmacy network (“Retail Co-Payments”) by individuals included in our clients’ benefit plans, and (iii) administrative fees for retail pharmacy network contracts where we are not the principal. Sales taxes are not included in revenue.
 
We recognize revenue in the Pharmacy Services Segment when: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred or services have been rendered, (iii) the seller’s price to the buyer is fixed or determinable, and (iv) collectability is reasonably assured. The following revenue recognition policies have been established for the Pharmacy Services Segment.
 
Revenues generated from prescription drugs sold by mail service dispensing pharmacies are recognized when the prescription is delivered. At the time of delivery, the Pharmacy Services Segment has performed substantially all of its obligations under its client contracts and does not experience a significant level of returns or reshipments.
 
Revenues generated from prescription drugs sold by third party pharmacies in the Pharmacy Services Segment’s retail pharmacy network and associated administrative fees are recognized at the Pharmacy Services Segment’s point-of-sale, which is when the claim is adjudicated by the Pharmacy Services Segment’s online claims processing system.
 
We determine whether we are the principal or agent for our retail pharmacy network transactions on a contract by contract basis. In the majority of our contracts, we have determined we are the principal due to us: (i) being the primary obligor in the arrangement, (ii) having latitude in establishing the price, changing the product or performing part of the service, (iii) having discretion in supplier selection, (iv) having involvement in the determination of product or service specifications, and (v) having credit risk. Our obligations under our client contracts for which revenues are reported using the gross method are separate and distinct from our obligations to the third party pharmacies included in our retail pharmacy network contracts. Pursuant to these contracts, we are contractually required to pay the third party pharmacies in our retail pharmacy network for products sold, regardless of whether we are paid by our clients. Our responsibilities under these client contracts typically include validating eligibility and coverage levels, communicating the prescription price and the co-payments due to the third party retail pharmacy, identifying possible adverse drug interactions for the pharmacist to address with the physician prior to dispensing, suggesting clinically appropriate generic alternatives where appropriate and approving the prescription for dispensing. Although we do not have credit risk with respect to Retail Co-Payments, we believe that all of the other indicators of gross revenue reporting are present. For contracts under which we act as an agent, we record revenues using the net method.
 
We deduct from our revenues the manufacturers’ rebates that are earned by our clients based on their members’ utilization of brand-name formulary drugs. We estimate these rebates at period-end based on actual and estimated claims data and our estimates of the manufacturers’ rebates earned by our clients. We base our estimates on the best available data at period-end and recent history for the various factors that can affect the amount of rebates due to the client. We adjust our rebates payable to clients to the actual amounts paid when these rebates are paid or as significant events occur. We record any cumulative effect of

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these adjustments against revenues as identified, and adjust our estimates prospectively to consider recurring matters. Adjustments generally result from contract changes with our clients or manufacturers, differences between the estimated and actual product mix subject to rebates or whether the product was included in the applicable formulary. We also deduct from our revenues pricing guarantees and guarantees regarding the level of service we will provide to the client or member as well as other payments made to our clients. Because the inputs to most of these estimates are not subject to a high degree of subjectivity or volatility, the effect of adjustments between estimated and actual amounts have not been material to our results of operations or financial condition.
 
We participate in the federal government’s Medicare Part D program as a PDP through our SilverScript Insurance Company subsidiary. Our net revenues include insurance premiums earned by the PDP, which are determined based on the PDP’s annual bid and related contractual arrangements with CMS. The insurance premiums include a beneficiary premium, which is the responsibility of the PDP member, but is subsidized by CMS in the case of low-income members, and a direct premium paid by CMS. Premiums collected in advance are initially deferred as accrued expenses and are then recognized ratably as revenue over the period in which members are entitled to receive benefits.
 
In addition to these premiums, our net revenues include co-payments, coverage gap benefits, deductibles and co-insurance (collectively, the “Member Co-Payments”) related to PDP members’ actual prescription claims. In certain cases, CMS subsidizes a portion of these Member Co-Payments and we are paid an estimated prospective Member Co-Payment subsidy, each month. The prospective Member Co-Payment subsidy amounts received from CMS are also included in our net revenues. We assume no risk for these amounts, which represented 6.4%, 7.0% and 7.7% of consolidated net revenues in 2014, 2013 and 2012, respectively. If the prospective Member Co-Payment subsidies received differ from the amounts based on actual prescription claims, the difference is recorded in either accounts receivable or accrued expenses. We account for fully insured CMS obligations and Member Co-Payments (including the amounts subsidized by CMS) using the gross method consistent with our revenue recognition policies for Mail Co-Payments and Retail Co-Payments. We have recorded estimates of various assets and liabilities arising from our participation in the Medicare Part D program based on information in our claims management and enrollment systems. Significant estimates arising from our participation in the Medicare Part D program include: (i) estimates of low-income cost subsidy, reinsurance amounts and coverage gap discount amounts ultimately payable to or receivable from CMS based on a detailed claims reconciliation, (ii) an estimate of amounts payable to CMS under a risk-sharing feature of the Medicare Part D program design, referred to as the risk corridor and (iii) estimates for claims that have been reported and are in the process of being paid or contested and for our estimate of claims that have been incurred but have not yet been reported. Actual amounts of Medicare Part D-related assets and liabilities could differ significantly from amounts recorded. Historically, the effect of these adjustments has not been material to our results of operations or financial position.
 
Retail Pharmacy Segment
 
Our Retail Pharmacy Segment recognizes revenue from the sale of front store merchandise at the time the merchandise is purchased by the retail customer and recognizes revenue from the sale of prescription drugs when the prescription is picked up by the customer. Customer returns are not material. Revenue generated from the performance of services in our health care clinics is recognized at the time the services are performed. Sales taxes are not included in revenue.

Our customer loyalty program, ExtraCare®, is comprised of two components, ExtraSavingsTM and ExtraBucks® Rewards. ExtraSavings coupons redeemed by customers are recorded as a reduction of revenues when redeemed. ExtraBucks Rewards are accrued as a charge to cost of revenues when earned, net of estimated breakage. We determine breakage based on our historical redemption patterns.

Vendor Allowances and Purchase Discounts
 
Pharmacy Services Segment
 
Our Pharmacy Services Segment receives purchase discounts on products purchased. Contractual arrangements with vendors, including manufacturers, wholesalers and retail pharmacies, normally provide for the Pharmacy Services Segment to receive purchase discounts from established list prices in one, or a combination, of the following forms: (i) a direct discount at the time of purchase, (ii) a discount for the prompt payment of invoices or (iii) when products are purchased indirectly from a manufacturer (e.g., through a wholesaler or retail pharmacy), a discount (or rebate) paid subsequent to dispensing. These rebates are recognized when prescriptions are dispensed and are generally calculated and billed to manufacturers within 30 days of the end of each completed quarter. Historically, the effect of adjustments resulting from the reconciliation of rebates recognized to the amounts billed and collected has not been material to the results of operations. We account for the effect of any such differences as a change in accounting estimate in the period the reconciliation is completed. The Pharmacy Services Segment also receives additional discounts under its wholesaler contracts if it exceeds contractually defined annual purchase

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volumes. In addition, the Pharmacy Services Segment receives fees from pharmaceutical manufacturers for administrative services. Purchase discounts and administrative service fees are recorded as a reduction of “Cost of revenues”.

Retail Pharmacy Segment
 
Vendor allowances received by the Retail Pharmacy Segment reduce the carrying cost of inventory and are recognized in cost of revenues when the related inventory is sold, unless they are specifically identified as a reimbursement of incremental costs for promotional programs and/or other services provided. Amounts that are directly linked to advertising commitments are recognized as a reduction of advertising expense (included in operating expenses) when the related advertising commitment is satisfied. Any such allowances received in excess of the actual cost incurred also reduce the carrying cost of inventory. The total value of any upfront payments received from vendors that are linked to purchase commitments is initially deferred. The deferred amounts are then amortized to reduce cost of revenues over the life of the contract based upon purchase volume. The total value of any upfront payments received from vendors that are not linked to purchase commitments is also initially deferred. The deferred amounts are then amortized to reduce cost of revenues on a straight-line basis over the life of the related contract.
 
We have not made any material changes in the way we account for vendor allowances and purchase discounts during the past three years.
 
Inventory
 
All prescription drug inventories in the Retail Pharmacy Segment have been valued at the lower of cost or market using the weighted average cost method. The weighted average cost method is used to determine cost of sales and inventory in our mail service and specialty pharmacies in our Pharmacy Services Segment. Front store inventory in our Retail Pharmacy Segment is stated at the lower of cost or market on a first-in-first-out (“FIFO”) basis using the retail method of accounting to determine cost of sales and inventory, and the cost method of accounting on a FIFO basis to determine front store 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 front store 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 store and a continuous cycle count process is the primary procedure used to validate the inventory balances on hand in each distribution center and mail facility to ensure that the amounts reflected in the accompanying 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 physical inventory loss trends.

Our total reserve for estimated inventory losses covered by this critical accounting policy was $189 million as of December 31, 2014. 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 aggregate risk, if any, associated with the uncertainties discussed above, a ten percent (10%) pre-tax change in our estimated inventory losses, which we believe is a reasonably likely change, would increase or decrease our total reserve for estimated inventory losses by about $19 million as of December 31, 2014.
 
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.
 
Goodwill and Intangible Assets
 
Identifiable intangible assets consist primarily of trademarks, client contracts and relationships, favorable leases and covenants not to compete. These intangible assets arise primarily from the determination of their respective fair market values at the date of acquisition.
 
Amounts assigned to identifiable intangible assets, and their related useful lives, are derived from established valuation techniques and management estimates. Goodwill represents the excess of amounts paid for acquisitions over the fair value of the net identifiable assets acquired.
 

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We evaluate the recoverability of certain long-lived assets, including intangible assets with finite lives, but excluding goodwill and intangible assets with indefinite lives which are tested for impairment using separate tests, whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. We group and evaluate these long-lived assets for impairment at the lowest level at which individual cash flows can be identified. When evaluating these long-lived assets for potential impairment, we first compare the carrying amount of the asset group to the asset group’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 asset group’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 asset group’s estimated future cash flows (discounted and with interest charges). Our long-lived asset impairment loss calculation contains uncertainty since we must use judgment to estimate each asset group’s future sales, profitability and cash flows. When preparing these estimates, we consider 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 and regulatory conditions, efforts of third party organizations to reduce their prescription drug costs and/or increased member co-payments, the continued efforts of competitors to gain market share and consumer spending patterns.
 
Goodwill and indefinitely-lived intangible assets are subject to annual impairment reviews, or more frequent reviews if events or circumstances indicate that the carrying value may not be recoverable.
 
Indefinitely-lived intangible assets are tested by comparing the estimated fair value of the asset to its carrying value. If the carrying value of the asset exceeds its estimated fair value, an impairment loss is recognized and the asset is written down to its estimated fair value.
 
Our indefinitely-lived intangible asset impairment loss calculation contains uncertainty since we must use judgment to estimate the fair value based on the assumption that in lieu of ownership of an intangible asset, the Company would be willing to pay a royalty in order to utilize the benefits of the asset. Value is estimated by discounting the hypothetical royalty payments to their present value over the estimated economic life of the asset. These estimates can be affected by a number of factors including, but not limited to, general economic conditions, availability of market information as well as the profitability of the Company.
 
Goodwill is tested for impairment on a reporting unit basis using a two-step process. The first step of the impairment test is to identify potential impairment by comparing the reporting unit’s fair value with its net book value (or carrying amount), including goodwill. The fair value of our reporting units is estimated using a combination of the discounted cash flow valuation model and comparable market transaction models. If the fair value of the reporting unit exceeds its carrying amount, the reporting unit’s goodwill is not considered to be impaired and the second step of the impairment test is not performed. If the carrying amount of the reporting unit exceeds its fair value, the second step of the impairment test is performed to measure the amount of impairment loss, if any. The second step of the impairment test compares the implied fair value of the reporting unit’s goodwill with the carrying amount of the goodwill. If the carrying amount of the reporting unit’s goodwill exceeds the implied fair value of the goodwill, an impairment loss is recognized in an amount equal to that excess.
 
The determination of the fair value of our reporting units requires the Company to make significant assumptions and estimates. These assumptions and estimates primarily include, but are not limited to, the selection of appropriate peer group companies; control premiums and valuation multiples appropriate for acquisitions in the industries in which the Company competes; discount rates, terminal growth rates; and forecasts of revenue, operating profit, depreciation and amortization, capital expenditures and future working capital requirements. When determining these assumptions and preparing these estimates, we consider each reporting unit’s historical results and current operating trends and our consolidated revenues, profitability and cash flow results, forecasts and industry trends. Our estimates can be affected by a number of factors including, but not limited to, general economic and regulatory conditions, our market capitalization, efforts of third party organizations to reduce their prescription drug costs and/or increase member co-payments, the continued efforts of competitors to gain market share and consumer spending patterns.
 
The carrying value of goodwill and other intangible assets covered by this critical accounting policy was $28.1 billion and $9.8 billion as of December 31, 2014, respectively. We did not record any impairment losses related to goodwill or other intangible assets during 2014, 2013 or 2012. During the third quarter of 2014, we performed our required annual impairment tests of goodwill and indefinitely-lived trademarks. The results of the impairment tests concluded that there was no impairment of goodwill or trademarks. The goodwill impairment test resulted in the fair value of our Pharmacy Services and Retail Pharmacy reporting units exceeding their carrying values by a significant margin. The carrying value of goodwill as of December 31, 2014, in our Pharmacy Services and Retail Pharmacy reporting units was $21.2 billion and $6.9 billion, respectively.

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Although we believe we have sufficient current and historical information available to us to test for impairment, it is possible that actual results could differ from the estimates used in our impairment tests.
 
We have not made any material changes in the methodologies utilized to test the carrying values of goodwill and intangible assets for impairment during the past three years.
 
Closed Store Lease Liability
 
We account for closed store lease termination costs when a leased store is closed. When a leased store is closed, we record a liability for the estimated present value of the remaining obligation under the noncancelable 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 contain 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.
 
Our total closed store lease liability covered by this critical accounting policy was $268 million as of December 31, 2014. This amount is net of $142 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, which we believe is a reasonably likely change, would increase or decrease our total closed store lease liability by about $14 million as of December 31, 2014.
 
We have not made any material changes in the reserve methodology used to record closed store lease reserves during the past three years.
 
Self-Insurance Liabilities
 
We are self-insured for certain losses related to general liability, workers’ 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 other standard insurance industry actuarial assumptions. On a quarterly basis, we review our self-insurance liability to determine if it is adequate as it relates to our general liability, workers’ compensation and auto liability. Similar reviews are conducted semi-annually to determine if our self-insurance liability is adequate for our health and medical liability.
 
Our total self-insurance liability covered by this critical accounting policy was $628 million as of December 31, 2014. 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, which we believe is a reasonably likely change, would increase or decrease our self-insurance liability by about $63 million as of December 31, 2014.
 
We have not made any material changes in the accounting methodology used to establish our self-insurance liability during the past three years.




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Income Taxes

Income taxes are accounted for using the asset and liability method. Deferred tax liabilities or assets are established for temporary differences between financial and tax reporting bases and are subsequently adjusted to reflect changes in enacted tax rates expected to be in effect when the temporary differences reverse. The deferred tax assets are reduced, if necessary, by a valuation allowance to the extent future realization of those tax benefits is uncertain.

Significant judgment is required in determining the provision for income taxes and the related taxes payable and deferred tax assets and liabilities since, in the ordinary course of business, there are transactions and calculations where the ultimate tax outcome is uncertain. Additionally, our tax returns are subject to audit by various domestic and foreign tax authorities that could result in material adjustments or differing interpretations of the tax laws. Although we believe that our estimates are reasonable and are based on the best available information at the time we prepare the provision, actual results could differ from these estimates resulting in a final tax outcome that may be materially different from that which is reflected in our consolidated financial statements.

The tax benefit from an uncertain tax position is recognized only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the consolidated financial statements from such positions are then measured based on the largest benefit that has a greater than 50% likelihood of being realized upon settlement. Interest and/or penalties related to uncertain tax positions are recognized in income tax expense. Significant judgment is required in determining our uncertain tax positions. We have established accruals for uncertain tax positions using our best judgment and adjust these accruals, as warranted, due to changing facts and circumstances.

New Accounting Pronouncement
 
In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standard Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers (Topic 606). ASU No. 2014-09 outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance, including industry-specific guidance. This new guidance is effective for annual reporting periods (including interim reporting periods within those periods) beginning after December 15, 2016; early adoption is not permitted. Companies have the option of using either a full retrospective or a modified retrospective approach to adopt the guidance. This update could impact the timing and amounts of revenue recognized. The Company is currently evaluating the effect that implementation of this update will have on its consolidated financial position and results of operations upon adoption and the method of transition. 

Proposed Lease Accounting Standard Update

In May 2013, the FASB issued a revised proposed accounting standard update on lease accounting that will require entities to recognize assets and liabilities arising from lease contracts on the balance sheet. The proposed accounting standard update states that lessees and lessors should apply a “right-of-use model” in accounting for all leases. Under the proposed model, lessees would recognize an asset for the right to use the leased asset, and a liability for the obligation to make rental payments over the lease term. The lease term is defined as the noncancelable term that takes into account renewal options and termination options if it is reasonably certain an entity will exercise or not exercise the option. The accounting by a lessor would reflect its retained exposure to the risks or benefits of the underlying leased asset. A lessor would recognize an asset representing its right to receive lease payments based on the expected term of the lease. The Company cannot presently determine the potential impact the proposed standard would have on its results of operations. While the Company believes that the proposed standard, as currently drafted, will likely have a material impact on its financial position, it will not have a material impact on its liquidity; however, until the proposed standard is finalized, such evaluation cannot be completed.


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Cautionary Statement Concerning Forward-Looking Statements
 
This annual report contains forward-looking statements within the meaning of the federal securities laws. In addition, 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 U.S. Securities and Exchange Commission (“SEC”) and in its reports to stockholders, press releases, webcasts, conference calls, meetings and other communications. 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 Health Corporation or any subsidiary, events or developments that the Company expects or anticipates will occur in the future, including statements relating to corporate strategy; revenue growth; earnings or earnings per common share growth; adjusted earnings or adjusted earnings per common share growth; free cash flow; debt ratings; inventory levels; inventory turn and loss rates; store development; relocations and new market entries; retail pharmacy business, sales trends and operations; PBM business, sales trends and operations; the Company’s ability to attract or retain customers and clients; Medicare Part D competitive bidding, enrollment and operations; new product development; and the impact of industry developments, as well as statements expressing optimism or pessimism about future operating results or events, are forward-looking statements within the meaning of the federal securities laws.
 
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.
 
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 as described in our SEC filings, including those set forth in the Risk Factors section within the 2014 Form 10-K, and including, but not limited to:

Risks relating to the health of the economy in general and in the markets we serve, which could impact consumer purchasing power, preferences and/or spending patterns, drug utilization trends, the financial health of our PBM clients or other payors doing business with the Company and our ability to secure necessary financing, suitable store locations and sale-leaseback transactions on acceptable terms.
 
Efforts to reduce reimbursement levels and alter health care financing practices, including pressure to reduce reimbursement levels for generic drugs.
 
The possibility of PBM client loss and/or the failure to win new PBM business, including as a result of failure to win renewal of expiring contracts, contract termination rights that may permit clients to terminate a contract prior to expiration and early or periodic renegotiation of pricing by clients prior to expiration of a contract.

The possibility of loss of Medicare Part D business and/or failure to obtain new Medicare Part D business, whether as a result of the annual Medicare Part D competitive bidding process or otherwise.
 
Risks related to the frequency and rate of the introduction of generic drugs and brand name prescription products.
 
Risks of declining gross margins in the PBM industry attributable to increased competitive pressures, increased client demand for lower prices, enhanced service offerings and/or higher service levels and market dynamics and regulatory changes that impact our ability to offer plan sponsors pricing that includes the use of retail “differential” or “spread.”
 
Regulatory changes, business changes and compliance requirements and restrictions that may be imposed by Centers for Medicare and Medicaid Services (“CMS”), Office of Inspector General or other government agencies relating to the Company’s participation in Medicare, Medicaid and other federal and state government-funded programs, including sanctions and remedial actions that may be imposed by CMS on its Medicare Part D business.

Risks and uncertainties related to the timing and scope of reimbursement from Medicare, Medicaid and other government-funded programs, including the impact of sequestration, the impact of other federal budget, debt and deficit negotiations and legislation that could delay or reduce reimbursement from such programs and the impact of any closure, suspension or other changes affecting federal or state government funding or operations.
 

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Possible changes in industry pricing benchmarks used to establish pricing in many of our PBM client contracts, pharmaceutical purchasing arrangements, retail network contracts, specialty payor agreements and other third party payor contracts.
 
A highly competitive business environment, including the uncertain impact of increased consolidation in the PBM industry, uncertainty concerning the ability of our retail pharmacy business to secure and maintain contractual relationships with PBMs and other payors on acceptable terms, uncertainty concerning the ability of our PBM business to secure and maintain competitive access, pricing and other contract terms from retail network pharmacies in an environment where some PBM clients are willing to consider adopting narrow or more restricted retail pharmacy networks.

The Company’s ability to fully integrate and to realize the planned benefits associated with the acquisition of Coram LLC in accordance with the expected timing.

The Company’s ability to timely identify or effectively respond to changing consumer preferences and spending patterns, an inability to expand the products being purchased by our customers, or the failure or inability to obtain or offer particular categories of products.

Risks relating to our ability to secure timely and sufficient access to the products we sell from our domestic and/or international suppliers.
 
Reform of the U.S. health care system, including ongoing implementation of ACA, continuing legislative efforts, regulatory changes and judicial interpretations impacting our health care system and the possibility of shifting political and legislative priorities related to reform of the health care system in the future.
 
Risks relating to any failure to properly maintain our information technology systems, our information security systems and our infrastructure to support our business and to protect the privacy and security of sensitive customer and business information.
 
Risks related to compliance with a broad and complex regulatory framework, including compliance with new and existing federal, state and local laws and regulations relating to health care, accounting standards, corporate securities, tax, environmental and other laws and regulations affecting our business.
 
Risks related to litigation, government investigations and other legal proceedings as they relate to our business, the pharmacy services, retail pharmacy or retail clinic industries or to the health care industry generally.
 
Other risks and uncertainties detailed from time to time in our filings with the SEC.
 
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 a material adverse effect 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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Management’s Report on Internal Control Over Financial Reporting
 
We are responsible for establishing and maintaining adequate internal control over financial reporting. Our Company’s internal control over financial reporting includes those policies and procedures that pertain to the Company’s ability to record, process, summarize and report a system of internal accounting controls and procedures to provide reasonable assurance, at an appropriate cost/benefit relationship, that the unauthorized acquisition, use or disposition of assets are prevented or timely detected and that transactions are authorized, recorded and reported properly to permit the preparation of financial statements in accordance with generally accepted accounting principles (GAAP) and receipt and expenditures are duly authorized. In order to ensure the Company’s internal control over financial reporting is effective, management regularly assesses such controls and did so most recently for its financial reporting as of December 31, 2014.
 
We conducted an assessment of the effectiveness of our internal controls over financial reporting based on the criteria set forth in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 Framework). This evaluation included review of the documentation, evaluation of the design effectiveness and testing of the operating effectiveness of controls. Our system of internal control over financial reporting is enhanced by periodic reviews by our internal auditors, written policies and procedures and a written Code of Conduct adopted by our Company’s Board of Directors, applicable to all employees of our Company. In addition, we have an internal Disclosure Committee, comprised of management from each functional area within the Company, which performs a separate review of our disclosure controls and procedures. There are inherent limitations in the effectiveness of any system of internal controls over financial reporting.
 
Based on our assessment, we conclude our Company’s internal control over financial reporting is effective and provides reasonable assurance that assets are safeguarded and that the financial records are reliable for preparing financial statements as of December 31, 2014.
 
Ernst & Young LLP, independent registered public accounting firm, is appointed by the Board of Directors and ratified by our Company’s shareholders. They were engaged to render an opinion regarding the fair presentation of our consolidated financial statements as well as conducting an audit of internal control over financial reporting. Their accompanying reports are based upon audits conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States).


February 10, 2015

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Report of Independent Registered Public Accounting Firm

The Board of Directors and Shareholders of CVS Health Corporation

We have audited CVS Health Corporation’s internal control over financial reporting as of December 31, 2014, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). CVS Health Corporation’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on CVS Health Corporation’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, CVS Health Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2014, based on the COSO criteria.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of CVS Health Corporation as of December 31, 2014 and 2013, and the related consolidated statements of income, comprehensive income, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2014 of CVS Health Corporation and our report dated February 10, 2015 expressed an unqualified opinion thereon.

 
 
/s/ Ernst & Young LLP
 
 
Boston, Massachusetts
 
February 10, 2015
 

26



Consolidated Statements of Income
 
 
Year Ended December 31,
In millions, except per share amounts
2014
 
2013
 
2012
Net revenues
$
139,367

 
$
126,761

 
$
123,120

Cost of revenues
114,000

 
102,978

 
100,632

Gross profit
25,367

 
23,783

 
22,488

Operating expenses
16,568

 
15,746

 
15,278

Operating profit
8,799

 
8,037

 
7,210

Interest expense, net
600

 
509

 
557

Loss on early extinguishment of debt
521

 

 
348

Income before income tax provision
7,678

 
7,528

 
6,305

Income tax provision
3,033

 
2,928

 
2,436

Income from continuing operations
4,645

 
4,600

 
3,869

Loss from discontinued operations, net of tax
(1
)
 
(8
)
 
(7
)
Net income
4,644

 
4,592

 
3,862

Net loss attributable to noncontrolling interest

 

 
2

Net income attributable to CVS Health
$
4,644

 
$
4,592

 
$
3,864

Basic earnings per share:
 

 
 

 
 

Income from continuing operations attributable to CVS Health
$
3.98

 
$
3.78

 
$
3.05

Loss from discontinued operations attributable to CVS Health
$

 
$
(0.01
)
 
$
(0.01
)
Net income attributable to CVS Health
$
3.98

 
$
3.77

 
$
3.04

Weighted average shares outstanding
1,161

 
1,217

 
1,271

Diluted earnings per share:
 

 
 

 
 

Income from continuing operations attributable to CVS Health
$
3.96

 
$
3.75

 
$
3.02

Loss from discontinued operations attributable to CVS Health
$

 
$
(0.01
)
 
$
(0.01
)
Net income attributable to CVS Health
$
3.96

 
$
3.74

 
$
3.02

Weighted average shares outstanding
1,169

 
1,226

 
1,280

Dividends declared per share
$
1.10

 
$
0.90

 
$
0.65

 
See accompanying notes to consolidated financial statements.
















27



Consolidated Statements of Comprehensive Income
 
 
Year Ended December 31,
In millions
2014
 
2013
 
2012
Net income
$
4,644

 
$
4,592

 
$
3,862

Other comprehensive income (loss):
 

 
 

 
 

Foreign currency translation adjustments, net of tax
(35
)
 
(30
)
 

Net cash flow hedges, net of tax
4

 
3

 
3

Pension and other postretirement benefits, net of tax
(37
)
 
59

 
(12
)
Total other comprehensive income (loss)
(68
)
 
32

 
(9
)
Comprehensive income
4,576

 
4,624

 
3,853

Comprehensive loss attributable to noncontrolling interest

 

 
2

Comprehensive income attributable to CVS Health
$
4,576

 
$
4,624

 
$
3,855

 
See accompanying notes to consolidated financial statements.

































 


28



Consolidated Balance Sheets


 
December 31,
In millions, except per share amounts
2014
 
2013
Assets:
 

 
 

Cash and cash equivalents
$
2,481

 
$
4,089

Short-term investments
34

 
88

Accounts receivable, net
9,687

 
8,729

Inventories
11,930

 
11,045

Deferred income taxes
985

 
902

Other current assets
866

 
472

Total current assets
25,983

 
25,325

Property and equipment, net
8,843

 
8,615

Goodwill
28,142

 
26,542

Intangible assets, net
9,774

 
9,529

Other assets
1,510

 
1,515

Total assets
$
74,252

 
$
71,526

Liabilities:
 

 
 

Accounts payable
$
6,547

 
$
5,548

Claims and discounts payable
5,404

 
4,548

Accrued expenses
5,816

 
4,768

Short-term debt
685

 

Current portion of long-term debt
575

 
561

Total current liabilities
19,027

 
15,425

Long-term debt
11,695

 
12,841

Deferred income taxes
4,036

 
3,901

Other long-term liabilities
1,531

 
1,421

Commitments and contingencies (Note 11)

 

Shareholders’ equity:
 

 
 

CVS Health shareholders’ equity:
 
 
 
Preferred stock, par value $0.01: 0.1 shares authorized; none issued or outstanding

 

Common stock, par value $0.01: 3,200 shares authorized; 1,691 shares issued and 1,140
 
 
 
shares outstanding at December 31, 2014 and 1,680 shares issued and 1,180 shares
 
 
 
outstanding at December 31, 2013
17

 
17

Treasury stock, at cost: 550 shares at December 31, 2014 and 500 shares at December 31,
 
 
 
2013
(24,078
)
 
(20,169
)
Shares held in trust: 1 share at December 31, 2014 and 2013
(31
)
 
(31
)
Capital surplus
30,418

 
29,777

Retained earnings
31,849

 
28,493

Accumulated other comprehensive income (loss)
(217
)
 
(149
)
Total CVS Health shareholders’ equity
37,958

 
37,938

Noncontrolling interest
5

 

Total shareholders’ equity
37,963

 
37,938

Total liabilities and shareholders’ equity
$
74,252

 
$
71,526

 
See accompanying notes to consolidated financial statements.



29




Consolidated Statements of Cash Flows 
 
Year Ended December 31,
In millions
2014
 
2013
 
2012
Cash flows from operating activities:
 

 
 

 
 

Cash receipts from customers
$
132,406

 
$
114,993

 
$
113,205

Cash paid for inventory and prescriptions dispensed by retail network pharmacies
(105,362
)
 
(91,178
)
 
(90,032
)
Cash paid to other suppliers and employees
(15,344
)
 
(14,295
)
 
(13,643
)
Interest received
15

 
8

 
4

Interest paid
(647
)
 
(534
)
 
(581
)
Income taxes paid
(2,931
)
 
(3,211
)
 
(2,282
)
Net cash provided by operating activities
8,137

 
5,783

 
6,671

Cash flows from investing activities:
 

 
 

 
 

Purchases of property and equipment
(2,136
)
 
(1,984
)
 
(2,030
)
Proceeds from sale-leaseback transactions
515

 
600

 
529

Proceeds from sale of property and equipment and other assets
11

 
54

 
23

Acquisitions (net of cash acquired) and other investments
(2,439
)
 
(415
)
 
(378
)
Purchase of available-for-sale investments
(157
)
 
(226
)
 

Maturity of available-for-sale investments
161

 
136

 

Proceeds from sale of subsidiary

 

 
7

Net cash used in investing activities
(4,045
)
 
(1,835
)
 
(1,849
)
Cash flows from financing activities:
 

 
 

 
 

Increase (decrease) in short-term debt
685

 
(690
)
 
(60
)
Proceeds from issuance of long-term debt
1,483

 
3,964

 
1,239

Repayments of long-term debt
(3,100
)
 

 
(1,718
)
Purchase of noncontrolling interest in subsidiary

 

 
(26
)
Dividends paid
(1,288
)
 
(1,097
)
 
(829
)
Proceeds from exercise of stock options
421

 
500

 
836

Excess tax benefits from stock-based compensation
106

 
62

 
28

Repurchase of common stock
(4,001
)
 
(3,976
)
 
(4,330
)
Net cash used in financing activities
(5,694
)
 
(1,237
)
 
(4,860
)
Effect of exchange rate changes on cash and cash equivalents
(6
)
 
3

 

Net increase (decrease) in cash and cash equivalents
(1,608
)
 
2,714

 
(38
)
Cash and cash equivalents at the beginning of the year
4,089

 
1,375

 
1,413

Cash and cash equivalents at the end of the year
$
2,481

 
$
4,089

 
$
1,375

Reconciliation of net income to net cash provided by operating activities:
 

 
 

 
 

Net income
$
4,644

 
$
4,592

 
$
3,862

Adjustments required to reconcile net income to net cash provided by operating activities:
 

 
 

 
 

Depreciation and amortization
1,931

 
1,870

 
1,753

Stock-based compensation
165

 
141

 
132

Loss on early extinguishment of debt
521

 

 
348

Deferred income taxes and other noncash items
(58
)
 
(86
)
 
(111
)
Change in operating assets and liabilities, net of effects from acquisitions:
 

 
 

 
 

Accounts receivable, net
(737
)
 
(2,210
)
 
(387
)
Inventories
(770
)
 
12

 
(853
)
Other current assets
(383
)
 
105

 
3

Other assets
9

 
(135
)
 
(99
)
Accounts payable and claims and discounts payable
1,742

 
1,024

 
1,147

Accrued expenses
1,060

 
471

 
766

Other long-term liabilities
13

 
(1
)
 
110

Net cash provided by operating activities
$
8,137

 
$
5,783

 
$
6,671

 
See accompanying notes to consolidated financial statements.

30



Consolidated Statements of Shareholders’ Equity
 
 
Shares
 
Dollars
 
Year Ended December 31,
 
Year Ended December 31,
In millions
2014
 
2013
 
2012
 
2014
 
2013
 
2012
Common stock:
 

 
 

 
 

 
 

 
 

 
 

Beginning of year
1,680

 
1,667

 
1,640

 
$
17

 
$
17

 
$
16

Stock options exercised and issuance of stock awards
11

 
13

 
27

 

 

 
1

End of year
1,691

 
1,680

 
1,667

 
$
17

 
$
17

 
$
17

Treasury stock:
 

 
 

 
 

 
 

 
 

 
 

Beginning of year
(500
)
 
(435
)
 
(340
)
 
$
(20,169
)
 
$
(16,270
)
 
$
(11,953
)
Purchase of treasury shares
(51
)
 
(66
)
 
(95
)
 
(4,001
)
 
(3,976
)
 
(4,330
)
Employee stock purchase plan issuances
1

 
1

 
1

 
92

 
77

 
47

Transfer of shares from shares held in trust

 

 
(1
)
 

 

 
(34
)
End of year
(550
)
 
(500
)
 
(435
)
 
$
(24,078
)
 
$
(20,169
)
 
$
(16,270
)
Shares held in trust:
 

 
 

 
 

 
 

 
 

 
 

Beginning of year
(1
)
 
(1
)
 
(2
)
 
$
(31
)
 
$
(31
)
 
$
(56
)
Transfer of shares to treasury stock

 

 
1

 

 

 
25

End of year
(1
)
 
(1
)
 
(1
)
 
$
(31
)
 
$
(31
)
 
$
(31
)
Capital surplus:
 

 
 

 
 

 
 

 
 

 
 

Beginning of year
 

 
 

 
 

 
$
29,777

 
$
29,120

 
$
28,126

Stock option activity and stock awards
 

 
 

 
 

 
535

 
588

 
955

Excess tax benefit on stock options and stock awards
 

 
 

 
 

 
106

 
69

 
28

Transfer of shares held in trust to treasury stock
 

 
 

 
 

 

 

 
9

Purchase of noncontrolling interest in subsidiary
 

 
 

 
 

 

 

 
2

End of year
 

 
 

 
 

 
$
30,418

 
$
29,777

 
$
29,120

Retained earnings:
 

 
 

 
 

 
 

 
 

 
 

Beginning of year
 

 
 

 
 

 
$
28,493

 
$
24,998

 
$
22,052

Changes in inventory accounting principles
 

 
 

 
 

 

 

 
(89
)
Net income attributable to CVS Health
 

 
 

 
 

 
4,644

 
4,592

 
3,864

Common stock dividends
 

 
 

 
 

 
(1,288
)
 
(1,097
)
 
(829
)
End of year
 

 
 

 
 

 
$
31,849

 
$
28,493

 
$
24,998

Accumulated other comprehensive loss:
 

 
 

 
 

 
 

 
 

 
 

Beginning of year
 

 
 

 
 

 
$
(149
)
 
$
(181
)
 
$
(172
)
Foreign currency translation adjustments, net of tax
 
 
 
 
 
 
(35
)
 
(30
)
 

Net cash flow hedges, net of tax
 

 
 

 
 

 
4

 
3

 
3

Pension and other postretirement benefits, net of
    tax
 

 
 

 
 

 
(37
)
 
59

 
(12
)
End of year
 

 
 

 
 

 
$
(217
)
 
$
(149
)
 
$
(181
)
Total CVS Health shareholders equity
 
 
 
 
 
 
$
37,958

 
$
37,938

 
$
37,653

Noncontrolling interest:
 
 
 
 
 
 
 
 
 
 
 
Beginning of year
 
 
 
 
 
 
$

 
$

 
$

Business combinations
 
 
 
 
 
 
5

 

 

End of year
 
 
 
 
 
 
$
5

 
$

 
$

Total shareholders’ equity
 

 
 

 
 

 
$
37,963

 
$
37,938

 
$
37,653



See accompanying notes to consolidated financial statements.

31



Notes to Consolidated Financial Statements

1     Significant Accounting Policies
 
Description of business - CVS Health Corporation and its subsidiaries (the “Company”) is the largest integrated pharmacy health care provider in the United States based upon revenues and prescriptions filled. The Company currently has three reportable business segments, Pharmacy Services, Retail Pharmacy and Corporate, which are described below.
 
Pharmacy Services Segment (the “PSS”) - The PSS provides a full range of pharmacy benefit management services including mail order pharmacy services, specialty pharmacy and infusion services, plan design and administration, formulary management and claims processing. The Company’s clients are primarily employers, insurance companies, unions, government employee groups, health plans, Managed Medicaid plans and other sponsors of health benefit plans and individuals throughout the United States.
 
As a pharmacy benefits manager, the PSS manages the dispensing of pharmaceuticals through the Company’s mail order pharmacies and national network of more than 68,000 retail pharmacies, consisting of approximately 41,000 chain pharmacies and 27,000 independent pharmacies, to eligible members in the benefits plans maintained by the Company’s clients and utilizes its information systems to perform, among other things, safety checks, drug interaction screenings and brand to generic substitutions.
 
The PSS’ specialty pharmacies support individuals that require complex and expensive drug therapies. The specialty pharmacy business includes mail order and retail specialty pharmacies that operate under the CVS/caremarkTM, CarePlus CVS/pharmacy® and Navarro® Health Services names. In January 2014, the Company enhanced its offerings of specialty infusion services and began offering enteral nutrition services through Coram LLC and its subsidiaries (See Note 2, “Coram Acquisition”).
 
The PSS also provides health management programs, which include integrated disease management for 17 conditions, through the Company’s Accordant® rare disease management offering.
 
In addition, through the Company’s SilverScript Insurance Company (“SilverScript”) subsidiary, the PSS is a national provider of drug benefits to eligible beneficiaries under the federal government’s Medicare Part D program.
 
The PSS generates net revenues primarily by contracting with clients to provide prescription drugs to plan members. Prescription drugs are dispensed by the mail order pharmacies, specialty pharmacies and national network of retail pharmacies. Net revenues are also generated by providing additional services to clients, including administrative services such as claims processing and formulary management, as well as health care related services such as disease management.
 
The pharmacy services business operates under the CVS/caremarkTM Pharmacy Services, Caremark®, CVS/caremarkTM, CarePlus CVS/pharmacy®, RxAmerica®, Accordant®, SilverScript®, NovoLogix®, Coram®, CVS/specialtyTM and Navarro® Health Services names. As of December 31, 2014, the PSS operated 27 retail specialty pharmacy stores, 11 specialty mail order pharmacies and four mail order dispensing pharmacies, and 86 branches and six centers of excellence for infusion and enteral services located in 40 states, Puerto Rico and the District of Columbia.
 
Retail Pharmacy Segment (the “RPS”) - The RPS sells prescription drugs and a wide assortment of general merchandise, including over-the-counter drugs, beauty products and cosmetics, photo finishing, seasonal merchandise, greeting cards and convenience foods, through the Company’s CVS/pharmacy®, CVS®, Longs Drugs®, Navarro® Discount Pharmacy and Drogaria OnofreTM retail stores and online through CVS.com®, Navarro.comTM and Onofre.com.brTM.
 
The RPS also provides health care services through its MinuteClinic® health care clinics. MinuteClinics are staffed by nurse practitioners and physician assistants who utilize nationally recognized protocols to diagnose and treat minor health conditions, perform health screenings, monitor chronic conditions and deliver vaccinations.
 
As of December 31, 2014, the retail pharmacy business included 7,822 retail drugstores (of which 7,765 operated a pharmacy) located in 44 states, the District of Columbia, Puerto Rico and Brazil operating primarily under the CVS/pharmacy, CVS, Longs Drugs, Navarro Discount Pharmacy and Drogaria Onofre names, the online retail websites, CVS.com, Navarro.com and Onofre.com.br, and 971 retail health care clinics operating under the MinuteClinic name (of which 963 were located in CVS/pharmacy stores).


32


Notes to Consolidated Financial Statements (continued)



Corporate Segment - The Corporate Segment provides management and administrative services to support the Company. The Corporate Segment consists of certain aspects of the Company’s executive management, corporate relations, legal, compliance, human resources, corporate information technology and finance departments.

Principles of consolidation - The consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries and variable interest entities for which the Company is the primary beneficiary. All intercompany balances and transactions have been eliminated.

The Company continually evaluates its investments to determine if they represent variable interests in a variable interest entity (“VIE”). If the Company determines that it has a variable interest in a VIE, the Company then evaluates if it is the primary beneficiary of the VIE. The evaluation is a qualitative assessment as to whether the Company has the ability to direct the activities of a VIE that most significantly impact the entity’s economic performance. The Company consolidates a VIE if it is considered to be the primary beneficiary.

Assets and liabilities of VIEs for which the Company is the primary beneficiary were not significant to the Company’s consolidated financial statements. VIE creditors do not have recourse against the general credit of the Company.
 
Use of estimates - The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.
 
Fair value hierarchy - The Company utilizes the three-level valuation hierarchy for the recognition and disclosure of fair value measurements. The categorization of assets and liabilities within this hierarchy is based upon the lowest level of input that is significant to the measurement of fair value. The three levels of the hierarchy consist of the following:
 
Level 1 - Inputs to the valuation methodology are unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access at the measurement date.
 
Level 2 - Inputs to the valuation methodology are quoted prices for similar assets and liabilities in active markets, quoted prices in markets that are not active or inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the instrument.
 
Level 3 - Inputs to the valuation methodology are unobservable inputs based upon management’s best estimate of inputs market participants could use in pricing the asset or liability at the measurement date, including assumptions about risk.
 
Cash and cash equivalents - Cash and cash equivalents consist of cash and temporary investments with maturities of three months or less when purchased. The Company invests in short-term money market funds, commercial paper and time deposits, as well as other debt securities that are classified as cash equivalents within the accompanying consolidated balance sheets, as these funds are highly liquid and readily convertible to known amounts of cash. These investments are classified within Level 1 of the fair value hierarchy because they are valued using quoted market prices.
 
Short-term and long-term investments - The Company’s short-term investments consist of certificates of deposit with initial maturities of greater than three months when purchased that mature in less than one year from the balance sheet date. The Company’s long-term investments of $51 million at December 31, 2014, which are classified as noncurrent other assets within the accompanying consolidated balance sheet, consist of certificates of deposit. These investments, which were classified as available-for-sale within Level 1 of the fair value hierarchy, were carried at fair value, which approximated historical cost at December 31, 2014 and 2013.
 
Fair value of financial instruments - As of December 31, 2014, the Company’s financial instruments include cash and cash equivalents, short-term and long-term investments, accounts receivable, accounts payable, contingent consideration liability and short-term debt. Due to the nature of these instruments, the Company’s carrying value approximates fair value. The carrying amount and estimated fair value of total long-term debt was $12.3 billion and $13.3 billion, respectively, as of December 31, 2014. The fair value of the Company’s long-term debt was estimated based on quoted rates currently offered in active markets for the Company’s debt, which is considered Level 1 of the fair value hierarchy. The Company had outstanding letters of credit, which guaranteed foreign trade purchases, with a fair value of $4 million as of December 31, 2014. There were no outstanding derivative financial instruments as of December 31, 2014 and 2013.

 

33


Notes to Consolidated Financial Statements (continued)



Foreign currency translation and transactions - For local currency functional currency, assets and liabilities are translated at end-of-period rates while revenues and expenses are translated at average rates in effect during the period. Equity is translated at historical rates and the resulting cumulative translation adjustments are included as a component of accumulated other comprehensive income (loss).

For U.S. dollar functional currency locations, foreign currency assets and liabilities are remeasured into U.S. dollars at end-of-period exchange rates, except for non-monetary balance sheet accounts, which are remeasured at historical exchange rates. Revenue and expense are remeasured at average exchange rates in effect during each period, except for those expenses related to the nonmonetary balance sheet amounts, which are remeasured at historical exchange rates. Gains or losses from foreign currency remeasurement are included in income.

Gains and losses arising from foreign currency transactions and the effects of remeasurements were not material for all periods presented.

Accounts receivable - Accounts receivable are stated net of an allowance for doubtful accounts. The accounts receivable balance primarily includes amounts due from third party providers (e.g., pharmacy benefit managers, insurance companies and governmental agencies), clients and members, as well as vendors and manufacturers. Charges to bad debt are based on both historical write-offs and specifically identified receivables.

The activity in the allowance for doubtful accounts receivable for the years ended December 31 is as follows:
 
In millions
2014
 
2013
 
2012
Beginning balance
$
256

 
$
243

 
$
189

Additions charged to bad debt expense
185

 
195

 
149

Write-offs charged to allowance
(185
)
 
(182
)
 
(95
)
Ending balance
$
256

 
$
256

 
$
243


Inventories - All inventories are stated at the lower of cost or market. Prescription drug inventories in the RPS and PSS are accounted for using the weighted average cost method. Front store inventories in the RPS stores are accounted for on a first-in, first-out basis using the retail inventory method. The RPS front store inventories in the distribution centers are accounted for using the cost method on a first-in, first-out basis. Physical inventory counts are taken on a regular basis in each store and a continuous cycle count process is the primary procedure used to validate the inventory balances on hand in each distribution center and mail facility to ensure that the amounts reflected in the accompanying consolidated financial statements are properly stated. During the interim period between physical inventory counts, the Company accrues for anticipated physical inventory losses on a location-by-location basis based on historical results and current trends.
 
Property and equipment - Property, equipment and improvements to leased premises are depreciated using the straight-line method over the estimated useful lives of the assets, or when applicable, the term of the lease, whichever is shorter. Estimated useful lives generally range from 10 to 40 years for buildings, building improvements and leasehold improvements and 3 to 10 years for fixtures, equipment and internally developed software. Repair and maintenance costs are charged directly to expense as incurred. Major renewals or replacements that substantially extend the useful life of an asset are capitalized and depreciated. Application development stage costs for significant internally developed software projects are capitalized and depreciated.

The following are the components of property and equipment at December 31: 
In millions
2014
 
2013
Land
$
1,506

 
$
1,460

Building and improvements
2,828

 
2,694

Fixtures and equipment
8,958

 
8,419

Leasehold improvements
3,626

 
3,320

Software
1,868

 
1,515

 
18,786

 
17,408

Accumulated depreciation and amortization
(9,943
)
 
(8,793
)
Property and equipment, net
$
8,843

 
$
8,615

 

34


Notes to Consolidated Financial Statements (continued)



The gross amount of property and equipment under capital leases was $268 million and $260 million as of December 31, 2014 and 2013, respectively. Accumulated amortization of property and equipment under capital lease was $86 million and $74 million as of December 31, 2014 and 2013, respectively. Amortization of property and equipment under capital lease is included within depreciation expense. Depreciation expense totaled $1.4 billion in 2014 and 2013, and $1.3 billion in 2012.
 
Goodwill and other indefinitely-lived assets - Goodwill and other indefinitely-lived assets are not amortized, but are subject to impairment reviews annually, or more frequently if necessary. See Note 3 for additional information on goodwill and other indefinitely-lived assets.
 
Intangible assets - Purchased customer contracts and relationships are amortized on a straight-line basis over their estimated useful lives between 10 and 20 years. Purchased customer lists are amortized on a straight-line basis over their estimated useful lives of up to 10 years. Purchased leases are amortized on a straight-line basis over the remaining life of the lease. See Note 3 for additional information about intangible assets.
 
Impairment of long-lived assets - The Company groups and evaluates fixed and finite-lived intangible assets for impairment at the lowest level at which individual cash flows can be identified, whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. If indicators of impairment are present, the Company first compares the carrying amount of the asset group to the estimated future cash flows associated with the asset group (undiscounted and without interest charges). If the estimated future cash flows used in this analysis 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 asset group’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 asset group’s estimated future cash flows (discounted and with interest charges).

Redeemable noncontrolling interest - In June 2012, the Company acquired the remaining 40% interest in Generation Health from minority shareholders and employee option holders for $26 million and $5 million, respectively, for a total of $31 million. The following is a reconciliation of the changes in the redeemable noncontrolling interest for the year ended December 31, 2012:
 
In millions
 
Balance, December 31, 2011
$
30

Net loss attributable to noncontrolling interest
(2
)
Purchase of noncontrolling interest
(26
)
Reclassification to capital surplus in connection with purchase of
 
noncontrolling interest
(2
)
Balance, December 31, 2012
$

 
Revenue Recognition
 
Pharmacy Services Segment

The PSS sells prescription drugs directly through its mail service dispensing pharmacies and indirectly through its retail pharmacy network. The PSS recognizes revenue from prescription drugs sold by its mail service dispensing pharmacies and under retail pharmacy network contracts where it is the principal using the gross method at the contract prices negotiated with its clients. Net revenues include: (i) the portion of the price the client pays directly to the PSS, net of any volume-related or other discounts paid back to the client (see “Drug Discounts” below), (ii) the price paid to the PSS by client plan members for mail order prescriptions (“Mail Co-Payments”) and the price paid to retail network pharmacies by client plan members for retail prescriptions (“Retail Co-Payments”), and (iii) administrative fees for retail pharmacy network contracts where the PSS is not the principal as discussed below. Sales taxes are not included in revenue.
 
Revenue is recognized when: (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred or services have been rendered, (iii) the seller’s price to the buyer is fixed or determinable, and (iv) collectability is reasonably assured. The following revenue recognition policies have been established for the PSS:
 
Revenues generated from prescription drugs sold by mail service dispensing pharmacies are recognized when the prescription is delivered. At the time of delivery, the PSS has performed substantially all of its obligations under its client contracts and does not experience a significant level of returns or reshipments.
 

35


Notes to Consolidated Financial Statements (continued)



Revenues generated from prescription drugs sold by third party pharmacies in the PSS’ retail pharmacy network and associated administrative fees are recognized at the PSS’ point-of-sale, which is when the claim is adjudicated by the PSS online claims processing system.
 
The PSS determines whether it is the principal or agent for its retail pharmacy network transactions on a contract by contract basis. In the majority of its contracts, the PSS has determined it is the principal due to it: (i) being the primary obligor in the arrangement, (ii) having latitude in establishing the price, changing the product or performing part of the service, (iii) having discretion in supplier selection, (iv) having involvement in the determination of product or service specifications, and (v) having credit risk. The PSS’ obligations under its client contracts for which revenues are reported using the gross method are separate and distinct from its obligations to the third party pharmacies included in its retail pharmacy network contracts. Pursuant to these contracts, the PSS is contractually required to pay the third party pharmacies in its retail pharmacy network for products sold, regardless of whether the PSS is paid by its clients. The PSS’ responsibilities under its client contracts typically include validating eligibility and coverage levels, communicating the prescription price and the co-payments due to the third party retail pharmacy, identifying possible adverse drug interactions for the pharmacist to address with the prescriber prior to dispensing, suggesting generic alternatives where clinically appropriate and approving the prescription for dispensing. Although the PSS does not have credit risk with respect to Retail Co-Payments, management believes that all of the other applicable indicators of gross revenue reporting are present. For contracts under which the PSS acts as an agent, revenue is recognized using the net method.

Drug Discounts - The PSS deducts from its revenues any rebates, inclusive of discounts and fees, earned by its clients. Rebates are paid to clients in accordance with the terms of client contracts, which are normally based on fixed rebates per prescription for specific products dispensed or a percentage of manufacturer discounts received for specific products dispensed. The liability for rebates due to clients is included in “Claims and discounts payable” in the accompanying consolidated balance sheets.
 
Medicare Part D - The PSS, through its SilverScript subsidiary, participates in the federal government’s Medicare Part D program as a Prescription Drug Plan (“PDP”). Net revenues include insurance premiums earned by the PDP, which are determined based on the PDP’s annual bid and related contractual arrangements with the Centers for Medicare and Medicaid Services (“CMS”). The insurance premiums include a direct premium paid by CMS and a beneficiary premium, which is the responsibility of the PDP member, but is subsidized by CMS in the case of low-income members. Premiums collected in advance are initially deferred in accrued expenses and are then recognized in net revenues over the period in which members are entitled to receive benefits.
 
In addition to these premiums, net revenues include co-payments, coverage gap benefits, deductibles and co-insurance (collectively, the “Member Co-Payments”) related to PDP members’ actual prescription claims. In certain cases, CMS subsidizes a portion of these Member Co-Payments and pays the PSS an estimated prospective Member Co-Payment subsidy amount each month. The prospective Member Co-Payment subsidy amounts received from CMS are also included in net revenues. SilverScript assumes no risk for these amounts. If the prospective Member Co-Payment subsidies received differ from the amounts based on actual prescription claims, the difference is recorded in either accounts receivable or accrued expenses.
 
The PSS accounts for CMS obligations and Member Co-Payments (including the amounts subsidized by CMS) using the gross method consistent with its revenue recognition policies for Mail Co-Payments and Retail Co-Payments (discussed previously in this document).

Retail Pharmacy Segment

The RPS recognizes revenue at the time the customer takes possession of the merchandise. Customer returns are not material. Revenue generated from the performance of services in the RPS’ health care clinics is recognized at the time the services are performed. Sales taxes are not included in revenue.

Loyalty Program - The Company’s customer loyalty program, ExtraCare®, is comprised of two components, ExtraSavingsTM and ExtraBucks® Rewards. ExtraSavings coupons redeemed by customers are recorded as a reduction of revenues when redeemed. ExtraBucks Rewards are accrued as a charge to cost of revenues when earned, net of estimated breakage. The Company determines breakage based on historical redemption patterns.
 
See Note 12 for additional information about the revenues of the Company’s business segments.




36


Notes to Consolidated Financial Statements (continued)



Cost of revenues
 
Pharmacy Services Segment - The PSS’ cost of revenues includes: (i) the cost of prescription drugs sold during the reporting period directly through its mail service dispensing pharmacies and indirectly through its retail pharmacy network, (ii) shipping and handling costs, and (iii) the operating costs of its mail service dispensing pharmacies and client service operations and related information technology support costs including depreciation and amortization. The cost of prescription drugs sold component of cost of revenues includes: (i) the cost of the prescription drugs purchased from manufacturers or distributors and shipped to members in clients’ benefit plans from the PSS’ mail service dispensing pharmacies, net of any volume-related or other discounts (see “Vendor allowances and purchase discounts” below) and (ii) the cost of prescription drugs sold (including Retail Co-Payments) through the PSS’ retail pharmacy network under contracts where it is the principal, net of any volume-related or other discounts.
 
Retail Pharmacy Segment - The RPS’ cost of revenues includes: the cost of merchandise sold during the reporting period and the related purchasing costs, warehousing and delivery costs (including depreciation and amortization) and actual and estimated inventory losses.

See Note 12 for additional information about the cost of revenues of the Company’s business segments.

Vendor allowances and purchase discounts
 
The Company accounts for vendor allowances and purchase discounts as follows:
 
Pharmacy Services Segment - The PSS receives purchase discounts on products purchased. The PSS’ contractual arrangements with vendors, including manufacturers, wholesalers and retail pharmacies, normally provide for the PSS to receive purchase discounts from established list prices in one, or a combination, of the following forms: (i) a direct discount at the time of purchase, (ii) a discount for the prompt payment of invoices, or (iii) when products are purchased indirectly from a manufacturer (e.g., through a wholesaler or retail pharmacy), a discount (or rebate) paid subsequent to dispensing. These rebates are recognized when prescriptions are dispensed and are generally calculated and billed to manufacturers within 30 days of the end of each completed quarter. Historically, the effect of adjustments resulting from the reconciliation of rebates recognized to the amounts billed and collected has not been material to the PSS’ results of operations. The PSS accounts for the effect of any such differences as a change in accounting estimate in the period the reconciliation is completed. The PSS also receives additional discounts under its wholesaler contracts if it exceeds contractually defined annual purchase volumes. In addition, the PSS receives fees from pharmaceutical manufacturers for administrative services. Purchase discounts and administrative service fees are recorded as a reduction of “Cost of revenues”.
 
Retail Pharmacy Segment - Vendor allowances received by the RPS reduce the carrying cost of inventory and are recognized in cost of revenues when the related inventory is sold, unless they are specifically identified as a reimbursement of incremental costs for promotional programs and/or other services provided. Amounts that are directly linked to advertising commitments are recognized as a reduction of advertising expense (included in operating expenses) when the related advertising commitment is satisfied. Any such allowances received in excess of the actual cost incurred also reduce the carrying cost of inventory. The total value of any upfront payments received from vendors that are linked to purchase commitments is initially deferred. The deferred amounts are then amortized to reduce cost of revenues over the life of the contract based upon purchase volume. The total value of any upfront payments received from vendors that are not linked to purchase commitments is also initially deferred. The deferred amounts are then amortized to reduce cost of revenues on a straight-line basis over the life of the related contract. The total amortization of these upfront payments was not material to the accompanying consolidated financial statements.
 
Insurance - The Company is self-insured for certain losses related to general liability, workers’ compensation and auto liability. The Company obtains third party insurance coverage to limit exposure from these claims. The Company is also self-insured for certain losses related to health and medical liabilities. The Company’s self-insurance accruals, which include reported claims and claims incurred but not reported, are calculated using standard insurance industry actuarial assumptions and the Company’s historical claims experience.
 
Facility opening and closing costs - New facility opening costs, other than capital expenditures, are charged directly to expense when incurred. When the Company closes a facility, the present value of estimated unrecoverable costs, including the remaining lease obligation less estimated sublease income and the book value of abandoned property and equipment, are charged to expense. The long-term portion of the lease obligations associated with facility closings was $207 million and $246 million in 2014 and 2013, respectively.
 

37


Notes to Consolidated Financial Statements (continued)



Advertising costs - Advertising costs are expensed when the related advertising takes place. Advertising costs, net of vendor funding (included in operating expenses), were $212 million, $177 million and $221 million in 2014, 2013 and 2012, respectively.
 
Interest expense, net - Interest expense, net of capitalized interest, was $615 million, $517 million and $561 million, and interest income was $15 million, $8 million and $4 million in 2014, 2013 and 2012, respectively. Capitalized interest totaled $19 million, $25 million and $29 million in 2014, 2013 and 2012, respectively.
 
Shares held in trust - The Company maintains grantor trusts, which held approximately 1 million shares of its common stock at December 31, 2014 and 2013, respectively. These shares are designated for use under various employee compensation plans. Since the Company holds these shares, they are excluded from the computation of basic and diluted shares outstanding.
 
Accumulated other comprehensive income - Accumulated other comprehensive income (loss) consists of changes in the net actuarial gains and losses associated with pension and other postretirement benefit plans, losses on derivatives from cash flow hedges executed in previous years associated with the issuance of long-term debt, and foreign currency translation adjustments. The amount included in accumulated other comprehensive loss related to the Company’s pension and postretirement plans was $234 million pre-tax ($143 million after-tax) as of December 31, 2014 and $172 million pre-tax ($106 million after-tax) as of December 31, 2013. The net impact on cash flow hedges totaled $16 million pre-tax ($9 million after-tax) and $22 million pre-tax ($13 million after-tax) as of December 31, 2014 and 2013, respectively. Cumulative foreign currency translation adjustments at December 31, 2014 and 2013 were $65 million and $30 million, respectively.

Changes in accumulated other comprehensive income (loss) by component are shown below:
 
Year Ended December 31, 2014(1)
In millions
Foreign Currency
 
Losses on Cash Flow Hedges
 
Pension and Other Postretirement Benefits
 
Total
Balance, December 31, 2013
$
(30
)
 
$
(13
)
 
$
(106
)
 
$
(149
)
     Other comprehensive income (loss) before
       reclassifications
(35
)
 

 

 
(35
)
     Amounts reclassified from accumulated
       other comprehensive income (2)

 
4

 
(37
)
 
(33
)
Net other comprehensive income (loss)
(35
)
 
4

 
(37
)
 
(68
)
Balance, December 31, 2014
$
(65
)
 
$
(9
)
 
$
(143
)
 
$
(217
)
 
 
 
 
 
 
 
 
 
Year Ended December 31, 2013(1)
 
Foreign Currency
 
Losses on Cash Flow Hedges
 
Pension and Other Postretirement Benefits
 
Total
Balance, December 31, 2012
$

 
$
(16
)
 
$
(165
)
 
$
(181
)
     Other comprehensive income (loss) before
       reclassifications
(30
)
 

 

 
(30
)
     Amounts reclassified from accumulated
       other comprehensive income (2)

 
3

 
59

 
62

Net other comprehensive income (loss)
(30
)
 
3

 
59

 
32

Balance, December 31, 2013
$
(30
)
 
$
(13
)
 
$
(106
)
 
$
(149
)

(1)
All amounts are net of tax.
(2)
The amounts reclassified from accumulated other comprehensive income for cash flow hedges are recorded within interest expense, net on the consolidated statement of income. The amounts reclassified from accumulated other comprehensive income for pension and other postretirement benefits are included in operating expenses on the consolidated statement of income.

Stock-based compensation - Stock-based compensation is measured at the grant date based on the fair value of the award and is recognized as expense over the applicable requisite service period of the stock award (generally 3 to 5 years) using the straight-line method.


38


Notes to Consolidated Financial Statements (continued)



Variable Interest Entity - In July 2014, the Company and Cardinal Health, Inc. (“Cardinal”) established Red Oak Sourcing, LLC (“Red Oak”), a generic pharmaceutical sourcing entity in which the Company and Cardinal each own 50%. The Red Oak arrangement has an initial term of ten years. Under this arrangement, the Company and Cardinal contributed their sourcing and supply chain expertise to Red Oak and agreed to source and negotiate generic pharmaceutical supply contracts for both companies through Red Oak; however, Red Oak does not own or hold inventory on behalf of either company. No physical assets (e.g., property and equipment) were contributed to Red Oak by either company and minimal funding was provided to capitalize Red Oak.

The Company has determined that it is the primary beneficiary of this variable interest entity because it has the ability to direct the activities of Red Oak. Consequently, the Company consolidates Red Oak in its consolidated financial statements within the Retail Pharmacy Segment. Revenues associated with Red Oak expenses reimbursed by Cardinal for the year ended December 31, 2014 and amounts due to Cardinal from Red Oak at December 31, 2014 were immaterial.

Cardinal is required to pay the Company 39 quarterly payments of $25.6 million which commenced in October 2014 and, if certain milestones are achieved, it will pay additional predetermined quarterly amounts to the Company beginning in the third quarter of 2015. The payments will reduce the Company’s carrying cost of inventory and will be recognized in cost of revenues when the related inventory is sold.

Related party transactions - The Company has an equity method investment in SureScripts, LLC (“SureScripts”), which operates a clinical health information network. The Pharmacy Services and Retail Pharmacy segments utilize this clinical health information network in providing services to its client plan members and retail customers. The Company expensed fees of approximately $50 million, $48 million and $32 million in the years ended December 31, 2014, 2013 and 2012, respectively, for the use of this network.

The Company’s investment in and equity in earnings in SureScripts for all periods presented is immaterial.

In September 2014, the Company made a charitable contribution of $25 million to the CVS Foundation (formerly CVS Caremark Charitable Trust, Inc.) (the “Foundation”) to fund future giving. The Foundation is a non-profit entity that focuses on health, education and community involvement programs. The charitable contribution was recorded as an operating expense in the consolidated statement of income for the year ended December 31, 2014.

Income taxes - The Company provides for income taxes currently payable, as well as for those deferred because of timing differences between reported income and expenses for financial statement purposes versus income tax return purposes. Income tax credits are recorded as a reduction of income taxes. Deferred income tax assets and liabilities are recognized for the future tax consequences attributable to differences between the carrying amount of assets and liabilities for financial reporting purposes and the amounts used for income tax return purposes. Deferred income tax assets and liabilities are measured using the enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recoverable or settled. The effect of a change in income tax rates is recognized as income or expense in the period of the change.
 
Discontinued Operations - In connection with certain business dispositions completed between 1991 and 1997, the Company retained guarantees on store lease obligations for a number of former subsidiaries, including Linens ‘n Things which filed for bankruptcy in 2008. The Company’s loss from discontinued operations includes lease-related costs which the Company believes it will likely be required to satisfy pursuant to its Linens ‘n Things lease guarantees.

Below is a summary of the results of discontinued operations for the years ended December 31:

In millions
 
2014
 
2013
 
2012
Loss on disposal
 
$
(1
)
 
$
(12
)
 
$
(12
)
Income tax benefit
 

 
4

 
5

Loss from discontinued operations, net of tax
 
$
(1
)
 
$
(8
)
 
$
(7
)

Earnings per common share - Earnings per share is computed using the two-class method. Options to purchase 2.1 million, 6.2 million and 5.9 million shares of common stock were outstanding as of December 31, 2014, 2013 and 2012, respectively, but were not included in the calculation of diluted earnings per share because the options’ exercise prices were greater than the average market price of the common shares and, therefore, the effect would be antidilutive.
 

39


Notes to Consolidated Financial Statements (continued)



New Accounting Pronouncement - In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standard Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers (Topic 606). ASU No. 2014-09 outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance, including industry-specific guidance. This new guidance is effective for annual reporting periods (including interim reporting periods within those periods) beginning after December 15, 2016; early adoption is not permitted. Companies have the option of using either a full retrospective or a modified retrospective approach to adopt the guidance. This update could impact the timing and amounts of revenue recognized. The Company is currently evaluating the effect that implementation of this update will have on its consolidated financial position and results of operations upon adoption and the method of transition. 

2      Coram Acquisition
 
On January 16, 2014, the Company acquired 100% of the voting interests of Coram LLC and its subsidiaries (collectively, “Coram”), the specialty infusion services and enteral nutrition business unit of Apria Healthcare Group Inc. (“Apria”), for cash consideration of approximately $2.1 billion, plus contingent consideration of approximately $0.1 billion. The purchase price was also subject to a working capital adjustment, which resulted in the Company receiving $9 million from Apria. Coram is one of the nation’s largest providers of comprehensive infusion services, caring for approximately 240,000 patients annually. Coram has approximately 4,600 employees, including approximately 600 nurses and 250 dietitians, operating primarily through 84 branch locations and six centers of excellence for patient intake.

The contingent consideration is based on the Company’s future realization of Coram’s tax net operating loss carryforwards (“NOLs”) as of the date of the acquisition. The Company will pay the seller the first $60 million in tax savings realized from the future utilization of the Coram NOLs, plus 50% of any additional future tax savings from the remaining NOLs. The fair value of the contingent consideration liability associated with the future realization of the Coram NOLs was determined using Level 3 inputs based on the present value of contingent payments expected to be made based on the Company’s estimate of the amount and timing of Coram NOLs that will ultimately be realized. The change in fair value of the contingent consideration liability recognized in earnings for the year ended December 31, 2014 was immaterial.

The following is a summary of the fair values of the assets acquired and liabilities assumed:
In millions
 
Accounts receivable
$
215

Inventory
77

Other assets
10

Property and equipment
49

Intangible assets
537

Goodwill
1,566

Current liabilities
(128
)
Deferred tax liabilities, net
(97
)
Other noncurrent liabilities
(91
)
Noncontrolling interest
(2
)
Total consideration
$
2,136


The goodwill represents future economic benefits expected to arise from the Company’s expanded presence in the specialty pharmaceuticals market, the assembled workforce acquired, and the expected synergies from combining operations with Coram. The goodwill is nondeductible for income tax purposes.

Coram’s results of operations are included in the Company’s PSS beginning on January 16, 2014. Pro forma information for this acquisition is not presented as Coram’s results are immaterial to the Company’s consolidated financial statements. During the year ended December 31, 2014, acquisition costs of $15 million were expensed as incurred within operating expenses.
 

40


Notes to Consolidated Financial Statements (continued)



3                 Goodwill and Other Intangibles
 
Goodwill and other indefinitely-lived assets are not amortized, but are subject to annual impairment reviews, or more frequent reviews if events or circumstances indicate an impairment may exist.
 
When evaluating goodwill for potential impairment, the Company first compares the fair value of its two reporting units, the PSS and RPS, to their respective carrying amounts. The Company estimates the fair value of its reporting units using a combination of a future discounted cash flow valuation model and a comparable market transaction model. If the estimated fair value of the reporting unit is less than its carrying amount, an impairment loss calculation is prepared. The impairment loss calculation compares the implied fair value of a reporting unit’s goodwill with the carrying amount of its goodwill. If the carrying amount of the goodwill exceeds the implied fair value, an impairment loss is recognized in an amount equal to the excess. During the third quarter of 2014, the Company performed its required annual goodwill impairment tests. The Company concluded there were no goodwill impairments as of the testing date.

Below is a summary of the changes in the carrying amount of goodwill by segment for the years ended December 31, 2014 and 2013:

In millions
Pharmacy Services
 
Retail Pharmacy
 
Total
Balance, December 31, 2012
$
19,646