10-Q 1 cvs20160930-10q.htm 10-Q Document


 
UNITED STATES
 
SECURITIES AND EXCHANGE COMMISSION
 
Washington, D.C.  20549
 
FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended September 30, 2016
 
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from __________ to _________.

Commission File Number 001-01011  
a1282016cvslogoa02.gif
CVS HEALTH CORPORATION
(Exact name of registrant as specified in its charter)   
Delaware
 
 
 
05-0494040
(State of Incorporation)
 
 
 
(I.R.S. Employer Identification Number)
 
One CVS Drive, Woonsocket, Rhode Island 02895
(Address of principal executive offices)
 
Registrant's telephone number, including area code:  (401) 765-1500
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes[X] No [   ]
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes [X] No [   ]
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer [X]
 
Accelerated filer [   ]
Non-accelerated filer [   ] (Do not check if a smaller reporting company)
 
Smaller reporting company [   ]
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [  ] No [X]
 Common Stock, $0.01 par value, issued and outstanding at November 1, 2016:
 
1,066,439,174 shares
 




INDEX
 
 
Page
 
 
 
Item 1.
Financial Statements
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 





Part I
 
Item 1

 
CVS Health Corporation
Condensed Consolidated Statements of Income
(Unaudited)
 
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
In millions, except per share amounts
2016
 
2015
 
2016
 
2015
 
 
 
 
 
 
 
 
Net revenues
$
44,615

 
$
38,644

 
$
131,555

 
$
112,144

Cost of revenues
37,123

 
31,983

 
110,304

 
92,917

Gross profit
7,492

 
6,661

 
21,251

 
19,227

Operating expenses
4,675

 
4,330

 
13,908

 
12,502

Operating profit
2,817

 
2,331

 
7,343

 
6,725

Interest expense, net
253

 
261

 
816

 
562

Loss on early extinguishment of debt
101

 

 
643

 

Income before income tax provision
2,463

 
2,070

 
5,884

 
6,163

Income tax provision
921

 
833

 
2,271

 
2,433

Income from continuing operations
1,542

 
1,237

 
3,613

 
3,730

Income (loss) from discontinued operations, net of tax
(1
)
 
10

 
(1
)
 
10

Net income
1,541

 
1,247

 
3,612

 
3,740

Net income attributable to noncontrolling interest
(1
)
 
(1
)
 
(2
)
 
(1
)
Net income attributable to CVS Health
$
1,540

 
$
1,246

 
$
3,610

 
$
3,739

 
 
 
 
 
 
 
 
Basic earnings per share:
 


 


 


 

Income from continuing operations attributable to CVS Health
$
1.44


$
1.10


$
3.34


$
3.31

Income from discontinued operations attributable to CVS Health
$


$
0.01


$


$
0.01

Net income attributable to CVS Health
$
1.44


$
1.11


$
3.34


$
3.32

Weighted average basic shares outstanding
1,068


1,114


1,076


1,122













Diluted earnings per share:











Income from continuing operations attributable to CVS Health
$
1.43


$
1.10


$
3.32


$
3.28

Income from discontinued operations attributable to CVS Health
$


$
0.01


$


$
0.01

Net income attributable to CVS Health
$
1.43


$
1.11


$
3.32


$
3.29

Weighted average diluted shares outstanding
1,073


1,121


1,082


1,130

Dividends declared per share
$
0.425


$
0.350


$
1.275


$
1.050

  
See accompanying notes to condensed consolidated financial statements.


3



CVS Health Corporation
Condensed Consolidated Statements of Comprehensive Income
(Unaudited)
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
In millions
2016
 
2015
 
2016
 
2015
 
 
 
 
 
 
 
 
Net income
$
1,541

 
$
1,247

 
$
3,612

 
$
3,740

Other comprehensive income (loss):
 

 
 

 
 

 
 

Foreign currency translation adjustments, net of tax
(3
)
 
(61
)
 
37

 
(100
)
Cash flow hedges, net of tax
1

 

 
2

 
1

Total other comprehensive income (loss)
(2
)
 
(61
)
 
39

 
(99
)
Comprehensive income
1,539

 
1,186

 
3,651

 
3,641

Comprehensive income attributable to noncontrolling interest
(1
)
 
(1
)
 
(2
)
 
(1
)
Comprehensive income attributable to CVS Health
$
1,538

 
$
1,185

 
$
3,649

 
$
3,640

 
 
See accompanying notes to condensed consolidated financial statements.


4



CVS Health Corporation
Condensed Consolidated Balance Sheets
(Unaudited)
 
In millions, except per share amounts
September 30,
2016
 
December 31,
2015
 
 
 
 
Assets:
 
 
 
Cash and cash equivalents
$
2,189

 
$
2,459

Short-term investments
74

 
88

Accounts receivable, net
13,625

 
11,888

Inventories
14,348

 
14,001

Other current assets
703

 
722

Total current assets
30,939

 
29,158

Property and equipment, net
9,901

 
9,855

Goodwill
38,214

 
38,106

Intangible assets, net
13,567

 
13,878

Other assets
1,535

 
1,440

Total assets
$
94,156

 
$
92,437

 
 
 
 
Liabilities:
 

 
 

Accounts payable
$
7,584

 
$
7,490

Claims and discounts payable
9,178

 
7,653

Accrued expenses
8,856

 
6,829

Short-term debt
340

 

Current portion of long-term debt
783

 
1,197

Total current liabilities
26,741

 
23,169

Long-term debt
25,610

 
26,267

Deferred income taxes
4,254

 
4,217

Other long-term liabilities
1,597

 
1,542

Commitments and contingencies (Note 12)

 

Redeemable noncontrolling interest

 
39

 
 
 
 
Shareholders’ equity:
 

 
 

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

 

Common stock, par value $0.01: 3,200 shares authorized; 1,705 shares issued and 1,066
 
 
 
shares outstanding at September 30, 2016 and 1,699 shares issued and 1,101 shares
 
 
 
outstanding at December 31, 2015
17

 
17

Treasury stock, at cost: 638 shares at September 30, 2016 and 597 shares at December 31,
 
 
 
2015
(32,991
)
 
(28,886
)
Shares held in trust: 1 share at September 30, 2016 and December 31, 2015
(31
)
 
(31
)
Capital surplus
31,541

 
30,948

Retained earnings
37,732

 
35,506

Accumulated other comprehensive income (loss)
(319
)
 
(358
)
Total CVS Health shareholders’ equity
35,949

 
37,196

Noncontrolling interest
5

 
7

Total shareholders’ equity
35,954

 
37,203

Total liabilities and shareholders’ equity
$
94,156

 
$
92,437

 
See accompanying notes to condensed consolidated financial statements.


5



CVS Health Corporation
Condensed Consolidated Statements of Cash Flows
(Unaudited)
 
Nine Months Ended September 30,
In millions
2016
 
2015
Cash flows from operating activities:
 
 
 
Cash receipts from customers
$
128,545

 
$
108,324

Cash paid for inventory and prescriptions dispensed by retail network pharmacies
(106,371
)
 
(89,530
)
Cash paid to other suppliers and employees
(11,092
)
 
(11,240
)
Interest received
14

 
15

Interest paid
(954
)
 
(423
)
Income taxes paid
(2,194
)
 
(2,305
)
Net cash provided by operating activities
7,948

 
4,841

 
 
 
 
Cash flows from investing activities:
 

 
 

Purchases of property and equipment
(1,607
)
 
(1,490
)
Proceeds from sale-leaseback transactions
230

 
34

Proceeds from sale of property and equipment and other assets
22

 
28

Acquisitions (net of cash acquired) and other investments
(333
)
 
(9,503
)
Purchase of available-for-sale investments
(40
)
 
(184
)
Sales/maturities of available-for-sale investments
76

 
115

Net cash used in investing activities
(1,652
)
 
(11,000
)
 
 
 
 
Cash flows from financing activities:
 

 
 

Increase in short-term debt
340

 
(685
)
Proceeds from issuance of long-term debt
3,455

 
14,808

Repayments of long-term debt
(5,185
)
 
(2,898
)
Purchase of noncontrolling interest in subsidiary
(39
)
 

Payment of contingent consideration
(26
)
 

Dividends paid
(1,384
)
 
(1,185
)
Proceeds from exercise of stock options
205

 
277

Excess tax benefits from stock-based compensation
72

 
132

Repurchase of common stock
(4,000
)
 
(3,871
)
Other
(6
)
 
(2
)
Net cash provided by (used in) financing activities
(6,568
)
 
6,576

Effect of exchange rate changes on cash and cash equivalents
2

 
(8
)
Net increase (decrease) in cash and cash equivalents
(270
)
 
409

Cash and cash equivalents at beginning of period
2,459

 
2,481

Cash and cash equivalents at end of period
$
2,189

 
$
2,890

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

 
 

Net income
$
3,612

 
$
3,740

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

 
 

Depreciation and amortization
1,847

 
1,510

Stock-based compensation
166

 
175

Loss on early extinguishment of debt
643

 

Deferred income taxes and other noncash items
119

 
(184
)
Change in operating assets and liabilities, net of effects from acquisitions:
 

 
 

Accounts receivable, net
(1,714
)
 
(2,530
)
Inventories
(337
)
 
(893
)
Other current assets
2

 
591

Other assets
(86
)
 
(13
)
Accounts payable and claims and discounts payable
1,570

 
2,038

Accrued expenses
2,077

 
523

Other long-term liabilities
49

 
(116
)
Net cash provided by operating activities
$
7,948

 
$
4,841

 
See accompanying notes to condensed consolidated financial statements.

6



CVS Health Corporation
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
Note 1 – Accounting Policies
 
Basis of Presentation
 
The accompanying unaudited condensed consolidated financial statements of CVS Health Corporation and its subsidiaries (collectively, “CVS Health” or the “Company”) have been prepared in accordance with the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”) regarding interim financial reporting. In accordance with such rules and regulations, certain information and accompanying note disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) have been condensed or omitted, although the Company believes the disclosures included herein are adequate to make the information presented not misleading. These condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto, which are included in Exhibit 13 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2015 (“2015 Form 10-K”).

In the opinion of management, the accompanying unaudited condensed consolidated financial statements include all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the results for the interim periods presented. Because of the influence of various factors on the Company’s operations, including business combinations, certain holidays and other seasonal influences, net income for any interim period may not be comparable to the same interim period in previous years or necessarily indicative of income for the full year.

Principles of Consolidation
 
The condensed consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries and variable interest entities (“VIEs”) for which the Company is the primary beneficiary. All material intercompany balances and transactions have been eliminated.

The Company continually evaluates its investments to determine if they represent variable interests in a 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 condensed consolidated financial statements. VIE creditors do not have recourse against the general credit of the Company.
 
Fair Value of Financial Instruments
 
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.
 


7



As of September 30, 2016, the carrying value of cash and cash equivalents, short-term investments, accounts receivable and accounts payable approximated their fair value due to the nature of these financial instruments. The Company invests in money market funds, commercial paper and time deposits that are classified as cash and cash equivalents within the accompanying condensed 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. The Company’s short-term investments of $74 million at September 30, 2016 consist of certificates of deposit with initial maturities of greater than three months when purchased that mature within one year from the balance sheet date. These investments, which are classified within Level 1 of the fair value hierarchy, are carried at fair value, which approximated historical cost at September 30, 2016. The carrying amount and estimated fair value of the Company’s total long-term debt was $26.4 billion and $28.7 billion, respectively, as of September 30, 2016. The fair value of the Company’s long-term debt was estimated based on quoted prices currently offered in active markets for the Company’s debt, which is considered Level 1 of the fair value hierarchy.

Redeemable Noncontrolling Interest

As a result of the acquisition of Omnicare, Inc. (“Omnicare”) in August 2015, the Company obtained a 73% ownership interest in a limited liability company (“LLC”). Due to the change in control in Omnicare, the noncontrolling member of the LLC had the contractual right to put its membership interest to the Company at fair value. Consequently, the noncontrolling interest in the LLC was recorded as a redeemable noncontrolling interest at fair value. During the first quarter of 2016, the noncontrolling shareholder of the LLC exercised its option to sell its ownership interest and the Company purchased the noncontrolling interest in the LLC for approximately $39 million.

Below is a summary of the changes in the redeemable noncontrolling interest for the nine months ended September 30, 2016:
In millions
 
 
Beginning balance
$
39

 
Net income attributable to noncontrolling interest
1

 
Distributions
(2
)
 
Purchase of noncontrolling interest
(39
)
 
Reclassification to capital surplus in connection with purchase of noncontrolling interest
1

 
Ending balance
$

 

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/LTC segments utilize this clinical health information network in providing services to its client plan members and retail customers. The Company expensed fees for the use of this network of approximately $7 million and $16 million in the three months ended September 30, 2016 and 2015, respectively, and expensed fees of $29 million and $37 million in the nine months ended September 30, 2016 and 2015, respectively. The Company’s investment in and equity in earnings of SureScripts for all periods presented is immaterial.

In connection with the acquisition of Omnicare in August 2015, the Company obtained an equity method investment in Heartland Healthcare Services, LLC (“Heartland”). Heartland operates several long-term care pharmacies in four states. Heartland paid the Company approximately $46 million and $116 million for pharmaceutical inventory purchases during the three and nine months ended September 30, 2016, respectively. Additionally, the Company performs certain collection functions for Heartland and then passes those customer cash collections to Heartland. The Company’s investment in Heartland as of December 31, 2015 and September 30, 2016 and equity in earnings of Heartland for the three and nine months ended September 30, 2016 is immaterial.

In April 2016, the Company made a charitable contribution of $32 million to the CVS Foundation (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 condensed consolidated statement of income for the nine months ended September 30, 2016.





8



New Accounting Pronouncements

In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers (Topic 606). ASU 2014-09 outlines a single comprehensive model for companies to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance, including industry-specific guidance. In March 2016, the FASB issued ASU 2016-08, “Principal Versus Agent Considerations (Reporting Revenue Gross Versus Net),” which amends the principal-versus-agent implementation guidance and in April 2016 the FASB issued ASU 2016-10, "Identifying Performance Obligations and Licensing," which amends the guidance in those areas in the new revenue recognition standard. Both ASU's were issued in response to feedback received from the FASB-International Accounting Standards Board joint revenue recognition transition resource group. This new revenue standard is effective for annual reporting periods (including interim reporting periods within those periods) beginning January 1, 2018; early adoption in 2017 is permitted. Companies have the option of using either a full retrospective or a modified retrospective approach to adopt the guidance. This standard could impact the timing and amounts of revenue recognized. The Company is currently evaluating the effect that implementation of this standard will have on its consolidated financial position and results of operations upon adoption, as well as the method of transition and required disclosures.
In November 2015, the FASB issued ASU 2015-17, Income Taxes (Topic 740). The new guidance simplifies the presentation of deferred income taxes by requiring that deferred tax assets and liabilities be classified as noncurrent in a classified statement of financial position. The updated standard is effective for the Company beginning on January 1, 2017 with early application permitted as of the beginning of any interim or annual reporting period. The Company elected to early adopt this standard as of January 1, 2016 and has, accordingly, reclassified the current deferred tax assets to noncurrent deferred tax liabilities for all periods presented. The following is a reconciliation of the effect of the reclassification on the Company's condensed consolidated balance sheet as of December 31, 2015:
In millions
 
As Previously Reported
 
Adjustments
 
As Revised
Deferred tax assets - current
 
$
1,220

 
$
(1,220
)
 
$

Total current assets
 
30,378

 
(1,220
)
 
29,158

Total assets
 
93,657

 
(1,220
)
 
92,437

Deferred tax liabilities - noncurrent
 
5,437

 
(1,220
)
 
4,217

Total liabilities and shareholders’ equity
 
93,657

 
(1,220
)
 
92,437


In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). Lessees will be required to recognize a right-of-use asset and a lease liability for virtually all of their leases (other than leases that meet the definition of a short-term lease). The liability will be equal to the present value of lease payments. The asset will be based on the liability, subject to adjustment, such as for initial direct costs. For income statement purposes, a dual model was retained, requiring leases to be classified as either operating or finance leases. Operating leases will result in straight-line expense (similar to current operating leases) while finance leases will result in a front-loaded expense pattern (similar to current capital leases). Lessor accounting is similar to the current model, but updated to align with certain changes to the lessee model (e.g., certain definitions, such as initial direct costs, have been updated) and the new revenue recognition standard. The standard is effective for public companies for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. Early adoption is permitted. The Company believes that the new standard will have a material impact on its consolidated balance sheet but it will not have a material impact on its liquidity. The Company is currently evaluating the effect that implementation of this standard will have on its consolidated results of operations upon adoption.

In March 2016, the FASB issued ASU No. 2016-09, Improvements to Employee Share-Based Payment Accounting, which amends Accounting Standard Codification Topic 718, Compensation - Stock Compensation, in three areas. (1) The new guidance eliminates accounting for tax benefits and deficiencies through equity to the extent of previous windfalls, and then to the income statement. The new requirement is to record all tax benefits and deficiencies through the income statement. This amendment is required to be applied prospectively. The amendment also requires the presentation of excess tax benefits on the statements of cash flows as operating activities, a change which may be applied prospectively or retrospectively at the election of the Company. The amendment requires the presentation of employee taxes paid on the statement of cash flows when an employer withholds shares for tax withholding purposes as financing activities, a change which must be applied retrospectively. (2) The new guidance also permits companies to withhold an amount up to the employees' maximum individual tax rate in the relevant jurisdiction without resulting in liability classification of the award. (3) Finally, the new guidance provides companies with an accounting policy election for the impact of forfeitures on the recognition of expense for share-based payment awards.

9



Forfeitures can be estimated, as required today, or recognized when they occur. If elected, the change to recognize forfeitures when they occur needs to be adopted using a modified retrospective approach, with a cumulative effect adjustment recorded to beginning retained earnings. The ASU is effective for annual reporting periods beginning after December 15, 2016, including interim periods within that annual reporting period. The Company is currently evaluating the effect of adopting this new accounting guidance.

In August 2016, the FASB issued ASU No. 2016-15, Classification of Certain Cash Receipts and Cash Payments. ASU 2016-15 is intended to add or clarify guidance on the classification of certain cash receipts and payments in the statement of cash flows and to eliminate the diversity in practice related to such classifications. The guidance in ASU 2016-15 is required for annual reporting periods beginning after December 15, 2017, with early adoption permitted. The Company is currently evaluating the effect on its consolidated statement of cash flows of adopting this new accounting guidance.

Note 2 – Acquisition

On August 18, 2015, the Company acquired 100% of the outstanding common shares and voting interests of Omnicare for $98 per share, for a total of $9.6 billion and assumed long-term debt with a fair value of approximately $3.1 billion. Omnicare is a leading health care services company that specializes in the management of complex pharmaceutical care. Omnicare’s long-term care (“LTC”) business is the nation’s largest provider of pharmaceuticals, related pharmacy consulting and other ancillary services to chronic care facilities and other care settings. In addition, Omnicare has a specialty pharmacy business operating primarily under the name of Advanced Care ScriptsTM, and provides commercialization services under the name of RxCrossroads®. The Company acquired Omnicare to expand its operations in dispensing prescription drugs to assisted-living and long-term care facilities, and to broaden its presence in the specialty pharmacy business as the Company seeks to serve a greater percentage of the growing senior patient population in the United States.

The following unaudited pro forma information presents a summary of the Company’s combined results of operations for the three and nine months ended September 30, 2015 as if the Omnicare acquisition and the related financing transactions had occurred on January 1, 2014. The following pro forma financial information is not necessarily indicative of the results of operations as they would have been had the transactions been effected on the assumed date, nor is it necessarily an indication of trends in future results for a number of reasons, including, but not limited to, differences between the assumptions used to prepare the pro forma information, basic shares outstanding and dilutive equivalents, cost savings from operating efficiencies, potential synergies, and the impact of incremental costs incurred in integrating the businesses.
In millions, except per share data
Three
Months Ended
September 30,
2015
 
Nine
Months Ended
September 30,
2015
Total revenues
$
39,374

 
$
115,652

Income from continuing operations
1,318

 
3,774

Earnings per share from continuing operations:
 
 
 
Basic
$
1.18

 
$
3.35

Diluted
$
1.17

 
$
3.32


Note 3 – Goodwill and Intangible Assets

Goodwill and indefinitely-lived trade names are not amortized, but are subject to annual impairment reviews, or more frequent reviews if events or circumstances indicate there may be impairment. During the three months ended September 30, 2016, the Company performed its required annual impairment tests and concluded there was no impairment of goodwill or trade names.

The Company's total goodwill was $38.2 billion and $38.1 billion as of September 30, 2016 and December 31, 2015, respectively.








10




The following is a summary of the Company's intangible assets as of September 30, 2016 and December 31, 2015:

 
September 30, 2016
 
December 31, 2015
In millions
Gross
Carrying Amount
 
Accumulated Amortization
 
Net Carrying Amount
 
Gross
Carrying Amount
 
Accumulated Amortization
 
Net Carrying Amount
Trademarks (indefinitely-lived)
$
6,398

 
$

 
$
6,398

 
$
6,398

 
$

 
$
6,398

Customer contracts and
  relationships and covenants not
  to compete
11,340

 
(4,624
)
 
6,716

 
10,594

 
(4,092
)
 
6,502

Favorable leases and other
1,132

 
(679
)
 
453

 
1,595

 
(617
)
 
978

 
$
18,870

 
$
(5,303
)
 
$
13,567

 
$
18,587

 
$
(4,709
)
 
$
13,878


Note 4 – Share Repurchase Program
 
During the nine months ended September 30, 2016, the Company had the following outstanding share repurchase program that was authorized by the Company’s Board of Directors:
In billions
 
 
 
 
 
 
Authorization Date
Authorized
Remaining
December 15, 2014 (“2014 Repurchase Program”)
 
$
10.0

 
 
$
3.7

 

On November 2, 2016, the Company's Board of Directors authorized a new share repurchase program for up to $15 billion of outstanding common stock (the “2016 Repurchase Program”). The 2014 and 2016 Repurchase Programs, which were effective immediately, permit the Company to effect repurchases from time to time through a combination of open market repurchases, privately negotiated transactions, accelerated share repurchase transactions, and/or other derivative transactions. The repurchase programs may be modified or terminated by the Board of Directors at any time.

During the three months ended September 30, 2016, the Company repurchased an aggregate of approximately 0.4 million shares of common stock for approximately $40.0 million pursuant to the 2014 Repurchase Program. During the nine months ended September 30, 2016, the Company repurchased an aggregate of approximately 41.4 million shares of common stock for approximately $4.0 billion pursuant to the 2014 Repurchase Program. This activity includes the accelerated share repurchase agreement (“ASR”) described below.

Pursuant to the authorization under the 2014 Repurchase Program, effective December 11, 2015, the Company entered into a $725 million fixed dollar ASR with Barclays Bank PLC (“Barclays”). Upon payment of the $725 million purchase price on December 14, 2015, the Company received a number of shares of its common stock equal to 80% of the $725 million notional amount of the ASR or approximately 6.2 million shares. The initial 6.2 million shares of common stock delivered to the Company by Barclays were placed into treasury stock in December 2015. The ASR was accounted for as an initial treasury stock transaction for $580 million and a forward contract for $145 million. The forward contract was classified as an equity instrument and was recorded within capital surplus on the condensed consolidated balance sheet as of December 31, 2015. On January 28, 2016, the Company received 1.4 million shares of common stock, representing the remaining 20% of the $725 million notional amount of the ASR, thereby concluding the ASR. The remaining 1.4 million shares of common stock delivered to the Company by Barclays were placed into treasury stock and the forward contract was reclassified from capital surplus to treasury stock in January 2016.

At the time they were received, the initial and final receipt of shares resulted in an immediate reduction of the outstanding shares used to calculate the weighted average common shares outstanding for basic and diluted net income per share.

Note 5 – Accumulated Other Comprehensive Income

Accumulated other comprehensive income consists of foreign currency translation adjustments, unrealized losses on cash flow hedges executed in previous years associated with the issuance of long-term debt, and changes in the net actuarial gains and losses associated with pension and other postretirement benefit plans. The following table summarizes the activity within the components of accumulated other comprehensive income.

11



Changes in accumulated other comprehensive income (loss) by component is shown on the below:
 
Three Months Ended September 30, 2016(1)
In millions
Foreign Currency
 
Losses on Cash Flow Hedges
 
Pension and Other Postretirement Benefits
 
Total
Balance, June 30, 2016
$
(125
)
 
$
(6
)
 
$
(186
)
 
$
(317
)
     Other comprehensive income (loss) before
reclassifications
(3
)
 

 

 
(3
)
     Amounts reclassified from accumulated
other comprehensive income
(2)

 
1

 

 
1

Net other comprehensive income (loss)
(3
)
 
1

 

 
(2
)
Balance, September 30, 2016
$
(128
)
 
$
(5
)
 
$
(186
)
 
$
(319
)
 
 
 
 
 
 
 
 
 
Three Months Ended September 30, 2015(1)
 
Foreign Currency
 
Losses on Cash Flow Hedges
 
Pension and Other Postretirement Benefits
 
Total
Balance, June 30, 2015
$
(104
)
 
$
(8
)
 
$
(143
)
 
$
(255
)
     Other comprehensive income (loss) before
reclassifications
(61
)
 

 

 
(61
)
     Amounts reclassified from accumulated
other comprehensive income
(2)

 

 

 

Net other comprehensive (loss)
(61
)
 

 

 
(61
)
Balance, September 30, 2015
$
(165
)
 
$
(8
)
 
$
(143
)
 
$
(316
)
 
 
 
 
 
 
 
 
 
Nine Months Ended September 30, 2016(1)
 
Foreign Currency
 
Losses on Cash Flow Hedges
 
Pension and Other Postretirement Benefits
 
Total
Balance, December 31, 2015
$
(165
)
 
$
(7
)
 
$
(186
)
 
$
(358
)
     Other comprehensive income (loss) before
reclassifications
37

 

 

 
37

     Amounts reclassified from accumulated
other comprehensive income
(2)

 
2

 

 
2

Net other comprehensive income
37

 
2

 

 
39

Balance, September 30, 2016
$
(128
)
 
$
(5
)
 
$
(186
)
 
$
(319
)
 
 
 
 
 
 
 
 
 
Nine Months Ended September 30, 2015(1)
 
Foreign Currency
 
Losses on Cash Flow Hedges
 
Pension and Other Postretirement Benefits
 
Total
Balance, December 31, 2014
$
(65
)
 
$
(9
)
 
$
(143
)
 
$
(217
)
     Other comprehensive income (loss) before
reclassifications
(100
)
 
1

 

 
(99
)
     Amounts reclassified from accumulated
other comprehensive income
(2)

 

 

 

Net other comprehensive income (loss)
(100
)
 
1

 

 
(99
)
Balance, September 30, 2015
$
(165
)
 
$
(8
)
 
$
(143
)
 
$
(316
)

(1)
All amounts are net of tax.
(2)
The amounts reclassified from accumulated other comprehensive income for losses on cash flow hedges are recorded within interest expense, net on the condensed 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 condensed consolidated statement of income.

12



Note 6 – Borrowings

On May 16, 2016, the Company issued $1.75 billion aggregate principal amount of 2.125% unsecured senior notes due June 1, 2021 and $1.75 billion aggregate principal amount of 2.875% unsecured senior notes due June 1, 2026 (collectively, the "2016 Notes") for total proceeds of approximately $3.5 billion, net of discounts and underwriting fees. The 2016 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 2016 Notes were used for general corporate purposes and to repay certain corporate debt.

On May 16, 2016, the Company announced tender offers for (1) any and all of its 5.75% Senior Notes due 2017, its 6.60% Senior Notes due 2019 and its 4.75% Senior Notes due 2020 (collectively, the “Any and All Notes”) and (2) up to $1.5 billion aggregate principal amount of its 6.25% Senior Notes due 2027, its 6.125% Senior Notes due 2039, its 5.75% Senior Notes due 2041, the 5.00% Senior Notes due 2024 issued by its wholly-owned subsidiary, Omnicare, Inc. (“Omnicare”), the 4.75% Senior Notes due 2022 issued by Omnicare, its 4.875% Senior Notes due 2035 and its 3.875% Senior Notes due 2025 (collectively, the “Maximum Tender Offer Notes” and together with the Any and All Notes, the “Notes”). On May 31, 2016, the Company increased the aggregate principal amount of the tender offers for the Maximum Tender Offer Notes to $2.25 billion. The Company purchased approximately $835 million aggregate principal amount of the Any and All Notes and $2.25 billion aggregate principal amount of the Maximum Tender Offer Notes pursuant to the tender offers, which expired on June 13, 2016. The Company paid a premium of $486 million in excess of the debt principal in connection with the purchase of the Notes, wrote off $50 million of unamortized deferred financing costs and incurred $6 million in fees, for a total loss on the early extinguishment of debt of $542 million which was recorded in income from continuing operations in the condensed consolidated statements of income for the nine months ended September 30, 2016.

On June 27, 2016, the Company notified the holders of the remaining Any and All Notes that the Company was exercising its option to redeem the outstanding Any and All Notes pursuant to the terms of the Any and All Notes and the Indenture dated as of August 15, 2006, between the Company and The Bank of New York Mellon Trust Company, N.A. Approximately $1.1 billion aggregate principal amount of Any and All Notes was redeemed on July 27, 2016. The Company paid a premium of $97 million in excess of the debt principal and wrote off $4.0 million of unamortized deferred financing costs, for a total loss on early extinguishment of debt of $101 million during the three months ended September 30, 2016.

The Company recorded a total loss on the early extinguishment of debt of $643 million which was recorded in the income from continuing operations in the condensed statements of income for the nine months ended September 30, 2016.

Note 7 – Stock-Based Compensation
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
In millions
2016
 
2015
 
2016
 
2015
Stock-based compensation:
 
 
 
 
 
 
 
Stock options
$
20

 
$
22

 
$
60

 
$
67

Restricted stock units
38

 
65

 
106

 
108

Total stock-based compensation
$
58

 
$
87

 
$
166

 
$
175


During the nine months ended September 30, 2016, the Company granted 4 million stock options with a weighted average fair value of $13.02 and a weighted average fair value exercise price of $104.75. The Company had 24 million stock options outstanding as of September 30, 2016 with a weighted average exercise price of $68.31 and a weighted average remaining contractual term of 3.94 years. During the nine months ended September 30, 2016, the Company granted 2 million restricted stock units with a weighted average fair value of $103.47. The Company had 5 million unvested restricted stock units as of September 30, 2016 with a weighted average grant date fair value of $56.20.


13



Note 8 – Sale-Leaseback Transactions

The Company finances a portion of its store development program through sale-leaseback transactions. The properties are
generally sold at net book value, which approximates fair value, and the resulting leases typically qualify and are accounted for
as operating leases. The Company does not have any retained or contingent interests in the stores and does not provide any
guarantees, other than a guarantee of lease payments, in connection with the sale-leaseback transactions. Proceeds from sale-leaseback transactions totaled $230 million and $34 million for the nine months ended September 30, 2016 and 2015,
respectively.

Note 9 – Interest Expense
 
The following are the components of net interest expense: 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
In millions
2016
 
2015
 
2016
 
2015
Interest expense
$
258

 
$
268

 
$
830

 
$
577

Interest income
(5
)
 
(7
)
 
(14
)
 
(15
)
Interest expense, net
$
253

 
$
261

 
$
816

 
$
562


Note 10 – Earnings Per Share
 
Earnings per share is computed using the two-class method. Options to purchase 7.7 million and 6.4 million shares of common stock were outstanding, but were not included in the calculation of diluted earnings per share, for the three and nine months ended September 30, 2016, respectively, because the options’ exercise prices were greater than the average market price of the common shares and, therefore, the effect would be antidilutive. For the same reason, options to purchase approximately 3.5 million and 2.4 million shares of common stock were outstanding, but were not included in the calculation of diluted earnings per share for the three and nine months ended September 30, 2015, respectively.

The following is a reconciliation of basic and diluted net income per share from continuing operations for the respective periods:
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
In millions, except per share amounts
2016
 
2015
 
2016
 
2015
Numerator for earnings per share calculations:
 
 
 
 
 
 
 
Income from continuing operations
$
1,542

 
$
1,237

 
$
3,613

 
$
3,730

Income allocated to participating securities
(7
)
 
(6
)
 
(18
)
 
(18
)
Net income attributable to noncontrolling interest
(1
)
 
(1
)
 
(2
)
 
(1
)
Income from continuing operations attributable to CVS Health
$
1,534

 
$
1,230

 
$
3,593

 
$
3,711

 
 
 
 
 
 
 
 
Denominators for earnings per share calculations:
 

 
 

 
 

 
 
Weighted average shares, basic
1,068

 
1,114

 
1,076

 
1,122

Effect of dilutive securities
5

 
7

 
6

 
8

Weighted average shares, diluted
1,073

 
1,121

 
1,082

 
1,130

 
 
 
 
 
 
 
 
Earnings per share from continuing operations:
 

 
 

 
 

 
 

Basic
$
1.44

 
$
1.10

 
$
3.34

 
$
3.31

Diluted
$
1.43

 
$
1.10

 
$
3.32

 
$
3.28


Note 11 – Segment Reporting
 
The Company has three reportable segments: Pharmacy Services, Retail/LTC and Corporate. The Retail/LTC Segment includes the operating results of the Company's Retail Pharmacy and LTC/RxCrossroads operating segments as the operations and economic characteristics are similar. The Company’s three reportable segments maintain separate financial information by

14



which operating results are evaluated on a regular basis by the Company’s chief operating decision maker in deciding how to allocate resources and in assessing performance. The Company evaluates its Pharmacy Services and Retail/LTC segments’ performance based on net revenue, gross profit and operating profit before the effect of nonrecurring charges and gains and certain intersegment activities. The Company evaluates the performance of its Corporate Segment based on operating expenses before the effect of nonrecurring charges and gains and certain intersegment activities. The chief operating decision maker does not use total assets by segment to make decisions regarding resources, therefore the total asset disclosure by segment has not been included.
 
The Pharmacy Services Segment provides a full range of pharmacy benefit management (“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. 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. 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. Through the Company’s SilverScript Insurance Company subsidiary, the Company is a national provider of drug benefits to eligible beneficiaries under the federal government’s Medicare Part D program. The Pharmacy Services Segment operates under the CVS CaremarkTM Pharmacy Services, Caremark®, CVS CaremarkTM, CarePlus CVS Pharmacy®, CVS SpecialtyTM, RxAmerica®, Accordant®, SilverScript®, NovoLogix®, Coram®, Navarro® Health Services and Advanced Care ScriptsTM names. As of September 30, 2016, the Pharmacy Services Segment operated 23 retail specialty pharmacy stores, 13 specialty mail order pharmacies, four mail service dispensing pharmacies, and 85 branches for infusion and enteral services, including approximately 74 ambulatory infusion suites and five centers of excellence, located in 41 states, Puerto Rico and the District of Columbia.

The Retail/LTC 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. With the acquisition of Omnicare, the Retail/LTC Segment now includes LTC operations, which is comprised of providing the distribution of pharmaceuticals, related pharmacy consulting and other ancillary services to chronic care facilities and other care settings, as well as commercialization services which are provided under the name RxCrossroads®. We added approximately 1,670 pharmacies through the acquisition of the pharmacies of Target Corporation ("Target") in December 2015, thereby expanding our presence in new and existing markets. The stores within Target sell only prescription drugs and over-the-counter drugs that are required to be behind the pharmacy counter. The Retail/LTC Segment also operates retail medical clinics under the MinuteClinic® name. MinuteClinics utilize nationally-recognized medical protocols to diagnose and treat minor health conditions, perform health screenings, monitor chronic conditions and deliver vaccinations. The clinics are staffed by board-certified nurse practitioners and physician assistants who provide access to affordable care without appointment. As of September 30, 2016, our Retail/LTC Segment included 9,694 retail stores (of which 9,638 were either the Company's retail stores that operated a pharmacy, or pharmacies located within Target stores) located in 49 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, 34 onsite pharmacies primarily operating under the CarePlus CVS Pharmacy®, CarePlus® and CVS Pharmacy® names, 1,136 retail health care clinics operating under the MinuteClinic® name (of which 1,129 were located in CVS Pharmacy and Target stores), and our online retail websites, CVS.com®, Navarro.comTM and Onofre.com.brTM. LTC operations are comprised of 151 spoke pharmacies that primarily handle new prescription orders, of which 32 are also hub pharmacies that use proprietary automation to support spoke pharmacies with refill prescriptions. LTC operates primarily under the Omnicare® and NeighborCare® names.

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


15



In millions
Pharmacy
Services
Segment(1)
 
Retail/LTC
Segment
 
Corporate
Segment
 
Intersegment
Eliminations(2)
 
Consolidated
Totals
Three Months Ended
 
 
 
 
 
 
 
 
 
September 30, 2016:
 
 
 
 
 
 
 
 
 
Net revenues
$
30,429

 
$
20,143

 
$

 
$
(5,957
)
 
$
44,615

Gross profit(3)
1,797

 
5,893

 

 
(198
)
 
7,492

Operating profit (loss)(4)(5)
1,458

 
1,773

 
(229
)
 
(185
)
 
2,817

September 30, 2015:
 

 
 

 
 

 
 

 
 

Net revenues
25,528

 
17,912

 

 
(4,796
)
 
38,644

Gross profit
1,468

 
5,373

 

 
(180
)
 
6,661

Operating profit (loss)(4)(5)
1,162

 
1,643

 
(309
)
 
(165
)
 
2,331

Nine Months Ended
 

 
 

 
 

 
 

 
 

September 30, 2016:
 

 
 

 
 

 
 

 
 

Net revenues
88,704

 
60,253

 

 
(17,402
)
 
131,555

Gross profit(3)
4,266

 
17,560

 

 
(575
)
 
21,251

Operating profit (loss)(4)(5)
3,278

 
5,255

 
(661
)
 
(529
)
 
7,343

September 30, 2015:
 

 
 

 
 

 
 

 
 

Net revenues
73,849

 
52,105

 

 
(13,810
)
 
112,144

Gross profit
3,735

 
15,990

 

 
(498
)
 
19,227

Operating profit (loss)(4)(5)
2,837

 
5,050

 
(712
)
 
(450
)
 
6,725


(1) 
Net revenues of the Pharmacy Services Segment include approximately $2.5 billion and $2.1 billion of retail co-payments for the three months ended September 30, 2016 and 2015, respectively, as well as $8.1 billion and $6.8 billion of retail co-payments for the nine months ended September 30, 2016 and 2015, respectively.
(2)
Intersegment eliminations relate to intersegment revenue generating activities that occur between the Pharmacy Services Segment and the Retail/LTC Segment. These occur in the following ways: when members of Pharmacy Services Segment clients (“members”) fill prescriptions at the Company's retail stores to purchase covered products, when members enrolled in programs such as Maintenance Choice ® elect to pick up maintenance prescriptions at one of the Company's retail stores instead of receiving them through the mail, or when members have prescriptions filled at the Company's long-term care pharmacies. When these occur, both the Pharmacy Services and Retail/LTC segments record the revenues, gross profit and operating profit on a standalone basis.
(3)
The Retail/LTC Segment gross profit for the three and nine months ended September 30, 2016 includes $5 million and $15 million, respectively, of acquisition-related integration costs. The integration costs are related to the acquisitions of Omnicare and the pharmacies and clinics of Target.
(4)
The Retail/LTC Segment operating profit for the three and nine months ended September 30, 2016 includes $52 million and $194 million, respectively, of acquisition-related integration costs. The Retail/LTC Segment operating profit for the three and nine months ended September 30, 2015 includes $12 million of acquisition-related integration costs. The integration costs are related to the acquisitions of Omnicare and the pharmacies and clinics of Target.
(5)
The Corporate Segment operating loss for the three and nine months ended September 30, 2016 includes $13 million of integration costs. The Corporate Segment operating loss for the three and nine months ended September 30, 2015 includes $115 million and $135 million, respectively, of acquisition-related transaction and integration costs.

Note 12 – Commitments and Contingencies
 
Lease Guarantees
 
Between 1991 and 1997, the Company sold or spun off a number of subsidiaries, including Bob’s Stores, Linens ‘n Things, Marshalls, Kay-Bee Toys, Wilsons, 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 has 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 September 30, 2016, the Company guaranteed approximately 87 such store leases (excluding the lease guarantees related to Linens ‘n Things, which have been recorded as a liability on the condensed consolidated balance sheet), with the maximum remaining lease term extending through 2047.



16



In April 2016, the parent entity of Bob’s Stores filed for Chapter 11 bankruptcy protection. As described above, the Company, through one or more of its affiliates, is alleged to have guaranteed certain of the Bob’s Stores’ leases (the “Bob’s Leases”). On June 20, 2016, the bankruptcy court approved the sale of substantially all of the assets of Bob’s Stores and certain other assets to a new entity (“Buyer”), which designated Buyer’s affiliate Bob’s Stores, LLC, a Delaware limited liability company (“New Bob’s”), to acquire substantially all of the assets of Bob’s Stores.

The Company, through its subsidiary, CVS Pharmacy, Inc., and New Bob’s have entered into an agreement dated October 14, 2016, pursuant to which, in exchange for an immaterial payment to be made by CVS Pharmacy, Inc., New Bob’s has agreed to accept the assignment of the Bob’s Leases and to be bound by certain restrictions regarding renewals, extensions and modifications to the Bob’s Leases. The Company believes these restrictions will potentially reduce the Company's exposure to liability under guarantees of the Bob's leases in the future. The assignment of the Bob’s Leases to New Bob’s will be subject to bankruptcy court approval. The Company will continue to monitor the bankruptcy proceedings.

Legal Matters
 
The Company is a party to legal proceedings, investigations and claims in the ordinary course of its business, including the matters described below. The Company records accruals for outstanding legal matters when it believes it is probable that a loss will be incurred and the amount can be reasonably estimated. The Company evaluates, on a quarterly basis, developments in legal matters that could affect the amount of any accrual and developments that would make a loss contingency both probable and reasonably estimable. If a loss contingency is not both probable and estimable, the Company does not establish an accrued liability. None of the Company’s accruals for outstanding legal matters are material individually or in the aggregate to the Company’s financial position.

The Company’s contingencies are subject to significant uncertainties, including, among other factors: (i) the procedural status of pending matters; (ii) whether class action status is sought and certified; (iii) whether asserted claims or allegations will survive dispositive motion practice; (iv) the extent of potential damages, fines or penalties, which are often unspecified or indeterminate; (v) the impact of discovery on the legal process; (vi) whether novel or unsettled legal theories are at issue; (vii) the settlement posture of the parties, and/or (viii) in the case of certain government agency investigations, whether a sealed qui tam lawsuit (“whistleblower” action) has been filed and whether the government agency makes a decision to intervene in the lawsuit following investigation.

Except as otherwise noted, the Company cannot predict with certainty the timing or outcome of the legal matters described below, and is unable to reasonably estimate a possible loss or range of possible loss in excess of amounts already accrued for these matters.

Caremark (the term “Caremark” being used herein to generally refer to any one or more PBM subsidiaries of the Company, as applicable) was named in a putative class action lawsuit filed in October 2003 in Alabama state court by John Lauriello, purportedly on behalf of participants in the 1999 settlement of various securities class action and derivative lawsuits against Caremark and others. Other defendants include insurance companies that provided coverage to Caremark with respect to the settled lawsuits. A similar lawsuit was filed in November 2003 by Frank McArthur, also in Alabama state court, naming as defendants, among others, Caremark and several insurance companies involved in the 1999 settlement. This lawsuit was stayed as a later-filed class action, but McArthur was subsequently allowed to intervene in the Lauriello action. The parties have entered into an agreement to resolve the matter. In connection with this agreement, the Company contributed a total of $80 million to the settlement fund and agreed to forego its right to have its insurer continue to reimburse its related legal fees. The Company had established reserves related to this matter to fully cover such payments and the payment was made in the three months ended September 30, 2016. In August 2016, the court entered final judgment dismissing the matter and approving the settlement. The Company denies any wrongdoing, and agreed to a settlement to avoid the burden, uncertainty and distraction of litigation.

Beginning in August 2003, various lawsuits were filed by pharmacies alleging that various PBMs were violating certain antitrust laws. In October 2003, two independent pharmacies, North Jackson Pharmacy, Inc. and C&C, Inc. d/b/a Big C Discount Drugs, Inc., filed three separate putative class action complaints in the United States District Court for the Northern District of Alabama, all seeking treble damages and injunctive relief. One complaint named three Caremark entities as defendants, and the other two complaints named PBM competitors. The North Jackson Pharmacy case against two of the Caremark entities was transferred to the United States District Court for the Northern District of Illinois; the case against the third Caremark entity was sent to arbitration based on contract terms between the pharmacies and that entity. The arbitration was stayed at the parties’ request and later closed by the American

17



Arbitration Association. In August 2006, the Judicial Panel on Multidistrict Litigation issued an order transferring all related PBM antitrust cases, including the North Jackson Pharmacy cases, to the United States District Court for the Eastern District of Pennsylvania for coordinated and consolidated proceedings with the cases originally filed in that court. The consolidated action is now known as In re Pharmacy Benefit Managers Antitrust Litigation. A motion for class certification filed by the North Jackson Pharmacy plaintiffs against the Caremark defendants in August 2015 is currently pending.

In February 2006, two substantially similar putative class action lawsuits were filed in the U.S. District Court for the Eastern District of Kentucky, and were consolidated and entitled Indiana State Dist. Council of Laborers & HOD Carriers Pension & Welfare Fund v. Omnicare, Inc. The consolidated complaint was filed against Omnicare, three of its officers and two of its directors and purported to be brought on behalf of all open-market purchasers of Omnicare common stock from August 3, 2005 through July 27, 2006, as well as all purchasers who bought shares of Omnicare common stock in Omnicare’s public offering in December 2005. The complaint alleged violations of the Securities Exchange Act of 1934 and Section 11 of the Securities Act of 1933 and sought, among other things, compensatory damages and injunctive relief. After dismissals and appeals to the United States Court of Appeals for the Sixth Circuit, the United States Supreme Court remanded the case to the district court. In October 2016, Omnicare filed an answer to plaintiffs’ third amended complaint, and discovery commenced.

In December 2007, the Company received a document subpoena from the Office of Inspector General (“OIG”) within the U.S. Department of Health and Human Services, requesting information relating to the processing of Medicaid and certain other government agency claims on behalf of its clients (which allegedly resulted in underpayments from our pharmacy benefit management clients to the applicable government agencies) on one of the Company’s adjudication platforms. In September 2014, the Company settled the OIG’s claims, as well as related claims by the Department of Justice and private plaintiffs, without any admission of liability. The Company is in discussions with the OIG concerning other claim processing issues.

In December 2009, a shareholder derivative lawsuit was filed by Mark Wuotila in the United States District Court for the District of Rhode Island against the directors and certain officers of the Company. The lawsuit includes allegations of, among other things, securities fraud, insider trading and breach of fiduciary duties and further alleges that the Company was damaged by the purchase of stock at allegedly inflated prices under its share repurchase program. The Company entered into an agreement to settle the matter, pursuant to which the Company agreed to maintain or implement certain corporate governance measures and pay the plaintiff’s legal fees of $270,000. In August 2016, the court entered final judgment dismissing the matter and approving the settlement. The Company denies any wrongdoing, and agreed to settle these matters to avoid the burden, uncertainty and distraction of litigation. The settlement was funded by insurance proceeds.

In March 2010, the Company learned that various State Attorneys General offices and certain other government agencies were conducting a multi-state investigation of certain of the Company’s business practices similar to those being investigated at that time by the U.S. Federal Trade Commission (“FTC”). Twenty-eight states, the District of Columbia and the County of Los Angeles are known to be participating in this investigation. The prior FTC investigation, which commenced in August 2009, was officially concluded in May 2012 when the consent order entered into between the FTC and the Company became final. The Company has cooperated with the multi-state investigation.

In March 2010, the Company received a subpoena from the OIG requesting information about programs under which the Company has offered customers remuneration conditioned upon the transfer of prescriptions for drugs or medications to the Company’s pharmacies in the form of gift cards, cash, non-prescription merchandise or discounts or coupons for non-prescription merchandise. In October 2016, the U.S. District Court for the Central District of California unsealed a qui tam complaint, filed in April 2009 against CVS Pharmacy and other retail pharmacies, alleging that the Company violated the federal False Claims Act, and the false claims acts of several states, by offering such programs. The federal government has declined intervention in the case.

On October 29, 2010, a qui tam complaint entitled United States et al., ex rel. Banigan and Templin v. Organon USA, Inc., Omnicare, Inc. and PharMerica Corporation that had been filed under seal with the U.S. District Court for the District of Massachusetts, was ordered unsealed by the court. The complaint was brought by two former employees of Organon, as private party qui tam relators on behalf of the federal government and several state and local governments. The action alleges civil violations of the federal False Claims Act based on allegations that Organon and its affiliates paid Omnicare and several other long-term care pharmacies rebates, post-purchase discounts and other forms of

18



remuneration in return for purchasing pharmaceuticals from Organon and taking steps to increase the purchase of Organon’s drugs in violation of the Anti-Kickback Statute. The U.S. Department of Justice declined to intervene in this action. Discovery is closed in this matter. In August 2016, the Court granted in part and denied in part Omnicare’s motion for summary judgment. The Company has tentatively agreed with the Department of Justice to resolve this matter for $23 million plus interest. These financial terms are contingent on approval by authorized officials at the Department of Justice, negotiation of terms of a settlement agreement, approval and releases from the OIG, the National Association of Medicaid Fraud Control Units, and the Department of Justice. While the Company believes that a final settlement will be reached, there can be no assurance that any final settlement agreement will be reached or as to the final terms of such settlement.

In January 2012, the United States District Court for the Eastern District of Pennsylvania unsealed a first amended qui tam complaint filed in August 2011 by an individual relator, Anthony Spay, who is described in the complaint as having once been employed by a firm providing pharmacy prescription benefit audit and recovery services. The complaint seeks monetary damages and alleges that Caremark’s processing of Medicare claims on behalf of one of its clients violated the federal False Claims Act. The United States declined to intervene in the lawsuit. In September 2015, the Court granted Caremark's motion for summary judgment in its entirety, and entered judgment in favor of Caremark and against Spay. In October 2015, Spay filed a notice of appeal in the United States Court of Appeals for the Third Circuit.

In February 2012, the Attorney General of the State of Texas issued Civil Investigative Demands and other requests, and has issued a series of subsequent requests for documents and information in connection with its investigation concerning the Health Savings Pass program and other pricing practices with respect to claims for reimbursement from the Texas Medicaid program.

In November 2012, the Company received a subpoena from the OIG requesting information concerning automatic refill programs used by pharmacies to refill prescriptions for customers. The Company cooperated and provided documents and other information in response to this request for information.

In 2013, Omnicare received subpoenas seeking information regarding Omnicare’s nationwide billing practices with regard to National Drug Code overrides and Omnicare’s May 2008 acquisition of Pure Service Pharmacy. In 2014, Omnicare received subpoenas seeking information regarding Omnicare’s Auto Label Verification system and Omnicare’s per diem arrangements. Omnicare has produced documents and provided information in response to these subpoenas and continues to cooperate in the investigations. In October 2016, the Department of Justice intervened for purposes of settling a qui tam complaint Ervin v. Omnicare which related to the subpoena seeking information with regard to National Drug Code overrides. In October 2016, the Company, the Department of Justice, OIG, and National Association of Medicaid Fraud Control Units finalized and signed settlement agreements for approximately $2.2 million plus interest. The Court unsealed and dismissed the False Claim Act claims of the complaint.

Omnicare reached an agreement regarding financial terms to resolve, for $1.5 million plus interest, the subpoena regarding the acquisition of Pure Service Pharmacy. These financial terms are contingent on approval by authorized officials at the Department of Justice, negotiation of terms of a settlement agreement, approval and releases from the OIG, the National Association of Medicaid Fraud Control Units, and the Department of Justice. While the Company believes that a final settlement will be reached, there can be no assurance that any final settlement agreement will be reached or as to the final terms of such settlement.
Omnicare reached an agreement regarding financial terms to resolve, for $8 million plus interest, the subpoena regarding Omnicare’s Auto Label Verification system. These financial terms are contingent on approval by authorized officials at the Department of Justice, negotiation of terms of a settlement agreement, approval and releases from the OIG, the National Association of Medicaid Fraud Control Units, and the Department of Justice. While the Company believes that a final settlement will be reached, there can be no assurance that any final settlement agreement will be reached or as to the final terms of such settlement.
On March 22, 2013, a qui tam complaint entitled United States et al., ex rel. Susan Ruscher v. Omnicare, Inc., et al., which had been filed under seal in the U.S. District Court for the Southern District of Texas, was unsealed by the court. The complaint was brought by Susan Ruscher as a private party qui tam relator on behalf of the federal government and several state governments alleging violations of the federal False Claims Act and analogous state laws based upon allegations that Omnicare’s practices relating to customer collections violated the Anti-Kickback Statute. In September 2015, the court granted summary judgment dismissing all claims against Omnicare and denied relator’s motion for summary judgment related to Omnicare’s counterclaims and thereafter, in October 2015, the court entered a

19



final judgment for Omnicare and stayed trial on the counterclaims pending an appeal from the relator. In October 2015, plaintiffs filed a notice of appeal in the United States Court of Appeals for the Fifth Circuit. In October 2016, the appellate court affirmed the district court’s grant of summary judgment dismissing all claims against Omnicare.

In March 2014, the Company received a subpoena from the United States Attorney’s Office for the District of Rhode Island, requesting documents and information concerning bona fide service fees and rebates received from pharmaceutical manufacturers in connection with certain drugs utilized under Part D of the Medicare Program, as well as the reporting of those fees and rebates to Part D plan sponsors. The Company has been cooperating with the government and providing documents and information in response to the subpoena.

The U.S. Department of Justice, through the U.S. Attorney’s Office for the Western District of Virginia, investigated whether Omnicare’s activities in connection with the agreements it had with the manufacturer of the pharmaceutical Depakote violated the False Claims Act or the Anti-Kickback Statute. Omnicare cooperated with this investigation and believes that it has complied with applicable laws and regulations with respect to this matter. In connection with this matter, on December 22, 2014, the U.S. Department of Justice filed a civil complaint-in-intervention in two qui tam complaints, entitled United States, et al., ex rel. Spetter v. Abbott Laboratories, Inc., Omnicare, Inc., and PharMerica Corp., and United States, et al., ex rel. McCoyd v. Abbott Laboratories, Omnicare, Inc., PharMerica Corp., and Miles White, alleging civil violations of the False Claims Act in connection with the manufacturer agreements described above. In July 2015, the parties filed a Joint Motion to Stay the Litigation stating that the parties have reached a proposed resolution of the monetary terms of a potential settlement agreement. In October 2016, the Company, the Department of Justice, OIG, and National Association of Medicaid Fraud Control Units finalized and signed a settlement agreement for approximately $28.1 million plus interest.

As part of Omnicare’s settlements with the Department of Justice, the Company entered into a corporate integrity agreement (“CIA”) with the OIG. The CIA has a term of five years commencing on October 11, 2016. The CIA imposes various compliance requirements relating to the provision of institutional pharmacy services. As part of entering into the CIA, OIG provided the Company with a release related to the previously described subpoena regarding Omnicare’s per diem arrangements. That release is more fully described in the CIA.
In May 2015, the Company received a subpoena from the OIG requesting information and documents concerning the Company’s automatic refill programs, adherence outreach programs, and pharmacy customer incentives, particularly in connection with claims for reimbursement made to the Minnesota Medicaid program. The Company has been cooperating with the investigation and providing information in response to the subpoena.

In July and September 2015, two related putative class actions, Corcoran, et al. v. CVS Health Corp., and Podgorny, et al. v. CVS Health Corp., were filed against the Company in the United States District Court in the Northern District of California and the Northern District of Illinois, respectively. The two cases have been consolidated in United States District Court in the Northern District of California. In March 2016, the Court granted in part and denied in part the Company’s first motion to dismiss. In July 2016, the Court granted in part and denied in part the Company's partial motion to dismiss the third amended complaint. Discovery is proceeding on the remaining allegations in the third amended complaint, which alleges that the plaintiffs overpaid for prescriptions for generic drugs filled at CVS pharmacies. The plaintiffs seek damages and injunctive relief under the consumer protection statutes and common laws of certain states and in October 2016 Plaintiffs moved for the certification of a class involving CVS customers from 11 states. In February 2016, two third-party payors filed a similar putative class action, Sheet Metal Workers Local No. 20 Welfare and Benefit Fund v. CVS Health Corp., against the Company in the United States District Court for the District of Rhode Island. The Company’s motion to dismiss remains pending. In August 2016, a similar complaint was filed by another third-party payor, Plumbers Welfare Fund, Local 130 v. CVS Health Corp., also in the United States District Court for the District of Rhode Island. The Company likewise intends to defend this action.

In September 2015, Omnicare was served with an administrative subpoena by the U.S. Drug Enforcement Agency (“DEA”). The subpoena seeks documents related to controlled substance policies, procedures, and practices at eight pharmacy locations from May 2012 to the present. The Company has been cooperating and providing documents in response to this administrative subpoena.

In October 2015, Omnicare received a Civil Investigative Demand from the United States Attorney’s Office for the Southern District of New York requesting information and documents concerning Omnicare’s cycle fill process for assisted living facilities. The Company has been cooperating with the government and providing documents and information in response to the Civil Investigative Demand.

20



In October 2015, the Company received from the U.S. Department of Justice a Civil Investigative Demand requesting documents and information in connection with a False Claims Act investigation concerning allegations that the Company submitted, or caused to be submitted, to the Medicare Part D program prescription drug event data that misrepresented true prices paid by the Company's PBM to pharmacies for drugs dispensed to Part D beneficiaries with prescription benefits administered by the Company’s PBM. The Company has been cooperating with the government and providing documents and information in response to the Civil Investigative Demand.

In November 2015, the United States District Court for the Eastern District of Pennsylvania unsealed a second amended qui tam complaint filed in September 2015, in an action captioned United States, et al., ex rel. Sally Schimelpfeinig and John Segura v. Dr. Reddy’s Laboratories Limited, et al. The U.S. Department of Justice declined to intervene in this action. The relators allege that the Company, Walgreens, Wal-Mart, and Dr. Reddy’s Laboratories violated the federal and various state False Claims Acts by dispensing prescriptions in unit dose packaging supplied by Dr. Reddy’s that was not compliant with the Consumer Product Safety Improvement Act and the Poison Preventive Packaging Act and thereby allegedly rendering the drugs misbranded under the Food, Drug & Cosmetic Act. The Company's motion to dismiss remains pending.

In February 2016, an ERISA class action lawsuit was filed against the Company, the Benefit Plans Committee of the Company, and Galliard Capital Management, Inc., in the United States District Court for the District of Rhode Island by Mary Barchock, Thomas Wasecko, and Stacy Weller, purportedly on behalf of the 401(k) Plan and the Employee Stock Ownership Plan of the Company (the “Plan”), and participants in the Plan. The complaint alleges that the defendants breached fiduciary duties owed to the plaintiffs and the Plan by investing too much of the Plan’s Stable Value Fund in short-term money market funds and cash management accounts. The Company has moved to dismiss the plaintiffs' amended complaint.

In April 2016, the Superior Court of the State of California (Sacramento) unsealed a first amended qui tam complaint filed in July 2013, in an action captioned State of California ex rel. Matthew Omlansky v. CVS Caremark Corporation, et al. The government has declined intervention in this case. The relator alleged that the Company submitted false claims for payment to California Medicaid in connection with reimbursement for drugs available through the Health Savings Pass program as well as certain other generic drugs. The Company's motion to dismiss the complaint was denied.

In June 2016, the Company entered into a settlement agreement with the U.S. Attorney’s Office for the District of Massachusetts, resolving alleged violations of the Controlled Substances Act (“CSA”). The Company paid a fine of $3.5 million in connection with the settlement in July 2016 which was previously fully reserved in the Company's financial statements. The Company is also undergoing several audits by the DEA Administrator and is in discussions with the DEA and the U.S. Attorney’s Office in several locations concerning allegations that the Company has violated certain requirements of the CSA.

In July 2016, the Company was served with a complaint filed on behalf of the State of Mississippi, in the Chancery Court of DeSoto County, Third Judicial District, alleging that CVS retail pharmacies in Mississippi submitted false claims for reimbursement to Mississippi Medicaid by not submitting as the pharmacy’s usual and customary price the price available to members of the CVS Health Savings Pass program. The Company has responded to the complaint, filed a counterclaim, and moved to transfer the case to circuit court.

The Company is also a party to other legal proceedings, government investigations, inquiries and audits, and has received and is cooperating with subpoenas or similar process from various governmental agencies requesting information, all arising in the normal course of its business, none of which is expected to be material to the Company. The Company can give no assurance, however, that its business, financial condition and results of operations will not be materially adversely affected, or that the Company will not be required to materially change its business practices, based on: (i) future enactment of new health care or other laws or regulations; (ii) the interpretation or application of existing laws or regulations as they may relate to the Company’s business, the pharmacy services, specialty pharmacy, retail pharmacy, long-term care pharmacy or retail clinic industries or to the health care industry generally; (iii) pending or future federal or state governmental investigations of the Company’s business or the pharmacy services, specialty pharmacy, retail pharmacy, long-term care pharmacy or retail clinic industry or of the health care industry generally; (iv) pending or future government enforcement actions against the Company; (v) adverse developments in any pending qui tam lawsuit against the Company, whether sealed or unsealed, or in any future qui tam lawsuit that may be filed against the Company; or (vi) adverse developments in pending or future legal proceedings against the Company or affecting the pharmacy services, specialty pharmacy, retail pharmacy, long-term care pharmacy or retail clinic industry or the health care industry generally.

21



Report of Independent Registered Public Accounting Firm
 
The Board of Directors and Shareholders
CVS Health Corporation:

We have reviewed the condensed consolidated balance sheet of CVS Health Corporation (the Company) as of September 30, 2016, the related condensed consolidated statements of income and comprehensive income for the three-month and nine-month periods ended September 30, 2016 and 2015, and the condensed consolidated statements of cash flows for the nine-month periods ended September 30, 2016 and 2015. These financial statements are the responsibility of the Company’s management.

We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

Based on our review, we are not aware of any material modifications that should be made to the condensed consolidated financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles.

We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of CVS Health Corporation as of December 31, 2015, and the related consolidated statements of income, comprehensive income, shareholders’ equity, and cash flows for the year then ended not presented herein, and we expressed an unqualified opinion on those consolidated financial statements in our report dated February 9, 2016. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of December 31, 2015, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.


 
 
 
/s/ Ernst & Young LLP
 
 
November 8, 2016
 
Boston, Massachusetts
 


22



Part I
 
Item 2
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
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 to complex challenges managing costs and care. 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 more than 9,600 retail pharmacies, more than 1,100 walk-in medical clinics, a leading pharmacy benefits manager with more than 80 million plan members, a dedicated senior pharmacy care business serving more than one million patients per year, and expanding specialty pharmacy services, we enable people, businesses and communities to manage health in more affordable, 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 Caremark®, to innovating how care is delivered to our patients with complex conditions through CVS SpecialtyTM, to improving pharmacy care for the senior community through Omnicare®, or by expanding access to high-quality, low-cost care at CVS MinuteClinicTM.

We have three reportable segments: Pharmacy Services, Retail/LTC and Corporate.
 
Pharmacy Services Segment
 
Our Pharmacy Services business generates revenue from a full range of pharmacy benefit management (“PBM”) solutions, 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 prescription drugs through our mail order pharmacies, specialty pharmacies, long-term care pharmacies and a 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 who require complex and expensive drug therapies. Our specialty pharmacy business includes mail order and retail specialty pharmacies that operate under the CVS Caremark®, CarePlus CVS Pharmacy®, Navarro® Health Services and Advanced Care ScriptsTM names. The Pharmacy Services Segment also provides health management programs, which include integrated disease management for 17 conditions, through our Accordant® rare disease management offering. In addition, through our SilverScript Insurance Company subsidiary, we are a national provider of drug benefits to eligible beneficiaries under the federal government’s Medicare Part D program. The Pharmacy Services Segment operates under the CVS Caremark® Pharmacy Services, Caremark®, CVS Caremark®, CarePlus CVS Pharmacy®, Accordant®, SilverScript®, Coram®, CVS SpecialtyTM, NovoLogix®, Navarro® Health Services and Advanced Care ScriptsTM names. As of September 30, 2016, the Pharmacy Services Segment operated 23 retail specialty pharmacy stores, 13 specialty mail order pharmacies, four mail order dispensing pharmacies, and 85 branches for infusion and enteral services, including approximately 74 ambulatory infusion suites and five centers of excellence, located in 41 states, Puerto Rico and the District of Columbia.
 





23



Retail/LTC Segment
 
Our Retail/LTC 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 Onofre TM retail stores and online through CVS.com®, Navarro.comTM and Onofre.com.brTM. The Retail/LTC Segment also includes providing the distribution of pharmaceuticals, related pharmacy consulting and other ancillary services to chronic care facilities and other care settings, as well as commercialization services which are provided under the name RxCrossroads ®. Our Retail/LTC Segment derives the majority of its revenues through the sale of prescription drugs, which are dispensed by our more than 30,000 pharmacists. Our Retail/LTC Segment also provides health care services through our CVS MinuteClinic offering. 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 September 30, 2016, our Retail/LTC Segment included 9,694 retail stores (of which 9,638 were either the Company's retail stores that operated a pharmacy, or pharmacies located within Target stores) located in 49 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, 34 onsite pharmacies primarily operating under the CarePlus CVS Pharmacy®, CarePlus® and CVS Pharmacy® names, and 1,136 retail health care clinics operating under the MinuteClinic® name (of which 1,129 were located in CVS Pharmacy and Target stores), and our online retail websites, CVS.com®, Navarro.comTM and Onofre.com.brTM. LTC operations are comprised of 151 spoke pharmacies that primarily handle new prescription orders, of which 32 are also hub pharmacies that use proprietary automation to support spoke pharmacies with refill prescriptions. LTC operates primarily under the Omnicare® and NeighborCare® names.

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, information technology and finance departments.

Results of Operations
 
The following discussion explains the material changes in our results of operations for the three and nine months ended September 30, 2016 and 2015, and the significant developments affecting our financial condition since December 31, 2015. We strongly recommend that you read our audited consolidated financial statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations included as Exhibit 13 to our 2015 Form 10-K along with this report.


24



Summary of the Condensed Consolidated Financial Results:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
In millions
2016
 
2015
 
2016
 
2015
 
 
 
 
 
 
 
 
Net revenues
$
44,615

 
$
38,644

 
$
131,555

 
$
112,144

Cost of revenues
37,123

 
31,983

 
110,304

 
92,917

Gross profit
7,492

 
6,661

 
21,251

 
19,227

Operating expenses
4,675

 
4,330

 
13,908

 
12,502

Operating profit
2,817

 
2,331

 
7,343

 
6,725

Interest expense, net
253

 
261

 
816

 
562

Loss on early extinguishment of debt
101

 

 
643

 

Income before income tax provision
2,463

 
2,070

 
5,884

 
6,163

Income tax provision
921

 
833

 
2,271

 
2,433

Income from continuing operations
1,542

 
1,237

 
3,613

 
3,730

Income (loss) from discontinued operations, net of tax
(1
)
 
10

 
(1
)
 
10

Net income
1,541

 
1,247

 
3,612

 
3,740

Net income attributable to noncontrolling interest
(1
)
 
(1
)
 
(2
)
 
(1
)
Net income attributable to CVS Health
$
1,540

 
$
1,246

 
$
3,610

 
$
3,739

 
Net Revenues
 
Net revenues increased approximately $6.0 billion, or 15.5%, and $19.4 billion, or 17.3%, in the three and nine months ended September 30, 2016, as compared to the prior year. Part of the increase was driven by the acquisition of Omnicare in August 2015, which positively affected both segments, and the pharmacies and clinics of Target in December 2015, which positively affected the Retail/LTC Segment. The increase in the Pharmacy Services Segment was also driven by pharmacy network claim volume growth primarily attributable to net new business and growth in specialty pharmacy. The increase in the Retail/LTC Segment was also driven by increased pharmacy same store sales. Net revenues in both segments were negatively impacted by an increase in generic dispensing rates, as well as continued price compression in the Pharmacy Services Segment and reimbursement pressure in the Retail/LTC Segment. Generic prescription drugs typically have a lower selling price than brand name prescription drugs.
 
Please see the section entitled “Segment Analysis” below for additional information regarding net revenues.
 
Gross Profit
 
Gross profit dollars increased $831 million, or 12.5%, and $2.0 billion, or 10.5% in the three and nine months ended September 30, 2016 as compared to the prior year. Gross profit as a percentage of net revenues decreased approximately 45 basis points in the three months ended September 30, 2016 to 16.8%, as compared to the prior year. Gross profit as a percentage of net revenues decreased approximately 100 basis points in the nine months ended September 30, 2016 to 16.2%, as compared to the prior year. The decrease in gross profit as a percentage of net revenues was driven by a change in the mix of business within both segments, as well as continued price compression in the Pharmacy Services Segment and reimbursement pressure in the Retail/LTC Segment. Gross profit dollars for the three and nine months ended September 30, 2016, were positively affected by an increase in generic dispensing rates, an increase in pharmacy network claims and specialty growth in the Pharmacy Services Segment compared to the prior year, as well as volume from the acquisitions of Omnicare and the pharmacies and clinics of Target.
 
Please see the section entitled “Segment Analysis” below for additional information regarding gross profit.







25



Operating Expenses
 
Operating expenses increased $345 million, or 8.0%, and $1.4 billion, or 11.3%, in the three and nine months ended September 30, 2016, respectively, as compared to the prior year. Operating expenses as a percentage of net revenues decreased approximately 75 basis points to 10.5% and 60 basis points to 10.6% in the three and nine months ended September 30, 2016, respectively, as compared to 11.2% and 11.1% in the three and nine months ended September 30, 2015, respectively. The increase in operating expense dollars in the three and nine months ended September 30, 2016, was primarily due to the addition of Omnicare, as well as incremental store operating costs associated with operating more stores, including the pharmacies and clinics of Target, in our Retail/LTC Segment. The improvement in operating expenses as a percentage of net revenues for the three and nine months ended September 30, 2016 was primarily due to expense leverage from net revenue growth.

Please see the section entitled “Segment Analysis” below for additional information regarding operating expenses.

Interest Expense, net
 
Interest expense, net, decreased $8 million and increased $254 million in the three and nine months ended September 30, 2016, respectively, as compared to the prior year. The decrease in the three months ended was primarily due to the amortization of bridge facility fees in the three months ended September 30, 2015. The increase in the nine months ended September 30, 2016, was primarily due to the $15 billion debt issuance in July 2015, the proceeds of which were used to fund the acquisitions of Omnicare and the pharmacies and clinics of Target, and the debt assumed through the Omnicare acquisition.
 
For additional information on our financing activities, please see the “Liquidity and Capital Resources” section below.

Loss on Early Extinguishment of Debt
 
During the three months ended September 30, 2016, the Company exercised its option to redeem outstanding senior notes of approximately $1.1 billion aggregate principal amount (see Note 6 to the condensed consolidated financial statements). The Company paid a premium of $97 million in excess of the debt principal in connection with the purchase of the senior notes and wrote off $4 million of unamortized deferred financing costs, for a total loss on the early extinguishment of debt of $101 million.

During the nine months ended September 30, 2016, the Company purchased approximately $4.2 billion aggregate principal amount of certain of its senior notes pursuant to its tender offer for such senior notes and option to redeem the outstanding senior notes (see Note 6 to the condensed consolidated financial statements). The Company paid a premium of $583 million in excess of the debt principal, wrote off $54 million of unamortized deferred financing costs and incurred $6 million in fees, for a total loss on the early extinguishment of debt of $643 million.

Income Tax Provision
 
Our effective income tax rate was 37.4% and 38.6% for the three and nine months ended September 30, 2016, compared to 40.2% and 39.5% for the three and nine months ended September 30, 2015. The difference in the effective income tax rate for the three and nine months ended September 30, 2016 was primarily due to the resolution for $49 million of income tax matters in open tax years through 2012, as well as other permanent items.

Income (Loss) from Discontinued Operations

The income from discontinued operations for the three and nine months ended September 30, 2015 of $10 million was primarily due to a change in the estimated lease obligation associated with guarantees of store lease obligations of Linens ‘n Things, a former subsidiary of the Company that became insolvent subsequent to its disposition. The $1 million loss from discontinued operations for the three and nine months ended September 30, 2016 primarily relates to the accretion of interest on the Linens ‘n Things store lease obligations.


26



Segment Analysis
 
We evaluate the performance of our Pharmacy Services and Retail/LTC segments based on net revenue, gross profit and operating profit before the effect of nonrecurring charges and gains and certain intersegment activities. We evaluate the performance of our Corporate Segment based on operating expenses before the effect of nonrecurring charges and gains and certain intersegment activities. The following is a reconciliation of our segments to the condensed consolidated financial statements:
In millions
Pharmacy
Services
Segment(1)
 
Retail/LTC
Segment
 
Corporate
Segment
 
Intersegment
Eliminations(2)
 
Consolidated
Totals
Three Months Ended
 
 
 
 
 
 
 
 
 
September 30, 2016:
 
 
 
 
 
 
 
 
 
Net revenues
$
30,429

 
$
20,143

 
$

 
$
(5,957
)
 
$
44,615

Gross profit(3)
1,797

 
5,893

 

 
(198
)
 
7,492

Operating profit (loss)(4)(5)
1,458

 
1,773

 
(229
)
 
(185
)
 
2,817

September 30, 2015:
 

 
 

 
 

 
 

 
 

Net revenues
25,528

 
17,912

 

 
(4,796
)
 
38,644

Gross profit
1,468

 
5,373

 

 
(180
)
 
6,661

Operating profit (loss)(4)(5)
1,162

 
1,643

 
(309
)
 
(165
)
 
2,331

Nine Months Ended
 

 
 

 
 

 
 

 
 

September 30, 2016:
 

 
 

 
 

 
 

 
 

Net revenues
88,704

 
60,253

 

 
(17,402
)
 
131,555

Gross profit(3)
4,266

 
17,560

 

 
(575
)
 
21,251

Operating profit (loss)(4)(5)
3,278

 
5,255

 
(661
)
 
(529
)
 
7,343

September 30, 2015:
 

 
 

 
 

 
 

 
 

Net revenues
73,849

 
52,105

 

 
(13,810
)
 
112,144

Gross profit
3,735

 
15,990

 

 
(498
)
 
19,227

Operating profit (loss)(4)(5)
2,837

 
5,050

 
(712
)
 
(450
)
 
6,725

 
(1) 
Net revenues of the Pharmacy Services Segment include approximately $2.5 billion and $2.1 billion of retail co-payments for the three months ended September 30, 2016 and 2015, respectively, as well as $8.1 billion and $6.8 billion of retail co-payments for the nine months ended September 30, 2016 and 2015, respectively.
(2)
Intersegment eliminations relate to intersegment revenue generating activities that occur between the Pharmacy Services Segment and the Retail/LTC Segment. These occur in the following ways: when members of Pharmacy Services Segment clients (“members”) fill prescriptions at our retail stores to purchase covered products, when members enrolled in programs such as Maintenance Choice ® elect to pick up maintenance prescriptions at one of our retail stores instead of receiving them through the mail, or when members have prescriptions filled at our long-term care pharmacies. When these occur, both the Pharmacy Services and Retail/LTC segments record the revenues, gross profit and operating profit on a standalone basis.
(3)
The Retail/LTC Segment gross profit for the three and nine months ended September 30, 2016 includes $5 million and $15 million, respectively, of acquisition-related integration costs. The integration costs are related to the acquisitions of Omnicare and the pharmacies and clinics of Target.
(4)
The Retail/LTC Segment operating profit for the three and nine months ended September 30, 2016 includes $52 million and $194 million, respectively, of acquisition-related integration costs. The Retail/LTC Segment operating profit for the three and nine months ended September 30, 2015 includes $12 million of acquisition-related integration costs. The integration costs are related to the acquisitions of Omnicare and the pharmacies and clinics of Target.
(5)
The Corporate Segment operating loss for the three and nine months ended September 30, 2016 includes $13 million of integration costs. The Corporate Segment operating loss for the three and nine months ended September 30, 2015 includes $115 million and $135 million, respectively, of acquisition-related transaction and integration costs.



27



Pharmacy Services Segment
 
The following table summarizes our Pharmacy Services Segment’s performance for the respective periods:
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
In millions
2016
 
2015
 
2016
 
2015
 
 
 
 
 
 
 
 
Net revenues
$
30,429

 
$
25,528

 
$
88,704

 
$
73,849

Gross profit
1,797

 
1,468

 
4,266

 
3,735

Gross profit % of net revenues
5.9
%
 
5.8
%
 
4.8
%
 
5.1
%
Operating expenses
339

 
306

 
988

 
898

Operating expense % of net revenues
1.1
%
 
1.2
%
 
1.1
%
 
1.2
%
Operating profit
1,458

 
1,162

 
3,278

 
2,837

Operating profit % of net revenues
4.8
%
 
4.6
%
 
3.7
%
 
3.8
%
Net revenues:
 

 
 

 
 

 
 

Mail choice(1)
$
10,872

 
$
9,735

 
$
31,668

 
$
27,592

Pharmacy network(2)
19,469

 
15,716

 
56,783

 
46,043

Other
88

 
77

 
253

 
214

Pharmacy claims processed:
 

 
 

 


 
 
Total
305.0

 
251.0

 
912.5

 
752.3

Mail choice(1)
22.4

 
21.9

 
66.3

 
63.5

Pharmacy network(2)
282.6

 
229.1

 
846.2

 
688.8

Generic dispensing rate:
 
 
 
 
 

 
 

Total
85.4
%
 
83.8
%
 
85.4
%
 
83.7
%
Mail choice(1)
78.5
%
 
76.5
%
 
78.0
%
 
76.3
%
Pharmacy network(2)
86.0
%
 
84.5
%
 
85.9
%
 
84.4
%
Mail choice penetration rate
18.1
%
 
21.1
%
 
18.0
%
 
20.5
%
 
(1) 
Mail choice is defined as claims filled at a Pharmacy Services mail facility, which includes specialty mail claims inclusive of Specialty Connect® claims filled at retail, as well as prescriptions filled at our retail stores under the Maintenance Choice® program.
(2)
Pharmacy network net revenues, claims processed and generic dispensing rates do not include Maintenance Choice, which are included within the mail choice category. Pharmacy network is defined as claims filled at retail and specialty retail pharmacies, including our retail stores and long-term care pharmacies, but excluding Maintenance Choice activity.

Net Revenues
 
Net revenues in our Pharmacy Services Segment increased $4.9 billion, or 19.2%, to $30.4 billion in the three months ended September 30, 2016, as compared to the prior year. Net revenues increased approximately $14.9 billion, or 20.1%, to $88.7 billion in the nine months ended September 30, 2016, as compared to the prior year. The increase is primarily due to increased pharmacy network claims, growth in specialty pharmacy, including the addition of Advanced Care Scripts ("ACS") through the acquisition of Omnicare, and inflation, partially offset by increased generic dispensing and price compression. As you review our Pharmacy Services Segment’s performance in this area, we believe you should consider the following important information about the business for the three and nine months ended September 30, 2016:
 
In the three months ended September 30, 2016, our mail choice claims processed increased 2.5% to 22.4 million claims compared to 21.9 million claims in the prior year. In the nine months ended September 30, 2016, our mail choice claims processed increased 4.3% to 66.3 million claims compared to 63.5 million claims in the prior year. The increase in mail choice claims was primarily driven by the continuing adoption of our Maintenance Choice offerings.
 
Our average revenue per mail choice claim increased by 8.9% and 10.0% in the three and nine months ended September 30, 2016, respectively, compared to the prior year. This increase was primarily due to growth in specialty pharmacy.
 


28



In the three months ended September 30, 2016, our pharmacy network claims processed increased 23.3% to 282.6 million claims compared to 229.1 million claims in the prior year. In the nine months ended September 30, 2016, our pharmacy network claims processed increased 22.9% to 846.2 million claims compared to 688.8 million claims in the prior year. The increase in the pharmacy network claim volume was primarily due to net new business.

Our average revenue per pharmacy network claim processed in both the three and nine months ended September 30, 2016 remained relatively flat compared to the prior year.

For the three months ended September 30, 2016, our mail choice generic dispensing rate increased to 78.5%, compared to 76.5% in the prior year. Our pharmacy network generic dispensing rate increased to 86.0%, compared to 84.5% in the prior year. For the nine months ended September 30, 2016, our mail choice generic dispensing rate increased to 78.0% in the nine months ended September 30, 2016, compared to 76.3% in the prior year. Our pharmacy network generic dispensing rate increased to 85.9%, compared to 84.4% in the prior year. These continued increases in mail choice and pharmacy network generic dispensing rates were primarily due to the impact of new generic drug introductions, and our continuous efforts to encourage plan members to use generic drugs when they are available and clinically appropriate. 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 brand and generic drug introductions and our success at encouraging plan members to utilize generic drugs when they are available and clinically appropriate.

Gross Profit
 
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, specialty mail and specialty retail pharmacies or indirectly through our retail pharmacy networks, (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 $329 million, or 22.4%, to approximately $1.8 billion in the three months ended September 30, 2016, as compared to the prior year. Gross profit increased $531 million, or 14.2%, to approximately $4.3 billion in the nine months ended September 30, 2016, as compared to the prior year. The increase in gross profit dollars was primarily due to growth in specialty pharmacy, growth in Medicare Part D lives, higher generic dispensing and favorable purchasing economics, partially offset by price compression. Gross profit as a percentage of net revenues increased slightly to 5.9% in the three months ended September 30, 2016, compared to 5.8% in the prior year. The slight increase in gross profit as a percentage of net revenues for the three months ended September 30, 2016 was primarily due to favorable generic dispensing. Gross profit as a percentage of net revenues decreased to 4.8% in the nine months ended September 30, 2016, compared to 5.1% in the prior year. The decrease in gross profit as a percentage of net revenues was primarily due to changes in the mix of our business and continued price compression, partially offset by favorable generic dispensing and purchasing economics.

As you review our Pharmacy Services Segment’s performance in this area, we believe you should consider the following important information about the business for the three and nine months ended September 30, 2016:
 
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 continue to have an impact on our gross profit dollars and gross profit as a percentage of net revenues. 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 limited our ability to offer plan sponsors pricing that includes retail network “differential” or “spread,” and 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 by patients of generic drugs has generally improved our gross profit margins but has also 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.

Our gross profit as a percentage of revenues benefited from the increase in our total generic dispensing rate, which increased to 85.4% in both the three and nine months ended September 30, 2016 compared to our generic dispensing rate of 83.8% and 83.7% in the three and nine months ended September 30, 2015, respectively. This increase was primarily due to new generic drug introductions and our continual efforts to encourage plan members to use clinically

29



appropriate generic drugs when they are available. We expect the trend in generic introductions to continue, albeit at a slower pace.

Operating Expenses
 
Operating expenses in our Pharmacy Services Segment include selling, general and administrative expenses; depreciation and amortization related to selling, general and administrative activities; and expenses related to specialty retail pharmacies, which include store and administrative payroll, employee benefits and occupancy costs.
 
Operating expenses increased $33 million to $339 million, or 1.1% as a percentage of net revenues, in the three months ended September 30, 2016, compared to $306 million, or 1.2% as a percentage of net revenues, in the prior year. Operating expenses increased $90 million to $988 million, or 1.1% as a percentage of revenues, in the nine months ended September 30, 2016, compared to $898 million, or 1.2% as a percentage of net revenues, in the prior year. The improvement in operating expenses as a percentage of net revenues for the three and nine months ended September 30, 2016 was primarily driven by expense leverage from our revenue growth. The increase in operating expense dollars for the three and nine months ended September 30, 2016 was primarily due to the addition of ACS and increased costs associated with the growth of our business.

Retail/LTC Segment
 
The following table summarizes our Retail/LTC Segment’s performance for the respective periods:

 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
In millions
2016
 
2015
 
2016
 
2015
 
 
 
 
 
 
 
 
Net revenues
$
20,143

 
$
17,912

 
$
60,253

 
$
52,105

Gross profit(1)
5,893

 
5,373

 
17,560

 
15,990

Gross profit % of net revenues
29.3
 %
 
30.0
 %
 
29.1
 %
 
30.7
 %
Operating expenses(2)
4,120

 
3,730

 
12,305

 
10,940

Operating expense % of net revenues
20.5
 %
 
20.8
 %
 
20.4
 %
 
21.0
 %
Operating profit
1,773

 
1,643

 
5,255

 
5,050

Operating profit % of net revenues
8.8
 %
 
9.2
 %
 
8.7
 %

9.7
 %
Prescriptions filled (90 Day = 3 Rx)(3)
302.9

 
258.7

 
908.9

 
744.1

Net revenue increase (decrease):
 
 
 

 
 
 
 

Total
12.5
 %
 
6.9
 %
 
15.6
 %
 
4.0
 %
Pharmacy
15.3
 %
 
10.4
 %
 
19.9
 %
 
7.0
 %
Front store
0.8
 %
 
(2.4
)%
 
0.9
 %
 
(3.7
)%
Total prescription volume (90 Day = 3 Rx)(3)
17.1
 %
 
10.7
 %
 
22.1
 %
 
7.7
 %
Same store increase (decrease)(4):
 
 
 

 
 
 
 
Total sales
2.3
 %
 
1.7
 %
 
2.8
 %
 
1.1
 %
Pharmacy sales
3.4
 %
 
4.6
 %
 
4.3
 %
 
4.3
 %
Front store sales
(1.0
)%
 
(5.8
)%
 
(1.0
)%
 
(6.6
)%
Prescription volume (90 Day = 3 Rx)(3)
3.0
 %
 
4.4
 %
 
4.1
 %
 
4.8
 %
Generic dispensing rate
85.8
 %
 
84.8
 %
 
85.8
 %
 
84.7
 %
Pharmacy % of total revenues
76.0
 %
 
74.1
 %
 
75.2
 %
 
72.5
 %
 
(1)
Gross profit for the three and nine months ended September 30, 2016 includes $5 million and $15 million, respectively, of acquisition-related integration costs related to the acquisitions of Omnicare and the pharmacies and clinics of Target.
(2)
Operating expenses for the three and nine months ended September 30, 2016 includes $47 million and $179 million, respectively, of acquisition-related integration costs related to the acquisitions of Omnicare and the pharmacies and clinics of Target. Operating expenses for the three and nine months ended September 30, 2015 includes $12 million of acquisition-related integration costs related to the acquisitions of Omnicare and the pharmacies and clinics of Target.
(3)
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.
(4)
Same store sales and prescriptions exclude revenues from MinuteClinic, and revenue and prescriptions from stores in Brazil, LTC operations and from commercialization services.


30



As of September 30, 2016, we operated 9,694 retail stores, compared to 7,911 retail drugstores as of September 30, 2015. The increase in the number of retail stores is due to the acquisition of the pharmacies of Target, as well as growth of our stand-alone retail stores.

Net Revenues
 
Net revenues in our Retail/LTC Segment increased $2.2 billion, or 12.5%, to approximately $20.1 billion in the three months ended September 30, 2016, as compared to the prior year. Net revenues increased $8.2 billion, or 15.6%, to approximately $60.3 billion in the nine months ended September 30, 2016, as compared to the year. As you review our Retail/LTC Segment’s performance in this area, we believe you should consider the following important information about the business for the three and nine months ended September 30, 2016:
 
Net revenues were positively affected by the addition of LTC which was acquired in August 2015. Net revenues from new stores, including the locations within Target stores, acquired in December 2015, accounted for approximately 680 and 690 basis points of the increase in our total net revenues for the three and nine months ended September 30, 2016, respectively.

Pharmacy same store prescription volumes and revenues were negatively affected in the three and nine months ended September 30, 2016 by slowing prescription growth in the overall market, partially driven by a soft seasonal business during the three months ended September 30, 2016.
.
Front store same store sales decreased by 1.0% for both the three and nine months ended September 30, 2016, compared to the prior year as the result of continued softer customer traffic, partially offset by an increase in basket size. For the nine months ended September 30, 2016, front store same store sales increased by approximately 40 basis points due to an additional day in 2016 related to leap year.

Pharmacy same store sales increased 3.4% and 4.3% for the three and nine months ended September 30, 2016, respectively, as compared to the prior year. The increase in pharmacy same store sales was primarily due to the increase in same store script growth of 3.0% and 4.1% for the three and nine months ended September 30, 2016, respectively, as well as approximately 40 basis points due to an additional day in 2016 related to leap year for the nine months ended September 30, 2016. We expect script growth to be negatively impacted for the next several quarters by recently announced restricted network relationships that exclude CVS Pharmacy.

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 declined by approximately 340 and 350 basis points for the three and nine months ended September 30, 2016, respectively, due to recent generic introductions. The generic dispensing rate grew to 85.8% for both the three and nine months ended September 30, 2016, compared to 84.8% and 84.7%, respectively, in the prior year. In addition, our pharmacy revenue growth has also been affected by the mix of drugs sold, continued reimbursement pressure and the lack of significant new brand name drug introductions.

Pharmacy revenue continued to benefit from the 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 as “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 (“ACA”). In addition, the increased use of pharmaceuticals as the first line of defense for individual health care contributed to the growing demand for pharmacy services.

Gross Profit
 
Gross profit in our Retail/LTC Segment includes net revenues less the cost of merchandise sold in the period and the related purchasing costs, warehousing costs, delivery costs and actual and estimated inventory losses.

31




Gross profit increased $521 million, or 9.7%, to $5.9 billion in the three months ended September 30, 2016, as compared to the prior year. Gross profit increased $1.6 billion or 9.8%, to $17.6 billion in the nine months ended September 30, 2016, as compared to the prior year. Gross profit as a percentage of net revenues decreased to 29.3% and 29.1% in the three and nine months ended September 30, 2016, respectively, compared to 30.0% and 30.7% in the three and nine months ended September 30, 2015, respectively.

The increase in gross profit dollars was primarily driven by the addition of the pharmacies and clinics of Target and LTC, as well as same store sales, partially offset by continued reimbursement pressure. The decrease in gross profit as a percentage of net revenues was primarily driven by a decline in pharmacy margins due to continued reimbursement pressure and the mix effect of the acquisitions of the pharmacies and clinics of Target and Omnicare, partially offset by increased front store margins. Front store margins increased due to changes in the mix of products sold and efforts to rationalize promotional strategies.
 
As you review our Retail/LTC Segment’s performance in this area, we believe you should consider the following important information about the business for the three and nine months ended September 30, 2016:
  
Front store revenues as a percentage of net revenues for the three and nine months ended September 30, 2016 was 22.7% and 23.5%, respectively, compared to 25.3% and 26.9% in the prior year, respectively. On average, our gross profit on front store revenues is higher than our gross profit on pharmacy revenues. Pharmacy revenues as a percentage of total revenues increased approximately 190 and 270 basis points in the three and nine months ended September 30, 2016, compared to the prior year. This was due to pharmacy revenues growing faster than front store revenues because of the addition of the pharmacies of Target and LTC as well as a shift in the base business. The mix effect from a higher proportion of pharmacy sales had a negative effect on our overall gross profit as a percentage of net revenues for the three and nine months ended September 30, 2016, compared to the prior year. This negative effect was partially offset by an increase in generic drugs dispensed, an improved front store gross margin rate, which includes efforts to rationalize promotional strategies.

During the three and nine months ended September 30, 2016, our front store gross profit as a percentage of net revenues increased compared to the same period in the prior year. The increase is primarily related to a change in the mix of products sold, including store brand products, as well as efforts to rationalize promotional strategies.

Our pharmacy gross profit rates have been adversely affected by the efforts of managed care organizations, PBMs and governmental and other third-party payors to reduce their prescription drug costs, including the use of restrictive networks, as well as changes in the mix of our business within the pharmacy portion of the Retail/LTC Segment. In the event the reimbursement pressure accelerates, 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 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.

Operating Expenses
 
Operating expenses in our Retail/LTC Segment include payroll and employee benefits, occupancy costs, selling expenses, advertising expenses, depreciation and amortization expense and certain administrative expenses.
 
Operating expenses increased $391 million to $4.1 billion, or 20.5% as a percentage of net revenues, in the three months ended September 30, 2016, as compared to $3.7 billion, or 20.8% as a percentage of net revenues, in the prior year. Operating expenses increased $1.4 billion to $12.3 billion, or 20.4% as a percentage of net revenues, in the nine months ended September 30, 2016, as compared to $10.9 billion, or 21.0% as a percentage of net revenues, in the prior year. The increase in operating expense dollars for the three and nine months ended September 30, 2016, was primarily due to the addition of the pharmacies and clinics within Target stores and LTC, including acquisition-related integration costs of $47 million and $179 million, respectively, and incremental store operating costs associated with operating more stores. Operating expenses as a percentage of net revenues for the three and nine months ended September 30, 2016 improved primarily due to expense leverage from net revenue growth.




32



Operating expenses for the nine months ended September 30, 2016, includes a gain from a legal settlement with certain credit card companies of $32 million. In April 2016, the Retail/LTC Segment made a charitable contribution of $32 million to the CVS Foundation to fund future giving. The CVS 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 nine months ended September 30, 2016.
 
Corporate Segment
 
Operating Expenses
 
Operating expenses in our Corporate Segment include expenses from the Company’s executive management, corporate relations, legal, compliance, human resources, information technology and finance departments. Operating expenses decreased $80 million, or 26.0%, to $229 million and decreased $51 million, or 7.3%, to $661 million in the three months and nine months ended September 30, 2016, respectively, as compared to the prior year. The decrease in operating expenses for the three months and nine months ended September 30, 2016 was primarily due to acquisition-related transaction and integration costs associated with the acquisition of Omnicare that occurred in August 2015, and the acquisition of the pharmacies and clinics of Target that occurred in December 2015.

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.
 
The change in cash and cash equivalents is as follows:
 
 
Nine Months Ended September 30,
In millions
 
2016
 
2015
Net cash provided by operating activities
 
$
7,948

 
$
4,841

Net cash used in investing activities
 
(1,652
)
 
(11,000
)
Net cash provided by (used in) financing activities
 
(6,568
)
 
6,576

Effect of exchange rate changes on cash and cash equivalents
 
2

 
(8
)
Net increase (decrease) in cash and cash equivalents
 
$
(270
)
 
$
409


Net cash provided by operating activities was approximately $7.9 billion in the nine months ended September 30, 2016, compared to $4.8 billion in the nine months ended September 30, 2015. The $3.1 billion increase in cash provided by operating activities is primarily due to the timing of payments for our Medicare Part D operations.
 
Net cash used in investing activities was approximately $1.7 billion in the nine months ended September 30, 2016, compared to $11.0 billion in the nine months ended September 30, 2015. The decrease in cash used in investing activities is primarily due to the $9.6 billion in cash consideration paid for the acquisition of Omnicare in August 2015.
 
Net cash used in financing activities was $6.6 billion in the nine months ended September 30, 2016, compared to net cash provided by financing activities of $6.6 billion in the nine months ended September 30, 2015. The cash used in financing activities increased $13.1 billion primarily due to lower long-term borrowings and higher net repayments of short and long-term debt in 2016.

As of September 30, 2016, the Company had the following outstanding share repurchase program that was authorized by the Company’s Board of Directors:

33



In billions
 
 
 
 
 
 
Authorization Date
Authorized
Remaining
December 15, 2014 (“2014 Repurchase Program”)
 
$
10.0

 
 
$
3.7

 

On November 2, 2016, the Company's Board of Directors authorized a new share repurchase program for up to $15 billion of outstanding common stock (the “2016 Repurchase Program”). The 2014 and 2016 Repurchase Programs, which were effective immediately, permit the Company to effect repurchases from time to time through a combination of open market repurchases, privately negotiated transactions, accelerated share repurchase transactions, and/or other derivative transactions. The repurchase programs may be modified or terminated by the Board of Directors at any time.

During the nine months ended September 30, 2016, the Company repurchased an aggregate of approximately 41.4 million shares of common stock for approximately $4 billion pursuant to the 2014 Repurchase Program which includes the accelerated share repurchase agreement (“ASR”) described below.

Pursuant to the authorization under the 2014 Repurchase Program, effective December 11, 2015, the Company entered into a $725 million fixed dollar ASR with Barclays Bank PLC (“Barclays”). Upon payment of the $725 million purchase price on December 14, 2015, the Company received a number of shares of its common stock equal to 80% of the $725 million notional amount of the ASR or approximately 6.2 million shares. The initial 6.2 million shares of common stock delivered to the Company by Barclays were placed into treasury stock in December 2015. The ASR was accounted for as an initial treasury stock transaction for $580 million and a forward contract for $145 million. The forward contract was classified as an equity instrument and was recorded within capital surplus on the consolidated balance sheet. On January 28, 2016, the Company received 1.4 million shares of common stock, representing the remaining 20% of the $725 million notional amount of the ASR, thereby concluding the ASR. The remaining 1.4 million shares of common stock delivered to the Company by Barclays were placed into treasury stock in January 2016 and the forward contract was reclassified from capital surplus to treasury stock.

At the time they were received, the initial and final receipt of shares resulted in an immediate reduction of the outstanding shares used to calculate the weighted average common shares outstanding for basic and diluted net earnings per share.

We had $340 million of commercial paper outstanding at a weighted average interest rate of 0.62% as of September 30, 2016. In connection with our commercial paper program, we maintain a $1.0 billion, five-year unsecured back-up credit facility that expires on May 23, 2018, a $1.25 billion, five-year unsecured back-up credit facility that expires on July 24, 2019, and a $1.25 billion, five-year unsecured back-up credit facility that expires on July 1, 2020. 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 September 30, 2016, there were no borrowings outstanding under the back-up credit facilities.

Our back-up credit facilities and unsecured senior notes contain customary restrictive financial and operating covenants. These covenants do not include a requirement for the acceleration of our debt maturities in the event of a downgrade in our credit rating. We do not believe the restrictions contained in these covenants materially affect our financial or operating flexibility.

On May 16, 2016, the Company issued $1.75 billion aggregate principal amount of 2.125% unsecured senior notes due June 1, 2021 and $1.75 billion aggregate principal amount of 2.875% unsecured senior notes due June 1, 2026 (collectively, the "2016 Notes") for total proceeds of approximately $3.5 billion, net of discounts and underwriting fees. The 2016 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 2016 Notes were us