Management's Discussion and Analysis of Financial Condition and Results of
Operations
We strongly recommend that you read our audited consolidated financial
statements and footnotes found on pages 22 through 38 of this Annual Report
along with this important discussion and analysis.
- --------------------------------------------------------------------------------
Bar Graph:
1998 1997 1996
Net Sales (In billions) ($15.3, $13.7, $11.8)
Operating Profit Percentage* (6.2%, 5.7%, 5.1%)
Diluted Earning Per Share** ($1.26, $1.05, $0.78)
- --------------------------------------------------------------------------------
* Percent of net sales before non-recurring charges and gain.
** Earnings from continuing operations before non-recurring charges and gains.
Introduction
1998 was an excellent year for CVS. We are pleased to report that despite the
significant challenges our company faced in integrating the operations of Arbor
Drugs, Inc. and Revco D.S., Inc., we achieved another record year in terms of
net sales, operating profit and diluted earnings per share, excluding the effect
of the non-recurring charges and gain.
Our strong performance in 1998 translated into a 72.7% return to our
shareholders. This compares to a total return of 18.1% for the Dow Jones
Industrial Average and 28.6% for the S&P 500. While we are extremely proud of
this accomplishment, we cannot guarantee that our future performance will result
in similar returns to shareholders. Our total market capitalization grew to more
than $21 billion at December 31, 1998.
As a result of the significant increase in our stock price, on May 13, 1998, the
Board of Directors approved a two-for-one common stock split, effective June 15,
1998. At that time, the Board also approved an increase in our annual post-split
cash dividend to $0.23 per share, underscoring their continued optimism in our
prospects for future growth.
Mergers
As you review our consolidated financial statements and footnotes, you should
carefully consider the impact of the following merger transactions and the
non-recurring charges that we recorded:
CVS/Arbor Merger
On March 31, 1998, we completed a merger with Arbor pursuant to which 37.8
million shares of CVS common stock were exchanged for all of the outstanding
common stock of Arbor. We also converted Arbor's stock options into options to
purchase 5.3 million shares of our common stock. The merger of CVS and Arbor was
a tax-free reorganization, which we treated as a pooling of interests under
Accounting Principles Board Opinion No. 16, "Business Combinations."
Accordingly, we have restated our historical consolidated financial statements
and footnotes to include Arbor as if it had always been owned by CVS.
The merger with Arbor made us the market share leader in metropolitan Detroit,
the nation's fourth largest retail drugstore market, and strengthened our
position as the nation's top drugstore retailer in terms of store count and
retail prescriptions dispensed. We believe that we can achieve cost savings from
the combined operations of approximately $30 million annually. This will come
primarily from closing Arbor's corporate headquarters, achieving economies of
scale in advertising, distribution and other operational areas, and spreading
our investment in information technology over a larger store base. Please read
the "Cautionary Statement Concerning Forward-Looking Statements" section below.
CVS/Revco Merger
On May 29, 1997, we completed a merger with Revco pursuant to which 120.6
million shares of CVS common stock were exchanged for all of the outstanding
common stock of Revco. We also converted Revco's stock options into options to
purchase 6.6 million shares of our common stock. The merger of CVS and Revco was
also a tax-free reorganization that we treated as a pooling of interests.
Accordingly, we have restated our historical consolidated financial statements
and footnotes to include Revco as if it had always been owned by CVS.
The merger with Revco was a milestone event for our company in that it more than
doubled our revenues and made us the nation's number one drugstore retailer in
terms of store count. The merger brought us into high-growth, contiguous markets
in the Mid-Atlantic, Southeast and Midwest regions of the United States.
14
Merger Charges
During the second quarter of 1998, we recorded a $158.3 million charge to
operating expenses for direct and other merger-related costs pertaining to the
CVS/Arbor merger transaction and related restructuring activities. At that time,
we also recorded a $10.0 million charge to cost of goods sold to reflect
markdowns on non-compatible Arbor merchandise.
During the second quarter of 1997, we recorded a $411.7 million charge to
operating expenses for direct and other merger-related costs pertaining to the
CVS/Revco merger transaction and related restructuring activities. At that time,
we also recorded a $75.0 million charge to cost of goods sold to reflect
markdowns on non-compatible Revco merchandise.
Integration Update
We are pleased to report that the integration of Arbor is well underway. We have
already converted Arbor to CVS' accounting and store systems and closed the
Troy, Michigan corporate headquarters facility. With respect to merger
synergies, we achieved approximately $20 million of cost savings in 1998 and we
believe we are on track to realize at least $30 million of cost savings in 1999
from the Arbor merger. Please read the "Cautionary Statement Concerning Forward
Looking Statements" section below. We are further pleased to report that the
integration of Revco is now complete and we have accomplished our goal of
achieving at least $100 million of annual cost savings from the Revco merger.
Where You Can Find More Information About
the Mergers
Please read the "Results of Operations" and "Cautionary Statement Concerning
Forward-Looking Statements" sections below and Notes 2 and 3 to the consolidated
financial statements for other important information about the mergers and the
non-recurring charges that we recorded.
Results of Operations
Net sales increased 11.1% in 1998 to $15.3 billion. This compares to increases
of 16.2% in 1997 and 12.5% in 1996. Same store sales, consisting of sales from
stores that have been open for more than one year, rose 10.8% in 1998, 9.7% in
1997 and 8.9% in 1996. Pharmacy same store sales increased 16.5% in 1998, 16.5%
in 1997 and 13.5% in 1996. Our pharmacy sales as a percentage of total sales
were 58% in 1998, 55% in 1997 and 52% in 1996. Our third party prescription
sales as a percentage of total pharmacy sales were 84% in 1998, 81% in 1997 and
80% in 1996.
As you review our sales performance, we believe you should consider the
following important information:
o Our pharmacy sales growth continued to benefit from our ability to attract
and retain managed care customers, our ongoing program of purchasing
prescription files from independent pharmacies and favorable industry trends.
These trends include an aging American population; many "baby boomers" are
now in their fifties and are consuming a greater number of prescription
drugs. The increased use of pharmaceuticals as the first line of defense for
healthcare and the introduction of a number of successful new prescription
drugs also contributed to the growing demand for pharmacy services.
o Our front store sales growth was driven by solid performance in categories
such as cosmetics, private label, seasonal, vitamins/nutrition, greeting
cards, skin care, film and photofinishing, and convenience foods.
o The increase in net sales in 1998 was positively affected by our efforts to
improve the performance of the Revco stores. To do this, we converted the
retained Revco stores to the CVS store format and relocated certain stores.
We are pleased to report that we are seeing improvements, especially in front
store sales. However, the improved performance has been aided by temporary
promotional events and the rate of progress has varied and, we expect it to
continue to vary, on a market-by-market basis.
o The increase in net sales in 1997 was positively affected by our acquisition
of Big B, Inc., effective November 16, 1996. Excluding the positive impact of
the Big B acquisition, net sales increased 11.3% in 1997 when compared to
1996. Please read Notes 2 and 3 to the consolidated financial statements for
other important information about the Big B acquisition.
o We have an active program in place to relocate our existing shopping center
stores to larger, more convenient, freestanding locations. Historically, we
have achieved significant improvements in customer count and net sales when
we do this. The resulting increase in net sales has typically been driven by
an increase in front store sales, which normally have a higher gross margin.
We believe that our relocation program offers a significant opportunity for
future growth, as 23% of our existing stores are freestanding. We currently
expect to have 35% of our stores in freestanding locations by the end of
1999. Our long-term goal is to have 70-80% of our stores located in
freestanding sites. We cannot, however, guarantee that future store
relocations will deliver the same results as those historically achieved.
Please read the "Cautionary Statement Concerning Forward-Looking Statements"
section below.
15
Gross margin as a percentage of net sales was 27.0% in 1998. This compares to
27.0% in 1997 and 27.9% in 1996. As you review our gross margin performance,
please remember to consider the impact of the $10.0 million charge we recorded
in 1998 to reflect markdowns on non-compatible Arbor merchandise and the $75.0
million charge we recorded in 1997 to reflect markdowns on non-compatible Revco
merchandise. If you exclude the effect of these non-recurring charges, our
comparable gross margin as a percentage of net sales was 27.1% in 1998, 27.6% in
1997 and 27.9% in 1996.
Why has our comparable gross margin rate been declining?
o Pharmacy sales are growing at a faster pace than front store sales. On
average, our gross margin on pharmacy sales is lower than our gross margin on
front store sales.
o Sales to customers covered by third party insurance programs have continued
to increase and, thus, have become a larger part of our total pharmacy
business. Our gross margin on third party sales has continued to decline
largely due to the efforts of managed care organizations and other pharmacy
benefit managers to reduce prescription drug costs. To address this trend, we
have dropped a number of third party programs that fell below our minimum
profitability standards. In the event this trend continues and we elect to
drop additional programs and/or decide not to participate in future programs
that fall below our minimum profitability standards, we may not be able to
sustain our current rate of sales growth.
Total operating expenses were 22.0% of net sales in 1998. This compares to 25.1%
in 1997 and 22.9% in 1996. As you review our performance in this area, please
remember to consider the impact of the following non-recurring charges:
o During 1998, we recorded the $158.3 million charge associated with the Arbor
merger.
o During 1997, we recorded the $411.7 million charge associated with the Revco
merger. We also recorded a $31.0 million charge for certain costs associated
with the restructuring of Big B. Please read Note 3 to the consolidated
financial statements for other important information about this charge.
o During 1996, we recorded a $12.8 million charge when Rite Aid Corporation
announced that it had withdrawn its tender offer to acquire Revco. This event
took place before we merged with Revco.
If you exclude the effect of these non-recurring charges, comparable total
operating expenses as a percentage of net sales were 20.9% in 1998, 21.9% in
1997 and 22.8% in 1996.
What have we done to improve our comparable total operating expenses as a
percentage of net sales?
o We eliminated most of Arbor's existing corporate overhead in 1998 and most of
Revco's in 1997.
o Our strong sales performance has consistently allowed our net sales to grow
at a faster pace than total operating expenses.
o Our information technology initiatives have led to greater productivity,
which has resulted in lower operating costs and improved sales. Our major IT
initiatives include: Supply Chain Management, Rx2000 Pharmacy Delivery
Project, and Rapid Refill.
As a result of combining the operations of CVS, Arbor and Revco, we were able to
achieve substantial annual operating cost savings in 1998 and 1997. Although we
are extremely proud of this accomplishment, we strongly advise you not to rely
on the resulting operating expense improvement trend to predict our future
performance.
Operating profit increased $510.8 million to $772.2 million in 1998. This
compares to $261.4 million in 1997 and $591.9 million in 1996. If you exclude
the effect of the non-recurring charges we recorded in gross margin and in total
operating expenses, our comparable operating profit increased $161.4 million (or
20.7%) to $940.5 million in 1998. This compares to $779.1 million in 1997 and
$604.7 million in 1996. Comparable operating profit as a percentage of net sales
was 6.2% in 1998, 5.7% in 1997 and 5.1% in 1996.
Other expense (income), net consisted of the following for the years ended
December 31:
- -----------------------------------------------------------
In millions 1998 1997 1996
- -----------------------------------------------------------
Gain on sale of securities $ -- $ -- $(121.4)
Dividend income -- -- (5.6)
Interest expense 69.7 59.1 84.7
Interest income (8.8) (15.0) (9.2)
- -----------------------------------------------------------
Other expense (income), net $ 60.9 $ 44.1 $ (51.5)
- -----------------------------------------------------------
During 1998, our other expense (income), net increased $16.8 million due to
higher interest expense and lower interest income. Our interest expense
increased because we maintained higher average borrowing levels during 1998 to
finance, in part, additional inventory. You should be aware that we purchased
the additional inventory to support several initiatives. First we converted the
Revco stores to the CVS merchandise mix. We also held promotional name change
events in most Revco markets and realigned our stores and distribution centers.
In order to properly support these important initiatives, we decided to
temporarily increase our inventory levels during
16
1998. We believe that our inventory levels were back to "normal" at December 31,
1998.
During 1997, our other expense (income), net increased $95.6 million to a net
other expense of $44.1 million from a net other income of $51.5 million in 1996.
As you review this change, you should consider the impact of the following
information:
o During 1997, we recognized interest income on a note receivable that we
received when we sold Kay-Bee Toys in 1996. This note was sold in 1997. We
also had lower interest expense in 1997 because we retired most of the higher
interest rate debt we absorbed as part of the CVS/Revco Merger.
o During 1996, we recognized a $121.4 million gain when we sold certain equity
securities that we received when we sold Marshalls in 1995.
Income tax provision - Our effective income tax rate was 44.3% in 1998. This
compares to 64.8% in 1997 and 42.1% in 1996. Our effective income tax rates were
higher in 1998 and 1997 because certain components of the charges we recorded in
conjunction with the CVS/Arbor and CVS/Revco merger transactions were not
deductible for income tax purposes.
Earnings from continuing operations before extraordinary item increased $319.9
million to $396.4 million (or $0.98 per diluted share) in 1998. This compares to
$76.5 million (or $0.16 per diluted share) in 1997 and $372.4 million (or $0.95
per diluted share) in 1996. If you exclude the effect of the non-recurring
charges we recorded in cost of goods sold and total operating expenses and the
gain on sale of securities included in other expense (income), net, our
comparable earnings from continuing operations before extraordinary item
increased 21.7% to $510.1 million (or $1.26 per diluted share) in 1998. This
compares to $419.2 million (or $1.05 per diluted share) in 1997 and $306.8
million (or $0.78 per diluted share) in 1996.
Discontinued Operations - In November 1997, we completed the final phase of a
comprehensive strategic restructuring program, under which we sold Marshalls,
Kay-Bee Toys, Wilsons, This End Up and Bob's Stores. As part of this program, we
also completed the spin-off of Footstar, Inc., which included Meldisco,
Footaction and Thom McAn, completed the initial and secondary public offerings
of Linens `n Things and eliminated certain corporate overhead costs. As part of
completing this program, we recorded an after-tax charge of $20.7 million during
the second quarter of 1997 and $148.1 million during the second quarter of 1996
to finalize our original liability estimates. Please read Note 4 to the
consolidated financial statements for other important information about this
program.
Extraordinary item - During the second quarter of 1997, we retired $865.7
million of the debt we absorbed when we acquired Revco. As a result, we recorded
a charge for an extraordinary item, net of income taxes, of $17.1 million. The
extraordinary item included the early retirement premiums we paid and the
balance of our deferred financing costs.
Net earnings were $396.4 million (or $0.98 per diluted share) in 1998. This
compares to $76.9 million (or $0.16 per diluted share) in 1997 and $208.2
million (or $0.52 per diluted share) in 1996.
Liquidity & Capital Resources
Liquidity ~ The Company has three primary sources of liquidity: cash provided by
operations, commercial paper and uncommitted lines of credit. Our commercial
paper program is supported by a $670 million, five-year unsecured revolving
credit facility that expires on May 30, 2002 and a $460 million, 364 day
unsecured revolving credit facility that expires on June 26, 1999. Our credit
facilities contain customary financial and operating covenants. We believe that
the restrictions contained in these covenants do not materially affect our
financial or operating flexibility. We can also obtain up to $35 million of
short-term financing through various uncommitted lines of credit. As of December
31, 1998, we had $736.6 million of commercial paper outstanding at a weighted
average interest rate of 5.8% and $34.5 million outstanding under our
uncommitted lines of credit at a weighted average interest rate of 4.8%.
Capital Resources ~ With a total debt to capitalization ratio of 25.4% at
December 31, 1998, we are pleased to report that our financial condition
remained strong at year-end. Although there can be no assurance and assuming
market interest rates remain favorable, we currently believe that we will
continue to have access to capital at attractive interest rates in 1999. We
further believe that our cash on hand and cash provided by operations, together
with our ability to obtain additional short-term and long-term financing, will
be sufficient to cover our future working capital needs, capital expenditures
and debt service requirements. Please read the "Cautionary Statement Concerning
Forward-Looking Statements" section below.
Capital Expenditures
Our capital expenditures totaled $502.3 million in 1998. This compares to $341.6
million in 1997 and $328.9 million in 1996. During 1998, we opened 184 new
stores, relocated 198 existing stores and closed 156 stores. During 1999, we
expect that our capital expenditures will total approximately $450-$500 million.
This currently includes a plan to open 140 new stores, relocate 300 existing
stores and close 130 stores. As of December 31, 1998, we operated 4,122 stores
in 24 states and the District of Columbia. This compares to 4,094 stores as of
December 31, 1997.
17
Goodwill
In connection with various acquisitions which were accounted for as purchase
transactions, we recorded goodwill, which represented the excess of the purchase
price we paid over the fair value of the net assets we acquired. The goodwill we
recorded in these transactions is being amortized on a straight-line basis,
generally over periods of 40 years.
We evaluate goodwill for impairment whenever events or changes in circumstances
suggest that the carrying amount may not be recoverable. Under these conditions,
we would compare our estimated future cash flows to our carrying amounts. If our
carrying amounts exceeded our expected future cash flows, we would consider the
goodwill to be impaired and we would record an impairment loss. We do not
currently believe that any of our goodwill is impaired.
Recent Accounting Pronouncements
In March 1998, the American Institute of Certified Public Accountants issued
Statement of Position 98-1, "Accounting for the Costs of Computer Software
Developed or Obtained for Internal Use," effective for fiscal years beginning
after December 15, 1998. This statement defines which costs incurred to develop
or purchase internal-use software should be capitalized and which costs should
be expensed. We are in the process of determining what impact, if any, this
pronouncement will have on our consolidated financial statements.
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Instruments
and Hedging Activities." This statement requires companies to record derivative
instruments on their balance sheet at fair value and establishes new accounting
practices for hedge instruments. This statement is effective for years beginning
after June 15, 1999. We are in the process of determining what impact, if any,
this pronouncement will have on our consolidated financial statements.
Discriminatory Pricing Litigation Against Drug Manufacturers and Wholesalers
The Company is a party to two lawsuits which have been filed against various
pharmaceutical manufacturers and wholesalers:
o The first lawsuit is a class action that alleges that manufacturers and
wholesalers conspired to fix and/or stabilize the price of the prescription
drugs sold to retail pharmacies in violation of the Sherman Antitrust Act. In
this lawsuit, CVS is a member of the plaintiff class.
o The second lawsuit was filed by individual chain pharmacies, including Revco,
as plaintiffs. This lawsuit alleges unlawful price discrimination against
retail pharmacies by manufacturers and wholesalers in violation of the
Robinson-Patman Act, and asserts a conspiracy in violation of the Sherman
Act. CVS became a party to this lawsuit when it acquired Revco.
With respect to the first lawsuit, fifteen defendants have agreed to settlements
totaling $720 million. The class plaintiffs were not able to reach settlements
with the four remaining defendants. As a result, a trial of the claims was
commenced in September 1998. The trial resulted in a directed verdict in favor
of the remaining defendents. The court has yet to approve a formula for
distributing the settlement proceeds to class members. While we believe that our
portion of the distribution could be significant, we can not predict an exact
dollar amount at this time.
With respect to the second lawsuit, a few settlements have been reached to date
and the case is expected to go to trial in the latter part of 1999. Our portion
of any settlement or judgment in this lawsuit could also be significant, but we
can not predict an exact dollar amount at this time.
Year 2000 Compliance Statement
The "Year 2000 Issue" relates to the inability of certain computer hardware and
software to properly recognize and process date-sensitive information for the
Year 2000 and beyond. Without corrective measures, our computer applications
could fail and/or produce erroneous results. To address this concern, we have a
work plan in place to identify the potential issues that could affect our
business. The following discussion will provide you with an update on where we
stand on this important matter.
Information Technology ("IT") Systems - We have completed the assessment phase
for each of our critical information technology systems. Our IT business systems
include point-of-sale, Rx2000 pharmacy, supply chain management, financial
accounting and other corporate office systems. To date, we have modified or
replaced approximately 85% of our critical IT business systems. We currently
expect to modify or replace the remaining critical business systems by the end
of the second quarter of 1999 and complete our systems testing by the end of the
third quarter of 1999.
Non-IT Systems - We are currently in the process of completing the assessment
phase for each of our critical non-IT business systems, including those with
embedded chip technology. Our non-IT business systems include distribution
center logistics, HVAC, energy management, facility alarms and key entry
systems. To date, we have modified or replaced approximately 30% of our critical
non-IT business systems. We currently expect to modify or replace the remaining
critical
18
non-IT business systems and complete our systems testing by the end of the third
quarter of 1999.
Business Partners - As part of our project work plan, we have been communicating
with our key business partners, including our vendors, suppliers, financial
institutions, managed care organizations, pharmacy benefit managers, third party
insurance programs and governmental agencies to determine the status of their
Year 2000 compliance programs. Although there can be no assurance that we will
not be adversely affected by the Year 2000 issues of our business partners, we
believe that ongoing communication will continue to minimize our risk.
Potential Risks - The potential risks associated with failing to remediate our
Year 2000 issues include: temporary disruptions in store operations; temporary
disruptions in the ordering, receiving and shipping of merchandise and in the
ordering and receiving of other goods and services; temporary disruptions in the
billing and collecting of accounts receivable; temporary disruptions in services
provided by banks and other financial institutions; temporary disruptions in
communication services; and temporary disruptions in utility services.
Incremental Cost -We currently estimate that the incremental cost associated
with completing our Year 2000 work plan will be approximately $10 million, about
half of which had been incurred through December 31, 1998. This estimate could
change as additional information becomes available. The cost to resolve our Year
2000 issues will be funded through our operating cash flows.
Contingency Plan - We are currently in the process of developing a contingency
plan for each area in our organization that could be affected by the Year 2000
issue. Although we currently anticipate minimal business disruption, the failure
of either the Company or one or more of our major business partners to remediate
critical Year 2000 issues could have a materially adverse impact on our
business, operations and financial condition. Please read the "Cautionary
Statement Concerning Forward Looking Statements" section below.
Cautionary Statement Concerning Forward-Looking Statements
We have made forward-looking statements in this Annual Report that are subject
to risks and uncertainties. For these statements, we claim the protection of the
safe harbor for forward-looking statements contained in the Private Securities
Litigation Reform Act of 1995. We strongly recommend that you become familiar
with the specific risks and uncertainties that we have outlined for you under
the caption "Cautionary Statement Concerning Forward-Looking Statements" in our
Annual Report on Form 10-K for the year ended December 31, 1998.
19
Management's Responsibility for Financial Reporting
The integrity and objectivity of the financial statements and related financial
information in this Annual Report are the responsibility of the management of
the Company. The financial statements have been prepared in conformity with
generally accepted accounting principles and include, when necessary, the best
estimates and judgments of management.
The Company maintains a system of internal controls designed to provide
reasonable assurance, at appropriate cost, that assets are safeguarded,
transactions are executed in accordance with management's authorization, and the
accounting records provide a reliable basis for the preparation of the financial
statements. The system of internal accounting controls is continually reviewed
by management and improved and modified as necessary in response to changing
business conditions and the recommendations of the Company's internal auditors
and independent auditors.
KPMG LLP, independent auditors, are engaged to render an opinion regarding the
fair presentation of the consolidated financial statements of the Company. Their
accompanying report is based upon an audit conducted in accordance with
generally accepted auditing standards and included a review of the system of
internal controls to the extent they considered necessary to support their
opinion.
The Audit Committee of the Board of Directors, consisting solely of outside
directors, meets periodically with management, internal auditors and the
independent auditors to review matters relating to the Company's financial
reporting, the adequacy of internal accounting controls and the scope and
results of audit work. The internal auditors and independent auditors have free
access to the Audit Committee.
/s/ Thomas M. Ryan
- ------------------
Thomas M. Ryan
President and Chief Executive Officer
/s/ Charles C. Conaway
- ----------------------
Charles C. Conaway
Executive Vice President and Chief Financial Officer
January 27, 1999
20
Independent Auditors' Report
[LOGO: KPMG LOGO]
Board of Directors and Shareholders
CVS Corporation:
We have audited the accompanying consolidated balance sheets of CVS Corporation
and subsidiaries as of December 31, 1998 and 1997, and the related consolidated
statements of operations, shareholders' equity, and cash flows for each of the
years in the three year period ended December 31, 1998. These consolidated
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of CVS Corporation and
subsidiaries as of December 31, 1998 and 1997, and the results of their
operations and their cash flows for each of the years in the three year period
ended December 31, 1998, in conformity with generally accepted accounting
principles.
/s/ KPMG LLP
- ------------
KPMG LLP
Providence, Rhode Island
January 27, 1999
21
Consolidated Statements of Operations
====================================================================================================================
Years Ended December 31,
In millions, except per share amounts 1998 1997 1996
- --------------------------------------------------------------------------------------------------------------------
Net sales $15,273.6 $13,749.6 $11,831.6
Cost of goods sold, buying and warehousing costs 11,144.4 10,031.3 8,530.7
- --------------------------------------------------------------------------------------------------------------------
Gross margin 4,129.2 3,718.3 3,300.9
Selling, general and administrative expenses 2,949.0 2,776.0 2,490.8
Depreciation and amortization 249.7 238.2 205.4
Merger, restructuring and other non-recurring charges 158.3 442.7 12.8
- --------------------------------------------------------------------------------------------------------------------
Total operating expenses 3,357.0 3,456.9 2,709.0
- --------------------------------------------------------------------------------------------------------------------
Operating profit 772.2 261.4 591.9
Gain on sale of securities -- -- (121.4)
Dividend income -- -- (5.6)
Interest expense, net 60.9 44.1 75.5
- --------------------------------------------------------------------------------------------------------------------
Other expense (income), net 60.9 44.1 (51.5)
- --------------------------------------------------------------------------------------------------------------------
Earnings from continuing operations before income taxes and extraordinary item 711.3 217.3 643.4
Income tax provision (314.9) (140.8) (271.0)
- --------------------------------------------------------------------------------------------------------------------
Earnings from continuing operations before extraordinary item 396.4 76.5 372.4
Discontinued operations:
Loss from operations, net of tax benefit of $31.0 -- -- (54.8)
Gain (loss) on disposal, net of tax provision (benefit) of $12.4, and $(56.2)
in 1997 and 1996, respectively and minority interest of $22.2 in 1996 -- 17.5 (109.4)
- --------------------------------------------------------------------------------------------------------------------
Earnings (loss) from discontinued operations -- 17.5 (164.2)
- --------------------------------------------------------------------------------------------------------------------
Earnings before extraordinary item 396.4 94.0 208.2
Extraordinary item, loss related to early retirement of
debt, net of income tax benefit of $11.4 -- (17.1) --
- --------------------------------------------------------------------------------------------------------------------
Net earnings 396.4 76.9 $ 208.2
Preference dividends, net of income tax benefit (13.6) (13.7) (14.5)
- --------------------------------------------------------------------------------------------------------------------
Net earnings available to common shareholders $ 382.8 $ 63.2 $ 193.7
====================================================================================================================
Basic earnings per common share:
Earnings from continuing operations before extraordinary item $ 0.99 $ 0.17 $ 0.98
Earnings (loss) from discontinued operations -- 0.05 (0.45)
Extraordinary item, net of tax benefit -- (0.05) --
- --------------------------------------------------------------------------------------------------------------------
Net earnings $ 0.99 $ 0.17 $ 0.53
- --------------------------------------------------------------------------------------------------------------------
Weighted average common shares outstanding 387.1 377.2 366.9
====================================================================================================================
Diluted earnings per common share:
Earnings from continuing operations before extraordinary item $ 0.98 $ 0.16 $ 0.95
Earnings (loss) from discontinued operations -- 0.05 (0.43)
Extraordinary item, net of tax benefit -- (0.05) --
- --------------------------------------------------------------------------------------------------------------------
Net earnings $ 0.98 $ 0.16 $ 0.52
====================================================================================================================
Weighted average common shares outstanding 405.2 385.1 383.6
====================================================================================================================
Dividends per common share $ 0.225 $ 0.220 $ 0.220
====================================================================================================================
See accompanying notes to consolidated financial statements.
22
Consolidated Balance Sheets
=========================================================================================================================
December 31,
In millions, except per share amounts 1998 1997
- -------------------------------------------------------------------------------------------------------------------------
Assets:
Cash and cash equivalents $ 180.8 $ 192.5
Accounts receivable, net 650.3 452.4
Inventories 3,190.2 2,882.4
Other current assets 327.9 364.8
- -------------------------------------------------------------------------------------------------------------------------
Total current assets 4,349.2 3,892.1
Property and equipment, net 1,351.2 1,072.3
Goodwill, net 724.6 711.5
Deferred charges and other assets 311.2 303.0
- -------------------------------------------------------------------------------------------------------------------------
Total assets $6,736.2 $5,978.9
=========================================================================================================================
Liabilities:
Accounts payable $1,286.3 $1,233.7
Accrued expenses 1,111.3 1,168.6
Short-term borrowings 771.1 466.4
Current maturities of long-term debt 14.6 41.9
- -------------------------------------------------------------------------------------------------------------------------
Total current liabilities 3,183.3 2,910.6
Long-term debt 275.7 290.4
Other long-term liabilities 166.6 163.3
Commitments and contingencies (Note 14)
Shareholders' equity:
Preferred stock, $0.01 par value: authorized 120,619 shares; 0 shares issued and outstanding -- --
Preference stock, series one ESOP convertible, par value $1.00:
authorized 50,000,000 shares; issued and outstanding 5,239,000 shares at December 31, 1998
and 5,324,000 shares at December 31, 1997 280.0 284.6
Common stock, par value $0.01: authorized 1,000,000,000 shares; issued 401,380,000 shares at
December 31, 1998 and 393,734,000 shares at December 31, 1997 4.0 3.9
Treasury stock, at cost: 11,169,000 shares at December 31, 1998 and 11,278,0000 shares
at December 31, 1997 (260.2) (262.9)
Guaranteed ESOP obligation (270.7) (292.2)
Capital surplus 1,336.4 1,154.0
Retained earnings 2,021.1 1,727.2
- -------------------------------------------------------------------------------------------------------------------------
Total shareholders' equity 3,110.6 2,614.6
- -------------------------------------------------------------------------------------------------------------------------
Total liabilities and shareholders' equity $6,736.2 $5,978.9
=========================================================================================================================
See accompanying notes to consolidated financial statements.
23
Consolidated Statements of Shareholders' Equity
========================================================================================================================
Years Ended December 31,
Shares Dollars
------------------------------ ------------------------------
In millions 1998 1997 1996 1998 1997 1996
- ------------------------------------------------------------------------------------------------------------------------
Preference stock:
Beginning of year 5.3 5.6 6.3 $ 284.6 $ 298.6 $ 334.9
Conversion to common stock (0.1) (0.3) (0.7) (4.6) (14.0) (36.3)
- ------------------------------------------------------------------------------------------------------------------------
End of year 5.2 5.3 5.6 280.0 284.6 298.6
========================================================================================================================
Common stock:
Beginning of year 393.7 369.3 357.5 3.9 3.7 357.5
Stock options exercised and awards under stock plans 7.5 10.9 4.1 0.1 0.1 4.1
Effect of change in par value -- -- -- -- -- (365.6)
Other 0.2 13.5 7.7 -- 0.1 7.7
- ------------------------------------------------------------------------------------------------------------------------
End of year 401.4 393.7 369.3 4.0 3.9 3.7
========================================================================================================================
Treasury stock:
Beginning of year (11.3) (11.7) (13.1) (262.9) (273.1) (304.6)
Conversion of preference stock 0.2 0.5 1.4 4.2 12.2 31.6
Other (0.1) (0.1) -- (1.5) (2.0) (0.1)
- ------------------------------------------------------------------------------------------------------------------------
End of year (11.2) (11.3) (11.7) (260.2) (262.9) (273.1)
========================================================================================================================
Guaranteed ESOP obligation:
Beginning of year (292.2) (292.2) (309.7)
Reduction of guaranteed ESOP obligation 21.5 -- 17.5
- ------------------------------------------------------------------------------------------------------------------------
End of year (270.7) (292.2) (292.2)
========================================================================================================================
Capital surplus:
Beginning of year 1,154.0 941.2 532.4
Conversion of preference stock 0.3 1.8 4.7
Stock options exercised and awards under stock plans 176.2 195.9 56.7
Effect of change in par value -- -- 365.6
Other 5.9 15.1 (18.2)
- ------------------------------------------------------------------------------------------------------------------------
End of year 1,336.4 1,154.0 941.2
========================================================================================================================
Retained earnings:
Beginning of year 1,727.2 1,737.9 1,956.7
Net earnings 396.4 76.9 208.2
Dividends:
Preference stock, net of tax benefit (13.6) (13.7) (14.4)
Redeemable preferred stock -- -- (0.1)
Common stock (88.9) (73.9) (51.7)
Footstar distribution -- -- (360.8)
- ------------------------------------------------------------------------------------------------------------------------
End of year 2,021.1 1,727.2 1,737.9
========================================================================================================================
Other:
Beginning of year -- (2.4) 0.2
Cumulative translation adjustment -- -- (0.2)
Unrealized holding gain (loss) on investments, net -- 2.4 (2.4)
- ------------------------------------------------------------------------------------------------------------------------
End of year -- -- (2.4)
========================================================================================================================
Total shareholders' equity $3,110.6 $2,614.6 $2,413.7
========================================================================================================================
See accompanying notes to consolidated financial statements.
24
Consolidated Statements of Cash Flows
===================================================================================================================================
Years Ended December 31,
In millions 1998 1997 1996
- -----------------------------------------------------------------------------------------------------------------------------------
Cash flows from operating activities:
Net earnings $ 396.4 $ 76.9 $ 208.2
Adjustments to reconcile net earnings to net cash provided by (used in) operating activities:
Depreciation and amortization 249.7 242.6 262.8
Merger, restructuring and other non-recurring charges 168.3 486.7 235.0
Deferred income taxes and other non-cash items 81.8 (218.5) 116.4
Net operating loss carryforwards utilized 7.2 69.4 15.3
Gain on sale of securities -- -- (121.4)
Extraordinary item, loss on early retirement of debt, net of tax -- 17.1 --
Income (loss) from unconsolidated subsidiary -- 0.3 (4.5)
Minority interest in net earnings -- -- 22.2
Change in assets and liabilities, excluding acquisitions and dispositions:
(Increase) in accounts receivable, net (197.9) (82.5) (0.8)
(Increase) in inventories (315.0) (566.1) (251.0)
(Increase) in other current assets, deferred charges and other assets (82.7) (74.2) (99.1)
Increase in accounts payable 52.6 174.7 176.5
(Decrease) in accrued expenses (280.4) (220.3) (215.5)
Increase (decrease) in federal income taxes payable and other liabilities 141.0 (11.9) (16.9)
- -----------------------------------------------------------------------------------------------------------------------------------
Net cash provided by (used in) operating activities 221.0 (105.8) 327.2
===================================================================================================================================
Cash flows from investing activities:
Additions to property and equipment (502.3) (341.6) (328.9)
Acquisitions, net of cash (62.2) -- (373.9)
Proceeds from sale of businesses and other property and equipment 50.5 192.7 240.4
Proceeds from sale of investments -- 309.7 485.8
- -----------------------------------------------------------------------------------------------------------------------------------
Net cash (used in) provided by investing activities (514.0) 160.8 23.4
===================================================================================================================================
Cash flows from financing activities:
Additions to (reductions in) short-term borrowings 304.6 466.4 (52.0)
Proceeds from exercise of stock options 121.1 169.1 62.1
(Reductions in) additions to long-term debt (41.9) (917.2) 128.5
Dividends paid (102.5) (87.6) (137.5)
Other -- -- (25.8)
- -----------------------------------------------------------------------------------------------------------------------------------
Net cash provided by (used in) financing activities 281.3 (369.3) (24.7)
===================================================================================================================================
Net (decrease) increase in cash and cash equivalents (11.7) (314.3) 325.9
Cash and cash equivalents at beginning of year 192.5 506.8 180.9
- -----------------------------------------------------------------------------------------------------------------------------------
Cash and cash equivalents at end of year $ 180.8 $ 192.5 $ 506.8
===================================================================================================================================
See accompanying notes to consolidated financial statements.
25
Notes to Consolidated Financial Statements
1 Significant
Accounting Policies
Description of business ~ CVS Corporation ("CVS" or the "Company") is
principally in the retail drugstore business. As of December 31, 1998, the
Company operated 4,122 retail drugstores, located in 24 Northeast, Mid-Atlantic,
Southeast and Midwest states and the District of Columbia. See Note 12 for
further information about the Company's business segments.
Basis of presentation ~ The consolidated financial statements include the
accounts of the Company and its wholly-owned subsidiaries. All material
intercompany balances and transactions have been eliminated. As a result of the
Company's strategic restructuring program, the results of operations of the
former Footwear, Apparel, and Toys and Home Furnishings segments have been
classified as discontinued operations in the accompanying consolidated
statements of operations. See Note 4 for further information about the Company's
strategic restructuring program and discontinued operations.
Stock split ~ On May 13, 1998, the Company's shareholders approved an increase
in the number of authorized common shares from 300 million to one billion. Also
on that date, the Board of Directors authorized a two-for-one common stock
split, which was effected by the issuance of one additional share of common
stock for each share of common stock outstanding. These shares were distributed
on June 15, 1998 to shareholders of record as of May 25, 1998. All share and per
share amounts presented herein have been restated to reflect the effect of the
stock split.
Cash and cash equivalents ~ Cash and cash equivalents consist of cash and
temporary investments with maturities of three months or less when purchased.
Accounts receivable ~ Accounts receivable are stated net of an allowance for
uncollectible accounts of $39.8 million and $39.2 million as of December 31,
1998 and 1997, respectively. The balance primarily includes trade receivables
due from managed care organizations, pharmacy benefit management companies,
insurance companies, governmental agencies and vendors.
Inventories ~ Inventories are stated at the lower of cost or market using the
first-in, first-out method.
Financial instruments ~ The Company's financial instruments include cash and
cash equivalents, accounts receivable, accounts payable, accrued expenses and
short-term borrowings. Due to the short-term nature of these instruments, the
Company's carrying value approximates fair value. The Company also utilizes
letters of credit to guarantee certain foreign purchases. As of December 31,
1998 and 1997, approximately $62.4 million and $58.2 million, respectively, was
outstanding under letters of credit.
Property and equipment ~ Depreciation of property and equipment is computed on a
straight-line basis, generally over the estimated useful lives of the asset or,
when applicable, the term of the lease, whichever is shorter. Estimated useful
lives generally range from 10 to 40 years for buildings and improvements, 3 to
10 years for fixtures and equipment, and 3 to 10 years for leasehold
improvements. Maintenance and repair costs are charged directly to expense as
incurred. Major renewals or replacements that substantially extend the useful
life of an asset are capitalized and depreciated.
Impairment of long-lived assets ~ The Company primarily groups and evaluates
assets at an individual store level, which is the lowest level at which
individual cash flows can be identified. When evaluating assets for potential
impairment, the Company considers historical performance and estimated
undiscounted future cash flows. If the carrying amount of the related assets
exceed the expected future cash flows, the Company considers the assets to be
impaired and records an impairment loss.
Deferred charges and other assets ~ Deferred charges and other assets primarily
include beneficial leasehold costs, which are amortized on a straight-line basis
over the shorter of 15 years or the remaining life of the leasehold acquired,
and reorganization goodwill, which is amortized on a straight-line basis over 20
years. The reorganization goodwill is the value of Revco D.S., Inc., in excess
of identifiable assets, as determined during its 1992 reorganization under
Chapter 11 of the United States Bankruptcy Code. See Note 11 for further
information about reorganization goodwill.
Goodwill ~ Goodwill, which represents the excess of the purchase price over the
fair value of net assets acquired, is amortized on a straight-line basis
generally over periods of 40 years. Accumulated amortization was $85.6 million
and $65.6 million at December 31, 1998 and 1997, respectively. The Company
evaluates goodwill for impairment whenever events or circumstances indicate that
the carrying amount may not be recoverable. If the carrying amount of the
goodwill exceeds the expected undiscounted future cash flows, the Company
records an impairment loss.
Store opening and closing costs ~ New store opening costs are charged directly
to expense when incurred. When the
26
Notes to Consolidated Financial Statements
Company closes a store, the estimated unrecoverable costs, including the
remaining lease obligation, are charged to expense in the year of the closing.
Advertising costs ~ External costs incurred to produce media advertising are
expensed when the advertising takes place.
Income taxes ~ Deferred tax assets and liabilities are recognized for the future
tax consequences attributable to differences between the carrying amount of
assets and liabilities for financial reporting purposes and the amounts used for
income tax purposes as well as for the deferred tax effects of tax credit
carryforwards. Deferred tax assets and liabilities are measured using enacted
tax rates expected to apply to taxable income in the years in which those
temporary differences are expected to be recovered or settled.
Stock-based compensation ~ During 1996, the Company adopted Statement of
Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based
Compensation." Under SFAS No. 123, companies can elect to account for
stock-based compensation using a fair value based method or continue to measure
compensation expense using the intrinsic value method prescribed in Accounting
Principles Board Opinion ("APB") No. 25, "Accounting for Stock Issued to
Employees." The Company has elected to continue to account for its stock-based
compensation plans under APB No. 25. See Note 7 for further information about
the Company's stock incentive plans.
Insurance ~ The Company is self-insured up to certain limits for general
liability, workers compensation and automobile liability claims. The Company
accrues for projected losses in the year the claim is incurred based on
actuarial assumptions followed in the insurance industry and the Company's past
experience.
Use of estimates ~ The preparation of financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts in the consolidated financial
statements and accompanying notes. Actual results could differ from those
estimates.
Reclassifications ~ Certain reclassifications have been made to the consolidated
financial statements of prior years to conform to the current year presentation.
Earnings per common share ~ During the fourth quarter of 1997, the Company
adopted SFAS No. 128, "Earnings Per Share" and restated previously reported
earnings per common share. Basic earnings per common share is computed by
dividing: (i) net earnings, after deducting the after-tax dividends on the ESOP
Preference Stock, by (ii) the weighted average number of common shares
outstanding during the year (the "Basic Shares").
Diluted earnings per common share normally assumes that the ESOP Preference
Stock is converted into common stock and all dilutive stock options are
exercised. Diluted earnings per common share is computed by dividing: (i) net
earnings, after accounting for the difference between the current dividends on
the ESOP Preference Stock and the common stock and after making adjustments for
certain non-discretionary expenses that are based on net earnings such as
incentive bonuses and profit sharing by (ii) Basic Shares plus the additional
shares that would be issued assuming that all dilutive stock options are
exercised and the ESOP Preference Stock is converted into common stock. In 1997,
the assumed conversion of the ESOP Preference Stock would have increased diluted
earnings per common share and, therefore, was not considered.
New accounting pronouncements ~ During 1998, the Company adopted: (i) SFAS No.
130, "Reporting Comprehensive Income," which established standards for the
reporting and display of comprehensive income and its components, (ii) SFAS No.
131, "Disclosures about Segments of an Enterprise and Related Information,"
which requires companies to report financial information based on how management
internally organizes data to make operating decisions and assess performance and
(iii) SFAS No. 132, "Employers' Disclosures about Pensions and Other
Postretirement Benefits," which revises the disclosure requirements for pensions
and other postretirement benefit plans. Adoption of the above disclosure
standards did not affect the Company's financial results. Comprehensive income
does not differ from the consolidated net earnings presented in the accompanying
consolidated statements of operations.
27
Notes to Consolidated Financial Statements
2 Business Combinations
Merger Transactions
On March 31, 1998, CVS completed a merger with Arbor Drugs, Inc. ("Arbor"),
pursuant to which 37.8 million shares of CVS common stock were exchanged for all
of the outstanding common stock of Arbor (the "CVS/Arbor Merger"). Each
outstanding share of Arbor common stock was exchanged for 0.6364 shares of CVS
common stock. In addition, outstanding Arbor stock options were converted at the
same exchange ratio into options to purchase 5.3 million shares of CVS common
stock.
On May 29, 1997, CVS completed a merger with Revco D.S., Inc. ("Revco"),
pursuant to which 120.6 million shares of CVS common stock were exchanged for
all of the outstanding common stock of Revco (the "CVS/Revco Merger"). Each
outstanding share of Revco common stock was exchanged for 1.7684 shares of CVS
common stock. In addition, outstanding Revco stock options were converted at the
same exchange ratio into options to purchase 6.6 million shares of CVS common
stock.
The CVS/Arbor Merger and CVS/Revco Merger (collectively, the "Mergers")
constituted tax-free reorganizations and have been accounted for as pooling of
interests under Accounting Principles Board Opinion No. 16, "Accounting for
Business Combinations." Accordingly, all prior period financial statements
presented have been restated to include the combined results of operations,
financial position and cash flows of Arbor and Revco as if they had always been
owned by CVS.
Prior to the Mergers, Arbor's fiscal year ended on July 31 and Revco's fiscal
year ended on the Saturday closest to May 31. These fiscal year-ends have been
restated to a December 31 year-end to conform to CVS' fiscal year-end. Arbor's
and Revco's cost of sales and inventories have been restated from the last-in,
first-out method to the first-in, first-out method to conform to CVS' accounting
method for inventories. The impact of the restatement was to increase earnings
from continuing operations by $0.5 million in 1998, $1.2 million in 1997 and
$15.5 million in 1996.
There were no material transactions between CVS, Arbor and Revco prior to the
Mergers. Certain reclassifications have been made to Arbor's and Revco's
historical stand-alone financial statements to conform to CVS' presentation.
Following are the results of operations for the separate companies prior to the
Mergers and the combined amounts presented in the consolidated financial
statements:
================================================================
Three Months Ended Years Ended
March 28, March 29, December 31,
In millions 1998 1997 1997 1996
- ----------------------------------------------------------------
Net sales:
CVS $3,333.6 $ 1,515.0 $12,738.2 $ 5,528.1
Arbor 267.9 237.0 1,011.4 886.8
Revco -- 1,645.8 -- 5,416.7
- ----------------------------------------------------------------
$3,601.5 $ 3,397.8 $13,749.6 $11,831.6
================================================================
Earnings from continuing operations:
CVS $ 121.3 $ 58.5 $ 37.3 $ 239.6
Arbor 10.7 9.4 39.2 31.6
Revco -- 24.2 -- 101.2
- ----------------------------------------------------------------
$ 132.0 $ 92.1 $ 76.5 $ 372.4
================================================================
Purchase Transactions
On December 23, 1996, the Company completed the cash purchase of Big B, Inc.
("Big B") by acquiring all of the outstanding shares of Big B common stock. The
aggregate transaction value, including the assumption of $49.3 million of Big B
debt, was $423.2 million. The Big B acquisition was accounted for as a purchase
business combination. The resulting excess of purchase price over net assets
acquired, $248.9 million, is being amortized on a straight-line basis over 40
years. For financial reporting purposes, Big B's results of operations have been
included in the consolidated financial statements since November 16, 1996.
The Company also acquired other retail drugstore businesses that were accounted
for as purchase business combinations. These acquisitions did not have a
material effect on the consolidated financial statements either individually or
in the aggregate. The results of operations of these companies have been
included in the consolidated financial statements since their respective dates
of acquisition.
28
Notes to Consolidated Financial Statements
3 Merger & Restructuring Charges
In accordance with Emerging Issues Task Force ("EITF") Issue No. 94-3,
"Liability Recognition for Certain Employee Termination Benefits and Other Costs
to Exit an Activity (Including Certain Costs Incurred in a Restructuring)" and
SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to Be Disposed Of," the Company recorded the following charges
in connection with the Mergers.
In connection with the CVS/Arbor Merger, the Company recorded a $158.3 million
charge to operating expenses during the second quarter of 1998 for direct and
other merger-related costs pertaining to the merger transaction and certain
restructuring activities (the "CVS/Arbor Charge"). Asset write-offs included in
this charge totaled $41.2 million. The balance of the charge, $117.1 million,
will require cash outlays of which $60.1 million had been incurred as of
December 31, 1998. The remaining cash outlays primarily include noncancelable
lease commitments and severance. The Company also recorded a $10.0 million
charge to cost of goods sold during the second quarter of 1998 to reflect
markdowns on noncompatible Arbor merchandise (the "Arbor Inventory Markdown").
In connection with the CVS/Revco Merger, the Company recorded a $411.7 million
charge to operating expenses during the second quarter of 1997 for direct and
other merger-related costs pertaining to the merger transaction and certain
restructuring activities (the "CVS/Revco Charge"). Asset write-offs included in
this charge totaled $82.2 million. The balance of the charge, $329.5 million,
will require cash outlays of which $269.3 million had been incurred as of
December 31, 1998. The remaining cash outlays primarily include non-cancelable
lease commitments and severance. The Company also recorded a $75.0 million
charge to cost of goods sold during the second quarter of 1997 to reflect
markdowns on noncompatible Revco merchandise (the "Revco Inventory Markdown").
Merger transaction costs primarily include fees for investment bankers,
attorneys, accountants, financial printing and other related charges. Employee
severance and benefits primarily include costs associated with terminating
approximately 200 Arbor and 1,000 Revco employees, all of which had occurred as
of December 31, 1998. Noncancelable lease obligations and duplicate facilities
primarily include noncancelable lease commitments and shut down costs. These
costs did not provide future benefit to the retained stores or corporate
facilities.
In accordance with EITF 94-3 and SFAS No. 121, the Company also recorded a $31.0
million charge to operating expenses during the first quarter of 1997 for
certain costs associated with the restructuring of Big B (the "Big B Charge").
This charge included accrued liabilities related to certain exit plans for
identified stores and duplicate corporate facilities, such as the cancellation
of lease agreements and the write-down of unutilized fixed assets. Asset
write-offs included in this charge totaled $5.1 million. The balance of the
charge, $25.9 million, will require cash outlays of which $10.0 million had been
incurred as of December 31, 1998. The remaining cash outlays primarily include
noncancelable lease commitments. These exit plans did not provide future benefit
to the retained stores or corporate facilities.
Following is a summary of the significant components of the above charges:
====================================================================================================================================
CVS/Arbor Charge CVS/Revco and Big B Charges
----------------------------------------------- -----------------------------------------------
Total 1998 Utilized Balance at Total 1997 Utilized Balance at
In millions Charge to Date Transfer 12/31/98(1) Charges to Date Transfer 12/31/98(1)
- ------------------------------------------------------------------------------------------------------------------------------------
Merger transaction costs $ 15.0 $ (15.9) $ 0.9 $ -- $ 35.0 $ (32.4) $ (2.6) $ --
Restructuring costs:
Employee severance
and benefits 27.1 (13.8) 0.3 13.6 89.8 (77.4) -- 12.4
Exit costs:
Noncancelable lease
obligations and
duplicate facilities 67.5 (25.8) (1.9) 39.8 211.6 (147.9) -- 63.7
Fixed asset write-offs 41.2 (41.2) -- -- 87.3 (87.3) -- --
Contract cancellation costs 4.8 (1.2) -- 3.6 7.4 (7.4) -- --
Other 2.7 (3.4) 0.7 -- 11.6 (14.2) 2.6 --
- ------------------------------------------------------------------------------------------------------------------------------------
$ 158.3 $ (101.3) $ -- $ 57.0 $ 442.7 $ (366.6) $ -- $ 76.1
====================================================================================================================================
(1) The Company believes that the reserve balances at December 31, 1998 are
adequate to cover the remaining liabilities associated with these charges.
29
Notes to Consolidated Financial Statements
Strategic Restructuring Program &
4 Discontinued Operations
In November 1997, the Company completed the final phase of its comprehensive
strategic restructuring program, first announced in October 1995 and
subsequently refined in May 1996 and June 1997. The strategic restructuring
program included: (i) the sale of Marshalls, Kay-Bee Toys, Wilsons, This End Up
and Bob's Stores, (ii) the spin-off of Footstar, Inc., which included Meldisco,
Footaction and Thom McAn (the "Footstar Distribution"), (iii) the initial and
secondary public offerings of Linens `n Things and (iv) the elimination of
certain corporate overhead costs.
The strategic restructuring program was completed without significant changes to
the Board approved plan. As part of completing this program, the Company
recorded, as a component of discontinued operations, an after-tax charge of
$20.7 million during the second quarter of 1997 and $148.1 million during the
second quarter of 1996 to finalize original liability estimates. The Company
believes that the remaining pre-tax reserve balance of $84.7 million at December
31, 1998 is adequate to cover the remaining liabilities associated with this
program.
Following is a summary of the strategic restructuring reserve:
================================================================
Total Utilized
In millions Reserve to Date Transfer Balance
- ----------------------------------------------------------------
Loss on disposal $ 721.8 $ (710.6) $38.8 $50.0
Lease obligations 187.4 (124.6) (32.8) 30.0
Severance 58.6 (47.9) (6.0) 4.7
Other 174.2 (174.2) -- --
- ----------------------------------------------------------------
$1,142.0 $(1,057.3) $ -- $84.7
================================================================
Following is a summary of discontinued operations by reporting segment for the
years ended December 31:
===============================================================
In millions 1997 1996
- ---------------------------------------------------------------
Net sales:
Footwear $ -- $1,391.1
Apparel 348.3 526.4
Toys and Home Furnishings -- 900.3
- ---------------------------------------------------------------
$348.3 $2,817.8
===============================================================
Operating (loss):
Footwear $ -- $ (12.4)
Apparel -- (171.3)
Toys and Home Furnishings -- (49.7)
- ---------------------------------------------------------------
$ -- $ (233.4)
===============================================================
As of December 31, 1998 and 1997, there were no assets or liabilities of the
discontinued operations reflected in the accompanying consolidated balance
sheets.
5 Borrowings and Credit Agreements
Following is a summary of the Company's borrowings at December 31:
==============================================================
In millions 1998 1997
- --------------------------------------------------------------
Commercial paper $736.6 $450.0
ESOP note payable(1) 270.7 292.1
Uncommitted lines of credit 34.5 16.4
9.125% senior notes -- 19.2
Mortgage notes payable 16.1 17.1
Capital lease obligations and other 3.5 3.9
- --------------------------------------------------------------
1,061.4 798.7
Less:
Short-term borrowings (771.1) (466.4)
Current portion of long-term debt (14.6) (41.9)
- --------------------------------------------------------------
$ 275.7 $ 290.4
==============================================================
(1) See Note 9 for further information about the Company's ESOP Plan.
The Company's commercial paper program is supported by a $670 million, five-year
unsecured revolving credit facility, which expires on May 30, 2002 and a $460
million, 364 day unsecured revolving credit facility, which expires on June 26,
1999 (collectively, the "Credit Facilities"). The Credit Facilities require the
Company to pay a quarterly facility fee of 0.07%, regardless of usage. The
Company can also obtain up to $35.0 million of short-term financing through
various uncommitted lines of credit. The weighted average interest rate for
short-term borrowings was 5.7% as of December 31, 1998 and 1997.
The Company was not obligated under any formal or informal compensating balance
agreements.
During the second quarter of 1997, the Company extinguished $865.7 million of
the debt it absorbed as part of the CVS/Revco Merger using cash on hand and
commercial paper borrowings. As a result, the Company recorded an extraordinary
loss, net of income taxes, of $17.1 million, which consisted of early retirement
premiums and the write-off of unamortized deferred financing costs. On January
15, 1998, the Company redeemed the remaining $19.2 million of 9.125% senior
notes.
At December 31, 1998, the aggregate long-term debt maturing during the next five
years is as follows: $14.6 million in 1999, $17.3 million in 2000, $21.6 million
in 2001, $26.5 million in 2002, $32.3 million in 2003, $178.0 million in 2004
and thereafter. Interest paid was approximately $70.7 million in 1998, $58.4
million in 1997 and $79.8 million in 1996.
30
Notes to Consolidated Financial Statements
6 Leases
The Company and its subsidiaries lease retail stores, warehouse facilities and
office facilities under noncancelable operating leases over periods ranging from
5 to 20 years, and generally have options to renew such terms over periods
ranging from 5 to 15 years.
Following is a summary of the Company's net rental expense for operating leases
for the years ended December 31:
===============================================================
In millions 1998 1997 1996
- ---------------------------------------------------------------
Minimum rentals $ 459.1 $ 409.6 $ 337.4
Contingent rentals 60.3 60.2 73.6
- ---------------------------------------------------------------
519.4 469.8 411.0
Less: sublease income (14.0) (9.5) (12.8)
- ---------------------------------------------------------------
$ 505.4 $ 460.3 $ 398.2
===============================================================
Following is a summary of the future minimum lease payments under capital and
operating leases, excluding lease obligations for closed stores, at December 31,
1998:
===============================================================
Capital Operating
In millions Leases Leases
- ---------------------------------------------------------------
1999 $ 0.4 $ 402.6
2000 0.4 381.1
2001 0.4 348.3
2002 0.2 323.3
2003 0.2 297.7
Thereafter 1.3 2,485.7
- ---------------------------------------------------------------
2.9 $ 4,238.7
Less: imputed interest (1.4)
- ---------------------------------------------------------------
Present value of capital lease obligations $ 1.5
===============================================================
7 Stock Incentive Plans
As of December 31, 1998, the Company had the following stock incentive plans
(including the pre-merger plans of Arbor and Revco). Effective with the Mergers,
outstanding Arbor and Revco stock options were exchanged for options to purchase
CVS common stock.
1997 Incentive Compensation Plan
The 1997 Incentive Compensation Plan (the "1997 ICP"), superseded the 1990
Omnibus Stock Incentive Plan, the 1987 Stock Option Plan and the 1973 Stock
Option Plan (collectively, the "Preexisting Plans"). Upon approval of the 1997
ICP, authority to make future grants under the Preexisting Plans was terminated,
although previously granted awards remain outstanding in accordance with their
terms and the terms of the Preexisting Plans.
As of December 31, 1998, the 1997 ICP provided for the granting of up to
23,321,821 shares of common stock in the form of stock options, stock
appreciation rights ("SARs"), restricted shares, deferred shares and
performance-based awards to selected officers, employees and directors of the
Company. All grants under the 1997 ICP are awarded at fair market value on the
date of grant. The right to exercise or receive these awards generally commences
between one and five years from the date of the grant and expires not more than
ten years after the date of the grant, provided that the holder continues to be
employed by the Company. As of December 31, 1998, there were 19,730,690 shares
available for grant under the 1997 ICP.
Restricted shares issued under the 1997 ICP may not exceed 3.6 million shares.
In 1998, 1997 and 1996, 155,400, 44,610 and 633,100 shares of restricted stock
were granted at a weighted average grant date fair value of $37.80, $23.02 and
$13.14, respectively. Participants are entitled to vote and receive dividends on
their restricted shares, although they are subject to certain transfer
restrictions. Performance-based awards, which are subject to the achievement of
certain business performance goals, totaled 56,346 at a weighted average grant
date fair value of $36.70 in 1998. No awards were granted in 1997 and 1996.
Compensation cost, which is based on the fair value at the date of grant, is
recognized over the restricted or performance period. This cost totaled $3.1
million in 1998, $3.5 million in 1997 and $3.9 million in 1996.
The 1996 Directors Stock Plan
The 1996 Directors Stock Plan (the "1996 DSP"), provides for the granting of up
to 346,460 shares of common stock to the Company's non-employee directors (the
"Eligible Directors"). The 1996 DSP allows the Eligible Directors to elect to
receive shares of common stock in lieu of cash compensation. Eligible Directors
may also elect to defer compensation payable in common stock until their service
as a director concludes. The 1996 DSP replaced the Company's 1989 Directors
Stock Option Plan. As of December 31, 1998, there were 263,554 shares available
for grant under the 1996 DSP.
31
Notes to Consolidated Financial Statements
Following is a summary of the fixed stock option activity under the 1997 ICP,
the Preexisting Plans and the pre-merger plans of Arbor and Revco for the years
ended December 31:
===================================================================================================================================
1998 1997 1996
-------------------------------- -------------------------------- --------------------------------
Weighted Average Weighted Average Weighted Average
Shares Exercise Price Shares Exercise Price Shares Exercise Price
- -----------------------------------------------------------------------------------------------------------------------------------
Outstanding at beginning of year 16,070,146 $ 16.95 23,569,930 $ 13.96 25,782,040 $ 14.06
Granted 3,119,410 37.16 3,695,530 23.62 6,609,229 14.80
Exercised (7,137,027) 15.01 (10,756,726) 12.99 (3,534,729) 11.62
Canceled (70,407) 26.48 (438,588) 14.48 (5,286,610) 17.35
- -----------------------------------------------------------------------------------------------------------------------------------
Outstanding at end of year 11,982,122 23.31 16,070,146 16.95 23,569,930 13.96
- -----------------------------------------------------------------------------------------------------------------------------------
Exercisable at end of year 6,127,402 11,729,688 10,011,179
===================================================================================================================================
Following is a summary of the fixed stock options outstanding and exercisable as
of December 31, 1998:
===================================================================================================================================
Options Outstanding Options Exercisable
------------------------------------------------------------ ----------------------------------------
Range of Number Weighted Average Weighted Average Number Weighted Average
Exercise Prices Outstanding Remaining Life Exercise Price Exercisable Exercise Price
- -----------------------------------------------------------------------------------------------------------------------------------
$ 5.00 to $20.00 6,024,451 5.5 $16.29 5,358,465 $16.24
20.01 to 35.00 2,857,611 7.1 23.10 697,787 22.20
35.01 to 46.50 3,100,060 9.1 37.16 71,150 37.45
- -----------------------------------------------------------------------------------------------------------------------------------
$ 5.00 to $46.50 11,982,122 6.8 $23.31 6,127,402 $17.16
===================================================================================================================================
The Company applies APB Opinion No. 25 to account for its stock incentive plans.
Accordingly, no compensation cost has been recognized for stock options granted.
Had compensation cost been recognized based on the fair value of stock options
granted consistent with SFAS No. 123, net earnings and net earnings per common
share ("EPS") would approximate the pro forma amounts shown below for the years
ended December 31.
=====================================================================
In millions, except per share amounts 1998 1997 1996
- ---------------------------------------------------------------------
Net earnings:
As reported $396.4 $76.9 $208.2
Pro forma 370.9 58.7 196.2
- ---------------------------------------------------------------------
Basic EPS:
As reported $ 0.99 $0.17 $ 0.53
Pro forma 0.92 0.12 0.50
- ---------------------------------------------------------------------
Diluted EPS:
As reported $ 0.98 $0.16 $ 0.52
Pro forma 0.91 0.12 0.49
=====================================================================
Beginning with grants made on or after January 1, 1995, the fair value of each
stock option grant was estimated using the Black-Scholes Option Pricing Model
with the following assumptions:
=============================================================
1998 1997 1996
- -------------------------------------------------------------
Dividend yield 0.40% 0.70% 1.07%
Expected volatility 22.49% 22.77% 20.51%
Risk-free interest rate 5.75% 5.50% 7.00%
Expected life 7.0 5.5 5.0
=============================================================
Pension Plans and
8 Other Postretirement Benefits
The Company sponsors various retirement programs, including defined benefit,
defined contribution and other plans that cover most full-time employees.
Defined Benefit Plans
The Company sponsors a non-contributory defined benefit pension plan that covers
certain full-time employees of Revco who are not covered by collective
bargaining agreements. On September 20, 1997, the Company suspended future
benefit accruals under this plan. As a result of the plan's suspension, the
Company realized a $6.0 million curtailment gain in 1997. Benefits paid to
retirees are based upon age at retirement, years of credited service and average
compensation during the five year period ending September 20, 1997. It is the
Company's policy to fund this plan based on actuarial calculations and
applicable federal regulations.
Pursuant to various labor agreements, the Company is required to make
contributions to certain union-administered pension plans that totaled $1.5
million in 1998, $1.6 million in 1997 and $1.2 million in 1996. The Company may
be liable for its share of the plans' unfunded liabilities if the plans are
terminated. The Company also has non-qualified supplemental executive retirement
plans ("SERPs") in place for certain key employees for whom it has purchased
cost recovery variable life insurance.
32
Notes to Consolidated Financial Statements
Defined Contribution Plans
The Company sponsors a Profit Sharing Plan and a 401(k) Savings Plan that cover
substantially all employees who meet plan eligibility requirements. The Company
also maintains a non-qualified, unfunded Deferred Compensation Plan for certain
key employees. The Company's contributions under the above defined contribution
plans totaled $26.4 million in 1998, $24.1 million in 1997 and $19.5 million in
1996. The Company also sponsors an Employee Stock Ownership Plan. See Note 9 for
further information about this plan.
Other Postretirement Benefits
The Company provides postretirement health care and life insurance benefits to
retirees who meet eligibility requirements. The Company's funding policy is
generally to pay covered expenses as they are incurred.
Following is a reconciliation of the benefit obligation, fair value of plan
assets and funded status of the Company's defined benefit and other
postretirement benefit plans:
===================================================================================================================================
Defined Benefit Plans Other Postretirement Benefits
In millions 1998 1997 1998 1997
- -----------------------------------------------------------------------------------------------------------------------------------
Change in benefit obligation:
Benefit obligation at beginning of year $ 253.3 $ 255.1 $ 14.4 $ 15.5
Service cost 0.5 7.6 -- --
Interest cost 19.5 19.2 1.0 1.0
Actuarial loss (gain) 49.3 (10.4) 0.5 (0.7)
Benefits paid (25.0) (18.2) (1.9) (1.4)
- -----------------------------------------------------------------------------------------------------------------------------------
Benefit obligation at end of year $ 297.6 $ 253.3 $ 14.0 $ 14.4
===================================================================================================================================
Change in plan assets:
Fair value at beginning of year $ 201.5 $ 172.8 $ -- $ --
Actual return on plan assets 28.4 20.0 -- --
Company contributions 18.2 26.9 1.9 1.4
Benefits paid (25.0) (18.2) (1.9) (1.4)
- -----------------------------------------------------------------------------------------------------------------------------------
Fair value at end of year(1) $ 223.1 $ 201.5 $ -- $ --
===================================================================================================================================
Funded status:
Funded status $ (74.5) $ (51.8) $ (14.0) $ (14.5)
Unrecognized prior service cost 1.3 1.6 (1.0) (1.1)
Unrecognized net loss (gain) 1.6 (8.4) (0.3) (1.0)
- -----------------------------------------------------------------------------------------------------------------------------------
Accrued pension costs $ (71.6) $ (58.6) $ (15.3) $ (16.6)
===================================================================================================================================
Weighted average assumptions:
Discount rate 6.75% 7.25% 6.75% 7.25%
Expected return on plan assets 9.00% 9.00% -- --
Rate of compensation increase 4.50% 4.50% -- --
===================================================================================================================================
(1) Plan assets consist primarily of mutual funds, common stock and insurance
contracts.
For measurement purposes, future health care costs are assumed to increase at an
annual rate of 6.5% during 1999, decreasing to an annual growth rate of 5.0% in
2002 and thereafter. A one percent change in the assumed health care cost trend
rate would change the accumulated postretirement benefit obligation by $1.0
million and the total service and interest costs by $0.1 million.
Following is a summary of the net periodic pension cost for the defined benefit
and other postretirement benefit plans:
===================================================================================================================================
Defined Benefit Plans Other Postretirement Benefits
In millions 1998 1997 1996 1998 1997 1996
- -----------------------------------------------------------------------------------------------------------------------------------
Service cost(1) $ 0.5 $ 7.6 $ 9.2 $ -- $ -- $ 0.4
Interest cost on benefit obligation 19.5 19.2 16.8 1.0 1.0 2.5
Expected return on plan assets (16.4) (14.9) (18.2) -- -- --
Amortization of net loss (gain) 1.2 0.3 6.1 (0.2) -- (1.1)
Amortization of prior service cost 0.1 0.3 0.4 (0.1) (0.3) --
Curtailment gain -- (6.0) (1.3) -- -- --
- -----------------------------------------------------------------------------------------------------------------------------------
Net periodic pension cost $ 4.9 $ 6.5 $ 13.0 $ 0.7 $ 0.7 $ 1.8
===================================================================================================================================
(1) The decrease in total service cost is primarily due to the suspension of
future benefit accruals under the Revco pension plan during 1997.
33
Notes to Consolidated Financial Statements
9 Employee Stock Ownership Plan
The Company sponsors a defined contribution Employee Stock Ownership Plan (the
"ESOP") that covers full-time employees with at least one year of service.
In 1989, the ESOP Trust borrowed $357.5 million through a 20-year note (the
"ESOP Note"). The proceeds from the ESOP Note were used to purchase 6.7 million
shares of Series One ESOP Convertible Preference Stock (the "ESOP Preference
Stock") from the Company. Since the ESOP Note is guaranteed by the Company, the
outstanding balance is reflected as long-term debt and a corresponding
Guaranteed ESOP obligation is reflected in shareholders' equity in the
accompanying consolidated balance sheets.
Each share of ESOP Preference Stock has a guaranteed minimum liquidation value
of $53.45, is convertible into 2.314 shares of common stock and is entitled to
receive an annual dividend of $3.90 per share. The ESOP Trust uses the dividends
received and contributions from the Company to repay the ESOP Note. As the ESOP
Note is repaid, ESOP Preference Stock is allocated to participants based on: (i)
the ratio of each year's debt service payment to total current and future debt
service payments multiplied by (ii) the number of unallocated shares of ESOP
Preference Stock in the plan. As of December 31, 1998, 5.2 million shares of
ESOP Preference Stock were outstanding, of which 1.6 million shares were
allocated to participants and the remaining 3.6 million shares were held in the
ESOP Trust for future allocations.
Annual ESOP expense recognized is equal to (i) the interest incurred on the ESOP
Note plus (ii) the higher of (a) the principal repayments or (b) the cost of the
shares allocated, less (iii) the dividends paid. Similarly, the Guaranteed ESOP
obligation is reduced by the higher of (i) the principal payments or (ii) the
cost of shares allocated.
Following is a summary of the ESOP for the years ended December 31:
================================================================
In millions 1998 1997 1996
- ----------------------------------------------------------------
ESOP expense recognized $25.8 $13.8 $15.4
Dividends paid 20.5 20.8 21.8
Cash contributions 25.8 22.9 19.3
Interest costs incurred on ESOP loan 24.9 26.4 27.5
ESOP shares allocated 0.4 0.4 0.4
================================================================
10 Supplemental Information
Following are the components of amounts included in the consolidated balance
sheets as of December 31:
===============================================================
In millions 1998 1997
- ---------------------------------------------------------------
Other current assets:
Deferred income taxes $ 248.7 $ 304.2
Supplies 16.8 13.6
Other 62.4 47.0
- ---------------------------------------------------------------
$ 327.9 $ 364.8
===============================================================
Property and equipment:
Land $ 91.0 $ 78.7
Buildings and improvements 290.2 231.5
Fixtures and equipment 1,178.4 938.9
Leasehold improvements 477.4 443.7
Capital leases 2.8 3.3
- ---------------------------------------------------------------
2,039.8 1,696.1
Accumulated depreciation and
amortization (688.6) (623.8)
- ---------------------------------------------------------------
$1,351.2 $1,072.3
===============================================================
Accrued expenses:
Taxes other than federal
income taxes $ 130.8 $ 127.5
Salaries and wages 99.4 99.6
Rent 92.2 84.8
Strategic restructuring reserve 84.7 102.8
Employee benefits 82.7 84.3
CVS/Revco/ Big B reserve 76.1 233.0
CVS/Arbor reserve 57.0 --
Other 488.4 436.6
- ---------------------------------------------------------------
$1,111.3 $1,168.6
===============================================================
Following is a summary of the Company's non-cash financing activities for the
years ended December 31:
===========================================================
In millions 1998 1997 1996
- -----------------------------------------------------------
Fair value of assets acquired $62.2 $ -- $423.2
Cash paid 62.2 -- 373.9
- -----------------------------------------------------------
Liabilities assumed $ -- $ -- $ 49.3
- -----------------------------------------------------------
Equity securities or notes
received from sale of
businesses $ -- $52.0 $172.4
===========================================================
Interest expense was $69.7 million in 1998, $59.1 million in 1997 and $84.7
million in 1996. Interest income was $8.8 million in 1998, $15.0 million in 1997
and $9.2 million in 1996.
34
Notes to Consolidated Financial Statements
11 Income Taxes
Deferred income taxes reflect the net tax effects of the temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes.
The Company's income tax (provision) benefit for continuing operations for the
years ended December 31 consisted of the following:
========================================================
In millions Federal State Total
- --------------------------------------------------------
1998:
Current $(197.3) $(41.4) $(238.7)
Deferred (51.2) (25.0) (76.2)
- --------------------------------------------------------
$(248.5) $(66.4) $(314.9)
========================================================
1997:
Current $(182.5) $(68.5) $(251.0)
Deferred 82.1 28.1 110.2
- --------------------------------------------------------
$(100.4) $(40.4) $(140.8)
========================================================
1996:
Current $(195.6) $(54.9) $(250.5)
Deferred (17.7) (2.8) (20.5)
- --------------------------------------------------------
$(213.3) $(57.7) $(271.0)
========================================================
Following is a reconciliation of the statutory income tax rate to the Company's
effective tax rate for the years ended December 31:
================================================================
1998 1997 1996
- ----------------------------------------------------------------
Statutory income tax rate 35.0% 35.0% 35.0%
State income taxes, net of
federal tax benefit 5.8 6.6 5.5
Goodwill and other 1.2 1.4 1.6
- ----------------------------------------------------------------
Effective tax rate before
merger related costs 42.0 43.0 42.1
Merger related costs (1) 2.3 21.8 --
- ----------------------------------------------------------------
Effective tax rate 44.3% 64.8% 42.1%
================================================================
(1) Includes state tax effect.
Income taxes paid (refunded) were $102.6 million, $258.9 million and $(33.8)
million during the years ended December 31, 1998, 1997 and 1996, respectively.
Following is a summary of the significant components of the Company's deferred
tax assets and liabilities as of December 31:
==========================================================
In millions 1998 1997
- ----------------------------------------------------------
Deferred tax assets:
Employee benefits $ 84.5 $119.0
Other assets 185.5 253.8
- ----------------------------------------------------------
Total deferred tax assets $270.0 $372.8
- ----------------------------------------------------------
Deferred tax liabilities:
Property and equipment $(44.0) $(27.0)
Inventories (1.6) (29.9)
Other liabilities -- (10.7)
- ----------------------------------------------------------
Total deferred tax liabilities (45.6) (67.6)
- ----------------------------------------------------------
Net deferred tax assets $224.4 $305.2
==========================================================
Based on historical pre-tax earnings, the Company believes it is more likely
than not that the deferred tax assets will be realized.
As of December 31, 1998, the Company had federal net operating loss
carryforwards ("NOLs") of $3.7 million that are attributable to Revco for
periods prior to its emergence from Chapter 11. The benefits realized from these
NOLs should reduce reorganization goodwill. Accordingly, the tax benefit of such
NOLs utilized during the three years ended December 31, 1998, $7.2 million,
$69.4 million and $15.3 million for 1998, 1997 and 1996, respectively, has not
been included in the computation of the Company's income tax provision, but
instead has been reflected as reductions of reorganization goodwill.
On October 12, 1996, the Company completed the Footstar Distribution which is
believed to be tax-free to the Company and its shareholders based on a legal
opinion provided by outside counsel. However, since opinions of counsel are not
binding on the Internal Revenue Service or the courts, it could ultimately be
determined that the Footstar Distribution does not qualify as a tax-free
distribution. If such occurred, the Company would be required to recognize a
capital gain for tax purposes equal to the difference between the fair market
value of the shares of Footstar stock distributed and the Company's basis in
such shares. The Company, however, believes the likelihood of the Footstar
Distribution not qualifying as a tax-free distribution to be remote.
35
Notes to Consolidated Financial Statements
12 Business Segments
The Company currently operates a Retail segment and a Pharmacy Benefit
Management ("PBM") segment. The Company's business segments are operating units
that offer different products and services, and require distinct technology and
marketing strategies.
The Retail segment, which is described in Note 1, is the Company's only
reportable segment.
The PBM segment provides a full range of prescription benefit management
services to managed care and other organizations. These services include plan
design and administration, formulary management, mail order pharmacy services,
claims processing and generic substitution.
The accounting policies of the segments are substantially the same as those
described in Note 1. The Company evaluates segment performance based on
operating profit, before the effect of non-recurring charges and gains and
intersegment profits.
Following is a reconciliation of the significant components of the Company's
consolidated net sales for the years ended December 31:
==================================================
1998 1997 1996
- --------------------------------------------------
Pharmacy(1) 57.6% 54.7% 51.6%
Front store 42.4 45.3 48.4
- --------------------------------------------------
Consolidated net sales 100.0% 100.0% 100.0%
==================================================
(1) Pharmacy sales includes the Retail segment's pharmacy sales, the PBM
segment's total sales and the effect of the intersegment sales elimination
discussed in the table below.
Following is a reconciliation of the Company's business segments to the
consolidated financial statements:
===========================================================================================================================
Retail PBM Intersegment Other Consolidated
In millions Segment Segment Eliminations(1) Adjustments(2) Totals
- ---------------------------------------------------------------------------------------------------------------------------
1998:
Net sales $15,081.1 $488.4 $(295.9) $ -- $15,273.6
Operating profit 927.8 12.7 -- (168.3) 772.2
Depreciation and amortization 248.6 1.1 -- -- 249.7
Total assets 6,652.1 119.6 (35.5) -- 6,736.2
Capital expenditures 498.0 4.3 -- -- 502.3
===========================================================================================================================
1997:
Net sales $13,649.4 $320.7 $(220.5) $ -- $13,749.6
Operating profit 771.2 7.9 -- (517.7) 261.4
Depreciation and amortization 237.8 0.4 -- -- 238.2
Total assets 5,937.3 60.6 (19.0) -- 5,978.9
Capital expenditures 339.6 2.0 -- -- 341.6
===========================================================================================================================
1996:
Net sales $11,766.3 $208.9 $(143.6) $ -- $11,831.6
Operating profit 602.5 2.2 -- (12.8) 591.9
Depreciation and amortization 205.2 0.2 -- -- 205.4
Total assets 6,003.5 32.8 (21.4) -- 6,014.9
Capital expenditures 326.9 2.0 -- -- 328.9
===========================================================================================================================
(1) Intersegment eliminations relate to intersegment sales and accounts
receivables that occur when a PBM segment customer uses a Retail segment
store to purchase covered merchandise. When this occurs, both segments
record the sale on a stand-alone basis.
(2) Other adjustments relate to the merger and restructuring charges discussed
in Note 3 and a $12.8 million charge that was recorded when Rite Aid
Corporation withdrew its tender offer to acquire Revco. This event took
place in 1996 before the CVS/Revco Merger. The merger and restructuring
charges are not considered when management assesses the stand-alone
performance of the Company's business segments.
36
Notes to Consolidated Financial Statements
13 Reconciliation of Earnings Per Common Share
Following is a reconciliation of basic and diluted earnings per common share for
the years ended December 31:
=============================================================================================================
In millions, except per share amounts 1998 1997 1996
- -------------------------------------------------------------------------------------------------------------
Numerator for earnings per common share calculation:
Earnings from continuing operations before extraordinary item $396.4 $ 76.5 $ 372.4
Preference dividends, net of tax benefit (13.6) (13.7) (14.5)
- -------------------------------------------------------------------------------------------------------------
Earnings from continuing operations available to common
shareholders, basic $382.8 $ 62.8 $ 357.9
- -------------------------------------------------------------------------------------------------------------
Earnings (loss) from discontinued operations -- 17.5 (164.2)
Extraordinary loss -- (17.1) --
- -------------------------------------------------------------------------------------------------------------
Net earnings available to common shareholders, basic $382.8 $ 63.2 $ 193.7
=============================================================================================================
Earnings from continuing operations before extraordinary item $396.4 $ 76.5 $ 372.4
Effect of dilutive securities:
Preference dividends, net of tax benefit -- (13.7) --
Dilutive earnings adjustments (0.8) -- (7.5)
- -------------------------------------------------------------------------------------------------------------
Earnings from continuing operations available to common
shareholders, diluted $395.6 $ 62.8 $ 364.9
- -------------------------------------------------------------------------------------------------------------
Earnings (loss) from discontinued operations -- 17.5 (164.2)
Extraordinary loss -- (17.1) --
- -------------------------------------------------------------------------------------------------------------
Net earnings available to common shareholders, diluted $395.6 $ 63.2 $ 200.7
=============================================================================================================
Denominator for earnings per common share calculation:
Weighted average common shares, basic 387.1 377.2 366.9
Effect of dilutive securities:
Preference stock 10.5 -- 11.7
Stock options 7.6 7.9 5.0
- -------------------------------------------------------------------------------------------------------------
Weighted average common shares, diluted 405.2 385.1 383.6
=============================================================================================================
Basic earnings per common share:
Earnings from continuing operations before extraordinary item $ 0.99 $ 0.17 $ 0.98
Earnings (loss) from discontinued operations -- 0.05 (0.45)
Extraordinary item, net of tax benefit -- (0.05) --
- -------------------------------------------------------------------------------------------------------------
Net earnings $ 0.99 $ 0.17 $ 0.53
=============================================================================================================
Diluted earnings per common share:
Earnings from continuing operations before extraordinary item $ 0.98 $ 0.16 $ 0.95
Earnings (loss) from discontinued operations -- 0.05 (0.43)
Extraordinary item, net of tax benefit -- (0.05) --
- -------------------------------------------------------------------------------------------------------------
Net earnings $ 0.98 $ 0.16 $ 0.52
=============================================================================================================
37
Notes to Consolidated Financial Statements
14 Commitments & Contingencies
In connection with certain business dispositions completed between 1991 and
1997, the Company continues to guarantee lease obligations for approximately
1,600 former stores. The Company is indemnified for these obligations by the
respective purchasers. Assuming that each respective purchaser became insolvent,
an event which the Company believes to be highly unlikely, management estimates
that it could settle these obligations for approximately $1.1 billion as of
December 31,1998. In the opinion of management, the ultimate disposition of
these guarantees will not have a material adverse effect on the Company's
consolidated financial condition, results of operations or future cash flows.
The Company is also a defendant in various lawsuits arising in the ordinary
course of business. In the opinion of management and the Company's outside
counsel, the ultimate disposition of these lawsuits, exclusive of potential
insurance recoveries, will not have a material adverse effect on the Company's
consolidated financial condition, results of operations or future cash flows.
15 Quarterly Financial Information (Unaudited)
===================================================================================================================================
In millions, except per share amounts 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
- -----------------------------------------------------------------------------------------------------------------------------------
Net sales:
1998 $ 3,601.5 $ 3,755.9 $ 3,725.1 $ 4,191.1
1997 3,397.8 3,406.8 3,328.7 3,616.3
- -----------------------------------------------------------------------------------------------------------------------------------
Gross margin:
1998 $ 1,006.9 $ 1,020.5 $ 995.3 $ 1,106.5
1997 967.9 873.0 905.6 971.8
- -----------------------------------------------------------------------------------------------------------------------------------
Earnings (loss) from continuing operations before extraordinary item:
1998 $ 132.0 $ 16.2 $ 102.4 $ 145.8
1997 92.1 (221.4) 82.2 123.6
- -----------------------------------------------------------------------------------------------------------------------------------
Net earnings (loss):
1998 $ 132.0 $ 16.2 $ 102.4 $ 145.8
1997 92.2 (221.1) 82.2 123.6
- -----------------------------------------------------------------------------------------------------------------------------------
Earnings (loss) per common share from continuing operations before
extraordinary item:
1998: Basic $ 0.34 $ 0.03 $ 0.25 $ 0.37
Diluted 0.33 0.03 0.25 0.36
1997: Basic 0.24 (0.60) 0.21 0.31
Diluted 0.23 (0.60) 0.20 0.31
- -----------------------------------------------------------------------------------------------------------------------------------
Net earnings (loss) per common share:
1998: Basic $ 0.34 $ 0.03 $ 0.25 $ 0.37
Diluted 0.33 0.03 0.25 0.36
1997: Basic 0.24 (0.60) 0.21 0.31
Diluted 0.23 (0.60) 0.20 0.31
- -----------------------------------------------------------------------------------------------------------------------------------
Market price per common share (New York Stock Exchange):
1998: High $ 37-7/16 $ 39-5/8 $ 46-1/2 $ 55-11/16
Low 31-1/16 33-3/8 36-3/8 42-1/16
1997: High 24 26-7/8 30 35
Low 19-1/2 22-1/8 25-7/16 27-5/16
- -----------------------------------------------------------------------------------------------------------------------------------
Dividends declared per common share:
1998 $ 0.0550 $ 0.0550 $ 0.0575 $ 0.0575
1997 0.0550 0.0550 0.0550 0.0550
- -----------------------------------------------------------------------------------------------------------------------------------
Number of registered common shareholders at year-end:
1998 10,500
===================================================================================================================================
38
Five Year Financial Summary
===============================================================================================================================
In millions, except per share amounts 1998 1997 1996 1995 1994
- -------------------------------------------------------------------------------------------------------------------------------
Results of operations:(3)
Net sales $15,273.6 $13,749.6 $11,831.6 $10,513.1 $9,469.1
Operating profit 772.2 261.4 591.9 271.7 416.8
Comparable operating profit(1) 940.5 779.1 604.7 486.8 416.8
Earnings from continuing operations before extraordinary item 396.4 76.5 372.4 83.4 185.9
Comparable earnings from continuing operations before
extraordinary item(2) 510.1 419.2 306.8 210.2 185.9
Net earnings (loss) 396.4 76.9 208.2 (547.1) 400.2
- -------------------------------------------------------------------------------------------------------------------------------
Per common share:
Earnings from continuing operations before extraordinary item:
Basic $ 0.99 $ 0.17 $ 0.98 $ 0.18 $ 0.47
Diluted 0.98 0.16 0.95 0.18 0.47
Comparable earnings from continuing operations before
extraordinary item:(2)
Basic 1.28 1.08 0.80 0.53 0.47
Diluted 1.26 1.05 0.78 0.53 0.47
Weighted average number of common shares outstanding used to
calculate comparable diluted earnings per common share 405.2 396.0 383.6 364.8 361.6
Cash dividends 0.225 0.220 0.220 0.760 0.760
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Financial position and other data:
Total assets $ 6,763.2 $ 5,978.9 $ 6,014.9 $ 6,614.4 $7,202.9
Total long-term debt 275.7 290.4 1,204.8 1,056.3 1,012.3
Shareholders' equity 3,110.6 2,614.6 2,413.8 2,567.4 3,341.4
Depreciation and amortization 249.7 238.2 205.4 186.4 169.5
Number of stores 4,122 4,094 4,204 3,715 3,617
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Percentage of net sales:
Operating profit 5.1% 1.9% 5.0% 2.6% 4.4%
Comparable operating profit(1) 6.2% 5.7% 5.1% 4.6% 4.4%
Earnings from continuing operations before extraordinary item 2.6% 0.6% 3.1% 0.8% 2.0%
Comparable earnings from continuing operations before
extraordinary item(2) 3.3% 3.0% 2.6% 2.0% 2.0%
Net earnings (loss) 2.6% 0.6% 1.8% (5.2%) 4.2%
===============================================================================================================================
(1) Comparable operating profit excludes the pre-tax effect of the following
non-recurring charges: (i) in 1998, $158.3 million ($107.8 million
after-tax) related to the merger of CVS and Arbor and $10.0 million ($5.9
million after-tax) related to the markdown of non-compatible Arbor
merchandise, (ii) in 1997, $411.7 million ($273.7 million after-tax)
related to the merger of CVS and Revco, $75.0 million ($49.9 million
after-tax) related to the markdown of non-compatible Revco merchandise and
$31.0 million ($19.1 million after-tax) related to the restructuring of
Big B, Inc., (iii) in 1996, $12.8 million ($6.5 million after-tax) related
to the write-off of costs incurred in connection with the failed merger of
Rite Aid Corporation and Revco and (iv) in 1995, $165.5 million ($97.7
million after-tax) related to the Company's strategic restructuring
program and the early adoption of SFAS No. 121, and $49.5 million ($29.1
million after-tax) related to the Company changing its policy from
capitalizing internally developed software costs to expensing the costs as
incurred, outsourcing certain technology functions and retaining certain
employees until their respective job functions were transitioned.
(2) Comparable earnings from continuing operations before extraordinary item
and comparable earnings per common share from continuing operations before
extraordinary item exclude the after-tax effect of the charges discussed in
Note (1) above and a $121.4 million ($72.1 million after-tax) gain realized
during 1996 upon the sale of certain equity securities received from the
sale of Marshalls.
(3) Prior to the Mergers, Arbor's fiscal year ended on July 31 and Revco's
fiscal year ended on the Saturday closest to May 31. In recording the
business combinations, Arbor's and Revco's historical stand-alone
consolidated financial statements have been restated to a December 31
year-end, to conform with CVS' fiscal year-end. As permitted by the rules
and regulations of the Securities and Exchange Commission, Arbor's fiscal
year ended July 31, 1995 and Revco's fiscal year ended June 3, 1995 have
been combined with CVS' fiscal year ended December 31, 1994.
39