CVS 2014 Annual Report Download - page 32

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Management’s Discussion and Analysis
of Financial Condition and Results of Operations
30
CVS Health
• The Pharmacy Services Segment recognizes revenues for its pharmacy network transactions based on individual
contract terms. Our Pharmacy Services Segment contracts are predominantly accounted for using the gross
method. See the “Revenue Recognition” description under “Critical Accounting Policies” later in this section for
further information on our revenue recognition policy.
Gross profit
in our Pharmacy Services Segment includes net revenues less cost of revenues. Cost of revenues
includes (i) the cost of pharmaceuticals dispensed, either directly through our mail service and specialty retail
pharmacies or indirectly through our pharmacy network, (ii) shipping and handling costs and (iii) the operating costs
of our mail service dispensing pharmacies, customer service operations and related information technology support.
Gross profit increased $534 million, or 12.6% to $4.8 billion in the year ended December 31, 2014, as compared to
the prior year. Gross profit as a percentage of net revenues decreased to 5.4% for the year ended December 31,
2014, compared to 5.6% in the prior year. The increase in gross profit dollars in the year ended December 31, 2014
was primarily due to volume increases, higher generic dispensing and favorable purchasing economics, partially
offset by price compression. The decrease in gross profit as a percentage of net revenues was due to price com-
pression, partially offset by favorable generic dispensing and purchasing economics. In addition, gross profit dollars
and margin for the year ended December 31, 2014, were positively impacted by $16 million related to the favorable
resolution of previously proposed retroactive reimbursement rate changes in the State of California Medicaid program.
During 2013, gross profit increased $429 million, or 11.3%, to $4.2 billion in the year ended December 31, 2013, as
compared to the prior year. Gross profit as a percentage of net revenues was 5.6% for the year ended December 31,
2013, compared to 5.2% in the prior year. The increase in gross profit dollars and gross profit as a percentage of net
revenues in the year ended December 31, 2013 was primarily due to an increase in generic dispensing.
As you review our Pharmacy Services Segment’s performance in this area, we believe you should consider the
following important information:
• Our gross profit dollars and gross profit as a percentage of net revenues continued to be impacted by our efforts
to (i) retain existing clients, (ii) obtain new business and (iii) maintain or improve the rebates and/or discounts
we received from manufacturers, wholesalers and retail pharmacies. In particular, competitive pressures in the
PBM industry have caused us and other PBMs to continue to share a larger portion of rebates and/or discounts
received from pharmaceutical manufacturers with clients. In addition, market dynamics and regulatory changes
have impacted our ability to offer plan sponsors pricing that includes retail network “differential” or “spread”. We
expect these trends to continue. The “differential” or “spread” is any difference between the drug price charged to
plan sponsors, including Medicare Part D plan sponsors, by a PBM and the price paid for the drug by the PBM to
the dispensing provider. The increased use of generic drugs has positively impacted our gross profit margins but
has resulted in third party payors augmenting their efforts to reduce reimbursement payments for prescriptions.
This trend, which we expect to continue, reduces the benefit we realize from brand to generic product
conversions.
• We review our network contracts on an individual basis to determine if the related revenues should be accounted
for using the gross method or net method under the applicable accounting rules. Our Pharmacy Services
Segment network contracts are predominantly accounted for using the gross method, which results in higher
revenues, higher cost of revenues and lower gross profit rates.