Is CVS Gearing up to Kill Rite Aid?

On Monday, CVS Caremark (NYSE: CVS  ) announced the launch of its new Family Vitamin Center. The project is being implemented online and it encourages customers to buy vitamins and supplements due to their various health benefits. For consumers this is a good thing, but for Rite Aid (NYSE: RAD  ) and GNC Holdings (NYSE: GNC  ) it could create some problems.

A look back at Rite Aid and GNC                                                                                                                                                       Since 1998, Rite Aid and GNC have been working together to grow their businesses in concert. This endeavor began as a partnership agreement that would require Rite Aid to add GNC locations within Rite Aid stores. By the end of 2012, there were 2,181 GNC stores set up inside of Rite Aid locations. While these stores represented 26.8% of GNC's store count, they made up only $60.75 million (or 2.5%) of the company's consolidated revenue.

To put this in perspective, the agreement between these two companies brought in revenue for GNC that amounted to less than $28,000 per store. These sales figures are dwarfed by the nearly $368,000 in revenue per location that GNC sees from its stand-alone outlets. However, what the deal lacked in revenue was made up for in profits. In 2012, GNC saw an operating margin of 40.3% from these locations. This is slightly higher than the 33.4% operating margin GNC earned through its franchised locations and far higher than the 19.4% seen in its retail segment.

Rite Aid does not provide financial results specific to its GNC partnership, but the company renewed its agreement to add an additional 300 GNC locations within its stores through 2019. This would bring the company's total count to more than 2,500 locations and is strong evidence that the financial results of this partnership must be positive.

CVS steps up its game                                                                                                                                                                         In an effort to grab as much market share as it can, CVS has done all it can to grow in size. Between 2008 and 2012, the company's number of locations has grown by 7.7% from 6,923 to 7,458. Over that same time-frame, sales have jumped an impressive 40.8% from $87.5 billion to $123.1 billion. In comparison, Rite Aid has seen its store count fall 5.7% from 4,901 to 4,623 over the past five years, while its sales have fallen 3.4% from $26.3 billion to $25.4 billion.

This situation has occurred because these companies have different goals. In four of the past five years, Rite Aid has posted net losses. Almost every year, this metric improves, but the only reason has been the company's decision to consolidate its business by closing unprofitable locations and focus on reducing costs wherever possible.

CVS, on the other hand, has had a very different agenda. As opposed to aiming its efforts toward cost reduction, management has done everything it can to grow sales. The upside to this strategy is that it allows the company to grab a hold of a larger market share quicker, but there is some downside.

For starters, the company will have to forgo profit now in the hope that it can achieve greater returns down the road. This has already been demonstrated by the trend in the company's net profit margin, which has fallen every year since 2010 from a high of 3.8% to 3.1%. Second, this strategy grants other companies opportunities to focus more fiercely on engaging in price wars, which could result in even smaller margins and, possibly, failure for CVS. A great example of the second scenario can be seen by looking at Kmart. It was Kmart's decision to try to beat Wal-Mart on price that brought about the company's downfall and subsequent merger with Sears Holdings in 2005.

In an attempt to grab even more market share and potentially offset the lower margins that have come with its growth, CVS likely decided to adopt a business model not too different from Rite Aid's. The company understands that the margins that GNC earns from its partnership with Rite Aid are large and growing. To capitalize on this, CVS decided to develop its own vitamin and supplement-oriented offering that avoids bringing in an additional partner so that it can either A) earn larger margins than Rite Aid has, or B) lower its prices to try and pressure Rite Aid and GNC out of the market.

Foolish takeaway                                                                                                                                                                                   Based on the evidence provided, investors can see that CVS has a very growth-oriented agenda. The downside to this growth is that it results in lower profitability for the company now but grants it an opportunity for a brighter future if the company's business operates appropriately. However, after seeing Rite Aid and GNC, two competitors profiting from one another by working in concert to grow their enterprises, CVS decided to reach for the low-hanging fruit by setting up its own vitamin and supplement-oriented operation.

Unfortunately, it will likely be months before any results come in regarding the website's launch, but with its larger market share and superior resources, investors shouldn't be surprised to see CVS profit while Rite Aid and GNC suffer moving forward. For this reason, the Foolish investor would be wise to keep a close eye on both Rite Aid and GNC for any financial releases that talk about the performance of their partnership, as any bad news could mean significant downside for Rite Aid and some minimal downside for GNC.

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  • Report this Comment On January 14, 2014, at 8:43 AM, Lendo wrote:

    could RAD be a takeover target for CVS?

  • Report this Comment On January 17, 2014, at 10:41 PM, RxPro wrote:

    RAD looks like a healthy takeover with the way they have recovered, but the time to buy them out was 4 years ago when they were trading well under $1. I don't think CVS or WAG is going to spend the kind of money it would take to own RAD at this point.

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