Why CVS Caremark Is Making a Mistake

Look to Dollar General to see CVS Caremark's mistake.

Feb 12, 2014 at 7:00AM

I get it. CVS Caremark (NYSE:CVS) is removing tobacco products because cigarettes are are unhealthy, addictive, and hurt society in general. It's only 2% of the company's sales, so it's seen as a small sacrifice in the long-term quest to be perceived as a health-enhancing company. A closer look at Dollar General (NYSE:DG), Walgreen (NASDAQ:WBA), and Rite Aid (NYSE:RAD) suggests this could be a costly mistake.

FortunefeaturesSource:  CNNMoney 

The CVS release
On Feb. 5, CVS made the announcement that it is exiting the tobacco industry by October. The company cited statistics that most of us are familiar with about the dangers of smoking including smoking being the No. 1 cause of premature death in the U.S. CVS believes the move "will make a significant difference in reducing the chronic illnesses associated with tobacco use." That sounds quite far fetched. It might be true if CVS was the only game in town, but in the year 2014 tobacco is literally available at every corner store. Customers will simply go elsewhere.

CVS went on to say that it expects to lose $2 billion in revenue annually and take a $0.17 per share hit in earnings. The company "has identified incremental opportunities that are expected to offset the profitability impact." Whatever opportunities those are can and should be implemented regardless, and therefore have nothing to do with removing tobacco.

Worse yet, sure, CVS will "only" lose $2 billion in sales and 4% of its earnings. There are two more problems with that. First, many customers buy tobacco products along with their other purchases. CVS is a convenience store for many people -- a place to buy booze, chips, beauty products, batteries, etc. in addition to tobacco. CVS is risking losing those additional purchases smokers would otherwise make, as they then choose to go elsewhere for all of the above in addition to tobacco itself.

Second, CVS isn't exactly a hyper growth company as it is. Sales for 2013 are expected to show 2.9% growth and another 4.9% growth in 2014. Reducing these sales by 2% before any additional product sales drop is significant. Rite Aid and Walgreen must be licking their chops.

Rite Aid is expected to show just 0.1% growth in sales this fiscal year, which is about to end, and just 0.9% growth next year. Any help Rite Aid can get to steer customers over to its stores and away from CVS will be most welcome I'm sure. Meanwhile, Walgreen is growing sales faster than both Rite Aid and CVS, with an estimated 4.8% and 7.2% increase this year and next, respectively. Any further help from CVS to further accelerate its sales will likewise be welcomed by Walgreen.

Dollar General
Dollar General is a great example of the sales and earnings power of tobacco that seems to extend beyond just the direct purchase of tobacco itself and onto the additional purchases smokers make. Last quarter, the company saw a rise in net sales by 10.5%, same-store sales jumped 4.4%, and earnings per share leaped 14%. Part of the reason for the sudden surge in sales and profits was the introduction of tobacco products, according to CEO Rick Dreiling. It seems highly unlikely that Dollar General caused a sudden wave of new smokers. It's far more likely that those who smoke already came to Dollar General and bought other products. CVS doesn't seem to get that.

Foolish final thoughts
It further begs the question: what else might CVS cut out of its product line? Obesity is the No. 2 cause of premature death in the U.S. Are the company's vast candy and other junk food aisles next to go? It seems equally against CVS' health initiatives to be selling diabetes drugs in the back while having seemingly endless rows of sugary foods elsewhere in the stores.

Fools may want to wait on the sidelines with CVS until they can study the full effect that this move will have on the numbers. As it is, CVS trades with a P/E ratio of just under 15 compared to Walgreen's 15-16 range. With Walgreen's much better growth and less uncertainty, the tiny premium suggests Walgreen may be the better bet between the two.

CVS and Wal-Mart may be dead soon anyway
To learn about two retailers with especially good prospects, take a look at The Motley Fool's special free report: "The Death of Wal-Mart: The Real Cash Kings Changing the Face of Retail." In it, you'll see how these two cash kings are able to consistently outperform and how they're planning to ride the waves of retail's changing tide. You can access it by clicking here.

Nickey Friedman has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Jun 12, 2015 at 5:01PM

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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