One Stock Doesn't Want Obamacare Profits

CVS announced first-quarter earnings last week. On the whole the future is bright, but analysts can't get their heads around how much the loss of tobacco sales will impact margins in the long run.

May 10, 2014 at 9:00AM

Changes in the Affordable Care Act have spurred shifts in the pharmacy industry, which led CVS Caremark (NYSE:CVS) to take a bold leap of faith. In March, CVS announced it was discontinuing the sale of tobacco products in an attempt to align itself with the principles of wellness and health care. Tobacco may not be the most profitable segment, but it increases foot traffic, which is why Dollar General (NYSE:DG) entered the market two years ago.

What exactly does an exit from the tobacco market mean? It means CVS is removing tobacco products from all 7,600 stores by Oct. 1, the beginning of the holiday season. The move is expected to cost the company about $2 billion in sales a year, which accounts for approximately 3% of total sales. Helena Foulkes, CVS' pharmacy president, told USA Today, "We really thought about this decision as it relates to the future as a health company -- it's good for customers and our company, in the long run."

CVS, your neighborhood health-care provider
Ultimately, CVS is exiting the tobacco market because it believes tobacco is in conflict with the wellness goals of Obamacare; the legislation encourages smokers to quit by allowing insurers to charge smokers up to 50% more for policies. It also offers employers discounts of up to 50% for employees who stop smoking. Clearly, tobacco use is being targeted by the American Healthcare Act, and some, like the president, are applauding the decision. President Obama -- a former smoker -- had this to say:

As one of the largest retailers and pharmacies in America, CVS Caremark sets a powerful example, and today's decision will help advance my administration's efforts to reduce tobacco-related deaths, cancer and heart disease, as well as bring down health care costs -- ultimately saving lives and protecting untold numbers of families from pain and heartbreak for years to come.

That alone may attract new customers and increase customer loyalty -- at least among non-smokers or those trying to quit. "[T]he response to our exit from the tobacco category continues to be extremely positive," the company said on the last earnings call, adding: 

And we remain confident that this strategic decision will lead to enhanced [enterprisewide] opportunities for growth as CVS Caremark plays an expanding role in our evolving health-care delivery system.

But at what cost, and how long will it take for the strategy to pay off?

Tobacco: good for sales, not margins
Dollar General, the largest retailer in the United States by store count, completed the rollout of tobacco in the second quarter of 2013. While tobacco products increase transactions, margins are extremely thin. "Given the rollout of tobacco, we expect contraction of our gross margin rate throughout the course of the year," Dollar General warned on the fourth quarter 2012 earnings call, the same call that announced the company's intentions to sell tobacco. Indeed, two quarters later, after the rollout was complete, the company reported the following:

Our gross profit rate of 31.3% of sales was 65 basis points less than last year's second quarter, with the majority of the rate compression resulting from our very successful launch of tobacco products across the chain. Tobacco sales contributed nicely to our sales growth and [selling, general and administrative] leverage.

The CEO went on to provide some clear benefits and insights on what selling tobacco products does for sales and traffic:

As I said earlier, we are seeing a significant increase in our traffic, and tobacco has been a key driver. Our experience so far reinforces my belief that traffic is the most important metric to watch as we measure the overall success of our decision to add tobacco products in our stores. Our sales and our traffic are continuing to build each week, along with our customers' awareness. Tobacco sales are consistently running about [one-third] tobacco-only, and the remaining [two-thirds] are tobacco plus one or more items.

In other words, tobacco sales are not about margin, they're about traffic. The strategy is to get more people in the store. As more people come in to buy tobacco, they may decide to buy something else.

From an entry perspective, tobacco decreases margins but increases sales and traffic. From an exit perspective, tobacco increases margins, but traffic and sales suffer. 

Tobacco use is detrimental to your health; it's been shown to cause cancer and a host of other illnesses. Clearly, discontinuing the sale of tobacco products is the morally responsible thing to do, especially if you're a health-care provider. But since when has morality been an argument for big business?

Indeed, this new strategy sends the country a message: CVS is about health care, not just making a profit, which worries investors with legitimate concerns about future sales. What's more, there's no real time table for how long it will take to build up the health-care business. Unless the company can find something to fill that space behind the register, sales will drop.

Net/net, what you will likely see in the fourth quarter of next year for CVS is a significant drop in same-store sales with a slight increase in margin. Dollar General, on the other hand, will likely see a boost in same-store sales along with a slight decrease in gross margin.

One thing is certain: CVS' CEO has a vision of health care for the company. But if this plan fails, the board may be showing the CEO a vision of the door.

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C Bryant has no position in any stocks mentioned. The Motley Fool recommends CVS Caremark. 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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