Was CVS' Cigarettes Decision the Right One?

Source: CVS Health.

Last fall, CVS Health Corp (CVS -0.62%) made national news when it announced that it would no longer sell cigarettes and other tobacco products in its 7,850 stores. CVS Health's decision to opt out of these products cost it $2 billion in annual sales, but does that mean CVS Health's decision was the wrong one? Let's take a closer look.

Tough call
The company's tobacco exit took a toll on its fourth-quarter financial performance. In the quarter, sales at the front of CVS Health's stores took a drubbing. Typically, steady prescription volume means that foot traffic leads to sales throughout the rest of the store that climb a few percentage points per year. However, without tobacco, CVS Health reports that front-end revenue tumbled 6.1%. If you take out tobacco's impact on results, then front-end sales would have grown by about 2%. That means exiting the tobacco business lopped off more than 8% from what would otherwise have been steady results.

Looking at the tobacco drag another way, CVS Health reports that lost tobacco sales caused retail operating profit to slip by 1.3% in Q4. If not for tobacco's weight, operating profit would have increased by 1.7%.

Long-term gain?
Walking away from $2 billion isn't an easy choice, but the sting of losing those sales was lessened by the fact that CVS Health generates tens of billions of dollars per year from employers and health-insurance companies that contract with it to manage their prescription drug plans.

Those healthcare payers hate that they have to pay out a tremendous amount of additional money every year to care for people suffering from tobacco-related illnesses, such as lung cancer.

Since CVS Health's pharmacy benefit management, or PBM, business generated a whopping $23.88 billion in revenue last quarter, up from $20.2 billion the year before, it's far more important to the broader picture than the cigarette business. That suggests that if the company can leverage the elimination of tobacco products from its stores to win additional employers and insurers for its PBM segment, its anti-tobacco stance will prove to be brilliant.

In due time
It's going to be a while before we know whether that will end up being the case. The company admitted in its first-quarter earnings conference call that the benefits it's seeing from its anti-tobacco stance are more qualitative than quantitative.

Although it's nice to hear that the company is getting positive feedback from clients regarding the decision, investors need to see top- and bottom-line deals that can fuel future growth. In the meantime, investors will need to be OK with knowing that tobacco headwinds will weigh down results, at least until we get at least a year beyond the decision to stop marketing them.

Fortunately, CVS Health's other businesses are growing fast enough to make up for the tobacco shortfall. In the first quarter, same-store sales in its back-of-store pharmacies grew 4.2% versus a year ago. Most of that growth has come from an aging and increasingly-insured America, but some is thanks to the company's Minute Clinic in-store healthcare clinics. The company opened 15 new clinics last quarter, bringing the total number of clinics to 986, and leading to Minute Clinic revenue growth of 21% from last year.

Looking ahead
Exiting the cigarettes business came at a price, but a good argument can be made that the lost tobacco business, which is low margin, will prove to be a short-term speed bump and that over time, long-term gains in other parts of its business will more than make up for the decision. Overall, I think the various puts and takes associated with CVS Health's cigarette decision will prove to be a bit of a wash. Instead, I think it makes more sense to focus on the fact that script growth is likely to go much higher over the coming decade because of aging baby boomers. After all, that's the trend that will move the needle for shareholders over the long haul.