In order to more closely align the products sold in its stores with its broader mission of improving the health of its customers, CVS Health (NYSE:CVS) made the bold decision in September to discontinue the sale of tobacco products.
It was an expensive decision, but the company's third-quarter results show that CVS Health can continue to grow despite tobacco related headwinds. CVS Health reported that front-end product sales slumped 4.5% in the quarter versus a year ago because of the halt; yet companywide sales during the quarter still increased a respectable 9.7% year over year to $35 billion. Since the absence of tobacco sales are likely to have a negative impact on CVS Health's results for the foreseeable future, let's look more closely at the impact they had on CVS Health's third-quarter results and how the company hopes to make up its revenue short fall in the coming quarters.
By the numbers
There's no question that exiting the tobacco business had a big negative impact on CVS Health's third quarter. The company's revenue growth would have been much better if not for eliminating its tobacco business.
During CVS Health's third-quarter conference call, the company noted that tobacco weighed down front end sales by 4.8%. That's a pretty big impact, especially since the company stopped selling tobacco just a few weeks before the quarter ended.
But even with tobacco's significant drag on its sales, CVS Health's top line still grew thanks to a strong showing from its pharmacy benefit management, or PBM, and back-of-store pharmacy businesses.
The company's PBM business enjoyed a 4.3% increase in the total number of prescriptions filled and that helped sales within the segment climb 15.7% from last year to $22.5 billion. Similarly, a 5.1% increase for in-store prescriptions helped lift retail pharmacy same store sales by 4.8% in the quarter versus a year ago.
Retail pharmacy sales growth would have been even better if it wasn't for a rising proportion of scripts being written for lower priced generics. Those generics reduced pharmacy sales by 1.9%. Importantly, CVS Health noted that it saw no discernible impact on its pharmacy business from its decision to stop selling tobacco. That suggests that pharmacy customers who smoke still chose to get their scripts filled at CVS Health, rather than shift their prescriptions to another pharmacy competitor like Walgreen (NASDAQ:WBA) or Rite Aid (NYSE:RAD), which still sell tobacco products. Considering the negative impact from exiting tobacco sales, CVS Health's overall retail sales growth of 3.1% was pretty solid.
Dropping to profit
Fortunately for investors, tobacco products are a pretty low margin item so while they had an outsized unfavorable impact on CVS Health's revenue, their impact on earnings was more muted.
Typically, retail margin on products like cigarettes totals roughly 15%, which is far less than the margin that CVS Health notches by selling health and beauty items, which can offer margins in the 30%-50% range.
Since tobacco's profitability is smaller than other products, such as CVS Health's private label brands, the company can use the new found behind-the-counter shelf space to hawk other items that may, over time, increase net income. That may already be happening given that CVS Health's third quarter retail gross profit margin improved from 30% a year ago to 31.26% in the third quarter and the company's retail operating profit expanded by 8.8%.
The company's margin tailwinds benefit even more from the rising generic drug sales. Those generic drugs provide better margin than branded drugs and as a result, companywide net income grew by 5%. Once you toss aside onetime items, such as charges associated with paying down debt early, CVS Health's apples to apples adjusted earnings per share grew 9% to $1.15.
CVS Health robust cash flow should allow the company to make good on its plans to return $5 billion to shareholders this year through both dividends and share repurchases.
Those repurchases will be important to helping blunt some of the expected bottom-line impact of the decision to stop selling tobacco. CVS Health estimates that tobacco will have a negative 9% impact on front end sales in the fourth quarter and that an absence of tobacco revenue will cut EPS by about $0.17 next year. Some of that pain will hopefully be offset by improving retail margin, which the company expects will climb from 4.5% last year to 6.25% in the fourth quarter.
Regardless, CVS Health's full year EPS guidance for this year remains pretty much in line with prior forecasts. The company simply tightened up its expected EPS range to between $4.47 and $4.50 from between $4.43 and $4.51.
If CVS Health can make up for the lost sales and earnings from tobacco over the next few quarters, then investors should find that the company is in even better shape heading into the end of 2015. That's because the company will have much easier year-over-year comparisons.