August 22, 2014

CVS Has Decided to Destroy Its $2 Billion Per Year Tobacco Business

For those of you who missed it last month, CVS Caremark, a publicly traded pharmacy / distributor / convenience store empire, generates about $123 billion in sales every year.  Of that, roughly $2 billion is from tobacco; mostly cigarettes.  It’s a highly profitable item that brings in repeat business (folks stop in for a pack and are likely to pick up a bottle of Coca-Cola, maybe a stick of gum, too).  Very few things in life drive that kind of repeat business.

Management decided it wanted to send a message telling the world what CVS means, values, and believes.  (It’s straight-up signaling theory.)  They think selling a product that kills is inconsistent with healing people.  Can’t fault them on the logic.

CVS Tobacco

With overall sales of $123 billion, the move represents about 1.6% of revenue.  But that’s deceiving.  Cigarettes are the second most profitable item sold in a convenience store environment, coming only after non-alcoholic beverages like Coca-Cola or Gold Peak Tea.  They have no fixed cost against them (the building still costs the same, the light bill costs the same, the employee salaries cost the same), meaning that to identify the profitability loss, you’d have to look at a roughly estimated gross margin, not net margins.  There are a few variables you have to try and sketch out but the bottom line is this move could cost the company between $300 and $400 million in pre-tax gross profits every year.  Before taxes, the move could lower operating earnings between 4% and 6% from what they would have been, but it is likely this will be hidden by new store openings, acquisitions, and price increases on other goods.

For a long-term owner, this may seem like a small, insignificant amount of money, but it’s not.  To put it into perspective, the management just destroyed a business roughly the same size as the entire Tupperware Brands corporation.  Ultimately, it won’t make a difference from a societal standpoint because the sales will shift to other outlets like specialty tobacco shops or Wal-Mart.

Was this the right move?  I can’t decide because I understand why they are doing it, but I think the idea that CVS thinks of itself as a health care company first is mostly the result of the Caremark division because the flagship retail empire is closer to a gas station or the Dollar Store than it is Johnson & Johnson.  When you’re selling knock-off chocolates and cheap stuffed bears from China, two-bit cologne and “As Seen on TV” tchotchkes, taking the high moral ground seems both admirable and foolish give that it won’t have an impact.

Should the owners be fine with losing billions of dollars in future wealth because management has moral qualms about a product society continually chooses to make legal and available, especially when it won’t cut net smoking but instead cause those profits to flow to competitors?

I’m not sure how I feel about it because they’re making it out to be some heroic stand, yet it changes nothing.  It inconveniences customers.  It costs the owners a tremendous amount of future wealth.  One potential solution would be a total switch to e-cigarettes, which management says it is considering, given that there are no risks like second hand smoke and they are generally much healthier on the lungs since you aren’t pumping black tar into them.

Not that it matters, but I have no stake in CVS either way, or any drugstore for that matter.  I did have my parents purchase some shares of Walgreen earlier in the year when it was trading at very close to its intrinsic value and offered a better relative opportunity cost than most other stocks at the time, which they continue to hold (though I wouldn’t recommend they add to the position since the shares surged by 20%+ in the past few weeks resulting in a situation where there are better deals out there).

  • BukaHanersib

    I was confused by this move myself. I’m not sure that I am interested in a retailer staking out moral ground. I don’t shop at CVS regularly, and this move will have zero impact on my decision to shop there in the future. I simply don’t understand what their angle is, although I’m confident they have one.

  • fran

    I believe the move is for their future plans to have medical professionals working in the stores. Perhaps docs or nurse practioners that can diagnose and prescribe. Perhaps even an urgent-care model? If they go this way, the revenue gains could far offset the losses.

  • Frederick

    This reminds me of the Korean TV show Pasta, where the chef demands they eliminate Foie Gras from the menu.

  • innerscorecard

    Business judgment rule, for better or worse.

    What do you think of Tim Cook’s statements on a similar vein in Apple’s recent shareholder meeting? The context was different, since Apple didn’t actually make any moves to destroy shareholder value. I think that was simply Cook refusing to justify each move on ROI grounds (even if all moves, including accessibility for the blind on iOS, could ultimately in fact be justified that way), as not being the way he wanted to look at things.

  • Lord Squidworth

    Its been ages since I’ve been to a CVS. Hannaford (the big grocery store in New England) carries all that stuff now.

    Even when I went, it was a couple times a year for something like cold meds late in the evening if I felt something coming on. They’re never really clean and remind me of gas stations shops.

  • mjinphoenix

    My confusion comes in the question of “what’s next?” Considering that over 4,000 of the stores sell beer and a great number also sell wine and spirits, will these also be considered counter to the health message? If so, what about soda? Candy? Potato chips? All contributors to obesity if eaten to excess. Does drinking alcohol cause cancer? We don’t know. Will drinking it to excess cause you to be an alcoholic? It depends. Will drinking 6 sodas a day cause you to become obese? It depends.
    To the point that was made about the store being closer to a Dollar Tree than J&J, I completely agree. The company has recently also completed a massive increase in consumables in their stores because they desired to increase their trips into stores by consumers and to increase the basket ring by those same consumers. Now the consumer has a choice in many markets: go to Rite Aid, DR, or Walgreens to get the same items. These smoking purchasers are the same consumers who purchase the beer, wine, and spirits and likely also through a 12pk of soda, a bag of chips, or some other high margin item in the basket.
    There is another component to all of this: the fact that CVS and other drug retailers have begun to open retail clinics across the country can not be forgotten. As ACA continues to dig deeper into the economy, not selling cigarettes will likely be an issue that was foreseen by CVS internal legal and business modeling staff. There will likely come a time when it will become a legal issue for them to be selling smokes in the store where they technically have a medical facility. I think that this was a move to beat competitors to the punch on an outcome that will affect other retailer sooner rather than later.

    • Bert

      According to the American Cancer Society: “Alcohol is a known cause of cancers of the mouth, throat, larynx, esophagus, liver, colon and rectum, and breast.”

      http://www.cancer.org/cancer/cancercauses/dietandphysicalactivity/alcohol-use-and-cancer

      So from a “health message” standpoint, and to be consistent, it would make sense for CVS to end all sales of alcohol. Of course, it’s rather silly to think that would actually happen.