CVS Health Has a Lot to Prove

The May earnings report I’m going to be paying the most attention to is CVS Health (NYSE: CVS). Like a lot of investors, I want to see if the drugstore operator and prescription plan manager’s bold gamble to stop selling tobacco last year is paying off.

CVS attracted a lot of media attention last year when it ended all tobacco sales in its 7,700 drugstores in September. The move was a bold one because CVS’s major competitors, Walgreens Boots Alliance (NASDAQ: WBA), Rite-Aid (NYSE: RAD), Walmart (NYSE: WMT) and Kroger (NYSE: KR), are all still selling cigarettes, chewing tobacco, and related items.

Value investors like myself are obviously wondering, how is not selling tobacco affecting CVS’s bottom line? So far the move does not seem to have had much of an impact on CVS’s financials. CVS reported a TTM revenue of $135.14 billion in September 2014 that increased to $139.37 billion in December 2014.

CVS Revenue Increased

CVS’s revenue increased by $3.77 billion during its first quarter without tobacco which shows the decision had little effect upon the bottom line. The company’s sales do not seem to have been impacted by discontinuing that particular group of product lines.

cvs house

Okay, to be fair, revenues are increasing across the pharmacy industry. Walgreen reported a TTM revenue of $77.62 billion in November 2014 that increased to $84.58 billion in December 2014. Rite Aid saw a smaller increase from $26.28 billion in November 2014 to $26.53 billion in February 2015. I will not look at Kroger and Walmart’s business here because they are general retailers for whom pharmacy is a sideline.

It looks as if CVS did not take much of a risk by dropping tobacco products. Its revenue is growing significantly without those products on the shelf. Although, the retailer did report a slight drop in net income over the last year; in June 2014 CVS reported a net income of $4.889 billion that fell to $4.644 billion by December 2014. That might indicate tobacco sales had more of an impact than management would like to admit.

CVS has lost some income over the past year, but it added revenue. Dropping tobacco looks like a good long-term move with short-term risks, which indicates a sensible management willing to experiment with new strategies.

What we need to watch for at CVS is whether the revenue grew in the first quarter of 2015 or not. The whole tobacco-free strategy seems to be based on long-term revenue growth. CVS management is probably betting that long-term revenue gains driven by prescription drug sales will more than make up for the tobacco losses.

Why Other Retailers Will Not Follow CVS’s Lead

The interesting development here will be if any other retailers decide to follow CVS’s lead and drop tobacco sales or at least cut back on them. My guess is that will not happen because tobacco is a small, high value item, the presence of which does attract some customers to stores.

CVS can afford to drop such a product because it is primarily a prescription processor. The drugstores are something of a sideline. Rite Aid cannot because it is basically a small box discounter that operates pharmacies in its stores. Rite Aid needs every high value item that it can get.

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Big retailers like Walmart, Kroger and Costco Wholesale (NASDAQ: COST), which operate pharmacies as a sort of loss leader, have little incentive to follow suit. Their business model is based upon having a wide selection of items at different prices. Tobacco, a high value item that does not take up much space, fits nicely into that model. The same goes for Walgreen, which does not manage prescription plans, so it is more dependent on its small box discount operations for part of its revenue.

Do not expect these retailers to follow CVS’s lead and go “tobacco free.” Walmart has the strong incentive of falling foot traffic, which it is struggling to reverse, to keep cigarettes.

These brick and mortar retailers have another strong incentive to keep tobacco. Tobacco is not normally sold online; you cannot order it through Amazon.com. One reason why Walmart’s foot traffic has fallen off is that people can order a lot of the stuff they used to buy at the big box stores online for much the same price. I seriously doubt retailers like Walmart and Target (NYSE: TGT) are going to get rid of any product that’s hard to find online.

My prediction is that CVS’s revenue will continue to grow but none of its competitors will follow its lead and go tobacco free. Instead, CVS will be something of an anomaly, which will buy it a lot of good publicity and support from the healthcare industry.

CVS is also a good basic stock and a value investment because of its strong earnings and dividend yield. It reported a dividend yield of 1.39% and an EPS of 3.679 on Dec. 31, 2014. That means going tobacco free can pay for companies and individuals.

Disclosure: the blogger and author of this post holds shares of Kroger.