Thursday, February 6, 2014

CVS, Tobacco and the Economically Rational Decision

Yesterday I was interviewed by a reporter for National Public Radio’s Marketplace program regarding the decision by CVS Drugstores to stop selling tobacco products. You can find the article here: I’m always happy to talk to the people at Marketplace, as it’s one of the few programs on National Public Radio that takes an even-handed approach to business affairs.

The issue of drug stores and pharmacies selling tobacco products is not new. The question used to get asked back in the 1990s when I was doing investor relations for Walgreens. The reason the question came up back then is that the provinces in Canada had begun to ban the sale of cigarettes in pharmacies beginning in 1994. Today, all but one province in Canada bans the sale of cigarettes by pharmacies.

What is interesting here to me is the communications aspect of this situation and how it compares with the business realities of selling tobacco. CVS has, of course, positioned their decision as the morally right thing to do. They are a healthcare related company, and they shouldn’t be selling products harmful to the public’s health. The decision has great appeal to a majority of people and earns them lots of good will. 

Underlying all of that may be other reasons that CVS has gotten out of the business of selling tobacco. In business school terms, what CVS has done is to compare the net present value of the profit stream it would receive from continuing to sell tobacco to the potential profit it will receive by virtue of being more closely associated with a healthcare image and the additional business that will bring in, both on the consumer and the health care benefits sides of their businesses. In this case, they have decided that healthcare is a better business choice, plus it makes them appear to be on the side of the angels.

However, here are a few business reasons why CVS may have gotten out of the business:
1. Tobacco usage has been declining in the United States for many years and the trend shows no signs of bottoming out.
2. Cigarettes are a relatively low gross profit margin product, with margins I estimate in the 15 – 16% range compared to an average of 30% for general merchandise in drug stores.
3. Typical sales in drugstores are for one or two packs of cigarettes at a time, meaning that you don’t make up for a low margin sale by having a big dollar sale, as you would by selling a carton.
4. With prices per pack as high as they are, smokers tend to be price sensitive, meaning that they are not your normal, loyal customer.
5. High prices also lead to more internal theft in this category than many others.
6. Local regulations prohibiting the sale of tobacco to minors leads to a headache at the cash register as clerks need to verify the age of many purchasers. 

So when the dust settles, CVS will have given up 2% of its revenues, but much less than that of its profits. Plus they probably looked north of the border and realized that the Canadian drug store industry hasn’t gone into a death spiral since they were prohibited from selling cigarettes.

All of this also helps to explain why you won’t see CVS eliminating the sale of salty snacks, sugary drinks of candy any time soon. All of these products don’t fit with the image of a healthcare provider, but they don’t share the same business trends as tobacco, so CVS will make the economically rational decision to keep selling them.

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