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: http://www.marketplace.org/topics/business/why-cvs-giving-smoking. 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.

Used Car Auctions, Disclosure and Investor Relations

Economists love auctions. Nowhere else can they as clearly observe the interplay of various causes upon supply and demand. It is capitalism at its most naked and allows economists to indulge their insatiable desire to measure the effect of different inputs upon prices. And sometimes they even come up with some useful stuff. 
The finance section of the November 24th edition of The Economist magazine featured an article on the work of several microeconomists that might actually have some useful application to real world markets. The one that caught my eye was a study by a couple of economists on the effect of information disclosure on used car auctions. (Information Disclosure as a Matching Mechanism: Theory and Evidence from a Field Experiment by Steven Tadelis and Florian Zettelmeyer, Electronic copy available at: http://ssrn.com/abstract=1872465).

Now you may roll your eyes and mutter, “What do car auctions have to do with investor relations?” but indulge me for a moment. What we are interested with here is the information being disclosed and its affect upon pricing, not the item being sold. To quote the authors of the article:

“A market’s efficiency critically depends on whether its participants have sufficient information about the nature of the goods and services being traded. The potential hazard a buyer faces when trading in markets with information asymmetries often leads to market imperfections and stifles efficient trade. Indeed, in resale, housing, labor, health care, and corporate securities markets, sellers may have better information than buyers about the good or service being traded. Furthermore, sellers may have control over how much information to disclose, and buyers may choose how much information to acquire.”
In a survey of over 8,000 used car auctions, what the authors found was that increased information disclosure regarding the quality of the cars increased expected revenues. This is in line with current academic theory. But there was an interesting twist to their findings. Cars in the middle of quality rankings saw only modest gains while the biggest gains in revenue resulting from increased disclosure came for the best and worst quality cars. You might expect this with higher quality cars, as people will bid up the price if they know they are getting higher quality, but if the disclosures are of bad quality, logic would lead you to the conclusion that prices would go down further. Here’s what the authors say about their findings:
“When disclosed information coincides with expectations given observables, then it does not affect the composition of bidders who bid on the vehicle, and as a consequence, the outcomes are the same as they would be without information disclosure. However, when the information disclosed is either a positive or negative surprise relative to expectations, it will attract bidders who are relatively strong given the disclosed information. This benefits the seller regardless of whether information is good or bad news.”
In other words, the additional disclosures, even if they are bad news, attracts new bidders who are interested in that class of goods and who may have a better understanding of the merchandise and its value to them. The result is that they pay more than bidders with a more general outlook. 
Now think of the implications for the stock market. Typically, weak performing companies tend to disclose as little as possible about their problems. As a result, there is usually a fair amount of uncertainty about their future performance and that helps keep their stock price depressed. According to this new research however, they would be better off to more fully describe their problems. By eliminating some of the information uncertainty, even though the news is bad, they will attract more value and deep value investors who are better able to assess the risks of the investment. The result would be a better alignment of the firm’s intrinsic value with its market value. (Of course, it will still be a lousy stock price because the outlook is bad, but it will be a better lousy stock price than without the additional disclosures.)
I would love to be able to test this academic theory in a real world setting where a company has hit a bad patch, but something tells me that I am more likely to find an honest used car salesman than I am to find a CEO willing to bare all about his company in bad times.

Economics, Incentives and Investor Relations

One of the favorite theories of economists is that people respond to incentives. Ask an economist about how to change a person’s behavior and they will respond that if you put into place the proper incentives, people will alter the way they do things.  Of course, there always seems to be unintended consequences, but that gives people like me something to write about.

Looking at incentives has a number of applications with respect to investor relations. For example, if you really want to understand why corporate managements are doing what they’re doing, look at the compensation programs their companies have in place. For example, if a company has as a key component of its incentive plan Return on Equity, investors need to consider the consequences. In itself, ROE as a measure used in compensation bonuses is not a bad thing, because it rewards efficient use of corporate capital and causes corporate managers to think twice before undertaking risky projects. However, the unintended consequence of using ROE may well be that instead of expanding the company through new projects, management will figure out that it is safer for their bonuses to buy back stock in order to lower the equity denominator in the ROE equation. As a result, the company may shift away from expanding its core business and focus instead on buying back stock, in essence becoming more driven by financial measures than operating measures.

Or consider how a company’s bonus plan is constructed. If management’s bonus is calculated off actual results, the focus will be on achieving that particular target, whether it is improvement in EPS or operating profit or something more exotic. However, if a compensation plan is constructed to measure against management’s plan for the coming year, then there is every incentive for management to sandbag the plan, thereby setting up easily achieved bonus goals. In such a case, investors need to ask “What’s the plan?” because if management exhibits a low opinion of its ability to hit operating goals, investors shouldn’t be expected to build in large gains into their stock performance expectations.

What caught my eye and started me thinking about incentives actually comes form the opposite side of the equation. As you may recall, the Dodd-Frank Financial Reform Act of 2010 contained language regarding payments to whistleblowers in fraud actions. In short, if a whistleblower provides independent information of fraud to the SEC that results in a successful enforcement action that recovers at least $1 million in sanctions, the whistleblower is entitled to recover at least 10% and up to 30% of the recovered funds. For more on the law, see my blog post “Whistle While You Work” dated February 28, 2011.

Now, a little over a year after the law went into effect, The Wall Street Journal through its Marketwatch web site reported on October 18, 2012 that the SEC is averaging 8 tips about fraud per day, for a total of 2,820 to date. It seems as if the incentive part of the law is working. Of course, receiving a tip and conducting a successful prosecution are two separate things, as the same article reports that to date, only one whistleblower has received a payout under the provisions of Dodd-Frank. The unintended consequence here may be that the SEC simply doesn’t have the resources to sift through all the information to determine the best cases to prosecute.