Gross margin improvements sweeten CVS third quarter take

Drug Store News, Nov 17, 2003 by Rob Eder

WOONSOCKET, R.I. -- Citing a more lucrative mix of sales at both the front end and pharmacy, CVS managed to wring more profit per dollar during the third quarter, the company reported late last month.

In all, CVS' sales grew 8.5 percent in the third quarter, reaching $6.38 billion for the 13-week period ended Sept. 27.

But the real story in the quarter was CVS' sharp gross margin improvement--even beyond its own strong expectations--which helped grow net earnings 14.2 percent to $187 million, executive vice president and chief financial officer David Rickard told analysts in a Oct. 29 conference call. Overall, gross margin improved 70 basis points to 26 percent of sales, Rickard explained, pointing to three key factors:

* Continued improvement in shrink.

* The benefit from the increase in generic drug sales.

* A more profitable sales mix.

While the company continued to make progress in its efforts to reduce shrink--total inventory losses in the third quarter were 0.92 percent of sales, versus 1.25 percent during third quarter 2002--Rickard insisted that improvement "was within our expectations and did not contribute to our overdelivery in gross margin." Improvements in shrink contributed 33 basis points to gross margin.

A much bigger contributor to CVS' gross margin performance, Rickard explained, was a favorable mix of product sold both in pharmacy and front store"--ultimately the, deciding factor behind CVS' Oct. 7 decision to raise its earnings guidance for the third quarter and the year. Indeed, same-store sales rose 6.4 percent in the quarter, driven by pharmacy comparable sales of 8.5 percent and front-end comps of 1.9 percent.

While generic utilization continues to pad CVS' margins, pharmacy sales pressure was reduced significantly in the third quarter. Generics shaved away only 110 basis points from CVS' top line, versus a 220-basis point hit from generics in the first quarter and a 200-basis point impact in the second quarter. CVS executives expect top-line pharmacy growth to improve steadily going forward, given the new Food and Drug Administration leadership under commissioner Mark McClellan and steps the agency has taken since his arrival to address the clogged drug approval pipeline---in particular, the lack of any new blockbuster drugs since 2000.

"We are very encouraged by some recent actions by FDA," Rickard said, alluding to the recent approvals of Crestor and Levitra, two new drugs with blockbuster potential, along with the Alzheimer's drug Namenda, which is expected to be introduced in January. "There are 111 drugs with blockbuster potential in the pipeline," Rickard continued. "If a number of these are approved over the next few years, it obviously would accelerate our sales growth."

In addition, pharmacy sales should continue to improve, Rickard explained, as CVS cycles through the negative impact in 2002 from the drop-off in hormone replacement therapy, as well as the December 2002 OTC switch of Claritin.

Though no numerical measure was given, Rickard noted that the investments CVS has made in pharmacy service and productivity continue to show results. Pharmacy Service initiative, which CVS unveiled to analysts in July and which allows its pharmacy staff to adjudicate prescription claims in about three minutes or less--usually before customers leave the drop-off counter--now is in more than 2,600 stores, 1,400 more than at the end of the second quarter. The company plans to complete the rollout by the end of the year.

Also in the third quarter, CVS completed the integration of its Assisted Inventory Management system with pharmacy, a system that the chain expects will enable it to improve in-stock positions and inventory turnover in pharmacy. "[AIM] has helped us reduce store inventory," Rickard said. "Our inventory turns of 4.82 times is slightly improved from the 4.77 times we achieved in the second quarter and was a healthy increase over the 4.5 times we experienced last year in the third quarter."

In the third quarter, CVS' inventories increased by only 1 percent versus the same period a year ago, compared with an 8 percent lift in sales. Improved inventory performance continues to be a major goal for the company, and Richard said CVS is on pace to hit the high side of its year-end goal of 4.8 to 4.9 turns.

Front-end flourishes

In the front store, a lively back-to-school season, a more profitable overall mix of product and the introduction of new digital image processing technology into all of its one-hour photo stores were major contributors to CVS' strong 1.9 percent front-end comps. CVS in July rolled out a new self-service, digital processing station from Kodak to 3,100 of its stores. Since then, CVS has printed 7 million digital images at 29 cents a print.

The chain's research has indicated that 13 percent of the customers that have used the new Kodak technology have been new customers to CVS, "so there is a business-building opportunity here perhaps beyond just photo," Rickard said. CVS is planning some new wrinkles to its photo offering; however, Rickard declined to provide further detail during the Oct. 29 conference call.