CVS Health Looks Healthier After Quitting Tobacco

Dropping tobacco products will actually help CVS stock long-term

CVS (CVS) may be No. 2 in the world of pharmacy retailing, but thanks to its decision to quit selling tobacco products it will be No. 1 in the hearts of investors for some time to come. In fact, the company’s commitment to emphasize its commitment to health care even went so far as changing its name to CVS Health.

cvs health stockThe reason is simple: CVS is actually living up to its stated mission to help “people on their path to better health.” Though it will lose about $2 billion in annual sales, that only represents about 1.5% of overall sales, so the impact will hardly be noticed. Indeed, from a business perspective quitting tobacco will be healthy for the bottom line over the long run.

Cigarette sales have also been plummeting for years for obvious reasons, and profit margins have been squeezed as a result. Data from the National Association of Convenience Stores shows that gross margins on tobacco products have dropped from 20.8% in 2002 to 14.6% in 2011. Sales of smokes are so bad that tobacco companies have to pay billions in”slotting fees” to make sure that their products stay stocked on store shelves.

Of course, the situation may be different with e-cigarettes, which are exploding in popularity despite being a small portion of the overall cigarette market. CVS Health has never sold e-cigarettes, though rivals such as Walgreen (WAG), Walmart (WMT) offer the products

By coming out so forcefully against tobacco, CVS Health has burnished its reputation among health care providers, who have campaigned for decades against smoking, along with the tens of millions of people who have lost a loved one to the ravages of tobacco addiction.

The timing couldn’t have been better, because CVS Health wants to ramp up its high margin pharmacy benefits and walk-in clinic operations. Remember, the Bureau of Labor Statistics pegs the number of physicians and surgeons in the U.S. and 691,400 and registered nurses at 2.7 million. Doctors and nurses have the ability to sway their patients along with their friends and family.   They also have powerful lobbying groups working for them such as the American Medical Association.

Smoking’s impact on public health is also huge. According to the Centers for Disease Control and Prevention, smoking is the leading cause of preventable death in the U.S. and kills almost half a million people annually. The impact on families of course is substantially larger.

Walgreen, along with other pharmacy chains, has refused to follow CVS Health’s lead even though they were asked to by a coalition of state attorneys general and the American Lung Association. In a statement released yesterday, Walgreen questioned whether having pharmacies quit selling tobacco products would do much to curb smoking rates since they only account for about 4% of overall sales.

While the company may have a valid point, it struck the wrong note from a public relations perspective and will hurt WAG stock over the long run.

Though Walgreen offers scads of anti-smoking products, it’s hard for the company to counter the inevitable accusations that it puts profits ahead of people. That position is even more untenable given that cigarette sales for Walgreen are probably as insignificant for its bottom line, as was the case for CVS Health. Other pharmacy operators including Walmart and Kroger (KR) are in the same predicament.

Unfortunately for investors, quitting smoking won’t translate into healthier profits for CVS immediately. The impact will be gradual, stretched over a periods of several years. Still, CVS stock is worth adding to most portfolios, currently trading ay a price-to-earnings multiple of about 20, which is cheaper than WAG’s 24.

Wall Street expects CVS revenue growth this year to hit 8.3%, which is better than WAG’s 5.7%. CVS stock, which has gained 14% this year, trades at a 5% discount to its average 52-week price target of $84.70. WAG, which has disappointed investors lately,  has more upside potential, trading 11% under analysts’ average 52-week target of $72.58. Keep in mind that WAG is in Wall Street’s dog house after its top two financial executives were ousted after an embarrassing $1 billion forecasting error.

All things considered, CVS stock is a better bet — but investors should wait until there is a price pullback before pulling the trigger.

As of this writing, Jonathan Berr did not hold a position in any of the aforementioned securities.

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