ALTERNATIVE ACCESS: DRUG STORES

Christina Veiders

There is no escaping the fact that pharmacy is drug stores' core business, representing nearly 70% of total sales. However, the draw of low-margin pharmacy has great potential to impact the higher-margin front end, where all three of the big chains are now offering an assortment of convenience food and other consumables.

John Heinbockel, an analyst with Goldman Sachs, New York, said the rule of thumb is that one of every two pharmacy customers will buy something at the front end, where food and consumables, over-the-counter drugs, and health and beauty care are sold. "So to the degree that your pharmacy traffic is healthy, that should feed into the front end," he noted.

Drug stores are merchandising an assortment of consumables consisting of beverages, snacks, some packaged foods and, in some cases, some perishables in the dairy and frozen cases.

While the assortment is small and represents about 5% of total drug store sales, according to analysts that SN interviewed, consider these figures: If the average drug store of a major chain does about $7 million a year, 5% of that amount comes to $350,000 a year in food, pointed out Heinbockel, who follows the three big drug chains.

"That is about what a good supermarket might do in a week," he said. However, multiply that amount by 5,000 stores for Walgreens, 5,000 stores for CVS and 3,000 stores for Rite Aid and you get some big dollars coming out of the market in drug store food purchases, he said.

So far Walgreens, Deerfield, Ill., has been the most proactive and innovative among the big chain drug competitors when it comes to food merchandising, analysts agreed. In addition to a large selection of convenience products, Walgreens has experimented with self-serve coffee, has placed Odwalla fruit drink coolers at the checkout, and has offered freshly made sandwiches in urban stores. But Heinbockel said that CVS and Rite Aid are catching up to a degree. Walgreens' advantage is the size of its stores, which are about 35% bigger than CVS, according to Andrew Wolf, analyst with BB&T Capital Markets, Richmond, Va.

"Walgreens is doing very well with food merchandising," he said, estimating that while Walgreens' front-end same-store sales grow an average of about 5%, its same-store sales on food are growing an average of about 50% a year.

"Obviously, every store they [Walgreens] open up has a full range of convenience food and coolers going as far as the eye can see. It makes a more compelling convenience stop," said Mark Husson, New York-based analyst with HSBC Securities, London.

"What makes Walgreens so well positioned is that they have the right size store to add increasing amounts of food," said Wolf. "So as food becomes increasingly profitable and a highly demanded section of the drug store, Walgreens is in the best position [over its competitors when it comes to food merchandising]."

CVS Adds Eckerd

CVS, Woonsocket, R.I., is merchandising convenient foods, too, but in a smaller space. The drug chain has an advantage over its competitors, said Heinbockel, in that CVS has developed an effective loyalty card program that helps drive front-end sales.

The company also was able to quickly integrate its $2.2 billion purchase of 1,268 Eckerd drug stores in Texas and Florida. Husson called the effort akin to making a silk's purse from a sow's ear. "CVS's lasting contribution this year has been to turn a whole small company in the south, Eckerd, into something that is full of sales growth and profitability," he said.

Heinbockel called CVS's Eckerd prototype "dynamic" with its color and new parallel-aisle scheme that exposes shoppers to front-end merchandise and takes them down a power aisle to the pharmacy.

Rite Aid, Camp Hill, Pa., is trying to play catch-up with the other two big chains, but it is weighted by debt and constrained when it comes to capital spending, said analysts.

Rite Aid's pharmacy sales are soft, which impacts the front-end traffic. However, it also has introduced a new prototype store that puts cosmetics and beauty in the center of the store. Consumables branches off from OTCs and HBA, said Heinbockel. "It's a different look. I think its good and better than a prior prototype, but its not as dramatic as CVS," he commented.

Analysts were positive about the long-term growth prospects for the sector. In a research note, David Magee, an analyst with SunTrust Robinson Humphrey, Atlanta, said he sees "a sustained period of earnings visibility for the drug retail sector" because of the number of generic conversions in 2006. Generics carry about 50% more gross profit than branded drugs.

Also, the Medicare prescription drug benefit is scheduled to become effective in January 2006, with more than 40 million seniors estimated to be eligible. According to Magee, drug store chains are poised to benefit as cash-paying seniors gain coverage and become more price-indifferent.

While analysts don't believe drug stores will get into fresh foods in a big way, they do see them continue to experiment and test the waters with consumables.

However, Paul Weitzel, vice president, Willard Bishop Consulting, Barrington, Ill., takes a different view. "We think drug stores will get into food in a big way in the next 10 years," he told SN. "With the aging population and people not being able to drive, the corner grocery store could be a big opportunity.

"Drug stores aren't there yet," he continued. "They've got refrigerated products and ice cream and milk and some grocery items. But they are still testing and slowly expanding. I think the corner grocery store could come back. If it does, it has the potential to come back through the drug channel. That is the format to watch."

CVS

Most recent fiscal year ended: Jan. 1, 2005

Revenues: $30.6 billion

Net income: $918.8 million

Profit margin: 3.0%

*Same-store sales: 5.5%

Food sales as a % of revenues: 5%

*Does not include the sales results of the 1,268 Eckerd drug stores acquired on July 31, 2004.

During the second quarter ending July 2, CVS completed the integration of the Eckerd drugstores it acquired in Florida and Texas, as well as Eckerd's pharmacy benefits management and mail-order pharmacy business. Half-year sales rose 33% to $18.3 billion, and net earnings were up 18% to $565.6 million for the 26-week period. Same-store sales for the second quarter increased 5.6%.

Rite Aid

Most recent fiscal year ended: Feb. 26, 2005

Revenues: $16.8 billion

Net income: $302.5 million

Profit margin: 1.8%

Same-store sales: 1.6%

Food sales as a % of revenues: 5%

At the half-year point, Rite Aid sales had slipped to $8.3 billion and net earnings had declined 56.7% to $31.8 million for the 26-week period ending Aug. 27. During the second quarter, same-store sales increased 0.5%.

Walgreens

Most recent fiscal year ended: Aug. 31, 2005

Revenues: $42.2 billion

Net income:$1.560 billion

Profit margin: 3.69%

Same-store sales: 8.2%

Food sales as a % of revenues: 5%

Coming off of flat fourth-quarter earnings due to a $54.7 million charge for expenses related to Hurricane Katrina, which forced Walgreens to close 74 locations, September performance bounced back. Sales for the month increased 10.9% to $3.5 billion. Comp-store sales rose 7.7%.