Drugs Aside, Drugstores Feel the Pain of Prudence
By KENNETH N. GILPIN
November 4, 2001
MARKET INSIGHT
In the face of it, the nation's big drugstore chains, which generate $180 billion in revenue, would seem to be immune to turns in the economy.
Recession or no recession, people need drugs. And as the nation grays, more people need more drugs.
That is the logic. The reality is something else. Drugstore sales are slumping. Chains are closing stores and laying off workers. Investors have been dumping the stocks.
Mark Husson, food and drug retailing analyst at Merrill Lynch (news/quote), spoke about the business last week. Following are excerpts from the conversation.
Q. Why are drug chains slumping?
A. First, there has been a slowdown in comparable-store sales and a heating up of the competitive environment.
The industry gets about 60 percent of its sales from drugs, which are nondiscretionary, and about 40 percent from convenience items. Profit margins are higher on convenience items.
In normal times, people go into the drugstore thinking they need 1.5 items, and to their surprise they come out with 2.3 items.
In tight times, you go in for 1.5 items, and that is what you come out with. And the stuff they are not selling, the candy, the Big Mouth Billy Bass, the weight loss pills, is the stuff with the highest profit margins.
Q. What is the other factor?
A. The second problem is what is called shrinkage, which is another word for staff and customer theft.
Rite Aid (news/quote) and CVS (news/quote) have talked about this, and Duane Reade is starting to talk about it.
And the reason it is more of a problem now is that retailers sell a lot of expensive stuff, from home diagnostic kits for diabetes to smoke-cessation products.
During the last recession, in the early 1990's, technology wasn't good enough to quantify the shrinkage amount. Now they know precisely what is happening.
Shrinkage is up about 30 basis points. Typically, it runs at 1.5 percent of sales. Now, it is about 1.8 percent of sales.
Q. Who competes with the big drug chains?
A. Outside of New York City, all the discretionary stuff you buy in the front of a drugstore you can get at a convenience store, a mass merchant or a supermarket.
It's interesting that in the United States, 70 percent of all drugstore customers are women, and 70 percent of all 7-Eleven (news/quote) customers are men. America has evolved where men buy stuff at convenience stores and women go to drugstores.
Outfits like Wal-Mart (news/quote) are not viable competitors on the drug side. But on the convenience side, the Wal-Marts, the Kmarts and Targets have always been extremely competitive.
Q. Are drugstore stocks defensive investments?
A. Drugstores have not proved themselves to be as defensive as food retailing stocks. And next year, when you are looking for something aggressive, they won't have as much upside potential as electrical or home improvement retailers, like Home Depot (news/quote).
If you want defensive growth, I would much rather own food distributors like Sysco (news/quote) or Performance Group, which supplies restaurants.
That said, as long as gross margins go back to normal after this decelerating phase is over, then drugstores are great investments. That should happen, but we can't say definitely when it will.
We are worried enough about the gross margin problem right now not to have any direct buy recommendations on the drugstore chain stocks right now. We would not mind accumulating Rite Aid and Walgreen on the dips, but we would not out-and-out buy them right now.
Q. When will Rite Aid be profitable again?
A. On an earnings-per-share basis, I would expect Rite Aid to become profitable in about three years.
Q. Walgreen, CVS and Rite Aid represent 30 percent of the market. Are smaller chains worth a look?
A. Duane Reade and Longs Drug Store are not national, but they are fine little companies. Duane Reade's sales per square foot are among the highest in the country, no matter what the good is being sold. At $900 per square foot, per year, it is twice the industry average. And they have made it extremely hard for others to get into the New York market.
Q. Does the aging of America make these companies viable long-term investments?
A. Once you get to age 55, your body starts malfunctioning. It is not going to be long before we see large numbers of malfunctioning bodies.
As a result, we see drug sales growing at a compound forward rate of 9 to 10 percent a year, year after year after year. By 2010, drugs will likely represent about 80 percent of drugstore sales.
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