CVS Management Follows Healthy Prescription for Growth

The drugstore chain has transformed itself from an ailing division to a strong retailing business.
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In just three years,

CVS

(CVS) - Get Report

has transformed itself from a handicapped division buried inside a decomposing conglomerate to a player with some of the healthiest vital signs in the drugstore business.

So why do investors still treat it like a sickly sibling compared with industry darling

Walgreen

(WAG)

?

Meredith Adler, an analyst with

Lehman Brothers

, estimates that CVS and Walgreen are neck-in-neck in terms of return on assets, making them joint industry leaders. Yet since she initiated coverage of both stocks in September 1997, Walgreen is up 119%, while CVS has gained 74%. On Monday, CVS closed at 48 13/16, while Walgreen closed at 29 13/16.

"Investors will pay up for a company that never misses a number," Adler says of Walgreen, which has been at the game longer than CVS. But Adler adds that CVS is starting to look like "a great value." (Her firm has participated in underwriting for CVS and Walgreen.)

Charles Conaway, CVS president, figures the discount is a remnant of the days when the company was part of

Melville

, a sprawling corporation that at one time owned everything from

Kay*Bee Toys

to

Marshalls

.

"They didn't create a lot of shareholder wealth," Conaway recalls of his former employer. So when CVS said it was going it alone in February 1996, investors were skeptical. "We were at a disadvantage," he says. "We met with a lot of resistance, because shareholders had heard a lot of things

from Melville that never came true."

Since then, CVS management, led by Chief Executive Thomas Ryan, has done much to dispel that cynicism.

In one of the largest retailing mergers, Woonsocket, R.I.-based CVS bought

Revco

in 1997 and integrated the company with hardly a hitch. It also snapped up

Arbor Drugs

, one of the largest chains in Michigan.

At the same time, the company has developed tight relationships with managed care organizations that give CVS a leg up in the competitive prescription arena. And the company has ventured into e-commerce -- all the while growing earnings at better than 20% a year.

Drugstore stocks have been a favorite of investors, thanks to several broad economic factors, including the aging of America and a thriving market for new prescription drugs. These chains also are benefiting as they relocate from strip centers to free-standing neighborhood stores, which are typically more profitable because they sell more "front-store" merchandise like beauty products that carry higher margins than do prescription drugs.

But lately, the sector has come under pressure, as the introduction of

online drugstores promise to ignite a turf war approaching the scale of the

Amazon

(AMZN) - Get Report

-

Barnes & Noble

(BKS) - Get Report

battle. (See related story.) Separately,

Rite Aid

(RAD) - Get Report

, the third-largest chain, recently blamed operational problems, related in part to acquisitions, for eating into fiscal fourth-quarter earnings.

CVS, too, has been on the acquisition path, and that may be another reason its valuation has trailed Walgreen, which has grown in what is perceived as a less risky manner by opening new stores. But unlike Rite Aid, CVS has integrated its new businesses in a heartbeat.

"Whatever CVS says they're going to do, they do below budget and ahead of schedule," says Steven Schuster, who has followed the company since it was part of Melville. Schuster, a former analyst with

First Manhattan

who now runs a hedge fund in New York, remembers one of CVS' first analyst meetings as a standalone company. As part of the breakup, CVS would inherit an employee-stock-option plan that had been fashioned for the original company, which in its heyday had $12 billion in annual sales. Investors worried that the stock plan would be a drain on the much smaller CVS, which at the time had only $5 billion in annual sales.

When asked how CVS would shoulder the burden, Conaway, who was then chief financial officer, deadpanned: "We'll just have to get back to $12 billion in sales."

CVS did it in two years.

"This is one of the best-executing management teams in retail," says Schuster, who has been accumulating CVS shares because he says they're undervalued, trading at 32 times projected earnings of $1.48 per share this year. That compares to Walgreen, which is trading at 47 times estimated earnings of 60 cents per share for the year ending in August. Both companies are expected to grow earnings at roughly 17% annually over the next few years.

In absorbing Revco, CVS set about remodeling some 1,900 stores. That meant discontinuing some 4,000 product categories at the old Revco stores and filling them with 4,000 new ones, installing a new computer system and closing a corporate headquarters. CVS finished the project three months ahead of schedule and saved more than $100 million from cost-cutting and buying synergies.

More importantly, the company was able to minimize customer inconvenience as the two companies consolidated -- a fact that some say is helping to boost sales at the old Revco stores. For instance, pharmacists at certain locations who were temporarily unable to fill prescriptions during the installation of a new computer system delivered medication to customers' homes in the evening after the stores closed.

That type of extra effort has helped sales at the old Revco stores climb to $400 per square foot, compared with $300 at the time of the acquisition, although productivity still falls short of CVS' $600 per square foot.

Another area where the old Revco stores are improving under CVS is in how often a pharmacy customer makes a higher margin, front-store purchase. CVS boasts a 47% conversion rate, while Revco, at the time of the acquisition, saw just 17% of its pharmacy customers also buy convenience items. Today, that number has climbed to 36%.

While all drugstore chains are forced to form relationships with third-party insurers in today's managed care environment, CVS has been aggressive in locking up partners. For instance, CVS has formed such a tight relationship with

Harvard Pilgrim

that four independent drugstores in Massachusetts filed a lawsuit alleging that the partnership has cost them millions of dollars in business, because it makes CVS virtually the sole beneficiary of the HMO's drug reimbursement plan. CVS declined to comment on the litigation.

With acquisitions digested, CVS is now focusing on opening some 440 stores this year, which would bring its total to 4,562, making it the largest chain in terms of number of units. Meanwhile, Conaway and his team are steering the company toward what he says is the future of drug retailing -- total health care providers. Through a partnership with Pfizer

(PFE) - Get Report

, many CVS stores now have a resident nurse to check blood pressure and answer medical questions.

All of which spells a healthy future.