Price of Low Inflation Showing Up at the Margin

The drugstore price war is beginning to take a toll.
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The inability of companies to raise prices has kept inflation at bay but it's taking a toll on margins, and the stress is starting to show up glaringly in retail earnings.

Everything from cars to nicotine gum has been discounted in the current environment as companies fight a fierce battle for market share. In effect, they're making a bet that stabilized demand will offset the damage to margins -- the difference between total sales and the cost of goods. But the wager isn't always working out.

"With the economy softening, consumers are focused on the price of goods," said Lisa Cartwright, an analyst at Salomon Smith Barney. "But as a result of promotions, gross margins are shrinking."

A prime example is drugstores. Shares of

CVS

(CVS) - Get Report

took a $7 haircut Tuesday after reporting earnings of $123.7 million, or 30 cents a share, down 16% from $147.2 million, or 36 cents a share, in the year-ago period.

A look at the profit statement shows that while revenue for the quarter rose 10.1% to $5.4 billion, the company could only raise its gross operating margin to $1.37 billion from $1.30 billion a year ago. Add higher SG&A and operating expenses and net income sank.

"What we're seeing in margin is greater than historical pressure on promotion and shrink," said David Rickard, the chief financial officer, in a conference call with analysts. "Shrink" refers primarily to stolen or broken goods.

On its Web site, CVS is advertising "super saver" deals: 14% off Nicorette, 25% off CVS diapers and 20% off L'Oreal cream.

And over the holidays, CVS is expected to keep offering discounts. That would be typical for the company. But CVS can't predict when regular pricing will return. "We don't know when promotional activity is going to lighten up," said Tom Ryan, chief executive of CVS in a conference call with analysts following the earnings release. "We're certainly ready to fight it."

Analysts have observed heightened promotional activity at other retailers as well, including

Albertson's

(ABS)

,

Safeway

(SWY)

and

Kroger

(KR) - Get Report

.

"The industry is in a price war," said Eric Bosshard, an analyst at Midwest Research. He's seen deals in fliers and on everyday prices at

Rite Aid

(RAD) - Get Report

and Eckerd drugstores. Bosshard has a neutral rating on both stocks.

The Conference Board's index of consumer confidence for October, which was released on Tuesday, fell to its worst level since early 1994.Given that consumers are reluctant to spend, it is likely companies will continue battling for their hard-earned dollars with lower prices. Some say such tactics, in and of themselves, are rarely enough.

"You can't win this game by giving away Coca-Cola, milk and bread," said Ryan. According to him, the issue is bringing value to the customer, which he thinks CVS can do.

CVS said in its third-quarter earnings report that 200 underperforming stores will be closed in the first quarter of 2002; one of 10 distribution facilities and a mail order facility will be shuttered; and an undisclosed number of jobs will be cut.

"These actions should eventually spur a sustainable turnaround," said John Heinbockel, an analyst at Goldman Sachs, in a research note following the earnings release. "This is just not going to happen, as we expected, in the first half of 2002." Heinbockel downgraded the stock to market performer from Goldman's recommended for purchase list.

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