Image Source: Mike Mozart
It is our belief the food retailing industry is in the midst of widespread disruption with Amazon’s attempt to break into the supermarket game with its audacious purchase of Whole Foods. The Whole Foods acquisition is not likely to be an isolated one-off event; instead, it may be a harbinger of Amazon’s ambition to break into new markets, thus expanding its overall percentage of retail sales. We update our views on Amazon and how the company may eventually impact newsletter portfolio holding CVS Health.
By Alexander J. Poulos
Emulating the Costco Model
Amazon’s (AMZN) purchase of Whole Foods (WFM) may be the initial step towards emulating the uber-successful Costco (COST) model where the bulk of profits is derived not from the hyper-competitive retail sector, but through a highly predictable subscription-based model. Costco derives the majority of its profits from requiring a membership fee for the right to purchase goods from its vast array of warehouse stores. The member will need to present their membership card at the point of sale before the merchandise can be rung up, thus providing Costco a treasure trove of data into what sells to a particular demographic.
Unlike most of its competitors, Costco can slice and dice its data down into unique data silos with pinpoint accuracy such as 35-40-year-olds with two kids living in this zip code tend to purchase… The uniqueness of the Costco model has afforded the company the negotiating muscle to generate a credit card swipe fee rate that remains the envy of the industry (keep in mind the swipe fees on credit and debit cards are a direct impediment on retailer’s profitability with little they can do to fight back). The loss of the exclusive Costco contract torpedoed the earnings prospects of the venerable American Express (AXP) sending the share price much lower; even in today’s inflated stock market, the share price of Amex has yet to regain the highs before Costco’s announcement.
Costco has earned its reputation for quality and low prices by keeping overhead as low as possible while passing savings on to consumers. Costco keeps a lid on pricing by limiting mark-ups to 15% or less while skimping on unnecessary costs such as bagging merchandise and restricting the form of payment accepted at the warehouse. Costco has inked an exclusive deal with Citigroup (C) and Visa (V) where the swipe fee charged per transaction is far below the rates charged by other merchants thus lowering the cost to conduct a transaction. By limiting costs combined with the uber-predictable subscription model, Costco has an enviable track record of consistent revenue and earnings growth (with only what can be considered a minor speed bump in profitability in 2009 during the depths of the recent recession). Interestingly, with Costco’s reputation for value and quality, the average shopper demographics tend to skew towards the more affluent sectors of the population with Sam’s Club a division of Wal-Mart (WMT) appealing to the mid- to-lower income shopper.
The Amazon Effect
We view Amazon’s move to acquire Whole Foods as one of the first steps in expanding the Amazon brand to the brick-and-mortar retail sector after years of online domination. Amazon may be attempting to use the high-end Whole Foods chain to lure the affluent shopper away from Costco, a move that may be difficult to achieve in scale. Amazon through its Amazon Prime membership model has an existing “subscription base” that tends to skew towards the more affluent households similar to Costco’s customer demographics.
Though we are skeptical Whole Foods can be transformed into a “Costco model” given that Whole Foods has the reputation as an ultra-expensive purveyor of organic food which has earned the derogatory moniker “Whole Paycheck” — which pales in comparison to Costco’s reputation for high-quality married with value pricing – we can’t rule it out. For one, the management team at Amazon is keenly aware of this fact and may be viewing Whole Foods as the opening gambit of its ambitious plan. For Amazon to build out a real competitor to Costco, however, additional services and locations outside of the 400 Whole Food market locations would need to be added to make a sizeable dent into Costco.
Foray into Pharmacy
We believe retail pharmacy is a complimentary business that can be seamlessly added to existing Whole Foods stores that will bring additional parity with the Costco model. Costco has a thriving pharmacy department in its warehouse clubs, helping engender further member loyalty as Costco’s prices tend to be the lowest in the industry. As we detailed in a recent piece on Amazon titled “Opinion: Is Amazon Prepared to Tackle the Pharmacy Market?,” in order for Amazon to gain any sort of scale in the PBM business, it must first enter it:
Amazon (AMZN) has quietly added a leader to build an in-house Pharmacy Benefit Manager (PBM) for its employees. Mark Lyons, formerly of Premera Blue Cross, has joined the e-commerce and web services giant, and we have little doubt that he is tasked with the building out a world-class PBM. In the same vein, however, we believe it may be premature to conclude that Amazon will fully enter the PBM space in the same manner as Express Scripts (ESRX), for example. Instead, the move can in some ways be considered a prudent cost-containment initiative to combat the rapid growth in Amazon’s workforce during the past few years. Amazon currently employees in excess of 300,000 employees, making it one of the top ten largest employers in the US. – Alexander J. Poulos
An opportunity for Amazon to purchase an existing PBM may become available once the long-running acquisition of a portion of Rite Aid’s (RAD) existing store base is completed. Rite Aid will offload a tad less than half of its 4,741 store network to Walgreens to raise cash to help mitigate some of the debt burden that continues to plague the company. The 2,186 stores combined with three distribution centers will help shrink Rite Aid’s overall store footprint as the company will exit some key markets in its entirety, thus ending the company’s aspiration to build out a credible national competitor to Walgreens and CVS Health (CVS).
Curiously, Rite Aid owns a growing PBM business that it acquired in 2015 called Envision RX Options that is not included in the deal with Walgreens. We find it interesting that Walgreens continues to focus on building out its network, while purposely shying away from the lower-margin PBM business as opposed to the hybrid model employed by CVS Health. Walgreens’ pure-play model allows for maximum optionality that can be operated through numerous partnerships, including a theoretical tie-up with Amazon should it choose to move forth with a foray into the pharmacy business. An acquisition of an existing PBM will accelerate the learning curve Amazon faces with entry into the field, though an outright purchase of an existing player may not be completely necessary for scale (it would make it easier though).
Effect on CVS Health
We have been disappointed with the lack of share-price strength with the equity price of CVS since it was added to the newsletter portfolios. We fully acknowledged that 2017 would be a transition year, as the sting of some high-profile contract losses would crimp this year’s earnings, but we felt as progress was made, the discount to our intrinsic fair value would narrow. To our great disappointment, however, the equity has traded in a sideways pattern throughout the year with little in the way of progress.
The catalyst for shares, the current contract negotiating season, is in the midst of wrapping up, and CVS has been caught flat-footed by the aggressive stance in negotiations taken by its primary rival Walgreens. We believe CVS may have underestimated the marketplace which Walgreens exploited to spur prescription (Rx) volume gains at the direct expense of CVS volumes. The decrease in Rx volumes has directly led to a reduction in profitability, as the last Rx filled is often the most profitable as the industry. Said differently, the decrease in Rx volume lowers earnings leverage, which forced management’s hand to enact broad-based cost cutting measurements which further hampers overall service levels.
The overarching issue in our opinion facing the healthcare provider industry is the aggressive cost-cutting on the part of the US government, which remains the largest individual payer of healthcare services in the US. The share-price action in a diverse group of providers remains weak, with recent examples of companies profiled this year such as Mednax (MD) a purveyor of doctor offices, Davita (DVA) one of the largest dialysis providers in the US and CVS Health–all struggling to post gains in a market that continues to ascend to new heights. The share price of Walgreens, the direct beneficiary of CVS contract loss, continues to struggle as earnings come in ahead of expectations, which underlines our concern for providers as a whole. An area of notable strength in the medical provider group has been the laboratory services industry, but the recent announcement of a cut in reimbursement for routine blood tests has turned a headwind into a sharp headwind–with shares of Quest Diagnostics (DGX) retracing the entirety of its sharp upward ascent thus far in 2017.
The entire healthcare provider industry is starting to get trapped in what we can best describe as a sort of “no man’s land” as the tsunami of an aging worldwide population is placing an undue strain on governmental healthcare budgets. We do not feel there is a dearth of easy solutions available either, as evidenced by the numerous failed attempts at healthcare reform. The path forward remains highly uncertain, but we feel the most natural target for cuts is to the providers–as an argument (one we do not agree with nonetheless) can be made that providers do not innovate in the same fashion as a medical device or biotech outfit. Instead, providers offer care that can arguably be cut in times of crisis.
Though we continue to include CVS Health in the newsletter portfolios, we’re starting to grow more and more cautious on shares. CVS Health’s equity has not advanced as we would have hoped, but the Dividend Growth Newsletter portfolio has solid healthcare exposure, with individual “positions” in Johnson and Johnson (JNJ), Gilead Sciences (GILD), Novartis (NVS) and the Healthcare Sector Select ETF (XLV), which continues to rocket higher. Our fair value estimate of CVS remains north of $100 (shares are trading just about $80 at the time of this writing).
Independent healthcare and biotech contributor Alexander J. Poulos is long Gilead Sciences, Citigroup, and Visa.