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Key Drivers Affecting CVS’s Profitability in 2015

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Why CVS Health’s profitability is falling

CVS Health’s (CVS) profitability is falling. Its gross margins have been on the decline, partly due to a shift in the sales mix in its Pharmacy Services segment. This segment is larger, earns lower margins, and is growing faster than its Retail Pharmacy segment. Gross margins for 1Q15 came in at nearly 17% compared to 18.2% in 1Q14. The company is also seeing price compression trends, which is likely to affect results in future quarters.

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Margins’ upside

The fall in margins is being partly compensated by a higher generic dispensing rate (or GDR) for both CVS segments. Generic drugs typically earn higher margins than their branded counterparts. The removal of tobacco products has also proved beneficial for margins. This factor will continue to positively impact results in 2Q15 and 3Q15 as well.

Front-store thrust

Front-store margins have benefited from the tobacco exit, but they’ve also been aided by the increase in sales of in-store brands. The share of in-store brands to total front-store sales rose to 20.9% in 1Q15, partly buoyed by the decision to exit tobacco products and partly due to higher penetration. The company is targeting a penetration rate of 25%.

CVS has also been looking to enhance front-store sales through an emphasis on health foods and beauty products. The company is looking to elevate its beauty category at thousands of stores this year through the introduction of new and exclusive private brands, among other initiatives.

Peer group comparisons

CVS earned a gross margin of 17.9% in the trailing 12 months. In comparison, peers Walgreens Boots Alliance (WBA), Rite Aid (RAD), and Diplomat Pharmacy (DPLO) earned margins of 26.6%, 28.8%, and 6.3%, respectively. The average for the S&P Food & Staples Retailing Index (FXG) (XLP) came in at 21.1% over the same period.

WBA and RAD derive a larger percentage of their sales from the retail side of their businesses, which earns relatively higher margins. DPLO, on the other hand, is a specialty mail order pharmacy. Specialty drugs typically earn lower margins.

You can read more on management guidance for 2015 in Part 11 of this series.

CVS is the top holding in the First Trust Consumer Staples AlphaDEX ETF (FXG) with a 4.9% weight.

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