Why CVS Is Not the Big Winner in Its $1.9 Billion Deal with Target

By Markets Fool.com

CVS Health has won a lot of praise for signing the $1.9 billion agreement that bought it Target's pharmacy operations, plus a handful of clinics.

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And rightfully so. This big set of assets should provide it with economies of scale to shave prices further, and thus give it a sharper edge in a very competitive market. I'd agree that it's very much to the company's advantage, but I believe Target benefits much more from the deal. Here's why.

Source: Mike Mozart via Flickr.

Pharma-see-you-later
Target was never particularly successful at being a pharmacist. Only 5%-7% of its customers utilized pharmacy services, and collectively, the category brought in revenue of about $4 billion per year -- only around 5% of the company's overall annual top line.

Those percentages are awfully skinny for a 1,660-strong business unit that takes up plenty of square footage in Target stores. Not to mention one that directly employs an army of around 14,000 workers (many of the skilled variety), and requires stacks of capital to be tied up in inventory.

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The original idea behind having pharmacies at Target was that they would boost traffic numbers; customers would come in for their subscriptions and pick up a few items from elsewhere in the store while they were at it. But again, the take-up figures are rather light, so we can conclude the retailer didn't enjoy much of an auxiliary lift from those visitors.

Cross-selling with CVS
Target seems to have had a difficult time convincing the afflicted to buy medicines at its pharmacies. But CVS won't.

More and more these days, the pharmacy segment is a contest of size and volume. Specialized medicines in particular are expensive. Lower prices made a big difference, then, and the larger an operation is, the harder it can bargain for better wholesale deals.

With the Target buy, CVS is set to become the largest pharmacy retail chain in the U.S. It'll have that much more bargaining power to drive its prices down even further.

That's a boon for it, obviously, but also for Target. In my opinion, a CVS can bring in far more pharmacy customers than the retailer ever could thanks to those prices and its well-known brand name. The resulting boost in overall store traffic, then, should be meaningful.

On top of that, Target will draw revenue from the pharmacies and clinics by just standing still. Under the terms of the deal, CVS is to pay annual rent of $20 million to $25 million to use the company's real estate for its new assets. Even if that's just a drop in the bucket of Target's overall take, it's money earned for almost no effort or expenditure. There's nothing as sweet as passive income.

Good riddance
At the end of the day, it seems Target benefits handsomely from several aspects of the deal. It's quickly getting rid of an under-performing unit for a nice chunk of change, letting another company draw in customers to grow overall foot traffic, and opening a steady, long-term source of passive income.

That $1.2 billion (the estimated net amount) will go a long way toward taking the sting out of Target's previous headline-grabbing retreat: its withdrawal from the Canadian market earlier this year, which, in marked contrast to the pharmacy sell-off, is costing the company significantly, in the form of a $5.4 billion writedown.

CVS, meanwhile, is finding the expenditure -- combined with its recent monster acquisition, Omnicare -- difficult to digest. It's reduced its current $6 billion stock buyback program by $1 billion, which won't do wonders for the stock. The company is sure to recoup its latest investment sooner rather than later, but unlike Target, it'll have to bite a sizable bullet in the meantime.

The article Why CVS Is Not the Big Winner in Its $1.9 Billion Deal with Target originally appeared on Fool.com.

Eric Volkman has no position in any stocks mentioned. The Motley Fool recommends CVS Health. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.