Walt Disney (NYSE: DIS) recently announced that, within the next few years, it’ll launch separate streaming services for ESPN sports and Disney content.
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In this episode of Industry Focus: Consumer Goods, Vincent Shen and Motley Fool contributor Dan Kline look at what Disney intends to offer with each service, how the media giant is planning to execute on this strategy, and some risks it faces.
The cast also looks into what it would take for Toys "R" Us to make a post-bankruptcy turnaround, and the strange new partnership between Kohl’s (NYSE: KSS) and Amazon.com (NASDAQ: AMZN).
A full transcript follows the video.
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This video was recorded on Sept. 26, 2017.
Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Vincent Shen, and we're pre-recording this episode for Sept. 26. In studio with me here at Fool headquarters is Fool.com contributor, Dan Kline. Good to see you, buddy.
Dan Kline: Hey Vince, it's nice to see you.
Shen: I know you had to grapple with the storm recently, and I'm glad you got through everything safely and that you could fly into Alexandria this week to check in with us. I'm really happy to have you here.
Kline: A very tense week but no major damage. Everybody's OK. So as good as we can hope for.
Shen: Yeah, that's what's important. So there have been some interesting, and in one instance kind of puzzling developments in the retail and consumer world this week. We'll lead off with a few of those stories before we move on to discuss the incoming streaming services from Walt Disney. First is the story that you pitched to me, and that is the bankruptcy of Toys "R" Us, the major toy store chain. This is a private company, but I think it's pretty safe to say that a lot of the challenges that put pressure on department stores, restaurants, and other brick-and-mortar retailers are coming into play here, too. What's your take?
Kline: I think it's a bigger trend. The problem Toys "R" Us has -- I'm a little bit older than you. When I was a kid, there was nothing better than going to Toys "R" Us. The department stores did not have great toy sections the way Target and Wal-Mart do now. So the only place you could see toys was Toys "R" Us. When the newspaper came on Sunday, you looked for a Toys "R" Us circular, and that became like a comic book. And as Toys "R" Us lost that, as toys became more common -- and the toy section at a CVS is pretty good now -- it lost some of that destination. And when you add that to the fact that Amazon, Wal-Mart, and Target are all cheaper than Toys "R" Us, all of the sudden you have this store that has no reason to be.
And they should have been becoming a destination. They should have been a place where you can play games, where little kids during the day could read books and play with Legos and all these exciting things that toys do. And they completely ignored that and just sort of moved forward exactly as they were and seemed surprised when they had less customers.
Shen: And in previous episodes, Daniel, in your very varied career history, you've been at a ton of different places, had a ton of different positions. I always love your stories.
Kline: I ran a toy store.
Shen: You managed this big toy store and had experience, and you talked then about how there was an importance to bring people in with the train sets that you talked about that were really sophisticated, very cool, just to get people in the store and develop some of that traffic.
Kline: Yeah, anything you could do. We would have Lego build events, or build a model, or classes, or reading time, or we'd bring in a Pinewood Derby track, because kids build these cars and only get to use them once. So anything you could, and you would have to accept, "I'm going to generate some foot traffic that, all they want is the free stuff and maybe some advice, and they're going to buy it at Amazon or Toys "R" Us or wherever is cheapest." I had all the competitors within two miles.
But if you cultivate a customer base by being special, by being something different, people are going to buy from you. We've talked about, we had Magic the Gathering cards, which Toys "R" Us sells, but Toys "R" Us doesn't play the game. So if a kid is playing, when he comes in, he's very likely to buy a pack or two. Even if he doesn't, he's going to buy a candy bar or a soda or whatever else you might have. And Toys "R" Us has not done anything to court that audience. They don't even do a lot of midnight openings to sell when new Star Wars toys come out, or whatever it is. They say they're going to do that. Their turnaround plan includes that. And they were absolutely constrained by the fact that they had so much debt that they couldn't invest a lot in their stores, or even justify, "We're going to take this out of the box and show it to someone." But, they have to go back and give a reason for people to be there, because if I'm going to go on price, Amazon has it, it's cheaper, I'm done.
Shen: We've talked about similar trends in recent episodes where, sometimes it's not about having the right inventory at your store to move a lot of merchandise, but to bring people in, build a little bit of that loyalty, connection to your brand. That can be enough to cultivate, as you said, that core customer base that you need.
Kline: Yeah. I found that most customers, once I connected with them -- if you saw someone coming in week after week, even if they were just browsing, and you chatted with them and it was eventually a relationship, when a birthday came around or Christmas, they would shop with us. So, you have to accept that if you have a really cool toy store, whether it be a Toys "R" Us or where I used to run, people are going to come in and not buy anything, because there's no occasion for them to buy a toy. And you have to support that and still make it fun, and eventually you'll get their business.
Shen: A little bit of background for Toys "R" Us, because you touched on a few things that I think ended up becoming a bit of a one-two punch for the company. In the past few decades, Toys "R" Us was, for me, too, when I was a kid, basically the leading toy store to go to. Now, they filed for bankruptcy protection. The biggest competition, call it 15 or 20 years ago, was more from their fellow big box stores. Think a Wal-Mart, for example. Wal-Mart was able to grab market share, and part of that was a combination of, they offer very low prices on the price competition side of it, but also, you make the trip to buy toys for your kids easier by having it be a part of your huge, big box store experience.
Kline: Wal-Mart and Target have traditionally used toys as a loss leader, to the point that when I ran in the toy store, I would go buy certain games at Target, because it was cheaper than I could buy them at pretty big quantities from the supplier. And you're right. If I'm a parent -- I am a parent -- and I want to go grocery shopping, there was about two years where, the price of a Hot Wheel car, which is $0.97, would get me through a shopping trip. If my son was good, he got to pick out a car. That was worth it to me, and it made Target a very valuable destination over a supermarket.
Shen: Absolutely. From the early 2000s, I feel like that was the main competitive push for them. And then in 2005, it's important to know that the company was taken private by a group of private equity firms and a real estate developer. They paid $7 billion to take Toys "R" Us private. And they wanted to apply the usual formula in a deal like this, where they close underperforming stores, they cut costs, they streamline the operations. And I believe they did see some early success in those first couple of years after 2005 where they had the top line grow over 20%, profitability was expanding.
And here's the part I actually experienced personally -- after they filed for an IPO in 2010, the deal was never really able to pick up steam after the financial crisis. Comparable store sales were starting to weaken. And I worked in the banking industry at this time. I remember seeing Toys "R" Us and their IPO in the upcoming offerings that we looked at and it always had a TBD, or to be determined, timeline. And as we know, in 2013, the company ended up withdrawing that IPO. Funny enough, again last year, there were reports in the news that after over a decade with these private equity firms tied up in Toys "R" Us, they haven't been able to harvest their investment, they were thinking that 2017 might be the year for them. But obviously, the results have not come out the way they wanted to, and that's fallen by the wayside again.
Kline: The problem has been, when you have a heavy load of debt and you're just trying to stay open, the reason the bankruptcy filing came now is, rumors of the bankruptcy filing got out, and a lot of their suppliers said, "We want cash." And Sears has had the same problem. Heading into the holiday season, I don't know which suppliers, but let's say they call up Hasbro and say, "We want $50 million worth of inventory." They're saying, "We want $35 million down." And that becomes, even if your operations are doing OK, you don't have the cash for that. So they're going to come back from this, mostly because the toy companies are going to be forgiving because they want Toys "R" Us as an outlet.
But hopefully for them, this frees up some capital to combine some Toys "R" Us and Babies "R" Us locations. That's part of the plan. So in places where they're not operating side by side, to put Babies "R" Us in with Toys "R" Us. And to make Toys "R" Us locations the interactive destination. I still don't think I love their plan there, they're not doing enough to cater to the hardcore toy gamer adults and teenagers who buy the Collectibles and the $60 board games, where they could really stand out, where Barnes & Noble has a niche but hasn't done that well. But they do seem to be earmarking about, it’s $290 million in capital to make some of those changes, which is money they couldn't spend under the current pre-bankruptcy setup.
Shen: And that's the problem. You mentioned, they had $5 to $6 billion of debt on their balance sheet all these years. And your annual interest payments for that coming out to $400 million or more, that's a lot tied up in those payments, leaving management very little to be able to reinvest in the business and grow it as conditions, in terms of competition, came in.
But our next story, we have the unlikely partnership between Kohl's and Amazon. There are two parts to this, and we can hit them one at a time. First, there was the announcement that Kohl's would test some store-within-a-store concepts that featured Amazon's smart-home products in a small number of their stores, and these are 1,000 square foot spaces launching in October. So they'll feature the well-known products of the Echo, the Fire TV, the Fire tablets, all in an interactive space like we've been talking about. And Amazon's sales associates will actually staff that space. So Dan, to me, this seems like a keep your friends close but your enemies closer kind of thing.
Kline: I love this. If you look at the retailers that have turned it around, I would say Best Buy is probably the most implausible turnaround. A few years ago, Best Buy was left for dead. And what they did was they invited Microsoft, Samsung, the cell phone providers, Apple, to build, to varying degrees, these store-within-a-store concept. And instead of Best Buy being this vague place full of electronics, it became a place to go for expertise, for hands-on products, for your kid to get to play the video game you're not going to buy. It became a destination. And you've seen, J.C. Penney is not doing as well as Best Buy, but it's certainly doing better than Sears, and part of that is the Sephora stores and the salon and the picture taking, and all the different store-within-a-store concepts. On that level, I like this partnership.
Shen: Well, let's get to the second part of it. That's the first part, which seems OK. And most recently, Kohl's announced that they're also going to be accepting returns for Amazon orders at almost 100 locations, so a bigger test for them. That means you can take your Amazon order to a Kohl's and return it like you bought the merchandise there, and Kohl's will actually pack it up and ship it back for you. There's no details yet that I could find as to how the compensation will work for Kohl's in offering this service, but the way I see it, for Kohl's itself, their comparable sales have been negative through the past four years. And it hasn’t reduced its footprint and closed a ton of stores like some of the other department stores have.
Kline: They're adding stores.
Shen: But it seems like these are some examples of initiatives for them where they're really trying to find ways to boost traffic.
Kline: This scares me. We've talked a little bit about the fox in the henhouse. There's an aspect where, if Kohl's and Amazon have not discussed where this might go, then I question it. The history, we talked about this earlier, of companies letting Amazon in -- Toys "R" Us being a big example, they managed, Amazon managed the Toys "R" Us website, which literally just redirected to Amazon, and there was a lawsuit, and there was a $51 million settlement. But it derailed Toys "R" Us on the digital end.
You could argue the same thing for a few other companies. But, I don't think that's what's happening here. Kohl's a few months back, said it was going to reduce the retail footprint of its stores to increase the back end to allow for more omni-channel delivery, meaning they were going to act as their own warehouses and not just supply stores, but also supply online orders. If this is the first step of a cozier relationship, maybe a purchase, or maybe just Kohl's stocking all the new Amazon apparel lines, that might be a positive driver. As just a traffic move, where I bring my Amazon return and walk into a Kohl's, I don't buy that Kohl's has enough impulse items, or I'm going to be like, you know what? I do need a new suit.
Shen: Even all the way at the back of the store, walking through all those aisles?
Kline: I don't think Kohl's sells the right merchandise for that. I think they mostly sell merchandise that you plan for. Now, if they were to add a section of impulse buys like at the front of Marshalls or the front of Bed Bath & Beyond, as seen on TV products, but that doesn't feel like the Kohl's brand. So just getting more people in, unless they're getting well paid by Amazon, which I don't think they are. But if this is the beginning of Kohl's and Amazon working back and forth, I could see some levels on the fulfillment end where Amazon could help with the Kohl's product, and where all these new Amazon branded lines would do very well from having a physical display in an 1,100 store chain.
Shen: I think it's important, too, what you brought up in terms of how they're shrinking the floor space for their actual merchandise and dedicating more of that for their back end fulfillment. The company said their fulfillment for online orders is over 30% now directly from their stores, that's obviously progress that they're seeing with that initiative. But overall, some of the people who I've seen who are more bullish on this partnership with these two different initiatives, they've spoken to the massive customer base that Amazon has and the potential, whether or not that pans out to boost traffic.
At the same time, you mentioned the fox in the henhouse kind of story here. We have another Fool.com contributor, Jeremy Bowman, he's much more bearish on this idea and he mentioned a few examples like Toys "R" Us, but also Borders and Target, companies that took the partnership with Amazon initially. Probably none of them are looking back on that collaboration praising what a good idea it was. But we'll have to see. The last part of this story, you spoke about very briefly, Kohl's shares are up over 10% in September so far as a result of this news. There's some talk of this being the courting process for the two companies. I'm curious what you think, so quickly and so soon after the Whole Foods buyout, if that's really something investors should be taking seriously at all.
Kline: Here's the thing, I think Amazon is kicking the tires. I think Amazon management is very keen, and they clearly very quickly believed in the Whole Foods merger. I think they're trying to figure out if Kohl's has a team that they could integrate. Having a physical retail presence in apparel, an area where they have marked for growth, yes, they have the look and some new techniques, but I still don't think the average man is going to buy a dress shirt, or a woman is going to buy a dress or a pantsuit, without trying it on, without the ability. Now, I might buy the second one. If I own a shirt, I bought it at Kohl's -- I actually think I bought it at J.C. Penney -- I would buy another one digitally. I'm not going to buy the first one, because you have to get the sizing right. Same is true with sneakers, hats, whatever it may be. I think Amazon sees the potential of that, just like it's a Whole Foods as a way into groceries. And I think they're considering it. But I think bidding up the stock because of that, it's way too early.
Shen: We have to wait, then, until the next quarterly report, most likely, from Kohl's, which is coming out in November, where hopefully management will share some initial takeaways from this partnership, how things are going.
For our last topic, we have the House of Mouse. In my opinion, if there's any company out there that can lean on its content library to create a competitive, major streaming service, I do believe it's Walt Disney. They have so much content that they're actually planning on two services. One is pulling from ESPN sports content, the other is built around Disney's film and television properties. Dan, before we dive into the details of what we know about the services and maybe what's driving this evolution in terms of the company's strategy, can you give us an idea of some of the challenges the company has been facing that they're trying to address with this?
Kline: The big challenge facing Disney is that the cable universe is shrinking. ESPN is by far the channel that gets the most per subscriber. It's almost $8. They don't release the numbers, so there are different estimates, but it's around $8 per subscriber. So every time the cable universe loses a million households, that's a million times $8 that they've lost. And the cable universe itself has shrunk since 2012 by somewhere between 5 and 6 million subscribers, depending on how exactly you look at the data. Some of those people have the digital streaming skinny bundles. So for Disney, you're seeing a world where younger people aren't getting cable, and if they ever do get cable, they may not want to spend for channels they don't watch. So the big drain on this, any one little channel that gets a couple of cents or a nickel isn't going to feel it that bad. But ESPN feels it deeply, and they've lost about 12 or 13 million.
Shen: Yeah, from a peak of 100 million just a few years ago, now to below 80 million, so you're right on point there.
Kline: Then the challenge for ESPN is, they have huge fixed costs. If you are your typical MTV and you lose a million subscribers, maybe you just cancel a show and you run some old programs --
Shen: More reality TV. [laughs]
Kline: MTV2 still runs Martin reruns, I don't know who's watching those. You repackage old stuff and call it classic. There's lots of ways to do cheap programming. ESPN is committed in rights deals, it's something like $11 billion a year in rights deals.
Shen: For all the various sports.
Kline: $2 billion alone for the NFL. So as those deals come up, it has the option of either not renewing them, bidding them lower, but maybe losing them to a rival, and then lowering its costs. But it can't lower its costs in the short term in any appreciable way. So it has to figure out how to cut costs, which, we've seen them cut staff, and we've seen them cut staff with five year contracts just so they could take the hit all in one quarter, even though they're still paying those people. And really, for them, they have to figure out a way to bring more revenue in.
Shen: If anything, we've seen the value of the price tags for some of these sports-related streaming rights only go up over time, phenomenally so, especially because you have non-traditional media companies also bidding for them. You have Facebook throwing in their hat, Twitter too, it only raises the prices.
Kline: You might see some peripheral sports. Maybe NASCAR will take a hit, maybe UFC won't get the deal their new buyers hope to get. But there will always be two bidders for the NFL. If ESPN lets that deal go, maybe the NFL will have to package it between Facebook and Twitter and a network, or do something, but they're going to get their $1.9 billion for that Monday night package.
Shen: If not more than that.
Kline: If not more than that.
Shen: So going to the services specifically, we have this context and background of what the company is facing off against and how they're trying to head that off. The ESPN service will make its debut in early 2018, spring is what I've heard.
Initially, it will be limited to sports content for baseball, hockey, soccer, tennis, and college sports. That's about 10,000 live events a year that are not currently available to pay-TV ESPN subscribers. I feel like management has been very sensitive to making it clear that it wouldn't be abandoning its traditional pay-TV partners, including the cable companies and the satellite providers. So the ESPN streaming service, there's been a big focus on the mobile side of things and the app. They say that the content will be accessible through the ESPN app, which already exists. It has news, scores, things like that. But then, it also expands so that ESPN content that traditional cable subscribers have, they'll be able to see all of that on the app as well once it's authenticated.
The most notable thing for me, looking out even further, is a quote I found from Bob Iger, it's something he said during his presentation at a Bank of America conference earlier this month. It's a decent length quote, but bear with me. He says
Over time, I think the way we have to look at this is, this will be a sports marketplace platform. Think what iTunes is, for instance, where you'll be able to go to the platform and actually buy almost on an à la carte basis a sport, a sporting event, a season, a league, maybe a conference, for instance. You'll be able to pick and choose over time what it is you want. It won't necessarily be a one-size-fits-all. We may launch it that way, but the goal eventually is to create something that the sports fan can essentially use to design what their sports media experience could be.
What he describes here is exactly what I hear people describe all the time when they talk about their ideal pay-TV package, because they want to pick what networks they pay for.
Kline: The problem is rights.
Kline: Let's just take the National Football League. The National Football League has an exclusive deal with DirecTV for over $1 billion, I don't know the exact amount, for Sunday Ticket. Every time that deal comes up to bid, DirecTV will bid whatever it takes to get it. So all of the sudden you're offering this everything sports package but it doesn't have NFL. And, oh, by the way, NBC and Comcast have the rights to the National Hockey League, a niche sport with a die-hard fan base that would absolutely pay for out of market games. So now, there's no NHL. ESPN only has part of the baseball package and part of the NBA package. So is it going to be able to get its partners -- Fox and the Turner channels and the various sports -- to agree to some sort of ESPN-led -- these are very difficult. Things like WWE already has a network. UFC already has a network. So creating this marketplace for a better than à la carte price, there's a lot of wrangling that has to happen.
Shen: It becomes an absolutely massive negotiation between a ton of different parties, competitors. It's definitely a goal that's way out of hand.
Kline: ABC, you said it right up the top, Disney, they are the only company that has the content to launch a Netflix or Hulu rival. The problem is, this plan of having a sports app and an entertainment app, if a family for $9.99 a month can get the equivalent of what ESPN has plus all the Disney kids programming, plus all the Disney Marvel programming with the possible exception of the Netflix shows, which I don't know what the rights are behind those, that's something I might pay for. You're going to hit all in the family, the sports fan, he might pay $12.99 a month. But you start splitting those up, even if they're only $6.99 or $7.99 or whatever the number is, it becomes less of a draw. As an adult, I think it's maybe harder for me to justify $10 a month for something only I watch, if it's sports, then it is to buy something that the whole family is going to use.
Shen: OK. Let's moves on to the second service. We've covered a little bit of the ESPN sports side. The second service isn't expected until 2019. To be clear, the pricing for both of these services has not yet been disclosed and probably won't come around until early next year. 2019 is the timeline for this service because that's when the company ends its current agreement with Netflix. Remember that Netflix and Disney originally signed a deal in late 2012 making Netflix the exclusive streaming home for a lot of Disney content, including the new releases from 2016 to 2018. Of course, once that finishes in 2019, Disney will roll out its Disney-branded service. Once Disney has that streaming control in 2019, the company will also be producing lots of new content for the service as well. Again, from that conference, Iger spoke about films and TV shows, he said four or five live-action films, four to five TV series, and three to four television movies are already in production or planned for the service specifically. He also added that the Marvel and Star Wars films initially, not sure if those are going to be included as part of the Disney-brand streaming package, they now will be for sure.
In total, about 400 to 500 films and about 7,000 episodes of TV will be available through this service. Again, I think that just reinforces just how much content this company can leverage when they're ready to roll something out like this.
Kline: I think what's been overplayed is the Star Wars and Marvel movies. The reality is, to the adult male who is the demographic for those, I'm seeing the Thor movie the day it comes out, and I've seen the Star Wars movie after waiting in line for two days the night it comes out.
Shen: Yeah, but this is for all the rewatchers, I guess. [laughs]
Kline: I think the Disney Family Library is what's the most valuable. It's those new television shows. Disney has very carefully not done a live-action Star Wars show. And they have all sorts of cartoons and Star Wars and Marvel, and they have some of the Marvel brand extensions on ABC. But think about the power of them saying, "We're doing the first-ever live action Star Wars television show."
Shen: You think this is them saving a little bit of dry powder.
Kline: Absolutely. That's what they're doing. If you look at the Disney deal with Netflix, the value is not that I can watch The Force Awakens eight months after it came out in the theater or whatever the timeline is. The value is Daredevil, Jessica Jones, Luke Cage. Those shows may continue on Netflix, it hasn't been cleared. But the ability to exploit those universes -- I'll watch any show starring a Marvel character. I will watch Ant-Man read the phone book. It's fine. So, I think that's where Disney can really leverage. Then, you add in all the timeless kids programming, aside from the old racist ones they can't show anymore, [laughs] Speedy Gonzales -- no, he's a Universal character. But a lot of those characters -- Mickey Mouse, Donald Duck -- those resonate, and little kids will watch stuff over and over again. So there's a huge library, and they can tie you and I in with just one or two must-see shows.
Shen: Absolutely. And they've talked about how important the kids audience is for them with a streaming package in general. Netflix, I think that was a big point of attraction for them when they originally signed this deal back in 2012. Last thing I want to bring up regarding this whole push from Disney has to do with BAMTech. BAMTech is the technological foundation that is going to power Disney's streaming services. The company started as a project from Major League Baseball, and Disney acquired a 33% stake of BAMTech a few years ago, and it's chosen to invest another billion-plus dollars to take an extra 40% stake, a controlling stake, given how important the delivery infrastructure will be for what amounts to hopefully millions of streaming subscribers once they launch the services.
The takeaway I had here for this was, it seems like that initial 33% investment, seeing the potential there, investing in that technology, and Disney has kind of been preparing itself for this move, hedging its bets. I'm not surprised at all that Iger has been behind all these decisions, considering the way he's led the company in the past.
Kline: The interesting piece about BAMTech is, as Disney makes all these moves, they have partners. They're the foundation, for example, for WWE's network. So are we going to see a situation like Amazon is finding where some of its rivals no longer want to use its technology? They don't break down revenue for BAMTech, so I don't know how much it gets from that. But having a good foundation, you know, if you're getting a streaming service and it works, you're going to keep it. If you go to log in to watch the recent boxing pay-per-view, and you've spend your $60 --
Shen: Or $90.
Kline: Yeah, $90 or $100 to watch Mayweather - McGregor, and you're one of those people who bought it digitally and it didn't play, you are not going to try that again for a very long time. It doesn't matter what they give you back, you missed the fight everyone was talking about. It would be the same thing. If Disney launched a streaming service and your three year olds couldn't watch Cars 2 -- you don't have a three-year-old, but pretend you do -- couldn't watch Cars 2, which is the only thing that will put them to sleep at the moment, you will cancel.
Shen: The execution does need to be seamless.
Kline: Very important.
Shen: We'll be following along this story as, for example, early next year, once we have more details about the ESPN service, once it launches, and as we get more details about the Disney-branded service as well. Dan, thanks a lot for coming in. It was great having you.
Kline: Thanks for having me.
Shen: As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Thanks for listening and Fool on!
Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool’s board of directors. LinkedIn is owned by Microsoft. Daniel B. Kline owns shares of Apple, Facebook, Microsoft, and World Wrestling Entertainment. Vincent Shen has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon, Apple, Facebook, Hasbro, Netflix, Twitter, and Walt Disney. The Motley Fool recommends CVS Health. The Motley Fool has a disclosure policy.