CVS-Eckerd: Headaches Ahead?


By Amy Tsao With J.C. Penney (JCP) selling off half of its struggling Eckerd drugstore chain to CVS (CVS), the Wall Street reaction has been swift and positive: Many see a win-win in this deal. J.C. Penney gets a handsome cash payment and can now refocus in on its department stores. CVS gets 1,260 additional stores -- and a presence in key Sun Belt states -- for a tidy price of $2.15 billion.

CVS shares are up about 8%, to $37.12, since the Apr. 5 announcement. This deal, however, may not be as handsome as it looks. The reason: Location, location, location.

When Eckerd's troubles started to mount a few years ago, many analysts pointed to poor store placement as part of the reason. Other national chains had newer, better-situated locations.

BIGGEST CHAIN. There's little evidence that much has changed from those past assessments. Indeed, one analyst wonders privately why Wall Street has made scant mention of the quality of Eckerd's store base since Penney put the stores on the block. "People used to be very quick to say how bad the locations are." Instead, in recent months as investment-banking fees have come into play, the blame for Eckerd's struggles seems to have shifted to management's shoulders.

For Woonsocket (R.I.)-based CVS, the Eckerd deal will bring its store count to 5,000 in 36 states, making it the largest chain in the U.S. Buying Eckerd clearly enhances its presence in two desirable states -- Texas and Florida. However, Eric Bosshard, analyst at FTN Midwest Research, figures that CVS could end up relocating as many as 300 of the Eckerd stores because of their lackluster spots. "Real estate will be one of the challenges," he says.

Certainly, making the acquisition work will require more than just changing the name on the Eckerd storefronts. Even in retirement-boom locations like the Sunshine State and the Lone Star State, Eckerd stores have performed poorly. Bosshard quantifies the chain's problems as 25% execution-related and 75% structural, especially where its stores butt heads with the likes of Walgreen (WAG), still No. 1 among drugstore chains in total revenue. Getting rid of management takes care of only a relatively small part of the chain's problems, he figures: "It suggests there were real structural factors."

"FREE PASS." The long-term question is whether the Eckerd stores will be able to grow as fast as CVS's existing stores. CVS should be able to boost earnings growth for a couple of years, says John Ransom, analyst at investment bank Raymond James & Associates in St. Petersburg, Fla., but he wonders if the deal will ultimately add to the "quality of the CVS franchise." CVS didn't return calls seeking comment for this story.

CVS has been on an aggressive buying spree since the 1980s, most notably with buyouts of Revco in 1997 and Arbor in 1998. Both were better-performing chains with fewer problems than Eckerd, in the view of most analysts. That's why Ransom figures the market will give CVS a "free pass for 18 months" before it begins to demand results on the Eckerd deal. Investors so far are applauding CVS's move largely because of the promised increase in earnings per share next year. CVS has said the deal will dilute EPS in 2004 by 12 cents to 15 cents but will add 15 cents to 20 cents in EPS in 2005.

Canada's Jean Coutu (T.PJC.A) drugstore chain, which runs Brooks pharmacies in the U.S., bought the other half of the Eckerd store base, 1,539 stores, for $2.38 billion in cash. That will increase its U.S. presence substantially, with stores in 13 Northeast and mid-Atlantic states. "For Jean Coutu, it could be an easy way to get attractive [U.S.] real estate," says Eric Jemetz, senior equity analyst at Rockefeller & Co., noting that the company has so far done well at integrating acquisitions.

CREDIT QUESTIONS. He's less sanguine on CVS's ability to turn the Eckerd stores around, however. Buyouts, Jemetz notes, are worth much less if the retailer ends up shuttering a lot of stores. Bosshard argues that CVS's previous acquisitions were well done, but he sees the Eckerd integration as far more challenging. "They never bought a bad business [before Eckerd]," Bosshard says.

Also, credit-rating agency Standard & Poor's is considering cutting CVS's rating as a result of the deal, citing an increased debt load. "Moreover, the transaction increases the company's business risk, as the Eckerd stores have underperformed the industry for a number of years," says S&P. CVS's debt-to-capital ratio rises to about 60% from 52.5% with the deal, and cash flow would also decline in the near-term.

CVS's credit profile should improve in 2005, S&P says, but in the next 12 to 18 months, the company will spend a total of $375 million to $440 million to upgrade the Eckerd stores.

No question, the Eckerd deal gives CVS a nice bump in store count. But over the next several years it could also create some problems, as CVS tackles what could be its most difficult acquisition yet. Tsao covers the markets for BusinessWeek Online in New York


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