LDG, Part V: Numbers Don't Lie, People Do

I don’t need to sit across the table from a CFO in a conference 1-on-1 to get the inside scoop on how it is managing its growth trajectory. I have a much better source – it’s called a balance sheet. Better yet, it is in the notes accompanying the balance sheet, where we find some very large obligatory payments that are treated by most on Wall Street as if they don’t exist.

Well, that’s something we just can’t let fly here at Research Edge.

I’m referring to the minimum rent obligations on a go-forward basis, which gives us some pretty solid insight into CVS leading up to its decision to buy Longs Drug. Why does this matter? Because aside from discretionary SG&A spending, these minimums represent the single most meaningful place a retailer could go to manipulate reported margins. Every CFO will argue with me on this, and give you fluffy reasons as to why they don’t do that. But the option is there.

How? There are 2 main ways this can manifest itself. 1) A retailer could guarantee a landlord a steep escalating rent structure in order to outbid a more profitable competitor with deeper pockets, 2) The retailer could sign rental agreements with much longer property lead times, taking on the risk from the landlord that the quality of the location does not pan out as planned.

Why? This usually happens when one of two factors exists – and both are bad. The first is when a management team is super bulled-up on its growth trajectory and thinks that it can fund a high hurdle rate for growth in rent payments regardless of the macro environment. These companies don’t ‘do macro.’ This includes Whole Foods and Dick’s (check out those charts). The second is when a retailer sees a growth or margin trajectory eroding, and management starts pulling levers to keep its margins high, instead of investing in better and more profitable growth platforms. This is Circuit City, DSW, and you guessed it, CVS.

Yes, lease escalators are in place for everyone. Including the likes of Wal*Mart – and especially CVS and LDG. But all leases that come due each year are backed out of this minimum. Hence, when it all nets out, no retailer should have minimum lease obligations 3-years out that are higher than they are today.

That’s where CVS looks so fascinating. The chart below shows the ratio of year 0 to year3 payments for CVS vs. LDG. As reference, $100 in rent today and $50 minimum in 3 years would equal a 200% ratio. That’s good. Unfortunately, both of these are sitting at about 100%. There are other small format retailers that operate near 100%, so I won’t dwell on absolute levels. But what concerns me more is the trajectory of CVS’ numbers.

Check out my Partner Tom Tobin’s 8/19 post on the secular slowdown in pharmacy revenue. We saw growth in Rx spend per capita peak in 2006, and then trend downward. Tom’s analysis builds a pretty strong case that it will continue eroding from here. Ironic that this is the precise time we began to see CVS’ longer-term rent minimums head higher relative to current payments (i.e. CVS either getting overly bullish or overly scared). Then by the time ’07 rolled around, the ratio continued to drop dramatically to what I’d call an unsustainable level, and CVS went ahead and bought Caremark in a transformational acquisition. Now it is sitting there almost 2 years since the announcement, and it needs yet another margin kicker. L-D-G.

Brian McGough
Director Of Research