Jean Coutu Group's American Headache

Integrating Eckerd drugstores into the Jean Coutu Group Inc. has been harder than expected.

No one said it was going to be easy. But Quebec drug store operator Jean Coutu Group Inc. has been having more headaches than expected integrating its blockbuster US$2.4-billion acquisition of U.S-based Eckerd from department store retailer JC Penney. And it looks like there is no magic pill to quickly solving problems at the unhealthy Eckerd chain.

Jean Coutu put out first-quarter results in mid-October that saw profit plunge by 50%. So analysts, many of whom cautiously applauded the deal when it was announced in April 2004, are now taking a go-slow approach to the stock. â??This quarterâ??s miss was clearly a disappointment,â? wrote Merrill Lynch analyst Patricia Baker in a research note after the results were announced. She said it appears that the challenge of integrating such a large acquisition, â??while doable, is proving a larger task than perhaps management assumed at the outset.â?

Shares of Jean Coutu (TSX: PJC) took a nosedive after it reported that net income for the quarter ended Aug. 27 fell to US$11.1 million, or 4¢ a share, from US$22.3 million, or 9¢ a share. Analysts had been expecting earnings to come it at around 17¢ a share. Sales actually increased, to US$2.68 billion from US$1.34 billion. (The results take into account Eckerd earnings for the full first quarter of 2005, but they include only one month of results from the first quarter of 2004, since the deal was completed in July of that year, two months into the reporting period.) The bad news came on the heels of Standard & Poorâ??s downgrading Jean Coutuâ??s debt to a lower level of â??junkâ? status, to B plus from double B-minus.

The stock has dropped more than 20% since the weak results were announced on Oct. 11, dipping below $15. Baker said some of this pullback might be related to concern that Jean Coutu could soon approach the limits of its debt covenants. While Baker said she does not feel this is likely, and that the company has enough debt flexibility to avoid any breach, her main concern is the â??limited visibility surrounding the integration of the Eckerdâ??s assets and managementâ??s ability to deliver in the near term.â? Added Baker: â??To date, the integration has been mired with delays and hiccups, and the company has yet to demonstrate an improving trend for profitability at Eckerd.â? Nor has it offered a clear timeline for when profitability might be achieved.

Jean Coutu management acknowledges that the problems surrounding the integration of Eckerd are more challenging than first expected. â??Letâ??s be clear,â? company CEO Francois Coutu said during a two-hour conference call peppered with questions from frustrated analysts looking for more detailed information. â??We are not satisfied with the speed of improvement so far.â? Analysts were told that integrating the information technology systems of the two retailers proved to be problematic. In July, the conversion to a different automatic inventory replenishment system caused problems with keeping basic items in stock, and it hurt the availability of seasonal and promotional goods. Same-store sales, or revenue from stores open more than one year, climbed by only 3.5% at Jean Coutuâ??s Canadian outlets, compared with 6.1% in the same quarter last year. The real problem, however, is with the companyâ??s 1,800-plus U.S. stores, which now make up about 85% of revenue. Same-store sales at the Eckerd stores climbed by only 0.3%, compared with 2.2% the previous year.

Perry Caicco, analyst at CIBC World Markets, said in a research report that the Eckerd acquisition was â??strategically sound,â? and added that Jean Coutu management have always been good merchants who know the pharmacy industry inside-out. But the Quebec retailer has been hampered from the start by constraints on capital spending. â??We have always felt that progress would be slow and steady â?? emphasis on the â??slow,â?? â? Caicco said. Eckerd was a â??damaged asset in need of a thorough renovation,â? he added, and the most recent results show â??just how damaged the Eckerd asset is.â? Caicco has lowered his target price on the stock to $19 from $21 and dropped his earnings estimate for the current year to US59¢ from US$1.

However, some analysts are more upbeat on the stock. Jennings Capital analyst Cynthia Rose-Martel says that with the completion of the Eckerd integration, â??the worst is over for Jean Coutu.â? She adds that management can â??now focus completely upon improving in-store operations and profitability.â? For the longer term, Rose-Martel paints a rosier picture, saying the drug store retailer has â??positioned itself as a major contender in the fast-growing North American drug store retailing industry. She is maintaining her Buy rating on the stock, along with earning estimates of US$1.08 per share for the current fiscal year, which ends May 2006, and US$1.45 for the next fiscal year. Sheâ??s banking that Jean Coutuâ??s remedies for the Eckerd chain means the companyâ??s headaches will soon be over.