Draft Report to the Canadian Association of Pharmacies and Association of Convenience Stores

Solution

QUESTION 1 - SOLUTION

DRAFT REPORT TO THE CANADIAN ASSOCIATION OF PHARMACIES AND ASSOCIATION OF CONVENIENCE STORES

In order to assist the Canadian Association of Pharmacies and Association of Convenience Stores (Athe Associations@ ) in supporting their position, it is necessary to clearly define the assertion the Associations are making. The Associations have made the following assertion: AThe PLA is earning exorbitant profits due to their monopoly position which in turn allows it to subsidize the mini- pharmacies and snack bar businesses. It is only as a result of the subsidy the PLA is providing, that these businesses can sell pharmaceutical products and snacks at below market price and remain profitable@. One key point which requires definition is Aexorbitant@. We have assumed that profits can be considered exorbitant if they are well above the industry average. There is no one definitive measure of profitability as profitability can be measured in various ways, such as gross and net margin, return on investment, return on equity etc. For the purpose of this report we will be defining profitability based on net margin as we have available comparable figures for businesses similar to the PLA.

It is also necessary to define Asubsidization@. We have considered any assistance provided to the 2 new businesses at no costs or at a very low cost relative to market, as a form of subsidization. Accordingly, we will look closely at the general costs allocated to these businesses as if they are not sufficient, this would allow these businesses to generate profits by charging lower prices than would be possible for a stand alone business. Subsidies can also be in the form of assisting these businesses to achieve higher sales than would be possible for a stand alone business simply due to the increased traffic provided by the PLA=s main business. It is, however, not possible to quantify this factor.

It should be noted that a separate audit opinion on the PLA financial statements is not issued; accordingly we have no way of being certain of whether the figures are accurate. Also, our analysis is based on historical figures and it is the future that is of more relevance in making the Associations= case. Therefore, in performing our analysis, where possible we have normalized income for the PLA=s operation to represent expected earnings in the future.

While the Associations will wish to show that the PLA alcoholic beverage operation is earning exorbitant profits and that the other businesses could not survive as stand alone businesses without the subsidies provided by the PLA, we would expect that the PLA will be averse to giving up their new businesses and will therefore attempt to disprove these points. Therefore, while we have attempted to provide strong arguments to support the associations= position, we have also attempted to anticipate the PLA=s arguments and where possible rebut them.

Professional Accounting Supplementary School (PASS)

Solution

Please be aware that this report focuses on the financial and economic arguments; the Associations should also get legal advice on the legal issue of unfair advantage/monopoly subsidization and predatory pricing as well as the issue of whether retail activity in non-liquor items is within PLA=s legislated mandate.

Profitability of the PLA = s Alcoholic Beverage Operations

In order to determine whether the PLA is earning exorbitant profits from its Alcoholic Beverage Operations (which are being used to subsidize the other two businesses) it is necessary to examine the 1999 normalized profits from the sale of alcoholic beverages. The normalized profits should reflect the expected level of profits the PLA can be expected to earn in the future. In normalizing income for the beverage business, it is necessary to remove the profits from the other 2 businesses. Also, it is important to note that profits from the sale of alcoholic beverages is lower in 1999 than in previous years which is likely at least partially due to some of the space being used by the other 2 businesses. Accordingly, it is important to attempt to calculate what the profits from alcoholic beverages would have been, in 1999 and what sales of alcoholic beverages would be in the future, if the PLA was involved exclusively in alcoholic beverage sales. This is important, as the premise of the Associations is that the PLA is making exorbitant profits from its monopoly on alcoholic beverages which allows it to subsidize the other operations.

We have assumed that the full decline in volume in 1999 related to allocating space to the other 2 operations, given that sales volume fell by 5%, and approximately 5% of the space in each store is being used for the other operations after pro-rating the space used by the other businesses (i.e. 21.6%) for 1 quarter of a year to take into account the fact that operations only likely began at the beginning of the last quarter of the year. Therefore, in computing the profitability of the alcoholic beverages it is necessary to add to the 1999 profits per the PLA F/S, the gross margin that would have been earned without a decline in sales of 5%.

The PLA will likely argue that the fall in sales did not relate to allocating space to other businesses, but that it is simply a function of poorer business conditions which are indicative of the future. We believe that this is not a strong argument, as it would stand to reason that if less space is available to sell alcoholic beverages, that sales would go down. Furthermore, there is a reasonably long history of stable sales and there is no reason to believe that beverage sales would have gone down if not for the fact that less space was available. The PLA may also argue that part of the reason for the decline in volume is that the sales mix in the current year included a higher percentage of more expensive beverages; given that people have limited budgets if they spend more per bottle they will purchase a smaller volume of beverages. This argument can not however account for the full decline in sales, given that total sales in dollars declined by 4%.

In Exhibit 1 we have made the adjustments necessary to normalize profits from the sale of alcoholic beverages. Based on Exhibit I the normalized income for the alcoholic beverage

Solution business is $5.85 million and sales are $124.99 million, resulting in a net margin of 4.7% which is well above the industry average of 2.5%. With a profit margin of almost double the industry average, it could be argued that exorbitant profits are being earned.

It is possible that the PLA will argue that it is not fair to base profitability on 1999 income. Therefore, before finalizing our analysis it will be necessary to obtain figures for previous years as average profitability over a period of time may be more indicative of normal profits for the PLA than 1999 profitability alone. However, given that sales in previous year are similar to the 1999 normalized profits, it is likely that the profits of previous years would further support the contention that the PLA is earning above average profits. The PLA may also question the industry profitability figure of 2.5% which is reflective of the whole industry. They may argue that it is necessary to compare the PLA=s performance with similar businesses. For example, the PLA is similar to large chains who would be likely to earn higher income than one store operations. Therefore, before finalizing our analysis, it is necessary to obtain more detailed figures for the industry, based on type of business.

Subsidization of Other Businesses

As discussed earlier, in order to prove that the PLA is using its Aexorbitant@ profits to Asubsidize@ the snack and pharmaceutical businesses and allow them to sell at prices below market, it will be important to show that in the absence of such subsidization the businesses could not have survived or at the least could not have earned a normal level of profits. Based on the information provided, both the snack and pharmacy businesses are quite profitable. However, this may be due to the PLA incurring costs or providing services to these businesses, without a proper charge or cost allocation. It is therefore critical to examine the allocation of costs to each of these businesses.

It appears that for the both the pharmacy operation and snack operations, general costs were allocated on the basis of square footage occupied by the businesses. This is reasonable, provided that the costs allocated are reflective of what these items would have cost the businesses as stand alone operations on a per unit basis (e.g. for rent per square foot) and that the allocation (i.e. use of square feet) is reasonable. For the costs associated with the rental of stores, and store depreciation, the use of square footage appears reasonable as an allocation basis, as these costs could be expected to correlate with space usage. The only question is whether these businesses as stand alone businesses could have obtained the same cost per square foot as the PLA. At this stage we have no reason to believe that this is not the case for rent.

For the case of salaries, the salaries relating to the pharmacists and salary of the vice presidents responsible for the pharmacy and snack operations should clearly be allocated 100% to these operations. For the remaining salaries the allocation should be based on the approximate time spent by staff on the pharmacy and snack businesses. For support staff such as accounting, MIS,

Solution human resources etc., it may be difficult to determine this precisely, as work performed may relate to all of the operations (e.g. accountant prepares financial statements for the whole entity). If it is therefore not practical to allocate on the basis of time, costs could be allocated on some other basis such as volume of business associated with the pharmacy and snack operations versus the alcoholic beverage operations. It is unlikely that store space correlates with volume given that turnover per square foot for the pharmacy operation is lower than for the beverage sales, while the turnover for snack sales is far higher (see exhibit II). It would, therefore, be more appropriate to allocate salaries on the basis of sales which should reflect volume, rather than space. One possible advantage that the snack business is enjoying relative to an independent business, regardless of how the allocation is performed, is that this business does not require a full salesperson per store and the allocation will reflect a fraction of a salesperson=s salary. As an independent business it would not be possible to hire a Afraction@ of a person.

Admin and selling should be allocated in a manner similar to salaries for support staff. That is, if it relates to a specific business it should be allocated to that business; otherwise it would be reasonable to base the allocation on sales. Regardless of the allocation basis used, one further point that needs to be looked at with regard to this expense is whether due to the fact PLA is a very large organization, they are able to enjoy lower costs per unit (e.g. due to discounts on office supplies) which are effectively passed on to the other 2 businesses.

The full incremental interest cost relating to the start up costs should be charged to the 2 new businesses. Interest that can not be traced to any one business can be allocated based on the size of the business; various measures such as sales, asset base based on market value could be used. It should be noted that the new businesses appear to be benefitting from the lower interest costs being paid by the PLA on short term debt. The bank indebtedness of the PLA as at December 31, 1999 was $7.9 million during the 1999 year. Assuming that this is representative of the average balance outstanding over the course of the year, based on interest expense of $332,000, this amounts to an interest rate on bank indebtedness for the PLA of only 4.2%, compared with an average rate in the capital markets of 4.9%. These businesses are even benefitting more from the fact that the PLA appears to have no debt in connection with its properties per the financial statements. While this is likely leading to substantial savings in interest for the new businesses, the PLA would quite likely argue that there are also private businesses who have fully paid off their mortgages.

In Exhibit III, the income for the pharmacy and snack operations have been adjusted to reflect a more reasonable allocation of costs. The income has also been normalized by removing/adjusting non- recurring items in order to better reflect the level of income which can be expected in the future. Unfortunately, insufficient information is available to perfectly quantify all potential adjustments. Based on the adjustments made, the pharmacy business appears to be profitable even after modifying the allocations and with a net margin of over 11%, it is far more profitable than the average pharmacy. Therefore, assuming that after adjusting the allocation of general

Solution costs, the costs included in the schedule are representative of the costs of operating a private chain of pharmacies, a strong case could be made that the pharmacy is profitable without subsidization.

The snack business is, however, not profitable after adjusting the allocation of general costs and it would therefore appear that it could not survive as an independent business without Asubsidization@.

A final point which should be brought to the attention of the government is the fact that neither the pharmacy nor the snack business pay income taxes due to their being operated by the PLA and therefore in competing with private sector competitors they have an unfair advantage. The associations may wish to lobby for the tax-free status to be repealed. While the PLA may argue that they pay a dividend to the province of 15% of their income which is similar to taxation, the rate of 15% is clearly lower than the average tax rate that would be paid by a private business.

Conclusion

In conclusion, a strong case can be made that the PLA is making a well above average income from the sale of alcoholic beverages. However, based on the analysis performed in this draft report, which was based on information currently available, it does not appear that the PLA is using their high profits from the sale of alcoholic beverages, to subsidize the mini-pharmacies. It will, therefore, be difficult to prove that they have an unfair advantage relative to private pharmacies, and convince the government to force them to terminate this business.

With regard to the snack business a strong case can be made to the government that subsidization is taking place. It is possible however, that the PLA will argue that this is not relevant, as the PLA stores only carry a small portion of the product complement of a convenience store and therefore do not compete Ahead on@ with the convenience stores. It is likely that the government would not accept these arguments, and agree with the position of the Association of Convenient Stores given that the PLA=s snack business is competing with the convenience stores even if only in some areas of their business.

Solution

EXHIBIT I Normalization of PLA Sales and Income from Alcoholic Beverages

Normalization of Sales ($millions)

Sales per 1999 F/S 127.00 less: Pharmacy line 4.10

Snack line 4.20 118.70

Plus: Add back of lost sales due to space allocation* 6.29

Sales of alcoholic beverages 124.99

* It is assumed that if the new businesses would not have been present in 1999, sales volume would have been increased by approximately 5.24 million liters (i.e. 5% higher than actual 1998 sales volume) and assuming that the sales mix remained the same, sales in dollars would have been $6.29 million (i.e. 5.24 x ($118.7/98.6) per liter) higher.

Normalization of PLA Sales and Income from Alcoholic Beverages

($millions)

Net income per 1999 F/S 3.50 less: Gain on sale of real estate (i.e. $4.3 - $3.8) .50

Reported pharmacy gross profit 2.60

Reported snack line gross profit 2.20

Add: Salaries relating to pharmacists 1.1

Salaries of Vice Presidents of new businesses .70

Start up costs 3.20

Reduction in lease expense for the stores .23

Gross margin on sales of alcoholic Beverages lost due allocation of space to other businesses* 2.42

Solution

Normalized pre-tax income $5.85

* Total gross margin percentage for the PLA on sales of alcoholic beverages is 38.5% based on sales of $118.7 and gross profit of $45.7 (i.e. $50.5-$2.6-$2.2). Accordingly, it is assumed that if sales were increased by $6.29 million, gross margin would be increased by $2.42 million. ** Ignored the impact of interest on start up costs as impact is assumed to be negligible.

EXHIBIT II

Turnover calculations ($millions)

Square footage allocated to pharmacy business 768/(56 x80) x 700,000 = 120,000 s.f.

Square footage allocated to snack business 200/(56 x80) x 700,000 = 31,250 s.f.

Turnover by square foot for alcoholic beverage business: $118.7M/(700,000-120,000-31,250) = $216 (note 1)

Turnover by square foot for Pharmacy sales $16.4M*/120,000 = $137/s.f. (note 2)

Turnover by square foot for snack business $16.8M*/31,250 = $538/s.f. (note 2)

1. Sales of $118.7 for alcoholic beverages, is based on total sales for the PLA per the 1999 financial statements, less sales relating to the snack and pharmaceutical businesses.

2. Annualized sales by multiplying by 4, as these businesses were in operation for only one quarter of the year.

Solution

EXHIBIT III

Adjusted Profitability Calculation for Pharmacy and Snack Business

Pharmacy Snack

($millions)

Net Income $1.70 $1.00

Non recurring incentive from Potato Chip Company -0.75

Correction of Error in Salary Add back original Allocation based on space (note1) Pharmacy: 17.1% x $6 million x 1/4 year 0.26 Snack: 4.5% x $34 million x 1/4 year 0.38 Deduct:

Salaries Relating Directly to Snack/Pharmaceutical Salaries relating specifically to Pharmaceutical (note 2) -1.5 Salaries relating specifically to Snacks -0.3

Remaining salary allocated based on sales Pharmacy: $4.1/$127 x 4.2 (i.e. $6-$1.50-$0.3) -0.14 Snacks: $4.2/$127 x 32.2 (i.e $34-$1.50-$0.30) -1.06

Admin and selling Add back original Allocation based on space Pharmacy: 17.1% x $8.8 million x 1/4 0.38 Snack: 4.5% x $8.8 million x 1/4 0.1 Deduct:

Adjusted costs allocated based on sales (note 3) Pharmacy: $4.1/$127 x $6.1 million -0.20 Snacks: $4.2/$127 x $6.1 million -0.20

Rent Add back original Allocation of store rent based on space Pharmacy: 17.1% x $2.3 million x 1/4 0.1 Snack: 4.5% x $2.3 million x 1/4 0.03

Deduct:

Allocation of store rent based on store space

Solution

after 10% reduction of original rent of $2.3 Pharmacy: 17.1% x $2.07 million x 1/4 -0.09 Snack: 4.5% x $2.07 million x 1/4 -0.02

Allocation of 10% warehouse space: $1.1 million x 10% (split evenly) (note 4) - 0.05 - 0.05

Adjusted net income $0.46 $(0.87) Net Margin (note 6) 11.28% N/A

Solution

EXHIBIT III

Adjusted Profitability Calculation for Pharmacy and Snack Businesses ($millions)

1. The space allocation takes into account that there are 4,480 square feet in a typical store and the pharmaceutical and snack operations account for 768 square feet and 200 square feet respectively. It is assumed that per the original allocation $6 million of salaries was allocated to the pharmacy business, as total salaries amounted to $34 and $28 of salaries relate to store sales staff and would not have been allocated to the pharmacy business.

2. Based on $1.1 million of salaries relating to pharmacists and $400,000 of salary for the senior management hired to run the pharmacy.

3. The gain on the sale of land and start up costs are removed from admin and selling costs. Both of these items are non recurring and should be excluded.

4. Total rent per the 1999 financial statements amounts to $3.4 million. As $2.3 million of this amount relates to the stores, $1.1 million relates to the warehouse.

5. Interest on the additional financing required to fund the start up of the snack and pharmacy businesses should have been attributed directly to these businesses. Furthermore, the use of space to allocate the interest which relates to the overall operations is also not appropriate. However, no adjustment has been made, as the impact would not be significant.

6. Net margin for the pharmacy is $.46 million / $4.1 million of pharmacy sales.