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2 prescriptions for drugstore profits
The market already likes what it sees at industry leader Walgreen, but runner-up CVS may be the better buy as long as it doesn't try to take on a big acquisition.
By Robert Walberg
Whether it was from Fiji or Thailand, Im not sure, but the flu strain that ravaged our household over the past couple of weeks was one of the nastiest in recent years. I spent several days caring for sick children and about one week trying to bounce back from the virus myself. Trips to school and work were replaced by regular visits to the doctors office and the local pharmacy. It was during one of these stops, while in a drugged-up daze, that I decided to take advantage of my illness and analyze the retail drug group.
Here in Chicagoland, drugstores are popping up all over the place. Its as if there is a race between Walgreen (WAG, news, msgs) and CVS Corp. (CVS, news, msgs) to occupy every corner free of retail. Im exaggerating a bit, but there has been a material increase in the number of new drugstore openings over the past couple of years.
One explanation comes from the realization by the drugstore chains that freestanding, drive-through locations are more profitable than those in strip malls. Consequently, older stores are either being closed or relocated to more promising locales.
Drugstore operators also understand the need for their stores to stay fresh-looking to combat the increased competition from superstores such as Wal-Mart Stores (WMT, news, msgs), Sams Club, Target (TGT, news, msgs) and Costco (COST, news, msgs). More and more grocery store chains are also adding pharmacies, forcing the drugstores to retaliate by expanding non-pharmacy retail space to accommodate cereal, chips and canned goods.
Throw in the aging of the U.S. population, which translates into increased demand for pharmaceutical products anyway, and it becomes increasingly clear why there are so many new drugstores opening their doors. Will the growth continue?
Drugstore haves and have-nots
Industry leader Walgreen says it will open approximately 450 new stores in 2004, pushing its total over 4,600, and plans as many as 500 new stores a year between now and 2010 to reach a total of 7,000 stores. Though not as aggressive in its new store growth, runner-up CVS is slated to open about 100 new stores this year, which would bring its total to about 4,300. The company also is making a strong run to acquire the 2,700-store Eckerd chain from J.C. Penney (JCP, news, msgs). If successful in its bid, CVS would vault ahead of Walgreen in terms of number of current stores.
Rite-Aid (RAD, news, msgs), meanwhile, has about 3,400 stores and little Longs Drug Stores (LDG, news, msgs) has a mere 470 stores. Neither is expected to post much in the way of new store growth over the next year, though it should be noted that Rite-Aid is also in the running to acquire Eckerd.
Clearly, if CVS wins the fight for Eckerd, the drugstore group will be a case of the haves (Walgreen and CVS) and the have-nots (Rite-Aid and Longs). For investors determined to own industry leaders, therefore, the choice thus comes down to owning Walgreen or CVS. If youre looking for consistency of performance, the nod definitely goes to Walgreen. The company has posted record results for 29 consecutive years and has paid a quarterly dividend ever since 1933, raising the dividend in each of the last 28 years.
With its strong growth targets and its ahead-of-the-curve technologies, Walgreen is well-positioned to continue delivering better than market and sector growth rates. Wall Street currently expects Walgreen to grow earnings by an annual average of 15% over the next five years. Though thats probably optimistic, the company should come close to that number.
Unfortunately, Walgreens growth story is well known within the marketplace, as evidenced by its lofty valuations. At present, the stock trades at 26.8 times projected earnings for 2004 and 1.02 times trailing 12-month sales. In contrast, CVS trades at 17.1 times estimated earnings and 0.56 times trailing sales.
CVS also has demonstrated success over the last year in improving operations, as gross margins, operating margins and inventory turns all were up smartly. If management can continue to improve results, the stock should continue to experience meaningful multiple expansion, closing the gap with Walgreen.
Big challenge for CVS
However, one big concern for CVS investors is the companys bid for Eckerd. Though the acquisition would make CVS the largest player in the industry, its almost certain to result in integration issues that have the potential to derail CVS recent operational success story. Though any such setback is apt to prove temporary, its possible that the deal would stall CVS shares steady climb. The stock is up 50% over the past year and is knocking on the door of its 52-week high of $38.51.
In other words, if CVS wins the battle over Eckerd, then investors will want to shy away until the dust settles and its clear that management has control over the integration of the two companies and the long-term plan. However, if CVS loses out on Eckerd to Rite-Aid or another bidder, the stock would be my clear favorite in the group because its valuations are much more compelling than Walgreen.
For a conservative investor with a long-term investment horizon, Walgreen is a relatively safe choice. Its valuations are rich, but the company has demonstrated that it knows how to compete and win. Management also deserves credit for actively working to enhance shareholder value.
As for the secondary players, Rite-Aids history of management missteps and its less-than-stellar financials make it very risky. Meanwhile, Longs Drug's stagnating growth at a time when the industry is growing suggests management timidity. The best chance at meaningful appreciation for this West Coast regional chain is through a sale to a larger player, though given its sluggish growth its difficult to imagine a bidder paying a significant premium.
So in this two-horse race, it comes down to consistency and dependability versus value and possible growth. Over the long term, both companies should fare reasonably well. But for the next six to 12 months, Walgreen probably will make investors, if not flu sufferers, feel better.
Editor's Note: At the time of publication, Robert Walberg did not own or control shares in any of the stocks mentioned in this column.
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