The Generic Shift Leaves Pharmacy Investors Well Positioned

Brian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

All three of the major pharmacy companies, Rite Aid (NYSE: RAD), CVS Caremark (NYSE: CVS), and Walgreen (NYSE: WAG), operate with similar business models, having both retail and pharmacy segments. Yet for all of these three companies, the pharmacy business is the most watched and produces the greatest difference in sales and margins. With that said, anyone following the space must be glad with what they are seeing develop.

A Top Performing Industry

<table> <thead> <tr><th> <p><strong>Company/Index</strong></p> </th><th> <p><strong>6 Month Return (rounded)</strong></p> </th></tr> </thead> <tbody> <tr> <td> <p>S&P 500</p> </td> <td> <p>13%</p> </td> </tr> <tr> <td> <p>CVS</p> </td> <td> <p>27%</p> </td> </tr> <tr> <td> <p>Walgreens</p> </td> <td> <p>40%</p> </td> </tr> <tr> <td> <p>Rite Aid</p> </td> <td> <p>131%</p> </td> </tr> </tbody> </table>

In the last six months all three large pharmacy companies have seen increases in valuation that far exceed the S&P 500, as seen above. This has occurred despite all three companies seeing slowed or a lack thereof growth. Instead of focusing on growth, investors have emphasized margins and volume, in which all three companies showed strength. Furthermore, an industry-wide macro shift to generics has investors excited about the future, as revenue declines, volume increases, and margins are booming!

Same-Store Sales

<table> <thead> <tr><th> <p><strong>Company </strong></p> </th><th> <p><strong>Same-Store Sales (from last quarter)</strong></p> </th></tr> </thead> <tbody> <tr> <td> <p>CVS</p> </td> <td> <p>(2.3%)</p> </td> </tr> <tr> <td> <p>Walgreens</p> </td> <td> <p>(2.70%)</p> </td> </tr> <tr> <td> <p>Rite Aid</p> </td> <td> <p>(3.10%)</p> </td> </tr> </tbody> </table>

The decline in same-store sales is because of the industry-wide presence of greater generic pressure. The patent cliff in biotechnology has been well-documented and covered as countless billion dollar drugs lost patents in the last 16 months. During this most recent quarter we saw as companies such as Pfizer, Bristol-Myers, Eli Lilly, etc. all saw weakness in year-over-year sales.

The generic companies have been those to benefit, as they each gain generic exclusivity to certain high-profile drugs by offering a smaller discount to consumers, and greater profit sharing with pharmacies. As a result of the prescription price declines overall sales for pharmacy companies have also declined, but with lower sales come much higher margins.

Same-Store Prescription Volume

<table> <thead> <tr><th> <p><strong>Company</strong></p> </th><th> <p><strong>Same-Store Prescription Volume</strong></p> </th></tr> </thead> <tbody> <tr> <td> <p>CVS</p> </td> <td> <p>2.0%</p> </td> </tr> <tr> <td> <p>Walgreens</p> </td> <td> <p>4.30%</p> </td> </tr> <tr> <td> <p>Rite Aid</p> </td> <td> <p>3.0%</p> </td> </tr> </tbody> </table>

The numbers from this chart above should be very telling to most investors. All three companies saw lower same-store sales yet large boosts in volume, which shows the number of lower priced generic drugs that are being pushed off the shelves. CVS in particular saw the smallest drop in same-store sales yet had the smallest rise in volume. This suggests that CVS is simply operating a much more efficient rate than its competitors -- or that it’s not selling generics at the same rate as Walgreens or Rite Aid -- or that maybe it is yet to transition many of the new generic drugs. For investors of CVS this should be a positive either way, because it suggests that margins will rise in the coming quarters as the company sells a greater number of generic drugs.

What’s good about all of these companies is that none have reached a peak in volume, all have room to grow, thus suggesting higher margins. The pharmacy business has always managed the tightest of margins with the exception of grocery, therefore all companies in the space trade at deep discounts to sales. As a result, with more high-profile generics scheduled to hit the market in the next 24 months, there is reason to believe that the pharmacy space could become even more of a Wall Street favorite.

One Last Telling Chart

<table> <thead> <tr><th> <p><strong>Company</strong></p> </th><th> <p><strong>Price/Sales Ratio</strong></p> </th><th> <p><strong>Profit Margin</strong></p> </th></tr> </thead> <tbody> <tr> <td> <p>CVS</p> </td> <td> <p>0.59</p> </td> <td> <p>3.15%</p> </td> </tr> <tr> <td> <p>Walgreens</p> </td> <td> <p>0.66</p> </td> <td> <p>2.91%</p> </td> </tr> <tr> <td> <p>Rite Aid</p> </td> <td> <p>0.09</p> </td> <td> <p>0.47%</p> </td> </tr> </tbody> </table>

I will conclude with the chart above, which is the fuel to my thesis that pharmacy stocks will be top performers in 2013/2014. We already know that generic drugs return higher margins to pharmacies, some a two-to-one ratio. We also know that margins are improving, and that sales are slightly declining. However, because of how cheap these stocks are compared to sales, it really doesn’t matter if these companies lose 5-10% of their sales with the generic shift, so long as margins improve another 0.50%-1.00%.

In the case of Walgreens and CVS, I wouldn’t be surprised to see 5% profit margins in the next two years, but in the case of Rite Aid, it has so much room for improvement that it could become the best performing stock for years to come. The company went from negative earnings to posting net income of $107.47 million for 2012 with just two good quarters, and this occurred almost solely because of the higher margins in generic drugs. Thus I suggest watching Rite Aid and the rest of the space closely, and expect larger gains as the market corrects a space that has traded at a deep discount to sales with margins on the rise. 

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Brian Nichols is long RAD. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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