An Indication Of More Gains For One Of The Market's Best Industries

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In 2013, the pharmacy space has been one of the best performing industries. Walgreen (NYSE: WAG) and Rite Aid (NYSE: RAD) have posted YTD gains of 30% and 115% respectively. Strangely, these gains have come as the industry as a whole has seen top-line declines.

During its most recent quarter, Walgreen’s revenue was flat. The company saw total comparable store sales decline 2.6% year-over-year and a 5.2% decline in traffic. Rite Aid was much worse, as its total revenue declined almost 10% year-over-year.

While overall traffic and sales have been declining for the pharmacies, profits have been rising. In an industry with historically low margins, the increase in profit has been viewed as a breath of fresh air.

Walgreens, in particular, saw its net income increase almost 11% year-over-year. This impressive improvement was seen despite a 5% increase in SG&A. The company saw its gross profit increase nearly $220 million over the prior year.

The strong profit improvements seen by Walgreen during its last quarter is due to new generic drugs. The company stated in its quarterly report, “the growth in margins was driven primarily by an increase in generic prescription drugs dispensed.” The increase in margins was from 5.9% to 6.5%, which is massive when you’re talking about a company that saw zero growth and has quarterly revenue of almost $19 billion.

In the case of Rite Aid, the transition from brand to generic drugs has changed the entire scope of its business – from operating as near bankrupt to having financial flexibility. Its difference is significantly more impressive. Remember, a near 10% revenue decline, and the company’s FQ4 net income went from ($161.25 million) to $123.09 million, a difference of more than $280 million!

As Walgreen mentioned – and also Rite Aid – the gains are due to an increase in generic scripts. Most are fully aware of the 5%-10% quarterly revenue losses that have been posted by Big Pharma. Those losses are due to the patent cliff and blockbuster drugs losing their patents. As a result, drugs such as Pfizer’s Lipitor have generics, and those generics pay anywhere from 10%-100% more than brand drugs to pharmacies. As a result, it doesn’t matter that volume and total sales are lower, because the companies are making more per script.

A Reason For Additional Optimism

Due to the generic transition, I have been highly optimistic and bullish on pharmacies. Since Rite Aid’s Q3 report, I’ve been the stock’s biggest cheerleader, buying at $1.23. However, as both Rite Aid and Walgreen announced monthly sales for May I became even more optimistic that we might get an even bigger quarterly surprise during earnings.

For the month, Rite Aid’s same-store sales fell 1.5% year-over-year, and the company specifically mentioned new generic introductions. Walgreens also mentioned new generic introductions, and saw its total sales grow 4.3% as comparable sales rose 2.8%. Granted, May was being compared to last year when the Express Script split had just occurred. However, this still paints a pretty picture when you consider the revenue and comparable sales losses seen by both companies during their last quarter.

Final Thoughts

The bottom line is that new generics are being introduced by the month, sales and volume is beginning to stabilize, and margins are rising sharply. Aside from the grocery industry, there isn’t another industry that trades at a deeper discount to sales compared to pharmacies. Walgreen and Rite Aid have price/sales ratios of 0.65 and 0.10, respectively, and with margins expanding Wall Street is rewarding both companies with large gains.

Now, with both seeing strong months in May, indicating strong trends in generics, and earnings season ahead, I’d watch both stocks closely, and would anticipate further gains in the months, and years, ahead.

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Brian Nichols is long Rite Aid Corporation. 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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