Make No Mistake, the Best Days Are Yet to Come in This Space

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After a 53% gain over the last year, shares of Walgreen Company (NYSE: WAG) are seeing a pullback after earnings. The stock, currently trading lower by almost 8%, follows Rite Aid’s (NYSE: RAD) 11.5% loss during the last five sessions. However, make no mistake about it, this is a pullback, not the start of a large trend lower, and these stocks are still a buy.

Lousy Stock Performance Does Not Indicate Bad Quarters

I always tell people, read the quarterly report first, listen to the conference call second, and by that time the stock will have found a steady trading range. In the meantime, make an assessment of the quarter based on the information in the conference call and in the quarterly report, not based on the stock’s performance. With that said, here is how I assess the quarterly reports of both Walgreen and Rite Aid.

Walgreens missed quarterly expectations and saw a horrible decline in store traffic of 3.9% year-over-year. However, the company saw great progress in other areas, including continued earnings/margin expansion.

On June 20, we saw that Rite Aid posted a 2.7% decline in total revenue year-over-year yet increased net income from a loss of $28.1 million to a profit of $89.7 million. Much like Walgreen, the company saw a 0.4% rise in comparable front store sales.

Walgreen saw a 3.2% rise in year-over-year revenue, but saw its adjusted earnings rise 29.3% over the prior year. Therefore, we are seeing exceptional margin improvements, including at CVS, and this trend is not expected to change.

The common trend among pharmacies is to see greater prescription volume, slower revenue growth, and massive net income growth. Walgreen's pharmacy business saw a 3.4% rise in year-over-year revenue but saw volume increase 8.7%, which further validates this trend.

The Importance of Generics & its Future Relevance

These companies have been able to record higher profits because of new generic introductions. In the pharmacy business, generics return higher margins to the pharmacy, as generic drug companies pay pharmacies a higher premium to switch from higher priced brand name drugs.

When you consider that Walgreen traded at just 0.40 times sales and Rite Aid traded at 0.05 times sales last year, it is clear to see why higher margins would produce large gains in the sector (110% gain for Rite Aid over the last year), as revenue is deeply discounted in this space.

Aside from the grocery business, the pharmaceutical industry has always had the lowest margins in the market. Today, the trend is changing, and pharmacies are seeing great growth in margins, which is evident based on the earnings of both Walgreen and Rite Aid.

Like I said, new generics are reshaping the outlook of this space, thus the “patent cliff” among big pharma is a blessing for pharmacies. In the last couple years we’ve seen Lipitor, Lexapro, Seroquel, and Plavix, among many more, lose patents and be offered in generic form.

According to Evaluate Pharma, between the years 2011 and 2016, drugs that generate $133 billion in U.S. sales alone will face generic competition. Here are a few of those drugs that will soon face generic competition (along with some that just recently made the move to generic).

<table> <thead> <tr><th> <p><strong>Drug</strong></p> </th><th> <p><strong>Annual Sales</strong></p> </th><th> <p><strong>Generic Year</strong></p> </th></tr> </thead> <tbody> <tr> <td> <p>Oxycontin</p> </td> <td> <p>$2.8 billion</p> </td> <td> <p>2013</p> </td> </tr> <tr> <td> <p>Suboxone</p> </td> <td> <p>$1.5 billion</p> </td> <td> <p>2013</p> </td> </tr> <tr> <td> <p>Zometa</p> </td> <td> <p>$1.5 billion</p> </td> <td> <p>2013</p> </td> </tr> <tr> <td> <p>Asacol</p> </td> <td> <p>$900 million</p> </td> <td> <p>2013</p> </td> </tr> <tr> <td> <p>Nexium</p> </td> <td> <p>$4.9 billion</p> </td> <td> <p>2014</p> </td> </tr> <tr> <td> <p>Cymbalta</p> </td> <td> <p>$4 billion</p> </td> <td> <p>2014</p> </td> </tr> <tr> <td> <p>Celebrex</p> </td> <td> <p>$2.5 billion</p> </td> <td> <p>2014</p> </td> </tr> <tr> <td> <p>Symbicort</p> </td> <td> <p>$3.1 billion</p> </td> <td> <p>2014</p> </td> </tr> <tr> <td> <p>Evista</p> </td> <td> <p>$1.3 billion</p> </td> <td> <p>2014</p> </td> </tr> <tr> <td> <p>Sandostatin</p> </td> <td> <p>$1.3 billion</p> </td> <td> <p>2014</p> </td> </tr> <tr> <td> <p>Actonel</p> </td> <td> <p>$1.6 billion</p> </td> <td> <p>2014</p> </td> </tr> <tr> <td> <p>Abilify</p> </td> <td> <p>$4.6 billion</p> </td> <td> <p>2015</p> </td> </tr> <tr> <td> <p>Copaxone</p> </td> <td> <p>$3.6 billion</p> </td> <td> <p>2015</p> </td> </tr> <tr> <td> <p>Gleevec</p> </td> <td> <p>$4.3 billion</p> </td> <td> <p>2015</p> </td> </tr> <tr> <td> <p>Crestor</p> </td> <td> <p>$6 billion</p> </td> <td> <p>2016</p> </td> </tr> <tr> <td> <p>Benicar</p> </td> <td> <p>$2.5 billion</p> </td> <td> <p>2016</p> </td> </tr> </tbody> </table>

Just to be clear, the above list is just a sampling, showing the number of blockbuster drugs that will be generics in the next three years. The improved margins that we’re seeing among pharmacies is mostly due to generic introductions from 2011 and 2012. In reality, 2013 has been a slow year, but in 2014 pharmacies are likely to have an incredible year with so many new generic introductions.

The point of my generic chart is to show you that any temporary weakness in pharmacies should be used as an opportunity, as the best days are yet to come. If you listen to a conference call or read an earnings transcript from any of the big three pharmacies, then you will quickly notice that every single company credits their margin improvements to new generic drugs, further proving that the next few years could be especially rewarding for investors.

Final Thoughts

With Rite Aid and Walgreen trading at just 0.10 and 0.64 times sales, respectively, I think this space has a lot of room to run higher. Currently, Walgreen is trading at just 12 times next year’s earnings and Rite Aid is trading at 11.5 times the last 12 month’s earnings.

Thus, these are cheap stocks, and with new generics, the future may be brighter than ever. So, the moral of the story is to not be spooked by temporary weakness in either stock -- it simply provides a better entry point, with the most lucrative days yet to come.

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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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