Drugstore Wars: Walgreen or CVS Caremark?

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

Drugstores should make viable investments going forward as a way to play the demand for drugs that will inevitably increase with an aging population that's led by the baby boomers. The Affordable Care Act, or "Obamacare," should also fuel demand for cheaper generics, as well as generate more foot traffic in stores such as Walgreen (NYSE: WAG) and CVS Caremark (NYSE: CVS)). So which drugstore makes a better investment for the future?

It's all about generics...

CVS Caremark recently reported stellar earnings, claiming that it would be able to retain up to 60% of former Walgreen customers who were obtained after Walgreen's dispute with Express Scripts. CVS Caremark was also helped by a more severe flu season than usual, as well as by increased profits from generic drugs, which tend to generate less revenue but increased profits due to higher margins. 

Walgreen has also benefited from the increased sales of generics. This is why drugstores seem to make a more viable investment over the long term than drug makers. When drug makers lose patents on their bread-and-butter, cash-cow blockbuster drugs (a.k.a. falling off the "patent cliff"), they can potentially lose millions and sometimes even billions of dollars. Drugstores don't care as much because they can sell generics of the former blockbuster and earn higher profits from them.

Walgreen looks like it now has a nice competitive advantage over CVS relating to generics, as well. After signing a decade-long deal with AmerisourceBergen (NYSE: ABC), Walgreen is looking to direct its distribution duties to AmerisourceBergen instead of distributing around 80% of its drugs on its own. Amerisource Bergen says that the contract could be worth up to $28 billion in fiscal 2014. Walgreen CEO Greg Wasson commented

"...AmerisourceBergen are experts in pharmaceutical supply chain distribution... We are very good at it, but the combination of what they both do to improve our supply chain, take that off of our hands, and improve our service levels is really the opportunity that we are excited about."

The deal was huge for AmerisourceBergen, and if Walgreen decides to exercise its right to eventually purchase up to 23% of its new distribution partner, it will be Amerisource's largest shareholder. AmerisourceBergen recently reported its fiscal second-quarter earnings-- which fell 78%. Revenue, however, saw slight growth, while gross margins climbed slightly higher.

With Walgreen as its new partner and potential minority stakeholder, the company also has much better growth prospects going forward-- and has raised its revenue forecasts. Earnings for the full year are still expected to be on the lower side, however. The company has also received a string of positive analyst upgrades lately, which should inject some more momentum into the stock going forward.

AmerisourceBergen may also be one of the most attractive plays to capture the growing trend in generics, as well-- especially with all the new sales that should materialize from its new partnership with the world's-largest drugstore.

Walgreen should be of great help to AmerisourceBergen's improved and sustainable profitability going forward. In turn, AmerisourceBergen will help Walgreen not only to grow in size and scale, but also negotiate better prices for lower-profit branded-prescription drugs that the company sells in bulk. AmerisourceBergen will also give Walgreen a more consolidated distribution network in not only the U.S. but in Europe as well--which brings us to our next topic.

International expansion...

CVS is almost exclusively based in the United States, and Walgreen used to be. That all changed when the company announced it would be partnering and also purchasing a large stake in the United Kingdom's largest drugstore -- Alliance Boots.

The deal put Walgreen outside of the U.S. and opened up new possibilities that don't exist for stateside competitors such as CVS. The partnership now allows for further expansion and growth, as Walgreen plans to be the first-and-largest drugstore chain in the global marketplace.

Walgreen, with Alliance Boots, is also looking to get into the emerging markets, after Alliance Boots spent $90 million to buy a 12% stake in Nanjing Pharmaceutical, China's fifth-largest drug wholesaler. CVS is looking to follow Walgreen into international territory, albeit slowly.

In early February, CVS announced that it had purchased Drogaria Onofre, Brazil's eighth-largest drugstore chain. Chief Executive of CVS, Larry Merlo stated:

"We view Brazil as an attractive market given that healthcare and pharmacy are expected to grow [in the] double digits for the next decade."

The purchase was the first attempt by CVS to venture outside of the U.S.


Now lets take a look at both CVS and Walgreen's valuations:

<table> <thead> <tr><th> </th><th>P/E</th><th>Forward P/E</th><th>PEG ratio</th><th>Dividend (yield)</th></tr> </thead> <tbody> <tr> <td>CVS</td> <td>19.4</td> <td>13.3</td> <td>1.1</td> <td>0.9 (1.6%)</td> </tr> <tr> <td>WAG</td> <td>21.8</td> <td>13.3</td> <td>1.1</td> <td>1.1 (2.2%)</td> </tr> </tbody> </table>

Data obtained from Yahoo! Finance, May 1. 

Both companies look similarly valued in the near term and beyond. What separates one from the other, however, seems to be the dividend. Not only does Walgreen yield more than CVS, it also has a better and more established track record of doing so:

<img alt="" src="http://g.fool.com/editorial/images/37850/screen-shot-2013-05-01-at-110427-pm_large.png" />

Walgreen is a dividend dynamo, and looking at the increases as a percentage shows why:

<img alt="" src="http://g.fool.com/editorial/images/37850/screen-shot-2013-05-01-at-110334-pm_large.png" />

The bottom line

Walgreen currently seems to be a much better investment than CVS when considering future prospects. Its huge deal with AmerisourceBergen gives it economies of scale that beat CVS.

While Walgreen is already the largest drugstore in the U.S., its strategic deal with Alliance Boots gives it a huge head start internationally over CVS and cements its place as the first-and-largest global drugstore in the world--now with a heavy presence in Europe and a growing foothold in emerging markets.

When looking at valuations, both companies look expensive if considering trailing P/E ratios, and look cheap going forward when keeping annual estimated earnings in mind. Walgreen distinguishes itself from CVS, however, with its explosive dividend growth and track record over the years. If I'm going to pay the same price relative to earnings, I want the better option between the two.

Walgreen is set up nicely to be the dominant global drugstore, and it will be hard to knock it down. If CVS retains 60% of Walgreen's former customers from the Express Scripts fallout, Walgreen might not notice much 10 years down the road. CVS appears to be attempting to play checkers in a chess game, while Walgreen is already setting up for the check-mate.

CVS might still make a good play to capitalize on U.S. demographics and Obamacare, but Walgreen (as of now at least) is king of the drugstore castle. It will be hard for another company to dethrone an already well-established, global leader-- and this is why I believe Walgreen will most likely continue to outperform.

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Joseph Harry owns shares of Walgreen Company. 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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