Is It Time To Invest in This Drugstore?

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

Shares of Walgreen (NYSE: WAG), the largest drugstore chain in the U.S., recently tumbled after the company missed analyst estimates on both the top and bottom lines for its third quarter. Walgreen earned $0.65 per share, or $624 million, up 16% from the prior year quarter. Revenue rose 3% to $18.31 million. Wall Street had been more optimistic, expecting the company to earn $0.91 per share on revenue of $18.4 million.

Despite its recent plunge, however, the stock is still up more than 50% over the past twelve months, and many analysts have recommended that investors buy shares on a post-earnings dip. Will Walgreen bounce back quickly, or is this slide a start of a bigger downtrend, especially considering the volatile state of the market?

I love you, I hate you, I need you

Walgreen spent most of last year tangled in a love-hate dispute with its long-time partner, Express Scripts (NASDAQ: ESRX). Express Scripts is a pharmacy-benefits manager, a middleman between drug makers and drug store pharmacies. Express Scripts pays Walgreen, CVS Caremark (NYSE: CVS) and Rite Aid (NYSE: RAD), the three largest drug stores in America, to fill its prescriptions.

However, in 2011, Express Scripts asked Walgreen to lower its required payments, which the company refused to do. In response, Walgreen terminated its partnership with Express Scripts at the beginning of 2012, a terribly rash move considering that Express Scripts prescriptions accounted for 7% of its top line in 2011.

Express Scripts filled an average of 80 million prescriptions annually for Walgreen. Those customers flocked to CVS and Rite Aid, causing Walgreen’s prescription sales to plunge 8.1% by the fourth quarter of 2012. Walgreen realized that it had made a grievous error in letting Express Scripts go, and resumed their partnership by September. By that time, however, Walgreen had already permanently lost many customers to its rivals. Walgreen addressed these concerns, stating that it had regained some of its lost customer base during the third quarter, which CVS Caremark confirmed in its first quarter earnings report.

Generic drugs equal higher margins, lower sales

Walgreen, CVS and Rite Aid have all been aided by an influx of generic drugs, which cost far less than their brand-name counterparts to purchase and to sell. This produces higher margins and profits, but generates lower revenue per sale. This influx was caused by Big Pharma’s loss of patent exclusivity over several major brands over the past two years, which has boosted sales for generic drug manufacturers. Increased sales of generic drugs at Walgreen contributed to a year-on-year rise in gross margin from 28.2% to 28.5%.

Walgreen’s total prescription sales, which comprised 63% of its top line during the quarter, rose 3.4% from the prior year quarter. Meanwhile, same-store prescription sales rose 2%. By comparison, same-store prescription sales at CVS rose 4.7%.

Walgreen’s total prescriptions filled rose 8.7% year-on-year (7.1% on a same-store basis) to 209 million. Its market share in U.S. retail pharmacy also rose from 18.4% to 19.2%. In other words, despite lower revenue growth, Walgreen’s pharmacy business is humming along nicely, and it is steadily regaining lost market share from its rivals.

These boots were made for synergizing

To give its operations the shot of adrenaline it needed to bounce back from the Express Scripts debacle, Walgreen bought a 45% stake in Switzerland-based Alliance Boots for $6.7 billion, its largest acquisition ever, last year. The partnership with Alliance Boots, which owns 3,300 health and beauty stores across 11 countries, is Walgreen’s first overseas expansion. In addition to its retail stores, Alliance Boots also delivers over 4.5 billion units of prescription drugs to health centers, pharmacies and hospitals annually.

During the third quarter, Alliance Boots contributed $0.10 to Walgreen’s adjusted earnings per share. Walgreen now expects cost-saving synergies from this partnership to come in at $125 million to $150 million for the first year, up from a prior forecast of $100 million to $150 million.

Versus competitors

A weak spot for Walgreen was its front-end (non-pharmacy) same-store sales, which grew by an anemic 0.4%. However, this was a considerable improvement from the 2.6% decline it reported a year earlier. It was in line with Rite Aid, which reported 0.3% growth, but far behind CVS Caremark’s 1.4% gain. From the following chart, we can see that CVS continues to outperform Walgreen in terms of top and bottom line growth as well.

Although Rite Aid is smaller than Walgreen and CVS, investors should also note that the company recently reported its third consecutive quarter of profitability, after spending several years deep in the red. A fundamental comparison of these three companies also shows that each one has its own merits.

 

Forward P/E

Price to Sales (ttm)

Return on Equity (ttm)

Debt to Equity

Operating Margin

Profit Margin

Walgreen

12.25

0.64

12.19%

33.51

4.86%

2.91%

CVS Caremark

12.75

0.57

10.65%

25.29

6.11%

3.30%

Rite Aid

11.24

0.10

N/A

N/A (5.91B Debt)

3.44%

0.94%

Advantage

Rite Aid

Rite Aid

Walgreen

CVS

CVS

CVS

Source: Yahoo! Finance, 6/26/2013

The Foolish Bottom Line

Looking forward, investors should keep an eye on the balance between top and bottom line growth in these three companies. While rising generic drug sales are a boon to margins and profits, they are heavily dependent on higher sales volume. Otherwise, sales growth will wane, as seen with Walgreen’s third quarter earnings. Some analysts are concerned about the sustainability of this business model, and others worry that the prices of generics will fall, crimping margins as well as revenue growth.

However, the federal government is planning to expand healthcare coverage to nearly 30 million Americans next year, which will boost demand for generics and drive up sales volumes at Walgreen, CVS and Rite Aid. In addition, when the turmoil in Europe subsides, Walgreen’s investment in Alliance Boots could yield substantial profits in the long run. If that’s the case, then Walgreen could be a great long-term buy on post-earnings dips like these.

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Leo Sun has no position in any stocks mentioned. The Motley Fool recommends Express Scripts. The Motley Fool owns shares of Express Scripts. 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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