Will These Drugstores Change Course in 2013?

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The competition between the two drugstores giants CVS Caremark (NYSE: CVS) and Walgreen (NYSE: WAG) continues. According to the recent quarterly reports CVS business keeps growing while Walgreen is slowly declining. Is Walgreen capable to turn it around in 2013? Will CVS's growth in revenues continue?  

In the last quarter of 2012, revenues of CVS spiked by nearly 10.9% compared to the same quarter in 2011 and by 3.9% compared to Q3 2012. The company's operating profitability also rose from 5% in Q4 2011 to 6.2%. On the other hand, Walgreen’s revenues fell by 4.6% in the recent quarter and its profit margin declined from 5% in the first quarter of the fiscal of 2012 to 4.1%. Let's try and examine the reasons for these results. First, let's turn to the recent industry developments:     

On a national level, retail sales rose last month. According to the recent retail sales report, total retail sales increased by 0.5% in December 2012 compared to November and by 4.7% compared to December 2011. Moreover, the report also shows the total sales in Health and Personal Care Stores increased by only 1% during 2012 compared to 2011. This sector's sales rose by 1.4% during December compared to November and by 1.1% compared to December 2011. Based on these numbers, the sales in U.S Health and Personal Care sector slightly increased not only in recent month but also during the entire year.  

This could suggest that most of the growth in revenues of CVS was less related to the growth of the industry and more to do with the inner changes in this industry. Specifically, CVS's revenues grew on account of Walgreen’s business.

During December, Walgreen’s revenues declined by 4% compared to December 2011. Most of the drop in sales was due to the decline in pharmacy sales by 4.9%. One of the main reasons for the drop in revenues of Walgreen was due to the company's former dispute with Express Scripts (NASDAQ: ESRX). This dispute resulted in a sharp drop in Walgreen’s Prescriptions filled revenues. But in January the sales in this segment grew by 13.6% compared to January 2012. Despite this dispute shares of Express Scripts spiked by 20.8% during 2012. From the beginning of the year this company's stock rose by 3.2%. On the other hand, the company's revenues changed direction and grew by 6.3% during January 2013. The rise in revenues of Walgreen during January was partly due to the bad flu season that struck the U.S.

If sales of Walgreen in Prescriptions filled segment will continue to rally this will also suggest revenues of Express Scripts will rise.

Moreover, if these companies' revenues will increase, this could impede the growth of revenues of CVS in the coming months.

Walgreen wasn't the only company with a drop in revenues, Rite Aid (NYSE: RAD) has also had a decline in revenues: in its latest quarterly report, the revenues of the company fell by 1.2%. The company's profit margin is the lowest of the three drugstore companies at 1%.

The sharp rise in revenues of CVS led to a rise in the company's free cash flow as it grew from $3.44 billion in 2011 to $4.82 billion in 2012. The company is putting its funds to use and continues to buyback its stock: in 2012 the company purchased nearly $3.5 billion worth of stocks. This direction is likely to keep the stock price from falling.

Rite Aid also has a positive free cash flow of $354 million despite its low profit margins.

Walgreen’s cash flow situation is much worse with a negative free cash flow of $(1.4) billion in the fiscal year of 2012. The company is buying back its stocks – in 2012 it bought $1.2 billion worth of shares – but it also raises debt. In 2012 the company took loans of $3 billion. Since the interest rates are very low, and since the company is paying a dividend yield of 2.66%, which is higher than the interest rate the company will pay for a loan, then this decision of switching stocks for debt seems reasonable. But this process will raise the company's debt to equity ratio, which is currently at 0.35. This could raise the financial risk of Walgreen.

The current financial situation of Walgreen could be better. The company's negative free cash flow, decline in revenues and increase in debt makes this company less attractive as an investment compared to CVS. In recent quarters, CVS benefited from the fallout between Walgreen’s and Express Scripts. But the resolved dispute might slowly bring back customers to Walgreen’s, which will raise its revenues and thus impede the growth of CVS.    

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Disclaimer: The author holds no positions in stocks mentioned and does not plan to initiate positions within 120 hours of the posting of this article. This article is to be used for educational, research and informational purposes only and does not constitute investment advice. There are no guarantees, expressed or implied, of future positive returns in regards to the subject matter contained herein. Understand the risks inherent in investing before making the decision to invest or consult an investment professional for more information. Reasonable due diligence has been performed in regards to the information in this article. However, the author expressly disclaims any liability for accidental omissions of information or errors in fact.


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