Why This Drugstore Stock Got Dragged Down

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Walgreen (NYSE: WAG) was down almost 10% last week despite an 18% year-over-year improvement in earnings. But Walgreen posted fiscal 3Q EPS of $0.85, $0.06 below analyst estimates. Margin expansion was smaller than expected and customer traffic in comparable stores decreased 3.9%. Despite the downturn, Walgreen has still outperformed chief competitor CVS (NYSE: CVS) by nearly 30 percentage points over the past year. 

So what's the play? Earnings hit a snag, but is Walgreen still a long-term investment opportunity?

The pharmacy company is the largest U.S. retail drug chain in terms of revenues and the company is still gaining market share. CEO Greg Wasson had this to say after the earnings release: "we continued to see a strengthening in our pharmacy performance as we maintained strong margins and increased our retail pharmacy market share from 18.4% to 19.2% year-over-year.” 

This market share gain was likely the result of its renewed multi-year pharmacy network agreement with Express Scripts (NASDAQ: ESRX). But it still remains questionable as to whether Walgreen can regain the $4 billion in sales that it lost due to the mishap.

Even still, Walgreen generated operating cash flow of $1.4 billion and free cash flow of $1.1 million last quarter, boosting cash on hand to $3 billion -- a 50% increase from the year-ago quarter. 

Part of Walgreen's growth opportunities include a 2012 merger with Alliance Boots that is expected to yield $125 million to $150 million in cost synergies. Most recently, the pharmacy company signed a deal with AmerisourceBergen, replacing Cardinal as its key supplier. The deal will increase its global pharmaceutical supply chain for branded and generic drugs. 

Top comp

CVS is Walgreen's top competitor. This pharmacy company should perform well on the back of market share gains related to the Walgreen-Express Scripts fallout. 

CVS also has a prescription benefit management (PBM) segment that offers mail order pharmacy services, specialty pharmacy services and plan design. The company generates about 55% of revenues from its PBM segment and 45% from its pharmacy retail operations. CVS also operates retail health care clinics under the MinuteClinic name. The clinics treat minor health conditions and perform routine vaccinations. 

Much like Walgreen, CVS has has an impressive cash flow and balance sheet. CVS ended last quarter with cash of $1.55 billion, up 12.3% sequentially. Free cash flow generated for the quarter was nearly $1.32 billion. 

CVS plans on returning about $5 billion to shareholders in 2013 with the help of expansion in its dividend payout ratio to 25%, from the current 21%. At the current price, this would boost CVS' dividend from the current 1.4% to 1.7%. 

CVS competes with the likes of Express Scripts in the PBM industry. Express acquired Medco Health in early 2012 for some $29 billion. The Medco acquisition put Express as the largest player in the PBM space, managing over a billion prescriptions annually. Express expects Medco to help with boosting the company's stronghold in the generics market. 

Express management estimates that $40 billion of specialty drugs will lose protection through 2020, which represents a $77 billion opportunity for the company in the specialty spends for these drugs. The company also expects that the increase in generic drug demand and higher use of mall orders will improve the company's margins. 

The one downside for Express is that its five largest clients make up nearly 40% of revenues. Most notably, its largest customers include Wellpoint (13% or revenue) and the Department of Defense (10.6%). 

Hedgie trade

Going into 2Q, CVS had a total of 46 hedge funds long the stock. The hedge fund with the largest position includes First Pacific, which had 4.4% of its 13F invested in the stock -- or over $400 million (see First Pacific's top picks). 

Walgreen had 52 hedge funds long the stock, with Peter Rathjens, Bruce Clarke and John Campbell's Arrowstreet Capital. Arrowstreet has a $84 million position in the stock (see Arrowstreet's top stocks).

Meanwhile, Express had the most interest among the three socks, with 68 hedge funds long the company; this was a 16% decrease from the previous quarter. Of the major hedge funds, Brave Warrior Capital has the largest position, making up 12.2% of its 13F portfolio (see Brave Warrior's new picks).

The bottom line

The pullback in Walgreen's stock price brings its dividend yield to 2.5%. Meanwhile, the industry has big tailwinds related to the increase in the expected rise number of individuals with insurance coverage due to the healthcare reform. I still like CVS as the best bet given its revenue mix between PBM and retail. CVS also trades at 17.9 times earnings, compared to Walgreen's 19.5 times. 

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Marshall Hargrave 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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