When Your Competition Stumbles, You Crush Them

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

When a company has a problem, competitors are there to try and cash in on the opportunity. The problems that Walgreen (NYSE: WAG) has had in the past with their relationship with Express Scripts (NASDAQ: ESRX) has allowed multiple pharmacies to take customers for the chain. While some companies like Wal-Mart, Target, and others benefit in a small way, the primary beneficiary of this problem has been CVS Caremark (NYSE: CVS). I've called the company one of the best deals in the market before, and their recent results just reinforce this point.

To say that CVS has been capitalizing on Walgreen's misfortune would be a huge understatement. Given that CVS and Walgreen fight for the same customers in their pharmacies, the issue with Express Scripts was a prime opportunity to get customers to switch. While Walgreen may claw its way back, and their relationship with Express Scripts is whole again, the aftershocks of this issue are still being felt. For instance, in Walgreen's last two quarters their comparable prescription sales were down 12.8% and 11.3%. In this same timeframe, CVS has seen significant growth in their prescription comps. At the same time CVS has seen growth, Express Scripts was able to do just fine without Walgreen for most of last year. This proves the point that Walgreen really needed Express Scripts more than Express Scripts needed Walgreen. If you look at CVS' quarterly earnings, you see a pattern of better results at the company's pharmacies, and their Pharmacy Services division is a hidden gem.

CVS pharmacies saw overall sales rise by 5.5% and same-store sales increased 4.3%. What is even more impressive is pharmacy same-store sales were up 5.3%. The company specifically called out Walgreen's issues by saying they realized a, “significant benefit associated with Walgreen not being part of the Express Scripts pharmacy provider network for the majority of the quarter.” In addition, the company's “front-end” same-store sales benefitted from the additional traffic and were up 2.2%. In case anyone thinks that these sales were due to higher pricing, consider that pharmacy same-store volumes actually increased by 8.7%. The bottom line is the chain gained more customers which resulted in more pharmacy and front-end sales. While these results by themselves are good, they look downright boring compared to CVS' Pharmacy Services business.

As one of the two primary competitors in pharmacy services, CVS Caremark's Pharmacy Services division generates just over half of the company's revenue. What is amazing is this division saw revenue growth of 22.2% driven primarily by new client starts. With pharmacy claims up 10%, this jump in revenue was fueled by strong organic growth. While Express Scripts is expected to show EPS growth of better than 17% in the next few years, you can see that CVS Caremark is more than capable of keeping up with its larger rival. In addition, if the economy continues to recover there will be more customers enrolled in one of these two programs because of additional workers. With millions of prescriptions being filled, there is more than enough business to support fast growth by both of these benefit managers. With this division leading the way, CVS was able to post overall revenue growth that exceeded 13%, and EPS jumped more than 21%. As you can see, there is a lot to like about the growth at CVS, but what continues to get me excited about the stock is the relative value and their potential for future dividend growth.

While it's true that CVS doesn't offer the same dividend yield as Walgreen with a yield of 1.87% versus nearly 3%, the company's cash flow makes this gap less of an issue. Walgreen recently paid out about 60% of their free cash flow in dividend payments, and at the same timeframe, CVS paid about 48%. There are two things I take from this. First, if CVS raised their payout ratio the yields would be closer. Second, given what analysts expect from both companies, CVS should be able to grow their dividend at a faster rate in the future.

Analysts generally expect about 13.3% growth from CVS in the next few years, and about 12.4% EPS growth from Walgreen. However, Walgreen is still dealing with the issues with Express Scripts, and this won't be an easy problem to overcome. Customers that are forced to change pharmacies aren't usually all that happy, and trying to get them back will be a challenge. For this reason, I wonder if Walgreen will be able to match analysts’ expectations in the next few years. In addition, CVS is buying back shares at a furious pace, and has retired nearly 5% of their diluted share count in the last year. I think that another good play in the space could be Express Scripts, but that company needs to release their free cash flow and pay a dividend already.

Analysts expect Express Scripts to grow earnings by about 17.5%, and the stock sells for a forward P/E ratio of about 13. On a relative basis, this looks better than CVS' 13.3% growth and forward P/E of 12.23. However, CVS pays a yield of 1.87% and this dividend has been growing by 30% annually in the last few years. Unless Express Scripts decides to pay a dividend, I think CVS offers a better combined value to investors. If you want a company crushing its competition, growing earnings, and growing its dividend, put CVS at the top of your Watchlist.

MHenage 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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