Take One of These and Call Me in the Morning

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Take a growing industry, a company that knows how to capitalize on that growth, and a good value, and usually you have a winning combination. It seems pretty obvious that CVS Caremark (NYSE: CVS) is positioned to benefit from two huge growth opportunities. The company not only will benefit from the increased usage of prescription drugs, but also from the aging population that relies on these medications. Given that CVS and its main competition, Walgreen (NYSE: WAG), and Wal-Mart (NYSE: WMT), all stand to benefit, it’s important to understand which of these three represents the best value for investors.

The Best of Both Worlds

The biggest difference between CVS and its competition is the fact that investors are actually acquiring two different companies inside of CVS at the same time. If investors like the growth prospects of a traditional pharmacy, and the potential of a pharmacy benefit manager like Express Scripts (NASDAQ: ESRX), CVS can fulfill both needs.

One of the main advantages of running two different businesses is, if one business slows down, the other can pick up the slack. This has happened on several occasions with CVS, and showed a stark contrast between Walgreen and CVS. When Walgreen’s results suffered because of its exit from the Express Scripts network, the company had no other growing division to fall back on.

Many people might not realize, but Wal-Mart is actually the third largest pharmacy in the country. With over 4,000 domestic locations, it is also one of the few retailers that can match CVS and Walgreen for convenience.

In the pharmacy benefit space, Express Scripts leads the way, but CVS Caremark is a major player as well. While it’s true that analysts expect Express Scripts to grow EPS at a rate of over 16%, compared to 13.8% at CVS, at least investors know that CVS’ numbers are real. Until the Express Scripts and Medco merger turns one year old, the company’s results are hard to trust.

Second Best, or Is It?

Investors normally don’t get too excited about the idea of buying the second best company in an industry. To the novice investor, Express Scripts' 16% earnings growth rate is the best in the industry. If this was all that was required to pick a winning stock, deciding between 16% earnings growth at Express Scripts, or between 9.3% and 13.8% growth at CVS, Wal-Mart, and Walgreens, the choice looks pretty easy.

When you consider that CVS trades for a forward P/E ratio of about 15, investors could be misled into believing the shares are more expensive than Wal-Mart or Express Scripts. While on the surface, Wal-Mart trades for roughly 14.3 times expected earnings, and Express Scripts trades for about 14.6 times earnings, each of these companies faces challenges that CVS does not. In fact, even Walgreen has one particular challenge, and the stock is already slightly more expensive than CVS.

Wal-Mart is focused on taking grocery market share and gets roughly 55% of its sales from this business. While this gives the company a massive new market, it also puts pressure on gross margins. With analysts calling for earnings growth of 9.39% at Wal-Mart, it seems this lower P/E ratio is deserved.

When it comes to Walgreen, the company faces the significant challenge of integrating the Alliance Boots partnership to offset the more than 9% increase in diluted shares, and additional debt. In a similar fashion, Express Scripts needs to show investors that the company will grow faster with Medco than it would have prior to this merger.

The good news for CVS investors is the company is still operating its two distinct divisions and doesn’t carry the uncertainty of compressed margins, a new partnership, or a huge merger.

Second to None

While the company’s growth and P/E ratio may not place first in its industry, by two different measures CVS is unmatched. First, the company had the best operating cash flow growth on a year-over-year basis from organic operations. Second, the company has the lowest free cash flow payout ratio of the bunch.

One way to compare companies is, to compare what I call their core operating cash flow (net income + depreciation) growth. On this basis, Express Scripts has to be disqualified because their massive merger with Medco causes results to hardly be comparable. Express Scripts reported operating cash flow growth of more than 190%, but the company’s diluted share count also increased by 70%.

If we look at the remaining three companies, Walgreen’s core operating cash flow increased by just 0.67%, and Wal-Mart showed an increase of 2.32%. By comparison, CVS increased core operating cash flow from about $1.2 billion last year to $1.45 billion this year, for a gain of more than 21%.

This significant increase in cash flow, also led CVS to report the lowest payout ratio of the group. To determine a fair payout ratio, I use core free cash flow (net income + depreciation – capital expenditures). By this measure, CVS generated a payout ratio of just under 25% in the last quarter. If you look at their share repurchases instead of dividends, Express Scripts carries a payout ratio of 34.5%. With payout ratios of 42% and 49% at Walgreen and Wal-Mart respectively, you can see the significant outperformance by CVS.

While CVS isn’t necessarily the best compared to their peers by every measure, investors are faced with the company generating significant cash flow growth, a low payout ratio, and a reasonable valuation. When you combine these factors with the intersection of increased prescription drug use, and an aging population, it seems like CVS could be the best play in the sector.

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Chad Henage owns shares of CVS Caremark. 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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