At the Forefront of Wellness

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

Despite threats from increased government regulation of the healthcare business and competition from large general retailers, the drugstore chains are thriving and evolving to meet the needs of customers in the 21st century. 

The industry is dominated by the three national chains, Walgreen (NYSE: WAG), CVS Caremark (NYSE: CVS), and Rite Aid (NYSE: RAD), which generate roughly $157 billion in annual sales through more than 20,000 stores. These three companies have spent the past two decades consolidating significantly to gain the operating efficiencies needed to compete against the mass merchandisers’ pharmacy businesses. 

While the Patient Protection and Affordable Care Act, passed by Congress in 2010, will add 33 million additional customers for the industry, profitability levels are likely to be negatively impacted by declining reimbursement levels and a continued shift to generic drugs.

As the primary point of contact in the drug dispensing process, drugstores are favorably positioned to provide added healthcare services, such as consumer education, medical profile reviews, and nutritional assessments.  Each of the companies have moved in that direction and are rebranding their stores as wellness centers with enhanced levels of customer service and a focus on prevention-based information tools. 

Walgreen and CVS have created in-store clinics, while Rite Aid has partnered with GNC to build in-store nutrition centers.  The companies are also heavily marketing their rewards programs to generate repeat customers and sell high-margin, private brand products.

Who’s worthy of your investment?

Walgreen is the largest U.S. drugstore chain with over 8,300 locations throughout the U.S. and Puerto Rico, as well as almost 700 in-store clinics.  The company grew its revenues by 21.3% over the past four fiscal years by opening new stores and making selective acquisitions, including the purchases of Duane Reade in 2010 and in 2011. 

In its latest fiscal year, Walgreen reported declines in revenues and operating income of 0.8% and 20.6%, respectively, year over year. Operating margins were negatively impacted by a 3.6% decline in comparable sales, primarily due to the loss of Express Scripts’ business over a pricing dispute.  While the two companies signed a new agreement that started September 15, regaining lost customers will take time as evidenced by a further decline in comparable sales in the most recent quarter.  However, Walgreen currently has 45 million members in its loyalty program and has expanded internationally with its purchase of a minority stake in European pharmaceutical provider Alliance Boots.

CVS Caremark is the leading provider of integrated pharmacy services with over 7,400 stores throughout the U.S. and Puerto Rico, including 600 MinuteClinics.  CVS also owns Caremark, one of the top pharmacy benefits managers (PBM), that provides plan design, administration, and network management to corporate HR departments. 

In the first nine months of FY2012, the company's retail pharmacy segment reported increases in revenues and operating income of 7.4% and 17.7%, respectively, compared to the prior year period.  Operating margins improved due to a 6.1% increase in comparable sales and an 8.9% increase in total filled prescriptions.  While CVS benefited somewhat from Walgreen’s troubles, it has built a loyalty program of 67 million members and is generating strong financial returns from its integrated business model.

Rite Aid is the third largest U.S. drugstore chain and has been the weakest player in the industry for some time, due to the high leverage it used to build a national store base.  Rite Aid has spent the past five years just trying to survive, as it reduced its store count by 9% and refinanced portions of its $6 billion debt load.  However, its restructuring activities are starting to bear fruit with improved efficiency, and the company has built a loyalty program with 52 million members. Like its competitors, Rite Aid has moved its stores toward a wellness format, which includes in-store GNC centers that provide co-branded vitamin and supplement products.

In the first nine months of FY2012, revenues have declined slightly due to fewer stores in operation, but adjusted EBITDA gained 17.9% and operating cash flow reached $599.2 million.  While comparable sales had a slight decline during the period, operating margins benefited from more efficient stores and a greater percentage of non-prescription sales from the company’s private label brands.  Based on the favorable results produced to date, management recently upgraded their forecast for FY2013 adjusted EBITDA to $1.1 billion and FY2013 EPS loss to between $.03 and $.05.  Things are improving, but the company needs to reduce their total debt to ensure long run success.

Looking Ahead

The drugstore chains have very favorable demographics with an aging population and greater access to insurance programs.  However, they need to continue strengthening their relationships with customers and position themselves as valued health services providers, rather than retailers of products. 

While Walgreen and CVS Caremark are good buys and trade at reasonable P/E multiples of 14.6 and 15.0, respectively, Rite Aid is a speculative investment despite an improved business outlook.  When it gets it debt to a more manageable level, though, it has tremendous operating leverage and upside.

rghanley has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. 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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