Head of the Pharmacy Class
William is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Investing in health care, an industry of need, can translate into superior long-term investment if properly executed. CVS Caremark (NYSE: CVS), a retail pharmacy, has dominated its sector on several fronts over the past 10 years.
CVS leads by revenue in absolute terms, and by growth. Revenue for CVS, Walgreen (NYSE: WAG), and Rite Aid (NYSE: RAD) stands at $117 billion, $72 billion, and $26 billion respectively. CVS’s revenue climbed 382% over the past 10 years, as you can see in the chart below. That's nearly triple the rate of Walgreen (134%), and it leaves Rite Aid (66%) even further behind.
Walgreen's and Rite Aid’s gross profit margins, 28% and 27%, respectively, exceed CVS’s 18%, as noted in the chart below. The lower margin in CVS’s pharmacy benefit management (PBM) segment dilutes CVS’s overall margins. Year to date, gross profit stands at $1.4 billion on revenue of $36.7 billion or 4% in CVS’s PBM segment. On the other hand, CVS’s retail pharmacy segment scored a gross profit of $9.3 billion on $31.9 billion, representing a 29% gross margin.
CVS tops the operating and net margin lists, beating Walgreen’s operating margin by 87 basis points. Rite Aid comes in last again, with a 1% operating margin. CVS’s net margin exceeds Walgreen’s by 108 basis points, while Rite Aid’s net margin hovers in the negative at -1%.
Net income for CVS also far exceeds the competition, both in growth and in absolute terms. The net income (or loss) for the trailing 12 months for CVS, Walgreen, and Rite Aid ranks at $3.7 billion, $2.1 billion, and a $290 million loss, respectively (see chart below). Net income growth clocked in at 378%, 79%, and an unbelievable -1,000%, respectively.
CVS stands out on cash-generating capability (see charts below) with 464% growth in operating cash flow, towering over Walgreen’s growth of 188% and Rite Aid’s 12%. Free cash flow skyrocketed 4,900% over the past 10 years for CVS. Walgreen’s free cash flow growth stands at 196%, and Rite Aid’s free cash flow shrunk 55%, during that time.
CVS’s debt-to-equity ratios fall in acceptable ranges. The total debt-to-equity ratio for the most recent quarter is 73%, below my personal threshold of 85%. Long-term debt to equity stands at 25% for CVS, below Walgreen’s 30% and way below Rite Aid’s 571%.
Walgreen’s return on equity of 14% beats CVS’s 10% and exceeds Rite Aid’s -5,000% return. Goodwill for CVS stands at $26.4 billion versus just $2.1 billion for Walgreens inflating CVS's asset base and lowering return on equity.
Year to date, CVS paid out only 13% of its free cash flow and 23% of cash and short-term investments in dividends, or $420 million, making this company more than dividend-capable.
Competition Pain = CVS Gain
Walgreen's potential as a superior long-term investment went out the window when it parted ways with Express Scripts (NASDAQ: ESRX), which processed approximately $5.3 billion worth of prescriptions for Walgreen in 2011. Walgreen managed to come to terms with Express Scripts, but hesitancy for some of its customers to return spell trouble for the aforementioned pharmacy giant, as evident from a letter I received from my health plan:
“Your may have heard that Express Scripts has reached an agreement to bring Walgreens back into our network of pharmacies. However, to help manage the cost your prescription-drug benefit, your plan sponsor selected a retail pharmacy network that does not include Walgreens.”
Some other major insurance providers may also decide to utilize other PBMs. Also, who’s to say whether what caused the breakdown between Walgreen and Express Scripts won’t provide a catalyst for future disruptions?
Rite Aid’s troubles abound, starting with an accounting scandal about 10 years ago. The company now survives on debt year after year. It hasn’t been profitable since 2007, with no turnaround in sight.
Weighing the Risks
The superior fundamentals highlighted above mean low fundamental risk for CVS. CVS lacks the red ink woes of Rite Aid and the bad blood relationships that plague Walgreen.
Wal-Mart may also eventually put a dent in CVS’s market share when it starts building mini-stores in CVS's markets.
Political risk actually ranks high with CVS, even though it operates mainly in the United States. Obamacare, along with other healthcare regulations, may restrict health care access and constrain business. Even though the need for pharmaceuticals may always exist the government may restrict the profitability of the company.
Market price risk for CVS is a little higher than Walgreen. Free cash flow yield for Walgreen lags that of CVS, standing at nearly 9%, versus 8% for CVS. The P/E ratio of 17 exceeds Walgreen’s P/E of 15. Rite Aid’s market risk is infinite.
CVS’s superior qualities translate into great upside potential. Excellent fundamentals mean it won’t be going bankrupt anytime soon. Its vertically integrated structure means that CVS’s PBM won’t bail on them. Political pressures will probably continue to mount on CVS and the healthcare industry as a whole. CVS stock price commands a small premium to Walgreen’s, but it’s worth it.
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