Express Scripts Debacle Overblown: Hold Off From CVS, Buy Walgreens Instead
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Many healthcare investors feel as though times are radically different now that the Affordable Care Act is likely to become the law of the land. In my view, however, not too much has changed. The insurance industry will still be dominated by private parties and drug stores will still be soliciting business from government and business consumers. I recommend buying shares of Walgreens (NYSE: WAG) and merely holding shares of CVS (NYSE: CVS). Below, I review the fundamentals of each.
Walgreens trades attractively at a respective 12.3x and 11.7x past and forward earnings. It has a dividend yield of 3.1% and is roughly as volatile as the broader market. Analysts are basically neutral on the stock and find that it is trading more or less at intrinsic value.
While the Street is basically neutral on the stock, I am much more bullish. Free cash flow over the TTM ending May 31 has grown from $600.9M in 2008 to $2.3B in 2012. Part of the reason why the Street is so bearish is due to the Express Scripts debacle, where the company lost a major network to competitor CVS. While this was indicative of poor management, it is not enough to justify the firm trading at this great a discount to the historical 5-year average 14.8x PE multiple. Profit margins have, after all, held relatively constant through good times and bad.
Moreover, the company achieved record operating cash flow of $3.7B for the 3Q with an impressive $371M returned to shareholders. The decision to end the relationship with Express Scripts for the year negatively impacted quarterly EPS by $0.06 per diluted share. This was offset, again, by sound cost management and a shareholder-friendly policy. The spread between gross profit dollar growth and SG&A dollar growth was a negative $78M, which indicates a favorable direction in terms of productivity.
In light of all the negativity surrounding Walgreens' loss of the Express Scripts network, it should not be surprising that CVS is trading both at a premium to Walgreens and its historical PE multiple. The firm trades at a respective 16.1x and 12.1x past and forward earnings (5-year average: 15.5x) with a low dividend yield of 1.4%. Volatility is around 26% less than the broader market, which suggest that upside will not be as great as Walgreens' from a full recovery. Analysts nevertheless are much more bullish on CVS and rate it near a "buy".
The problem with CVS is that it does not offer a meaningful discount to intrinsic value. Analysts forecast 12.7% annual EPS growth over the next 5 years, which is around 250 bps more than what was realized in the preceding 5. Assuming that the company nevertheless meets expectations, 2016 EPS will come out to around $5.41. At a 15.5x multiple, the future value of the stock comes out to $83.86. Discounting backwards by 10% yields a present value of $52. This is less than the 25% margin of safety that I think is required to justify calling the business a "value play".
On the profit margin side, the company has been somewhat on the downward trend over the last five years. Free cash flow for the TTM ending 2Q12 was $4.8B versus $4.3B in 2Q11 but $6.2B in 2Q08. I would recommend holding out from the business and going for underdog Walgreens. The latter may have rightfully had its comeuppance from a poor handling of the Express Scripts networks, but it is now at too much of a discount to peers.
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