Turnaround Mode in Pharmacies Creating Buying Opportunities
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From the Express Scripts loss at Walgreen, to the near bankruptcy of RiteAid, pharmacies are generally in turnaround mode right now. Since companies are ultimately valued based on their future, and risk tends to overly discount the fundamentals, one may be compelled to buy stock in all potential turnaround plays. However, there are instances where the risk outweighs the reward. Below, I review three possible investments in the pharmacy space.
Over the last 12 months, CVS has skyrocketed 44.6% in value - far outpacing the 8.1% return from Walgreen over the same time. CVS is now 51.6% above its 52-week low and virtually at its 52-week high - at this point, however, it looks quite expensive. In contrast to CVS, Walgreen trades at a single-digit forward earnings multiple. At a dividend yield of 3%, this makes the stock highly compelling from a turnaround perspective.
The next two months will be critical for Walgreen in terms of retaining investors. Should the company be successful in regaining consumers in its prescription segment, multiples will inevitably expand. If it fails, it is already at depressed multiples, so the hit won't be too significant. Fourth quarter sales were weak, with comparable store sales falling 11.1% year over year on rising competition from generics. Fortunately, the relationship with Alliance Boots looks like a game changer, as the business looks to brand itself as the first global pharmacy and health retailer. The acquisition of Alliance Boots creates the largest pharmacy distribution network in the world, an unparalleled supply chain, and, perhaps most importantly, a way to expand into emerging markets.
I am also optimistic about Walgreen's other attempts to "size up" in the competitive Rx market. Takeovers of Crescent, Infusion, and USA drug will help the firm increase pricing power while opening up greater store access to consumers. And despite all of the chatter about how weak the quarter was, cash flow for the year hit a record $4.4 billion--$800 million more than in the preceding year. More than two-thirds of the $2.9 billion in free cash flow was also paid to shareholder in the form of dividends and share repurchases.
CVS is ultimately a strong pick in its own right. Analysts forecast that it will grow EPS by 12.7% annually over the next 5 years, which at a multiple of 16x, translates to a future stock value of $86.72. Discounting backwards by 8% yields a present value of $59, which is more than a 20% premium to the current market assessment. Thus, there is more reward than risk in the stock right now.
RiteAid (NYSE: RAD)
Compared to Walgreen, RiteAid is facing a "do or die" turnaround situation. The company has been bleeding cash for some time now, and analysts forecast a loss of $0.09 per share next year. The Street rates the stock a 2.8 out of 5, where a 5 is a "sell," and the stock has a beta of 2.33, which indicates considerable volatility.
A same store sales decline of 0.7% in September also put a damper on the bulls' expectation for a major surprise recovery. As for rebranding the company, it announced the opening of an additional "wellness store." In my view, this is very akin to what JCPenney has been doing to turn around its own business. And, just like JCPenney, I expect Rite Aid to fail to deliver results.
While I am optimistic about the future of the wellness+ customer loyalty program in the long-term, I believe short-term competition will be intense and keep upside from materializing. 74% of front end sales in 2Q12 came from wellness+ members, which demonstrates a strong mechanism to drive sustainable streams of free cash flow. Several years down the road, this will pay dividends as consumers become "glued" to a program. For now, however, I would hold out until greater certainty over same-store sales materializes.
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