Which Drugstore Is Undervalued?

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

From the Affordable Care Act to the Express Script debacle, pharmacies are facing a wildly new market. In my view, I wouldn't get too caught up in what the "experts" suggest. If a stock is beaten down, it may very well be overly beaten down, especially in this industry where investors jump at any sign of instability. The companies below either have excellent turnaround potential, growth, or improving fundamentals that skew an investment more towards reward than risk.

Buy CVS (NYSE: CVS)

While CVS's stock price is up 26.4% over the last 12 months, it has gone nowhere over the last half of that period. At least it didn't fare as poorly as Rite Aid (NYSE: RAD), which plummeted more than 25% in those last 6 months. And the company is also fairly safe as volatility goes with only a beta of 0.75. Analysts forecast 12.7% annual EPS growth over the next 5 years. Assuming CVS meets forecasts, it will generate 2016 EPS of $5.42. At a multiple of 15x, this translates to a future stock value of $81.30. Discounting backwards by 10% yields a present value slightly above the current market assessment. This means there is strong upside on top of some, albeit not excellent, margin of safety.

Fortunately, all of this is complemented by excellent performance. Over the last 5 quarters, management has beaten consensus consistently more or less by an average of 2.9%. For example, in the most recent quarter, management grew EPS by 25% y-o-y and came out $0.01 above the high-end of guidance. Much of the growth came from tailwinds of Express Scripts customers migrating over. In fact, results have been so strong that management has increased the guidance for the full year to a midpoint of $3.35 per share--up $0.07 from the last guidance and $0.15 from initial projections.

It is particularly important to note that excellence has continued despite a competitive pricing environment and contract losses. Management has also done a strong job in not relying on momentum to make its case to investors. It has been streamlining PBM business through productivity improvements and capacity refocusing in a way that cuts costs. The company aims to deliver more than $1 billion in cumulative savings from 2011 to 2015.

Buy a Smaller Stake in Walgreen (NYSE: WAG)

On the surface, Walgreen looks like a "buy." It trades at just 9.4x forward earnings, provides a 3.2% dividend yield, and is forecasted for 12.8% annual EPS growth. The problem is that the fundamentals have been weak. Aside from several misses over the last 5 quarters, there is little room for gross margins to expand, since they are already at a substantial premium to competitors. 

On the positive side, however, free cash flow has gone up markedly from $831 million for the TTM ending August 2008 to $2.9 billion four years later. The increasing stake in Alliance Boots should help offset the loss of business from Express Scripts. Alliance Boots is European drug store and a leading health and beauty store with more than three thousand units and excellent momentum. Moreover, the company has been more aggressive in increasing its payouts to shareholders than CVS has been.

Furthermore, the company is making meaningful attempts to expand into emerging markets. According to one analyst, the company will also be a main beneficiary of the Affordable Care Act's imposed penalties on hospitals. On a more private level, the company will also gain share as Rite Aid slides into the red.

The bears argue that Rite Aid is now rated a "sell" and has little momentum (or, more precisely, momentum in the wrong direction) to stymie the decline in shareholder value. They further argue that it has lost $0.33 per share over the twelve trailing twelve months and is highly volatile at 2.33. However, performance has been significantly above expectations. In 2Q12, the company actually generated a profit of one cent per share. And, in the third quarter, performance was 37.5% better-than-expected. In a sense, I see the stock as the drug store version of Sprint. If it can continue to defy bearish arguments, it will eventually recover the lost shareholder value. Fortunately, it is on a great start. I recommend buying a small speculative stake alongside Walgreen and CVS.

 


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