4 Important Factors To Look At Before Buying Pharmacy Stocks

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

If you are looking to get into pharmacy stocks, there are several variables you should considers: (1) customer networks, (2) competitive position, (3) financial position, and (4) growth potential. Below, I review three stocks with these 3 variables in mind. I encourage preferentially buying in companies that are smaller and therefore likely to see positive catalysts from greater attention on the Street. For this reason, I have included a special small cap stock within this article.

Walgreen (NYSE: WAG) Vs. CVS Caremark (NYSE: CVS)

At a respective 14.9x and 9.9x past and forward earnings, Walgreen is cheap compared to peer CVS, which trades at corresponding figures of 15.7x and 12.3x. Much of the discount Walgreen faces arose as a result of the company's loss of the Express Scripts network. Now that it has regained this major customer base, however, shares have yet to fully recover--although they are up 28.6% from the 52-week low. Will this bull run continue and help the firm outperform CVS?

There are several factors to look at for Walgreen. First, the business has done well with its Balance Rewards program, as evidenced by the loyalty card program hitting a 28 million member milestone late last month. Although the company saw front-end sales decline 2.9% (below analyst expectations), this miss was largely the result of Sandy and does not say anything about the long-term fundamentals. The partnership with Alliance Boots to build the world's first pharmacy-managed global health & wellbeing enterprise represents an under-appreciated catalyst--and it is evidently "under-appreciated" because shares have not meaningfully outperformed since the announcement. Moreover, as a major shareholder of the interest, premier private equity firm KKR will hold management accountable for delivering strong results to shareholders.

But it will nevertheless be hard for the company, to its own admission, to win back Express Scripts customers from CVS given how "sticky" this market can be. Why not just go with CVS for an investment? Warren Buffett may have recently sold 5.3 million shares of the company in his recent report, but its "blowout" third quarter is representative of a customer shift away from Walgreen and to CVS. Management believes it will retain around 60% of these new clients--above earlier estimates. Analysts forecast 10.1% annual EPS growth over the next 5 years and rate the stock a 1.9 out of 5 where "1" is a "buy." This low-downside position merits an investment.

Why You Should Buy Shares In PetMed Express (NASDAQ: PETS)

If you are looking for an alternative, even higher-reward business, consider buying a small cap peer. Specifically, for those special pets in your life. PetMed sells health products for animals and trades at 15.7x past earnings with a clean balance sheet. There is no debt, but the current ratio stands at 9.6x. PetMed has $3.12 in cash per share, which represents around a quarter of the market cap. Moreover, it is paying a 4.8% dividend yield and is forecasted for 5% annual EPS growth. This will provide a stable ~10% annual return that is relatively safe from downside.

Limited downside is evidenced by the 0.6x beta, which means the stock is 40% less volatile than the broader market. Free cash flow, although holding relatively steady during the past 4 years, stands at $19.2 million, or a yield of 7.7%. Return on invested capital stands at a very impressive 18.7%, which is more than 800 bps greater than the industry average. And the current PE multiple compares favorably to the 15.1x industry average and 21x sector average. In light of the companies cash chest, strong free cash flow generation, and superior margins (profit margins are 460 bps higher than average), it has the ability to gain superior financing and thereby grow in scale.

PetMed also has strong fundamentals. Revenue has been on the rise from a 2011 slip and capital expenditures are being planned for a high return on invested capital. Though it has missed expectations, the growth is still consistent and reflected in a generous capital allocation policy that reflects volumes about the future. For this reason, I definitely recommend an investment.

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