Is the Bull Run over for These 3 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, the temptation is to look at those with turnaround potential. These highly risky stocks supposedly have attractive returns that will compensate investors for the degree of risk they take on, right? Below, I review this proposition by focusing on the real numbers and facts behind Walgreen (NYSE: WAG) and RiteAid (NYSE: RAD).

Walgreen in a stronger position

Walgreen's latest acquisition of USA Drug from Stephen L. LaFrance Holdings cost the company $416 million, but contributed over $100 million in value in the company's first fiscal quarter of 2013. The company’s capital expenditures may have gone up by 4.5%, but Walgreen still added over 230 new locations --140 from USA Drug -- to its total count of 8,000. The company may not regain more than 40% of the lost Express Scripts customers that went to CVS (NYSE: CVS), but the Alliance Boots $6.7 billion investment made it a global pharmacy.

In addition, vaccine makers are seeing so much demand that they are reporting shortages in their inventories. This puts Walgreen in a strong position to flip its cash flow into advertising that wins back more customers.

Hedge with CVS?

However, Walgreen is underperforming the industry. CVS and RiteAid have both reported strong results while Walgreen has shown soft front-end monthly same-store sales. And with the stock near its 52-week high and 63% above the 52-week low, a lot of the upside has already been factored into the stock price. It now trades at a 10% premium to peer CVS despite missing expectations.

CVS, in my view, is more attractive than Walgreen. At 13.9 times forward earnings and a 14% forecasted growth rate, CVS is comparatively undervalued. The stock is up only 44% from the 52-week low -- comparatively little.

I am also optimistic that CVS's mid single-digit pharmacy sales growth will offset industry-wide weakness in front-end sales. All in all, Walgreen has more to lose with the proliferation of dollar stores, so I encourage hedging with CVS. In addition, compared to the drug retail average, CVS is forecasted for a 100 bps greater EPS growth rate over the next five years.

A turnaround stock?

RiteAid is showing that it can successfully turnaround business. Free cash flow and EPS have come out ahead of expectations, and reignited investor interest. Recent free cash flow growth was 141%. And it's not like the market has overreacted in pushing the stock from below $1 to just above $2.77 -- the free cash flow yield is still incredibly compelling at 10%.

Investors are also becoming more optimistic after RiteAid favorably refinanced its debt obligations with lower interest costs. However, I believe they are missing something big. In the recent severe flu season, RiteAid's inventories, unfortunately, saw shortages, and the company was forced to quickly re-supply its locations to keep up with the unexpected demand. So, if anything, growth should have been stronger than what was seen from this positive catalyst.

Recall that comparative store sales were up just 0.3% year-over-year in January despite the strong tailwind from the flu season, which largely obscured the dip in pharmacy sales. Drugstore sales actually fell 0.5% for that month. Moreover, the company also reported a 2.2% same-store revenue decline in December.

Conclusion

Pharmacy stocks have been on a roll. However, this has limited the value potential and, in some instances, obscured fundamentally weak performance. For this reason, I recommend generally avoiding these stocks.

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David Gould has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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