They call it an earnings surprise. But the fact that the three
top drugstore chains beat analyst consensus earnings forecasts
for the first quarter, with room to spare, shocked no one.
The group's stock performance, on the other hand, has caught
some industry onlookers off guard. As a group, drugstores are up
27% year-to-date -- better than double the S&P 500's
) has posted a 32% advance.CVS Caremark (
) jumped 20%.Rite Aid 's (
) battered shares have soared 90%, although they're still trading
well below 3.
What's the draw? Drugstore chains are benefiting from higher
margins thanks to a wave of generic drugs replacing brand name
drugs falling off the so-called "patent cliff," losing their
patent protection. Investors are also anticipating increased
demand from the Affordable Care Act going into effect in January
2014, wrote Joseph Agnese, an analyst with S&P Capital IQ, in
a client note April 20.
Those factors have boosted the five-stock drugstore group to a
No. 13 ranking Friday among 197 industries tracked by IBD, up
from a No. 134 ranking at the start of March.
Brand-name drugs with $35.1 billion in annual sales --
including some of the biggest blockbusters in history -- lost
patent protection in 2012, according to Evaluate Pharma. And the
trend is continuing.
"By 2016, medicines that generate sales of $133 billion for
their manufacturers in the U.S. alone will be exposed to
generics," the industry consulting firm reported. Once drugs lose
patent protection, their revenues could plunge as much as 90%.
Generics typically cost 30% of the brand-name price tag, but
carry wider margins for retailers.
That means drugstores face slower revenue growth as generics
take over brand-name drugs. Prescriptions account for at least
two-thirds of all sales. Third-party payers, government programs,
private insurers or pharmacy benefit managers pick up the tab
almost entirely. A cut in reimbursement rates would squeeze
drugstores' profits and margins.
Demographics And ObamaCare
An aging U.S. population is expected to live longer than ever.
About 10,000 baby boomers celebrate their 65th birthday every
day, becoming eligible for the federally funded Medicare
prescription drug program. That, and a spike in the number of
insured thanks to the Affordable Care Act, set to go into effect
in 2014, pledges a swarm of new pharmacy customers.
Evaluate Pharma forecasts prescription drug sales will
increase by 4% per year between 2010 and 2016.
"We expect that the estimated additional 27 million people who
will be covered by health insurance in 2014, as well as the
closing of the 'doughnut hole' in Medicare Part D, will have a
positive impact on our business," Rite Aid stated in its 10-K
report for the fiscal year ended March 2, 2013.
The so-called doughnut hole, a coverage gap under Medicare
Part D, requires seniors to pay a higher rate after spending
$2,970 on prescriptions. Once they spend $4,750, "catastrophic
coverage" kicks in. Under ACA, that gap tapers off, then
disappears by 2020 .
Store Growth And Acquisitions
From a customer's standpoint, CVS, Walgreen and Rite-Aid
stores may all look largely similar.
CVS is the largest player in the group, with a market
capitalization of $71.6 billion and 2012 revenue hitting $123.1
billion. It opened a net of 131 new stores in 2012, bringing its
total to 7,525 locations. The Woonsocket, R.I.-based chain plans
to increase total store square footage by 2% to 3% this year. It
expanded overseas this year by acquiring Brazilian pharmacy chain
Drogario Onofre, with 44 stores and a 9% market share in the
country, for undisclosed terms.
Walgreen weighs in with a much smaller market cap, $46.9
billion, and 2012 sales of $71.6 billion. But it owns the most
stores, with 8,537 locations in 50 states, the District of
Columbia, Guam and Puerto Rico. And location is often key to
snatching pharmacy business.
This chain is also rapidly building its overseas presence.
In August, Walgreen paid $6.7 billion in cash and stock for a
45% stake in U.K.-based Alliance Boots, which runs 3,000
pharmacies and a wholesale drug unit with 370 distribution
centers serving more than 170,000 pharmacies in 21 countries. It
has an option to buy the remaining 55% for $9.5 billion in three
"Walgreen expects combined synergies across both companies to
be between $100 million and $150 million in the first year and $1
billion by the end of 2016," the company said in a statement.
Last year, it also bought regional drugstore chain USA Drug
and an 80% interest in Cystic Fibrosis Foundation Pharmacy
Rite Aid, the third-largest U.S. drugstore chain based on
revenues and store count, has 4,623 stores in 31 states. The Camp
Hill, Pa.-headquartered firm plans to open one new store,
relocate 19, remodel 400 into its "Wellness" format, while
closing 50 stores in fiscal 2014, Frank Vitrano, Rite Aid's chief
financial and chief administrative officer, said during a
fourth-quarter fiscal 2013 conference call on April 11.
Rite Aid's Wellness stores take a page out of natural food
grocerWhole Food Market 's (
) playbook. They offer gluten-free products, natural personal and
home-care products, health-related magazines and books in
addition to workout equipment, and private consultations with
pharmacists. In a partnership withGNC Holdings (
), it also houses GNC stores within its stores at 2,100 locations
and plans to open more.
The ABCs Of PBMs
CVS is largely differentiated from its peers by Caremark, the
pharmacy benefits manager (PBM) business it acquired in 2007.
Caremark competes with independent PBMs includingCatamaran (CTRX)
andExpress Scripts (ESRX). The industry's supply chain is
complex. PBMs negotiate pricing deals between drugmakers and
employers, and manage employee drug plans.
PBMs pay drugstore chains to dispense drugs. The chains obtain
the bulk of their drug supplies through large distributors, such
asCardinal Health (CAH) andMcKesson (MCK).
CVS' PBM operations accounted for 60% of first-quarter revenue
and 30% of operating profit.
Walgreen sold its more modest PBM operation to Catalyst Health
for $525 million in 2011. (Catalyst was then bought by SXC Health
Solutions, which subsequently merged with rival Medco Health
Solutions and changed its name to Catamaran.)
As a result, Walgreen has fought a pitched battle with Express
Scripts, losing in the struggle an estimated $4 billion in fiscal
CVS, on the other hand, may be poised for a double benefit
from the oncoming Affordable Care Act, analysts say, with both
its retail and PBM operations set to grab a piece of the
increasing pool of insured consumers.
On the stock market side, the companies have also invested
heavily to please shareholders.
CVS spent $4.3 billion on share buybacks and $829 million on
dividends in 2012. It plans to spend $4 billion on repurchases
this year, which will reduce the number of shares outstanding by
5.2%, according to S&P Capital IQ. CVS currently pays an
annual dividend of 90 cents a share.
Walgreen has $425 million remaining through the end of
December 2015 from a $2 billion buyback plan announced in
mid-2011. It currently pays a $1.10 a share annual dividend.
"We have paid a dividend in 321 straight quarters (more than
80 years) and have raised our dividend for 37 consecutive years,"
Michael Polzin of Walgreen's corporate communications told IBD.
"Most recently, we raised our dividend 22.2% in June 2012. Over
the past five years, our dividend rate has grown by a compound
annual growth rate of nearly 24%."
The struggling Rite Aid is the exception, with no buyback
plans and no dividend since 2000.
Walgreen is battling to win back the customers it lost during
its 2011-12 dispute with Express Scripts. CVS and Rite Aid
benefited from the dispute, which forced Express Scripts drug
card users to switch pharmacies or pay more for meds from
Analysts with Lazard Capital Markets estimate Walgreen has
recovered about 40% of those customers, since resolving the issue
in July 2012. Lazard estimates Walgreen will ultimately lure back
50% of its lost clientele.
Drugstores face stiff competition from online and mail-order
providers, warehouse clubs, dollar stores, grocery stores,
convenience stores and mass retailers with aggressive discounts
on generic drugs such as Target and Wal-Mart.
They could suffer from "sluggish growth in front-end sales,
which are rather sensitive to broader economic trends and
consumer spending habits," Raymond James analysts wrote in a
client note April 12.
While both CVS and Walgreen have remained steadily profitable,
Rite Aid is just climbing out of seven years of losses. It
devotes a huge chunk of its cash flow to service a $6 billion
debt -- almost three times its market value. If interest rises
considerably, analysts contend the company will have to sell
assets or refinance at unfavorable terms.