Drugstore Chains Write Prescription For Growth

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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 pace.

Walgreen ( WAG ) has posted a 32% advance.CVS Caremark ( CVS ) jumped 20%.Rite Aid 's ( RAD ) 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.

Generic-Drug Boom

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 years.

"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 LLC.

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 ( WFM ) 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 ( GNC ), 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 2012 revenue.

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.

Investment Risks

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 Walgreen.

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.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Investing Ideas

Referenced Stocks: CVS , GNC , RAD , WAG , WFM

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