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Drugstores, Auto Parts Chains Outpace Market

By: Investor's Business Daily
Posted: 5/9/2014 3:19:00 PM
Referenced Stocks: CVS;WAG;RAD;ORLY;AZO

Auto-parts retailers, dollar stores and drugstore chains serve different consumer needs. But both share defensive traits that have powered them ahead of other retail segments and bolstered the stocks even as the general market has skidded.

As a group, drugstores are up 13% year to date, compared with only a 1% gain for the S&P 500 Index and a 5.11% decline in the S&P Retail Index.

What's the draw? Potential benefits from the Affordable Care Act, an aging U.S. population and the opportunity to boost margins amid a new wave of generic drugs coming to market have helped spark investor enthusiasm over the group, which includes chains such asCVS Caremark ( CVS ),Walgreen ( WAG ) andRite Aid ( RAD ).

All three chains are trading at all-time highs. Rite Aid's share price has rocketed to its highest level in 13 years.

"The backdrop for all three (drugstore chains) is a rising tide lifts all boats," said Jefferies analyst Mark Wiltamuth. "Health care reform could add 3% to the industry's prescription volumes over time once the new insurance coverage is digested by the market."

There's also a "nice macro trend with the aging of the baby boomers," who will require more medication when they reach Medicare age at 65.

Wiltamuth notes that consumers ages 65 and over spend an average of $1,300 a year on prescription drugs vs. $150 for those 18 to 44.

Another plus: There's likely a new wave of generic drugs coming to market in late 2014 into 2015. "Generic drugs carry more profit dollars for a pharmacy even though they go for a cheaper price," Wiltamuth said.

He adds that pharmacies generally make 50% or more per prescription selling a generic drug vs. a branded drug.

Cold Hearts, Spare Parts

The auto-parts retail and distributors group includesO'Reilly Automotive ( ORLY ),AutoZone ( AZO ) andAdvance Auto Parts (AAP). O'Reilly and AutoZone have been on a long-running winning streak with double-digit earnings growth.

As a group, the industry's shares are up 8% year to date.

What's revving up their performance? While a long, tough winter has dragged on many retail segments, it has increased wear and tear on cars and trucks, driving up demand for auto parts.

The economic recovery's initial surge in new car sales has slowed, and the overall age of the U.S. auto fleet continues to inch higher.

"The primary driver in the near term has been weather," said Wedbush analyst Seth Basham.

The extremely cold winter and early spring weather in several parts of America have led to a lot of stress on car parts, particularly batteries, starters and alternators, Basham says.

That stress results in stalling and breakage. That means more business for the auto-parts retailers from the do-it-yourself customers and the commercial garages that fix the cars.

Batteries and starters need to be fixed immediately, says Basham. And the do-it-yourself customer, typically a lower-end consumer, needs to fix the car so he or she can get to work.

"That's led to a nice pop in sales (for the do-it-yourself auto sector) in the fourth quarter and into the first," he said. "Our expectation is we'll continue to see strong sales in the second and third quarters."

The cold and snowy winter also means more potholes and salt on the roads. They cause stress on under-car parts, Basham says, creating many problems that will be addressed in the spring and into the summer.

A hot summer would compound those issues and lead to additional part failure.

Another driver: New car sales continue to rise but at a slower pace. The seasonally adjusted annual rate of car sales in units rose 2% in the first quarter. It's a drop from an 8% rise in the first quarter of 2013 and even higher levels in 2012, wrote Basham: "We view this as an incremental positive for DIY auto sales, as not as many consumers purchase or consider purchasing new cars and instead repair and maintain existing vehicles."

Another trend that helps the auto parts retailers: People are holding onto their cars longer.

Last year, the average age of light vehicles was a record 11.4 years, according to auto research firm Polk.

Fistful Of Dollars

Another defensive retail segment is the variety discounters such asDollar Tree (DLTR),Family Dollar Stores (FDO) andDollar General (DG).

As a group, they're down 5% year to date. But that is among the best performances among retail industry groups.

And variety discounters continue to outrun the broader industry in same-store sales growth, according to Ken Perkins, president of Retail Metrics.

"The dollar stores have great value and convenience," said MKM Partners analyst Patrick McKeever. And "overall they're doing better than other retail sectors."

However, growth is slowing from two years ago, when the group was generating mid-single-digit same-store sales growth, to low single digits now, he says.

He adds that Family Dollar Stores is the weak link in the group now. Family Dollar's earnings slipped 30% in its second quarter ended March 1, and its same-store sales fell 3.8%.

It's going through a restructuring, which includes closing around 370 stores and job cuts.

Overall, dollar stores continue to strike a chord with consumers by offering ultralow prices on everything from food to home goods.

But their core low-income consumer is feeling pressure on a number of fronts.

"Some of it is macro," McKeever said. "The weak recovery in some instances has left the core dollar-store customer behind."

Added Piper Jaffray analyst Peter Keith: "We've seen bifurcated recovery, with asset appreciation in home prices and stock market gains largely benefiting mid- and upper-income consumers. The lower-half income demographic is not participating in the wealth effect, because this demographic has much lower ownership rates in home and equities."

A headwind: what McKeever calls a pullback in government assistance to the dollar stores' core customers, including cuts in extended unemployment benefits and a reduction in food-stamp assistance effective Nov. 1.

Drugs On The Rise

The climate for the drugstore chains continues to be favorable.

"Retail pharmacies make more profit per generic drug dispensed than branded drugs," said UBS analyst Steven Valiquette. "From 2011 to 2015, there is the biggest generic opportunity in the history of the industry to capitalize on."

He estimates that $115 billion worth of branded drugs will have gone generic in that period, compared to an estimated $79 billion from 2006 to 2010.

"A big part of why these stocks are doing well has to do with their ability to capitalize on this current generic drug wave," he said. "Our view is that most investors believe the generic opportunity will slow down dramatically from 2016 to 2020. However, our $82 billion view for this time period still creates an excellent opportunity for retail pharmacies."

Added Wiltamuth: "These health care themes, including the new generic drug wave, the aging baby boomers and the Affordable Care Act, all help the sector against a more sluggish economic recovery."

Auto retailers are likely to continue seeing a boost from the weather.

John R. Lawrence at the financial-services firm Stephens says he likes the stocks and the group. The question, he said, is "how long will the harsh weather continue to favorably affect the purchase of auto parts as far as creating demand? There could be a long tailwind."

The variety discounters could continue to face challenges.

"2014 is going to continue to be a challenging year following a tough 2013, given the pressure on the lower income demographic, which is their core customer," said Wedbush analyst Joan Storms.

"There's going to continue to be a negative mix shift toward lower-margin consumables because that demographic is buying what they need when they need it, and they're not buying discretionary products like apparel."

The shift toward lower-margin consumables "has the potential to put pressure" on same-store sales, she added.