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Monday, April 12, 1999

An Investment Opinion
by Alex Schay

Prescription Profits

The public chain drugstores advanced almost 75% in 1998, and this heavily scrutinized segment of the market has seen valuations soar over that period. Duane Reade (NYSE: DRD), the largest drug chain in New York on the basis of sales volume, experienced some valuation deflation today dropping $1 1/2 to $24 7/8. The market is possibly pricing in yet to be revealed first quarter results and/or same store sales figures -- with most of the company's high profile brethren already coming in with strong Easter sales (CVS reported 16.9%, Walgreen came in with 15.6%, Eckerd jumped 16.8% and Rite Aid saw 10.8% growth).

Duane Reade's prescription drug sales (as reflected by same-store pharmacy sales) grew 21.5% in 1998 compared to 1997. Sales of prescription drugs represented 28.3% of total sales in 1998 compared to 25.1% of total sales in 1997. The firm has some of the lowest prescription processing numbers (per store, per week) at around 970 (Q4) compared with the big-chain average of 1100, but this is due to both the lack of third-party plans in the New York City area and the firm's business concentration in commercial areas. Prescription drug sales as a percentage of overall sales are among the lowest in the industry at Duane Reade:

Prescription Sales % Total CVS (NYSE: CVS) 58% Duane Reade (NYSE: DRD) 28.3% Longs Drug Stores (NYSE: LDG) 37% (Q1) Rite Aid (NYSE: RAD) 54.2% Walgreens (NYSE: WAG) 50%

However, this certainly hasn't dampened the company's sales metrics, as evidenced by the comparison with one of the industry leaders.

Rev./ Tot Rev./ Cap. Stores Rev. Store Sq.ft. Sq.ft. Ex.
CVS 4122 15.3b 3.711m 30.6 m $500 $502.3m DRD 128 587.4m 4.589m 564,838 $1040 $33.266m

So, why has the firm been trading at such a substantial discount to its peers? Well, long-term debt to equity of 13-1, and net operating losses that are projected to continue in 1999 (it will pay cash taxes some time in 2000) have considerable sway. With a full 75 of its 128 stores located in the depths of Manhattan's business and residential districts, the company is probably not interested in purchasing a pharmacy benefits manager. The firm operates with an extremely flexible store format, ranging from 2,600 to 22,000 total square feet, which is a virtue when acquiring city real estate (but probably discourages possible acquirers due to different merchandising requirements).

As with other chains, execution on real estate acquisition will determine future operating results. Duane Reade plans to expand into residential areas where average volume per store is higher -- the average sales of the 34 residential stores in the first year of operation were about $100,000 per week. Although current accounts look like debt coverage is not a problem, investors interested in adding a drug chain should take a closer look at sequential cash flows and return on marginal capital (ROMC).

The retail drugstore business is extremely competitive, but the central issues that determine success are surprisingly mundane, and seem more characteristic of the real estate world than the merchandising arena -- the mantra is location, location, location. CVS management recently outlined its competitive strategy, and the factors it reported are valid across the chain universe. Chains compete principally on "the basis of: (i) store location and convenience, (ii) customer service and satisfaction, (iii) product selection and variety, and (iv) price."

Overall there are more than 30,000 pharmacies operated nationwide by traditional chain pharmacy companies, supermarkets, and mass merchandisers. As well, there are another 20,000 independent pharmacies that pose interesting opportunities for combination (or purchase of prescription files). The number of retail prescriptions dispensed each year increased from 2.0 billion in 1992 to 2.8 billion in 1998 -- which represents a compound growth rate of 5.77%). Taken with over-the-counter medication sales, as well as health and beauty aids, the annual revenues generated in the industry come to about $135 billion. A business that will continue to attract investors -- online and offline.

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