CVS and Walgreen Heading in Opposite Directions

It's safe to say CVS Caremark (NYSE: CVS  ) and Walgreen (NYSE: WAG  ) aren't on each other's holiday gift list. It wasn't long ago that CVS Caremark CEO Larry Merlo was giddy after learning of Walgreen's fallout with Express Scripts (Nasdaq: ESRX  ) . Merlo immediately went on the offensive, ratcheting up marketing efforts to target disgruntled Walgreen consumers. That made sense at the time, but Merlo's objective of retaining 50% of those new customers, even after Walgreen and Express Scripts kissed and made up, seemed overly optimistic.

And then along comes CVS's Q3 2012 earnings results, just a day after Walgreen announced disappointing same-store sales numbers. Adding another wrinkle to the sector's two-day information bonanza, Express Scripts -- the wild card in the CVS/Walgreen free-for-all -- announced 2013 guidance well below analyst estimates. In fact, Express Scripts not only announced slower growth than expected next year, but it also essentially blamed analysts for overreaching on their estimates to begin with. That, not surprisingly, wasn't taken too well, as evidenced by Express Scripts' 15% drop in share price at the open.

CVS results
OK, I'll fess up -- I was not expecting this from CVS. The earnings, revenues, and operating cash flow all impressed, as did the guidance Merlo and team provided for CVS going forward. Net revenues rose to a record $30.2 billion, same-store retail pharmacy sales jumped more than 4% for the quarter, and CVS's earnings per share were off the charts -- up 21.4% compared with Q3 of 2011. Whoa.

But as stellar as CVS Caremark's Q3 was, and its results are nothing short of phenomenal, I was more shocked to read Merlo's comments regarding those aggressively targeted former Walgreen customers. Turns out CVS doesn't expect to retain the 50% of former Walgreen customers alluded to after the CVS Q2 announcement. Now, according to the CVS Q3 earnings announcement, Merlo expects to retain 60%. And, based on the 55% of former Walgreen customers already enrolled in the CVS auto refill program, and the 85% who are CVS loyalty card members, 60% sounds about right.

There are two things to consider regarding the 60% figure: One, Walgreen must have really dropped the ball as it relates to servicing its customers. And two, CVS's committed effort to secure, and retain, Walgreen's former customers worked like a charm. Both bode well for CVS and call into question the long-term impact on Walgreen's growth objectives.

Walgreen news
The Nov. 5 announcement of a 5.9% drop in same-store sales, along with Walgreen's total sales decline of 2.1%, inadvertently set the stage for CVS Caremark's earning's news the following day. The reupping of the Express Scripts contract is too new to have positively affected Walgreen's same-store sales, so that should at least be considered when you review its sales results.

But the shift in calendar days versus the same period last year that improved Walgreen's woeful same-store sales results, by 2.3%, can't be explained away. With all things being equal, Walgreen actually saw same-store sales decline 8.2% compared with 2011. Ouch.

The announcement on Nov. 1 that Walgreen set up a jointly owned company with Alliance Boot -- Walgreen Alliance Boot Development -- solidified its international partnership with the European pharmacy leader. That's great news and will eventually pay off as Walgreen truly becomes a global enterprise. But after the past few days, the Walgreen Alliance Boot partnership already seems like a distant memory.

Now what?
After the recent developments, it's clear CVS Caremark warrants its slightly higher valuation than Walgreen, smaller dividend yield or not. At 16 times trailing earnings, CVS may appear a bit steep compared with Walgreen's 14 P/E. But its recent upward earnings revision to $3.40 (give or take) a share makes CVS a steal at 13.7 times expected 2012 earnings, and its aggressive stock-repurchase program will continue to add shareholder value.

As for the wild card? A worse-than-expected 2013 from Express Scripts will hurt Walgreen more than CVS. Why? Because Walgreen's resurgence is more reliant on revenues from its renewed Express Scripts partnership than CVS's is. As for CVS, holding on to Walgreen's old customers is just fine.

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