The drug store industry is changing, and while it's not all for the best, profitability is likely to improve for one simple reason.
CVS continues to impress
While Walgreen (NYSE: WAG ) and Rite Aid (NYSE: RAD ) saw revenues decline in 2012, CVS Caremark (NYSE: CVS ) didn't skip a beat. Here's revenue (in millions) for CVS over the past five years:
- 2008: $87,472
- 2009: $98,729
- 2010: $96,413
- 2011: $107,100
- 2012: $123,133
In the second quarter, CVS saw net revenue increase 1.7% year over year. This had a lot to do with volume growth in the Pharmacy Services segment (2%). The Pharmacy Services segment caters to employers, insurance companies, unions, government employee groups, and more. Based on industry trends, it was expected that CVS would show a boost in earnings, and that held true, with CVS reporting adjusted EPS of $0.97, a 19.5% jump year over year.
The Retail Pharmacy also performed well, with revenue improving 1.9%. Prescription volumes moved higher by 0.4%. Also as expected, pharmacy comps improved (0.4%), whereas front-end sales dropped (0.4%). The front-end simply refers to the front of the store, where everyday products are sold, including snacks, beauty products, books, and toys. The drug stores haven't been performing well in this area due to increased competition from other drug stores, dollar stores, and other discount retailers.
A forward-looking tailwind is that baby boomers are beginning to retire in droves. As this massive generation ages, they will need more drugs to care for various conditions, which bodes well for CVS and its peers.
Increased competition (for the most part)
CVS has managed to buck the trend of declining revenue for drug stores thanks to pharmacy volume growth and increased drug prices. Walgreen would likely be right in line with CVS if it hadn't lost so many customers after deciding to cut ties with Express Scripts. However, Walgreen is back on board with Express Scripts by offering its Smart90 Walgreen, which will allow clients to pick up 90-day prescription drug supplies at Walgreen locations. Walgreen had already been getting some of its customers back, and this move should further boost momentum.
CVS and Walgreen have mostly traded together throughout the years, with Walgreen being the stronger all-time performer. However, CVS has outperformed Walgreen over the past three years, with the stock appreciating 107%, versus 86% for Walgreen. In most market environments, these would be stupendous numbers, but in today's market, or since March of 2009, it's nothing special, especially considering another company has outperformed CVS and Walgreen over the past three years. The much smaller Rite Aid has seen stock appreciation of 200% over a three-year time frame.
In a bull market, traders want to jump into low-priced, high-potential stocks, because they know the broader market's momentum will carry these smaller players higher and offer the best returns. However, over the long haul, this isn't where you want to be. Rite Aid is the only company of the three that didn't manage to remain profitable during The Great Recession, and it currently sports a net margin of just 0.94%, whereas CVS and Walgreen sport net margins of 3.30% and 3.01%, respectively. Rite is also the only company of the three that doesn't pay a dividend. As mentioned earlier, Walgreen currently yields 2.50%. CVS yields 1.50%.
Rite Aid sees the generic drugs trend picking up steam, and it's planning to expand in that area, which looks to be a wise decision. However, it doesn't offer brand recognition and strategic locations like its peers. If the economy were to falter, Rite Aid might have trouble competing with deeper-pocketed rivals. Rite Aid can be considering for a speculative trade, but I don't recommend it as a long-term investment.
Then there's Wal-Mart, a company that enjoys steamrolling small players in hot industries. Wal-Mart sees what's happening with generic drugs, and it's in attack mode. Wal-Mart has a couple of advantages. One, it attracts many consumers thanks to its wide array of product offerings (this can lead to increased drug sales and stolen market share from CVS). Two, it has low-cost manufacturing, primarily in India, which means it will have the ability to sell generic drugs for cheaper prices than peers.
Despite threats from Walgreen and Wal-Mart, CVS should still be capable of growth, especially on the bottom line. Top-line growth is likely, but it will be more challenging due to lower-cost generic drugs becoming the drug option of choice for consumers. It would be difficult to go wrong with CVS or Walgreen over the long haul. However, it's highly recommended that you scale into these positions slowly as a safety measure against any downside moves in the broader market.
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