Pharmacy Stocks in 2015: What to Watch

This healthcare edition of Industry Focus looks at the big three pharmacy stocks: Rite Aid (RAD), CVS Health (CVS 0.75%), and Walgreens (WBA 0.68%). Consumers often consider the three interchangeable, and indeed they stores are often found within a stone's throw of one another, but from an investment perspective the stocks are far from equal.

How do these major contenders stack up in an aging America -- and one where patients spend billions every year on smoking-related diseases? CVS and Rite Aid have taken the plunge into in-store clinics, while CVS has an important additional revenue source that many investors don't even know about.

A full transcript follows the video.

Michael Douglass: All about pharmacies in 2015; this is Industry Focus.

Hi Fools, healthcare analyst Michael Douglass here and I am talking to one of our healthcare contributors, Todd Campbell today. Todd, how are you doing?

Todd Campbell: I'm doing well. I just got back from my local Rite Aid store, picking up a couple things, so this is the perfect time to talk about pharmacies!

Douglass: Not that that biases you, of course, right? I feel like we've all had good and bad pharmacy experiences. Important to be careful there!

Let's jump right into it. People think about pharmacies a lot -- when you're going in and you're getting your prescription or you're getting your People magazine or whatever -- but let's face it, the business model often goes a lot beyond that. I think it's really important.

These are intriguing investments, and I think they're very interesting for a lot of people, so let's dive into the major things people should be watching for pharmacies in 2015. What's on your mind for that, Todd?

Campbell: I think one of the most important things that investors need to understand about the pharmacy business is the long-term trend that is changing this entire industry.

Historically, pharmacies were operated as two distinct businesses. You had the main part of the store, the front end of the store, where of course you could get your People magazine or your pack of cigarettes, or whatever it happened to be at the time. At the back end of the store, you had this separate business that was filling prescriptions for individuals.

Now, the future of pharmacy is a holistic approach where you're finding ways to get the back and the front of the store referring people to each other. Now they're not just talking about, "What were my sales in the pharmacy, and what were my sales on the front end?" You're talking about, "What are my sales overall?"

It's a perfect time to do that, to take that holistic approach, because you have so many trends that are likely to send demand and store visits and everything higher for these pharmacy operators -- Rite Aid of course, CVS Health, and Walgreens.

Douglass: I think that's a very good point, especially when we consider some of these major trends, and we'll get to those in just a minute.

To my mind, one of the other big things for people to really be thinking about is sticky relationships. At the Fool, especially I'd say in tech and in consumer goods, they talk a lot about sticky relationships.

How do you increase those switching costs, especially when you have pharmacies that are across the street from each other? It seems whenever you see a Walgreen, there's a Rite Aid right next to it and a CVS maybe one block away. How do you build that sticky relationship, to make sure that people keep coming to your pharmacy when the other one is only 20 feet away?

I think that we're seeing a lot of spade work that's been done by all the pharmacies to try and make that happen. I'd say CVS has been the early adopter, and perhaps the early winner in that, but Rite Aid and Walgreen are both definitely fighting to catch up.

Campbell: I think without a doubt that the biggest way that pharmacies are trying to create that stickiness is through opening in-store health care clinics. It's such a perfect, natural extension of their pharmacy business because now you're saying, "I'm not just relying on someone having gone to the doctor, the doctor writing out a script, that script then being brought to whichever pharmacy happens to be closest."

Instead what I'm saying is that you're not going to have to wait in a doctor's office to see the doctor for flu or a sprain or something. You can come right into our store, sit down with one of our trained nurse practitioners.

That nurse practitioner is going to evaluate what treatment option is best for you, and then you can walk out of that clinic, right into the main part of the store, buy all the over-the-counter medication that you might need, be it a cough medicine or whatnot, and at the same time go to the back of the store and maybe get a prescription filled for whatever you happen to need as well.

Douglass: Let's face it, we know that the pharmacy side, as opposed to the candy bar and People magazine or whatever in the front, has been really driving a lot of the same-store sales growth, and we have seen positive same-store sales growth overall. I think that's going to be a big trend for people.

Rite Aid of course, purchasing RediClinic last year, is just starting to really get into this. CVS has a much bigger Minute Clinic footprint, but it'll be very interesting to see whether Rite Aid is able to capture a significant share there, and then build out this clinic presence.

Campbell: Rite Aid has a tremendous amount of catching up to do, there's no getting around it.

Full disclosure, I happen to be long Rite Aid stock, but I will be the first to admit that they are behind the 8 ball.

Rite Aid is a unique player in this industry. Walgreens and CVS are far larger companies. Rite Aid went out and made a very expensive acquisition of a competitor, Eckerd, back in 2007 -- tons of debt on the balance sheet as a result, just as the great recession hit.

As a result, they lost so much money that while CVS and Walgreen were able to fuel investments in these new programs, new stores, etc., Rite Aid was too busy putting out fires, trying to figure out, "How can I refinance this debt? What stores do I need to close?" etc.

Now Rite Aid is in catch-up mode. They've had a couple years in a row now where they're making some money. They've got some financial flexibility again, and those investments are starting to be made back into growth like, as you mention, the RediClinics.

What's important about the RediClinics is ... look at what CVS has accomplished. CVS went from having virtually no in-store clinics at all, back six years ago, to now having almost 1,000 Minute Clinics open in their stores and plans to have 1,500 Minute Clinics by 2017.

The revenue from the Minute Clinics alone is remarkable. They're planning on almost $350 million in revenue just from the Minute Clinics.

To your point that you made previously, the front end of the store helps revenue, but these things are low margin items. For example, cigarettes. CVS Heath CEO was invited to the State of the Union address last night for a reason, and that reason was because they have decided not to sell cigarettes anymore in their stores.

That's a low margin business. Now they can get rid of the cigarettes, they can replace it with more profit-friendly items. They can devote more time and attention toward developing chronic health care programs -- things that are going to create that stickiness that you mentioned earlier.

Douglass: Yes, and when it comes down to it, that's the name of the game. That's why you have store loyalty programs -- which, to be fair, I know Rite Aid has one. That's why you have so many consumer goods companies, retailers, trying to find ways to keep those people in the store, at the store, not going to competitors.

Certainly, CVS has carved out an interesting moat for itself with the smoking cessation-only pharmacy plan that they're planning to roll out, which could be a really big thing for them. On that point, do you think that Rite Aid and Walgreen will ultimately be in a position where they need to follow CVS's lead and get rid of, as you pointed out, a low margin business?

Campbell: I think it's inevitable, I really do. The reality is that we're spending, as a nation, over $100 billion a year in direct medical costs on smoking-related diseases. It just seems silly.

The study that prompted CVS to get rid of cigarettes in their store showed that a significant percentage of the people who had smoking-related diseases were getting their prescription filled and then going to the front of the store and buying packs of cigarettes. It just doesn't make sense.

I think ultimately we will see that; I think Walgreens more likely sooner than Rite Aid, because Rite Aid is more concerned at this point with just making sure that its top line is able to grow, and that its margins can continue to improve. It may be a little slower to adopt that. Time will tell.

Douglass: Yes. You made a good point earlier, that I want to bring out and talk about a little bit, which is let's talk demographics. Let's talk about this rising tide that could potentially lift all boats for these pharmacies, in 2015 and beyond.

These major demographic changes in the United States that are going to, we think probably, help drive this investing thesis for these pharmacies and make them potentially really good long-term holdings.

Campbell: Ten thousand people, boomers, are turning 65 every day. That is amazing. The aging of America is a massive trend, and it could prove to be very friendly for investors in pharmacy stocks.

Rite Aid recently reported a slide deck that showed that the average person who is over 65 is filling more than two times the number of prescriptions per year as the person who's under 40 years old. That is a phenomenal tailwind.

These big players -- Rite Aid, Walgreen, CVS -- they're capturing a larger and larger share of all of that prescription demand. CVS, for example, has reported that in the last five years it's captured almost a third of every new prescription that's been written. That's tremendous opportunity for these companies.

Douglass: Yes I think that's a good point, and definitely something that makes these interesting to watch, moving forward. What is your favorite pharmacy stock for 2015?

Campbell: Well, I'm long Rite Aid but that's a speculative stock. Not every investor is going to want to have some of that, and it is a small position for me. It's one of those positions that I've taken a little bit of a longer term look at and said I think that they can do well over the course of the next 5-10 years, and play some catch up.

CVS overall, CVS Health, is my favorite because they have the size, they already have the scale with the Minute Clinics. They're just continuously innovating in creating new ways to serve aging America.

They've got this phenomenal business that's $76 billion in revenue in pharmacy benefit management, where they're actually running drug programs for insurance companies and employers, so I think CVS Health is overall my favorite in the space.

Then for speculative investors, they may want to consider Rite Aid.

Douglass: Yes, I think that's very fair. Yes PBM, the pharmacy benefits management, as you mentioned in CVS has bigger revenue than the actual retail stores, which is just an amazing and I'd say largely unknown -- and I think by most people largely missed -- and very key part of the CVS investing thesis.

Certainly these will be stocks that we'll be wanting to watch very closely, and following into 2015 and beyond. Todd, as always, thanks for your fantastic analysis.

For The Motley Fool I'm Michael Douglass. Check back to Fool.com for all of your investing -- healthcare and otherwise -- needs, and of course also the Industry Focus podcast, and Fool on!