Playing Defense With the Drugstore Industry

The stock market is currently trading at a four-month high, but it could still be volatile. Some investors worry that the U.S. economy is in the midst of a slowdown, which could be exacerbated by any major slowing of the housing market. In any case, it's always a good idea for Fools to try to recession-proof their portfolios.

This mindset could be one of the primary reasons that shares of the three largest domestic drugstore chains have performed well this year. Economic concerns usually cause investors to shift to more defensive names that can grow in any economic environment. As a result, Walgreen (NYSE: WAG  ) , CVS (NYSE: CVS  ) , and Rite Aid (NYSE: RAD  ) have experienced share gains ranging from 15%-20% so far this year. While the run may be over for now, the industry has long-term appeal, and recent sales details show just who is the leader of the pack.

Favorable secular trends
Regardless of which way the economy is shifting, consumers always need to have their prescriptions filled. Plus, as baby boomers age, demographic trends will likely increase demand for drugs from the likes of Pfizer (NYSE: PFE  ) , Merck (NYSE: MRK  ) , and GlaxoSmithKline (NYSE: GSK  ) . And while these major pharmaceutical companies have been losing patent protection on some of their major products, this plays right into the hands of the drugstore chains. While sales may be smaller, the drug retailers capture a higher percentage of the markup, making generic profitability superior to that of the patented alternatives.

Additionally, a new Medicare program called Part D is expected to benefit the bigger drugstore chains thanks to their relationships with larger insurance companies, which are responsible for administering the plan for retired Americans. That may hurt the mom-and-pop pharmacies, and could be one of the reasons Happy Harry's on the East Coast decided to sell out to Walgreen earlier this year. Walgreen is also working to create its own pharmacy benefit management (PBM) business to fill prescriptions for large insurers and through snail mail, which is currently dominated by the large PBMs such as Caremark (NYSE: CMX  ) .

Telling tales in August sales
Walgreen, CVS, and Rite Aid issue monthly sales to keep investors abreast of near-term trends. While the numbers below are only for one month, they do a sufficient job of demonstrating who is No. 1, 2, and 3 in industry positioning.

Drugstore chains have two primary sales channels: pharmacy and merchandise. Enter any store and you'll notice the general merchandise, such as basic groceries, snacks, toiletries, and other household items, located at the front end of the store. That's a strategic decision made by the companies in the hope that consumers will make impulse buys on their way to picking up drug prescriptions at the back of the stores. Here is a quick rundown of those sales as well as total and same-store sales growth for August.

Sales Growth %

WAG*

CVS*

RAD**

Total

17.2%

23.4%

4.7%

Same-store

10.6%

8.9%

3.8%

Pharmacy Comps

13%

10.3%

4.7%

Merchandise Comps

6.3%

5.8%

2.2%

* four weeks ended August 26, 2006
**five weeks ended September 2, 2006

Walgreen was tops in all August numbers except total sales, where CVS benefited from the acquisition of 700 Sav-On and Osco drugstores. CVS relies on the purchase of outside drugstores for a good chunk of its growth strategy. CVS also has a higher total store count than Walgreen, at 6,163 versus 5,461, but the latter is the undisputed leader in total sales ($47.4 billion for fiscal 2006) and relies almost entirely on organic, or internal, growth.

Walgreen also has a much better track record in driving same-store sales, though pharmacy sales as a percent of total sales are higher at CVS (70.4% in August) as compared to Walgreen (66.5%). Pharmacy sales accounted for 64% of Rite Aid's total sales for August, which is a distant third in most operating metrics.

To keep pace with the leaders, Rite Aid recently agreed to acquire 1,858 stores from Canadian firm Jean Coutu Group for about $3.4 billion. If you recall, Jean Coutu purchased Eckerd drugstores from JC Penney a couple of years ago, but appears to have bitten off more than it could chew and has decided to sell out; it will also have an ownership stake in Rite Aid. Rite Aid will still be third behind Walgreen and CVS, but its new store count is estimated at just under 5,200, or much closer to the two leaders in terms of total count. Unfortunately, Rite Aid has been unable to post solid sales or profitability trends; time will tell if the new Eckerd stores will enhance operational trends.

The Foolish bottom line
The historical results also point to Walgreen as the growth leader; it has been able to grow sales and earnings about 15% per year for at least the past five years. And while CVS has grown sales 13% over this time frame, earnings are up just under 10% per year due to much higher indebtedness. Rite Aid has even more debt and is looking for more consistent profitability trends. In any case, the drugstore industry is worthy of consideration for any portfolio, though judging by historical numbers, gravitating toward the top two players is probably best.

For related Foolishness:

Pfizer is aMotley Fool Inside Valuerecommendation. Merck and GlaxoSmithKline are bothIncome Investorselections. Try these or any of the Fool's newslettersfree for 30 daysand watch the symptoms of an underperforming portfolio vanish.

Fool contributor Ryan Fuhrmann is long shares of Walgreen and Pfizer but has no financial interest in any other company mentioned. Feel free to e-mail him with feedback or to discuss any companies mentioned further. The Fool has an ironclad disclosure policy.


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