Yesterday, Longs Drug Stores (NYSE: LDG ) slightly beat analyst expectations in reporting its third-quarter earnings.
Longs, which operates 502 drug stores concentrated on the West Coast, posted earnings of $0.32 per diluted share on $1.23 billion in revenue. Analysts' consensus called for Longs to generate $0.31 in earnings per diluted share on $1.22 billion in revenue. Profits from the retail drug stores, the bulk of company sales, were up a total of 3.8%. A 5.5% increase in pharmacy sales was offset by sluggish retail sales, which fell 1.8% from the year-ago period.
The pharmacy benefit services, which contribute roughly 6.5% of total sales, continue to benefit from increased revenues from the three new prescription drug plans offered under Medicare Part D. Longs' CEO, Warren Bryant, commented in the press release that the RxAmerica subsidiary, which offers the new Medicare plans, was a main contributor to the 42% net income growth.
Longs should continue to benefit from the underlying favorable industry dynamics, barring the effects of Wal-Mart's (NYSE: WMT ) new $4 generic plan, which has yet to hit California. However, the positive industry dynamics are also creating some of Longs' operational struggles.
Longs will continue to struggle with its smaller size as economy of scale becomes a larger factor in the success of the drugstore-chain business model. Rite Aid (NYSE: RAD ) recently purchased more than 1,800 stores from the Jean Coutu Group to get bigger. The scale of Walgreen (NYSE: WAG ) and CVS (NYSE: CVS ) , the two largest players in the market, allows them to generate more than 5% in operating margins; that's two to three percentage points higher than Longs'.
It might sound like a small difference, but that margin gap leaves Longs unable to generate enough excess cash to spend on growth or to return value to its shareholders. Store growth has been modest, and Longs' dividend hasn't increased since 1993. Its share buybacks serve mainly to offset share dilution from Longs' use of employee stock incentives. Last year, Longs repurchased 1.4 million shares, only to increase share count by 1.2 million through various share-based compensation plans.
I don't see value in Longs until it can gain more operational efficiencies. Until then, I would stay on the sideline. The stock trades at a higher forward price-to-earnings multiple than both Walgreen and CVS, but both of those larger rivals have arguably stronger operations.
Fill your prescription for further Foolishness: