This morning, Walgreen (NYSE:WAG) and CVS (NYSE:CVS) investors found their stocks chopped up by a bit of news from Wal-Mart (NYSE:WMT). It seems the retail giant will introduce a pilot program next year to sell generic drugs for $4 a month in its Florida stores. This is opposed to the $30 a month that CVS and Walgreen charge. Should investors hit the panic sell button?
I own all three stocks. So when I turned on the TV and heard comments like "WMT will drive CVS and Walgreen out of business!" I walked to the water cooler, got a drink, sat down, and put on some opera music (loud -- it helps me think). I came to the conclusion that it's a brilliant move for Wal-Mart (way to go, Wal-Mart!) and almost a non-event for Walgreen and CVS. Here's why:
Wal-Mart's program has the biggest impact on consumers who are paying for prescriptions out of their own pocket, which accounts for a very small portion of CVS's and Walgreen's sales. In fact, only 5.9% and 7.1% of CVS and Walgreen pharmacy sales are paid by consumers directly; the bulk is paid by third parties (insurance companies, government, and states). Out of this 5.9% and 7.1%, a portion goes to branded drugs and the rest goes to vitamins and generics. I think the impact on Walgreen's and CVS' future sales should be negligible.
The only way the news would have a meaningful impact on CVS or Walgreen is if the insurance companies and government suddenly decided that $4 is a fair price for a generic drug -- a very unlikely scenario. Both companies operate on razor-thin margins as it is. They have very large store bases and armies of loyal customers, and they're likely to join forces to fight insurances companies that would lower their compensation for generic drugs.
Wal-Mart will probably not be making money on generics, but it doesn't have to. Where pharmaceuticals represent greater than two-thirds of sales for stand-alone pharmacies, pharmacy sales are a mere rounding error on Wal-Mart's electric bill.
Wal-Mart will be subsidizing pharmacy sales by (hopefully) getting old customers into their stores more often and bringing new customers through the doors. Have you ever tried to buy just one thing at a Wal-Mart? I think it's physically and psychologically impossible -- at least, it's never happened to me. If this pilot is successful, it should offset the loss of profitability in the pharmacy by generating sales of other general merchandise and groceries. Also, Florida is a perfect testing ground for this program, as it has more "blue hair" -- the main consumers of drugs -- per capita than any other state.
This move may also help to cool off the criticism against Wal-Mart on the PR front -- the company is working to lower medical costs to U.S. consumers, after all. The brilliance of this move lies in trying to bring market forces into the fight.
I think the Wall Street reaction to the news is overblown. But the news added a level of uncertainty to pharmacy stocks, and Wall Street doesn't like uncertainty. It also raises the question, "What else does Wal-Mart have up its sleeve?" But while Wal-Mart has a competitive advantage over many other retailers, its competitive advantage against Walgreen and CVS is very limited. These companies don't try to compete on price because insurance companies are the ones most often footing the bill; insured consumer out-of-pocket expense (the copayment) for drugs is the same at any store. One doesn't go to Walgreens or CVS because they have the best prices. People shop there because of convenience -- smaller stores, quick in-and-out trips, proximity of location -- not something Wal-Mart is going, or wants, to replicate.
Before this news, Walgreen and CVS stocks were pushing all-time highs. In my estimate, CVS was approaching a fair price valuation -- it was a couple of dollars from our target sale price -- and Walgreen was trading with little margin of safety, if any. (My firm sold shares of Walgreen a couple of weeks ago on the valuation concern.)
These stocks have big tailwinds behind them. High predictable growth rates are likely to persist in the future. On top of all this, baby boomers are not getting any younger and are consuming drugs by the pound. If you loved those stocks when they were 10% higher, you must love them today; their businesses haven't changed as much as you may think.
Wal-Mart is a Motley Fool Inside Value recommendation.
Fool contributor Vitaliy Katsenelson can be reached at www.contrarianedge.com. He is a vice president and portfolio manager with Investment Management Associates , and he teaches practical equity analysis and portfolio management at the University of Colorado at Denver's Graduate School of Business. He and his company own shares of CVS and Wal-Mart, and his company also owns shares of Walgreen. The Motley Fool has a disclosure policy .
