CVS (NYSE:CVS) and Walgreen (NYSE:WAG): they’re the Coca-Cola (NYSE:KO) and PepsiCo (NYSE:PEP) of the retail pharmacy business. Together they have more than 15,500 stores in all 50 states and the District of Columbia, combined annual sales of almost $180 billion and nearly 450,000 full-time employees. But which one is the best bet for investors?
Both companies are facing a time of dramatic change in the retail pharmacy industry. Although pharmacy sales weathered the recession well, growth in the $223 billion market has been relatively flat over the past five years, according to IBIS World analysts.
From now to 2017, pharmacy-sales growth is expected to accelerate, but traditional pharmacies face margin pressure from grocers such as Kroger (NYSE:KR) and retailers such as Wal-Mart (NYSE:WMT) and Target (NYSE:TGT), which are enhancing their pharmacy operations.
Although health reform likely will boost prescription-sales volume if it survives in its current form, pharmacy operations likely will have to reduce prices. That essentially leaves chains with a choice of two competitive strategies: owning pharmacy benefit-management providers (PBMs) that can cut costs through mail-order fulfillment and other efficiencies, or acquiring smaller retail competitors to generate economies of scale.
But which of these head-to-head competitors — CVS or Walgreen — has the edge? And more important, which one will give investors healthier returns in the long run? Here’s the breakdown:
By the Numbers
WAG has 8,290 retail pharmacies and is the largest pharmacy chain by number of stores. Its Take Care Health Systems subsidiary operates more than 700 in-store clinics and work-site health-and-wellness centers. Walgreen’s fiscal 2011 sales totaled more than $72 billion; earnings were $2.7 billion.
CVS has 7,300 retail pharmacies and about 550 in-store health clinics. CVS became the largest PBM provider in the U.S. after its nearly $27 billion acquisition of Caremark in 2007, but it has since fallen to second place. CVS’s fiscal 2011 revenue totaled $107 billion; earnings were $6.3 billion.
WAG’s lies in expanding its retail empire. Walgreen sold off its PBM unit to Catalyst Health Solutiongs (NASDAQ:CHSI) for $525 million in cash last year to take its focus off the PBM business. WAG acquired 199 stores last year, and earlier this month it completed its acquisition of BioScrip Inc.‘s (NASDAQ:BIOS) specialized pharmacy and mail order operations for $225 million.
CVS’s biggest opportunity is continuing to grow its PBM business. The Caremark unit now handles pharmacy benefits for more than 50 million customers. In January, Caremark began administering the $3 billion Federal Employee Program contract it won last year, just one of several big payor wins in 2011.
CVS also has cashed in big on a contract dispute between Walgreen and the industry’s largest PBM, Express Scripts (NASDAQ:ESRX). CVS’s quarterly earnings, released this month, beat the Street on the top and bottom lines, and pharmacy sales grew 10% during the quarter.
WAG has taken a beating since it stopped accepting Express Scripts prescriptions because of a dispute over the insurer’s rates. If Walgreen doesn’t find a way to come to terms with Express Scripts, it could lose out on 88 million prescriptions a year — more than $5 billion in annual sales. Walgreen’s April same-store sales slipped 6%, and it filled 8% fewer prescriptions last month. To make matters worse, Express Scripts has acquired Medco Health Solutions for $29 billion. Medco accounted for more than 100 million Walgreen prescriptions last year. WAG next reports earnings on June 26.
CVS is at risk of being hurt by the Express Scripts-Medco deal, too, except the impact will be different. The combined $116 billion PBM giant now replaces CVS Caremark as the nation’s top PBM company. If the merged entity really can save $87 billion by cutting better deals with drug manufacturers and retail outlets, CVS will have a much tougher row to hoe in its PBM and retail pharmacy businesses. CVS’s margins have been declining in recent months as it is.
With a market cap of $57.6 billion, CVS is trading around $45 — more than 43% above its 52-week low last August. It has a price-to-earnings growth (PEG) ratio of 1.2, indicating that it’s slightly overvalued. It also has a forward P-E of 12. It has a current dividend yield of 1.4% and a one-year return of nearly 19%.
Walgreen has a market cap of $27 billion and is trading in the $31 range — 31% below its 52-week high last June. It has a PEG ratio a hair higher than CVS’s at 1.3 and a slightly better forward P-E of 11. The biggest difference is in the dividend, which has grown more than 20% over the past year (current yield is 2.9%) and the one-year return: negative -27%.
CVS is the hands-down winner in the face-off between the top two drug chains, with one caveat.
Although we’ve focused exclusively on CVS and WAG, the retail pharmacy market is not a duopoly as long as third-place Rite Aid (NYSE:RAD) is in the mix.
RAD has about 4,650 stores in 31 states and the District of Columbia, and 47 were closed in the past year. The company posted a net loss of $413 million on $25.4 billion in revenue last fiscal year, an improvement from the $555.4 million loss the year before. Rite Aid has a market cap of $1.2 billion, and its stock is trading around $1.30.
But RAD’s April same-store sales rose nearly 3% as its Wellness+ services and cost-cutting initiatives yielded results. Rite Aid also benefited from WAG’s Express Scripts spat.
So what changes if Walgreen — which, unlike CVS, is focused on growing its retail pharmacy business — makes a play for RAD? Credit Suisse analyst Edward Kelly has suggested such a pairing, according to The New York Times.
A merger between WAG and RAD would result in $400 million to $650 million in savings, Kelly said, adding that divesting a mere 3% of the combined entity’s stores should satisfy regulators.
Kelly concluded that WAG historically has been too conservative to make such a play. Still, I think the temblors rattling this market — from mega-mergers to health reform to the myriad high-dollar drugs that will emerge as higher-margin generics — make this a time for WAG to consider making a bold bet.
I rank CVS a buy with a target of $48, which would be nearly $4 a share higher than its all-time record price in mid-2008. I’d hold on WAG unless a deal gets done with Express Scripts-Medco in the next six weeks or so. If it does, I’d buy with a target of $35, but if this contract is not resolved soon and Walgreen’s Medco revenue remains in jeopardy, I’d rank WAG a sell because the short-term damage could be brutal.
As of this writing, Susan J. Aluise did not hold a position in any of the stocks named here.