When It Comes to Drug Stores, Second-Place CVS Gets the Gold

by Jonathan Berr | September 13, 2013 9:28 am

Remember the old Avis commercials that said the people should patronize the company, which “tried harder” because it was the second-largest auto rental company? The same approach might work today for drug store retailers.

Walgreen (WAG[1]) might be the market leader for retail drug stores, but CVS Caremark (CVS[2]) is still having a good year. Despite disappointing earnings, both are up by double-digit percentages this year thanks to growing sales of generic drugs. And third-place Rite Aid (RAD[3]) is barely worth a mention.

What’s powering CVS and WAG but weighing down on RAD? Let’s take a closer look at each.

Ride Aid

The No. 3 player in this sector is Rite Aid, which is cheaper than both of its larger competitors with a 15.2 multiple. Unfortunately, as Reuters notes, that’s a 5-year high. Shares of the Pennsylvania company, which has weathered an accounting scandal and economic uncertainty, are trading well above their average 52-week target of $2.98.

Rite Aid has outperformed the shares of its much larger rivals this year, surging 165%. But keep in mind that this is a low-priced stock, trading recently at $3.63, which magnifies even the smallest price gains.

The chain, though, is in the midst of a turnaround, at least in the minds of some. Hedge fund manager David Einhorn has recently disclosed a stake of 20.2 million shares in the retailer. Many people — including me back in the 1990s – have been burned waiting for the good times to roll at Rite Aid. My colleague Lawrence Myers[4] noted in July that a turnaround in Rite Aid was “years away” if it occurs at all.

“Execution will have to be perfect, and the company will have to come up with some kind of amazing strategy to push back on all the outside competition — not to mention competition from stores in its own sector.”

CVS

CVS is by far the best of this bunch, despite some setbacks earlier in the year. It wound up in Wall Street’s penalty box in the second quarter after it was forced to delay share buybacks during a settlement negotiation with the Securities & Exchange Commission over how it disclosed sales of securities by employees.

As a result of the holdup in the repurchase, the company’s share count for the year will be higher than expected, forcing it to lower the top end of its earnings guidance. But CVS’ earnings were otherwise fine and came in ahead of Wall Street’s expectations. The company even expects to complete the $4 billion in share purchases it had this year; however, it’s worth mentioning that the company is paying $20 million to resolve the matter, which dates to 2009.

Walgreen

Walgreen, on the other hand, deserves the ire of investors. The company’s latest earnings report — issued in June — was dismal, missing analysts’ expectations on both the top and the bottom lines. Chief Executive Greg Watson spoke of front-end sales “not being up to expectations” because of a “challenging” economy.

Adding to the company’s woes, officials in Missouri, Wisconsin and California have accused Walgreen of overcharging customers. Missouri Attorney General Chris Koster has sued the chain, which denies wrongdoing, over the matter.

Some analysts, though, believe that Walgreen has been punished enough. Goldman Sachs recently added the stock to its Conviction Buy list. Analysts at SunTrust also raised their rating on Walgreen to buy and gave the shares a $60 price target, which is well above the average analysts’ price target of $51.66.

In more positive news for the company, it announced plans to acquire Kerr Drug, a closely held chain based in Raleigh. The terms of the acquisition were not disclosed, though Walgreen noted that Kerr’s sales were $381 million in the latest fiscal year. That’s peanuts, however, for a company that analysts expect to earn more than $72 billion in the current fiscal year.

Verdict

The sector still has plenty of headwinds. Costco, for example, sell generic drugs below cost, which can be a huge draw for people with ongoing medical issues Walgreen will do fine in this environment, though CVS should do better. Advantages like the company’s Minute Clinics, which can be a godsend to consumers who get minor aches and pains but can’t get a doctor’s appointment, make it the better buy over WAG.

The time to buy CVS is now. Walgreen might be worth acquiring on a pullback, but Rite Aid should be avoided at all costs.

As of this writing, Jonathan Berr did not hold a position in any of the aforementioned securities. Follow him on Twitter @jdberr

Endnotes:
  1. WAG: http://studio-5.financialcontent.com/investplace/quote?Symbol=WAG
  2. CVS: http://studio-5.financialcontent.com/investplace/quote?Symbol=CVS
  3. RAD: http://studio-5.financialcontent.com/investplace/quote?Symbol=RAD
  4. Lawrence Myers: http://investorplace.com/2013/07/go-ahead-be-dumb-buy-rite-aid/

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