CVS (CVS) delivered a prescription for growth Tuesday, reporting fourth-quarter results that beat analyst expectations.
The nation’s second-largest drug store chain made news recently because of its decision to stop selling tobacco products at its 7,600 stores. Given that news and the solid earnings for CVS stock, CVS has thrown down the gauntlet and forced Walgreen (WAG) into a corner. Walgreen’s reaction should tell investors exactly how it views its competition with CVS.
The road ahead looks to be an interesting one.
CVS seems ready to chart a course less reliant on some of the traditional consumer staples like cigarettes, etc. Will CVS stock miss the $2 billion in annual revenue or 10 cents in earnings? I doubt it. As for whether its decision makes it a better or worse long-term play … well, that’s still to be determined.
Despite there being many unanswered questions, I still see CVS stock as a better investment than WAG stock. Here’s why.
Things to Like About CVS Stock
The bigger picture: CVS CEO Larry Merlo knows that healthcare is his company’s future. Selling cigarettes simply doesn’t jibe with its existing business model, which was first set in course back in 2000 when it opened MinuteClinic, a walk-in clinic staffed by nurse practitioners. Nobody, including smokers, will miss cigarette sales in its stores. It’s a bold step, but if CVS wants to be taken seriously as a “quasi” vertically integrated healthcare provider, the butts had to go … even if that means a near-term hit on CVS stock earnings.
Free cash flow: When I last discussed CVS stock, I mentioned free cash flow as one of the pros for owning it. At the time, the company suggested 2013 free cash flow could be as high as $5.1 billion, although it actually came in around $4.4 billion. However, if you add back taxes and proceeds from sale-leaseback and property disposition transactions, its adjusted free cash flow for 2013 was $7.7 billion — $200 million higher than in 2014. The cause: Its operating cash flow was a billion dollars lighter in 2013 due to higher taxes paid. That’s nothing more than a timing issue. On an adjusted basis, its free cash flow is 6% of revenue, approximately 180 basis points higher than Walgreen’s.
Share repurchases: CVS has been on a buying binge the last few years. In 2013 the company repurchased 66 million shares of CVS stock at an average cost of $60.24 per share. In the last five years it has reduced its share count by 17% to 1.23 billion. If you owned 1% of the shares at the end of 2008, you now own 1.2% of CVS stock without spending a nickel. That might not seem like a lot, but it would have increased your investment at the time by $78 million or 20% more for an additional two basis points. In that respect, shareholders have definitely won.
As for the competition…
Things to Like about WAG Stock
International expansion: In August 2012, Walgreen acquired 45% of Alliance Boots, a European drug store chain with 3,100 stores in 20 countries. Paying $4.03 billion in cash for 83.4 million shares, WAG has the option to buy the remaining 55% for approximately $5.1 billion and 144.3 million shares. The move gives the company a nice entry into the European market. In the first quarter ended Nov. 30, 2013, the European investment generated $151 million in equity earnings. Interestingly, Alliance Boots has a private equity group that invests in small- and medium-sized health and wellness businesses. Its first acquisition was announced Feb. 7; expect more in the future.
Scale: Ever since Walgreen’s disastrous spat with Express Scripts (ESRX) finally ended in July 2012, CEO Greg Wasson has been busy building more heft. First, he made a deal with Alliance Boots and then he hooked up WAG with a 10-year drug distribution deal in the middle of 2013, worth something like $28 billion in drug purchases annually. Facing constant pricing pressures, the best way to keep profits growing is to better control the flow of those drugs. By partnering with Alliance Boots and AmerisourceBergen (ABC) it ensures it has more to say in the future about the price it pays for drugs, which should give comfort to WAG stock investors.
Cigarettes: It’s hard to believe but Walgreen could actually benefit from continuing to sell cigarettes. Goldman Sachs (GS) continues to rate WAG stock a “conviction buy” suggesting it could gain as much as three cents in earnings per share from CVS’ exit. With January same-store sales failing to meet expectations, WAG stock could use a little bit of cheer. Ultimately I think it will also exit cigarette sales, but not before taking some profits away from its chief rival.
WAG vs CVS Stock: Who Wins?
Since Walgreen has gotten back with ESRX its stock has doubled. So I’m not expecting WAG stock to rise that quickly again. With the easy money off the table and CVS stock possessing a much better valuation, I believe CVS stock wins this horse race in comfortable fashion.
As of this writing, Will Ashworth did not own a position in any of the aforementioned securities.