In the next two years, it’s expected that Big Pharma companies will see $30 billion in U.S. sales for some of its major drugs up for generic competition. That’s because the patent protection on drugs like Pfizer‘s (NYSE:PFE) Lipitor and Bristol-Myers Squibb‘s (NYSE:BMY) Plavix are expiring.
This is great news for both Walgreen (NYSE:WAG) and CVS Caremark (NYSE:CVS), as drugstores make 48% gross margins on generic drugs compared to 9% for branded drugs. Both companies stand to win in this equation. But ultimately, investors must decide which is the better choice. Here are three reasons you should sell CVS and buy WAG:
Dividend Aristocrat
Are you familiar with the Dividend Aristocrats index? These are companies within the S&P 500 that have increased dividend payments annually for 25 consecutive years. And, during the past five years, the Dividend Aristocrats index has beaten the S&P 500 by 420 basis points annually. It’s not some crazy theory. Investing in these stocks works because companies that consistently increase dividends also increase earnings per share.
Walgreen is on the list. CVS isn’t.
DividendGrowthInvestor.com uses three criteria to shrink the list of 42 companies to a more elite list by restricting eligibility to companies whose P/E ratio is less than 20, whose dividend payout ratio is less than 60% and whose current dividend yield is at least 2.5%. Now remember, CVS doesn’t even make the Dividend Aristocrats index. This alone suggests WAG is the better stock, at least according to dividend investors. For the record, however, Walgreen’s P/E is 11.2, its dividend payout ratio is 31% and its dividend yield is 2.7%. At the present moment, Walgreen meets all three of the stricter criteria.
Express Scripts
This could change. Walgreen is in the midst of a contract dispute with Express Scripts (NASDAQ:ESRX), one of the country’s largest pharmacy benefit management companies. Many of Express Scripts’ customers use Walgreen to fill their prescriptions. If they can’t agree on a service contract whereby both benefit, Express Scripts customers will have to go elsewhere. If this happens, Walgreen stands to lose $5 billion in annual revenue.
On the surface, it seems that Walgreen has everything to lose in this dispute. Express Scripts management appears confident it will be able to find new homes for affected customers. Other pharmacies — including CVS — might benefit. But let’s think about what’s being proposed here. If Walgreen can’t make enough from each prescription filled through its association with Express Scripts, what’s the point of having the business in the first place?
All businesses exist because of profits. I see CEO Greg Wasson’s frank admission during the company’s fourth-quarter conference call that it likely wouldn’t be part of the Express Scripts network in 2012 as realistic and financially sound. Walgreen is the largest retail pharmacy in the nation. It fills one out of every five retail prescriptions. With more than 8,000 locations nationwide, it is the most convenient source for the average consumer. Management will find a way to replace this revenue at margins it finds acceptable. To me, it sounds like smart business.
Earnings Growth
Obviously, the previous information casts a doubt on some of Walgreen’s ability to grow. Chief Financial Officer Wade Miquelon suggests the loss of Express Scripts’ business will affect its earnings per share anywhere from 28 cents if it loses all of this business down to seven cents if it loses 25% of the $5 billion in revenue.
The analyst consensus in 2012 has Walgreen earning $2.98 per share. Let’s assume it loses 100% of that revenue. This translates into a 10% reduction in its earnings. While it’s not what any company ever wants to see, it’s certainly not the end of the world. Especially when you consider the opportunities that exist in the next couple of years as branded drugs come off patent protection. It’s possible that of the $5 billion in revenue Walgreen loses in the short term, it will gain that back within two or three years while also significantly improving its profitability.
Current expectations for earnings growth over the next five years is 9% annually. If the above were to come true, I suspect Walgreen’s growth would be in the double digits. Therefore, WAG shareholders actually could benefit from this temporary loss of business.
Bottom Line
Year-to-date, Walgreen’s stock is down 13.3% versus CVS, which is up 5.9%. As the deadline for securing a contract with Express Scripts comes closer, WAG stock has taken a beating. During the month of October, it was up less than 1% while CVS stock was up 8.5%. Contrarian investors should see this as a great opportunity and entry point.
As of this writing, Will Ashworth did not own a position in any of the aforementioned stocks.
