Finding Ideal Risk/Reward in Pharmacy Stocks: Walgreen Company (WAG), CVS Caremark Corporation (CVS)

When choosing between pharmacy investments, there are several different bull / bear stories you will encounter concerning (1) lost customers, (2) market rallies, (3) partnership deals, and (4) turnaround opportunities. In my view, investors should appreciate the differences in risk/reward and take a balance between backing the beaten down stocks and those that have consistently grown.

Walgreen Company (NYSE:WAG)Walgreen Company (NYSE:WAG) : A Turnaround Story?

Walgreen, the largest pharmacy retail company in the US, has been through ups and downs. Y-o-y store prescriptions have been volatile, at one point declining in the double-digits. Analysts are doubting their ability to gain back customers lost of Express Scripts, so, in my view, there is upside potential from here. The stock trades at only 10.8x forward earnings; CVS Caremark Corporation (NYSE:CVS) , by contrast, trades at 13.2x forward earnings.
Much of the negativity surrounding Walgreen has to do with erosion of the fundamentals. Sales in early October went down 2.9%–well below the 1.1% growth  that many analysts had anticipated. The company, however, has sought to enhance its platform by partnering with Alliance Boots, a European prescribed medicine seller, in creating the first real global pharmacy business. In this deal, Walgreen secured a 45% stake in the company for a price of $6.7 billion. To put that into perspective, the investment represents 18% of the market cap. So, a good portion of Walgreen’s future hinges on the success of this partnership. With the stock up near the 52-week high and 44% above the 52-week low, Walgreen is on a bull run.

Only time will tell if investors continue to flip from CVS to Walgreen. CVS’s decision to increase its dividend by 38%, however, certainly didn’t help the chances. Investors are often looking for stability in the healthcare sector, so a more generous capital allocation policy goes a long way. In addition to hiking the dividend distribution, management  also plans to repurchase more than $4 billion worth of shares. Analysts now expect that CVS will keep at least 60% of customers that left Walgreen, higher than originally anticipated. At the same time, CVS is also moving into higher margin segments, such as in Pharmacy Benefit Management (PBM). It is up “only” 25% from its 52-week low.

High Risk / High Reward for Rite Aid Corporation (NYSE:RAD)

If you are looking for higher returns, I encourage you to consider Rite Aid. It is just entering profitable territory and carries a powerful brand. The free cash flow yield is at 18.1%, and analysts are forecasting high single-digit growth over the next five years. The price to cash flow ratio of 2.9x is well below the 10.9x industry average, 14.2x sector average, and 11.6x industry average. And, ironically, liquidity is better than the industry average if measured by the current ratio, which is 1.75x for Rit Aid.

Rite Aid is now slowly exiting its troubled recent past, and with the constant pressure from their two biggest competitors, Walgreen and CVS. The company is regaining market share, and this is evidenced by growth rates. Amongst pharmacies, Rite Aid saw the greatest growth (an amazing 19.5%), their first successful push since 2007. Performance has also been better than expected with 3Q12 EPS going up 9 cents above consensus estimates.

Conclusion

I recommend investing in all three businesses right now with the greatest concentration towards Walgreen. While Rite Aid offers high upside, it also carries significant risk as a result of just hovering between black and red territory. Walgreen is a consistent grower at this point and yet trades at a discount. With momentum and several growth opportunities working in its favor, I expect this discount to be closed.

The article Finding Ideal Risk/Reward in Pharmacy Stocks originally appeared on Fool.com and is written by David Gould.

Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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