Why Walgreen Is the Best Drug Store Stock Right Now

As healthcare costs and expenditures go up, stocks in the healthcare industry are going up too. While these companies represent a good opportunity, there  is also solid opportunity in the companies that sell healthcare products – namely, drug store chains. Add to this the trend of drug stores operating like convenience stores (buy a gallon of milk, a greeting card, toothpaste, toilet paper and cosmetics at the same place you fill your prescription) and you have solid moneymakers.

These drug stores, like Walgreen (WAG) and CVS Caremark (CVS) and RiteAid (RAD), present great opportunities. Drug store chain CVS has a $59 billion market cap and is up over 9% so far this year while rival RiteAid, which is much smaller with a market cap of $1.61 billion, is up almost 39% – the market is up roughly 10%.

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Walgreen, which has a $29 billion market cap, has returned just over 2%, which obviously isn’t that great, but we think the low valuation of Walgreen is mainly because of the expiration of its pharmacy benefit management contract with Express Scripts (ESRX). Walgreen has stopped filling prescriptions for customers in the Express Scripts network since the beginning of this year because of the contractual conflict. Analysts expect Walgreen will lose about $4 billion worth of sales from this in 2012, but that estimate could be conservative. In February, same-store prescriptions sales fell by 8.6%, outpacing analysts’ expectations of 7.2%.

It may sound like a pretty big negative but we think the negative impact of the Express Scripts issue will be partly offset by the openings of new stores and cost reduction. Walgreen also has a focus on growth and expansion, both internally and through acquisition. In 2010, Walgreen acquired Duane Reade, including two distribution centers and 257 drug stores, for $1.1 billion in cash.

The acquisition enables Walgreen to have a leading position in the New York drug store market.  Moreover, Walgreen’s strengths are in pharmacy merchandising while Duane Reade is stronger in non-pharmacy. Therefore, the acquisition will also enable Walgreen to diversify its strengths. Overall, the deal is expected to create about $120-130 million worth of synergies to be realized in three years.

CVS is also growing through strategic acquisitions and alliances. The company has signed new pharmacy benefit management clients, which is expected to boost its total sales by 12.5% in 2012. It has also made several strategic acquisitions recently that should help improve its position in the market. CVS acquired Caremark RX for about $26.5 billion in 2007, a combination of two of the largest pharmacy benefit managers in the United States. The company also completed the acquisition of Longs Drug Stores for about $2.9 billion at the end of 2009, which made it the largest retail drug store chain in California and Hawaii.

Both CVS and Walgreen are currently trading at attractive multiples. CVS’ current P/E ratio is 17.21, on par with the industry average of 17.7. The Walgreen company is expected to earn $3.27 per share this year, which means its forward P/E ratio is 13.68, a discount to the industry average of 15.45.

In addition to attractive valuation levels, CVS and Walgreen also both have impressive records of increasing their dividend payouts. Currently, CVS has a dividend yield of 1.45% and Walgreen’s dividend yield is 2.70%. Though the yields are not very high, we see great potential of future dividend growth. Earnings of both companies are expected to grow at about 12% per year over the next couple of years. This strong earnings growth should allow the companies to up their dividend payouts. These companies also have low payout ratios – CVS’ payout ratio is 19% and Walgreen’s is 27%. This indicates that they have the abilities of maintaining or raising their dividend payments.

Hedge funds like these drug stores too. At the end of 2011, there were 46 hedge funds with CVS positions and 36 hedge funds with Walgreen positions in their 13F portfolios. For instance, Warren Buffett had nearly $300 million invested in CVS at the end of last year while Jim Simons, Lee Ainslie, and Bill Miller also had over $100 million invested in the company. Cliff Asness and Ray Dalio were bullish about Walgreen. Their funds had $51 million and $17 million invested in Walgreen, respectively, as of December 31, 2011.

RiteAid is not positioned nearly as well as CVS or Walgreen. It does not pay a dividend and it is suffering from a range of losses over the past couple of years. The company is expected to lose $0.36 per share in 2012 and $0.27 per share in 2013. RiteAid also has a large amount of debt on its balance sheet. As of February 2011, the company had $6.2 billion of debt, with a significant amount maturing in 2015. This means the company has to use a large part of its cash flow for debt payments.

With numbers like this, we do not recommend investors buy into Rite Aid. Instead, we prefer CVS and Walgreen. The latter’s contract expirations do gave investors some pause and as a result the stock is trading at a discount. We think this is an opportunity to outperform the market over the long-term.