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Drugstore Wars: Walgreen Vs. CVS

Wednesday, April 16, 2014 - 3:30pm

I hope I'm not dating myself too much, but I remember when the neighborhood chain drugstore was almost a one-stop shop for human needs.

For example, you dropped off your film to get developed. You could get the ointment for that embarrassing itch. You could even get a BLT and some fries. (Not necessarily in that order.)

The BLTs and fries are long gone, but the chain drugstore on the neighborhood corner has continued to evolve and embed itself into our daily lives. And it will continue to do so in an even bigger way going forward.

By far, the two biggest players in the drugstore space are Walgreen Co. (NYSE: WAG) and CVS Caremark (NYSE: CVS). If two-thirds of the Earth is covered by water, the remaining third is covered by these two companies. But which stock makes the most sense for your portfolio?

Side by side, there doesn't seem to be much difference between the two. Both have massive retail presence nationwide. Both are adapting to the rising tide of change brought on by the Affordable Care Act (aka Obamacare).

One area both chains are exploring thanks to the health care evolution is offering onsite primary-care clinics staffed by a physician's assistant or a nurse practitioner. Similar to an urgent- or immediate-care model, this idea provides consumers -- who are already familiar with the drugstore's brand -- access to quick, basic, professional care attached to a pharmacy. Makes sense to me.

Both companies will benefit from demand generated by a growing elderly population (read: baby boomers) -- but there are some stark differences in their businesses once you start drilling down.

The Biggest -- And The Best?
With over 8,000 stores throughout the U.S. and Puerto Rico, Walgreen's is by far the largest drugstore chain by retail revenue. Naturally, this marketplace dominance is reflected in the performance of the stock.

Overall, the business is relatively stable. Sales are expected to grow by about 5% from a little better than $72 billion in 2013 to nearly $75 billion for this year. Earnings per share (EPS) this year are expected to grow 33% over last year, to $3.41. But the question is: Can the company execute?

Flickr/Ron Cogswell
With 7,660 stores throughout the U.S., Puerto Rico and Brazil, CVS is a close second to Walgreen in the retail drugstore business. However, thanks to a more diverse business model, CVS is the largest pharmacy health care provider in the U.S., hands down.

Over the past two years, Walgreen's has spent $8.6 billion on acquisitions in the retail and wholesale distribution channels. While increasing its footprint is certainly one way to grow revenue, I'm concerned about margin compression in a business where margins are already slim, especially in the face of the seismic shift in the domestic healthcare landscape.

Big isn't always bad. But too big can be a problem.

Another concern is the tenuous relationship Walgreen's has with pharmacy benefits manager Express Scripts (Nasdaq: ESRX). At the beginning of 2012, Walgreen let its network member contract with Express Scripts expire. Almost overnight, 88 million prescriptions regularly filled by Walgreen's were affected. The company was only able to retain about 13 million. No surprise that Walgreen's 37-year streak of consecutive record sales and earnings increases came to an end.

The conflict has since been resolved, and Walgreen's is once again part of the Express Scripts network. But Express Scripts isn't the only pharmacy benefits manager around, and with the health insurance climate in turmoil, I wouldn't be surprised to see more conflict in the future.

Perhaps the days of consistent growth are over for Walgreen. If so, the stock has gone as high as it can go. And if that's the case, shareholders will vote with their feet.

Healthy Alternative
With 7,660 stores throughout the U.S., Puerto Rico and Brazil, CVS is a close second to Walgreen in the retail drugstore business. However, thanks to a more diverse business model, CVS is the largest pharmacy health care provider in the U.S., hands down. The stock has benefited.

You'll note that CVS' chart is quite similar to Walgreen's chart. However, the underlying businesses are starkly different. While Walgreen is dabbling with onsite health care and focusing on owning every street, CVS is building a true, comprehensive, consumer driven, basic health care access model.

While the CVS brand is seemingly on every other corner in suburban America, 54% of annual sales, which clocked in at over $126 billion last year, are generated by a full range of pharmacy benefit management services.

In addition to its huge presence in pharmacy benefit management, CVS is also the largest operator of retail health clinics in in the U.S. with 800 clinics under the MinuteClinic name. CVS plans to open 150 MinuteClinics this year and have 1,500 in operation by 2017.

When you drill down the basic elements of each of the businesses, there are distinct differences. The same is true when you stack the numbers side by side.

Aside from CVS' long-term debt-to-capitalization ratio and WAG's superior dividend yield, CVS is clearly the better choice. With over $6 billion in annual cash flow, there's room for its dividend to grow, and 16 times forward earnings is a reasonable price to pay for consistent earnings growth of 9%-plus from a company generating over $120 billion in annual sales.

Risks to Consider: Both companies face the same headwinds in an increasingly uncertain health care environment. The biggest risk is a greater-than-expected decrease in drug reimbursements from federal and state governments. This threat looms larger for Walgreen. CVS' diverse portfolio is better suited to playing defense.

Action to Take --> Walgreen's shares have probably done as much as they can for the time being. Investors should consider taking profits. CVS shares are a much better choice based on the company's solid operating history and strong business mix. Although the current price near $74 is on the higher end of its range, the stock makes sense for long-term, growth-oriented investors. An 18-month price target of $100 is attainable; that would bring the total return to nearly 38%. Any pullback in the stock price should be used as an opportunity to add to positions.

P.S. Great yielding stocks that have plenty of cash for dividend growth are the foundation for Amy Calistri's "Daily Paycheck" investing strategy. To see how she's used this strategy to earn $49,000 in dividend checks since 2010, click here.

Adam Fischbaum does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.