Profit From The Drug Store War With This Trade

Friday, October 3, 2014 - 1:30pm

by Eric Winter

When most people start investing, they are urged to go with what they know.

Used Colgate toothpaste all your life?  Buy some CL stock. Can't imagine a day without a can of Coke?  Time to buy some KO shares.

While I agree with the underlying premise, it proves a point about what I consider the "tangibility" of a brand.  Many stocks make their way into portfolios because they are seen, used or visited on a consistent basis by their investors.

Falling under that argument are U.S. retail pharmacies, which seem to find a home on every other major intersection in cities and towns across the country.  Drugstores like CVS Health, Walgreen, and Rite Aid are just as ubiquitous as Wal-Mart or Home Depot these days, making them prime candidates for investment under the "go with what you know" mantra.

It's a great starting point to whittle down your investing universe, but drugstores in particular happen to have many characteristics that make attractive investments in their own right.

For long-term investors, the allure of drugstores centers on the two main industries they are tied the closest to -- consumer staples and pharmaceuticals.

The first can be explained by recent pull-backs in the S&P 500, causing many analysts to wonder if this five-year bull market has finally topped out.

If we are, in fact, headed for rougher times, consumer staples stocks are about to be in vogue in a big way.  Walk into any CVS or Walgreen and you'll be met with all of the necessities -- food/drinks, paper products, basic grooming supplies, etc.  These products don't lose their popularity even when the economy is hurting.  The right time to buy is when the market has topped and begins to enter a bearish cycle, which could be now.

On the pharmaceutical side of the business, the U.S. population is not getting any younger.  Combine that with new drug formulations hitting the market and a wider pool of insured Americans under Obamacare and you can quickly see the need for pharmacies -- and many of them, at that.

Despite their similar business models, each company has its own drivers. Let's take a closer look at what makes them tick.

CVS Health Corp. (NYSE: CVS) operates more than 7,700 stores under the CVS Pharmacy and Long's Drugs brands. The chain has been in the news lately due its latest rebranding from CVS to CVS Health.  The main push behind the transition was the decision to no longer sell tobacco products -- one which will cost the company $2 billion in annual sales.

In order to make up that difference, CVS Health has set itself apart by expanding operations elsewhere. The introduction of "Minute Clinics" in some stores have made the brand a health care provider as well, and the company is betting that its focus on healthier living will win over consumers.    

Walgreen Co. (NYSE: WAG) bests CVS' retail operations by being the largest retail pharmacy chain in the United States, operating more than 8,200 stores.  The brand is going through growing pains of its own, completing its total purchase of Alliance Boots pharmacies in Europe this summer.  WAG bought a 45% stake for $6.7 billion in 2012 and is in the process of acquiring the other 55%, disgruntling some investors in the process.

Disappointment emerged after Walgreen decided to stay domiciled in the United States versus cutting taxes by relocating its headquarters to Switzerland.  The stock tumbled 14% on the announcement, although I expect the merger's synergy to close that gap eventually.

Rite Aid Corp. (NYSE: RAD) is practically in a class of its own, mostly due to its size compared to CVS and WAG.  Rite Aid possesses a market cap of $4.8 billion, putting it into small cap territory.  Alternatively, CVS and WAG come in at $92.1 and $56.3 billion, respectively.

For a number of reasons (including its size and low share price), I don't see RAD finding a spot in a long-term portfolio when up against its larger brothers.  The company has struggled recently with lower profits from the sale of generic drugs and has cut future earnings forecasts.  In addition, the stock has tumbled 43% since its June highs, showing more volatility than I'd like to see.

My Prescription: buy WAG and short CVS in a basic pairs trade. Walgreen should be realizing the accretive nature of its merger soon.  The company also has incredible institutional support -- it's one of the most popular stocks among hedge funds, according to Goldman Sachs. CVS will be hurting in the short-term due to its lack of tobacco revenue.  By shorting one share of CVS for every share of WAG, an investor would enter in at a pair price around $20.

We're hoping that the stock prices converge in the near term -- three-to-six months. Less than two months ago, the pair was trading around the $5 mark. A march back in that direction would keep you hedged from the overall market while earning cash in the process.

Risks to consider:  While Walgreen and CVS have a stronghold on the retail pharmacy market, increased competition from dollar stores and smaller iterations of Wal-Mart coming to market could steal business. Be wary of those developments.

Action to take --> Turning your next retail pharmacy play into a pairs trade takes some of the uncertainty out of your position and could provide some protection if the market turns over. CVS and WAG operate similarly enough that they are often traded jointly by funds and mirroring those same moves could prove profitable for you as well.

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Eric Winter 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.