Since I first published an article that evidenced just how undervalued CVS Caremark (CVS) is to Walgreen (WAG), the former is up 10.8% while the latter is down 1.1%. In addition, CVS substantially outperformed the market and continues to be well positioned to gain relatively even more from a recovery. I find that the company is uniquely exposed to gain from the healthcare reform law and losses at Walgreen.
From a multiples perspective, Walgreen is the cheaper of the two. It trades at a respective 11.4x and 11x past and forward earnings, while offering a dividend yield of 2.7%. Meanwhile, CVS trades at a respective 16.7x and 13x past and forward earnings, while offering a much lower dividend yield of 1.6%. Even still, analysts are right to see through this and rate CVS near a "strong buy" versus a "hold" for its competitor.
At the recent third quarter earnings call, Walgreen's CEO noted challenges and dilution from the Express Scripts (ESRX) debacle .
"[W]e reported record first quarter sales of $18.2 billion, up 4.7% from $17.3 billion a year ago. First quarter net earnings were $554 million, and first quarter earnings per diluted share were $0.63. Compared to the prior year, the delay in cough/cold and flu season impacted net earnings per diluted share by $0.01, while the strategic decision to no longer be part of Express Scripts pharmacy network as of January 1, 2012, cost $0.01 per diluted share in comparable pharmacy sales and $0.01 per diluted share in related expenses. Cash flow from operations for the quarter was $809 million, and free cash flow was $309 million. We returned $803 million to shareholders in the quarter, including the largest dividend payment in the company's history, and $601 million in stock repurchases, up nearly 18% over the first quarter last year".
Comparable December sales growth of 0.4% was below the consensus of 1%, as a result of the Express Scripts transition, poor pharmacy results, and a weak start to the flu season. Traffic was soft and, if the deceleration of new store growth is any indication, penetration could be at its peak. Investors continue to be worried about reimbursement rates, as pharmacy benefits gain negotiating power and budgets are cut back. Net debt is modeled to nearly triple to $2.1B in 2014, but will be outweighed by the rise of ROIC to around 17.1%.
Consensus estimates for Walgreen's EPS are that it will grow by 2.7% to $2.71 in 2011, and then by 11.4% and 9.3% in the following two years. Assuming a multiple of 13.5x and a conservative 2012 EPS of $38.88, the company is roughly at fair value. If the economy worsens, the multiple is likely to fall to 10x and being 8.6% below consensus would erase 17.6% of shareholder value.
In light of this backdrop, CVS is the ideal pharmacy play. It acquired UAM's Part D business, which will capitalize off of the healthcare reform law. This transaction helps shift the company to a more stable older age population that is showing greater utilization rates for prescriptions. In addition to positioning itself in ideal segments, management is also committed to returning free cash flow to shareholders and has significant room to expand gross margins, which are around 740 basis points below that of Walgreen.
Consensus estimates for CVS's EPS are that it will grow by 4.1% to $2.80 and then by 15.7% and 12% more in the following two years. Assuming a multiple of 16.5x and a conservative 2012 EPS of $3.18, the rough intrinsic value of the stock is 16.5x, implying 25.6% upside. Even if the multiple were to contract to 14x and 2012 EPS turns out to be 5.6% below consensus, the stock would be roughly at fair value. Accordingly, CVS merits its near "strong buy" rating.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
