With the Supreme Court's decision to uphold the constitutionality of the Affordable Care Act, pharmacies are well positioned to benefit from greater insurance coverage. In some instances, like Walgreen (WAG), pharmacies are undervalued while in others, like CVS (CVS), they are mostly priced on growth expectations. Rite Aid (RAD), which has been bleeding cash, is also trumpeted as a "turnaround play". Below, I review the fundamentals and growth expectations of each company.
Walgreen is currently cheap at a respective 10.5x and 10.4x past and forward earnings with a generous 3.6% dividend yield. Moreover, growth has not been fully factored into the stock price given that the PEG ratio is below 1.
Analysts expect 2013 EPS to be $2.93 and grow 11.3% annually in the near-term - in-line with the past 5 year's historical average. That means 2016 EPS of $4.04, which, at a 14x multiple, translates to a future stock value of $56.56. Discounting backwards by 9% yields a price target of $36.76 for more than a 20% margin of safety. This isn't incredible risk/reward, but it nevertheless strong enough for a "buy" recommendation when coupled with the 3.6% dividend yield.
The firm has an excellent economic moat with around 8K stores in the United States and the possession of valuable eCommerce sites, like Drugstores.com, VisionDirecto.com, and Beauty.com. Competitor CVS started to gain an edge after losing the Express Scripts' (ESRX) network, but the discount to CVS's valuation is unreasonable. It is unreasonable, since Walgreen has taken meaningful steps to address the issue, such as working with other PBMs. Moreover, Walgreen has consistently risen dividends over nearly four decades and is a free cash flow machine.
CVS is meaningfully more expensive than Walgreen at a respective 18x and 13x past and forward earnings with a PEG ratio of 1.5. It also has a much lower dividend yield of 1.4% but comes with the benefit of lower volatility. Analysts expect the pharmacy to generate slightly higher earnings growth than its competitors at 11.9% over the next 5 years. Assuming a 14x multiple and a discount rate of 10% under those assumptions, CVS is worth $45.14 in present terms - slightly less than the current market value. Accordingly, the market sees growth being greater than expectations at the standard 10% discount rate.
Is the consensus 11.9% EPS growth figure over the next 5 years too low? Over the past 5 years, CVS only grew EPS by 10.1% annually. Going forward, it will be a beneficiary of health reform and drug innovation. As large biotech and pharmaceutical companies undergo patent cliffs, more generics will come out and there will be greater pressure for R&D. Under this environment, I agree with the market's perception that 11.9% growth forecasts are too low. Accordingly, I anticipate CVS to outperform from rising expectations.
Rite Aid is worth only a fraction of CVS and Walgreen but has a strong physical presence with more than half (4.7K) the number of stores that Walgreen has. Losses have declined from more than $2.9B in 2009 to less than $369B in 2012. Shareholder value has been justly rewarded with the stock tripling from the start of June to today. At the same time, Rite Aid has dramatically underperformed peers over the last three quarters with a 16.1% drop in value versus a 8.4% drop for Walgreen and a 10.2% rise for CVS.
Shares are highly volatile and any signs of a takeover or quicker-than-expected turnaround will drive outperformance. As it stands, Rite Aid is a valuable brand with excellent performance relative to consensus. In fact, the company has beaten consensus by an average of 43% over the last 5 quarters. EBITDA growth is accelerating largely thanks to the success of generics and Wellness+. Same-store sales were weak in June, but this was due to poor timing with the July 4th holiday.
I also believe that risk factors, such as pharmacy reimbursement pressure and intense retail promotions, have been overblown. Healthcare consumers place a lot of emphasis on convenience, so the Express Scripts-Walgreen debacle will help Rite Aid improve its competitive edge.
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.