A prescription for drugstore investors

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Much of the talk this week around the tie-up between Loblaw Cos. Ltd. and Shoppers Drug Mart Corp. revolved around the benefits of having more groceries in the drugstore and more cosmetics in the grocery.

It's a distracting message for investors. The real reason to buy the shares of North American drugstore chains is, after all, the drugs – a growing and profitable business, especially at a time when the number of elderly Canadians and Americans is growing rapidly.

The Loblaw-Shoppers merger underscores the enormous appeal of pharmacies. CIBC analyst Perry Caicco, who suggested the deal in a February report, says an acquisition of Jean Coutu Group Inc. by Metro Inc. also makes sense.

The problem is cost. Merger fever has driven the shares of Coutu, already the most expensive of the five North American drugstore chains, to new heights, above the earnings multiple Shoppers just fetched.

Investors who want a piece of the drugstore action would be well advised to take their eyes off the Canadian market and look south of the border, where pharmacy chains trade at much lower valuations than here. What's more, U.S. druggists are likely to benefit in coming years from tens of millions of new customers, courtesy of the Affordable Care Act, known colloquially as ObamaCare.

Once the new act takes effect, Americans will "presumably start buying more drugs, so you should get a volume benefit from that next year," says analyst Jeffrey Jonas of Gabelli & Co. Inc. "And there's no new taxes, no new regulations for the pharmacies, no negatives – they're winners. We don't know the exact magnitude, but we know they will benefit from this."

While the two Canadian drugstore chains trade for more than 11 times their EBITDA, or earnings before interest, taxes, depreciation and amortization, their three U.S. counterparts change hands for no more than 8.8 times EBITDA, according to S&P Capital IQ.

That makes shares of Rite Aid Corp., CVS Caremark Corp. and Walgreen Co. look like relative bargains. There are clear differences among the U.S. chains, however.

Rite Aid, is the smallest and most troubled of the trio. Investors may still remember its accounting scandal from over a decade ago. While that's ancient history, the debt load is not, and the company's profit for the fiscal year ended in March was its first annual profit since 2007.

However, William Frohnhoefer of "special situations" firm BTIG LLC argues Rite Aid will benefit more from the Affordable Care Act than its larger rivals. "One of the knocks on Rite-Aid has been not only that it's regional, but also that it tends to be located in lower-income Zip codes of the U.S. The view is CVS and Walgreen are more upscale because they're distributed across all income zones."

But with its presence in low-income areas, Rite Aid is the local pharmacy for many of the millions of people who will get drug benefits under the new law. "What you're doing is accessing a large, underserved part of the U.S. population coming into a drugstore, maybe for the first time. Rite-Aid will capture more than their fair share of those customers."

If you don't feel like betting on Rite Aid's resurgence, look at its larger and more consistent rivals.

CVS Caremark gets the latter portion of its name from Caremark, a pharmacy benefit manager, or PBM, it acquired in 2007. PBMs process and pay prescription drug claims for insurers or employers. In the "traditional" model Caremark uses, the PBM negotiates a discount on the prices of drugs, marks up the cost to its client, and can also take an additional per-prescription fee.

John Ransom, an analyst for Raymond James, says the PBM business adds a nice element of stability to CVS's earnings. As branded drugs face increasing competition from generic rivals, the sellers of those drugs will face revenue pressures.

But PBMs have what Mr. Ransom calls "all-cycle" profits as drugs move from branded to generic.

In addition, a PBM can provide a boost to drugstore sales since one of its tasks is to compile a list of pharmacies that can fill prescriptions for the consumer. Caremark, as it happens, includes its CVS retail locations on those lists of preferred locations. "If they can move 10 per cent of the members from other people's drugstores into their own, instead of making $2 for paying the claim, they can make $15 on filling the prescription," Mr. Ransom says. "It's a much higher gross profit, in dollars, if you can move them into their stores."

Walgreen illustrates the perils of not owning a PBM. It got into a pricing dispute with Express Scripts, one of the largest PBMs in the United States, and lost a relationship that brought it an estimated 80 million annual prescriptions. The two mended fences and resumed a relationship last year, but Walgreen is still showing the effects in its store traffic and financial metrics, Gabelli's Mr. Jonas says. "People form habits, and had been going to other pharmacies for a year. It's hard to get them to change back."

Walgreen, however, has moved ahead of CVS Caremark in valuation. Investors are growing excited about its deal to acquire Alliance Boots GmbH, a company with a dominant position in the U.K. and toeholds in a number of emerging markets. The plan is to market the combined entity as "Earth's Drugstore."

In addition, Walgreen and Alliance Boots struck a deal with drug distributor AmerisourceBergen that will likely make the combined company the largest buyer of generic drugs in the world.

According to Mr. Jonas's estimates of future earnings, Walgreen now trades for 10.5 times EBITDA, while CVS Caremark is at 8.5. He favours CVS because it is "not quite as expensive, they have a much better management team, and they've finally gotten this PBM right." (The difference between the two companies' valuations is much smaller when consensus earnings estimates are used, as S&P Capital IQ does.)

Mr. Ransom, of Raymond James, likes all three chains for different reasons. He says CVS "has a track record of beating earnings, it's a better business model, a better earnings story over the next two years – it's a very consistent company."

But Walgreen, he says, is intriguing because of the Alliance Boots deal. "You've got a struggling company in turnaround mode that could get a huge reset in earnings from this deal. It may not hit every last number they've said, but we think the deal will work."

Editor's note: The original newspaper version of this article and an earlier online version should have included David Milstead's disclosure that he owns shares of two of the companies mentioned, CVS Caremark Corp. and Walgreen Co.