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A customer enters a Shoppers Drug Mart in Toronto on Feb. 7, 2011.

Deborah Baic/The Globe and Mail

Toronto-based Shoppers Drug Mart Corp. has been struggling to get off the critical list, but upticks in vital signs during 2011 have led to more encouraging diagnoses. Specifically, four of the 12 analysts covering the company have upgraded to "buy" over the past six months while none have downgraded. This leaves the overall distribution of recommendations at five "buys" and seven "holds."

Prior to 2008, shares in Canada's largest drugstore chain traded at a premium to the market – over 22 times the consensus in 12-month earnings projected by analysts. Shoppers was then growing at double-digit rates thanks to various strategies that included expanding store count, enlarging outlet size, and offering more cosmetics, food and other convenience items. Investors also perceived the chain's common shares as both a defensive and growth play since usage of drugs and health-care products is relatively immune to recessions, yet rises over time as the population ages.

The stock now trades at 14 times projected earnings, according to data provided by Peter Sklar of BMO Nesbitt Burns Inc. The price was swept down with the rest of the market during the last recession even though the company's earnings and dividend grew 5 per cent in 2009. The stock tumbled again when the Ontario government moved to rein in the cost of its drug plan by slashing generic drug prices (to 25 per cent of branded drug prices) and banning rebates that generic-drug makers paid to retailers for shelf space.

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With its concentration in Ontario, Shoppers' growth dynamic was hit hard. Lower generic drug profits made it more difficult to open new outlets since it would take a lot longer for them to become profitable, as Perry Caicco of CIBC World Markets Inc. has noted. And the smaller outlets would be hard pressed to recoup lost drug profits because space is limited for adding convenience items. Mr. Caicco, one of the top analysts covering Shoppers according to StarMine Inc. rankings, has an 18-month price target of $42 and a "hold" rating on the stock.

Earnings growth was set to go into reverse but management cut costs, slowed down new store openings and boosted sales of convenience items. The result was flat to slightly positive growth over the past year, which exceeded some analysts' expectations and caused them to upgrade their price targets and investment recommendations.

There were also some shareholder-friendly moves. With the scaling back of store openings, more of Shoppers' considerable cash flow from operations was freed up. Management diverted some of it toward hiking the dividend by 11 per cent in February, topping previous dividend hikes (and extending the streak to five straight years). The dividend, yielding about 2.5 per cent, is well supported by a payout ratio of 35 per cent.

Executives are also directing cash flow toward buying back nearly 9 million shares; they recently disclosed that purchases under the program would be ramped up in the second half of 2011. This "should help support the stock around current levels," indicated another top StarMine analyst, Michael Van Aelst of TD Newcrest. He has a "hold" recommendation with a 12-month price target of $44.

Short-term performance has held up reasonably well, given the considerable volatility in the broader market.

What about the longer term? There is a lot of uncertainty on this front.

Shoppers' initiative to develop private-label generic drugs under the Sanis banner looks promising – however, the Ontario government continues to fight it in the courts on the grounds it represents a conflict of interest. If the Ontario government wins its legal challenge, Shoppers will be dealt a serious blow.

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If the politicians lose, the launch of the Sanis line can go ahead and take much of the sting out of regulatory changes in Ontario. Drug manufacturing costs are low enough to yield good profit margins for a retailer like Shoppers, even when selling at 25 per cent of branded drug prices. There are also plans to distribute Sanis drugs to wholesalers, other drug stores and export markets.

A caveat is the competitive setting. Other major pharmacy chains, including those operated by Wal-Mart Canada and Loblaw Cos., can be expected to launch their own versions of private-label generic drugs.

In the other eight provinces where private-label generics are allowed, they now constitute 44 per cent of Shoppers' generic prescriptions after launching only a year ago. Nevertheless, if more provinces follow Ontario's lead in targeting drug costs, rebates and private-label generics, successes in these provinces could be limited or rolled back.

A bigger uncertainty is the ongoing search for a new chief executive officer following Jurgen Schreiber's departure in February. There were expectations a new CEO would be announced this summer but interim CEO David Williams has conveyed that it will likely take longer.

"At this stage, we would not be surprised if a new CEO is only appointed closer to year-end," Mr. Van Aelst estimates. The lengthy absence of a CEO is an issue for many investors, several analysts point out. The fear is that the company's turnaround efforts may suffer from a lack of focus or continuity.

Still, the regulatory changes bring an opportunity for Shoppers to add to its leading market share. Independently owned and operated pharmacies (half the industry total) derive an average 80 per cent of their revenue from prescription sales whereas the figure for Shoppers is 50 per cent. The smaller outfits will thus be hit harder by government restrictions and many could end up exiting the industry, leaving customers behind for Shoppers. Also, smaller drug stores and chains will likely come up for sale at good prices, presenting Shoppers with a chance to pursue a growth-by-acquisitions strategy.

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The other big drug chains, such as Jean Coutu Group Inc. and Walgreen Co., will also pick up customers from pharmacies that close down. They also want to make acquisitions as the industry consolidates. Shoppers' lack of a CEO could be a handicap in the jostling for the spoils, cautions Mr. Caicco.

"Lacking a CEO, Shoppers is not likely to participate at this level, and any action that excludes them could materially hurt the company's position in the market," he says.

RBC Dominion Securities analyst Irene Nattel, who also has a good showing in the StarMine survey, sees better times ahead: in July, she upgraded the company to "outperform" from "sector perform."

"Shoppers has managed to deliver flat to marginally higher earnings in the quarters subsequent to drug reform, implying that underlying earnings are continuing to grow by low double digits," Ms. Nattel wrote in a report. And since Shoppers has now "cycled past the most severe of the year-to-year impact" of the reforms, perhaps underlying earnings growth will become more visible in quarters ahead.

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