Why Drugstore Chains Are In Good Health

Toothpaste and prescriptions aren't glamorous, but they've helped top drugstore-chain stocks outperform the Standard & Poor's 500-stock index by about 100% over the past five years. Mergers generated most of the big gains, but analysts aren't abandoning the sector, even though the pace of consolidation may slow. They note that an aging population is buying more drugs, often paid for in part by managed-care plans. Drugmakers have also been investing in new drugs and boosting advertising. Indeed, 2.6 billion prescriptions were filled in 1997, up 29% from five years ago, reports the National Association of Chain Drug Stores.

Rising sales and profits from expansion have helped push price-earnings ratios of the top drug chains--Walgreen, CVS, and Rite Aid--to about 30 times estimated 1998 earnings (table). That compares with 23 for the S&P. But "I don't see anything keeping them from continuing to outperform," says Jonathan Ziegler, retail analyst at Salomon Smith Barney.

Mergers have hit the industry with sudden force. Just over a year ago, CVS was the fifth-largest drug chain, by number of stores. It shot to No.1, with 4,100 outlets nationwide, after buying Revco D.S. for $2.8 billion in stock and Arbor Drugs for $1.48 billion in stock in February. No.2 Rite Aid, many analysts' current favorite, is close behind. After buying Thrifty Payless, it now runs nearly 4,000 stores. Merger mania is also pushing up prices of the remaining midsize chains. Shares of Longs Drug Stores, headquartered in Walnut Creek, Calif., have been edging up amid takeover speculation. And Genovese Drug Stores, based in Melville, N.Y., has jumped 19%, to 22 3/4, since Mar. 20 despite lower-than-expected 1997 fourth-quarter earnings. Analysts say Genovese management isn't interested in selling, and the obvious buyers, CVS or Rite Aid, are still digesting acquisitions.

Genovese is likely to be a victim of the titans, though, since the next drugstore battleground is New York City, where CVS has been aggressively opening stores. Duane Reade, which dominates the market with an 18% share, made an initial public offering in February to pay debts from a failed leveraged buyout. The chain's shares jumped 31%, to 22 3/4, the day of the IPO amid rumors CVS might buy the chain. Both companies denied the tale, and Duane Reade's shares have been flat since then.

The one chain that has eschewed acquisitions, Walgreen, is doing well by sticking to a strategy of growing by building its own stores. It recorded income of $171 million for the quarter ended Feb. 28, up 16% from a year ago, on revenues of $4 billion. Whether they do it via mergers or expansion from within, however, drugstore chains need to grow to survive. Increased size allows them to market more efficiently and gives them an advantage in negotiating with health-care plans on prescription prices.

One reason many independents and smaller chains have folded is that the plans have forced down gross pharmacy margins from 40% five years ago to 20% now. That decline seems to be bottoming out as the bigger chains fight back. In Boston, Phoenix, and Detroit, for example, big chains now claim 40% to 50% of the market. "That negotiating leverage has helped stem the erosion in margins," says Ramin Arani, who runs the Fidelity Select Retailing Portfolio. To be sure, the chains would suffer in any economic slowdown, but analysts think they would fare better than other retailers. Prescription drugs and toothpaste aren't optional for consumers--or some investors.

    Before it's here, it's on the Bloomberg Terminal.