Why CVS May Be the Pick of the Pack

While Walgreen is considered the drugstore sector's blue chip, CVS has a much cheaper p-e and plenty of upside potential

By Amy Tsao

Of all retailing's niches, perhaps the strongest is drugstores. After all, aspirin, toothpaste, and hair-brush sales are hardly cyclical. Plus, aging baby boomers and their increasing use of prescription drugs have been -- and will remain -- a lucrative market for national chains such as Walgreen (WAG ), CVS (CVS ), Rite-Aid (RAD ), and Eckerd, which is owned by J.C. Penney (JCP ).

For years, Walgreen has been the drugstore group's only true blue chip, the others having seen their share of missteps. Rite-Aid is still recovering from a 1999 accounting fraud scandal, while Eckerd has struggled to maintain sales growth, according to some analysts.


  What about CVS? Technically, it's the largest drugstore chain, with 4,100 outlets nationwide. That puts it just ahead of Walgreen, which boasts 4,029 stores (but plans to operate 7,000 by 2010).

Where CVS trails significantly behind its smaller rival is in sales and earnings -- partly the result of a spate of recent troubles. In the third quarter of 2001, CVS disclosed a shortage of pharmacists, glitches with implementing a pharmacy workflow system, inadequate inventory management, and increased store theft. In 2002, it embraced a painful remedy by closing 229 stores, a distribution center, and a mail-order facility.

That doesn't mean CVS is necessarily a lousy investment. The reason: It strikes some analysts as a steal compared to its competitors. At $26.60, or 13.9 times 2003 earnings-per-share expectations, CVS is trading at less than half Walgreen's price-earnings ratio of 30. Compared to Rite-Aid and Eckerd, CVS looks like the "lower-risk value name in the group," says Tim Ghriskey, head of investment advisers Ghriskey Partners in Bedford, N.Y. "If you're looking for exposure to [drugstore stocks] but want to buy it wholesale, CVS seems to be the way to go."


  The Woonsocket (R.I.)-based outfit appears to be making the right moves. Operating margins improved to 9.6% in 2002, from 8.2% in 2001, and execs say they should be better still in 2003. In the recent quarter, CVS says it decreased theft. And over the past year, it has hired additional pharmacist technicians and implemented an inventory-management system. "They have a lot more room for improvement," says Joe Agnese, industry analyst at Standard & Poor's, noting that the stock is trading close to historical lows. He recently reiterated CVS's 5-STARS rating, or strong buy, S&P's highest.

Drugstores are measured by both performance of the prescription business and the so-called front end -- sales of consumer goods not related to pharmaceuticals. Walgreen has been turning in stellar results in both departments, but CVS's numbers haven't been too shabby, either.

First-quarter earnings, released on May 6, matched analysts' consensus expectations. Sales at CVS stores that have been open for at least a year rose 3.9% quarter-to-quarter. Pharmacy sales in the first quarter were up 7.1%. The one not-so-bright spot: Nonpharmacy was down 2.7%. But Agnese says it appears to be stabilizing. And CVS generates 68% of sales from its less economically sensitive pharmacy departments, vs. Walgreen's 60%.


  Some analysts express frustration that the chain isn't more focused on expansion. "CVS has been trying to protect share, not grow share," says Morningstar's Tom Goetzinger. This year, it will add about 125 stores, while Walgreen plans to open 325. Goetzinger, who still prefers Walgreen at around $33 over CVS, notes that CVS has an uphill battle to prove it can match Walgreen on sales and earnings consistency.

Over the last decade, CVS achieved its current size mainly with large acquisitions, notably its 1997 purchase of Revco and the 1998 pickup of Midwest chain Arbor Drugs. Now, it has to show that it can grow by expanding its roster of stores and increasing productivity. Says Goetzinger: "That's tricky because you don't make a profit on day one."

Not to worry, CVS officials say. By 2005, they intend add from 400 and 450 new stores. "You'll be seeing us move into tremendously fruitful areas where we haven't even existed before," promises spokesman Todd Andrews. Over the next several years, CVS hopes to reap big gains in high-growth markets such as the Phoenix and Las Vegas metropolitan areas, Central and Southern Florida, and Texas.


  In the long-term, CVS and its drugstore brethren will have to adapt to a more competitive marketplace, as retail supercenters from Wal-Mart (WMT ) and Target (TGT ) pop up across the American landscape. Also, supermarkets, Web sites, and mail-order outfits are joining the fray. "Pharmacy has carried the business, but it's under attack," notes retail consultancy Retail Forward.

In response, watch for drugstores to add more health-care-related services and to increase emphasis on quick-stop convenience shopping. Catching up with Walgreen will surely be difficult. But CVS has the potential to close the gap. And that might make it shares seem like pain relievers.

Tsao covers financial markets and health care issues for BusinessWeek Online in New York

Edited by Douglas Harbrecht

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