Drug Retailers' Winning Formula

S&P thinks big drug retailers will continue to thrive despite the poor economy, and ranks CVS Caremark as its top pick in the group

By Sam Stovall From Standard & Poor's Equity Research

S&P 1500 Drug Retail Index vs. S&P 1500 as of 1/23/09

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While flipping through my relative strength charts, I stumbled across a constructive-looking one for the S&P 1500 Drug Retail subindustry index. Its relative strength level is above 100, indicating that its performance over the past year has beaten that for the overall market. Indeed, during the past 52 weeks, this group declined 20.2%, vs. a 37.2% tumble for the S&P Composite 1500. In addition to an encouraging chart, I noticed that the group's S&P STARS ranking is 4.2 out of 5.0, which is very favorable, and the S&P equity analyst who covers this subindustry has a positive outlook on the group.

Whenever I go three for three on anything, I am very pleased.

Take a look at the accompanying chart. As a reminder, the jagged blue line represents the subindustry index's rolling 52-week price performance as compared with the 52-week performance for the S&P 1500. Any point above 100 indicates market outperformance over the prior year, while points below 100 indicate market underperformance. The red line is a rolling 39-week moving average, while the two green bands indicate one standard deviation above and below the index's long-term mean relative strength.

Positive Fundamental Outlook

There are two large-cap stocks in the S&P 1500 Drug Retail subindustry index: CVS Caremark (CVS) and Walgreen Co. (WAG).

Joseph Agnese, who follows this group for S&P, has a positive fundamental outlook for the Drug Retail subindustry for the next 12 months. Agnese believes benefits from favorable demographic trends, industry consolidation, and improving merchandise offerings will lead to increased traffic, higher average basket sizes, and wider margins, despite an adverse economic environment and competition from nontraditional retail formats. S&P believes national chains are well positioned as their pharmacy departments continue to gain in importance, with prescription sales increasing in the mid-single digits on a comparable-store basis and approaching 70% of total sales.

In addition, Agnese thinks front-end (non-pharmaceutical) sales trends at national chains are better positioned to compete against alternative formats due to better customer service levels and improved merchandising.

Despite increased price competition from discount retailers, Agnese believes prospects are bright for 2009, as national chains continue to differentiate merchandising through exclusive product offerings and to improve the convenience of their stores through the expansion of store hours, increased number of stand-alone locations, and additional drive-thru service. As a result, S&P thinks stronger front-end business will reduce gross margin pressure, since such items typically carry wider margins than pharmaceuticals.

Margin Benefits

However, prescription volume growth may remain weak in 2009, according to Agnese, with flat to low single-digit growth, as consumers continue to stretch prescriptions, skip doses, and split pills in an effort to save money in an adverse economic environment. Although he expects prescription sales to be negatively affected by increased conversion to generic drugs from branded drugs, the analyst expects profitability to benefit, as generics carry wider margins than the branded drugs they replace. Additionally, while S&P sees in-store health clinic offerings as a long-term traffic driver that will help drive both prescription and front-end sales, Agnese does not see any positive contributions from them in the near term.