Markets & Finance

Time to Prescribe Drugstore Stocks?


With favorable momentum trends and solid industry fundamentals, S&P says shares should continue to perform well

From Standard & Poor's Equity ResearchThe Standard & Poor's 1500 Drug Retail subindustry index recently saw its relative strength ranking (RSR) rise to three from two, indicating that its trailing 12-month price performance is now in the middle 40% of all 136 subindustry indexes in the S&P 1500 (it had been in the lowest 30%). Year to date through May 31, the S&P Drug Retail Index gained 10.9%, vs. an 8.5% gain for the S&P 1500. In the past 13 weeks, this subindustry index gained 11.9% compared to the market's climb of 8.8%.

Take a look at the accompanying chart of this subindustry index's rolling 12-month price performance compared with that for the S&P 1500. Any point above 100 indicates sector outperformance vs. the S&P 1500 over the prior year, while points below 100 show sector underperformance. The red line is a rolling nine-month moving average, while the two green bands indicate one standard deviation above and below the index's longer-term mean relative strength.

There are three companies in the S&P Drug Retail subindustry index: CVS Caremark (CVS), ranked 5-STARS (strong buy), and Longs Drug Stores (LDG) and Walgreen (WAG), each of which is ranked 4-STARS (buy).

Rise of the National Chains

Analyst Joseph Agnese, who covers the group for S&P, has a positive fundamental outlook for the subindustry. He believes benefits from favorable demographic trends, increased sales of generic drugs, industry consolidation, and improving merchandise offerings will lead to increased traffic trends, higher average transaction sizes, and wider margins.

Agnese believes national chains are well-positioned as their pharmacy departments continue to rise in importance, with prescription sales as a percentage of total sales approaching 70% and increasing in the midteens overall. In addition, front-end (nonpharmaceutical) sales trends at national chains continue to improve, on better customer service levels and improved merchandising, in S&P's view. However S&P believes that shares of regional chains, which derive a majority of their sales from nonpharmacy items, may be pressured by intense competition from both national chains and other retail formats.

Despite increased pricing competition from discount retailers, Agnese believes prospects are bright for drug retailers in 2007, as national chains continue to improve the convenience of their stores through the expansion of store hours, an increased number of standalone locations, the addition of drive-through pharmacies and in-store digital photo-finishing capabilities.

Wal-Mart Effect

As a result, S&P believes stronger front-end business should reduce gross margin pressure, since such items typically carry wider margins than pharmaceuticals. Profitability should also benefit from increased sales of generic drugs, which carry wider margins than the branded drugs they replace.

Agnese believes significant prior underperformance reflected investor uncertainty regarding a new pricing strategy implemented by Wal-Mart Stores (WMT). However, due to the large role played by third-party payers in the retail drug industry, and S&P's belief that the program's goal is to generate positive media for the discounter, Agnese thinks this new pricing program is likely to have only a minor impact on drug chain pricing and demand. As a result, S&P looks for improving retail drug valuations in the coming 12 months.

So there you have it. The group's longer-term momentum is firm by S&P's analysis, and the group's overall fundamental outlook is positive, indicating that from fundamental and momentum perspectives, this subindustry index should continue to see strong price performances in the period ahead.

Industry Momentum List Update

Here is this week's list of the industries in the S&P 1500 with RSRs of 5 (price performances in the past 12 months that were among the top 10% of the 136 subindustries in the S&P 1500), along with a stock that has the highest S&P STARS rank (tie goes to the issue with the largest market value).

Subindustry

Company

S&P STARS Rank

Price (6/1/07)

Apparel, Accessories

Quiksilver (ZQK)

5

$14

Commercial Printing

R.R. Donnelly (RRD)

4

$43

Computer Hardware

Apple (AAPL)

4

$118

Construction & Engineering

Jacobs Engineering (JEC)

5

$59

Construction Materials

Vulcan Materials (VMC)

2

$122

Consumer Electronics

Harman Intl. (HAR)

4

$118

Diversified Metals & Mining

Freeport-McMoRan Copper (FCX)

3

$80

Fertilizers & Agr. Chem.

Monsanto (MON)

3

$62

Footwear

Nike (NKE)

4

$57

Integrated Telecom. Svcs.

Citizens Communications (CZN)

4

$16

Internet Retail

Amazon (AMZN)

2

$69

Metal & Glass Containers

Ball Corp. (BLL)

4

$56

Steel

U.S. Steel (X)

4

$117

Tires & Rubber

Goodyear (GT)

2

$36


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