Underreported Potential Windfall for Largest Drug Store Chains

Bloomberg.com is running a story about an underreported potential windfall for the nation’s largest drug store chains Walgreen (WAG) and CVS Caremark (CVS). The reason for the optimism is the end of patent protection for the world’s two best selling drugs Lipitor and Plavix. Soon after blockbuster drugs lose patent protection is a very profitable time for drug stores as they have more control over pricing, and even though generic drugs are cheaper than branded drugs, they generally provide better profit margins for the pharmacies. According to the article, pharmacies pay 90% less for the generics, but do not pass all of those savings on to end consumers.

Bigger and Longer

The last large wave of patent expirations came in 2006 and 2007, when branded drugs generating sales of $43 billion faced generic competition, according to Norwalk, Connecticut-based IMS Health Inc., a market research firm. That helped boost CVS earnings per share by 20 percent in 2007 and Walgreen’s by 19 percent in the fiscal year that ended in August 2007.

“This cycle is bigger and it’s longer” than the introduction of generic drugs in 2006 and 2007, Taner, the Invesco fund manager, said in an interview. Invesco increased its holdings to 5.68 million Walgreen shares and 5.96 million CVS shares as of Sept. 30, according to Bloomberg data.

CVS and Walgreen will also benefit because they have expanded in recent years, gaining pricing power, said Massey, the SunAmerica investor. Still, prices pharmacies pay for drugs won’t drop as much in the next cycle because there are fewer manufacturers as a result of mergers. — Bloomberg.com 2/5/2010

Current analysts’ estimates call for CVS to grow earnings by 11% in 2011 and 14% in 2012, and Walgreen is expected to grow at 17% in both years. However, judging by the explosive earnings growth of the last major wave of generics, even those impressive estimates may be too tame. All other things being equal, earnings growth of this magnitude would surely drive both stocks higher.

Generic alternatives for Lipitor and Plavix will not be available and therefore accretive to earnings until early 2012 at the earliest. Even at current estimates for forward-looking earnings, we think both of these stocks are Undervalued at the current price level. We selected WAG as one of our Five Blue Chips Fit For Ben Graham when asked to do a special report for Forbes.com early last September, and the stock’s price is at about the same as it was then. At that time, we were not aware that the new wave of generic drugs was as promising as it appears to be, and we continue to believe that both of these stocks have substantial value to investors. Both stocks have sold off heavily in the past three trading sessions which generally makes these stocks even more attractive to long term, value investors.

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