Activist investing and special situations for the retail side.

The Winner of the Pharma Battle Royale

Added on by Lee Ho Fook.

Be sure to check out our detailed stock analysis (click here). CVS Caremark (NYSE: CVS) and Walgreen (NYSE: WAG) are the two leaders in the pharma industry, however, the questions is, which is the better investment? A quick look at the valuation and the continued success of CVS' market share gains could mean that CVS is your best bet in the pharma industry. 

Top pick

CVS is the largest provider of prescription and related health care services in the U.S. The company has three segments, pharmacy services, retail pharmacy, and corporate. Its pharmacy services business provides a full range of prescription benefit management (PBM) services, including mail order pharmacy services, specialty, and plan design and administration. 

CVS' retail segment continued its growth last quarter, with revenue increasing 5% on the back of a 4% growth in same-store sales. This was in part triggered by the benefit from market gains due to the Express Scripts-Walgreen contract fallout. As for its other initiative, MinuteClinics, the segment posted impressive growth last quarter, up 38% year over year and adding 31 new clinics during the quarter. 

What I see as its real competitive advantage includes its pharmacy benefits management (PBM) business. Last quarter, CVS recorded performance growth for the ninth consecutive quarter in this segment. This segment, coupled with CVS' MinuteClinics, enabled the company diversify its revenue streams, which is an advantage over Walgreen. This might also be the reason for CVS' lower volatility, having a 0.8 beta compared to Walgreen's 1.0. 

The company has also been winning new clients. CVS currently has 15.8 million lives covered by over 1100 plans under the Maintenance Choice program, which is a nice increase from the 10.2 million at the end of 2011. 

Hedge funds remained relatively neutral on CVS during the fourth quarter, with a total of 45 hedge funds owning the stock, only a 2% fall from the third quarter. But this was before the company managed to post record market share gains; it will be interesting to see how hedge funds traded CVS during the first quarter of this year (see which hedge funds love CVS).

Walgreen-Express Scripts fallout

The record gain in market share for CVS comes after the Walgreen and Express Scripts(NASDAQ: ESRX) contract termination, which still appears to be a big headwind for Walgreen. CVS remains optimistic that it can retain some 60% of the prescription volumes gained from the fallout.

What's more is that of all the pharmacies snatching up Walgreen customers during the fallout, CVS managed to win the most prescriptions, an estimated 33%. This has helped move CVS' total domestic market share up to 21%. 

Even so, Billionaire Paul Tudor Jones added Walgreen to his portfolio last quarter, putting the stock as his 15th largest holding (check out Tudor's other shakeups).

Walgreen has managed to secure a ten-year primary distribution agreement with AmerisourceBergen for branded and generic products, which is expected to be a long-term positive for the company. The agreement also allows both Walgreen and Alliance Boots the right to acquire a minority equity stake in AmerisourceBergen.

As a result of the agreement, Walgreen decided not to renew its agreement with Cardinal Health, but I think the setback has created a great buying opportunity (read more about Cardinal's undervaluing)

PBM industry 

Not only does CVS compete with the likes of Walgreen, but CVS' pharmacy benefits management (PBM) segment is in direct competition with Express ScriptsHowever, this is more a benefit than a hindrance, speaking of the diversity of CVS' business model. CVS estimates that it owns 26% of the PBM market share, compared to 34% for Express Scripts. 

The real downfall for Express Scripts is the immense competition it faces in its only business line, the PBM industry. As a result, margins could come under pressure. What's more is that Express, like many PBMs, depends on a small number of customers, with its top five customers accounting for over 55% of revenue. Even still, billionaire Daniel Och added Express to his portfolio during the fourth quarter (check out Och's newest additions).

By the numbers 

From a debt load and profitability standpoint, both CVS and Walgreen are very similar; however, it's their dividend and valuation that set them apart. Walgreen does pay the more robust dividend yield at 2.3%, compared to CVS' 1.65%, but Walgreen's dividend payout ratio is double that of CVS'; Walgreen pays out 46% of its earnings in dividends, versus 21% for CVS. 

Despite Walgreen's higher dividend, CVS is much better positioned from a valuation standpoint. 

 WalgreenCVS1821 Price to earnings8.510.65EV to EBITDA

What's more is that not only is CVS the cheapest, but a look at analysts' expected growth rates puts CVS as a better opportunity at a reasonable price. CVS' PEG (price to earnings to growth) ratio is only 1.34, whereas Walgreen's is 1.64. 

Don't be fooled

Walgreen is still struggling from the Express Scripts fallout. CVS managed to snatch up market share as a result. I believe that CVS is the best positioned pharma stock, offering investors interesting exposure to the healthcare sector via pharmaceuticals, health clinics, and pharmacy benefits management