The 2008 Select List report has been released. Same format as the prior two years, 10 stocks, one from each of the S&P’s sector groups (financials, energy, tech, telco, materials, utilities, industrials, healthcare, staples, discretionary). To give you all a sneak peak, let me go into some detail about one of the areas I think is ripe for investment right now.
Last week the major drugstore chains saw their share prices get whacked after less than exciting same store sales numbers. If we ignore the short term monthly and quarterly fluctuations, I think the drugstore area is attractive for long term investors. Let me explain why.
The way I see it, drugstores are a combination play on the healthcare and consumer staples sectors. Both of these areas stand to benefit in a cautious market environment, which we clearly are facing right now. While drugstores will likely feel less of a reduction in consumer spending than a discretionary retailer (think clothing, electronics, travel vacation, etc) would in times like these, I think the bigger advantage to these stores is how they are positioned to capitalize on opportunities in the pharmacy business. There are two ways the pharmacy business is poised for strong growth.
First, the aging of and growth in the overall population is the more obvious one. As the country’s population continues to grow and get older as baby boomers reach retirement age, the demand for prescribed medications is only going to accelerate. This is certainly going to help the major drugstore chains on the volume side.
Second, the shift from brand name drugs to generics helps the pharmacies, while at the same time hurting the large pharmaceutical companies. From a business perspective, generic drugs are far more profitable for pharmacies than brand name drugs are. This might be counterintuitive since branded drugs can cost several dollars per pill and generics can now be had for as low as $4 for a 30-day supply. However, the markups on generics far exceed those of more expensive branded drugs. So, while sales in dollar terms will decline with expanded use of generics, profit margins (what investors should really care about, despite an obsession with same store sales on Wall Street) will expand, leading to earnings growth far exceeding revenue growth.
If we look at the demographic makeup in this country over the next five or ten years, and combine that with the patent expiration outlook for the large drug companies, I can’t help but get excited about investing in the drugstore sector (which has been beaten up lately and no longer commands a premium valuation), which is why I chose one for the consumer staple slot in this year’s Select List.
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True that generics carry higher margins than branded drugs. But also keep in mind that >90% of prescription drugs are paid for by third parties (Medicare Part D, private health insurers etc.) These 3rd party payers are looking at those gross margins on generics, sometimes as high as 50-70%, and thinking that’s an easy place to cut fat by squeezing the pharmacy chains and generic makers on reimbursements. And wait until the politicians or a new Democrat president takes aim. About 2/3 of the drug chains revenues come from the pharmacy counter (at least that’s the figure at Walgreen’s). That’s a big chunk of revenues with a big target on it. WalMart is also taking aim. Despite the pounding, I’d say the drug chains are about fairly valued now based on future cash flows, maybe slightly undervalued – I peg WAG at worth $38, not sure which stock is on your select list. If you wait, I believe you can get them cheaper.