A Far Cry from the Five and Dime

05/13/2013 7:45 am EST

Focus: STOCKS

This company is ushering in a new era for drugstores, says John Persinos of Personal Finance.

Walgreen (WAG) operates the largest chain of drugstores in the US, with over 8,000 freestanding locations throughout all 50 states, the District of Columbia, and Puerto Rico.

An improving job market and resurgent household wealth are lifting consumer spending, resulting in greater business in the pharmacy and at the merchandise cash register. The stock also serves as a defensive consumer sector play, if the market stumbles this year.

The Patient Protection and Affordable Care Act (PPACA), commonly called Obamacare, is another tailwind for Walgreen, as retail pharmacies get ready to serve an estimated 32 million newly insured Americans.

Prescription drugs comprise about two-thirds of Walgreen's sales. The remainder stems from general merchandise, cosmetics, over-the-counter medications, and groceries. The company also provides pharmacy management services for complex health conditions.

Walgreen is implementing a merchandising and remodeling overhaul to create "all-in-one" stores that are boosting sales, reducing overhead costs, and enhancing the overall shopping experience.

This strategy is transforming drugstore retailing by integrating products and services to create an ambiance for shoppers. For example, store sections devoted to beauty products also offer onsite professional manicures.

With a current dividend yield of 2.25%, the company has paid a dividend in 322 straight quarters—amounting to more than 80 years—and has raised its dividend for 37 consecutive years.

Walgreen is well positioned to benefit from the generic alternatives that will flood the market in coming years as patents expire on blockbuster drugs. For drugstore chains such as Walgreen, generic prescriptions provide less revenue than branded drugs, but they're roughly twice as profitable.

Walgreen's second-quarter earnings were $915 million, for earnings per share (EPS) of 96 cents, compared with earnings of $767 million or 88 cents in EPS in the year-ago quarter. Walgreen boosted its retail prescription market share 50 basis points compared to the first quarter.

Walgreen enjoys several advantages over its main rivals, CVS Caremark (CVS) and Rite Aid (RAD), as it continues to reap efficiencies from shrewd strategic partnerships and global expansion.

Last year, Walgreen bought Alliance Boots, a chain of pharmacies in the UK and health and beauty retail stores in 11 countries. That deal vaulted Walgreen to the position of world's largest pharmacy chain.

In March, Walgreens and Alliance Boots signed a ten-year deal with wholesale pharmaceutical distributor AmerisourceBergen (ABC), one of the world's largest providers of pharmaceutical services for physicians, hospitals, and drugmakers. This will allow Walgreen to generate even greater supply chain efficiencies, as well as expand its footprint in fast-growing overseas markets.

Walgreen is now in a position to buy generic drugs cheaper than anyone else—and also to sell them for cheaper.

To be sure, Walgreen took a huge $4 billion hit to revenue as a consequence of its bitter 2012 breakup with Express Scripts (ESRX), a pharmacy benefits manager (PBM). More than 210 million Americans now fall under the purview of a PBM, which is a third-party administrator of prescription drug programs.

Walgreen argued that Express Scripts, the nation's largest PBM, wouldn't pay adequate drug reimbursement rates. However, the contract dispute is now settled, and the two companies last year inked a new deal that puts Walgreen back into the rapidly growing PBM field.

Shares of Walgreen sport a trailing 12-month price-to-earnings (P/E) ratio of 21.8, which seems pricey when compared to the trailing P/E of 16.9 for the drugstore sector. But Walgreen's relentless march into promising new regions makes its stock price reasonable for patient investors. And the robust dividend yield is the right prescription.

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