From the June 2007 issue of Research Magazine • Subscribe!

The Right Prescription

As baby boomers age, drug retailers should see rising pharmacy use and growing sales in coming years, analysts say.

John W. Ransom

Raymond James Associates

727-567-2593

John.Ransom@RaymondJames.com

Area of Coverage: Retail Drug Stores

Industry Outlook: Overall, we continue to expect a strong 2007 for the drug store chains, as the majority of perceived headwinds that had weighed on shares late last year have proven to be only modest threats against more positive catalysts, such as continued growth in generic drugs, Medicare Part D utilization, relatively stable reimbursement and company-specific efforts to boost front-end profitability.

Furthermore, the drug store chains have typically been perceived as viable defensive investments, and as such, we should expect strong performance from the group even as broader uncertainties over the health of the economy begin to resonate.

Strong Buy: CVS Caremark (CVS)

About CVS Caremark: While our investment outlook is generally positive for the group, we continue to recommend shares of Strong Buy-rated CVS Caremark due to its strong same-store sales growth, potential upside to 2007 earnings estimates driven by the integration of the 701 acquired Albertson's drug stores, final turnaround at the roughly 1,100 Eckerd stores acquired in August 2004, and, of course, the anticipated synergies from the Caremark merger.

Looking at Albertson's, management met expectations of $0.10-$0.12 per share dilution from the transaction in 2006 and should experience modest accretion in 2007, aided by strong top-line opportunities, purchasing synergies, shrink improvement, and the rollout of the company's extensive health and beauty product offerings to the new stores.

Other longer-term catalysts include the investment in Minute Clinics, which are expected to be a $0.05 drag on 2007 EPS, but should encourage customer growth and, we believe, could bring future benefits through the prescription benefit manager, PBM, or specialty offerings. Of course, while there could be some immediate uncertainty at the PBM as Caremark's major contracts come up for renewal, we believe that the strategic opportunities presented by the combined company will likely encourage growth at Caremark over the next several years. Finally, CVS shares trade at a compelling valuation, at about 16.2 times 2008 EPS, the cheapest in its peer group.

Outperform: Walgreen Co. (WAG)

About Walgreen: We also remain positive on our 2007 and longer-term outlook for Outperform-rated Walgreen, given its stellar track record, sustainable 8-9 percent annual organic square-footage growth (2007 guidance calls for 400 net new stores), the potential for gross margin improvement through higher generic penetration and better front-end performance, and increased focus on ancillary healthcare services such as home infusion, home health, and specialty pharmacy services (illustrated by its recent roughly $69 million acquisition, including working capital, of specialty pharmacy operator Familymeds). Furthermore, Walgreen has low exposure to high-risk Medicaid states including New York, New Jersey, and Pennsylvania, which should help insulate the company from Medicaid Rx cuts.

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Steve West

A.G. Edwards

314-955-6531

Area of Coverage: Retail Drug Stores

About CVS Caremark: CVS Caremark is the country's largest drugstore chain in terms of store count with about 6,200 drug retail locations and an estimated $49 billion in FY07 sales; combined with one of the largest PBMs in the country, this company has remade itself into a health-care powerhouse, which should generate $75 billion in FY07 revenues.

Typically, large-scale acquisitions involving under performing assets take more time than expected to reap the synergies/benefits. CVS is on track to achieve predicted synergies ahead of schedule from the Albertson's acquisition, just as they did with Eckerd. The store remodels, information technology integration, and pricing and product mix overhaul have all been virtually completed.

With the Eckerd acquisition in the bag and Albertson's almost there, CVS moves forward to replicate this success with the recently acquired PBM -- Caremark.

With the aging of the baby boomers, drug retailers stand to benefit from a demographic shift that will increase prescription drug utilization in the years to come.

With the Eckerd and Caremark acquisitions, we are concerned with the balance sheet going from a conservatively financed machine to a highly levered, higher risk profile. Through CVS' recent progress on working capital and the addition of the Caremark PBM, this company could prove to be a cash-generating machine and get the balance sheet back into shape in relatively short order.

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