Here’s Why Pharmacy Stocks Are a Bargain Right Now

So why pharmacy stocks are a bargain right now?

My investment management firms portfolio has a large position in the healthcare sector and with AB fees sixty three billion dollar takeover bid for allergen earlier this week it’s timely to review why we bought into this sector without commenting on allergen shares of which we own or AbbVie which we do not healthcare companies in general are non cyclical health care consumption is stable and independent of the whims of the global economy the world’s population is aging rapidly and as people get older they consume more healthcare services this creates a strong tailwind these are good businesses in general they have solid balance sheets above average returns on capital and they generate a lot of cash which is used to pay dividends and buybacks stock these defensive features have not mattered much lately as we’re entering the tenth year of uninterrupted economic expansion accordingly these companies are significantly undervalued how undervalued let’s answer that question by examining two stocks in our portfolio in closer detail we’ll start with McKesson the media mainly 60 minutes has likened drug distributors exposure to opioid lawsuits to Philip Morris International ‘s 150 billion-dollar tobacco settlement yet comparing Philip Morris to drug distributors makes no sense the job of these well-regulated companies is to deliver fda-approved drugs produced by FDA approved manufacturers and sold by DEA than his Drug Enforcement Administration approved pharmacies the opioid crisis in the u.s. is a true tragedy but drug distributors are not responsible for it an important point to remember when you read another heartbreaking article the most likely conclusion to this Fiasco is that drug distributors will either settle these lawsuits for a few billion dollars collectively keep in mind McKesson learns more than three billion dollars a year or they’ll get dismissed by the courts a connecticut judge already dismissed one case Wall Street estimates mcKesson’s per share earnings will grow to $18 from $14 over the next three years and our estimates are very similar McKesson stock is trading at about one hundred and thirty dollars and in the second half of 2019 the company will spin off change healthcare in which by our estimates is worth twenty to thirty dollars a share if you take out change healthcare investors are paying around six to seven times earnings for the stable and still growing business McKesson should be trading at thirteen to seventeen times earnings will settle for fifteen and value McKesson shares and around two hundred and fifty dollars to three hundred dollars if this analysis reads like a broken record it is despite the additional research we’ve done our thinking on McKesson has not changed while the company’s fundamentals have only improved next is Walgreens boots Alliance our initial analysis of Walgreens boots Alliance projected 3% to 5% revenue growth stable margins and earnings per share growth of about 7% to 8% helped buy share buybacks the last quarter has thrown a wrench at these assumptions despite growing revenues reimbursement pressures and the lack of new generic drugs have reduced Walgreens pharmaceutical merchants there is a good chance that last quarters performance was a bit exaggerated by temporary events but it is likely that our assumptions of stable margins need to revisit though we still believe volume will continue to grow as the aging population gulps more drugs over the past few months we have spent a lot of time reanalyzing Walgreens trying to figure out the worst case for earnings Walgreens US pharmacies historically made about $11.50 to 11 dollars and 70 cents of gross profit per script filled the average store filled about 340 scripts per day in the latest quarter by our estimates Walgreens gross profit per script declined to eleven dollars and 20 cents in an attempt at killing the business we assume that gross profit per script declines to nine dollars a drastic assumption but even then we could not get Walgreens core earnings to less than five dollars a share a few years out at a conservative no growth price to earnings of ten times Walgreens core business is worth about $50 a share in addition Walgreens owns about 26 percent of a Mara source Bergen mcKesson’s competitor which is worth another five to ten dollars a share bringing our worst case valuation of Walgreens to fifty five to sixty dollars a share the stock’s current $52 price is just under our worst-case scenarios fair value any positive development to the company should present upside for the shares moreover Walgreens market share has grown consistently Walgreens and CVS health care together control almost half the US retail pharmacy market Walgreens and CVS market shares are 22 percent and 24 percent respectively their stores fill larger volumes of scripts than smaller pharmacies and thus can stay profitable at lower gross profit per script at $9 gross profit per script that is the assumption that we use when trying to kill Walgreens stock smaller lower volume pharmacies would start dropping like flies it is unlikely that the insurance companies and the government would want this but if it happens Walgreens will be the beneficiary as its market share will rise at an even faster pace our original expectation that Walgreens will earn $8 in a few years may prove to be too optimistic today the street is projecting per share earnings to grow to six dollars and fifty cents from six dollars over the next three years we’re not sure whether the street is right or wrong but we don’t totally dismiss the possibility of Walgreens earning eight dollars a share in a few years in our original analysis we valued Walgreens as a growing enterprise and thus gave it a price to earnings ratio of 15 so at $8 of earnings per share our fair value was one hundred and twenty dollars if Walgreens struggles to produce much growth it will likely trade at twelve to thirteen times earnings deserving a per share valuation of around $80 Walgreens CEO who owns 13 percent of the stock and the company’s management are not sitting still that is why it is dangerous to draw straight lines through the negative articles you read about Walgreens today the front end of the store which occupies 80% of the real estate and generates only 25% of sales is an underutilized asset Walgreens is bringing LabCorp into 600 of its stores it is working with Kroger tubing Kroger groceries and lower pricing to its stores wall grain has a deal with Microsoft to improve its technology it is working on bringing boots cosmetics to 3,000 of its stores Boots dominates the cosmetics market in the UK has its own successful private label brand yet even if Walgreens management doesn’t succeed in growing earnings at today’s stock price we see little downside no permanent loss of capital there is also an upside to the recent setback first Walgreens is spending billions of dollars on share buybacks the recent weakness in the stock is allowing the company to buy more shares and second a setback has brought an urgency to the company to improve its front end store that is non pharmacy business if you look solely at the recent performance of healthcare stocks you’d think these companies were on the verge of going at a business nothing can be further from the truth these companies are profitable enterprises which generate enormous cash flows that will probably only continue to grow over time.

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