Walgreens, CVS may get earnings 'windfall' from new generics

Profit at CVS Caremark Corp. and Walgreen Co., the largest U.S. pharmacy chains, may rise at least 20 percent starting next year as branded drugs with more than $100 billion in sales become available as generics.

The record arrival of generic drugs, which can be twice as profitable for pharmacies as branded products, will bring an earnings "windfall" to CVS and Walgreen from 2011 through 2013, said Derek Taner, who manages the $1 billion Invesco Aim Global Health Care Fund from Houston. Drugs losing patent protection include the world's two best sellers, Pfizer Inc.'s cholesterol pill Lipitor and the blood thinner Plavix.

The cycle isn't fully accounted for in analysts' estimates and not reflected in the stock prices, according to Taner and John Massey, a money manager at SunAmerica Asset Management Corp. Both used the companies' earnings growth during the last major introduction of generics, in 2006 and 2007, to come up with estimates.

"There is a tremendous amount of profit to be had and that profit continues to roll through for a period of time," Massey, based in Jersey City, New Jersey, said in a telephone interview. "It's a multiyear process that builds on the next period."

Taner sees increases of at least 20 percent in the companies' earnings in 2011, 2012 and 2013. Sales won't rise as fast because generics are cheaper than the branded products, he said. Massey estimates profit at Walgreen and CVS will rise 20 percent to 30 percent in 2011, 2012 and part of 2013, before the growth starts slowing down.

CVS Chief Financial Officer Dave Denton said it's too early to make predictions because profits will be determined by pricing, and prices are unknown.

"The generic pipeline is robust," Denton, 44, said in a Feb. 1 telephone interview. "The percentage boost is not something we have analyzed to that level of depth. Pricing is very competitive and we can't know for sure what it will look like at that time."

Generic drugs tend to be more profitable than branded ones, especially in the early phases after patents expire, Wade D. Miquelon, chief financial officer of Deerfield-based Walgreen, said in an interview. CVS has a division in Northbrook.

"It will definitely help us, but to that magnitude, considering there are other things that play in, I would hesitate to give any guidance," said Miquelon, 45. "There are lots of moving parts in this business and different people factor them in different ways."

Walgreen, the largest U.S. drugstore chain, rose 7 cents to $33.52 at 9:59 a.m. in New York Stock Exchange composite trading. The stock jumped 49 percent last year. Woonsocket, Rhode Island-based CVS, up 12 percent in 2009, rose 3 cents to $31.18.

Analysts project CVS's earnings per share will advance 11 percent in 2011 and 14 percent in 2012. Walgreen's may rise 17 percent in each of those years, according to average estimates.

Drug stores pay as much as 90 percent less for generic drugs than for the branded equivalent, said Adam J. Fein, president of Philadelphia-based Pembroke Consulting, a health- care consulting firm. The pharmacies don't reduce prices to customers and third-party payers such as insurance companies by as much, which adds to profit, he said.

Those pricing tactics have given pharmacies average gross margins of 48 percent on generics compared with 8.9 percent for branded drugs, Fein estimates. He based his calculations on a 2008 report from the U.S. Department of Health & Human Services, which provided data on more than 18,000 prescriptions filled under the Medicare program, including almost 11,000 generics.

The last large wave of patent expirations came in 2006 and 2007, when branded drugs generating sales of $43 billion faced generic competition, according to Norwalk, Connecticut-based IMS Health Inc., a market research firm. That helped boost CVS earnings per share by 20 percent in 2007 and Walgreen's by 19 percent in the fiscal year that ended in August 2007.

"This cycle is bigger and it's longer" than the introduction of generic drugs in 2006 and 2007, Taner, the Invesco fund manager, said in an interview. Invesco increased its holdings to 5.68 million Walgreen shares and 5.96 million CVS shares as of Sept. 30, according to Bloomberg data.

CVS and Walgreen will also benefit because they have expanded in recent years, gaining pricing power, said Massey, the SunAmerica investor. Still, prices pharmacies pay for drugs won't drop as much in the next cycle because there are fewer manufacturers as a result of mergers.

Most patents expire 20 years from the date of the application with the U.S. Patent and Trademark Office, allowing generic drugmakers to enter the market. The time frame can change based on various extensions and litigation. Because of a boom in drug development starting in the 1980s, a number of patents are about to lapse.

Branded drugs with $24 billion in global sales face possible competition from generics this year, according to IMS. They include Pfizer's Effexor XR, used to treat depression, in July. Generics of drugs with $42 billion in sales may come to the market in 2011, including Abbott Laboratories' cholesterol drug TriCor in March and Lipitor, the best-selling drug with $12.4 billion in 2008 revenue, in November of that year.

Any potential profit from Lipitor won't come until 2012 and 2013, said CVS's Denton.

A generic version of Plavix, from Sanofi-Aventis SA and Bristol-Myers Squibb Co., may arrive on the U.S. market in early 2012. Plavix was the No. 2 drug in 2008 with $9.45 billion in revenue. In total, drugs that generate $109 billion in sales face competition in the next four years, according to IMS data.

Massey, the SunAmerica money manager, sees CVS shares rising to $54 over the next six to twelve months, a 73 percent increase from yesterday's closing price. The price is based on a multiple of 16 times Massey's estimate for 2011 earnings-per- share of $3.20. Analysts surveyed by Bloomberg project adjusted earnings of $3.10, on average.

Walgreen's stock may rise to $45 a share over the same period, assuming a multiple of 15 times a 2011 earnings estimate of $3 a share, Massey said. Analysts project $2.70 on average for fiscal 2011.

SunAmerica funds own CVS and Walgreen shares and have $13 billion in assets under management, he said.

CVS stands to gain more than Walgreen from generic introductions, Richard England, an Atlanta-based money manager with Atlanta Capital Management Co., said in a telephone interview. Atlanta Capital owned 3.45 million CVS shares as of Sept. 30, after selling about 58,000 shares, according to Bloomberg data. It held no Walgreen stock.

CVS has improved the performance of its pharmacy benefits management, or PBM, unit, England said. The PBM unit accounts for about half CVS's sales, following its 2007 acquisition of Caremark RX Inc. CVS said in November that it had lost $4.8 billion in 2010 contracts, including $3.7 billion in the third quarter, because of pricing and customer service issues.

"Even if they didn't get it fixed, they would clearly benefit from this," England said of the arrival of generic drugs. "It's a very significant positive for CVS and it's absolutely not priced into the stock."