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CVS and Walgreens: A Duopoly That's Hard to Ignore

- By Shudeep Chandrasekhar

Not enough investors fully appreciate the art of dividend investing. While a 2% dividend yield might not look very attractive, a company that's continually growing revenues provides the added benefit of asset appreciation over time. Put those two factors together and what you often have is a stock that's ignored by income investors and overlooked by total-return investors.


Though these two stocks aren't necessarily in the "ignored and overlooked" bucket, a lot of investors have yet to discover the value hidden in this dividend duopoly.

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When it comes to pharmacy retail, CVS Health Corporation (CVS) and Walgreens Boots Alliance (WBA) rule the roost. The best part about investing in them is that despite hitting the size and scale they currently possess, there's still plenty of room to grow.

Moreover, because they dominate the drugstore space, they're going to be around for a long time; as long, in fact, as there is a growing need for prescription and over-the-counter medication in the U.S. and around the world. That's the kind of moat in which you want to invest.

The competitive landscape

Revenues for both companies have been expanding at an impressive pace over the past decade with both firmly in the $100 billion club. On revenues, CVS has been ahead of Walgreens since before the great recession, and it has widened the gap considerably. Nevertheless, Walgreens has also shown strong growth in the past year or so, making it a powerful duo with a moat so wide that even a company like Walmart (WMT) will have a tough time crossing it and entering Walgreens' territory.

Both command significant market share in the metros in which they operate, and Walmart is possibly the only other retailer in this space that deserves mention. With the upcoming acquisition of Rite Aid (RAD) by Walgreens, that moat of which I spoke is going to get even wider.

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Growth by acquisition

Yet another commonality between these two drugstore giants is their acquisition strategy. Not counting store growth and overseas opportunities, the only way for them to grow fast is through acquisition. Acquisitions are not only accretive to their earnings, but they also open up opportunities to make the group more efficient through store closures and human, technology and resource redundancy.

The most important part of the strategy, however, is that it deepens and widens the moat around the business that much more.

Walgreens has had its eye on Rite Aid for awhile now, and the company is confident that the deal will go through by the end of the year. The deal is estimated at $17.2 billion with a current discount to deal price of 21%, down two percentage points since July 6; more details to follow over the next two quarters.

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At CVS, the purchase of Target's (TGT) pharmacy and clinic unit for $1.9 billion gave it 1,672 pharmacies and 79 clinics. Both will continue to operate on-premises at Target locations, and future Target outlets will also carry the pharmacies and clinics, all under the new CVS/pharmacy and MinuteClinic brand names.

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From an acquisition perspective, both companies are going to go all out and buy anything that comes their way. With the U.S. now running out of opportunities for this, CVS and Walgreens must necessarily look at more Boots-type deals overseas.

Comp sales

On the comparative store sales front, CVS has been having some trouble delivering strong numbers like Walgreens has. You should remember, however, that Target's pharmacy unit wasn't making money, and that's one of the reasons Target sold it in the first place - to boost operating margins that were sagging because of the now-divested units.

However, we also need to be aware that CVS has skills more suited to running a pharmacy and clinic chain - something that Target didn't have.

Nevertheless, both groups continue to show positive comps across their stores.

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Source: Bidness Etc.

Free cash flow, payout ratio and dividend yield

From an FCF perspective, both companies are in the $5 billion-plus range; while CVS has shown a sixfold increase in FCF over the past decade, WBA is not far behind with a 4X increase.

More importantly, both have payout ratios well below the 50% level. That gives them a lot of room for dividend growth over time, which is what income investors like to see.

It's obvious that both companies are reserving cash for possible future acquisitions, share buybacks and dividend growth.

CVS announced a 21% dividend increase at the beginning of the year and also raised EPS guidance for the full fiscal.

Walgreens is known for taking care of its investors, having increased dividends for 40 consecutive years, putting them in contention to become a Dividend King over the next decade. Though they've suspended their $3 billion share buyback program in preparation for the upcoming acquisition, dividends will most likely keep increasing even if at a slower-than-normal rate.

As such, I don't expect either company to slow down on either acquisitions or dividend growth for the foreseeable future.

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Sources: CVS, Walgreens

The investment angle

The logic of investing in a duopoly like CVS/WBA is simple: you put money into the industry segment when you invest in both companies. The fact that they form a duopoly means the moat is extremely wide and prohibitive to newer players. In this particular case, we've seen how this duopoly is keeping even giants like Walmart at bay within the niche.

From a valuation viewpoint, both are comparable. Their forward P/E ratios (CVS - 14.7; WBA - 15.7) signify that the market expects them to keep growing, which they will both continue to do - either through organic or acquisitive gains.

From the liabilities perspective, their acquisition strategies necessarily dictate high but sustainable levels of debt.

In its third quarter 2016 earnings release , WBA declared an LTD of $13.151 billion against $13.315 billion for last year, total assets of $67.333 billion and operating income of $4.86 billion for the nine months ended May 31.

CVS, during its first-quarter release in May this year, reported an LTD of $26.267 billion, which it has maintained since last year, and total assets of $92.634 billion. Operating profit was reported at $2.176 billion for the three-month period ended March 31.

In terms of profitability, both show operating margins in the 4% to 7% range, and both have shown EPS increases in their last respective quarterly reports: $1.14 to $1.18 year over year for CVS and $1.02 to $1.18 year over year for WBA - both adjusted, non-GAAP, per diluted share.

Though neither CVS nor WBA have significantly large amounts of cash on hand, both companies' balance sheets show enough strength to support growth.

They cannot and will not let even the most seemingly insignificant acquisition opportunity slip from their grasp.

In fact, the competition between them will only get fiercer by the year, making them more responsive, leaner and more agile despite their size. They have not only achieved the scale required to remain at the top of their games but the money muscle to acquire any new potential competition.

In summary, the fundamentals look solid, but the most important factor is the ever-expanding moat they are creating around their businesses. It's not just about the size, however; it's the industry segment in which they operate. Recession or no, this is not a business that's going to fade into the sunset even if it does get hit.

As an investor, going DRIP on both stocks would be the ideal approach, but you'll need to stay on board for at least five years for your portfolio to grow by a significant multiple.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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This article first appeared on GuruFocus.