Should You Buy After Blowout Pharmacy Earnings?

Walgreen nearly created new highs on Tuesday after delivering an incredible earnings report. The company once more proved why pharmacy stocks have outperformed the broader market in 2013. After such large gains, are pharmacy stocks still a buy?

What's so impressive?
From a top/bottom-line stance, Walgreen simply met expectations. What's impressive are the continued trends of increased script volume, strong revenue, and higher margins.

In particular, total sales rose 5.1%. This was driven by a 6.1% rise in prescription revenue. The script revenue is surprising because pharmacies have seen a macro shift to lower-priced generics as patents expire, and this shift is expected to continue through 2015 at a rapid rate.

Yet an 8.2% rise in script volume allowed sales to rise. Generic drugs have higher payouts per script to pharmacies than brand-name drugs, so Walgreen's bottom line improved 15.9% year over year.

This combination of events drove shares more than 4.5% higher as a result.

Continuing the trend
By the quarter, pharmacies are proving that their strong performances are not flukes. Back in mid-September Rite Aid delivered a phenomenal report that catapulted its shares to multiyear highs, making its one-year stock gain 325%.

After five years of consistent operating losses, Rite Aid has delivered four consecutive quarters of net income. While Rite Aid's revenue has essentially been flat year over year, the company has continuously noted a higher mix and introduction of new generic drugs as the reason for the margin boost.

While Rite Aid's 1% rise in same-store sales is minimal compared to Walgreen's 4.6% rise, low expectations coupled with a cheap stock has allowed for industry-leading gains.

Up next
So far, it's two down and one to go for pharmacy earning reports. With Rite Aid's and Walgreen's impressive quarter, you have to like CVS' chances of also delivering a strong report.

CVS is scheduled to report earnings in the first week of next month, but the stock itself has significantly lagged its peers with gains of just 20% in 2013. One reason is that CVS has not seen the same rate of growth compared to Walgreen, and with operating margins that are about 150 basis points better, upside is considered limited.

However, CVS' strong margins are more a result of better front-end sales, as its pharmacy's margins are consistent with its peers'. Therefore, as industry margins rise with new generics, so should CVS' performance.

This opinion is even validated by the company's results last quarter, as sales grew just 1.7% and net earnings rose 16% year over year. Thus CVS should remain on your watchlist as its earnings approach.

Final thoughts
Surprisingly, even after large industry gains, there is a lot to like in this industry, as all stocks are still relatively cheap.

*Data from multpl.com.

While the P/E and price/sales ratios do not tell an entire investment story, both are popular metrics used by retail investors to identify value in the stock market. Clearly, the industry as a whole is significantly cheaper than the S&P 500, and much of the reason can be linked to the sudden rise in margins.

Now, you can see that P/E ratios are much closer to the valuation of the S&P versus price/sales. The reason is because margins are still tight for pharmacies in comparison with other industries. But as margins continue to rise, each company's value relative to sales will serve as a basis for improvement.

In other words, even a 100-basis-point margin improvement with such large revenue will significantly alter the P/E ratio of these stocks. For pharmacies, grocers, and some retailers, minor margin improvements equal massive profits, and it's those future profits that still make pharmacies a good long-term investment opportunity.

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The article Should You Buy After Blowout Pharmacy Earnings? originally appeared on Fool.com.

Fool contributor Brian Nichols owns Rite Aid. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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