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What Amazon's Pharmacy Launch Means for CVS and Walgreens

It could bring more competition, but not enough to change our valuations.

Shares of CVS Health CVS and Walgreens Boots Alliance WBA dropped Nov. 17 in response to Amazon’s AMZN rollout of its own pharmacy as well as a prescription savings benefit for Prime members. We are maintaining our fair value estimates, however.

While this service may add some competition for CVS, especially for its retail stores, we had already built in some long-term pressure on CVS' business after Amazon's purchase of PillPack in 2018. So, Amazon's announcement does not materially change our view of CVS or its narrow moat rating. Also, the diversity of CVS' operations, with roughly 60% of profits from medical insurance and pharmacy benefit management, should provide some shelter from Amazon's new online pharmacy business.

Overall, we think Amazon's new service could put pressure on CVS, primarily in its retail store operations, and provide another hurdle to CVS reaching its goal of double-digit earnings growth by 2022. However, there will still be a need for physical stores for acute prescription fulfillment and to accommodate patients with chronic needs. Also, CVS' HealthHub strategy could bolster foot traffic at retail stores as a potentially more convenient option than booking an appointment with a primary care physician. Also, we see many ways to boost earnings growth from CVS’ current lackluster levels, including synergies between the legacy operations (particularly the pharmacy benefit manager) and the recently acquired medical insurance operations, lower interest expenses as the company actively deleverages, and the reimplementation of share repurchases once the leverage goal is met next year. Also, CVS recently announced a CEO transition, and we suspect this may add urgency to accelerate earnings growth at CVS once the new team takes control in 2021.

CVS' profit growth remains weak compared with its managed-care peers, which has constrained the shares. In our opinion, CVS’ shares remains undervalued at 9 times 2020 expected earnings and a dividend yield over 3%.

We anticipate Amazon’s launch to create some headline risk for Walgreens in the near term. We acknowledge this to be an incremental headwind, but we view Walgreens as somewhat insulated as it remains a market leader addressing immediate care needs with ease of pickup and comprehensive offerings. We do not anticipate Amazon will garner a notable share of the market; rather, it is likely to pose a more immediate threat to dispensers of treatments for chronic conditions, such as mail order, and also to independent pharmacies, which face challenges to survive in a fiercely competitive market. Historically, Amazon’s competitive pricing on consumer products has adversely affected Walgreens' front-end sales, which have stabilized and started to improve with the latter company's aggressive rationalization of stock-keeping units and strategic initiatives.

Walgreens' strategy has focused on leveraging its partnerships to drive more traffic to its convenient locations. Through its infrastructure investments and partnerships, Walgreens has started to address more comprehensive care, including lab, imaging, and regular physician visits through its partnership with WebMD. Though it's in the early stages, this approach will allow the company to focus on outcomes longer term, which we view to be critical in improving wellness and providing differentiation in a fiercely competitive market. Additionally, convenience and ability to dispense more-complex drugs will be an important differentiator with the rise of specialty drugs that require special handling and consultations. Further, in the current market with notably low Treasury rates, Walgreens’ 4%-plus dividend yield remains an attractive consideration. We maintain our narrow moat rating and fair value estimate for Walgreens.

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