Walgreens, CVS or Rite-Aid: Which Tenant Is Best in 2009?

Walgreens, CVS or Rite-Aid: Which Tenant Is Best in 2009?

There are 3 major drugstore chains in the US: Walgreens, CVS, and Rite Aid. The table below ranks the companies by market capitalization and sales revenue as of June 2009:

1. Walgreens ranks #1 with market cap of $31.46 Billion, $61 Billion in revenue, 6443 stores and S&P rating of A+.
2. CVS ranks #2 with market cap of $45.2 Billion, $89.54 Billion in revenue (CVS revenue alone is less than Walgreens if revenue from its Caremark group is taken out), 6923 stores and S&P rating of BBB+.
3. Rite Aid ranks #3 with market cap of $1.1 Billion, $26.29 Billion in revenue, 4901 stores and S&P rating of B+.

Investors purchase properties occupied by these drugstore chains for the following reasons:

1. The drugstore business is very recession-insensitive. People need medicine when they are sick, regardless of the state of the economy. Both rich and poor people in the US have access to medicine. Some even argue that low-income people use more medicine due to free or low-cost drugs offered by government-assisted programs.
2. The drugstore business has a good prospect in the US:

· People are living longer and need more medicine to sustain longevity. Older people tend to use more medicine than younger ones. As the 78 million baby boomers are getting closer to retiring age starting from 2008, the drugstore chains anticipate the demand for medicine to increase in next 20 years.

· The drug market continues to expand as the US population will continue to grow.

· There are new drugs to treat old or previously untreatable illnesses, and new diseases, e.g. Viagra for men’s unhappiness, Zoloft for depression, Avastin for colon cancer, Herceptin for breast cancer, Nicotine patches for smokers to kick the habit, Tamiflu for a potential bird flu pandemic, vaccine for swine (H1N1) flu pandemic, Tekturna/Rasilez for hypertension and various new drugs for AIDS and Attention Deficit Disorder (ADD). The new medicines are very expensive, e.g. a year’s supply of Avastin costs about $55,000. Eli Lilly has sold about $4.8 billion of Zyprexa in 2007 for schizophrenia and yet most people have never heard of this medicine.

· Big advances in genetics, biology and stem cells research are expected to produce a new class of drugs to treat diabetes, Parkinson’s and various rare genetic disorders. For example the new drug Ilaris from Novartis targets genetic causes of an inherited disorder that there are only 7000 known cases worldwide. However, Novartis hopes to gradually broaden its drugs to a blockbuster drug to more common disorders caused by similar genetics.

· Technology and modern life introduce and require new products, e.g. pregnancy test kits, diabetic monitors, electronic toothbrushes, contact lenses, lenses cleaners, diet pills, vitamins, birth-control pills, IUDs, nutrition supplements and Cholesterol-lowering pills (Americans spent nearly $26B in 2006 on Cholesterol medications alone per IMS Health, a Connecticut-based consulting company that monitors pharmaceutical sales.) There are also more surgeries: C-sections, Kidney transplants, open-heart triple by-pass, and breast augmentations. More surgeries mean more medicines are needed such as potent pain killers, and Warfarin to prevent blood clots in surgeries.

· Before the customers can get to the medicine aisles or pharmacy counters, they have to pass by chocolates, sodas, digital cameras, watches, toys, dolls, wines, cosmetics, video games, flowers, fragrances, greeting cards, etc. As a result, customers buy more than their prescriptions and medicine in these drugstores. CVS reported that non-pharmacy sales represented 30% of the company’s total sales in January of 2007. The figure for Walgreens is 34% and 33% for Rite Aid. Many pharmacy locations are in effect convenience stores especially ones that are in residential or rural areas.

3. These companies sign very long-term, NNN leases, guaranteed by their corporate assets. This makes the investment in the underlying property fairly low risk, especially for Walgreens with an A+ S&P rating. In fact, these properties are sometimes referred to as investment-grade properties. Once the drugstore chains sign the lease, they pay the rent promptly and timely. This author is not aware of any properties leased by one of these drugstore chains in which the tenants failed to pay rents. Even when the stores are closed due to weak sales (Walgreens closed 119 stores in 2007), these companies may sublease the properties to other companies and continue to pay rents on the master leases.

Investment Risks

Although the pharmacy business in general is recession-insensitive, there are risks involved in your investment:

1) The main downside about investing in pharmacies is there is little or no rent bump for a long time, e.g. 20-50 years, especially for Walgreens. So the rent is effectively reduced after inflation is factored in. This is one of the main reasons these properties do not appeal to younger investors.

2) The 3 drugstore chains now have a new formidable competitor, Wal-mart. Wal-mart sells prescription drugs in more than 4000 Wal-mart, Sam’s Club and Neighborhood Market stores in 49 states. The retail giant is known for launching in 2006 a highly-publicized $4 generic prescription drug program which now sells 350 generic medications for a 30-day supply. The actual number of medications is less as the medications with different strengths are counted as different medications. For example, Metformin 500 mg, 850 mg, and 1000 mg are counted as 3 medications.

3) Investment in a property leased by Rite Aid is riskier compared to one leased by Walgreens.

Among 3 drugstore chains, Walgreens and CVS pharmacies in general have the best locations—at major intersections while Rite Aid has the worst locations. The new Rite Aid pharmacies tend to concentrate in smaller cities where it may be the only pharmacy in town with little or no competition.

1) Walgreens: Walgreen Company was founded in 1901 by Charles Walgreen, Sr. in Chicago. While the company has existed for more than 100 years, most stores are only 5-10 years old. This is the best managed company among the three drugstore chains and also among the most admired public companies in the US. Due to its superior financial strength--S&P A+ rating-- and premium irreplaceable locations, properties with leases from Walgreens get the highest price per square foot and/or the lowest cap rate among the 3 drugstore chains. In addition, Walgreens gets flat rent or very low rent increase for 20 to 60 years. The cap rate is often in the low 6% to 7.25% range in 2009. Investors who buy Walgreens tend to be closer to retirement age. They are looking for a safe investment where it’s more important to get the rent check than appreciation. They often compare the returns on their Walgreens investment with the lower returns from US treasury bonds or Certificate of Deposits from banks.

2) CVS Pharmacy: CVS Corporation was founded in 1963 in Lowell, MA by Stanley Goldstein, Sidney Goldstein, and Ralph Hoagland. The name CVS stands for “Consumer Value Stores”. As of 2009, CVS has about 6300 stores in the US, mostly through acquisitions. In 2004, CVS bought 1,200 Eckerd Drugstores mostly in Texas and Florida. In 2006, CVS bought 700 Savon and Osco drugstores mostly in Southern California. And in 2008 CVS acquired 521 Longs Drugs stores in California, Hawaii, Nevada and Arizona for $2.9B dollars. The acquisition of Long Drugs appears to be a good one as it CVS does not have any stores in Northern CA and Arizona. Besides, the price also included real estate. It is also bought Caremark, the largest pharmaceutical services company and changed the corporation name to CVS Caremark. When CVS bought 1,200 Eckerd stores, it formed a single-entity LLC (Limited Liability Company) to own each Eckerd store. Each LLC signs the lease with the property owner. In the event of a default, the owner can only legally go after the assets of the LLC and not from any other CVS-owned assets. Although the owner loses the guaranty security from CVS corporate assets, this author is not aware of any incident where CVS closes a store and does not pay rent.

3) Rite-Aid: Rite Aid opened its first store in 1962 as “Thrif D Discount Center” in Scranton, Pennsylvania. It officially incorporated as Rite Aid Corporation in 1968. Rite Aid is the weakest financially among the 3 drugstore chains. In 2007, Rite-Aid acquired about 1,850 Brooks and Eckerd drugstores, mostly along the East coast to catch up with Walgreens and CVS. In the process, it added a huge long term debt (currently owes over $6 Billion) and is the most leveraged drugstore chain. The integration of Brooks and Eckerd did not seem to go well. Revenue from some of these stores went down as much as 20% after they change the sign to Rite Aid. As of 2009, Rite-Aid has over 4900 stores and over $26 Billion in revenues. Compared to Walgreens and CVS, Rite Aid is the weakest financially. Its one-year stock price declined by 92%. On January 21, 2009 Moody’s Investor Services downgraded Rite Aid from “Caa1” to “Caa2”, eight notches below investment grade. Both ratings are “junk” which indicate very high credit risk. Rite Aid has contacted a number of its landlords in 2009 trying to get rent concession to improve the bottom line.

Things to consider when invested in a pharmacy

If you are interested in investing in a property leased by drugstore chains, here are a few things you should consider:

1. If you want a low risk investment, go with Walgreens. In stable or growing areas, the degree of safety is the same whether the property is in California where you get a 6% cap or Texas where you may get a 7.5% cap. So, there is no significant advantage to invest in properties in California as the property value is based primarily on the cap rate. In 2009, the offered cap rate for Walgreens seems to increase about 1% compared to previous years. So you might be able to get some appreciation in your investment when you sell at a lower cap rate in the future.
2. If you are willing to take more risk, then go with Rite-Aid. Some properties outside of California may offer up to 9.5% cap rate in 2009. However, among the 3 drug chains, Rite Aid has a very real high risk of going under in 2009. Should it declare bankruptcy, Rite Aid has the option to pick and choose which locations to keep open and which locations to terminate the lease. To minimize the risk that the store is shuttered, choose a location with strong sales and low rent to revenue ratio. This is especially critical on Rite Aid in smaller cities as Rite Aid seems-- for reasons unknown to this author-- to pay premium rents, i.e. 25-50% higher than market rents for properties in small towns.
3. If you are not a conservative investor or risk taker, you may want to consider a CVS pharmacy. It has BBB+ S&P credit rating. Its cap rate is higher than Walgreens but lower than Rite Aid. Some leases may offer better rent bumps. On the other hand, some CVS leases, especially for properties in hurricane areas are not truly NNN leases where landlords are responsible for the roof and structure. So make sure you adjust the cap rate down accordingly. Some of the CVS locations have onsite Minuteclinic staffed by registered nurses. Since this clinic idea was introduced recently, it’s not clear having a clinic inside CVS is a plus or minus to the bottom line of the store.
4. All 3 drugstore chains have similar requirements. They all want highly visible, standalone, rectangular property around 12,000 - 14,000 SF on a 1.5 - 2 acre lot, preferably at a corner with about 75 - 80 parking spaces in a growing and high traffic location. They all require the property to have a drive-thru. Hence, you should avoid purchasing an inline property, i.e. not standalone and property with no drive-thru windows, as there is a chance that these drugstores may not want to renew the lease. In addition, if you acquire a property that does not meet the new requirements, for example a drive-thru, you may have a problem getting financing as lenders are aware of these requirements.
5. If the pharmacy is opened 24 hours a day, it is in a better location. Drugstore chains do not open the store 24 hours day unless the location draws customers.
6. Some properties may have a percentage lease, i.e. the landlord can get additional rent when the store’s annual revenue exceeds a certain figure, e.g. $5M. However, the revenue used to compute percentage rent often excludes a page-long list of items, e.g. wine and sodas, tobacco products, items sold after 10 PM, drugs paid by governmental programs, etc. The excluded sales revenue could account for as much as 70% of store’s gross revenue. As a result, this author has never seen a store in which the landlord is able to collect additional percentage rent. The store with a percentage rent is required to report its monthly sales to the landlord. As an investors, you want to invest in a store with strong gross sales, e.g. over $500 per square foot a year. In addition, you also want to check the rent to revenue ratio. If the figure is in the 2-3% range, the store is likely to be very profitable so the chance the store is shut down is low.
7. It does not matter how good the tenants are, avoid investing in declining and/or low-income areas or small towns with less than 30,000 residents. These properties are easy to buy now and hard to sell later. In 2009 where the credit market is tight, you won’t be able to get any lenders to finance these properties.
8. Many properties have an existing loan that the buyer must assume. If you have a 1031 exchange, think twice about buying this property. You should clearly understand loan assumption requirements of the lenders before moving forward. Should you fail to assume the existing loan (assuming an existing loan is a lot more difficult than getting a new loan), you may run out of time for a 1031 exchange and may be liable to pay capital gain.
9. About 10% of the drugstore properties for sale and typically CVS pharmacies require very small amount of equity to acquire, e.g. 10% of the purchase price. However, you are required to assume an existing fully-amortized loan with zero cash flow. That is, all of the rent paid by the tenant must be used to pay down the loan. The cap rate may be in the 7% range, and the interest rate on the loan could be attractive in the 5.5% to 6% range. Hence, the investor pays off the loan in 10 to 20 years. However, the investor has no positive cash flow. This requires you to come up with outside cash to pay income tax on the rental profits (the difference between the rent and mortgage interest). The longer you own the property, the more outside cash you will need to pay income taxes as the mortgage interest will get less and less toward the end. So who would buy this kind of property?

- The investors who have substantial losses from other properties or stocks market. By acquiring this zero cash flow property, they may offset the income from the drugstore tenant against the losses from other properties or stocks market. For example, a property has $105,000 of rental profits a year, and the investor also has rental losses of $100,000 from other properties. As a result, the combined profits are only $5,000.

- The uninformed investors who fail to consider that they have to raise additional cash to pay income taxes.