Drugstores operating in North America are great businesses in which to invest because, analysts say, as populations in Canada and the U.S. age, their increasing need for medication will boost sales.

In addition, margins are increasing as drugstores sell more generic drugs with their low base prices. That allows retailers to add a larger fee than for brand-name products.

The shift to generics is the result of U.S. insurance companies — as well the Canadian and the U.S. governments — putting pressure on doctors to write prescriptions for lower-cost generic drugs. In addition, there’s increasing availability of generics because patents for a number of widely used drugs have recently expired.

One company benefiting from these trends is Toronto-based Shoppers Drug Mart Corp. , which is among the top three drugstore companies in the world, according to global money managers — some of whom even say it’s the best of the bunch.

Charles Burbeck, head of global equities at HSBC Halbis Partners in London, calls Shoppers a sensational success story: “It has shone out over its global peers.”

Stéphane Champagne, a portfolio manager at Signature Advisors, a unit of CI Investments Inc. in Toronto, is equally enthusiastic, calling Shoppers the “best drugstore chain in the world.”

Champagne describes Shoppers as three to five years ahead of the competition — the best of which are Deerfield, Ill.-based Walgreen Co. and Woonsocket, R.I.-based CVS Caremark Corp. — in increasing “front of store” sales, moving upmarket in its cosmetic offerings and renovating stores. He also likes the company’s dominant position in Canada, particularly in Ontario.

Burbeck agrees, but notes that Walgreen is considered the slightly better operator and is the purest play in the sector. Walgreen has been very successful in growing organically. But, at the present time, most analysts do not favour it over CVS and Shoppers.

Managers who prefer CVS include Champagne; Martin Hubbes, chief investment officer at AGF Funds Inc. in Toronto; and analysts at J.P. Morgan Securities Ltd. in New York.

Although Champagne loves Walgreen, he prefers CVS because he considers the latter company more visionary. Its merger with Birmingham, Ala.-based Caremark Rx Inc. gives it a presence in the pharmacy benefit-management (PBM) sector, which he believes will result in increased sales for CVS.

PBMs are a U.S. phenome-non. They manage the prescription business for the insurance companies that pay the medical costs of most Americans. Champagne expects CVS to offer discounts to Caremark customers, which should drive up sales volumes.

Hubbes is a big fan of PBMs. He foresees CVS offering to split the discounts the Caremark operations get on bulk prescription drugs with big corporate clients. He also notes that CVS has the most upside because its valuation has been depressed by concerns over the Caremark acquisition.

J.P. Morgan calls CVS “the most sophisticated health-care offering today with a strong PBM offering via Caremark, and a first-mover advantage.”

Here’s a closer look at the three companies:

> CVS Caremark Corp. CVS merged with Caremark in March. Pre-merger CVS was about 15% bigger than Caremark, with revenue of US$43.8 billion in the fiscal year ended Dec. 31, 2006, vs Caremark’s US$36.7 billion in the same period.

CVS was also slightly more profitable, with net income of US$1.4 billion on 2006, or 3.1% of revenue, vs US$1.1 billion, or 2.9% of revenue, for Caremark.

A number of observers aren’t sure about how well the merger will work out. The share price of the combined entity has been trading around 16 times 2007 earnings, vs 19 times for Walgreen and 21 times for Shoppers. But the tide may be turning.

J.P. Morgan, for example, just upgraded CVS’s stock’s rating to “overweight” from “neutral.” Although Caremark has lost major contracts since the merger, J.P. Morgan thinks this is fully priced into the shares and believes that “the market over time will appreciate the merits of the combined entity, resulting in multiple expansion toward the blended rate of PBM and retail competitors.”

That would see CVS shares trading at about 19.4 times 2008 earnings, which would mean a 18% increase in the share price. The 1.8 billion widely held shares were trading at US$38 a share in early October on the New York Stock Exchange.

Champagne and Hubbes are also upbeat about CVS. They are attracted by the possibility of increased sales from Caremark customers. Champagne points out that CVS always grows by acquisition. It picked up 1,258 Eckerd stores from Plano, Tex.-based J.C. Penney Co. Inc. in 2004 and also bought the 700 Osco and Sav-on stores from Boise, Idaho-based Albertsons Inc. in 2006.

@page_break@But Patricia Fee, money manager at IG International Management Ltd. in Dublin, says it’s too soon for synergies to emerge. So, there is risk and investors remain wary. However, she says, the stock may be an investment opportunity because it has more upside than Shoppers or Walgreen. She also thinks the Caremark merger might generate a new model for the U.S. industry.

Net income for the merged company was US$1.13 billion in the six months ended June 30, down slightly from the US$1.15 for the two companies combined a year earlier. Merger and integration costs accounted for a US$250-million hit after taxes to the bottom line.

Revenue for the first half was US$33.9 billion, well down from the combined US$38.9 billion for the two companies a year earlier, the result of Caremark losing some major contracts. CVS’s same-store sales were up 5.7% in the second quarter from a year earlier.

The merger pushed up long-term debt to US$8.4 billion as of June 30 from US$2.9 billion at Dec. 31.

> Shoppers Drug Mart Corp. William Chisholm, an analyst at MacDougall MacDougall & MacTier Inc. in Toronto has a “buy” rating on Shoppers, with a target price of $60 a share. The 215.3 million widely held shares were trading at $55 a share on the Toronto Stock Exchange in early October. Although $60 is 23 times projected fiscal 2008 earnings, which is at the high end of North American valuations of retail drugstore chains, Chisholm says, Shoppers “must be viewed as being among the best in the industry.”

Both National Bank Financial Ltd. of Montreal and UBS Securities Canada Inc. of Toronto also have an “overweight” rating on Shoppers, with a slightly higher target price of $61 a share. UBS describes Shoppers as a “very well-managed, high-quality, growth company.”

For its part, NBF thinks Shoppers is a better defensive stock than food retailers. “Despite relatively high valuation multiples, we believe Shoppers’ proven earnings growth strategy, the more friendly political environment in Canada and strong organic industry growth justify our ‘outperform’ rating,” states a Sept. 4 NBF report.

Shoppers’ net income was $197.4 million for the 24 weeks ended June 16, up 18.8% from $166.1 million for the same period a year prior, on sales of $3.8 billion, which were up 11% from $3.4 billion. Long-term debt was $298.7 billion.

Chisholm finds the 161-basis-point increase in gross margin in the second quarter “quite reassuring.” This came from more sales of both generic pharmaceutical and private-label items, self-shipment of food products from the company’s distribution centres and a continuing shift toward higher-margin products, including cosmetics. These factors “are expected to become even more pronounced over the next couple of years,” he says.

NBF also expects margin expansion to come from increased private-label penetration and sourcing of product offshore.

Meanwhile, Shoppers’ store expansion program, which is aimed at increasing selling space by 10% a year, is expected to continue for the next three to five years, which should sustain growth in sales and earnings, Chisholm notes.

One potential negative is the new pharmacy regulations in Ontario under which the government is asking for a portion of the discounts the companies get for buying in bulk. The province pays for about 20% of the prescriptions in Ontario.

However, Chisholm notes, no dampening effect has yet shown up in Shoppers’ numbers, even though competitors’ numbers have been affected. Shoppers also expects to benefit disproportionately from fees that the government will now pay for professional services. Shoppers has long provided customers with detailed information on their prescriptions, both verbally and in written form.

> Walgreen Co. As enthusiasm for CVS increases, the company affected the most is Walgreen. In a Sept. 25 report, J.P. Morgan downgraded Walgreen to “neutral” from “overweight” at the same time as it upgraded CVS to “overweight.” J.P. Morgan believes Walgreen’s health-care strategy lags CVS’s.

“If Walgreen wants to compete more effectively,” the report says, “it may need to make additional acquisitions, an area in which this management team is not very experienced, therefore raising integration risk potential.”

In the past three years, Walgreen has bought three specialty pharmacy product or solutions companies. But this isn’t enough, in J.P. Morgan’s view: it believes that additional acquisitions or joint ventures will be necessary if Walgreen is to compete fully against CVS.

The 993.6 million widely held shares were trading around US$40 a share on the NYSE in early October.

Like Shoppers, Walgreen wants to increase square footage growth, aiming at 8% a year, vs Shoppers’ 10%. This will come mainly from new stores. Walgreen has 5,500 stores and expects to have 7,000 by 2010. It tends to locate in less affluent areas, in which many customers are covered by Medicaid, Fee says.

Walgreen relies heavily on prescriptions, which account for 65% of its sales. (At Shoppers, it is 50%.) And increased selling, occupancy and administration costs took their toll on Walgreen’s results in the fourth quarter ended Aug. 31. Yet net income for fiscal 2007 was US$2 billion, up from US$1.8 billion the year prior. Net sales were US$53.8 billion in 2007, vs US$47.4 billion. There is little debt.

One threat is Benton-ville, Ark.-based Wal-Mart Stores Inc. But, Fee says, Walgreen isn’t worried: it believes its costs are much lower — which is reasonable, given that Wal-Mart treats its pharmacy business as a loss leader to get people into its stores.

Walgreen has owned a small PBM for some time, Champagne notes. Wal-green is very well managed, he adds, but is less visionary than CVS. IE