If your clients are looking for a way to play the expected growth in the pharmaceuticals industry, now could be a good time for them to buy into Toronto-based Shoppers Drug Mart Corp. and, possibly, Longueuil, Que.-based Jean Coutu Group (PJC) Inc. — as long as your clients aren’t looking for quick profits.

The shares of these companies have been beaten down by onerous new regulations in Ontario and uncertainty about what the other provinces will do. Until that is known, Martin Hubbes, executive vice president and chief investment officer with AGF Investments Inc. in Toronto, and Marie-Eve Savard, an associate, portfolio manager and research analyst with Standard Life Investments Inc. in Montreal, don’t think either stock is likely to move up sharply — although both stocks have probably found a floor.

The changes in Ontario’s regulations, effective July 1, 2010, have reduced the prices drugstores can charge for generic prescription drugs to 25% of the branded equivalent from 50%, disallowed “professional allowances” paid to pharmacies to warehouse and distribute products and forbids the sale of private-label generic products, which Shoppers was planning to offer. These changes were only somewhat offset by an increase in dispensing fees.

So far, only British Columbia has also come out with new, less onerous regulations: generics’ prices have been reduced to 35% of the branded equivalent; there are no restrictions on professional allowances or the sale of private-label generics.

Quebec, which has legislation that forbids higher pricing than elsewhere in the country, is expected to make an announcement in the next few months. Alberta made its changes before Ontario, although, Hubbes says, Alberta could launch a review next year. As for the other provinces, they have yet to make any announcements.

Ontario is the most important province for Shoppers because of its 50% market share there; however, Shoppers does have a significant presence in B.C., Alberta and Quebec, along with stores across the rest of the country.

Hubbes and Savard both say Shoppers is very well run and should be able to cope without many problems — particularly as the regulations are even more onerous for independent drugstores, thereby providing opportunities for Shoppers to make acquisitions.

The same situation is likely to happen in Quebec, to the benefit of Jean Coutu. But that could be offset by bad news about its 30% interest in struggling Rite Aid Corp. of Pennsylvania, whose turnaround efforts have yet to bear fruit.

Longer-run prospects for drugstores are excellent — thanks to the aging population, which will see more people aged 65 or older than those 14 or younger beginning in 2015-21, according to Statistics Canada. People take more prescription drugs as they age and spend more on other health-related costs. They also buy anti-aging products, often sold by drugstores, and appreciate the convenience of one-stop shopping for the food items now available at drugstores.

Other positives for the sector are the continuing trend toward more generic drug use, for which margins will remain higher than for brand names — even in Ontario. And although Shoppers won’t be able to sell private-label generics in Ontario, it can — and plans to — do so elsewhere. These drugs are not forbidden in B.C.; Jean Coutu already sells them in Quebec.

Both Shoppers’ and Jean Coutu’s stock prices are affected by the performance of their U.S. counterparts — Woonsocket, R.I.-based CVS-Caremark Corp., Deerfield, Ill.-based Walgreen Co. and Rite Aid. These firms’ stocks have been depressed by sluggish consumer spending in the U.S. David Andrews, director of investment management and research with Richardson GMP Ltd. in Toronto, doesn’t think any of these stocks are likely to do much in the short run because prescription refills are down due to the sluggish economy and high unemployment.
@page_break@Although CVS and Walgreen are both considered good companies, Matt Quinlan, an equities analyst with Franklin Templeton Investments Corp. in San Mateo, Calif., says it’s unclear which one will do best in the future. The vertical integration that has resulted from CVS’s acquisition of Caremark, a pharmacy benefits manager that processes and pays prescription drug claims, gives CVS the opportunity to sell more front-of-store items to Caremark customers who get their PBM prescriptions filled in CVS stores.

Hubbes notes that CVS is good at acquisitions, although this is its first foray into PBMs. On the other hand, Walgreen has a good track record of growing organically and isn’t exposed to the risk of entering a new business.

Here’s a closer look at Shoppers and Jean Coutu:

> Shoppers Drug Mart Corp. is considered the leading North American drugstore company. Its success is derived from increasing front-of-store sales, a result of bringing in high-end cosmetics and increasing its array of convenience items, as well as providing a pleasurable shopping experience. Andrews says the shopping experience at Shoppers is “vastly superior” to that of U.S. drugstores.

Just after Shoppers had released its financial results for the quarter ended June 24, a report from UBS Securities Canada Inc. rated Shoppers’ stock a “buy”; a report from TD Newcrest, a unit of TD Securities Inc., released the same day rated the stock a “hold.” (Both UBS and TD are based in Toronto.)

The 12-month target for Shop-pers’ stock in the UBS report was higher ($40) than that in TD’s ($38). Shoppers’ shares closed at $36.18 on Sept. 9.

Shoppers isn’t being specific about how it plans to offset the revenue losses resulting from Ontario’s new regulations. However, certain things are clear, says Savard: “[Shoppers] really wants to boost productivity [which is lower than Jean Coutu’s].” This will involve more automation of prescriptions, she adds, including “working with suppliers to get prepackaged pills.”

The UBS report notes the focus on prescription sales, calling it a good strategy because increased traffic can be converted into higher front-of-store sales. But the report notes that there will be increased costs that won’t be matched by higher revenue in the short run.

Shoppers’ net income in the 24 weeks ended June 19 was $260.2 million vs $243 million for the same period in 2009, on sales of $4.7 billion vs $4.5 billion.

> Jean Coutu Group (PJC) Inc. A July 7 report from UBS had a “buy” rating on Jean Coutu’s stock, with a 12-month target of $10 — well above the Sept. 9 share price of $8.66.

The big drag for Jean Coutu is its 30% interest in Rite Aid. A UBS report dated June 23 had a “buy” rating on Rite Aid, with a target price of US$4. That report said the results for the 13-week period ended May 29 were “strong, considering the environment.”

A June 24 report from New York-based J.P. Morgan Securities Inc. rated Rite Aid “neutral” and said the near term could be bumpy due to the impact of the economy and the considerable work to be done in executing its strategic plan.

Jean Coutu’s net income was $86 million for the 26 weeks ended May 29 vs a loss $723.3 million in the same period in 2009, on sales of $1.3 billion vs $1.2 billion. There were no losses attributable to Rite Aid in this period, vs a loss of $799.7 million in the same period in 2009. IE