Stocks in drugstore chains have been a good bet of late, as they typically are when the economy stumbles, on the theory that even in uncertain economic times people will still tend to their health.

Yet customers at so-called drugstores nowadays are more likely to be on the hunt for a light bulb or a bag of pretzels than a new prescription. Indeed, these so-called front-end goods now make up about 75% of profits at the nation's drugstore chains, says Eric Brosshard, an analyst at

Midwest Research

, an independent firm with no investment banking business. With general merchandise items at drugstore chains considerably more expensive than those sold in supermarkets or discount department stores, some people are wondering just how recession-proof drugstore stocks are.

"Drugstores are not impervious to a falling economy," Brosshard says.

Running

Amid the current economic slowdown and stock market collapse, drugstore chain stocks have performed remarkably well. Since September, shares in

Walgreen

(WAG)

and

CVS

(CVS) - Get Report

, the nation's two largest drugstore chains, have risen 18% and 48%, respectively.

Longs Drug Stores

(LDG)

, a lesser chain concentrated on the West Coast, has been a similarly good investment, rising 53% since September. And

Rite Aid

(RAD) - Get Report

, the nation's third-largest drugstore chain, emerging from well-publicized accounting irregularities and mountains of debt, has enjoyed an identical rise in its share price over the same period. Compare these stellar gains with the performance of the

S&P 500

, which has slipped 24% since September.

Pushing Ahead
Big drugstore chains vs. the Nasdaq

As a result, most shares are relatively expensive, a fact many bullish analysts now acknowledge. For example, Walgreen trades at more than 45 times future earnings, while CVS'

price-to-earnings ratio is a more moderate 26 times 2001 estimated earnings; both have estimated five-year annual growth rates of 17%.

With just 25% of profits coming from actual drug sales, drugstores have seen a sharp change in their earnings mix from a decade ago, when drugs accounted for about half of profits. That's because gross margins for front-end products are in the low-to-mid 30% range, vs. the low-to-mid-20% range for prescription drugs. Accordingly, the average square footage devoted to front-end products has increased during the past decade from about 7,000 to between 10,000 and 11,000. The upshot is that drugstores now more closely resemble supermarket and mass-market merchandisers such as

Wal-Mart

(WMT) - Get Report

, says Brosshard.

According to surveys Brosshard has done, prices for these front-end products are anywhere from 10% to 25% more expensive in drugstores than in stores like Wal-Mart. "When times aren't so good, it is possible that consumers would go out of their way to buy these products at, say, Wal-Mart, and forgo the convenience," he says. (Brosshard has a neutral rating on all four drugstore stocks.)

And as retail concepts converge, it is instructive to compare valuations of drugstore stocks with other retailers. For example, take supermarket chain

Kroger

(KR) - Get Report

, which trades at about 15.6 times forward earnings estimates on 16% estimated annual growth. This makes Kroger, which runs pharmacies within its grocery stores, cheaper than the aforementioned drugstore stocks. And consider Wal-Mart's valuation: It trades at around 30 times earnings with a 15% growth rate, in the middle of the pack when lined up against the drugstore chains. But as most retail investors often say, no one ever competes with Wal-Mart and wins.

Beside the Point?

Many sell-side analysts recite the familiar argument that drugstores will continue to benefit over the long term, as aging baby boomers become more dependent on prescription drugs. "Walgreen believes it is relatively insulated from the difficult economic conditions, due to the continued strength in demand for medicines and toiletries," wrote

UBS Warburg

analyst Neil Currie in a note Tuesday, a day after Walgreens met analyst expectations when it reported quarterly earnings. "Longer term, the expected impact of the aging population got the CEO very excited. He went so far to say that he expected the number of healthy seniors to 'skyrocket,' due in part to increased prescription usage. He believes that the economic opportunity for drugstores has never been greater. We agree." (Currie has a buy rating on Walgreen, and his firm does not have an underwriting relationship with the company.)

But with 75% of drugstore profits tied to products other than prescriptions, how much does this matter?

One fund manager acknowledges the valuation risk, though he emphasizes it is a risk he finds tolerable in a market with few bright spots.

"No question about it, it's a risk," says Robert Shoss, a co-manager of

AIM Funds'

$400 million large-cap growth fund, which owns Walgreen shares. "But it becomes a relative game. Am I concerned about that as much as some other retailers or technology companies? No."