No wonder investors feel puzzled by current drugstore trends.

Just look at what happened to Walgreen ( WAG) and CVS-Caremark ( CVS) this week. In a troubling turn of events, Walgreen suddenly announced that brisk sales of cheap generics -- once a potent boost to earnings -- had hurt its quarterly results. Specifically, Walgreen claimed that sales of generic cholesterol drug Zocor tripled -- but, with reimbursement rates plunging, Walgreen failed to collect any extra profits from those transactions.

Investors, by now accustomed to juicy profits from generic drugs, hammered Walgreen's stock and then went on to bloody CVS-Caremark as well. They even punished Medco ( MHS) and Express Scripts ( ESRX) -- pure-play pharmacy benefit managers that stand to benefit from the situation.

Then they reconsidered their stand.

"If Walgreen is receiving lower reimbursement for some generics, it means that PBMs are paying the company less for generic drugs," Wachovia analyst Matt Perry surmised on Tuesday. "In other words, the PBMs' drug purchasing costs have gone down. We think the selloff in shares of Medco and Express Scripts is unwarranted."

Thus, Perry reiterated his outperform rating on both PBMs. In fact, he went a step further and continued to embrace CVS-Caremark -- Walgreen's closest rival -- as well. His firm has investment banking ties to CVS-Caremark and owns at least 1% of the company's stock itself.

Like many, Perry decided that Walgreen's rare quarterly miss had resulted from poor execution -- with costs rising faster than sales -- instead of a reversal in favorable industry trends.

"We don't think pricing of generics had changed," Perry declared. "CVS has been discussing declines in generic reimbursement for at least two to three quarters. ... What's surprising is that pricing declines caught Walgreens by surprise."

Walgreen stock fell to a new 52-week low Tuesday before recovering to finish little changed on the day. In contrast, the company's rivals began to recover some lost ground. CVS-Caremark posted the biggest gain, climbing more than 2% and approaching last week's record high.

Generic Cycle

With Walgreen dragging down the group, investors saw good reasons to pounce on CVS-Caremark's shares.

For starters, CVS-Caremark quickly responded to Walgreen's bombshell by promising to meet its own profit targets. Moreover, as Perry pointed out, CVS-Caremark has been discussing falling generic rates for months and -- one would assume -- has set its expectations accordingly. Finally, experts noted, the company operates a big PBM that should benefit from falling generic rates and help offset any resulting pain felt by its drugstore business.

"PBMs are not subject to the same reimbursement rate pressures on generics as drugstores," Credit Suisse analyst Edward Kelly stressed on Tuesday. "PBM contracts have standardized reimbursement for all generics" instead.

Drugstores face a more volatile situation. They profit most when brand-name drugs first lose their patents and become available in cheaper generic form from exclusive suppliers. But as that so-called exclusivity period ends, more suppliers enter the market, driving down generic prices and drugstore profits with them.

Unlike PBMs, which continue to enjoy fat margins beyond this exclusivity period, drugstore chains could soon see their own generic cycle peak. This year, experts note, some $21 billion worth of new generic drugs will help pad drugstore profits. But next year, they say, generic introductions will total just $13 billion.

Thus, experts question Walgreen's "sudden" problems on the generic front.

"This is no surprise," Kelly insisted after Walgreen's poor results. Moreover, "we believe investors have already anticipated much of this roll-over, as drug retail multiples have compressed about 10% since April-May 2007 despite earnings beats."

Kelly remains cautious on Walgreen even after its latest fall. He, like many, sees CVS-Caremark as the more attractive bet. His firm seeks to do business with the companies it covers.

Industry Headwinds

But Bear Stearns analyst Robert Summers sees possible headwinds for both companies.

"We believe the industry as a whole is heading into a very difficult period, as the generic margin benefit begins to roll off dramatically," Summers wrote on Monday. "This is not quarter-specific and is not company-specific, in our opinion."

"This has been our general cautious thesis on the sector" for some time.

Summers has repeatedly voiced his concerns about a generic downturn in recent months. In fact, the issue surfaced quite prominently when he was attempting to value Walgreen's closest rival this summer.

In a "fresh top-down view" of the new CVS-Caremark, Summers listed several key metrics -- starting with generic introductions -- that should drive the company's performance.

The "retail business could face some actual margin headwind, as some multi-source drugs are repriced and moved out of the most profitable phase without enough new generics to replace" them, wrote Summers, whose firm holds a significant position in CVS-Caremark's debt. "The PBM business model does not face the same degree of margin lifecycle in generic drugs, but pacing of new generics will influence script profitability" nonetheless.

Following its big merger, experts feel, CVS-Caremark now looks more like Walgreen than its former -- and potentially safer -- PBM peers. For its part, CVS-Caremark feels that it belongs in a class of its own. Still, some feel, the company has plenty left to prove.

"To date, the incremental data points since the closing of the merger primarily have been on the negative side of the ledger," Summers wrote in August. "While the company has reassured investors that customers are embracing the new model, the hard evidence on that fact remains elusive."

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