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.
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.