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investor's edge

Pedestrians walk past a Jean Coutu pharmacy in Montreal.

For years, Jean Coutu Group's stock was sicker than some of the customers who visit its drugstores.

From a high of nearly $22 in 2005, the shares plunged to about $6 in late 2008, hammered by the financial crisis and by its disastrous foray into the U.S. market.

But lately, the stock's been on the mend, and executives of Quebec's largest drugstore chain are sounding remarkably upbeat. Sales and profits are rising as the company opens new stores, expands existing ones and rolls out more high-margin private label products.

What's more, Jean Coutu is poised to capture a growing share of the lucrative generic drug market with its 2007 purchase of Pro Doc Ltée., a fast-growing generic manufacturer.

"Those of you who have visited our stores can see the difference. Our stores are bigger. Our stores are probably in better shape than ever before," chief executive officer François Coutu, son of chairman and founder Jean Coutu, said on the third-quarter conference call in January. "We're on a roll."

Analysts agree. Of the 11 analysts who follow the company, seven have a "buy" recommendation on the stock, three have a "hold" and just one has a "sell." The average target price is $11.50 - an 18-per-cent premium to Friday's close of $9.75.

Why such optimism? One reason is that the troubled U.S. Rite Aid Corp. chain is no longer hammering Jean Coutu's bottom line. Last year, the Canadian company wrote off its 28.4-per-cent equity stake after its share of Rite Aid's losses exceeded the carrying value on its books.

That removed a big distraction for shareholders, said Colum McKinley, portfolio manager with Sionna Investment Managers. Sionna began acquiring Jean Coutu stock in early 2008 and made a profit on its shares, a portion of which it has since sold.

With Rite Aid no longer dragging down Jean Coutu's results, "investors aren't seeing the downside from quarter to quarter. But eventually, if Jean Coutu were to sell or exit that position, there's a potential for them to have a financial windfall," he said. Based on Rite Aid's closing price of $1.51 (U.S.) on Friday, Jean Coutu's 252 million shares are worth about $380-million.

In Canada, Jean Coutu is coming off an unusually strong third quarter, when the H1N1 flu pandemic helped to boost same-store sales of non-prescription items by 6.6 per cent.

"While customers were in the store buying cough and cold medicine, antibacterial gels and masks, they picked up a lot more beauty products, confectionery and cosmetics as well," TD Securities analyst Michael Van Aelst said in a note.

Such a strong sales increase "is not realistically sustainable, in our view," he said. But he remains bullish on the stock, citing store expansions and renovations, better merchandising, tighter inventory control and - perhaps most important - the growing contribution of Pro Doc.

Pro Doc manufactures generic drugs and its sales are growing quickly as health insurers seek to control health care costs. In the third-quarter ended Nov. 28, Pro Doc's revenue nearly tripled to $26.8-million (Canadian) from a year earlier.

As Pro Doc manufactures a wider selection of generic drugs, and as more Jean Coutu franchisees buy from it, its sales should continue growing, analysts say.

Kathleen Wong, an analyst with Veritas Investment Research, said Pro Doc has a big opportunity as branded drugs with annual sales of about $150-billion (U.S.) are expected to lose patent protection over the next five years, including Pfizer's cholesterol pill Lipitor, the world's top-selling drug.

"Jean Coutu bought Pro Doc to get vertical integration," she said. As its sales grow, "Pro Doc is going to increase the profit margin for Jean Coutu." She rates Jean Coutu a "buy" with an intrinsic value estimate of $11.20 (Canadian) a share.

Longer term, a key question is how Jean Coutu will be able to generate additional growth, Mr. McKinley said.

"They are somewhat opportunity-constrained. How will they ever grow beyond [their core market in Quebec] They tried to grow in the United States and it didn't work," he said.

"If you reach that point when you can't grow your business effectively and generate strong returns for shareholders, then I think the prudent thing to do is return capital to shareholders. And the mechanisms to do that are through strong dividends and share buybacks."

Jean Coutu has raised its dividend twice in the past three years - it now pays 18 cents annually, for a yield of 1.9 per cent - and more hikes are possible, Mr. McKinley said. That's a welcome change from the previous five years, when the dividend didn't budge. It's also one of the clearest signs that the company has turned the corner.

*****

Jean Coutu on the mend

Third quarter fiscal 2010*

Third quarter fiscal 2009

Revenue

$678.1-million

$620.3-million

Operating income before amortization

$71.5-million

$60.1-million

Share of loss in Rite Aid

-

$431.7-million

Net profit

44.6-million

($399.2-million)

Share profit

19¢

($1.66)

*Third quarter ended Nov. 28, 2009

Source: Company reports

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