I believe Walgreen's offers one of the most attractive risk-adjust investment opportunities in the market today. A compounder, Walgreens is ripe for a long-term buy and hold investment regardless of one's view on the stock market's prospects. Walgreens has been written up several times over the years. I suggest everyone seeking further clarity review the fantastic presentations by Natey1015 on CVS and WAG, and Pilot72 on WAG. My complete write-up is below.

Walgreen Company (WAG)

*Data is calculated using LTM financials and a share price of $30.00 USD of 06/01/2012

Investment Thesis

Walgreens (WAG) presently offers one of the most attractive risk-adjusted investment opportunities available in the market.  I believe that fear, uncertainty, and doubt have caused Walgreen’s stock to price in a valuation that does not reflect upside surprise, or the true value of Walgreen’s assets and competitive moat.  The main points of my thesis are as follows:

• Walgreens’ dispute with Express Scripts (ESRX) does not make economic sense. It is not in the long term interest of either company to carry on without reaching an agreement.
• Express Scripts’ view that Walgreens has zero value add to the healthcare industry is false.  The facts point to a situation in which Express Scripts’ desire to reduce costs is marginal in comparison to the deduction in access.
• The pharmacy industry is set to benefit from a host of secular tailwinds including healthcare reform, aging demographics, and the branded-drug patent cliff.  Accordingly, Walgreens offers a great deal of visibility over the coming decade.
• Despite a considerable increase in earnings and revenue, Walgreens’ stock is the cheapest it has been in over a decade.
• Walgreens’ management has a history of returning value to shareholders.  Even under a worse case earnings outcome, Walgreens is in a position to grow earnings over the coming years.
• Walgreens holds considerable value in its real estate assets. These assets are in the top quintile of hard-corner locations, and the analyst community overlooks their value.
• Walgreens’ real estate provides the company with a considerable competitive advantage.  The   #1 player in the industry, Walgreens has increased market share to become a national chain with dominant footholds in key regions.

Walgreens is the nation’s largest pharmacy chain with 2011 revenues of $72 billion.  During the year it filed 819 million prescriptions, or roughly 20% of the American Rx market. Walgreens currently operates 8,300 locations[1] in all 50 states with large concentrations in California, Texas, Florida, Illinois and New York.  75% of the US population currently lives within five miles of a Walgreens store, positioning Walgreens for instrumental convenience and brand recognition.

Express Scripts

On January 1^st, 2012 negotiation failures resulted in the removal of Walgreens from Express Scripts’ PBM network.  The dispute has added significant overhang to Walgreens’ story, as failure to renegotiate has dampened near-term earnings.  In 2011 Walgreens filled 88MM scripts on behalf of ESRX members, or 11% of WAG’s total scripts.  Assuming Walgreens is unable to retain any ESRX clients, this equate to an estimated $0.28 negative EPS impact for 2012. 

To add further cloudiness, the Department of Justice recently approved ESRX’s merger with Medco Health Solutions (MHS). This will create the nation’s largest PBM with 22% market share. While Walgreens management has indicated that it is in good standing with MHS, investors fear Walgreens will be unable to renew when its contract comes due in 2013.  Under this dire scenario it is plausible for Walgreens to lose $11.5B in direct Rx sales resulting in a total $0.50 negative EPS impact (my estimate).

Where Express Scripts is losing

At first glance, the data resulting in the wake of the failed plan renewal has been to the detriment of Walgreens.  The ESRX impact on comparable scripts has resulted in double digit declines during the first quarter (-10.6% Jan-12, -10.7% Feb-12, -10.7% March-12).  While this data is clearly negative for Walgreens, I would argue that behind the scenes Express Scripts is fighting a difficult battle to renew clients, deliver on their cost reduction promises, and justify the resulting decrease in member access / convenience.  While such difficulties are not yet apparent in retail news, evidence is readily available in the conference calls of competing PBMs and will become more apparent during the next PBM selling season.

At the heart of the dispute is Express Scripts’ proposal to cut reimbursement rates to unacceptable levels.  According to Walgreens, Express Scripts’ proposed cuts fail to provide fair compensation for Walgreen’s convenience and the value they provide.  On numerous occasions Express Scripts CEO, George Paz, has stated that “merely dispensing a drug itself is not a value-added endeavor.”  While I agree that healthcare is a multifaceted equation of varying value add, Mr. Lopez’s premise is false. According to a 2011 Gallop Poll on the nations’ most trusted professions, pharmacist ranks #2.  Pharmacists explain prescription details, fight for insurance reimbursement, and accurately dispense drugs in an environment where mistakes can mean life or death.  To take a long-time pharmacist away from a high medication client is not necessarily justified by a small reduction in drug costs.

Quality, Cost & Access – over the next decade these three words will be at the center of the healthcare debate.  The key to healthcare is figuring out how to increase quality and access while reducing cost. The heart of Express Scripts’ argument relies on their claim that their reduction in prescription costs via a narrower network justifies the reduction in access of eliminating Walgreens.   This claim stands in stark contrast to communications from Catalyst Health Solutions’ CEO, David Blair:

“I think that clearly Walgreens is an important part of our pharmacy network. There has been a lot of mis-information in the market place that perhaps suggests that Walgreens is not as price competitive, and that has certainly not been our experience. In addition to having the most 24 hours stores and providing our members with terrific access, we tend to have higher generic utilization at Walgreens and we have as deeper, just deeper discounts as Walgreens.”  - Q3 2011 Conference Call.

According to a Walgreen’s white paper, a study conducted by a large PBM demonstrates that networks without Walgreens do not result in meaningful cost reductions.[2]  Mathematically this makes sense. Assuming that Express Scripts allocates its ninety-million annual WAG prescriptions across the market’s remaining 80% of Rx fills, it results in roughly a 2.7% annual increase in prescription fills.  With industry dynamics favoring the direct generic purchasers of CVS, RAD, WAG, and WMT, it is hard to see the remaining pharmacies driving down unit costs low enough to justify the access disruption.  Factor in the logistical issues of increased travel time and gasoline costs on part of the consumer, and ESRX’s claim is marginal at best.

Finally, Walgreen’s 20% market share is partially the result of having large concentrations in key metropolitan areas.

Source: 2010 US Census / www.walgreens.com

As evidenced by the data above, Walgreens has above average person per store concentrations in three of the nation’s five largest states.  In the cases of California and New York, Walgreens has large market share concentrations in the metropolitans of New York City and San Francisco. With nearly 20% of Fortune 500 companies located in the cities of New York (45), Houston (22), Dallas (10), Chicago (8), San Francisco (8), San Antonio (5), large employers are unlikely to remove Walgreens from their employee’s network.

In review, the economic fallout on both sides of the table can be meaningful to shareholders.  By not coming to an agreement Walgreen’s risks a potential $11B in revenue reductions, while Express Scripts risks losing market share to competitors in the next PBM selling season. This is not rational.  I believe shareholders pressure as well as the Invisible Hand will ultimately lead to a new agreement between ESRX and WAG within the next 6 months.

Industry Dynamics

According to Chain Drug Review the drugstore industry continues on its trend towards duopoly dominance.  Based on a study of the 100 largest pharmacy markets in the US, Walgreens and CVS occupy the No.1 position in 89 of these markets.  Of these, Walgreens finds itself as the number pharmacy 49 times. A 2012 Harris Poll study of 38,500 consumers lends support to for the continuation of this trend, “citing consumers are more likely to make pharmacy purchases at traditional drug stores like Walgreens, CVS, and Rite Aid than at the pharmacy departments of mass merchants like Wal-Mart, Target, Costco, and Kmart.[4]” Of the top three players, Walgreens ranked first amongst consumers due to familiarity and purchase considerations.

Over the past two decades market share of independent pharmacies has continually declined due to the competitive pricing, convenience, and retail offerings of the traditional drug store chains. Today, Walgreens and CVS represent roughly 40% of the Rx industry. Rite Aid and Wal-Mart add an additional 15% for a combined market share of 55% amongst the four largest players.  This is extremely important as the size of the four largest players allow each to engage in the direct purchase of generic drugs.  The remaining 45% of the industry must purchase their generic drugs through the purchase of a middleman distributor; causing a decrease in per script profitability to the tune of 25%.

The pharmacy business is likely to benefit over the coming years due to several secular trends.  The first of these trends is the branded drug patent cliff that began in 2011 and will see numerous blockbuster drugs come off patent into 2015. Generic drugs are a boon to the pharmaceutical industry as they allow for significant margin expansion to those able to engage in direct purchasing.  For self-distributing pharmacies like Walgreens, this equates to a 40% incremental margin increase for every branded drug script that goes generic. 

Second, demographics are offering an increase in the script base of the Rx industry.  For the next 20 years – 10,000 people will turn 65 every day.  By 2020 this equates to a net increase of roughly 15MM people to the age 65 and older demographic.  Since elderly citizens consume nearly four times the amount of prescriptions as an average American, the pharmaceutical industry should benefit from a long-term trend of demographic growth and consumption.

Lastly, Walgreens is set to benefit from an estimated 33 million Americans who could gain healthcare and prescription drug coverage under 2014 healthcare reform.  This is a win for Walgreens in two ways.  One, it allows vast opportunities for Rx growth as Walgreens 20% market share will allow it to capture an estimated 155 million annual prescription fills, and $2.3 billion in estimated profit.  Two, the availability (or lack thereof) of doctors leads healthcare analysts to hypothesize that the majority of these individuals will not be using primary care physicians.  I believe many of these individuals will find themselves seeking care in one of Walgreens’ 350 in-store Take Care health clinics. This in turn will provide incremental sales in health care services, Rx, and front-of store retail sales.

Financials

Over the past decade Walgreens has increased its revenues roughly 2.5x while increasing its earnings per share nearly 3-fold. Despite these accomplishments Walgreens’ stock has declined in value; underperforming the S&P by an annualized -4.63% over the past 10 years.  Today, the stock finds itself at its lowest valuation in a decade: 

Growth Metrics – Revenue, EBIT, and Dividends presented In Millions (Fiscal Year End 08/30)

*Today’s Price of $30.00 / share

Over the past decade Walgreens’ business model has been a value creator, delivering high returns on invested capital:

Source: Morningstar

Shareholder Value

Over the past decade Walgreens management has returned $10,439 MM, or 40% of the company, to shareholders via dividends and stock repurchases.  This comes despite a capital-intensive store expansion from 2004 to 2007 that saw Walgreens’ store count swell from 4,579 to 6,934.  Over the past two years Walgreens has effectively distributed close to 100% of free cash flow after allowing for cap-ex and new store expansion.

While it I do not wish to explore hypothetical scenarios, my firm recently communicated to management our belief that Walgreens should publicly articulate an aggressive share repurchase plan.  Should Walgreens take advantage of the low-rate environment and borrow $6 billion (leverage on par with CVS at 1.16x DEBT/EBITDA) we believe such action would 1) provide clear direction to the shareholder base 2) take advantage of a valuable market opportunity 3) Capitalize on a low interest rate environment 4) allocate future cash flows to those who believe in the prospects of the company.  We estimate such action would prompt a 20% appreciation in Walgreen’s earnings per share.

Real Estate

One of the largest factors distinguishing Walgreens from its peers is the value of its real estate.  While the quality and value of Walgreens real estate is well known to seasoned developers, we believe the assets are often overlooked by Wall Street when comparing Walgreens to the likes of its peers. Walgreens currently owns 21% of their stores (est. 1,724 locations) versus CVS’ 6% (440) and Rite-Aid’s 5.8% (259).

After speaking with Walgreen preferred developers from around the country we concluded the real estate owned by Walgreens beneficially follows an 80/20 rule, whereas Walgreens usually owns the top quintile of its locations.   While the current interest rate environment would make it unproductive to monetize all or a portion of these assets at this time, there exists incredible value in Walgreens’ real estate that we believe is rarely mentioned in analyst research.

Using CVS’ ownership count as an example, hypothetically Walgreens does not need to own so many locations.  While the current interest rate environment does not warrant the current monetization of these assets (5.5% cost of capital < 6.81% cap rate), the assets provide future optionality.   The company could seek to sell its holdings or underwrite a bond collateralized by underlying leases (yield seeking pensions would be a bulk buyer); the proceeds of which could be used for strategic alternatives or additional stock repurchases.

Below you will find the last ten sales of Walgreen sites.  Using the information we have conservatively valued Walgreen’s real estate.  To account for any error we have used an average of recent comps (vs. top quartile for WAG sites), estimated a 7.0% cap rate vs. 6.81%, and reduced average store rent from $375,000 per annum to $350,000 per annum. We have averaged valuation methods to conclude that Walgreens’ real estate is worth roughly $7.53 billion, or 28% of the company’s current market capitalization. Based on our experiences this is a conservative estimate of the true worth of Walgreens’ real estate.  We recently sold a similar pad at an upper quartile location for a 6.5 cap, and have seen comps going for as low as a 6.0 cap.

Recent Comps (last 10 domestic sales)

Cap Rate Valuation

Estimated Store Count: 1,724

Estimated Per Store Rent: $350,000 – Triple Net – 20 year Lease

Estimated Total Synthetic Rent: $603,400,000 / Year

Replacement Cost Valuation

Hard Costs: $120 / Square Foot * 14,800 square feet = $1.77 Million

Land / Pad : $1.50 Million

Soft Costs (Architectural, brokerage, and development fees): $500,000

Total Replacement Value per Store: $3.74 Million

Total Raw Replacement Value: $3.82M x 1,724 Stores = $6.45 Billion

The quality of Walgreens real estate is the direct result of the quality of its real estate management team.  During Walgreens last major development phase (2004-2008), management clued into the trend that many developers were selling the building following the completion of the lease.  Walgreens took advantage of the boom time craze to secure 25-year leases, with two options for additional 25-year extensions. Many of these long-term leases were secured with no CPI adjustments over the entire 75-year term (except for extremely high strike points for percentage rent).  For the investor that worries about the prospect of future inflation, we believe Walgreens’ astute leases provide an attractive form of protection.

Store Maturity

As previously noted Walgreens made a significant store development several years ago, with many of their stores coming on line in 2007 and 2008.  Reviewing the real estate strategies of Walgreens versus its peer CVS, illustrates the potential for margin expansion for Walgreens. 

Historically CVS has built its scripts via acquisition. Under the process CVS would purchase a competitor’s pharmacy, build a new store on a more attractive lot, and then close the existing pharmacy. Doing so effectively brought in an already established customer base that has allowed CVS to achieve high store maturity levels, but at an expensive cost and without the ownership of similarly attractive real estate.

On the other hand Walgreens built the majority of its customer base via organic growth.    Rather than pay for existing locations, Walgreens uses its real estate expertise to tie up hard corners in some of the most attractive demographic locations.  Accordingly these locations have to build their script base client by client, and take longer to achieve maturity. With 2200 (35%) of Walgreen’s location base being built since 2007, it is reasonable to assume that many of Walgreen’s stores are operating at below average profitability.  Since current corporate strategy has reduced Walgreen’s expansion, I believe the company will see an increase in profitability from its current store base.

Business Viability

While it is easy to estimate the replacement cost of a raw asset such as real estate, it is much more difficult to measure the intangible replacement value of a company’s brand and competitive moat.  Warren Buffett has described an effective test to determine investment suitability by asking ‘could I challenge the competitiveness of the company if I had $1 billion?’

Running the $1 billion exercise with Walgreens we can point to first-hand evidence of the dominance of Walgreens’ moat.  For the past decade Rite-Aid has levered up to the tune of billions of dollars in order to try to out position CVS and Walgreens.  Several year later Rite-Aid now finds itself losing market share and on the verge of an extremely difficult debt maturity.  Walgreens & CVS continue to garner increased market share as a result of the brand loyalty and competitive moats they have achieved from their real estate footprint.  The two companies own some of the hardest corners on the busiest intersections of the country.  While companies can verbally state their desire to expand and compete into these areas I would argue that many developers now find that the best real estate is simply not available.  To duplicate Walgreens & CVS’ footprint with a $1 billion would be all but impossible.  As a result, competitors like Rite Aid are left with sub-par stores in sub-par locations.  The difference between the competitive aspects of this moat can be seen in sales per store figures, which support the fact that people go to Walgreens & CVS to shop more so than their competitors.

In 2009 SXC Health Solutions (SXCI) and Catalyst Health Solutions (CHSI) were both $1 Billion dollar companies. Three years later they have agreed to a merger that will create a combined company producing $13 billion in annual revenues. [5] While their continued success is not guaranteed, the recent appreciation of their shares recognizes their strong prospects inside the PBM business.  To quote SXC CEO Mark Thierer on their Q4, 2011 conference call:

“I would say that I'm somewhat surprised this has gone on this long, and we just won our first account that was a direct derivative of the dispute between ESI and Walgreens. And so there had been a lot of talk on how much business has moved. I don't think a lot of business moved late last year, but we just won our first. And candidly, there are a good number of employers and health plans evaluating what is the impact on the network, and there is a level of discomfort around the notion of not having Walgreens in the network, and for many, many buyers, that's a big problem. So it is, for sure, creating opportunity and not just for us, for others in the middle market. And so that coupled with the Medco-ESI merger discussions and the lengthening of that process through the Federal Trade Commission, these things taken together are for sure driving new activity and a lot of new discussions. And so we're just running fast to capitalize on a lot of this confusion. I will tell you, we just won our first account that was also a direct result of the Medco-ESI merger. And so we're starting to see tangible fallout from these kind of large scale dislocations in the form of new wins. 

While it is not our intent to analyze the prospects of SXC Health Solutions, Mr.Thierer’s comments lend evidence on how the competitive forces of the PBM industry allows for rapid competitive encroachment during times of dislocation. Knowing the Walgreen versus Express Scripts debate has weakened the short-term prospects for each company, our review of the competitive replacement value of each company lends credit to our thesis.  For further evidence I ask the reader to ask the following questions: 

• When was the last time you visited a CVS or Walgreens?
• Do you know the PBM provider on your insurance plan?
• How often do you interact with your PBM?
• Do you converse your PBM or your pharmacist for insurance questions regarding your medication?
• Do you converse your PBM or your pharmacist regarding medication questions?
• With a national gasoline average of $3.60/g would you prefer to drive an additional 5 miles for your prescription for 200bps savings on a five-dollar generic?
• Based on all of the above, which company’s competitive advantage favors the long-term prospects surrounding the WAG / ESRX disagreement?

Peer Group Valuation (LTM Financials)

WAG                                                                                           CVS

EBITDA: $4,905                                                                           EBITDA: $8,052

EV/EBITDA: 5.54x                                                                        EV/EBITDA: 7.86x

EBIT/EV: 15.53%                                                                        EBIT/EV: 10.16%

Debt/EBITDA: 0.44x                                                                    Debt/EBITDA: 1.16x

LTM P/E: 11.23x                                                                          LTM P/E: 16.6x

Implied Discount to CVS*

EV/EBITDA upside:  42%

EBIT/EV upside:  53%

P/E upside: 48%

Average Upside: 47.67%

*18 months ago fears over CVS’ integration of Caremark accounted for a virtually identical discount of CVS to Walgreens. The fears were short lived and an investment into CVS has proven to be extremely prosperous.

Valuation

Assuming Walgreens continues its share repurchase program at its recent run rate (roughly $1.8 Billion / year since an aggressive authorization in 2009) I believe that Walgreens can effectively earn its way out of even the direst scenario.

With the retail pharmacy business on the forefront of many secular tailwinds I believe Walgreens is positioned to compound at an above market rate for the foreseeable decade.  While I cannot predict whether WAG and ESRX can come to terms, I believe that the potential earnings outcomes prompt investment into this best-of-breed company:

No Resolution

2012E - $2.72 X 10 multiple = $27.20 

Resolution

2012E - $2.93 X 12.5 multiple = $36.63 + $0.45 (half-year dividends) = $37.07

2013E - $3.67 x 15.0 multiple = $60.60 + $1.35 (1.5 years dividends) = $56.40

Conclusion

To paraphrase Warren Buffett, the goal of buy and hold investing is to find a best-of-breed Company with strong economics suffering from a one-time, fixable mistake.  Walgreens presents a compelling opportunity to invest into one of America’s all-time great retail brands.  At its current valuation Walgreens is considerably discounted to bad news surrounding their disagreement with Express Scripts.  A market leader, Walgreens is well positioned in an accelerating industry with multiple secular tailwinds.  An investment in Walgreens offers investors a large margin of safety in a company whose economics will provide for the long-term compounding of earnings.

Catalysts

1)     Walgreens and Express Scripts negotiate a new contract (most immediate potential)

2)     On Friday, 06/01/12 Walgreens and Express Scripts agreed to drop their respective dispute claims that were filed in court in 2011. While there is no    indication of the parties coming to terms on a new pharmacy agreement, it indicates that communication is active.

3)     Walgreens announces an aggressive buy back strategy

4)     Branded drug patent cliff & aging demographics

5)     Analyst or value realization of real estate assets

Risks

The three largest risks to Walgreens are as follows:

1)     Express Scripts merger with Medco Health Solution results in the loss of all MHS contracts when their existing contract expires in 2013

2)     Since no resolution has been announced as of yet, the firms are more likely to remain in stalemate until greater clarity is cast on the next PBM selling season

3)     The longer WAG and ESRX stand in opposition, the more likely a current ESRX client will try and permanently transfer to a new pharmacy

Catalysts

1)     Walgreens and Express Scripts negotiate a new contract (most immediate potential)

2)     On Friday, 06/01/12 Walgreens and Express Scripts agreed to drop their respective dispute claims that were filed in court in 2011. While there is no indication of the parties coming to terms on a new pharmacy agreement, it indicates that communication is active.

3)     Walgreens announces an aggressive buy back strategy

4)     Branded drug patent cliff & aging demographics

5)     Analyst or value realization of real estate assets