WALGREEN CO WAG
July 24, 2010 - 7:33pm EST by
pilot72
2010 2011
Price: 30.00 EPS $2.12 $2.48
Shares Out. (in M): 982 P/E 14.0x 12.0x
Market Cap (in $M): 29,300 P/FCF 13.0x 14-15
Net Debt (in $M): 56 EBIT 0 0
TEV ($): 29,200 TEV/EBIT 0.0x 0.0x

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Description

This piece on WAG is a long-only equity recommendation that was originally submitted in early July as an application for membership to the Value Investor Club.  There has since been another member who posted a WAG recommendation on 7/8/2010, thus prohibiting a second long equity recommendation for the same security until 2011.  Please excuse the work around to get these thoughts posted (I'm posting this under the "other" investment type category).  However, the other piece was a rather brief summary, and I believe this compliments it in that the details of specific earning drivers are addressed.  I believe this would benefit VIC members who might want more detail on the WAG investment thesis, and I thought it would be worth posting for that reason.  The stock has appreciated about 14% off its bottom, but there may still be opportunity in the names.  While I am probably too specific (I recognize the problem of false precision in our line of work) in describing the building blocks behind earnings power in this recommendation, the details are provided just to answer the question on specifically WAG will be able to build up from ~$2 in earnings in FY2010 to $3 by FY2012.  The three drivers behind that notion are 1) more normal comp sales, although I believe "normal" is much diminished from the heady comp sales the company did in the mid 2000's (I assume +2%); 2) cost savings and share buybacks; and 3) an upcoming generics wave that should augment profitability, albeit likely not as dramatically (per individual generic drug) as we saw previously in 2006. There is no reason WAG shouldn't trade at 12-14x $3 as we look forward 18 months, and I suggest $36 - $42 is more appropriate for WAG than is $30 (or $26-$27 at the time of the more detailed recommendation).   At $39, that would offer 30% upside for WAG, a stable and leading American business.  The early July write-up follows.
note: since the original work, I've learned that WAG's capex will temporarily increase in FY2011 for about $200MM in POS equipment installation.  The company believes this increase is one-time in nature and that capex will fall thereafter.
 

Summary

 

Walgreen Company (WAG) has earned between $2.00-$2.12 per share since FY2007 (FY ends August), and looks set to earn $2.10 to $2.15 again in FY 2010.  This analysis argues that WAG’s earnings power is closer to $3.00 per share, and that FY2011 will be a bridge year that gets the company about half way to that level, with the remainder achieved in 2012.  A recent earnings miss has caused the stock to sell off, and it appears that expectations are rooted more closely to the $2.00 earnings estimate than the $3.00 potential.  WAG is a value buy here, and that value should be realized – barring a severe second leg of U.S. consumer spending retrenchment – as we move through FY2011 and WAG’s earnings power is demonstrated quarter by quarter.  Free cash flow has also recently gapped up, and should remain sustainably high based on a slower rate of new store growth and better inventory management.  This work-up walks through the earnings and cash levers during WAG’s bridge from $2 per share in earnings power to $3 per share.

 

There’s no reason WAG shouldn’t trade at 12x earnings power of $3.00 per share, or $36.  At the current price, my 10-year DCF model, employing a 10% discount rate and static operating margins (i.e. no credit for the current cost-base reset or the profit impact of slowing store growth) at current year levels, suggests WAG at $26 is priced to grow at 2% per year over that time frame with a terminal value of about 11x FCF in year 10.  Either way, WAG is too cheap today, and downside risk is slight.  The $36 per share submitted as upside is 36% above the stock’s closing price on 7/2/10.  A 2.1% dividend yield augments the proposed upside.

 

Recent Situation

 

WAG has lost 28% since its May 12th close (from $36.57 to $26.36 on July 2nd) due to 1) weakness in the general stock market (the S&P 500 is down 13% over that same time frame), 2) weak comp store sales (April, May, and June comps were -0.2%, -0.2%, and 2%, respectively), 3) an ill-advised public dispute with Caremark PBM (7% of WAG sales) during June which has since been successfully resolved, and 4) a weaker than expected FYQ3 report, which printed earnings per share of $0.51 (adjusted for $0.04 for “the elimination of the tax benefit for the Medicare Part D subsidy) compared with $0.53 in the year earlier period.  This was 10-11% lower than Street estimates, thus drawing venom from sell-side analysts. 

 

The stock now trades at 10.5x a very achievable estimate of $2.50 for FY2011 (the consensus is at $2.51, but some of the most visible Street analysts at Citi, Credit Suisse, and BofAML are between $2.33 and $2.44).  Wall Street seems focused on only the next couple quarters, which face tough comps from last year’s flu season, and they seem intent on extrapolating today’s softness years into the future.  By contrast, I assume a slow recovery to a “new normal” comp sales range of +2-3%, which compares to high single digit to low double digit WAG comps 3-6 years ago.

 

Why WAG will do $2.50 in FY2011 and $3.00+ in FY’s 2012 – 2013

 

This report does not attempt to argue the complete bull case on WAG that is already described in a 10/28/2007 V.I.C. write-up by contributor skca74, but it does update the case to present day.  (Note: one can also get succinct overviews of WAG from The Value Line and from recent company conference presentations:

 

http://investor.walgreens.com/events.cfm ). 

 

Competitive advantages persist. WAG owns half the 24 hr. pharmacies in the U.S. and half the drive through pharmacies; it has an attractive store base with locations within 5 miles of 70% of the U.S. population, scale efficiencies, and the number 1 market share in retail pharmacy, estimated at around 18%.  We also continue to have tailwinds from demographics, an underutilization of pharmaceuticals for chronic conditions, a big generics wave in 2012, and increased rolls of insured people starting in 2014 compliments of U.S. healthcare reform.  On the other hand, reimbursement pressure has intensified, and this is accounted for in my discussion.

 

Presently, WAG’s attributes are masked by an exaggerated and myopic fear, and there is value in plain sight for America’s premier retail pharmacy.

 

1.     WAG will hit its savings targets from its “Rewire for Growth” plan. 

 

WAG has a cost savings plan called “Rewire for Growth” that purports to save $1B in costs from the company’s 2008 cost base.  75% of the savings are to come from efficiency programs related to indirect spending, corporate overhead, and store labor, and the company reports good progress along these lines.  The other 25% are to come from a program to streamline pharmacy paperwork and prescription filling.  Let’s break down the sources of savings. 

 

In 2008, when this program was introduced, WAG indicated that they spend $3.5B annually with 60,000 vendors on indirect spending (i.e., items not sold through to customers).  It seems reasonable to think there are $250MM, or 7% of $3.5B, in cost savings available in that bucket, primarily through procurement efficiencies.  Consolidating suppliers should get WAG most of the way toward their goal.  Another $500MM was targeted at store labor and corporate overhead spending.  A recent conversation with the company revealed the level of corporate spending is about $600MM, so the bulk of the $500MM is to come from reorganization at the store level.  Given $14B in SG&A costs in 2009, ($500MM/$14B) = 3.5% also seems reasonably achievable.   

 

The final 25% of the cost-takeout program is from an initiative called “transforming community pharmacy.”  About 25-30% of WAG prescriptions (prescriptions will be referred to henceforth as “Rx”) are for next day pick-ups.  They have found they can save costs and free up pharmacists by filling these at a central location overnight.  WAG also sees opportunities in how pharmacists handle paperwork.  It’s estimated that 90% of the work in a pharmacy is paperwork.  With the use of information technologies, WAG can shift paperwork on an as-needed basis from busy locations to less busy locations, thus freeing the pharmacists to more efficiently attend to customers. This model has been in practice for some time in FL with reported success.  In an example in Texas markets, WAG reported an ability to handle over 4x normal patient Rx volumes using overnight central filling and paperwork transfers during recent hurricane disruptions.  They are implementing these central filling and paperwork transfer practices on a wider scale, which ought to lead to leaner pharmacy staffing at the store level. With more free time for pharmacists to interact with patients, we ought to also expect a selling opportunity here.  For example, pharmacists less encumbered by paperwork will allow WAG to leverage their time to give immunization shots.  91% of WAG stores have 2 full time pharmacists now certified to administer flu shots as well as vaccinations for tetanus, shingles, and other indications.

 

The company reports $0.37 per share in “Rewire” savings since the start of this cost-out program in 2009.  Backing that up through the P&L ($0.37 x 990 shares x (1 – 37% tax rate)) shows about $580MM of to-date savings.  Wall Street was recently upset that the 3Q’10 report didn’t show a brisk enough quarterly pace of savings, but I estimate about $440MM of savings in Q3 2010 compared to Q3 2009 based on company disclosures (same methodology as above), which leads me to believe the company’s $500MM annual objective for 2010 is on track with one quarter left to go.  Management has repeatedly communicated publicly that they’re very confident in delivering another $500MM of savings in 2011 to fulfill the goal, and I don’t see any reason, based on progress thus far, to think they’ll come up short.  This incremental savings of $500MM in 2011 would equate to an incremental $0.32 per share on the current share base (980MM shares).  While other things like weak comp sales and lower reimbursement may be obscuring some of the savings from this program to date, “Rewire” is on track and I account for $0.32 more in savings in 2011 v. 2010.  The lower cost base should stick and provide a platform from which to operate going forward.

 

Note that Table VI. at the end of this report will summarize all earnings drivers discussed.

  

2.    Slowing store growth will unleash the earnings power of WAG’s store base.

 

WAG plans to slow store openings from 500-600 (2007-2009) to ~335 in 2010 and ~210 in 2011. Table I. shows how drug store expansion has proceeded at WAG from 2007-2009, along with projections for 2010-2012 based on company targets.

 

Table I.

Source: WAG disclosures and my estimates for 2010-2012

 

 

 

2012E

2011E

2010E

2009

2008

2007

Drugstores

 

7882

7702

7542

6997

6443

5997

New/Relocations

 

210

210

335

556

596

501

Closed/Replaced

 

30

50

70

72

67

85

     Net New

 

180

160

265

484

529

416

Acquired

 

 

 

280

70

32

120

 

 

 

 

 

 

 

 

 

Total Locations

 

8379

8199

8039

7496

6934

6112

 

 

Not shown are other selling locations such as worksites (378), home care locations (103), specialty pharmacies (14), and mail facilities (2), but these are included in total locations at the bottom of the table.  The store growth thesis is primarily about drug stores as these other locations haven’t been growing much recently. 

 

The impact of slowing store growth is powerful to profitability.  Table II. shows my estimate of the profitability of the average new WAG drug store in the year after it’s opened.

 

Table II.

$ amounts in thousands

 

Estimate of new WAG store economics

2009

2008

2007

Sales per store at 65% of avg. store*

 $5,491.96

 $5,533.91

 $5,717.49

Merchandise gross profit of 32%

 $1,757

 $1,771

 $1,830

Less rent per location

$329

$322

$331

Less SG&A per location

 $1,916

 $1,904

 $1,979

Op. profit per location

 $(488.40)

 $(455.25)

 $(480.08)

Op. margin per location

-9%

-8%

-8%

 

 

 

 

* We know that new COST store typically do about 60-70% of the sales levels of the corporate avg.

 

I’ve used Costco’s revenue growth curve for new stores as a proxy for WAG’s growth curve for its new stores (COST discloses store revenues by age cohort along with company averages in each annual report: on average, a new store does 60-70% of the revenue of its average store, and that it takes about 5 years for a new store to get to 90% of an average store’s revenue).  We can also get WAG’s average rent cost by taking its annual rent expense from the 10-K, and dividing that by the 80% of its locations that are leased as shown in Table III.

 

Table III.

WAG Rent per store from 2009 10-K

 

 

 

 

2009

2008

2007

Rent expense (net) $MM

$1,975

$1,787

$1,619

Locations rented, 80% of total base

5997

5547

4890

Rent per location

$329,342

$322,145

$331,111

 

WAG’s SG&A per location averages about $1.9MM per location (2007-2009 average), and I use WAG’s gross margin less its rent as a % of sales to estimate its merchandising gross margin.  So new stores earn about -$450K (rounding to the nearest $50K for simplicity) in their first year, on average.

 

So, what can we do with these per store economics numbers?  First, we can calculate the earnings drag for new stores in year 1.  For 2011, for example, I estimate that the earnings drag from opening 210 new stores in FY2011 is 210 x -$450K = $94.5MM pre-tax, or $0.06 per share after tax (37% tax rate, 980MM share base).  For years 2007-2009, when WAG opened 550 new stores on average, the drag from new stores in year 1 was $0.16 per share annually.  This starts to shed some light on why earnings have been stuck at around $2 per share in recent years. 

 

We can also get an idea of how the seasoning of WAG stores should impact WAG’s P&L.  Since most retail costs are fixed at the store level, the annual increases in profitability are really dependent on sales growth once a store is opened.  I’ve chosen to illustrate how the seasoning of the store base will impact WAG’s P&L by looking at the earnings impact of sales growth rather than illustrating a year-by-year margin change.  The latter is, after all, dependent on the former, and we can make some estimates for the entire store base using this comp sales approach. 

 

Again, I’m assuming that a new WAG store does 65% of the sales of an average store in its first year.  WAG’s average store did $8.5MM in sales in FY2009.  At a 2008 investor day, WAG estimated that its average store was just over 4 years old, and that’s probably still in the ballpark today given new store additions since then.  So, we need to get from $5.5MM in sales to $8.5MM in sales by year 4.   That’s $750K more per year per store in sales x 4 years to get to $3M more in sales through year 4.  WAG will have added 1988 new stores 2007-2010, equal to about 26.5% of its total store base.  However, with lower than average sales per store, those stores’ sales total about 22% of total company sales.  With this group of stores effectively building its sales at 11% per year ($750K/($5.5MM + $8.5MM)/2), 22% of  total WAG revenues x 11% sales growth = a 2.4% contribution to total WAG same-store (or “comp”) sales.  Let’s look at what contribution can we expect from the remaining 78% of WAG’s sales base.

 

 

Here’s how WAG’s comp sales have looked for the total company recently.

 

Table IV.

Source: WAG quarterly earnings releases

WAG Comp Sales

3Q 2010

2Q 2010

1Q 2010

4Q 2009

3Q 2009

2Q 2009

1Q 2009

4Q 2008

3Q 2008

Rx $

1.0%

0.6%

6.1%

4.5%

3.8%

2.9%

2.6%

2.8%

2.7%

Front-end

0.1%

-1.6%

2.7%

-1.4%

0.9%

-1.2%

0.0%

3.7%

4.6%

T. Sales

0.7%

-0.2%

4.9%

2.4%

2.8%

1.3%

1.7%

2.6%

3.4%

Rx. Vols

2.5%

3.4%

9.2%

5.9%

4.9%

4.0%

1.5%

0.6%

1.1%

 

 

I find it more instructive to look at the trend of front-end only comps on a trailing twelve-month basis in order to discern what’s happened to WAG in this recession.

 

Table V.

 

 

3Q 2010

2Q 2010

1Q 2010

4Q 2009

3Q 2009

2Q 2009

1Q 2009

4Q 2008

3Q 2008

WAG front end comps TTM avg.

-0.1%

0.2%

0.3%

-0.4%

0.9%

1.8%

3.1%

4.2%

4.8%

 

 

WAG’s front-end comp sales ran in the 5-6% range in 2004-2007, and then turned negative over the time frame in Table V.  Given unemployment trends, this seems intuitively appropriate. 

 

Pharmacy comp sales have also trended down from the high single digits in the mid 2000’s to the low single digits more recently.  I would reference a piece on pharmacy industry growth by Sanford Berstein’s Helene Wolk from 2/2009 entitled “Healthcare Distribution: Prescription Drug Market Forecast – How Low Can it Go?” In this piece we see that quantities of drugs consumed have been compressing from 8-9% growth in 2001-2002 to around 1% growth in recent years.  There is very little demographic impact on growth as population growth is pretty steadily around 1% per year, and the Baby Boom shift doesn’t add a lot to that 1%. But utilization growth in the number of Rx per person per year has recently flattened out after growing robustly throughout the early to mid 2000’s.  Reasons may be intuitive: a lack of innovation in new drugs (for a great example of this, see big pharma stock charts) and rising out of pocket co-pays seem likely to be the two most impactful factors.  Nonetheless, reports from IMS Health for 1Q 2010 still show that total Rx volumes grew 1%, and WAG has reported growing its comp store Rx volumes an average of 2.1% above the industry growth rate over the past 10 quarters. 

 

I believe it’s reasonable to estimate 1% Rx industry volume growth going forward, primarily based on population growth with flat per person utilization growth.  Given WAG’s convenient locations, there’s no reason they can’t continue to produce an additional 1-2% in market share gains.  This leads to 2-3% Rx volume growth at WAG.  Now we have to deal with the price impact.  Or do we? Generic drugs are 70% of industry (and WAG) volumes, but only 20-25% of sales.  There is price pressure on generics, and there still remains price inflation for branded drugs.  However, rather than the sales line, it’s really the gross profit line that’s important for estimating pharmacy growth because generic drugs cost much less than brands (leading to top line pressure) yet have superior profitability.  Therefore, I use volumes as a proxy for pharmacy same store sales growth, and deal with swings from reimbursement pressures (i.e. gross profit pressures) and brand/generic conversions as separate factors in this analysis since we have company disclosures and industry data that can help us model the impact.  Therefore, for Rx comp “sales,” I assume the pharmacy can do 2-3%.

 

For front-end sales, I assume 1-2% growth based on a slow, gradual recovery in consumer activity, only a fraction of the growth back in the halcyon days of easy credit and consumer excesses, when the front-end routinely grew comp sales at 5-6%. Summing up the comp sales contributions from new stores and the older store base,

 

(i)             Comps sales contribution from new stores = 22% x 11% = 2.4%;                 

(ii)           For the other 78% of the sales base:

a.      Pharmacy comps of 2.5% contribute 0.65 x 2.5% x 78% = 1.3%;

b.     Front-end comps of 1-2% contribute 0.35 x 1.5% x 78% = 0.4%;

(iii)          Summing up gives total WAG comps = 4.1%

 

Note: Rx sales are 65% of WAG sales; front-end is 35%.  Front-end is more profitable such that front-end earnings are likely nearly 50% of total WAG earnings.

 

While this shows that there should be better comps sales ahead, +4% seems aggressive in this environment.  This is where the art of interpretation comes into the analysis.  We know that recent comps have been coming in closer to 0-2%, and there is a tough comparison this fall with the swine flu season from 2009.  We also have problems getting job growth started in the U.S.  Therefore, I suggest a contribution from comp sales increases (and the corresponding profit contribution) of +1-2% for the near term, building to 2%, and then 3% beyond that.  Each comp point contributes $0.12 per share (dropping the gross margin of 28% down to the bottom line, tax effecting, and dividing by shares outstanding).  Therefore, as shown in Table VI. 1-2% comps contributes $0.18 in FY2011, and 2% comps = $0.24 in FY2012.  I believe this is supported by the seasoning of newer stores, even if the more mature base sees something incrementally less in terms of comp sales.

 

Even though I’ve mitigated the above estimate to adjust for a harsh consumer environment, we can estimate that the tailwind from new stores seasoning is on the order $0.29 per share per year (2.4% comp contribution x $0.12 per WAG comp point) as the 2007-2010 new store base seasons.  Checking this against company disclosures, company slides show new stores going from unprofitable (avg. of -$100K per store) in years 0-3 to profitable (avg. of about +$550K) in years 3-8 (see the recent slide deck from the BofAML conference on the WAG IR site).  We can estimate that 2000 stores increasing profitability by $100K per year would contribute $200MM to WAG’s op income, or $126MM after tax, equal to $0.13 per share.  Given that more rapid progress happens earlier (supported by a similar slide from the 2008 investor day slide deck, which I can no longer find on-line), I believe $200K per year per store improvements are better estimates for a nascent store base, and the corresponding +$0.26 per share tailwind is close to my $0.29 per share new store tailwind per my comp sales approach.

 

Again, I settle on the net result of adding $0.18 - $0.24 per share in 2011-2012 from improvements to store profitability as estimated by sales improvements, and this amount is used in Table VI. at the end of this analysis.   

 

There is also a merchandising program called CCR (“Consumer Centric Retailing”) that is consuming $40-$50K per store to remodel stores and improve SKU assortments.  This has become a red herring for Wall Street analysts as success has been choppy.  WAG has historically not driven increased basket size from merchandising efforts, and this is an attempt to improve that.  It’s really just incremental to WAG’s opportunity, just as is the newly introduced beer and wine opportunity, and I don’t feel it needs separate accounting.  However, there is an associated cost to reset the stores, and I take this out of FY2011 at the level of -$0.04 per share.  CCR remodels will be completed in FY2011, and will ultimately impact about 5500 stores.  An additional 1500 stores will be remodeled in 2011 v. 2010, 1500 x -$45K x (1-37%) / 980MM shares = $0.04.

 

3.    A strong balance sheet and the share repurchase opportunity.

 

WAG has a $2B share repurchase authorization outstanding, under which $638MM has been already used.  Assuming they execute the remainder over the next 12 months at an avg. of $30 per share, this would reduce shares outstanding by 45.4MM shares.  Due to timing, I assume that FY2011 weighted avg. shares outstanding are 30MM lower than FY2010.  This repurchase activity contributes $0.06 per share. 

 

A quick word on options issuance is necessary here.  Near the stock market lows of FY2009, WAG management must have decided to exercise the old adage about making lemonade from the lemons life deals because they quietly issued themselves about 4x their normal level of option grants at the then-depressed price of $28.4 per share.  This 16.8MM options issuance compares to 4.3MM in 2008 and 3.6MM in 2007.  We should check that we’re accounting for these extra $28 per share options via the treasury method when considering the size of the share base for FY2011.  In fact, let’s also assume they opportunistically issue another 3.2MM options presently, and use 20MM shares for this exercise.  A back-of-the envelope calculation of the dilution via the treasury method at $35 per share shows that this options grant would add about 4MM shares to the share base:

 

(i)             20MM shares x $28 = $560MM,

(ii)           $560MM/$35 = 16MM shares,

(iii)          20MM shares – 16MM shares = 4MM shares of dilution.

 

Now, WAG accounted for a dilutive effect of 5.6MM share in the recently reported Q3 compared to a 1MM dilutive effect last year, so my starting share base of ~ 980MM based on Q3’10 diluted shares outstanding for all calculations in this analysis seems appropriate as it appropriately accounts for the 2009 options dilution (the share price was high enough in Q3’10 to account for the dilution at share price levels close enough to our price target).  At least this is close enough to be approximately right – another 1MM of share dilution would be a 0.1% change to shares outstanding.

 

Before moving away from the cash situation and free cash flow, it’s worth a quick comment on the $1.4B in planned capex in FY2011 versus the $1.2B in FY2010.  Why the extra $200MM when store growth is slowing?  I can provide a partial answer.  WAG owns about 20% of its stores, and leases 80%.  From a capex standpoint, it spends $5-$6MM to establish a new, owned store, and $700K for a new, leased store.  Therefore, establishing 210 new stores in FY2011 would cost:

 

                  (20% x 210 x $5.5MM) + (80% x 210 x $700K) = $348.6MM

 

The only comments from the company I can find lead me to believe the other $1.05B will be spent on DC’s and technology investments.  For FY2011, per my estimates, WAG will do about $2.4B in net income, have $1B in D&A, and have about $1.4B in capex.  With net working capital control afforded by slowing store growth, free cash flow should be around $2B.  This should be sustainable thereafter.  With ~$600MM in dividends scheduled annually ($550MM in FY2010), about $1.4 should continue to be available for share repurchases annually.  I set aside repurchase timing considerations after FY2011, and assume the entire $1.4B is spent up-front on a $36 stock in FY 2012, augmenting EPS by ~$0.10 a share.  This is done to approximate earnings power in 2012 and 2013. 

 

(i)             $1.4B/$36 per share = 39MM shares

(ii)           39MM share/935 outstanding at 9/2011 = 4.2% taken out

(iii)          4.2% x $2.50 per share = $0.10 per share added

 

4.    Reimbursement pressures will continue to detract from earnings.

 

We’ve known for some time that generic drugs typically fall to 20% of the branded price within 12 months post patent expiry.  Since generics manufacturing is a commodity business, generics continue to decline in price beyond that period.  During this tail period, payers like PBM’s set reimbursement limits called maximum allowable cost, or “MAC,” that limit what they’re willing to reimburse for any generic.  Over time, retail pharmacies will complain that they’re getting their reimbursement squeezed by “MAC” pricing, and this becomes more evident to investors and observers when there aren’t new generics inflows to offset the price pressures from the tail generics.  Right now is such a time, and WAG reports $0.01 to $0.02 per Q of price pressure from this dynamic, and expects that pressure to continue through 2011. Further, as a result of states negotiating tougher reimbursement for Medicaid pricing, WAG is seeing another $0.02 per Q in pricing pressure from states in FY2010 ($80-$90MM in FY2010 per mgmt. comments).  The reason states are pressing on AWP pricing is a result of the 2009 AWP litigation settlement described in this article:  http://benefitslink.com/articles/guests/washbull090406a.html.

This source of pressure is about to abate, or anniversary, and there will be easier comparisons for a couple quarters.  However, states will take another cut starting in May 2011 when Medicaid switches from a reimbursement model based on average wholesale pricing (AWP) to average manufacturers price (AMP).  WAG management recently disclosed that a maximum impact from the AMP change could be $200MM, or $0.13 per share, after tax.

 

I account for reimbursement pressure as such:

 

A.     I assume $0.01 to $0.02 in per quarter pressure into perpetuity

B.     I assume the Medicaid pressure resulting from this year’s negotiations abates after 4Q 2010, per management comments, but

C.     I assume that WAG sees the full $200MM pre-tax Medicaid-AMP-based hit over one full year starting in May 2011.

 

These numbers will be summarized in the earnings power summary toward the end of this write-up.

 

5.    The generics boon.

 

This is an excerpt from the 10/2007 V.I.C. piece on the profitability of generic drugs:

 

“When a drug goes generic, there are significant excess profits made by the drug chains during a 6 month exclusive period; this raises gross profits dramatically from $10 to $20 per script up to $40-$60.  After this exclusive period ends, profitability drops to back to $20 to $30 – still better than branded drugs.”

 

In FY 2007, WAG saw a 60 bps gross margin increase, despite a negative mix shift as pharmacy sales grew ahead of front-end sales (note that front-end margins > pharmacy margins).  This 60 bp increase translated to a $322MM gross profit increase compared to a case where gross profit margins would have remained flat.  The company highlighted that two drugs moving from branded status to generic status really drove this shift.  Zocor and Zoloft were said drugs, and they went generic in June 2006, and had $7.7B in total sales the year prior.  Could two drugs really increase profits by about $150MM each?  In a recent conversation with the company regarding the aforementioned Medicaid-AMP reimbursement pressure of $200MM, WAG investor relations contact Rick Hans happened to mention that a “good generic” by itself could cover that cost.  With visions of $200MM generic profits per drug dancing in our heads, here are the scheduled upcoming generic entries: (just for the biggest drugs, smaller ones are not included):

 

 

Figure 1.

2011-2012 Major Drug Patent Expiries, 2009 WW Sales Per Drug, and Expected Generic Entry Dates

source: pharma company reports and FDA Electronic Orange Book

 

Aromasin, $483B, April 2011

Femara, $1.3B, June 2011

Total for WAG FY 2011 = $1.8B

 

Advair, €5.0B, September 2011

Zyprexa, $4.9B, October 2011

Plavix , $6.6B, November 2011

Caduet & Lipitor, $11.9B, November 2011

Avandia, €770, March 2012

Viagra, $1.9B, March 2012

Seroquel, $4.9B, March 2012

Total for WAG FY2012 = $37B

 

Singulair, $4.6B, August 2012

Diovan, $6.0B, September 2012

Geodon, $1.1B, September 2012

Atacand, $1.4B, December 2012

Partial look at early FY2013, 9/2012 through 12/2012, $13B

 

WAG’s FY2012 could really be a boon year.  In aggregate the 2011-2012 brand value losing patent protection amounts to ~2.5x the 2009-2010 level.  If $7.7B in expiring branded sales in 2006 could produce an incremental ~$300MM in 2007 profits, how much might $37B produce in FY2012?  The proportionate 2012 expiring branded sales level is about 5x the Zocor/Zoloft amount from 2006, and a direct proportion to WAG’s gross profit gain would be about $1.4B in incremental profits.  This incremental $0.93 per share seems a little too good to be true. Payers have gotten savvier, and PBM’s and distributors have promised investors they’ll also benefit from the generics wave.  People have had time to plan for it.   And we did have Cozaar go generic in FY 2010 ($3.5B in annual brand value), and Effexor XR ($2.75B) just went generic on July 1. I’ve cut this amount to about 40% to avoid being overly optimistic, and suggest an earnings boost of $0.35 per share in FY2012.  For FY2013, I’ve not performed the same level of analysis on big drugs going generic (I’ve just stopped at CY end 2012).  The late 2012 drugs will provide their own profit boost, and I’ve assumed a $0.10 headwind for FY2013 as a place holder guestimate (i.e. the loss of FY2012 profits are not completely made up).   Nonetheless, profitability for WAG should remain well in excess of $3.00 as more patent expiries continue (for example, I’d note the Cymbalta patent (with >$4B in sales) expires in June of 2013) and as comp growth improves the profitability of WAG’s store base.

 

 

6.    Summing up WAG earnings power.

 

Table VI. summarizes the FY2011 earnings impacts discussed in this report.  I choose a 1 ½ % sales comp for my base case, leading to $2.50 in per share earnings for this FY.  In front of the generics wave of FY2012, there’s no reason 2011E eps shouldn’t see a 14x multiple, leading to a $36 per share stock price.  Or, with earnings power of at least $3 per share in FY2012 (Table VII.), $36 per share is also 12x what should be sustainable earnings power of $3.00+ per share going forward. 

 

As a check on this methodology, a 10 year DCF at a 9% discount rate, a touch over 4% growth (2% comps + 2% new stores), steady EBIT margins at 6.0% (my estimate after the cost base reset), and capex and working capital requirements about $200-$300MM ahead of D&A charges, would also equate to $36-$37 per share.

 

 

 

Table VI.

WAG 2011 Earnings

 

 

 

 

 

Aggregate

WAG 2011 Earnings Estimates

Pre-tax

After-tax

Per share

EPS tally

2010 Net Income

 

2,100.00

2.14

2.14

Rewire Savings

500.00

315.00

0.32

2.46

CCR remodels

(67.50)

(42.53)

(0.04)

2.42

Continued reimbursent

 

 

 

 

Pressure at $0.04 to $0.08

(93.00)

(58.59)

(0.06)

2.36

AWP to AMP change

(66.00)

(41.58)

(0.04)

2.32

210 new stores, -$450K per

(94.50)

(59.54)

(0.06)

2.26

Share repurchase

 

 

 

 

$1.4B @ $30/shr.

wt'd share base 30MM lower

 

0.06

2.32

Comp sales contribution

 

 

 

 

4% comp

754.49

475.33

0.49

2.80

3% comp

565.87

356.50

0.36

2.68

2% comp

377.24

237.66

0.24

2.56

1% comp

188.62

118.83

0.12

2.44

0% comp

0.00

0.00

0.00

2.32

-1% comp

(188.62)

(118.83)

(0.12)

2.20

-2% comp

(377.24)

(237.66)

(0.24)

2.08

 

 

 

 

 

 

 

 

 

Table VII.

WAG 2012 -2013 Earnings Power

Note: the company expects the recent Duane Reade acquisition to become accretive in FY2012.

 

WAG 2012 Earnings Power

2011 EPS 

 $             2.50

Duane Reade

 $             0.06

Reimbursement

 $          (0.15)

New stores

 $          (0.06)

2% comp

 $             0.24

Share repos

 $             0.10

Generics

 $             0.35

 

 $               3.04

 

 

WAG 2013 Earnings Power

2011 EPS

 $             3.04

Reimbursement

 $          (0.08)

New stores

 $            (0.06)

2%-3% comp

 $             0.30

Share repos

 $             0.10

Generics

 $            (0.10)

 

 $               3.20

 

 

                 

 

7.    Risks.

 

The biggest risks to this thesis on WAG’s earnings power are:

 

A.         Same store sales disappoint, which could happen with a second leg down in unemployment and consumer spending

B.              Reimbursement pressure are much worse than I’ve estimated

C.          Or a general decline in the overall stock market such that earnings multiples employed are too aggressive or the equity risk premiums too light.

 

As a downside estimate, I’d suggest that with -2% comps, WAG could again see $2.00-$2.15 in FY2011, and the stock might stay stuck at $22-$25.  On a DCF basis, $24 per share basically equates to 0% sales growth and no margin improvement for WAG over 10 years using a 10% discount rate.  That seems much more than appropriately bearish as a downside estimate for America’s best retail pharmacy chain.

 

Summary

 

In summary, despite $2.10 in earnings power based on prior years’ results, WAG has closer to $3.00 in earnings power.  This should become evident with FY2011 earnings growth in the mid teens, and then $3.00+ in earnings in 2012 and 2013 on the back of a big generics wave.  In 2014, the U.S. may see around 40 million people gain health insurance coverage.  This would again provide a boon to WAG, it Rx volumes, and its front-end sales.  At $26 per share in July 2010, the stock price anticipates none of this. Investors should.  36% upside and 9% downside by this conservative analysis is a good deal.

Catalyst

There is no specific "catalyst" for this idea; it's an old-fashioned value idea that I'd expect to out-earn expectations over time.  My take is that the current share price is more tied to the current FY's $2 in earnings rather than the $3 that WAG should climb toward over the next 12-18 months (on a run rate basis).
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