October 03, 2011 - 5:07am EST by
2011 2012
Price: 32.89 EPS $3.24 $3.64
Shares Out. (in M): 895 P/E 10.2x 9.0x
Market Cap (in $M): 29,437 P/FCF 10.2x 9.0x
Net Debt (in $M): 853 EBIT 4,378 4,768
TEV ($): 30,290 TEV/EBIT 6.9x 6.4x

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In a market/economy where there is much uncertainty there are few industries/businesses that have a great deal of visibility over the next decade--the two dominant U.S. retail pharmacy chains (Walgreens & CVS) is one of them. Please see my write-up on CVS Caremark from 2/27/11 as it goes through in detail the economics of the drugstore chain's business model, provides a competitive analysis for WAG/CVS and discusses the industry/macro background information, which is a large part of my WAG thesis.
Seven months ago CVS was priced at $32.94 while WAG was at $41.55. Now CVS is at $33.59 and WAG is at $32.89. WAG's stock priced has declined 21% over the past 7 months while its EBITA over the past 3 quarters has grown over 12% and its diluted shares outstanding have declined over 7% YoY. Suffice it to say I believe both stocks are very cheap and I like them both for many of the same, but also for some different reasons.
WAG was written up twice in July, 2010 by two different VIC members in the $28-$30 range. WAG's valuation is just as cheap if not cheaper today than it was 5 quarters ago given LTM EBITA has increased by 15.2% while diluted shares outstanding have declined by 8.6%. Please see pilot72's WAG write-up from 7/24/10 as it has a lot of good information worth reading on WAG.
I am going to attempt to make this write-up as minimally redundant as possible with respect to pilot72's and my CVS write-up from earlier this year. I am going to focus on timely, pertinent points with respect to WAG that were not covered in either write-up, which can hopefully explain why the stock has sold off so dramatically as well as just how cheap WAG truly is.
Investment Thesis
WAG is trading at ~10x CY2011E cash EPS and ~9x CY2012E cash EPS. One must make a few adjustments to get to cash EPS from reported earnings:
1) WAG reports using LIFO in order to lower its tax bill (hence why it has a ~37% tax rate vs. CVS' ~39%). Since there is drug price inflation of 6-8% per year on brand drugs that make up ~75% of its pharmacy's CoGS, its gross profit was $208M less in the LTM than had it reported it under FIFO. FIFO is a more accurate reflection of the economics of the business.
2) WAG had ~$220M of amortization of intangibles in the LTM related to its prescription file buys (independents that are retiring will sell their files to a chain store nearby; CVS/WAG retain 90%+ of these customers), its acquisitions of small chains like Duane Reade as well as its most recent acquisition of Drugstore.com. Since amortization of intangibles is non-cash coupled with the fact that the customers of the entities it has acquired are sticky/retained, I believe one should add this back.
3) WAG had $70M of restructuring and Duane Reade integration costs in the LTM. In the most recent quarter it also incurred $41M of SG&A from drugstore.com (the first quarter it owned the business) with no earnings benefit since it has yet to integrate the business.
4) WAG has a fiscal year ending 8/31. Since most investors look at companies on a calendar basis there is another 4 months of EPS growth that must be factored in. While it might not seem like much, in the most recent quarter its adjusted EPS increased by $0.09. So that's ~$0.12 on a $3.12 LTM cash EPS base or ~4%.
Paying 9-10x EPS is very cheap for the #1 drugstore chain in the U.S. with ~20% market share, which should grow its EPS at a CAGR of 15%+ over the next 5+ years. WAG's drugstore business has tremendous value given a very strong economic moat due to its large scale (2nd largest purchaser of prescription drugs in the U.S.) and solid earnings growth opportunities (generic wave, growing 65+ year old population, etc.) over the next 5 years that are as close to guaranteed as I've ever seen. One gets 2 "free call options" (32+ million people gaining healthcare coverage and a RAD restructuring) that could hit in ~2014 and be fairly material to WAG's earnings power.  WAG's pharmacy business is a compounder. Since half of all retail prescriptions administered are unplanned, physical pharmacies are required for just-in-time dispensing. It would be extremely difficult for most large organizations to have a prescription drug plan that excludes either Walgreens or CVS for dispensing prescriptions. Because WAG (as well as CVS) has such a large footprint that would be near impossible (and take many years) to replicate, it is an essential part of drug distribution and as a result will continue to have a relatively dominant negotiating position vis-à-vis other players in the supply chain. Also, the shift of scripts to the PBM mail channel has barely increased over the past 5 years, which strongly suggests bricks & mortar will continue to be the main end-point of delivery. Market leading businesses with industry growth tailwinds don't normally trade for 9-10x earnings.
Why WAG Sold Off
On 6/21/11 WAG announced that as of 1/1/12 it was planning to no longer be in Express Scripts' (ESRX) network since WAG didn't feel it was being paid a "fair" amount for its services. ESRX is the 3rd largest Pharmacy Benefit Manager or PBM behind Medco (MHS) and Caremark. If WAG and ESRX don't come to a resolution, in a downside scenario assuming it has zero recapture of ESRX related revenue, WAG stands to lose up to $5.3B of pharmacy sales (plus some associated front-end sales) equal to ~$0.35 or ~11% of CY2011E cash EPS. However, what complicates the issue even further regarding a downside scenario is that ESRX and MHS are currently in the midst of getting regulatory approval to merge. Thus investors fear that if WAG does not have a deal with ESRX and then ESRX/MHS merge, down the road WAG would walk away from the MHS network (its public stance) if the ESRX executive management team (which is slated to run the combined entity) were to impose the same reimbursement rates for MHS that it already does for ESRX. Thus a worst case scenario would be that it loses an additional ~$6B of revenue, but at a higher incremental margin since there would be less available overhead to cut. For a rough guess I assume it would be ~$0.55 of additional EPS loss on top of the ~$0.35 related to ESRX. Thus maybe investors are fearful of WAG's EPS declining to ~$2.74 in for CY2012E (from my $3.64 estimate), which would put it at ~12x CY2012E cash EPS assuming 100% loss of both ESRX and MHS related business.
Why WAG (and CVS) Has Leverage over the PBMs
You can read all the back and forth rhetoric from both companies for their respective positions as well as the numerous analyst notes out there, but I'm going to try to explain my independent viewpoint based on logic. At the end of the day WAG and CVS have their respective 20% and 18% retail pharmacy market shares for a 38% combined share (relative to their combined ~24% location share) because that is where people have chosen to go due to more convenience, better services and nicer stores vs. its competition. Unlike medical insurance, very few Rx plans have a restricted network so people generally have the ability to get their Rx from just about any drugstore. The reason that is the case is because prescription Rx amounts to a relatively small 10%-15% of total healthcare spend. At the same time the Rx cost trend has been relatively benign due to the generic dispensing rate increasing from ~59% in 2006 to ~76% in 2011. Since the generic dispensing rate is going to increase to ~90% in 2015 the cost trend is going to remain subdued. Therefore plan sponsors have not and are unlikely to consider "drastic" measures such as restricted networks to lower their Rx costs until the cost trend increases at a high rate. That being said plan sponsors are rational and will consider just about any healthcare cost control mechanism relative to the resulting savings.
If one excludes only WAG or CVS from the network, guess what the resulting savings is to the plan sponsor? Practically NOTHING! Why, you logically ask? Because the only way a PBM can garner savings with a restricted network is to have a VERY restricted network in order to drive enough increased volume to the remaining network participants so that the PBM can get lower reimbursement rates from those remaining network participants. The only other way there could be materially high savings from just cutting WAG out of the network would be if it were receiving much higher reimbursement rates than all of the other drugstores in the network, which does not appear to be the case.
ESRX's plan sponsors' members have ~90M Rx filled at WAG's drugstores in a given year. U.S. drugstores fill ~4.1B Rx per year. If you allocate that 90M of Rx across the pro-rata share of the remaining 59k pharmacy locations (WAG has ~8k out of the industry's 67k locations), then it would result in a small bump in sales/profits to those pharmacies. Let's go through the math:
# of annual 30-day equivalent Rx dispensed at non-WAG drugstores: ~3,300M
# of Rx to be gained by non-WAG drugstores from WAG leaving ESRX's network: ~90M
Increase in Rx dispensed annually to non-WAG drugstores: ~2.7%
Since the average drugstore would make hardly any more profit from just WAG being excluded from the network then it's fairly clear as to why ESRX cannot offer the plan sponsor any real savings from this maneuver. If you're a plan sponsor why would you accept disruption to your employees benefits for no cost savings in return? It simply doesn't make sense. Rather the plan sponsor could switch to Caremark and have a complete network with WAG and find other ways to save money such as using its maintenance choice plan or it could consider a very restricted network, but few employers have chosen to go this route.

Last month a well-known sell-side firm published a research note that included a survey of 50 Fortune 1000 employers. It asked the HR benefits manager (who chooses which PBM to use) of these companies a conditional 2 part question: 1) Would it consider a less than 100% complete retail pharmacy network; 2) If yes, what is the % of savings needed in order for you to do it? 57% of the respondents said there was NO AMOUNT of savings that could persuade it to use a restricted network. 30% said it would need a 5% discount. ESRX cannot deliver a 5% savings to the plan sponsor from solely excluding WAG from its network. Thus a majority of Fortune 1000 companies have little to no interest in any kind of limited pharmacy network.
The only Fortune 1000 company (I'm aware of) that has chosen to do a very restricted network is CAT. They decided to basically use just WAG and WMT, which largely satisfies the urban and rural footprint for where their employees live. By cutting out ~81% of the industry's locations CAT was able to drive enough volume to the remaining 19% of locations (owned by WAG & WMT) to get them both to agree to fill CAT's Rx at a lower cost. Let's look at the math (assuming a hypothetical 10M of Rx fills for CAT employees) to see how this works:
Pre-restricted network WAG was filling ~2M of CAT's Rx. Post-restricted network WAG is filling ~7M of CAT's Rx. Thus you can see that a very restricted network can increase the in-network pharmacy's volume by ~3.5x, which is enough of a volume increase to allow for lower reimbursement rates.
Lastly, WAG's 20% market share is made up by having much larger shares in many key major metropolitan areas like New York, Chicago and San Francisco. The bottom line is if an employer has any major presence in a key Walgreens market there is little chance it would be willing to not have those pharmacies in its network.
Major Incentives for WAG & ESRX to Get a Deal Done
The grand irony of this whole spat is that in the off chance that no deal gets done between WAG & ESRX, both would be significantly strengthening their #1 competitor, CVS Caremark, in a major way. First, CVS would stand to pick up 15M+ in annual Rx fills at its drugstores, which would help increase CVS' 2012E EPS by ~3%. Second, by ESRX (and potentially MHS) not having WAG in the network, Caremark would be the only major PBM in the upcoming selling season that can guarantee plan sponsors that it has a complete network with Walgreens in it. While WAG knows its worst case scenario in terms of how many Rx it stands to lose from not being apart of ESRX's and MHS' network, ESRX and MHS don't truly know how many clients they might lose as a result of not having WAG in their network. The reason is because until this benefit is cut, the HR benefits manager won't know how much this will upset its employees. If there are enough upset employees that vocally complain to HR then it would be enough to get the employer to switch PBMs. The HR benefits manager has 2 goals at work in order to not get fired: 1) make sure the healthcare cost trend is in check; 2) make sure employees are satisfied with their benefits.
WAG's Margin Expansion Opportunity
On an apples-to-apples basis (FIFO adjusted, backing out one-time expenses) CVS' retail LTM EBITA margin was 7.5% vs. WAG's at 6.2%. This is despite the fact that both drugstore chains have approximately the same sales per sq. ft. of ~$850. So how can this be? WAG has a lot more stores that are unprofitable and/or below maturity levels compared to CVS. WAG has 22.3% more retail sq. ft. than CVS, but fills only ~11% more 30-day equivalent Rx. About 3/4 of CVS' store base was built through acquisition where it would close down the acquired stores after opening a brand new one close by. Essentially it brought a built-in customer base to its new stores. On the other hand WAG's growth was mainly organic and did not have as much of a built-in customer base for its stores so its stores take longer ramp up. Almost 30% of WAG's store base was opened in the past 5 years; 12% in the past 3 years (vs. 8.2% for CVS). As a result I believe WAG has a lot more unprofitable and below average stores dragging down the company's profitability. The question is will those stores ultimately ramp up over time? I don't have the answer, but it appears to be a free call option at the current valuation. Plus as the company continues to slow its new store openings to less than a 3% increase per year combined with immature stores continuing to ramp up, margins should naturally increase over time.
Shareholder Friendly Use of Free Cash Flow
In the LTM, WAG generated $3,643M of operating cash flow. It spent $1,213M on capex of which ~$300M was for new stores. Thus ~$900M is maintenance capex, which equals depreciation. Out of the $2,430M of free cash flow, it paid out $647M in dividends and used $1,784M to repurchase shares thereby returning 100% of FCF to shareholders. Said another way only 11% of OCF - maintenance capex was spent on new stores that have a questionable ROIC on a stand-alone basis, but likely help preserve/grow the economics of the overall business by virtue of increasing its market share over time.
How the WAG/ESRX Conflict Likely Plays Out
Of the ~90M ESRX related Rx WAG fills ~11% of it is tied to Medicare Part D (drug plans for seniors). Seniors have the ability to change plans once a year during enrollment season, which is from Oct. 15 - Dec. 7. Seniors choose their plans mainly based on which drugs are covered and what pharmacies are in the network. Walgreens is making it very clear to seniors that if you have an ESRX Part D plan it may not have WAG in the network come 2012. This is basically a free shot for WAG to take a pound of flesh from ESRX with little consequences to its business. I suspect after Dec. 7 (if not sooner) negotiations will heat up again and a deal will get done in mid/late December before mutual self-destruction occurs beginning January 1, 2012. If I'm wrong then we have an idea what the worst case scenario earnings looks like for WAG with and without an ESRX/MHS merger.
Reward/Risk (over 2 years): 3.5x
2 Year Upside (ESRX resolution): 13x ~$4.20 CY2013E cash EPS + $1.80 (2 years of dividends) = ~$56 (+70%)
Immediate Downside (no ESRX/MHS Rx): 10x ~$2.74 CY2012E cash EPS = ~$27 (-20%)


WAG and ESRX settle their contract dispute. The generic wave kicks in beginning with Lipitor likely going off patent in November, 2011.
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