Walgreens WAG
October 28, 2007 - 9:18pm EST by
2007 2008
Price: 40.18 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 40,433 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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Due to a recent EPS miss and a poorly worded earnings press release, Walgreens (WAG), one of the great growth stories of the past 20 years, gapped down 25% last week.  Despite consistently growing sales and earnings at 14% and 15% since 1997, the company is now trading at a decade-low multiple.  The underlying causes driving the miss were: SG&A that rose ahead of earnings and a miscalculation on reimbursements for two generic drugs (a one time problem).  Management can fix this.  When it does, the stock should rebound dramatically.  Further compounding the markets misunderstanding is that its true earnings power and returns on capital are being masked by the growing yet still immature store base. 


For a company still growing (1) revenues at a low double digit rate assuming a 6-8% square footage growth and mid single digit comps, and (2) earnings in the mid-teens with a free cash flow yield of approximately 8% (fiscal 2009 which ends in August), the stock is unduly being discounted.  We believe if you value the current store base at a 15x multiple, you have a $60 stock or 50% upside from here.  We would either recommend buying the stock or a leveraged play by buying the January 2010 $20 Calls at $22 which provides over 70% upside from here.

Why it got cheap?


When WAG”s stock headed south recently, it was due to the following reasons:


-          Lower reimbursements: The year end earnings release cited lower reimbursements on some popular generic drugs (generic version of Zocor in particular).  This implied that there may be a structural issue in generic reimbursement; as a result Walgreen’s stock was hit at its low point by over 15% and CVS by over 8% on that day.  In reality, there are no structural issues as nothing has changed for generic reimbursements as was implied by the press release; specifically:

o       Zocor went generic in early July/late June of 2006.  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.  If the drug is big like Zocor, this can have a material impact on profitability if costs are not reined in – which the company did not do. This is not a new phenomenon and subsequent conversations with the CEO reinforced that this was not new and competitors simply managed the transition better than WAG; subsequent conversations with CVS also gave us reassurance that nothing has changed and WAG should have seen this coming


-          Higher SG&A costs: due to salary and store expenses, along with increased advertising.  Many Wall Street analysts subsequently downgraded the stock believing that this was a permanent issue for the company.  However, management can and will bring down SG&A expenses more quickly than people think; Note: CVS – runs 20% SG&A as a % of sales in 2006 while WAG is at 22.5% for this fiscal year.  Half of SG&A is payroll which the company has admitted was not appropriately matched with sales when gross profit dollars came down due to above phenomenon.  The company also hired a number of management consultants to help them with some of the growth initiatives (e.g. biologics, clinics) which can obviously be cut where appropriate.  Discretionary spending on advertising (promotions) will also be reined in and the CEO admitted that they simply got careless on where and how effective dollars were being spent.  We estimate that the increase in advertising was over 60% year over year and could easily be corrected for the next quarter.


-          Older News: Last year, both WAG’s and CVS’s stock became cheap for several reasons.  The main reasons included Wal-Mart’s (WMT) $4 generics - introduced September 2006, AWP and AMP affecting reimbursements, and risks associated with a soon to be elected Democratic Congress.  For more details on these issues, please see the CVS write-up from December 2006.


Business Description

Over 100 years old, Walgreen’s is the largest drug store retail chain based on both prescription dollars and number of prescriptions filled at retail.  Its 6,014 stores make it the second largest (to CVS) but with its 475 planned net new stores, the company will finish 2008 in the lead at roughly 6,500 and growing.  The company’s stated goal is to have over 7,000 stores open by 2010 – a number they should achieve by late 2009. 


The annual sales/store and sales/sqft are $8.9MM and $797/sqft, respectively, up from $7.9MM and $719/sqft three years ago.  These metrics continue to trend upwards as the company continues to grow in a growing industry.  It is important to note that stores take time to mature and that pharmacy traffic is incredibly sticky. 


Approximately 64% of sales are prescription drugs up from 62% five years ago.  11% is non-prescription drug sales and 25% is general merchandise sales.  93% of these prescription drug sales are to customers covered by third party insurance and 63% of drug sales are generic drug sales.  More than half of the non insurance drug sales are lifestyle drugs where buyers are price insensitive.  Private label currently represents 19% of front-end sales and has been trending up over the last few years (just 17% last year). 


The company also has a managed care division, Walgreens Health Services, which includes the company’s mail order, specialty, home care, Take Care health clinics and other adjacent sectors of pharmacy. 


Overall, the company has $53.8B in TTM revenue and a market cap of $39B and TTM earnings of over $2B.  It is a behemoth in the retail distribution of drugs.

Strong Competitive Advantages

Walgreen’s has the following competitive advantages:

-          Convenience: If ever there was a good moat in the distribution of pharmaceuticals, it is through great retail locations.  WAG was forward thinking over 15 years ago when it started down the path of building free-standing pharmacies with drive-thru windows (5,033 stores) and 24 hour access (1650 stores)  to make it more convenient for seniors and busy moms – the purchasers of over 80% of drugs.  There is no substitute for this convenience.  


-          Outstanding Customer Service: Walgreens is known for their outstanding customer service.  This shows with their company average of filling over 300 scripts/day, the highest in the industry


-          Attractive, young, and clean store base: The average age of the stores are just over 5 years and over 90% of the store base has been built in the past decade.  In the last five years, close to 50% of the store base has been opened or remodeled


-          Lowest cost of capital in the industry: Extremely attractive financing terms - amongst the best in the industry.  85% of the leases don’t have escalation clauses during the lease term which is typically 50 years; note that lease terms now being signed are 75 years.  The company owns roughly 20% of its store base


-          #1 market share leads to scale/purchasing efficiencies: Smaller chains and independents do not have economies of scale, thus enabling WAG to be a lowest cost competitor.  The growing share makes advertising, purchasing and distribution more efficient – leading to a network-type effect.  With market share of 17% up from 14% in 2003,  WAG continues to gain mainly at the expense of independent chains, a group that now accounts for 21% share versus 30% just 10 years ago


 Extremely Strong Industry Trends


WAG further benefits from fantastic long-term industry trends:


-          US Population Growth: The US population will continue to grow at 2% per year; thus the market size continues to grow.


-          Aging population: An aging population that is living longer and takes more drugs should fuel growth for a long time (see CVS write-up dated 12/04.06 for statistics)

o       1 in 8 Americans is over the age of 65 and by 2020 that will climb to 1 in 6 Americans


-          Growth in chronic conditions: The growth in chronic conditions in this country cannot be emphasized enough.  Diabetes, heart disease and cancer are highly treatable diseases.  Further, prescription drug use is the number one method to keep patients out of the hospital – the most expensive and risky proposition for patients and payors.


-          Generic Utilization: Generic utilization should continue to increase as cheaper priced drugs help increase compliance (which means more profits and more scripts for Walgreens); generic usage was 50% (of scripts) in 2004 and is now 63% and moving higher


-          Future Generic Waves: 2004 to 2006 was the first big generic wave (drugs coming off patent).  But 2009 and 2011-2012 will see major generic waves as well.


-          New Drugs: The biotech pipeline, despite numerous failures and great expense to get drugs to market, is quite robust.  Professionals consistently underestimate the pace of progress.  These new drugs come with very high price tags and thus profits for the pharmacies.  These drugs will treat old and previously untreatable illnesses (e.g. Viagra, Zoloft for depression, Avastin for colon cancer, Herceptin for breast cancer, Tamiflu for a potential Bird Flu pandemic, and various new drugs for AIDS and Attention Deficit Disorder (ADD))


Strong and experienced management team


-          The average store manager, average district manager and average store operations (vp tenure) has over 12 years, 20 years and 27 years of experience, respectively


-          Jeffrey Rein, the recently appointed CEO in July 2006, worked his way up through store operations over 25 years.  He started as a pharmacist in the stores, then store manager, district manager, treasurer, then ran the whole marketing division, and later became President and COO prior to his promotion


-          The company history and depth of management is shown by its industry leading averages in prescriptions per store, etc.


-          Real Estate Team: WAG’s real estate team is widely regarded as the best in site location and assembly as well as deal-making


What are the opportunities?


The opportunities are both from within the store as well as outside the “box.”  They are as follows:


-          Instore Opportunities:


o       Filling more prescriptions: The Company has been growing its scripts per pharmacy for years.  Many stores do in excess of 700-800 scripts/day.  We expect this trend should continue

o       Clinics - Recently purchased, Take Care Clinics is expanding from the current 60 clinics to over 400 by the end of 2008 and perhaps thousands over the next five years.  These clinics are great for simple needs like soar throats

§         Studies have shown that 50-70% of Americans do not have or use a primary care physician and therefore over-utilize emergency rooms and acute care clinics

§         In terms of economics, the average emergency room visit costs $300-$400 (125MM ER visits last year) while the average cost of a Take care clinic visit is $50-$60; so it is easy to see why this could be a significant long-term opportunity

o       Private or exclusive brands now represent 19% of front-end sales which could grow to 25-30% (where many supermarkets are now)

o       Other initiatives being tested or recently rolled out

§         Inkjet Refill machines in photo finishing departments – costing around 50% the cost of buying a new one

§         Café W – is a beverage bar offering hot and cold drinks and snacks


-          Store growth is still significant (8% in fiscal 2008) and is being financed through internally generated cash flows

o       The company already has 1,400 approved deals (3 years of growth) for new stores and has not changed hurdle rates for these store.  This is key as there is significant competition for prime sites from CVS, Starbucks and other retail chains.


-          Cost cutting/efficiency gains

o       SG&A will be reined is as the company scrutinizes discretionary spending – which is a fairly quick fix

o       Other efficiencies include more efficient distribution centers and streamlined workflows


-          Under leveraged balance sheet

o       The company owns approximately 20% of its store base and currently has 0.2x debt/EBITDA while CVS is over 2x (which itself is conservative)

§         This could easily be levered 3x which would represent over 30% of the current market cap

o       The company announced a $1bn share repurchase in January 2007 to be completed over the next 4 yrs


-          Expanding into adjacent sectors of pharmacy

o       Specialty Pharmaceuticals - The company is expanding its specialty pharmacy business recently acquiring Option Care making it the 4th largest Specialty provider in the nation (#1 independent specialty provider and #2 home infusion with a national platform)

§         Specialty Pharmacy is a $60bn industry growing at 20% annually

o       Seniormed – WAG recently took full ownership of this joint venture, which primarily provides for medication needs of long-term (lower-touch) care facilities, which is a significant growth area as the population ages

o       Familymed – operates 30 small pharmacies in medical complexes, medical buildings, and employer campuses

o       Mail order – the company has less than 3% share in this $50bn industry and believes it can be a great complement to its retail presence


-          Decision to Slow growth/True Earnings Power is Masked

o       Because pre-opening costs are expensed as incurred, should the company slow down its growth, it’s ROIC will balloon and margins will expand materially

§         ROIC’s for all stores are around 10%, while ROIC’s excluding stores that are 3 years or younger are 15-16%

§         The hit to EBIT is over $300MM which represents about 10% of total company EBIT

o       We do know that this option is being discussed at the Board level and the CEO of McDonald’s (Jim Skinner) is helping to decide whether this makes sense




1) Growth has been a significant drag to free cash flow and returns on capital.  We believe it is more appropriate to value the current store base excluding growth from adding new stores.  Current store base valuation: As of fiscal 2007 (ending in August), the company had 5,997 stores which will all operate at a 15% return on capital in 3 years:


            Stores                          5,997 (in 3 yrs all stores will have a 15% ROC)

            Cost/store:                  $4.5MM

            ROC:                           15%

            Nopat = FCF:              $4,048 (Deprec = Maint Capex)

            Multiple:                     15x     

            Diluted Shares:           1,006


            Value:                          $60 (50% upside from here)


Note: we have assumed corporate expenses (3-4% of sales) are offset by Walgreen’s Health Services.


- The company will start doing analysts calls after releasing earnings – 1st one will be December 21
- Cost cuts show improvements in SG&A, could be as soon as Q1, which ends in Nov
- CVS earnings call – reiterates industry fundamentals
- Increase in Buybacks
- Recap – although given current capital markets (unlikely)
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