Have been looking at Walgreens for awhile been slipping a bit want to get in around 40
Walgreen WAG
by Mitchell P. Corwin, CFA, CPA
Thesis 01-24-2006
Competitive threats should continue to challenge Walgreen, but we think the firm's head start in finding and developing the best store locations should ensure its continued dominance and wide-moat status. Since the early 1990s, the company has had a laserlike focus on being the first to build larger, freestanding stores on high-traffic corners, recognizing that convenience is paramount in driving traffic and building consumer loyalty. Walgreen's steady pace of internal growth and high store productivity has led to consistent double-digit earnings growth and the highest returns on invested capital of any drugstore chain. With plenty of room left for expansion and trends favoring sustainable growth in prescription drug spending, we believe Walgreen can sustain its impressive results.
Prescription drug spending is expected to grow rapidly in the years ahead. An aging baby boomer population, increased usage of pharmaceuticals as a solution for health-care needs, a new Medicare prescription drug benefit, and more generic drug introductions should all provide strong tailwinds for the industry over the next decade. Prescription drug spending is key for Walgreen, since it derives 64% of its total sales from dispensing pharmaceuticals.
Despite the numerous options available for consumers looking to fill prescriptions, many still favor the convenience of the corner drugstore, and Walgreen is adept at choosing the best corners. We estimate that a Walgreen store, on average, generates 30% more sales than its nearest competitor, CVS CVS, thanks to an average of more than 260 prescriptions filled per store per day compared with CVS' average of about 215. This volume advantage is important because, with low incremental margins on prescription drugs, increased customer counts lead to increased sales of higher-margin convenience items like health and beauty products and snacks.
More productive stores equate to better earnings per store and robust free cash flow. This abundance of free cash flow not only ensures that Walgreen will open its 7,000th store in 2010, but also enables the company to opportunistically invest in infrastructure such as its distribution system, which is the most modern in the industry. Technology investments, such as load balancing, also enhance Walgreen's ability to better serve its time-strapped customers while improving productivity. Finally, the firm can proactively invest in complementary businesses, such as home health-care services.
Valuation
After reviewing Walgreen's latest 10-Q filing and incorporating cash flows received by the firm, we are increasing our fair value estimate to $51 per share from $50. As the firm dispenses more lower-priced, higher-margin generic drugs at the expense of branded drugs, top-line growth will probably continue to slow, but profitability should rise. We assume sales increase 11.5% in 2006 and 2007 before heading back up to around 12.5% as the effects of the mix change from branded to generic drugs become less pronounced. We assume operating margins rise to 6.2% in the next few years, compared with the 5.9% earned in 2005, which excluded the impact of Hurricane Katrina. Walgreen's operating margins could widen further if more of the gains from higher sales of generic drugs flow to the bottom line. However, we think the firm will continue to boost spending on labor, store hours, and promotions to improve market share. Our operating margin forecasts don't include the impact of stock-option expensing. These expenses are accounted for separately.
Risk
Competition from discounters, supermarkets, and other drugstore operators, such as CVS, remains a constant threat. Also, pharmacy-benefit management companies have taken market share in recent years through mandatory mail programs that allow consumers to bypass the pharmacy counter. Reimbursement rates could be further pressured, especially as the U.S. government gets more involved in coverage through its new Medicare prescription drug benefit plan.
See Previous Analyst Reports
Close Competitors TTM Sales $Mil Market Cap $Mil
Walgreen 42,202 43,216
* CVS 36,197 22,276
* Rite Aid 16,802 1,885
* Morningstar Analyst Report Available | Compare These Stocks
Data as of 12-31-2004
Strategy
Walgreen plans to grow from about 5,000 stores currently to 7,000 stores by 2010. Convenience remains the key driver of business success. Besides better locations, the company has developed more freestanding stores with drive-through pharmacies and expanded business hours, keeping more than 1,500 stores open 24 hours a day. The company is also expanding into more managed-care services.
Management & Stewardship
Walgreen likes homegrown talent and has had little turnover at the top--just five CEOs have led the company since its founding in 1901. Chairman and CEO Dave Bernauer worked his way up the corporate ladder and has spent nearly 40 years with Walgreen. We would prefer the company split the chairman and CEO positions. We think Bernauer's salary and bonus, which totaled about $2.1 million last year, is reasonable. Bernauer beneficially owns more than 1 million shares of Walgreen stock, so his incentives appear to be aligned well with those of the company's shareholders. We like that Walgreen issues restricted shares but would rather management be offered those shares in lieu of--not in addition to--stock options. The firm gives scant details regarding incentive compensation, although restricted stock is granted based on earnings goals subject to a minimum return on invested capital, which is fine by us. Directors stand for election annually and receive 50% of their compensation in the form of Walgreen stock, which we like. We were pleased to see Walgreen recently bring in McDonald's MCD CEO James Skinner to serve on the board. Certainly Skinner has a keen understanding of what it takes to operate a large store base.
Profile
Walgreen operates more than 5,000 drugstores in 45 states and Puerto Rico. Prescription drugs account for 64% of total sales. The remainder of sales include nonprescription drugs, health and beauty items, toiletries, food, beverages, and general merchandise. The firm operates its own pharmacy-benefit manager service.
Growth
While still robust, growth has slowed a bit as sales of lower-priced generic drugs have increased at a faster clip than sales of branded drugs. We expect overall top-line growth to average around 12% annually over the next five years.
Profitability
Operating margins, excluding the effect of a one-time charge related to Hurricane Katrina, increased to 5.9% in fiscal 2005 from 5.7% in fiscal 2004 as a result of higher sales of generic drugs. We think operating margins will increase to about 6.2% long term.
Financial Health
Walgreen sports a pristine balance sheet with no debt, and operations throw off plenty of cash. The company has a lot of operating leases, but we capitalize those leases, and the coverage ratios appear adequate.
Morningstar Rating
01-24-2006
Stock Price
As of 01-24-2006
$42.70
Fair Value Estimate
$51.00
Consider Buying
$43.50
Consider Selling
$67.00
Business Risk
Below Avg
Economic Moat
Wide
Stewardship Grade
B
Analyst Note
Drugstores Report December Sales
Mitchell P. Corwin, CFA, CPA 01-10-2006
See All Notes
Bulls Say
Walgreen's growth remains strong. The firm posted 12.5% sales growth and netted 371 new stores in fiscal 2005. The company expects to net 390 stores in fiscal 2006.
We think Walgreen is years ahead of its peers in scouting locations for future stores, and the firm aggressively pursues the sites it wants, paying premium dollars for prime locations.
The Centers for Medicare & Medicaid Services estimates that the average annual rate of prescription drug spending will grow at about 10.2% through 2014.
Walgreen's focus on convenience is clear, as the company boasts the highest percentage of freestanding, 24-hour, and drive-through stores in the industry.
We believe the Walgreens Health Services division, which houses the company's own pharmacy-benefit management business, is poised to grow at a faster rate than the company's retail operations over the next five years.
Bears Say
Legislative changes to the Medicare prescription drug plan could lower reimbursement rates and squeeze profitability for the drugstore chains.
The acquisition of Eckerd stores in Florida and Texas gives competitor CVS a foothold in some lucrative markets Walgreen is counting on for growth.
Thanks to a history of outstanding performance, Walgreen has traditionally traded at a very high price/earnings multiple. Any dent in expected growth in sales and earnings could hammer the stock.
A nationwide shortage of pharmacists could hinder Walgreen's expansion
Walgreen WAG
by Mitchell P. Corwin, CFA, CPA
Thesis 01-24-2006
Competitive threats should continue to challenge Walgreen, but we think the firm's head start in finding and developing the best store locations should ensure its continued dominance and wide-moat status. Since the early 1990s, the company has had a laserlike focus on being the first to build larger, freestanding stores on high-traffic corners, recognizing that convenience is paramount in driving traffic and building consumer loyalty. Walgreen's steady pace of internal growth and high store productivity has led to consistent double-digit earnings growth and the highest returns on invested capital of any drugstore chain. With plenty of room left for expansion and trends favoring sustainable growth in prescription drug spending, we believe Walgreen can sustain its impressive results.
Prescription drug spending is expected to grow rapidly in the years ahead. An aging baby boomer population, increased usage of pharmaceuticals as a solution for health-care needs, a new Medicare prescription drug benefit, and more generic drug introductions should all provide strong tailwinds for the industry over the next decade. Prescription drug spending is key for Walgreen, since it derives 64% of its total sales from dispensing pharmaceuticals.
Despite the numerous options available for consumers looking to fill prescriptions, many still favor the convenience of the corner drugstore, and Walgreen is adept at choosing the best corners. We estimate that a Walgreen store, on average, generates 30% more sales than its nearest competitor, CVS CVS, thanks to an average of more than 260 prescriptions filled per store per day compared with CVS' average of about 215. This volume advantage is important because, with low incremental margins on prescription drugs, increased customer counts lead to increased sales of higher-margin convenience items like health and beauty products and snacks.
More productive stores equate to better earnings per store and robust free cash flow. This abundance of free cash flow not only ensures that Walgreen will open its 7,000th store in 2010, but also enables the company to opportunistically invest in infrastructure such as its distribution system, which is the most modern in the industry. Technology investments, such as load balancing, also enhance Walgreen's ability to better serve its time-strapped customers while improving productivity. Finally, the firm can proactively invest in complementary businesses, such as home health-care services.
Valuation
After reviewing Walgreen's latest 10-Q filing and incorporating cash flows received by the firm, we are increasing our fair value estimate to $51 per share from $50. As the firm dispenses more lower-priced, higher-margin generic drugs at the expense of branded drugs, top-line growth will probably continue to slow, but profitability should rise. We assume sales increase 11.5% in 2006 and 2007 before heading back up to around 12.5% as the effects of the mix change from branded to generic drugs become less pronounced. We assume operating margins rise to 6.2% in the next few years, compared with the 5.9% earned in 2005, which excluded the impact of Hurricane Katrina. Walgreen's operating margins could widen further if more of the gains from higher sales of generic drugs flow to the bottom line. However, we think the firm will continue to boost spending on labor, store hours, and promotions to improve market share. Our operating margin forecasts don't include the impact of stock-option expensing. These expenses are accounted for separately.
Risk
Competition from discounters, supermarkets, and other drugstore operators, such as CVS, remains a constant threat. Also, pharmacy-benefit management companies have taken market share in recent years through mandatory mail programs that allow consumers to bypass the pharmacy counter. Reimbursement rates could be further pressured, especially as the U.S. government gets more involved in coverage through its new Medicare prescription drug benefit plan.
See Previous Analyst Reports
Close Competitors TTM Sales $Mil Market Cap $Mil
Walgreen 42,202 43,216
* CVS 36,197 22,276
* Rite Aid 16,802 1,885
* Morningstar Analyst Report Available | Compare These Stocks
Data as of 12-31-2004
Strategy
Walgreen plans to grow from about 5,000 stores currently to 7,000 stores by 2010. Convenience remains the key driver of business success. Besides better locations, the company has developed more freestanding stores with drive-through pharmacies and expanded business hours, keeping more than 1,500 stores open 24 hours a day. The company is also expanding into more managed-care services.
Management & Stewardship
Walgreen likes homegrown talent and has had little turnover at the top--just five CEOs have led the company since its founding in 1901. Chairman and CEO Dave Bernauer worked his way up the corporate ladder and has spent nearly 40 years with Walgreen. We would prefer the company split the chairman and CEO positions. We think Bernauer's salary and bonus, which totaled about $2.1 million last year, is reasonable. Bernauer beneficially owns more than 1 million shares of Walgreen stock, so his incentives appear to be aligned well with those of the company's shareholders. We like that Walgreen issues restricted shares but would rather management be offered those shares in lieu of--not in addition to--stock options. The firm gives scant details regarding incentive compensation, although restricted stock is granted based on earnings goals subject to a minimum return on invested capital, which is fine by us. Directors stand for election annually and receive 50% of their compensation in the form of Walgreen stock, which we like. We were pleased to see Walgreen recently bring in McDonald's MCD CEO James Skinner to serve on the board. Certainly Skinner has a keen understanding of what it takes to operate a large store base.
Profile
Walgreen operates more than 5,000 drugstores in 45 states and Puerto Rico. Prescription drugs account for 64% of total sales. The remainder of sales include nonprescription drugs, health and beauty items, toiletries, food, beverages, and general merchandise. The firm operates its own pharmacy-benefit manager service.
Growth
While still robust, growth has slowed a bit as sales of lower-priced generic drugs have increased at a faster clip than sales of branded drugs. We expect overall top-line growth to average around 12% annually over the next five years.
Profitability
Operating margins, excluding the effect of a one-time charge related to Hurricane Katrina, increased to 5.9% in fiscal 2005 from 5.7% in fiscal 2004 as a result of higher sales of generic drugs. We think operating margins will increase to about 6.2% long term.
Financial Health
Walgreen sports a pristine balance sheet with no debt, and operations throw off plenty of cash. The company has a lot of operating leases, but we capitalize those leases, and the coverage ratios appear adequate.
Morningstar Rating
01-24-2006
Stock Price
As of 01-24-2006
$42.70
Fair Value Estimate
$51.00
Consider Buying
$43.50
Consider Selling
$67.00
Business Risk
Below Avg
Economic Moat
Wide
Stewardship Grade
B
Analyst Note
Drugstores Report December Sales
Mitchell P. Corwin, CFA, CPA 01-10-2006
See All Notes
Bulls Say
Walgreen's growth remains strong. The firm posted 12.5% sales growth and netted 371 new stores in fiscal 2005. The company expects to net 390 stores in fiscal 2006.
We think Walgreen is years ahead of its peers in scouting locations for future stores, and the firm aggressively pursues the sites it wants, paying premium dollars for prime locations.
The Centers for Medicare & Medicaid Services estimates that the average annual rate of prescription drug spending will grow at about 10.2% through 2014.
Walgreen's focus on convenience is clear, as the company boasts the highest percentage of freestanding, 24-hour, and drive-through stores in the industry.
We believe the Walgreens Health Services division, which houses the company's own pharmacy-benefit management business, is poised to grow at a faster rate than the company's retail operations over the next five years.
Bears Say
Legislative changes to the Medicare prescription drug plan could lower reimbursement rates and squeeze profitability for the drugstore chains.
The acquisition of Eckerd stores in Florida and Texas gives competitor CVS a foothold in some lucrative markets Walgreen is counting on for growth.
Thanks to a history of outstanding performance, Walgreen has traditionally traded at a very high price/earnings multiple. Any dent in expected growth in sales and earnings could hammer the stock.
A nationwide shortage of pharmacists could hinder Walgreen's expansion
