I am presenting this analysis in response to discussion on Fat Pitch Financials regarding the recent article "52-week-low-list-packed-with-quality-names" posted by George. Walgreen Company was a topic in the reader comments thread, and curiosity arose as to whether WAG is an attractive buy at current price levels. I promised to take an in-depth look and present my findings.

WAG Shares Drop Below $40:
Walgreen Company (nyse:WAG) traded around $48 on September 28, 2007 before it missed Q4 earnings estimates reporting 40c versus consensus of 47c. WAG shares fell nearly 17% to $40/share in response to the rare disappointment, and subsequently declined below $38 over the following trading sessions. With Walgreen trading at lower multiples (19x ttm), the natural question becomes “Is WAG undervalued?” It is the opinion of this analyst that Walgreen shares are reasonably valued @ $39ish, yet given potential risks, WAG would need to trade around $33-34 to provide a reasonable margin of safety.

Price Decline Stems From Risk Reassessment:
Walgreen shares plummeted due to a host of reasons, slowing growth prospects, competition worries, etc. I believe the primary factor behind the significant sell-off was the re-pricing of risk inherent in Walgreen. WAG shares have historically traded at a premium with trailing P/E ratios around 30x. Before the earnings miss, WAG traded around 24x trailing EPS.

Historically, Walgreen’s financial performance was very stable and predictable, thus investors required a lower return on equity relative to other stocks. Essentially, the high level of certainty pertaining to Walgreen’s prospective margins, ROE, EPS etc. resulted in investors paying higher multiples. This would suggest that beta values for WAG should be relatively low which coincides with the betas reported by various sources:

Zacks: .40
Google: .23
MSN: .16
ValueLine: .75

In the past 5 years, ROE has been in a tight range: 17.5% - 18.4%, and operating margins 5.7%. Prior to last quarter, Walgreen had only missed estimates 7 times in 21 quarters: 6 misses by a penny / 1 miss by two cents. Risk is defined by uncertainty, and with less uncertainty involving Walgreen translates into lower K(e) (required return on equity) and higher P/E multiples.

The 7 cents earnings disappointment raises questions about Walgreen’s consistency and predictability causing investors to reassess the entailed risk. Investors no longer are willing to pay inflated multiples for WAG since performance has become less predictable than previously thought. Walgreen’s share price falls to reflect increased risk as its trailing P/E multiple contracts from 24x to 19x. Ostensibly, reduced growth rate expectations play a partial role as well.

Q4 Earnings Disappointment:
Walgreens posted 40 cents a share versus estimate of 47 cents, with growth flat year over year. Sales grew 10.3% with front-end sales of comparable stores growing 6.1%. The major reasons for the profit miss were higher than expected SG&A expenses and lower reimbursement rates for the generic form of Zocor. Many analysts attributed the earnings miss due to internal budgeting mistakes such as increasing discretionary spending items such as salaries and advertising. Apparently, Walgreen failed to keep expenditures in line with level of reimbursements it was receiving, likely due to an overestimation of reimbursements resulting in overspending given actual receipts. These issues are expected to persist for the next 1-2 quarters, but analysts believe Walgreen can will easily remedy these problems and the long-term picture remains intact.

Major Advantages:
1) Increasing number of ”health maintenance” drugs
2) Aging baby boomer population
3) Prime store locations
4) High market share translating into scale benefits

Major Risk Factors:
1) Peaking generic drug cycle
2) Slowing growth- store saturation
3) CVS/Caremark competition
4) Non-drugstore competition- Wal-Mart, Target, other grocery retailers

Peaking Generic Drug Cycle:
The amount of branded drugs converting to generic is expected to drop in 2008 to 13b versus 21b for 2007. It’s likely the generic outlook has already been priced in evidenced by the 10% multiple compression (since May 2007) of the major drugstore stocks despite exceeding earnings estimates.

Walgreen reaps its highest margins from blockbuster drugs becoming available in generic form. Insurers pay hefty reimbursements for generic drugs that just went off patent to encourage switching from the higher-priced branded drugs. Typically, after six months or longer, those inflated payments begin to shrink. Thus, WAG relies on the continued release of new generic drugs to maintain its high margins. For example, Walgreen sold three times as much generic Zocor last quarter than a year ago, yet its profit from those sales remained about the same for both periods.

Store Saturation:
Walgreen’s principal growth engine has been store expansion. Currently WAG operates almost 6000 stores and plans to attain the 7000 store mark by 2010. Certainly, Walgreens still has room for expansion, but as more stores are added logically implies fewer prospective locations remain. In my opinion, the low hanging fruit has been picked, and new locations will be accompanied by competition from the likes of CVS, Rite Aid, and big box retailers such as Wal-Mart and grocery stores.

Walgreen’s competitive strength has been store location. Management careful scouts potential locations and often builds new stores from the ground-up. Walgreen stores are usually positioned on high traffic corners which also anchor large residential neighborhoods. Premium locations allow WAG stores to be highly productive, averaging 275 prescriptions daily versus 200 for its peers. The convenience of Walgreen locations insulates the drug retailer from competition due to consumers’ preference for accessibility versus price. Walgreen’s scale and high volume translates into pricing advantages over other pharmacies. The major threats of price competition belong to Wal-Mart and similar big-box retail/grocers. Walgreen has not been impacted significantly because of superior convenience of its locations

Since Walgreen depends heavily on store location, I believe store expansion will be challenging since WAG is very selective. Thus, how many prospective locations exist that would be a good fit for Walgreen? The law of large numbers is working against Walgreen, thus growth will moderate in the years to come from store count approaching the saturation point.

CVS / Caremark Competition:
The Caremark (pharmacy benefit manager) acquisition affords CVS a couple advantages. It provides scales, negotiating power, and reduced reimbursement rate pressures than normal drugstores. If this merger proves to be successful, then Walgreen will feel pressure to follow suit by acquiring a PBM. In addition, CVS is opening in-store clinics to treat patients for minor illnesses. Walgreen is introducing the same concept in its stores. The competitive theme between the two appears to be “as one company does, so will the other.”

CVS operates slightly more stores than WAG in an overlapping footprint, yet not necessarily in all the same markets. As CVS and WAG continue to increase store locations, it’s inevitable that the two will find each other on opposing street corners in the years ahead. CVS being a formidable competitor will impose a limit to Walgreen’s growth via store expansion.

Wal-Mart & Other Big-Box Retailers:
WMT announced last year that it would be offering select drugs for $4. Target followed with its own similar program. Large retailers and grocery chains are using prescription drugs to boost foot traffic in its stores. In some cases, drugs are “loss leaders” which entails pricing high demand items at a loss with the expectation that customers will also purchase high margin products during the visit. On the surface, this appears to be a huge concern for Walgreen. In fact, the impact on WAG has been slight to none for the past year. The reason is simple. Ninety-five percent of Walgreen’s customers have insurance meaning that they only pay $5 for a prescription, just $1 more than WMT and TGT. The slight pricing differential has not been enough to lure customers to Wal-Mart, possibly because of the hassle and lack of convenience associated with WMT and other similar retailers. Customer demographics are different; hence they are not competing for the same customer.

The future may be different. In the years ahead, Wal-Mart may succeed with its invasion of cities. If WMT opens smaller city-sized stores in close proximity to Walgreen locations, WAG would definitely feel the pain. If these low-price retailers can leverage their operating scale in the form of smaller, convenient store location they would have a competitive edge over existing incumbents. I expect we are many years away from this coming to fruition, yet it is a potential risk to consider.

Outlook:
In conjunction to Walgreen’s slowing growth and dwindling store expansion opportunities, substantial competitive risks are brewing on the horizon. This combination creates a tough sell for assigning WAG a relatively high multiple.

Walgreen was overvalued from some time, which explains the stock’s poor returns. The last time WAG traded below $40 was back in December 2004 (shares are up only 4% since then). For nearly three years, shares were primarily contained to $44-46 price range, breaking above $50 briefly. See Chart. The past five years, WAG shares are up 11.2% vs. 68% on the S&P 500. Earnings growth has averaged 15% for the last 5 years and sales growth has average 14%, yet share appreciation has been stagnant. Even as earnings increased, the P/E multiple steadily declined resulting in little change to WAG share price.

WAG projected EPS 5-year growth rate is 13.8% and shares currently trade @ 18x and 16x this year’s and next year’s estimates, respectively. PEG ratio is 1.3 based on this year’s expected P/E.

Considering the risks and prospective growth of Walgreen, I believe shares should trade @ 15x this year’s EPS estimate, translating into a fair value share price of $33.30.

I would feel that WAG was attractive at current levels if it weren’t for the negative sentiment overhanging the stock. The risks I outlined above are more what I think investors’ concerns to be, than that of my own. Since it’s the collective opinion of investors that move share prices, understanding the collective concerns is most important.

With poor stock returns and questions regarding Walgreen’s future, I don’t foresee a catalyst that would boost optimist and spark share demand. In short, I don’t expect any news of a magnitude capable of really boosting share prices.

Summary:
I believe that the recent swoon in Walgreen’s share price was mostly due to investors reconsidering the involved risk in WAG shares, for the underlying story remains unchanged. WAG valuations had been rich for sometime, and the earnings disappointment spurred the market to seek justifications for such a high multiple. Slowing growth and a less predictable future for Walgreen results in a contraction of its formerly lofty P/E to more reasonable levels. With Walgreen’s poor stock performance, investor’s are likely to find shares unappealing for sometime. Walgreen is a quality name, with great potential and competitive advantages, but superior returns will only arise from a lower share price.

October 26, 2007