Description

Thesis: 

 

Our thesis on Long’s Drugs (“LDG” or the “Company”) is that (1) the Company owns substantial real estate assets that are highly valuable, easy to monetize, and are not being reflected in the current market valuation and (2) the Company has significant strategic/scarcity value in the retail drug store industry due to the concentrated store base in the state of California, and the Company’s position as the last publicly traded acquisition opportunity in the industry.  With the retirement of Robert Long (board member since 1968 and former CEO) in May, there is no longer a connection between the Company and the Long family, so there are no conflicts of interest or barriers to a change in control that you see in so many family controlled businesses that are ripe for a buyout.

 

Business Description

Since this is a pretty straightforward business to understand, I’ll just do a quick summary here and spend more time on exploring the valuation parameters and investment thesis. 

 

As of 1/25/07, Longs Drug Stores operates 509 retail drug stores on the West Coast, making the Company among the largest operators in its markets.  Long’s store base is highly concentrated geographically in California (86% of stores).

 

LDG Stores by Location:				#	% of Total
California				437	85.9%
Hawaii				32	6.3%
Nevada				17	3.3%
Washington				12	2.4%
Colorado				9	1.8%
Oregon				2	0.4%
Total				509	100.0%

 

Note that the Company has announced plans to close or divest its stores in Washington, Colorado and Oregon.  Much of this has already taken place, so on a pro forma basis, LDG will only have operations in California, Hawaii and Nevada.

 

Though LDG is significantly smaller in overall size than WAG, CVS or RAD, the geographic concentration in California gives the Company a strong #2 market share position (tied for #2 w/ WAG) in one of the most important healthcare markets in the US.  Only RAD (594 stores) has a higher market share in California, with WAG at 438 stores and CVS at 373 stores.

 

LDG’s average store size is 15,400 selling square feet which makes the average store larger than others in the industry, though larger store sizes tend to be common on the West Coast so LDG’s boxes tend to be similar to competitors within its markets.

 

Within LDG’s RxAmerica business segment, the Company operates a pharmacy benefits management (PBM) business as well as a Medicare Part D drug plan (PDP) which was launched on January 1, 2006.  In the PBM business, RxAmerica manages prescription benefit plans covering approximately 7.1 million lives.  In the PDP business, the Company provides prescription drug benefits to approximately 220,000 Medicare participants.

 

Summary Financials:

		FY Ended 1/31,
	LTM	2007	2006	2005
Revenues	$5,165.7	$5,097.1	$4,670.3	$4,607.9
Gross Profit	1,311.9	1,287.6	1,227.1	1,186.5
EBITDA	230.6	219.3	201.1	168.2
EBITDAR	325.2	313.9	292.5	256.9
Margin:
Gross Profit	25.4%	25.3%	26.3%	25.7%
EBITDA	4.5%	4.3%	4.3%	3.7%
EBITDAR	6.3%	6.2%	6.3%	5.6%

 

 

Investment Thesis #1 - Real Estate Value

 

LDG owns substantial real estate assets.  The Company owns 29% of its locations outright and another 11% are either ground leased or partially owned.  This represents a substantial amount of California based drug store real estate located in and around the major urban centers in California.  The Company has significant concentration of stores in some of the most highly valued real estate markets in the country including Los Angeles, Orange County, San Francisco Bay Area and San Diego. 

 

LDG’s level of real estate ownership, at 40% of stores, contrasts quite sharply with the rest of the industry.  WAG, CVS and RAD own 18%, 6% and 6.5% of their locations, respectively. 

 

So what is all of this real estate worth?  A great comp is found in CVS’s acquisition of the Albertson’s retail drug store business (“Sav-on”) in 2006.  In that transaction, CVS acquired 700 stores operating under the Sav-On and Osco banners, 338 of which were located in California.  The transaction was structured in 2 parts: (1) CVS acquired the drug stores for $2.93 billion and (2) CVS acquired the real estate interests in certain of those drug stores for $1 billion.  The real estate interests acquired included 200 owned properties and 71 properties on ground lease, representing 28.6% and 10.1% of the total store base, respectively (quite close to the percentage of owned real estate for LDG).

 

The average Sav-on store has 12,490 selling square feet, implying 2.5 million of total selling square feet worth of owned real estate and 0.9 million square feet of real estate on ground lease.  Using these figures and a $1 billion transaction value, the implied value per selling square foot was $340 for an owned store and $170 for a store on ground lease.  Applying these same multiples to LDG’s store base (148 owned stores and 56 stores on ground lease, with an avg. size of 15,400 selling square feet), and making conservative assumptions for the value of LDG’s other owned real estate gets you to the following aggregate real estate value:

 

		Sq. Feet (mm)	Price / SF	Value ($mm)
Owned Real Estate		2.3	$340.0	770.9
Ground Lease		0.9	$170.0	146.2
Corporate Offices		142,000	$175.00	24.9
Salt Lake City, UT		26,000	$50.00	1.3
Patterson, California		800,000	$50.00	40.0
Ontario, California		353,000	$100.00	35.3
Honolulu, Hawaii		48,000	$100.00	4.8
Total RE Value				$1,023.4

 

As a further check to the real estate value, we looked at aggregate rents paid across the industry for WAG, CVS, RAD and LDG’s leased properties.  This analysis yielded a data point that the average industry rental rate per selling square foot is $25.24 per year.  Applying a 6.5% cap rate to this figure yields a per selling square foot value of $388.  When CVS closed the $1 billion real estate transaction they noted that they were looking at sale leasebacks at rates from 5.5% to 6.5%.  Cap rates have probably moved up a little bit since then, but I still believe the high end of that range is conservative.  Further, given that the geographic concentration for LDG in California where property values are higher is greater than Sav-on or the overall industry, I believe that there is upside to my assumptions.

 

Also, just to answer the question before I get it, all of the real estate values per square foot were calculated using selling square feet because that is what is disclosed.  Usually in real estate you would quote values in terms of gross square feet or rentable square feet, so if the per square foot assumptions seem high, that is why.  I don’t think that this methodology compromises the overall valuation methodology as the difference between gross and selling square feet is consistent across the comps. 

 

Investment Thesis #2 – LDG’s Strategic Value

 

The second part of the investment thesis is that LDG has considerable strategic value given its concentration in California and one of the last remaining targets (only publicly traded target) of any size in the retail drug store industry.  The industry has been consolidating for years and is expected to continue to consolidate as chains seek to gain greater purchasing power and leverage in negotiations with drug companies, PBMs, and insurers.

 

The California market is important to the retail drug store industry because it is a large and high growth market, containing 8 of the top 25 drug store markets in the US.  Furthermore, securing attractive locations in these markets is extremely difficult.  Thomas Ryan, CEO of CVS, said the following to investors upon announcing the Sav-on transaction: “As you know Southern Cal is a tough market to penetrate due to location availability, cost and certainly permitting requirements” and “finding desirable real estate in Southern California is challenging and takes longer than in most other parts of the country.  This transaction offers speed to market in these fast growing regions.”

 

LDG has other assets that have strategic value as well – the PBM and PDP businesses are important to industry participants and these are assets that drive incremental value for LDG as compared to CVS’s acquisition of Sav-on.  Further, it is worth noting that none of the other major chains have any exposure to Hawaii, where the Company maintains its second highest number of stores.

 

I believe that LDG would be a highly attractive acquisition candidate for a strategic buyer, given the difficulty of growing organically in California and especially in light of the potential to do an immediate sale leaseback transaction that would significantly reduce the capital requirements to complete a transaction (more on this later).  It is also worth noting that on WAG’s most recent earnings call, it was stated that “during the past quarter, our main focus and biggest opportunity continued to be drug store expansion.  This will drive our company’s growth well into the future as we remain on track to operate more than 7,000 stores in 2010. And as more industry consolidation takes place, we’ll consider select acquisitions, such as the one that resulted in this quarter’s opening of 30 former Familymeds Group pharmacies.  We are also looking for other pharmacy related healthcare opportunities…..”

 

Valuation

 

LDG’s valuation parameters are as follows:

 

Stock Price			$53.15
Basic Shares Outstanding			38.1
Options - TM			1.4
FD Shares Outstanding			39.5
Equity Market Value			$2,096.9
Debt			119.1
Cash			24.7
Enterprise Value			$2,191.2
EV / Revenues			0.4x
EV / EBITDA			9.5x

 

On the surface, this suggests the Company is priced at the low end of the range for the industry.  But when you factor in the value of the real estate, at a valuation of $1.0 billion ($25.35 per share), the numbers start to get really interesting. 

 

Assuming a strategic or private equity buyer were to buy the Company and execute a sale leaseback transaction at a 6.5% cap rate, the Company could be acquired w/o the real estate for $1.1 billion.  This would represent a multiple on revenues of 0.2x and an EBITDA multiple of 6.9x.  We actually believe that the PBM business, which generated only 6.6% of the Company’s LTM revenues and $40mm of operating income is likely worth about $350 million alone. 

 

Industry Valuation Multiples
		LDG	WAG	RAD	CVS	Sav-on Acq.
EV / Revenues		0.2x	0.9x	0.4x	0.8x	0.5x
EV / EBITDA		6.9x	13.4x	10.2x	11.3x	11.0x
			Implied
		Average	LDG Value
EV / Revenues		0.7x	$112.71
EV / EBITDA		11.5x	$72.08

 

Note:  Valuation for LDG is pro forma for a sale leaseback transaction.  Valuation for Sav-On includes only the purchase price for the store operations ($2.93 billion) and is pro forma for the $1 billion real estate acquisition and subsequent sale leaseback transaction – acquisition multiples would be much higher for Sav-on prior to the sale leaseback transaction.  For comparability, valuation of CVS is as of YE 2006, before the Caremark acquisition.

 

As shown above, LDG is significantly undervalued based on these metrics.  Clearly the EBITDA multiple is a more conservative valuation method, but I add the revenue multiple to show potential upside in a margin improvement case.  LDG’s EBITDAR margins are the lowest in the industry as shown in the following table.  Margins have just recently started to rebound and the Company has brought in significant new management resources over the past few years in order to improve operations.  So far the Company appears to be making good progress on these fronts.  I am not betting on a full reversion to industry average margins, but I don’t think you need to assume that in order to make a great return here.  I simply point out the additional upside potential because there is pretty good reason to believe margins can improve from here and they are currently moving in the right direction.

 

Margin Analysis
		LDG	WAG	RAD	CVS
Gross Margin		25.4%	27.8%	26.9%	27.2%
EBITDA Margin		4.5%	6.9%	3.5%	7.2%
EBITDAR Margin		6.3%	9.9%	6.9%	10.4%

Note: For comparability, CVS margins are for 2006, prior to the Caremark acquisition.

 

When CVS acquired Sav-on, Dave Rickard (CFO of CVS) said enthusiastically, “we are purchasing very high quality assets at a multiple of about 0.5x sales”.  This multiple was based on the $2.93 billion purchase price, not including the amount paid for real estate.  Using this same valuation parameter along with a real estate sale would yield a valuation of $87 for LDG, and I am not sure why Sav-on would be considered a better asset than LDG.

 

So what is Wall Street missing?  Simply put, the real estate value.  Even though LDG’s real estate assets comprise nearly 50% of enterprise value, I have not seen a single analyst attempt to quantify this value.  In one of the more amazing instances of analyst gross negligence, refer to Goldman Sachs’ initiation report on LDG from November 2006.  In a section titled “solid asset value”, the analyst correctly compares LDG’s valuation to the metrics of the Sav-on acquisition.  However, the analyst completely misses the mark by reasoning that “CVS paid $2.9 billion for Savon/Osco’s 700 stores, or $4.1 million per store”, and then applying this metric to LDG’s store base and getting to a downside price target around $40.  But, they completely missed the $1 billion that CVS paid for the underlying real estate which makes the transactions comparable.  Correcting for the analyst’s mistake here yields a valuation of around $70 using the rest of the same assumptions – and this was the valuation methodology the analyst was using in order to derive downside protection!

 

Conclusion

 

LDG is an asset rich company, with solid real estate assets, a store base that is strategically valuable in the industry and an important PBM business that is performing quite well.  There is significant upside in the status quo scenario if a private equity or strategic buyer were to acquire the company and do a sale leaseback.  There is enormous upside potential if management can execute on its plan to increase margins in the core business.  The management team has been strengthened considerably over the past few years and with the retirement of Robert Long, there are no family members around to block shareholders from receiving maximum value.  There are no major impediments to an activist investor becoming involved, and the staggered board was eliminated at last year’s shareholder meeting.

Catalyst

Strategic or private equity buyer sees value in the real estate and/or store base; activist investor gets involved seeking to gain from the arbitrage potential in a sale leaseback transaction; mgmt. shows progress on its plan to increase margins.