Description

Walgreen has a long history of profitable organic growth.  In fact, 2009 broke a history of 34 straight years of record sales and earnings (and only slightly lower in 2009 - note the August year end so the entire recession was in that one fiscal year for Walgreen). 

Walgreen is the #1 drugstore chain in the U.S. with over 8,000 stores.  Their recent acquisition of Duane Reade (which was not very big and looks reasonably priced) aside, this is a company which has avoided the M&A disasters which have plagued its competitors (esp. Rite Aid and more recently CVS) for the last ten years.  I never understood why anybody would pay 12x EBITDA for a drugstore chain, and it turned out to be not such a great idea.  6x is a different ballgame.

Positives:

• 1) Number 1 in its business. While their scale is important in the usual ways for a retailer (scope of advertising dollar leverage, leverage over suppliers), it is especially important for Walgreen to be number one nationally and dominant in certain regions (for example San Francisco, Minneapolis and now New York City). A big part of the fear in the stock is that it is just another cost to be squeezed out of the health care monster, and their recent dispute with CVS/Caremark underscored that tension. But their scale and scope really matter in negotiating with PBMs or government payers. You can't not have Walgreen in your network, and Walgreen knows that.
• 2) Great balance sheet. Little net debt even after Duane Reade close. They own 20% of their stores.
• 3) Extremely cheap relative to its history at 12x earnings, 6x EBITDA.
• 4) Dialing back growth which will lead to increased free cash flow. New store growth has historically been high single digits. This year it is going to 5% and next year to 2.5%. I would expect cap-ex to fall from historically $2 billion to 1.1-1.2 billion. Quite possibly lower than that when the remodels are done in two years. Free cash flow looks like it could go to $2.7 billion or more in 2011-2012 while still growing square footage organically at 2.5%. That looks like a pretty attractive valuation to me for a well managed industry leader.
• 5) Seem committed to return cash to shareholders. Dividend rose about 20% last year and I would expect a similar increase in dividend each of the next couple years, well in excess of earnings growth (taking up the payout ratio to the 30-35% they are targeting) and for the first time seem committed to buying back stock with the rest of the excess cash.
• 6) They are a beneficiary of the expirations of high profile drug patents - I'm sure we've all at least looked at Pfizer, for example. Generic drugs are highly profitable to Walgreen, and there has been an air pocket between "patent cliffs" which resumes in about a year when we start seeing the Lipitors and most of Eli Lilly go generic. A year is an eternity to an institutional investor these days, and I suspect this explains some of the drop in the stock recently.

Negatives:

• 1) Health care reform is a wildcard with any health care related name and many types of health care stocks look very cheap. Walgreen looks like a relatively safe place to be in this chain, without the risk of pharmaceutical pipelines and patent expirations, or the wide range of outcomes possible in an HMO's future.
• 2) I didn't like the Duane Reade acquisition at first because it was inconsistent with the returning cash flow to shareholders story. However, at 60% of revenues if they can get anything like the $120 million of synergies they project the acquisition makes financial sense. Strategically as I referenced above, Duane Reade is a very valuable asset as it gives its owner dominant share in the New York City market and makes you that much more irreplaceable to a payer who wants to get tough.
• 3) Supermarkets, Target, Walmart - it seems as if everybody has entered this business. So far though there has been plenty of business for Walgreen - supermarkets doing their own pharmaceutical department is not a new thing, but certainly bears watching.

The views expressed are those of the author and do not necessarily represent the views of any other person. The information herein is obtained from public sources believed to be accurate, reliable and current as of the date of writing.  The author will not undertake to supplement, update or revise such information at a later date.  The author may hold a position in the securities discussed.

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