By
Jeremy Johnson
:
Business
Walgreen Co. (
WAG
) operates a total of 8,290 facilities across the U.S., comprising
7,841 drugstores, 354 worksite health facilities, 82 infusion and
respiratory services facilities, 11 specialty pharmacies and two
mail service facilities. In addition, during the current quarter
the company acquired around 33 specialty pharmacies from BioScrip (
BIOS
) in an asset sale.
The largest portion of Walgreen's revenue comes from retail
drugstores. These stores are located throughout the U.S. and the
company claims that 63% of Americans are less than 3 miles from a
Walgreen location. For the fiscal year ending August 31, 2011, the
company filled 819 million prescriptions, although this number
should fall in excess of 5% in 2012 due to the loss of a key
pharmacy benefit manager, Express Scripts (
ESRX
). About 65% of Walgreen's revenues are from prescriptions, while
the remaining 35% are from "front-end" merchandise.
The company's worksite facilities provide medical, pharmacy and
fitness services at large employer facilities. These facilities
were acquired by Walgreen through the purchase of Whole Health
Management in 2008. The company does not disclose financial or
operational data for the facilities, but the number of owned
facilities has been decreasing since the acquisition suggesting
some closures.
The third largest piece of the business in terms of facilities
is infusion and respiratory services. These facilities infuse drugs
on an outpatient basis and serve as infrastructure for a home care
network that is active in the same activity.
Walgreen also owns a network of specialty pharmacies that
process difficult to handle or complex drugs such as cancer
treatments. In addition, the company recently purchased
drugstore.com, an online store selling products similar to a
traditional drugstore.
Historical Trends
In evaluating historical financial performance the best summary
measure to evaluate is returns based on gross assets and gross cash
flow, in my view. While monitoring and cross checking all the
financial trends is important, this measure neatly summarizes cash
generation and investment. Gross assets include current assets,
gross property, plant and equipment, gross intangibles and
capitalized advertising and operating lease expenses. Gross cash
flow includes net income, depreciation, interest and current year
advertising and lease expense, and has been adjusted to remove
certain special items such as the gain on sale of Walgreen Health
Initiatives in 2011.
The information in the above figure is not useful for directly
establishing valuation because it is a simplified measure; rather,
its usefulness is in evaluating the historical trend. Later, we
will use a more precise measure of return for valuation purposes.
Of note, certain items in the TTM period have to be estimated due
to lack of disclosure; therefore, firm conclusions should be
restricted to the fiscal year end figure, although directionally it
safe to say there has been a flattening.
Gross cash flow has grown from $3.1 billion in 2004 to $6.3
billion in 2011, a growth rate of 10.6% per annum. The average
return on gross assets over the same period was 11.2%. The number
of facilities increased from 4,613 to 8,210 over the same period,
an 8.6% compound growth rate, and since has grown an additional 80
locations to 8,290. Gross cash flow per facility of $680,000 in
2004 increased to $770,000 in 2011.
While returns bounced around from 2004 to 2009, they have broken
down over the last several years and are now below the average
coming in at 10.8% for 2011 and the TTM period. Identifying the
overall weak trend will help in thinking about the future evolution
of the business and its value, but first we will look at valuation
around the current level of returns.
Earnings Valuation
In order to establish valuation parameters for Walgreen two
closely related residual income models will be used, both of which
are transformations of the same equation, albeit with slightly
different ways of calculating the inputs. The main feature of a
residual income model is that it creates a capital charge for
assets deployed in the business. A large part of getting a residual
income valuation correct is identifying all the capital invested in
the business, whether it is recognized on the balance sheet or
not.
In Walgreen's case, one of the primary assets of the company not
reflected on the balance sheet are its operating leases which are
relatively long-term in nature and after adjustment constitute over
half the invested capital in the company. Because it is an
important valuation factor, providing a little more detail on the
lease capitalization may be helpful. Leases have been capitalized
using a real (in other words the rate excludes inflation) rate of
2.5%. For Walgreen, this is similar to capitalizing the leases at
10x when used in an EV to EBITDAR framework when looked at in terms
of net (as opposed to gross) capital.
In terms of sensitivity analysis, capitalizing leases at a lower
rate
increases
the amount of the capitalized asset and in Walgreen's case
decreases
the calculated value of the firm. In other words, in a strict sense
capitalization is a negative value factor and more of it is more
negative. In Walgreen's case, in my view the assumptions made tend
to lead toward over capitalization rather than under capitalization
when compared to industry norms, although the goal has been
accuracy not conservatism.
Walgreen is currently employing gross capital of about $59
billion and based on analyst expectations for EPS of $2.66 in the
twelve months ending 1Q13, about $6.3 billion of gross cash flow.
Asset life is calculated at 17.8 years leading to a corporate wide
IRR of 8.6%. Given the company's ability to reinvest cash, this has
been modified to 7.9%. This modification adjusts for one of the
weaknesses of the IRR calculation which assumes all cash flows are
reinvested at the IRR.
Given a real IRR-based cost of capital of 5.4% and economic
capital of $42.5 billion, a value for the total firm is derived
from the residual income model of $62.2 billion. This figure
includes the value of operating leases; therefore, it will appear
much larger than publicly reported figures of enterprise value. The
per share value of equity after deducting these and other
liabilities and adding back cash is $39.86 per share, based on the
current
level of earnings. In order to double check this estimate, a second
related model known as economic margin is used. This model handles
the reinvestment issue in a more conservative manner which involves
less assumptions than the prior model and results in a per share
valuation of $38.95. For companies with relatively low returns on
capital such as Walgreen the two models often give very similar
results.
It cannot be stressed enough that these are not estimates of
Walgreen's value as an investment; rather they are simply
mathematical estimations of the value of the current earnings
stream. From here, qualitative assessments need to be made to
determine if the earnings stream is in jeopardy to determine if
Walgreen is a good investment. This is a slightly different
paradigm than a DCF model where explicit projections of cash flows
are made far into the future, which embody a set of beliefs about a
company.
Currently, the market price of Walgreen is quite a bit below the
$39-40 range; as of May 4th, the market price is about $30. We can
run the model in reverse to see what level of gross cash flow and
earnings the market is discounting or implying which yields a
figure of about $5.6 billion of gross cash flow and EPS of $1.88.
However, there is another way for the market to be right and for
profitability to not fall and that is if the capital invested in
the business increases at a greater rate than cash flow - in other
words, over a series of years, returns on capital fall.
Over the long-term, the IRR would need to fall about 1.5
percentage points to justify the current market value. This is only
a rough calculation because depending on how long that transition
takes, investors will receive the present value of the excess
return for the number of years it takes to reach that lower level,
although this would only amount to a few dollars per share. From a
qualitative viewpoint, it is likely the market is discounting a
fall in returns to lower than 7% because of this factor. In
reality, the market is probably assuming a little of both factors -
that long-term returns on capital will fall due to both extra
capital coming into the business which will not earn historical
rates of return and a near-term and sustained fall in
profitability.
Outlook
We are now left to think qualitatively about the future of the
Walgreen franchise and compare that to what is discounted by
current earnings and the market valuation. As with any company, the
future will continuously bring new information and the thesis will
need to be modified and adjusted in real time.
The key strategic strength of Walgreen is the breadth of its
network which gives not only a certain economy of scale, but more
importantly bargaining power with payers, especially pharmacy
benefit managers. The company also can count as an asset strong
name recognition built up over decades of being a major national
pharmacy. And, while the drugstore business is certainly
competitive, the emergence of a number of larger players means that
pricing should at least stay rational. Meanwhile, the company
should benefit from an ageing population more apt to use
prescription medications.
One area that is both a threat and an opportunity is the
front-end of the store. Walgreen and the pharmacy industry in
general are fortunate in my view to have relatively small stores.
The industry never tried to drive growth by expanding into marginal
categories that would demand much larger stores. With competition
emerging from the internet for so many items, it is a positive that
Walgreen does not have a large store to fill with merchandise.
Still, the recent purchase by Walgreen of drugstore.com shows
that online purchases are a threat to the core business. On the
other hand, more and more specialty retailers are also being
impacted by internet sales and the economy in general. For example,
whereas a decade ago a specialty beauty supply store could survive
in a marginal area, today it is less likely and Walgreen is a
beneficiary - and the more impacted the area economically, the more
likely it is that smaller specialty retail with have
difficulties.
The biggest overall threat to Walgreen's business at present is
the emergence of the pharmacy benefit managers as concentrated
players with control of the supply chain. Walgreen is in its own
squabble with Express Scripts which had made the problem very real
in terms of earnings, but the issue goes beyond just this one
relationship. The benefit managers will have increasing industry
clout and will continue to push the boundaries on how much
economics they will keep for themselves. Walgreen's challenge is to
build enough scale to provide a counterweight to an increasingly
concentrated benefit manager industry. The problem will only grow
worse now that Express Scripts and Medco Health are combined.
The dispute with Express Scripts is likely a large part of the
reason for the weak recent stock performance and low market value
placed on current earnings for Walgreen. However, given what the
market is discounting in terms of future earnings levels or
declines in returns on capital Walgreen is at worst fairly valued,
in my view. Indeed, the story could turn out much better than the
market is discounting now based upon a partial recovery of some of
the economics lost in ending the relationship with Express Scripts.
Over the long-term though the real issue is how much of the pie
will go the benefit managers and it is this area that needs to be
watched most closely in the future.
Trading History
(click to enlarge)
A look at the chart shows that over the past three years,
Walgreen has traded as high as about $44 and as low as a little
under $26, with quite a few significant levels in between. The
recent break below the $33-34 level is likely driven by overall
market weakness as much as anything specific to Walgreen although
continued weak comparable sales reported by the company on a
monthly basis are a potential factor as well. While the company may
in fact be undervalued at today's level, we could see a test of
$26-28 before a stabilization occurs. One factor that could lead to
further weakness in the stock is forward estimates for 4Q12 and
1Q13 that predict some rebound from recent negative trends which
may not occur. Although more pessimistic numbers would hardly
impact the valuation (less than 50 cents per share of market
value), sentiment would suffer. Nevertheless I remain long the
shares and would look to add on weakness unless the long-term
fundamentals change materially.
Disclosure:
I am long [[WAG]].
See also
Investors Bide Time Ahead Of Earnings
on seekingalpha.com