1 Lauren Soulis [email protected]Philip Griffin [email protected]Bill Rugg [email protected]Recommendation: SELL WAG CVS Comp. Agg. Current Price: $ 45.16 $ 24.38 Market Cap: $ 46.44 B $ 19.82 B P/E (ttm): 25.5 20.38 19.7 P/E (fwd): 22.14 15.14 19.3 PEG (5 yr fwd): 1.54 1.40 1.3 EV/EBITDA: 15.471 10.079 11.279 Debt Rating A+ A- Walgreen Co. NYSE: WAG Consumer Sector Drug Retailing 11/3/2005 Key Points: • Overvalued on DCF and comparable basis. • Underperforming drug retailing segment. • Institutional holdings reflect a significant net sale of holdings. Insiders have sold 249,716 shares in past 12 months vs. 640 shares purchased. Conveys a lack of confidence in future prospects for WAG. • Proposed changes in the structure of Medicaid reimbursement fee calculation could put pressure on margins at the retail level, encouraging further consolidation. • WAG is largest drug retailer by market cap, but CVS is a formidable competitor with more locations and fewer employees. • Stiffer competition will lead to erosion in margins. • Gross margin growth rates have decelerated by .04% over the past five years. • No long-term debt—not necessarily a positive. • Half of their stores are less than 5 years old. Company Overview: Walgreens is a drug-retailer that sells prescription and nonprescription drugs as well as other healthcare products and general merchandise (toiletries, cosmetics, household goods, a limited offering of food and beverages, and photofinishing.) Walgreen Co. is the largest company in the drug retailing sub-sector ($43.86B market cap) and one of the largest within consumer staples. They operate 5,000 retail locations in 45 states and Puerto Rico, as well as internet and mail-order pharmacies. Through its strong organic growth initiatives, Walgreen Co. has more than doubled the number of stores it operates in the past 10 years. In this time it has distinguished itself as the leading drug retailer by market cap and sales through strong revenue and earnings growth. They plan to operate more than 7,000 locations by 2010. Investment Thesis: This year, Walgreens has acquired two smaller drug chains in an effort to continue strengthening its market position (a break-away from its traditional method of growth.) CVS, historically a serial acquirer, operates more locations and has established itself as a serious competitor to Walgreens’ claim to the number one position. While the population is aging and demand for health care products is predicted to increase as a result, we are not optimistic about Walgreen’s ability to maintain margins and market share in a climate of increasing competition and erosion of leverage with drug wholesalers. (See discussion below about comp sales and gross margin compression.) Many describe Walgreens’ organic growth, strong cash position and lack of long- term debt as qualities that make it “best of breed.” We question management’s discipline and ability to invest in projects that improve Walgreen Co.’s competitive position with cash to spend and no debt to service.
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Recommendation: SELL Key Pointsp2.smu.edu/undergrad_practicum/reports/06/sell/wag.pdf · Philip Griffin [email protected] Bill Rugg [email protected] Recommendation: SELL WAG CVS Comp.
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• Overvalued on DCF and comparable basis. • Underperforming drug retailing segment. • Institutional holdings reflect a significant net sale of
holdings. Insiders have sold 249,716 shares in past 12 months vs. 640 shares purchased. Conveys a lack of confidence in future prospects for WAG.
• Proposed changes in the structure of Medicaid reimbursement fee calculation could put pressure on margins at the retail level, encouraging further consolidation.
• WAG is largest drug retailer by market cap, but CVS is a formidable competitor with more locations and fewer employees.
• Stiffer competition will lead to erosion in margins. • Gross margin growth rates have decelerated by .04%
over the past five years. • No long-term debt—not necessarily a positive. • Half of their stores are less than 5 years old.
Company Overview: Walgreens is a drug-retailer that sells prescription and nonprescription drugs as well as other healthcare products and general merchandise (toiletries, cosmetics, household goods, a limited offering of food and beverages, and photofinishing.) Walgreen Co. is the largest company in the drug retailing sub-sector ($43.86B market cap) and one of the largest within consumer staples. They operate 5,000 retail locations in 45 states and Puerto Rico, as well as internet and mail-order pharmacies. Through its strong organic growth initiatives, Walgreen Co. has more than doubled the number of stores it operates in the past 10 years. In this time it has distinguished itself as the leading drug retailer by market cap and sales through strong revenue and earnings growth. They plan to operate more than 7,000 locations by 2010. Investment Thesis: This year, Walgreens has acquired two smaller drug chains in an effort to continue strengthening its market position (a break-away from its traditional method of growth.) CVS, historically a serial acquirer, operates more locations and has established itself as a serious competitor to Walgreens’ claim to the number one position. While the population is aging and demand for health care products is predicted to increase as a result, we are not optimistic about Walgreen’s ability to maintain margins and market share in a climate of increasing competition and erosion of leverage with drug wholesalers. (See discussion below about comp sales and gross margin compression.) Many describe Walgreens’ organic growth, strong cash position and lack of long-term debt as qualities that make it “best of breed.” We question management’s discipline and ability to invest in projects that improve Walgreen Co.’s competitive position with cash to spend and no debt to service.
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Indications of Slowing Growth: Same store sales, or sales figures for locations open at least one year, indicate that growth in revenues may not be sustainable at historic rates. For six of the past seven months comp sales have been below the average for the trailing twelve month period. Furthermore, total store sales year-over-year (including newly opened locations) for those same six months were also below the trailing twelve month average. While some of the slower growth could be attributable to exogenous economic factors (i.e. rising interest rates and lower consumer spending) it is reasonable to expect performance to remain stable during this economic climate. Whether partly due to economic factors or not, it is clear that sales growth is decelerating at least in the short-term. Slower growth in the short-term could be a symptom of increasing competition, market saturation and maturation of the company as a whole. It is unreasonable to believe that there is unlimited demand in the market for pharmaceutical products.
Comp Sales Total Sales Apr-05 5.3 % 9.6 %
May-05 8.8 13.5 Jun-05 7.8 12 Jul-05 5.9 10
Aug-05 7 11.7 Sep-05 7.7 10.9 Oct-05 6.5 9
12 mo. Avg. 7.97 12.05 Std Dev 2.24 2.41
Macro Outlook: Knowing that consumer staples and health care sectors tend to be less sensitive to rising interest rates and energy costs than more cyclical sectors like consumer discretionary and technology, the drug retailing sub-sector is positioned well in the current economic climate. The continuation of the interest rate tightening cycle, marked by the eleventh consecutive quarter-point increase in interest rates by the Fed, combined with high oil prices leads to the reasonable conclusion that a deceleration in spending on discretionary items will continue in the near term. Additionally, with the aging population will inevitably come an increase in demand for prescription drugs and cosmetics as a growing number of people need pharmaceutical help to stay healthy and looking young. This growth in consumers supports the rationale for the aggressive expansion characteristic to the drug chain growth model. The question then becomes, at what point will consumer demand be fully supported by the drug retailers? Market Sentiment: Volume of short selling has increased over the past three months—an indication that the Street is possibly becoming more bearish on Walgreens.
Short Interest
Month Shares
(Mil) %
Outs. %
Float Days
10/10/05 16.514 1.626 1.637 3.479
09/08/05 14.594 1.437 1.447 5.437
08/08/05 13.249 1.305 1.313 5.379
07/08/05 13.277 1.307 1.316 4.844
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Source: www.reuters.com
Valuation— Discounted Cash Flow Analysis: Assuming continued earnings growth at consensus estimates, with modest margin compression, our model fairly values Walgreens with a price target of $61.50 per share. So, assuming continued growth at historical earnings growth rates, Walgreens is a very attractive buy. This intrinsic valuation includes a beta assumption of .5 which is roughly splitting the difference between the .3 and .87 reported by different sources. A beta of .3 produces a price target of over $200 per share versus approximately $26 per share with a beta of .87 holding all other assumptions constant. Furthermore, this scenario includes an increase in capital spending for FY06 as projected in the FY05 WAG press release. After 2006 the model trends capital spending back down to the historical average of 2.5 times depreciation. If the cash flows are modeled assuming FY06 growth more in-line with the fiscal year 2005, and slightly more margin compression, the intrinsic value is calculated to be $37.48 per share. (Assuming the same beta of .5.) Under this scenario of expected revenue growth in FY06 of 12.5%, COGS growth of 11.5% and SGA growth of 15.5%, Walgreens would still realize above-average earnings growth of 16.71% for the year.
Key Assumptions for the models: Date of valuation 11/3/2005 Risk Free Rate: 3.50% Equity Market Risk Premium: 7.00% Long term inflation: 2.50% Terminal Growth: 5.00% Equity beta: 0.5 No. of shares (diluted): 1,028 Current Market Price per share: $45.16
Valuation model used Summary
Equity $M $ Per Share Unlevered value $38,526 $37.47 Adjusted Present Value $38,526 $37.47 Flow to Equity $38,562 $37.50 WACC with FCF $38,524 $37.46 AT-WACC with UFCF $38,535 $37.47 Average across models $38,537 $37.48 Price deviation across models $1 0.1%
Five valuation techniques were used to arrive at the intrinsic value and a price deviation of .1% existed across the models for the scenario with the margin compression we feel is going to occur. As Walgreen Co. has no meaningful long-term debt, the unlevered value is essentially the same as the other valuation models. For further detail of the DCF analysis, see below exhibits.
Comparable Analysis Continued: The comparable aggregate prices Walgreens at $34.69 per share on a forward P/E basis, using FY06 consensus estimates. This coincides with our price target from DCF and supports the argument that Walgreens is trading expensive relative to its peers. On an EV/EBITDA basis the comp. aggregate suggests a fair value of $33.96 per share.
WAG actual Comp. Agg. Fair Value Price / EPS (ttm) 25.5 19.7 $ 30.14 Price / EPS (fwd) 22.1 19.6 $ 34.69 EV / EBITDA 15.03 11.28 $ 33.96 Price / Book 5.09 4.28 $ 38.04 EV / Net Income (FY06) 25.46 21.73 $ 38.46 Average Price: $ 35.06
On a trailing basis Walgreens looks especially expensive due to soft Q4 and FY05 earnings. Despite unimpressive earnings for 2005 (partially due to a $54.7 M pre-tax charge for expenses related to Hurricane Katrina,) the stock has performed well since the earnings announcement. We see the modest earnings in FY05, however, as another indicator of a slowdown in growth.
source: BigCharts.com
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Risks to these Opinions: The main risk in the aforementioned assumptions and investment thesis is a return to historic growth levels and stable margins that are unaffected by the competitive climate. If proposed legislation to change Medicaid reimbursement procedures does not materialize, there is less risk for margin compression. It is reasonable, however, that other competitive issues could put pressure on market share and profitability even if they are unscathed by changes to Medicaid. Competitive Environment: Aside from the rivalry between Walgreens and CVS, competition could intensify significantly depending on the fate of Albertsons. Albertsons, which operates both supermarkets and drug stores (Osco Drug and Sav-on Drugs,) announced in September that it is putting itself up for sale. This is significant because they are the fourth largest player in drug retailing by dollar volume and the top supermarket chain by pharmacy sales. Kroger, the second largest supermarket chain by pharmacy sales is one of the four companies that have placed bids for Abertsons. The other three bidders are drug retailers (CVS, Walgreen Co., and Rite Aid) that have bid solely on Albertsons’ drugstores. A deal with any of these bidders could significantly affect the competitive environment both due to the size of the players involved and the regional strength of the Osco and Sav-on chains.
Total Debt and Stock 4,234 5,207 6,230 7,196 8,228 8,889 10,060 11,143 12,169 13,266 14,419 15,641 16,938 18,322 19,805 21,400
Net Working Capital (Current Assets Minus Current Liabilities) (Inc. Normal Cash, ex. Debt due) 2,938 3,687 3,835 4,043 4,473 4,883 5,269 5,627 5,955 6,253 6,520 6,757 6,966
Change in Net Working Capital + Normal Cash 749 149 208 429 410 386 358 328 298 267 237 208
R(u) - required return for firm if unlevered 7.00%
No. of shares (diluted): 1,028 R(e) - required return for equity as levered 7.00%
WACC 7.00%
Current Market Price per share: $45.16 AT-WACC 7.00%
(a) Represents 38659 Ending Debt Balance. LT Debt is adjusted for MV @ 1
Rough adjustment for midyear (b) Average tax rate for after tax interest rate adjustment: 37.5%Adjustment to the present: (c) Implied Market Cap equals shares 1,028 times Stock Price of $45.16 $37.48 (Actual vs. avg. model price)
Average valuation at Beg. 2005 $37.48 Check on model's internal consistency:
Increase for passage of time: $39.44 We are checking here to see if the debt level is staying constand in market value terms
2005 EFCF/Share *3/4 $0.14 If growth in MV of Equity is much different from growth in Debt, then firm is changing leverage: only APV model works right.
Approximate value as of Sept. 05 $39.31 unless R(e) and the WACC are adjusted to account for changing leverage
Growth in Market Value of Equity (10 yrs) 4.47% Computed from current intrinsic value and value at terminal
Growth in Debt (10 yrs) -100.00% Computed from balance sheet
Other useful summary stats to think about:
1. Implicit Dividend Yield (EFCF/Market Cap.) 0.5% Captures div yield plus stock repurch
2. Growth in Book Equity 8.8%
Forecast years
Summary
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Walgreen
DCF Inputs
(Dollars in Thousands) Time "0" 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Terminal
Operations Net Income 1,359$ 1,573$ 1,858$ 2,097$ 2,343$ 2,585$ 2,815$ 3,029$ 3,226$ 3,403$ 3,560$ 3,695$
R(u) - required return for firm if unlevered 7.00%
No. of shares (diluted): 1,028 R(e) - required return for equity as levered 7.00%
WACC 7.00%
Current Market Price per share: $45.16 AT-WACC 7.00%
(a) Represents 38656 Ending Debt Balance. LT Debt is adjusted for MV @ 1
Rough adjustment for midyear (b) Average tax rate for after tax interest rate adjustment: 37.5%Adjustment to the present: (c) Implied Market Cap equals shares 1,028 times Stock Price of $45.16 $61.50 (Actual vs. avg. model price)
Average valuation at Beg. 2005 $61.50 Check on model's internal consistency:
Increase for passage of time: $64.73 We are checking here to see if the debt level is staying constand in market value terms
2005 EFCF/Share *3/4 $0.14 If growth in MV of Equity is much different from growth in Debt, then firm is changing leverage: only APV model works right.
Approximate value as of Sept. 05 $64.59 unless R(e) and the WACC are adjusted to account for changing leverage
Growth in Market Value of Equity (10 yrs) 5.19% Computed from current intrinsic value and value at terminal
Growth in Debt (10 yrs) -100.00% Computed from balance sheet
Other useful summary stats to think about:
1. Implicit Dividend Yield (EFCF/Market Cap.) 0.3% Captures div yield plus stock repurch