A 6% Drop in the Largest National Drugstore Is a Buying Opportunity

Anh is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Walgreen (NYSE: WAG) has recently experienced a nearly 6% drop to around $45.20 per share, losing nearly $2.7 billion in market capitalization within just one trading day. The daily drop was caused by Walgreen’s recent third quarter earnings results, which missed analysts’ estimates.

Should long-term investors consider this drop a buying opportunity? Let’s find out.

Third quarter earnings results grew but missed estimates

Walgreen’s third quarter results are not declining or staying flat, the company actually managed to grow both its top line and bottom line. Net sales experienced a 3.2% growth; from $17.75 billion last year to more than $18.3 billion this year while the net income rose by 16.2% to $624 million. The diluted Earnings Per Share (EPS) came in at $0.65, 4.8% higher than last year EPS. These Include acquisition and Last In First Out (LIFO) accounting  costs for Alliance Boots.  Its adjusted EPS was much higher at $0.85. However, those results were lower than analysts’ expectations of $18.43 billion in revenue and $0.91 EPS.

Greg Wasson, the company’s President and CEO felt excited about the company’s year-over-year gain in the retail pharmacy market share, from 18.4% to 19.2%. He was also bullish about the 18.1% growth in adjusted EPS, thanks to the company’s cost control and the first year synergies with Alliance Boots of $125-$150 million and the earnings contribution from Alliance Boots.

10-year agreement and vertical integration with AmerisourceBergen

What might make investors bullish about the largest national drugstore is its recent 10-year agreement with AmerisourceBergen (NYSE: ABC) and the option to expand the business vertically with AmerisourceBergen’s stake. Walgreen currently distributed more than 80% of its own drugs, however, this agreement would let Walgreen utilize AmerisourceBergen’s network for daily drug distribution. Moreover, Walgreen and Alliance Boots had the right to acquire up to 7% stake in AmerisourceBergen in the open market and warrants are exercisable for an additional 16% stake. With this vertical integration, all of these three businesses definitely have more bargaining power in the pharmaceutical sector and operate more efficiently.

Walgreen’s agreement with AmerisourceBergen represented a big customer loss for Cardinal Health (NYSE: CAH) as Walgreen used to contribute more than $22.5 billion to its revenue, accounting for 21% of Cardinal Health’s total revenue. While Cardinal Health could renew its contract with its biggest customer, CVS Caremark, it lets AmerisourceBergen take away Walgreen, its second largest customer.

Many investors might consider the loss of big customer could harm Cardinal Health’s overall business, however, it has some positive consequences. When the Walgreen contract expires, Cardinal Health would need lower inventory and account receivables. Because of the lower working capital needs, the company expects to generate an extra cash of $500 million. Moreover, as the Walgreen contract was a low margin business, the loss of Walgreen could push up Cardinal Health’s distribution margin, from 1.6% to 2%.

Among the three companies, investors might like Cardinal Health and Walgreen because of their decent dividend yields, at 2.6% and 2.3%, respectively, while the dividend yield of AmerisourceBergen is the lowest at 1.5%.

Of the trio, Walgreen is the most expensively valued. At $45.20 per share, it is worth $42.80 billion on the market. The market values Walgreen at 10.8 times its trailing (Earnings before interest, taxes, depreciation and amortization) EBITDA. AmerisourceBergen is trading at $53.60 per share, with the total market cap of $12.40 billion. It is valued at nearly 9 times its trailing EBITDA. Cardinal Health has the lowest EBITDA multiple. At $46.60 per share, it is worth $15.90 billion on the market. The market values Cardinal Health at 7.4 times its trailing EBITDA.

My Foolish take

Income investors might still consider both Cardinal Health and Walgreen as long-term stocks for their portfolios due to their decent dividend yields. Cardinal Health, with the potential higher distribution margin with lower working capital needs and low valuation, could be a good buy for shareholders. Walgreen, with their global leading positions, the potential synergies with Alliance Boots and the vertical integration with AmerisourceBergen could also fit well in long-term investors’ portfolios. 

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Anh HOANG has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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