Walgreens- Bad Quarter, Good Buy?

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Walgreens (NYSE: WAG) reported earnings recently, revealing a 25% drop in profit. The company also saw a drop in prescriptions filled in their stores, although the decline was significantly less then in the previous two quarters. The decline in profits may be attributed to the loss of customers resulting from Walgreens's dispute over reimbursement rates with Express Scripts (NASDAQ: ESRX). Some analysts estimate that $4 billion in annual revenues will be lost due to the temporary stand-off with Express Scripts- a situation that has since been resolved. Walgreens CEO, Greg Wasson, commented on winning back Express Scripts customers who left for other competitors, stating:

"We're certainly feeling good with where we are... They're coming from every player. We feel good with our win-back."

The disappointing quarter comes at a time when rival Rite Aid (NYSE: RAD) is seeing its first profit since 2007, with filled prescriptions rising 3.6%. Is Walgreens dead in the water or making a rebound from its Express Scripts fall-out?

Strengths:

Walgreens is relatively strong financially and generates sufficient free cash flow:

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If Walgreens can continue recovering customers (and/or adding to their customer base) they should be fine. The company does seem to be slowly gaining customers back, or adding new ones, and even though the number of prescriptions filled and profits have dropped YOY, they are slowly improving from the previous quarters of this year.

Weaknesses:

Other than temporary customer losses from the Express Scripts debacle (which is slowly becoming less of a weakness), the company is also seeing declining revenues from an increase in customer conversions from brand to generic drugs. Customers switching to generics apparently accounted for an impact in sales of $883 million. Even though Walgreens makes less in total sales dollars selling generics, they also see increased gross margins selling them. According to Forbes:

"The positive impact on gross profit margins and gross profit dollars is typically significant in the first several months after a generic version of a drug is first allowed to compete with the branded version."

With more and more drugs going off patent, generics will most likely continue to be a drag on sales.

Opportunities:

Walgreens, unlike competitors, may be "hedged" against potentially negative consequences of "Obamacare," as Forbes put it. According to Analyst Mark Miller:

"The U.S. government's becoming the larger payer of prescription drugs could be a larger long-term challenge for pharmacy reimbursement."

Walgreens may be expanding overseas to hedge themselves against the new healthcare laws in America, attempting to avoid potentially problematic regulations and difficulties that may arise from increased governmental control. This is one of the advantages resulting from the company's decision to purchase such a large stake in the European health and drugstore company Alliance Boots.

The Alliance Boots deal gave Walgreens instant access to overseas markets in Norway, Ireland, the Netherlands, Thailand, the UK and Lithuania- and makes them the first and largest global drugstore in the world. The Walgreens/Alliance Boots merger is also expanding into emerging markets, which should eventually pay-off in the form of profits from explosive growth that comes from formerly impoverished nations increasing their demand for quality health care.

Another, more temporary, opportunity for Walgreens is the upcoming flu season. The flu season should increase sales as well as overall store traffic. This could help make Walgreens next quarter a little less grim. The center for disease control has projected that this will be the worst flu season in 10 years, and increasing demand for flu shots means good things for Walgreens.

Threats:

The biggest threat currently facing Walgreens is permanent retention of customers by competitors, due to the past Express Scripts problem. If these customers don't come back, it will continue to put a drag on the company's earnings. Rite Aid most likely profited from the migration, and CVS Pharmacies (NYSE: CVS) did as well. William Blair analyst Mark Miller stated that:

"We continue to view CVS's outlook for retention as conservative, as we estimate Walgreens has recaptured roughly 25 percent of prescriptions lost during the impasse thus far through October..."

CVS has obviously benefited from ex-Walgreen customers, and like competitor Rite Aid, posted a profit. CVS also raised their forecasts for next year. Walgreen's, by surrendering customers to competitors, helped to give power to their biggest threats, and it may take a very long time (if ever) to win back their former customer base in its entirety. Currently, competitors are flourishing while Walgreens is floundering, but that doesn't mean that they won't acquire new customers from an aging American population and catch up to these flourishing competitors over time, either.

The Bottom Line

The problems facing Walgreens are most likely temporary, but how long they will drag down earnings is unknown. Competitors such as CVS may continue to retain and benefit from the Walgreens/Express Scripts fall-out. With a more long-term view of the company, however, buying Walgreen's may be a great opportunity at current levels. Walgreens will eventually regain its ground, and will also benefit from an eventual European recovery, as well as its newly established presence in emerging markets. Walgreens is attractively valued now, and pays a nice dividend, at around 3%. They have also raised their dividend for over 25 years. Buying shares of Walgreens on any pull-backs may be very rewarding long-term.


Jharry1 owns shares of Walgreen Company. The Motley Fool owns shares of Express Scripts. Motley Fool newsletter services recommend Express Scripts. 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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