Don’t Be Shortsighted on Walgreen
Justin 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) and Express Scripts (NASDAQ: ESRX) have finally agreed to work together again. This has ended a long protracted battle that has raged for more than a year. The battle created great opportunity for patient investors to buy a high-quality, dividend growing company below intrinsic value. I highlighted the stock value in a blog at the start of the year when shares were trading around $33. Since then, the stock fell below $30 following weak investor opinion of the $6.7 billion acquisition of Alliance Boots, a leading retail pharmacy in Europe. The yoyo ride continues with the stock surging more than 10% on the agreement with Express Scripts. Despite the surge in the stock, investors shouldn’t just walk away- instead they should jump in with both feet.
The stock represents a great opportunity to own a high-quality company with all the attributes to steadily beat the market over the long term. If anything, the surge should mark a bottom in the stock while eliminating a huge headwind. The stock traded in the mid-$40’s prior to the battle with Express Scripts, but even after the surge, it remains nearly $10 per share lower than its 2011 high. There is still plenty of upside in the stock owing to the strong economic moat and attractive valuation.
Walgreen is the nation’s largest retail pharmacy with more than 8,000 locations and 176,000 employees. Currently, prescription drugs account for more than 60% of the company’s $72 billion in annual revenues. They have roughly a 20% market share of the U.S. retail prescription industry. CVS Caremark (NYSE: CVS) is not far behind with 7,300 locations. They have been on the winning end of the WAG/ESRX battle in anticipation of picking up market share. CVS' stock looks vulnerable following a 25% gain in the last year and trading at a 45% premium to Walgreen on a price-to-earnings basis.
Walgreen's stock, on the other hand, looks very attractive after having been “stuck” over the last decade as the company transitioned from their massive store expansion toward a profitable model. The company added more than 1000 stores in 2008, but less than 300 in 2011. These transitions are not easy as investors and analysts fail to grasp the full financial statement impact. This is especially true when same-store-sales fall from 8% in 2007 to 2-4% in the prevailing years. But now the stock is trading at HALF its then lofty 25x P/E ratio. Operationally, the company has bounced back to reach a new high in sales per square foot following modest leakage the previous two years.
The valuation on Walgreen is really quite rare for a company with such a favorable economic moat. The stock trades at 12x earnings and is one of the few high-quality companies with a 3% dividend yield that hasn’t seen the P/E ratio bid up into the upper teens. Adding to the appeal is the GROWTH potential of dividend distributions, which have grown in excess of 20% annually over the last five years. This can easily be maintained given the company’s modest payout ratio of just 25%. Dividends are also supported by the robust free cash flow generation, which exceeded $2.4 billion in 2011. This, against a market capitalization of $26.9 billion, produces a deep-value FCF yield of 8.9%.
Walgreen is a great secular story as the aging population will create higher drug demand. The Alliance Boots acquisition paves the way for years of international growth opportunities. The company has a solid economic moat, extremely cheap valuation, and consistent operational performance metrics. This stock makes for a core holding, especially in the consumer staples space where many stocks trade rich. Don’t be biased by today’s surge, but instead note that the stock still has 30% upside if it were to trade at 17x earnings- which is in-line with CVS and many other blue-chip consumer companies.
market8 has no positions in the stocks mentioned above. 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.If you have questions about this post or the Fool’s blog network, click here for information.