'There's a Way' – Just Not Sure Walgreens Knows
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Walgreens (NYSE: WAG) recently updated their tag line to “there's a way.” The problem is I'm not convinced that the company's management is sure which way the company is going. The theory behind the new slogan is Walgreens will help them make informed choices. There is one “informed choice” that Walgreens management needs to make now -- the company needs to realize they need Express Scripts' (NASDAQ: ESRX) business.
It's really simple, Walgreens is one of many pharmacies that can fill prescriptions from Express Scripts. However, Express Scripts, now with Medco, does not necessarily need Walgreens. The numbers are staggering and should make some wonder if the FTC was asleep at the wheel when it approved this merger. On a combined basis, Express Scripts with Medco is expected to command 115 million total prescriptions, and about 60% of the mail order drug market. Losing Express Scripts has the potential to cost Walgreens about 80 million prescriptions worth about $4 billion. This certainly hurts, but losing an additional 35 million or more would be an even worse move.
In the last three months, analyst estimates for Walgreens have come down. The company's 2012 earnings have been cut by 3.3% and 2013 earnings have taken a 4.63% hit. The reason is the expectation that over time more and more people will switch their prescriptions away from Walgreens. In 2011 Walgreens filled 716 million prescriptions, about 80 million were from Express Scripts. This means Express Scripts accounted for about 11.17% of Walgreens prescription business in 2011. Prescription sales account for 61% of total sales for Walgreens. Look at same store sales of prescriptions in the last four quarters:
(adjusted for seasonal factors and lower flu prescriptions)
As you can see, Walgreens is definitely beginning to feel the pinch of not having the Express Scripts relationship.
The numbers don't lie, and there is a bigger problem that Walgreens management needs to realize. Even if Walgreens does resolve its issues with Express Scripts, there is no guarantee that the customers who have already switched pharmacies will come back. Think about how frustrated customers who've had to switch must be with Walgreens. They chose a pharmacy, had their prescription information at that pharmacy, now they have to start over. The bottom line for Walgreens is, it's one thing to try to protect your margins, however 100% of zero sales to Express Scripts customers is still zero.
Another factor worth watching at Walgreens is their dividend, in particular since the company just raised their annual payout to $0.90 per share. Without Express Scripts, Walgreens stands to lose about $4 billion in sales. With a net profit margin last year of 3.75%, this equates to a loss of at least $150 million in income. Without this $150 million in income in 2011, their free cash flow would have been about $2.28 billion. With Walgreens recently upgrading their dividend, the dividend cost will be $776 million per year. This still means that Walgreens free cash flow payout ratio is just 34%.
However, one way that Walgreens was able to keep up its EPS growth in the last two years was share repurchases. With the cost of dividends going up by $129 million and potential loss of $150 million of cash flow from lost sales, there won't be as much available for share repurchases. The bottom line is Walgreens is fine when it comes to their new dividend, but share repurchases will have to slow down unless something changes with the Express Scripts situation. Less share repurchases in theory means slower earnings per share growth.
For each Express Scripts that switches to another pharmacy, Walgreens future growth slows down slightly. So bottom line, Walgreens management should remember that 100% of zero is still zero. Protect your margins, but get a resolution to the Express Scripts issues as soon as you possibly can. Each day that goes by, you lose customers and many of them might not come back. I already have my red thumbs-down CAPSCall until this situation is resolved. Let me know what you think in the comments section below.
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