Oh What Could Have Been
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
If only, that's what I keep thinking, if only Walgreen (NYSE: WAG) hadn't decided to put their foot down. The company was once a champion of the retail industry. You could count on growth in earnings in the teens year after year, and higher dividends. The idea of a large decrease in same-store sales was a bad dream that investors didn't have to worry about. That's what could have been, what actually occurred of course is the company decided to draw a line in the sand, and now the company is paying for it big time.
A few months ago I looked at Walgreens and took a guess about what effect not having the Express Scripts (NASDAQ: ESRX) relationship would have on the company. Looking at the company's last earnings release, we can get a very clear picture. The numbers are not good, and depending on how some things shake out in the future, they could get worse. I never thought I would see Walgreen post a 3.37% decrease in sales, or an over 10% decline in EPS. However, those two numbers are the headliners in the last report. Beyond these headline numbers, things get sort of scary.
The company's prescription sales were down 6.6%. Now the company did clarify that generic drug sales reduced this number by 3.2%. However, no matter what the company says, there is no escaping that comparable prescription sales dropped 9.9%. In the past, the company could count on prescription sales to drive up front-end sales. Apparently the correlation works in reverse as well. Front-end sales were up just 2.8%, but comparable sales were down 0.9%. The only thing that saved Walgreen from reporting worse EPS numbers is the company has repurchased enough shares that the number of diluted shares decreased over 6% from last year. There are a few other things I noticed in the report that might have escaped the casual reader.
First, look at the company's cash flow situation. It appears that Walgreen managed to show an increase in operating cash flow. Technically this is not the case. The company reported a $1.1 billion increase in inventories that added to operating cash flow. If you back out this one-time event, operating cash flow actually fell by 22%. With this adjustment the company's operating cash flow was closer to $2.56 billion. When you consider the company spent $1.1 billion in capital expenditures, and paid $593 million in dividends, this still leaves the company free cash flow left over, but it's much less than the reported numbers. The second issue I noticed was the company's commentary on what their target dividend payout ratio should be. Walgreen says their long-term dividend payout ratio target is 30-35% of net earnings. Given that the average analyst expects 2012 full year earnings of $2.61, the company is already paying out 42% of net earnings. Even if you look to 2013 full year earnings, the company is paying about 37.5% of next year's expected earnings. In plain English, this does not argue well for dividend increases in the future.
I know that investors are sure that Walgreen will get past the initial hit of losing the Express Scripts contract, and continue to grow. However, there is an upcoming event that might change this thought. Traditionally speaking, companies change their medical plans for employees sometime in the fall of each year. This is a timeframe for employees to make elections for next year's benefits. Since Medco is now part of Express Scripts, this could be a big deal for Walgreen. Last year, Express Scripts accounted for about 88 million prescriptions that Walgreen filled. These prescriptions added up to about $5.3 billion in sales. The company says it is seeing a retention rate of about 15% of this business. If you do the math, this means about $4.5 billion in lost sales just from the Express Scripts issue. However, Medco is still accepted at Walgreen, and last year Medco accounted for 125 million prescriptions filled, worth about $7.1 billion. If during insurance elections this fall, there is any fallout where customer's who are currently covered by Medco are switched to Express Scripts; that does not have a contract with Walgreen, the company could stand to suffer further losses. So what's the end game, and what should investors do?
The end game whether Walgreen realizes it or not is they need Express Scripts more than Express Scripts needs Walgreen. CVS (NYSE: CVS) will be more than happy to pick up these jilted Walgreen customers and fill their prescriptions. CVS is expected to grow by about 12% over the next few years compared to about 10% growth in earnings at Walgreen's. This 2% difference could widen significantly if there is continued fallout from the Express Scripts and Medco merger. CVS also has been significantly increasing their dividend in the last few years, all while their payout ratio has declined. With CVS selling for just 14 times forward earnings, this seems like the stock to buy in the sector. Walgreen cannot afford to let customers go to other pharmacies or other retailers like Target and Wal-Mart, both who offer prescription services. The company needs to swallow its pride and make an agreement with Express Scripts happen. The current Express Scripts represented over 213 million prescriptions last year and over $12.4 billion in sales to Walgreen last year. These numbers are just too large to ignore. Further fallout from this broken relationship would not only harm Walgreen's reputation further, but could challenge the company's ability to pay its dividend, and continue to expand. Sorry Walgreen, you probably thought you were doing the right thing at the time. The problem is, you were wrong.
MHenage 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.
