It's About Time!

By Chad Henage - July 23, 2012 | Tickers: CVS, ESRX, TGT, WMT, WAG | 0 Comments

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After months of speculation that this might never happen, Walgreen (NYSE: WAG) finally came to its senses and struck an agreement with Express Scripts (NASDAQ: ESRX). I've covered the effect that this lost relationship had on Walgreen in a prior post, finding that same-store sales were negatively affected by a tremendous amount. By point of reference, same-store sales in January, February, and March of this year decreased by at least 6% each month. While it's always important for companies to watch out for their best interests, it doesn't make sense for one of the largest drugstore chains to cut itself off from one of the largest pharmacy benefit managers. My thought at the time was that, “Walgreen management should remember that 100% of zero is still zero.” With this new agreement, where do we go from here?

The primary thing that Walgreen shareholders should be happy about is, simply the fact that the company has an agreement with Express Scripts. While the financial details were not disclosed, Walgreen repeated multiple times that customers will have the widest acceptance in the Express Scripts network. However, the biggest challenge going forward lies in the comment made at the beginning of their press release. Walgreen said, “most of the patients we served in calendar 2011 who participated in a plan for which Express Scripts served as pharmacy benefit manager transitioned to another pharmacy after we exited the network on January 1, 2012.” The importance of this statement cannot be underestimated. In plain english, Walgreen will now need to win back as many of these former customers as possible.

The company said that this will negatively affect their results, as there will be a marketing push to try and win back former patients. In the short term, Walgreen expects continuing adverse effects for the fourth quarter generally comparable to third-quarter. Longer-term, the company expects this agreement to, “positively affect net sales, net earnings, and cash flows over time.” According to the press release, Express Scripts manages more than 1 billion prescriptions each year for tens of millions of people. Even if Walgreen captures a smaller portion than previously, there's no question this relationship will help results. What investors need to be aware of is, this is not a silver bullet that will immediately solve the company's recent challenges.

To get an idea of the type of results the company could achive, it makes sense to look at one of Walgreen's last quarterly reports before losing the Express Scripts relationship. In the 4^th quarter of 2011, the company saw a 6.5% increase in sales. The sales were positively affected by a 5.3% increase in prescriptions, which also helped front end sales increase 4.4%. This positive relationship between prescription sales increases and front-end sales increases, worked against the company when the Express Scripts relationship ended. With analysts calling for just over 10% EPS growth, and the company's dividend now paying a 3.2% yield, the stock again looks attractive. Without this relationship, that was simply not the case. If you're one of Walgreens competitors though, all is certainly not lost.

The primary competitor that seems to have benefited from this issue during the last 7 months, is CVS Caremark (NYSE: CVS). There is no question that as Walgreen cut off former Express Scripts members, these patients chose other pharmacies, with CVS being the most likely choice. In fact, analysts have raised their growth expectations for the company to 11.88% over the next few years. While CVS does not pay as impressive of a dividend as Walgreen does, there are two factors that still seem to favor this company. First, in a previous post I found that CVS produced $1.1 billion worth of average cash flow even after dividends in the last 4 quarters. Compare this to Walgreen, which produced $311 million average cash flow after dividends, and you can see which company should be able to reward shareholders more in the future. In addition, CVS shows impressive dividend growth over the last 10 years. In fact, in the last 4 years, the average dividend increase has been over 28%. As you can see, while CVS current yield cannot match Walgreen, if the company continues raising its dividend at a high rate this won't be the case for long. With just a 17% payout ratio last year, the company's dividend is also well covered. You can see that CVS should continue to benefit from these transferred patients, but who else benefits from Walgreen's prior losses?

It seems logical that two of the largest retailers in America have also benefited directly. Walmart (NYSE: WMT) and Target (NYSE: TGT) have expanded, and promoted their pharmacies. Further promotion is likely, as these sales are insulated from Internet competition. Most customers still physically go and pick up their prescriptions at a retailer. While Walmart's stock has been on the run and is not as cheap as it used to be, the shares trade for less than 15 times forward earnings. The company is expected to grow at over 8%, and pays a greater than 2% dividend. Where Target is concerned, the company has pushed its prescription benefit by offering a $10 gift card to anyone who brings a new prescription to the pharmacy. What is interesting is, Target sells for a slightly cheaper P/E ratio than Walmart, but is expected to grow at a faster rate (11%). Target also pays a respectable 2.3% dividend and should warrant consideration as an alternative play on the pharmacy industry. As you can see, while Walgreen will definitely benefit by having Express Scripts back in the fold, there is no guarantee that the company returns to its former glory. That being said, it at least should warrant consideration, versus prior to this agreement I would not have suggested touching the stock.

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