Is It 2013 Yet?
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
You know that things have been difficult for a company when investors start to question a dividend aristocrat. I've written several articles about Walgreen (NYSE: WAG) this year as the company had issues with the loss of its relationship with Express Scripts (NASDAQ: ESRX) and then renegotiated this contract to try and get these customers back. Each time I've written about Walgreen, I've gotten comments to the effect of “please stop writing about this;” but with over 8,300 total stores Walgreen is one of the largest drugstore chains in the US, and changes to the company's potential customer base should be big news to investors. There is good news and bad news out of the company's recent earnings report. The good news is, this quarter is over and the company is moving forward. The bad news is, the company is still suffering from its rift with Express Scripts.
The Pharmacy Industry – Simpler But Fiercely Competitive
The pharmacy industry has gotten simpler in the last few years even though some customers and pharmacies might not like it. At this point there are essentially two mega-benefit managers. One is Express Scripts, and the other is CVS Caremark (NYSE: CVS). Each of these benefit managers handles millions of prescription reimbursements per quarter, and any pharmacy that doesn't participate in one or both of these networks is at a serious disadvantage.
In addition, in the pharmacy industry there are basically two larger players and then everyone else. Walgreen is probably the most well known pharmacy, but CVS is right behind it. Both companies offer similar store footprints and seem to be popping up anywhere there is spare land. Each company relies heavily on prescription sales, but also benefits with stronger front-end sales when prescription sales are up. Unfortunately, both face increased competition from two huge rivals: Target and Wal-Mart (NYSE: WMT).
The Wal-Mart Threat:
You might not think Wal-Mart would be a major threat, but the world's largest retailer is actually the third largest pharmacy behind only Walgreen and CVS. The fact that over 200 million customers shop at Wal-Mart each week worldwide should make Walgreen and CVS tremble. Since Wal-Mart is visited much more frequently than its competition, it makes sense that shoppers are deciding to fill their prescriptions at the store as well. In the past, the problem with this was that the pharmacy was located in an inconvenient part of the store, usually near the back. The company has been changing the location of its pharmacy in newer stores to make it more visible.
For example, in a new Wal-Mart near where I live, the pharmacy is located almost exactly in the middle of the store. Surrounding the pharmacy are over-the-counter medication displays, vitamins, and the like. I can't help but think that Wal-Mart is taking a page from Walgreen and CVS' playbook. If you have ever been in either of these stores, they locate the pharmacy nearest to the over-the-counter medicines and vitamins. I'm sure Wal-Mart realizes that customers are accustomed to looking in this location for the pharmacy.
Wal-Mart is also trying to address the convenience factor by locating its pharmacy in the middle of the store. Walgreen and CVS for years trumpeted that it was easier to get in and out of their stores as a competitive advantage. Wal-Mart’s move of the pharmacy closer to the front of the store is smart, and lessens this issue for customers. When you combine the improved location of the pharmacy with the convenience of a one stop shop, Wal-Mart is coming up in Walgreen's rear view mirror and coming up fast.
Walgreen Has A Hard Road Ahead
Walgreen's earnings just didn't look good at all. Revenue was down 5% and adjusted EPS was down 4.55%, but that doesn't begin to tell the story. The company benefitted from stronger pharmacy sales before its Express Scripts issues, and is still feeling the brunt of this reversal. Walgreen's all important prescription sales were down 8.1%, and comparable prescription sales dropped 12.8%.
As proof that this loss of sales wasn't just from a switch to less profitable generics, the company saw its number of filled prescriptions drop 6.9%. These negative results filtered down to the company's financial statements as well. Walgreen's operating cash flow minus asset and liability adjustments dropped 13.34% from last year. The company also said it expects tough comparisons going forward as it continues to deal with trying to win back Express Scripts customers.
So What Is The Company Doing To Turn Things Around?
The first thing I should point out is that even though the company is suffering from tough comparisons, it did still generate over $3 billion in operating cash flow. Walgreen also has a history of increasing its dividend, a history that currently spans 37 straight years. This next year, the company expects to leverage its rewards program to help drive repeat business into the stores. The company also cited its strategic partnership with Alliance Boots as a growth driver, but any benefits from the venture will be diminished in the short-term as Europe goes through its own economic issues. However, eventually Europe will stabilize and this partnership should benefit Walgreen longer-term.
The company's reentry into the Express Scripts’ network is the biggest positive factor in Walgreen’s favor. Almost as if on cue, I've seen yard signs at my local Walgreen's saying “Welcome Back Express Scripts Members.” This is the single most important message the company can send in the next few years, as evidenced by the company’s offer of a $10 or $25 Walgreen's card for customers that transfer a prescription to Walgreen if they are an Express Scripts member.
While Walgreen certainly has its work cut out for it, the company's stock is about as reasonably priced as I have seen. Walgreen currently sells for about 14 times forward earnings and is expected to grow at about 11.4%. For years I saw Walgreen's yield languish in the sub-1% or sub-2% range as the stock performed well. This uncertainty over the last ten months has created a decent income play for investors with the yield currently at about 3%.
CVS, with a nearly identical forward P/E ratio and an expected growth of 13%, is still my favorite play in this space. While CVS' dividend yield of just 1.34% can't match Walgreen's, CVS has been growing its dividend by 28% over the last few years.
Investors might also consider Express Scripts. The company does not pay a dividend, but its forward P/E ratio of just under 17 and 18% earnings growth make this stock attractive as well.
The best news for Walgreen's is that this year is almost over. If the company can win back Express Scripts customers and continue growing, this could be a good buying opportunity for long-term investors.
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.