3 Positives, But Lots Of Work Still Ahead

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

There is no nice way to say this, Walgreen (NYSE: WAG) management made a huge tactical error last year. The company assumed that they could strong arm Express Scripts (NASDAQ: ESRX) and it didn't work. The company made the decision to exit the Express Scripts network, and Walgreen's stock paid the price. Since renegotiating with Express Scripts, Walgreen's investors have bid the stock up, but there is a lot of work left to be done.

Play Nice Or You Know What Will Happen:

Walgreen's last earnings report capped off what by all accounts was a pretty bad year. In the last three months, sales dropped 4.6% and EPS fell 18.31%. For investors who were used to double-digit earnings growth in prior years, 2012 was a rude awakening to the shift in the balance of power for pharmacies. Whether Walgreen's management likes to admit it or not, the company needs pharmacy benefit managers more than they need the pharmacies. Though Walgreen has over 8,500 locations, their competition CVS Caremark (NYSE: CVS) has over 7,500 locations of their own, plus they are the second largest pharmacy benefit manager. This is a key difference between the two companies, one somewhat controls its own destiny (CVS), and the other has to rely on good relationships with others (Walgreen). In case investors don't believe that this Express Scripts issue was a big deal, look at what has been going on with Walgreen's same-store sales.

The Before And After Story:

In years prior to the Express Scripts fallout, Walgreen would like clockwork turn out mid to high single digit same-store sales growth, which was usually led by the company's prescription sales. Since the Express Scripts network exit, the decline in prescription sales has led the company in the other direction. When nearly 64% of your sales are down 7.2%, you know the company is having problems. Walgreen's gets about 64% of its total sales from prescriptions, and this 7.2% decline was the year-over-year drop in this type of sale. What was even worse is prescription comparable sales dropped 11.3%. While in the past Walgreen could rely on higher prescription sales to boost front-end sales, the company found this also works in reverse. Front-end comparable store sales were down 2%, and as long as prescription sales are down, front-end sales will be under pressure.

Is There Any Good News?

Walgreen investors should take heart as there are several bright spots to the company's story. First, if you are looking for income, Walgreen's yield beats CVS handily at nearly 3% versus less than 2%. Since Express Scripts stubbornly refuses to pay a dividend, they can't compete for income hungry investors dollars.

Second, Walgreen has a much higher gross margin because they don't operate a pharmacy benefit management company. Express Scripts' gross margin in their last quarter was just over 10%, and CVS managed an 18.68% gross margin. By comparison, Walgreen's gross margin was 28.32% in the last three months. In theory, if Walgreen can turn around their sales results, good earnings and cash flow should follow from this higher margin.

Third, I'm not willing to say the pain is over in prescription sales declines, but there are a few positive signs. In the prior quarter, Walgreen saw a decline of 8.1% in prescription sales versus a 7.2% decline this quarter. In addition, comparable prescription sales were down 12.8% three months prior versus a decline of 11.3% this time around. Another encouraging sign is, filled prescriptions were down just 3.2% on a year-over-year basis. This indicates that most of the decline in sales was due to lower pricing and not necessarily less customers.

What's Next?

The main problem that Walgreen's faces is that of perception, and unfortunately this isn't something that is easily cured. Customers who were part of the Express Scripts network last year who had been with Walgreen found themselves cut off. They were forced to find another pharmacy to fill their prescriptions, and this type of change can cause resentment that lasts for years. Walgreen will need to make sure to keep their participation in all the major benefit managers networks in place to avoid any issues like this in the future.

Conclusion:

In the meantime, investors have a choice to make. Walgreen does offer the best yield of the bunch, but the company still offers the lowest expected EPS growth rate of the three companies we have looked at. While the stock also sells for a P/E ratio that is lower than their competition, it may be a while before Walgreen resumes being a growth stock. In the meantime, CVS is eating Walgreen's lunch. The company is growing faster, seeing positive prescription sales growth, and the Caremark unit is growing by leaps and bounds. In addition, CVS has been raising their dividend significantly faster than Walgreen in the last few years. On the other hand, Express Scripts appears undervalued relative to both CVS and Walgreen. Express Scripts pays no dividend, but the company is expected to grow by over 17.5% in the next few years compared to 13.3% at CVS and 12.4% at Walgreen. The fact that Express Scripts sells for a similar P/E ratio makes the stock one to watch. If you believe that Walgreen will regain its former glory, the higher dividend makes it easier to wait. However, there is a lot of work to do, and the company has a long road ahead.


MHenage has no position in any stocks mentioned. The Motley Fool recommends Express Scripts. The Motley Fool owns shares of 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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