Why the Market Undervalues this Stock

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

I must confess I’m fed up of hearing discussion of behavioral finance in investment circles. Well, actually I love the subject matter, it’s just that I’m tired of hearing some idiot or other trying to impress the investment world with his ‘knowledge’ of the next big investment topic without ever actually demonstrating that he understands the subject. Usually they are trying to get you to stay invested with them (after their rubbishy performance) by avoiding the near-term myopic loss-aversion heuristic. Simply put, this is the tendency to overweight near-term risk of loss. We all do it. It’s hard wired in us. However if investors can try and overcome this, I think Walgreen (NYSE: WAG) provides a good example of how to profit from it.

Walgreen and Myopic Loss Aversion

No one likes holding a stock exposed to near-term risk and with Walgreen I will be explicit here. I think that it will find it harder than many people may think to win back the customers lost in the Express Scripts (NASDAQ: ESRX) debacle. Indeed its competitors have all been saying that they are confident they can hold onto the customers using a variety of methods. Its largest competitor, CVS Caremark (NYSE: CVS), wouldn’t disclose granular detail on how it plans to retain customers, but appeared confident. Similarly Wal-Mart (NYSE: WMT) claimed confidence in retaining business won from Walgreen.  The last of the majors to win business from Walgreen was Rite-Aid (NYSE: RAD). Of the total business that Walgreen claims to have won back from the majors, 33% came from CVS, 10% from Wal-Mart and 9% from Rite-Aid.

Thinking longer term about industry dynamics WMT remains a threat to the Pharmacy Benefit Managers (PBM) like Express Scripts because it could try to circumvent them and the fact that Walgreen (unlike CVS) exited the PBM business rather suggests that Wal-Mart and Walgreen are singing from the same hymn sheet.  

In summary, all of these companies are sounding confident about keeping business and Walgreen appears to be lagging estimates. I think the chances are that it could continue.  

But really, who cares?

Win Money Not Medals

As an investor no one is going to give you a medal for picking the best performing company from an operational perspective. All you are usually trying to do is buy an evaluation of a stock and then hope to sell it on at a higher price. Little else matters.

In the case of Walgreen, so what if it doesn’t win back all the customers?  As I argued previously, its valuation is attractive in its own right. The company is on a cheap valuation and is starting to lap the losses caused by the Express Scripts debacle. In other words the optics will be better going forward and in any case Walgreen has some other powerful growth drivers.

It’s not just a question of winning back customers. Walgreen is also on the end of some favorable demographic trends with an aging population and increasing sales of generics will increase margins. Generics tend to be higher margin for retailers but come with lower selling prices so sales tend to fall while profits rise. The real loser in this process is the branded pharmaceutical company. As for private label brands, Walgreen significantly increased its penetration by two points to 22%. Walgreen also makes a play on its ‘community health care’ and I think this is an aspect of US corporate life whose importance is often underestimated.

The last of its key drivers will be the realization of synergy benefits following its investment in Alliance Boots.  This deal is somewhat problematic because it is not a controlling interest and investors will suffer a lack of the usual immediate transparency with earnings. Indeed, Walgreen announced that there would be a one quarter reporting lag for the investment in Alliance Boots rather than the originally planned one month. On the other hand there are significant synergies to be generated here and Alliance Boots is a relatively stable business with good growth drivers in its own right.

The Bottom Line

In conclusion, I think comparisons will get better for Walgreen going forward. The company stands on an EV/Ebitda multiple of 8.2x and a forward PE of less than 11x. This is not expensive for a company with such favorable end market drivers. I think investors should ignore the near term ‘disappointments.’

Walgreen will win customers back and if this is the trough of earnings and cash flow then investors should recall that usually in troughs companies will typically command high PE ratios as the market prices in an earnings recovery. In this case the stock looks cheap and has recovery prospects. I’m happy to hold.

 


SaintGermain has a position in Walgreen. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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