Walgreen Not Dead In The Water Just Yet
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
From the Affordable Care Act to pharmacy network losses, drug stores have been through a lot of changes over the past 5 years. This tumultuous environment has caused investors to shift towards the safest pharmacies. Has this caused firms with smaller economic moats to become relatively undervalued? Below, I cross compare CVS and Walgreen.
Avoid CVS Caremark (NYSE: CVS)
CVS is not only near its 52-week high but also its historical high. Over the last 12 months, it has gained ~20% in value, largely as a result of the migration of Express Scripts (NASDAQ: ESRX) customers from Walgreen (NYSE: WAG) to CVS. Performance has been modestly above expectations, but nothing terrific by any means. While Warren Buffett may have sold 5.3 million shares in the recent disclosure, analysts are still calling the stock a "buy." It trades reasonably at 15.4x past earnings with a forecast for 12.7% annual EPS growth over the next 5 years. And despite the all-time high, management is implementing a new $6 billion share repurchase program.
Still, the story is a bit of a mixed bag. The company will be sending refunds to 13,000 Medicare beneficiaries who were overcharged, and though the explicit cost of this return is insignificant, it will make it more difficult to retain a targeted 50% of the migrating Express Scripts customers. A new pharmacy agreement between Walgreen and Express Scripts has effectively ended the dispute between the two parties. Cleveland Research has warned investors that it may be difficult for CVS to realize this target in light of greater promotional activity from Walgreen. But prescription customers tend to be sticky, so I wouldn't expect too much downside from the recent agreement. Especially after they already switched, why would they want to go through the hassle again?
Assuming expectations are met, 2016 EPS will come out to $5.47. At a multiple of 15x, this translates to a future stock value of $82.05. Discounting backwards by 10% yields a present value of $50.95. This 10% margin of safety and 6.6% FCF yield is not incredible, so I recommend only slightly buying shares, if any.
Walgreen Changing The Tide
To its credit, Walgreen has been able to orchestrate a bit of an operational turnaround. The new pharmacy agreement with Express Scripts is a multiyear contract, wherein Express Scripts customer can now get prescriptions at Walgreen. Express Scripts represented 10% of 819 million prescriptions filled in 2011--$5 billion worth of annual business. Further, the JV agreement with Alliance will build synergies and tap into the wealthy Switzerland market. So, this deal will help prevent CVS from locking in too much market share. In addition, the decision to launch a line of green products as a way of differentiating itself from the competition may not be exactly "groundbreaking", but it clearly sends a signal to the market that management is moving and not merely letting inertia run the business.
Operations, however, not panned out as expected. Negatively impacted by Hurricane Sandy, October front end sales saw a 2.9% decline. In addition, prescriptions filled and administered flu shots were below expectations as well. Some claim that corporate missteps relating to Express Scripts have permanently scared off customers, but I believe these bulls are not giving enough attention to Walgreen's customer loyalty program.
While the ESRX retention rate of rivals is most likely better than Walgreen expected, management is still forecasting revenue topping $130 billion by 2016. At a profit margin of 3.2%, this translates to earnings of $4.16 billion. Walgreen would be a $62.4 billion company by 2016 at a 15x multiple, or $38.7 billion in present terms. So, Walgreen has around a 30% margin of safety, which is well complemented by a 3.4% dividend yield, and a $38.76 price target. I strongly encourage making an investment for this reason.
TakeoverAnalyst 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!