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WAG AT A GLANCE

P/E ► 17.4 AVG EV/EBITDA ► 9.45 AVG ROA ► 8.5% AVG ROE ► 15% AVG Debt to Equity ► 0.816 AVG Current Ratio ► 1.71 AVG Interest Coverage Ratio ► 37.9 HIGH

 

 

 

 

 

 

Walgreens (NYSE:WAG) is a U.S. drug retailer that sells both prescription and non-prescription drugs as well as retail merchandise (cosmetics, convenience foods, photo processing services, seasonal merchandise). In addition to its store offerings, Walgreens provides pharmacy services like prescription fulfillment through mail-order, telephone, and internet.^[1] The company operated 6,443 retail locations in the U.S. in 2008, a 9.5% increase from 2007,^[2] although CEO Greg Watson has stated that they will slow the pace of new store openings to 3% by 2011.^[3]

Walgreens benefits from the aging baby boomer population. Seniors are an important demographic for retail pharmacies like Walgreens due to their greater spending on medical products and services. In addition, the increased use of generic drugs in place of branded pharmaceuticals both lowers costs for consumers (which increases demand) and generates higher gross margins for retail pharmacies.

However, several obstacles to growth exist for Walgreens and other retail pharmacies in the coming years. As is common in industries with strong growth prospects, pharmaceutical retail has attracted larger market-cap competitors from adjacent industries, the most notable being Wal-Mart. In 2006, the behemoth omni-retailer announced that it would undercut pricing on generic drugs by as much as 50% compared to Walgreens.^[4] This ignited a price war,^[5] which increased pressure on the company's drug margins and front-store sales (Walgreens makes higher margins on beauty products, snacks, etc. and depends heavily on cross-category sales from those who come in to fill prescriptions). In addition, the private-public Medicare Part D program, which went into effect in 2006, reduced reimbursements for prescription drugs supported by that program. Further cuts in Medicare spending would add to the margin squeeze for the company.

In FY2008, Walgreen's sales grew 10% from $53.8 billion to $59.0 billion. ^[6] This places the company behind CVS Caremark Corporation (CVS)'s $76.3 billion in FY2007 revenue, and this gap will likely grow with the 2008 CVS acquisition of Longs Drug Stores (LDG). ^[7]

Business Operations

A Walgreens Pharmacy

Founded in 1901, Walgreens had revenues of $63.3 billion in fiscal 2009. As of Aug. 31 2009, the company operated 6,997 drugstores in 50 states, DC, and Puerto Rico versus 6,443 a year ago. In fiscal 2009 Walgreens added 544 new drugstores, including 70 by acquision, growing by 8.6%. However, Walgreens announced that it will slow its rate of store expansion in 2010 to 5%.^[8]

The company’s growth has been mostly organic, with the percent of its stores opened by Walgreens rather than acquired comprising 84% of all stores in 2005, compared to only 31% in 1995.

• Pharmacy Retail (75% of sales): Walgreens is one of the largest U.S. chain drugstores by sales and profits, and the company depends on its retail pharmacies to bring in a large percentage of revenues. In fiscal year 2009, Walgreens derived 65% of its sales from prescription drugs and 10% from over-the-counter drugs, unchanged from 2007. ^[9]

• Front Store Operations (25% of sales): This segment includes general merchandise such as cosmetics, toiletries, household items, food, beverages, and photofinishing. ^[10] The typical Walgreens retail outlet devotes more square footage to its front-end compared to rivals such as CVS/Caremark and Rite Aid (RAD).^{[citation needed]} With a higher mix of consumables than its competitors, Walgreen’s front store serves as a convenient alternative to supermarkets. Additionally, Walgreens private brand now comprise approximately 20% of front-end merchandise by sales, up from 12% in 2000 ^[11] In 2010, in a move that may bring it further in competition with grocery stores, Walgreens announced plans to introduce fresh foods and prepared meals at all of its locations. ^[12]

Business Growth

Walgreen's revenues increased 7.3% in FY2009 to $63.3 billion. Prescription drugs comprise 65% of this revenue, with the rest coming from OTC drugs (10%) and front-end sales (25%). Net earnings, however, decreased 7.0% to $2.01 billion. ^[13]

In October 2008, Walgreens announced a three-pronged strategy to achieve double-digit growth by 2011. The three strategies are: Leveraging the Best Community-Based Store Network in America, Enhancing the Customer Experience for Shoppers, Patients and Payers, and Targeting $1 Billion in Annual Cost Reductions by Fiscal 2011.^[14] Walgreens expects that following these strategies will enable it to improve revenue and return its EPS growth to the strong double-digits.

Walgreens Sales by Category^[15]

Quarterly Business Financials

Walgreens posted net earnings of $2.01 billion in fiscal 2009, down 7.0% compared to the previous year. In FY 2009, Walgreens had from 63.3 billion in sales, an increase of 7.3% on the previous year.

The biggest driver of growth was in prescription sales, which grew 8.2%, compared to 3.2% in competing stores. By the end of the third quarter, Walgreens had opened or acquired 40 stores and installed its CCR initiatives into 35 pilot stores. ^[16]

For the three months ended November 30, 2009, Walgreen’s reported $16.4 billion in revenues, a 9.5% increase over the same period in 2008, while operating income grew 19.1%, to $797 million. Growth was driven by expansion, as Walgreen’s increased from 6,630 drugstores on November 30, 2008 to 7,147 on November 30, 2009.

Trends and Forces

Customer-Centric Retailing

Customer-centric retailing (CCR) refers to one of Walgreens' initiatives to enhance the customer experience, one of the three strategies by which the company plans to return to double-digit growth. CCR focuses on enhancing store formats, pricing, promotions, and vendor relationships to provide a better experience for the customer. In Q3 of 2009, Walgreens rolled out its CCR strategy in 35 pilot stores and saw immediate improvements in cleanliness and shopping efficiency.^[17] Walgreens' ability to scale CCR into the rest of its franchises may be important to its ability to improve margins and market share.

Aging Population

An aging American population segment, known as the baby boomers, continues to fuel an increase in demand for prescription drug sales. The American Association of Retired Persons (AARP), reports that while people in the 25-54 age group fill between 5 and 12 prescriptions each year, people over the age of 55 fill between 19 and 24 prescriptions and spend much more of their disposable income on drugs. ^[18] As this generation of boomers gets older, chain drugstores will experience an increase in prescription sales for the next 10+ years.

Medicare Part D and Medicaid

Government cuts in Medicaid and the introduction of Medicare Part D in January of 2006 have affected pharmacies like Walgreens.

While Medicare Part D had over 27 million enrollees at the start of 2010 (many of whom who were previously uninsured)^[19], many of these used to be Medicaid patients. Medicaid reimburses more for drugs than Medicare, so cuts in the former and increases in the latter have resulted in two competing effects on pharmacies: more customers but lower margins. While revenues have continued to increase, Walgreens did report in 2008 a decline in pharmacy margins for senior prescriptions as millions of cash payors continued to enroll in Medicare Part D.^[20]

At the same time, certain provisions of the Deficit Reduction Act of 2005 seek to reduce federal spending by altering the Medicaid reimbursement formula for multi-source (i.e., generic) drugs. These changes are expected to result in reduced Medicaid reimbursement rates for prescription drugs. In addition, a class action settlement with two entities that publish the average wholesale prices (AWP) of drugs, AWPs have been reduced for many brand-name prescription drugs effective September 26, 2009. While Walgreen’s has reached understandings with most of its third-party payors to adjust reimbursements to correct for this change in methodology, but state Medicaid programs that utilize AWP as a pricing reference have not taken action to make similar adjustments, resulting in reduced Medicaid reimbursement for drugs affected by the change. ^[21]

Generic Prescription Drugs

The retail drugstore industry will benefit from accelerated generic prescription drug sales, as a significant number of branded drugs were set to come off patent between 2006-2009. While generic drugs are priced at lower costs, margins for these products tend to be higher for drug retailers. ^[22]

Threat of Mail-Order Pharmacies

Mail-order pharmacies compete with retail drugstores, benefiting from an ability to charge lower prices for prescription drugs. The mail-order segment is the the fastest growing retail pharmacy business and currently comprises about 19-20% of total U.S. prescription sales. ^[23] Walgreens does have its own pharmacy benefit management (PBM) services, allowing the company to offer its large customer base the option of migrating towards mail order pharmacy.

Competition

Market Share: Prescription Drugs and Front Store Sales^[24][25]

Drugstore competitors to Walgreens include:

• CVS/Caremark (CVS) generated $86 billion in combined sales for 2008. CVS is the largest drugstore retailer and also has its own PBM business. Walgreens lags behind CVS in terms of market capitalization but has historically led in terms of revenue and operating margins until 2007. However, CVS's sales and profits grew significantly when CVS completed its merger with Caremark, a leading PBM, in March 2007 as a part of its recent acceleration of its physical and geographical expansion. The company continued to aggressively expand in 2008 with the acquisition of Longs Drug Stores (LDG), which will further raise revenues. In 2008, CVS reported a net income of $3.34 billion, for an EPS of $2.27.

• Rite Aid (RAD) generated $26.3 billion in 2008 revenue, but totaled a net loss of $2.9 billion. Rite Aid recently acquired Brooks/Eckerd on the East coast, but both companies are currently struggling. Walgreens could stand to benefit from their decline.

In addition to other drugstore retailers, Walgreens also competes for market share with supermarkets, convenience stores, mass merchants, dollar stores, Internet drugstores, and PBMs. Of late, supermarkets and mass merchants have lost considerable market share (currently at 12%) in the retail prescription business.

In particular, Wal-Mart (WMT) has grown its retail pharmacy business at its retail mega-stores. Wal-Mart is the third largest domestic retailer in terms of pharmacy sales, and it has continued to increase the number of total pharmacies in its installed store base. Wal-Mart also announced a strategy to aggressively undercut prices of generic drugs compared to traditional drugstores such as Walgreens. Such actions may catalyze pricing wars, which could put significant pressure on drugstore retailer margins.

References

1. ↑ Walgreens 10-K 2008. Section 1 - Business. pg 1
2. ↑ Walgreens 10-K 2008. Section 1 - Properties. pg 4
3. ↑ Walgreens F3Q09 (Qtr End 5/31/09) Earnings Call Transcript
4. ↑ Wal-Mart to Cut Prices for Generic Drugs
5. ↑ CVS slashes generic drug costs, escalates price war
6. ↑ Walgreens 10-K 2008. Section 2 - Five-Year Summary of Selected Consolidated Financial Data. pg 1
7. ↑ CVS Caremark 10-K 2007. Section 2 - Financial Statements and Supplementary Data. pg 32
8. ↑ The Wall Street Journal Online, "Walgreen to Slow Expansion"
9. ↑ Walgreens 10-K 2009. Section 1 - Business. pg 1
10. ↑ Walgreens 10-K 2009. Section 1 - Business. pg 1
11. ↑ [http://archives.chicagotribune.com/2008/mar/17/business/chi-mon-walgreen-wag-clothes-mar17| Chicago Tribune. "Walgreens shifts self-promotion, Private-label line grows, includes clothing. 17 March 2008."
12. ↑ [1]
13. ↑ Walgreens 10-K 2009. Section 2 - Five-Year Summary of Selected Consolidated Financial Data. pg 1
14. ↑ Walgreen Co. Outlines Strategic Growth and Value Creation Initiatives at Analyst Meeting
15. ↑ Walgreens 10-K 2008. Section 2 - Five-Year Summary of Selected Consolidated Financial Data. pg 1
16. ↑ Walgreen Co. Reports Third Quarter 2009 Earnings
17. ↑ Walgreens F3Q09 (Qtr End 5/31/09) Earnings Call Transcript
18. ↑ AARP report on Prescription Spending by People Age 65+"
19. ↑ HHS Monthly Summary on Medicare Part D Enrollment. January 2010.
20. ↑ Walgreens 10-K 2008. Section 2 - Results of Operations. pg 13
21. ↑ [2]
22. ↑ Drug Channels. "The Attack on Generic Profits in Drug Channels." 21 November 2001.
23. ↑ Nu-Retail.com "Exclusionary Practices in the Mail Order Pharmacy Market." 21 Sept 2005
24. ↑ CVS Caremark 10-K 2007. Section 1 - Business. pg 4
25. ↑ Market Wire. "BIGresearch Retail Ratings: CVS Closes Prescription Drug Gap With Walgreens." October 2008.