Transcript Walgreen Co. (WAG) - UIUC College of Business

Walgreen Co.
(WAG)
Matthew McDonnell
Contributions by James Herr
14-September-2006
Company Overview

Founded in 1901 by Charles Walgreen


1st store in Chicago
Currently 5,251 stores operating in 45 states and
Puerto Rico


131, 400 employees as of 11/30/2005


Median store age is approx. 5.4 years old
Avg. years of experience for store managers is 12.6 years
Goal is to have 7,000 stores by 2010
Company Overview

David Bernauer



Chairman of the Board since 2003
Chief Executive Officer since 2002
President and Chief Operating Officer from 1999-2003


Jeffrey Rein

President and Chief Operating Officer since 2003


Has been with Walgreens since 1974
George Eilers replaced by Kevin Walgreen, great-grandson of Charles
Walgreen, as Senior VP of Store Operations (Southern Region) in early 2006 due
to Mr. Eilers’ retirement

Eilers had been with Walgreens for 46 years


Has been with Walgreens since 1966
Kevin Walgreen has been with company since 1979
William Rudolphsen

Senior Vice President and Chief Financial Officer since 2004

Has been with Walgreens since 1977
Source Data: Walgreen Co. Jan. 11, 2006 Annual meeting and www.walgreens.com
RCMP Position




Own 1000 shares in Walgreens
Purchased at $25/share on 10/06/1999
Cost Basis is $25,000
Stock is now trading at $49.31/share



Valued at $49,310
Represents 13.75% of portfolio MV
Gain of $24,310, or 97.24%
Macroeconomic Overview- General
Economy

Earlier this summer, the markets trended
downward due to a number of factors:


Uncertain economic outlook stemming from repeated
releases of conflicting economic indicators
Repeated non-official statements made by Federal
Reserve Board members regarding the health of the
economy, possible future actions


See May 1, 2006 on-air comments by CNBC reporter Maria
Bartiromo
Continuing political uncertainty and worries regarding
oil supplies as violence increased in Iraq and Iran
defied US and UN fueled higher energy prices and
muted hampered US and world equity markets
Macroeconomic Overview- General
Economy

Since mid-July, the markets have trended
somewhat higher on high volume but gains have
not been substantial


The market as a whole currently feels that a pause in
interest rate hikes is indeed likely
One of the leading inhibitors for better performance
remains continued uncertainly regarding the health of
the economy stemming from conflicting economic
indicators

See Friday, September 8, 2006 release of cost of wages and
economic growth
Macroeconomic Overview- Trailing
6 Month Market Performance
Macroeconomic OverviewDemographics

Aging Population

Around 36 million people are 65+

12.6% of the total U.S. population



Retirement of “Baby Boomers”



17.6% live in Florida
By 2030, there will be almost 72 million people 65+
Currently, around 77 million Baby Boomers
representing almost 27% of the population
Over 50% of Baby Boomers live in CA, TX, NY, FL, PA,
IL, OH, MI, NJ
Americans begin to start taking more drugs in
their early 50’s
Source Data: www.metlife.com
Macroeconomic Overview- Political

Medicare Part D prescription drug program


Prescription Drug coverage




In effect as of January 1st, 2006
Covers both generic and prescription drugs for those who qualify
for Medicare
Designed to protect those with high drug costs
May allow pharmaceutical industry to create new drugs
that are “safer” and more effective
At this point it is too early to tell how the new plan will
affect Walgreens, as the “kinks” are being resolved
Drug Store Industry

Decreasing customer loyalty


Relationship with customers deteriorating
Customers now have more convenient or
economically viable options


Generic drugs seen as a low-cost alternative to namebrand prescription and non-prescription medications =
Mail order threat
Walgreens is combating the mail order threat by
offering customers a choice between 90-day mail
order prescriptions and 90-day at retail option, known
as Advantage90

Advantage90 is currently offering prescriptions at $10
discount to 90-day mail orders
Source Data: Walgreen Co. Jan. 11, 2006 Annual meeting
Drug Store Industry

Highly Competitive Industry



Competition with other drugstore chains, independent drugstores,
mail order prescription providers, internet pharmacies
Other competitors include various grocery stores, mass merchants,
and dollar stores
Main competitors:

CVS Corp. (CVS)




Recently purchased 700 stand alone Sav-On and Osco drugstores
through its $9.7 billion buyout of Albertson’s Inc.
This move will give CVS a significantly greater Midwest foothold
Rite Aid Corp. (RAD)
“Partial” competitor

Wal-Mart (WMT)

Pharmaceutical more than grocery department

In FY 2004, Pharmaceuticals were 9% of Wal-Mart’s sales
 In total, about $6 billion/year (25%) less in net sales than Walgreens
Source Data: Wal-mart’s 2004 10-K
Porter’s 5 Forces: Drug Store
Chains
Threat of new
entrants
MODERATE
Power of
Customers
LOW
Power of Suppliers
HIGH
Overall Threat
Level:
High
Industry Rivalry
HIGH
Threat of
Substitutes
MODERATE
Competitors
Market Cap:
Employ-ees:
Qtrly Rev Growth
(yoy):
Revenue (ttm):
Gross Margin (ttm):
EBITDA (ttm):
Oper Margins (ttm):
Net Income (ttm):
EPS (ttm):
P/E (ttm):
PEG (5 yr
expected):
P/S (ttm):
WAG
46.40B
131,400
CVS
24.89B
78,500
RAD
WMT
Industry
2.08B
189.61B 24.47B
38,448 1,700,000 78.50K
10.20%
43.21B
9.10%
37.01B
0.90%
16.84B
8.60% 12.50%
312.43B 37.01B
27.96% 26.76% 25.19%
2.93B
2.61B 662.08M
23.06% 26.76%
23.25B
2.61B
5.63%
1.58B
1.536
29.85
1.65
1.06
5.46%
2.47%
1.21B 208.92M
1.45
0.394
21.08
10.05
1.49
0.66
CVS = CVS Corp.
RAD = Rite Aid Corp.
WMT = Wal-Mart Stores Inc.
Industry = Drug Stores
Source: Yahoo! Finance available at: http://www.finance.yahoo.com
11.37
0.12
5.93%
11.23B
2.682
16.98
4.83%
1.22B
1.54
23.01
0.97
0.6
1.65
0.66
Interesting Facts

Earnings:





The average grocery store earns $12/ sq. ft.
The average drug store chain earns $20/sq. ft.
Wal-Mart earns $26/sq. ft.
Walgreens earns $46/sq. ft.
Prescriptions




(average per store)
Grocery stores fill 131 prescriptions/day
Mass retailers fill 143 prescriptions/day
Chain drug stores fill 180 prescriptions/day
Walgreens fills 263 prescriptions/day

Walgreens fills more prescriptions than all grocery stores
combined!
Source Data: Walgreen Co. Jan. 11, 2006 Annual meeting
Strategy



Enter new markets
“Dense up” existing markets
Organic store growth





Invest heavily in high-tech store and distribution systems which
drive service up and costs down
“An agile elephant” – Must continue to find ways to leverage the
benefits of scale without losing the ability to react quickly to
changes in customer needs
Healthcare offerings beyond that of a traditional pharmacy


Relocate
Remodel
Offer an online drugstore web site totally integrated with our retail stores
Attract and maintain top talent
Source data: www.walgreens.com
Strategy
Growth, Growth, Growth!


Walgreens is currently increasing their net
stores operated by approximately 1 store per
day
The company, which currently operates 5,156
stores, plans to operate at least 7,000 stores
by 2010

All this expansion is funded by cash flow from
operations, as opposed to long-term debt or equity
issuances
Innovations

Introduced freestanding stores in early 1990s
with drive thru pharmacies


Today, more than 80% of Walgreen Co.’s stores
have drive thru pharmacies
Nation-wide 1 hour photo service


Available at more than 98% of stores
New Digital Photo Service

Allows you to upload your photos at home and pick
them up at any Walgreens store 1 hour later!


Much time and effort has been put into this project so
that they stay ahead of competition
Touch tone prescription refills
Source data: www.walgreens.com
Innovations

Largest private user of satellite technology



Second only to the United States government
Today, 125 million people live within 2 miles of a
Walgreens
Walgreens plans to increase their business by
investing in prime locations, technology, and
customer service initiatives
Source data: www.walgreens.com & 2005 10-K
Products
Product Class
Percentage
2005
2004
2003
64
63
62
Nonprescription Drugs
11
12
12
General Merchandise
25
25
26
Total Sales
100
100
100
Prescription Drugs
By 12/31/06
Source data: Walgreen Co. 2005 10-K
Generic
59
Not Generic
41
Generic
67
Walgreens – Locations by State
Source data: www.walgreens.com
Positioning


Walgreens well positioned for Baby Boomer era
Top 5 states with largest number of stores:






#1
#2
#3
#4
#5
=
=
=
=
=
Florida with 673 stores
Texas with 530 stores
Illinois with 500 stores
California with 419 stores
Arizona with 223 stores
Over 50% of Baby Boomers live in FL, TX,
IL, CA, NY, PA, OH, MI, NJ
Source Data: www.metlife.com
New Workings

Medicare Part D prescription drug program



Walgreens has recently integrated a program into their computer
system that lets the pharmacists look at a patient’s list of drugs
and match the patient with the Medicare drug program that will be
most cost-effective for them
Best of all, it’s free!
New Acquisitions


Walgreens recently acquired SeniorMed, an assisted living
prescription business in hope that it will give them a “big
boost” in a business area where they had previously lost
customers
In addition, WAG is now partnered with TakeCare and InterFit
to operate small clinics in WAG stores
Source Data: Walgreen Co. Jan. 11, 2006 Annual meeting
New Workings

Dial-A-Pharmacist (in 14 languages)


Automatically connects a patient with a Walgreens
pharmacist somewhere in USA who speaks that particular
language
Highway Signs

New Federal Regulations are allowing 24-Hour pharmacies
to put up signs on major highways (Just like McDonald’s and Shell)


Walgreens already has 7 put up in Illinois
Solar powered roofs


Walgreens will begin to start using solar powered roofs in 100 of
their stores
These will allow each store to generate 20-50% of it’s own
electricity.
Source Data: Walgreen Co. Jan. 11, 2006 Annual meeting
Porter’s 5 Forces: Drug Store
Chains
Threat of new
entrants
MODERATE
Power of
Customers
LOW
Power of Suppliers
HIGH
Overall Threat
Level:
High
Industry Rivalry
HIGH
Threat of
Substitutes
MODERATE
SWOT Analysis
Strengths
Weaknesses

Innovative in controlling costs and
expanding sales
 Expanding store base to reach more
markets
 Has made efforts to serve growing nonEnglish-speaking communities
 Experienced management

Opportunities
Threats
Rapidly expanding elderly demographic
 New innovations in Medicare may
increase sales
 Little competition in nursing home
services
 Large proportion of US w/o health
insurance, may be drawn to low-cost instore clinics


No prior experience managing current
growth rates
 Cost/benefit analysis of firm’s extremely
rapid growth difficult to determine
Business susceptible to severity of
cold/flu season
 Possible competition from online sources
 May face difficulty in passing costs onto
consumers b/c Medicare/insurance
companies
5 Year Performance
Adjusted for stock splits and dividends
Date
1/4/2005
1/4/2004
1/4/2003
1/4/2002
1/4/2001
1/4/2000
1/4/1999
1/4/1998
1/4/1997
1/4/1996
Stock Price
10 Year Performance
Performance
60
50
40
30
20
10
0
20 Year Performance vs. S&P 500
5 Year Performance vs. S&P 500
5 Year Performance vs. Competitors
Walgreens vs. Portfolio
Cumulative Performance
100.00%
Percentage Change
80.00%
60.00%
40.00%
20.00%
0.00%
-20.00%
-40.00%
-60.00%
Oct. 1999 - Feb. 2006
Portfolio
S&P 500
WAG
Correlation Matrix
AEE
AEOS
CPRT
FR
JKHY
JPM
KMB
MS
MVSN
SRCL
SRZ
WAG
AEE
1
0.155
0.226
0.326
0.196
0.338
0.266
0.255
0.179
0.151
0.09
0.239
AEOS CPRT
1
0.2044
0.1321
0.4141
0.3896
0.2115
0.4217
0.3539
0.21
0.2398
0.3095
1
0.3377
0.2727
0.2462
0.2871
0.2745
0.226
0.0315
0.0847
0.2281
FR
1
0.237
0.231
0.341
0.265
0.106
0.169
0.171
0.175
Note: Table assumes equal-weighted portfolio
JKHY JPM KMB
1
0.498
0.283
0.494
0.397
0.207
0.28
0.31
1
0.272
0.745
0.422
0.28
0.269
0.325
MS
MVSN SRCL
1
0.361
1
0.194 0.489
1
0.311 0.24 0.1317
0.172 0.342 0.2099
0.323 0.434 0.2319
SRZ
1
0.161
1
0.329 0.158
WAG
1
“Fit” With RCMP Portfolio:
Appraisal Ratios

Appraisal ratio
: Risk-adjusted measure of excess
returns provided by a security
= alpha/(std error^2)

Suggests user add (short) the security if alpha is
significant and appraisal ratio is greater than
alternatives
Appraisal Ratios
Apprasial ratio=
WAG
CVS
RAD
α/(std. error^2)
1.263132978
0.717603164
0.126937097
Note: alpha for all 3 securities above is not positive with
95% certainty but is significant at slightly lower levels of
confidence
Source Data: Yahoo! Finance
Relative Multiple Analysis
Growth Implied by PEG Ratios
1
P/E Ratio over
2
Peg Ratio
= Implied Growth
= Implied growth as % of
industry implied growth
WAG
29.37
1.66
17.69277108
128%
CVS
RAD
WMT
Industry
20.49
9.95
16.98
23.01
1.5
11.31
0.098
1.66
13.66 0.879752 173.2653 13.86145
99%
6%
1250%
100%
Here we see that the market has already priced significant
growth into Walgreen stock.
•Unless the firm can grow almost 18% annually ad
infinum, the stock will likely undergo a correction.
Source Data: Yahoo! Finance
Relative Multiple Analysis
Firm P/E over
Industry P/E
= Firm P/E as % of
Industry P/E
Market P/E
(approx)
= Firm P/E as % of
market P/E
WAG
29.37
23.01
CVS
20.49
23.01
RAD
9.95
23.01
WMT
Industry
16.98
23.01
23.01
23.01
128%
89%
43%
74%
100%
18
18
18
18
18
163%
114%
55%
94%
128%
Here we see that Walgreen’s P/E Ratio is high not only to the
market but also it’s industry.
•This serves as additional evidence of the significant
“premium” the market has placed on the firm’s stock.
Valuation Process of a DCF

To refresh, intrinsic value of a firm’s common
equity is determined as follows:
1.
2.
3.
4.
5.
Forecast free cash flow over a period of X years and
a terminal value via:
[FCF final period*(1+LT growth rate)]/[WACC-LT
Growth Rate]
Calculate WACC via: (we*ke)+[wd*kd*(1-tax rate)]
Discount all Ncash flows and arrive at enterprise
value via:Σ1 FCF i/[(1+WACC)^i]
Subtract LT debt from enterprise value
Divide by common shares outstanding to get price
per share
Valuation Step 1:
Forecasting Free Cash Flows
FY 2006
FY 2007
forecasted forecasted
Net sales:
Less: Operating costs
Taxes paid
Net investment
∆ Working capital
= Free Cash Flow
47,525.69
53,073.23
(44,792.96) (50,021.52)
(1,047.69) (1,176.83)
(825.46)
(767.58)
853.14
659.29
859.58
1,107.30
FY 2008
FY 2009
FY 2010
forecasted forecasted forecasted
58,764.67
64,505.80
70,166.19
(55,385.70) (60,796.71) (66,131.63)
(1,323.66) (1,485.10) (1,663.71)
(677.82)
(563.62)
(441.44)
617.55
1,146.98
1,490.68
1,377.49
1,660.37
1,929.40
Valuation Step 2:
Calculating WACC


Sensitivity to WACC is a major issue for most DCF models, and is of
extraordinary importance when modeling Walgreen Co.
 I will revisit this topic later in the presentation
Since WAG is 100% equity, WACC=ke. Below is ke (and thus, WACC)
calculated via CAPM
CAPM:
rf=
β=
rm=
ke=
4.77%
0.4
11.00%
7.26%
Valuation Step 3:
Finding Enterprise Value
WACC=
LT Growth
Rate=
Year
1
7.26%
4.50%
2
3
4
5
FY 2006
FY 2007
FY 2008
FY 2009
FY 2010
forecasted forecasted forecasted forecasted forecasted
Free cash flow
Terminal Value
PV of FCFs
Total
Enterprise
53,467.33
859.58
801.40
1,107.30
962.48
1,377.49
1,116.28
1,660.37
1,254.45
6
Terminal
1,929.40
1,359.04
73,051.61
47,973.68
Steps 4 & 5:
Subtract LT Debt and Divide by
Shares Outstanding
Step 4: Subtract LT Debt

This step is not necessary as the firm is 100% equity
Step 5: Divide by Shares Outstanding
Total enterprise
value over
Shares
outstanding
=Price Per Share
53,467.33
1,025.40
+ 10%
57.36
- 10%
46.93
52.14
HOWEVER…
Accounting Rules vs. Economic
Reality

WAG only owns approximately 18% of it’s store base. What
about the other 82%?



They are leased. These leases are structured/accounted for as
operating leases.
This means that although these leases (and other minor off-balance
sheet obligations) carry significant future commitments ($26.078
billion), these commitments are not counted as liabilities on the
firm’s balance sheet.
So are these commitments LT debt?

Liabilities:
“probable future sacrifices of economic benefits arising from present
obligations of a particular entity to transfer assets or provide services
in the future as a result of past transactions or events” [FASB
Concept Statement 6, paragraph 5]

Answer:
YES! These are (economic) liabilities!
Accounting for Significant OffBalance Sheet Liabilities

The most precise method of accounting for these
operating leases would be to back the costs of rent out
of “Selling, Operating, and Administrative Expenses”
(SO&A) and restate the firm’s financials as if they owned
the stores



This would entail separating interest expense, depreciation, and
amortization
In addition to restating the firm’s financials, the analyst would
need to calculate a new WACC, estimating a weight and cost of
debt
Unfortunately, the firm does not provide nearly this level
of information so we must pursue other, less precise
methods
Adjusting ROE:
An ad hoc solution

Although academic theory holds that a firm’s
value is not affected by it’s capital structure1,
this is not the case in reality


Modigliani and Miller’s theory does not account for,
among other things, taxes or the increasing marginal
barrowing rates associated with increasing leverage
Therefore, investors should demand a return in
excess of the ke-derived WACC we used earlier
to compensate them for the risk associated with
WAG’s quasi-leverage
1. For more information, see: The Cost of Capital, Corporation Finance and the Theory of Investment.
F Modigliani, MH Miller . The American Economic Review. 1958. American Economic Association
CAPM, ROE, and Everything InBetween

Below we have 2 measures of ke: CAPM, and ROE
ROE via DuPont Analysis
Total assets over
Total equity
CAPM:
rf=
β=
rm=
ke=
4.77%
0.4
11.00%
7.26%
Sales over
Total assets
Net income over
Sales
Equity multiplier times
Total asset turnover times
Profit margin
14,608.80
8,889.71
= Equity multiplier
1.643338
42,201.60
14,608.80
= Total asset turnover
2.89
1,559.50
42,201.60
= Profit margin
3.70%
1.64
2.89
3.70%
= Return on Equity
17.54%
CAPM, ROE, and Everything InBetween
WACC
Below is a matrix listing possible combinations of WACC and
LT Growth and the corresponding stock prices
6.50%
7.00%
7.50%
8.00%
8.50%
9.00%
9.50%
10.00%
10.50%
11.00%
11.50%
12.00%
3.50%
49.97
42.48
36.87
32.51
29.04
26.20
23.84
21.85
20.15
18.68
17.40
16.27
Growth Rate
4.00%
4.50%
59.13
72.86
48.87
57.81
41.55
47.79
36.07
40.64
31.82
35.29
28.42
31.14
25.65
27.82
23.35
25.12
21.40
22.87
19.74
20.97
18.31
19.35
17.05
17.94
5.00%
95.75
71.22
56.53
46.74
39.76
34.54
30.48
27.24
24.60
22.40
20.55
18.96
5.50%
141.53
93.58
69.63
55.28
45.72
38.90
33.80
29.84
26.68
24.09
21.95
20.13
Importance of ROE Sensitivity



The stock’s current price of approximately $49.00 is
supported only when assuming unrealistically high LT
Growth or an unrealistically low WACC (i.e. CAPM ke or
below).
Due to the risk associated with the firm’s LT (economic)
debt, I do not feel CAPM WACC is an appropriate
measure and thus WACC must be adjusted upward to
account for this risk.
THESE TWO FACTORS PRODUCE SIGNFICANT
DOWNSIDE RISK FOR THE STOCK PRICE
Recommendation



I recommend that 50% or 500
shares of WAG be sold at the market
I feel WAG is currently trading at a significantly inflated
price that, in the long term, cannot be sustained
Why not sell it all?


WAG currently has considerable momentum, having beaten analyst
EPS estimates for 3 consecutive quarters. Retaining some portion
of the stock exposes us to the potential upside of continued
momentum
Walgreen has always traded at a “premium” price and thus, we
cannot know if, when, and to what degree these premiums will
evaporate
Negating Scenarios
WAG posts a Q4 that beats analyst consensus
1.

Although I feel such a scenario is unlikely due to both
heightened expectations and the firm’s Q1-Q3 margins, such an
accomplishment would no doubt propel stock price in the shortterm
CVS posts poor results and/or fails in new initiatives
2.

As WAG’s main (and only real) competitor, a CVS failure will
allow WAG to increase pricing power and will decrease pressure
to expand
WAG makes a key unexpected acquisition into a
business line in which CVS does not operate
3.

With competition within the drug store industry becoming
increasingly competitive, any opportunity for a player to enter a
profitable business area in which the other does not operate will
give the firm a first mover advantage, as well as pricing power
not available in the duopoly environment.
Questions?