Wednesday, November 21, 2012

Walgreen Looks Good Value

Sometimes as investors we can over-analyze and spend so much time looking at fine details that we miss the bigger picture. I think this is exactly what many are doing with Walgreen (NYSE: WAG). Every investor is trying to analyze how many of the lost customers Walgreen will regain from the Express Scripts (NASDAQ: ESRX) debacle, but does a debate over the marginal amount really matter when the stock is so cheap? I don’t think it does.

Time to Confess

OK, I admit it: I am one of the guilty parties. I hold a position in CVS Caremark (NYSE: CVS), and quite frankly I think Walgreen will find it difficult to win back lost customers from the likes of CVS and Wal-Mart (NYSE: WMT). I even articulated this view in a previous article.

Investors should understand that whole industries are structured around the reason why Walgreen will find it hard to win customers back. Customer inertia is a very powerful force; not for nothing do insurance companies lower premiums on first time buyers in order to increase their hold over them in future years. Customers tend to stick around because they overvalue the hassle of switching. The same principle will be at work here, and CVS and Wal-Mart are both companies that know exactly how to retain customers in their pharmacy businesses.

But Really, Who Cares?

There is a great temptation to get sucked into a Walgreen vs. CVS argument, and then maybe conclude that CVS is better and buy that. But even if you share my view that CVS is the more attractive company, who said you can’t buy both stocks?

Even a cursory look at the valuation shows that Walgreen is hardly stretched. Despite the effect on revenue and profits from the loss of the Express Scripts business, Walgreen is still trading on some very attractive multiples.  A current PE of 14.5x and an EV/EBITDA multiple of 8.2 is not expensive.  It doesn’t stop there; the company just generated $2.9 billion worth of free cash flow, which represents around 7.5% of its enterprise value.

The point I’m making is that the stock is already attractive on a current basis even without arguing over whether it will regain X percentage of customers.  The fact is that Walgreen will recover customers, and I’m convinced that the stock (and the sector) have a lot of positive growth drivers.

Alliance Boots

I like the Alliance Boots deal. Even though it only has a non-controlling 45% share and there is a bit of an issue with transparency –it is a private company- I think this is the right sector in Europe to be investing in. Wall Street analysts might not agree with me for two reasons. First, they hate not having (or rather not having the perception of) transparency and a direct handle on earnings prospects. Second, they tend to have a join-the-dots mentality to macro issues.

In response to the first point I would argue that it doesn’t really matter what analysts think. If they give the stock a negative rating but it delivers earnings then few investors will care. Earnings move share prices in the long term.

With the second issue, few analysts like or are allowed to put their necks on the line by making macro calls so they tend to just go with the macro consensus. It’s usually a fair approach but in this case they might miss the fact that European austerity measures are playing into the hands of pharmacy companies. European generics penetration is lower than the US so as Governments seek to cutback by expanding generics sales this will benefit pharmacies because generics tend to give them higher margins than branded drugs. It is the pharmaceutical companies that suffer a loss of earnings.

Walgreen’s Growth Drivers

Aside from the drivers discussed above, Walgreen is favored by long term demographic trends (older people require more medication), and it has a wonderful opportunity to expand its own private label in-store brands and consumer health products.

Everyone talks favorably about this issue with Wal-Mart and CVS, and if you look at the valuation of Perrigo (NASDAQ: PRGO) it is clear that the market loves the idea too. Perrigo develops and manufactures over the counter (OTC) and generic prescription drugs for the likes of Walgreen, CVS and Wal-Mart. I like the stock a lot, but question whether 27x earnings is the right price for it. As we saw recently, any disappointment will see the stock hit. No matter, the market buys the idea so I think the market should buy the potential for Walgreen and CVS to expand margins by increasing their own brand penetration.

The Bottom Line

I think Walgreen is attractive, even with the near term issue of possibly missing expectations of how many customers it’s able to claw back. Putting together the arguments expressed here paints a picture of a company with some strong near and long-term drivers that is priced on as very reasonable valuation. There is a pretty decent 3% yield, and investors shouldn’t let some near term loss myopia get in the way of a good long term investment.