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Walgreen Disappoints But is it a Buying Opportunity?
Investors in Walgreen(NYSE: WAG)
have had a pretty good time of it over the last year with a near 50%
gain as I write however, the recent results were somewhat disappointing.
The market did what it does with an earnings miss and promptly marked
the stock down. By now most interested parties will be aware of the
situation so I decided to take a more in-depth look at what happened.
In summary, I think that this report contained some of the themes
that have been repeatedly seen in the mass consumer market in recent
years and this gives cause for optimism.
A tough mass consumer market?
Frankly the last few years have been difficult for the mass consumer
market. It has been dogged with the levels of unemployment and sluggish
spending that it wasn’t structured to deal with. As a consequence many
of the old strategies aren’t working. For example the challenges facing a company like Procter & Gamble(NYSE: PG)
have been emblematic. It is known to have classic brands with which it
can try and hold pricing (at the expense of volumes) during the downturn
and then benefit from profit expansion when the upturn comes and
volumes come back.
Unfortunately that upturn hasn’t happened yet –at least in the mass
market- and the whole sector has been locked in a circular game of
raising marketing and promotional activity, seeing volumes rise, then
trying to take pricing, only to then see volumes and footfall decline as
customers walk away to competitors. Then the cycle is repeated again
with the company hoping that ‘next time round’ it’ll get lucky.
It turns out that the way to play this type of market has been to buy
companies with good brands who are under-performing but about to make
these changes. Procter & Gamble has been a good example of this.
It has had to fight hard to stabilize its core North American market,
but its emerging market performance hasn't been great recently. No
matter, the market has rewarded it for sorting out its pricing strategy.
Procter & Gamble's 25% stock price rise over the last year is a
testimony to what can be achieved when companies start to leverage the
underlying strength of their brands. For example it recently stated that
two thirds of its business in the U.S. (defined by sales) had held or
increased sales in the last quarter. This compares very favorably with a
figure of only 15% for the June quarter last year.
And Walgreen another?
All of which leads me into Walgreen’s Q3 report. Earnings missed
estimates and the disappointment is centered on comparable same store
sales only being up .4% and comparable store traffic down 3.9%. It
appears to be a familiar story of Walgreen cutting back on promotions
and discounts only to see customers walk away to competitors like CVS Caremark(NYSE: CVS) or even a big box retailer like Costco Wholesale(NASDAQ: COST).
With regards to Costco its performance in the last quarter, as discussed here,
stands in contrast to much of the sector. Costco’s traffic remained
stable, but its frequency was up 4-5%. In other words its customers are
making more trips, on average, to the store in the quarter. This is a
good indication that it is doing a good job engendering customer loyalty
and understanding the purchasing needs of its members. This is easier
said than done, especially in a quarter categorized by issues such as
unseasonable weather, delayed tax refunds, rising gasoline prices, the
sequester and payroll tax increases. Costco may have done well thanks to
its gasoline sales driving customers as well as its relentless focus on
pricing.
Unfortunately Walgreen did not fare so well and frankly this wasn’t
the time to cutback on pricing and promotions. With that said Walgreen
has recognized the problem and a renewed focus on promotions and pricing
was initiated in mid May. Essentially it is trying to drive traffic and
same store sales growth. This is likely to impact margins, but Walgreen
is quite candid that it is more focused on gross profit than margins.
Which means that it is willing to discount and promote (which reduces
margins) in order to drive revenue and profit growth.
Elsewhere its script comparables were up 7.1% in a market where
physician visits were reported to be down 2.7% in May. Therefore I don’t
think it’s fair to conclude that the weak sales are a consequence of
ongoing weakness due to the Express Scripts debacle. Walgreen is winning customers back.
CVS reported results at the start of May and its front store business
comparables were only up 1.4% with front store traffic ‘down slightly’
although it claimed to have gained market share. CVS claimed its market share compared to other drug retailers was up 1.2% and 0.1% against multi-outlet retailers. The former number suggests CVS has taken market share from Walgreen.
As ever, investors will focus on the CVS vs. Walgreen debate but
frankly I see no reason why you can't hold both! If you like the long
term trends of increasing generics sales (which tend to slow revenue
growth but increase margins), expanding private label sales (higher
margin) and the demand pull from an aging demographic than both are set
to grow over the long term. These trends have resulted in substantive
increases in free cash flow for these businesses over the last few
years.
In conclusion, I think there are reasons to be positive. Its
retail traffic and sales problems appear to be issues related to
pushing its balanced rewards card and losing focus of promotions and
discounts. The good news is that recent history suggests that these
issues can be rectified in due course within the retail sector. If
customers aren’t ‘loyal’ to Walgreen then they are not likely to be
loyal to CVS, Wal-Mart, Costco or whoever. Moreover the
balanced reward card gives Walgreen more data with which it can better
manage its sales initiatives. It can also use reward cards to drive
promotions and pricing.
Long-term growth looks assured and history suggests that customers
are price sensitive. In other words when Walgreen makes the necessary
pricing and promotional adjustments it should see traffic and front
store sales growth come back. The valuation remains attractive and I
think it's a decent opportunity to pick some up.
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