Walgreen's Growth Prospects

Walgreen investors are used to looking at the company from the highly visible vantage point of its drugstores. However, Fools may have to rethink this assumption because Walgreen has taken significant measures to transform its business, creating several significant growth opportunities. Let's look at three primary strategic growth drivers more closely.

Walgreen's long-term growth opportunity
Before going into detail on these long-term profit drivers, some background on how Walgreen changed its course. The first significant change occurred in 2011 when Walgreen sold its pharmacy benefit management, or PBM, business to Catalyst Health Solutions.

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Walgreen Looks Good For 2014

Investors in Walgreen  have watched their stock rise more than 50% in 2013, but is there more to come in 2014? The key to answering this question lies the development of its strategic partnerships with pharmaceutical distributor AmerisourceBergen  and European pharmacist Alliance Boots.  Furthermore, its deal with Theranos offers a disruptive threat to part of Quest Diagnostics'  and LabCorp's   operations. There is a lot going on at Walgreen as it strives to reach its long-term strategic objectives.

Walgreen's long-term plan
The plan is based on five key financial targets for the fiscal year 2016. Revenue (including its share of a fully purchased Alliance Boots and joint ventures) is expected to reach $130 billion, with adjusted operating income of $9.0 billion to $9.5 billion. Meanwhile, the operating cash flow target is $8 billion with net debt expected at $11 billion. Finally, synergies from its partnerships are expected to reach $1 billion.

It's time to put these targets into context by playing with some assumptions. Walgreen currently has 949 million shares in issue, and expects to issue around 228 million shares in order to acquire the remaining 55% of Alliance Boots. This means that Walgreen could have around 1,177 million shares in issue.

The company's trailing 12 month operating income is $4,159 million, and its enterprise value (market cap plus debt) is $58.8 billion, or around 14.1 times operating income. Assuming that Walgreen hits $9 billion in operating income in 2016, and taking the current 14.1 times ratio as a benchmark, that means its enterprise value could be around $126 billion in 2016. Stripping out the $11 billion in debt leaves a market cap of around $115.9 billion, and if there are 1,177 million shares in issue, this implies a share price of $98.

Furthermore, even from a cash flow perspective, Walgreen looks attractive if it can hit its targets. Its current enterprise value is 13.7 times last year's operating cash flow. Assuming the $8 billion operating cash flow target for 2016, means that Walgreen could trade on an enterprise value of $109 billion. Stripping out the forecast $11 billion in debt gives you a share price target of $83.

All of which is wonderful, as these two targets represent a 70% and 45% premium to the current share price, but will Walgreen hit its targets?

Walgreen, AmerisourceBergen and Alliance Boots
On its recent conference call, Walgreen's management discussed the 2016 operating income target, and declared that its performance to date "is currently tracking a bit below the CAGR required to meet this goal." However, CEO, Greg Wasson went on to say:

...we think that we have got ways to achieve those goals. The CAGR on the operating adjusted income is a little bit soft but we think the change in the mix of the business will allow us to get it.

Future macroeconomic conditions will obviously play a part, and there is little that Walgreen can do about that. However, there are three reasons why Foolish investors should feel optimistic.

First, operating synergies between Alliance Boots and Walgreen are already tracking ahead of plan. Walgreen is targeting $350 million to $400 million in synergies for 2014, but has already reported $107 million in the first quarter alone. And this comes after Walgreen delivered net synergies of $154 million in 2013 versus its initial target of $125 million to $150 million.

Second, the AmerisourceBergen deal was done after the original targets were set. The deal involves AmerisourceBergen distributing Walgreen's pharmaceuticals, and enables the latter to receive daily delivery to its stores. In addition, it includes Alliance Boots, so Walgreen should be able to generate even more synergies from it.

Third, Walgreen has a host of initiatives to drive growth. Plans involve expanding its balance rewards scheme, selling Boots beauty products in Walgreens, expanding its own-label products, and expanding its local community reach via offering more vaccinations and ongoing treatment facilities.

However, the tie-up with Theranos is the most eye-catching. In September, Walgreen and Theranos inked a deal to bring the latter's lab testing service to Walgreen's stores on a national level. Theranos owns a medical device that can detect diseases in the blood from a minute sample within a short space of time. While this sort of solution is perfect for Walgreen's aim of transforming "the role of the community pharmacy" toward ongoing care, it does pose questions for testing labs like Quest Diagnostics and LabCorp. These two companies essentially run a duopoly on central lab testing of blood, and if individuals can now do these tests at Walgreen/Theranos then what will happen to end demand for blood testing at Quest Diagnostics and LabCorp?

Where next for Walgreen?
All told, the potential upside for Walgreen is significant, and the integration plan appears to be working well so far. On the other hand, it's still early days and investing in the health care sector comes with the usual caveat of political risk. Nevertheless, based on current valuations, the stock looks attractively priced provided the 2016 targets are hit.

Walgreen and CVS will Benefit from Obamacare

Another set of earnings and another solid performance from drug store and pharmacy services company CVS Caremark (NYSE: CVS  ) . The company raised its earnings guidance, and suggested its participation in public and private health care insurance exchanges would make it a net beneficiary of the Affordable Care Act, or ACA. There is a lot to like about CVS and its rival Walgreen (NYSE: WAG  ) , and despite strong share price appreciation this year, they both look like good values.

CVS gets healthier
After delivering better-than-expected performance in 2013, CVS raised its full year EPS forecast to $3.94-$3.97 versus a previous estimate of $3.90-$3.96. In addition, it kept its free cash flow forecast at $4.8 billion-$5.1 billion, and pledged to return $5 billion in dividends and share buybacks to its investors.

How the Affordable Care Act is good news for CVS
While this year's performance seems assured, Foolish investors will want to look forward to see how CVS might fare in the new health care environment. Essentially, public and private health insurance exchanges are marketplaces set up in accordance with the ACA. They are being created to offer personalized health care plans in a standardized and regulated way. CVS is the second biggest pharmacy benefits manager, or PBM, after Express Scripts (NASDAQ: ESRX  ) .  One possible concern with both companies is that they may lose some business as a consequence of employers moving their employees to the new exchanges.

In its earnings presentation, however, CVS outlined why it sees itself as benefiting from the ACA.

• In the public health exchanges, it will participate as a PBM via its health plan clients, where the client offers pharmacy benefits as part of an integrated plan.

• It will act as a PBM via its health plan clients within private health exchanges as well.

• It will act as a stand-alone PBM where it can offer direct prescription offerings in other situations.

• CVS is already the leading player in managed Medicaid, so any expansion of that program should allow it gain business.

In other words, CVS is positioning itself to benefit from health care reform.

In any case, it may not turn out to be as big of a shift as many think. For example, CVS and Express Scripts are both forecasting that employers will be reluctant to shift employees to the private exchanges.The thrust of the argument, as outlined by Express Scripts CEO George Paz, is that employers will not want to make the shift because they won't want to pay the cost of risk coverage.

Employers have to pay 60% of the total cost of medical services in order to avoid a tax penalty. This means that the employer's risk goes up because it could losing control of what plans its employees are buying. If the cost of the plan goes up over time, possibly because the employee didn't buy a suitable plan, then the employer will still have to meet 60% of the rising cost.

Express Scripts predicts that "private exchanges represent less than 0.25% of prescriptions in 2013 and are projected to reach approximately 2% by 2016." CVS management forecasts:

Well, the fact is that less than 1% of covered lives are expected to move to private exchange products in 2014. And based on conversations we have had with our PBM clients and private exchange partners, we believe that most large employers are taking a wait and see approach to private exchanges, particularly with their active employees.

In other words, CVS and Express Scripts are positioning themselves to benefit should there be wide-scale shifts from employees. Even if this shift doesn't take place, they can benefit from lower income groups getting insurance.

Walgreen and CVS set to benefit
Unlike CVS, Walgreen doesn't have a PBM operation anymore. There is another catalyst to growth from the ACA, however. The reforms are likely to lead to more people being insured, and this should drive prescription demand for the drugstores.

Walgreen is aggressively transforming its business in preparation for these reforms. A big part of Walgreen's plans is to offer services whereby they administer ongoing treatments for indications like diabetes or rheumatoid arthritis, and CVS is doing the same with its MinuteClinics. Again, if more people are covered for these kinds of treatments (recall that the exchanges require standardized coverage) then CVS and Walgreen will benefit.

The bottom lineAll these stocks look attractive from a valuation perspective. CVS may seem expensive in the following chart, but consider that this is a trailing chart and CVS is expecting to generate 37% of its free cash flow for the year in its fourth quarter.

ESRX EV to Free Cash Flow (TTM) data by YCharts.

Moreover, all of these companies have double-digit earnings forecasts for 2014. With Obamacare looking set to provide them with opportunities, they all look like good values.

Johnson & Johnson Now Relying on Pharma

Health care giant Johnson & Johnson (NYSE: JNJ  ) recently delivered a mixed set of quarterly results that produced more questions than answers. It's hard to be too critical of a company that beats estimates and raises full-year guidance, but there are a few considerations to ponder.

Yet again, the stand-out performer in the quarter was its pharmaceutical division. However, the underlying performance in its consumer and medical devices and diagnostics divisions contained some warning signs. Moreover, whenever pharmaceutical stocks are analyzed the usual approach is to estimate the future value of its pipeline, rather than focus on current earnings. The market should do the same here.

Pharma (40.1% of sales) stands out

While it's pleasing to see an increase in revenues of $523 million (3.1%), the pharma division contributed $634 million of that figure. Ultimately, pharma offset a reduction of $141 million in medical devices and diagnostics revenues and a paltry $30 million gain from consumer products. In other words, the non-pharma divisions (60.5% of revenues) saw their revenues fall by $111 million on a combined basis.

The pharma division is rapidly expanding sales of some of its newer drugs like Stelara (psoriasis), Xarelto (anti-coagulant), Zytiga (castration-resistant prostate cancer), and Invega Sustenna (anti-psychotic). In fact, these drugs contributed $572 million of the $634 million in increased sales in the pharma segment.

Going forward, Johnson & Johnson has high hopes of developing sales of Invokana (type 2 diabetes) although it may face competition in future for its leading treatment Remicade (rheumatoid arthritis). Naturally, it will vigorously defend its Remicade patents, especially given that the therapy represents 24% of its pharma sales.

Consumer products (20.5% of sales)

Operational sales actually rose 2% (and 4% excluding divestitures), but currency effects reduced reported growth to just 0.8%. In addition, this is the year that Johnson & Johnson planned to reintroduce 75% of the consumer brands that were affected by product quality issues. Indeed, two of the affected brands, Tylenol and Motrin (painkillers), were cited as "positive contributors" in the quarter. While their contribution is an obvious plus, it suggests that the underlying performance within consumer products is weak.

There was even some discussion of consumers trading down to store brands. Frankly, this wouldn't be a surprise because the likes of CVS and Walgreen (NYSE: CVS  ) have been aggressively expanding their in-store brand sales. Moreover, the drug stores are likely to keep pushing generic versions of pharma companies' over-the-counter (OTC) and prescription drugs.

Ultimately, growth in the consumer segment will rely on emerging markets, as the U.S. mass market consumer remains challenged by a weak economy.

Medical devices & diagnostics (39.4% of sales)

Orthopedics make up a third of the division's revenues, and unfortunately they only grew 1.1% operationally in the quarter. Despite the long-term growth prospects coming from aging population, there is a note of caution going forward. On the conference call, the management cited pricing competition primarily in the trauma segment in the U.S. In addition, pricing in U.S. orthopedics remains an issue as pricing declines of 3%, 1.5% and 4% were declared for hips, knees and spine solutions, respectively.

Incidentally, this is pretty much in line with what Zimmer (NYSE: ZMH  ) said in its last results. Zimmer saw pricing down 1.3% in the second quarter. Knee pricing declined 1.4% with hip pricing down 2.1%. In a foretaste of what Johnson & Johnson would say, Zimmer had outlined on its conference call: "Competitive pressures, most notably in the United States, slowed our Trauma growth for the quarter, but were mitigated by the company's consistently strong performance in overseas markets."

The worry is that more intensive price competition will extend beyond the trauma market and increase pricing headwinds in the U.S. orthopedics market for all the leading players.

Elsewhere, its eye-care numbers were somewhat disappointing with US growth of only 1.9%, and international operational growth at 4.9%. Contact lens specialist Cooper Companies (NYSE: COO  ) sees the global lens market growing at 4%-6% this year, but for the second quarter running it recorded only 4% growth. Given that Johnson & Johnson' s overall operational growth was only 3.9%, it's reasonable to worry that Cooper's growth might continue at the low end of its targeted range.

The bottom line

The pharma division is firing on all cylinders, and looks set to continue in future quarters. However, there are some warning signs in the other divisions. It's unreasonable to expect all its divisions to be performing well at the same time, but the trend of pharma outperforming has been here for nearly a year now.Much depends on the future pipeline.

All told, the stock looks close to fair value. A forward P/E of around 16.6 times earnings isn't especially cheap for a stock forecast to grow earnings at 6%-7% rate over the next few years. The current dividend yield of 2.9% will attract income seekers, but otherwise the stock looks pretty fairly valued at $91.

Walgreen is Transforming Itself, Investors Should too

Superficially, a drugstore chain like Walgreen (NYSE: WAG  ) is a simple business to run. It opens up a store, sells a large volume of drugs and health products, and makes a small profit margin for itself in the process.  While this is a perfectly adequate way looking at the company, it doesn't go anywhere near assessing the growth opportunities that Walgreen has thanks to the initiatives it has taken over the last couple of years. The recent results confirmed that it's on track with many of them, and despite the strong rise this year, the stock remains attractive.

Walgreen working smarter

There are three main ways in which Walgreen is transforming itself in order to drive the business forward. First, it is using data management (of its customer base) in order to be able to better manage its sales.

For example, early in the year it had reported disappointing front-end comparable store sales of only 0.4%. Walgreen responded by initiating a renewed focus on pricing and promotions in mid-May in order to regenerate traffic and sales. It worked.

Source: Company presentations.

This nicely illustrates how Walgreen can use information garnered from its balanced reward card scheme to help better target pricing and promotional activity. In addition, with a stronger understanding of the treatments that its customer base requires, Walgreen is able to expand its specialty drug support. This includes drugs for long-term conditions like rheumatoid arthritis and diabetes, both of which will help Walgreen's aim to establish itself as a pharmacy in the community. 

Transforming the business

The second driver of growth is coming from the way that Walgreen is aggressively transforming its business through deal making. The 10-year deal with pharmaceutical distributor AmerisourceBergen (NYSE: ABC  ) went live on Sept. 1 . It started with the distribution of Walgreen's branded pharmaceuticals, and AmerisourceBergen has plans to move onto distributing Walgreen's generics within the next 12 months as well.

One big plus for the distributor is that the deal also includes Walgreen's partner Alliance Boots. Walgreen will now get daily delivery to its stores, and this means that it should be able to improve inventory management and benefit from economies of scale, particularly in purchasing drugs.

Moreover, the deal will allow Walgreen to generate even more synergies out of its partnership with Alliance Boots. Indeed. Walgreen achieved $154 million in net synergies this year, compared with its earlier estimate of $125 million to $150 million.

Leverage opportunities in its own stores

The third key growth opportunity relates to the potential to leverage sales in its own stores. Fortunately, it can do this in many ways. One way is to expand sales of its private-brand products. Indeed, private-brand sales increased their penetration of Walgreen's front-end sales by nearly 0.9% to 22.3% in the last quarter. Similarly, it has now launched Alliance Boots'  Boots No. 7 product line in stores across the U.S.

Furthermore, in the long term Walgreen should be able to increase margins thanks to increased generics sales. Generics tend to be higher gross margin (but lower revenue) products for retailers, and in the long term they are likely to increase due to pressures on medical costs.

And finally, Walgreen recently announced a long-term partnership with lab-testing company Theranos in order to provide less invasive lab testing services to Walgreen's customers. The big advantage is that customers -- particularly those who require frequent blood testing -- will be able to get test results quickly and easily. In turn, this sort of initiative will help keep customers loyal to Walgreen.

Where next for Walgreen?There is plenty going on at Walgreen, and the company deserves credit for aggressively transforming its business in order to deal with changes in health care needs. The partnership with Alliance Boots is working ahead of expectations, and there are more synergies to come. Expanding generics and private brand sales offer margin expansion opportunities in future, the Theranos deal promises to engender customer loyalty to customers who are likely to be frequent purchasers of Walgreen's products. 

The Key Earnings to Look out for this Week

There are some interesting earnings being released this week that should offer up a few investment ideas and shed some light on which sectors are set to outperform in the fourth quarter. Investors need to be selective, because the market has gone up significantly this year, while global GDP growth forecasts have been reduced. Consequently, valuations are likely to be high at precisely the point when some earnings might disappoint due to slower growth.

Monday

This morning saw shell egg producer Cal-Maine Foods (NASDAQ: CALM  ) deliver quarterly results. The company's earnings of $0.36 per share fell $0.13 short of analyst estimates. However, revenue of $319.5 million was up 17% from the year-ago quarter and well ahead of estimates of $272.9 million. This owed partly to the company's rising sales of cage-free, organic, and nutritionally enhanced eggs, which are growing ever more popular among consumers.

 

Cal-Maine is attractive for long-term investors, because it has the potential to grow irrespective of the economy. In other words, it gives you good diversification in your portfolio. Egg demand tends to be price-inelastic (i.e., demand doesn't change much in response to price movements), so when feed costs, rise Cal-Maine can usually pass on prices, albeit with some loss of margin.

 

Source: Company accounts.

 

However, the key to its prospects is what happens with industry egg supply. Note that its gross margins were extremely high in 2008, thanks to the financial crisis (and high feed costs in the first half of 2008), making it difficult for less efficient egg-producers to obtain credit.

 

Cal-Maine directly benefited because it's the largest independent egg-producer in the U.S. In the longer term, Cal-Maine can profit from consolidating the industry via acquisitions and expanding its higher-margin specialty egg sales.

 

Small-business service-provider Paychex (NASDAQ: PAYX  ) , due to report after today's market close, has long been a favored stock among dividend hunters, but it's also a great barometer of the state of the small and medium-sized business market.The key metric to follow is its checks-per-payroll number. Last quarter, its checks per payroll rose a miserly 0.9%, and it was even suggested that this growth would "moderate" in the quarter.

 

Furthermore, Paychex forecast that payroll services revenue growth would be 3% to 4% this year, but this is mainly due to price increases to customers rather than gains in checks per payroll. Look to see whether the price increases are sticking and the checks-per-payroll metric has improved. In addition, any update on its plans to develop an integrated management tool (so customers can use all of its separate services on one application) would be useful, too.

 

Tuesday

Lighting distributor Acuity Brands (NYSE: AYI  ) is one to watch because it is a direct play on a pick-up in construction activity in the U.S., as well as a backdoor way to play the increasing use of LED lighting solutions. Although management claims that its margins on LED lighting aren't any higher than on conventional lighting, it still has good growth opportunities. LED lighting will drive new demand, and Acuity is also able to sell LED lighting controls as an add-on solution.

 

The stock looks a bit rich going into these results, and Acuity tends to be volatile over earnings, so you need to be on your toes. One thing to look out for is its commentary on the state of the commercial and industrial lighting market. Architectural Billings Index data has perked up a bit lately, so the "favorable trend in June order rates" discussed previously might continue through the quarter for Acuity. We shall see.

 

Source: The American Institute of Architects.

 

Pharmacy giant Walgreen (NYSE: WAG  ) missed earnings last go-round, and the key thing to look out for in the upcoming results is whether its plan to revive store traffic and same-store sales growth is working. Last time, same-store sales came in at just 0.4%, with store traffic down 3.9%. In response, Walgreen initiated a renewed focus on pricing and promotions in mid-May, and since then conditions have improved. For example, comparable-store sales increased 4.8% in August, and its basket size, or average transaction value, increased 3.7%. On a more negative note, customer traffic was down 1.5% in August.

 

Watch to see whether the increased sales came at the expense of margins. Another thing to look out for is Walgreen's commentary on its balanced reward card program. Walgreen is trying to gather data from the cards so it can better target sales promotions.

CVS is Still a Buy

Sometimes the best thing to do in investing is nothing. In the case of the pharmacy chains CVS (NYSE: CVX) and Walgreen(NYSE: WAG), this policy has been a winning one over the last year.

Their stock prices have risen by 34% and 39.4% respectively in that period, mixed with short downward moves as investors looked to cash in. Meanwhile, both companies continue to generate huge amounts of cash flow, and according to analyst estimates, they're set for double-digit growth in the near future. The "good news" is that the market marked down CVS following its results, and this looks like a good entry point for long-term investors.

CVS’s optical illusion

The stock market apparently lives in a "shoot first, ask questions later" world, since CVS seemed to fall almost at the moment that its management updated guidance.

CVS adjusted its 2013 EPS forecast to a range of $3.90 to $3.96, from the previous $3.89 to $4.00.  Eagle-eyed readers will note the midpoint has been lowered to $3.93 from around $3.95. Before you rush to pull the sell trigger, you should consider a few things.

First, CVS outlined that it has had to delay share purchases this year while it reached a settlement with the SEC over previous actions. In other words, the ‘S’ bit in ‘EPS’ is larger than it was expected to be at this stage in the year. Moreover, CVS outlined that the timing issue could reduce full-year EPS by “as much as $0.04.”  In other words, it could reduce earnings by more than it just lowered its mid-point by. In this sense, CVS just raised guidance.

Secondly, on the conference call, CVS argued that its key target of retaining 60% of the customers gained following the Express Scripts/Walgreen debacle was well on track. Management declared that it was “very confident” that at least 60% would be retained in 2013, and this augers well for the next few quarters.

Thirdly, all of its long-term growth prospects remain in place. The trend towards increasing generic drug sales continues apace, even if last year’s strong growth will make the second half’s comparables a bit tougher for CVS.  CVS and Walgreen are both key beneficiaries of this trend, because generics tend to come with higher margin for the retailer. However, though they slow revenue growth due to being more cheaply priced.

Another positive trend-welcomed by cost conscious consumers is each store's increase in private-label brands. In addition, CVS and Walgreen are both keen to personalize offerings by using the huge amounts of data that they both have on their customers' spending habits. In particular, Walgreen is trying to increase retail traffic by using its balanced reward card program.

Still a good value

Analysts will spill a lot of ink debating the merits of Walgreen vs. CVS, but frankly, both stocks look good value on a historical basis. There is no rule of investing that says you can’t hold both. Both stocks have seen some dramatic increases in cash flow generation as the long-term benefits (discussed above) start to drop into the bottom line.

Readers should note that  during the time period in the following chart, Walgreen lost some of its business because of the Express Scripts impasse.

WAG Free Cash Flow TTM data by YCharts

In addition, don’t let CVS’s trailing free cash flow numbers fool you. In its conference call, management reaffirmed guidance for $4.8 billion to $5.1 billion in free cash flow for 2013. This figure represents around 6% of its current enterprise value, which suggests there is plenty of room to grow its dividend.

The bottom line

In conclusion, the market has somewhat overreacted to these results. Despite its strong rise over the last year, CVS still looks like a good value. Long-term demographic trends favor the drugstore industry, and there was even some noise about CVS following Walgreen’s lead in terms of making substantive international investments. There is plenty of upside potential in the sector, and it represents one of the safer ways to invest in health care right now.

You rarely find stocks with double-digit growth prospects and high free cash flow yields, but when you do, it usually makes sense to pick some up.

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.

WAG Free Cash Flow TTM data by YCharts

And despite good stock price performance, both companies look like good values.

WAG Price to Cash Flow TTM data by YCharts

The bottom line

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.