Shares of Walgreen Company (WAG) have recovered by 14.1% from their 3-month low of $32.23 touched in November. At $36.76, the stock is trading very close to the 52-week high of $37.34. Should investors buy into the current upward momentum? In this article, I will elaborate on the stock value analysis that may help you in formulating the investment decisions.
From a relative valuation perspective, Walgreen shares appear to be cheap based on the company's solid financial performance compared to the peers' (see comparable analysis chart below). Sell-side analysts on average predict Walgreen's revenue, EBITDA, and EPS to grow at 3-year CAGRs of 3.6%, 9.9%, and 16.1%, respectively, over the current and next 2 fiscal years. Those consensus growth estimates are generally superior to the averages of 3.3%, 10.5%, and 11.7%, respectively, for a peer group consisting of Walgreen's primary competitors. Similarly, the company's EBITDA margin is forecast to expand by 1.3% over the same period, compared to the peer average of just 0.9%.
On the profit side, Walgreen has demonstrated a superior margin performance as most of the firm's profitability and capital return metrics are considerably above the par. The company carries a low level of debt as reflected by its below-average debt to capitalization and debt to EBITDA ratios. In terms of liquidity, Walgreen's trailing free cash flow margin of 3.5% is markedly above the group average. Due to the robust profitability and the low leverage, the firm was able to maintain a healthy interest coverage ratio. Both Walgreen's current and quick ratios are fairly in line with the peers', reflecting a healthy corporate balance sheet.
To summarize the financial comparisons, given the company's better growth prospects, robust profitability, and solid liquidity position, I expect the stock to trade at least in line with the peer-average valuation. Nevertheless, the current valuations at 7.1x forward EV/EBITDA and 11.4x forward P/E represent an average discount of 7.6% to the peer-average trading multiples, suggesting that the stock is currently trading somewhat below its intrinsic level. It should also be noted that Walgreen's 0.90x PEG is 13.8% below the peer average at 1.04x.
Moreover, the stock's forward P/E multiple is now trading at a 15.4% discount to the same multiple of the S&P 500 Index despite the fact that 1) Walgreen's long-term estimated earnings growth of 12.7% is substantially above the average estimate of 7.9% for the S&P 500 companies; and 2) the stock's dividend yield of 3.0% is also considerably above the 2.2% average level for the S&P 500 Index (see chart below).
To support my above conclusion, I also performed a DCF valuation which incorporates the market's consensus revenue and EBITDA estimates from fiscal 2013 to fiscal 2015 (see DCF chart below). To be conservative, I model the revenue growth to gradually decrease from the market estimate of 3.4% in fiscal 2015 to 2.5% in the terminal year, and the EBITDA margin after fiscal 2015 to remain the same as the level in fiscal 2013. Other free cash flow related items (i.e. tax expense, depreciation expense, capital expenditure, and net working capital investment) are projected based on the historical ratio between their figures relative to the revenues as the ratio trends are fairly stable over time. To account for the financial projection risk, a company-specific risk premium of 3.0% is applied in the cost of equity calculation. A normalized risk-free rate is used instead of the current depressed 10-year Treasury Bond yield.
As such, based on a WACC of 9.4% and a terminal growth rate of 2.5%, this conservative but reasonable DCF model yields a stock value of $40.07, representing a 9% upside from the current share price. This estimated share price implies a forward P/E of 12.4x, which is 5.4% below the peer-average P/E ratio of 13.1x.
As a result of the free cash flow growth, Walgreen has increased its dividend per share three times since 2010 by 26.8%, 28.6%, and 22.2%, subsequently. Given that the company's free cash flows in recent years were substantially above the annual dividend payment (see chart below), I believe the ample financial capacity should ensure the current pace of the dividend growth to be sustainable. In addition, the upside for Walgreen's 3.0% dividend should be somewhat limited as the current low-interest market environment will likely continue supporting investor demand for high-yield assets. As such, assuming a target dividend yield range between 3.0% and 3.8% and supposing that the annualized dividend would be raised by just 15.0% from the current $1.10 level to $1.27 in the August 2013 payment period, this conservative scenario would suggest a share price range between $33.73 and $42.17, or a price return range from -8.2% to 14.7% without considering the 3.0% dividend income.
Walgreen has recently released the higher than expected November same-store-sales figure. According to Morgan Stanley's research analyst, Mark Wiltamuth (sourced from Thomson One, Equity Research):
Walgreen reported November SSS of -6.2% vs. MS at -6.5% and consensus at -6.7%...Walgreen's November SSS report showed a better than expected improvement in pharmacy script comps. While anecdotal reports from competitors like CVS, Rite Aid, Kroger, and Roundy's indicated no meaningful movement in customers, November's script comp is a significant jump from October and could be a sign that Walgreen's is making progress in its efforts to win back customers that it lost during the Express Scripts (ESRX) dispute.
Bottom line, given the stock's somewhat cheap valuations and attractive dividend yield of 3.0%, the investment appears to have a tempting risk/reward profile. I believe a fair value range for Walgreen would be between 12.5x to 13.5x forward P/E. Based on the mid-point P/E and analysts' average fiscal 2014 EPS estimate of $3.59, the 1-year target stock price can be calculated to be $46.67, representing a 27.0% upside. As such, in light of Walgreen's limited downside risk and a potential room for valuation correction, I recommend acquiring the shares now.
The comparable analysis and DCF charts are created by the author, all other charts are sourced from Capital IQ, and all historical and consensus estimated financial data in the article and charts are sourced from Capital IQ.
Disclosure: I am long WAG.