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By Cagdas Ozcan

Walgreen (WAG) is the biggest drugstore chain operating more than 8,000 mostly freestanding stores in all 50 U.S. states, the District of Columbia, and Puerto Rico. Prescription drugs account for about two-thirds of sales; the rest comes from general merchandise, over-the-counter medications, cosmetics and groceries. Most Walgreen stores offer drive-through pharmacies and one-hour photo processing. In a strategic shift, Walgreen has become increasingly acquisitive. Having blanketed the U.S. with its drugstores, ubiquitous Walgreen is now looking to Europe and fill-in acquisitions at home for growth.

Walgreen has increased its dividend payments for 37 consecutive years. In June last year, the company raised its dividend payments by 22.20%. Currently, the stock offers annual dividend of $1.10 per share, yielding 2.60%. The payout ratio of the company based on free cash flows is very low at about 30%. The low payout ratio allows the company to manage and grow its dividend payments easily. Over the past 12 months, Walgreen paid $845 in cash dividends and generated $2.7 billion in free cash flows. In this article, I analyze the free cash flows and debt of the company in order to gauge the dividend stability of the company.

Free Cash Flows

Free Cash Flows

2012

2011

2010

Net Income

$2,127

$2,714

$2,091

Depreciation and other noncash charges

$1,166

$1,086

$1,030

Funds from Operations (FFO)

$3,293

$3,800

$3,121

change in noncash current assets

$689

$86

$327

change in noncash current liabilities

$449

$71

$296

Operating Cash flows

$4,431

$3,643

$3,744

Capital Expenditures

$1,550

$1,213

$1,014

Free Operating Cash Flow

$2,881

$2,430

$2,730

Source: SEC Filings

Over the past three years, the company has experienced some volatility in its net income. Especially in 2011 the net income went up substantially. The same pattern is evident in funds from operations of the company. However, cash flows from operations were at the lowest level in 2011 over the evaluation period. Capital expenditure is a substantial expense for the company, and over the past three years, capital expenditure has remained between $1 and $1.5 billion. At the end of 2010, the firm spent $1.014 billion in capital expenditures; however, by the end of 2012 the capital expenditures for Walgreen had gone up to $1.55 billion.

The company generates healthy free cash flows, which has improved over the past three years. At the end of 2010, the company reported $2.7 billion in free cash flows, which went up to $2.88 billion by the end of 2012.

Essential Metrics

Essential Ratios

2012

2011

2010

Funds from Operations(FFO)/Total Debt

0.81

1.59

1.31

FFO/Capital spending requirements

2.12

3.13

3.08

Free Operating Cash Flow + interest expense/ Interest expense

289.10

35.23

33.12

Debt Service coverage

2.18

44.21

39.47

For my analysis, I have used four ratios. The first ratio indicates that the debt of the company is adequately covered with the FFO. The ratio has shown a mixed trend over the past four years. FFO to total debt ratio was the highest in 2011; however, its current level (0.81) is adequate to cover its long-term debt. The second metric indicates that capital expenditures of the firm are easily covered with the FFO of the company. Capital expenditures are a big expense for the company, and the ratio indicates that it should not have any trouble meeting its capital spending requirements.

The last two metrics in the table indicate that the firm is able to meet its interest and debt payments sufficiently. Interest coverage is extremely strong for the company, and it should not face any trouble paying its interest obligations. Furthermore, debt service coverage is also covered with cash flows. Debt service coverage for the past 12 months has come down due to an increase in the short-term debt. Overall, the solvency position of the company is solid.

Summary

I have analyzed quite a few companies using my free cash flow model, and Walgreen comes out with some of the best results. The company has substantial room in free cash flows to grow dividends in the future. Furthermore, the debt of the company is comfortably covered with the funds from operations. I believe Walgreen is one of the best dividend payers in the market, and it has the ability to grow its dividends in the future. Walgreen should be a solid addition to any income portfolio.

Source: How Safe Is Walgreen's Dividend?