I recently ran the H-Model (Gordon Growth Model) on 22 Dividend Aristocrats to try and estimate their true long-term values based on their current dividends and dividend growth history. This screen suggested that a more accurate valuation of Walgreen (NYSE:WAG) shares might be $54.43 (an upside of just over 25%). The inputs I used were very simplistic, so I decided to do more research.
When I buy a stock for its dividend, I am looking to find a stable long-term source of income. The best companies for this are those that have a durable competitive advantage and the best person at finding durable competitive advantage in my lifetime has been Warren Buffett. This analysis attempts to duplicate the methods described in the excellent book Warren Buffet and the Interpretation of Financial Statements and compares Walgreen to Wal-Mart (NYSE:WMT) (which is both a Buffett investment and a competitor). Walgreen has an admirable dividend history but does it have the kind of moat that will allow it to keep paying me market-beating returns for the next twenty years?
To know that, we will need to do some digging into the financial statements. For each item I highlight here, we're looking for consistency (ideally with improvement over time) and outperforming their competitors.
Gross Profit Margin - Selling things for more than they cost you is at the heart of any good business. Walgreen operated at an average of 28.7% over the last four quarters. They have also been increasing their GPM pretty consistently over the last five years. Wal-Mart has a 25% GPM with a flat or slightly negative trend (depending on whether you prefer TTM numbers or a linear trend line). Improving margins and beating the competition - that is what we're looking for.
Interest Expenses - A good company will be able to fund their operations mostly or entirely from the cash they generate. This means they will have low interest expenses as a percentage of revenue. Walgreen, despite issuing $4 billion of debt (very cheaply) in September still only pays 0.7% of last quarter's revenue in interest expenses. Before that, interest was consistently about 0.4%. Wal-Mart's interest expenses are a very consistent (and still good) 2.1%. If WAG keep ramping up the debt, I might start to be concerned, but I can't object to them taking some cheap money.
Net Income / Revenue - This is the famous bottom line. Of every dollar that comes in the door how much do the shareholders get to keep? For Walgreen it was 3.0% last year (and just 2.39% last quarter). It is also pretty flat over the last five years - retail is a pretty cut-throat business. Wal-Mart does slightly better at 3.7% last year and managed to post an impressive (relatively speaking) 4.38% last quarter. Walgreen does make up for slim margins with volume and consistency, but there's room for improvement here.
Cash (and Equivalents) - Having cash on hand is good for a business. It gives them the ability to weather storms or take advantage of opportunities. It's also a strong sign that their business activities are consistently profitable. Walgreen had 61% of 2012 net revenue or 3.9% of total assets as cash. This has dropped from 7.2% in 2010, but is still more than Wal-Mart (39.8% of Net Revenue and 3.4% of Total Assets). I'm no retail expert but it seems like this is a fairly sweet spot - enough to be comfortable, not so much they are bloated.
Return on Total Assets - This is a measure of how effectively a business is using its assets. Walgreen managed 6.4% last year. This is down from 9.9% in 2011 and 8.0% in 2010. Wal-Mart on the other hand is more efficient and more consistent - 8.5% down from 8.8% both 2011 and 2010. The decline is a potential warning sign, but WAG is still doing better than many of its other competitors like CVS (NYSE:CVS) (5.9%) or Rite Aid (NYSE:RAD) (3.2%).
Years of Net Earnings to Repay Long Term Debt - This measures a company's ability to repay its debt. Walgreen's recent debt issue pushed the long term debt up to 1.9 years of net earnings, which is still low and less than Wal-Mart's 2.9 years
Total Liabilities to Shareholder's Equity Ratio - When looking at Shareholder's Equity, you should adjust for the presence of Treasury shares as in real life they serve to increase the share of the business that stockholders have claim to over debt-holders. This is another confirmation of Walgreen's conservative ways, with Debt:Equity of just 72%. For comparison, Wal-Mart are at 170%.
Goodwill - Goodwill is an accounting trick mostly used to make balance sheets balance after acquisitions at greater than book value. The less of it the better and Walgreen has goodwill of just 6.5% of net assets . Wal-Mart has slightly more at 10.7% and CVS (which is the poster child for acquisition growth) have a whopping 40% of "assets" tied up in Goodwill.
Capital Expenditure - Buying new property and equipment is a necessary evil for most businesses. Walgreen spent more in 2012 (as a percentage of net earnings) than in the previous two years (73% vs 44.7% and 48.5%). This is higher than I would like in a perfect business, but still lower than Wal-Mart (82.1%, 79.6%, 81.4%).
So, the numbers seem to suggest that Walgreen is a well run company with a reasonable but not great competitive advantage. It compares favorably financially to Wal-Mart although Buffett built his Wal-Mart position at (much) more favourable prices than it currently trades at. Let's look at the less quantifiable attributes.
Sound and understandable business model - Check. Prescriptions and convenience items are not something that will be replaced by the Internet any time soon.
Significant Market Share - Check. They fill 19.2% of retail prescriptions. 75% of the US population live within 5 miles of a Walgreen store.
Durability of Competitive Advantage - This is my big worry. As we say from the numbers Walgreen's advantage is good but not great. It is not based on strong proprietary knowledge (like Coke or Moody's) so they are somewhat vulnerable. That said, they do have an established brand and store locations (consumer habit is a wonderful thing for investors). They launched a loyalty program last year that will help with customer loyalty and as a source of intelligence.
Good Management - The current CEO is a pharmacist who has moved up through the Walgreen ranks, much like previous CEOs. I like this as retail is evolutionary not revolutionary so experience with the company is valuable. He's also less likely to feel pressure to show that he is shaking things up. This does not mean the company is stagnant though - they are trying new things (Alliance Boots, drugstore.com, Amerisource Bergen) without being desperate.
Overall, I think Walgreen is a good but not quite great company by Buffett's standards. The low margins and weak moat will prevent it from ever being a superstar. That said, the stock is worth buying if you can get a good price.
I don't think the current market price is a particularly good one. The P/E ratio is above 20 and the PEG ratio is 1.08 which suggests the market has priced in the future growth pretty accurately. The current dividend yield just isn't enough right now, so I'll be waiting for the stock to pull back (I'd like to see it hit more of an 0.8 PEG or a 3% yield) before buying.