The U.S.' largest drug store chain, Walgreen (WAG), reported lackluster third quarter results Tuesday morning, but the results did not deviate enough from our forecast to warrant a change in our valuation. Revenue increased 3.2% year-over-year to $18.3 billion, falling slightly short of consensus estimates. Earnings per share were also a bit lighter than consensus expectations, increasing 18% year-over-year to $0.85 per share on a non-GAAP basis.
Although results were only marginally below consensus estimates, we believe the negative reaction can be attributed to the weak comparable-store sales growth in front-end items (candy, soda, etc.), which carry higher gross margins. Front-end same-store sales increased just 0.4% in the third quarter, even though the company benefited from its new rewards program. Traffic fell 3.9%, driving the majority of the weakness in sales. We think the weakness may result from consumers "wising up" to the additional margin that is baked into items at pharmacies. Front-end same-store sales at competitor CVS (CVS) grew only 1.4% during its most recent quarter, so we think it's likely that consumers are simply purchasing these front-end items at peers such as Target (TGT) and Kroger (KR) to save a money. Management didn't give much detail, but sounded optimistic that Walgreen would fix the problem, saying:
"…with 75 million members now enrolled in Balanced Rewards, the insight we have, we're able to now strategically drive promotions through Balanced Rewards to drive traffic and sales as well."
Image Source: Walgreen Q3 FY2013 Presentation
As the chart above reveals, Walgreen's number of prescriptions filled has rebounded after the firm renewed its relationship with Express Scripts (ESRX). Total prescription sales increased just 3% driven by a 2% increase in comparable-store prescriptions sales. The disconnection between the total number filled and actual sales is related to a generic push, which is actually positive for Walgreen' gross margin mix.
Walgreen's gross margin increased 30 basis points compared to the year prior to 28.5%, even though front-end sales were weak. SG&A as a percentage of revenue increased 50 basis points year-over-year to 23.8%, more than cancelling out the gain achieved from stronger gross margins. Management cited a tough comparison as a result of not being part of the Express Scripts Network during the same quarter in the previous year.
Of course, the Alliance Boots acquisition remains intriguing, and management noted that synergies were running ahead of plan, allowing Walgreen to narrow its cost-savings guidance to $125 million to $150 million (was $100 million to $150 million). We still believe Walgreen' $1 billion synergy target is a bit optimistic, though we like the ability of the combined company to lower the cost of generics. The deal added $0.10 per share of earnings in the third quarter, and it remains the main source of earnings growth for Walgreen' going forward.
Even though we believe Walgreen's quarter was mediocre, shares of the pharmacy giant still look fairly valued. More than anything, we think the poor quarter may have led to some profit-taking-shares are up 22% year-to-date and 53% during the past year.
All things considered, we think Walgreen has a decent dividend-growth profile with excellent dividend growth potential. However, we aren't fans of its valuation, nor do we think a 2.4% dividend yield is particularly compelling in light of the recent sell-off in high-yielding equities. We would need a larger margin of safety before considering the company for the portfolio of our Dividend Growth Newsletter.