A little more than a year ago, I wrote an article titled, An Outstanding Opportunity To Go Long Walgreen (WAG). WAG at that time had fallen below $30.00 and had a single digit P/E. WAG had just purchased the European health and beauty store company Alliance Boots, and was involved in a dispute with Express Scripts (ESRX) over pharmacy reimbursements. Despite all the negative news around WAG, I saw opportunity and said the following.
On Friday, June 22nd, I purchased Walgreen for $29.80; I bought a full position with one purchase because I wanted the stock below $30.00, and all day Friday it bounced between the $29.00 and $30.00. I am happy with the $29.80 cost basis and am fully confident the price will rise over time. As with most stocks I buy, this will not be a rocket ship; I believe I may have to wait three years to see the full effects of Walgreen transformation reflected in the stock price. But in the meantime, I am collecting a 3.7% dividend that will continue to rise over the years.
I believe unique investment opportunities occur very infrequently. And I believe this is one of those opportunities. Walgreen is an established leading company selling at a historically low P/E, entering into a deal that will make them a leading "worldwide" company, and that is immediately accretive to earnings. We know when the merger is completed, they will have greater pricing flexibility, more outlets to sell their private label brands and more countries to expand in. We also know they have historically raised their dividend every year and have stated they have every intention to continue raising the dividend in the future. I am looking forward to owning Walgreen as they transform and grow the company.
Although I was confident buying WAG at a historically low price was a good investment, I was surprised by how far and fast the stock price rose, rising from $29.00 to over $50.00 in approximately one year. However, in the last few weeks, WAG has dropped down to the $45.00 range, after reporting 3rd quarter results that disappointed some. Although all the numbers showed year-over-year improvement, earnings were below analyst estimates, resulting in a 12% decline in the stock price.
So after a year in which WAG went almost straight up, followed by the recent decline, the question now is, where will WAG go from here?
Walgreen Is Just Getting Started
A year ago, when WAG announced the merger with Alliance Boots and was battling Express Scripts to get a better deal, numerous analysts issued downgrades on the stock. Below is a summary of some of the thoughts from analysts following the merger.
Walgreen stock is retreating after a number of research firms reacted negatively to the company's acquisition of a 45% stake in British drugstore chain Alliance Boots yesterday. The deal, which gives Walgreen the option to acquire a 100% stake in Alliance Boots in about three years, will not solve Walgreen's problems in the U.S., research firms Citigroup and Macquarie contended. The transaction creates execution risks, as Walgreen has limited integration experience and U.S. retailers have not historically acquired international companies, Citigroup said in a note to investors this morning. Moreover, the deal increases Walgreen's exposure to Europe, added the firm, which lowered its price target for Walgreen shares to $27 from $29 while maintaining a Sell rating on the stock. Similarly, research firm Macquarie contends that the transaction doesn't address Walgreen's deteriorating U.S. traffic trends and declining pharmacy volumes. The firm downgraded the stock to Neutral from Outperform and reduced its target on the shares to $34 from $38.
If owners of WAG had followed that short-sighted advice, they would have missed an approximately 70% move in the stock price. What the analyst failed to see was that over time, the Alliance Boot merger is going to be transformational for WAG and that their U.S. same store sales decline was temporary due to the Express Scripts issue. What they also failed to see was that WAG was ripping up the old drug store playbook and creating a new retail category, a pharmacy-led health and wellness store.
In the last year, WAG not only closed on the 45% stake in Alliance Boots, it also signed a multiyear agreement with Express Scripts, acquired USA Drug and Crescent Pharmacy, allowing WAG to add premier locations in the mid-South, and signed a 10-year deal with AmerisourceBergen (ABC) for daily drug distribution . The deal with AmerisourceBergen also has the option for WAG to eventually take a 23% stake in AmerisourceBergen. As you can see this is not a company standing still; WAG is completely changing their business plan.
Making a lot of deals is nice, but it has to show up on the bottom line if the deals are going to benefit the shareholders. In WAG's case, the results are beginning to show up and will continue to grow. Looking at the most recent 3rd quarter financial report, we see WAG nicely improved results from a year ago.
Note - All amounts are in millions, except EPS.
|Adjusted Operating Income||$1,016||$1,249||22.9%|
|Adjusted Net Earnings||$628||$812||29.3%|
|Adjusted Diluted EPS||$.72||$.85||18.1%|
WAG also generated $1.1 billion of free cash flow and increased its pharmacy share to 19.2% from a previous 18.4%. It is also important to note that Alliance Boots added $.10 to WAG's earnings per share in the 3rd quarter, and management believes Alliance Boots will add $.16 to WAG's FY-13 earnings per share.
Don't Look Back, Look Forward
The key to my investing thesis for WAG is that by 2016, WAG will have completely re-invented its operations and will be aided by favorable demographic trends.
- The Alliance Boots merger will be complete, making WAG the global leader in pharmacy-led health and well-being retail with more than 11,000 stores in 12 countries. The combined entity will also have more than 370 distribution centers delivering drugs to more than 170,000 pharmacies, doctors, heath-centers and hospitals.
- The store re-imaging will be complete, changing the stores from the traditional drug store layout to a wellness center destination. In some locations, pharmacists will be located in the front of the store to answer questions and nurse practitioners will be onsite providing vaccinations and health testing. WAG will also sell more of their own private label products along with popular Alliance Boots products such as the No7 and Botanic line of beauty products.
- The United States and European populations will be older and the Affordable Care Act will be providing healthcare to those who may previously been unable to afford it. Walgreen, with its huge footprint, will be the beneficiary of those trends.
How much will those trends add to WAG's bottom line? Well, let's take a look at WAG's goals for 2016.
|FY 2012||FY 2016 Goals|
|Revenue||$72 Billion||>$130 Billion|
|Operating Income (GAAP)||$3.5 Billion||$8.5 -$9.0 Billion|
|Adjusted Operating Income||$4.1 Billion||$9.0 - $9.5 Billion|
|Operating Cash Flow||$4.4 billion||$8 Billion|
|Debt||$4.1 Billion||$11 Billion|
Every one of the categories shown represents a huge increase, in some cases more than doubles, from FY 2012 results, and all are positive indicators, with the exception of debt. The debt is related to the Alliance Boots purchase and will be easily serviceable with WAG's excellent cash flow.
I know there are no guarantees that WAG will make those goals, but even if they fall a little short, there is no doubt that strong cash flow, income and revenue improvements are on the way for WAG. Keep in mind, WAG is cheap at its current valuation with a PEG (price to earnings growth) of 1.09
Using David Fish's excellent The DRIP Investing Resource Center (here) we find that Walgreen is a dividend champion, having raised its dividend 37 consecutive years with a ten year average dividend growth rate of 21.2%. The dividend payout ratio is 49%, which allows plenty of room for future increases, especially with the expected rapid increase in free cash flow. WAG should be announcing its 38th year of increasing its dividend in the months ahead, as a dividend increase is due in September.
So while you watch WAG re-invent itself and watch the earnings and revenue grow, you also get to collect a 2.5% dividend that has been growing for years at a double digit pace.
Finding companies that offer the opportunity for substantial growth while also paying a healthy dividend are difficult to find. It is also difficult to see a company's future business trends. However, with WAG, we know management has forecast significant increases in, revenue, income, and earnings in the years ahead. We know the population is aging and will be in need of additional healthcare. We know the Affordable Care Act will increase the number of people seeking healthcare. We know WAG will have the opportunity for cost savings, using its large footprint to derive better deals from suppliers. We know WAG will have an increased opportunity for expansion as it moves into countries it previously did not operate in. We also know WAG pays a 2.5% dividend that is increased double digits every year.
Although an investor can never be 100% sure of anything, it is fairly likely that all of the above will occur to some degree. That is why I continue to believe WAG will be a rewarding investment in the years ahead.