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Before selecting a stock, there are a number of things that you need to consider in order to ensure that you are buying the stock of a high-quality company whose shares are poised to grow in value over time. Some of these concerns include what the company does, its competitive advantages, valuation, dividend payouts and sustainability, and earnings consistency.

Another important thing that you need to consider is the financial condition of the company in question. You want to know if the company is able to continue paying its bills and how much debt it carries. The balance sheet is one of the most effective tools that you can use to evaluate a company's financial condition. In this article, I will discuss the balance sheet of Walgreen (WAG) in order to get some clues as to how well this company is doing.

I will go through the balance sheet, reviewing the most important items, in order to assess the financial condition of Walgreen. The information that I am using for this article comes from the company's most recent annual report, which can be found here. Note that this article is not a comprehensive review as to whether Walgreen should be bought or sold, but rather, just an important piece of the puzzle when doing the proper due diligence.

This article might be a bit too basic for some and too long-winded for others, but I hope that some of you can derive benefit from it.

Background

Walgreen is the largest drugstore chain in the United States. Between the U.S., Guam and Puerto Rico, Walgreen has 8,582 locations, with 8,116 of them being drugstores. 75% of Americans live within 5 miles of a Walgreen location. At their locations and through their websites at walgreens.com and www.drugstore.com, the company sells prescription and non-prescription drugs, and general merchandise like household items, convenience and fresh foods, personal care items, beauty items, as well as photofinishing and candy.

In addition to drugstores, Walgreen also operates worksite health and wellness centers, infusion and respiratory services facilities, specialty pharmacies and mail service facilities. The company owns 20% of its retail drugstores, and leases the rest. In addition to those, the company owns a 45% equity investment in Alliance Boots, an international pharmacy-led health and beauty group that has retail, wholesaling and distribution operations. Walgreen has an option to buy the other 55% between February and August 2015.

During fiscal year 2013, Walgreen locations averaged 6.2 million visitors per day. Their websites received 54 million visitors per month during that same period. The company aims to grow through new store openings and acquisitions. Over the past 12 months, the company had a net increase of 197 locations. During fiscal 2014, they plan to add 85 to 160 new drugstores.

Prescription drugs accounted for 63% of the company's sales during fiscal 2013. During that time, they filled 683 million prescriptions.

Cash and Cash Equivalents

The first line in the Assets column of the balance sheet is for the amount of cash and cash equivalents that the company has in its possession. Generally speaking, the more cash the better, as a company with a lot of cash can invest more in acquisitions, repurchase stock, pay down debt, and pay out dividends. Some people also value stocks according to their cash positions. Some of the larger and more mature companies tend not to carry a lot of cash on their balance sheets, as they might be more inclined to buy back stock with it, or pay out dividends.

As of Aug. 31, 2013, Walgreen had $2.11B in cash and equivalents that can easily be converted into cash. During fiscal year 2013, Walgreen paid out $1.04B in dividends. Last July, the company announced a 15% increase to its regular dividend. They also repurchased $615M worth of stock in support of their employee stock plans. Both the dividends and buybacks were well-covered by the company's free cash flow of $3.09B.

Inventory

With retail companies like Walgreen, I like to keep an eye on inventory levels. I usually like to see inventory levels stable or slightly rising from one year to the next. If I see inventory levels rising, then I want to see revenues rising as well to indicate higher demand for the company's products. I don't like to see rapidly fluctuating inventory levels that are indicative of boom and bust cycles. In some instances, if inventory ramps up without increases in volumes or revenues, then it may indicate that some of the company's products are going obsolete.

At the end of fiscal 2013, Walgreen had $6.85B worth of inventory, which amounts to 9.49% of the company's sales for that year. At the end of fiscal 2012, this level was at 9.83% of sales, while at the end of fiscal 2011, it was at 11.1% of sales. This shows that the company's inventory levels are steady relative to the revenues. I don't see anything here that would indicate boom and bust cycles or the possibility of a large number of their products going obsolete. So, I see nothing to worry about here at this time.

Current Ratio

Another factor that I like to look at is the current ratio. This helps to provide an idea as to whether or not the company can meet its short-term financial obligations in the event of a disruption of its operations. To calculate this ratio, you need the amount of current assets and the amount of current liabilities. Current assets are the assets of a company that are either cash or assets that can be converted into cash within the fiscal year. In addition to cash and short-term investments, some of these assets include inventory, accounts receivable and prepaid expenses. Current liabilities are expenses that the company will have to pay within the fiscal year. These might include short-term debt and long-term debt that is maturing within the year, as well as accounts payable (money owed to suppliers and others in the normal course of business). Once you have these two figures, simply divide the amount of current assets by the amount of current liabilities to get your current ratio.

If a company's operations are disrupted due to a labor strike or a natural disaster, then the current assets will need to be used to pay for the current liabilities until the company's operations can get going again. For this reason, you generally like to see a current ratio of at least 1.0, although some like to see it as high as 1.5.

The current ratio of Walgreen is 1.34, which is very good.

Quick Ratio

Most of the time when it comes to short-term liquidity, I end the discussion at the current ratio. However, with companies that have a significant amount of their current assets in inventories, one has to wonder whether all of that inventory can quickly be converted into cash in the event that the company suddenly needs it. Some of the inventory might be obsolete or have to be disposed of for less than it was originally valued at.

To address this issue, I calculate what I call the quick ratio. The quick ratio is calculated simply by subtracting the inventory from the total current assets and then dividing the remainder by the current liabilities. I usually like to see a quick ratio of at least 1.0. That way, even if the company's inventory is worthless, they will still have enough other current assets on hand to meet their short-term financial obligations in the event of an unlikely disruption to their operations.

The quick ratio of Walgreen is 0.57, which is less than ideal. At this point in time, the company could withstand up to a 44% writedown in the value of its inventory before its current assets would be outweighed by its current liabilities. However, when considering these numbers, you need to think about the odds of the operations of Walgreen coming to a screeching halt. With more than 8,000 locations spread throughout the United States, this is not likely to happen. So, while the quick ratio is less than ideal for Walgreen, I am not as concerned by it as I would be if the company in question had all of its operations concentrated in just one or two places.

Long-Term Investments

On the most recent balance sheet of Walgreen, there are $7.1B worth of long-term investments. This includes the $6.26B equity investment in Alliance Boots, as well as the $839M call option that the company has on the remaining stake in Alliance Boots. This transaction involving Alliance Boots happened in 2012.

Property, Plant, and Equipment

For retail companies like Walgreen to operate, a certain amount of capital expenditure is required. Land has to be bought, stores have to be built, machinery has to be purchased, and so on. However, less may be more when it comes to outlays for property, plant and equipment, as companies that constantly have to upgrade and change their facilities to keep up with competition may be at a bit of a disadvantage. However, another way of looking at it is that large amounts of money invested in this area may present a large barrier-to-entry for competitors.

Right now, Walgreen has $12.1B worth of property, plant and equipment on its balance sheet. This figure is inline with the $12.0B that it reported at the end of fiscal 2012, and the $11.5B that the company reported at the end of fiscal 2011. In its 10-K filing, the company said that 40% of these assets are in equipment, while 21% are in buildings at company-owned locations, 18% are in land at company-owned locations, and 10% are in leasehold improvements.

Goodwill

Goodwill is the price paid for an acquisition that's in excess of the acquired company's book value. The problem with a lot of goodwill on the balance sheet is that if the acquisition doesn't produce the value that was originally expected, then some of that goodwill might come off of the balance sheet, which could, in turn lead to the stock going downhill. Then again, acquisitions have to be judged on a case-by-case basis as good companies are rarely purchased at or below book value.

Walgreen has $2.41B worth of goodwill on its most recent balance sheet, which is just a bit more than the $2.16B and $2.02B worth of goodwill that it reported in each of the preceding two years, respectively. This increase was due mostly to the company's $436M acquisition of USA Drug from Stephen L. LaFrance Holdings. In this transaction, $220M was allocated to goodwill.

Usually, I don't like to see goodwill account for more than 20% of a company's total assets for the reason that I discussed at the beginning of this section. Since goodwill accounts for only 6.8% of the assets of Walgreen, I don't see much to be concerned about here.

Return on Assets

The return on assets is simply a measure of the efficiency in which management is using the company's assets. It tells you how much earnings management is generating for every dollar of assets at its disposal. For the most part, the higher the better, although lower returns due to large asset totals can serve as effective barriers-to-entry for would-be competitors. The formula for calculating return on assets looks like this:

Return on Assets = Net Income / Total Assets.

For Walgreen, the return on assets would be $3B in core earnings over the last 12 months, divided by $35.5B in total assets. This gives a return on assets for fiscal 2013 of 8.45%, which is decent. I also calculated the company's returns on assets over fiscal 2012, fiscal 2011 and fiscal 2010 for comparative purposes. This can be seen in the table below.

Symbol2013201220112010
WAG8.45%7.76%8.73%7.98%

Table 1: Consistent Returns On Assets At Walgreen

These are good returns on assets that have been very consistent. This shows that management is doing a good job with the assets that are at its disposal. Over the last three years, the asset base of Walgreen grew from $26.3B to $35.5B, while its core earnings grew from $2.1B to $3B, showing that the company's earnings are outpacing its asset base, which is what we want to see.

Short-Term Debt Versus Long-Term Debt

In general, you don't want to invest in a company that has a large amount of short-term debt when compared to the company's long-term debt. If the company in question has an exorbitant amount of debt due in the coming year, then there may be questions as to whether the company is prepared to handle it.

The balance sheet of Walgreen shows that the company is currently carrying $570M of short-term debt, mostly in unsecured variable-rate notes. With an average free cash flow generation of almost $3B per year over the last three years, this debt should not be a problem at all for them.

Long-Term Debt

Long-term debt is debt that is due more than a year from now. However, an excessive amount of it can be crippling in some cases. For this reason, the less of it, the better. Companies that have sustainable competitive advantages in their fields usually don't need much debt in order to finance their operations. Their earnings are usually enough to take care of that. A company should generally be able to pay off its long-term debt with 3-4 years' worth of earnings.

Right now, Walgreen carries $4.48B in long-term debt. This is slightly above the $4.07B that was reported at the end of fiscal 2012, and well above the $2.40B that was reported at the end of fiscal 2011.

The increase that was seen in 2012 was due to a $3B bridge loan that the company obtained in connection with its equity interest in Alliance Boots. During the last 12 months, the company repaid this loan and borrowed another $4B.

Of its $4.48B in long-term debt, only $1.75B is due within the next 5 years. Maturities on their long-term debt range from 2015 to 2042, and interest rates range from 1.0% to 5.25%.

In determining how many years' worth of earnings it will take to pay off the long-term debt, I use the average of the company's core earnings over the last 3 fiscal years. The average core earnings of Walgreen over this period is $2.67B. When you divide the long-term debt by the average earnings of the company, here is what we find.

Years of Earnings to Pay off LT Debt = LT Debt / Average Earnings

For Walgreen, here is how it looks: $4.48B / $2.67B = 1.68 years

This is great for Walgreen, in that the company could pay off its long-term debt with an amount that is less than two years' worth of earnings if it wanted to. For this reason, I don't see anything at all to worry about when it comes to the long-term debt position of Walgreen.

Debt-To-Equity Ratio

The debt-to-equity ratio is simply the total liabilities divided by the amount of shareholder equity. The lower this number, the better. Companies with sustainable competitive advantages can finance most of their operations with their earnings power rather than by debt, giving many of them a lower debt-to-equity ratio. I usually like to see companies with this ratio below 1.0, although some raise the bar (or lower the bar if you're playing limbo) with a maximum of 0.8. Let's see how Walgreen stacks up here.

Debt-To-Equity Ratio = Total Liabilities / Shareholder Equity

For Walgreens, it looks like this: $16.0B / $19.5B = 0.82

In the table below, you can see how this ratio has changed over the last few years.

Symbol2013201220112010
WAG0.820.840.860.83

Table 2: Debt-To-Equity Ratio At Walgreen

In Table 2, we see that the debt-to-equity ratio of Walgreen has been very consistent, and at decent levels over the last several years.

Return On Equity

Like the return on assets, the return on equity helps to give you an idea as to how efficient management is with the assets that it has at its disposal. It is calculated by using this formula.

Return On Equity = Net Income / Shareholder Equity

Generally speaking, the higher this figure, the better. However, it can be misleading, as management can juice this figure by taking on lots of debt, reducing the equity. This is why the return on equity should be used in conjunction with other metrics when determining whether a stock makes a good investment. Also, it should be mentioned that some companies are so profitable that they don't need to retain their earnings, so they buy back stock, reducing the equity, making the return on equity higher than it really should be. Some of these companies even have negative equity on account of buybacks.

Walgreen is not one of these companies. The return on equity for Walgreen is equal to $3.00B in net income, divided by shareholder equity of $19.5B, which is equal to 15.4%.

To illustrate how the returns on equity of Walgreen have changed over the last few years, I have created the table below for the return on equity.

Symbol2013201220112010
WAG15.4%14.3%16.2%14.6%

Table 3: Returns On Equity At Walgreen

Here, we see that returns on equity have been consistently strong at Walgreen, as the company's earnings growth has kept up with the 35% growth in the company's equity position since the end of fiscal 2010. Overall, these returns are good, and they show that management is making efficient use of its equity.

Retained Earnings

Retained earnings are earnings that management chooses to reinvest into the company as opposed to paying it out to shareholders through dividends or buybacks. It is simply calculated as:

Retained Earnings = Net Income - Dividend Payments - Stock Buybacks

On the balance sheet, retained earnings is an accumulated number as it adds up the retained earnings from every year. Growth in this area means that the net worth of the company is growing. You generally want to see a strong growth rate in this area, especially if you're dealing with a growth stock that doesn't pay much in dividends or buybacks. More mature companies, however, tend to have lower growth rates in this area, as they are more likely to pay out higher dividends.

On its most recent balance sheet, Walgreen shows an impressive retained earnings figure of $21.5B. In the table below, you can see how this figure has grown over the last three years. Over this time period, we see that retained earnings grew by a cumulative 28% since the end of fiscal 2010. While this is not explosive growth by any stretch, it is still pretty decent, leaving Walgreen with money left over to reinvest into its business.

Symbol

2013

2012

2011

2010

WAG

$21.5B

$20.2B

$18.9B

$16.8B

Table 4: Retained Earnings At Walgreen

Off Balance Sheet Arrangements

Not included in this analysis are obligations that are associated with operating leases that the company holds. The liabilities that are associated with these leases do not show up on the balance sheet, as the lessee (Walgreen) does not assume the risk of ownership of the properties in question, like it would in a capital lease. Because of this, operating lease obligations (rents) are regarded as operating expenses that deduct from earnings, but do not represent actual debt. For this reason, I did not include it in the above analysis, but added it here, so that readers can be aware and use the information how they wish.

Walgreen currently has $35.3B of these operating lease obligations, with $2.52B due within the next 12 months, $12.1B due in the next 5 years, and the remaining $23.2B due beyond 5 years. So far, the company has been able to post consistent gross margins of 28-30% with these expenses included. If the company can maintain this level of profitability, then they should be able to manage fine in the face of these expenses.

Conclusion

After reviewing the most recent balance sheet, there are several things to like about the financial condition of Walgreen. While the company has made several acquisitions over the years, Walgreen has managed to keep its goodwill in check, at less than 7% of total assets. This reduces the likelihood that any future writedowns of goodwill will have a catastrophic effect on the stock price. The company has shown very consistent returns on assets and equity over the last few years, that have been highlighted by earnings growth and increases in the company's asset base as it continues to grow. The company's debt levels are very manageable as can be seen by its relatively low debt-to-equity ratio and long-term debt that can be paid off with an amount that's equal to less than two years worth of earnings. The company has also exhibited decent retained earnings growth over the last several years. This gives the company more money to reinvest for future growth.

While this is not a comprehensive review as to whether Walgreen should be bought or sold here, I think that its overall financial condition is very good at this point in time.

Thanks for reading and I look forward to your comments!

Source: Time For A Check-Up On The Financial Condition Of Walgreen