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Walgreen (NYSE:WAG) is one of the leading drug retail store chains in the U.S. Walgreen sells prescription and non-prescription drugs and general household items including fresh food, personal care, and beauty products. The company operates 8200 drugstores and 481 other locations that include specialty pharmacies, worksite health and wellness centers, infusion and respiratory services facilities and post office services. The purpose of this article is to estimate the fair value of the stock incorporating the company's future growth and the future outlook of the industry.

Recent First Quarter results:

The sales for the first quarter grew 5.9% to $18.3 billion compared to the sales of the first quarter of 2013 that were $17.3 billion. The increase was mainly driven by increased prescription sales that grew by 7.7% compared to the sales of the same quarter of the previous year. The operating income for the quarter was $924 million compared to the first quarter of the previous year that was $705 million. The 31% increase in the operating income was mainly due to equity earning in Alliance Boots. The company has a 45% equity ownership in Alliance Boots, and these quarterly earnings were $151 million compared to the same quarter of the previous year that were only $4 million. The company generated an operating cash flow of $133 million during the first quarter compared to $601 million in the first quarter of the previous year. The decrease was primarily the result of working capital changes associated with their transition to AmerisourceBergen (NYSE:ABC).

Future Outlook of the Industry:

The long-term outlook of prescription utilization remains strong due to the aging population and the increasing utilization of generic drugs. Healthcare spending is 17% of GDP in the U.S. and is expected to grow to 20% by 2020. The healthcare system in the U.S. is the most expensive in the world, and Americans spend over twice as much per capita on healthcare than any other citizens of an average developed country.

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Source: Healthcare premier.

The graph above shows that spending on healthcare in the U.S. is higher than all other countries, so this spending has a favorable impact on the company's revenue, because it operates 8,200 drug stores and has a 19.1% market share of the retail pharmacy industry in the U.S.

Company's Future growth:

In August 2012, the company acquired a 45% equity stake in Alliance Boots that is one of the leading drug, health, and beauty retailer in Europe. The company achieved $154 million combined synergy from this acquisition in 2013 and going forward, the company is aiming to achieve between $350 million to $400 million synergies in fiscal year 2014.

Source: Annual shareholder meeting 2014

The company is also enhancing their beauty product range and launched Boots no7 product in partnership with Alliance Boots. The company is confident that these new products will increase their revenue in the coming years.

Last year, the company entered into a 10 year distribution agreement with AmerisourceBergen. Through this agreement, the company will be able to deliver their drugs and consumer goods more frequently to their stores at a lower cost, because AmerisourceBergen has the leading distribution network in America. Walgreen is confident that it will be able to achieve economies of scale via operational efficiency and better rates of their generic goods.

The partnership with Alliance Boots and AmericsourceBergen gives the company a unique opportunity to leverage their combined assets and capabilities to be more efficient and effective in their core business. The deal will also help Walgreen and Alliance Boots expand their operations in Europe where generic drugs are underutilized and in emerging Asian and African markets where pharmacy growth is robust.

By year-end 2016, the company is aiming to achieve the following four goals:

  1. Sales of $130 billion from Alliance Boots shares, associates, and joint venture sales.
  2. Synergies of $1 billion.
  3. An operating cash flow of $8 billion.
  4. Net debt of $11 billion.

Dividends:

The company has a great history of dividend payments and increased their dividends for the 38th consecutive year. In 2013, the company paid dividend per share of $1.14 and announced it would pay $1.26 per share in 2014.

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Source: Annual shareholder meeting 2014

The dividends are very attractive for value investors who are seeking a quarterly income from their stocks. The company's dividend yield is 1.89 compared to the industry dividend yield of 1.29. I believe that the company will able to maintain its past trends in the future, because it has a strong future outlook. The dividend coverage ratio is 3.39 based on operating cash flow/dividends, and this shows that the company is able to sustain its dividends in the future. Considering the company's future growth and increasing demand of prescription sales, the company will receive better net margins and cash flows generation and this will ultimately be transferred to shareholders in the future.

Conclusion:

If we analyze the stock price based on the price P/E ratio and price to cash flow ratio, it denotes overvaluation of stock because Walgreen's growth is 13.66% compared to the average industry growth of 12.18%. However, after incorporating the future growth of the company and industry trends, I believe that the stock still seems to be a good investment and has potential for upside in the future. The distribution agreement with AmerisourceBergen is still in its early stages, and I believe that the company has a competitive edge in the coming years, because it is said that the contract will be worth $400 billion over a decade. Therefore, I give the company a strong buy rating.

Source: What Will Drive The Future Growth For Walgreen?