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Summary

  • WAG shares were crushed yesterday on several news events.
  • The inversion rumor proved not to be true but other positive events occurred as well.
  • WAG shares offer value now that the speculators are gone.

Well, that was interesting. Yesterday, Walgreen (WAG) had a slew of news come out, bombarding investors with information. Unfortunately, the reaction of investors was, shall we say, unpleasant, sending shares down better than 14% in yesterday's session. We'll take a look at the news events and their relative impact on WAG's business and in the context of the longer term value of the company to see if investors are overreacting or if the caution is warranted.

To do this, I'll use a DCF-type model you can read more about here. In essence, the model takes inputs such as earnings estimates, which I'm sourcing from Yahoo!, dividend estimates, which are my own, and a discount rate, which I'm estimating at 9%. I always derive my discount rate as the 10 year Treasury rate plus a risk premium, which I've estimated at 6.5% for WAG. It's important to note these estimates are just that and that yours may differ from mine.

 

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

       

Prior Year earnings per share

 

$3.12

$3.35

$3.79

$4.37

$5.04

$5.81

x(1+Forecasted earnings growth)

 

7.40%

13.10%

15.28%

15.28%

15.28%

15.28%

=Forecasted earnings per share

 

$3.35

$3.79

$4.37

$5.04

$5.81

$6.69

        

Equity Book Value Forecasts

       

Equity book value at beginning of year

 

$22.39

$24.48

$26.91

$29.81

$33.26

$37.35

Earnings per share

 

$3.35

$3.79

$4.37

$5.04

$5.81

$6.69

-Dividends per share

 

$1.26

$1.36

$1.47

$1.59

$1.71

$1.85

=Equity book value at EOY

$22.39

$24.48

$26.91

$29.81

$33.26

$37.35

$42.19

        

Abnormal earnings

       

Equity book value at begin of year

 

$22.39

$24.48

$26.91

$29.81

$33.26

$37.35

x Equity cost of capital

9.00%

9.00%

9.00%

9.00%

9.00%

9.00%

9.00%

=Normal earnings

 

$2.02

$2.20

$2.42

$2.68

$2.99

$3.36

        

Forecasted EPS

 

$3.35

$3.79

$4.37

$5.04

$5.81

$6.69

-Normal earnings

 

$2.02

$2.20

$2.42

$2.68

$2.99

$3.36

=Abnormal earnings

 

$1.34

$1.59

$1.95

$2.35

$2.81

$3.33

        

Valuation

       

Future abnormal earnings

 

$1.34

$1.59

$1.95

$2.35

$2.81

$3.33

x discount factor(0.09)

 

0.917

0.842

0.772

0.708

0.650

0.596

=Abnormal earnings disc to present

 

$1.23

$1.34

$1.50

$1.67

$1.83

$1.99

        

Abnormal earnings in year +6

      

$3.33

Assumed long-term growth rate

      

3.00%

Value of terminal year

      

$55.53

        

Estimated share price

       

Sum of discounted AE over horizon

 

$7.56

     

+PV of terminal year AE

 

$33.11

     

=PV of all AE

 

$40.67

     

+Current equity book value

 

$22.39

     

=Estimated current share price

 

$63.06

     

As you can see, the model produces a fair value of $63 for shares right now based upon the inputs I described above. As shares, after yesterday's pounding, are trading around $4 below that number, they would appear to offer some value. But before we run out and hit the 'buy' button, we need to understand what we're looking at.

To start, the model produces a fair value and not a price target. The distinction is important as the model is indicating that shares are worth $63 right now based upon the inputs I described. This is not the same as a price target, which for WAG would be somewhat higher depending on your outlook. In other words, you can buy WAG for any price under $63 today and you should be getting a good value for your investment. As we are at $59 at the time of this writing, it would appear long investors are in good shape.

However, I'd be remiss if I didn't mention the spate of news items we received yesterday and their impact on the company's shares. To start, WAG cut its guidance for 2016, much to the dismay of analysts. While the guidance cut isn't severe, in my view, Wall Street certainly took the news hard and killed shares, in part, because of it. However, if you look at my model above, the $4.25 to $4.60 guidance given is right in line with what I show analysts were forecasting anyway. Thus, I find the reaction to this news to be unwarranted and I encourage investors not to be alarmed by the guidance.

The company also announced a massive $3B share repurchase program yesterday, which Moody's responded to by putting the company's debt on review for downgrade. We'll have to wait and see what Moody's does but for WAG shareholders, this move will be good enough to buy back about 5.3% of the company's float, a worthy reduction indeed. I love buybacks so I'm happy that WAG is putting some cash to work by reducing the float and even though Moody's doesn't like it, I'm not sure any equity investors actually care what they think anyway, having missed enormous red flags leading up to the crisis. At any rate, this is a net positive for shares in my view.

Finally, there is the big one; the announcement that WAG will indeed purchase the remainder of Alliance Boots and that it will keep its headquarters here in the US instead of inverting to the UK in favor of lower taxes. Time will tell how the AB purchase plays out but from what I've read, it appears significant cost savings in the neighborhood of $1 billion annually are likely, which would represent a worthy improvement in the combined company's operating margin if it comes to fruition. This deal was telegraphed a long time ago and I don't think anyone is surprised the deal finally came through; this really wasn't a news event in my view since we knew it was coming.

The other piece of that puzzle, however, was the news that WAG has chosen not to invert to the UK. I believe this was the bulk, or perhaps the entirety, of the reason shares were crushed yesterday as the move to the UK would have netted enormous tax savings for the company. As it sits currently, no such savings will accrue to the company. However, if you consider the value that was destroyed yesterday, roughly $9.5 billion, and the tax savings that may have accrued from the inversion deal, I think it was an overreaction. It isn't as though WAG would have paid no taxes or something of that nature; management guided yesterday for taxes in the high 20% range and if the inversion had occurred, we'd probably be talking about the high teens or so, given the UK's lower tax rate on businesses. And while this would have been a terrific savings, the curious part of the story is that WAG never said it was going to invert. In fact, this was simply a rumor that obviously never came to fruition.

I think what we have with WAG is a case of a stock that got way ahead of fundamentals due to the inversion story and the AB alliance. Let's face it; WAG was expensive until yesterday on the idea that the inversion story would play out and save the company enormous sums of money. That story, it turned out, didn't occur and shares were pummeled for it. However, I think this is ultimately good news for shareholders, new ones at least, as it means the business is actually fairly priced now. Earlier this week, when shares were $72 area, they were very expensive. It was almost like the fervor of M&A speculation on WAG; the company's shares were trading at nosebleed valuations because of a rumor. However, now that the distraction is behind the company, we are left to evaluate the business and it looks pretty good right now. I like WAG after the selloff as the speculators are gone and we are left with investors looking for value; I think they've found it in WAG.

Source: Walgreen: What To Do After The Bloodbath