Walgreen (WAG) has lost more than 25% of shareholder value since six months ago. The Express Scripts (ESRT) fiasco has generated a great deal of uncertainty and has overly depressed positive developments, as I illustrate here. There has been some speculation in the media and by analysts that the pharmaceutical company could buy out Rite Aid (RAD). This would be an interesting transaction in light of the latter's net debt and losses. With that said, I find some plausibility in a transaction.
From a multiples perspective, Walgreen is incredibly cheap. It trades at a respective 11.4x and 10.7x past and forward earnings while offering a dividend yield of 2.7%. Management has shown a commitment to returning free cash flow to shareholders and buying out Rite Aid may compromise the effort. The company has increased its dividend by the highest amount it ever has a few months back. Walgreen has also reached, and even exceeded, its $1B target for cost savings in the 3-year Rewiring for Growth initiative. On the other hand, investors are concerned about pharmacy comps and Rite Aid has seen improvement.
At the third quarter earnings call, Rite Aid's CEO, John Standley, noted:
"Based on our strong third quarter results, we are raising our adjusted EBITDA guidance… One of the most important initiatives for this quarter was our immunization program. We had over 11,000 certified immunizing pharmacists in place by the time our flu immunization campaign kicked off in August, giving us the ability to offer flu shots at every Rite Aid pharmacy for the first time in our company's history. As a result of this well-planned and executed program, we administered 1.4 million flu shots to date, more than doubling the 675,000 shot last year, which helped us grow our same-store script count and pharmacy sales. We're also on pace to achieve our goal of administering more than 1.5 million flu shots this year.
Our customer loyalty program, wellness+, continues to be an enormous success, thanks to the program's robust reward structure and the overall Rite Aid's team commitment to making sure our customers know what wellness+ has to offer. We now have more than 47 million customers enrolled in the program, of which, 74% used their card in the last 26 weeks and 54% used their card more than once in the last 26 weeks".
This is the stuff that turnaround stories are made of. It was the fourth straight quarter that same store sales and EBITDA grew. Front-end SSS were flat while pharmacy SSS grew by more than 2.9%. Note that Walgreen is anticipated to have just the reverse: it will be flat in pharmacy in SSS from 2012 - 2014, but grow by an annual average of 3.7% in front end SSS during that same time period. A combination could thus bridge one another's challenges and boost shareholder value in the process.
Other highlights for Rite Aid's third quarter include the normalization of gross margins, expense control, and 1.8% year-over-year sales growth. SG&A as a percent of revenue declined by 36 basis points despite the investments made in Wellness+. 2 stores were relocated; 119, remodeled; and 18 closed. While the third-quarter results generally beat expectations, analysts were still expecting better margins expansion and trimming of SG&A.
In particular, Rite Aid's Wellness+ customer loyalty program offers meaningful sustainability and would be an attractive catalyst to make up for Walgreen's lost business from Express Scripts. Wellness+ enrolled over a staggering 47M by the end of the third quarter and is still growing rapidly. I am anticipating that ROIC will accelerate to 17.3% by 2013, a more than 1,100 bps improvement. On the other hand, the fact that leverage will be flat may preclude buyout activity. Net debt currently stands at $6.2B, 5.6x market value. Walgreen only has $1.6B worth of cash, which is exceed slightly by its debt.
Consensus estimates for Rite Aid's EPS are that losses will shrink by 39.1% to -$0.39 in 2011 and then by 17.9% and 34.4% more in the following two years.
As for Walgreen, I anticipate that the company will grow ROIC to around 19% by 2013 as its cost base is reduced and revenue expands (click here for a graphical illustration of this). The company's multiples are well below the historical average and after the ESI impact is better understood, it is an uphill story from there.
Consensus estimates for Walgreen's EPS are that it will grow by 6.8% to $2.82 in 2012 and then by 10.3% and 10.6% more in the following two years. Assuming a multiple of 14x and a conservative 2013 EPS of $3.06, the rough intrinsic value of the stock is $42.84, implying 27.9% upside. Even if the multiple were to hold steady at 11.4x and 2013 EPS turns out to be 3.9% below the consensus, the stock would still not decline. The Street currently rates it a "buy".