Due to inelastic market demand, pharmacies are commonly viewed as a safe bet against an uncertain domestic economy. But Walgreen's (WAG) recent horrifying debacle proved that this is not always the case. Still, there are significantly undervalued firms like Assured Pharmacy (OTCQB:APHY) and HealthWarehouse.com (OTCQB:HEWA) out there that are selling at bargain prices. As an investor relations consultant, I anticipate that these under-followed firms will generate meaningful returns from greater press coverage. Towards that end, I plan on writing focus pieces on these undervalued gems at a later time.
In the meanwhile, larger firms like Walgreen will receive a disproportionate amount of attention. In this article, I will run you through my DCF analysis on Walgreen and then triangulate the result with an exit multiple calculation and a review of the fundamentals compared to Rite Aid (RAD) and CVS Caremark (CVS).
First, let's begin with an assumption about revenues. Walgreen finished FY2011 with $72.2B in revenue, which represented a 7.1% gain off of the preceding year. Analysts model an 8.6% per annum growth rate over the next half decade - reasonable in light of it being around 200 basis points below what is expected for the S&P 500.
Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I expect cost of goods sold to eat 72% of revenue versus 22.5% for SG&A. I model capex trending from 2% to 1.5% over the half decade projection period. Taxes are estimated at 37% of adjusted EBIT (accounting for non-cash depreciation charges).
We then need to subtract out net increases in working capital. I estimate that this will hover around 0.5% of revenue.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 9.35% yields a fair value figure of $31.07, implying around 10% downside. I find this WACC through the capital asset pricing model wherein the unlevered beta is calculated at 1.06.
All of this falls within the context of strong performance despite losing the Express Scripts:
As you saw in our release this morning, we reported record first quarter sales of $18.2 billion, up 4.7% from $17.3 billion a year ago. First quarter net earnings were $554 million, and first quarter earnings per diluted share were $0.63. Compared to the prior year, the delay in cough/cold and flu season impacted net earnings per diluted share by $0.01, while the strategic decision to no longer be part of Express Scripts pharmacy network as of January 1, 2012, cost $0.01 per diluted share in comparable pharmacy sales and $0.01 per diluted share in related expenses. Cash flow from operations for the quarter was $809 million, and free cash flow was $309 million. We returned $803 million to shareholders in the quarter, including the largest dividend payment in the company's history, and $601 million in stock repurchases, up nearly 18% over the first quarter last year.
From a multiples perspective, Walgreen is decently attractive. It trades at a respective 11.7x and 11.8x past and forward earnings versus 17.6x and 12.4x for CVS.
Assuming a multiple of 13x and a conservative 2013 EPS of $3.59, the rough intrinsic value of CVS is $46.67. The company is gaining momentum off of Walgreen losing Express Scripts. The number of transfers from Walgreen to CVS has also been higher than anticipated. It demonstrated strong execution in the fourth quarter with $700M worth of free cash flow generated - yet again better than expected.
Rite Aid, on the other hand, may be a takeover target. The latter is working on reigning in losses and going under a strong brand name would speed up the process. Analysts are currently expecting that the firm will still lose $0.18 per share in three years from now. For investors looking to benefit from higher risk-adjusted returns, Rite Aid is an attractive bet.
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.