On Friday, June 22nd, I initiated what I would consider a full position in Walgreen (WAG) at $29.80. In a previous article here I discussed the four "pillars" of my portfolio; Walgreen will become the fifth pillar.
Walgreen, as I am sure most of you know, is the leading drug store in the United States with approximately 8,000 stores in the United States and Puerto Rico. Walgreen is also the owner of Take Care Health Systems a Walgreen' subsidiary that is the largest manager of worksite health and wellness centers, with more than 700 locations throughout the country. In addition, Walgreen owns the websites Drugstore.com, Beauty.com and VisionDirect.com.
As I mentioned in previous articles, when I buy stock in a company, I am looking for Good Valuation, Dividend Growth, a Wide Moat and a Catalyst that may propel the stock higher. I believe Walgreen currently has all these elements. Let's take a look at each of these elements and see why I think Walgreen is offering a rare opportunity for long term dividend growth as well capital gains.
Valuation - Walgreen closed Friday, June 22nd at $29.57, which is approximately 33% off of the 52 week high of $44.26. The price has fallen back as Walgreen has been involved in a protracted dispute with Express Scripts (ESRX) over the cost of filling prescriptions within the Express Scripts network. The contract between the two companies was terminated in January, and since then Walgreen has seen sales fall as the number of prescriptions filled has also fallen. In the most recent quarter, Walgreen reported sales fell 3.4% from a year ago (Here).
Walgreen currently has a P/E of 10 and a PEG (price to earnings growth) of 1.09, both of which are historically very low. In fiscal year 2011 Walgreen had Diluted Earnings per Share of $2.94, which was a gain of 38.7% over 2010 (Here). Although the Express Scripts dispute has hurts sales, I believe this will be short term as Walgreen has stated they are taking action to move on from the dispute. Here is a recent statement from Walgreen concerning their dispute with Express Scripts, "Walgreen plans to work with other PBMs and with health plans to recapture Express Scripts script volume over time. We believe those PBMs and health plans with Walgreen in their networks will be at a significant advantage during next year's selling season." (More on the Express Scripts dispute here) More importantly, I also believe, as I will discuss in more detail later that Walgreen is in the process of transforming the company away from the old drug store concept.
Dividend Growth - Using David Fish's excellent The DRIP Investing Resource Center (here) we find that Walgreen is a dividend champion having raised its dividend 36 consecutive years with a ten year average dividend growth rate of 18.9%. On June 19th, Walgreen announced a dividend increase from an annual rate of $0.90 to $1.10 a share, an increase of 22.5%, payable September 12th. That will then make 37 straight years of dividend growth. Walgreen has stated they intend to maintain a dividend payout range of 30 to 35 percent of their net earnings to shareholders (here). When it comes to dividend growth, Walgreen easily passes the test.
Approximate # Stores
$2,91 per share
$2,59 per share
Loss $0.43 per share
As you can see the two largest and the two most profitable companies are Walgreen and CVS, Rite Aid has struggled with profitability for years and is not real a threat to Walgreen or CVS. In essence, Walgreen and CVS operate as a duopoly in the drug store business. Granted, companies like Wal-Mart and others have entered the pharmacy business, but as a pure drug store play, Walgreen has a significant moat.
Catalyst - This is the key to my investment thesis, although I do believe Walgreen is selling at a very good valuation, pays a generous and growing dividend, and does operate in a business with a wide moat to entry, without this catalyst I may not be as interested in the stock as I currently am.
I believe Walgreen is in the middle of a significant transformation of their business which will completely change how one thinks about Walgreen. I believe Walgreen has decided the old drug store model of dispensing prescriptions and offering some front end sales is not going to be as profitable in the future. It is Walgreen intention to turn their drug stores into "Health and Wellness Stores".
In 2009, Walgreen announced their "Plan to Win." The plan focused on leveraging the best store network in America; enhancing the customer experience; and achieving major cost reduction and productivity gain. The goal is to become America's most trusted and convenient provider of consumer goods and services and pharmacy, health and wellness solutions. The first step in this transformation began with a re-imaging of their stores. To date Walgreen has re-imaged over 5,000 stores into the Customer Centric Retailing initiative. The new stores have shown improved sales and customer satisfaction. The stores offer more fresh healthy foods, wellness clinics that offer basic health care like flu-shots, various health screening, an updated check out experience and more customer services in the beauty and pharmacy areas.
The second part of this transformation occurred last week when Walgreen announced they were purchasing 45% of Alliance Boot Group, a leading international pharmacy led health and wellness group. The deal includes the option to purchase the remaining 55% of Alliance Boot in three years. In announcing the deal, the companies referred to the combined business as "The First Global Pharmacy-Led Health and Wellbeing Leader."
Alliance Boot has 3,300 health and beauty stores, operates 370 pharmaceutical wholesale distribution centers, and develops its own beauty products like No7, and Soltan, the leading European sun protection product. Under the Boots name, it is the leading European pharmacy store with stores in the United Kingdom, Norway, Republic of Ireland, the Netherlands, and Lithuania. It is also growing its presence in emerging markets in Asia, Turkey, Egypt, and through a joint venture in China. It also operates Boots Opticians with 625 practices in the United Kingdom. Alliance Boot has grown earnings 88% in the last five years and has grown free cash flow. Walgreen has forecast that the merger will be immediately accretive to earnings by $0.23 - $0.27 a share in fiscal year 2013. The above merger information can be found here.
Together, the two companies will be the world's largest purchaser of prescription drugs, which should allow them price flexibility with the manufacturers. They will have 11,000 retail stores in 12 countries. The strong portfolio of beauty products produced by Alliance Boots will be expanded throughout the Walgreen' network. Their respective private label brands will be expanded throughout the new retail network. I believe the combination of these two companies will result in the world's first and largest pharmacy health and wellness store chain that will continue to grow for many years.
Action Taken - On Friday, June 22nd, I purchased Walgreen for $29.80, I bought a full position with one purchase because I wanted the stock below $30.00 and all day Friday it bounced between the $29.00 and $30.00. I am happy with the $29.80 cost basis and am fully confident the price will rise over time. As with most stock I buy, this will not be a rocket ship, I believe I may have to wait three years to see the full affects of Walgreen transformation reflected in the stock price. But in the mean time I am collecting a 3.7% dividend that will continue to rise over the years.
I believe unique investment opportunities occur very infrequently. And I believe this is one of those opportunities. Walgreen is an established leading company selling at a historically low P/E, entering into a deal that will make them a leading "worldwide" company and that is immediately accretive to earnings. We know when the merger is completed, they will have greater pricing flexibility, more outlets to sell their private label brands and more countries to expand in. We also know they have historically raised their dividend every year and have stated they have every intention to continue raising the dividend in the future. I am looking forward to owning Walgreen as they transform and grow the company.