Much has been made of Walgreen's fight with Express Scripts and Express Scripts' subsequent denial of a new benefits contract with Walgreen's. Walgreen's stock has been pummeled. Is this an overreaction or is the big haircut deserved? To answer the question we have to look inside the numbers.
First let's look at Walgreen's pharmacy business. The pharmacy accounts for 65% of the company's business. For fiscal 2011 Walgreen's filled 819 million prescriptions or 1 in 5 retail prescriptions in the United States. Express Scripts accounted for roughly 88 million of those prescriptions. Of those 88 million, Walgreen's has secured new agreements(dropped Express and stayed with Walgreen's) with about 10 million. So Walgreen's will lose about 78 million prescriptions because of the Express Scripts situation. That would be a 10% reduction in total prescriptions approximately. So using a little fuzzy math and some generalization, Express Scripts accounts for 6.5% of Walgreen's revenue. A recent NYT article states it is 7% of revenue. Same difference.
The crux of the matter comes down to one thing; Does a 6.5% reduction in revenue from last fiscal year make Walgreen's as a business worth 25% less, which is the amount the stock has declined since the original announcement? Logic and common sense say no. But as a wise man once said, 'Common sense ain't all that common.' Another possible justification for the price decline would be that Walgreen's was already overvalued and that the news about Express Scripts was just the catalyst for the sell off. Let's look into this explanation as well.
Using a discounted cash flow model*, Walgreen's was worth $65.33 a share before the Express Scripts contract dispute. The stock was trading between $45 and $46 a share just prior to the announcement, so you could argue that it was undervalued prior to the announcement. Obviously the Express Scripts departure will have some effect on Walgreen's future cash flows, so what is Walgreen's stock worth now? I'd say, once again using fuzzy math and the discounted cash flow model, a very conservative $52.22 a share. I calculated this by accounting for both Express Scripts past contributions to cash flows as well as an absence of those cash flows in the future. In other words, I backed out both past and future cash flows that could be attributed to Express Scripts. Sounds complicated, doesn't it? Well it wasn't. I simply input a reduced growth rate in cash flows into my calculator. Since the growth rate is based in part on past performance, reducing the rate helps account for reduced cash flows in both past and future. Basically I took the projected 15% annualized growth in cash flows over the next 5-10 years and cut it down to 8% annualized growth. A very conservative estimate considering that Express Scripts accounted for 6.5% of revenue last year. A more accurate figure would be 12-13% annualized cash flow growth, but I erred on the side of caution.
Walgreen's common stock closed at $32.63 on Friday, January 13th. That's roughly 63% below what I believe the company is worth, conservatively. Warren Buffett, a name everyone is familiar with, generally looks for companies that are undervalued by 40% or more. He adjusts that figure on occasion, paying up for quality. While I could argue that Walgreen's is worth paying up, say purchasing when it is 20-30% undervalued. At 63% below fair value, I believe Walgreen's to be a screaming buy.
And that's just on a strict numbers argument. Take into account, at present, that it has only two real competitors in the national brick and mortar pharmacy/retail space; CVS and Walmart. I'm sure some would argue that the grocery store space has expanded into the pharmacy space. But in most cases, the pharmacies located in grocery stores are there to draw additional traffic in to buy more groceries. If they happen to turn a profit, it's a bonus. Walgreen's, CVS, and Walmart view pharmacies as either their primary business or as a business segment that can contribute a lot to the bottom line. CVS has poor management according to my metrics when compared to Walgreen's. Walmart, while well managed, cannot easily open a store in downtown Chicago or New York without significantly changing their business model or through possible acquisition. Walgreen's is well entrenched in both small and big town America already. In addition, it's business model is well suited for expansion into dense population centers. As long as there is a need for physical brick and mortar pharmacies, Walgreen's will do well. They have a long history of creating shareholder value across several management regimes and I have no reason to believe that they will not continue to do so in the foreseeable future.
*discounted cash flow model – a model that attempts to estimate a present value on future growth. It uses net income figures in it's estimates and backs out more ethereal statistics like depreciation and amortization while keeping expense figures like R&D and Capital Expenditures.
Note - Statistics taken from Walgreen's 2010 and 2011 annual reports as well as an Associated Press article written by Tom Murphy entitled “Walgreen pushes to keep Express Scripts clients, Walgreen unveils plan to keep Express Scripts clients after contract between companies ends” December 31, 2011. Price and growth calculations were calculated using vuru.co website's DCF calculator.
Comments
Kos, I bless any buy of WAG below 40. lol Good luck! I'll be joining you soon as long as it stays below 40.
Drewski I pulled the trigger since it made a higher low. 1/2 size @ $34.48 stop below last weeks low.
Not to mention what would happen if WAG got the contract back again down the road. *lol* Great post Drew. Thank you very much!
Ryan and Kos, your questions are valid and intuitive. However any answers are hard to quantify. I can offer my opinion and feelings on the matters, but no hard numbers. In my DCF calculation I cut cash flow growth to half of the so-called historical CF growth rate to compensate for these unknowns. I tried to overestimate ESRX's impact in other words. This should (over)compensate for both pharma and retail impacts. I think that management knows what they are doing. Take the short term lumps to avoid the long term bumps(in the road). Like I said, the answers are based more on feelings and opinion than something more quantifiable. WAG has demonstrated an ability to navigate difficult environments over the years and I feel they will navigate through this situation at least adequately. If they continue to increase their web presence and at least keep their present relationships with benefits managers and insurance companies, they will be just fine over the long run.
I have to wonder.......if RX represents 65% of WAG income, how much of the 35% [in-store sales] were generated by ESRX customers themselves when picking up their scripts. idk but could be a reason why the stock was punished more than expected.
as a side note ill point out the chart pattern i see. the 2008,2010 and 2011 lows are ridding a support line. if we also take the last 2008 peak, 2009 high and 2011 high are another resistance line. id call that a valid channel. it would be a $10-15 price projection if it broke out of that range.
seems a bit extreme to me but if WAG got to $15 id certainly start looking for buy points. the long term chart makes me think of a more volatile WMT. a 90's rock star that has had to pay the price of excessive partying. this probably adds to the caution over the express fallout.
i like the work drew. as with anything i have questions.
It is stated that express represents 6-7% of revenue. My question is, how much of express scripts products represented future expected growth? are their products high growers and the rest of the portfolio stagnant? also a question of margins; does this narrow or expand margins? does it mean they'll get bullied in future deals and have to cut a less favorable deal (i.e. margin compression)? my way of thinking is yes and for a company with sub 4% margins that can potentially hurt.
I don't think WAG is going anywhere but i do thing these are valid questions that people are asking (or perhaps they know and i don't). would love to hear your thoughts on these issues.