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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.
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