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Published: July 6, 2010
A recent spat between the two largest
drugstore chains in the nation has sent the shares of each
company to the bargain bin. In the case of one, the stock has
approached levels not seen for a decade even though sales and
earnings have both grown in the low double digits during that
timeframe.
That consistency spans a period containing two major recessions,
brought on by the Internet and housing bubbles. But no matter
the economic climate, individuals need to have prescriptions
filled and even tend to buy cosmetics and other basic
merchandise on their way to the checkout line from the pharmacy
at the back of the store.
The two firms in question are Walgreen (NYSE: WAG) and
CVS Caremark (NYSE: CVS). Walgreen recently announced
that it would steer new customers away from CVS' pharmacy
benefit management (PBM) business, which processes and pays
prescription drug claims among other things, and toward its
competitors instead. CVS responded in kind by dropping all
Walgreen customers. The two have since made up, but the damage
had already been done to both firms' shares.
Both Walgreen and CVS are appealing investments at current share
price levels, but CVS has a more uncertain outlook given a
number of controversies in its PBM business from the acquisition
of Caremark back in 2007.
Walgreen is a purer play on retail drugstores, though it has
also had to adapt to a more competitive industry and reach
customers through its own PBM business, worksite and home care
facilities, as well as specialty pharmacies. But despite the
added delivery channels, the sale of prescription drugs drives
the company and has accounted for 65% of total sales for each of
the last three fiscal years.
Many see Walgreen's store base as mature and slow growing.
However, the company believes it can still double its store
presence in the United States. This is supported by the fact
that it is far from reaching saturation in many markets and that
demographics highly favor increased prescription drug usage,
given the aging U.S. population. Recent healthcare legislation
will also bring millions of formerly uninsured individuals into
the industry, which is expected to increase demand for
pharmaceutical drugs and related healthcare services.
Overall, Walgreen is a compelling
investment as it combines growth potential with sales and profit
stability. Better yet, because of the short-term issues
identified above and a quarterly earnings miss, the valuation is
extremely favorable. The forward P/E is just over 12 times
earnings, and the multiple has continued to shrink during the
past decade as the stock has been relatively flat and earnings
have grown +12.5% annually during this period.
Another positive is that management has used the recession as an
opportunity to wring costs out of operations. As a result,
operating
cash flow has nearly doubled in the past couple of years.
Last year it came in at $4.1 billion. Subtracting out capital
expenditures of $1.9 billion and
free cash flow of about $2.2 billion, or $2.25 per diluted
share, this puts the trailing free cash flow multiple at less
than 12 -- a compelling value.
Action to Take ---> It's
difficult to find a safer investment than Walgreen. Other firms
may have higher upside potential as their operations are tied
more closely to a business cycle that will improve significantly
in a recovery. However, the timing of that improvement is
uncertain and the economy could stall out numerous times before
a recovery fully takes hold.
No matter the economic climate, Walgreens will continue to fill
prescriptions and expand its retail foothold across the United
States. If it can continue to grow profits in the double digits,
then the shares are undervalued by at least 50%.
-- Ryan Fuhrmann
Contributor
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