The pharmaceutical industry landscape will change dramatically in the coming years. By 2016, generic alternatives will become available for some of the highest revenue drugs, including products such as Lipitor®, Plavix®, Seroquel®, Actos® and Singulair®, as the patents on those drugs expire. Estimates of the amount of worldwide revenue impacted by drugs going off-patent over the next five years range from about $80 billion to $250 billion; a significant percentage of the over $850 billion worldwide pharmaceuticals market. In addition to the “patent cliff” faced by branded pharmaceuticals, long awaited regulations providing an approval pathway for biosimilar drugs as alternatives to patent-protected brand name biologic drugs may further open the door to more generic drugs. With about 120 drugs going off-patent over the next ten years, the growing percentage of generics appears to represent a long term trend. This trend will pressure the sales and earnings of some companies, but may benefit others. Industries subject to rapid change often prove highly inhospitable to investors as unpredictable conditions frustrate efforts to assess underlying business values and durable competitive advantages. And failing to properly assess underlying business value and competitive advantage violates the first two rules of investing (Rule#1, don’t lose money, Rule#2, don’t forget Rule#1). However, it appears that changes in the pharmaceuticals arena are unlikely to infect the stability of the major drugstore chains that after years of consolidation now dominate their industry. Indeed, as retailers earn higher profit margins on generic prescriptions than their branded counterparts, drugstore chains may actually benefit from the increase in the number of generic prescriptions that they can be expected to fill in the coming years. Possible beneficiaries of this situation are the two companies that fill the largest number of prescriptions in the U.S., Walgreen Co. (WAG) and CVS Caremark (NYSE:CVS). In the case of Walgreens, current conditions make it particularly worthy of consideration.
Walgreens’s stock price is down recently, at least in part due to a dispute with pharmacy benefits manager Express Scripts (NASDAQ:ESRX) that led the two companies to end their business relationship (a situation likely to be further magnified when Express Scripts merges with Medco). Of course, relative stock prices have no real meaning to an analyst (a stock that was overpriced before a significant drop in price, may still be overpriced and, in fact, may not be a good company to invest in at any price). Investors who focus on stock prices, just like investors who focus on movements of the overall stock market, are making the classic error of confusing price and value. The issue for the long term investor is whether Walgreens is available at a price that bears a rational relationship to the underlying intrinsic value of the company to deliver a superior return on investment (in other words, the exact opposite approach to that of speculators in the Internet bubble). It is the ability to discern the difference between the price of a company and its underlying value as a business that allows one to purchase at a price below value, thus achieving the “margin-of-safety” urged by Ben Graham. It is only with such a margin-of-safety that an investor can minimize risk, when risk is properly defined as the likelihood of permanently losing money--recalling the first two rules of investing noted above. And any investment that does not minimize risk should be considered a poor choice regardless of its ultimate performance (a gambler may be up one day but his luck will eventually run out). Of course, to reasonably estimate the intrinsic value of a company (and it is always just that--an estimate), one has to have a fairly high degree of certainty about what the company will look like in 10, 15 or 20 years, hence the need to assess durable competitive advantage.
Merely operating in an industry with long term favorable prospects, such as the drugstore industry, does not alone guarantee a company’s success. Long term investment results tend to correlate to competitive advantages that endure over long periods of time (to verify this one need only compare the long term stock returns of leading branded product manufacturers such as Coca-Cola and Wrigley to those of companies that manufacture commodities). A company that lacks a durable competitive advantage will receive no benefit even as the industry in which it participates grows because some if not all of that growth will be attributed to its competitors. Only companies with such a durable competitive advantage are likely to consistently generate high returns on capital and sustainably grow their earnings over time.
Durable Competitive Advantage
Determining whether a company has a competitive advantage is difficult and determining whether that competitive advantage is truly durable is many times so. In industries subject to rapid change, such as most industries that rely heavily on new technological developments, it becomes almost impossible to make such an assessment. However, assessing competitive advantage must be performed on a case by case basis.
One good test for whether a company holds a durable competitive advantage is whether the company can be seriously harmed by a competitor that is not concerned with profits. Most retailers cannot survive that test as retailers often emulate one another and compete aggressively on the basis of price. Although Walgreens operates in a highly competitive environment that includes other drugstore chains such as CVS and Rite Aid, big box retailers, such as Walmart, and grocery stores, mom and pop drug stores, and internet sites, Walgreens appears to have developed a privileged position. Walgreens is the largest drugstore chain in the United States with 8,210 locations and $72.2 billion in sales in the fiscal year ended August 31, 2011. The average Walgreens store writes more prescriptions than the average CVS store, Walgreens closest competitor, allowing it to generate more customer traffic.
Determining whether a company has a durable competitive advantage requires both a qualitative analysis and a quantitative analysis. In assessing the long term economics of Walgreens from a qualitative perspective, one will note that it has a long and consistent operating history with strong brand recognition, excellent locations and a high level of service that has allowed it to forge strong relationships to its customers. Although it is a retailer, it has built a recognizable and valuable brand. Despite the many alternative avenues for customers to purchase pharmaceuticals, Walgreens enjoys high customer loyalty. Walgreens’ durable competitive advantage is quantitatively evidenced by its growth and consistently high return on equity (with relatively little debt), even in the face of increasing competition over the past few years:
|Year||Revenues ($mil)||Earnings ($mil)||Return on Average Equity (%)|
As shown above, earnings have grown at a pace of about 11% annually for the past 10 years. And returns on equity have been consistently above 15% for most of the past 15 years. Especially noteworthy is the company’s growth and high returns in recent years despite aggressive price competition from larger retailers such as Walmart and Target. Although establishing a durable competitive advantage in an industry subject to substantial and rapid change is difficult, Walgreens appears to have accomplished just that.
Just as investors must make rational decisions in allocating their capital, a company’s management must also behave in a rational manner as it allocates the company’s capital. In its dispute with Express Scripts, Walgreens refused to agree to Express Scripts pricing terms on prescription products. Similar to GEICO’s decision in the 1970s to refuse to write unprofitable policies even though it would lose market share, Walgreens’s decision not to write unprofitable prescriptions though it will likely reduce revenues appears to be a rational business judgment. Unlike many managers who seek growth at any price, Walgreens’s management appears to be making a business judgment that prioritizes long term shareholder value of the company over short term expansion.
The rational business owner purchases a company for the earnings that company will produce for the owner over time. Although there are several ways to estimate the value of a company, the most applicable way for a long term investor to estimate the intrinsic value of a company is to view it from the perspective of a long term business owner and look at the sum of future owner earnings that the company will generate over time and discount those earnings to their present value (using a reasonable discount rate that approximates a risk free rate of return--for example, that of the 30-year U.S. treasure bond). This provides an objective approach like valuing a bond. It is plain to see the necessity of a fairly predictable earnings stream to determine underlying business value in this manner. A durable competitive advantage is critical to this level of predictability.
The table below illustrates a two-stage model for estimating intrinsic value using a growth rate of 5% and a discount rate of 7% (as current 30 year U.S. treasury bonds yield a historically low rate, a more typical rate is used) for the next ten years, with growth leveling off after 10 years to 3% and using a 10% discount rate to compute a residual value. Owner earnings refers to actual cash earnings available to the owner--adding non-cash charges back to net income and taking capital expenditures into consideration. In this instance, however, net income approximates owner earnings, therefore, net income is used in the calculation.
|FY Year Ending||Estimated owner earnings ($mil)||Et/(1+k)t||Present Value ($mil)|
|Sum of Present Values||$20,494.73|
|Residual value after 10 years:|
|earnings in year 11||3,883.04|
|capitalization rate (k-g)||10%-3%=7%|
|value at end of year 10||$55,472|
|discount factor at end of year 10||0.5083|
No matter how strong a company’s economics, it is essential to pay the correct price to achieve a desired rate of return. One can only pay a correct price once one knows the intrinsic value and then compares that to the currently available market price.
Margin of Safety: Price vs Value
The first objective with every investment should be to avoid risk. Contrary to popular belief, this cannot be accomplished by diversification--indeed diversification likely adds to risk by diluting one’s ability to assess the economics of each business. In contrast, purchasing stock in a company at a discount to its value provides a margin of safety to protect against mistakes in judging the economics of the business and consequently its future earnings. At a previous closing price per share of $32.63 and with 873,500,000 shares outstanding, the total market capitalization of Walgreens is about $28.5 billion. This is about a 59% discount to the above estimate of the company’s current intrinsic value of $48.7 billion.
Disclosure: The author owns shares of Walgreen Company and CVS/Caremark.