Why are Cooperman and Soros Shopping in Walgreens?

Leon Cooperman and George Soros recently bought into Walgreens (WAG), the nation's largest retail pharmacy, providing consumer goods and services along with health and wellness services through a large network of drug stores across the United States. The company’s strengths can be seen in multiple areas such as its good cash flow from operations, reasonable debt levels, and its recognizable store brand. Walgreens, historically, is one of the most recession-proof companies in the economy, operating in an industry based on providing necessities consumers use in everyday life. A current P/E of 13.5 and forward P/E of 9.7 for a counter-cyclical is quite cheap. Also, their operating cash flow has doubled in the last year as a result of higher demand for the company’s products stemming from positive changes in the pharmaceutical industry and an aging demographic group constantly in need of pharmacy service.



The Hidden Value in Walgreens: In-store Clinics

The stock is attractively valued with a forward P/E of 9.7, trading at a major discount to its respective industry and main competitors. Walgreens' current P/E ratio of 13.5 is below the S&P 500 P/E ratio of 17.7 and that of its closest competitor CVS (NYSE:CVS), which carries a P/E ratio of 15.6. Walgreens' hidden value comes from its well-recognized brand name and established convenient store base, where customers associate Walgreens with consistent and dependable products that meet their daily needs.

The company, furthermore, has a huge new opportunity with in-store health clinics, which can provide basic care more cheaply than doctor’s offices and hospitals. In the Obama Care era, there is a higher demand for cheaper health care than ever so if Walgreens can pull off the creation of in-store clinics, it has potential to draw more customers to its business. The company currently trades at a price of $36.10, up 28% from its 52-week low of $28.53.

Expanding Margins on Declining Debt

Walgreens' debt-to-equity ratio fell and now stood at 0.30. The company has historically had a strong balance sheet and improving margin levels. Walgreens' slowing store growth expects to result in higher margins, a smart move considering that most new stores often post losses in their first years, which cuts into profitability. The company’s product mix shift from branded drugs to generic drugs is also helping to support growing margins between the new generic drugs and old branded drugs, further expanding Walgreens' margins.

Increasing Demand Lifting Operating Cash Flow

Net operating cash flow has significantly increased by 112.15% to $768 million when compared to the same quarter last year. Health-care spending growth, the aging population, and the generics wave provide secular tailwinds that boost Walgreens' cash flow results. Pharmacy traffic continues to increase as an aging U.S. baby boomer generation, with 10,000 people turning 65 years old every day, has resulted in increased demand for prescription drug offerings.

“While we controlled costs and generated strong cash flow in the fourth quarter, our performance also reflected a strategic shift in promotional spending,” said CEO Gregory Wasson of Walgreens. Much of the promotional spending can be attributed to the fact that the company is targeting its older customer and promoting its pharmaceutical services. Additional revenue synergies are being generated from the sharing of best practices, particularly in pharmacy operations, health and wellness services and logistics.

The Conflict with Express Scripts

On the negative side, the disputes between Walgreens and pharmacy benefit manager (PBM) Express Scripts (ESX) is putting a dent in Walgreens' sales, as the company has always depended on the majority of its revenue from customers’ prescription drug plans. Walgreen’s sales declined 0.7%, to $71.6 billion, reflecting lost customers due to a pharmacy benefit management conflict with Express Scripts. Walgreens and Express locked horns in 2011 over a payment dispute which cost Walgreens more than $4 billion in the annual revenue. In June of last year, the two companies began a battle over contractual payment issues, which left the two companies to part ways. Millions of the Americans with Express drug plans were left to search for a new pharmacy. Walgreen’s admitted to investors that regaining customers lost from its contract dispute with Express, which was going to be a tough sled. Pharmacy customers tend to be sticky and most patients had little incentive to return to Walgreens after transferring their prescriptions elsewhere. Following the fallout, fourth-quarter net income fell 55 percent to $353 million, the dip in net income obviously related to the loss of business from the Express contract dispute. The stock's valuation continues to be somewhat suppressed from average historical values after the company lost customers following the expiration of its pharmacy benefit management contract with Express.

Competitors Threatening to Take Business Away

Walgreens, with its decline in revenue, underperformed the rest of the pharmaceutical industry. Since the same quarter one year prior, revenues slightly dropped 5%. Weakness in the company's revenue seems to have hurt the bottom line, decreasing earnings per share. On the other hand, CVS experienced revenue growth of around 5% in the last year. This is troubling considering that CVS stores tend to operate within the same vicinity as Walgreens. There’s a good chance that if you have a Walgreens in your area, there’s also a CVS. Walgreens, in particular, also lagged CVS in updating its stores to a more attractive and consumer-friendly format. Increased competition between the retail pharmacies are further eroding Walgreens' economic moat in the drug store retail industry. Pharmaceuticals, in general, account for a tiny portion of diversified retailers' total sales, in contrast to Walgreens, which relied on prescription drugs for nearly two thirds of its revenue. Continued pressure on revenue may limit Walgreens' upside, especially when its price is currently trading near its 52-week high of $37.35.

Reasonable Valuation on Depressed Revenue

Wall Street has diverse opinions about the company's future. Among analysts, seven rate Walgreens as a buy while nine rate the company as a hold. The company once boasted reliable double-digit revenue growth and remarkably steady sales. But those days are long gone as the country has become saturated with Walgreens stores and therefore, competitive pressure has intensified. However, Walgreens' strengths of strong operational cash flow combined with low debt levels outweigh the fact that the company has had subpar growth in net income. The company still hopes to continue benefiting from the aging population, the generics wave, and a stable customer base. With attractive valuation based on depressed revenue, Walgreens could be a quality stock on sale.

Disclosure: Authors have no position in the stocks discussed above.

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