Walgreen Co. (WAG)

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Walgreen Co.(WAG)

• Matthew McDonnell
• Contributions by James Herr

14-September-2006
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Company Overview

• Founded in 1901 by Charles Walgreen
• 1st store in Chicago
• Currently 5,251 stores operating in 45 states and
  Puerto Rico
• Median store age is approx. 5.4 years old
• 131, 400 employees as of 11/30/2005
• Avg. years of experience for store managers is
  12.6 years
• Goal is to have 7,000 stores by 2010

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Company Overview

• David Bernauer
• Chairman of the Board since 2003
• Chief Executive Officer since 2002
• President and Chief Operating Officer from
  1999-2003
• Has been with Walgreens since 1966
• Jeffrey Rein
• President and Chief Operating Officer since 2003
• Has been with Walgreens since 1974
• George Eilers replaced by Kevin Walgreen,
  great-grandson of Charles Walgreen, as Senior VP
  of Store Operations (Southern Region) in early
  2006 due to Mr. Eilers retirement
• Eilers had been with Walgreens for 46 years
• Kevin Walgreen has been with company since 1979
• William Rudolphsen
• Senior Vice President and Chief Financial Officer
  since 2004
• Has been with Walgreens since 1977

Source Data Walgreen Co. Jan. 11, 2006 Annual
meeting and www.walgreens.com
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RCMP Position

• Own 1000 shares in Walgreens
• Purchased at 25/share on 10/06/1999
• Cost Basis is 25,000
• Stock is now trading at 49.31/share
• Valued at 49,310
• Represents 13.75 of portfolio MV
• Gain of 24,310, or 97.24

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Macroeconomic Overview- General Economy

• Earlier this summer, the markets trended downward
  due to a number of factors
• Uncertain economic outlook stemming from repeated
  releases of conflicting economic indicators
• Repeated non-official statements made by Federal
  Reserve Board members regarding the health of the
  economy, possible future actions
• See May 1, 2006 on-air comments by CNBC reporter
  Maria Bartiromo
• Continuing political uncertainty and worries
  regarding oil supplies as violence increased in
  Iraq and Iran defied US and UN fueled higher
  energy prices and muted hampered US and world
  equity markets

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Macroeconomic Overview- General Economy

• Since mid-July, the markets have trended somewhat
  higher on high volume but gains have not been
  substantial
• The market as a whole currently feels that a
  pause in interest rate hikes is indeed likely
• One of the leading inhibitors for better
  performance remains continued uncertainly
  regarding the health of the economy stemming from
  conflicting economic indicators
• See Friday, September 8, 2006 release of cost of
  wages and economic growth

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Macroeconomic Overview- Trailing 6 Month Market
Performance
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Macroeconomic Overview- Demographics

• Aging Population
• Around 36 million people are 65
• 12.6 of the total U.S. population
• 17.6 live in Florida
• By 2030, there will be almost 72 million people
  65
• Retirement of Baby Boomers
• Currently, around 77 million Baby Boomers
  representing almost 27 of the population
• Over 50 of Baby Boomers live in CA, TX, NY, FL,
  PA, IL, OH, MI, NJ
• Americans begin to start taking more drugs in
  their early 50s

Source Data www.metlife.com
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Macroeconomic Overview- Political

• Medicare Part D prescription drug program
• In effect as of January 1st, 2006
• Prescription Drug coverage
• Covers both generic and prescription drugs for
  those who qualify for Medicare
• Designed to protect those with high drug costs
• May allow pharmaceutical industry to create new
  drugs that are safer and more effective
• At this point it is too early to tell how the new
  plan will affect Walgreens, as the kinks are
  being resolved

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Drug Store Industry

• Decreasing customer loyalty
• Relationship with customers deteriorating
• Customers now have more convenient or
  economically viable options
• Generic drugs seen as a low-cost alternative to
  name-brand prescription and non-prescription
  medications Mail order threat
• Walgreens is combating the mail order threat by
  offering customers a choice between 90-day mail
  order prescriptions and 90-day at retail option,
  known as Advantage90
• Advantage90 is currently offering prescriptions
  at 10 discount to 90-day mail orders

Source Data Walgreen Co. Jan. 11, 2006 Annual
meeting
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Drug Store Industry

• Highly Competitive Industry
• Competition with other drugstore chains,
  independent drugstores, mail order prescription
  providers, internet pharmacies
• Other competitors include various grocery stores,
  mass merchants, and dollar stores
• Main competitors
• CVS Corp. (CVS)
• Recently purchased 700 stand alone Sav-On and
  Osco drugstores through its 9.7 billion buyout
  of Albertsons Inc.
• This move will give CVS a significantly greater
  Midwest foothold
• Rite Aid Corp. (RAD)
• Partial competitor
• Wal-Mart (WMT)
• Pharmaceutical more than grocery department
• In FY 2004, Pharmaceuticals were 9 of Wal-Marts
  sales
• In total, about 6 billion/year (25) less in net
  sales than Walgreens

Source Data Wal-marts 2004 10-K
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Porters 5 Forces Drug Store Chains
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Competitors
Source Yahoo! Finance available at
http//www.finance.yahoo.com
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Interesting Facts

• Earnings
• The average grocery store earns 12/ sq. ft.
• The average drug store chain earns 20/sq. ft.
• Wal-Mart earns 26/sq. ft.
• Walgreens earns 46/sq. ft.
• Prescriptions (average per store)
• Grocery stores fill 131 prescriptions/day
• Mass retailers fill 143 prescriptions/day
• Chain drug stores fill 180 prescriptions/day
• Walgreens fills 263 prescriptions/day
• Walgreens fills more prescriptions than all
  grocery stores combined!

Source Data Walgreen Co. Jan. 11, 2006 Annual
meeting
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Strategy

• Enter new markets
• Dense up existing markets
• Organic store growth
• Relocate
• Remodel
• Invest heavily in high-tech store and
  distribution systems which drive service up and
  costs down
• An agile elephant Must continue to find ways
  to leverage the benefits of scale without losing
  the ability to react quickly to changes in
  customer needs
• Healthcare offerings beyond that of a traditional
  pharmacy
• Offer an online drugstore web site totally
  integrated with our retail stores
• Attract and maintain top talent

Source data www.walgreens.com
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Strategy

• Growth, Growth, Growth!
• Walgreens is currently increasing their net
  stores operated by approximately 1 store per day
• The company, which currently operates 5,156
  stores, plans to operate at least 7,000 stores by
  2010
• All this expansion is funded by cash flow from
  operations, as opposed to long-term debt or
  equity issuances

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Innovations

• Introduced freestanding stores in early 1990s
  with drive thru pharmacies
• Today, more than 80 of Walgreen Co.s stores
  have drive thru pharmacies
• Nation-wide 1 hour photo service
• Available at more than 98 of stores
• New Digital Photo Service
• Allows you to upload your photos at home and pick
  them up at any Walgreens store 1 hour later!
• Much time and effort has been put into this
  project so that they stay ahead of competition
• Touch tone prescription refills

Source data www.walgreens.com
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Innovations

• Largest private user of satellite technology
• Second only to the United States government
• Today, 125 million people live within 2 miles of
  a Walgreens
• Walgreens plans to increase their business by
  investing in prime locations, technology, and
  customer service initiatives

Source data www.walgreens.com 2005 10-K
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Products
Source data Walgreen Co. 2005 10-K
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Walgreens Locations by State
Source data www.walgreens.com
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Positioning

• Walgreens well positioned for Baby Boomer era
• Top 5 states with largest number of stores
• 1 Florida with 673 stores
• 2 Texas with 530 stores
• 3 Illinois with 500 stores
• 4 California with 419 stores
• 5 Arizona with 223 stores
• Over 50 of Baby Boomers live in FL, TX, IL, CA,
  NY, PA, OH, MI, NJ

Source Data www.metlife.com
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New Workings

• Medicare Part D prescription drug program
• Walgreens has recently integrated a program into
  their computer system that lets the pharmacists
  look at a patients list of drugs and match the
  patient with the Medicare drug program that will
  be most cost-effective for them
• Best of all, its free!
• New Acquisitions
• Walgreens recently acquired SeniorMed, an
  assisted living prescription business in hope
  that it will give them a big boost in a
  business area where they had previously lost
  customers
• In addition, WAG is now partnered with TakeCare
  and InterFit to operate small clinics in WAG
  stores

Source Data Walgreen Co. Jan. 11, 2006 Annual
meeting
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New Workings

• Dial-A-Pharmacist (in 14 languages)
• Automatically connects a patient with a Walgreens
  pharmacist somewhere in USA who speaks that
  particular language
• Highway Signs
• New Federal Regulations are allowing 24-Hour
  pharmacies to put up signs on major highways
  (Just like McDonalds and Shell)
• Walgreens already has 7 put up in Illinois
• Solar powered roofs
• Walgreens will begin to start using solar powered
  roofs in 100 of their stores
• These will allow each store to generate 20-50 of
  its own electricity.

Source Data Walgreen Co. Jan. 11, 2006 Annual
meeting
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Porters 5 Forces Drug Store Chains
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SWOT Analysis
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5 Year Performance
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10 Year Performance
Adjusted for stock splits and dividends
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20 Year Performance vs. SP 500
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5 Year Performance vs. SP 500
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5 Year Performance vs. Competitors
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Walgreens vs. Portfolio
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Correlation Matrix
Note Table assumes equal-weighted portfolio
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Fit With RCMP PortfolioAppraisal Ratios

• Appraisal ratio
• Risk-adjusted measure of excess returns
  provided by a security
• alpha/(std error2)
• Suggests user add (short) the security if alpha
  is significant and appraisal ratio is greater
  than alternatives

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Appraisal Ratios
Note alpha for all 3 securities above is not
positive with 95 certainty but is significant at
slightly lower levels of confidence
Source Data Yahoo! Finance
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Relative Multiple Analysis

• Growth Implied by PEG Ratios

• Here we see that the market has already priced
  significant growth into Walgreen stock.
• Unless the firm can grow almost 18 annually ad
  infinum, the stock will likely undergo a
  correction.

Source Data Yahoo! Finance
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Relative Multiple Analysis

• Here we see that Walgreens P/E Ratio is high not
  only to the market but also its industry.
• This serves as additional evidence of the
  significant premium the market has placed on
  the firms stock.

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Valuation Process of a DCF

• To refresh, intrinsic value of a firms common
  equity is determined as follows
• Forecast free cash flow over a period of X years
  and a terminal value via
  FCF final period(1LT growth
  rate)/WACC-LT Growth Rate
• Calculate WACC via (weke)wdkd(1-tax rate)
• Discount all cash flows and arrive at enterprise
  value viaS1N FCF i/(1WACC)i
• Subtract LT debt from enterprise value
• Divide by common shares outstanding to get price
  per share

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Valuation Step 1 Forecasting Free Cash Flows
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Valuation Step 2 Calculating WACC

• Sensitivity to WACC is a major issue for most DCF
  models, and is of extraordinary importance when
  modeling Walgreen Co.
• I will revisit this topic later in the
  presentation
• Since WAG is 100 equity, WACCke. Below is ke
  (and thus, WACC) calculated via CAPM

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Valuation Step 3 Finding Enterprise Value
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Steps 4 5Subtract LT Debt and Divide by
Shares Outstanding

• Step 4 Subtract LT Debt
• This step is not necessary as the firm is 100
  equity
• Step 5 Divide by Shares Outstanding

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• HOWEVER

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Accounting Rules vs. Economic Reality

• WAG only owns approximately 18 of its store
  base. What about the other 82?
• They are leased. These leases are
  structured/accounted for as operating leases.
• This means that although these leases (and other
  minor off-balance sheet obligations) carry
  significant future commitments (26.078 billion),
  these commitments are not counted as liabilities
  on the firms balance sheet.
• So are these commitments LT debt?
• Liabilities
• probable future sacrifices of economic benefits
  arising from present obligations of a particular
  entity to transfer assets or provide services in
  the future as a result of past transactions or
  events FASB Concept Statement 6, paragraph 5
• Answer YES! These are (economic) liabilities!

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Accounting for Significant Off-Balance Sheet
Liabilities

• The most precise method of accounting for these
  operating leases would be to back the costs of
  rent out of Selling, Operating, and
  Administrative Expenses (SOA) and restate the
  firms financials as if they owned the stores
• This would entail separating interest expense,
  depreciation, and amortization
• In addition to restating the firms financials,
  the analyst would need to calculate a new WACC,
  estimating a weight and cost of debt
• Unfortunately, the firm does not provide nearly
  this level of information so we must pursue
  other, less precise methods

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Adjusting ROE An ad hoc solution

• Although academic theory holds that a firms
  value is not affected by its capital structure1,
  this is not the case in reality
• Modigliani and Millers theory does not account
  for, among other things, taxes or the increasing
  marginal barrowing rates associated with
  increasing leverage
• Therefore, investors should demand a return in
  excess of the ke-derived WACC we used earlier to
  compensate them for the risk associated with
  WAGs quasi-leverage

1. For more information, see The Cost of
Capital, Corporation Finance and the Theory of
Investment.F Modigliani, MH Miller . The
American Economic Review. 1958. American Economic
Association
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CAPM, ROE, and Everything In-Between

• Below we have 2 measures of ke CAPM, and ROE

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CAPM, ROE, and Everything In-Between

• Below is a matrix listing possible combinations
  of WACC and LT Growth and the corresponding stock
  prices

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Importance of ROE Sensitivity

• The stocks current price of approximately 49.00
  is supported only when assuming unrealistically
  high LT Growth or an unrealistically low WACC
  (i.e. CAPM ke or below).
• Due to the risk associated with the firms LT
  (economic) debt, I do not feel CAPM WACC is an
  appropriate measure and thus WACC must be
  adjusted upward to account for this risk.
• THESE TWO FACTORS PRODUCE SIGNFICANT DOWNSIDE
  RISK FOR THE STOCK PRICE

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Recommendation

• I recommend that 50 or 500 shares of WAG be sold
  at the market
• I feel WAG is currently trading at a
  significantly inflated price that, in the long
  term, cannot be sustained
• Why not sell it all?
• WAG currently has considerable momentum, having
  beaten analyst EPS estimates for 3 consecutive
  quarters. Retaining some portion of the stock
  exposes us to the potential upside of continued
  momentum
• Walgreen has always traded at a premium price
  and thus, we cannot know if, when, and to what
  degree these premiums will evaporate

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Negating Scenarios

• WAG posts a Q4 that beats analyst consensus
• Although I feel such a scenario is unlikely due
  to both heightened expectations and the firms
  Q1-Q3 margins, such an accomplishment would no
  doubt propel stock price in the short-term
• CVS posts poor results and/or fails in new
  initiatives
• As WAGs main (and only real) competitor, a CVS
  failure will allow WAG to increase pricing power
  and will decrease pressure to expand
• WAG makes a key unexpected acquisition into a
  business line in which CVS does not operate
• With competition within the drug store industry
  becoming increasingly competitive, any
  opportunity for a player to enter a profitable
  business area in which the other does not operate
  will give the firm a first mover advantage, as
  well as pricing power not available in the
  duopoly environment.

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• Questions?