Note: This report contains substantially new information. Subsequent reports will have changes highlighted.
Reason for Report: 2Q14 Earnings
Previous Ed.:Jan 21, 2014; 1Q14Earnings (broker material considered till Jan 7, 2014)
Brokers’ Recommendations: Positive: 61.9% (13 firms);Neutral: 28.6% (6); Negative: 9.5% (2) Prev. Ed.: 12; 7; 1
Brokers’ Target Price: $68.72(↑$6.32 from the last edition; 18 firms) Brokers’ Avg. Expected Return: 2.4%
*Note: Though dated Apr 23, 2014, share price and brokers’ material as ofApr 3, 2014.
*A Flash Update on ‘2Q14 Earnings’ was done onMar 25, 2014.
Note: The tables below for Revenue, Margins, and Earnings per Share contain fewer brokers’ material than the brokers’ material used in the Valuation table. The extra figures in the Valuation table come from reports that did not have accompanying spreadsheet models.
Portfolio Manager Executive Summary
Walgreens (WAG) operates retail drugstore chains in the U.S. These drugstores sell prescription and non-prescription drugs, and general merchandise. General merchandise includes beauty care, personal care, household items, candy, photofinishing service, greeting cards, seasonal items, and convenience food. Customers can have prescriptions filled at the drugstore counter as well as through telephone, mail and the Internet.
Of the 21 firms covering Walgreens, 13(61.9%) assigned positive ratings,6 (28.6%) provided neutralratingsand 2 (9.5%) conferred a negative rating on the stock.
Positive or equivalent outlook (13/21firms):Despite mixed 2Q14 results, these firms adopt a bullish stance on Walgreens owing to its widespread footprint and strong business fundamentals. The firms are of the opinion that the company will gaingood returnswith a more favorable generic cycle and greater tangible benefits from the loyalty card investment for FY14.The bullish firms are optimistic about improvement in business trends in the future. They are also optimistic about the benefits of the Alliance Boots partnership and AmerisourceBergen deal over the long haul. These firms especially are hopeful about the incremental benefits the company should achieve from the Alliance Boots synergies in FY14.The firms are positive that Walgreens will gain significantly from the improved supply chain performance on a global basis on account of the deal with AmerisourceBergen. These firms are also enthusiastic about management’s commentary on Walgreens’ timely progress toward attaining synergy targets following the first year of the Alliance Boots deal. They also expect significant accretion from the deal and expect the company to achieve its synergy target of $1 billion through FY16.Moreover they are optimistic about increasing benefits from the company’s Balance Rewards program going forward and are encouraged by its strategic initiatives to improve financial results.These firms view positively Walgreens’s ability to leverage its store assets by expanding services such as diagnostic testing across its stores. They also derive comfort from the company’s cost control measures.At the same time they are upbeat about the company’s strategy of shutting down almost 1% of its stores in 2H14. They are of the view that this step will lead to Walgreens holding a better positioned store portfolio.According to these firms, the healthcare reforms in the U.S. have led to increased prescription volumes from the beginning of calendar year 2014. Based on these tailwinds, the firms are confident about Walgreens ability to meet its set goal for FY16.
Neutral or equivalent and Negative outlook (6/21 firms):These firms remain on the sidelines on account of the sluggish recovery of Walgreens partially due to severe winter weather, slower generic trends and weaker flu season. For most of the firms, earnings missed their forecasts, while for some firms the it was at par with their estimates. However, these firms are optimistic about the company’s increased focus on high margin products to accelerate its core organic growth. They are skeptical about the pending acquisition of Alliance Boots in 2015 as the same represents a meaningful change in the business model. Besides, they consider the strategic long-term deal with AmerisourceBergen as a long-term growth driver. Presently, one of the major concerns of these firms is the slowdown in the introduction of generic drugs in the industry. Although these firms expect the introduction of generics to expand the company’s margins significantly, they are wary about the generic wave hampering the company’s top line. According to these firms, the gross margin in 2Q14 lagged their expectations. They do not expect the gross margin to improve in the next two quarters due to low new generic drug introduction rate, high promotional expenses, investment in the loyalty card program and tough competition in the market. The cautious firms also believe that Walgreens might not be able to win back all its Express Scripts customers lost during the impasse. While these firms are wary about Walgreens’ ability to win back all of its previous Express Scripts customers lost during the impasse, they expect the company to return to its growth trend on account of the multi-year agreement with the latter. These firms are also contemplating that Walgreens might increase its focus on returning cash to shareholders through increased dividend and meaningful share repurchases. They consider the retail pharmacy market highly competitive and believe that Walgreens might struggle to gain market share in the future. In the end, these firms reckon that the stock is appropriately valued given the clouded business environment.
Apr 23, 2014
Overview
Overview
Headquartered in Deerfield, IL Walgreens is principally a retail drugstore chain that sells prescription and non-prescription drugs and general merchandise. Generalmerchandise includes, among other things, household items, convenience and fresh foods, personal care, beauty care, photofinishing services andcandy. Customers can have prescriptions filled in retail pharmacies as well as through the mail, and may also place orders by telephone andonline.
As of Feb 28, 2014, Walgreens operated 8,681 locations in all 50 states, the District of Columbia, Puerto Rico and Guam and the U.S. Virgin Islands, including 8,210 drugstores (138 more compared with the year-ago period). The company also operates infusion and respiratory service facilities, worksite health and wellness centers, specialty pharmacies and mail service facilities. Its Take Care Health Systems subsidiary manages more than 750 in-store convenient care clinics and worksite health and wellness centers. The company’s website is The company’s fiscal year ends on Aug 31; all calendar references differ from the fiscal year.
The firms identified the following factors for evaluating the investment merits of WAG:
Key Positive Arguments / Key Negative ArgumentsHealth & Wellness Division: Walgreens is strengthening its health and wellness division with acquisitions and is growing its presence in specialty pharmacy, which has substantial growth potential. / Express Scripts Win: Although Walgreens’ efforts are focused to compensate for the losses incurred since the termination of the Express Scripts deal, winning back clients remains crucial. While Walgreens is optimistic on this count, most of the firms adopt a cautious stance on account of intensified client retention efforts by its competitors.
Initiatives: The company is constantly introducing strategic initiatives to boost growth. Many firms are encouraged with Walgreens’strategic partnership with Alliance Boots to form the world’s first pharmacy driven health and wellbeing retail. Besides the recently formed alliance with AmerisourceBergen is considered as another upside. / Regulations: The continued efforts of health maintenance organizations (HMOs), managed care organizations, PBMs, and other third party payors, including government agencies such as Medicaid, to cut costs by reducing prescription drug costs and reimbursement rates could pose a threat to Walgreens’ future operating performance.
Strong Balance Sheet: Based on a strong balance sheet, the company returns value to shareholders through dividends and share repurchases. Moreover, a strong cash balance augurs well for acquisitions. / Low Generic Drugs Introduction Rate: Walgreens is facing low front-end sales due toconsiderable low introduction rate of new generic drugs.
Improved Supply Chain: The long-term deal with AmerisourceBergen is another upside. The firms are sanguine about improved supply chain performance in the next fiscal. Moreover, they are encouraged by the expected accretion from this deal.
Apr 23, 2014
Long-Term Growth
Walgreens has long been considered as one of the premier chains in the drug retailing industry with its superior execution and strong position in many major U.S. drug store markets that provide it with a significant sharein managed care. It is an industry leader commanding impressive market share and high levels of execution and brand loyalty, which position it well tocapture growth off the aging baby boomers and a government-led expansion of prescription drug coverage.
Over the past several years, Walgreens has taken a number of strategic steps to stimulate customer demand amid a challenging macroeconomic scenario. Subsequent to acquiring a 45% stake in Alliance Boots GmbH for $6.7 billion, this leading retail pharmacy chain acquired a mid-South U.S.-based regional drugstore chain for $438 million. While some firms take note of these bold strategic moves, others are of the view that the Alliance Boots deal could lead to a loss of focus from the current issues in the U.S. Walgreens also partnered with a number of hospitals and health systems to improve patient care, provide greater access to important pharmacy and healthcare services, and reduce costs.
The firms are also encouraged to note the company’s consistent efforts to support the positive momentum going forward. During the 2Q13 conference call, Walgreens had disclosed a 10-year comprehensive primary distribution agreement with AmerisourceBergen for branded and generic products effective Sep 1, 2013, to improve its global pharmaceutical supply chain. In addition, the company will team up with AmerisourceBergen on worldwide supply chain opportunities. The company is also expecting to establish a leading position in the $7.4 billion immunization market.
On Jan 8, 2014, Walgreens announced its plans for strategic developments in FY14. The management is expecting the U.S. health care spending to grow 3% to 20% of gross domestic product by 2020. Aging population and health care reforms are considered to be the major tailwinds. Walgreens is planning to capitalize on the shift in payment models to pay-for-performance in health care. In an effort to strengthen its foothold in the $2.6 trillion health care market, the company will focus on three strategic growth drivers: creating a new and improved store format called Well Experience, advancing community pharmacy and establishing an efficient global platform on behalf of its customers and shareholders.
Walgreens has been increasing its focus on customer care. Along with great infrastructure, Walgreens store with‘Well Experience’ employs people to provide excellent guidance to customers about the product. The number of stores based on this concept has increased to 600 during 2013.
Management also announced their strategy for enhancing health care services by advancing community pharmacy. The company plans to increase the number of stores with health care services, enter into strategic partnerships with healthcare service providers and focus on certain chronic diseases.
Management is also strengthening its presence globally. Walgreens and Alliance Boots will utilize their resources to achieve this goal. Walgreens is aiming to make the global pharmaceutical distribution channel more efficient. It is focusing on establishing leading positions in markets beyond the U.S and Europe and also in some of the emerging markets.
FY16 Outlook: During the 1Q14 conference call, Walgreens listed its long-term goals. It expects to record revenues of $130 billion through FY16. Adjusted operating income is envisaged at around $99.5 billion, while adjusted operating cash flow of about $8 billion and total synergy goal of $1 billion are expected for FY16. The bullish firms are optimistic about the company achieving its long-term goals.It also expects a combined net debtof $11 billion at the end of fiscal 2016. The company was also of the opinion that they will review the components of significant measuresin accordance with their progress mix and opportunities across each of these measures.
The firms believe that the company’s financials continue to be strong and that Walgreens is progressing steadily towards achieving its FY16 goals.
The firms believe that key drivers for long-term growth include the improved supply chain due toAmerisourceBergen relationship, incremental Alliance Boots synergies, and new initiatives along with accelerated cost savings. With the current generic wave, the generic prescription drug volume growth is projected to accelerate over the next few years. The firms also believe that there will be good return with a more favorable generic cycle and more tangible benefits from the loyalty card investment.
Walgreens is optimistic about the financial and operational benefits from the AmerisourceBergen deal for FY14 with margin expansion and bottom-line accretion. Given this backdrop, the firms are also optimisticabout the long-term deal which should boost Walgreens’ presence in the retail drug purchasing space.
Apr 23, 2014
Target Price/Valuation
Rating DistributionPositive / 61.9%↑
Neutral / 28.6%↓
Negative / 9.50%↑
Avg. Target Price / $68.72↑
Maximum Target / $90.00↑
Minimum Target / $30.00
No. of Analysts with Target price/Total / 18/21
Upside from current / 2.4%
Maximum Upside from current / 34.1%
Minimum Downside from current / 55.3%
Risks to the target price include lower than forecasted growth in the retail business, increased industry regulation or changes to the existing health care law, or a material loss of business, weak front-end business compelling the company to take a promotional stance, or inability to meet the synergy goals.
Recent Events
On Mar 25, 2014, Walgreens reported fiscal 2Q14results. Highlights are as follows:
Walgreensreported adjusted EPS of $0.91 in 2Q14, down 5.2% y/y.
Revenues in 2Q14 increased 5.1% y/y to $19.6 billion.
Guidance: The company estimates that accretion from the Alliance Boots deal in 3Q14 will be an adjusted $0.13–$0.14 per share. Further, it estimates the joint synergy program to deliver second-year combined synergies of $375-$425 million
On Apr 3, 2014, Walgreens announced signing a definitive agreement with Water Street Healthcare Partners LLC allowing the latter to acquire a majority interest in Take Care Employer Solutions, LLC. Simultaneously, Water Street signed another agreement to invest in CHS Health Services. Moreover, Water Street has planned to merge Take Care Employer Solutions and CHS Health services. The new company will comprise nearly 500 worksite health and wellness centers across the U.S. and will cater to the needs of around 200 leading corporations. Financial details of this transaction, which is expected to close by mid-2014, remain undisclosed.
Walgreen will hold a significant minority interest in the new company while Water Street will own a majority stake in the same. Moreover, Walgreen’s representatives will be present on the new company’s board of directors.
However, Walgreen does not expect the transaction to be accretive to its earnings per share in fiscal 2014.
Revenue
Revenues in 2Q14increased 5.1% y/y to $19.6 billion. The Zacks Digest total revenue in 2Q14was in line with the company’s report.
Provided below is a summary of segment revenue as compiled by Zacks Digest:
Revenue ($ in million) / 2Q13A / 2013A / 1Q14A / 2Q14A / 3Q14E / 4Q14E / 2014E / 2015E / 2016EDigest Average / $18,647.0 / $72,217.0 / $18,329.0 / $19,605.0 / $19,194.6↓ / $18,867.1↓ / $75,809.7↓ / $79,073.3↓ / $97,448.8
Digest High / $18,647.0 / $72,217.0 / $18,329.0 / $19,605.0 / $19,350.0↓ / $19,152.0↓ / $76,436.0↓ / $80,258.0↓ / $127,668.0
Digest Low / $18,647.0 / $72,217.0 / $18,328.5 / $19,605.0 / $19,011.9↓ / $18,626.2↑ / $75,254.5↓ / $77,786.7↑ / $80,407.4
Y/Y Growth / 0.0% / 0.8% / 5.8% / 5.1% / 4.8%↓ / 5.2% / 5.0%↓ / 4.3%↓ / 23.2%
Same-Store sales / 7.7% / 2.2% / 7.0% / -2.1%↓ / -1.7%↓
Store growth / 1.4% / 4.3% / 3.6% / 3.8% / 4.3%
Total sales in comparable storesimproved4.3% y/y in 2Q14, while front-end comparable store sales (those open for more than a year) rose2.0% y/y. In addition, customer traffic in comparable stores was down 1.4% while basket size increased3.4% in the quarter. The company is optimistic about the front-end comparable store sales owing to the impetus of strategies and the recent promotional decision designed to balance traffic, basket size and profitability.
Prescription sales (accounting for 62.2% of sales in 2Q14) moved up 7.0% y/y, and prescription sales in comparable stores increased 5.8%.Moreover, during the quarter, Walgreens filled 214 million prescriptions (up 2.8% y/y). Prescriptions filled at comparable stores raised2.2% y/y. Walgreens gained retail prescription market share by 20 basis points (bps) to 19.0% in 2Q14.
The drug stores at Walgreens alsoadminister flu vaccines and other immunizations. The company sold 8.6 million flu shots during 2H14. Moreover, it continued to make good progress in the non-flu vaccine market.
MarchSales Details: Walgreens posted 4.5% y/y sales growth to gross $6.43 billion in the month.
Total front-end sales decreased 2.6% y/y and comparable store front-end sales declined 3.4%. The major reason behind the decrease was the delayed timing of Easter which coincided with March 31 in 2013 compared to April 20 in 2014. Customer traffic in comparable stores decreased 4.0% whereas basket size increased 0.6% y/y.
Prescriptions filled at comparable stores increased 5.1% (or up 4.2% on a calendar day-shift adjusted basis). According to Walgreens, a calendar shift led to a 0.9% increase inprescriptions filled at its comparable stores in March as the month had one additional Monday and one lesser Friday than the same month a year ago.
Walgreens experienced a negative impact of 0.3% on prescriptions filled at comparable stores due to a lower incidence of flu in March. Moreover, total comparable sales also suffered by 0.2% on account of the same reason.
Meanwhile, total sales in comparable stores rose 3.5% on a y/y basis. The calendar day shifts increased comparable store sales by 0.6% while the generic wave in the pharmaceutical industry over the last 12 months led to an adverse impact of 1.0% on comparable store sales.