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Walgreen Co. (WAG)


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Title: Walgreen Co. (WAG)

Walgreen Co.(WAG)
  • Matthew McDonnell
  • Contributions by James Herr

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

Company Overview
  • David Bernauer
  • Chairman of the Board since 2003
  • Chief Executive Officer since 2002
  • President and Chief Operating Officer from
  • 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
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

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

Macroeconomic Overview- General Economy
  • Since mid-July, the markets have trended somewhat
    higher on high volume but gains have not been
  • 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

Macroeconomic Overview- Trailing 6 Month Market
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
  • 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
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

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
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
  • In total, about 6 billion/year (25) less in net
    sales than Walgreens

Source Data Wal-marts 2004 10-K
Porters 5 Forces Drug Store Chains
Source Yahoo! Finance available at
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
  • 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
  • Offer an online drugstore web site totally
    integrated with our retail stores
  • Attract and maintain top talent

Source data www.walgreens.com
  • 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
  • All this expansion is funded by cash flow from
    operations, as opposed to long-term debt or
    equity issuances

  • 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
  • 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
Source data Walgreen Co. 2005 10-K
Walgreens Locations by State
Source data www.walgreens.com
  • 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
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
  • In addition, WAG is now partnered with TakeCare
    and InterFit to operate small clinics in WAG

Source Data Walgreen Co. Jan. 11, 2006 Annual
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
Porters 5 Forces Drug Store Chains
SWOT Analysis
Strengths Innovative in controlling costs and expanding sales Expanding store base to reach more markets Has made efforts to serve growing non-English-speaking communities Experienced management Weaknesses No prior experience managing current growth rates Cost/benefit analysis of firms extremely rapid growth difficult to determine
Opportunities Rapidly expanding elderly demographic New innovations in Medicare may increase sales Little competition in nursing home services Large proportion of US w/o health insurance, may be drawn to low-cost in-store clinics Threats Business susceptible to severity of cold/flu season Possible competition from online sources May face difficulty in passing costs onto consumers b/c Medicare/insurance companies
5 Year Performance
10 Year Performance
Adjusted for stock splits and dividends
20 Year Performance vs. SP 500
5 Year Performance vs. SP 500
5 Year Performance vs. Competitors
Walgreens vs. Portfolio
Correlation Matrix
Note Table assumes equal-weighted portfolio
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

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
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

Source Data Yahoo! Finance
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.

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

Valuation Step 1 Forecasting Free Cash Flows
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
  • Since WAG is 100 equity, WACCke. Below is ke
    (and thus, WACC) calculated via CAPM

Valuation Step 3 Finding Enterprise Value
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
  • Step 5 Divide by Shares Outstanding


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!

Accounting for Significant Off-Balance Sheet
  • 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

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
CAPM, ROE, and Everything In-Between
  • Below we have 2 measures of ke CAPM, and ROE

CAPM, ROE, and Everything In-Between
  • Below is a matrix listing possible combinations
    of WACC and LT Growth and the corresponding stock

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.

  • 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
  • Walgreen has always traded at a premium price
    and thus, we cannot know if, when, and to what
    degree these premiums will evaporate

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
  • 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.

  • Questions?
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