Investors in Walgreen (NYSE: WAG ) have watched their stock rise more than 50% in 2013, but is there more to come in 2014? The key to answering this question lies the development of its strategic partnerships with pharmaceutical distributor AmerisourceBergen (NYSE: ABC ) and European pharmacist Alliance Boots. (NYSE: CVS ) Furthermore, its deal with Theranos offers a disruptive threat to part of Quest Diagnostics' (NYSE: DGX ) and LabCorp's (NYSE: LH ) operations. There is a lot going on at Walgreen as it strives to reach its long-term strategic objectives.
Walgreen's long-term plan
The plan is based on five key financial targets for the fiscal year 2016. Revenue (including its share of a fully purchased Alliance Boots and joint ventures) is expected to reach $130 billion, with adjusted operating income of $9.0 billion to $9.5 billion. Meanwhile, the operating cash flow target is $8 billion with net debt expected at $11 billion. Finally, synergies from its partnerships are expected to reach $1 billion.
It's time to put these targets into context by playing with some assumptions. Walgreen currently has 949 million shares in issue, and expects to issue around 228 million shares in order to acquire the remaining 55% of Alliance Boots. This means that Walgreen could have around 1,177 million shares in issue.
The company's trailing 12 month operating income is $4,159 million, and its enterprise value (market cap plus debt) is $58.8 billion, or around 14.1 times operating income. Assuming that Walgreen hits $9 billion in operating income in 2016, and taking the current 14.1 times ratio as a benchmark, that means its enterprise value could be around $126 billion in 2016. Stripping out the $11 billion in debt leaves a market cap of around $115.9 billion, and if there are 1,177 million shares in issue, this implies a share price of $98.
Furthermore, even from a cash flow perspective, Walgreen looks attractive if it can hit its targets. Its current enterprise value is 13.7 times last year's operating cash flow. Assuming the $8 billion operating cash flow target for 2016, means that Walgreen could trade on an enterprise value of $109 billion. Stripping out the forecast $11 billion in debt gives you a share price target of $83.
All of which is wonderful, as these two targets represent a 70% and 45% premium to the current share price, but will Walgreen hit its targets?
Walgreen, AmerisourceBergen and Alliance Boots
On its recent conference call, Walgreen's management discussed the 2016 operating income target, and declared that its performance to date "is currently tracking a bit below the CAGR required to meet this goal." However, CEO, Greg Wasson went on to say:
...we think that we have got ways to achieve those goals. The CAGR on the operating adjusted income is a little bit soft but we think the change in the mix of the business will allow us to get it.
Future macroeconomic conditions will obviously play a part, and there is little that Walgreen can do about that. However, there are three reasons why Foolish investors should feel optimistic.
First, operating synergies between Alliance Boots and Walgreen are already tracking ahead of plan. Walgreen is targeting $350 million to $400 million in synergies for 2014, but has already reported $107 million in the first quarter alone. And this comes after Walgreen delivered net synergies of $154 million in 2013 versus its initial target of $125 million to $150 million.
Second, the AmerisourceBergen deal was done after the original targets were set. The deal involves AmerisourceBergen distributing Walgreen's pharmaceuticals, and enables the latter to receive daily delivery to its stores. In addition, it includes Alliance Boots, so Walgreen should be able to generate even more synergies from it.
Third, Walgreen has a host of initiatives to drive growth. Plans involve expanding its balance rewards scheme, selling Boots beauty products in Walgreens, expanding its own-label products, and expanding its local community reach via offering more vaccinations and ongoing treatment facilities.
However, the tie-up with Theranos is the most eye-catching. In September, Walgreen and Theranos inked a deal to bring the latter's lab testing service to Walgreen's stores on a national level. Theranos owns a medical device that can detect diseases in the blood from a minute sample within a short space of time. While this sort of solution is perfect for Walgreen's aim of transforming "the role of the community pharmacy" toward ongoing care, it does pose questions for testing labs like Quest Diagnostics and LabCorp. These two companies essentially run a duopoly on central lab testing of blood, and if individuals can now do these tests at Walgreen/Theranos then what will happen to end demand for blood testing at Quest Diagnostics and LabCorp?
Where next for Walgreen?
All told, the potential upside for Walgreen is significant, and the integration plan appears to be working well so far. On the other hand, it's still early days and investing in the health care sector comes with the usual caveat of political risk. Nevertheless, based on current valuations, the stock looks attractively priced provided the 2016 targets are hit.
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