Walgreen’s Renewed Growth Momentum Makes for a Great Stock Pick in 2014

Walgreen's recent focus on becoming a global pharmacy has started to pay off in a big way with impressive net income growth in the first quarter of fiscal 2014.

Jan 7, 2014 at 1:50PM

Walgreen (NASDAQ:WBA), the country's largest drug store chain, kicked off the first quarter of fiscal 2014 on a very strong note. The company recorded an awe-inspiring 68% year-over-year net income increase as its tie-up with Alliance Boots started to pay off handsomely. That blistering bottom-line growth rate belies the company's huge size, and serves as an indicator of the major changes taking place in the drug distribution landscape. The growth looks even more impressive when you consider that it came with a backdrop of a rather soft macro environment.

Express Scripts showdown a blessing in disguise
Walgreen reported its fiscal first-quarter 2014 results on Dec. 20, 2013 and posted sales of $18.35 billion, a 6% increase from the same period in 2013. Comparable-store sales climbed 5.5%. The company finally seems to have fully recovered from the Express Scripts (NASDAQ:ESRX) fiasco.

Many investors still remember the showdown between Walgreen and Express Scripts, the country's largest pharmacy benefit manager, or PBM, in 2011. During the standoff, many Walgreen customers fled to rivals CVS Caremark (NYSE:CVS), the second-largest PBM, and Rite Aid. Consequently, this led to a heavy decline in sales for the company. By the end of 2012, Walgreen was on the ropes and seriously bleeding after its sales tanked by a jaw-dropping 8.1%. The company was left with little choice but to acquiesce to Express Scripts' terms.

The showdown served as a wake-up call for Walgreen, and the company came to appreciate the sheer importance of size in this business. Express Scripts was able to call the shots and arm-twist Walgreen so easily simply because with a huge 37% share of the market, it was probably the only PBM large enough to handle Walgreen's business comfortably.

What seemed like a dead-end for Walgreen has turned out to be a blessing. The company quickly moved to reorganize its operations to avoid a repeat of the Express Scripts drama. The company took a 45% stake in Alliance Boots, Europe's largest drug-led retailer, in 2012 for a total of $6.7 billion. It is now, thankfully, reaping the rewards.

Walgreen regains pharmacy market share
Walgreen filled 213 million prescriptions in the first quarter of 2014, a record for the company. Its pharmacy market share improved to 19.4%, exceeding the industry growth rate by 2.9%. The Express Scripts showdown had seen Walgreen's pharmacy market share fall from 19.6% to 17.4%. Luckily for the company and its investors, Walgreen has almost recovered the lost ground, and even looks to overtake it in the coming quarters.

Walgreen believes that the growth in market share occurred because of the return of Express Scripts customers after the two drug distribution giants resolved their differences, as well as Walgreen winning new Medicare Part D customers. Walgreen's growth in Medicaid Part D outpaced the industry average by a mile.

The company has also been recording a high demand for flu shots, with the company administering 1.1 million more flu shots in the first quarter of 2014 than it did in the same period last year, which brought the total shots provided during the season to 6.4 million.

New partnerships help to expand global operations
Walgreen has been busily restructuring its operations in a bid to become a global pharmacy. To this end, the company has pursued new market opportunities, optimized its global supply chain, and expanded its brand portfolio. Walgreen is using its partnership with Alliance Boots to gain a foothold in the European market.

Walgreen achieved $154 million in net combined synergies with Alliance Boots in fiscal 2013, and it expects these synergies to grow to $300-$400 million in fiscal 2014. Alliance Boots contributed $0.14 per diluted share to Walgreen's first-quarter 2014 results.

Walgreen also entered a huge 10-year agreement worth $400 billion with AmerisourceBergen (NYSE:ABC). By combining its distribution in both the U.S. and Europe with AmerisourceBergen, Walgreen will be in a better position to negotiate better prices for both generic and branded drugs. The company expects to realize the full benefits of lower drug distribution costs by fiscal 2015.

AmerisourceBergen will also benefit hugely from the Walgreen deal, since a good 30% of its $81 billion in annual sales is already covered for the next ten years. This provides excellent future revenue visibility for the company. It also eliminates a huge competitive risk element for AmerisourceBergen that the company faces whenever its contracts expire, as it faces bare knuckle competition with its bigger-and better-heeled rivals Cardinal Health (NYSE:CAH) and McKesson.

Rapidly shifting drug distribution landscape
Walgreen is not the only drug distribution company that has been hunkering for huge deals and bulking up. Express Scripts merged with Medco Health in 2012 to form the biggest PBM in the country. The new Express Scripts commands almost twice the market share of its closest rival CVS Caremark with a 37% share of the market vs. a 20% share for CVS.

CVS Caremark also tied up with Cardinal Health in 2013 to form the largest generic-drug-sourcing entity in the world.

Both Express Scripts and CVS Caremark are expected to record admirable growth in sales by riding the huge growth in the specialty drugs market, as a recent CVS Caremark report outlines.  According to the report, the market for specialty drugs is expected to quadruple to $400 billion by 2020. Express Scripts has an industry-leading 52% share of the specialty drugs market, while CVS Caremark commands a 15% market share.

The bottom line
Although Walgreen experienced some degree of margin compression during the quarter due to a lower rate of generic drug substitution, the pressure is likely to ease in the coming quarters since around $15 billion worth of branded drugs are expected to come off patent in the next three years, opening these pharma up to generic competition. Meanwhile, Walgreen's partnerships seem to be bringing home the bacon and reinvigorating its bottom line in a big way.

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Fool contributor Joseph Gacinga has no position in any stocks mentioned. The Motley Fool recommends Express Scripts. The Motley Fool owns shares of Express Scripts. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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