Why This Hedge Fund Is Excited About Walgreen

Couple an aging population with an activist investor set on boosting margins, and this drugstore company could be one of the best investments around.

Jul 15, 2014 at 5:18PM

Jana Partners, an activist hedge fund, returned 20.4% in 2013, earning it the 7th highest ranking from Activist Insight. The fund focuses on companies that appear undervalued by the market and that have one or more catalysts to unlock that value. It appears that Jana has found once such opportunity in the retail pharmacy space. Its largest position is Walgreen (NASDAQ:WBA). Walgreen has underperformed its top peer, CVS Caremark (NYSE:CVS), substantially over the past three years.

Walgreen is no longer just a U.S. focused pharmacy. It took a 45% stake in Alliance Boots during 2012. Boots is a European pharmacy operator, beauty products maker, and drug wholesaler with 3,330 stores, mainly focused in the U.K. Its drug wholesale unit includes 370 distribution centers. Walgreen has an option to buy the other 55% of Boots by 2015, and is reportedly exploring doing so. The move is a big bet on Europe. Together, the two would operate 11,000 drugstores across Europe, the U.S. and Asia.

The business is no longer just pharmacy retail, thanks to the stake in Alliance Boots and agreement with AmerisourceBergen. It's becoming more of an integrated drug company. The big opportunity that Jana sees with Alliance Boots is to boost company margins. The EBIT margins at Boots are double Walgreen's. The businesses are virtually the same, thus Jana believes Walgreen can learn a lot. Walgreen has a profit margin that's only 3.7%, which is below CVS' 4.4%. Jana Partners believes there's an opportunity to boost its margins. Part of that will come from the integration of Alliance Boots into Walgreen's business. 

Walgreen would have more purchasing power in the generic drug space with Alliance Boots on its side. But Alliance Boots is also a big seller of beauty products, which could help Walgreen become more effective at selling creams and makeup in the U.S. The margins on household and beauty products are higher than prescriptions.

One of the things that Jana is pushing for is a tax inversion. That would mean that Walgreen would become domiciled outside of the U.S. and benefit from a more favorable tax rate. Walgreen could save upward of $4 billion in taxes over the next five years by doing this.

Where CVS is focusing
CVS is also focused on broadening its presence in other markets. CVS already gets around 54% of its revenues from its pharmacy-services segment. However, Express Scripts is a formidable opponent in the pharmacy benefits management space. Express Scripts owns 50% of the pharmacy benefits-management market for large employers.

With Walgreen getting more involved in the generic side of the business, CVS is making specialty drugs a priority. Its acquisition of Coram last year is expected to add $1.4 billion to revenue in the first year. Its key products include medications administered via a vein or tube. These are used to treat immune and nutritional deficiencies.

The other big news is that CVS will stop selling tobacco products in October. Walgreen hasn't given in to the mounting pressure by the state attorneys general. Analysts expect that Walgreen has a big opportunity to capture CVS' lost market share, which could add billions in additional revenue. CVS has reported that it could lose upward of $2 billion in annual revenue due to its ceasing of the sale of tobacco products.

Bottom line
The drugstore industry should continue to see robust demand from the aging population. As the largest pharmacy chain, with lots of opportunity in generics and internationally, I think Walgreen is in a uniquely good position. For investors looking for a solid play in the drugstore industry, Walgreen is worth a closer look.

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Marshall Hargrave has no position in any stocks mentioned. The Motley Fool recommends CVS Caremark. 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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