The Case for Buying Walgreen

Eric Mara is senior analyst at Pavis Capital, a value- and research-driven hedge fund headquartered in Boston. The below investment thesis was originally posted on SumZero, the leading community for hedge fund and mutual fund investment analysts where professional investors share investment ideas exclusively with one another. Through The Motley Fool, select content from SumZero is now available to individual investors. 

I. Investment Thesis
An investment in Walgreen (NYSE: WAG) at $29.27 per share presents investors with an opportunity to own a cycle-resistant, investor-friendly, dividend-paying, zero-net-debt business at 6.3x EBITDA (or a 9.9% unlevered FCF yield). Given the company's capital structure and below-average exposure to the business cycle, at $29.27/share, the market is valuing Walgreen as if it is in secular decline. To the contrary, WAG is poised to benefit from a multitude of secular, cyclical, and business-specific trends that should facilitate organic growth well in excess of domestic GDP growth -- and the expectations of sell-side analysts -- over the next three to five years.

On an absolute basis, we value WAG at $46.30/share today (58% upside, representing 7.9x 2011E EBITDA) and estimate that it will be worth $52.00/share by the end of 2012, representing 7.4x 2012E EBITDA, and implying 78% upside from current prices, and an annualized return of 39%.

II. Market Opportunity
WAG's share price has fallen over 30% from its 52-week high -- creating an opportunity for value investors -- because of several factors:

1. Growth-oriented investors have fled the stock following management's announcement in late 2009 that the company would be rapidly reducing its rate of new store openings in order to focus on enhancing the profitability of its existing store base.
2. Short-term traders are focused on 2H 2010 earnings expectations. 2009 comps are tough due to the H1N1 flu scare.
3. Lack of clarity into the impacts of health-care reform has created uncertainty amongst investors who used to view the health-care space as a safe haven for capital in a tough economy.

III. Catalysts
We believe there are several mid- and long-term potential catalysts that will help drive the price of WAG toward fair value:

1. Investor focus on patent expirations of branded drugs: A record pipeline of patent expirations on branded drugs, starting in 4Q11, will materially improve WAG's gross profit. Wall Street analysts are aware that there is a directional benefit to WAG, but they have not yet quantified the impact and included it in their valuation models.
2. Increased profitability from "Rewire for Growth" SG&A reduction initiative and focus on existing store base over new locations: The market has not given WAG any credit for a targeted $1 billion reduction of SG&A or enhanced profitability from an aging store base, because the results have not yet flowed through financial statements. The market should react positively to any news relating to enhanced profitability from either of these initiatives.
3. 2010 flu earnings exceed 2009 flu earnings: WAG has 40% more pharmacists doing flu shots this year as more states are allowing pharmacies to administer flu shots. There is some probability that WAG will actually administer more shots than last year -- even on a weaker flu season -- from share gain.
4. Value as its own catalyst: WAG is cheap on an absolute basis and relative to historical multiples.

IV. Margin of Safety: Trading at a Discount even in a 0% Growth Scenario
An investment in WAG at $29.27/share offers a margin of safety derived from the fact that the company's last-12-months (LTM) free cash flow (FCF) has to actually shrink into perpetuity to justify the current valuation. Thus, if we are completely wrong about our growth assumptions, an investment in WAG should generate a more than fair return on our capital relative to the risk we are taking, even if the company never grows again.

We calculate that WAG generated $3.3 billion of cash earnings (defined as net income + non-cash expenses, + tax-effected net interest expense) in the LTM period. WAG executives have suggested that the company needs to invest about $500 million annually to maintain its existing base of stores, which suggests that the company should be able to generate $2.8 billion of free cash flow per annum and maintain a 0% rate of growth in cash earnings for perpetuity.

We then capitalize that FCF using WAG's weighted average cost of capital (WACC)* to calculate that investors should be willing to pay 10.7x FCF to own this stream of cash flows for perpetuity assuming 0% growth, implying a valuation of $30.05/share, or 2.7% higher than the current share price. [*10.0% cost of equity (Rf = 5.0%, Rm = 6.0%, Beta = 0.82), 3.83% cost of debt; 92% equity/8% debt]

The conclusion is that at a $30.05/share cost basis, owners of WAG common stock can expect to realize a satisfactory return on their investment if FCF never grows again. The remainder of this memo will be dedicated to explaining why we think WAG is poised to meaningfully increase its annual FCF, thus creating an opportunity to generate outsized investment performance.

V. Business-Specific Value Drivers

1. Generics pipeline
WAG is poised to benefit from a record volume of patent expirations on branded prescriptions drugs, starting in late 2011 and extending through 2015. Walgreen receives lower revenue but higher gross profit dollars per prescription (scripts) on generic drugs vs. branded drugs. In the LTM period, we estimate that 72% (492 million) of the 638 million scripts filled at WAG stores were generic drugs. By the end of 2012, we estimate that WAG could be on track to fill 95 million more generic scripts per year.

According to company executives, WAG currently makes an average of $15/script in gross profit on branded drugs (off of an average estimated sales price of $118/script). When drugs come off patent, WAG can make $35-$55 in gross profit per generic script during a six-month exclusivity period, before making a more sustainable average of $25/generic script, or $10/script more than the company makes from selling branded scripts, off of an average estimated selling price of $42/script.

There are 88 drugs coming off patent between now and the end of 2015, with a total sales volume of $107 billion. 24% of those sales are currently going through mail order pharmacies, and WAG has an estimated 20.5% share of the remaining market. In total, we estimate that $16.7 billion of WAG's branded scripts sales are subject to patent expirations through 2015.

We looked up the maximum price/script for each of the 88 drugs that are coming off patent, and then backed into an estimate of the number of scripts of each drug that WAG is likely selling [(Branded sales/maximum price per prescription)*WAG market share = WAG scripts per branded drug]. Our estimates suggest that WAG's gross profit could sustainably expand by as much as $1.2 billion per annum from the generics pipeline by the end of 2015, with two-thirds of that gross profit (~$800 million) likely to flush through the P&L by the end of 2012. For context, WAG's LTM gross profit is $18.5 billion, so $800 million is a 4.3% increase, most of which should fall straight to the bottom line. We do not include any benefit from the exclusivity period (in which gross profit/script can be much higher) in our estimates as we are focused on sustainable earnings, but we note that there could be substantial upside to our valuation from excess profits generated during exclusivity periods.

We calculate that WAG will generate an additional sustainable $500 million of FCF in 2012 as a result of the generics pipeline ($800 million taxed at 35%, with slightly higher maintenance CapEx), for a total unlevered 2012E FCF of $3.3 billion, which assumes no other FCF growth off the LTM base other than from the generics pipeline. Between now and the end of 2012, WAG should be able to generate $4.6 billion in excess cash flow. If we assume that WAG's LTM cash flows only grow between now and 2012 due to the boon from the generics pipeline, and that its cash flows never grow again after that, we can calculate that WAG will be worth $40.20/share on 12/31/2012 [$3.3 billion unlevered FCF capitalized at 9.4% WACC, plus net cash of $4.6 billion], representing 37% upside and a 17% compound annual return.

2. Maturation of store base
WAG management announced in 2009 that it was planning to dramatically slow its pace of new store openings to focus on achieving greater profitability in mature stores. Conversations with company executives and sell-side analysts suggest that the EBIT of a WAG store is as follows (in millions of dollars):

Year 1: -$0.15
Year 2: -$0.10
Year 3: -$0.05
Year 4: $0.15
Year 5: $0.54
Year 6: $0.79
Year 7: $0.85

Looking at the existing store base, 417 pharmacies are less than one year old, 605 are two years old, and 554 are three years old. Applying the average profitability above to those cohorts suggests that those 1,576 stores are losing -$151 million per year in EBIT. By the end of 2012, if those stores mature on schedule, they will generate $821 million in positive EBIT, which suggests that an incremental $972 million in EBIT could be unlocked from WAG's income statement from normal enhanced profitability in its store base.

We have not explicitly included any benefit from the maturation of the store base in our model or valuation, but note that this phenomenon should enable WAG to start beating earnings estimates, providing a positive catalyst for the stock, and material upside to our price target.

3. SG&A reduction
WAG is halfway through a $1 billion SG&A reduction program called Rewire for Growth. Management expects to reduce SG&A by $1 billion off a 2008 base by the end of 2011, having already achieved an estimated $500-plus million in savings through the most recent quarter. We give the company very little credit for these initiatives in our model -- less than $100 million net off the '08 base -- because disclosure around the sources of the cost savings has been inadequate to judge the viability of the plan, and the first $500 million came at ~$500 million in one-time restructuring costs, obscuring the impact of the program in the company's historical financials. Most importantly, we do not need to believe in these SG&A savings to make a compelling case for an investment in WAG. With that in mind, for every $100 million in SG&A savings the company can realize, we calculate that there is a positive $0.90/share in upside, or ~$8.50/share of upside to our valuation if WAG achieves its targets.

VI. Secular and Cyclical Growth Trends
In addition to the company/industry-specific growth drivers discussed above, WAG is also positioned to benefit from a number of externalities, which should facilitate FCF growth both cyclically and secularly.

• Increased penetration of prescription drugs relative to population growth.
• Prescriptions purchased over the last 10 years have grown seven times faster than population growth.
• Age distribution of the population drives increased prescription drug use per capita.
• 55+ age group accounts for ~2/3 of the U.S. population, and is forecast to increase.
• Aging population is also driving demand for preventative drugs, which can be both prescription and OTC.
• ~30% of scripts are sold to people aged 65 or older.
• Increasing life expectancy contributes to this secular growth driver.
• Insurance coverage is likely to increase, driving greater demand for prescription drugs relative to GDP growth.
• Health-care reform will result in an estimated 32 million people who did not have any health-care coverage receiving new coverage.
• Any recovery in employment will drive incremental demand for prescription drugs as more people receive health-care benefits for being part of the work force.
• Prescription drugs are recession resistant.
• WAG profits should be relatively insulated from the business cycle.
• 95%+ of expenditures on prescription drugs are covered by third-party payers, so generally not a huge burden on consumers.
• Even for the uninsured, prescriptions are health-related, and thus less discretionary than the average consumer purchase.

VII. Valuation
We value WAG on an absolute basis, using a discounted cash flow model. We believe we have been conservative in both our financial forecast (recall that our projections do not include the benefit of SG&A savings programs, the maturation of WAG's store base, or the outsized returns generated during the exclusivity period on newly off-patent drugs) and our WACC assumptions:

Risk free rate: We assume 5.0%, as compared to actual U.S. 10 year treasury rate of 2.8%
Risk Premium: We assume 6.0%, as compared to calculated implied market risk premium of 4.5% - 5.0% for S&P 500 in 2010
Beta: 0.82, which is consistent with what we would expect from a zero net debt, recession-resistant business
Terminal FCF Growth: 2.0%, below long-term expectations for inflation, population growth, and fixed cost leverage

Our 2012 DCF-derived price target price of $52.00 represents 7.3x 2012E EBITDA, and a 9.1% levered FCF yield (ex. cash) on a negative net debt company. This compares conservatively to WAG's five-year average EV/EBITDA multiple of ~10.0x, and suggests to us that at $29.27/share, an investment in WAG offers exceptional return characteristics relative to its risk.

Variant View
The market is valuing WAG as if the company will never grow LTM FCF. We believe that WAG is positioned to grow its cash flows significantly over the next three to five years. Specifically:

1. The market has not yet internalized the magnitude of the coming wave of patent expirations on branded prescription drugs, or its impact on WAG's gross profit.
2. Investors oriented toward top-line growth have written off WAG following management's announcement that the company intends to slow its pace of new store openings. However, fewer store openings should facilitate material incremental FCF generation as the existing store base (which is relatively young) matures and becomes more profitable, and growth CapEx declines.
3. The market is ascribing no value to WAG's ongoing $1 billion SG&A savings program.
4. The market is not assigning any value to long-term growth trends, including inflation/population growth, the aging of the U.S. population, and increased insurance coverage.

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