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Investment Overview for Walgreen Co. (NYSE:WAG)
Recent Developments
In June 2012, Walgreen acquired a 45% stake in European pharmacy business Alliance Boots for $6.7 billion, paying $4 billion in cash and 83.4 million in shares and it intends to acquire the remaining stake by 2015. The deal was received with investor skepticism about the cost and timing of the deal and the risks associated with increased exposure to current European economic uncertainties and increase in debt (~$11 billion). Nonetheless, Walgreen sees long-term sense in the trans-Atlantic alliance as the deal creates the first global pharmacy business with 11,000 stores in 12 countries. It provides Walgreen with a large platform for further international expansion based on Alliance's experience in expanding into new markets such as China and Latin America, along with the opportunity to turn Alliance Boots into a global wholesaler. Walgreen also expects the deal to provide cost and revenue benefits of $100 million to $150 million in the first year and $1 billion by the end of 2016 for both the companies. The two together will also be the world's largest buyer of prescription drugs and health products which will give them leverage to negotiate better prices for generic drugs and other non-pharmacy products.
Alliance Boots is the largest European pharmacy-led drug retailer and health and well being products seller that generated $40 billion (£25 billion) in revenue and $2 billion in operating income in 2011, and we believe the market may be discounting the combined entity's lone-term earnings and growth potential over short-term uncertainties. Nonetheless, integrating a company of the size of Alliance Boots is unprecedented and a challenging task for Walgreen.
In July 2012, Walgreen acquired a 144-store strong regional drug retail chain, USA Drug, owned by Stephen L. LaFrance Holdings Inc., in a $438 million mostly-stock deal. The retail chain includes names such as USA Drug, Super D Drug, May's Drug Stores, Med-X Drugs and Drug Warehouse and has a major presence in mid-Southern United States. The 144 stores posted sales of about $825 million in 2011.
In March 2013, Walgreen and Alliance Boots, furthering their relationship as “Earth’s Drugstore” signed a deal with U.S. distributor AmerisourceBergen that will pool purchasing power to buy generic and branded prescription drugs around the world. The 10-year agreement with AmerisourceBergen, is worth $28 billion in fiscal 2014 and will bring an end in August'13 to Walgreen’s relationship with rival distributor Cardinal Health. Walgreen currently distributes more than 80 percent of its own drugs but over time most if not all of that distribution will be handled by AmerisourceBergen.
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Walgreens's Share of Retail Prescriptions Filled in the US: Walgreens' share of the total prescriptions filled in the US declined to 17.4% in 2012 as a result of its dispute with Express Scripts and loss of a major chunk of the corresponding 90 million prescriptions. The two reached a fresh agreement to allow Express customers fill prescriptions at Walgreen stores, starting September 15, 2012. Accordingly, we expect the market share to improve back to 18.1% in 2013, assuming Walgreen succeeds in winning back old customers post the disruption. We believe the market share could gradually improve to historical levels of 19.5% over our forecast period based on the strength of its retail network as well as an increase in online sales post the acquisition of Drugstore.com. If, however, Walgreen's market share in retail prescriptions stays close to the 18% level due to slow growth, inability to attract lost and sticky customers or loss of more business, there could be a 5% downside to our current price estimate.
EBITDA Margin for Prescription Drug Sales: We currently forecast the EBITDA margins for prescription drugs sales to rise consistently over our forecast horizon from 10% in FY 2011-12 to about 11.5% over the next few years. This increase is largely expected due to higher pharmacy margins resulting from an increase in generic drug sales, cost savings resulting from Walgreen's restructuring initiatives and greater buying power as a result of the agreement with AmerisourceBergen. Sales of lower priced generic drugs are expected to increase faster than branded drugs with patents for a large number of branded drugs expiring in the near future (eg. Pfizer’s Lipitor drug with $11 billion in annual sales lost patent protection in Nov 2011). Over the next three years, over $170 billion worth of drugs would lose patent protection, opening them to generics and driving higher margins. Gross profit dollars are approximately 50% higher on generic drugs than on the branded drugs. With the generic wave, each script is expected to bring an incremental $5-7 in profits, allowing up to 10% growth in EBIT margins. If, however, there is increased reimbursement pressure from Pharmacy Benefit Managers (particularly in light of the ongoing industry consolidation) and the gross margins stay close to the current levels, there could be a 10% downside to the Trefis price estimate.
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Walgreen is the largest drugstore chain in the US, which sells both prescription and non-prescription drugs as well as retail merchandise (cosmetics, convenience foods, photo processing services, seasonal merchandise). In addition to its store offerings, Walgreen provides pharmacy services like prescription fulfillment through mail order, telephone and internet.
Walgreen operates the largest network of over 8500 locations across the US, with over 75% of US population living within a five mile radius of a typical Walgreen retail store.
Walgreen's operational efficiency is noteworthy as its average chain wide retail sales per square foot is approximately $800, higher than that of Wal-Mart and other retail stores that sell drugs and general merchandise. Of these, around $300 come from general merchandise sales. Prescription drug sales account for over 60% of total revenues for Walgreen.
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Prescription drug sales are the biggest source of value for Walgreen Co., accounting for close to two-thirds of its total value.
Accessibility and affordability by virtue of largest U.S. drugstore network
Walgreen has the largest network of over 8500 pharmacy locations conveniently located within a five mile of nearly three-quarters of all Americans.
Walgreen's health service providers communicate face-to-face, on a personal level, with patients in ways to improve overall health care outcomes. Walgreen stores prove to be convenient, easily accessible and more affordable to its customers as a result of their significant scale and deeper penetration in the U.S. pharmacy market.
Poised to rake in higher sales than any U.S. retailer
Because of its strong market position Walgreen has over $800 in retail sales per square foot out of which prescription drug sales generate about $500 per square foot. This is higher than Wal-mart's $400 sales per square foot.
Walgreen has 18% share of retail prescriptions filled in U.S. and it is expected to increase in the future as Walgreen's pace of new store additions is expected to be higher than that of any other US retail drugstore chain. Walgreen thus has a highly advantageous and strong positioning among all the drug retail chains.
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Increasing demand and utilization of prescription drugs in the U.S.
The U.S. has an aging population, and as older people contribute to a larger proportion of expenditure on drugs (people above 60 spend an average 2-3 times more than those below 40), this will lead to an increase in the prescription drugs market in the U.S. The 2010 U.S. health reform legislation is also expected to increase prescription drug sales, as over 30 million uninsured Americans will gain coverage and the U.S. government will accordingly increase outlay on prescription drugs. This will be driven by an expansion of Medicaid and Medicare Part D plans.
Accelerating sales of generic drugs to positively impact margins
Sales of lower priced generic drugs are expected to increase faster than the sales of branded drugs. This growth will be supported by the fact that patents for a large number of branded drugs will expire in the near future (For example Pfizer’s Lipitor drug with $11 billion in annual sales lost patent protection in Nov 2011). Expansion of generic drugs in the U.S. market will impact retail pharmacy gross margins as they have a lower cost but higher margins compared to those of branded drugs. Gross profit dollars are approximately 50% higher on generic drugs than on the branded drugs, and with the generic wave, each script will bring an incremental $5-7 in profits, allowing up to a 10% growth in EBIT margins.
Trefis Forecast Rationale for Walgreen's Share of Retail Prescriptions Filled in the US
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${forecast} refers to the number of prescriptions filled by Walgreen through its network of retail stores, work site locations, mail order pharmacy etc, as a percentage of the total number of retail prescriptions filled annually in the US.
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${forecast} increased from 16.6% in 2007 to 19.6% in 2011 in line with an increase of over 2,000 stores and Duane-Reade and Drugstore.com acquisitions in the corresponding period. It declined to 18% in 2012 as a result of its dispute with Express Scripts and the loss of a major chunk of the corresponding 90 million prescriptions for the first nine months of 2012. The two reached a fresh agreement to allow Express customers fill prescriptions at Walgreen stores, starting September 15. Accordingly, we expect the market share to improve back to 18% in 2013, assuming Walgreen succeeds in winning back old customers post the disruption. We believe the market share could gradually improve to 19.5% over our forecast period based on the strength of its retail network as well as an increase in online sales post the acquisition of Drugstore.com.
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Trefis considered the following factors for its forecast
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- Acquisition of Duane Reade and prospective acquisitions to support market share growth
- The Duane Reade acquisition, completed in 2010, is expected to have increased Walgreen's retail prescriptions by 13 million, thereby having led to an increase in ${forecast} by over 0.3%. Trefis expects that strategic acquisitions similar to that of Duane Reade in the future will help Walgreen increase its market share.
- In July 2012, Walgreen acquired a 144-store strong regional drug retail chain, USA Drug, owned by Stephen L. LaFrance Holdings Inc., in a $438 million mostly-stock deal. The retail chain includes names such as USA Drug, Super D Drug, May's Drug Stores, Med-X Drugs and Drug Warehouse and has a major presence in mid-Southern United States. The 144 stores posted sales of about $825 million in 2011.
- Resolution of Express Scripts disruption
- In June 2011, Walgreen announced the discontinuation of filling prescriptions for people covered by Express Scripts from Jan 2012 after its contract renewal negotiations failed on the grounds of uncompetitive reimbursement rates offered by the pharmacy benefits manager. In 2011, Express Scripts represented $5.3 billion worth of business for Walgreen with around 90 million prescriptions, representing over 7% of Walgreen’s sales.
- The two reconciled in July 2012 and Walgreen would start filling prescriptions for Express Scripts customers from Sep 15, 2012. Walgreen is likely to lose 60 million prescriptions over the first nine months of 2012 taking the market share down to 18%. Thereafter, we expect the market share to improve back to 19.5% in 2013, assuming Walgreen succeeds in winning back most of its old customers from its competitors like CVS Caremark post the disruption.
- The deal also reduces uncertainty over the future of Walgreen's business with Medco Health Solutions (that merged with Express Scripts in April 2012) after the existing contracts expire.
- Acquisition of Drugstore.com
- The acquisition of Drugstore.com will provide a seamless shopping experience to Walgreen customers. The redesigned website's traffic has increased by 50% in the last 2 years.
- The multichannel experience will also leverage its 8,400 strong in-store network which covers about 63% of the population within a 3 miles radius of its stores. Its attempt to offer a 1-hour in-store pick up with quick turning of prescriptions will also differentiate it from other online drug retailers. This will drive up customer loyalty and basket sizes.
- Customer-Centric Retailing (CCR) initiative
- The CCR initiative that currently covers more than 50% stores along with the pilot loyalty program continues to gain traction and has helped drive more traffic and increasing the basket and ticket size.
- As a result, comparable store prescription sales are expected to contribute to a 2.5% growth in prescription sales in 2012.
- Growth in market share to be supported by addition of new stores
- Walgreen's management has targeted an organic growth of about 4.5% in 2010 followed by 3% from 2011 onward. Trefis expects that future store growth that is above the average for other U.S. drugstore chains will help Walgreen increase its market share of prescriptions filled annually. The following snippet from Walgreen’s annual report forecasts an above-industry average store growth for Walgreen.
- “Our annual organic store growth beginning in 2011 of between 2.5 and 3 percent is greater than the current pace of new store openings of all other U.S. drugstore chains.”
- Diversification of services and increased immunization activity
- Walgreen plans to expand its pharmacy services like the expansion of immunization services and its re-positioning as Triage centers to drive up revenues.
- Vaccination offers a huge market of over $40 billion in the U.S. in 2011-12. As the Center for Disease Control and Prevention (CDC) now recommends flu shots every season for everyone over six months of age, the demand for vaccination is strong especially in the flu season. The market is likely to expand to $65 billion by 2015 with an aging population and ease of access to immunization services.
- With its extensive network of pharmacies and clinics, Walgreen is well placed to tap into a decent size chunk of the immunization market.
- Walgreen greatly expanded its flu-shot program in 2009-10, offering more than 7.5 million vaccinations, providing more flu-shot immunizations than any other entity. In 2011, Walgreen has further expanded its flu shot program to extend vaccination availability to “every store, every clinic, every day”, with more than 27,000 certified immunizing pharmacists lined up to meet its objective of tapping into the immunization market.
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