Key Factors Impacting Walgreen’s $45 Valuation

Walgreen (NYSE:WAG), the largest drugstore chain in the U.S. has seen its price increase by over 30% since the start of this year, mainly on account of it dispute resolution with Express Scripts and its expanding footprint in new markets. The company showed renewed growth momentum by reporting a modest y-o-y rise (8%) in its July 2013 sales figures. Walgreen’s calendar 2013 sales to date (as of July) stand at $42.02 billion, which is 3.4% higher compared to the same period last year.

The aging U.S population, new drug therapies and the Affordable Care Act expanding insurance to millions of Americans are some of the key factors driving growth in the U.S. pharmaceutical industry. Being present across 8,571 locations across the U.S., the District of Columbia, Puerto Rico and Guam, we believe that Walgreen is in a strong position to leverage the above trends.

Our price estimate of $45 for Walgreen is at a discount of under 10% to the current market price. While we remain positive on the company’s long-term outlook, we think that the intense competition from Rite Aid (NYSE:RAD), CVS Caremark (NYSE:CVS) and the Wal-Mart pharmacy can limit its growth potential in the future. In this article we discuss key trends impacting Walgreen’s business.

View our analysis for Walgreen

The Aging U.S. Population To Increase Prescription Drug Sales

The U.S. has an aging population and as older people contribute to a larger proportion of drug expenditures (people above 60 spend an average 2-3 times more than those below 40), this will lead to growth in the prescription drugs market in the U.S. The U.S. Census Bureau projects that within the next two decades, the proportion of total population over 65 years will increase from 13% to 19%, whereas those between 20 years and 65 years of age will decline from 60% to 55%.

In addition to the aging U.S. population, the rising government expenditures on healthcare will drive drug sales. The 2010, U.S. health reform legislation is expected to extend health coverage to more than 30 million uninsured Americans. Total prescription revenue earned by U.S. drugstores are expected to reach $350 billion by the end of 2015, growing at 5.3% annually. ^[1]

Walgreen has the highest number of stores in the U.S. and accounts for around 18% of the total retail prescription filled in the U.S.

Rising Proportion Of Lower Cost Generic Drugs Lower Revenues But Improve Margins

Generic drugs are comparitively lower priced but offer higher margins than branded drugs. Gross profit dollars are approximately 50% higher on generic drugs than on branded drugs. Generic drugs had a 7.3% negative impact on Walgreen’s comparable store revenues for the first six months of fiscal 2013, but increased gross margins by about 1.3%.

The total generic dispensing rate, which implies the percentage of generic drugs in a consumer’s prescription, grew to 78.5% in 2012, from 74.1% and 71.5% in 2011 and 2010, respectively. Though the substitution of generic drugs will continue for the next three to five years, the pace is expected to slow down. Nevertheless, an estimated $15 billion worth of branded product will come off patent in the next three years, opening them to competition from generic drugs. ^[2] With the expansion of generic drug sales in the U.S., each script will bring an incremental $5-7 in profits, allowing up to 10% growth in EBIT margins.

Dispute Resolution With Express Scripts Re-Accelerates Growth

In 2012, a total of 3.76 billion prescriptions were filled in the U.S. and Walgreen accounted for 17.4% of the sales, a marginal decline from 2011 (19.6% market share) as the dispute with Express Scripts led to a loss of a major chunk of the corresponding 90 million prescriptions for the first nine months of 2012. Handling prescriptions for millions of people, Express Scripts runs prescription drug plans for employers, insurers and other customers. As a result of the dispute between the two companies, many of Walgreen’s customers switched over to its competitors.

However, Walgreen and Express Scripts entered into a fresh agreement in September 2012, which allows Express customers to fill prescriptions at Walgreen stores. Walgreen claims to be winning back old customers post the deal and declared that the proportion of Express Scripts prescriptions returning to its stores continued to rise in July 2013.

Recently, Walgreen and Express Deals launched a new option for clients that allow them to pick up 90-day supplies of prescription drugs at Walgreen’s retail stores. Known as Smart90 Walgreens, the program will offer plan members convenient access to in-person pharmacist consultations and a wide-range of health and wellness services that can improve medication adherence and lower overall healthcare costs.

Recent Aquisitions To Expand Footprint In New Markets

Last year, Walgreen entered into two new partnerships with Alliance Boots and AmerisourceBergen. In August 2012, it completed an initial 45% investment in Alliance Boots, the largest European pharmacy-led drug retailer, with an aim to create a global pharmacy by expanding its operation in new markets including Europe, China, Latin America, etc. It expects the collaboration to provide cost and revenue benefits of $100 – $150 million in the first year and $1 billion by the end of 2016 for both companies.

Recently, Walgreen also entered into a 10-year agreement with AmerisourceBergen (ABC) to jointly source generic drugs and generate logistical efficiencies. ABC provides drug distribution and related services designed to reduce costs and improve patient outcomes.  By combining its distribution in the United States and Europe with ABC, Walgreen will be able to negotiate better prices for bulk drugs. Much of what Walgreen sells now are bulk, low-profit prescriptions.

Understand What Drives a Stock at Trefis

1. New Study Predicts $350 Billion U.S. Pharmacy Industry by 2015, Identifies Risks to Profitability, Pembroke Consulting, July 30, 2013 [↩]
2. CVS Caremark’s CEO Discusses Q2 2013 Results – Earnings Call Transcript, Seeking Alpha, August 6, 2013 [↩]