Walgreen (NYSE:WAG), the largest drugstore chain in the U.S., closed its fiscal 2013 with only a marginal rise in sales but reported a 13.7% growth in its operating income. Its revenue base declined in fiscal 2012 as its dispute with the pharmacy benefits management company Express Scripts led to a significant loss in the number of Express Scripts’ prescriptions filled at Walgreen stores. However, following the dispute resolution between the two companies in September 2012, Walgreen has seen its growth accelerate in subsequent months. Higher revenue combined with Walgreen’s cost-cutting measures significantly improved its bottom line in fiscal 2013. (Read: Walgreen’s Earnings Confirm Its Renewed Growth Momentum)
Walgreen’s company wide operating profit stood at 10% in calendar year 2012, and we estimate its operating margin to rise to 12% over our review period. In this article we discuss the rationale supporting our belief that Walgreen’s topline will continue growing over our review period.
Our price estimate of $50 for Walgreen is at a 15% discount to the current market price of $60.
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Expanding Revenue Base
Improving customer value, providing innovative products and services, developing a systematic globalized offering, and designing the most relevant network and formats are four key focus areas for Walgreen. With 8,597 stores operating across the U.S., the District of Columbia, Puerto Rico and Guam, we believe that Walgreen is in a strong position to gain from an aging U.S. population and from the Affordable Care Act expanding insurance to millions of Americans. We forecast Walgreen’s total revenue to cross $100 billion over our review period. In addition to being the largest drugstore chain in the U.S. here are some other factors supporting our view:
- Dispute resolution with Express Scripts: Due to its dispute resolution with Express Scripts, which runs prescription drug plans for employers, insurers and other customers, Walgreen lost 2.2% of its market share in the retail prescription filled in the U.S. in 2012. 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 that it is winning back old customers post the deal and the proportion of Express Scripts prescriptions returning to its stores continues to rise.
- Acquisition to expand footprint in new markets: Aiming to become a leading global pharmacy Walgreen is pursuing new market opportunities, expanding its brand portfolio and optimizing its global supply chain. The acquisition of Duane Reade and Drugstore .com, an investment in Alliance Boots and an agreement with AmerisourceBergen (ABC) are some examples Walgreen expanding its reach. Walgreen collaborated with Alliance Boots (the largest European pharmacy-led drug retailer) in August 2012 with an aim to create a global pharmacy by expanding its operation in new markets including Europe, China, Latin America, etc. This year Walgreen also launched a joint venture in Berne, Switzerland and achieved $154 million in combined net synergies for fiscal year 2013.
Generic Substitution Will Aid Margin Growth
Though generic drugs are comparatively lower priced than branded drugs, they offer higher gross margins. 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 factors 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. Generic drugs continued to replace branded drugs in 2013, albeit at a slower pace. Generic drug substitution in the last 12 months had a 0.7% negative impact on Walgreen’s comparable store sales, compared to a 2% and 9% negative impact on comparable prescription sales in Q4 2013 and Q1 2013 respectively. Walgreen anticipates a low rate of introduction of new generics in the first half of fiscal 2014.
Nevertheless, an estimated $15 billion worth of branded products will come off patent in the next three years, opening them to competition from generic drugs.  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.
Agreement With ABC To Enhance Pricing & Margins
Recently, Walgreen entered 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.
Walgreen has transitioned the distribution and delivery of branded pharmaceuticals to ABC. By combining its distribution in the United States and Europe with ABC, Walgreen will be able to negotiate better prices for branded as well as generic drugs. The deal can improve Walgreen prices and enhance its margins as it triples the company’s buying power.  Walgreen is anticipated to realize full benefits of lower distribution costs by fiscal 2015.
Drawback: Lower Reimbursement Rates Can Put Pressure On Margins
The reimbursement rate by US Medicaid and Medicare Plan D as well as health insurance providers is expected to decline in line with the rising proportion of generic drugs. To address the mounting fiscal cliff, the U.S. government has been forced to lower medical reimbursement rates. In April’s budget sequester, it reduced the medicare payments to doctors, hospitals and other healthcare providers by 2%. Lower reimbursement rates impact the margins of pharmacy service providers and drug manufacturers.
Additionally, the ongoing consolidation in the Pharmacy Benefit Management (PBM) industry, like the merger of two of U.S.’s largest pharmacy benefit managers (Express Scripts and Medco Health Solutions), can increase reimbursement rate pressure over drug retailers.Notes:
- CVS Caremark’s CEO Discusses Q2 2013 Results – Earnings Call Transcript, Seeking Alpha, August 6, 2013 [↩]
- Walgreen Looks Abroad for Growth, The Wall Street Journal, November 3, 2013 [↩]