Walgreen Is Worth $38 As Express Scripts Customers Return

The U.S.’s largest drug retailer, Walgreen (NYSE:WAG), reported annual revenues of $71.6 billion, down by 0.8% year-on-year for FY 2012 last week. This was despite the company losing Express Scripts business for eight months in the period as a result of its dispute with the latter. Prescriptions from Express Scripts constituted almost 11% of the total prescriptions filled by the company in FY 2011, yet the number of prescriptions filled in 2012 stood at 784 million compared to 819 million 2011. This was a result of aggressive promotions and higher incidences of flu during the period.

The company currently operates 7,930 drugstores and competes with CVS Caremark (NYSE:CVS) and Rite Aid (NYSE:RAD) among others. We expect short term slow down in the revenue growth for the company as Express Scripts customers slowly get back to using Walgreen’s services and generic drugs gain prominence.

View our analysis for Walgreen

Express Scripts customers expected to return but slowly

The primary reason for the decline in the number of prescriptions filled was the loss of Express Scripts user-base. Prescription Drug Sales amount for approximately 60% of our estimate for the company and a drop in number of prescriptions filled is bound to have a negative impact on the company’s fair value. We don’t expect it to gain back all of the user-base it lost because of the dispute and the customers who come back are expected do so in a staggered manner. The company is offering customers who shift back a $25 gift card. Besides the gift card, the customers will now have access to the Balance Rewards loyalty program. Competitors have been aggressively promoting their loyalty programs and offering steep discounts in a bid to retain the Express Scripts users they gained and this would make it tough for the company to quickly regain their ex-customers. We currently estimate the company’s market share in the Retail Prescriptions filled in the U.S. to jump back in 2013 as the customers of the recently acquired regional pharmacy chain USA Drug join their fold and some of the Express Scripts customers move back.

Aging American population could boost the total number of prescriptions

We expect the total number of prescriptions filled in the U.S. to increase as the average age of American population rises and given the increasing incidence of obesity. These two factors support the outlook for the pharmacy industry. Also, as more ailments and disorders that were considered part of the human condition are being treated and require medication, this will help boost pharmacy sales over the coming years.

Popularity of Generic Drugs will impact top-line sales but help margins

We expect the company’s margins to benefit from the proliferation of generic drugs while the top-line growth gets limited since generics cost much less compared to their branded counterparts. The Economist estimates that blockbusters with a combined $170 billion in annual sales will go off-patent by 2015.

On average, generic drugs provide 50% higher gross margin dollars, although there would be increased reimbursement rate pressure on the drug retailers from the Pharmacy Benefit Managers, which are also trying to cash in on the generics expansion. We expect this to result in a drop in the revenue per retail prescription over the forecast period which would negatively impact the revenues from prescription drugs.

We have revised our price estimates to $38 for the company in view of the prevailing conditions.

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