Walgreen Co.

(WAG) Matthew McDonnell Contributions by James Herr

14-September-2006

Company Overview

    Founded in 1901 by Charles Walgreen  1 st store in Chicago Currently 5,251 stores operating in 45 states and Puerto Rico  Median store age is approx. 5.4 years old 131, 400 employees as of 11/30/2005  Avg. years of experience for store managers is 12.6 years Goal is to have 7,000 stores by 2010

Company Overview

    David Bernauer    Chairman of the Board since 2003 Chief Executive Officer since 2002 President and Chief Operating Officer from 1999-2003  Has been with Walgreens since 1966 Jeffrey Rein  President and Chief Operating Officer since 2003  Has been with Walgreens since 1974 George Eilers replaced by Kevin Walgreen, great-grandson of Charles Walgreen, as Senior VP of Store Operations (Southern Region) in early 2006 due to Mr. Eilers’ retirement  Eilers had been with Walgreens for 46 years  Kevin Walgreen has been with company since 1979 William Rudolphsen  Senior Vice President and Chief Financial Officer since 2004  Has been with Walgreens since 1977 Source Data: Walgreen Co. Jan. 11, 2006 Annual meeting and www.walgreens.com

RCMP Position

     

Own 1000 shares in Walgreens Purchased at $25/share on 10/06/1999 Cost Basis is $25,000 Stock is now trading at $49.31/share

 Valued at $49,310

Represents 13.75% of portfolio MV Gain of $24,310, or 97.24%

Macroeconomic Overview- General Economy

 Earlier this summer, the markets trended downward due to a number of factors:  Uncertain economic outlook stemming from repeated releases of conflicting economic indicators   Repeated non-official statements made by Federal Reserve Board members regarding the health of the economy, possible future actions  See May 1, 2006 on-air comments by CNBC reporter Maria Bartiromo Continuing political uncertainty and worries regarding oil supplies as violence increased in Iraq and Iran defied US and UN fueled higher energy prices and muted hampered US and world equity markets

Macroeconomic Overview- General Economy

 Since mid-July, the markets have trended somewhat higher on high volume but gains have not been substantial   The market as a whole currently feels that a pause in interest rate hikes is indeed likely One of the leading inhibitors for better performance remains continued uncertainly regarding the health of the economy stemming from conflicting economic indicators  See Friday, September 8, 2006 release of cost of wages and economic growth

Macroeconomic Overview- Trailing 6 Month Market Performance

Macroeconomic Overview Demographics

 Aging Population    Around 36 million people are 65+  12.6% of the total U.S. population  17.6% live in Florida  By 2030, there will be almost 72 million people 65+ Retirement of “Baby Boomers”   Currently, around 77 million Baby Boomers representing almost 27% of the population Over 50% of Baby Boomers live in CA, TX, NY, FL, PA, IL, OH, MI, NJ Americans begin to start taking more drugs in their early 50’s Source Data: www.metlife.com

Macroeconomic Overview- Political

    Medicare Part D prescription drug program  In effect as of January 1 st , 2006 Prescription Drug coverage   Covers both generic and prescription drugs for those who qualify for Medicare Designed to protect those with high drug costs May allow pharmaceutical industry to create new drugs that are “safer” and more effective At this point it is too early to tell how the new plan will affect Walgreens, as the “kinks” are being resolved

Drug Store Industry

 

Decreasing customer loyalty

  Relationship with customers deteriorating Customers now have more convenient or economically viable options  Generic drugs seen as a low-cost alternative to name brand prescription and non-prescription medications = Mail order threat Walgreens is combating the mail order threat by offering customers a choice between 90-day mail order prescriptions and 90-day at retail option, known as Advantage90  Advantage90 is currently offering prescriptions at $10 discount to 90-day mail orders Source Data: Walgreen Co. Jan. 11, 2006 Annual meeting

Drug Store Industry

   Highly Competitive Industry   Competition with other drugstore chains, independent drugstores, mail order prescription providers, internet pharmacies Other competitors include various grocery stores, mass merchants, and dollar stores Main competitors:   CVS Corp. (CVS)   Recently purchased 700 stand alone Sav-On and Osco drugstores through its $9.7 billion buyout of Albertson’s Inc.

This move will give CVS a significantly greater Midwest foothold Rite Aid Corp. (RAD) “Partial” competitor  Wal-Mart (WMT)  Pharmaceutical more than grocery department  In FY 2004, Pharmaceuticals were 9% of Wal-Mart’s sales  In total, about $6 billion/year (25%) less in net sales than Walgreens Source Data: Wal-mart’s 2004 10-K

Porter’s 5 Forces: Drug Store Chains

Threat of new entrants

MODERATE

Power of Customers

LOW

Overall Threat Level:

High

Power of Suppliers

HIGH

Industry Rivalry

HIGH

Threat of Substitutes

MODERATE

Market Cap: Employ-ees: Qtrly Rev Growth (yoy): Revenue (ttm):

Competitors

WAG 46.40B

131,400 CVS 24.89B

78,500 RAD 2.08B

WMT 189.61B

38,448 1,700,000 10.20% 43.21B

9.10% 37.01B

0.90% 16.84B

8.60% 312.43B

Industry 24.47B

78.50K

12.50% 37.01B

Gross Margin (ttm): EBITDA (ttm): 27.96% 26.76% 2.93B

25.19% 2.61B 662.08M

23.06% 23.25B

26.76% 2.61B

Oper Margins (ttm): Net Income (ttm): EPS (ttm): P/E (ttm): PEG (5 yr expected): P/S (ttm): 5.63% 1.58B

1.536

29.85

5.46% 2.47% 1.21B 208.92M

1.45

0.394

21.08

10.05

1.65

1.06

1.49

0.66

11.37

0.12

5.93% 11.23B

2.682

16.98

4.83% 1.22B

1.54

23.01

0.97

0.6

1.65

0.66

CVS = CVS Corp.

RAD = Rite Aid Corp.

WMT = Wal-Mart Stores Inc.

Industry = Drug Stores Source: Yahoo! Finance available at: http://www.finance.yahoo.com

Interesting Facts

  Earnings:   The average grocery store earns $12/ sq. ft.

The average drug store chain earns $20/sq. ft.

  Wal-Mart earns $26/sq. ft.

Walgreens earns $46/sq. ft. Prescriptions (average per store)  Grocery stores fill 131 prescriptions/day    Mass retailers fill 143 prescriptions/day Chain drug stores fill 180 prescriptions/day Walgreens fills 263 prescriptions/day  Walgreens fills more prescriptions than all grocery stores combined!

Source Data: Walgreen Co. Jan. 11, 2006 Annual meeting

      

Strategy

Enter new markets “Dense up” existing markets Organic store growth   Relocate Remodel Invest heavily in high-tech store and distribution systems which drive service up and costs down “An agile elephant” – Must continue to find ways to leverage the benefits of scale without losing the ability to react quickly to changes in customer needs Healthcare offerings beyond that of a traditional pharmacy  Offer an online drugstore web site totally integrated with our retail stores Attract and maintain top talent Source data: www.walgreens.com

Strategy Growth, Growth, Growth!

  Walgreens is currently increasing their net stores operated by approximately 1 store per day The company, which currently operates 5,156 stores, plans to operate at least 7,000 stores by 2010  All this expansion is funded by cash flow from operations, as opposed to long-term debt or equity issuances

Innovations

   Introduced freestanding stores in early 1990s with drive thru pharmacies  Today, more than 80% of Walgreen Co.’s stores have drive thru pharmacies Nation-wide 1 hour photo service  Available at more than 98% of stores  New Digital Photo Service  Allows you to upload your photos at home and pick them up at any Walgreens store 1 hour later!

 Much time and effort has been put into this project so that they stay ahead of competition Touch tone prescription refills Source data: www.walgreens.com

Innovations

   Largest private user of satellite technology  Second only to the United States government Today, 125 million people live within 2 miles of a Walgreens Walgreens plans to increase their business by investing in prime locations, technology, and customer service initiatives Source data: www.walgreens.com

& 2005 10-K

Products

Product Class Prescription Drugs Generic Not Generic 59 41 2005 64

67 By 12/31/06 Generic

Nonprescription Drugs General Merchandise Total Sales 11 25 100 Percentage 2004 63 12 25 100 2003 62 12 26 100 Source data: Walgreen Co. 2005 10-K

Walgreens – Locations by State

Source data: www.walgreens.com

Positioning

   Walgreens well positioned for Baby Boomer era Top 5 states with largest number of stores:  #1 = Florida with 673 stores     #2 = Texas with 530 stores #3 = Illinois with 500 stores #4 = California with 419 stores #5 = Arizona with 223 stores

Over 50% of Baby Boomers live in FL, TX, IL, CA, NY, PA, OH, MI, NJ

Source Data: www.metlife.com

New Workings

 Medicare Part D prescription drug program   Walgreens has recently integrated a program into their computer system that lets the pharmacists look at a patient’s list of drugs and match the patient with the Medicare drug program that will be most cost-effective for them Best of all, it’s free!

 New Acquisitions   Walgreens recently acquired SeniorMed, an assisted living prescription business in hope that it will give them a “big boost” in a business area where they had previously lost customers In addition, WAG is now partnered with TakeCare and InterFit to operate small clinics in WAG stores Source Data: Walgreen Co. Jan. 11, 2006 Annual meeting

New Workings

   Dial-A-Pharmacist (in 14 languages)  Automatically connects a patient with a Walgreens pharmacist somewhere in USA who speaks that particular language Highway Signs  New Federal Regulations are allowing 24-Hour pharmacies to put up signs on major highways (Just like McDonald’s and Shell)  Walgreens already has 7 put up in Illinois Solar powered roofs   Walgreens will begin to start using solar powered roofs in 100 of their stores These will allow each store to generate 20-50% of it’s own electricity.

Source Data: Walgreen Co. Jan. 11, 2006 Annual meeting

Porter’s 5 Forces: Drug Store Chains

Threat of new entrants

MODERATE

Power of Customers

LOW

Overall Threat Level:

High

Power of Suppliers

HIGH

Industry Rivalry

HIGH

Threat of Substitutes

MODERATE

SWOT Analysis

S trengths  Innovative in controlling costs and expanding sales  Expanding store base to reach more markets  Has made efforts to serve growing non English-speaking communities  Experienced management O pportunities  Rapidly expanding elderly demographic  New innovations in Medicare may increase sales  Little competition in nursing home services  Large proportion of US w/o health insurance, may be drawn to low-cost in store clinics W eaknesses  No prior experience managing current growth rates  Cost/benefit analysis of firm’s extremely rapid growth difficult to determine T hreats  Business susceptible to severity of cold/flu season  Possible competition from online sources  May face difficulty in passing costs onto consumers b/c Medicare/insurance companies

5 Year Performance

60 50 40 30 20 10 0

10 Year Performance

Performance Date

Adjusted for stock splits and dividends

20 Year Performance vs. S&P 500

5 Year Performance vs. S&P 500

5 Year Performance vs. Competitors

100.00% 80.00% 60.00% 40.00% 20.00% 0.00% -20.00% -40.00% -60.00%

Walgreens vs. Portfolio

Cumulative Performance Oct. 1999 - Feb. 2006

Portfolio S&P 500 WAG

Correlation Matrix

AEE AEOS CPRT FR JKHY JPM KMB MS MVSN SRCL SRZ WAG

AEE AEOS CPRT

1 0.155

1 0.226 0.2044

1 0.326 0.1321 0.3377

FR

1 0.196 0.4141 0.2727 0.237

0.338 0.3896 0.2462 0.231

0.266 0.2115 0.2871 0.341

0.255 0.4217 0.2745 0.265

0.179 0.3539

0.226 0.106

0.151

0.21 0.0315 0.169

0.09 0.2398 0.0847 0.171

0.239 0.3095 0.2281 0.175

JKHY

1 0.498

0.283 0.272

0.494 0.745 0.361

0.397 0.422 0.194 0.489

0.207

JPM

1

KMB

1 0.28 0.311

MS

1

MVSN SRCL

1 0.24 0.1317

0.28 0.269 0.172 0.342 0.2099

0.31 0.325 0.323 0.434 0.2319

1 0.161

SRZ

1 0.329 0.158

WAG

1 Note: Table assumes equal-weighted portfolio

“Fit” With RCMP Portfolio: Appraisal Ratios



Appraisal ratio : Risk-adjusted measure of excess returns provided by a security = alpha/(std error^2)

 Suggests user add (short) the security if alpha is significant and appraisal ratio is greater than alternatives

Appraisal Ratios Apprasial ratio=

WAG

CVS RAD α/(std. error^2)

1.263132978

0.717603164

0.126937097

Note: alpha for all 3 securities above is not positive with 95% certainty but is significant at slightly lower levels of confidence Source Data: Yahoo! Finance

Relative Multiple Analysis

Growth Implied by PEG Ratios

WAG

CVS RAD WMT P/E Ratio 1

over

Peg Ratio 2 = Implied Growth = Implied growth as % of industry implied growth

29.37

1.66

17.69277108

128% 20.49

9.95

16.98

23.01

1.5

11.31

0.098

1.66

13.66 0.879752 173.2653 13.86145

99% 6% 1250% Industry 100% Here we see that the market has already priced significant growth into Walgreen stock.

•Unless the firm can grow almost 18% annually ad infinum , the stock will likely undergo a correction.

Source Data: Yahoo! Finance

Relative Multiple Analysis

Firm P/E

over

Industry P/E = Firm P/E as % of Industry P/E Market P/E (approx) = Firm P/E as % of market P/E

WAG 29.37

23.01

128% 18 163%

CVS 20.49

23.01

89% 18 114% RAD 9.95

23.01

WMT 16.98

23.01

Industry 23.01

23.01

43% 18 74% 18 100% 18 55% 94% 128% Here we see that Walgreen’s P/E Ratio is high not only to the market but also it’s industry. •This serves as additional evidence of the significant “premium” the market has placed on the firm’s stock.

Valuation Process of a DCF

 1.

To refresh, intrinsic value of a firm’s common equity is determined as follows: Forecast free cash flow over a period of X years and a terminal value via: [FCF final period*(1+LT growth rate)]/[WACC-LT Growth Rate] 2.

3.

4.

Calculate WACC via: (w e *k e )+[w d *k d *(1-tax rate)] Discount all cash flows and arrive at enterprise value via:Σ 1 N FCF i /[(1+WACC)^i] Subtract LT debt from enterprise value 5.

Divide by common shares outstanding to get price per share

Valuation Step 1: Forecasting Free Cash Flows

FY 2006 forecasted FY 2007 forecasted FY 2008 forecasted FY 2009 forecasted FY 2010 forecasted

Net sales: 47,525.69

58,764.67

64,505.80

Less: Operating costs Taxes paid Net investment ∆ Working capital

= Free Cash Flow

(44,792.96) (1,047.69) (825.46) 853.14

859.58

(50,021.52) (1,176.83) (767.58) 659.29

1,107.30

(55,385.70) (1,323.66) (677.82) 617.55

1,377.49

(60,796.71) (1,485.10) (563.62) 1,146.98

1,660.37

(66,131.63) (1,663.71) (441.44) 1,490.68

1,929.40

Valuation Step 2: Calculating WACC

 Sensitivity to WACC is a major issue for most DCF models, and is of extraordinary importance when modeling Walgreen Co.

 I will revisit this topic later in the presentation  Since WAG is 100% equity, WACC=k e . Below is k e calculated via CAPM (and thus, WACC)

CAPM:

r f = β= r m =

k e =

4.77% 0.4

11.00%

7.26%

Valuation Step 3: Finding Enterprise Value

WACC= LT Growth Rate= 7.26% 4.50% Year 1 2 3 4 5 6 FY 2006 forecasted FY 2007 forecasted FY 2008 forecasted FY 2009 forecasted FY 2010 forecasted Terminal

Free cash flow Terminal Value PV of FCFs Total Enterprise 53,467.33

859.58

1,107.30

1,377.49

1,660.37

801.40

962.48

1,116.28

1,254.45

1,929.40

1,359.04

73,051.61

47,973.68

Steps 4 & 5: Subtract LT Debt and Divide by Shares Outstanding

Step 4: Subtract LT Debt  This step is not necessary as the firm is 100% equity Step 5: Divide by Shares Outstanding Total enterprise value

over

Shares outstanding 53,467.33

=Price Per Share

1,025.40

52.14

+ 10% - 10% 57.36

46.93

HOWEVER…

 

Accounting Rules vs. Economic Reality

WAG only owns approximately 18% of it’s store base. What about the other 82%?

  They are leased. These leases are structured/accounted for as operating leases. This means that although these leases (and other minor off-balance sheet obligations) carry significant future commitments ($26.078 billion), these commitments are not counted as liabilities on the firm’s balance sheet.

So are these commitments LT debt?  Liabilities: “probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services in the future as a result of past transactions or events” [FASB Concept Statement 6, paragraph 5]  Answer:

YES! These are (economic) liabilities!

Accounting for Significant Off Balance Sheet Liabilities

  The most precise method of accounting for these operating leases would be to back the costs of rent out of “Selling, Operating, and Administrative Expenses” (SO&A) and restate the firm’s financials as if they owned the stores   This would entail separating interest expense, depreciation, and amortization In addition to restating the firm’s financials, the analyst would need to calculate a new WACC, estimating a weight and cost of debt Unfortunately, the firm does not provide nearly this level of information so we must pursue other, less precise methods

Adjusting ROE: An ad hoc solution

  Although academic theory holds that a firm’s value is not affected by it’s capital structure 1 , this is not the case in reality  Modigliani and Miller’s theory does not account for, among other things, taxes or the increasing marginal barrowing rates associated with increasing leverage Therefore, investors should demand a return in excess of the k e -derived WACC we used earlier to compensate them for the risk associated with WAG’s quasi-leverage 1. For more information, see: The Cost of Capital, Corporation Finance and the Theory of Investment.

F Modigliani, MH Miller . The American Economic Review. 1958. American Economic Association

CAPM, ROE, and Everything In Between

 Below we have 2 measures of k e : CAPM, and ROE

ROE via DuPont Analysis

Total assets

over

Total equity 14,608.80

8,889.71

= Equity multiplier 1.643338

CAPM:

r f = β= r m =

k e =

4.77% 0.4

11.00%

7.26%

Sales

over

Total assets Net income

over

Sales 42,201.60

14,608.80

= Total asset turnover 2.89

1,559.50

= Profit margin 42,201.60

3.70% Equity multiplier

times

Total asset turnover

times

Profit margin 1.64

2.89

3.70%

= Return on Equity 17.54%

CAPM, ROE, and Everything In Between

Below is a matrix listing possible combinations of WACC and LT Growth and the corresponding stock prices 6.50% 7.00% 7.50% 8.00% 8.50% 9.00% 9.50% 10.00% 10.50% 11.00% 11.50% 12.00% 3.50% 49.97

42.48

36.87

32.51

29.04

26.20

23.84

21.85

20.15

18.68

17.40

16.27

Growth Rate

4.00%

4.50%

59.13

48.87

41.55

72.86

57.81

47.79

36.07

31.82

28.42

25.65

23.35

21.40

19.74

18.31

17.05

40.64

35.29

31.14

27.82

25.12

22.87

20.97

19.35

17.94

5.00% 95.75

71.22

56.53

46.74

39.76

34.54

30.48

27.24

24.60

22.40

20.55

18.96

5.50% 141.53

93.58

69.63

55.28

45.72

38.90

33.80

29.84

26.68

24.09

21.95

20.13

Importance of ROE Sensitivity

   The stock’s current price of approximately $49.00 is supported only when assuming unrealistically high LT Growth or an unrealistically low WACC (i.e. CAPM k e or below).

Due to the risk associated with the firm’s LT (economic) debt, I do not feel CAPM WACC is an appropriate measure and thus WACC must be adjusted upward to account for this risk.

THESE TWO FACTORS PRODUCE SIGNFICANT DOWNSIDE RISK FOR THE STOCK PRICE

Recommendation



I recommend that 50% or 500 shares of WAG be sold at the market

  I feel WAG is currently trading at a significantly inflated price that, in the long term, cannot be sustained Why not sell it all?

  WAG currently has considerable momentum, having beaten analyst EPS estimates for 3 consecutive quarters. Retaining some portion of the stock exposes us to the potential upside of continued momentum Walgreen has always traded at a “premium” price and thus, we cannot know if, when, and to what degree these premiums will evaporate

Negating Scenarios

1.

2.

3.

   WAG posts a Q4 that beats analyst consensus Although I feel such a scenario is unlikely due to both heightened expectations and the firm’s Q1-Q3 margins, such an accomplishment would no doubt propel stock price in the short term CVS posts poor results and/or fails in new initiatives As WAG’s main (and only real) competitor, a CVS failure will allow WAG to increase pricing power and will decrease pressure to expand WAG makes a key unexpected acquisition into a business line in which CVS does not operate With competition within the drug store industry becoming increasingly competitive, any opportunity for a player to enter a profitable business area in which the other does not operate will give the firm a first mover advantage, as well as pricing power not available in the duopoly environment.

Questions?