Hi folks,

Here are my notes for my investment club meeting.  We make our quarter stock reports to our club the month following the quarter releases.  Our meeting is the 2nd week of the month so oftentimes these releases come out in a matter of days (sometimes hours!) after our meeting.

Walgreen Company (WAG) Q2 2007 Report

Quarter sales were up 14.6%; 12.3% for the year so far
Quarter EPS were up 24.7%; (vs. 27% depending on data file used)
PTP was 24.3%
Same store sales were up 8.9%

Drugs are 64% of total sales
Generics are 63% of that

Generics will lower sales but increase margins
Morningstar expects 14% sales in 2007; then 11% after that
They recommend buying below $43; selling above $70
Fair value is $56.60

Positive Influences – How will this stock grow?
We’ve got a favorable, long term industry outlook
Baby boomers are aging
Prescriptions are expected to grow in high single digits for the next 5 years
Part D will help bring in more traffic
Generics are higher margin
WAG is years ahead of the competition in locations
WAG’s PBM is poised to grow faster than the company as a whole
Convenience remains key driver w/24 hour stores and drive up windows
Plus they are growing their managed care division

They just got their 6^th CEO since 1901; he started with WAG in 1982
Management compensation is reasonable
Plenty of stock ownership at the top to align their interests with shareholders

Negative Influences – What do we need to watch out for?
The CVS/Caremark merger is a done deal
Jury is still out on its effect on WAG; stock is weak due to this uncertainty
That makes it a buying opportunity if you believe in their strength
Competitive threats are not new to WAG; they have a niche with store locations
But Mass merchandisers, mandatory mail order, the CVS merger, Rite Aid shopping spree, $4 prescriptions, rising healthcare costs for the government and a national shortage of pharmacists will definitely affect this industry.  The strongest will survive.

Now, they are on track to hit their saturation goal of 7,000 stores by 2010; 5,641 now.
That means we need to make our money NOW.

No changes to the SSG; keeping 11% sales and 14% EPS forward estimates;
26 & 18 for the P/Es.
The pullback from CVS puts the stock squarely in the buy zone. 
I recommend we buy.

Submitted by Lynn Ostrem
garbagecop@earthlink.net

Thanks Lynn for the excellent recap of WAG 2nd quarter.   I would add two items under the Negative Infulences.

1.  Free cash flow, which I like to look at, is minimal. FCF is listed at at -14.6% YTD over 2006 YTD.   This is due of course to capex spending to build new stores.  However with a company trading at 24X forward earnings which is pricey compared to the industry, I like to see a little more in the FCF area.

2.  Additionally, while analysts like to point to the 'pristine' balance sheet, WAG actually has liability for $26.4B in operating leases.  If this were treated as debt, it would equate to a 64% debt/cap ratio.  They are listed by Moody's with an Aa3 credit rating with a negative outlook.

I own WAG so I watch it closely, its in the 'buy' range on my SSG as well, however, I'm wating for a more positive TA chart before buying more.

Here are some thoughts about WAG that I recently posted on MI...

I never could get on board with either WAG or CVS because I had long term issues with their basic business model.  I felt that over time prescriptions would move to direct mail and the health & beauty aid (HBA) business would move to discount HBA stores found in lower cost strip malls like Harmon (owned by BBBY) and Sally's Beauty Holdings.  As a result, I felt WAG & CVS traffic counts would decline & they would be left with lots of high cost under-utilized stores a la the over-built bowling alley craze of the 1960s (or maybe it was the '70s).

However, an article in the WSJ about two new strategic thrusts (expanding wellness ctrs & specialty pharmacies) causes me to revisit my assumptions about WAG.
_____________________________________
How Walgreen Changed
Its Prescription for Growth
By AMY MERRICK
March 19, 2008; Page B1

Walgreen Co. thrived for decades by opening stores faster than its competitors -- a new location pops up every 16 hours -- and by pushing out more prescriptions per year than any other chain.

But facing pressure from rivals, a weak economy and cracks in the health system, Walgreen is changing its time-tested formula. Instead of simply bottling pills, it is refashioning itself into a broad health-care provider.

On Monday, the Deerfield, Ill.-based company announced plans to buy I-trax Inc. and Whole Health Management, two companies that run a total of 350 health centers at corporate offices. The centers offer services from treating simple illnesses to counseling patients on managing diabetes.

Walgreen expects to open more pharmacies at work sites and to attract employees, their family members and retirees to its stores. The acquired companies will form part of Walgreen's new health and wellness division and will include Take Care Health Clinics, which operate 136 clinics inside Walgreen stores.

"This is only the beginning of our presence in this sector," Walgreen Chief Executive Jeffrey Rein said in a conference call with analysts. In the U.S., there are more than 7,600 office sites with 1,000 or more employees that could support a health-care center, he said.

In the last few years, Walgreen has begun making bolder moves. It has dropped its longtime aversion to acquisitions and snapped up specialty pharmacies that are experts in infertility, cancer, AIDS and other conditions that are expensive to treat. It is opening pharmacies in hospitals and assisted-living facilities. Last year, it quadrupled the number of pharmacists certified to give flu shots and other immunizations.

Investors, though, aren't sure it is taking the right approach....

...two of Walgreen's big rivals, Wal-Mart Stores Inc. and CVS Caremark Corp., are expanding in what they consider a big growth area: the business of managing employer drug-benefit programs....

...At a January meeting with store managers, Wal-Mart Chief Executive Lee Scott signaled that the giant discounter plans to expand health-care cost-cutting initiatives. Among other things, Mr. Scott said the retailer is initiating a pilot program to help "select employers ... manage how they process and pay prescription claims."...

CVS has staked its business on the future success of pharmacy-benefit managers, or PBMs, purchasing Caremark last year in a landmark deal. PBMs provide prescription-drug coverage to workers at most U.S. companies, striking deals with retail pharmacies for lower prices and collecting rebates from drug manufacturers. CVS Caremark executives say the combined company will be able to lower employer costs and simplify patient access to prescriptions.

But Mr. Rein, Walgreen's chief executive, has said his drugstore chain doesn't plan to pursue buying a major PBM. "Our relationships with employers and health plans will grow because of our independence from major PBMs," he said Monday.

Walgreen has its own, smaller PBM, but it doesn't play a major role in its new strategy. In the past, Mr. Rein has questioned whether PBMs, which depend heavily on rebates from drug companies, will survive in the long run.

"We believe that the services provided by PBMs are essential to the functioning of the health-care system and will always be needed," said Eileen Howard Dunn, a spokeswoman for CVS Caremark. "Healthy PBMs don't have an overreliance on rebates."

While Walgreen shares have fallen, CVS Caremark shares have risen 17% in the last 52 weeks. Last year was the first time since 2002 that Walgreen shares posted an annual decline.

Walgreen's share price has recovered some ground since the beginning of the year. But drugstores' profits are currently under pressure, because fewer generic-drug launches are planned for the first half of this year, compared with the same period last year. Walgreen plans to report earnings for its fiscal second quarter this coming Monday.

"What folks are missing is that multiple strategies are able to win in such a big area," Gregory Wasson, Walgreen's president, said in an interview. "It's easy to see something big and tangible. CVS has had its shareholders gain value. Ours is a winning strategy. People may not have realized the value yet."

Meanwhile, the business of health care is getting trickier. U.S. prescription sales grew just 3.8% last year, to $286.5 billion, marking the slowest growth rate since 1961, according to a report released last week by market-research firm IMS Health.

Walgreen has responded to the shifting environment in part by expanding into specialty pharmacy, where drug sales are growing much faster than the overall prescription market.

Specialty pharmacy, a $60 billion business, is increasing 15% to 20% a year, Walgreen says. It also is highly profitable. Many of the newest drugs can't be produced in pill form, and must instead be infused into the patient's bloodstream or injected by an experienced technician.

In September, Walgreen completed its $850 million purchase of OptionCare, which specializes in infusion drugs, such as certain cancer treatments. It was the largest deal in Walgreen's 107-year history, and it made Walgreen the nation's largest independent specialty-pharmacy company.

Although the gross profit margin for specialty drugs is lower on a percentage basis, the profit dollars per prescription are much greater, because specialty drugs are so much more expensive than traditional medicines. Some specialty drugs can cost $1,000 or more per prescription, compared with $75 for the average prescription in 2006, according to the National Association of Chain Drug Stores, a trade group.

Walgreen executives envision bringing together its Take Care clinics, specialty operations and workplace centers, using electronic prescriptions and medical records, to cover a range of needs.

Patients might visit a Walgreen-owned clinic in their office building, for example, and then pick up a prescription at a Walgreen pharmacy at work or on the way home.

"The real opportunity is to begin to connect the dots," says Mr. Wasson, Walgreen's president.
__________________________

The above doesn't begin to cope with all the health & drug issues facing the retail drug segment but, it does open some opportunities that I hadn't recognized before... if they can connect the dots.

Pat Landers wrote: “I have attached my recent SSG: I used sales growth of 10%. This is a rough average of VL, Reuters, Microsoft Money, Yahoo financial, and Take Stock. I used the preferred procedure for earnings: PTM of 5.8% and Tax rate of 37%.”

Pat:

- Your High Price is much higher than mine because you were more optimistic than I was in terms of estimated EPS (9.4% vs 7.0%) and Forecast High PEs (24.0 vs 22.0).  As a result, you got a 17.4% Total Return while I got only 12.8% which is below the 15% criteria;

- You did not say what your Preferred Procedure used for estimated Shares Outstanding.  If you had used VL’s estimate of 975M, your EPS would have increased from 9.4 to 12.9%;

-  How come your SSG is dated 12-22-07, but seems to have a WAG price that’s later?

- WAG sold for $39.96 yesterday (3-26) having lost 20.4% per share in the last 6 months;

- I would add Lynn’s SSG if she ever responded to your questions.

Armin

ps: you never responded to my comparison of our SSGs for FDS: was it something I said?

Armin,

Here is what I came up with on WAG:

WAG has recently released quarterly and 1^st ½ results for the current fiscal year. The VL report also published an updated report of the Co.

Sales:

     1. Sales seem to be slowly decreasing as observed in the Stock Analyst balance sheet report. With an R^2 value of 1.00, the sales per share have gone from 14.9% in the past 10 years, to 13.2% in the past 5years, to 12.9% in the past 3 years.

     2. VL estimated annual growth rate for sales per share to be 12%. The rate of annual revenue growth from the future revenue prediction is around 10.25%.

     3. Take Stock future growth rate is 12.7%

     4. Implied Growth is 13.2%

     5. Management has not provided guidance for future sales or earnings.

Earnings:

     1. Sales, Income and Earnings/Share are all trending  parallel to each other. PERT graphics trend lines are very close to being parallel for sales and earnings. (See slide 1)

     2. Take Stock’s trend graph from page 1 of the TSSW shows future earnings growth of 12.7%; the business model shows growth of 12.2%.

     3. My SSG with the preferred procedure shows growth in earnings of 9.7% (See slide 2)

     4. Preferred procedure with VL future data shows earnings growth of 11.6%. (See slide 3)

     5. Analysts estimates ranged from 11.11% to 15%

Management:

1. SSG Part 2=Even and UP
2. VL Industry Average-better than the average gross margin, operating margin, profit margin and ROE. (See slide 4)
3. BI Online SSG-WAG  #1 in PTM, ROE, lowest Total Debt and Debt/Capital (See slide 5)-as pointed out by Karen O Boyle,this does not include the $$ spent on rent, which is apparently quite high. (I could not find this figure; I assume it is included in the SG&A costs.) From the recent 10Q, I found the number of store openings for the 1^st ½ of this year compared to last. In 08, Net store openings was 240; of those, 136 were leased. In 07, net store openings was 180: of those, 138 were leased.
4. Ratio Analyzer-Liquidity ratios mostly green due to little debt. Efficiency ratios mostly yellow because of growing AR and Inventory. Cash Flow ratios appear OK with exception of Free Cash Flow-has decreased 30% from same period last year. Also, FCF margin is <1%. Profitability and Asset ratios appear OK.

PE ratio:

      1. PERT B-High and Low PE trending down. Latest 5 year average was high 29.7 and low 22.6

      2. VL future PE High 24.6, Low 20.4

      3. Take Stock PE High 29.3, Low 22.5

Because the recent low PE was 15.7 in January, and the recent high PE was 23.2, I have lowered those values on my SSG. (See slide 6). If the price of the stock continues to drop, these numbers may be too high.

Growth Strategies:

1.      The Co. is moving to specialty pharmacy care, It has recently purchased 2 specialty pharmacy businesses. This segment of it’s business is increasing by 15% to 20% a year. Many of these medications are administered intravenously or injected into muscle. Lower Margins

2.      Take Care Health clinics-Worksite health centers. These centers allow large Co. employees as well as health plan members and their dependents, to visit clinics near their homes or at work. Operate 500 clinics now.

3.      Openings new drug stores-7000 total net stores by the end of 2008, 15,000 long term. The best margins are from sales of generic drugs and front end sales-the 2 most competitive areas the Co. is in.  

I plan on contacting the IR person at WAG to ask about future growth-is there a big push to enter into these new business lines, what is the expected growth from these lines. Does the Co. see front end sales as the segment with the best margins in the future. What other growth strategies do they have for the future.

To answer your question about earnings growth, it came from the preferred procedure on my SSG. Where did your earnings growth come from? Are you anticipating higher taxes or more shares in the future? (I tweaked my PEs a little)

 Pat:

“With an R^2 value of 1.00, the sales per share have gone from 14.9% in the past 10 years, to 13.2% in the past 5years, to 12.9% in the past 3 years.”

- I’m pretty sure you mean that sales growth, not sales per share, has declined.

- When I look at the change in Historical Growth Rates in TK5, I see 13.4% sales growth for the last 5 years and 12.7% for the last 3 (whereas you see 13.2% and 12.9% in your SA). 

Could it be that both programs read the same S&P data differently? (I hope not!)

“VL Industry Average-better than the average gross margin, operating margin, profit margin and ROE. (See slide 4)”

- The VL Industry Average is relatively small and consists of only those companies that VL covers.  MSN Money is much better for comparison purposes.

- For example, WAG is in the Pharmacy Services Industry at VL which consists of 10 companies.  At MSN, WAG is in the Retail Drug Store sub-industry which consists of 25 companies.  Moreover, not only are the MSN and VL statistics different because of the different industry size, but MSN has industry data for 5 year average PTPM and ROE.

“Because the recent low PE was 15.7 in January, and the recent high PE was 23.2, I have lowered those values on my SSG. (See slide 6). If the price of the stock continues to drop, these numbers may be too high.”

- You previously posted your March SSG and I see even more changes than the two you mention: you lowered your High PE from 24.0 in March to 23.0 in currently, lowered your Low PE from 16.0 to 15.0, raised your EPS growth from 9.4% to 9.7%, and lowered your Low Price from $30.18 to $28.86.

- However, your Power Point doesn’t show your current Upside-Downside Ratio nor your Total Return (they were 7.0 and 17.4% in March) so it’s not possible to evaluate your changes.

“To answer your question about earnings growth, it came from the preferred procedure on my SSG.”

- My questions were something else: I asked what you used for shares outstanding in your Preferred Procedure, and why your SSG date showed 12-22-07 but your $35.96 price seemed to be for a later date.

“Where did your earnings growth come from? Are you anticipating higher taxes or more shares in the future? (I tweaked my PEs a little”

- WAG was different than my usual "preferred procedure" [grin]: because of its steep price decline (-22.8% last 12 months and – 6.4% last three months), I chose 7.0% which was the lowest EPS estimate of all seven of the analysts that I surveyed.

Armin

Ps: as a WAG stock watcher, you might want to respond to Michael Schickler who asked for thoughts about CVS vs WAG

Here are the questions and responses I got from WAG. The current stock relative PE is around 89, which seems like an opportunity based on the value of the stock. I am a holder right now, until growth improves.

Dear Pat,

Thank you for your interest in Walgreen Co.

What strategies does the Co. have for future growth?  Is the main growth driver for the next 5 years new store openings?.

1.  Growth will mainly be based on real estate growth (i.e. finding the best corners in America) and acquiring specialty business that support our overall goal healthcare goals.

 I noticed on the last 10Q that you have gone into specialty pharmacy as well as wellness clinics. What kind of growth do you see in these areas?

2  The specialty industry is expected to grow by tens of billions of dollars over the next decade.

 What are the margins in these areas?

3.  The margins are fairly low (similar to brand name drugs in general), but gross profit dollars are very high.

Is front end sales predicted to be the area with the best margins?

  FE will  most likely continue to have very strong margins, especially with our growing private label.

 I noticed that for the past 3 QTR. earnings have grown much slower than sales. Why is that and do you see it turning around in the near future?

5.  Sales have been less than earnings because SG&A has been growing faster than sales.  We see this as an area for improvement, and have seen improvement in the past few quarters.

 Future growth is from Comps and new store openings? Is there anything else?

6.  In addition to new store openings, we will see growth from our new specialty businesses and new generic introductions.

We do not provide guidance.  The projections we have stated included:

1.  $2.0 billion in Cap Ex in FY08
2.  475 Net New Stores in FY2008
3.  8% Sq. Footage Growth

We have also said that is our long-term goal  is to grow earnings at 15%.

Thank you,


Jay Jorbin, MBA
Finance Department, Walgreen Co.
Office Phone: 847.914.2361

Pat,

Thanks for posting your Q&A with WAG IR.  I'm also a holder with a wait and see attitude.

Bob

Hey Bob,

What are you using for future sales and/or earnings for WAG. Because they do not provide guidance, it becomes a bit of a guessing game.

I think that comps and revenue from new stores is straight forward. The problem is that the company does NOT include specialty pharmacy and wellness clinics in their comps. They have stated in a recent 10Q that they expect that area to grow by 15% to 20% in the near and far future. But without knowing where those sales are today, it is hard to predict where they will be in the future.  Here is the last E-mail I got from the Investor Relations person regarding this matter:

         Pat,

"I'm sorry, but due to Regulation FD, we cannot provide information that is material and nonpublic.  With our new Prime contract, it is very possible that we will begin to report this number, but at the moment we have chosen not segment this category of business.

With regards to sales, keep in mind that they are impacted by the introduction of new generics.  These introductions can significantly lower sales, but can provide greater gross profit dollars and improve the bottom line."

So here is my best shot of future sales for 1 year for WAG:

In 2006 the Co had revenue of $47,409M. Comps were 8.1% in 2007, so sales from existing stores was $51,249M. There were 536 new stores opened in 2007 that made $3.5M each for a total of $1,876M. Revenue from existing stores and new stores was $53,125. TOTAL revenue in 2007 was $53,762M; therefore, $637M or so, came from specialty pahrmacy.

The Co reported sales of $56,541M in it's latest quarter (TTM). They are also giving comp guidance of 4.7% going forward. So sales from existing stores should be $59,198M in 1 year. They are planning on opening 475 new stores which should add $1,661M. And if the specialty business grows by 15%, it should generate $733M. Adding all those numbers, you get Revenue for 1 year from now of $61,592M. That is 9% above the current total Revenue. If earnings grow at roughly the same rate as sales, as my SSG predicts, earnings in 1 year should be about $2.30.

If the stock sells for the average future PE in one year (19 on my SSG), the price of the stock will be $43.70. At the current price of $35.39, that will be a return of 23%. (Sounds too good to be true).

Do you think this is s perfect storm scenario or does it seem reasonable?

So for taking so long to reply but I just replaced my computer!  Don't sure how VISTA and I are going to get along. (G)

I have my concerns about Walgreen's.  New CEO.  Walmart and now Target cutting price of both 30 day and 90 day generic drugs.  Consumer Discretionary items being stretch (Front Store).  Medical Aid Stations in Beta test.  CVS coming on strong!

Walgreen's does have strong management and a good track record.  We shall see.  Maybe we'll need our life-preservers and floatation devices.

Bob