Prescription for a 5-Star Retailer

 Walgreen's (WAG) stock has sold off sharply in recent months, and I have used the opportunity to add the shares to the Tortoise Portfolio that is inside Morningstar StockInvestor. Here to go into more detail about Walgreen (which is having its annual meeting today, Jan. 9) is senior analyst Mitch Corwin, who has covered the firm for Morningstar since 2004.

Q: Can you give some background concerning how Walgreen is positioned today?

A: Walgreen today has over 6,100 stores and fills roughly 17% of the prescriptions in this country. This compares to less than 2,400 stores 10 years ago and about 450 in 1990. Reimbursement rates on prescription drugs have been in decline, making scale paramount to making it in the drugstore business. Much of the company's growth has come at the expense of smaller drugstore operators that lack its resources and economies of scale.

In total there are about 56,000 pharmacies. Walgreen's largest drugstore competitors are  CVS Caremark (CVS) and  Rite Aid (RAD), which have 6,200 and 5,100 stores, respectively. The company also competes for retail prescriptions against discounters like  Wal-Mart (WMT) and supermarkets such as  Kroger (KR) that operate pharmacies in their stores.

Q: Very few retailers attain a "wide" moat rating. What competitive advantages does Walgreen have that make it special?

A: Having an economic moat in retail requires offering something that can reliably keep consumers coming back to your stores. Wal-Mart and  Home Depot (HD) offer the lowest prices. For Walgreen, it's about being most convenient, and that means building the right stores in the right locations. It pioneered the use of larger, freestanding locations with more convenient entrances and exits and devoted parking. It was also the first chain to realize the potential for 24-hour and drive-through pharmacies.

While many of its competitors have grown through acquisitions, Walgreen has spent most of the 1990s and this decade growing organically, securing some of the best real estate and building larger stores. In 1992, 13% of the firm's stores were freestanding and less than 1% had drive-through pharmacies. Today, about 85% of Walgreen's stores are both freestanding and have drive-through pharmacies. To put this in a competitive perspective, 56% of Rite Aid's stores today are freestanding.

Q: How do these advantages show up in the numbers?

A: I think the best measurement of efficiency and sustainability of customer traffic is prescriptions per store per day because pharmacy customers tend to be stickier. Walgreen fills about 275 prescriptions per store per day in its conventional drug stores versus an industry average of less than 200.

Q: What separates Walgreen from CVS Caremark? The firms are now roughly the same size, and the retail stores are not all that different.

A: There are differences in the look of the stores and in some of the merchandise, but they aren't significant. If one offers something inside the store that becomes popular, it can typically be copied. Take in-store clinics, for example. CVS was first to recognize the advantage of offering walk-in health-care clinics staffed by nurse practitioners and acquired MinuteClinic. Walgreen was not about to cede that advantage and went ahead and bought another operator, Take Care. Both firms are now ramping up the number of stores offering these clinics.

I think what really separates Walgreen from CVS is its organic growth model. CVS Caremark has relied on acquisitions to drive a large amount of its store growth. While the company has done a fine job integrating those acquisitions and improving the productivity of the acquired stores, when you acquire, you take everything, the good and bad. In addition, there aren't any large acquisition candidates left for CVS Caremark. While Walgreen is still growing its square footage about 8% per year, CVS Caremark's organic square footage growth rate is 3%. Walgreen will surpass CVS Caremark this year in store count and continue to widen its lead in the years ahead.

Q: What about the merger of CVS with the pharmacy benefits manager Caremark. What are the chances of this being a disruptive force in the drugstore industry?

A: I think the success of the merger will dictate how disruptive it is for both retail drugstores and other pharmacy benefits managers, like  Medco  and  Express Scripts . Obviously, CVS Caremark has another avenue to market to consumers and drive store traffic, with direct access to 95 million lives through managing their pharmacy benefit. In addition, the combination gives CVS Caremark considerable scale in procurement and a more holistic offering to both plan providers and consumers.

On the flip side, there are a lot of risks to the transaction. These are two very different companies coming together, and the new firm has a huge target on its back. I would expect the competing drugstore chains and other PBMs to go after them pretty hard. I think Walgreen is in a wait-and-see mode as far as deciding whether or not to also pursue a combination with a large PBM. Whatever happens, I think it's important to understand that CVS Caremark and Walgreen are the only retailers that can pull this type of thing off on a nationwide level.

Q: Has the Wal-Mart generic-drug program hurt the business at all?

A: Both Walgreen and CVS have said they have lost less than one prescription per store per day, on average, in stores that compete against Wal-Mart's generics program. I think a lot of that has to do with the fact that around 95% of drugstore prescription sales are to consumers covered by insurance. Wal-Mart's discount is more pronounced for the uninsured. With co-pays for generic drugs already fairly low, consumers have little reason to change pharmacies at this point. Overall, it's been a nice PR move for Wal-Mart, but it hasn't had a noticeable effect on the drugstore chains.

Q: What about government reimbursements?

A: It's hard to say there's a lot of fat when talking about dispensing prescription drugs because gross margins here tend to be in the low 20s. Walgreen earns a much higher margin on the products it sells in the front of the store. However, that isn't stopping the federal government from looking at lowering reimbursement rates as a way to drive down its own costs. In 2008, reimbursements under the federal Medicaid program will likely drop, so the drugstore chains are trying to persuade the states to offset the cuts by raising dispensing fees. Lower reimbursement rates from federal programs are always a risk, but the nice thing about the government insuring a greater amount of the population is that it makes health care more affordable for more people and therefore drives up the overall demand for prescriptions.

Q: Walk me through the main assumptions in your valuation model.

A: Over the next five years, I assume the company grows sales 11% annually, on average, and gains incremental margin expansion as higher-margin generic drugs continue to become a more pronounced portion of the prescription-drug mix. This equates to 13% average operating profit growth. Sales should be driven by around 8% growth in square footage and increases in same-store sales.

Q: How confident are you in your fair value?

A: Very confident for two reasons: First, the aging of the baby boomers will ensure over two decades of strong growth in prescription-drug spending. Second, Walgreen has a proven growth model and has far from saturated its addressable market. There is no reason, in my view, why the company can't double its store base, from 6,000 to 12,000 stores, over the next 10 years. Very few companies can match Walgreen's track record of consistent growth, a record I do not foresee being broken.  

A version of this article appeared in the November 2007 issue ofStockInvestor.

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