Walgreen Co. (WAG)

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					    Walgreen Co.
      (WAG)

    Matthew McDonnell
Contributions by James Herr


                         14-September-2006
                 Company Overview
   Founded in 1901 by Charles Walgreen
       1st 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 1st, 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
                                                     Power of Suppliers
   Customers
                                                          HIGH
     LOW
                             Overall Threat
                                Level:
                                High



                                                Threat of
          Industry Rivalry
               HIGH
                                               Substitutes
                                              MODERATE
                                         Competitors
                                               WAG          CVS       RAD      WMT     Industry
                 Market Cap:                   46.40B      24.89B      2.08B   189.61B 24.47B
                 Employ-ees:                  131,400      78,500     38,448 1,700,000 78.50K
                 Qtrly Rev Growth
                 (yoy):                       10.20%        9.10%      0.90%     8.60% 12.50%
                 Revenue (ttm):               43.21B       37.01B     16.84B   312.43B 37.01B

                 Gross Margin (ttm):          27.96% 26.76% 25.19%             23.06% 26.76%
                 EBITDA (ttm):                 2.93B  2.61B 662.08M            23.25B  2.61B

                 Oper Margins (ttm):            5.63%       5.46%   2.47%        5.93%    4.83%
                 Net Income (ttm):              1.58B       1.21B 208.92M       11.23B    1.22B
                 EPS (ttm):                      1.536        1.45   0.394        2.682     1.54
                 P/E (ttm):                      29.85       21.08   10.05        16.98    23.01
                 PEG (5 yr
                 expected):                        1.65        1.49    11.37      0.97     1.65
                 P/S (ttm):                        1.06        0.66     0.12       0.6     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
                                                                 Percentage
                                                          2005     2004       2003
        Prescription Drugs                                64        63        62
                                       Generic       59
                                       Not Generic   41


                         By 12/31/06   Generic       67


        Nonprescription Drugs                             11        12        12

        General Merchandise                               25        25        26

        Total Sales                                       100       100       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
                                                     Power of Suppliers
   Customers
                                                          HIGH
     LOW
                             Overall Threat
                                Level:
                                High



                                                Threat of
          Industry Rivalry
               HIGH
                                               Substitutes
                                              MODERATE
                         SWOT Analysis
Strengths                                  Weaknesses
 Innovative in controlling costs and       No prior experience managing current
expanding sales                            growth rates
 Expanding store base to reach more        Cost/benefit analysis of firm’s extremely
markets                                    rapid growth difficult to determine
 Has made efforts to serve growing non-
English-speaking communities
 Experienced management


Opportunities                              Threats
 Rapidly expanding elderly demographic     Business susceptible to severity of
 New innovations in Medicare may          cold/flu season
increase sales                              Possible competition from online sources

 Little competition in nursing home        May face difficulty in passing costs onto
services                                   consumers b/c Medicare/insurance
 Large proportion of US w/o health        companies
insurance, may be drawn to low-cost in-
store clinics
5 Year Performance
                                                                      Stock Price




                                                                10
                                                                     20
                                                                          30
                                                                                40
                                                                                     50
                                                                                          60




                                                            0
                                                 1/4/1996




Adjusted for stock splits and dividends
                                                 1/4/1997


                                                 1/4/1998


                                                 1/4/1999


                                                 1/4/2000


                                                 1/4/2001




                                          Date
                                                                                               Performance




                                                 1/4/2002


                                                 1/4/2003


                                                 1/4/2004


                                                 1/4/2005
                                                                                                             10 Year Performance
20 Year Performance vs. S&P 500
5 Year Performance vs. S&P 500
5 Year Performance vs. Competitors
                              Walgreens vs. Portfolio
                                     Cumulative Performance

                    100.00%

                    80.00%

                    60.00%
Percentage Change




                    40.00%

                    20.00%

                     0.00%

                    -20.00%

                    -40.00%

                    -60.00%
                                              Oct. 1999 - Feb. 2006

                                          Portfolio    S&P 500        WAG
                            Correlation Matrix
          AEE      AEOS CPRT           FR        JKHY JPM KMB          MS   MVSN SRCL       SRZ     WAG
AEE           1
AEOS      0.155         1
CPRT      0.226    0.2044         1
FR        0.326    0.1321    0.3377       1
JKHY      0.196    0.4141    0.2727   0.237          1
JPM       0.338    0.3896    0.2462   0.231      0.498       1
KMB       0.266    0.2115    0.2871   0.341      0.283   0.272       1
MS        0.255    0.4217    0.2745   0.265      0.494   0.745   0.361     1
MVSN      0.179    0.3539     0.226   0.106      0.397   0.422   0.194 0.489      1
SRCL      0.151      0.21    0.0315   0.169      0.207    0.28   0.311 0.24 0.1317        1
SRZ        0.09    0.2398    0.0847   0.171       0.28   0.269   0.172 0.342 0.2099   0.161     1
WAG       0.239    0.3095    0.2281   0.175       0.31   0.325   0.323 0.434 0.2319   0.329 0.158         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=                                α/(std. error^2)
WAG                                              1.263132978
CVS                                              0.717603164
RAD                                              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     Industry
         1
P/E Ratio over                   29.37       20.49     9.95    16.98    23.01
          2
Peg Ratio                         1.66         1.5    11.31    0.098     1.66
= Implied Growth           17.69277108       13.66 0.879752 173.2653 13.86145
= Implied growth as % of
industry implied growth          128%           99%                6%   1250%   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

                                     WAG        CVS      RAD      WMT    Industry
Firm P/E over                           29.37    20.49     9.95    16.98    23.01
Industry P/E                            23.01    23.01    23.01    23.01    23.01
                = Firm P/E as % of
                Industry P/E            128%      89%      43%      74%     100%
Market P/E
(approx)                                   18      18        18       18       18
                = Firm P/E as % of
                market P/E              163%     114%      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
    To refresh, intrinsic value of a firm’s common
     equity is determined as follows:
    1.    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.    Calculate WACC via: (we*ke)+[wd*kd*(1-tax rate)]
    3.    Discount all Ncash flows and arrive at enterprise
          value via:Σ1 FCF i/[(1+WACC)^i]
    4.    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    FY 2007        FY 2008    FY 2009    FY 2010
                          forecasted forecasted     forecasted forecasted forecasted

Net sales:                 47,525.69   53,073.23     58,764.67   64,505.80   70,166.19

Less: Operating costs     (44,792.96) (50,021.52)   (55,385.70) (60,796.71) (66,131.63)
      Taxes paid           (1,047.69) (1,176.83)     (1,323.66) (1,485.10) (1,663.71)
      Net investment         (825.46)    (767.58)      (677.82)    (563.62)    (441.44)
      ∆ Working capital       853.14      659.29        617.55    1,146.98    1,490.68
= Free Cash Flow              859.58    1,107.30      1,377.49    1,660.37    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=ke. Below is ke (and thus, WACC)
    calculated via CAPM


                       CAPM:
                          rf=       4.77%
                          β=           0.4
                         rm=       11.00%
                          ke=       7.26%
                      Valuation Step 3:
                   Finding Enterprise Value
                         WACC=          7.26%
                         LT Growth
                         Rate=          4.50%


                 Year        1          2          3          4          5           6

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

Free cash flow               859.58   1,107.30   1,377.49   1,660.37   1,929.40
Terminal Value                                                                    73,051.61
PV of FCFs                   801.40    962.48    1,116.28   1,254.45   1,359.04   47,973.68

Total
Enterprise   53,467.33
              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              53,467.33
Shares
outstanding              1,025.40
                                    + 10%               57.36
=Price Per Share           52.14
                                    - 10%               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 structure1,
           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 ke-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 ke: CAPM, and ROE
                       ROE via DuPont Analysis
                       Total assets over                          14,608.80
                       Total equity                                8,889.71
                                                    = Equity multiplier         1.643338

    CAPM:              Sales over                                   42,201.60
       rf=    4.77%    Total assets                                14,608.80
                                                    = Total asset turnover         2.89
       β=        0.4
      rm=    11.00%    Net income over                              1,559.50
     ke=      7.26%    Sales                                       42,201.60
                                                    = Profit margin               3.70%

                       Equity multiplier times                         1.64
                       Total asset turnover times                    2.89
                       Profit margin                                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
                            Growth Rate
                    3.50%   4.00%    4.50%   5.00%    5.50%
            6.50%   49.97   59.13    72.86   95.75   141.53
            7.00%   42.48   48.87    57.81   71.22    93.58
            7.50%   36.87   41.55    47.79   56.53    69.63
            8.00%   32.51   36.07    40.64   46.74    55.28
    WACC




            8.50%   29.04   31.82    35.29   39.76    45.72
            9.00%   26.20   28.42    31.14   34.54    38.90
            9.50%   23.84   25.65    27.82   30.48    33.80
           10.00%   21.85   23.35    25.12   27.24    29.84
           10.50%   20.15   21.40    22.87   24.60    26.68
           11.00%   18.68   19.74    20.97   22.40    24.09
           11.50%   17.40   18.31    19.35   20.55    21.95
           12.00%   16.27   17.05    17.94   18.96    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 ke 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.       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
2.       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
3.       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?