Walgreens Suffers The Retailing Curse

By Sham Gad | December 04, 2009 AAA

Drug store chain Walgreens (NYSE:WAG) recently reported November sales that on the surface would appear to please Mr. Market. November, 2009 sales were up 8.7%, while pharmacy sales were up nearly 10%. Comparable stores sales, the favorite metric of analysts was up 3.9%. Unfortunately, Wall Street was forecasting 6.1%, and that alone is causing an unfavorable assessment of the current stock price.

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In a Word: Competition
From a numbers basis, Walgreens is certainly a healthy, well-run business. The company generates ample levels of free cash flow, the balance sheet shows reasonable net debt, and the pharmacy business does a good job of driving store traffic. But the fact that Walgreens missed analysts estimates isn't the real reason to be concerned. After all, analysts are humans who are prone to making mistakes. The big issue for Walgreens is simply competition from the larger stores, most namely Wal-Mart (NYSE:WMT).

In fact, competition is the primary reason the Longleaf Funds, run by one of my favorite value investors Mason Hawkins, sold of out Walgreens in the third quarter. Aside from the fact that Walgreens competes with CVS Caremark (NYSE:CVS) and to a lesser extent Rite-Aid (NYSE:RAD), Wal-Mart is a very serious threat to many retailers now and in the future.

The Writing on the Wall
Of course at a certain price Walgreens shares would become an attractive investment. But any price paid would have be discounted enough to account for future competitive threats. After all, if profit margins slowly erode over time, the earnings multiple assigned to businesses like Walgreens may decline implying which would unfavorably affect the stock price. Prudent investors must always be thinking about competitive threats when investing. Often, its better to pay a higher price for a business with little or no significant threats versus buying something cheap that goes up against stronger and bigger competitors. (For more, see Economic Moats: A Successful Company's Best Defense.)

Bottom Line
While Walgreens report is simply a monthly tally, the next earnings release may follow suit and disappoint analysts. No matter how the numbers are presented, interested investors should focus on the competitive threats.

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