Irrelevance is an intractable opponent. If your grandparents grew up in a major city, talk to them about what the neighborhoods used to look like. Chances are there were certain staples like a neighborhood butcher shop, a neighborhood bakery, a neighborhood dry goods store and a local bar (or three). A lot of this has frankly disappeared over the years, and Walgreen (NYSE:WAG) needs to be creative and aggressive if it is going to stay relevant in a landscape where the core drug business is increasingly moving out of drugstores. (For more on retail stores, read The 4 R's Of Investing In Retail.)

Investopedia Markets: Explore the best one-stop source for financial news, quotes and insights.

An Okay End to the Fiscal Year
Walgreen's fiscal fourth quarter results were solid but a bit confusing, as a lower tax rate and share count did help boost reported earnings per share. Sales rose more than 6% on better than 4% comps, putting Walgreen ahead of other drugstore rivals CVS Caremark (NYSE:CVS) and Rite Aid (NYSE:RAD) in terms of sales momentum. Drug sales were up about a percentage point less than overall sales, but the comp sales were similar, and prescription drugs are still about two-thirds of the sales base.

Matters get a little more complicated below the top line. Gross margin fell again - this time by about 20 basis points - on lower front-end margins. Some of this could be a byproduct of more aggressive promotional efforts. The company did relatively well on SG&A, though, and operating income grew more than 11% as operating margin improved about 20 basis points.

Playing Chicken Versus Express Scripts
One of the darkest clouds over Walgreen is the ongoing dispute with Express Scripts (Nasdaq:ESRX). In short, Walgreen has decided to leave the ESRX network on January 1 unless Express Scripts changes (which means "increases" in this case) how it compensates Walgreen. Walgreen feels that it offers a host of value-added services that Express Scripts is not compensating it for fairly.

This is a risky move for Walgreen. The drugstore has at least $5 billion in prescription revenue at risk from this move, not to mention profitable ancillary revenue that comes when a customer goes to Walgreen to grab a prescription and leaves with a gallon of milk, toothpaste or a six-pack of beer. With those sales, then, also go gross profit and SG&A leverage. Making matters worse is the fact that Express Scripts could turn to CVS as a replacement (even notwithstanding the competition in the PBM business).

Can Walgreen squeeze better terms out of Express Scripts? It's going to be a difficult argument. Express Scripts is maintaining that Walgreen needs it more than it needs Walgreen, and that may be correct - especially with the impending acquisition of Medco (NYSE:MHS). On the flip side, maybe Walgreen can spin this as an example of Express Scripts trying to bully it and evidence that the acquisition of Medco should be blocked by the government. If Walgreen can get any traction with that argument, Express Scripts may see it as cheaper in the long run to simply buy off Walgreen with better terms. (To learn more about mergers and acquistions, read What Makes An M&A Deal Work?)

What's the Next Niche?
Longer term, there are some existential concerns about Walgreen. More and more drug sales are going through direct mail, and it's unclear that there's a sustainable niche here when Walgreen's primary advantage over the likes of Wal-Mart (NYSE:WMT) and Target (NYSE:TGT) seems to be in offering more SKUs of shampoo and make-up.

Still, don't count out Walgreen. Drugstores have been exceptionally adaptive over the years. Drugstores sold patent medicines (and legitimate drugs as well) before there even was a real pharmaceutical industry. Later, soda companies like Coca-Cola (NYSE:KO) and PepsiCo (NYSE:PEP) basically got their start through drugstore snack counters.

Who knows what could be next. Walgreen is already pushing service offerings like flu shots, and perhaps there's room to offer even more medical services through the pharmacies. In the meantime, at least the company has some major generic launches to look forward to, as Pfizer's (NYSE: PFE) Lipitor, Eli Lilly's (NYSE:LLY) Zyprexa and Forest Labs' (NYSE:FRX) Lexapro all face generic launches in the next six months (and each has had more than $2 billion in branded sales).

The Bottom Line
Walgreen's mission is straight forward - adapt or die. While Walgreen likely has a defensible niche as a small-footprint "general store" in dense urban areas, the company will have to be creative to make its stores relevant and sticky in suburban areas. Drugstores have always been surprisingly adaptive, though, so investors should not count out this company just yet. The challenges are formidable, but the stock is not too expensive, and management knows that it has a lot to prove before Wall Street will give them their due. (For more, read Analyzing Retail Stocks.)

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

Related Articles
  1. Personal Finance

    A Day in the Life of an Equity Research Analyst

    What does an equity research analyst do on an everyday basis?
  2. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Downside Hedged

    Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
  3. Mutual Funds & ETFs

    ETF Analysis: iShares Morningstar Small-Cap Value

    Find out about the Shares Morningstar Small-Cap Value ETF, and learn detailed information about this exchange-traded fund that focuses on small-cap equities.
  4. Mutual Funds & ETFs

    ETF Analysis: ProShares Large Cap Core Plus

    Learn information about the ProShares Large Cap Core Plus ETF, and explore detailed analysis of its characteristics, suitability and recommendations.
  5. Mutual Funds & ETFs

    ETF Analysis: iShares Core Growth Allocation

    Find out about the iShares Core Growth Allocation Fund, and learn detailed information about its characteristics, suitability and recommendations.
  6. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI USA Minimum Volatility

    Learn about the iShares MSCI USA Minimum Volatility exchange-traded fund, which invests in low-volatility equities traded on the U.S. stock market.
  7. Stock Analysis

    Should You Follow Millionaires into This Sector?

    Millionaire investors—and those who follow them—should take another look at the current economic situation before making any more investment decisions.
  8. Professionals

    What to do During a Market Correction

    The market has corrected...now what? Here's what you should consider rather than panicking.
  9. Mutual Funds & ETFs

    ETF Analysis: WisdomTree SmallCap Earnings

    Discover the WisdomTree Small Cap Earnings ETF, a fund with a special focus on small-cap and micro-cap stocks with positive earnings.
  10. Mutual Funds & ETFs

    ETF Analysis: iShares US Regional Banks

    Obtain information and analysis of the iShares US Regional Banks ETF for investors seeking particular exposure to regional bank stocks.
RELATED TERMS
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Profit Margin

    A category of ratios measuring profitability calculated as net ...
  3. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis ...
  4. Debt Ratio

    A financial ratio that measures the extent of a company’s or ...
  5. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing ...
  6. Net Present Value - NPV

    The difference between the present values of cash inflows and ...
RELATED FAQS
  1. What is the formula for calculating compound annual growth rate (CAGR) in Excel?

    The compound annual growth rate, or CAGR for short, measures the return on an investment over a certain period of time. Below ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. When does the fixed charge coverage ratio suggest that a company should stop borrowing ...

    Since the fixed charge coverage ratio indicates the number of times a company is capable of making its fixed charge payments ... Read Full Answer >>
  4. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  5. What is the difference between the return on total assets and an interest rate?

    Return on total assets (ROTA) represents one of the profitability metrics. It is calculated by taking a company's earnings ... Read Full Answer >>
  6. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>

You May Also Like

COMPANIES IN THIS ARTICLE
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!