What Is Walgreen's Next Trick?

By Stephen D. Simpson, CFA | September 30, 2011 AAA

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.)

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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.)

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