Tickers in this Article: WAG, CVS, WMT, TGT, ESRX, MHS, CHSI
There is a lot about Walgreen (NYSE:WAG) that would seem to make it a no-brainer for long-term investors. It is the second-largest drug retailer in the country, and people always need drugs, right? Moreover, a Walgreen is within a short drive or walk for a rather large percentage of the country so there is a definite convenience aspect as well. On top of that, the company has generated fairly solid returns on capital and would seem to be transitioning to a point where its capital base is not so demanding on cash flow.

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A Second Quarter Bedeviled By Expectations
If an investor did not know the expectations around Walgreen going into the earnings report, the 7% drop in the stock on Tuesday would not make all that much sense. After all, revenue did rise almost 9% this quarter and that beat the average estimate. Within those numbers, total comps rose more than 4%, with pharmacy comps up just slightly less than that.

The problems, such as they are, came in the income statement. Gross margin actually declined a bit (five basis points), and that is a much-watched detail with this company. So, backsliding here is not great news. Operating income was a bit better though, as the company controlled the SG&A line and operating income grew a bit more than 11%. The company also picked up a penny from share buybacks, though, and that is how the company met the EPS target for the quarter. (For more, see The Bottom Line On Margins.)

The bottom line for the Walgreen quarter, then, goes something like this - sales were pretty good, but gross margin slipped and that gross margin is a really sensitive topic with some investors. On top of that, Walgreen beat expectations in the prior two quarters by healthy margins, so in-line is something of a letdown.

The Business Isn't Getting Any Easier
On first blush, drug retailing would seem to be an attractive, stable business. Unfortunately for Walgreen, it is never quite that simple. Pharmacy benefit managers like Medco Health Solutions (NYSE:MHS) and Express Scripts (Nasdaq:ESRX) control more and more about how people access prescription drugs, and Medco in particular has been aggressive in pushing policyholders towards cheaper mail-order fulfillment.

On top of that, other retailers have significantly stepped up their competitive efforts. Large discount retailers like Wal-Mart (NYSE:WMT) and Target (NYSE:TGT) have gotten increasingly aggressive with low-priced generic offerings, knowing that they can win a margin-versus-volume battle with pharmacies. (For related reading, see Measuring The Medicine Makers.)

Walgreen Is Getting Smarter
To its credit, Walgreen is not standing still. The company recognized that running a drug store chain and PBM simultaneously was not working, and it sold its PBM to Catalyst Health Solutions (Nasdaq:CHSI) for $525 million in cash. That is going to put some pressure on one Walgreen's biggest rivals, as CVS Caremark (NYSE:CVS) has yet to really validate its structure and prove that a joint drug store / PBM system has leverageable benefits.

What's more, Walgreen is integrating the Duane Reade acquisition and the expense control in this quarter suggests that is going alright. On top of that, the company's large store base would suggest that cap-ex is going to be less of a drain on free cash flow than in the past.

The Bottom Line
Life is not going to get any easier for Walgreen. Certainly there is some upper limit on mail penetration for PBMs, but Medco does not believe it is there yet. Likewise, CVS, Wal-Mart and Target are all formidable competitors that are not simply going to stop trying to grab share.

All of that said, none of this is new and Walgreen has shown it can hold its own. While the dividend yield here is not great, the company is pretty good about returning cash to shareholders (through dividends and buybacks). Moreover, although the stock is not strikingly cheap, it is undervalued in an overheated market and seems like a reasonably good long-term holding for more conservative investors. (For more, see PBMs: Making The Most Of Generics.)

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