Let me introduce another member of the Rule One investor community - Abe Silk. Here is his Rule One analysis of an old standby great company, Walgreens (WAG). I've re-arranged a few paragraphs to fit my 4M model, added some comments and put additional comments at the end:
MEANING:
Walgreen Company, founded in Chicago in 1901, is the largest drugstore chain in the United States, and provides access to consumer goods and services and pharmacy, health and wellness services in through its retail drugstores, Walgreens Health Services division and Walgreens Health and Wellness division. Walgreens Health Services offers pharmacy patients and prescription drug and medical plans through Walgreens Mail Service Inc., Walgreens Home Care Inc., Walgreens Specialty Pharmacy LLC and SeniorMed LLC (a pharmacy provider to long-term care facilities). Walgreens Health and Wellness division includes Take Care Health Systems. Walgreens has a pretty clear meaning: It’s one of two ubiquitous drugstores in the country that is trusted by tens of millions of people each year. With seniors living longer and baby boomers reaching retirement age, there’s sure to be a strong demand for prescription drugs and pharmaceutical items for years to come. Walgreens has 7,733 drugstores as of June 30, 2011, and operates 8,210 locations in total across all 50 states, the District of Columbia and Puerto Rico. In 2010, pharmacy contributed 65% of sales (3rd party, 95.3% of Rx); and other general merchandise, were 35%. Stores average $8.9 million in annual sales. The company has about 244,000 employees.
[NOTE: How about telling us what a company has to do to compete in this industry? That's the real point of Meaning - proving we know enough about the key issues of making a successful business in this industry. This gets shorted way too much in our analysis.]
Moat: Walgreens certainly faces stiff competition. In addition to major competitor CVS, there are also smaller pharmacies like Rite Aid and Duane Reade. Supermarkets and big box stores such as Target and Wal-Mart offer pharmacies as well, and mail-order pharmacies have become increasingly prevalent. Still, Walgreens has locations nearly everywhere, and convenience is a huge advantage in the retail pharmacy market. It also has a strong brand and a loyal customer base.
WAG is absolutely a Rule 1 stock by the numbers. Its Big 5 are beautiful and remarkably consistent.
ROIC: 16% (10yr); 15.2% (5yr);
BVPS: 15% (10yr); 12.5% (5yr);
EPS: 13% (10yr); 10% (5yr)
Sales: 13.5% (10yr); 12.5% (5yr)
Cash Flow: 14% (10 yr); 12.5% (5yr)
[NOTE: Starting with the numbers is a good way to determine that a moat might exist. Good numbers mean there must be some kind of moat. Its important to see whether there is a decline in the numbers as you go from long term to short term. In this case there is a definite decline in evidence. We need to not only see it, but to understand what we're seeing and then ask the pertinent question: Is this a company with permanently slowing growth?]
Management: Gregory Wasson is WAG’s President, CEO, and Director, who joined the company as in intern in 1980. In 2010 he earned a base salary of $1.06 million, and took home just over $8 million in total. Alan McNally is director of the board and made grand total of just under $1.5 million. Wade Miquelon is the CFO and Executive VP, and he made $3.5 million. None of these totals are out of line with a company of Walgreen’s size (~$28.7 billion market cap), and a Google search netted no negatives about these executives.
[NOTE: I agree that management income is important as a way to judge their purpose. I wonder this: are employees being squeezed for every nickel at WAG while their leaders enjoy princely retainers regardless what the industry standard is? Isn't leadership about setting an example, taking the moral high ground? I'm just saying....]
Margin of Safety:
The analysts’ 5-yr growth rate is 12.6%. The 10-yr PE values range from 46.4 to 13.9, with the historical average PE being 26.
Using the more conservative growth rate of 12.6%— the analysts’ rather than the BVPS— and a future PE of 25, we get a Sticker Price of $59.50, so our Margin of Safety price is $29.75. Walgreens is currently selling for $32.22, and has been in something of a free fall over the past 6 months due to problems with its deal with Express Scripts (ESRX). It seems as if this may be a prime buying opportunity—I’ve seen similar sentiments on Seeking Alpha and elsewhere.
It should also be noted that the stock has a 2.5% dividend, but to be honest, I’m not really sure how to use that in my valuation. A healthy dividend is certainly not a bad thing, though, and the dividend was raised just last month.
Possible Red flags:
Walgreens has been around for 110 years, and it won’t be going anywhere for awhile. Still, there are a couple of red flags. Competition is an issue, though Walgreens is so large that it should be able to compete with anyone on price due to economies of scale. Also concerning is uncertainty around healthcare reform, though the demand for prescription medicine is practically certain to rise in the near-to-medium term future, so this concern is mitigated considerably as well.
[NOTE: I really like it that Abe put this section in. We should include it from now on - a section that tells us what can go wrong with the STORY. I want to see a new section called STORY. We have to have a STORY about the company. What makes this good to buy (or short) at this time.]
ADDITIONAL COMMENTS:
Thanks for the thoughtful and rational argument in favor of a WAG buy, Abe. Let’s talk about the projected growth rate of 12.6%. While it is a lower number than the historical BVPS, its lower than the 5 year EPS growth rate of 10%. Here’s another view of the numbers from my Toolset (coming next week, so they tell me):
Notice how these great 'green' numbers turn 'yellow' at the 3-year point? This slide down is continuing with mixed results in the 1-year numbers. Analysts are hanging a big number up there for a company that is this large with this much of a slide. I'd be more conservative here and project something like 10% with a 20 PE.
What I’d ask you to do, Abe, is to try to tell me where the growth is going to come from that will double the earnings of this business in the next 6 years (which is what a 12.5% growth rate will do). Once we know that we can feel a whole lot more secure that the analysts aren’t sucking up to Walgreens management so they can get an investment banking deal. Unfortunately it’s the nature of the industry so we have to account for it particularly when it’s a big company that may have hit the limits of growth.
Here's the Toolset Valuation tool analysis of WAG:
Note that the Sticker Price is $38 with a $19 MOS using my estimate of future long-term sustainable growth. That would make it a bit pricy at today's price of $33. However, notice that the Tools show a 7 year Payback Time price is $31. That's a wonderful payback time and a great price for a really good company. That makes this quite buyable at $32.
Regarding the dividend: This might be the secret formula for this business. If WAG is slowing its growth and its stock price is suffering accordingly as the Big Guys bail (since there may be anemic growth in the near term) WAG management may decide the best place for the free cash flow is back in the pockets of the owners of the company – the stock investors. Let’s take a look at how fast they are increasing the size of their dividend.
Notice that the dividend has 2.5 doubles in 10 years. That's a double every 4 years and produces about an 18% growth rate for dividends.
The dividend is growing from increasing free cash as well as buy backs. Note the number of shares of stock is going down meaning there is more cash per share for dividend payouts:
Watch what this does to our Basis (the amount we have in the stock at any point in time):
Start with current dividend of $0.75 and grow it at 18% per year. That's a double every four years, right? So in 4 years the dividend is at $1.50, in 8 years its at $3 and in ten it grows to about $4.50. You can add up this growth on an excel spreadsheet and see what it does to the Basis - what we still have in the stock after cash flows reduce our original investment:
33% per year cash on remaining cash return in ten years is huge. I love the concept of reducing basis. That's why I really like the looks of WAG.
Of course, these are just projections and are going to be wrong in some sort of way, either too high or too low, but I think they are reasonable and point to WAG as being more than a little interesting right now.
Now go play.
