Red Raider Analysts - Texas Tech University

86 Pages·2005·0.34 MB·English

Red Raider Analysts

10H

A Valuation of

As of April 1, 2005

Barakha Yadav
[email protected]
C.J. Lauzon
[email protected]
Ira Freilich
[email protected]
Andrew Armstrong
[email protected]
Rudy Garza
[email protected]
Table of Contents

Executive Summary-------------------------------------- 2

Business & Industry Analysis---------------------------- 5

Company Overview----------------------------------------- 5

Five Forces Model------------------------------------------ 5
Characterization of Industry------------------------------ 13

Key Success Factors---------------------------------------- 14
Competitive Analysis--------------------------------------- 14
Industry Conclusion----------------------------------------- 15

Accounting Analysis-------------------------------------- 17

Key Accounting Policies----------------------------------- 17
Accounting Flexibility-------------------------------------- 18
Evaluating Accounting Strategy--------------------------- 20
Quality of Disclosure---------------------------------------- 21
Screening Ratio Analysis----------------------------------- 22
Potential Red Flags----------------------------------------- 27
Undoing Accounting Distortions--------------------------- 28

Ratio Analysis & Forecast Financials-------------------- 29

Financial Ratio Analysis------------------------------------- 29
Trend (Time Series) Analysis-------------------------------- 30
Cross-sectional Benchmark Analysis----------------------- 40
Financial Statement Forecasting Methodology----------- 53
Analysis & Forecasting Conclusion------------------------- 55

Altman Z-Score Analysis------------------------------------- 56

Valuation Analysis------------------------------------------ 57

Method of Comparables------------------------------------- 57
Estimating Weighted Average Cost of Capital----------- 60

Intrinsic Valuation Models----------------------------------- 62
Discounted Free Cash Flows------------------------------------ 63
Discounted Dividends-------------------------------------------- 64
Residual Income-------------------------------------------------- 65
Abnormal Earnings Growth------------------------------------- 66
Long-run Average Residual Income Perpetuity-------------- 68
Summary of Valuations-------------------------------------- 69

References-------------------------------------------------- 70

Appendices----- ------------------------------------------ -- 71
- 1 -
Executive Summary

Company Valued: Walgreens Co.

Inves tment Recommendation: Undervalued—Buying Opportunity Date of Valuation: April 1, 2005

WAG ----- NYSE (04/13/05) $43.71 EPS Forecast
52 Week Prick Range $32.40 - $46.75 FYE 8/31 2004(A) 2005E 2006E 2007E
Revenue (2004) $37,508,200 EPS 1.44 1.4 1.6 1.82
Market Capitalization $44,800,000,000
Industry
Shares Outstanding 1.02 B Walgreens Average
Valuation Ratio Comparison
Dividend Yield 0.48% Trailing P/E 32.81 29.46
3-month Avg Daily Trading Volume 3,095,409 Forward P/E 31.17 19.49
Percent Institutional Ownership 61.10% Forward PEG 1.87 3.79
M/B 5.42 11.96
Book Value Per Share (mrg) 8.48
ROE (most recent year) 18.11% Valuation Estimates
ROA (most recent year) 11.10%
Est. 5 year EPS Growth Rate 14.25% Actual Current Price (1 April 2005) $43.71
Cost of Capital Estimates Beta R2 Ke Ratio Based Valuations
Ke Estimated 0.484 4.87% P/E Trailing $39.24
5-year Beta 0.272 3.26% 4.23% P/E Forward $41.52
3-year Beta 0.484 12.77% 4.87% PEG Forward $5.05
2-year Beta 0.355 3.81% 4.48% Dividend Yield $0.47
Published Beta 0.256 4.19% M/B $43.71
Ford Epic Valuation $57.67
Kd 16.17%
WACC(bt) 6.03% Intrinsic Valuations
Discounted Dividends $8.58
Altman Z-Score 6.55 Free Cash Flows $50.57
Residual Income $57.73
Abnormal Earnings Growth $46.94
Long-Run Residual Income Perpetuity $3.47

- 2 -
Recommendation—Undervalued Firm
We have valued Walgreens through a variety of intrinsic valuations and have arrived at the conclusion
that Walgreens is a buying opportunity.
The drug retailing industry is a reasonably competitive industry with high entry barriers. Government
regulations pose serious industry restraints; however, supermarkets like Wal-Mart and Albertson’s
have begun introducing their own pharmacies that compete with the traditional drug retailer. With
these factors in place, the market is pretty much set without any foreseeable change. After CVS
purchased Eckerd’s in 2004, the drug retailing industry became an even smaller market leaving four
major players. The industry is characterized by emphasizing differentiation and not cost leadership,
resulting in the companies avoiding a pricing war. Despite this, the players are competing in a buyer’s
market so the players attempt to “dense up” existing markets by driving out competition from the same
locations. In addition to the practice of “densing up,” the drug retailers are constantly looking to
diversify their company resulting in a broad array of services for the consumer.

Industry Demand Drivers
The drivers of growth for this industry will be continued government legislation making it more difficult
for consumers to purchase drugs elsewhere. In addition to government involvement, strategic
alliances between employers and drug retailers will drive the industry. As companies begin to
stipulate which drug providers their employees must use, the drug retailer best able to negotiate will
grab market share. Furthermore, diversification of services provided attract more customers which
would also mean more market share thus driving the industry demand.
The drug retailing industry will continue to grow because the nation is slowly becoming obsessed with
health and pharmaceuticals in order to combat the spiraling hysteria surrounding healthy living and
good looks. However, with the buyer’s power steadily increasing, the company with the most
convenient and user-friendly interfaces will grab most of the market share.

Walgreens is well positioned
Walgreens is a leader in the industry. Their already firmly established internet and phone
prescription-filling systems are just beginning to be initiated by competitor Rite-Aid. This convenience
for the customers allows them to grab more of the market share. Plus, being a leader in the industry
allows them to “dense up” their existing markets and driving out smaller competitors.

Margin Expansion
In order to increase Walgreens gross margin, they are streamlining efficiency in order to drive costs
down and sales up. In addition, Walgreens’ high capital outlays for new services like a state-of-the-art
- 3 -
photo lab are beginning to pay off. Therefore, the future presumably shows higher sales as
Walgreens continues to look for new investments to expand their business.

Marginal Financials
Overall, Walgreens’ financials are somewhat hard to navigate and should be looked with suspicion,
but upon further analysis, the numbers are simply hidden; any analyst would be able to find the
required numbers. Overall there are no potential red flags that we should be concerned about.
Overall, the ratios are constant over time, and show that Walgreens is in better condition than its
competition.

Valuation
Based on the valuation models, Walgreens’ stock price is currently undervalued. According to our
reasonable cost of equity, weighted average cost of capital, and growth estimates, we arrived at a
stock price in the range of $53.44 which is an average of the valuation models (Discounted Free Cash
Flows, Residual Income, Abnormal Earnings Growth, and Long Run Average Residual Income
Perpetuity). Discounted Dividends was excluded as an outlier. Using proper estimation techniques
that estimate its share value after the recent slums in the economy, Walgreens stock price went as
low as $30 per share and as high as $46 per share. Our forecasted earnings follow the trend of
increasing earnings over the past five years. While the stock has peaked at $46 dollars, according to
our valuations, it should continue to grow until it hits a stock price near $53.44.

Other Criteria
Walgreens has about a third institutional holdings and analyst feelings are mixed with about four large
research firms downgrading the firm to either a hold or a sell, whereas three other large research
firms have upgraded the firm to a buy.

Risks
As customers begin to move to one-stop shopping, supermarkets are posing large threats to the
traditional drug retailing market share. In addition, CVS’s purchase of Eckerd’s last year is putting the
heat on Walgreens in terms of growth. Undaunted, Walgreens has continued to maintain
expectations and large company growth which may be an overestimate due to the maturity of the
industry as a whole
- 4 -
Business & Industry Analysis

Company Overview
Walgreens is in the business of offering “customers the best drugstore service in
America.” They focus on the customer in everything they do from customer service to
the invitingness of the store’s outside environment. Walgreens was founded in 1901 by
Charles R. Walgreen, Sr. in Chicago, Illinois. Since then, it has continued to grow
reporting total operating revenues at 37.5 billion dollars for fiscal year 2004, ending
August 31, 2004. Walgreens continues to employ innovative retail thinking and
management to further enhance the consumer’s shopping experience.

Drug Retail Industry

(cid:131) Rivalry Among Existing Firms: moderate

(cid:131) Threat of New Entrants: low

(cid:131) Threat of Substitute Products: high

(cid:131) Bargaining Power of Buyers: high

(cid:131) Bargaining Power of Suppliers: moderate

Five Forces Model

Force 1: Rivalry among Existing Firms
Industry growth:
Due to the myriad of products sold, millions of dollars of capital must be raised in order
to ascertain the goods to sell. This is an entry barrier into the drug retailing industry, so
in respect to new entrants, industry growth is low.

Other factors that might affect industry growth include drug sales over the Internet and
people buying their drugs in other countries (i.e. Canada or Mexico) to avoid the rising
health care costs in the United States. The Internet is the only domestic growing
opportunity of the drug retailing industry, and Walgreens has already taken steps to
- 5 -
combat competing drugs sales of the Internet by offering a computerized system of
prescription refill services. In addition, it also allows customers to shop for goods other
than drugs online. Furthermore, the market of people purchasing their drugs in other
countries to avoid the health care costs in the United States will become stagnate
because, according to SuddenlySenior.com, by February 2005 Canadian government
may stop their drug stores from selling to American consumers. Therefore, because of
Walgreens initiative to incorporate a user-friendly e-commerce website and the pending
legislation stifling American’s abilities to buy foreign drugs, the growth of industry is low.

Concentration:
Walgreens has 4 major competitors in the drug retailing industry: CVS, Rite-Aid, and
Long’s Drug Store. Walgreens is by far the leader of the industry posing a market cap
much larger than that of its nearest competitor CVS. Therefore, Walgreens is the
largest player in terms of drug retailers which means that there is a high concentration
and low competition. One must not forget, however, that Walgreens sells more than
just drugs, and with the beginning of pharmacies in supermarkets like Albertson’s and
Wal-Mart, Walgreens faces competition from a new source—not just chain retail drug
stores. In addition to drugs, these supermarkets can steal customers on other goods.
This competition from new sources leads to a lower concentration, which increases
competition. The resulting conclusion from this analysis is that concentration of
Walgreens industry is moderate, which means moderate competition.

Degree of Differentiation and Switching Costs:
Walgreens’ homepage, www.walgreens.com, says their mission statement is to “offer
customers the best drugstore service in America.” Competing based on customer
service is a differentiation Walgreens employs to avoid the competition from large
supermarkets. However, in order to do this, they sacrifice lower prices; so, if the
customer is willing to pay a premium on service, he or she will shop at Walgreens. The
differentiation Walgreens uses leads to lower competition, but in regards to the goods
they sell, cost leadership is more than likely the most profitable enterprise concluding
that competition based on this element is moderate.
- 6 -
Their homepage also indicates that their strategy is to aggressively enter new markets.
Entering new markets like the recent market for digital photo labs has switching costs
associated with it. However, as Nathan Slaughter of the Motley Fool indicates in his
article, Walgreens Seeing Green, Walgreens is “beginning to reap the rewards from the
substantial costs associated” with Walgreens’ push to new markets. By its very
strategy, Walgreens has large switching costs to employ new facets of the retail
industry. High switching costs of the company lead to higher competition because it
forces the company to compete instead of abandoning ship.

Scale/Learning Economies:
One of the advantages Walgreens has in comparison to its competitors is its scale of
economies. Their strategy illustrates this as they try to “dense up” existing markets.
This allows them to offer a lower price than their chain drug store competitors. In fact,
in fiscal year 2004, Walgreens.com indicated that they had opened 436 new stores.
However, its competitor CVS, with its acquisition of Eckerd’s last year, has more stores,
so in this context, competition is high amongst existing rivals because they are all trying
grow and employ a large scale of economies. There really is not any scale of learning
for the retail industry, and new innovations are soon copied by competitors.

Fixed-Variable costs:
Walgreens has fixed costs of warehousing, stores, and trucking costs. In order to pay
off these fixed costs, Walgreens stores are usually stocked with its goods. They utilize
the space in their stores for customers, so in this context most costs to Walgreens are
variable relating to the amount of goods purchased by the consumer. However, since
variable costs are more than their fixed costs, Walgreens is not compelled to lower
prices in order to induce maximum inventory turnover which equates to lower
competition.

- 7 -
Excess Capacity and Exit Barriers:
Since consumers can purchase goods at Walgreens just as easily as they can at its
competitors, supply exceeds demand. One would expect Walgreens to cut its prices in
order to get more customers, but since Walgreens views itself as a differential leader
and not a cost leader, they do not. This means that competition in the market is high,
but Walgreens does not conform to the market, which decreases competition.
Therefore, competition is moderate.

One must also examine the exit barriers of the drug retail industry. Government passes
legislation about who can sell prescriptions, so exit barriers are high, which leads to
higher competition. However, contrary to drugs, the other goods Walgreens sells are
not highly specialized or legislated so exit barriers are low, which causes lower
competition. Therefore, excess capacity and exit barriers lead to moderate competition
in the retail drug industry.

Force 2: Threat of New Entrants
Economies of scale: High
The amount of investment necessary for a pharmacy would be very high for a new
entrant. In addition to the aforementioned economies of scale in terms of the industry,
an individual drug store must have a pharmacist who is certified because government
does not allow the distribution of prescription drugs without a certified pharmacist. The
pharmacist must know everything about all of the medicines sold. The pharmacist must
be able to counsel the customer about the drug and be able to answer any questions
that the customer might have. This requires a high economy of scale because the
company must have the means to make sure they employ a well qualified pharmacist
who will be able to help customers as needed and make everyone feel safe and worry-
free about having to take drugs. This idea reflects Sold on Seniors, Inc. recent market
study that found “until seniors feel they can trust you, they will not buy from you at any
price.” Also, pharmacists should be paid well so they do not leave the company, and the
company should compete to get the best qualified pharmacist. Besides the pharmacist,
it is also really expensive to stock a pharmacy and have the proper software to do it.
- 8 -
Drugs are expensive and in order to attract more customers, a pharmacy must carry the
best variety of drugs.

In terms of the rest of the items that Walgreens sells, the economies of scale are
relatively low. Nonprescription drugs and general merchandise are items that almost
anyone can sell easily. The pharmacy part of the store is what makes this business
more expensive.

First mover advantage: Moderate
Walgreens has been around for 104 years. They have been around longer than any of
their competitors. For this reason, Walgreens is able to be the first one to do a lot of
things. Since Walgreens has been around so long, they know the trade and know
where to look for the best suppliers for nonprescription drugs and general merchandise.
Since the bargaining power of prescription drug suppliers is high, Walgreens does not
have a first mover advantage with regards to prescription drugs. Walgreens also
continues to explore and implement online means so customers can get what they need
more conveniently. Walgreens has been around long enough to start doing things
online with the implication of Intercom Plus, their interactive, advanced technology that
“serves customers' needs better than any other pharmacy resource.”

Access to Channels of Distribution and Relationships: Moderate
Building relationships and networks with different distribution channels is always difficult
at first. One channel that Walgreens has taken advantage of is television. Walgreens
hosts a “Walgreens Health Corner,” which is a half-hour TV segment on WGN that
teaches people about healthy living. Since Walgreens has a good relationship with
WGN, it would be hard for any other company to build a relationship to start a TV show
on that network. This TV show benefits all the people who strongly care about healthy
living. At this time and age there is a huge population that is adamant about health.
Walgreens’ TV show serves as a great advertising tool that sets it apart from its
competitors. However, other distribution channels exist besides television and are
- 9 -