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Watching Walgreen, the Drug Store That's Delivered for Investors

Katherine Hobson

In a world of beaten-down retail stocks, one of the most talked about is an old favorite -- and one of the most expensive.

Walgreen (WAG Quote), the 3,000-plus chain of drugstores, has managed to do what CVS (CVS Quote) and Rite Aid (RAD Quote) haven't: Make money for its investors. In the past two years, the Deerfield, Ill.-based company's stock has risen 63%; in the same period, Rite Aid's has plunged 89% and CVS' is down 5%.

The company's secret: consistent earnings growth, a disciplined expansion strategy, a clean balance sheet and impeccable execution, say money managers who still like Walgreen stock even though it's trading at a whopping 48 times earnings. The company is particularly attractive right now, when uncertainty -- about the effect of the Fed's interest-rate increases on consumer demand and about the ability to maintain strong comparable-store sales growth -- is making investors nervous about almost every other retail stock. (As TSC noted previously, even leaders like Wal-Mart (WMT Quote) and Home Depot (HD Quote) aren't immune to the retail jitters.)

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Brian Gilmartin, portfolio manager with Trinity Asset Management, says his firm is buying a lot more Walgreen stock lately. Gilmartin thinks drug-store stocks will get a boost from a jump in the availability of generic drugs (a generic version of Prozac could be out as soon as February, while ulcer medication Prilosec and allergy drug Claritin lose patent protection later this year and in 2002, respectively). And a Medicare prescription drug benefit (currently just a political football) would ding drug-store margins but also increase foot traffic. All that helps sales of higher-margin stuff in the front of the stores.

But more foot traffic from generics and demographic changes -- Hot news! Baby boomers are getting older and sicker! -- presumably mean more demand for drugstores in general. Why, then, are money managers talking up Walgreen in particular?

With Rite Aid and Eckerd struggling, the only real national competition is the Woonsocket, R.I.-based CVS, whose comp sales and earnings growth are about the same as Walgreen's. One difference: Walgreen, more than any other chain, is found at the prime Main Street locations, and when it finds a particularly good spot, it buys it outright for more control, says Elizabeth Shamir, analyst with PNC Advisors. (She rates Walgreen a market perform on valuation, and her firm hasn't done recent underwriting for the company.)

Location, Etc.

"The big thing about us, in a nutshell, is that we have better real estate and better locations," says Mark Wagner, vice president and treasurer at Walgreen. "They outperform any strip center or mall store out there." About 72% of Walgreen stores are freestanding, he says. "Customers love the quick-in, quick-out locations," he says.

And unlike the competition, Walgreen has grown by opening new stores, not by acquisition. "We pick the sites," says Wagner. "If you grow by acquisition, you're buying old tired sites, and you may have to relocate." Analysts and investors also like the grow-it-yourself strategy, since integrating acquisitions is perceived as riskier. It takes Walgreen about three years to make a new store profitable. "It takes incredible discipline to do what they do," says a hedge fund manager who is long the stock and didn't want to be identified. "There are not a lot of balance sheets around that can stomach that."

Right now, the company has more money-losing stores than ever -- about a third of the store base is less than three years old, says Wagner. "In two years from now, that will all flip over from red to black," the hedge fund manager says. "The numbers could explode." And the company is still growing -- it plans to hit 6,000 stores by 2010. Once in place, its stores have better sales per square foot than its rivals -- a key measure of productivity.

The Price Is ... Right?

Not everyone is so enamored of Walgreen -- especially with its stock at these levels. Skeptics point to impending competition from CVS in markets like Chicago, and Orlando and Tampa, Fla. Wagner says he's not worried. "We're already competitive with CVS in other markets," he says. "I don't think they'll enter a new market and slash prices."

While PNC's Shamir calls Walgreen's fundamentals "really beautiful," the fact that she rates it market perform instead of a buy highlights the biggest complaint about it as an investment: It's simply too pricey. At $34.90, the stock is close to its all-time high of $36, and the hefty multiple is more than twice that of CVS.

"They run the cleanest story in the industry," says the hedge fund manager. "The question is, what premium do you want to pay for the leader?" With everyone nervous about consumer demand and searching for a proven retail name, in Walgreen's case the answer is: a lot.