Wall Street Cools on Walgreen's Hot Numbers

Walgreen(WAG Quote) continues to outshine its competitors, but Wall Street is increasingly distracted by the stock's dark side.

Monday morning the drugstore giant met earnings expectations for the second quarter, as it continues to win market share and maintain solid profit margins. But analysts, saying the stock is pricey even for a strong performer in the feast-or-famine retail crowd, worry that a price-cutting campaign aimed at competing with mass merchandisers such as Wal-Mart(WMT Quote) could backfire, putting a chink in long-term profit growth.

In the second quarter the drugstore chain earned $326.6 million, or 32 cents a share, up 10% from a year ago and in line with analysts' expectations, according to Thomson Financial/First Call. Revenue rose 16.5% to $7.5 billion, also matching analyst estimates. Same-store sales, which measure activity in shops open at least a year, rose 10.2%.

Shares dipped 10 cents recently to trade at $39.71.

The company said it gained market share in 55 of its top 60 categories; prescription drug sales rose a robust 21.4%. Gross margins, meanwhile, fell 38 basis points from a year ago, to 27.2%. While margins were expected to fall because of growing prescription drug sales -- drugs are less profitable to drugstores than other items such as toiletries and snacks -- analysts had expected gross margins to fall a steeper 60 to 70 basis points.

"As you've come to expect, margins were pressured by the growth in pharmacy as a percentage of overall sales," said Rick Hans, Walgreen's director of finance, in a prerecorded call for investors and analysts. "But some of that impact was offset this quarter by consumers shifting to more generic medications."

Careless Whisper

Analysts, however, were hoping to get a better explanation. The company, unlike most other publicly traded outfits, does not host a live conference call for analysts and investors to ask questions.

Walgreen of Worry Stock too high for some tastes

"It seems on the surface of it that the benefit from generic substitution is bigger than it has historically been," says Robert Summers, who covers the company for Banc of America Securities and rates the company market perform. Summers, like other analysts, was waiting for a call back from the company for more information and was critical of the company's failure to hold a live call.

"I think it's atypical for a $40 billion market company" to not have a call, he says. "It's almost surprising they can get away with it in this environment."

"We don't think it's the most effective way of getting information out," says Michael Polzin, spokesman for Walgreens. "Analysts and investors are free to follow up with questions." Polzin says Walgreens, which also never gives financial guidance, has no plans to start hosting live conference calls.

Two issues could weigh on the company's stock in the near term: valuation and worries over price-cutting for so-called front items, the snacks and lightbulbs and other goods that make up the bulk of profits at most drugstore chains.

The company said the margins fell among front-end merchandise because of more aggressive advertising and more in-store promotions. The aim is to compete more on price with mass merchants like supermarkets and Wal-Mart, a change from the past when drugstore chains emphasized convenience as their selling point with consumers.

While some say the recession has forced the price-cutting and that an improved economy would give drugstores more pricing power, Summers doesn't buy that. "Pent-up demand for front-end items? Give me a break," he says.

Compounding

Worries over the long-term effect of price-cutting at the front-end only compounds concerns over valuation. Walgreen trades at roughly 40 times this year's estimated earnings of $1 per share, more than twice its estimated earnings growth rate of 17%, a valuation that analysts are finding increasingly hard to justify even if the company is the dominant outfit in its industry.

Summers notes that other retailers that top their sectors, such as Bed Bath & Beyond(BBBY Quote), Starbucks(SBUX Quote), Home Depot(HD Quote) and Kohl's(KSS Quote), all boast expensive valuations. But he says that none of those highfliers, when measured against growth rates, is more expensive than Walgreen. All of these companies have growth rates of at least 20% annually.

This has even analysts who don't worry about pricing advising investors to hold off on the stock, at least in the short term. "This is a company that knows how to execute," says Liz Shamir, an analyst at PNC Advisors, which gives stock recommendations to money managers and has a market perform rating on Walgreen. "Valuation is what stops us from being more aggressive."

Indeed, by those measures some of Walgreen's beleaguered competitors may be a better investment. For example, J.P. Morgan upgraded CVS(CVS Quote), Walgreen's main rival, Monday from market perform to buy on improved sales and easier year-ago comparisons starting in March. The bank, however, kept its market perform rating on Walgreen, mainly because of valuation.