Walgreen Not Immune to Industry's Ills

Sure, CVS is another case altogether, but competition could hurt results even at big Walgreen.
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Walgreen

(WAG)

won't turn into a pumpkin too, will it?

Sell-side analysts certainly don't think so, even in the wake of a massive earnings warning Tuesday from

CVS

(CVS) - Get Report

. CVS has its own problems, analysts agree, and many investors continue to see drugstore stocks as a safe haven in a recession, noting that historically these names have weathered bad times quite well.

But some observers say those assumptions ignore the sector's eroding fundamentals -- a trend that will play out most damagingly for investors at Walgreen, the last drugstore chain to boast a premium valuation. While the industry's increasing reliance on sales of mass-market items such as snacks, magazines and light bulbs has boosted growth, it has also exposed these companies to price competition from the likes of

Wal-Mart

. That could mean an earnings shortfall soon at richly priced Walgreen.

Price Wars

"Convenience was the major competitive focus of the operators in this business," wrote Eric Bosshard, an analyst at the independent research firm Midwest Research, who has a neutral rating on Walgreen. His firm doesn't do investment banking. But he said that now, growth and competition have "forced all operators to resort to more aggressive pricing as the main competitive tool, a trend we believe is putting pressure on gross margins."

Walgreen is trading at about 32 times this fiscal year's estimated earnings -- a rich valuation for a company whose profits are expected to rise 17% annually, according to Thomson Financial/First Call. It is expected to earn 18 cents a share for the current first quarter of its fiscal year -- up 3 cents from the year-ago period -- which it is scheduled to report on Jan. 2.

The company recently met fourth-quarter earnings expectations, but that was helped by a 100-basis-point drop in the tax rate, notes Bosshard. A 23% rise in inventories should "limit results in the quarters ahead," he says.

Staying the Course

For its part, Walgreen says competing with mass merchandisers is nothing new; a spokesman notes that the company mentioned it as far back as its 1990 annual report. The company does acknowledge that in recent years it has begun lowering prices of certain items. "What we have been trying to do is close the gap with the mass merchandisers," says Michael Polzine, a Walgreen spokesman, "and still have our convenience as a feature for consumers."

Polzine says Walgreen's customer traffic declined for a week or two in the aftermath of the Sept. 11 terrorist attacks but has since rebounded.

As for the safe-haven argument, drugstore stocks have been anything but good investments as the economy has struggled. After a good

start early this year, they have stumbled, losing wads of money for shareholders. Walgreen has lost 21% and CVS 59%, compared with an 8% loss for the S&P retail index. (Another drug retailer,

Rite Aid

(RAD) - Get Report

, has more than doubled this year, but that was from a low single-digit price that followed fears of bankruptcy. The company still loses bundles of money.)

Pumpkin pie, anyone?