Is Walgreen’s Too Expensive?

I’ve always believed that it’s better to pay extra for the dominant company in a sector than to go hunting for an undervalued second-tier stock. But how much is too much?
Nobody doubts that Walgreen‘s (WAG) is a great stock. The company has increased its sales and earnings for 31 straight years. But it trades at 27 times earnings while CVS (CVS) trades at just 18 times earnings. CVS has been working to close the gap.

“There’s a case for Walgreen’s to be at a premium,” says Neil Currie, an analyst who covers both stocks at UBS Investment Research. “But CVS is closing the gap in terms of execution, so there’s also a strong case for the [valuation] gap between the two to be closer than it is.”
CVS is Mr. Currie’s top pick in the U.S. drug-retail area and he has a “buy” rating on the stock. His firm makes a market in CVS shares but hasn’t done investment-banking work for the firm, and he doesn’t own shares of the company. Mr. Currie has a $39 price target on CVS shares.
CVS shares fell 13 cents to $26.79 in 4 p.m. composite trading on the New York Stock Exchange yesterday, while Walgreen slipped a penny to $47.18.
The valuation gap widened when CVS early last month trimmed its estimate for third-quarter profit by a penny, and the stock fell almost 10% over the next three weeks as investors feared the Eckerd integration wasn’t going well.
Since then, CVS has reiterated its forecast for full-year profit and told investors it is pleased with progress on the Eckerd front. Management reiterated a positive outlook for newly acquired Eckerd stores in a meeting with Wall Street analysts last week.
The acquisition is key for the firm’s effort to sharpen its focus on attractive markets. The Eckerd acquisition gave CVS a far bigger presence in markets with a higher concentration of senior citizens, such as Florida and Texas.
If the company were to outbid rivals for Albertson’s drugstores, its presence in the West, particularly the attractive Southern California market, would increase, too.
It is easy to see why investors might feel more comfortable with Walgreen. The Deerfield, Ill., company has mostly grown by opening stores, rather than buying competitors. That is a less risky route than acquisitions and keeps a crop of recently opened, fast-growing stores in the pipeline. The company says that more than half of its 5,000 stores are less than five years old.
Also, Walgreen was a leader in recent years as pharmacies expanded into everything from film processing to soft drinks, and built ever-larger stand-alone locations. Walgreen has the most 24-hour and drive-through stores in the industry, which the company says has been a top differentiator between it and other drugstores for time-strapped customers.
On average, Walgreen outlets write more prescriptions than CVS pharmacy counters, partly because Walgreen has more senior citizens in a 1.5-mile radius than CVS, according to UBS’s Mr. Currie. That edge will be tough to chip away, partly because research has shown that consumers are often reluctant to switch pharmacies once a store has their information on file.
Morningstar’s Mr. Corwin believes that both CVS and Walgreen are fairly valued, and that the valuation gap between the two stocks is merited.
However, as baby boomers age, investors sizing up the two leaders’ price tags might counter that while CVS might not be a better business than Walgreen, the No. 2 company could be the better stock in coming quarters.

Walgreen’s stock has a better long-term record, but the two stocks have tracked each other pretty closely for the past four years.

Posted by Eddy Elfenbein on November 22nd, 2005 at 1:35 pm

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.