Berkshire Ruminations

Friday, May 19, 2006

Permanent Holding - Part 2

Walgreens is still hovering around $40/share. Should we buy? Consider the following.

Two things happened in 2005 that hurt sales and increased costs, yet the company thrived nonetheless. The first is Hurricane Katrina, which cost the company about $55 million in addition to the lost sales at the 74 locations that were temporarily or permanently closed. The second is substantial costs in preparation for the launch of Medicare Part D. The company spent a great deal educating both its employees and seniors about the upcoming changes.

But Medicare Part D will benefit Walgreens tremendously as the program takes off. First of all, many more seniors will be filling prescriptions simply because they now have prescription drug coverage, whereas they did not before. According to the Kaiser Family Foundation, the 28% of Medicare recipients without prescription drug coverage spent 42% less on prescriptions than their covered counterparts. Should these individuals get coverage, it stands to reason their spending will increase significantly.

Second, as Walgreens management points out in the 2005 Annual Report, these new beneficiaries should be indifferent among pharmacies since their copay will be the same at every retail location. This is when Walgreen’s competitive advantage – outstanding convenience and location – will generate value. I expect that most new pharmacy patients will gravitate towards Walgreens over its competitors.

So is Walgreens still cheap? Let’s look at the financials. The company, which has no debt, has maintained a return on equity in excess of 15% as far back as I can calculate (at least ten years). So these equity shareholders, who supply capital at a cost much less than 15%, are getting a healthy, consistent and reliable return.

Same-store sales have increased in every category for the last two years, contributing to a growth in gross margins as well. Margins are up to 27.9% in 2005, from 27.2% and 27.1% in 2004 and 2003 respectively.

So when we calculate owner earnings for this company, I think we can have great confidence that optimistic projections are attainable. But it will take those optimistic projections to come up with an intrinsic value in the ballpark of the current $40 stock price.


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