Time to WAG the Dog

05/18/2012 11:30 am EST

Focus: STOCKS

There were high hopes for this stock, but when things keep going wrong, you have to stop hoping and start selling, observes Paul Larson of Morningstar StockInvestor.

I waived adios to Walgreen (WAG) a few weeks ago and haven't looked back, selling the final 110 shares to create a 13.7% realized loss.

It’s not too often I completely sell a position from either portfolio. But in the case of Walgreen, the company’s competitive positioning has deteriorated to the point where I no longer feel comfortable holding the shares over the long haul.

It’s been a painful ride owning this stock; initially purchased in 2007 when the company was rated with a wide moat. It is only a narrow-moat firm today, and the moat continues to erode. For an investment that was clearly a mistake on my part, I am thankful the realized loss was not larger. (Chalk one up to the benefit of margin of safety.)

The thing that tipped me over the edge was the recent spat with Express Scripts (ESRX). When the two companies parted ways at the start of 2012, Express Scripts was able to retain 95% of its clients after taking Walgreen out of its network.

Walgreen was on the other side of this, with roughly 85% of the prescriptions from Express Scripts members immediately lost. Clearly, employers (the ultimate payor of pharmacy expenses) care much more about keeping overall health-care spending in check (Express Scripts’ value-add) than they do about maintaining maximum convenience (Walgreen’s value-add).

Meanwhile, pharmacies have relatively high fixed costs, so the reduction in volume will have an oversized effect on profitability.

Beyond a deteriorating business position, Walgreen’s stock was in the neighborhood of its fair-value esti­mate. Another reason I sold Walgreen was to simply keep the number of companies within the Tortoise and Hare portfolios at a reasonable number. Going to 50 stocks with my newest purchase—Express Scripts—would have been a bit much.

Walgreen Analyst Report
Walgreen’s store base offers unmatched convenience, and its brand name is one of the most recognized in the retail pharmacy business. However, we are highly concerned about competitive pressures. We think Walgreen’s business model will have to rapidly evolve for the company to remain relevant.

Walgreen has a store within three miles of 63% of the US population, giving a significant convenience advantage over most of the competition. The company benefits from secular tailwinds, such as the aging population and growth in pharmaceutical spending.

Finally, Walgreen has decided to slow its new store openings after decades of rapid expansion, which will also boost margins, as mature stores are considerably more profitable. Peak store profitability usually isn’t reached until stores are open seven years or longer.

Despite these positive drivers, we suspect that the company faces more competitive and reimbursement pressure today than it ever has in the past.

Pharmacy benefit managers like Express Scripts and Medco are patients’ first point of contact with the pharma­ceutical supply chain. These PBMs are using their massive scale to wield unprecedented bargaining power over retailers, and they are encouraging consumers to switch to their own low-cost mail-order facilities instead of retail drugstores.

Wal-Mart (WMT) poses another competitive threat with its $4 generics program, which has been imitated by other big-box retailers and supermarkets. These competitors are particularly dangerous for Walgreen; because pharmacy is only incidental to Wal-Mart's core businesses, they may be willing to earn thin or even negative margins on pharmaceuticals to increase traffic to other parts of their stores. By contrast, Walgreen relies on pharmaceuticals for about two-thirds of sales.

We think Walgreen’s convenience advantage is being eroded by cheap prescriptions offered through the mail and by many other retailers. Only time will tell if offering clinical services alongside the pharmacy is enough to keep traffic strong at Walgreen’s stores.

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