Walgreen (WAG) Downgraded to Underperform

We have downgraded Walgreen (WAG) to Underperform with a target price of $26.00.

Walgreen had reported an EPS of $0.47 during the third quarter of fiscal 2010, way below the Zacks Consensus Estimate of $0.57 and the year-ago quarter’s $0.53. Net sales increased 6.1% year over year to $17.2 billion, with same-store sales (those open for more than a year) increasing 0.7%. Front-end same-store sales increased 0.1% and were affected by a weak demand for discretionary goods and lower-than-anticipated sales of flu-related products.

After experiencing robust same-store sales growth rates of 7.7% and 8.1% in fiscal 2006 and 2007, respectively, total sales in same stores increased only 0.7% during the third quarter of fiscal 2010. However, we note that the situation at its primary competitor, CVS Caremark (CVS) is better. During the latest reported quarter, same-store sales increased 2.2% at CVS.

Walgreen’s operating income came down by 2%, while operating margin declined 40 bps to 4.8%. This was due to an 8.5% increase in selling, general and administrative expenses driven by an increase in salary and occupancy costs with the opening of new stores in the East and West coasts.

The other factor that may affect margins going ahead is store conversion costs as part of the customer centric retailing initiative. Although, the company has scaled down the number of stores to be converted to 2,000 by the end of fiscal 2010 as compared with its earlier target of 2,500-3,000, the conversions are getting costlier.

In the third quarter of fiscal 2010, the conversion cost per store was $40,000-55,000, higher than the second quarter’s $30,000-50,000. This might have an adverse impact on Walgreen’s expenses in the near term, thereby affecting its margin.

Walgreen had a negative impact of $0.02-0.03 per share on its earnings due to the slow introduction of generic products during the quarter. This situation is unlikely to improve before the end of 2011. Moreover, a weakening U.S. economy has impacted discretionary spending, thereby affecting the company’s overall sales.

WALGREEN CO (WAG): Free Stock Analysis Report

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