Evaluation of Walgreens Company

Gregory D. Wasson is the president of Walgreens, and CEO effective since February 1, 2009. Wasson joined the company as a pharmacy intern in 1980 while attending Purdue University’s school of pharmacy, and managed stores in the Houston area before being promoted to a district manager position in 1986. Wasson was promoted to a regional vice president of the store operations division in 1999. In 2001, he was promoted again to Walgreens vice president and made an executive vice president of Walgreens Health Initiatives, the company’s pharmacy benefit manager (PBM). Wasson was promoted to president of Walgreens Health Initiatives in 2002, Walgreens senior vice president in 2004 and to a Walgreens executive vice president in 2005. He was named president and chief operating officer of Walgreens in
2007. Following the departure of Jeff Rein from the position of CEO, Wasson was chosen as the new officer after a nationwide search for candidates, the first including external possibilities.

He sits on the Board of Directors of the Consumer Goods Forum. Wasson, 54, received compensation valued at about $12 million for the fiscal year that ended Aug. 31, according to the Deerfield, Ill., company’s annual proxy statement filed Monday. That represented a 1 percent drop compared to fiscal 2011. Wasson, who became CEO in 2009, received a $1.3 million salary, which represented an 8 percent increase from the previous year. The executive also received a performance-related bonus of $1.2 million that was 57 percent smaller than the previous year. Stock and option awards totaled $8.9 million in the recently completed fiscal year. The CEO also received $657,304 in other compensation, according to the proxy. That consisted largely of an executive deferred profit sharing plan and dividend equivalents on unvested restricted stock.CEO, Mr. Gregory D. Wasson R.ph, currently posses 332,814 shares. He also posses following stock options:

In Walgreens board of directors there are two inside directors which is acceptable ratio. Best practice recommends at least ¾ of board members should be independent which is in case of Walgreens satisfied. From other indicators of lack of independence there is only business relationship issue because Nancy M. Schlichting, President and Chief Executive Officer, Henry Ford Health is customer of the Walgreens Co. Also Stefano Pessina, Executive Chairman, Alliance Boots GmbHis customer of the company and his company is in the joint ventures with Walgreens in Europe.Also he is one of the major direct share holders of the company. Having one major share holder in board of directors is generally good because he has big interest to represent interest of the shareholders in the board. We didn’t find that any of the board members were employed with the company in the past and interlocking directorship is not found neither. There is three female board members which is very good number taking the highest number of females in the board in just couple of USA companies is four.

How much trading volume is there on the stock?
AvgVol (3 month):| 6,476,330|
AvgVol (10 day):| 7,636,960|

Does the firm has any has publicly traded debt?

Societal constraint
http://www.walgreens.com/topic/sr/social_responsibility_home.jsp Liquidity ratios
Net working capital = Total Current Assets – Total Current Liabilities = 12.322 – 8.083 = 4.239 Net working capital / total sales = 4.239 / 72.184 = 5.8%

The number one reason most people look at a balance sheet is to find out a company’s working capital (or “current”) position. It reveals more about the financial condition of a business than almost any other calculation. It tells you what would be left if a company raised all of its short term resources, and used them to pay off its short term liabilities. The more working capital, the less financial strain a company experiences. By studying a company’s position, you can clearly see if it has the resources necessary to expand internally or if it will have to turn to a bank and take on debt. Since the retail industry average is 4.44% WAG is good above average. Current ratio = current assets / current liabilities = 12.322 / 8.083 = 1.52 The current ratio is another test of a company’s financial strength. It calculates how many dollars in assets are likely to be converted to cash within one year in order to pay debts that come due during the same year. For most industrial companies, 1.5 is an acceptable current ratio.

As the number approaches or falls below 1 (which means the company has a negative working capital), you will need to take a close look at the business and make sure there are no liquidity issues. Quick ratio = (current assets-inventory) / current liabilities = (12.322-8.044) / 8.083 = 0.53 An indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets. The higher the quick ratio, the better the position of the company.it measures the ability of the average company to come up with cold, hard cash literally in a matter of hours or days. Since the retail industry average is 0.15 WAG is good above average. Average collection period = Accounts receivables / (revenue / 360) = 2.497 72.184 / 360) = 12.48 The approximate amount of time that it takes for a business to receive payments owed, in terms of receivables, from its customers and clients. Profitability Analysis ratios

Return on assets = net income / total assets = 2.714 / 27.454 = 9.8 % An indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Since the drug store industry average is 4.1% WAG is good above average. Return on Equity = Net Income / Shareholder’s Equity = 2.714 / 14.847 = 18.3% The amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation’s profitability by revealing how much profit a company generates with the money shareholders have invested. Since the drug store industry average is 10.1% WAG is good above average. Return on revenues = net income / total revenue = 2.714 / 72.184 = 3.7%

A measure of a corporation’s profitability that compares net income to revenue. Return on revenue is calculated by dividing net income by revenue. Since the drug store industry average is 2.3% WAG is good above average. Return on total capital employed= EBIT / (total assets – current liabilities) = 4.294 / (27.454-8.083) = 22% A ratio that indicates the efficiency and profitability of a company’s capital investments. ROCE should always be higher than the rate at which the company borrows, otherwise any increase in borrowing will reduce shareholders’ earnings. With this ratio WAG is far above borrowing rate. Profit margin = net income / sales = 2.714 / 72.184 = 3.7%

A ratio of profitability calculated as net income divided by revenues, or net income divided by sales. It measures how much out of every dollar of sales a company actually keeps in earnings. Since the drug store industry average is 2,6 % WAG is good above average. Earnings per share = net income / number of common shares outstanding = 2.714 / 915.1 = 2.9$ The portion of a company’s profit allocated to each outstanding share of common stock. Earnings per share serves as an indicator of a company’s profitability. Since the drug store industry average is 0.76$ WAG is good above average. Activity analyses ratios

Assets Turnover Ratio = sales / total assets = 72.184 / 27.454 = 2.62 The amount of sales generated for every dollar’s worth of assets. Asset turnover measures a firm’s efficiency at using its assets in generating sales or revenue – the higher the number the better. It also indicates pricing strategy: companies with low profit margins tend to have high asset turnover, while those with high profit margins have low asset turnover. Inventory turnover ratio = sales / inventory = 72.184 / 8.044 = 8.97 A ratio showing how many times a company’s inventory is sold and replaced over a period. A low turnover implies poor sales and, therefore, excess inventory. A high ratio implies either strong sales or ineffective buying. High inventory levels are unhealthy because they represent an investment with a rate of return of zero. It also opens the company up to trouble should prices begin to fall. Inventory / sales = 11.1%

The Inventory To Sales ratio measures the percentage of Inventories the company currently has on hand to support the current amount of Net Sales. An increasing Inventory to Sales ratio is generally a negative sign, showing the company may be having trouble keeping inventory down and/or Net Sales have slowed. This often indicates larger financial problems the company may be facing.Industry average in retail industry in general is 10.82% and WAG is slightly above average but that can be attributed to the specifics of the retail drug industry. Capital Structure Analysis Ratios

Interest Coverage Ratio = EBIT / interest expense = 4.294 / 88 = 39.36 A ratio used to determine how easily a company can pay interest on outstanding debt. The lower the ratio, the more the company is burdened by debt expense. When a company’s interest coverage ratio is 1.5 or lower, its ability to meet interest expenses may be questionable. An interest coverage ratio below 1 indicates the company is not generating sufficient revenues to satisfy interest expenses. Debt / equity ratio = total non current liabilities / equity = 4.524 / 14.847 = 0.30 Optimal debt-to-equity ratio is considered to be about 1, i.e. liabilities = equity, but the ratio is very industry specific because it depends on the proportion of current and non-current assets.

The more non-current the assets (as in the capital-intensive industries), the more equity is required to finance these long term investments. For most companies the maximum acceptable debt-to-equity ratio is 1.5-2 and less. For large public companies the debt-to-equity ratio may be much more than 2, but for most small and medium companies it is not acceptable. US companies show the average debt-to-equity ratio at about 1.5 (it’s typical for other countries too). In general, a high debt-to-equity ratio indicates that a company may not be able to generate enough cash to satisfy its debt obligations. However, a low debt-to-equity ratio may also indicate that a company is not taking advantage of the increased profits that financial leverage may bring. Capital Market Analysis Ratios

Price Earnings Ratio=market price of common stock per share / earnings per share = 37.94* / 2.9 = 13.08 A valuation ratio of a company’s current share price compared to its per-share earnings. Results of this ratio is pretty high so investors can expect high earnings. *Last 52 weeks average

Overall risk of company

The yearly returns in graph show huge volatility in returns. The graph shows risk that would investors face if they had invested in Walgreens stock in the period from January the first of 2007 to December of 2011. Looking at the summary statistics average return monthly was -0.06 what would mean that overall price of shares has fallen. If looking at yearly basis annual return on stocks was -0.71%. From graph we can see that return on stocks was highest in September of 2009 (with return of 24.61%), and lowest in October of 2010 (with return of -17.78%). Although that overall stock price had slightly decreased dividend payment has risen from $0.078 in 2007 to $0.225 in 2011. Annualized standard deviation and annualized variance for that period where high, in particular standard deviation for that period was 28.70% and variance was 344.45%. From this we can conclude that in this period there was huge volatility on the market. But to assess the risk of the company better we have to compare it with the industry to see the trends in overall market.

Marginal investors in the company
Number of outstanding shares Walgreens C.O. has is 944,055,000. Percentage of stock held by institutional investors is around 67% of overall stocks. Top institutional holder s in Walgreens C.O. are domestic inventors . The biggest institutional holder in the company is Vanguard Group and their core business are investments.

Source: http://finance.yahoo.com/q/mh?s=WAG+Major+Holders
Estimate the default risk and cost of debt of your company
“The default risk of a firm is a function of its capacity to generate cash flows from operations and its financial obligations – including interest and principal payments”. Default risk is important for borrowers because they want to minimize the risk of borrowing. In corporate world assessment of default risk had been solved by rating agencies such as Standard and Poor’s and Moody. As estimation of default risk of Walgreens. Co. we have used corporate bond rating. Our company was rated as BBB and according to S&P it means : “Has adequate capacity to repay, but adverse economic conditions or circumstances are more likely to lead to risk” We can conclude that risk in investing in our company is medium. As our company has issued bonds we took yield to maturity of 2.14% as a percentage of the cost of debt. Weights of debt and equity

To estimate the weights of debt and equity we have used market value of shares outstanding and multiplied it with the price of a share. As market value of debt was difficult to assess we have used book value of debt. Walgreens has 944,055,000 shares outstanding with the price of $ 32.80, in other words amount of equity is $ 30.92 bill. Amount of book value of debt in our company is calculated by summing long term debt of $ 4.07 bill. and short term debt of $1.32 bill. which in total is $ 5.39 bill. Regression

The intercept of the regression provides a simple measure of performance during the period of the regression. We will use intercept to calculate how did stock preformed during 5 year period compared to the market. Furthermore, Jensen’s alpha will be the model for assessing the performance. To continue it is important to mention that we will divide T-bond rate in period from 2007-2011 with percentage of 3.05% annually with 12 months, so we could get monthly risk free rate of 0.254% which we will use in our Jensen’s Alpha model.

To carry on, it is essential to explain regression model that we had got on the base of five year period. Intercept was 0.002 when calculated with Jensen’s Alpha model it shows us that Walgreens did 0.205% better then market based on monthly returns and 2.49% based on annual excess returns. Even though our annual excess return was 2.49% our company has underperformed market when compared with other firms in industry. As we can se from the table firm’s specific Alpha for industry of pharmacy services was 8.24% Using Jensen’s Alpha model we have come to the cocnlusion that our company has underpreformed market adjusted for the risk during that specific period. In other words our competitors did better in average then our company.

Slope of our regression was 1.020 and that means that our company has risk similar to market. For example if there is an slight improvement on market for 1% that means that our stock will rise for 1,02%, but because this regression model is based on 5 year time we can not take this beta as some relevant estimator of risk. If we want realistic betas we should base our estimation on a much longer period. Our adjusted R2 simple shows us the amount of firm’s market risk, in other words 38% percent of companies risk is market risk and it is not diversifiable.

WACC and CAPM
In estimation of CAPM of company as a risk free rate we have used U.S government bond. Our beta was taken form regression model that we have used and as a market premium we have used historical market premiums. Our CAPM is 7.55% and it means that the managers of company are obliged to make this rate of return to the investors.

The weighted average cost of capital (WACC) is defined as the weighted average of the costs of the different components of financing used by a firm. Firstly we should explain what are the inputs for the model and how did we obtained the data. Market value of equity we have calculated by multiplying the number of shares outstanding 944,055,000 with price of the share. Book value of debt was obtained from balance sheet of the company. Tax rate for company was 37% according to Damodoran. As a cost of debt we have used yield on Walgreens long term bond. Using the formula for WACC we have calculated that weighted average cost of capital is 6.62%.

Evaluating the firm´s current investment
As it is difficult to come to information about current investments of a company in this chapter we will just calculate Return on equity(ROE) and Return on capital (ROC) and compare them to WACC and CAMP. To begin with we will calculate ROE. To asses ROE we need to divide net income with book value of equity. ROE=net incomebook value of equity

ROE=net incomebook value of equity

Net income for August in year 2012 according to yahoo finance was $2.12 in millions and book value of equity was $18.26 in millions. When calculated our ROE is 11.65%. Comparing it to the cost of equity 7.55% we can see that there is significant difference of 4.1% .

ROC=EBIT(1-tBook value of debt+book value of equity-cash ROC=EBIT(1-tBook value of debt+book value of equity-cash

All data for ROC where obtained from the financial statements from yahoo finance. ROC was 9.76% and compared with our WACC of of 6.62%. Therefore the difference is 3.14%.

Choice of the optimal financing mix

Exhibit #1
An important factor for any business establishment is to minimize its financing cost and make sure that they are in abundance in order for the firm to be able to meet and undertake all the projects that are having positive NPV. In the current economic conditions, many of the banks in the US are shortening their line of credit to many businesses that are having, or are expected to have troubles repaying their obligations. In the scenario that we can observe on exhibit #1 it is assumed that with the current

Exhibit #2
financial indicators the company is having in exhibit #2, Walgreens has the lowest weighted average cost of capital when the firm has 51% of its capital structure financed with debt. The company is currently having really low portion of its financing coming from debt, around 11% which is something typical for cyclical companies in the United States. US companies are sometimes reluctant of issuing debt, and WAG specifically has been paying off large chunk of its debt obligations during the last two years amounting to 3 billion dollars. This could be the fact given the monetary policy employed by the FED and the historical rock bottom interest rates in the United States. Many companies are repurchasing their debt obligations, in cases of callable bonds, and are reissuing at interest rates that are not as income intensive(lower interest rates).

Exhibits #3 and #4
According to the industry norms, Walgreens is in the 42th percentile when it comes to debt, which means that there are many other companies that are loading on more debt and are creating a lower WACC for their company. We can also see on exhibit #3 that at some points Walgreens had only 6% of its financing done through debt. This is definitely not healthy for the investors because if the cost of projects and the return on equity or total cost in general was higher, the business would be adding higher amounts of values to shareholders. We can conclude from the later observations that shareholders might have to push the company to undertake some more debt and maximize shareholder values. As we can see from the scenario enlisted under exhibit #1, if the company is having 51% of its projects financed with debt, the cost of average financing would be the lowest. There is definitely a margin for financing rate improvement.

Exhibit #5
From exhibit #5 we can see that the main competitor of Walgreens, CVS has been undertaking on more debt than the former which might be a better strategy given the lowest interest rates known to the business world for a long time. Analyses of the current financing decisions

Walgreens is currently financing its operations with equity and some issuance of bonds. Given the low debt to equity ratio, we can conclude that management prefers equity financing regardless of its higher demand on the operating income of the company. For companies that are highly profitable, empirical data shows that they have really low outstanding debt because profits and debt have negative correlation. Basically the more company has as profits the more they put down on their debt financing. In the US, although on some occasions investors see addition of debt as positive trait, management seems to disagree with the fact.

Looking through the eyes of the investors, some of them, the followers of the Static Trade-off theory seem to believe that trading off tax savings in favor of financial distress is a better decision for Walgreens. This is the case since the company is well established with a big market share and a really stable cash flow environment which predisposes for taking on higher debt and creating the tax trade-off just as in the case with utility companies. Utility companies that are having stable and easily determined free cash flows in the future take on more debt. The same paradigm should be used by Walgreens for the well-being of their investors.

Dividend Policy Evaluation
Question#1- How much the firm has returned

Exhibit #1
When talking dividend policy, one has to understand first the playfield the particular company is being part of. Walgreen as a grocery store and a pharmacy/drug distributer is being one of the top three players in the industry, second to CVS. Given the nature of the industry, competitiveness is really high, and it seems that Walgreens has occupied and positioned itself in the high end of the lower class drug distributers which is a pointer telling that their business strategy is to deliver good service at a low price with high consistency margins. Walgreens has a non-cyclical business cycle. What that means is that the company does not depend or have increased sales during a particular season that deviate strongly for another season. Another factor of non-cyclicality is that even in times of deep recession or economic downturn the pharmacies are still going to be selling just as much drugs as in good times which is a predisposition for stable cash flows. Having the later in mind, stable cash flows lead to higher payout ratios which can be observed in Walgreens behavior towards their dividend policy.

It is important to mention that although the company has been out there for quite some time, dividends had dramatic increases during the last twenty years because of the growth strategy the company was going after. Historically, Walgreens has been paying dividends, but as we can see on exhibit #1, dividends have been steadily increasing during the last 5 years. This could be the case given that the company is having a lot of excess cash, or is trying to signal, being an important financial indicator, to investors its future optimistic financial position. According to modern dividend policy, a company that has a steady increase in its dividend policy signals investors positive future of their investments. Another case for increase in the dividends paid and stock repurchases, which can also be seen as a type of dividend, is that the WAG(Walgreens) has went in to the maturity cycle of its business and is having excess cash that is not being invested in other positive NPV project.

We can from the cash flows of the company that this is not that case given that monumental capital expenditures that the company is undergoing during the last few years: Walgreens still has a place to grow and has not reached its maturity point yet. This statement is also supported by the conclusions reached by executive management in their investment relation statements published during the last year. Coming back to exhibit #1 again, we can see that as EPS for the company is going up, the dividend yield is also going up. From the stock performance of the company we can see that although the firm has been having some though times during the last few years earnings arebeing stable and create the benchmark for higher dividend. From the summarized data we can also conclude that in near future dividends are going to be at least as high as they are now: it is highly likely that they are going to increase in the next 2-4 years because the CAPEX that was invested in billions is going to start to pay off and create value for investors.

The payout ratio of the firm seems consistent with the business model employed and the corporate strategy given the nature of the business environment. Also, taking in to account that the business is financing a lot of its projects from retained earnings and common equity, higher payout ratio is not to be expected during the next few years. The company had announced a 2 billion of stock repurchase program that is about the expire at the beginning of 2013 and future developments in this scenario are not at hand leading us to believe that more repurchases (in big amounts) are not to occur in near future.

Exhibit #3 and #4
Moving our attention to exhibit #2 and #3 we can see that although the percentage wise of dividend increase has been smooth to some extent, the cash equivalents are not saying the same story. A substantial increase of 300+ millions paid in cash out to stockholders in the form of dividends between the years of 2007-2012 gives us a pretty opportunistic view of how well the company is doing. Adding to the later, stock repurchases, in terms of cash spend accordingly, has been also in high amounts. During years 2011-2012 alone, the company has spent around 3 billion for stock repurchases and by the start of 2013 the number is likely to grow to 4 billion. This could be another financial indicator for investors that management believes the stock is undervalued and that is why they are implementing these programs to have it bought back and reissued in a later period.

It is safe to assume that the stock is not being bought off because of an unfriendly takeover that is endangering WAG’s autonomy. Another interesting factor we can see from exhibit #3 is that the company is having high reserves of cash on its financial statements. According to recent reports of leading company analysts, having excess cash reaffirms investors’ faith in to the business one governs and helps attract more risk adverse investors. We are not concluding that this is the case for Walgreens given our limited information and research regarding the issue, but one should know that such a trend exists out there for US companies and take it in to account when doing company evaluation or investment decision.

Exhibit # 4
Turning our attention to exhibit #4 we need to make some assumption and proceed evaluating the information with some caution. When trying to compile the information for this particular table, we found it difficult to find all the financial information on one report, the SEC filing, and needed to derive the numbers from other sources. The reason was that depreciation expense was not listed on the financial statements filed with SEC. There is a small chance that we have not seen it, but regardless of the fact the numbers presented are coming from four different sources. When computing the free cash flows to equity by using the method underlined by our instructor in school, we are getting a result for free cash flows that seem not in line with the financial data presented on the Walgreens investors relation report. The results for FCF have been presented next to our computation and will be used in to the further assumption of our decisions since we assume the FCF computed by management are more diligently done then ours.

Looking at the exhibit we can see that there have been exponential increase in the amounts of working capital and change in debt. What this is telling us is that due to the CAPEX expansions more working capital is needed to have the business operate in regular manner. It is important also to see that debt is being paid off in high amounts leading to pointers that the company might believe it is paying a rate too high according to what it can currently borrow at.

This could be the case because of the historically low interest rates that the federal government of the US is trying to hold in order to revitalize the economy: the later makes it easy for business with improving credit rating to borrow and refinance their outstanding debt at rock bottom rates. The connection between all listed factors and dividends is that although the company is having big capital expenditures and debt pay offs, it is still being able to increase the dividends paid and able to maintain a liquid enough environment to conduct its business without serious troubles or operations risk. By operation risk, we mean that the operating cash flows are not low enough to endanger the sustainability of the company. As we can see also in the exhibit, net income is going up which is another financial indicator that management is doing something right.

Exhibit #5
The conclusions regarding the distribution of the FCFE can be observer in exhibit #5. We can see that during the last four years more and more of the free cash flows are being redirected to the owners/shareholders of the company. The company does not need to borrow any funds in order to pay its dividends and they are completely financed by internal cash that is being generated by the day to day activities the business conduct. It might be a good idea for portion of the dividends to be financed with debt though. This conclusion is based on the Pecking Order Theory which states that issuance of debt is being seen by investors as positive factor and usually leads to higher share price. On another note, as being a profitable company, we can also see that big amounts of debt are being paid off, which is a great time for financial restructuring and putting some extra debt on the company shoulders. The later can also improve some agency issues, in theory, since we have not really observed any in WAG. Distribution of dividends is not going to out-leg free cash flows to equity according to analysts’ projections in the next few years going ahead, ceteris paribus.

Exhibit #6
Comparing Walgreens to its major competitors, we can see that the company is floating somewhere in the middle based on payout ratio and dividends yield. It should be taken in to account that Wal-Mart is not direct competitor of Walgreens, but only a part of its business is(due to the fact that the pharmacy part of Wal-Mart is not listed in a manner where information for this presentation can be extracted, we are generalizing and taking the final numbers of the company for comparative actions). Given the information in exhibit #6, we can conclude that with strong yields on their dividends and relatively higher payout ratios than competitors, Walgreens has a good financial condition and dividend policy that is intact with the financial goals of the company. It is safe to assume and build on the high dividend yield of 2.18% that Walgreens has created an environment that enriches investors and adheres to the needs of these “clientele” that are dividend hungry.

Reference:

WAG annual report for 2011.
http://finance.yahoo.com/q/is?s=WAG&annual
http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/wcdata.html http://beginnersinvest.about.com/od/analyzingabalancesheet/a/current-ratio.htm http://www.creditguru.com/ratios/inr.htm
http://money.cnn.com/magazines/fortune/global500/2009/performers/industries/profits/index.html http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/wcdata.html http://pages.stern.nyu.edu/~adamodar/

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