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Disagreeing With a Giant



I respect Mr. Greenberg's opinion very highly. However, I disagree with him with respect to yellow flagging CVS Corp (CVS) yesterday in his RealityCheck newsletter. First of all, any company will pale in comparison to Walgreen's (WAG) as it is simply one of the very best run companies in the U.S. I know this is a very strong statement, but Walgreen's deserves it, just look at WAG's historic operating performance.

While CVS is a very well managed company, it arguably doesn't have the incredible culture of Walgreen's (then again very few companies do).

I agree with Herb on the issue of a corporate plane. Yes, Walgreen's executives fly coach whereas CVS's enjoy the luxury of a corporate jet, but that is a sad reality of corporate America. And the fact that employment contracts dictate that CVS's CEO and his wife have to use a corporate jet for personal travel for security reasons makes absolutely no sense to me. So Herb, you don't get a disagreement from me here. But is that enough to yellow check the company?

Let's take a closer look at some details...

Inventory Turnover: arguably the best measure of a retailer's performance. On the surface, WAG's inventory turnover appears superior to CVS, however, that is due to the different methods these companies utilize to value their inventory (FIFO vs. LIFO). Once WAG's inventory turnover is adjusted for LIFO reserve, the inventory turnover ratios look very similar.

Accounts Receivables: CVS' accounts receivables are a bit higher than WAG, but that is done by design. A larger portion of CVS sales come from pharmaceuticals (where payers are insurance companies that pay in 30-40 days). For WAG, a higher portion of sales come from front end (non-pharmaceutical products such as toilet paper, milk, cigarettes etc.) relative to CVS where accounts receivable days are instant (cash) or take just a few days (checks and credit cards).

Debt: On the surface WAG appears to have no debt, where CVS has about $3 billion of debt. Debt numbers for both companies are understated, where the majority of debt is hidden to the naked eye (but properly disclosed in footnotes) in property leases. Both WAG and CVS buy their stores and then sell them back to investors, where leases are backed by the corporate balance sheet. When credit agencies (i.e. S&P, Moody's) look at capital structure they consider leases a debt, which it is, as companies have to make lease payments whether a store is open or closed. Total debt (where debt is adjusted for corporate leases) to assets for WAG and CVS is about the same.

Sales Growth: WAG and CVS have much different histories and thus sales growth paths are different as well. WAG made an acquisition a long time ago, but it found that it didn't mesh well with its corporate culture, thus it favored opening new stores as opposed to making acquisitions. By contrast, CVS was originally a collection of loosely related retailers and to refocus on pharmacy retailing the company chose to make a very large acquisition in late '90s. The problem was that the company it purchased did not have great real estate. So for some time, CVS was relocating stores from strip malls to stand alone stores (a move it took right from Walgreen's playbook). As soon as the stores were relocated they received a very nice bump in same store sales.

Right before CVS made the Eckard's acquisition last year it finally started to open net new stores.

Eckard's acquisition: CVS did not make the same mistake twice, as the Eckard's stores it purchased were not well managed but had great real estate (stand alone stores) and were located in growth states, Texas and Florida. CVS installed its systems, re-designed and re-branded Eckard's stores and this acquisition looks like it was a good success. Margins are likely to expand going forward and same store sales growth for Eckard's stores is likely to accelerate in the near future as well.

CVS is putting the finishing touches on Eckard's stores. Next year CVS plans to open 125 net new stores (new stores minus closing stores), resulting in 3.5% square footage growth. This number is lower than WAG's, but is likely to pick up after next year as store closings are likely to decline. Also, Eckard's stores should be a big contributor to higher same store sales and help to drive margins higher.

Valuations: Herb, it is hard to argue with your affection for Walgreen's. It is easy to love Walgreen's consistent performance, its very unique culture where management has to come through the ranks (start in the store and move up), but the Street's love affair is priced handsomely into WAG's very rich valuation (it trades at 27 times August '06 projected earnings). CVS trades at a much lower valuation of 20 times December '06 projections. In fact, long-term growth rates for both companies are very similar (as both companies are properly positioned to benefit from two major trends: aging baby boomers and explosive growth of generic drugs due to mega billion expirations of branded drugs) arguably CVS will start catching up to Walgreen's in the near future.

Herb - looking forward meeting you in less than two weeks at Minyans in the Mountains II!

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Positions in WAG and CVS

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