When Monsters are Created ...

Cover Story, by Mark Robertson, Managing Partner September 1st, 2008

Has CVS painted Walgreen into a corner with limited strategic options.

Colgate-Palmolive Stock Certificate Vignette. This historic document was printed by the American Bank Note Company and has an ornate border around it with a vignette of an allegorical woman sitting and holding a wheel with wings in her right hand with various chemistry instruments at her feet. Colgate-Palmolive is a leading global consumer products company, including oral care items like toothpaste.

It’s absolutely a beautiful thing when we engage friends and family and lead them to the discovery of long-term investing. The opportunity to make a substantial difference, enabling better futures, is massive. We know that long-term investors also often become loyal (even rabid) consumers for the companies that they own. Regular vigilance combines with routine consumption. I wish I could change the names in the following story to protect the guilty … but it serves as a reminder of how powerful these forces of discovery can be.

I’d made the sojourn again from southeastern Michigan back to the shores of the Mississippi River in northwestern Illinois. As a fairly frequent traveler, my bags are generally packed carefully to make sure that I have all of the necessities for effective travel. I’d arrived back at my parent’s residence well after midnight and settled in for a good night’s sleep knowing that I’d see them at the breakfast table in the morning.

Sunrise came … but something was wrong. It was one of those gnawing feelings. I could have sworn that I stuck that tube of toothpaste in my overnight bag. No matter how deep I dug, it was clear that I was on the road without this necessary item? But my toothbrush was there? If it was there, how in the world did I forget the tube of toothpaste?

Sure enough, Mom and Dad were already seated at the kitchen table. We exchanged hugs and greetings and my instincts began to kick in.

“Dad, you wouldn’t have any idea why I can’t find my toothpaste, would you?”

Grinning, as he often does, like a Cheshire Cat but with his face aimed at his cereal, he responded, “Hmmm. That’s too bad, sorry to hear that. I probably have some real toothpaste you can use.” He was now snickering and giggling while continuing to munch on his cereal. He was also clearly avoiding eye contact.

“What’s with the Annual Report standing next to the bathroom mirror?”

Mom mumbled something along the lines of, “… Oh no. Here we go again.” The cereal crunching continued, but he offered up, “You’ve been warned.” There was still no eye contact.

“Enlighten me, Dad. I don’t seem to recall any warnings?” (It was a white lie. Hairs were now standing on the back of my neck and I was clearly in the danger zone.)

“You should know better than to bring that contraband into this house.”

Mischievous giggling continued. Mom was now grinning, siding with the suspect.

“Why don’t you join the rest of the world and use Colgate toothpaste instead of that ‘stuff’ from Cincinnati? Would you like to see a Fact Sheet?”

It was crystal clear now. My toothpaste had been hijacked and replaced with a Colgate-Palmolive annual report. Dad became a Colgate stakeholder after seeing a company presentation at an investment conference a few years ago. It seems he also became an ardent evangelist and enforcer for their products.

The Rest of the Story …

I wish it ended there, but that would be too easy. It turns out that a few years ago Mom and Dad were shopping for some stocks to add to their IRAs and they wanted to discuss Walgreen and CVS.

(Some of you, probably Walgreen shareholders, know where this is headed … and you know that it’s not going to be pretty.)

At the time, I’d answered, “They’re both good.” (And they were/are.)

The problem is that Dad added Walgreen at the same time that Mom (and my wife) chose CVS for their portfolios. Gulp.

The Battlefield Unravels

I’ve been scratching my head over this one for several months as the Walgreen stock price has sagged from more than $50 to the mid-$30s.

I now believe the answer really does reside in the Caremark transaction. I realize the jury is still out with respect to the strategic value of embedding a pharmacy benefits manager (PBM) within the infrastructure of a CVS or Walgreen — but the long-term impact on profitability appears to be potentially significant.

Profitability Trends & Forecasts. Keep in mind that both Walgreen and CVS achieve margins at the top of the industry. The trend for CVS (relative to WAG) is quite favorable according to current forecasts.

Caremark, a PBM, achieved net margins of 4-5% during 2001-2003 prior to its own acquisition of AdvancePCS in 2004. Caremark was essentially a $30 billion business being combined with $50 billion CVS at the time.

Therefore, it appears that CVS — achieving net margins closer to 3.0% — could make a case for margins closer to 4.0% if the merger could be effectively executed. It now appears that additional synergies and optimizations are possible and that margin enhancement has been achieved with further gains expected.

To get some idea of the potential, take a look at the forecasted net margin for Express Scripts (ESRX), a rival bidder for AdvancePCS back in 2004. As the accompanying industry snapshot illustrates, ESRX has a net margin forecast of 7.3%.

Industry Analysis: Pharmacy Services. This summary is sorted by forecasted net margin (%) — descending. The leadership position of CVS Caremark is pretty clear with respect to the rest of the field.

Could Walgreen attempt to consume ESRX? Sure, but the margin impact would be muted and the cost would probably be prohibitive based on the lower PAR for ESRX.

Medco brings more “scale” but lower margins and MHS is also expensive relative to the Caremark transaction.

Taking a look at the playing field using the accompanying industry snapshot, the candidates are generally too expensive, not enough margin impact to make a difference or simply don’t offer enough size/presence to make a difference when combined with Walgreen.

CVS recently announced the purchase of Longs Drug Stores. Although Longs has lower margins, the real estate aspects and potential optimizations (to impact margins at the Longs component) is compelling and is probably causing even more discomfort at Walgreen HQ.

Has CVS painted Walgreen into a corner with limited strategic options?

Mark Robertson

Mark Robertson is founder and managing partner of Manifest Investing, a source for research and portfolio management focusing on strategic long term investors.