Walgreen's - good March '07 and spectacular q2 '07

Walgreen's reported March '07 comp's this morning that were in line with expectations, and told investors that due to the calendar location of the Easter weekend, April '07 comp's will be combined with March '07 comp's (as was done last year) to get a true reading of the two month activity.

In March, '07, WAG's same store comp's rose 8%, while prescription comp's rose 8.8% and front-end comp's increased 5.6%. There has been some slowing in the monthly data for Walgreen's, but not dramatically so, as the retail drug store group continues to have the best comp's in all of retail, month-in and month-out, and WAG continues to take market share from competitors.

Still, it is hard to put too positive a spin on WAG's 2q earnings reported last week: year-over-year (y/y) revenues rose 15%, eps rose 26%, and operating income rose 36% (albeit against the weakest quarter of '05) as the gross margin expanded 124 bp's to 29.68%, the operating margin expanded 129 bp's to 8.04%, and the net profit margin expanded 37 bp's to 4.68%.

WAG continues to get expense and SG&A leverage out of their formidable business model, as WAG has not had one single quarter of less than dounble-digit sales growth since 1998.

While most analysts note WAG's forward P/E of 23(x) the current '07 estimate of $2.07, WAG is cheaper on a cash-flow basis, trading at just 17(x) 4q trailing cash from operations, as the company has ended the last two quarters with free-cash-flow on a 4q trailing basis of $1 bl or more, the first time that has happened since we began tracking the company in 1995. As of the February '07 quarter, WAG was generating $2.78 in four-quarter trailing cash flow per share, about 150% higher than net income, and a good litmus test for earnings quality (i.e. cash flow as a percentage of net income).

One of the bigger internal improvments WAG has made in the past few years has been working capital, as their working capital efficiency through most of the 1990's and early 2000's was in fact pretty poor. Today however, even with continued store growth, and just 50% through their ultimate store build-out of 11,500 stores, WAG is generating free-cash-flow that is very healthy, which will hopefully continue.

Bottom line: trading at less than 1(x) 4q trailing sales, and 23(x) forward earnings for recent eps growth of 26%, and 17(x) 4q trailing cash flow (enterprise value) you would think that WAG would be a table pounding buy by most of Wall Street, but analysts look at the stock price action and the two year trading range between $40 - $50 and the horrid P/E compression, and think "I'd better stay away until the stock breaks out".

Fundamentally the stock is a great value here, and technically it looks pretty good too, as the next upward thrust should take WAG over the September '06 high of $52 per share.

Could the stock price be discounting a new business model in the form of CVS/Caremark ? Absolutely. Could the lagging stock price be forecasting as yet unseen changes down the road in insurance co-pay's (the biggest risk to WAG's business model) ? Sure, absolutely. The stock price could be discounting any number of untoward events or circumstances including the current complete disgust for large-cap growth stocks (the most likely reason), but that is the challenge in investing.

We do our homework, do the bottoms-up analysis, read what the anlaysts are saying, follow the charts and technicals and stay with the quality growth businesses, and we continue to believe that WAG is one of the best.

position in WAG