On Tuesday morning, Walgreen Co. (NYSE:WAG), the second largest retail pharmacy operator, reported earnings that largely disappointed analysts and investors. The stock was weak during morning trade, although it rebounded midday despite an opposite move in the stock market.
Let’s look at the numbers. The company reported revenue of $19.4 billion versus an estimate of $19.44 billion. Despite the miss, the company grew its revenues by about 6 percent for the year. Most of this was due to same store sales growth, which came in at 4.8 percent.
However, what disappointed investors were the company’s weak profit margins. Gross margins fell by 40 basis points to 28.1 percent. This resulted in a 3-cent-per-share miss on EPS, which came in at 91 cents per share excluding extra items.
It may not seem like a big deal that the company missed by just 3 cents per share on earnings, but keep in mind that this means the company is growing by about 4 to 5 percent slower than analysts expected. For a company that trades at about 25 2times earnings, this is a big deal. Furthermore, investors have to keep in mind that when analysts see earnings growth acceleration or deceleration, they extrapolate it into the future.
Recently — that is, over the past couple of years — Walgreen has shown sales growth and profit growth acceleration. This led to a sizable revaluation of the stock, which hit a peak of about $45 per share in 2011 and which hit a peak of $76 per share within the past few weeks. This large share price increase was justifiable because analysts believed that earnings growth would continue to accelerate.
But now, one has to question that thesis. Walgreen is still showing relatively strong revenue and earnings growth in the mid- to high-single digits, but it is no longer accelerating, and this means that if we project earnings a few years out, we get a different picture, with 91 cents per share as opposed to the expected 94 cents per share.
Investors should therefore take a step back and re-evaluate their positions in this stock. The shares have had a very nice run, especially for what would be considered a relatively defensive large-cap retailer. The shares are trading at 25 times earnings because expectations grew dramatically, but the company is not meeting these heightened expectations.
Investors need to consider the possibility that the current growth rate is here to stay, and that it may even decline. The end result is that the price-to-earnings multiple is simply too high at the current valuation and that there is a heightened likelihood that the shares will decline in value.
With that being, said I think that the shares put in an intermediate top last week, and we are probably in for a sizable correction as the stock consolidates the gains we saw since it bottomed in 2012 at about $30 per share. Even if we only see a correction representing one-third of these gains, or about $15 per share, the stock still has about a $60 per share price target.
That would still put the shares at about 20 times earnings, which isn’t cheap. Therefore, I think that the correction can be even steeper than this, and investors should avoid buying this dip. Those who got in early are urged to take profits while analysts and investors are still relatively optimistic.
Disclosure: Ben Kramer-Miller has no position in Walgreen Co.