Financial Analysis Of Walgreens Vs. Cvs

Executive Summary

The initial intent of this analysis was to identify changes in accounting methods within the financial statements of Walgreens and CVS, as well as to compare and contrast their financial statements, in order to draw conclusions about which company had better earnings. However, in the process of this analysis, with the exception of a minor change to lease accounting by Walgreens, there were no major changes in accounting methods identified. In examining the financial statements for these two drugstore industry leaders, the analysis shows that while each company conducts retail drugstore operations in similar ways, their business models for carrying out these operations greatly vary. These variances in business model led the analysis to focus on earnings from operations, operations costs, balance sheet analysis, cash flow analysis, inventory accounting, debt financing, retirement plans and benefits, and stock options.

Of the differences that were explored, it was their level of conservatism that most separated these two companies. Walgreens chooses a more conservative approach to their operations by growing organically, while CVS assumes a riskier business model by growing through acquisitions. This fundamental difference in the two organizations cascades throughout their financial statements in the form of debt for CVS which is offset by growth of margins and profits; and in the form of a much healthier balance sheet for Walgreens. This analysis shows the results of each company's operations, the ramification of those operations on their financial statements, and the conclusion that because of their more conservative, less risky business model, Walgreens maintains a healthier operation, despite equally impressive growth by both companies.

Ultimately, the value of each company is left for the investors to determine. The data, however, shows that Walgreens is winning the earnings race for drugstore/retail operations, despite CVS' attempt to use liberal accounting methods to boost earnings.

Operations Analysis

On a comparable revenue basis during fiscal 2005, Walgreens generated net revenues of $42.2 billion, compared to CVS' net revenues of $37.0 billion. Although CVS' CAGR (compound annual growth rate) over the past 4 years was 11.2%, slightly higher than Walgreens 10.1%, these two drugstore giants have undertaken very different strategies to achieve this tremendous growth. Walgreens has expanded organically via new store openings, while CVS has undertaken a strategy of acquiring competitors. Despite having similar store operations, this fundamental difference has led to a variance in comparable operating performance.

From an earnings perspective, not only are they a larger company by revenues, but Walgreens is also run more efficiently, leading to higher profitability. This is evidenced by a net income margin (Net Income / Sales) of 3.7% during 2005, compared to CVS' net income margin of 3.3% during 2005, indicating that for every $1 of sales, Walgreens earns $0.037 while CVS only earns $0.033 per dollar of sales. Table 1 shows the increases in net income and margin between both companies over time. Net income is the resulting capital after expenses are paid.

The significance of this chart is that despite a higher CAGR for CVS over the same period, Walgreens has maintained a consistently higher net income from its operations than CVS. Additionally, it shows both companies ability to keep their capital growing with time.

Walgreens typically reports higher gross margins, which are partially offset by higher SG&A expenses as a percentage of net revenues. As a result, Walgreens reported an earnings before income and taxes margin (EBIT/Sales) of 5.7% of net revenues in 2005, which was slightly higher than CVS' 5.5%. Although these EBIT margins are comparable, Walgreens differentiates itself with a net income margin of 3.7% vs. CVS' 3.3% primarily due to Walgreen' lack of interest expense associated with no on-balance sheet financing and interest income. This 0.2% difference, while overtly small, is substantial as the difference is attributed to CVS' highly leveraged position. The chart in Table 2 shows the edge Walgreens maintains over CVS and how that edge has been maintained with time.

Revenues

From 2002 to 2005, Walgreens reported a compounded annual growth rate of 10.1%, growing to $42.2 billion in total revenues. This strong revenue growth was primary driven by organic expansion through new store openings. Since 2002, Walgreens has added 1070 net new stores (22% increase) while CVS has added 1,384 net new stores (25% increase), of which 86%, or 1200 of CVS' store additions, were due to the 2004 acquisition of Eckerd. As a result, although CVS reported an impressive 21% increase in sales from 2004 to 2005 compared to Walgreens 12.5% (a decline from 15.3% in 2003 to 2004), it was primarily due to CVS experiencing the full effect of the mid-2004 acquisition of the 1200 Eckerd stores. Table 3 shows the year-over-year comparison of Walgreens total revenues to CVS'.

The significance of this chart is the upward growth of both companies as well as the increasingly large gap Walgreens has maintained over CVS.

Gross Margins

As shown in Table 4 on the next page, Walgreens was able to improve its gross margin by a total of 1.4% from 26.5% during 2002 to a record high of 27.9% during fiscal 2005. On the other hand, although CVS achieves lower gross margins than Walgreens, CVS was also able to improve its gross margins by a total of 1.6% from 25.1% during 2002 to 26.7% during 2005. Much of Walgreens higher margins are attributable to higher percentages of higher margin storefront sales versus lower margin pharmacy sales. Because CVS uses the first-in, first-out (FIFO) method of accounting for inventory valuation, as opposed to Walgreens' use of the last-in, first-out (LIFO) method, during times of rising inventory costs, CVS utilizes a lower cost of goods sold, leading to higher margins. This is indicative of CVS' liberal accounting procedures and Walgreens' conservatism.

For both retailers, as pharmacy sales continue to grow at a faster rate than storefront sales, total gross margins are negatively effected because pharmacy sales have lower gross margins than storefront sales. Sales mix is a distinguishing factor between these two companies that sell similar products. For example, of Walgreens total sales, pharmacy average 63%, indicating that

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