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. % 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. % (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 the remainder of the sales was from storefront items, which carry higher gross margins than pharmacy sales.
On the other hand, CVS’ pharmacy sales were averaging 70% of total sales, creating lower overall gross margins than Walgreens. To compound the issue of lower margin pharmacy sales, third-party insurance company reimbursed pharmacy sales are lower margin than non-third-party pharmacy sales. Furthermore, the percentage of total pharmacy sales that are covered under third-party insurance programs continues to increase as a percentage of sales. CVS’ portion of pharmacy sales that were reimbursed by third party insurance programs was 93.
2% during 2003 and 94. 1% during 2004 and 2005.On the other hand, Walgreens was 90. 6% during 2003, 91.
7% during 2004, and 92. 7% during 2005. The significance of this data is that these lower percentages demonstrate how Walgreens is able to drive higher margins on their pharmaceutical sales, effectively increasing their revenues. Operating Expenses Despite having higher gross margins than CVS, Walgreens has historically reported higher SG&A (selling, general and administrative expenses) as percentage of sales than CVS, meaning that on a comparable basis, for each $1 of sales, Walgreens has operating expenses of $0.
2 and CVS has operating expenses of $0. 19.Operating expenses include, but are not limited to, expenses associated with running a business but are not considered directly applicable to the current line of goods and services being sold. Examples include sales and marketing, general and administrative, operating leases, and employee benefits.
The following represents highlights of the major operating expenses between the two companies and their impact on earnings.During 2005, Walgreen operating expenses were modestly higher at 21% of net revenues, up from 20. % during 2004, primarily due to a one time charge of $54. 7 million associated with inventory and equipment loses and lease charges resulting from the 74 stores damaged by Hurricane Katrina.
Additionally, during 2004, CVS recorded a $65. 9 million pre-tax charge associated with an operating lease accounting adjustment in response to a SEC judgment on lease accounting methods. Walgreens was also affected by the SEC pronouncement, but elected to incorporate the change in 2005 (no charge) and restated prior years’ earnings.The cumulative effect of Walgreens adjustments was estimated at $148 million pretax.
A major expense for these companies is store rent. As both companies lease the majority of their store locations, operating leases are a major component of operating expenses. As of December 31, 2005, although Walgreen’s had 518 fewer stores that CVS, its total operating lease expense (rent) was $53 million higher than CVS (Walgreen’s total operating lease expense was $1. 31 billion compared to CVS’ $1.
257 billion.The difference is attributed to variances in building square footage as Walgreens stores are, on average, approximately 4,000SF larger than CVS’ stores. CVS contends that SG;A expense as a percentage of sales have been negatively affected by the company’s acquisition of 1200 Eckerd stores in 2004 because the Eckerd stores had higher operating expenses as a percentage of sales. This is typical when an underperforming company is purchased by a competitor and explains why it will take time for CVS to make the appropriate costs reductions in order to bring the Eckerd stores into alignment with CVS’ business model.
Since the acquisition, CVS was able to lower its overall expenses as a percentage of sales, which could be a combination of increasing sales on existing stores and reducing operating expenses. CVS’ total assets at FYE 2005 were $15. 3 billion, which was slightly larger than Walgreen’ $14. 6 billion.
This is material because while assets are reported on the balance sheet, a company must depreciate its fixed assets over their useful life and report the associated depreciation expense on the income statement.Depreciation expense was approximately 1. 6% of net revenues ($589 million) for CVS, compared to 1. 1% of net revenues ($482 million) for Walgreens.
Other Expenses/Income During 2005 and 2004, CVS reversed $52. 6 million and $60. 0 million of accrued tax reserves. The rationale for this disclosure is not made by CVS.
Walgreens reported $31. 6 million of interest income associated with its $494 million of short-term investments as of FYE 2005 which is down from $1. 2 billion in investments at FYE 2004.For CVS, as a result of the on-balance sheet financing of the Eckerd acquisition, total interest expense during 2005 was $110 million, up from $58 million during 2004.
Assuming interest rates continue to rise, this differentiating factor between Walgreens and CVS will continue to grow, as Walgreens will earn a proportionally higher return on investments while CVS is required to refinance its maturing senior notes at higher interest rates. The impact of this debt burden puts CVS in a very risky position if a major impact to the retail industry is encountered in the marketplace.Walgreens had no interest expense during 2004 or 2005. The significance of this fact for Walgreens is that their balance sheet does not reflect any debt.
Instead, Walgreens purports off-balance sheet debt. Balance Sheet Analysis From a liquidity perspective, both companies are considered fairly liquid with a current ratio of 1. 56 for Walgreens and 1. 20 for CVS at FYE 2005.
As indicated by Table 5, both companies have increased their liquidity and strengthened their ability to pay short-term debts with current assets.Despite CVS’ heavy long-term debt obligations, they are well-suited to thwart short-term financial commitments. As a result of Walgreen’s strategy of organic growth, it reported less inventory on hand and had better inventory management ratios, as evidenced by Days Average Inventory (Table 6) of 62 days at the end of fiscal 2005. This is made possible by technological advances such as satellite technology and scanners, as well as state-of-the-art distribution centers that make just-in-time deliveries of inventory.
CVS on the other hand reported 75 days, which was fairly consistent over the past four years.This indicates that Walgreens is able to sell their merchandise more quickly than CVS, which allows them to record revenue more quickly and with greater frequency. This supports the higher revenues indicated on the income statement. Although CVS’ 2005 annual revenues are approximately $5 billion less than Walgreens, CVS total assets of $15.
2 billion are larger than Walgreens total assets of $14. 6 billion, which is directly attributable to $1. 7 billion for goodwill. This is primarily associated with the aforementioned 2004 acquisition of the Eckerd stores, which carried $903 million of goodwill.
In an acquisition, goodwill appears on the balance sheet of the acquirer (CVS) in the amount by which the purchase price exceeds the net tangible assets of the acquired company (Eckerd). Between 2002 and 2005, Walgreens did not utilize conventional on-balance sheet debt to finance its operations and growth, thus reporting low book leverage of 0. 64, as measured by Total Liabilities/Net Worth. On the other hand, as a result of CVS’ desire to grow via acquisitions, CVS reported higher book leverage of 0.
84 at FYE 2005, as the company had $2. 1 billion of conventional bank debt.Goodwill is considered an intangible asset; therefore, book leverage would have been significantly higher if measured on a tangible asset basis. During 2004, in order to finance the $2.
1 billion acquisition of Eckerd, CVS issued $1. 2 million of Senior Notes. The $2. 1 billion of net assets acquired included $900 million of goodwill and $500 million of other intangibles.
Another metric to analyze performance is asset turnover, which is the amount of sales generated for every dollar’s worth of assets. It is calculated by dividing sales by assets.Asset turnover measures a firm’s efficiency of using its assets in generating revenue. Walgreens asset turnover ratio was 2.
9 for 2005, which was higher than CVS asset turnover of 2. 4. This metric also supports the conclusion that Walgreens operates more efficiently than CVS. Cash Flow Analysis During 2005, CVS’ generated $1.
6 billion of cash flow from operations, which in conjunction with proceeds of $178 million from the exercise of stock options, was sufficient to internally finance $911 million of net investing activities, a $626 million net reduction in bank debt and $131 million of shareholder dividends.Consequently, the company improved its cash position by $121 million at FYE 2005 with $392 million of cash and cash equivalents. Walgreens generated $1. 37 billion of cash flow from operations, which was sufficient to internally finance $434 million of net investing activities and $804 million net outflow of cash for financing activities.
This left $132 million of excess cash at the end of the year, improving cash on the balance sheet to $576 million at FYE 2005. Significant aspects of each companies’ statement of cash flows follow:CVS Operating Activities – The $1. 612 billion of cash flow from operations was composed of $1. 81 billion of cash flow from operations (net income plus non cash charges) partially offset by a negative $200 million of working capital.
Investing Activities – The $911 million of net investing activities included $1. 49 million of additions of PP;E, offset by $539 million of proceeds from sale leaseback transactions, $32 million of proceeds from the sales of assets, and $12 million of cash from acquisitions.This demonstrates that CVS continues to invest in PPE (property, plant and equipment) at a level greater than depreciation, which was $589 million during the year. Financing Activities – Operating Activates and Investing Activities generated $700 million of positive cash flow which CVS used in addition to a cash inflow of $178 million from proceeds from stock options, to pay its annual shareholder dividend of $131.
6 million, or $0. 1325/share. This reduced on-balance sheet debt by approximately $616 million.Walgreens Operating Activities – Although the $1.
7 billion of cash flow from operations was less than CVS during 2005, it was composed of higher cash flow from operations and offset by a negative $707 million increase in working capital, primarily due to an $854 million increase in inventories. Investing Activities – The use of $434 million for investing activities included a $1. 2 million use of cash for additions to PPE, partially offset by $15. 5 million of asset sale proceeds, $10.
1 million of life insurance proceeds, and approximately $800 million of investment proceeds.This is significant because it demonstrates that Walgreens also continues to invest in PPE at a level greater than depreciation, which was $482 million during the year. Financing Activities – Of the $804 million in net financing activities, the company utilized cash flow to pay a $214 million dividend, purchase $781 million of treasury stock, which was partially offset by $178 million of proceeds from employee stock plans and $14 million of uncategorized other inflows. The $226 million in declared dividends equated to $0.
2225/share, which was higher than CVS’ (as of 12/31/05 Walgreens paid $214. 5 million in dividends).
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