The Market Should Reward This Aggressive Transformation

Superficially, a drugstore chain like Walgreen is a simple business to run. It opens up a store, sells a large volume of drugs and health products, and makes a small profit margin for itself in the process.  While this is a perfectly adequate way looking at the company, it doesn't go anywhere near assessing the growth opportunities that Walgreen has thanks to the initiatives it has taken over the last couple of years. The recent results confirmed that it's on track with many of them, and despite the strong rise this year, the stock remains attractive.

Walgreen working smarter
There are three main ways in which Walgreen is transforming itself in order to drive the business forward. First, it is using data management (of its customer base) in order to be able to better manage its sales.

For example, early in the year it had reported disappointing front-end comparable store sales of only 0.4%. Walgreen responded by initiating a renewed focus on pricing and promotions in mid-May in order to regenerate traffic and sales. It worked.

Source: Company presentations.

This nicely illustrates how Walgreen can use information garnered from its balanced reward card scheme to help better target pricing and promotional activity. In addition, with a stronger understanding of the treatments that its customer base requires, Walgreen is able to expand its specialty drug support. This includes drugs for long-term conditions like rheumatoid arthritis and diabetes, both of which will help Walgreen's aim to establish itself as a pharmacy in the community. 

Transforming the business
The second driver of growth is coming from the way that Walgreen is aggressively transforming its business through deal making. The 10-year deal with pharmaceutical distributor AmerisourceBergen went live on Sept. 1 . It started with the distribution of Walgreen's branded pharmaceuticals, and AmerisourceBergen has plans to move onto distributing Walgreen's generics within the next 12 months as well.

One big plus for the distributor is that the deal also includes Walgreen's partner Alliance Boots. Walgreen will now get daily delivery to its stores, and this means that it should be able to improve inventory management and benefit from economies of scale, particularly in purchasing drugs.

Moreover, the deal will allow Walgreen to generate even more synergies out of its partnership with Alliance Boots. Indeed. Walgreen achieved $154 million in net synergies this year, compared with its earlier estimate of $125 million to $150 million.

Leverage opportunities in its own stores
The third key growth opportunity relates to the potential to leverage sales in its own stores. Fortunately, it can do this in many ways. One way is to expand sales of its private-brand products. Indeed, private-brand sales increased their penetration of Walgreen's front-end sales by nearly 0.9% to 22.3% in the last quarter. Similarly, it has now launched Alliance Boots'  Boots No. 7 product line in stores across the U.S.

Furthermore, in the long term Walgreen should be able to increase margins thanks to increased generics sales. Generics tend to be higher gross margin (but lower revenue) products for retailers, and in the long term they are likely to increase due to pressures on medical costs.

And finally, Walgreen recently announced a long-term partnership with lab-testing company Theranos in order to provide less invasive lab testing services to Walgreen's customers. The big advantage is that customers -- particularly those who require frequent blood testing -- will be able to get test results quickly and easily. In turn, this sort of initiative will help keep customers loyal to Walgreen.

Where next for Walgreen?
There is plenty going on at Walgreen, and the company deserves credit for aggressively transforming its business in order to deal with changes in health care needs. The partnership with Alliance Boots is working ahead of expectations, and there are more synergies to come. Expanding generics and private brand sales offer margin expansion opportunities in future, the Theranos deal promises to engender customer loyalty to customers who are likely to be frequent purchasers of Walgreen's products. 

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Lee Samaha has a position in Walgreen. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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