**Dear Reader, I hope you enjoy this article. - Vitaliy**
Oil is by my father, Naum Katsenelson
Investors Have Misdiagnosed Amazon's Push Into The Pharmacy Business
Companies everywhere, in every business, are paranoid about Amazon.com.
This sort of paranoia is healthy for the long-term well-being of our
investment portfolio, as it is creating interesting buying
opportunities.
A case in point: My firm spent a lot of time thinking about pharmacies
when we were analyzing investments in McKesson
and other drug distributors. We struggled with a question: How will the
retail pharmaceutical industry look in the future? Or more precisely,
how will Amazon's entrance into the retail pharmacy business change
this industry?
Our inability to answer this question kept us away from retail
pharmacies. Then we had a small but important insight that shifted our
thinking on Walgreens Boots Alliance. The preponderance of drugs in the
U.S. is consumed by an older population, whose habits change slowly or
not at all. Accordingly, it's likely that Amazon's online pharmacy
will not significantly impact the existing drug industry.
Here's why: Americans currently spend $450 billion a year on drugs.
Walmart is the fourth-largest pharmacy in the U.S., with sales of $21
billion, or 4.6% of the company's total sales. Let's say that over
the next five years Amazon gets to Walmart's sales level of $21
billion. If the U.S. pharmaceutical industry grows 2% a year over that
time, total drug sales will have increased by $45 billion, or the
equivalent of two Walmarts (we are ignoring compounding here), to $495
billion. Walgreens, with its pharmacy selling about $70 billion a year,
would barely notice Amazon's presence.
I've made this point before, but it is important to repeat: 10 years
ago Amazon was not taken too seriously. Giants like Google, now
Alphabet, and Microsoft ignored Amazon's entry into cloud hosting,
thinking "What does a bookseller know about the cloud?" They have
regretted it ever since.
Nowadays everyone is taking Amazon too seriously, bestowing CEO Jeff
Bezos with walk-on-water-like superpowers. Boardrooms today are filled
to overflowing with chatter about Amazon. There's admittedly a lot
Corporate America can learn from Bezos (for instance, about ignoring
short-term results), but Bezos is not superhuman and Amazon cannot bend
the laws of economic gravity.
Walgreens' U.S. business, which is about 75% of its total sales, is
impressive. A single stand-alone store produces revenues of about $10
million a year - $7 million in the pharmacy and $3 million in
front-end sales (milk, candy bars, T-shirts, etc.) A single store fills
about 121,000 scripts a year (up from 97,000 four years ago). Walgreens
has one of the highest sales-per-square-foot numbers in the retail
industry, at around $1,000 per-square-foot (compared to Walmart's
$450, Kroger's $550, and Target's $300). (Note that Tesco's U.K.
stores have sales per square foot of $1,100 - this is why we like the
U.K. grocery business more than ones in the US).
Walgreens also has an underutilized asset: the front end of the store.
Think about it: The pharmacy takes up 20% of the floor space but
generates 70% of revenue. In other words 80% of the store (the front
end) brings in only 30% of revenue. Walgreens is experimenting with
different ways to optimize this underutilized asset - it's opening
medical clinics and bringing LabCorp into its stores, for instance.
In 2018 Walgreens bought 1,900 stores from Rite Aid, bringing its total
U.S. store count up to around 10,000. Store-count growth days are behind
Walgreens, but the scripts-per-store-growth will continue, since baby
boomers are not getting any younger. Accordingly, total sales growth
will continue at a level of at least 2%-3% a year. When retailers mature
and cannot open new stores, their free cash flows explode. Which begs
the question, what will Walgreens do with its cash?
Already Walgreens is taking a quite different approach than its largest
counterpart, CVS Health Corp. CVS owns one of the largest pharmacy
benefit management (PBM) companies (a business that has a lot of
political risk, as it's ridden with conflicts of interest), and CVS is
doubling down on complexity and buying Aetna , a health insurance
company. CVS is trying to become an integrated healthcare provider. We
don't know if CVS will be successful in this endeavor, but the
historical odds of success with acquisitions of this complexity clearly
do not favor CVS.
Walgreens is run by Stefano Pessina, who owns 13% of the company; and
thus 13 cents of every dollar spent is his. Walgreens has therefore been
deleveraging its business, buying back stock, and paying a dividend.
Walgreens is expected to earn $6 a share in 2018. My estimate is that
earnings, helped by the Rite Aid acquisition, same-store sales growth,
and share buybacks (WBA repurchased 8% of its shares in 2018 and has an
authorization to buy another 13%), will exceed $8 per share in 2021.
If Walgreens shares trade at 13 times its $8 earnings per share in three
years, then the upside from here is about 70%; if it trades at 15 times
then it's a double (Walmart trades currently at 18 times estimated
2018 earnings, while Target is at 15 times). We bought Walgreens at a
little over 10 times estimated 2018 earnings in July 2018. Walgreens is
a better business than Target and at least as good a business as
Walmart. At this valuation, heads we win, tails we win - the only
question is by how much.
http://ima142.acemlnb.com/lt.php?s=d3a86c5bf25e4b6449b942f14ab85ca9&i=267A294A4A2367
Digital Painting is by my brother Alex Katsenelson
Bruch Concerto for Two Pianos
Today I'd like to share with you
**Concerto for Two Pianos** by German composer Max Bruch (1838-1920).
Max Bruch is well known for his first violin concerto, which probably
ranks in the top three most-performed violin concertos. This concerto
for two pianos sounds refreshingly different from other piano concertos
from the classical and romantic eras. Parts of it sound like a requiem
(a hymn for the repose of the souls of the dead), and then there are
bursts of optimism that sound almost like themes from an American
Western movie. The piece often sounds like it was written by multiple
composers.
Click here to listen
**Vitaliy Katsenelson, CFA**
Student of Life
I am the CEO at Investment Management Associates
, which is anything but your average
investment firm. (Seriously, take a look .)
I wrote two books on investing, which were
published by John Wiley & Sons and have been translated into eight
languages. (Even in Polish!)
In a brief moment of senility,
**Forbes** magazine called me "the new Benjamin Graham." (They must have
been impressed by the eloquence of the Polish translation.)
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