A prescription for growing profits

DEERFIELD, Ill. -- In 1993, Walgreen Co. told Joe Resendez it was closing the Walgreens drugstore he managed in a Pasadena, Texas, strip mall and opening a bigger one at a better spot: across the street.

Three years later, Walgreen closed that store and opened another one. It was on another corner of the same street, a couple of blocks away. "Some of the customers thought we were going crazy," Resendez said.

He didn't mind, though. With each move, his store's annual sales shot up more than 20 percent. Such obsession with store location has served Walgreen well. While competitors have been gobbling up other companies to expand and big retailers such as J.C. Penney are buying their way into the business, Walgreen continues to rack up the biggest profits and sales of any U.S. drug chain the old-fashioned way: One store at a time. "They don't bite off more than they can chew, and everything they do is home-grown," said Martin Bukoll, an analyst for Northern Trust, which held 9.7 million Walgreen shares in June. He ranks Walgreen in retailing's top tier along with Wal-Mart Stores and Home Depot. Without acquisitions, Walgreen in the last five years has boosted its total stores by 35 percent to 2,550, funding them with internally generated cash. Its earnings have almost doubled in that period to $511 million, or $1.02 a share, in the fiscal year ended Aug. 31 on sales of $15.31 billion. That was its 24th straight year of record sales and earnings. Walgreen's strategy has been a hit with investors: Its shares have risen 73 percent this year, compared with a 23 percent rise in the Standard & Poor's 500 Index. Walgreen's performance ranks it 26th among the 500 stocks in the index and outshines the likes of Time Warner and IBM. The challenge now for Deerfield-based Walgreen is to continue its growth as its industry consolidates into fewer, more powerful hands. They're all eager to capitalize on one of retailing's hottest segments, thanks to the aging U.S. population and increased demand for health-care products. Retail prescription drug sales rose 14 percent last year to $89 billion. CVS Corp. has used acquisitions of Revco and other drug chains to become a close No. 2 to Walgreen in sales, while No. 3 Rite Aid has grown to $11.4 billion in sales. J.C. Penney bought No. 4 Eckerd drugs and last week agreed to acquire Genovese Drug Stores. Wal-Mart, Kroger and other retailers also are beefing up their drug businesses. "What I worry about" is whether the more-concentrated competition will allow Walgreen "to continue this rapid store expansion," said Jeff Parker, assistant portfolio manager with Eagle Asset Management, where the stock is a top 10 holding. Daniel Jorndt, Walgreen's chief executive and president, sees no reason to doubt its strategy. "We think being convenient is the best way" to compete, said Jorndt, the latest former pharmacist to run Walgreen since it was founded in Chicago in 1901 by druggist Charles Walgreen Sr. Jorndt's predecessor as chief executive was Charles Walgreen III, also a former pharmacist and the founder's grandson. He remains chairman. What Jorndt means is that Walgreen will continue to go about its business as methodically as, well, a pharmacist filling a prescription. It will put stores on the busiest intersections in town, with plenty of free parking, amenities such as drive-thru prescription service and, increasingly, 24-hour operations. It will embrace technology to lower costs and make shopping easier. And it will stay away from strip malls and other locations where a Walgreen store has less visibility -- and where a Wal-Mart or big supermarket may be lurking. About half of Walgreen's stores are "freestanding," or physically isolated from other retailers, a concept invented by the company. "They were laughed at initially" but rivals now are doing the same thing, said Thomas Buynak, a Society Asset Management analyst. CVS, Rite Aid and Penney all have more stores than Walgreen. But Walgreen gets much more out of each store than its rivals do, largely because it picks its sites better. Last year, for example, its stores averaged $6 million in sales, compared with $3.3 million for CVS and $2.9 million for Rite Aid. "Walgreen has a tremendous amount of confidence in its ability to go into a market and find the right spot," said Derek Leckow, an analyst with Barrington Research in Chicago. If the right spot isn't available, Walgreen will wait. A pin stuck in a map at its headquarters identifies Paducah, Ky., as a market it wants to enter, for example. It hasn't, though, because the busiest corner in town is taken and that's the only site Walgreen will consider. Walgreen's acquisition-minded rivals, meanwhile, are spending to get many of the stores they bought up to snuff. CVS is converting 2,600 former Revco stores, while Rite Aid is revamping about 1,300 acquired stores. "They've grown very fast, but they've also had to pay for it," said Barrington's Leckow. In Jorndt's view, a lot of the stores his rivals are buying aren't worth sprucing up anyhow. "When you grow by acquisition you're going to acquire a lot of strip center stores," he said. "We don't think there's much future (for drugstores) in strip centers." Walgreen was once itself an acquirer, partly because it thought that was the easiest way to move into a new territory. But it hasn't made an acquisition since 1986 -- and it has entered 43 new markets since 1992, including Oklahoma City where it now has 13 stores. Many of the new markets are in Southern and West Coast havens for retirees, who buy more prescriptions and appreciate Walgreen's fixation on convenience. "This graying of America fits right into Walgreen's hands," said Northern Trust's Bukoll. Walgreen is also outdoing most of its competitors in adopting technology, analysts say. A computerized system lets its customers fill prescriptions at any Walgreens in the country, for example, and also phones customers to remind them when it's time for a refill. Such innovations have helped Walgreen's prescription sales grow to 50 percent of its total from 41 percent five years ago. In addition, cost cuts generated through technology and other means enable Walgreen to make a profit while meeting demands from health maintenance organizations and other groups for cheaper prescriptions. Such third-party payers accounted for about 80 percent of Walgreen's prescription sales last year, versus 30 percent a decade ago. Walgreen also has refused to do business with health plans that it says insisted on contracts that would have produced unsatisfactory profits. It has dropped six such plans this year. All this pays off, says Society Asset Management's Buynak. "You have a bunch of pharmacists running this company -- and they understand how this business is run," he said. Deborah Cohen prepared this article for Bloomberg News.

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