Walgreen: On Sale, Cheap

The stock market kicked Walgreen in the teeth in September on news that Wal-Mart would sell generic drugs at rock-bottom prices. Was this another instance of a knee-jerk Wall Street overreaction? Looks that way.

It happens often: Shares of a successful company blow up on a negative news report -- before investors take the time to think the story through. It could be a subpoena or a government inquiry into accounting practices, or maybe a jury's decision in a discrimination case. These stories can trigger a sell-off that slashes a company's stock market value by billions of dollars, even if the firm's actual liability stands to be much lower or turns out to be nothing at all if, say, an adverse court decision is overturned on appeal.

The shoot-first-ask-questions-later mentality often results in fabulous buying opportunities. So, it pays to watch the daily and weekly lists of biggest percentage losers. Consider Sherwin-Williams, which plunged from $54 to $37 in March on reports that it lost an opening round in a Rhode Island lawsuit about health problems from lead-based paint. Once it became clear that the company's liabilities would come nowhere near the lost $2.3 billion in market value, the stock rebounded quickly and now stands at $57.

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Walgreen, the nation's largest chain of drug stores, looks like a similar case. Its shares dropped from $50 to $43 over two days in September after Wal-Mart announced a pilot program to sell some generic drugs for $4. Before you could say Zoloft, trigger-happy traders concluded that mobs of cash-strapped customers would desert traditional pharmacies for Wal-Mart's version of four-buck Chuck. That, in turn, would force Walgreen (symbol WAG) and other drug stores to slash prices, leading to slimmer profits.

Then cooler heads began to look more carefully at the Wal-Mart announcement and its ramifications. They figured out that most working people pay for prescriptions through their insurance plans and that Wal-Mart caters more to the uninsured. They also realized -- call it a Duh! moment -- that for many customers, the convenience of a corner pharmacy trumps the lower prices of far-flung Wal-Mart stores. It turns out, moreover, that all Wal-Mart has done so far is describe an experiment that covers a relatively limited range of generic drugs.

Beyond the Wal-Mart panic, there's little reason for investors to be sour on Walgreen. The Deerfield, Ill.-based chain, with nearly 5,500 stores in 47 states and Puerto Rico, has been generating strong sales and earnings growth. In early October, it reported that same-store sales (retailing lingo for sales at locations open at least one year) rose a solid 8.5% in September and 9.7% for the last full quarter. Although it's not an exact comparison because of the different merchandise mix, Wal-Mart has been straining to boost its same-store sales by even 2%.

Value Line, Merrill Lynch, Lehman Brothers and Standard Poor's are all shouting that Walgreen is a buy at $44 (the shares closed at $44.88 on October 4). The stock trades for 22 times the average analysts' earnings estimate of $1.99 per share for the fiscal year that ends this August. That's below the stock's normal price-earnings ratio and is one reason why the $50-and-up one-year price targets that some analysts have placed on the shares look reasonable.