I would like to suggest a long Walgreen’s (WAG), short CVS (equal size) pair trade. Currently trading at 35.67 and 47.43 respectively. I expect a 20% return on the long/short position over the next year, with no market or industry correlation. Given the quantity and quality of available research and assuming familiarity of most investors with these companies, I will not go into a detailed description of the business.
Historically, WAG was considered the better company. This can be seen in comparing the trading multiples for both companies. From 1998 through 2007, WAG garnered a premium valuation to CVS, Initially, this premium was very high around 50%-75% (looking at either P/E or EV/EBITDA ratios). Over time this premium narrowed, until late 2007, when CVS overtook WAG. They have been trading in a much narrower range since, with WAG still more expensive most of the time.
Did WAG justify the premium multiple? Well, that depends on the timeframe measured, but generally it did not.
While WAG maintained, and continues to maintain a ~5% ROC advantage over CVS, CVS matched WAG on growth until 2007 and them steamrolled ahead with the 2006 Caremark acquisition. At the same time, we got a stronger multiple compression at WAG. From the end of 1998 to today CVS returned about 70% to investors (plus dividends) compared with a 20% return for WAG (again plus dividends).
So where are we now?
It seems that the two companies have traded places in the eyes of the market, with CVS now trading at a ~20% premium to WAG. This is not without cause, as WAG has been having some issues lately, most notably, the feud with Express Scripts (now largely resolved) to the costly Alliance Boots acquisition.
So where is the opportunity?
I contend that despite the recent noise, bloopers, and setbacks, WAG is still the better company, with higher return on capital and lower leverage. In any event, CVS does not deserve current the multiple premium.
By going long WAG and short CVS I believe investors stand a good chance of capturing ~20% as the valuation gap closes. In any event I view the investment as extremely low risk, given the size of the companies (which practically rules out any buyout scenario), and relatively stable industry characteristics.
The Statistical Arbitrage Case:
1. Percent of the time in the last 10 years that CVS traded at more than a 20% trailing normalized P/E premium to WAG: Less than 1%
2. Median WAG 1 year outperformance when CVS traded at over 15% premium: 14%
3. Median WAG 1 year outperformance when CVS traded at over 20% premium: 26%
These are both excellent companies, but at the current valuation, I find neither extremely compelling on a stand alone basis. I think that as a pair trade this presents an attractive risk/reward case.