Ahead of the Bell: Credit Suisse upgrades Walgreen

The analyst upgraded the stock to "Outperform," from "Neutral" Wednesday morning. He said that plans to scale back store growth and reduce capital spending should lead to improved store productivity and better returns, helping boost the drug store chain's stock price.

The analyst said he has advocated slowing store expansion since late last year, and praised the company's decision to take that step. The plan, announced last week, is aimed at saving $500 million.

Kelly noted Walgreen's stock price is near a five-year low. "We believe the market currently views Walgreen as late cycle growth and assumes that the company will not be able to achieve its historical growth rate while maintaining returns," he wrote in a note to clients. "In other words, investors are no longer willing to pay for the company's previous long-term growth targets."

Walgreen still plans to have more than 7,000 stores operating by 2010, up from its current 6,297.

While Kelly said the drug retailing sector is weakening because of slowing growth in pharmacies at the same time "front end," or merchandise sales, are falling. "The front-end malaise has been driven primarily by economic weakness, as drugstores have been more promotional to drive traffic," he wrote.

High levels of competition, including the introduction of cheap generic drug sales, have also hurt. "The expansion of $4 generics to supermarkets has added additional pressure to chain drugstore sales (Walgreens admitted for the first time after its June sales release that $4 generics are beginning to pressure sales). These issues should persist at least through the end of the year and possibly into 2009."

Kelly trimmed his earnings projections for 2008 to $2.16 per share from $2.17 per share, and for 2009 to $2.40 per share from $2.43 per share to reflect weak industry trends.

Nevertheless, the reduction in the company's expansion plans should help improve earnings growth and increase free cash flow and help boost the share price, the analyst said. He kept a $42 price target on the stock, implying he expects shares to rise about 30 percent from Tuesday's closing price of $32.33 over the next year.