Walgreens: Shunned By The Market – Why I See An Opportunity (NASDAQ:WBA)

Walgreens Boots Alliance (WBA) is the red-headed stepchild of Wall Street. Prior to last week’s earnings call, the company had reported a 4.1% increase in sales in FY19. However, Q3 results are dismal.

Naysayers point to a share price less than half that of late 2018. Some fear Amazon (AMZN), others competition from Walmart (WMT). Bears point to declining store traffic, falling generic drug prices, possible political headwinds, and the effects of COVID-19.

I, however, see a Dividend Aristocrat with long term stable bottom line profits and cash flows.

Yes, the company has its challenges. However, you cannot assess Walgreens as an investment unless you understand the bulk of revenues are earned in that little section to the rear of the store… the pharmacy.

Although the retail-side business is at a virtual standstill, the pharmacy segment is progressing well and initiatives are gaining steam.

A Tale Of Two Quarters

After thrashing estimates in Q2, management warned COVID-19 would adversely impact results for the remainder of FY20. In Q3, Walgreens estimated COVID-19-related headwinds cost from $700 to $750 million in sales.

The US retail pharmacies notched 3.2% sales growth in Q3; however, Boots UK market recorded a $2 billion non-cash impairment charge.

The positive US numbers were due to a 15.9% increase in specialty drug sales. However, prescription volumes grew slower than in Q2 due to fewer physician visits and hospital admissions.

Walgreens’ pharmaceutical wholesale revenue grew 5.3% YoY. Although the company beat analysts’ Q3 revenue estimates (average of $34.35 billion), there was a measly 0.1% increase YoY. Even worse, Walgreens recorded a net loss of $1.7 billion, equal to $1.95 a share, versus net income of $1 billion, or $1.13 a share in Q3 2019.

Analysts’ estimates for non-GAAP (adjusted) net income was $1.17 a share. The company fell short with net income of $723 million, or $0.83 per share. That was just over half of Q3 2019 results when adjusted net income hit $1.3 billion, or $1.47 per share.

Management models FY20 adjusted EPS of $4.65-4.75. This follows the Q2 2020 earnings report, which detailed a near-4% increase in sales across all segments. In that quarter, International retail pharmacy sales dropped 0.8%, while US retail pharmacy sales increased 3.8%. The wholesale pharmacy division recorded 6% sales growth.

Combining the first two quarters, FCF stood at roughly $1.8 billion, an increase from $0.4 billion YoY. Management reported retail comps grew by 26% during the first three weeks of March, driven by pandemic-related buying.

(Source: Q2 2020 Earnings Call Presentation)

Initiatives Galore

Last October, Walgreens joined with Jenny Craig to provide in-store weight loss services. These include private one-on-one consultations, a customized menu plan, and meal delivery. Jenny Craig will be offered in 20 states and across 100 locations, including Dallas, Houston, Philadelphia, and Phoenix.

In 2017, the company teamed with FedEx (FDX) to provide package drop-off and pickup service in Walgreens stores. Last October, the service was expanded to allow online returns in Walgreens stores. I see this as a means to use ecommerce, the bane of brick-and-mortar retailers, to drive incremental store traffic.

The company teamed with FedEx and Wing, a subsidiary of Alphabet (GOOGL), to test delivery of prescriptions by drones. Described as a “store-to-door” service, Walgreens claims Wing deliveries could arrive at one’s home in as little as five minutes after order placement.

This March, following the successful test of Postmates, an on-demand delivery service, Walgreens expanded the initiative to include 13 additional cities.

Walgreens also began offering “drive-thru” pickup for more than 60 “essential” retail items. Pharmacy techs fetch items immediately, provided there are no customers in the drive-thru lines. Otherwise, the customer parks and the items are delivered to the vehicle. This lessens sales losses from customers that don’t enter the store.

(Source: Q2 2020 Earnings Call Presentation)

Walgreens also announced the expansion of Walgreens Find Care platform designed to connect customers with health care services and local providers. Use of the app increased 40% YoY and grew 12% in 2020.

There is speculation among industry analysts that Kroger (KR) and Walgreens will strike a deal mirroring the Target (TGT)-CVS Health Corp. (CVS) agreement. In 2015, Target sold its pharmacies to the latter company for $1.9 billion.

In April, the company expanded drive-thru nasal swab testing for COVID-19. Stores in 49 states and Puerto Rico offer the program, and Walgreens projected it would administer over 50,000 tests per week.

Last December, McKesson (MCK) and Walgreens formed a joint venture combining the companies’ pharmaceutical wholesale businesses in Germany. Walgreens has a 70% equity interest in the joint venture versus McKesson’s 30% share. The new business should drive growth and result in more efficient distribution operations in the German market.

Walgreens and Kroger expanded a strategic partnership into 35 stores in East Tennessee.

Another initiative is an agreement with Kroger to form a group purchasing organization. Known as the Retail Procurement Alliance, it is designed to lower costs and deliver “purchasing efficiencies.”

Viewed separately, the initiatives listed above may be of little significance; however, collectively they should provide the company with significant momentum.

The initiative that will undoubtedly move the needle is the company’s Transformational Cost Management Program, designed to reduce annual costs by $2 billion by fiscal 2022. The program calls for the closure of nearly 200 underperforming stores in 2020, renegotiating contracts with suppliers, and streamlining the field organization. According to management, the initiative is progressing well and adding substantially to the bottom line.

(Source: Q2 2020 Earnings Call Presentation)

The Doctor Will See You Now

Last week, Walgreens stock surged on the announcement that the company will partner with VillageMD to provide 500-700 of its stores with physician-staffed primary care clinics.

The deal, which will result in the company holding a 30% stake in VillageMD, will cost Walgreens “$1 billion in equity and convertible debt in VillageMD over the next three years.” The deal requires VillageMD to use 80% of the investment to fund clinics.

The average Walgreens has 10,500 square feet of sales space and another 3,000 square feet of non-public space. The average VillageMD clinic will cover 3,300 square feet, with some as large as 9,000 square feet. Consequently, Walgreens has plans to sacrifice retail space to accommodate the clinics.

A Little-Known Side Of Walgreens

Many investors have scant knowledge of Alliance Healthcare, a subsidiary of Walgreens that distributes wholesale and retail pharmaceutical, surgical, medical, and healthcare products throughout Europe. With 300 distribution points, Alliance supplies over 115,000 pharmacies, doctors, and hospitals in 11 countries.

CVS/WBA Comparison

Over the last few years, the companies have begun to morph away from each other. CVS is the more diversified of the two, so although each company runs retail pharmacies, there are distinct differences.

Following the Aetna acquisition, CVS froze the dividend and stopped stock buybacks. However, the most interesting comparison of the two companies resides in retail store metrics. Walgreens averages $13 million in revenue per store versus $8.6 million for CVS. The company also generates more than double the sales of CVS in the pharmacy division.

In quoting these metrics, my intent is not to claim that Walgreens is the better investment. However, I note Walgreens outperforms CVS in the core business (or at least the business that defines the companies in most investors’ minds).

Positive Secular Trend

The aging populations in the US and Europe should drive the pharmacy side of Walgreens business for years to come. I will not belabor that point, as I believe it is well-understood by most investors.

(Source: Avalere)

The ABCs of Walgreens

Walgreens has a 27% interest in AmerisourceBergen Corp. (ABC), and is that company’s largest customer. ABC approached Walgreens with an offer to buy the latter company’s pharmaceutical wholesale business for $6 billion. That operation falls mainly within the Alliance Healthcare brand.

Walgreens’ relationship with ABC highlights the advantages inherent in scale. As the fourth-largest retailer in the world, Walgreens leverages scale to lower costs and raise profits.

The company’s relationship with ABC is a prime example. According to Morningstar, the distribution terms between the two companies allow 40 days for payments, double the industry norm of 15 days. Walgreens also has a 20-basis point advantage in drug pricing versus the closest peer.

Higher service levels and inventory thresholds, as well as direct delivery to Walgreens retail locations, are included in the contract.

Steady Growth On The Horizon

Forecasts predict Walgreens’ net revenue will increase from $137 billion in 2019 to $148 billion in 2022.

Revenues from the pharmacy segment should increase by over 14% to $10.9 billion during that time frame, more than offsetting lagging retail sales.

The Pharmaceuticals Wholesale segment revenues are modeled to increase by nearly $1 billion from 2019 to 2022, an increase of 4%.

Debt, Dividend, And Valuation

WBA’s credit is rated BBB/stable by S&P and Baa2/stable from Moody’s. Last April, the company issued $500 million of 3.2% notes due 2030 and $1 billion of 4.1% notes due 2050.

Its yield is approximately 4.8%. The 5-year dividend growth rate is 6.58%, and the payout ratio is a tad above 33%.

Management’s goal is to pay a dividend of about 30-35% of adjusted earnings.

The shares currently trade for $40.02. The average 12-month price target of 20 analysts is $46.64. The price target for the 7 analysts rating the company since the last quarterly report is $42.28.

My Perspective

One aspect of the company’s operations that go unnoticed by many is the scale advantage enjoyed by Walgreens.

While growth is not robust and the retail segment is contracting, the company’s pharmacy and pharmaceutical wholesale businesses exhibit reasonable growth.

When considering the forward P/E and price to cash flow ratios, the company currently trades for roughly half the historical valuation. I will add that much of the company’s revenues come from essential items that are immune to pandemic concerns and economic cycles.

Walgreens dispenses over a billion prescriptions annually, representing a quarter of the drug market. With a yield well nearing 5% and a conservative payout ratio, I view the company as a solid investment.

I rate WBA a Buy.

I’ll admit I spent a great deal of time pondering whether I should rate the stock a Buy or a Hold; however, I firmly believe the company will emerge from the pandemic with strong revenues and free cash flow. I can easily imagine a future date when members of the SA community brag about investing in WBA when the yield neared 5%.

I will add that investors in the stock will likely need to exercise patience, as the market can be slow to return to an out-of-favor stock. However, the proverbial race between the turtle and hare come to mind when considering this company.

One Last Word

I hope to continue providing articles without cost to SA readers. If you found this article of value, I would greatly appreciate your following me (above, near the title) and/or pressing “Like this article” just below. This will aid me greatly in continuing to write for SA. Best of luck in your investing endeavors.

Disclosure: I am/we are long WBA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I have no formal training in investing. All articles are my personal perspective on a given prospective investment and should not be considered as investment advice. Due diligence should be exercised, and readers should engage in additional research and analysis before making their own investment decision. All relevant risks are not covered in this article. Readers should consider their own unique investment profile and consider seeking advice from an investment professional before making an investment decision.

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