2023-10-20 10:56:42 ET
Summary
- Rite Aid's bankruptcy has caused concerns for Walgreens Boots Alliance investors due to the association between the two companies.
- Walgreens faces competition from big box stores, cosmetic stores, and Amazon's pharmacy, as well as theft issues.
- The financial picture of Rite Aid before its collapse showed a decline in income and cash flow, while Walgreens Boots has shown different trend lines.
- Lawsuits will remain an issue as will store closures encompassing negative catalysts.
Similarities and differences of your neighborhood pharmacies
Walgreens Boots Alliance ( WBA ) investors are getting a chill up their spine and a reverberation from the now-bankrupt Rite Aid ( OTC:RADCQ ). By revenue size, Rite Aid was not a small operation. A nearly $25 Billion revenue generator, they are only about 18% the size of Walgreens Boots Alliance which rakes in $139 Billion in sales on a TTM basis, but their corner stores are seared in the minds of Americans.
The cross-associations will be there. Other negatives of the corner-store pharmacy business loom. Massive competition from big box stores like Walmart ( WMT ) and Target ( TGT ), popular cosmetic stores like Ulta Beauty ( ULTA ), and of course everyone's lunch eater, Amazon ( AMZN ) now has an online pharmacy. Massive theft issues also remain. Lawsuits regarding opioids ensue.
This high-yielding dividend aristocrat is a small holding of mine, not purchased as a top-down analysis, but more of a byproduct of indexing the Dow 30. Let's examine if this beaten-down company is worth cutting our hands on.
What to do about theft?
Living within a stone's throw of several major Northern California cities, I've been able to observe Walgreens and CVS ( CVS ) stores in central, major metro markets. The business model is good in theory, supplying pharmaceuticals and everyday goods with a minimal staff. I often only see one employee in the store both tending to the register and stocking the shelves. While thieves do not affect the pharmacies, which have supplies behind locked doors and glass windows, the other goods are all too easy to grab and exit unnoticed.
Often the theft is brazen. Thieves sometimes bring garbage bags into the stores to load up. These employees, even if allowed to deter criminals by state laws, would still have no incentive to risk their lives doing so. There is nothing to do about the theft other than close stores in areas like those around Fisherman's Wharf, the Embarcadero, and other central points in cities that have no laws against retail theft. As long as the theft is under $1,000 in most of these cities, the crime is only a misdemeanor and usually goes unpunished.
Rite Aid's financial picture before collapse
Keep in mind that the lawsuits for Rite Aid are being identified as the straw that broke the camel's back, but it is also worthwhile to investigate the balance sheet and income trends for the two to see if there are any similarities:
Income trends
From a net income and cash flow point of view, using EBITDA as a proxy for cash flow, we see Walgreens being well into the positive on both of these metrics for the last 10 years whereas Rite Aid was on a slow, steady decline. Walgreens saw a very nice bump during COVID-19, with COVID-19 testing and vaccine distribution whereas Rite Aid saw no reaction. Post-COVID, however, you could argue that the income and cash flow situations for Walgreens look even more dire, with a big snap back.
Balance sheet trends
Current assets for Walgreens remain well ahead of long-term debt, with long-term debt only being about 68% of current assets. Rite Aid was nearing long-term debt being about 90% equivalent to current assets near the end point. Both had a flat to slightly declining share count since 2020.
Unusual items, overreaction?
The unusual items are what have spurned some of the overtly negative items on the charts above. Any similarities with Rite Aid ? Let's take a look at Walgreen's press releases:
Operating loss in fiscal 2023 was $6.9 billion compared to operating income of $1.4 billion in the year-ago period. Operating loss in the period reflects a $6.8 billion pre-tax charge for opioid-related claims and litigation , partly offset by higher Boots UK intangible assets impairment charges in the year ago period.
Fourth quarter operating loss was $450 million compared to an operating loss of $822 million in the year-ago quarter. Operating loss in the current quarter reflects certain legal and regulatory accruals and settlements, and higher costs related to the Transformational Cost Management Program. Year-over-year improvement in operating loss is due to lapping a $783 million non-cash impairment charge related to intangible assets in Boots UK in the year-ago quarter.
Of those pharmaceutical providers included in the lawsuit that still remain in business we have the following :
- Teva to pay up to $3.34 billion over 13 years and to provide either $1.2 billion of its generic version of the drug Narcan over 10 years or $240 million of cash in lieu of product, as each state may elect;
- Allergan to pay up to $2.02 billion over 7 years;
- CVS to pay up to $4.90 billion over 10 years;
- Walgreens to pay up to $5.52 billion over 15 years; and
- Walmart to pay up to $2.74 billion in 2023, and all payments to be made within 6 years.
With the slated 15-year payment plan, Walgreens Boots Alliance is on the hook for about $368 million in legal payments per annum. The impairment was immediate and up front which should save quite a bit in taxes, and initially preserve some cash flow.
Another lawsuit settled
From Seeking Alpha:
Walgreens Boots Alliance has agreed to offer $192.5M to reach a deal with Rite Aid investors who allege that the drugstore chain misled them as part of a 2015 bid to acquire its smaller rival.
Fresh off the press today, Walgreens Boots Alliance has just reached an agreement with Rite Aid investors regarding the proposed buyout of the company by Walgreens that never materialized. The proposal sent the stock up considerably, which attracted new investors. Those investors were subsequently hurt when the buyout deal was ultimately deemed void and unrealistic to begin with.
Free cash flow crush
Speaking of free cash flow, we can see that Walgreens trends around $3-5 billion in free cash flow per annum in this last decade trending downward. The number has now sunken into negative territory with the pre-tax charges and the reconfiguring of stores. Let's see the slated dividends and figure out the revenue to net income conversions, and the net income to free cash flow conversions with the proposed store closures in mind.
Slated dividends
Firstly, let's take a look at the upcoming dividend liability:
- $1.92 FWD per share dividend, equivalent to a 9.04% current yield.
- 863 million shares outstanding.
- $1.65 Billion dividend liability.
If we look at 2019 onward in profitable years, the average free cash flow during this period was closer to the $3 Billion line:
Store closures
Here is a brief on upcoming store closures from retailcustomerexperience.com :
Pharmacy chain Walgreens will shut 150 stores in the U.S. and 300 in the U.K. due to slower consumer spend and a declining demand for COVID-19 vaccines.
The retailer made the announcement during a recent earnings call and said the closures are part of a cost savings strategy, according to a CNN report .
Walgreens operates nearly 9,000 stores in the U.S. The closures should be completed by the summer of 2024.
Revenue per store
From the 1031 exchange promotion site, Realized, we see the average sales volume per store estimated at $8.5 million USD :
Using the above logic across all stores, the proposed revenue hit would be 450 stores X $8.5 million = $3.825 Billion.
Revenue to net income conversion
Harkening back to the last profitable year in 2022, Walgreens Boots Alliance had $132 Billion in revenue versus $4.33 Billion in net income, a 3.2% conversion. Free cash flow for the year was $3.8 Billion, a conversion of 87%. If we reduce revenue into the $128 Billion range, this would give us the following under this model:
- Net income of $4.096 Billion
- Free cash flow of $3.56 Billion under an 87% conversion ratio assumption.
Surprisingly, the dividend still looks well covered under this scenario, but I have an inkling that the CAPEX and expenses in closing down these stores are going to be underestimated. Even at $3 Billion free cash flow, it would only be a payout ratio of 55%.
If we include the annual liability payments, we're down into the $2.7 Billion Free Cash Flow range, increasing the payout ratio to 61%.
What is the Transformational Cost Management Program?
From Walgreens Boots Alliance Investor Relations :
- Transform and align the core by building the pharmacy of the future to support and enable its healthcare strategy; Reimagining retail through expanded health and wellness offerings and mass personalization; Accelerating WBA brands and digital offerings; Expanding the Transformational Cost Management program.
- Build the next growth engine with consumer-centric healthcare solutions: Accelerating the path to become a leading provider of local clinical care services; Leveraging a consumer-centric technology and pharmacy network to deliver and enable others to deliver value-based care; Strengthening partnerships with payors, providers, and patients.
- Focus the portfolio and optimize capital allocation: Prioritize core assets and healthcare ambitions and maintain the commitment to return cash to investors.
- Build a high-performance culture and a winning team: Attract and retain a best-in-class, diverse team.
Interestingly enough, I don't see any items regarding loss or shrinkage in the "Transformational Cost Management Program". The company is so profitable based on just the pharmaceutical sales, that they can afford massive shrinkage of the everyday products. Analysts from Bank of America estimate that 80% of revenue and profit comes from just the Pharmaceuticals alone. With such a huge margin, it was bound to invite competition. The digital space will be where the fight for survival ensues.
Amazon has entered the room
Amazon ((AMZN)) wants to eat everyone's lunch. They are nimble and capable of entering any space that requires a digital interaction. Pharmaceuticals have historically been an in-person "brick and mortar" experience, but this was all bound to change. Let me ask you, do you enjoy coming in for an order and being told to walk around the store for 30 minutes while the Pharmacist inspects and sorts your pills? Neither do I.
To be fair Walmart ((WMT)) and Walgreens Boots Alliance also have their online digital pharmacies set up and operational. The problem is, that Walgreens Boots Alliance doesn't have other businesses to subsidize any difficulties or negative profit margins while it fights other digital competition. If cost-cutting online becomes a war, Walgreens Boots Alliance is not best equipped to handle it with their large physical store overhead and lack of other revenue sources.
Valuation models
Based solely on book value and forward earnings, the company is very cheap . Using a traditional Graham Number to evaluate the company since cash flow is going through a major upheaval seems more appropriate rather than a discount model. Let's find the price at which the price to earnings X the price to book crosses Benjamin Graham's magic number of 22.5:
- Book Value $23.18.
- FWD EPS estimates $3.36 [2024 estimates].
- SQRT 22.5 X BV X EPS = SQRT 22.5 X $23.18 X $3.36 = $41.86.
Based on this very conservative valuation, the stock is almost 50% undervalued.
Risks
My biggest risks are lawsuits and store closures eating into the free cash flow to an extent that creates a dividend cut. With online competition heating up, they may also need to preserve capital to subsidize the business. A dividend cut of this aristocrat would create the next leg down.
Conclusion
I have cut my exposure to both Walgreens Boots Alliance and CVS significantly. I will hold a small amount and compound the large dividend which may or may not be something to look forward to. I can see the analysts' points in why it is a good deal after the unusual one-time items and lawsuits are worked through. I consider this a hold or spec buy.
Amazon is one of my larger positions, and I continue to see them ruining a lot of brick-and-mortar models in years to come. The stock looks cheap, but this is one case where my future belief in where the economy is going overrides my desire for a good deal.
The short answer is, Walgreens Boots Alliance is much different than Rite Aid from a net income trend line perspective. Rite Aid was in slow, steady decline for quite some time, the lawsuits just put them out of their misery. Walgreens Boots Alliance is still the leader in brick-and-mortar pharmacies, but I can see too much digital competition coming that could eat up their margins. They should also be operating in smaller locations without all the additional home goods. I need to see some better pivot plans to sublease parts of stores to other tenants and feasibly grow delivery before I'm in. Hold.
For further details see:
Walgreens Boots Alliance: Another Rite Aid?