- A 46% increase in the share price has driven the yield below 2%, and management may not be able to increase the payout appreciably.
- Sales growth improved over the last quarter, but has been stagnant for two years on pricing pressures.
- The acquisition of Alliance Boots may disappoint investors on poor earnings quality and a backlash to tax inversion deals.
Shares of Walgreen (WAG) have surged over the last year even as sales growth stagnated. The jump in the share price has driven the dividend yield down considerably and income investors may no longer be interested in the stock. Weak growth and the potential for the Alliance Boots acquisition to disappoint may keep the company from being able to increase the dividend significantly enough to attract income investors and the outlook may not be enough to drive the share price higher.
No Longer a dividend stock
Walgreen is the largest retail pharmacy in the United States with more than 8,600 drugstores and accounts for nearly 19% of the total retail drug market. The shares are included in the S&P 500 Dividend Aristocrats with 38 consecutive years of higher dividends and a payout since 1933. However, the strong argument for inclusion in an income portfolio has broken down over the last year.
The table below shows the decreasing significance of the yield for investors. The yield return for investors has dropped from an annualized rate of nearly 2.5% over the five-year period to just above 2.1% over the last year. The surge in the shares has dropped the current yield down to 1.7% on an annual basis.
If you've enjoyed the run over the last year then you're probably asking, "Who cares whether returns have shifted from yield to price?"
There are two problems with the decreasing yield significance and the surge in share price. First, the lower yield will not attract dividend investors and interest in the stock will falter. Income investing is a popular theme, especially with a growing demographic that is increasingly looking for spending power from their investments. If the shares cannot offer the same promise of yield as they have in the past, then investors will want to see prices continue higher on growth.
That need for future growth is the second problem for the shares. Sales growth of 5.9% over the most recent quarter was a welcome change from no growth over the two fiscal years through 2013. Management has noted pricing problems on both the supplier and reimbursement end of the business in recent quarters. Sales on generic drugs have been increasing as a percentage of total revenue but do not offer the same margins as patented prescription drugs. With higher inflation in healthcare costs, the government has been pressuring the industry through lower reimbursement schedules as well.
Cash flow from operations plummeted in the last quarter of 2013 on inventory issues and CFO is down 15.5% over the last four quarters compared to fiscal 2013. Free cash flow increased by $208 million in 2013 but only on a decrease of $338 million in capital expenditures.
Management slashed the buyback by nearly half last year and the dividend payout ratio has increased to 43% of income relative to an average payout of 35% over the last five years. On weak cash flow and marginal growth, I do not see how management will be able to increase the dividend to return the yield to its historic significance.
Alliance Boots acquisition could work against shareholders
Walgreen acquired a 45% stake in Swiss-based Alliance Boots in 2012 with the right to acquire the remaining 55% over a six-month window ending August 2015. The move is seen by many as a plan to acquire the smaller European pharmacy operator and to change Walgreen's official domicile to the cheaper tax jurisdiction. The tax strategy, called tax inversion, has gotten a lot of attention on Capitol Hill lately. While a move may save the company money paid on taxes, I am not sure the political or consumer backlash would be worth it.
While the acquisition may help to diversify sales for the U.S. retailer, it is probably not worth it without the potential to a tax inversion deal. Earnings quality and cash flow have weakened considerably at Alliance Boots. Sales increased just 4.3% last year after falling in 2012. Despite the weak top-line growth, the company posted an 18.4% increase in net income on an increase in joint ventures and lower taxes. Cash flow from operations actually decreased 6.3% in 2013 and I am not optimistic that the company can continue to boost income without cash flow or top-line growth.
If laws are passed in Washington before Walgreen can complete a takeover and move its domicile, then the acquisition may end up being a losing deal.
Shares are trading at 24.9 times trailing earnings, well above the industry average of 21.6 times earnings and a 50% premium on the company's average multiple of 16.6 times earnings over the last five years. The market is expecting earnings of $3.35 this year, bringing the multiple down to 21.0 times but still well above the historic average.
Management would have to increase the dividend by nearly 12% to $1.41 per share just to return the shares to a 2% yield. On a weak environment for growth, I do not believe this will happen and the shares are already relatively expensive. I like the company's position in a growing market for prescription drugs but investors may want to wait for a better entry point and a higher yield.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.