Walgreens Earnings Redux: Are More Stores The Long-Term Answer?

About: Walgreens Boots Alliance, Inc. (WBA)
by: Brian Gilmartin, CFA

Margins continue under pressure, both gross and operating margins have narrowed for 5 straight quarters.

The $5 bl share repo plan will likely emphasize share buybacks over the dividend payout.

Dividend dollars as a % of free-cash-flow at 28% - 30% is still reasonable.

Could Walgreens be like other retail - the inevitable death by Amazon ?

Walgreens Boots Alliance (NASDAQ:WBA) reported their fiscal Q3 '17 financial results last week, and while the stock got a strong pop immediately following earnings, the market weakness on Thursday, June 29th, later pulled down the stock and limited the gain on the day.

The big news around the earnings report was that Walgreens was abandoning the Rite-Aid merger (NYSE:RAD) and instead buying 2,186 RAD stores at a bigger discount than the merger had the stores initially valued.

In addition, WBA announced a $5 billion share repurchase program which is scheduled to expire on August 31, '18 or in the next 15 months.

Here is a quick recap of the quarterly earnings:

1.) The quality of earnings was thought to be poor as WBA had a lower effective tax rate once again at 13%. WBA's effective tax rate has been under 20% since late 2015 and have been volatile since late 2014.

2.) WBA is set to declare its next dividend increase, and the y/y growth has slowed:

5/17 $1.50 4%
5/16 $1.44 7%
5/15 $1.35 7%
5/14 $1.26 15%
5/13 $1.10 22%

Source: internal spreadsheet

Using the quarter just reported, 4-quarter trailing free-cash-flow was $6 billion as of May '17, so the $5 billion share authorization plan will consume most of the free-cash over the next 5 quarters, as it looks right now.

My guess is WBA shareholders will likely see a modest dividend increase with the dividend announcement this quarter.

3.) It looks like front-end comp's were negative again although just slightly at -0.4%, but the front-end, which is WBA's higher margin business continues to struggle.

4.) Gross and operating margins have now compressed for 5 straight quarters.

Analysis / conclusion:

Without getting into a long treatise for readers, most of the growth this quarter at WBA came not from the retail operations but wholesale, and yet, the RAD deal saw Walgreens buy 2,100 more stores - albeit at a better price than the original merger deal price - but it still adds "front-end" or retail stores to WBA's business model at a time when retail remains under severe pressure - and, as noted in the WBA earnings preview here, Amazon will soon be entering the retail prescription business.

WBA looks fairly valued to slightly undervalued, so the near 2% dividend yield isn't as compelling as with other sectors.

The other aspect to the failed RAD merger is that RAD was - I thought - going to bring a sizable PBM presence to Walgreens, giving WBA a PBM footprint that would help WBA compete with CVS.

It seems to me that that aspect to the merger is now dead.

Walgreens is working hard to reinvent the business in the last 5 years, but the progress is slow. It took a long-time to see the end of the old "front-end" model - and that isn't dead - but thanks to Amazon's pressure on other retail and the constant price pressure within retail, "front-end" seems like it will be gradually less attractive over the years.

And yet WBA added more stores - 2,186 to be exact - for the front-end.

WBA is testing its 200-week moving average and is now as oversold as it was in early, 2016 but further support resides in the low $70's.

For me it is truly amazing what Amazon had done and is still in the process of doing in the American retail landscape. Can WBA and CVS survive and grow or is this another "general merchandise" retail segment that gets the "death by Amazon" treatment ?

Be careful out there.

(Long AMZN, CVS. CVS is a small position.)

Disclosure: I am/we are long CVS, AMZN. 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.