Walgreens Boots Alliance (WBA) has lost 20% since last month and has thus fallen to a 3-year low. The reason behind the plunge is the rumor that Amazon (AMZN) may enter the pharmacy business. Nevertheless, as such a plunge is unusual for Walgreens, the big question is whether the plunge is justified or the stock has now become a bargain.
First of all, Walgreens is a dividend aristocrat that has raised its dividend for 42 consecutive years. Even more impressively, it has grown its dividend at an average 20% rate over the last decade while its payout ratio remains remarkably low, at 38%. This degree of consistency only confirms the strength of the business of the company and its reliable execution. Moreover, the low payout ratio indicates that there is ample room for the company to meaningfully grow its dividend for many more years.
It is also remarkable that the performance of the company is so strong that it requires a minimum amount of capital expenses for growth and maintenance. To be sure, capital expenses have "eaten" only 1/6 of the operating cash flows during the last 12 months while they have eaten less than 1/3 of the operating cash flows for 7 consecutive years. As a result, the company has enjoyed ample free cash flows, which have enabled it to post impressive growth through major acquisitions. Moreover, its net debt currently stands at $28.7 B, which may seem high on the surface but it is only 7 times the annual earnings of the company. Therefore, the debt is at a reasonable level and hence it leaves ample financial flexibility to the company without exposing it in the event of unforeseen headwinds.
Walgreens also greatly benefits from some favorable trends. The demographics of US certainly favor the company, as an aging population is expected to result in increased demand for health care and drugs in the long term. In addition, Walgreens is the largest retail pharmacy in the US and Europe, with about 13,000 stores and 390 distribution centers and a 20.5% market share in the domestic market. Therefore, the company enjoys excellent economies of scale and strong pricing power over its suppliers.
Thus it is somewhat surprising that the stock is trading at a deep discount compared to S&P. More precisely, while S&P is trading at a P/E above 20, Walgreens is trading at a remarkably low trailing P/E=13.0 and forward P/E=12.0. This is a markedly cheap valuation, particularly given the dominant position of the company and its consistent earnings growth. Obviously the market is greatly concerned that Amazon may disrupt the business model of the company.
On the bright side, Amazon mostly targets the youngest segment of the population, which is tech savvy, while the elderly people are likely to stay away from technology and continue to visit their local pharmacy. Therefore, as the elderly people visit the pharmacy much more often than the young ones, the potential entrance of Amazon into the pharmacy business may be viewed by some investors as more of a long-term threat than a short-term threat for Walgreens.
However, Amazon has an immense scale, which can disrupt the business model of most retailers within a short period. To be sure, the online giant has exceeded 80 million members this year. Even better, it can leverage this scale in many directions, as it has an enormous database from which it can collect information about its customers. For instance, it could identify customers who suffer from depression from their searches for self-help books.
Some investors may claim that Amazon will not attempt to enter the pharmacy retail business due to its razor-thin margins. For instance, Walgreens, the dominant player in the industry, has an operating margin that has fluctuated around 5% during the last decade and currently stands at 4.8%. Indeed low industry margins constitute a major barrier to entry for potential new entrants in most cases. However, Amazon is not discouraged by low margins, as this is actually its game. To be sure, it recently entered the grocery sector, which is characterized by even lower margins, in the area of 3%. Therefore, while thin margins generally discourage new entrants from a market, Amazon has proved that it is certainly an exception to the rule.
I have also heard some shareholders of Walgreens saying that it will take more than a decade for Amazon to reach the market share of Walgreens and hence the former cannot impose a threat to the latter. On the one hand, it is true that it will take several years to Amazon to reach the market share of Walgreens. However, this point is irrelevant to the plunge of the stock of Walgreens. More specifically, Amazon does not need to reach the market share of Walgreens to cause its earnings to decrease. Even if Amazon grabs just a small portion of the market, it will strongly challenge the growth trajectory of its competitor. Moreover, Amazon will extract the best customers, i.e., the customers who do not occupy a great amount of time in pharmacies and thus prefer to switch to the online giant. Consequently, the conventional pharmacies will be left with the most demanding customers, who will demand a great amount of information and time from their local pharmacists.
At this point, it is critical to note that the retail pharmacy is already a highly competitive business. There are minimum differences between the stores of the various competitors and hence the latter compete strongly on price. The above mentioned operating margins only confirm the strength of the competition in the sector.
Moreover, there is increasing frustration of consumers over the increasing costs of health care and drugs. Thus consumers transfer the pressure to politicians, who eventually exert pressure on pharmacy retailers for lower prices. As this trend is not likely to attenuate anytime soon, Walgreens is not likely to be able to meaningfully raise its prices in the years ahead.
Despite the intense competition, Walgreens has been able to grow in recent years thanks to a series of acquisitions. However, as it has now grown to a dominant player, it will not be able to continue to grow via acquisitions, as it will face the wall of anti-trust authorities. This has already been evident in the case of Rite-Aid (RAD), as Walgreens eventually bought 2186 stores of Rite-Aid instead of acquiring the whole company due to the objection of the regulatory authorities.
Finally, Walgreens has a $5 B share repurchase program in place, which may be considered by some investors to offer some protection to the stock price. However, this amount can reduce the share count by only 7% at the current stock price. Therefore, if Amazon enters the pharmacy business, this amount of share buybacks will be clearly insufficient to support the stock price.
To conclude, there is a good reason behind the recent plunge of Walgreens. On the one hand, if Amazon enters the pharmacy business, it will take at least two years for its impact to be reflected in the results of the traditional players. Therefore, Walgreens is likely to experience a temporary rebound from its current oversold levels. However, investors should keep in mind that the market has priced a probability much lower than 100% of the Amazon move in the stock price of Walgreens. If Amazon eventually makes the move in the pharmacy business, Walgreens will experience significant additional downside.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.