After 43 Years, Walgreens Dividend Growth Is Just Getting Started

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Includes: CVS, WBA
by: Michael Henage

Summary

Two competitive threats seem to be overblown.

Walgreens has been increasing its dividend, buying back shares, and paying down debt; yet the payout ratio still dropped.

Walgreens' investors should expect dividend growth like 2013 and 2014.

Unless you’ve been hiding under a rock, you probably know about Walgreens Boots Alliance (NASDAQ: WBA) and its decades of dividend increases. If the perfect business has constant demand and increasing prices, you couldn’t ask for better than the retail pharmacy business. Walgreens showed its confidence in the future by announcing yet another dividend increase, and a $10 billion share repurchase program. Though there are many challenges facing the company, investors have several reasons to expect strong growth in Walgreens’ dividend over the next several years.

The competition

When Amazon announced it was acquiring PillPack, several companies including Walgreens declined as investors reacted in fear. CVS Health Corporation (NYSE: CVS) is attempting to buy Aetna, to create a top-down solution that would in theory give it a competitive advantage. Each of these events poses a risk to Walgreens, but I believe both are overblown.

Amazon has been a disruptive force in almost every market it attempted to move into, so the PillPack acquisition is making retail pharmacy investors nervous. Investors in Walgreens need to remember two things: 1. Amazon doesn’t always win with new business. 2. PillPack has some built in disadvantages compared to a physical pharmacy.

Not everything Amazon touches turns into gold. The PillPack acquisition reminds me of the Fire Phone. Prognosticators and analysts were quick to assume the Fire Phone would take market share from other companies based on the strength of Amazon’s brand. However, the response to the device was so bad that the company wrote off a loss of $170 million and stopped selling the device completely. The reality is, just because Amazon can compete in an industry doesn’t mean it should.

Even if PillPack doesn’t go the way of the Fire Phone, there are two massive hurdles in trying to take market share in the pharmacy business. First, filling a prescription at a physical pharmacy like Walgreens requires almost no planning. In the case of an immediate need like an antibiotic, PillPack’s own web site says, “we recommend filling at a local retail pharmacy.”

To use PillPack for repeat medications, customers need the prescription, the currency pharmacy, insurance information, and a payment method. If I have multiple prescriptions, the process becomes more tedious, and “it typically takes between two weeks to one month to receive your first PillPack.” The short version is, customers must believe PillPack will save them time and/or money to move away from their local pharmacy. Nothing that PillPack offers at present seems to scream that this service is a huge value.

Where the CVS and Aetna tie-up is concerned, the main issue I’ve heard is that CVS would be able to eliminate competition. The concern is that an Aetna insured client would ultimately be required to go to a CVS pharmacy. It seems this assumption operates outside of reality.

Antitrust regulators and the Justice Department have blocked Walgreens from buying all of Rite Aid, Aetna wasn’t allowed to buy Humana, and Cigna and Anthem weren’t allowed to get together. When it comes to anti-competitive worries, investors are probably over-reacting. It’s possible the CVS and Aetna deal gets killed by regulators. Even if it does go through, the company will face significant oversight to make sure anti-competitive practices aren’t an issue. The bottom line for Walgreens is, the market is constantly finding ways to worry, yet Walgreens keeps moving forward.

Show me the money

Assuming that Walgreens isn’t going to be undone by competition in the near future, the next issue to look at is the company’s performance and how it relates to the dividend. Relative to its primary competitor, Walgreens most recent quarter looks good.

The company’s U.S. pharmacy business increased sales by 15%, whereas CVS’ retail pharmacy business grew sales by 5.6%. Walgreens also announced a $10 billion share repurchase program and raised the dividend by 10%.

Walgreens’ increased sales lead to a net income increase of nearly 5%. This rise in net income produced strong free cash flow. The company’s free cash flow helped pay down debt and pay dividends.

Quarter

Core FCF

LTD net of cash

November 2017

$860m

$10.9b

February 2018

$1.2b

$10.7b

May 2018

$1.2b

$10.6b

(Source: WBA 10-Q for Nov ’17Feb ’18May ’18)

The company’s increased core free cash flow not only paid down debt, but over the last year, 8% of Walgreens’ shares were retired. The good news for Walgreens’ investors is they should expect more of the same in the future. Analysts are calling for Walgreens to generate just under 12% annual EPS growth over the next five years. This seems like a reasonable assumption, as CVS is expected to grow earnings by just over 11% during this same time frame. With strong earnings and cash flow growth, the next issue to look at is Walgreens’ payout ratio.

Even with Walgreens’ recently announced dividend increase, the company’s payout ratio is just 34%. This is just slightly higher than CVS’ current payout ratio of 27%. In addition, Walgreens payout ratio has dropped over the last couple of quarters, from 48% last November, to 34.5% in February.

This makes perfect sense as the company is aggressively retiring shares, which in turn decreases the company’s dividend expenditure. We know the company will continue buying back shares, but how fast will the dividend rise in the future?

Party like it's 2013 (or 2014)

Investors trying to gauge Walgreens’ dividend growth, can learn a lot from the company’s last several years.

As we can see, between 2013 and 2014, dividends increased by 10%+. From 2015 to the beginning of 2018, the company’s increases dropped to single digit growth. The recent dividend increase of 10% seems to build a road map to what the company can deliver over the next several years.

We saw analysts are expecting earnings growth of just under 12% annually over the next five years for Walgreens. This number may be low, as the company has beaten estimates each of the last four quarters by an average of 6%. Even if analyst predictions are right on track, Walgreens should deliver free cash flow growth that grows close to in-line with earnings.

Even if Walgreens only grew core free cash flow by half its earnings, or 6%, its payout ratio is so low that 10% to 15% dividend increases should be the norm for the next several years. The company was comfortable with a payout ratio just a few years ago of nearly 50%.

If Walgreens committed to a 15% annual increase in the dividend, we can see that even with just 6% core free cash flow growth, it would be a few years before the payout ratio even hit 50%.

Year

Per Share Dividend

Dividend Expense

Core FCF

Payout Ratio

2019

$2.02

$2b

$5b

40%

2020

$2.32

$2.3b

$5.3b

43.4%

2021

$2.67

$2.7b

$5.6b

48.2%

2022

$3.07

$3b

$5.9b

50.8%

(Author’s projections – 15% annual dividend growth – no share repurchases – 6% annual core FCF growth)

If I’m a Walgreens investor, the above table makes me excited. The company could afford four years of 15% dividend increases and the payout ratio would creep up to just over 50%. This isn’t the whole story. Walgreens is aggressively repurchasing shares and likely will continue to do so. In the next four years with our assumptions, the company would have nearly $12 billion in free cash flow after dividends to either pay down debt, retire shares, or both.

As we can see, even after 43 years of dividend increases, Walgreens seems to represent a significant growth and income opportunity today.

Disclosure: I am/we are long CVS.

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.