Walgreens: Where's The Growth?

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About: Walgreens Boots Alliance, Inc. (WBA), Includes: ABC, CAH, CI, CVS, HUM, MCK, UNH, WMT
by: Douglas Adams
Summary

In contrast with the greater market to date, Walgreens' market performance collides with a reality of shrinking margins on prescription drugs that comprise 76% of annual revenues.

By way of comparison, CVS faces similar industry constraints with the added onus of outsized debt associated with its 2018 Aetna purchase.

Both companies have launched pilot programs testing walk-in clinics in selected markets, targeting the chronically ill.

Both CVS and Walgreens are deep in bear territory from their respective market peaks in November and December, respectively.

Walgreens will shed a further 15% to an end-of-year price of roughly $46/share.

Absorbing the 1,900 Rite Aid stores it purchased last year continues to be a difficult slog for Walgreens (WBA) (red-green bars). The 4.6% increase in overall company sales in its 2nd quarter fiscal filing appears largely due to the mathematical increase in the number of stores contributing to the company’s final sales total. Even the gift of an effective tax rate that fell from 27.4% through its 2nd quarter earnings through the end of the February 2017 to 16.7% in the current quarter didn’t appear to have much of an upside impact.

Forward earnings guidance has now dropped from a range of 7% to 12% that was confidently announced just this past December to essentially flat through the end of the company’s fiscal year in August. While the greater market has soared to YTD heights (black dotted line), Walgreens finds itself deep in bear territory, down just over 36% from its December market peak (red shaded area). Investors had already sent the stock tumbling another 13 percentage points last week on Tuesday’s earnings report (see Figure 1, below). The company’s forward earnings outlook will likely include a slow, steady drift to the downside of another 15% by the end of the company’s 1st fiscal quarter in December with a target share price of between $46 and 47/share.

Figure 1: Walgreens Boots Alliance and the S&P 500

https://c.stockcharts.com/c-sc/sc?s=WBA&p=D&st=2018-01-01&en=2019-04-16&i=p6372636733c&r=1555436838072

CVS (CVS) (red-green bars) shares have fallen upon similar market woes. Last year’s completion of the company’s $78 billion Aetna deal has proved to be a difficult pill to swallow despite yield-hungry investors running up a whopping $120 billion in over-subscribed orders for the Group’s debt issue, one of the largest to date. Total revenues through the end of last year were up just over 5%. Interest expense more than doubled for the year to $2.6 billion as the company issued $45 billion in new debt to finance the Aetna purchase and assumed about $8 billion of Aetna existing debt.

CVS total debt now stands at $71.4 billion, about 3.38% of current revenues - 83 basis points about the current yield of the 10-year Treasury note and about 160 basis points shy of its current growth rate. Not a lot of room for error in the event of a market downturn or an unexpected uptick in borrowing costs. Operating income fell 57% for a net income loss of $596 million for the year. The net income hit saw earnings drop from $6.45/share in 2017 to -$0.57/share through the close of 2018, a drop of 109% YOY.

Almost all of the downside beats a path back to the Aetna purchase. The stock fell just over 20% within a month of the November completion announcement. In the New Year, the stock is down 17% on the year and a humiliating 34% since the November announcement. CVS shares also have the potential to fall to about $46/share by year’s end, about 15% to the downside.

Figure 2: CVS against the S&P 500

https://c.stockcharts.com/c-sc/sc?s=CVS&p=D&st=2018-01-01&i=t5488661047c&r=1555437005385

It goes without saying that both companies need to create new paths for growth from their respective mainstay prescription drug sales which comprises 76% of their respective revenues according to the most recent company filings with the SEC. In its annual report on generic drugs, the Association of Accessible Medicines aptly outlines the back-and-forth between the price inflation of branded drugs that drive costs and the price deflation of generic drugs that drive savings. Generics and biosimilars control about 90% of all US prescriptions, but just 23% of total prescription spending. On the flip side, branded drugs account for about 10% of all US prescriptions but a whopping 77% of total spending. Prices for generics have dropped 37% since 2014, while branded drug prices have soared 60% over the same period.

In 2017, patients with branded scripts were two to three times more likely to drop their medication due to cost considerations, at the risk of further complicating their medical conditions. The average co-pay for a generic prescription is $6.06. That same co-pay comes to $40.30 for branded drugs through the end of 2017. About 93% of all generic prescriptions come to $20 or less. The savings over branded drugs is about $265 billion through the end of last year. Generics saved the average state saved $5.2 billion through the end of 2017, with California and New York saving a whopping $23.4 billion and $22.1 billion, respectively, over the period. Unsurprisingly, insurer reimbursement rates have been falling in lockstep. It doesn’t take a crystal ball or glowing orb to predict shrinking pharmacy revenue streams moving forward.

Pharmacies have fought back through the age-old business practice of consolidation and control. Essentially, three large buying consortia control about 90% of the supply of generics to the marketplace. CVS and Cardinal Health (CAH) share a 50% stake in closely held Red Oak Sourcing, LLC. Walgreens owns a 27% stake in AmerisourceBergen (ABC) for sourcing both generic and branded pharmaceuticals for the company’s US operations. Health insurer Cigna (CI) bought ExpressScripts, UnitedHealthcare (UNH) owns OptumRX. Retail behemoth Walmart (WMT)’s wellness sectors hit $39 billion in sales, about 10% of total revenues for the company. McKesson (MCK) is the largest distributor of pharmaceuticals in the US with over 40,000 customers and revenue of $174.2 billion through the end of last year. The end result is an ever-shrinking level of competition in the pharmaceutical supply chain.

That said, single-digit growth from the prescription drugs remains tight. While both companies struggle to turn investors’ attention away from current growth deficiencies, each has latched on to similar growth paths moving forward from rather different market perspectives. Both companies see growth in the targeting customers with chronic medical conditions - diabetes, heart disease, asthma, hypertension and behavioral disorders - and turning an ever-growing percentage of their respective store counts across the country and around the world into walk-in clinics providing services that range from diagnostics to lab tests to medical consultations. CVS calls these centers “health hubs”. Walgreens calls them “neighborhood health destinations.”

Both companies are targeting the 69% slice of Americans that have at least one chronic disease which helped to drive the $3.3 trillion spent in the US on healthcare through the end of last year. Without a doubt, many have trouble with taking prescribed medicines to mitigate their conditions. Many more have difficulty paying for their treatments. Diets laced with high saturated fats and sodium usually crowd out recommended daily allotments of whole grains, fruits and vegetables. Add risk behaviors such as smoking and excessive alcohol consumption with low levels of exercise and you have the essential ingredients that drive current levels of healthcare spending in America.

The Walgreens strategy is more horizontal in approach. Walgreens plans to invest $300 million/year over the next three+ years in strategic partnerships forged with dozens of companies, from food to software to primary care, in its effort to become a go-to destination for healthcare advice, monitoring, diagnosis - as well as prescriptions. The partnership with Kroger is an effort to bring a greater variety of high-volume food items to increase foot traffic on the retail end. Microsoft (NASDAQ:MSFT) is digitizing Walgreens and its partnership links to manage, chronicle customer contacts and ongoing treatments as well as to unearth new opportunities in delivering healthcare services to its customers.

In yet another attempt at putting the company’s role in the Theranos scandal to rest, LabCorp is providing blood testing with the hopes of providing the service in over 600 retail stores over the next three years. Humana (HUM) will bring in primary care targeted toward seniors. Closely-held Verily brings diabetes diagnosis to the equation. The effort is to drive efficiency and further service opportunities across the supply chain for both Walgreens and its partners.

For its part, CVS is more vertical in its approach. CVS has a long history of exerting control over its assets - witness the Aetna, Minute Clinic Chain and Caremark acquisitions of recent years. CVS is looking to shift its existing in-store clinics decisively in the direction of managing complex and chronic conditions. Minute Clinics are being equipped with retinopathy imaging machines for patients receiving diabetic treatment and diagnostics.

End-to-end sleep apnea diagnosis, complete with in-home sleep testing and monitoring services are on order. Continuous positive airway pressure (CPAP) therapy and supplementary care will be on offer. Licensed dietitians will be on staff for nutritional outreach, training and ongoing advice. Wellness rooms for seminar purposes will also be part of the mix. The company plans a remake of its existing MinuteClinic program in both Target and CVS retail stores across the country.

Not to be outdone, Walmart plans more store upgrades this year in 36 states which will include $265 million for Texas, $173 million for Florida and $145 for California. New store openings have slowed to a crawl. Walmart spent about $2.2 billion last year on re-outfitting stores last year and plans another $11 billion in 2019. Unsurprisingly, pharmacy department upgrades are receiving particular attention.

Building a low-level healthcare delivery mechanism across thousands of walk-in clinics represents in many ways a quantum leap from the pharmacy business model of old. Professional relationships with pharmacists stretch back to the apothecary shops on the cobblestone streets of New York, Boston and Philadelphia when doctors and pharmacists were one in the same person. Fast forward several hundred years, pharmacists and doctors have gone down very different patient/doctor relational paths. Outside of rural America where pharmacies are often few and very far between, urban retail customers likely have little if any contact with pharmacists in the past. There is little reason to expect that relationship to change under the new regime of operation.

At first glance, keeping the chronically ill out of expensive ER facilities for the delivery of most medical services is a cost conscious plus for patients, insurers and taxpayers. After all, existing walk-in clinics across the country treat low-level ailments and injuries numbering in the thousands on a daily basis at cost differentials significantly lower than doctors or hospitals. The watchword here is convenience. Making the delivery of healthcare convenient across thousands of walk-in clinics does not necessarily translate into healthcare cost savings.

Revenue growth plays on convenience as well as creating the necessary economies of scale. Perceptions aside, the more numerous these walk-in clinics become, the greater potential for revenue growth over time. Similarly, the greater the convenience factor, the more healthcare that is ultimately used. That about 70% of the US urban population lives within three miles of a CVS retail store, leaves convenience as a key to the model’s future success.

An even bigger hurdle comes from staffing. The emerging pharmacy business model envisions an ever-growing percentage of low-level healthcare delivery moving from doctor offices and hospitals to walk-in clinics. These facilities are staffed with physician assistants, nurse practitioners, licensed dietitians, lab technicians, even yoga instructors not only present a perceptional hurdle for consumers that will take time to overcome. Most of these healthcare providers likely don sufficient skillsets for the routine and maintenance needs of the chronically ill. Recognizing the ever-changing conditions and complications and dispensing the proper medical advice, however, could be much more problematic.

The new emphasis on the delivery of myriad healthcare services from walk-in pharmacy clinics will also share, for the foreseeable future, floor space with a disconcerting array of high-volume retail goods of dubious health standing, from soda to candy to high-sodium snack foods—to known carcinogens like tobacco products and ever-present alcohol. Through the end of 2015, 79% of all US pharmacies sold tobacco products, the same products that are responsible for 1 in 5 American deaths annually.

Since 2014, CVS is the only major pharmacy to have unilaterally banned tobacco products from its low-growth retail segment. The decision resulted in an estimated $2 billion loss for the company through the end of that year. While Walgreens started an 18-month tobacco-free pilot program in 2018 in a variety of markets across the country, the company has no current plans of pulling tobacco products from its stores. Meanwhile, the company’s limited de-emphasis of tobacco sales already has erased an estimated 125 basis points of retail sales through its fiscal 2nd quarter.

It goes without saying, most of the retail items sold in pharmacies can be purchased in every convenience, discount and grocery store across America and around the developed world. Annualized growth of CVS retail remain anemic at 3.17% through September YOY with an annualized growth rate of 5.2% since 2015, trending to the downside. For Walgreens, US retail sales were up 1.3% through the FY 2nd quarter YOY with comparable sales down 3.8% over the same period.

Just how quickly walk-in clinic revenue will supplant the retail end of the pharmacy business model is conjectural at this juncture, but at least the question is being asked. Still, combined with OTC drugs, beauty products, cosmetics and personal care goods - the segment comprises about 24% of total annual revenue for both CVS and Walgreens over the past three years. The death of pharmacy retail will remain greatly exaggerated for some time to come.

Equally exaggerated for the foreseeable future will be positive revenue streams from walk-in clinics for either company. Both companies’ pilot programs are ongoing. Decisions still have to be made regarding the level of services to be provided. Markets need to be identified. Staffing requirements need to be met. Capital is still to be spent. Both CVS and Walgreens will continue their respective market slides until such time when the walk-in delivery of low-end healthcare takes hold in consumer’s minds.

This means few of the chronically ill will be making pharmacy walk-in clinics their primary care destination any time soon - if ever. The more realistic question for CVS and Walgreens, not to mention investors, is just how many of the chronically ill will make walk-in clinics a destination for some of their more routine and maintenance needs and how long will the necessary transition take. In the meantime, CVS and Walgreens wallow deep in bear territory from their November and December market peaks. Sustainable growth over the intermediate term remains elusive.

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.