Walgreens: The Contrarian Dividend Growth Stock

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About: Walgreens Boots Alliance, Inc. (WBA)
by: Kody's Dividends
Summary

Walgreens has raised its dividend every year since the Carter administration, making it a Dividend Aristocrat.

While the company has its fair share of risks, I believe that management can navigate those risks and guide the company into the future.

Walgreens is trading at a 12% discount to fair value, which I believe is an adequate margin of safety for a company of Walgreens' quality.

Between the 3.4% dividend yield, the likely 6-7% earnings growth, and 1.3% valuation multiple expansion, it is likely Walgreens will deliver alpha over the next decade.

A tenet of successful dividend growth investing is to constantly be searching for high-quality companies that are in sectors resilient to the ebbs and flows of the economy.

Given the demographics of the United States and the increasing demand for prescription drugs as the population ages, it should come as no surprise that spending on prescription drugs is expected to grow 4.6% this year and at an average CAGR of 6.1% through 2027.

While there are no doubt risks associated with pharma chains mainly through political and regulatory action, and this is reflected in the fact that Walgreens Boots Alliance (WBA) stock has fallen 23.6% YTD, I believe that the company will be able to execute its turnaround plan and return to meaningful growth early next decade, which is why I'll be discussing the reasons for my bullishness towards Walgreens at its current price.

I'll be discussing the company's dividend safety and growth profile, its turnaround plan, the balance sheet, risks to consider, and the company's current stock price with relation to its fair value. I will then conclude by offering my estimated average annual total returns over the next decade.

Reason #1: A Very Safe Dividend With High Single Digit Growth Potential Over The Long-Term

In order to assess the safety of Walgreens' dividend, we'll be examining both the company's EPS payout ratio and FCF payout ratio.

During FY 2018, Walgreens generated diluted EPS of $5.05 while paying dividends per share of $1.60 during that same time, for an EPS payout ratio of 31.7%.

Given that the company recently updated its guidance to basically flat for FY 2019, the payout ratio will increase a bit to around 34.9% assuming the same diluted EPS of $5.05 for FY 2019.

These are both very sustainable payout ratios for Walgreens, leaving the company plenty of retained capital to reinvest into the business and execute its turnaround plan.

Moving to the company's FCF, Walgreens generated $8.265 billion in operating cash flow less capital expenditures of $1.367 billion, for total FCF of $6.898 billion during FY 2018. When we take into account that the company paid dividends of $1.739 billion during that time, the company's FCF payout ratio for FY 2018 was 25.2%.

While the company's payout ratio will likely increase this fiscal year due to stagnant operating cash flow and increased capital expenditures, the dividend still remains very safe, in my opinion.

Image Source: Simply Safe Dividends

Unsurprisingly, Simply Safe Dividends and I are in agreement that Walgreens' dividend is safe for the foreseeable future.

While the company's dividend is safe, we still need to consider the company's dividend growth prospects before we can determine if the company meets our criteria for investment.

Image Source: Simply Safe Dividends

As demonstrated above, Walgreens boasts a set of very impressive dividend growth rates.

While the 14% DGR of the past 20 years won't be replicated in the next 20 and the next couple years will be rough on the dividend growth front, I do believe Walgreens is capable of continuing that upper single digit dividend growth rate it has delivered the past 5 years, in the range of 7-8% over the long-term.

When we consider that Yahoo Finance and Nasdaq are projecting annual earnings growth rates of 5.1 and 8.2% over the next 5 years, respectively, I believe my above DGR estimates are reasonable.

We'll now delve into why despite Walgreens' rough current situation, analyst estimates will likely prove to be correct in the case of Walgreens.

Reason #2: A Satisfactory Balance Sheet And Viable Turnaround Plan

Walgreens is one of the largest pharmacy retailers and drug distributors in the world, operating over 18,000 pharmacy stores across the globe.

Upon the completion of Walgreens' $5.3 billion cash and 144.3 million share acquisition of the remaining 55% of Boots Alliance in 2014, the company became the largest retail pharmacy and health destination across both the United States and Europe.

In addition to the Walgreens brand, the company operates Duane Reade and Boots stores, as well as health and beauty brands such as Botanics, No7, Soap & Glory, and Liz Earle.

Walgreens operates in the following three business segments:

Retail Pharmacy USA: This division has pharmacy-led health and beauty retail offerings in 50 states, the District of Columbia, Puerto Rico, and the US Virgin Islands. The company operated 9,560 retail stores in this division as of August 31, 2018, according to page 3 of the company's most recent 10-K. As a testament to the prevalence of Walgreens in this segment, 78% of the population in the United States lives within 5 miles of a Walgreens, Duane Reade, or acquired Rite Aid pharmacy, as of August 31, 2018. The segment accounted for 73.6% of the company's revenue in FY 2018, per page 3 of the company's most recent 10-K.

Pharmaceutical Wholesale: This division which primarily operates under the Alliance Healthcare brand, supplies medicines, other healthcare products, and related services to 110,000 pharmacies, doctors, health centers, and hospitals each year across 291 distribution centers in 11 countries, as of August 31, 2018. This segment's revenue is derived from the 26% equity stake Walgreens owns in AmerisourceBergen, the second largest pharmaceutical distributor in the US. The division accounted for 9.2% of the company's revenue in FY 2018.

Retail Pharmacy International: The third and final division has pharmacy-led health and beauty retail businesses in eight countries. As of August 31, 2018, the company operated 4,767 stores in the division. The segment comprised the remaining 17.2% of the company's revenue in FY 2018.

The company derives its highest margins from retail pharmacy, which was 5.0% in the United States and 6.9% in its much smaller international segment. In contrast, the lowest margin business was the Pharmaceutical Wholesale segment, which had an operating margin of 2.9% in FY 2018.

As a retail pharmacy company, Walgreens has been able to leverage its economies of scale and well-known brand to growth both its sales and its bottom line for decades, allowing the company to grow its dividend each year since the Carter administration.

The company has proven itself capable of executing acquisitions that both increase the company's footprint and are accretive to the bottom line over the long-term, with the above acquisition of Boots Alliance, the 2010 acquisition of Duane Reade for $1.1 billion, and its deal for Rite Aid, to name a few.

These acquisitions in the past few years have led Walgreens to become the largest retail pharmacy in the United States, and the fourth largest pharmacy benefits manager or PBM in the US, with 823.1 million prescriptions filled in 2018 (Walgreens 2018 10-K, page 4).

While Walgreens has recently revised its earnings growth guidance to roughly flat for FY 2019, it is important to note that the company is in the midst of an ambitious turnaround plan to adapt to the ever-changing environment it operates in.

Image Source: Walgreens Boots Alliance Second Quarter 2019 Earnings Conference Call Presentation

The first component to the company's turnaround plan is the continuation of cost-savings efforts in order to boost or at the very least stabilize margins in the likely event of continued declining reimbursement rates.

While the company saved $1.5 billion between 2014 and 2017 with its Cost Transformation Program, the company announced its plans late last year to cut another $1 billion in expenses over the next 3 years.

The company also entered into a 10-year agreement with Fareva in 2017 to manufacture and supply its beauty brands, which should further streamline the company's cost savings plan (Walgreens' 2018 10-K, page 10).

In addition to these cost savings efforts, Walgreens also has announced plans to focus on maximizing growth in drug sale volumes through its preferred pharmacy strategy, whereby Walgreens offers PBMs discounted generic drug prices to be their preferred pharmacy to fill customer prescriptions.

Image Source: Walgreens Boots Alliance Second Quarter 2019 Earnings Conference Call Presentation

The third piece of Walgreens' turnaround plan centers around its partnership with LabCorp to open 600 Walgreens Patient Service Centers between 2019 and 2023 indicates that Walgreens is following a reasonable plan to adapt to a dynamic industry environment.

Finally, Microsoft and Walgreens have recently established a strategic partnership to explore new healthcare delivery models, technology, and retail innovations to improve the quality of healthcare and transform the delivery of healthcare.

In a rapidly changing business environment, it is reassuring to know that Walgreens is collaborating with an innovative company such as Microsoft to develop new healthcare delivery models, which could potentially drastically reshape the landscape of healthcare as we know it, and place Walgreens at the forefront of the dynamic healthcare landscape.

From my viewpoint, Walgreens management is taking the necessary steps to adapt to the changing healthcare environment.

It also helps that the company has a balance sheet that is flexible while the company spends the billions of dollars necessary to reshape its future.

According to page 32 of Walgreens' most recent 10-K, the company generated EBIT of $5.975 billion against $616 million in interest expense, for a respectable interest coverage ratio of 9.7. It is for this reason Walgreens enjoys an investment grade BBB credit rating from the major credit rating agencies.

When we take into consideration that Walgreens has a viable turnaround plan in place and a reasonably strong balance sheet, I believe Walgreens is a solid contrarian play for dividend investors confident in the company's turnaround plans.

Risks To Consider:

While Walgreens is an investment that has done very well for investors over the long-term, it is only fair for me to note that Walgreens faces its fair share of risks that could harm the investment thesis over the short-term or even break it altogether over the long-term.

The first risk is that while Walgreens is primarily a company with a domestic focus, the acquisition of Boots Alliance has allowed the company access to international markets.

Because a portion of the company's total sales are derived in foreign currencies, there is the risk of unfavorable foreign currency translation, although this type of risk tends to even out over time (Walgreens 2018 10-K, page 14).

The risks that are more enduring associated with foreign operations include price controls differing from the United States, instability of foreign economies and governments, possibly adverse tax consequences, and additional US regulations governing international operations, such as the regulation under the Foreign Corrupt Practices Act (Walgreens 2018 10-K, pages 12-13).

The next risk facing Walgreens is actually the demographic tailwind in the United States, which is driving increased demand for drugs and medical services.

Ironically, it is the industry's largest tailwind that may ultimately pose considerable challenges to the viability and profitability of the industry.

When we consider that US healthcare spending is expected to increase at a CAGR of 5.5% through 2027, this will only increase the pricing pressure on companies such as Walgreens as federal, state, and local governments are expected to fund 47% of national health spending by 2027.

Because 98% of Walgreens' prescription revenue is from third-party payers, such as private insurance, PBM companies, and government agencies, the dynamic that is gaining steam to take measures to cut costs as much as possible may erode the margins of Walgreens (page 4 of Walgreens' most recent 10-K).

We've already seen some of these tactics in play. The best example that comes to mind is the recent shift in pharmacy mix toward lower margin plans, such as 90-day prescriptions rather than the higher margin 30-day prescriptions of the past. In order to secure relationships with Medicare Part D plans serving seniors with significant pharmacy needs, Walgreens has had to accept lower reimbursement rates (Walgreens 2018 10-K, page 9). As the cost of healthcare spending continues to increase and become a growing share of the economy, these measures will only continue to be ramped up.

Yet another risk to Walgreens is that rising healthcare costs have led to the formation of the alliance of Amazon, Berkshire Hathaway, and JP Morgan Chase to create a non-profit company designed to supply healthcare to their US employees. Hoping to leverage their collective strength in technology, insurance, and finance, this massive partnership is part of a trend in the healthcare industry to consolidate, in the effort to increase scale, and leverage that in negotiations with companies such as Walgreens (Walgreens 2018 10-K, page 10).

Although there are concerns that Amazon's recent acquisition of PillPack for $753 million could lead to disruption of the industry Walgreens operates in, we need to remember that Walgreens has an absolutely massive scale which Amazon will find difficult to replicate, even as the giant that it is.

It's true that the preference of consumers to fulfill their needs online is an increasing trend and that could play to Amazon's advantage, possibly leading to a reversal of the vast majority of prescriptions being picked up at retail pharmacy stores, but we need to consider that Walgreens' recent partnership with Fedex to deliver prescriptions has the fastest delivery times across the nation for prescriptions, which is a testament to the company's leadership in its industry.

While their peer, CVS Health, recently completed the $78 billion mega-merger with Aetna, Walgreens has taken a more cautious approach and has not completed any significant mergers since its acquisition of Boots Alliance in 2014 besides the deal for Rite Aid.

While it's understandable that Walgreens has been cautious around mega M&A deals given that most fail to create wealth for shareholders, in an industry that is rapidly changing, this cautious approach may actually be detrimental to the company over the long-term.

When we consider that Walgreens has experienced same-store retail sales declines for the past several years as a result of the rise of e-commerce, it is going to be increasingly important for the company to not only execute upon its plan to maximize cost savings and drive higher prescription volume, but the company needs to increase its leverage with the fewer, larger customers in the industry with more leverage over companies such as Walgreens.

In fact, three third-party payers accounted for 32% of the company's revenue in 2018, which is a concern in the event Walgreens is unable or unwilling to retain business with those third party payers (Walgreens' 2018 10-K, page 7).

Another risk is that as a company seeking to compete in an increasingly competitive environment, Walgreens is in the middle of a turnaround plan to hopefully achieve the above objectives we just discussed.

Executing upon this plan will require the company to ramp up its capex to revamp stores, decrease its focus on lower margin retail items, and to convert stores into the same kind of healthcare hubs that CVS has recently done, which would likely lead to increased margins through delivering higher margin medical services to customers.

Investors looking for clarity and certainty would probably do better to avoid this name if they can't handle the increased risk profile around Walgreens. There is a reason this company is trading at a massive discount to its typical valuation. An investment in Walgreens is ultimately a vote of confidence that management will be able to execute its turnaround plan, returning the company to a more promising future of growth. It's also worth mentioning that in the midst of this turnaround plan, investors will need to temper their expectations for dividend growth due to the increased capex necessary for Walgreens' plan to succeed.

While this list of risks is by no means comprehensive, I believe the risks outlined above are the most pertinent risks facing Walgreens. I would refer interested readers to pages 8-27 of Walgreens' most recent 10-K for a more complete listing of all the risks facing Walgreens.

Reason #3: A Wonderful Company Trading At A Discount

While Walgreens certainly has its fair share of risks, I believe concerns around the company have created a solid buying opportunity. We'll be analyzing exactly how undervalued shares of Walgreens are at the present time.

The first valuation metric we'll examine is the 13 year median yield. According to Gurufocus, the company's 13 year median yield of 1.85% is well below its current yield of 3.39%, and the yield is 0.1% off an all-time high.

Even in a scenario in which the company's shares only warrant a fair value yield of 3% (which is reasonable for a company whose floor is at least mid-single digit dividend growth potential over the long-term and whose ceiling is high-single digit dividend growth), this implies that shares are currently trading at an 11.4% discount to their fair value of $58.67 a share and offer 12.9% upside from the current price of $51.97 a share.

The second valuation metric we'll examine is the 13 year median PE ratio. Walgreens' TTM PE ratio of 9.77 is well below the median of 17.76. While I don't believe we'll see a reversion to the upper end of that range, I do believe it is likely we'll see a reversion to a PE of 12 in a somewhat conservative scenario. This would imply that shares of Walgreens are trading at an 18.6% discount to fair value and offer 22.8% upside with a reversion to a fair value of $63.83 a share.

Image Source: Investopedia

The final valuation method we'll use is the dividend discount model or DDM.

The first variable of the DDM formula is the expected dividend per share, which is simply the expected annualized dividend per share. Walgreens' current annualized dividend per share is $1.76.

The second variable of the DDM formula is the cost of capital equity, which is just another term for an investor's required rate of return. I require a rate of return of 10% because that is historically a bit higher than the broader market's returns.

The final variable of the DDM formula is the dividend growth rate, which is the only variable that one needs to predict in this formula, although it can be quite difficult to predict.

There are a variety of considerations that go into setting a realistic expectation for the long-term dividend growth rate, including a company's dividend payout ratio, the company's balance sheet, the likely earnings growth rate over the long-term, and industry fundamentals.

Given that I wouldn't want Walgreens' payout to expand much more, it's reasonable to conclude that the company's dividend growth rate will roughly mirror whatever the company can achieve as its long-term earnings growth rate. I believe that Walgreens' will be able to grow its earnings around 7% annually over the long-term, but we'll use a 6.75% DGR to err a bit on the side of caution.

This gives us a fair value of $54.15 a share, which implies Walgreens' shares are trading at a 4.0% discount to fair value and offers 4.2% upside from its current price.

When we average the three fair values together, we arrive at a fair value of $58.88 a share. This indicates that Walgreens' shares are trading at an 11.7% discount to fair value and offer 13.3% upside.

Summary: A Blue-Chip Stock With A High Likelihood Of Delivering Alpha

Walgreens is a company operating in a defensive industry, and the company is a Dividend Aristocrat for that very reason. I believe the current mix of yield and the company's dividend safety offer a nice blend for investors once the company fully executes its turnaround plan.

While the company faces its fair share of risks, including a failure to execute its turnaround plan in a challenging industry environment, and political/regulatory concerns, I believe that management will prove to be successful in their turnaround plan.

It's these risks that have caused Walgreens' yield to reach a near all-time high and that have sent shares to their lowest levels in nearly 6 years. For a patient, contrarian dividend investor, I believe Walgreens' current stock price warrants a non-core position in most DGI portfolios.

Between the current 3.4% yield, likely earnings growth of 6-7%, and valuation multiple expansion of 1.3%, Walgreens is likely to generate annual total returns in the ballpark of 10.7-11.7% over the next decade.

Disclosure: I am/we are long WBA. 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.