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Walgreens: Update On Restructuring

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About: Walgreens Boots Alliance, Inc. (WBA)
by: Hans Centena
Hans Centena
Research analyst
Summary

Headwinds in the US retail pharmacy have forced Walgreens Boots Alliance to seek more meaningful partnerships/JVs.

The company confirmed it will close 200 stores in its international segment.

New restructuring plan anticipates $1 billion in gross savings.

Lowering drug prices is currently a bipartisan issue. There may continue a stalemate in the US Congress for any legislation to be signed into law over the next fifteen months. A few democrats may not be receptive to give a win to Trump in the healthcare arena ahead of the 2020 elections.

In the proposed bill, the US health secretary would negotiate drug prices on the top 250 drugs with the highest total cost to Medicare and the entire US health system without competition from at least two generic, biosimilar or interchangeable biologics.

The proposed bill would establish an international price index. It would establish an upper limit for the price of any drug in negotiation to no more than 1.2 times the volume-weighted average price of six countries (Australia, UK, France, Canada, Germany and Japan). It would take into consideration the cost of production, domestic/international sales information and alternative treatment information.

Once a price is established for a negotiated drug, a manufacturer will not be allowed to increase the price faster than inflation in subsequent years until sufficient price competition enters the market.

Notably, the US pharma supply chain is likely to experience the most negative impact of this bill. Against this backdrop, Walgreens Boot Alliance Inc.'s (NASDAQ:WBA) challenges in its retail pharmacy business have intensified thus forcing the company to search for avenues of growth.

Store Closures

Over the next six to eighteen months, WBA confirmed it will close 200 stores in the international segment. Around two-thirds of the stores to be closed are loss-making. WBA closed 2,485 UK stores in operation at the end of 2018. The remaining staff would be transferred to nearby Boots branches. To offset the losses, the company intends to cut head office staff costs in Nottingham (England) by 20% while it undergoes a store portfolio review and pursues restructuring.

The company's international pharmacy segment remains challenging. EBIT sharply fell approximately 24% in the fourth quarter of 2019 versus the 14.5 % drop in the third quarter. Needless to say, it resulted from the constantly challenging market in the United Kingdom.

Growth outlook would surely remain challenged until the market backdrop in the UK will recover. I believe the store closures along with incremental savings would render minor support to growth.

In its US Retail Pharmacy segment, the company is already in the middle of converting the format of its stores. More particularly, WBA has selected Gainesville, Florida where it is piloting new store formats and service offerings.

I hold a positive view that the new store formats could potentially accelerate in the long term. New store formats would lessen the stock keeping unit (SKU) count, offer wider clinical offerings, improved leverage residual square footage as well as leverage customer level data in a more efficient manner. Also, this controlled environment in Florida would allow WBA to effectively monitor its pricing models.

Lower Than Expected Brand Inflation

A number of industry-wide factors are more indicative of pressures facing US drug retailers. At an investor conference, WBA acknowledged experiencing similar challenges to CVS Health Corp. (NYSE: CVS) that includes sustained reimbursement pressure and less benefit from generic drugs as well as lower than expected brand inflation.

Brand inflation would seem to be suspended as drug price increases would be capped to overall inflation. The inflation rebates could alter pricing significantly if a drug manufacturer would lower its prices to prior levels.

WBA called out lower brand inflation as a headwind in 2019. More particularly, the company has experienced brand inflation of around 2% at the onset of 2019. This data is lower as compared to 8% in the same quarter last year. Thus, I expect earnings expectations will be around mid-single digits for the year.

Branded drug pricing was up 3% as of June this year which is largely in-line with the year-to-date average. Average brand inflation in the first half of this year was around 220 basis points lower than the same period last year.

Average generic inflation in the first half of 2019 has been 130 basis points less negative than the same period of 2018. Conversely, generics deflation in June came in at negative 4% year-on-year, which is modestly less negative than the -5% forecasted average for 2019.

Lowest SGA Base

The company delivered greater than 15.7% topline compounded annual growth rate (CAGR) and a 20.2% net income CAGR over the past four years. The company demonstrated its capability to achieve topline growth (albeit with acquisitions).

The company's selling, general and administrative expenses (SGA) as a percent of sales have significantly improved over the last few years. WBA has cut its SGA as a percentage of sales from 22.7% to 18.8% over the same timeframe. Its partnerships have helped contribute to a 300 basis points increase in its market share over the past three years.

Astonishingly, WBA has the lowest SGA base of other retail comps as a percent of sales. The company's SGA levels relative to retailer comps would make investors become more lukewarm to anticipate big reductions in SGA moving forward, while they acknowledge there could be room to further slash down costs given the announced $1 billion restructuring plan.

Source: Company data, Goldman Sachs Global Investment Research.

Beyond the cut in footprint, WBA would continue to expect margins within the retail business to improve going forward. Front end gross margins would improve sequentially, while pharmacy margins will be pressured attributed to reimbursement pressures and store portfolio mix.

I noted that prescription growth has been sluggish (on an organic basis). Similarly, the reimbursement environment continues to be a challenge. I just hope that its new store initiatives and partnerships will help to overcome it.

CEO and Executive Vice-Chairman, Mr. Stefano Pessina has some realistic and unequivocal thoughts in a recent investor conference about WBA's strategic outlook:

"We found ourselves facing a combination of increased reimbursement pressure in the quarter, lower generic deflation, lower brand inflation and lower-than-anticipated benefits from our work to refresh and renew our retail offerings, primarily in the U.S. Of course, the pharmacy trends are not only impacting our business. They are impacting the overall market and will likely continue to do so over the coming months.

Let me be clear, however. I am convinced that our existing strategic priorities are the right ones and will help us to deliver sustainable growth into the future. Let me remind you of our 4 priorities: accelerating the digitalization of our company; transforming and restructuring our retail offering; creating neighborhood health destination around a more modern pharmacy; and rolling out our Transformational Cost Management Program."

Recent Restructuring Efforts: How Effective?

The merger of Walgreens and Boots brought together two leading retail companies with iconic brands, shared values, trusted healthcare services and complementary geographic footprints via community pharmacy care. Subsequently, there is a tremendously greater sense of urgency for the merged entities to engage in M&A after the company's postulated takeout of AmerisourceBergen (NYSE: ABC), the takeover of 1,932 Rite Aid (NYSE: RAD) stores and further industry consolidation in Cigna's (NYSE: CI) purchase of Express Scripts.

WBA initiated a new restructuring plan which it anticipates to yield $1 billion in gross savings. These savings are still on top of the outlined $650 million savings related to the acquisition of Rite Aid stores. Although details of this new restructuring program remain to be less transparent.

WBA has not yet disclosed openly the aggregate upfront cost of its restructuring program and the overall expected net benefit to earnings. Savings would be utilized for three key purposes:

  1. Help deploy future partnership build-outs,
  2. Allowing savings flow through to the bottom line,
  3. Mitigate pressures across the organization (UK losses and reimbursement cuts).

The company has been diligent in efficiently managing its balance sheet while it is proactively searching for potential M&A opportunities. It has eminent stock valuation multiples across the US healthcare services landscape that emphasized the inherent advantages of its unencumbered business model.

The company downplays the pending vertical mergers of its industry peers which could represent an opportunity for WBA with any associated market disruption.

Equally important to note, free cash flow was negatively affected by the $2.4 billion year-on-year corporate pressures that include:

  • 2019 legal settlements,
  • Cash charges for corporate restructuring,
  • RAD store optimization and integration program and,
  • RAD's working capital benefits in 2018.

Stock Valuation

I'm Neutral on WBA stock with a price target of $61.5 on NTM P/E of 10X.

Source: Seeking Alpha.

WBA is targeting a double-digit EPS growth over the long term while I believe transparency on positive earnings outlook is not yet visible enough. The key valuation variables to consider are the company's continuing partnership contributions should help to mitigate the UK uncertainties and reimbursement challenges.

Analyst Consensus

Source: CNN Business.

At the same time, contributions from RAD would ramp along with possible benefits from front end initiatives. Residual tax reform tailwinds and diligent focus on costs should also be considered by the investors. I should also stress the mid-to-high single price deflation for generic pricing.

I estimated the midpoint of earnings guidance implies EPS growth of 10% in 2019 which might be adequate to make several investors more optimistic on WBA stock.

My Takeaway

WBA's retail transformation would take years to come to fruition. To better utilize its increasingly inefficient retail footprint, WBA is pursuing several partnerships or joint ventures which are certainly worth looking forward to.

The company still appears to be in the early period of testing several of its partnerships that it has announced. The timing of any significant rollout could be up to five years. WBA currently ensures that returns are adequate before rolling out more partnerships.

That said, investors would be led to believe that these initiatives, even if scaled, are not likely to deliver enough upside potential to offset its declining core retail pharma business.

I also anticipate inconsiderable earnings growth outside of the company's share repurchases, store optimization savings and new cost-savings programs. Investors may become less expectant to ascribe a high stock valuation multiple as against strong organic growth.

Lastly, the company would need to depend on cost-cutting measures to spur its EBIT while the company still plans to roll out some stores in the absence of incremental growth drivers. The operational risk surrounding WBA's restructuring program is only magnified.

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.

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