Walgreens And CVS: I Prefer One, But Both Are Undervalued

Jan. 28, 2020 1:14 PM ETCVS Health Corporation (CVS), WBA92 Comments
Daniel Schönberger profile picture
Daniel Schönberger
9.97K Followers

Summary

  • Walgreens Boots Alliance and CVS Health Corp. are the two major pharmaceutical retailers in the United States with about 10,000 pharmacies each.
  • When comparing several metrics like margins, return on invested capital or dividends, Walgreens and CVS Health show a similar picture.
  • While CVS acquired Aetna and introduced its HealthHUB concept, Walgreens announced partnerships with Kroger and is focusing on its cost management program.
  • Walgreens is not only a dividend aristocrat with a rather high dividend yield, but the stock is also supported from a technical point of view.
  • Looking for a helping hand in the market? Members of Moats & Long-Term Investing get exclusive ideas and guidance to navigate any climate. Get started today »

In the past two years, I covered CVS Health Corp. (NYSE:CVS) several times and the company is also part of my marketplace watch list. However, its closest competitor in the pharmaceutical retail business - Walgreens Boots Alliance (NASDAQ:WBA) - I only covered once about two years ago. In this article, I called Walgreens Boots Alliance a solid investment, but made clear, that I preferred CVS Health Corp.

In the following article, I will take a closer look at Walgreens Boots Alliance again as it is now trading about 25% lower than at the time of publication. And we are not only trying to find out if Walgreens Boots Alliance is a good investment right now, but we are also comparing the two major pharmaceutical retailers to decide which is the better investment. We start by describing Walgreens' business and take a look at recent results.

Business Description

Walgreens Boots Alliance is a pharmaceutical retailer and pharmaceutical wholesale company. Together with the companies in which it is invested, it has over 18,750 stores in 11 countries. Additionally, Walgreens has one of the largest global pharmaceutical wholesale distribution networks with over 400 distribution centers delivering to more than 240,000 pharmacies. Walgreens Boots Alliance was formed in December 2014 after Walgreens purchased the 55% stake in the UK and Switzerland-based Alliance Boots that it did not already own. Today, the company is reporting in three segments:

  • Retail Pharmacy USA: In fiscal 2019, this segment has been responsible for $104.5 billion in sales and could report an adjusted operating margin of 5.03%. The segment operates 9,277 retail stores in the division and about 74% of revenue was generated from pharmacy (the sale of prescription drugs and provision of pharmacy-related services) and 26% of revenue was generated from retail (the sale of healthcare and retail products including non-prescription drugs, beauty, toiletries, and general merchandise).
  • Retail Pharmacy International: In fiscal 2019, this segment has been responsible for $11.5 billion in sales and reported an adjusted operating margin of 6.52%. At the end of August 2019, the company operated 4,605 stores. The segment is operating in Europe, Mexico, Thailand, and Chile. In contrast to the USA segment, retail sales were responsible for 64% of total revenue while pharmacy sales were only accounting for 36% of revenue.
  • Pharmaceutical Wholesale: In fiscal 2019, the segment generated $23.1 billion in annual sales and the adjusted operating margin was 4.07%. This segment supplies medicines, other healthcare products, and related services to more than 115,000 pharmacies, doctors, health centers, and hospitals from 300 distribution centers in 11 countries.

In March 2013, Walgreens, Alliance Boots GmbH, and AmerisourceBergen Corporation (ABC) announced various agreements and arrangements including a ten-year pharmaceutical distribution agreement between Walgreens and AmerisourceBergen. As of August 31, 2019, Walgreens Boots Alliance owns about 57 million common shares of AmerisourceBergen, which is representing about 27% of outstanding shares and this equity investment contributed about $164 million in equity earnings for Walgreens Boots Alliance.

In September 2017, Walgreens Boots Alliance agreed to purchase 1,932 stores, three distribution centers and related inventory from Rite Aid Corporation (RAD). The purchase of these stores occurred in waves during fiscal 2018.

Three weeks ago, the company reported quarterly results, and aside from sales and comparable sales, which could both increase 1.6%, the other numbers were not so great. Operating income declined 27.6%, net earnings declined 24.8%, and earnings per share declined 19.8%. All these numbers are on a GAAP basis, but even the adjusted numbers declined rather steeply.

(Source: WBA Investor Presentation)

When looking at the last two years, we see a rapid shift at the beginning of 2019. The sales for the Retail Pharmacy International segment decreased every quarter during the last two years. Until the first quarter of 2019, this was not a problem as Retail Pharmacy USA could report double-digit growth, and as a consequence, the company could report high sales growth. But since the second quarter of 2019, not only Retail Pharmacy International had to report negative growth but Retail Pharmacy USA could also grow only about 2% in these quarters and earnings per share declined in the last four quarters with EPS declining more than 50% in the fourth quarter of 2019.

(Source: Own work)

When looking at the valuation of Walgreens Boots Alliance, the stock is trading at rather low multiples (which is not surprising considering the numbers the company was reporting in the last few quarters). Right now, Walgreens Boots Alliance is trading at a P/E GAAP (TTM) ratio of 13.21 with the company's 5-year average being 19.55 and the sector median being 24.95. During the last five years, the P/E ratio of Walgreens Boots Alliance constantly declined showing us that investors are getting more and more pessimistic about the company.

WBA and CVS: Almost a Draw

But investors don't always have to be right and sentiment is often a contra-indicator. It is also worth noting that not only Walgreens Boots Alliance is trading at low multiples. The company's closest competitor, CVS Health Corp., is also trading at depressed valuation multiples. Both stocks also behaved very similarly during the last three years.

When trying to compare the two companies, we can look at different metrics. We can start by looking at the company's earnings per share and revenue growth. While WBA could report an average annual revenue growth of 7.83%, CVS could report 9.63% annual average revenue growth. When looking at the average annual EPS growth during the last ten years, it is a little difficult to compare the numbers as CVS had to report a negative GAAP EPS due to goodwill impairment charges. While WBA could report an average EPS growth rate of 8.20%, CVS could report an average growth rate of 12.28% during the last decade when ignoring the 2018 fiscal results. And if we are ignoring the 2018 EPS once again, CVS also shows higher consistency and stability in its revenue and EPS growth.

(Source: Own work based on numbers from Morningstar)

Aside from growth metrics, we can also look at the company's margins. In both cases, we see slightly declining margins over the last few years, which is never a good sign. But while WBA's gross margin keeps declining, CVS could improve its gross margin in fiscal 2018 and the average gross margin for the last four quarters is 17.7% and, therefore, 230 bps higher than in fiscal 2017. When looking at average numbers during the last decade, WBA could report a higher gross margin (26.39% vs 18.13% for CVS), but CVS Health could report a higher operating margin (5.97% vs. 4.77% for WBA).

(Source: Own work based on numbers from Morningstar)

When looking at the return on invested capital, the numbers of both companies are more or less the same. The 10-year average RoIC was 10.97% for Walgreens Boots Alliance, while the RoIC for CVS Health was 8.52% and, therefore, a little lower.

When looking at the company's dividend, we see a pretty similar picture for both stocks. Although CVS Health Corp. had to keep its dividend stable in the recent past, the average annual dividend growth during the last decade was 23.47% for CVS Health, while Walgreens Boots Alliance could increase its dividend only 13.05% on average. Walgreens Boots Alliance, on the other hand, is a dividend aristocrat as it increased its dividend 42 years in a row. And with a dividend yield of 3.40% for Walgreens Boots Alliance compared to a dividend yield of 2.73% for CVS Health, Walgreens Boots Alliance could be more interesting for dividend investors.

(Source: Own work based on numbers from Morningstar)

Additionally, CVS could reduce its number of outstanding shares over the last decade and only in 2019 increased the number of outstanding shares again due to the acquisition of Aetna (not reflected on the chart above). Right now, CVS stopped its share buyback program until the debt levels are brought down to an acceptable level.

WBA

CVS

Dividend Yield

3.52%

2.80%

Payout Ratio

31.26%

28.43%

10year average dividend growth

13.05%

23.47%

P/E GAAP

13.21

21.01

D/E ratio

0.69

1.33

10year annual revenue growth rate

7.83%

9.63%

10year annual EPS growth rate

6.86%

3.73%

10year average gross margin

26.39%

18.13%

10year average operating margin

4.77%

5.97%

10year average RoIC

10.97%

8.52%

Aside from fundamentals, we can also compare the stock performance of the two pharmaceutical retailers.

ChartData by YCharts

Over the long term (since the beginning of January 1980), Walgreens Boots Alliance outperformed CVS Health Corp. in an impressive way and WBA would have been the better pick for a long-term investor. But when looking at the chart of the last three years, we see that both stocks behaved very similarly in 2017 and 2018, but in spring 2019, sentiment for CVS changed and in the last few months, we see a clear outperformance of CVS.

ChartData by YCharts

Outperformance of CVS

When trying to search for reasons why CVS outperformed WBA in the last few months, the extremely low valuation for CVS might certainly be a reason. When taking management's own guidance for this fiscal year (about $6.90 adjusted EPS), the stock was trading at a multiple as low as 8 and such low multiples are not justified for a company that is expecting to grow in the low double digits from 2022 going forward and some kind of reversion to the mean has to happen sooner or later.

(Source: CVS Health Investor Presentation)

Additionally, CVS Health Corp. made some good strategic decisions in the last few years. First of all, we have to mention the 53 HealthHUB locations CVS has right now and management plans to increase that number to 1,500 by the end of 2021. The company is replacing about 20% of its lower-margin retail floor space with higher-margin clinics. The overall goal is to bring customers to the stores for different reasons - filing a prescription, getting checked out or buying some beauty products. Once the customers are in the store, cross-selling opportunities might arise and the results of the last few quarters indicate, that it is working.

(Source: CVS Health Investor Presentation)

But CVS is not just rolling out its HealthHUB locations but also acquired Aetna - a company that is offering health insurance as well as dental, vision, and other plans - and this acquisition created a "healthcare powerhouse" which will not only have strategic advantages when competing with other major corporations but could also create synergy effects for CVS. Market participants seemed to be skeptical for quite some time (due to high debt levels and uncertainties if the deal was approved by the judge), but the market seems, finally, to value the deal and starting to price in the growth potential CVS clearly has.

The competitive advantage I also see for CVS Health is the fact that CVS is also a pharmacy benefit manager and this segment has a very wide economic moat. As pharmacy benefit manager, CVS Health is operating in an oligopoly with only three major companies operating in this space.

One might argue that Walgreens Boots Alliance can easily copy the strategy of CVS Health and be similarly successful, but that is only partially true. We have to admit that this part of CVS's business is not really protected by an economic moat and Walgreens could copy it in theory. But if Walgreens would try to copy the strategy, it would take several years for various reasons. First of all, CVS already had its MinuteClinic in more than 1,100 locations and the HealthHUB is building on these clinics and Walgreens has only about 370 Healthcare Clinic locations. Second, Walgreens Boots Alliance could also acquire a health insurance company, but this would increase the company's debt levels. Right now, WBA has about $10.6 billion in long-term debt and $6.2 billion in short-term borrowings. Compared to a total equity of $24.3 billion, this leads to a D/E ratio of 0.69, which is acceptable. When comparing the outstanding debt to the annual operating income of $4.5 billion (last fiscal year), it would take Walgreens Boots Alliance almost four years to repay the outstanding debt. These numbers are no reason to be worried, but a huge acquisition would be extremely problematic for WBA right now.

But not only CVS Health is investing in the future and making strategic decisions but Walgreens Boots Alliance is also doing that as well; however, the focus is a little bit different. When looking at the investor presentations of the last several quarters, Walgreens is focused, for example, on cost management and this could save about $1.5 billion annually until 2022. Management will focus on four aspects: Smart spend (i.e. energy management efficiency program), smart organization (additional HQ reductions in Mexico, Chile, and Thailand), divisional optimization (closures of stores and operating small format stores), and digitalization (implementation of new IT operating model).

(Source: WBA Investor Presentation)

Additionally, Walgreens is focusing on digitalization (an aspect that CVS Health and many other companies are also focusing on) and is accelerating its efforts. Walgreens' app was downloaded 60 million times (up 12% vs. last year) and on the Black Friday weekend, online sales increased 45% YoY. The total digitally initiated sales were about $3.7 billion for the last quarter and over $15 billion for the last fiscal year.

Another aspect management is focusing on are strategic partnerships like the partnership with Kroger. In the fourth quarter, management reported that the Kroger offer was extended to 50 Walgreens locations and Walgreens owned Health & Beauty brands are available in 17 Kroger locations. And according to the last earnings presentation, pilot stores are experiencing a strong sales lift.

In contrast to CVS Health, which is mostly focused on two major strategic initiatives - acquiring and now integrating Aetna in its business as well as rolling out its HealthHUB locations - Walgreens is rather focused on several smaller strategic initiatives. Examples are weight loss management programs in about 100 Walgreens stores or two of five VillageMD primary care locations opened in Houston. In the spring of 2019, management also reported that a small format concept was currently undergoing a testing phase. One of the three strategic priorities is to "create neighborhood health destinations" and as this is a similar goal as CVS is pursuing with its HealthHUB concept, the two major pharmaceutical retailers might not be so different after all. Walgreens might take only a path that is a little different and is maybe a few steps behind CVS.

(Source: WBA Investor Presentation)

Intrinsic Value Calculation

When looking at the performance during the last four decades, we see, on the one hand, that Walgreens Boots Alliance (and its predecessors) could increase revenue as well as net income between 12% and 13% annually every single year. But we can also see that growth slowed down and since 2010, revenue could "only" increase with a CAGR of 8.19% while net income reported a CAGR of 7.42%.

Since 1980

Since 2000

Since 2010

Revenue CAGR

12.21%

8.99%

8.19%

Net Income CAGR

12.92%

10.31%

7.42%

For the foreseeable future, management is expecting adjusted EPS to stay more or less flat in 2020, and after 2020, adjusted EPS growth is expected to be in the mid-to-high single digits (according to second quarter 2019 presentation).

To calculate the intrinsic value of Walgreens Boots Alliance, we will make several very cautious assumptions. As a basis, we take the free cash flow of fiscal 2019 ($3,892 million), which is the lowest number since 2014 and assume that Walgreens Boots Alliance will be able to keep its free cash flow stable in 2020 and 2021. Following these two years, we assume 5% annual growth until the end of the first decade. For perpetuity, we assume a moderate 3% growth rate and these assumptions lead to an intrinsic value of $67.63 for Walgreens Boots Alliance.

Positive Aspects

I made it very clear that I am optimistic about CVS Health and see it as the better investment of the two, but that doesn't mean I want to trash Walgreens Boots Alliance here. When looking at the numbers from above, Walgreens Boots Alliance is superior to CVS Health Corp in several aspects (like higher average gross margin and higher average RoIC during the last decade). CVS Health took some steps in the right direction in the last few years, but Walgreens Boots Alliance might be just a few steps behind and is getting punished right now as the strategic decisions are not showing results yet (as CVS was punished a few quarters ago as it traded in the low 50s). Both companies are the two major pharmaceutical retailers in the United States (with WBA having about 9,300 stores and CVS having about 10,000 stores) and I am pretty confident these two will survive the challenging retail environment we are seeing right now.

And considering the great long-term performance of Walgreens, its status as dividend aristocrat (increasing the dividend for 42 consecutive years) as well as a current dividend yield of 3.5% an investment in Walgreens Boots Alliance might make sense. And even when calculating with very conservative numbers, the stocks seem to be undervalued and trading about 30% below its intrinsic value. And one could also bet on a buyout by KKR & Co Inc. (KKR), which would be a chance for investors to sell Walgreens Boots Alliance at a premium (current buyout estimates see a premium of 50% compared to current prices).

And a final argument for Walgreens Boots Alliance can come from technical analysis. With the stock trading close to $50, it is supported by several strong technical indicators. We have the 200-month simple and exponential moving average at $51 and $53. We have former highs from 2000, 2005 till 2007 and 2011 between $46 and $50 and we also have the 38 Fibonacci retracement at $50.31.

(Source: Own work based on Traderfox)

Conclusion

In my opinion, CVS Health is still positioned better for the long-term and would be my favorite pick. But Walgreens Boots Alliance is a very close second and to achieve diversification, splitting a position and investing in both stocks could be a reasonable plan. Both companies are undervalued right now and good picks in an overvalued market.

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This article was written by

Daniel Schönberger profile picture
9.97K Followers
Part-time investor and contributor for Seeking Alpha since 2016. My analysis is focused on high-quality companies, that can outperform the market over the long-run due to a competitive advantage (economic moat) and high levels of defensibility. Focused on European and North American companies, but without constraints regarding market capitalization (from large cap to small cap companies). My academic background is in sociology and I hold a Master’s Degree in Sociology (with main emphasis on organizational and economic sociology) and a Bachelor’s Degree in Sociology and History.I also write about investing, economy and similar topics on Medium: https://medium.com/@danielschonberger

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.

Additional disclosure: I might open a position in WBA within the next few days.

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