- The market rally has left Walgreens behind in deep-value territory.
- Walgreens continues to see growing demand as evidenced by its growing sales.
- Margin pressures will eventually stabilize, and the company will benefit from the long-term growth trend in healthcare spend.
- Walgreens is transforming itself into a localized community healthcare provider of goods and services, which will benefit the company long-term.
With the market having mostly recovered from the pandemic-induced drops in March and April, it would seem that everything is back to normal. However, there are still widely dislocated sectors with the most obvious ones being the hospitality, airline, and banking industries.
While those industries are understandably challenged in the near to medium term, amidst the rubble are some stocks that have been unfairly lumped into the underperformance category, and Walgreens (NASDAQ:WBA) is one of them. I believe the stock is set for market-beating returns at the current overly pessimistic valuation today due to its transformational efforts and macro-health trends.
(Source: Drug Store News)
Shares Have Vastly Underperformed
Walgreens has vastly underperformed against the S&P 500 over the last six months. As seen below, the market recovery that began in April has left Walgreens shares in the dust, with shares underperforming by a wide 25%. Not only that, but it has also underperformed its peer CVS Health (CVS) by 16%.
(Source: Yahoo Finance)
While it may seem based on the chart above that all is doom and gloom for Walgreens, I believe that is simply not the case, as the company has a number of things going for it.
Over-Pessimism Is Not Justified
Walgreens actually grew its revenues at 4.1% on a constant-currency basis, suggesting that demand for its stores and services is not waning.
(Source: Company Presentation)
What's likely drawing the ire of the market is the 12% decline in operating income that it experienced. While management noted that it was partly due to the trend of lower pharmacy gross margins, it was also attributed to one-time impacts that are not expected to be repeated.
(Source: Company Presentation)
Looking past fiscal 2020 and into the future, I expect the company's Transformational Cost Management Program to start bearing fruit, as management has communicated that it is on track to deliver in excess of $1.8 billion in annual cost savings by fiscal year 2022.
Doing some back-of-the-napkin math, by applying the 1.8 billion in savings against the $25.3 billion in operating expenses for the trailing 12 months, I calculate that this could generate a significant 7% in annual recurring earnings contribution on a like-for-like constant basis.
I expect pharmacy gross margins to stabilize at some point. Although it's difficult to predict exactly when that will happen, I expect profitability to increase at a strong clip when a base does form. That's because according to CMS, national healthcare spend is projected to grow at an average rate of 5.5% per year through 2027 and reach an astounding $6.0 trillion by 2027. This puts healthcare spend on pace to grow at 0.8 percentage point faster than the US GDP, resulting in 1 in 5 dollars of the GDP being healthcare related within a decade.
I also expect Walgreens to be one of the key beneficiaries of this trend, especially as it transforms its physical stores into an integrated and localized community healthcare delivery model. This is evidenced by its five VillageMD locations that are currently open and the partnership with insurance juggernaut UnitedHealth Group (UNH) on opening up to 14 resource centers.
In addition, LabCorp is now operating in 109 Walgreens sites across 12 states. For Walgreens, I see these examples as both a participation in the healthcare growth trajectory and as a defensive move against online competition.
On the retail front, I like the new formats that management is developing, such as the 50 pilot Kroger Express (KR) stores format, which provides an ambient atmosphere and sells a broader range of groceries including fresh produce. This helps to further the "essentialness" of Walgreens locations, even after COVID, as a staple for the communities that it operates in.
Lastly, share buybacks continue to be an integral part of investing in Walgreens, as buybacks contributed 1.7% to earnings growth since August of last year. For comparison, share buybacks in the prior fiscal year reduced the share count by 6%. While repurchases are down from last year due to COVID uncertainty, I like the fact that the company is getting a much better ROI for shares bought this year due to depressed prices.
One risk for Walgreens is its international footprint, which saw a 1.7% revenue decline in the latest quarter. Its market share in the UK is holding steady, but management noted that the overall UK retail segment is in decline, which gives pause for concern. This is mitigated by the fact that the international presence represents just 8.5% of the total company revenue based on the latest quarter.
Another risk comes from continued pressures on reimbursements and pharmacy margins. Although I expect these pressures to stabilize at some point, and eventually offset by the long-term growth trajectory in healthcare spend, it is something investors should be watchful of.
Lastly, e-commerce from the likes of Amazon's (AMZN) PillPack presents an ever-present threat, especially if Walgreens' digitization and transformation efforts do not ramp up fast enough to offset these pressures.
Walgreens has been undeservedly left behind by the market rally. Its revenue continued to grow, and I expect margin pressures to eventually stabilize and for profitability to grow in the coming years as healthcare spend takes an increasingly higher share of the GDP. I'm encouraged by the transformational efforts that management has undertaken on its operations and on the transition to a localized community healthcare provider model.
The dividend currently sits at a historically high 4.4% at a safe payout ratio of just 33%. I'm also encouraged by management reiterating its commitment to growing its dividend every year on the latest earnings call.
I view shares as being highly undervalued at the current price of $41.40 with a PE ratio of just 7.4. At this valuation, the market is essentially pricing in a no-growth to negative earnings growth scenario into perpetuity, which I do not believe is the case for Walgreens. I have a price target of $55 per share, which brings the PE ratio to a more reasonable 9.8 and represents significant upside from today's levels.
(Source: F.A.S.T. Graphs)
This article was written by
I'm a U.S. based financial writer with an MBA in Finance. I have over 15 years of investment experience, and generally focus on stocks that are more defensive in nature, with a medium to long-term horizon. My goal is to share useful and insightful knowledge and analysis with readers. Contributing author for Hoya Capital Income Builder.
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in WBA over 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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