Walgreens: Healthcare Segment Growth Potential May Not Offset Overall Weak Margin
Summary
- Recent healthcare acquisitions in the US provide rapid entry into the retail healthcare space with great potential in the coming years.
- Heavy costs and expenses drag on the margin don't show signs of improvement.
- Operating cash flow at risk of further declining.
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Investment Thesis
Company Overview
Walgreens Boots Alliance (NASDAQ:WBA) is an integrated healthcare, pharmacy, and retail store chain, founded in 1901 and headquartered in Deerfield, Illinois. It has over 13,000 locations worldwide, with portfolio retail and business brands including Walgreens, Boots, and Duane Reade. Its operations are conducted through three reportable segments, US Retail Pharmacy, International, and US Healthcare.
Strength
Walgreens' rapid spending in healthcare aims at the company's transformational goal - leveraging its current system and pharmacy network to deliver value-based healthcare clinics. After its recent acquisitions of Shields, VillageMD, and CareCentrix, its healthcare portfolio includes pharma, pre-acute and post-acute care, primary care, and specialty care.
Walgreens US Healthcare Segment Portfolio (From Company Presentation)
This transition makes logical sense as the company looks for growth drivers. 2022 was the first year the company started to report in its 10-k with healthcare as a business segment in its sales breakdown. By Feb 28, 2023, US healthcare's 6-month sales have grown 4x in YoY comparison, from $577 million to $2.6 billion. If we annualize it, there would be $5.24 billion per year.
Walgreens 6 months Sales Breakdown by Segment (Calculated and Charted by Waterside Insight with data from company)
Before being acquired by Walgreens, Shields Health's estimated revenue was $2 billion per year, VillageMD was about $1.3 billion, and CareCentrix was roughly $1.5 billion before Walgreens acquired them. Totally that will be in the range of $4.8 billion. The full acquisition of Shields closed in December 2022, VillageMD's acquisition of Summit Health, which is one of its competitors, closed in January, and CareCentrix is expected to close in Q3. So in all, these newly acquired assets together will have 5.2 billion in sales by then. We estimate that will add another 30% to the total US Healthcare segment sales by Feb 2024. By the current estimates on a pro forma sales growth basis, VillageMD is expected to deliver 30-38% of YoY growth, counting the added lives from Summit Health and CityMD, Shields with 40%, and CareCentrix with 25% of growth. Then a weighted average growth of all the main US healthcare segment sales drivers will produce about 34% pro forma growth YoY. That is something we will factor in when valuing the stock.
Outside of its topline growth, Walgreens' gross profit has maintained at its higher level within a range since 2016, while net income has recovered from a recent sharp slump.
Walgreens Quarterly Net Income vs Gross Profit (Calculated and Charted by Waterside Insight with data from company)
In the meantime, the company has dialed back its inventory, dropping by a large portion compared to its peak in 2020, while as a percentage of revenue, its inventory has reached the lowest level.
Walgreens Inventory Analysis (Calculated and Charted by Waterside Insight with data from company)
Weakness/Risks
Walgreens' free cash flow decline doesn't seem to halt soon. The company has two strikes against it: both the decline in operating cash flow and the rise of capital expenditure. One can almost say its free cash flow is behaving as if it has just experienced a recession, because the difference between the two is approaching its historic level immediately post 2008. But the recession hasn't even officially started yet. To generate a better free cash flow, it needs to halt the trend in one or both of them. Without organic changes internally, if the company relies on recession-induced lower costs, then it might have lower operating cash flow as well. It's hard to see a sustained clean win in the near term. If zooming into its most recent operating cash flow, for the six months ending on February 28, 2023, its net earnings were negative $3.3 billion, with an increase of deferred income taxes liability of $1.6 billion, a modest decline of $221 million account receivables and a sharply higher $1.28 billion of account payables. The largest provision to its operating cash flow was $6.8 billion of accrued litigation obligations. Had it not been for the cash saved up for the legal issues, it would have had an operating cash flow of negative $5.56 billion in the last six months, which is almost equal to the full-year positive operating cash flow it attained in 2020. That will deeply push its free cash flow into the red. One thing is evident; it is not yet turned around the corner in snapping out of this declining trend.
Walgreens Capex vs Operating Cash Flow (Calculated and Charted by Waterside Insight with data from company)
On the other hand, its net cash flow also has been trending lower. Although the recent acquisitions of almost $6.8 billion in 2022, which was the largest acquisition spending in its history, were mostly to blame for this decline in net cash flow, the trend is still worrying as it started in 2019 and continues.
Walgreens Cash Flow Anlaysis (Calculated and Charted by Waterside Insight with data from company)
From the margin's perspective, its gross profit margin and EBITDA margin have dropped to the lowest level, with the latter ever close to zero. As the company described, some of the lower revenue and subsequentially lower gross profit in 2022 than in 2021 were due to the "COVID-19 headwind". This is a bit of a head-scratcher to us, as Covid is a rare event, and the boost in 2021 shouldn't be counted as usual. What it shows is actually the fading away of the boost effect, and its gross profit margin reverted to how they were pre-pandemic, only that its EBITDA has worsened.
Walgreens Margin Analysis (Calculated and Charted by Waterside Insight with data from company)
One of the reasons for these margins to be vulnerable is the costs and expenses. Its cost of revenue plus operating expenses is almost equal to its revenue, which already came down from its earlier highs of 1.2x. They have always been as high as around 95%. But since the pandemic, this level has reached a new range higher. If the normalization of the Covid boost effect continues, we are curious to see if the costs and expenses will also come down.
Walgreens Costs and Expenses Analysis (Calculated and Charted by Waterside Insight with data from company)
Although Walgreens is the second largest pharmacy, only to CVS, in the country, other players are also keen on disrupting the traditional healthcare model. Walmart (WMT), Amazon (AMZN), and CVS (CVS) have all made their respective acquisitions and partnership with other smaller network and care providers. It is yet to be seen how the landscape will turn out in a few years' time.
Financial Overview
Walgreens Financial Overview (Calculated and Charted by Waterside Insight with data from company)
Valuation
Based on our estimates of its newly acquired US healthcare portfolio's growth of 34% YoY, we projected it statically forward by assuming no growth in Pharmacy and International segments. It can be seen that the contribution grows from 2.5% to eventually 12.8% of the total sales. Considering the heating-up competition, we believe this is an optimistic scenario for the US healthcare's topline growth.
Walgreens US Healthcare Segment Static Growth Projection (Calculated by Waterside Insight with data from the company)
Certainly, this is an overly simplified estimate. In reality, not only is the topline growth non-static, but its bottom line growth would be even more volatile considering the company's high costs-and-expenses ratio, as mentioned earlier.
We consider all the analysis above and use our proprietary models to assess Walgreens' fair value by projecting its growth prospects ten years ahead. We use a cost of equity of 5.75% and a WACC of 8.6%. In our bullish case, Walgreens has a continuation of weaker margins in '23 and '24, followed by a strong recovery with a normalized growth rate in mid to high single-digit growth in later years; it was valued at $43.12. In our bearish case, the company's weaker growth further extended into '24, and the immediate recovery after that wasn't as rapid and strong; it was valued at $30.82. In our base case scenario, it registered a weaker margin of '23 and '24, and a strong recovery, but the competition's dilution to its US healthcare growth started to kick in after about 4 years; it was valued at $39.70. The current price is a bit toward the bearish side.
Walgreens Fair Valuation (Calculated and Charted by Waterside Insight with data from company)
Conclusion
Walgreens as the second largest pharmacy retailer in the country has been going on an acquisition spree to join in the disruptive force to change the retail healthcare space. It is not only a logical move in search of growth but could have strong potential in the long term. However, the company's fundamental obstacle in unlocking its value still stemmed from its high costs and expenses overall. We can see its transformation goes through producing profits and sales growth, but the drag on the margin will not be improved within a year or two, considering the macro headwinds on top of covid boost fading away. Although the stock appears inexpensive, we recommend a hold on the sideline.
This article was written by
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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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Comments (16)
Management is trying to buy their way out of a rut with acquisitions. But the company is too big to be significantly affected by even a successful acquisition, and the company aready has the problem that it is too huge to be easily manageable. They should pursue the improvement of internal efficiencies. Operating improvements might distance them from the ultimate fate of bankruptcy.
I don't believe the author comments share buybacks, but that issue is mentioned in other articles ; a dumb thing to do : as a shareholder why do I want management to use my money to buy more of this low-growth, low-margin retail operation? And in any case buybacks are a shell game : on paper it results in perceived better earnings per share. But that is achieved at the expense of a weakened balance sheet as it means the company is financed by more debt and less equity.
