Walgreens' Prescription for Growth

Founded in 1901, Walgreens Boots Alliance WBA is the leading pharmacy retailer, leveraging its scale to provide convenience. The company generates nearly $140 billion in revenue and dispenses over 1 billion prescriptions annually, representing one fourth of the drug market. Its 10,000-plus domestic stores are strategically located in high-traffic areas to generate over $13 million per store, which drives scale and helps the company to negotiate more effectively with suppliers. Scale remains critical in an increasingly competitive market that has witnessed some rationalization of subscale peers. The core business is centered on the pharmacy, which accounts for nearly three fourths of revenue and is the main driver of traffic. Management will need to pull through more volume in the recently acquired Rite Aid locations along with stores abroad as reimbursement stabilizes in Europe.

Management has been focused on leveraging scale to foster strategic partnerships to increase traffic and cross-selling opportunities with a long-term focus on improving coordinated care. Historically, the company’s strategy was based on footprint expansion, but having established a scalable infrastructure, the focus has evolved and the concentration has shifted to improving store utilization and strategically aligning with healthcare partners to address the macro trend of localized community healthcare. WBA has incurred most of the operating and capital investments to successfully complete numerous clinical and consumer packaged goods trials. The successful rollout of these initiatives has not been incorporated into guidance but should help offset continued reimbursement pressures.

Narrow Moat From Cost Advantage WBA has established significant scale, which has enabled it to foster meaningful partnerships and gain negotiating power with suppliers. WBA has a differentiated ability to generate significant volume through its convenient locations nationwide. It dispenses over 1 billion adjusted prescriptions annually, accounting for nearly three fourths of overall sales. Each WBA location generates approximately $13 million in revenue (over $800 per square foot), which is notably better than closest peer CVS' CVS $8.6 million and more than double the pharmacy average of $6.5 million. The ability to drive incremental volume to an average store is probably driven by the convenience-oriented concept, helped by having the best locations and regularly updated stores, coupled with macro trends, including the preference of the aging population to purchase prescriptions at physical locations while de-emphasizing mail order pharmacy. Scale allows WBA to leverage fixed costs (pharmacist and rent) more effectively than subscale peers, which has contributed to the declining market share of smaller independent pharmacies and deterioration of the third-largest competitor, Rite Aid.

Through strategic partnerships, WBA has consciously shared pricing information to improve transparency, drive traffic, and negotiate payer relationships. These services also increase cross-selling opportunities. Key partnerships serve different purposes and include AmerisourceBergen (distribution), Express Scripts (pharmacy benefit manager), Prime Therapeutics (specialty pharmacy benefit manager), Humana (payer), LabCorp (diagnostics), Kroger (grocer), United Healthcare (payer), and Optum (pharmacy benefit manager).

For example, WBA has favorable distribution terms in its contract with AmerisourceBergen that was extended through 2026, including 40 days for payment (compared with the market norm of 15 days or 20 days for the closest peer). This enables the company to optimize working capital. Further, WBA accounts for a third of AmerisourceBergen’s revenue and is charged an average fee of 40 basis points versus 60 basis points for the closest peer, as noted in Drug Channels research. This distribution agreement also covers higher service levels, including increasing inventory thresholds and direct delivery to WBA’s retail locations. This shifting of inventory to the distributor reduces the need for WBA to maintain central distribution centers, which significantly lowers overhead expense. This arrangement has also supplemented synergies for WBAD, a Swiss generic purchasing joint venture, by increasing generic volume from AmerisourceBergen customers. The combination of WBAD, AmerisourceBergen, Prime, and the recent acquired Rite Aid stores manages roughly a third of generic drug volume, which is helpful in pricing negotiations and sourcing. WBA has about a 26% stake in AmerisourceBergen through the conversion of warrants into equity shares.

WBA’s scale has provided the ability to establish strategic partnerships to enhance store traffic as well. One example is the partnership with Prime Therapeutics to form AllianceRx, the third-largest specialty provider. This arrangement has complemented the focus on limited-distribution and specialty drugs, a key driver in overall drug spending (and a significant component of Food and Drug Administration drug approvals). Through this partnership, WBA won a sizable specialty contract with the Blue Cross and Blue Shield Federal Employee Program away from incumbent CVS; this contract was estimated at $3 billion in 2017. As a result, we estimate WBA generates annual specialty revenue of over $20 billion, representing nearly a third of the specialty market.

The company has conducted partnership trials and the costs have been reflected in operating results, but none of those benefits have been included in future periods. Such key partnerships include Kroger and LabCorp. Kroger has strong pricing leverage for consumer packaged goods, and the ability for WBA to obtain such pricing could improve cross-selling of front-end products and thus improve profitability. This trial was recently completed in Kentucky, where grocer has a leading market share. WBA will roll out similar store-in-store concepts with Kroger and others, ancillary services like lab and imaging, primary-care clinics, and various other clinical services such audiology and optical to improve the utilization of stock space that will no longer be needed, given direct store deliveries from AmerisourceBergen. These initiatives are likely to foster increased foot traffic and possibly work toward the improved care coordination long-term objectives with the recently announced partnership with Humana and Advocate Healthcare to offer primary care.

Lastly, WBA is considered one of the most valued tenants by landlords and real estate investment trusts and has significant negotiating leverage. This is especially important because WBA leases most locations and many of the 15- to 25-year term leases will need to be renewed in the near term. In our view, negotiated rates are likely to benefit WBA. Based on a sensitivity analysis of market rates (fully loaded retail rental rates of $35 per square feet), we estimate each dollar negotiated in favor of WBA would benefit the company by $150 million-$200 million annually. We do not believe these figures have been incorporated into management’s outlook but may possibly come into play in the long-term cost-saving initiative.

The company’s scale has been instrumental in steadily expanding quarterly market share (19% in November 2014 to 22.3% in February 2019) and supporting double-digit returns.

Medium Fair Value Uncertainty Rating WBA operates in a mature, competitive market with significant share. Its main risks are associated with reimbursement pressure from public and private third-party payers, a shift in mix toward 90-day prescriptions and Medicare Part D, increases in the cost of procurement of pharmaceuticals, and significant changes in federal or state drug regulations. The company has a significant market share, so the entry of a new competitor is unlikely, but any significant changes to the economy or market dynamics could pose a risk.

Further, the decrease of utilization of drugs--driven by slower new drug introductions, fewer alternative generic options, or formulary constraints by the pharmacy benefit manager--would affect management’s ability to leverage the significant fixed costs of maintaining stores with high rent and staffing them with pharmacists. WBA may also be affected by the consolidation of healthcare companies and providers, which could influence where prescriptions are filled.

In its international operations, WBA faces all the same risks associated with reimbursement, mix, cost of procurement, competitive positioning, entry of new competitors, and decreasing utilization, but each of these risks would vary by region; WBA operates in 25 countries. Lastly, significant fluctuations in currency could hurt international operating results.

As of fiscal 2018, the company has nearly $1 billion in cash and equivalents, offset by $14 billion in debt with a debt/capital ratio of 36%. Fiscal 2019 gross leverage is nearly 2 times adjusted EBITDA. Even though a significant portion of its cash balance was used for the acquisition of approximately 1,900 stores from Rite Aid, it does not appear that WBA will need to issue new debt. We believe the company will be able to rebuild its cash balance through the normal course of business. Free cash flow generation was $2 billion in fiscal 2018 because of the transaction, but we expect it to return to normalized levels of $6 billion in 2020.

Annual common stock dividends have averaged $1.7 billion over the past couple of years with forward yields of over 3%. WBA has repurchased over $10 billion worth of stock in the past couple of years, and management has indicated plans to repurchase $700 million worth through the balance of the fiscal year. Longer term, management expects to purchase roughly $1.7 billion annually.