Why We Like Walgreens, But at a Better Price

Walgreens WBA recently turned in strong fiscal second-quarter results and increased its earnings growth outlook for 2021 to the mid- to high single digits from the low single digits. We were already expecting growth in the midsingle digits, so we do not expect to change our fair value estimate. However, we appreciate the more positive trends at Walgreens in recent quarters, and it appears that new CEO Rosalind Brewer has the wind at her back as she takes the reins of this top-tier retail pharmacy.

During the quarter, Walgreens beat FactSet consensus on both the top and bottom lines. Including discontinued operations, the company turned in sales of about $37.6 billion, well above consensus of $36.4 billion. Comparable-store sales increased 2% in the United States in the quarter, as the company benefited from growth in its pharmacy operations while front-of-store operations declined slightly as the weak cold and flu season remained a key constraint on results. On the bottom line, though, Walgreens performed well. Strong international performance, better pharmacy margins than expected, solid cost management, vaccination tailwinds, and a lower-than-expected tax rate helped the company turn in $1.40 per share of adjusted earnings in the quarter (including $0.14 from discontinued operations and $0.40-$0.45 of estimated COVID-19 constraints), which beat consensus of $1.09. Free cash flow in the first half of the fiscal year also increased 5%.

Given these strong trends and expected momentum, management raised its bottom-line outlook for fiscal 2021. The company now expects mid- to high-single-digit adjusted earnings growth, up from only low-single-digit growth projected previously. Investors appeared to appreciate this positive momentum, which compares favorably with key peer CVS CVS. CVS only expects a roughly flat bottom line in 2021, despite its exposure to typically higher-growth segments than retail pharmacy, including medical insurance and pharmaceutical benefit management.

Narrow Moat Comes From Cost Advantage

Founded in 1901, Walgreens Boots Alliance is the leading pharmacy retailer, leveraging scale to provide convenience. The company generates approximately $140 billion in revenue and dispenses over a billion prescriptions annually, representing one fourth of the drug market. Its 9,000-plus domestic stores are strategically located in high-traffic areas to generate over $13 million per store, which drives scale and remains a critical consideration in an increasingly competitive market that has witnessed rationalization. The core business is centered on the pharmacy, which accounts for nearly three fourths of revenue and is considered the main driver of traffic.

Management has been focused on leveraging scale to foster strategic partnerships to increase traffic and cross-selling opportunities with a long-term focus to improve 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.

Walgreens’ significant scale has enabled it to foster meaningful partnerships. It has a differentiated ability to generate significant volume through convenient locations across the nation. The company dispenses over 1 billion adjusted prescriptions annually, accounting for nearly three quarters of overall sales. Each Walgreens location generates approximately $13 million in revenue (over $800 per square foot), which is notably better than even its closest peer, CVS, and roughly double the pharmacy average. The ability to drive incremental volume to any given average store is likely driven by the convenience-oriented concept and helped by macro trends, including the preference of the aging population to purchase prescriptions at physical locations while de-emphasizing mail order pharmacy. Scale allows the company 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.

Partnerships Are Key

Through strategic partnerships, Walgreens has consciously shared pricing information to improve transparency, drive traffic, and negotiate payer relationships. These complementary services also increase cross-selling opportunities. Key partnerships serve different purposes and include AmerisourceBergen, Prime Therapeutics, Kroger, LabCorp, Humana, United Healthcare, and VillageMD.

As an example, Walgreens’ beneficial distribution arrangement with Amerisource, which was extended through 2029, enables the company to optimize working capital while offsetting certain operational considerations to maintain quality. This distribution agreement includes higher service levels, including increasing inventory thresholds and direct delivery to Walgreens retail locations. This shifting of inventory to the distributor reduces the need for Walgreens to maintain central distribution centers, which significantly lowers overhead expense. This arrangement has also supplemented synergies for Walgreens Boots Alliance Development, a Swiss generic purchasing joint venture, by increasing generic volume from Amerisource customers. The combination of WBAD, AmerisourceBergen, and Prime Therapeutics manages roughly a third of generic drug volume, which is helpful in pricing negotiations and sourcing. Walgreens has nearly a 30% stake in Amerisource through the conversion of warrants into equity shares.

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

The company has conducted partnership trials whose 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 of Walgreens to obtain such pricing could improve cross-selling of front-end products, thus improving profitability. This trial was recently completed in Kentucky, a market where the grocer has a leading market share. Management will roll out similar store-in-store concepts with Kroger and others, ancillary services (lab and imaging), primary care clinics, and various other clinical services (audiology and optical) to improve the utilization of stock space that will no longer be needed with direct store deliveries from Amerisource. These initiatives are likely to foster increased foot traffic and possibly work toward long-term objectives of improved care coordination with a recently announced partnership with Humana and Advocate Health Care to offer primary care.

Lastly, Walgreens is considered a valued tenant by landlords and real estate investment trust, and it has significant negotiating leverage. This is especially important as the company leases most locations and many of its 15- to 25-year leases will need to be renewed in the near term. In our view, negotiated rates are likely to benefit Walgreens. Based on fully loaded retail rental rates of $35 per square foot, we estimate each dollar negotiated in favor of Walgreens would benefit the company by $150 million-$200 million annually. We do not believe these figures have been incorporated into company guidance but may possibly come into play in the long-term cost-saving initiative.

Changes in Reimbursement and Regulation Are Risks

We assign Walgreens a medium uncertainty rating. The company operates in a mature competitive market, where it has garnered significant share. The main risks are associated with reimbursement pressure from public and private third-party payers and any significant changes in federal or state drug regulations. The company is somewhat insulated from the rise of a new competitor, but any significant changes to the economy or market dynamics could pose a risk.

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

Walgreens’ international operations face 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 based on the country (Walgreens operate in 11 countries). Significant fluctuations in currency could negatively affect international operating results.

As of the first quarter of 2021, cash and equivalents were over $500 million, excluding the anticipated cash payment of $6.25 billion from AmerisourceBergen, offset by $15 billion in debt. Fiscal 2020 gross leverage was roughly 2 times adjusted EBITDA. The company continues to focus on its core assets, and the recently announced divestiture of its international wholesale business should allow it to pay down debt and fund strategic initiatives to improve its long-term positioning. We believe the company will be able to rebuild its cash balance through the normal course of business. Free cash flow generation was over $4 billion in fiscal 2020 and is expected to normalize in the near term.

Annual common stock dividends have averaged $1.7 billion over the past couple of years with forward yields of over 4%. Walgreens has repurchased over $15 billion worth of stock in the past four years, and management will likely continue to opportunistically repurchase shares.