Walgreens Boots Alliance (WBA): A Dividend Aristocrat Held by Bill Gates

With 41 straight years of dividend increases, Walgreens Boots Alliance (WBA) is a favorite among many dividend growth investors and a member of the select group of 51 dividend aristocrats in the S&P 500.

 

The stock is even a holding in Bill Gates’ dividend portfolio here.

 

Let’s take a closer look at what has made Walgreens such a great business, one marked by very fast dividend growth (13.4% annual payout growth over the last 30 years), and see if this defensive stock is likely to continue generating double-digit total returns in the years to come.

 

Walgreens’ stock has trailed the S&P 500 by more than 10% over the past year and trades at a discount to the broader market, so today is a good time to review this potentially undervalued dividend aristocrat for a diversified dividend growth portfolio.

 

Business Overview

Founded in 1901 (but with roots going back to 1849) in Deerfield, Illinois, Walgreens Boots Alliance is now one of the world’s largest pharmacy retailers and drug distributors, operating what is soon to be 15,400 stores in 12 countries under the Walgreens, Duane Reade, Boots and Alliance Healthcare brands.

 

And when you factor in Walgreens’ equity stakes, its overall global presence rises to more than 25 nations.

 

 

In addition, the company’s wholesale pharmacy business operates 390 distribution centers around the world, serving over 230,000 pharmacies, doctors, health centers, and hospitals in more than 20 countries.

 

The company has three business segments:

• Retail Pharmacy USA: 71.4% of fiscal 2016 revenue
• Retail Pharmacy International: 11.3% of revenue
• Pharmaceutical Wholesale: 19.3% of revenue

 

Walgreens sources its drugs from AmerisourceBergen (ABC), of which it owns a 24% equity stake (and one board seat).

 

Business Analysis

The retail pharmacy and wholesale drug distribution business is hardly a wide moat industry. There are few noticeable differences inside of a Walgreens or CVS store, which causes companies in the industry to compete largely on price, brand recognition, and convenience of store locations.

 

There is massive competition in the form of mega rivals such as CVS Health (CVS), and most of the 740.1 million prescriptions that Walgreens filled in the U.S. last year were paid for by Pharmacy Benefit Managers, or PBMs.

 

Meanwhile, most prescriptions overseas are handled by government organizations, and so whether private or public, ultimately Walgreens is facing large counterparties that have massive incentives to drive down drug costs.

 

However, despite these challenges, Walgreens, thanks in large part to growth through acquisitions, has been able to generate very strong sales growth and even more importantly, free cash flow (what ultimately pays the dividend) increases over the years.

 

 

And while it’s true that margins and returns on shareholder capital have been declining in recent years, Walgreen’s management has done an admirable job of using its massive size to generate economies of scale that result in some of the industry’s top profitability.

 

Walgreen’s Trailing 12-Month Profitability

 

There are two main drivers behind Walgreens’ success.

 

First, the company has proven itself highly successful at consolidating rivals that help it to maximize economies of scale, such as:

• Acquiring Duane Reade for $1.1 billion in 2010
• Buying a 45% stake in Alliance Boots in 2012, followed by the rest of the company in 2014 to become the world’s #1 generic drug buyer and achieve $1 billion in cost savings as a result
• The recently announced acquisition of 2,186 pharmacies from Rite Aid (RAD), about half its stores, for $5.5 billion, with anticipated annual cost synergies of $400 million

 

After this latest acquisition, Walgreens will have over 10,000 U.S. stores that reach 75% of the population, and its global store base will further dwarf all of its rivals outside of CVS.

 

 

Convenient store locations have helped Walgreens generate one of the top 100 most powerful brands in the world and make it an obvious shopping choice for many consumers who need to refill subscriptions, driving traffic into its store to sell other high-margin merchandise.

 

The company’s extensive store base also benefits from lengthy operating histories that date back to the early 1900s for Walgreens and 1849 for Boots Alliance.

 

Besides convenience for consumers, scale is especially important in this commoditized industry due to the building amount of pressure to take costs out of the healthcare system.

 

Falling government reimbursement rates for prescriptions and consolidation throughout other parts of the healthcare chain are putting pressure on players such as Walgreens to take costs out of their businesses.

 

By acquiring other drugstores, Walgreens gains significant cost synergies from procurement savings on the purchase of drugs and merchandise. With more than 740 million prescriptions filled last fiscal year, Walgreens is one of the biggest purchasers of prescription drugs and healthcare products.

 

As such, the company can offer customers lower costs compared to its smaller rivals. Its 2013 supply deal with distributor AmerisourceBergin is one example of the favorable contracts a company of Walgreens’ size can attain. Smaller retail pharmacy companies will become increasingly uncompetitive as their scale becomes even smaller compared to Walgreens.

 

In addition, like CVS, which has a thriving PBM business, Walgreens is also breaking into that industry with the recent $720 million collaboration with Prime Therapeutics, America’s fourth largest PBM, in order to create AllianceRx Walgreens Prime.

 

AllianceRX has already proven that it’s capable of playing in the big leagues, having won two contracts to serve Tricare, a DOD health plan, from CVS in November 2016.

 

These acquisitions allowed Walgreens to increase its market share by 1.1% to 20.5% in fiscal Q3 of 2017, and thus achieve the kinds of economies of scale that allowed it to convert consolidated 2.1% sales growth into adjusted EPS growth of 12.7%.

 

In addition to growth, Walgreens is focusing strongly on cost cutting, including through:

• a generic drug sourcing joint venture between itself, AmerisourceBergen, Rite Aid, and ExpressScripts (ESRX).
• a corporate restructuring it calls Cost Transformation Program ($700 million in annual savings, not counting Rite Aid acquisition by end of 2017)
• a 10-year supply agreement with Fareva to take over the manufacturer of the company’s numerous beauty brands and private label products

 

Going forward, Walgreens is also attempting to use technology to further improve its cross marketing to customers via a multi-channel approach (online + traditional retail), through things like the refill by scan app and online customer service surveys (via Apple and Google App stores).

 

For example, according to Deepika Pandey, Group Vice President of Customer Experience, Direct and Digital Marketing, customers who engage Walgreens via online (70% of customers) and mobile (50% of customers) channels are 3.5 and six times more profitable to the company, respectively.

 

In other words, Walgreens is investing heavily in technology to not only help it manage its data, inventory, and cost cutting efforts, but to attempt to build brand loyalty and thus better compete with rivals, including disruptive threats such as Amazon (more on this in a moment).

 

Key Risks

There are four main risks to remember before investing in Walgreens.

 

The first is that this is a highly mature and slow growing industry, especially in the markets in which Walgreens operates (mostly the U.S. and Europe).

 

Therefore, growth through consolidation is very important; however, because Walgreens is already such a dominant player, regulatory approval for further acquisitions might be harder than in the past.

 

For example, back in 2015 Walgreens initially offered to pay $17.2 billion (including debt assumption) to acquire Rite Aid outright.

 

However, the Federal Trade Commission had major misgivings about the deal on antitrust grounds, and even with Walgreens offering to sell 1,200 stores to rival Fred’s Inc (FRED), the deal has now been abandoned in lieu of a smaller acquisition of only 2,186 Rite Aid stores. The failure of this deal resulted in Walgreens paying Rite Aid a $325 million breakup fee.

 

However, even that deal needs regulatory approval, and as one analyst mentioned on the company’s most recent conference call, there is still a lot of state level overlap for the stores Walgreens is attempting to buy, which is primarily what the FTC was concerned about.

 

In other words, after a lengthy 22-month process (FTC review still not done), Walgreens’ shareholders are out $325 million with nothing to show for it, except a potentially smaller growth deal that could still be blocked (and result in yet more break up fees).

 

Even if the deal is approved, Walgreens plans to buy the stores over a six-month period, meaning that investors will be waiting even longer for the boost to the bottom line.

 

And it’s not just U.S. regulators Walgreens needs to worry about. For example, in the most recent quarter, constant currency UK pharmacy sales were down 0.4% due to decreased pharmacy funding from the UK’s National Health Service.

 

This exemplifies another major risk for all large pharmacy chains, specifically that concerns over fast-rising medical costs, especially for drugs, could (and are) causing governments and PBMs to demand lower prices that could hurt Walgreens’ sales and margins.

 

 

While Medicare and Medicaid, which represent 21% of Walgreens’ U.S. drug sales, don’t yet negotiate bulk purchases, future regulations could easily change that since it represents relatively low-hanging fruit for saving the government money.

 

Changes in Medicare and Medicaid funding and continued consolidation throughout the entire healthcare chain could pose unexpected challenges to Walgreens’ pharmacy operations. Margins could be compressed, or competition from low-cost retailers such as Walmart could increase and take away some store traffic.

 

And of course, we can’t forget that PBMs (which are also consolidating and gaining greater pricing power) are also highly interested in cutting costs to the bone, which has resulted in various medical distributors, such as Cardinal Health (CAH), aggressively reducing guidance and causing its share price to plunge up to 12% in a single day.

 

The third major risk to consider is the limited moat of this industry. Specifically, Walgreens is acting primarily as a middleman, with the majority of profits coming from servicing prescriptions.

 

However, recently Amazon (AMZN), the bane of the brick-and-mortar retail world, has announced it is considering getting into the retail pharmacy industry, where it believes its focus on low cost and maximum convenience can win it a lot of market share.

 

While Walgreens’ loyalty card program has about 103 million members, should Amazon decide to go full bore into pharmacy retail, Walgreens could find that it’s customer loyalty collapses in the face of Amazon’s far superior Prime program, which analysts estimated had 65 to 80 million members at the end of 2016 (and growing quickly).

 

The bottom line is that the pharmacy industry (which makes up 66% of Walgreens’ overall sales) is undergoing massive shifts right now, and Walgreens is racing to achieve sufficient volume and technological scale to avoid a race to the bottom on profits that could be a major impediment to future profit and dividend growth.

 

Finally, we can’t forget that because Walgreens operates in so many countries (including recent store openings in South Korea), it has a fairly high degree of currency risk, especially from a strong dollar that can result in slower reported growth in sales, earnings, and cash flows over short periods of time.

 

For example, in the last quarter, over half of Walgreens’ reported sales growth was eaten away by negative currency swings, especially the decline of the British Pound (due to concerns over Brexit).

 

Walgreens’ Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

 

Walgreens has a Dividend Safety Score of 100, indicating a rock solid payout, which is what you would expect from a company that has raised its dividend every year since 1976.

 

 

Walgreens’ solid Dividend Safety Score is primarily supported by three factors.

 

First, the retail pharmacy industry is highly defensive, meaning that even in recessions sales, earnings, and cash flows remain relatively stable and predictable. In fact, Walgreens’ sales and free cash flow grew each year during the financial crisis.

 

Second, management has been highly disciplined about growing the dividend inline with EPS and FCF per share, ensuring low payout ratios that essentially guarantee that the dividend is protected by a large safety buffer (funded three to four times over) during any given year.

 

 

Finally, Walgreens’ dividend is secured by a strong balance sheet, marked by low relative net debt levels and a current ratio (short-term assets/short-term liabilities) that’s well over one.

 

 

When we compare the company’s debt metrics to its peers in this capital intensive industry, we can see just how strong Walgreens really is.

 

 

For example, Walgreens boasts a below average leverage ratio (Debt/EBITDA), as well as a low debt/capital ratio. Combined with a high interest coverage ratio, this gives it an investment-grade credit rating that allows it to borrow cheaply (average interest rate 4.7%) to help fund growth through acquisitions while still delivering highly secure and steadily growing dividends that investors have come to expect.

 

While the company’s large acquisitions have increased risk, the company’s consistent cash flow generation reduces some of the concern and easily protects the dividend.

 

Overall, Walgreens’ dividend appears to be very safe for several reasons. The company sells recession-resistant products, maintains low payout ratios, generates predictable free cash flow, and has a reasonable balance sheet. Its iconic brand and convenient store locations will likely continue to serve it well for many years to come.

 

Walgreens’ Dividend Growth

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

Walgreens has a Dividend Growth Score of 80, indicating investors can likely expect above average (relative to S&P 500’s 20 year median dividend growth rate of 5.9%) payout growth in the coming years.

 

That shouldn’t be a surprise given that, except for the last few years of relatively slow growth, Walgreen’s has generated decades of double-digit payout increases.

 

 

While shareholders shouldn’t necessarily expect the same kind of torrid pace of the last decade, Walgreens’ 6% to 7% long-term sales growth, courtesy of ongoing acquisitions and growing demand for prescription drugs from an aging population, ongoing cost cutting, and aggressive buybacks (management just authorized another $5 billion to this purpose) could deliver close to 10% to 11% annual EPS and FCF per share growth.

 

Combined with the low payout ratios, this means that 10% to 11% long-term dividend growth could be realistic and still in line with the company’s historical growth rates. Walgreens may opt for somewhat slower payout growth over the short-term as it restores its balance sheet, which was stretched to finance some of its deals in recent years.

 

Valuation

Over the past year, Walgreen’s shares have underperformed the S&P 500 by approximately 15%. However, this creates a potentially appealing buying opportunity.

 

For example, Walgreen’s forward P/E ratio of 15.0 is much lower than the S&P 500’s 17.4, as well as the industry median of 20.2 and the stock’s historical norm of 19.1.

 

Walgreens’ dividend yield of 1.9% is about in line with the market’s 1.9% and industry median of 2.0%, but it is nearly double the company’s 22-year average yield of 1.2%. In fact, over the past two decades Walgreen’s has only offered a higher yield about 14% of the time.

 

Of course, for some investors, such as retirees currently living off dividends, this may not yet be high enough to meet your needs. Our high dividend stocks list is a better source of ideas.

 

But for investors focused more on long-term total returns, Walgreens’ stock offers potential for annual total returns between 11.9% and 12.9% (1.9% dividend yield plus 10% to 11% annual earnings growth), assuming everything goes as planned.

 

Conclusion

While the pharmacy industry is sure to undergo massive transitions in the coming years and decades, Walgreens’ proven management team, safe dividend, impressive scale, and secure balance sheet should help it continue enriching income investors for many years to come.

 

With Walgreens’ shares trading at some of their most attractive levels in years, today could represent an interesting time to give this future dividend king closer consideration.

 

However, investors need to keep in mind that Walgreens could end up looking cheap for a reason. From changing government-funded reimbursement models to the continued rise of Amazon, the entire distribution chain that delivers drugs from manufacturers to patients is rapidly evolving and under different pressure points.

 

Walgreens certainly appears to have a number of competitive advantages to help it adapt and seems to be in a much better spot than its smaller rivals (including CVS), but it’s important to maintain a well diversified dividend portfolio.