Walgreens' Dividend Remains Safe But Pandemic Increases Growth Challenges

Walgreens Boots Alliance reported earnings on July 9, providing a closer look at the pandemic's impact on its business.

From March through May, Walgreens' sales actually increased slightly but the firm's adjusted EPS fell 43%.

In its core Retail Pharmacy USA segment (about 75% of profits last year), same-store sales grew 3% as consumers continued snapping up essential items.

However, a surge in lower-margin home deliveries, a shift away from more profitable discretionary retail goods, and higher costs to clean stores and pay employees ate into margins (adjusted operating income slumped 38%).

Walgreens' Retail Pharmacy International business (11% of profits), which consists mostly of Boots (a pharmacy-led health and beauty retailer in the UK), was hit especially hard.

Retail same-store sales slumped 48% as some of its stores were forced to temporarily close, leading management to take a $2 billion impairment charge in recognition of Boots' weaker outlook. (Walgreens acquired Alliance Boots for $22 billion in two stages, closing the final deal in 2014.)

This business swung to a loss due to the high fixed costs of brick-and-mortar retail and the jump in e-commerce sales, which are less profitable due to higher fulfillment costs.

Overall, in its fiscal year ended August 2020, Walgreens estimates COVID-19 will reduce its sales by about 1% and its adjusted EPS by nearly 20%.

Investors sent Walgreens' shares falling as much as 10% on the news, pushing the stock's dividend yield to nearly 5%.

Is Walgreens' dividend still safe? We think so.

Despite one of the most challenging quarters in the company's history, Walgreens still managed to generate about $660 million of free cash flow.

For context, that's more than enough to cover its dividend, which costs roughly $400 million per quarter (about a 60% payout ratio).

Walgreens also maintains a BBB investment grade credit rating from Standard & Poor's, which in mid-April 2020 reaffirmed its stable outlook on the pharmacy chain.

Coupled with ample short-term financial flexibility, including $3.6 billion of borrowing capacity through its credit facility, Walgreens was confident enough last week to increase its dividend by 2%.

That said, Walgreens' 45-year dividend growth streak can't hide the fact that the company continues struggling to adapt to changing retail and healthcare environments.

In its U.S. pharmacy business (about 50% of sales), insurers are pushing to reduce healthcare costs. As a result, Walgreens' margins have fallen due to lower reimbursement rates for prescriptions filled in its stores. This trend seems likely to continue.

Online pharmacy upstarts also have potential to pressure Walgreens, though the company has continued reporting steady prescription volume growth.

The pharmacy industry's complex web of doctors, insurers, regulations, copay structures (harder to compete on price), and patients' ingrained habits has helped insulate pharmacy chains from e-commerce rivals thus far.

Despite maintaining a solid base of prescriptions, which help drive foot traffic, non-pharmacy sales (beauty products, toiletries, over-the-counter drugs, etc.) have experienced low single-digit declines in recent years both in the U.S. and internationally.

Online retailers are chipping away at this business by offering free shipping and faster delivery options, challenging Walgreens' core value proposition of convenience.

The pandemic has only accelerated the shift to digital as more consumers find ways to get what they need while staying safe at home.

Feeling more pressure to adapt its drugstore business model, Walgreens is responding in several ways.

The firm is accelerating its digital investments to improve engagement with customers, opening doctors' offices in its stores to expand its healthcare services, and taking more costs out of its business (increased annual cost savings target from $1.8 billion to $2 billion by 2022, or about 1.5% of sales).
If these actions are enough to return Walgreens to long-term profitable growth, then the stock and its dividend look attractive today.

However, these strategies will take time to play out, and it's hard to see the secular headwinds in Walgreens' core pharmacy (reimbursement rate pressure) and retail (e-commerce) businesses reversing.

Generally speaking, we prefer to invest in companies that have clearer paths to becoming larger and more profitable in the long term. It's harder to get there with Walgreens given the changes taking place in the drugstore industry.

With that said, Walgreens seems unlikely to fade quickly if it is unable to reverse course.

In addition to the drugstore industry's insulating factors previously discussed, America's aging population should result in a growing market for prescription orders.

Walgreens' popular locations (78% of the U.S. population lives within five miles of a Walgreens-owned store) also provide a solid foundation from which to offer healthcare services and delivery options.

And if the stock's valuation gets low enough, perhaps management will revisit the idea of taking the company private like Walgreens supposedly discussed in late 2019, providing somewhat of a valuation floor (though the merits of levering up a struggling business during a pandemic is another debate).

Walgreens' dividend continues to look safe barring a more drastic strategic pivot by management (e.g. a large acquisition), but there's obviously a lot more to the story.

Investors have to decide if they believe Walgreens can eventually return its business to growth in the face of various secular pressures. And if they are willing to stay patient for what is shaping up to be a long, bumpy turnaround.

Ultimately, the conclusion from our January 2020 note remains true:

The healthcare and retail sectors are increasingly complex and rapidly evolving. Amazon and others are taking share from brick-and-mortar retailers as more consumers shop online, and drug prices are under pressure as governments and private insurers seek to control rising healthcare costs.

When combined with the potential for a major acquisition, there's a lot of uncertainty surrounding the pace of Walgreen's future dividend increases and long-term earnings growth. The company should continue to pay a safe dividend, but conservative investors need to have realistic growth expectations and may prefer investing elsewhere until the industry settles into a steadier state.

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