Is Walgreens' Dividend Safe? CEO Termination Clouds Outlook

Rosalind Brewer stepped down as CEO this morning, ending a nearly three-year run at the drug retailer that tried to refocus Walgreens on its core U.S. business and expand into health services with billions of dollars invested in acquisitions and growth initiatives.

This announcement follows news in July that CFO James Kehoe, who said this summer that Walgreens was "absolutely committed to the dividend," was leaving the company to pursue an opportunity in the tech sector.

In addition to announcing the CEO change (no permanent replacement has been named), Walgreens said it now expects full-year 2023 adjusted EPS to be at or near the low end of its previously stated range.

This could reflect a continued slower-than-expected ramp in the profitability of Walgreens' health services, which need to scale up their patient bases faster as we discussed in June.

The consumer spending environment has shown more cracks in certain areas, too.

Front-end retail accounts for around 25% of Walgreens' sales. From bath and body products to Band-aids and snacks, a lot of this marked-up merchandise carries higher margins than prescription drug sales.

The latest reports from retailers have shown that many consumers are tightening their belts when it comes to spending on discretionary goods.

CVS in early August said it is "looking at slightly softening consumer demand in the back part of the quarter" following "a little bit of pullback in consumer behavior in June."

Dollar General this week reported a decline in store traffic last quarter and noted its "core customers continue to tell us they feel financially constrained."

And Target, speaking with investors in mid-August, said "consumers are choosing to increase spending on services like leisure travel, entertainment and food away from home, putting near-term pressure on discretionary products."

All of this suggests Walgreens may face a prolonged recovery in earnings as retail sales slow and its health services strategy struggles to gain faster traction (this segment was last projected to break even within the first half of the upcoming fiscal year, which begins in September).

New leadership will presumably look to shake up the company. This could mean pulling back on health services, or perhaps doubling down on efforts to evolve the business. Without a new CEO being named, it's hard to say what the near-term cash flow implications could be.

Appetite for a transformative acquisition could also be on the table if a faster pace of change is desired.

This could spell trouble for the dividend since Walgreens' balance sheet, which S&P assigns a BBB credit rating with a negative outlook, doesn't have great capacity to take on more debt without risking its investment-grade status. A smaller payout would make more cash available for investments or deleveraging.

The bottom line is that Walgreens' sudden leadership changes in the middle of an expensive strategic push create a lot of uncertainty about the firm's future capital allocation priorities, especially as rivals pull further ahead in their own vertical integration efforts to make the healthcare sector more efficient.

In recognition of these developments and the much wider range of outcomes they have created, we are downgrading Walgreens' Dividend Safety Score from Safe to Borderline Safe. The thesis that Walgreens' cash flow and leverage were on the verge of meaningful improvement as health services turn the corner looks to be broken.

That said, Walgreens still has some discretion on whether to maintain its dividend. For example, the company could pull back further on opening in-store clinics and take more aggressive actions to slash costs, quickly improving free cash flow coverage.

At the end of last quarter, Walgreens also maintained a stake in AmerisourceBergen valued at $5 billion. Selling down this stake (including a $1.85 billion sale announced in August) could help chip away at the firm's $12 billion of book debt or cover the $1.7 billion dividend.
If we were shareholders, Walgreens' sudden leadership changes and impending strategic shift would likely be the deciding factor that prompts us to cut our losses and sell our shares.

While the company's core retail pharmacy business still looks like a durable cash cow with modest growth potential, Walgreens could be facing years of work getting its business mix where it wants it to be for the long term, all while trying to preserve its investment-grade balance sheet and (frozen) dividend.

A number of quality dividend stocks have sold off over the past year as interest rates have increased, providing some alternative income ideas with yields near 6% or higher (in no particular order):

  • Enterprise Products Partners (EPD): BBB+ rated master limited partnership with a diversified mix of midstream services protected by long-term, fixed-fee contracts and volume protections.
  • Enbridge (ENB): large Canadian pipeline company with a self-funded business model, BBB+ credit rating, and mission-critical assets.
  • UGI (UGI): diversified utility undergoing strategic review to unlock value (see our recent note here); nearly 140 years of uninterrupted dividends.
  • Crown Castle (CCI): wireless infrastructure REIT facing near-term growth headwinds from slower telecom spending and higher rates (see our recent note here). 
  • Main Street Capital (MAIN): investment-grade rated business development company that benefits from higher-for-longer interest rates and has paid uninterrupted dividends since 2007.
  • Physicians Realty Trust (DOC): BBB rated medical office buildings REIT with a diversified set of tenants and properties; uninterrupted dividends since 2013, albeit with little growth.
  • W.P. Carey (WPC): diversified REIT with BBB+ credit rating and reasonable payout ratio near 80%; higher rates and office exposure are unlikely to harm long-term outlook (see our recent note here).
We will continue watching Walgreens closely and provide updates as soon as new developments emerge. The firm's next earnings report and dividend announcement usually arrive in mid-October.

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