Description

CERTAIN STATEMENTS CONTAINED HEREIN REFLECT THE OPINION OF THE AUTHOR AS OF THE DATE WRITTEN. NO INVESTMENT DECISIONS SHOULD BE BASED IN ANY MANNER ON THE INFORMATION AND OPINIONS SET FORTH IN THIS REPORT. YOU SHOULD VERIFY ALL CLAIMS, DO YOUR OWN DUE DILIGENCE AND/OR SEEK ADVICE FROM YOUR OWN PROFESSIONAL ADVISOR(S) AND CONSIDER THE INVESTMENT OBJECTIVES AND RISKS AND YOUR OWN NEEDS AND GOALS BEFORE INVESTING IN ANY SECURITIES MENTIONED. Please see additional Important Disclaimers at the end of this analysis.

Investment Pitch: Walgreens Boots Alliance (Nasdaq: WBA) core businesses structurally have a difficult time growing over time. This statement is coming from someone who used to be long Walgreens and wrote it up on VIC as a buy about 10 years ago. I do not see any easy way out for WBA to transform itself into a growing company. Here is the simple short thesis for its three main business segments, which the financials over the past number of years support:

1)    U.S. Retail Pharmacy: This business is largely made up of selling pharmaceutical drugs and to a lesser degree Over-the-Counter (OTC) and general front-end store merchandise through over 9,000 stores under the Walgreens and Duane Reade banners. Regarding the U.S. retail pharmacy business, WBA as well as CVS, RAD and all the other independent pharmacies are all price takers with practically no ability to push back on the reimbursement pressure it faces from Pharmaceutical Benefit Managers (PBMs).

The reason for this is that the three largest PBMs (owned by CVS, Cigna and UnitedHealth) control 77%[i] of the market and dictate pricing terms to retail pharmacies. While WBA has approximately 19%[ii] retail pharmacy market share, it only has about 9,000 out of approximately 88,000[iii] U.S. pharmacies. Thus there are plenty of substitute pharmacies for consumers to get their prescriptions. The last time Walgreens got in a spat with a PBM was about a decade ago. It decided to push back against Express Scripts’ (now part of CI) pricing terms and ultimately lost that battle as its stores were removed from the Express Scripts retail pharmacy network. Walgreens saw its operating profit decline by over 20% from FY2011 to FY2012.

One of the most interesting insights into this business was from a meeting I had with various Express Scripts executives many years ago at their corporate offices in St. Louis. I asked them how could so many independent pharmacies stay in business with volumes per store so much lower than the average Walgreens, CVS, Rite-Aid and Walmart. Their response was that they generally reimburse independent pharmacies at higher rates for the same drugs dispensed compared to the major pharmacy chains. By doing so, this helps keep tens of thousands of independent pharmacies in business, which pleases government since there is plenty of consumer choice. But it also allows the PBMs to keep the big chains in check and slowly take more of their economics over time. Essentially any cost savings programs from better procurement, automation, etc. by retail pharmacies will over time be offset by lower reimbursement rates by the PBMs.

The front end of the store is the other main part of this business. Amazon continues to be successful in taking consumer packaged goods (CPG) share with help from programs like subscribe and save. Walmart is also investing heavily into its ecommerce business. Lastly, many retailers selling CPG products such as grocery chains are increasingly partnering with delivery companies like Door Dash, Uber and Instacart that help make location less relevant to the consumer as more of these purchases move to delivery. The bottom line is that the days where the convenient retail pharmacy corner store location provided a real advantage to the company are coming increasingly to an end when it comes to this part of the business.

Operating profit was $5.1 billion in FY2015 and was at about the same LTM level as of the last quarter reported (ending 2/29/20) heading into the COVID-19 pandemic.[iv] Keep in mind that while operating profit was flat over this 4.5 year period, it would have been down had WBA not added over 20% to its store base with the purchase of nearly 2,000 Rite-Aid stores for approximately $4.4 billion in FY2018.[v] The pandemic hurt WBA’s business, which saw operating profit decline by nearly 20% over the following 12 months and began to recover back to prior COVID-19 levels last quarter (ending 5/31/21).

2)    Retail Pharmacy International: This segment operates 4,428 retail stores under the Boots, Benavides and Ahumada banners in the UK, Thailand, Norway, Republic of Ireland, Netherlands, Mexico and Chile.[vi] Heading into the COVID-19 pandemic LTM (ending 2/29/20) operating profit was $635 million compared to $616 million in FY2015.[vii] Again, another no-growth business where Walgreens is a price taker with hardly any ability to successfully negotiate. The main reason for this is that its stores operate in largely single payer healthcare systems whereby the government dictates reimbursement rates.

3)    Pharmaceutical Wholesale: From FY2017 through LTM (ending 2/29/20) heading into the COVID-19 pandemic, operating profit was exactly flat at $922 million. Tough retail pharmacy reimbursement rates from single payer systems impact the entire supply chain, which makes it difficult for this business to expand margins and profits over time.

Valuation/Expected Return: Pre-COVID-19 LTM (ending 2/29/20) operating profit for WBA was $4.2 billion. In January 2021 WBA sold its Alliance Healthcare business to AmerisourceBergen (NYSE: ABC) for $6.3 billion in cash and 2 million shares of ABC.[viii] Adjusted operating profit of this business in FY2020 was $0.4 billion. So pro forma for this sale, we have pre-COVID-19 operating profit of $3.8 billion relative to an enterprise value of $50 billion ($42 billion market cap). This equates to ~17x EPS. Compare that to a high-quality company like Alphabet (Nasdaq: GOOG), which is expected to grow revenue mid-teens and EPS by low-mid 20s, trades at ~21x 2023E EPS. Or compare it to other low/no-growth retailers like The Gap (NYSE: GPS), which trades at ~8.5x 2023E EPS. Applying a 10x P/E multiple to my pro forma pre-COVID-19 EPS of ~$3.10 equates to a $31 stock. Add in $2 of annual dividends and you get to $33 over the next 12 months or a ~32% return.

Risks: It makes a transformative acquisition.

Important Disclaimers

The provision of this report does not constitute (and should not be construed as) a recommendation, financial promotion, investment advice, encouragement or solicitation to buy, sell, or hold the security of the subject issuer (the “Security”), or any other securities, discussed herein. This report is for informational purposes only. All of the information contained herein is based on publicly available information with respect to the security and the author’s analysis of such information. Past performance is no guarantee, nor is it indicative, of future results.

Certain statements reflect the opinions of the author as of the date written, may be forward-looking and/or based on current expectations, projections, and/or information currently available. The author cannot assure future results and disclaims any obligation to update or alter any statistical data and/or references thereto, as well as any forward-looking statements, whether as a result of new information, future events, or otherwise. Such statements/information may not be accurate over the long-term. The views are those of the author acting in his individual capacity and not as a representative of the firm.  The author’s opinions on this Security may change at any time in the future and the author will not, and disclaims any obligation to, update this report to reflect any change in opinion. The author further disclaims any obligation to respond to any comments or questions posted regarding the Security discussed herin.

NO INVESTMENT DECISIONS SHOULD BE BASED IN ANY MANNER ON THE INFORMATION AND OPINIONS SET FORTH IN THIS REPORT.  YOU SHOULD VERIFY ALL CLAIMS, DO YOUR OWN DUE DILIGENCE AND/OR SEEK ADVICE FROM YOUR OWN PROFESSIONAL ADVISOR(S) AND CONSIDER THE INVESTMENT OBJECTIVES AND RISKS AND YOUR OWN NEEDS AND GOALS BEFORE INVESTING IN ANY SECURITIES MENTIONED. AN INVESTMENT IN THE SECURITY DOES NOT GUARANTEE A POSITIVE RETURN AS STOCKS ARE SUBJECT TO MARKET RISKS, INCLUDING THE POTENTIAL LOSS OF PRINCIPAL.

The author or his or her respective employer or employer’s clients, affiliates, officers, managers and directors, may or may not hold positions in the Security noted in this article. These parties may trade at any time, without notification to this community, and will not disclose this information to this community. The author and his employer disclaims any liability for investment losses that you may incur under any circumstances.

The author does not hold a position with the issuer of the Security such as employment, directorship, or consultancy.

[i] https://www.drugchannels.net/2021/04/the-top-pharmacy-benefit-managers-pbms.html

[ii] https://www.statista.com/statistics/734171/pharmacies-ranked-by-rx-market-share-in-us/

[iii] https://en.wikipedia.org/wiki/Pharmacies_in_the_United_States

[iv] WBA Financial Statements

[v]https://www.forbes.com/sites/brucejapsen/2018/03/28/rite-aid-says-all-1932-stores-transferred-to-walgreens/?sh=41427b1f17d0

[vi] WBA FY2020 10-K

[vii] WBA Financial Statements

[viii]https://investor.walgreensbootsalliance.com/news-and-events/financial-news/financial-news-details/2021/AmerisourceBergen-and-Walgreens-Boots-Alliance-Announce-Strategic-Transaction/default.aspx

Catalyst

Further struggles for its business. Market realizes post COVID-19 business recovery is not that strong.