Description

Industry Outlook

There was a time, not too long ago, when a patient would go to his local pharmacy to get a doctor’s drug prescription filled.  The transaction was straight forward, easy and seamless. The pharmacy industry sat squarely between the drug manufacturers and the patients who required those drugs.  Over the years, this simple transaction has gotten significantly more complicated as drug distributors, insurance companies, federal and state governments, along with pharmacy benefit managers (PBM) have inserted themselves into the equation, impacting a pharmacy’s prescription fulfillment and their profitability.  Federally operated Medicare Part D, along with state-sponsored Medicaid programs, routinely and without warning, change the eligibility requirements and reimbursement rates for its members. Insurance companies, as well as PBMs, are also actively changing which name-brand and generic drugs they cover and their reimbursement rates.  A pharmacy customer may discover that the generic medication they were receiving for the past 5 years is no longer on their pharmacy’s PBM list or that the price of their name-brand drug has suddenly increased from $25/month to over $65/month.  All of this makes it challenging for pharmacies to navigate the changing and competitive healthcare landscape while trying to project out their future cash flows and profitability. 

With life expectancy in the US increasing from 73.6 years in 1990 to over 78.7 years today, prescription drugs and its efficacy is providing a more active and a higher quality of life, especially for the elderly.  Americans 55 years and older (Baby Boomers & Seniors) represent approximately 32% of the US population and over 70% of $425 billion spent each year on prescription drugs.  Even as the proliferation of lower-cost generic prescriptions (90% of all prescriptions) has lowered the overall cost of drugs dispensed, the long-term demand and cost for prescription and specialty drugs are only expected to increase. 

The pharmacy industry has become highly fragmented with health insurers, PBMs, hospitals, supermarkets, mass merchants, and online/eCommerce operations entering the market and impacting the way prescriptions are fulfilled and dispensed.  In turn, pharmacies have recognized that scale is not the only key to their future profitability, but their survival.  Through consolidation, acquisition and growth, CVS and Walgreens Boots Alliance (WBA) have emerged as the two largest US pharmacy systems with a national footprint and over 42% of the US market.  To achieve that scale, CVS and Walgreens have chosen two different paths: CVS has focused on vertical integration with its 2006 acquisition of Caremark (PBM) and its 2018 purchase of health insurer, Aetna.  Walgreens has scaled up its operations with its 2014 horizontal merger of Alliance Boots (international pharmacy & drug wholesaler), and the 2017 purchase of over 1900 Rite Aid stores.

Company Overview

In its current form, Walgreen Boots Alliance is a global pharmacy, health/wellness and beauty retailer, and an international wholesale drug distributor company with around 14,000 global retail locations, the majority of which (over 9,500) are located throughout the US.  The company dispenses just under 1.1 billion US prescriptions and immunizations (adjusted on a 30-day basis) a year which has been growing around 7% per year over the past few years.  With approximately 78% of the US population living within 5 miles of a Walgreens store (includes Duane Reade and Walgreens’ owned Rite Aid stores), its in-store and online interactions have increased to over 8 million per day.  The company’s operations are reported under three segments: Retail Pharmacy USA, Retail Pharmacy International, and Pharmaceutical Wholesale which delivers to over 110,000 pharmacies, doctors’ offices, and hospitals through its Alliance Healthcare brand in Europe. 

The US Pharmacy industry has been under consistent margin pressure from lower reimbursement rates year after year.  However, until recently, Walgreens has been able to more than offset this downward pressure with three areas of business and operational growth: A steady volume of name-brand drugs going off-patent and converting to generic drugs (lower revenue but with higher margins), expansion of its nationwide store footprint, and the formation WBAD in 2012. 

From the mid-1990s through the mid-2000s, Walgreens was in a land grab against CVS and Rite Aid to open stores as fast as they could.  In some cases, Walgreens was opening new stores as often as every 18-24 hours.  Theses cookie-cutter stores were accretive to earnings in years 2 through 6, continued to grow faster than GDP & employment through year 10, and then fell in line with overall economic growth.  The company’s organic store growth has slowed significantly since 2009, leaving a mature store footprint that is badly in need of renovation and an updated retail strategy. 

WBAD is a global purchasing organization formed by Walgreens Boots Alliance that sources and contracts generic pharmaceuticals on behalf of its members (Walgreens, Alliance Boots, Amerisource Bergen, and Express Scripts).  Today, it represents nearly 25% of the worlds generic volume and uses its position to gain below-market pricing for its members. 

In the past couple of years, WBA has only been able to offset 50-60% of the decline in reimbursement payments as the conversion from name-brand to generic, store growth, and WBAD volumes have mostly leveled off.  The company had expected these tailwinds to subside, but the timing coincided with two acquisitions and integrations:  Alliance Boots in 2014 and the Rite Aid store purchases in 2017.  With its time, money, and focus on these two integrations, Walgreens Boots Alliance was slow to respond to the changing retail landscape and the overall decline in the front end of its stores.

In the US, 72% of Walgreen’s sales are generated by its pharmacy which takes up just 20% of the store’s footprint, with the remaining 80% of the store dedicated to retail (front-end).  In the past, the revenue mix between pharmacy and the front-end of the store was more balanced at 65/35, with higher margins for retail sales.  With stiff competition from eCommerce (Amazon) and mass merchandisers (WalMart & Costco), and the lack of a comprehensive retail strategy focused on monetizing its retail space, WBA’s overall US retail sales have been in a steady decline since 2015.  To be clear, this decline has not impacted all front-end sales.  Sales of beauty and personal care (20% of retail sales), as well as health and wellness (25% of retail sales), have been growing year over year since 2015, as a May 2019 report in the Wall Street Journal found that less than 10% of health, personal care, and beauty products are purchased online.  Where front-end sales have truly fallen is in the general merchandising and consumer products segment of the store (approximately 55% of retail sales).

Can Walgreens compete in the changing healthcare landscape?

Walgreens’ revenues and profits are being squeezed on both the pharmacy and retail segments of their business, with no short-term tailwind insight.  Additionally, management appears to be slow in responding to the changing healthcare landscape and vertical mergers between Cigna and Express Scripts, and CVS’s acquisition of Caremark and Aetna, instead choosing to focus on a horizontal merger with Alliance Boots and purchasing Rite Aid stores.  The reality is that both CVS and Walgreens are taking a very similar approach to changes within healthcare but are using different operating models.  CVS has undertaken two very large, transformative deals over the past 12 years:  The acquisition of Caremark, a PBM for $21 billion, and the recent $70 billion acquisition of health insurer, Aetna.  Both vertical acquisitions were initiated to gain scale, drive more business into their pharmacy, recapture pharmacy reimbursement rates, make healthcare more affordable, and improve CVS’s overall profitability through synergies.  In addition, with Caremark controlling 30% of the PBM market and Aetna representing 8% of the health insurance market, CVS has guaranteed itself a seat at the table and influence over the uncertain future of the healthcare landscape. 

Walgreens also recognizes that scale and scope is critical to its survival and that is why its past acquisitions centered around building out its national footprint with a focus on international growth.  WBA has also been negatively impacted by the declining reimbursement rates, but instead of trying to recapture those rates internally, the company has decided to partner with key players in both the PBM and the health insurance market.  Being the only other national pharmacy with both scale and scope, Walgreens is a natural partner to 70% of the PBM market and over 90% of the health insurance market not being serviced by CVS.  Over the last few years, Walgreens has announced a steady flow of partnerships and investments with AmerisourceBergen, Prime Therapeutics, Humana, United Health, and LabCorp to improve reimbursement rates and leverage its store’s footprint by providing healthcare services like lab testing, senior-focused health clinics, walk-in/urgent care clinics, and a specialty and mail service company.  Most of the in-store healthcare services are structured with a fixed monthly cost/rent with an opportunity to participate in the future growth and upside.  Of course, Walgreens will not recapture all their reimbursement fees through these collaborations, but it is also not clear whether CVS acquisitions will produce hard and fast synergies or the long-term returns that they have projected.

The one thing that is clear is that the healthcare system is transitioning from fragmented, unconnected segments operating independently of one another, to an industry whose clearly defined operating lines of the past are becoming increasingly blurred.  At the center of this industry transformation is the pharmacy, which is becoming a healthcare hub for physicians, health insurers, PBMs, pharmacists and healthcare services to all interact seamlessly with the patient.

Retail

Walgreens has made it clear that they are focused on becoming less reliant on drug reimbursement rates by finding new and improved revenue streams.  Part of those revenue streams are intended to come from in-store healthcare service partnerships.  Another key component is turning around its retail operations and margins.  Taking a page from its successful partnerships on the pharmacy/in-store healthcare services side of the business, Walgreens has been partnering with different vendors to augment its retail sales.  In 2017, Walgreens began partnering with FedEx’s Onsite program for package delivery and pre-packaged/pre-label shipments at over 8,000 Walgreens stores.  With its vast nationwide footprint within 5 miles of 78% of the US population, and its extended daily hours (6am – 12am), Walgreens became a strategic partner for FedEx deliveries and pickups.  That relationship was further enhanced when Walgreens began offering next-day prescription drug delivery, turning each store into a mini distribution center.  With FedEx making pickup and deliveries 3-5 times per day across the Walgreens network, prescription deliveries can be routed to a wide array of stores based on availability, location and fulfillment time.  Recently, Walgreen began partnering with Narvar Concierge for package delivery and returns.  Navar Concierge manages the delivery logistics for brands like Cole Haan, Levi’s, and Urban Outfitters.  Now customers of these brands and more can pick up their packages or drop off their return items to their local Walgreens store.

Kroger is another partnership that Walgreens is exploring.  In select locations, Kroger began stocking Walgreens stores with up to 2,000 SKUs (most grocery stores are 40,000 to 50,000 SKUs) including private-label groceries, Home Chef meal kits, and fresh produce.  Walgreens recognizes that it does not have the scale to compete with large retail grocers, and instead, decided to work with Kroger to lower its purchasing costs.

Future Growth and Operational Opportunities

All these partnerships are a good start in helping to monetize the company’s established footprint, but the heavy lifting will need to come from continued investments in technology, transforming and restructuring general merchandising and retail offerings, modernizing pharmacy operations, and rolling out a cost management program to help offset these and other future investments.

Recently, Walgreens announced that it would be working with Microsoft’s Azure cloud and AI platforms to consolidate, digitize and analyze company data.  This is part of a WBA’s much larger technology investment to better manage inventory, reduce shrinkage, improve pharmacy utilization and sales, and streamline its back-office operations.  Ultimately, the technology investment will improve operations, lower expenses, and reduce the cost of care for its customers.  In addition, new mobile pharmacy and retail solutions will be available to Walgreens’ 88 million rewards members making health care interactions more personal, accessible, and affordable.  Walgreens is also exploring the possibility of rolling out frictionless transactions – the ability of customers to pick up their prescription and other items and pay by passing their phone over a scanner without requiring any additional employee interaction.

Walgreens’ cost management program is in the process of being rolled out and is expected to reduce the company’s expenses by up to $1.5 billion on a 2022 run rate.  The company is already working on streamlining the international wholesale drug division, right-sizing stores and employee needs, and upgrading and improving health/wellness and beauty/personal care retail segments.  By hiring beauty specialists and integrating Alliance Boots’ high-end and private label beauty products into US stores, Walgreens believes they can start to improve sales and margins in their beauty and personal care retail segments in the near future.

Valuation

Over the past 20 years, Walgreens price earnings ratio has averaged around 22x.  This reflects the significant organic store growth witnessed through mid-2000.  By 2009, WBA’s organic growth had moderated leaving a mature store footprint and an average PE ratio of around 17.5x.  During the past couple of years, with mounting pressure from declining reimbursement rates, higher operating costs, and weakening retail sales, Walgreens PE ratio began to fall as the market became more pessimistic toward Walgreens’ growth prospects.

In June 2018, Walgreens Boots Alliance’s board authorized a $10 billion share repurchase program, and over the past 11 months, the company has actively repurchased over $6 billion worth of shares at an average price of $67.20/share.  WBA has guided that over the next quarter (Q4) it expects to repurchase an additional $1 billion worth of shares, leaving $3 billion left on its authorization.  Share repurchases have helped offset the negative impact on the company’s EPS.  It is expected that once the current $10 billion repurchase authorization is completed, the board will authorize an additional $10 billion share repurchase.

Aetna’s merger with CVS is negatively impacting WBA’s revenues and earnings as Walgreens’ pharmacy traffic from Aetna is being rerouted to CVS.  This happened much quicker than anticipated and should continue to impact WBA’s revenues throughout the end of the calendar year 2019 before leveling off.  As contracts get renegotiated and as other health insurers actively move their business away from CVS because of its merger with Aetna, WBA should start to see a rebound in pharmacy traffic over the next 6-12 months.

Starting in the fiscal year 2020, many of the cost reductions, retail initiatives, and continued share repurchases should start to have an impact on EPS in the latter half of the year.  This should continue to help Walgreens chip away at the reimbursement pressure it receives annually.  By 2021, Walgreens should be on much firmer ground as the cost management initiatives and technology investments begin to have an impact, pharmacy traffic from new contracts take hold, and some of the retail partnerships and initiatives start to show positive momentum.

At $54.50/share, Walgreens is trading at roughly 9.1x 2019 EPS estimate of $6/share, as the market remains pessimistic about the company’s future growth prospects.  Investors should not expect a quick turnaround in WBA’s share price, but if the company begins to execute and shows a path for continued improvement, both its EPS and multiple should trend higher.  Anticipating slight growth for 2020, WBA’s earnings could improve to $6.18/share followed by $6.70/share in 2021.  By 2022, Walgreens anticipates the rising contribution of its partnerships to start impacting the bottom line.  Additionally, the full impact of its cost management program should take hold, saving the company in excess of $1.5 billion per year.  This will more than offset the little over $1 billion in reimbursement pressure that Walgreens expects annually going forward and should be reflected in the company’s growing EPS.  Gone are the days of 20 plus PEs, but a 12.5x – 15x multiple is not only respectable but achievable. 

Conclusion

The Pharmacy industry continues to be plagued by reimbursement pressure and will be for the foreseeable future.  Walgreens’ stock is currently trading below the bottom end of its 20-year PE channel, reflecting the markets pessimistic outlook for the company and its industry.  In the short-term, Walgreens is adjusting its retail offerings, actively repurchasing its shares, and partnering with vendors to drive more foot traffic into their stores in attempts to offset this margin compression.  In the long-term, WBA’s goal, through its partnerships, is to create a healthcare hub for physicians, healthcare services, health insurers, PBMs, and pharmacists to all interact seamlessly with the patient.  In turn, this creates efficiency, helps to lower its customers’ healthcare costs, improves Walgreens’ earnings, making the company a key component to the future of healthcare.

Investors should not invest in Walgreens with the hope of a quick recovery.  It took years of management's "growth and any cost" business plan and failure to respond to the changing landscape to get to where the company is today.  However, if management remains focused on repairing its declining retail sales, targets and fosters long-term healthcare partnerships, invests in optimizing operations while cutting overhead costs, Walgreens can remake itself into a significant and important part of the healthcare system.  Positive execution of its long-term business strategy over the next 3 years will be reflected in a stronger share price which could be meaningfully higher than where it is today.

I do not hold a position with the issuer such as employment, directorship, or consultancy.

Catalyst

• Reinvestment and focus on front-end of the store
• Technology investment - Streamlining operations, better inventory management, and improving utilization
• Cutting $1.5 billion in annual expenses and overhead by 2022
• Long-term partnerships with key healthcare insurers/providers/services
• Long-term Execution