Walgreen's: Moving ahead

Walgreen’s: Moving Ahead:  Walgreen’s (WBA) and RiteAid deal concludes, finally.   After several unsuccessful attempts at getting government approval for its acquisition of RiteAid, WBA has adjusted its appetite for more stores and has agreed to purchase 2,187 locations around half of RiteAid total sites.   While smaller than initially desired, the $5.75 bill purchase should quickly get FTC approval.  

Since its beginning in 1901, WBA has been one of the most effective retail operators and has emerged a major player within the pharmaceutical supply chain. The firm processed approximately 19% of total U.S. prescriptions during its fiscal 2016, which makes it one of the largest retail pharmacies. The firm filled 929 million 30-day equivalents prescriptions last year.  With the merger of European-based Alliance Boots, WBA has a unique global retail pharmacy footprint.  

About 2/3 of revenues are derived from the distribution of pharmaceuticals, and puts WBA squarely in the crosshairs of healthcare reform and costing.  WBA’s profitability will be driven from synergies of the acquisition of additional stores and pushing more sales from the “front end” or non-pharmaceutical items.   

As most investors can appreciate, the competition for drug sales continues to intensify.  With fewer third party payers, which are the majority of WBA’s clients, distribution profits have been squeezed as payers negotiating positions improve with volume strength.  WBA has been countering margin pressures by growing both in size and importance in the distribution channel, hence the addition of almost 2,200 more stores. 

The merger with Boots has altered Walgreen's front-end retail marketing approach to emphasize higher margin cosmetic’s and limited grocery items.   However, if the most recent quarter is any indication with total same-store-sales SSS growing by 2.4%, the -0.8% decline in front-end continues to be an issue.

Historically, WBA has been a retail growth powerhouse with same-store-sales SSS in the low double digits, driving high Return on Invested Capital.  However, as SSS declined, so did ROIC.  According to fastgraph.com, in 1996, WBA generated ROIC of 20%, in 2006 18%, and in 2016 8.5%.  As a comparison, Walmart generated ROIC of 12%, 13%, and 11%, and Target generated ROIC of 7%, 11%, and 12%, respectively.  

Over the past year WBA has been an obvious under-performer vs S&P 500.  WBA is down about 5% while SPY is up by a bit more than 15%.  

With the overhang of the RiteAid drama now in the rear-view mirror, management can focus on improving performance.  

The bullish case for WBA is as compelling as the bear and neutral case.  

75% of the US population resides within the geographic reach of its 8,100 stores. This coverage increases its desirability to drug providers and provides scale in pricing negotiations.  

Indisputably, pharmaceutical sales will continue to grow, both in the US and Europe.  WBA is unique in the combination of both these markets, giving investors both the benefits and pitfalls of a multinational health care company.

WBA has generated strong operating cash flow.  In FY (Aug) 2016, WBA generated $7.8 billion in operating cash flow and $8.1 billion over the previous 12 months.  OCF has almost doubled from an average of $4.4 billion from 2007 to 2015and has created a current cash balance of $11.8 billion, before the RiteAid acquisition.  OCF growth is expected to continue its growth with the addition of more retail locations.       

Cost containment and cost reductions continues to be a key focus of management. since 2010, operating expenses as a percentage of sales has declined from a high of 23% to 18%, offsetting drug distribution margin pressures. 

In addition to higher operating cash flow and lower operating expenses, WBA has been aggressive in its cash and working capital management.  In 2013, the average cash conversion days, or how fast a company can convert cash on hand into inventory and accounts payable, through sales and accounts receivable, and then back into cash, was 32 days. As of last quarter, conversion days had dropped by almost 2/3s to 13.5 days, representing a substantial improvement in working capital management. 

In March 2013, WBA and wholesaler AmerisourceBergen Corp (ABC) announced a 10-year agreement (subsequently extended to 2026) to source all drugs through a newly formed strategic partnership which would enable sharing of synergies by layering ABC's generic volume into WBA. Previously, WAG sourced branded pharmaceuticals through Cardinal Health Inc., specialty pharmaceuticals through ABC and generics directly from manufacturers. WBA currently owns approximately 26% of ABC.  This relationship helps build profitability for the longer term.  

WBA’s valuations are in line with its major competitor, CVS Heath.  Investors should expect the Beta to come down as the trials and tribulations of the RiteAid acquisition fall by the wayside.  

While not all is rosy at WBA, most analysts have a favorable opinion of the future for Walgreens.  The average price target is in the $95 range, for a potential gain of 21%.  Driving share growth will be earnings growth from the current $5.00 estimates for this year to $6.00 in 2019.  

This article first appeared in the July 2017 issue of Guiding Mast Investments.  Thank you for reading, George Fisher