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Image Source: Walgreens Boots Alliance Inc – Third Quarter Fiscal 2020 IR Earnings Presentation

By Callum Turcan

On July 9, Walgreens Boots Alliance Inc (WBA) reported its third-quarter fiscal 2020 earnings (period ended May 31, 2020) and raised its dividend by ~2% on a sequential basis. Walgreens has increased its annual dividend over the past 45 consecutive years, earning it Dividend Aristocrat status, though we caution its net debt load weighs negatively on its forward-looking dividend coverage. Shares of WBA yield ~4.6% as of this writing.

Walgreens suspended its share buyback program to preserve cash in the face of the ongoing coronavirus (‘COVID-19’) pandemic and additionally, management initiated full year guidance for Walgreens’ fiscal 2020 during its latest earnings report. The pharmacy store operator expects it will post $4.65-$4.75 in non-GAAP adjusted EPS this fiscal year, and please note that guidance includes the estimated negative impact of COVID-19 to the tune of $1.03-$1.14 per share (in terms of EPS headwinds). In the upcoming graphic down below, management provides details on how Walgreens sees COVID-19 impacting its operations this fiscal year.

Image Shown: Walgreens expects COVID-19 will weigh negatively on its fiscal 2020 financial performance. Image Source: Walgreens – Third Quarter Fiscal 2020 IR Earnings Presentation

Quarterly Overview

Walgreens noted that the pandemic shaved $700 million-$750 million off its top-line during the fiscal third quarter. Those headwinds were primarily felt at its international business as Walgreens’ Boots UK division posted -48% (negative 48%) year-over-year comparable store sales growth last fiscal quarter. Management mentioned that Boots.com saw its e-commerce sales explode last fiscal quarter, growing by 78% year-over-year, though that was not enough to offset a sharp drop off in foot traffic at its physical stores (due in large part to strict quarantine efforts imposed in the UK during this period).

Sales at Walgreens’ ‘Retail Pharmacy International’ segment fell by just under 32% year-over-year last fiscal quarter (and a little over 26% on a constant currency basis). Walgreens’ ‘Pharmaceutical Wholesale’ division held up much better and posted just under 1% year-over-year sales growth last fiscal quarter, which was held back by significant foreign currency headwinds (~480 basis points).

The pharmacy’s strong sales performance in the US last fiscal quarter, primarily the result of increasing demand for consumer staples products due to the pandemic, helped offset international weakness. Walgreens reported that its ‘Retail Pharmacy USA’ division saw 3% year-over-year comparable store sales growth last fiscal quarter, with division-wide revenue up a little more than 3%. On a company-wide GAAP basis, Walgreens’ revenues grew marginally year-over-year in the third quarter of fiscal 2020.

Walgreens’ GAAP gross margin tanked by almost 300 basis year-over-year last fiscal quarter (we will cover that in just a moment), which combined with a 33% year-over-year increase in SG&A expenses (higher sanitation-related costs and bonuses for frontline employees) resulted in the firm posting a GAAP operating loss. Management expects margin pressures will continue going forward due to adverse product mix changes and rising fulfillment costs due to rising home deliveries (generally speaking, e-commerce is less lucrative for traditional retailers than in-store sales). Here’s what Walgreens’ management team had to say on the issue during the firm’s latest earnings call:

“The biggest issue on margin though is not necessarily the absolute increase in the online margins because we actually have had a very attractive margin profile in the UK on our e-commerce business. The issue is prior to the COVID pandemic, 70% of the orders were picked up in store and right now it's less than 20%.

Now the biggest incremental cost we have is the fact that it has a zero cost is somebody is picking it up in store and it's probably cost you $3 to $4 more to actually ship it to somebody's house. So we believe that will reverse but it's probably six months away. So as consumers get much more comfortable coming back for the High Street, they will also become much more comfortable at pickup in store, which will reduce the headwind on margin as we move forward.”

In the US, Walgreens’ margins took a beating from its product mix shifting away from higher margin discretionary products to lower margin “essential” (consumer staples) products. Walgreens also had to contend with rising domestic fulfillment costs and its business was negatively impacted by a reduction in prescriptions last fiscal quarter (which was attributed to a reduction in doctor’s visits in the US).

Cost Savings Target Increased

Walgreens’ near-term outlook is lackluster, and investors have aggressively sold off shares of WBA year-to-date as of this writing. Management responded by increasing the annualized cost savings target (expected to be achieved by fiscal 2022) from Walgreens’ Transformational Cost Management Program to $2.0+ billion from $1.8 billion previously. The pharmacy provides an overview of that program in the upcoming graphic down below.

Image Shown: Walgreens is targeting meaningful cost cuts to improve its financial outlook. Image Source: Walgreens – Third Quarter Fiscal 2020 IR Earnings Presentation

A key part of this strategy involves closing stores and rationalizing its physical footprint. This is part of an ongoing process that Walgreens has been steadily pursuing since acquiring over 1,900 stores and three distribution centers from Rite Aid Corporation (RAD) through a ~$4.4 billion deal. The agreement covering that deal was reached in September 2017, though it took several years to complete.

The pharmacy decided to double down on cost cutting by targeting additional savings. During Walgreens’ latest earnings call, management noted the firm was targeting job reductions at the firm’s Boots Opticians business in the UK:

“This has been a very tough decision, but we're taking this action to ensure a sustainable future at the time of economic uncertainty and are shifting customer behavior towards online and digital channels. We are proposing a reduction of over [4,000 jobs] in total across Boots Opticians, representing around 7% of the current workforce. This includes a proposed reduction of approximately 20% of our employees in our head office, around 7% of our store colleagues and the closure of 48 Boots opticians [out of ~600 total Boots Optician stores].”

Walgreens needs to improve its cost structure to improve its cash flow profile given its large net debt load. At the end of May 2020, Walgreens had $0.8 billion in cash and cash equivalents on hand versus $4.4 billion in short-term debt and $12.1 billion in long-term debt. Walgreens owned ~28% of AmerisourceBergen Corporation’s (ABC) outstanding stock at the end of May 2020. As of this writing, such a stake would be worth ~$5.8 billion. Even if one were to assume Walgreens’ stake in ABC is a cash-like position, Walgreens still carried a large net debt load at the of the May 2020.

Please note that Walgreens’ net debt load severely limits its financial flexibility during these challenging times. Walgreens generated $2.4 billion in free cash flow during the first nine months of fiscal 2020, though that was consumed by $1.3 billion in cash dividend payments and $1.4 billion in share repurchases.

As mentioned previously, management announced Walgreens had suspended its share repurchasing program during its latest earnings report. Walgreens’ dividend coverage on a forward-looking basis is stressed by its net debt load, though its ability to generate meaningful free cash flows offers some protection.  

Adding Doctors’ Offices to its Stores

Walgreens aims to turn things around not just through cost cuts, but also by enhancing its in-store offerings. On July 8, 2020, Walgreens and VillageMD announced a partnership that would add 500 – 700 primary-care clinics to Walgreens’ US locations over the next five years. These clinics would be physician-led, and the goal is to add hundreds more locations after the initial rollout period. Walgreens intends to invest $1.0 billion in VillageMD through equity and convertible debt over the next three years which included a $0.25 billion equity investment which was expected to be completed in the first half of July. Here is what management had to say on the deal during Walgreens’ latest earnings call:

“We'll be opening between 500 and 700 full service Village Medicals in more than U.S. markets within the next five years. These doctor-led clinics located at Walgreens pharmacies will provide comprehensive primary care services and will focus on developing relationships with patients to manage their long-term conditions.

Once we've completed his initial role out we intend to build several hundred more clinics in at least 20 additional US markets. Very importantly beyond the physical locations we'll be developing home based monitoring and telemedicine services leveraging VillageMD integrated data and technology and our own fine care platform.

We're investing $1 million of debt and equity in the partnership over the next three years including a $250 million equity investment announced yesterday. On completion of this investment, we expect our ownership interest of approximately 30% in VillageMD.”

This is an interesting deal and one that could really differentiate Walgreens from its domestic competitors including Kroger Company (KR), Walmart Inc (WMT), and Target Corporation (TGT). Physical retailers that have been able to successfully stave off e-commerce giants like Amazon Inc (AMZN) generally have been able to do so by offering in-store services that Amazon and other e-commerce players can not readily replicate. This is not an easy task. Amazon acquired PillPack to support its ability to push into the US pharmacy space, highlighting the perennial threat e-commerce poses to physical retailers in any category.

Ulta Beauty Inc (ULTA) and its in-store salon operations offer up a prime example of a business model that was doing better than most its peers when it comes to fending off Amazon (particularly before COVID-19 came into the picture). Ulta Beauty grew its GAAP net revenues and GAAP operating income by over 500% and 750%, respectively, from fiscal 2010 (period ended January 29, 2011) to fiscal 2019 (period ended February 1, 2020). Its ability to get customers in the door by offering salon services was key to Ulta Beauty’s historical success. Though Ulta Beauty’s outlook appears stressed in the short-term due to the pandemic disrupting its in-store operations, should a COVID-19 vaccine get discovered its outlook would improve materially.

Concluding Thoughts

We will be monitoring the success of the Walgreens-VillageMD partnership over the coming years and wonder if other major pharmacies will follow suit. Shares of WBA have been on a steady downward trend since 2017 as investors are losing faith in Walgreens ability to cut costs and grow its sales over the long haul. Doubling down on its long-term cost savings program and embarking on the VillageMD partnership may help revive Walgreens’ long-term outlook, though it will take time to see how successful these endeavors could be given the ongoing headwinds created by COVID-19.

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Dollar Store and Department Store Industries – KSS M JWN BIG DG DLTR PSMT

Household Products Industry – CHD CLX CL ENR HELE JNJ KMB PG

Personal Services Industry – BFAM HRB HI RGS SBH SCI ULTA WW

Specialty Retailers Industry – AAN BBBY BBY GME HD LOW LL ODP SHW TSCO WSM

Food Retailing Industry – CASY COST CVS KR SYY TGT WBA WMT

Related: ABC, CAH, HSIC, MCK, PDCO, CI, HCA, ANTM

Other: AMZN, FDS, SPY, VDC

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Callum Turcan does not own shares in any of the securities mentioned above. Dollar General Corporation (DG) and Johnson & Johnson (JNJ) are both included in Valuentum’s simulated Best Ideas Newsletter portfolio. Johnson & Johnson is also included in Valuentum’s simulated Dividend Growth Newsletter portfolio. Vanguard Consumer Staples ETF (VDC) is included in Valuentum’s simulated High Yield Dividend Newsletter portfolio. Both the Best Ideas Newsletter and Dividend Growth Newsletter portfolios include a SPDR S&P 500 ETF Trust (SPY) put option holding with a $295 per share strike price that expire on August 21, 2020. Some of the other companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.