(Published by Bob Ciura on June 30)
Walgreens Boots Alliance Inc. (WBA, Financial) unveiled robust fiscal third-quarter earnings on June 29, proving retail is not dead.
Far from it—despite the cascade of bad news that has hit the industry over the past year, some retailers are still seeing strong results.
Investors may be convinced e-commerce retail giant Amazon.com Inc. (AMZN, Financial) is about to take over the entire industry. But that is far from reality.
Walgreens posted growth in both sales and earnings per share, no small feat in this climate.
In addition, the company has a long track record of rewarding shareholders. It has increased its dividend for 41 years in a row.
It is a Dividend Aristocrat, which is a group of 51 stocks in the S&P 500 Index with at least 25 years of consecutive dividend increases.
Walgreens’ continued success in a very difficult time for the retail industry is due to several key factors.
Business overview
Walgreens Boots Alliance is a global pharmacy giant. It operates all over the world after the huge merger between Walgreens and Alliance Boots in December 2014.
The combined company is the largest retail pharmacy in the U.S. and Europe.
Source: Q3 Earnings Presentation, page 16
Walgreens handed in the proverbial “beat-and-raise.” Not only did the company surpass analyst expectations for last quarter’s earnings, but it also raised its forecast for the remainder of the year.
For the quarter, Walgreens had profit of $1.2 billion on sales of $30.1 billion. EPS rose to $1.07, an increase of 5.9% from the same quarter last year.
Adjusted EPS, which excludes various nonrecurring items, was $1.33. This beat analyst expectations of $1.30.
Revenue for the quarter also beat analyst forecasts by approximately $400 million.
In addition, Walgreens raised the low end of its earnings guidance for the rest of 2017. Full-year EPS are expected in a range of $4.98 to $5.08, up from a prior range of $4.90 to $5.08.
Walgreens posted very strong growth rates across the board, particularly after excluding the impact of currency exchange.
Source: Q3 Earnings Presentation, page 4
In addition to the quarterly earnings results, the company announced a revised agreement with smaller competitor Rite Aid Corp. (RAD, Financial), which Walgreens had previously planned to acquire.
Instead of a full takeover, Walgreens will acquire 2,186 Rite Aid stores along with associated warehouses and inventory.
The reason for the change is Walgreens' management began to doubt whether an acquisition would receive regulatory approval. The pending deal was subjected to an unusually long review by the Federal Trade Commission, which prompted the company to reconsider.
Despite the failed acquisition attempt, Walgreens still has compelling future growth catalysts.
Growth prospects
Even though the retail industry is struggling, Walgreens still has growth potential up ahead because of its niche.
Pharmaceutical sales are an attractive segment demographically. The U.S. is an aging population, which should result in a sustained increase in demand over the long term.
This is why Walgreens’ U.S. pharmacy business continues to be the company’s best-performing business. Segment sales increased 10.3% last quarter thanks to 5.8% growth in comparable store sales.
Source: Q3 Earnings Presentation, page 7
Prescriptions rose 8.5% for the quarter, the best performance in more than seven years. This performance was due to Medicare Part D growth as well as volume growth from new pharmacy partnerships.
In addition, the company’s pharmacy market share increased 110 basis points to 20.5%. Walgreens commands huge market share in a growing business, which is a great sign for the future.
Another growth catalyst is its pharmaceutical wholesale business, which operates under the Alliance Healthcare brand.
Constant-currency comparable sales increased 3.7% last quarter and adjusted operating profit soared 53% year over year in the pharmaceutical wholesale segment.
Competitive advantages and recession performance
Walgreens’ biggest competitive advantage is scale. It has a presence in more than 25 countries around the world.
It currently operates over 13,000 stores and over 390 distribution centers. This provides the company with economies of scale, which allows it to pressure suppliers for low prices.
Companies like Wal-Mart (WMT, Financial) or Costco (COST, Financial) pass these savings onto consumers. Walgreens sells its goods for higher prices than traditional discount retailers. The company’s convenient corner store locations, smaller store sizes and pharmacy entice consumers to buy goods at slightly higher prices. The effect can be seen in Walgreens’ operating margin in its retail business:
- Walgreens US retail adjusted operating margin: 6.5%
- Wal-Mart operating margin: 4.7%
- Costco operating margin: 3.1%
- Amazon operating margin (including AWS): 2.9%
Separately, Walgreens benefits from a strong brand. Its long operating history and huge number of stores make it a popular destination for customers who need prescriptions filled or health care products.
These competitive advantages provide Walgreens with a recession-resistant business.
Consumers cannot go without prescriptions or health care products, which helps the company generate steady profits each year, even when the economy goes into recession.
Walgreens suffered only a slight decline in EPS during the Great Recession, followed by a quick recovery:
- 2007 EPS of $2.03
- 2008 EPS of $2.17 (6.9% increase)
- 2009 EPS of $2.02 (7.2% decline)
- 2010 EPS of $2.16 (6.9% increase)
- 2011 EPS of $2.64 (22% increase)
Walgreens’ consistent profitability provides a solid floor underneath the stock valuation.
Valuation and expected total returns
In the trailing four fiscal quarters, Walgreens generated adjusted EPS of $4.86. On this basis, the stock trades for a trailing price-earnings (P/E) ratio of 16.
This is significantly below the valuation of the S&P 500 Index, which trades for an average P/E ratio of 26.
Based on the company's high-quality business model, growth potential and low valuation, the stock appears to be undervalued.
An expanding valuation multiple could generate significant returns, as will Walgreens’ earnings growth and dividends.
A reasonable breakdown of potential returns is as follows:
- 4% to 6% organic revenue growth.
- 1% margin expansion.
- 2% share repurchases.
- 2% dividend yield.
As a result, the stock could generate 9% to 11% annualized returns moving forward, with the added potential of an expanding P/E multiple.
Cash returns will make up a significant portion of shareholder returns going forward.
For example, along with its quarterly earnings results, the company announced a new $5 billion share repurchase authorization.
The buybacks will be conducted over the next year and represent approximately 6% of the company’s market cap.
If the company utilizes the entire $5 billion, total shareholder returns could be even greater.
Final thoughts
This is a very challenging time for retail, but not all retailers are struggling.
Walgreens remains very healthy. Its sales and earnings are growing, which allows the company to pursue new strategic growth initiatives, buy back stock and raise its dividend.
Walgreens has raised its dividend each year for more than four decades, which speaks to the strength of its business model.
As a result, Walgreens is an attractive stock for dividend growth investors.
Disclosure: I am long WMT.
