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Walgreens Boots Alliance (WBA)

Founded in 1901 (but with roots going back to 1849), Walgreens Boots Alliance (WBA) is one of the world’s largest pharmacy retailers and drug distributors, operating 13,200 pharmacy stores in 11 countries. Including its equity stakes, the company's 385,000 employees operate in over 25 countries. Walgreens Boots Alliance is the largest retail pharmacy, health, and daily living destination across the U.S. and Europe.
Source: Walgreens Investor Presentation
Besides its retail stores, Walgreens owns 390 distribution centers that deliver pharmaceuticals to more than 230,000 pharmacies, doctors, health centers, and hospitals each year in over 20 countries. In addition, Walgreens Boots Alliance is one of the world’s largest purchasers of prescription drugs and many other health and wellbeing products. 

The company has a portfolio of retail and business brands, including Walgreens, Duane Reade, and Boots stores, as well as increasingly global health and beauty product brands, such as No7, Soap & Glory, Liz Earle, Sleek MakeUP and Botanics.

The company has three business segments:

  • Retail Pharmacy USA: 73% of revenue
  • Pharmaceutical Wholesale: 17% of revenue
  • Retail Pharmacy International: 10% of revenue

The company's highest margins are from retail pharmacy, with 6.7% and 8.4% adjusted operating margins in the U.S. and internationally, respectively. The pharmaceutical wholesale business, which primarily distributes prescription medicines to pharmacists, has an adjusted operating margin of just 2.5%. 

Walgreens sources its drugs from AmerisourceBergen (ABC), of which it owns a 26% equity stake (and has one board seat). The company has the right to purchase up to 15% more Amerisource shares, which would give it the right to an additional board seat. 

Business Analysis

The retail pharmacy business is a very tough industry characterized by fierce price competition and little differentiation. After all, there are few noticeable differences inside of a Walgreens or CVS store.

This is why Walgreens and its large rivals count on convenient store locations (76% of the U.S. population lives within five miles of a Walgreens or Duane Reade retail pharmacy), strong branding power, and large economies of scale to drive top and bottom line growth.

Walgreens' management has done an admirable job of achieving relatively strong growth in both sales and earnings, which has allowed the company to deliver 41 consecutive years of dividend growth.

Acquisitions have been a key growth driver for the company. Some of its notable deals include:

  • Acquiring Duane Reade for $1.1 billion in 2010
  • Buying a 45% stake in Alliance Boots (Europe's biggest pharmacy chain) in 2012, followed by the rest of the company in 2014 in a $8.5 billion deal. 
  • In March 2017, Walgreens closed a $720 million deal to buy Prime Therapeutics, a pharmacy benefits manager (PBM) owned by 14 Blue Cross Blue Shield insurance plans. 
  • In September 2017, Walgreens completed the acquisition of 1,932 Rite Aid (RAD) stores in a $4.4 billion cash and debt acquisition. 

These deals have made Walgreens the largest retail pharmacy in America, the fourth biggest PBM (filled 765 million prescriptions in 2017, up from 740 million in 2016), and one of the largest medical/wellness product sellers in the world. In fact, in the most recent quarter Walgreens' market share in U.S. drug sales hit 21.4%, up 1% from a year ago.

The company's growth plans going forward are focused on four things. First, Walgreens wants to maximize economies of scale to drive down costs. The company plans to pursue numerous efficiency initiatives including: 

  • A generic drug sourcing joint venture between itself, AmerisourceBergen, Rite Aid, and Express Scripts (ESRX)
  • A corporate restructuring it calls Cost Transformation Program ($700 million in annual savings, not counting Rite Aid acquisition synergies, which remain on track)
  • A 10-year supply agreement with contractor Fareva to take over the manufacturing of the company’s numerous beauty brands and private label products

Next, Walgreens wants to maximize growth in drug sale volumes, specifically through what it calls its preferred pharmacy strategy. Walgreens essentially offers PBMs discounted generic drug prices in order to become the preferred choice for customers to fill their prescriptions. 

Third, the company is attempting to boost its retail sales (non-pharmacy products) through two main efforts. First, Walgreens' is refocusing its product mix, with a greater emphasis on its own branded products, especially in beauty and wellness categories. 

Second, the firm has been investing heavily into revamping its stores to emphasize this beauty focus, including improvements at about 2,800 U.S. stores so far. Management says the stores that it's revamped generally enjoy about 2% higher operating margins (about 8.7%). 

Finally, the company is investing heavily into technology, both in terms of streamlining its supply chain, but also its digital engagement with customers. For example, in the U.S. Walgreens' rewards program has 89 million users, and its mobile app has been downloaded over 51 million times. 

Over 20% of the company's prescription refills are now mobile based. The goal for the company is to maximize total digital engagement with customers. That's because according to Deepika Pandey, Group Vice President of Customer Experience, Direct and Digital Marketing, customers who buy products online and through mobile (over 70% and 50%, respectively) are three to six times as profitable. 

Ultimately, Walgreens plans to remain one America's, and the world's, most important health retailers and suppliers of vital medications. If management can execute on its growth plans and adapt to the rapidly changing nature of the industry, then Walgreens has the potential to be a strong long-term income growth investment. 

Key Risks

There are several main risks to understand before investing in Walgreens. The first is that the same demographic tailwinds that are driving increased demand for medical services and drugs could also pose significant challenges to the company's profitability.

For example, according to the Centers for Medicare/Medicaid Services, U.S. healthcare spending is expected to rise by about $2 trillion per year, from 18% of U.S. GDP to 20% by 2025.
Source: HCP Investor Presentation
Rising healthcare expenditures have resulted in both the government and private companies putting increasing pressure on margins via a push for lower reimbursement rates. 

That could prove a major challenge for Walgreens because in 2017, about 98% of drug sales were to managed care organizations, governmental agencies, PBM companies, and private insurance. That includes 23% of U.S. pharmacy sales being to Medicaid/Medicare, which is up from 21% a year ago as a rising number of Medicare-enrolled seniors increases the company's exposure to government-funded healthcare.

The Centers for Medicare/Medicaid Services has unveiled new policies designed to lower drug costs as well, including allowing generic drugs to be entered into a formulary at any time of the year (rather than just once a year), and eliminating the provision that Medicare Part D plans had to be significantly different from each other. This is meant to increase competition for supplemental Medicare insurance policies.

Meanwhile, government health systems in Europe are also attempting to lower costs on an annual basis. Part of this is through higher use of generic drugs, which create lower margins for the pharmacy segment, though better margins for wholesale drug distribution.

In addition, Amazon, (AMZN), Berkshire Hathaway (BRK.B), and JPMorgan Chase (JPM), have announced they are partnering to create a non-profit company designed to supply healthcare to their U.S. workers. The goal is to combine each company's expertise in technology-based distribution, insurance, and finance to create a lower cost option for both themselves and possibly other companies in the future.

The strong need to lower medical expenses and fend off competition from growing threats such as Amazon has led to massive consolidation across the healthcare industry. That includes CVS Health's (CVS) planned $69 billion acquisition of insurance giant Aetna (AET). This massive deal is being funded by both stock and a lot of debt, and resulted in CVS recently announcing it would end its 13-year dividend growth streak and freeze its payout until it could close the deal, integrate the companies, and deleverage the balance sheet.

Walgreens has been rumored to be considering an acquisition of health insurer Humana (HUM), in what would likely be a $40 billion deal. The company might end up in a pricing war with Walmart (WMT), however, whicj is also reportedly considering buying the insurance company.

Meanwhile, in February 2018, the Wall Street Journal reported that Walgreens was also considering buying the remaining 74% of Amerisourcebergen, its wholesale distribution partner and drug supplier. The rationale behind this deal would be to increase Walgreens' vertical integration by giving it more control over its supply chain to keep more of the margin it earns from drug sales.

At current prices, and assuming a modest 20% premium, that deal would likely be for about $17 to $18 billion. If either acquisition occurs, then there is a risk that Walgreen's future dividend growth rate might become much slower. 

The fast pace of disruption in the medical industry right now means companies like Walgreens are increasingly having to grow through acquisitions in order to maximize economies of scale and become more efficient. However, every large acquisition comes with key execution risks.

From overpaying for a deal, to diluting shareholders, to combining work forces, supply chains, technology, and corporate cultures, many factors can cause disruption and result in targeted synergistic cost targets not being achieved.

Meanwhile, front-end retail sales continue to be a challenge for Walgreens. While retail same-store sales are growing at a healthy 2% rate, thanks largely to strong growth in pharmacy sales, traditional retail same store sales fell 2.7% in the most recent quarter in the U.S. and dipped 2.8% internationally.

Consumers are increasingly shopping online, reducing their need for many of the goods sold at higher prices in drugstores, which are perhaps seeing their convenience value erode in today's digital world. 

Retail is a notoriously competitive industry after all. While Walgreens certainly offers convenient locations, enjoys meaningful scale, and draws in steady traffic thanks to its prescription fulfillment business, giants such as Amazon, Walmart, and Target are making a big push into online sales. Walgreens might have trouble competing with them for market share.

Even if the company can turn around the struggling retail side of the business, it is likely to require significant capital investment to revamp thousands of stores.

Besides competing on the retail side, Amazon has expressed interest in selling prescriptions online. Per The Wall Street Journal, about 9 out of 10 prescriptions are stilled picked up at a retail pharmacy store. Not much has changed over the decades despite the boom in technology and the fact that doctors primarily send their prescriptions to drugstores electronically.

While Walgreens has a large base of conveniently located stores, online shopping is still easier and more seamless for a growing number of people. With that said, Amazon faces a number of major hurdles before it can be an effective rival in this space. For one thing, pharmacies are required to have a state-issued license to sell medicines, and The Wall Street Journal notes that "the patient usually doesn't pay directly for their prescription drugs."

Regardless, with so much uncertainty and consolidation in the medical industry right now, Walgreens might be trapped in an arms race in which it has to grow at all costs, and as fast as possible. That can lead to ill-conceived acquisitions that can take far longer to complete, as seen with the Rite Aid acquisition that took nearly three years to close and ultimately resulted in about three times less net store growth than previously expected.

Even if Walgreens is able to execute on its strategy of driving higher volume growth and maximizing cost savings through economies of scale and investments into digital drug distribution, margin pressure could remain a problem. That's because industry consolidation means that the company will be dealing with a smaller number of large customers who can command stronger pricing power.

As a result, management's efforts to cut costs might only be able to keep margins flat, rather then grow them over time. The end result could be slower earnings and free cash flow growth compared to the past, weighing on future dividend growth prospects.

Closing Thoughts on Walgreens Boots Alliance

With 41 straight annual dividend increases under its belt, Walgreens Boots Alliance has proven itself to be one of the most shareholder-friendly companies in America. The drugstore business has long been a solid cash cow, benefiting from high regulations, economies of scale, and consistent foot traffic from prescription pick ups that created ample opportunity to sell high-margin retail goods.

However, the healthcare and retail sectors are increasingly complex and rapidly evolving. Amazon and others are increasingly taking share from brick-and-mortar retailers as more consumers shop online, and drug prices are under pressure as governments and insurers seek to control rising healthcare costs. 

Simply put, the entire distribution chain that delivers drugs from manufacturers to patients is under different pressure points. Walgreens has managed to continue growing despite increasingly challenging industry conditions, but the lines continue to blur between insurers, PBMs, drugstores, and other players. 

While rising overall medical spending could continue to drive steady growth for the company, the question facing Walgreens and investors is whether or not the firm will be able to continue adapting fast enough to maintain its overall profitability. 

When combined with the potential for a major acquisition, there is a lot of uncertainty surrounding the pace of Walgreen's future dividend increases. The company should continue to pay a safe dividend, but conservative investors may be better off going elsewhere for predictable payout growth until the industry settles into a steadier state. 

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