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Walgreens Boots Alliance: Over 40 Straight Years of Dividend Growth

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 over 18,000 pharmacy stores around the world.

Following its 2014 merger with European pharmacy giants Boots, Walgreens changed its name to Walgreens Boots Alliance and became the largest retail pharmacy, health, and daily living destination across the U.S. and Europe.

The company operates 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.

Besides its retail stores, Walgreens owns distribution centers that deliver drugs to pharmacies, doctors, health centers, and hospitals. In addition, the firm is one of the world’s largest purchasers of prescription drugs and many other health and wellbeing products. 

Walgreens has three business segments:

  • Retail Pharmacy USA: 74% of revenue, 76% of operating profit.
  • Pharmaceutical Wholesale: 9% of revenue, 13% of operating profit
  • Retail Pharmacy International: 17% of revenue, 11% of operating profit 

The company's highest margins are from retail pharmacy, with 5.0% and 6.9% 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 2.9%.  

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 3% more AmerisourceBergen shares, which would give it the right to an additional board seat. 

With 43 consecutive years of dividend growth, Walgreens is a dividend aristocrat and well on its way to becoming a dividend king in 2026. 

Business Analysis
The retail pharmacy business is a 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 (78% 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 over 40 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. 
  • Closing a $720 million deal in 2017 to buy Prime Therapeutics, a pharmacy benefits manager (PBM) owned by 14 Blue Cross Blue Shield insurance plans. 
  • Completing the acquisition of 1,932 Rite Aid (RAD) stores in a $4.4 billion cash and debt acquisition in 2017. 
  • Purchasing a 40% stake in a leading retail pharmacy chain in China for $416 million in July 2018. 

These deals have made Walgreens the largest retail pharmacy in America, the fourth biggest PBM (filled over 800 million prescriptions in 2018), and one of the largest medical/wellness product sellers in the world. In fact, in 2018 Walgreens' market share in U.S. drug sales hit 22.4%, according to management.

The company's growth plans going forward are focused on four priorities. 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, which between 2014 and 2017 saved $1.5 billion (in late 2018 the firm announced a new three-year savings plan targeting $1 billion of expenses)
  • A 10-year supply agreement with contractor Fareva to take over the manufacturing of the company’s beauty brands and private label products

The second part of management's plans focus on maximizing growth in drug sale volumes, specifically through what the firm 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 in revamping its stores to emphasize this beauty focus. Management says the thousands of stores that it's revamped generally enjoy operating margins that are nearly 200 basis points higher than its other stores. In November 2018 Walgreens also announced a partnership with LabCorp to install at least 600 patient service centers (similar to CVS Minute Clinics) at Walgreens locations between 2019 and 2023. Those would replace lower margin retail space with more profitable and faster growing healthcare offerings. 

The final component of Walgreens' growth plan calls for significant investments in 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 88 million users, and its mobile app has been downloaded over 50 million times. 

Thanks to these efforts, 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 to create stickier relationships and higher profits. According to Deepika Pandey, Group Vice President of Customer Experience, Direct and Digital Marketing, customers who buy products online and through mobile are three to six times as profitable.

Overall, Walgreens believes its multi-pronged approach to increasing sales and cutting expenses, when combined with buybacks, will boost adjusted EPS by 7% to 12% in the year ahead. That's roughly in line with the long-term EPS growth rates analysts expect (9.5% annually over the coming five years) and should support many more years of high single-digit dividend growth.
Source: Walgreens Investor Presentation
Ultimately, Walgreens plans to remain one of the world's most important health retailers and suppliers of vital medications. If management can execute on its growth plans and adapt to the changing nature of the industry, then Walgreens has the potential to be a solid long-term dividend 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 5.5% annually over the next decade to about $6 trillion per year (20% of GDP). Medicare spending will lead the way with 7.4% annual growth as more baby boomers join the system.

Rising healthcare costs will likely cause strong pricing pressure from insurers including private payers, three of which account for approximately 24% of Walgreens' total revenue. 

Medicare and Medicaid account for another 18% of the firm's revenue. In total, 98% of Walgreens' prescription revenue is from third-party payers (managed care organizations, governmental agencies, PBM companies, and private insurance), many of whom have been consolidating in recent years (via M&A) in order to build scale and squeeze their suppliers.

This highlights the big downside to the entire medical sector. Yes, scale matters, and Walgreens' acquisitions over the years have made it a dominant name. But increasingly large size is merely a necessity to help prevent margin erosion by leveraging economies of scale and further cutting costs.

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.

One way that insurance companies (including Medicare) are trying to save money is by switching to longer 90-day prescriptions compared to 30-day refills that were the standard a few years ago. Here's what Walgreens says about this product mix shift in its 2018 annual report:

"Our Retail Pharmacy USA division has experienced a shift in pharmacy mix towards 90-day at retail in recent years. Our 90-day at retail offering for patients with chronic prescription needs typically is at a lower margin than comparable 30-day prescriptions.

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) now completed $78 billion acquisition of insurance giant Aetna. This massive deal is being funded by both stock and $40 billion in new debt, and resulted in CVS recently announcing it would end its 14-year dividend growth streak and freeze its payout until it could close the deal, integrate the companies, and deleverage the balance sheet.

In 2018 Walgreens was rumored to be considering an acquisition of health insurer Humana (HUM), in what could have been a $40 billion deal. There was some speculation that Walgreens might have to get into a bidding war with Walmart (WMT), which has also considered buying an insurance company.

Fortunately, in November 2018, CEO Stefano Pessina said at an industry conference that he plans to merely do joint ventures with Humana, commenting, "You don't have to go as far as full integration." Such a joint venture would include Walgreens and Humana taking undisclosed stakes in each other

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.

Ultimately, Walgreens decided against such a major move and instead again went with strategic agreements with Humana and LabCorp. 

Basically, the fast pace of disruption in the medical industry right now means companies like Walgreens are increasingly feeling pressure 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 workforces, supply chains, technology, and corporate cultures, many factors can cause disruption and result in targeted synergistic cost targets not being achieved. Thus it's reassuring that Walgreens is finding smart joint ventures and exclusive deals with partners rather than trying to buy its way to stronger growth.

However, it could also be argued that Walgreens' lack of transformative M&A represents a timidity that might hurt it in the long term. After all, in a dynamic sector such as healthcare, sometimes you have to make larger and riskier moves, which so far Walgreens has been unwilling or unable to make. 

Meanwhile, front-end retail sales continue to be a challenge for Walgreens. While overall U.S. comps are growing thanks to strong performance from pharmacy, same-store retail sales declined 0.3%, 1.0%, and 2.4% in fiscal 2016, 2017, and 2018, respectively. The international retail story isn't much better, with same-store sales declining 1.5% in 2018 due to what management called a "challenging retail environment" in Europe. 

Given the solid margins this part of the business carries, Walgreens needs to stabilize and improve the competitiveness of its retail operations.

The challenge is that 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. That's despite Walgreens attempts to build consumer loyalty via its rewards program (which actually lost 1 million U.S. members in 2018). 

This might explain why the company is looking to follow CVS's model of increasing the number of clinics in its sites to replace declining and low-margin retail items with more popular and higher-margin medical services. 

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. About 9 out of 10 prescriptions are stilled picked up at a retail pharmacy store, per The Wall Street Journal. 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, Walgreens is adapting. The firm partnered with FedEx in 2017 and claims to have the fastest delivery across the nation for prescriptions.

Amazon also 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 noted 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 much less net store growth than initially 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 than 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 43 consecutive 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 pickups 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 need to have realistic growth expectations from this dividend aristocrat and may even prefer investing elsewhere until the industry settles into a steadier state.

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