Walgreens on Tuesday reduced its full-year adjusted earnings guidance by about 12%, driven by lower than expected demand for Covid vaccines and testing, softer consumer spending on discretionary goods, and a weaker cold and flu season.
Most of these issues seem unlikely to alter the pharmacy chain's long-term outlook. But the firm's costly push into health services, which represent the key driver behind Walgreens' hopeful return to stronger growth in the years ahead, experienced a setback.
As a refresher, Walgreens has responded to retail pharmacy challenges like reduced drug reimbursements and online shopping by expanding into services such as primary care. See our July 2022 note for more background information.
Source: Walgreens Investor Presentation
Walgreens has invested billions of dollars in acquisitions and growth initiatives (e.g. opening in-store clinics) to build out this relatively new division, which now accounts for about 6% of sales. But scaling its patient base is taking longer than expected, attributed partly to the slower cold and flu season.
As a result, management expects this segment to record an adjusted operating loss of $550 million to $600 million in fiscal 2023, compared to a deficit of $330 million to $350 million projected last October. (For context, Walgreens' operating cash flow was $3.9 billion last year.)
With this division now tracking to break even within the first half of the upcoming fiscal year, which begins in September, management acknowledges that the anticipated profit ramp in healthcare services is "probably 6 to 12 months behind" where Walgreens hoped it would be.
The company's free cash flow will remain under pressure during this extended period of margin pressure and elevated growth spending. While Walgreens is expected to return to generating free cash flow in the year ahead, dividend coverage will be tight.
Source: Simply Safe Dividends
Lower profits for longer will also keep Walgreens' leverage ratio elevated. Moody's in January downgraded the firm's credit rating to Baa3 (equivalent to BBB-), and S&P's BBB rating could face scrutiny. Management prioritizes maintaining an investment-grade rating.
All of this adds up to more pressure on the dividend and leads us to downgrade Walgreens' Dividend Safety Score from 79 to 70 within our Safe bucket.
Should the company's plan face any additional setbacks, another score downgrade is likely.
For now, we are willing to give Walgreens more time to execute. Following this reset, the firm is stepping up cost savings plans, closing unprofitable stores, and slowing its pace of new clinic openings to focus more on profitable growth.
If all goes well with the ramp in healthcare services from here, Walgreens over the next two years should see leverage return to investment-grade levels and its free cash flow payout ratio fall below 50%.
In the meantime, even with little retained cash flow, Walgreens can improve its balance sheet through non-core divestitures, including its remaining stake in AmerisourceBergen valued at $5 billion.
For context, the firm carries roughly $12 billion of book debt (excluding operating leases), and Walgreens' dividend costs about $1.7 billion per year.
All of these factors, including expectations for losses to sharply reduce in health services next quarter, gave management confidence to issue strong support for the payout:
"So I want to make it crystal clear, we are absolutely committed to the dividend, absolutely committed both to the dividend and our investment-grade rating."
– CFO James Kehoe, 6/27/23 Earnings Call
Walgreens has historically increased its dividend in mid-July. We would guess another token increase is around the corner.
Until the company shows a clearer path to higher profits and improves its balance sheet, Walgreens will likely remain a "show me" story with investors.
If we owned shares of Walgreens, we'd likely maintain our position and give the company another 6 to 12 months to show improving profitability and traction in healthcare services, which have largely remained in a developmental phase.
Underneath these less proven growth initiatives, the core retail pharmacy business should remain a cash cow due to its entrenched market position and growth in prescription orders as America's population ages.
That should eventually set a floor on the stock's price and buy management time to gradually evolve the business, barring a need to move more aggressively as the healthcare industry evolves.
We will keep monitoring Walgreens' turnaround and provide updates as needed.
