Rising Debt Costs Increase Odds of a Walgreens Dividend Cut
Interest rate expectations have ratcheted higher over the past month, increasing the odds that Walgreens will cut its dividend to provide more financial flexibility as it works to reinvent itself.
Since the start of September, when Rosalind Brewer stepped down as CEO of Walgreens, the 10-year Treasury yield has jumped from 4.2% to 4.7%, reaching its highest level since mid-2007.
Meanwhile, on the short end of the curve, the Fed in September once again increased its projections for the Federal funds rate to stay higher for longer as the battle against inflation continues.
Source: The Wall Street Journal
The Federal funds rate influences short-term borrowing costs throughout the economy, including the interest owed on the approximately 35% of Walgreens' debt that has floating rates.
Around 30% of the retail pharmacy's fixed-rate debt also matures through 2025. The average interest rate on these notes, which sits below 4%, will likely jump a couple of percentage points once the debt is refinanced.
If borrowing costs across Walgreens' variable-rate debt and fixed-rate maturities through 2025 increased an average of 2% compared to their current levels, we estimate the pharmacy chain's annual pre-tax interest expense would rise by approximately $130 million.
That might not sound like too much compared to the $1.9 billion of free cash flow the firm is projected to generate in the year head.
But Walgreens' dividend costs $1.7 billion annually, and it's worth noting that management opted to freeze rather than raise the dividend in August (a token 1% increase would've added less than $20 million to the payout's annual cost).
Source: Simply Safe Dividends
Barring a jump in free cash flow, rising debt costs leave the firm with even less wiggle room to retain capital for reinvestment or debt reduction.
That latter point is important because Walgreens' BBB credit rating has a negative outlook from S&P. Management wants to retain an investment-grade rating to ensure the company maintains access to debt capital on reasonable terms.
Coupled with an ongoing search for a permanent CEO and a potential need to invest more in a long-term growth strategy, Walgreens looks increasingly likely to cut its dividend, perhaps as soon as the company's October 12 earnings report. Recognizing the more expensive financing environment that makes debt reduction an even more attractive capital allocation priority, we are downgrading Walgreens' Dividend Safety Score from Borderline Safe to Unsafe.
Although a lot of managerial discretion is involved with this type of decision, a 30% to 50% cut seems most likely if Walgreens decides to change capital allocation priorities.
That would save at least $500 million per year and put in place a more comfortable payout ratio for a company making significant growth investments.
With Walgreens' shares already pricing in a lot of bad news, the question now is how shareholders should proceed.
Although the stock's valuation has further declined since our note earlier this fall, our concluding thoughts haven't changed:
If we were shareholders, Walgreens' sudden leadership changes and impending strategic shift would likely be the deciding factor that prompts us to cut our losses and sell our shares.
While the company's core retail pharmacy business still looks like a durable cash cow with modest growth potential, Walgreens could be facing years of work getting its business mix where it wants it to be for the long term, all while trying to preserve its investment-grade balance sheet and (frozen) dividend.
When it comes to "turnaround" stocks, the success rate we've observed is generally low. Anecdotally, maybe one in three work out well.
While the winners can win big, we prefer to avoid companies that face a prolonged battled to return to profitable growth and shore up their balance sheets.
Walgreens seems to fall into this camp since its business model relies on bringing foot traffic to its stores (front-end retail generates 25% of revenue and carries higher margins than prescription drug sales).
Offering health services with an emphasis on in-store clinics – the crux of Walgreens' recent strategy – might not be enough to stand out from the pack, as demonstrated by the firm's slower-than-expected growth in its patient base.
For investors interested in alternative ideas, we think the following stocks have more attractive long-term outlooks, safer dividends, stronger balance sheets, and comparable dividend yields:
Enterprise Products Partners (EPD): BBB+ rated master limited partnership with a diversified mix of midstream services protected by long-term, fixed-fee contracts and volume protections.
Main Street Capital (MAIN): investment-grade rated business development company that benefits from higher-for-longer interest rates and has paid uninterrupted dividends since 2007.
Enbridge (ENB): large Canadian pipeline company with a self-funded business model, BBB+ credit rating, and mission-critical assets.
NNN REIT (NNN): triple-net retail REIT with over 90% fixed-rate debt, few maturities through 2025, a diversified portfolio of more than 3,000 properties, and a BBB+ credit rating.
We plan to provide another update for our members following Walgreens' October 12 earnings report and will continue monitoring the company's turnaround strategy.
