Walgreens: Ridiculously Cheap at Current Levels

The combination of a high yield and low valuation make the pharmacy retailer a buy

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Jun 18, 2020
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Just over a week ago, I highlighted several stocks I thought looked attractive based on their valuations and dividend yields relative to their historical averages.

Of these names, Walgreens Boots Alliance (WBA, Financial) was trading the furthest below its 10-year average valuation. The stock also offers a 4%+ dividend yield at the moment, which is nearly double the stock’s average yield since 2010. A year-to-date share price decline of 28% has aided in realizing these figures.

Given the valuation and yield, I believe Walgreens to be far too cheap and find the stock is strong buy today.

Quarterly highlights

While I’ve already stated I am interested in the stock because of its valuation and dividend, Walgreens’ most recent quarter was solid. Revenue grew 3.7% to $35.8 billion for the second quarter of fiscal 2020, beating analysts' estimates by $575 million. Excluding the impact of currency translation, revenue was higher by 4.1%. Adjusted earnings per share decreased 7.3% to $1.52, though this was 6 cents higher than Wall Street analysts were looking for. Earnings declined mostly due to a challenging retail market in the UK.

The Retail Pharmacy U.S. segment had sales growth of 3.8% to $27.2 billion. Comparable same-store sales for locations opened at least one year were higher by 2.7%. Pharmacy sales were up 5.3%, with comparable sales growing 3.7%. The total number of prescriptions filled reached 296.8 million, 3.7% higher than the previous year. Even with this growth, prescription market share decreased 50 basis points to 21%. Still, Walgreens' prescription market share is second only to CVS Health Corporation (CVS, Financial), which means the company is still a dominant player in the U.S. market.

Retail Pharmacy U.S.'s retail business had a sales decline of 0.3%, but, excluding tobacco sales, improved 1.9%. Overall, comparable sales were up 0.6%. Strong demand in Health & Wellness due to cold, cough and flu season aided results.

Retail Pharmacy International decreased 0.8% to $3.1 billion. In constant currency, sales were lower by 4.6%. This segment maintained its share as the market in the UK as a whole declined.

Pharmacy Wholesale performed quite well, with sales growing 5.7% to $6.1 billion. Excluding the impact from currency, sales were up 8%. This segment saw strong growth rates in the UK and emerging markets.

Wrapping up second quarter results, net cash provided by operating activities almost doubled to $2.5 billion while free cash flow improved $1.4 billion to $1.8 billion. Walgreens stated that it remains on target in its efforts to reduce annual costs by $1.8 billion by fiscal 2022.

Walgreens had expected EPS to be flat year-over-year, but has now pulled its full year guidance due to the pandemic. According to Yahoo finance, analysts expect that the company will produce $5.45 of EPS in fiscal 2020.

The company also reviewed some of its growth initiatives on the conference call. First, it expects to close a total of 400 underperforming stores between its U.S. and UK businesses. So far, 156 total stores have been closed.

Walgreens has also partnered with the Kroger Company (KR, Financial) to form a purchasing organization to reduce costs and bring each other’s products to a select number of stores. This has now been accomplished in 50 Walgreens stores and 17 Kroger stores.

The company’s digital platform was accessed two million times in the second quarter, a 40% increase from the first quarter of fiscal 2020. The Walgreens app has now been downloaded 62 million times, a 22% increase from the prior year. A good portion of this growth can be attributed to the Covid-19 pandemic. Some consumers may not use the app once the pandemic has settled, but many will likely continue to use the company’s digital platform the more comfortable they become with it. As a result of an increase in the number of consumers using the company’s digital platform, Walgreens saw digitally initiated sales grow 7% to $4.1 billion.

In review, Walgreens' second quarter saw better than expected performance on the top and bottom lines. The UK segment remains challenged, but Walgreens was able to keep its market share in a difficult retail environment. Overall, I don’t see too much in the company’s business to be overly concerned. On the other hand, there was some real strength to be had, with the company’s U.S. and Wholesale businesses performing quite well.

Dividend analysis and valuation

Walgreens has increased its dividend for the past 44 years. The company’s dividend has a compound annual growth rate of:

  • 3.6% over the past three years.
  • 5.4% over the past five years.
  • 11.7% over the past 10 years.

The company’s most recent raise was 4% for the Sep. 12, 2019 payment. Walgreens is expected to be announcing a dividend increase sometime in early July. The dividend growth rates have slowed over the years, especially over the past five years. Still, Walgreens has an impressive dividend growth streak that not many companies can match.

Income investors should note that the stock has a yield of 4.3% based off of Wednesday’s closing price. According to Value Line, shares have an average dividend yield of 2.1% and 2.2% over the past five and 10-year periods of time, respectively. There is a massive difference between the current yield and these average yields for the stock. Comparing the dividend yield alone, Walgreens appears to be especially cheap.

Dividend yield isn’t the only thing that shows that shares of Walgreen are undervalued. The stock’s valuation is so incredibly low compared to its history. Walgreens had EPS of $5.99 last year. Based off the most recent closing price of $42.15, shares of the company have a trailing price-earnings ratio of 7. Using expected earnings for fiscal 2020, the stock has a forward price-earnings ratio of 7.7. For context, the average price-earnings ratio over the last five years is 15.3. The average earnings multiple expands to 15.9 when going back a decade.

Despite Wall Street analysts expecting EPS for fiscal 2020 to decline 9% year-over-year, the forward price-earnings ratio is about half of the 10-year average. This tells me that there is a major disconnect between what is occurring within the company’s business and how the market is valuing shares of Walgreens.

Walgreens did see weakness in parts of its business, but the U.S. segment, the company’s largest, had solid growth. The Wholesale segment, which is the second largest within the company, performed even better. And the weakest part of the business, the Retail Pharmacy International, managed to keep its market share intact even as sales were lower year-over-year.

For caution's sake, let's suppose that Walgreens’ decade-long average valuation is a thing of the past. A valuation range of 11 to 13 may make more sense in the short term. Let’s also suppose that Walgreens manages to deliver on its expected EPS for the year. If shares were to trade within this range, then the stock should be worth $60 to $71. This would be a gain of 42% to 68% from the most recent closing price. On top of that, investors would still receive a dividend yield of 2.6% to 3.1% if the stock were to hit my target valuation range. It should be noted that this yield is still higher than either the five or 10-year average yield for the stock.

Final thoughts

Walgreens posted a beat on both revenue and EPS estimates in its most recent quarter. The company did see some weakness in its international business, but its two largest segments still had year-over-year growth. The company also has several growth initiatives working in its favor as well as a cost savings plan that should reduce annual costs by almost $2 billion by fiscal 2022.

The company also has a stellar dividend growth track record, and the current dividend yield is almost double the 10-year average yield. Shares of Walgreens are also trading at half of their normal price-earnings ratio.

Altogether, I believe that shareholders of Walgreens could see a minimum of a 45% total return just from shares trading with a valuation that is still well-off its 10-year average. Therefore, I rate Walgreens as a strong buy.

Author disclosure: the author is long CVS Health Corporation

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