Dividend Aristocrats In Focus Part 26 of 54: Walgreens

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Oct 23, 2014
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In part 26 of the 54 part Dividend Aristocrats In Focus series, I take a look at the competitive advantage and growth prospects of drug store chain Walgreens (WAG, Financial). Walgreens has experienced decades of expansion as customers have grown accustomed to the store’s convenience. Walgreens has increased its dividend payments for 39 consecutive years. In the section below I will analyze the company’s business operations to get a feel for the company’s operations.

Business overview

Walgreens operates more than 88,000 drug stores, primarily in the U.S. The company has a market cap of $59 billion and competes with larger rival CVS Pharmacies (CVS, Financial) which has a market cap of about $96 billion. Together, the two businesses make up the majority of the largely consolidated U.S. drug store market.

Walgreens is very much in transition after the company’s management has positioned it for future growth. In 2013, the company entered into a strategic agreement with drug wholesaler AmerisourceBergen (ABC, Financial). The deal aligns the interests of both companies by giving Walgreens warrants and purchase rights for a total of 23% of the company. In addition, the deal will allow Walgreens to appoint 2 members to AmerisourceBergen’s board of directors. The deal is a net positive for Walgreens as it closely allies the company the second largest generic drug wholesaler in the US. Not to be outdone, CVS later aligned itself with the third largest generic drug wholesaler in the US, Cardinal Health (CAH, Financial); Cardinal health is also a dividend aristocrat. The AmerisourceBergen deal has helped Walgreens have competitive pricing in the extremely important generic drug market.

Walgreens other strategic maneuver was to acquire a 45% stake in Alliance Boots in 2012. Alliance Boots is a drug store chain based in Switzerland, but with the bulk of its operations in the United Kingdom and Ireland. The drug store chain has a presence throughout much of Europe and Thailand as well (a bit of an odd geographic combination). In addition to its drug store chain operations, Alliance Boots also manufactures and sells the No. 7 line of beauty products, among others. Walgreens has announced it will acquire the remaining 55% of Alliance Boots, and expects the deal to close in the first quarter of 2015.

In addition to expanding Walgreens into a global operation, the Alliance Boots transaction could have given Walgreens significant tax advantages by moving the company’s headquarters to Switzerland where Alliance Boots is headquartered. Walgreens’ management decided not to capitalize on the tax inversion strategy due to fears of negative publicity arising from “tax fairness” questions.

Competitive advantage

Walgreens’ competitive advantage rests in its scale both in the U.S. and in Europe through the Alliance Boots acquisition. The company’s relatively small (compared to grocery stores and big box stores) store layouts and locations on the corners of intersections (hence the "corner store" name) make shopping very convenient. In addition, the company offers low prices on prescription medicine. Customers who need to refill prescription medication on a regular basis present an opportunity not only for recurring prescription revenue for Walgreens, but also for additional sales if the customer enters into the store to fill his/her prescription. Once inside, customers are likely to make additional purchases.

The company’s AmerisourceBergen partnership creates a strong competitive advantage in generic prescription pricing by lowering the company’s costs. The company’s rival CVS matched Walgreens’ competitive advantage by striking a similar agreement with AmerisourceBergen’s largest competitor Cardinal Health. Still, Walgreens and CVS stand alone in their purchasing power and pricing ability in generic pharmaceuticals thanks to their recent strategic partnerships.

Growth prospects

As mentioned above, Walgreens failed to capitalize on potential tax savings by not going through with its tax inversion plan. Despite this, the company has significant growth prospects ahead. The company is expected to generate between $4.25 and $4.60 in EPS in fiscal 2016, once the full acquisition of Alliance Boots is integrated with the company. The company currently has EPS of about $3.00 per share. This is a compound annual growth rate of about 20% through 2016.

Over the long term, Walgreens’ growth will come from rising prescription use as the global population ages, especially in the developed world where Walgreens has the largest presence. The company stands to benefit from both an aging population in Europe and the U.S. brought about by the “baby boomer” population bulge, and from rising prescription drug use and greater health care coverage and usage in general. Walgreens has managed to grow revenue per share at 7.8% per year over the last decade. The company will likely be able to maintain an 8% revenue per share growth rate going forward as the trends listed above propel growth.

Dividend analysis

Walgreens has grown its dividend payments at over 20% per year over the last decade, while earnings per share have increased at about 8.5% per year. The company will not be able to grow dividends well above earnings per share indefinitely. The company currently has a payout ratio of 30% to 35%, and a current payout ratio of about 45%. The company is expecting a big increase in EPS through 2016. If the company hits the mid-range of its EPS target for fiscal 2016 of $4.43, it will have a dividend payment of $1.55 per share for 2016. This comes to a 7.2% dividend growth rate over the next two years. Past that, I expect the company to grow dividends at around 8% to 9% a year, in line with overall company revenue and earnings per share growth. If Walgreens can maintain a 9% dividend growth rate after 2016 (which I believe is likely), shareholders who purchase today will have the following yield on cost over various time frames:

  • 3 Years: yield on cost of 2.75%
  • 5 Years: yield on cost of 3.27%
  • 10 Years: yield on cost of 5.03%

Final thoughts

Walgreens ranks in the Top 40 based on the 8 Rules of Dividend Investing due to its strong 10 year revenue per share growth rate of about 7.8%, its below average price standard deviation, and its below average payout ratio. The company is in a state of transition right now as it plans to integrate the remaining 55% of Alliance Boots operations into its own. The company is benefitting from favorable long-term trends in the health care industry. Overall, Walgreens is not my first choice, second choice, or even third choice in the health care sector, but it is a solid holding for a highly diversified dividend growth portfolio.