Walgreens: Waiting To See If New Medicine Works (NASDAQ:WBA) (2024)

I came across Walgreens Boots Alliance, Inc. (NASDAQ:WBA) while screening for stocks trading at cheap valuations. With a non-GAAP Fwd P/E of just 5.5x, Walgreens is certainly one of the cheapest large-cap stocks in the market (Figure 1).

However, stocks are typically not this cheap without a reason. So what's the reason behind Walgreens' weakness, and is this a turnaround story investors should get behind?

Overall, there are green shoots to the Walgreens story, with a new management team in place and potentially better margins via adopting 'cost-plus' pricing. However, I feel it is simply too soon to buy. I would rather wait and see better financial performance before placing my bets. I rate Walgreens a hold.

Company Overview

Walgreens Boots Alliance is an integrated healthcare and pharmacy retailer serving customers for more than a century. The current version of the company was formed in 2014 when Walgreens acquired 55% of U.K.-based Alliance Boots which it did not already own, forming an international retail pharmacy giant in the process.

Today, Walgreens operates nearly 13,000 stores across the U.S., Europe, and Latin America, providing critical retail pharmacy services to customers. Walgreens also owns a majority stake in VillageMD, a chain of primary and urgent care clinics across the United States, and Boots, a chain of optical stores in the U.K.

A Decade Of Underperformance

Despite owning a 20%+ market share in the U.S. retail pharmacy market and filling more than 1.2 billion 30-day equivalent scripts in 2023, Walgreens' stock has been on a never-ending downtrend. Since peaking in August 2015, WBA shares have lost an incredible 76% in value, even after accounting for its often handsome dividend (Figure 2).

Retail pharmacies have faced many challenges in recent years. First, the proliferation of online shopping and specialty cosmetic retailers like Sephora have pressured pharmacies' front-store sales, often a key driver of profitability. In fact, if I recall correctly, the key motivation for the Boots acquisition was to distribute Boots' proprietary high-street cosmetic brands like Boots No. 7 to American consumers.

In the dispensary, customers are also increasingly opting for online pharmacy services, especially when it comes to chronic medications, with even Amazon wading into the fray. This is problematic for brick-and-mortar pharmacies like Walgreens because chronic medications are often the easiest to fill (think off-the-shelf blister packs) with some of the highest margins. Without easy-to-fill chronic medications to balance the load, brick-and-mortar pharmacies are often left with complex scripts (think whipping up a topical ointment from base ingredients) or urgent-care medications that are costly to fulfill.

Furthermore, the American healthcare system is unique in that it is highly specialized (some say 'broken'), with lots of middlemen called Pharmacy Benefit Managers ("PBM") that negotiate the pricing of medicines between insurance companies and drug manufacturers (Figure 3).

While Walgreens appears to be a giant with $145 billion in LTM revenues, compared to the PBMs like UnitedHealth Group Incorporated (UNH), The Cigna Group (CI) and CVS Health Corporation (CVS), Walgreens is but a minnow with low negotiating power. Therefore, profits for retail pharmacies have been under a never-ending squeeze, especially after CVS, another large chain of retail pharmacies, moved up the value chain and acquired the PBM Caremark in 2007. This move allowed CVS to not only fill prescriptions but also affect the formularies (i.e., what insurance companies are willing to pay for) and pricing.

Comparing the stock performance of CVS vs. Walgreens shows the impact of corporate strategies on companies over the long run (Figure 4). Those with foresight and good strategies like CVS have seen their shares rise 97% since the Caremark acquisition (but still worse than the S&P 500 Index), while those that doubled down on the weak retail pharmacy business model like Walgreens have seen their shares decline by 61%. Some, like Rite Aid, have even gone bankrupt.

History Of Writedowns Show Poor Management

Speaking of corporate strategy and management, Walgreens has an incredible track record of restructuring and impairment charges, spanning at least half a decade (Figure 5). This was capped most recently by a gargantuan $12.4 billion impairment charge recorded in the second quarter, which included a $5.8 billion after-tax impairment on VillageMD, the chain of clinics that was only acquired in January 2023.

With this level of mismanagement, is it any wonder the stock has lost 76% of its value in the past decade?

Will the New CEO Shake Things Up?

While some shareholders and analysts may rejoice at the recent appointment of Tim Wentworth as CEO of Walgreens, I am more skeptical. True, Mr. Wentworth has an impeccable resume, having previously been the CEO of both Evernorth, the health services division of Cigna Group, and Express Scripts, a large PBM. However, Stefano Pessina remains Mr. Wentworth's boss as Executive Chairman of Walgreens.

Mr. Pessina was the CEO of Walgreens from 2015 to 2021 and was formerly the Executive Chairman of Alliance Boots. If one of the key architects of the current Walgreens mess is still a leading executive, how much change will investors really see?

Cost-Plus May Be The Perfect Medicine

Recently, there has been a push for 'cost plus' pricing for common medicines. In this new business model pioneered by billionaire Mark Cuban, customers pay a 'straightforward' acquisition cost for individual drugs, plus a small markup covering dispensing and service costs for the pharmacy. The idea behind 'cost plus' pricing is to improve the transparency of medicine prices and push the onus (and consumers' ire) of high prices back onto the insurance and pharmaceutical companies.

Walgreens' newly appointed CEO, Tim Wentworth, has signaled that he is supportive of the new business model on the company's Q1 earnings call: "We welcome and will work with payer and PBM partners on any model that recognizes and reimburses pharmacies for the unmatched value we provide patients, including pharmacy services, as well as those models that can ensure more transparency and predictability in reimbursem*nt".

While 'cost plus' could improve Walgreens' margins (i.e. less reimbursem*nt squeeze from PBMs), I am not certain if this is a long-term cure for Walgreens' ills. The problem is that brick-and-mortar retailers like Walgreens have a fundamentally higher cost structure relative to online pharmacies like Mark Cuban's Cost Plus Drug. What is a profitable markup for online 'ghost' pharmacies may not be enough for Walgreens.

Valuation Appears Cheap

When it comes to valuations, Walgreens certainly looks cheap at first glance. As I mentioned at the outset, Walgreens is trading at just 5.5x non-GAAP Fwd P/E, a large discount to its closest peer, CVS, which trades at 8.0x (Figure 6).

However, Walgreens shares are also quite risky, as the company has a bad balance sheet with $34.6 billion in debts and leases (Figure 7).

So on a Fwd EV/EBITDA basis (which looks at enterprise value including debt), Walgreens is not that cheap, trading at 10.5x compared to CVS at 8.0x.

However, one point in Walgreens' favour is its dividend, which is currently an attractive 5.6% yield (Figure 8).

Walgreens cut its dividend nearly in half in late 2023, so the current dividend rate is likely safe unless the business deteriorates further.

Risks To Walgreens

The biggest risk to Walgreens is that the latest restructuring and business model changes may not be enough to turn around the company's fortunes. Time may not be on the company's side as it has a heavy debt load that needs to be serviced.

However, on the upside, if the Q2 write-off was new management's 'clearing the decks' moment, then perhaps I am too harsh on the company, and it may start to report better financial performance. Already, adjusted earnings came in better than expected in Q2, although these were overshadowed by the giant $12.4 billion impairment charge (Figure 9).

Conclusion

Walgreens is a long-underperforming retail pharmacy giant trading at very low valuations. With a recently appointed new CEO, Walgreens hopes to turn around its business by adopting more 'cost plus' pricing, which will help stabilize pharmacy margins. However, I believe it is simply too early to pass a verdict on the turnaround efforts.

I recommend placing Walgreens on a watch list and rate the company as a hold for now.

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