And the hits just keep on comin’.
Walgreens (NASDAQ:WBA) opened the year trading for $26 and change. But before earnings debuted last week, the stock was trading for a bit below $16 a share. Fast-forward a couple of days, and WBA now trades for less than $12, and has now plummeted 56% in 2024.
If there is a bright side to this story, it is that the quarterly dividend now yields 8%-plus. Veteran investors may wonder if that represents a sucker yield or an opportunity to lock in a hefty source of passive income pending a possible turnaround.
There is a great deal to unfold in the Q3 earnings, and arguably the most important take from the earnings call lies beyond the numbers.
Dissecting The Earnings Report
WBA reported Q3 2024 non-GAAP EPS of $0.63 cents, missing analysts’ $0.68 forecast. Revenue of $36.4 billion also missed the $35.9 billion consensus.
Adjusted operating income for the retail pharmacy segment was $501 million, well below the $962 million recorded in Q3 of 2023. This was despite an increase in sales to $28.5 from $27.9 billion.
Walgreens also reported an operating loss of $13.1 billion for the first three quarters of this fiscal year. That is an increase from $6.4 billion during the first three quarters of 2023.
Note that figure includes a $5.8 billion goodwill impairment charge related to VillageMD.
Management now guides for FY EPS in a range of $2.80 to $2.95, well below the prior forecast of $3.20 to $3.35 a share.
In addition to the mostly dismal financial results, Walgreens revealed that it plans to close what could potentially be a large number of stores. The company reported that a quarter of all stores are not turning a profit. Additionally, there is a significant problem with shrink in many locations.
Management did not provide the number of planned store closures; however, during earnings it was stated that a “significant portion” of these underperforming stores will be closed over the next three years.
We are at a point where the current pharmacy model is not sustainable, and the challenges in our operating environment require we approach the market differently.
Tim Wentworth, CEO
One problem the company will face is that many of the stores have long leases.
During the earnings call, the CEO stated that the proposed divestiture of the Boots business in the United Kingdom is once again off the table.
However, after investing $5.2 billion in 2021 to acquire a controlling stake in VillageMD, WBA and VillageMD leadership are now working to pare back Walgreens’ stake.
While the VillageMD initiative seemed promising, the business never turned a profit on a non-adjusted basis.
Walgreens’ Headwinds
When assessing WBA as a potential investment, it is important to understand that the bulk of the company’s revenues are generated by the pharmacies. Walgreens’ front-of-store offerings only generate about a fourth of the firm’s sales.
The fiercest headwind WBA is facing, is the reimbursement rates pharmacy-benefit managers (PBMs) provide for prescription drugs. This is not a new dynamic, but it is one that has worsened over the last few years.
PBM’s contract with insurers, and therein lies the problem for chain drug stores like WBA and CVS. Three large PBMs control approximately 80% of U.S. prescriptions, and one path for lowering costs for insurance companies and their patients is to shrink reimbursement rates for the likes of Walgreens.
The question is, why do they keep taking these lower and lower reimbursement rates? And the answer is that while the contracts are still profitable, the PBMs are going to push this right to the line every time.
John Ransom, analyst, Raymond James
Investors must understand that despite their seeming ubiquity, chain drug stores only constitute about 35% of the pharmacies in the US supermarkets, including Target (TGT), Kroger (KR), Walmart (WMT), and Costco (COST), also operate about a third of the pharmacies in this country.
Now consider that supermarkets use pharmacies to drive foot traffic into their larger retail operations. Pharmacies for those firms are nearly the equivalent of loss leaders. Consequently, those retailers are not too focused on the profit margins they wring out of their contracts with PBMs.
Additionally, an increase in the use of generic drugs is also weighing on Walgreens’ profit margins: in 2009, only 75% of all prescription drugs were generic. By 2018, the number of prescriptions for generic drugs in the US had risen to 90%.
WBA also experienced a significant increase in foot traffic from those seeking COVID vaccinations, but with the waning of the coronavirus, the number of customers being vaccinated has dropped markedly.
Another negative, and one that is not addressed in quarterly reports or by analysts, are reports of employee burnout among pharmacists. Results from Mayo Clinic’s Well-Being index found that roughly two thirds of pharmacy professionals reported that they suffered from “burnout.” That number was higher than any other medical profession.
Perhaps the greatest concern regarding this trend is that overworked pharmacists are more likely to make errors at their workplace, and those errors could literally be deadly. One researcher for the American Public Health Association estimated pharmacies make about 2.3 million dispensing errors a year. With that in mind, it is not hard to imagine that a potential class action lawsuit could be lurking on the horizon, in my opinion.
A Handful Of Positives
Mail order pharmacies, considered by some to pose a serious threat to the likes of WBA and CVS, constitute well under 1% of all pharmacy operations. Furthermore, the share of prescriptions filled by mail-order pharmacies is not growing at a pace that significantly affects chain drug stores.
Prescriptions filled by mail-order pharmacies hit 9% in 2022, up from 7% in 2012. In that same time frame, chain drug stores’ market share of prescriptions in the US dropped by a mere 1%, from 48% to 47%.
With approximately 13,000 stores in 9 countries, including about 8,700 in the US, WBA has a significant scale advantage. Also, approximately 78% of the US population lives within 5 miles of a Walgreens store.
WBA’s Debt, Dividend And Valuation
Walgreens’s credit ratings are BBB from S&P and Ba2 from Moody’s. Standard & Poor’s rating is on the lowest rung of investment-grade ratings. Moody’s is below investment grade.
Walgreens’ current yield is a hair below 8.27%. In the first quarter of this year, management cut the dividend by 48%. The current dividend payout ratio is just above 46%. It is important to note that in years past, management stated that the long-term targeted payout ratio was t 30% to 35%.
Although WBA has the financial strength to continue paying the dividend at the current level, I noted that there was no mention of the dividend during the last earnings call nor in the one prior.
I took a quick look at Walgreens’ investor relations site and found no information touting the dividend. As one that often peruses earnings calls when companies face a turnaround, I’ll note it is common for management to reassure investors that a dividend cut is not under consideration. While I’ll not claim that a dividend cut is on the horizon, I find management’s failure to even discuss the dividend disconcerting.
Shares of WBA currently trade for $11.73 per share. The average 12-month price target of the 19 analysts that follow the company is $15.65. Of those, 4 rate WBA as a Sell or Strong Sell, and 12 rate the stock as a Hold.
The forward P/E for the WBA is 4.24x, well below the average P/E over the last five years of 8.33x. The 5-year PEG ratio is 3.74x.
Is Walgreens a Buy, Sell, Or Hold?
Walgreens’ share price is now down over 55% year to date.
If you’re new to the stock, it may come as a bit of a shock to learn that Walgreens’ total revenue grew from $42.2 billion in 2005 to $103.4 billion in 2015. From 2015 through 2022, with the single exception of 2020, when COVID sanctions stifled sales, Walgreens reported adjusted operating income of $5 billion or more each year.
In FY 2023, the company’s adjusted operating income fell to $3.7 billion.
In a move to right the ship, management is negotiating with health insurers and PBMs in an effort to increase profits.
Walgreens also plans to launch a retail pharmacy initiative designed to improve the consumer’s customer experience in store. Store closures are on the horizon, and the scaling back of the VillageMD business is well underway.
We recognize where we are is a turnaround. We recognize that we need to be focused on what are the parts of the business that we believe are contributing and have a future, and some of those need to change.
Tim Wentworth, CEO
That comment sums up the problem investors face when evaluating WBA as a potential investment. Turnarounds are uncertain, generally take years to materialize, and even when successful, they often result in periodic wild gyrations in the share price.
Of course, big swings in a stock’s price can garner traders’ hefty returns.
For that reason, I pondered rating WBA as a Speculative Buy; however, when I considered that even with the low forward P/E the stock has a 5-year PEG ratio of 3.74x, and the fact that management has not mentioned the dividend in at least two earnings reports, I think that there is a better than 50/50 chance that the stock has more downside.
I rate WBA as a Hold.
I have a small investment in Walgreens that I initiated in years past. I have no intention of adding to that position for the foreseeable future.
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