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Why Walgreens Is A Long-Term Buy Now

Why Walgreens Is A Long-Term Buy Now by Ben Reynolds, Sure Dividend

Walgreens (WBA) was founded in 1901 in Chicago, Illinois by Charles Rudolph Walgreen.

115 years later, Walgreens is the 2nd largest drugstore chain in the United States based on its market cap of $89 billion.  For comparison, CVS (CVS) has a market cap of $100 billion.

The only other publicly traded drug store in the United States of significance is Rite Aid (RAD), which has a market cap of $8 billion.  Walgreens plans to acquire Rite Aid – more on that in the ‘Current Events’ section of this article.

Walgreens business historically was focused primarily in the United States.  That changed in 2012 when Walgreens acquired 45% of European drugstore and distributor Alliance Boots.  Walgreens acquired the remaining 55% of Alliance Boots in 2014 to become Walgreens Boots Alliance.

Walgreens operates in 3 primary segments:

  • Retail Pharmacy USA
  • Retail Pharmacy International
  • Pharmaceutical Wholesale

The Retail Pharmacy USA segment is by far the company’s largest, generating $4.26 billion in adjusted operating income through the 1st 9 months of fiscal 2016.  For comparison, the Retail Pharmacy International segment generated $0.91 billion and the Pharmaceutical wholesale segment generated $0.50 billion over the same time period.

The company’s Pharmaceutical wholesale segment includes Walgreens’ investment in AmerisourceBergen (ABC).  Walgreens currently owns 23.9% of AmerisourceBergen shares.

Walgreens is a high quality business with a long history of success.  The company is one of 50 Dividend Aristocrats – stocks with 25+ years of consecutive dividend increases without a reduction.  You can see all 50 Dividend Aristocrats here.

Walgreens currently ranks as a buy and Top 10 dividend stock using The 8 Rules of Dividend Investing.  Keep reading this article to learn more about the compelling investment prospects of Walgreens.

Current Events

Walgreens posted excellent results for the 3rd quarter of fiscal 2016.  The company saw adjusted earnings-per-share grow 15.7% versus the same quarter a year ago.

The growth was due in large part to synergies from the Alliance Boots acquisition.  Cost savings from the deal reached a combined amount of $1 billion in the quarter.

Walgreens plans to propel growth again with another large acquisition…

The company plans to acquire Rite Aide – the 3rd largest drugstore chain in the United States – for $17.2 billion.  The deal was announced in October of 2015.  It has faced much regulatory scrutiny; which you’d expect when 2 of the 3 largest drugstores in the United States are planning to become one company.

Walgreens owned and operated 8,173 stores in the United States, the U.S. Virgin Islands, and Puerto Rico according to its 2015 annual report.

Rite Aid has around 4,600 stores.  The acquisition of Rite Aid will grow Walgreens’ store count by around 50% if it doesn’t have to divest any stores.

A recent Walgreens press release (9/8/16) shows that Walgreens is expecting the acquisition to pass regulatory scrutiny.  The company believes the acquisition will close in the 2nd half of fiscal 2016.  An excerpt from the press release is below.

“Walgreens Boots Alliance and Rite Aid remain actively engaged with the Federal Trade Commission (FTC) regarding its review of the pending acquisition. As a result of the progress of these discussions with the FTC staff, Walgreens Boots Alliance is exploring potential divestiture remedies to address certain issues raised in those discussions.

In order to expedite that process, Walgreens Boots Alliance now expects that the most likely outcome will be that the parties will be required to divest more than the 500 stores previously communicated, but still continues to expect that fewer than 1,000 stores will be required to be divested.”

The market viewed this news favorably.  Walgreens stock was up around 2% following the announcement.

The Rite Aid acquisition will provide further growth for Walgreens.  The company is expecting to reach $1 billion in synergies within 4 years of the acquisition.

Risk Factors

Walgreens is a high quality business in a growing industry with global scale.  The company is a low risk investment (as far as equity investing goes).

With that said, the company is not without risks.  Changes in government and 3rd party reimbursement levels for prescriptions could negatively impact the company’s profits.  The health care industry in the United States underwent significant changes with the 2010 Affordable Care Act.  Health care reminds a hot political topic.  Changes in health insurance and government involvement in health care could be detrimental to Walgreens.

If the Rite Aid acquisition does not pass regulatory hurdles, the company would likely see its stock price decline.

None of the risk factors facing Walgreens today appear particularly severe or likely.  As discussed above, Walgreens is a relatively low risk stock.

Competitive Advantage & Recession Performance

Walgreen’s competitive advantage comes from a mix of its global scale and convenient locations.

The ‘cornerstore’ drugstore approach has managed to successfully compete with both big box retailers like Wal-Mart (WMT) and Target (TGT), as well as with online giant Amazon (AMZN).

This is because the cornerstore/drugstore combination is especially convenient.  WBA typically looks for locations on the corners of major streets.  This makes it easy for customers to ‘stop in’ (or use the prescription drive through) to pick up prescriptions or miscellaneous over-the-counter medicine, food, or tobacco products.

Walgreens has historically performed well during recessions.  The company’s earnings-per-share fell just 7% during the worst of the Great Recession.  People must fill their presciriptions regardless of the overall economic climate.  This provides a steady flow of customers to Walgreens, even during recessions.  The company’s performance over the Great Recession and subsequent recovery is shown below:

  • 2007 Earnings-per-share of $2.03 (EPS high)
  • 2008 Earnings-per-share of $2.17 (new EPS high)
  • 2009 Earnings-per-share of $2.02 (recession low)
  • 2010 Earnings-per-share of $2.16
  • 2011 Earnings-per-share of $2.64 (new EPS high)

Growth Prospects & Total Return

Walgreens has above-average growth prospects – especially for a blue chip dividend stock.

The company has compounded its earnings-per-share at 9.8% a year over the last decade.  Growth has come from a mix of organic expansion and acquisitions.

As discussed in the current events section of this article, the pending Rite Aid acquisition will likely propel growth for Walgreens.  The acquisition will grow the Walgreens’ store count by around 50%.

Walgreens will benefit from 2 trends going forward:

  • Increased prescription use across all age segments
  • Longer life expectancies

More prescriptions means more traffic, sales, and earnings for Walgreens.

Simply put, older people tend to take more prescription medication.  As the baby boomer generation ages, they will (on average) have more prescriptions per person.  Retail prescriptions filled at pharmacies by age bracket for 2015 is shown below:

  • Age 0 to 18: 1 prescriptions
  • Age 19 to 64: 6 prescriptions
  • Age 65+: 0 prescriptions

Source:  kff.org

Not only does prescription use rise with age, it is also rising in general in the United States.

Walgreens

Source:  Statista

Walgreens

This trend is likely to continue as medical advances continue to push the boundaries of what prescriptions can treat.  More people with access to health care will also cause prescription use to increase over time.

Going forward I expect WBA to continue compounding its earnings-per-share at around 10% a year going forward.  This growth combined with the company’s current 1.8% dividend yield gives Walgreens investors an expected total return of around 12% a year moving forward.

Valuation & 8 Rules Rank

Walgreens has historically traded for a 1.1x multiple to the S&P 500’s price-to-earnings ratio over the last decade.

The company’s premium pricing makes sense given its safety and return profile.  The S&P 500 is currently trading for a price-to-earnings ratio of around 25.  This implies a ‘fair’ price-to- earnings ratio of around 27.5 for Walgreens.

The company is currently trading for an adjusted price-to-earnings ratio of 19.1 using adjusted earnings-per-share.  The company appears to be undervalued relative to the S&P 500 at current prices.

The S&P 500 is trading for an inflated price-to-earnings ratio, however.  It’s historical average price-to-earnings ratio is 15.6.  It can be argued that the market is actually slightly undervalued right now when one factors in interest rates.

Walgreens has traded for an average price-to-earnings multiple of around 19 over the last decade.  The company is trading around fair value using its historical price-to-earnings ratio.  It is likely undervalued relative to the market today.

Walgreens is ranked as a Top 10 dividend stock and a buy using The 8 Rules of Dividend Investing.  The section below shows WBA rankings over a variety of metrics, along with why those metrics matter.

Consecutive Years of Dividend Increases:  Walgreens has paid increasing dividends for 41 consecutive years.  The company easily passes the pass/fail screen of having 25+ years of steady or rising dividends.  There are currently 186 businesses in the Sure Dividend database that pass this screen.

Why it matters: The Dividend Aristocrats (stocks with 25-plus years of rising dividends) have outperformed the S&P 500 over the last 10 years by 3.2 percentage points per year.
Source: S&P Factsheet

Dividend Yield:  Walgreens has a dividend yield of 1.8%.  The company is ranked at 145 out of 186 using dividend yield.  What Walgreens lacks in yield it makes up for in other categories.

Why it Matters: Stocks with higher dividend yields have historically outperformed stocks with lower dividend yields. The highest-yielding quintile of stocks outperformed the lowest-yielding quintile by 2.2 percentage points per year from 1928 to 2013.
Source: Dividends: A Review of Historical Returns

Payout Ratio:  Walgreens has a payout ratio (using adjusted earnings) of just 34%.  The company’s low payout ratio is ranked at 33 out of 186.  Lower payout ratios give a business more room for error to pay rising dividends if earnings fall.  Low payout ratios also make it possible for management to grow dividends in excess of earnings-per-share for a period of time.

Why it Matters: High-yield, low-payout ratio stocks outperformed high-yield, high-payout ratio stocks by 8.2 percentage points per year from 1990 to 2006.
Source: High Yield, Low Payout by Barefoot, Patel, & Yao, page 3

Long-Term Growth Rate:  I expect WBA to grow its earnings-per-share at around 10% a year, as discussed in the ‘Growth Prospects & Total Return’ section of this article.  The company’s above average growth rate ranks it at 31 out of 186 for this metric.

Why it Matters: Growing dividend stocks have outperformed stocks with unchanging dividends from 1972 through 2015.
Source: An Economic Perspective on Dividends

Long-Term Volatility:  Walgreens annualized 10 year stock price standard deviation is 28.5%.  The company has an ‘average’ standard deviation relative to other stocks in the sure Dividend database, and ranks at 95 out of 186 for this metric.

Why it Matters: The S&P Low Volatility index outperformed the S&P 500 by 2 percentage points per year for the 20-year period ending September 30th, 2011.
Source: Low & Slow Could Win the Race

Final Thoughts

Walgreens is a relatively low yielding Dividend Aristocrat.  The company’s safety and growth prospects more than make up for its mediocre yield.  Walgreens is a good candidate for a low yield stock to include in your dividend growth portfolio.

The company is operating in a growing industry.  It trades for a reasonable valuation.   It has a strong potential growth catalyst in the pending Rite Aid acquisition.   I believe Walgreens is a buy at current prices for long-term investors.