Walgreens: Sticking It Out For $50+/Share (NASDAQ:WBA)

Timing

My timing couldn’t have been worse after I wrote my final article discussing Walgreens Boots Alliance (NASDAQ:WBA). WBA’s Q3 FY ‘22 outcomes introduced on June 30 despatched the inventory into an all-too-familiar tailspin, simply as I had argued for the agency as an undervalued, long-term purchase. Furthermore, I urged, in that very same article, that CVS (CVS) was overvalued and due to this fact its inventory was due for a pullback. As a substitute, CVS’ inventory soared following the discharge of their very own Q2 FY ‘22 outcomes earlier this month. Whereas each shares simply took a beating attributable to (one other) opioid-case ruling, my thesis within the prior article is taking part in out in reverse…a minimum of for the second.

Notes:

• Knowledge in Figures 1 and a couple of as of market shut August 19, 2022.

Some readers took me to process. In my protection, I didn’t argue particularly that WBA was going to take-off following Q3 FY ‘22 outcomes, nor that CVS would crater following their Q2 FY ‘22 earnings announcement. Reasonably, I proposed a “imply reversion” for each shares, with WBA probably advancing extra shortly than a pending decline in CVS’ shares. Maybe, I overestimated the tempo of a restoration in WBA’s share worth. Regardless, on this evaluation, I need to desk the dialogue on CVS for a second. As a substitute, I need to focus solely on WBA and the present bearish arguments towards the inventory.

From my point-of-view, the bearish place towards WBA is summarized as:

1. The core (retail + pharmacy) enterprise could also be weakening.

2. Walgreens Well being is an “unknown”. WBA tried the same technique prior to now solely to see it fail. The phase presently operates at a loss and its success is much from assured.

3. Adequate capital to gas Walgreens Well being growth could also be unavailable with the core enterprise below strain, administration’s failure to dump Boots UK, and the corporate’s current debt load.

On this evaluation, I discover these bearish arguments towards the agency below the lens of Q3 FY ‘22 outcomes, supply a pathway to long-term progress primarily based on a “correct” context of Q3 efficiency, and eventually current some ideas on the place shares could also be headed.

Setting Their Sights Decrease

It’s value noting early on that plenty of analysts turned more and more bearish on WBA following Q3 FY ‘22 earnings, with a number of reducing their worth targets for the agency.

Utilizing the (restricted) knowledge from Determine 3, we will simply calculate that the typical analyst goal dipped from $47.40 to $42.40, or a decline of over (10%). The final response amongst analysts following the earnings announcement was unsurprising. Allow us to revisit WBA’s efficiency for Q3 FY ‘22, and use it as a lead-in to our principal dialogue.

Questioning the Core

Okay, let’s get the plain out of the best way. WBA’s Q3 FY ‘22 outcomes weren’t that nice. Amongst different issues:

• Gross sales from persevering with operations of $32.6B decreased (2.8%) in fixed forex. Nonetheless, we must always notice that web gross sales got here in barely forward of analysts’ common estimate of $32.2B.

• The enterprise incurred a GAAP working lack of ($320M) versus GAAP working earnings of $1.1B in the identical prior yr interval. Non-GAAP working earnings was $1.0B within the quarter, representing a lower of (33.5%) versus the prior interval on a continuing forex foundation.

• GAAP EPS from persevering with operations decreased (73.8%) to $0.33 versus the prior interval. GAAP EPS was considerably under the estimate of $0.66. Keep in mind, nonetheless, that GAAP EPS contains WBA’s authorized bills related to its opioid-case settlement with the State of Florida. Adjusted EPS of $0.96 declined (28.9%) versus the prior quarter in fixed forex, however managed to beat the estimate of $0.92.

• US phase (retail + pharmacy) gross margin declined (60) foundation factors to twenty.8% versus 21.4% within the prior interval.

• US pharmacy comparable scripts gross sales declined (1.8%) versus the prior interval, and complete US pharmacy gross sales decreased (9.7%).

• After pushing for the sale of Boots UK to liberate capital for growth of Walgreens Well being and different strategic initiatives, administration’s evaluation of the enterprise concluded with a choice to retain the enterprise.

On the floor, these outcomes would probably lead an investor to query the well being of the core enterprise. For instance, administration famous that comparable scripts gross sales really grew 2.1% within the US throughout the quarter excluding immunizations. However, we additionally notice that comparable scripts progress, a key revenue driver, has been trending decrease, with 6.2% and 4.7% progress in Q1 FY ‘22 and Q2 FY ‘22 respectively. Now, contemplating the “entire” of the phase, if gross sales and margins are declining in the US – the agency’s largest working phase which has generated practically 97% of adjusted working earnings YTD – these circumstances clearly act to restrict the quantity of capital that administration can divert to its “poster-child” progress engine, Walgreens Well being. And, after all, WBA’s choice to retain – or failure to dump – Boots UK doesn’t assist issues for the reason that anticipated capital from such a sale is unavailable. And, nearly with out query, traders would look unfavorably upon a choice by administration so as to add to their present $33.4B debt load to assist finance their healthcare ambitions. As such, it’s simple to attract the fast conclusion, if solely from Q3 FY ‘22 outcomes, that WBA’s core enterprise is just not headed in the correct course, imperiling administration’s capability to develop Walgreens Well being at a ample fee to determine a aggressive presence and to offset future declines within the core.

In Context

On the floor, the image seems to be considerably bleak and Q3 FY ‘22 outcomes appear to mirror the final perspective of Raymond James analyst John Ransom, who I famous in one other article on WBA as saying:

[The] drawback is I can title 5 issues incorrect with the core enterprise and never a lot proper.

Nonetheless, as we parse WBA’s efficiency, maybe we’d maintain just a few issues in thoughts:

1. WBA, like everybody else, was battling a tricky inflationary setting on the finish of their Q3 FY ‘22. And with inflation largely peaking within the Could-June interval, their Q3 ended throughout the “worst of the storm”.

2. The corporate was lapping a very sturdy Q3 FY ‘21 that was bolstered by COVID-19 tailwinds.

3. Many WBA areas haven’t but returned to regular working hours attributable to labor shortages/constraints.

4. “[Challenging] monetary market circumstances past [WBA’s] management” prevented administration from offloading Boots UK, and a “fireplace sale” didn’t appear warranted given sturdy efficiency from the enterprise.

5. Administration continues to be within the (comparatively) early phases of constructing out Walgreens Well being. The phase is just not but worthwhile and introduces an EPS headwind; however that headwind is predicted to say no in FY ‘23 because the operation turns to profitability thereafter.

6. WBA elevated its stake in AllianceRx Walgreens specialty pharmacy to 100% in Q1 FY ‘22 noting “…there can be a 7% decline in [US] revenues because of roughly an $8 billion decline within the AllianceRx Walgreens Prime enterprise. Administration is presently restructuring the enterprise, inclusive of its funding in Shields.

The factors above aren’t meant to function excuses for WBA’s efficiency, however relatively give some context for the agency’s working setting in Q3 FY ‘22, and FY ‘22 generally. Certainly, a better take a look at Q3 FY ‘22 outcomes reveal a greater efficiency than some could have initially understood:

• “[Net] gross sales [from continuing operations] exceeded expectations, rising 3% excluding the destructive impression of the decline in AllianceRx Walgreens enterprise and the gross sales progress from Walgreens Well being.” In different phrases, WBA’s core enterprise minus specialty pharmacy nonetheless grew throughout Q3 FY ‘22.

• Web gross sales of $100.3B for the 9 months ended Could 31, 2022 mirrored a rise of two.7% in fixed forex. Furthermore, “…[front-of-store] margins [were] up considerably year-on-year.”

• US retail comparable gross sales elevated 2.4%, excluding tobacco, versus the prior quarter. The decline within the AllianceRx enterprise, talked about above, acted as an “…850 foundation level headwind to [US] gross sales”. It’s affordable to count on WBA’s largest phase to return to progress because the specialty pharmacy enterprise emerges with a “…extra energized…technique.”

• US pharmacy gross sales declined (9.7%) throughout Q3 FY ‘22, however comparable pharmacy gross sales really grew 2.0%. Once more, context is necessary with respect to WBA’s Q3 FY ‘22 US pharmacy outcomes, because the agency lapped a very sturdy quarter within the prior interval that was bolstered by COVID-19 tailwinds. Even so, comparable pharmacy gross sales elevated, with administration explaining that “…[pharmacy] volumes stay challenged by staffing shortages and momentary working hour reductions.”

• Worldwide phase gross sales grew 9.3% in Q3 FY ‘22 to $5.3B versus the prior quarter in fixed forex, with adjusted working earnings doubling to $174M. The phase’s web gross sales for the 9 months ending Could 31, 2022 stood at $16.7B, reflecting a 15.7% improve versus the prior interval in fixed forex. Boots UK grew gross sales 13.5% throughout the quarter and drove 103% adjusted working earnings for the Worldwide phase as a complete in Q3 FY ‘22.

• GAAP web money from working actions of $1.6B and free money stream of $1.3B for Q3 FY ‘22r; GAAP web money from working actions of $3.8B and free money stream of $2.6B for 9 months ended Could 31, 2022. GAAP web money from working actions within the quarter declined (7%) and (11.5%) for the 9-month interval. Free money stream (“FCF”) declined (13%) and (22.2%) for the quarter and 9-month interval, respectively. Whereas each money from operations and FCF decreased, once more keep in mind that WBA lapped a very sturdy Q3 FY ‘21, was managing by inflationary circumstances, and lots of shops are nonetheless not working on their regular schedule.

• Walgreens Well being gross sales of $596M for Q3 FY ‘22. Walgreens Well being gross sales throughout the quarter elevated 13% on a sequential foundation, with the phase reporting $527M in gross sales for Q2 FY ‘22. Additional, with 2.3M coated lives on the finish of Q3 FY ‘22, WBA is already forward of their 2M coated lives CY ‘22 purpose.

So, with context, WBA’s Q3 FY ‘22 outcomes have been arguably not that dangerous.

A Mannequin for Constant Development

We at the moment are naturally led to ask how the agency will return to a path of constant progress and improved profitability. I elaborate my ideas as follows:

1. Stabilizing and rising the core: As talked about above, the core enterprise, though not with out its points, is arguably performing higher than many give it credit score for. Administration has been working to deal with pharmacy staffing points with sturdy hiring incentives. Additional, they’re working to return hundreds of shops to regular working hours. Thus, whereas staffing and working challenges could lumber into This autumn FY ‘22, there may be purpose to hope they are going to be largely resolved heading into and through FY ‘23. Additionally, the core enterprise might even see a greater margin efficiency in FY ‘23 with the restructure of the specialty pharmacy enterprise, as mentioned within the subsequent level, and as administration continues its push for US pharmacy efficiencies with the rollout of further micro-fulfillment facilities. These facilities take away routine duties from “the arms” of pharmacists, permitting them to give attention to affected person interplay and affected person care. Whereas WBA is a bit behind their anticipated rollout of those facilities, the expectation is that “…[the] facilities [which] fill about 20% of retailer scripts immediately, [will head] to 40% to 50% over time.”

2. A revitalized specialty pharmacy technique: WBA CFO James Kehoe remarked throughout the firm’s Q1 FY ‘22 earnings name that the choice to buy 100% of AllianceRx was pushed by the necessity to restructure the enterprise, and the view that “…[it’s] most likely higher below one proprietor to do [it] faster.” With that sense of urgency in thoughts, traders would possibly see an improved top-line and profitability image shifting into FY ‘23 pushed (partially) by the reorganized specialty pharmacy enterprise; a enterprise that carries larger margins than, for instance, generic medication. Furthermore, the specialty pharmacy enterprise, inclusive of Shields, will play an necessary function within the coming fiscal interval with administration noting that “…[they] count on decrease ranges of exercise on COVID vaccinations subsequent yr…[and that] does generate a large headwind subsequent yr.” Accordingly, the upper margins supplied by the AllianceRx enterprise will assist to offset declines in COVID-19 vaccinations. Traders also needs to acknowledge the specialty pharmacy enterprise as a progress automobile for WBA as that specific market maintains a CAGR that’s larger than the general prescription drug market, and represents an annual $30B alternative based on administration.

3. Walgreens Well being growth: Mr. Kehoe defined additional throughout the Q3 FY ‘22 earnings name that “[WBA is] spending doubtlessly extra within the second half of [FY ‘22 on Walgreens Health] due to timing. However the headwind on Walgreens Well being will go from 6% this yr, all the way down to very low single digits subsequent yr.” Therefore, whereas Walgreens Well being is more likely to nonetheless produce a loss in FY ‘23, the ensuing EPS headwind ought to be far weaker. Administration reported that the corporate, which elevated its stake in VillageMD to 63% in 2021, stays on observe to open 200 co-located clinics by the top of the calendar yr. These openings might be complemented by the opening of 100 Walgreens Well being Corners by the top of CY ‘22, with every in-store “nook” permitting well being plan sufferers to speak straight with pharmacists and different medical professionals. The corporate appears to be “on observe” to realize $2B in web gross sales for the phase in CY ‘22 (not FY ‘22), and to realize a run-rate of $10B in gross sales by FY ‘25.

4. Nurturing Boots UK for a future sale: Maybe it is going to show a “blessing in disguise” that administration was unable to dump Boots UK with, as already talked about, that enterprise rising gross sales 13.5% throughout the quarter and driving 103% progress in adjusted working earnings for the Worldwide phase in Q3. Clearly, ought to administration proceed to reveal progress in and viability of the enterprise, the phase will fetch a better valuation sooner or later, particularly as world market circumstances (hopefully) enhance. Certainly, WBA CEO Roz Brewer made positive to say throughout the Q3 FY ‘22 earnings name that “…[WBA] will keep open to all alternatives to maximise shareholder worth.” Understanding that the Worldwide phase generates a minority of WBA’s earnings, I’ve little doubt Boots UK might be offered in some unspecified time in the future to liberate capital for growth in healthcare companies and specialty pharmacy, and for debt discount.

5. Continued expense discount: WBA’s Transformation Value Program, which started in December 2018, has been very profitable and continues to be so. With an authentic goal of $1.5B of annual value financial savings by FY ‘22, the goal has been repeatedly raised and now stands at $3.5B in annual financial savings by FY ‘24.

Whereas there are not any ensures, the sum of the actions above supply a pathway for WBA to trace towards its long-term progress algorithm of low single-digit adjusted EPS progress in FY ‘22 (re-affirmed following Q3 FY ‘22 earnings outcomes) and ~4% progress for FY ‘23 by FY ‘24, at the same time as the corporate faces down a major COVID-19 headwind shifting into This autumn of this fiscal yr and heading into FY ‘23. As I typically love to do, I created the next diagram to try to seize the connection between the weather of this part, specifically administration’s monetary targets versus their underlying initiatives and investments.

Observe that Determine 5 above displays my interpretation of WBA’s strategic mannequin and doesn’t straight map to administration’s mannequin; though, after all, they overlap.

A Robust End?

So, if we’d agree WBA’s core enterprise and technique aren’t the “misplaced trigger” that many might need us consider, how will the remainder of the yr play out? This actually has not been yr for WBA shares; particularly when in comparison with CVS.

Notes:

• Knowledge as of market shut August 19, 2022.

Attempting to foretell what’s going to occur on the finish of WBA’s FY ‘22 is, after all, anybody’s guess. Past all of the macroeconomic and geopolitical uncertainty, WBA administration notes that they “…anticipate some headwinds within the fourth quarter…Vaccinations are an anticipated headwind of 15 to 17 share factors. Investments to construct out…Walgreens Well being phase may lead to 10% to 12% impression on fourth quarter EPS. Different headwinds embody labor investments of round 5 share factors and lapping prior yr one-time features of roughly 4 share factors of EPS progress. Mixed, these headwinds quantity to an anticipated 34% to 38% year-on-year headwind and results in full yr EPS progress of low single digits.”

In contrast towards This autumn FY ‘21 adjusted EPS of $1.17, the normalized EPS estimate for This autumn FY ‘22 does certainly quantity to a greater than (30%) lower versus the prior interval.

With shares already “beat up”, a This autumn FY ‘22 shock may clearly spark the inventory fairly a bit larger. Then once more, I proposed the identical concept earlier than Q3 FY ‘22 and look how that performed out. However, to reiterate, WBA did beat adjusted EPS and web gross sales estimates in Q3; though the efficiency was not sturdy sufficient to excite the market.

What may result in a considerable beat in This autumn FY ‘22? I speculate that the next may very well be (affordable) potentialities:

1. Cooling inflation as a gross sales driver. As mentioned earlier, WBA’s Q3 FY ‘22 ended simply because the inflation fee was peaking in the US. With inflation cooling off, and shoppers spending their “new” financial savings, WBA, like different retailers, would possibly see a gross sales bump by the top of the yr.

2. An surprising COVID-19 increase. Whereas the charges of recent COVID-19 infections and fatalities fortunately proceed to fall, the World Well being Group simply famous that there have been nonetheless 15,000 COVID-related deaths prior to now week world wide, describing the statistic as “fully unacceptable”. So, whereas WBA administration is anticipating a considerable COVID-19 headwind within the fourth quarter, it’s nonetheless potential {that a} 4th COVID-19 shot advice should still be “within the playing cards”. And, as I discussed in my final article discussing WBA, administration’s FY ‘22 steering doesn’t consider a 4th COVID-19 shot. As I’ve stated so many instances in order to sound like a “damaged file”, each time the world thinks the pandemic is “completed”, it appears to return roaring again. Therefore, there may be nonetheless “room” for a COVID-19 tailwind in This autumn.

3. Higher than anticipated value administration outcomes. Once more, one in every of administration’s ongoing highlights is the success of the Transformational Value Administration Program. Optimistically, this system could over-deliver within the fourth quarter and help a greater bottom-line efficiency as in comparison with present estimates.

So, I believe it’s affordable, not assured, to suppose WBA may ship a robust end to the present fiscal yr significantly with plenty of dangerous information already baked into the inventory worth. One specific threat is WBA’s looming monetary accountability associated to the Ohio opioid-case ruling talked about earlier. Nonetheless, it isn’t clear that WBA, or CVS and Walmart (WMT) for that matter, might be required to make any instant funds; and WBA plans to attraction the ruling. So, shares may simply rally because the yr wraps up, particularly noting that the inventory had been marching larger, buying and selling above $42/share earlier than information of the opioid-case broke.

Operating Some Numbers: A Quantitative View on Shares

Past the affordable chance of a robust end to FY ‘22, we’d attempt to have a look at the rest of the fiscal interval in a extra quantitative method. I nonetheless argue that WBA is undervalued and that its valuation multiples are more likely to revert to the imply, particularly as the corporate features extra traction with Walgreens Well being and its specialty pharmacy companies – two faster-growing, higher-margin segments that assist to justify larger multiples for the agency. Contemplate WBA’s P/S and P/B multiples:

We see that WBA’s multiples are properly under these of CVS. Additional, WBA lags CVS on a P/E foundation as properly, with Searching for Alpha knowledge offering us with trailing-twelve-month (“TTM”) P/E multiples of seven.08 and 12.14 for WBA and CVS, respectively. After all, we will argue that CVS deserves larger P/S, P/B, and P/E multiples as its advantages and pharmacy companies companies supply traders an organization with a better progress and profitability trajectory. It is a legitimate argument; but it surely doesn’t essentially invalidate the argument that WBA may very well be undervalued primarily based on its present multiples. The truth is, utilizing knowledge from Macrotrends, WBA’s historic common P/B is revealed to be roughly in-line with CVS’ present P/B of ~1.8. Utilizing that single knowledge level and most-recent quarter (“MRQ”) e book worth knowledge, we’d arrive at a share worth of $54.68.

WBA share worth through P/B a number of = 1.8 * $30.38 e book worth/share

= $54.68

Notes:

• MRQ e book worth/share knowledge from Yahoo Finance.

Macrotrends equally affords historic P/E knowledge for WBA with a mean worth of ~15. Clearly, this P/E worth would lead to a share worth greater than double what it’s proper now.

Am I saying that WBA shares are headed to $50+, or $60+, and even $70+? I don’t know precisely the place shares are headed within the near-term. Nonetheless, as Walgreens Well being turns a nook “into the black” and administration “rights the ship” with respect to the specialty pharmacy enterprise to drive higher total core efficiency, I do suppose WBA shares might be buying and selling considerably larger. Certainly, shares have been buying and selling above $70 not all that way back in early 2019.

Once more, noting that shares have been trending larger earlier than the newest opioid-case ruling, I’m betting that traders choosing up shares now within the excessive $30s have likelihood to be rewarded with the potential for a better-than-expected This autumn. Even when shares solely attain the typical analyst goal of $42.40 from Determine 3, shares immediately supply greater than 10% upside, which is to say nothing of the present 5% dividend yield. I’m bullish that shares could finish the calendar yr as they started: above $50. Merely, I believe that the market goes to “determine” that administration is heading in the right direction, and that shares warrant a better valuation.

Sticking It Out

Usually, I believe that lengthy traders who’re “keen to stay it out” as WBA achieves scale with Walgreens Well being and its specialty pharmacy companies are going to be rewarded. I, for one, have been (cautiously) including to my lengthy place for the reason that inventory tanked following the Q3 FY ‘22 earnings announcement.

If I come again to my define of the three principal parts of the bear argument towards WBA, I’d retort as follows primarily based on this evaluation:

1. The core enterprise carried out admirably throughout Q3 when discounting the impression from AllianceRx and investments in Walgreens Well being. This efficiency was delivered regardless of a tricky working setting, together with excessive inflation and staffing challenges. Furthermore, administration is performing appropriately to stabilize/develop the enterprise, significantly with respect to restructuring of the specialty pharmacy phase.

2. Walgreens Well being, whereas nonetheless embryonic, is on observe to realize its CY ‘22 objectives, together with $2B in web gross sales and the opening of 200 co-located VillageMD areas. A key distinction with WBA’s healthcare technique “this time round” is their choice to spend money on a strategic associate (i.e. VillageMD) versus making an attempt to “go it alone”, thereby lowering their threat. Whereas the continuing transformation of Walgreens’ total enterprise will carry threat, indications thus far are optimistic.

3. With a steady/rising core, the expectation can be that WBA’s conventional retail + pharmacy operations ought to be capable of throw off ample capital to help Walgreens Well being growth, with out administration needing to resort to further debt. Additional, with the profitability trajectory of VillageMD areas well-understood, older (early) areas ought to begin working “within the black” within the close to time period, thereby serving to to help the opening of extra new areas. As extra VillageMD areas cross the edge into profitability, the cycle turns into self-reinforcing. Additionally, one of many proposed advantages of co-locating VillageMD main care places of work subsequent to Walgreens pharmacies is to drive scripts progress. So, VillageMD ought to begin to “feed” the core increasingly as time goes on, offering further help for Walgreens Well being growth. Lastly, I do count on that Boots UK might be ultimately offered; and administration will clearly make the suitable choice at the moment if and the best way to distribute that capital with respect to Walgreens Well being.

To reiterate, I believe traders are going to “determine all this out” themselves and reward the inventory appropriately. However, what in regards to the lowered worth targets supplied by analysts as seen in Determine 3? Are all these analysts merely incorrect with their destructive outlook on shares? It’s tough to make such an assertion. Nonetheless, it may be truthful to say they’re too pessimistic of their view. I learn a report from one analyst who said, in so many phrases, that he most popular to attend and see how the story with Walgreens Well being performs out earlier than making a name on the inventory. However, for these traders searching for undervalued companies, does it make sense to take a position after a technique has confirmed itself as such an apparent success that the inventory now trades at a better valuation? In different phrases, does it make sense to take a position now with the inventory “beat up” however with indications that the corporate might be profitable within the long-term; or, does it make sense to take a position later when the inventory has “caught up” with its truthful worth as a result of the market has lastly acknowledged the agency’s strategic potential? It ought to be clear from this report how I really feel.

As with most issues in life, there are not any ensures. Nonetheless, I reiterate that WBA’s technique is one which appears to place the agency for long-term success, which might be correspondingly mirrored within the share worth.