(NGS: WBA). While WBA is in a much better position to weather the COVID-19 pandemic than many companies in our retail coverage group, it has been under pressure from lower sales of discretionary items as social distancing has reduced store traffic. Third-quarter pharmacy volume was also hurt because COVID-19 kept many patients from going to the doctor and reduced hospital admissions. Our outlook extends beyond the current crisis and reflects concerns that reimbursement pressure will weigh on pharmacy gross margins in both the United States and the United Kingdom. We are now reducing our five-year estimate to 4%. This does not have an impact on our valuation because we have been using lower growth rates in our valuation analysis.
On October 15, WBA reported a 29% decrease in fiscal 4Q adjusted earnings, to $1.02 per share. The GAAP earnings were lower, because they included restructuring and acquisition costs.
WBA provided FY21 earnings guidance for low single-digit growth. Adjusted EPS came to $4.74 in FY20; a 2% increase from that level would take FY21 adjusted EPS to $4.84. There was not a big difference between reported and currency-adjusted earnings in FY20 and we aren’t modeling a major swing in FY21.
Adjusted operating income fell 27.7% to $1.13 billion in 4Q. The adjusted 2Q gross margin fell 190 basis points to 19.6% as customers bought fewer high-margin products and supply-chain costs rose.
Sales in the biggest segment – Retail Pharmacy USA – were up 3.6% in 4Q. Retail sales got a boost from products to protect against COVID-19. Retail traffic was down about 10%, with traffic in large cities and near travel destinations down almost 40%. Adjusted operating income of $884 million was down 22% for the division and lagged the StreetAccount consensus of $918 million.
Sales of $2.3 billion in the International business just beat consensus on a 15.4% sales decline. UK pharmacy comps were down just 0.4%, but the pandemic hurt front-of-store sales as shoppers consolidated their shopping at grocery stores. Retail comps at Boots UK were down 29.2%. This was a smaller loss than the $40 million the street expected. Sales in the Wholesale division exceeded consensus, increasing 4.3% to $6 billion. The division delivered better-than-expected operating income at $245 million.
EARNINGS & GROWTH ANALYSIS
We are initiating a FY22 estimate of $5.15 per share. This reflects about 3% sales growth, a small decline in gross margin, and a decline in the expense rate.
Since the beginning of the year, we have been saying that our bias is for reducing our five-year earnings growth rate forecast to 3%-4% from 7%. We are now reducing our five-year estimate to 4%. This does not have an impact on our valuation because we have been using lower growth rates in our valuation analysis.
FINANCIAL STRENGTH & DIVIDEND
We don’t expect to drop our rating to Medium-Low, but the company has BBB/Baa2 credit ratings and negative outlooks. One cut would take them to BBB-/Baa3 which is the lowest investment grade rating.
This has been a particularly acute source of pressure for Boots in the United Kingdom.
One telling statistic is that the company’s gross margin has declined from 29.24% in FY13 to 21.97% in FY19 and 20.2% in FY20. Our FY21 estimate is below 20%.
One tangible effect is that we have been considering valuation scenarios that use higher discount rates (or lower P/E/multiples) because of potentially higher risk.
We don’t know if a cut to BBB-/Baa3 would affect the short term ratings, but we will check.
MANAGEMENT & RISKS
COVID-19 is a major risk, even to a company that sells medicine. While the company’s stores have been open for business and many suburban stores have pharmacy drive-through windows, the U.S. stores could be hurt if shoppers are reluctant to enter a store where there might be sick people. WBA could also be hurt in the U.S. and in the UK if shoppers are not buying higher margin seasonal or particularly beauty products. The company has (and is) a vast supply chain that could be subject to disruptions. The company could lose sales of some products to Amazon or online sellers and it could lose market share to grocery stores if shoppers seek to minimize the number of stores they enter.
The company recognizes this and continues to be very aggressive in reducing costs.
Until very recently there had been heightened concern that healthcare companies could be under pressure because some of the more ‘progressive’ Democratic presidential candidates favored an expanded government role in healthcare. The plan, or concept, is known as ‘Medicare for All.’ We believe that former Vice President Biden would support the status quo which was shaped by ‘Obamacare,’ the Affordable Care Act that was a pillar of the Barack Obama Presidency under which Mr. Biden served. To be sure, many Americans feel that healthcare is too expensive and it would be imprudent to assume that the risk of some government option has disappeared. The COVID-19 crisis has raised concerns that for most Americans health insurance is linked to employment and being able to pay for health insurance is dependent on being well enough to work.
At the end of July, Stefano Pessina announced that he would step down as CEO to become Executive Chairman when a new CEO is named. Mr. Pessina was 78 as of October 28, 2019, according to the Annual Report for FY19. James Skinner, who was formerly CEO of McDonalds, will step down as Executive Chairman but remain on the board to facilitate a smooth leadership transition.
We give Mr. Pessina great credit for his capital discipline. We expect this to continue. He treats shareholder capital as though it is his own; in fact much of it is. He avoided making a transformative bad deal that destroyed shareholder value. He also led a successful cost cutting effort that reduced SG&A as a percentage of sales. This not only sent dollars to the bottom line, it gave the company a lean cost structure to face competition. The fact that his business Alliance Boots, (with Kohlberg Kravis Roberts), was taken over by Walgreen and he wound up in charge of the combined enterprise cements his legend as a deal maker. Still some investors hoped to see more deals under his tenure. He creatively emphasized alliances rather than takeovers and he said on a number of occasions that he is always looking for deals.
WBA could also lose sales if other drugstore operators make low bids to participate in restricted networks.
On April 2, 2019, Walgreens Boots cut its earnings guidance because third-party payers, including pharmacy benefit managers, insurance companies and government agencies are paying the company less for dispensing prescription drugs. This ‘reimbursement pressure,’ as it is often called, is significant because approximately 97% of pharmacy sales in the big Retail Pharmacy U.S.A. division come from payers whose members are covered by various prescription plans. Reimbursement pressure is certainly not a new issue, but it has become particularly acute at a time when there are few offsets because there isn’t much inflation in branded drugs, U.S. comparable sales are a little weak, and the UK market is under pressure.
The company has almost 14,000 stores in 9 countries, including 9,277 in the U.S. WBA owns 56.8 million shares of AmerisourceBergen, 27% of the company. WBA’s fiscal year ends on August 31.
But the multiple has declined steadily as gross margin has eroded.
Some of the concerns are reimbursement pressure; fear that a competitor will strike a deal that will raise the level of competition in the industry (as WBA did when it accepted lower margins to win sales in a closed network); fear that Amazon will further disrupt the pharmacy business; fear that the U.S. government will play a more aggressive role in trying to lower drug prices; and fear that business models are changing rapidly and making it hard to predict future cash flows.
Reimbursement pressure has significantly weighed on the shares. WBA is currently trading at about 9-times trailing EBIT. CVS was trading at about 9-times before it took on the additional debt for the Aetna acquisition. Our calculation does not include operating leases in the debt component.
Based on a simple earnings model with our FY21 and FY22 estimates and the expectation that EPS will grow by 4% over the following three years, EPS would rise to about $5.80.
On October 16 at midday, HOLD-rated WBA traded at $37.34, down $0.30.