Adjusting Walgreens’ Moat Rating Over Sustained Reimbursement Pressures; Lowering FVE to $44
Adjusting Walgreens’ Moat Rating Over Sustained Reimbursement Pressures; Lowering FVE to $44
Analyst Note| by Dylan FinleyUpdated Jul 14, 2021
After taking a fresh look at Walgreens Boots Alliance, we are lowering its narrow moat rating to none and maintaining our negative moat trend rating, as we believe ongoing reimbursement pressure has already impaired its moat. Gross margins have steadily declined from just under 30% in 2013 to 20% in 2020, primarily as a result of reimbursement pressures from pharmacy benefit managers. The top three PBMs combined adjudicate nearly 80% of all prescription drug claims on the behalf of health plan payers. By comparison, the top three retail pharmacy chains control just under half of all prescription drug revenue and have relatively less negotiation leverage. In addition, PBMs’ relationship to payers and central role in designing pharmacy networks on behalf of beneficiaries affords them leverage in negotiations with retail pharmacies. Our high uncertainty rating reflects questions surrounding the rate of margin deterioration going forward, and where the floor on prescription drug margins is. Combining our reduced moat rating with the probability-weighted increase of our estimated long-term U.S. tax rate to 26% from 21%, we are lowering our fair value estimate to $44 from $50.
We believe management is aware of these risks and should be able to partially offset these pressures long term through cost-reduction programs ($2 billion in selling, general, and administrative savings by fiscal 2022) and new revenue streams associated with strategic growth areas. Long term, Walgreen’s initiatives toward becoming a destination for healthcare services could complement its current business strategy and increase margins. Walgreens has invested over $1 billion in VillageMD to support the opening of up to 700 primary-care clinics across the U.S. in Walgreens locations. Placing clinics inside existing retail locations could be an efficient and synergistic use of space and provide a structural cost advantage over traditional clinics with larger footprints and higher lease costs.
Business Strategy and Outlook| by Dylan FinleyUpdated Jul 14, 2021
Founded in 1901, Walgreens Boots Alliance is a leading global retail pharmacy chain. In fiscal 2020, the company generated approximately $140 billion in revenue and dispensed over a billion prescriptions annually, representing just under a quarter of the U.S. drug market. The firm's over 9,000 domestic stores are strategically located in high-traffic areas to generate over $13 million per store, which drives scale and remains a critical consideration in an increasingly competitive market that has witnessed rationalization. The core business is centered around the pharmacy, which accounts for about three fourths of revenue and is considered the main driver of traffic.
Despite Walgreens’ scale as a leading purchaser of prescription drugs and competitive advantage over smaller retail pharmacy chains, gross margins have come under pressure in recent years as a result of pharmacy benefit managers’ negotiation leverage and market power. These pressures have affected margins across the entire retail pharmacy industry, pushing the largest players (Walgreens, CVS, Walmart) to branch into other healthcare services. Walgreens has been focused on leveraging scale to foster strategic partnerships to increase traffic and cross-selling opportunities with a long-term focus to improve coordinated care.
While Walgreens has expanded into omnichannel offerings, we think the company’s high-traffic brick-and-mortar locations and convenience-oriented approach is less susceptible to pressures from e-commerce and mass merchandisers, particularly in the health and wellness categories, than other retailers. Historically the company’s strategy was based on footprint expansion but having established a scalable infrastructure, the focus has evolved and the concentration has shifted to improving store utilization and strategically aligning with healthcare partners to address the macro trend of localized community healthcare. The company’s partnership with VillageMD to establish primary-care clinics in select Walgreens locations further establishes the drugstore as a one-stop shop for care.
Economic Moat| by Dylan FinleyUpdated Jul 14, 2021
We do not believe Walgreens possesses a moat. Despite the retail pharmacy chain’s scale and brand, the company lacks structural advantages that typically support a moat in the highly competitive retail landscape. Walgreen’s scale as a leading purchaser of prescription drugs has led to some cost advantages in procurement from wholesalers, which are more than offset by reimbursement pressures, resulting in gross margins collapsing about 900 basis points since 2013 and adjusted ROICs falling below the weighted average cost of capital. Nevertheless, Walgreens has made some headway with selling, general, and administrative cost reductions, and we project sustained mid-single-digit operating margins long term due to the convenience-oriented nature of brick-and-mortar retail pharmacies that partially insulate the company from the competitive pressures of online retail and mass merchandising.
General merchandisers that we award moats to (Costco and Walmart, for example) often have exceptional cost advantage or membership models that improve the stickiness of their customer base. By comparison, Walgreens’ U.S. nonpharmacy retail sales are less than one fifth of wide-moat Walmart’s U.S. general merchandise and health and wellness sales, resulting in less supply chain leverage and a comparatively smaller base to spread operating costs across. Additionally, Walgreens’ business model is not meaningfully different from other drugstore chains’, and customers generally face minimal switching costs in transferring prescriptions between pharmacies. In some cases (most Medicare Part D prescription drug plans), a health insurance plan may encourage the use of certain pharmacies, resulting in switching costs for the consumer. However, these preferred networks are often to the detriment of margins, with pharmacy benefit managers saving costs for the payer by negotiating lower reimbursement rates with the pharmacy.
The growing prevalence of home delivery by a local pharmacy (frequently used by customers during the COVID-19 pandemic) and a gradual shift toward 90-day supply prescriptions are risks that could result in less store traffic long term—which is a driver of incremental front-of-store sales volumes. These trends will likely take longer to materialize, since despite the ease of obtaining prescriptions by mail, most customers continue to physically pick up their prescriptions in stores. Additionally, for cases of acute illness, mail-order is a poor substitute for prescriptions that need to be filled quickly.
As one of the largest purchasers of U.S. generic drugs, Walgreens partners with suppliers on preferred terms. In 2013, Walgreens and prescription drug wholesaler AmerisourceBergen entered into a 10-year primary distribution agreement for branded and generic drugs, which has subsequently been extended through 2029. By using Amerisource as its primary source of generics, rather than purchasing directly from manufacturers, Walgreens can significantly lower overhead expenses associated with distribution centers and logistics and bargain for lower-price drugs. While this strategy uses Walgreens’ scale to its advantage, similar strategies have been pursued by rivals CVS (with wholesaler Cardinal Health) and Walmart (with wholesaler McKesson), making this type of arrangement the status quo rather than a differentiated approach.
Despite Walgreens’ advantages from its scale in the niche chain drugstore market, any cost advantage in procurement from wholesalers is more than offset by reimbursement pressures from PBMs, which have significantly eroded gross margin and driven down Walgreens’ ROICs. The top three PBMs combined adjudicate nearly 80% of all prescription drug claims on the behalf of health plan payers. By comparison, the top three retail pharmacy chains control just under half of all prescription drug revenue and have relatively less negotiating leverage. In 2011, Walgreens attempted to hold out against reimbursement pressures by leaving Express Scripts’ pharmacy network—a move that resulted in a 10% decline in U.S. prescription drug revenue, as beneficiaries were forced to transfer their prescriptions away from Walgreens retail locations. While network exclusions generally have been rare, PBMs establish preferred pharmacy networks for some payers to lower costs, involving financial incentives (lower co-pays and out-of-pocket expenses) for beneficiaries using a specified pharmacy. This structure has become nearly ubiquitous in Medicare Part D prescription drug plans, with nearly all plans having a preferred network.
Long term, Walgreens’ initiatives toward becoming a destination for healthcare services could complement its business strategy, increase margins, and support an economic moat. Walgreens has invested over $1 billion in VillageMD to support the opening of up to 700 primary-care clinics across the U.S. in Walgreens locations. Placing clinics inside existing retail locations could be an efficient and synergistic use of space and provide a structural cost advantage over traditional clinics with larger footprints and higher lease costs. Walgreens has also made a majority investment in iA, a provider of automation services that dispenses medication in bulk at centralized facilities, allowing the pharmacists to focus on services such as vaccinations and medication management as an integrated part of Village Medical locations. The millions of COVID-19 vaccinations administered at Walgreens locations give insight into consumers’ willingness to seek medical treatment and services at the retail pharmacy and highlights the underutilized potential of pharmacists as providers of medical services. Rival retail pharmacy chain CVS is also diversifying more into healthcare services, offering chronic-care management services at HealthHubs in CVS retail locations. Beyond CVS, however, the lack of comparable retail pharmacy chains of scale would make it very difficult to replicate a similar strategy.
Fair Value and Profit Drivers| by Dylan FinleyUpdated Jul 14, 2021
We are lowering our fair value estimate for Walgreens to $44 from $50, reflecting the impairment of the company’s moat related to reimbursement pressures and the probability-weighted increase of our estimated long-term U.S. tax rate to 26% from 21%.
We anticipate that overall revenue will grow in the low single digits as the firm stabilizes after the pandemic, in line with its U.S. retail pharmacy business, with some international headwinds. Following the company's 2021 Alliance Healthcare divestment, we project annual revenue growth just under 3%, driven by an increase in prescriptions in the pharmacy segment, and the company's omnichannel efforts and targeted consumer advertisements contributing to front-end store growth. Gross margins in 2021 have been favorably affected by higher-margin COVID-19 vaccine revenue, but with the rate of vaccinations in the U.S. slowing down, we anticipate margins will gradually fall as a result of ongoing reimbursement pressures. Operating margins are anticipated to improve by 2022 as a result of the company’s cost-optimization program, but afterward will likely be largely flat with some support from the rollout of various strategic partnerships.
Risk and Uncertainty| by Dylan FinleyUpdated Jul 14, 2021
We assign Walgreens a high uncertainty rating. The company operates in a mature competitive market, where it has garnered a significant share. However, uncertainty surrounding gross margins as a result of reimbursement pressures from public and private third-party payers weigh on the company. Also, any significant changes in federal or state drug regulations pose a risk to the industry. The company is somewhat insulated from the rise of a new competitor due to scale and entrenched relationships with drug wholesalers, but any significant changes to the economy or market dynamics could pose a risk.
Further, a decrease in drug utilization either driven by slower new drug introductions, fewer alternative generic options, or formulary constraints by the PBMs would adversely affect management’s ability to leverage the significant fixed costs of maintaining stores with high rents and staffing them with pharmacists. Walgreens may also be affected by the consolidation of healthcare companies and providers that could influence where prescriptions are filled.
With its international operations, Walgreens faces similar risks associated with reimbursement, mix, cost of procurement, competitive positioning, entry of new competitors, and decreasing utilization as in the U.S., but each of these risks would vary based on the countries that the company operates (Walgreens operates stores in 11 countries). Lastly, significant fluctuations in currency could negatively affect international operating results.
Data privacy and security breaches from hacking are a key environmental, social, and governance risk for Walgreens and other retail pharmacy chains that handle customers’ prescription orders and other personal data. Any material breach could create distrust among consumers and lead to the transferring of prescriptions to rival pharmacies. Additionally, there are risks related to product governance for the variety of general and health and wellness merchandise sold at Walgreens.
Capital Allocation| by Dylan FinleyUpdated Jul 14, 2021
We assign Walgreens a Standard capital allocation rating, which reflects our assessment of a sound balance sheet, fair investments, and appropriate shareholder distributions.
Walgreens’ balance sheet is sound, with medium unleveraged business risk. Revenue cyclicality is low, and while seasonality around cold and flu season affects revenue, on an annual basis, revenue tends to have less correlation with macroeconomic events because the demand for prescription drugs is relatively inelastic. Adjusting for cash proceeds from the June 2021 Alliance Healthcare divestment, the company’s balance sheet risk is low, with 70% of total debt maturing in more than three years, and a net debt/enterprise value ratio of 0.18%.
Walgreens’ recent investment strategy has been to divest from noncore areas (Alliance Healthcare wholesale unit) and redeploy capital toward core pharmacy and growth initiatives. As of January 2021, Walgreens owns a majority share of iA, a provider of automation solutions for pharmacies, lessening the burden of medication dispensing labor to centralized locations. Walgreens anticipates that, by freeing up pharmacist time, it can use staff for other greater value-added (and potentially higher-margin) tasks like vaccinations, diagnostics, and medication management. Walgreens owns a majority stake in VillageMD and has a strategic partnership with the company to install nearly 700 Village Medical primary-care clinics inside existing Walgreens locations. We assess Walgreens’ investment strategy as fair, and by taking advantage of its brick-and-mortar locations to provide healthcare services, the company may face less margin compression from ongoing reimbursement pressures going forward.
Walgreens’ distributions are appropriate, with its trailing payout ratio of around 40% and the company repurchasing over $15 billion worth of stock in the last five years. Walgreens’ strong free cash flow from operating activities affords it the flexibility to reduce debt, repurchase shares, and deploy capital to strategic initiatives going forward.