In October, before earnings, I warned that Walgreens Boots Alliance’s (NASDAQ:WBA) dividend safety had plummeted due to high-interest rates, making it far harder to service its debt.
I recommended three 9%-yielding, SWAN quality (or better) alternatives.
Then we’ve had earnings, a credit rating change, and interest rates have fallen 0.6%. And guess what? Walgreens stock has fallen almost 10% more, now yielding a record high 9%.
Let’s look at whether anything has changed for Walgreens that might make the lowest P/E in over 20 years either a warning sign or the buying opportunity of a lifetime.
Walgreens: No Silver Lining in Sight
The only good news is that interest rates are down significantly, and the bond market is confident that the Fed will slash rates by 1% in 2024 and some economist teams, like Goldman Sachs, think as much as 1.75%.
That certainly would help WBA’s goals of refinancing debt at lower interest rates, though this isn’t as clear-cut a benefit as you might think.
The bond yields investors charge a company are based on the risk-free rate (treasury yield) + a risk premium.
Walgreens is now on the brink of junk bond credit rating, which would mean about 1% higher interest rates, more than offsetting the rate decline triggered by a treasury bond market rally.
WBA’s negative outlook means a 33% chance within two years of becoming a junk bond-rated company. Typically, companies will cut the dividend to try to prevent such a downgrade.
Earnings were just one reason S&P took a hatchet to WBA’s rating, which now indicates an 11% chance or 1 in 9 that WBA will default on its debt within 30 years and its stock go to zero.
Results fell significantly below our expectations for fiscal 2023. We note free cash flow was only $665 million in the year ended Aug. 31, 2023 by the company’s calculations, a material decrease of $1.5 billion from 2022 amid lower earnings. The company said this came from opioid settlement payments and increased capital spending including for growth initiatives related to U.S. pharmacy and U.S. health care. We find this to be a very low amount of cash flow for a company with almost $140 billion in sales.” – S&P
Free cash flow was cut in half to less than $700 million. The trouble is that Walgreens’ dividend costs $425 million per quarter.
1200% Free Cash Flow Payout Ratio
The payout ratio has soared to 1200%, and next year it will drop to 77%, still too high…if there is no recession and free cash flow soars 1500%.
We also note Walgreens’ material $6.9 billion operating loss in fiscal 2023, compared to operating income of $1.4 billion in the year-ago period. This was mainly from the $6.8 billion pre-tax charge for opioid-related claims and litigation. The company said on an adjusted operating income constant-currency basis the decline was 24%.
Overall, this performance translated to S&P Global Ratings-adjusted leverage increasing to 4.6x for fiscal 2023 from 4.1x in the year-ago period. This was as lower profitability offset balance sheet debt reduction. We consider the opioid-related settlement obligations akin to debt.” – S&P Global.
WBA’s leverage ratio (debt/EBITDA) is approaching 5, and if we get a recession next year (99% probability according to the bond market), then that ratio could rise over 5.
The CEO change was fairly sudden, in our view. Rosalind Brewer has been CEO since 2021 and helped pursue the company’s healthcare strategy. We also note the company’s chief information officer departed in October, just a year after he was first hired. Complicating the executive turnover and sustained execution of a stable financial and operating strategy, in our view, is the ongoing involvement of vocal executive chairman Stefano Pessina, a former CEO before Brewer who is still a large shareholder. All of these issues led us to revise our management and governance score to fair from strong.” – S&P (emphasis added).
A new CEO got the boot after two years, and S&P is less confident that the new management team can turn things around.
The company is trying to preserve capital, and we believe will continue to pay down debt in the coming year. It has halted stock buybacks and recently announced a sharp cut in capital spending by about $600 million as well as planned cost reductions of at least $1 billion. Still, we note it pays large dividends, with $1.7 billion this past year.” – S&P.
Whenever rating agencies start commenting on how a company struggling to slash costs and pay down debt, including through asset sales, yet is still paying a “large dividend,” that’s a major red flag.
Rating agencies don’t care about dividends, they care about debt being repaid, and they will often pressure a company with an ultimatum. Cut or get downgraded to junk bond status.
In 8 years as an analyst, I’ve never heard of a company choosing to save the dividend at the expense of an investment-grade credit rating.
If I had, I would have advised against investing in that company, which would be reckless and a sign of poor capital allocation. As S&P further states (emphasis added):
The negative outlook reflects the risk that Walgreens’ new healthcare strategy will not yield the expected improvement in its profitability. At the same time, its core business continues to face various headwinds over the coming months.
We could lower our ratings on Walgreens if:
- Walgreens faces execution issues with both its core and new strategies that lead to performance setbacks or additional cost pressures that diminish its competitive position and lead us to a worse view of the business relative to peers;
- Leverage remains greater than 4x, and interest coverage approaches 4.5x sustainably.
We could take a positive rating action on Walgreens if:
- It significantly improves its operating performance and
- Leverage declines materially below 4x on a sustained basis.”
Suppose Walgreens can improve its debt metrics next year, but not as much as analysts expect. In that case, S&P will consider slapping it with a BB+ junk bond credit rating, instantly making its bonds uninvestable to many pension funds and institutional investors.
- Analysts expect WBA’s debt/EBITDA to fall to 3.7X next year
- in a recession, it would be above 4.
What kind of interest costs would a junk bond rating get WBA? Its current bonds yield 6.4%, and a downgrade to BB+ would likely push it up about 1% to 7.4%.
To show you how badly high rates and poor execution on its turnaround have hurt WBA, its current average interest rate is 1.8%.
It can sell bonds at 6.4%, with a 33% chance of going to 7.4%.
- 3X to 4X increase in borrowing costs.
Do you see why I do not like WBA’s dividend safety?
Growth Outlook Falls Off A Cliff
Walgreens’s growth consensus has collapsed and is now at about -5 %.
And that’s one of the more bullish estimates.
At a -5 % growth rate, Walgreen’s earnings and dividends would be cut in half every 14 years, or about a 75% reduction over 30 years.
And since earnings, cash flow, and dividends are what intrinsic value is based on, that would also likely mean a 75% reduction in share price.
A -8% growth rate would mean a 50% reduction every nine years.
Or approximately a 90% reduction over 30 years.
What about the dividend? 9.6% yield -4.9% growth is a 4.5% long-term total return, 2% after inflation.
- 30 year Treasury bond (US30Y) is a relatively risk free alternative to WBA for the next 30 years.
90% Chance Walgreens Is A Bad Business To Avoid
In 2016, Walgreens reported a record unlevered free cash flow of $6.2 billion.
In 2027, it’s expected to generate $4 billion in free cash, or 50% less…11 years later.
Catastrophic negative free cash flow growth like this is possible at a good business if there is a lot of bad luck, a perfect storm of negative headwinds.
But 90% of the time, it’s just because a company is a bad business.
I continue to scratch my head as to why Walgreens exists when its rivals offer the same services with better convenience or, like CVS Health (CVS), have other value propositions like Minute Clinics and integrated health insurance operations.
CVS Made The Right Decision Integrating Vertically, And Walgreens Played It Safe…Wrong Choice