Walgreens Boots Alliance: Likely A Value Trap, But Could Be A Speculative Long-Term Play

Walgreens Boots Alliance, Inc. (NASDAQ:WBA) is one of the most well-known pharmacy chains in the United States. The firm operates as an integrated healthcare, pharmacy, and retailer in the United States (U.S.), the United Kingdom, Germany, and internationally.

We have started covering WBA in December 2022, when we assigned the firm a “buy” rating. We have reiterated this bullish view a month later in January 2023.

Our investment thesis did not age well, unfortunately. We have based our “buy” recommendation on a dividend discount model. This model assumed a required rate of return of 9% and a perpetual dividend growth rate of 1.5% to 4%, resulting in a fair value range of $26 to $45 per share. Since then, however, the share price has been continuously declining. In this period, WBA has lost roughly 70% of its market cap, while the broader market has gained more than 38%.

The aim of our article now is to revisit WBA and discuss the validity of our previously used dividend discount model. We will question the validity of the previous input parameters, as well as the suitability of the method itself. Later, we are also going to highlight several risk factors that could help current shareholders and potential investors decide whether WBA could be an attractive position in their portfolios or not.

Dividend discount model

In our earlier writings, we have claimed that the dividend discount model is an appropriate method to value WBA’s stock as the firm is in the mature growth phase, and it has a long history of paying and growing its dividends.

While the firm still pays quarterly dividends, it has been significantly reduced – from $0.48 per share to $0.25 in 2024.

So what are the consequences of this?

1. We believe that from a fundamental perspective, it was necessary to cut the dividend. The firm could not afford these payments anymore, and they had to get their capital allocation priorities straight.

2. From a dividend- and dividend growth investor point of view, this action is of course the most desirable thing to happen, as the income that they have been counting on has been roughly slashed to half.

3. This decline, however, does not make the dividend discount model unsuitable, it just needs to be adjusted using a new starting value for the dividend and, naturally, the estimation of the growth in the near future and in perpetuity becomes more uncertain.

Let us now update our dividend discount model and see what fair value we would get. To do so, we will be using the firm’s latest weighted average cost of capital (WACC) as our required rate of return, and we will use three different growth scenarios for the dividend growth in perpetuity.

The following table shows WBA’s WACC. This is currently estimated to be 5.3%. We will use this figure as the required rate of return in our calculation.

For our dividend growth estimates, we will assume that the firm remains a going concern. Without this assumption, there is no need to do any valuation.

1. Scenario: Dividend will be completely eliminated until 2030, so that the firm has enough time to change its strategy and turn around. From then onwards, a dividend will be initiated, which is equal to the current $0.25 per share, which will grow at a rate of 2.5% in perpetuity.

2. Scenario: Dividend will stay at the current level until 2030, and from then on, a growth rate of 2.5% will be used in perpetuity.

3. Scenario: Dividend will grow at a rate of 1.5% in perpetuity – equivalent to the company’s 10 year CAGR dividend growth rate.

These scenarios give the following fair values for WBA’s stock:

All these calculations indicate that WBA’s stock is deeply undervalued. Also, when we check a set of traditional price multiples, we can see that WBA is trading at a significant discount compared to both its own historic valuations as well as to the sector median.

Does this mean however that we should rate WBA as a buy once again? To answer this question, we have to go through several risks that might impact WBA going forward. In our previous articles, we have falsely believed that WBA is a value play, which eventually appears to be turning out as a value trap.

Risks

Dividend safety

While we created a scenario in which the dividend has been eliminated until 2030, there is a potential that the dividend may be eliminated for much longer.

Currently, WBA does not seem to be able to afford even the lowered payments. Cash flow from operations was negative twice in the last four quarters. If there is no cash generated, the company has to use its cash reserves to pay out dividends. This is not a sustainable practice and likely not the best use of cash either.

For this reason, investors who are considering a potential investment need to be aware that further dividend cuts or even a complete elimination of the dividend may come.

Debt

WBA has more than $33 billion in debt. This is a huge number. This is more than the entire market cap of the firm currently, which is roughly 9%.

According to the latest annual report (from 2023) the firm has significant amounts of debt maturing in the coming years. It means that they likely need to be refinanced at a much higher rate, as the interest rate cuts have not commenced yet.

This in turn could lead to higher interest expenses, declining profitability, and eventually lower net income.

One example is the latest announcement of $750 million senior unsecured notes at 8.125% to retire outstanding 3.800% notes due 2024. The difference in the cost of financing is huge. Also, we need to note here that as a result, cost of capital is likely to increase, which makes our previous 5.3% required rate of return estimate possibly overly optimistic.

Restructuring

The firm feels the need to streamline its operation and generate/ save cash. While there are several key projects ongoing, we would like to see the outcomes and results first, before we could get optimistic about these.

Examples include the possibility of the entire sale of its VillageMD stake or the further cuts in stake in Cencora.

Market sentiment and momentum

We believe that the current market sentiment, the overall macroeconomic environment, and the stock’s momentum all add further headwinds and likely indicate that a recovery in the stock price may take years if it materialises at all. As an example, WBA has been one of the most shorted S&P500 stocks in June.

Conclusions

According to our updated dividend discount model and a set of traditional price multiples, WBA’s stock appears to be significantly undervalued. But we came to this conclusion in our previous analysis as well, and since then, the stock price has declined by roughly 70%.

There are significant risks ahead, including concerns about the dividend safety and sustainability, the upcoming debt maturities, the restructuring efforts, and the current market sentiment.

For these reasons, despite the apparent attractive valuation, we cannot be bullish on WBA anymore. We do not recommend this stock for dividend- or dividend growth investors; however, it could be a speculative, long-term bet as a part of a larger portfolio.

We downgrade our rating to “hold.”