October Update

I unfortunately haven’t put out any posts in the past couple of weeks so I wanted to provide a quick update. The other week I was working on a write up on Walgreens, but that didn’t pan out the way I expected. Instead of a full stock analysis post, I’ll spitball some of my ideas below. Then last week I was working on putting out my quarterly portfolio update, but the brokerage where much of my stocks are held was having maintenance off and on all week. Plus work and family life has been hectic the past couple of weeks, but I should be getting back into my rhythm again soon.

Brokerage Woes

Originally when I started buying stocks, I went with the brokerage that had some of the cheapest commissions. I ended up creating an account with Trade King, but after a while Ally Financial bought them. Ally’s brokerage website has given me problems in the past, but usually its just a mild inconvenience. However last week Ally was intermittently down, then was down Friday through Monday, was up a little Monday afternoon, then down again in the evening. Needless to say that I will be looking to transfer my accounts to a reasonable brokerage like Fidelity or Interactive Brokers. Hopefully I can get the portfolio update post out in a couple of days.

Walgreens Analysis

When I first looked at Walgreens in my Idea List post, it seemed very undervalued based on historical profit margins. The other week I spent more time digging into the company. WBA is facing margin pressure on the pharmaceutical sales, and also weak consumer demand for the retail merchandise. Other retailers are facing headwinds (Dollar General, Big 5 Sporting Goods) with lower income consumers, so Walgreens seems to be in a similar boat. This seems to be a temporary phenomenon. On the pharmacy side, Walgreens has to deal with 3rd party payors such as Medicare, Medicaid, and pharmacy benefit managers (PBMs) that keeps driving down gross margins. On the US retail pharmacy segment, WBA gets about 75% of their revenue from pharmacy sales, and 25% from merchandise sales. Over the past 5 years, gross margins have declined about 1% a year, currently hovering around 17%. It does not appear that Walgreens will get an reprieve from these 3rd parties anytime soon.

With my initial valuation of Walgreens, I figured if the company could achieve 3-3.5% operating margins (a few years ago it was closer to 5%) then the company would be quite undervalued. Walgreens managed to produce this range of operating margin last year if you adjust for the Opioid settlement, goodwill impairments, restructuring charges, etc. The problem is that Walgreens was not able to maintain 3% margins this year, with last quarter showing 1.7% adjusted operating margin. These poor profit margins are starting to make Walgreen’s debt to EBITDA ratio look not great, and the company might have to cut its dividend again or suspend it.

I could handle a scenario where the margins are depressed because of a weak consumer environment that will eventually bounce back. But 1% decline in gross margin on the pharmacy business equates to $1.4B on a $140B in sales. That $1.4B in very impactful considering Walgreens would be undervalued if they produced $5B in operating profit, but shaving off one or two multiples of $1.4B rapidly sours the valuation. There is a lot of competition in the pharmacy space with CVS across the street, Walmart, Krogers, Costco’s and such, plus Amazon. At least Rite Aid going bankrupt is one less competitor. It just appears to me that Walgreen’s has little bargaining power with these 3rd party payors, so I’m pessimistic gross margins can rebound.

Walgreen’s is planning on closing down underperforming stores, which might help margins but at a cost. It sounds like WBA is dialing back its investments in its money losing primary health care segment, and may sell the business. Likewise there is talk of selling the Boots stores in the United Kingdom. I think these actions would stabilize Walgreens, but any cash generated would probably be used to shore up the balance sheet and not help out shareholders.

Long story short, Walgreens initially looked like a good value stock, but now looks more like a value trap. I’ll probably end up removing the stock from my watchlist, but maybe check in every now and then to see if margins have miraculously improved.