Walgreens Boots Alliance (NASDAQ:WBA) has too slowly transitioned to the digital realities of the modern retail environment, but the stock drop after FQ3 results was a clear overreaction. The quarterly results weren’t as bad as the stock reaction for a stock already down about 20% from the previous highs. My investment thesis is more bullish on the stock following this dip below $40, as Walgreens Boots gets more aggressive with its digital plans and expands into more personalized healthcare services after a slow start.
Image Source: Walgreens Boots
Weak Quarter Explained
A retailer reliant on physical stores was naturally hurt during the quarter ending May 31. The quarter faced the worse part of the economic hit in the U.S. and the U.K. during April and May.
Despite the nice revenue beat, some investors expected far better earnings when the company clearly faced higher costs such as cleaning expenses to keep stores open. Walgreens Boots somehow beat revenue estimates by $310 million and missed EPS by a wide $0.39 margin.
The EPS miss is hard to explain from the analyst point of view. The company had higher SG&A expenses to keep stores open with additional cleaning expenses and employee costs. Somehow, analysts forecast the company earning $1.22 per share, down from $1.47 last FQ3, with revenues only flat.
The company entered the crisis with forecasts for revenue growth in the low-single-digit range, so any hit to revenues was bound to pressure margins at the same time that costs were bound to rise due to COVID-19. Walgreens Boots estimates an adverse sales hit of up $750 million, which would’ve placed the retailer with over 2% revenue growth for the quarter.
Most U.S. investors probably don’t understand that despite solid growth in the U.S. that the U.K. Boots stores were generally closed or limited to health-related sales. While the U.S. retail pharmacy business quickly overcame weakness to post a 5% comp sales boost in June, Boots U.K. is still getting hit with retail sales down 40% last month while pharmacy sales were up 7%.
Source: Walgreens Boots FQ3’20 presentation
The weak retail sales in the U.K. continue to smash margins as costs are higher while sales are lower. Boots U.K. saw FQ3 gross margins down 440 basis points. Even the U.S. retail pharmacy business saw operating margins down 2 percentage points despite sales up a strong 3.2%.
The case can be made that Walgreens did a solid job during the quarter with strong sales for the stores open. The biggest issue were stores forced to be closed and the additional costs that will eventually disappear.
Naturally, with the virus still hitting the U.S and the U.K., the company lowered its FY20 EPS guidance to $4.70 at the midpoint. The amount is over $1.00 below the normalized earnings once COVID-19 disappears.
Source: Walgreens Boots FQ3’20 presentation
The hit for FQ4 is up to $0.50, and the new corporate estimate is ~$.030 below current analyst estimates. The vast majority of the earnings hit was in FQ3 with the potential of the pharmacy retailer only facing an additional EPS drag of $0.50 in the current quarter.
The key here is to look beyond the current crisis to normalized business in FY21. The U.S. operations saw limited overall impact, showing that a Walgreens store was indeed essential. The Boots U.K. stores were not seen as essential outside of the pharmacy part of the store. Regardless, the case has to be made for a rebound in sales once the U.K. fully eases restrictions.
The company raised the dividend payout by 2.2% to $0.4675. The annual payout is now $1.87 for a dividend yield of 4.8% with the stock at $39. The dividend yield is now the highest in the last decade in a sign of strong value.
Despite the disappointment of eliminating share buybacks at the low, the stock is a buy based on this dividend yield alone. The payout is only 40% of lowered EPS estimates for the virus crisis, providing a sign of value even at the weak earnings levels here.
A return to normal earnings in FY21 above $5.70 would make this stock an eternal steal, especially considering the weak results weren’t based on any lost business. In addition, the company is moving forward with digital sales initiatives with Microsoft (MSFT) and Adobe (ADBE) while pushing forward with in-store health clinics with VillageMD. Both moves are bullish for the business even if the process has taken far too long with Amazon (AMZN) nipping at the door.
The key investor takeaway is that Walgreens is far too cheap here after the stock took a hit from the virus crisis. The stock only trades at 7x normalized earnings while offering a 4.8% dividend yield.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in WBA over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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