For some of you reading this, it is no secret that the big drug stores have been a great way to make lots of money over the second half of the 20th century through today. During the past thirty years, Walgreens stock–now officially called Walgreens Boots Alliance with the ticker symbol WBA–has compounded at almost 16% so that a $25,000 investment in 1985 would be worth $2.1 million today.
It makes intuitive sense why drug companies have been such successful investments. There are strong drug networks selling products that people need to pick up in person rather than through the mail. There are basic consumer items that get purchased as well that add to the shopping cart total. The founder of Walgreens was so shrewd about getting the location right that he created the enduring cultural mandate to only set up shop at street corners so the locations will be highly visible and accessible. If you ever see a Walgreens that is not at a street corner, the location must have been a predecessor to something that wasn’t Walgreens and then later got bought out.
And yet, each Walgreens store is not quite the money-printing machine that you think it is. Operating margins are only 7.5%, and once you include the building costs of rolling out new stores each year, the net profit margin is only 3.8%. Considering that the Walgreens pharmacy contributes 64% to overall sales, you would expect higher margins than that. At least, I did.
When you review Walgreens history, and get a feel for how the company goes about creating earnings growth, you may come to the same conclusion as me: Walgreens needs to keep rolling out more and more stores to keep the profit line charging upward.
That is an important observation because it distinguishes Walgreens from a company like Starbucks. It is not unusual for Starbucks to have a good year in which same-store sales grow 7%. Sure, rolling out new stores will help boost the Starbucks bottom line, but it could survive just fine and give shareholders satisfactory returns with the existing store count.
That is not true for Walgreens. This conclusion challenged my assumption, as I initially figured that Walgreens would be the type of company that could deliver same-store sales growth on a regular basis without much issue. But that’s just not the case.
Take a look at the 2004-2014 comparison period. In 2004, there were 4,800 Walgreens stores that were chugging out $1.4 billion. By 2014, it had 8,300 stores making $2.8 billion. In order to double profits over ten years, it had to roll out 3,600 additional stores across each one of the United States and Puerto Rico. It had to increase its store count by 73% in order to create 100% profit growth.
In this light, the Rite Aid (RAD) actually that was announced today makes perfect. A growing store count is the oxygen that keeps the Walgreens growth engine breathing. It can’t just sit around and grow sales at the existing 8,300 Walgreens–shareholders get rich when the management team builds new stores or adds new stores to the corporate umbrella rather than devising innovative ways to attract more customers to existing stores or get the existing customers to spend more at the stores.
The latest bit of news is that Walgreens is purchasing Rite Aid for $9 per share. Some of the Rite Aid (RAD) shareholders are howling that the deal is an unfair price, but they are using the achoring bias of remembering the summer high of $9.50 and using that as a reference point to determine what is fair.
That’s the wrong way to think. Getting bought out at intrinsic value is fair (or perhaps at a premium to intrinsic value to adjust for the mandatory tax consequences and the opportunity cost of finding a new investment that necessarily arises). And getting bought out for more than the company is worth is a blessing.
Rite Aid is not an impressive company. The real question I have for existing shareholders is this: Why on earth did you become a Rite Aid shareholders in the first place? What was going through your head that made you decide to buy this rather than CVS or Walgreens in the past couple decades? CVS and Walgreens grow profits and raise the dividend every year. Rite Aid…not so much.
There are no dividends paid out at Rite Aid. It lost a lot of money in the late 1990s. A short stretch between 2003 and 2005 were the only times the company was profitable before the financial crisis. The profit margins are atrocious for the amount of revenue that Rite Aid generates on a regular basis. It sells $30 billion worth of stuff each year, yet only $215 million flows through to shareholders as profit. The core business is terrible–it consumes a whole lot of capital, and doesn’t spit out much in return.
The current operating margins are only 4%, and the net profit margins are only 0.7%. Those are pitiful, anemic figures and they represent nearly an all-time high for the company. It doesn’t have much of a coherent strategy–buying stores, shuttering stores, constantly shifting the strategy between wanting to become a national powerhouse and wanting to be a specialty boutique drugstore operator.
And, of course, you know what happens you spent 20+ years generating losses. Either large scale dilution or big swaths of debt. In the case of Rite Aid, the answer is both. Rite Aid has diluted shareholders almost four-fold in the past sixteen years: raising the share count from 259 million to over 1 billion in 2015.
The balance sheet is junk–Rite Aid has $7.2 billion in debt that is now going to greet Walgreens shareholders, and $1.7 billion of it is due within the next five years. Walgreen is going to transition from being a $16 billion in debt company to being a $23 billion in debt company. And Rite Aid is only going to augment Walgreen’s overall profits by 5% in the first year.
At this point, it will probably surprise none of you when I say that Rite Aid has over $1 billion classified as off-balance sheet debt. This is when the company doesn’t own the real estate on which it operates, and has signed long-ranging leases putting it on the hook for over $1 billion in rental payments through 2021. This isn’t like the Bob Evans of the 1980s or the McDonalds of now where the parent corporation owns the land and there is no need for income to be diverted to some corporate landlord.
The Walgreens CEO mentioned that Rite Aid will maintain its corporate identity for the time being, but will eventually be merged into the Walgreens name. This is no doubt a smart move–the brand affinity for Walgreens is much stronger for Walgreens than Rite Aid.
You need to understand that this move is coming at a significant cost to Walgreens. It is taking on a whole lot of debt, and company that is trailing Walgreens significantly on every measure of overall corporate profitability. The thing is, Rite Aid has 4,600 stores. Walgreens needs to get its hands on these stores to keep earnings per share rising. This move is going to take Walgreens from 8,300 stores to 12,900 stores.
The interesting question is whether Walgreens management has the talent to improve a sagging brand with an unstable corporate history into one of its own. If it can treat the Rite Aid stores as skeletons to be integrated into “The Walgreens Way”, then this deal could be a heist. If the Rite Aid stores could get their profit margins up to the Walgreens level, suddenly those $200 million profits could be turned into $600 million overnight.
I am agnostic on whether Walgreens management possesses the skill to improve these Rite Aid stores, as I have no knowledge of Walgreens embarking on a similar effort before. Desperate may be a strong word to describe the Walgreens bid, so I’ll say this fact without judgment: Walgreens needs additional stores to keep its fantastic growth story going, and with over 8,000 stores already in existence, it needs a large acquisition to move the needle. The 4,000+ store count at Rite Aid makes the company one of the few targets that could be appropriate for Walgreens.
I should mention that Walgreens officers and directors have an unusually high 21% ownership of the company. They eat their own cooking. I can only think of a half dozen other examples of large-billion dollar firms having this high level of insider ownership. If you have been a Walgreens shareholder for a long time, it should bring you solace to know that the Walgreens execs and directors have got their own money on the line with this thing, and they are not playing with other people’s money when they embark upon this latest addition to the empire.
On the regulatory side, the execution of this deal is not yet a sure thing. It may raise antitrust concerns to see Walgreens acquire the third largest competitor in the market, and a 12,000 store behemoth that only has CVS as the principal competition may give regulators pause. I am agnostic on what divestitures or concessions may be required to complete this deal, and I will only make the common-sense observation that when two of the three biggest players in an industry merge, it would be foolish to assume that the deal is a sure thing.
This transaction has a lot more unknowns than some of the other mergers and acquisitions I have covered. When Reynolds acquired Lorillard, it was clear that the two tobacco companies were quite similar and the integration would generally go smoothly. When 3G buys a company, it is well-documented that costs get obliterated and earnings shoot to the moon before another merger needs to happen because the management team is not proficient at growing sales.
This Walgreens acquisition of Rite Aid will, in the short term, lower the quality of Walgreens’ overall earnings by adding gobs of debt and taking on a drugstore that does not have its act together–the profits are miniscule and inconsistent. Does Walgreens turn Rite Aid into a lucrative extension of itself, or is the Rite Aid cultural rot so resistant to change that it swallows precious shareholder capital of Walgreens?
If a Walgreens shareholder sold their stock and said, “See ya, I want the sure thing of CVS”, I wouldn’t criticize the move. That would lock-in 9-12% annual total returns with little downside risk. By sticking with Walgreens, you are taking on a greater range of outcomes. If the Rite Aid deal goes through and is successfully integrated, Walgreens shareholders could achieve returns in the 15% ballpark over the next 5-10 years. If Rite-Aid continues to perform according to its past history, then Walgreens could become a business that trails the overall performance of the S&P 500. Walgreens shareholders are looking at a wide 6-15% annual return range from here, whereas the 9-12% offered by CVS is much tighter. This Walgreens move is fundamentally different from the company’s past behavior–current Walgreens shareholders have a lot to mull over in the coming months.
Originally posted 2015-10-28 05:10:01.