I was not surprised to see the news earlier this year that Walgreens was resisting calls that it refrain from selling tobacco products at its 14,800 drug stores across the world. As a result, many market commentators have compared Walgreens’ stock unfavorably to CVS, which stopped selling cigarettes during a phase-out program over the past three years on the basis that being a health-store was morally incompatible with selling a product that causes cancer and other severe health ailments.
The reason why Walgreens has held off on dropping cigarettes is because cigarettes are a much larger portion of their overall revenue pie than it ever was at CVS. At CVS, tobacco sales were only 0.4% of its total sales. At Walgreens, tobacco sales are 0.7% of its total sales because about 1,500 of Walgreens’ 14,800 locations are in areas that are described as high-smoking areas according to the Campaign for Tobacco-Free Kids.
You hear numbers like “0.4%” or “0.7%” and it can be hard to get a clear understanding of what exactly that means for the company’s bottom line. In the case of Walgreens, it sells $136 billion worth of goods per year. It sells $952 million worth of tobacco per year, and the retailer average profit margin on tobacco products is 23.5%. In others, $223 million in annual profit flows to the bottom line of shareholders each year. Over the past ten years, tobacco has been responsible for $2 billion in cumulative profits at Walgreens. Even if cigarette volumes were to decline at a 3% rate over the next ten years, but assuming the price of cigarettes were to increase at a price of 6.5% over the same time frame, the question becomes: “Is Walgreens willing to part with an easy $3 billion in net profit over the next decade?” The company is answering that question heck no, and for what it’s worth, it bears a much higher opportunity cost of ceasing tobacco sales than its healthstore peers that are doing the same.
Right now, Walgreens earns $5.5 billion in profits per year. If Walgreens were to stop selling tobacco products, its products would come down to $5.27 billion, for a 4-5% profit hit. But, of course, the opportunity cost is more than that because it would mean that Walgreens would be giving up an easy $223 million net profit stream that hits the balance sheet year after year. The company pays out $1.5 billion per year in shareholder dividends–about 15% of the dividend is currently funded by tobacco profits alone.
As I studied the political realities behind Walgreens’ decision to continue selling cigarettes, I took the opportunity to study the company again. The stock has come under fire because of the sense that the prescription drug market, from which it derives 72% of its sales, is subject to intensifying competition, but really, Walgreens has managed to hold its own because it only collects a 4% profit margin on each transaction. Wal-Mart, for what it’s worth, earns 3.4% profit margins. It is a surprisingly fair comparison to analogize that competing with Walgreens in the pharmacy sector is analogous to competing with Wal-Mart in the retail sector.
And, like Wal-Mart, Walgreens is capital intensive in that it requires an immense capital outlay to construct a new brick-and-mortar location in order to grow its profits. Selling software or intellectual property this is not. When you have 14,800 stores, and you require the capital investment of a new store to aid in profit growth, it would be quite unexpected to grow annual earnings in excess of the 8-12% range from that point.
In 2016, Walgreens was trading at $102 per share while earning $4.59 per share in profits. That was a P/E ratio of 22.2x earnings. That was a problem because large retailers typically trade at valuation ranges of 12-15x earnings. The business was great, but the price of the stock was not.
Now, we fast forward three years, and the terms have changed. Now, driven by reimbursement pressures and deflation in the price of generics, the price of the stock is down to $55. Meanwhile, profits per share have grown to $6 each. The business performance these past years has been fine, with 30% cumulative annual earnings per share growth from 2016 through 2019. But the price of the stock has cut in half because people were just paying too much in 2016.
Today, the value proposition is quite different. With $6 per share in profits and a $55 price tag, the P/E ratio is 9. Based on current profits, the stock is worth at least $72. I think the business will continue to grow at a 8-11% clip, and will probably see a P/E ratio of 12-13 over the next five years. In other words, the stock should trade above $100 per share at some point by the end of 2024. In addition, with the stock so much, investors are collecting a dividend yield of 3.27%, which is only 29% of Walgreens’ annual profits so it will have some room to expand in the years ahead.
When markets get overheated, it can be easy to abandon rationality because a lot of investments are making money that, on their face, shouldn’t. The cryptocurrencies, meat alternatives, and weed stocks will always be with us to the extent that new, shiny objects with theoretical potential will always capture the public’s imagination. It is the definition of speculation to guess how that all plays out.
But when you are dealing with real money that you need to compound, you can always focus on businesses that are attractive by traditional, objective measures that deliver honest-to-gosh products and are growing profits. These businesses almost always work out well as investments, but get discounted because there is something somewhere else making money faster. What people who ignore the Walgreens of the world are missing out on is the high probability of investment success that will result for someone who owns the stock for ten years. Beyond Meat shareholders do not have that assurance.
Finally, it is helpful to guard against the human folly of judging growing businesses by recent performance. Buying Walgreens stock at 9x earnings is a fundamentally different proposition than buying it at 22x earnings in 2016. The odds are stacked in your favor now, they weren’t then. But someone out there is probably dumping Walgreens stock because it has fallen 50% over the past three years even though the business has grown profits by 30% over that same time frame and the fault rests solely with the investor that overpaid for his shares.
In short, Walgreens is a beast of a company because it keeps competition at bay by only taking razor-thin margins from its pharmaceutical division, it will keep selling tobacco because it is easy money and almost an eighth of its locations are in smoker-heavy areas, and the valuation of the stock is presently at a generational-low price, which is objectively great but subjectively incredible in light of the overvaluation elsewhere.