Companies everywhere, in every business, are paranoid about Amazon.com. This sort of paranoia is healthy for the long-term well-being of an investment portfolio, as it is creating interesting buying opportunities.
A case in point: My firm spent a lot of time thinking about pharmacies when we were analyzing investments in McKesson and other drug distributors. We struggled with a question: How will the retail pharmaceutical industry look in the future? Or more precisely, how will Amazon’s entrance into the retail pharmacy business change this industry?
Our inability to answer this question kept us away from retail pharmacies. Then we had a small but important insight that shifted our thinking on Walgreens Boots Alliance.
The preponderance of drugs in the United States is consumed by an older population, whose habits change slowly or not at all. Accordingly, it’s likely that Amazon’s online pharmacy will not significantly impact the existing drug industry.
Americans currently spend $450 billion a year on drugs. Walmart is the fourth-largest U.S. pharmacy, with sales of $21 billion, or 4.6% of the company’s total sales.
Let’s say that over the next five years Amazon gets to Walmart’s pharmacy sales level. If the U.S. pharmaceutical industry grows 2% a year over that time, total drug sales will have increased by $45 billion, or the equivalent of two Walmarts (we are ignoring compounding here), to $495 billion. Walgreens, with its pharmacy selling about $70 billion a year, would barely notice Amazon’s presence.
Ten years ago, Amazon was not taken too seriously. Giants like Google, and Microsoft ignored Amazon’s entry into cloud hosting, thinking “What does a bookseller know about the cloud?” They have regretted it ever since.
Nowadays, though, everyone is taking Amazon too seriously, bestowing CEO Jeff Bezos with walk-on-water-like superpowers. Boardrooms are filled to overflowing with chatter about Amazon. There’s admittedly a lot corporate America can learn from Bezos (for instance, about ignoring short-term results), but he’s not superhuman and Amazon cannot bend the laws of economic gravity.
Walgreens’ U.S. business, which is about 75% of its total sales, is impressive. A single stand-alone store produces revenue of about $10 million a year — $7 million in the pharmacy and $3 million in front-end sales (milk, candy bars, T-shirts, etc.).
A single store fills about 121,000 scripts a year (up from 97,000 four years ago). Walgreens has one of the highest sales-per-square-foot numbers in the retail industry, at around $1,000 (compared to Walmart’s $450, Kroger’s $550, and Target’s $300).
Despite that, the front end of Walgreens’ stores in an underutilized asset. The pharmacy takes up 20% of the floor space but generates 70% of revenue. In other words, 80% of the store brings in only 30% of revenue. Walgreens is experimenting with different ways to optimize this asset — it’s opening medical clinics and bringing LabCorp into its stores, for instance.
In 2018, Walgreens bought 1,900 stores from Rite Aid, bringing its total U.S. store count up to around 10,000. Store-count growth days are behind Walgreens, but the scripts-per-store growth will continue, since baby boomers are not getting any younger.
Accordingly, total sales growth will continue at a level of at least 2% to 3% a year. When retailers mature and cannot open new stores, their free cash flows explode. Which begs the question, what will Walgreens do with its cash?
Already Walgreens is taking a quite different approach than its largest counterpart, CVS Health Corp.
CVS owns one of the largest pharmacy benefit management (PBM) companies (a business that has a lot of political risk, as it’s ridden with conflicts of interest). The company also is doubling down on complexity by trying to buy Aetna, a health insurance company, to become an integrated health-care provider. We don’t know if this endeavor will be successful, but the historical odds of success with acquisitions of this complexity clearly do not favor CVS.
Walgreens is run by Stefano Pessina, who owns 13% of the company, and thus 13 cents of every dollar spent is his. Walgreens has therefore been deleveraging its business, buying back stock, and paying a dividend. Walgreens is expected to earn $6 a share in 2018.
My estimate is that per-share earnings, helped by the Rite Aid acquisition, same-store sales growth, and share buybacks (WBA repurchased 8% of its shares in 2018 and has an authorization to buy an additional 13%), will exceed $8 per share in 2021.
If Walgreens shares trade at 13 times its $8 earnings per share in three years, then the upside from here is about 70%; if it trades at 15 times then it’s a double (Walmart trades currently at 18 times estimated 2018 earnings, while Target is at 15 times).
We bought Walgreens at a little over 10 times estimated 2018 earnings in July 2018. Walgreens is a better business than Target and at least as good a business as Walmart.
At this valuation, heads we win, tails we win — the only question is by how much. But whatever the result, it will have very little to do with Amazon.
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