Undervalued Dividend Growth Stock of the Week: Walgreens Boots Alliance (WBA)

The U.S.-China trade war.

The Federal Reserve.

Politics, interest rates, a fracturing Europe.

So much going on.

What should an investor do? 

Ignore the noise. 

All of it.

It’s advice that Warren Buffett has repeated many times.

And it’s advice I follow.

This advice has helped me build up my six-figure FIRE Fund.

That’s my real-money stock portfolio.

It generates the five-figure passive dividend income I live off.

That dividend income has rendered me financially independent.

I quite my job and retired in my early 30s – something almost anyone can do, as I lay out in my Early Retirement Blueprint.

A long-term investor focuses on businesses.

Not just any businesses, though.

High-quality businesses.

And some of the highest-quality businesses in the world are those that pay reliable and growing dividends.

That’s because a quality business produces a lot of growing profit.

So much growing profit, it eventually has to flow back to the owners (the shareholders).

This is a big reason why I’m a dividend growth investor.

Jason Fieber's Dividend Growth PortfolioTake a look at the Dividend Champions, Contenders, and Challengers list to see what I mean.

That list contains data on more than 800 US-listed stocks that have raised dividends each year for at least the last five consecutive years.

It shouldn’t be a surprise that many companies on that list are world-class enterprises.

Quality is very important.

But it’s not everything.

Valuation at the time of investment is also critical.

Price tells you what you pay, but value tells you what you get.

And value relative to price will have a lot to say about your investment results.

An undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and reduced risk.

That’s relative to what the same stock might otherwise offer if it were fairly valued or overvalued.

All else equal, because price and yield are inversely correlated, a lower price results in a higher yield.

This higher yield leads to greater long-term total return potential.

Total return is, after all, the sum of investment income and capital gain.

Boosting yield gives you more potential investment income.

Capital gain gets a potential boost, too, via the “upside” between a lower price and higher intrinsic value.

These favorable dynamics also reduce risk.

Undervaluation introduces a margin of safety.

That’s a “buffer” that protects the investors downside against unforeseen issues.

An undervalued high-quality dividend growth stock can be a tremendous long-term investment.

Fortunately, finding undervalued high-quality dividend growth stocks in the market isn’t extremely difficult.

Fellow contributor Dave Van Knapp has made this a much easier process.

Make sure to read his Lesson 11: Valuation, part of an overarching series on dividend growth investing, for more on how to go about valuing dividend growth stocks and spotting opportunities.

With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…

Walgreens Boots Alliance, Inc. (WBA)

Walgreens Boots Alliance, Inc. (WBA) is one of the world’s largest pharmacies, with more than 18,000 stores across 11 countries.

Major brands include: Walgreens, Duane Reade, Boots, and Alliance Healthcare.

With a corporate history dating back more than 100 years, this company now operates as a global behemoth across the retail pharmacy space.

Revenue breaks down across the following segments: Retail Pharmacy USA, 75% of FY 2018 sales; Pharmaceutical Wholesale, 16%; and Retail Pharmacy International, 9%.

In addition to the retail pharmacy business its wholly owns and controls, Walgreens Boots Alliance owns approximately 26% of AmerisourceBergen Corp. (ABC).

This significantly exposes the company to pharmaceutical distribution, as AmerisourceBergen is one of the largest wholesale drug companies in the US.

It’s been previously reported that Walgreens Boots Alliance is considering acquiring the rest of AmerisourceBergen. But the recent wave of opioid litigation has cast some doubt over this.

While the company does have a global footprint, the majority of its sales are still tied to its legacy US pharmacy business.

This is both a gift and a curse.

On one hand, the United States is an incredibly affluent country. It’s one of the most profitable and desirable markets in the world.

Furthermore, an older (and aging) population and an expensive healthcare system that requires the likes of PBMs and public pharmacies bodes extremely well for the likes of Walgreens Boots Alliance.

On the other hand, any major changes to the US healthcare system could directly, and negatively, affect the business. For instance, any kind of “Medicare for All” law would almost certainly be a net negative for the company.

Also, being so heavily tied to the US does limit their growth, as the U.S. market is largely mature.

Another major challenge is the ongoing shift to e-commerce.

That shift could drastically alter the company’s fundamental nature and competitive positioning in two ways.

First, the shipment of pharmaceuticals opens up new competition while simultaneously making the company’s brick-and-mortar buildings less advantageous.

This would greatly reduce one of their primary competitive advantages.

Second, less traffic in stores means less retail sales.

Pure retail sales made up approximately 25% of the company’s largest segment.

Large and continued drops in ordinary retail sales would cause substantial harm to the company’s overall revenue and profit.

But challenges aren’t new to Walgreens Boots Alliance.

They’ve been navigating challenges and changes for more than 100 years.

And they’ve been paying a growing dividend for much of that time.

In fact, they’ve increased their dividend for 44 consecutive years.

That’s almost half a century.

We’re talking a span of time that included numerous wars, Black Monday, ever-changing politics, 9/11, and the Great Recession.

And it’s not like the US healthcare system hasn’t changed over the last 44 years.

Yet Walgreens Boots Alliance kept on pumping out an increasing dividend.

The ten-year dividend growth rate stands at an impressive 15.0%, but I do think that’s somewhat misleading.

More recent dividend raises have been modest. There’s been an obvious deceleration in dividend growth.

For example, the most recent dividend increase was approximately 4.0%.

But with a payout ratio of 36.0%, there’s still plenty of room for the company to increase the dividend for years to come – even absent much profit growth.

That comes with a market-beating yield of 3.36%.

This yield, by the way, is more than 140 basis points higher than the stock’s own five-year average yield.

Of course, investors are more interested in where a company is going than where it’s been.

We invest in the future.

While almost 50 years of dividend raises does say a lot about the company’s wherewithal and willingness to pay a growing dividend, it’s even more important to gauge where the company and its dividend are going to be in the future.

Therefore, I’m going to build out a forward-looking trajectory of growth.

I’ll build this trajectory estimate out by first showing you what Walgreens Boots Alliance over the last decade, using that as a proxy for the long haul.

Then I’ll compare that to a near-term professional forecast for profit growth.

Combining the proven past with a future forecast like this should tell us a lot about where the company might be going.

Revenue is up from $63.335 billion in FY 2009 to $131.537 billion in FY 2018.

That’s a compound annual growth rate of 8.46%.

While impressive, the growth isn’t all organic.

There are a lot of moving parts to account for here.

The company, in 2014, acquired the remaining 55% of Alliance Boots it didn’t own (they previously owned 45%).

This was a transformational deal worth more than $15 billion. It gave the combined company additional international exposure to both retail pharmacy and pharmaceutical wholesaling.

They also exercised warrants to purchase 45,393,824 shares of AmerisourceBergen in 2016. This is essentially now a JV that requires Walgreens Boots Alliance to use the equity method of accounting.

Then they acquired 1,932 Rite Aid Corporation (RAD) stores for $4.2 billion in 2018.

The company is undoubtedly bigger and more diversified than it was a decade ago.

But let’s cut through the noise and take a look at how this has impacted the bottom line on a per-share basis.

Earnings per share increased from $2.02 to $5.05 over this period, which is a CAGR of 10.72%.

So the company actually grew its EPS faster than revenue growth, which is pretty stunning.

What that tells me is that they’ve been smart about making sure moves were accretive, while also managing the outstanding share count.

I’ll sometimes see these big deals from companies end up making them really bloated with way too many outstanding shares.

Meanwhile, Walgreens Boots Alliance has approximately the same number of outstanding shares today that they did a decade ago.

I’d certainly rather see the number reduced, but you have a lot more revenue and net income being dispersed across the same number of shares. That’s good news.

On the other hand, the law of large numbers tells us that it’ll naturally be a bit more difficult for Walgreens Boots Alliance to grow at the same rate as they once did.

I mean, the company is taking in more than $130 billion in revenue. That’s a sizable sales base from which to grow from.

Looking forward, CFRA is predicting that Walgreens Boots Alliance will compound its EPS at an annual rate of 6% over the next three years.

That’s a fairly significant drop from what’s transpired over the last decade. But I think it’s reasonable when looking at more recent EPS growth.

Indeed, the company’s most recent guidance is calling for 0% constant currency EPS growth for FY 2019.

CFRA believes modest increases in sales, aggressive share buybacks, and cost structure improvements will be somewhat offset by margin pressure (from reimbursement pressures) and secular headwinds in the industry.

There’s also a lot of uncertainty regarding drug pricing and healthcare reform.

If Walgreens Boots Alliance can compound its EPS at an annual rate of 6% over the next three years, that would allow the company to grow its dividend in a similar range and keep that extremely low payout ratio.

The big question is whether or not that 6% EPS growth will materialize.

The long-term track record regarding EPS and dividend growth is obviously great. I’m willing to give them the benefit of the doubt.

But there’s admittedly a lot of apprehension about the state of pharmacies.

Moving over to the balance sheet, the company maintains a rock-solid balance sheet.

Now, it’s not as great as it once was. This company used to have a fortress balance sheet.

There’s been some deterioration, but it’s all relative. The balance sheet is still in great condition.

The long-term debt/equity ratio is 0.48, while the interest coverage ratio is approximately 12.

I have no concerns whatsoever about these numbers as they sit.

However, I think it’s worth keeping in mind that the company is not as flexible as they once were.

This is another question mark in an era in which the state of the industry is in major flux. Walgreens Boots Alliance can not as easily use their balance sheet to adapt to changes.

They’ve fired a few bullets from that “balance sheet gun” already, so this gives them less options moving forward.

Therefore, anyone investing in this business must believe that the moves management has made are worth the balance sheet deterioration, setting the company up well to compete and prosper for years to come.

Profitability is particularly robust.

I say that because the company is heavily exposed to low-margin retail and low-margin wholesale.

Over the last five years, the firm has averaged annual net margin of 3.49% and annual return on equity of 14.58%.

These numbers are right in line with their largest competitor, CVS Health Corp. (CVS).

All in all, I think Walgreens Boots Alliance has the track record and fundamentals that indicate a high-quality business.

But there are risks to consider.

Regulation, litigation, and competition are omnipresent risks in every industry.

Industry dynamics are quickly changing. I noted the possible headwinds from the rise of e-commerce and what could eventually be widespread shipment of pharmaceuticals.

And if a nationalization of US healthcare were to materialize, there would be significant ramifications to companies that are part of the US healthcare value chain.

The company’s large size is also something to be mindful of. The larger the numbers get, the harder it becomes to grow at a constant rate.

In addition, there’s currently backlash building up against drug pricing. This is something the company will have to manage.

Whereas the major competitor CVS Health has decided to become vertically integrated from PBM to pharmacy to health insurance provider, Walgreens Boots Alliance has basically doubled down on its core pharmacy business.

I see advantages and disadvantages to both approaches, but investors can see clear differences between these two major players.

There has been deterioration in the fundamentals.

And there’s arguably more uncertainty than ever before.

But with the stock down more than 35% from its 52-week high reached in the fall of 2018, it arguably looks more appealing on a valuation basis than ever before…

The stock is trading hands for a P/E ratio of 11.05.

That’s way off of the broader market’s much higher earnings multiple. It’s also less than half of the stock’s own five-year average P/E ratio of 22.9.

The sales multiple of 0.4 is also half that of the stock’s five-year average P/S ratio of 0.8.

And the yield, as noted earlier, is substantially higher than its own recent historical average.

So the stock does look cheap. But how cheap might it be? What would a reasonable estimate of intrinsic value look like? 

I valued shares using a dividend discount model analysis.

I factored in a 10% discount rate and a long-term dividend growth rate of 7%.

This DGR is less than half of what Walgreens Boots Alliance has done over the last decade in terms of dividend growth.

It’s also way off of the company’s long-term EPS growth rate.

Plus, the payout ratio is very low.

But I’m erring on the side of caution here.

The company has been struggling over the last year or so, the most recent dividend increase came in at about 4%, and the forecast for EPS growth over the next three years is just 6%.

I think this is a case where the future will not look like the past. But the company is positioned well to deliver mid-single-digit (or better) dividend growth for years to come.

The DDM analysis gives me a fair value of $65.27.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

I don’t believe I was being aggressive with my valuation, yet the stock still looks very cheap.

But we’ll now compare that valuation with where two professional stock analysis firms have come out at.

This adds balance, depth, and perspective to our conclusion.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.

1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates WBA as a 4-star stock, with a fair value estimate of $68.00.

CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.

They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

CFRA rates WBA as a 3-star “HOLD”, with a 12-month target price of $60.00.

I came out somewhere in the middle. Averaging out the three numbers gives us a final valuation of $64.42, which would indicate the stock is possibly 18% undervalued.

Bottom line: Walgreens Boots Alliance, Inc. (WBA) is a high-quality company that has shown an amazing ability to adapt to changing trends. There are some uncertainties in the industry right now. But with 44 consecutive years of dividend raises, a very low payout ratio, a market-beating yield, and the potential that shares are 18% undervalued, dividend growth investors would be wise to take a good look at this stock right now.

-Jason Fieber

Note from DTA: How safe is WBA’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 79. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, WBA’s dividend appears Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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