Published on January 22nd, 2017 by David Kim
David Kim is a writer on Seeking Alpha, where he enjoys sharing his financial insights in layman’s terms. David has a background in commercial banking and financial accounting.
Walgreens Boots Alliance, Inc. (WBA) is a storied retailer that has grown dividends for 42 years. Bob Ciura recently highlighted Walgreens in the Dividend Aristocrats in Focus series. And in 2016, our own Ben Reynolds wrote about Walgreens on gurufocus.
But, 2017 was tough year for Walgreens. It was tough, because of strategic uncertainties including questions over Rite Aid acquisition and speculations around whether Amazon would enter the pharmacy business. This all took place during a year when there was a general malaise in the retail sector in general; Amazon and e-Commerce were taking over the world.
So, I thought it would be timely to dig into the company’s recent financial performance to analyze how safe the company’s dividends might be. Will Walgreens keep growing its dividends and be crowned a Dividend King in a few years’ time?
Past Performance Is…
Here’s a pop quiz for you. Is the below quote from the 2017 or the 2016 annual report?
“Walgreens, the nation’s largest drugstore chain, recorded its 28th year of consecutive sales and earnings growth. During the year, the company opened 471 stores while 108 were closed.”
The answer: neither!
That quote comes from Walgreens’ 2002 Form 10-K. In that same report, the management also shared that the company operated 3,880 locations in 43 states plus Puerto Rico. And “the company plans to operate more than 7,000 stores by 2010.”
By August 31, 2009, the Company disclosed that it “operated 7,496 locations in 50 states, the District of Columbia, Puerto Rico and Guam.” That detail comes out of the 2009 Form 10-K.
I don’t know if you have any experience in forecasting for a Fortune company. But, that level of planning and execution is astounding. In that brief look-back, we see a company that set a concrete plan, then executed on that plan on time (in fact, ahead of time). Those dividends don’t grow themselves through magic. Growth happens through value-adding effort of all the people who run the company for the shareholders, from the people defining the highest level of strategy to the people fulfilling orders at the distribution centers.
In my opinion, history is a very important indicator of dividend safety. When it comes to dividend aristocracy, it seems, past performance is an indicator of future success!
One other historical tidbit I found interesting. Back in 2002, Walgreens generated 17% of its sales from Florida stores. In fact, the following table summarized Walgreens sales distribution:
Source: Walgreens 2002 10-K.
Imagine, nearly half the revenues came from the top four states. Back in 2002, there was just one reportable segment. No international operations. Walgreens was an American “retail drugstore business.” Since 2002, Walgreens has gone onto steadily grow organically and through acquisition, all the while focusing and expanding its business platform.
Walgreens opened its 5,000th store in Richmond, VA in October of 2005 (company history). In 2006, the company acquired Happy Harry’s drugstore chain. In 2007, it acquired Care Health Systems. Of course, a big expansion came in 2012 with the Alliance Boots merger announcement. But, that didn’t stop Walgreens from gobbling up other regional drugstores, like the 2013 acquisition of the North Carolina-based Kerr Drug stores.
Source: Author’s table, compiled from 10-K’s.
Sales grew in tandem with geographic footprint, from $32.5 billion in 2003 to $118.2 billion in sales for the fiscal year ended August 31, 2017. And the scope of the business has grown. Today, Walgreens Boots Alliance describes itself as the “first global, pharmacy-led health and wellbeing enterprise with … [the mission] … to help people across the world lead healthier and happier lives (2017 10-K).”
How Safe Is Walgreens’ Dividend?
The Company’s history is reassuring and it is a reflection of the “Quality Rule” in Sure Dividend’s the 8 Rules of Dividend Investing. But, how safe is the dividend? In other words, let’s dig into rule #3 of the 8 Rules of Dividend Investing. The Company’s dividend history chart below emphasizes the history of growth. The Company’s 2017 dividend per share has grown tenfold (10x) from the 2002 level!
Source: Company website.
Still, what we want to know in exploring the “Safety Rule” is that the Company is not paying out all of its income as dividends. A Company should be able to fund the dividends and maintain a level of operating capital cushion.
It’s worth pausing to think about this common sense rule. In your household, you might be able to spend more than you earn through borrowing. But, if you keep that practice up, then you run into trouble. Similarly, a company can pay out more cash dividend than its free cash flows allows in any given year (or two). However, in the long-run, the money out has to correspond to money in. A prolonged excessive payout might indicate structural problems in the business. Such problems could be declining sales, low gross margins, high operating expenses, or other financial red flags.
More on The Payout Ratio …
So, how do you measure the dividend payout ratio? For some, this might be a hot button topic. You’ll forgive me if I simplify the computation details to illustrate a point. We focus on getting the big picture right.
First, I looked at gurufocus, and noticed that Walgreens’s current payout ratio is 40%. But, how is it computed? Looking at the gurufocus calculation, I see that the ratio is dividends per share divided by EPS without non-recurring items (“EPS without NRI”).
Source: gurufocus WBA payout.
My methodology will be different and I’ll briefly explain.
A Company like Walgreens report its financial results based on SEC (or international) accounting rules, like GAAP or IFRS. At its most basic, that means publicly traded companies report their earnings using accrual-basis accounting.
Let’s say you own a business making custom wooden tables. You completed an order to a customer in December, and shipped the table off. The customer has received the $10,000 table before December 31. You didn’t require the payment to be made until January 31 of the following year. So, you have accrued earnings of $10,000 from that sale, but you have $0 cash in your pockets from that sale. Ideally, you should pay out dividends from the cash you have.
In general, I believe that using the cash flows as a basis for dividends paid is more appropriate. But, the cash flow should be appropriately adjusted. The basic idea is to take cash flows from operations (CFO), then take out depreciation & amortization and stock compensation expenses. That becomes an “adjusted cash flows from operations (or Adj. CFO).” From there, I reduce that Adj. CFO by capital expenditure on PP&E as well as non-strategic business and intangible acquisitions.
Let’s pause. Some of you might wonder why we are reducing CFO by depreciation & amortization expense. Isn’t that typically an item added back to net income to get to CFO? Yes. For a company like Walgreens with a physical store footprint, it is absolutely necessary to maintain an inviting retail space in order to remain competitive. Compare a brightly lit Walgreens store to a run-down Rite Aid store in your town. And you begin to see why it is necessary to leave that “non-cash” expense out of the adjusted free cash flows meaningful to our discussion.
However, we also reduce the adjusted operating cash flows by PP&E capital expenditure. So, aren’t we double counting a little? That’s possible. But, I believe the PP&E spending largely reflects new stores or improvements to existing stores necessary to compete. Consider the money that Walgreens spent in 2012 to upgrade the stores to LED lighting. That’s different from just keeping the wall paint and floor tiles fresh. Make all of these adjustments, and you get adjusted free cash flows (Adj. FCF).
[An aside: Oftentimes, technical computation of free cash flows involves computing net operating profit after tax (NOPAT). But, among other challenges, it’s really hard to make the right adjustments for a business like Walgreens; such adjustments will include computing proper corporate tax rates and implied interest expense of lease payments.]
With that explanation, I present the adjusted free cash flows as follows. Further, I show stock purchases and cash dividends paid by the company against those adjusted free cash flows.
Source: Author’s table compiled from 10-K’s.
For most of the years since 2009, the overall variance is negative. But, the table above does not show the net impact of long-term debt issuance, which makes up for the difference over time. In general, the Adj. FCF sufficiently covers cash dividends in most years (note the exceptions in 2011 and 2014). Let’s see this graphically.
As we said above, Adj. FCF is sufficient to cover cash dividends in most years. In fact, since 2014, the payout ratio has come down significantly. In 2017, using my computation, the dividend payout ratio was 42%. (Incidentally, that figure is not far from the gurufocus calculation of 40%.) The following illustrates the trend in percent figures.
If we include stock repurchases, then the net variance appears larger in most years, and particularly noticeable in years 2010-2011. We see this graphically below.
What happened in 2010-2011? In 2011, Walgreens announced it would divest Express Scripts, the pharmacy benefits manager. By 2012 the management would announce the merger with Alliance Boots. After 2012, the common stock of WBA would shoot for the skies before retreating during 2017.
Could it be that management was lining up the appropriate capital structure for the new strategy then in discussion inside of the board room, to focus the business around pharmacy-lead well being and to expand internationally? In other words, timing might have been ripe for reducing the shares outstanding as earnings were about to get a big boost.
In 2017 and beyond, the story may be different. It is true that stock repurchases would have less impact than before under declining effective corporate tax rates (queue Trump tax cuts). But, payout ratio is historically low, long-term debt level is manageable (currently below 20% of market cap), and Walgreens has built a large global pharmacy platform it can leverage. Certainly, the relatively large 2017 share buybacks should boost per share earnings in 2018 and beyond.
Walgreens has a proven history of sales growth and operational excellence. Simply put, the Company is reliable and has grown to be one of the strongest players in the pharmacy-lead health market. The cash dividend has steadily grown for decades, and the payout ratio remains low. In fact, the cash dividend payout ratio in 2016 – 2017 was lower than it was in 2009 – 2015 time period. The 2017 dividend payout ratio stood at ~40% of adjusted free cash flows.
Moreover, the sizeable share repurchases in the recent years, particularly in 2017, should help increase the per share earnings going forward. All the while, the company’s long-term debt to equity ratio is less than 20% and its geographic footprint bigger than ever.
There is no sure thing in business. Still, given these trends I expect that Walgreens’ dividend growth will be safe and secure for many more years to come. The company’s dividend is currently secure as it is well covered by adjusted free cash flow.