Many investors fail to perform well over the long run.
They often buy high and sell low.
However, I follow a totally different motto.
It’s all about buying high-quality businesses and holding for the long term.
My motto is: buy cheap and keep.
This motto has helped me totally transform my financial position in life.
Indeed, I was able to go from below broke to financially independent in just six years.
I retired in my early 30s!
I lay out exactly how I went about doing that in my Early Retirement Blueprint.
Suffice to say, a large part of the Blueprint involves intelligently investing in great businesses for the long run.
Buy high-quality stocks at appealing valuations. Then just sit on your hands, collecting and reinvesting growing dividends along the way.
Look, I never made much money in my career. I had a very middle-class job working at a car dealership.
Yet I was able to build my FIRE Fund in a relatively short period of time because I was smart with the money I saved.
The Fund generates the five-figure and growing passive dividend income I need to cover my essential expenses.
It’s chock-full of high-quality dividend growth stocks, just like those you’ll find on the Dividend Champions, Contenders, and Challengers list.
I cheaply buy and keep high-quality dividend growth stocks for simple reasons.
That situation can lead to paying shareholders rising cash dividend payments.
Well, these payments can be used as a wellspring of passive and growing cash flow to fund your entire life.
Meanwhile, the underlying equity tends to increase in value over time because these companies are becoming more profitable and worth more.
This usually leads to higher stock prices over time.
Of course, buying cheap requires undervaluation.
An undervalued dividend growth stock should present a higher yield, greater long-term total return potential, and reduced risk.
This is relative to what the same stock might otherwise offer if it were fairly valued or overvalued.
Price and yield are inversely correlated. All else equal, a lower price results in a higher yield.
This in turn leads to greater long-term total return potential.
Total return is comprised of investment income and capital gain.
A higher yield, assuming no change to a dividend, means more investment income.
However, capital gain is also given a possible boost via the “upside” available between a lower price and higher intrinsic value.
If a stock is worth more than you paid, there’s a good chance the market will at some point realize this and reprice the stock more accurately.
This is on top of whatever capital gain is possible as a quality business naturally becomes worth more over time.
Moreover, these dynamics should reduce risk.
Paying a price well below intrinsic value builds in a margin of safety.
This protects an investor against a myriad of prospective issues that could pop up and reduce a company’s value.
Think malfeasance, new competition, additional regulation, etc.
Paying a price equal to, or higher than, fair value gives you no buffer.
Of course, intrinsic value is never known down to the penny.
It’s ultimately an estimate.
Fortunately, though, these estimates can be surprisingly reliable.
Fellow contributor Dave Van Knapp has even put together a fantastic template that helps investors estimate intrinsic value.
Part of an overarching series of articles designed to teach dividend growth investing from the ground up, Lesson 11: Valuation is a fantastic resource that can be referenced over and over again.
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)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 reported that Walgreens Boots Alliance is considering acquiring the rest of AmerisourceBergen.
As we can see, despite its global footprint, the company is largely tied to its US business – both through retail pharmacy and distribution.
This is both good and bad.
The US is one of the wealthiest and most profitable markets in the world. An older (and aging) population and an expensive healthcare system that requires the likes of PBMs and public pharmacies bodes well for the company.
On the other hand, any major changes to the US healthcare system – such as a national privatization of healthcare – could directly, and negatively, affect the business.
Another major challenge is perhaps just as existential in nature. This relates to the ongoing shift to e-commerce.
That shift could drastically alter the company’s fundamental nature in two ways.
First, the shipment of pharmaceuticals opens up new competition while simultaneously making the company’s brick-and-mortar buildings less advantageous.
Second, less traffic in stores means less retail sales. Pure retail sales made up approximately 1/4 of the company’s largest segment. Large and ongoing drops in ordinary retail sales would cause substantial harm to the company’s overall revenue and profit.
That said, Walgreens Boots Alliance has navigated numerous challenges and changes over the last century.
Dividend Growth, Growth Rate, Payout Ratio and Yield
And they’ve been paying a growing dividend for almost half a century.
The company has increased its dividend for 43 consecutive years, which is one of the most impressive track records in all of retail. It’s one of the more impressive track records in any industry.
The 10-year dividend growth rate stands at 15.0%, although there has been some marked deceleration in dividend growth in recent years.
The most recent dividend increase was still stout, though, at 10.0%.
With a payout ratio of 33.1%, there’s absolutely no evidence that Walgreens Boots Alliance will have any issue with paying and increasing its dividend for years to come.
Outside of a radical and sudden change in US healthcare, most of their challenges are more incremental in nature. And the dividend is currently one of the more well-covered payouts out there.
But it gets better.
The stock yields a mouth-watering 3.19% right now.
That yield is almost 130 basis points higher than its five-year average.
This is an eye-popping delta that can’t be ignored.
But if the company is truly in dire straits, this dividend won’t help much. A large drop in profit would cause the payout ratio to rise. And a true existential threat to the business would lead to a lot of question marks about the dividend.
Revenue and Earnings Growth
So let’s take a look at the company’s fundamentals and growth profile to see what’s going on here.
I’m going to first show you what they’ve done over the last decade in terms of top-line and bottom-line growth.
Then I’ll compare that to a near-term professional forecast for profit growth.
Combining the known past and estimated future in this manner should allow us to extrapolate out a growth trajectory and appraise their long-term earnings power.
This will help us value the business and its stock.
Walgreens Boots Alliance grew its revenue from $63.335 billion in FY 2009 to $131.537 billion in FY 2018. That’s a compound annual growth rate of 8.46%.
However, this was far from totally organic.
The company, in 2014, acquired the remaining 55% of Alliance Boots it didn’t own (they previously owned 45%). This was a tranformative deal worth more than $15 billion. It gave the 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.
We can see they’ve been quite busy.
Cutting through some of this noise a bit, let’s look at earnings per share growth.
This will drill down into exactly how much everything has affected profit on a per-share basis.
Earnings per share advanced from $2.02 to $5.05 over this period, which is a CAGR of 10.72%.
This is very solid growth. Even better than revenue growth. I don’t see why anyone would be disappointed with this.
But we invest in where a company is going, not where it’s been.
Looking out over the next three years, CFRA is predicting that Walgreens Boots Alliance will compound its EPS at an annual rate of 6%.
This would be quite the drop from what we see has transpired over the last decade.
But a drop in forward-looking expectations seems to be warranted.
The company released its Q2 FY 2019 earnings report on April 2 – and it was, to put it mildly, terrible.
Notably, Walgreens Boots Alliance updated its guidance to reflect an anticipated 0% constant currency EPS growth for FY 2019. That compares extremely unfavorably against prior guidance of 7-12% EPS growth for FY 2019.
Results across the board were downright horrible. Sizable decreases in YOY sales and EPS led the way.
Investors weren’t happy, sending the stock down more than 10% on the day.
And that’s what led me to putting this piece together today.
Remember what I mentioned at the outset?
Buy cheap and keep.
After that drop, even knowing what we now know, the stock is deep into value territory.
The stock is the cheapest it’s been in five years – a period which includes numerous large deals to improve and grow the business. To put this in perspective, the company’s net income is more than twice what it was in 2014, yet the stock is now priced significantly lower than it was at the end of FY 2014.
Investors get more revenue and profit for less money. It’s that simple.
Now, I would expect dividend growth to slow quite a bit moving forward. So it’s not quite an apples-to-apples comparison.
However, in exchange, investors are locking in a yield that is historically very high for this stock.
Even if near-term dividend growth is half of the 10-year mark, that’s still a good number with this yield.
Financial Position
Moving over to the balance sheet, it’s solid.
But it used to be a fortress. There’s been some deterioration here.
The company has been active in M&A in recent years, so this isn’t a surprise.
With a long-term debt/equity ratio of 0.48 and interest coverage ratio of approximately 12, there’s absolutely no reason to be concerned about the balance sheet.
But they are less flexible than they used to be. They’re less adaptable in the face of changing industry dynamics.
They’ve fired a few bullets from that “balance sheet gun” already, so this gives them less options moving forward. Anyone investing in this business should think that the moves they’ve made thus far are worth the deterioration, setting them up well to compete for years to come.
Profitability is quite robust when considering that a major part of the business is low-margin retail. And they’ve got material exposure to 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).
Overall, I see Walgreens Boots Alliance, Inc. as a high-quality company.
There’s nothing, fundamentally, that would indicate anything to the contrary. The numbers across the board range from solid to excellent.
It has one of the best long-term dividend track records around. This has long been a blue-chip holding for many investors. Being able to buy it at the cheapest it’s been in five years should be looked at as a unique opportunity.
Of course, there are risks.
Regulation, litigation, and competition are omnipresent risks to every company.
Industry dynamics are no doubt changing. I noted the possible headwinds from the rise of e-commerce and what could eventually be large-scale pharmaceutical shipment.
And if a nationalization of US healthcare were to come to be, the ramifications could be significant to companies with heavy exposure to the 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, which is something that this company will have to manage.
Whereas CVS Health Corp. has decided to become vertically integrated from PBM to pharmacy to health insurance provider, Walgreens Boots Alliance, Inc. has basically firmed up and doubled down on its core pharmacy business.
I see pros and cons to both approaches, but investors can see clear differences between these two major players.
Even with the risks in mind, though, the stock appears cheap after a ~35% drop from its recent December highs…
Stock Price Valuation
The P/E ratio is sitting at 10.38 right now, which is less than half the broader market.
It’s also less than half the stock’s own five-year average P/E ratio.
The current P/S ratio is also half its five-year average.
And the multiple on cash flow is about 25% lower than its three-year average.
Plus, the yield, as noted earlier, is substantially higher than its recent historical average.
The stock looks extremely cheap. But how undervalued might it be? What would a reasonable estimate of intrinsic value look like?
I factored in a 10% discount rate.
And I assumed a long-term dividend growth rate of 7%.
The long-term DGR I’ve modeled in is less than half of the stock’s demonstrated 10-year DGR.
However, I think this deceleration is warranted.
Management is guiding for very low expectations.
And there’s a lot of uncertainty in the industry.
I think it makes sense to err on the side of caution.
The DDM analysis gives me a fair value of $62.77.
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.
Even with what I feel is a pretty conservative valuation, the stock still looks like a bargain here. This shouldn’t be a surprise when looking at those basic valuation metrics outlined above.
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 $73.00.
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.
Averaging the three numbers out gives us a final valuation of $65.26, which would indicate the stock is potentially 18% undervalued right now.
Bottom line: Walgreens Boots Alliance, Inc. (WBA) is a high-quality company with excellent fundamentals across the board. Industry dynamics are undoubtedly changing, but this firm has weathered countless storms over the last 100+ years. More than 40 consecutive years of dividend increases, a 3%+ yield, double-digits long-term dividend growth, a low payout ratio, and the potential that shares are 18% undervalued are all great reasons why dividend growth investors should look at prescribing this stock for their portfolios.
-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 81. 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 very safe with an extremely unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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