It's been a difficult year for Walgreens Boots Alliance (WBA -0.86%), with the stock down about 60% during the past 12 months. The question for investors is whether this is a great buying opportunity or if there is more downside ahead.
Let's take a closer look at why Walgreens stock has struggled and what the company can do to turn itself around.
Reimbursem*nt pressures and a poor acquisition
The single biggest issue facing Walgreens is drug reimbursem*nt prices that the company receives from pharmacy benefit managers (PBMs), which are organizations hired to keep healthcare costs down. PBMs act as middlemen between drug companies, health insurers, and pharmacies to help get discounted pricing and rebates for drug companies and set the prices insurance companies pay to pharmacies.
PBMs, meanwhile, get paid via an administrative fee as well as through capturing some of the price rebate from pharmaceutical companies and the spread between the price an insurer pays and the pharmacy pays. Notably, though, the three largest PBMs are now all owned by insurance companies.
During the past decade, PBMs have put considerable pricing pressure on pharmacies, including Walgreens. This has led to a lot of margin narrowing over the years. For example, Walgreens saw its gross margin go from 28.2% in its fiscal year 2014 to 19.5% last fiscal year, which ended in August 2023. This means for every sale it makes, it is making less profit, in this case almost nine percentage points less.
In addition to reimbursem*nt pressure, Walgreens also made a poor acquisition when it acquired a majority stake in VillageMD and then helped the company expand through its purchase of Summit Medical. The owner of primary care medical clinics was unable to successfully expand beyond its core geographical footprint and has been a drag on Walgreens' operationing results. Walgreens also recently revealed that VillageMD was in default of a $2.25 billion secured loan it had provided to the company.
Image source: Getty Images.
How to fix the company
In a regulatory filing, Walgreens noted that it was evaluating its options with regard to VillageMD, including a potential sale of the entire business. This would be the best option in my view. While Walgreens would undoubtedly lose money on any sale, it would be addition by subtraction getting rid of its majority stake in this money-losing investment.
As for its core pharmacy business, the company has started to shut down unprofitable stores across the country. This is a good move for several reasons. First, it will reduce costs by having fewer stores and less overhead. Second, while it will lose some revenue, it will also likely retain a lot of sales as customers move their business to other nearby locations. This should help boost same-store sales and margins, as it handles more traffic volume under a smaller cost structure.
Over the long term, the company still needs to try to alleviate the constant reimbursem*nt squeeze. On that front, Walgreens has been in talks with PMBs and payers to implement a cost-plus drug pricing model where it gets paid based on the amount of service it provides. Eventually the reimbursem*nt pressure will need to be alleviated and new models considered because forcing pharmacies out of business isn't going to be good for anyone over the long run.
Is it time to buy the dip?
From a valuation perspective, Walgreens is clearly on the clearance rack. It trades at a paltry 5 times earnings based on next year's analyst estimates. Meanwhile, using an enterprise value-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) multiple to take into consideration its debt, the stock trades at just over 4 times.
WBA PE Ratio (Forward 1y) data by YCharts
That's cheap any way you look at it. That said, a turnaround is going to take some time. The company needs to dump VillageMD, which, if it can find a buyer, will help reduce some of its debt load. Then it needs to optimize its store footprint and convince PBMs to implement a more favorable model than the one currently being used.
If it can do these things, the stock could have a lot of potential upside. If it cannot complete these actions, then the stock could turn out to be a value trap.
With that in mind, I would take a position in Walgreens because I think eventually the company should be able to see better days ahead. However, I would keep the position small given the potential risks.
Geoffrey Seiler has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
