The Long and Short

Is Walgreens dividend cut enough to hold ratings?

Meredith Contente | January 5, 2024

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Spreads on the debt of Walgreens Boots Alliance (WBA) widened significantly at the end of last year after Moody’s two-notch downgrade to ‘Ba2.’ The downgrade forced bonds out of the investment grade index despite S&P’s ‘BBB-‘ rating. S&P has a negative outlook on WBA based on the company’s higher leverage, with weak operating performance more than offsetting debt reduction. WBA has cut its dividend, but it might not be enough to hold its S&P rating.

With WBA’s new CEO and CFO, the market was looking for some guidance on ratings in the company’s fiscal first quarter 2024 earnings. While both the top and bottom lines beat expectations, there was no mention of a leverage target or a commitment to investment grade ratings. WBA did cut its dividend 48%, which will free up approximately $800 million of capital. However, management noted on the earnings call that it will be looking to invest the excess capital in growing the pharmacy and healthcare business, as well as debt reduction.

While the dividend cut should be viewed as a slight positive in helping to maintain its ‘BBB-‘ rating, it might not be enough to move the needle with respect to leverage. S&P is looking for leverage to move below 4.0x, relative to current leverage of 4.8x (including S&P adjustments). WBA would need to repay over $5 billion of debt in order to reach the S&P’s target. Unless WBA were to pursue asset sales, excess free cash flow is not enough to cover its debt reduction needs. With risk of a further downgrade by S&P, WBA spreads could see further pressure as they trade too tight relative to high yield retailers. Given that WBA derives the majority of its revenues and operating profit from the retail pharmacy business, WBA should be considered a retailer versus a healthcare company.

Exhibit 1. WBA curve relative to US retail BB curve

Source: Company Reports; Bloomberg TRACE; Santander US Capital Markets

Leverage increased in the quarter

WBA hardly discussed the balance sheet in the earnings call and made no mention of ratings or a leverage target. However, the company included a slide towards the end of its presentation regarding its non-GAAP financial lease-adjusted net debt ratio. WBA’s calculation does not account for its opioid liability nor the standard rating agency adjustments. That said, according to the company’s leverage calculation, net leverage increased a tick sequentially from fiscal year end 2023, to 3.5x. Factoring in the opioid liability, which S&P views as debt, as well as other S&P adjustments, leverage actually increased two ticks sequentially to 4.8x.

Dividend cut might not be enough

Management’s decision to cut the dividend was necessary to try and stave off a downgrade by S&P. While the agency is likely to view the cut as a positive, the continued pressure on operating profit and cash flow is keeping leverage high. Management noted that they are on pace to deliver $1.0 billion in cost savings in an effort to improve its cost structure and increase cash flow. Consensus estimates are calling for $2.4 billion of free cash flow in fiscal 2024. Given that the dividend is now only expected to consume $863 million and factoring in the company’s $360 million opioid payment in 2024, excess free cash flow will be roughly $1.2 billion. Assuming management is successful in reducing capex by roughly $500 million this year, that brings available proceeds for debt reduction up to $1.7 billion, roughly a third the amount needed to bring leverage closer to 4.0x.

Furthermore, management’s comments about debt reduction followed its priority for reinvesting in the pharmacy and healthcare businesses. Management noted that it will take a balanced approach to capital allocation priorities which includes both opportunistic investments to sustainably grow both the pharmacy and healthcare business and debt reduction. That said, its unlikely that all excess cash flow will be used for debt reduction.

Management would need to rely on the monetization of assets to come closer to the more than $5.0 billion of debt reduction needed. Management did highlight the financial flexibility their portfolio of assets presents and noted that their investments in Cencora and Brightspring as well as other minority interests will all be evaluated as the company looks to sharpen its strategic focus moving forward. WBA has been slowly monetizing its Cencora stake, with its current ownership stake at roughly 15%. This is down from approximately 27% in 2022.

Shrink remains a problem

Shrink continues to plague the retail industry and WBA noted that higher levels of shrink accounted for much of the gross margin contraction witnessed in the company’s fiscal first quarter of 2024. WBA’s fiscal first quarter gross margin contracted 110 bp from the year-ago period. Management highlighted that shrink will continue to negatively impact second quarter results. Its impact, in addition to retail trends, is anticipated to negatively impact fiscal second quarter EPS in the $0.17-$0.20 range. To quantify, that’s roughly 15%-17% of the $1.16 in EPS generated in fiscal second quarter of 2023.

Meredith Contente
meredith.contente@santander.us
1 (646) 776-7753

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