Drugstores are not the investment darlings they used to be.

They’ve been struggling for years – more than a decade, actually – and those struggles are now front and center. According to a newly published report from Health Affairs (Vol. 43, No. 12), “More U.S. pharmacies closed than opened in 2018-21.”

In fact, “of the 88,930 retail pharmacies operating during 2010-20, 29.4% had closed by 2021.” And there have been plenty more closures since.

That’s quite the contrast to my commercial real estate development heyday, to say the least. You might be sick of me saying stuff like this, but I used to build for drugstores.

That is to say, I built for one of them: Eckerd. And wow, it was a great company to work with.

Based in Florida, it actually dates all the way back to 1898. And there’s a reason why it lasted the next 99 years despite growing competition from fellow chains like Walgreens Boots Alliance (WBA) and CVS (CVS).

Management knew what it was doing. The company was extremely interested in expansion, but it did so intelligently. Eckerd did its research, understood its books, and respected its consumer base.

Really, I think its biggest mistake was to sell its entire operation over to Rite Aid in 2007. That company might have been larger, but not nearly as intelligent.

Rite Aid went right to work rebranding all of Eckerd’s 2,900 locations. But that was about all it did to make the deal work out in its favor.

It took on a lot of debt from the acquisition, and it suffered the consequences from that point onward. The situation got so bad that it had to declare Chapter 11 bankruptcy earlier this year before converting into a privately held company.

Moreover, it could get worse from here. I’m not betting on Rite Aid surviving as-is one way or the other.

But Walgreens and CVS do deserve closer looks – even if one outclasses the other by far.

Walgreens Is Still the One to Beat in Size, but It’s Struggling

Let’s start with the once mighty Walgreens, which you probably know is facing challenges.

In fiscal year 2024, the drugstore chain reported a net loss of $8.6 billion. And as part of its strategy to return to profitability, it plans to close 1,200 of its 12,500 stores over the next three years.

This should help improve core profitability while also providing immediate help from a cash flow perspective.

The larger industry has faced significant competition over the last two decades from online resources to grocery stores opening up their own pharmacies. But Walgreens’ high cost of capital has been its biggest issue.

In fact, it’s been spending so much that it had to cut its dividend by 48% in January – after raising it for 47 years in a row. Which just goes to show you that the past is not a completely accurate prediction of the future.

In 2021, Walgreen’s free cash flow was $4.1 billion with about $1.6 billion in dividends being paid. That translates to a healthy payout ratio of only 38.72%. Yet the very next year, free cash flow dropped to $2.1 billion and then again to $141 million in 2023.

Even today, with its slashed dividend, the drugstore is in trouble with:

• Negative $363 million in free cash flow,

• $33 billion in total debt, and

• Just $18.3 billion in assets.

So it should be no surprise that its earnings per share are on the decline. Or that it’s expected to continue falling from here.

I expect Walgreens to have to cut its dividend again before long.

Believe it or not, though, I don’t see it going the way of Rite Aid. Chances are high that this massive drugstore chain will survive. Maybe it will even go on to excel again.

It’s just going to take a lot of work to get there. And I’m not willing to fund it on that journey.

CVS Has a Much Better Financial Position

CVS is the “little brother” of the two remaining drugstore powerhouses with only 9,000 stores. Yet it’s in a better place by far.

CVS has successfully integrated its business model using its retail network to provide a broader range of services alongside its Aetna health insurance platform, which boasts 27 million members. And that’s a good thing.

What isn’t so great is how a surge in Medicare Advantage enrollment has put pressure on CVS. Enough so to impact its profitability.

As CFO Thomas Cowhey pointed out on the third-quarter 2024 earnings call last month:

This increase was primarily driven by higher utilization, higher acuity in Medicaid, the premium impact of lower stars ratings for payment year 2024, and an update to our 2024 individual exchange risk adjustment accruals.

It seems that Medicare Advantage members have been the least profitable segment for CVS’ insurance unit because of poor negotiations of benefit terms, as well as the rapid rise in members.

Now quarterly sales were $95.4 billion, up 6.3% year-over-year. But adjusted operating income was down 43% to $2 billion. And adjusted earnings per share fell from $2.21 to $1.09.

So the company clearly has its own issues to work through – even if they’re nowhere as weighty as Walgreens’.

Still, CVS has an investment-grade rating of BBB. And analysts are forecasting 19% growth in 2025 with 14% growth in 2026.

Free cash flow next year should be $6.61 per share, which translates into a 43% payout ratio. In which case, the dividend appears sustainable despite its current 6% yield.

Regards,

Brad Thomas
Editor, Wide Moat Daily