The “Dogs of the Dow” investing strategy is a very simple way for investors to achieve diversification and income in their portfolios while remaining in the sphere of more conservative blue chip stocks. It simply consists of investing in the 10 stocks in the Dow Jones Industrial Average (DJIA) – an index of 30 large cap (i.e., “blue chip”) U.S. stocks – with the highest dividend yields.
As a result, the Dogs of the Dow strategy produces above average income and concentrates on stocks that typically trade at lower valuations relative to the rest of the DJIA. Given that the DJIA represents some of the largest companies in the world, its “dogs” are typically companies with strong track records that have hit temporary problems. For value investors looking to purchase good businesses that are currently out of favor, this is a great and simple strategy.
One of the current “Dogs of the Dow” is Walgreens Boots Alliance (WBA).
Walgreens Boots Alliance is one of the largest retail pharmacy in both the United States and Europe. Through its flagship Walgreens business and other business ventures (including equity investments), Walgreens has a presence in more than 25 countries and employs more than 415,000 people. In its leading retail pharmacy business, Walgreens operates approximately 18,500 stores in 11 countries and also operates one of the largest global pharmaceutical wholesale and distribution networks, with more than 390 centers that deliver to upwards of 230,000 pharmacies, doctors, health centers and hospitals each year.
The company has been one of the most successful retail operators since its founding in 1901 and remains so today, given that the firm processes ~20% of total U.S. prescriptions each year. The acquisition of Europe-based Alliance Boots expands the growth runway and economies of scale by giving Walgreens a global reach.
However, Walgreens is undergoing challenges currently due to rising pricing power among large pharmacy benefit managers, lower generic deflation, and consumer market challenges. After reporting Q2 results, CEO Stefano Pessina stated that this was the most difficult quarter since the formation of Walgreens Boots Alliance. Adjusted operating income decreased by a whopping 10.4% and adjusted earnings per share declined by 5.4%, leading them to reduce their adjusted earnings per share 2019 guidance to flat year-over-year as opposed to growing by approximately 9.5% at the mid point of guidance after Q1.
The company is combating this challenge by diversifying product offerings outside of pharmaceuticals while also consolidating offerings in order to increase sales volumes. While this strategy will likely have its desired effect, it will also likely reduce profitability since Walgreens will be moving out of its area of competitive advantage and circle of competence and selling retail products that are typically much lower margin. The company also plans on accelerating the digitization of the company to tap into more online growth, invest in creating neighborhood health destinations as part of transforming and restructuring the company’s retail offering, and implementing a transformational company cost management program to help improve margins.
Walgreen’s cost management program involves implementing better spending visibility and benchmarking across the store fleet where management believes there are many areas of opportunity for cost cutting, improving policies and IT efficiencies, and increased automation across the company.
The company is also implementing a preferred pharmacy program in conjunction with its recent acquisition of half of Rite Aid’s stores as a way of leveraging its position as the largest pharmacy store chain in the country. This program will leverage its geographic networking and economies of scale advantages by enabling it to discount its generic drug inventory as a preferred pharmacy in PBM retail networks. This, in turn, should increase customer traffic and therefore increase sales of its other retail products.
In addition to this program, Walgreens is focused on boosting its pharmacy business volume through other partnerships, improving operational effectiveness through data analytics, focusing more on outcomes-based reimbursement, and ultimately delivering a more modernized pharmacy as a community health center concept. On the retail front, management is hoping that driving more foot traffic here through various promotions and products will helps its pharmacy in turn. As part of this, the company is investing in flagship brands with an increased focus on health and wellness (again, as part of its drive to turn pharmacies into community health centers) as well as implementing more information technology to enhance customers’ shopping experiences as well as driving brand and store loyalty.
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During the past decade shares of Walgreens have traded with an average price-to-earnings ratio of 16.2. However, this was during a time when the company’s growth rate was much more robust than it is at present. As a result, its price to earnings multiple should be lower today to better reflect a slower anticipated future growth rate. Despite the revised outlook, however, shares still appear to trade at a compelling valuation with the share price standing at a mere 8.8x expected 2019 earnings per share. Moreover, the 3.33% dividend yield ought to add meaningfully to returns in the years to come, especially when considering that Walgreens is a very reliable annual dividend grower. Given its low ~30% payout ratio, there is ample room for the dividend to continue to grow moving forward.
In addition to the competitive advantages stemming from its scale, network, and brand-name recognition, Walgreens has recession resiliency (earnings dipped just 6.9% in 2009) and solid balance sheet liquidity ($818 million in cash, $19.9 billion in current assets, and $6 billion in annual earnings against $25.3 billion in current liabilities). These qualities help insulate it against macroeconomic challenges, making its business-specific headwinds seem less of a risk to the long-term survivability of the business.
Walgreens Boots Alliance is a “Dog of the Dow” because of falling profitability due to increased competition and reduced pricing power. However, it has scale and network advantages that it is flexing to transition its business to overcome these challenges while also cutting costs to help shore up margins. Meanwhile, the pharmacy business has proven to be recession resistant and the company’s valuation, dividend yield, and balance sheet give it a wide margin of safety to overcome these challenges while still providing shareholders an attractive return at current prices.