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The New Cigarette Policy Shows Why Walgreens Stock Is Broken

Vince Martin

Walgreens Boots Alliance (NASDAQ:WBA) is having a rough go of it lately. Walgreens stock trades at its lowest levels in almost six years. Sales are declining, so are earnings.

walgreens stock wba stock

Source: Mike Mozart via Flickr

The company’s decision this week to raise the buying age for tobacco to 21 in its stores doesn’t really change the case for Walgreens stock. Walgreens may be giving up some sales, but it’s likely a small amount of total revenue. Cigarette sales likely aren’t high-margin, either, meaning the impact on profits likely will be even smaller.

But that doesn’t mean the decision is immaterial to WBA stock. The problem for Walgreens, and one key reason why WBA shares have struggled so much of late, is that the company simply isn’t executing well. The change in tobacco policy is just one symptom of that ongoing problem. As cheap as Walgreens stock looks, that execution needs to improve before investors look to buy the dip here.

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Walgreens Moves the Cigarette Age to 21

Walgreens’ move to raise the buying age for tobacco to 21 didn’t come out of the blue. Rather, it came because the Food & Drug Administration (FDA) was breathing down the company’s neck. The agency announced in February that Walgreens was the top violator among pharmacies that sell tobacco products, with 22% of locations making illegal sales.

To be fair, Walgreens is the largest pharmacy seller of tobacco products by far. Rival CVS Health (NYSE:CVS) stopped selling tobacco back in 2014, and smaller Rite Aid (NYSE:RAD) now is following Walgreens’ lead. At the same time, however, this is an ongoing problem for Walgreens which dates back nearly a decade and includes some 240 penalties incurred just since 2010.

The inability to control tobacco sales on its own might not seem like a big problem. But in conjunction with disappointing results of late, it certainly seems like something is not working at the store level for Walgreens. Instead of simply fixing the tobacco problem and avoiding fines, Walgreens is making a blanket policy change.

Again, the issue isn’t necessarily financial. When CVS ended tobacco sales, on conference calls at the time it cited a 5-8 point hit to sales growth. But it also highlighted better margins: cigarette sales simply aren’t that profitable.

But Walgreens’ current struggles mean the company needs all the help it can get. More broadly, even with WBA stock at a multi-year low, Walgreens needs a turnaround at the store level. The decision to raise the buying age isn’t comforting on that front.

Why WBA Stock Is Id Scraping Lows

Tobacco aside, Walgreens sales simply are headed in the wrong direction particularly outside of pharmacy. According to SEC filings, comparable retail sales dropped 1.0% in fiscal 2017 and 2.4% the following year. Performance has been even worse in the first two quarters of this fiscal year: a 3.5% drop including a 3.8% decline in the disappointing Q2.

Admittedly, there are some industry-wide factors at play. CVS and Rite Aid are seeing similar struggles in terms of retail sales and their stock prices. CVS stock is near a six-year low, though its acquisition of Aetna hasn’t helped. Rite Aid just executed a reverse stock split and trades near a ten-year low.

All three chains are struggling with retail sales. Pressures from generic drug pricing are hitting pharmacy revenue but the companies aren’t getting the corresponding savings on the cost side. Amazon.com (NASDAQ:AMZN) looms after its acquisition of PillPack. And grocers like Kroger (NYSE:KR) are looking to pharmacy and convenience sales to boost their own weakening growth profiles.

But industry headwinds alone aren’t enough of an excuse for Walgreens. Execution clearly isn’t good, given declining sales. The company radically overhauled its Balance Rewards program last year. The Rite Aid acquisition hardly looks smart, given a non-zero chance Walgreens could have picked up stores out of bankruptcy. (And bear in mind that it was the FTC that kept Walgreens from acquiring the entire chain).

Simply put, Walgreens needs to do better at the store level.

But Walgreens Stock Is Cheap…

Even with those concerns, however, Walgreens stock is tempting. WBA trades at less than 9x FY19 EPS estimates. The balance sheet is much cleaner than that of CVS post-Aetna or Rite Aid. Amazon might be a threat at some point, but so far all has been quiet on that front.

Drug pricing pressures may ease at some point. It remains to be seen how PBMs (pharmacy benefit managers) will be treated, and how those changes will echo down to the retail level.

The story here isn’t over. All hope isn’t lost, and there’s an intriguing case to buy the dip here. But for WBA stock to rally, store-level performance needs to improve. And investors might want to see some evidence of that improvement before jumping in with both feet.

As of this writing, Vince Martin has no positions in any securities mentioned.

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