While I wouldn’t go quite so far, if Walgreens reports a dud on July 9, the odds of its stock climbing out of its hole — WBA has a year-to-date total return of -25% through July 6 — are slim to none.
On the other hand, unless the third quarter is a complete disaster — Rite Aid’s (NYSE:RAD) same-store sales grew 6.6% in the first quarter — Walgreens’ will continue to provide investors with a compelling value proposition.
So, the question is whether or not it needs a positive earnings surprise when it reports its Q3 2020 results, to keep its stock moving higher.
I would argue that the downside risk of owning Walgreens stock is already baked into its price. Except for some piece of negative news out of left field, I don’t see its share price being affected very much.
However, a positive surprise could do wonders for its share price. Here’s why.
Walgreens Stock Has Serious Free Cash Flow Yield
On May 11, InvestorPlace contributor Mark Hake discussed Walgreens’ excellent second-quarter results. He was mainly focused on its free cash flow generation.
“[F]ree cash flow grew more than 400% to $1.8 billion as a result of its restructuring efforts. This means that the company has a very good FCF yield. FCF will be more than $5.2 billion this year, the same as last year. This gives the stock an FCF yield of over 14.5%,” Hake wrote in May.
Whenever I mention FCF yield, I like to point out that value stocks are generally considered such when they yield, on a free cash flow basis, more than 8%. WBA is well over that bugaboo.
One thing to keep in mind: I like to use enterprise value in my FCF yield because it takes into consideration debt. My colleague was using the more traditional definition, which uses market capitalization as the denominator in the equation. On that basis, it currently has an FCF yield of 13.8%, down slightly from May due to a small amount of capital appreciation.
Critical Test for WBA
All three of America’s leading drug-store operators are valued by investors at approximately the same free cash flow multiple. This is why Vince Martin believes Walgreens has to deliver a same-store-sales growth story on July 9 that’s equal to or higher than Rite Aid’s. If it delivers 3% same-store sales growth, for example, investors will rotate away from WBA stock toward RAD stock.
It’s that simple.
Barron’s recently published a piece suggesting investors shouldn’t get too excited about Walgreens’ earnings report.
“Analyst Ricky Goldwasser reiterated an Equal Weight rating on the shares, while shaving $4 off her price target, to $45,” Barron’s reported on July 2. “With Walgreens down 29% year to date, she notes that investors are understandably asking whether or not the risks the company faces are already priced into the shares.”
The analyst estimates that Walgreens will earn $5.48 a share in fiscal 2020, 4 cents higher than the analysts’ mean estimate of $5.44, and 55 cents lower than its 2019 earnings per share. Of the 22 analysts covering WBA, the average target price is $46.33, providing a current upside of 6.5%.
Goldwasser also pointed out that CVS’ front-of-the-store same-store sales were down in the latest quarter while Rite Aid’s were up, suggesting that Walgreens’ could be somewhere in between.
The Bottom Line
If you’re thinking of buying Walgreens stock ahead of earnings, betting that the stock will rise on better-than-expected results, I wouldn’t count on it.
The three drug store chains’ stocks are cheap for a reason. Investors expect sales will continue to be sluggish for the remainder of 2020. All the cost reductions in the world won’t help increase sales growth.
Until the novel coronavirus is a thing of the past, Walgreens ought to continue to face significant headwinds.
As Barron’s headline said, I wouldn’t expect too much from Walgreens’ upcoming earnings.
Will Ashworth has written about investments full-time since 2008. Publications where he’s appeared include InvestorPlace, The Motley Fool Canada, Investopedia, Kiplinger, and several others in both the U.S. and Canada. He particularly enjoys creating model portfolios that stand the test of time. He lives in Halifax, Nova Scotia. At the time of this writing Will Ashworth did not hold a position in any of the aforementioned securities.