Income investors, beware.
Walgreens Boots Alliance (WBA -3.15%) did something last week it hasn’t done in quite a while: It made shareholders happy.
The big pharmacy retailer and wholesaler announced in its fiscal 2024 fourth-quarter update that it plans to close around 1,200 stores over the next three years. The news caused Walgreens’ shares to deliver the biggest gain so far in 2024.
Despite Walgreens’ recent bounce, the company still faces considerable uncertainty. Income investors especially have reason to hold off on any celebrations.
Reasons for concern about Walgreens’ dividend
Walgreens’ forward dividend yield currently stands at a lofty 9.27%. An ultra-high dividend yield doesn’t always indicate a dividend is in jeopardy. For example, real estate investment trusts (REITs) typically offer juicy yields because they’re required to return at least 90% of taxable income to shareholders as dividends.
But Walgreens isn’t a REIT; it’s a healthcare company. The healthcare sector has the fourth-lowest average dividend yield of the 11 sectors in the S&P 500. Walgreens’ stratospheric dividend yield should at minimum raise a yellow flag.
Some income investors might feel that Walgreens’ dividend should be safe because the company already slashed its dividend earlier this year. This move came after 47 consecutive years of dividend increases. Surely, Walgreens wouldn’t anger shareholders by cutting its dividend again, right? Don’t bet the farm on it.
UBS analyst Kevin Caliendo noted in Walgreens’ Q4 earnings call that he “didn’t necessarily hear full endorsement of the current dividend” in management’s comments. Caliendo asked Walgreens CEO Tim Wentworth about his thoughts on the dividend. Income investors would have loved to hear Wentworth affirm the company’s commitment to the current dividend payout. But he didn’t give them any reason for confidence.
Instead, Wentworth said, “[W]e will absolutely continue to monitor and make changes to our capital allocation, including better aligning our dividend with our long-term earnings power if we believe that’s the appropriate thing to do.” After mentioning Walgreens’ efforts to monetize some nonstrategic assets, Wentworth added, “But everything’s on the table.” This reply left the door wide open for further dividend cuts.
Worrisome numbers
Wentworth’s comments in the Q4 earnings call aren’t the biggest worry for income investors. Walgreens’ financial numbers provide a greater reason to be concerned about the reliability of its dividend.
The big pharmacy company’s dividend payout ratio is roughly 291%, according to Morningstar. This metric alone raises serious questions about the sustainability of Walgreens’ dividend. No company can pay out more in dividends than it generates in earnings indefinitely.
Granted, earnings can sometimes be misleading because of one-time charges and other accounting factors. That’s the case for Walgreens, which recorded $2.3 billion in non-cash charges in Q4 alone that weighed on its earnings. Free cash flow is more useful in evaluating the ability of a company to pay its dividend. Unfortunately, the picture doesn’t look much better using free cash flow.
In the 12 months ending Aug. 31, 2024, Walgreens paid $1.26 billion to fund its dividend. During that same period, it generated free cash flow of only $23 million.
Changes needed
Clearly, something must change for Walgreens to avoid another dividend cut. It’s encouraging that management is committed to making changes.
The company’s recent announcement of store closures should help. Wentworth said in the Q4 call that around 6,000 of Walgreens’ over 8,000 stores are profitable. Closing 1,200 unprofitable stores will no doubt improve its bottom line and boost free cash flow. So could any potential sales of non-core businesses.
However, I doubt these moves will deliver benefits quickly enough to prop up the dividend. Walgreens’ fiscal 2025 guidance projects a worsening bottom line with adjusted earnings per share (EPS) between $1.40 and $1.80 compared to adjusted EPS of $2.88 in fiscal 2024.
In Walgreens’ annual 10-K regulatory filing last week, the company mentioned several strategic initiatives intended to improve its operations and cash flow. The store closures featured prominently in this discussion. But if you read all of the commentary, you’ll notice another potential change the company is considering: “re-evaluating capital allocation priorities, including an assessment of our dividend policy.”
Is Walgreens’ ultra-high-yield dividend in jeopardy again? All signs point to yes. Income investors, beware.
Keith Speights has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.