October 13, 2023

This week’s note includes our comments on earnings from Walgreens Boots Alliance (WBA) and Wells Fargo & Co (WFC). Next Thursday, we get earnings from Nokia (NOK). The deluge starts the following week with eight companies scheduled to report.

Comments on Earnings

Walgreens Boots Alliance (WBA) – Once a retail pharmacy powerhouse, Walgreens faces secular challenges from an overbuilt, mature and poorly-run store base facing plenty of competition along with enduring pricing pressure in its pharmacy operations. The company’s initial foray into healthcare services has hit a wall. The initial turnaround CEO left in September 2023. We await the arrival of a new leader who could restore confidence in the company’s outlook.

Walgreens reported an incrementally encouraging fiscal fourth quarter in that the near-term fundamentals appear to have mostly bottomed out and the arrival of a new CEO later in October provided some hope that the business will be turned around. The company has immense challenges ahead, including fixing its U.S. retail business, proving that the Healthcare segment can produce worthwhile profits and convincing investors that Walgreens has an overall prosperous future. None of these are assured, but the fourth-quarter results and conference call forestalled what has been in effect a shareholder rebellion.

All-in, we are retaining our Buy rating on Walgreens shares.

The company missed its revenue and profit guidance by small amounts, but the results were close enough to assuage investors for now. Guidance for FY2024 was for modest sales growth and 9-12% growth in underlying adjusted net income per share. Excluding the “underlying” part which factors in a sale/leaseback deal and fall-off in Covid vaccines, adjusted net income per share was guided to a 12-20% decline.

In the quarter, revenues rose 9% (+8% ex-currency) while adjusted operating profits ex-currency fell 10%. Walgreens included immense adjustments of $1.1 billion, including everything from “Transformational Cost Management” to acquisition-related amortization to legal settlements and a LIFO provision. The adjustments converted a GAAP operating loss of $(450) million into an adjusted operating profit of $683 million. While many of these adjustments are acceptable, Walgreens won’t get full/much credit for improvements until it reports cleaner numbers.

The U.S. Retail Pharmacy segment revenues rose 4%, due entirely to higher pharmacy prices as non-pharmacy sales fell 3%. Adjusted operating profits fell 30% (down $232 million) but the noise from one-offs was large, and the adjusted gross margin continued to shrink. Overall, this segment needs help with its basic operating model.

International operations were strong. Sales rose 7% ex-currency and adjusted operating profits increased 52% to $259 million. The $96 million increase in adjusted operating profits offset close to half the decline in the U.S. Retail Pharmacy profits. The International gross margin of 4.5% was sharply higher than the 3.2% margin a year ago, suggesting the recovery in sales is converting to a recovery in profits. Overall, this segment seems to need only minimal help.

Our view is that both International businesses (Boots U.K. and German wholesale) should be sold while performance is strong and capital markets seem more receptive than a year ago. A full exit would bring in valuable cash, clarify/focus Walgreens as a U.S.-only business and ideally push the empire-building chairman (Stefano Pessina who is a 17% shareholder) and spouse/International Chief Operating Officer Ornella Barra out of the company entirely.

U.S. Healthcare segment revenues tripled but most of this was due to acquisitions. Adjusted for acquisitions, the pro forma sales growth was 19%, a deceleration from the 22% pace in the third quarter. Adjusted EBITDA improved to a $(30) million loss from a $(133) million loss a year ago. The company’s strategy for this segment will be familiar to tech investors: keep sales growing at a healthy pace but rationalize the unwieldy cost structure to convert losses into profits.

Wells Fargo & Co. (WFC) – Wells Fargo is one of the nation’s largest banks. Under its previously weak leadership, the company never fully recovered from the 2009 financial crisis and its loose compliance culture led to a fake accounts scandal and other reputation-tarnishing problems. Also, like all banks, it is struggling with low interest rates and limited loan growth, although the much-feared pandemic-related loan losses no longer look likely. An additional constraint is a regulator-imposed cap on Wells Fargo’s asset size. Under CEO Charles Scharf, the bank is aggressively restructuring its operations, cost structure and regulatory compliance.

Wells reported decent and encouraging third-quarter results. Core operating profits, as measured by the wonky “pre-tax, pre-provision profit,” rose 47%. Revenues growth of 7% was good and costs fell 8%. Credit costs increased by 53% but to a level that remained modest. Lower taxes incrementally boosted results. The bank’s capital ratio increased to a healthy 11%. No change to our Buy rating.

At yesterday’s closing price, the shares traded at 106% of updated tangible book value of $37.43, and about 8x estimated 2023 earnings of about $5.00. We see the valuation as too low for a bank that is clearly improving and will eventually extract itself from its regulatory burdens.

In the quarter, revenues rose 7% and were about 4% above estimates. Adjusted earnings of $1.39/share increased 7% and were about 12% above estimates.

The Consumer Banking segment is clearly improving. Revenues increased 3% and lower credit costs and operating expenses (combined, down 13%) drove profits up 81%. This segment generated almost 40% of the bank’s total profits.

Commercial Banking segment profits rose 15%, helped by higher interest income on its loans. Operating costs were essentially flat.

Corporate/Investment Banking revenue growth was impressive at 21%. Credit costs fell compared to the second quarter and are still quite modest. Expenses rose 15% but much of this was due to higher revenues – employees tend to get paid based on revenues generated.

Wealth Management profits sagged 17%. Revenues were flat but expenses rose 8% due to higher compensation and other costs.

Wells is benefiting from higher interest rates. The net interest margin of 3.06%, essentially the profit on lending, ticked down modestly from the second quarter but remains at a healthy level and above the year-ago margin. We expect to see flattish margins ahead as the bank ticks up the interest rate it pays on deposits to help retain them.

Like all banks, deposits slipped (down 5%) as customers shifted to higher-yielding products. This is more clearly seen in the 24% decline in interest-free checking balances. We don’t see the declines as worrisome, partly as it appears that customers are merely moving deposits within the bank rather than out of the bank. And a trickle-out of deposits is less meaningful to Wells as it has low loan growth, plenty of deposits relative to its loans, and remains under a regulator-imposed cap on its assets.

Wells operating expenses fell 8% from a year ago, but most of this was due to sharply declining operating losses outside of the core business. While favorable, this is not a recurring source of lower costs. Headcount fell 5% but personnel costs rose 5%. Personnel costs are two-thirds of total costs, so improvement here is critical. Outside professional services (fees paid to consultants) remained high at $1.3 billion. This spending will likely continue until the operational, technology and regulatory turnaround is complete.

Credit quality remains high. Total loan charge-offs were only 0.36% of loans (might be 1-2% in a typical recession). Commercial real estate losses were modest at 0.24%. Reserves for future losses increased, so, all-in, Wells’ credit picture is unchanged/incrementally stronger.

Friday, October 13, 2023 Subscribers-Only Podcast:

Covering recent news and analysis for our portfolio companies and other topics relevant to value/contrarian investors.

Today’s podcast is about 9 minutes and covers:

• Earnings updates
• Comments on recommended companies
  
  • Walgreens Boots Alliance (WBA) – Capable new CEO.
  • Western Digital Corp. (WDC) – In final talks to acquire Kioxia.
• Elsewhere in the market
  
  • Even more macro chaos
  • Engaging and dis-engaging
  • Value shops and libraries.

Disclosure: The chief analyst of the Cabot Turnaround Letter personally holds shares of every Rated recommendation. The chief analyst may purchase securities discussed in the “Purchase Recommendation” section or sell securities discussed in the “Sell Recommendation” section but not before the fourth day after the recommendation has been emailed to subscribers. However, the chief analyst may purchase or sell securities mentioned in other parts of the Cabot Turnaround Letter at any time. Please feel free to share your ideas and suggestions for the podcast and the letter with an email to either me at bruce@cabotwealth.com or to our friendly customer support team at support@cabotwealth.com. Due to the time and space limits we may not be able to cover every topic, but we will work to cover as much as possible or respond by email.