Walgreen Aims for Overseas Growth

By Tom Gibbs - June 23, 2012 | Tickers: CVS, ESRX, WMT, WAG | 0 Comments

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Walgreen Co. (NYSE: WAG) fell nearly 9% over a prolonged three-day hit the week of June 18 over concerns of the drugstore operator's most recent quarterly performance and its acquisition of European-based health and beauty retailer Alliance Boots.  Although the stock has rebounded slightly, the difficult week adds to the troubling fall the stock has experienced since summer 2011 highs.  Why so much pessimism in the Walgreen camp?

The Acquisition

Walgreen’s sales have slumped over the past several months since it stopped filling prescriptions with Express Scripts (NASDAQ: ESRX), the largest US pharmacy benefits manager.  The less-than-stellar performance over the past quarter – revenues fell 3.4% year-over-year to $17.8 billion – was hardly unexpected, as Walgreen’s management stated in late 2011 that it would rather give up revenues it received from Express Scripts than continue to fill unprofitable prescriptions.  The corporation has not enjoyed the subsequent decrease in same-store sales as customers switched to rival drugstores including CVS Caremark (NYSE: CVS) and Wal-Mart (NYSE: WMT).

This being said, a large majority of the per-share price slump is obviously driven by the acquisition news.  Walgreen purchased 45% of Alliance Boots for $6.7 billion -- $4 billion in cash, the remainder in stock – with an option to acquire the rest of the company at a later date.  The acquisition is hardly inconsequential when compared to Walgreen’s current market cap of around $25 billion, but it does represent the corporation’s first push outside of its key United States market.  Through the acquisition of Alliance Boot’s 3,300 health and beauty retail stores (located in 11 countries, primarily in Europe), Walgreen management has hopes of diversifying and growing its top line while continuing its battle with Express Scripts. 

The Price Drop

The market’s concerns regarding Walgreen’s new exposure to the troubling European market are not unfounded.  One cannot deny, however, that combined with Walgreen’s dividend increase announcement this week, the stock is becoming increasingly attractive.  The 22% dividend hike to 27.5 cents/share per quarter provides a near 3.8% yield based on Wednesday morning prices around $29/share, which is more than double the five year quarterly average yield of 1.64%. 

Even more attractive is Walgreen’s long history of dividend increases and its growing percentage of EPS payout to shareholders.

2012 payout ratio based on consensus EPS estimates of $2.62/share

Following the consecutive two-day price drop, Walgreen is also considerably cheaper on an historic earnings basis.  The corporation’s forward P/E of around 10x is close to 33% off its past five-year average. 

A Good Deal?

Dividend-seeking investors will undoubtedly be attracted to Walgreen’s current yield and the corporation’s continued prospects of dividend and payout ratio hikes.  This being said, was the purchase of Alliance Boots an attractive acquisition given the deal’s metrics? 

The European-based health/beauty retailer generated £1.44 billion of EBITDA on £23 billion in revenue in the most recent fiscal year ending March 31.  With an Alliance Boots enterprise value of around £17.5 billion, Walgreen paid in excess of 12x trailing twelve month EBITDA for the acquisition.  This is not extremely cheap considering Walgreen itself currently trades for around half the valuation, and the corporation boasts comfortably higher margins. 

Although the market is undoubtedly concerned about the newly acquired exposure to the European market and some have argued that Walgreen would have been better off simply purchasing itself (at a less expensive valuation) via stock buyback, there is reason to look at the Alliance Boots acquisition in a positive light:

• Strong Financial Performance: Alliance Boots has grown revenues at a 13% CAGR over the past five years, including a 18.4% revenue and 12.4% profit increase in 2011.
• Walgreen management expects $100-$150 million per year in cost savings due to increased buying power for prescription and over-the-counter drugs as well as general merchandise
• Market overreaction has shot Walgreen to the bottom-end of its five year P/E, P/B, and EV multiple ranges (and the top of its dividend yield range)

The short-lived market pessimism surrounding the acquisition should continue to fade as the faster-growing Alliance Boots top and operating lines become integrated into Walgreen's future filings.  The smaller health/beauty retailer has exemplified its resilience to the rather weak European market -- primarily due to its heavier presence in the U.K. -- and the new revenue stream should end up pleasing investors in the long run as Walgreen launches out of its primary U.S. market and supplements its top line from the recent Express Scripts troubles.  With current valuations at the bottom of their historic ranges, it might be the perfect time to pick up some Walgreen shares on the cheap.

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