Walgreen’s Investment in Alliance Boots is Baffling
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To little fanfare, Walgreen (NYSE: WAG) announced third quarter earnings on Tuesday that were overshadowed by the firm’s sizable investment in British drugstore chain Alliance Boots. The deal is valued at $6.7 billion, with Walgreen receiving a 45% equity stake in exchange for $4 billion in cash and $2.7 billion worth of Walgreen stock. The deal includes an option for Walgreen to buy the rest of Alliance Boots for $4.9 billion in cash, another 144.3 million shares of Walgreen stock, and assumption of all of Alliance Boots’ outstanding debt.
Merger news obscured the poor results from Walgreen’s fiscal 2012 third quarter. The firm’s failure to come to an agreement with Express Scripts (NASDAQ: ESRX) had an impact of $0.06 per share on earnings, which were down to $0.62 compared to $0.65 a year ago. Front-end (non-prescription) same-store sales decreased by 0.9% for the third quarter, whereas CVS (NYSE: CVS) posted a 5.3% same-store sales growth rate in its most recent quarter. Same-store prescription sales tumbled 9.9% on a 9.1% decrease in volume compared to the same quarter in the previous year.
With same-store sales falling, we assumed Walgreen’s next step was to undertake increased capital spending to create better shopping experiences and compete with CVS. Although the drugstore front-end price structure tends to be higher than dollar stores, which have posted great results recently, CVS has managed to maintain positive momentum, thanks in part to its loyalty program and willingness to sell some grocery items at lower margins. Walgreen has followed suit, as it is in the early stages of a rewards program itself. We also thought the company might want to work out a deal with Express Scripts to recapture some of the lost traffic resulting from the feud.
We’re a bit surprised by the deal. Not only does this complicate the actual day-to-day running of the business, but it doesn’t result in many, if any, cost synergies, in our view. Instead of focusing on a struggling domestic business, Walgreen will have to focus on a British firm that operates under a different set of rules overseas. We expect that there will be no synergies in terms of compliance costs, nor do we see much negotiating leverage with pharmacy benefit managers like Express Scripts because these companies are primarily regional rather than global entities. We think acquiring a pharmacy benefit manager, the way CVS acquired Caremark, would have been more accretive than simply buying entrance into another market. It’s important to note that Walgreen does think it can yield nearly $1 billion in cost savings by the fifth year of the deal, but we think some of the proposed synergies, like “Best Practice Sharing” is hard to quantify.
On the positive side, it looks like Walgreen may have paid a reasonable price for a company that will add $0.23-$0.27 in earnings per share. This pegs the price paid by Walgreen at 6.3x FY2012 EBITDA, which isn’t absurd in our view. While the deal certainly adds some earnings power, we just aren’t sure why the firm entered into the transaction in the first place, when the US business is soft. Either the company is effectively allowing CVS to take market share, or it thinks it can become a global empire. The firm generates solid free cash flow, but wasn’t in a position where it was so cash-rich that management didn’t know what to do.
Regardless, our fair value for the firm remains at $34 per share, after considering the earnings accretion and cost of the deal. The firm did raise its dividend by 22% compared to the previous quarter, which now gives it an annual yield in excess of 3.5%. We still believe Walgreen has excellent dividend growth potential, though the Valuentum Dividend Cushion rating is only good, at 2.2. The firm registers a Valuentum Buying Index score of 4, suggesting we wouldn’t look to start a position in its shares until both its valuation and technicals became more attractive. However, with a single-digit forward PE, a chance of reconciliation with Express Scripts, and a large dividend yield, we could see the firm converging to our fair value estimate in a relatively short period.
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