Walgreen Hopes That It Can Buy Growth

By Stephen D. Simpson, CFA | June 25, 2012 AAA

Walgreen (NYSE:WAG) management cannot be faulted for being passive in response to the challenges it is facing in producing growth. With an arguably saturated U.S. market, ongoing challenges from the likes of Walmart (NYSE:WMT) and Target (NYSE:TGT), further penetration from mail-order pharmacies and its ongoing dispute with Express Scripts (Nasdaq:ESRX), the company had to do something. The question remains, though, whether paying up for KKR's British-based Alliance Boots is the long-term solution to what ails Walgreen.

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Plenty of Pressure in Fiscal Q3
Everyone knew that the loss of Express Scripts was going to hurt Walgreen, and indeed that is proving to be the case. Revenue fell more than 3% this quarter (slightly worse than expected), as front-end comps dropped about 1% and total comps fell 6.5% on a -9.8% comp in some-store prescriptions.

Walgreen saw about 10 basis points of positive gross margin development this quarter, but lost a little momentum through its operating expenses. As a result, operating income fell 8%, though the ultimate per-share number was just slightly better than expected.

SEE: A Look At Corporate Profit Margins

Just How Bad Is It?
Sell-side analysts have been estimating a roughly 10% negative impact to Walgreen comp sales from the loss of Express Scripts business. While Walgreen is fighting this in court, it is also trying to reposition its pharmacy offerings to customers and prescription benefit plans.

How this is going depends in large part on whether you accept that 10% estimate on the impact of Express Scripts. Rite Aid (NYSE:RAD) reported that pharmacy comps were up 1% in May, while Walgreen's were down 8.5%. On an adjusted basis, then, it looks like Walgreen is at least holding its own with Rite Aid (CVS Caremark (NYSE:CVS) doesn't report monthly comp data).

Are These Boots Made for Growing?
Even if Walgreen is perhaps not doing as bad as feared in the U.S. pharmacy business, it is hard to find much excitement out there for the business - the average sell-side revenue estimates for this and next fiscal year translate into about 1% revenue growth. Now the company is making a big bet that getting bigger and more global will create value for shareholders.

Walgreen has entered into a multi-year deal with KKR that could result in the company taking 100% ownership of Alliance Boots in three years. Alliance Boots (which was taken private by KKR in a deal announced in mid-2007) is a mixed business of pharmacies, pharmaceutical wholesaling, joint ventures, and private health and beauty plans. While the Alliance Boots website refers to over 3,300 health and beauty retail stores across 11 countries (including over 3,200 pharmacies), the press release announcing the deal referred to 11,000 stores including alliances and joint ventures.

Walgreen is paying $6.7 billion upfront for a 45% stake, made up of $4 billion in cash and over 83 million shares of Walgreen stock. The deal includes an option to buy the remaining 55% for $9.5 billion within three years. That said, revenue at Alliance Boots grew better than 10% last year and growth has been accelerating in recent years, while EBITDA has also been growing (albeit at a somewhat lesser rate). Interestingly, the core store-based growth has been unimpressive, with much of the growth coming from the wholesaling business. On a valuation basis, Walgreen seems to be paying (assuming it buys all of the company at $16.2 billion) just above 0.4-times sales (including associates and joint ventures) but more than 7-times trailing EBITDA.

SEE: Analyzing An Acquisition Announcement

The Bottom Line
Although the market initially didn't seem to like the combination of earnings news and the Boots transaction, sentiment seemed to improve during pre-market trading last Tuesday morning. All in all, this is a very bold move, and one that carries a lot of risk, but it's also one that makes some sense. It is hard for me to see how Walgreen was going to be anything other than a slow-growth story pressured on multiple fronts by retailers, dollar stores and mail-order pharmacies. This deal does at least give the company a global platform and the opportunity to wring growth from that wholesaling business.

The nature of the Boots deal makes this company hard to value. Nevertheless, while I don't think highly of the company's U.S. operations, I do believe the transition to a global operator will bring a lot more interest to the stock and at least a new story for management to sell for the next few years.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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