Walgreens ‘n’ Boots: What’s the Deal?

Walgreens announced a major acquisition Tuesday (June 20), with a $16.2 billion purchase of Alliance Boots, the largest pharmaceutical wholesaler in the world and the largest drugstore chain in the U.K.  This was a total surprise to the Street, given the company’s penchant for only small acquisitions in the past, to complement its consistent rollout of new stores.

When you strip the deal down to the fundamentals, WAG gets a faster-growing business (albeit operating in slower-growing markets in Europe), it’s immediately additive to earnings, and it now has a path to longer-term future growth.  While that path is shrouded by fog, it’s still a path.  Its growth potential in the U.S. has been shrinking as its store base moves closer to total national coverage and near-saturation.  In response, WAG cut back on new store openings, which has helped to dramatically improve the company’s free cash flow.  Those are the outright positives of the deal.

In the market’s eyes, however, this is mainly the story of a company which can’t do anything right anymore.  WAG stock fell as much as 12% by midday Wednesday before recovering slightly since then.  The only thing that investors want out of Walgreens right now is the resolution of the company’s dispute with Express Scripts, allowing all those PBM customers to return to WAG’s stores, and to prevent the threat of Medco’s PBM customers possibly being told to shop somewhere other than WAG.  Express Scripts acquired Medco in April, casting even more doubt on WAG’s ability to hold onto its customers after it lost 6% of its sales to the Express Scripts debacle.  Instead of getting that, investors now get a transformative deal they don’t understand, and whose benefits management can’t exactly pinpoint.  The reason why the message is lost is that there really can’t be a clear message yet; again, this is a transformative deal.  In the long run, WAG’s stores might still look the same, but it will be quite a different company in how it merchandises, sources medicines, and grows geographically.

Background on ESRX

WAG’s latest troubles began about a year ago, when it announced it couldn’t come to terms with Express Scripts, and thus would not be accepting any Express Scripts PBM patients, starting on 1/1/12.  PBMs like Express Scripts control the patient’s buying of drugs, on behalf of health insurance plans (such as PHP).  PBMs decide how much each drug will cost to patients, and they pay drugstores a set fee to fill each prescription.  If a patient with health insurance wants his insurer to pick up part of the tab for his drugs, he needs to comply with his PBM’s rules.  So now, Express Scripts patients can’t get their prescriptions filled at Walgreens, unless they want to pay the whole bill out-of-pocket.  PHP, for the record, uses Medco as its PBM.

Outside the companies, no one really knows which party was driving the harder bargain; the answer is probably closer to “both.”  So, should have Walgreens sucked it up and taken whatever Express Scripts offered?  That is the $10 billion question (the amount of market capitalization WAG stock has lost since the announcement).  The market seems pretty confident in its answer (yes).  At any given time, however, the two could come back together.

Deal Specifics

WAG will obtain a 45% stake in Alliance Boots in the first step, by paying $6.7 billion, $2.7 billion of which will be WAG stock, and $4 billion cash.  WAG then will have the right to acquire the remaining 55% in 2015 for $9.5 billion, of which $4.6 billion will be in WAG stock and $4.9 billion in cash.  It is not required for WAG to acquire the remaining 55% stake, but obviously it intends to.

The total deal consideration of $16.2 billion is obviously huge, but it buys a huge company which will add 55% to WAG’s sales base.  Issuing debt to fund the cash portion makes for extremely cheap financing these days, while issuing WAG stock at $29 is not great, because the stock is so low.  So, while the deal price is somewhat high at around 10x EBITDA, it still adds to WAG’s annual earnings per share by $0.23 – $0.27 right away, largely thanks to the cheap debt costs.  In other words, borrowing money to do virtually anything is going to pay off at today’s low rates!

Alliance Boots is currently two-thirds owned by private equity buyout firm KKR and one-third by chairman Stefano Pessina, who jointly took the company private in 2007, at the tail end of the LBO boom of the 2000s.  In that deal, worth £12.4 billion ($19 billion) at the time, KKR and Pessina put in $2 billion of equity and borrowed the rest.  It is the biggest LBO ever in the UK.  The subsequent financial crisis of 2008-09 made the buyout look horrifically-timed, but the company was still able to roll over debt maturities, even paying off quite a bit of debt, all the while growing earnings 100% in the 5 years since.  KKR is happy to get out of the deal with a profit, and will be taking cash for its stake.  Pessina will be taking WAG stock for his entire stake (as a billionaire, he doesn’t need the cash), and thus will become an 8% shareholder of WAG.  The first step of the deal is set to close by September 1, 2012.

The new company will operate more than 11,000 stores (WAG:  8,300, Boots 3,300) in 12 countries, as well as the world’s biggest pharmaceuticals wholesaler, with operations out of 370 distribution centers in 21 countries.

Cost synergies will be $150 million in the first full year post-merger, and will run up to $1 billion annually by 2016, through procurement economies of scale, best practices, and (inevitably) personnel redundancies.

Positives of the Deal

  • Adds to earnings immediately
  • Adds to WAG’s earnings growth rate
  • Creates a road map to geographic expansion, where it had none before, and into emerging markets
  • Instantly diversifies WAG geographically, by business mix, and by payor
  • Long time horizon to consummating a full acquisition (in 2015).  All large mergers come with complicated integrations.  Business practices are shared and optimized between the two companies.  Personnel decisions are made.  Perhaps most importantly, technology platforms are merged.  While WAG would seem to most people to be merely a collection of stores, in fact, one of its greatest assets is its technology.  Patient records and complicated drug interactions are of utmost importance to patients, and WAG has long been regarded as the industry leader in patient safety.  Having 2 ½ years to migrate their systems will be a boon.


  • High valuation, although mitigated (and justified) by low borrowing costs, making the deal immediately additive to earnings.
  • Expansion into Europe.  Is Europe now red-lined?  You’d guess so, based on the commentary from Street analysts about the deal.  While this is more-or-less a consumer company, and thus vulnerable to further fiscal austerity measures taken on the continent, this is not a luxury company.  Drugstores sell health care necessities and other products driven largely by convenience.  Any debate about whether this is a consumer staples or discretionary company should be answered by the (100%) growth experienced by the company amidst the 2 recessions and fiscal austerity the UK has suffered in the last 5 years.
  • S&P indicated it will lower its credit ratings on WAG from A to BBB, a 3 notch downgrade, simply to account for the increased debt load (not due to European concerns).
  • WAG has suspended its share buyback program, which had reduced its share count by 12% in the last 2 years.  WAG will instead direct cash flow to reducing debt and to its much higher dividend (see below).


In other news

Commensurate with the deal announcement, WAG announced earnings that were as expected, down 5% from last year.  Sales fell 3%.  Same-store pharmacy sales fell 9.9%, thanks to the Express Scripts departure, which is worse than management had predicted coming into 2012, and which has slightly deteriorated as 2012 has progressed.  “Front-end” (the rest of the store outside the pharmacy) same-store sales fell only 1%, so many of the Express Scripts patients who aren’t buying their prescriptions at Walgreens are still coming to buy other stuff.


The really good news was the increase in WAG’s dividend from $0.90 per share annually to $1.10 per share, a 22% increase!  At current prices, that’s a yield of 3.8%!  Obviously, management is quite comfortable with the cash flow story of the combined companies.

To summarize, finally

As we said at the top, the story here is that management is under a dark cloud on Wall Street.  Nothing they can do is good enough, unless it’s re-marrying Express Scripts.  So, by definition, the bigger the action, the worse the perception.

But WAG still has a long track record of successful strategic decisions.  In merchandising, it has always been the industry leader, moving first to freestanding stores, drive-through pharmacy, and diving into new areas where it could become a category killer, like photo (which had a good, long run even though it’s not exactly growing anymore), beauty, in-home health monitoring, and in-store clinics.  In capital deployment, WAG has bought back a ton of stock and increased its dividend at a 22% annual rate in the last 10 years.  In M&A, it has done well to make tuck-in acquisitions of pharmacies across the land, where it was cheaper to buy than build (small, failing pharmacy chains) and where it was unfeasible to build (Duane Reade in NYC).   WAG continues to generate a ton of predictable free cash flow, to the tune of $2-3 billion/year, and this will become much higher with the addition of Boots.

Analysts pretty much had nothing intelligent to say about the deal.  As a bunch, they appear to be highly confused, which in turn makes them frustrated.  Analysts like nothing more than predictability and visibility.  One analyst wrote, “Investors are asking why Walgreen would diversify away from its U.S. business, where it is facing increased competition, slow U.S. growth, and drug-reimbursement issues….”  Didn’t he just answer his own question?  This seems to encapsulate the feeling out there in the market.  Perhaps what these confused souls mean to say is that management needs to spend more time trying to get Express Scripts back to the negotiating table, rather than deviating down some other profitable path.  Our opinion is that time and attention have nothing to do with what is keeping the Express Scripts re-marriage from happening.

At the end of the day, we still believe the “payor issue” will get sorted out with Express Scripts, and we can value the company based on its asset base, its competitive advantages versus its competition, and a historical record of the strategic decisions it has made.  We won’t know the strategic value of the Boots acquisition for many years.  But even if we assume it doesn’t add any value to Walgreens, WAG stock at a P/E of less than 10 and a 3.7% dividend yield is a once-in-a-generation buy.