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Walgreen (NYSE:WAG) stock has risen almost 10% since the company announced its Q3 2013 results on Tuesday. The rise was backed by a strong performance during the quarter and the announcement of a 10-year agreement with AmerisourceBergen (NYSE:ABC). As per the agreement, ABC will help Walgreen with daily drug distribution, enabling the latter to increase the sales of pricey specialty drugs.

AmerisourceBergen Corporation is one of the world's largest pharmaceutical services companies with a focus on the pharmaceutical supply chain. The company provides drug distribution and related services designed to reduce costs and improve patient outcomes. Similar to competitors CVS Caremark (NYSE:CVS) and Rite Aid (NYSE:RAD) which have a generic drug penetration of 75-80% in the drugs they dispense, much of what Walgreen sells now are bulk, low-profit prescriptions. By combining its distribution in the United States and Europe with ABC, Walgreen will be able to negotiate better prices for the bulk drugs. In addition, it will have access to more specialized drugs, like those for cancer treatment. Besides supplementing the product mix, the agreement is expected to reduce Walgreen's cost in sourcing drugs.

Here we take a look at the agreement between the two companies and its implications.

10-Year Agreement With Distribution, Strategic And Equity Components

Walgreen and Alliance Boots' long-term relationship with AmerisourceBergen is part of Walgreen's strategy to create an unprecedented global platform. The new agreement has three main components: a distribution agreement, strategic collaboration and equity alignment.

a) Branded and Generic Pharmaceutical Distribution Contract

AmerisourceBergen has serviced Walgreen's specialty business for several years. Under the new agreement, it will expand it services to include distribution of branded and generic pharmaceuticals to Walgreen's retail stores, mail order and specialty pharmacies. Branded and generic drugs constitute more than 80% of Walgreen's drug mix, distribution for most of which will now shift to AmerisourceBergen. Initially, Walgreen used to independently manage distribution of these drugs. We think that by combining distribution in the United States and Europe with AmerisourceBergen, Walgreen will be able to negotiate better prices for the bulk drugs. The move will also give Walgreen access to better rates on specialty drugs used for treating diseases such as cancer, rheumatoid arthritis and multiple sclerosis, which have higher profit margins but are also more expensive to keep on hand. The lower costs would translate into higher gross margins for the company. We expect the agreement to have a positive impact on Walgreen's earnings and cash flow from operations.

The agreement also provides for daily deliveries of drugs at Walgreen stores. This is an improvement on the service level that Walgreen has in its sources to whom it goes directly once a week in most cases. Daily delivery by AmerisourceBergen also frees up capacity with Walgreen's distribution centers for front-end products. The company could use this capacity to stock more items in new format stores that it has been promoting over the past year.

The distribution contract is effective September 1, 2013, and initially will include branded pharmaceutical products that Walgreen has historically sourced from distributors and suppliers. Beginning calendar year 2014, AmerisourceBergen will increasingly assume the distribution of generic products that Walgreen has historically self-distributed. The working capital was negotiated to essentially have a neutral impact on both parties. Specifically, the reduction in inventory days at Walgreen will be offset by a decrease in accounts payable days over time.

b) Strategic Collaboration Through Knowledge Sharing

The three companies have also agreed to collaboratively share best practices and work together to provide manufacturers with integrated solutions for global clinical trial logistics and innovative global third party logistics services. The strategic collaboration will expand the international reach and create significant knowledge sharing opportunities to improve access to pharmaceuticals.

c) Aligning Interest Through Equity Agreement

The equity agreement is designed to align common interests and enable joint value creation. A joint venture established with Alliance Boots also gets the right, but not the obligation to purchase up to 7% of fully diluted equity of AmerisourceBergen in the open market. In addition, AmerisourceBergen has granted to Walgreen and Alliance Boots equity warrants exercisable for 16% in the aggregate of the fully diluted equity of AmerisourceBergen. Walgreen will be able to appoint one director to AmerisourceBergen's board upon Walgreen and Alliance Boots together acquiring a 5% equity stake and a second director upon exercise in full of the first warrants.

To summarize, the financial benefits for Walgreen are improved commercial agreement rates, synergies and dividend income that comes from the investment. The reduced costs due to better rates on drugs and capacity and capability sharing are expected to support net margin growth for the company.

We have a $42 Trefis price estimate for Walgreen, which is 10% below the market price.

Disclosure: No positions.

Source: What Does The 10-Year Contract With AmerisourceBergen Mean For Walgreen?