Walgreen (WAG) stock has been climbing steadily this year, and has increased approximately 50% since this time last year. This dramatic increase is well deserved as Walgreen's business performance has been consistently good over the past decade even though the stock had "gone nowhere" during the same time period. The catalysts for the recent jump upward have been the resolution of Walgreen's highly public contract dispute with Express Scripts, Walgreen's transformational combination with Alliance Boots, and Walgreen's strategic transaction with AmerisourceBergen (ABC). The question on shareholders' minds is whether Walgreen's stock can continue to rise. In the remainder of this article, I will outline why I believe that Walgreen shares could double over the next three years.
Walgreen's Financial Performance Over Last 10 Years
Before moving on to the future outlook, let's look at the business numbers for Walgreen over the past 10 years. Over the last decade, Walgreen's revenue has increased from $32.5 billion to $71.6 billion (an increase of 121%), earnings have increased from $1.17 billion to $2.13 billion (an increase of 82%), and earnings per share have increased from $1.14 to $2.42 (an increase of 112%). These numbers, although not spectacular, show a consistent trend upward with only brief downturns in 2009 (financial crisis) and 2012 (Express Scripts dispute). Walgreen's longer-term trajectory in earnings per share growth and dividend growth has been impressive. Walgreen has increased its dividend every year for 38 years, and it has increased its dividend over the past five years at an annual compound growth rate of 23%.
Ok, so how will Walgreen's shares continue to appreciate over the next few years? What are the catalysts going forward? I believe the answer can be gleaned by understanding the background and motivations of Walgreen's new executive chairman, and largest shareholder, Stefano Pessina.
Stefano Pessina's Consolidation of Pharmaceutical Retail and Distribution
Stefano Pessina is an Italian billionaire who has made his fortune consolidating pharmaceutical retail and wholesale businesses throughout Europe. Over the past four decades, he has completed over 1500 deals to build his business. His three most transformational deals have occurred since 2006, and Pessina has made it clear that his goal is to continue to consolidate the industry on a global basis. In 2006, he merged his pharmaceutical wholesaler "Alliance Unichem" with the United Kingdom retail pharmacy chain "Boots." A year later, he took the entire Alliance Boots group private with the help of private equity firm KKR. He invested $2.6 Billion personally in the venture. Since then, Pessina has continued to grow the size and power of the Alliance Boots group by completing significant deals in China, Germany and Turkey.
Pessina's deal with Walgreen is his most remarkable achievement yet as it gives him a huge footprint in the United States, the world's largest market for pharmaceuticals. In June 2012, Walgreen announced its agreement to purchase 45% of Pessina's Alliance Boots for $6.7 billion. Under the terms of the agreement, Walgreen also has the option to purchase the remaining 55% of Alliance Boots in 2015. Now that the first step of this transaction has been completed, Pessina owns approximately 8% of Walgreen shares, and he has stated that he has no intention of selling those shares. In fact, he has been recently buying even more shares. If Walgreen completes the second step of the transaction in 2015, which seems likely considering Pessina's large ownership share and statements made by Walgreen CEO Greg Wasson, Pessina could own approximately 20% of Walgreen shares in 2016. As the largest stakeholder in a global Walgreen, Pessina has no plans to slow down the global expansion he started 40 years ago. Even at 71-years of age, Pessina has a vision to turn Walgreen-Alliance Boots into a truly global player with a retail footprint and distribution network that cannot be replicated by any other company. Pessina has succeeded in the pharmaceutical industry by pioneering and honing the strategy of vertically integrating pharmaceutical retailers and distributors to gain negotiating power and leverage with pharmaceutical suppliers and improve the efficiency of the delivery of drugs to retailers.
Shortly after announcing the Walgreen and Alliance Boots transaction, Pessina acted quickly to begin his vertical integration strategy in the United States by striking a long-term partnership with the pharmaceutical distributor AmerisourceBergen that includes the right for Walgreen to acquire 7% of AmerisourceBergen shares on the open market and warrants that would allow Walgreen to acquire another 16% of AmerisourceBergen shares (for a total of 23% of the company). This relationship with AmerisourceBergen makes Walgreen-Alliance Boots the largest purchaser of pharmaceuticals in the world. The group's buying power will only get stronger as Pessina continues to acquire and partner with distributors and retailers throughout the world. An additional benefit of the transaction with AmerisourceBergen is that Walgreen's pharmacies will receive deliveries of drugs daily instead of weekly. This advantage should ensure that customers are served better and not face shortages of needed medications. As you can see from this background of Pessina, even though Walgreen will be "acquiring" Alliance Boots in 2015, the reality is that this transaction is one where Pessina is acquiring a controlling interest in the combined Walgreen-Alliance Boots and moving further along in his goal of building a global pharmacy retail and distribution business that has capabilities and economies of scale that no other company can match.
How Walgreen Can Double Over Next Three Years
How is Pessina's vision and the combination of Walgreen with Alliance Boots going to increase the price of Walgreen stock? My theory is that the transformational nature of the Walgreen-Alliance Boots combination has not been truly reflected in Walgreen's stock price, and investors have the opportunity to buy shares now before the benefits of the combination become clear after the second stage of the acquisition closes in 2015. To determine what the company and the stock will look like after the second stage of the acquisition, we can do some back of the envelope math based on the 2016 goals for the joint company outlined by management (see table below). Currently Walgreen only owns 45% of Alliance Boots, and due to the equity method of accounting, Walgreen's earnings do not currently reflect the true earnings power of the joint company. However, once Walgreen purchases the remainder of Alliance Boots in 2015, the true earning power of both companies will flow down into Walgreen's earnings statement. The estimated 2016 numbers listed by management assume only the completion of the Alliance Boots transaction and no other major acquisitions or strategic transactions (for example, these projections don't include the AmerisourceBergen relationship). Walgreen management estimates that the projected shares outstanding after the Alliance Boots transaction in 2016 will be approximately 1.1 billion shares (assuming no share repurchases). Therefore, we can use the low end of management's operating income projection ($8.5 Billion) and multiply it by an average earnings multiple of 15 to get a market cap of $127.5 billion. Given the projected number of shares outstanding in 2016, we can calculate that each share would be worth approximately $116 in 2016. Currently shares trade at $51 per share. This would imply a gain of 127% over today's quotation (plus dividends) for a three-year holding period, or over a 30% compound annual growth rate. This could end up being a conservative estimate as Pessina continues to expand the business through ventures such as the AmerisourceBergen transaction.
Walgreen Management Goals for 2016
FY 2016 Goals (Walgreen +Alliance Boots)
Operating Income (GAAP)
$8.5 -$9.0 Billion
Adjusted Operating Income
$9.0 - $9.5 Billion
Operating Cash Flow
As in any investment, there are risks involved with buying Walgreen shares right now. Currently Walgreen trades at an above-average valuation, and the price of the stock could fall to lower levels if future earnings do not materialize as management expects. Walgreen will be more leveraged after completing the Alliance Boots transaction, and the additional debt could cause problems down the road if the business results suffer. Other pharmaceutical retailers and wholesalers could take market share from Walgreen and Alliance Boots. Regulations in the United States and Europe around pharmaceutical reimbursement could cause problems for the company. Companies such as Express Scripts could choose to take actions that hurt Walgreen by sending their insured customers elsewhere. Additionally, contrary to the investment thesis above, Stefano Pessina could sell his shares of Walgreen and cause a big drop in the stock price.