By Jeff Bailey
Walgreen (WAG) shares are trading near an all-time high and at a fancy multiple for a drug store chain - a forward PE ratio of more than 20 - as investors focus on whether the company will engage in a tax inversion as part of its expected acquisition of the 55% of Alliance Boots, the European drug store chain, not already owned by Walgreen.
In a tax inversion, a U.S. company acquiring an overseas concern essentially swaps its headquarters and taxing locale to get a lower tax rate than it enjoys in the U.S. Yes, it's legal. And it's all the rage in recent weeks as pharmaceutical companies in particular go shopping for foreign drug firms that could lower their tax rates. AbbVie (NYSE:ABBV) is after Irish drug maker Shire (OTCPK:SHPGF) for that reason. And earlier, Pfizer (NYSE:PFE) was in pursuit of AstraZeneca (NYSE:AZN) to gain a lower tax rate; AstraZeneca seems to have fought off the effort for now.
The potential tax inversion is one of a number of moves some investors are hoping to see from Walgreen management, and more on those later. In the meantime, it seems investors are looking past a lackluster operating performance at Walgreen. As noted by Mark Miller, the astute retailing analyst at William Blair & Co. in Chicago, Walgreen has missed analysts' quarterly projections in five of the last six quarters.
In the fiscal third quarter, ended in May, Miller points out, "Gross margins were weaker than expected, and management indicated that it no longer believed it could achieve its fiscal 2016 operating profit objective provided two years ago."
Generic drugs, formerly a wind at the back of drug store chains because wholesale prices regularly fell, widening margins for the retailers, have instead begun to cost more at wholesale as time goes on. Some of the generic price increases have been astounding and the drug manufacturers are clearly several steps ahead of government efforts to reduce costs. It's a profit margin squeezer for Walgreen and likely for other drug store chains like CVS (NYSE:CVS) and Rite Aid (NYSE:RAD).
Front-end sales - the mishmash of stuff one buys at a drug store other than prescription drugs and non-prescription drugs - have for several years been unimpressive at Walgreen. Miller, the analyst, notes front-end traffic has been negative since October 2011. Walgreen, at the risk of being the "unhealthy drug store," is picking up some shoppers because it has continued selling cigarettes after CVS announced it was banishing the stuff from its stores.
But as we reported at length in early 2013, Walgreen's an uninspired retailer, and some of its stores are dingy and staffed by customer-averse employees.
So, the current stock price and any movement up from here would seem contingent on Walgreen management actually doing some of the stuff activist investors are hoping for:
-The tax inversion, which analyst Miller estimates could add 70 cents to EPS. The decision and potential fallout will be interesting to watch. Walgreen, as noted in a smart column by Andrew Ross Sorkin in the New York Times, gets nearly a quarter of its annual revenue from the federal government in the form of Medicare and Medicaid reimbursements. Dodging taxes with one hand and collecting $17 billion in sales with another could certainly test the government's good humor on tax inversions.
-Some investors would like to see Walgreen leverage up and return more cash to shareholders. The completion of the Alliance Boots deal alone will stretch the balance sheet. Dividend hikes that have outpaced EPS growth have already sent the payout ratio into historical thin air for Walgreen, a problem YCharts identified previously. Big buybacks or a materially higher dividend would certainly raise the risk profile and, as seen with generic prices, the healthcare world has become less predictable.
-Miller notes that some investors would like to see Greg Wasson, the Walgreen CEO, step aside in favor of Alliance Boots management. The European chain is known as a more fashionable and adept retailer. CEO's voluntarily exiting, of course, are rare. Investors are also hoping for bigger-than-promised cost cutting, though how that squares with improving the retail experience isn't clear.
All of the tax inversion excitement has pushed Walgreen shares up to a significant premium over those of CVS. That's occurred despite the fact that Leuthold Group singled out CVS for being best positioned among a group of healthcare supply chain companies that includes Walgreen, Rite-Aid, Express Scripts (NASDAQ:ESRX), AmerisourceBergen (NYSE:ABC), Cardinal Health (NYSE:CAH), McKesson (NYSE:MCK) and Catamaran Corp (NASDAQ:CTRX).
Analyst sentiment, despite the rich valuation, is favorable on Walgreen. Sentiment was unfavorable when the stock was cheap! Miller rates the stock outperform, despite misgiving about fundamentals, because he expects some of the shareholder-friendly moves to be implemented, including the tax inversion.
Even if it happens, someone has to run a giant drug store chain more effectively.