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Summary

  • Walgreen stock took a severe hit after announcements on Wednesday that the company would complete its acquisition of Alliance Boots GMBH.
  • The newly formed Walgreen Boots Alliance has to cut costs and refine operations to make the union work but it is putting the right people in place.
  • Walgreen Boots Alliance has strong potential for long term growth, but it may take a couple years to get there.
  • Buy in now while the price is low for larger gains later.

Walgreen (WAG) opened at under $58 on Wednesday, down some 16% from its closing price on Tuesday. The fall happened after the $58 billion market cap drugstore chain made several announcements. Walgreen's share price recovered somewhat to hover around $60 by midday - but the stock's price look like it might be down, at least for now.

Investment Thesis

Walgreen announced several strategic decisions - a complete acquisition of Alliance Boots GMBH, retaining corporate domicile in the US, introducing a stock buyback plan, and boosting its quarterly dividend - and its stock took a dive. The company has its work cut out for it if it is going to successfully recoup its investment and maintain its profitability. Boots is a major expense and the company has a lot of debt.

Walgreen needs to manage Boots' debt and lean up its operations while also making back the money it would have saved by relocating its corporate domicile. The company tried to charm shareholders with buybacks and a dividend increase but its share price still took a dive. This is bad news for long time shareholders of the stock, but this reduction in share price may make a good entry point for investors looking to Walgreen for long term gains.

Walgreens Boots Alliance

The most prominent issue to come forward Wednesday was Walgreen's announcement that it would purchase the remaining 55% stake in UK-based Alliance Boots GMBH for $15 billion. "Walgreen said it decided to exercise its option to buy the rest of Alliance Boots earlier than the original option period of between February and August 2015. The company, which expects the deal to close in the first quarter next year, struck a deal to buy 45% of Alliance Boots in 2012 for about $6.7 billion," reports the Wall Street Journal. "Under the terms of the revised agreement, Walgreen will acquire the remaining 55% for $5.29 billion and about 144.3 million shares, worth about $10 billion, based on the closing price Tuesday."

"The newly named Walgreens Boots Alliance, aside from any future cuts, will now have a total of 350,000 employees, over 11,000 stores and 370 distribution centers. Crucially, it will have over 100 million loyalty card members, all spending and creating a useful data profile for the company," explains Forbes. "By 2016, the business hopes to have a total annual revenue of up to $130 billion."

Changes on the Horizon

Walgreen issued a statement Wednesday morning revising its guidance to include its acquisition of Boots, setting an adjusted EPS goal of $4.25 to $4.60 for FY 2016. The company also said that it would institute a series of cost-cutting measures to "achieve $1 billion in savings by the end of fiscal 2017."

The task is not a small one, but acquiring Boots may have been the best way for Walgreen to preserve the value of its initial investment. When Walgreen initially took a 45% stake in Boots in 2012, the deal was counted as a "game changing step" for Walgreen. Combining forces made the pair the largest single purchaser of prescription drugs in the world, providing opportunities for leveraging economies of scale to reduce certain overhead costs. It also gave Walgreen access to emerging markets, like China, and bring in revenue from more stable economies in Europe. It expands Walgreen's brand portfolio to include some of the top skincare brands in Europe as well. Brands like No7 were already sold in Target and on Walgreen's drugstore.com and beauty.com websites. Those facts have not changed.

Harnessing Opportunity

By Walgreen taking full control of the reins, it can have greater control over these opportunities and managing the costs associated thereto. It looks like the newly forming Walgreen Boots Alliance will do just that. "Walgreens has demonstrated a strong focus on cost control as adjusted SG&A growth has slowed significantly from historical trends," said Wasson in a statement announcing the Boots acquisition.. "We have made this impact by driving efficiencies across the enterprise, and we are continuing to focus on that. Earlier this year, we announced enterprise optimization initiatives to further accelerate these efforts, which we've executed this fiscal year through strategic closures of certain distribution centers and stores, exiting certain businesses and driving cost reduction programs at our headquarters and in the field. We also plan to expand these efforts as we leverage the expertise of both companies and move forward integrating Walgreens and Alliance Boots."

While management of the two companies will become blended, Walgreen executives will take charge of core operations. Walgreens President CEO and board member Greg Wasson will be president and CEO of Walgreens Boots Alliance while Tim Theriault, chief information, innovation and improvement officer at Walgreens, will assume the role of executive vice president and global chief information officer of Walgreens Boots Alliance. Improving IT will have huge importance going forward for Walgreens Boots Alliance. According to Forbes, "Costs will be slashed and efficiency improved across a number of major areas including procurement and the supply chain, store planning, loyalty schemes, and e-commerce, all of which have a huge involvement from Walgreens' and Boots' IT department."

In contrast, Boots executives who have been operating in more foreign markets will take the lead in strategy and expansion. Stefano Pessina, executive chairman of Alliance Boots, will be executive vice chairman of the combined company and responsible for strategy and M&A.

Valuation

The market was not encouraged by Walgreen's announcement of a $3 billion stock buyback plan and its quarterly dividend increase by 7.1% to 33.75 cents a share. Its share price still took a huge hit on Wednesday.

Walgreen also announced that despite taking full ownership of Boots it would retain its corporate domicile in the US and NOT pursue redomiciling in Switzerland to lower its tax rate. According to Bloomberg, "moving overseas could have saved Walgreen at least $4 billion in taxes over five years." This means Walgreens Boots Alliance will not enjoy some of the savings that had been forecasted and, combined with the costs of acquiring Boots, a few lean years are likely - at least in the short term.

But that doesn't mean Walgreen Boots Alliance is going to stay down forever. At its reduced price, the company is priced around 21 times its current earnings, compared to a PE ratio of roughly 25 for its industry and close to the pricing of its closest rival CVS (CVS), which has a PE ratio of just under 20. And, the new Walgreen Boots Alliance has greater potential for growth.

CVS is currently priced at $77 per share with a consensus price estimate of $82.35, while Walgreen is trading at $59 with a one year price target of $77.74. And both have forward PE ratios of just over 15, suggesting that Walgreen is priced low relative to future earnings as is.

If Walgreen Boots Alliance makes good on its forecast to bring in $4.25 to $4.60 EPS for fiscal 2016, it will exceed CVS's earnings per share of $3.93. Walgreen's EPS is currently at $2.84. Last quarter, "Walgreens missed quarterly expectations and saw a horrible decline in store traffic of 3.9% year over year. However, the company saw great progress in other areas, including continued earnings/margin expansion," explains GuruFocus. "Walgreens saw a 3.2% rise in year-over-year revenue, but saw its adjusted earnings rise 29.3% over the prior year… The common trend among pharmacies is to see greater prescription volume, slower revenue growth and massive net income growth. Walgreens' pharmacy business saw a 3.4% rise in year-over-year revenue but saw volume increase 8.7%, which further validates this trend."

Takeaway

Walgreen Boots Alliance has a hard road ahead, but its not impossible. The company is aligning management strengths with appropriate divisions and it has good prospects for growth, even without Boots. Factoring the international drug chain into that equation means that Walgreen Boots Alliance could deliver even more value. Take advantage of the current sell-off to buy into the Walgreen Boots Alliance low and position yourself for large gains later. It may take a couple years as the company refines its operations, but the wait may just be worth it.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Source: Walgreen: Buy In While Momentum Drives The Price Low For Big Gains Later