Walgreen - Bad News Show Warrants A Bigger Short-Term Correction

| About: Walgreens Boots (WBA)


Walgreen has some bad news for investors: the company saw soft operating performance, while the Alliance Boots deal discussions are problematic.

Investors stand to receive an update about the potential deal for the 55% remainder stake later this summer.

Investors are furthermore hoping on a tax inversion move, following the potential completion of the deal.

Shares offer appeal if a decent correction might occur in the coming weeks.

Investors in Walgreen (WAG) were not too pleased with the company's third-quarter results, which were a bit soft. Even more worrisome, the company pulled its long-term 2016 targets, citing problematic discussions regarding the acquisition of its remainder 55% stake in Alliance Boots.

I will await the company's update regarding the deal, which is anticipated later this summer, before possibly taking a position in this long-term quality name.

Third-Quarter Headlines

Walgreen reported third-quarter revenues of $19.40 billion, up 5.9% as reported compared to last year. Analysts were looking for revenues to come in at $19.44 billion.

Reported earnings attributable to shareholders came in at $722 million, up by 15.7% as reported.

The company experienced very modest dilution, but reported GAAP earnings of $0.75 per share, which is ten cents more compared to last year.

Non-GAAP earnings came in at $0.91 per share, which is three cents lower than anticipated by analysts.

Looking Into The Operations

Reported sales growth is driven by comparable store sales, which rose by 4.8%. The remainder of the sales was driven by modest store openings totaling 39 on a net basis.

Front-end comparable store sales were up 2.2%, driven by a 2.9% increase in basket size and a 0.7% decline in traffic. Prescription sales rose by 8.4%, driven by comparable store sales growth of 6.3%. The company filled 218 million prescriptions, which is 4.5% more compared to last year, with prescription revenues now making up more than 64% of total sales.

Just like competitor Rite (NYSE:RAD) pointed out last week, Walgreen faced gross margin compression, as well with gross margins being down 40 basis points to 28.1% of sales. Lower reimbursements and fewer brand-to-generic drug conversions, as well as generic drug price inflation squeezed margins from all sides. This is despite purchasing synergies realized from the joint venture with Alliance Boots.

Selling, general and administrative expenses fell by 36 basis points to 23.5% of sales as the company effectively leveraged revenue growth on its cost base. Of interest, equity earnings in Alliance Boots were up by $6 million compared to a year earlier, coming in at $137 million.

As such operating earnings fell by 10 basis points to 5.3% of sales, with operating earnings totaling $1.03 billion. Thanks to a lower effective tax rate of 31.5%, the company managed to boost reported GAAP earnings.

Valuing Walgreen

The drug store operator ended the quarter with $2.13 billion in cash and equivalents. Total debt of $4.53 billion is relatively limited, resulting in a net debt position of just $2.4 billion. Note that the company carriers its Alliance Boots investment at little over $7 billion on its balance sheet, or close to $8 billion including the call option to acquire the remainder of the shares.

Walgreen has been reporting trailing revenues of about $75 billion and earnings of about $2.7 billion. At $72 per share, equity commands a market valuation of $70 billion. This values equity at around 0.9 times sales and 25-26 times annual earnings, which are not cheap multiples.

Walgreen pays a quarterly dividend of $0.315 per share, providing investors with a 1.8% dividend yield.

Update On Alliance Boots

Walgreen stresses that its board is making progress in the consideration of the second step in the Walgreen and Alliance Boots deal. While this is the official talk, the company admits in the press release that discussions are tougher than anticipated: "We are working through complex issues in planning for step two, and we are taking the appropriate time to come to the right resolution for the combined enterprise."

Including in the considerations and talks are topics like a deal structure, cost-savings initiatives and potential capital structures.

Pulling The 2016 Goals

Back in 2012, Walgreen announced an ambitious set of goals for 2016. The disappointing operational performance and slower-than-anticipated progress with Alliance Boots are the two main reasons for the decision.

The company anticipates to make key decisions in July or August regarding the Alliance Boots deal, and will hold a meeting in which it will set new goals and metrics for 2016.

The good news surrounding the partnership with Alliance Boots is that Walgreen expects cost savings of $400 to $450 million this year, $25 million more than previously anticipated. On the other hand, fourth quarter accretion is seen at "just" six to seven cents per share, versus accretion of $0.15 per share in the third quarter.

Sales for the quarter have been soft as well. Reported sales were up by 5.9%. This followed a 8.8% jump in April sales and a 6.0% increase in sales for the month of May. This implies that sales for the month of June have been pretty weak.

Takeaway For Investors

Clearly, investors have reasons to be disappointed, as operating performance was relatively weak, while there is more uncertainty about the Alliance Boots deal and the impact for the long-term targets.

Under the long-term targets, as reiterated in an investor presentation held last year, Walgreen targets $130 billion in revenues by 2016. This is based upon $72.2 billion in Walgreen revenues for 2013, a full consolidation of Boots, which posted revenues of $38.4 billion, and solid operational growth.

This should boost operating earnings to $9.0 to $9.5 billion by 2016, including a billion in anticipated synergies.

In comparison, operating earnings are just half of that at the moment, while the company originally anticipated $11 billion in net debt by 2016, given the purchase of the remainder 55% stake in Alliance Boots.

Takeaway For Investors

Investors have some digesting to do on Tuesday following the two disappointing announcements.

Nothing has fundamentally changed on the growth strategy, with the three main drivers being the well experience, community pharmacy business and global platform. The problem is probably disappointing execution in its core business, while investors were hoping for quick progress on the deal with Alliance Boots, with possibly even the announcement of a tax inversion move.

Just about one and a half weeks ago, I last checked out Walgreen's prospects, as a potential tax inversion move was already creating public backlash. I concluded that a tax-induced move towards Switzerland could save the shareholder some serious cash, probably close to a billion per year. Combined with the anticipated Alliance Boots acquisition and solid growth, this could push net earnings to $7 billion by 2016 under the original plan. Given the company's withdrawal of this outlook, this no longer appears to be the case.

I concluded to be a buyer, irrelevant of the future tax situation of the firm, given the operational growth and the Alliance Boots deal. I did stress that I was not a buyer at all costs, but was hoping and waiting for a significant correction before picking up some shares.

I reiterate the conclusion at the moment, but will await the announcements in July or August containing an update on the deal before making a decision. If the company can reiterate its 2016 targets, I am a buyer on potential dips around $65 per share.

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.

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