Were You Really Owning Walgreen For A Tax Inversion?

| About: Walgreens Boots (WBA)
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On August 6th Walgreen announced a bevy of news; including acquisition, “tax inversion,” guidance, repurchase and dividend updates.

The “market” hated the news, sending bids for shares down over 17% from Tuesday’s open.

However, this seems to be more “hoopla” than a true concern as none of these events appear particularly troubling from a long-term view.

News comes in waves. At least that's the message Walgreen (WAG) delivered when it recently announced an update regarding the Alliance Boots transaction. Within this announcement, there were at least 5 noteworthy news items to take into consideration: the Walgreen Company will acquire the remaining 55% of Alliance Boots it did not already own, despite rumors to the contrary the company would remain domiciled in the U.S., guidance for fiscal year 2016 was in the $4.25 to $4.60 range, a new $3 Billion share repurchase program had been announced and the board decided to increase the dividend by 7.1%.

So what was the market's reaction? As you saw from above or already know, it wasn't pretty. Shares opened 16% lower on the news - and that's after a nearly 4% decline the previous day.

Yet I would contend that - for long-term investors - this seemingly devastating paper loss isn't quite as distressing as it might seem. (This especially holds true for investors who purchased shares back in the 2008 to 2012 range, but really it's applicable to anyone with a long-term view.)

Let's look over each of the 5 major announcements to get a better idea of what I mean.

We'll start with the headline.

Walgreen exercises option to acquire remaining 55% of Alliance Boots

Although this was probably the most influential announcement to the company's future, it was long anticipated. Walgreen has previously laid out the benefits of partnering with this company to become the worldwide leader in well-being solutions. Due to the transaction's foreseeable future, this likely didn't move the stock much if at all.

New Walgreen Boots Alliance company will be domiciled in the U.S.

This second bit of news, on the other hand, was a bit of shock. It had been rumored that Walgreen would consider a "tax inversion" whereby the company would switch its American tax domicile and pay a lower rate. Instead of paying 35% in the U.S., the company might pay 16% in the U.K., for instance. In general it was thought of as good news if it happened and thus we saw the strong negative market reaction when Walgreen shunned the move.

However, I believe there's a bit more to the story than that. It's a little more involved than saying: "I want to pay this tax rate." In fact, I take solace in the idea that Walgreen management looked into the move. Specifically, they had this to say in the announcement:

"The Company and Board undertook a balanced, rigorous, and extensive analysis of the inversion question."

"The Company and Board looked at the full range of issues, including the potential opportunities and benefits, as well as the risks associated with an inversion, and determined that an inversion was not in the long term best interests of our company and its shareholders."

Among the reasons cited included political, public and IRS uncertainty coupled with the ideas that doing so might not be as beneficial as assumed and the economics of the Alliance Boots deal would have to be restructured.

Whether you agree or disagree, think about the situation. You have a group of people that spend their whole day looking at this stuff - they have more experience and know the company better than anyone else on the planet. Some investors came to them and said: "Hey, why not look into an inversion while you're doing this Alliance Boots deal?" Walgreen management responds: "Ok, we hear you, we'll look into it." Then they come back and say: "We looked into it the inversion idea from every angle and found that it had the potential to be a really big headache and it might not even benefit the shareholders." Who are we to disagree? I didn't spend months of my time looking at the deal - I just read some reports and know that 35% seems larger than 16%.

Plus, you have to consider that management has quite a bit of skin in the game. This amasses close to the tune of 74 million shares or nearly $4.5 billion worth (of course $4.4 billion of that is attributable to Stefano Pessina, but it holds that the remaining insiders have average stakes in the half-a-million dollar range). Sure it's possible that they just didn't want the extra publicity, negative connotation or took pride in paying U.S. taxes, but it's comforting to know that people with larger stakes than I felt this was the best move.

Moreover, an argument could be made that even if the tax inversion was a good deal for Walgreen, it could have been a bad deal for Walgreen shareholders. You see, in a tax inversion deal the U.S. company is technically being acquired - regardless of whether or not it will be the controlling force. As such, this becomes a taxable event. Your old shares are swapped for new ones and the increase over cost would be treated as a capital gain. This would have been especially disconcerting given that shares have doubled in the past 2 years. You would have been forced into facing taxes irrespective of whether or not you had any intention to sell.

Here was the third major announcement:

2016 Guidance = $4.25 to $4.60

In isolation this means nothing. In comparison to estimates in the $5 range it could be perceived as bad news - the market likes to be right and "punishes" the possibility of looking foolish. Additionally, as a long-term investor, certainly you would prefer $5 in earnings over say the mid-point of $4.43 during fiscal year 2016. Yet keep in mind that this isn't exactly catastrophic - it's not like the company is expected to lose money or even make less money in the future.

At a "normal" P/E of around 18 in the last decade or so, this would have represented a future price premium of about 14% to the pre-announcement share price (now closer to 33%). Perhaps more importantly, Walgreen has indicated that the company anticipates paying out 30% to 35% of its profits in the form of dividends. In other words, the company could raise its dividend by 7% in each of the next two years and still remain within its desired payout range.

$3 billion share repurchase program

This 4th announcement is ordinarily perceived as good news: the company intends on rewarding shareholders. However, this announcement also received some scrutiny. Specifically, Moody's placed Walgreen's unsecured rating on review for a downgrade as a result. Moody's indicated this share repurchase program along with the aforementioned guidance as the primary and secondary culprits.

Sure, if Walgreen makes less money and buys back shares instead of repaying debt there could be a problem. But that's where the logic stops. It's not as if a repurchase authorization is an ironclad agreement. Management has discretion in its use of funds. An authorization simply means they have the ability, but not the obligation, to do so. Do you truly believe that Walgreen management would be buying back shares if it thought it couldn't handle its debt load? How would that meeting go? "Well, we said that we would like to buy back shares a couple of years ago and we certainly aren't obligated. Doing so would put the company in danger of defaulting, but a non-promise is a non-promise: order the share buybacks, forget the debt." Investors get that repurchase programs are finicky.

Walgreen management even made this point in their presentation: "Pursue share repurchases with excess capacity." Note that it doesn't say 'with all capacity.' The intention and implication, is that they would only do so when they believed they could handle it. Further, the very next line read: "commitment to solid investment grade credit ratings." Any reaction to a review for a downgrade seems a bit one-sided.

Increased the dividend by 7.1%

Finally, what was missed in all the reports was that Walgreen also announced a dividend increase of 7.1%. This marks the 39th consecutive year that the company has not only paid but also increased its dividend. In my mind this might be the most important bit of information. Certainly for a dividend growth investor with a long-term time horizon, this is what they would be checking in on. Other than the increase not being as high as its massive increases in the recent past, it's hard to argue with receiving more money each year. I'd imagine this had little effect on the share price move.

Interestingly, I would further assert that the news is only noteworthy in that it was a large one-day move. Had you invested at say $30 in 2012 and woken up today to a price of $60, you'd be quite pleased. (Or else upset you hadn't bought more back in 2012 or couldn't buy more at that price today) You would have doubled your paper wealth and collected a nice string of income checks along the way. Looking out a decade or two you'd probably expect more or less of the same (not the quick price performance, but certainly the income boosts and an increasingly profitable business).

In sum, Walgreen recently announced quite a bit of news. As demonstrated by the share price movement, the market absolutely hated the information. If you only owned the company due to the prospect of a tax inversion - well that was a bet that didn't pay off. Yet when you look at it line by line, it doesn't seem all that bad. In fact, for the long-term investor the prospects of the company appear just fine. Let's review. The company told you: it was continuing its efforts to be the world's largest well-being enterprise, wasn't forcing you to pay capital gains, will make more money in the future, would like to reduce the overall share count and is now paying you more money. Perhaps I'm the eternal optimist, but it seems that Walgreen investors need not be altogether concerned.

Disclosure: The author is long WAG. 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.