Walgreens Tumbles On Costly Global Deal
Amid a contract standoff with competitor Express Scripts (ESRX) and sales losses to CVS Caremark (CVS) , Walgreens (WAG), the largest drugstore chain in the U.S., is hitting back after taking a 45% stake in European pharmacy giant Alliance Boots for $6.7 billion, in a cash and stock deal.
For Walgreens, the deal could transform the company into an international pharmacy powerhouse with a top presence in the U.S. and Europe, while giving it a growth and M&A strategy that differs from competitors Express Scripts and CVS Caremark who have scaled their U.S. presence through large deals in recent years.
However, analyst reactions and Walgreens tumbling shares signal that the company has to prove now is the time to invest in an international and European growth push, and that it can offset prospective market share losses in the fast-consolidating U.S. pharmacy industry.
With Alliance Boots, Walgreens will become one of the world’s top drug store and pharmacies with over 11,000 stores in 12 countries, primarily in North America and Europe. For both companies, the deal fills a big strategic need; however, it comes at a big cost.
Walgreens will pay $4 billion in cash and $2.7 billion in its stock for a 45% stake in Alliance Boots and will have the option to buy a remaining 55% stake in Alliance Boots for $9.5 billion in coming years. That prospective $16.2 billion takeover valuation also comes with roughly $11 billion in Alliance Boots debt after its 2007 private equity buyout led by private equity giant KKR (KKR).
Already, Walgreens has lined up $3.5 billion in bridge financing from Goldman Sachs and Bank of America Merrill Lynch to pay for the first leg of the deal.
Faced with a standoff on a $5 billion drug prescriptions contract with Express Scripts, and key customer losses to CVS Caremark, Tuesday’s stake acquisition gives Walgreens a growth plan to counter quarterly sales losses. Meanwhile, Alliance Boots has found an entry into the U.S. after its chairman and part owner Stefano Pessina said that he would look for a “transformational” deal to turn the company from a European powerhouse into an international player.
“In our view, [Walgreens] has taken a bold strategic step with its announced acquisition of a majority stake in Alliance Boots,” wrote UBS analyst Jason DeRise in a Tuesday note to clients.
“We applaud Walgreen management for no longer sitting on its hands from a strategic perspective given the ongoing Express Scripts impasse. Our sense is that investors will now begin to refocus on Walgreen as more of a growth investment opportunity as opposed to trading opportunity around a potential resolution (or lack thereof) to the ESRX dispute.”
The question is whether the timing of Walgreens bold international push and the strategy can add to the company’s earnings, which may be hit by its Express Scripts standoff and customer losses.
“It is not surprising to see Walgreens pursue a substantial investment to mitigate the risk of lost Medco Health Solutions business and its limited opportunity to recover Express Scripts business,” wrote Bank of America Merrill Lynch analyst Robert Willoughby, in a note to clients. However, Willoughby re-iterated an underperform rating on Walgreens and a $26 a shareprice target, citing continued U.S. market share losses to Express Scripts and CVS Caremark.
In a press release, Walgreens said that the deal may add up to 27 cents to its diluted earnings per share after the deal closes, on an expected $150 million in annual cost savings and up to $1 billion in synergies through 2016. The deal is expected to close by the end of September.
Guggenhein Securities analyst John Heinbockel said that Walgreens expected EPS gain “seems reasonable” based on Boots’ earnings and low-cost debt financing for the deal. Nevertheless, in a note to clients, Heinbockel questions the timing of the European expansion and also cautions that the deal may not offset a prospective earnings loss if Express Scripts takes its existing contracts with Medco, after their merger.
“[We] always thought that such expansion efforts would occur further down the line, be relatively modest in scale, and be initially centered on the faster growing Latin American markets,” writes Heinbockel.
Walgreen also said it would increase its quarterly dividend to 27.5 cents per share from 22.5 cents.
In early Tuesday trading, Walgreen shares tumbled over 6% to $29.95, near 52-week lows hit in pre-market trading. The Deerfield, Ill- based company’s shares are off nearly 10% in 2012, underperforming double digit 2012 stock gains by Express Scripts and CVS Caremark.
Separately, Walgreen reported fiscal third quarter earnings per share of 62 cents, meeting street estimates; however, a sales fell 3.4% year-over-year to $17.8 billion, slightly missing estimates. Last month, Nottingham, England -based Alliance Boots reported a 12% increase in annual profit, on growth at its wholesale pharmaceuticals business
In a sense, the deal marks a second attempt to buy Alliance Boots and turn a profit. In 2007, KKR and Alliance Boots Chairman Stefano Pessina took the company private in $12 billion pound buyout that was the largest private equity deal at the time. Since then, KKR says that Alliance Boots profits have surged 88%.
As part of 45% stake acquisition by Walgreen, KKR will receive $2 billion in cash and stock for roughly half of its Alliance Boots stake after it made a $2.45 billion investment in 2007. The private equity giant will also gain a seat on Walgreen’s board.
“We are looking forward to working with Alliance Boots to leverage our combined strengths and provide an even broader range of innovative, cost-effective products and services to patients and customers across the healthcare landscape,” said Walgreens chief executive Gregory Wasson, of Tuesday’s stake acquisition.
“Together we will be ideally positioned to expand our customer offerings in our existing markets and become the health and wellbeing partner of choice in emerging markets.”
That strategy counters other long-speculated options for Walgreens, including a takeover of debt-laden pharmacy and drug store giant Rite Aid (RAD).
In November, Susquehanna Financial Group analyst Joseph Stauff wrote in a note to clients that Rite Aid could be a target of Walgreen, the largest U.S. drugstore chain. With Rite Aid, Walgreen would further bolster its near 30% market share, distancing it from CVS Caremark (CVS), the industry second, noted Stauff.
In March, Credit Suisse analyst Edward Kelly said that a Rite Aid acquisition would help Walgreen push against drugstore competition by pharmacy benefits managers like CVS Caremark and Express Scripts, which completed a $29 billion 2011 acquisition of Medco Health Solutions (MHS).
Tuesday’s deal counters those expectations and Walgreens previous M&A history, as it shifts its strategy internationally. In 2010, Walgreen spent $1.1 billion to buy New York-based drug-store chain Duane Reade from private equity firm Oak Hill Capital and was a bidder for Longs Drug Stores, another U.S. chain that was eventually bought by CVS Caremark.
For more on investing in drug stores and pharmacy giants see why Rite Aid’s earnings overtake deal hopes and why Express Scripts could be sandbagging synergies.