On Monday June 18th Walgreen Co. (WAG) announced a two-stage transaction to purchase Alliance Boots, a retail and wholesale pharmacy group in Europe, paying $6.6 billion for a 45% equity stake in the company, with an option to purchase of the remainder within the next three years.
Alliance Boots operates as both a retailer and a wholesaler of pharmaceuticals. The retail side trades under the Boots brand and operates retail facilities selling beauty, pharmacy and sundry items primarily in Great Britain although Norway, Ireland, the Netherlands and Thailand are also served. The business closely resembles Walgreen's core business although the stores are typically much smaller and the front-end merchandise more limited and focused on certain categories.
The wholesale business distributes drugs to pharmacies in Germany, France and the U.K. as well as several smaller, primarily European countries. The wholesale pharmacy is somewhat uniquely a European business model because the ownership of pharmacies by corporations is forbidden by law in countries such as Germany and France. While in the U.S., Walgreen and its competitors self-distribute a majority of their pharmaceutical products, in Europe, the individual pharmacies do not have the requisite scale and therefore rely on wholesalers to handle these activities.
Given the existing $11 billion of debt at Alliance Boots, Walgreen's purchase implies a valuation of about 11x EBITDA (£17.5 billion of enterprise value and £1.57 billion of EBITDA). Running Alliance Boots through a residual income valuation model yields a warranted value in the area of 8.5x EBITDA based on stable operating results. In a recent valuation of Walgreen using the same process, it was suggested that fair value was in the region of $40 per share or 7.25x EBITDA; however, Walgreen's current market valuation is under 6x EBITDA. The principle driver of Alliance Boots' warranted EBITDA premium over Walgreen is its tax rate, which is significantly lower, meaning the company keeps more its cash flow.
In order to explain the slightly greater than 2.5x EBITDA premium paid by Walgreen (the difference between the 11x paid and the fair value of 8.5x), we will have to bring synergies to the table. If it is assumed the new combined entity has a warranted EBITDA multiple of a little over 7.5x, then the company would need to generate about $1 billion of long-term synergies to bring the acquisition to fair value. Somewhat amazingly in my view, this is exactly the level of synergies the company is projecting.
Alliance Boots is potentially more attractive from a growth perspective because it has higher returns on capital than Walgreen. According to the model, Alliance Boots generates an IRR of about 11.1% compared with Walgreen's 8.6%. While a company needs actual growth to take advantage of its returns on capital, should it grow, it will receive greater economic benefits because every dollar invested in growth generates more dollars returned to shareholders.
As a counterbalance to higher returns on capital, it should be noted that Alliance Boots operates in economically regulated markets. Especially in the wholesale business, regulators actively determine industry margins. To the extent the company's growth increases margins and industry concentration, regulators could remove some of the benefits from Alliance Boots of that growth. This is not in any way just a hypothetical concern as in the last year both France and Germany have instituted measures that have impacted gross margins causing an actual revenue decline in France for Alliance Boots. The impact in Germany is more difficult to understand because Alliance Boots made a large acquisition there recently and the financial reporting is light on detail.
Even with the somewhat better underlying return profile of the business, it is surprising that Walgreen was forced to essentially pay for all the proposed synergies. In a typical deal, the acquirer will be able to keep some of the value from synergies for itself instead of paying all of them. Management has intimated that there is more on the table than just the initial $1 billion, but the larger the numbers get the more difficult it is to risk-adjust; surely, the next $1 billion will be much harder than the first. The two-part deal structure is a small counterbalance, but does not change the fact that Walgreen will ultimately be paying for all the proposed synergies.
This is probably the aspect that has investors most concerned in that it shows management is perhaps not especially savvy when it comes to negotiation and capital allocation. Given the way the Express scripts (ESRX) affair turned out this seems to be a developing pattern, not to mention a number of other capital allocation decisions that have seemed questionable; for example, the purchase of drugstore.com for what is likely an astronomical multiple and the sale of the company's PBM business, which removed a potentially significant strategic lever from Walgreen's arsenal.
The current management team of Walgreen has only been in place a few years and in a very short period of time has engaged in a number of transactions. The current CEO, Gregory Wasson, is a pharmacist by training and has worked at Walgreen for essentially his entire career. While he did run the company's PBM for many years, an interesting fact in and of itself, and was the COO for a period of time it is not completely clear that an individual with such a background would have the right set of capital allocation skills for a company of Walgreen's size and complexity. On the other hand, the role of Chairman and CEO are split meaning there is significant oversight concerning his capital decisions.
Adding some fuel to the fire, the CFO, Wade Miquelon, has had his share of personal issues recently, although admittedly his ability to legally drive himself to work does not directly pertain to his ability to complete multi-billion dollar transactions in the best interests of shareholders.
Considering management further, Walgreen gains a shrewd, influential and economically motivated board member in the form of Stefano Pessina. Walgreen management could certainly benefit from his business acumen and it is possible he serves as a bridge to better managing PBM relationships. Given the way the economics have flowed from Walgreen to Alliance Boots and Mr Pessina in this transaction, it is almost as if Alliance Boots is the ultimate controlling party here. It will be interesting to see how the relationship develops over time between these two individuals.
Turning back to valuation, while we have made some sense of the multiple paid on current earnings, there is some worry about future operating results not remaining stable due to the economic situation in Europe and recent reports of weak operating results. Leaving Europe's future for others to debate, recent reports suggest Alliance Boots' business is slowing. Most importantly:
"Total sales were down 3.4% to USD27.8bn, and adjusted EBITDA down 7.7% to USD1.2bn, for its third financial quarter for 2012.
Total comparable store sales dropped 6.6%, on declines of 9.9% in the pharmacy business."
The article in question is likely quoting figures available to holders of Alliance Boots' syndicated loans, which is nominally public information, but is not widely distributed. In evaluating yearly financial trends from the company's annual reports it appears the company has performed well year-over-year making the above quote somewhat difficult to interpret. Greater clarity from Walgreen on recent operating trends at Alliance Boots would be helpful in this regard.
Another concern is the amount of debt Walgreen needs to take on in order to buy the Alliance Boots equity. The ramp up in debt will leave Walgreen a triple-B rated company compared with its single-A rating prior to the deal. In a small way, there is a silver lining to this as it will likely prohibit the Walgreen management team from continuing to make acquisitions that stray away from its core business.
Having spent a considerable amount of time working through this deal, a mixed picture has emerged in my mind. On a financial level, some sense can be made of the multiple paid and there is a good chance that it will at least turn out to be value neutral over the medium term. On the positive side, this will allow the combined organization and current Walgreen shareholders to at least gain all the long-term benefits of scale and market position. In addition, as highlighted in detail above, my view is that having Mr. Pessina involved will be a tremendous asset to Walgreen shareholders.
However, there are ultimately three issues with the transaction that are problematic. First, management clearly paid a steep price. While valuation was not completely insensible, it would have been far preferable to have derived some economic benefit in the short- to medium-term from the synergies, instead all this value was paid to Alliance Boots. Because of this fact and taking into consideration the outcome of Express scripts, it starts to call management's capabilities into question. Second, Walgreen is no longer a domestic U.S.-focused healthcare company. There is no getting around the fact that now Walgreen is subject not only to market conditions in Europe, but also substantial regulatory risk from foreign jurisdictions that are much more difficult for U.S. investors to understand. Third, Walgreen has substantially increased its leverage making its equity a riskier proposition. The conclusion is that even if the deal makes some financial and strategic sense, it is unclear whether the company remains a good investment.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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