Investors, Analysts Wary of Walgreen’s Push Into Europe with Boots Deal
The effort by Walgreen to build a global pharmaceutical retailing brand with its two-stage purchase of Alliance Boots was met with skepticism by financial markets; why make a push into Europe now?
At first sight, the decision by Walgreen Co. (WAG.N) to spend $6.7 billion to acquire half of Alliance Boots GmbH, the privately-held company that owns the iconic British drug store chain, Boots, appears intriguing and potentially transformative. In the United States, the Walgreen stores offer run-of-the-mill merchandise and discount store brands of everything from tissues to drinks. In the United Kingdom and more recently elsewhere in Europe, Boots has become an upscale vendor of its own higher-margin health and beauty products, a status that so far has eluded the Walgreen stores. Perhaps some of that brand magic could spill over onto Walgreen?
There also are some more fundamental reasons why Walgreen may have decided it was a good idea to pay up for the stake in Alliance Boots. A dispute with Express Script Holdings (ESRX.O) over the terms of a contract has meant that millions of customers have been forced to abandon Walgreen and fill their prescriptions elsewhere. That has contributed to a flattening in same-store sales trends. In June 2011, pharmacy SSS grew 4.9% over year-earlier levels; this month, pharmacy SSS are expected to plunge 10%. Storewide, same-stores sales grew 4.8% in June 2011 over levels reported in June 2010, but this month analysts surveyed by Thomson Reuters expect Walgreen to post a decline in SSS for the sixth month running, of about 7.1%. Meanwhile, Alliance Boots reported its revenue grew 15.1% in its last fiscal year, while profits also expanded at an only slighter slower pace.
The concept of turning Walgreen and Boots into a global behemoth (you can buy sunscreen at a Boots in Thailand, or aspirin at a Turkish outlet) that will become the single largest purchaser of generic drugs has some allure. Still, the synergies and possible cost savings didn’t seem to appeal much to investors or analysts at first glance yesterday. The share price went on a wild ride, down nearly 10% at one point in the trading day, before ending at $29.21, down 2.92%; in trading today, it has recovered some of that ground, rising 10 cents to $29.31 a share. Still, it is hard to find anyone on Wall Street with a good word to say for Walgreen and its strategic initiative: some analysts cut their ratings on the stock, while even those who stood pat were skeptical of the transaction. One frequently heard refrain: Why pay a premium price for exposure to the European market and its beleaguered consumers? Diversification, one noted, comes with a price tag – and a lot of execution risk. Moreover, Walgreen’s willingness to pay what could end up being a total price of $27 billion (including the assumption of debt on Alliance Boots’s balance sheet) for the entire company raised questions among analysts. What does it say about the company’s outlook for its core U.S. pharmacy retailing business? While some analysts admit that the transaction may contribute value in the long term, one even dubbed it a “drastic” step.
The good news for investors is that Walgreen’s stock price looks cheap in both absolute and relative terms according to two key StarMine proprietary models, the StarMine Intrinsic Valuation Model (IV) and the StarMine Relative Valuation Model (RV). The IV model identifies systematic biases in longer term analysts’ earnings forecasts and leverages these to deliver SmartGrowth earnings projections, which in turn are used in the intrinsic value calculations: the model finally rates companies on a scale of 1-100, with 100 assigned to the cheapest stocks. Walgreen scores 79 on the StarMine IV model, indicating that it may be undervalued. It does slightly better on the RV model, with a score of 80; this metric combines information from six valuation ratios as well as share buyback activity in a single comprehensive measure of the stock in question relative to others in the region.
Stocks can remain cheap or undervalued for long periods of time, however, and for now, those readings don’t seem to be enough to convince investors that the company wasn’t making a costly strategic blunder, or to offset the sense on the part of analysts that the underlying headwinds for Walgreen in the U.S. market might not be more serious than originally supposed. Even the bankers weren’t happy, as this Thomson Reuters BreakingViews analysis makes clear. None of the bankers who financed the large-scale buyout of Books back in 2007 were invited by that company to advise it on this transaction. (The honor was given to one of the new boutiques that has sprung up on Wall Street in recent years, Centerview Partners.) As BreakingViews reports, big merger deals have been thin on the ground in Europe of late, so the snub is significant. But what is more crucial is whether this oddly-timed transaction turns out to be profitable for Walgreen’s shareholders. Can it reverse the trend toward flat operating profit margins and falling returns on net operating assets? If so, Walgreen’s executive team will be hailed for their prescience and knack for risk taking; if the gamble doesn’t pay off, however, the pain Walgreen’s shareholders already have suffered may simply worsen in the coming months and years.