1 Strategy That May Allow Walgreen to Surpass CVS and Crush Rite Aid

Source: Wikimedia Commons

On April 14, news broke that a group of investors who control about 5% of Walgreen's (NYSE: WAG  ) shares met in Paris last Friday to discuss the benefits of the business engaging in a tax inversion. By doing this type of transaction, Walgreen could boost its profits by up to 75%; this would make it far more profitable when placed next to Rite Aid (NYSE: RAD  ) and CVS Caremark (NYSE: CVS  ) . In spite of these potential benefits, however, the company has been reluctant to make this change, presumably out of fear of alienating its largest customer base and because of potential political risks.

A tax inversion could mean big bucks!

Source: Alliance Boots

In a nutshell, a tax inversion is made possible when a company decides to merge with, and become a subsidiary of, a foreign company that is headquartered in a country that charges a lower corporate tax rate than the original company's country does. In the case of Walgreen, the tax inversion that investors are pressing management to consider would be made possible by Walgreen becoming a subsidiary of Alliance Boots.

Walgreen purchased a 45% stake in Alliance Boots, a pharmacy and pharmaceutical distribution business, for $6.5 billion in 2012. In addition to getting a stake in the firm, the company received the right to buy the remaining 55% chunk of Alliance Boots for $9.5 billion, split between cash and 144.3 million Walgreen shares. Because of the size of the share swap, Walgreen would likely be eligible to transfer itself from being domiciled in the U.S. to being domiciled in Switzerland.

Based on current estimates, a transfer from the U.S. to Switzerland would decrease the company's tax rate from an estimated 37.5% for its 2014 fiscal year to 20%. Using 2013's pre-tax income of $3.9 billion, Walgreen's bottom line of $2.45 billion would have increased 27% to $3.1 billion, which equates to a net profit margin of 4.3%.

  Walgreen with U.S. Tax Walgreen with Swiss Tax CVS Rite Aid
Net Profit Margin 3.4% 4.3% 3.6% 0.9%

Source: Walgreen, CVS, and Rite Aid

In contrast, both Rite Aid and CVS would fail to measure up to Walgreen's profitability. In its most recent fiscal year, Rite Aid's net profit margin stood at just 0.9%, while CVS's came in at a respectable 3.6%. What this means is that, for every dollar in revenue reported by Rite Aid and CVS, they earned $0.009 and $0.036 in profits, respectively. Meanwhile, Walgreen reported a profit of $0.043.

The deal is attractive for investors, but what about customers?
If completed, the benefits Walgreen's shareholders would receive are undeniable. Because of the higher net profit margin, Walgreen would sport a P/E ratio (again, using 2013's numbers and excluding the profits it will receive from acquiring the rest of Alliance Boots) of 20 compared to its current P/E of 25.6. While this is still more expensive than CVS's 18.9 times earnings, it's far lower than Rite Aid's 31.1 times. Adding in the undisclosed net profit from Alliance Boots will make the company look even cheaper.

  Walgreen with U.S. Tax Walgreen with Swiss Tax CVS Rite Aid
P/E Ratio 25.6 20 18.9 31.1

Source: Yahoo! Finance

However, one of the things holding management back is likely the fallout that could harm business. At the end of its 2013 fiscal year, Walgreen had 8,582 locations in operation. Of these, almost 99% were located in the U.S. with the remaining 1% based in Puerto Rico and Guam.

Even after Walgreen buys up the rest of Alliance Boots, about $72.2 billion of the company's $110 billion in consolidated sales will come from the U.S. As its largest market and at a time when corporate taxes are a major source of debate, Walgreen's management team has to approach any situation involving a tax inversion cautiously, if at all.

Foolish takeaway
Based on the data, it's not hard to see why some investors find the idea of a tax inversion appealing for Walgreen. In addition to creating immediate shareholder value, a deal of this nature would allow the business to capitalize on low taxes in perpetuity.

This could allow the company to expand more rapidly than it already has, and possibly to return some extra cash to shareholders down the road. However, it comes at the risk of being used as a political tool in the U.S. and being negatively affected by customers who find its move to be a slap in the face. For this reason alone, investors would be wise not to base their entire investment thesis on this catalyst. Instead, they should evaluate the long-term performance of the company to determine whether or not an investment makes sense.

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Because of the possibility of the tax inversion, Walgreen shares may soar if management decides to pursue this route.  In the event that such a move is made, the upside seen for shareholders may outweigh the downside.  For this reason alone, there is a chance that Walgreen may be the best stock to hold for 2014 but are there better opportunities awaiting the Foolish investor?

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