Walgreen (NASDAQ: WBA ) is reportedly considering an acquisition of the remaining 55% stake of Alliance Boots that it doesn't already own. Walgreen purchased a 45% stake in the company back in 2012 for $6.7 billion and now has a six-month option to acquire the rest starting in 2015. Therefore, assuming this deal eventually occurs, as expected, how will it affect Walgreen's investment value, particularly against the likes of Rite Aid (NYSE: RAD ) and CVS Caremark (NYSE: CVS ) ?
Why buy Alliance Boots?
Alliance Boots operates the UK's largest chain of pharmacies; therefore in expanding globally, investors can identify that an acquisition gives Walgreen room for European expansion. Moreover, Alliance Boots is a large company...and fast-growing.
For fiscal 2014, revenue grew 4.3% to $32 billion, and net profit increased 31% to $1.3 billion in part due to cost-synergies associated with the Walgreen ownership. While adding a business of this size would most certainly create further synergies and perhaps boost the investment value of Walgreen, the real value lies in tax rates.
Industrywide margin improvements despite high taxes
The top corporate tax rate in the U.S. sits at 35%, in which all three of the largest pharmacies, Walgreen, CVS, and Rite Aid, are forced to pay. The pharmacy sector in general has historically had among the lowest operating margins of any sector in the market, joined with grocery. However, the patent cliff -- $130 billion of brand drugs lose patent protection between 2011 and 2016 -- has driven margins higher over the last few years.
The reason generics generate higher margins is because the drugs are bought in bulk, saving on logistical costs, and have more flexibility for mark-ups. Specifically, Rite Aid has staged a return to profitability since 2012, including an accumulative operating margin increase of more than 5%, which has consequently driven stock gains of more than 600% since late-2012. Up until recently, Rite Aid had zero revenue growth, and its stock gains were all tied to margins. However, in 2014, its stock gains of 50% have been largely a result of new-found growth, including an April same store sales increase of nearly 5%, putting it on par with CVS and Walgreen.
Nonetheless, these three enormous pharmacies create more than $220 billion in combined annual revenue, are all expected to generate year-over-year growth in the next two years, and pay the highest possible tax rate in the U.S. Currently, Rite Aid's operating margin is about half of its two larger peers; and as more generics are introduced to the market, many believe it has the most to gain as it continues to see bottom-line improvements.
Boots gives Walgreen a clear advantage
However, if Walgreen acquires Alliance Boots for a remaining $9.5 billion, $16.2 billion total, it'll then have the upper hand from an investment perspective. Already, CVS' valuation has come into question, and it has an industry-best 6.5% operating margin, leaving the least amount of room for operational upside. Specifically, CVS's pharmacy gross margin increased just 40 basis points in its last quarter, growing far slower than retail, showing that profits are getting tighter in comparison to the last two years.
Albeit, Rite Aid and Walgreen are largely considered the two companies with the most upside moving forward, and the Boots acquisition may sway sentiment in the latter's favor. If Walgreen acquires the remaining stake in Boots, it'll almost certainly relocate to the U.K., ending a 113-year history as a U.S. company, based in Chicago. Investors might wonder why, and the answer is to capitalize on the U.K.'s 21% tax rate, a luxury that no other pharmacy will have.
To put this in perspective, Walgreen is more than twice the size of Boots in revenue and profits and is by operational standards a more efficient company. Yet, it's estimated that by being in the U.K., Boots profits more than $165 million a year versus being in the U.S., or about a 12% boost to its bottom line.
If we look at Walgreen, think of what a 12% boost to its bottom line could do for the stock along with acquiring another $1.3 billion in profits and $32 billion in revenue from Boots. Essentially, this combination could add substantial value to Walgreen's stock and make it the clear stock to own in the pharmacy space.
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