Description

Walgreens Boots Alliance (WBA) is well-positioned to benefit from favorable demographics, with an aging population and increasing reliance on pharmaceuticals driving prescription demand, and think that investors are underappreciating the number of initiatives the company is undertaking which should continue to support above-market growth, preserve margins despite significant reimbursement pressures, and improve returns on capital.  

Since 2012, WBA has undertaken a strategy of horizontal integration and vertical partnerships to best position itself in an evolving marketplace. With pharmacy retailers facing margin pressure from a slowing generics wave, reimbursement pressures, and increased usage of restricted networks, WBA horizontally integrated with a leading European pharmacy and wholesale distributor, Alliance Boots (as well as through its pending acquisition of Rite Aid), while also partnering with wholesale distributors and branded pharmaceutical manufacturers to aggressively attack its cost structure, drive procurement savings, and reduce the amount of working capital tied up in its business. Additionally, the company has taken an open network approach to its relationships with the PBM industry – in direct contrast to CVS/Caremark’s approach – in a bid to drive incremental traffic into its stores.

While these preferred network agreements are less advantageous on a per script profit basis and will further pressure pharmacy gross margins, WBA is offsetting this hit by improving the front end of its store to drive higher margin health and beauty product sales. Even absent the mix shift in the front of the store, however, these partnerships make sense to us as the additional volume is returns accretive given the business’s high fixed cost base and limited incremental costs per script. Moreover, we believe the incremental volumes can create a virtuous cycle wherein higher volumes result in better leverage of WBA’s fixed assets and improved bargaining power with suppliers to drive profits higher. These higher profits are then reinvested to improve clinical outcomes and offer more competitive contracts with PBMs, which results in higher share and increased volumes.

The architect of WBA’s strategy is their current CEO, Mr. Stefano Pessina, a legend in the industry and deal-maker extraordinaire who has been on a multi-decade quest to consolidate the industry to help control costs and improve clinical outcomes, while at the same time becoming fabulously wealthy. By constantly staying ahead of the competition, Mr. Pessina has transformed a struggling family pharmacy distribution business in Italy into a $12 billion stake in the largest retail pharmacy company in the world. While Mr. Pessina appears to be relinquishing his day-to-day responsibilities to focus on more strategic endeavors, he shows no signs of slowing at 75. Moreover, since taking over as CEO in 2015, he has replaced legacy WAG executives with core insiders who have been around him for a period of decades, so the bench is deep.

At a recent $81, shares are trading at ~16x NTM EPS, a discount vs. its historical average of ~17.0x since 2005 and the current S&P 500 multiple of ~17x, as a challenging reimbursement environment and scrutiny over industry pricing has weighed on operating results and multiples. Fortunately, WBA took the exact opposite path as CVS, opting to partner with all the major PBMs (rather than owning the PBM outright), which shelters it from the ongoing debates over (1) who is the best owner of the PBM and (2) how much value does a actually PBM provide. While concerns about their ability to close the RAD acquisition are likely to weigh on shares in the interim, the strategic and financial merits of the deal make it worth the wait, in our view. With that said, we expect shares to outperform regardless given their prospects for above market growth and upside potential even absent the RAD deal. We see a reasonable path forward to 15% annual returns from (1) +HSD% EBITDA growth, (2) a 1.7% dividend yield with 41 year track record of dividend increases, (3) debt pay-down (~$5bn annually, equating to ~5% equity value growth), and share repurchases (resuming in 2018 after RAD debt is paid down). 

Company Overview

Walgreens Boots Alliance (WBA) is a global, pharmacy-led health and wellbeing enterprise with sales of ~$117bn. The company is the largest retail pharmacy, health and daily living destination across the U.S. and Europe, and – along with companies through which it has equity investments in – has a presence in more than 25 countries. Combined, WBA has over 13,200 stores in 11 countries and over 390 distribution centers delivering to more than 230,000 pharmacies, doctors, health centers, and hospitals each year in more than 20 countries. WBA was incorporated in 2014 and is the successor to Walgreen Co. (formerly WAG), which traced its roots back to 1909.  

Key brands inlcude Walgreens, Duane Reade, Boots, and Alliance Healthcare, as well as increasingly global health and beauty product brands, such as No7, Botanics, Liz Earle, and Soap & Glory.  The company divides its operations into 3 businesses: (1) Retail Pharmacy USA; (2) Retail Pharmacy International; and (3) Pharmaceutical Wholesale. The Retail Pharmacy USA business (legacy Walgreens), accounts for the majority of sales and profits, while the Retail Pharmacy International business (legacy Boots) enjoys the highest profit margins.

Retail Pharmacy USA: The Retail Pharmacy USA business operates ~8,200 retail stores across all 50 states, Washington D.C., Puerto Rico, and the US Virgin Islands. Its principal brands include Walgreens and Duane Reade. The company is the 2nd largest pharmacy retailer in the U.S., trailing only CVS, with ~75% of the U.S. population living within 5 miles of one of their pharmacy. Roughly 2/3 of the division’s sales are Pharmacy (the sale of prescription drugs and pharmacy-related services), while 1/3 of sales are Retail (sale of healthcare and retail products including non-prescription drugs, beauty, toiletries, and gen. merchandise). In 2016, WBA’s Retail Pharmacy division filled 928.5mn prescriptions (adjusted to 30-day equivalents). Roughly 97% of Pharmacy sales receive reimbursement of some form from MCOs, governmental agencies, PBM companies, and private insurance. Sales from Medicaid plans were ~4% of divisional sales and sales from Medicare Part D plans were ~17% of divisional sales.

Retail Pharmacy International: The Retail Pharmacy International business operates ~4,700 retail stores throughout the United Kingdom, Thailand, Norway, the Republic of Ireland, the Netherlands, Mexico, and Chile. Within the UK, the company is a market leader, operating ~2,500 retail pharmacies, over 600 Optician practices, and over 400 Hearingcare practices, while ~90% of the population lives within 10 minutes of a Boots store. Roughly 1/3 of Boots UK store sales are generated from pharmacy operations, while traditional front store sales account for the remaining 2/3 of sales.  

The division’s retail sales, gross margins, and gross profit dollars are impacted by the competitive nature of the health and beauty category, while its pharmacy sales and profits are impacted by governmental agencies and other third party payors. In the UK (Boots’ largest market), the amount of government funding available for pharmacy services is reviewed and agreed upon with the pharmacy on an annual basis. In FY17, the UK Department of Health has indicated that they plan to implement funding cuts to reduce costs within the NHS (the publicly-funded healthcare system).

Pharmaceutical Wholesale: WBA’s Pharmaceutical Wholesale division operates mainly under the Alliance Healthcare brand and supplies to more than 110,000 pharmacies, doctors, health centers, and hospital each year from 288 distribution centers in 11 countries, primarily in Europe. The company is one of the largest pharmaceutical wholesalers and distributors in Europe, and ranks in the top 3 in many of the countries it operates in. In addition to distribution, the Pharmaceutical Wholesale division provides services to pharmaceutical manufacturers, including pre-wholesale and contract logistics, direct deliveries to pharmacies, and specialized healthcare services, covering clinical homecare, medicine support, dispensing services, medicine preparation, and clinical trial support.

Investment Highlights

(1)Favorable demographic trends support continued industry growth. As the second largest pharmacy operator in the US (largest pro forma for Rite Aid), largest pharmacy operator in the UK, and a leading distributor throughout Europe, WBA is well positioned to benefit from an aging population and rising life expectancy. The 65+ population – historically the cohort which consumes the most pharmaceuticals per day - is expected to exceed 20% of the population in North America and 22% in Europe by 2030 (vs. 15% and 17%, respectively, in 2015). This aging demographic, combined with advances in drug development and an increasing reliance on pharmaceuticals to manage chronic conditions should help drive growth in prescription drug utilization.

(2) Contract wins support above average growth prospects. We expect WBA to outgrow the industry as it captures incremental Rx volumes from recent contract wins beginning in 2017. More broadly, we look favorably on the company’s strategy of partnering with multiple PBMs (rather than owning a PBM outright like CVS does) in order to drive volumes into its stores. While the economics of these deals are likely less advantageous on a per script basis, we believe the incremental script volume will more than offset lower margins needed to win these preferred agreements. Key announcements in 2016 include:

• 90-Day Prescription Partnerships: (1) OptumRx: Announced in March 2016, UNH’s captive PBM, OptumRx, announced that WBA will provide eligible OptumRx members the option to fill 90-day prescriptions at WBA stores at home-delivery copay levels beginning in January 2017. Optum Rx is the third-largest PBM in the market with 64 million members and manages over 1bn prescriptions annually; (2) ESRX: In August 2016, ESRX announced the launch of its Diabetes Care Value Program whereby patients will be able to receive a 90-day supply of diabetes medications from over 10,000 preferred pharmacies across the U.S., including all Walgreens locations, and via ESRX mail order. The announcement is incremental to the two companies’ agreement from 2013; and (3) EnvisionRx: In September 2016, WBA and RAD’s captive PBM, EnvisionRx, announced a 90-day prescription program that gives EnvisionRx members the option to fill 90-day prescriptions at WBA stores for the same price as home delivery. EnvisionRx is a much smaller PBM, processing roughly less than 100mn prescriptions annually.

• Prime Therapeutics Partnership: In August 2016, WBA and Prime (the 5th largest PBM with 21mn members) announced a long-term strategic alliance that makes WBA the only preferred retail pharmacy for Prime’s PBM members. In addition, the two companies intend to combine their central specialty pharmacy and mail services businesses (subject to regulatory approval).

• TRICARE/DoD Pharmacy Network: In October 2016, WBA announced that its retail pharmacies would become part of the TRICARE pharmacy network beginning 12/1/16, displacing CVS in the network. TRICARE is the DoD healthcare program that serves 9.5mn active duty service members, National Guard and Reserve members, retirees, their families, survivors, and certain former spouses worldwide. WBA was previously in the TRICARE network, but was taken off the list of approved pharmacies during its contract dispute with ESRX in 2012.

• UNH: In 2017, UNH will introduce a new low-premium prescription drug plan in collaboration with WBA. The AARP MedicareRx Walgreens PDP plan will include Walgreens and Duane Reade pharmacies in the preferred retail pharmacy network and will include a low $22.50 premium as well as $0 co-pays for tier 1 medicines and $0 deductible for tier 1 and 2 medications purchased at Walgreens and Duane Reade pharmacies.

Altogether, analysts estimate that WBA could add an incremental 25-40mn scripts in FY2017 (and 36-58mn scripts annualized) from recent contract wins / partnerships, which compares to ~930 million prescriptions (30-day adjusted) filled in FY16, providing basis for continued absolute and peer relative same-store volume growth.

(3) Vertical and horizontal integration efforts provide scale to lower costs and improve returns in a market with significant margin pressure. WBA’s pharmacy business is facing significant margin pressure from (1) a slowing of the generic wave and general drug cost inflation, (2) reimbursement pressure driven by an increase in government health plan enrollment coupled with consolidation by commercial payors, and (3) the growth of restricted networks, where pharmacies are required to offer concessions to be included in PBM’s preferred networks. In response to these dynamics, WBA has been active making investments up the supply chain to help offset procurement costs. Since its initial investment in Alliance Boots in June 2012, which reduced costs by driving procurement savings and sharing best practices, WBA has undertaken the follow efforts to improve distribution/leverage scale to lower sourcing costs:

• In October 2012, WAG and Alliance Boots formed a joint venture – the Walgreens Boots Alliance Development (WBAD) JV to control purchasing and help deliver procurement synergies based on the combined companies’ global scale.

• In March 2013, WAG and Alliance Boots announced a 10-year supply agreement with distributor AmerisourceBergen (ABC) whereby ABC will be exclusive distributor of branded pharmaceuticals (WAG previously used CAH), generics (WAG previously self-distributed), and specialty pharmaceuticals (ABC already had this relationship). Starting in 2013, ABC began sourcing generics and branded pharmaceuticals through WBAD to further capitalize on scale benefits and lower procurement costs. In return, WAG received better delivery speeds/quality of service and was able to reduce working capital. WAG also got 7% ownership of ABC with a board seat, and both WAG and AB received warrants to add a combined 16% ownership stake (subsequently exercised).

• In December 2015, WBA announced a 20-year fulfillment agreement with Valeant where WBA is a direct distribution partner for VRX’s dermatology and ophthalmology products. VRX will lower wholesale prices by ~10% and will record sales on a consignment basis, but will be able to offer copay assistance and discounted cash prescriptions on these sales.  WBA will receive a fee for dispensing and for ensuring adherence. VRX will also partner with WBA to distribute 30 branded products – where generics are available – at generic prices. The decline in price is greater than 50% on these products.

In our view, WBA’s efforts to gain scale and drive efficiencies in its supply chain have reduced their internal capital requirements and provided significant cost savings, which has helped preserve margins in a challenging marketplace. Moreover, we believe its focus on lowering costs and expanding market access has the potential to create a virtuous cycle wherein higher volumes result in better leverage of WBA’s fixed assets and improve the company’s bargaining power with suppliers to drive profits higher. These higher profits are then reinvested to improve clinical outcomes and offer more competitive contracts with PBM, which results in higher share and stronger volumes.

(4) WBA is effectively a call option on one of the most effective operators in business today. The architect of WBA’s strategy is their current CEO, Mr. Stefano Pessina. Mr. Pessina is a legend in the industry, having transformed his family’s struggling distribution business in Italy into a $12bn stake in the largest retail pharmacy in the world today through more than 1,500 acquisitions.

• Brief background on Stefano Pessina: Through a dizzying array of investments, partnerships, and acquisitions, Mr. Pessina rolled up the distribution industry - first in Italy and then in France - before moving through the rest of Europe. In 1997, Mr. Pessina entered the big leagues, merging his wholly-owned distribution business (Alliance Sante) with UniChem, one of the U.K.’s largest pharmacy chain and a public company, for ~$500mn in stock (~37% of the combined company). Mr. Pessina initially was not named the CEO, but when the integration ran into challenges, he leveraged his large ownership stake to take over, gaining valuable experience running a retail operation and managing a public company.  In the coming years, he set his sights on Boots, the largest U.K. drugstore chain, ultimately succeeding to engineer a merger of the two companies into Alliance Boots in 2005. As Executive Chairman of AB with ~15% ownership, Mr. Pessina did not sit idly by, opting to join forces with KKR to take the company private in 2007. The company remained private until legacy WAG made its initial investment in 2012.

• Overview of WAG/AB transaction and the events that lead to Pessina becoming CEO: In June 2012, WAG announced that it was investing $6.7bn (~$4bn in cash and 83.4mn shares) to acquire a 45% interest in Alliance Boots, with the option to acquire the remaining 55% after 2.5 years for an additional $5bn in cash plus 144.3mn shares subject to a $31/share price floor. With the initial 45% acquisition by WAG, Pessina converted a portion of his AB ownership into 8% of WAG shares. Notably, WAG was embroiled in a pricing dispute with ESRX that (a) negatively impacted its stock price and (b) likely put them at a disadvantage negotiating with AB [legacy WAG’s first mistake]…  In June 2014, WAG withdrew long-term guidance due to what was later revealed to be a $1bn forecasting error [second mistake]… In August 2014, WAG announced it was purchasing the remaining 55% ownership of Alliance Boots, with WAG CEO Greg Wasson staying on as the CEO of the combined entity. With the full acquisition at the end of 2014, Stefano Pessina increased his ownership in WBA to over 13%.  Notably, however, WAG opted to not conduct a tax inversion and the market reacted poorly. Shares fell 15%+ on the day, and this decision apparently was the last straw for the legacy WAG team… In December 2014, WAG announced its 56-year old CEO was retiring upon completion of the Alliance Boots merger, and Stefano Pessina would be interim CEO until a successor was found. He later was named permanent CEO and went about removing legacy WAG executives and installing his own team.

While Mr. Pessina appears to be relinquishing his day-to-day responsibilities to focus on more strategic endeavors, he shows no signs of slowing at 75. Moreover, since taking over as CEO in 2015, he has replaced legacy WAG executives with loyal insiders who have been around him for a period of decades, so the core business is in good hands. As an investor, we can think of no better outcome than giving arguably the best strategic thinker in the industry with substantial skin in the game more time to plot the best path forward for WBA!

(5) RAD deal looks attractive at multiple levels. WBA’s pending acquisition of Rite Aid (RAD), an all-cash deal valued at ~$14.5bn ($6.50-7/RAD share plus assumption of RAD debt), which equates to roughly 7x EV/LTM EBITDA post-synergies, is an accretive deal that should help the company continue to drive above market earnings growth over the next couple of years as RAD’s operations are integrated and synergies (over $1bn) are realized. While net leverage will increase from ~1.0x currently to ~2.5x pro forma, we expect WBA to de-lever quickly as excess cash flow (estimated at ~$5bn annually) is deployed to pay down debt. Though the deal has not yet closed, the recent extension of the merger timeframe to the end of July and accompanying cut to the deal price (from $9/share prior) increases suggests that both parties are committed to getting the deal done. We see the following benefits if the deal is approved by RAD shareholders and the FTC:

• Additional scale to negotiate with both customers and suppliers. The additional footprint could help WBA negotiate deals with drug manufacturers similar to the VRX deal. Its size also could make it difficult to exclude in PBM’s preferred networks.

• Potential upside to cost synergies. Management has included procurement savings estimates in its synergy estimates, but only from the harmonization of drug prices between the two companies. We ultimately expect RAD stores to switch its distributor relationship from MKC to ABC to drive further purchasing power into the WBAD purchasing organization.

• Potential to improve RAD stores. While admittedly a multi-year opportunity, RAD has significantly underperformed peers CVS and WBA in a variety of metrics. An improvement in store operations towards industry peers would provide significant upside to results.

• PBM optionality. The acquisition of RAD also provides WBA with its own pharmacy benefit management (PBM) business. WBA exited the PBM business in 2011 when it divested its own sub-scale operation, but RAD acquired standalone PBM EnvisionRx from TPG in June 2015 for ~$2.0bn. EnvisionRx is a relatively small player with less than 2% market share, but gives management an option to learn more about the industry and study the synergies of operating a PBM alongside its retail pharmacies or (more likely) another asset to divest.

Valuation. At a recent $81, WBA is trading at ~10x 2017E EV/EBITDA, which compares to its 5-yr average of 9.6x. On a PE basis, WBA is trading at ~16x forward earnings, which compares to its 5-yr average of 16.3x. Broadly, the pharmacy retailers are trading at a premium vs. the rest of the healthcare distribution chain, which we believe is supported by stronger sales growth and margin outlooks coupled with solid returns.

Risk Factors: Key risks relate to (1) Reimbursement Pressure, (2) Merger with RAD is blocked or encounters integration challenges, (3) Beauty rollout in the US, (4) Brexit uncertainty in the UK, and (5) A general weakening demand environment.

• WBA faces reimbursement pressures from public and private payors, and to the extent it is unable to offset these pressures with increased volume and lower costs, margins could be negatively impacted.

• WBA’s acquisition of RAD is still subject to regulatory uncertainty which could negatively impact sentiment. If the deal were to close, the company would continue to face integration risk, though we view this risk as minimal given management’s experience integrating large acquisitions.

• WBA’s rollout of beauty in the US is designed to capture more value from the additional Rx volumes brought into the store and offset some of the gross profit compression from its preferred network strategy. To the extent U.S. consumers do not warm to their new offering, sales and profits could be impacted. Notably, our estimates do not embed much, if any, recovery in front store sales (+1%/+2% comps in 2017/2018, respectively), as we think the initiative is too new and too unproven to effectively model.

• The UK vote to leave the European Union could slow growth or send the region into recession, which would negatively impact the Retail Pharmacy International segment, though pharmacy sales would likely be more resilient than the economy at large.

• A general weakening of demand would impact valuation multiples and limit demand for discretionary demand, though retail pharmacy sales held up well in the last recession (sales grew threw downturn, while profits remained stable).

Scenario Analysis: Key upside/downside scenarios not embedded in our estimates include:

Upside Scenario 1: RAD deal approval is received. We assume integration of remaining RAD stores + synergy realization will ultimately be ~$0.80 accretive = ~$14 of potential upside.

Upside Scenario 2: Potential upside to RAD synergies: Each $100mn of potential upside is $0.06 of accretion = $1 of equity value.

Upside Scenario 3: Improvement in RAD stores to WBA levels. After adjusting for synergies, RAD stores will generate ~$100K less profits than WBA stores. An increase in per store profitability to WBA levels would be ~$0.20 accretive = ~$3.50 of potential upside

Upside Scenario 4: Divestiture of Envision Rx. RAD bought Envision Rx in 2015 for ~$2bn… Assuming it could be sold for a comparable amount would add ~$2 of equity value (depending on tax basis)

Upside Scenario 5: Initiative to drive beauty sales takes hold, improving front of the store mix. We estimate each 1% of gross margin improvement in front store sales = Each 100bps of gross margin improve results in ~$0.16 EPS accretion = $2.50 - $3 of equity value.

Upside Scenario 6: Change in tax rate: Each 100bps change is results in $0.07 - $0.08 of EPS accretion = $1 to $1.50 of equity value.

Downside Scenario 1: Primarily relates to per script profitability compression. For every 20bps of incremental Pharmacy gross margin compression, there is a $0.08 hit to EPS = ~$1.50 hit to equity value. Note – we are embedding an 80bps decline in FY17 and an additional 70bps decline in FY18 despite higher generic mix (typically 2x gross profits with 20x higher margins).

Catalyst

Improving pharmacy volumes, market share gains

A resolution of the RAD transaction