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Walgreen Co. Investors in the Driver’s Seat; Upgrading to Overweight Walgreens’ management and Board appear toLink to Barclays Live for interactive charting U.S. Food & Drug Retailing Meredith Adler, CFA 1.212.526.7146 meredith.adler@barclays.com BCI, New York Sean Kras 1.212.526.1057 sean.kras@barclays.com BCI, New York U.S. Health Care Distribution & Technology Eric Percher +1 212 526 5496 eric.percher@barclays.com BCI, New York Onusa Chantanapongwanij, M.D. +1 212 526 6166 onusa.chantanapongwanij@barclays.com BCI, New York Investors should consider this report as only a single factor in making their investment decision. PLEASE SEE ANALYST CERTIFICATION(S) AND IMPORTANT DISCLOSURES BEGINNING ON PAGE 48. " id="pdf-obj-0-2" src="pdf-obj-0-2.jpg">

Walgreen Co.

Investors in the Driver’s Seat; Upgrading to Overweight

Walgreens’ management and Board appear to have begun to internalize the

constructive criticisms of increasingly vocal shareholders. We believe the Board is actively considering changes that could materially boost earnings and the stock price. Potential initiatives include reducing expenses and optimizing the capital structure, which can be implemented at any time, as well as inverting the existing corporate structure to achieve tax savings, which is a more complicated undertaking. We are upgrading Walgreens to Overweight from Equal Weight and increasing our price target to $92 (ex-inversion) from $56, representing a 26% increase from the June 16 close.

We believe investors are in the driver’s seat and see a near-term catalyst for WAG

shares. Our review of Walgreens’ bylaws suggests that shareholders can replace the board relatively quickly if it appears that value-creating steps are not being planned. Proposals addressing shareholder-friendly actions may be included in the proxy filing for Phase 2 of the Alliance Boots transaction in late summer or early fall of this year.

Our model suggests incremental opportunities will drive earnings in excess of FY16

consensus, even assuming conservative core growth and excluding inversion. We believe cost reduction initiatives and adoption of a more balanced capital structure could drive FY16 EPS of $5.51, 11% above the consensus estimate of $4.97, even

before accounting for potential FY16 inversion accretion of $0.99.

We expect considerable upside as WAG identifies and executes against the opportunities we have cataloged, despite the strong run the shares have had in anticipation of change (WAG +46% over the last 12-months vs. the S&P 500 +19%).

Our price target of $92 represents a 15x multiple on our FY18E EPS of $7.79, discounted back three years at Walgreens’ cost of equity (9%). If WAG achieves inversion, we project FY18 EPS of $9.05, implying upside to $108 (acknowledging that

inversion will likely cause domestic Walgreens shareholders to incur capital gains).

WAG: Quarterly and Annual EPS (USD)

 

2013

2014

2015

Change y/y

FY Aug

Actual

Old

New

Cons

Old

New

Cons

2014

2015

Q1

0.55A

0.63A

0.63A

0.72A

N/A

N/A

0.85E

15%

N/A

Q2

0.91A

0.91A

0.91A

0.91A

N/A

N/A

1.06E

0%

N/A

Q3

0.77A

0.91E

0.93E

0.94E

N/A

N/A

1.04E

21%

N/A

Q4

0.71A

0.85E

0.87E

0.86E

N/A

N/A

0.99E

23%

N/A

Year

2.93A

3.31E

3.35E

3.44E

3.95E

4.23E

3.92E

14%

26%

P/E

25.0

21.9

 

17.3

 

Source: Barclays Research. Consensus numbers are from Thomson Reuters

Barclays Capital Inc. and/or one of its affiliates does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report.

Equity Research

Consumer | U.S. Food & Drug Retailing 18 June 2014

Stock Rating

OVERWEIGHT

from Equal Weight

Industry View

NEUTRAL

Unchanged

Price Target

USD 92.00

raised 64% from USD 56.00

Price (16-Jun-2014)

USD 73.29

Potential Upside/Downside

+26%

Tickers

WAG

Market Cap (USD mn)

69943

Shares Outstanding (mn)

954.33

Free Float (%)

92.27

  • 52 Wk Avg Daily Volume (mn)

5.9

Dividend Yield (%)

1.7

Return on Equity TTM (%)

13.73

Current BVPS (USD)

21.78

Source: Thomson Reuters

Price Performance

Exchange-NYSE

  • 52 Week range

USD 75.84-43.31

Walgreen Co. Investors in the Driver’s Seat; Upgrading to Overweight Walgreens’ management and Board appear toLink to Barclays Live for interactive charting U.S. Food & Drug Retailing Meredith Adler, CFA 1.212.526.7146 meredith.adler@barclays.com BCI, New York Sean Kras 1.212.526.1057 sean.kras@barclays.com BCI, New York U.S. Health Care Distribution & Technology Eric Percher +1 212 526 5496 eric.percher@barclays.com BCI, New York Onusa Chantanapongwanij, M.D. +1 212 526 6166 onusa.chantanapongwanij@barclays.com BCI, New York Investors should consider this report as only a single factor in making their investment decision. PLEASE SEE ANALYST CERTIFICATION(S) AND IMPORTANT DISCLOSURES BEGINNING ON PAGE 48. " id="pdf-obj-0-384" src="pdf-obj-0-384.jpg">

U.S. Food & Drug Retailing

Meredith Adler, CFA

1.212.526.7146

meredith.adler@barclays.com BCI, New York

Sean Kras

1.212.526.1057

sean.kras@barclays.com BCI, New York

U.S. Health Care Distribution & Technology

Eric Percher

+1 212 526 5496 eric.percher@barclays.com BCI, New York

Onusa Chantanapongwanij, M.D. +1 212 526 6166 onusa.chantanapongwanij@barclays.com BCI, New York

Investors should consider this report as only a single factor in making their investment decision. PLEASE SEE ANALYST CERTIFICATION(S) AND IMPORTANT DISCLOSURES BEGINNING ON PAGE 48.

Barclays | Walgreen Co.

U.S. Food & Drug Retailing

Industry View: NEUTRAL

Walgreen Co. (WAG)

Stock Rating: OVERWEIGHT

Income statement ($mn)

2013A

2014E

2015E

2016E

CAGR

Price (16-Jun-2014)

 

USD 73.29

Revenue

72,217

5,331

4,048

3,849

2,437

2.93

955.2

1.10

76,146

79,121

125,224

20.1%

Price Target

USD 92.00

EBITDA (adj)

6,011

7,262

10,847

26.7%

Why Overweight? We expect WAG's management to

EBIT (adj)

4,683

5,867

8,393

27.5%

take steps that will boost the earnings power and

Pre-tax income (adj)

4,413

5,724

7,339

24.0%

value of the company, including cutting expenses,

Net income (adj)

2,707

3,546

4,783

25.2%

leveraging owned generic brands, and optimizing the

EPS (adj) ($)

3.35

4.23

5.51

23.4%

capital structure. In addition, the combination with

Diluted shares (mn)

963.1

963.1

967.5

0.4%

Alliance Boots and the partnership with

AmerisourceBergen give the company greater buying

DPS ($)

1.26

1.36

1.73

16.3%

clout and new avenues of growth.

Margin and return data

Average

Upside case

USD 108.00

     

EBITDA (adj) margin (%) EBIT (adj) margin (%) Pre-tax (adj) margin (%)

7.4

5.6

5.3

3.4

10.1

13.4

9.5

7.9

6.1

5.8

9.2

7.4

7.2

8.7

6.7

5.9

8.3

6.5

6.1

If a tax inversion can be implemented, WAG's EPS will

be higher and even at the same multiple, the stock

could increase. Our upside case represents 15x our

Net (adj) margin (%)

3.6

4.5

3.8

3.8

adj. cash FY18 EPS forecast of $9.05, discounted back

ROIC (%)

10.9

13.3

12.5

11.7

to FY15 at the 9.2% cost of equity.

 

ROE (%)

14.2

16.7

21.0

16.3

ROA (lease adjusted) (%)

9.8

10.7

8.8

9.7

Downside case

 

USD 60.00

Balance sheet and cash flow ($mn)

CAGR

If various initiatives are not implemented smoothly or the external environment deteriotes, EPS will be

Tangible fixed assets

12,138

2,410

2,106

35,481

5,047

16,027

2,941

19,454

667

4,301

1,212

3,089

12,271

16,137

15,514

8.5%

lower. Our downside scenario represents 14.0x our

Intangible fixed assets

2,455

10,225

10,225

61.9%

adjusted cash FY16 EPS forecast of $4.65, discounted back one year at a 9.2% cost of equity.

Cash and equivalents

2,568

1,952

3,099

13.7%

Total assets

38,020

69,374

71,192

26.1%

Short and long-term debt

4,516

14,168

25,760

72.2%

Upside/Downside scenarios

Upside/Downside scenarios

Total liabilities

16,386

36,124

48,469

44.6%

Net debt/(funds)

1,948

12,215

22,661

97.5%

Shareholders' equity

21,633

33,250

22,723

5.3%

Change in working capital

357

-52

-67

N/A

Cash flow from operations

3,855

4,502

7,267

19.1%

Capital expenditure

1,391

1,424

1,833

14.8%

Free cash flow

2,464

3,078

5,435

20.7%

Valuation and leverage metrics

Average

P/E (adj) (x)

25.0

13.8

4.3

1.0

3.6

1.5

3.1

 
  • 21.9 19.4

17.3

13.3

EV/EBITDA (adj) (x)

  • 12.1 11.5

11.4

8.6

Equity FCF yield (%)

  • 4.0 24.1

    • 5.1 9.3

P/Sales (x)

  • 0.9 0.6

    • 0.9 0.8

P/BV (x) Dividend yield (%)

  • 3.3 3.1

    • 2.1 3.0

  • 1.7 1.9

2.4

Adj debt/EBITDAR (x)

  • 1.9 POINT® Quantitative Equity Scores
    3.1

3.7

  • 2.8 3.2

 

Selected operating metrics

Average

Same store sales growth (%) Square footage growth (%) Inventory growth (%) Capex/sales (%) -0.7 4.7
Same store sales growth (%)
Square footage growth (%)
Inventory growth (%)
Capex/sales (%)
-0.7
4.7 3.6
3.3 2.7
2.4
0.8 0.9
0.9 1.2
-2.6
5.4 12.8
44.7
3.9
1.7
1.8 1.7
1.8
1.5
 

Value

Value Quality Sentiment

Quality

Value Quality Sentiment

Sentiment

Selected operating metrics Average Same store sales growth (%) Square footage growth (%) Inventory growth (%)
Selected operating metrics Average Same store sales growth (%) Square footage growth (%) Inventory growth (%)
Selected operating metrics Average Same store sales growth (%) Square footage growth (%) Inventory growth (%)
Selected operating metrics Average Same store sales growth (%) Square footage growth (%) Inventory growth (%)
Selected operating metrics Average Same store sales growth (%) Square footage growth (%) Inventory growth (%)
U.S. Food & Drug Retailing Industry View: NEUTRAL <a href= Stock Rating: OVERWEIGHT Income statement ($mn) 2013 A 2014E 2015E 2 016E CAGR Price (16-Jun-2014) USD 73.29 Revenue 72,217 5,331 4,048 3,849 2,437 2.93 955.2 1.10 76,146 79,121 125,224 20.1% Price Target USD 92.00 EBITDA (adj) 6,011 7,262 10,847 26.7% Why Overweight? We expect WAG's management to EBIT (adj) 4,683 5,867 8,393 27.5% take steps that will boost the earnings power and Pre-tax income (adj) 4,413 5,724 7,339 24.0% value of the company, including cutting expenses, Net income (adj) 2,707 3,546 4,783 25.2% leveraging owned generic brands, and optimizing the EPS (adj) ($) 3.35 4.23 5.51 23.4% capital structure. In addition, the combination with Diluted shares (mn) 963.1 963.1 967.5 0.4% Alliance Boots and the partnership with AmerisourceBergen give the company greater buying DPS ($) 1.26 1.36 1.73 16.3% clout and new avenues of growth. Margin and return data Average Upside case USD 108.00 EBITDA (adj) margin (%) EBIT (adj) margin (%) Pre-tax (adj) margin (%) 7.4 5.6 5.3 3.4 10.1 13.4 9.5 7.9 6.1 5.8 9.2 7.4 7.2 8.7 6.7 5.9 8.3 6.5 6.1 If a tax inversion can be implemented, WAG's EPS will be higher and even at the same multiple, the stock could increase. Our upside case represents 15x our Net (adj) margin (%) 3.6 4.5 3.8 3.8 adj. cash FY18 EPS forecast of $9.05, discounted back ROIC (%) 10.9 13.3 12.5 11.7 to FY15 at the 9.2% cost of equity. ROE (%) 14.2 16.7 21.0 16.3 ROA (lease adjusted) (%) 9.8 10.7 8.8 9.7 Downside case USD 60.00 Balance sheet and cash flow ($mn) CAGR If various initiatives are not implemented smoothly or the external environment deteriotes, EPS will be Tangible fixed assets 12,138 2,410 2,106 35,481 5,047 16,027 2,941 19,454 667 4,301 1,212 3,089 12,271 16,137 15,514 8.5% lower. Our downside scenario represents 14.0x our Intangible fixed assets 2,455 10,225 10,225 61.9% adjusted cash FY16 EPS fore cast of $4.65, discounted back one year at a 9.2% cost of equity. Cash and equivalents 2,568 1,952 3,099 13.7% Total assets 38,020 69,374 71,192 26.1% Short and long-term debt 4,516 14,168 25,760 72.2% Upside/Downside scenarios Total liabilities 16,386 36,124 48,469 44.6% Net debt/(funds) 1,948 12,215 22,661 97.5% Shareholders' equity 21,633 33,250 22,723 5.3% Change in working capital 357 -52 -67 N/A Cash flow from operations 3,855 4,502 7,267 19.1% Capital expenditure 1,391 1,424 1,833 14.8% Free cash flow 2,464 3,078 5,435 20.7% Valuation and leverage metrics Average P/E (adj) (x) 25.0 13.8 4.3 1.0 3.6 1.5 3.1 21.9 19.4 17.3 13.3 EV/EBITDA (adj) (x) 12.1 11.5 11.4 8.6 Equity FCF yield (%) 4.0 24.1 5.1 9.3 P/Sales (x) 0.9 0.6 0.9 0.8 P/BV (x) Dividend yield (%) 3.3 3.1 2.1 3.0 1.7 1.9 2.4 Adj debt/EBITDAR (x) 1.9 POINT® Quantitative Equity Scores 3.1 3.7 2.8 3.2 Selected operating metrics Average Same store sales growth (%) Square footage growth (%) Inventory growth (%) Capex/sales (%) -0.7 4.7 3.6 3.3 2.7 2.4 0.8 0.9 0.9 1.2 -2.6 5.4 12.8 44.7 3.9 1.7 1.8 1.7 1.8 1.5 Value Quality Sentiment Low High Source: POINT®. The scores are valid as of the date of this report and are independent of the fundamental analysts' views. To view the latest scores, please go to the equity company page on Barclays Live. " id="pdf-obj-1-642" src="pdf-obj-1-642.jpg">
U.S. Food & Drug Retailing Industry View: NEUTRAL <a href= Stock Rating: OVERWEIGHT Income statement ($mn) 2013 A 2014E 2015E 2 016E CAGR Price (16-Jun-2014) USD 73.29 Revenue 72,217 5,331 4,048 3,849 2,437 2.93 955.2 1.10 76,146 79,121 125,224 20.1% Price Target USD 92.00 EBITDA (adj) 6,011 7,262 10,847 26.7% Why Overweight? We expect WAG's management to EBIT (adj) 4,683 5,867 8,393 27.5% take steps that will boost the earnings power and Pre-tax income (adj) 4,413 5,724 7,339 24.0% value of the company, including cutting expenses, Net income (adj) 2,707 3,546 4,783 25.2% leveraging owned generic brands, and optimizing the EPS (adj) ($) 3.35 4.23 5.51 23.4% capital structure. In addition, the combination with Diluted shares (mn) 963.1 963.1 967.5 0.4% Alliance Boots and the partnership with AmerisourceBergen give the company greater buying DPS ($) 1.26 1.36 1.73 16.3% clout and new avenues of growth. Margin and return data Average Upside case USD 108.00 EBITDA (adj) margin (%) EBIT (adj) margin (%) Pre-tax (adj) margin (%) 7.4 5.6 5.3 3.4 10.1 13.4 9.5 7.9 6.1 5.8 9.2 7.4 7.2 8.7 6.7 5.9 8.3 6.5 6.1 If a tax inversion can be implemented, WAG's EPS will be higher and even at the same multiple, the stock could increase. Our upside case represents 15x our Net (adj) margin (%) 3.6 4.5 3.8 3.8 adj. cash FY18 EPS forecast of $9.05, discounted back ROIC (%) 10.9 13.3 12.5 11.7 to FY15 at the 9.2% cost of equity. ROE (%) 14.2 16.7 21.0 16.3 ROA (lease adjusted) (%) 9.8 10.7 8.8 9.7 Downside case USD 60.00 Balance sheet and cash flow ($mn) CAGR If various initiatives are not implemented smoothly or the external environment deteriotes, EPS will be Tangible fixed assets 12,138 2,410 2,106 35,481 5,047 16,027 2,941 19,454 667 4,301 1,212 3,089 12,271 16,137 15,514 8.5% lower. Our downside scenario represents 14.0x our Intangible fixed assets 2,455 10,225 10,225 61.9% adjusted cash FY16 EPS fore cast of $4.65, discounted back one year at a 9.2% cost of equity. Cash and equivalents 2,568 1,952 3,099 13.7% Total assets 38,020 69,374 71,192 26.1% Short and long-term debt 4,516 14,168 25,760 72.2% Upside/Downside scenarios Total liabilities 16,386 36,124 48,469 44.6% Net debt/(funds) 1,948 12,215 22,661 97.5% Shareholders' equity 21,633 33,250 22,723 5.3% Change in working capital 357 -52 -67 N/A Cash flow from operations 3,855 4,502 7,267 19.1% Capital expenditure 1,391 1,424 1,833 14.8% Free cash flow 2,464 3,078 5,435 20.7% Valuation and leverage metrics Average P/E (adj) (x) 25.0 13.8 4.3 1.0 3.6 1.5 3.1 21.9 19.4 17.3 13.3 EV/EBITDA (adj) (x) 12.1 11.5 11.4 8.6 Equity FCF yield (%) 4.0 24.1 5.1 9.3 P/Sales (x) 0.9 0.6 0.9 0.8 P/BV (x) Dividend yield (%) 3.3 3.1 2.1 3.0 1.7 1.9 2.4 Adj debt/EBITDAR (x) 1.9 POINT® Quantitative Equity Scores 3.1 3.7 2.8 3.2 Selected operating metrics Average Same store sales growth (%) Square footage growth (%) Inventory growth (%) Capex/sales (%) -0.7 4.7 3.6 3.3 2.7 2.4 0.8 0.9 0.9 1.2 -2.6 5.4 12.8 44.7 3.9 1.7 1.8 1.7 1.8 1.5 Value Quality Sentiment Low High Source: POINT®. The scores are valid as of the date of this report and are independent of the fundamental analysts' views. To view the latest scores, please go to the equity company page on Barclays Live. " id="pdf-obj-1-645" src="pdf-obj-1-645.jpg">
U.S. Food & Drug Retailing Industry View: NEUTRAL <a href= Stock Rating: OVERWEIGHT Income statement ($mn) 2013 A 2014E 2015E 2 016E CAGR Price (16-Jun-2014) USD 73.29 Revenue 72,217 5,331 4,048 3,849 2,437 2.93 955.2 1.10 76,146 79,121 125,224 20.1% Price Target USD 92.00 EBITDA (adj) 6,011 7,262 10,847 26.7% Why Overweight? We expect WAG's management to EBIT (adj) 4,683 5,867 8,393 27.5% take steps that will boost the earnings power and Pre-tax income (adj) 4,413 5,724 7,339 24.0% value of the company, including cutting expenses, Net income (adj) 2,707 3,546 4,783 25.2% leveraging owned generic brands, and optimizing the EPS (adj) ($) 3.35 4.23 5.51 23.4% capital structure. In addition, the combination with Diluted shares (mn) 963.1 963.1 967.5 0.4% Alliance Boots and the partnership with AmerisourceBergen give the company greater buying DPS ($) 1.26 1.36 1.73 16.3% clout and new avenues of growth. Margin and return data Average Upside case USD 108.00 EBITDA (adj) margin (%) EBIT (adj) margin (%) Pre-tax (adj) margin (%) 7.4 5.6 5.3 3.4 10.1 13.4 9.5 7.9 6.1 5.8 9.2 7.4 7.2 8.7 6.7 5.9 8.3 6.5 6.1 If a tax inversion can be implemented, WAG's EPS will be higher and even at the same multiple, the stock could increase. Our upside case represents 15x our Net (adj) margin (%) 3.6 4.5 3.8 3.8 adj. cash FY18 EPS forecast of $9.05, discounted back ROIC (%) 10.9 13.3 12.5 11.7 to FY15 at the 9.2% cost of equity. ROE (%) 14.2 16.7 21.0 16.3 ROA (lease adjusted) (%) 9.8 10.7 8.8 9.7 Downside case USD 60.00 Balance sheet and cash flow ($mn) CAGR If various initiatives are not implemented smoothly or the external environment deteriotes, EPS will be Tangible fixed assets 12,138 2,410 2,106 35,481 5,047 16,027 2,941 19,454 667 4,301 1,212 3,089 12,271 16,137 15,514 8.5% lower. Our downside scenario represents 14.0x our Intangible fixed assets 2,455 10,225 10,225 61.9% adjusted cash FY16 EPS fore cast of $4.65, discounted back one year at a 9.2% cost of equity. Cash and equivalents 2,568 1,952 3,099 13.7% Total assets 38,020 69,374 71,192 26.1% Short and long-term debt 4,516 14,168 25,760 72.2% Upside/Downside scenarios Total liabilities 16,386 36,124 48,469 44.6% Net debt/(funds) 1,948 12,215 22,661 97.5% Shareholders' equity 21,633 33,250 22,723 5.3% Change in working capital 357 -52 -67 N/A Cash flow from operations 3,855 4,502 7,267 19.1% Capital expenditure 1,391 1,424 1,833 14.8% Free cash flow 2,464 3,078 5,435 20.7% Valuation and leverage metrics Average P/E (adj) (x) 25.0 13.8 4.3 1.0 3.6 1.5 3.1 21.9 19.4 17.3 13.3 EV/EBITDA (adj) (x) 12.1 11.5 11.4 8.6 Equity FCF yield (%) 4.0 24.1 5.1 9.3 P/Sales (x) 0.9 0.6 0.9 0.8 P/BV (x) Dividend yield (%) 3.3 3.1 2.1 3.0 1.7 1.9 2.4 Adj debt/EBITDAR (x) 1.9 POINT® Quantitative Equity Scores 3.1 3.7 2.8 3.2 Selected operating metrics Average Same store sales growth (%) Square footage growth (%) Inventory growth (%) Capex/sales (%) -0.7 4.7 3.6 3.3 2.7 2.4 0.8 0.9 0.9 1.2 -2.6 5.4 12.8 44.7 3.9 1.7 1.8 1.7 1.8 1.5 Value Quality Sentiment Low High Source: POINT®. The scores are valid as of the date of this report and are independent of the fundamental analysts' views. To view the latest scores, please go to the equity company page on Barclays Live. " id="pdf-obj-1-648" src="pdf-obj-1-648.jpg">
U.S. Food & Drug Retailing Industry View: NEUTRAL <a href= Stock Rating: OVERWEIGHT Income statement ($mn) 2013 A 2014E 2015E 2 016E CAGR Price (16-Jun-2014) USD 73.29 Revenue 72,217 5,331 4,048 3,849 2,437 2.93 955.2 1.10 76,146 79,121 125,224 20.1% Price Target USD 92.00 EBITDA (adj) 6,011 7,262 10,847 26.7% Why Overweight? We expect WAG's management to EBIT (adj) 4,683 5,867 8,393 27.5% take steps that will boost the earnings power and Pre-tax income (adj) 4,413 5,724 7,339 24.0% value of the company, including cutting expenses, Net income (adj) 2,707 3,546 4,783 25.2% leveraging owned generic brands, and optimizing the EPS (adj) ($) 3.35 4.23 5.51 23.4% capital structure. In addition, the combination with Diluted shares (mn) 963.1 963.1 967.5 0.4% Alliance Boots and the partnership with AmerisourceBergen give the company greater buying DPS ($) 1.26 1.36 1.73 16.3% clout and new avenues of growth. Margin and return data Average Upside case USD 108.00 EBITDA (adj) margin (%) EBIT (adj) margin (%) Pre-tax (adj) margin (%) 7.4 5.6 5.3 3.4 10.1 13.4 9.5 7.9 6.1 5.8 9.2 7.4 7.2 8.7 6.7 5.9 8.3 6.5 6.1 If a tax inversion can be implemented, WAG's EPS will be higher and even at the same multiple, the stock could increase. Our upside case represents 15x our Net (adj) margin (%) 3.6 4.5 3.8 3.8 adj. cash FY18 EPS forecast of $9.05, discounted back ROIC (%) 10.9 13.3 12.5 11.7 to FY15 at the 9.2% cost of equity. ROE (%) 14.2 16.7 21.0 16.3 ROA (lease adjusted) (%) 9.8 10.7 8.8 9.7 Downside case USD 60.00 Balance sheet and cash flow ($mn) CAGR If various initiatives are not implemented smoothly or the external environment deteriotes, EPS will be Tangible fixed assets 12,138 2,410 2,106 35,481 5,047 16,027 2,941 19,454 667 4,301 1,212 3,089 12,271 16,137 15,514 8.5% lower. Our downside scenario represents 14.0x our Intangible fixed assets 2,455 10,225 10,225 61.9% adjusted cash FY16 EPS fore cast of $4.65, discounted back one year at a 9.2% cost of equity. Cash and equivalents 2,568 1,952 3,099 13.7% Total assets 38,020 69,374 71,192 26.1% Short and long-term debt 4,516 14,168 25,760 72.2% Upside/Downside scenarios Total liabilities 16,386 36,124 48,469 44.6% Net debt/(funds) 1,948 12,215 22,661 97.5% Shareholders' equity 21,633 33,250 22,723 5.3% Change in working capital 357 -52 -67 N/A Cash flow from operations 3,855 4,502 7,267 19.1% Capital expenditure 1,391 1,424 1,833 14.8% Free cash flow 2,464 3,078 5,435 20.7% Valuation and leverage metrics Average P/E (adj) (x) 25.0 13.8 4.3 1.0 3.6 1.5 3.1 21.9 19.4 17.3 13.3 EV/EBITDA (adj) (x) 12.1 11.5 11.4 8.6 Equity FCF yield (%) 4.0 24.1 5.1 9.3 P/Sales (x) 0.9 0.6 0.9 0.8 P/BV (x) Dividend yield (%) 3.3 3.1 2.1 3.0 1.7 1.9 2.4 Adj debt/EBITDAR (x) 1.9 POINT® Quantitative Equity Scores 3.1 3.7 2.8 3.2 Selected operating metrics Average Same store sales growth (%) Square footage growth (%) Inventory growth (%) Capex/sales (%) -0.7 4.7 3.6 3.3 2.7 2.4 0.8 0.9 0.9 1.2 -2.6 5.4 12.8 44.7 3.9 1.7 1.8 1.7 1.8 1.5 Value Quality Sentiment Low High Source: POINT®. The scores are valid as of the date of this report and are independent of the fundamental analysts' views. To view the latest scores, please go to the equity company page on Barclays Live. " id="pdf-obj-1-651" src="pdf-obj-1-651.jpg">
Low High Source: POINT®. The scores are valid as of the date of this report and
Low
High
Source: POINT®. The scores are valid as of the date of this
report and are independent of the fundamental analysts'
views. To view the latest scores, please go to the equity
company page on Barclays Live.

Source: Company data, Barclays Research Note: FY End Aug

Barclays | Walgreen Co.

TABLE OF CONTENTS

Executive Summary:

...(Page

4)

The Pathway for Change: A review of Walgreens’ Board structure and bylaws as well as the mechanisms which shareholders may utilize to exert pressure on the Board and the timing of potential Board proposals…(Page 14)

Walgreen Pro Forma Model FY16-FY18: Our new Walgreens model, including stand alone projections for FY14-FY16 core and synergy contributions and consolidated projections extending to FY18… (Page 17)

Synergy Expectations: An examination of both generic and non-generic synergy contributions. We leverage our proprietary generic market model to provide a forecast of generic synergies extending through FY18…(Page 19)

The Almus Opportunity: We provide an overview of the Almus private-label opportunity, leveraging our generic model to determine sales potential and working with our global generics research team to estimate private label profitability…(Page 21)

AmerisourceBergen Contribution. Projections for the timing and size of equity income accruing to Walgreens from its ownership stake in AmerisourceBergen… (Page 23)

Managing Costs More Effectively. A review of Walgreens’ cost structure and the sizable opportunities for more effectively managing corporate and regional overhead…(Page 26)

Leveraging the Balance Sheet. In partnership with our Barclays Credit Research counterpart, we examine the extent to which Walgreens can increase leverage while maintaining its investment grade rating and forecast the potential benefits of leveraged recapitalization… (Page 30)

Inversion Benefits Defined. An overview of inversion requirements and benefits, including our projections for cash tax savings enabled by inversion…(Page 34)

Qualifying for Inversion. We consider the modifications that must be made to the current Walgreens - Alliance Boots agreement to meet the requirements for inversion and audit the potential mechanisms for achieving these changes…(Page 34)

Appendix WAG/AB/ABC Overview. A brief history of the Walgreens/Alliance Boots/AmerisourceBergen relationships…(Page 43)

Tax Matters. An overview of deferred profit and transfer pricing…(Page 45)

Barclays | Walgreen Co.

EXECUTIVE SUMMARY:

We are upgrading Walgreens to Overweight from Equal Weight and increasing our price

target to $94, from $56. Walgreen’s commentary at the Barclays Retail & Consumer Conference on April 30 th suggests management and the Board have begun to internalize criticisms leveled by increasingly vocal shareholders and are actively considering changes that extend beyond the much discussed possibility of inversion to include easier to achieve (but perhaps equally valuable) opportunities related to the company’s cost and capital

structure.

Our Overweight rating is predicated on opportunities available under the current Walgreens-Alliance Boots partnership agreement, independent of potentially large

inversion benefits. We believe incremental cost reduction initiatives and adoption of a more balanced capital structure (among other items) could drive FY16 EPS of $5.51, 11% above the consensus estimate of $4.97, even before accounting for potential inversion benefits which could drive FY16 EPS to $6.56 (cost reduction and leveraged recapitalization result in $0.64 and $1.16 in incremental EPS in FY16 and FY18, as compared to inversion

which results in $1.05 and $1.31, respectively).

While the current Walgreens - Alliance Boots transaction structure will not qualify for inversion, we believe the most logical corporate structure for a combined Walgreens

and Alliance Boots would involve inversion. We outline possible paths for altering the transaction to constitute an inversion. Achieving inversion would drive our EPS estimates to $6.56 in FY16, $7.88 in FY17 and $9.11 in FY18. However, given the uncertainty and complexity inherent to changing terms and structure as well as potential political pressures,

we assume no inversion benefit in our price target.

We are increasing our price target to $92 from $56. Our 12-month price target of $92 is arrived at by applying an earnings multiple of 15x to our FY18 estimate of $7.79 and then discounting the result back three years at Walgreens cost of equity of 9.2%. Should the company achieve inversion, we project FY18 EPS of $9.11, and foresee upside to $108. However, we note that the domestic Walgreens shareholders are likely to incur capital gains as a result of inversion.

FIGURE 1

Walgreens Pro Forma Earnings Projections

$10.00 $9.05 $9.00 $7.83 $7.79 $8.00 $6.71 $6.50 $7.00 $6.00 $5.51 EPS $5.00 $4.23 $4.00 $3.35
$10.00
$9.05
$9.00
$7.83
$7.79
$8.00
$6.71
$6.50
$7.00
$6.00
$5.51
EPS $5.00
$4.23
$4.00
$3.35
$3.00
$2.00
$1.00
$0.00
FY14
FY15
FY16
FY17
FY18
Base case
with Inversion

Source: Barclays Research

Barclays | Walgreen Co.

Pathway Leads to Incremental Upside

In our opinion, management’s recent commentary, which suggests a pathway for Walgreens management and board members to work constructively with increasingly

active shareholders, represents an inflection point in the Walgreens story. We have been highly encouraged by the recent statements of Walgreen’s management acknowledging the need to address the company’s cost structure and indicating that they

are examining opportunities to optimize capital structure and maximize tax efficiencies.

We have identified three factors which we believe are driving the change in tone:

  • 1. Increasing influence of Alliance Boots Executive Chairman Stefano Pessina, who owns 8% of outstanding WAG shares after Phase 1 and will own approximately 17%-18% when the transaction is closed. Mr. Pessina has demonstrated a more aggressive approach to optimizing cost structure, leverage and tax efficiencies than has Walgreen’s current board and management.

  • 2. A Board structure and bylaws that give little protection to current members, providing a potent incentive for the Board to be responsive to shareholder concerns. Our review of Walgreens bylaws suggests that if investors conclude that the current board and management team are unlikely or incapable of taking the steps necessary to increase shareholder value, shareholders are well positioned to replace them quite quickly.

  • 3. Core Walgreens and Alliance Boots operational performance is running below the run rate needed to achieve FY16 guidance provided when the transaction was announced. This puts increasing pressure on management to take action could help to offset softness in core operational performance.

While Mr. Pessina’s experience and reputation have been well known for some time, we believe increasing shareholder engagement and extremely weak corporate defenses have served as a wakeup call for the Board. Meanwhile, Alliance Boots’ FY14 (end March) results provided another data point that core operations are running below the levels anticipated at the time of the announcement, though better-than-projected synergies have so far helped to offset this shortfall. We believe these factors all played a role in leading to the shift in tone from the company’s March 25th earnings conference call to our April 30th Retail and Consumer Conference.

We think it is likely that Walgreens board and management are currently formulating proposals for completion of the Walgreens and Alliance Boots combination, which may significantly alter the terms and structure of the transaction. Specifically, the company’s statements at our April conference lead us to believe that Walgreens is considering adjusting the deal terms to optimize capital structure and maximize tax efficiencies (perhaps including a structure that enables inversion).

In our view, Walgreens’ management is likely to formalize its intentions with the publication of the proxy statement recommending the completion of the Walgreens-

Alliance Boots transaction, to be provided between late August and early October. The proxy statement should outline any changes to the terms of the agreement and the structure of the combined entity, both of which would need to be amended to achieve inversion (detailed later in this report). We expect the board to also outline proposals regarding 1) post transaction management structure; 2) a cost reduction plan, inclusive of a specific savings target; and 3) new capital structure and allocation targets. Should the board reach a conclusion on any of these last three items, it is possible that the company could comment prior to the end of the summer.

If inversion is being considered, we expect the company will want to delay the proxy until later in this window so as to minimize the time between public announcement and

Barclays | Walgreen Co.

completion (to reduce political pressures that are likely to be raised by an inversion announcement). That said, we think the company must provide shareholders with clarity by early October in order to avoid more aggressive shareholder activism.

Planned vs. Incremental Opportunities

We believe that potential benefits from the Walgreens and Alliance Boots partnership extend well beyond those identified by the companies when the partnership was

entered into in August of 2012. We first examine the FY16-18 outlook for previously targeted opportunities (including core operational performance, synergy expansion opportunities and consolidation of AmerisourceBergen equity ownership) and then turn our attention to incremental opportunities not anticipated at the time of the transaction, (including tackling a historically bloated cost structure, adopting a more aggressive capital

composition and re-domiciling the company in a more favorable tax jurisdiction).

In Figure 2 we outline the impact of each of these areas on our earnings estimate. Note that our published estimate excludes the impact of inversion.

FIGURE 2

Incremental Opportunities Drive Growth, Even Absent Inversion

EPS Components

 

CAGR

FY13

FY14

FY15

FY16

FY17

FY18

13-18

EPS - Status Quo*

$2.93

$3.26

$3.94

$4.65

$5.32

$6.06

16%

ABC Equity Income

-

-

-

$0.14

$0.32

$0.34

Almus Benefits

-

-

-

$0.03

$0.09

$0.17

Cost Reduction (Cumulative)

-

0.09

$0.29

$0.34

$0.44

$0.44

Leverage

-

-

-

$0.34

$0.55

$0.77

EPS - Barclays Estimate

$2.93

$3.35

$4.23

$5.51

$6.71

$7.79

22%

 

EPS - Barclays w/Inversion

$2.93

$3.35

$4.23

$6.50

$7.83

$9.05

25%

Diff. from base case

-

-

18%

17%

16%

Source: Barclays Research *The Status Quo includes FY16 synergy benefits but excludes ABC equity income and Almus benefits which may be included in consensus estimates.

Targeted Opportunities:

1) Core Operations: We model FY16 GAAP operating profit of $8.0bn, inclusive of $1.040bn in synergies (but excluding the incremental cost savings initiatives outlined

within this report), well below management’s initial guidance of $8.5-9.0bn. At the time of the transaction, Walgreens announced FY16 financial goals which included GAAP operating profit of $8.5-9.0bn and adjusted operating income (adjusted for LIFO and amortization expense) of $9.0-9.5bn, inclusive of $1.0bn in synergies. Management has noted over the last two quarters that financial performance is running below the run rate required to achieve this guidance but has synergies are running ahead of expectations. If the status quo is maintained and incremental opportunities are not executed upon, we estimate that operating profit will total only $7.8bn in FY16. This equates to a status quo EPS estimate of $4.69 ($4.86 including three quarters worth of contributions from ABC and Almus synergy benefits), 6% below the current first call consensus of $4.97. We believe management must adopt strategies which take advantage of the incremental opportunities outlined below and view the status quo as a conservative base case upon which to layer incremental benefits.

Barclays | Walgreen Co.

2) Synergy: We project FY16 synergy of $1.040bn on $540mn in generic synergy and $500mn in non-generic contributions, with generic synergy expanding rapidly in FY17

and FY18 as Almus private label generics are adopted by WAG and ABC. We project that in aggregate the combination of Walgreens, Alliance Boots and Amerisource should drive a total of $540 million in sourcing benefits to Walgreens for the 12-months ending August 2016, with $400 million attributable to discounts provided by generic manufacturers, $104 million related to distribution discounts provided to Walgreens by Amerisource (brand discounts and generic savings relative to the prior Cardinal contract) and $37 million attributable to Almus brand generics (within this note we publish for the first time a model

for Almus contributions).

We assume little transfer pricing benefit in our model, but foresee a large opportunity for

intercompany sales of private label generics. While we expect that Walgreens will obtain some benefits from transfer of intangible property and shared services over time, we have included no transfer pricing benefits in our projections. As the business ramps in FY16, we project Almus achieves 3% penetration of the $6.8bn WAG/ABC combined generic book of business (after discounts) resulting in a profit contribution of $44mn and net income of $37mn. We anticipate that penetration will expand sharply in FY17 and FY18m, reaching 8% in FY18. Applying an 8% penetration rate to WAG/AB U.S. generic expenditures of $7.9bn, leads to a FY18 profit contribution of $210mn and net income of $175mn. Over the long-term, we believe Almus can obtain penetration in the low double digits and margins of

35%, 10% above the broader generic industry. Almus benefits are included in our base case synergy number of $544mn (or $.0.04 in EPS accretion) in FY16. For FY17 and FY18, we

believe Almus will drive $0.09 and $0.17 of incremental EPS, respectively.

FIGURE 3

Walgreens FY16 Generic Sourcing and Distribution Benefit

$, Billions

$600 $37 $540 $104 $500 $500 $177 $400 $400 $300 $223 $200 $100 $0 WAG-AB JV
$600
$37
$540
$104
$500
$500
$177
$400
$400
$300
$223
$200
$100
$0
WAG-AB JV
Benefit
ABC Benefit (to
WAG/AB)
Total Sourcing
WAG
Almus Profit
Benefit
Distribution
Potential
Contract Benefit
Total Sourcing &
Distribution
Benefit
WAG/AB Gx
Synergy
Guidance

Source: Barclays Research Estimates

Barclays | Walgreen Co.

FIGURE 4

WAG – Generic Sourcing Benefit Estimates

Sourcing Benefits

FY15

FY16

FY17

FY18

WAG-AB JV Benefit

$139

$223

$260

$281

ABC Benefit (to WAG/AB)

$87

$177

$219

$236

 

WAG Distribution Benefit

$102

$104

$106

$108

 

Almus Net Profit Potential

$10

$37

$95

$184

Total Sourcing & Distribution

$338

$540

$680

$809

Source: Barclays Research

Accounting for Equity Income from Ownership in ABC

3) AmerisourceBergen Equity Ownership: Our base case model accounts for the contribution from equity income related to Walgreens and Alliance Boots’ ownership of

AmerisourceBergen shares. Our projections for Walgreens ownership and Amerisource share base, suggest that Walgreens will cross the 20% ownership threshold (at which time the company will begin consolidating its pro rata share of profits under the income method) in the March quarter of 2016. We project Walgreens’ share of Amerisource earnings is worth $0.14, $0.32, and $0.34 in incremental EPS to FY16-18, respectively, adding 3-6%

growth to the status quo EPS projection.

FIGURE 5

Targeted Opportunity: AmerisourceBergen Income

ABC Equity Income Component

FY16

FY17

FY18

Note

Incremental benefit to Status Quo scenario (in $mn, except EPS)

   

EBIT accretion (cumulative)

158

343

363

Assuming WAG and AB fully exercise their ABC warrants, we hit the 20%

Tax rate applied

0%

0%

0%

threshold for consolidating ABC equity ownership in the March Q of 2016

Net income accretion

158

343

363

No.

of shares - assumption

1,103

1,085

1,062

EPS accretion

$0.14

$0.32

$0.34

 

% EPS accretion over Status Quo case

3%

6%

6%

 

Source: Barclays Research

Incremental Opportunities:

4) Cost Structure: Alliance Boots management could play a key role in driving material expense reduction at Walgreens, though both corporate and store-based opportunities are difficult to ascertain. Walgreens year-to-date SG&A growth of less than 1% suggests the company is already taking actions to reduce corporate expense by an estimated $250mn (relative to our estimate of normalized SG&A growth of 2-3%). We believe that focused reductions and additional streamlining provide an incremental opportunity to reduce corporate expense by $500mn over the three-year period FY15 to FY17. We project cumulative cost reduction efforts will drive incremental EPS of $0.29 in FY15, $0.34 in FY16 , $0.44 in FY17 and FY18. Thus, this incremental opportunity alone represents 7%-8% EPS accretion over WAG’s status quo EPS scenario.

Our base model assumes that Walgreens laps dual promotional investments in FY15 but does not project benefits from reduced promotional expenditures or increased promotional

Barclays | Walgreen Co.

support from vendors in FY16. We believe these items could boost gross margin by 25-50 BP as we look out to fiscal 2017 and 2018.

Finally, we take a cautious view of store level expense, assuming that low hanging fruit was removed as part of the ‘Rewire for Growth’ initiative, savings in the pharmacy are limited and occupancy costs cannot be reduced. Therefore we project no additional store level expense reductions through FY18.

FIGURE 6

Incremental Opportunity: Cost Structure

SG&A (Cost savings) Component

FY16

FY17

FY18

Note

Incremental benefit to Status Quo scenario (in $mn, except EPS)

   

EBIT accretion (cumulative)

600

750

750

Assumes $250mn of corporate cost reduction in FY14. Additional $500mn of

Tax rate applied

37%

37%

37%

Net income accretion

378

473

473

corporate and regional cost reduction over the three year period FY15-FY17. Amount shown is cumulative.

No.

of shares - assumption

1,103

1,085

1,062

EPS accretion

$0.34

$0.44

$0.44

 

% EPS accretion over Status Quo case

7%

8%

7%

 

Source: Barclays Research

5) Adopting a more aggressive approach to capital structure could enable Walgreens to apply greater resources to dividend issuance and share repurchase, elevating FY16 -

FY18 shareholder returns. Historically, Walgreens has sought to maintain a strong investment grade rating (single-A category) in order to ensure low borrowing costs and favorable terms from creditors, including landlords and trade partners. Over nearly the last two years, the company has operated with lower ratings, in the mid- to high-BBB range, without appearing to have experienced material increases in lease costs or possibly access liquidity, and recent management commentary to equity and debt investors suggests

Walgreens management has made peace with its BBB rating status.

Moving forward, we expect it is likely that Walgreens will formally adopt a long-term target of a mid-BBB credit rating and adjusts the company’s capital structure to take advantage of the higher leverage levels enabled by such a rating. Discussions with our Barclays High Grade Credit Research counterpart, Priya Ohri-Gupta, suggest that given Walgreens’ historical credit rating and demonstrated success reducing leverage after Phase I was completed, the company could temporarily increase debt levels to complete a leveraged recapitalization without endangering its investment grade status as long as it lays out a path for reducing leverage (via debt reduction or EBITDA growth) over a 12-24 month period. Specifically, we believe that Walgreens could increase leverage by a full turn at completion of the merger ($13.6bn), leading the lease adjusted debt to EBITDAR ratio at year end FY15 (August, 2015) to increase from 3.1x (assuming no debt issued at close, 3.5x if $4.9bn is issued to cover transaction costs under the current structure), to 4.2x while providing rating agencies with guidance for $5bn of debt reduction and $3bn of EBITDAR growth over the three years FY16-FY18. This would reduce the debt to EBITDAR ratio to 3.6x by the end of FY16 and 3.0x by the end of FY18. While such an aggressive move could result in a negative outlook or even one notch downgrade from the rating agencies, we do not believe it would endanger Walgreens investment grade status (we place the acceptable steady- state leverage ratio for maintaining its current ratings of Baa1 at Moody’s and BBB at S&P at approximately 3.25x). We do note that a potential one notch downgrade at S&P could impair access to the tier 2 commercial paper (CP) market, however WAG had not borrowed in the CP market for several years prior to the most recent fiscal quarter, when the company maintained a daily average balance of only $14mn.

Barclays | Walgreen Co.

The rationale for engaging in a leveraged recapitalization at closing would in part be to optimize the capital structure and in part to repurchase shares at a price which does not fully reflect potential upside from completion of the merger and so might be valued attractively. Adopting a more aggressive approach to capital structure and deployment represents a significant incremental opportunity, above and beyond guidance provided by Walgreens at the time of the transaction. We forecast this scenario to contribute an additional $0.34 to our FY16 EPS estimate, while we expect ongoing repurchase activity drives incremental EPS growth of $0.55 and $0.77 in FY17 and FY18 EPS, respectively. Thus, this incremental opportunity alone represents 7%-13% EPS accretion over WAG’s status quo EPS scenario.

FIGURE 7

Incremental Opportunity: Capital Structure

Leverage Component

FY16

FY17

FY18

Note

Incremental benefit to Status Quo scenario (in $mn, except EPS)

   

Dividends

(1,674)

(2,019)

(2,288)

Share Issuance (repurchase)

(14,300)

(3,160)

(4,080)

FY16 repo via increase in leverage, FY17 and FY18 repo via cash flow

Net Debt issuance (reduction)

(3,000)

(1,000)

(1,000)

Assumes debt issuance of $13.6bn at time of close. Repayment of $5bn

Total

(18,974)

(6,179)

(7,368)

FY16-FY18

Incremental interest expense

-584

-584

-584

Incremental debt at 4.5%

Tax rate applied

37%

37%

37%

Net income accretion

-368

-368

-368

No. of repurchased shares from leverage

130

0

0

Repurchase attributable to leverage recap

No. of shares - assumption

973

955

932

Lease-adj debt/EBITDA ratio

3.9 x

3.4 x

3.5 x

Additional leverage increases ratio from 3.1 to 4.2x at deal closing

EPS accretion

$0.34

$0.55

$0.77

 

% EPS accretion over Status Quo case

7%

10%

13%

 

Source: Barclays Research

6) Inversion: We believe the most logical and effective corporate structure for a combined Walgreens and Alliance Boots would be to invert the existing configuration so

that Alliance Boots becomes Walgreen’s parent corporation. However, as currently structured, the Walgreens Alliance Boots transaction will not constitute an inversion, necessitating that the terms and structure of the transaction are altered prior to completion.

Specifically, the transaction would need to be restructured so that 1) Walgreens becomes the subsidiary of a foreign parent: Alliance Boots or a new foreign parent (i.e. Alliance Boots or a newly created foreign entity acquire all Walgreens stock in return for stock in the new foreign entity or other consideration), and 2) stock and consideration paid are altered such that Walgreens shareholders receive less than 80% of the foreign parent entity’s shares (i.e.: Alliance Boots shareholders, primarily KKR, must accept stock rather than cash compensation, and WAG shareholders must accept exchanging their WAG

stock for a combination of stock in the new company and a cash payment). While any change in structure represents a hurdle, we believe that the substantial benefits unlocked via inversion provide a strong incentive for all parties to align in order to achieve it.

Should Walgreens and Alliance Boots restructure the terms and structure of the purchase agreement to enable inversion, we size incremental annual cash tax savings attributable to an inversion-enabled recapitalization at $797mn. To get to this number, we assume that Walgreens is able to take advantage of the current deductibility of interest expense payable on debt held by a foreign parent (inter-company debt) equal to 50% of FY16 adjusted taxable income of $7,969mn and that the differential in tax rates between U.S. based Walgreens and Switzerland based Alliance Boots is 20% (if domiciled in the U.K., we foresee a differential of 18%). Simply stated, Walgreens U.S. tax rate would stay

Barclays | Walgreen Co.

unchanged but its taxable income is reduced for deductible interest payments on inter- company debt. (above and beyond any potential transfer pricing benefits).

A few notes on the tax rate assumption. 1) The U.S. tax rate for WAG is currently close to 37% while the underlying Alliance Boots tax rate is roughly 18%, suggesting a delta of 19%. 2) We believe the benefit from the differential could actually be in excess of 20% given that income paid in the Canton of Zug [where Alliance Boots GMBH is domiciled] may be exempt from federal level taxation and that further tax rate reductions may be applicable to holding companies. 3) While the corporate tax rate of Switzerland is more attractive than that of the U.K., the US-UK income tax treat may provide advantageous treatment of withholdings on tax dividends. Should the inverted entity be domiciled in the U.K., we expect the tax rate would be 19%, suggesting a 18% delta. We view both options as attractive from a tax benefit perspective.

Tax rate impact. We assume that Walgreens will hold all foreign profits offshore, leading to a roughly 220 bps decline in the consolidated FY16 tax rate, from 37% in FY15 to 34.8% in FY16, prior to inversion benefits. In the inversion scenario, after incorporating the impact of inter-company debts, we project the tax rate can decline even further to 24.2% in FY16. Our model assumes that Walgreens’ tax rate will increase FY16 to FY18 as Walgreens profits grow at a faster rate than does foreign profit and the inter- company tax benefit remains steady. This could prove conservative if Walgreens is able to execute against transfer pricing opportunities or is able to add additional inter- company debt over time.

FIGURE 8

FY16 EPS Sensitivity to Inversion Scenario Assumptions – Incremental EPS Contribution

% of WAG EBITDA subject to earnings stripping

Tax rate differential

$782.76

12%

14%

16%

18%

20%

22%

30.0%

$0.44

$0.50

$0.55

$0.61

$0.67

$0.72

35.0%

$0.50

$0.56

$0.63

$0.69

$0.76

$0.82

40.0%

$0.55

$0.63

$0.70

$0.78

$0.85

$0.93

45.0%

$0.61

$0.69

$0.78

$0.86

$0.94

$1.03

47.5%

$0.64

$0.73

$0.81

$0.90

$0.99

$1.08

50.0%

$0.72

$0.82

$0.91

$1.00

$1.10

$1.19

Source: Barclays Research

The cash tax savings from inversion enabled intercompany debt of $783mn annually, increases FY16 EPS by $0.99. We assume this tax savings remains constant in FY17 and FY18 EPS. Given that the share count declines, the impact of this tax savings on EPS increases to $1.12 in FY17 and $1.27 in FY18. In the inversion scenario, we expect cash tax savings from intercompany debt opportunity to account for additional 16%-18% EPS accretion over WAG’s status quo EPS scenario.

Barclays | Walgreen Co.

FIGURE 9

Incremental Opportunity: Inversion

Inversion Scenario

FY16

FY17

FY18

Note

WAG-only EBITDA

8,240

8,652

9,084

EBITDA at time of recapitalization

% of EBITDA on earnings stripping

47.5%

48%

48%

We assume 47.5%, below the maximum of 50% to allow for existing debt

WAG EBITDA shielded by earnings stripping

3,914

4,109

4,315

Amount of EBITDA that can be shielded

Tax rate - foreign parent

17%

17%

17%

Assuming 17% tax rate at the foreign parent level on interest income (from

Tax differential from US tax rate

20%

20%

20%

intercompany debt)

Tax savings

783

783

783

We assume that the capital structure remains constant post FY16. The company may be able to recap additional equity as EBITDA grows.

Non-inversion tax expense

2,556

2,648

3,038

% Non-inversion effective tax rate

35%

31%

32%

Post-inversion tax expense

1,774

1,865

2,255

% Post-inversion effective tax rate

24%

22%

24%

EPS accretion

$0.99

$1.12

$1.27

 

Includes benefit of increased share repurchase enabled by 1) additional

% EPS accretion over Base Case EPS

18%

17%

16%

EBITDA and 2) cash/stock election (retiring of WAG shares)

 

Source: Barclays Research

Valuation & Price Target

Walgreens shares have performed well over the last year, even as management has noted that core operations are likely to fall short of FY16 operational targets.

Recognition of the potential for transaction benefits and operational improvements has led to a 46% increase in WAG shares over the 12-months ending June 16 th , 2014, as compared to a 19% increase in the S&P500. Nonetheless, our analysis of the base business, potential synergies, and incremental opportunities suggests that WAG shares remain undervalued

relative to our earnings growth outlook even excluding potential inversion.

FIGURE 10

FY13-FY18 Earnings CAGR

 

CAGR

EPS

FY13

FY14

FY15

FY16

FY17

FY18

FY13-18

Status Quo

$2.93

$4.65

$5.32

$6.06

Barclays Estimate

$2.93

$3.35

$4.23

$5.51

$6.71

$7.79

Barclays Scenario w/ Inversion

$2.93

$6.50

$7.83

$9.05

Status Quo

10%

15%

14%

Barclays Estimate

14%

27%

30%

22%

16%

Barclays Scenario w/ Inversion

54%

20%

16%

16% 22% 25%
16%
22%
25%

Source: Barclays Research

We are increasing our price target from $56 to $92. Our 12-month price target is arrived at by applying an earnings multiple of 15x to our FY2018 estimate of $7.79 and then discounting the result back three years at Walgreens cost of equity of 9%. The 15x multiple represents a discount to WAG’s five-year average of 16x (17x excluding the period of the Express scripts dispute). Applying this multiple to our 2018 EPS estimate of $7.79, we arrive at a 2018 price target of $118, which we discount to arrive at our price target of $92, up 26% from current levels. Should the company achieve inversion, we project FY18 EPS will total $9.05, and foresee upside to $108, up 48% from current levels. The previous price target of $56 was based on 14.7x our previous adjusted cash FY15 EPS forecast of $3.95 (excluding our $0.14 LIFO estimate add back).

Barclays | Walgreen Co.

Barclays | Walgreen Co.

THE CASE FOR CHANGE

After an extended period of suboptimal operational performance and strategic missteps, we believe the completion of the Alliance Boots acquisition will position Walgreens to make material improvements to its U.S. retail pharmacy business. We think the company will be able to take advantage of numerous new optimization and growth opportunities enabled by its relationships with Alliance Boots and AmerisourceBergen. However, given the current management team’s track record, we think many shareholders are doubtful that the desired changes will be made, and pressure is mounting to bring in a new team. A favored option is to put Alliance Boots management in charge of the joint company.

While we agree with many of the critiques of current management, we have concerns that regime change could lead to internal disruption, so are hopeful that a middle way can be found in which Alliance Boots Executive Chairman Stefano Pessina and Walgreens CEO Greg Wasson work jointly to address the many challenges and opportunities in front of the company. As such, we have been highly encouraged by the recent statements of Walgreen’s management that acknowledge the need to address the company’s cost structure and indicating that they are examining opportunities to optimize capital structure and maximize tax efficiencies.

We believe the Board and management have begun to internalize investor critiques and are actively formulating a response that is likely to target opportunities that extend well beyond those identified when the company entered its partnership with Alliance Boots and agreement with AmerisourceBergen. This would likely help offset core operational performance, which is running below the run rate needed to achieve the original FY16 guidance. We expect management will formalize its intentions with the publication of the proxy proposal related to the completion of the Walgreens-Alliance Boots transaction, to be provided as early as August and no later than October.

Pathway for Change

Walgreen’s current Board structure and bylaws provide little protection for current board

members and so deliver a potent incentive to be responsive to shareholder concerns. If investors conclude that the current Board and management team are unlikely or incapable of taking the steps necessary to increase shareholder value, they may engage in an effort to unseat and replace them. Our review of Walgreen’s bylaws indicates that the company does not have formidable defenses against such an initiative, though the current Board is able to take action to create stronger defenses without the consent of shareholders. Key

provisions in the bylaws include:

Board Structure: 1) Directors are elected annually not on a staggered basis, meaning that the entire board may be replaced in a single year. 2) Members may be removed with or without cause by a simple majority of shares entitled to vote, meaning shareholders need not prove cause to remove a director at a special meeting or by written consent (a high bar which often prevents director removal).

Voting Structure: 1) Voting is cumulative, enabling shareholders to concentrate votes on specific nominees. 2) As with removal, only a majority of shareholders is required to elect new directors.

Initiating a Vote: 1) The annual meeting will likely to occur on or around January 8th of 2015, with director nominations due between September 10th and October 10th of 2014. 2) A special meeting can be called at any time by shareholders owning 20% or more of the voting power. 3) The bylaws also allow for shareholders to act by written consent.

Barclays | Walgreen Co.

Walgreens Defense: 1) Walgreens does not currently have a poison pill in place, however the company does have “blank check” preferred stock and the board could easily adopt a poison pill at any time. In addition, the Board has the authority to adopt, amend or repeal most bylaws without shareholder approval, but changes must consider fiduciary responsibility.

It appears that Walgreen’s has not adopted many of the corporate defenses that have

become the norm over the last thirty years. Most significantly, Walgreens bylaws allow for cumulative voting, which is likely tied to the company’s incorporation (and long roots) in Illinois. Under cumulative voting, each shareholder receives one vote for each seat/office being voted upon (in the case of WAG, 13 seats), and may aggregate their votes and concentrate them on a single candidate. This dramatically increases the ability of minority shareholders to gain representation on the board. The combination of cumulative voting, election by a simple majority and the annual (rather than staggered) term provides the Walgreens board far fewer protections than its peers within the S&P 500, suggesting that members must be responsive to investor sentiment or risk being unseated.

Catalyst for Change

The annual meeting, to be held at or near January 8th of 2015 (one month prior to the opening of the window for Phase 2 of the Alliance Boots transaction) provides shareholders with an opportunity to exert significant pressure on the current board and management team. Specifically, from September 10th to October 10th of 2014, shareholders may nominate new directors (either a partial or full slate) to be voted on at the January 2015 meeting. The threat of removal could compel the current board and management to begin to act on investor’s priorities in the hope of reaching a compromise prior to the actual vote.

We believe this effect is already visible, as at the Barclays Retail & Consumer Discretionary Conference on April 30th, Walgreens management stated the company was open to evaluating the possibility of inversion and noted a focus on expense management and willingness to reconsider its capital structure (after completing the

Alliance Boots acquisition). This represented a significant reversal from the March 25th Q2 earnings call on which Greg Wasson stated ‘no intention’ of inversion or re-domiciling the company. We view management commentary positively, particularly with respect to expense management, as it shows a willingness to consider investors’ views that was heretofore absent and suggests a compromise may be possible. We expect that shareholders will provide the current board and management with room to address these issues over the next several months. We will, however, look for a demonstration of commitment to structural change, perhaps including renegotiation of the current Walgreens and Alliance Boots transaction terms and structure to enable inversion before

the proxy nomination window closes on October 10th.

Should investors desire to effect change prior to the annual meeting or without needing to call a special meeting, written consent enables shareholders to propose to recall

remove and replace board members over a relatively short time period. If a shareholder chooses to act by written consent, the Board would issue a record date (typically within ten days of receiving the request), opening a 60-day voting window during which proxy solicitors working for the initiator/activist and the Board would attempt to garner votes for

their respective proposals.

While the Walgreens shareholder base skews toward relatively conservative institutions, we do not believe this represents an insurmountable barrier to change.

A review of the most recent proxy shows large holdings of the stock among index funds

and long-only shareholders who in the past have demonstrated relatively limited appetites for risk (hedge funds are shown to hold just 6%). While this may have

Barclays | Walgreen Co.

represented a significant barrier just a few years ago, we note that Institutional Shareholder Services, or ISS (which often influences how index and other such institutions vote on contested matters), has demonstrated a willingness of late to embrace activist shareholder proposals. Moreover, our discussions with a large cross section of institutional investors suggests there is dissatisfaction with current management’s performance and an openness to potential changes, though opinions on inversion are more divided.

Stefano Pessina is precluded from voting his shares against the recommendation of the Walgreens’ board. We would expect Walgreens’ board to recommend shareholders vote against any new slate or activist shareholder proposal. It is worth noting that Stefano Pessina’s agreement with WAG, put in place as part of Phase 1 of the transaction, prohibits him from voting his shares against the recommendation of the existing Walgreens Board as long as he is a member of either the Walgreens’ or Alliance Boots’ Boards. We believe, however, that he is permitted to resign from the two Boards in order to implement changes to the other directors, and can include himself in a new slate. Note that with 7.7% of the total outstanding following Phase 1, and an estimated 17% to 18% pose Phase 2, Mr. Pessina is the only board member with more than 1% of voting shares.

Next Step

We think it is likely that Walgreens Board and management are currently formulating proposals for completion of the Walgreens and Alliance Boots combination that may

significantly alter the terms and structure of the transaction. Specifically, the company’s statements at our April conference lead us to believe that Walgreens is considering adjusting the deal terms to optimize capital structure and maximize tax efficiencies (perhaps

including a structure that enables inversion).

In our view, Walgreens management is likely to formalize its intentions with the publication of the proxy statement recommending the completion of the Walgreens-

Alliance Boots transaction, to be provided between late August and early October. In order to complete the second step of the Alliance Boots transaction, Walgreens must obtain shareholder approval. The purchase agreement requires that Walgreens and Alliance Boots cooperate in preparing a proxy via which the Walgreens Board will recommend that shareholders approve the second step of the transaction (or potentially, an alternative transaction). We expect the proxy will outline any proposed changes to the terms and structure of Phase 2, perhaps including a more aggressive stance toward leverage and possibly a proposal for inversion. We expect the proxy may also include or be accompanied

by a revised view of capital allocation priorities and cost structure reduction opportunities.

While the call exercise period for Phase 2 of the Alliance Boots acquisition does not begin until February 5th, 2015, the purchase agreement allows that the buyer and seller may agree to alter the exercise period. We expect that should the company target an inversion, it may seek to complete the transaction in calendar year 2014, in order to avoid any potential changes to tax regulations that could occur and impact 2015. We are confident, though, that the material changes to the qualifications for inversion will require legislative changes that are unlikely to occur before 2016.

Should the Walgreens Board recommend completion of the transaction as it currently stands, without addressing investor concerns, we think shareholders may engage in an

effort to unseat and replace board members. Given shareholders’ stated concerns, we are hopeful that Mr. Pessina and Mr. Wasson can work jointly to address the many challenges and opportunities in front of Walgreens. However, should we begin to approach early October without a change in direction, shareholders may propose removal and replacement of current Board members in advance of the October 10th deadline for the Jan 2015 proxy.

Barclays | Walgreen Co.

Walgreen Pro Forma FY16 Model

With this report, we are publishing a new Walgreens model which includes 1) updated standalone projections for Walgreens and Alliance Boots through FY16, 2) updated

projections for Walgreens and Alliance Boots synergies in FY15 and FY16, and 3) a consolidated view of FY16 – FY18, pro forma for the second step of the Alliance Boots acquisition (as currently structured). After laying out the base case in this section, we go on to focus on a number of incremental opportunities that we believe could lead to substantial benefits in FY16 and beyond.

Walgreens has maintained its adjusted operating income target range of $8.5-$9.0 billion in FY16 while acknowledging that performance to date, most likely at both companies, is

tracking below the CAGR required to achieve this goal. Our pro forma model, which has been updated to reflect recent performance and cost reduction efforts at Walgreens and FY14 (end March 31 st ) results for Alliance Boots, projects FY16 operating income of $8.0 billion if we excluded cost reduction initiatives in FY15 and FY16 (which were not anticipated n management’s guidance), well short of Walgreens’ stated goal. However, we believe that Walgreens will benefit over the next three years from synergy and accretion opportunities not originally contemplated in guidance. It is assuming the achievement of a portion of these supplemental opportunities (built upon a rather conservative base) that

leads to our ratings upgrade.

Walgreens Base Case Model Assumptions

Sales Assumptions

At the front-end, we assume the sales trend improves over time as the company is able to use its marketing and merchandising funds more efficiently because of the Balance Rewards program. The company is gathering data about its customers shopping patterns that will allow it to send targeted promotional offers, though it is unclear whether that is being done right now. Nonetheless, we expect that further maturation of the program will yield more effective results that will be beneficial to both traffic and ticket over time. We forecast front-end comps improve to +1.8% in FY14, +2.5% in FY15, and +3.0% in FY16. The average annual front-end comp from FY10-FY13 was 3.0%.

At the pharmacy, we expect annual calendar adjusted script growth will remain at the recent pace of ~4% through FY16. This will be driven by a number of factors, including an aging population and increased access to pharmacy coverage through public exchanges and expansion of Medicaid. Sales will be further boosted by inflation in branded drugs, which has averaged low to mid single-digits in recent months. This will be partially offset by the impact of new generic introductions which will accelerate as WAG exits FY14, but will moderate again in FY17 and drop off further in FY18 and FY19.

Gross Margin Assumptions

In looking at the next 2 1/2 years, we took three main factors into account when modelling Walgreens gross margin trends: new generic introductions, a cycling of double promotional investments in the front end, and the more fundamental ability to lower spending on promotions gradually as the company makes more targeted offers using data from the Balance Rewards program. We also assume vendors provide more promotional support as Walgreens gives them better customer data.

Generics. To estimate the benefit from new generics for the remainder of fiscal 2014, we looked at the drugs that are entering the market this year and whether they will be single sourced or multi-sourced from the beginning, and then compared them to last year’s new introductions. We did the same analysis for fiscal 2015 and fiscal 2016, though the data becomes less reliable later in time, since introductions can be delayed and/or the number of competitors can vary.

Barclays | Walgreen Co.

Cycling Investment. Our forecast assumes that WAG cycles dual investments in promotions in the fourth quarter of fiscal 2014 but continues the elevated investment level at the same pace through fiscal 2015. In fiscal 2016 we expect the company to rely somewhat more on targeted promotions using data from its rewards card.

Targeted Promotion Benefit. Looking out beyond FY16, the rewards program should allow Walgreens to start shifting more of its promotional spending to its most loyal customers. Walgreen’s program is different than the ones used by CVS and Kroger (points are earned only on certain purchases), but we believe the data it accumulates will still be useful for its own marketing purposes and to vendors, who may give it more promotional support as the quality of the data it shares gets better. The company may get some guidance in this process from Boots, but we believe that more targeted merchandising could be accomplished on its own, once it has enough data about customers to draw conclusions about their spending. Every retailer must find the appropriate balance between targeted and broad-based promotions, so it may take a number of years before Walgreens gets the optimal benefit from the program.

Selling, General, and Administrative Expenses Assumptions

Historically, SG&A dollar growth at Walgreens has been both high and variable, and the

company has rarely explained the results adequately, if at all. Expense growth did moderate once Walgreens started to slow square footage growth in fiscal 2010, but the correlation was far from perfect and the dispute with Express Scripts came right as the benefits of the square footage reduction should have been experienced, masking the benefit. Only in 2011 did WAG manage to get gross profit dollars growing more quickly than SG&A. With the Express Scripts dispute in 2012, SG&A dollar growth slowed as the company worked hard to reduce operating costs to offset the impact of declines in script volume and market share, but these actions were not enough to keep EPS from declining. In FY13, SG&A dollar growth re-accelerated somewhat as volume began to return to the stores, yet the pace of growth remained lower than it had been over the previous five years, in part because new store growth had slowed. FY13 benefited from the peak profit period for many new, single-source generics, so revenue growth was very modest while gross profit dollars grew faster than SG&A dollars.

Estimating a run rate for expenses growth should be relatively straight forward as wages benefits, insurance, and credit card fees all rise steadily unless mitigating efforts are

made. Our base case models normalizes SG&A growth at 2.5%-3.0%, reflecting the growth rate in operating costs experienced by most retailers, including CVS. Given all the variability in growth at Walgreens expenses over the past few years, this is no more than a reasonable

guess. We note that SG&A growth has been running at a lower pace year to date in fiscal 2014 (~1.0%), and we have some information suggesting that the company is currently cutting corporate overhead. However, Walgreens has provided neither details about what expenses have been eliminated so far this year nor what its plans are for the future, hence we use a normal growth rate for the period of fiscal 2015 – fiscal 2018.

Other Walgreens Transaction Considerations

We expect incremental LIFO and transaction amortization of ~$500mn.

Alliance Boots Assumptions

Our projections for Alliance Boots are based its recently reported fiscal 2014 results for the period ended 3/31/14 (reported on May 15, 2014).

Revenue Projections. We project total FY16 revenue of ~£43 billion, which assumes 3% growth in the wholesale business, no growth in the Boots pharmacy business, and modest growth in the retail, optical and other segment (which is very small); we also include the recent Farmacias Ahumada transaction. The company operates in mature

Barclays | Walgreen Co.

markets with significant control of wholesale and retail pricing and margins by UK and European governments. Growth in the wholesale operations has generally come from acquisitions, which has been a focus for Alliance Boots’ management, though we do not forecast any additional acquisitions going forward.

Margin Expectations. We expect margins will be relatively static despite ongoing reimbursement reductions as the company has proven itself to be nimble at offsetting reimbursement pressure by operating the business more efficiently. Given our relatively limited visibility into Alliance Boots accounting and markets we have adopted what we believe to be a realistically conservative model.

Synergy Expectations

Walgreens purchased 45% of U.K. based retail pharmacy operator and wholesale drug distributor Alliance Boots on August 2, 2012, and formed the Walgreens Boots Alliance Development GmbH (WBAD) joint venture global sourcing entity in Bern, Switzerland, on October 30, 2012. On March 19, 2013, Walgreens and Amerisource announced a 10-year distribution agreement as part of which Amerisource would take on both Walgreens’ brand distribution (previously served by Cardinal) and generic distribution (previously sourced from manufacturers by Walgreens and distributed via the Walgreens retail distribution network) while moving to purchase all generic products via the WBAD global sourcing entity.

With the original Alliance Boots relationship of June 2012, Walgreens stated an expectation for $1 billion in synergies, of which 90% of the total (or $900 million) would be attributable to procurement, and 50% of the total (or $500 million) would be attributable specifically to generic procurement. Walgreens reported $154 million in total synergy benefits for its fiscal 2013, the first year of the relationship, and has provided guidance for $350-$450 million of synergies in its fiscal 2014. It has provided no commentary on the respective sources of synergies reported to date but has stated that both generic and non-generic procurement synergies are building and has repeatedly reiterated the total synergy goal of $1 billion.

Alliance Boots stated that its fiscal 2014 synergies, for the 12-months ending March 31, 2014 were ‘ahead of target’ though it is unclear whether that refers to timing or the dollar amount. Alliance reported that its share of post-tax earnings of the Walgreens Boots Alliance Development JV (WBAD) totalled £58 million, or $98 million, in fiscal

2014.

Generic Procurement Synergies

With respect to generic synergies, it is our opinion that Walgreens’ initial plans (and guidance) for Alliance Boots were extremely ambitious, as they included both large international generic sourcing benefits and significant gains from moving to self

distribution, both of which involve a high degree of execution risk. Specifically, our projections suggest that the sourcing benefits available to Walgreens and Alliance Boots absent the agreement with AmerisourceBergen were well below $500 million. Rather, we believe that the synergies outlined at the time of the WAG-AB partnership were dependent on working with a large, U.S. based distributor such as AmerisourceBergen, which when combined with Walgreens led to significant generic procurement scale in the U.S. The importance of the Amerisource volume should not be understated as the U.S. remains the largest and most profitable generic market in the world, and generic discount tiers (that relate discounts to volume levels) are well established here. It is our opinion that the combination of Walgreens and Amerisource’s domestic volume has played a key role in driving the WBAD JV’s success to date. We also note that Amerisource took on Walgreens’ brand and generic distribution, providing what we believe to be a considerable savings

relative to the prior contract with Cardinal Health.

Barclays | Walgreen Co.

Walgreens-Alliance Boots Generic Sourcing. The generic purchasing market model developed by Barclays Healthcare Distribution and Technology team (outlined in greater detail in the initiation report dated May 4th, 2014) projects global sourcing benefits accruing from the WBAD Generic Sourcing Joint Venture formed by Walgreens and Alliance Boots (prior to inclusion of Amerisource) at $223 million in fiscal 2016, well below guidance for $500 million in total generic sourcing benefits. (Note that our $223 million estimate for fiscal 2016 is in line with our previously published estimate of $250 million for calendar year2016.)

Walgreens-AmerisourceBergen Generic Sourcing. However, we project that the addition of Amerisource’s U.S. volume to the WBAD purchasing entity greatly increased negotiating leverage with generic manufacturers, enabling Walgreens to garner an additional $177 million in sourcing benefits, aside from gains accruing to AmerisourceBergen.

Walgreens-AmerisourceBergen Distribution Contract. Beyond sourcing benefits, we believe that Walgreens benefits from its ten-year distribution agreement with Amerisource, which was likely provided at below market rates in return for participation in the WBAD joint venture. We project the discounts and GPO fees generated by this contract will lower Walgreen’s distribution/sourcing cost by an additional $104 million in FY16. We attribute these savings both to reduced brand distribution expense and lower secondary generic support relative to the legacy contract with Cardinal. (Note that Walgreens included self-distribution savings in the original Alliance Boots generic sourcing synergy target of $500 million – we view this as misplaced given long established systemic reasons for retailers to employ distributors and that any such benefits would be domestic, and so do not fit with the suggested ‘global’ nature of the $500mn synergy target).

Almus Generics Opportunity. The Walgreens and Amerisource relationships provide a valuable channel for Alliance Boot’s Almus Pharmaceuticals generic brand (detailed in the following section) to enter the U.S. market. We estimate Almus contributes $37mn in after-tax income in FY16 based on 2% penetration of the $6.8 billion WAG/ABC combined generic book of business (after discounts).

We project that in aggregate the combination of Walgreens, Alliance Boots and Amerisource should drive a total of $540 million in sourcing benefits to Walgreens for the 12-months ending August 2016, with $400 million attributable to discounts provided by generic manufacturers, $104 million related to distribution discounts provided by Amerisource (brand discounts and generic savings relative to the prior Cardinal contract) and $37 million attributable to Almus brand generics.

Barclays | Walgreen Co.

FIGURE 11

Walgreens FY16 Generic Sourcing and Distribution Benefit

$, Billions

$600 $37 $540 $104 $500 $500 $177 $400 $400 $300 $223 $200 $100 $0 WAG-AB JV
$600
$37
$540
$104
$500
$500
$177
$400
$400
$300
$223
$200
$100
$0
WAG-AB JV
Benefit
ABC Benefit (to
WAG/AB)
Total Sourcing
WAG
Almus Profit
Benefit
Distribution
Potential
Contract Benefit
Total Sourcing &
Distribution
Benefit
WAG/AB Gx
Synergy
Guidance

Source: Barclays Research Estimates

FIGURE 12

Sourcing Benefits Increase Over Time: With Almus as the Key Driver

Sourcing Benefits

FY15

FY16

FY17

FY18

WAG-AB JV Benefit

$139

$223

$260

$281

ABC Benefit (to WAG/AB)

$87

$177

$219

$236

 

WAG Distribution Benefit

$102

$104

$106

$108

 

Almus Net Profit Potential

$10

$37

$95

$184

Total Sourcing & Distribution

$338

$540

$680

$809

Source: Barclays Research

Transfer Pricing Considered: The Almus Opportunity

(For a detailed discussion of transfer pricing, see the Appendix, page 44)

We assume no transfer pricing benefits in our model, but foresee a large opportunity for

intercompany sales of Almus private label generics. Walgreens owns numerous trademarks and trade names and holds more than 75 patents but does not engage in material research and development activities. Consequently, we expect that the company’s ability to transfer IP to favourable tax domains will be limited as compared to those enjoyed by pharmaceutical manufacturers. While we expect that Walgreens will obtain some benefits from transfer of intangible property (IP, of which intellectual property is a sub- category) and shared services over time, we have included no transfer pricing benefits in our projections. Rather, we believe the most material inter-company opportunity will come from simply driving penetration of Alliance Boots’ existing private label generic, OTC and beauty brands in Walgreens (and AmerisourceBergen’s) U.S. markets via intercompany transactions.

For the purposes of our model, we focus on the Almus private label, which represents an opportunity for increasing the overall profitability of the generic business. The Walgreens

Barclays | Walgreen Co.

and Amerisource relationships provide Alliance Boot’s Almus Pharmaceuticals generic brand with a valuable channel for entering the U.S. market (Almus obtains the IP, such as formulation and clinical data used to support the ANDA necessary to manufacturer a generic product and then engages a contract manufacturer to produce the product, capturing a portion of traditional generic profits). Our model assumes that Almus must acquire new IP and contract with new plants to enter the U.S. market (i.e.: the company cannot simply repurpose product produced for the European market) and so profits and market penetration ramp over a multiyear period.

As outlined in our synergy numbers, we expect Almus will be one of the primary drivers of post FY16 generic benefits. We view FY14 and FY15 as investment years, during which Walgreens and Alliance Boots will obtain IP, set up the manufacturing contracts and establish intercompany transfer pricing via the WBAD joint venture.

We project that the incremental margin from private label manufacturing can exceed that of the broader generic industry (of roughly 25%), as the private label manufacturer is able to target its product mix based on captive end market demand and as the manufacturer incurs no sales and marketing expense.

Margins should ramp as the business gains scale in FY16. We project Almus achieves 2% penetration of the $6.8bn WAG/ABC combined generic book of business (after discounts) in FY16 resulting in a profit contribution of $44mn and net income of

$37mn.

We project penetration expands to 8% in FY18 while WAG/AB U.S. generic expenditures expand to $7.9bn, driving a FY18 contribution of $222mn in profit or $184mn in net income. Over the long-term, we expect Almus can obtain penetration in the low double digits and margins of 35%, 10% above the broader generic industry.

We assume that Almus will taxed at the company’s foreign tax rate of 17%, though we believe it is possible that Alliance Boots will hold the majority of IP in Switzerland, where it may be subject to a substantially lower tax rate. Alternatively, Alliance Boots could develop new IP in the U.K. under new ‘Patent Box’ regulations which holds tax on U.K. derived patents to 10%.

FIGURE 13

Private Label Generics Represent the Most Significant Intercompany Opportunity

Almus Benefits FY15 FY16 FY17 FY18
Almus Benefits
FY15
FY16
FY17
FY18

US Gx Expenditure at Cost (WAG & ABC)

6,318

6,807

7,352

7,938

Penetration Rate 1% 2% 5% 8%
Penetration Rate
1%
2%
5%
8%

Almus

U.S. Sales

$78

$168

$364

$635

Almus Margin 15% 26% 31% 35%
Almus Margin
15%
26%
31%
35%

Almus Gross Profit from US sales

$12

$44

$114

$222

Barclays | Walgreen Co. and Amerisource relationships provide Allian ce Boot’s Almus Pharmaceuticals generic brand with

Foreign Tax Rate*

17%

17%

17%

17%

Barclays | Walgreen Co. and Amerisource relationships provide Allian ce Boot’s Almus Pharmaceuticals generic brand with

Almus Net Income from US sales

$10

$37

$95

$184

Source: Barclays Research

Barclays | Walgreen Co.

FIGURE 14

We Project Almus Reaches 8% Penetration and 35% Margins in FY18

% Almus Penetration of WAG & ABC Gx Expenditures

 

Almus profit margin

 

184

5%

10%

15%

20%

25%

30%

35%

0%

$0

$0

$0

$0

$0

$0

$0

2%

$7

$13

$20

$26

$33

$40

$46

4%

$13

$26

$40

$53

$66

$79

$92

6%

$20

$40

$59

$79

$99

$119 $138 $158 $184
$119
$138
$158
$184

8%

$26

$53

$79

$105

$132

10%

$33

$66

$99

$132

$165

$198

$231

12%

$40

$79

$119

$158

$198

$237

$277

14%

$46

$92

$138

$184

$231

$277

$323

Source: Barclays Research

Non Generic Synergy

Walgreens has indicated that about 50% of the $1 billion of synergies it plans to generate from the acquisition of Alliance Boots will come from areas outside of

pharmaceutical procurement. About $400 million is to come from procurement of not- for-resale items such as shopping bags and pill containers, commodity items such as cotton balls and combs, private label merchandise such as OTC medications and children’s care products, and seasonal merchandise; some synergies may be generated in services as well. Obviously there are differences in the products sold in the US and the UK, but we think there is likely to be enough potential among all these opportunities to hit the $400 million goal. As a reminder, in FY13 WAG alone spent an estimated $17.1 billion on the cost of front-end merchandise (assuming ~35% of sales comes from the front end and the average gross margin is 32%).

The final $100 million of synergies is the anticipated profit from selling Boots private

label products, such as No. 7 and Botanics, in Walgreens’ U.S. stores. Assuming that these are incremental sales, and using a gross margin of 40% (though it may be higher), this means Walgreens would need to generate an incremental $250 million of revenues, which represents only about a 1% increase in estimated front-end sales. Generating this level of sales should be achievable, as it is a relatively low bar (could probably occur if only a sub-set of customers bought one or two products each year).

We are sceptical, however, that WAG can duplicate a Boots beauty department that sells primarily private brands in the U.S. We note that relative to the U.K., the U.S. is a large market, and the cost of developing brand recognition is very high, and the process can take a long time. Most beauty brands in the US have been around for decades, and we have frequently seen new ones fail after large marketing expenditures have been made, even when they are introduced by established manufacturers. In addition, sales of prestige beauty products are well-developed at U.S. department stores, with some sold at dedicated beauty stores such as Sephora, while “masstige” beauty products are sold at Sephora and Ulta. The U.K. beauty business is not segmented in this way, nor is there the same broad- based competition from dedicated beauty stores such as Ulta and Sephora.

Consolidating ABC Stock Ownership

Our published estimates include the contribution from equity income related to

Walgreens and Alliance Boots’ ownership of AmerisourceBergen shares. Our projections for Walgreens ownership and Amerisource share base, suggest that Walgreens will cross the 20% ownership threshold in March of 2016 (at which time the company will begin

consolidating its pro rata share of profits under the income method). Our published estimates include this benefit.

Barclays | Walgreen Co.

Key assumptions:

WAB Holdings (jointly owned by WAG and AB) will gradually increase its stake in ABC from 10.4mn shares at the end of February 2014 (as reported on the balance sheet of WAG) to 19.9mn shares in March 2016 (the maximum allowed for open market purchase from the Framework Agreement dated March 2013).

ABC will continue its share repurchase program beyond cancelling out the dilutive effect of warrants given to WAG and AB. Our model assumes ABC’s average diluted shares outstanding decline from 234.3mn shares at the end of March 2014 to 231.1mn in FY14 (ABC FY ending in September), 221.5mn in FY15, and 211.3mn at the end of FY16.

For simplicity, we assume WAG and AB will each exercise in full their warrants to purchase 11.35mn shares of ABC by March 31, 2016 (exercisable at a price of $51.50, during the 6-month period beginning March 1, 2016). We assume WAG and AB will each exercise in full their warrants to purchase 11.35mn shares of ABC by March 31, 2017 (exercisable at a price of $52.5, during the 6-month period beginning March 1,

2017).

FIGURE 15

Forecasted equity ownership in ABC by WAG and AB (FY of ABC)

35% 31% 31% 30% 9% 9% 25% 20% 20% 21% 20% 20% 9% 10% 9% 11%
35%
31% 31%
30%
9% 9%
25%
20% 20% 21% 20%
20%
9% 10% 9%
11% 11%
15%
9%
10%
5%
4% 5% 6% 6% 6% 7% 7% 8% 8% 9%
5% 5% 5% 5%
5% 5% 5% 5%
11% 11%
0%
Equity ownership in ABC
  • WAG via Walgreens Pharmacy Strategies, LLC

  • AB via Alliance Boots Luxembourg S.à.r.l.,

Source: Barclays Capital

  • WAB Holdings Total WAG and AB

Figure 15 shows our forecasted equity ownership of ABC by WAG and AB. Based on the

assumptions above, total equity ownership will hit 20% in March of 2016, at which point WAG will recognize ABC equity income on its income statement. (For the time preceding this, during which WAG and AB will hold less than a 20% ownership of ABC, the companies carry their ABC stakes on the balance sheet at market value.) We project Walgreens’ pro- rata share of Amerisource earnings is worth $0.14 in FY16, $0.32 in FY17 and $0.34 in

FY18 (included in our published estimates).

Barclays | Walgreen Co.

FIGURE 16

Targeted Opportunity: AmerisourceBergen Income

ABC Equity Income Component

FY16

FY17

FY18

Note

Incremental benefit to Status Quo scenario (in $mn, except EPS)

   

EBIT accretion (cumulative)

158

343

363

Assuming WAG and AB fully exercise their ABC warrants, we hit the 20%

Tax rate applied

0%

0%

0%

threshold for consolidating ABC equity ownership in the March Q of 2016

Net income accretion

158

343

363

No.

of shares - assumption

1,103

1,085

1,062

EPS accretion

$0.14

$0.32

$0.34

 

% EPS accretion over Status Quo case

3%

6%

6%

 

Source: Barclays Research

Barclays | Walgreen Co.

POTENTIAL SOURCES OF INCREMENTAL BENEFIT

We believe that the potential benefits from the Walgreens and Alliance Boots partnership extend well beyond those identified by Walgreens when the partnership was entered into in August of 2012 and FY16 financial goals were provided. These incremental benefits include 1) a partner and management team from Alliance Boots whose historic experience in difficult markets positions them well to enable (or drive) Walgreens to address its historic weakness relative to cost structure, 2) a chance to adopt a more aggressive capital structure (if perhaps temporarily), 3) an opening to move to re-domicile the company in a more favourable tax jurisdiction.

  • 1. Addressing a Bloated Cost Structure

Corporate & Regional Overhead

We have been saying for years that WAG’s cost structure is too high and needs to be

reduced. Although the company has never disclosed the amount it is spending on corporate and regional overhead, the chart below shows the steady rise in SG&A over an extended time frame. Comparing SG&A growth to gross profit dollar growth, we find a multi-year gap in the two metrics. As we indicated earlier in the report, the exceptions to this trend were 1) when the company decided to slow square footage growth, which was implemented in fiscal 2010 but first showed up in a slowing of SG&A dollar growth in fiscal 2011; and 2) when the peak of the generic wave boosted the gross margin in 2012 and 2013. Unfortunately, the dispute with Express Scripts pressured both sales and gross profit dollar growth in fiscal 2012, more than offsetting the benefit of both the slowdown in square footage growth and the generic wave. Walgreens did make adjustments to expenses in fiscal 2012 in an effort to offset the impact of lower script volumes and front-

end traffic, but expenses still grew faster than gross profit dollars.

FIGURE 17

WAG Difference in YoY Growth Rates: Gross Profit vs. SG&A

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013

Gross Profit

15.9%

15.6%

11.7%

15.8%

9.1%

5.9%

7.7%

8.0%

-0.7%

3.8%

SG&A Expense

16.1%

15.7%

13.3%

14.3%

9.1%

8.9%

8.0%

6.7%

1.6%

3.5%

Difference

-0.2%

-0.1%

-1.6%

1.4%

0.0%

-3.0%

-0.3%

1.3%

-2.3%

0.3%

Source: Company reports and Barclays Research

SG&A growth has been running at a slower pace year to date in fiscal 2014 (~1.0%) than what would be normal for other retailers and is well below the average for Walgreens over time. We have some information suggesting that the company is currently cutting corporate overhead, though the company has only barely

acknowledged this despite local Chicago media reports. Assuming that SG&A growth remains on its year to date trend for all of fiscal 2014, we estimate the company will

have cut expenses by about $250 million by year end.

We project that the company could cut another $500 million over the three year period, FY15-17. However we have little information about what has already been cut or what is left to be reduced, either at the corporate office or within the local/regional

field organizations. Alliance Boots is thought to run a much leaner operation and would be able to guide WAG in this process, so we believe these cuts are possible. In fact, investors have expressed a desire for more specificity about what additional

efficiencies can realistically be achieved.

Barclays | Walgreen Co.

If Walgreens can cut $750 million over the four year period FY14-2017, then at the end of that period we believe the company will have achieved a reasonable cost structure and instituted strong expense controls. From that point on, we expect SG&A dollar growth will normalize at 2.5%-3.0%.

Store Level Operational Improvement

As a large, well-established drug retailer that grew across the U.S. very successfully for

many years, we believe Walgreens’ operations are fundamentally sound. In the past 5-7 years, the company has addressed important issues, including reducing the SKU count and making the stores easier to shop by lowering shelf heights and cleaning up aisle displays. For years the company did no consumer research, and it waited too long, in our opinion, to introduce a rewards program. Both are in place now, however, and will contribute to front-

end improvement over time.

Based on our current understanding of the business, the biggest opportunity to improve WAG’s results in the short run is to optimize marketing and merchandising expenditures.

This spending has been unusually high for the past year as the company has been forced to

maintain its broad-based ad circular program while also developing its new rewards program, which was introduced in September, 2012.

The company will be cycling the dual set of investments this spring, and may even be able to moderate the broad-based promotions in the following months, as customers recognize the ease of getting promotional deals directly on the Balance Rewards card. Right now Walgreens does not appear to be using data from specific customers to tailor the offers they get, but over time WAG should be able to target its marketing monies towards its best customers, thereby getting a higher “yield” on that spending. It will also give WAG a much better understanding of what its customers are buying, allowing it to adjust and localize its in-store offering and promotional events. Access to better data would also be valued by large suppliers, so promotional support could increase over time.

In our view, WAG would have been able to realize most of the benefits of the rewards program without buying Boots, but given that company’s experience with loyalty marketing, the merger may allow it to move faster or be more efficient in its effort. Customer behaviour will naturally be different in the US and the UK, so we think what Boots can share relates to process rather than to specific actions.

Figuring out how to lower store costs is much tougher, though some observers have said that CVS runs a more efficient front-end operation. Several years ago, WAG implemented a cost-cutting initiative it called ‘Rewire for Growth’. The steps taken included eliminating district support personnel in areas like beauty, as well as reducing the number of SKUs, A streamlined merchandise offering should have brought down store labor costs related to the handling of inventory. It is not clear, though, if WAG got the outcomes it was hoping for or if there is still more potential to improve efficiency. That is an area where Boots might be able to be helpful, though again the US and the UK markets are very different.

Making the pharmacy more efficient would probably be difficult. WAG operates high- volume pharmacies, and some sources say they work their pharmacy staff very hard. Other sources have said that labor could be used more efficiently, but given the volumes being handled and WAG’s historical investments in technology, it is hard to imagine that the incremental opportunity in the pharmacy comes close to that in the front end.

A barrier to store-level cost reduction is lease costs. As shown in the table below the rent per square foot that WAG pays on its stores has been rising steadily since fiscal 2005, and compared to CVS, it is now paying substantially more per square foot, even though it owns

Barclays | Walgreen Co.

more of its stores. Drug store leases tend to be long (20+ years), and WAG has attractive locations, so lowering this cost would be difficult and perhaps unwelcome.

FIGURE 18

Rent Comparison: Walgreen vs. CVS Caremark

Walgreen FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13
Walgreen
FY03
FY04
FY05
FY06
FY07
FY08
FY09
FY10
FY11
FY12
FY13

Annual Rent ($ in millions)

$ 1,010 $ 1,161 $ 1,307 $ 1,432 $ 1,619 $ 1,787 $ 1,975 $ 2,218 $ 2,500 $ 2,571 $ 2,628

Retail Selling Sq. Ft. (millions)

46

51

55

60

65

71

79

84

86

87

89

Percent of Retail Stores Owned

17.0%

18.0%

18.0%

18.0%

19.1%

19.0%

21.0%

20.0%

21.0%

20.0%

20.0%

Percent of Retail Stores Leased

83.0%

82.0%

82.0%

82.0%

80.9%

81.0%

79.0%

80.0%

79.0%

80.0%

80.0%

Leased Retail Selling Sq. Ft. (millions)

39

41

45

49

53

58

62

67

68

70

72

Rent Per Average Square Foot

% Change

$

29.0 $ 30.2 $ 30.3 $ 31.7 $ 32.3 $ 32.9 $ 34.3 $ 37.1 $ 37.4 $ 37.1

4.2%

0.3%

4.4%

1.9%

1.9%

4.4%

8.2%

0.6%

0.6%