The Market May Have Overreacted To Walgreen’s Decision Against Tax Inversion

Walgreen’s (NYSE:WAG) stock price has declined by approximately 15% since the company announced earlier this week its plan to complete the acquisition of Europe-based Alliance Boots.  Driving this sharp decrease was the board’s decision to retain its US tax domicile, rather than opting for an “inverted” structure that would shift its headquarters overseas to escape high US and state corporate tax regimes. The company alos lowered guidance, contributing to the downward pressure.

In August 2012, Walgreen acquired a 45% stake for $6.7 billion in Alliance Boots, the largest European pharmacy-led drug retailer, with an aim to create a global pharmacy by expanding its operation in new markets including Europe, China, Latin America, etc. The agreement gave Walgreen an option to acquire the remaining 55% of Alliance Boots within three years time. Walgreen completed the second step of its strategic transaction with Alliance Boots ahead of the original option period, which was to be between February and August 2015. The company plans to pay around $15 billion for the reaming stake, with $5 billion in cash and the remainder in stock. ^[1] Walgreen expects to close the transaction in the first quarter of calendar 2015.

Walgreen’s decision to not opt for corporate tax inversion, shifting of a company’s headquarter outside the U.S. to avail itself of lower tax rates, did not go down well within the investor community. The company, as we noted, also lowered its initial financial guidance for fiscal year 2016, which further added to the negative sentiment among investors. Walgreen now expect its fiscal 2016 revenue to be in the range of $126 billion to $130 billion (its initial estimate was $130 billion), and adjusted earnings per share of of $4.25 to $4.60. Earnings prior to the deduction of interest, tax and amortization expenses is expected to be “flat to a little up” through 2016. Walgreen’s new $3 billion share repurchase authorization (through the end of fiscal 2016) and increased dividend (7.1% annual increase) didn’t help much in lifting investor sentiment.

We believe that the market over-reacted to the news and  that Walgreen stands to gain a lot from the Alliance Boots acquisition.

Our price estimate of $64 for Walgreens is now at at an approximate 10% premium to the current market price.

View our analysis for Walgreens

Tax Inversion Would Have Led To Substantial Tax Saving Over The Years But Could Have Instigated Possible Consumer & Political Backlash

With the pharmaceutical industry battling rising costs and reimbursement pressures, tax inversion is being considered by at-least a dozen U.S. companies, as reincorporating in lower-tax jurisdictions overseas is one way to significantly cut the annual tax burden. In the past decade around 47 U.S. companies have undergone inversions, according to the Congressional Research Service. ^[2]

Walgreen’s tax rate (as of 2013) is in excess of 36% as the company earns a significant majority of its revenue from the domestic market. Tax inversion would have helped the company cut its effective tax rate from to the high 20% range, translating into significant savings in the next few years. According to Bloomberg, shifting its headquarter overseas (Switzerland) could have saved Walgreen at least $4 billion in taxes over five years. ^[3] A June Deutsche Bank report estimated that a tax inversion could save Walgreen nearly $1 billion in taxes by 2018, increasing EPS by about 15%. ^[4]

However, Walgreen believes that the potential risks of the possible tax inversion could have put the company in a significantly worse position, such as a protracted controversy with the IRS and possible litigation which could go on for anywhere between three to ten years. An equally important factor behind the company’s decision was the possible consumer backlash and political ramifications, including the risk its business faces from the government. Walgreen gets millions of dollars in revenue from the federal Medicare and Medicaid programs.

Alliance Boots Transaction Will Aid Walgreen’s Growth

Walgreen’s acquisition of Alliance Boots, subject to shareholder and various regulatory approvals, will help form the first global pharmacy-led, health and well-being enterprise. The combined entity will be named Walgreens Boots Alliance and will have four key divisions –

1. Walgreen Co. – the largest drugstore chain in the U.S.

2. Boots – the U.K. and Republic of Ireland’s leading pharmacy-led health and beauty retailer.

3. Pharmaceutical Wholesale and International Retail – including Alliance Healthcare, Europe’s largest pharmaceutical wholesaler.

4. Global Brands

Additionally, the holding company is establishing a cross-divisional global pharmacy market access group.

The combined entity will have more than 11,000 stores in 10 countries and unparalleled portfolio of retail and business brands, as well as increasingly global health and beauty product brands. Additionally, it will have the world’s largest pharmaceutical wholesale and distribution network with more than 370 distribution centers delivering to more than 180,000 pharmacies, doctors, health centers and hospitals in 20 countries. Walgreens Boots Alliance will be the world’s largest purchaser of prescription drugs and many other health and well-being products. The large scale and global operations will help the two companies address the rising cost of prescription drugs in America and worldwide. ^[5]

Walgreen achieved $154 million in combined net synergies with Alliance Boots in fiscal 2013 and estimates combined synergies in the range of $300 – $400 million for fiscal 2014. It anticipates cost savings of $1 billion by the end of fiscal 2017. 

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1. Walgreen Stays in U.S. as It Buys Rest of Alliance Boots, Bloomberg, August 7, 2014 [↩]
2. Walgreens stock smacked after tax inversion out, USA Today, August 6, 2014 [↩]
3. Walgreen Stays in US as It Buys Rest of Alliance Boots, Bloomberg, August 7, 2014 [↩]
4. What Walgreen’s tax-inversion move means for investors, Smarter Investing, July 17, 2014 [↩]
5. Walgreens Board of Directors Exercises Option to Complete Second Step of Strategic Partnership with Alliance Boots and Fully Combine Both Companies, Creating First Global Pharmacy-Led, Health and Wellness Enterprise, Walgreens Newsroom, August 6, 2014 [↩]