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Walgreen Moves No Game Changer; Shares Still Not Compelling

Walgreen's acquisition of Alliance Boots is positive from a strategic standpoint, but the firm will still lack significant long-term competitive advantages, says Morningstar’s Vishnu Lekraj.

On Wednesday,  Walgreen (WAG) announced its intention to purchase the remaining 55% of Alliance Boots in the first calendar quarter of 2015. Management also lowered its previously announced 2016 goals, citing greater competition, supplier pricing pressure, and unfavorable reimbursement trends as the main catalysts. Management now believes it will be able to produce $126 billion-$130 billion in revenue by 2016, which is below previous guidance of greater than $130 billion. With the lowered assumptions, the firm will look to cut its combined cost structure by more than the $1 billion projected by management in 2012. These cost reductions will happen over the next three years and include material store closures. Additionally, the firm announced it will maintain its corporate domicile in the United States and will not be executing a tax inversion. These developments fall in line with our assumptions, and we are reiterating our $58 fair value estimate and no-moat rating for the retailer.

On balance, we believe Walgreen's acquisition of Alliance Boots is positive from a strategic standpoint. The combined entity will have enhanced supplier purchasing power, and this dynamic will be a critical variable moving forward, given the significant pricing pressure Walgreen faces from both suppliers and payers. Additionally, Alliance Boots has been relatively successful in driving solid results from both its pharmacy and front-store operations in its core European market. Thus, the opportunity to share best practices, drive global operating synergies, and leverage key management assets from both entities will be highly positive for Walgreen over the long term.

Nevertheless, we believe Walgreen will still lack significant long-term competitive advantages and these recent strategic partnerships are in direct response to a highly turbulent operating environment. From our perspective, Walgreen is trying to offset lower payer reimbursement rates by enhancing its supplier pricing negotiating power through the Alliance Boots acquisition and partnership with AmerisourceBergen. With that said, we are not totally convinced these strategic partnerships will be able to significantly change the long-term trajectory of the firm's ability to produce consistent economic profits. While returns on invested capital will be positively influenced by these tactics, we believe the efficiencies gained will not offset the pricing power of drug plan payers and the variability of consumer discretionary spending.

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