Walgreen Said to Agree to Boots Deal on Lower U.K. Risk

Walgreen Co. (WAG) agreed to acquire a stake in Alliance Boots GmbH because its business is mostly in the U.K., which it viewed as less risky than the rest of Europe, according to a person familiar with the situation.

Walgreen executives considered whether it was the right time to acquire Alliance Boots given Europe’s economic challenges and potential shareholder concern, said the person, who asked not to be identified because the talks were private.

Walgreen, the biggest U.S. drugstore operator, said yesterday it agreed to buy a 45 percent stake in Alliance Boots, the U.K.’s largest drugstore-chain company. As its top shareholder, Walgreen will control more than 11,000 stores in 12 countries and 370 distribution centers to pharmacies, doctors and hospitals, with an option to buy all of Alliance Boots in about three years.

“Walgreen is making an expensive acquisition of a company that is highly exposed to the weak U.K. and European markets, with greater uncertainty about how things develop in the next few years or even months,” Meredith Adler, a New York-based analyst at Barclays Capital, wrote in a note to clients. She rates the shares the equivalent of a sell.

Walgreen fell 2.9 percent to $29.21 at the close in New York. The shares have slipped 12 percent this year.

Christopher Graja, an analyst at Argus Research Co. in New York, downgraded Walgreen to hold from buy yesterday.

“We would prefer to see the company focus on the challenges and opportunities in the U.S.,” he wrote in a note.

Deal Structure

The two companies began talks about 18 months ago, initially discussing a joint venture, said the person. As the talks evolved into a possible equity investment, there were months of due diligence and analysis of potential cost savings, the person said. They also had to work out details such as the deal structure and the terms under which Walgreen could boost its stake, the person said.

Walgreen Chief Executive Officer Gregory Wasson is looking to goose growth, which has been slowing amid a spotty U.S. recovery. Walgreen’s contract to sell prescriptions through Express Scripts Inc. also ended Dec. 31, leading to lower same-store sales as customers switched to CVS Caremark Corp. (CVS), Wal-Mart Stores Inc. (WMT) and other drugstore rivals.

Falling Profit

Third-quarter net income fell 11 percent to $537 million, or 62 cents a share, from a year earlier, the Deerfield, Illinois-based company reported yesterday. Sales at stores open at least a year dropped 6.6 percent.

“There is no question this deal does diversify Walgreen away from the United States and creates a separate profit stream that could counter any added Express Scripts-related hits,” John Heinbockel, a Guggenheim Securities LLC analyst in New York, wrote in a note to clients. He rates the shares buy.

Walgreen will pay $4 billion cash and the remainder in stock for its biggest-ever deal, with an option to gain full control in about three years, the companies said yesterday. The stake is being acquired from a group led by KKR & Co. (KKR) and Alliance Boots Chairman Stefano Pessina, who bought the company in a 12.1 billion-pound ($19 billion) buyout five years ago.

KKR and Pessina will become shareholders in the combined business. Pessina, an Italian billionaire, said on a conference call yesterday that he’ll own an 8 percent stake in Walgreen and doesn’t want to take money out. In the second phase of the tie-up, Walgreen will assume the Alliance Boots debt. As of March 31 the U.K. company had about 7 billion pounds in debt, according to a May 16 earnings statement.

Erase Hit

Walgreen projected the Alliance Boots transaction will boost per-share profit by 23 cents to 27 cents this year. That will essentially erase an earnings hit of 25 cents to 28 cents on an annualized basis from the end of the Express Scripts contract, according to Ann Hynes, an analyst at Mizuho Securities USA Inc.

Walgreen estimated the tie-up with Alliance Boots, which is based in Zug, Switzerland, would generate savings of $100 million to $150 million in the first year because of increased buying power for prescription and over-the-counter drugs as well as general merchandise.

Both companies will benefit from sharing best practices in store design, customer loyalty programs and selling online, Wasson said. Full integration is planned over three years, minimizing initial disruption of business, he said.

Integration Risks

Integration risks remain, according to Brian Sozzi, an independent analyst in New York.

“There’s a lot of risk to computers and other systems that, if they go wrong, calls into question whether they can meet their targets,” Sozzi said in an interview yesterday. He doesn’t rate Walgreen shares.

Europe’s financial crisis made Walgreen’s investment in Alliance Boots “very surprising,” according to Heinbockel.

“We always thought that such expansion efforts would occur further down the line, be relatively modest in scale, and be initially centered on the faster-growing Latin American markets,” Heinbockel said.

Several analysts questioned the timing.

“We think international expansion is a prudent strategy,” Hynes wrote in a note yesterday. “But the timing is off given the economic backdrop and debt crisis in Europe, where a majority of revenue is generated.” She rates Walgreen neutral, the equivalent of a hold recommendation.

While “the stock may not go anywhere for a while,” the tie-up will look “pretty darn smart” once Europe recovers from its debt crisis, said Bill Smead, who oversees about $180 million, including 167,252 Walgreen shares, as chief investment officer at Seattle-based Smead Capital Management Inc.

“In this era where everyone is afraid to take risks, this may be the first step in establishing global drugstore chains,” Smead said by telephone yesterday. “Maybe you wake up in 10 years and these guys own 30,000 drugstores around the world.”

To contact the reporters on this story: Chris Burritt in Greensboro at cburritt@bloomberg.net; Jeffrey McCracken in New York at jmccracken3@bloomberg.net

To contact the editors responsible for this story: Robin Ajello at rajello@bloomberg.net; Celeste Perri at cperri@bloomberg.net

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