Amended Deal With Rite Aid Has Leerink More Cautious On Walgreens Shares

Leerink said in a note on Thursday it remains incrementally more cautious on the shares of Walgreens Boots Alliance Inc WBA following the release of its quarterly results and after analyzing the new Rite Aid Corporation RAD deal.

Following a year-and-a-half dilly-dallying since the deal was announced, Walgreens and Rite Aid had to terminate the agreement in the wake of reduced possibility of securing anti-trust approval. Instead, Rite Aid announced the sale of 2,186 of its stores, located predominantly in the Northeast, Mid-Atlantic and Southeastern regions to Walgreens.

Beat-And-Raise, But Not

Reviewing Walgreen's results, Leerink analysts David Larsen and Matt Dellelo said although the company's earnings beat the consensus estimate by $0.03, the quality of earnings was low. The earnings beat and the upward revision of full-year earnings per share estimate by $0.08, according to the analysts, came from a lower tax rate.

Leerink noted that the good U.S. retail volumes came about due to a lower price, putting pressure on reimbursement and gross margin. The operating income growth, which came despite operating margins holding steady, came about due to SG&A cost reduction efforts, the firm noted.

The firm expressed concern that much of the SG&A cost reduction efforts from the Alliance Boots merger will be complete by the end of 2017.

"We are also becoming more cautious on 'restructuring charges' that management is consistently reporting," the firm added.

Paying Through The Nose

Leerink thinks the price tag for the new Rite Aid deal is high, though still a positive, as it keeps the deal alive and also adds about 2,186 stores. The firm estimates that these stores would generate about $13 billion in revenues and $390 million in EBITDA. According to the firm, the EBITDA margin assumption of 3 percent is low, since the deal is for stores and not corporate overhead.

FTC Could Still Play Spoilsport

The firm thinks the FTC could still block the deal. "However, in our view the FTC staff may be seeking to 'save face' and 'flex its muscle' when reviewing this transaction," the firm opined.

The firm differed with Walgreen's view that the FTC may not focus on the Herfindahl-Hirschman Index, which is a commonly accepted measure of market concentration. Leerink also pointed to the FTC's somewhat biased view toward healthcare transactions due to staff's view that consolidation caused prices to rise. The firm put the odd of the new deal going through as 50/50.

Dragging International Markets

Leerink said gross and operating margins at Walgreen's Retail Pharmacy International are also under pressure. The international wholesale division saw flat operating income and deteriorating gross margins, the firm added.

Lowering Estimates

Incorporating the Rite Aid deal, Leerink estimates a 6-cent accretion to Walgreen's 2018 earnings per share from the deal, provided it is consummated. However, citing the newly structured Rite Aid transaction and lower margins across the business, the firm lowered its 2018 and 2019 earnings per share estimates by $0.25 and $0.15, respectively.

"While we are becoming incrementally more cautious on WBA's earnings power, we do expect the firm to generate nearly $5B in FCF in F2017, and we are encouraged by the new $5B share repurchase program," the firm said.

As such, Leerink maintains its Outperform rating on the shares of Walgreens but lowered its price target from $90 to $86.

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