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Mulling an LBO at Walgreens

| November 8, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Walgreens Boots Alliance’s (WBA) stock trading was recently halted prior to headlines that the company was exploring a deal to take the company private. According to news reports, WBA is said to have held talks with Evercore Partners and KKR to vet its go-private attempt, sending shares up by mid-single digits (Exhibit 1) and bonds wider by roughly 35 bp across the curve (Exhibit 2). If the leveraged buyout is taken off the table and bond spreads re-trace to pre-LBO levels, this would be viewed as a selling opportunity for investors.

Equity weakness amid a changing landscape

Even with the jump in the equity price on the heels of the news, WBA stock is down roughly 13% year-to-date, compared to its closest investment grade (IG) peer CVS, whose stock is up nearly 9% year-to-date. WBA’s poor equity performance coupled with a dramatically changing landscape that has seemed to evolve away from traditional pharmacy brick-and-mortar and more towards a vertically integrated healthcare model are likely the underlying factors behind management’s exploration of an LBO. Furthermore, WBA’s CEO, Stefano Pessina, remains the largest shareholder with a 16.25% stake – more than double that of the next largest shareholder.

Exhibit 1. WBA equity performance year-to-date

Source: Bloomberg

Largest LBO in history?

With a market capitalization of roughly $53 billion and $16.8 billion of debt outstanding, an LBO of WBA would become the largest levered buyout in history, topping the sale of TXU to KKR /TPG for $45 billion including debt back in 2007.  WBA would likely need to raise between $55-to-$65 billion to fund the take out as well as the refinancing of debt, as all bonds contain a $101 change of control (COC) put. While market conditions “appear” ripe for an LBO, given the historically low rate environment and continued demand for corporate bonds, a deal over $50 billion would be difficult to absorb in the high yield (HY) market. The HY market has not witnessed a deal larger than $20 billion, and HY spreads relative to IG spreads, have started to diverge. While the LUACTRUU index is hovering around the tights for the year, the LF98TRUU index has begun to sell off.   Additionally, the HY market has not forgotten the last retail LBO, Toys R Us, which filed for Chapter 11 and then converted to a Chapter 7 case last year.

Exhibit 2. WBA 3.45% 6/1/26 spread history (8/7/19-11/7/19)

Source: Bloomberg

An LBO of a retailer is typically predicated on two reasons: real estate and cash flows.  Retail LBOs have historically been used to extract value from real estate holdings that could be sold off in pieces, under the premise that the parts are worth more than the whole. Additionally the sale of real estate does not affect EBITDA profile of the company. If real estate is not the primary driver, then it’s the large and predictable cash flow base. Neither of the aforementioned factors can really be used to describe WBA.  As of 8/31/19, WBA owned only 9.3% of its total store base: out of 13,882 stores in the USA and internationally, WBA only owned 1,297.  While WBA has other real estate holdings such as distribution centers (13 owned out of 21), pharmaceutical distribution centers (113 owned out of 300) and principal office facilities (10 owned out of 22), these tend to carry lower valuations per square foot than commercial retail space.

From a cash flow perspective, WBA’s margins have been in decline since fiscal 2016 as the EBITDA margin has contracted from 7.1% to 5.6% currently.  Additionally, cash flow/sales has deteriorated by 50% over the same time period, down from 5.6% in fiscal 2016 to 2.8% in fiscal 2019. Increased capital expenditures coupled with higher working capital needs are the primary drivers behind the cash flow decline.

What’s next?

WBA stock has sold off since the rumors hit the tape on 11/5/19, suggesting that the investment community may be skeptical that an LBO is likely. Should the company decide not to pursue an LBO, concerns remain that management may look to pursue some type of leveraged recapitalization to help lift the stock price. WBA ended the most recent fiscal year with lease adjusted leverage of 3.7x.  This is high for the current Baa2/BBB ratings and up from the 3.3x posted in FY18. Adding $10 billion of debt to the balance sheet for shareholder rewards would increase leverage to the 4.5x area.

Any type of leveraged recapitalization would mark a distinct shift in financial policy and would likely result in negative rating actions. Additionally, the $101 change of control put does not protect bondholders from downside risk in a leveraged recapitalization scenario. However, if the LBO is taken off the table and spreads retrace close to pre-LBO headline trading levels, that would be viewed as a better selling opportunity .

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