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Fitch Affirms Walgreens Boots Alliance at 'BBB' Following Revised Rite Aid Corp Transaction
June 29, 2017 / 4:11 PM / 5 months ago

Fitch Affirms Walgreens Boots Alliance at 'BBB' Following Revised Rite Aid Corp Transaction

(The following statement was released by the rating agency) NEW YORK, June 29 (Fitch) Fitch Ratings has affirmed Walgreens Boots Alliance, Inc.'s (WBA) 'BBB' Long-Term Issuer Default Rating (IDR) following its proposed purchase of 2,186 Rite Aid Corporation locations for $5.175 billion. A full list of ratings follows at the end of this release. Fitch views the new proposal, which replaces WBA's previous proposal to acquire Rite Aid in its entirety, to be a strategic positive based on increased geographic coverage, including the Northeastern U.S., although neutral to its credit profile. WBA's 'BBB' rating incorporates the company's leading position and increasing market share in the growing drugstore category. WBA's ample free cash flow (FCF) provides it the financial flexibility to invest strategically in its business and new opportunities while managing its balance sheet. The addition of 2,186 Rite Aid locations offers WBA the ability to strengthen its competitive position while generating synergies of around $400 million as guided by management. Given the significantly reduced purchase price, pro forma adjusted debt/EBITDAR is expected to remain around 3.3x, similar to latest 12-month levels (excluding funded debt associated with the proposed Rite Aid acquisition). Fitch expects adjusted leverage to remain near these levels over the next 24-36 months, absent further investment opportunities. Rating concerns include ongoing pressure on U.S. pharmacy reimbursement rates, WBA's under-penetration in the U.S. specialty pharmacy business, and integration risks with the addition of Rite Aid stores. KEY RATING DRIVERS Since Walgreen Co. (WAG) completed its merger with Alliance Boots to form WBA on Dec. 31, 2014, the combined entity has developed a holistic strategy to grow its presence in the U.S. healthcare market. The company has undertaken a number of strategic priorities to drive the business, including the following: --AmerisourceBergen Corp. (ABC) Long-Term Relationship: In March 2013, WAG and wholesaler ABC announced a 10-year agreement (subsequently extended to 2026) to source all drugs through a newly formed strategic partnership which would enable sharing of synergies by layering ABC's generic volume into WBA. Previously, WAG sourced branded pharmaceuticals through Cardinal Health Inc., specialty pharmaceuticals through ABC and generics directly from manufacturers. Management also believed an economic interest in ABC was important and structured warrants and an open-market purchase program. WBA currently owns approximately 26% of ABC at a cost of approximately $3.1 billion after exercising its final warrants for $1.2 billion. --Cost Structure Opportunities: The company has identified $1.5 billion in cost reduction opportunities primarily in the Walgreens U.S. business, up from $1 billion initially identified in June 2012 at the announcement of the WAG/Alliance Boots partnership, and plans to complete the program by the end of fiscal 2017. Key areas of focus have included retail footprint optimization, headquarters rationalization and store operations efficiencies. WBA has a multifaceted strategy in terms of the front-end, which represents around 30% of enterprise sales volume, three-quarters of which is generated via Walgreens stores in the U.S. First, new management sees an opportunity to improve basic operations such as inventory management and shrink reduction. Second, management believes Walgreens has historically been overly focused on promotions, with many loss-leaders driving down margins. WBA has been reducing promotions and relying more on strong operations and its Balance Rewards loyalty program to drive sales. Third, WBA plans to revitalize its beauty offering in the U.S., using elements of the successful Boots model including owned brands such as No 7, Soap & Glory and Botanics. Fitch views as positive efforts to drive installed loyalty programs as a means to improve customer stickiness. RATING STRENGTHS Category Growth and Competitive Resilience WBA benefits from share gains in its U.S. pharmacy business, which accounts for approximately 50% of total company sales, with the industry expected to grow 1%-2% annually each in volume and pricing. The industry has benefitted from an aging U.S. population, enrollment increases due to the Affordable Care Act (ACA), and prescription price increases, particularly for specialty pharmaceuticals. Unlike many other retail categories, Fitch views pharmacies as having limited competition from new formats given fixed-price contracts and pharmacist supply constraints. Mail-order, which emerged as a major threat to retailers over the past several decades, appears to have peaked, particularly given "90-day at retail" offers across the industry as well as a number of branded drugs shifting to over-the-counter. However, there has been significant pharmacy reimbursement pressure due to shifts to managed care from cash over the 1990s through mid-2000s and growth in Medicaid/Medicare over the last few years, and this pressure is expected to continue over the next few years as payers strive to contain healthcare costs. Economics of scale are critical to negotiate better pricing on pharmaceutical purchases to help offset some of the reimbursement pressure. As a result, Fitch expects WBA will continue to drive U.S. share gains with volume growth in the 2%-3% range while the overall industry grows at 1%-2%. Fitch has currently not modelled any impact on total coverage, volume, or pricing based on potential changes to the ACA or other legislative activity affecting the pharmaceutical industry. Front-end sales have grown in the low single digits in recent years, and have shown resilience to competition from channels including discounters and online. Fitch believes that WBA's low front-end ticket at less than $10 in most cases, convenience model, and purchase immediacy have allowed it to effectively compete against new entrants. Fitch expects WBA's front-end comparable store sales (comps) to be slightly positive over the next three years. Market Share Gains Expected to Continue With 20% prescription market share, WBA is the second-largest player in the U.S. and has driven market share through execution and scale benefits. As a leading market player with strong loyalty from a sticky customer base, WBA is a preferred retail partner and can compete effectively for inclusion in pharmacy networks with acceptable financial terms. WBA's size also permits cost-effective pharmaceuticals buying, enhanced by its partnership with wholesaler ABC, to leverage the combined buying scale. As a result of WBA's scale and execution, the company has built a long track record of growth, including U.S. comparable prescription volume growth of 3.5% and 2.3% in fiscal 2015 and fiscal 2016, respectively. This growth reflects market share gains in light of the structural challenges facing the retail pharmacy space. Industry challenges, such as increased concentration of payers (including the government), mail-order, and narrow networks, have not had a negative impact on Walgreens' volume growth and, in Fitch's view, have likely helped it gain share against smaller operators and independents. However, these challenges have dampened gross margins and Fitch expects WBA's U.S pharmacy gross margins to decline 30bps-40bps annually. Despite overall market strength, WBA is underpenetrated in specialty pharmaceuticals relative to the market and competitors such as CVS Caremark (CVS), which has made targeted investments into the specialty category and benefits from its purchase of pharmacy benefits manager (PBM) and mail-order operator Caremark in 2006. CVS currently has approximately a 25% share of the U.S. specialty market, which Fitch estimates at more than twice that of Walgreens. As specialty pharmaceutical growth will dominate overall spending growth over the rating horizon, WBA is somewhat structurally disadvantaged. The company's recently announced strategic alliance to combine its specialty pharmacy business with Prime Therapeutics LLC could improve its growth profile while benefitting from scale efficiencies. WBA's proposed acquisition of 2,186 Rite Aid locations would yield increased geographic coverage, particularly in certain Northeastern markets of the U.S., improving its ability to compete for inclusion in narrow and preferred pharmacy networks. At the end of fiscal 2016, 76% of the U.S. population lived within a five-mile radius of a Walgreens or Duane Reade (also owned by WBA) and Fitch anticipates the coverage is likely to rise modestly following the Rite Aid stores acquisition. Fitch anticipates WBA can grow its U.S. pharmaceuticals sales at around 4% annually, by taking share in non-specialty categories while maintaining or losing modest share in the specialty category. Fitch expects WBA's international business, approximately 30% of total company sales, to grow in the low single digits annually over the forecast horizon, driven by 1%-2% comps in international retail and modest growth in the international wholesale business. International gross margins are expected to be flattish in the low-20% range, as the dynamics pressuring gross margins in the U.S. are less prevalent abroad. RATING CONCERNS Gross Margin Pressure Fitch sees continued gross margin pressure on sales of pharmaceuticals in the U.S. Structural margin pressure has been a consequence of increased penetration of the government as a pharmaceutical payer under the Medicare and Medicaid programs, ongoing pressure from commercial payers, and a mix shift toward the "90-day at retail" offering. This pressure has been somewhat mitigated by the growth in generic penetration over the last few years, though this is expected to taper off given a lighter calendar of branded expirations. Projected margins may also be affected by the growth in preferred/narrow networks, as WBA sacrifices margin for network inclusion to drive volume. Over the forecast horizon, Fitch expects U.S. pharmacy gross margins to decline 30bps-40bps annually, while U.S front-end gross margins are expected to remain relatively flat. Fitch has also assumed modest gross margin pressure in WBA's international retail pharmacy and wholesale businesses. Cash Flow Deployment Options/Lack of Financial Targets WBA has shown a willingness to use cash and leverage to grow its business. Examples include its strategic investment in ABC and its announced merger with Rite Aid. Management has expressed support of partnerships and the need to reduce inefficiency in the U.S. healthcare system. This mindset, coupled with management's lack of publicly stated financial targets, yields some risk with regard to the pace of debt paydown. Front-End Competition from Online Players WBA's enterprise front-end sales have been resilient to strengthened competition from discounters and online channels. Fitch believes this is due to low average ticket prices, WBA's convenience model, and purchase immediacy. However, online merchants, Amazon.com, Inc. in particular, continue to improve their business models and speed of delivery, which could affect WBA's higher-margin front-end sales in the future. Amazon.com's proposed purchase of Whole Foods Market, Inc. suggests the online retailer could be an increasing threat for share gains in some of WBA's categories like food consumables. DERIVATION SUMMARY WBA's 'BBB' rating incorporates the company's leading position in the growing drugstore category, which has proven to be resilient to discount and online competition. The rating also considers the company's ample FCF generation and balance sheet management. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer include: --Fitch expects 2.5%-3% sales growth at legacy WBA, driven by 4% U.S. pharmacy and 0%-1% U.S. front-end comps and low-single-digit growth in the company's international retail and wholesale businesses. Sales growth for the acquired Rite Aid stores could initially be somewhat negative given Rite Aid's current trajectory, but should improve to modestly positive if WBA is able to reverse the trend. --Standalone EBITDA, which was $9 billion in fiscal 2016, is expected to increase toward $10 billion over the next 36 months, primarily on sales growth. Margins are expected to be range-bound given ongoing reimbursement rate pressure. EBITDA of approximately $9.4 billion on a pro forma basis including the acquired Rite Aid stores could improve toward $10.5 billion over the 36 months following the close of the transaction on modest core growth and Rite Aid synergies. --FCF is projected to be around $4.5 billion on a pro forma basis, prior to merger-related expenses and restructuring charges. FCF is expected to increase toward $5 billion on Rite Aid synergies in the 36 months following the close of the acquisition. Pro forma leverage is expected to be around 3.3x and remain near this level, absent further investment opportunities. --Standalone FCF is projected to be around $4 billion annually beginning fiscal 2017, and could be used to resume WBA's share repurchase program while maintaining leverage in the low-3.0x range. RATING SENSITIVITIES Future Developments That May, Individually or Collectively, Lead to Negative Rating Action --Persistently negative front-end comparable store sales or flattish prescription volume growth, indicating market share erosion; --Unsuccessful execution yielding flattish or modestly declining EBITDA from pro forma levels, driven by greater-than-expected gross margin declines on worsening reimbursement rates or weak implementation of merchandising/systems initiatives; --A debt-financed transaction which diminishes confidence in WBA's ability to sustain adjusted leverage below 3.5x. Future Developments That May, Individually or Collectively, Lead to Positive Rating Action Given WBA's lack of stated targets with respect to financial leverage, an upgrade is unlikely due to the risk of a leveraging transaction. However, Fitch would view positively a public commitment to sustain leverage below 3x. LIQUIDITY At May 31, 2017, the company had $12.2 billion in cash and full availability on its revolvers. WBA had $19 billion of debt at May 31, 2017, of which approximately $6 billion was expected to finance the Rite Aid acquisition. Given the revised transaction terms, Fitch expects WBA to pay down debt in addition to the $3.5 billion of notes redeemed in June 2017. Year-end debt is expected to be in the $13 billion range, consisting primarily of unsecured notes. Fitch would expect to withdraw its ratings of redeemed debt upon repayment. FULL LIST OF RATING ACTIONS Fitch has affirmed WBA's ratings as follows: Walgreens Boots Alliance, Inc. --Long-Term Issuer Default Rating (IDR) at 'BBB'; --Unsecured revolver (as co-borrower) at 'BBB'; --Unsecured term loans at 'BBB'; --Unsecured bonds at 'BBB'; --Short-Term IDR at 'F2'; --Commercial paper at 'F2'. Walgreen Co. --Unsecured revolver (as co-borrower) at 'BBB'; --Unsecured term loan (as co-borrower) at 'BBB'; --Unsecured bonds at 'BBB'. The Rating Outlook is Stable. Contact: Primary Analyst David Silverman, CFA Senior Director +1-212-908-0840 Fitch Ratings, Inc. 33 Whitehall St. New York, NY 10004 Secondary Analyst Monica Aggarwal, CFA Managing Director +1-212-908-0282 Committee Chairperson Ellen Itskovitz, CFA Senior Director +1-312-368-3118 Media Relations: Alyssa Castelli, New York, Tel: +1 (212) 908 0540, Email: alyssa.castelli@fitchratings.com. Summary of Financial Statement Adjustments - Financial statement adjustments that depart materially from those contained in the published financial statements of the relevant rated entity or obligor are disclosed below: --Historical and projected EBITDA is adjusted to add back non-cash stock-based compensation and exclude restructuring charges. In fiscal 2016, Fitch excluded $1.1 billion in one-time restructuring charges related to WBA's cost initiatives and mergers, LIFO provisions, and merger-related amortization. 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