February 27, 2017 / 1:52 PM / 2 years ago

Fitch Rates Walgreens Boots Alliance, Inc.'s New Term Loans and RCF 'BBB'

(The following statement was released by the rating agency) NEW YORK, February 27 (Fitch) Fitch Ratings has assigned a 'BBB' rating to Walgreens Boots Alliance, Inc.'s (WBA) new $4.8 billion and $1 billion term loan credit facilities as well as its $1 billion revolving credit facility (RCF). These facilities, which are expected to be used to finance the proposed Rite Aid acquisition, replace $6.8 billion in funding commitments which expired Jan. 27, 2017. The $4.8 billion term loan is structured in two $2.4 billion tranches, maturing Oct. 27, 2019 and Oct. 27, 2021, respectively. The $1 billion term loan is structured in two $500 million tranches, which expire on the first anniversary of the date of funding and the earlier of the same date or March 30, 2018, respectively. Both term loan commitments expire July 31, 2017 with potential extensions to Oct. 31, 2017. The $1 billion revolver, which has an accordion feature for additional commitments of up to $250 million, is a 364-day facility which became effective Feb. 1, 2017 and may be used for general corporate purposes including the funding of its Rite Aid acquisition. Fitch Long-Term Issuer Default Rating (IDR) for WBA is 'BBB'/Stable Outlook. A full list of ratings follows at the end of this release. On Jan. 30, 2017, WBA announced a renegotiated Rite Aid merger agreement, which both lowers the purchase price and extends the agreement to July 31, 2017. The previous $17 billion purchase price was reduced by $2.2 billion to $2.7 billion, with the final price dependent on required store divestitures, which could be up to 1,200, higher than the original plan of up to 1,000 stores. Fitch estimates a total purchase price for Rite Aid of approximately $14.5 billion, including the assumption of $2.3 billion (from a total $7 billion) of Rite Aid's existing unsecured debt. WBA has obtained $12.8 billion in financing for the acquisition, including approximately $6 billion each of unsecured notes and term loans and $1 billion in revolver availability. The 'BBB' rating incorporates WBA'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 debt-financed Rite Aid acquisition offers WBA the ability to strengthen its competitive position and generate significant procurement and cost synergies. Incremental debt is expected to yield elevated leverage of around 4.0x on a pro forma adjusted debt/EBITDAR basis from an LTM 3.3x times on a standalone basis (eliminating $6 billion in funded debt associated with the Rite Aid acquisition). Fitch expects WBA to return adjusted leverage to the mid-3x level by fiscal 2019 (August) and toward the low-3x range thereafter. 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 Rite Aid. 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. As of February 2017, WBA owns 26% of ABC at a cost of approximately $3.1 billion after exercising its final warrants for $1.2 billion. --Rite Aid Purchase: In October 2015, WBA announced the proposed purchase of Rite Aid, designed to add to the company's national retail coverage and purchasing scale. Rite Aid - which has approximately 6% share of the U.S. prescription market - has strong presence in key markets where Walgreens has lower market share such as California and the Northeast. The company is also targeting $1 billion in cost synergies, including leveraging scale in sourcing and eliminating duplicative corporate expenses. Fitch has modelled synergies approaching $750 million by fiscal 2020. --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, of which three-quarters 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, 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 Affordable Care Act or other legislative activity impacting 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 30-40bps 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. Fitch anticipates WBA can grow its U.S. pharmaceuticals sales in the 4% range 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. Rite Aid EBITDA Opportunity Fitch views the proposed purchase of Rite Aid, which reported sales of $33 billion and EBITDA of $1.3 billion in the LTM ended November 2016, positively due primarily to the procurement and cost structure opportunities gained by exploiting the combined entity's scale. The company's $1 billion cost synergy target is predicated largely on improved sourcing, in addition to reducing duplicative costs in the combined entity. Fitch believes at least $750 million of synergy savings are possible by fiscal 2020, though mitigated by around $300 million EBITDA reduction, assuming the FTC mandates approximately 1,200 store divestitures due to local market share concerns. Depending on final store divestitures, Rite Aid would improve WBA's national retail coverage, particularly in Southern California and Northeastern U.S. markets, positioning it well to compete for inclusion in narrow and preferred pharmacy networks. At the end of fiscal 2015, 76% of U.S. households operated within a five-mile radius of a Walgreens or Duane Reade (also owned by WBA) and Fitch anticipates the coverage is likely to rise to the mid-to-high 80% range at the close of the acquisition. Beyond the synergy benefits, WBA may also benefit from store consolidations over the next few years, where a Rite Aid or Walgreens store is closed and the prescription file is transferred to another nearby location. The drugstore industry has historically driven EBITDA improvements through these consolidations. Additionally, Rite Aid has historically had lower per-store sales productivity than its larger peers given significant lack of investments, and WBA plans to improve comps through its operating expertise. Fitch has not incorporated upside from either of these opportunities into its forecast. Size and Scale Enables Financial Flexibility WBA's scale affords significant financial flexibility, allowing the company to invest in its existing business and capitalize on new opportunities while reducing leverage post the Rite Aid acquisition, which could add approximately $12 billion of debt to WBA's existing $13 billion (as of Nov. 30, 2016 and excluding $6 billion in unsecured notes intended to finance the Rite Aid acquisition), yielding pro forma leverage of approximately 4.0x, up from current leverage of 3.3x (excluding debt associated with the Rite Aid acquisition). Fitch believes the purchase of Rite Aid and accompanying synergies could drive EBITDA to close to $12 billion in fiscal 2020 compared to $9 billion in fiscal 2016 excluding Rite Aid and about $10 billion on a pro forma WBA/Rite Aid basis. Fitch expects pro forma FCF to be around $4 billion after dividends, before one-time cash restructuring/merger expenses and prior to any potential working capital improvements. FCF should increase to the $5 billion range by fiscal 2020 on synergies and reduced merger expenses, and is expected to be used primarily for debt paydown. Fitch believes debt paydown could yield adjusted leverage in at around mid-3x by fiscal 2019 and toward the low-3.0x range thereafter, absent any large-scale acquisitions. Should the Rite Aid acquisition not be consummated, Fitch expects WBA to end fiscal 2017 with leverage in the low-3.0x range. The company would likely use FCF to resume share repurchases, absent any other acquisition opportunities. 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. Rite Aid Integration Risk Fitch assumes WBA can achieve $750 million of the planned $1 billion in synergies by fiscal 2020. Fitch expects WBA will enact a number of changes to Rite Aid operations, including store closures/consolidations, supply chain/procurement changes, and merchandising updates. Any of these could cause inventory interruptions and customer dissatisfaction, putting at risk both synergy forecasts and Rite Aid's ongoing sales trajectory. KEY ASSUMPTIONS --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 combined entity is projected to be around 2%-3% after adjusting for an assumed 1,200 Rite Aid divestitures. --Standalone EBITDA, which was $9 billion in fiscal 2016, is expected to increase toward $10 billion over the next 36 months. EBITDA of around $10 billion on a pro forma basis including Rite Aid could improve to around $12 billion over the 36 months following the close of the acquisition on modest core growth and Rite Aid synergies. --FCF after dividends is projected to be around $4 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. FCF is expected to be used primarily to reduce debt to the mid-3.0x range in fiscal 2018 and the low-3.0x range in fiscal 2019. --Standalone FCF is projected to be in around $4 billion 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 A negative rating action could occur given some combination of the following: --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 the Rite Aid integration or merchandising/systems initiatives; --A debt-financed transaction or divergence of cash flow to unanticipated strategic priorities, limiting debt paydown; --Diminished confidence in WBA's ability and willingness to reduce leverage below 3.5x by fiscal 2020, absent an unforeseen debt-financed acquisition. 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 Nov 30, 2016, the company had $9.4 billion in cash (which excludes $174 million of deposits restricted under agency agreements, law,or other obligations) and full availability on its revolver. WBA had $18.9 billion of debt at Nov. 30, 2016, composed of a GBP 1.4 billion term loan (or USD$1.8 billion equivalent) with the remainder in unsecured notes, of which approximately $6 billion is expected to finance the Rite Aid acquisition. WBA is funding the acquisition with approximately $12 billion of debt, including the assumption of $2.3 billion of Rite Aid's existing unsecured debt. FULL LIST OF RATING ACTIONS Fitch currently rates WBA as follows: Walgreens Boots Alliance, Inc. --Long-Term Issuer Default Rating (IDR) 'BBB'; --Unsecured revolver (as co-borrower) at 'BBB'; --Unsecured term loans 'BBB'; --Unsecured bonds 'BBB'; --Short-Term IDR 'F2'; --Commercial paper 'F2'. Walgreen Co. --Unsecured revolver (as co-borrower) 'BBB'; --Unsecured term loan (as co-borrower) 'BBB'; --Unsecured bonds '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 Megan Neuberger, CFA Managing Director +1-212-908-0501 Media Relations: Elizabeth Fogerty, New York, Tel: +1 (212) 908 0526, Email: elizabeth.fogerty@fitchratings.com; Hannah James, New York, Tel: + 1 646 582 4947, Email: hannah.james@fitchratings.com. Date of Relevant Rating Committee: May 4, 2016 Financial Statement Adjustments 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. Fitch added back $115 million in non-cash stock-based compensation to its EBITDA calculation. --Fitch has adjusted the historical and projected debt by adding 8x yearly operating lease expense. 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