Fitch Rates Walgreens Boots Alliance, Inc. $1B Unsecured Term Loan 'BBB'

NEW YORK--()--Fitch Ratings has assigned a 'BBB' rating to Walgreens Boots Alliance, Inc.'s (WBA) $1 billion unsecured term loan. The loan is structured in two $500 million tranches, with one maturing in March 2017 and the other maturing one year following the date of the close of the Rite Aid Corporation (Rite Aid) acquisition, pending regulatory approval. Proceeds will be used to partly fund the company's acquisition of Rite Aid. Fitch rates WBA's Long-Term Issuer Default Rating (IDR) 'BBB'/Stable Outlook. A full list of ratings follows at the end of this release.

Of the total $17 billion purchase price for Rite Aid, Fitch estimates WBA will fund the acquisition with $14.6 billion of debt, including the assumption of $2.3 billion of Rite Aid's existing unsecured debt. As WBA has obtained $6 billion in term loans and $6 billion of unsecured notes, the company will need to raise another $0.3 billion in financing. WBA has disclosed that this could include bank financing, commercial paper and/or private debt placement.

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.

While incremental debt is expected to yield elevated leverage at 4.2x on a pro forma basis, Fitch expects WBA to return adjusted leverage to its historical low-3.0x levels by fiscal 2019 (August). 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 (extension of three years announced on May 5, 2016) 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 August 2016, WBA owns 24% of ABC at a cost of approximately $3.1 billion after exercising its final warrants for $1.2 billion (announced August 25, 2016).

--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 2019. The transaction is expected to close in the second half of calendar 2016.

--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.

In terms of the front-end, which represents around 30% of enterprise sales volume (three-quarters via Walgreens stores in the U.S.), WBA has a multifaceted strategy. 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 (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.

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 overall industry grows at 1%-2%.

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 (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 1.8% and 3.5% in fiscal 2014 and fiscal 2015, respectively. This growth reflects market share gains due to 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 negatively impacted 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 30-40 basis points (bps) 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 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 $31 billion and EBITDA of $1.4 billion in 2015, 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. Based on visibility into these synergy opportunities, Fitch believes at least $750 million of synergy savings are possible by fiscal 2019, though mitigated by around $400 million EBITDA reduction, assuming the FTC mandates approximately 1,000 store closures due to local market share concerns.

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 historically has produced 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 will add approximately $14 billion of debt to WBA's existing $14 billion (as of May 31, 2016) yielding pro forma leverage of approximately 4.2x, up from latest 12 months (LTM) leverage of 3.2x.

Fitch believes the purchase of Rite Aid (assumed in Fitch's modelling to occur in early fiscal 2017 if approved by the FTC) and accompanying synergies could drive EBITDA to close to $12 billion in fiscal 2019 compared to a projected $9 billion expected in fiscal 2016 excluding Rite Aid and $10 billion on a pro forma WBA/Rite Aid basis.

Fitch expects FCF to be $3.5 billion-$4 billion in fiscal 2016-2017 (after dividends and one-time cash restructuring/merger expenses but prior to any potential working capital improvements) but should increase to the $5 billion range by fiscal 2018, and is expected to be used for debt paydown. Fitch believes debt paydown could yield adjusted leverage in the mid-3x range at the end of fiscal 2018 and below 3.5x within 36 months of closing the Rite Aid acquisition, absent any large-scale acquisitions.

Should the Rite Aid acquisition not be consummated, Fitch expects WBA to end fiscal 2016 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 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 penetration is expected to taper 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 30-40bps 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 concern that WBA will prioritize strategic growth over balance sheet management in the medium term.

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 impact WBA's higher-margin front-end sales in the future.

New Management Yields Operational Changes

WBA is making a number of changes in operations, including corporate realignment/headcount reduction, streamlining of store-level operations, systems overhauls, and front-end merchandising changes in categories like beauty. While these changes could improve margins while boosting sales, they create operating risk which could result in poor store execution and inventory mismanagement.

Rite Aid Integration Risk

Fitch assumes WBA can achieve $750 million of the planned $1 billion in synergies by fiscal 2019. 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. Rite Aid pharmacy comps are expected to be in the 2% range, with slightly positive front-end comps. As a result, sales growth for the combined entity is projected to be around 2%-3% after adjusting for an assumed 1,000 Rite Aid closures.

--Combined gross margin is expected to remain in the 25% range, as 30-40bps of annual U.S. pharmacy gross margin pressure is mitigated by Rite Aid synergies. SG&A growth should be modestly lower than sales growth due to fixed-cost leverage and Rite Aid synergies. Total Rite Aid synergies are expected to be $750 million by fiscal 2019.

--EBITDA is expected to be $9 billion in fiscal 2016, improving to close to $11 billion in fiscal 2017 due to the Rite Aid acquisition and toward the $12 billion range in fiscal 2019 on core business growth and Rite Aid synergies. Should the acquisition not close, Fitch would expect standalone WBA EBITDA to increase toward $10 billion over the next 36 months.

--FCF after dividends is projected to be $3.5 billion-$4.0 billion in fiscal 2016-2017, increasing to around $5 billion beginning fiscal 2018 on EBITDA growth and substantial reduction of one-time integration charges.

--FCF is expected to be used to reduce debt to the mid-3.0x range in fiscal 2018 and the low-3.0x range in fiscal 2019, at which point WBA could resume share repurchases (in addition to those offsetting stock-option exercises).

--If the Rite Aid acquisition does not close, FCF is projected to be in the $4 billion range 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 2019, 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 3.0x.

LIQUIDITY

At May 31, 2016, the company had $6.1 billion in liquidity, consisting of $3.1 billion in cash (which excludes $174 million of deposits restricted under agency agreements and by law and other obligations) and full availability on its $3 billion revolver.

WBA had $13.5 billion of debt at May 31, 2016, composed of a GBP billion term loan ($2.1 billion U.S. dollar equivalent) with the remainder in senior unsecured notes. WBA is funding the acquisition with $14.6 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 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.

Date of Relevant Rating Committee: May 4, 2016

Additional information is available on www.fitchratings.com.

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 2015, Fitch excluded $1.6 billion in one-time restructuring charges related to WBA's costs initiatives and mergers, LIFO provisions, and merger-related amortization. Fitch added back $109 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.

Applicable Criteria

Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage (pub. 17 Aug 2015)
https://www.fitchratings.com/site/re/869362

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Contacts

Fitch Ratings
Primary Analyst:
David Silverman, CFA, +1-212-908-0840
Senior Director
Fitch Ratings, Inc.
33 Whitehall St.
New York, NY 10004
or
Secondary Analyst:
Monica Aggarwal, CFA, +1-212-908-0282
Managing Director
or
Committee Chairperson:
Megan Neuberger, CFA, +1-212-908-0501
Managing Director
or
Media Relations:
Alyssa Castelli, +1-212-908-0540
New York
alyssa.castelli@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst:
David Silverman, CFA, +1-212-908-0840
Senior Director
Fitch Ratings, Inc.
33 Whitehall St.
New York, NY 10004
or
Secondary Analyst:
Monica Aggarwal, CFA, +1-212-908-0282
Managing Director
or
Committee Chairperson:
Megan Neuberger, CFA, +1-212-908-0501
Managing Director
or
Media Relations:
Alyssa Castelli, +1-212-908-0540
New York
alyssa.castelli@fitchratings.com