Barclays on Walgreen - Investors in the Driver's Seat; Upgrading to Overweight

7/22/2019 Barclays on Walgreen - Investors in the Driver's Seat; Upgrading to Overweight

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Equity Resear

Consumer | U.S. Food & Drug Retaili

18 June 20

Barclays Capital Inc. and/or one of its affiliates does and seeks to do business with companiescovered in its research reports. As a result, investors should be aware that the firm may have aconflict of interest that could affect the objectivity of this report.

Investors should consider this report as only a single factor in making their investment decision.

PLEASE SEE ANALYST CERTIFICATION(S) AND IMPORTANT DISCLOSURES BEGINNING ON PAGE 48.

Walgreen Co.

Investors in the Drivers Seat;

Upgrading to OverweightWalgreens management and Board appear to have begun to internalize the

constructive criticisms of increasingly vocal shareholders. We believe the Board is

actively considering changes that could materially boost earnings and the stock price.

Potential initiatives include reducing expenses and optimizing the capital structure,

which can be implemented at any time, as well as inverting the existing corporate

structure to achieve tax savings, which is a more complicated undertaking. We are

upgrading Walgreens to Overweight from Equal Weight and increasing our price target

to $92 (ex-inversion) from $56, representing a 26% increase from the June 16 close.

We believe investors are in the drivers seat and see a near-term catalyst for WAGshares. Our review of Walgreens bylaws suggests that shareholders can replace the

board relatively quickly if it appears that value-creating steps are not being planned.

Proposals addressing shareholder-friendly actions may be included in the proxy filing

for Phase 2 of the Alliance Boots transaction in late summer or early fall of this year.

Our model suggests incremental opportunities will drive earnings in excess of FY16

consensus, even assuming conservative core growth and excluding inversion. We

believe cost reduction initiatives and adoption of a more balanced capital structure

could drive FY16 EPS of $5.51, 11% above the consensus estimate of $4.97, even

before accounting for potential FY16 inversion accretion of $0.99.

We expect considerable upside as WAG identifies and executes against the

opportunities we have cataloged, despite the strong run the shares have had inanticipation of change (WAG +46% over the last 12-months vs. the S&P 500 +19%).

Our price target of $92 represents a 15x multiple on our FY18E EPS of $7.79,

discounted back three years at Walgreens cost of equity (9%). If WAG achieves

inversion, we project FY18 EPS of $9.05, implying upside to $108 (acknowledging that

inversion will likely cause domestic Walgreens shareholders to incur capital gains).

WAG: Quarterly and Annual EPS (USD)

2013 2014 2015 Change y/y

FY Aug Actual Old New Cons Old New Cons 2014 2015

Q1 0.55A 0.63A 0.63A 0.72A N/A N/A 0.85E 15% N/A

Q2 0.91A 0.91A 0.91A 0.91A N/A N/A 1.06E 0% N/A

Q3 0.77A 0.91E 0.93E 0.94E N/A N/A 1.04E 21% N/A

Q4 0.71A 0.85E 0.87E 0.86E N/A N/A 0.99E 23% N/A

Year 2.93A 3.31E 3.35E 3.44E 3.95E 4.23E 3.92E 14% 26%

P/E 25.0 21.9 17.3

Source: Barclays Research.

Consensus numbers are from Thomson Reuters

Stock Rating OVERWEIGH

from Equal Weig

Industry View NEUTRAUnchang

Price Target USD 92.0

raised 64% from USD 56.

Price (16-Jun-2014) USD 73.

Potential Upside/Downside +26

Tickers WA

Market Cap (USD mn) 699

Shares Outstanding (mn) 954.

Free Float (%) 92.

52 Wk Avg Daily Volume (mn) 5Dividend Yield (%) 1

Return on Equity TTM (%) 13.

Current BVPS (USD) 21.

Source: Thomson Reuters

Price Performance Exchange-NY

52 Week range USD 75.84-43

Link to Barclays Live for interactive charting

U.S. Food & Drug Retailing

Meredith Adler, CFA

1.212.526.7146

[email protected]

BCI, New York

Sean Kras

1.212.526.1057

[email protected]

BCI, New York

U.S. Health Care Distribution & Technology

Eric Percher

+1 212 526 5496

[email protected]

BCI, New York

Onusa Chantanapongwanij, M.D.

+1 212 526 6166

[email protected]

BCI, New York
https://live.barcap.com/go/NYF/flex/equity/EquityChart.jsp?ticker=WAG&legend=Walgreen%20Co.&shortlegend=WAG&currency=USD&enddate=20140616&begindate=20130616&userId=krassean&appName=RPShttps://live.barcap.com/go/NYF/flex/equity/EquityChart.jsp?ticker=WAG&legend=Walgreen%20Co.&shortlegend=WAG&currency=USD&enddate=20140616&begindate=20130616&userId=krassean&appName=RPS


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Barclays | Walgreen Co.

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U.S. Food & Drug Retailing Industry View: NEUTRAL

Walgreen Co. (WAG) Stock Rating: OVERWEIGHT

Income statement ($mn) 2013A 2014E 2015E 2016E CAGR Price (16-Jun-2014) USD 73.29

Price Target USD 92.00

Why Overweight?We expect WAG's management totake steps that will boost the earnings power and

value of the company, including cutting expenses,leveraging owned generic brands, and optimizing thecapital structure. In addition, the combination withAlliance Boots and the partnership withAmerisourceBergen give the company greater buyingclout and new avenues of growth.

Upside case USD 108.00

If a tax inversion can be implemented, WAG's EPS willbe higher and even at the same multiple, the stockcould increase. Our upside case represents 15x ouradj. cash FY18 EPS forecast of $9.05, discounted backto FY15 at the 9.2% cost of equity.

Downside case USD 60.00

If various initiatives are not implemented smoothly orthe external environment deteriotes, EPS will belower. Our downside scenario represents 14.0x ouradjusted cash FY16 EPS forecast of $4.65, discountedback one year at a 9.2% cost of equity.

Upside/Downside scenarios

POINT Quantitative Equity Scores

Source: POINT. The scores are valid as of the date of thisreport and are independent of the fundamental analysts'views. To view the latest scores, please go to the equitycompany page onBarclays Live.

Revenue 72,217 76,146 79,121 125,224 20.1%

EBITDA (adj) 5,331 6,011 7,262 10,847 26.7%

EBIT (adj) 4,048 4,683 5,867 8,393 27.5%

Pre-tax income (adj) 3,849 4,413 5,724 7,339 24.0%Net income (adj) 2,437 2,707 3,546 4,783 25.2%

EPS (adj) ($) 2.93 3.35 4.23 5.51 23.4%

Diluted shares (mn) 955.2 963.1 963.1 967.5 0.4%

DPS ($) 1.10 1.26 1.36 1.73 16.3%

Margin and return data Average

EBITDA (adj) margin (%) 7.4 7.9 9.2 8.7 8.3

EBIT (adj) margin (%) 5.6 6.1 7.4 6.7 6.5

Pre-tax (adj) margin (%) 5.3 5.8 7.2 5.9 6.1

Net (adj) margin (%) 3.4 3.6 4.5 3.8 3.8

ROIC (%) 10.1 10.9 13.3 12.5 11.7

ROE (%) 13.4 14.2 16.7 21.0 16.3

ROA (lease adjusted) (%) 9.5 9.8 10.7 8.8 9.7

Balance sheet and cash flow ($mn) CAGR

Tangible fixed assets 12,138 12,271 16,137 15,514 8.5%

Intangible fixed assets 2,410 2,455 10,225 10,225 61.9%

Cash and equivalents 2,106 2,568 1,952 3,099 13.7%

Total assets 35,481 38,020 69,374 71,192 26.1%

Short and long-term debt 5,047 4,516 14,168 25,760 72.2%

Total liabilities 16,027 16,386 36,124 48,469 44.6%

Net debt/(funds) 2,941 1,948 12,215 22,661 97.5%

Shareholders' equity 19,454 21,633 33,250 22,723 5.3%

Change in working capital 667 357 -52 -67 N/A

Cash flow from operations 4,301 3,855 4,502 7,267 19.1%

Capital expenditure 1,212 1,391 1,424 1,833 14.8%

Free cash flow 3,089 2,464 3,078 5,435 20.7%

Valuation and leverage metrics Average

P/E (adj) (x) 25.0 21.9 17.3 13.3 19.4

EV/EBITDA (adj) (x) 13.8 12.1 11.4 8.6 11.5

Equity FCF yield (%) 4.3 4.0 5.1 24.1 9.3

P/Sales (x) 1.0 0.9 0.9 0.6 0.8

P/BV (x) 3.6 3.3 2.1 3.1 3.0

Dividend yield (%) 1.5 1.7 1.9 2.4 1.9

Adj debt/EBITDAR (x) 3.1 2.8 3.1 3.7 3.2

Selected operating metrics Average

Same store sales growth (%) -0.7 4.7 3.3 3.6 2.7

Square footage growth (%) 2.4 0.8 0.9 0.9 1.2

Inventory growth (%) -2.6 5.4 44.7 3.9 12.8

Capex/sales (%) 1.7 1.8 1.8 1.5 1.7

Source: Company data, Barclays ResearchNote: FY End Aug

Value

Quality

Sentiment

Low High
https://live.barcap.com/go/BC/composite/GER_COMPANY?ticker=WAGhttps://live.barcap.com/go/BC/barcaplive?menuCode=MENU_FI_WELCOMEhttps://live.barcap.com/go/BC/barcaplive?menuCode=MENU_FI_WELCOMEhttps://live.barcap.com/go/BC/composite/GER_COMPANY?ticker=WAG


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TABLE OF CONTENTS

Executive Summary: ...(Page 4)

The Pathway for Change:A review of Walgreens Board structure and bylaws as well as the mechanisms which shareholders

may utilize to exert pressure on the Board and the timing of potential Board proposals(Page 14)

Walgreen Pro Forma Model FY16-FY18: Our new Walgreens model, including stand alone projections for FY14-FY16 core and

synergy contributions and consolidated projections extending to FY18(Page 17)

Synergy Expectations:An examination of both generic and non-generic synergy contributions. We leverage our proprietary

generic market model to provide a forecast of generic synergies extending through FY18(Page 19)

The Almus Opportunity: We provide an overview of the Almus private-label opportunity, leveraging our generic model to

determine sales potential and working with our global generics research team to estimate private label profitability(Page 21)

AmerisourceBergen Contribution. Projections for the timing and size of equity income accruing to Walgreens from its

ownership stake in AmerisourceBergen(Page 23)

Managing Costs More Effectively. A review of Walgreens cost structure and the sizable opportunities for more effectively

managing corporate and regional overhead(Page 26)

Leveraging the Balance Sheet. In partnership with our Barclays Credit Research counterpart, we examine the extent to which

Walgreens can increase leverage while maintaining its investment grade rating and forecast the potential benefits of leveraged

recapitalization(Page 30)

Inversion Benefits Defined.An overview of inversion requirements and benefits, including our projections for cash tax savings

enabled by inversion(Page 34)

Qualifying for Inversion. We consider the modifications that must be made to the current Walgreens - Alliance Boots

agreement to meet the requirements for inversion and audit the potential mechanisms for achieving these changes(Page 34)

AppendixWAG/AB/ABC Overview. A brief history of the Walgreens/Alliance Boots/AmerisourceBergen relationships(Page 43)

Tax Matters. An overview of deferred profit and transfer pricing(Page 45)


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EXECUTIVE SUMMARY:

We are upgrading Walgreens to Overweight from Equal Weight and increasing our price

target to $94, from $56. Walgreens commentary at the Barclays Retail & Consumer

Conference on April 30th suggests management and the Board have begun to internalize

criticisms leveled by increasingly vocal shareholders and are actively considering changes

that extend beyond the much discussed possibility of inversion to include easier to achieve

(but perhaps equally valuable) opportunities related to the companys cost and capital

structure.

Our Overweight rating is predicated on opportunities available under the current

Walgreens-Alliance Boots partnership agreement, independent of potentially large

inversion benefits. We believe incremental cost reduction initiatives and adoption of a

more balanced capital structure (among other items) could drive FY16 EPS of $5.51, 11%

above the consensus estimate of $4.97, even before accounting for potential inversion

benefits which could drive FY16 EPS to $6.56 (cost reduction and leveraged recapitalization

result in $0.64 and $1.16 in incremental EPS in FY16 and FY18, as compared to inversion

which results in $1.05 and $1.31, respectively).

While the current Walgreens - Alliance Boots transaction structure will not qualify forinversion, we believe the most logical corporate structure for a combined Walgreens

and Alliance Boots would involve inversion. We outline possible paths for altering the

transaction to constitute an inversion. Achieving inversion would drive our EPS estimates to

$6.56 in FY16, $7.88 in FY17 and $9.11 in FY18. However, given the uncertainty and

complexity inherent to changing terms and structure as well as potential political pressures,

we assume no inversion benefit in our price target.

We are increasing our price target to $92 from $56. Our 12-month price target of $92 is

arrived at by applying an earnings multiple of 15x to our FY18 estimate of $7.79 and then

discounting the result back three years at Walgreens cost of equity of 9.2%. Should the

company achieve inversion, we project FY18 EPS of $9.11, and foresee upside to $108.

However, we note that the domestic Walgreens shareholders are likely to incur capital gainsas a result of inversion.

FIGURE 1

Walgreens Pro Forma Earnings Projections

Source: Barclays Research

$3.35

$4.23

$5.51

$6.71

$7.79

$6.50

$7.83

$9.05

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

$7.00

$8.00

$9.00

$10.00

FY14 FY15 FY16 FY17 FY18

EPS

Basecase withInversion


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Pathway Leads to Incremental Upside

In our opinion, managements recent commentary, which suggests a pathway for

Walgreens management and board members to work constructively with increasingly

active shareholders, represents an inflection point in the Walgreens story. We have

been highly encouraged by the recent statements of Walgreens management

acknowledging the need to address the companys cost structure and indicating that they

are examining opportunities to optimize capital structure and maximize tax efficiencies.

We have identified three factors which we believe are driving the change in tone:

1. Increasing influence of Alliance Boots Executive Chairman Stefano Pessina, who owns8% of outstanding WAG shares after Phase 1 and will own approximately 17%-18%

when the transaction is closed. Mr. Pessina has demonstrated a more aggressive

approach to optimizing cost structure, leverage and tax efficiencies than has

Walgreens current board and management.

2. A Board structure and bylaws that give little protection to current members, providing apotent incentive for the Board to be responsive to shareholder concerns. Our review of

Walgreens bylaws suggests that if investors conclude that the current board and

management team are unlikely or incapable of taking the steps necessary to increase

shareholder value, shareholders are well positioned to replace them quite quickly.

3. Core Walgreens and Alliance Boots operational performance is running below the runrate needed to achieve FY16 guidance provided when the transaction was announced.

This puts increasing pressure on management to take action could help to offset

softness in core operational performance.

While Mr. Pessinas experience and reputation have been well known for some time, we

believe increasing shareholder engagement and extremely weak corporate defenses have

served as a wakeup call for the Board. Meanwhile, Alliance Boots FY14 (end March) results

provided another data point that core operations are running below the levels anticipated at

the time of the announcement, though better-than-projected synergies have so far helped

to offset this shortfall. We believe these factors all played a role in leading to the shift intone from the companys March 25th earnings conference call to our April 30th Retail and

Consumer Conference.

We think it is likely that Walgreens board and management are currently formulating

proposals for completion of the Walgreens and Alliance Boots combination, which may

significantly alter the terms and structure of the transaction. Specifically, the companys

statements at our April conference lead us to believe that Walgreens is considering

adjusting the deal terms to optimize capital structure and maximize tax efficiencies (perhaps

including a structure that enables inversion).

In our view, Walgreens management is likely to formalize its intentions with the

publication of the proxy statement recommending the completion of the Walgreens-

Alliance Boots transaction, to be provided between late August and early October. The

proxy statement should outline any changes to the terms of the agreement and the

structure of the combined entity, both of which would need to be amended to achieve

inversion (detailed later in this report). We expect the board to also outline proposals

regarding 1) post transaction management structure; 2) a cost reduction plan, inclusive of a

specific savings target; and 3) new capital structure and allocation targets. Should the

board reach a conclusion on any of these last three items, it is possible that the company

could comment prior to the end of the summer.

If inversion is being considered, we expect the company will want to delay the proxy until

later in this window so as to minimize the time between public announcement and


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completion (to reduce political pressures that are likely to be raised by an inversion

announcement). That said, we think the company must provide shareholders with clarity

by early October in order to avoid more aggressive shareholder activism.

Planned vs. Incremental Opportunities

We believe that potential benefits from the Walgreens and Alliance Boots partnership

extend well beyond those identified by the companies when the partnership was

entered into in August of 2012. We first examine the FY16-18 outlook for previouslytargeted opportunities (including core operational performance, synergy expansion

opportunities and consolidation of AmerisourceBergen equity ownership) and then turn our

attention to incremental opportunities not anticipated at the time of the transaction,

(including tacklinga historically bloated cost structure, adopting a more aggressive capital

composition and re-domiciling the company in a more favorable tax jurisdiction).

In Figure 2 we outline the impact of each of these areas on our earnings estimate. Note that

our published estimate excludes the impact of inversion.

FIGURE 2

Incremental Opportunities Drive Growth, Even Absent Inversion


*The Status Quo includes FY16 synergy benefits but excludes ABC equity income and Almus benefits which may be

included in consensus estimates.

Targeted Opportunities:

1) Core Operations: We model FY16 GAAP operating profit of $8.0bn, inclusive of

$1.040bn in synergies (but excluding the incremental cost savings initiatives outlined

within this report), well below managements initial guidance of $8.5-9.0bn. At the time

of the transaction, Walgreens announced FY16 financial goals which included GAAP

operating profit of $8.5-9.0bn and adjusted operating income (adjusted for LIFO and

amortization expense) of $9.0-9.5bn, inclusive of $1.0bn in synergies. Management has

noted over the last two quarters that financial performance is running below the run rate

required to achieve this guidance but has synergies are running ahead of expectations. If

the status quo is maintained and incremental opportunities are not executed upon, we

estimate that operating profit will total only $7.8bn in FY16. This equates to a status quo

EPS estimate of $4.69 ($4.86 including three quarters worth of contributions from ABC and

Almus synergy benefits), 6% below the current first call consensus of $4.97. We believe

management must adopt strategies which take advantage of the incremental opportunities

outlined below and view the status quoas a conservative base case upon which to layer

incremental benefits.

EPS Components FY13 FY14 FY15 FY16 FY17 FY18 CAGR13-18

EPS - Status Quo* $2.93 $3.26 $3.94 $4.65 $5.32 $6.06 16%

ABC Equity Income - - - $0.14 $0.32 $0.34

Almus Benefits - - - $0.03 $0.09 $0.17

Cost Reduction (Cumulative) - 0.09 $0.29 $0.34 $0.44 $0.44

Leverage - - - $0.34 $0.55 $0.77

EPS - Barclays Estimate $2.93 $3.35 $4.23 $5.51 $6.71 $7.79 22%

EPS - Barclays w/Inversion $2.93 $3.35 $4.23 $6.50 $7.83 $9.05 25%

Diff. from base case - - 18% 17% 16%


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2) Synergy: We project FY16 synergy of $1.040bn on $540mn in generic synergy and

$500mn in non-generic contributions, with generic synergy expanding rapidly in FY17

and FY18 as Almus private label generics are adopted by WAG and ABC. We project that

in aggregate the combination of Walgreens, Alliance Boots and Amerisource should drive a

total of $540 million in sourcing benefits to Walgreens for the 12-months ending August

2016, with $400 million attributable to discounts provided by generic manufacturers, $104

million related to distribution discounts provided to Walgreens by Amerisource (brand

discounts and generic savings relative to the prior Cardinal contract) and $37 millionattributable to Almus brand generics (within this note we publish for the first time a model

for Almus contributions).

We assume little transfer pricing benefit in our model, but foresee a large opportunity for

intercompany sales of private label generics. While we expect that Walgreens will obtain

some benefits from transfer of intangible property and shared services over time, we have

included no transfer pricing benefits in our projections. As the business ramps in FY16, we

project Almus achieves 3% penetration of the $6.8bn WAG/ABC combined generic book of

business (after discounts) resulting in a profit contribution of $44mn and net income of

$37mn. We anticipate that penetration will expand sharply in FY17 and FY18m, reaching

8% in FY18. Applying an 8% penetration rate to WAG/AB U.S. generic expenditures of

$7.9bn, leads to a FY18 profit contribution of $210mn and net income of $175mn. Over thelong-term, we believe Almus can obtain penetration in the low double digits and margins of

35%, 10% above the broader generic industry.Almus benefits are included in our base case

synergy number of $544mn (or $.0.04 in EPS accretion) in FY16. For FY17 and FY18, we

believe Almus will drive $0.09 and $0.17 of incremental EPS, respectively.

FIGURE 3

Walgreens FY16 Generic Sourcing and Distribution Benefit

Source: Barclays Research Estimates

$400

$540$500

$223

$177

$104$37

$0

$100

$200

$300

$400

$500

$600

WAG-AB JVBenefit

ABC Benefit (toWAG/AB)

Total SourcingBenefit

WAGDistribution

Contract Benefit

Almus ProfitPotential

Total Sourcing &Distribution

Benefit

WAG/AB GxSynergy

Guidance

$, Billions


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FIGURE 4

WAG Generic Sourcing Benefit Estimates


Accounting for Equity Income from Ownership in ABC

3) AmerisourceBergen Equity Ownership: Our base case model accounts for the

contribution from equity income related to Walgreens and Alliance Boots ownership of

AmerisourceBergen shares. Our projections for Walgreens ownership and Amerisource

share base, suggest that Walgreens will cross the 20% ownership threshold (at which timethe company will begin consolidating its pro rata share of profits under the income method)

in the March quarter of 2016. We project Walgreens share of Amerisource earnings is

worth $0.14, $0.32, and $0.34 in incremental EPS to FY16-18, respectively, adding 3-6%

growth to the status quo EPS projection.

FIGURE 5

Targeted Opportunity: AmerisourceBergen Income


Incremental Opportunities:

4) Cost Structure: Alliance Boots management could play a key role in driving material

expense reduction at Walgreens, though both corporate and store-based opportunities

are difficult to ascertain. Walgreens year-to-date SG&A growth of less than 1% suggests

the company is already taking actions to reduce corporate expense by an estimated$250mn (relative to our estimate of normalized SG&A growth of 2-3%). We believe that

focused reductions and additional streamlining provide an incremental opportunity to

reduce corporate expense by $500mn over the three-year period FY15 to FY17. We project

cumulative cost reduction efforts will drive incremental EPS of $0.29 in FY15, $0.34 in FY16 ,

$0.44 in FY17 and FY18. Thus, this incremental opportunity alone represents 7%-8% EPS

accretion over WAGs status quo EPS scenario.

Our base model assumes that Walgreens laps dual promotional investments in FY15 but

does not project benefits from reduced promotional expenditures or increased promotional

Sourcing Benef its FY15 FY16 FY17 FY18

WAG-AB JV Benefit $139 $223 $260 $281

ABC Benefit (to WAG/AB) $87 $177 $219 $236

WAG Distribution Benefit $102 $104 $106 $108

Almus Net Prof it Potential $10 $37 $95 $184

Total Sourcing & Distribution $338 $540 $680 $809

ABC Equi ty Income Component FY16 FY17 FY18 Note

Incremental benefit to Status Quo scenario (in $mn, except EPS)

EBIT accretion (cumulative) 158 343 363

Tax rate applied 0% 0% 0%Net income accretion 158 343 363

No. of shares - assumption 1,103 1,085 1,062

EPS accretion $0.14 $0.32 $0.34

% EPS accretion over Status Quo case 3% 6% 6%

Assuming W AG and AB fully exercise their ABC warrants, we hit the 20%

threshold for consolidating ABC equity ownership in the March Q of 2016


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support from vendors in FY16. We believe these items could boost gross margin by 25-50

BP as we look out to fiscal 2017 and 2018.

Finally, we take a cautious view of store level expense, assuming that low hanging fruit was

removed as part of the Rewire for Growth initiative, savings in the pharmacy are limited

and occupancy costs cannot be reduced. Therefore we project no additional store level

expense reductions through FY18.

FIGURE 6

Incremental Opportunity: Cost Structure


5) Adopting a more aggressive approach to capital structure could enable Walgreens to

apply greater resources to dividend issuance and share repurchase, elevating FY16 -

FY18 shareholder returns. Historically, Walgreens has sought to maintain a strong

investment grade rating (single-A category) in order to ensure low borrowing costs and

favorable terms from creditors, including landlords and trade partners. Over nearly the last

two years, the company has operated with lower ratings, in the mid- to high-BBB range,

without appearing to have experienced material increases in lease costs or possibly access

liquidity, and recent management commentary to equity and debt investors suggests

Walgreens management has made peace with its BBB rating status.

Moving forward, we expect it is likely that Walgreens will formally adopt a long-term target

of a mid-BBB credit rating and adjusts the companys capital structure to take advantage of

the higher leverage levels enabled by such a rating. Discussions with our Barclays High

Grade Credit Research counterpart, Priya Ohri-Gupta, suggest that given Walgreens

historical credit rating and demonstrated success reducing leverage after Phase I was

completed, the company could temporarily increase debt levels to complete a leveraged

recapitalization without endangering its investment grade status as long as it lays out a path

for reducing leverage (via debt reduction or EBITDA growth) over a 12-24 month period.

Specifically, we believe that Walgreens could increase leverage by a full turn at completion

of the merger ($13.6bn), leading the lease adjusted debt to EBITDAR ratio at year end FY15

(August, 2015) to increase from 3.1x (assuming no debt issued at close, 3.5x if $4.9bn is

issued to cover transaction costs under the current structure), to 4.2x while providing ratingagencies with guidance for $5bn of debt reduction and $3bn of EBITDAR growth over the

three years FY16-FY18. This would reduce the debt to EBITDAR ratio to 3.6x by the end of

FY16 and 3.0x by the end of FY18. While such an aggressive move could result in a

negative outlook or even one notch downgrade from the rating agencies, we do not believe

it would endanger Walgreens investment grade status (we place the acceptable steady-

state leverage ratio for maintaining its current ratings of Baa1 at Moodys and BBB at S&P at

approximately 3.25x). We do note that a potential one notch downgrade at S&P could

impair access to the tier 2 commercial paper (CP) market, however WAG had not borrowed

in the CP market for several years prior to the most recent fiscal quarter, when the company

maintained a daily average balance of only $14mn.

SG&A (Cost savings) Component FY16 FY17 FY18 Note



Tax rate applied 37% 37% 37%

Net income accretion 378 473 473


EPS accretion $0.34 $0.44 $0.44


Assumes $250mn of corporate cost reduction in FY14. Additional $500mn of

corporate and regional cost reduction over the three year period FY15-FY17.

Amount shown is cumulative.


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The rationale for engaging in a leveraged recapitalization at closing would in part be to

optimize the capital structure and in part to repurchase shares at a price which does not

fully reflect potential upside from completion of the merger and so might be valued

attractively. Adopting a more aggressive approach to capital structure and deployment

represents a significant incremental opportunity, above and beyond guidance provided by

Walgreens at the time of the transaction. We forecast this scenario to contribute an

additional $0.34 to our FY16 EPS estimate, while we expect ongoing repurchase activity

drives incremental EPS growth of $0.55 and $0.77 in FY17 and FY18 EPS, respectively. Thus,this incremental opportunity alone represents 7%-13% EPS accretion over WAGs status

quo EPS scenario.

FIGURE 7

Incremental Opportunity: Capital Structure


6) Inversion: We believe the most logical and effective corporate structure for a

combined Walgreens and Alliance Boots would be to invert the existing configuration sothat Alliance Boots becomes Walgreens parent corporation. However, as currently

structured, the Walgreens Alliance Boots transaction will not constitute an inversion,

necessitating that the terms and structure of the transaction are altered prior to completion.

Specifically, the transaction would need to be restructured so that 1) Walgreens becomes

the subsidiary of a foreign parent: Alliance Boots or a new foreign parent ( i.e. Alliance

Boots or a newly created foreign entity acquire all Walgreens stock in return for stock in

the new foreign entity or other consideration), and 2) stock and consideration paid are

altered such that Walgreens shareholders receive less than 80% of the foreign parent

entitys shares (i.e.: Alliance Boots shareholders, primarily KKR, must accept stock rather

than cash compensation, and WAG shareholders must accept exchanging their WAG

stock for a combination of stock in the new company and a cash payment). While any

change in structure represents a hurdle, we believe that the substantial benefits unlockedvia inversion provide a strong incentive for all parties to align in order to achieve it.

Should Walgreens and Alliance Boots restructure the terms and structure of the

purchase agreement to enable inversion, we size incremental annual cash tax savings

attributable to an inversion-enabled recapitalization at $797mn. To get to this number,

we assume that Walgreens is able to take advantage of the current deductibility of interest

expense payable on debt held by a foreign parent (inter-company debt) equal to 50% of

FY16 adjusted taxable income of $7,969mn and that the differential in tax rates between

U.S. based Walgreens and Switzerland based Alliance Boots is 20% (if domiciled in the U.K.,

we foresee a differential of 18%). Simply stated, Walgreens U.S. tax rate would stay

Leverage Component FY16 FY17 FY18 Note


Dividends (1,674) (2,019) (2,288)

Share Issuance (repurchase) (14,300) (3,160) (4,080) FY16 repo via increase in leverage, FY17 and FY18 repo via cash flow

Net Debt issuance (reduction) (3,000) (1,000) (1,000)

To ta l (18, 974) (6, 179) (7,368)

Incremental interest expense -584 -584 -584 Incremental debt at 4.5%


Net income accretion -368 -368 -368

No. of repurchased shares from leverage 130 0 0 Repurchase attributable to leverage recap

No. of shares - assumption 973 955 932

Lease-adj debt/EBITDA ratio 3.9 x 3.4 x 3.5 x Additional leverage increases ratio from 3.1 to 4.2x at deal closing

EPS accretion $0.34 $0.55 $0.77


Assumes debt is suance of $13.6bn at time of c lose. Repayment of $5bn

FY16-FY18


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unchanged but its taxable income is reduced for deductible interest payments on inter-

company debt. (above and beyond any potential transfer pricing benefits).

A few notes on the tax rate assumption. 1) The U.S. tax rate for WAG is currently closeto 37% while the underlying Alliance Boots tax rate is roughly 18%, suggesting a delta

of 19%. 2) We believe the benefit from the differential could actually be in excess of

20% given that income paid in the Canton of Zug [where Alliance Boots GMBH is

domiciled] may be exempt from federal level taxation and that further tax ratereductions may be applicable to holding companies. 3) While the corporate tax rate of

Switzerland is more attractive than that of the U.K., the US-UK income tax treat may

provide advantageous treatment of withholdings on tax dividends. Should the inverted

entity be domiciled in the U.K., we expect the tax rate would be 19%, suggesting a 18%

delta. We view both options as attractive from a tax benefit perspective.

Tax rate impact. We assume that Walgreens will hold all foreign profits offshore, leadingto a roughly 220 bps decline in the consolidated FY16 tax rate, from 37% in FY15 to

34.8% in FY16, prior to inversion benefits. In the inversion scenario, after incorporating

the impact of inter-company debts, we project the tax rate can declineeven further to

24.2% in FY16. Our model assumes that Walgreens tax rate will increase FY16 to FY18

as Walgreens profits grow at a faster rate than does foreign profit and the inter-

company tax benefit remains steady. This could prove conservative if Walgreens is able

to execute against transfer pricing opportunities or is able to add additional inter-

company debt over time.

FIGURE 8

FY16 EPS Sensitivity to Inversion Scenario Assumptions Incremental EPS Contribution


The cash tax savings from inversion enabled intercompany debt of $783mn annually,

increases FY16 EPS by $0.99. We assume this tax savings remains constant in FY17 and

FY18 EPS. Given that the share count declines, the impact of this tax savings on EPS

increases to $1.12 in FY17 and $1.27 in FY18. In the inversion scenario, we expect cash

tax savings from intercompany debt opportunity to account for additional 16%-18% EPS

accretion over WAGs status quo EPS scenario.

Tax rate differential

$782.76 12% 14% 16% 18% 20% 22%

30.0% $0.44 $0.50 $0.55 $0.61 $0.67 $0.72

35.0% $0.50 $0.56 $0.63 $0.69 $0.76 $0.82

40.0% $0.55 $0.63 $0.70 $0.78 $0.85 $0.93

45.0% $0.61 $0.69 $0.78 $0.86 $0.94 $1.03

47.5% $0.64 $0.73 $0.81 $0.90 $0.99 $1.08

50.0% $0.72 $0.82 $0.91 $1.00 $1.10 $1.19

% of WAG EBITDA

subject to earnings

stripping


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FIGURE 9

Incremental Opportunity: Inversion


Valuation & Price Target

Walgreens shares have performed well over the last year, even as management has

noted that core operations are likely to fall short of FY16 operational targets.

Recognition of the potential for transaction benefits and operational improvements has led

to a 46% increase in WAG shares over the 12-months ending June 16th, 2014, as compared

to a 19% increase in the S&P500. Nonetheless, our analysis of the base business, potential

synergies, and incremental opportunities suggests that WAG shares remain undervalued

relative to our earnings growth outlook even excluding potential inversion.

FIGURE 10

FY13-FY18 Earnings CAGR


We are increasing our price target from $56 to $92. Our 12-month price target is arrivedat by applying an earnings multiple of 15x to our FY2018 estimate of $7.79 and then

discounting the result back three years at Walgreens cost of equity of 9%. The 15x multiple

represents a discount to WAGs five-year average of 16x (17x excluding the period of the

Express scripts dispute). Applying this multiple to our 2018 EPS estimate of $7.79, we arrive

at a 2018 price target of $118, which we discount to arrive at our price target of $92, up

26% from current levels. Should the company achieve inversion, we project FY18 EPS will

total $9.05, and foresee upside to $108, up 48% from current levels. The previous price

target of $56 was based on 14.7x our previous adjusted cash FY15 EPS forecast of $3.95

(excluding our $0.14 LIFO estimate add back).

Inversion Scenario FY16 FY17 FY18 Note

WAG-only EBITDA 8,240 8,652 9,084 EBITDA at time of recapitalization

% of EBITDA on earnings stripping 47.5% 48% 48% We assume 47.5%, below the maximum of 50% to allow for existing debt

WAG EBITDA shielded by earnings stripping 3,914 4,109 4,315 Amount of EBI TDA that can be shielded

Tax rate - foreign parent 17% 17% 17%

Tax differential from US tax rate 20% 20% 20%

Tax savings 783 783 783

Non-inversion tax expense 2,556 2,648 3,038

% Non-inversion effective tax rate 35% 31% 32%

Post-inversion tax expense 1,774 1,865 2,255

% Post-inversion effective tax rate 24% 22% 24%

EPS accretion $0.99 $1.12 $1.27

% EPS accretion over Base Case EPS 18% 17% 16%

Includes benefit of increased share repurchase enabled by 1) additional

EBITDA and 2) cash/stock election (retiring of WAG shares)

Assuming 17% tax rate at the foreign parent level on interest income (from

intercompany debt)

We assume that the capital structure remains constant post FY16. The

company may be able to recap additional equity as EBITDA grows.

EPS FY13 FY14 FY15 FY16 FY17 FY18CAGR

FY13-18

Status Quo $2.93 $4.65 $5.32 $6.06

Barclays Estimate $2.93 $3.35 $4.23 $5.51 $6.71 $7.79

Barclays Scenario w/ Inversion $2.93 $6.50 $7.83 $9.05

Status Quo 10% 15% 14% 16%

Barclays Estimate 14% 27% 30% 22% 16% 22%

Barclays Scenario w/ Inversion 54% 20% 16% 25%


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Walgreens Defense: 1) Walgreens does not currently have a poison pill in place,however the company does have blank check preferred stock and the board could

easily adopt a poison pill at any time. In addition, the Board has the authority to adopt,

amend or repeal most bylaws without shareholder approval, but changes must consider

fiduciary responsibility.

It appears that Walgreens has not adopted many of the corporate defenses that have

become the norm over the last thirty years. Most significantly, Walgreens bylaws allow forcumulative voting, which is likely tied to the companys incorporation (and long roots) in

Illinois. Under cumulative voting, each shareholder receives one vote for each seat/office

being voted upon (in the case of WAG, 13 seats), and may aggregate their votes and

concentrate them on a single candidate. This dramatically increases the ability of minority

shareholders to gain representation on the board. The combination of cumulative voting,

election by a simple majority and the annual (rather than staggered) term provides the

Walgreens board far fewer protections than its peers within the S&P 500, suggesting that

members must be responsive to investor sentiment or risk being unseated.

Catalyst for Change

The annual meeting, to be held at or near January 8th of 2015 (one month prior to the

opening of the window for Phase 2 of the Alliance Boots transaction) providesshareholders with an opportunity to exert significant pressure on the current board and

management team. Specifically, from September 10th to October 10th of 2014,

shareholders may nominate new directors (either a partial or full slate) to be voted on at the

January 2015 meeting. The threat of removal could compel the current board and

management to begin to act on investors priorities in the hope of reaching a compromise

prior to the actual vote.

We believe this effect is already visible, as at the Barclays Retail & Consumer

Discretionary Conference on April 30th, Walgreens management stated the company

was open to evaluating the possibility of inversion and noted a focus on expense

management and willingness to reconsider its capital structure (after completing the

Alliance Boots acquisition). This represented a significant reversal from the March 25th Q2earnings call on which Greg Wasson stated no intention of inversion or re-domiciling the

company. We view management commentary positively, particularly with respect to

expense management, as it shows a willingness to consider investors views that was

heretofore absent and suggests a compromise may be possible. We expect that

shareholders will provide the current board and management with room to address these

issues over the next several months. We will, however, look for a demonstration of

commitment to structural change, perhaps including renegotiation of the current

Walgreens and Alliance Boots transaction terms and structure to enable inversion before

the proxy nomination window closes on October 10th.

Should investors desire to effect change prior to the annual meeting or without needing

to call a special meeting, written consent enables shareholders to propose to recall

remove and replace board members over a relatively short time period. If a shareholder

chooses to act by written consent, the Board would issue a record date (typically within ten

days of receiving the request), opening a 60-day voting window during which proxy

solicitors working for the initiator/activist and the Board would attempt to garner votes for

their respective proposals.

While the Walgreens shareholder base skews toward relatively conservativeinstitutions, we do not believe this represents an insurmountable barrier to change.

A review of the most recent proxy shows large holdings of the stock among index funds

and long-only shareholders who in the past have demonstrated relatively limited

appetites for risk (hedge funds are shown to hold just 6%). While this may have


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represented a significant barrier just a few years ago, we note that Institutional

Shareholder Services, or ISS (which often influences how index and other such

institutions vote on contested matters), has demonstrated a willingness of late to

embrace activist shareholder proposals. Moreover, our discussions with a large cross

section of institutional investors suggests there is dissatisfaction with current

managements performance and an openness to potential changes, though opinions on

inversion are more divided.

Stefano Pessina is precluded from voting his shares against the recommendation ofthe Walgreens board. We would expect Walgreens board to recommend shareholders

vote against any new slate or activist shareholder proposal. It is worth noting that

Stefano Pessinas agreement with WAG, put in place as part of Phase 1 of the

transaction, prohibits him from voting his shares against the recommendation of the

existing Walgreens Board as long as he is a member of either the Walgreens or Alliance

Boots Boards. We believe, however, that he is permitted to resign from the two Boards

in order to implement changes to the other directors, and can include himself in a new

slate. Note that with 7.7% of the total outstanding following Phase 1, and an estimated

17% to 18% pose Phase 2, Mr. Pessina is the only board member with more than 1% of

voting shares.

Next Step

We think it is likely that Walgreens Board and management are currently formulating

proposals for completion of the Walgreens and Alliance Boots combination that may

significantly alter the terms and structure of the transaction. Specifically, the companys

statements at our April conference lead us to believe that Walgreens is considering

adjusting the deal terms to optimize capital structure and maximize tax efficiencies (perhaps

including a structure that enables inversion).

In our view, Walgreens management is likely to formalize its intentions with the

publication of the proxy statement recommending the completion of the Walgreens-

Alliance Boots transaction, to be provided between late August and early October. In

order to complete the second step of the Alliance Boots transaction, Walgreens must obtainshareholder approval. The purchase agreement requires that Walgreens and Alliance Boots

cooperate in preparing a proxy via which the Walgreens Board will recommend that

shareholders approve the second step of the transaction (or potentially, an alternative

transaction). We expect the proxy will outline any proposed changes to the terms and

structure of Phase 2, perhaps including a more aggressive stance toward leverage and

possibly a proposal for inversion. We expect the proxy may also include or be accompanied

by a revised view of capital allocation priorities and cost structure reduction opportunities.

While the call exercise period for Phase 2 of the Alliance Boots acquisition does not begin

until February 5th, 2015, the purchase agreement allows that the buyer and seller may

agree to alter the exercise period. We expect that should the company target an inversion,

it may seek to complete the transaction in calendar year 2014, in order to avoid any

potential changes to tax regulations that could occur and impact 2015. We are confident,

though, that the material changes to the qualifications for inversion will require legislative

changes that are unlikely to occur before 2016.

Should the Walgreens Board recommend completion of the transaction as it currently

stands, without addressing investor concerns, we think shareholders may engage in an

effort to unseat and replace board members. Given shareholders stated concerns, we are

hopeful that Mr. Pessina and Mr. Wasson can work jointly to address the many challenges

and opportunities in front of Walgreens. However, should we begin to approach early

October without a change in direction, shareholders may propose removal and replacement

of current Board members in advance of the October 10th deadline for the Jan 2015 proxy.


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Walgreen Pro Forma FY16 Model

With this report, we are publishing a new Walgreens model which includes 1) updated

standalone projections for Walgreens and Alliance Boots through FY16, 2) updated

projections for Walgreens and Alliance Boots synergies in FY15 and FY16, and 3) a

consolidated view of FY16 FY18, pro forma for the second step of the Alliance Boots

acquisition (as currently structured). After laying out the base case in this section, we go

on to focus on a number of incremental opportunities that we believe could lead tosubstantial benefits in FY16 and beyond.

Walgreens has maintained its adjusted operating income target range of $8.5-$9.0 billion

in FY16 while acknowledging that performance to date, most likely at both companies, is

tracking below the CAGR required to achieve this goal.Our pro forma model, which has

been updated to reflect recent performance and cost reduction efforts at Walgreens and

FY14 (end March 31st) results for Alliance Boots, projects FY16 operating income of $8.0

billion if we excluded cost reduction initiatives in FY15 and FY16 (which were not

anticipated n managements guidance), well short of Walgreens stated goal. However, we

believe that Walgreens will benefit over the next three years from synergy and accretion

opportunities not originally contemplated in guidance. It is assuming the achievement of a

portion of these supplemental opportunities (built upon a rather conservative base) that

leads to our ratings upgrade.

Walgreens Base Case Model Assumptions

Sales Assumptions

At the front-end, we assume the sales trend improves over time as the company is able

to use its marketing and merchandising funds more efficiently because of the Balance

Rewards program. The company is gathering data about its customers shopping patterns

that will allow it to send targeted promotional offers, though it is unclear whether that is

being done right now. Nonetheless, we expect that further maturation of the program will

yield more effective results that will be beneficial to both traffic and ticket over time. We

forecast front-end comps improve to +1.8% in FY14, +2.5% in FY15, and +3.0% in FY16.

The average annual front-end comp from FY10-FY13 was 3.0%.

At the pharmacy, we expect annual calendar adjusted script growth will remain at the

recent pace of ~4% through FY16. This will be driven by a number of factors, including an

aging population and increased access to pharmacy coverage through public exchanges

and expansion of Medicaid. Sales will be further boosted by inflation in branded drugs,

which has averaged low to mid single-digits in recent months. This will be partially offset

by the impact of new generic introductions which will accelerate as WAG exits FY14, but

will moderate again in FY17 and drop off further in FY18 and FY19.

Gross Margin Assumptions

In looking at the next 2 1/2 years, we took three main factors into account when

modelling Walgreens gross margin trends: new generic introductions, a cycling of double

promotional investments in the front end, and the more fundamental ability to lower

spending on promotions gradually as the company makes more targeted offers using data

from the Balance Rewards program. We also assume vendors provide more promotional

support as Walgreens gives them better customer data.

Generics. To estimate the benefit from new generics for the remainder of fiscal 2014,we looked at the drugs that are entering the market this year and whether they will be

single sourced or multi-sourced from the beginning, and then compared them to last

years new introductions. We did the same analysis for fiscal 2015 and fiscal 2016,

though the data becomes less reliable later in time, since introductions can be delayed

and/or the number of competitors can vary.


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markets with significant control of wholesale and retail pricing and margins by UK and

European governments. Growth in the wholesale operations has generally come from

acquisitions, which has been a focus for Alliance Boots management, though we do not

forecast any additional acquisitions going forward.

Margin Expectations. We expect margins will be relatively static despite ongoingreimbursement reductions as the company has proven itself to be nimble at offsetting

reimbursement pressure by operating the business more efficiently. Given our relativelylimited visibility into Alliance Boots accounting and markets we have adopted what we

believe to be a realistically conservative model.

Synergy Expectations

Walgreens purchased 45% of U.K. based retail pharmacy operator and wholesale drug

distributor Alliance Boots on August 2, 2012, and formed the Walgreens Boots Alliance

Development GmbH (WBAD) joint venture global sourcing entity in Bern, Switzerland, on

October 30, 2012. On March 19, 2013, Walgreens and Amerisource announced a 10-year

distribution agreement as part of which Amerisource would take on both Walgreens brand

distribution (previously served by Cardinal) and generic distribution (previously sourced from

manufacturers by Walgreens and distributed via the Walgreens retail distribution network)

while moving to purchase all generic products via the WBAD global sourcing entity.

With the original Alliance Boots relationship of June 2012, Walgreens stated an

expectation for $1 billion in synergies, of which 90% of the total (or $900 million) would

be attributable to procurement, and 50% of the total (or $500 million) would be

attributable specifically to generic procurement. Walgreens reported $154 million in total

synergy benefits for its fiscal 2013, the first year of the relationship, and has provided

guidance for $350-$450 million of synergies in its fiscal 2014. It has provided no

commentary on the respective sources of synergies reported to date but has stated that

both generic and non-generic procurement synergies are building and has repeatedly

reiterated the total synergy goal of $1 billion.

Alliance Boots stated that its fiscal 2014 synergies, for the 12-months ending March 31,2014 were ahead of target though it is unclear whether that refers to timing or thedollar amount. Alliance reported that its share of post-tax earnings of the Walgreens

Boots Alliance Development JV (WBAD) totalled 58 million, or $98 million, in fiscal

2014.

Generic Procurement Synergies

With respect to generic synergies, it is our opinion that Walgreens initial plans (and

guidance) for Alliance Boots were extremely ambitious, as they included both large

international generic sourcing benefits and significant gains from moving to self

distribution, both of which involve a high degree of execution risk. Specifically, our

projections suggest that the sourcing benefits available to Walgreens and Alliance Boots

absent the agreement with AmerisourceBergen were well below $500 million. Rather, webelieve that the synergies outlined at the time of the WAG-AB partnership were dependent

on working with a large, U.S. based distributor such as AmerisourceBergen, which when

combined with Walgreens led to significant generic procurement scale in the U.S. The

importance of the Amerisource volume should not be understated as the U.S. remains the

largest and most profitable generic market in the world, and generic discount tiers (that

relate discounts to volume levels) are well established here. It is our opinion that the

combination of Walgreens and Amerisources domestic volume has played a key role in

driving the WBAD JVs success to date. We also note that Amerisource took on Walgreens

brand and generic distribution, providing what we believe to be a considerable savings

relative to the prior contract with Cardinal Health.


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Walgreens-Alliance Boots Generic Sourcing. The generic purchasing market modeldeveloped by Barclays Healthcare Distribution and Technology team (outlined in greater

detail in the initiation report dated May 4th, 2014) projects global sourcing benefits

accruing from the WBAD Generic Sourcing Joint Venture formed by Walgreens and

Alliance Boots (prior to inclusion of Amerisource) at $223 million in fiscal 2016, well

below guidance for $500 million in total generic sourcing benefits. (Note that our $223

million estimate for fiscal 2016 is in line with our previously published estimate of $250

million for calendar year2016.)

Walgreens-AmerisourceBergen Generic Sourcing. However, we project that theaddition of Amerisources U.S. volume to the WBAD purchasing entity greatly increased

negotiating leverage with generic manufacturers, enabling Walgreens to garner an

additional $177 million in sourcing benefits, aside from gains accruing to

AmerisourceBergen.

Walgreens-AmerisourceBergen Distribution Contract. Beyond sourcing benefits, webelieve that Walgreens benefits from its ten-year distribution agreement with

Amerisource, which was likely provided at below market rates in return for participation

in the WBAD joint venture. We project the discounts and GPO fees generated by this

contract will lower Walgreens distribution/sourcing cost by an additional $104 million

in FY16. We attribute these savings both to reduced brand distribution expense and

lower secondary generic support relative to the legacy contract with Cardinal. (Note

that Walgreens included self-distribution savings in the original Alliance Boots generic

sourcing synergy target of $500 million we view this as misplaced given long

established systemic reasons for retailers to employ distributors and that any such

benefits would be domestic, and so do not fit with the suggested global nature of the

$500mn synergy target).

Almus Generics Opportunity. The Walgreens and Amerisource relationships provide avaluable channel for Alliance Boots Almus Pharmaceuticals generic brand (detailed in

the following section) to enter the U.S. market. We estimate Almus contributes $37mn

in after-tax income in FY16 based on 2% penetration of the $6.8 billion WAG/ABC

combined generic book of business (after discounts).

We project that in aggregate the combination of Walgreens, Alliance Boots andAmerisource should drive a total of $540 million in sourcing benefits to Walgreens

for the 12-months ending August 2016, with $400 million attributable to discounts

provided by generic manufacturers, $104 million related to distribution discounts

provided by Amerisource (brand discounts and generic savings relative to the prior

Cardinal contract) and $37 million attributable to Almus brand generics.


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FIGURE 11

Walgreens FY16 Generic Sourcing and Distribution Benefit

Source: Barclays Research Estimates

FIGURE 12

Sourcing Benefits Increase Over Time: With Almus as the Key Driver


Transfer Pricing Considered: The Almus Opportunity

(For a detailed discussion of transfer pricing, see the Appendix, page 44)

We assume no transfer pricing benefits in our model, but foresee a large opportunity for

intercompany sales of Almus private label generics. Walgreens owns numerous

trademarks and trade names and holds more than 75 patents but does not engage in

material research and development activities. Consequently, we expect that the companys

ability to transfer IP to favourable tax domains will be limited as compared to those enjoyedby pharmaceutical manufacturers. While we expect that Walgreens will obtain some

benefits from transfer of intangible property (IP, of which intellectual property is a sub-

category) and shared services over time, we have included no transfer pricing benefits in

our projections. Rather, we believe the most material inter-company opportunity will come

from simply driving penetration of Alliance Boots existing private label generic, OTC and

beauty brands in Walgreens (and AmerisourceBergens) U.S. markets via intercompany

transactions.

For the purposes of our model, we focus on the Almus private label, which represents an

opportunity for increasing the overall profitability of the generic business.The Walgreens

$400

$540$500

$223

$177

$104$37

$0

$100

$200

$300

$400

$500

$600

WAG-AB JVBenefit

ABC Benefit (toWAG/AB)

Total SourcingBenefit

WAGDistribution

Contract Benefit

Almus ProfitPotential

Total Sourcing &Distribution

Benefit

WAG/AB GxSynergy

Guidance

$, Billions

Sourcing Benef its FY15 FY16 FY17 FY18

WAG-AB JV Benefit $139 $223 $260 $281

ABC Benefit (to WAG/AB) $87 $177 $219 $236

WAG Distribution Benefit $102 $104 $106 $108

Almus Net Prof it Potential $10 $37 $95 $184

Total Sourcing & Distribution $338 $540 $680 $809


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and Amerisource relationships provide Alliance Boots Almus Pharmaceuticals generic

brand with a valuable channel for entering the U.S. market (Almus obtains the IP, such as

formulation and clinical data used to support the ANDA necessary to manufacturer a

generic product and then engages a contract manufacturer to produce the product,

capturing a portion of traditional generic profits). Our model assumes that Almus must

acquire new IP and contract with new plants to enter the U.S. market (i.e.: the company

cannot simply repurpose product produced for the European market) and so profits and

market penetration ramp over a multiyear period.

As outlined in our synergy numbers, we expect Almus will be one of the primary drivers

of post FY16 generic benefits. We view FY14 and FY15 as investment years, during which

Walgreens and Alliance Boots will obtain IP, set up the manufacturing contracts and

establish intercompany transfer pricing via the WBAD joint venture.

We project that the incremental margin from private label manufacturing can exceedthat of the broader generic industry (of roughly 25%), as the private label manufacturer

is able to target its product mix based on captive end market demand and as the

manufacturer incurs no sales and marketing expense.

Margins should ramp as the business gains scale in FY16. We project Almus achieves2% penetration of the $6.8bn WAG/ABC combined generic book of business (afterdiscounts) in FY16 resulting in a profit contribution of $44mn and net income of

$37mn.

We project penetration expands to 8% in FY18 while WAG/AB U.S. generic expendituresexpand to $7.9bn, driving a FY18 contribution of $222mn in profit or $184mn in net

income. Over the long-term, we expect Almus can obtain penetration in the low double

digits and margins of 35%, 10% above the broader generic industry.

We assume that Almus will taxed at the companys foreign tax rate of 17%, though webelieve it is possible that Alliance Boots will hold the majority of IP in Switzerland, where

it may be subject to a substantially lower tax rate. Alternatively, Alliance Boots could

develop new IP in the U.K. under new Patent Box regulations which holds tax on U.K.derived patents to 10%.

FIGURE 13

Private Label Generics Represent the Most Significant Intercompany Opportunity


Alm us Benef its FY15 FY16 FY17 FY18

US Gx Expenditure at Cost (WAG &

ABC)6,318 6,807 7,352 7,938

Penetration Rate 1% 2% 5% 8%

Alm us U.S. Sales $78 $168 $364 $635

Almus Margin 15% 26% 31% 35%

Alm us Gro ss Prof it fr om US sales $12 $44 $114 $222

Foreign Tax Rate* 17% 17% 17% 17%

Alm us Net Incom e f rom US sales $10 $37 $95 $184


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FIGURE 14

We Project Almus Reaches 8% Penetration and 35% Margins in FY18


Non Generic Synergy

Walgreens has indicated that about 50% of the $1 billion of synergies it plans to

generate from the acquisition of Alliance Boots will come from areas outside of

pharmaceutical procurement. About $400 million is to come from procurement of not-

for-resale items such as shopping bags and pill containers, commodity items such as cotton

balls and combs, private label merchandise such as OTC medications and childrens care

products, and seasonal merchandise; some synergies may be generated in services as well.

Obviously there are differences in the products sold in the US and the UK, but we think there

is likely to be enough potential among all these opportunities to hit the $400 million goal.

As a reminder, in FY13 WAG alone spent an estimated $17.1 billion on the cost of front-end

merchandise (assuming ~35% of sales comes from the front end and the average gross

margin is 32%).

The final $100 million of synergies is the anticipated profit from selling Boots private

label products, such as No. 7 and Botanics, in Walgreens U.S. stores. Assuming that

these are incremental sales, and using a gross margin of 40% (though it may be higher),

this means Walgreens would need to generate an incremental $250 million of revenues,

which represents only about a 1% increase in estimated front-end sales. Generating thislevel of sales should be achievable, as it is a relatively low bar (could probably occur if only a

sub-set of customers bought one or two products each year).

We are sceptical, however, that WAG can duplicate a Boots beauty department that sells

primarily private brands in the U.S. We note that relative to the U.K., the U.S. is a large

market, and the cost of developing brand recognition is very high, and the process can take

a long time. Most beauty brands in the US have been around for decades, and we have

frequently seen new ones fail after large marketing expenditures have been made, even

when they are introduced by established manufacturers. In addition, sales of prestige

beauty products are well-developed at U.S. department stores, with some sold at dedicated

beauty stores such as Sephora, while masstige beauty products are sold at Sephora and

Ulta. The U.K. beauty business is not segmented in this way, nor is there the same broad-based competition from dedicated beauty stores such as Ulta and Sephora.

Consolidating ABC Stock Ownership

Our published estimates include the contribution from equity income related to

Walgreens and Alliance Boots ownership of AmerisourceBergen shares. Our projections

for Walgreens ownership and Amerisource share base, suggest that Walgreens will cross

the 20% ownership threshold in March of 2016 (at which time the company will begin

consolidating its pro rata share of profits under the income method). Our published

estimates include this benefit.

Alm us pr ofi t margi n

184 5% 10% 15% 20% 25% 30% 35%

0% $0 $0 $0 $0 $0 $0 $0

2% $7 $13 $20 $26 $33 $40 $46

4% $13 $26 $40 $53 $66 $79 $92

6% $20 $40 $59 $79 $99 $119 $1388% $26 $53 $79 $105 $132 $158 $184

10% $33 $66 $99 $132 $165 $198 $231

12% $40 $79 $119 $158 $198 $237 $277

14% $46 $92 $138 $184 $231 $277 $323

% Almus Penetrati on

of WAG & ABC GxExpenditures


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Key assumptions:

WAB Holdings (jointly owned by WAG and AB) will gradually increase its stake in ABCfrom 10.4mn shares at the end of February 2014 (as reported on the balance sheet of

WAG) to 19.9mn shares in March 2016 (the maximum allowed for open market

purchase from the Framework Agreement dated March 2013).

ABC will continue its share repurchase program beyond cancelling out the dilutive effectof warrants given to WAG and AB. Our model assumes ABCs average diluted shares

outstanding decline from 234.3mn shares at the end of March 2014 to 231.1mn in FY14

(ABC FY ending in September), 221.5mn in FY15, and 211.3mn at the end of FY16.

For simplicity, we assume WAG and AB will each exercise in full their warrants topurchase 11.35mn shares of ABC by March 31, 2016 (exercisable at a price of $51.50,

during the 6-month period beginning March 1, 2016). We assume WAG and AB will

each exercise in full their warrants to purchase 11.35mn shares of ABC by March 31,

2017 (exercisable at a price of $52.5, during the 6-month period beginning March 1,

2017).

FIGURE 15

Forecasted equity ownership in ABC by WAG and AB (FY of ABC)

Source: Barclays Capital

Figure 15 shows our forecasted equity ownership of ABC by WAG and AB. Based on the

assumptions above, total equity ownership will hit 20% in March of 2016, at which point

WAG will recognize ABC equity income on its income statement. (For the time preceding

this, during which WAG and AB will hold less than a 20% ownership of ABC, the companies

carry their ABC stakes on the balance sheet at market value.) We project Walgreens pro-

rata share of Amerisource earnings is worth $0.14 in FY16, $0.32 in FY17 and $0.34 in

FY18 (included in our published estimates).

5% 5% 5% 5%

11% 11%

5% 5% 5% 5%

11% 11%9% 9% 10% 9%

9% 9%

4% 5% 6% 6%

6% 7% 7% 8%

8% 9%

20% 20% 21%20%

31% 31%

0%

5%

10%

15%

20%

25%

30%

35%

EquityownershipinABC

WAGviaWalgreensPharmacyStrategies,LLCAB viaAllianceBootsLuxembourgS..r.l.,WABHoldingsTotalWAGandAB


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FIGURE 16

Targeted Opportunity: AmerisourceBergen Income


ABC Equi ty Income Component FY16 FY17 FY18 Note




Net income accretion 158 343 363No. of shares - assumption 1,103 1,085 1,062

EPS accretion $0.14 $0.32 $0.34


Assuming W AG and AB fully exercise their ABC warrants, we hit the 20%

threshold for consolidating ABC equity ownership in the March Q of 2016


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POTENTIAL SOURCES OF INCREMENTAL BENEFIT

We believe that the potential benefits from the Walgreens and Alliance Boots partnership

extend well beyond those identified by Walgreens when the partnership was entered into

in August of 2012 and FY16 financial goals were provided. These incremental benefits

include 1) a partner and management team from Alliance Boots whose historic experience

in difficult markets positions them well to enable (or drive) Walgreens to address its historic

weakness relative to cost structure, 2) a chance to adopt a more aggressive capital

structure (if perhaps temporarily), 3) an opening to move to re-domicile the company in a

more favourable tax jurisdiction.

1. Addressing a Bloated Cost StructureCorporate & Regional Overhead

We have been saying for years that WAGs cost structure is too high and needs to be

reduced. Although the company has never disclosed the amount it is spending on

corporate and regional overhead, the chart below shows the steady rise in SG&A over an

extended time frame. Comparing SG&A growth to gross profit dollar growth, we find a

multi-year gap in the two metrics. As we indicated earlier in the report, the exceptions to

this trend were 1) when the company decided to slow square footage growth, which was

implemented in fiscal 2010 but first showed up in a slowing of SG&A dollar growth in fiscal

2011; and 2) when the peak of the generic wave boosted the gross margin in 2012 and

2013. Unfortunately, the dispute with Express Scripts pressured both sales and gross profit

dollar growth in fiscal 2012, more than offsetting the benefit of both the slowdown in

square footage growth and the generic wave. Walgreens did make adjustments to

expenses in fiscal 2012 in an effort to offset the impact of lower script volumes and front-

end traffic, but expenses still grew faster than gross profit dollars.

FIGURE 17

WAG Difference in YoY Growth Rates: Gross Profit vs. SG&A

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Gross Profit 15.9% 15.6% 11.7% 15.8% 9.1% 5.9% 7.7% 8.0% -0.7% 3.8%

SG&A Expense 16.1% 15.7% 13.3% 14.3% 9.1% 8.9% 8.0% 6.7% 1.6% 3.5%

Difference -0.2% -0.1% -1.6% 1.4% 0.0% -3.0% -0.3% 1.3% -2.3% 0.3%

Source: Company reports and Barclays Research

SG&A growth has been running at a slower pace year to date in fiscal 2014 (~1.0%)than what would be normal for other retailers and is well below the average for

Walgreens over time. We have some information suggesting that the company is

currently cutting corporate overhead, though the company has only barely

acknowledged this despite local Chicago media reports. Assuming that SG&A growth

remains on its year to date trend for all of fiscal 2014, we estimate the company willhave cut expenses by about $250 million by year end.

We project that the company could cut another $500 million over the three yearperiod, FY15-17. However we have little information about what has already been cut

or what is left to be reduced, either at the corporate office or within the local/regional

field organizations. Alliance Boots is thought to run a much leaner operation and

would be able to guide WAG in this process, so we believe these cuts are possible. In

fact, investors have expressed a desire for more specificity about what additional

efficiencies can realistically be achieved.


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If Walgreens can cut $750 million over the four year period FY14-2017, then at theend of that period we believe the company will have achieved a reasonable cost

structure and instituted strong expense controls. From that point on, we expect SG&A

dollar growth will normalize at 2.5%-3.0%.

Store Level Operational Improvement

As a large, well-established drug retailer that grew across the U.S. very successfully for

many years, we believe Walgreens operations are fundamentally sound. In the past 5-7years, the company has addressed important issues, including reducing the SKU count and

making the stores easier to shop by lowering shelf heights and cleaning up aisle displays.

For years the company did no consumer research, and it waited too long, in our opinion, to

introduce a rewards program. Both are in place now, however, and will contribute to front-

end improvement over time.

Based on our current understanding of the business, the biggest opportunity to improve

WAGs results in the short run is to optimize marketing and merchandising expenditures.

This spending has been unusually high for the past year as the company has been forced to

maintain its broad-based ad circular program while also developing its new rewards

program, which was introduced in September, 2012.

The company will be cycling the dual set of investments this spring, and may even beable to moderate the broad-based promotions in the following months, as customers

recognize the ease of getting promotional deals directly on the Balance Rewards card.

Right now Walgreens does not appear to be using data from specific customers to tailor

the offers they get, but over time WAG should be able to target its marketing monies

towards its best customers, thereby getting a higher yield on that spending. It will

also give WAG a much better understanding of what its customers are buying, allowing

it to adjust and localize its in-store offering and promotional events. Access to better

data would also be valued by large suppliers, so promotional support could increase

over time.

In our view, WAG would have been able to realize most of the benefits of the rewardsprogram without buying Boots, but given that companys experience with loyaltymarketing, the merger may allow it to move faster or be more efficient in its effort.

Customer behaviour will naturally be different in the US and the UK, so we think what

Boots can share relates to process rather than to specific actions.

Figuring out how to lower store costs is much tougher, though some observers havesaid that CVS runs a more efficient front-end operation. Several years ago, WAG

implemented a cost-cutting initiative it called Rewire for Growth. The steps taken

included eliminating district support personnel in areas like beauty, as well as reducing

the number of SKUs, A streamlined merchandise offering should have brought down

store labor costs related to the handling of inventory. It is not clear, though, if WAG got

the outcomes it was hoping for or if there is still more potential to improve efficiency.

That is an area where Boots might be able to be helpful, though again the US and the UKmarkets are very different.

Making the pharmacy more efficient would probably be difficult. WAG operates high-

volume pharmacies, and some sources say they work their pharmacy staff very hard. Other

sources have said that labor could be used more efficiently, but given the volumes being

handled and WAGs historical investments in technology, it is hard to imagine that the

incremental opportunity in the pharmacy comes close to that in the front end.

A barrier to store-level cost reduction is lease costs. As shown in the table below the rent

per square foot that WAG pays on its stores has been rising steadily since fiscal 2005, and

compared to CVS, it is now paying substantially more per square foot, even though it owns


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more of its stores. Drug store leases tend to be long (20+ years), and WAG has attractive

locations, so lowering this cost would be difficult and perhaps unwelcome.

FIGURE 18

Rent Comparison: Walgreen vs. CVS Caremark

Source: Company reports and Barclays Research

In sum, we believe that Alliance Boots management can play a key role in driving

material expense reduction, though both corporate and store-based opportunities are

uncertain. We believe that Walgreens may have already taken actions in FY14 to reduce

corporate expense by $250mn. Our model assumes that Walgreens laps dual

promotional investments in FY15 but does not project benefits from reduced promotionsexpenditure or increased promotional support in FY16. We expect these items could add

25-50 BP ofgross margin benefit as we look out to fiscal 2017 and 2018. Finally, we

take a cautious view of store level expense, assuming that low hanging fruit was

removed as part of the Rewire for Growth initiative, savings in the pharmacy are limited

and leased costs cannot be reduced. Therefore, we project no additional store level

expense reductions through FY18.

Walgreen FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13

AnnualRent($inmillions) 1,010$ 1,161$ 1,307$ 1,432$ 1,619$ 1,787$ 1,975$ 2,218$ 2,500$ 2,571$ 2,628$

RetailSellingSq.Ft.(millions) 46 51 55 60 65 71 79 84 86 87 89

PercentofRetailStoresOwned 17.0% 18.0% 18.0% 18.0% 19.1% 19.0% 21.0% 20. 0% 21.0% 20.0% 20. 0%

PercentofRetailStoresLeased 83.0% 82.0% 82.0% 82.0% 80.9% 81.0% 79.0% 80. 0% 79.0% 80.0% 80. 0%

LeasedRetailSellingSq.Ft.(millions) 39 41 45 49 53 58 62 67 68 70 72

RentPerAverage SquareFoot 29.0$ 30.2$ 30.3$ 31.7$ 32.3$ 32.9$ 34.3$ 37.1$ 37.4$ 37.1$%Change 4.2% 0.3% 4.4% 1.9% 1.9% 4.4% 8.2% 0.6% 0.6%

CVSCaremark FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13AnnualRent($inmillions) 890$ 1,068$ 1,258$ 1,396$ 1,601$ 1,724$ 1,899$ 2,035$ 2,117$ 2,193$ 2,230$

RetailSellingSq.Ft.(millions) 33 44 45 59 57 66 68 70 72 73 75

Percentof

Retail

Stores

Owned 4.0% 3.0% 3.0% 6.0% 3.6% 5.2% 4.2% 5.0% 6.0% 5.0% 5.9%

PercentofRetailStoresLeased 96.0% 97.0% 97.0% 94.0% 96.4% 94.8% 95.8% 95. 0% 94.0% 95.0% 94. 1%

LeasedRetailSellingSq.Ft.(millions) 31 42 43 55 54 63 65 66 67 69 71

RentPerAverageSquareFoot 29.1$ 29.4$ 28.3$ 29.2$ 29.4$ 29.7$ 31.0$ 31.7$ 32.1$ 31.9$%Change 1.0% 3.6% 3.1% 0.6% 1.1% 4.4% 2.3% 1.1% 0.8%

Note:AsofDec.31,2013,owned~5.9%ofitsretailstores. Morethanonethirdofstoreswereopenedorsignificantly remodeledwithinthelastfiveyears.

Note:AsofAug.31,2013,owned~20%ofitsretailstores. Notincludingtheapproximately5,000locationsthatwereconvertedundertheCustomerCentric

RetailinginitiativeconcludedinFY12,~24%ofstoreshavebeenopenedorremodeledduringthepastfiveyears.


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FIGURE 19

Incremental Opportunity: Cost Structure


SG&A (Cost savings) Component FY16 FY17 FY18 Note



Tax rate applied 37% 37% 37%Net income accretion 378 473 473


EPS accretion $0.34 $0.44 $0.44


Assumes $250mn of corporate cost reduction in FY14. Additional $500mn of

corporate and regional cost reduction over the three year period FY15-FY17.Amount shown is cumulative.


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2. Leveraging the Balance Sheet.

Note: In order to adequately reflect Walgreens and Alliance Boots lease obligations, our

leverage analysis is based on lease-adjusted gross debt/EBITDAR. EBITDAR is derived from

EBITDA plus rent expense, while lease-adjusted debt is calculated by adding lease obligation

(assuming 8x rent expense) to total debt.

Adopting a more aggressive approach to capital structure could enable Walgreens to

apply greater resources to dividend issuance and share repurchase, elevating FY16 -

FY18 shareholder returns. Historically, Walgreens has sought to maintain strong

investment grade ratings (in the single-A category) in order to ensure low borrowing costs

and favourable terms from creditors, including landlords and trade partners. The company

maintained a lease-adjusted debt to EBITDAR ratio of 2.5x-2.6x from 2001 to 2008

(supporting an A+ credit rating

Barclays on Walgreen - Investors in the Driver's Seat; Upgrading to Overweight

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