(Disclaimer: Excel file attached below the post)
I came across the news of Walgreens being taken private by Sycamore back in March and the recent approval, and wanted to analyze the deal, but I've been so pre-occupied with work and other chores that I didn't really get the chance to do so. But, I have a couple of days now, and figured this to be as good a time as any. The company announced back in March that it has agreed to be purchased by an SPV owned and operated by Sycamore; the PE firm has agreed to pay WBA $11.45 per share in cash, which represents about 8% premium. The total value of the transaction is expected to be around $23.7BB which includes $3.00 per DAP Rights, plus net debt, capital leases and present value of the company's opioid liabilities. What could the returns look like for the sponsors? The lenders? The target? I will try to analyze the deal in as much a detail as I can, and will try to not lose you along the way. Without any delay, lets dive right in.
Walgreens Boots Alliance
Walgreens is an integrated healthcare, pharmacy and retail leader serving millions around the country for the past 175 years. A global and well know brand, the company has ~12,500 locations across the U.S., Europe and Latin America; the company plays a critical role when it comes to the overall healthcare system of the U.S. through dispensing medicines, improving access to pharmacy and health services, providing high quality health and beauty products and offering anytime, anywhere convenience across its digital platforms. The company owns ~311,000 employees with presence in eight countries and consumer brands including: Walgreens, Boots, Duane Reade, No7 Beauty Company and Benavides. With this brief introduction, lets start looking at Walgreen's historical financials. Below is snapshot of the company's historical income statement:
The retail pharmacy and health services sector has recently been going through a bit of turmoil, not only with the emergence of digital pharmacies such as as Amazon and Walmart but also due to the negative perception around litigious issues such as the Opioid lawsuits to name one. WBA's topline growth has been suboptimal at best, the company reported revenues of $148BB for FY '24 which was a 6.2% increase from last year's reported revenues of $139BB. The company's cost of sales or COGS has gradually been increasing over the last few years; the company reported cost of sales of $104BB (78.8% of total revenues) for FY '21 and fast forward to today, the company reported cost of sales of 82% or $121BB for FY '24; clearly over the last few years the company has either lost its competitive advantage or it has dwindled significantly as is evident from a higher growth in cost of sales when compared with the company's topline. This mismatch of growth between revenues and cost of sales can also be seen in the company's gross margins; the company's gross margins have shrunk from 21% in FY '21 to 18% in FY '24.
Speaking next of the company's indirect costs, SG&A has always, for obvious reasons, been a huge part of the company's income statement. Company's SG&A for the most recent year was $28BB or 19% of total revenues which is in line with the company's historical reported SG&A numbers. Additionally, WBA reported a goodwill impairment charge of $13BB for FY '24 majorly due to its acquisition and subsequent investment in VillageMD. Due to the above reasons, i.e., the slower growth in sales, faster growth in COGS and somewhat increased SG&A, the company's margins have collapsed over the last few years; the company's reported operating margins of -9.5% in FY '24 as opposed to 1.8% for FY '21. An avid reader might wonder if the margins look any better without the reported impairment of goodwill, sadly, they do not; even if we were to take the impairment of goodwill out of the equation, we still end of with an operating loss of roughly $1.4BB or margins of ~-0.9%. Finally, moving down to the company's bottom-line, the company reported NI of -$8.6BB (or net margins of -5.8%) which is a further reduction into negative territory when compared to last year's NI which was -$3BB (net margins of -2.2%). With an overview of the company's income statement, I think we should now look at the company's historical balance-sheet and see it has weathered the last few years.
On the assets side, at the end of the company's last reported fiscal year, the company had $3.1BB in cash and cash equivalents, I have included marketable securities in cash only because I believe that these are securities that are short-term and liquid and so they should be considered cash for analytical purposes. Company does seem to have a healthy need for NWC on YOY basis as evident by the year over year increase over the last few years which, of course, translates into cash outflow. Let's now break the working capital down to its pivotal factors and see how the company fares in terms of its DSO, DPO and DIH. If we look over the course of the last few years, namely last four years, we can see that the company's DSO has improved from 15.6 days back in FY '21 to 14.5 days in FY '24, this, of course, means that WBA has been able to recoup their receivables at a faster pace which translates into a cash inflow and helps the company with its liquidity. Moving onto company's DIH, which measures how long it takes on average for the company to sell and replace its inventory, we can see that WBA has also improved this metric; from 28.5 days in FY '21 to 25.07 by the end of FY '24. Lastly, DPO, which measures how long it takes for the company to pay its suppliers and business partners, we can see that WBA has also managed to enhance this measure as well; from 38.9 days in FY '21 to 42.43 days by the end of FY '24.
Let's move onto the other side of the balance sheet, liabilities and equity. WBA had short-term debt of $1.5BB by the end of FY '24 as well as $8BB in long-term debt. The company also reported operating lease liabilities (short and long-term), which for the purpose of this exercise I will treat as debt, of roughly $23BB. Lastly, the company reported total equity (which includes preferred stock, common stock and APIC, treasury stock and retained earnings and non-controlling interests) of 12BB for its latest fiscal year. The last statement we need to look at before we move onto our LBO analysis is the cash flow statement. As I suspect most of you understand, cash flow statement really is the ONE statement we have to analyze in order to better understand any given company's liquidity and true cash inflows and outflows for reasons that I will not delve into in this post. Here is a snapshot of the company's historical cash flow statement:
Looking at the company's investing activities, primarily capex, we can see that capex has historically been within the 1-1.5% of total sales range. Total cash flow from investing activities was positive due to the proceeds from the sale of assets as well as the proceeds received from the sale of leaseback transactions and other activities. Last but not least, apart from miniscule financing activities, we can see that the company's management is pretty comfortable with raising debt and then paying it back or refinancing it. The financing activities also shows the fact that the company paid a constant amount of dividends ($1.7BB) but ending up curtailing it to $1.26BB for FYE '24. What does all this mean? It means that Walgreen's has been adding onto its cash balance for the last three years.
With an understanding of what the company does, and its historical financial statements, I believe that I am in a good enough position to start discussing the crux of this analysis: the LBO.
LBO Analysis
I should preface this analysis with two distinct facts: first, I do this to satiate my own thirst and secondly, I have had to make a few assumptions. To start off, let's look at the various assumptions that I have made.
LBOs are typically structured either as an explicit offer per share or as a multiple of EBITDA, and even though I have used the offer price per share option, I have left the multiple optionality in the model. As announced, the offer price per share was $11.45, and given the diluted shares outstanding of 865MM, we get an equity value (or an offer value) of $9.9BB. As of the latest 10K, the company had total debt (excluding leases) of $9.5BB, non-controlling interest of $1.7BB and cash and cash equivalents of $3.1BB resulting in an enterprise value of $18BB; I have ignored the DAP rights and other earnouts which is why this is lower than the proposed enterprise value of ~$23.7.
Additionally, since I couldn't find the exact break down of the new capital structure, I have assumed 5 different debt structures that the sponsors could potentially pursue, and as we will see down the analysis, returns can look drastically different depending on the chosen structure. For the sake of this analysis, I have assumed structure 3 to be the prevailing capital stack which includes a revolver commitment of $2BB, term loans A, B, and C with principal amounts of $6BB, $4BB, and $2.5BB, respectively, senior notes of $2BB and subordinated notes of $2.3BB, all of which results in an equity contribution of roughly $2.7BB. I have also assumed amortization of $292MM in financing fees and an immediate expense of $198MM in transaction and other fees.
With the transactions assumptions out of the way, lets review my base case scenario.
Future
LBO transactions are structured in a certain way, and there are a few levers that the PE sponsor can pull in order to improve their returns at exit. I would like to go over some of those levers in my base case.
- Sales
- The company reported sales growth rate of 4.8% and 6.2% for fiscal years '23 and '24, respectively, and I do not see a significant delta either way going forward and there are a few reasons for that. Firstly, the company has been facing an increased amount of competition over the last few years resulting from online pharmacies such as Amazon and Walmart as well as from its traditional rivals such as CVS. Secondly, over the last few years while its competitors such as CVS have been able to pivot their business model, Walgreens stuck with its retail pharmacy business as the main source of revenue. Lastly, the overall drug and pharmacy industry has been severely impacted by various litigious and pending legal issues. In my base case, I think given Sycamore's strength in this industry and their portfolio, top line revenue should grow from 6.2% in FY '24 to 6.7% by the end of FY '29, and then gradual reduction to 6.5% by the end of FY '34. I believe that this modest growth in sales over the next five years is reasonable given the headwinds and issues the new owners will have to cope with.
- Cost of Sales
- Another lever that the sponsors and their management team can pull is reduce the costs over the holding period which results in higher margins and therefore higher value at exit. Walgreens reported COGS as a percentage of sales of 82%, 80.5%, and 78.7% for fiscal years '24, '23 and '22, respectively. I believe over the next five years, the sponsors should be able to gradually reduce the costs to around 80% of total sales by the end of FY '29. I see these cost reductions resulting from better asset utilization, reduction through better trade and vendor relationships resulting from Sycamore's expertise in the industry and from various potential divestitures.
- Deleveraging
- In my base case, I believe the company will operate at minimum cash which I have assumed to be at $500MM. Moreover, I believe that the company generates enough cash flows for the management to be able to meet their obligations such as interest expense and debt amortization. As the debt schedule shows, not only is the company able to pay its terms loans early due to cash sweep, but also that the management does not have to draw on its revolver for any of the years in the holding period- which I have assumed to be 10, even though LBOs are typically held for 5-7 years.
- EBITDA Expansion
- Given my assumptions around sales and COGS, I expect the company's adjusted EBITDA to grow from $5.2BB (3.6% margins) in FY '24 to $7.8BB (3.9% margins) by the end of FY '29. I believe this higher EBITDA will for sure result in higher value for the sponsors at exit.
- Multiple Expansion
- Multiple expansion is considered by professionals to be one of the hardest ways for PE sponsors to amplify their returns and for good reasons too. Multiple expansion is a matter of how well the markets are, the industry's performance and not to mention the size of the company and access to capital, and since I don't care to venture a guess on any of these variables, I will assume that the company exits at the same multiple that it entered which is 3.4x.
Pro-forma Financial Statements
With the assumptions out of the way, let's now look at what the income statement could like going forward, please note that I have forecasted for the next 10 years instead of 5.
As mentioned in the assumptions section, I expect the company's total sales to grow from $148BB in FY '24 to $202BB by the of FY '29 (year 5), and I have already gone over where I see that growth stemming from. Moving on, assuming my prognostications around the company's COGS, I expect the company's gross margins to improve from 18% in FY '24 to 20% by the end of year 5. If everything plays out the way I expect it to, I believe the company's operating margins will improve from -9.5% in FY '24 to 2.1% by the end of FY '29. Moving onto the non-operating expenses, we can clearly see the impact of new interest expense on the company's earnings as the company could have around 2% in net margins by the end of the holding period (five years). Having discussed the company's income statement, let's move onto the company's balance sheet.
As the pro-forma balance sheet shows, I expect the company to operate at its minimum cash balance which I have assumed to be $500MM. Moving onto the important part of the balance sheet, we can see that the management will have to deal $16.5BB in debt (excluding leases), and we can also see that through operations defined by growth initiatives and cost reductions the company should be able to reduce its debt balance from $16.5BB in FY '25 to $2.2BB by the end of year 5; this very clearly signifies Walgreens ability to generate significant cash flows that could make this LBO a successful transaction for the sponsors as well as the lenders and the management. Let's review the company's pro-forma cash flow statement and see how that looks in my base case.
As the cash flow statement shows, despite accrual based losses in income statement, the company generates a healthy amount of operating cash flows which in turn fuel the investment and the financing activities. Additionally, as evident from the screenshot above, interest income is almost trivial which is why I ignored it in the income Statement. What does all of this mean? Well, let's look at the returns in my base case and look at what the PE sponsors can expect when they decide to exit in five years.
Returns Analysis
If we make an assumption that the sponsors exit at the same multiple that they entered at which is 3.4x, we can see that the IRR in FY '29 or year 5 could be 58% while the MOIC (money-on-money) multiple could be around 10x. PE firms typically target IRR in the range of 20%-30% depending on the industry and other factors, and by that target, this seems like it could be a great deal for Sycamore and its partners. This, of course, is in my base case, and if we were to make more optimistic or pessimistic assumptions, our returns could look either good or really bad. Let's look at some additional stuff to further understand how good or bad a deal this could be.
Summary Financial Data
As is evident from the screenshot above, the company will need to operate at minimum cash balance, and also that the company is able to pay off all of its debt by year 7 which is fiscal year 31. Additionally, we can also see that the company is able to pay off all of its senior debt by the end of year 5. Let's last look at the potential credit statistics.
The image above shows a similar story which is the fact that the company is able to operate in such an efficient way that they are able to expand their EBITDA and lower their obligations which result in pretty good statistics by the end of year 5.
Conclusion
I conduct these analyses not to criticize the teams or the firms that have worked on the transactions, but to purely quench my own intellectual curiosity. Based on what I have assumed in my base case, the transaction seems pretty lucrative from IRR, MOIC and deleveraging perspective. As always, I am well aware that everyone thinks and strategizes differently, and so I have linked the Excel file right below the post for you to play with and put in your own assumptions and make your own conclusions.
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