Walgreen Bulls Bet Investor Activism Will Cure Tax Pain

By Inyoung Hwang Sep 18, 2014 7:00 PM ET

The entry of an activist shareholder into the board of Walgreen Co. (WAG) may be just what the doctor ordered for options traders betting on the largest U.S. pharmacy chain after a 17 percent plunge.

While the Deerfield, Illinois-based company’s stock has tumbled since reaching a record in June, bullish contracts are the most expensive relative to bearish ones in almost seven years, data compiled by Bloomberg show. Investors are lured by the potential for share buybacks and earnings growth as hedge fund Jana Partners LLC, which has agitated for a more shareholder-friendly use of Walgreen’s cash, struck a deal with the company on three board seats.

Walgreen dropped 14 percent on Aug. 6 after saying it won’t shift its tax address out of the U.S. even as it announced a $15.3 billion purchase of the rest of Switzerland-based Alliance Boots GmbH. Investor disappointment over that decision waned this month after the board changes.

“Jana Partners getting board seats is a very positive step and shows they are being pretty shareholder-friendly,” Jeff Jonas, a portfolio manager at Gabelli & Co., which manages $43 billion and owns Walgreen shares, said in an interview. “Walgreen can be more aggressive in cutting costs. There is room for improvements and Jana is going to be aggressive in pushing for them. When the deal is ultimately done with Alliance Boots, it will be a very attractive company.”

‘Stronger Voice’

As part of the settlement on Sept. 8, Jana founder Barry Rosenstein joined Walgreen’s board, got his choice of a second director and a joint say in picking a third. The changes will result in a stronger voice for shareholders in the combined company, Mark Wiltamuth, an analyst at Jefferies Group LLC in New York, wrote in a note.

The $11 billion investment-fund Jana, which owned 1.2 percent of Walgreen shares as of June 30, will use the board positions to push for more buybacks, a person familiar with the matter said. The owner of more than 8,500 pharmacies operating in every U.S. state reports fourth-quarter earnings on Sept. 30.

The same day it said it will keep its domicile in the U.S., Walgreen announced a smaller-than-expected buyback plan of $3 billion and cut its forecast for adjusted earnings by $2 billion. The drug retailer has also missed analysts’ profit estimates for the last two quarters, according to data compiled by Bloomberg.

Walgreen’s 17 percent loss since reaching an all-time high of $76.08 on June 18 compares with the Standard & Poor’s 500 Index’s advance of 2.8 percent in the same period.

Profit Growth

Analysts project Walgreen’s earnings will jump 16 percent in 2015, according to data compiled by Bloomberg. Profit this year is estimated to climb 4 percent, the slowest growth rate since earnings contracted in 2009, the data show.

Walgreen bought a 45 percent stake in Alliance Boots, Europe’s largest pharmacy chain, in 2012 and had the option to gain full control of the chain. The agreement reached in August allows it to buy the remaining 55 percent by Feb. 5, 2015.

Investors had favored the deal, among other things, for its potential to reduce the company’s tax liability. They pushed the stock up 12 percent in the second quarter amid speculation the deal was imminent. Deutsche Bank AG said in June that a tax inversion -- moving the legal address to a low-tax country -- would add as much as $15 to the share price.

While tax inversions are increasing as European countries aim to boost economic competitiveness by slashing corporate-tax rates, Walgreen has faced political pressure not to do one. Senator Richard Durbin, an Illinois Democrat, said in a July 22 letter to the company that such a shift would amount to “turning your backs on the very people that have allowed Walgreen’s to thrive and prosper.”

‘Caution Necessary’

Walgreen’s business faces challenges and Jana’s agreement on the board seats comes with a standstill limitation of not owning 5 percent or more of shares outstanding for some time, according to Steven Halper, an analyst at Friedman Billings Ramsey & Co. Pressures in reimbursements and higher costs in procuring generic drugs are among the challenges, he said. Halper has a market-perform rating, the equivalent of a hold, on Walgreen and predicts the shares will climb to $66 each in the next year.

“It’s our view that investors should be a little cautious,” Halper said by phone from New York. “Walgreen has been conservative in the buyback area, but it’s impossible to know which direction the board will go post-Jana, post-merger.”

Calls betting on a 10 percent rally in Walgreen cost 1 point more than puts betting on a decline of that size on Sept. 8, according to data on two-month contracts compiled by Bloomberg. That was the most since October 2007.

Jim Graham, a spokesman for Walgreen, declined to comment on the options trading in his e-mail response.

Bullish Bets

Walgreen calls outnumbered puts, with bullish wagers totaling 491,193 on Sept. 17, compared with 367,520 bearish options, according to data compiled by Bloomberg.

Of the 10 most-owned contracts, seven were bullish. Calls betting on a gain to $72.50 by Oct. 18 had the highest ownership, followed by those wagering on a gain to $70 over the same period, Bloomberg data show.

Walgreen’s sales on a month-by-month basis are stabilizing and pharmacy demand is slowly accelerating, David Magee, an analyst at SunTrust Robinson Humphrey Inc. in Atlanta, said. He recommends investors buy the stock and projects it will climb to $72 in a year.

“The company is coming off a major disappointment, so some faster money has left the name right now,” Magee said. “At the same time, if you sift through last month’s wreckage, there are reasons for optimism.”

To contact the reporter on this story: Inyoung Hwang in London at ihwang7@bloomberg.net

To contact the editors responsible for this story: Cecile Vannucci at cvannucci1@bloomberg.net Srinivasan Sivabalan, Jeremy Herron

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