Walgreens’ acquisition of Rite Aid should help the company strengthen its position and market presence in the pharmaceutical retail industry and cement its place as a leader.
The question is whether the combined free cash flows are sufficiently high to justify the current stock price.
In our view, the stock looks overvalued, even though the company is operating in an attractive growth industry.
Walgreens Boots Alliance Inc. (NASDAQ:) is a holding company in pharmaceutical manufacturing, wholesale and distribution. With the secular trend of rising healthcare spending and a further prediction of an annual 5.6% growth in the next 5 years (), the race is on to strengthen positions in the U.S. pharmacy retail industry. Walgreen's competitors have been actively investing large sums of their earnings in growth activities in form of mergers and acquisitions. On October 27, 2015, Walgreens announced the purchase of competitor Rite Aid for $17.2 billion. If the FTC approves the acquisition, Walgreens will be able to solidify its position as a leader in the healthcare retail sector, thanks to significant cost cutting in SG&A, distribution, and management.
The question is whether the combined free cash flows are sufficiently high to justify the current stock price. In the following section, we will estimate the intrinsic value of the stock based on the combined company's ability to generate cash flows. We will also assess the relative richness/cheapness of Walgreens' ordinary stock compared to its peers.
Our valuation model for Walgreens is based on the company's ability to generate cash. The key measure of cash flows that we use is free cash flow, which is the total cash inflow from operations minus dividends and capital expenditure outlays. This is effectively the amount of "excess" cash that the company...