For Walgreen Co., A Choice With Growth And Risk

Walgreen Co. (NYSE: WAG), the largest U.S. drugstore operator, is facing challenges it has never seen in its 111-year history and this week it responded with a high-stakes strategic move.

The Deerfield, Ill., company may be a victim of its own long string of success: Since Charles Walgreen Sr. launched his business in 1901, it has grown to more than 7,800 stores in the U.S. In 2010, it bought ubiquitous New York chain Duane Reade for $623 million and saw revenue rise the next year to $72.1 billion.

But now, the iconic company faces challenges from the evolving pharmeceutical industry and limited U.S. expansion possibilities, where it has saturated cities such as New York with a store on virtually every corner.

Walgreen had a weak first quarter and recently terminated its partnership with pharmacy supply manager Express Scripts Inc. after an ugly dispute. Walgreen shares have fallen around 11 percent this year, and the company is facing more competition from CVS Caremark (NYSE: CVS).

The company once boasted reliable double-digit revenue growth and remarkably steady margins. However, those days are long gone as the country has become saturated with Walgreen stores, competitive pressure has intensified and pharmacy benefit managers have gained bargaining leverage, wrote Matthew Coffina, a Morningstar Inc. analyst in a June research note.

This week, Walgreen made a bold choice: It will spend $6.7 billion in cash and stock to buy a 45 percent stake in the European pharmacy retailer Alliance Boots. It also increased its dividend by 22.2 percent to 27.5 cents per share, the largest in the company's history. The two moves would appear to reflect the company's financial strength, but Wall Street was skeptical, knocking down the shares another 0.21 percent to $29.15 on Thursday.

With its eroding supplier network, Walgreen decided to look overseas, eventually settling on Alliance Boots because of its concentration in the UK, which has remained relatively insulated from the euro crisis, according to Bloomberg News. But its proximity to the troubled continent is still a concern for analysts.

Walgreen is making an expensive acquisition of a company that is highly exposed to the weak UK and European markets, with greater uncertainty about how things develop in the next few years or even months,” wrote Meredith Adler, an analyst with Barclays Capital, in a research note this week.

Walgreen's move appears to be a way to appease Wall Street's hunger for growth companies -- a category that Walgreen has slipped from. In its fiscal third quarter, Walgreen's earnings fell 10.8 percent to $537 million, and earnings per diluted share were down 4.9 percent to 62 cents. Same-store sales were down 5.8 percent in the month, and prescriptions were down 7.6 percent in May following the end of the partnership with Express Scripts' network. With such weak results, a bold move could be the company's only answer to fight a slow erosion of its share price.

The Alliance Boots deal could revitalize Walgreen, but it carries risks. Walgreen has the option of buying the entire company before 2016, which would make it one of the largest global pharmacy companies. However, Standard & Poor's and Moody's both put Walgreen's debt on review after the announcement of the Alliance Boots deal, because a full merger would move the European company's $10.9 billion in debt onto Walgreen's books.

On one hand, Europe may represent the clearest path of expansion for Walgreen.

But if the deal goes sour, it jeopardizes not only the company's high divdend, which has been paid out to investors for more than 79 years, but also the financial health of the entire company.