Top investor Paul Hill on the worst share tips from the week’s press and brokers’ reports. This week – a flaw in a recent merger will store up problems for the future.
Turkey of the week: Alliance Boots (AB., 766p), tipped as a BUY by The Daily Telegraph
Alliance Boots (AB) was born last week from the marriage of Boots and Alliance UniChem (AU). However, there is an important strategic flaw with the merger that hasn’t been properly addressed. The rationale is to create an international pharmacy-led healthcare and beauty business. Combining Boots’ chemists with AU’s pharmacies is consistent with this strategy, since it creates Europe’s largest pharmacy firm.
However, there is very little justification for vertically integrating AU’s low margin wholesale business (sales £8.7bn) with the group’s retail activities (sales £7.4bn). Vertical integration rarely works, especially in retail. Newsagent WH Smith is currently separating its own retail and distribution operations for this very reason.
AU’s distribution division serves approximately 125,000 outlets across Europe, of which about 3,000 are either owned by AB or its associates. Thus there is a serious risk that many of AU’s larger wholesale customers will move their accounts to different suppliers to avoid competing head-on with AB on the high-street. This is why you don’t see Sainsbury using Tesco’s trucks to deliver groceries to its stores – Sainsbury just would not allow itself to become reliant on such a large competitor.
If my suspicions are correct, then the wholesale division may in fact experience future revenue declines, rather than the organic growth that analysts predict. Moreover, I am a strong believer in the benefits of competition to drive out waste. By vertically integrating the wholesale and retail units, inefficiencies can be locked into the supply chain, rather than eliminated by the natural forces of competition.
So let’s assume that management identifies this problem and decides to
sell the wholesale activities (although this is not presently the intention).
What would the group’s sum-of-the-parts valuation be? Well, I would rate the distribution business on a maximum 2006 p/e of 14, which would generate a fair value of roughly £1.8bn.
For the stores, a sector p/e of 15 looks reasonable, which makes the retail activities worth about £5.3bn. Merger synergies at £100m a year create another £700m of value. Nevertheless, after deducting net debt of £1.1bn and a pension deficit of £125m, this generates a fair value for the shares of only around 680p. In other words, at 766p, I believe the stock currently trades at a 13% premium to its underlying value.
I suspect that part of the premium is because the City thinks AB will deliver more than £100m of synergies. But even if it does, the majority of these extra savings will have to be re-invested in the shops as price discounts.
Finally, Boots only owns about 6% of its properties and so there is less chance of an asset-backed bid by a private-equity house. Moreover, the dividend yield is set to fall from around 3.8% currently to less than 3.0% next year, due to a change in payout policy.
In light of the unresolved strategic issue, the ongoing penetration of Boots’ traditional markets by supermarkets, and the toppy valuation, I believe the shares are a sell.
Recommendation: SELL at 766p
Paul Hill’s personal portfolio has gone up by 483% over the last five years. To find out more about his own specialist share-tipping service, ‘Precision Guided Investments’, click on the link below