Weekly Puzzle #10: Leveraged Recapitalization

What is it?

In a leveraged recapitalization, a company keeps its operations intact and changes its mix of debt and equity. That change usually requires borrowing money (which increases debt) and either buying back stock or paying dividends (both of which reduce the aggregate value of equity). The central question on whether a leveraged recapitalization is value adding, neutral or destructive boils down to whether the company doing the leveraged recapitalization was under levered, correctly levered or over levered prior to the transaction. If under levered, the recapitalization will increase value even though the financial standing of the firm will look worse after the recap (a drop in bond rating, an increase in both equity risk and default risk). If over levered, the transaction will make the firm worse off, with the increase in risk overwhelming any tax benefits from the additional debt.

The Walgreens tussle

Walgreens is a US retailer that sells a mix of pharmacy and consumer products. In 2014, Walgreens was targeted by activist investors as a company that could benefit from a recapitalization. The rationale for the activist investor push is at this link. You will see both the activist viewpoint (that Walgreens has too little debt and can borrow more) and the company's perspective (that its ratings will fall below investment grade).

Since both sides have agendas and neither side seems to be looking at the whole picture, it may be worth your time to look at Walgreens' financials on your own. You can get the most recent annual report for Walgreen at this link and a summary of their numbers over the last decade here.

Key Questions to Answer

1. The weakest link in the activist investors' argument is that they define debt narrowly as interest bearing debt. Walgreens is a retailer with significant lease commitments. Using the lease commitments that Walgreesn reported in their annual report in 2014, estimate Walgreens' debt burden (in dollar terms, as a percent of capital and as a multiple of EBITDA).
2. Using the financial data for Walgreens and my spreadsheet for optimal capital structure, evaluate whether Walgreens is in a positive to do a leveraged recapitalization. (You can get betas by sector, if you need them, here).
3. If the answer is no, how should Walgreens make its case to stockholders.
4. If the answer is yes, how much should Walgreens borrow? Should it buy back stock or pay special dividends?
5. If the answer is to buy back stock, what is the "fair" price for the buyback (where those selling the shares nor those holding on to their shares are equally benefited)?