U.S.’s third largest drug retailer Rite-Aid‘s (NYSE:RAD) stock has gained more than 50% value in the last three months amid healthy sales growth, improved revenue guidance, a recent debt refinancing, and most interestingly, rumors that drug retail giant Walgreen (NYSE:WAG) could be planning a takeover of Rite Aid.
The stock had also jumped in November last year after analysts at Susquehanna Financial Group speculated that it may be a potential takeover target of Walgreen. There was similar speculation of a CVS Caremark (NYSE:CVS) takeover of Rite Aid after Walgreen acquired Duane Reade in 2010. Let us look at why Walgreen could be interested in acquiring Rite Aid.
PBM Consolidation Prompting Retailer Consolidation
Walgreen recently parted ways with Express Scripts letting go of more than 90% of the 90 million Express prescriptions after the two failed to renew their contract for 2012 with disagreement over the reimbursement rates.
To add to the challenges, U.S.’s two largest PBMs Express Scripts and Medco are attempting to merge, pending FTC review. If the merger gets regulatory approval, the resulting entity would not only control more than 35% market share, the consolidation in the PBM industry would also greatly increase their pricing power.
Walgreen also faces the risk of a possible reimbursement rate negotiation with Medco as with Express if it folds in with Express Scripts. Therefore, large drug retailers could see industry consolidation as a way to regain some of their bargaining power.
Low Interest Rates Ease M&A
With the Federal Reserve guaranteeing low interest rates for the next two years, the access to cheaper financing there is a higher likelihood of mergers and acquisitions activity.
If Walgreen Acquires Rite-Aid
Walgreen’s prescriptions business grew ahead of the industry in 2011 with addition of 2,000+ stores and acquisitions of Duane-Reade and drugstore.com. Yet, its market share is expected to decline in 2012 as a result of its dispute with Express Scripts.
Walgreen targets an organic store growth of 2.5-3% going forward and may look towards Rite Aid, which occupies 7-8% prescription market share with more than 4,500 locations, as a potential acquisition to quickly grow its prescription business and retail presence.
Rite Aid has posted healthy sales growth over the past few quarters, but it still lags its peers in terms of profitability with challenges like weaker cash flows, high debt and limited capital for investment. If it gets acquired by a bigger retailer with more cash for investment, the new owner could invest in improving its key performance metrics like prescription volume per store and front-end sales per unit area and make these assets more productive.