Walgreens To Buy Rite Aid At A Great Price, To Become The Largest U.S. Pharmacy

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Ahead of its annual FY’15 earnings release, Walgreens (NASDAQ:WBA) announced that it will acquire rival Rite Aid (NYSE: RAD) for $17.2 billion dollars, all in cash. [1] For quite some time, there was speculation around Rite Aid being a potential acquisition target for Walgreens. Earlier in March this year, we published a post on why we think Walgreens might consider acquiring Rite Aid. While conditions have remained largely similar all this while, competition in the healthcare space has increased due to consolidation, which might have prompted Walgreens to act sooner rather than later.

The deal will create the largest pharmacy chain in the U.S. with almost 13,000 stores across the country, leaving rival CVS Health (NYSE:CVS) behind, which has about 10,000 stores (including the recently acquired Target pharmacies). The resulting scale puts Walgreens in a strong position to negotiate prices with drug manufacturers and will help offset the negative effects of other gross margin headwinds. Given the largely similar business models of the two drug retailers, we believe the integration risks are fairly low, enabling the merged entity to effectively extract synergies.

Below we discuss the potential benefits that Walgreens stands to gain from this deal. We are in the process of updating our model to refelect the recent earnings release.

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View our analysis for Walgreens

A Vast Network Of Stores

Walgreens’ strategy is markedly different from its competition in that it decided to focus only on the pharmacy business and not to diversify into adjacent markets. For example, rival CVS earns about 60% revenues from its pharmacy benefit management business. As part of this pure play strategy, it acquired Alliance Boots, a European retailer of health and wellness products, which is as big as Rite Aid (4500+ stores).

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But, competition was catching up and CVS had become the largest chain when it acquired all of Target’s 1600+ in-store pharmacies [2]. As it also owns the second largest PBM in the country, CVS’ model was (and still is) better equipped to manage margin pressures. With the government’s intention to cut down healthcare expenditure, the headwinds are expected to persist for a while. Therefore, we believe this acquisition comes at the right time for Walgreens as it will be able to use its larger scale to lower drug acquisition prices.

However, given the size of the resulting entity (13,000 stores across the U.S.), the transaction will likely draw scrutiny from antitrust regulators. We believe Walgreens will have to divest stores in a few states where the concentration of stores will be too high. For example, in New York, Illinois and Michigan, the combined entity will have more than 2,200 stores compared to about 1,000 CVS stores. Similarly, in states with more than 500 stores (of the combined entity), Walgreens will have 70% more stores than CVS on average.

Below is a more detailed depiction of the post-acquisition store distribution by region.

Store Distribution

What is interesting is that Rite Aid will be a subsidiary owned by Walgreens and will continue to operate stores under its own brand. We believe this decision has more to do with Rite Aid’s branding efforts in the recent past, where stores were modified to the ‘wellness’ format. Stores under this format have been performing better than the rest of the chain with higher comps growth. As these investments in branding are likely to reap more benefits in the future, we think the decision to continue with the Rite Aid brand is the right one.

Huge Synergies And Margin Benefits

For quite some time, the profitability of pharmacies has been under pressure because of multiple reasons, including low reimbursement rates, increasing power of PBMs, and a decline in the uncovered population (who pay the full price for drugs versus a PBM-negotiated one). With increasing bargaining power against drug manufacturers, however, Walgreens has managed to maintain profitability and is likely to do so in the future too.

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In fiscal 2015 (ending August), Walgreens likely generated $650 million in synergies and expects another $1 billion in FY 2016 (both from the Alliance Boots acquisition), mostly from procurement activities [3]. With the acquisition of Rite Aid, the company expects to realize another $1 billion in synergies taking the total amount to almost $2.7 billion in the next one year. Furthermore, long-term synergies are likely to be significant given the advantages of owning a PBM and potential share gains associated with owning a truly large (almost ubiquitous) network of stores.

All This At A Great Price

At $9.00 a share, Walgreens got a very good deal for the benefits it stands to gain. While the acquisition price is at a 48% premium to Rite Aid’s pre-acquisition stock price of $6.10, we believe the intrinsic value of the company is much higher, closer to the Trefis price estimate of $8.67. Adjusting for Rite Aid’s acquisition of EnvisionRx, the estimate comes down to about $8.20, which implies a very reasonable acquisition premium of 10% (considering the potential synergies).

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In fact, it is the recent sell-off in Rite Aid’s stock (after its Q2 earnings release) that makes the acquisition price appear too steep. As earnings fell due to one-time expenses and what we believe are short-term concerns, its stock price slumped by 30% in a week’s time. In spite of the negative earnings surprise, we have maintained our optimistic view of the company’s business and our price estimate refelcts the large upside available. More importantly, Walgreens seems to share our view on Rite Aid’s value, making it a good buy.

A Short-Term Spike In Leverage

Included in the $17.2 billion transaction value is about $7.3 billion in net debt acquired from Rite Aid. Walgreens expects to finance the remaining amount through a combination of existing cash resources ($3 billion) and issuance of new debt.

Walgreens’ current debt level at 46% of equity is close to that of competitor CVS’ 35%. Including any new debt issuance (assumed to be $7 billion), the total debt on Walgreens’ books after the completion of the merger is likely to reach $27 billion, which translates to a debt-equity ratio of 0.90 (i.e. 90% of equity). This level of debt is significantly high compared to industry peers and as the company’s CFO rightly puts, “we will be running a relatively inefficient balance sheet for a short period of time“.

However, Walgreens has decided to suspend its share buyback program temporarily to redeploy capital to partly fund the transaction. Overall, considering the high operating cash flows ($5.7 billion in FY 2015) that the company is able to generate and the planned $1.5 billion cost-savings program, we believe Walgreens will be in a strong position to bring leverage back to normal levels over time.

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Data Source: Drug Store News

Earnings Transcript: Seeking Alpha

Notes:
  1. Walgreens Boots Alliance Press Release []
  2. CVS to Buy All of Target’s Pharmacy Stores — A Win-Win For Both, Trefis []
  3. Seeking Alpha Earnings Transcript, Walgreens Q3 2015 Results []