The pharmacy retail market in the U.S. is about to shrink to just two dominant players in the coming quarters as consolidation continues. Walgreens Boots Alliance (WBA, Financial) has placed a bid of $9.4 billion for the acquisition of close rival Rite Aid (RAD, Financial).
The announcement of the bid is fantastic news to Walgreens investors as it seeks to expand its addressable market to the larger Pharmacy Benefits Management (PBM) market. This acquisition will also increase Walgreens' market share in the oharmacy retail market from 31% to about 41% which will give it a better chance of competing with the current market leader CVS Health (CVS, Financial), which holds 58%.
Walgreens and CVS Health are already the top two companies but once this acquisition takes place, the market could become a duopoly.
Overview of the U.S. retail pharmacy business
Walgreens and CVS Health have been heading the consolidation of the pharmacy retail business in the U.S. over the last few years. The company has added USA Drugs, Kerr Drugs and Duane Reade among others to its portfolio, while CVS Health acquired Navarro Discount Pharmacy, Medicine Chest and Long’s Drug.
Rite Aid completed the acquisition of PBM company EnvisionRx for $2 billion in June after announcing the deal early in February. This put it third in terms of market share in the PBM industry behind Express Scripts (ESRX, Financial), which posted $100 billion in revenue last year, and CVS Health which had $88 billion in pharmacy-only revenues.
EnvisionRx posted just $5 billion, which makes it look like an underdog in the market, but following the acquisition by Rite Aid, the PBM industry is about to become a little more competitive given the resulting size of the Deerfield, Ill.-based company.
Retail pharmacy, PBM and clinic businesses are expected to continue merging through the fourth quarter and beyond as small players find it hard to improve margins following the signing into law of the Affordable Care Act.
So how will this acquisition change Walgreens?
Camp Hill, Pa.-based Rite Aid has about 4,600 stores in 31 states while Walgreens already has 8,200 compared to CVS Health’s 7,800. The acquisition will give Walgreens a combined total of about 13,000 stores in the U.S. alone.
However, Walgreens is actually interested more in the deal because of the exposure to the PBM market that Rite Aid will provide via EnvisionRx than just the growth in presence it will have in the retail pharmacy market. This move has also cast doubts over another rumored deal of Walgreens', acquiring PBM industry giant Express Scripts, which has a market cap of $58 billion. However, Walgreens now appears set to get its hands on the lucrative Pharmacy Benefit Management market without having to consider the acquisition of Express Scripts.
Pharmacy-benefit managers are companies charged with the processing of prescriptions for the groups that pay for drugs such as insurance companies or corporations. They use their size to negotiate better deals with drug makers and pharmacies thereby enabling them to cover for the low price margins with volume sales.
In 2014, Rite Aid posted revenues of $26.5 billion while Walgreens reported a figure of $76.4 billion. This means that the company’s top line could rise to about $113 billion annually without including synergies, and this will bring it closer to CVS Health’s figure of $139 billion posted last year.
The acquisition of Rite Aid will also expand Walgreens' addressable market in RediClinics (walk-in centers that can give flu shots and tend to ailments) as well as in offering organic food and natural personal-care products given Rite Aid’s portfolio of 1,859 wellness stores.
Is the deal really happening?
Walgreens is paying $9.00 per share in an all cash acquisition, which prices the deal at about $17.2 billion including assumed debt of about $7.4 billion. This represents a premium of 48% on Rite Aid shares based on the preannouncement price of about $6.08 per share.
Walgreens is likely to face some scrutiny from antitrust regulators before completing the deal, as the issue of competition is pointed out, but given the diverse nature of the drugstore retail market in the US, the deal is widely expected to go through.
Notice that other companies such Walmart (WMT, Financial) are also involved in the Pharmacy Retail business, while Target (TGT, Financial) recently sold its struggling pharmacy business to CVS Health.
So should you buy Walgreens now or after the deal?
Shares of Walgreens and Rite Aid rallied 6.4% and 43%, respectively to $95.16 per share and $8.67 per share following the announcement of the deal on Tuesday. This move indicates a vote of approval by investors, which means there are high expectations.
At this moment, investors are buying into what could happen following the completion of the deal, including expansion into other business segments as well as the consolidation of market share in the drugstore retail chain market.
However, shares of both companies have since shaded off some of those gains as some investors moved quickly to cash out some of their holdings following the spike in prices. Currently, shares of Walgreens are trading at $83.88, which translates to a P/E ratio of 21.55x for trailing 12-month period as compared to the industry average of 21.05x.
On the other hand, Rite Aid is currently priced at $7.88 or 4.06x in P/E. This means that the overall post acquisition P/E ratio for Walgreens is likely to be lower than the industry average thereby making it an interesting opportunity for investors. Walgreens expects an improvement in adjusted EPS one year after the completion of the deal, as well as about $1 billion worth of synergy benefits.
Therefore, buying shares of Walgreens now makes more sense than waiting to buy later because clearly the resulting company is currently undervalued, given the fact that the resulting weighted P/E ratio would be about 18.84 compared to industry average of 21.05.
Conclusion
Walgreens is expanding its market reach to a more lucrative segment in the pharmaceuticals industry in the form of Pharmacy Benefits Management.
The company is also consolidating its market share in the pharmacy retail segment, and the acquisition of Rite Aid is bound to be accretive in terms of adjusted EPS, which could make the stock look a lot cheaper than it is now.
It is better to buy now than wait for everything to clear out for everyone to see, at which point the price of the stock may have rallied too much. The recent trackback makes it more attractive for those who missed the opportunity in the past week.
