Rite Aid (RAD, Financial) is the third-largest drug store retailer in the U.S. and is the target of an acquisition by Walgreens Boots Alliance (WBA, Financial).
A few months ago, CNBC reported that the FTC is likely to approve the Rite Aid sale to Walgreens Boots Alliance. On Sept. 12 Walgreens provided an update, per the requirements stated by the U.S. Federal Trade Commission; for the acquisition to be closed, both must divest between 500 and 1,000 of its stores. That’ll leave them around 12,000 total stores.
I'm not going to focus on fundamentals of this company but rather discuss a strategy that Warren Buffett (Trades, Portfolio) and many of the greatest investors have used to generate significant yield – risk arbitrage. In fact, in his 1988 letter, Buffett talks about his arbitrage commitments.
Starting in 1956, I applied Ben Graham’s arbitrage principles, first at Buffett Partnership and then Berkshire (BRK.A, Financial)(BRK.B, Financial). Though I’ve not made an exact calculation, I have done enough work to know that the 1956-1988 returns averaged well over 20%.
Rite Aid has a who’s who of guru investors with Jim Simons (Trades, Portfolio), David Einhorn (Trades, Portfolio), John Paulson (Trades, Portfolio), Jeremy Grantham (Trades, Portfolio) and Leucadia National (Trades, Portfolio) all owning shares.
Right now, the stock trades at $8.05 with a deal price of $9.00 per share still on the table. That’s a 12% yield, which if it closes by the end of 2016 would be an annual return north of 57%. Using a Buffett trick and buying on margin would net you closer to 500% gains in three months; here’s how.
Deal terms
- Walgreens –Â acquirer.
- Rite Aid –Â target.
- $8.05 share price.
- $9.00 target price.
Cash position
- 1,000 shares of Rite Aid.
- $8,050 investment.
- $950 profit potential.
Margin position
- 1,000 shares of Rite Aid.
- $8,050 investment.
- 2% margin rate.
- $161 margin cost.
- $950 profit potential.
- 490% ROI potential.
If you use interactive brokers, the margin rate would be under 1%, increasing your gross profit if the deal closes at the $9 target. That’s the biggest risk in these trades – if the deal doesn’t close or the price is readjusted.
In this case, the addition of the nation's No. 3 drugstore chain would aid (no pun intended) Walgreens' competitive advantage, which means that closing 6% to 10% of its stores to be able to add 60% more net net might be a good idea.
Walgreens doesn’t need Rite Aid to continue growing and providing value to shareholders, and adding Rite Aid will add more debt to the balance sheet; however, adding new stores with the Walgreens management efficiency will help Walgreens leap over CVS (CVS, Financial) into leadership position in the market, by store count at least. The next step is increasing the sales and profit within each to really overtake CVS.
All that said, this is an arbitrage trade and only dependent on whether Walgreens can close. I only mention CVS because last year it merged with Omnicare, which will help the Walgreens/Rite Aid case. CVS generates well over $150 billion in annual revenue and if Walgreens and Rite Aid are successful, its total sales will likely climb to the $130 billion range, still behind but in a much better position to gain ground fast.
Disclosure: I do not have a position in Rite Aid, Walgreens or CVS.
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