Walgreens Boots Alliance (WBA, Financial) announced on Oct. 27 it would acquire Rite Aid (RAD, Financial) in a deal worth more than $17 billion, combining the largest and third-largest drugstore chains in the country in terms of number of stores.
Walgreens will pay $9.00 per share in cash — a premium of 48% from Rite Aid’s closing price on Oct. 26 — and will acquire Rite Aid’s net debt. The deal is expected to close in the second half of 2016.
It wasn’t long after the announcement that the deal drew antitrust questions. Sen. Amy Klobuchar, a Democrat from Minnesota who serves on the Senate Judiciary Committee's antitrust subcommittee, has said the merger raises serious concerns. Sen. Mike Lee, the subcommittee’s chair, also said regulators should closely scrutinize the proposed deal.
GuruFocus provides a checklist feature on each stock page to help investors make their own evaluation of possible investments. Along with a fully customizable checklist, one of the predefined lists is John Paulson (Trades, Portfolio)’s Merger Arbitrage Checklist. Paulson’s hedge fund, Paulson & Co., specializes in event-driven situations, including merger arbitrage, bankruptcy reorganizations and restructuring. Paulson’s flagship Partners Fund focuses on merger arbitrage and was down 4.2% in August, trimming the overall gain from the beginning of the year to August to 6.52%.
Using Paulson’s checklist, investors can evaluate the Walgreens and Rite Aid deal.
Do the merger parties have definitive agreements instead of agreements in principle?
The joint press release on both Walgreens and Rite Aid’s websites clearly state the parties have a definitive agreement, meaning due diligence procedures have been done to both company’s satisfaction. In his book “Risk Arbitrage: An Investor’s Guide,” author Keith Moore wrote that a deal announced today with only an agreement in principle is a warning sign for investors.
Does the merger have strategic rationale behind it?
The merger will add 4,600 Rite Aid stores for Walgreens, putting it squarely ahead of competitor CVS Corp. (CVS, Financial) in terms of number of locations. According to a map from The Wall Street Journal, Walgreens’ foothold would strengthen by at least 50% and even up to 200% in key markets on the East and West Coast.
Some analysts have said the merger can make the combined company a top choice to include in preferred networks for insurance.
In some ways, Walgreens and Rite Aid compete with not only other drugstores but also grocery stores with pharmacies such as Walmart (WMT, Financial) and Kroger (KR, Financial). Ultimately, the rationale behind the merger is sound as Walgreens seeks to compete with larger rivals.
The merger has no financing condition
Walgreens and Rite Aid do not have a financing condition, as Walgreens plans to finance the deal through existing cash, assuming Rite Aid’s debt and by issuing new debt.
The merger has no due diligence condition
Since the parties have a definitive agreement, it can be assumed that both Walgreens and Rite Aid have completed their due diligence procedures. This means Walgeens has looked at the necessary aspects of absorbing Rite Aid’s stores and business. According to the press release, what the deal now depends on is approval from Rite Aid shareholders, antitrust reviews and other customary closing procedures.
The deal has a solidly performing target
Rite Aid has about 4,600 stores in 31 states and D.C., with a strong presence on both the East and West Coasts. Over the past five years, revenue per share has declined by about 2.5% annually, while diluted EPS has followed an increasing trend. Rite Aid pulled out of the red in 2013 after six years of losses and posted EPS of $2.08 for FY 2015.
For FY 2015, Rite Aid had an operating margin of 3.16%, just above the industry median of 2.88%. Its current ratio is 1.69, which indicates enough cash to cover short-term obligations.
Though Rite Aid has a relatively healthy balance sheet, the company does not have a consistent history of revenue and earnings growth. Therefore, we rate the company as between “neutral” and “worst” on the checklist.
The deal has a reasonable valuation
Over the past year, Rite Aid’s price has risen 53%, closing at $7.92 on Nov. 4 at 4x earnings. The Peter Lynch earnings line suggests the stock is highly undervalued, with the earnings line at $30.01.
Walgreens will pay $9.00 per share to acquire Rite Aid, a 48% premium from the company’s closing price on Oct. 26. This price is far above Rite Aid’s book value, however, and Walgreens has stated it will issue new debt to help finance the merger. This could be a problem, as Walgreens already has more than $13 billion in long-term debt as of FY 2015.
There is limited regulatory risk
As mentioned previously, lawmakers and others have called for antitrust regulators to examine the deal closely. As both Walgreens and Rite Aid are already two of the biggest players in the drugstore sector, regulators are likely to examine regions where Walgreens and Rite Aid stores overlap, and whether the combined company would have too much influence with drugmakers and pharmacy benefit managers.
Walgreens recently announced it would be willing to divest up to 1,000 stores in order to win approval for the merger, which would be about 8% of the combined store count. One complication with selling these locations would be finding a buyer. Indeed, CVS is the only other major drugstore chain in the country, and selling the locations to smaller, regional chains could become a time-consuming process.
It’s hard to speculate whether the deal will be approved, but it’s clear that regulators will be looking at several aspects of the merger.
Imputing these considerations into the checklist returns a score of 3.9 out of 5 for the merger.
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