What If Walgreen buys Rite-Aid?

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Rite-Aid's (NYSE: RAD  ) shares rose 9%, hitting a 52-week high. The reason: Credit Suisse analyst Edward J. Kelly speculated that Rite-Aid might be a prospective takeover target for fellow drug retailer Walgreen (NYSE: WAG  ) . However, this is purely speculation. Kelly, in fact, sees a 33% chance of a deal taking place between the two.

But what if the deal actually takes place? Who would stand to benefit?

Why Rite-Aid?
First, let's deal with this question: Why would Walgreen undertake such a merger? Walgreen recently split up with its pharmacy benefits manager, Express Scripts (Nasdaq: ESRX  ) , and the breakup has affected it dearly. Since Walgreen has stopped filling out prescriptions for Express Scripts' customers, its sales have taken a hit. Same-store sales last month at the Deerfield-based retailer fell 8.6%, much more than the 7.2% analysts had forecasted, with prescription volumes dropping by 9.5%. The loss is there for all to see.

Last year Express added $5.3 billion to Walgreen's pool, which was essentially 7% of the total amount that Walgreen brought home. So, no wonder Walgreen might be in the market for a new source of revenue.

Why the merger makes sense
If the merger takes place, it'll create a huge new drugstore as the first- and third-largest dedicated drug chains would join forces. The two together would then be able to push back against pharmacy benefits managers, or PBMs, from pushing down the compensation received for drugs. This is especially relevant as Express Scripts is in the midst of an attempted a merger with Medco Health Solutions (NYSE: MHS  ) . The deal, worth $29 billion, would create a company which would control nearly one-third of the PBM pie.

Rite-Aid brings to the table close to 4,700 stores across U.S., as well as 71,604 employees. Last year, the company's top line was $25.4 billion -- and there's your source of revenue for Walgreen. According to Mr. Kelly, the alliance would save between $400 million to $650 million in synergies. The combined entity could fill 30% of overall prescriptions, as well as 21% of all pharmacy counters. So together they can generate huge returns and bring in plenty of green.

All can't be good...can it?
We've seen the pros, so let's consider the cons. According to Kelly, the tie-up is not without risk. The friction points might be:

  • Walgreen would have to deal with a substantial 60% increase in its store base. Also, "Rite Aid has many sub-par locations, and most stores need a large capital injection."
  • A deal would result in Walgreen's credit rating being cut unless the retailer chooses to fund for the deal with equity.
  • Walgreen will end up acquiring over 71,000 Rite-Aid employees, of which nearly 30% are unionized. Walgreen would be forced to deal with labor negotiations.

Overall, Kelly concluded, "Ultimately, the deal might carry too many risks for a traditionally conservative Walgreen."

It's a sticky situation, but one thing is clear: Walgreen must look for a new source of growth -- either organic or inorganic -- or run the risk of an eroded market share. In fact, peer CVS Caremark (NYSE: CVS  ) recently upped its annual outlook as it expected to gain more customers from the Walgreen-Express impasse. Walgreen can't afford to lose more customers, and it should look to compensate for the Express loss. Who knows -- CEO Gregory Wasson may take this rumor seriously.

While the outlook for these companies may still be cloudy, it's all sunny skies for "The Motley Fool's Top Stock for 2012." The emerging-market retailer has the most upside potential we've seen in a while. You can learn more by clicking here.

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Fool contributor Shubh Datta doesn't own any shares in the companies mentioned above. Motley Fool newsletter services have recommended buying shares of Medco Health Solutions. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (2) | Recommend This Article (13)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 19, 2012, at 2:42 PM, prginww wrote:

    WAG has lost some revenue temporarily, yes, but the bottom line net from these lost sales is not as big a percentage. Still, a WAG-RAD deal could present some awesome opportunities down the road. A few years ago (before the so-called Great Recession) WAG wanted 10,000 stores eventually, then scaled growth back. With RAD it would have around 15,000 and the leeway to close numerous underperforming locations. Just need to get rid of that pesky labor issue.

  • Report this Comment On March 19, 2012, at 11:43 PM, prginww wrote:

    Either way, RAD is great buy!

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