Walgreens Shows its Hand, Scoops Up Rite Aid

Our top healthcare story this week revolves around the announcement of Walgreens (WBA -0.23%) acquiring Rite Aid (RAD 5.26%) for over $17 billion. Will the FTC allow this to go through? Does an overlapping footprint mean the two retail pharmacies will step on each other's toes? What is CVS Health's (CVS 1.15%) next move?

Our healthcare analysts Michael Douglass and Kristine Harjes will try to answer all these questions and more, on this episode of Industry Focus.

A full transcript follows the video.

 

Kristine Harjes: Walgreens shows its hand. This is Industry Focus.

Hey, everyone! Welcome to Industry Focus, healthcare edition. I'm your host, Kristine Harjes, and although Todd Campbell is not back to join me today, I am pleased to welcome healthcare analyst, Michael Douglass to the show.

Michael Douglass: Thank you, Kristine. It's wonderful to be back. Hopefully a few folks have missed me. Maybe. Probably not many though.

Harjes: I'm sure plenty have. I'm glad you're here. We have a really fun topic today to talk about. Big news that came out recently that Walgreens is acquiring Rite Aid. This made quite a splash, even when the Wall Street Journal reported it, but as of this morning, the official announcement is out there. This is a $17.2 billion, all cash transaction where Walgreens is paying $9 per share to acquire its fellow competitor, Rite Aid.

This is pretty big for the industry because this is a space totally dominated by three players. You've got Rite Aid, Walgreens, and then you've got CVS. As it stands, this looks like it could bring the number two and number three players together to surpass the number one player. Is that what you're seeing, Michael?

Douglass: Yeah. This is definitely a push for additional scale by Walgreen. I think that's very clear. You've seen CVS also working to scale up elsewhere. Earlier this year CVS announced plans to acquire Target's pharmacies and put mini-CVS' in there. This is the name of the game across healthcare right now. Everyone is just consolidating and you're seeing it, not just in the retail pharmacies, but you're seeing it in biotech, in pharma, in insurance; everyone is looking to bulk up, it seems.

Harjes: Yeah. This is a trend that we're seeing pretty much across the board. Sometimes you get a little bit of ambiguous explanations for it like "We expect synergies in this particular deal. We're expecting $1 billion in synergies. It remains to be seen whether those will actually be achieved. I would have thought it's for better leverage in negotiations, your scale; but then you turn to this morning's conference call and they said that's not the case.

Douglass: Yeah. The CEO, Stefano Pessina, that's Walgreens Boots Alliance CEO said "We have not done this to increase our negotiating power." Just a full stop. So you sit there and you're like "Okay. Then what was the goal?"

Harjes: One thing that I came across in my research, Forbes wrote an article quite a while ago, well before this was announced. I think it came out in March. They noted that Walgreens' sales per square foot is about 54% above those of Rite Aid. If they could get that sort of profitability out of all these new Rite Aid stores; that would stand at a $12.5 billion revenue boost if you can take these stores that are under performing and max them out and get them to perform at the level of a Walgreens.

Of course, you run into the issue of seeing a Walgreens right next to a CVS, right next to a Rite Aid; are they really expected to keep all those stores open and also push up their productivity?

Douglass: There are a couple of issues packed in there. First off, the issue of store cannibalization. When Rite Aid bought Eckerd back in '07 there was enormous store cannibalization and falling same store sales. You actually saw Rite Aid reduce its count of stores until 2015.

Harjes: Anybody that remembers that history is throwing up a flag at this deal saying "Is the same thing going to happen again?"

Douglass: Right. The fact of the matter is, Rite Aid is certainly more concentrated in certain markets, whereas Walgreen does have a broader, national exposure.

Harjes: And international.

Douglass: And international with the Boots Alliance transaction, which was completed earlier this year. I think the other piece we have to ask with this Walgreens/Rite Aid transaction is: OK, Rite Aid has already been improving its store productivity through the wellness remodels and when Rite Aid released earnings a couple months ago, one of the things they talked about was that their wellness remodeled stores were outperforming on same store comps by something around 3.5 percentage points in growth.

That's an enormous amount. You have to wonder how Walgreens is going to improve those numbers. Is it going to be putting the wellness remodels out all across all Rite Aids? Currently it's about 41% of the store count. Is it going to take some of whatever Walgreens secret magic is and adding that on top of the wellness remodel? They might even take some best practices from the wellness remodels and bringing them over to Walgreens stores. It's not very clear, and management hasn't really done much to tell us specifically what they're planning to do.

Harjes: There definitely wasn't any specific sign posting in this conference call. One other thing for me, looking at this, I said "Maybe this is the heart of why they did this." That was the PBM side of things. You have Rite Aid acquiring EnvisionRx, their pharmacy benefits manager; but to me it seems like it would be small potatoes to Walgreens.

I wonder if their plan is to expand that and develop this in house PBM from this small company that Rite Aid originally acquired. If that really looked like such a promising business to begin with, couldn't Walgreens just have acquired it on their own, before Rite Aid actually nabbed it up? This leaves me with a lot of questions.

Douglass: Sure. Let's face it; Walgreens could have come in with a higher price point, too. They're bigger, they're not weighted down by debt like Rite Aid has been. It's interesting because, reading through that call transcript you didn't really get the sense that the PBM was that core to their investing thesis. You really got the sense that the PBM was a nice thing to have; it's a top 10 PBM.

That's nice to have, and it would give them some better understanding of the Medicare landscape and a few other pieces, but you didn't really get the sense that was core to their investing thesis here. In my head, it's very much Walgreens doubling down on this retail pharmacy centric mind-set that they've had.

In a lot of ways that's very different from what CVS Health has done. Theoretically, you have these two companies that are retail pharmacies. I'm putting that in scare quotes, for our listeners. "Retail pharmacies", but really very different companies. You have CVS which has really focused on the PBM side.

The majority of their revenue flows through the PBM and while they've certainly done a lot with the retail pharmacy, they've accepted a loss on tobacco on the retail pharmacy side, in part, to help prop up that PBM business and make it a more attractive business in contract negotiations. While they'll never be able to point to a specific number, that's what they've done. You've got Walgreens that's reaffirmed that they plan to stay the course on selling tobacco, they really seem to be doubling down on this retail pharmacy centric model.

Harjes: Exactly. As you mentioned, one of the big questions that's still left here is: will this deal be allowed to go through by the FTC? Of course, they want to prevent this kind of monopolization, or in this case it would be a duopoly, of the retail pharmacy business. Traditionally the FTC doesn't like duopolies and they will shut that kind of thing down.

However, it's my suspicion that given this push toward lower drug prices; I bet the FTC would let it go because of that particular point. If they can say "This is bringing down this exorbitant cost that drugs are taking on Americans, maybe it could be a good thing." They'd rather have that than shut down the duopoly.

Douglass: Neither of us are legal experts so this is totally speculation on our parts, but the other piece is, if you think about just retail pharmacies; you've got CVS, Walgreens, Rite Aid and there's not really anybody else that's of any serious size. When you think about pharmacies that do retail -- essentially retail pharmacies that are owned by other competitors -- you've got Kroger, you've got Walmart, even Costco has made some noise about entering the pharmacy space.

You've got a lot of other ways that people can fill their prescriptions and get their flu shots. I think while in the stand-alone retail pharmacy space it looks like this consolidation would be substantial, when you really think about the broader "How can patients get drugs from stores?" There are a lot of other opportunities outside of these strict retail pharmacies.

We're not even talking yet about mail order pharmacies, specialty pharmacies, and all these other things that are disrupting the industry, to some extent. As a result they're competing in these other ways. In my head there's still a great deal of competition.

Harjes: That's a great point. When I'm looking at this and I see this deal is probably going to go through, it's clearly going to make a splash; who are the winners and who are the losers? As investors, what should you be doing with your money?

Douglass: We don't give financial advice, but in my head, thinking about it from the three spaces Walgreens shareholder, Rite Aid shareholder, and CVS shareholder assuming that everything goes according to plan and the FTC steps in; I think Rite Aid shareholders just got a 48% premium on what your stock was trading for a couple days ago.

Harjes: And the stock popped very nicely yesterday. It's given a little bit of that back, but I think you're still up around 40%. That's not bad.

Douglass: Yeah. If the deal goes through you get $9 a share, which is a pretty substantial gain if you purchased before this week. I think for Rite Aid this was a pretty darn good deal. Given the company's continuing difficulties achieving scale and closing underperforming stores and all these other things; in my head, this is a 'take the money and ride into the sunset' and 'congratulations, things went really well' kind of deal. In my head, for CVS shareholders, even if this deal goes through, I think it's really too soon to say that this is negative for CVS.

Again, CVS has done a very good job of expanding over the years. They acquired Caremark a few years back to get in the PBM business, they acquired the Target pharmacies earlier this year and at a pretty good price point; they're doing a great deal to grow their network. Since this is a differentiated business in a lot of ways, particularly because of tobacco, CVS is still sitting pretty in my head.

I think what CVS shareholders will want to keep an eye on is what happens, whether this goes through, and then afterward, how the integration goes over the next couple of quarters. Walgreens didn't really do much to sign post what's going to happen over the next few quarters, so we'll be looking forward to seeing. Although, I believe they expected it to close sometime next year. I think it's a wait and see, but CVS is still in a very good spot.

Harjes: What about as a shareholder of Walgreens? I'm not personally a shareholder, and I don't believe you are either. I think if I were I would be a little bit concerned with their debt right now. This is a company that already had $11.7 billion in debt. They're going to be leveraging to make this deal happen, and they're also acquiring Rite Aid's debt, which is pretty substantial. Rite Aid is sitting on $7.3 billion in debt that is now going to be Walgreens' debt.

Douglass: Right. CVS actually sits on a fair amount of debt on their own, so I'm not too worried about the debt. The real question is going to be "What about store cannibalization? Is this going to be a Rite Aid/Eckerd again?" We certainly hope not. To be fair, Walgreens has been pretty aggressive about closing stores. They closed 75 this past quarter. You can probably imagine that those underperforming stores -- this is a point you brought up before -- were probably right next to a Rite Aid, right?

Chances are that in a lot of ways they're already planning for what this might look like. Hopefully this will reduce the possibilities of cannibalization. That said, I think it's still a very real possibility. These are fairly large footprint companies in the same line of business. This is not like Alliance Boots where you really had a lot of stores in foreign countries which are not competing with the U.S. stores, obviously.

I think this is a 'wait and see' thing for Walgreens' shareholders. I've got to be up front: I think that CVS has had a much better strategy for approaching what is becoming of healthcare in the retail pharmacy space than Walgreens has. I think the sole focus on retail pharmacies isn't necessarily a good move long term as that industry is continually disrupted. I think CVS has done a lot more to invest in those disruptions and those disruptors.

If you are confident in your investing thesis of Walgreens already and you have confidence in management; give them the benefit of the doubt. If you're like me and you're a bit of a doubter of Walgreens' management and the direction of the company; this has done nothing to change that thesis in my mind.

Harjes: The point that you bring up is that we are still figuring all of this out and it is a bit of a 'wait and see' game at this point. All of our Foolish healthcare analysts are still digesting the news and I would encourage everybody to check back to Fool.com for our ongoing coverage of this story.

I know some of our analysts have already published their own takes on it and they've been really interesting to read. While you're at it, check out Focus.Fool.com. This is our landing page where we are offering you, awesome listeners of the show, our best pricing on our flagship newsletter stock picking service, which is called Stock Advisor.

Again, that's Focus.Fool.com. There was one other piece of healthcare news that caught my eye this week that I wanted to talk about. First I wanted to put it out there, as always, folks on this show may have interests in the stocks that they talk about and The Motley Fool might have formal recommendations for or against them. As always, do your own research and don't buy or sell based solely on what you hear today.

Our final story of the day: the World Health Organization released a report earlier this week, on Monday, saying that eating processed meat can cause cancer. This was a study of 800 epidemiological cases that said processed meat pretty much correlates to having a higher chance of developing certain cancers. Of course, this made a huge splash whenever you combine the words "bacon" and "cancer".

People are going to get all up in arms. I think the thing to realize here is that what actually came out of this is that processed meat is now going on what's called the "Group 1" list. That means there is sufficient evidence of there being a link to cancer. People see the news and say "Oh my Gosh! This Group 1 list has things like tobacco and asbestos on it."

These are things that you certainly want to avoid if you're worried about increasing your chances of getting cancer. However, what the Group 1 list really means is not that there's as much of a chance of you developing cancer, as is you were a heavy lifetime smoker. It's rather that the scientific evidence is as strong that there is a correlation of some magnitude.

Douglass: In my head this is one of those things where everyone needs to -- pardon the pun -- 'digest' the data. I couldn't resist. It's The Motley Fool. We have to make puns from time to time. I think everyone needs to take some time and think about that data and think about what sort of meal planning they want to do as a result.

Harjes: Really pick at the meat of the matter?

Douglass: Oh, gosh. We're just going to keep going on this aren't we? I regret everything. I think we've known for a while that red meat has a lot of negative health consequences if it's not eaten in moderation. I think it's another warning flag people should keep an eye out for. I imagine that the conversation around it will evolve a lot more over the coming weeks, months, and years.

Harjes: Again, it's a long term puzzle and its' one more piece to put in it. Hopefully, if you dig into the study itself you can take something out of it. Just pay attention to your diet. That's the most important thing. I think in the short term, the best thing I can think of to come out of it is, now that red meat is apparently scary, you could totally be a strip of bacon for Halloween! That's coming up this weekend. What do you think?

Douglass: Something to look forward to. I'm sure we'll see quite a bit of that around here at Fool HQ.

Harjes: Folks, you heard it here first. The most popular Halloween costume this year is going to be a strip of bacon. All right, Michael. Thank you so much for joining me today. Folks, thanks for listening as always, and Fool on!