Consolidation has been the name of the game in the healthcare industry, and yesterday we saw one more giant deal being forged with the creation of a veritable duopoly in the pharmacy industry.
Walgreens buys Rite Aid, and Wall Street rejoices
As rumored during midday trading on Tuesday and confirmed after the closing bell, Walgreens Boots Alliance (NASDAQ:WBA) agreed to buy Rite Aid (NYSE:RAD) for $17.2 billion in an all-cash transaction. The deal will pay Rite Aid shareholders $9 per share, a 48% premium to Monday's closing price, which includes net debt as well.
The deal, according to research from IBISWorld.com, courtesy of USA Today, will combine Walgreens' 31% pharmacy/drugstore market share (by revenue) with Rite Aid's 10.3% share. CVS Health (NYSE:CVS) maintains another 58.1%, with the "other" category garnering a meager 0.6% of total revenue. In other words, the pharmacy industry is about to become a two-horse field based on revenue. For the time being, Walgreens has decided to keep the Rite Aid brand name but may change its mind at some point in the future.
Why merge? Aside from wanting to obtain more share to effectively compete against CVS Health, Walgreens Boots Alliance believes that being bigger could give it and its peer CVS more leverage when negotiating with drug developers and also defend the brick-and-mortar pharmacies from mail-order drug companies, online pharmacies, and health clinics.
Potential synergies are also important. The two companies believe they could realize "in excess of $1 billion" in synergies from merging. This will likely come about via cost cuts -- which may include job cuts and store closures -- but also through the company's increased size and potential clout when it comes to negotiating better drug prices.
Walgreens Boots Alliance anticipates that the deal will be accretive to its bottom line in the first full year following the merger's completion and that its deeper pockets will allow Rite Aid to reinvest in its stores to drive sustainable growth.
Overall, Wall Street seems pretty happy with the deal. Shares of Rite Aid closed Tuesday up 43% to $8.67 (the official deal wasn't announced until after the closing bell), while Walgreens Boots Alliance gained $5.68, or more than 6%.
This isn't a good deal for Walgreens
If there's anyone who should be cheering yesterday's deal, it's Rite Aid shareholders who have endured six consecutive years of losses between 2007 and 2012, numerous debt concerns, and relatively stagnant revenue since 2008. Although Rite Aid shares briefly topped $9 earlier this year, the $9 price point would represent a level shareholders haven't witnessed with any regularity since 2001. It's been a long wait for long-term Rite Aid shareholders to get back to par.
For Walgreens, though, the deal is a head-scratcher from my perspective. I can understand the desire to merge to save on costs and use its combined size to negotiate better drug deals, but I don't believe Walgreens truly understands what it's getting itself into, or how much it may have overpaid for the right to deal with Rite Aid's woes.
If paying more than seven times trailing 12-month EBITDA for a business whose sales have been stagnant for years wasn't enough of an eye-popper, Walgreens agreed to take on $7.3 billion in net debt. Mind you, that debt probably would have hindered Rite Aid's ability to rapidly expand its store count or update existing stores to make them competitive against CVS and Walgreens. In other words, Rite Aid's balance sheet gave it minimal leverage, yet it somehow negotiated a premium of more than 50% over its Monday closing price as the buyout price. The buyout is also more than 21 times Rite Aid's book value, which is dragged lower by its substantial debt load.
This is noteworthy because Walgreens Boots Alliance already has $11.7 billion in net debt and should see that figure rise even further. Remember, this is an all-cash deal, meaning Walgreens will either need to access the credit markets or dilute shareholders with a share offering to raise capital. If the company decides to use some of its existing cash on hand and access capital markets (which seems plausible given low lending rates), Walgreens could come out on the other side of this deal with somewhere between $25 billion and $30 billion in debt.
Another major problem is that, sans discounting, Rite Aid has really struggled to get traffic in its stores for years. Beginning with the purchase of Eckerd in 2006, which really hastened Rite Aid's decline, it's struggled to differentiate its front-of-store and pharmacy business from peers such as Walgreens and CVS.
The recent solution has been the introduction of its Wellness+ rewards program. While rewards programs do tend to draw in traffic, they also bring in cost-conscious consumers who can eat into Rite Aid's margins. Over the past decade, Rite Aid has been unable to push its gross margins above 28.8% for the full year, and they're currently sitting at just 27.5% over the trailing 12-month period. Without a dangling carrot of discounts, Rite Aid might struggle to get customers in the door.
I also believe Walgreens should be sent to the corner with a dunce cap on for even considering the idea of keeping the Rite Aid brand. The Rite Aid brand is what keeps consumers predominantly loyal to Walgreens and CVS. Reinvesting in Rite Aid's stores is unlikely to net the type of return that rebranding Rite Aid stores as Walgreens could potentially bring to the bottom line. When Rite Aid failed to modernize and expand in step with Walgreens and CVS in years prior, it simply lost its customer base, and it would take nothing short of a miracle to win them back at this point.
Where do Walgreens and Rite Aid go from here?
The big question on the table now is whether the Federal Trade Commission would approve a merger of drugstores between the No. 2 and No. 3 in the industry. As my Foolish colleague Dan Caplinger noted yesterday, the precedents at the FTC aren't in favor of allowing duopolies, so it would appear there are certainly hurdles to overcome in gaining approval. However, the desire to curb drug pricing may play into the FTC's eventual decision.
Walgreens is a company that I viewed to have strong growth prospects over the long run, especially with an aging baby boomer population in the United States. But taking on Rite Aid's mammoth debt load and attempting to reinvigorate its stagnant store base is a challenge that could weigh on Walgreens' stock.
It may be too early to be as hyper-critical of the deal as I am, but I firmly believe the bullishness surrounding this buyout is unwarranted, given the many issues Rite Aid has failed to work through over the years. Only time will tell which side is correct.