Last week, top U.S. drugstore operator Walgreens Boots Alliance (NASDAQ:WBA) revealed plans to acquire its smaller rival Rite Aid (NYSE:RAD). Walgreens will pay $17.2 billion (including the assumption of debt) in a deal that has been the subject of rumors for so long that it seemed inevitable to many industry observers.
From a strategic perspective, the merger makes perfect sense. Bigger is better in the pharmacy industry today, because of the huge scale of the companies that drugstores need to negotiate with. At the same time, merging two of the country's three big pharmacy chains could raise some tricky antitrust problems. Walgreens and Rite Aid don't appear to have fully worked through those potential issues yet.
Pharmacies are getting squeezed
In recent years, pharmacies' profit margins have come under pressure as massive pharmacy benefit managers, or PBMs, such as Express Scripts used their purchasing power to negotiate lower reimbursement rates for prescription drugs.
No. 2 U.S. drugstore operator CVS Health (NYSE:CVS) has been mostly insulated from this trend because it also owns the second-largest PBM. But Walgreens and Rite Aid have had to work hard to cut their own costs and to seek better deals from drugmakers to offset this pressure.
Rite Aid's smaller size relative to Walgreens -- it's expected to have about $31 billion of revenue this year, compared with more than $120 billion for the multinational Walgreens -- put it at a disadvantage in this context. Rite Aid has attributed its falling pharmacy gross margin this year to the tough reimbursement rate climate.
A combination would give Walgreens and Rite Aid more heft to push back against pressure from PBMs to reduce reimbursement rates. The combined company would also be able to secure lower prices from drugmakers and distributors. There would probably be opportunities to generate synergies from closing overlapping stores as well.
Antitrust concerns could be a major problem
As appealing as these synergies are, a merger between two of the three big U.S. pharmacy chains will get substantial scrutiny from antitrust regulators. In recent years, regulators haven't been afraid to challenge big M&A deals. In some cases, the government has won concessions, and in several others it has blocked the transactions entirely.
As The Wall Street Journal recently noted, buying Rite Aid would more than double Walgreens' footprint in 14 states. Walgreens' management has argued that this doesn't matter that much because in addition to CVS, the combined company would face competition from supermarkets, discounters, independent pharmacies, and mail-order pharmacies.
In general, that's true -- but it's not equally true everywhere. For example, in the Pacific Northwest, CVS has barely any presence today. In that region, Walgreens should be able to satisfy regulators by selling off some stores to CVS. That might add enough competition to the existing mix of local pharmacies, discounters, and mail-order pharmacies.
On the other hand, in some major urban markets where Wal-Mart doesn't have a large presence, Walgreens, Rite Aid, and CVS have a combined pharmacy market share of 75% or more. (This market concentration could be aggravated by CVS's pending takeover of about 1,700 pharmacy departments inside Target stores.)
Federal regulators may balk at having such a large percentage of the pharmacy market dominated by two chains in these major metro areas, even if online and mail-order alternatives exist. Yet with no other major pharmacy chains left in the U.S., it's not clear that anyone would be interested in buying stores from Walgreens to inject more competition into these markets.
It's too early to know what concessions Walgreens will have to make to get antitrust approval -- or whether regulators will endorse the merger at all. The only thing that seems certain now is that Walgreens and Rite Aid will face some tough questions as they try to make the case for their merger.
Adam Levine-Weinberg has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Express Scripts. The Motley Fool recommends CVS Health. 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.