Walgreens, Rite Aid Earnings And The End Of The Merger

Last week, both Walgreens Boots Alliance (NASDAQ:WBA) and Rite Aid Corporation (NYSE:RAD) posted their quarterly earnings. While Walgreens continued its strong performance in its fiscal third quarter and posted revenues of $30.12 billion, an increase of 2.1% over the prior year quarter, Rite Aid posted weak first quarter results and reported revenues of $7.8 billion, a decline of 5% year over year (y-o-y). On the EPS front, Walgreens posted EPS of $1.33 per share, 3 cents higher than market expectations, while Rite Aid posted negative EPS of 5 cents a share, 4 cents lower than market expectations.

However, it was the latest development in the ongoing Walgreens-Rite Aid merger which caught everyone’s attention, as the two companies put an end to their negotiations just days before the approaching merger deadline of July 7. Instead, the two have entered into a new agreement under which Walgreens will acquire around half (2,186) of RiteAid’s stores, inventories and certain distribution assets for $5.175 billion in cash, subject to regulatory approval. Additionally, Rite Aid will receive $325 million as merger termination fee. Unsurprisingly, this development adversely impacted Rite Aid’s share price, which tumbled to $2.61, a 52-week low, immediately after the press release.

History of the Proposed Acquisition

Per the initial proposal, Walgreens was to acquire all of Rite Aid’s store for a price of $9 a share or approximately $9.4 billion in total, and the deal was slated to close in the second half of 2016. However, the date of the merger was pushed back to January 2017 as the companies could not find suitors for required divestitures of Rite Aid stores. In December 2016, Fred’s became a key stakeholder in the acquisition between the two companies when it agreed to buy 865 of Rite Aid’s stores in order to satisfy the concerns of the regulatory authorities.

In January, the two companies again pushed back the merger deadline by another six months, in hope of meeting regulatory requirements. However, this time Walgreens altered the merger terms by reducing the price per share, from $9 to $6.50-$7, depending on the number of store divestitures, which was increased from 865 to between 1,000 to 1,200. In May of this year, the two companies issued “certified compliance”, thereby meaning that if the FTC did nothing within the set time limit of sixty days, the merger was to go through. However, just days before the deadline of July 7th 2017, it was announced that the merger was terminated and Walgreens would purchase 2,186 Rite Aid stores for a price of $5.175 billion. This would still make Walgreens the biggest pharmaceutical retail chain in the U.S., outnumbering CVS in store count.

What’s Next for Walgreens?

In the last quarter, Walgreens continued to perform well. The company’s quarterly revenues of $30.18 billion were 2% higher over the prior year quarter. The Retail Pharmacy U.S division, the main contributor to the company’s revenue, reported revenues of $22.5 billion, an increase of 6% over the prior year quarter. The increase in revenues was primarily attributed to a 3.7% increase in comparable store sales. Pharmacy sales increased 10.3% over the prior year quarter, while retail sales declined 1.8%. The number of prescriptions filled in comparable stores rose 8.5% over the prior year quarter, primarily driven by increase in Medicare Part D volume and successful partnership with Prime Therapeutics. Additionally, the company reported its highest ever retail prescription market share of 20.5%, an increase of 110 basis points.

Going forward, Walgreens is poised to increase its presence in the domestic market, which should aid its growth. The addition of 2,186 stores, to the 8,138 it currently operates, should give the company an edge over CVS, which has a store count of 9,676.

Additionally, since the new deal does not currently involve any debt, Walgreens’ capital structure should remain unaffected by Rite Aid’s highly levered structure. The company expects the deal to bring cost synergies of almost $400 million per annum within two to three years of the deal closure. Moreover, the company expects the new stores to be modestly accretive to earnings in the first year of deal completion.

What’s Next for Rite Aid?

The new deal negatively impacted Rite Aid, as the company’s share price tumbled to its 52-week low of $2.61 immediately after the release. Despite the company reporting moderate growth in its revenues in seven of the last eight quarters, investor sentiment was not particularly positive. With the new deal, the company will receive more value per store than it would have received under the terms of the original deal.

Post the completion of the new deal, Rite Aid’s store count will be significantly lower, which should enable the company’s management to concentrate its resources on improving the performance of the remaining stores. Additionally, with the new deal, the company will have an option to procure drugs from Walgreen’s affiliates. This should enable the company to lower drug costs and improve its margins as Walgreens, with its size and volumes, is able to procure drugs at a considerably lower price than Rite Aid.

Moreover, Rite Aid still has control over EnvisionRx, its PBM business. With an increasingly ageing population and rising drug prices, the PBM business is expected to grow at 7.1% annually till 2019. The company can plan to develop its growth model around Envision Rx’s operations, which are more profitable than the retail operations.

Rite Aid will receive $5.175 billion in cash for the sale of its stores, along with $325 million in termination fees. The injection of cash into the company’s operations can help it improve its leveraged balance sheet. While Rite Aid doesn’t have any payment obligations until 2019, it can utilize the cash received to repay its debt obligations. This will not only enable the company to improve its capital structure, it will also bring down its interest expenses, which will improve its bottom line. Conversely, Rite Aid could look for another suitor for its remaining stores.

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