This morning WAG announced that it had acquired Duane Reade for roughly $1.1B including the assumption of $457MM in debt. This represents a reasonable ~.58x purchase price/sales transaction, in line with larger deals consummated in the drugstore chain industry over the last few years. More importantly, this deal strikes me as a solid way for WAG to solidify its presence in the greater NYC area at a time when the economy has taken its toll on smaller drug store chains, including Duane Reade, as well as RAD. Further, mom and pop chains, according to my checks in 2009, also got slammed by tighter consumer budgets on top of AWP Medicaid reimbursement rollbacks (In September 2009, AWP paid to pharmacies was reduced to 120% of wholesale prices). Although DR’s comps are not available, RADs are, and its pharmacy and front end comps have consistently trailed that posted by WAG and CVS. Many mom and pop chains have closed down, liquidated, and sold themselves since the recession began.
Highlights of the Deal Include:
*As mentioned, the purchase paid multiple looks reasonable and in-line with past deals done in the space. The deal is expected to add over $120MM in synergies by year-end 2013E and be accretive to EPS by the second half of 2011E. Deal is expected to close by August 31, 2010.
*NYC is one of the top 10 leading drug store chain markets in the US according to Chain Drug Review. Through industry contacts, I surmise Duane Reade posted above average sales per square foot.
*The deal more than doubles WAGs presence in the state of NY; at the end of F2009, WAG had roughly 245 locations in the state. The incremental 257 stores is a positive and puts WAG in a position where they have more locations in the state than CVS (436 end of CY09) and modestly less than RAD (674 at end of F2009).
*WAG was already planning on adding beer and wine category to its stores, and the Duane Reade deal plays right into this. I estimate beer/wine will reflect less than 5% of sales but will likely boost basket size and add incremental traffic. Recall that front-end is vital to drugstores: although they reflect only 35% of sales, they are higher margin than scripts.
*This strikes me as a good use of cash, since WAG was trading at roughly a 7% earnings yield last night and the longer-term benefits of owning the NYC market I would think supersede the benefits of repurchasing stock at 14x F2010E consensus estimates (~18MM shares assuming WAG used the cash portion of the deal to buy back stock at the $33-34 level). WAG certainly has the cash flow horsepower to pay down the assumed debt. I also believe WAG will use its efficiencies to improve DRs comps and spread its cleaner cost-structure across the newly acquired stores.
BOTTOM LINE: WAG was expected to do a deal given its prodigious cash flow. At the end of FQ1:10, WAG had tripled its operating cash flow y/y to $1.2B and was sitting on a $3B+ cash pile. I view the WAG deal positively and would play the stock long in the low 30s. After its CCR (customer centric retailing – WAG expects this “major store refurbishing” initiative to be in 3,000 stores by Fall of this year) and Rewire for Growth (estimated to add $1B in EBIT savings by end of F11) strategic initiatives are completed, the stock is bound to regain a higher multiple closer to its historic mean (~16x) and reward investors who can see past the SG&A mess that will likely throw off performance-hungry investors over the next several quarters. One can play the deal through the backdoor through significantly more speculative RAD, whose chances of getting acquired significantly increase after WAGs announcement. RAD is losing money and saddled with debt but is still strong on a location basis and could get picked off by a PE shop or strategic buyer that believes it can improve EBITDA better than current RAD management can. Risks to my ideas here: if CVS spins off its PBM, there is a chance WAG holders will rotate into CVS, given the latter’s depressed multiple; further economic turbulence could continue to dampen WAG comps; a CCR/Rewire failure would force the Street to reset estimates downward.