Likelihood Of A Rite Aid-Walgreens Deal Has Increased

| About: Walgreens Boots (WBA)

Summary

The election of a new regime will have a profound impact on regulatory approvals.

I think the Rite Aid-Walgreens merger was a crapshoot under President Obama, but it seems more likely now.

Less regulatory concern and a lower modeled tax rate will drive this deal to be completed.

The election of President Trump is certain to bring about significant regulatory changes in key US industries like energy, healthcare, and finance. One field that looks entirely uncertain to me: mergers. As fellow Seeking Alpha contributor Chris DeMuth has pointed out, cross-border M&A could come under fire, particularly if the Trump administration is skeptical about allowing foreign capital to acquire US assets. However, the merger between Rite Aid (NYSE:RAD) and Walgreens (NASDAQ:WBA) could be another story. I believe the story will be intentionally prolonged as the companies wait for Trump/Republicans to take control. Overall, I have increased my odds from a 65% chance of occurring to a 75% of happening under the new administration, though the IRR will be lower. Below are a few key factors that I think change and improve the likelihood of deal completion.

Factor #1: Obama Administration has been tough on retail mergers

We need to look no further than the Staples (NASDAQ:SPLS)-Office Depot (NYSE:ODP) merger to know that the Obama Administration has placed high value on retail remaining competitive. Here we have two companies with highly uncertain futures that likely needed to merge to squeeze out a few additional years of existence, yet the government squashed the merger.

Earlier in the Obama Administration, the merger between AT&T (NYSE:T) and T-Mobile (NASDAQ:TMUS) was struck down. Ultimately, this created a strong and motivated competitor in T-Mobile that has positively impacted the competitive landscape for consumers in the mobile space. I suspect the current regulatory regime points at this as a prime example of anti-trust legislation having a positive impact on the consumer.

Therefore, we have a strong legacy (and some rationale) for the outgoing administration to be tough on retail mergers. Based on prior comments and targeting divested store amounts, I think the current Administration believes eliminating too many Rite Aid stores creates a competitive landscape that is far too favorable for CVS (NYSE:CVS) and Walgreens.

How this can change

I liken this merger more closely to Staples-Office Depot than AT&T-T-Mobile. While it will limit consumer choice, it is arguable that Rite Aid does not have the financial ware withal to survive without a merger. Additionally, there actually is demand for these stores. Kroger (NYSE:KR), though unwilling to keep the existing locations open, is willing to move pharmacies within existing Kroger grocery stores. In my view, this is more of a concern than eliminating some choice in front-end consumer staples sold at pharmacies. I think a new administration will be more open to the Kroger solution than the previous administration.

Factor #2: Target FTC approval is the end of January

Walgreens has communicated a desire to close the deal by the end of January. This would involve a solution that satisfies the Department of Justice. From what we have heard so far, the only satisfactory solution is likely a large divestiture to a private equity fund or a strategic buyer at a favorable price. This is not the best outcome for Walgreens shareholders, but it would help the deal close.

How the timeline changes

If I were running the process for Walgreens, I would start letting deadlines slip and move this approval date to the end of February or even March. Under this circumstance, you can likely bet on a new regime that is friendlier to a merger, thus receiving the most valuable packages for the available stores. Since this will improve the returns for Walgreens shareholders, I think this package will have a better chance of getting approved by senior management and the board.

Factor #3: lower tax assumptions

Though it would be irresponsible to model in any deal model at this time, I am certain that Walgreens is now running sensitivities to value the Rite Aid acquisition at lower tax rates. Without question, this improves the value of the deal as well as the likelihood of a transaction.

Overall, I think the deal will be closer later but the certainty is much higher. Though it will be risky, I think the company will wait for any deal to be approved until a new administration comes aboard. Given the current hostile environment for consumer mergers, it is hard not to believe that the new regime increases the odds of regulatory approval at least modestly. Additionally, waiting slightly longer will allow Walgreens to receive better value for its divestiture candidates, improving returns for its shareholders. Lastly, Walgreens will model a new, lower tax rate as an upside sensitivity, making management even more comfortable in the deal value. Though the IRR will be worse than previously expected, this deal is 75% likely to close in 2017, in my view.

Disclosure: I am/we are long RAD.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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Tagged: , M&A, , Drug Stores
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