As the holidays approached and management of both teams faced the prospect of missing out on time with their respective families, Rite Aid (NYSE:RAD) finally came to terms with small-cap southeastern pharmacy Fred's (NASDAQ:FRED). The final divestiture package will come to $950 million for 865 stores, assigning each store an average value of $1.1 million. The transaction suddenly catapults Fred's into the number three pharmacy in the country, and I suspect it will be a suitable "third competitor" that the Federal Trade Commission likely desired.
Ultimately, I think the odds the Rite Aid/Walgreens (NASDAQ:WBA) merger is approved is now over 90%. From its current share price, Rite Aid offers a 4.4% absolute return with an IRR of 53% if the deal closes within 30 days. I continue to hold my position in the stock as I see little financing risk and little regulatory risk at this time.
Do you know Fred? The financing can get done
My first reaction to the deal announcement this morning was effectively, "Fred who?" Although I was familiar with the name from rumor mongering, I took a look at the market capitalization and assumed that rumors of Fred's involvement were simply posturing from Rite Aid's bankers to extract a better price from Kroger (NYSE:KR) and private equity buyers. Geographically, I spend most of my time in the Midwest as well as in the Northeast and Pacific Northwest, so I simply have not encountered the company in the wild.
And frankly, we should all be a bit surprised that Fred's was the winning bidder. The company has 647 stores and had a market cap of $420 million before the announcement. The company posted trailing twelve months sales of just $2.15 billion, and it looks poised to post its third straight year of negative EBIT.
The company is small enough that it did not have an internal team to evaluate the acquisition - it relied on consulting firm A.T. Kearney to lead diligence. In my experience, outsourcing diligence does not provide me with a great deal of confidence. However, at the very least, the Kearney team likely possessed deal experience - an internal team may not have ever even evaluated an acquisition. Sure, Kearney likely had conflicting motivations like a big future pay day on integration work, but I am not a Fred's shareholder and thus ultimately not very concerned about the impact of the divestiture on Fred's long-term future. Fred's shares are up nearly 80% after the announcement, so I suppose the market does not care that the "new" Fred's is going to look a lot like the old Rite Aid that couldn't survive on its own.
Well, the current earnings profile is not robust, but the company must have a robust balance sheet, right? Well, not exactly. The company has $77 million in long-term debt against a cash balance of just $6 million. Yet, Fred's noted in its press release that it had secured financing. This seems a bit outlandish, but I estimate that Fred's paid about 7-8x TTM EBIT for the stores which should add an incremental ~$125-140 million in pretax operating income. The Fred's management team is essentially making a private equity bid using a public company. I don't know if this will work as planned, but because of its similarities to a private equity deal, I do not think there will be any issue regarding certainty to close.
Happy regulators, happy life
Rumors have consistently speculated that regulators wanted someone to buy the divested Rite Aid stores in size to maintain competition. In fact, it looked Kroger would have completed a deal in November had regulators demonstrated a willingness for Kroger to close existing stores and move locations. Given the size of the transaction relative to its current size, I suspect Fred's is happy to have every store included. I do not believe there will be a synergy objection because I doubt we will see Fred's attempting to extract significant overlap synergies.
More importantly, I suspect the Rite Aid/Walgreens team worked closely with regulators to contemplate certain deal structures and how said deal structures would impact approvals. Unlike Fred's, Walgreens has several seasoned deal veterans who understand exactly how the process works, and I suspect they have taken special caution to check all boxes.
Bottom line: Rite Aid/Walgreens in the clear, Fred's Steer Clear?
Ultimately, I think this was the ideal transaction to consummate a deal. Although it feels very private equity-like to me, it looks like a public company taking on a lot of stores to expand. Financing concerns should be fairly minimal, and I think the Rite Aid spread will continue to close as a deal becomes more and more likely. Though not as enticing as it was prior to this announcement, I think the existing spread offers excellent risk and time-adjusted returns.
As for Fred's, I am willing to admit that I know next to nothing about this company. There are many red flags, in my view, but I will simply follow my usual edict and not touch something that I am completely ignorant about. The deal looks to me like it is creating another Rite Aid that many believed could not survive on its own.
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.