Walgreens Outmaneuvers Rite Aid

| About: Rite Aid (RAD)
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Summary

Walgreens has struck itself a much better deal for Rite Aid, though it may have to divest even more stores.

I do not understand the FTC's rationale for not accepting Fred's' proposal.

Rite Aid shareholders lose big time, but management has no confidence they will receive a higher bid.

I am moving on due to continued regulatory uncertainty.

Monday morning, Walgreens (NASDAQ:WBA) and Rite Aid (NYSE:RAD) announced an amended merger agreement with considerably lower terms. Walgreens will now pay as low as $6.50 per share if it has to divest 1,250 stores and as much as $7.00 per share if Walgreens "only" has to divest 1,000 stores. The total sum will be adjusted to compensate for however many divestitures Walgreens is forced to perform. Rite Aid is tied now obligated to pay $325 million to Walgreens if it leaves Walgreens at the alter, and Walgreens is required to pay a $325 million termination fee if it dumps Rite Aid. However, the fee falls to $162.5 million in the even that Rite Aid's TTM EBITDA falls below $1 billion. The deal now has another 6 months to close. Overall, I think Walgreens is the real winner, paying $2 billion less for an asset that could actually have higher earnings power if we see corporate tax reform. Shareholders will now receive only a modest premium to the unaffected share price from October of 2015. I have closed my position in Rite Aid.

Where I went wrong and why I sold Rite Aid

I have to admit that I got this situation completely wrong. While I did not believe that Fred's (NASDAQ:FRED) had a strong future ahead of itself, I assumed regulators would see the writing on the wall for Rite Aid. The pharmacy was not in a great position to survive on its own. The "new" Fred's will not be in a strong position either. In fact, I strongly believe that the most logical outcome would have been for regulators to allow a merger to preserve the most competition possible between Walgreens and CVS (NYSE:CVS).

However, I should have followed the common HSR testing metric, the Herfindahl Index. Regulators were not going to be pleased with a market dominated by two national players and one third place player, though lagging in a distant third, become even less competitive The FTC even provided precedent in the Office Depot (NYSE:ODP) / Staples (NASDAQ:SPLS) merger. However, I ignored the precedent, betting on turnover of key regulators that would have a laissez faire attitude towards consolidation. As well, I assumed, and assumed very wrongly, that regulators would have learned that consolidation in markets already dominated by one or two players likely prolongs how long stores remain open and local levels of competition.

That said, I have closed my position. I do not feel that there are any great suitors to create a strong third national chain. I think the FTC may be more likely to "preserve competition" and see Rite Aid fizzle out naturally. Further, Rite Aid is clearly not very confident in its ability to perform in a standalone entity. Management and the board were assured that they wouldn't find a higher bid from a competitor, agreeing to pay a fairly substantial sum if a new bidder does emerge. The $325 million breakup free for Walgreens, on the other hand, is practically immaterial.

At its current price, I don't think the risk/reward looks very tempting. The return will be somewhere between 12-22% with significant potential downside if the deal breaks. I think I will opt not to pick up pennies in front of regulatory steamrollers.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.