Reworked Rite Aid Deal Still Has to Clear Regulators' Review

(Bloomberg) -- A reworked deal to sell 2,186 Rite Aid Corp. drugstores to Walgreens Boots Alliance Inc. will still have to win the blessing of antitrust regulators, who are likely to review whether a smaller Rite Aid can remain competitive in the U.S.

A proposed takeover of Rite Aid by Walgreens was pulled amid fears that the U.S. Federal Trade Commission would quash it over competition concerns. Under a slimmed-down pact unveiled on Thursday worth $5.18 billion, Walgreens would acquire almost half of Rite Aid’s stores, and Rite Aid would remain a freestanding company.

The less ambitious transaction isn’t a sure thing. There’s a higher chance that this deal goes through than the last one, said Bloomberg Intelligence analyst Jonathan Palmer, but he didn’t think it was a “slam dunk.” Walgreens is the No. 2 U.S. drugstore chain, while Rite Aid is a distant No. 3.

The FTC will examine Rite Aid’s ability to compete and whether it will be a true constraint against an even bigger Walgreens, said Andrea Agathoklis Murino, an antitrust lawyer at Goodwin Procter in Washington. The agency won’t want to see Rite Aid become a “a shell of itself” after the sale, she said.

“They can’t create a situation where the remaining Rite Aid stores, whatever that looks like, are not going to be competitively significant,” she said. “There will certainly be serious questions that Rite Aid has to respond to about how they will be a viable competitive entity in those areas where they compete with Walgreens.”

Debt Paydown

Rite Aid will have one advantage -- a trove of cash to pay down debt and reposition the company in a market crowded with deep-pocketed, diversified rivals.

“It really gives them a lifeline whereas there probably wasn’t one if they had just gotten the deal scuttled and there was no transaction,” Palmer said. “I don’t think it’s an easy path forward for them but it’s certainly an easier path than stand-alone Rite Aid with the mountain of debt.”

There’s another potential loser, as well -- regional pharmacy chain Fred’s Inc., which is attempting to executive a turnaround of its business. Under the now-busted Walgreens-Rite Aid pact, Fred’s would have gained as many as 1,200 stores. Without them, it faces an even more daunting competitive landscape than Rite Aid, which is likely to lean on its pharmacy-benefits management business as it refashions itself.

Reworked Rite Aid Deal Still Has to Clear Regulators' Review

Both Rite Aid and Fred’s fell sharply Thursday after the new deal was announced -- Rite Aid lost 26 percent and Fred’s fell 23 percent. They dropped further on Friday: Rite Aid was down 7.1 percent to $2.69 at 10:40 a.m. in New York, and Fred’s declined 2.6 percent to $9.26.

Rite Aid has almost $7.2 billion in long-term debt, according to its balance sheet for the quarter ended June 3. After selling the stores to Walgreens, Rite Aid’s ratio of debt to earnings before interest, tax, depreciation and amortization will be around 4.8 times, according to Mizuho Securities USA LLC analysts. The asset sale, if approved by regulators, would leave Rite Aid as a regional chain with concentrations of stores on the West Coast, Michigan, Ohio, Pennsylvania, and New Jersey.

‘Smaller but Stronger’

“The transaction will transform Rite Aid into smaller but stronger company that will have less exposure to the pharmacy reimbursement rate pressures that have had such a negative impact on our business,” said John Standley, Rite Aid’s chief executive officer, on a conference call with analysts.

While the deal may reduce its debt, Rite Aid is facing operational challenges. The Camp Hill, Pennsylvania-based company said Thursday that revenue declined 4.9 percent in the fiscal first quarter ended June 3 to $7.8 billion, from $8.2 billion the previous year. Same-store sales decreased 3.9 percent. The company posted a net loss of 7 cents a share after essentially breaking even in the previous year.

“They are going to struggle unless they get more scale,” said Adam Fein, president of Pembroke Consulting, which advises drugmakers on sales and distribution.

Rite Aid “is kind of stuck in the middle” between the two big national chains -- Walgreens and no. 1 CVS Health Corp. -- and small independent pharmacy chains, Fein said. As a result, it has trouble competing for placement on narrow pharmacy networks that health plans and pharmacy-benefit managers have been increasingly putting into place, Fein said, and getting smaller won’t do anything to solve this problem.

With less debt, the remaining parts of Rite Aid could be attractive to private-equity buyers, Fein said. Rite Aid could also try to buy Fred’s, which has stores in the South, where Rite Aid will have few stores left if the asset sales go through.

Fred’s Chief Executive Officer Michael Bloom said the collapse of its planned store purchases was “disappointing” but “the termination of the transaction has no impact on the company’s transformation strategy or our ability to execute.”

Analysts said that the Rite Aid deal would have given Fred’s greater negotiating power and diversified its store base beyond small rural towns where the business isn’t growing.

“There was a good portion of the investment community that thought that Fred’s had a real opportunity to turn those divested Rite Aid stores into a decent-sized chain, which technically would’ve been the third largest chain in the country,” Nicholas Mitchell, an analyst at Northcoast Research, said. “It provided a solution overnight to expand the footprint.”