Rite Aid (RAD) and Fred’s (FRED) – Merger Arbitrage With Hedge – 9% upside

Current Price –$8.25

Offer Price – $9.00

Upside – 9.0%

Expiration Date - Jan 2017

SEC Filling

This is another large cap merger arbitrage deal where the spread of 9% is mostly due to pending regulatory approval. Recent developments suggest the deal is likely to close. At the same time there is opportunity to hedge the risk of the deal failing.

Background

Walgreens Boots Alliance (WBA) has agreed to purchase Rite Aid at $9 per share. This transaction was first announced in Oct 2015. Currently the deal is extended till 27th of Jan 2017 and the spread remains at 9%. The transaction is widely followed and there is plenty of info about it, so I will not go into all the details (just google for it, or browse through some articles in SA)

The key here is the approval by FTC, which is still pending. Initially it was expected that WBA will need to divest only 500 stores to get FTC approval. Then in Sep 2016 WBA announced that it will need to divest 500-1000 stores to get the approval and signaled that FTC is kind of ok with the plan. But then in October, FTC approval was still not reached and WBA was forced to extend the WBA/RAD transaction till 27th of Jan, 2017.

All of this culminated in announcement on 20th of Dec to sell 865 stores to Fred’s for $950m, which would establish Fred’s as the third largest drugstore chain in US and likely satisfy FTC’s aim for more competition.

In my opinion, this announcement significantly de-risked the transaction and right after the announcement the spread narrowed to 3%. But now RAD trades again at pre-announcement levels of $8.2/share with 9% spread.

Why is the spread at 9%?

Fred’s transaction was likely reached while keeping FTC in the loop and my guess is FTC ok’ed it as sufficient divestment for approval. So positive announcement from FTC might be imminent. However, until something is announced uncertainty persists. FTC might be concern about Fred’s ability to integrate and operate additional 865 stores (which more than doubles its current size) and remain a viable competitor (FRED operates unprofitably and would be highly leveraged after the transaction).

Additionally, recent Rite Aid performance has been disappointing and investors might be worried about WBA walking out from the deal.

Hedging by shorting FRED

Fred’s share price shot up by 80% after the store acquisition plan was announced. This was mainly due to market’s perception that stores are being acquired on the cheap (WBA/RAD are in a way forced sellers) for $1.1m per store vs WBA/RAD deal value of c. 3.7m per store. However, divestiture negotiations were carried with multiple parties, so it is quite likely that $1.1m per store is close to fair valuation (probably the worst performing stores are being sold – hard to tell without any further details provided).

In any case, it is obvious that Fred’s share price would collapse back to $11 (40% drop) if FTC does not give approval and WBA/RAD deal breaks. At the same time if WBA/RAD deal gets approved, I do not expect FRED’s shares to trade higher as the current levels already reflect very positive outcome.

Now for RAD, if the deal is rejected the share price will likely drop to c. $6/ share – 25% downside. Thus to hedge long RAD position, I am shorting 60% dollar equivalent of FRED.

Risks

The main risk for this hedged trade is that Fred’s share price will also increase upon WBA/RAD approval and might increase by more than 15% (break-even point). Fred’s share price has been very volatile over the last few days and there might be better opportunities to enter the short (I have shorted closer to $20). Alternatively, one can just buy RAD as a long without hedging – FTC approval seems to be very likely.

19 COMMENTS

  1. Kang Cheng

    It looks Alden Capital is currently after Fred’s. Do you think it will impact the deal in some way?

    1. dt

      Yes, I saw that and should have mentioned it in the write-up. Alden obviously has confidence in the WBA/RAD deal going through, I doubt they would be buying FRED otherwise. So it is a positive for the RAD longs. But it is a negative for FRED shorts (the hedging part), as Alden has acquired 2/3 of their stake after the store transfer plan was announced – so Alden presumably believes FRED is a worthy investment at $19+ share price.

      What is interesting, however is that Alden started buying FRED on 28th of November and by the time store transfer deal was announced, it has accumulated 2.5m shares (7% of all outstanding) with average price of $10.5. Detailed daily share purchases are listed here (https://www.sec.gov/Archives/edgar/data/724571/000092189516006396/sc13d08392006_12212016.htm). On some days Alden was responsible for more than 50% of the daily volume. So Alden’s guys were really busting their asses to buy as much FRED as possible and do it fast. Alden single-handedly lifted FRED’s share price by almost 20% from the 28th of Nov till 19 of Dec.
      Maybe there are reporting reasons for such fast accumulation of shares (Alden managed to consolidate 25% stake before it issued the first material shareholding report). Call me a skeptic, but it really seems that Alden knew (or correctly guessed) about the upcoming stores transfer announcement.

      Some more info on Alden Capital:
      http://www.poynter.org/2011/randall-smith-alden-global-capital-newspaper-companies/139962/
      https://dfmworkers.org/2016/01/28/alden-global-capital-101/

      One of Alden Capital funds (maybe there is only one) was rated as no. 32 hedge fund by Barron’s after 2014 performance (2014 return 9.3%):
      http://www.barrons.com/articles/best-100-hedge-funds-for-2015-1431743869

      It dropped to 50 place in 2015 (2015 return 5.7%)
      http://www.barrons.com/articles/best-100-hedge-funds-1466223924

  2. dt

    Having contemplated about this a bit more over the new year, I have decided to close out FRED short. The main reason – now I think FRED shares will jump by an equal amount or more upon announcement of WBA/RAD deal closure. So although this hedge provided a good downside protection, it would probably eat any upside from WBA/RAD spread.
    Still long RAD.

  3. Michael Lax

    I used options to replicate this trade: I bought RAD options with a strike price of 8.5 and expiration of January 27th at .30 each,while hedging by buying FRED $15 strike price puts at .55 each ( I figured that Fred would decline from 15 to 11 if the deal is called off, so calculated the amount of the hedge needed accordingly)

    1. dt

      Michael, correct me if I am wrong, but with this option trade you are betting on the deal getting cancelled before the 27th of Jan.
      You spent $0.85 to buy both options.
      Three outcomes:
      1) Deal approved – call is worth $0.5 and put is worthless. Overall net loss of $0.35.
      2) Deal cancelled – call is worthless, and put is worth $4. Net gain $3.15.
      3) Deal is delayed – both of your options expire worthless. Net loss $0.85.

      1. Michael Lax

        I only bought enough Fred puts to hedge the RAD position, with a little margin for profit. Therefore, I am essentially betting that a decision will be made before the 20th, which is likely, since the democratic FTC will want to make a decision before the new sheriff comes to town.

  4. Joe Hill

    Looks like the deal may be breaking, from Bloomberg:

    Walgreens Said to Face U.S. Antitrust Concerns Over Rite Aid Fix
    2017-01-20 15:40:36.364 GMT

    By David McLaughlin, Robert Langreth and Sara Forden
    (Bloomberg) — Walgreens Boots Alliance Inc.’s plan to win
    U.S. antitrust clearance for its acquisition of Rite Aid Corp.
    hasn’t satisfied officials at the Federal Trade Commission,
    according to people familiar with the matter.
    With just a week left before the companies’ deadline to
    complete the deal, FTC lawyers aren’t sold on Walgreen’s
    proposal to sell 865 drugstores to Fred’s Inc. to get approval
    to take over Rite Aid, said two people, who asked not to be
    identified because the discussions are confidential.
    That runs counter to the sentiment of investors, who have
    grown optimistic that the deal will get done. The spread between
    Walgreen’s offer price of $9 a share and Rite Aid’s current
    price has fallen to less than 50 cents from a high of $2.57
    reached on Nov. 3.
    The $9.4 billion transaction would merge the No. 2 and No.
    3 pharmacy chains in the U.S., vaulting the combined company
    past CVS Health Corp. to become the leading drugstore chain by
    number of stores. It would also expand its prescriptions
    business. FTC officials are concerned the sale doesn’t go far
    enough to preserve competition that would be lost in the tie-up,
    one of the people said. It isn’t clear whether the staff has
    made a formal recommendation, that person said.

    Breakup Fee

    The commission is unlikely to complete its review by the
    companies’ Jan. 27 deadline to close the deal, the second person
    said. If the deal doesn’t win antitrust clearance, Walgreens
    would have to pay Rite Aid a termination fee of $325 million or
    $650 million “in certain circumstances,” according to a company
    filing.
    In October, Walgreens said it was “confident” it would
    close the deal early this year as it postponed the merger
    deadline from Oct. 27 because its discussions with regulators
    were taking longer than anticipated.
    Spokesmen for Walgreens, Rite Aid and the FTC declined to
    comment. Fred’s chief financial officer Rick Hans, reached by
    phone, declined to comment.
    The FTC has been scrutinizing the proposed tie-up for more
    than a year. The review continues as the agency is poised to be
    reshaped under the Trump administration. Trump will have three
    empty seats on the commission, including the chairman’s post, to
    fill after Chairwoman Edith Ramirez steps down on Feb. 10.

    Trump Transition

    Trump’s adviser for the transition is Joshua Wright, a
    conservative law professor with a laissez-faire approach to
    antitrust enforcement who says mergers rarely harm consumers and
    can often generate benefits for consumers — including lower
    prices and higher quality.
    Under the Obama administration, the FTC has paid particular
    attention to competition in the health-care sector to protect
    consumers, targeting hospital mergers and deals that postpone
    the market entry of generic drugs.
    The FTC carefully assesses buyers of assets to determine
    whether the acquirer can restore competition. It hasn’t always
    made the right call. Divestitures ordered by the FTC in
    Albertsons Cos. takeover of Safeway Inc. and Hertz Global
    Holdings Inc.’s acquisition of Dollar Thrifty both failed.
    In 2014, the FTC ordered Hertz to spin off its Advantage
    Rent A Car business to a company owned by an industry veteran
    and Macquarie Capital. Four months after the commission closed
    its investigation and signed off on the acquisition, Advantage
    filed for bankruptcy.
    The buyer of divested supermarkets in Albertsons’ takeover
    of Safeway collapsed after acquiring those stores.
    CVS Chief Financial Officer David Denton said at a
    conference earlier this month that Fred’s won’t be a viable
    competitor over time.

    To contact the reporters on this story:
    David McLaughlin in Washington at dmclaughlin9@bloomberg.net;
    Robert Langreth in New York at rlangreth@bloomberg.net;
    Sara Forden in Washington at sforden@bloomberg.net
    To contact the editors responsible for this story:
    Sara Forden at sforden@bloomberg.net
    David S. Joachim

  5. exponential

    hi dt-

    wondering what your thoughts are on today’s news and your best guess of probability a deal still gets done down the line? thanks in advance!

  6. dt

    Indeed, the rumors appear to be quite negative and stock reacted accordingly. After such a long discussions with FTC and announcement about store disposal it seemed FTC already gave non-official OK for the deal.

    What happens next is only guess work, especially without any info on what specifically was not ok for FTC. Currently it is just rumors, which might be either reversed or confirmed next week. If the rumors are correct, I doubt the deal gets done by 27th of Jan (if at all) and after this date Walgreens could reevaluate the whole transaction.

    What I find strange, is that FRED’s stock has remained relatively resilient – it seems FRED’s shareholders see higher likelihood of deal closing or even expect increased store drop-downs from Walgreens (in order to satisfy FTC). Really bizarre.

    I though about closing out the position after the spread narrowed to 4% last week. With hindsight, that clearly would have been smart decision as the risks of the deal remained almost the same, but the upside narrowed down significantly (from 9% to 4%). But with hindsight all decisions seem easy.

  7. jason kravitz

    Does the risk/reward favor sticking with this or taking the losses and moving on?

    1. dt

      Jason, obviously the deal has been delayed beyond the initial schedule, which is a huge blow to my initial M&A arbitrage thesis after the FRED store divestment was announced. Outside of various rumors, the only confirmed info is from WBA CEO who said (on 26th of Jan) that:

      “The only thing I can repeat is that we are actively engaged in dialogue with the FTC and we are doing everything we can to support their work < ...> These discussions include taking into account anything required to gain approval for the transaction”
      From: http://www.reuters.com/article/us-rite-aid-m-a-walgreens-boots-idUSKBN15A2LY

      If deal falls apart, downside is probably around $6/share. If the deal happens then its $9/share (if terms do not get amended). So it looks like its $1 down vs $2 up risk/reward. However, I have no idea about the probabilities of either happening – your guess is as good as mine.

  8. Joe Hill

    Wow, I guess RAD really needs to get a deal done:

    Walgreens Boots Alliance and Rite Aid Enter into Amendment and Extension to Merger Agreement
    2017-01-30 13:30:00.201 GMT

    Walgreens Boots Alliance and Rite Aid Enter into Amendment and Extension to
    Merger Agreement

    Business Wire

    DEERFIELD, Ill. & CAMP HILL, Pa. — January 30, 2017

    Walgreens Boots Alliance, Inc. (Nasdaq: WBA) and Rite Aid Corporation (NYSE:
    RAD) today announced that they have entered into an amendment and extension of
    their previously announced definitive merger agreement under which Walgreens
    Boots Alliance will acquire all outstanding shares of Rite Aid, a U.S. retail
    pharmacy chain.

    This Smart News Release features multimedia. View the full release here:
    http://www.businesswire.com/news/home/20170130005563/en/

    Under the terms of the amendment, the parties have agreed to reduce the price
    for each share of Rite Aid common stock to be paid by Walgreens Boots
    Alliance. The revised price will be a maximum of $7.00 per share and a minimum
    of $6.50 per share. In addition, Walgreens Boots Alliance will be required to
    divest up to 1,200 Rite Aid stores and certain additional related assets if
    required to obtain regulatory approval. The exact price per share will be
    determined based on the number of required store divestitures, with the price
    set at $7.00 per share if 1,000 stores or fewer are required for divestiture
    and at $6.50 per share if 1,200 stores are required for divestiture. If the
    required divestitures fall between 1,000 and 1,200 stores, then there will be
    a pro-rata adjustment of the price per share. Walgreens Boots Alliance
    agreement to divest up to 1,200 Rite Aid stores represents an increase of up
    to 200 stores over the 1,000 stores that Walgreens Boots Alliance had agreed
    to divest under the terms of the original agreement.

    Additionally, Walgreens Boots Alliance and Rite Aid agreed to extend the end
    date under the previously announced agreement from 27 January 2017 to 31 July
    2017 in order to allow the parties additional time to obtain regulatory
    approval.

    The transaction is subject to approval by the holders of Rite Aid’s common
    stock, the expiration or termination of applicable waiting periods under the
    Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, and other
    customary closing conditions.

  9. dt

    I have closed out my RAD position at 30% loss. My afterthoughts:
    - MAIN ONE – if spread narrows to 3%-5% (as happened two weeks ago) and uncertainty remains the same, just close the position. Hopefully some of you were smarter than me and have done exactly that.
    - M&A arbitrage on large cap stocks is probably a game of luck as the market is quite efficient for these. M&A spreads within small cap area should result in more predictive outcomes.

    1. jsl zc

      Now it says the M&A price will reduced to 6.5-7 and may be done by Jul. 200 more stores should be divested, which makes the price of Fred drop less than RAD. Do you thinkd the current price (about $5.4) of RAD is worth to take a shot? And somehow shorting Fred still can hedge the position, even 200 more stores aren’t that benificial to Fred’s business?

      1. dt

        Spread is indeed larger than when I wrote it up. However, all the signs that I imagined were pointing towards regulatory approval turned out to be incorrect. So my thinking about situation was flawed and I do not have any additional insights that would make me more confident about the deal getting done. Timeline has also been extended.
        RAD might be oversold at the moment due to temporary negative sentiment and 23% spread surely looks inviting, but due to above reasons I am staying out.

Leave a Reply

Your email address will not be published. Required fields are marked *