Current Price –$8.25
Offer Price – $9.00
Upside – 9.0%
Expiration Date – Jan 2017
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.
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.
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.