Rite Aid (RAD) – Merger Arbitrage – 77% upside

Current Price –$3.67

Expected Price - $6.5

Upside – 77%

Expiration Date - Dec 2017

This is my second look at the pending WBA/RAD merger – I was spectacularly wrong the first time and the only consolation is that market was wrong as well – the spread narrowed to 3% before the deal started collapsing. The merger agreement has been adjusted – instead of $9/share WBA is planning to acquire RAD at $6.5-$7/share (77% upside) and higher number of stores will be divested to FRED in order to satisfy FTC requirements. As before the key concern/risk is FTC rejection of the transaction.

Two things prompted me to look at this merger again:

1) Firstly, the share price drifted down from c. $6/share after the initial deal cancellation to $3.7/ share currently and now offers a very juicy 77% spread;

2) Secondly, this tweet from SumZero – I obtained and read the full article (due to copyright unable to share it here). I find the arguments for betting on this merger spread quite convincing. Below I provide summary of the key ideas from this article.

Keep in mind that this is a large cap and widely followed transaction so the spread is likely to correctly reflect market realities. I am not claiming to have any specific insight or that market is misprising the situation.

 

Key arguments for betting on this M&A spread

1) Attractive upside vs downside – standalone RAD would be worth $2.84/share using DCF method and factoring EBITDA growth starting with 2018 (currently RAD operations are deteriorating). This results in 25% downside vs potential 77% upside (1:3). Calculating implied valuation by Fred’s Offer (865 stores at $950m) results in even higher standalone value of $4.68/share. Consensus in arbitrage community seems to be $2.25/share in case the deal breaks, which still suggests that the upside is two times larger than the downside.

2) FTC will have hard time proving that the transaction reduces the competitiveness of the market. It was reported that FTC solicited further information from Walgreens vendors and rivals, suggesting that FTC is preparing to challenge the merger (this caused RAD share price to drop further 10%). If FTC challenges, the deal will go to court (as per WBA/RAD merger agreement). However, on a national level the prescription drug market is competitive (HHI score 928) and would remain competitive after the merger (HHI score 1055). Markets might get more concentrated if calculated on a local level (which FTC is expected to look at), however store divestitures to FRED should help to overcome this issue at a local level.

3) Contrarian view. Consensus seems to be that FTC challenges the transaction and then WBA/RAD lose in court. So market is pricing high probability of deal getting rejected and low probability of it getting approved (which seems to be in line with limited downside on standalone valuation). Contrarian view is that WBA/RAD have a good chance of winning in court due to unconcentrated market even after the merger. However, FTC is on a winning streak having recently won a number of trials that blocked large cap transactions - this likely adds to investor pessimism regarding WBA/RAD deal.

Also worth noting one additional risk that comes with the new merger agreement – there is a minimum LTM EBITDA threshold of $1bn for RAD. If not achieved WBA could renegotiate the deal (i.e. lower the price) or simply walk away (doubt this will happen as WBA is trying to takeover RAD already for 19 months). FY 2017 adjusted EBITDA stood at $1.13bn, down from $1.4bn in FY2016.

Timeline: FTC has to announce its decision by the 7th of July. If this goes to court, it is likely to take until Dec before the opinions are issued.

This is tiny position for me as I do not have a very high conviction and am mostly attracted here by the 3:1 reward/risk ratio. There is likely to be further sell-off if FTC challenges the transaction. I do not intend to wait for the spread to close fully and might sell out of the position opportunistically.

18 COMMENTS

  1. Joe Hill

    Oh RAD, you are a cruel mistress. I am always getting too greedy with this name.

  2. over2u

    As I understood, there are some speculations around re RAD WBA transaction closing – many people think that redemption of deal financing debt by WBA and letter to employees by RAD missing statement “high likelihood of transaction” are hints toward negative resolution from FTC. Don’t want to speculate on this.
    So, dt, what is your strategy here – just a contrarian view that chances that deal closes are underestimated, but then didn’t understand your last sentence – “might sell opportunistically”. What would be the trigger – positivie rumours like the one above? Thx

    1. dt

      Agreed – there was considerable amount of negative press suggesting the deal is likely to fall apart, however, judging from market reaction, all of this is already reflected in the RAD share price.

      My game here is a bet on 3 times larger upside relative to downside. I do not think anyone can estimate probabilities on the deal closing or falling apart, as this is a binary event on FTC/court’s judgement.

      With the last sentence I meant to say, that if RAD share price jumps for some reason (eg. rumors) I might close out the position earlier rather than wait till I capture the full spread of 70%.

  3. Dan T

    BRIEF-FTC staff to advise blocking Rite Aid-Walgreens merger- CNBC, citing report
    12:30 PM ET, 06/09/2017 – Reuters
    June 9 (Reuters) -

    * FTC staff to advise blocking Rite Aid-Walgreens merger- CNBC, citing report

    you still going to hold? It looks like the street is valuing the company at about $3 without the merger.

    1. dt

      Yes still holding, albeit this is a tiny position for me. I have no reason to believe that the rumors reported by Capitol Forum are incorrect. However, worth noting that the same Capitol Forum reported similar rumors already back in April:

      https://www.bloomberg.com/news/articles/2017-04-19/rite-aid-falls-on-report-ftc-may-sue-to-block-walgreens-takeover

      Also, I think that shares will drop further if/when FTC confirms its decision to block the deal, so $3/share is probably still above the levels where the market would value stand alone RAD.

  4. over2u

    Interesting development of the situation: Health insurer Humana is trying to kill a subpoena from the Federal Trade Commission tied to the agency’s review of Walgreens Boots Alliance’s $7 billion acquisition of Rite Aid. But the FTC is demanding the D.C. district court require Humana to cough up the documents by June 26, according to court filings.
    As a result RAD price increased to the level of +$3.4 and then retraced back slightly.

    1. dt

      I think this is a bearish signal – FTC is likely trying to find documents to support their case for rejection of the deal.

  5. over2u

    Some movements here, though didn’t find any good reason except for some speculations.

    1. dt

      Would not call 40% up as ‘some movements’. But you are right, currently it is all just speculation.

      Last week Capital Forum published further analysis that the merger is unlikely – http://www.foxbusiness.com/markets/2017/06/23/ftc-likely-to-ok-lawsuit-blocking-rite-aid-walgreens-merger-report.html

      But then over the weekend another report from a reputable M&A research company claimed that the merger is likely to be approved – http://ctfn.news/jun-26-2017-fred-rad-wba-11669/

      So stock is volatile and if there is a further spike today I will happily close out the position.

      1. over2u

        Tried to be sarcastic:) And agree with your approach – given that is all speculation quick profits may become huge losses in a matter of one tweet.

  6. dt

    I have closed my RAD position today with 10% gain. Never had a very strong conviction for this trade and I am simply using market volatility (which is driven by rumors rather than actual news) to exit profitably. One factor that changed since the write-up is the perceived downside – shares have traded down as low as $2.9 with the merger still on the table, suggesting that my previous assessment of the downside case if the merger gets cancelled ($2.8) was probably way to optimistic.Now I am thinking shares are likely to drop below $2/share if the merger is blocked. So risk/reward no longer seems as favorable.

    FTC decision is expected shortly (some articles say Thursday tomorrow)

  7. Freedomist

    Rite Aid (RAD) tanked 15%, Walgreens (WBA) climbed 5%, after the companies announced they had broken off their $9.4 billion merger effort. Walgreens agreed instead to buy about half of Rite-Aid’s stores for $5.1 billion.

    Sell and run now?

  8. dt

    RAD/WBA deal keeps on surprising, and I am purely lucky to have exited upon rumor driven price spike just the day before.

    Today RAD also announced disappointing Q1 earnings which probably added to the share price pressure.

    Upon the first look the new deal values the company significantly below the previous agreement. Taking into account termination fee and for sake of simplicity assuming all the stores have the same value, the latest transaction is valuing the whole RAD at $11.5bn, whereas previous deal resulted in $13.8bn valuation ($6.8bn market cap at $6.5/share + $7bn in net debt). RAD must be really desperate to agree to an even lower price.

  9. over2u

    So based on this simplistic assumption Target price shall be $4.2 per share.

  10. over2u

    DT, what is your view here, assuming that asset sale will happen? For me it looks like share price should be traded at the level of $4 per share rather than $2.5 (based on pro-forma EBITDA ex. asset sale). Don’t really understand what I am missing here.
    Another point, it rumored that other potential buyers may be interested in smaller RAD (private equity, Amazon, etc.) that may create some speculative buying (analogous to your idea with RAD/WBA speculative buying). Thanks

    1. dt

      Any valuation is a bit of a guess work before the pro-forma numbers get published (management promised these shortly). Information provided by management so far indicates c. $2.5bn in net debt and $0.7bn in EBITDA after the asset sale. So currently the company is trading at 7xEBITDA which is couple turns below peers. Assuming the remaining RAD stores will be far healthier than the average store currently and that the company will turn around the operations, a reasonable multiple would be 9x (in line with industry peers). At that level RAD shares are valued at $3.6/share.

      But before the pro-forma numbers get published, this exercise is relying on vague communication by management, who so far have mislead the investors. Also the new WBA deal is still subject to FTC approval and is not yet a done deal.

      Almost half of the market cap changed hands after the merger agreement has been cancelled – so there definitely was quite a bit of selling pressure. It might be that this technical selling alone is causing the low share price. This would mean a great buying opportunity and announcement of pro-forma numbers will likely serve as a catalyst. Due to this I intend to initiate a small position again.

      Most of the rumors on RAD so far turned out to be useless chit-chat, so I am not paying too much attention to the new ones either, even-though PE acquisition and deleveraging of smaller RAD might make sense at current share price levels. Amazon just agreed to acquire Whole-Foods, so their hands seem to be quite full for the moment being.

  11. dt

    Pro-forma numbers have been published:
    https://www.sec.gov/Archives/edgar/data/84129/000114420417037045/v470942_ex99-1.htm

    Pro-forma EBITDA stands at $743m and net debt appears to be lower than indicated in my comment above. The exact amount of net debt is a bit unclear – counting in only the mentioned 2023, 2027 and 2028 notes would mean that a total of $5.07bn would need to be repayed, however only $4.92m of the sale proceeds would be used this purpose. It might be that the difference of $150m will be covered by cash generated from operations (I assume cash on the balance sheet is necessary to run the business and would not be used for debt repayment).

    Taking more conservative approach, I calculate that debt after the sale will be at $2.35bn, which results in $5.1bn EV and EBITDA multiple of only 6.8x even after yesterday’s share price run-up.

    This seems cheap relative to competitors (trading at 9x). But the pending questions are whether FTC will approve the store sale to WBA and whether the remaining stores can be turned around and stop the revenue decline. Also one needs to trust that management’s guidance on pro-forma figures will turn out to be correct.

    1. over2u

      Probably another special situation in RAD presented itself. Based on revised number fair level of stock price should be at $3.5-4.0 level. Agree with the risks outlined, though will be very stange to see FTC blocking the asset sale – meaning total incompetence of WBA management in M&A process/dynamic.

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