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.