We Got It Wrong With Rite Aid -- Now What?

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In our 2015 "Walgreens Shows Its Hand, Scoops Up Rite Aid" episode, Motley Fool analyst Kristine Harjes speculated that regulators would give the nod to Walgreens Boots Alliance's (NASDAQ: WBA) deal to acquire Rite Aid (NYSE: RAD) lock, stock, and barrel. That prediction missed its mark. Now, Walgreens and Rite Aid are waiting for regulators to weigh in on a revised deal that would have Walgreens buying about half of Rite Aid's stores. Will this agreement pass muster with government watchdogs?

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In this clip from Industry Focus: Healthcare, host Kristine Harjes and Motley Fool contributor Todd Campbell discuss why Walgreens and Rite Aid's previous deal failed, whether their new deal will win approval, and whether Rite Aid's shares are a value trap or a bargain-bin buy.

A full transcript follows the video.

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This video was recorded on Aug. 23, 2017.

Kristine Harjes: Here's a clip from our Oct. 28, 2015, show. This show was called "Walgreens  Shows Its Hand, Scoops Up Rite Aid."

(Harjes): As you mentioned, one of the big questions that's still left here is, will this deal be allowed to go through by the FTC, which of course wants to prevent this kind of monopolization, or, in this case, it would be a duopoly, of the retail pharmacy business? Now, traditionally, the FTC doesn't like duopolies, and they will shut that kind of thing down. However, it's my suspicion that, given this push toward lower drug prices, I bet the FTC would let it go because of that particular point. If they can say, "This is bringing down this exorbitant cost that drugs are taking on Americans," then maybe it could be a good thing, and they would rather have that than shut down a duopoly.

So that was my speculation. For some context, the original deal that we were talking about was for $9.7 billion. It was announced in October of 2015 that Walgreens would acquire Rite Aid for $9 a share. That was later revised down to about $6.50-$7. It all depended on how many stores were divested. For some additional context here, these are the two major retail pharmacy players in the United States, and therefore the FTC did not want the type of power consolidation that could be involved with this deal. That's why there was the first revision of the plan. And eventually, we found out in June 29 of this year that the entire deal had fallen through, and the original FTC decision had been scheduled for July 7, but Walgreens ended up saying, "You know, they're just not going to approve this, so we're going to offer up a new deal to acquire just about half of Rite Aid's stores," which is a heck of a lot smaller than the original deal. And that's where we stand now. We had more details about this new version of the deal on the episode that we did on July 5, but there's no getting around the fact that back in October of 2015, I was just totally off the mark saying the FTC would let this deal go through.

Todd Campbell: You were just hopeful! You were hopeful! There's nothing wrong with hopeful. Yes, you were optimistic. As investors, we sometimes get optimistic, and we connected some dots, and the dots were, with the push to try and drive down prices, maybe they would let this go through. The reality is, however, there's no denying that the pharmacy marketplace has gotten very consolidated since 2000. You've got a handful of players who dominate that market. You have Walgreens, you've got CVS, and you've got Rite Aid. So, combining Walgreens and Rite Aid together, OK, yeah, that would have created a behemoth in the space, and theoretically, that could have eliminated competition in certain local markets to the point where they weren't going to get this deal approved. Shares of Rite Aid, Kristine, have been absolutely pummeled on the news of the new revised deal.

Harjes: Yeah, they fell 26%.

Campbell: I'm curious to put you on the spot again for next year's episode --

Harjes: Oh, great! [laughs]

Campbell: -- and see if you have any thoughts for Rite Aid from here. Will this deal get through?

Harjes: Yeah, I'm really hesitant to speculate again on it. But it's really hard not to do, because watching what has happened to Rite Aid's shares over the past 22 months -- I think that's the right number -- since Walgreens started talking to the FTC about potentially scooping up some or all of Rite Aid, it is fascinating. Rite Aid's shares are down to about one-third of the level they were before this deal was ever announced. They're down 73% just since the beginning of this year. Right now, they're hovering around $2.25 a share. If you recall, the original deal was for $9 per Rite Aid share, so the market has just completely crippled Rite Aid.

Campbell: Kristine, just to jump in for one quick second because I don't want to forget this point, what's interesting to think about, in that original deal, if you include debt, that deal was worth over $17 billion. So Walgreens was willing to pay, including debts, $17 billion to get its hands on Rite Aid. Now, what's Rite Aid's market cap today?

Harjes: $2.34 billion.

Campbell: $2.34 billion, and they still have half their stores, and they still have their pharmacy benefit manager. So I wonder if there's a little bit of a disconnect. Maybe that's the uncertainty. The uncertainty is, we don't know whether or not the deal will close, and if it doesn't close, you still have Rite Aid as a relatively troubled and highly indebted company.

Harjes: Yeah, they have $7.2 billion in debt. I think, actually, I have learned from being wrong the first time about this, because I'm so intrigued by Rite Aid as a value play right now, but I haven't bought any shares, and I think that actually is the hesitation of, I was wrong about whether or not the FTC would let this go through once. I could be wrong again, even though right now, sitting here looking at it, I'm going to say, I do think this will go through. And even if not, I think Rite Aid is grossly undervalued. But that being said, I still haven't put my money behind it, because I'm looking at this like, well, I understood the situation incorrectly the first time around, so I'm going to try to learn from that and say deals are not done deals until they go through. It's dangerous to try to grab an arbitrage opportunity, especially because if you look at what happens when these deals fall through, the stocks are absolutely crushed. And while it doesn't look like to me that Rite Aid has farther that it could really fall based on the value of the business alone, it could. And who am I to say that won't?

Campbell: Right. Is this a falling knife or a value trap? Or is this truly a bargain-bin buy? That's the big question. I had a mentor back in the '90s, Kristine, and one of the things that I learned from that mentor was, don't worry too much about the bottom 10% of a move or the top 10% of a move. Focus your attention on that 80% in the middle. So I think investors should basically take a step back and say, "I don't need to be perfect in timing my entry and trying to get to the bottom. Why don't I let this play out a little bit, because it's likely that if it does close, there will be opportunities for me to benefit and make that 80% of the move after, rather than trying to be a hero and stepping up into the uncertainty?"

Harjes: Yeah, I think that's great advice. For investors looking to do that here, take a look at the value of the stores. Consider that Walgreens will be able to cherry-pick the ones that it wants. Also consider that the way in which it will cherry-pick them will have a lot to do with what the FTC says it's allowed to choose as far as the geographical footprint goes. Also, look at its PBM. Rite Aid has EnvisionRx, its pharmacy benefits manager. That's a whole other part of this business that doesn't really get talked about a lot, and I suspect the value of that isn't really being considered in the full market cap of this company.

Campbell: Yeah, Kristine, just to jump in again on that point, because it's a good one, I crunched some numbers on that not that long ago in an article I posted on The Motley Fool, and one of the conclusions I came to is, as a stand-alone company, that EnvisionRx could be worth anywhere between $2.4 and $4 billion on its own, which is intriguing.

Harjes: Interesting. Yeah, I don't think I read that one yet, so I will definitely go ahead to the site and look for it. If anyone listening wants to read it, shoot us an email at industryfocus@fool.com, and I will dig it up and send it along for you.

Kristine Harjes has no position in any of the stocks mentioned. Todd Campbell has no position in any of the stocks mentioned. The Motley Fool recommends CVS Health. The Motley Fool has a disclosure policy.