Acquisitions aren't for the faint of heart, especially when you're a shareholder of the company that's to be purchased.
Rite Aid (NYSE: RAD) shareholders have experienced that firsthand over the past few weeks. Walgreens Boots Alliance (NASDAQ: WBA) and Rite Aid announced a new twist to their merger agreement on Jan. 30. In an effort to convince the Federal Trade Commission (FTC) to approve the deal, Walgreens agreed to sell up to 1,200 Rite Aid stores -- up from 1,000 in the previous version of the two companies' merger agreement.
The bad news for Rite Aid, though, is that the price its stock will fetch was reduced from $9 per share to somewhere between $6.50 and $7 per share, depending on the actual number of stores that have to be sold. Rite Aid's stock plunged on the development, but now might actually be a good time for investors to jump aboard.
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Playing the odds
Rite Aid's shares are currently trading around 20% below the low end of range for the latest Walgreens' offer. That implies a lot of pessimism about whether the deal will ultimately win approval from the FTC. While there certainly is a chance the FTC will turn down the merger of the two pharmacy retailers, I suspect the odds are more in favor of approval than rejection.
Walgreens' proposal to sell up to 1,200 Rite Aid stores should improve the prospects that approval is obtained. Assuming Walgreens sold that number of stores, the combined company would have roughly 11,500 stores. That would give Walgreens around 19% of the total number of pharmacies in the U.S. compared to CVS Health's (NYSE: CVS) 16% share.
The FTC really can't make a legitimate case that the combination of Walgreens and Rite Aid would deprive most Americans of choices to meet their pharmacy needs. Neither does the agency have a strong argument that prices would go up because of the merger. The most likely outcome is that the FTC requires Walgreens to divest stores in specific areas where the merger could cause antitrust concerns.
Politics could also work to Rite Aid's and Walgreens' advantage. President Trump will be able to nominate three commissioners to the five-member FTC panel, and he will probably nominate individuals who are less likely to be pro-regulation.
Let's suppose the worst-case scenario occurs: Walgreens' proposed acquisition of Rite Aid falls through. Where would that leave Rite Aid?
The current price of the stock is 14% below where it was the day before Walgreens' offer was announced on Oct. 27, 2015. However, Rite Aid's most recent quarterly earnings are also around 30% lower than they were then.
I think Rite Aid's stock could easily drop another 20% if the Walgreens' deal doesn't happen. Assuming my estimate is on target, the maximum upside of buying Rite Aid (around 34%) is higher than the potential downside. Still, the potential for loss is significant if the FTC rules against the acquisition.
The option option
Although my view is that the FTC will give a green light to the merger, there is a way for investors to hedge their bets. Buying a January 2018 call option for Rite Aid shares at the $7 strike price (the price at which the option can be exercised) could limit risk while allowing the opportunity to profit if the deal goes through.
Why go with a January 2018 option date? It gives plenty of time past the current agreement expiration date of July 31, 2017. There is also a reason to use a $7 strike price. It's the maximum share price offered by Walgreens and is the closest strike price to the low end of Walgreens' offer. If the deal is approved, Rite Aid's stock will immediately shoot up relatively close to the $7 level.
If the FTC doesn't approve the acquisition, the most you could lose would be the relatively low amount spent purchasing the call option. On the other hand, if the deal is approved like I expect it will be, you would receive close to the same amount of profit as you would had you bought Rite Aid shares (less the cost of buying the option).
This option approach could allow investors to win from a Walgreens' acquisition of Rite Aid -- with only minimal faintness of heart involved.
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