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Retail Newsline: The Dope on the Drug Store Merger

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By Garrick Brown, Vice President, Research – West Region

Welcome to this week’s Newsline. As Drug Storepromised, this week I am sharing my take on Walgreens’ pending acquisition of Rite Aid. But before I get into those, if you missed last week’s issue I shared my forecast for this year’s holiday sales season. I would like to invite you to check out the Cushman & Wakefield 2015 Holiday Sales Season Preview. It’s a great interactive piece our incredible Creative Department put together for me that showcases my holiday forecast as well as some interesting and amusing bits of data you might not have known.

But let’s get to the big news; last week the Walgreens Boots Alliance proposed to buy Rite Aid for $17.2 billion (this includes acquiring Rite Aid’s current net debt of $9.3 billion). In the proposed deal, Walgreens will pay about $9 per share in cash to Rite Aid (this includes a premium of 48% to the closing share price on the day before the announcement). Financing will be through a combination of existing cash, the issuance of new debt and Walgreens’ assumption of existing Rite Aid debt.

The merger must be consummated by October 27, 2016 or the deal is off. That deadline could be extended to January 27, 2017 under some circumstances. If Rite Aid walks away from the deal they will be on the hook for a $325 million termination fee to Walgreens. They may also be required to pay up to $45 million in additional charges to cover expenses incurred by Walgreens. The same more or less holds true in the reverse; Walgreens will forfeit $325 million to Rite Aid if it is not able to secure regulatory approval for the deal. That amount could double to $650 million if Walgreens enters into, consummates or announces certain acquisitions within eight to 12 months of the date of the merger agreement with Rite Aid. So clearly Walgreens has a fairly costly incentive to make sure that this deal gets done and it gets through the regulatory process.

And there is a very good chance that the Federal Trade Commission (FTC) might object to this deal on the grounds that it will effectively turn the US drug store market into a duopoly. That being said, the continued presence of grocery store pharmacies and the rise of online players will probably mean the deal ultimately gets approval. After all, Walmart still operates about 4,000 pharmacies in their grocery stores while Kroger has about 2,000 and Safeway/Albertson’s also remains active.

But what might be most likely is that the FTC might push for Walgreens to divest themselves of ownership of some stores. This is what they did with the Family Dollar/Dollar Tree deal (ultimately 330 Family Dollar stores were sold to private equity firm Sycamore Partners to clear the way for that deal). Who knows how many stores the FTC might target, but I have a hunch it will be a lot. And, my guess is so did Walgreen’s because the details of the deal actually touch on that topic. But we’ll get to that in a minute. First, let’s get to the most important question here…

Why do this now?

Sure, Walgreens says that they expect this transaction to add to their bottom line within the first full year after the deal closes (the deal is unlikely to close until the latter half of next year).

They expect to save more than $1 billion in synergies (i.e. layoffs of redundant employees). At least initially Rite Aid would continue to operate under that name, but as a wholly-owned subsidiary of Walgreens. However, Walgreens might (i.e. almost certainly will) eventually rebrand Rite Aid stores as Walgreens.

The new Walgreens would have more than $130 billion in sales. It is expected to have a gross margin of more than 26% and an EBITDA margin of 5.6%. All of these should translate into a boost in stock value, plus Walgreens scored some major immediate growth.

The size of the new entity also has its own advantages. They will certainly be in a better position to command deals from vendors as well as pharmaceutical companies. This last point is something Wall Street is acutely aware of; McKesson (Rite Aid’s drug distributor) stock fell 4.1% while AmerisourceBergen (Walgreen’s supplier) stock rose 4.2% on news of the transaction.

But better buying power, savings through synergies and instant mega growth are not the primary reasons why this deal is happening.

Right now CVS is the market leader in this retail sector. CVS currently has about 7,800 stores nationally (fewer than Walgreen’s) but their current market share is estimated at 58.1%. And they are in the midst of buying Target’s pharmacy business and another 1,700 units. This $1.9 billion deal is still under review by the FTC. Meanwhile, remember CVS also purchased drug services provider Omnicare in a $10.1 billion deal in May so not only are they growing bigger, they also effectively purchased one of their key suppliers in a move that is guaranteed to help their bottom line even further.

The biggest was about to get even bigger… that’s why this deal is happening now as opposed to… let’s say six years ago when Rite Aid was teetering on the verge and probably could have been bought out for a much cheaper price. All woulda, coulda, shoulda’s aside, the deal makes a lot of sense for both Walgreen’s and Rite Aid. It effectively combines the nation’s second and third largest drug store chains; Walgreens 31.0% market share is followed by Rite Aid’s 10.3%. Together their 41.0% +/- market share is a whole lot more competitive with CVS at 58.1%. But that, again, is based on simply combining the numbers of the two players. And, as I mentioned before, there is a pretty good chance that the FTC will require Walgreens to divest themselves of a sizable number of stores in order to clear the way for this thing to close.

To that end, in paperwork filed with the SEC, Walgreen’s has stated that they are willing to divest as many as 1,000 locations, or other holdings not to exceed an aggregate value of $100 million. How they would divest these locations is a challenging question. This deal effectively reduces the drugstore market in the US to a two horse race; CVS vs. the new Walgreens. Would CVS be in the market to buy 1,000 Walgreen’s locations? Maybe but that is probably a longshot. A deal to a private equity firm like what happened with the Family Dollar deal is more likely—assuming there is a player out there looking to get into the drugstore game as a very, very distant third place player. And you can’t rule out the possibility of some of this divestiture to be in the form of flat out store closures… but I wouldn’t expect much (if any) of that.

Walgreen’s currently has about 8,200 stores nationally. Rite Aid has just under 4,600 stores. The combined entity would have close to 12,800 total stores throughout the United States. Walgreen’s is in all 50 states. Rite Aid is in 31 states plus the District of Columbia. There are 14 states where this deal would double Walgreen’s current footprint; Michigan, Pennsylvania and New York lead the way but there is a decent amount of overlap in California, Ohio and a number of other major states. Meanwhile, there is little overlap in the critical markets of Florida, Illinois and Texas.

In my analysis of the data, comparing current locations for both chains, I found roughly 3,100 zip codes where there are two or more of either store type. There are actually about 400 zip codes where there are four or more of either brand. Something you also have to keep in mind is that while it has been nearly a decade since Rite Aid was in organic growth mode, Walgreen’s had been averaging anywhere from 200 to 300 new ground up stores annually until about two years ago. Both drug stores, at certain times and in certain markets, have employed the tactic of going head to head with their competition. I know of a couple of instances personally where Walgreens specifically chose sites directly across the street from existing Rite Aid stores where they felt they could snag market share. This is not an uncommon tactic among the biggest players for any retail category. But it certainly makes mega-mergers like this a little more challenging.

If we were to assume that the new Walgreens is forced to close, sell off or otherwise divest their ownership in 1,000 stores in order to make this deal happen… we are still talking about the new Walgreens having between 11,000 and 12,000 post-merger units. Let’s assume that this first step is handled perfectly in terms of strategy. That is, that Walgreens is able to shed 1,000 redundant stores across geographies in a way that enables them to spin these units off (which is a huge assumption, by the way). This still means that we could be seeing another 2,000 or more redundancies in the new system post-merger.

It is not unreasonable to assume that there may be as many as 3,000 existing Walgreens and Rite Aid stores today that will eventually be closed or sold off over the next few years as a result of this deal. This could play out with as many as 1,000 units before the deal closes and I estimate up to 2,000 more stores after the deal closes.

The post-merger Walgreens real estate imperative will be to minimize cannibalization. And this is where we get back to those 3,100 instances of multiple stores within the same zip code. In many instances we are talking about competing Rite Aid and Walgreens stores across the street from one another. Who will win in those instances? In most cases, it will be the Walgreens location simply because Walgreens sales per square foot are typically higher. But there is a critical real estate component here as well. Rite Aid has a lot of older stores in larger formats. While Walgreens has been actively growing with new stores typically coming in at (or near) 16,000 square feet (SF) for the past decade or more, it’s been a while since Rite Aid was in organic growth mode. The last time that they were in growth mode was a decade ago and their last big spurt of growth is going back 20 years. At that time they were chasing a larger format, with stores often well above the 40,000 SF mark. Remember this is going back to the late 1990s as the big box was becoming the dominant retail format and bigger was better. Fast forward to now and those stores are not only old and feeling a little tired, but they also are not as effectively merchandised and typically have much lower sales per square foot levels than their smaller counterparts even within the Rite Aid system. There will be a move to close the older, larger Rite Aid locations for the most part. Walgreens likes their smaller format and that is what they merchandise for.

So what does this mean? Are we looking at 1,000 Walgreens stores with an average size of 16,000 SF being shuttered in the next year or two or only to be followed by another 2,000 closures where the store sizes will be closer to 50,000 SF?

Probably not—it’s still unclear what the FTC will demand of Walgreens in terms of divesting itself. We don’t know a number and we don’t know if Walgreen’s might simply be able to sell off 1,000 units to another player in the market and we don’t see any real estate coming back to market up front. But a worst case scenario for the nation’s landlords would mean a potential 16 million square feet (MSF) of space that could come back to market. Doubtful, but possible.

But the post-merger redundancy closures I expect to probably come close to 2,000 units when all is said and done. Because I think the balance of these closures will fall more heavily on the Rite Aid side and will fall more heavily on older, large format stores I anticipate a considerable amount of space to be returned to the marketplace. The good news for landlords is that this will almost certainly happen over the course of years—not months. I believe that in most cases that Walgreens will seek to close these redundant stores as leases expire or they will strategically look to buy their way out of older leases. Additionally, we cannot rule out that the chain may find a way to sell off many of these redundancies. Who knows? Perhaps whatever private equity firm that buys the units the FTC forces them to offload for regulatory approval will be in the market to pick these up as well and we won’t see a ton of space coming back to market. My assumption, however, is that even if they are able to sell off some redundancies that we are probably still looking at a bare minimum of 1,000 closures in this second phase.

Let’s assume for Phase II that we are not talking about a mix of larger format and smaller format stores and that the average store size being closed is 25,000 SF. If we are talking about 1,000 closures; this is a whopping 25 MSF of space coming back to market. And if we are talking about 2,000 closures then we are talking about 50 MSF being returned to market. However, this is likely to be staggered over a number of years. I would anticipate at least five, if not possibly as many as ten.

In a worst case scenario where Walgreens is forced simply to close 1,000 units to get deal approval and then eventually ends up closing another 2,000 stores based upon the logic I just detailed… we could be looking at as much as 66 MSF of current drug store space going dark. But that scenario is highly unlikely.

What I think most likely is somewhere between 30 and 40 MSF of space gets returned to the marketplace; most of it over the course of the next six years. This certainly isn’t good news for retail landlords and those with larger Rite Aid stores in their shopping centers (particularly if there is a nearby well-performing Walgreens) have a lot to worry about. Not just because you are likely to lose this tenant, but because the pool of tenants looking to lease in the 40,000 to 60,000 SF range is infinitely smaller than those active in junior box spaces of 20,000 SF or below. But realistically, the return of an average of six to seven million square feet of space annually over the next few years will be something that the marketplace (on the whole) will be able to absorb. It’s not good news for landlords, but it’s not in the “sky is falling” territory either.

This post is commentary from the latest weekly edition of our Cushman & Wakefield Retail Newsline, which you can subscribe to for free by e-mailing garrick.brown@cushwake.com.

garrick-brownGarrick joined Cushman & Wakefield (formerly DTZ / Cassidy Turley) in October 2010. He serves as Vice President of Retail Research for the Americas. He speaks frequently at industry events and has been a keynote speaker at symposiums, conferences and market forecasting events for groups like the Appraisal Institute, Urban Land Institute, CREW, ICSC and PRSM. He is also a member of Lambda Alpha International, an invitation-only land use society for those who are involved in the ownership, management, regulation and conservation of land, but also those who are involved in its development, redevelopment and preservation.

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