WBA could simply close 1,000 (or more) RAD outlets and still have an accretive deal that meets its strategic needs (of defending gross margins as pharmacy networks narrow)

Richard
Print Friendly
Share on LinkedIn0Tweet about this on Twitter0Share on Facebook0

SEE END OF THIS REPORT FOR IMPORTANT DISCLOSURES

Richard Evans / Scott Hinds / Ryan Baum

203.901.1631 /.1632 / .1627

revans@ / shinds@ / rbaum@ssrllc.com

@SSRHealth

January 26, 2017

WBA could simply close 1,000 (or more) RAD outlets and still have an accretive deal that meets its strategic needs (of defending gross margins as pharmacy networks narrow)

  • The strategic point of the WBA/RAD combination is to defend against gross margin pressures brought by narrowing retail pharmacy networks
  • The percent of the US population living in an area from which a chain cannot be excluded from a pharmacy network that complies with common proximity standards is the best index of how well positioned a chain is to resist narrowing networks. For WBA alone this figure is 30.7%, and for CVS the figure is 31.7%. For a WBA/RAD NEWCO that divests 865 RAD outlets, that figure is between 39.9% and 40.7%
  • The percent of the US population living in an area from which WBA/RAD cannot be excluded from proximity compliant networks is remarkably insensitive to the number of outlets divested, and to the question of whether or not those outlets remain in operation. For example if WBA/RAD divested 1,000 RAD outlets, the percent of persons living in an area from which WBA/RAD cannot be excluded falls by at most 1.9%. The simple point is that WBA/RAD can afford to shed many more outlets, and still meet their strategic objective
  • The 865 outlets slated for divestiture to FRED well exceeds the number required to meet the FTC’s usual 35% limit on share of outlets by metropolitan statistical area (MSA). The fact that FTC has not agreed to the merger at such a high level of divestiture implies either that they’ve moved the goalposts, or that they don’t believe FRED can keep the acquired outlets open
  • On the chance that FTC’s concern is the latter, we note that WBA/RAD can afford to simply close well more than 1,000 of the acquired RAD outlets and still have an earnings-accretive deal at the $9 cash bid, based solely on the fact that RAD outlet margins are likely to move toward (but not completely to) the higher levels of their WBA siblings post-deal. And, this is before considering the very high likelihood that the NEWCO would have higher gross margins over time than WBA alone

The strategic motive for the WBA/RAD combination survives even higher levels of outlet divestiture / closure

The strategic usefulness of the WBA/RAD merger is to give the NEWCO a means of better defending against the price erosion associated with narrowing pharmacy networks. We believe the best means of benchmarking how well the NEWCO achieves this aim is to measure the percent of the US population that lives in an area from which WBA today, or the WBA/RAD NEWCO tomorrow, cannot be excluded from a ‘proximity-compliant’ retail pharmacy network

By ‘proximity-compliant’, we’re simply referring to the commonly observed proximity standard that requires networks to offer at least one in-network pharmacy within a given distance of 90% of beneficiaries. For urban beneficiaries that distance is 2 miles, for suburban 5 miles, and for rural 15 miles. An area from which WBA or WBA/RAD cannot be excluded is one in which the proximity standard cannot be met without including either WBA or WBA/RAD in the pharmacy network

For WBA alone, 30.7% of the US population lives in an area from which WBA cannot be excluded from a proximity compliant pharmacy network (the figure for CVS is 31.7%). For WBA/RAD, assuming the divestiture of 865 outlets to FRED, that percentage rises to somewhere between 39.9%, and 40.7%, depending on whether, in areas that WBA is required to divest RAD outlets, it divests the RAD outlet serving the greatest number of persons (39.9%), or instead divests the RAD outlet serving the least number of persons (40.7%)

Notably, the gain in percent of persons living in an area from which WBA/RAD cannot be excluded is fairly insensitive to the number of outlets divested (or closed), and also to whether the outlets are divested or closed outright. Exhibit 1 shows, for four levels of store divestiture (by row) how this key percentage changes. And, the exhibit shows (by column) how the percent changes based on whether we assume the outlets are sold (columns 2,3) or closed (columns 3,4), and on whether we assume the RAD outlets with the highest (columns 3,5) or lowest (columns 2,4) population densities (in a given area from which divestiture is required) are sold or closed

If FTC had required divestitures in line with past practice (maximum 35% outlet share by MSA), and had assumed the divested outlets remained open, the expected divestiture number would have been 426, at which point the share of persons living in areas from which WBA/RAD cannot be excluded would become 41.3% to 41.7%. If instead the FTC had applied the 35% share of outlets limit assuming all stores divested would close, the divestiture count rises to 616, and the share of persons living in areas from which WBA/RAD cannot be excluded becomes 40.7% to 41.4% … at most a 0.6% drop. The current ‘bid’ for number of outlets divested is 865, at which level the share of persons living in areas from which WBA/RAD cannot be excluded becomes 39.9% to 40.7% … at most a 1.4% drop from the ideal (426 outlet) case. Finally, if we assume WBA/RAD divests a full 1,000 outlets, the share of persons that cannot be excluded value falls only to 39.4% to 40.4% … at most a 1.9% drop from the ideal case

The simple conclusion is that the true motive for the transaction is largely insensitive, within a practical range, to the number of outlets that need to be divested, and to whether or not the outlets continue operating

WBA/RAD could simply close 1,000 RAD outlets – without selling them to anyone – and still have an accretive deal at the $9 cash bid

Because the number of outlets slated to be sold to FRED so dramatically exceeds the number required to get WBA/RAD below the FTC’s traditional 35% outlet share figure, the commission’s hesitation to approve the merger may hinge on questions of whether FRED can keep the divested outlets operating – more specifically whether FRED will be over-extending itself by paying for the RAD outlets. Setting aside the very real opportunity for WBA to address these concerns by improving the terms under which the outlets are sold, we analyzed a last ditch alternative for WBA – simply closing the requisite number of outlets without selling them to anyone

The operating margins of RAD outlets are well below those of WBA outlets. This will be for a number of reasons, some of which are addressed by the transaction (procurement efficiencies) and some of which are not (desirability of locations). We feel strongly that much of the operating margin deficit will be closed, which is a powerful driver of potential accretion

More specifically (Exhibit 2), we analyzed the earnings accretion (y-axis) that would occur if RAD simply closed a given number of outlets (x-axis), under any of 4 scenarios: the difference between RAD outlet margins and WBA outlet margins closed by 25%, 50%, 75%, or 100% of the current operating margin gap. As an example, if we assume the lower margin RAD outlets expand their operating margins so that they close 50% of the gap to WBA outlets’ higher margins, we find that WBA could afford to shutter 1,590 RAD outlets before losing the positive earnings accretion achievable at the $9 cash bid. Crucially, these accretion calculations make no provision for the impact of the WBA/RAD combination on the NEWCO’s gross margins – and because the NEWCO plainly will be better able to defend its gross margins than WBA as a stand-alone, the true accretion impacts of the combination are likely to be substantially more generous than those shown in Exhibit 2

©2017, SSR, LLC, 225 High Ridge Rd, 2nd Floor, Stamford, CT 06905. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein. The views and other information provided are subject to change without notice. This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results. In the past 12 months, through a wholly-owned subsidiary SSR Health LLC has provided paid advisory services to Pfizer Inc (PFE), BioPharmX (BPMX), Gilead Sciences (GILD), Bristol-Myers Squibb (BMY) and Sanofi (SNY) on both securities-related and non-securities-related topics

Print Friendly