Description

Disclaimer:  I think this is good trade, and half of the reason of the post is looking for pushback (we are risking ~ 3% of our equity on the idea) from those familiar.  Therefore, I'm not going to dress it up too much.  Feel free to vote against it as a membership submission requirement.

RAD is trading at $3.20 today, which is a large discount to the $6.50 cash price of its merger with Walgreens.  The merger was signed back in 2015 at $9.00, and was recently cut to $6.50 after RAD's results deteriorated, WBA was required to divest more RAD stores that expected, and the original deal had reached its end date after extended antitrust review.  The merger is pending before the FTC and the parties have certified substantial compliance thereby forcing the FTC to make a decision.  The FTC will make a decision by July 7.  I expect to hear something any day.

The market is implying a roughly 20% probability that the FTC approves the RAD / WBA merger.  I believe this probability is far too severe given the competitive nature of the combination and the unprecedented state of the FTC at with two sitting commissioners  (https://www.wsj.com/articles/as-seats-go-unfilled-on-federal-panels-businesses-face-uncertainty-1496589147) where the Republican is acting chair.  No formal chair appointment or additional commissioners are expected in the very near term.

My personal odds of approval are over 50%, but even if I am completely wrong I think it is hard for the "intrinsic" expected value to much below RAD's stock and call option prices.

For example, the July $5.00 calls are trading at 25c.  Make $1.25 net vs. lose 25c net = 17% EV-neutral probability of FTC approving and deal doing through at $6.50.  This is rough math, as the proxy is not yet definitive so there would be some holding period after expiry.  Note there are also intermediate scenarios involving litigation or price cuts where the deal could still happen so it's not a perfect gauge relative to the implied odds of the stock.  With the deal in the hands of a single Republican, 20% probability (in either direction) is too convicted.

The sole Republican and acting chair is a longtime commissioner and a centrist.  On antitrust matters, the only time she has bucked voting with the majority was dissenting from the U.S. Foods / Sysco lawsuit.  Her votes to block mergers have occured when the parties were merging into fairly obvious monopolies:  multiple regional hospital mergers, SPLS/ODP (hat tip to the VIC write-up predicting the block on grounds of monopoly in contract business), and Fanduel/Draftkings (daily fantasy sports).  I see no analogues to the competition issues in RAD/WBA, where WBA competes against CVS in everything plus WMT, mail-order pharmacies, etc.

The FTC is hamstrung by having only two commissioners because it takes a majority to do anything:  bring lawsuits, approve consent orders, dismiss lawsuits, etc.  Ohlhausen (R) and McSweeney (D) are opposed on many matters pending before the commission including the recent FTC lawsuit against QCOM and proposed settlement offers by DTV.  Therefore, nothing can happen unless both are on board 2-0.  It is fair to assume that McSweeney will not vote to approve the WBA divestiture to FRED, and many reports have indicated the FTC Staff will also recommend against.  Therefore Ohlhausen is in a tricky spot if she wishes to approve the deal.  Without McSweeney's vote, WBA could close without a legally enforceable consent order.  While there are precedents for this (2000 - 2001 the commission was deadlocked 2-2 after recusals on both Quaker/Pepsi and General Mills / Pillsbury and both deals proceeded with divestitures without a formal consent order), FRED's is a rickety acquirer of RAD assets so it is probably a bad idea.  If she is unwilling to proceed on a 1-1 basis w/o an enforceable consent order, she might vote with McSweeney to authorize a lawsuit but indicate she finds WBA's divestiture acceptable but must wait for a Republican majority in the commission to resolve this and other matters (like QCOM).

The competition issues seem low to me here.  Front of store, RAD and WBA are basically expensive convenience stores.  In the pharmacy, approx. 98% of their revenues source from third-party payors like PBMs and insurers.  For pharmacy cash-paying customers, cash prices vary widely by drug and store and there is little evidence of stores impacting each other's cash pay prices.  Anyway, at 1200 stores WBA is divesting 26% of RAD's store base and is resolving local markets with high pro forma concentration.  Some articles have cited that the combination will increase market power against PBMs and payors, but there appears to be an industry trend of greater penetration of preferred pharmacy networks inside these plans where the pharmacies trade drug margin back to the sponsor in exchange for greater foot traffic with the aim of capturing front-of-store sales (and customer data).  WBA has been especially competitive bidding for preferred status, as evidenced by its almost universal status as a preferred pharmacy in the large Medicare Part D plans, but it will still be bidding against CVS.

Rite-aid has deteriorated during the 18 months of the deal.  It is highly levered and has generates little FCF, though there are no significant maturities until 2020.  I think there could be significant severity in the stock, so I think various strikes/expiries of WBA are interesting ways to express the views here.  I assume RAD falls 50% if WBA walks, although there is a case that RAD stock at that level holds significant optionality to the mgmt team no longer operating under the constraints of the merger agreement.

Catalyst

FTC approval