Hurdles for Walgreens could tilt Longs balance in CVS’ favor

NEW YORK Investors were taken by surprise Friday evening when Walgreens stepped in with an offer to snap up Longs Drug Stores for $75 per share—a 5 percent premium to CVS Caremark’s bid. Now that the dust has begun to settle, some industry observers are expressing concern that such a deal could represent regulatory hurdles for Walgreens and result in substantial store divestitures.

As previously reported by Drug Store News, Walgreens stepped in with an unsolicited bid to buy Longs for nearly $3 billion in cash and debt assumption, a move that aims to quash a takeover agreement Longs management had already approved with CVS.

CVS—which is no stranger to acquisitions—announced in mid-August that it plans to buy for $2.9 billion, including debt, Longs’ 521 retail locations in California, Hawaii, Nevada and Arizona, as well as its PBM services.

While Walgreens offer, which is subject to regulatory approvals and the completion of due diligence, represents a $3.50 per share premium over the cash purchase price to be paid to Longs shareholders under the proposed acquisition by CVS, the bid from Walgreens has raised the eyebrows of several industry analysts.

“Walgreens has significant overlap with Longs and the transaction would result in combined market share greater than 50 percent in 20 of the 33 markets in which Longs operates. We estimate that the company could be required to divest up to 10 percent to 15 percent of Longs stores,” stated Credit Suisse analyst Edward Kelly in a recent research note. Kelly predicts that divestitures could reduce gross synergies by $30 million to $40 million.

Furthermore, Walgreens would be required to pay—if the deal were successful—a $115 million breakup fee related to CVS’ proposed offer.

Commented Morgan Stanley analyst Mark Wiltamuth in a research note, “As with the CVS offer, we believe this transaction would be modestly dilutive to near-term EPS for Walgreens, but the Walgreens’ deal (and dilution economics) faces the added uncertainty of significant store divestitures that may be required to satisfy antitrust regulators.” Wiltamuth stated in the note that “CVS could have the advantage in bidding for Longs as it does not face the problem of store divestitures” and has passed Hart-Scott-Rodino regulatory hurdles. On Sept. 5, the waiting period under the Hart-Scott-Rodino Antitrust Improvement Act expired, satisfying a condition to the closing of CVS’ offer.

Wiltamuth noted that, in a letter to Longs, “Walgreens has set an upper limit of store divestures totaling up to 40 percent of Longs’ operating profit. We assume this would be a worst case scenario, but it is indicative of the potential size of the divesture required.” Echoing the sentiment, SunTrust Robinson Humphrey analyst David Magee stated in a research note, “If Walgreens is successful, it will most likely have to close more stores than CVS. Of the top 14 markets in California, totaling some $30 billion in sales, we estimate that there is serious overlap in about one-third of the markets. So, given that Longs has about 450 of its 500 stores in that state, there are roughly 150 stores in those areas of major overlap. Going further, perhaps up to 75 of those stores (or 15 percent of the overall Longs chain) could be considered candidates for closure.”

The news of the Walgreens bid has also sparked speculation as to whether CVS will sweeten its offer even though Tom Ryan, chairman, president and chief executive officer of CVS, maintains that it will “stand firm on our price.”

Following the news of Walgreens’ bid, Standard & Poor’s Ratings Services announced on Monday that it placed its ratings on Walgreens, including the ‘A+’ corporate credit and ‘A-1’ short-term ratings, on CreditWatch with negative implications.

“The CreditWatch placement reflects Walgreen’s more aggressive financial policy, the expected increase in debt leverage to fund the acquisition, and its limited track record in integrating large acquisitions,” explained S&P credit analyst Ana Lai.

Also on Monday, as Drug Store News reported, S&P’s Rating Services stated that Walgreens’ competing higher offer has no effect on CVS’ ratings.

“Although it is uncertain whether CVS will make a revised offer for Longs, an upsized offer funded with incremental debt that results in total debt to EBITDA increasing to pro forma debt leverage of over 3.4x from 3.2x currently could result in an outlook revision to negative. However, this would require a significant amount of additional debt and we do not view this as likely,” S&P stated.