By Allison Collins
with contributions from Faye Brookman
 on June 29, 2017
A Walgreens location in New York.

Walgreens and Rite Aid have inked a new merger agreement that will leave Walgreens with fewer Rite Aid locations, but still increase the company’s  presence in the Northeastern U.S.

“We were relatively weak on the East Coast, so this was our main objective – particularly in the Northeast,” said Walgreens Boots Alliance chief executive officer Stefano Pessina. “Would we like to have a few hundred stores more on the West Coast? Yes of course … but at the end of the day, our presence there is already stronger than it is in the Northeast.”

Under the terms of the new deal, Walgreens will buy 2,186 Rite Aid stores, three distribution centers and related inventory for $5.18 billion. The business will assume related real estate leases and other liabilities. Originally, Walgreens proposed a $9.4 billion merger in October 2015. That transaction faced scrutiny from the Federal Trade Commission, and Walgreens devised a plan to divest 865 of the Rite Aid stores to Fred’s Pharmacy.  That deal is now off.

“When we first began discussions with Rite Aid, it was a vision of increasing our network,” Pessina said on the company’s earnings call Thursday. “This transaction, though smaller than the original, is true to our original strategic aim.”

Neil Saunders, managing director of GlobalData Retail, called the cancellation of the original deal “unsurprising.”

“While this will still be subject to FTC scrutiny, it will, at least in theory, be easier to gain approval because it avoids the dilution of store competition in some markets and leaves Rite Aid as a viable player in the pharmacy space,” Saunders wrote in an analyst’s note.

Walgreens will need to pay a $325 million termination fee to Rite Aid. The transaction is expected to result in more than $400 million in synergies over the next three years.

“For Rite Aid, the deal is a good one. The proceeds of Walgreens’ payment will allow it to reduce debt and restore its balance sheet to health,” Saunders continued. “After the deal, the group will have 2,337 stores – around half the number it has now. This will be punishing on economies of scale, especially for a company that is already struggling to turn a profit even before interest payments are taken into account. The answer lies in the agreement with Walgreens, which will allow Rite Aid to become a member of Walgreens Boots Alliance’s group purchasing organization. In our view, this will be highly beneficial and will allow Rite Aid to improve pharmacy margins drastically.”

The merger deal, originally announced in October 2015, has dragged on and hindered some efforts for both chains as far as beauty, suppliers said.

Pending approval of the Walgreens’ plans, Rite Aid can get back to business building upon what it started, suppliers from beauty companies said. Also, with an ever-compressing number of chains, keeping Rite Aid in the mix offers brands another chain to help expand distribution. A benefit to Rite Aid is that a smaller core of stores can continue to open up avenues to elevate the experience as first unveiled a few years ago in Rite Aid’s Wellness Stores format.

Many of those doors have curated beauty brands not found in typical drugstores. For example, some Rite Aid’s stock a fan favorite indie called Senna cosmetics as well as the on-trend Eddie Funkhouser brand. Other enhancements Rite Aid has made include large and well-stocked nail bars, separate men’s departments and natural lines such as Éclair Naturals.

 Those familiar with the stores Rite Aid is expected to retain said they are mostly on the West Coast and are among the most productive. “Rite Aid will be on much better financial footing and can rebuild,” said one supplier to the beauty department.

No matter what, Rite Aid is expected to oversee all of the stores, even those slated to be sold, for at least the next two years.

The merger shift came at the same time as Walgreens’ third-quarter earnings, in which it posted gains in sales and earnings.

Net earnings were up 5.3 percent to $1.2 billion for the quarter, while diluted net earnings per share increased 5.9 percent year-over-year to $1.07. Net sales increased 2.1 percent to $30.1 billion.

For the first nine months of the fiscal year, net earnings increased 4.2 percent year-over-year to $3.3 billion, with diluted net earnings per share up 4.9 percent to $3.02. Sales dipped 0.7 percent for the first nine months of the fiscal year versus the year-ago period, but were up 2.3 percent on a constant-currency basis.

Walgreens raised the lower end of its fiscal 2017 guidance by 8 cents a share, and now expects adjusted diluted net EPS of between $4.98 and $5.08.

Walgreens executives called out beauty and wellness as a bright spot for the company’s retail operations on the earnings call (U.S. retail operations were down 1.8 percent in the quarter, in part due to the closures of Drugstore.com and Beauty.com). The business opened its first Boots franchise in South Korea in April, which chief financial office George Fairweather called “strategically important for sourcing innovative products.”

In the U.S., Walgreens is on track to expand its enhanced beauty offering into 1,000 more doors by the end of 2017. In addition to expanding its beauty offerings, Walgreens is focused on simplifying them, according to Alex Gourlay, co-chief operating officer.

“We’re moving into a phase beyond the beauty differentiation phase of simplifying our core offering, and rolling it out to 1,000 stores by the end of the year,” Gourlay said.

“After that we will have another phase, which will be based on technology,” Pessina said. “We are making big investments, big efforts, in updating our technology. We will have a completely new system in a few years…at that point, we’ll be able to make another jump in the organization of our stores.”

 

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