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A Botched Merger Sent Rite Aid's Shares Reeling 16% In June

What happened

After Walgreens Boots Alliance (NASDAQ: WBA) threw in the towel on plans to acquire Rite Aid (NYSE: RAD), Rite Aid's shares tumbled 16.4% to end June, according to S&P Global Market Intelligence.

So what

In a bid to win over regulators, Walgreens and Rite Aid renegotiated their merger agreement in January to involve fewer stores; however, that wasn't enough to convince regulators that this combination should be approved, so the two companies scuttled their merger in favor of a scaled-down agreement on June 29.

IMAGE SOURCE: GETTY IMAGES.

Now, rather than buy Rite Aid lock, stock, and-barrel, Walgreens hopes to buy 2,186 Rite Aid stores for $5.18 billion in cash.

Walgreens says the deal will be accretive to its earnings; however, it's unclear how Rite Aid will perform as a much smaller company, especially since it has struggled lately to generate earnings. Falling profit margins on generic drugs, fewer prescriptions being filled, and shoppers picking up fewer items during their visits caused Rite Aid to lose $0.02 per share in its fiscal fourth quarter and an additional $0.05 per share in its recently reported fiscal first quarter.

Now what

Bulls will argue that a leaner Rite Aid with improved cash flow from paying off debt can reinvest in itself and achieve consistent profitability. This argument is supported by management's plan to use money from Walgreens to cut its leverage in half. Management can also cut expenses by executing an option that allows it to buy generic drugs at the same cost as Walgreens for the next 10 years. 

Bears, however, aren't convinced that the FTC will approve the new store sale deal or that, if it does, Rite Aid can thrive as a smaller company. They have reason to be skeptical. Pharmacy retail is very competitive, and price compression has significantly favored larger competitors in the past.

Perhaps, however, the sell-off in Rite Aid shares is getting overdone. Rite Aid's shares closed below $2.50 yesterday, and that gives it a sub-$3 billion market cap. An argument can be made that this price undervalues Rite Aid's pharmacy services business, Envision Rx. Rite Aid paid $1.8 billion, plus stock, to buy Envision Rx in 2015, when its sales were $4 billion. This year, Envision Rx's sales are tracking at a $6 billion pace. Express Scripts, the biggest pharmacy services business, trades at a price-to-sales ratio of 0.40, and if we apply that ratio to Envision Rx, then it's arguably worth $2.4 billion on its own. 

Nevertheless, Rite Aid's future is murky, and investors, understandably, hate murky. Therefore, Rite Aid will remain a high-risk stock, at least until regulators give their latest revised deal with Walgreens their blessing. 

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Todd Campbell has no position in any stocks mentioned. His clients may have positions in the companies mentioned. The Motley Fool owns shares of Express Scripts. The Motley Fool recommends CVS Health. The Motley Fool has a disclosure policy.