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Could a Reckoning at Rite Aid Spark an Amazon.com Acquisition?

Rumors are swirling that Amazon.com (NASDAQ: AMZN) may have its sights set on getting into the prescription drug business. If so, then recent news that Walgreens Boots Alliance (NASDAQ: WBA) is giving up on its attempt to buy Rite Aid (NYSE: RAD) outright may provide Amazon.com with a simple way to scale quickly in this more than $300 billion market. Can Rite Aid survive on its own? And could Amazon.com come knocking on its door? Analyst Kristine Harjes is joined by investor Todd Campbell to discuss that (and more!) in this week’s Industry Focus: Healthcare podcast.

A full transcript follows the video.

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This video was recorded on July 5, 2017.

Kristine Harjes: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's July 5th, and I'm your Healthcare show host, Kristine Harjes. I'm on the phone today with Todd Campbell, a fool.com healthcare specialist. Todd, how was your Independence Day?

Todd Campbell: It was great, I was actually up in northern Maine in the quaintest little village. They did a parade that was basically just people walking down the street led by a drum major to a brass band.

Harjes: That sounds awesome.

Campbell: It was, it was so down home.

Harjes: Was there anybody around to watch the parade, or was the whole town in it?

Campbell: There [were] at least 15 people on the sidelines.

Harjes: Solid, good turnout.

Campbell: [laughs] But, it was a very nice Fourth of July. Didn't get to see any fireworks, though, how about you?

Harjes: I saw enough for the both of us. I live in D.C., so you kind of have to.

Campbell: Oh. I could hear them from afar, but those dreaded pine trees were blocking my view.

Harjes: Oh, man. Maybe next year, come visit HQ, we'll watch some fireworks.

Campbell: There we go.

Harjes: I don't know about you, but I'm actually very happy to be back after the long weekend. I'm kind of happy to just be back in the office and in the studio. For the show today, we're talking about retail pharmacies. Rite Aid and Walgreens' attempts to make a deal were all over the news last week, before we took a hiatus for the long weekend, so we're going to digest these headlines for you all, and then talk about the pharmacy space at large. Sound good, Todd?

Campbell: Yeah, there were a lot of fireworks last week, related to this merger, right?

Harjes: That's a good way of putting it.

Campbell: It's unfortunate, I know a lot of listeners are probably looking at it and saying, "Please tell me something good." This was a deal that was supposed to go through, it's hopefully going to go through. Back in 2015, investors were thinking they were going to get $9 a share --

Harjes: For Rite Aid?

Campbell: Yeah, for Rite Aid, Walgreens offering over $9 billion to acquire the company, lock, stock, and barrel. Now, Rite Aid shares sitting below $3, you need to triple before you get back to those levels, and it's all about the FTC. And to mix a bunch of metaphors together, no joy in Mudville last week, the FTC has struck out the Rite Aid-Walgreens merger.

Harjes: Right. Digging through the timeline here a little bit, as you said, back in October 2015, that's when you had the original deal that was announced. That was since revised because the FTC was like, "No, you guys can't just get together, there wouldn't be enough competition in this space," which is perhaps not surprising when you consider that, between CVS, Rite Aid, and Walgreens, they completely dominate the retail pharmacy space.

Campbell: It's crazy, Kristine. You have this top tier, because of consolidation over the last decade, of players that includes those three that you just mentioned, plus, Wal-Mart is a big player in that, too. But if you conclude just that top tier, they control two-thirds of market share in prescription drug volume by revenue. And that's just an amazingly consolidated industry to be trafficking in. And that's why, obviously, the FTC was concerned that pairing these two companies up together might be a problem.

Harjes: Right. So, the two to revise their agreement down to an acquisition price of between $6.50 to $7.00 per share of Rite Aid, depending on how many of the Rite Aid stores were divested. That was going to be between either 1,000 and 1,200 stores sold to a company called Fred's, so that $6.50 to $7.00 range was dependent on how many stores, between 1,000 and 1,200, were divested.

Campbell: Yeah. I felt like this whole deal was all about, "What if we try this? What about this?" And they just kept throwing darts at the wall, hoping that the FTC would say, "Oh, that works for us." But no.

Harjes: Yeah. That was plan B. Last Monday, Rite Aid shares soared 30% on news that the merger is more likely than not to be approved by the FTC coming up ahead of their deadline of July 7th. But, now we're on to plan C because the deal fell apart again.

Campbell: Yeah. Rumors and innuendo, don't buy stocks because of them. This is a prime example of, you never know if a deal is going to close until the deal closes, especially when you're talking about a very competitive market like pharmacy and pharmacy retail. Walgreens is the second largest player in terms of retail pharmacy market share with about 13.8%, Rite Aid clocks in about 5%; combine the two together, and they come out to about 19% market share in retail pharmacy. Obviously, that was too concentrated for the FTC to go ahead and say, "Yeah, we're OK with it." So, back to the drawing board for yet another try at a very different deal.

Harjes: Right. So, now the deal is that Walgreens will acquire around half of Rite Aid stores, 2,186 of them, and they'll get some other things like inventory as well. In return, they will give Rite Aid $5.175 billion in cash, and Rite Aid will also receive a $325 million merger termination fee.

Campbell: Yeah. Thank goodness that they were able to at least get this deal -- well, it's not approved yet -- but, to announce this deal at the same time that they announced Walgreens was abandoning the prior bid, because who knows where the share price would have gone on Rite Aid.

As a refresher, to go back in time for investors, Rite Aid took on a tremendous amount of debt back in the late 2000s to expand, because they recognized, "If we want to keep up with CVS and Walgreens, we need to grow our footprint, build up our buy power." So, they did a lot of acquisitions, but unfortunately they did those acquisitions with debt, that debt was costly, and it really hamstrung them. For Walgreens to step in and say, "We'll buy you, including all the problems you may have profitability wise," was great. Now we're looking at a situation where those problems still exist, there's still a tremendous amount of debt on the balance sheet, you have some questions regarding how bloated corporate expenses are relative to some of their other retailing peers -- there's a lot of things that make people nervous about this company surviving or thriving against CVS and Walgreens on a stand-alone basis. Some may be unfounded, though.

Harjes: Yeah. I actually kind of like where this leaves Rite Aid. As you mentioned, they're sitting on a ton of debt, it's over $7 billion last time I looked. Right now, when they get $5 billion-plus from Walgreens, a lot of that is going to be able to de-lever them and help bring down interest expense. They paid $432 million in interest expense just last year. So, I like this shift in strategy from them, where they're not going to be trying to take on a bunch more debt to expand their footprint. In fact, they're doing the opposite. They're selling these stores to Walgreens so that they can actually focus on their own profitability. And, this is an important thing to note, they also have a PBM business, EnvisionRx is their pharmacy benefits management business, and that's going to become a more important segment of Rite Aid now that they don't have as many stores to worry about.

Campbell: Yeah, it's almost like, we gave you the bad news, now maybe here's the good news, the silver lining, what could go right in the playbook for Rite Aid as you go forward. Without a doubt, like you said, EnvisionRx is a big part of that, because the pharmacy benefit management business is a higher EBITDA generating as a percentage of sales, it's more profitable than the retail store business. So, you're going to get a shift in revenue mix that would theoretically provide a tailwind to the company's profitability once this deal closes -- assuming, obviously, the FTC doesn't block it.

The FTC could still halt this deal in its tracks, so people should be aware that risk still exist. It doesn't yet have the blessing of the regulators. If EnvisionRx is able to continue to grow against some very large players, including Express Scripts and CVS Health, UnitedHealthcare has a PBM business as well, then theoretically, an argument, I think, could be made that investors are overreacting with how much they've driven down the share price. If I just look at price to sales for Express Scripts, it's about 0.40 right now. If I look at the fact that the EnvisionRx business is going to do $6 billion in sales, you could make an argument that that's worth $2.4 billion, and the market cap of Rite Aid right now is about $2.7 billion. So, would you pay $300 million for 2,000 stores? I would.

Harjes: Yeah, absolutely. That's a really interesting point. Before we take a break, what about Walgreens in this situation? Where does this leave them?

Campbell: Walgreens, I think, is a winner in this. Theoretically, they've got to go through, look at their entire footprint, figure out what stores they could get from Rite Aid that would dovetail perfectly within their own model. They say they're going to be able to make this deal accretive within one year. They think they can carve $400 million in synergies, i.e., cost savings, layoffs, whatever, out of this deal. So they're going to make money on this deal. So, from Walgreens' perspective, we don't get the problems, we don't have to buy the problems, we can just buy the stores we want, walk away, and theoretically this makes us bigger, stronger, and even more profitable. So, I think they are a winner. Rite Aid is more of a mixed bag, because you're looking at it and saying, how much of the debt will we pay off? Will we be lean and mean enough to be able to survive and thrive as we go forward? There is something else, though, Kristine, that we didn't mention, and we should probably touch on really quick, and that's the ability to piggyback on Walgreens' buying power.

Harjes: Oh, yeah, this is an important detail, here. I'll let you go into the details, but essentially, Rite Aid can still buy drugs at cost from Walgreens affiliates for up to 10 years.

Campbell: Right. One of the big reasons that Rite Aid stores have suffered profitability-wise has been a lot of payback and compression on margins in the back end of the store, the pharmacy business at the retail stores. And a lot of that has come from generic drugs, which are obviously lower-cost, lower-margin drugs, and they represent 90% of all prescriptions written. So, the ability to team up and piggyback on Walgreens' purchasing power -- because Walgreens is much larger and they get much better deals on these drugs -- theoretically, that should boost store profitability. There [are] also opportunities to boost store profitability by investing in RediClinics, which are in-store clinics that could drive additional volume there as well, and doing remodeling. They have about 60% of their footprint will be updated to the most recent model that they like, the format that they like, the wellness format, and I assume they'll double down and get the rest of that 40% upgraded to those stores, too.

Harjes: We talked a little bit about what is next for these major retail pharmacies, but we left out the risk that they will be disrupted entirely. It may come as little surprise that Amazon is a threat to the front-of-store sales in the brick-and-mortar stores, but the threat doesn't stop there. Amazon could effectively compete with these companies' entire operations, and it's not as far-fetched as it seems.

Campbell: Amazon is, without a doubt, one of the most innovative and aggressive retailers out there, and they have successfully disrupted business after business after business. In May, some people and some chatter started about it potentially getting into the pharmacy retailing business. Again, this is rumor, and we don't want to buy stocks based on rumor. However, there is some smoke that could indicate there's fire here to the idea that Amazon might try and figure out a way to either use its newly acquired Whole Foods stores to help with prescription fulfillment somehow, as delivery centers or pickup centers, and there is some other evidence that they're making a push into the pharmacy benefit management business, which we talked about a little bit earlier in the show, for their own use, and that they could theoretically open that pharmacy benefit manager up to anyone, to all sorts of employers across the nation.

Harjes: And that's so Amazon of Amazon, to do it like that, where they create something for their own internal usage and then flip it to be external-facing, where anybody can come in and use it then. And they're so good at doing this. In fact, actually, this reminds me of an article I read recently in TechCrunch called "Why Amazon Is Eating The World." If anyone listening is interested in this article, it was a really amazing deep dive into how Amazon is poised to win everything because of this model of developing things internally and then exposing them externally. Anyway. Specifically about the PBM, Amazon has 128,000 employees. CNBC reports that they're creating an internal pharmacy benefits manager for those employees. This is a business where scale is everything. Margins are slim, efficiency is huge. So, when you look at Amazon, that sounds exactly like something Amazon could win. They're amazing at supply chain efficiencies, all their sourcing, and their distribution. If they're able to harness that kind of scale and those efficiencies, I can really see them competing in this space.

Campbell: With that many employees, you know you're spending a heck of a lot of money on healthcare. So, from an internal perspective, developing your own pharmacy benefits manager -- as a refresher, what those pharmacy benefit managers do is negotiate for lower drug prices with the drug manufacturers and the distributors. So, the bigger scale you have, the better price you can get. Amazon is a huge employer, and it's probably not lost on them that if they took their size and paired it up with some of the other large employers in the country, maybe we can really get their expenses to drop when it comes to healthcare cost.

So, there is reason to think that without a doubt, they're doing the PBM. They already hired somebody earlier this year, that's a fact. Based on just looking at LinkedIn profiles, I found a gentleman named Mark Lyons, who used to work for Premera Blue Cross, which handles or ministers the health insurance program for Amazon employees, they hired him to theoretically develop this pharmacy benefit manager. There's also been some talk of job postings out there for other positions that would also be tied into developing this pharmacy business of some sort. So, I think that's a very intriguing angle for them. I don't think it would be out of the question for them to try and pursue it. They're going to have to overcome some regulatory hurdles anyway internally, so why not leverage all of those lessons learned to expand it more broadly? Also, Kristine, it shouldn't be ignored that over in Japan, where, of course, you have a different regulatory framework, they're experimenting by doing some partnerships with pharmacies in major population centers where you can order your prescription online, have it validated by a pharmacist, and then you can go pick it up at the pharmacy. That way, that model, is kind of similar to a deal that Amazon had with drugstore.com way back in the day. Kristine, do you remember drugstore.com?

Harjes: I do not.

Campbell: This was the internet heyday, late 1990s, "Wouldn't it be great if we could order things online like our prescription medicine?" It came out at around the same time that mail order pharmacy was really starting to become a big thing. Amazon took a 40% stake in drugstore.com, and drugstore.com had a 10-year supply relationship with none other than Rite Aid. So, it's interesting to think that Bezos was on drugstore.com's board, that Amazon was a big investor in this early on play, and that there was already some familiarity with Rite Aid via that deal. Now, I don't want to start flaming the fire that maybe Amazon would come knocking on Rite Aid's door, but it did dawn on me that Rite Aid already has EnvisionRx, and Amazon has shown it has an interest in retail store footprints by buying Whole Foods. So, why couldn't you just buy the PBM business from Rite Aid, plus the stores, and voila, you're in the pharmacy business.

Harjes: Yeah. I could see that. Obviously, you and I are just speculating, here, but I would be really interested to see a map of the store footprint overlay of Amazon distribution centers, plus the Whole Foods stores they just acquired, plus existing Rite Aid stores that are not going to end up being sold to Walgreens. I don't think you actually even know that last part yet, I don't think they've cherry-picked just yet which stores they would actually take. That's probably contingent on this deal actually being approved by the FTC.

Campbell: It's going to actually be rolled out, Kristine, in phases. They're going to take some stores at a time. They do have a pro forma map out there that would show the concentrations afterwards. Rite Aid will be mostly West Coast and Northeast. So, something to keep in mind for anyone at home as they're drawing their own maps, sketching it out with their own paper and pencil, "Would this really makes sense?"

Harjes: Yeah, I'm kind of doing this in my head right now, and from the overlay maps that I've seen of Whole Foods and Amazon, that's kind of already where they are, it's a lot of Amazon on the coast, and Whole Foods also on the coast, but filling in some of the gaps in the Midwest region.

Campbell: Yeah, and the smaller footprint of Rite Aid stores, Kristine, I have a Rite Aid near me, but I don't have a Whole Foods anywhere near me.

Harjes: Interesting.

Campbell: So, I think there are opportunities for them to fill in the gaps. Again, this is pure speculation, people. We don't know what's going to end up happening, or how Amazon will pursue this, or even if they will pursue it. They definitely throw a lot of things at the wall to see what sticks. There just happens to be some interesting evidence that they've been interested in this industry in the past via drugstore.com, that there are some drum beats to the idea that they might be exploring doing the PBM, and then, of course, with the recent news of the deal falling apart with Walgreens, it just makes it interesting to speculate and say, "Hmm, would Rite Aid be intriguing to Amazon?" It's anyone's guess how this will all shake out, but it's definitely, definitely something that people are going to want to keep an eye on, because wow, the reverberations would be huge.

Harjes: Oh, absolutely. This isn't just you and me speculating on this. There are clearly investors everywhere that are making the connections between these two different spaces. For example, on the day of the acquisition announcement of Whole Foods, I was looking at shares of some of these pharmacies, and I remember seeing both CVS and Walgreens down about 4.5% each, just on that day. For example, Walgreens gets 78% of its total gross profit from retail pharmacy. So, these industries are very much intertwined, and I suspect they will become even more so.

Campbell: Yeah. You want to really start putting on your look-forward cap -- what would it look like in the future? If you were a Prime member, would you qualify for free delivery, if you were somehow able to be vetted so that you knew your medicine could show up to your door like mail-order, very simple [to] be able to use it and order it? I mean, who out there does not have an Amazon account at this point? They have, what, 80 million Prime members, or something ridiculous like that. Theoretically, you could create one heck of a rewards program around this whole thing.

Harjes: Yeah, and they are a trusted name. In a Wells Fargo survey, they found that five in 10 adults would use or probably use an Amazon pharmacy.

Campbell: I would.

Harjes: I would, too. I absolutely would. So, yeah, you made a good point earlier about how you really do need to look far out into the future if you're going to be a long-term investor, like we preach here at The Motley Fool.

Campbell: Absolutely. And with over $300 billion in prescription drug spending in the U.S. alone, this is a massive market that's ripe for disruption, and there's no one who's better at supply chain, as you indicated earlier, than Amazon. If somebody can figure out a way to shave an additional percentage off of cost, it's going to be Amazon.

Harjes: Absolutely. Todd, thank you, as always, for calling into the show today. Folks, as always, people on the program may have interests in the stocks that they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. Feel free to email us any time at industryfocus@fool.com. For Todd Campbell, I'm Kristine Harjes, thanks for listening and Fool on!

John Mackey, CEO of Whole Foods Market, is a member of The Motley Fool's board of directors. Kristine Harjes owns shares of Whole Foods Market. Todd Campbell owns shares of Amazon. The Motley Fool owns shares of and recommends Amazon and Whole Foods Market. The Motley Fool owns shares of Express Scripts. The Motley Fool recommends CVS Health and UnitedHealth Group. The Motley Fool has a disclosure policy.