What is going on at Walgreens, Rite Aid and Fred’s?

Nobody seems to know exactly what is going on with the Walgreens Boots Alliance (NASDAQ: WBA)/Rite Aid (NYSE: RAD) merger plans. Even WBA’s CEO Stefano Pessina seems to be as clueless as the rest of us.

All Pessina would say at Walgreens’ annual meeting was that the company was “actively in discussions” with Rite Aid, Fortune reported. Pessina did not even say if the merger deadline which was supposed to expire on January 27, would be extended. Instead the company sent out a press release stating that the merger agreement had been extended to July 31, on January 30. The release also set Walmart’s offer for Rite Aid at $7 a share.

Media speculation is that the Federal Trade Commission (FTC) does not like plans to sell 865 Rite Aid locations to Fred’s (NASDAQ: FRED). Some FTC lawyers are reportedly afraid that Fred’s; a smaller drugstore operator in the South, simply lacks the money and resources to operate all those stores.

The FTC might be afraid that Fred’s will collapse; or forced to close large numbers of locations, leaving many neighborhoods and towns without pharmacies. It might be concerned about the development of “drugstore deserts;” areas without access to prescription medications developing. Some urban neighborhoods and small towns are caught in food deserts because of lack of supermarkets.

Are Drugstores a Good Investment?

All this raises the question are drugstores a good investment? The answer provided by Fred’s finances is no.

Fred’s is in pretty sorry shape, it reported a negative net income of -$47.97 million, a negative cash from operations figure of -$13.93, a negative profit margin of -7.43% and a negative earnings per share figure of -1.31 on October 31, 2016. Fred’s shareholders were punished with a return on equity of -28.25.

All this indicates that the FTC has a very good point about Fred’s; it does not have the resources to operate all those Rite Aid locations. Fred’s reported revenues of $2.15 billion, a free cash flow of $28.25 million, assets of $740.88 million and cash and short-term investments of $5.692 million on October 31, 2016.

The only way Fred’s would be able to get the money to absorb those new locations would be to take on a lot of debt. Yet there’s indication it would be able to pay off that debt, even if a lender willing enough to go along would be found.

Rite Aid is also in lousy condition according to the available numbers. It generated $32.57 billion in revenue but made just $90.18 million in net income during third quarter 2016, ycharts reported. That led to a profit margin of .19% and an earnings per share (EPS) figure of .0756.

Rite Aid is also having some serious cash flow problems; it reported free cash flow of $24.58 million, $493.32 million in cash from operations and $220.30 million in cash and short-term investments on November 30, 2016. That indicates high-operating costs that are eating up whatever cash it can generate.

So the answer is that standalone drugstores are a pretty lousy investment in the United States. That raises serious doubts about Mr. Pessina’s decision to buy Rite Aid. Perhaps the FTC is doing Pessina and Walgreen’s shareholders a favor.

Is Walgreens Making Money

Walgreen’s Boots Alliance is making money, but it is struggling to maintain revenue growth. WBA’s revenues actually fell for the first time since 2012, in third quarter 2016.

Walgreens reported revenues of $117.35 billion in August 2016 and $116.82 billion in November 2016. Although its other numbers were very impressive, Walgreens reported a net income of $4.117 billion, a profit margin of 3.7%, and a diluted EPS of 3.77.

That gave WBA a lot of float in the form of $2.681 billion in cash from financing, $7.64 billion in cash from operations, $9.598 billion in cash and short-term investments and $71.91 billion in assets. All that makes Walgreens a value investment, but it raises serious questions about the viability of smaller drugstores.

To generate all that cash WBA has to operate 12,755 stores in nine countries. Rite Aid can barely stay afloat even though it operates around 4,600 stores here in the USA.

This should give investors serious doubts about the drugstore business. They should ask how long can Walgreens’ 37.5¢ a share dividend and 13.7% return on equity continue. More importantly, is the $81.50 share price reported on January 27, justified and sustainable?

The Quick and Dirty Drugstore SWOT analysis

A great way to gain insight into those questions is with a quick and dirty Strengths, Weaknesses, Opportunities and Threats or SWOT analysis for drugstores. Here is a SWOT analysis that can be applied equally to Rite Aid, Fred’s and Walgreen’s US operations:

• Strengths: Large foot print, diversified business model, reliable streams of income from government and private-insurance payment of prescriptions. Selling products that many customers need simply to stay alive.

 

• Weaknesses: Low profit margin, low markup on many nonprescription products, high-operating costs, and lots of competition. Lack of amenities many customers value including gas stations, delis, large grocery selection, etc.

• Opportunities: Growing number of Americans with health insurance, public clamor for expansion of government health insurance, growing number of Americans on Medicaid and Medicare, aging population. Potential for integration with ecommerce, adding shipping services to stores. Changing shopping habits, many customers prefer convenient neighborhood shopping and smaller quantities to big box and bulk purchases.

 

• Threats: ecommerce operators like Amazon (NASDAQ: AMZN) offer larger selection and lower prices on items like toiletries and makeup with free shipping Supermarkets like Kroger (NYSE: KR) and Safeway using prescriptions as a loss leader offering discounts to prescription switcher. Dollar stores. Big and small box discounters that operate pharmacies including Walmart (NYSE: WMT), Target (NYSE: TGT) and Costco (NASDAQ: COST). Growing income inequality and wage stagnation leaves middle and working class Americans with less disposable income.

Some of these weaknesses and threats explain the recent revenue downturn at both Walgreen and Rite Aid. The breakneck growth of Amazon and dollar stores; and the escalating grocery war between Walmart, Safeway and Kroger are beginning to affect drugstores’ bottom lines.

Given the low operating margins in this retail sector; all it would take to affect Walgreens’ bottom line is for Amazon to take 1% or 2% of its’ nonprescription retail business. Walmart, Safeway and Kroger are more destructive because they can snatch prescription customers.

A major menace to Walgreens is Kroger and Safeway’s popular loyalty card programs with offer discounts on fuel and groceries for pharmacy customers. Also problematic is Kroger and Walmart’s deep discounting on specific generic prescriptions.

It looks as if the drugstore business in the United States is no longer capable of significant growth. Pessina would be well advised to reduce Walgreens’ footprint and rework its business model rather than acquire Rite Aid. Such steps might be needed to maintain profitability in today’s retail warzone.