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Walgreens-Rite Aid deal poses too much uncertainty, risk
By Neil Averitt . Originally published on FTC:Watch on June 2, 2017
Walgreens' proposed acquisition of Rite Aid, which would create the nation's largest drugstore chain, is getting close to a decision point. There's a good chance the deal will be approved by the Federal Trade Commission, subject to some substantial divestitures. It shouldn't be.
The problem isn't that the proposed divestiture is incapable of working. Rather, the problem is that the divestiture still leaves us with too many uncertainties and risks. Where a merger is close to the line and the remedy is questionable, the members of the public shouldn't be the ones to bear the risk of a bad outcome.
The business terms of this transaction have already been reported by my MLex colleagues Matthew Newman, Curtis Eichelberger and Leah Nylen.
The proposed merger has a definite end-of-an-era quality to it. Walgreens, with 8,200 stores, proposes to acquire Rite Aid, with 4,600 stores. The deal would combine the second- and third-largest chains, and the combined entity would pass CVS to become the industry leader. No other chain has a comparable national footprint, so this deal would be in some senses a 3-to-2 merger. Apres moi le deluge.
(Let it also be said, however, that other kinds of stores, such as Walmart and Kroger, now can include pharmacies, and that convenience stores are growing larger and are starting to move into the drugstore space.)
Not surprisingly, a deal of this magnitude has raised a number of competitive concerns. Some people fear that the combined chain would have too much clout with pharmacy benefit managers (PBMs), and would be able to claim excessive reimbursement for themselves. Others fear that the merged firm might make strategic use of Rite Aid's own in-house PBM and have it manipulate incentives to drive more traffic to the firm. Still others are concerned about a loss of traditional retail competition, as customers in some local markets see the number of nearby drugstores fall below a critical threshold.
Faced with these questions, the merging firms have proposed a series of hopefully curative divestitures to the FTC. Those offers have been sweetened during the 19 months the matter has been under review. Last December, Walgreens offered to divest 865 Rite Aid stores to Fred's, a regional chain based in the Southeast. On May 3, Rite Aid announced an update to the price that it expects to receive per share, with the new level suggesting that the Fred's divestiture offer has been increased to 1,200 stores, plus, presumably, warehouse and support facilities to match. This would be one of the largest retail divestitures in recent years. Its significance can be measured by the effect it has had on the deal valuation. When Walgreens first proposed the merger it was valued at $ 9.4 billion. With the expected divestitures the value has now dropped to about $6.8 billion.
All these issues are rapidly coming to a head. On May 8, Walgreens and Rite Aid jointly announced that they had certified substantial compliance with the FTC's second request. This starts the clock ticking: The agency now has only a limited time to either seek an injunction or see the deal go forward. That time is normally 30 days; here it has been extended to 60 days, or until July 7.
The parties are under their own time pressures. They plan to complete the merger by July 31, and Walgreens reportedly must pay Rite Aid a termination fee of $325 million if the deal doesn't close.
It is by no means certain, but seems likely, that the FTC will approve the transaction. To be sure, there are some caution flags flying. The New York Post reports that the agency has just issued civil investigative demands for additional information. But the structural incentives of the situation still push strongly toward approval.
A merger settlement always allows the agency to declare victory. The agency can declare that it has achieved divestiture of just the right number of assets, neither too many nor too few (think of Sherwin-Williams and Valspar). The substantial divestitures already offered will make that assertion particularly colorable here. And who can show that it is false? The merits cannot be known with certainty until a retrospective economic study is done some years hence — when all the people involved will have moved on to other things.
A settlement may particularly suit the FTC's managers. It would let acting Chairman Maureen Ohlhausen point to a win, point to a large divestiture, and point to an enforceable order, while still not risking the political fallout of suing to block a merger.
And yet we hope the agency will rise above these temptations and will block this transaction nonetheless.
The proposed remedy raises entirely too many risks.
One risk is, of course, that the divestiture could go spectacularly wrong, either leaving Fred's bankrupt, or forced to sell stores. This scenario has gotten considerable attention in light of similar problems in other recent settlements. Dollar Express was forced to sell off the discount stores that it had acquired just 18 months earlier as part of the settlement of the Dollar Tree-Family Dollar merger. Advantage Rent a Car was sold to new owners as part of the Hertz-Dollar Thrifty merger. It filed for bankruptcy within a few months. The small West Coast grocer Haggen went bankrupt shortly after buying 146 stores that were divested as part of the Albertsons-Safeway deal.
Other risks are more subtle but more likely to occur. Under the proposed divestiture, Fred's would be moving outside the areas of its core competence in many ways. So even if the firm survives, it may not be efficient enough to be a fully effective constraint on the conduct of CVS and the merged Walgreens-Rite Aid.
Fred's would be almost tripling in size — from its current inventory of 650 stores to about 1,850. It will be expanding its geographic footprint from a regional chain in the Southeast to a national chain with a presence on both coasts. It would become far more heavily involved in pharmacy operations; at present it has pharmacies in only about half of its stores, but it would be taking over Rite Aid stores where this is a near-universal department.
And it would begin to serve a significantly different customer demographic. For many years the firm operated under the name of "Fred's Super Dollar." It describes itself in its current 10-K filing as serving "low, middle and fixed income families located in small- to medium-sized towns," and as providing them with deep-discounted products for "everyday needs." In other words, Fred's presently competes with rural Dollar Stores, and would be asked to shift to operating a big-city drugstore chain.
Does anyone really believe that Fred's can do this reliably?
Granted, the shift isn't impossible. To improve the potential for success, Fred's recently announced, with great fanfare, that it was bringing onto its board of directors three new people with substantial experience in retail and drugstore operations. But still, taking on simultaneous challenges on so many different fronts clearly creates a significant risk of shortfalls, new managers notwithstanding.
How great are these risks?
Renowned economist John Kwoka has reviewed the literature on merger retrospectives and found that the debatable mergers led on average to significant price increases. However, his sample size is limited and the methodology of the underlying studies sometimes unclear. The FTC has conducted its own review and found that about 80 percent of the agency's divestitures led to lasting and effective presence in the markets. But this study is impressionistic and doesn't track actual price effects. And the success rate drops to 70 percent when only a limited package of assets is divested.
What's clear from both studies is that the riskiest situation is one where the merger is close to the line in enforcement terms, and where the remedy doesn't involve the simple sale of an ongoing business unit. And that is precisely the current situation.
The antitrust system intends that the risks of an ineffective remedy should be borne by the merging firms, not by the consuming public. That is why Congress framed the Section 7 standard to reach acquisitions that "may" substantially lessen competition.
In light of this, the proposed settlement here should be rejected. The fig leaf just isn't big enough.
But what do we do going forward to prevent these sorts of risks from reappearing and tempting enforcers toward weak settlements in future cases?
In a Feb. 3 speech, Ohlhausen reminded us that we shouldn't try to push the error rate to zero and ensure that every divestiture is successful. That's unrealistic and it would be undesirably restrictive in any event.
What's needed instead is a systematic set of guidelines on merger presumptions. These would be considerably more nuanced and detailed than the thresholds set out in the Horizontal Merger Guidelines. They would also define the points where mergers become presumptively unlawful under various circumstances. Mergers beyond those points would not be automatically banned. Case-by-case analysis would still be available. But the merging firms would then bear the burden of proof.
The presumptions would have to be determined in a careful, systematic way, ultimately aimed at supporting litigation. The FTC and the Department of Justice could convene a series of workshops and combine those with further empirical work of their own. With such a foundation the results should be persuasive to the courts. District judges aren't experts in this field and are likely to welcome credible help.
A moment's thought will show that this is really how things have to be. The only way to govern a large country is through general rules — with some flexibility in the details, but still being more predictable than ad hoc.
And under almost any application of such a rule, the Walgreens-Rite Aid transaction poses too many risks to be acceptable.