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A01-02-0001 Rite Aid Corporation We continue to recommend shares of Rite Aid with a Strong Buy rating. We view Rite Aid’s announcement that it will acquire PCS Health Systems, the nation’s largest pharmacy benefit manager (PBM) from Eli Lilly (LLY, $80 rated Strong Buy by Paula Brooke, target $98) as a bold move that will significantly strengthen its PBM and retail pharmacy business. Following this announcement, we raised our 1999 EPS estimate by $0.02, to $1.77, and our 2000 estimate by $0.06, to $2.06. In addition, we believe RAD will benefit from its agreement with General Nutrition Companies (GNCI, $17, rated Strong Buy by Bruce Missett, target $25) due to its increased traffic as well as a lower cost of goods for its private-label vitamins, which could facilitate upside to our earnings estimates for 2000 and beyond. We expect RAD to benefit from its aggressive expansion and remodel program, strong sales growth, and the benefits from its investments in technology and distribution. We raised our 12- month price target on the shares by $6, to $60, or 29 times our earnings estimate (the fiscal year ending February 2001) of $2.06, given that RAD remains one of our favorite stocks and share price appreciation resulted in the stock price approaching our former target.1 Company Background By February 1999, Rite Aid Corporation was one of the largest retail drugstore chains in the United States. During the late 1990s, the company’s stock price rose significantly (see Exhibit 1) and the com- pany experienced rapid growth in sales and the number of retail outlets (see Exhibit 2). The company’s 3,821 drugstores, which varied in size from 7,200 to 25,000 square feet, were located in the eastern, southern and western regions of the U.S., as well at the District of Columbia (see Exhibit 3). The company’s founder, Alex Glass, entered the wholesale grocery business in Harrisburg, Penn- sylvania and expanded into health and beauty aids in 1958. In 1962, Glass opened his first discount drugstore under the name ThrifD Discount Center in Scranton, Pennsylvania. In 1968, the company’s name was changed to Rite Aid and the company went public in an initial public offering at $25 per share. The grocery business was spun off into a separate company, Super Rite Foods, with Glass becom- ing Rite Aid’s chairman and CEO. The company grew rapidly through acquisitions during the next two and a half decades. In 1970, Rite Aid acquired Fountain Drugs (19 stores) and Cohen Drugs (39 stores). By 1972, ten years after its humble beginning,DO Rite Aid operatedNOT 267 stores in COPYten states. In 1976, Rite Aid acquired Keystone Centers, Inc., a chain of 55 drugstores. In April 1977, Rite Aid acquired Read’s, Inc., a chain of 99 drug stores, for $18 million. Other acquisitions during the two and a half decades included Red Shield (12 stores), Shop Rite (nine stores), Quality Drug (seven stores), Shields (six stores), Fay’s (30 stores), Mann Drugs (26 stores), SupeRx Drug (113 stores), Grey’s Drug-Drug Fair (420 stores) and People’s Drug- 1 Rite Aid (RAD): PCS: A Bold Acquisition that Complements Already Aggressive Expansion Plans, Morgan Stanley Dean Witter (January 21, 1999). Copyright © 2002 Thunderbird, The American Graduate School of International Management. All rights reserved. This case was prepared by Professor Graeme Rankine for the purpose of classroom discussion only, and not to indicate either effective or ineffective management. Lane Drug (99 stores). In 1989, Alex Glass’s son, Martin Glass, who had joined Rite Aid in 1978, became the company’s president and COO. By 1990, Rite Aid had grown to a chain of 2,352 stores operating in 22 states and the District of Columbia. In March 1995, Martin Glass succeeded his father in the position of Chairman and CEO. Acquisitions of small regional chains continued through the mid-1990s, adding 502 stores to Rite Aid’s store count. However, the size of Rite Aid’s targets took a dramatic turn in 1995. On November 29, 1995, Rite Aid announced an agreement to purchase Revco D.S., a chain of 2,100 drug stores, for $27.50 per share in cash and stock in a deal valued at $2.1 billion. The combination of Rite Aid, the largest drugstore chain in terms of stores, and Revco, the second largest chain by store count, would have a total of 4,500 outlets located in 22 states. With revenues of $11 billion, the combined company would be comparable in size to Walgreen Company, the largest retail drug chain based on sales.2 The offer represented a premium of 15.8% over Revco’s stock price of $23.75 four weeks prior to the an- nouncement.3 Rite Aid had previously tried to acquire Revco after it emerged from bankruptcy in 1992. In characterizing the underlying rationale for the Revco deal, Martin Glass, Rite Aid’s chairman and chief executive officer, noted that there was a “need to be big and more efficient to compete with pharmaceutical distribution companies.”4 However, Rite Aid withdrew its offer for Revco on April 24, 1996 after the Federal Trade Commission asserted that the new company would have control of the retail drug market in nine states.5 Undaunted by its failure to conclude a deal with Revco, Rite Aid announced the acquisition of Thrifty Payless Holdings on October 14, 1996. Thrifty Payless operated the largest drug store chain on the West Coast and one of the largest chains in the United States. The retail drug chain had 1,049 retail units, operating under the Thrifty, Payless and Bi-Mart names, located throughout the Western United States including 677 in California, 155 in Washington, 113 in Oregon and 104 in Alaska, Arizona, Colorado, Hawaii, Idaho, Nevada, Utah and Wyoming. Rite Aid’s stores were located primarily in the eastern U.S. and several Midwestern states. The $2.3 billion deal was completed by the issuance of Rite Aid stock and the assumption of about $890 million of Thrifty’s debt. The transaction represented a premium of 37.2% over Thrifty Payless’s stock price of $17 per share four weeks prior to the announce- ment.6 The Rite Aid/Thrifty Payless combination created a chain with over 3,500 units nationwide and $10 billion in annual sales. Thrifty Payless was created when the Thrifty Corporation, a Los Angeles-based drugstore chain acquired by Green Equity Investors (GEI) in 1992, acquired Payless Drug Stores from Kmart Corp. in 1994. After the initial public offering of Thrifty Payless on April 15, 1996, GEI and Kmart owned 24% and 19% of the outstanding shares, respectively. According to analysts, Thrifty stores had been “under- performers” and were perceived as having “relatively high prices and were not known for customer service.”7 For the year ended September 1995, Thrifty Payless reported a net loss of $13.5 million on sales revenues of $4.7 billion. In August 1996, analysts estimated that Thrifty Payless would report net income of $30.6 million (EPS of $0.65) and $62.1 million (EPS of $1.05) for the years ending Septem- ber 1996 and 1997, respectively.DO8 Noting NOT that the company “continuesCOPY to make strides toward realizing the synergistic savings from the combination of Thrifty and Payless drug stores,” analysts gave the company an “outperform” rating.9 For the year ending September 1996, Thrifty Payless reported a net loss of $35.2 million on sales revenue of $4.8 billion. At September 29, 1996, Thrifty had total assets of $2.1 billion, long-term debt of $794 million and stockholders’ equity of $379 million. After the Rite 2 “Rite Aid to Acquire Revco for $1.8 Billion,” The Wall Street Journal (November 30, 1995). 3 Source: Database of Mergers & Acquisitions, Securities Data Corporation. 4 “Rite Aid to Acquire Revco for $1.8 Billion,” The Wall Street Journal (November 30, 1995). 5 “Revco: It’s Great to be Alive, Sort of,” Business Week (May 13, 1996). 6 Source: Mergers & Acquisitions Database, Securities Data Corporation. 7 “Thrifty Payless Holdings, Inc.,” Bear Strearns (May 24, 1996). 8 “Thrifty Payless Holdings, Inc.” Donaldson, Lufkin & Jenerette (August 19, 1996). 9 Ibid. 2 A01-02-0001 Aid/Thrifty Payless merger announcement, Martin Glass, Rite Aid’s CEO, noted that “We need to be able to become the low-cost operator to thrive in the industry… If you’re not the low-cost operator, I don’t think you’ll survive.”10 Further consolidations occurred in the drug store industry. Phar-Mor announced plans to merge with ShopKo for about $580 million while Revco launched an unsolicited $330 million bid for Big B Inc. In addition, J.C. Penny’s Thrift Drug unit acquired Fay’s Inc. for $285 million. On February 7, 1997 CVS Corp. announced that it was in talks to acquire Revco for more than $40 per share. The $2.9 billion deal, including the assumption of $900 of Revco’s debt, was completed on May 29, 1997 after receiving approval from the Federal Trade Commission. The CVS/Revco combination boosted CVS’s total store count to 3,900. The deal was completed less than nine months after CVS lost out to J.C. Penny in its bid to acquire Eckerd Corp., the largest drugstore chain in the Southeast. Although drug chains such as Rite Aid and CVS had grown rapidly through acquisitions, Walgreen Company preferred to grow “organically,” having reportedly “sworn off acquisitions as a growth strategy.”11 During 1997, Rite Aid continued its acquisition strategy.