CVS Caremark to Swallow Longs Drugs for $2.9B

CVS, the industry leader, has 6,300 stores and annual revenue of approximately $85 billion. Longs, which generates approximately $5.3 billion in annual revenues, has 521 retail drug stores in California, Hawaii, Nevada and Arizona, including 490 stores in Central and Northern California and Hawaii where Longs is a leading player and where CVS is not currently represented. All told, Longs' portfolio includes stores in 10 non-CVS markets that are among the top 100 drugstore markets in the country.

CVS chief executive Tom Ryan told analysts shortly after the announcement that given the extraordinary cost and complexity of site selection in major markets in Northern California and Hawaii it would take CVS at least 10 years to otherwise assemble the same portfolio, which would give it leading positions in markets such as San Francisco, San Jose, Oakland, Sacramento, and Honolulu. The deal also includes 24 stores in Nevada, which would give the company instant leadership in Reno, a market that is forecast to grow at twice the national average, and where CVS currently has only three stores."We entered California organically in 2004 and then quickly acquired 335 Save-On stores [in Southern California]; now [we stand to be] the leading player in Central and Northern California and Hawaii," he told analysts. "From when we entered California, in just four years we will have more than 830 stores in the state, more than anybody else."Another very attractive part of the deal for CVS is that Longs owns more than 200 of its properties--the stores plus three distribution centers and its headquarters--located in markets where commercial real estate values are among the highest in the country and where prime locations are especially difficult to acquire. CVS "conservatively" estimates the value of the owned properties at more than $1 billion. Ryan told investors that CVS will be "monetizing a substantial portion of these assets over time" through sale-leasebacks. CVS' $1-billion estimation of the value of Longs owned portfolio is based on an assumption that it will be able to sell the building at a certain cap rate it declined to disclose, but said that on recent sale-leaseback transactions it has been achieving cap rate of between 6.5% and 7.5%.

"We believe we'll achieve lower cap rates than Longs would have on a standalone basis just because of our balance sheet strength and our history, and what we have done over time," Ryan said. "We don't have to rush through it. If real estate follows the economy for a while we will hold onto them."

Approximately 92% of the 521 Longs locations are full-service retail drug stores, averaging approximately 23,000 sf, of which approximately 16,000 sf is devoted to selling space, according to its most recent annual report. As of the start of the year, 59% of its stores were leased from third parties, 28% were company-owned buildings on company-owned land, and 13% were company-owned buildings on leased land.

Ryan

In addition to the real estate and inventories, the deal also includes Longs' Rx America subsidiary, which offers prescription benefits management services to over 8 million members and prescription drug plan benefits to approximately 450,000 Medicare beneficiaries. CVS says it expects to achieve cost synergies of approximately $100 million in 2009 and approximately $140-$150 million in 2010, resulting from purchasing efficiencies and a reduction of SG&A expense.

The acquisition will be effected through a tender offer to be launched shortly by a subsidiary of CVS Caremark for all outstanding Longs shares. The tender offer will be subject to, among other things, the condition that at least two-thirds of the outstanding Longs shares are tendered. CVS Caremark plans to finance the acquisition with a $1.5 billion bridge loan facility, together with existing cash and liquidity. The transaction is expected to be completed in the fourth quarter of 2008. If the deal goes through, CVS will operate approximately 6,800 drugstores in 41 states and the District of Columbia, and will fill or manage more than 1.2 billion prescriptions per year.

Ryan told analysts that $300 million has been allotted for remodeling the Longs stores in 2009 and 2010. Despite the strong Long's brand, he said the stores in California and Nevada would be converted to the CVS brand "over time" while the stores in Hawaii will not be converted. "Hawaii is kind of a stand-alone market from a distribution standpoint and an advertising standpoint so you don't lose economies of scale by [not changing the branding]," he said. "In fact, we believe that Hawaiians feel that Longs is kind of a homegrown chain."

In the 2008 fiscal year Longs closed all 23 of its locations in Washington, Oregon and Colorado along with eight stores in California. In the 2009 fiscal year, it had been planning to open or relocate approximately 20 to 30 stores and remodel an additional 40 stores.

As part of the integration of the Longs chain into CVS, Ryan said CVS will look to relocate 10% to 15% of the Longs stores in Northern California that aren't already well-located to freestanding locations "if we can find them, but there's no rush," he said. In addition, he said CVS would look to learn a little something from Longs about its general merchandise business, which accounts for more of the stores' overall sales than CVS stores, and use that to improve operations at its existing CVS stores in California.

Lehman Brothers and Deutsche Bank are serving as financial advisors to CVS Caremark on this transaction and provided the bridge loan commitment. Davis Polk & Wardwell and Mintz Levin Cohn Ferris Glovsky and Popeo P.C. served as legal advisors to CVS Caremark. J.P. Morgan Securities Inc. served as financial advisor to Longs and Wachtell, Lipton, Rosen & Katz served as its legal advisor.

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