CVS Angles for Longs' Real Estate Bounty

Shareholders say the buyout target has undervalued its real estate portfolio -- the real prize of any merger.
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OKLAHOMA CITY --

CVS

(CVS) - Get Report

knows how to strike - and win -- a deal.

Granted, in its current quest for

Longs Drug Stores

(LDG)

, CVS now faces some pesky competition from rival

Walgreen

(WAG)

, which offered $75 a share for Longs just three days before CVS's own $71.50-a-share tender offer was set to expire.

Unable to win enough support for its lower bid - and unwilling, for now, to raise it any higher - CVS has given Longs shareholders another month to make up their minds.

Ultimately, CVS tends to get its way. Last time around, the company overcame a higher bid from rival

Express Scripts

(ESRX)

to win control of Caremark despite investor outrage.

Less than 18 months after that deal closed, CVS adopted a similar approach with Longs. In both cases, CVS promised rich payouts to its target's top executives and secured attractive buyout prices -- sheltered by strict deal-protection measures -- in return.

Of course, Caremark shareholders fought back and forced CVS to repeatedly raise its bid. From the start, Longs shareholders have aimed to do the same.

"The (Longs) board -- well aware of the material insider benefits the Caremark board secured via its sale to CVS -- was eager to cater a sale of the company to CVS in order to receive similar benefits and to secure lucrative change-in-control payments that board members and management would not have received absent the proposed buyout," shareholders claimed in one of two class-action lawsuits they recently settled with the company. "Accordingly, the board catered the sales process exclusively to CVS and made no attempts to adequately canvas the market to ensure that they were securing the best possible price for the company's shares."

At first blush, CVS's $2.9 billion offer for Longs looked quite fair. After all, CVS was promising $71.50 a share for a stock that had fetched just half that amount before Longs secretly began contemplating a possible sale. While the stock marched past $50 during those negotiations, investors could still add another 32% to their recent gains.

Longs shareholders feel robbed, nonetheless. Essentially, they believe that management rushed into a deal that throws in some -- if not all -- of the company's real estate for free.

Longs operates 521 drugstores in high-priced markets like California and Hawaii. The company controls a number of valuable leases and owns more than 200 drugstores outright. Using vague and admittedly conservative terms, CVS has valued that property at "more than $1 billion."

To some major shareholders at Longs, that looks like an outright steal. Thus, even though CVS has refused to raise its bid so far, they are banking on a much better deal in the end.

"CVS has gone out of its way to lock Longs into this transaction," says Richard Clayton, research director at CtW Investment Group. "They're very eager to get this deal done, and they have a full year to do it.

"I have trouble imagining that they would go to all that effort and then walk away if they can't get the deal done at the bottom of the range."

Jefferies analyst Scott Mushkin wonders what caught CVS' eye. After all, he noted last month, CVS had "always shied away" from Longs in the past.

After purchasing another West Coast drugstore chain two years ago, in fact, CVS seemed hesitant to pursue any major acquisitions at all.

"What else do we need to acquire to get where we want to be?" the company's CFO challenged in an interview with

The Wall Street Journal

back in March of 2006. "We've got the tools we need to be a very successful, high-growth business for the foreseeable future."

Yet CVS started chasing its biggest target ever before that year came to an end.

In November 2006, CVS announced plans to unite with Caremark in a so-called "merger of equals" that would shower Caremark's executives with riches but afford its shareholders no premium at all. After months of intense fighting, which forced CVS to raise its offer three different times, Caremark shareholders finally approved the controversial deal the following spring.

Longs attracted a possible suitor shortly after watching that high-profile saga unfold. During the first half of 2007, regulatory filings show, "Party A" (widely identified as Walgreen) contacted Longs to discuss a possible deal. Longs rebuffed that offer, however, and seemed reluctant to sell itself until CVS came along.

Still, Walgreen never gave up. After suffering its first rejection in 2007, regulatory filings show, "Party A" came back in April o2008 with a specific proposal. It offered up to $65 a share for Longs' stock - and then promised a sweetener - even as it waited for detailed information on the company.

Walgreen CEO Jeffrey Rein reminded Longs of those overtures when presenting the company with its new offer on Friday.

"In our prior discussions we expressed a willingness to offer up to $70 per share (for Longs), subject to our receipt of customary due diligence materials," Rein wrote in an open letter to the board. However, "as you know, we were never provided with the due diligence."

In its own version of events, supplied in formal regulatory filings, Longs indicated that it had in fact provided Walgreen with some due diligence information. After reviewing that information, the timeline further suggests, Walgreen hinted that it might lower its price and freed Longs to reach out to CVS instead.

Just five days after Walgreen supposedly backed away from its bid, the timeline shows, Longs contacted CVS and found the company "very interested" in a possible deal. Two weeks passed before CVS actually came up with a price, and the company wound up offering less than Walgreen had. After Longs supplied its due diligence, however, CVS came back with its current $71.50 offer.

The very next day, the two parties learned that Pershing Square Capital Management - a well-known activist hedge fund - had been gobbling up Longs' stock and now ranked as one of the company's largest shareholders. The deal moved rapidly from there.

"Pershing's announcement effectively put the company 'in play' and susceptible to offers from potentially interested bidders," Longs shareholders claim in one of their class-action lawsuits. "The board did not take the opportunity to conduct a full and fair auction for the company presented by Pershing's announcement, however.

"Instead, the board entered into a proposed buyout just one week later, catering the entire process to the interests of CVS and eschewing any attempt to maximize shareholder value."

CVS drove a hard bargain.

Under the terms of the buyout, Longs cannot solicit other buyers or supply them with non-public information except in limited circumstances. If Longs does overcome those obstacles and secure a higher offer, the company must allow CVS the opportunity to match it. It must then pay CVS a sizable breakup fee - exceeding even the high end of the normal range - if it backs out of the deal.

As Longs' financial adviser, JP Morgan, deemed the offer fair. Notably, however, the banking firm stands to pocket almost $15 million if the buyout takes place. It will secure just $1 million otherwise.

It has ties to both parties.

JP Morgan used various earnings-related models to estimate Longs' value, never once reaching a price that exceeds the CVS offer. However, regulatory filings state, the banking firm "did not conduct or was not provided with any valuations or appraisal of any assets" during its review.

CVS has long relied on its top lawyer -- who has been around since the company's inception -- to oversee its real estate development program. It has since admitted that it would need at least a decade to assemble a portfolio like the one that Longs controls.

Meanwhile, outsiders continue to review Longs' real estate on their own. After conducting a detailed analysis, CtW concluded that the portfolio is worth $1.18 billion to $1.25 billion even under conservative scenarios. Others have since presented higher estimates ranging from $1.5 billion all the way up to CVS's entire $2.9 billion offering price.

Even CVS has portrayed Longs' real estate as valuable and pointed to it as a key attraction of the deal.

"An opportunity like this to acquire hundreds of quality locations in these markets is rare," CVS CEO Tom Ryan stated when announcing the deal last month. "Our team looked at all of the available opportunities in the market, (and) the Longs real estate locations definitely came out on top."

To some, CVS seems more interested in Longs' real estate than it is in the company's actual operations. The drugstore business is struggling after all, with even heavyweight Walgreen complaining about the "tightest prescription market" in a quarter-century. In many ways, with its regional focus and limited scale, Longs faces bigger challenges than most.

Still, when it comes to making deals, CVS often knows best. Even before the company inked its controversial merger with Caremark - which some still view as a bargain -

The Wall Street Journal

had already labeled CVS "one of the savviest and most successful acquirers" in the entire retail arena. Now, with its purchase of Longs, CVS plans repeat history and extend that winning streak.

"It's a great opportunity for us," Ryan stated simply. "We wanted to seize the day."