This Merger Could Mean Returns Of Up To 40%

Shares of Valeant Pharmaceuticals (NYSE: VRX) plunged nearly 15% when the company finally reported its 1st quarter earnings on June 7 on a reduced 2016 outlook and a laundry list of other issues.

More than 100 million shares traded that day, five times the previous day's volume, as investors rushed for the exit and short sellers danced a jig.

But for those listening closely to the conference call, CEO Joseph Papa dropped a bombshell and tipped investors off to what could be one of the best positioned companies for the foreseeable future.

Most investors didn't catch it because shares of this market leader closed just 0.6% higher on the day. This company is already a powerhouse in a growing industry and about to close a merger that will cement its place on top.

Who Will Control Tomorrow's Healthcare
Valeant investors were stunned when the company reported that it was selling some drugs through its relationship with Walgreens Boots Alliance (Nasdaq: WBA) at a loss to its own costs. The advantage came to Walgreens on activity-based fees negotiated in the distribution contract, which are additional fees Walgreens receives on Valeant drugs depending on whether the purchase is paid in cash or through insurance coverage.

Valeant is a relatively small part of Walgreens' business, with the potential for about four million prescriptions filled against the company's 2015 total of 894 million prescriptions, but the deal shows the pharmacy retailer's amazing negotiating power. Valeant has said it will renegotiate the deal, but who is going to continue to have the most power in that conversation?

Combine Walgreens' negotiating power with increasing demand for pharmacy drugs due to universal healthcare and aging demographics and you've got the making for a cash flow machine.

The company's free cash flow has doubled over the last five years to $5.1 billion and its dividend has grown at compound annual rate of 18.7% over the last decade.

Even better, Walgreens could be close to getting approval for its acquisition of Rite Aid (NYSE: RAD), a deal that will boost its dominance of the retail pharmacy market and bring a very important piece to its healthcare delivery strategy.

Walgreens controls 19% of the U.S. retail pharmacy market, roughly equal to competitor CVS Caremark (NYSE: CVS), and the acquisition of Rite Aid will put Walgreens in the lead by several percentage points. The acquisition calls for selling or closing up to 1,000 stores, an opportunity for Walgreens to improve profitability as it closes non-performing locations. Management expects the merger to close in the second half of 2016 and to be accretive to earnings in the first year, with synergies of up to $1 billion.

Beyond its dominance at home, Walgreens also controls the largest global pharmaceutical and distribution network in the world, with wholesale coverage in 19 countries. The company is building its market presence in China with two joint venture companies, Guangzhou Pharmaceuticals and Nanjing Pharmaceutical.

Revenue climbed 35% last year and net income more than doubled on a consolidated basis. Pharmacy sales jumped 9.3% even as pressure on reimbursement rates and drug prices weighed on the industry. Online pharmacy orders increased 65% on a year-over-year basis as the company built out its virtual storefront.

Of greater importance than the additional retail pharmacy share is Rite Aid's pharmacy benefits manager (PBM), Envision Pharmaceuticals. PBMs are a critical piece of the healthcare delivery system, carrying extra negotiating and administration weight between drug manufacturers and retailers. CVS acquired its PBM in 2007 with the Caremark acquisition and now Walgreens will have one as well.

Medical costs will continue to be a hot-button issue in Washington, and drug pricing will likely face downward pressure. Walgreens should be able to use its integrated delivery network and massive size to pass much of that pressure on to the drug manufacturers, keeping its own margins intact.

The merger, still subject to regulatory scrutiny, puts Walgreens' $3 billion repurchase program on hold and the combination may take a few quarters to fully integrate, but it will further position Walgreens as a power in the growing healthcare system.