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CtW Investment Group Believes Longs RE Undervalued - Calls for Greater Disclosure

WASHINGTON, Sept. 3 /PRNewswire/ -- The CtW Investment Group sent the following letter today to Longs Drug Stores Corporation Governance and Nominating Committee chairperson Dr. Mary S. Metz in response to the news that Longs entered into a previously undisclosed agreement with CVS/Caremark (CVS) not to reveal the value of its real estate portfolio.

The text of the letter follows:

September 2, 2008

Dr. Mary S. Metz

Chairperson, Governance and Nominating Committee

Longs Drug Stores Corporation

141 North Civic Drive

Walnut Creek, California 94596

Dear Dr. Metz,

We are disturbed by the news that Longs entered into a previously undisclosed agreement with CVS/Caremark (CVS) not to reveal the value of its real estate portfolio. We read public statements by David Heller, the Chairman of Advisory Research Inc., concerning information to this effect that he received from Longs' Chairman and CEO Warren Bryant. Like Mr. Heller, we view this as a highly questionable decision on Longs' part, since we believe there are reasonable grounds to suspect that the current tender offer from CVS, which the Longs board has endorsed, undervalues the company's real estate assets. We urge you, as Chairperson of the Longs board's Governance and Nominating Committee, to immediately disclose any such agreement, if it exists, and to explain to shareholders why the board agreed to withhold information necessary for shareholders to make a fully informed decision with respect to the CVS offer. If no such agreement exists, we urge you to comply with Advisory Research's request and disclose additional information concerning the value of the real estate portfolio, preferably via an independent, third party appraisal.

Given the numerous concessions already disclosed that Longs' board made to CVS in its negotiations, including a price at the low end of the range that Longs had believed appropriate, a termination fee that exceeds the rule-of-thumb for transactions underDelaware law, and limitations on Longs' ability to seek out or accept a superior offer from other potential acquirers, among others, it is critical that shareholders have the information they need to determine if tendering their shares is in their best interest. The timely disclosure of an independent, third party valuation of Longs' real estate holdings would allow Longs' shareholders to make a fully informed decision at this critical moment.

The CtW Investment Group works with pension funds sponsored by unions affiliated with Change to Win, a federation of unions representing more than 6 million members. Many of these funds are substantial long-term Longs shareholders.

1. Reason to Question Offering Price

Since the announcement of the merger agreement, the two largest shareholders in Longs have expressed the view that CVS's $71.50 offer appears to undervalue the company. Both Pershing Square Capital Management and Advisory Research have argued that the apparent valuation of Longs' real estate portfolio is too low. We agree with Pershing Square and Advisory Research that there are solid grounds on which to question the valuation the CVS offer ostensibly places on Longs real estate portfolio, and hence on the company as a whole.

In a number of statements, CVS has indicated that it valued Longs' wholly-owned (buildings and land) and partly-owned (building only) stores together at more than $1 billion. Moreover, CVS has indicated that it views such a valuation as conservative. In its press release announcing the merger agreement, CVS noted that Longs owns over 200 store locations as well as other properties, and stated that it has "conservatively valued the store locations alone at more than $1 billion." During the companies' joint conference call following the merger announcement, CVS Chairman and CEO Tom Ryan was asked what capitalization rate had been assumed by CVS in connection with its valuation of Longs real estate, and Ryan again emphasized that "it's a conservative - it's a decent -- a reasonable [capitalization rate]." These statements certainly suggest that Mr. Ryan believes that the "more than $1 billion" valuation for Longs' owned retail real estate is if anything on the low rather than the high end of reasonable estimates.

Indeed, in the discussion of the background to this transaction, the tender offer statement suggests that Longs' Chairman and CEO Warren Bryant may have shared this view. For instance, on July 8, 2008, Mr. Bryant "conveyed [to Mr. Ryan] his expectation that the offer price would be in the mid-70s," and on July 31 Mr. Bryant "reiterated [to Mr. Ryan] Longs position on price." Each of these reported conversations took place after CVS submitted a non-binding letter to Longs that outlined a price range of $70-$76 per share, which reinforces our sense that Mr. Bryant and Mr. Ryan each recognized that Longs' fair value likely exceeds the $71.50 price per share that Longs' board eventually approved.

2. Estimating the Value of Longs' Real Estate

In light of these credible grounds for questioning whether the CVS offer provides adequate consideration to Longs' shareholders given the value of the company's real estate, we have estimated the value of these properties using two methods. First, we have surveyed all retail drugstore sales since January 1, 2006, in those states where Longs wholly- or partly-owns stores:California (88% of Longs' owned stores),Nevada (4.7%), andHawaii (7.3%). We calculate an average price per square foot for retail drug stores in each state based on the sales data. Next, Longs states in its most recent 10-K that the company wholly-owns 28% of its stores, or 141 stores, and partly-owns 13%, or 67 stores. Finally, Long's reports that 92% of its stores have square footage averaging 23,000, while its remaining stores are averaging under 4,000 square feet. For the purposes of these estimates, we conservatively assume square footage per store of 20,000, below the weighted average of 21,480. Multiplying this estimate by the average price per square foot for each state, and weighting by each state's share of stores, we estimate the value of the 141 wholly-owned stores at approximately $1.04 billion.

To estimate the value of the partly-owned stores, we examined the assessments of land value and calculated the average ratio of land value to sale price for retail drug stores in each state. We then calculated the value of the 67 partly-owned stores as above, and reduced their value by this ratio. These calculations yielded an estimate of $229 million, for a total valuation of Longs'- owned store portfolio of $1.26 billion. This estimate exceeds by over 25% the minimum value of $1 billion that CVS has ostensibly attributed to this part of Longs' real estate portfolio.

Second, we estimated the value of Longs' owned store portfolio based on the "conservative" capitalization rates identified by Mr. Ryan during the joint conference call in his response to the question noted above. After noting that the capitalization rate applied would depend on the state and market where the store is located and whether the store was wholly- or partly-owned, Mr. Ryan stated that "the range is going to be in the 6.5, 7.5, 7 to 7.5." We assume that Mr. Ryan's qualifying comments indicate that the lower end of the range (which would indicate a higher asset value) would be applied to the wholly owned stores and the higher end of the range to the partly-owned stores. Using Longs' EBITDA for the year to July 31, 2008, of $280.1 million, and considering that the retail drugstore segment of the company accounts for approximately 70% of operating profit, we estimate that the retail drug segment generated EBITDA of $196 million. Since 28% of its stores are wholly-owned, we estimate their contribution to EBITDA to be $54.9 million. Using the low-end capitalization rate identified by Mr. Ryan, we estimate the value of these stores at $845 million. For the partly-owned stores, which constitute 13% of Longs' total, we estimate they generated EBITDA of $25.5 million. Using the high-end capitalization rate identified by Mr. Ryan, we estimate the value of these stores at $340 million. Combining these values, we estimate the Longs'-owned store portfolio is worth $1.18 billion.

Both methods we have utilized suggest that the $1 billion price tag CVS has ostensibly attached to Longs' drug store properties underestimates their true value significantly: by at least 18% and by perhaps as much as 26%. Moreover, Longs owns significant other properties: three office buildings, three distribution centers, and a number of additional retail and undeveloped properties. Using reported assessments or (where available) current asking prices, we estimate these additional properties are worth $140 million. Given that the current CVS offer of $71.50 per share would provide shareholders with a total consideration of $2.57 billion, and assuming that this price reflects the valuation of Longs' retail store real estate at least $1 billion, we can estimate that CVS has attributed up to $1.57 billion to value in Longs not associated with retail real estate ownership. Adding this estimate to our estimate of the market value of Longs' real estate implies a fair value for Longs of between $76.62 and $78.81 per share.

In its recommendation that shareholders accept the CVS offer, the Longs board of directors stated that it believed Longs "would not be able to readily liquidate or monetize its real estate in a manner that would be certain to yield value to the Company and its shareholders in excess of the Offer consideration and that there were significant tax implications to doing so." This argument seems strangely incongruous, both because CVS has clearly stated that it intends to pursue a series of sale-leaseback arrangements to monetize this portfolio (an option Longs presumably could have pursued), and because any such view on the board's part would not justify recommending acceptance of a tender offer that undervalues shareholders' investment. It is or should be within the board's power to clarify this issue by disclosing an independent valuation of its real estate holdings.

3. Deal Protections Increase the Urgency of Full Disclosure

Such full disclosure is all the more urgent given the extensive deal protections CVS has secured, and to which the Longs board agreed. These protections will likely have the effect of deterring potential alternative suitors, thereby limiting Longs' shareholders to the choice of the CVS offer or no transaction. These protections include:

-- a termination fee payable by Longs to CVS of $115 million or 4.6% of deal value, above the 3% threshold that serves as a rule-of-thumb inDelaware;

-- a "top-up" option allowing CVS to purchase from Longs any shares it needs following a successful tender to complete a short-form merger;

-- a joint application to the NYSE for an exemption from Rule 312, which could otherwise require Longs to hold a shareholder vote if exercise of the top-up results in Longs issuing more than 20% of shares outstanding;

-- a "last look" provision that grants CVS five days to respond to a superior, third-party merger proposal; and

-- a requirement that CVS receive any materials Longs delivers to a third party related to such a superior merger proposal.

Considering further the merger agreement states shareholders will not have appraisal right with respect either to the tender offer or the merger, it is imperative that the board ensure shareholders have the information they need as soon as possible.

Conclusion

If in addition to these deal protections, Longs also entered into an agreement with CVS not to disclose the value of its real estate portfolio, then the Longs board of directors has a clear duty to disclose this fact to its shareholders, and to explain how such an agreement serves the interests of Longs' shareholders. If no such agreement exists, then the Longs board should quickly grant the request of Advisory Research, Inc. and provide additional information to shareholders concerning the value of its real estate portfolio, ideally by disclosing an independent, third-party valuation of these properties.

I look forward to hearing from you soon, and if you have any questions concerning this letter, please contact me at (202) 255 6433.

Sincerely,

Richard W. Clayton III

Research Director

cc: Longs Board of Directors

SOURCE Change to Win

Tags: ,MTC,RLT,TNM,POL,CtW-Longs/CVS-merger

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