TORONTO - Two of Canada's biggest retailers have struck an agreement to combine their operations, with Loblaw Companies Ltd. (TSX:L) buying Shoppers Drug Mart Corp. for $12.4 billion in cash and stock.

The acquisition will keep Shoppers' brand name in place and allow it to operate as separate division of Loblaw, the companies said on Monday.

But, it also raises questions about the next major deal in Canada's hotly pursued pharmacy retailer sector.

Last month, fellow grocer Sobeys picked up the Canadian assets of grocer Safeway for $5.8 billion in a deal that included 199 in-store pharmacies.

"With today's transformational partnership between Loblaw and Shoppers Drug Mart, we are changing the retail landscape in Canada," Galen Weston, executive chairman of Loblaw, said Monday.

"I've long believed that becoming a Canadian health and wellness, and nutrition, champion represented the most powerful next chapter for Loblaw."

Loblaw is offering $33.18 in cash plus about six-tenths of a Loblaw share for each Shoppers Drug Mart common share. The proposal was valued at $61.54 per Shoppers Drug Mart common share based on Loblaw's share price before it was announced, more than a 29 per cent premium on Shoppers' average trading price.

About 54 per cent of the deal will be paid in cash while the rest will come in Loblaw shares.

Investors reacted positively on the Toronto Stock Exchange, with shares of Shoppers (TSX:SC) rising 24 per cent, or $11.72, to close at $60.12 and while Loblaw shares were up $2.58 or more than five per cent at $50.13.

Supermarket operator Metro Inc. (TSX:MRU) has expressed interest for picking up pharmacy retailer Jean Coutu in the past. It recently sold its stake in convenience store operator Alimentation Couche-Tard, a move that increased speculation about a possible deal.

Jean Coutu (TSX:PJC.A) saw its stock rise 4.9 per cent to $18.98 on Monday as investors gambled another deal could be in the works. Metro shares were also higher, rising $1.59 to $72.05, on the TSX.

Canadian retailers have faced increasing competition from large U.S. chains over the past few years, with the expansion of Walmart and the recent entry of Target, both which offer a variety of food options as well as merchandise and pharmacy items.

"The grocery space is kind of under siege right now from a lot of other retailers," said Bobby Hagedorn, equity analyst at Edward Jones in St. Louis.

"We're seeing increased competition, but the growth really isn't there, and that kind of lends itself to an acquisition-friendly environment."

Weston and other executives of the two companies said they anticipate cross marketing of each company's products — mentioning the Loblaw President's Choice and Blue Menu brands and Shopper's Life brand — as well as services such as their loyalty points programs.

Aside from an increased company size and scale for its private-label products, Gareth Watson, vice-president at Richardson GMP Ltd. said there seems to be little within the deal that's "revolutionary."

"This deal hasn't made Loblaws more competitive in the grocery space, as far as I'm concerned, or at least not to the degree that's worth 12 billion bucks," he said.

"I think the bottom line when it comes to this food industry is price, that's where the competition is coming from. I don't think this transaction really changes that competitive position whatsoever."

The combined operations of Loblaw and Shoppers would be a massive revenue force. Last year, the two companies took in a combined $42 billion in sales and had $1 billion of free cash flow.

Loblaw said it expects to produce $300 million in cost savings after three years, without store closures.

The deal still requires approval from at least two-thirds of the votes cast by Shoppers Drug Mart shareholders at a special meeting expected to take place in September. A majority of Loblaw shareholders must also approve the deal because of the number of shares being issued.

Holders of Shoppers stock have the option of receiving $61.54 cash or, alternatively, 1.2941 Loblaw common shares plus one cents cash, subject to caps on the total number of shares and total amount of cash. The amount of cash is capped at $6.7 billion and the number of shares is capped at 119.9 million.

Assuming Shoppers investors opt for the maximum amount of Loblaw equity, they would own about 29 per cent of the combined company.

In a related move, George Weston Ltd. (TSX:WN) will subscribe for 10.5 million additional shares of Loblaw — its main subsidiary — valued at $500 million. Weston will pay $47.55, the closing price for Loblaw shares on Friday.

Proceeds from the offering will be used to pay a portion of the Shoppers purchase. George Weston will control about 46 per cent of the Loblaw voting rights after the acquisition.

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