Don’t Chase Rite Aid Corporation (RAD) Stock Down the Toilet

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RAD stock - Don’t Chase Rite Aid Corporation (RAD) Stock Down the Toilet

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Thursday was a very bad day for Rite Aid Corporation (NYSE:RAD) stock. And that’s not just because RAD stock fell 26%. There are other, longer-term concerns created by the two big pieces of news, both of which imply Rite Aid could have even further to fall.

Don't Chase Rite Aid Corporation (RAD) Stock Down the Toilet

The headline news, obviously, was the official end of the announced merger between Rite Aid and Walgreens Boots Alliance Inc (NASDAQ:WBA). But an ugly fiscal Q1 report from Rite Aid also contributed to the dip in shares..

After Thursday’s move, another 7% on Friday and a long decline heading into this week, Rite Aid stock now trades at a four-year low. But that doesn’t make this a buying opportunity. There are real concerns about the business, even if a proposed, smaller transaction with Walgreens goes through.

Rite Aid still has hope, whether through a turnaround in its business or a return to the M&A arena. The cash from Walgreens should help the balance sheet – for now. But investors expecting a quick rebound in RAD stock will be disappointed.

And they should remember that the risks are very real — and very significant.

The New Deal With Rite Aid

Walgreens and Rite Aid canceled the original merger, in which Walgreens would buy out Rite Aid stock at $6.50-$7 per share. (That price was cut from an original $9.) Instead, Walgreens is paying $5.175 billion for 2,186 Rite Aid stores – along with a $325 million merger termination fee.

That would seem like good news for RAD stock. Some deal should be better than no deal.

That’s not necessarily the case. The $5.5 billion in cash will help Rite Aid’s balance sheet. But the company still have a reasonable amount of debt. Rite Aid finished Q1 with $7.2 billion in long-term debt. Meanwhile, the sale of nearly half its stores should have a significant impact on earnings. According to Bloomberg, Mizuho Securities USA LLC analysts estimated the company’s leverage ratio (debt to Adjusted EBITDA) still would be 4.8x after the sale.

That’s a reasonably high level, even if it is more manageable than the current figure over 6x. And the deal itself raises a question about the current valuation of Rite Aid stock.

Walgreens is paying $2.37 million per store in the deal. That in turn, would value the remaining stores at about $5.5 billion. With $1.8 billion in debt left, that per-store valuation still only implies RAD stock is worth about $3.35 per share.

That’s about 20-25% upside from current levels, to be sure. But it also implies that Rite Aid can sell the remaining stores – even though a clear buyer isn’t apparent. Amazon.com, Inc. (NASDAQ:AMZN) has been rumored after its announced intent to purchase Whole Foods Market, Inc. (NASDAQ:WFM).

But a rumor is just that. And 20%-25% upside in an M&A scenario simply isn’t enough for RAD stock, given the clear risks still on the table.

Q1 Earnings Hurt the Bull Case

Most notably, the case for someone buying the other (and presumably less valuable) half of Rite Aid is tougher to make after a very poor Q1 report.

Rite Aid missed analyst estimates on both revenue and earnings. It seems likely that if the Walgreens merger wasn’t part of the story, Rite Aid stock still would have declined on the news.

Same-store sales fell 3.9% in the quarter — and 5% in the pharmacy business. That compares to a 5.8% increase at Walgreens, who reported its fiscal Q3 earnings on the same day.

That disparity seems to imply shrinking market share for Rite Aid – a problem seen repeatedly in the last few quarters. And that’s a problem likely to be exacerbated by selling ~half of its stores. Rite Aid simply doesn’t have the scale to compete with Walgreens or CVS Health Corp (NYSE:CVS) as is, let alone at half its current size.

Those declines, in turn, are pressuring margins. Adjusted EBITDA margins fell 100 bps year-over-year in the quarter. That might not sound like much, but margins were just 3.5% a year ago. As a result, Adjusted EBITDA fell 33% year-over-year, after a 31% decline in Q4 (even with an extra week).

As a result, Rite Aid looks like a declining and shrinking business. And if EBITDA keeps declining, its balance sheet concerns will return. The combination means its stock’s declines are due to more than just the change in the Walgreens deal.

RAD stock Is In No Man’s Land

All told, Rite Aid seems too small to compete with Walgreens and CVS — and it’s getting smaller. And the company doesn’t have much in the way of options.

A sale would be nice, but if CVS or Amazon aren’t interested, it’s tough to find a buyer. Private equity isn’t interested in high-debt companies — it likes to issue the debt itself, to guarantee upfront returns. A merger with Fred’s Inc. (NASDAQ:FRED), who was cut out of the revised Walgreens-RAD deal, could make some sense. But combining two struggling companies rarely creates a successful one.

The decline in Rite Aid isn’t just arbitrage traders running for the hills. There are real concerns, real risks and real questions as to whether RAD stock still deserves a ~$3 billion market capitalization.

Rite Aid may not be heading to zero, necessarily. But there’s still room for plenty more downside if the company stays on its current trajectory.

As of this writing, Vince Martin did not hold a position in any of the aforementioned securities.

After spending time at a retail brokerage, Vince Martin has covered the financial industry for close to a decade for InvestorPlace.com and other outlets.


Article printed from InvestorPlace Media, https://investorplace.com/2017/06/dont-chase-rite-aid-corporation-rad-stock-down-the-toilet/.

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