After its planned merger with Walgreens Boots Alliance Inc (NASDAQ:WBA) fell through, Rite Aid Corporation (NYSE:RAD) stock fell down — by about 30%.
And then it continued to slide. In about two weeks, RAD stock had fallen from roughly $4 to right around $2.20. But investors are starting to pick up the scraps in the selloff and RAD stock is up about 20% over the past five days.
Is the rally justified? Should you jump in and buy RAD stock today? I think so. Here’s why.
The New Rite Aid Has Value
The Rite Aid that will emerge from the WBA deal will be much different than the company that existed before the deal.
Here’s the context. Walgreens was going to buy RAD for $9.4 billion, or about $9 per share. That was back in October 2015. The Federal Trade Commission (FTC) didn’t like that idea, so it told Walgreens and Rite Aid to go back to the drawing board. They did, and came back with a new deal that involved selling some Rite Aid stores to Fred’s, Inc (NASDAQ:FRED) and lowering the acquisition price to $6.50 to $7 per share.
But that got scrapped by the FTC, too. So now WBA is simply going to buy 2,186 Rite Aid stores for $5.2 billion in cash. That is about half of Rite Aid’s total store base (4,523 as of June 2017).
Coming out of this deal, then, Rite Aid will look completely different. Its store base will be essentially cut in half to about 2,300, but its cash will have surged from about $200 million to $5.4 billion. Financially speaking, that is an entirely different company.
Management plans to use that cash to pay down debt, which has been the biggest overhang on RAD stock for some time. After all, a company with a lot of debt and deteriorating operations is a prime bankruptcy candidate. Rite Aid has about $7.2 billion in total debt, compared to a market capitalization of $3 billion. That’s a troublesome situation.
Paying down $5.2 billion in debt, though, would bring the debt balance to somewhere around $2 billion. That feels a whole lot more manageable for a company with a market cap of about $3 billion.
Paying down that much debt will also help the company’s annually recurring financial results. How? A lot less in interest expense, and that’s a big deal for a company whose interest expense has been bigger than its pre-tax income in four of the past five years.
All in all, the new Rite Aid will have less stores, less debt and lower expenses. That should translate into a smaller business with significantly higher profit margins and a stronger balance sheet.
That trifecta of changes should push RAD stock significantly higher than where its currently trading.
The New RAD Stock Also Has Challenges
But there are also risks to the new Rite Aid, and they pretty much all come down to one question: Where will Rite Aid be in 12-24 months?
Yes, the upside scenario is that RAD stock will be a smaller drug store operator with higher margins and less debt than before, but there is also a downside scenario.
With only 2,300 stores versus 4,500 before, RAD will be significantly smaller. A significantly smaller drug store chain could have trouble negotiating for and competing on prices. It could also have trouble generating enough cash to fund new growth projects, or use advertising to drive traffic.
All in all, RAD could be just another victim to the Amazon.com, Inc. (NASDAQ:AMZN) takeover. If Amazon attacks the pharmacy market all by itself, the smaller players will be the ones who get their lunch eaten first. Just look at retail. It isn’t Wal-Mart Stores Inc (NYSE:WMT) or Target Corporation (NYSE:TGT) declaring bankruptcy; It’s the Wet Seal and the Quiksilver retailers of the world.
In this day in age, being small is not an advantage.
At these depressed levels, the potential upside is greater than the potential downside. Yes, RAD could be victim to AMZN encroachment, but it could also be a buyout target for the retail behemoth. With less debt and higher margins in its future, RAD stock looks like a buy here.
As of this writing, Luke Lango was long AMZN and RAD.
