I can understand why investors might be tempted to time the bottom in Rite Aid Corporation (NYSE:RAD). The revised deal with Walgreens Boots Alliance Inc (NASDAQ:WBA) clearly is a disappointment. Walgreens originally had been willing to pay $9 per share for RAD stock, after all … and it now trades just above $2.
But all hope might not be lost.
The new deal will allow Rite Aid to pay down nearly $5 billion in debt, according to a July presentation. As such, interest expense will come down markedly — and cash flow should increase. Retained stores actually have higher sales than the chain does at the moment. And RAD stock, based on post-sale figures, trades at a marked discount to what Walgreens is paying for the acquired stores.
There’s one key problem, however. Rite Aid’s business is in a steady decline. As cheap as RAD shares might look at the moment, they’ll only get more expensive as earnings decline.
If the current trend doesn’t change, Rite Aid will wind up right back where it started: with too much debt and not enough growth. Until that trend changes, investors should stay away.
Fixing Rite Aid’s Balance Sheet
Fundamentally, there is a bull case to be made for RAD stock.
At the end of the first quarter (ending June 3), Rite Aid had $7.09 billion in net debt. According to the company’s pro forma results presentation, however, some $4.92 billion of the $5.5 billion being received from Walgreens (including a $325 million breakup fee from the original deal) will be used for debt reduction.
That cash seems to fix RAD’s balance sheet — at least for the moment.
At the end of Q1, Rite Aid’s leverage ratio (net debt to adjusted EBITDA) was a whopping (and concerning) 6.8x. That figure, based on pro forma net debt of $2.17 billion and Adjusted EBITDA of $743 million, would be under 3x — albeit at the end of Q4. (Rite Aid hasn’t released pro forma numbers for Q1.)
Guidance for the specific debt to be paid back — including the revolving credit facility, two term loans, and two bond issues — suggests something like $230 million in annual interest savings.
That’s obviously a huge number, which provides a material boost to RAD’s cash flow generation. Pro forma figures suggest that the sale would only have cost Rite Aid $394 million in pre-tax profit in fiscal 2017. Interest savings alone are returning more than half of that loss. Rite Aid is significantly de-risked by the deal.
RAD Stock Suddenly Looks Cheap
And near $2, Rite Aid stock suddenly looks reasonably inexpensive. The multiple Walgreens is paying for roughly half of Rite Aid’s stores suggests the market is substantially undervaluing the other half.
Pro forma figures suggest an EV/EBITDA multiple — again, at the end of FY17 — of about 6.25x. But Walgreens is paying likely more than 10x, even excluding the breakup fee. (Rite Aid is projecting $96 million in corporate savings, which implies something like $490 million in store-level profits.) A 10x multiple for the remaining EBITDA would value Rite Aid stock at about $4.50. (Enterprise value in this scenario would be ~$7.4 billion, less net debt of $2.2 billion for a market cap of $5.2 billion. That’s roughly double current levels.)
Similarly, Walgreens is paying about $2.36 million per Rite Aid store. Using the same valuation for the remaining stores, RAD stock would be worth about $3. But Rite Aid’s remaining stores actually are better than the ones it’s selling. Per-store revenue and profits are higher.
Either way, it looks as if Rite Aid could sell the rest of its business for $4 per share, or more. And that seems to imply real upside from a current price closer to $2.
The One Big Problem
There’s one big catch here (and two smaller ones).
The big problem for RAD stock is that those numbers are looking backward — but going forward, profits are going to decline. First-quarter adjusted EBITDA (as reported) fell 33%. Pharmacy sales growth has steadily turned negative, moving from +3.9% in Q1 FY16 to -5% in both Q4 FY17 and Q1 FY18.
Those profits are going to continue falling, at least in the near-term. Management said on the Q1 conference call that margins in pharmacy would be challenged for at least the rest of the year. Reimbursement rate pressure continues unabated. Rite Aid does have some room for improvement, but it’s already cut store-level spending, and that figure likely will rise going forward due to labor and healthcare cost inflation.
Rite Aid still has enough debt that its valuation can’t handle falling profits. Assuming pro forma EBITDA falls from $743 million in FY17 to $600 million in FY18 — a much better performance than Q1 implies — the leverage ratio suddenly rises back toward 4x. The EV/EBITDA multiple expands to a more normalized 8x. And the seeming premiums in a buyout largely evaporate; a 10x multiple only values Rite Aid stock at $3.
Avoid RAD Stock
That’s not enough, because there isn’t a natural buyer for the rest of Rite Aid. CVS Health Corp (NYSE:CVS) likely has little interest in going through the same drama that Walgreens did. Rite Aid’s EnvisionRx PBM is too small for massive rivals like Express Scripts Holding Company (NASDAQ:ESRX), CVS’ CareMark, or UnitedHealth Group Inc (NYSE:UNH) to have any interest.
Even if earnings stabilize, Rite Aid stock isn’t cheap. And even that ignores the still-present risk that the revised deal might fall through.
RAD stock might look cheap, and this might look like a bottom. But if current trends hold, Rite Aid stock has further to fall.
As of this writing, Vince Martin did not hold a position in any of the aforementioned securities.
