Shares of Rite Aid Corporation (NYSE:RAD) have taken a beating in 2017, falling more than 70% so far on the year. What once looked like a slam dunk in a deal with Walgreens Boots Alliance Inc (NASDAQ:WBA) has now burned investors. Longs were betting on a deal. Then they were betting on RAD stock being too cheap. Now they’re left scratching their heads.
It leaves us with the question: Is there anything left to pick over on the carcass?
My initial feeling is simple. Why buy RAD stock when there are so many wonderful companies to choose from? I would rather pay a premium for a great company than a discount for a poorly run one.
That said, there could be value worth exploring in RAD stock, and therefore we should take a closer look.
Rite Aid’s Deal With Walgreens
After the FTC dragged out the WBA-RAD acquisition, WBA suddenly pulled out of the deal. Walgreens paid Rite Aid a cool $325 million termination fee to free itself of the original agreement. It then agreed to acquire nearly 2,200 RAD locations for $5.175 billion.
Fred’s, Inc. (NASDAQ:FRED), which was set to purchase some RAD locations in order for the original WBA-RAD deal to gain regulatory approval, was cut out from the new deal. So as it stands, RAD will receive a $325 million termination fee and $5.175 billion (should the deal pass) for its assets. It will part ways with 2,186 retail locations and three distribution centers.
Is This a Good Deal?
The deal leaves Rite Aid with just over half of its current retail footprint. The deal seemingly grabs a lot of locations on the East Coast. However, management argues it will have some its best performers still on the table, with locations along the West Coast and in states like New Jersey, Ohio, Michigan and Pennsylvania.
It’s hard for me to believe WBA would shell out almost $5.5 billion (termination fee included) for RAD’s worst and mediocre stores. But if Rite Aid really is left with some of its best-performing locations, maybe it has a chance. Its financial are far from beautiful, though. As of last quarter, Rite Aid had about $214 million in cash. Debt stands at a daunting $7.24 billion — roughly three times the size of its $2.43 billion market cap.
However, if RAD adds WBA’s $325 million breakup fee to its cash position, it now has half a billion in cash. The company said it plans to reduce debt by $4.9 billion, bringing the total down to a far more manageable $2.45 billion. Management also expects average sales per store to climb to $6.1 million from $5.7 million. Adjusted EBITDA per store should also increase. These are positive trends for investors to grasp.
Will this work? First we need the deal to go through. Buying RAD stock is speculating that is indeed the case. In a way, this deal is sort of like a bankruptcy filing, albeit, far healthier in this case. Rite Aid can use this deal to reorganize its best-performing stores, shed debt, boost cash and hopefully get back on track.
The Bottom Line on RAD Stock
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Despite the company’s continual struggle to produce a profit, investors can be optimistic that operating cash flows aren’t too bad. With low capital expenditures, the cash generation at Rite Aid is surprisingly decent. Its ability to “significantly reduce leverage and provide flexibility to invest in the business” is certainly a positive.
Rite Aid’s participation in the WBA Development program gives RAD a chance to lower its drug prices for the next decade. That should help with margins and getting its overall net income from red to black, and hopefully to green.
RAD is making the right moves to ensure it doesn’t go the way of Radio Shack. It may still fail, but it’s increasing the odds that it doesn’t. RAD stock is building a solid base near the $2.20 level. Should that level hold, speculative investors can justify starting a long position in the low-$2 range.
They should know that if the deal fails, RAD stock could go substantially lower. However, the latest developments are positive and there is a limited-risk situation presenting itself for investors who know those risks.
Bret Kenwell is the manager and author of Future Blue Chips and is on Twitter @BretKenwell. As of this writing, Bret Kenwell did not hold a position in any of the aforementioned securities.
