Rite Aid Corporation (RAD) Stock Boosted by Buoyed Buyout Hopes

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The pending merger between Rite Aid Corporation (NYSE:RAD) and Walgreens Boots Alliance, Inc. (NASDAQ:WBA) has been shrouded in uncertainty. As a result, RAD stock has crumbled, with investors worried that without a deal, Rite Aid looks like a weak No. 3 in the drugstore world.

However, Rite Aid got a boost today by the third party in this deal — Fred’s, Inc. (NASDAQ:FRED), which said it’s still committed to buying as many as 1,200 Rite Aid locations. Moreover, the New York Post says “more than one prominent investor has recently approached Fred’s Inc. about investing money in the regional drugstore chain,” which would help give it the cash needed to pull off the acquisitions.

It’s an important condition for the Walgreens-Rite Aid merger to get Federal Trade Commission approval. That — and assurances from Walgreens CEO Stefano Pessina that he believes the deal will be approved soon — and has RAD longs breathing a sigh of relief today, to the tune of about 7%.

Rite Aid needs this. While Walgreens can survive without bringing Rite Aid under the fold, RAD is in a stickier position.

Can Rite Aid Get Over Merger Hurdles?

Back in January, Walgreens extended the deadline on the Rite Aid merger to July 31, though the company in March set an FTC approval deadline for July 1.

The FTC is currently weighing whether Walgreens and Rite Aid are giving up enough to avoid antitrust issues, and part of the deal was the sale of 850 stores to Fred’s.

On Thursday, though, Fred’s said it “is working collaboratively with Walgreens Boots Alliance, Rite Aid and the Federal Trade Commission to help obtain the FTC’s approval of Walgreens Boots Alliance’s pending acquisition of Rite Aid and the divestiture of certain Rite Aid assets to Fred’s Pharmacy,” and that the company is committed to buying up to 1,200 stores, which many believe could be enough to get the FTC’s OK.

Should the deal fall apart, WBA will have to pay Rite Aid a $325 million breakup fee. Judging from last quarter’s drop in sales, RAD is better off working out a deal than taking the fee.

Why RAD Stock Is in Trouble

Rite Aid has made a few investments that hurt net income in prior quarters but could pay off over time; for instance, in Q2, RAD spent $1.78 billion buying Envision, a pharmacy benefit manager. This raises its leverage ratio but management set a forecast for the unit being accretive to cash EPS in 2017.

Still, Rite Aid likely will underperform for several quarters if the deal falls through, as management has been mostly distracted from running the business, and instead focused on getting this deal done.

Rite Aid stock

In Rite Aid’s third quarter, the company reported flat revenue growth and earnings of just 2 cents per share. Revenues from the retail pharmacy segment dropped 3.1% year-over-year to $6.5 billion. Same-store sales were worse, off 3.4%.

The remodeling of 95 stores may help improve sales in the quarters ahead. The problem is that it has 4,547 stores in total, so the updates may not help sales.

Downside Target Too Pessimistic

One thing that’s odd: Deutsche Bank recently posted a 53% downside target for RAD and ~14% downside outlook for WBA.

Yes, Deutsche Bank is right to be pessimistic about the outlook for RAD stock. In addition to all of the above, Rite Aid also has unmanageable debt levels, with a debt-to-equity ratio of 11.3. It needs Walgreens’ steady cash flow to sustain the business.

But the negative forecast for Walgreens makes little sense. Once it acquires Rite Aid’s stores, it may close underperforming stores, cut costs, optimize operations and boost returns from the stores. And fundamentally speaking, WBA is handling its business fine, not to mention, it should enjoy upside from its recent contract with the Tricare Pharmacy Network, taking business away from rival CVS Health Corp (NYSE:CVS).

The real danger here is Rite Aid. The company has underperforming stores and a mountain of debt. Walgreens has the leadership needed to fix the business, but Rite Aid doesn’t.

If Fred’s nudge helps a deal get through, RAD stock has massive upside potential since much of the deal premium has been flushed out of shares. But if the merger fails, expect Rite Aid to fall to $2 per share or worse.

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

Chris Lau is a contributing author for InvestorPlace.com and numerous other financial sites. Chris has over 20 years of investing experience in the stock market and runs the Do-It-Yourself Value Investing Marketplace on Seeking Alpha. He shares his stock picks so readers get actionable insight to achieve strong investment returns.


Article printed from InvestorPlace Media, https://investorplace.com/2017/04/rite-aid-corporation-rad-stock-gets-an-assist-from-freds/.

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