On June 29, Walgreens Boots Alliance Inc (NASDAQ:WBA) and Rite Aid Corporation (NYSE:RAD) announced they were calling off the previous merger agreement where Walgreens would buy Rite Aid outright. Because it couldn’t secure regulatory approval, Walgreens is instead buying 2,186 Rite Aids stores — mostly in the Northeast, Mid-Atlantic and Southeastern regions.
Rite Aid’s total store count at the end of the first quarter was 4,523, so the deal will leave just over half of the pre-deal stores. That’s quite a drop. All of the locations in California, Oregon, Michigan and Washington state will remain. Many will remain in Ohio. Its store presence in the other states will drop rather dramatically.
Before the deal, Walgreens boasted 13,200 stores in 11 countries. The deal is certainly not transformative for Walgreens, but the new locations account for nearly 17% of its total existing store count.
So, it is still a significant deal and adds to an already significant debt load of nearly $19 billion — Walgreens is paying Rite Aid cash for the stores.
The Bright Side for RAD Stock
The deal actually helps Rite Aid out immensely. Of course it cuts the stores in half, but Rite Aid had nearly $7.3 billion in debt. Rite Aid will receive $5.2 billion in cash for selling its stores and said the bulk of the proceeds (it expects net proceeds of $4.9 billion) will go to paying down debt. And Rite Aid is also getting $325 million from Walgreens since the deal fell through. Not a bad consolation prize.
The overall deal is actually great for Rite Aid investors. Lower debt will help it cut interest expense that was running in excess of $400 million annually. Reported profits had been dwindling, falling from $2.1 billion in fiscal 2015 to less than $4 million last year. Overall, interest expense will take a much smaller bite from the income statement.
Rite Aid’s cash flow trends were more consistently higher, but also erratic. Operating cash flow hit nearly $1 billion in 2016, but also fell to only $225 million in 2017. And capital spending was averaging around $500 million over the past five years. Less interest expense is also less cash flow going out the door each year.
It’s actually difficult to see what the pro forma financials will be after Rite Aid sells its stores. Interest expense and capital spending will go down, but so will depreciation and amortization. In a recent earnings presentation management spent too much time on EBITDA (earnings before interest, taxes, depreciation and amortization), showing the net effect of the changing financials.
Demonstrating why EBITDA is a silly metric, it actually falls 35% for Rite Aid’s current year when accounting for the store sales. But that is a GOOD thing because interest expense is much lower, even netting out the lower depreciation from less stores.
Again, it’s hard to say for sure, but let’s say annual cash flow improves a couple of hundred million from the net effect of lower interest expense, lower depreciation and lower capital spending. That could be as much as 20 cents per share.
That could push free cash flow up to around 50 cents per share, or only about 4.6 times the current share price of around $2.29 per share. For comparison purposes, Walgreens trades at more than 16 times free cash flow. CVS Health Corp (NYSE:CVS) is right around there in the low double digits.
Rite Aid is no Walgreens or CVS, but it’s reasonable to see the shares double from current levels. There is also takeover appeal from anyone BUT Walgreens at this point. CVS might have an interest in the rest of the stores. Smaller rival Fred’s, Inc. (NASDAQ:FRED) was set to get some of the Rite Aid stores that Walgreens was trying to offload to get the original deal through. It or other small fry in the industry might also want to acquire what is left of Rite Aid.
I wouldn’t plan to load up on Rite Aid stock. Management doesn’t have much of a track record of successfully managing its store base. It certainly falls short of the growth and returns that Walgreens and CVS have been able to post over the past decade.
But it does have some speculative appeal. Much-lower debt lowers any bankruptcy risk significantly. Based off the improved financial position, cash flow should be consistently higher. This alone could push the share price up. And there is takeover appeal to the stock from the likes of CVS, or even a grocery store operator such as Kroger Co (NYSE:KR). A $1 share price rise would be a gain of 44% for shareholders at current prices.
As of this writing, Ryan Fuhrmann was long shares of Walgreen and Kroger.