The ongoing will-they, wont-they merger drama between Rite Aid Corporation (NYSE:RAD) and Walgreens Boots Alliance (NYSE:WBA) appears to be nearing its end with the two parting ways without a full-scale acquisition. Instead, Walgreens is planning to purchase nearly half of Rite Aid’s stores as well as three of its distribution centers for $4.38 billion in addition to the $325 million the firm will pay RAD after backing away from the original merge.
The new deal has done very little to revive Rite Aid stock- shares are down more than 70% so far this year. However, the influx of cash coupled with a leaner organization may be just the recipe for a RAD stock boost and although it’s a risky play, RAD may actually make investors some money in the coming months.
A Worse Deal for Rite Aid?
Investors were initially expecting Rite Aid to sell 254 more of its stores to Walgreens, which would have brought in approximately $1 billion more. However, in order to satisfy regulators and avoid further antitrust concerns, WBA has agreed to give up locations that raised questions.
News of the lower payout caused RAD stock to plummet as investors worried about whether or not the lost cash would weigh on Rite Aid’s revival. While it’s true that an extra billion dollars would have been useful in paying off Rite Aid’s debt burden, the new deal should cut down on the firm’s interest expense more than enough to raise Rite Aid’s operating income significantly.
Debt Paydown
The new deal isn’t the rescue Rite Aid was looking for, but it does offer a lifeline that will keep the firm from going under. RAD has a massive $7.3 billion debt load, if the majority of the proceeds from the new WBA deal go toward paying that figure down, the company will be on much firmer footing. That translates into more than halving Rite Aid’s current debt obligation, which will massively improve cash flow as it will cut down on interest payments.
On its own, lowering RAD debt is probably enough to bring the stock higher because the firm’s quarterly reports will likely start to look a little more solid without the $432 million in interest expense that the firm has been running up each year. As my colleague Ryan Fuhrmann pointed out, following the new deal we can expect to see profits and operating cash flow start to stabilize.
If Rite Aid follows through and puts $4.3 billion toward its existing $7.3 billion debt load, that could slash interest expenses by roughly 59% to just $177 million. Rite Aid is losing 42 percent of its stores, so we can assume that the firm’s operating income will decline by the same amount to $276 million. Once interest expense is deducted, Rite Aid is left with $99 million, more than double the $48 million that the firm posted with all of its stores on the books.
Upping the Ante
The other big thing that the Walgreens deal does for RAD is that it puts a price on the firm’s stores. Walgreens is buying 1,932 of Rite Aid’s locations for $4.38 billion in cash. Of course Rite Aid’s profitability from store to store is varied, but that essentially means that WBA believes that each Rite Aid store is worth around $2.26 billion.
To put that into perspective, RAD’s total market cap is $2.5 billion. So even if we assume that Walgreens is paying a bit of a premium, it still suggests that Rite Aid is worth a lot more than the market is giving it credit for. The deal leaves Rite Aid with 2,689 stores- which based on these figures, are worth upwards of $6 billion.
There’s potential that the stores WBA is buying are the most profitable ones, but Rite Aid’s management has said that with a smaller footprint and a leaner organization, profitability should be more attainable.
Here Comes the Speculation
All of the above figures don’t matter much if you think RAD is going to drive this bus into the ground. However, if you think that management can pull it together, even a little bit, RAD stock might be able to deliver.
I don’t think RAD is going to go under. Instead, I see one of two situations playing out, either of which would be great for shareholders. First- theres the potential that Rite Aid can go it alone, turn the ship around and eek out profits from its slimmed-down store portfolio. At very least, I think RAD will be able to show improvement over the next year based on the calculations above.
The second, more desirable scenario is that Rite Aid gets another buyout offer once the WBA deal is done. With a lower debt load and half of its stores up for grabs, RAD might be an attractive prospect for other pharmacy chains like CVS Health Corp. (NYSE:CVS) or those trying to get a foot in the door like Amazon.com Inc. (NASDAQ:AMZN).
Of course, another buyout deal is highly speculative but it’s not impossible. CVS acquiring RAD is unlikely due to the regulatory headache that Walgreens already suffered- but an Amazon deal wouldn’t be that far-fetched.
The Bottom Line
The new Walgreens deal isn’t as bad as the market would have you think. On paper it looks like it will boost the share price significantly as long as management follows through and uses the cash to pay off its debts. Buying RAD stock doesn’t come without risks, but the rewards might make it worth the uncertainty.
As of this writing, Laura Hoy was long RAD.
