There Aren’t Many Good Reasons to Buy Rite Aid Stock Ahead of Earnings

Don't let the share price fool you, RAD stock has further to fall

For Rite Aid (NYSE:RAD), things have gone from bad to worse to even more terrible. There seems to be no end to the suffering for its loyal long-term shareholders. RAD stock recently hit 51 cents, adding insult to injury for anyone who purchased shares for as much as $8.50 several years ago.

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Unfortunately, there’s no clear sign that things are about to get better. In fact, with earnings on deck, things could get even worse. Rite Aid still doesn’t have a clear corporate strategy.

The aborted merger with Albertson’s looked like a desperation move. Rite Aid’s management has now left, but it’s unclear if the new folks taking over will be able to make anything out of Rite Aid’s dire situation.

Walgreens Poor Performance: What It Means For Rite Aid

It’s no secret that companies within a sector tend to trade together. In fact, a large portion of a stock’s overall returns can be correlated to its sector’s returns.

Investors often blow this effect out of proportion, for example, when folks dump the whole semiconductor sector when an Nvidia or Intel misses earnings. In some cases, though, the performance of your sector peers is highly important. Walgreens Boots Alliance (NYSE:WBA) is one such case.

Walgreens missed earnings in dramatic fashion last week. Management described it as the single worst quarter in the company’s history since the merger with the United Kingdom’s Alliance Boots in 2014.

While Walgreens was able to increase revenues modestly, everything else plunged. Earnings slumped 8% year-over-year, margins tanked, and operating performance declined across all business segments. Walgreens also slashed its 2019 guidance from 7-12% earnings growth to merely flat results. That’s a drastic change in outlook.

This is bad for RAD stock the obvious reason that since both Walgreens and CVS Health (NYSE:CVS) are reporting difficult results and seeing their shares plunge to multi-year lows, it indicates that Rite Aid is facing strong headwinds as well.

However, things get even worse for RAD stock. Consider that Rite Aid just sold several thousand stores to Walgreens. Now Walgreens is reporting its worst quarterly results in years, and is shutting down some of the former Rite Aid stores it acquired.

This suggests that Rite Aid’s locations were in even worse shape than both the market and Walgreens’ management had anticipated. Given Rite Aid’s spotty management track record, it’s unlikely things have improved materially for the remaining Rite Aid stores either.

Look at the sudden decline in Walgreens operating performance – post Rite Aid store purchase – as a serious red flag for the quality of Rite Aid’s other locations.

RAD Stock: Don’t Let The 57 Cent Share Price Fool You

It’d be easy to look at RAD stock down under 60 cents and assume it is cheap. Walgreens was supposed to buy the whole company for $9 before antitrust concerns fouled things up. Surely a more than 90% drop from Walgreens’ bid represents deep value, right? Not so fast.

For one thing, this is one of those cases where the share price is misleading. Yes, RAD stock is quoted at 57 cents, but they have a gigantic number of shares outstanding. As a result, the total market cap is still over $500 million despite the low apparent share price.

Furthermore, Rite Aid’s shareholders recently gave management permission to reverse split RAD stock. The upcoming split will be between 1:10 and 1:20, which would take RAD stock from ~60 cents today to either $6 or $12 per share.

There will be no material change in the business’ value, but the apparent “cheap” share price will look more normal following the change. Historically, stocks tend to trade downward following reverse splits. This represents a short-term risk to RAD stock.

Rite Aid Stock Versus Its Bonds

Many times equity investors overlook the bond market. That can be a big mistake. For one thing, the bond market gives you a good indicator whether the smart institutional money thinks a company is at serious risk of bankruptcy or not. If a stock plunges but its bonds hold their value, it’s often a sign that the market is overreacting.

On the other hand, if the bonds plunge, there’s a good chance that the stock is going to zero. Remember that common equity has to end up essentially worthless before bondholders suffer any losses. If they are willing to sell their paper at a big discount to par, it’s a major concern.

And in the case of Rite Aid, the creditors are worried. Rite Aid’s 6.87% bonds maturing in 2028 have plummeted from 120 in 2016 in just 60 now. Bond prices are generally set at 100 and then trade up or down from there before the company ultimately redeems them for 100 at maturity.

In previous years, Rite Aid’s bonds traded over 100 as the nearly 7% interest rate was a huge appeal in a world of low interest rates. Since Rite Aid has hit the rocks, however, the bonds have plummeted to just 60 cents on the dollar.

If you are bullish on Rite Aid’s chances of turning things around, the bonds are likely a better play than the stock today. For one, you get the interest payments. Rite Aid now yields more than 11% annually (15% if you count gains to par as well).

That means you can, for example, buy $10,000 face value of bonds paying $687 a year in interest for just ~$6,000. Additionally, if Rite Aid survives to 2028, you would get paid the full $10,000 face value of the bonds despite buying at $6,000.

Sure, if Rite Aid can thrive again, the stock would have even more upside. But the bonds pay more than 10% a year in interest and offer solid upside as well.  Also, in a worst case scenario, the bonds offer meaningful downside protection.

RAD Stock Verdict

I know it’s tempting to buy stocks after a huge decline, such as the one Rite Aid has recently experienced. But there’s still a ton of risk here, despite the apparent low share price. Both CVS and Walgreens are struggling mightily, and they have more scale, better balance sheets, and superior management teams.

If those companies are suffering from current market conditions, it’s hard to imagine Rite Aid turning things around first. The earnings report on Thursday is likely to be disappointing, given the results from Walgreens.

There’s also the matter that Rite Aid is stuck with its Pharmacy Benefit Manager business. They’ve been trying to sell this, but they have apparently not been able to find a buyer at a reasonable price. That’s probably not surprising, as PBMs are under heavy political fire.

That’s unlikely to change prior to the 2020 presidential election. CVS has a PBM as well, and it is also under pressure right now. Again, it’s hard to get excited about Rite Aid, which is playing with a weak hand, trying to wheel and deal with assets that are badly out of favor. CVS and Walgreens have time to ride out this terrible cycle for pharmacies, for Rite Aid, the clock is loudly ticking.

At the time of this writing, Ian Bezek owned WBA stock. You can reach him on Twitter at @irbezek.

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