I see an asymmetrical trade with Rite Aid Corporation (NYSE:RAD) and a few ways to play it. “Asymmetrical” means that there seems to be more possible return on one side of the trade in a certain period of time than downside on the opposite side of the trade.
What is the situation with RAD stock? Well, it’s what I call a “special situation.” It’s not a growth stock. It’s not a value stock. There is risk but I think it is limited.
On Wednesday, RAD stock closed at $2.42. This is quite a ways lower than when it looked like RAD stock might merge with Walgreens Boots Alliance Inc (NASDAQ:WBA). Normally, when you have a situation like RAD stock, shareholders demand a turnaround artist come in. A turnaround team looks at the entire company and decides on how to completely re-envision the approach and execution. McDonald’s Corporation (NYSE:MCD) is a great example.
However, the situation with RAD stock is different. A fast food chain like MCD can be repositioned and reinvented. It’s darn near impossible to reinvent a drug store. They tried — all of the chains tried. Rite Aid, and all the others, added food and refrigerated products to the stores. They added aisles for hardware staples and toys and canned foods.
Yet all that really did was take a pharmacy and make it into a convenience store that also happened to fill prescriptions. It just offered all these products at the same price as a grocery store albeit without much of a convenience store premium markup.
Management really only has one goal at this point: Sell the company, so they can sell their Rite Aid stock.
Now, we know that Cerberus Capital already looked into purchasing a large number of Rite Aid stores. Private equity shops like Cerberus are mostly interested in one thing: taking assets that are doing okay, bringing in some really smart people and figuring out how to enhance cash flow.
Private equity loves cash flow. If an asset already has it, that’s even better. The more cash flow is enhanced, the quicker the private equity shop will make back its money. If the cash flow situation is substantially improved, the private equity shop will spin the company out into a new IPO and cash out.
RAD stock is the perfect candidate for this situation. While the situation has been worsening at Rite Aid, it is not beyond repair. Because RAD appears ready to sell a chunk of stores, it will bring in a ton of cash and reduce debt by about 72%. That in turn means less money spent on debt service.
What does that mean? Higher cash flow, almost $300 worth of additional cash flow.
I believe investors have a way to make some money here. Because RAD stock was as high as $7 when there was merger talk, there is substantial upside from $2.42 per share.
If stores get sold and private equity buys up the remaining assets, RAD stock will definitely be worth more than $2.42. Will it be worth $7? Probably not. However, Rite Aid had a whopping $32 billion in revenue in its last fiscal year. WBA stock trades at 0.75x revenues. Even at 0.2x revenues, RAD stock goes for more than 100% of today’s closing price. I offer that extremely conservative multiple to make up for the 0.75x debt-to-capitalization ratio vs. WBAs of 0.16.
Consider buying RAD stock outright or perhaps consider buying the 18 Jan. 2019 $2 calls for a mere $1. That gives you 17 months for the situation to shake out.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance, and is the Manager of The Liberty Portfolio at www.thelibertyportfolio.com. He is long RAD stock and RAD January 2019 calls. He has 22 years of experience in the stock market and has written more than 1,600 articles on investing. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com.
