It's been a tumultuous week for Rite Aid amidst a high profile merger attempt with Walgreens and investigation by the Federal Trade Commission. Investor Brandon Paulson shared a long idea on Rite Aid a few months ago on SumZero, and though his original hope for a merger has been dashed, Paulson continues to see Rite Aid as an opportunity stock with much more upside than down.
Luke Schiefelbein, SumZero: What’s going on with Rite Aid these days? A lot has happened in the last few months for the company.
Brandon Paulson: Rite Aid recently agreed to terminate its merger with Walgreens, after an Federal Trade Commission review that lasted over 500 days. The decision followed strong indications from the FTC that the merger would not be approved by the Commission. Rather than defend the deal through litigation, Walgreens and Rite Aid mutually agreed to terminate the transaction. Walgreens agreed to pay Rite a $325m termination fee.
Rite Aid also agreed to sell 2,186 stores to Walgreens for $5.175b in cash. The Company plans to use the $5.5b in cash it will receive from Walgreens to reduce the debt on its balance sheet. After paying off liabilities related to the store assets it will divest to Walgreens. Rite Aid anticipates it will have $4.5-$4.7b in cash to pay down debt, reducing its leverage ratio by 50%. While that transaction will reduce the strain of the Company’s debt load on its operations, it will also leave Rite Aid with only 52% of the store footprint it currently has.
Schiefelbein: What is the market missing and why? Why are you still long Rite Aid even though the merger with Walgreens has fallen through?
I don’t think the market is necessarily missing anything. Investors have mandates. While the merger process was active, most shareholders probably had event-driven mandates. Now that the Walgreens merger is over, the event-driven investors have to sell the stock to shareholders with a long-term horizon. It’s reasonable to expect short-term selling pressure while the shareholder base reconstitutes itself.
What I think the market does underestimate is the desire of Rite Aid management to sell the company. They just went through a sale process that lasted almost 2 years. It does not seem likely that the management team would suddenly change tack and decide to operate the business for the long-term. They want to make a deal, and the deleveraging that the asset sale to Walgreens enables should provide financial flexibility that increases the universe of interested acquirers.
Schiefelbein: After selling a huge number of stores to its chief competitor, how can Rite Aid possibly compete in the long term, especially with additional pressure from Amazon? Does this affect your valuation?
Paulson: First, there is no current pressure on Rite Aid from Amazon. Amazon does not currently participate in the distribution of prescription drugs, nor will it via its acquisition of Whole Foods. Any competitive threat from Amazon to Rite Aid is largely theoretical at this point. It is true that the two companies compete on “front-end” items (e.g., grocery) but the bread-and-butter of Rite Aid’s business is selling drugs, a business where Amazon is a potential entrant not a current participant.
In connection with the asset sale to Walgreens, Rite Aid received a 10-year option to purchase generic drugs from Walgreens’ purchasing organization. That gives Rite Aid the benefits of Walgreens’ scale while allowing it to shrink into a more easily-managed store footprint. It’s not a permanent solution, but ten years gives Rite Aid a lot of runway to figure things out.
Though Rite Aid will be giving up ~48% of its store footprint, management indicated that it will be keeping more than the implied pro rata share of total profit: in other words, the stores it plans to keep are more profitable than the ones it plans to sell. Higher operating profits combined with lower interest expense should increase returns to shareholders.
Schiefelbein: What will catalyze the market to realize the true value for Rite Aid?
Paulson: The most likely near-term catalyst for Rite Aid’s true value to be realized is another acquisition offer, probably from a financial buyer like a private equity firm.
There has been a lot of speculation that Rite Aid would be an attractive target for Amazon. I don’t think Rite Aid will be acquired by Amazon for several reasons. First, Amazon has its hands full with the Whole Foods acquisition and Rite Aid has the asset sale to Walgreens to complete (and FTC approval to obtain to do that). Prescription drug distribution is also highly regulated and Amazon may not think the learning required is worth the hassle. Third, pharmacy chains have been under a lot of revenue pressure due to lower reimbursement rates. It would seem that a better time for Amazon to enter the market would be when reimbursement rates stabilize.
I think the transaction that makes the most strategic sense for Rite Aid is to go private. A smaller, nimbler Rite Aid with a more flexible balance sheet should be attractive to private equity firms. Being private would allow management to deal with the reimbursement rate pressure out of the public eye. It would allow management to replenish its equity compensation in a potentially lucrative fashion. It would reward faithful shareholders with a control premium. And it could be executed quickly, without the lengthy FTC review that would probably accompany an offer from a strategic acquirer.
Absent an acquisition offer, the most likely event that would catalyze a change in the market’s attitude toward Rite Aid would be a stabilization of reimbursement rates.
Schiefelbein: What key metrics should investors be paying attention to as your thesis matures?
Paulson: Gross margin is the most important metric to monitor in the near-term. Declining reimbursement rates have done the most recent harm to Rite Aid’s business. Rite Aid does not report a metric that embodies reimbursement rates, but their effect is felt in the Company’s gross margin. Between fiscal years 2015 and 2017, gross margin fell from 28.6% to 23.7%. If management can reverse that trend performance will quickly improve, especially with lower interest expenses after the asset sale to Walgreens happens.
Another salient metric is sales growth. One of management’s strategic priorities is to increase sales by offering a wider array of healthcare services (e.g., immunizations). Another strategic initiative is the remodeling of existing locations into “wellness stores” that have improved interior design, expanded clinical pharmacy services and new merchandising and wellness product offerings. The ultimate success of these initiatives will depend on whether they drive sales.
Schiefelbein: What are the biggest risks associated with the trade in your view?
Paulson: The biggest risk of the trade I originally recommended was that the merger would be called off, which is exactly what happened. I did not think Walgreens and Rite Aid would fail to defend the deal in court against an FTC lawsuit after working on the deal for almost two years, but I was clearly mistaken. Regulatory risk remains an issue for Rite Aid because it needs FTC approval to complete the asset sale to Walgreens, and it needs to complete the asset sale to fix its balance sheet.
Going forward, the open question is whether Rite Aid will have the requisite scale to attract the interest of third-party payor networks. Currently five third-party payors represent ~75% of Rite Aid’s pharmacy sales. That sort of customer concentration gives the payors leverage to continue pushing down reimbursement rates. There is a risk that a smaller Rite Aid could be less attractive to these payor networks and either be dropped from coverage or have its reimbursement rates (read: gross margins) lowered further.