Rite Aid: Cleaned house? What now? – Rite Aid Corporation (NYSE: RAD)

The case against RAD Stock

I wrote back in August, with RAD close to $ 1.50, that the biggest problem was that the stock was not cheap. Almost 50% lower in March, and below $ 1, it is still to some extent.

The problem is the debt burden. Rite Aids pro forma net debt at the end of Q3 (end of December 1) was around $ 2.9 billion. ($ 3 billion net debt reported, returning ~ $ 160 million for the pending sale of two Walgreens distribution centers, plus a reimbursement payment to Q4, per comment on the Q3 call.) This figure is about 5, 2x the midpoint of FY19 Adjusted EBITDA Guidance of $ 545 – $ 570 Million. The RAD share may have been almost halved since August; But with my numbers, companies' value assigned to the business (including that debt) has only dipped about 15% over that stretch.

Meanwhile, the two obvious peers have drawn at the same time:

Data by YCharts

6-month map

At the center of guidance, RAD is trading at approx. 6.7x on an EV / EBITDA basis. Walgreens, in my estimation, is 8.2x in twelve months (through November 30). CVS (CVS) has a number of moving parts due to the acquisition of Aetna, but it appears to be below 8x based on the 2019 guide.

Equity-based valuations do not change history much. The focal point of FY19 guidance is $ 557.5 million. Capex is managed for $ 250 million this year. Interest expense was $ 56 million in the third quarter, and probably over $ 200 million annually in the future, even though further deletions are expected with the final payments from Walgreens.

Assuming zero cash tax (likely for the foreseeable future), the free cash flow may be [$ $ 100 million before working capital adjustments. A 8.2 x P / FCF majority seems attractive. But WBA trades on less than 10x FY19 EPS estimates; CVS is 8x. Both major peers – again – probably trade with only a modest premium when it comes to P / FCF. Both have much more scale, and even consider the Aetna agreement, cleaner balances.

On a relative basis, RAD, even near the lichen, seems almost not so undervalued. WBA and CVS – both of whom have their own problems – still deserve some RAD prizes at the moment, giving lower debt and greater reach.

And certainly RAD hardly seems cheap. 8x free cash flow is not an attractive multiple given leverage here. The bond market is pricing at a significant chance of restructuring at a time:

Rite Aid 7.7% notes due February 2027. source: FINRA

Rite Aid 6.875% Fixed Rate Notes Due December 2028. Source: FINRA

Mostly, this is still a declining business at the moment. EBITDA pro forma for TSA (Transitional Service Agreement, where Walgreens Refunds Rite Aid for Operational Stores after handover) Walgreens fees were $ 825.3 million in FY17. The number fell 21.6% in FY18. Guidance suggests a further 14% reduction this year – and a rough fourth quarter. Whole year guidance involves Q4 EBITDA of $ 115 – $ 140 million – down 19-33% year on year (again pro forma).

Whatever Standley's mistakes and mistakes, they are in the past. Looking at Rite Aid now, and in the future, is looking at a seriously challenged business. Margins are extremely thin and thinner: the center of guidance suggests an EBITDA margin of 2.55% this year, down 105 bps from FY17. The TSA fees go away in October, per management comment. (Walgreens can add two six-month extensions.) The balance is lent 5 times while earnings fall. And the industry is facing considerable pressure. WBA is at its lowest level for over four years (save for a very short blip last year). CVS trades at levels that have not been seen since 2013.

In this context, 8x free cash flow and 6.7x EBITDA do not look cheap. Rather, this looks like a dangerous business at all costs.

Bulls Case for Turnaround

Bulls can answer these concerns by pointing out that the numbers are largely recurring – and that is a fair point. There is hope for a turn – not least because Rite Aid has already withdrawn from the abyss once before. The shares traded close to zero in the depths of the financial crisis. As recently as 2012, Rite Aid was still 6x + leveraged, and seen in the first bond chart of its debt traded at depressed prices until the beginning of that year.

There are reasons to believe that Rite Aid can perform a similar turnaround time (although the expectations of another bounce from under $ 1 to over $ 7 seems too high, especially in this environment). First, performance in recent quarters has actually not been as poor. Rite Aid reduced guidance under the Albertsons agreement, which is attributed to weaker than expected savings from generic drugs. The updated outlook after the third quarter shifted the midpoint of the EBITDA guidance down (the range reduced from $ 540- $ 590M to $ 545- $ 570M).

Nevertheless, there have been some signs of life in terms of store performance. In the second quarter, the same store sales increased 1%, including a 1.6% increase in the pharmacy. The number of written regulations (on a 30-day basis) increased by 1.1%. In the third quarter, the company called its best prescription amount for over two years – and its strongest composition for more than three years. The same store sales jumped 1.6%, and the same store prescription amount increased 2.4%.

To be sure, this performance is not exactly dry. Rite Aid has benefited in both quarters from simple comparisons. Throughout the year, guidance (per 3rd quarter) for the same store sales is to rise 0.5% -1% – against a decrease of 2.9% last year, according to 10-K. The figures also appear to lead to continued market share losses, at least against larger rivals: CVS grew by 6% in 2018 (it also had a simple comparison), while Walgreens growth was 1.5% in FY18 (according to 10-K) and 1% in the first quarter.

However, in the context of new performance, YTD results mean somewhat close to stabilization. Generic pricing is still a headwind, taking 100 plus bps from pharmacy expertise in both Q2 and Q3 (and thus close to 70 bps outside of consolidated numbers). Rite Aid has made some efforts to improve merchandising, and there are still ~ 30% of stores not converted to the Wellness format. On the Q2 call, Standley noticed that there were still several stores that could get face lift – which increases sales – and at the same time we see that the company looked at potential moves of some stores.

It is at least enough in the latest results to suggest that a new management team could do better – the second reason for optimism here. There are simply so many moving parts to the business that modest movements can make a difference. And the EBITDA margins are so narrow – again, 2.5-2.6% – the small savings here and small savings that can lead to significant improvements in terms of cash flow and lifting profile.

Rite Aid takes some action against improvement. Standley on the Q3 call revealed a new partnership with the delivery service Instacart. Immunizations grow nicely. The company is pushing a 90-day prescription to increase adherence. Rite Aid is already closing some stores and may seem to do more on that front if the lease expires. And new management will have time: a refinancing done in December means that no debt will mature before early 2022.

It is difficult from the outside to find out what can or should be done. But again it doesn't take much. In fact, the big gain in the RAD share at the beginning of the decade came largely because Adjusted EBITDA increased 40% in FY13 and FY14 combined – at the back of basically flat comps. This growth began seriously less than two years after Standley was installed as CEO in June 2010.

EnvisionRxOptions

Perhaps the most interesting – and important – decision the incoming CEO has to make concerns Envision PBM. ) Rite Aid paid about $ 2 billion for Envision back in 2015 with the goal of building a "narrow network" (where the sponsor gets reduced costs in exchange for access to specific pharmacies only – in this case, Rite Aid).

The Agreement has not worked so far. Rite Aid made a write-down of $ 283 million on the acquisition in the second quarter. Revenues in the Pharmacy Services segment almost doubled 8% in FY18, per figure from 10-K. And, as an industrial observer pointed out, the intersegment eliminations fell after the purchase. This is a problem, as these eliminations occur when an EnvisionRx recipient fills a recipe with Rite Aid (since the company cannot order this purchase twice). In other words, the expected revenue synergies of the agreement were not materializing.

But here are some modest signs of life in FY19. Revenue from pharmacy services has increased by 4% so far this year (but, like retail, benefits from a lighter comparison). The management has spoken up the strength of the Medicare Part D business, and in the Q2 call, "some early advances" noted increased network access for the calendar year 2020.

Margins saw significant pressure in the first half: Adjusted EBITDA in the YTD segment is down 13% according to 10-Q. But in the third quarter, the business actually increased the result for the year (albeit with modest margin compression) – again some progress. And eliminations have also bounced back, rising 4.5% so far this year

There has still been calls for a while for Rite Aid to consider selling the business. There is still a small and potential subscale player, with part D market share well below 2%. Intersegment eliminations are less than 1% of total revenue; It is difficult to make the case that Envision actually moves the needle as far as retail. Wall Street Journal 's Charley Grant in September wrote that analysts at RBC estimated a potential price of $ 2.2 billion.

It seems very loud, given pressure to the room. Express Scripts sold to Cigna (CI) for about 9x EBITDA – which would value Envision at $ 1.4- $ 1.5 billion. The nearly $ 300 million write-down against the $ 2 billion purchase price suggests a valuation somewhere in that ballpark.

Having said that, even some $ 1.5 billion will clear up Rite Aids balance in a hurry. Assuming $ 160 million in full-year EBITDA for pharmacy services (YTD's $ 120 million), Rite Aid will remain with about $ 1.4 billion in net debt – and nearly $ 400 million in retail sales results. It would impact down to a more affordable 3.5x. Even a discounted 6x EV / EBITDA multiple on the retail will make RAD back up over $ 1, negate the need for potential reverse split and propose 30% + upside even from the afterhour levels. It is likely that the incoming CEO – the one who turns out to be – will at least give this option a certain rating.

Looking Ahead

All said, there is hope for RAD at these difficult levels. But there is a lot of work to do, many decisions to be made, and pressure that goes far beyond mere execution. Standley does not run Walgreens or CVS – but investors also dump shares of the generally respected companies. Repayment printing does not go anywhere, and Rite Aid must navigate an environment filled with ever-increasing players ahead.

The industry still doesn't seem so healthy – just one of the reasons I'm fascinated, but not close to jumping in. I have not been sold on Envision, given weakening margins and falling sales on a two-year basis. And it's hard to bet on new management without knowing who that management might be.

Meanwhile, near-time trading is probably volatile. Quarterly earnings fall due next month, and even though they are getting guidance, it becomes disappointing. FY20 guidance will be closely monitored; Stabilization in relation to EBITDA increases the shares, but there is much to ask. The management has said several times – most recently at a conference in January – that they could find $ 96 million in cost savings to compensate for the loss of TSA fees. But Rite Aid expects only $ 55 million from the extensive audit, which appears to be part of the original cost savings. (In the release announcing the management changes, the company wrote that the savings "will make up for an expected reduction in revenue related to its weaker obligations in the transitional agreement.")

The $ 42 million in savings expected in the FY20 should counteract the impact of TSA after October. But I am not convinced that the underlying business is ready to quit. There is certainly little sign of it in the 4th quarter of the guide; I wouldn't be surprised if the FY20 guide suggests a half improvement (thanks to the simpler comparisons), and investors, given Rite Aids latest history, show little faith in that vantage point. $ 0.76 seems cheap – but it made $ 1.50. RAD can fall further.

Truly I hope it works for RAD. It's been a long, ugly stretch since the first Walgreens deal broke. But as the old saying goes, the market does not care about what the cost base is. And it doesn't matter what Standley did in 2018 or 2012, or how obscene his compensation was.

It cares about the present value of future cash flows that can be returned to Rite Aid shareholders under the new CEO. And it will take solid decision-making, better implementation, and perhaps even some help from the health care system that the figure should come over $ 0. It is possible that the figure will prove positive – but investors should remember, even under new management that there are real risks that it will not.

Notice: I / We have no positions in any of the aforementioned stocks and no plans to start any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I do not receive compensation for it (other than from Seeking Alpha). I have no business relationship with a company whose stock is mentioned in this article.