Many Rite Aid (RAD) shareholders finally got what they wanted. CEO John Standley is leaving. On Tuesday evening, the company announced a wholesale shakeup of its top executives: Standley will depart when his successor is named, while President and COO Kermit Crawford and CFO Darren Karst have been replaced. Other managers and executives are being relieved of their duties as well, with the company eliminating “approximately 400” positions.
Many RAD shareholders are celebrating (see the comments here), and the stock did rise 12% in after-hours trading Tuesday. It’s certainly difficult to see Standley’s departure as a negative, given that in barely two years RAD has gone from a $9 per share takeover offer from Walgreens Boots Alliance (WBA) to trading at well under $1 per share, even after the post-market gains. As many shareholders see it (and with some justification), Standley has made millions while losing the original Walgreens deal (after an 18-month FTC review process), entering into an aborted transaction with grocer Albertsons, and watching his company’s profits dwindle.
The enthusiasm for new management – any new management – does make some sense. But the long decline in RAD stock isn’t just a matter of management missteps. There are very real challenges facing the industry – challenges to which even Rite Aid’s larger rivals haven’t proven immune. Looking forward, there’s still an enormous amount of risk when it comes to RAD – and a very real chance of a restructuring. RAD is tempting here, and there’s a path out. But I’d caution investors to remember that just because a new CEO is on the way, that doesn’t necessarily mean that Rite Aid can find that new path – or recover from the mistakes made on its old one.
The Case Against RAD Stock
I wrote back in August, with RAD near $1.50, that the biggest problem was that the stock wasn’t cheap. Nearly 50% lower in March, and below $1, that’s still the case to some extent.
The problem is the debt load. Rite Aid’s pro forma net debt at the end of Q3 (ending December 1) was about $2.9 billion. ($3 billion net debt as reported, adding back ~$160 million for the pending sale of two more distribution centers to Walgreens, plus a payment made to a reinsurer early in Q4, per commentary on the Q3 call.) That figure is about 5.2x the midpoint of FY19 Adjusted EBITDA guidance of $545-570 million. RAD stock may have been nearly halved since August; but by my numbers, the enterprise value assigned the business (including that debt) has only dipped about 15% over that stretch.
Meanwhile, the two obvious peers have plunged at the same time:
At the midpoint of guidance, RAD trades at about 6.7x on an EV/EBITDA basis. Walgreens, by my calculations, is at 8.2x on a trailing twelve-month basis (through November 30). CVS (CVS) has a number of moving parts due to its acquisition of Aetna, but it appears to be under 8x based on its 2019 guidance.
Equity-based valuations don’t change the story much. The midpoint of guidance for FY19 is $557.5 million. Capex is guided to $250 million this year. Interest expense was $56 million in Q3, and likely above $200 million on an annual basis going forward even assuming further deleveraging with the final payments from Walgreens.
Assuming zero cash taxes (likely for the foreseeable future), free cash flow is maybe $100 million before working capital adjustments. An 8.2x P/FCF multiple does seem attractive. But WBA trades at less than 10x FY19 EPS estimates; CVS is at 8x. Both larger peers – again – likely trade at only a modest premium in terms of P/FCF. Both have much more scale, and even considering the Aetna deal, cleaner balance sheets.
On a relative basis, then, RAD, even near the lows, hardly seems that undervalued. WBA and CVS – both of whom admittedly have their own issues – still deserve some premium to RAD at the moment, given lower debt and larger reach.
And on an absolute basis, RAD hardly seems inexpensive. 8x free cash flow is not an attractive multiple given the leverage here. The bond markets are pricing in a material chance of a restructuring at some point:
Rite Aid 7.7% notes due February 2027. Source: FINRA
Rite Aid 6.875% fixed-rate notes due December 2028. Source: FINRA
Most notably, this remains a declining business at the moment. EBITDA pro forma for the TSA (transition services agreement, under which Walgreens reimburses Rite Aid for operating stores as they are handed over) fees from Walgreens was $825.3 million in FY17. The figure declined 21.6% in FY18. Guidance suggests another 14% reduction this year – and a rough fourth quarter. Full-year guidance implies Q4 EBITDA of $115-140 million – down 19-33% year-over-year (again pro forma).
Whatever Standley’s failings and missteps, they’re in the past. To look at Rite Aid now, and going forward, is to see a severely challenged business. Margins are exceedingly thin and getting thinner: the midpoint of guidance suggests a 2.55% EBITDA margin this year, down 105 bps from FY17. The TSA fees are going away in October, per management commentary. (Walgreens can add two six-month extensions.) The balance sheet is leveraged 5x while profits decline. And the industry is facing significant pressure. WBA is at its lowest level in over four years (save for one very brief blip last year). CVS trades at levels not seen since 2013.
In that context, 8x free cash flow and 6.7x EBITDA hardly look cheap. Rather, this looks like a dangerous business at any price.
The Case for a Turnaround
Bulls might answer those concerns by pointing out that the figures are largely backward-looking – and that’s a fair point. There is hope for a turnaround – not least because Rite Aid already has pulled itself from the abyss once before. The stock traded near zero at the depths of the financial crisis. As late as 2012, Rite Aid still was still 6x+ leveraged, and as seen in the first bond chart above its debt traded at distressed prices until the beginning of that year.
There are reasons to think Rite Aid can execute a similar turnaround (even if expectations for another bounce from under $1 to over $7 seem far too high, particularly in this environment). First, performance in recent quarters actually hasn’t been that bad. Rite Aid did pull down guidance during the Albertsons deal, which it attributed to weaker-than-expected savings from generic drugs. The updated outlook after Q3 moved the midpoint of EBITDA guidance down (the range narrowing from $540-590M to $545-570M).
Still, there’s been some signs of life in terms of store performance. In Q2, same-store sales increased 1%, including a 1.6% increase in pharmacy. The number of prescriptions written (on a 30-day basis) rose 1.1%. In the third quarter, the company called out its best prescription count in over two years – and its strongest comps in more than three years. Same-store sales jumped 1.6%, and the same-store prescription count increased 2.4%.
To be sure, that performance isn’t exactly torrid. Rite Aid benefited in both quarters from easy comparisons. Full-year guidance (per the Q3 call) is for same-store sales to rise 0.5%-1% – against a 2.9% decline last year, according to the 10-K. The figures also appear to imply continued market share losses, at least against larger rivals: CVS grew comps 6% in 2018 (it too had an easy comparison), while Walgreens’ growth was 1.5% in FY18 (according to its 10-K) and 1% in Q1.
In the context of recent performance, however, YTD results do imply something close to stabilization. Generic pricing still is a headwind, taking 100-plus bps off pharmacy comps in both Q2 and Q3 (and thus close to 70 bps off the consolidated figure). Rite Aid has made some efforts to improve merchandising, and there’s still ~30% of stores that haven’t been converted to the Wellness format. On the Q2 call, Standley noted that there were still more stores that could get a facelift – which boost sales – while also noting that the company was looking at potential relocations of some stores.
There’s at least enough in recent 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 moves can make a difference. And EBITDA margins are so narrow – again, 2.5-2.6% – that small savings here and small savings there can add up to material improvements in terms of cash flow and the leverage profile.
Rite Aid is making some moves toward improvement. Standley on the Q3 call disclosed a new partnership with delivery service Instacart. Immunizations are growing nicely. The company is pushing 90-day prescriptions to boost adherence. Rite Aid already is closing some stores and could look to do more on that front if leases expire. And new management will have time: a refinancing executed in December means no debt will mature before December 2022 at the earliest.
It’s difficult from the outside to determine what exactly can – or should – be done. But, again, it doesn’t take that much. Indeed, the huge gains in RAD stock at the beginning of the decade came in large part because Adjusted EBITDA increased 40% in FY13 and FY14 combined – on the back of basically flat comps. That growth began in earnest less than two years after Standley was installed as CEO in June 2010.
Perhaps the most interesting – and important – decision the incoming CEO has to make concerns the Envision PBM (pharmacy benefit manager.) Rite Aid paid about $2 billion for Envision back in 2015 with the goal of building a “narrow network” (in which a sponsor gets reduced costs in exchange for access to only specific pharmacies – in this case, Rite Aid).
The deal hasn’t quite worked out so far. Rite Aid took a $283 million write-down on the acquisition in the second quarter. Revenue in the Pharmacy Services segment dipped almost 8% in FY18, per figures from the 10-K. And as an industry observer pointed out, intersegment eliminations declined soon after the acquisition. That’s a problem, given that those eliminations are occurring when an EnvisionRx beneficiary fills a prescription at Rite Aid (since the company can’t book that purchase as revenue twice). In other words, the projected revenue synergies of the deal weren’t materializing.
But here, too, there are some modest signs of life in FY19. Pharmacy Services revenue has risen 4% so far this year (though, like the retail business, it is benefiting from an easier comparison). Management has talked up strength in the Medicare Part D business, and on the Q2 call noted: “some early progress” in gaining increased network access for calendar year 2020.
Margins saw significant pressure in the first half: Adjusted EBITDA in the segment YTD is down 13% according to the 10-Q. But in Q3, the business actually grew profits year-over-year (albeit with modest margin compression) – again showing some progress. And eliminations, too, have bounced back, rising 4.5% so far this year
Still, there have been calls for some time for Rite Aid to consider selling the business. It remains a tiny and potential subscale player, with its Part D market share well under 2%. Intersegment eliminations are less than 1% of total revenue; it’s tough to make the case that Envision really is moving the needle as far as the retail business goes. The Wall Street Journal‘s Charley Grant in September wrote that analysts at RBC estimated a potential $2.2 billion price tag.
That seems awfully high, given pressure on the space. Express Scripts sold to Cigna (CI) for roughly 9x EBITDA – which would value Envision at $1.4-1.5 billion. The nearly $300 million write-down against the $2 billion purchase price suggest a valuation somewhere in that ballpark.
That said, even something in the range of $1.5 billion would clean up Rite Aid’s balance sheet in a hurry. Assuming $160 million in full-year EBITDA for Pharmacy Services (the YTD figure is $120 million), Rite Aid would be left with about $1.4 billion in net debt – and nearly $400 million in retail-level profit. That would get leverage down to a more manageable 3.5x. Even a discounted 6x EV/EBITDA multiple on the retail business would get RAD back up above $1, negating the need for the potential reverse split and suggesting 30%+ upside even from the after-hours levels. It’s likely the incoming CEO – whoever he or she turns out to be – will at least give that option some consideration.
All told, there is hope for RAD at these distressed levels. But there is a lot of work to do, many decisions to be made, and pressures that go well beyond mere execution. Standley doesn’t run Walgreens or CVS – yet investors are dumping shares of those generally well-respected companies as well. Reimbursement pressures aren’t going anywhere, and Rite Aid will have to navigate an environment filled with increasingly larger players going forward.
The industry still doesn’t seem that healthy – just one of the reasons why I’m intrigued, but not close to jumping in. I’m not sold on Envision, given weakening margins and declining revenue on a two-year basis. And it’s tough to bet on new management without knowing who that management might be.
In the meantime, near-term trading is likely to be volatile. Q4 earnings are due next month, and even if they hit guidance will be disappointing. FY20 guidance will be closely watched; stabilization in terms of EBITDA likely boosts the stock, but even that’s a lot to ask for. Management has said repeatedly – most recently at a conference in January – that they could find $96 million in cost savings to offset the loss of TSA fees. But Rite Aid is only expecting $55 million from the wide-ranging management overhaul – which appears to be part of those original cost savings plans. (In the release announcing the management changes, the company wrote that the savings “will serve to offset an expected reduction in income associated with its diminishing obligations under the Transition Services Agreement.”)
The $42 million in savings expected in FY20 should offset the post-October impact of the TSA. But I’m not convinced the underlying business is ready to stop declining. There’s certainly little sign of that in Q4 guidance; I wouldn’t be surprised if FY20 guidance suggests back-half improvement (thanks to those easier compares), and investors, given Rite Aid’s recent history, show little faith in that outlook. $0.76 seems cheap – but so did $1.50. RAD can fall further.
Truthfully, I hope it does work out for RAD. It’s been a long, ugly stretch since the first Walgreens deal broke. But as the old saying goes, the market doesn’t care what your cost basis is. And it doesn’t care what Standley did in 2018, or 2012, or how obscene his compensation was.
It cares about the net present value of the future cash flows that can be returned to Rite Aid shareholders under the new CEO. And it will take solid decision-making, better execution, and maybe even some help from the healthcare industry for that figure to get above $0. It’s possible that figure will turn out to be positive – but investors should remember, even under new management, that there are real risks that it won’t.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.