As Rite Aid’s (RAD) shares have plunged over the past two-plus years, the problem has remained rather consistent: over that stretch, RAD’s stock simply has never been that cheap. It’s become cheaper than it was, certainly, but never on its face a value play for two reasons. First, profits and cash flow have steadily declined: Adjusted EBITDA fell 22% on a pro forma basis in FY18 (ending March 3), rose less than 1% in fiscal 2019, and is guided to drop again in FY20. Free cash flow, based on guidance, is likely to be roughly breakeven, or maybe slightly positive, in this coming year after a significant (if largely working capital-driven) burn in fiscal 2019. Secondly, the most obvious peers – Walgreens (WBA) and CVS (CVS) – have seen their own multiples shrink. Both larger drugstore rivals trade at five-year lows. Rite Aid’s heavy debt load means similar multiple reductions have an outsized impact on its equity value; indeed, since the beginning of 2018, its enterprise value loss is almost exactly equivalent to that of Walgreens:
Data by YCharts With RAD closing Friday at its lowest level in almost exactly ten years, that problem remains. The midpoint of FY20 EBITDA guidance values Rite Aid right at 7x EV/EBITDA (pro forma for the pending sale of its distribution centers to Walgreens). WBA, based on my estimates using its updated FY19 guidance, trades at about 7.3x. CVS, on a similar forward basis, is trading at about 7.5x. Meanwhile, RAD’s P/FCF multiple, based on FY20 numbers, most likely is in the 30x+ range – which on its face requires growth going forward.
From a fundamental standpoint, RAD simply is not cheap – still. It trades at only a modest discount to larger, better-scaled peers with stronger balance sheets (even CVS, post Aetna, should have net leverage below 4x EBITDA against a worrisome 6x figure for Rite Aid at the midpoint of FY20 guidance). Admittedly, there has long been a ‘sum of the parts’ case for RAD, based on the value of the EnvisionRxOptions PBM, for which Rite Aid paid about $2 billion, plus a per-store value based on the $2 million-plus Walgreens paid for each of the 1,932 Rite Aid locations it acquired. That case, however, has taken a substantial hit as well. EnvisionRx profits continue to decline (though the PBM did show some life in Q4) and the steady declines in WBA and CVS shares suggest that Walgreens overpaid even in the revised deal. (There’s also pretty much no logical acquirer for the 2,469 stores remaining as of the end of Q4.) So, as has been the case since the original Walgreens deal broke, Rite Aid remains a bet on a turnaround. And I still see little reason why that bet should be attractive – even though the upside admittedly is enormous if Rite Aid can pull it off. The RAD Turnaround and Management Concerns Can Rite Aid turn itself around? Certainly. New management may help: CFO Matt Schroeder and COO Bryan Everett made their first appearance on the Q4 call, and CEO John Standley – the focus of shareholder ire, to put it mildly – is departing at some point in the not-too-distant future. (Standley said on the call that the Rite Aid board is “actively working” on the search for his replacement.) Margins are thin: EBITDA margins were just 2.6% in FY19, and at the midpoint are guided to compress further in fiscal 2020. And, again, leverage is high. It doesn’t take much in the way of improvement to move the stock price materially. 3% margins at $22 billion in revenue – modestly above FY20 guidance of $21.5-$21.9 billion – moves RAD’s stock up roughly 130%, even with no multiple expansion. Will Rite Aid turn itself around? That’s a different question. The bullish narrative often seems to rest on the idea that RAD’s management has been so incompetent that anyone would be an improvement – and that new management can unlock the ‘true’ value in Rite Aid’s stock. Indeed, RAD’s stock initially rose over 10% when the management change was announced last month, as investors seemed to buy that case.
But that narrative seems far too simplistic – which is one reason why RAD kept falling after the initial pop following the management reorganization. Admittedly, Standley and his team haven’t done a great job of late. Shareholders have valid concerns about executive compensation and the wisdom of the aborted merger with Albertsons. Those concerns are in the past, however – and don’t necessarily read across to the operating business. On that front, there are real headwinds hitting pharmacies across the space, not just Rite Aid. The argument that Rite Aid would be fine – and/or grow profits – with different management is belied by the fact that Walgreens and CVS have many of the same problems. Rite Aid, CVS, and Walgreens For Rite Aid in particular, there are three clear headwinds that have pressured margins and profits of late (particularly since the WBA deal closed): Front-end sales are declining; Generic introductions are hurting same-store prescription revenue growth – but Rite Aid isn’t benefiting enough from savings on the cost side; and Reimbursement rates are being pressured. As far as front-end sales go, the trend has been negative for eight quarters now:
Source: Rite Aid Q4 earnings slides But this isn’t just a Rite Aid problem. In fact, it could be argued that Rite Aid is outperforming its larger peers in the front of the store. CVS same-store Front Store sales rose 0.5% in CY18, according to its 10-K – after declines of 2.6% and 1.5% in 2017 and 2016, respectively. That’s roughly the same ~-2% two-year stack as Rite Aid – and a weaker three-year performance. Per its 10-K, Walgreens’ comparable retail sales fell 1.0% in FY17 and 2.4% in FY18 – and are even worse in its fiscal 2019. Through two quarters, same-store front-end revenues are down 3.5% – including an ugly 3.8% print in a Q2 that sent WBA shares tumbling.
Relative to recent history, Rite Aid’s Q4 performance admittedly is more concerning, with the 1.9% decline the worst figure of the past four years. But it’s still not far from the average front-end results at its larger peers. There are some external factors as well: for instance, on the Q4 earnings call, CFO Schroeder called out a hit from the end of tobacco sales in certain New York locations starting January 1, as well as a compare against a tough flu season the year before. To be honest, those explanations aren’t satisfying: New York represented only about one-eighth of the store count as of the end of FY18 (this year’s 10-K hasn’t been filed yet), and the regulation only hit for about 70% of the quarter. And former COO Kermit Crawford said on last year’s call that the company then, too, had a difficult compare against a “hugely successful” flu season the year before. Front-end sales should be better. Still, the experience of peers shows there’s more at play here than just assortment and traffic problems that can be easily fixed. Consumers simply are buying less front-end goods at pharmacies across the country – not just Rite Aid outlets. Generics, meanwhile, have been a sore spot of late. Pricing has hit pharmacy same-store sales by a combined ~300 bps over just the last two years. But there, too, Rite Aid isn’t alone. Walgreens cited impacts of 140 bps in FY18 and 240 bps the year before. CVS called out similar pressure in its annual report, without quantifying it. The issue has been that generics have hit revenue – without doing enough on the cost side to offset rising reimbursement rate pressure. Rite Aid pulled down its FY19 guidance during the Albertsons deal, forecasting that “generic drug purchasing efficiencies are expected to be significantly below Rite Aid’s previous experience”, and estimating an $80 million impact to EBITDA – a substantial hit. A renewed distribution agreement with McKesson (MCK) hopefully would have ameliorated that issue somewhat. Schroeder did cite benefits from that deal (though in the Q&A the company declined to quantify them) – but noted that “industry headwinds” surrounding generics would “more than offset” the gains from that agreement.
But here, too, Rite Aid isn’t the only pharmacy chain with those problems. Here’s CVS CFO Eva Boratto on her company’s Q4 call: Continued reimbursement pressure without the full benefits of traditional offsets is also causing contraction. Historically, reimbursement pressure has been primarily offset by growth in generics as well as inflation on branded pharmaceuticals. We will experience a larger year-over-year headwind from a lower contribution from break-open generics and diminished return on generic dispensing increases. Walgreens called out the same issues on its Q2 call earlier this month. Simply put, there are structural changes happening in the prescription supply chain that are manifesting themselves in the pharmacy industry. That’s not to say that Rite Aid’s execution has been flawless, or that its management is blameless. Clearly, neither is true. Standley himself admitted on the Q4 call that the company had work to do on its front-end assortment, with a focus on ‘better for you’ products, the recent introduction of CBD-based products (though, per the call, topical solutions only), and increasing own brand penetration. Forecasting on the generic front has been disappointing, and the McKesson deal looks underwhelming, even in the context of pressures elsewhere. CVS and Walgreens have had similar challenges – but both posted operating income growth in their respective fiscal years. (Walgreens’ adjusted EBIT has declined year-to-date, however.) Rather, the point is that new management isn’t going to instantly fix these industry-wide, external, headwinds – and that current/former management isn’t solely to blame for those pressures. For instance, I’ve seen Rite Aid criticized for choosing McKesson over an option to sign a ten-year deal with Walgreens to purchase generics at a price “substantially equivalent” to that of Walgreens. But Walgreens’ own cost savings aren’t enough to offset headwinds – even with its greater purchasing scale. Should Rite Aid have chosen Walgreens over McKesson, it would still have the same margin pressures coming from generics.
Again, both WBA and CVS are at five-year lows and facing declining profits from their respective U.S. pharmacy businesses. There are real risks, and real worries, about the health of the entire industry. Fresh eyes may find a better response to those risks for Rite Aid – but they don’t make them disappear. The Case For, and Against, RAD In that context, the core problem with trying to time the bottom in RAD is that, now, CVS and WBA are relatively similarly priced. Meanwhile, a turnaround in the Rite Aid pharmacy business almost certainly is going to require some of these industry-wide headwinds to abate – which should benefit those larger rivals as well. (It’s worth noting that CVS, at least on its Q4 call, seemed project brighter days on the generic front in 2020.) I personally would rather take that bet with larger, less-leveraged WBA at a single-digit earnings multiple than with Rite Aid, which is headed for ~zero cash flow and potentially negative earnings this year, even on an adjusted basis. Rite Aid isn’t going to be able to cut its way out of this mess: it has a large cost savings plan on the way, but those savings basically are going to offset the lost TSA (transition services agreement) fees from Walgreens, as management reiterated on the Q4 call. Rite Aid still expects 2-2.5% wage and benefit inflation, per the Q&A, which means 0 to 1% comps, as is guided for FY20, aren’t enough to improve margins. As such, betting on RAD at this price – still, even 90%+ off early 2017 levels – is a bet on a top-line turnaround, likely in both the front end and in prescription count (which was positive this year, admittedly) and revenue. In the context of a difficult industry, with remodeling to the new Wellness format mostly complete, and no other obvious catalyst at play, that’s not a bet that seems compelling. That said, the case for RAD can’t be dismissed completely out of hand. For one, it very well could be the biggest beneficiary if and when the industry turns around. The equity here now is less than 15% of the enterprise value. Make Rite Aid 10% more valuable – whether through EBITDA growth and/or multiple expansion – and RAD’s stock rises 70%. There is a scenario here where industry pressures recede, WBA and CVS recover – and RAD significantly outperforms those peers. (That’s precisely what happened coming out of the financial crisis.) The risks are high here, but so are the rewards: it’s unlikely that WBA or CVS will triple any time soon, but with a successful turnaround, RAD could do so in a matter of quarters. (Think 7.5x FY21 EBITDA of $640 million, as margins expand ~25 bps and comps turn positive.)
The most intriguing aspect of the bull case is the Envision PBM. Full-year FY19 performance looks like more of the same, with Adjusted EBITDA down 8%. But profitability actually has improved of late, with a 3% increase in Q3 followed by a 13.7% rise in Q4. Medicare Part D membership growth has helped revenue rise in both quarters, and margins actually improved in the fourth quarter. The decline in consolidated EBITDA for FY20 is coming from the retail pharmacy business, which implies ~stable profits for the Pharmacy Services segment (which is EnvisionRx) this year as well. It still looks like Rite Aid overpaid, with the $2 billion purchase price about 12x FY19 EBITDA for the business. Express Scripts sold to Cigna (CI) for 9x, and Envision remains a fraction of the size of that market leader. Standley, in particular, was highly unlikely to sell that business, as he has continually argued it was key to getting the combined entity into more “narrow network” plans. And, for what it’s worth, intersegment revenue eliminations (which should measure pharmacy revenue from EnvisionRx beneficiaries, as that revenue can’t be counted twice), after dipping initially after the acquisition, are starting to rise, perhaps showing some fulfillment of that promise. But could a new CEO look to sell Envision to de-risk the story here? There might be some interest. Unlike rivals, EnvisionRx simply passes along rebates to its customers in its “transparent” model. As BofA Merrill Lynch analyst William Reuter pointed out in the Q4 Q&A, negative headlines and regulatory risk around those rebates might make Envision’s model more attractive to an acquirer – and to potential partners. Could Rite Aid get, say, $1.5 billion for Envision – a similar multiple to that received by Express Scripts, given green shoots in its performance and potentially a qualitative edge that can drive further growth? That gets net leverage down toward a more reasonable 4.5x or so. (Net debt was $3.19 billion at the end of FY19, pro forma for $157 million in proceeds from a still-pending sale of distribution centers to Walgreens, per the Q4 slides. FY19 Adjusted EBITDA for the retail pharmacy business was $405 million, which guidance suggests should drop to ~$375 million in FY20.)
Perhaps. But we don’t know that a new CEO would look to make that move. Even so, the retail business would need a 6x+ EV/EBITDA business to drive upside in this model – and I’m truthfully not sure RAD is getting that valuation with WBA at 7x+ EBITDA and less than 9x FY19 EPS estimates. Envision can help the story here, and help solve near-term liquidity concerns, but a sale might not be the most effective route – and that highlights the broad problem here. Even as far as RAD’s stock has fallen, there are no quick fixes. The stock is not cheap based on its debt, profits, and recent performance. A management change doesn’t mean external challenges are over. It’s still going to take a multi-quarter, and likely multi-year, improvement for RAD to show upside. RAD Isn’t Cheap Again, the core problem here remains the same as it was last year. Even down 69% over the past year, RAD simply isn’t cheap. Free cash flow is roughly breakeven. A modest EV/EBITDA discount to better-scaled, less-leveraged peers isn’t attractive, either. That doesn’t mean RAD’s stock is headed for zero – or that it can’t rise from current levels. But getting simply to EBITDA growth is going to be a long, tough slog. Management already has taken out close to $100 million in costs; it’s unlikely even a new CEO is going to find more low-hanging fruit, particularly with so much of the company’s expense at the store level. Not even Walgreens can manage to grow amid the current state of the industry, which raises clear concerns about Rite Aid’s ability to do the same. Meanwhile, Rite Aid does have time, with debt not maturing until 2023. (That assumes the company can renegotiate notes due that year; otherwise, the $2.7 billion revolver matures at the end of 2022.) But it will take time to drive improvement; the margin for error already is thin, and will get thinner with each passing quarter. The bond market proves it: the 7.7% 2027 notes trade at 57, yielding 18%, while the 6.875% 2028 issue last traded at 60, with a 14% yield. Rite Aid closed fiscal 2018 with another $4.4 billion in operating lease commitments; that figure likely will be lower when the company files its 10-K later this month, owing to store closures, but total commitments likely remain in the $4 billion range.
In that context, Rite Aid simply isn’t that attractive. In fact, it’s downright risky. It’s a heavily leveraged – as high as 6x at the low end of guidance, a result that would hardly be stunning given performance the last few years – and declining business in an industry facing serious challenges. Looking backward at the original $9 offer, or the missteps made by Standley, many shareholders seem to think the current price is unfair – and that might be true. But looking forward, Rite Aid likely needs to improve simply to support the current valuation. Given the struggles of its larger peers, the new CEO will have his or her hands full in trying to drive that improvement. And at the least, it seems worthwhile to wait for that new CEO – and some evidence of a change – before jumping in.
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.