Shareholders of Rite Aid (NYSE:RAD) including myself were happy to see news of a divestiture flash Tuesday morning. This event seemed to be the last big hurdle preventing the FTC from approving the acquisition by Walgreens Boots Alliance (NASDAQ:WBA), and with its resolution, odds are good that the final seal of approval is just around the holiday corner. However, the biggest winners of the day didn't seem to be shareholders of RAD or even WBA. Fred's Inc. (NASDAQ:FRED), which scooped up the 865 storefronts for $950M to be financed by asset backed debt saw its stock storm up 80% by the day's end.
How could a company with barely any positive operating metrics, and a new found 10X+ increase in debt load nearly double its market cap in a single day? I think any investor trying to answer this question needs to look at the prices paid in transactions for these stores, and I believe the WBA-RAD deal is a pretty comparable transaction to start with. Here is how the economics work out:
WBA announced they would be acquiring RAD for $17.2B total enterprise value including debt, and for that price they would receive around 4,600 storefronts. That comes out to about $3.7M per storefront. Not a bad price to pay for stores that on average produced about $6.7M last year.
FRED as mentioned before has agreed to purchase 865 of these same storefronts for $950M. That price comes out to about $1.1M per storefront, or about 70% less than the price paid by WBA. Assuming these stores are "generally representative" of the overall pre-divestiture RAD as FRED management stated, shareholders today received about $5.8B additional revenue and around $230M in EBITDA based on last year's rate. The table below shows the price FRED investors paid for a dollar of revenue and EBITDA before and after the deal. The Enterprise Value after the deal includes $950M debt consideration, and stock price closing of $20.20/share, while EV prior deal uses $78M debt and $11.15/share.
What This Means for FRED Investors
As you can see from the table above, revenue is forecasted to nearly quadruple, which explains an equivalent rise in the forecasted enterprise value, and EBITDA is increasing dramatically over last year's amounts. Assuming the above metrics work out to be reasonably correct, it looks like investors in FRED today are still getting the company at a reasonable sub-7Xs EBITDA and 0.2X Revenue, and while these stores were not necessarily well run in the first place (compared to WBA who makes double FRED's forecasted EBITDA margins), there definitely is room to the upside if things work out. Since the current enterprise value seems to be a fair price, any operational efficiencies or increased store performance would likely be met with an equivalent increase in the enterprise value. Given how much leverage the company will have, that can mean quite a drastic increase in stock price. However that also means any deterioration has an equally negative drastic effect on the price of FRED stock.
What This Means for WBA Investors
From WBA perspective, yes they had to give up stores at a huge discount to their original price, but they also avoided the $325M termination fee which seemed inevitable otherwise. With this divestiture checking the boxes of reasonable size while creating a medium sized competitor in the deals wake - who won't close down the stores after purchase - the company should soon be able to move on to accomplish its original goal in acquiring RAD. The new footprint won't be as dramatic as originally advertised, but the bump of an additional 3,700+ storefronts still pushes WBA's US pharmacy count past CVS's ~10K total.
What This Means for RAD Investors
Most of the upside that was available in the stock, along with the uncertainty, has been chiseled away over the past couple months. While options can be a viable manner to squeak out a bit less upside for a bit less downside, I am personally just holding onto my current position. The deal looks good to close shortly after FTC gives their blessing, as there is still about 4-5% absolute returns which can be made within that short amount of time for a good rate of return.
There is still the risk that the deal does not close, and that would affect each company in their own way, and I believe it would be a close tie between FRED and RAD for which would drop the most if the deal fell through.
While the news was more than welcome for RAD and WBA shareholders, the true winners seem to be FRED investors. Although first instincts to write-off 80% jumps as extreme can serve to protect investors from over-enthusiasm, sometimes the enthusiasm is well deserved. Shareholders in FRED can be happy they were in the right place at the right time (with the right financiers).
Disclosure: I am/we are long RAD.
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.