Rite Aid: $2 Billion Problem

| About: Rite Aid (RAD)
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Summary

Shares of Rite Aid plummeted after news broke that it and Walgreens had agreed to drastically reduce how much the latter will pay to acquire the former.

The transaction's final price will depend on how many locations must be divested but, no matter how you stack it, the change is ugly.

That said, given the spread between its current share price and where it will close at if a deal is completed, it's a risky but maybe worthwhile prospect to consider.

So far, 2017 has been kind to the market but it has been anything but for investors holding shares of Rite Aid (NYSE:RAD). On January 30th, the management team at the firm, as well as the management team at Walgreens Boots Alliance (NASDAQ:WBA) announced that they had reached an agreement to reduce how much the latter would be paying to acquire the former. In response to this, shares of Rite Aid plummeted nearly 18% at one point, taking a sizable chunk of market value off of the company's shares. In what follows, I will look at this decline and give my thoughts on what it means for investors in the firm and detail whether or not Rite Aid might make for an interesting investment prospect following the crash.

Recent news regarding the acquisition

On October 27th of 2015, the management teams at both Walgreens and Rite Aid announced that Walgreens would be acquiring Rite Aid in a transaction valued at $17.2 billion (including debt on Rite Aid's books). Shareholders in the transaction would receive cash consideration of $9 per share which, at Rite Aid's current share count, would have valued the equity of the business at $9.74 billion.

In October of last year, the two sides agreed to an extension, during which time they would have more time to complete any asset sales required as part of the regulatory process, giving them until January 27th to have everything finalized. Well, in today's announcement, recognizing that the process is taking longer than anticipated, Rite Aid and Walgreens agreed to extend the agreement once more. Now the date to have everything regarding the acquisition finalized has been pushed to July 31st of this year.

In between these two extensions, some progress was made, however. On December 20th, it was made public that Rite Aid had reached an accord with Fred's Inc. (NASDAQ:FRED) wherein the latter would buy from Rite Aid 865 locations for $950 million in cash. This put Walgreens well on its way to the 1,000 locations the firm had said it would be willing to part with in order to close the deal and the cash could be used, in theory, to help offset some of the cash-based purchase price of the business for Walgreens.

All-in-all, this situation appeared reasonable but, in its latest announcement (the one where Walgreens and Rite Aid agreed to an extension through July of this year), the parties said that the purchase price of Rite Aid had been cut considerably. As opposed to the $9 per share for Rite Aid, Walgreens will now pay between $6.50 per share and $7 per share. This reflects not only a decrease in the perceived value that Rite Aid brings on a net basis (which I assume will be reflected in Walgreens realizing synergies well under the $1 billion per year they said they would when the announced the transaction), but also reflects a larger divestiture requirement in order for the government to not block the deal on antitrust grounds.

The price per share that Rite Aid's investors will receive will depend on how many stores, exactly, Walgreens must divest the combined company of. If, for instance, they are required to sell off 1,000 locations or less, Rite Aid's shareholders will walk away with $7 per share in cash. However, if management ends up having to sell off 1,200 stores, the price per share will be decreased to $6.50 per share. What, then, might be the cost if management does away with, say, 1,050 locations or 1,125 locations? In the table below, I provide a pro rata analysis of the price per share, as implied by management, what the ultimate cash consideration to common shareholders should be.

*Created by Author

What you can see by looking at this is that, even under an optimistic scenario where management sells off 1,000 stores or less, the haircut on a percentage basis and on an absolute dollar basis is tremendous. Compared to the original agreement, we are looking at a haircut of at least $2.10 billion and this number could soar to $2.63 billion if 1,200 locations or more are gotten rid of.

If I were an investor in Rite Aid right now, I would be furious because such a large decline for such a small business is unacceptable in my opinion. That said, I would also, despite my anger, consider adding onto my position at this time. As of the time of this writing, shares of Rite Aid can be purchased for $5.74 apiece. Even if investors must walk away with only $6.50, this represents a premium over today's share price of 13.2% and if shareholders are lucky and happen to receive $7 per share, that premium comes out to 22%.

There is, however, one risk in buying or holding shares you currently have. In order for the transaction to be completed, Rite Aid's shareholders must approve the sale under these terms in order for anything to be finalized. In the event that the acquisition is shot down (and that is certainly possible given the haircut), the end result could be a material downside movement in the company's stock price. Whether or not such a move would be warranted based on Rite Aid's fundamentals is up for debate, but even if it's not warranted it's probable that investors could be crunched there.

Takeaway

At this moment, Mr. Market is punishing Rite Aid's share price and for a very good reason. With shareholders having expected a nice premium for their stock, the unexpected revision lower takes billions of dollars off the table and there's a chance that it could leave the company's investors selling off the firm for less than what it is worth. That said, if I were a shareholder today, I would probably consider buying into its stock but do so with the understanding that transaction risk remains. One way to counter this is to buy puts to cushion the fall or investors could sell calls. However, for those concerned that shareholders may shoot down the transaction, another possibility is to take your losses and look elsewhere for opportunities.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in RAD over 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.