After management at Rite Aid (RAD) announced that it was going to merge with Albertsons, I didn't think any big developments would come along for the drugstore chain. I was dead wrong. On February 27th, the management team at the company announced plans to buy back up to $900 million worth of long-term debt in order to reduce leverage and lower annual interest expense. As a rule of thumb, I am supportive of debt reduction, especially when it involves higher interest-rate debt like Rite Aid's, and when I first saw the announcement, I believed it was a brilliant step forward. Now, though, after reviewing the data, I believe this tender is a non-starter.
A great idea to reduce debt
Often times, when I see companies push to pay down debt, I see them make the mistake of paying off low-interest debt with (usually) near-term maturities. This typically takes the form of revolving credit facilities. In some cases, like where the lender may reduce the firm's borrowing capacity for some business-specific reason, such debt reduction is a necessary evil, but in others it's nonsensical. Rite Aid, at first glance, appears to be avoiding this at least in part.
*Taken from Rite Aid
As you can see in the image above, the drugstore chain is offering to buy back from investors three different classes of Senior Notes: 9.25% ones due in 2020, 6.75% ones due in 2021, and 6.125% ones due in 2023. In all, these issues come out to $3.51 billion, but this isn't the full amount Rite Aid is able or willing to cover. Instead, the firm intends to allocate approximately $900 million to these buybacks. Unlike in many cases I have seen in the past, where the issuer assigns tiers of priority to different notes, Rite Aid intends to treat these three issuances on a pro rata basis. That means that if all $3.51 billion worth were tendered, for instance, the business would allocate the percentage of the principal from each relative to the whole toward what it actually purchases. As an example, the 9.25% Senior Notes, while the most appealing to buy back because of the high interest rate, represent 25.7% of the $3.51 billion at $902 million. If all notes were tendered, Rite Aid would buy back just $231.80 million (or 25.7%) worth of the 9.25% ones.
This makes it less flexible for management, whose goal is to improve returns, but management cited the indentures as requiring this treatment. Even so, while this perhaps limits potential for shareholders, the results are still positive. In the worst case scenario (and assuming management can allocate all $900 million toward buying the notes back), the firm will be able to reduce annual interest expense by $55.13 million. In the best case, where management buys back the 9.25% Senior Notes only, that figure rises to $83.25 million. The weighted-average interest rate of these notes is 7.07%, so a good target might be $63.63 million.
*Taken from Rite Aid
Under these terms, I applaud management's objective. You see, in its latest update regarding the sale of its stores to Walgreens Boots Alliance (WBA), Rite Aid stated that it had completed the transfer of 1,114 of its planned divestiture of 1,932 locations to the firm. Total proceeds so far from the $4.375 billion deal have come out to $2.424 billion, so it's probable that management has paid down some of its revolving credit facility or term loan debt. However, with total outstanding debt between its facility and its tranches of term loans of $2.895 billion, it's not possible for Rite Aid to have paid off all or even much more than half of this debt.
*Taken from Rite Aid
Although management will be limited by what its credit facility lenders dictate, the end goal of Rite Aid should be to pay off as little of the facility and term loans as possible. As you can see in the image above, the weighted-average interest expense on this variable rate debt stands at 3.82% compared to the business' fixed debt rate of 7.11%. The $1.925 billion in credit facility borrowings (with $1.91 billion outstanding as of the last quarterly report Rite Aid issued) has a low rate of 2.92% per annum. Paying off this facility with $900 million would reduce annual interest expense by a paltry $26.28 million.
But there's a catch
Looking at all this data, I would call management's maneuver brilliant, but there's an issue: I don't think this tender has legs. What I mean by this is that I don't think Rite Aid is likely to get much, if any, interest in this offer. If you'll recall the first image I posted in this article, you might notice that management intends to pay noteholders 100% of par value for the notes, plus any accrued and unpaid interest up to the date the notes are acquired.
Paying 100% of par is just fine in cases where notes have a tendency to trade at a discount to par (I've seen tenders made for notes of some companies well below par). However, this is not the case for Rite Aid. In the images below, you can see how the 2020, 2021, and 2023 Senior Notes for the drugstore chain have traded over the past 12 months.
Taken from FINRA
*Taken from FINRA
*Taken from FINRA
As you might notice, there have been times over the past year where each of these notes have traded below par value, but that is not the case now. As of the time of this writing, Rite Aid's 2020 Senior Notes are going for $101.25 per every $100. Their 2021 Senior Notes are going for $102.25, and their 2023 Senior Notes can be purchased for $101.90. This means that any shareholder that tenders their notes is taking a haircut compared to selling them on the open market. Adjusting for the implied interest that is accruing to these notes allows you to reduce these prices by between $0.51 and $0.77, but even in that scenario you are taking a haircut.
I had thought that perhaps the market was just excited about the idea of the buybacks and that investors might have flooded in in order to gobble up the free lunch and pushed the prices of the Senior Notes up as a result, but there's no substantive evidence of that happening. The last time the 2020 Senior Notes traded below par was February 22nd, a full five days before the tender was announced. I sifted through FINRA trade data dating back to at least February 16th and couldn't find any date back to then where the 2021 Senior Notes traded below par.
The one exception here might be with the 2023 Senior Notes. As recently as February 28th, there was a dip below par, but not by much. This suggests that perhaps some buying and subsequent tendering of units might have taken place, but considering where the units trade at today, it's probable that any rational person would withdraw their tender and just sell the units on the open market if they don't want to hold onto the notes for the long haul.
This brings me to the central issue for Rite Aid. While I love the company's move to pay down low interest debt, they need to pay up. Paying 100% of par when notes are trading at a discount is great and can be beneficial for shareholders and noteholders alike. But paying par when notes are already above par makes me doubt the ability of management to get anywhere near the $900 million commitment they are hoping to achieve. More likely than not, management will need, if they want to truly take these Senior Notes off the market, to offer a premium of 3% or more.
I like management's objective a great deal here. Using proceeds from its massive asset sale to reduce outstanding borrowings with high rates of interest is perfectly logical and, to the extent possible, far better than reducing low-interest debt. However, because of the high price that these Senior Notes can already be purchased for, this looks more like a dud than the brilliant strategy it could have been.