- Albertsons' offer for Rite Aid is not a shareholder-friendly deal.
- Cerberus is relying on RAD management's opportunism and investor fatigue.
- It may just work.
By most accounts, Albertsons' offer to acquire Rite Aid (RAD) is not a shareholder-friendly deal for those with a stake in the latter company. I made clear in my article on RAD last week (read here) that I think Rite Aid is toast without an acquisition and that a higher offer would be unlikely. In this article, I'll discuss why I think this deal erodes value for current RAD shareholders and why the deal is likely to go through regardless.
Quick recap, Albertsons is offering the following: For every 10 shares of RAD, shareholders can either elect to receive 1) $1.83 in cash and 1 share of Albertsons or 2) 1.079 shares of Albertsons. The implied valuation is as follows:
- 10 shares of RAD = 1 share of Albertsons + $1.83
- 10 shares of RAD = 1.079 shares of Albertsons
- 1 share of Albertsons + $1.83 = 1.079 shares of Albertsons
- $1.83 = 0.079 shares of Albertsons
- 1 share of Albertsons = ~$23
- 10 shares of RAD = 1 share of Albertsons + $1.83 = ~$23 + $1.83 = ~$25
- 1 share of RAD = $25/10 = $2.50
The problem is that the market doesn't seem to think a share of Albertsons is worth all that much as RAD is still trading significantly below the implied buyout price:
As I mentioned in my previous piece, the implied price leaves a 25%+ premium for investors right? Well, hold on. Rite Aid is currently struggling, yes, but a merger with Albertsons would completely eliminate whatever slim chance exists for a turnaround. If Rite Aid is a small boat in the middle of the ocean with little chance of making it back to shore, Albertsons is an anchor that would slowly drag the whole thing down. Albertsons is similar to Rite Aid in that it is debt-laden, has a good base of net sales that it can only convert into thin (and getting thinner) profit margins, and operates stores in desperate need of makeovers. It's basically a larger-scale version of Rite Aid.
No matter which option RAD shareholders choose (cash + Albertsons stock or just Albertsons stock), part of the assessment for voting "yes" or "no" must be to consider what the value of the combined company would be because shareholders in RAD will become shareholders in the new entity. If the market doesn't like what this new entity has to offer, the value of the entity's stock might make the implied buyout price, which is based on Albertsons' assumption of its value, lower than the $2.50 buyout price Albertsons' estimates suggest. So let's examine what a pairing would look like.
Both Rite Aid and Albertsons are suffering from the same underlying illness: Amazon (AMZN) and its ilk. Combining the companies together would just create a bigger company with the same problems and the same bleak outlook. I think it's apparent this deal is not beneficial for all involved parties, specifically, and especially, RAD shareholders. So what's going on here?
Let's start with Albertsons' side of things: why does Albertsons want to merge with Rite Aid? Here are some of the proposed benefits for Albertsons:
- Acquiring Rite Aid provides $375 million in operating expense synergies within three years according to the companies.
- Reduced supply chain complexity due to geographic overlap of stores.
- The acquisition includes Rite Aid's PBM, EnvisionRx, which also happens to be the PBM for 280,000 of Albertsons' employees.
- Adding more pharmacy locations provides better leverage for acquiring drugs.
- Traffic to current Rite Aid stores can help sell Albertsons' grocery products.
While these may all be well-founded, there's another, and in my opinion, more important reason for this acquisition that has to do with Albertsons' current puppet master: Cerberus Capital Management. Under the current offer, Albertsons will be rolled into Rite Aid, providing Cerberus a way to sell its existing stake in Albertsons quickly and easily without having to find and negotiate with another private equity firm. Easy, right?
Just one problem: Cerberus has decided to make a bet on the opportunism of Rite Aid's current management team and the fatigue of RAD shareholders by providing an offer well below what the company is actually worth. I've been on the bear train since my first article on the stock last year, but even I can acknowledge that the current offer is not shareholder-friendly in the slightest. As SA contributor Chris Lau noted in his RAD article (read here), while Walgreens (WBA) paid $2.28 million per store, the current offer from Albertsons values the rest of Rite Aid's stores at just $970,000 per location. In other terms, Walgreens paid $4.375 billion for 1,932 Rite Aid stores and Albertsons wants to pay $2.6 billion for the remaining 2,670 stores.
For the sake of being conservative, let's assume the value of Rite Aid's remaining 2,670 stores are worth 11% less than what Walgreens paid per store, which comes out to about $2 million per location, that would yield a market value of $5.34 billion for the rest of Rite Aid's stores. Subtract $3 billion in long-term debt and that gives us $2.34 billion in company value. That values RAD at about $2.20 per share.
However, we also have to consider Rite Aid's PBM, which was purchased in 2015 for $2 billion. For fun, let's assume that this business inexplicably lost 50% of its value over the past three years, which would give us a total market value for RAD of $3.34 billion or about $3.15 per share, a 50%+ premium to current price levels and 25% higher than the implied price of the offer currently on the table. Even with overly conservative estimates, the offer from Cerberus seems to be lowballing Rite Aid's true value.
Here we come to the crux of the issue: if this deal is lowballing Rite Aid's value, why does Rite Aid management team seem so eager to play ball anyways? Because Cerberus knows how the management team of a flailing company usually thinks: they would rather take a quick, easy payout than have to engineer a turnaround over the next few years or longer. That's why Rite Aid's current CEO, John Standley, will be the CEO of the combined Albertsons-Rite Aid entity (as well as a board member), and had this to say about the merger:
This powerful combination enables us to become a truly differentiated leader in delivering value, choice, and flexibility to meet customers’ evolving food, health, and wellness needs.
Standley might truly believe that, but he also must know that accepting the current offer would be detrimental to RAD shareholders. However, perhaps putting up a fight would hurt his chances of a top position at the new company.
Cerberus is also counting on something else: investor fatigue. Sure, some investors have bought RAD in the low single digits (think $1-3 per share) fairly recently and will be disappointed by this deal, but many others have been holding shares since much earlier than that and would just like to see an end to this unfortunate saga. Not to mention institutional owners like Vanguard, Oppenheimer, and BlackRock that might just be content to eat the loss and simply move on. By extending such a blatantly low offer, Cerberus is likely hoping shareholders will simply throw up their hands and take the deal if just to end the misery.
And you what? I think it'll work. I don't think opposed shareholders will be able to muster the resistance to get this offer rejected. Getting a deal like this done without the support of board members seems unlikely, indicating that the larger institutional stakeholders are already on board for this move. The only thing that could sink this merger now in my opinion is an activist investor or another bid from a third party that forces Cerberus to sweeten the deal, which both seem like unwise events on which to pin an investment.
With that said, institutional ownership is only about 50% of shares outstanding with another 1% owned by insiders (apparently not too much confidence in the stock!) so a "grassroots" campaign to get this offer rejected is perhaps not impossible, but the odds do not appear to be in favor of this becoming reality. In all likelihood, this deal will go through to the disappointment and frustration of many shareholders and be referred to over the next few years as an example of how management's self-interest and investor fatigue can lead to poor shareholder returns.
To cap this off, let's evaluate some scenarios for RAD shareholders using the conclusions in the article:
1) If you're a RAD shareholder who thinks an Albertsons-Rite Aid combination could succeed, maybe you don't mind Albertsons getting Rite Aid for a bargain price in which case you should keep your RAD shares, exchange them for Albertsons shares when a deal is consummated, and hold on tight. Personally, this doesn't seem like a very appealing option considering the baggage and deteriorating performance both companies have.
2) If you're a RAD shareholder who wants nothing to do with Albertsons shares and instead want a higher buyout price, I think you're probably out of luck. The deal has the support of Rite Aid management, and there's no indication that the board opposes the deal. If you're in this boat, you should assess what a share in Albertsons is worth and determine if it makes more sense to sell your RAD shares right now or if you should wait until you can get cash and a share of Albertsons (I'd go for the former).
3) If you're a RAD shareholder who doesn't want a buyout at all and wants to go it alone, you're welcome to hold your shares and vote "no" to the current offer, but ultimately I think Rite Aid going it alone would be an even worse alternative to Albertsons' current offer due to Rite Aid's operating struggles.
4) If you're a RAD shareholder who wants a higher buyout price and will vote no on the current offer expecting it to be rejected, I think you might benefit from a more pragmatic approach. The deal has approval from Rite Aid's management and the BOD has expressed no reservations, therefore holding RAD in hopes of a rejection and higher buyout price seems futile.
5) If you're a RAD shareholder who is holding onto shares because you think a third-party will swoop in and offer a better deal than Albertsons' current offer, I think you are likely to be disappointed. Rite Aid has declining comps, is barely eking out a profit, and still has $3 billion in debt, which don't make for an attractive acquisition target. Albertsons buying the company seems more like an act of desperation as it would just combine together two entities that are both struggling mightily against the same market trends.
I don't really see any appealing path forward for RAD shareholders at this point. The offer currently on the table undoubtedly undervalues the company's shares even with conservative estimates, but I don't think that will matter in the grand scheme of things. The deal is likely to be approved due to support from Rite Aid's management and lack of opposition, so far, from the BOD. I don't think Albertsons' stock is particularly appealing and, if I were a RAD shareholder, I wouldn't really be happy with that as my buyout prize. I think the optimal strategy for investors is to simply sell the stock and move on.
Best of luck!
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