Kroger, Not Albertsons, Should Get Rite Aid

Summary

• Kroger is a better choice than Albertsons to get Rite Aid.
• Everybody would end up better off.
• Except the Rite Aid CEO, that is.

In my opinion, Rite Aid's (NYSE:RAD) stock is a "hold" at this point, having been beaten down to a level not seen in several years. The current merger with Albertsons (ABS) appears to some as a bad deal for RAD, but RAD's stock is now a speculative buy at this price for upside "arbitrage" on the merger. If the Albertsons-RAD "newco" stock comes out at a favorable price, there is immediate profit. The downside risk is that the stock may start trading at a drastically undervalued level, either as a result of market forces (or deliberately?), or that the newco stock price may plunge so fast that RAD shareholders don't have a chance to dump it before it tanks. Such speculation didn't work in the earlier Walgreens Boots Alliance (WBA) deal, and may not work here, either.

A few days ago, on March 29, 8 million shares of RAD moved in several big block trades, according to a SA comment from Catalyst7 in my previous article on RAD. A buying trend might signal a growing consensus for successful arbitrage, but only if it continues. One potential tailwind is that if the newco stock price were set too low (hypothetically), the SEC might take notice.

Some might feel that the merger is beset by "miasmas of suspicions." This would not be the first time for stockholder accusations. After the original merger with WBA was proposed there was litigation that makes interesting reading, although class action lawsuits are not uncommon and often do not prevail on the merits. Item 4 in that lawsuit document says:

"The Proposed Transaction is the product of a hopelessly flawed process that failed to maximize shareholder value and was designed to ensure the sale of the Company to the buyer willing to pay significant merger-related bonuses, and provide acceleration and rollover of unvested equity interests, for the Board and Rite Aid management."

Sound familiar? Now, let's look at some recent RAD developments.

The results of the recent tender offer for some of RAD's outstanding high interest notes at face value show that the offer was greeted with hilarity by the 2020 and 2021 noteholders, who collectively tendered only around 1% of their notes, preferring to wait until the notes either mature or are involuntarily redeemed, while happily collecting their high yield. It seems odd to make a tender offer without a substantial premium attached. Unless RAD can buy back these notes and pay down its debt, the cash from the store sales to WBA may sit idle.

Conspiracy theorists might wonder if RAD chose a tender offer in lieu of expedited redemption in order to delay paydown of debt, so that the upcoming earnings report might not be as favorable, making the deal with Albertsons seem more reasonable at the upcoming shareholder vote. I have not been able to discern whether the tender offer was a legal requirement prior to redemption of notes, or indeed which and how many of the various notes are callable.

Is it conceivable that RAD's implementation of a "poison pill" shareholder rights provision was done less to protect a NOL tax loss carryforward and more to lock out any other bidders besides Albertsons? Since RAD's CEO is slated to be the CEO of newco, he does, after all, have a personal interest in making sure the deal goes through with this particular partner only, although I accuse no one of impropriety or wrongdoing.

Similarly, was RAD's recent withdrawal of the poison pill an effort to remove a potential basis for litigation while leaving so little time before a shareholder vote on the Albertsons merger that valid competitors would not have time to perform the necessary due diligence prior to submitting a bid?

Let's look at another aspect of the deal. Did Rite Aid executives contact Kroger (KR) during their due diligence for a RAD merger, before they agreed to merge with Albertsons? A simple question, but one with broad implications.

KR and Albertsons are similar companies. They each used leveraged buyouts to expand their holdings, taking on similar levels of debt ($12 billion). However, KR is a much larger company, with 2016 revenues of $115 billion (from p. 79 of KR annual report) compared to Albertson's $59 billion.

The KR pharmacy segment, historically, is a profitable and growing business, operating over 2,000 pharmacies, and in 2015 held the fifth position in the number of pharmacies operated in the U.S. According to Wikipedia, "Kroger is also the third-largest retailer in the world and the third largest private employer in the United States." Although the company has leveraged itself with its considerable debt, it is growing earnings, according to Yahoo Finance.

KR is in the process of selling its convenience stores to a European buyer for about $2 billion, so that gives KR some ready cash, which it could use to pay down some of its debt of $12 billion (mentioned above and here) - or it could apply that money to an ever better use: buying RAD.

Albertsons has about 2,000 pharmacy "counters" in supermarkets and other stores, by my calculation. A striking similarity to KR, isn't it? Why would Albertsons be interested in RAD and KR not be?

One reason might be that the funding for the Albertsons merger will come from what is basically an IPO, printing money out of thin air and selling it to buyers who base their purchase on the hope that the company will prosper. In the case of newco, those buyers may be overoptimistic.

A large chunk of the new company will go to RAD shareholders, with the rest going to the big players, who might be able to hedge and dump at their leisure - although to repeat, I accuse no one of wrongdoing. If RAD shareholders start to sell out immediately after the merger, the price of the stock could plummet, and only frontrunning short sellers may emerge intact.

From the previous (unsuccessful) IPO filings, it appears that Albertsons claims revenues of $32 billion, net loss of over half a billion dollars, total assets around $22 billion, total liabilities over $21 billion, and shareholder equity of just under $600 million. What does Albertsons bring to the table in this merger?

Readers may wish to peruse various filings related to the Albertsons IPO, such as the one here, for instance p. 14, which says, in part:

"Our Sponsors will indirectly control us through their respective ownership of Albertsons Investor and Kimco and will continue to be able to control the election of our directors, determine our corporate and management policies and determine, without the consent of our other stockholders, [Author's emphasis] the outcome of any corporate transaction or other matter submitted to our stockholders for approval, including potential mergers or acquisitions, asset sales and other significant corporate transactions."

Although the terms of the current merger proposal have not yet come out, is this the kind of corporate governance that RAD shareholders want to be associated with?

By contrast, look at the proxy statement language in KR's 2016 annual report. I have quoted it because it feels good just to read it. The quoted section goes down to the end of the list with the little checkmarks.

"Kroger’s Corporate Governance Practices

Kroger is committed to strong corporate governance. We believe that strong governance builds trust and promotes the long-term interests of our shareholders. Highlights of our corporate governance practices include the following:

Board Governance Practices

✓ Strong Board oversight of enterprise risk.

✓ All director nominees are independent, except for the CEO.

✓ All five Board committees are fully independent.

✓ Robust code of ethics.

✓ Annual evaluation of the Chairman and CEO by the independent directors, led by the independent Lead Director.

✓ Annual Board and committee self-assessments.

✓ Commitment to Board refreshment and diversity.

✓ Regular executive sessions of the independent directors, at the Board and committee level.

✓ Strong independent Lead Director with clearly defined role and responsibilities.

✓ High degree of Board interaction with management to ensure successful oversight and succession planning.

✓ All directors are elected with a simple majority standard for all uncontested director elections and by plurality in contested director elections. Shareholder Rights

✓ Annual election of all directors.

✓ No poison pill (shareholder rights plan). [Author's note: I especially liked this one.]

✓ Shareholders have the right to call a special meeting.

✓ Regular engagement with shareholders to understand their perspectives and concerns on a broad array of topics, including corporate governance matters.

✓ Commitment to responsiveness to shareholder feedback. Compensation Governance

✓ Pay program tied to performance and business strategy.

✓ Majority of pay is long-term and at-risk with no guaranteed bonuses or salary increases.

✓ Stock ownership guidelines align executive and director interests with those of shareholders.

✓ Prohibition on all hedging, pledging and short sales of Kroger securities by directors and executive officers.

✓ No tax gross-up payments under Kroger executive plans."

If you're a shareholder and your company is going to merge with another, would you prefer the governance of KR or that of Albertsons?

How can Albertsons afford RAD? It would be helpful to have someone explain the track record of synergies from previous Albertsons acquisitions, with real data rather than "forward looking statements." What are the projections for stock price increase of newco in the future, based on increased EPS?

Tangentially, how does it happen that the RAD share price has been beaten down to penny stock levels recently, when RAD is a viable business enterprise with a bright future, standalone?

How can KR afford RAD? Perhaps we should ask, how can they not afford to buy RAD - unless maybe they would prefer to wait until Albertsons possibly goes bankrupt in a few years, and then they can pick up pharmacies for even fewer pennies on the dollar than the current RAD stock price.

KR appears to have respect for its shareholders, at least that's what their governance guidelines imply. Depending on their charter, they could possibly issue a secondary stock offering to raise a few billions, but that would disadvantage their current stockholders through dilution. This is the cynical approach, and is possibly why KR would refuse to do such a deal with RAD, if asked.

Alternately, KR could contact a private equity firm, perhaps a competitor to Cerberus, and ask for a long-term debt placement of $8 billion or so at favorable rates, and then jump into the fray and buy out RAD in a hostile takeover at a reasonable price for all. They could then deal fairly with RAD executives, sell off the corporate headquarters, and wait to reap the same putative profits from synergies that Albertsons seems to think will arrive in due course.

A merger of RAD with either KR or Albertsons raises many questions that can't easily be answered with information in the annual reports. Company financials are moving targets when there are acquisitions whose synergies have not been fully realized or when future changes will affect the bottom line.

By what percentage will drug wholesale prices (cost of goods sold) for pharmacies decrease under the Walgreens Boots Alliance deal? Starting in 2019 for 10 years, RAD gets to piggyback on the WBA wholesale drug supply chain. This issue is worth clarifying, because from the annual reports of both RAD and WBA, it appears that the pharmacy markup (gross profit divided by cost of goods sold) is already similar for the two firms. If there's not a big drop in drug purchase costs from higher volume, or a significant savings by using the WBA channel rather than the current distribution agreement with McKesson (MCK), that could be a problem.

By what percentage does RAD benefit from lower purchase prices on store front end products (sundries, dry goods, food items, etc.) from higher volumes and perhaps using a different distributor?

What are the potential savings from "consolidation" in sales, general and administrative costs (SG&A)? I.e., how many people will be reassigned, integrated, or, euphemistically, "made redundant"? Will the corporate offices be sold off, and if so, for about how much?

Does the newco plan to use future profits to grow the company, to pay a dividend, or rather to disproportionately reward its executives and (legally, of course) feather the nests of its large stakeholders?

If KR were to come in with a hostile takeover bid, would RAD shareholders, KR shareholders, and perhaps most parties involved (except perhaps the RAD CEO) be better off.

It may well turn out that RAD already contacted KR early on and found no interest expressed. If so, perhaps someone else out there might want to buy a profitable business on the cheap.

No more RAD poison pill. It's open season.

Readers may legitimately criticize this article as containing more questions than answers. These questions are worth raising, in light of the upcoming RAD shareholder vote. In my view, given the information available, RAD is a hold. Do your own due diligence.

Analyst’s 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.

Long and still holding, but another sharp drop in the stock price could impel me to reevaluate.