Rite Aid Post Mortem

Summary

• After a massive bear raid, the merger with Albertsons may destroy Rite Aid shareholder value.
• The impending merger agreement is little more than a dilution and reverse split.
• It is unlikely that much can be done to prevent it.

[Important Note! This article contained a mathematical error that has invalidated some of its content. The Albertsons IPO attempt at about $1.7 billion was only for a portion of the company, not the whole thing. See the comments for further discussion. - Author]

In a previous article I described Rite Aid (NYSE:RAD) as a "hold." Based on new information, or rather, based on information I had seen before but which hadn't registered, I have changed my opinion and now believe that RAD is a sell. I reached an erroneous conclusion earlier, because of a "red herring" in the announcement of the merger between RAD and Albertsons.

The red herring was the choice of cash or stock for a portion of the buyout, as reported by the New York Times. "Rite Aid shareholders would get $1.83 in cash and one share of Albertsons stock, or 1.079 shares of Albertsons stock, for every 10 shares of Rite Aid they owned."

Companies sometimes give shareholders this kind of offer during stock splits. Under normal circumstances the cash and the fractional shares are roughly equal. If they weren't, then all holders would opt for the more valuable choice, and there would have been no reason to offer the two alternatives in the first place. The stock choice may be pegged slightly more valuable, because that gives holders an incentive to take the stock and thereby saves the company out of pocket cash. Based on those assumptions, it appeared to me that $1.83 was equivalent to .079 shares of the new company (newco) stock, meaning that the stock price would come out around 23. That now looks like a mistake.

Floating in the swamp of information about the merger is the following, from Forbes, "leaving Rite Aid shareholders with ownership of between 28% to 29.6% of the combined company." This is the giant warning sign that I missed earlier, and the implications are clear. RAD has about a billion shares outstanding. After the 1:10 "reverse split," that turns into 100 million shares of newco stock. Using a nominal 29% of newco for that 100 million shares, one concludes that the total number of outstanding shares in newco will be 100 million divided by 0.29 equals about 345 million.

Albertsons previous failed IPO attempted to raise around $1.5 billion to $1.7 billion, more or less. The number of shares and the IPO price are not relevant. What is important is the proposed market cap amount. if the previous attempt didn't work at that level, it is unclear why anyone would value the Albertsons portion of newco much higher than that. True, there will be some synergies from higher total purchase volumes and thus reduced costs of goods sold in the pharmacies, but that shouldn't affect the grocery business; moreover, the synergies will be offset by integration costs.

The RAD portion of the company already has a valuation on its market cap: the current stock price, approximately $1.60, times the number or shares outstanding (about one billion) equals $1.6 billion.

In my view, that is preposterously low, given that RAD retains 2,668 stores at a putative value -- from the recent Walgreens Boots Alliance (WBA) purchase -- of about $2 million per store, equals about $5.3 billion, minus $3 billion in remaining debt equals $2.3 billion liquidation value, at least. Given a billion outstanding shares, that translates to $2.30 per share. Yet the stock is trading at substantially below that price. Why?

Here's one possibility. The newco will consist of two components with a likely combined market cap of around: $1.7 billion (Albertsons) plus $1.6 billion (Rite Aid) equals $3.3 billion. Divide $3.3 billion by the number of shares in newco, 345 million, and we get $9.60. This implies to me -- and please show me the error if I'm going down a false trail -- that newco stock will come out at around $10, in the best case. Combined with the $1.83 cash, that means for every ten RAD shares a RAD stockholder will end up with a value of $11.83, or $1.18 per old share. It could indeed be lower.

In fairness, if Albertsons believes they can convince the public to buy newco stock with a market cap higher than $3.3 billion -- valuing RAD higher than its current market cap -- the newco stock could open higher, although I see no motivation for Albertsons/Cerberus to do that. Indeed some might expect Cerberus and its allies to gobble up all the newco stock at an artificially low issue price. Ironically, newco/Cerberus might possibly use some of the cash generated by RAD from the store sales to WBA to fund the buyout of the existing RAD shareholders, essentially getting the company nearly for free, with only some debt service to deal with.

That could be the ultimate leveraged buyout: use the target company's own money to buy out its shareholders. In retrospect, the windfall of $4 billion from the sales of RAD stores to WBA would not have gone unnoticed on Wall Street. If RAD hasn't started paying down its debt, there's almost enough money not only to buy out the RAD shareholders with freshly printed newco shares and a little cash, but also to make a tender offer for those shares and take newco private again, although it seems more financially advantageous for newco to remain public. Somewhere down the road we may find that the inexplicable withdrawal of the RAD "poison pill" played an important role in this transaction.

How much is RAD actually worth? Yahoo! Finance thinks the enterprise value is about $4.8 billion. RAD's current stock price is far below the ratio of market cap to enterprise value of comps like WBA and others. Let's run some additional numbers.

WBA 2016 net income was $4.17 billion. At that time they had a total of 8,175 stores. The net profit per store was $4.17 billion divided by 8,175 stores equals about half a million dollars net profit per store. Paying about $2 million per store they bought from RAD (1,932 stores for around $4 billion) was a real bargain, even if they had to close many of those stores, because the cost is fully amortized over half a dozen years or so.

If RAD were properly run, it should generate about that same profit per store. With 2,668 remaining stores, using the WBA piggyback drug purchase agreement, and taking out about $300 million annually for the remaining debt interest payment, RAD could in theory generate about a billion dollars per year of net profit, or about $1 EPS. Since a P/E ratio of 9 is very reasonable for a solid company, the RAD stock price should be at least $9.00, probably higher, in this scenario.

The financial waters of RAD have been muddied for years due to one-time credits and charges, distribution center costs and benefits, the EnvisionRx acquisition and the expensive capex for store refurbishment. Those are distractions from the financial crux: per-store profits. Admittedly, the RAD per-store profits are not at a competitive level now, but since competitors can do it, RAD could also, or else could sell out at a fair price to someone who knew how.

So let's ask again, why is the RAD stock price so low? It is difficult to find a rational explanation, except the possibility that someone saw this merger coming, or perhaps even precipitated it through a massive bear raid. However, conspiracy theories without evidence are sophistry.

From Yahoo! Finance statistics we see that institutions hold nearly half of RAD stock. Let's assume they're long-term holders, or at most options hedgers, not short sellers, and that while their shares are regarded as part of the "float," they don't really trade actively. That leaves half the float, or about 500 million shares, bouncing around the market. There are about 180 million shares sold short recently, which appears to have tanked the stock price, and there are more shares short this month than last month, so any new buyers are being offset by an increase in short sellers, keeping the price down.

Who are these short sellers? One possible answer: someone who wants to buy up the company on the cheap using the profits from betting on the earlier stock price decline. If we put together the short sellers and a potential gradual exodus of discouraged retail investors over the past few months, it spells "bear raid," in my view. RAD has lost around $5 billion in market cap since the second failed WBA merger offer, for no good reason.

Although there could be litigation to stop what some would call an egregious travesty, the Albertsons merger is likely to succeed. As some might put it, the big players must have thought their Machiavellian scheme through carefully. This is not the only instance of such goings on in recent times. Take a look at the stock prices and executive actions of Dry Ships (DRYS) and Nordic American Tankers (NAT) over the past year. The DRYS pre-splits-adjusted price of over 700 is now down to less than 4. The retail investor is at a great disadvantage when caught in the maelstrom of corporate intrigues.

This is only the tip of the iceberg. I haven't delved into the evident conflicts of interest in having the RAD CEO become a lead officer of the combined firm. I haven't explored the possibility that certain large RAD shareholders might have been aware of this impending deal long ago and sold short through third parties or used options (long puts or deep in the money covered call LEAPS) to protect their gains while seeming to hold and maintain confidence -- which might help explain the mystery of why RAD's stock price has fallen so far, when the company seems finally poised for a turnaround.

I have to wonder about an arms-length relationship between the two firms, when a former RAD senior officer is now working as an executive at Albertsons. One could also ask whether the large RAD stockholders have any other deals with Cerberus, a major sponsor of Albertsons, that might allow them to offset possible losses in RAD if they vote "yes" on this Venus flytrap merger.

In all this I accuse no one of wrongdoing. "They" can afford very smart lawyers in deals of this size to help ensure that nobody who tries to leave the Underworld of stock loss can get past Cerberus. It's nothing personal: strictly business.

Is there hope for existing RAD shareholders? Only if major RAD institutional holders have the integrity to vote "no" on the merger. Stranger things have happened, but I am not optimistic. Cerberus is a huge hedge fund with far-reaching influence in many sectors. It is unlikely that even an impartial institutional investor would want to irritate Cerberus by voting against the merger, particularly since the head of Cerberus, Mr. Stephen Feinberg, has the ear of the current White House administration. It may be better just to move on.

The head of Cerberus is known for turnaround plays. According to Eurekaencyclopedia, he "... excelled by gaining control of companies in bankruptcy and nursing them back to financial health." From Cerberus' website we learn, "... we have excelled at distressed investing since our inception and have built a highly regarded reputation for our focus on deep value." Cerberus has $30 billion under management, and could perhaps turn newco around and make investors rich; but I only see that applying to new shareholders, not the old ones from RAD.

Therefore, I have sold all my RAD holdings at a huge loss, because at this point the stock price could go lower, and I can't take the risk. Indeed, if the upcoming earnings report turns out to be unfavorable, with RAD delaying the paydown of debt, such ostensible bad news could drive the price down more and help further justify a merger that some might allege is little more than legalized theft. Even if the RAD stock price increases after the earnings report due to a surprise "beat," I would expect it to fall again once the merger terms are announced -- if my assumptions hold.

On the bright side (for others), if the merger terms and newco IPO price do turn out to be far better than I have inferred, that is a potential upside that should not be overlooked. However, a small increment won't make long-term shareholders whole from RAD's stock slide from around 9 to 1.60. Even if Cerberus were downright generous and tried to bring out newco with a market cap of $5 billion -- which I doubt the market would take seriously -- RAD shareholders would only get the equivalent of a few cents above the current stock price. $5 billion divided by 345 million shares of newco equals about $14.50. The 1:10 reverse split yields $1.45 plus $1.18 cash equals $1.63.

In order to give "fair value" to RAD shareholders, let's say a price equivalent of at least $2.50 per share, the market cap of newco would have to be over $8 billion (see above calculation method). To give RAD shareholders a price of around $7 per share, similar to the second WBA offer, the newco market cap must be over $20 billion. That's a real stretch. Surprisingly enough, or maybe not, that figure is nearly identical to the market cap of Kroger (KR), a profitable company that in my view would be a better match for a RAD merger than Albertsons is.

It may well be that I am wrong and that those who continue to hold are right and will prosper. I hope so. I was wrong on upside arbitrage on the first WBA merger offer, similarly wrong on the second WBA offer, and wrong to believe the RAD stock price would increase after the sale of stores to WBA, which I expected to drive EPS higher as a result of deleveraging and reducing interest expenses. Although I remain convinced that RAD is undervalued, the market does not agree. Do your own due diligence before making any investment decisions. Don't rely on the advice of others -- which was how many of us got into RAD in the first place -- without performing an in-depth review of financials, prospects, and very important: management.

It was a good run while it lasted. No, actually it was a terrible run, at least for me. Adieu Rite Aid.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.