When CEO was a good guy.
source: pennlive.com
After strong opposition from shareholders and advisory firms, the management announced that Rite Aid’s (RAD) merger with Albertsons has been officially terminated.
From the very beginning the proposed merger looked like a way for Cerberus to gain liquidity for its stake in Albertsons after multiple failed attempts to IPO. Rite Aid shareholders were going to be diluted to ~29% of the combined entity, effectively forcing them to accept a permanent loss on the stock as it would have been difficult for a $24 billion (enterprise value) grocer to grow meaningfully.
Although the merger would have capped Rite Aid’s upside, it also had the benefit of providing a floor on the stock. With the deal now pulled, Rite Aid shareholders could once again hope to recapture some of the losses suffered over the past two years (-75%); however, any interim support for the stock is also gone as evidenced by its 10% decline after the cancellation of the merger.
So what’s in store for Rite Aid shareholders now?
Continued Deterioration In The Short-term
The company recently updated its FY 2019 outlook and all financial metrics were adjusted downward.
Old Guidance | New Guidance | |
Adj. EBITDA | $615-$675 million | $540-$590 million |
Net Loss | $40-$95 million | $125-$170 million |
Adjusted EPS | $0.02-$0.06 | $(0.04)-$(0.00) |
Source: data from company press release
Recall that the old guidance was reiterated little over a month ago when the company reported first quarter earnings. The fact that we are seeing such a strong deterioration in expectations over the course of one month casts serious doubt on the management’s ability to steer the business in the right direction.
While the company blamed industry conditions for the lowered guidance, its peer Walgreens (WBA) had actually increased its annual guidance. If there were negative developments that were expected to impact the whole industry, I don’t think Walgreens would have been so confident, especially when the company has consistently beaten earnings in the past.
I think a better explanation for the shortfall would be management distraction due to the merger. This is not unique to Rite Aid, as any merger consumes significant management time as they slog through the legal process. The merger was probably even more tiresome for Rite Aid’s management due to shareholder backlash.
As the management had hoped for a successful merger, they were unlikely to have developed a meaningful contingency plan to prop up the business should it fail, which would explain the expected financial underperformance.
Enough Time For Management Shakeup
Along with the cancellation of the merger, the company announced that the board is “evaluating governance changes at the company.”
I think by now it’s clear that many shareholders are not happy with the current management, so new leadership should provide a temporary boost in optimism that could send the stock higher.
Normally I would be skeptical of management changes of a distressed company, as it would often be a race against the clock (i.e. looming debt maturities), giving new management little time to execute a turnaround, even if one eventually happens. I’ve personally experienced this with Dex Media. However, even though the company’s debt is trading as low as 76 cents on the dollar (chart below), the maturity profile gives the management plenty of time to execute a turnaround.
Source: FINRA
The closest maturity is the $190 million note due in January 2020. With $447 million of cash on the balance sheet as of Q1 and another $220 million to be received from Walgreens after September, I don’t think repayment is an issue. The management gets a year and half after that before another $805 million is due in June 2021. If we give the company couple of months prior to the due date of the 2021 bond, the management has roughly two and half years to inspire investor confidence to ensure a successful refinancing. I think that is more than enough time.
Conclusion
Rite Aid investors opened themselves to more upside at the expense of downside protection. I don’t believe that there will be any near-term improvement as evidenced by the meaningfully lowered guidance for fiscal 2019. However, the company did hint that they may be open to a new management team, which could provide a temporary boost for the stock. Furthermore, despite pessimistic trading of the company’s bonds, a capable new management should have sufficient time to execute a turnaround plan.
Overall, I don’t think the stock is a worthy long right now as management’s execution has been horrendous; however, if there are strategic changes or new management, Rite Aid could become more interesting.
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